UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-K

 

 

Commission file number 1-13179

 

FLOWSERVE CORPORATION

(Exact name of registrant as specified in its charter)

 

 

Registrant’s telephone number, including area code:

(972) 443-6500

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

Securities registered pursuant to Section 12(g) of the Act:

None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  þ

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer þ     Accelerated filer o     Non-accelerated filer o

 

Indicate by check mark whether the registrant is a shell company.  Yes o     No þ

 

The aggregate market value of the common stock held by non-affiliates of the registrant, computed by reference to the closing price of the registrant’s common stock as reported on June 30, 2006 (the last business day of the registrant’s most recently completed second fiscal quarter), was approximately $2,010,083,768. For purposes of the foregoing calculation only, all directors, executive officers and known 5% beneficial owners have been deemed affiliates.

 

Number of the registrant’s common shares outstanding as of February 16, 2007 was 56,657,523.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Certain information contained in the definitive proxy statement for the registrant’s Annual Meeting of Shareholders to be held on May 17, 2007 is incorporated by reference into Part III hereof.

 

 

FLOWSERVE CORPORATION

 

FORM 10-K

 

TABLE OF CONTENTS

 

 

GENERAL

 

Flowserve Corporation is a world leading manufacturer and aftermarket service provider of comprehensive flow control systems. Unless the context otherwise indicates, references herein to “Flowserve,” “the Company” and such words as “we,” “our” and “us” include Flowserve Corporation and its subsidiaries. We were incorporated in the State of New York on May 1, 1912. We develop and manufacture precision-engineered flow control equipment, such as pumps, valves and seals, for critical service applications that require high reliability. We use our manufacturing platform to offer a broad array of aftermarket equipment services, such as installation, advanced diagnostics, repair and retrofitting.

 

We sell our products and services to more than 10,000 companies, including some of the world’s leading engineering and construction firms, original equipment manufacturers (“OEMs”), distributors and end users. Our products and services are used in several distinct industries across a broad geographic reach. Our bookings mix by industry in 2006 consisted of:

 

 

The breakdown of the geographic regions in which our sales were originated in 2006 were as follows:

 

 

We have pursued a strategy of industry diversity and geographic breadth to mitigate the impact on our business of an economic downturn in any one of the industries or in any one part of the world we serve. For information on our sales and long-lived assets by geographic areas, see Note 17 to our consolidated financial statements included in this Annual Report.

 

We conduct our operations through three business segments:

 

 

FINANCIAL INFORMATION ABOUT SEGMENTS AND GEOGRAPHIC AREAS

 

In addition to the information presented below, Note 17 “Business Segment Information” of the notes to our consolidated financial statements contains additional information about our business segments and geographic areas in which we have conducted business for fiscal years 2006, 2005 and 2004.

 

FLOWSERVE PUMP DIVISION

 

Through FPD, we design, manufacture, distribute and service engineered and industrial pumps and pump systems, replacement parts and related equipment, principally to industrial markets. FPD’s products and services are primarily used by companies that operate in the oil and gas, chemical processing, power generation, water

treatment and general industrial markets. Our pump systems and components are currently manufactured at 27 plants worldwide, of which 9 are located in North America, 11 in Europe and 7 in South America and Asia. We also manufacture a small portion of our pumps through several foreign joint ventures. We market our pump products through our worldwide sales force and our regional service and repair centers or through independent distributors and sales representatives.

 

In June 2006, Flowserve entered into a joint venture agreement with the Al Rashaid Group to build the largest original pump equipment service and repair and learning center facility in Saudi Arabia. In addition to service and repair, the facility will have the capability to engineer, assemble and test new and upgraded pumping equipment. Construction of the 20,500 square meter (220,660 square feet) complex will be located at the Al Rashaid Oil Field Center in Dhahran, Saudi Arabia and is expected to be completed by end of 2007.

 

In December 2006, Flowserve acquired the assets of Canada Alloy Castings. The business will be integrated into Flowserve Pumps, but will continue to operate under the name Canada Alloy Castings (CAC). CAC specializes in large alloy castings, up to 35,000 lbs gross weight. CAC provides Flowserve with a secure source of supply and will support future FPD growth. We also expect significantly shortened lead times on critical castings supplied by CAC.

 

FPD Products

 

We manufacture more than 150 different active pump models, ranging from simple fractional horsepower industrial pumps to high horsepower engineered pumps (greater than 30,000 horsepower). Our pumps are manufactured in a wide range of metal alloys and with a variety of configurations, including pumps that utilize mechanical seals (sealed pumps) and pumps that do not utilize mechanical seals (magnetic-drive and other pumps).

 

The following is a summary list of our pump products and globally recognized brands:

 

FPD Product Types

 

FPD Services

 

We provide engineered aftermarket services through our global network of 50 service centers in 20 countries. Our FPD service personnel provide a comprehensive set of equipment maintenance services for flow management control systems, including repair, advanced diagnostics, installation, commissioning, re-rate and retrofit programs, machining and full service solution offerings. A large portion of our FPD service work is performed on a quick response basis, and we offer 24-hour service in all of our major markets.

 

FPD New Product Development

 

Our investments in new product research and development have consistently led to the production of more reliable and higher efficiency pump designs. In line with our end-user strategy, the majority of our new FPD products and enhancements are driven by our customers’ need to achieve higher production rates at lower costs. As a result, we continually collaborate with our customers in developing advanced technical solutions to improve the availability and productivity of their pumping systems. This type of technology advancement is best demonstrated by our recent release of the IPS Tempo product. The flagship of our Intelligent Pumping Series, IPS Tempo is a product developed and designed to incorporate our operating intelligence and protection logic in the control of pumps installed at unmanned locations. Much of our new product development is applied to projects where customer funding is available to support the investment. In addition, several of our new technology initiatives are partially funded by third parties including:

 

 

In addition to Product and Technology development, FPD Research and Development personnel continue to support many of the organizations leading the industry (HI, API, ISO, Europump) and have been recognized as leaders in pump technology. Bruno Schiavello, our hydraulics specialist, has been recently awarded the prestigious 2006 ASME Fluids Machinery Design Award for his many years of service in the fluids design discipline.

 

FPD Customers

 

FPD’s customer mix is diversified, including leading engineering procurement and construction firms, OEMs, distributors and end users. Our sales mix of original equipment products and aftermarket services diversifies our business and somewhat mitigates the impact of economic cycles in our business.

 

FPD Competition

 

The pump industry is highly fragmented, with more than 100 competitors. We compete, however, primarily against a relatively limited number of large companies operating on a global scale. Competition is generally based on price, expertise, delivery times, breadth of product offerings, contractual terms, previous installation history and reputation for quality. Some of our largest pump industry competitors include ITT Industries, Ebara Corporation, KSB Inc., The Weir Group PLC, Sulzer Pumps and United Technologies Corporation.

 

The pump industry has undergone considerable consolidation in recent years, primarily caused by (1) the need to lower costs through reduction of excess capacity and (2) customers’ preference to align with global full service suppliers in simplifying their supplier base. Despite the consolidation activity, the market remains highly

competitive. We believe that we are the largest pump manufacturer serving the oil, chemical and power generation industries, and the third largest pump manufacturer overall. We believe that our broad range of pumps for the oil, power and chemical industries, our strong customer relationships and more than 100 years of experiences in pumping equipment, and our reputation for providing quality engineering solutions are our major sources of competitive advantage.

 

FPD Backlog

 

FPD’s backlog of orders at December 31, 2006 was $1.3 billion, compared with $703.5 million on December 31, 2005. We expect to ship approximately 85% of our FPD backlog as of December 31, 2006 during 2007.

 

FLOW CONTROL DIVISION

 

FCD, the second largest business segment within Flowserve, designs, manufactures and distributes a broad portfolio of industrial valve products, including actuators, controls and related equipment. In addition, FCD leverages its experience and application know-how by offering a complete menu of engineered services to complement its expansive product portfolio. Valve products, used to direct the flow of liquids and gases, are an integral part of any flow control system. Typically, our valve products are customized, being engineered to perform specific functions within each of our customer’s unique flow control environments.

 

Our products are primarily used by companies that operate in the chemical, power generation, oil and gas and general industries including water, mining and pharmaceutical. We produce the vast majority of our products at 20 principal manufacturing facilities, with only 5 of the 20 plants located in the United States. A small portion of our valves are produced through foreign joint ventures.

 

FCD Products

 

Together, our valve, actuator and automated valve accessory offerings represent one of the most comprehensive product portfolios in the flow control industry. Our valves are used in a wide variety of applications, from the more customary general service operations to the most extreme of environments, involving high degrees of corrosion, temperatures and or pressures. FCD’s “smart” valve technologies, which integrate high technology sensors, microprocessor controls and digital positioners into a high performance control valve, permit real time system analysis, system warnings and remote services. These “smart” valve technologies are in response to the growing demand for increased automation, improved process control efficiency and digital communications at the plant level. We are committed to further enhancing the quality of our product portfolio by continuing to upgrade our existing offerings with cutting-edge digital technologies.

 

The following is a summary list of our generally available valve products and globally recognized brands:

 

FCD Product Types

 

 

FCD Brand Names

 

 

FCD Services

 

We provide aftermarket services through our network of 17 service centers located throughout the world. Our service personnel provide a comprehensive set of equipment maintenance services for flow control systems, including advanced diagnostics repair, installation, commissioning, retrofit programs and field machining capabilities. A large portion of our service work is performed on a quick response basis, including 24-hour service in all of our major markets. We believe our ability to offer these types of services provides us with a unique competitive advantage and unparalleled access to our customers’ installed base of flow control products.

 

FCD New Product Development

 

Our research and development investment has been targeted in areas that will advance our technological leadership and further differentiate our competitive advantage from a product perspective. The investment priority has been focused on significantly enhancing the digital integration and interoperability of the valve top works (positioners, actuators, limit switches, and associated accessories) with Distributed Control Systems (“DCS”). Our efforts in this area continue to pursue the development and deployment of next-generation hardware and software for valve diagnostics, and the integration of the resulting device intelligence through the DCS to provide a practical and effective asset management capability for the end-user. In addition to developing these new capabilities and value-added services, our investments also include product portfolio expansion and fundamental research in material sciences in order to increase the temperature, pressure, and erosion-resistance limits of existing products. These investments are made by adding new resources and talent to the organization, as well as leveraging the experience of FPD and FSD, and increasing our collaboration with third parties. We expect to continue our research and development investments in the areas mentioned above.

 

FCD Customers

 

FCD’s customer mix spans across several industries, including the chemical, petroleum, power, water and general industries. FCD’s product mix includes original equipment, aftermarket parts and services.

 

FCD Competition

 

While in recent years the valve market has undergone a significant amount of consolidation, in relative terms, the market remains highly fragmented. Some of the largest valve industry competitors include Crane Co., Dresser Inc., Emerson, Kitz and Tyco.

 

Our assessments show that the top 10 global valve manufacturers collectively comprise approximately 30% of the valve market. Based on independent industry sources we believe that we are the third largest industrial valve supplier on a global basis. We believe that our comprehensive portfolio of valve products and services, our focus on

execution and our competency in severe corrosion and erosion applications are key sources of our competitive advantage.

 

FCD Backlog

 

FCD’s backlog of orders at December 31, 2006 was $314.3 million, compared with $240.6 million on December 31, 2005. We expect to ship approximately 93% of our backlog on December 31, 2006 during 2007.

 

FLOW SOLUTIONS DIVISION

 

Through FSD, we design, manufacture and distribute mechanical seals, sealing systems and parts, and provide related services, principally to process industries. Rotating equipment containing mechanical seals require replacement throughout the products’ useful lives. The replacement of mechanical seals is an integral part of our aftermarket services. Our mechanical seals are used on a variety of rotating equipment, including pumps, mixers, compressors, steam turbines and other specialty equipment, primarily in the petroleum, natural gas, chemical processing, mineral and ore processing and general industrial end-user markets.

 

We manufacture mechanical seals at four plants in the U.S. and at five plants outside the U.S. Through our global network of 67 Quick Response Centers (“QRCs”), we provide service, repair and diagnostic services for maintaining components of flow control systems. Our mechanical seal products are primarily marketed to end users through our direct sales force and, on a commission basis, to distributors and sales agents. A portion of our mechanical seal products is sold directly to original equipment manufacturers (“OEMs”) for incorporation into rotating equipment requiring mechanical seals.

 

FSD Products

 

We design, manufacture and distribute approximately 210 different models of mechanical seals and sealing systems. We believe our ability to deliver engineered new seal product orders within 72 hours from the customer’s request through design, engineering, manufacturing, testing and delivery provides us with a leading competitive advantage. Mechanical seals are critical to the reliable operation of rotating equipment for prevention of leakage and emissions of hazardous substances and the reduction of shaft wear caused by non-mechanical seals. We also manufacture a gas-lubricated mechanical seal that is used in high-speed compressors for gas pipelines and in the oil and gas production and process markets. We continually update our mechanical seals and sealing systems to integrate emerging technologies.

 

The following list summarizes our seal products and services and globally recognized brands:

 

FSD Product Types

 

 

FSD Brand Names

 

 

FSD Services

 

We provide aftermarket services through our network of 67 QRCs located throughout the world, including 24 sites in North America. We also provide asset management services and condition monitoring for rotating equipment. Approximately 75% of our service work is performed on a quick-response basis, and we offer 24-hour service in all of our major markets.

 

FSD New Product Development

 

Our investments in new product research and development focus on developing longer lasting and more efficient products and value-added services. Approximately 30% of our original equipment mechanical seal sales for 2006 consisted of products developed within the past five years. In addition to numerous product upgrades, our recent mechanical seal and seal system innovations include: (1) low valve project seal; (2) batch chemical process seal; (3) improved split seal for water markets; (4) pump systems; and (5) expanded mineral and ore processing seal line.

 

We also market “Flowstar.Net,” an interactive tool used to actively monitor and manage information relative to equipment performance. Flowstar.Net enhances our customers’ ability to make informed decisions and respond quickly to plant production problems, extends the life of their production equipment and lowers maintenance expenses. This data has been expanded to include applications for developing new products and assisting in field applications.

 

None of these newly developed seal products required the investment of a material amount of our assets or was otherwise material.

 

FSD Customers

 

Our mechanical seal products and systems are sold directly to end users and to OEMs for incorporation into pumps, compressors, mixers or other rotating equipment requiring mechanical seals. Our mechanical seal sales are diversified among several industries, including petroleum, natural gas, chemical, mineral and ore processing and general industries.

 

FSD Competition

 

We compete against a number of manufacturers in the sale of mechanical seals. Among our largest global mechanical seal competitors are John Crane, a unit of Smiths Group Plc. and Eagle Burgmann, Inc., which is a joint venture of two traditional global seal manufacturers, Chesterton and AES. Based on independent industry sources, we believe that we are the second largest industrial mechanical seals supplier in the world. Our ability to quickly manufacture customers’ requests for engineered seal products, from design to engineering, manufacturing, testing and delivery, is a major competitive advantage.

 

FSD Backlog

 

FSD’s backlog of orders at December 31, 2006 was $74.4 million, compared with $61.2 million at December 31, 2005. We expect to ship approximately 79% our backlog on December 31, 2006 during 2007.

 

GENERAL BUSINESS

 

Competition

 

Despite the consolidation trend over the past 10 years, the markets for our products are fragmented and highly competitive, with competition occurring on the basis of price, technical expertise, timeliness of delivery, contractual terms, previous installation history and reputation for quality and reliability. Timeliness of delivery, quality and the proximity of service centers are important considerations for our aftermarket products and services. In geographic regions where we are positioned to provide a quick response, customers have traditionally relied on us, rather than our competitors, for aftermarket products relating to our highly engineered and customized products. However, aftermarket competition for standard products is very competitive, and price competition has generally been

increasing due to supply availability. Price competition tends to be less significant for OEMs than aftermarket services and generally has been increasing. In the aftermarket portion of our service business, we compete against large and well-established national and global competitors and, in some markets, against regional and local companies who produce low cost replicators of spare parts. We also compete with in-house maintenance departments of our end user customers. In the sale of aftermarket products and services, we benefit from our large installed base of pumps, seals and valves, which require maintenance, repair and replacement parts. In the petroleum industry, the competitors for aftermarket services tend to be the customers’ own in-house capabilities. In other industries, except the nuclear power industry, the competitors for aftermarket services tend to be local independent repair shops and low cost replicators. We possess certain competitive advantages in the nuclear power industry due to our “N Stamp,” a prerequisite to serve customers in that industry, and our considerable base of proprietary knowledge.

 

Generally, our customers are attempting to reduce the number of vendors from which they purchase, thereby reducing the size and diversity of their inventory. Although vendor reduction programs could adversely affect our business, we have been successful in entering into global arrangements with a number of customers to leverage competitive advantages.

 

Our ability to use our portfolio of products and solutions to meet customer demands is a competitive strength. We continue to explore and develop potential new solutions, as well as products (pumps, valves, and seals), with our customers to improve service opportunities and increase our market share.

 

New Product Development

 

We spent approximately $29.7 million, $24.3 million and $25.2 million during 2006, 2005 and 2004, respectively, on research and development initiatives. Our research and development group consists of engineers involved in new product development and improvement of existing products. Additionally, we sponsor consortium programs for research with various universities and jointly conduct limited development work with certain vendors, licensees and customers. We believe current expenditures are adequate to sustain our ongoing research and development activities.

 

Customers

 

We sell to a wide variety of customers in the oil and gas, chemical, power generation, water treatment and general industries. No individual customer accounted for more than 5% of our consolidated 2006 revenues.

 

We are not required to carry unusually high amounts of inventory to meet customer delivery requirements. We have been working to increase our overall inventory efficiency to improve our operational effectiveness and to reduce working capital needs. We generally do not provide rights of product return for our customers and do not offer extended payment terms.

 

Selling and Distribution

 

We primarily distribute our products through direct sales by employees assigned to specific regions, industries or products. In addition, we use distributors and sales agents to supplement our direct sales force in countries where business practices or customs make it appropriate, or wherever it is not economical to have direct sales staff. We generate a majority of our sales leads through existing relationships with vendors, customers and prospects or through referrals.

 

Intellectual Property

 

We own a number of trademarks and patents relating to the name and design of our products. We consider our trademarks and patents to be an important aspect of our business. In addition, our pool of proprietary information, consisting of know-how and trade secrets related to the design, manufacture and operation of our products, is considered particularly important and valuable. Accordingly, we attempt to proactively protect such proprietary information. We generally own the rights to the products which we manufacture and sell and are unencumbered by any license or franchise to operate. Our trademarks can typically be renewed indefinitely as long as they remain in

use, whereas our existing patents generally expire 20 years from the dates they were filed, which has occurred at various times in the past. We do not believe that the expiration of any individual patent(s) will have a material adverse impact on our operations.

 

Raw Materials

 

The principal raw materials used in manufacturing of our products are readily available and include bar stock and structural steel, castings, fasteners, gaskets, motors, silicon and carbon faces and fluoropolymer components. While substantially all raw materials are purchased from outside sources, we have been able to obtain an adequate supply and anticipate no shortages of such materials. We continue to expand worldwide sourcing to capitalize on low cost sources of purchased goods.

 

We are a vertically integrated manufacturer of certain pump and valve products. Certain corrosion-resistant castings for our pumps and quarter-turn valves are manufactured at our foundries. Other metal castings are either manufactured at our foundries or purchased from outside sources.

 

We also use highly engineered corrosion resistant plastic parts for certain pump and valve product lines. These include rotomolding as well as injection and compression molding of a variety of fluoropolymer and other plastic materials. We do not anticipate difficulty in obtaining raw materials in the future.

 

Suppliers of raw materials for nuclear markets must be qualified by the American Society of Mechanical Engineers and, accordingly, are limited in number. However, to date we have experienced no significant difficulty in obtaining such materials.

 

Employees and Labor Relations

 

We have approximately 14,000 employees globally. A portion of the hourly employees at our pump manufacturing plant located in Vernon, California, our pump service center located in Cleveland, Ohio, our valve manufacturing plant located in Lynchburg, Virginia and our foundry located in Dayton, Ohio, are represented by unions. Additionally, some employees at select facilities in the following countries are unionized or have employee works councils: Argentina, Australia, Austria, Belgium, Brazil, Canada, Finland, France, Germany, Italy, Japan, Mexico, the Netherlands, Spain, Sweden, Switzerland and the United Kingdom. We believe relations with our employees throughout our operations are generally satisfactory, including those employees represented by unions and works councils. No unionized facility produces more than 5% of our revenues. We entered into new multi-year collective bargaining agreements with our unions in Dayton, Ohio and Australia during 2006.

 

Environmental Regulations and Proceedings

 

We are subject to environmental laws and regulations in all jurisdictions in which we have operating facilities. These requirements primarily relate to the generation and disposal of solid and hazardous waste, air emissions and waste water discharges. We periodically make capital expenditures to abate and control pollution and to satisfy environmental requirements. At present, we have no plans for any material capital expenditures for environmental control equipment at any of our facilities. However, we have incurred and continue to incur operating costs relating to ongoing environmental compliance matters, although certain costs have been reduced by successful waste minimization programs. Based on existing and proposed environmental requirements and our anticipated production schedule, we believe that future environmental compliance expenditures will not have a material adverse effect on our financial position, results of operations or cash flows.

 

We use hazardous substances and generate hazardous wastes in many of our manufacturing and foundry operations. Most of our current and former properties are or have been used for industrial purposes and may require some clean-up of historical contamination. During the due diligence phase of our acquisitions, we conduct environmental site assessments in an attempt to determine any potential environmental liability and to identify the need for clean-up. We are currently conducting follow-up investigation and/or remediation activities at those locations where we have known environmental concerns. We have cleaned up a majority of the sites with known historical contamination and we are addressing the remaining identified issues.

 

Over the years, we have been involved as one of many potentially responsible parties (“PRP”) at former public waste disposal sites that are or were subject to investigation and remediation. We are currently involved as a PRP at four Superfund sites. The sites are in various stages of evaluation by government authorities. Our total projected “fair share” cost allocation at all four of these sites is expected to be less than $100,000. See Item 3. “Legal Proceedings” for more information.

 

We have established reserves that we believe to be adequate to cover our currently identified on-site and off-site environmental liabilities.

 

Exports

 

Our export sales from the United States (“U.S.”) to foreign unaffiliated customers were $283.9 million in 2006, $221.6 million in 2005 and $275.6 million in 2004.

 

Licenses are required from U.S. government agencies to export certain products. In particular, products with nuclear applications are restricted, as are certain other pump, valve and mechanical seal products.

 

We are responding to an investigation by the U.S. Securities and Exchange Commission (“SEC”) relating primarily to products that two of our foreign subsidiaries delivered to Iraq from 1996 through 2003 under the United Nations Oil-for-Food Program. These two foreign subsidiaries have also been contacted by governmental authorities in their respective countries concerning their involvement in the United Nations Oil-for-Food Program. We engaged outside counsel in February 2006 to conduct an investigation of our foreign subsidiaries’ participation in the United Nations Oil-for-Food program. The outside counsel’s investigation has found evidence to date that, during the years 2001 through 2003, certain non-U.S. personnel at the two foreign subsidiaries authorized payments in connection with certain of our product sales under the United Nations Oil-for-Food Program totaling approximately €0.6 million which were subsequently deposited by a third party into Iraqi-controlled bank accounts. These payments were not authorized under the United Nations Oil-for-Food Program and were not properly documented in the subsidiaries’ accounting records but were expensed as paid. We intend to continue to cooperate fully in the investigations by the SEC and foreign authorities which are ongoing. See Item 3. “Legal Proceedings” for more information.

 

We are continuing a process to determine our compliance posture with respect to U.S. export control laws and regulations and to disclose to the applicable U.S. governmental authorities, any past potential violations of the U.S. export control laws. See Item 3. “Legal Proceedings” for more information.

 

AVAILABILITY OF FORMS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION

 

Our shareholders may obtain, free of charge, copies of the following documents (and any amendments thereto) as filed with, or furnished, to the SEC as soon as reasonably practical after such material is filed with or furnished to the SEC:

 

 

A copy of these filings may be obtained by going to our Internet website at www.flowserve.com and selecting “Investor Relations” and selecting “SEC Filings.”

 

Copies may also be obtained by providing a written request for such copies or additional information regarding our operating or financial performance to Zac Nagle, Vice President of Investor Relations, Flowserve Corporation, 5215 N. O’Connor Blvd., Suite 2300, Irving, Texas 75039. Except as otherwise stated in these reports, the

information contained on our website or available by hyperlink from our website is not incorporated into this Annual Report or other documents we file with, or furnish to, the SEC.

 

We have adopted Corporate Governance Guidelines for our Board of Directors and Code of Ethics and Business Conduct for our Board of Directors, our Chief Executive Officer, principal financial and accounting officers and other persons responsible for financial management and our employees generally. We also have charters for the Audit Committee, Finance Committee, Organization and Compensation Committee and the Corporate Governance and Nominating Committee of our Board of Directors. Copies of the foregoing documents may be obtained on our website as noted in the above paragraph, and such information is available in print to any shareholder who requests it.

 

Any of the events discussed as risk factors below may occur. If they do, our business, financial condition, results of operations and cash flows could be materially adversely affected. Additional risks and uncertainties not presently known to us, or that we currently deem immaterial, may also impair our business operations.

 

We are currently subject to securities class action litigation, the unfavorable outcome of which might have a material adverse effect on our financial condition, results of operations and cash flows.

 

A number of putative class action lawsuits have been filed against us, certain of our former officers, our independent auditors and the lead underwriters of our most recent public stock offerings, alleging securities laws violations. We believe that these lawsuits, which have been consolidated, are without merit and are vigorously defending them and have notified our applicable insurers. We cannot, however, determine with certainty the outcome or resolution of these claims or the timing for their resolution. The consolidated securities case is currently set for trial on October 1, 2007. In addition to the expense and burden incurred in defending this litigation and any damages that we may suffer, our management’s efforts and attention may be diverted from the ordinary business operations in order to address these claims. If the final resolution of this litigation is unfavorable to us, our financial condition, results of operations and cash flows might be materially adversely affected if our existing insurance coverage is unavailable or inadequate to resolve the matter.

 

The ongoing SEC and foreign government investigation regarding our participation in the United Nations Oil-for-Food Program could materially adversely affect our Company.

 

On February 7, 2006, we received a subpoena from the SEC seeking documents and information relating primarily to products that two of our foreign subsidiaries delivered to Iraq from 1996 through 2003 under the United Nations Oil-for-Food Program. We believe that the SEC’s investigation is focused primarily on whether any inappropriate payments were made to Iraqi officials in violation of the federal securities laws. The investigation includes periods prior to, as well as subsequent to, our acquisition of the foreign operations involved in the investigation. We may be subject to certain liabilities if violations are found regardless of whether they relate to periods before or subsequent to our acquisition.

 

In addition, the two foreign subsidiaries have been contacted by governmental authorities in their respective countries concerning their involvement in the United Nations Oil-for-Food Program. We are unable to predict how the foreign governmental authorities will pursue either of these matters in the future. We believe that the SEC and the foreign governmental authorities are also investigating other companies in connection with the United Nations Oil-for-Food Program.

 

We engaged outside counsel in February 2006 to conduct an investigation of our foreign subsidiaries’ participation in the United Nations Oil-for-Food program. The Audit Committee of the Board of Directors has been regularly monitoring this situation since the receipt of the SEC subpoena and assumed direct oversight of the investigation in January 2007. We currently expect the investigation will be completed during the second quarter of 2007.

 

Our investigation has included, among other things, a detailed review of contracts with the Iraqi government under the United Nations Oil-for-Food Program during 1996 through 2003, a forensic review of the accounting

records associated with these contracts, and interviews of persons with knowledge of the events in question. Our investigation has found evidence to date that, during the years 2001 through 2003, certain non-U.S. personnel at the two foreign subsidiaries authorized payments in connection with certain of our product sales under the United Nations Oil-for-Food Program totaling approximately €0.6 million, which were subsequently deposited by a third party into Iraqi-controlled bank accounts. These payments were not authorized under the United Nations Oil-for-Food Program and were not properly documented in the subsidiaries’ accounting records but were expensed as paid. During the course of the investigation, certain other potential issues involving non-U.S. personnel were identified at one of the foreign subsidiaries, which are currently under review.

 

We have taken certain disciplinary actions against persons who engaged in wrongful conduct, violated our ethics policies or failed to cooperate fully in the investigation, including terminating the employment of certain non-U.S. senior management personnel at one of the foreign subsidiaries. Certain other non-U.S. senior management personnel at that facility involved in the above conduct had been previously separated from the Company for other reasons.

 

We will continue to fully cooperate in both the SEC and the foreign investigations. The investigations are in progress but, at this point, are incomplete. Accordingly, if the SEC and/or the foreign authorities take enforcement action with regard to these investigations, we may be required to pay fines, disgorge profits, consent to injunctions against future conduct or suffer other penalties which could potentially materially impact our business, financial condition results of operations and cash flows.

 

Potential noncompliance with U.S. export control laws could materially adversely affect our business.

 

We have notified applicable U.S. governmental authorities of our ongoing investigation, analysis, and voluntary disclosure of certain apparent past violations of the U.S. export control laws, subject to further analysis and verification, through, in general, the export and reexport of products, services and technologies without the licenses that may be required by such authorities. If any apparent violations are identified, confirmed and voluntarily disclosed as part of our investigation, which is being conducted in conjunction with outside counsel, we could be subject to substantial fines and other penalties affecting our ability to do business outside the United States.

 

Our risks involved in conducting our international business operations include, without limitation, the risks associated with certain of our foreign subsidiaries autonomously conducting, under their own local authority and consistent with U.S. export laws, business operations and sales, which constitute approximately 1% to 2% of our consolidated global revenue, in Iran, Syria and Sudan, which have each been designated by the U.S. State Department as state sponsors of terrorism. Due to the growing political uncertainties associated with these countries, we have begun our voluntary withdrawal, on a phased basis, from conducting new business in these countries. These subsidiaries may continue to honor certain existing contracts, commitments and warranty obligations that are in compliance with U.S. laws and local and regulations.

 

The Internal Revenue Service (“IRS”) is auditing our tax returns, and a negative outcome of the audit would require us to make additional tax payments that may be material.

 

The IRS substantially concluded its audit of our U.S. federal income tax returns for the years 1999-2001 during December, 2005. Based on its audit work, the IRS has issued proposed adjustments to increase taxable income during 1999 through 2001 by $12.8 million, and to deny foreign tax credits of $2.4 million in the aggregate. The tax liability resulting from these proposed adjustments will be offset with foreign tax credit carryovers and other refund claims, which were approved by the Joint Committee on Taxation on July 24, 2006, and therefore should not result in a material future cash payment The effect of the adjustments to current and deferred taxes has been reflected in previously filed consolidated financial statements for the applicable periods.

 

During the third quarter of 2006, the IRS commenced an audit of our U.S. federal income tax returns for the years 2002 through 2004. While we expect the current IRS audit to be similar in scope to the recently completed examination, this audit may be broader. Furthermore, the results from the audit of 1999 through 2001 are not indicative of the future result of the audit of 2002 through 2004. The audit of 2002 through 2004 may result in additional tax payments by us, the amount of which may or may not be material, but will not be known until that IRS

audit is finalized. We do not anticipate that the audit of 2002 through 2004 will be completed prior to the third quarter of 2008, and may extend past such quarter, depending on the issues raised by IRS with respect to such years.

 

In the course of the tax audit for the years 1999 through 2001, we have identified record keeping and other material internal control weaknesses, which caused us to incur significant expense to substantiate our tax return items and address information and document requests made by the IRS. Due to these record keeping issues, the IRS has issued us a Notice of Inadequate Records for the years 1999 through 2001 and may issue a similar notice for the years 2002 through 2004. While the IRS has agreed not to assess penalties for inadequacy of records with respect to the years 1999 through 2001, no assurances can be made that the IRS will not seek to assess such penalties or other types of penalties with respect to the years 2002 through 2004. Such penalties could result in a material impact to the consolidated results of operations. Additionally, the record keeping issues noted above may result in future U.S. state and local tax assessments of tax, penalties and interest which could have a material impact to the consolidated results of operations.

 

The recording of increased deferred tax asset valuation allowances in the future could affect our operating results.

 

We currently have significant net deferred tax assets resulting from tax credit carry forwards, net operating losses, and other deductible temporary differences which are available to reduce taxable income in future periods. Based on our assessment of our deferred tax assets, we determined, based on projected future income and certain available tax planning strategies, that $210 million of our deferred tax assets will more likely than not be realized in the future and no valuation allowance is currently required for this portion of our deferred tax assets. Should we determine in the future that these assets will not be realized, we will be required to record an additional valuation allowance in connection with these deferred tax assets and our operating results would be adversely affected in the period such determination is made.

 

Economic, political and other risks associated with international operations could adversely affect our business.

 

A substantial portion of our operations is conducted and located outside the U.S. We have manufacturing or service facilities in 31 countries and sell to customers in over 70 countries, in addition to the United States. Moreover, we outsource certain of our manufacturing and engineering functions to, and source our raw materials and components from China, Eastern Europe, India, Latin America and Mexico. Accordingly, our business is subject to risks associated with doing business internationally, including:

 

 

 

For example, political unrest and a two-month nation-wide work stoppage in Venezuela in 2002 negatively impacted demand for our products from customers in that country and other customers, such as U.S. oil refineries, that were affected by the resulting disruption in the supply of crude oil. Similarly, the military conflict in the 2003 Middle East softened the level of capital investment and demand for our products and services in that region, notwithstanding the historically high prices for oil. Additionally we are investigating or have investigated certain allegations regarding foreign management engaging in unethical practices prohibited by our Code of Business Conduct which could have inappropriately benefited them at Company expense.

 

We are exposed to fluctuations in foreign currencies, as a significant portion of our revenue, and certain of our costs, assets and liabilities, are denominated in currencies other than U.S. dollar. The primary foreign currencies to which we have exposure are the Euro, British pound, Indian rupee, Swiss franc, Singapore dollar, Mexican peso and Canadian dollar. Certain of the foreign currencies to which we have exposure, such as the Argentinean peso, have undergone significant devaluation in the past. Although we enter into forward contracts to economically hedge our risks associated with transactions denominated in foreign currencies, no assurances can be made that exchange rate fluctuations will not adversely affect our financial condition, results of operations and cash flows.

 

Our international operations are subject to a variety of laws and regulations, including the U.S. Foreign Corrupt Practices Act and regulations issued by the U.S. Customs Service, the Bureau of Industry and Security, the Office of Foreign Assets Control and various foreign governmental agencies, including applicable export controls, customs, currency exchange control and transfer pricing regulations and various programs administered by the United Nations, as applicable. No assurances can be made that we will continue to be found to be operating in compliance with, or be able to detect violations of, any such laws or regulations. In addition, we cannot predict the nature, scope or effect of future regulatory requirements to which our international operations might be subject or the manner in which existing laws might be administered or interpreted.

 

We are continuing our voluntary disclosure to applicable U.S. governmental authorities through an audit of our compliance with the U.S. export control laws and will voluntarily self-disclosure of any potential violations identified. If any violations are identified, then such disclosure could result in substantial fines and other penalties. See Item 3. “Legal Proceedings” for more information.

 

In order to manage our day-to-day operations, we must overcome cultural and language barriers and assimilate different business practices. In addition, we are required to create compensation programs, employment policies and other administrative programs that comply with laws of multiple countries. We also must communicate and monitor standards and directives across our global network. Our failure to successfully manage our geographically diverse operations could impair our ability to react quickly to changing business and market conditions and to enforce compliance with standards and procedures.

 

Our future success will depend, in large part, on our ability to anticipate and effectively manage these and other risks associated with our international operations. Any of these factors could, however, adversely affect our international operations and, consequently, our results of operations, financial condition and cash flows.

 

There are inherent limitations to the effectiveness of internal control over financial reporting.

 

In connection with our 2006 assessment of internal control over financial reporting under Section 404 of the Sarbanes-Oxley Act of 2002, our management concluded that as of December 31, 2006, our internal control over financial reporting was effective.

 

While assessed as effective, because of its inherent limitations, there is a risk that internal control over financial reporting may not prevent or detect misstatements. These inherent limitations include the possibility of human error and the circumvention or overriding of the controls and procedures. Also, projections of any evaluation of effectiveness in internal control over financial reporting to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with existing policies or internal control procedures may deteriorate.

We may be unable to deliver our backlog on time which could affect our future sales and profitability
and our relationships with customers.

 

At December 31, 2006, backlog reached $1.6 billion. In 2007, our ability to meet customer delivery schedules for backlog is dependent on a number of factors including, but not limited to, sufficient manufacturing plant capacity, access to the raw materials and other inventory required for production, an adequately trained and capable workforce, project engineering expertise for certain large projects, and appropriate planning and scheduling of manufacturing resources. Many of the contracts we enter into with our customers require long manufacturing lead times and contain penalty clauses related to on-time delivery. Failure to deliver in accordance with customer expectations could subject us to financial penalties, may result in damage to existing customer relationships, could negatively impact our financial performance, and potentially cause adverse changes in the market price of our outstanding common stock.

 

Our business depends on the levels of capital investment and maintenance expenditures by our customers, which in turn are affected by the cyclical nature of their markets and their liquidity.

 

Demand for most of our products depends on the level of new capital investment and planned maintenance expenditures by our customers. The level of capital expenditures by our customers depends, in turn, on the general economic conditions and their industries, and the expectations of future market behavior.

 

The businesses of many of our customers, particularly oil and gas companies, chemical companies and general industrial companies are, to varying degrees, cyclical and have experienced periodic downturns. Our customers in these industries historically have tended to delay large capital projects, including expensive maintenance and upgrades, during economic downturns. For example, demand for our products and services from our general industrial customers, such as steel and pulp and paper manufacturers, was negatively impacted by the U.S. recession in the early part of this decade. Similarly, in response to high oil and natural gas prices and a weak demand for their products due to the soft economy, during the past several years our chemical customers reduced their spending on capital investments and operated their facilities at lower levels, reducing demand for our products and services. Some of our customers may delay capital maintenance even during favorable conditions in their markets. For example, while high oil prices generally spur demand for our products and services in upstream petroleum markets, they often reduce demand for our products and services from oil refineries, as refiners seek to take advantage of favorable margins by operating at high levels of capacity utilization and deferring maintenance.

 

The ability of our customers to finance capital investment and maintenance may be affected by factors independent of the conditions in their industry.

 

Recently, amid increasing demand for crude and its derivatives and the tight market conditions, oil refineries have been scheduling maintenance activities and upgrading equipment to meet environmental regulations. In addition, chemical companies had been able to invest and maintain their equipment as they pass through the price increases to the end user. This recent evidence suggests a potential change in how the customer response to market conditions may impact our business activities.

 

The diminished demand for our products and services could lead to excess manufacturing capacity and subsequent accelerated erosion of average selling prices in our industry, which could adversely affect our business, results of operations, including profit margins, financial condition, and cash flows.

 

We sell our products in highly competitive markets, which results in pressure on our profit margins and
limits our ability to maintain or increase the market share of our products.

 

The markets for our products are fragmented and highly competitive. We compete against large and well-established national and global companies, as well as regional and local companies, low cost replicators of spare parts and in-house maintenance departments of our end user customers. We compete based on price, technical expertise, timeliness of delivery contractual terms, previous installation history and reputation for quality and reliability, with price competition tending to be more significant for sales to original equipment manufacturers. Some of our customers are attempting to reduce the number of vendors from which they purchase in order to reduce the size and diversity of their inventory. To remain competitive, we will need to invest continuously in

manufacturing, marketing, customer service and support and our distribution networks. No assurances can be made that we will have sufficient resources to continue to make the investment required to maintain or increase our market share or that our investments will be successful. If we do not compete successfully, our business, financial condition, results of operations and cash flows could be adversely affected.

 

Environmental compliance costs and liabilities could adversely affect our financial condition, results of
operations and cash flows.

 

Our operations and properties are subject to extensive regulation under environmental laws. These laws can impose substantial sanctions for violations or operational changes that may limit production. We must conform our operations to applicable regulatory requirements and adapt to changes in such requirements in all countries in which we operate.

 

We use hazardous substances and generate hazardous wastes in many of our manufacturing and foundry operations. Most of our current and former properties are or have been used for industrial purposes, and some may require clean-up of historical contamination. We are currently conducting investigation and/or remediation activities at a number of locations where we have known environmental concerns. In addition, we have been identified as one of many potentially responsible parties at four Superfund sites. The projected cost of remediation at these sites, as well as our alleged “fair share” allocation, is uncertain and speculative until all studies have been completed and the parties have either negotiated an amicable resolution or the matter has been judicially resolved.

 

We have incurred, and expect to continue to incur, operating and capital costs to comply with environmental requirements. In addition, new laws and regulations, stricter enforcement of existing requirements, the discovery of previously unknown contamination or the imposition of new clean-up requirements could require us to incur costs or become the basis for new or increased liabilities that could adversely affect our financial condition, results of operations and cash flows.

 

We are party to asbestos-containing product litigation that could adversely affect our financial condition,
results of operations and cash flows.

 

We are a defendant in a large number of lawsuits that seek to recover damages for personal injury allegedly resulting from exposure to asbestos-containing products formerly manufactured and/or distributed by us. All such products were used as self-contained components of process equipment, and we do not believe that there was any significant emission of ambient asbestos-containing fiber during the use of this equipment. Although we are defending these allegations vigorously and believe that a high percentage of these lawsuits are covered by insurance or indemnities from other companies, there can be no assurance that we will prevail or that payments made by insurance or such other companies would be adequate, and unfavorable rulings, judgments and/or settlement terms could adversely impact our business, financial condition, results of operations and cash flows.

 

Our business may be adversely impacted by work stoppages and other labor matters.

 

As of December 31, 2006, we had approximately 14,000 employees, approximately half of whom were located in the U.S. Of our U.S. employees, approximately 7% are represented by unions. We also have unionized employees in Argentina, Australia, Austria, Belgium, Brazil, Canada, Finland, France, Germany, Italy, Japan, Mexico, the Netherlands, Spain, Sweden, Switzerland and the United Kingdom. Although we believe that our relations with our employees are good and we have not experienced any material strikes or work stoppages recently, no assurances can be made that we will not in the future experience these and other types of conflicts with labor unions, works councils, other groups representing employees, or our employees generally, or that any future negotiations with our labor unions will not result in significant increases in the cost of labor.

 

Inability to protect our intellectual property could negatively affect our competitive position.

 

We rely on a combination of patents, copyrights, trademarks, trade secrets, confidentiality provisions and licensing arrangements to establish and protect our proprietary rights. We cannot guarantee, however, that the steps we have taken to protect our intellectual property will be adequate to prevent misappropriation of our technology. For example, effective patent, trademark, copyright and trade secret protection may be unavailable or limited in

some of the foreign countries in which we operate. In addition, while we generally enter into confidentiality agreements with our employees and third parties to protect our intellectual property, such confidentiality agreements could be breached, and may not provide meaningful protection for our trade secrets and know-how related to the design, manufacture or operation of our products. If it became necessary for us to resort to litigation to protect our intellectual property rights, any proceedings could be burdensome and costly, and we may not prevail. Furthermore, adequate remedies may not be available in the event of an unauthorized use or disclosure of our trade secrets and manufacturing expertise. If we fail to successfully enforce our intellectual property rights, our competitive position could suffer, which could harm our sales, results of operations and cash flows.

 

If we are unable to obtain raw materials at favorable prices, our operating margins and results of operations may be adversely affected.

 

We purchase substantially all electric power and other raw materials we use in the manufacturing of our products from outside sources. The costs of these raw materials have been volatile historically and are influenced by factors that are outside our control. In recent years, the prices for energy, metal alloys, nickel and certain other of our raw materials have increased, with the prices for energy currently exceeding historical averages. We also strive to offset our increased costs through Continuous Improvement Process (“CIP”) initiative, where gains are achieved in operational efficiencies. If we are unable to pass increases in the costs of our raw materials to our customers, our operating margins and results of operations may be adversely affected.

 

Significant changes in pension fund investment performance or assumptions relating to pension costs may have a material effect on the valuation of our obligations under our defined benefit pension plans, the funded status of these plans and our pension expense.

 

We maintain defined benefit pension plans that are required to be funded in the U.S., the United Kingdom, India, Japan, Mexico and the Netherlands, and defined benefit plans that are not required to be funded in Germany, France, Austria and Sweden. Our pension liability is materially affected by the discount rate used to measure our pension obligations and, in the case of the plans that are required to be funded, the level of plan assets available to fund those obligations and the expected long-term rate of return on plan assets. A change in the discount rate can result in a significant increase or decrease in the valuation of pension obligations, affecting the reported status of our pension plans and our pension expense. Significant changes in investment performance or a change in the portfolio mix of invested assets can result in increases and decreases in the valuation of plan assets or in a change of the expected rate of return on plan assets. Changes in the expected return on plan assets assumption can result in significant changes in our pension expense. We currently expect to make substantial contributions to our U.S. and foreign defined benefit pension plans during the next three years, and may make additional substantial contributions thereafter. In addition, pension reform legislation was passed in late 2006 which included minimum funding requirements effective for 2008. We are reviewing our funding policy related to the U.S. Pension Plan in accordance with the new law.

 

We may continue to have exposure to liabilities arising from our failure to maintain registration under the Securities Act for certain acquisitions of interest in our common stock fund in the Flowserve Corporation Retirement Savings Plan (“401(k) plan”).

 

Between May 1, 2005 and September 29, 2006 (the “Relevant Period”), due to the then non-current status of our filings with the SEC in accordance with the Securities Exchange Act of 1934, our registration statement on Form S-8 was not available to cover offers and sales of securities to our employees and other persons. As a result, the acquisition of securities by the 401(k) plan on behalf of participants in our 401(k) Plan during the Relevant Period did not comply with the registration requirements of the Securities Act. During the Relevant Period units of interest (“Units”) representing a total of 464,033 shares of our common stock were purchased on behalf of participants in our 401(k) Plan through application of: (i) salary reduction contributions from employees, (ii) fixed matching source funds from Flowserve and (iii) intra-plan transfers of funds by participants out of other investments in the 401(k) Plan into Units. Our failure to maintain the effectiveness of our registration statement on Form S-8 gave the participants who directed the 401(k) Plan to purchase Units during the Relevant Period the right to rescind these purchases (or recover damages if they had sold their Units) for up to one year under federal law following the

purchase of these Units. In order to address this compliance issue, we conducted a rescission offering that expired on January 8, 2007. Under the terms of the rescission offering, we made payments to participants who accepted the offer and who had sold shares acquired during the Relevant Period at a loss. We also acquired shares from accepting participants who had acquired shares during the Relevant Period at a price (together with interest at the applicable state rate) that exceeded the closing price of a share of our common stock on January 8, 2007 ($48.98). Participants from whom we acquired shares in the rescission offering received the acquisition price they paid for their shares, together with interest. We paid a total of $386,750.59 to accepting participants (which included $15,557.95 for shares sold at a loss, and $371,192.64 as acquisition price (i.e., participant’s actual cost) and interest) for the 6,766 shares we acquired from participants pursuant to this rescission offering.

 

It is unclear, however, whether or not participants in our 401(k) plan continue to have any rescission rights under the federal securities laws following the expiration of the rescission offering. It is the view of the SEC staff that a right of rescission created under the Securities Act may survive a rescission offer. However, federal courts in the past have ruled that a person who rejects or fails to accept a rescission offer is precluded from later seeking similar relief. The remedies and statute of limitations under state securities laws vary and depend upon the state in which the shares were purchased. We believe, however, that the acquisitions of Units made on behalf of participants during the Relevant Period were exempt from state registration requirements.

 

Based upon our current stock price, we believe that our current potential liability for rescission claims is not material to our financial condition or results of operations; however, our potential liability could become material in the future if our stock price were to fall below participants’ acquisition prices for their interest in our stock fund during the one-year period following the unregistered acquisitions and if it were determined by competent legal authorities that our rescission offering did not effectively terminate the rights of participants to seek rescission.

 

We may incur material costs as a result of product liability and warranty claims, which could adversely affect our financial condition, results of operations and cash flows.

 

We may be exposed to product liability and warranty claims in the event that the use of one of our products results in, or is alleged to result in, bodily injury and/or property damage or our products actually or allegedly fail to perform as expected. While we maintain insurance coverage with respect to certain product liability claims, we may not be able to obtain such insurance on acceptable terms in the future, if at all, and any such insurance may not provide adequate coverage against product liability claims. In addition, product liability claims can be expensive to defend and can divert the attention of management and other personnel for significant periods of time, regardless of the ultimate outcome. An unsuccessful defense of a product liability claim could have an adverse affect on our business, results of operations and financial condition and cash flows. Even if we are successful in defending against a claim relating to our products, claims of this nature could cause our customers to lose confidence in our products and our company. Warranty claims are not generally covered by insurance, and we may incur significant warranty costs in the future for which we would not be reimbursed.

 

Our outstanding indebtedness and the restrictive covenants in the agreements governing our indebtedness limit our operating and financial flexibility.

 

We are required to make mandatory payments and, under certain circumstances, mandatory prepayments on our outstanding indebtedness, which may require us to dedicate a substantial portion of our cash flows from operations to payments on our indebtedness, thereby reducing the availability of our cash flows to fund working capital, capital expenditures, research and development efforts and other general corporate purposes and could limit our flexibility in planning for, or reacting to, changes in our business and in the industry.

 

In addition, the agreements governing our bank credit facilities impose certain operating and financial restrictions on us and somewhat limit management’s discretion in operating our businesses. These agreements limit our ability, among other things, to:

 

 

 

In addition, our bank credit facilities contain covenants requiring us to deliver to lenders leverage and interest coverage financial covenants and our audited annual and unaudited quarterly financial statements. Our ability to comply with these covenants may be affected by events beyond our control. Failure to comply with these covenants could result in an event of default which, if not cured or waived, may have a material adverse effect on our financial condition, results of operations and cash flows.

 

We may not be able to continue to expand our market presence through acquisitions, and any future acquisitions may present unforeseen integration difficulties or costs.

 

Since 1997, we have expanded through a number of acquisitions, and we may pursue acquisitions of businesses that are complementary to ours in the future. Our ability to implement this growth strategy will be limited by our ability to identify appropriate acquisition candidates, covenants in our credit agreement and other debt agreements and our financial resources, including available cash and borrowing capacity. In addition, acquisition of businesses may require additional debt financing, resulting in higher leverage and an increase in interest expense, and could result in the incurrence of contingent liabilities.

 

Should we acquire another business, the process of integrating acquired operations into our existing operations may encounter operating difficulties and may require significant financial resources that would otherwise be available for the ongoing development or expansion of existing operations. Some of the challenges associated with acquisitions include:

 

 

Furthermore, no guarantees can be made that we will realize the cost savings, synergies or revenue enhancements that we may anticipate from any acquisition, or that we will realize such benefits within the time frame that we expect. If we are not able to timely address the challenges associated with acquisitions and successfully integrate acquired businesses, or if our integrated product and service offerings fail to achieve market acceptance, our business could be adversely affected.

 

Forward-Looking Information is Subject to Risk and Uncertainty

 

This Annual Report and other written reports and oral statements we make from time-to-time include “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, Section 21E of the Securities Exchange Act of 1934 and the Private Securities Litigation Reform Act of 1995. All statements other than statements of historical facts included in this Annual Report regarding our financial position, business strategy, plans and objectives of management for future operations, industry conditions, market conditions and indebtedness covenant compliance are forward-looking statements. In some cases forward looking statements can be identified by terms such as “may,” “will,” “should,” “expect,” “plans,” “seeks,” “anticipate,” “believe,” “estimate,” “predicts,”

“potential,” “continue,” “intends,” or other comparable terminology. These statements are not historical facts or guarantees of future performance but instead are based on current expectations and are subject to significant risks, uncertainties and other factors, many of which are outside of our control.

 

We have identified factors that could cause actual plans or results to differ materially from those included in any forward-looking statements. These factors include those described under the heading “Risk Factors” above, or as may be identified in our other SEC filings from time to time. These uncertainties are beyond our ability to control, and in many cases, it is not possible to foresee or identify all the factors that may affect our future performance or any forward-looking information, and new risk factors can emerge from time to time. Given these risks and uncertainties, you should not place undue reliance on forward-looking statements as a prediction of actual results.

 

All forward-looking statement included in this Annual Report are based on information available to us on the date of this Annual Report and the risk that actual results will differ materially from expectations expressed in this report will increase with the passage of time. We undertake no obligation, and disclaim any duty, to publicly update or revise any forward-looking statement or disclose any facts, events or circumstances that occur after the date hereof that may affect the accuracy of any forward-looking statement, whether as a result of new information, future events, changes in our expectations or otherwise. This discussion is provided as permitted by the Private Securities Litigation Reform Act of 1995 and all of our forward-looking statements are expressly qualified in their entirety by the cautionary statements contained or referenced in this section.

 

None.

 

Our corporate headquarters is a leased facility located in Irving, Texas, which we began to occupy on January 1, 2004. The lease term is for 10 years, and we have the option to renew the lease for two additional five-year periods. We currently occupy 125,000 square feet at this facility.

 

Our major manufacturing facilities operating at December 31, 2006 are presented in the table below. See “Item 1. Business.” for further information with respect to all of our manufacturing and operational facilities, including QRCs:

 

 

We own most of our major manufacturing facilities. We maintain a substantial network of U.S. and foreign service centers and sales offices, most of which are leased. Our leased facilities are generally covered by long-term leases. We believe we will be able to extend leases on our service centers and sales offices where desired, as they expire. See Note 11 to the consolidated financial statements included in this Annual Report for additional information regarding our operating lease obligations.

 

We are a defendant in a large number of pending lawsuits (which include, in many cases, multiple claimants) that seek to recover damages for personal injury allegedly caused by exposure to asbestos-containing products manufactured and/or distributed by us in the past. Any such products were encapsulated and used only as

components of process equipment, and we do not believe that any emission of respirable asbestos fibers occurred during the use of this equipment. We believe that a high percentage of the applicable claims are covered by applicable insurance or indemnities from other companies.

 

In 2003, related lawsuits were filed in federal court in the Northern District of Texas (the “Court”), alleging that we violated federal securities laws. Since the filing of these cases, which have been consolidated, the lead plaintiff has amended its complaint several times. The lead plaintiff’s current pleading is the fifth consolidated amended complaint (the “Complaint”). The Complaint alleges that federal securities violations occurred between February 6, 2001 and September 27, 2002 and names as defendants our company, C. Scott Greer, our former Chairman, President and Chief Executive Officer, Renee J. Hornbaker, our former Vice President and Chief Financial Officer, PricewaterhouseCoopers LLP, our independent registered public accounting firm, and Banc of America Securities LLC and Credit Suisse First Boston LLC, which served as underwriters for our two public stock offerings during the relevant period. The Complaint asserts claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, and Rule 10b-5 thereunder, and Sections 11 and 15 of the Securities Act of 1933. The lead plaintiff seeks unspecified compensatory damages, forfeiture by Mr. Greer and Ms. Hornbaker of unspecified incentive-based or equity-based compensation and profits from any stock sales, and recovery of costs. On November 22, 2005, the Court entered an order denying the defendants’ motions to dismiss the Complaint. The case is currently set for trial on October 1, 2007. We continue to believe that the lawsuit is without merit and are vigorously defending the case.

 

In 2005, a shareholder derivative lawsuit was filed purportedly on our behalf in the 193rd Judicial District of Dallas County, Texas. The lawsuit names as defendants Mr. Greer, Ms. Hornbaker, and current board members Hugh K. Coble, George T. Haymaker, Jr., William C. Rusnack, Michael F. Johnston, Charles M. Rampacek, Kevin E. Sheehan, Diane C. Harris, James O. Rollans and Christopher A. Bartlett. We are named as a nominal defendant. Based primarily on the purported misstatements alleged in the above-described federal securities case, the plaintiff asserts claims against the defendants for breach of fiduciary duty, abuse of control, gross mismanagement, waste of corporate assets and unjust enrichment. The plaintiff alleges that these purported violations of state law occurred between April 2000 and the date of suit. The plaintiff seeks on our behalf an unspecified amount of damages, injunctive relief and/or the imposition of a constructive trust on defendants’ assets, disgorgement of compensation, profits or other benefits received by the defendants from us, and recovery of attorneys’ fees and costs. We strongly believe that the suit was improperly filed and have filed a motion seeking dismissal of the case. The Court has since ordered the plaintiffs to replead. The trial is currently set for March 2007, although the parties have submitted an agreed motion to continue the trial date.

 

On March 14, 2006, a shareholder derivative lawsuit was filed purportedly on our behalf in federal court in the Northern District of Texas. The lawsuit names as defendants Mr. Greer, Ms. Hornbaker, and the following board members Mr. Coble, Mr. Haymaker, Mr. Kling, Mr. Rusnack, Mr. Johnston, Mr. Rampacek, Mr. Sheehan, Ms. Harris, Mr. Rollans and Mr. Bartlett. We are named as a nominal defendant. Based primarily on certain of the purported misstatements alleged in the above-described federal securities case, the plaintiff asserts claims against the defendants for breaches of fiduciary duty. The plaintiff alleges that the purported breaches of fiduciary duty occurred between 2000 and 2004. The plaintiff seeks on our behalf an unspecified amount of damages, disgorgement by Mr. Greer and Ms. Hornbaker of salaries, bonuses, restricted stock and stock options, and recovery of attorneys’ fees and costs. We strongly believe that the suit was improperly filed and have filed a motion seeking dismissal of the case.

 

On February 7, 2006, we received a subpoena from the SEC seeking documents and information relating primarily to products that two of our foreign subsidiaries delivered to Iraq from 1996 through 2003 under the United Nations Oil-for-Food Program. We believe that the SEC’s investigation is focused primarily on whether any inappropriate payments were made to Iraqi officials in violation of the federal securities laws. The investigation includes periods prior to, as well as subsequent to, our acquisition of the foreign operations involved in the investigation. We may be subject to certain liabilities if violations are found regardless of whether they relate to periods before or subsequent to our acquisition.

 

In addition, the two foreign subsidiaries have been contacted by governmental authorities in their respective countries concerning their involvement in the United Nations Oil-for-Food Program. We are unable to predict how

the foreign governmental authorities will pursue either of these matters in the future. We believe that the SEC and the foreign governmental authorities are also investigating other companies in connection with the United Nations Oil-for-Food Program.

 

We engaged outside counsel in February 2006 to conduct an investigation of our foreign subsidiaries’ participation in the United Nations Oil-for-Food program. The Audit Committee of the Board of Directors has been regularly monitoring this situation since the receipt of the SEC subpoena and assumed direct oversight of the investigation in January 2007. We currently expect the investigation will be completed during the second quarter of 2007.

 

Our investigation has included, among other things, a detailed review of contracts with the Iraqi government under the United Nations Oil-for-Food Program during 1996 through 2003, a forensic review of the accounting records associated with these contracts, and interviews of persons with knowledge of the events in question. Our investigation has found evidence to date that, during the years 2001 through 2003, certain non-U.S. personnel at the two foreign subsidiaries authorized payments in connection with certain of our product sales under the United Nations Oil-for-Food Program totaling approximately €0.6 million, which were subsequently deposited by a third party into Iraqi-controlled bank accounts. These payments were not authorized under the United Nations Oil-for-Food Program and were not properly documented in the subsidiaries’ accounting records but were expensed as paid. During the course of the investigation, certain other potential issues involving non-U.S. personnel were identified at one of the foreign subsidiaries, which are currently under review.

 

We have taken certain disciplinary actions against persons who engaged in wrongful conduct, violated our ethics policies or failed to cooperate fully in the investigation, including terminating the employment of certain non-U.S. senior management personnel at one of the foreign subsidiaries. Certain other non-U.S. senior management personnel at that facility involved in the above conduct had been previously separated from the Company for other reasons.

 

We will continue to fully cooperate in both the SEC and the foreign investigations. The investigations are in progress but, at this point, are incomplete. Accordingly, if the SEC and/or the foreign authorities take enforcement action with regard to these investigations, we may be required to pay fines, disgorge profits, consent to injunctions against future conduct or suffer other penalties which could potentially materially impact our business, financial condition, results of operations and cash flows.

 

In March 2006, we initiated a process to determine our compliance with U.S. export control laws and regulations. Upon initial investigation, it appeared that some product transactions and technology transfers were not necessarily in full compliance with U.S. export control laws and regulations. As a result, in conjunction with outside counsel, we are currently involved in a systematic process to conduct further review, validation, and voluntary disclosure of certain apparent export violations discovered as part of this review process. We currently believe this process will not be substantially complete until the first quarter of 2008, given the complexity of the export laws and the current scope of the investigation. Any violations of U.S. export control laws and regulations that are identified and disclosed to the U.S. government may result in civil or criminal penalties, including fines and/or other penalties. Because our review into this issue is ongoing, we are currently unable to determine the full extent of any confirmed violations or determine the nature or total amount of potential penalties to which we might be subject to in the future. Given that the resolution of this matter is uncertain at this time, we are not able to reasonably estimate the maximum amount of liability that could result from final resolution of this matter. We cannot currently predict whether the ultimate resolution of this matter will have a material adverse effect on our business, including our ability to do business outside the U.S., or on our financial condition.

 

Between May 1, 2005 and September 29, 2006 (the “Relevant Period”), due to the then non-current status of our filings with the SEC in accordance with the Securities Exchange Act of 1934, our registration statement on Form S-8 was not available to cover offers and sales of securities to our employees and other persons. As a result, the acquisition of securities by the 401(k) plan on behalf of participants in our 401(k) Plan during the Relevant Period did not comply with the registration requirements of the Securities Act. During the Relevant Period units of interest (“Units”) representing a total of 464,033 shares of our common stock were purchased on behalf of participants in our 401(k) Plan through application of: (i) salary reduction contributions from employees, (ii) fixed matching source funds from Flowserve and (iii) intra-plan transfers of funds by participants out of other investments in the

401(k) Plan into Units. Our failure to maintain the effectiveness of our registration statement on Form S-8 gave the participants who directed the 401(k) Plan to purchase Units during the Relevant Period the right to rescind these purchases (or recover damages if they had sold their Units) for up to one year under federal law following the purchase of these Units. In order to address this compliance issue, we conducted a rescission offering that expired on January 8, 2007. Under the terms of the rescission offering, we made payments to participants who accepted the offer and who had sold shares acquired during the Relevant Period at a loss. We also acquired shares from accepting participants who had acquired shares during the Relevant Period at a price (together with interest at the applicable state rate) that exceeded the closing price of a share of our common stock on January 8, 2007 ($48.98). Participants from whom we acquired shares in the rescission offering received the acquisition price they paid for their shares, together with interest. We paid a total of $386,750.59 to accepting participants (which included $15,557.95 for shares sold at a loss, and $371,192.64 as acquisition price (i.e., participant’s actual cost) and interest for the 6,766 shares we acquired from participants pursuant to this rescission offering.

 

It is unclear, however, whether or not participants in our 401(k) plan continue to have any rescission rights under the federal securities laws following the expiration of the rescission offering. It is the view of the SEC staff that a right of rescission created under the Securities Act may survive a rescission offer. However, federal courts in the past have ruled that a person who rejects or fails to accept a rescission offer is precluded from later seeking similar relief. The remedies and statute of limitations under state securities laws vary and depend upon the state in which the shares were purchased. We believe, however, that the acquisitions of Units made on behalf of participants during the Relevant Period were exempt from state registration requirements.

 

Based upon our current stock price, we believe that our current potential liability for rescission claims is not material to our financial condition or results of operations; however, our potential liability could become material in the future if our stock price were to fall below participants’ acquisition prices for their interest in our stock fund during the one-year period following the unregistered acquisitions and if it were determined by competent legal authorities that our rescission offering did not effectively terminate the rights of participants to seek rescission.

 

We have been involved as a potentially responsible party (“PRP”) at former public waste disposal sites that may be subject to remediation under pending government procedures. The sites are in various stages of evaluation by federal and state environmental authorities. The projected cost of remediation at these sites, as well as our alleged “fair share” allocation, is uncertain and speculative until all studies have been completed and the parties have either negotiated an amicable resolution or the matter has been judicially resolved. At each site, there are many other parties who have similarly been identified, and the identification and location of additional parties is continuing under applicable federal or state law. Many of the other parties identified are financially strong and solvent companies that appear able to pay their share of the remediation costs. Based on our information about the waste disposal practices at these sites and the environmental regulatory process in general, we believe that it is likely that ultimate remediation liability costs for each site will be apportioned among all liable parties, including site owners and waste transporters, according to the volumes and/or toxicity of the wastes shown to have been disposed of at the sites. We believe that our exposure for existing disposal sites will be less than $100,000.

 

We are also a defendant in several other lawsuits, including product liability claims, that are insured, subject to the applicable deductibles, arising in the ordinary course of business. Based on currently available information, we believe that we have adequately accrued estimated probable losses for such lawsuits. We are also involved in a substantial number of labor claims, including one case where we had a confidential settlement reflected in our 2004 results.

 

Although none of the aforementioned potential liabilities can be quantified with absolute certainty except as otherwise indicated above, we have established reserves covering exposures relating to probable contingencies, to the extent believed to be reasonably estimable and probable, which we believe to be reasonable based on past experience and available facts. While additional exposures beyond these reserves could exist, they currently cannot be estimated. We will continue to evaluate these potential contingent loss exposures and, if they develop, recognize expense as soon as such losses become probable and can be reasonably estimated.

 

We are also involved in ordinary routine litigation incidental to our business, none of which we believe to be material to our business, operations or overall financial condition. However, resolutions or dispositions of claims or

lawsuits by settlement or otherwise could have a significant impact on our operating results for the reporting period in which any such resolution or disposition occurs.

 

As a consequence of all legal matters, including settlements of both publicly disclosed litigation and otherwise, we recognized expenses of approximately $8 million, $7 million and $17 million in 2006, 2005 and 2004, respectively. Total legal fees and expenses, including the amounts above, were approximately $27 million, $16 million and $31 million in 2006, 2005 and 2004, respectively.

 

None.

 

Market Information

 

Our common stock is traded on the NYSE under the symbol “FLS”. On February 16, 2007, our records showed approximately 1,839 shareholders of record. The following table sets forth the range of high and low prices per share of our common stock for the periods indicated.

 

PRICE RANGE OF FLOWSERVE COMMON STOCK
(Intraday High/Low Prices)

 

STOCK PERFORMANCE GRAPH

 

The following graph compares the most recent five-year performance of the Company’s common stock with the S&P 500 Index and S&P 500 Industrial Machinery (formerly referred to as Machinery (Diversified) — 500 Index). It shows an investment of $100 on December 31, 2001, and the reinvestment of any dividends over the following five years.

 

COMPARISON OF 5-YEAR CUMULATIVE TOTAL RETURN
AMONG FLOWSERVE CORPORATION,
S&P 500 INDEX AND INDUSTRIAL MACHINERY INDEX

 

 

ASSUMES $100 INVESTED ON DEC. 31, 2001
ASSUMES DIVIDEND REINVESTED
FISCAL YEAR ENDING DEC. 31, 2006

 

TOTAL RETURN TO SHAREHOLDERS
(INCLUDES REINVESTMENT OF DIVIDENDS)

 

 

We did not pay dividends on our common stock in 2006. On February 28, 2007, our board of directors authorized the payment of a quarterly cash dividend of 15 cents per share payable on April 11, 2007 to shareholders or records as of March 28, 2007. Any subsequent dividends will be reviewed on a quarterly basis and declared by our board or directors at its discretion dependent on the board’s assessment of our financial situation and business outlook at the applicable time.

 

The declaration and payment of dividends is subject to limitations under our credit facilities, which prohibit declaration and payment of dividends at any time there is a default thereunder and cap the aggregate amount of dividends that may be made during the term of the new credit facilities. See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation — Liquidity and Capital Resources — Credit Facilities” for additional information on our credit facilities.

 

Unregistered Sales of Equity Securities

 

As noted elsewhere in this Form 10-K during the Relevant Period (the period from May 1, 2005 through September 29, 2006) our registration statements on Form S-8 were not available to cover offers and sales of our securities to employees and other persons because our financial statements were not current. As a result, the acquisition of units of interest (“Units”) representing a total of 464,033 shares of our common stock by our 401(k) plan on behalf of participants in our 401(k) Plan during the Relevant Period did not comply with the registration requirements of the Securities Act. Our failure to maintain the effectiveness of our registration statement on Form S-8 gave the participants who directed the 401(k) Plan to purchase Units during the Relevant Period the right to rescind these purchases (or recover damages if they had sold their Units) for up to one year under federal law following the purchase of these Units. In order to address this compliance issue, as explained elsewhere in this Form 10-K we conducted a rescission offering that expired on January 8, 2007 pursuant to which we made certain payments to accepting participants. It is unclear, however, whether or not participants in our 401(k) plan continue to have any rescission rights under the federal securities laws following the expiration of the rescission offering. It is the view of the SEC staff that a right of rescission created under the Securities Act may survive a rescission offer. However, federal courts in the past have ruled that a person who rejects or fails to accept a rescission offer is precluded from later seeking similar relief. The remedies and statute of limitations under state securities laws vary and depend upon the state in which the shares were purchased. We believe, however, that the acquisitions of Units made on behalf of participants during the Relevant Period were exempt from state registration requirements. Based on our current stock price, we believe that our current potential liability for rescission claims is not material to our financial condition or results of operations; however, our potential liability could become material in the future if our stock price were to fall below participants’ acquisition prices for their interest in our stock fund during the one-year period following the unregistered acquisitions and if it were determined by competent legal authorities that our rescission offering did not effectively terminate the rights of participants to seek rescission.

 

During 2006, we issued an aggregate of 415,070 shares of restricted stock to employees pursuant to the 2004 Stock Compensation Plan. We believe these securities are not subject to registration under the “no sale” principle or were otherwise issued pursuant to exemptions from registration under Section 4(2) of the Securities Act as transactions by an issuer not involving a public offering.

 

Issuer Purchases of Equity Securities

 

 

 

 

 

 

 

 

 

The impact of this change in accounting method on periods prior to January 1, 2002 is reflected as an increase of $14.9 million to beginning retained earnings as of January 1, 2002.

 

The following discussion and analysis is provided to increase the understanding of, and should be read in conjunction with, the accompanying consolidated financial statements and notes. Please see “Risk Factors” and “Forward-Looking Statements” sections for a discussion of the risks, uncertainties and assumptions associated with these statements. Unless otherwise noted, all amounts discussed herein are consolidated.

 

EXECUTIVE OVERVIEW

 

We are an established leader in the fluid motion and control business, with a strong portfolio of pumping systems, valves, sealing solutions, automation and services in support of the oil and gas, chemical, power generation, water treatment and general industrial markets. These products are integral to the movement, control and protection of fluids in customers’ critical processes, whether it is a refinery, a power generation facility or a transportation pipeline. Our business model is heavily influenced by the capital spending of these industries for the placement of new products into service and for maintenance on existing facilities. The worldwide installed base of our products is another important source of revenue, where products are expected to ensure the maximum operating time of many key industrial processes. The aftermarket business includes parts, service solutions, product life cycle solutions and other value added services, and is generally a higher margin business and a key component to our profitable growth.

 

We have experienced favorable conditions in 2006 in several of our core markets, specifically oil and gas. The rise of the price of crude oil and natural gas, in particular, has spurred capital investment in the oil and gas market, resulting in many new projects and expansion opportunities. Favorable market conditions have resulted in corresponding growth, much of which is in non-traditional areas of the world where new oil and gas reserves have been discovered. We believe the outlook for our business remains favorable; however, we believe that oil and gas prices will fluctuate in the future and such volatility could have a negative impact on our business in some or all of the geographical areas in which we conduct business. We and our customers are seeing rapid growth in the Middle East and Asia, with China providing a significant source of project growth. We continue to execute on our strategy to increase our presence in all of these regions to capture aftermarket business through the current installed base, as well as new projects and process plant expansions. The opportunity to increase the installed base of new products and drive recurring aftermarket business in future years is a critical by-product of these favorable market

conditions. Although we have experienced strong demand for our products and services in recent periods, we face challenges affecting many companies in our industry and/or with significant international operations.

 

We currently employ approximately 14,000 employees in more than 55 countries who are focused on six key strategies that reach across the business. See “Our Strategies” section of this Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) for a discussion of our six key strategies. We continue to build on our geographic breadth with the implementation of additional Quick Response Centers (“QRCs”) with the goal to be positioned as near to the customers as possible for service and support in order to capture this important aftermarket business. Along with ensuring that we have the local capability to sell, install and service our equipment in remote regions, it becomes equally imperative to continuously improve our global operations. Our global supply chain capability is being expanded to meet global customer demands and ensure the quality and timely delivery of our products. Significant efforts are underway to reduce the supply base and drive processes across the divisions to find areas of synergy and cost reduction. In addition, we are improving our supply chain management capability to ensure it can meet global customer demands. We continue to focus on improving on-time delivery and quality, while reducing warranty costs across our global operations through a focused Continuous Improvement Process (“CIP”) initiative. The goal of the CIP initiative is to maximize service fulfillment to customers such as on-time delivery, reduced cycle time and quality at the highest internal productivity. This program is a key factor in our margin expansion plans.

 

RECENT DEVELOPMENTS

 

Legal and Regulatory Matters

 

On February 7, 2006, we received a subpoena from the SEC seeking documents and information relating primarily to products that two of our foreign subsidiaries delivered to Iraq from 1996 through 2003 under the United Nations Oil-for-Food Program. We believe that the SEC’s investigation is focused primarily on whether any inappropriate payments were made to Iraqi officials in violation of the federal securities laws. The investigation includes periods prior to, as well as subsequent to, our acquisition of the foreign operations involved in the investigation. We may be subject to certain liabilities if violations are found regardless of whether they relate to periods before or subsequent to our acquisition.

 

In addition, the two foreign subsidiaries have been contacted by governmental authorities in their respective countries concerning their involvement in the United Nations Oil-for-Food Program. We are unable to predict how the foreign governmental authorities will pursue either of these matters in the future. We believe that the SEC and the foreign governmental authorities are also investigating other companies in connection with the United Nations Oil-for-Food Program.

 

We engaged outside counsel in February 2006 to conduct an investigation of our foreign subsidiaries’ participation in the United Nations Oil-for-Food program. The Audit Committee of the Board of Directors has been regularly monitoring this situation since the receipt of the SEC subpoena and assumed direct oversight of the investigation in January 2007. We currently expect the investigation will be completed during the second quarter of 2007.

 

Our investigation has included, among other things, a detailed review of contracts with the Iraqi government under the United Nations Oil-for-Food Program during 1996 through 2003, a forensic review of the accounting records associated with these contracts, and interviews of persons with knowledge of the events in question. Our investigation has found evidence to date that, during the years 2001 through 2003, certain non-U.S. personnel at the two foreign subsidiaries authorized payments in connection with certain of our product sales under the United Nations Oil-for-Food Program totaling approximately €0.6 million, which were subsequently deposited by a third party into Iraqi-controlled bank accounts. These payments were not authorized under the United Nations Oil-for-Food Program and were not properly documented in the subsidiaries’ accounting records but were expensed as paid. During the course of the investigation, certain other potential issues involving non-U.S. personnel were identified at one of the foreign subsidiaries, which are currently under review.

 

We have taken certain disciplinary actions against persons who engaged in wrongful conduct, violated our ethics policies or failed to cooperate fully in the investigation, including terminating the employment of certain

non-U.S. senior management personnel at one of the foreign subsidiaries. Certain other non-U.S. senior management personnel at that facility involved in the above conduct had been previously separated from our company for other reasons.

 

We will continue to fully cooperate in both the SEC and the foreign investigations. The investigations are in progress but, at this point, are incomplete. Accordingly, if the SEC and/or the foreign authorities take enforcement action with regard to these investigations, we may be required to pay fines, disgorge profits, consent to injunctions against future conduct or suffer other penalties which could potentially materially impact our business, financial condition, results of operations and cash flows.

 

In March 2006, we initiated a process to determine our compliance posture with respect to U.S. export control laws and regulations. Upon initial investigation, it appeared that some product transactions and technology transfers were not necessarily in full compliance with U.S. export control laws and regulations. As a result, in conjunction with outside counsel, we are currently involved in a systematic process to conduct further review, validation, and voluntary disclosure of certain apparent export violations discovered as part of this review process. We currently believe this process will not be substantially complete until the first quarter of 2008, given the complexity of the export laws and the current scope of the investigation. Any violations of U.S. export control laws and regulations that are identified and disclosed to the U.S. government may result in civil or criminal penalties, including fines and/or other penalties. Because our review into this issue is ongoing, we are currently unable to determine the full extent of any confirmed violations or determine the nature or total amount of potential penalties to which we might be subject to in the future. Given that the resolution of this matter is uncertain at this time, we are not able to reasonably estimate the maximum amount of liability that could result from final resolution of this matter. We cannot currently predict whether the ultimate resolution of this matter will have a material adverse effect on our business, including our ability to do business outside the U.S., or on our financial condition.

 

Other matters

 

On September 29, 2006, our Board of Directors authorized a program to repurchase up to two million shares of our outstanding common stock. Shares may be repurchased to offset potentially dilutive effects of stock options issued under our equity-based compensation programs. We commenced the program in October 2006 and repurchased 1.3 million shares for $68.4 million during the fourth quarter of 2006. Subsequent repurchases as of February 26, 2007 have totaled 0.5 million shares for $25.0 million. We expect to conclude the program by the end of the second quarter of 2007.

 

BUSINESS OVERVIEW

 

Our Company

 

We believe that we are a world-leading manufacturer and aftermarket service provider of comprehensive flow control systems. We develop and manufacture precision-engineered flow control equipment such as pumps, valves and seals, for critical service applications that require high reliability. We use our manufacturing platform to offer a broad array of aftermarket equipment services such as installation, advanced diagnostics, repair and retrofitting.

 

Operations are conducted through three business segments that are referenced throughout this document:

 

 

Our product portfolio is built on more than 50 well-respected brand names such as Worthington, IDP, Valtek, Limitorque, and Durametallic. This portfolio is believed to be one of the most comprehensive in the industry. The products and services are sold either directly or through designated channels to more than 10,000 companies, including some of the world’s leading engineering and construction firms, original equipment manufacturers (“OEMs”), distributors and end users.

 

Our Markets

 

Our products and services are used in several distinct industries: oil and gas, chemical, power generation and water treatment, as well as a number of other industries that are collectively refer to as general industries.

 

Demand for most of our products depends on the level of new capital investment and planned maintenance expenditures by our customers. The level of capital expenditures depends, in turn, on the general economic conditions, which are related to the phase of the cycle in their industries and the expectations of future market behavior. The levels of maintenance spend are driven by the reliability of the equipment, planned downtimes for maintenance and the required capacity utilization of the process.

 

The oil and gas industry represented approximately 43% and 35% of our bookings in 2006 and 2005, respectively. High petroleum prices generally drove additional investment in upstream (exploration and production) petroleum projects and significantly contributed to the increase in bookings. Many of these projects were in Asia, Africa, the Middle East and South America and reflect opportunities with national, international, and other major oil companies. Based on the current and future expectations of oil and gas price levels as compared to historical levels, oil and gas companies are encouraged to evaluate new resources, new technologies and explore different options such as oil sands, deepwater, heavy oil and the Arctic region.

 

In the downstream segment of the industry (refining and transportation), high crude oil prices have historically reduced the demand for our products and services from crude oil refineries and natural gas processors as they sought to take advantage of favorable refining margins by operating at high levels of capacity utilization and deferring maintenance. The current global demand for larger amounts of oil and oil derivatives has been stimulated by the rapid economic growth in developing countries and general growth in the rest of the world. The available refining capacity is not currently adequate to meet the market demand for refined products. The refineries are additionally pressured by new clean fuel regulations, which result in activities such as revamps and upgrades to address these environmental concerns. These situations have been positive for our products as oil and gas companies try to address the supply to the market with increased capacity and the right quality of products to meet tightening regulations.

 

Output of the worldwide chemical industry during 2006 expanded slightly as compared with 2005. This was mirrored in increased capacity utilization rates in key chemical producing countries such as the United States (“U.S.”) and Germany, which recovered modestly throughout 2006. The good growth in profitability among major chemical companies and a legacy of underinvestment from 2000 to 2003 encouraged increased global capital expenditure by the chemical industry during 2006. The growth in the U.S. chemical industry, however, was slower than in 2005. In contrast, Asia-Pacific, (particularly China) continues to be a major focus of investment for the chemical industry. Although the global chemical industry is in a more mature phase of its cycle, output growth predictions provided by independent third parties for 2007 are modestly higher than for 2006. We are also seeing increased opportunities in alternative energy sources such as ethanol. We believe this and the forecasted growth in capital expenditures should help sustain continuing healthy demand for our products from this industry. The chemical industry represented approximately 15% and 18% of our bookings in 2006 and 2005, respectively.

 

Early in 2006, high natural gas prices diminished the profitability of many power generators that in recent years made significant investments in power plants fueled by natural gas. The profitability of these power generators improved throughout 2006, as natural gas prices trended lower. The power generators have been able to recover a portion of their higher costs through rate increases, but their liquidity is still challenged due to overinvestment in these power facilities in recent years and volatility in natural gas prices. This volatility has led to a renewed interest in coal and nuclear generation plants.

 

A number of nuclear power generators are planning significant maintenance activities. We have seen an increase in orders in this industry, and it has been a positive contributor to 2006 bookings, sales and earnings. In addition, there are several coal-fired power plants planned for the U.S. and China, and we are actively pursuing the flow control opportunities for these projects. The revenue opportunity for products at a coal-fired plant typically can be three times that of a natural gas power plant. We are also seeing increased activity in alternative energy sources such as geothermal. The power industry represented approximately 13% and 14% of our bookings in 2006 and 2005, respectively.

 

Worldwide demand for fresh water and water treatment continues to create demand for new facilities or for upgrades of existing systems, many of which require products that we offer, especially pumps. We believe we are a global leader in the desalination market, which is an important source of fresh water in the Mediterranean area and the Middle East. We expect that this trend in desalination will expand from the traditional areas, as previously mentioned, to other coastal areas around the globe. This is a significant market for pump and valve actuation products. In 2006 and 2005, the water market represented approximately 6% and 7%, respectively, of our bookings.

 

General industries comprises a variety of different businesses, including mining and ore processing, pulp and paper, food and beverage, and other smaller applications, none of which individually represents more than 5% of total bookings in 2006 and 2005. General industries represented approximately 23% and 26% of our bookings in 2006 and 2005, respectively. We saw some improvement in these businesses in 2006, most notably mining and ore processing and expect stable growth in 2007.

 

Our customers include engineering contractors, OEMs, end users and distributors. Sales to engineering contractors and OEMs are typically for large project orders, as are certain sales to distributors. Project orders generally have lead times in excess of three months. Project orders are typically procured for customers either directly from us or indirectly from contractors for new construction projects or facility enhancement projects.

 

The quick turnaround business, which we also refer to as the “book and ship” business, is defined as orders that are received from the customer (booked) and shipped within three months of receipt. These orders are typically for more standard products, parts or services. Each of our three business segments generates certain levels of this type of business.

 

We use our manufacturing platform to offer a broad array of aftermarket equipment services such as installation, advanced diagnostics, repair and retrofitting. Timelines of delivery, quality and the proximity of service centers are important considerations for aftermarket products and services. In geographic regions where we are positioned to provide quick response, we believe customers have traditionally relied on us, rather than our competitors, for aftermarket products due to our highly engineered and customized products. However, the aftermarket for standard products is very competitive, and price competition has generally been increasing. Price competition tends to be less significant for OEMs than aftermarket services and OEM prices have generally been increasing due to decreased levels of supply availability. In the sale of aftermarket products and services, we benefit from a large installed base of pumps, seals and valves, which require maintenance, repair and replacement parts.

 

The reporting of trends by product type, customer type and business type is based upon analytical review of individual operational results and knowledge of their respective businesses, as we do not formally track revenues by any of these categories. These trends are analyzed as a secondary reporting mechanism that is not derived directly from our general ledger system.

 

Our Strategies

 

Our overarching objective is to grow our position as a product and integrated solutions provider in the flow control industry. This objective includes continuing to sell products by building on existing sales relationships and marketing the power of our portfolio of products and services. It also includes delivering specific end- user solutions that help customers attain their business goals by ensuring maximum reliability at a decreased cost of ownership. Sustainable, profitable growth is being driven using six strategies that are well communicated throughout our company. These strategies include: organic growth, globalization, process excellence, portfolio management, organizational capability and technology/innovation. The key elements of these strategies are outlined below.

 

Organic Growth

 

Organic growth is an important initiative focused on growing revenues from the existing portfolio of products and services, as well as through the development of new customer-driven products and services. An overarching goal is to focus on opportunities that can maximize the organic growth from existing customers and to evaluate potential new customer-partnering initiatives that maximize the capture of the product’s total life cycle. We are one of the few pump, valve and seal companies that can offer customers a differentiated option of products and services as well as offer an additional option that includes any combination of products and solution support packages across

a very broad portfolio. The combined pump and seal end-user teams have historically been particularly successful in delivering new solution programs and increasing organic aftermarket growth.

 

We seek to capture additional market share by creating mutually beneficial opportunities for us and our customers through sourcing and maintenance alliance programs pursuant to which we provide all or an agreed portion of customers’ parts and servicing needs. These customer alliances enable us to develop long-term professional relationships with our customers and serve as an effective platform for introducing new products and services to our customers and generating additional sales.

 

We also seek to continue to review the substantial installed pump, seal and valve base as a means to expand the aftermarket services business, as customers are increasingly using third-party aftermarket service providers to reduce their fixed costs and improve profitability. To date, the aftermarket services business has provided us with a steady source of revenues and cash flows at higher margins than original equipment sales. This allows us to be in frequent contact with customers, building on the knowledge of customer needs and providing cross-selling opportunities. We are building on our established presence through an extensive QRC global network to provide the immediate parts, service and technical support required to effectively manage and win the aftermarket business from the installed base.

 

New product and service development is driven through our product management organization, working in concert with engineering, operations and sales. The goal is to increase our revenues from new products and services developed during the last five years. The new product development process has made significant progress in demonstrating a pipeline of new and modified products and services. We expect our research and development costs to increase in 2007 to support the goal of increased revenues from new products and services.

 

Globalization

 

The globalization business initiative has several facets that include:

 

 

We believe there are attractive OEM opportunities in international markets, particularly in South America, the Middle East and Asia-Pacific and intend to continue to utilize our global presence to further penetrate these markets. In 2006 we signed an agreement for a joint venture in Saudi Arabia with Al Rushaid Group to develop a full service repair facility and training school in support of the region. A manufacturing facility lease was signed for a joint pump, seal and valve facility in Suzhou, China and construction was initiated on a new pump facility in Coimbatore, India. The former pump facility in Bangalore will be used by our valve division to expand its local footprint. The work force at our engineering center in Chennai, India was expanded, as well as at our facilities in China.

 

In the aftermarket services business, we seek to strategically add sites as the customers and the customer base grows in order to provide rapid response, fast delivery and onsite field repair. A number of new QRC’s have been added in 2006.

 

We are focused on shifting, as appropriate, certain manufacturing and engineering functions to, and increasing the supply of materials and components from, lower cost areas such as India, China, Mexico, South America and Eastern Europe. In 2006 these areas accounted for approximately 20% of our direct material spending, compared to approximately 5% in 2001. We are focused on utilizing supply chain management to reduce procurement costs, including expanding purchases through reverse auctions and further consolidating the procurement of goods at a better value.

 

In addition, we have expanded our China presence with additional sales and supply chain professionals, new management and growth plans. These growth plans include acquisition or development of new capabilities that will

enhance the penetration of products in China for oil and gas and power projects, as well as provide a base for the export of products.

 

Process Excellence

 

The process excellence initiative encapsulates ongoing programs that drive increased customer fulfillment at the lowest cost, or internal productivity. This initiative includes:

 

 

We seek to increase our operational efficiency through our CIP initiative, which utilizes tools such as Six Sigma methodology, lean manufacturing and constraint management to improve quality and processes, reduce product cycle times and lower costs. Recognizing that employees are our most valuable resource in achieving operational excellence goals, we have instituted broad CIP training. To date, more than 1,000 employees are CIP-trained or certified as “Green Belts” or “Black Belts” and are deployed on CIP projects throughout our company in operations and the front office of the business. As a result of the CIP initiatives, we have developed and implemented processes to reduce our engineering and manufacturing process cycle time, improve on-time delivery and service response time, lower inventory levels and otherwise reduce costs. We have also experienced success in sharing and applying best practices achieved in one of our business segments and deploying those ideas to other segments of the business.

 

We are actively working to standardize processes and simplify our information technology platform. To date, standard processes have been designed and agreed to by our Manufacturing, Supply Chain, Sales and Service and Finance departments, creating a standard blueprint for our company. Implementation of these processes using a common enterprise resource planning (“ERP”) software platform has been completed in two sites, with four sites currently in the last stages of preparation for implementation. Several additional sites are in the planning stages.

 

We seek to continue to improve our working capital utilization, with a particular focus on improving the management of accounts receivable and inventory. See further discussion in the “Liquidity and Capital Resources” section of this MD&A.

 

Portfolio Management

 

The continued management of our portfolio of products and services is critical to our success. While we will continue to pursue selective acquisitions, we have been focused on smaller niche additions to the portfolio and rationalizing the current portfolio of products and services to ensure alignment with customers.

 

We intend to continue to evaluate acquisition, joint ventures and other investment opportunities as we seek to broaden our product portfolio and operational capabilities and to expedite expansion into the faster growing Asian, African and South American markets. During the past year, we took advantage of smaller niche opportunities that helped round out our presence or filled small gaps in the portfolio. These smaller acquisitions included current and non-current assets and intellectual property. Product management teams also continue to work to streamline the portfolio by rationalizing products that competed internally, had been superseded by new products or were not able to reach internal rates of return.

 

Organizational Capability

 

We believe there are several elements to building an enhanced organizational capability, including:

 

 

 

We continue to focus on training through the distribution of electronic learning packages in multiple languages for our Code of Business Conduct, workplace harassment, facility safety, export compliance and other regulatory and compliance programs throughout our company. In addition, in 2006 we launched a new rotating equipment specialist program aimed at capturing internal intellectual capital and improving the capabilities of the internal workforce in an effort to provide better service to our customers. This is a very comprehensive program that will continue through 2007 and 2008 with the goal of educating more than 2,000 of our front line employees across the globe.

 

Technology/Innovation

 

The infusion of new product technologies has become a core requirement as we evaluate the development of new products and services. The objective is to improve the percentage of new products as a function of revenue during the next five years with the investment in technology being a critical part of success. In 2006, a number of opportunities were pursued in technology for smart equipment, energy efficiency of products, use of radio frequency identification, advanced technology for monitoring wear, sub-sea and geothermal technologies, as well as developing new products to meet the demands of customers. This investment in technology will continue to increase in 2007. A cross-divisional technology team is in place to ensure that the technologies developed are available for wide use across all divisions to maximize the return on investments. The primary application of advanced technology is in adding self-diagnostic capabilities into our products. This includes the intelligence required to provide customers with advanced warning of required maintenance, allowing their operations to reach optimal productivity.

 

OUR RESULTS OF OPERATIONS

 

Effective December 31, 2006, we changed our method of accounting for U.S. inventories from the last-in, first-out method to the first-in, first-out (“FIFO”) method. In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 154, “Accounting Changes and Error Corrections,” we have retrospectively adjusted prior interim and annual periods to reflect the results and balances that would have been reported had we applied the FIFO method of accounting for inventories for all periods presented in this MD&A and in the consolidated financial statements, included in this Annual Report on Form 10-K for the year ended December 31, 2006 (“Annual Report”). The impact of the change in accounting principle increased net earnings for the years ended December 31, 2006, 2005 and 2004 by $6.0 million, $5.2 million and $2.9 million, respectively, or $0.10, $0.09 and $0.06 per diluted share, respectively, and increased both total assets and total shareholders’ equity at December 31, 2005 by $21.6 million. See additional detail in Note 6 to our consolidated financial statements, included in this Annual Report.

 

As a result of selling certain non-core service operations, collectively called the General Services Group (“GSG”), which was previously included in FCD, in December 2005, and our Government Marine Business Unit (“GMBU”), an FPD business, in November 2004, we treated these dispositions as discontinued operations for the years ended December 31, 2005 and 2004. The gain of $1.0 million from discontinued operations in 2006 represents the reduction in the loss on the sale of GSG as a result of the resolution of the contingent sales price. The loss from discontinued operations, net of tax, increased $32.7 million in 2005, compared to a loss of $1.7 million in 2004. The increase is due primarily to the impairment of certain assets owned by GSG, which is more fully discussed in Note 2 to our consolidated financial statements, included in this Annual Report.

 

Bookings and Backlog

 

 

We define a booking as the receipt of a customer order that contractually engages us to perform activities on behalf of our customer with regard to manufacture, service or support.

 

Bookings for continuing operations in 2006 increased $685.1 million, or 23.4%, as compared with the same period in 2005. Total bookings in 2006 increased by $594.7 million, or 19.7%, as compared with 2005. The increase includes currency benefits of approximately $24 million. Total bookings in 2005 include $90.4 million of bookings for GSG, a discontinued operation that was sold effective December 31, 2005. Increased bookings are primarily attributable to strength in the oil and gas industry, which has positively impacted each of our divisions, particularly in North America and the Middle East. The power, chemical and water treatment industries have also contributed to the improvement.

 

Bookings for continuing operations in 2005 increased by $407.1 million, or 16.1%, as compared with 2004. Total bookings in 2005 increased by $364.9 million, or 13.7%, as compared with 2004. The increase includes currency benefits of approximately $10 million. Total bookings in 2005 and 2004 include $90.4 million and $116.1 million, respectively, of bookings for GSG. Total bookings in 2004 also includes $16.6 million of bookings for GMBU, a discontinued operation that was sold effective November 2004. Bookings for Thompsons, Kelly and Lewis, Pty. Ltd (“TKL”), which was acquired in March 2004, increased $28.8 million in 2005 as compared with 2004. Increased bookings are also attributable to improved bookings in Europe, the Middle East and Africa (“EMA”) for FPD and improved bookings in Asia Pacific for FPD and FCD. Establishment of customer alliances has resulted in increased bookings in FSD as described below. Bookings have also been positively impacted by continued strength in the oil and gas industry and recovery of major valve markets.

 

Backlog represents the accumulation of uncompleted customer orders. Amounts presented above include backlog related to discontinued operations of $0, $0 and $11.2 million for 2006, 2005 and 2004, respectively. Backlog of $1.6 billion at December 31, 2006 increased by $635.9 million, or 64.0%, as compared with 2005. Currency effects provided an increase of approximately $101 million. The increase resulted primarily from increased bookings as discussed above. The increase in total bookings reflects an increase in orders for engineered products, which naturally have longer lead times, as well as expanded lead times at the request of certain customers. By the end of 2007, we expect to ship over 85% of this backlog. Backlog of $994.1 million at December 31, 2005 increased by $157.7 million, or 18.9%, as compared with 2004. Currency effects provided a decrease of approximately $67 million. The increase in backlog is primarily attributable to the strong bookings performance in 2005, as well as an increase in large oil and gas project orders in EMA for FPD.

 

Sales

 

 

Sales in 2006 increased by $365.8 million, or 13.6%, as compared with 2005. The increase includes currency benefits of approximately $39 million. The increase in sales is primarily attributable to continued strength in the oil and gas industry, particularly in North America and the Middle East, which has significantly impacted FPD and FCD. FCD has also been positively impacted by strength in the process valve industry, particularly in Asia. Additional capacity has enabled FSD to increase its aftermarket sales.

 

Sales in 2005 increased by $172.8 million, or 6.9%, as compared with 2004. The increase includes currency benefits of approximately $8 million. The increase in sales is attributable to all three of our segments and primarily

due to continued growth in the oil and gas industry, which has positively impacted FPD and FSD, and the continued recovery and strengthening of major valve markets.

 

Sales to international customers, including export sales from the U.S., were approximately 67% of sales in 2006 compared with 65% of sales in 2005 and 68% of sales in 2004. Sales to EMA were approximately 42%, 39% and 43% in 2006, 2005 and 2004, respectively. Sales into the Asia Pacific region were approximately 15%, 14% and 14% in 2006, 2005 and 2004, respectively. We believe that our sales to international customers will continue to increase as a percentage of total sales, as we believe our highest revenue growth opportunities are in Asia, the Middle East and South America.

 

Gross Profit and Gross Profit Margin

 

 

Gross profit margin in 2006 of 32.9% increased from 32.3% in 2005. Gross profit margin in 2006 was positively impacted by various CIP and supply chain initiatives. Our CIP initiative is driving increased throughput on existing capacity, reduced cycle time, lean manufacturing and reduced warranty costs. Our supply chain initiatives focus on materials costs savings through low cost supply sources, long-term supply agreements and product outsourcing. Gross profit margin in 2006 was also positively impacted by pricing increases in FCD and FSD, as well as increased sales in all of our divisions, which positively impacts our absorption of fixed costs. These were partially offset by an increase in original equipment sales, primarily by FPD, which generally carries a lower margin.

 

Gross profit margin in 2005 of 32.3% increased from 30.3% in 2004. Gross profit margin in 2005 was positively impacted by operational improvements attributable to our CIP initiative, which resulted in cost savings, a higher mix of aftermarket business, which generally has a higher margin, and increased sales, which favorably impacts our absorption of fixed costs. Additionally, the charge to cost of sales to increase the reserve for obsolete and slow moving inventory was significantly lower in 2005 than the charge recorded in 2004, which had a favorable impact on gross profit margin.

 

Selling, General and Administrative Expense (“SG&A”)

 

 

SG&A is impacted by growth in our underlying business, various initiatives to improve organizational capability, compliance and systems and infrastructure improvements. In each of the three years presented, at least 55% of SG&A consisted of employee-related costs, which includes payroll, benefits and incentive payments. SG&A in 2006 increased by $98.2 million, or 14.4%, as compared with 2005. Currency effects provided an increase of approximately $6 million. The increase is primarily attributable to an increase in employee-related costs of $54.0 million as follows: increased marketing and engineering personnel to support increased sales; development of in-house capabilities for tax, Sarbanes-Oxley compliance, internal audit, and financial planning and analysis; increased equity incentive arising from higher share price ($6.5 million primarily related to restricted stock) and the adoption of SFAS No. 123(R), “Share-Based Payment” ($6.9 million related to stock options); costs associated with our expansion in Asia; and severance charges related to an outsourcing initiative ($1.3 million). The increase is also due to an increase in travel expenses of $12.1 million, due to increased global selling and marketing activity to support overall business growth and increased compliance initiatives, an $8.0 million increase in information technology expenses related to infrastructure and ERP application upgrades and a $11.4 million increase in legal fees and expenses, partially offset by a $12.6 million decrease in finance-related professional fees due to the development of in-house capabilities discussed above. Additionally, we incurred charges of $11.6 million

associated with the relocation of product lines to different facilities and the severance of redundant personnel in Europe, which accounts for 40 basis points of our SG&A as a percentage of sales.

 

SG&A in 2005 increased by $79.2 million, or 13.1%, as compared with 2004. Currency effects provided an increase of approximately $3 million. The increase in SG&A is due primarily to the following: employee-related costs of $38.5 million including sales commissions, incentive compensation and equity incentive programs arising from improved performance and the higher share price ($11.1 million); severance and transition expenses ($8.1 million); and modification of stock options expiration terms for former executives, current and retired employees and board of directors ($7.2 million). See further discussion of stock modifications in Note 7 to our consolidated financial statements, included in this Annual Report. The increase in SG&A is also attributable to increases in professional fees resulting from the restatement of 2002, 2003 and the first quarter of 2004, which includes a $24.1 million increase in audit fees and a $13.8 million increase in other professional fees related to tax consulting, accounting and internal audit assistance. These increases in professional fees were partially offset by a $15.5 million decrease in legal fees and expenses and a $6.8 million decrease in costs incurred related to Sarbanes-Oxley compliance.

 

Operating Income

 

 

Operating income in 2006 increased by $40.8 million, or 20.5%, as compared with 2005. The increase includes currency benefits of approximately $6 million. The increase is primarily a result of the $136.7 million increase in gross profit, partially offset by the $98.2 million increase in SG&A, discussed above.

 

Operating income in 2005 increased by $32.7 million, or 19.7% as compared with 2004. Currency had a negligible impact on operating income for the period. The increase is primarily a result of the $107.4 million increase in gross profit, partially offset by the $79.0 million increase in SG&A, discussed above.

 

Interest Expense and Loss on Repayment of Debt

 

 

Interest expense in 2006 decreased by $8.4 million as compared with 2005 primarily as a result of the refinancing of our 12.25% Senior Subordinated Notes in August 2005 with the proceeds of borrowings under our Credit Facilities. Interest expense decreased by $6.3 million in 2005 as compared with 2004, also as a result of our 2005 refinancing. See further discussion of our refinancing in the “Liquidity and Capital Resources” section of this MD&A and in Note 11 to our consolidated financial statements included in this Annual Report. At December 31, 2006 approximately 77% of our debt was at fixed rates, including the effects of $435.0 million of notional interest rate swaps.

 

Interest income in 2006 increased by $4.2 million as compared with 2005 due primarily to higher interest rates, higher average cash balance and the receipt of interest on a long-overdue receivable that was collected in 2006. Interest income in 2005 increased by $1.5 million as compared with 2004 due to significantly higher average cash balances.

 

During 2006, we incurred charges of $0.7 million on debt repayments and extinguishment primarily as a result of our repayments of amounts outstanding under our European Investment Bank (“EIB”) credit facility. During 2005, we incurred a charge of $27.7 million as a result of debt repayments and extinguishment related to our 2005 refinancing. Expenses incurred as a result of the refinancing are more fully described in the “Liquidity and Capital Resources” section of this MD&A. During 2004, we incurred a charge of $2.7 million on debt repayments and

extinguishment related to the accelerated write-off of deferred loan costs resulting from $160.0 million of optional debt prepayments and $167.9 million of mandatory debt prepayments triggered by the GMBU divestiture ($22.9 million), the issuance of the EIB credit facility ($85.0 million) and receivables securitization ($60.0 million).

 

Other Income (Expense), net

 

 

Other income (expense), net in 2006 increased by $14.8 million to income of $6.4 million as compared with 2005, primarily due to a $14.2 million increase in unrealized gains on forward exchange contracts. Other income (expense), net in 2005 decreased by $5.7 million to expense of $8.4 million as compared with 2004, primarily due to a $2.6 million decrease in unrealized losses on derivative contracts, as well as foreign currency transaction losses.

 

Tax Expense and Tax Rate

 

 

The 2006 effective tax rate differed from the federal statutory rate of 35% primarily due to the net impact of foreign operations and certain U.S. non-deductible expenses.

 

The 2005 effective tax rate differed from the federal statutory rate of 35% primarily due to Extraterritorial Income (“ETI”) exclusion benefits of $1.9 million, state income tax benefits of $2.7 million resulting primarily from net reductions in valuation allowances and $12.7 million of net tax impact from foreign operations.

 

The 2004 effective tax rate differed from the federal statutory rate of 35% primarily due to ETI exclusion benefits of $4.9 million, $22.0 million of net tax impact from foreign operations resulting from approximately $85 million in foreign earnings repatriation to pay down U.S. debt.

 

We have operations in European and Asian countries that provide various tax incentives. In 2003, we were granted a preferential tax rate of approximately 10% in Switzerland for certain sales and marketing activities. This incentive is not likely to provide a benefit after 2006. During 2004, we received a 5-year, 10% tax rate in Singapore for income in excess of a prescribed base amount generated from certain regional headquarter activities, subject to certain employment and investment requirements. In India, we were granted 100% tax exemptions for profits derived from export sales and certain manufacturing operations in prescribed areas for a period of 10 years. The Indian tax exemptions expire in 2011 and 2007, respectively.

 

On October 22, 2004, the American Jobs Creation Act of 2004 (the “2004 Act”) was signed into law, creating a temporary incentive for U.S. multinationals to repatriate accumulated income earned outside the U.S. at an effective tax rate of 5.25%, versus the U.S. federal statutory rate of 35%. During 2004, we repatriated approximately $46 million (as part of the $85 million discussed above) pursuant to a dividend reinvestment plan as described by the 2004 Act. We have not recognized the lower tax rate on these dividends in our financial statements due to uncertainties surrounding the interpretation of the 2004 Act. To the extent this uncertainty is favorably resolved in a future reporting period, the benefit associated with these dividends will be recognized in that period.

 

The 2004 Act also provides for a phase out of the existing ETI exclusion for foreign export sales, as it was viewed to be inconsistent with the international trade protocols set by the European Union. This phase out provides that the benefit for our otherwise qualifying export sales in 2005 and 2006 will be limited to approximately 80% and 60%, respectively. As a replacement for the loss of the ETI export incentive, the 2004 Act provides a deduction for income from qualified domestic production activities, which will be phased in from 2005 through 2010. This manufacturing deduction had no impact to our 2006 and 2005 tax rates, and the impact to our future tax rate has not yet been quantified. Under the guidance of Financial Accounting Standards Board Staff Position No. FAS 109-1, “Application of FASB Statement No. 109 to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004,” the tax deduction on qualified production activities will be treated as a

special deduction, as described in Statement of Financial Accounting Standards (“SFAS”) No. 109, “Accounting for Income Taxes”. As such, the special deduction will be reported in the period in which the deduction is claimed on our tax return.

 

On May 17, 2006, the Tax Increase Prevention and Reconciliation Act of 2005 was signed into law, creating an exclusion from U.S. taxable income for certain types of foreign related party payments of dividends, interest, rents, and royalties which, prior to 2006, have been subject to U.S. taxation. This exclusion is effective for the years 2006 through 2008, and applies to certain of our related party payments.

 

In July 2006, the Financial Accounting Standards Board issued Financial Interpretation (“FIN”) No. 48, “Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement No. 109.” FIN No. 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS No. 109, “Accounting for Income Taxes.” FIN No. 48 also prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return, as well as guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. We are still evaluating the impact of FIN No. 48 on our consolidated financial condition and our 2007 effective tax rate.

 

Our effective tax rate is based upon current earnings and estimates of future taxable earnings for each domestic and international location. Changes in any of these and other factors, including our ability to utilize foreign tax credits and net operating losses or results from tax audits, could impact the tax rate in future periods. As of December 31, 2006 we have foreign tax credits of $21.4 million, expiring in 2010 through 2016 against which we recorded $0.5 million in valuation allowances. Additionally, we have recorded other U.S. net deferred tax assets of $86.5 million, which relate to net operating losses, tax credits and other deductible temporary differences which are available to reduce taxable income in future periods, most of which do not have a definite expiration. Should we not be able to utilize all or a portion of these credits and losses, our effective tax rate would be negatively impacted.

 

Net Earnings and Earnings Per Share

 

 

Income from continuing operations in 2006 increased by $62.6 million to $114.0 million, or $2.00 per diluted share, as compared with 2005. The increase is primarily attributable to the $40.8 million increase in operating income and the $27.0 million decrease in loss on debt repayment and extinguishment, partially offset by the $32.6 million increase in tax expense, as discussed above.

 

Income from continuing operations in 2005 increased by $22.6 million to $51.4 million, or $0.91 per diluted share. The increase is primarily attributable to the $32.7 million increase in operating income, the $6.3 million decrease in interest expense and the $5.7 million decrease in other income (expense), net, partially offset by the $25.0 million increase in loss on debt repayment and extinguishment, as discussed above.

 

Net earnings in 2005 declined as compared with 2004 primarily as a result of impairment charges of $30.1 million related to GSG, which is included in discontinued operations and is more fully discussed in Note 2 to our consolidated financial statements, included in this Annual Report.

 

Other Comprehensive Income (Expense)

 

Other comprehensive income (expense) in 2006 increased by $127.2 million to income of $63.5 million as compared with 2005. The increase is due to the weakening of the U.S. dollar exchange rate versus the Euro and the British pound during 2006. Pension and other postretirement gain of $23.9 million in 2006 increased from expense of $31.9 million in 2005, primarily as a result of an increased discount rate.

 

Other comprehensive income in 2005 decreased by $78.8 million to expense of $63.7 million as compared with 2004. The decline is primarily a result of a decrease of $56.3 million in currency translation adjustments as compared with 2004. The decrease is due primarily to the strengthening of the U.S. dollar exchange rate versus the Euro and the British pound during 2005. Pension and other postretirement expense of $31.9 million in 2005 increased as compared with expense of $8.2 million in 2004, primarily as a result of a decreased discount rate.

 

Business Segments

 

We conduct our business through three business segments that represent our major product areas. We evaluate segment performance and allocate resources based on each segment’s operating income. See Note 17 to our consolidated financial statements included in this Annual Report for further discussion of our segments. The key operating results for our three business segments, FPD, FCD and FSD are discussed below.

 

Flowserve Pump Division Segment Results

 

Through FPD, we design, manufacture and distribute highly engineered pumps, industrial pumps and pump systems (collectively referred to as “original equipment”). FPD also manufactures replacement parts and related equipment, and provides a full array of support services (collectively referred to as “aftermarket”). FPD has 27 manufacturing facilities worldwide, of which nine are located in North America, 11 in Europe, five in South America and two in Asia. FPD also has more than 30 service centers, which are either free standing or co-located in a manufacturing facility.

 

 

Total bookings in 2006 increased by $535.2 million, or 34.0%, as compared with 2005. The increase includes currency benefits of approximately $15 million. The increase is primarily due to a $360.1 million increase in EMA, which is attributable to strength in the oil and gas, power and water industries and a $131.1 million increase in North America, which is primarily attributable to the oil and gas industry. The increase in bookings includes a 46% increase in original equipment bookings, attributable to all regions, and an 18% increase in aftermarket bookings, particularly in EMA. Of the $2.1 billion of total bookings in 2006, approximately 54% were from oil and gas, 16% power, 9% water, 6% chemical and 15% general industries.

 

Bookings for continuing operations in 2005 increased by $253.2 million, or 19.2%, as compared with 2004. Total bookings in 2005 increased by $236.6 million, or 17.7%, as compared with 2004. The increase includes currency benefits of approximately $3 million. Total bookings in 2004 includes $16.6 million of bookings for GMBU, a discontinued operation. The increase in bookings is primarily due to increases in all regions: EMA bookings increased $131.3 million; North and South America bookings increased by $45.9 million and $24.2 million, respectively, due primarily to large engineered projects; and Asia Pacific increased $36.3 million due primarily to TKL, which was acquired in March 2004. The increase is also attributable to continued growth in the oil and gas

industry. Of the $1.6 billion of total bookings in 2005, approximately 46% were from oil and gas, 17% power, 11% water, 7% chemical and 19% general industries.

 

Sales in 2006 increased by $219.3 million, or 15.7%, as compared with 2005. The increase includes currency benefits of approximately $24 million. The increase is primarily attributable to EMA, which increased $141.1 million, and North America, which increased $59.7 million. Oil and gas sales to the Middle East region have contributed the most significant growth in EMA, while domestic oil and gas sales have contributed the most significant growth in North America. Original equipment increased to approximately 56% of sales in 2006, as compared with approximately 53% of sales in 2005.

 

Sales in 2005 increased by $68.6 million, or 5.2%, as compared with 2004. The increase includes currency benefits of approximately $4 million. Sales in North and South America increased by $24.2 million and $19.4 million, respectively. In North America, higher sales were primarily attributable to an improvement in general industrial products, as well as in parts and service. Asia Pacific increased $18.8 million due primarily to TKL.

 

Gross profit margin in 2006 of 28.3% did not change as compared with 2005. In 2006, gross profit margin was positively impacted by higher sales, which favorably impacts our absorption of fixed costs, as well as CIP and supply chain initiatives. However, these were offset by a 23% increase in sales of original equipment, which carries a lower margin. Aftermarket sales increased by 8%.

 

Gross profit margin in 2005 of 28.3% increased from 25.9% in 2004 primarily as a result of the increase in sales, which favorably impacts our absorption of fixed costs, a higher mix of historically more profitable general industrial and nuclear products and services and increased productivity.

 

Operating income in 2006 increased by $22.9 million, or 15.3%, as compared with 2005. The increase includes currency benefits of approximately $4 million. The increase is primarily a result of the $61.6 million improvement in gross profit, partially offset by increased commission expenses and travel to support increased bookings and sales, expenses related to stock options and increased information technology project costs. Also, 2006 includes $5.0 million of severance costs associated with the termination of redundant personnel in Europe, which accounts for 30 basis points of our SG&A as a percentage of sales.

 

Operating income in 2005 increased by $36.2 million, or 31.9%, as compared with 2004. The increase includes negative currency effects of approximately $1 million. The increase is primarily a result of the $51.0 million increase in gross profit, partially offset by increases in marketing expenses to support increased bookings and sales and increased information technology costs.

 

Backlog of $1.3 billion in 2006 increased by $559.8 million, or 79.6%, as compared with 2005. Currency provided an increase of approximately $82 million. The increase in backlog is primarily attributable to the growth in bookings discussed above. Backlog of $703.5 million in 2005 increased by $127.7 million, or 22.2%. Currency provided a decrease of approximately $52 million. The increase in backlog is primarily attributable to the strong bookings performance in 2005 across all regions, as well as an increase in large oil and gas project orders in EMA.

 

Flow Control Division Segment Results

 

Our second largest business segment is FCD, which designs, manufactures and distributes a broad portfolio of industrial valve products, including modulating and finite valves, actuators and controls. FCD leverages its experience and application know-how by offering a complete menu of engineered services to complement its expansive product portfolio. FCD has manufacturing and service facilities in 19 countries around the world, with only five of its 20 manufacturing operations located in the U.S.

 

 

Bookings for continuing operations in 2006 increased by $124.9 million, or 13.3%, as compared with 2005. Total bookings in 2006 increased by $34.5 million, or 3.4%, as compared with 2005. The increase includes currency benefits of approximately $6 million. Total bookings in 2005 includes $90.4 million of bookings for GSG, a discontinued operation. The increase is primarily attributable to continued strengthening of several of our key end-markets. Increased bookings in the process valve market resulted from growth in the China chemical and coal gasification industries, as well as across the board strength in the North American and Middle Eastern oil and gas markets. Growth in the Russian district heating market, increased project business in the U.S. and Western European steam recovery systems, improved project business in the European chemical market, and improvements in the Asian pulp and paper industries also contributed to the increase. Of the $1.1 billion of total bookings in 2006, approximately 40% were from general industry, 29% chemical, 19% oil and gas and 12% power.

 

Bookings for continuing operations in 2005 increased by $84.3 million, or 9.9%, as compared with 2004. Total bookings in 2005 increased by $58.6 million, or 6.1%, as compared with 2004. The increase includes currency benefits of approximately $3 million. Total bookings in 2005 and 2004 include $90.4 million and $116.1 million, respectively, of bookings for GSG. The increase in bookings is primarily attributable to increases in order volume, particularly in Asia Pacific coupled with what we believe to be sustainable price increases in all of our core end-markets including the oil and gas, power and chemical industries. Of the $1.0 billion of total bookings in 2005, approximately 42% were from general industry, 30% chemical, 14% oil and gas and 14% power.

 

Sales in 2006 increased by $100.5 million, or 11.2%, as compared with 2005. This increase includes currency benefits of approximately $10 million. The increase is primarily attributable to notable improvements in the process valve industry, specifically in the Middle Eastern petroleum and German chemical markets, as well as the North American oil and gas industry. Also contributing to the growth in the process valves business were strong sales in Asia’s chemical market, specifically acetic acid and coal gasification projects in China. Successful completion of several projects in the North American power industry also helped drive the improvement, as well as improvements in both the Asian oil and gas and European fine chemicals markets. In 2007, FCD expects to institute modest price increases based upon the increased metals cost and manufacturing lead times. The achieved benefit, if any, will be dependent on the ability of our customer base to absorb these price increases into their capital spending plans.

 

Sales in 2005 increased by $55.6 million, or 6.6%, as compared with 2004. This increase includes currency benefits of approximately $2 million. The recovery of major valve markets that began in 2004 strengthened as 2005 progressed and drove sales increases to our process and power valve customers. Sales in 2005 reflects an increase in sales volume, improvement in worldwide power markets and U.S. chemical markets. Sales in 2005 also reflect improvement in the Asian and Russian markets.

 

Gross profit margin in 2006 of 34.0% increased from 32.2% in 2005. The increase is due to the increase in sales, which favorably impacts our absorption of fixed costs. Strong focus on realizing margin improvements on aftermarket sales for our installed base, improved sharing of materials pricing risk with our customers, our successful implementation of various other CIP and supply chain initiatives and implementation of broad-based price increases in the latter-half of 2005 also contributed to the improvement.

 

Gross profit margin in 2005 of 32.2% increased from 30.2% in 2004. The increase is due to our efforts to continuously monitor inventory levels, coupled with successful management of aged inventory, which resulted in a charge to cost of sales to increase the reserve for obsolete and slow moving inventory of $3.7 million in 2005, which was significantly lower as compared with the $14.1 million charge recorded in 2004. Further, the aforementioned volume and sales price increases and a more favorable mix of aftermarket sales, which typically have a higher margin, positively impacted gross profit margin.

 

Operating income in 2006 increased by $23.8 million, or 25.8 as compared with 2005. This increase includes currency benefits of approximately $1 million. The increase is primarily attributable to the $50.6 million improvement in gross profit, partially offset by higher SG&A, driven primarily by increased headcount, which contributed an additional $8.5 million of compensation costs, a $1.7 million increase in information technology project costs, a $2.3 million increase in travel costs, a $1.5 million increase in equity-based incentive compensation and higher external commission expense resulting from increased sales. In 2006, we recognized $1.2 million in bad debt expense related to the bankruptcy of a single customer. Also, 2006 includes $6.6 million of costs associated with the relocation of product lines to different facilities, which accounts for 70 basis points of our SG&A as a percentage of sales.

 

Operating income in 2005 increased by $26.5 million, or 40.4%, as compared with 2004. This increase includes currency benefits of less than $1 million. The increase is driven primarily by the $34.7 million increase in gross profit, partially offset by higher sales commissions incurred to generate the sales increase, higher costs associated with Sarbanes-Oxley compliance, costs incurred in expanding our footprint in Asia.

 

Backlog of $314.3 million at December 31, 2006 increased by $73.7 million, or 30.6%, as compared with 2005. Currency effects provided an increase of approximately $16 million. The increase in backlog is primarily attributable to increased bookings, as discussed above, which should yield increased sales in 2007. Backlog of $240.6 million at December 31, 2005 increased by $24.1 million, or 11.1% as compared with 2004. Currency effects provided a decrease of approximately $12 million. The increase in backlog is primarily attributable to the strong bookings performance in 2005.

 

Flow Solutions Division Segment Results

 

Through FSD, we engineer, manufacture and sell mechanical seals, auxiliary systems and parts, and provide related services, principally to process industries and general industrial markets, with similar products sold internally in support of FPD. FSD has added to its global operations and has nine manufacturing operations, four of which are located in the U.S. FSD operates 67 QRCs worldwide, including 24 sites in North America, 16 in Europe, and the remainder in South America and Asia. Our ability to rapidly deliver mechanical sealing technology through global engineering tools, locally sited QRCs and on-site engineers represents a significant competitive advantage.

This business model has enabled FSD to establish a large number of alliances with multi-national customers. Based on independent industry sources, we believe that we are the second largest mechanical seal supplier in the world.

 

 

Bookings in 2006 increased by $41.6 million, or 9.0%, as compared with 2005. This increase includes currency benefits of approximately $4 million. This increase is due to a $28.7 million increase in customer bookings, which is primarily attributable to EMA and South America, as well as a $12.9 million increase in interdivision bookings (which are eliminated and are not included in consolidated bookings as disclosed above). The increase is attributable to growth from projects including OEMs and end user markets with the majority of the increase coming from regions outside North America. Success in the end user market continues to be a strength based on the FSD business model, which places a premium on servicing customers locally through an increasing network of QRCs. During the period we added, rebuilt, upgraded or relocated 15 QRCs to further improve our ability to service our customers in their locale. The bookings improvement continues to reflect FSD’s ability to establish long-term customer alliance programs, including fixed fee contracts. This strategy of signing special fixed fee alliances in conjunction with the higher levels of local service that comes from the strategically located QRCs has led to market share gains in 2006 over 2005. Of the $505.0 million of bookings in 2006, approximately 48% were from oil and gas, 27% chemical and 25% general industries.

 

Bookings in 2005 increased by $68.4 million, or 17.3%, as compared with 2004. This increase includes currency benefits of approximately $4 million. This increase in bookings reflects increased business in projects, which includes OEMs, and the aftermarket. We experienced strong growth in compressor and pump seals in the project business and continued success with end users due to a focus on servicing customers locally through our increasing network of QRCs. In addition, the bookings improvement reflects FSD’s success in establishing longer-term customer alliance programs, including fixed fee alliances. Fixed fee alliances are contractual agreements with customers wherein the customer pays us a fixed amount each period (usually monthly) for the term of the agreement. In return for this fixed cost, the customer is entitled to new seals, repairs, upgraded equipment, replacements and maintenance services as defined within the scope of each agreement. We believe the fixed fee strategy coupled with higher levels of customer service, reliability, drive for repair business, equipment upgrades, replacements and maintenance services have led to increases in market share in 2005 and 2004. Of the $463.4 million of bookings in 2005, approximately 46% were from oil and gas, 29% chemical and 25% general industries.

 

Sales in 2006 increased by $53.0 million, or 11.9%, as compared with 2005. The increase includes currency benefits of approximately $5 million. The increase is attributable to a $44.4 million increase in customer sales, primarily in North America and EMA, our two largest markets, as well as an $8.6 million increase in interdivision sales (which are eliminated and are not included in consolidated sales as disclosed above). The increase in customer sales is primarily attributable to aftermarket sales, where FSD has expanded capacity to enable it to meet customer demand for fast turnaround. Additionally, sales growth occurred in the project business and original equipment. Aftermarket and original equipment sales growth occurred in the oil and gas, chemical and mineral and ore processing industries.

 

Sales in 2005 increased by $49.6 million, or 12.6%, as compared with 2004. This increase includes currency benefits of approximately $3 million. The increase is due to strength in the oil and gas industry led by oil prices and high demand; share growth in the mineral and ore processing industry due to strong demand; and increased sales in the gas compressor business due to growth in the natural gas industry.

 

Gross profit margin in 2006 of 44.1% increased slightly from 43.9% in 2005 primarily as a result of various supply chain initiatives and our ability to pass along price increases. Gross profit margin in 2005 of 43.9% increased from 43.4% in 2004 primarily as a result of the ability to pass along price increases and improved product mix in the aftermarket, which typically has a higher margin.

 

Operating income in 2006 increased by $11.0 million, or 12.6%, as compared with 2005. The increase includes currency benefits of less than $1 million. The improvement in 2006 reflects the $24.1 million increase in gross profit, partially offset by an increase in SG&A, which is attributable to increases in our global engineering and sales functions to both support our sales growth and maintain the level of service and support response that gives us our competitive advantage.

 

Operating income in 2005 increased by $14.5 million, or 19.9%, as compared with 2004. This increase includes currency benefits of less than $1 million. The improvement in 2005 reflects the $24.1 million increase in gross profit and greater control of SG&A.

 

Backlog of $74.4 million at December 31, 2006 increased by $13.2 million, or 21.6%, as compared with 2005. Currency provided an increase of approximately $3 million. Backlog at December 31, 2006 includes $14.7 million of interdivision backlog (which is eliminated and not included in consolidated backlog as disclosed above). The increase in backlog is primarily attributable to the increased bookings discussed above. Capacity expansions in South America, Asia-Pacific and EMA in 2006 helped to significantly increase shipments, helping to limit the increase in backlog. Backlog of $61.2 million in 2005 increased by $17.5 million, or 40.1%, as compared with 2004. Currency provided a decrease of approximately $2 million. The increase in backlog is primarily attributable to the strong bookings performance in 2005.

 

LIQUIDITY AND CAPITAL RESOURCES

 

 

Cash Flow Analysis

 

Cash generated by operations and borrowings available under our existing revolving line of credit are our primary sources of short-term liquidity. Our sources of operating cash generally include the sale of our products and services and the reduction of our working capital, particularly accounts receivable and inventories. Our total cash balance at December 31, 2006 was $67.0 million, compared with $92.9 million in 2005 and $63.8 million in 2004.

 

The cash flows provided by operating activities in 2006 as compared with 2005 primarily reflect a $98.0 million increase in net income, offset by a $32.6 million decrease in cash flows from working capital, particularly due to higher inventory of $98.4 million, especially project-related work in process inventory required to support future shipments of products in backlog. Further, operating cash flows in 2006 reflect a decrease of $8.5 million in funding of U.S. pension plans as compared with 2005, an increase to net deferred taxes ($4.5 million) and an increase in equity compensation ($11.3 million) due to the expensing of stock options under SFAS No. 123(R) also had positive impacts on cash flows from operating activities.

 

The decrease in cash flows provided by operating activities in 2005 as compared with 2004 primarily reflect a $125.6 decrease in cash flows provided by working capital, particularly higher accounts receivable of $37.2 million from the impact of the termination of our accounts receivable securitization agreement of $48.7 million. Operating cash flows in 2005 reflect a lower than anticipated return on pension assets and increased funding of U.S. pension plans of approximately $29.4 million as compared with 2004. The negative cash flow impact of increases to net deferred taxes ($27.6 million) is offset by positive cash flow impacts related to the following non-recurring events: non-cash expense related to our debt refinancing ($27.7 million) and impairment of assets related to discontinued operations ($30.1 million). An increase in equity compensation also provided a positive cash flow impact of

$12.0 million. In addition, incremental factoring of certain non-U.S. receivables contributed $23.4 million in 2006, contributed $0.7 million in 2005 and used $3.4 million in 2004.

 

Our goal for days’ sales receivables outstanding (“DSO”) is 60 days. For the fourth quarter of 2006, we achieved a DSO of 56 days as compared to 58 days for the same period in 2005. For reference purposes based on 2006 sales, an improvement of one day could provide approximately $10 million in cash. Increases in inventory used $98.4 million of cash flow for 2006 compared with uses of $20.6 million of cash flow for 2005 and contributions of $21.0 million in 2004. Inventory turns were 4.4 times at December 31, 2006, compared with 4.8 times and 4.7 times at December 31, 2005 and 2004 respectively, reflecting the substantial increase in sales, partially offset by the large increase in inventory. For reference purposes based on 2006 data, an improvement of one turn could yield approximately $102 million in cash.

 

Cash outflows for investing activities were $77.7 million, $39.3 million and $14.1 million in 2006, 2005 and 2004, respectively, due primarily to capital expenditures. Capital expenditures during 2006 were $73.5 million, an increase of $24.3 million as compared with 2005, which reflects increased spending to support capacity expansion, enterprise resource planning application upgrades and information technology infrastructure.

 

Cash outflows for financing activities were $114.5 million in 2006 compared with $53.3 million in 2005 and $250.6 million in 2004. The change in 2006 results primarily from debt paydown and repurchase of common shares, partially offset by proceeds from stock option activity. The change in 2005 is primarily a result of the debt paydown.

 

Our cash needs for the next 12 months are expected to be substantially similar to 2006, except for decreases in payments of long-term debt and repurchases of common shares (see discussion below), partially offset by an increase in capital expenditures related to information technology infrastructure and capacity expansion, as well as prospective dividend payments. Our pension contributions are currently expected to be less in 2007 as compared with 2006, but will be re-evaluated later in 2007. We believe cash flows from operating activities, combined with availability under our revolving line of credit and our existing cash balances, will be sufficient to enable us to meet our cash flow needs for the next 12 months. However, cash flows from operations could be adversely affected by economic, political and other risks associated with sales of our products, operational factors, competition, regulatory actions, fluctuations in foreign exchange rates and fluctuations in interest rates, among other factors. We believe that cash flows from operating activities and our expectation of continuing availability to draw upon our revolving credit agreements are also sufficient to meet our cash flow needs for the periods exceeding the next 12 months.

 

We had a substantial number of outstanding stock options granted in past years to employees and directors under our stock option plans that were previously unexercisable due to the non-current status of our filings with the SEC. On September 29, 2006 we became current with our filings with the SEC, and reopened our stock option exercise program. As of December 31, 2006, optionees have exercised 1.9 million of these outstanding options, which provided cash proceeds of $40.7 million during 2006. Approximately 0.8 million outstanding options remain exercisable as of December 31, 2006.

 

On September 29, 2006, our Board of Directors authorized a program to repurchase up to two million shares of our outstanding common stock. Shares may be repurchased to offset potentially dilutive effects of stock options issued under our equity-based compensation programs. We commenced the program in October 2006 and repurchased 1.3 million shares for $68.4 million during the fourth quarter of 2006. Subsequent repurchases as of February 26, 2007 have totaled 0.5 million shares for $25.0 million. We expect to conclude the program by the end of the second quarter of 2007.

 

Payments for Acquisitions

 

We regularly evaluate acquisition opportunities of various sizes. The cost and terms of any financing to be raised in conjunction with any acquisition, including our ability to raise economical capital, is a critical consideration in any such evaluation.

 

During 2006, we completed four small asset acquisitions for an aggregate purchase price of $8.0 million. Assets acquired primarily include inventory, fixed assets and intangible assets.

In March 2004, we acquired the remaining 75% interest in TKL for approximately $12 million. We paid for the acquisition with cash generated by operations. Prior to the acquisition, we held a 25% interest in TKL. As a result of this acquisition, we strengthened our product offering in the mining industry, broadened our manufacturing capacity in the Asia Pacific region and gained foundry capacity.

 

Capital Expenditures

 

 

Capital expenditures are funded primarily by operating cash flows and, to a lesser extent, by bank borrowings. In 2006, our capital expenditures were focused on capacity expansion, ERP application upgrades, information technology infrastructure and cost reduction opportunities. In 2005, our capital expenditures were focused on new product development, information technology infrastructure and cost reduction opportunities. Capital expenditures in 2004 include approximately $5 million for the purchase of a building we previously leased for the manufacture of valves. In previous years, capital expenditures were less than depreciation expense due to excess capacity and the upgrading of equipment through integration processes. In 2007, we expect that our capital expenditures will focus on capacity expansion, ERP application upgrades, information technology infrastructure and cost reduction opportunities and are expected to be between approximately $85 million and $90 million. Certain of our facilities may face capacity constraints in the foreseeable future, which may lead to higher capital expenditure levels.

 

Financing

 

Debt, including capital lease obligations, consisted of:

 

 

Credit Facilities

 

On August 12, 2005, we entered into Credit Facilities comprised of a $600.0 million term loan maturing on August 10, 2012 and a $400.0 million revolving line of credit, which can be utilized to provide up to $300.0 million in letters of credit, expiring on August 12, 2010. We refer to these credit facilities collectively as our Credit Facilities. We used the proceeds of borrowings under our Credit Facilities to refinance our 12.25% Senior Subordinated Notes and indebtedness outstanding under our previous credit facilities. Further, we replaced the letter of credit agreement that guaranteed our EIB credit facility (described below) with a letter of credit issued as part of the Credit Facilities.

 

Borrowings under our Credit Facilities bear interest at a rate equal to, at our option, either (1) the base rate (which is based on greater of the prime rate most recently announced by the administrative agent under our Credit Facilities or the Federal Funds rate plus 0.50%) or (2) London Interbank Offered Rate (“LIBOR”) plus an applicable margin determined by reference to the ratio of our total debt to consolidated Earnings Before Interest, Taxes, Depreciation and Amortization (“EBITDA”), which as of December 31, 2006 was 1.5% for LIBOR borrowings.

 

EIB Credit Facility

 

On April 14, 2004, we and one of our European subsidiaries, Flowserve B.V., entered into an agreement with EIB, pursuant to which EIB agreed to loan us up to €70.0 million, with the ability to draw funds in multiple currencies, to finance, in part, specified research and development projects undertaken by us in Europe. In August 2004, we borrowed $85.0 million at a floating interest rate based on 3-month U.S. LIBOR that reset quarterly. We repaid the outstanding principal balance and terminated this facility on December 15, 2006, using cash generated from operations. As a result of this repayment, we incurred expenses of $0.5 million related to the write-off of unamortized deferred financing costs.

 

Additional discussion of our Credit Facilities and other debt instruments no longer in effect as of December 31, 2006, is included in Note 11 to our consolidated financial statements, included in this Annual Report.

 

We have entered into interest rate and currency swap agreements to hedge our exposure to cash flows related to the credit facilities discussed above. These agreements are more fully described in “Item 7A. Quantitative and Qualitative Disclosures about Market Risk.”

 

Debt Prepayments and Repayments

 

The following summarizes our repayment of obligations under our various credit facilities:

 

 

 

 

Loans under our Credit Facilities are subject to mandatory repayment with, in general:

 

 

 

In 2006, we made mandatory repayments of $14.4 million, using the net cash proceeds from the sale of GSG, and $0.9 million, using excess cash flows as defined by the Credit Facilities.

 

We may prepay loans under our Credit Facilities in whole or in part, without premium or penalty.

 

We incurred $9.3 million in fees related to the Credit Facilities, of which $0.8 million were expensed in 2005. Prior to the refinancing, we had $11.8 million of unamortized deferred loan costs related to previous credit facilities and Senior Subordinated Notes, which were called immediately following our refinancing. Based upon the final syndicate of financial institutions for the Credit Facilities, we expensed $10.5 million of these unamortized deferred loan costs in 2005. In addition to the total loan costs of $11.3 million that were expensed, we recorded a charge of $16.4 million for premiums paid to call our 12.25% Senior Subordinated Notes, for a total loss on extinguishment of $27.7 million recorded in 2005. The remaining $8.5 million of fees related to the Credit Facilities were capitalized and combined with the remaining $1.3 million of previously unamortized deferred loan costs for a total of $9.8 million in deferred loan costs included in other assets, net. These costs are being amortized over the term of the Credit Facilities using the effective interest method.

 

Accounts Receivable Factoring

 

Through our European subsidiaries, we engage in non-recourse factoring of certain accounts receivable. The various agreements have different terms, including options for renewal and mutual termination clauses. Our Credit Facilities, which are fully described in Note 11 to our consolidated financial statements, included in this Annual Report, limit factoring volume to $75.0 million at any given point in time as defined by our Credit Facilities.

 

Debt Covenants and Other Matters

 

Our Credit Facilities contain leverage and interest coverage financial covenants. Under the leverage covenant, the maximum permitted leverage ratio stepped down in the fourth quarter of 2006, with a further step-down beginning in the fourth quarter of 2007. Under the interest coverage covenant, the minimum required interest coverage ratio stepped up in the fourth quarter of 2006, with a further step-up beginning in the fourth quarter of 2007. Compliance with these financial covenants under our Credit Facilities is tested quarterly.

 

Our Credit Facilities include events of default usual for these types of credit facilities, including nonpayment of principal or interest, violation of covenants, incorrectness of representations and warranties, cross defaults and cross acceleration, bankruptcy, material judgments, ERISA events, actual or asserted invalidity of the guarantees or the security documents, and certain changes of control of our company. The occurrence of any event of default could result in the acceleration of our and the guarantors’ obligations under the Credit Facilities. We complied with the covenants through December 31, 2006.

 

CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS

 

The following table presents a summary of our contractual obligations at December 31, 2006:

 

 

 

 

The following table presents a summary of our commercial commitments at December 31, 2006:

 

 

We expect to satisfy these commitments through performance under our contracts.

 

PENSION AND POSTRETIREMENT BENEFITS OBLIGATIONS

 

Our pension plans and postretirement benefit plans are accounted for using actuarial valuations required by SFAS No. 87, “Employers’ Accounting for Pensions,” and SFAS No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions.” We consider accounting for retirement plans critical because management is required to make significant subjective judgments about a number of actuarial assumptions, including discount rates, salary growth, long-term return on plan assets, retirement, turnover, health care cost trend rates and mortality rates. Depending on the assumptions and estimates used, the pension and postretirement benefit expense could vary within a range of outcomes and have a material effect on reported earnings. In addition, the assumptions can materially affect accumulated benefit obligations and future cash funding.

 

Adoption of SFAS No. 158

 

As discussed in Notes 1 and 12 to our consolidated financial statements, included in this Annual Report, we adopted SFAS No. 158 effective December 31, 2006. The impact of the adoption is summarized below (“MPL” refers to minimum pension liability):

 

 

The estimated prior service benefit for the defined benefit pension plans that will be amortized from accumulated other comprehensive loss into pension expense in 2007 is $1.4 million. The estimated net loss for the defined benefit pension plans that will be amortized from accumulated other comprehensive loss into pension expense in 2007 is $7.5 million.

 

Plan Description

 

We and certain of our subsidiaries have defined benefit pension plans and defined contribution plans for regular full-time and part-time employees. The defined benefit pension plan in the U.S. is the Flowserve Corporation Pension Plan and the defined contribution plan is the Flowserve Corporation Retirement Savings Plan.

 

Approximately 66% of total defined benefit pension plan assets and 54% of benefit obligations are related to the U.S. plan as of December 31, 2006. The assets for the U.S. plan are held in a single trust with a common asset allocation. Unless specified otherwise, the references in this section are to total plans (i.e., the U.S. plan together with international plans).

 

Benefits under our defined benefit pension plans are based primarily on years of credited service and on participants’ compensation. Assets under our defined benefit pension plans consist primarily of equity and fixed-

income securities. At December 31, 2006, the fair market value of plan assets for our defined benefit plans increased to $365.1 million from $311.6 million at December 31, 2005. Assets were allocated as follows:

 

 

The projected benefit obligation for our defined benefit pension plans was $544.5 million and $520.6 million as of December 31, 2006 and 2005, respectively.

 

None of our common stock is directly held by these plans.

 

We sponsor a defined benefit postretirement health care plan covering most current retirees and a limited number of future retirees in the U.S. This plan provides for medical and dental benefits and is administered through insurance companies. We fund the plan as benefits are paid, such that the plans hold no assets in any period presented. Accordingly, we have no investment strategy or targeted allocations for plan assets. The benefits under the plan are not available to new employees or most existing employees.

 

The accumulated postretirement benefit obligation for our defined benefit postretirement health care plan was $71.4 million and $73.8 million as of December 31, 2006 and 2005, respectively.

 

Accrual Accounting and Significant Assumptions

 

Consistent with the requirements of SFAS No. 87, we account for pension benefits using the accrual method, recognizing pension expense before the payment of benefits to retirees. The accrual method of accounting for pension benefits necessarily requires actuarial assumptions concerning future events that will determine the amount and timing of the benefit payments.

 

Our key assumptions used in calculating our cost of pension benefits are the discount rate, the rate of compensation increase, and the expected long-term rate of return on plan assets. We, in consultation with our actuaries, evaluate the key actuarial assumptions and other assumptions used in calculating the cost of pension benefits, such as discount rate, expected return on plan assets for funded plans, life expectancy of participants and assumed rate of wage increases, and determine such assumptions as of December 31 of each year to calculate liability information as of that date and pension expense for the following year. Depending on the assumptions used, the pension expense could vary within a range of outcomes and have a material effect on reported earnings. In addition, the assumptions can materially affect accumulated benefit obligations and future cash funding. Actual results in any given year may differ from those estimated because of economic and other factors.

 

The assumed discount rate used for determining future pension obligations is based on indices of AA-rated corporate bonds, except for two foreign locations which use government bonds. The assumed rate of compensation increase used for determining future pension obligations reflects an estimate of the change in actual future compensation levels due to general price levels, productivity, seniority and other factors. The expected long-term rate of return on assets was determined by assessing the rates of return for each targeted asset class, return premiums generated by active portfolio management and by comparison of rates utilized by other companies.

 

In 2006, net pension expense for our defined benefit pension plans included in income from continuing operations was $31.4 million compared to $26.5 million in 2005 and $22.9 million in 2004. The postretirement benefit expense for the postretirement health care plan was $0.7 million in 2006 compared to $0.8 million in 2005 and $3.8 million in 2004. The decline in 2005 is primarily attributable to plan amendments capping our liabilities and to a decrease in the number of participants.

 

The following are assumptions related to our defined benefit pension plans for the year ended December 31, 2006:

 

 

The following provides a sensitivity analysis of alternative assumptions on the U.S. qualified and aggregate non-U.S. pension plans and U.S. postretirement plans.

 

Effect of Discount Rate Changes and Constancy of Other Assumptions: