福斯 (FLS) 2006 Q3 法說會逐字稿

Good morning and welcome to the Flowserve Corporation third quarter earnings conference call with senior management. Today's call will be recorded and transcribed. Flowserve wishes to emphasize to everyone listening on the call that certain statements made during the course of this call are forward-looking, These statements are not guarantees of future performance and are subject to significant risks and uncertainties that could cause actual results to differ materially from those discussed during the call. [OPERATOR INSTRUCTIONS] I will now turn the call over to Zac Nagle, Vice President of Investor Relations. Please go ahead, sir.

Thank you, operator, and hello, everyone. Welcome to the Flowserve investor conference call. Thank you for joining us. This call's also being webcast, including a Power Point presentation, via our website at www.flowserve.com under the investor tab. For those of who you have accessed today's call through our dial-in phone number and wish to also follow along with the presentation by our website, please click on the "click here to listen via phone" icon at the bottom of the event details page. A replay of this call will also be available on our website today beginning at 2:00 P.M. eastern standard time. Joining me today from Flowserve are Lewis Kling, President and CEO, CFO Mark Blinn and our Chief Accounting Officer, Dick Guiltinan.

We'll start the call with some opening comments on the state of the business and the third quarter financial performance from Lew, followed by Mark, who will provide more details on the financials for the quarter. Lew will then come back and add as few closing comments before we open the lines up for Q&A. In addition, I'll remind you that today's discussion may contain forward-looking statements that are subject to known and unknown risks, uncertainties and other factors. Please refer to our annual report and form 10K and Q for the Company's Safe Harbor statements, which can also be viewed on the Company's website for a full discussion of these risks. Now I would like to turn the call over to Lew Kling, President and CEO of Flowserve.

Thanks, Zac, and good morning. On September 29th, when we file our first and second quarter 10Qs for 2006, I announced that Flowserve had finally become current with its SEC filings. As of yesterday, with the release of our third quarter 10Q, we began honoring our commitment to both you and ourselves to remain a current filer. With that behind us, I would like to provide an overview of the third quarter financials and an update on the excellent health of the Company. I will then turn it over to Mark to get into the details of the numbers. Let's begin with some of the high points for the quarter shown in slide four. I'm very pleased to announce we have now turned in our seventh straight quarter of significant bookings growth. Our third quarter bookings from continuing operations were up over 15% when compared with 2005 and over 24% year-to-date. In addition, there has been an acceleration in sales, which are up sharply to almost 19% for the quarter and over 11% year-to-date.

Gross profit dollars were up almost 18% for the quarter and over 14% for the year. The operating income was up over 10% for the quarter and over 24% year-to-date. This growth trend has been occurring at the same time we are managing our internal performance metrics that drive our business, such as on-time delivery, which is now approaching about 90%, a significant increase from a few short years ago. As you can see on slide five, there has been a significant quarter over quarter bookings growth in the business, with the third quarter adding another 15% to our order book. Comparing our orders to 2004, before the significant organic bookings growth, we have consistently been experiencing over 40% quarter over quarter increase in orders. It should be noted that these figures all exclude discontinued operations, while leadership teams are successfully managing this growth in our factories by increasing productivity, carefully increasing capacity where necessary and maintaining our operational metrics.

The next slide shows off historic year-over-year bookings growth. The growth in years 2001 through 2002 were mainly driven by acquisitions, including the IDP pump business acquired in 2000 and the IFC valve business acquired in 2002. Since 2003, our accelerated growth has been primarily organic. As we look into the fourth quarter this year, we continue to see strong end markets in all of our sectors. Our sales growth is also strong and improving as we continue to convert our significant backlog into revenues. As we have said previously, the conversion time from bookings to sales has increased due to the extended customer directed delivery schedules. These are due to three factors. The increased size and complexity of the projects, which tends to fall right into our sweet spot, the customer's desire to ensure availability of Flowserve's manufacturing capability by getting into our queue early, and the general tightness of the supply chain as it relates to the customers' balance of their plans.

Since there has been no significant acquisitions since 2002, the sales growth since 2003 is truly representative of the organic growth we're experiencing in our core markets. As you can see on slide eight, we have broken out the third quarter year-to-date numbers to give you a better idea of where the growth and bookings in sales is actually coming from. While oil and glass are obviously driving a significant amount of this growth, we are also experiencing growth in our general industry segment, water segment and power segment, while holding steady in our chemical and pharmaceutical business. On a geographic basis, our largest year-over-year sales growth has been led by Asia Pacific, North America and the combination of Europe, Middle East and Africa known as EMA, led by the sales growth in the Middle East. This means we truly have a geographically diverse global business, which is not dependent on any one particular region of the world.

Slide nine shows the net income at the end of the third quarter increasing 176% from $27 million to $74 million on a year-over-year basis. This year-to-date improvement is comprised of increased gross profit and reduced interest expense slightly offset by some increased SG&A expense. The improvement was also impacted by the $28 million refinance charge taken in 2005, which was needed to replace our old high yield debt with lower cost financing and our highly successful $1 billion refinancing at much lower rates. When we look at Q3 in more detail on slide ten, we see a 15.3% increase in bookings quarter over quarter and a year-to-date increase of 24.4% as compared to 2005, excluding discontinued operations. When excluding currency, the year-to-date growth was over 25%. Sales increased 18.7% quarter over quarter and 11.3% year-to-date reflecting the strong growth in our markets especially oil and gas. This also reflects the acceleration of sales that were beginning to convert our strong bookings growth.

As you can see on slide 11, gross profit increased almost 18% to $248 million in the third quarter and increased 14.3% to $714 million year-to-date. Our gross profit margin decreased 30 basis points on significantly higher sales in the third quarter, driven primarily by a shift in product mix resulting from a significantly higher growth rate in original equipment sales versus aftermarket sales in our Pump division and a few shipments delayed to Q4, most of which have already been shipped and thereby increasing revenues for Q4. Having some small delays on large projects is very typical in any business with zero to 24 month billed cycles and when these delays come at the end of a period it impacts the margin temporarily. In fact, we expect continued momentum in our sales growth and improved gross product efficiency in the fourth quarter.

On the year-to-date basis, our gross profit margin has increased 90 basis points to 32.8%. Our operating income for the quarter increased over 10% to $60 million and increased almost 25% to $170 million year-to-date. The operating margin decreased 60 basis points in the third quarter due to the decrease in gross margin just mentioned and a slight increase in the percentage of SG&A. As I have just noted, we expect improved gross profit efficiency in the fourth quarter which should positively impact operating margins. On a year-to-date basis, our operating income margin increased 80 basis points to 7.8%. On a year-to-date basis, our operating income margin increased 80 basis points to 7.8%. I would like to close with a discussion of our stock repurchase program, which we have previously announced, as well as our stock option overhang and some possible executive stock sales.

With respect to the share repurchase program, the board of directors in September approved the repurchase of up to 2 million shares of Flowserve stock on the open market. We have not been able to commence this program due to our compliance with SEC Safe Harbor regulations prohibiting this action until after we filed the third quarter 10Q. We do believe that our stock buyback program is a good investment for the Company and its shareholders and a good use of our short-term cash flow. While the top management of the Company has been in the blackout period, former executives as well as other employees have exercised approximately 1.6 million options in the open market since September 29th, over half of which came from former CEOs. It should be noted that the market absorbed this additional equity without the repurchase program even being implemented.

As to existing management, we expect to see a limited amount of option exercises and stock sales by current officers and directors to handle cash tax liabilities and, in the case of two long-term employees, asset diversification and part of the prudent retirement financial planning. In all cases, the selling officers will still maintain substantial ownership in the Company. I want to emphasize that neither Mark or I are planning to sell any Flowserve holdings. Furthermore, I want to add that this share repurchase should not significantly restrict our ability to move on strategic acquisitions, pay dividends or purchase additional stock as we have strengthened our balance sheet substantially over the past few years. Now let me turn it over to Mark for more details on our third quarter and year-to-date performance.

Thank you, Lew, and good morning, everyone. Today what I am going to discuss with you are the division financials. We'll talk about consolidated highlights, including SG&A, EPS growth, working capital, cash flow and debt, and talk about our investment in capital expenditures. Before I get into my presentation, there are some things I want to cover with you. First of all, as Lew mentioned, bookings are converting to sales and you are starting to see an acceleration in sales. Also with respect to our Pump division, our annual trends remain strong. This is not a quarter to quarter business. Mix and timing of sales can impact margins. In fact, Q3 over Q3 we saw an 800 basis point shift in original equipment sales as original equipment sales grew faster than aftermarket. With respect to SG&A, we're seeing that the impact of additional finance resources and professional fees has slowed.

Having said that, one-third of the total SG&A increase for the quarter and the year has resulted from an increase in sales resources, commissions, sales travel and related expenses. This is an investment in our Company to secure the bookings growth [TECHNICAL DIFFICULTY]. Also, the SG&A was impacted in the third quarter by a stock modification of $5.6 million, as well as stock option expense, which is new this year. With respect to working capital, we continue to fund growth in orders with operating cash flow. In addition, we put $36 million into our pension plan and paid $38 million in professional fees. I'll remind you that growth in orders results in an increase in inventory and commissions. Also, as we ramp up sales, we expect to see accounts receivables increase. Turning to slide 14, I'll review our Pump division with you. As you can see, for the third quarter, bookings increased 19.4% [TECHNICAL DIFFICULTY], a record quarter. For the year, bookings have increased 35.8% to 1.546 billion.

And I'll remind you that the ramp up in orders in the Pump division began in the third quarter of '05, so the third quarter increase is lapping a bigger increase last year. If you look at sales, sales for the third quarter increased 24.6% to 401 million, as we start to see the conversion of bookings to sales. For the year, sales have increased 12.2% or 1.116 billion. Turning to gross profit. Gross profit increased $18 million or 20%. Gross margin did decrease by 100 basis points. Let me review some aspects of that. As Lew mentioned, we did see a shift of OE is to sales. More sales were OE. Also there were timing of shipments as well as a few discreet charges in the third quarter that impacted gross profit. If you look at the year-to-date gross profit increase of 15.2% or $41 million to $309 million, the annual trend remains strong. In fact, gross margin increased 70 basis points, 27.7%.

If you look at operating income, operating income for the quarter in the Pump division increased $10 million to $39 million and margin improved 70 basis points. So despite the decrease in gross margin percentage, operating margin increased 70 basis points. If you look at the growth of operating income year-to-date, we had a $17 million increase to $111 million and operating margin improved 140 basis points. I'll refer back to the gross profit increase for the year-to-date of 70 basis points and point out that we were able to leverage 140 basis points of operating margin increase on that gross profit increase. As I mentioned, this is not a quarter to quarter business. One example I'll give to you is if you look back in Q4 of 2005, we had 30% gross margins, 15% operating margins. So the results can fluctuate from quarter to quarter but annual trends remain strong. You look for the third quarter in our Flow Control division. They had outstanding performance. In the third quarter, bookings increased 14.8% to $264 million. Year-to-date bookings increased 15.8% to $806 million. This represents a stable growth in bookings.

If you look at sales for the third quarter, sales increased 14.8% to $258 million and year-to-date sales were up 9.8% to $728 million. Again in the Flow Control division, we are seeing accelerating growth. I will point out at this point that the sales mix was 87% original equipment and the balance was aftermarket. If you look at gross profit, you can see gross profit increased $15 million to $87 million, representing a 180 basis point increase in gross margin. Year-to-date, gross profit increased 14.6% to $248 million, representing 140 basis point increase in gross profit. Operating income for the third quarter increased $9 million to $34 million, or 13.1% operating margin, 180 basis point increase. Year-to-date, operating income has increased $15 million or 120 basis points of operating margins to 12%. We are getting good leverage on our original equipment sales in this division. We are seeing accelerating growth and strong gross profit in operating margin efficiency.

Turning to our Flow Solutions division, we see continued outstanding performance. Bookings increased 7.8% to 126 million. Year-to-date bookings increased 6.5% to 376 million. Sales for the third quarter increased 8.6% to 123 million and year-to-date growth was 11.6% to 366 million. What we're seeing in the Flow Solutions division is stable growth in bookings and sales. The mix of sales was 25% original equipment, 75% aftermarket. Turning to gross profits, you can see that the stable growth in bookings and sales has yielded increasing efficiency in gross margin and operating income. Gross profit increased $6 million in the third quarter to $56 million, representing 130 basis point increase in gross margin. For the year, gross profit is increased 13.7% to $164 million representing an 80 basis point increase in gross profit.

Turning to the operating income line, you can see that operating income increased $3 million to $26 million for the quarter, representing a 50 basis point increase in operating margin. For the year, we saw a $10 million increase in operating income to $76 million. That was a 15.6% increase and margins increased by 70 basis points. We are seeing stable growth in the Flow Solutions division with improving gross and operating margin. Turning to slide 17, I'll review the consolidated income statement. Sales increased in the third quarter by $121 million or 18.7% to $771 million. Gross profit increased by $37 million or 17.6% to $248 million. Gross margin did decrease by 30 basis points, driven by the gross margin decrease in our Pump's division. SG&A increased $32 million and I'll review that with you in just a moment. If you look at operating income, operating income increased by $5 million, which represented the incremental gross profit offset by the SG&A increase.

If you look at interest expense, interest expense reduced by $3 million, which reflects the impact of our refinancing last year offset by an increase in libor rates and working capital needs. Net earnings of $27 million or $0.48, represent a $22 million increase or $0.40 increase versus last year. I'll remind you, as Lew did, that last year we took $28 million charge in the third quarter in connection with our refinancing. Turning to our year-to-date consolidated income statement, you can see that trends remain strong. Sales increased by $221 million or 11.3% to $2.178 billion. Gross profit increased by $89 million or 14% to $714 million. Gross margin during the year has increased by 90 basis points. SG&A has increased by $56 million and we'll discuss that on the next slide. Operating income for the year has increased $33 million or 24% to $170 million. Operating margins have increased 80 basis points to 7.8%.

Interest expense has gone down by $11 million, as I mentioned earlier, impacted by the refinance and change in rates and working capital. Net earnings of $74 million or $1.29 for continued operations represents a $47 million increase or $0.82 increase, also taken into consideration the refinance charge from last year. Turning to slide 19, I'll review SG&A with you. I'll pay particular focus to Q3 of 2006. You can see that we had a $32 million increase from 156 million last year in the quarter to 188. This was driven by a $14 million increase in salary and benefits. I'll break it out as follows. We saw $7 million increase in selling resources and commissions during the quarter, as we invest into our bookings growth. In addition, we also saw a $2 million impact in connection with the annuitization of the pension plan and our change in pension assumptions from last year. Also, I'll point out that last year we had $5 million of credits in G&A in connection with medical claims and insurance benefits that did not occur this year. That comprises the most of the $14 million change.

With respect to stock-based compensation, you can see a $9 million increase quarter over quarter. The primary driver of that is the $5.6 million stock modification that occurred during the third quarter, as well as the additional option expense under FAS 123R. You can see that finance professional fees went down in the quarter relative to last year. Travel went up by $3 million and, as we've discussed before, about half of this comes from the selling and marketing organization, as we drive bookings growth, and the other half comes from our increased compliance efforts as we internalize our internal audit and compliance function, as well as our management leadership group going to the sites to drive continued performance. Research and development increased by $1 million versus the last quarter and it's been $4 million for the year. What I want to point out is that there's a lot of research and development that is in cost of sales or customer directed which is significant above the amounts increase you see here. We are continuing to invest in R&D in our Company, either directly or through our customers.

Turning to slide 20, I'll review with you briefly professional fees. You can see that they are starting to trend down. We believe that these are more than the normalized run rate, if you can see as we've committed to you that these fees are starting to trend down. On slide 21, I'll review with you briefly an earnings per share attribution analysis. You can see that year-over-year, year-to-date that we've seen $1.58 improvement from gross profit improvements offset somewhat by an increase in SG&A and option expense. Turning to slide 22, I'll now review with you our working capital. If you look at the third quarter of 2005, you see that receivables represented 15.9% of sales. I'll remind you that we had at that time in place a securitization which took certain receivables off balance sheet. That represented about 1.2% of sales. So if you add that to the 15.9% on a comparable basis we're at 17.1%. This year in Q3 of 2006, we received 17.8% as a percent of sales and receivables. That is a growth in connection with the acceleration of the sales growth that you saw in the third quarter.

With respect to inventory, we've talked about this before, that orders are followed by inventory and commissions. We did see inventory grow from 15.2 to 16.8% as we have started to create inventory to execute the sales in the period. I will point out that in the 16.8%, that does not include $81 million of progress billings that we have in accrued liabilities, which would represent approximately 2.8% of sales. You look at our cash flow statement on slide 23, I'll call your attention to the cash provided by operating activities. We generated $14 million. We are funding the growth in our operations through operating cash flow. In addition to this, we did pay $36 million in pension payments this year and approximately $38 million in professional fees.

Slide 24 shows how we historically paid our debt down and it's remained stable over the last year as we continue to invest in our Company. Which brings me to our last slide, slide 25, you can see the capital expenditures year-to-date. In the Pump division we've invested $17 million. This includes our India expansion, additional capacity to serve our increasing Middle East business and other required strategic expansion. You look at our Flow Solutions division you can see that year-to-date we've spent $10 million. One of the primary drivers has been our Mexico expansion to drive more low cost manufacturing. And finally, if you look under the IT capital expenditures, this represents our investments in systems and our ERP platform. Bottom-line is we continue to invest in our business to support growth. With that, I'll conclude my comments and turn it back over to Zac for question and answer. Operator, I'd like to turn it over.

[OPERATOR INSTRUCTIONS] Our first question is from the line of Scott Graham with Bear Stearns.

Yes, good morning.

Good morning, Scott.

I really just have one or two questions for you. The -- I know that guidance is not something that you guys are going to do and I've told you before I commend you for that. The corporate line, however, should it be benefiting by more than just the reduction of professional fees than what we're -- you showed a little bit of a sequential improvement there. Obviously, the corporate expense number is still a pretty high number. Is that a number that can go down over time beyond the professional fees?

Yes, Scott. We talked about the professional fees before. What I pointed out for the third quarter is we are not at normalized run rates. Having said that, and we've talked about this before, that we do think we have an opportunity from a event-driven efficiencies in our corporate line. And then also we talked about that over time as we start to simplify our platform with our ERP systems that will also drive efficiency in our SG&A number from a consolidated basis. So that's all of our SG&A spend.

That's helpful. My follow-up question is simply that within your 10Q you wrote a lot about how the sales trends were improved from your, I think you call the EMA regions as sort of rest of world, if you will, but certainly there's a lot of activity going on in the United States in oil and gas and in chemical. Could you speak to that a little bit, what you guys are seeing and right here in the U.S. what you guys are benefiting from? I assume those sales are up?

As I mentioned, this is Lew. As I mentioned in the presentation, we're seeing increased orders and therefore they'll become sales in North America. And that comes really from what's going on in Canada, obviously. And a lot of the refineries around the United States, they may not be building new refineries and they haven't since 1972, but they are really expanding. Also the aftermarket's expanding. So looking at the entire North American area, it's been an expansion market for us.

I guess, Lew, you hit on a point that I maybe wanted to explore a little bit further on this. Maybe this one market that I'd like to drill down into more of the refining market where there has been a fair amount of turnaround activity in 2006 because refining margins have been so volatile, a number of operators, as we understand it, have from time to time taken things down. I guess I'm a little bit surprised that that did not help you in terms of aftermarket mix in your Pump business.

We still feel that that big bubble of aftermarket business, when they take things down, is probably still in front of us. We have seen some of it but a lot of the facilities have not been taken down yet, because with the price of oil holding where it is, taking down some of the facilities to change out and make some modifications is very expensive. So we've seen some but we think there's a lot more out there.

And Scott, I'll point out, we talked about this on the last call, if you look at it our aftermarket growth on an absolute basis has grown. It's just with a lot of our project wins that we started to experience towards the end of last year, our original equipment orders and sales are growing at a much faster rate. It's not to suggest we're not seeing growth in the aftermarket, we are.

Very good. Thank you.

Your next question is from Michael Schneider with Robert W. Baird.

Good morning, guys.

Good morning, Mike.

Just want to focus on Pump margins for minute. Specifically, Mark, you mentioned that there were discreet expenses that hit the Pump group this quarter that sound like they were unusual or maybe differently timed than you had expected. What dollar amount were they and I guess what did they relate to?

Sure. Mike, it was approximately $2 million and it related to a specific warranty issue. We had a benefit plan that took a charge and also some lower cost to market adjustments. Some of those are permanent and some of those can reverse in future periods.

I'm sorry, you said a benefit plan?

Yes, it was a specific union benefit plan where we took a charge.

Okay. That is part of the warranty issue you mentioned or that is over and above the 2 million.

No, that's separate. The benefit plan, the warranty issue, the lower cost to market are three of the items that really comprise those discreet charges.

Okay. Then specifically in the Flowserve Pump division, during the quarter the incremental margins on the higher volume were significantly lower than the trend line had been. Can you discuss, while there is certainly a much greater mix of project activity, it still looks like the incremental margins were lower certainly than I had expected and lower than the trend line. Can you give us some color in terms of what type of projects have shipped this quarter and if that changes the margin profile going forward? You've mentioned timing issues, what were they and how much did that impact the incremental margin as well?

As Lew mentioned, we had a couple of shipments that were late. There was one particular nuclear project that did not ship in the third quarter and has shipped in the fourth. As to your comment on the incremental margins, in the first half of this year, you had a different aftermarket mix as the overall percent of sales, if you'll recall. Actually sales growth had been slower during that period of time. As you start to see original equipment accelerate, while they do have on a relative basis it may drive incremental gross margins down, it is still accretive, we believe, going forward to our gross margins and to our operating income. That's what I wanted to point out. When we reviewed the gross profit for the quarter and year-to-date for the Pump division, you saw growth in absolute dollars in the gross profit. And even though gross margins for the third quarter went down, operating margins went up. And the point here is these are very large dollar sales and anything that is really accretive to our operating margins and to our gross margins will take them up on a large dollar sale.

That probably drives to the heart of the stock being down this morning and what the potential is going forward. Gross margins in Pumps in the fourth quarter if you adjust for these timing of the nuclear projects, some of these other expenses, should we expect gross margins in Pump to be up year-over-year in the fourth quarter? Because that would presumably mean that much of this third quarter negative reverses itself and makes it up in the fourth quarter.

Yes. I don't want to guide on the fourth quarter margins, Mike, but a couple of things to call out. There was a project that shipped late. So, we'll get the benefit of that in the fourth quarter. And to the extent some of these discreet items reverse, you get the the benefit in the future period as well. The only thing I will call out to you is the fourth quarter historically has been a very strong quarter in our Pump division. That's why I pointed out the fourth quarter of last year. They had 30% margins and 15% operating margins. So they get phenomenal leverage through their income statement. But with that said, I really don't want to guide to fourth quarter margins. But do point out that we do like our annual trends in all of our businesses.

Just a follow-up on that. So fourth quarter of last year, you're right, Pump had an extraordinary performance of 14.9 operating margin. Is there anything unusual, though, in that number that next quarter we're going to be talking about that was unusually beneficial to that fourth quarter or was it volume? Because I'm trying to get expectations in line here such that next quarter we're not talking about a decline against a tough comparison because of some unusual benefits in fourth quarter of last year.

As I said, not to comment on the comparison quarter over quarter, but there was really nothing significant in that quarter last year. You hit the point on the operating margins. And the gross margins were 30%. It shows you the ability of incremental gross margins and how that can flow through your operating margin line. That's your operating and fixed cost leverage.

In other words, 14.9 last year was a reasonable expectation? There's no unusual benefits or negatives in that number.

There's nothing significant in there, Mike.

Thank you. I'll get back in line.

Your next question is from the line of Mark Grzymski of Needham & Co.

Good morning.

Good morning, Mark.

Not to stick to the same topic as Michael there, but just looking at the quarter, did you guys -- and I had some trouble with my speakerphone here, but did you have -- did you mention the percentage of OEM business in the Pump division for Q3 and if so, could you --

Yes. For Q3 it was 60% original equipment versus 40% and that's compared to 52 versus 48 last year.

52 to 48, great, thank you. Looking at the backlog in the Pump division, what percentage would you say is OEM of that remaining backlog?

A good portion of the backlog in the Pump division is project work.

Is it fair to say greater than 60%?

I don't have that number with me right now. We don't report out on that number. If you look at it, there's a lot of book and shift projects. But these projects tend to have long lead times so they'll manifest themselves in a backlog number. So a significant portion of the backlog is project work.

And my follow-up to that is given that percentage, are you, and I know you touched on it in prior questions, but do you feel comfortable that even with that project business lingering that you have a pretty good grasp of the gross margins for that division right now? Are you confident that there's potential there for that to grow?

Yes, we do. As we talked about, we talked about the shift, the timing and some discreet items. We know specifically what's going on, what action plans we need to take, what we need go do, and we are confident. I'll point out, as I did in the Flow Control division, they had 87% original equipment and look at their proficiency and performance. Original equipment can be very good business.

Yes. Just wanting to clarify here. Lew, just one question for you. Looking at the environment right now being current and having a different perspective going forward, what's your feeling on the acquisitions right now? How's the environment?

Well we've become now an acquisitive Company, I guess, almost officially because I brought on board some people to start looking at acquisitions. So we are listening. We don't have to do an acquisition. We feel we have the products that we need in the marketplace and obviously we're doing pretty well with those products. But we are beginning to look. That's about all I can say right now. We have done, by the way, in the last year a couple of very small acquisitions, one in Perth and a few other places. They were basically technology acquisitions. Or the one in the Czech Republic, instead of building a QRC we actually purchased a QRC. We have been doing a little bit, but going forward we are becoming acquisitive.

Mark, let me add to that. As we evaluate opportunities out there, we really evaluate them versus other alternatives of use of our cash flow. And the other thing to consider is if you look in the markets right now, we're well aware of where valuations are. And also we will also take into consideration the cost of complexity with any potential acquisition and price that in, vis-a-vis SOX and integration and other issues as well. All that will be considered and the bottom-line is that it needs to drive us to our 15% margin target and also it needs to return in excess of our cost to capital. Those are going to be the parameters as we look at things.

Thanks for the color. Thanks for taking my questions.

Your next question is from the line of Wendy Caplan with Wachovia.

Good morning.

Good morning, Wendy.

In terms of your OEM related project business in the Pump group, can you give us some indication how much of that business is centrifugal pumps versus process pumps? Certainly, as you know, the process pump aftermarket is relatively insignificant in terms of versus the centrifugal pump.

Wendy, actually, I don't have that information with me.

Okay. Perhaps we can get it later.

I'm happy to share that with you later.

A follow-up, the management of Flowserve, the prior managements and current and the predecessor companies, have spoken about this negative mix shift towards project pumps for at least ten years. Given the presence of pump pirates who try to aim to secure that business and the fact that that strategy really has never paid off, what gives you the confidence that it's a good thing this time around?

You're talking about the shift of original equipment versus aftermarket?

Exactly, in the Pump.

Two things. One overall for the Pump business that our aftermarket business is continuing to grow. The other thing is the discipline around the way we price our original equipment bids. This is a stronger market than it was a couple of years ago and we believe we're taking market share and have pricing power. But that's what gives us confidence going forward is that we are getting the type of business and pricing that we want. A lot of that's been driven by on-time delivery and the fact that our relationships are better with the engineering contractors and our customers. That's what gives us confidence.

Okay. And the question about the on-time delivery now at 90%, is there any meaningful contribution in that number from customers delaying shipments? Have there been any cancellations? Can you comment on that, please?

Sure. We haven't seen any significant cancellations, Wendy. We do from time to time and it is not frequent to see a customer during the project maybe extend a month or two. I think more significant, Wendy, what we're seeing is that at the onset of the relationship or in the contract we're seeing customers direct longer lead times. For their capacity planning, their supply planning and the benefit to us is it helps us plan our capacity as well.

Finally one quick one. About four years ago we wrote a note talking about your Flowserve strategy to prior management of moving production to low-cast regions. At the time the manufacturing in low cost countries was about 9 or 10% of sales. Can you talk about where we are now in that process?

Well, in the last two years, Wendy, it's increased over 50%. It's probably more closer between 20 and 30% right now. We'll continuing to look at that. As you probably know, we're opening up a pump valve and seal manufacturing facility in Suzhou, China. That'll happen in March. We're opening up a new pump manufacturing facility in [Komadou], India. We're expending the valve facility, when pump moves out of Bangalore. We are also putting engineering centers into India. We have right now the engineering center for the development of our seals actually in Chennai, India and we're looking at putting an engineering center into China. We've also added a lot of capability, especially in machining capability and machining centers into Mexico. We have a major move in all the low-cost areas to make sure we have the products being built in the lowest cost facility.

Thank you very much.

You're welcome.

Your next question is from the line of Charles Brady with BMO Capital Markets.

Good morning. This is actually [INAUDIBLE] sitting in for Charlie. I just have a quick question on your valve segment. I think you mentioned within the Q that the chemical orders were coming back and obviously you had a really nice spike in the margins this quarter. We understand that you don't provide guidance but can you sort of comment on whether this current trend is sustainable or it's just sort of a general idea as to where you're headed there? And I have a couple of follow-ups after that.

Sure. If you look at our valve division, they are getting accelerating sales. And what you're also seeing is the benefit of where the markets right now are in pricing and their focus on execution. When they deliver on time, the customers will pay them for it. Also, in terms of the low-cost sourcing and manufacturing that we talked about earlier, they are moving aggressively into low-cost manufacturing markets which is giving them additional spreads in their margins. We are seeing strength in their markets, strong execution in their business and that is flowing through in efficiency in terms of their gross margins and operating margins.

Perfect. Just to follow-up on Wendy's earlier question about lead time. Can you give us an idea as to -- I mean, did the customers play a big -- I understand that a customer preferring a longer lead time was definitely a contributor but was that a very meaningful portion of the longer lead time? Also, why are the customers preferring longer lead time again? I'm not sure if I heard it correctly. Thank you.

Sure, that is a big portion of why we're seeing, what we talked about earlier, the conversion of bookings to sale has slowed recently because -- primarily because of longer customer directed lead times. In addition to that, and it correlates to that, we're seeing larger projects, just larger dollar, larger plants being built, they take more time. We think this is really being driven by a couple of things, the general supply base out there. Keep in mind, our products represent maybe 6 to 8% of an overall plant. So there's a lot of other constituencies that the customer has to deal with. So to that point they are negotiating longer lead times. Also, we think that they are getting us the queue. In other words, securing manufacturing slots early on. The point that I had is that also gives us a better planning cycle for our capacity management and our supply base as well.

Finally, of the current backlog [INAUDIBLE], can you give us an idea as to how much of that can be realized over the next 12 months?

Yes. We don't really want to give guidance on the backlog going forward. But I think the point we'll make, and we talked about this on the last call relative to bookings conversion to sales, is that you are starting to see the bookings convert to sales and sales accelerate.

Thank you.

Your next question is from Michael Schneider from Robert W. Baird.

Mark, I apologize for the granularity here, if you could look at the fourth quarter Pump mix from last year, I'm just trying to get a sense of -- we were up eight points in OEM mix in Pumps this quarter. What is the comparison for the fourth quarter?

I'm looking, Mike.

That's fine.

I've got three months and the nine months year-to-date. Let me just tell you some of the shift that we've seen. Year-to-date the mix of OE to aftermarket was 56/44. Even on a year-to-date basis you saw it trend up 400 basis points. I would say that just based on general recollection, it was probably closer to the 52, 53% mix last year, but that's without having the numbers right at hand.

The reason I ask is I'm trying to get a sense -- you had an eight point jump in OEM mix this quarter, year-over-year, does that figure grow in the fourth quarter?

In terms of -- you mean does original equipment?

Yes.

Again, I don't want to guide on what we will see in the fourth quarter. I can tell you that we did see, starting last year, strong bookings growth trend more towards original equipment. So you are starting to see the impact of that. As to what it's going to be in the fourth quarter, we are still seeing strong aftermarket sales on a growing basis but as I pointed out earlier, original equipment is growing very quickly. So I'll just give you those general indications without actually setting what we think the ratio will be in the fourth quarter.

What I'm getting at, Mark, is just another way of attacking is the fourth quarter margin in Pumps going to be up or down, because if the mix started to shift dramatically in the fourth quarter of last year, and unfortunately that data wasn't in the 2005 K, but if the fourth quarter started that mix shift, it would seem to me the incremental hit from shipping more project [worth] in the fourth quarter would be lesser-so than it was this quarter, which again would seem to enable you to at least hold margins flat or grow in Pumps in the coming quarter.

Yes. That makes sense. What I want to point out is, I guess simply put, is if you have $2 of aftermarket at 50% flow through or $10 at 25% margins, you still get accretive value to your operating margins and you can to your gross margins as well. We're staying very disciplined about how we take projects in. And these are large dollar projects that come through with good gross profit dollars, which go down to the operating income line. So two things I mentioned, if you see the execution on our original equipment in our Flow Control division you can make good margin off of that. And we believe we can do that as well in the Pump division. And with the size of the growth we think that will contribute to operating income and operating margins to get us to our target.

If you look back over the last three years, Pump margins in the third quarter have sequentially been down from second quarter to third quarter. Is that primarily just Europe taking vacation during the third quarter or why are Pump margins usually lower in the third quarter versus the second quarter, as they were this quarter?

I hate to admit it but you're spot on. A lot of it is Europe, which has been very strong for us. You're right, we have seen that sequential trend. One of the reasons is August is a slow month in Europe.

Fair enough. And then final question, just on the commissions. At our conference this week, you were discussing how many of the commissions paid on project work are paid at the time of booking not necessarily the time of shipping.

Right.

How does that play through the P&L now as project work becomes so significant in the mix and specifically, not quantitatively but qualitatively, how did it hurt the third quarter?

I went through it earlier. If you look at the impact of selling and selling related expenses, that was a third of our G&A increase in the quarter and has represented a third of our SG&A increase for the year. It's significant, but the point is that, as we talked about, commissions and inventory follow a booking but lead a sale. So as you get to that point of critical mass, for lack of a better term, as your sales start to accelerate, then you start to benefit and get leverage across those expenses but the expenses come first.

Precisely Thank you.

[OPERATOR INSTRUCTIONS] Your next question is from Jim Fong with Gabelli & Co..

Hi, good morning.

Good morning, Jim.

I was just wondering if you could just give us an idea of what you think the normal run rate is for corporate expense? Maybe you can give it to us as a percent of sales or maybe in absolute dollars.

This goes back to the issue of guidance, Jim. Let me just tell you, we do expect our fees to normalize. We do not see that as we start to achieve the sales behind the bookings that we've had that we are going to need to lever up our SG&A on a prorata basis so we should get leverage So I would expect that as a percent of sales over time we will be able to drive that down for a number of reasons. One on the fees and the other one is we start to simplify our platform. Over the next couple of years we've [yet] SG&A efficiency.

How long do you think it will take to get to your level where you think you'll be more normalized?

The sooner the better, Jim.

Okay. And then just shifting gears in terms of the Flow Control. You've done a great job in the execution there. Is there anything different in that business that you can't repeat in the Pump?

Not at all. I mean, one thing that's distinct is just the size and the duration of the projects. But there are a lot of things that are transferable. That's the point I wanted to make is if you look at our seals business and you can see its performance, that's 75% aftermarket, roughly 25% original equipment. So you can see the power of the aftermarket business. But that's not to say that there isn't power in original equipment business with the mix you see in the valve group as well. So we think that we can lend those benefits right to our Pump division and we're starting to see it.

Okay, great. Thanks very much.

Welcome.

Your next question is from Matt [Fawsnotch] with Clovis Capital.

I have another question about the Pump margin in the quarter.

Sure.

The Pump revenue was up 14 million from the second quarter and the profit was down 8 million. The margin in the second quarter was obviously 12.1 and then it went to 9.7. How much of the margin going down was the wave of OE orders coming through versus these one-off situations like late order shipments. And my second question is could you just explain a little bit more about why shipping an order late affects your margins in this quarter? Were they costs you accrued on those orders that you won't have when you ship the order? Can you explain that a little bit more, please?

Yes, I'll explain that briefly. What I want to point out is keep in mind the gross profit in Pump division went up year-over-year and quarter over quarter on a year-to-date basis and a quarterly basis. On the margin basis, the original equipment shipped, all other things being equal, will tend to have a downward impact on your incremental margins going forward. Having said that, those incremental margins may still be very strong and will be accretive to operating margins for us. On the second question, yes, timing of a shipment can have certain cost adjustments when you don't recognize all the revenue, depending on whether it is a percentage of completion or a project that falls under our requirements for percentage of completion as you build up the cost and don't realize the revenue until you achieve the sale. It either can be percentage of completion or smaller projects or other service items that are delayed shipping where you don't really receive the benefit and you've aggregated the cost.

I think you talked about some one-time stuff in here earlier. $2 million, that was in the Pump margin, right?

Yes.

That would have been about 50 basis points there. And how much do you think this late shipment affected the margin in the quarter? Roughly.

From what? If it was 50/50 mix, we've got to have kind of a standard variation and it's probably not worth really going into that analysis here. The point I want to make is that original equipment business doesn't mean that margins are going down. It's good dollar volume business. We've got pricing discipline around it and it certainly can continue to drive operating income, gross profit growth and operating income growth. The way I've highlighted that is if you look at, despite the fact that we had a 100 basis point decrement in our margin, we were still able to improve operating income by $10 million or 70 basis points. If you look year-to-date, we had a 70 basis point increase in gross margin and approximately 140 basis point increase in our operating margins.

We have a question from the line of Charles Brady with BMO Capital Markets.

Hi. I just had a couple of follow-ups. Within your Q you talk about incurring some expenses related to your upcoming IRS audit for 2002 through 2004. I know you mentioned you expect to incur some expenses that are similar in nature to those that were incurred from '99 through 2001. Do you think -- obviously I guess you can't comment on the exact figure, but do you expect the amount to deviate much from what it was in the previous audit?

Yes, let me just talk about this. This is a regular audit of the Company for 2002 to 2004. And what we did indicate was in the prior audit we'd gotten behind on providing some documentation and reconciliations. We've been very aggressive on that going forward and we have spent professional fees to make sure that we're very responsive and we have been and it's going well. So to that point we're investing fees right now to make sure that we're very responsive. The audit will take a period of time and it is yielding good results. We're going to do whatever it takes to be very responsive, now and going forward but I do expect that it'll start to trend down in terms of the professional fees we're going to have to spend to achieve that.

Okay. Finally, you mentioned the strength in the Russian district heating market as one of the drivers on the solid bookings in the valve business. Can you give us a little bit more color on what's going on over there, why it's strong?

We've seen in Russia, there's an awful lot of demand coming in for heating with people moving and people getting into new homes or places where they need heat. Our valve business is seeing just expansion in all areas for all of those types of valves.

Thank you very much.

We have reached our allotted time for questions. I will now turn the call over to Mr. Nagle for closing remarks.

Thank you all for joining us and we look forward [TECHNICAL DIFFICULTIES].

This concludes the Flowserve third quarter earnings conference call. Thank you for your participation.