福斯 (FLS) 2006 Q4 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 the 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. Hello to everyone. Welcome to Flowserve's Q4 and 2006 investor conference call. Thank you very much for joining us. This call is also being webcast, including a PowerPoint presentation via our website at www.flowserve.com under the investor tab. You will also find a PDF version of the presentation slides if you'd like the hard copy to print off.

For those of you who have accessed today's call through our dial-in phone number and wish to also follow along with the presentation via 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 the website beginning at approximately 2:00 p.m. Eastern time.

Joining me today from Flowserve are Lew Kling, President and CEO; CFO, Mark Blinn; and our Chief Accounting Officer, Dick Guiltinan. We will start the call with some opening comments on the state of the business and the market from Lew followed by Mark who will provide more details on the financial performance of the quarter. . Lew will then come back and provide closing comments and summarize our outlook for 2007. In addition, I 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 10-K for the Company's Safe Harbor statement which can be viewed on the Company's website for a full discussion of these risks. Now I'd like to turn it over to Lew Kling, President and CEO of Flowserve.

Thanks, Zac, and good morning. I'm pleased to report this has been a great year for Flowserve led by a very strong fourth quarter and a record year for bookings, revenue, and earnings. Our fourth quarter bookings grew 21% over a very strong fourth quarter the year before. Full year bookings were up over 23% led by our pump growth with a very strong 34% growth year-over-year reflecting the continued strength of our core markets. This sends us into 2007 with the largest and strongest backlog in the history of the Company. Our revenue grew almost 20% in the fourth quarter and just under 14% for the year. Our gross profit, operating income, net income, and earnings per share also achieved record levels for the year.

In addition, the management team has continued to work on our operational excellence initiatives which supported the year-over-year increases in both gross margin and operating margin while experiencing a significant increase in original equipment orders in our pump division, and we're very pleased with this high rate of original equipment business because as it was billed a lucrative installed base for profitable aftermarket business going forward thus enhancing the positive outlook for the Company.

Turning to cash flow, we repurchased 1.8 million Flowserve shares to date including 500,000 shares since year end. Of the 2 million share repurchase program that was approved by the Board of Directors last year, we plan to complete this repurchase in the near future. We also continued to decrease our debt, fund our retirement programs and reinvest in our business. We are also very pleased to announce the resumption of a quarterly dividend that was previously suspended in early 2000.

As discussed in yesterday's press release Flowserve will pay a $0.15 quarterly dividend to shareholders of record as of March 28, which will be payable on April 11. We intend to pay regular quarterly dividends for the foreseeable future but any future dividend will be reviewed and approved by the Board of Directors at their discretion. The resumption of this quarterly dividend demonstrates our confidence in our ability to continue to deliver strong cash flows while returning cash to our shareholders without sacrificing the investments required to grow the business.

While our management team achieved record levels in bookings, revenue, and income, invested in our future, and lowered our debt we also fully remedied our internal control environment and reported no material weaknesses for 2006. This was accomplished using significant internal and external resources but the investment in our people and systems was well worth the high cost of success. In short, we are proud to announce we accomplished our mission by achieving our commitment to file our SEC financial reports on time and without any material weaknesses in our internal controls. We can now focus more intensely on program initiatives we have put in place to further improve gross margin and reduce SG&A to support significant improvements in 2007 which mark will review later in the call.

As you can see in slide 3, the fourth quarter saw significant continued growth in bookings even when compared to the excellent fourth quarter achieved in 2005. Revenues continued to accelerate in 2006 driven by a large growth in bookings from late 2005, which we successfully converted to revenue, and as previously mentioned, backlog increased to its highest levels in Flowserve's history, adding to our confidence for a strong 2007. This was all accomplished while lowering overdue backlog and raising on-time delivery broadly throughout the organization. Gross profit also continued to increase and was 19% in Q4 and was over 14% for the full year.

Our operating income adjusted for some realignment charges, such as product line relocation and reduction in force increase over 25% in Q4 and over 25% for the full year. Adjusted net income improved over 71% in Q4 and 131% for the full year. This led to an adjusted earnings per share of $2.15, which is an increase over 131% over last year, or $2.00 per share including the realignment charges mentioned earlier. These results and improvements in the business fundamentals reflect why I'm extremely pleased with the Company's performance in 2006.

I would like to spend a few minutes talking about the $12.9 million in realignment charges we experienced in 2006 that led to the adjusted earnings we have just seen. These charges reflect the selected realignment investment we made to improve our infrastructure of the pump and flow control segments as we better positioned the business for the future. These charges cover initiatives such as product line relocations, outsourcing IT functions, and the resulting reductions in force primarily in Europe. These actions were all geared towards increasing the operational efficiency of the business which we expect to see in 2007 and beyond.

As you can see on slide 5, our financial performance was not limited to the income statement. Our strong cash flows in 2006 also enabled us to continue to pay down debt and drive our net debt-to-capital ratio to a seven-year low of 33% and within the range we consider to be the proper capital structure for the Company at this time.

Slide 6 gives awe picture of how closer bookings growth has occurred on a quarter to quarter basis since 2004. The accelerated ramp in growth began in the third quarter of 2005 and has continued to climb to the levels we see today with the fourth quarter of 2006 being the biggest bookings quarter in the history of the Company. While looking at aquarter over quarter bookings from a growth perspective, we've seen explosive growth since 2004. Even with the significant quarterly bookings growth rate of 23% in the fourth quarter of 2005, the fourth quarter of 2006 grew an additional 21%. I'd like to further point out that in every quarter since 2004, we have seen a two-year quarterly growth rate of over 40% with the fourth quarter approaching 50%.

Slide 8 shows the relative conversion times between bookings and sales from 2001 to 2006. As you can see, on average, bookings won in one year relatively translate into the revenues for the following year, suggesting a consolidated one year bookings to sales conversion cycle. In 2006 sales were $3.06 billion, mostly from bookings won the previous year of $3.02 billion. The 2006 record bookings of $3.61 billion represent a large percentage of pump orders than in previous years, many of which were significantly larger and more complex original equipment projects. This has led to customer requested delivery dates generally moving out a few months from the recent one-year conversion cycle. This should be partially offset by increased valve and seal orders as well as increased aftermarket orders which generally have shorter delivery schedules.

It should also be noted that these strong project orders today should lead to significant high margin aftermarket orders tomorrow, based on our experience in this industry over many years. As you can see in the year-over-year comparison of Flowserve's bookings by market, the Company saw growth in almost all of its core markets last year with the largest double-digit growth areas in the oil and gas, power and water markets. As we looked at sales by global region, we likewise saw growth throughout most of the regions, though we have been particularly successful in the Middle East and the Asia Pacific regions. These are regions where we continue to invest more of our assets such as opening a pump, valve, and seal manufacturer in Suzhou, China, and a new quick response center in Shenzen, China, and a new pump manufacturing facility in Coimbatore, India, as well as we're expanding our valve facility in Bangalore, India, and we have announced a joint development of the largest aftermarket repair service and test and teaching center in Saudi Arabia, covering all our products in the region.

As we have discussed in the past, we have six key strategies that we have communicated throughout the Company to drive aligning and support. I would like to briefly review some of the progress we have made on these key strategies with respect to our near-term focus. As mentioned earlier we are driving growth in the emerging markets, specifically in Asia Pacific and China, supported by our new manufacturing and technology centers in China and India. These facilities will become our entree for further penetrations into the China and the Asia Pacific markets as well as increasing our global low-cost sourcing initiatives. They will also further expand our global intellectual capital through the development of new technology centers in Suzhou, Bangalore, and [Chunai]. We have also continued to increase our low-cost sourcing initiatives in Mexico and Eastern Europe.

In addition, we have continued to increase the number of black belts and green belts delivering productivity increases throughout the Company. This includes launching a new lean initiative across our footprint supported by an intensive training program that should further reduce costs throughout the organization. We have also continued to increase our global presence by adding additional quick response centers worldwide to be closer to our customers and to increase our aftermarket capture rate. Funding has been increased for internal research and development and we experienced significant increases in customer-funded product development in areas such as geothermal and subsea oil and gas production. And finally we continue to make progress on operating on a more efficient integrated platform by standardizing our ERP systems and developing shared service support initiatives across the operations.

The next slide shows two initiatives that represents some of the work our new strategic sourcing group has been doing during the past few years. By initiating the reverse auction process as well as commodity managers across our manufacturing footprint supported by integrated sourcing specialists within the divisions, we have been able to accelerate sourcing segments across the Company. We have also accelerated the use of low-cost country sourcing in India, China, Mexico, and Eastern Europe. The trends on these charts are extremely positive and represent substantial progress in our commitment to reduce costs. They are only the beginning. We will continue to drive strategic sourcing as a commodity strategy as we drive savings throughout the supply chain and the low cost sourcing initiatives.

As we continue to drive our continuous improvement initiatives in 2006 we expanded the number of green belts to approximately 900 and black belts to approximately 100. While our continuous improvement program has been primarily built around Six Sigma it is now being expanded to focus on lean in 2007 and will include all functions within the Company, not just manufacturing.

The next chart represents a good example of one of our many black belt programs across the Company. Our pump division needed to focus on driving costs out of our warranty expense. As the graph indicates, over the past two years we have reduced our warranty costs almost 40% as a percent of sales. This was done through the implementation of root cause analysis, corrective action programs, value stream mapping, and controlled plans and metrics geared towards quick response to problems preventing poor quality in manufacturing and tests and eliminating repeated errors. We continue to monitor our key markets and are pleased to see the European industrial forecasting group showing consistent five-year CAGR of approximately 4% in our core markets. A recent internal study with a major strategy consulting firm helped us verify this growth pattern for the future and, in fact, their estimates were even higher. We are obviously seeing growth rates significantly higher than those projections which appear to represent a combination of conservative forecasting and increased market share. We also continue to see the announcement of additional investments specifically in the Middle East and Asia where the demands for our products continue to grow. I would now like to turn the meeting over to Mark Blinn, our CFO, for a more detailed look at the financials.

Thank you, Lew, and good morning. We do have a lot of information to cover but I want to give you an overview of what I'm going to discuss before we get into the slides. First, I'm going to review the snapshot of fourth quarter and the full year, and Lew has covered a lot of this but you will recognize that our bookings did start to convert to sales and we saw sales acceleration in the fourth quarter. We'll talk about the impact of original equipment and product mix on gross margin and also the impact of significantly improved valve margins.

We'll discuss the increase in SG&A in the fourth quarter and for full year and later on talk about what we're going to do to drive that down and achieve scale. We'll spend time on each one of the segments reviewing pumps, the impact of original equipment shift, and some of the products, valves, strong margin improvement through pricing and manufacturing efficiency, and continued steady performance in seals. When we look at SG&A we'll review what drove our increase and where we have opportunities for scale. Some overriding themes to consider are the ERP design phase. As you know, we're moving into ERP implementations and last year we spent a lot of time on design, and that is expense. Also finance costs. We've talked about this for two years, and we see a substantial opportunity in 2007.

Finally, the stock modification. In the last two years we've had stock modifications resulting from transition of executive management and the expiration of our window for option exercise. We do not anticipate that in 2007. I'll touch on interest expense, cash flow and working capital and provide an outlook for 2007. With that, I will turn it back over to Lew for some final comments.

If you turn to the next slide and Lew has covered a lot of this, let me just highlight some things here. Revenues increased 19.6% to 883.5 million. Gross profit had a strong increase of 19.1% to 286.9 million. Gross profit for the third quarter was 32.5% representing a 10-basis-point decrease, and the general themes here is that we did see in the fourth quarter a 550-basis point increase in original equipment which impacted margins, and that was offset by substantially higher valve margins. If you look at SG&A, SG&A increased 23.7% in the fourth quarter to 227.1 million. We'll review that in just a moment.

SG&A as a percent of sales in the fourth quarter increased 40 basis points. Reported operating income increased 10.2% to 63.3 million. It is important to note that as you compare the fourth quarter in '05 and '06 there were realignment charges in both years. If you adjust those, operating income increased 25.4% to 75 million and and margins increased 40 basis points. Reported earnings per share increased to $0.58 for the fourth quarter representing a 45% increase, and if you exclude the impact of the realignment, it increased almost two-thirds to $0.70.

Looking at the full year, revenues increased 13.6%, representing a conversion of our bookings from the prior year. Gross profit increased 15.7% to over $1 billion. SG&A increased 14.4% to 782.5 million representing a 20 basis point increase over the prior year. Operating income for the full year increased 20.5% to 239.6 million representing a 40-basis-point increase, and again, if you exclude the impact of the realignment in both years operating income increased 25.5% to 252.5 million, representing a 70-basis-point increase year-over-year. It is important to note that in the 2005 full year financial information, there was the charge of $27 million for the refinancing.

Turning to Flowserve pumps on the next slide, you can see the bookings increased 29.2% to 564.7 million, a substantial increase year-over-year. Revenues increased 24.3% increase year-over-year. Revenues increased 24.3% to 501.4 million this does include a shift from 2004 to 2005 of 550 basis points as a percent of sales to original equipment. Gross profit increased 16.1% to 144.6 million, and in the fourth quarter, gross profit margin decreased 210 basis points. As I mentioned earlier, this resulted from the original equipment shift mix of 550 basis points, and in addition, while we had ebulators and specialty nuclear pumps increase year-over-year we had a higher concentration of shipments of these pumps in the fourth quarter of 2005.

Operating income decreased 6.3% to 58.6 million. This does include the impact of 5 million of realignment charges in the fourth quarter. If you exclude that, operating income was relatively flat, and operating margin was down 280 basis points. There was some additional impact in the fourth quarter on SG&A in the pump division. There were increased sales and engineering resources to support the strong bookings. In addition, commissions were higher in the fourth quarter. This resulted from the fact that they had an outstanding year on their bookings performance, and many of the sales organization exceeded their quota in the fourth quarter resulting in higher commission payouts. They had stock option expense, increased IT costs related to an ERP design and implementation which took place in the first part of this year, and, of course, as I mentioned earlier, the $5 million realignment charge.

If you look at bookings for the full year, we had a strong increase of 34% to 2.110 billion. Revenues increased 15.7% to 1.017 billion. Gross profit increased 15.6% to 457.4 million. Again this gross profit number includes approximately 310 basis point shift of original equipment shipments during the year. Operating income increased 15.3% to 172.7 million, and margins were relatively flat year-over-year, but this does include a $5 million impact of the realignment charges in the fourth quarter.

The next slide shows the impact of shift mix. And what this shows, you can see that we were able to sustain margins in our pump division despite a significant shift of original equipment.

Turning next to the flow control division, they had outstanding performance year-over-year. Bookings increased 7.7% to 255 million. Revenues increased 15.4% to a little less than 267 million. Gross profit increased 25.2%. Again, this resulted from very strong pricing in manufacturing efficiency year-over-year as well as benefits from sourcing from more low-cost areas of the world.

Gross profit increased 260 basis points in the fourth quarter year-over-year. It is important to point out in that 2005 there was approximately a 60-basis-point impact from a specific warranty accrual. Operating income increased a little less than 36% to 26.2 million, and operating margin reported increased 140 basis points to 9.8%. This does include a $5.4 million impact of realignment charges. If you put that back in, operating income increased 63.7% to 31.6 million, representing a 350-basis-point increase in operating margin in the fourth quarter.

If you look for full year, bookings increased 13.3% to 1.60 billion. Revenues increased 11.2% to a little less than 995 million, and gross profit increased 17.6% to 338 million, representing a 180-basis-point increase in gross profit margin. A lot of that flowed through the operating income line, as you can see, as operating income increased 25.8% to 115.9 million as reported, and this does include a $6.6 million impact from realignment. If you put that back in, operating income increased 33% to 122.5 million, representing a 200-basis-point increase. An outstanding year for our valve division.

Looking at our flow solutions division good, strong, steady performance year-over-year. Bookings increased 16.7% in the fourth quarter, revenues increased 13% to 130 million. Gross profit increased 9.1% to a little less than 55 million, and gross profit margin was down year-over-year 150 basis points. It is important to point out that there were two things that impacted the gross margins in the fourth quarter. We had a substantial amount of projects that shipped out. In addition, in the flow solutions division, we had a beta site for our ERP implementation in our Dortman location and we took a very slow and methodical process in implementing that site which did impact their results for a short period of time, and we've recovered this year.

Operating income reported increased 3.9% to 22.2 million, and margin decreased by 150 basis points. If you add back the realignment charge last year, in the seal division, you can see that operating income decreased 5.7% to 22.2 million. For the full year, bookings increased 9% to 505 million. Revenues increased a little less than 12% to 496.6 million, and gross profit increased 12.4% to 219 million representing a 20-basis-point increase year-over-year. Operating income increased 12.6% to 98.5 million, and operating margin increased 10 basis points year-over-year.

On the next slide what I would like to do is just take you through a year-over-year SG&A comparison and show the impact of certain line items. What this does is show a year-over-year comparison in the fourth quarter 2005, 2006, and a full-year comparison in the change in the far right column. What we'll do is review each of these items and talk about the opportunity for scale. The realignment charges, as you can see, in the quarter and in the year had an increased impacts on SG&A as a percent of sales. As Lew mentioned, we think these will provide a quick payback on terms of these expenses within one to two years and drive more efficiency in our gross margin and our operating margin.

Selling expenses were 12% for the quarter and 12.2% for the year. We did see scale for the full year, not for the fourth quarter, as I mentioned earlier, a lot of this resulted from -- a lot of our selling organization exceeding their plans with the strong bookings growth that we saw this year. We do anticipate that we'll see continued scale in selling expenses going forward as our bookings start to convert to sales.

Legal expenses increased year-over-year both for the quarter and for the full year, representing expenses related to our compliance efforts. IT expenses increased for the quarter and the year, as I mentioned earlier, last year we were in the design phase of our ERP systems, and a lot of those costs are expensed as incurred. Finance professional fees both for the quarter and the year we saw scale, and we anticipate further scale as we look into 2007, and I'll talk about that more in just a minute.

Salaries for the fourth quarter, we saw leverage for the full year. We had an increase year-over-year. This is really representing the full year impact of the engineers we hired, the finance resources that we put in place. We do see opportunity for scale in years going forward. Again, as we have discussed before, travel was up year-over-year, and I will talk about that in just a moment.

Next we'll turn to the finance professional fees slide and this will be the last time that we show this slide. Let me get to the far right column on the full year and give you the bottom line. We anticipate the corporate finance charges which are shown as 38 million in 2006 should range between 12 to 15 in 2007. The other amounts shown below for international audit and other advisory do include international audit fees. We anticipate that that amount will be roughly half of what it was in 2006.

Turning to interest expense, net interest expense was down $13 million year-over-year. It it's important to point out that approximately 70% of our term debt was -- is fixed at an average rate of 6.4%. Our balance on average for the year of this term debt was $650 million. Our average revolver balance during the year was approximately $145 million and it is LIBOR-based borrowing. LIBOR and other European short term rates did increase 160 basis points on average versus 2005. Bottom line, we do anticipate that interest expense will be less in 2007.

If you look at next slide and see our major uses of cash, you can see the impact of our share repurchase net of option proceeds. As Lew mentioned we did pay down $101 million of debt. We spent $74 million on CapEx in 2006. Approximately $30 million of that was on maintenance and machinery. We spent $22 million on expansion, particularly in low-cost areas. And 16 million on our ERP and IT systems. The remaining six was primarily health and safety and other items. We spent $36 million on our optional U.S. pension payment. Considering where current legislation is we felt that this was the right thing for the Company and its employees. And again we spent $51 million in cash on finance related professional fees, and we expect that to go down substantially in 2007.

If you look at primary working capital you can see that as a percent of sales it was 22.4% at the end of 2006. We did see an increase in inventory year-over-year, and that was to support bookings. We also saw, in the accrued liability section, which is not presented here, a substantial increase in advanced payments as we were able to get cash up-front from our customers to support our inventory levels and the project work. The impact of these advanced payments and accrued liabilities is approximately 250 basis points on primary working capital in 2006. The next slide just highlights what the impact on receivables, inventory, and accounts payable resulting from increased bookings and sales.

And now I'm happy to turn to a full-year 2007 outlook and what our initiatives and where we're spending our time and effort. We do see an opportunity to increase gross margins 25 to 50 basis points in fiscal year 2007. This will come from volume leverage, additional low-cost sourcing, continued operational excellence and pricing, and some of the things that will be impacting this will be material price increases, also the shift of original equipment to aftermarket, and business segment mix. Year-over-year, our pump bookings have been significantly higher than our other divisions, and so we will see a shift more, we believe, in sales to the pump business.

As we look at our opportunities for improvement in SG&A, there's a number of areas that we'll be focused on. We will be driving down professional fees, not only in the finance area but in other areas. We'll focus on tight headcount management, operational excellence in the SG&A, division SG&A reduction, scaling corporate to overhead, reduced travel, some of the offsets will be additional ERP implementation, and selling expensed tied to strong bookings. As I mentioned earlier, as people exceed their quotas they get more commissions but the Company benefits because it has more bookings to support future sales. Included in these numbers here as we have talked about before, substantially reduced finance fees and the lack of the stock modification in 2007. And with that I will turn it back to Lew.

Thanks, Mark. Turning to our last slide, you can see why I have a lot of confidence in Flowserve's ability to compete and win in our chosen market and to deliver a strong return to our shareholders. We see the markets we compete in as remaining strong as we head into 2007 and beyond and believe this provides great opportunity for the Company. We, therefore, are arranging our 2007 revenue estimate at between 3.4 billion and $3.6 billion. And as we discussed previously on the call, this includes the increased conversion time between bookings and revenue as customer directed lead times are generally extended.

We also spent some time discussing margins and the exciting opportunities we see for expansion. With the initiatives we have in place we believe we can drive between 25 and 50 basis points of improvement in gross margins in 2007, and drive much greater gains in future periods as these initiatives take even greater hold. On the SG&A front, we talked about a number of things we're working on to significantly improve our cost structure. In 2007 we believe we can drive consolidated SG&A savings of between 175 and 250 basis points through these and other programs to achieve even greater savings in future periods. We should continue to generate significant cash flow that will allow us financial flexibility as we go forward.

In closing, I just want to say that the end of the day it's all about execution, and that is what we're doing at Flowserve. I'm extremely excited about what I have seen since joining Flowserve two-and-a-half years ago, and I'm even more excited about what we see in the future. And with that, I'll turn it over to the operator to begin the question-and-answer period. Operator.

[OPERATOR INSTRUCTIONS] Thank you. At this time, your first question comes from Mike Schneider of Robert Baird.

The obvious topic is the pump margins, and I guess, can you walk through, were margins in Q4, operating margins, that is, in the pump division, below budget, and I guess I ask because it certainly was below analyst estimates, but maybe we were just too optimistic. So I'm curious relative to your budget were they below expectations?

Well, Mike, we don't really go into our budgets, but I can tell you we were very happy with the fourth quarter results. And when you were, I think, comparing year-over-year, one of the things that I mentioned is we did see a strong growth year-over-year, '05 to '06, in our ebulator pumps and specialty nuclear pumps. We just had a higher concentration of those shipments in the fourth quarter of 2005. We saw good growth in that and strong shipments in 2006 and believe that's a continued opportunity going forward.

On the -- just on the SG&A side, as I mentioned before, I can tell you one thing, when you set a budget at the beginning of the year I don't know that anybody really anticipated the level of bookings growth we were going to have during the year. It was outstanding performance. And when that occurs, especially in the fourth quarter, the selling organization starts to get in a sense in the money on their commissions because they exceed their quotas, we want that. I mean, that's my comment. Those were the two primary impacts on the operating margins for the quarter.

Great. Certainly nobody is complaining about the revenue growth but Q4, Mark, incremental margins were basically 0. In the pump division I think they were 3% even adjusting for the restructuring expenses. So is that a -- an expectation you'd have going forward, especially with orders up 23 and backlog up 64, or is there something unusual about Q4 that would make it more realistic to look back to the 20 and 30% type incremental margins you have had historically in the pump division?

Yes, Mike, as we talked about before, I really don't want to get into quarter by quarter guidance going forward, other than to say that we did see a big shift mix during that period, if you're talking about the gross margins, and then the impact of the incremental SG&A for the reasons I talked about before. We have seen bookings far outstrip the sales for quite a period. You saw that start -- the sales start to accelerate in the fourth quarter, and in addition to that we saw a big shift mix over that period of time. If you look at our bookings, our bookings, I think, shifted for, in the pump division, for the quarter and the year to about 62% as original equipment.

So there may still be additional shift, which could suppress the margins, all other things being equal, but we still have the opportunity in our backlog around the price increases that we have seen. Again, the point here is going back to the illustration we gave you before. Let's assume, for this example, that original equipment margins are 15%, and aftermarket margins are 45%. If you have a 50/50 mix, your implied gross margins for that would be 30%. If you increased both by, let's say, 200 basis points to 17 and 47, but your shift is 10%, you would have a 29% gross margin but in effect what you've done is two things. You have increased pricing and increased your margins and your efficiency and you have also built an installed base for the future.

I guess maybe then just looking at the backlog, you state in the K that you expect 85% of it to ship this year. I know this is reaching, but if you were to go back a year what do you think the backlog that existed at the end of 2005, what percent of that shipped in 2006, just to give us a sense of this lengthening of the backlog conversion?

That's a good question. I could tell you, just because of the conversion, I would anticipate that a higher level than that -- if that's, in fact what we end up shipping out during 2007, on a comparative basis, I think a higher amount would have shipped out during that period. The only thing I can do really is, looking at the conversion cycle, as Lew mentioned, we have seen them extend out a couple months.

Is I'll get back in line. Thank you again, guys. Congratulations on the entire 2006.

Thank you, Mike.

Thanks, Mike.

Your next question comes from the line of Charlie Brady of BMO Capital Markets.

Hi. Thanks. Good morning. A lot of discussion about the push-out in the project business stretching out, just got finished talking about that but I'm wondering, when you're looking at and talking to your customers and seeing the specific projects you are on, and trying to figure out when you would have slotted into that, at what point do we sort of get to catch-up to where our bookings on these stretched out project business starts catching up and we really -- this installed base starts making a difference on the aftermarket margins? Do you think that starts converting over to strong aftermarket year and a half out, two years out?

This is Lew. Normally what happens is, after you ship, you have got to go through your warranty period which could be a year could, be a year and a half two, years. On the average it's probably some where in between, but during that period you have start-up spares. So that's where the aftermarket first hits, because whenever you start up a large project, there's usually about 10% or so of start-up spares, so it starts then. Then after the warranty period obviously you start getting a lot of the aftermarket. So there is a delay from shipping until the warranty period is over. Could be a year, could be up to two years. But as I said, sometime in the beginning of that process you have the start-up spares which you start converting.

And, Charlie, I'll add on the conversion, if you're looking to when things may compress to shorter time periods, it's typically when your bookings, excuse me, and your sales become more steady state on a relative basis. What you have seen is you have seen very, very strong bookings growth, and a lot of -- underlying that on the customer-directed times are the overall supply base that's extended that out. So as bookings and sales start to converge, you will see more of a normalized impact year-over-year. Also, it's where the supply base is at the point in time. We look at this positively because the supply base is tight for customers, which means ours is as well. This gives us a longer planning cycle and it is important that we continue to execute and deliver on time.

Okay, I guess for my follow-up, on the realignment costs, safe to assume that what you had to get done you got done and '07 shouldn't experience that or is there a little bit more moving stuff to go around?

Well, as you can see from what we have discussed, last year we took a hard look and took a realignment charge in our seal division, and management spent a lot of time this year looking at, cross its footprint and its resources and looked at -- and took those charges right at the end of 2006. We'll always take a look at these. These are opportunities to optimize our footprint, or our resources, but what I can say in looking backward is those resulted from lengthy looks and consideration around the opportunities to optimize our footprint at this time.

So is it fair to say you feel you have an optimized footprint currently?

I think we're always looking for additional opportunities to optimize. I'm not going to say we're done. It's a continuous improvement process, but I think these three charges over the last year and a half were a step in the right direction.

Thanks.

Your next question comes from the line of Ned Armstrong of FBR & Company.

Thank you. Good morning.

Good morning.

My question really regarded some of your end markets, notably the oil and gas market. If you could just give us a little bit of color as to what you are seeing out there as far as how demand is shaking out internationally versus North America, oil versus gas, and just give us a little bit more substance there if you could.

Right now, as you can see from the numbers, on North America is doing extremely well. We haven't seen any major cancellations. Obviously we still see some of the stretch-outs with respect to deliveries, but those are all customer directed, and we talk a lot about the fact that the supply chain is causing some of that but a lot of it is because of the fact that projects are larger and they are more complex, which falls right into the sweet spot for Flowserve because of our engineering capability. Internationally, especially in Saudi Arabia and in China, we're still seeing an acceleration of orders. It's going extremely well. In the Middle East, probably 70% of the oil coming out of the Middle East comes out of Saudi. There are just a lot more projects to come. In fact, I was with some people yesterday from Saudi, and it looks very positive.

Okay. And then with regard to the wastewater performance, this is one of the few times that you have really explicitly mentioned very good performance there, and where I was going with that is do you anticipate that business to be a growing portion of your business, and are you generating the business vis-a-vis taking market share, or just growing with the market?

The water side of the business, we're in two parts of it. One of it is wastewater, but another part is desalinization side. We a major player in the desalinization side and we are a player in the wastewater side, as an example, winning a large project locally in Texas. We believe we're doing very well. Actually grew double-digit this year, and the whole market probably didn't grow that well, so, therefore, I'd assume we're taking a little bit of share, but the main area would be in the desalinization side.

Good. I'll get back in line. Thank you.

Thank you.

Your next question comes from the line of Scott Graham of Bear Stearns.

Good morning. I have just a couple of housekeeping questions, because there was a lack of a full fourth quarter P&L, and I was just hoping, Mark, you could tell us what exactly the single point numbers were for interest expense, other income, and corporate? Attempts to back into these numbers using the first three-quarters didn't necessarily work.

Sure, sure. I'll go through it right now. Sales, 883.59. Cost of sales 596.683. Gross profit 286.907 million, SG&A 227 million, net earnings from affiliates 3.6 million. Operating income of 63.3 million. Interest expense 17.4 million. Interest income 3.8 million. Loss on early extinguishment of debt about $0.5. Other income expense net 2.5 million. Earnings before income taxes 51.7 million. Provision for income taxes 18.4 million. Income from continued operations 33.35 million.

Very helpful. Thank you.

You're welcome.

Now, from that, what -- and I hope that doesn't count as my first question -- from that--.

A lot of people had that question.

Yes. What would be your thinking on the tax rate for 2007?

Yes. Well, good question. We do expect our tax rate to be lower. One of the unknowns that we have, and a lot of companies have right now that we're still evaluating, is the impact of FIN 48. As you know, that's new guidance and requirements around how companies account for taxes and how it impacts their provision. But as you can see, during the course of this year we have been driving our rate down, as we indicated. We are starting to invest in some of our tax planning strategies, so we do, at this point, see that our tax rate is going to be lower.

Okay. So no specifics, but just lower than the full year '06?

Correct. Our full year was 39.1% and we anticipate it to be lower than that.

Okay. And -- actually, I forgot to attach this on to the initial housekeeper, was, to the extent that you can give us FX by segment, that would be helpful as well, but the meat, sort of the follow-up meat question would be, you have a pretty aggressive SG&A reduction guidance, and certainly you did a nice job in laying out where that can come from, of course not necessarily giving us specifics on the buckets, but SG&A has been an issue with you guys for sometime, and it seems to me that with the need to support the bookings that you're doing, and certainly, Mark, you and I, Lew, you and I have talked about this, there's a requirement to spend money to support those bookings this is actually a good thing. So I guess, why would you come out with a guidance of that magnitude when, in fact, if this type of bookings level increases I would think that you would actually want to spend more money to support your infrastructure?

Yes, agreed. And what we're not suggesting is that the area of reductions are going to be in those areas around R&D, around selling expense, around engineering resources. The point that we're making is we believe we have a clear line of sight as I mentioned earlier, realignment, some of the finance costs, travel, things that are directly within our control, and we don't think are going to impact the bookings, the business, our margins, or anything going forward that we can achieve during this year. So that's the point we want to make. We are not suggesting, nor would we, that we're going to sacrifice our top line or our margins or our opportunities to do that. We think we can do that and reduce SG&A as we indicated.

Very good.

For example, Scott, if you look at our finance fees, you can see there will be a significant drop-off year-over-year.

Understand.

Stock modification as well. Then the realignment.

The FX? Do you have that?

You know what, I do not, Scott. I'll to have get back to you on that. Are you asking for the FX impact in the fourth quarter?

Sales, and particularly sales by segment. Bookings I can live without, but sales by segment would be most helpful.

In the fourth quarter year-over-year?

Yes, please.

We'll get that information to you.

Great.

Your next question comes from the line of Mark Grzymski of RBC Capital.

Thanks for the detail on the presentation. It's obviously helpful. Lew, you mentioned earlier, maybe at a prior caller's question about the landscape domestically in the oil and gas market, as well as other markets. I'm curious if you could kind of comment on the competitive landscape since I think in your release you talked about market share gains. I'm just curious where that's coming from, given the fact that most of your end markets are real strong. I'm just curious where you think you're gaining most market share.

Well, really, we believe we're gaining market share across the board. We look constantly at our competitors across the board and some of them are doing very well, but if you look at their orders for the year and for the fourth quarter, compared to our orders for the year and for the fourth quarter, in almost every case we're beating everyone. If you take a look at those numbers, compared to what the average market is, two of our consultants are talking about, that's between 4 and 5, in some cases 6% growth, and we're growing well into double figures, obviously we have to be taking market share. And we are growing faster than every one of our competitors that we compare against. So it's really across the board. It's obviously the Middle East a lot, in China, and in North America. Our North American business has done very, very well.

Okay. And then just a follow-up. As it relates to the North American market and the oil and gas, some analysts following that space are saying that market is kind of coming to a peak. Just wondering if you can comment on that?

Well, we haven't seen the peak yet. We are doing extremely well in those markets. Interesting when you take a look at the markets that we play in, in the U.S., and you look at refineries, there may not be a new refinery being built, but if you take a picture of it today, from 10,000 feet, and a picture of it, let's say, two years ago at 10,000 feet, you can see that most of them have really expanded, and that's where it is. It's a lot of aftermarket. There are some projects on the board right now, but most of it is considerable aftermarket. And remember, we build an awful lot of product in our U.S. factories that do go to the Middle East, do go to China, do go to the rest of the world. So a lot of North American business could be shipped out to other areas of the world.

Okay. I think that's my two questions. Thanks.

[OPERATOR INSTRUCTIONS] Your next question comes from Adam Comora of EnTrust.

First, I just want to congratulate you guys on cleaning up all the control issues and putting all that behind you.

Thank you.

My question is the EBIT margin guidance of up 250 basis points, the midpoint, is that on the GAAP operating income margin that we reported or the adjusted in 2006?

It's on the adjusted.

It's on the adjusted?

Yes.

All right. Terrific. And then my second question is, can you give us a feeling for what the debt levels might average in '07? I know it's a difficult question. I'm just trying to figure out what a better gauge of interest expense really should be.

You know what, actually, let me go back to your earlier question on adjusted. Part of the SG&A opportunity is the lack of realignment. I did not answer your question correctly. Our stated margins we think we have an opportunity up above that because we are not going to have the realignment charges and that's part of the improvement in SG&A year-over-year. Can you ask your next questioning again?

Yes, I'm just trying to get a better feel for the interest expense. You ended the year with 560 of net debt, or of debt on the balance sheet. Given that the average interest expense on that debt is somewhere around 7% can you give us a gauge for how much the revolver might average in '07 just so we can get a better handle on the interest expense?

Well, a lot of that is going to depend on our working capital needs but as you know, we did take right at the end of the year our term debt down by $100 million. That is termed out. So we will not be drawing on that facility again. I would -- we did see a significant increase in our primary working capital levels this year which draw on our revolver balance so as long as -- if bookings continue to increase very, very strong, I would expect that we'll continue to use that revolver in the interim periods to fund the working capital. But we will continue to use other avenues for cash flow as we talked about in terms of advance payments. So a lot of it depends on where the bookings go during this year.

Okay. But it seems like the interest expense should be somewhere in the 40s?

As I said, we do anticipate that it's going to be lower.

Okay.

But if you just take, for example, if you just take $100 million increase -- decrease, excuse me, in our term debt, at a 6.4% rate that would imply that all other things being equal we reduce interest expense by $6.4 million. The rest is going to depend on the interim working capital draws and where short-term rates go. And I don't have any idea where short-term rates are going to go.

Me neither. Thanks.

Your next question comes from the line of Rob Lietzow of Lakeway Capital.

Yes, hi. I already had my questions answered. Thanks a lot. Oh, you know what, actually, though, I do have one question, because you guys haven't really expanded on the concept of buyback. And I do applaud your efforts so far, but I would like to get a little more commentary on that.

In terms of the buyback that we have already announced?

No, in terms of additional.

Oh. Well, as we look at all of our cash flow opportunities, here's where we've come from. We announced the buyback back last fall, we purchased 1.8 million shares. We still have the opportunity to buy additional shares back under that approval going forward. Now we have declared a dividend for this year. As we look forward to our cash flow opportunities we still have additional opportunities on capital expenditures this year to invest in expansion opportunities and low-cost jurisdiction, our ERPs and other maintenance and equipment. As we talked about comparatively we expect finance fees to be substantially lower. We are going to have strong cash generation, and we are going to continue to evaluate how we deploy that cash, and that could result in a number of things. It could result in increased investment, it could also result in an additional share buyback or an increased dividend. We are just not willing to declare what we are going to do at this point.

That's fine. Thanks a lot. Keep up the good work.

[OPERATOR INSTRUCTIONS] Your next question comes from the line of Wendy Caplan of Wachovia.

On page 33 of your slides you talk about your reconciliation of LIFO to FIFO, and you state that the conversion has little impact on year-over-year comparisons and earnings growth. $0.09 added in '05, $0.10 additive in '06. I would disagree that that's little impact. And you mentioned that your decision to convert was driven by your need for comparability with industry peers. I'm not sure what peers you're looking at, but the peers that we look at of Flowserve's are all at least partially LIFO, if not all LIFO. Can you tell us what the real reason was for changing your accounting?

That is the real reason, Wendy. If you look back, our LIFO was a legacy approach that we took from historical times, and most of our sales are international, and a lot of the international jurisdictions don't allow for LIFO accounting. So we're really matching the type of business we are to the markets that we participate in, because a lot of the statutory filings in our foreign locations don't allow LIFO, and we have to convert back to FIFO. Secondly, we don't use LIFO for tax calculations or tax payment purposes. So we created a booked tax difference. Finally, as we have worked on simplifying our platform, internal controls, it is a big administrative effort to convert the statutory filings from foreign locations to U.S. LIFO. And what we have done is we have laid it out here, and so in a lot of our competitors are in foreign jurisdictions, and they don't use LIFO.

My follow-up question, given your backlog in the pump project business can you tell us how long the mix shift toward projects versus aftermarket will remain, and are you -- can you comment on the -- whether you're making money on your pump projects today that are going through the P&L?

Yes, two things. On how long we're going to see original equipment outstrip aftermarket on a relative basis, even though both of them are growing, we have still seen, as we talked about last year, bookings in the fourth quarter and for the full year had 62% of original equipment. So that is an increase over the sales ratio in 2006. So we still see strong project work coming through, and that will ultimately yield, as Lew talked about to aftermarket business. The answer is on our original equipment, yes, we are seeing profitable original equipment sales.

Any measure of that profitability?

No. We really don't break it out by project and by aftermarket other than to say that we see typically gross margins relative in the original equipment to the aftermarket around 2 to 3 times, and I think the example I gave earlier of roughly 15% on original equipment and 45% on aftermarket is a good indicator of where we have been historically. And those are gross margin numbers? Yes.

Thank you.

Your next question comes from the line of Charlie Brady of BMO Capital Markets.

Thanks. Back on the SG&A, kind of related to Scott's earlier question, as a percentage of sales, great job on your guidance as far as taking it down in '07, but looking at beyond '07, and historically where Flowserve has had SG&A at 21.5, 22% of revenues, I understand it's a vastly different business than it was then, and you've got to fund the growth, but I'm just curious as to beyond the '07 take-down of SG&A, is that just a lot of low hanging fruit, then we are going to flatten out beyond that, or do you see maybe another 50, 100 basis points beyond '07 of SG&A expense getting taken out?

We do see additional opportunity beyond 2007. I think what we're trying to point out here in 2007 is we clearly have line of sight to these opportunities but there are more, more efficiency that we can drive, a number of things. ERP implementation is going to drive incremental efficiency, how we align our resources is going to drive it as well. So there is opportunity going forward, and we will continue to drive that down.

Okay, thanks. Just on my follow-up question, just some clarification. In your comments you talked about your current capital structure saying you feel you kind of have the proper capital structure. You could almost read into that that as far as a debt paydown that that's going to slow a little bit. Am I correct in that, or would you expect Flowserve to continue paying down additional debt throughout '07? Given what your cash positions are going to be.

Yes, we have stated before that we look at our capital structure to be optimal around 30 to 35%, and we have seen actually debt pay down slow over the last couple of years as we've had good alternative uses of our cash. So going forward, what we'll do, is we are going to look at the best uses of our cash and how we deploy it and assuming we couldn't find an alternative for that we'd continue to pay debt down but we think there's going to be good deployment opportunities for our cash. So at this point from where we are right now saying that our capital structure we like where it is right now, we don't see the need to pay a substantial amount of debt down going forward.

Thanks.

[OPERATOR INSTRUCTIONS] Your next question comes from the line of Mike Schneider of Robert Baird.

Just a couple of follow-ups and housecleaning items. First on this LIFO to FIFO change, Mark, to be clear, the fourth quarter, as I calculate it, actually was depressed by the conversion by about $200,000. Is that math correct?

No, I don't understand where that's coming from. Fourth quarter, I'm sorry, of 2005 or 2006?

2006, because in the K you have given us the last seven quarters and the impact of the conversion from LIFO to FIFO, but we just got the fourth quarter number not with the LIFO calculation and the FIFO calculation, and at least by my math it looks like it was actually a detriment in the quarter of a minor amount, but a detriment.

No, I don't think that would be the case. First of all, we were not on LIFO in the fourth quarter, so there's -- that's why there's, in a sense, really no comparators. So I'm not sure I understand where your calculation. If anything, Mike, if you look at quarters two and three and the trend, and a lot of it depends on what the pricing of materials were, inventory levels and everything, and honestly we did not go through that calculation because we were off of LIFO at the time, but in the third quarter I think it was a $0.01 impact. That might be a good proxy for the fourth quarter, but as I sit here, I just -- I don't know, because we didn't do the calculation.

So on slide 33, Mark, where you say -- you've got the full year number computed under LIFO, net income, and operating income, and then computed under FIFO, technically the LIFO column would be three months of -- I'm sorry, nine months of LIFO, then three months of FIFO?

Correct. That is correct, yes.

I misinterpreted that. Okay. But regardless, if we use the third quarter of a $0.01 benefit as a proxy, that would be reasonable?

As I said, we haven't done the calculation. I was just referring to the third quarter. It could be $0.01, $0.02, or $0.03. I don't think it'd be much more than that.

Q4's share count we didn't get the precise number for just the fourth quarter, diluted share count. Could we get that?

Hold on just a second. For the fourth quarter, looks like 57.745 million.

Okay, and how is it that the full year -- sorry to get so granular -- how is it that the full year share count of 56.9 is below any of the share counts in the individual quarters?

Well, there's a couple of things going on, really under the treasury stock method, you take the average for the period that you're considering. Let me just give you a couple of things to consider. In the fourth quarter, if you will remember, we had a significant amount of stock option exercises in the first part of the quarter, and so that would serve, in effect, to dilute shares. We did buy shares back towards the end of the quarter, but you would have taken the average of the quarter. Then for the full year, that impact of those option exercises would be less because it was, let's say, 60 days before we started buying shares in of a quarter that would be two-thirds, of a year that would be one-sixth. The other thing to this question, I don't have the calculus or the math here, is you've got to keep in mind also during the year are basically some options expired, because our option program was closed, and they were, in a sense, reinstituted by shareholder approval with the stock modification. So I think those things there, and we'll try to get this information in more detail to you. Those are what have impacted those numbers.

Okay. And just one request. Is it possible you guys just file a Form 8-K or something and give us the restated financials by segment for the last -- for 2005 and 2006 quarterly? We've got the total company figures, but we can't -- we can no longer model by segment because we don't have the restated numbers.

Mike, we'll certainly take that into consideration.

Okay. Thank you.

You're welcome.

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

We'd like to thank everyone for joining us on this Friday, and we look forward to speaking with you soon. Thanks.

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