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, 2002.

[ ] 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
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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. [X]

The aggregate market value of the voting stock held by non-affiliates of
the Registrant as of June 12, 2002 was $16,647,314.90.

As of June 12, 2002, there were outstanding 1,648,249 shares of common
stock, $.10 par value. As of June 12, 2002, there were outstanding 1,648,249
common stock purchase rights.

DOCUMENTS INCORPORATED BY REFERENCE

(1) Notice of Meeting and Proxy Statement for the 2002 Annual Meeting of
Stockholders is incorporated by reference into Part III of this filing.

An Exhibit Index is located at page 36 of this filing under the sequential
numbering system prescribed by Rule 0-3(b) of the Act.

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PART I

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, 2002 ("FY 2001-2002") 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.

FY 2001-2002 U.S. sales were $41.1 million, an increase of 1% from the
previous fiscal year.

New orders in FY 2001-2002 were $52.1 million, up 22% from the previous
fiscal year. Year end backlog stood at $36.5 million, compared to $25.5 million
on March 31, 2001 and $23.7 million on March 31, 2000.

The Company recognized in the Fourth Quarter significant termination
charges in consequence of the cancellation of certain large condenser contracts.
The perceived need for additional power generating capacity in the United States
offers a potential for significant sales to this market for the next decade.

Activity in the power generating market, which previously showed promise
for significant growth, was depressed by the September 11 attack and the
collapse of Enron. The Company will continue to pursue this market, although at
a reduced pace for the time being. The Company sees significant activity in the
cogeneration market, where Graham is a major supplier of condensers.

The Company sees the chemical market as entering a recovery. Petrochemical
demand is expected to grow 4.5% per year by 2010, requiring additional capacity.
Several contracts for new world-scale ethylene plants have been awarded to
engineering and construction companies, something not seen in the last two to
three years.

Graham was successful in obtaining several large crude oil vacuum
distillation orders for domestic and foreign destinations. The Company is in the
forefront of this technology, backed by many years of experience with our
continuous research and development effort. The refinery market is expected to
remain active, with the implementation of the Clean Air Act requiring low sulfur
fuels. Small turbine exhaust condensers and ejectors often are required for
these upgrades, with larger vacuum systems replaced when the vacuum tower is
optimized. The Company has furnished equipment for upgrades of oil sands
production facilities in Canada and Latin America. Further such expansions in
the near term should be likely as long as oil prices remain at favorable levels.
Current oil price levels also favor offshore exploration and production,
presenting opportunities for Graham's UK subsidiary in the supply of specialized
vacuum equipment.

For smaller products such as liquid ring vacuum pumps, small standard
ejectors, Heliflows(R), and plate heat exchangers, which are susceptible to
domestic economic conditions, the downturn in market conditions was noticeable
during the past Fiscal Year. The economy is showing signs of recovery and the
Company is executing strategies to increase its market share.

The Company's U.S. export sales represented 24.3% of U.S. sales in FY
2001-2002, compared to 31.9% of U.S. sales in the previous year. Export sales
reflected a prolonged recession in Asia and Latin America. However, the Asian
and Latin American markets for the Company's products have demonstrated early
signs of recovery. Now that oil prices appear to have stabilized and significant
mergers in the oil industry have been completed, the consensus in the industry
is that opportunities in the refinery markets are expected to increase.

1

The Company had 288 employees in the United States as of March 31, 2002.

UNITED KINGDOM OPERATIONS

During FY 2001-2002, the Company's U.K. operations were undertaken 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 FY 2001-2002 stood at $7,432,000, an increase of 38% compared
with the previous year, reflecting at least in part GPPL's success in the
introduction of its line of dry vacuum pumps.

GPPL achieved substantial growth in sales and profitability against the
background of a depressed European economy. Notable successes were achieved in
winning and executing substantial orders in the petrochemical, offshore and gas
industries. During FY 2002, GPPL completed fabrication of its largest single
vacuum pump order to-date for a major South African company for the production
of cosmetics. Future business could materialize as a result of this order. UK
operations have been successful in penetrating the German market and will
continue expanding to other countries in the European Union during FY 2003.

GPPL employed 60 people on March 31, 2002.

CAPITAL EXPENDITURES

The Company's capital expenditures for FY 2001-2002 amounted to $688,000.
Of this amount, $607,000 was for the U.S. business and $81,000 was for the U.K.
business.

(b) FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS

(1) Industry 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 segment
information is set forth in Note 13 to the Consolidated Financial Statements on
pages 31-33 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
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. They accomplish this without involving
any moving parts and 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 and titanium plants;
liquified 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

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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

The Company experienced no serious material shortages in FY 2001-2002.

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.

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, 2002 was $37,322,000 compared to
$28,458,000 at March 31, 2001 and $27,302,000 at March 31, 2000.

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, 2002, 2001, and 2000 the Company
spent approximately $248,000, $250,000, and $255,000, 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.

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(d) FINANCIAL INFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS AND EXPORT SALES

The information called for under this Item is set forth in Note 13 to
Consolidated Financial Statements, on pages 31-33 of this Annual Report on Form
10-K.

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 $36,294,000 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 $611,000.

ITEM 3. LEGAL PROCEEDINGS

Not applicable.

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

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

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PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS

(a) The information called for under this Item is set forth under Item 8,
"Financial Statements and Supplementary Data," in the Statement of Quarterly
Financial Data appearing on page 33 of this Annual Report on Form 10-K.

(b) On June 12, 2002, there were approximately 400 holders of the Company's
common stock. This figure includes stockholders of record and individual
participants in security position listings who have not objected to the
disclosure of their names; it does not, however, include individual participants
in security position listings who have objected to disclosure of their names. On
June 12, 2002, the closing price of the Company's common stock on the American
Stock Exchange was $10.10 per share.

(c) The Company has not paid a dividend since January 4, 1993, when it paid
a dividend of $.07 per share. The Company will evaluate on an ongoing basis
whether to pay a dividend in the foreseeable future. Restrictions on dividends
are described in Note 5 to the Consolidated Financial Statements included in
this Report.

(d) Equity Compensation Plan Information

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ITEM 6. SELECTED FINANCIAL DATA

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(1) The financial data presented for 2002 - 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 1996-1992 is for the respective twelve months ended December
31.

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

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

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, Ltd.).

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.

ANALYSIS OF CONSOLIDATED OPERATIONS

RESULTS OF OPERATIONS

For an understanding of the significant factors that influenced our
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.

2002 COMPARED TO 2001

Consolidated sales (net of intercompany sales) were $47,396,000 for the
year ended March 31, 2002 as compared to sales of $44,433,000 for the prior
twelve months. Sales from the USA operation increased about 1%. Surface
condenser sales increased about 68% or about $7,000,000 in fiscal year end
("FYE") 2002 due to opportunities in the electric power industry. The "power
industry" includes sales to merchants, cogeneration and independent production
facilities. Increased sales in condensers were largely offset by reduced
shipments in other product lines. Export shipments, as a percent of total sales,
were the lowest they have been since 1990. The broad decline in demand for
Graham's USA products is believed to be temporary. Principal reasons for fewer
projects under construction by contractors in the three major segments the
Company serves (refinery, chemical and petrochemical) are: (1) limited capital
spending due to poor global economic conditions, (2) the strong US dollar, (3)
merger and acquisition activity, (4) revamping of financial infrastructure needs
in Asia, and (5) caution resulting from the war on terrorism.

Sales from UK operations increased about 38% over FYE March 2001, or about
$2,000,000. Significant sales increases were achieved in the categories of
liquid ring pump packages, offshore pumps, dry pumps and spares. The increased
sales in pump packages resulted from the shipment of one large order valued at
about $1,400,000 to South Africa for the petrochemical industry. Going forward,
targeting larger orders will be a strategic objective. In FYE 2001 Graham
purchased Leybold's dry pump line. Increased dry pump sales in the current year
is due to further establishing the product line under Graham's offerings. This
product is predicted to show continued sales growth going forward. Spare part
sales increased as a result of the market demand for offshore activity and to
the success of the dry pump line.

8

The consolidated gross profit margin was 21%, down from 22% last year and
down from a recent historical range of about 25-28%. The UK operations posted a
38% gross profit, up from 31% for the prior year, due to improved product mix.
In the current year the UK operations significantly increased their sales in
offshore pumps and spares. These pumps require high quality standards and
special fabrication techniques. Accordingly, they bear a higher profit margin.
In the USA the gross profit percent was 18%, down from 20% in FYE March 2001.
The lower gross profit margin was attributed to depressed selling prices
together with greater employment costs in the areas of incentive compensation
and medical and workers compensation insurances.

Selling, general and administrative expense for the current year was about
22% of sales as compared to about 21% for the prior year. USA costs approximated
FYE 2001 costs. The 1% increase occurred in the UK and related to greater costs
for additional sales personnel and more sales commissions and royalty payments
on higher sales.

Interest expense for the current year decreased 54% from FYE 2001. Bank
debt was about 5% of equity, or $1,050,000, at March 31, 2002 as compared to 27%
of equity, or $4,709,000 as of March 31, 2001.

The provision for income taxes for the current year of $1,172,000
approximated statutory rates at 34% as compared to a net tax benefit of $221,000
for the FYE 2001.

Consolidated net income for the year was $2,305,000 or $1.38 per diluted
share. In the fourth quarter of FYE March 2002 some orders for the power
generating industry were cancelled. Net of related expenses and income taxes,
cancellation income of about $2,633,000 was recorded. (See Note 11.) Net income
for FYE 2001 was $195,000 or $0.12 per diluted share.

2001 COMPARED TO 2000

For FYE 2001 Graham Corporation's consolidated sales (after elimination of
intercompany sales) were $44,433,000, producing a net income of $195,000, or
$0.12 per diluted share. This compares to FYE 2000 with sales of $38,728,000
resulting in a net loss of $833,000 or $0.55 per diluted share.

Consolidated sales were up 15% in FYE 2001 over FYE 2000. USA operations
increased sales by $5,887,000 or 17%. About $3,400,000 of this increase came
from the increase in sales into Canada. This new business is due to
mega-projects in the synthetic fuel markets. Other export gains over FYE 2000
were made in Asia where orders to oil refinery and petrochemical plants were won
and in the Middle East where two large orders, one for an oil refinery upgrade
and the other an ethylene petrochemical facility, were awarded to Graham. These
increases in sales resulted from the timing of when these refining and
petrochemical facilities were to be built.

The consolidated gross profit margin was 22% for FYE 2001 as compared to
26% for FYE 2000. This is a lower gross profit margin than usual and was a
result of several factors including depressed selling prices, rising material
costs and overall product mix bearing lower contribution margins than the
Company's traditional core product margins. Major equipment sales (contracts in
excess of $75,000) increased 25% over the year 2000. These orders usually carry
a lower contribution percentage and a higher ratio of material costs to sales
dollars than non-major equipment sales; material content as a percentage of
selling price was thus 10% greater than material costs for the prior year.
Selling prices were depressed during 2001 because the sales opportunities
available to sell vacuum and heat transfer equipment were less. Merger and
acquisition activity, along with poor economic conditions, depressed capital
spending by the process industries. On average, selling prices were depressed by
6%.

Consolidated selling, general and administrative expenses increased about
6% over FYE 2000. In the USA Graham's costs rose 4% as a result of greater sales
commissions due to increased sales and the launching of a comprehensive
advertising agenda. In the UK SG&A costs rose 21%. This increase resulted from
gearing up for the future manufacturing and selling of Graham's Leybold dry pump
acquisition (e.g., staff, sales office in Germany). Overall, consolidated SG&A
expenses were 21% of sales compared to FYE 2000 when SG&A costs equaled 23% of
sales.

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Interest expense was up due to prime rate increases and borrowings to
support higher inventories and sales activities.

The income tax provision for FYE 2001 resulted in a net tax benefit of
$221,000 due to resolving certain federal and state income tax matters. The net
tax benefit for FYE 2000 of $280,000 resulted from the termination of the UK
defined pension plan.

SHAREHOLDERS' EQUITY

2002 COMPARED TO 2001

Shareholders' Equity increased $2,499,000 or nearly 15% for the current
year as compared to about 0% for FYE 2001. Ninety-two percent of the increase
was due to current earnings. Net book value increased to $11.91 per share at
March 31, 2002 from $10.52 as of March 31, 2001 for a 13% increase in book value
per share. The trading price of Graham's common stock followed with a 23%
increase in share price at March 31, 2002 from March 31, 2001 ($11.00 and $8.95,
respectively).

2001 COMPARED TO 2000

Due to a minimal net income, shareholders' equity increased only slightly
in FYE 2001. Book value per share decreased about 7% as a result of the sale at
fair market value of 117,800 treasury shares in FYE 2001. This sale will result
in long-term stock ownership by officers and board members of the Corporation.

LIQUIDITY AND CAPITAL RESOURCES

2002 COMPARED TO 2001

Consolidated cash flow from operations was $4,464,000 for the current year
as compared to negative cash flow of $822,000 for FYE 2001. The increase was due
to net income of $2,305,000 and other changes in working capital items of
$2,650,000. At March 31, 2002 trade account receivables were $17,053,000, up
$9,099,000 from March 31, 2001. This increase significantly related to amounts
due on cancelled and suspended electric power generating business. In April and
May 2002 the majority of the outstanding balance was collected.

Capital expenditures for the year ending March 31, 2003 are budgeted to be
$975,000 (USA, $749,000; UK, $226,000). This amount approximates estimated
depreciation expense for the upcoming year.

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The Company plans to fund cash needs through earnings, cash investments,
and, if needed, lines of credit. At March 31, 2002 the USA unused bank line of
credit was $12,557,000. The UK operation had an unused line available of
$149,000.

2001 COMPARED TO 2000

Consolidated cash flow from operations was negative $822,000 in FYE 2001
compared to negative cash flow of $1,620,000 for the prior year. The FYE 2001
shortfall was due to an increase in inventory of 41% or $2,743,000. This buildup
was due to scheduled first half FYE 2002 shipments, billings (minus related cost
of goods sold) on seven percent-of-completion jobs (net of progress payments),
the newly acquired dry pump product line, rising raw material costs, and buying
ahead to protect from raw material price escalations on fixed price contracts
having extended shipment dates.

ORDERS AND BACKLOG

Graham's consolidated backlog at March 31, 2002 is $37,322,000. This amount
represents an increase of about 31% or $8,864,000 greater than at March 31,
2001. Included in the backlog is $8,791,000 of orders for electric power plant
business that has been put on hold by the customer. Possible release to commence
construction could be received in FYE 2003, although notices have not been
received to-date. All suspended orders are protected with cancellation charges.
The backlog, except for suspended electric power plant orders, is expected to be
converted into sales in FYE March 31, 2003.

Orders increased 17% over FYE 2001. Major active industries were power
fossil and petroleum refining. Going forward Graham expects the power fossil
market to continue for an extended period of time, but at a slower pace than
orders were received in the past year. The Company believes activity will
continue to provide excellent opportunities for new business in the coming year
and beyond in the petroleum refinery industry. This work will be largely related
to upgrades required to meet clean air emission standards as well as upgrading
facilities for processing lower cost crude oils. Additionally, early signs of a
pick up in petrochemical expansions and enhancements, and in particular China,
are beginning to surface. In all markets served, pricing will continue to be
competitive in FYE 2003.

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

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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 2002 and 2001 variable rate debt, a 1% change in interest
rates would impact annual interest expense by $10,500 and $47,000, respectively.

Graham's international consolidated sales exposure for the current year
approximated 33% of annual sales as compared to 37% for the year 2001. 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 to U.S. dollars. The substantial portion of Graham's sales is collected
in the local currencies. In 2002 and 2001, sales in foreign currencies were 1.5%
and 1.1%, 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 2002 and
2001, purchases in foreign currencies were 5% 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 income of $505,000 as
compared to $41,000 for FYE 2001. As currency exchange rates change,
translations of the income statements of the UK business into US dollars affects
year-over-year comparability of operating results. We do 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
income by approximately $50,500 for FYE 2002 and $4,100 for the previous year.

The Company has a Long-Term Incentive Plan which provides for awards of
share equivalent units (SEU) for outside directors based upon the Company's
performance. The outstanding SEU's 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 quarterly results of operations. Based
upon the SEU's outstanding at March 31, 2002 and 2001 and a $11 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
$84,000 to $125,900 for FYE 2002 and $48,000 to $72,000 in FYE 2001. Assuming
required net income is met, and based upon a market price of the Company's stock
of $11 per share, a 50-75% change in the stock price would positively or
negatively impact the Company's operating results by $109,000 to $163,400 in
2003, $114,000 to $170,900 in 2004, and $119,000 to $178,400 in 2005 and
thereafter.

OTHER MATTERS

Increases in material and labor costs traditionally have been offset by
cost cutting measures and selling price increases. Obtaining price increases are
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.

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CRITICAL ACCOUNTING POLICIES

The significant accounting policies are disclosed in Note 1 to the
consolidated financial statements. The following discussion addresses the most
critical accounting policies, which are those that are most important to the
portrayal of the financial condition and results, and that require judgment.

REVENUE RECOGNITION

PERCENTAGE-OF-COMPLETION

The Company recognizes revenue and all related costs on contracts with a
duration in excess of three months and with revenues of $1,000,000 and greater
using the percentage-of-completion method. 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

Contracts with values less than $1,000,000 are accounted for on 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.

USE OF ESTIMATES

We have made a number of estimates and assumptions relating to the
reporting of assets and liabilities, the disclosure of contingent assets and
liabilities, and reported amounts of revenue and expenses in preparing our
financial statements in conformity with accounting principles generally accepted
in the United States of America. Actual results could differ from these
estimates.

NEW ACCOUNTING PRONOUNCEMENTS

In FYE March 2002, the Company adopted Statement of Financial Accounting
Standards ("SFAS") No. 133 ("Accounting for Derivative Instruments and Hedging
Activities") as amended by SFAS Nos. 137 and 138. These statements establish
accounting and reporting standards for derivative instruments. The Company did
not enter into any derivative transactions in the current fiscal year.

For affect in the 2003 fiscal year, the Financial Accounting Standards
Board issued SFAS Nos. 141, "Business Combinations," and 142, "Goodwill and
Other Intangible Assets" in June 2001. Neither of these pronouncements will have
an impact on Graham's financial statements for the year ended March 2003.

In August 2001, the FASB issued SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets." SFAS No. 144 addresses financial
accounting and reporting for the impairment or disposal of long-lived assets to
be held and used, to be disposed of other than by sale and to be disposed of by
sale. Although the Statement retains certain of the provisions of SFAS No. 121,
"Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to
Be Disposed Of," it supercedes SFAS No. 121. The Statement is effective for
financial statements issued for fiscal years beginning after December 15, 2001,
and therefore, will be adopted by the Company, as required, on April 1, 2002.
The adoption of SFAS No. 144 is not expected to have a material impact on the
Company's consolidated financial position, results of operations or cash flows.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Included in Item 7, Management's Discussion and Analysis -- Market Risk.

13

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

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

CONSOLIDATED STATEMENTS OF OPERATIONS

See Notes to Consolidated Financial Statements.

14

CONSOLIDATED BALANCE SHEETS

See Notes to Consolidated Financial Statements.
15

CONSOLIDATED STATEMENTS OF CASH FLOWS

See Notes of Consolidated Financial Statements.

16

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY

See Notes to Consolidated Financial Statements.
17

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 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 Company recognizes revenue and all related costs on contracts with a
duration in excess of three months and with revenues of $1,000,000 and greater
using the percentage-of-completion method. 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 revenue of less than $1,000,000 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.

Shipping and Handling Fees and Costs

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

18

Investments

Investments consist primarily of fixed-income debt securities with
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. 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. Impairment losses are recognized when the carrying value of an asset
exceeds its fair value. The Company regularly assesses all of its long-lived
assets for impairment and recognized an impairment loss of $17,000 in 2000. No
such impairment losses were required in 2002 or 2001.

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 using the intrinsic value
method prescribed in Accounting Principles Board Opinion No. 25, "Accounting for
Stock Issued to Employees," (APB 25) and related Interpretations. 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.

Per Share Data

Basic earnings (loss) per share is computed by dividing net income (loss)
by the weighted average number of common shares outstanding for the period.
Common shares outstanding includes share equivalent units which are contingently
issuable shares. Diluted earnings (loss) per share is calculated by dividing net
income (loss) by the weighted average number of common and, when applicable,
potential common shares outstanding during the

19

period. A reconciliation of the numerators and denominators of basic and diluted
earnings per share is presented below.

Options to purchase shares of common stock which totaled 131,600, 116,500
and 187,250 in 2002, 2001 and 2000, respectively, were not included in the
computation of diluted earnings (loss) per share as the effect would be
anti-dilutive.

Cash Flow Statement

The Company considers all highly liquid investments with a maturity of
three months or less when purchased to be cash equivalents.

Actual interest paid was $161,000 in 2002, $319,000 in 2001, and $230,000
in 2000. In addition, actual income taxes paid (refunded) were $(521,000) in
2002, $(376,000) in 2001, and $331,000 in 2000.

Non cash activities during 2002, 2001, and 2000 included capital
expenditures totaling $112,000, $93,000 and $3,000, respectively, which were
financed through the issuance of capital leases. In 2000, the minimum pension
liability adjustment, net of a tax benefit, totaling $1,191,000 that was
originally recognized in 1999 was subsequently reversed.

Accumulated Other Comprehensive Loss

Comprehensive income is comprised of net income (loss) 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
foreign currency translation adjustments and minimum pension liability
adjustments.

Accounting and Reporting Changes

On April 1, 2001, the Company adopted Statement of Financial Accounting
Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging
Activities" and SFAS No. 138, which amended certain provisions of SFAS No. 133.
There was no effect on the Company's consolidated financial position, results of
operations or cash flows resulting from the adoption of SFAS No. 133, as
amended, during fiscal year 2002.

In August 2001, the FASB issued SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets." SFAS No. 144 addresses financial
accounting and reporting for the impairment or disposal of long-lived assets to
be held and used, to be disposed of other than by sale and to be disposed of by
sale. Although the Statement retains certain of the provisions of SFAS No. 121,
"Accounting for the Impairment of Long-Lived
20

Assets and for Long-Lived Assets to Be Disposed Of," it supercedes SFAS No. 121.
The Statement is effective for financial statements issued for fiscal years
beginning after December 15, 2001, and therefore, will be adopted by the
Company, as required, on April 1, 2002. The adoption of SFAS No. 144 is not
expected to have a material impact on the Company's consolidated financial
position, results of operations or cash flows.

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:

NOTE 4 -- LEASES:

The Company leases equipment and office space under various operating
leases. Rent expense applicable to operating leases was $123,000, $150,000, and
$141,000 in 2002, 2001, and 2000, respectively. Rent expense in 2000 is net of
sublease income of $11,000.

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

Amortization of property, plant and equipment under capital lease amounted
to $149,000, $133,000, and $192,000 in 2002, 2001, and 2000, respectively, and
is included in depreciation expense.

21

As of March 31, 2002, future minimum payments required under non-cancelable
leases are:

NOTE 5 -- DEBT:

Short-Term Debt Due Banks

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

The Company may borrow under domestic repurchase agreements from its
investment banker. The interest rate is based upon the federal funds rate and
the type of collateral securing the loan. At March 31, 2001, the interest rate
was 5.35%. The borrowings were secured by the Company's short-term investments
totaling $4,905,000.

The United Kingdom subsidiary has a revolving credit facility agreement
which provides a line of credit of 920,000 pounds sterling ($1,316,000 at the
March 31, 2002 exchange rate) including letters of credit. The interest rate is
the bank's rate plus 1 1/2%. The bank's base rate was 4% and 5.75% at March 31,
2002 and 2001, respectively. The United Kingdom operations had available unused
lines of credit of $149,000 at March 31, 2002. The United Kingdom short-term
bank borrowings are secured by assets of the United Kingdom subsidiary which
have a book value of $611,000 at March 31, 2002. The United States operation
does not provide a corporate guarantee or any security for the United Kingdom
revolving credit facility. The weighted average interest rate on short-term
borrowings in 2002 and 2001 was 4.4% and 6.5%, respectively.

Long-Term Debt

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

The United States revolving credit facility agreement provides a line of
credit of up to $13,000,000 including letters of credit, through October 31,
2002. The agreement allows the Company to borrow at prime minus a

22

variable percentage based upon certain financial ratios. The Company was able to
borrow at a rate of prime minus 125 basis points at March 31, 2002 and prime
minus 100 basis points at March 31, 2001.

The agreement allows the Company at any time to convert balances
outstanding not less than $2,000,000 and up to $9,000,000 into a two-year term
loan. Under this conversion feature which is available through October 2002, the
Company may convert the principal outstanding on the revolving line of credit to
a two-year term loan. The bank's prime rate was 4.75% and 8% at March 31, 2002
and 2001, respectively. The United States operations had available unused lines
of credit of $12,557,000 at March 31, 2002.

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 1/4% 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 additional long-term debt. In addition, the United States
operations cannot make any loans or advances exceeding $500,000 to any
affiliates without prior consent of the bank.

NOTE 6 -- 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, 2002 and 2001, 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, 2002 and 2001, the Company was contingently
liable on outstanding standby letters of credit aggregating $558,000 and
$828,000, 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 counterparties 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, 2002 and 2001, there were no foreign exchange forward
contracts held by the Company.

Fair Value of Financial Instruments:

The methods and assumptions used to estimate the fair value of financial
instruments are summarized as follows:

INVESTMENTS -- The fair value of investments at March 31, 2002 and
2001 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.

23

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

NOTE 7 -- INCOME TAXES:

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

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

24

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 which may be carried forward indefinitely and investment tax
credits which expire from 2007 to 2017. A valuation allowance of $292,000 at
March 31, 2002 is deemed adequate to reserve for the foreign net loss
carryforwards which are not considered probable of 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, 2002, such undistributed earnings totaled $1,317,000.
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 8 -- EMPLOYEE BENEFIT PLANS:

Retirement Plans

The Company has a qualified defined benefit plan covering employees in the
United States 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 for 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.

25

The components of pension cost are:

Changes in the Company's benefit obligation, plan assets and funded status
for the pension plan are presented below:

The current portion of the pension liability as of March 31, 2002 and 2001
is included in the caption "Accrued Compensation" and the long-term portion is
separately presented in the Consolidated Balance Sheets.

In October 1999, the Company terminated the defined benefit pension plan in
the United Kingdom. This plan was contributory with the employer's share being
actuarially determined. Benefits were based on the employee's years of service
and average earnings for the three highest years for the ten year period
preceding retirement. As a result of the plan termination, a curtailment loss of
$1,682,000 was recognized. This charge is included in the caption "Other
(Income) Expense" in the 2000 Consolidated Statement of Operations. Employees
may participate in a defined contribution plan which has replaced the defined
benefit plan.

Pension expense for the U.K. Plan was $209,000 in 2000.

26

Assets of the United States plan consist primarily of equity securities at
March 31, 2002 and 2001. The unrecognized net asset at transition is being
amortized over the remaining service lives of the participants which
approximates 19 years.

The Company has a Supplemental Executive Retirement Plan which provides
retirement benefits associated with wages in excess of the legislated qualified
plan maximums. Pension expense recorded in 2002, 2001, and 2000 related to this
plan was $26,000, $0, and $26,000, respectively. At March 31, 2002 and 2001, the
related liability was $118,000 and $92,000, respectively, and is included in the
caption "Accrued Pension Liability" in the Consolidated Balance Sheets.

The Company has defined contribution plans covering substantially all
employees. Company contributions to the domestic plan are based on the
profitability of the Company and amounted to $669,000, $43,000, and $51,000 in
2002, 2001, and 2000, respectively. In fiscal year 2000, a defined contribution
plan was established in the United Kingdom. Company contributions to this plan
are based on a percentage of base salary which varies with the participant's
age. Company contributions were $73,000, $69,000 and $43,000 in 2002, 2001 and
2000, respectively.

The Company has a deferred compensation plan that allows certain key
employees to defer a portion of their compensation. The principal and interest
earned on the deferred balances are payable upon retirement. The accrued
compensation liability under this plan was $647,000 and $755,000 at March 31,
2002 and 2001, respectively.

Other Postretirement Benefits

In addition to providing pension benefits, the Company has a United States
plan which provides health care benefits for eligible retirees and eligible
survivors of retirees. The Company recognizes the cost of these benefits on the
accrual basis as employees render service to earn the benefits. Early retirees
who are eligible to receive benefits under the plan are required to share in
twenty percent of the medical premium cost. In addition, the Company's share of
the premium costs has been capped.

The components of postretirement benefit cost are:

The assumptions used to develop the accrued postretirement benefit
obligation were:

The medical care cost trend rate used in the actuarial computation
ultimately reduces to 4 1/2% in 2010 and subsequent years. This was accomplished
using 1/2% decrements for the years 2003 through 2010.

27

Changes in the Company's benefit obligation, plan assets and funded status
for the plan are as follows:

The current portion of the postretirement benefit obligation is included in
the caption "Accrued Compensation" and the long-term portion is separately
presented in the Consolidated Balance Sheets.

Assumed medical care cost trend rates could have a significant effect on
the amounts reported for the postretirement benefit plan. However, due to the
caps imposed on the Company's share of the premium costs, a one percentage point
change in assumed medical care cost trend rates would not have a significant
effect on the total service and interest cost components or the postretirement
benefit obligation.

NOTE 9 -- STOCK COMPENSATION PLANS:

The 2000 Graham Corporation Incentive Plan to Increase Shareholder Value
provides for the issuance of up to 150,000 shares of common stock in connection
with grants of incentive stock options and non-qualified stock options to
officers, key employees and outside directors. The options may be granted at
prices not less than the fair market value at the date of grant and expire no
later than ten years after the date of grant.

The 1995 Graham Corporation Incentive Plan to Increase Shareholder Value
provides for the issuance of up to 192,000 shares of common stock in connection
with grants of incentive stock options and non-qualified stock options to
officers, key employees and outside directors. The options may be granted at
prices not less than the fair market value at the date of grant and expire no
later than ten years after the date of grant.

The Company has a Long-Term Incentive Plan which provides for awards of
share equivalent units for outside directors based upon the Company's
performance. Each unit is equivalent to one share of the Company's common stock.
Share equivalent units are credited to each outside director's account for each
of the first five full fiscal years of the director's service when the profit
target of $500,000 is met. The share equivalent units are payable in cash or
stock upon retirement. The cost of performance units earned and charged to
pre-tax income under this Plan in 2002, 2001, and 2000 was $50,000, $0, and $0,
respectively.

28

The Company applies APB 25 and related Interpretations in accounting for
its plans. 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 awards under those plans in accordance with the optional methodology
prescribed under SFAS 123, the Company's net income (loss) and net income (loss)
per share would have been the pro forma amounts indicated below:

The weighted average fair value of the options granted during 2002, 2001,
and 2000 is estimated as $5.81, $5.15, and $3.54, respectively, using the Black
Scholes option pricing model with the following weighted average assumptions:

Information on options under the Company's plans is as follows:

At March 31, 2002, the options outstanding had a weighted average remaining
contractual life of 6.82 years. There were 189,023 options exercisable at March
31, 2002 which had a weighted average exercise price of $12.75. The remaining
options are exercisable at a rate of 20 percent per year from the date of grant.
The outstanding options expire May 2003 to July 2011. Options available for
future grants were 163,300 at March 31, 2002 and 176,150 at March 31, 2001.

29

NOTE 10 -- SHAREHOLDER RIGHTS PLAN:

On July 27, 2000 the Company adopted a Shareholder Rights Plan. Under the
Plan, as of September 11, 2000, one share Purchase Right ("Right") is attached
to each outstanding share of Common Stock. When and if the Rights become
exercisable, each Right would entitle the holder of a share of Common Stock to
purchase from the Company one one-hundredth (1/100) interest in a share of
Series A Junior Participating preferred stock, at a price of $45.00 per one
one-hundredth (1/100) interest in a share of preferred stock, subject to
adjustment. The Rights become exercisable upon certain events: (i) if a person
or group of affiliated persons acquires 15% or more of the Company's outstanding
Common Stock; or (ii) if a person or group commences a tender offer for 15% or
more of the Company's outstanding Common Stock.

The Company may redeem the Rights for $.01 per Right at any time prior to
the acquisition by a person or group of affiliated persons of beneficial
ownership of 15% or more of the Company's outstanding common stock ("Acquiring
Person").

In the event that any person or group of affiliated persons become an
Acquiring Person, each holder of a Right other than Rights beneficially owned by
the Acquiring Person will have the right to receive upon exercise a number of
shares of Common Stock having a market value of twice the purchase price of the
Right. In the event that the Corporation is acquired in a merger or other
business combination transaction or fifty percent (50%) or more of its
consolidated assets or earning power is sold, each holder of a Right will have
the right to receive, upon exercise, a number of shares of common stock of the
acquiring corporation that at the time of such transaction will have a market
value of two (2) times the purchase price of the Right.

NOTE 11 -- OTHER (INCOME) EXPENSE:

In January 2002, the Company received notice from a customer to cancel four
orders for the electric power generating industry. The contracts for the
cancelled orders entitled the Company to cancellation charges amounting to
$4,168,000 which was paid to the Company in April 2002. This income, net of
costs incurred on the contracts of $179,000, is presented separately in the
caption "Other (Income) Expense" in the 2002 Consolidated Statement of
Operations.

As discussed in Note 8, during fiscal year 2000, the defined benefit
pension plan in the United Kingdom was terminated which resulted in a
curtailment loss of $1,682,000. In addition, the Company incurred fees and
expenses of $33,000 in administering the closure of the plan. The curtailment
loss and related expenses are included in the caption "Other (Income) Expense"
in the 2000 Consolidated Statement of Operations.

In October and March of fiscal year 2000, the United Kingdom subsidiary, in
an effort to reduce costs, restructured its work force by eliminating positions
at the staff and senior management levels. As a result, a restructuring charge
of $186,000 was recognized which included severance and related employee benefit
costs. This charge is also included in the caption "Other (Income) Expense" in
the 2000 Consolidated Statement of Operations. As of March 31, 2002 and 2001,
there is no liability remaining on the Consolidated Balance Sheets.

NOTE 12 -- RELATED PARTY TRANSACTIONS:

Director H. Russel Lemcke is President of the H. Russel Lemcke Group, which
the Company engaged in May 1999 to assist it in making an acquisition in
fulfillment of its strategic plan. Pursuant to this engagement, in the event
that the Company were to acquire a business entity as a result of such
assistance, Mr. Lemcke would be paid a fee of $100,000 plus 1% of the purchase
price of the acquired entity.

In April 2000, the Board of Directors adopted a Long-Term Stock Ownership
Plan to encourage officers and directors to broaden their equity ownership in
the Company. The Board authorized the sale under the Plan of up to 160,000
shares of the Company's common stock that was held as treasury stock. Of the
amount authorized, eligible participants purchased 117,800 shares at fair market
value. The eligible participants paid cash equal to the par value of the shares
and a note receivable was recorded by the Company for the remaining balance due
on the purchase of the shares. The notes receivable are fixed rate interest
bearing notes with a term of ten years. The notes are repayable in equal
quarterly installments beginning June 30, 2002. The notes contain certain
provisions which grant a security interest to the Company in the shares and any
proceeds from the sale of the shares.
30

NOTE 13 -- SEGMENT INFORMATION:

The Company's business consists of two operating segments based upon
geographic area. These segments were determined based upon the manner in which
financial information is used by management in operating the Company. The United
States segment designs and manufactures heat transfer and vacuum equipment. Heat
transfer equipment includes surface condensers, Heliflows, water heaters and
various types of heat exchangers. Vacuum equipment includes steam jet ejector
vacuum systems and liquid ring vacuum pumps. These products are sold
individually or combined into package systems for use in several industrial
markets. The Company also services and sells spare parts for its equipment. The
operating segment located in the United Kingdom manufactures vacuum equipment
which includes liquid ring vacuum pumps, Dryflo pumps, piston pumps, ejectors
and complete vacuum pump systems.

Intersegment sales represent intercompany sales made based upon a
competitive pricing structure. All intercompany profits in inventory are
eliminated in the consolidated accounts and are included in the eliminations
caption below. In computing segment net income or loss, corporate expenses
incurred by the United States segment have been charged to the United Kingdom
segment on a management fee basis. Operating segment information is presented
below:

The operating segment information above is reconciled to the consolidated
totals as follows:

Total segment interest income, interest expense, depreciation and
amortization and expenditures for long-lived assets are equivalent to the
consolidated totals for each of these items. Operating segments incurred
research and development costs of $248,000, $250,000, and $255,000 in 2002,
2001, and 2000, respectively.

Net sales by product line follows:

32

The breakdown of net sales and long-lived assets by geographic area is:

QUARTERLY FINANCIAL DATA:

A capsule summary of the Company's unaudited quarterly results for 2002 and
2001 is presented below:

- ---------------

(1) In the fourth quarter the Company recognized income from cancellation
charges, net of related costs, of $3,989,000. (See Note 11).

33

INDEPENDENT AUDITORS' REPORT

Board of Directors and Shareholders of
Graham Corporation
Batavia, New York

We have audited the accompanying consolidated balance sheets of Graham
Corporation and subsidiaries as of March 31, 2002 and 2001, and the related
consolidated statements of operations, changes in shareholders' equity, and cash
flows for each of the three years in the period ended March 31, 2002. These
financial statements are the responsibility of the Corporation's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.

We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.

In our opinion, such consolidated financial statements present fairly, in
all material respects, the financial position of Graham Corporation and
subsidiaries as of March 31, 2002 and 2001, and the results of their operations
and their cash flows for each of the three years in the period ended March 31,
2002 in conformity with accounting principles generally accepted in the United
States of America.

/s/ Deloitte & Touche LLP
Deloitte & Touche LLP
Rochester, New York
May 17, 2002

34

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

None

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS

The information called for under this Item is set forth in statements under
"Election of Directors" on page 5 and "Executive Officers" on page 8 of the
Company's Proxy Statement for its 2002 Annual Meeting of Stockholders, which
statements are hereby incorporated herein by reference.

ITEM 11. EXECUTIVE COMPENSATION

The information called for under this Item is set forth in statements under
"Compensation of Directors" on page 7 of the Company's Proxy Statement for its
2002 Annual Meeting of Stockholders and also under "Executive Compensation" on
pages 8 to 13 of such proxy statement, which statements are hereby incorporated
herein by reference.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

(a) SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS

The information called for under this Item is set forth in statements under
"Security Ownership of Certain Beneficial Owners and Management" on pages 2 to 4
of the Company's Proxy Statement for its 2002 Annual Meeting of Stockholders,
which statements are hereby incorporated herein by reference.

(b) SECURITY OWNERSHIP OF MANAGEMENT

The information called for under this Item is set forth in statements under
"Security Ownership of Certain Beneficial Owners and Management" on pages 2 to
4, "Election of Directors" on page 5 and "Executive Compensation" on pages 8 to
13 of the Company's Proxy Statement for its 2002 Annual Meeting of Stockholders,
which statements are hereby incorporated herein by reference.

(c) CHANGES IN CONTROL

(Not applicable.)

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

The information called for under this Item is set forth in statements under
"Certain Relationships and Related Transactions" on page 17 of the Company's
Proxy Statement for its 2002 Annual Meeting of Stockholders, which statements
are hereby incorporated herein by reference.

35

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

(a) (1) The following are Financial Statements and related information
filed as part of this Annual Report on Form 10-K.

(a) (2) In addition to the above, the following Financial Statement
Schedules and related information are required to be filed as part of this
Annual Report on Form 10-K by Items 8 and 14(d) of Form 10-K:

Other financial statement schedules not included in this Annual Report on
Form 10-K have been omitted because they are not applicable or because the
required information is shown in the financial statements or notes thereto.

No items have been reported on Form 8-K since the Company's filing of Form
10-Q for the quarter ended December 31, 2001.

36

INDEPENDENT AUDITORS' REPORT

Board of Directors and Shareholders of
Graham Corporation
Batavia, New York

We have audited the consolidated financial statements of Graham Corporation
and subsidiaries as of March 31, 2002 and 2001, and for each of the three years
in the period ended March 31, 2002 and have issued our report thereon dated May
17, 2002; such report is included elsewhere in this Annual Report on Form 10-K.
Our audits also included the consolidated financial statement schedule of Graham
Corporation and subsidiaries, listed in Item 14(a)2. This financial statement
schedule is the responsibility of the Corporation's management. Our
responsibility is to express an opinion based on our audits. In our opinion,
such financial statement schedule, when considered in relation to the basic
financial statements taken as a whole, presents fairly in all material respects
the information set forth therein.

/s/ Deloitte & Touche LLP

Deloitte & Touche LLP
Rochester, New York
May 17, 2002

37

GRAHAM CORPORATION AND SUBSIDIARIES
SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS

- ---------------
Notes:

(a) Represents foreign currency translation adjustment.

(b) Represents a bad debt recovery and a foreign currency translation
adjustment.

(c) Represents a reversal of the reserve.

(d) Represents a write-off of obsolete inventory thereby reducing inventory and
the reserve.

(e) Represents the final settlement payment for the Batavia Landfill EPA claim.

38

(a) (3) The following exhibits are required to be filed by Item 14(c) of
Form 10-K:

- ---------------
+ Incorporated herein by reference from the Annual Report of Registrant on
Form 10-K for the fiscal year ended March 31, 1998.

++ Incorporated herein by reference from the Registrant's Proxy Statement for
its 2001 Annual Meeting of Shareholders.

+++ Incorporated herein by reference from the Registrant's Proxy Statement for
its 2000 Annual Meeting of Shareholders.

* Incorporated herein by reference from the Annual Report of Registrant on
Form 10-K for the year ended December 31, 1989.

** Incorporated herein by reference from the Registrant's Current Report on
Form 8-K dated August 23, 2000 and Registrant's Form 8-A dated September
15, 2000.

*** Incorporated herein by reference from the Registrant's Proxy Statement for
its 1991 Annual Meeting of Shareholders.

**** Incorporated herein by reference from the Registrant's Proxy Statement for
its 1996 Annual Meeting of Shareholders.

39

Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this annual report to be
signed on its behalf by the undersigned, thereunto duly authorized.

GRAHAM CORPORATION

DATE: June 12, 2002 By /s/ J. RONALD HANSEN
------------------------------------------
J. Ronald Hansen
Vice President-Finance & Administration and Chief
Financial Officer (Principal Accounting Officer)

Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.

40

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SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D. C. 20549

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EXHIBITS

FILED WITH

FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d)

OF

THE SECURITIES EXCHANGE ACT OF 1934

FOR THE FISCAL YEAR ENDED MARCH 31, 2002

------------------------

GRAHAM CORPORATION

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