福斯 (FLS) 2006 Q2 法說會逐字稿

Welcome to the Flowserve second quarter 2006 earnings conference call.

[OPERATOR INSTRUCTIONS]. I would now like to turn the conference over to Michael Conley, Vice President of Investor Relations. Please go ahead, sir.

Thank you, Mary, and hello to everyone, and welcome to the Flowserve investor conference call. Thank you for being with us. Today's call is also being webcast with slides via our website at www.flowserve.com. Just click on the investor relations tab to access that. Before we get started today, I want to make one technical note. For those of you who accessed today's call through our dial-in phone number, and also wish to simultaneously follow along with the slides via our website, please click on the "click here to listen by phone" icon at the bottom of the event details page. Again, if you have dialed in to today's call through the dial-in phone number and also wish to simultaneously follow along with our slides through our website, please click on the "click here to listen via phone" icon at the bottom of the event details page.

I'll remind you that the replay of this call will be available today beginning at 2 p.m. Eastern Time through 11:59 p.m. Eastern Time on Thursday, November 9. The access number is 800-405-2236 and outside the U.S., it's 303-590-3000. The pass code is 11072999# for either of those numbers. You may also access a replay of this call through our website and I'll repeat this information at the end of today's call. Joining me today are Lew Kling, President and CEO of Flowserve, CFO, Mark Blinn, and Chief Accounting Officer, Dick Guiltinan. Lew will have some opening comments and will share his perspectives. Next Mark will discuss some of the financial details and then we'll move into the Q&A session.

Regarding forward-looking statements, I'll refer you to our September 29th and today's news releases for Flowserve's remarks on that topic. The Safe Harbor statement in those releases, which I'll not repeat here in the interest of time, also applies to all statements made during this conference call. Information in this conference call, including the initial statements by management, plus their answers to questions related in any way to any projections or other forward-looking statements are subject to the previous Safe Harbor statement. And with that I'll turn it over to Lew.

Thanks, Mike. And good morning. It has now been several days since we issued our earnings release and filed our financial reports for the first half of 2006. And as you can imagine, there have been a lot of smiles around here. I'm very pleased to say that with our September 29th filing of the first and second quarter 10-Qs for 2006, Flowserve is now current with our SEC filings.

In addition, as you may have seen in our press release this morning, our third quarter bookings continue to show significant strength. These third quarter bookings of approximately $900 million were up 16% over comparable 2005 bookings from continuing operations, a new third quarter record for the Company. This is particularly important due to the fact the bookings for the third quarter of 2005 of $774 million from continuing operations were up over 22% from the comparable 2004 results and that was the former third quarter record for the Company. So as you can see, we are taking full advantage of our growing markets and continue to see benefits of our operational excellence initiatives in winning new business.

Before we get into reviewing the financial results for the first half of 2006, I want to focus on some of the more noteworthy items that clearly provide compelling evidence that Flowserve is indeed executing on its strategies, increasing its efficiency and improving its execution. To get started, let's review our six core Flowserve strategies because most of our success is built around staying consistent in these strategies with respect to our employees, our shareholders, and our customers.

Organic growth has played a major role in our success. As you can see from the numbers, Flowserve has been taking full advantage of our very strong market conditions with record quarter-over-quarter booking growth rates. We also have a strong new product development pipeline and we continue to drive our life cycle advantage program, creating a guaranteed cost of ownership option for our customers. We also have a number of globalization programs underway that support our growth initiatives and improve our ability to serve our customers. For example, we recently announced a joint venture with the Al Rushaid Group to construct the Middle East's largest pump valve and seal repair manufacturing and training facility in Dhahran, Saudi Arabia.

A new combined pump valve and seal manufacturing facility was announced in Suzhou, China in August to support both our domestic and international customers, which is scheduled to begin operations in March of next year. A Flowserve quick response center was established early this year in Shenzhen, China to support the needs of our local customers. A new pump facility is being established in Coimbatore, India that is planned to be operational in March of next year. We are also doubling the size of our valve facility in Bangalore, India, and we're establishing a number of additional pump service centers and quick response centers in Latin America, Middle East, and North America. These additions are focused on supporting our expanding customer requirements and capturing additional higher margin end-user after market business.

So as you can see, Flowserve is continuing to position itself to take advantage of attractive opportunities around the world and build in our success by being located close to our customers so we may respond quickly with technical support, parts and repair services. Our customers are asking us to follow them as they seek new global opportunities. And we are right there with them.

You've heard me talk about process excellence ever since I came to Flowserve. As you have seen in our numbers and will soon hear again, we continue to make good progress on our key metrics and initiatives that result in expanding margins. For example, Flowserve has continued to increase its internal customer on time delivery metric to about 90% year-to-date, which is significantly higher than it was just a few short years ago.

In addition, even with the significant growth in bookings, we have seen a reduction in overdue backlog, which is another positive sign for the business. Our supply chain and continuous improvement programs have attacked cost in all areas of our business and have resulted in significant and continuous gross margin improvement. We have started to make substantial progress in our ERP standardization program with a number of domestic and international sites ready to migrate to a more integrated program. And we are continuing as a priority to invest in and improve our legal and financial compliance processes as well as building a stronger company-wide culture of compliance in all areas.

These are just a few of the major process excellence drivers for both our continually increasing financial performance as well as our substantial bookings growth, which we believe is significantly better than that of the market. While we have been making Flowserve better, before we got bigger, we have also been making small moves in our portfolio of corporate assets. We have made some small, yet strategically important bolt-on additions to our portfolio.

In addition, we have divested a couple of non-core businesses as part of our portfolio management strategy. We will continue to make smaller moves in this area as evidenced by our recent acquisition of HTO, a Czech Republic mechanical seal manufacturer which gave us a quick response center and a low-cost manufacturing facility in eastern Europe. As we have begun to improve our operations, we have also begun to look at additions to our business, including related product lines, building on existing product lines, or adjacencies in our markets to further offer an enhanced solution to our customers, and these future additions will be consistent with our goal of achieving 15% margins and our internal cost of capital requirements.

We will also continue to pursue technology opportunities to internally funded programs, customer funded programs, joint ventures, and targeted acquisitions. Some of the potential customer-driven opportunities include energy-saving products, sub-sea products, geothermal products, and predictive diagnostics. We have also continued to build greater organization capability across the Company. For example, we trained 20% more customers at our technical learning center in 2006 year-to-date than in 2005 and trained 30% more employees. We have also recently added a new technical learning center in Essen, Germany, and, as mentioned earlier, we're adding one to our Saudi Arabia facility in Dhahran and our new facility in Suzhou, China.

In addition we're also evaluating adding an engineering center to our Asia-Pacific region. These investments in people allow us to continue to build a strong cadre of competent associates to support our customers worldwide. Now let's turn to the financial results.

As you know, for the first six months of 2006, Flowserve reported net income from continuing operations of $47 million compared with $21.5 million on the same basis for the first six months of 2005. A 119% increase. On a quarter by quarter basis, this translates into net income from continuing operations of $14 million in Q1 and $33 million in Q2. We also saw solid improvement in all of our business segments in terms of bookings, sales, gross margin, and operating profit. Clearly, our strong end markets and our process excellence initiatives continue to have a significant, positive impact on our business.

Taking a look at first half reported bookings, you can see that they're up 25% year-over-year. And excluding the effects of currency and discontinued operations, organic bookings were up over 32% over the same period last year. In addition, first-half 2006 sales were up 8% year-over-year. And excluding the effects of currency these sales are up about 9%.

We are also continuing to see strong activity in all of our end markets, particularly oil and gas. The chemical sector seems to be strengthening, especially in China. We expect the trend to continue. Easing oil prices could also have a further positive effect on the sector and the power generations sector continues to expand worldwide with the advent of additional coal-fired, coal gasification, and nuclear plants being planned or built.

When looking at our first half bookings mix, we find about two-thirds projects and one-third after market. This skewing towards projects is normal for this stage of the growth cycle and will serve Flowserve well as this strong project business should become tomorrow's high margin after market business. Incidentally, I do want to point out that the difference between project margins and after market margins is not as pronounced as it once was. This very positive effect is due to the expansion of the project-related margins and not a reduction in the after market margins. This margin expansion in projects is due to several important factors. First, our markets have been very strong, so we have been able to benefit from increased pricing leverage, which incidentally helps to offset raw material price increases.

Second, as we have said many times, we have been more selective in the business we take with respect to acceptable margins and contract terms and conditions. And third, we have been gaining traction in our operational excellence initiatives, which helped reduce our production costs. As our markets have continued to be very robust, as illustrated by our strong growth in bookings, our backlog has also risen dramatically. Our second quarter 2006 ending backlog was 61% higher than it was for the second quarter of 2005. And 14% higher than it was for the first quarter of 2006.

This has led to many questions as to the size of the gap between our sales and bookings as we continue to be successful in the marketplace. So I would like to take a moment and address this development. As we have said before, and as continues to be the case, we are in general seeing larger customer directed lead times on our project-related bookings. This is a function of a couple of things. First, the growing tightness in our industry capacity means customers are more likely to submit orders but get in the queue earlier than they normally would. Second, in some cases, a given project's other components like compressors, steel fabrication, heat exchangers, concrete emoters, may also be experienced longer lead times or even some delays. And third, the projects are getting larger and more complex, which fits into our sweet spot.

This means that our products may not be needed quite as early in the project's construction process and therefore customers have been pushing out some of the delivery dates as much as one to three quarters. When looking at our total sales, our recent history indicates that sales in one year is generally equivalent to the booking levels from the previous year. For example, in 2005, our annual sales were just slightly greater than our annual bookings in 2004. Following this trend, our reported bookings for the first half of 2005 was approximately 9%. This would lead to an expectation that the sales for the first half of 2006 would also be approximately equivalent to that 9% level. And the results show they were actually about 9.1% excluding currency which seems to reaffirm the correlation between bookings in one year driving sales the next.

Given the large number of major projects, which were won during the last half of 2005 and continuing into 2006, we would expect this relationship between bookings and sales to be lengthened a little. So now that you can see why we're so excited about the extreme high organic growth rate in bookings for the second half of 2005 and the first half of 2006. In 2006, our strong markets and our positive improving margins have translated into some very positive gross margin and operating margin results. In the first half of 2006, gross profit increased 13% to $466 million versus the first half of 2005, while sales grew almost 8% to $1.4 billion.

We also posted a gross profit margin of 33.4% in the first half of 2006 versus 32% in 2005, a 140 basis point increase. The improvement in our gross profit and our strong flow through reflects the increase in sales, which favorably impacts absorption of fixed costs and the cost savings from our operational excellence initiatives. The first half of 2006 operating income increased 34% to $110 million while the first half operating margin improved 150 basis points to 7.8%. This results from an operating margin of 5.7% in Q1 and 9.6% in Q2.

Let us take a quick look at the individual business segments in terms of profitable growth, operational excellence and key initiatives. The pump division's 2006 reported bookings increased 46% in the first half, including an amazing 55% increase in the second quarter compared with the same period last year.

First half sales increased 6%, the higher number of large project bookings won by the pump division also helped to create this large gap between bookings and sales in the first half. More importantly the resulting increase in backlog bodes very well for the pump division's future financial success. Their gross profit increased 13% or $23 million, which is more than twice their growth rate in sales, resulting in an incremental margin of 55%, which reflects an excellent flow through for the division.

Their year-to-date gross margin percentage also improved 160 basis points to 28.1%. Their first half 2006 operating income increased 29% or $16 million and their operating margin percentage increased to 10%, a jump of 180 basis points. It is important to note that their second quarter operating margin exceeded 12%. In our flow control division or valves division, the first half 2006 bookings from continuing operations improved 16% while sales increased 7%, both compared to the first half of 2005. It should also be noted that continuing operations excludes the general service group which was divested effective December 31, 2005.

Gross profit increased 11% or $16.3 million, which was significantly greater than the growth rate in sales, which seems to confirm that our operational excellence initiatives are working. And again, as in pumps, they achieved significant flow through from sales to the gross margin line as the gross margin improved 130 basis points to 34.1%.

Valves' first half 2006 operating income increased 16% or $7.2 million and its operating margin improved 90 basis points to 11.4%. In addition on large projects, valves are usually purchased approximately 6 months after the procurement of pumps. So the large increase in pump bookings during the first half of 2006 could have a positive effect on valve bookings later in the cycle.

Our flow solutions division or seals division's first half 2006 bookings increased 6% with a sales increase of 13%. This was due to the short delivery cycle and the large percentage of after market business. Even though the division's performance has been outstanding, you may have noticed that Q2 bookings declined approximately 1% year-over-year. This was driven by several substantial orders received during the same period last year that we believed would not repeat this year. This was offset by the 14% bookings growth in Q1. The first half gross profit increased $13.8 million or nearly 15%. And the gross margin percentage increased 60 basis points to 44.5%. The first half operating income also increased $7.7 million or 8% -- excuse me, 18% and operating margin improved 80 basis points to 20.8%.

So, as you can see, I'm extremely pleased by our continuing improvements and our operations and financial results as well as the continuing strength of our markets worldwide. In addition, our strategic initiatives clearly are gaining traction. And due to the hard work of many people, we are now current with our SEC filings once again. We will also continue to do the right things to strengthen our competitive position both operationally and geographically and we will also continue to invest in our people. So as you would expect, I'm obviously very upbeat about Flowserve's future.

And now, I'll turn it over to Mark to discuss the financial details. Mark?

Thank you, Lew. And good morning, everybody.

What I'm going to do this morning, let me review what I'm going to cover with you. First of all, we're going to review consolidated highlights, that will be the components of the income statement. And there'll be a focus particularly on the strong gross profit flow through. We'll talk about SG&A, the consolidated spend, focusing on salaries and benefits as well as travel. And then we'll spend some time on stock compensation expense and finance professional fees.

We'll review interest expense, which will reflect the impact of the refinancing, which is somewhat offset by higher LIBOR rates, review the tax rate, go through an EPS attribution analysis which will show the impact of the gross profit flow through, discuss working capital, debt and cash flow, and finally investment and capital expenditures. The focus of my presentation is going to be on 6 month year-to-date information unless I call out a quarter specifically.

Turning to slide 15, which is our consolidated income statement, sales of $1.407 billion represented a $99 million increase over the prior year, which was a 7.6% increase, or 9.1%, if you exclude the impact of currency. Gross profit, which showed a strong increase of $466 million represented a $52 million increase. It was up 12.6%, but more importantly, it represented a gross profit flow through of 52.6%. That allowed us to accrete gross margin of 140 basis points. SG&A of $356 million for the first half of the year did increase by $24 million, representing a 7.4% increase, however, as a percentage of sales it did drop by 10 basis points.

Operating income increased $28 million or 34%. More importantly it represented a 21.8% flow through on the incremental dollar of sales. That was also 150 basis point increase in operating margin. Interest expense decreased by $8 million. And net earnings, which include discontinued operations, increased by $33 million to $47 million. The result is net earnings, EPS was 56 -- $0.81 versus $0.25 in the prior year for -- including discontinued operations and $0.81 versus $0.38 in the prior year or a $0.43 increase for dis -- for continuing operations.

Turning briefly to the components. As Lew reviewed with you, bookings increased strongly year-to-date. Reported bookings was 24.7% increase. If you look at year-to-date bookings, they're up $408.9 million or 29.6%, excluding discontinued operations, and if you exclude discontinued operations and currency, bookings were up for the first half of the year 32.2%. This represents four consecutive quarters of organic bookings growth greater than 22%. Sales as I mentioned earlier, were up $99.4 million or 7.6%, this was driven by strength in the engineered pump products, strength in oil and gas, expansion in the Asia-Pacific region, and also, as Lew talked about, it reflects the bookings to sales conversion cycles and how it's been extended due to growth in project business and longer customer directed lead times.

Also, backlog increased by $402.5 million or 40.5% and it had a currency impact of $55 million. Gross margin, as I mentioned earlier, increased $52.3 million, which represented a 12.6% increase, and that was an incremental gross margin of 140 basis points. This reflects the operating leverage, pricing discipline and operational excellence initiatives that we've been driving through the Company. Division operating income increased $31 million, or 21.5%, which represented 140 basis point increase. This is attributable to the increase in gross margin and has been offset somewhat by increases in SG&A. We'll talk about this a little further, but one thing I want to highlight at this point is in our valve division, we did during this period have a structuring bad debt reserve and some continuing expenses associated with our disposition of GSG. This totalled approximately $3 million.

If you look at our gross profit flow through, and we've talked about this before, 52.6% incremental gross profit flow through and it was really across all divisions for the reasons I stated earlier. I do want to focus on our pump division, which showed a 10% increase in gross profit flow through. That is on a sale -- incremental sales of $41.9 million, or a 6.2% increase. This was driven by pricing, operating leverage, and incremental after market. But again, all three divisions showed substantial increase in gross profit flow through.

Looking at consolidated SG&A and operating income, consolidated SG&A increased $24.4 million or 7.4%, and we'll get into this a little bit further later in the discussion. Operating income increased $27.9 million or 34%. This represented an accretion of 150 basis points to our operating margin. And again, I'll reiterate, importantly it represented a 28.1% operating income flow through on incremental sales.

The next slide is slide 20 and we've shown a slide like this before. It is a walk forward of SG&A. And what it does for quarters and year-to-date is it shows the previous year spend and then it walks it forward to the current year spend. What I'm going to do is focus on the far right column, which is the year-to-date expense for the six months. And as you can see for the prior year that expense was 332 million. Now we've added $14 million of salary and benefits. And let me go through this a little bit because we've talked about this before.

In finance we've been investing in capabilities, tax, internal audit, compliance, policy, and controls. Also we've invested in our supply chain organization and capabilities and resources in China and Asia, and also a lot of our divisions in the regional and sector levels have added resources. Now the important thing to know is a lot of these incremental resources came on right at the middle of last year. So you're seeing a year-over-year impact where these resources were not in place in the first half of last year. Also in this incremental amount are increase in commissions. As you know, when bookings go up, we pay commissions based on bookings and incremental bookings will drive higher commissions and also higher inventory levels, which I'll talk about a little later. Also this amount includes a modest merit increase.

If you look at stock based compensation year-to-date you can see that it had no impact, although there is a lot of movement within these lines and I'm going to talk about that in just a moment. Also you can see that finance professional fees increased year-over-year by $2 million. Now I will call out the first quarter of '06 and you can see a $5 million increase, this was primarily driven by the restatement. I'll go into this in a little more detail, but you can see the movement between the fees, audit, and SOX, as I go into this in detail a little bit later.

Travel did increase by $5 million year-to-date and this represents pursuing our initiatives in China, India, and Saudi Arabia. Also, as I mentioned, there's a lot of new management in the division, regional and sector levels. They spent a lot of time visiting their operations and driving incremental growth. Also there's a lot of sales travel as we get closer to the customer and pursue incremental sales opportunities. And also in the finance organization, we used to use external resources and pay fees to support some of our training and compliance. Now we're using our internal resources and they're going to the sites to provide incremental training and to support our SOX and audit efforts.

Going further, you can see our incremental investment in research and development of $2 million. As we indicated, we were going to double our R&D spend and you can see it start to take place. Turning to the next slide, we'll review stock based compensation. And the impact year-over-year is $200,000, but there is movement in each one of the line items. Taking a look at restricted stock expense, you can see that year-over-year it increased by $2.9 million. This was driven by our higher stock price that we amortized through over the period of the restricted stock grant.

Also the Company adopted FAS 123R and is applying the modified prospective method. Basically what this means is that we are expensing options this year and you can see the impact year-over-year of $3.5 million. This is a new accounting requirement. Last year, we had stock modification in connection with former executives that had a $6.2 million impact that did not impact us in the first half of this year.

So you can see that the year-over-year impact is small, but you can see the changes that will be reflected in our financial statements going forward. Below that, I just show a quarter attribution which will help you tie it back to the previous page. One thing to point out and we did disclose in our Q recently, is that we do expect a $6 million non-cash charge in the third quarter of 2006 for the modification of our plan to extend options which would allow us time to get current, which we are.

Turning to the next slide, page 22, we'll review finance professional fees, and again I will focus on the year-to-date numbers. You can see an increase in audit fees from $9 million for the first half of last year to 16 this year. Last year, the $9 million spend primarily related to the '04 audit and the restatement. This year the 16 million does include some restatement in '04 audit, but it also includes the bulk of our '05 audit. If you look at our tax spend, it remains stable year-over-year. Last year we spent expense money in connection with the restatement in the IRS support. Again this year we had expense in connection with the restatement, the '05 financials and preparation for the 2002 to 2004 IRS audit.

As you can see, the SOX expense declined from $4 million to 1. And that 1 was in the first quarter of this year and as we discussed last time, we have internalized this capability and expect that this expense will be negligible going forward. An accounting and internal audit expense last year of $2 million decreased to $1 million. This is primarily driven by the ending of the restatement. So you can see for the corporate professional fees, we had a $2 million increase, but there's really a lot of movement year-over-year. More importantly is that the SOX expense is going down and that the primary driver was the high amount of audit fees this year.

At this time we do want to show the impact of international audit fees because these amounts are reflected in the division SG&A numbers. And you can see that year-over-year there was no increase, but we had a $4 million spend for the first half of this year. This is primarily international audit fees from our auditor that are billed to the sites. And as I mentioned, we do expect these fees to go down and I'll talk about this in just a minute.

So where will we go from here? Audit fees for 2005 were $19.1 million, which is primarily reflected in the $16 million run rate. We do expect that to go down the latter half of this year and start to normalize in 2007. Bottom line is that we think our 2006 fees -- audit fees will go down relative to 2005. This does include international, however, keep in mind that a bulk of our fees will be incurred this year as we're pulling a lot of our audit work to this year so that we can file in early March.

Again, I think our audit fees for 2007 even though we're going through the planning process, including international, should go down relative to 2006. With respect to the tax spend, we do expect that to come down. We still will have some outsourcing in place. But we will start seeing the fees shift to planning which will provide us benefit in our tax provision.

Turning to the next slide, quickly review interest expense. You can see that interest expense was reduced by $7.9 million, but there's a few components to this. 10.6 benefit was in connection with our refinancing last year. Also we've seen a $1.7 million increase related to the reduced principal amounts as we've paid down debt year-over-year. Now LIBOR has increased year-over-year about 150 basis points, which has resulted in an incremental interest expense of $3.6 million and also we've had incremental fees of $800,000 just primarily related to the amendment in the first half of this year. One thing to point out that you do not see in our ending balances for any period is that on average the first half of this year we had our revolver drawn about $145 million at LIBOR rates.

Turning briefly to our tax rate schedule. As you can see our tax rate for the first half of the year was 45.2%. If you look at our U.S. statutory rate of 35%, our foreign operations contributed about 10.1% of incremental tax expense, this was driven by losses in our foreign entities that were not benefited in our tax provision as well as worldwide reserves. You can also see in the extraterritorial income exclusion how the government has phased out and how that impacts our tax provision. Having said that, there are other deductions that have been put in place that we will take advantage of going forward, for example, the manufacturing deduction. We do expect our rates for '06 and '07 to be lower.

Going through our EPS attribution for 2006 versus 2005 first half. Turning quickly to the gross profit improvement, you can see that had a $0.92 impact year-over-year and that is on a sales increase of $99 million. So we almost achieved a $0.01 for every $1 million of incremental sales. You can see the impact of the increase in SG&A expenses. This does increase, it included the high fees that we've had this year in the finance area, particularly. You can see the impact of FAS 123 option expense, interest expense, that is resulting -- $0.14 benefit resulting from our refinancing last year. And we also had a pickup year-over-year relative to our derivatives, currency, transactions, and other. As you remember when we discussed the results from last year, we had a significant loss in the first half of the year as a result of our mark of our derivatives. Those marks have changed primarily resulting of the strengthening in the Euro and where rates have gone. And you can also see the impact of $0.10 of the higher effective tax rate which we are working on going forward.

Turning to primary working capital. You can see that the Company has continued to focus on managing working capital efficiency in connection with our growing business. At this time two years ago, we had primary working capital as a percent of sales was 26.9%. At June of 2005, it was 20.8%, but you need to remember that we had the securitization in place and if you include the impact of the securitization, primary working capital as a percent of sales would have been 22.5%. So you can see that year-over-year we've continued to achieve efficiency.

I want to bring particular focus to our inventory as a percent of sales which I want to talk about on the next page, as we discuss cash flow. You can see the impact of the increase in inventory of $52 million. Now as I mentioned earlier, bookings are followed by increased commissions in inventory. Inventory will support the future sales. In fact, inventory grew more than $52 million, but this was somewhat offset by increased progress billings which resulted from our disciplined contract approach. If you look at cash provided by operating activities, what this reflects is that we've been able to fund our growth with our operating cash flow and at the same time we've been able to continue to invest in our Company and pay down debt. The result on slide 28 is you can see that how our debt position has come down over the last three years.

Looking at capital expenditures, this really reflects how we're investing in our business going forward. And we're focusing on capacity, capability, and cost reduction. Going through each one of the divisions and the corporate, you can see that we spent $11 million in the pump division. This was to provide incremental test capabilities, expansion in existing locations in India and additional machinery in certain locations. In our controls division, this included expansion and machinery. In our seal division, this represented incremental QRCs, expansion and additional machinery. Our IT spend are really for systems and ERPs which we think will increase capability and reduce costs.

As we mentioned in our earlier disclosure, we expect to spend $75 million in capital expenditures this year and those will be to drive capacity, capability, and cost reductions. If you look at our deployment of free cash flow, the top three items we've already talked about are disclosed. We did make a $36 million pension payment in September of 2006. As we announced at the end of September, we have approved a stock repurchase program of up to 2 million shares. And also we're going to invest in capital expenditures. Going forward, we will consider other investments and acquisitions, dividends, or additional repurchases or JV buyouts. There are many options for our free cash flow going forward.

That concludes my remarks and I'll turn it back over to Mike.

Okay, Mark. Thank you very much. Now let's go to Q&A. I'll ask the callers to limit themselves to one question with one follow-up. Mary, if you could set us up for that, please?

[OPERATOR INSTRUCTIONS] And our first question comes from Michael Schneider with Robert W. Baird. Please go ahead..

Good morning, guys.

Good morning, Mike.

Congratulations on becoming current. And I guess in that regard, just looking forward, now, pump margins seem to one of the bigger swing factors. Can you give us a sense, you finished last year with about a 15% margin in pumps. And given what you've said on your discipline on pricing et cetera, can we expect that pump margins exceed that type of rate as we exit '06 and into '07?

Yeah, Mike, we seem to get into these discussions each time. And what we don't want to do is get into the area of guidance. But let me give you some general commentary on that. As you know, our fourth quarter and our pump division usually tend to be our strongest quarters. And with pricing and the operating leverage, that gives us a strong tail wind on our margin going forward.

And with regard to the, I guess, the longer lead time since your customers are requesting, there's been some concern expressed at least during this kind of quiet period on your filings that the lower crude price, lower gas prices may be feeding in the project cancellations, have you seen any types of cancellations, any type of hesitancy on your customers now to take the very orders that have been stretched out at their request?

This is Lew. We haven't seen any really cancellations, we've seen some stretch outs moving out maybe a month or two, maybe even as far as three. But really no cancellations of any projects and I've asked and asked have we seen any double bookings and we haven't seen that either. So right now our customers are still pretty bullish.

And stretchouts for what reason, Lew? I don't want to misinterpret your comment?

Stretchouts because they're looking at these large projects and we hear that some of them are coming in pretty high in budget, so therefore some are being rebid. And other cases, projects themselves even though they've ordered, as I've mentioned before, the pumps, the valves, and the seals from us, they don't need them as early as they used to because some of the other parts of projects are being delayed. Steel, compressors, things of that sort.

Therefore what they're doing even though they're buying things a little bit early from us, they're going ahead and saying don't deliver for an extra quarter or two because the rest of the project's not going to be ready. Remember we're only about 6-8% of these large projects. Therefore we represent a small percentage of what has to get done and we're pretty close to the end where they're installing. So they have to get the steel up first and a lot of things put in place before we ship. And that's the only thing we've seen as far as delays are concerned.

Okay. I've got many more, but maybe just a quick one. Mark, can you give us a sense of what backlog was you gave us the bookings for the third quarter? Can you give us what backlog was at the end of the third quarter?

No, we haven't provided that information out. We will talk about it when we issue our third quarter Q and have a subsequent conference call.

I'll get back in line, thank you.

Thank you, your next question comes from Mark Grzymski with Needham and Company. Please go ahead.

Good afternoon, everyone.

Hi, Mark, how are you doing this morning?

Doing well, thanks, Mark. I just wanted to go through the -- you said two-thirds of bookings are related to projects, correct? Roughly --

That's correct, two-thirds and one-third.

Okay. Great. Now what percentage of that -- of those bookings and projects are really the kind of book and ship type business as opposed to sales that have much larger lead times?

Most of those have larger lead times -- these are large projects coming in through areas throughout the world. So that's what we mean by projects. They could be a year, a year and a half. In the after market is where you usually where you get a book and ship. Now there are areas like in the valve side where, you know, we get commodity valves and they come and they go out pretty quickly. Two-thirds is normally large long lead projects.

Okay. Okay. Thank you for the clarification. And just a follow-up to that, if I look at the growth in bookings in the pump division in the second half of last year, obviously it was very robust up near 30%. And if I heard you correctly you're basically saying that even with the extended lead times, a lot of that growth in bookings should actually come through later this year and into '07, is that correct?

Again, without, you know, giving guidance that's -- if you take a look at the numbers and remember what I said about the fact that with the large bookings some of that's been extended out a little bit, you can use that as your ideas to, create numbers but I really don't want to give out guidance.

Last quick question and I'll jump back in the queue. Now that you have, debt to total cap, you're very comfortable with you have the opportunity to do a buy back. And obviously you're in the position of -- for to look at potential acquisitions, is there any way you can rank in order, what you would prefer to do if the environment was, you know, favored one or the other?

No. I mean, Mark I'm not going to rank them. But we'll review those opportunities really through the eyes of our shareholders, what provides the best return.

Thanks for taking my questions.

Thank you, next question comes from Ned Armstrong with Friedman, Billings Ramsey. Please go ahead.

Yes, thank you, good morning.

Good morning, Ned.

Hi, Ned, how are you?

Very well. With regard to your capital spending, you're estimating 75 million for this year. Do you see that level remaining the same in forward years or decreasing, increasing?

I don't, I don't see them remaining at that level in future years. They'll be lower, but I don't want to go into specifics because we haven't gone through our capital planning process.

Okay. And with respect to your tax rates, you're talking about them decreasing for the remainder of this year and into '07. Any -- can you frame the magnitude of decrease? Are you talking just a couple hundred basis points or much more than that?

Yeah, Ned, this goes into the area of kind of forward-looking information. We did indicate we expect our rate to be lower this year than it was last year and as I talked about on the call last time we're going to initiate a lot of planning activities towards the end of this year and next year and I think we'll start to see the full benefit of that in 2008. And we've also talked about the fact that, I think a company with our international footprint with all of the planning in place can achieve, approximately a 35% rate or potentially lower.

Okay, good, thank you.

You're welcome.

Thank you your next question comes from Charles Brady with BMO Capital Markets. Please go ahead.

Good morning. This is Kunihiko sitting in for Charlie Brady, can you hear me okay?

Sure can.

I just have a couple quick questions. First we saw in your 10-Q you mentioned that from a customer added to your SG&A. Can you give us more details on that?

Yeah, I mean, and I talked about it a little earlier in my presentation in the context of a restructuring in that division, bad debt and some incremental costs associated with the group we disposed of last year. But this bad debt as we go through and evaluate our customers had to do with the customer that was on the precipice of bankruptcy, so we took a bad debt reserve.

Okay. And now switching gears to your solutions, can you give us a little more color on, I guess, the capital expansion specific to that division? Maybe a little bit of how much you plan to allocate and the timing of them?

Right. If you look at year-over-year, you can see an incremental allocation to our seals group and a lot of this is expanding, one of our plants in Mexico, which is running very well and we want to provide incremental capacity. And in addition as I talked about earlier, incremental QRCs. And we discussed in our strategy, our quick response centers are critical to our strategy and being proximate to our customers. Really, we'll look at the opportunities through the eyes of our customers and what is best to continue to drive the results that seals division has been able to achieve at this point.

And finally can you give us idea as to what is a normalized corporate expense? After you remove all those expenses in the future, what that would look like either as a dollar figure or maybe as a percent of sales?

Well, again, no. I really don't want to go into P&L details on a forward-looking basis, but as we talked about before we do anticipate our audit fees for the '06 audit to come down relative to '05, and that our professional fees should start to next year. And also to the extent we continue to invest fees in our tax organization it will go right to those planning activities I talked about earlier.

Okay. Thank you.

Thank you, next question comes from Scott Graham with Bear Stearns. Please go ahead.

Good morning, Lew, Mark, and Mike. How are you guys doing?

Good morning, Scott.

Hi, thank you. I've got a couple questions for the second quarter you indicate some of the call them swing factors in the second quarter bookings for valves and seals. If you were to sort of commonize the year, make it comparable. Bookings have been up 5-10 rather than flat kind of thing. Would you suggest something like that?

Help me understand your question a little bit.

Well, you said you had a nonrepeat sale and, I think, you said in seals and I think you mentioned something else in timing on the, I might have these mixed up. If you were to look at those bookings, sort of on an ongoing basis and maybe sort of weed out some of that noise from the year ago. Would you suggest that those bookings in those two businesses are still rising perhaps 5-10%?

Well, without giving again forward-looking data, the -- in the seal side I did mention the fact that in the second quarter we had a 1% decrease in orders because we're comparing it to the second quarter of 2005 where there are a couple of large orders that didn't repeat, which we did expect. So therefore you saw that, but the first quarter had a 14% increase in bookings, therefore the average was obviously about half of that, maybe 6-7%. Without giving out numbers, we're still seeing very, very strong responses in the seal business.

Going ahead and looking at the valve side comment I made was that valves on these large projects are usually not all the time, but usually purchased about 6 months after pumps are purchased. It's just the way the purchasing system goes in most of our big customers. So therefore, we're seeing very, very large increases in pump orders as we see today with second quarter was 55% and we showed you orders were obviously pretty high in the third quarter. Therefore, there's a possibility without saying it will happen that valves six months from now may see some big impacts based on what happened to pumps six months earlier.

I do understand that, I guess what I'm trying to get at here is more specifically to valve. Solutions I'm not overly concerned about because, but the valves business is still a little bit more of a stand alone animal. And here maybe is my question more succinctly. while I know they follow pumps on project work, a lot of valves business is in fact quick turn business. Probably more as a percentage of total for the bookings of the overall company. If I'm wrong in that, you'll tell me. The chemical business is a big area for the valves and your comment is that we're starting to see chemical improvement in international markets. Our research is showing that the chemical business in Europe capital spending wise is kind of running off the charts right now. I'm wondering why maybe you didn't see that business.

Let me just jump in real quick. You said the for Q2 year-over-year the valve bookings growth was flat. Actually if you look at slide 10, it was almost 14% year-over-year.

I apologize, unfortunately I'm offsite and I cannot get to the slides.

Not a problem at all. I can understand the misunderstanding if you can't see the slides. Q1 showed a 19.1% growth and Q2 showed 13.7% growth and take into consideration the lag effect you saw where pumps was last year and lag effect of valves. Actually we're very bullish on that division it's showing great improvement in both its operations and sale pursuits.

Okay. So thank you for that. And apologies for the misunderstanding. So you are in fact then seeing chemicals related business in the valves area run through the sales as we speak?

Yes.

Okay. On a go forward basis I'm not asking for guidance, just more commentary. When do you expect to report your third quarter earnings? What's sort of the cycle now for you guys? Conference calls I assume will come with the earnings reports. Are you guys going to be non-guidance givers. My personal favorite were guidance givers. How is that going to work out from here?

As we talked about before, couple of things on the calls. There will be a compression between the time we release information and we give the call. So it will be quicker following the filing of information. In addition to that on the guidance, we're not going to give guidance. We've talked about this going forward and at this point we're not going to give sales guidance or margin guidance.

You need to keep in mind if you look at the trends we've been talking about right now with our very robust market and these trends going forward, you can see that we've seen a substantial increase in activity in our business. And what we'd like to focus on looking forward is making sure we deliver to our customers, not drive our results to some sales guidance range or other ranges out there.

Good for you. I don't mind that at all. Ask this last question. The corporate expense number. Obviously right after the second of the two large acquisitions by the prior regime, the corporate expense number was probably on an annualized basis running somewhere in the $60 million range and right now it's running in about the $130 million range. I'm not asking what that number should be or anything, but would it be fair so say Mark that that number on the on a year-over-year basis that we should start to see an improvement on that number in a year-over-year basis? We really haven't seen that with any consistency. But beginning in 4Q, you have an easy comp, the whole thing, we start to see that and on into 2007 quarters of year-over-year corporate expenses starting to drift down.

Yes. And come out and say we do expect that to improve and we talked about this openly that we're driving to have that corporate expense between 2 and 300 basis points of sales.

Very good, thank you.

Thank you next question comes from Bob Cornell with Lehman Brothers. Please go ahead.

Hey, first-time caller.

Hey, Bob, how are you?

Hi, Bob.

I heard a lot of comments about the strength of the business and so forth and what I get asked is what I think is where we are in the cycle. Do you have a comment on that maybe reflect on what a comment -- what be relative to North America versus Asia and Europe?

We could be mid way at the cycle. I've spoken to a lot of customers and customers in Saudi Arabia say the cycle's going to be 10 years maybe 12 years long. You speak to people in a Asia and I just got back from there, they're looking at very, very long cycles. In the U.S., people talk about shorter cycles could be 3-5 years. The data we're getting from the European industrial forecasting group, which we use in all of our presentations, show a 5-year to be somewhere between 3.5-5%. They're looking at a cycle of probably at least 5 years. We're looking at overall, pretty healthy cycle led by, of course, Saudi and Asia have a lot longer cycles. Like nuclear, which will put a boost to the cycles, also.

I heard your comment about some of the mix and things relative to project. How have big projects changed as a percent of your business, from two years ago to one year ago to now?

Well, if you look back, let's say a year ago, our projects were more like 55-45. And after market was 45%. We're now seeing more like 65% on an average versus 35%. So there are a lot more projects and they are getting more sophisticated and they are getting a lot bigger. And that's good for us because that as I mentioned before falls right into our sweet spot of the large complex projects. So it's really been very positive for Flowserve.

Bob, one thing I want to point out, and we've talked about before, we may not have the chance to visit with you about it, but our pricing discipline and where the markets are now. Whereas two years ago, the ability to get more pricing and higher margin on this project is substantially increased over the last two years.

Good point, thank you.

You're welcome.

That you thank you, next question comes from Adam Comora with EnTrust Capital.

Yes, guys, I had two quick questions. One was I wanted to understand a little bit better the general comments you were making about how bookings flow through into revenues. And just to use an example. I guess last year in the third quarter, without the discontinued operations, I think the bookings were around $775 million or something like that, is that the number we look at that translates into revenues a year out? Or do I look at what third quarter bookings were last year versus third quarter of '04 and apply that kind of a percentage to last year's revenues? I'm just trying to understand how all of that works?

Yeah, and again, I don't want to translate Q3 last year's bookings for sales of Q3 this year. As we talked about before, you can look at historical relationships of how bookings have converted to sales and there are a couple of factors to consider in the markets we're in right now. First of all, the mix or the increase really in pump engineered projects. These are larger projects, meaning more dollars, more complex projects, and they also include longer negotiated lead times at the customer's request. So you need to overlay that really to your analysis from prior years, however you want to walk it forward. Now also keep in mind that there's a very high focus here on on time delivering past due backlog. So whereas in prior years there may have been an impact of the project being delivered late, we focus, measure, and compensate people on that this year.

Okay. So -- all right. Let me ask a different question also, as well. The SG&A rate, the commission rates that we pay on bookings versus revenues, what kind of an impact does that have on our -- on profitability? Can you give us a ballpark of how much we pay out on commissions on bookings? And I guess just theoretically when does that start to normalize? Is that when revenue growth is faster than booking growth?

Yes, I mean, I'm not going to get into the detail of any of our compensation programs. The point I was making earlier was that incremental bookings yield incremental commissions. The commissions follow on bookings and precede sales and so you should anticipate if bookings are going up, the commissions are going up.

Okay, is it -- what kind of drag on margins? I don't know, I'm not looking for the exact numbers in terms of commissions. Is that something that impacts margins 10, 20, 30 basis points? Is it more than that? It normalizes and flips over when revenues go up faster than bookings?

I guess you could say that as bookings decline it may impact commissions, but in terms of the impact on margins, look at our gross profit flow through over the last couple of reported periods and I would hope that an incremental dollar sales commission is continuing to to those gross profit margins.

Okay. Thanks.

Thank you, . [OPERATOR INSTRUCTIONS] And our next question is a follow-up from Michael Schneider with Robert W Baird. Please go ahead.

Mark, in the first half of the year can you give us what the split was between MRO and projects so we can compare it to what the bookings ratio is?

On the, MRO projects on the sales?

Yes, just MRO projects split in the first half in revenue.

Yes. On the sale side, I think we were at more towards the high 50s, low 40s on the mix. Looking here at my financial data. You want to ask your next question, I will look this up and get back to you.

Well, with that trend, I guess what I'm trying to determine now is as more projects flow through the top line because of this bookings ratio increasing, what should we expect about incremental margins in particular, let's focus on pumps because you highlighted in your slides that you did 55% incremental gross margin in pumps during the first half. As more project activity comes through, can you sustain that ratio? Or that flow through?

The flow through ratio? Yeah we talked about this a little bit before. Let me tell you the drivers of gross profit flow through. We still see the benefits of operational excellence. We still see the benefits of incremental after market which both contribute to market increase, operating leverage, and pricing. Those were all driving relative margins up in our view. Now if your question is if we exchange a dollar of original equipment for a dollar of after market, that would tend to suppress margins going forward. But again, let me remind you we have a flow through of 52.6% which is well above our 33% current margin rate. So in my view, even with the original equipment business, which is today's installed base and tomorrow's after market, at the pricing levels we have, we still have an opportunity even with the incremental OE to accrete gross margins.

But at a lower rate than the 52 you stated?

You know, as I said I don't want to -- we talked about this last time, I don't want to give gross profit flow through guidance going forward because last time we talked about a 60% flow through, 52% if you exclude old and slow-moving inventory and that was '05 versus '04 and here we are again first half of '06 versus first half of '05 and we're still at 52%.

Okay. Fair enough. And then specific to the valves division, you mentioned that you wrote off a receivable, you had some restructuring, et cetera. Can you give us some dollar amounts so we can somewhat calculate a pro forma margin for valves in Q2?

Yes, I think I mentioned it in my presentation, but it was for the restructuring, the bad debt, and also incremental costs in connection with the disposition of GSG, it was $3 million.

Okay.

Approximately $3 million.

Okay. And then just talk about the MRO momentum. We obviously see the project business surging here. But what are you seeing on the day-to-day business? and maybe you could address it by geography.

Sure, I mean I'll comment generally and we can talk about, what we see in the businesses, but if you, for example, if you look at our sales for the first half of this year, particularly in the pump business, you saw an increase in after market, an absolute increase as a percent and as a percent and also an increase on a dollar basis. So we are seeing growth in the after market business. What you are seeing in our bookings is that growth is in a sense being overwhelmed by the increase in project business. But we still are seeing good profitable after market on an incremental basis coming through. As to regions, --

I guess if you take a look at the Middle East as an example, significant after market, in fact most big projects you get almost all of it same thing going on in China. In the U.S. you get a percentage of it. So going around the world, it's different everywhere. But it's pretty high return.

Okay. And then just on productivity, one of the challenges of the past has been just getting product out the door and properly quoting projects, can you discuss, Lew, what metrics you're watching and what progress has been made on one or two of those key metrics, say over the last two years?

I guess the most important metric that we follow is our internal metric of on time delivery. Take a look at our customers, that's what they really want, they want a great product delivered on time and a fair price not at the lowest price, but at a fair price. The number one metric for our customers, which does help drive these tremendous amounts of orders we get in is on time delivery.

If I go back a couple of years ago, it was probably in the 50% range, maybe 50-60, I don't remember what the exact numbers were, but now when we look at all three of our businesses, we're pretty close to 90%. We're really driving that metric hard. We also look at bill of material excellence, it's very important that our bill of material are correct. As I mentioned, if bill of material accuracy is 90%, it may sound very good, but that means 10% of our what you build or buy is wrong. Therefore we're driving for a 99.9% accuracy on all of our materials and we're driving it well because we're paying incentive compensation.

Cycle time is also very important metric, we're trying to lower cycle time across the board in all of our factories, which is allows us to put more into our factories, which is also extremely important. These metrics are all used to compensate our employees. So when we set up our metrics and sometimes there's 4, 5, or 6 different metrics, these are actually used for the incentive compensation program.

Mike, I owe you an answer, for the first half it was a 60/40 split. 60 OE, 40 aftermarket. On sales.

Okay. And Lew, I guess one of the things that I've harped on over the last couple of years has been turnover. Put it bluntly, it was a mass exodus during some of these challenges, can you report on what turnover is say among your mid and senior management levels?

I don't really have the numbers with me, but the turnover in the management levels in the mid to senior management level is fairly low. When I got here it was high, we were replacing a lot of people below the division presidents. We're pretty stable now. There's always going to be turnover of some people. They leave because they want to or get better jobs somewhere because it's a very tight industry right now and our customers are hiring a lot of our people. But overall, we're seeing a significant decrease in turnover across the board.

Okay and Project Star for those of us with long memories, we remember Flow Server.

Yes, I'm glad I wasn't here for that.

Can you give us a sense of where Project Star is on a baseball innings analogy and how you prevent this from morphing into something much greater than it is?

Well, if you go back to Flow Server, that was a single ERP system that was going to be spread out through the company. In different places around the world. What Project Star is doing is taking a basic ERP system, Oracle and saying based on the needs needs of the business we're going into certain locations and upgrading those systems. It's going very well, we're prepared in the next month to start turnover of some of those large operations into an oracle type based system.

It's all based on the priority, which is based on the need. We're not going in and making one swoop and changing everything at one time. And the teams that do the first, second, or third system will help do the fourth, fifth, and sixth. We're going to use the knowledge based on the gain of one system to help the next person down the line.

And one of the focuses, Mike, just so you can understand, is around standardization with respect to the financial platform. We view this more as a migration, we put for the implementation. And we are driving standardization because we think that will yield cost reduction over time.

Okay. Thank you, again.

Thank you, next question comes from Jim Foung with Gabelli and Company. Please go ahead. Hi, good afternoon.

Hi, Jim.

Just a couple quick questions. In terms of your backlog, would you say that the margins in the backlog are higher than your current shipment given the increase in engineered products that you've seen?

The comment we can make on that without going into forward numbers is the fact that we have -- an organization now that reviews all of the contracts, we have passed on contracts that do not have sufficient margins even in the large projects or have terms and conditions that are not acceptable to Flowserve. So therefore, low margin projects that don't have a lot of aftermarket we'll actually pass on.

Jim when I reviewed earlier, I talked about the pump division incremental profit flow through --

Right.

One of the comments, among other things indicative of trend on pricing and pricing discipline.

Okay. And I guess related to this question, with the increase in major project business that you're seeing, does that change or stretch out your goal of trying to achieve a 15% margin over the next couple of years for the whole --

No, it really doesn't. You know, we still have plans we feel that, that's a goal across the board and the fact that we have a lot more business coming in may even help.

Okay. Even though most -- even though high proportion of that is major project versus MRO?

Yeah, but Jim, remember when we talked about earlier, our pricing discipline. And we believe these projects will continue, will allow us to accrete margin both on the operating margin. I'll remind you our OI incremental flowthrough was the period that we talked about and the other thing to keep in minds this represents a strategic installed base. Today's installed base is tomorrow's after market. I think it positions us very well to achieve that going forward without really sacrificing margins substantially now because where we are in the pricing curve.

Right. Okay. Terrific. And then one last question is given the tightness in the oil and gas market within the last year, did you see a real pickup in the quick turn around business? As refineries didn't want to stop production because of the increased demand?

Well, we've seen as you see good growth in the after market business if that's what you want to the after market business if that's what you want to call quick turn around, that's products and services in both our pump and seal division which have a big proportion of their revenues generating the oil and gas industry. So, we've seen growth in that area, as well.

Well, referring to not the regular maintenance after market business, but the more of the kind of the quick turn around for quick repairs and stuff. Did you see a pickup in that?

Yes.

Great, thanks a lot.

We'll be able to take one more question before we have to sign off for today.

At this point, there are no further questions.

Okay. Thank you very much. Remember, a replay of this call will be available today beginning at 2 p.m. eastern time through 11:59 eastern time on Thursday, November 9th. The access number is 800-405-2236 and outside the U.S. is 303-590-3000 and the pass code is 11072999#. You may also access a replay of this call through our website a www.flowserve.com. On behalf of everyone at Flowserve, thank you for participating today. Good-bye and have a pleasant day.

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