福斯 (FLS) 2007 Q2 法說會逐字稿

Good morning. My name is Tiara. I will be your conference operator today. At this time, I would like to welcome everyone to the Flowserve Q2 2007 conference call. All lines have been placed on mute to prevent any back background noise. After the speakers' remarks there will be a question-and-answer session. (OPERATOR INSTRUCTIONS) Thank you.

Mr. Nagel you may begin your conference.

Hello everyone. Thank you for joining us. Welcome to the Q1 2007 Flowserve investor conference call. Today's call is being webcast for the earnings presentation via our website at www.flowserve.com. Click on the Investor Relations tab to access the webcast.

Before we get started I wanted to make one technical note. For those of you who have accessed today's call through our dial-in phone number and also wish to follow along with the earnings presentation slides via our website, please hit the click here to listen via phone icon at the bottom of the event details page. I'd also like to note our webcast will be posted on our website, for replay, approximately two hours following the end of the call. The replay will remain on the site on demand for next few months. On the call are Lew Kling, President, and CEO of Flowserve, Chief Financial Officer, Mark Blinn, and Chief Accounting Officer, Dick Guiltinan. Following our commentary we'll begin the Q-and-A session.

Regarding any forward-looking statements I'll refer to yesterday's earnings release, the earnings presentation, for Flowserve's safe harbor statement on this topic. The safe harbor statement is also outlined in our 10-Q filed yesterday in our 10-K filing. All this information can be found on the Flowserve website under the Investor Relations section. I encourage you to read these statements carefully with respect to our conference call this morning. Information in this conference call including initial statements by management plus our answers related in any way to projections or other forward-looking statements are subject to Flowserve's safe harbor statement. Now I would like to turn over to Lew to begin the formal presentation.

Thanks, Zac, and good morning. I'm extremely pleased to report the second quarter was another great quarter for Flowserve.

The team executed well against our strategic priorities and continued to make marked progress towards achieving the goals we set out for 2007 and beyond. In the next few slides I will take you through some of the significant highlights for the quarter, outline our financial performance, at a macro level, and walk you through what we're seeing in our key markets at both the segment and geographic level to highlight where we've been and what we're seeing going forward. Lastly, I will take a few minutes to outline some of the key investments we're making in the business to drive success over the long term.

Slide three provides some of the significant highlights of the second quarter. And you'll note, we continue to set a number of new records for the company. The first and maybe the most important record was earnings per share was up 91% versus the second quarter 2006 to $1.11 per share including a one-time tax benefit. This brought the year to date EPS to another record of $1.69 up 88% versus the prior year. During the quarter, we continue to achieve some very strong bookings with the second consecutive quarter of bookings exceeding the $1 billion mark which was another second quarter record.

Growth in bookings was a very healthy 16% coming on the heels of a 31% growth rate in bookings in the second quarter of last year. Record second quarter sales continue to accelerate to $931 million up 24%, reflecting continued strong conversion of existing backlog to sales and strong end user aftermarket capture. It should also be noted that the strong aftermarket sales includes just the early stages of the aftermarket growth that should occur from the significant ramp-up in original equipment project wins which began in the third quarter 2005. These projects in most cases have not yet completed their warranty phase or may not even have been scheduled for shipment by this point in time. This means there should be a significant amount of potential aftermarket opportunity that lies ahead as these project progress through their order completion and warranty periods.

Flowserve is poised extremely well to capitalize on these aftermarket opportunities because it's our original equipment entrenched in these project. We have also made significant progress on operating margins as we drive towards our goal of between 200 and 300 basis points improvement in 2007. In the second quarter SG&A as a percentage of sales was reduced 180 basis points to 22.5% and is down 210 basis points year to date to 23.8%. We drove an additional 70 basis point improvement in operating margins to 10.4% surpassing the 10% operating income level for the first time in five years. We've also seen our end market conditions continue to be very favorable in the second quarter.

Further, the outlook heading into the back half of 2007 remains favorable across our markets and geographies. As we discussed on our first quarter earnings call based on the strength of our end markets we have continued to invest in the growth of the business in strategic locations most notably production and test capabilities in Mexico, India, China, and the Middle East. And in the second quarter we continued to invest in quick response center expansion building on our strategy of continuing to be close to our customers to provide them with the products, solutions, and aftermarket support they need when they need it and where they need it. Additionally, in Q2 we completed our 2 million share buyback program as planned.

We're also pleased to announce that earlier this week we completed a favorable amendment to our current credit agreement. This amendment includes a two-year maturity extension to 2012 of the $400 million revolving line of credit. It also includes a reduction in the interest rate charged on revolving debt, reduced fees associated with letters of credit, and lower commitment fees on the unused portion of facility which when combined should yield cost savings of more than $1 million annually. Additionally, the amendment produces greater flexibility on the use of cash to pay dividends and repurchase shares. And also significantly loosens restrictions on acquisitions and capital expenditures.

Lastly, we are reaffirming our previously announced 2007 financial targets. We now expect sales to come in towards the high end of the range we provided between $3.4 and $3.6 billion dollars. We continue to expect operating margin improvement between 200 and 300 basis points. Simply put, a strong top and bottom-line performance in Q2 gives us increased confidence in our ability to delivering against the 2007 targets. Slide four shows in detail many of the second quarter P&L highlights I outlined on the previous page. I won't go into every number but you can clearly see that our performance in the second quarter and year to date was extremely positive from the top to the bottom of the P&L with strong bookings, strong sales, reduced SG&A as a percent of sales and strong earnings.

As you measure our own internal scorecard we continue to be especially proud of our global team's ability to drive net income and earnings per share growth faster than we are driving our sales. This demonstration -- demonstrates that our ongoing focus and discipline in operational excellence and SG&A cost reduction programs have been delivering the results we need to drive success throughout the business. As highlighted in the front section of the presentation, our bookings growth continues to be strong topping the $1 billion mark for the second time this year and the second time in the history of the company.

Additionally, our record second quarter bookings highlighted our 8th consecutive quarter of high double-digit bookings growth of the same quarter of the prior year. Sales throughput continued to be strong in the second quarter as we converted existing backlog and focused on a strategy of strong aftermarket sales and service capture. Sales were up 24% versus 2006. The highest growth rate in five years. Slide seven highlights our bookings performance by industry for both the second quarter and year to date. It also provides some examples of how we are positioning ourselves to win in our core markets.

In the second quarter we delivered strong results in all industries with particularly strong performance in water and chemical, each growing over 30% over the second quarter of last year. Our strength in water was driven by continued growth in global he demand requiring infrastructure development and ongoing upgrades to existing facilities. With our recent joint venture in China and continued investment in supporting reverse osmosis for decentalisation, we are strengthening our competitive capabilities in this premises market.

In the chemical market we continue to see new custom production capacity investments in both Asia and the Middle East. Additionally, customer investments in chemical productivity improvements continue to be strong in mature markets such as Europe and North America. Our internal investments in this market include fugitive emission control capabilities to meet enhanced environmental standards and special allies for caustic material flow and high pressure requirements. In addition to the tremendous growth we've enjoyed in water and chemical we also saw continued strong growth in our other major markets, oil and gas, power, and general industry.

It is important to point out that the 9% growth rate for the quarter and 23% year-to-date growth in oil and gas was on top of an extraordinary growth rate in the second quarter of 2006 of approximately 83%. The overall growth rate of oil and gas remains strong due to the increased global demand driving significant investments in exploration and production as well as large investments in North America refining. In addition, key internal and customer funded investments at R&D such as subsea technology align well with planned and future offshore projects.

Strong growth in the power market driven by increased demand on a worldwide basis continue to create opportunities in areas such as infrastructure upgrades and new power plant projects. For example, in China alone power demand is expected to increase at a rate of 11% per year driving requirements for new power plants at a rate of more than 30 sites per year. India has also experienced substantial demands for increased power. Flowserve's status as a longstanding leading supplier for critical power plant flow and control components is helping us maintain our competitive edge in this growing industry. We are also well positioned to serve coal gasification and nuclear projects, which are on the rise due to increased focus on CO2 emissions, increased demands for power worldwide, and a drive towards alternate fuels and chemical feed stock.

Lastly, the general industry segment remains a solid growth market. For example, our capabilities in serving both the mining and pulp and paper industries provide good growth opportunities in this segment. Turning to regional performance in the second quarter we saw strong sales growth broadly across every major mark with 19% or greater growth in each segment. In North America we saw a good balance across multiple industries driven by needs in power and refining capacity expansion rebuilding of water infrastructure and productivity increases in chemical production. Canada also experienced good growth driven by continued investment in tar sands and in Europe we continue to experience good growth across multiple industries.

Our investments in manufacturing optimization, service and test capabilities, as well as low-cost sourcing, should provide a platform from which we continue to improve our competitive position in this critical segment. In the Middle East we continue to benefit from the steady investments in upstream oil and gas as well as increased chemical infrastructure buildout, where our technologies particularly in pumps have provided many major product wins in this region. Our investments in service and support capabilities need to buy in Abu Dhabi as well as partnership with Al Rashaid in Saudi Arabia provide a strong base of securing the aftermarket business in this region. And in Asia Pacific we're experiencing growth on a number of fronts with capital investments occurring in our key served industries.

Our recently opened Suzhou manufacturing facility in China is now shipping pump, valve, and seals for both the Chinese market and for export, and the start-up of our joint venture with Changsha Pump will expand capabilities to participate in the aggressive growth of the Chinese water and nuclear power market. This combined with our internal capability to supply enstamp product for nuclear power generation is positioning us well for the pending growth in this market. While in the southeastern Asia area we have made investments in testing capabilities for compressors and expanded QRC capabilities which will enhance our ability to serve the aftermarket business in this region.

In India our investments in manufacturing capacity, low cost sourcing, R&D engineering centers and expansion of our JV partnerships are providing a competitive platform to serve the local market as well as the export mark. In Russia we are making investments in local resources and facilities to serve the indigenous market such as oil and gas and district heating as Russia invests heavily to refurbish their aging systems. Finally in Latin America the growth is being lead by oil and gas, as improving economies in the region support increased doubles investment particularly by the national oil companies.

Before I hand things over to Mark to cover the financials and segment performance in more detail I want to take a moment to review some of our key strategic objectives reached at this point. In our emerging market expansion plans we have increased our ability to serve these growth areas with our new manufacturing sites becoming operational and expansion of our joint venture businesses in China and India. We are particularly excited about our joint venture with Changsha Pump's, which increases our abilities to serve both the China water and China nuclear industries. Under operational excellence, our on-time delivery remains high, while our sales volume is growing, and we continue to get good traction on SG&A reduction programs.

We are continually driving operational improvements with increased test capacity for pumps in Europe, North America, and the Middle East, increased lean initiatives to support productivity as well as lower cost design development achieved through our Bangalore and Chennai RNV and engineering centers. In the area of product and solutions we are leveraging customer funded research, in development to gain technological advantages in key markets such as subsea, geothermal, nuclear, and coal gasification. Also our lifestyle advantage service model continues to gain acceptance as we've seen our strategic goal customers signing additional multi-site service agreements helping to secure future aftermarket business.

Our future on computer systems integration is also driving standardization across the company. And our global supply chain programs are linking low-cost sources in China, India, Mexico, and eastern Europe with many of our manufacturing sites worldwide producing additional cost savings. On the human resource front we have significantly enhanced our company-wide succession planning process focused on managing and developing the current and future leaders of the company.

So in summary, as we continue to drive growth in our company's performance we will maintain our focus on our customers, our capabilities, employees and shareholders. I would now like to turn it over to mark for a more detailed look at the financials, our segment performance, and our outlook for the remainder of 2007. Mark.

Thank you, Lew, and good morning. As Lew mentioned, we are very pleased with our second quarter and year-to-date results and with the progress we're making towards our objectives.

Before I get into the presentation I just want to highlight a couple of things for the quarter. We see continued strong demand for our products and services which did contribute to our strong bookings and our continued sales acceleration. Particularly in the profitable original equipment business but also we saw good growth in the aftermarket business.

We saw solid gross profit improvement year-over-year. We did see a year-over-year decline in gross margin and a lot of this was driven by OE growing faster than aftermarket and also we saw a 5% increase in the pump division as a percent of sales versus the other division. This was in most offset by improved pricing, operational excellence, absorption, product management, and other initiatives. In SG&A we did see continued traction in SG&A leverage. We got a benefit from good expense management.

As I talked about earlier, there was a shift to more OE and pump business has become a bigger percentage of our sales. That also does give us a benefit in terms of SG&A leverage because it typically carries a lower marginal SG&A burden. We have over the last year, though, continued to invest in selling resources, engineers, R&D, and the RP systems. In fact, a little over half of our year-over-year SG&A increase is those -- are those items. Our tax rate for the quarter we had a favorable tax rate for the quarter. We did see a $7.4 million benefit from resolution of certain tax audits and the tax law change. More importantly, we are starting to see the benefit of our tax planning efforts. As we've talk about, we are a global company with a global footprint with the opportunity for good tax planning strategies and we're starting to sea the benefit of that investment.

Looking at working capital we have seen the impact of strong order growth on working capital particularly in work in process in our pump business. We're able to offset a lot of this with progress billings in advance cash and I'll talk a little bit more about that later, but as we've talked about before over the last couple of calls historically this company generates substantial amount of its cash flow over the back half of the year.

With that I will turn to our second quarter consolidated financial results. As you can see, bookings increased $141 million to $1.053 billion representing a 15.5% increase. Sales increased almost $178 million to $930.7 million representing a 23.6% increase. Gross profit increased $49.8 million to $302.4 million representing slightly less than 20% increase. Gross profit margin did go down 110 basis points to 32.5% but this does include a 600 basis shift in original equipment in the pump business and a 5% increase in pump sales as a percentage of overall sales. SG&A increased 26.2% to $209.5 million and we did see an SG&A benefit during the quarter of leverage of 180 basis points.

Operating income increased $23.5 million to $96.9 million, a 32% year-over-year increase, showing 70 basis point improvement in operating margin. Net income year-over-year increased almost $30 million or 88.1%. That was driven by the improvement in operating income and the favorable tax rate. Earnings per share increased $0.53 to $1.11, and if you exclude the benefit of discrete tax ate temperatures was an improvement to $0.98. If you look for the year bookings have increased $351 million to $2.142 billion slightly less than a 20% increase. Sales have increased $327.4 million to $1.734 billion. As you can see sales have now gained traction with respect to bookings growth. Gross profit improved $97.3 million to $567.9 million representing a 20% increase.

If you look at SG&A. SG&A has increased $49.2 million to $413 million and as I mentioned before over half of that increase is selling resources, ERP, and R&D as well. SG&A as a percent of sales decreased 210 basis points indicating that we are getting traction on our targets and initiatives. Operating income increased $49.8 million to $164.3 million and operating margin improved year to date 140 basis points. Earnings year to date have improved 85.4% to $96.8 million and earnings per share have increased slightly less than 88% to $1.69.

Turning to the pump division, they had very strong performance for the quarter and year to date. They have seen success in profitable project wins which increased their installed base in their presence in strategic markets. They've been driving end user strategy which leads to more aftermarket business. Not only have they been capturing Flowserve's installed base but our competitors' installed base. They've been driving their re-engineering and upgrade strategy, where they seek to improve efficiency existing pump assets in the field. Also they have been driving their aftermarket growth through alliances, QRCs, and service centers.

Turning to results you can see that bookings increased $86.6 million to $616 million year-over-year in the quarter, representing a 16% increase. Sales increased $138 million to $525 million representing almost a 36% increase. So they are getting strong sales acceleration. Gross profit increased $34.2 million to $144.1 million representing a 31% increase. Gross margin did decrease 100 basis points to 27.4%, and this does include the 600 basis point shift in original equipment during the quarter. SG&A increased to $16.6 million to $80.1 million but SG&A as a percent of sales declined by 110 basis points. This was driven by two things. One, cost management but also as we talked about, the shift to more original equipment does provide a widening gross margin, but also does give us a benefit in SG&A.

Operating income increased $17.7 million to $65.2 million representing 37% increase. For the year, the numbers are similar. A $250 million increase in bookings for the quarter -- for year-to-date to $1.274 billion. Sales increased for the year $228 million to $943.8 million representing a 32% increase. Gross profit increased $56.8 million to $261.1 million representing a 28% increase. Gross margin was at 27.7% representing a decrease year-over-year of 90 basis points driven by a 700 basis point shift in original equipment sales.

If you look at SG&A, SG&A increased to $25.6 million to $156.9 million. Again, I will point out that over half of this was increased selling resources over 2006, R&D, ERP spend as we talked about before. SG&A as a percent of sales was 16.6% representing 180 basis point decline. They are getting leverage in their business. Operating income increased $32.5 million to $107 million representing a 43.6% increase. Operating margin for the pump business increased 90 basis points. They are getting leverage in their business.

The next slide shows the pump division mix and the shift and as I talked about before for the quarter, you can see that had 600 basis point shift in original equipment. For the year a 700 basis point shift. More importantly, what I want to do, is call your attention to the aftermarket bookings and sales growth. You can see that for the quarter and for the year we've had very strong bookings growth in our aftermarket business. And as Lew talked about a lot of the growth in our orders that you saw a couple years ago a lot of those projects are not necessarily installed or past their warranty period at this point. A lot of this has been driven by end user strategy. You look at the sales mix we saw good aftermarket growth in the quarter and for the year.

Turning to our flow control division they had very strong performance for quarter and year-to-date, tremendous operating leverage. We've seen strong top-line growth as they have had good penetration in the oil and gas and chemical market and also they've had good success in delivering a quality product on tame which has given them pricing power. They've also taken advantage of strategic market opportunities in the nuclear and district heating business. As Lew talked about, district heating is a great opportunity for this company. That is infrastructure in emerging countries and all parts of Europe that are fairly antiquated, 50 to 75 years old, and need more investment, and with the improving economies in those regions of the world, they are investing in that infrastructure and we are poised to take advantage of it.

We saw significant improved manufacturing efficiency through lean and CIP and absorption, and tight expense control. They have invested in selling and R&D as well, good focus on product management but they've done a great job at tight expense control. You look at bookings growth, bookings grew $41 million to $314.9 million representing a 15% increase. Sales increased for the quarter $32.7 million to $285.1 million. Gross profit improved $15 million to $101.4 million representing a 17.4% increase. And gross profit margin increased 140 basis points to 35.6%. SG&A increased only $4.1 million, and SG&A leverage improved by 120 basis points. So they're getting true leverage through their entire P&L.

Operating income increased $11.3 million to $41.1 million representing a 37.9% increase. Operating margin improved 260 basis points to 14.4%, a tremendous quarter. If you look at the year, the numbers are very similar. 82.4% gross in bookings -- $82.4 million growth in bookings representing a 15% increase, an $83 million increase in sales to $553.7 million representing slightly less than an 18% increase in sales. Gross profit grew $32.7 million to $194.5 million representing a 20% increase, and gross margin for the year is improved 70 basis points. SG&A as a percent of sales has declined 150 basis points which has given them 230 basis points of improvement in their operating margin. Once again, a tremendous quarter and year for the flow control division.

Turning to the flow solutions division they've had continued strong performance. This is an organization that is constantly investing to stay ahead of their competitors. They are focused on top-line growth through incremental project sales and installed base, expanding their QRC network and expanding in adjacencies. This includes areas like auxiliary systems, which sit around the pump for example, lube systems. These are areas of opportunity for this segment. They are focused on cost but they have been investing heavily in QRCs, selling resources, engineers, and ERP systems. This is an organization that is a number two competitor in the marketplace and wants to be number one.

Bookings increased $15.7 million to $138.4 million or 13% representing return of the investment on the selling resources they have put in place. Sales increased $9.5 million to $134.5 million, a 7.6% increase and gross profit increased $4.6 million to $61.2 million, gross profit margin increased 20 basis points for the quarter. SG&A did go up by $5.4 million over half of this spend was selling resources and staffing the QRCs. If you look at operating income, operating income year-over-year did decline $1.3 million. This was reflected in the gross profit improvement offset by the additional investments they've made in selling resources and in their QRCs. If you look at the year results again they are similar. $28.4 million increase in bookings to $279 million representing 11.3% increase. Sales increased $20.5 million to $263.7 million. Gross profit improved by $10.1 million to $118.4 million and gross profit margin increased by 40 basis points.

You look at their operating income, operating income did increase by $0.2 million and operating margin for the year has declined 160 basis points. This is primarily driven by their investment in the infrastructure to grow the top line. If you turn to SG&A corporate-wide we have continued to see traction in our SG&A initiatives. We have been investing over the last year in selling resources, engineers, R&D and our ERP systems. If you look down the various line items you can see we have gotten good traction for the quarter and the year in selling and marketing expenses and global finance professional fees.

As I mentioned to you last quarter we have been increasing our investment in tax planning opportunities and we're seeing the benefit of that. We are also investing is in our IT systems as Lew talked about to simplify our infrastructure. Calling your attention quickly to the other column you can see a 60 basis point decline year-over-year, inefficiency. I want to point out that last year we did have a one-time benefit of a resolution of an insurance claim that was over half of that different.

Turning to our tax rate we did have a favorable tax rate of 24.7% for the quarter. We did see a one-time benefit of $7.4 million, approximately $0.13 cents a share from the resolution of certain tax audits and tax law change. I do want to point out that there were a number of audits that were resolved, some favorable, some unfavorable but the net effect was favorability we do see now our Q3 and Q4 estimated tax rates to be a 35%. This is excluding any potential discrete items such as additional tax audit resolutions or the impact of FIN 48. Also, looking into 2008, we do see expected tax rate improvements that will occur in Q3 and Q4 to continue to occur in 2008. As I've talked to you about before we will see volatility in our tax rate but underpinning this is a declining systemic rate as we see the benefits of our tax planning strategies taking advantage of our global footprint.

Turning to working capital, our strong order growth in sales, have put pressure on working capital. If you look at receivables, receivables did increase on an absolute basis in percent of sales this has been driven by our strong sales and sales acceleration. Inventory did increase. This was primarily pump work in process as we are building these projects to deliver them to the customer. Also in areas such as motors we have been pre-ordering motors to make sure they are available when the pump is complete because that's the last thing that we install before we test it and deliver it to the customer.

Now we have been able to offset a lot of this increase in inventory by the $58 million increase in advanced payments from our customers. If you look at payables, relative to year end, payables went down on an absolute basis and as a percent of sales. As you can imagine as we are able to take advantage of advance payments from our customers our suppliers want payment as well. But more importantly, we are making sure that our suppliers are paid so that they will deliver their components on time because our primary focus at this company is on-time delivery to our customers. We will use our balance sheet to ensure that we deliver our production on time.

Once again I will remind you, that historically our cash flow is generated in the back half of the year. Just looking at our year to date cash flows two things to point out on slide 19. Capital expenditures are up year-over-year to $46 million. This includes the test loop capacity that we've put in all over the world. Our investment in India and China, ERP migration, additional machine capacity particularly in our seal division, and the significance of this is this is automated computerized machine that cuts labor time and costs down by a half or three-quarters. Also you can see through the payment of dividends in share repurchase we've returned $54 million back to the shareholder.

Turning to slide 21 and our outlook and we've talked about these metrics before. I just want to summarize one item. As Lew mentioned we've raised our sales target to the top end of the range that we provided earlier this year. A lot of that is driven by stronger original equipment and pump division growth. And as we've talked about before that will provide a gross margin head wind but also will give us somewhat of a tail wind in our SG&A as the marginal SG&A burden of original equipment and pump business tends to be lower on a relative basis.

So, our full year summary looking forward our end markets continue to show broad strength driven by increasing global infrastructure needs. These are populations that are moving from rural areas to cities and also we're seeing these emerging economies are strengthening and they are investing in new infrastructure and upgrading old infrastructure. Also, with constrained natural resources the world is looking for alternative sources of energy. All of these opportunities for us are core to our applications, and if you look generally on infrastructure, the supply of infrastructure cannot meet demand. Also strong original equipment sales is expected to continue to provide gross margin expansion head wind but we will get a tail wind from SG&A.

SG&A as a percent of sales, reduction opportunities still robust. We also, as Lew mentioned, are reaffirming our target in sales area and taking it to the higher end of the range and we are reaffirming 200 to 300 basis point improvement in operating margin. As I mentioned earlier our third and fourth quarter tax rates are estimated to be approximately 35%. We have a strong focus on cash flow and with our new amendment greater flexibility in how we deploy cash flow. Bottom line is execution remains our biggest key to success. This is a good time to be at Flowserve because we feel our destiny is within our control. With those comments I'll turn it it back over to Zac for questions and answers.

Operator, we're ready to take questions.

(OPERATOR INSTRUCTIONS) Your first question comes from Charlie Brady.

Great quarter. Can we talk for minute about the margins on the valve side of the business? Obviously best probably margins we've seen in a number of years. What's really driving that improvement in the gross margin there and was there anything in particular in this quarter that drove that higher that was maybe a little unusual and do you see that as kind of a sustainable level?

Yes, I wouldn't say there was anything unusual in terms of the gross in both the operating margins that drove it for the quarter. As you look at the valve business it's more along the lines of your traditional industrial products business. They have seen very strong pricing power in these markets. A lot of that is driven by the markets but also their ability to deliver quality products on time. Also their seeing a benefit from product management efforts. They are constantly investing in R&D and coming up with products and applications that the market wants. I talked earlier about the district heating opportunity. There's a big bow wave of demand for upgraded and new infrastructure all over the world to provide heating to their population. Also, their efforts around lean and CIP are driving more efficiency in their plants so they're getting additional capacity and lower cost capacity through plants through these initiatives. And the other thing is they're -- their focus on expense control. If you look at their increase for the quarter of SG&A they spent more than that year-over-year in adding selling resources, R&D in their ERP and other areas but they were able to offset that with good expense control. So the best way to sum this up Charlie, it's good focused management.

Okay. And on the valve and the bookings in the que you talked about getting large control valve order from LNG plant. Could you quantify sort of what part -- how much of the bookings in the quarter were from that large order?

No. I mean, it's -- it's not anything that we would disclose separately. But we just talk about that to show you the trends we're in but we typically don't call those out and quantify them.

Okay. Just more broadly in terms of hiring a lot of engineers and other sorts of people, where do you think you are sort of in this continuum of where you need to hire more people and sort of where that my start leveling off a little bit to help on the SG&A?

Well, I'll just tell you generally I want to make something clear, the biggest activity of hiring has really been during the course of 2006 and some has come over to this year, so we're still adding but we talked more about this last year, the reason I call that out is because we're doing compares to the first and second quarter. And we were adding those resources. As far as hiring concern with respect to engineering we are probably a little ahead of the game in engineering hiring. We'll continue to look around the world for the right engineers, not just North America but in Europe and India and China. Always good to stay a ahead because there is a turnover in the engineering ranks throughout the world. With respect to direct labor, that's hiring based on orders. As orders go up we'll continue to obviously hire direct labor people but we're very, very careful about hiring indirect labor people, the support people. We're making sure we keep that as low as we can to make sure that we don't over hire. So we're watching hiring around the company very carefully.

Charlie, one more thing on the direct labor. In certain parts of the world we do use temporary labor so that we can variablize that cost as needy.

Thanks. I'll get back in the queue.

Your next question comes from Ned Armstrong.

Thank you. Good morning.

Good morning, Ned.

Could you talk about acquisitions? Specifically in terms of how the opportunities might be affected about the worries out there about financing, if you see going forward more divestitures from the private equity area and then if could you touch on some adjacent areas to your pump valve and seal businesses that might be interesting for acquisitions. And I say that with that last part with respect to the lube equipment that Mark alluded to in his remarks.

Yes. Let me answer one thing about financing. We got this amendment done, at a reduced interest rate at a time time where the markets were as difficult as they've been probably over the last 15 years. So when we look at our company and our balance sheet we think we're imminent financeable the way we've got a very solid balance sheet. The other thing I will point out is we have made acquisitions in the lube system area and the auxiliary systems. There was a U.S. boils acquisition we made last year in the seal business that provided this additional capability. As to kind of overall acquisition strategy I will turn it over to Lew but I did want to point out market impacts around financing and we -- we don't think are going to be a head wind in this area.

As we've said before, in the area of acquisitions, we are at a point right now where we could, if the right acquisition came along, at the right price that would do the right things for the company, have the right margins to make sure that we continue to drive towards the goals that we've set for ourselves, are we actively in any acquisitions? No, we are right now -- we really believe at this point in time they will come to us but we could do an acquisition but we're not actively out there, talking to anybody. We have set up an acquisition group. A few people that are looking at a lot of different things but nothing on the horizon.

From a product strategic perspective with regard to acquisitions, does it make sense to you to look at adjacency areas such as in pumps, more of a focus on positive displacement pumps or within the valve area maybe a bit of a focus on some instrumentation? Just if you could let us know how you're thinking about it in that respect.

Our thought process is in two ways. Number one is, you know, additional pumps or additional valves, additional seals. That's always in the thought. But also the adjacency and even the possibility of a fourth leg. These things are all plausible things to look at. But as I said, right now there's nothing we're looking that it would fall in those big categories, but those are the categories that we look at, exactly what you're saying. Other pump type systems, other fuel type systems, and adjacencies, things that use rotating equipment or are rotating equipment.

Ned, just one other thing because I want to highlight, you know, some of the activity that you've seen occur in this company over the last couple years. We have made small acquisitions, tuck-in acquisitions that have been technology plays or some product that we want but also we have other ways of basically making, quote unquote, acquisitions. That could be in the form of joint ventures. We'll enter into joint ventures that will give us a market presence or a product presence in existing market. The Changsha example is a great example of that. That gave us an entry into the China water business. Also, it's how we use our capital. In the acquisition you can go buy versus build. We've made significant investment in geothermal applications, subsea applications, cryogenic applications. So, you know, we're not standing still. We don't want to suggest we're standing still at all. We're moving but what we take into consideration are the valuations in the market, you know, how we're positioned relative to that, complexity of the opportunity and our infrastructure as well. And those are all factors were considered, but at the end of the day we're moving and we're investing.

Ned, the other thing is in the last couple years we've made a $1 billion acquisition. It's called organic growth. We have been able to integrate that very well into the company.

Okay, good. Thank you.

Thanks, Ned.

Your next question comes from Mark Grzymski.

Hi, good afternoon. It's Mark Grzymski.

Good morning Mark.

Wonder if we could touch on gross margins. You're still maintaining the 33.2 to 33.4 gross margin for the year. Again that implies a pretty robust number in Q3 and Q4. I'm just wanting some clarification on, you know, is that going to come from the improvement in the ongoing improvement in valves, or are we going to see a nice uptick in the pump margin?

Well, I'm not going to make a call because we don't necessarily talk quarter by quarter. We did talk about we do see a head wind on that gross margin primarily from the shift to original equipment sales. We've seen a significant shift there and also in the pump sales. We have taken our sales towards top end of our range which -- and that has been primarily driven by that original equipment and the pump division sales. But we still have initiatives underneath all this to drive incremental gross margins. If you look at the impact of shift mix in the pump business, it would have been more profound just by the shift. We were able to offset a lot of that through some of the things I talked about. If you look at the valve business they in fact drove valve margin up and have consistently been doing that over the last couple of quarters and last couple of years for that matter. In the seal business they actually drove -- they continue to drive their gross margins up. You saw their bookings growth and sales growth, so those are the things we look at. We do recognize there's a head wind but we don't apologize for it because as I talked about earlier, what drives most of that head wind does give me an SG&A benefit as well. We're focused really on the operating margin of the business.

I completely understand that but I'm just trying to get my arms around the -- your target margin, and, you know, whether or not that target is achievable given the fact that, you know, you're mentioning head win, but, you know, with the gross margin that we've already got on the first half, we're kind of looking at like a 33.5% number in the back half of the year. So, yes, I just was trying to get clarification.

Sure, sure. No, I mean, it is a target. It is more difficult than it was at that time beginning of the year because of the shift that we've seen. The other thing is if you look at our business, we tend to ship a lot of our product and get more absorption during the fourth quarter and we continue to drive to it. We're not giving up, but we will readily acknowledge it's more difficult now than it was six months ago for good reasons.

And then kind of -- material prices, you know, there are some that are -- the impact there seems to be subsiding from what I can see in some -- on some materials. So that the head wind might not be as strong later in the year as it works through inventories. Is that accurate based upon my assessment?

We're seeing the same thing you just said. If you go back a year or so ago when material was really going up and down, like a yo-yo, and you saw copper prices exploding and nickel and, of course, steel because of China, a lot of that is subsiding so that makes things a little bit easier.

Couple of things. You can look to generally that could provide gross margin opportunities for this company are going to be the increased absorption and materials as you've talked about. We've talked over the last couple of periods about pricing increases and that continues to embed itself in the backlog and you relieve it as you start to sell things out the door. So those are what provide us the opportunities.

What type of price increases did we see in Q2 that kind of helped out? Can you break that out?

We don't talk about our price increases specifically, but we did in our valve division. They generated nice price increase towards the end of the first quarter we also saw some in our pump business as well. As you can imagine a lot of those are very specifically negotiated projects but what we are seeing is continued pricing power out in the markets.

Fantastic. Thanks for taking my questions guys.

Sure.

(OPERATOR INSTRUCTIONS) Your next question comes from Wendy Caplan.

Hi, good morning.

Good morning Wendy.

Question about your investment in the business your strategic thoughts about this. You talked about investing in people in terms of engineering and sales, but from publicly available data we calculate that you spent about 1% of sales in R&D last year versus the, I don't know, the average of the peer group would be about 2.5%. Can you talk about how you feel about what your thoughts are about spending plans on R&D and what we should see in terms of trends going forward.

Yes, as you can see, we have raised the R&D spending that we call our internal R&D, but what doesn't come out is the number that's relatively higher than the internal R&D, and that's our customer funded R&D. We get a lot of customer funding for things like geothermal, deep sea, and a lot of other different technologies that our customers want to us to develop for them which we can use obviously for everyone else. So therefore that part you don't see. In the area of R&D going forward it will go up slightly but our customer funded will probably be going up even a lot more Wendy.

So if 1% of sales was internally generated would it it be a like amount in terms of the customer-generated R&D?

We don't break that out specifically, Wendy, but it would be more. A lot of these are sitting in the projects. If you think about it, when we go negotiate a project for a new production facility there's a lot of R&D that goes into that application or a subsea application. So it's -- my estimate is it's going to be higher than our internally generated R&D.

Okay. Thank you. And I was somewhat concerned despite your explanation in terms of higher SG&A in the seal segment, or solutions, I guess. Because it's been so much, you know, for so long it's been the most profitable segment, and this is the third consecutive decline in quarterly operating margin in Q2. Can you -- do you expect that trend to continue as you increase your investment, or will it level off at some point? Will we get back to the -- you know, the low 20% range, or what are you thinking in terms of that?

Well, yeah, we won't comment on future trends and margins of the division but I can tell you this. If we look relative to our competitors, we believe above average margins and those do come with investment, and if you look at it, just a small change in SG&A can change those margins, so we're not concerned about their margins. We have encouraged them to go out and invest in people and drive the top line and also to continue to drive project orders to increase their installed base. When you put a new QRC in the ground you have to staff it. There's labor there. The business ultimately comes to that. And so we've been encouraging them to invest and drive their business, drive the top line, because you're right, it is our most profitable business, and the way that we make it it bet ser by driving top-line growth. But we're it not concerned about their margins.

Okay.

In fact, if you look from an operating standpoint, their gross margins have held and have improved.

Thank you. And one quick question, Mark. Could you give us an update on the ERP system consolidation, where we are today and?

Yes, we've -- as we've talked about on our ERP migration, it's -- there's a global backbone with infrastructure associated with that, but we're doing it on a site by site basis because aside from the requirement, global requirements and infrastructure there's business applications that go site it by site. So we're taking them one by one. We are probably, I would say, about 15 to -- about 20% through our evident in terms of that migration. So we expect to see it through this year. We expect to see continued investment through next year, and then it will follow on through most of the following year.

Okay. Thanks very much.

You're welcome.

(OPERATOR INSTRUCTIONS) Your next question comes from [Rob Leitza].

Hey, guys. How are you doing?

Hi, Rob.

You guys obviously are pretty pleased with where the plan is going. I guess what I'm trying to understand, in the past you've talked about bookings and the lag of turning bookings into sales, yet I understand -- looks like it's about 99% this quarter.

Yes. And -- but I'll -- fair point, but I will remind you, Rob -- I will say it now that we're on the other side. This is not a quarter-to-quarter business. We did see good sales acceleration in the pump business but we have still seen the underlying principles still are there in that these projects are bigger and we do see still longer lead times but we saw a good catch-up in this quarter, particularly in pump business.

Right. But I mean, I think the assumptions that people are making is that it the's 70% or 80% not in the 90s, which is probably more reality. And I guess the other question I wanted to ask you, I mean, when we look out into '08 and '09, where, you know, obviously the aftermarket will start to kick in, you guys have talked in the past about, you know, kind of this target 15% op margin. Can you comment on that at all today?

That 15% op margin is still our target. And as I mentioned all this year, as of this year, tied all the long-term compensation to all the key employees of the company to those numbers.

If you -- we're making progress towards that right now, Rob.

Oh, clearly.

Yes, and so we, you know, again, these are good conversations to have. We're making progress on our objectives, and we can see that the opportunity is there.

Right. And so I guess if you look at where this company is going, it's going to have clearly well in excess of $4 billion of revenues, and, you know, I think everybody's got a calculator, they can figure out what that means in earnings, but it's obviously a multiple of the earnings of the company today. And I guess -- I just don't quite understand when somebody asked you a question today about gross margin, I -- the way I heard it was gross margin is going down. There's all these head winds, and everything is terrible, yet gross margins continue to go up.

That's not what you heard. You heard that gross margin did go down but operating margin did go up. The point is, if original equipment becomes part of the sales of gross faster, for now, and FPD grows by 5% that does provide a head wind to gross margin. We offset a lot of that but also keep in mind that business tends to carry a significantly lower SG&A burden to it as well.

Right.

So there's no apologies, there's no excuses.

No, and I think the reason I asked it is I wanted to kind of test you on that. And I guess the one thing that I don't know if everybody really understands as well is kind of what the shift -- even if you have flat sales, if you went from heavy OEM to heavy aftermarket, if that shifted, your margin would explode in that situation.

Aftermarket business in gross margin in the operating margin line is more profitable than original equipment. So you know, that's -- that's a fact. But, the point I've been trying to make, for a period of time, is the original equipment business is profitable business.

Oh, yes, no, I understand that. And it's also installed base factor right? I mean, the more you put out there the more your aftermarket is going to grow in the out years.

Yes.

That's the right way to think about it, right?

Yes. That's a good way to think of it. As we put more of installed base driver end user strategy that will lead to more aftermarket activity.

I mean this year we're seeing 200 to 300 basis points in the margin, and obviously that gets you to around 10% op margin, and the goal is 15%. Is it fair to look out and say, up, we're going to kind of get --

(OPERATOR INSTRUCTIONS)

Rob, we may have lost you. I think we were going to what margins might be going forward, and we won't comment on those.

If there are no further questions this will conclude the Flowserve Q2 2007 earnings call. Thank you for joining this morning. You may now disconnect.