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 o     No þ

 

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 an accelerated filer.  Yes þ     No 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, 2005 (the last business day of the registrant’s most recently completed second fiscal quarter), was approximately $1,140,689,796. 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 June 23, 2006 was 56,514,546.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

None.

 

 

EXPLANATORY NOTE

 

As a result of the significant delay in completing our (1) Annual Report on Form 10-K for the year ended December 31, 2004 which included the restatement of our annual 2002 consolidated financial statements, our annual and interim 2003 consolidated financial statements and (2) Quarterly Report on Form 10-Q for the quarterly period ending March 31, 2004 (the “2004 Restatement”) and the obligations regarding internal control certification under Section 404 of the Sarbanes-Oxley Act of 2002 (Section 404), we were unable to timely file with the Securities and Exchange Commission (“SEC”), this Annual Report and our Quarterly Reports on Form 10-Q for the quarterly periods ended March 31, 2005, June 30, 2005, September 30, 2005 and March 31, 2006. We will continue to work towards becoming current in our quarterly filings with the SEC as soon as practicable after the filing of this Annual Report. For information regarding the 2004 Restatement, see our Annual Report on Form 10-K for the year ended December 31, 2004 that was filed on February 13, 2006.

 

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. It was incorporated in the state of New York on May 1, 1912. 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 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 sales mix by industry in 2005 consisted of oil and gas 35%, chemical 19%, general industrial 25%, power generation 14% and water treatment 7%. Our revenues by geographic region in 2005 originated in North America 43%, Europe, the Middle East and Africa 44%, Asia Pacific 7% and Latin America 6%. 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 revenues and 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 do business for fiscal years 2005, 2004 and 2003.

 

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 November 2004, we sold our Government Marine Business Unit (“GMBU”), a business within FPD, to Curtiss-Wright Electro-Mechanical Corporation for approximately $28 million, generating a pre-tax gain of $7.4 million after the allocation of approximately $8 million of goodwill and $1 million of intangible assets. GMBU, which provided pump technology and service for U.S. Navy submarines and aircraft carriers, did not serve our core market and represented only a small part of our total pump business. We used net proceeds from the disposition of GMBU to reduce our outstanding indebtedness. As a result of this disposition, we have presented the assets, liabilities and results of operations of the GMBU as discontinued operations for all periods included in this Annual Report.

In March 2004, we acquired the remaining 75% interest in Thompsons, Kelly & Lewis Pty. Ltd. (“TKL”) for approximately $12 million. TKL is a leading Australian designer, manufacturer and supplier of centrifugal pumps, railway track work products and steel castings. 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. TKL had total assets of approximately $24 million at the time of this acquisition and sales of approximately $36 million in 2003.

 

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 Brand Names

 

 

  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 Flowserve 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, 2005 was $703.5 million, compared with $576.8 million on December 31, 2004. We expect to ship approximately 95% of our FPD backlog as of December 31, 2005 during 2006.

 

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 industry including water, mining and pharmaceutical. We produce the vast majority of our products at 22 principal manufacturing facilities, with only 5 of the 22 plants located in the U.S. A small portion of our valves are produced through foreign joint ventures.

 

During the first quarter of 2005, we made the decision to divest the General Services Group (“GSG”), which provides online repair and other selected third-party services in an attempt to better align Flowserve’s business portfolio with our core strategic objectives. GSG was sold on December 31, 2005 for approximately $16 million in gross cash proceeds (subject to final working capital adjustments). The divestiture encompassed the selected third party valve repair and online services businesses, which included 34 service center locations, located primarily in the U.S. FCD’s OEM service, repair and distribution locations were not included as part of the divestiture. As a result of this transaction, the $103.1 million in revenues generated by GSG in 2005 will be reported as discontinued operations. See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” for additional information regarding the GSG disposition.

 

  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. The list does not include GSG products and/or 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 service 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, 2005 was $240.6 million, compared with $216.5 million on December 31, 2004. We expect to ship approximately 90% of our backlog on December 31, 2005 during 2006.

 

FLOW SOLUTIONS DIVISION

 

Through FSD, we design, manufacture and distribute mechanical seals, sealing systems and parts, and provide related services, principally to process industries. Flow control products require mechanical seals to be replaced 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-markets.

 

We manufacture mechanical seals at three plants in the U.S. and at four plants outside the U.S. Through our global network of 64 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 200 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 transmission and in the oil and gas production 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 Services

 

We provide aftermarket services through our network of 64 QRCs located throughout the world, including 25 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 2005 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) light hydrocarbon seal; (2) batch chemical process seal; (3) improved split seal for water markets; (4) high pressure gas compressor seal; (5) large diameter compressor seal; and (6) strengthened mineral and ore processing seal. 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, extend the life of their production equipment and lower maintenance expenses. 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, a joint venture of two traditional global seal manufacturers. 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, 2005 was $61.2 million, compared with $43.7 million at December 31, 2004. We expect to ship approximately 97% our FSD backlog on December 31, 2005 during 2006.

 

GENERAL BUSINESS

 

Competition

 

Despite the consolidation trend over the past 10 years, the markets for our products are 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 has increased. Price competition tends to be more 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 or global competitors and, in some markets, against smaller regional and local companies, as well as the 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 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. Low cost replicators of spare parts are competitors for spare parts for all industries except for the nuclear power industry. 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 $24.3 million, $25.2 million and $24.9 million during 2005, 2004 and 2003, 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 2005 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 13,000 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 Cleveland and Vernon in 2005.

 

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 and cash flows.

 

We use hazardous substances and generate hazardous wastes in most of our manufacturing and foundry operations. Many 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.

 

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 U.S. to foreign unaffiliated customers were $221.6 million in 2005, $275.6 million in 2004 and $203.6 million in 2003.

 

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 SEC investigation regarding the past sales of goods and services that certain foreign subsidiaries delivered to Iraq from 1996 through 2003 during the United Nations Oil-for-Food Program. In an apparently related action, one of our foreign subsidiary’s operations is cooperating with a foreign governmental investigation of that site’s involvement in the United Nations Oil-for-Food Program. We are continuing fully cooperate in both the SEC and the foreign investigations. Both investigations are in progress but, at this point, are incomplete. See Item 3. “Legal Proceedings” for more information.

 

We have also initiated a process to determine our compliance posture with respect to U.S. export control laws and regulations and, if applicable, 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, without charge, copies of the following documents as filed with, or furnished, to the Securities and Exchange Commission (“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.” 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.

 

Copies may also be obtained by providing a written request for such copies or additional information regarding our operating or financial performance to Michael E. Conley, Vice President of Investor Relations, Flowserve Corporation, 5215 N. O’Connor Blvd., Suite 2300, Irving, Texas 75039.

 

We have adopted Self Governance Guidelines for our Board of Directors and Code of Ethics and Business Conduct for our Board of Directors, our Chief Executive Officer, 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.

 

The certifications of our Chief Executive Officer and Chief Financial Officer required pursuant to Sections 302 and 906 of the Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley”) are included as exhibits to this Annual Report. Our Chief Executive Officer certified to the New York Stock Exchange (“NYSE”) on December 22, 2005, pursuant to Section 303A.12 of the NYSE listing standards, that he was not aware of any violation by the Company of the NYSE corporate governance listing standards as of that date.

 

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 have material weaknesses in our internal control over financial reporting, which could adversely affect our ability to report our financial condition and results of operations accurately and on a timely basis.

 

In connection with our 2005 assessment of internal control over financial reporting under Section 404 of Sarbanes-Oxley, we identified material weaknesses in our internal control. We have taken measures to strengthen our internal control in response to the previously identified material weaknesses, including by implementing strengthened control procedures for information technology infrastructure, enhancing company-level monitoring controls processes and expanding our internal audit and corporate compliance functions, and engaged outside consultants to assist us in our efforts. For a discussion of our internal control over financial reporting and a description of the identified material weaknesses and of the steps that we have taken to remediate these and previously identified material weaknesses, see “Item 9A. Controls and Procedures — Management’s Report on Internal Control over Financial Reporting.”

 

Material weaknesses in our internal control over financial reporting could adversely impact our ability to provide timely and accurate financial information. While we have taken measures to strengthen our internal control in response to the previously identified material weaknesses, including by implementing strengthened control procedures for information technology infrastructure, enhancing company-level monitoring controls processes and expanding our internal audit and corporate compliance functions, and engaged outside consultants to assist us in our efforts, additional work remains to be done to address the identified material weaknesses. If we are unsuccessful in implementing or following our remediation plan, or fail to update our internal control as our business evolves or to integrate acquired businesses into our controls system, we may not be able to timely or accurately report our financial condition, results of operations or cash flows or maintain effective disclosure controls and procedures. If we are unable to report financial information timely and accurately or to maintain effective disclosure controls and procedures, we could be subject to, among other things, regulatory or enforcement actions by the SEC and the NYSE, including a delisting from the NYSE, securities litigation, events of default under our new credit facilities, debt rating agency downgrades or rating withdrawals, and a general loss of investor confidence, any one of which could adversely affect our business prospects and the valuation of our common stock.

 

Furthermore, there are inherent limitations to the effectiveness of any system of controls and procedures, including the possibility of human error and the circumvention or overriding of the controls and procedures. We could face additional litigation exposure and a greater likelihood of an SEC enforcement or NYSE regulatory action if further restatements were to occur or other accounting-related problems emerge. In addition, any future restatements or other accounting-related problems may adversely affect our financial condition, results of operations and cash flows.

 

If we fail to comply with the requirements of Section 404 of Sarbanes-Oxley, our business prospects and stock valuation could be adversely affected.

 

Section 404 of Sarbanes-Oxley of 2002 requires our management to report on, and our independent registered public accounting firm to attest to, the effectiveness of our internal control over financial reporting. This legislation is relatively new, and neither companies nor accounting firms have significant experience in complying with its requirements. We expended significant resources to comply with our obligations under Section 404 with respect to 2004 and 2005. If we are unable to comply with our obligations under Section 404 in the future or experience delays in future reports of our management and outside auditors on our internal control over financial reporting, or if we fail to respond timely to any changes in the Section 404 requirements, we may be unable to timely file with the SEC our annual or periodic reports and may be subject to, among other things, regulatory or enforcement actions by the SEC and the NYSE, including delisting from the NYSE, securities litigation, events of default under our new credit

facilities, debt rating agency downgrades or rating withdrawals and a general loss of investor confidence, any one of which could adversely affect our business prospects and the valuation of our common stock.

 

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 March 27, 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 regarding goods and services that certain foreign subsidiaries delivered to Iraq from 1996 through 2003 during the United Nations Oil-for-Food Program. This investigation includes a review of whether any inappropriate payments were made to Iraqi officials in violation of the Foreign Corrupt Practices Act. 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 liabilities if violations are found regardless of whether they relate to periods before or subsequent to our acquisition.

 

In addition, one of our foreign subsidiary’s operations is cooperating with a foreign governmental investigation of that site’s involvement in the United Nations Oil-for-Food Program. This cooperation has included responding to an investigative trip by foreign authorities to the foreign subsidiary’s site, providing relevant documentation to these authorities and answering their questions. We are unable to predict how or if the foreign authorities will pursue this matter in the future.

 

We believe that both the SEC and this foreign authority are investigating other companies from their actions arising from the “Oil-for-Food” program.

 

We are in the process of reviewing and responding to the SEC subpoena and assessing the implications of the foreign investigation, including the continuation of a thorough internal investigation. Our investigation is in the early stages and has included and will include a detailed review of contracts with the Iraqi government during the period in question and certain payments associated therewith. Additionally, we have and will continue to conduct interviews with employees with knowledge of the contracts and payments in question. We are in the early phases of our internal investigation and as a result are unable to make any definitive determination whether any inappropriate payments were made and accordingly are unable to predict the ultimate outcome of this matter.

 

We will continue to fully cooperate in both the SEC and the foreign investigations. Both 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, consent to injunctions against future conduct or suffer other penalties which could potentially materially impact our business financial statements 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 plans to investigate, analyze and, if applicable, disclose past potential violations of the U.S. export control laws through, in general, the export of products, services and technologies without the licenses possibly required by such authorities. If and to the extent

violations are identified, confirmed and so disclosed, we could be subject to substantial fines and other penalties affecting our ability to do business outside the United States.

 

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.

 

We have recently concluded an IRS audit of our U.S. federal income tax returns for the years 1999 through 2001. 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, and therefore should not result in a material future cash payment, pending final review by the Joint Committee on Taxation. We anticipate this review will be completed by December 31, 2006. The effect of the adjustments to current and deferred taxes has been reflected in previously filed financial statements.

 

During 2006, the IRS will commence an audit of our U.S. federal income tax returns for the years 2002 through 2004. While we expect that the upcoming IRS audit will be similar in scope to the recently completed examination, the upcoming audit may be broader. Furthermore, the preliminary 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 be material, but will not be known until that IRS audit is finalized.

 

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. We expect to incur similar expenses in future periods with respect to the upcoming IRS audit of the years 2002 through 2004.

 

Due to the record keeping issues referred to above, the IRS has issued 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 $239 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.

 

We operate and manage our business on a number of different computer systems, including several aging Enterprise Resource Planning (“ERP”) systems that rely on manual processes, which could adversely affect our ability to accurately report our financial condition, results of operations and cash flows.

 

We operate and manage our business on a number of different computer systems, including disparate legacy systems inherited from our predecessors. Some of our computer systems, as well as some of our computer hardware, are aging and contain inefficient processes. For example, several of our older ERP systems rely on manual processes, which are generally labor intensive and increase the risk of error. Furthermore, as discussed below under “Item 9A. Controls and Procedures”, as of the end of 2005, we did not maintain adequate information technology

general controls, as our information technology general controls supporting restricted access to financial applications, programs and data. Unless we are able to enhance our computer systems generally and information technology general controls specifically, our ability to identify, capture and communicate pertinent information may be compromised, which in turn may compromise our ability to timely and accurately report our financial condition, results of operations or cash flows.

 

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 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, Canadian dollar, Mexican peso, Japanese yen, Singapore dollar, Brazilian real, Australian dollar, Argentinean peso and Venezuelan bolivar. 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, various foreign governmental agencies, including applicable customs, currency exchange control and transfer pricing

regulations and various programs administered by the United Nations. 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 have notified applicable U.S. governmental authorities of our plans to conduct a voluntary thorough audit of our compliance with the U.S. export control laws and, if applicable, make a voluntary self-disclosure of any potential violations identified, as applicable. If violations are identified, then such disclosure could result in substantial fines and other penalties.

 

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.

 

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, 2005, backlog reached $994.1 million, a record level for the Company. In 2006, our bookings and backlog have continued to increase through, at least March 31, 2006. 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 maintenance expenditures by our customers. The levels of capital expenditures by our customers depend, in turn, on the general economic conditions and conditions in their industry, as well as on their liquidity.

 

The businesses of many of our customers, particularly general industrial companies, chemical companies and oil refineries, 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. For example, despite high natural gas prices in 2003, there was little additional investment or maintenance activity by our gas customers, many of which have experienced liquidity constraints as a result of financial difficulties related to their former energy trading activities.

 

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.

 

As we expand our customer alliance programs, an increasing portion of our revenues will be on a fixed-fee basis, subjecting us to the risks associated with cost overruns.

 

As part of our customer alliance programs, we enter into maintenance agreements that are fixed-fee arrangements. Under these agreements, we provide maintenance services, including replacement parts and repair services, at a specified fixed fee and, accordingly, bear the risk of cost overruns. While we conduct a detailed analysis of the customers’ equipment prior to entering into fixed-fee maintenance agreements and benefit from our extensive experience in the flow control industry, our failure to estimate accurately the anticipated equipment failures and maintenance costs could have a material adverse effect on our 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, 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, our 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 most of our manufacturing and foundry operations. Many 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.

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 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 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, 2005, we had approximately 13,000 employees, approximately half of whom were located in the United States. 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 recent strikes or work stoppages, 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.

 

Our success will depend to a significant extent on our ability to retain senior executives and other key personnel.

 

During 2004 and 2005, we appointed a new Chief Executive Officer, Chief Financial Officer, Corporate Treasurer, Controller and Chief Accounting Officer, Chief Compliance Officer, Chief Information Officer, Vice President of Tax and a Vice President of Human Resources, and we created and staffed new positions responsible for accounting policy and procedures, financial reporting, tax compliance and internal audit. Our future success depends to a significant degree on the skills, experience and efforts of our newly appointed and existing senior management and other key personnel. The loss of the services of our Chief Executive Officer, Chief Financial Officer or other key personnel could adversely affect our ability to implement our business strategy. To promote continuity of senior management, in March 2005 our Board of Directors approved a Transitional Executive Security

Plan, which provides financial incentives to key management personnel to remain employed by us for the near term. No assurances can be made, however, that we will be successful in our efforts to retain key members of our senior management.

 

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 Program (“CIP”), 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 United States, the United Kingdom, Canada, 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.

 

An exemption from the registration requirements of the Securities Act may not be available for certain acquisitions of interest in our common stock fund in the Flowserve Corporation Retirement Savings Plan (“401(k) plan”) which exposes us to potential liabilities, including rescission rights.

 

As of May 1, 2005, due to the non-current status of our financial filings with the SEC, our Registration Statements on Form S-8 were no longer available to cover offers and sales of securities to our employees and other persons. Since that date, the acquisition of interests in our common stock fund under our 401(k) plan by plan participants may have been subject to the registration requirements of the Securities Act of 1933 or applicable state securities laws and may not have qualified for an available exemption from such requirements. Federal securities laws generally provide for a one-year rescission right for an investor who acquires unregistered securities in a transaction that is subject to registration and for which no exemption was available. As such, an investor successfully asserting a rescission right during the one-year time period has the right to require an issuer to repurchase the securities acquired by the investor at the price paid by the investor for the securities (or if such security has been disposed of, to receive damages with respect to any loss on such disposition), plus interest from the date of acquisition. These rights may apply to affected participants in our 401(k) plan. 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.

A significant number of stock option exercises following the removal of the current suspension on stock option exercises would have a dilutive effect on our earnings per share

 

We have a substantial number of outstanding stock options granted in past years to employees under our stock option plans which have not been exercisable for an extended period due to our non-current filing status relating to our SEC financial reports. Given the significant increase in our share price during the period in which optionees have been unable to exercise their options, it is possible that many holders may want to exercise soon after they are first able to do so. If, following our removal of the current suspension on stock option exercises, the holders of a large number of these options promptly exercise, there would be some dilutive impact on our earnings per share. The impact on our earnings per share is dependent upon share price, number of shares and strike price of shares exercised.

 

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 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 and our other outstanding indebtedness impose significant 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, the 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 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 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. We recently expanded our leased facility by 25,000 square feet due to our growth and began to occupy this additional space on February 3, 2006.

 

Our major manufacturing facilities operating at December 31, 2005 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 obligations under leasing arrangements.

 

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.

 

On February 4, 2004, we received an informal inquiry from the SEC requesting the voluntary production of documents and information related to our February 3, 2004 announcement that we would restate our financial results for the nine months ended September 30, 2003 and the full years 2002, 2001 and 2000. On June 2, 2004, we were advised that the SEC had issued a formal order of private investigation into issues regarding this restatement

and any other issues that arise from the investigation. On May 31, 2006, we were informed by the staff of the SEC that it had concluded this investigation without recommending any enforcement action against us.

 

During the quarter ended September 30, 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 the 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 March 27, 2007. We continue to believe that the lawsuit is without merit and are vigorously defending the case.

 

On October 6, 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.

 

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 current board members Hugh K. Coble, George T. Haymaker, Jr., Lewis M. Kling, 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 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 regarding goods and services that certain foreign subsidiaries delivered to Iraq from 1996 through 2003 during the United Nations Oil-for-Food Program. This investigation includes a review of whether any inappropriate payments were made to Iraqi officials in violation of the Foreign Corrupt Practices Act. 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 liabilities if violations are found regardless of whether they relate to periods before or subsequent to our acquisition.

 

In addition, one of our foreign subsidiary’s operations is cooperating with a foreign governmental investigation of that site’s involvement in the United Nations Oil-for-Food Program. This cooperation has included responding to an investigative trip by foreign authorities to the foreign subsidiary’s site, providing relevant documentation to these authorities and answering their questions. We are unable to predict how or if the foreign authorities will pursue this matter in the future.

We believe that both the SEC and this foreign authority are investigating other companies from their actions arising from the“Oil-for-Food” program.

 

We are in the process of reviewing and responding to the SEC subpoena and assessing the implications of the foreign investigation, including the continuation of a thorough internal investigation. Our investigation is in the early stages and has included and will include a detailed review of contracts with the Iraqi government during the period in question and certain payments associated therewith. Additionally, we have and will continue to conduct interviews with employees with knowledge of the contracts and payments in question. We are in the early phases of our internal investigation and as a result are unable to make any definitive determination whether any inappropriate payments were made and accordingly are unable to predict the ultimate outcome of this matter.

 

We will continue to fully cooperate in both the SEC and the foreign investigations. Both 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, consent to injunctions against future conduct or suffer other penalties which could potentially materially impact our business financial statements 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 appears that some product transactions and technology transfers may not technically been in compliance with U.S. export control laws and regulations and require further review. With assistance from outside counsel, we are currently involved in a systematic process to conduct further review which we believe will take about 18 months to complete given the complexity of the export laws and the scope of the investigation. Any potential violations of U.S. export control laws and regulations that are identified 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 potential violations or the nature or 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 United States, or on our financial condition.

 

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 $7 million in 2005, $17 million in 2004 and $25 million in 2003.

 

None.

 

Market Information

 

Our common stock is traded on the NYSE under the symbol “FLS”. On June 23, 2006, our records showed approximately 1,904 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)

 

 

We did not pay dividends on our common stock in 2005 or the completed portion of 2006, and have no plans to commence payment of cash dividends. The declaration and payment of dividends is subject to limitations under our new 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 — Senior Credit Facilities” for additional information on our new credit facilities.

 

Unregistered Sales of Equity Securities

 

As of May 1, 2005, due to the non-current status of our financial filings with the SEC, our Registration Statements on Form S-8 were no longer available to cover offers and sales of securities to our employees and other persons. Since that date, the acquisition of interests in our common stock fund under our 401(k) plan by plan participants may have been subject to the registration requirements of the Securities Act of 1933 or applicable state securities laws and may not have qualified for an available exemption from such requirements. Federal securities laws generally provide for a one-year rescission right for an investor who acquires unregistered securities in a transaction that is subject to registration and for which no exemption was available. As such, an investor successfully asserting a rescission right during the one-year time period has the right to require an issuer to repurchase the securities acquired by the investor at the price paid by the investor for the securities (or if such security has been disposed of, to receive damages with respect to any loss on such disposition), plus interest from the date of acquisition. These rights may apply to affected participants in our 401(k) plan and their affected interest in this plan may involve up to 270,000 shares of our common stock acquired pursuant to the 401(k) plan during 2005 and an indeterminate number of shares acquired during 2006. 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.

 

During 2005, we issued an aggregate of 434,710 shares of restricted stock to employees pursuant to the 2004 Stock Compensation Plan and 10,750 shares of restricted stock pursuant to the Flowserve Corporation 1998 Restricted Stock 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 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. See “Item 1A. Risk Factors” and “Forward-Looking Information” 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 power, oil and gas, chemical, and other process markets. These products are mission critical in the movement, control and protection of fluids in our 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 in service. The worldwide installed base of our products is another important source of revenue where our products are expected to ensure the maximum operating time of the many key industrial processes. The aftermarket business is generally a higher margin business and a key component to our profitable growth.

 

We have experienced steadily improving conditions in 2004 and 2005 in several core markets, including oil and gas, chemical, and numerous general industries. The rise and continued elevation 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. Although feedstock costs are increasing in the chemical market, greater global demand is allowing companies to pass through pricing and strengthen the global market. The opportunity to increase our installed base of new products and drive recurring aftermarket business in future years is a critical by-product of these market conditions.

 

We have six key strategies that have been well communicated throughout the business. One of our key strategies is the globalization of our business. See “Our Strategies” section of this Management’s Discussion and Analysis for a discussion of our six key strategies. We currently have approximately 13,000 employees in more than 56 countries. We continue to implement new Quick Response Centers (“QRCs”) to be better positioned as near to our customers as possible for service and support, as a means to capture this important aftermarket business. Our markets have improved and we see corresponding growth in our business, much of which is in non-traditional areas of the world where new oil and gas reserves have been discovered. We and our customers are seeing rapid growth in Asia, with China providing a source of significant project growth. We have a strategy in place to increase our presence in China to capture the aftermarket business with our current installed base as well as new projects and process plant expansions.

 

Along with ensuring that we have the local capability to sell, install and service our equipment in remote regions, it becomes more imperative to continuously improve our global operations. Our global supply chain capability is being expanded to meet the 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 insure we 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 our 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

 

SEC Matters

 

On February 4, 2004, we received an informal inquiry from the SEC requesting the voluntary production of documents and information related to our February 3, 2004 announcement that we would restate our financial results for the nine months ended September 30, 2003 and the full years 2002, 2001 and 2000. On June 2, 2004, we were advised that the SEC had issued a formal order of private investigation into issues regarding this restatement and any other issues that arise from the investigation. On May 31, 2006, we were informed by the staff of the SEC that it had concluded this investigation without recommending any enforcement action against us.

 

On February 7, 2006, we received a subpoena from the SEC regarding goods and services that certain foreign subsidiaries delivered to Iraq from 1996 through 2003 during the United Nations Oil-for-Food Program. This investigation includes a review of whether any inappropriate payments were made to Iraqi officials in violation of the Foreign Corrupt Practices Act. 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 liabilities if violations are found regardless of whether they relate to periods before or subsequent to our acquisition.

 

In addition, one of our foreign subsidiary’s operations is cooperating with a foreign governmental investigation of that site’s involvement in the United Nations Oil-for-Food program. This cooperation has included responding to an investigative trip by foreign authorities to the foreign subsidiary’s site, providing relevant documentation to these authorities and answering their questions. We are unable to predict how or if the foreign authorities will pursue this matter in the future.

 

We believe that both the SEC and this foreign authority are investigating other companies from their actions arising from the United Nations Oil-for-Food program.

 

We are in the process of reviewing and responding to the SEC subpoena and assessing the implications of the foreign investigation, including the continuation of a thorough internal investigation. Our investigation is in the early stages and has included and will include a detailed review of contracts with the Iraqi government during the period in question and certain payments associated therewith. Additionally, we have and will continue to conduct interviews with employees with knowledge of the contracts and payments in question. We are in the early phases of our internal investigation and as a result are unable to make any definitive determination whether any inappropriate payments were made and accordingly are unable to predict the ultimate outcome of this matter.

 

We will continue to fully cooperate in both the SEC and the foreign investigations. Both 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, consent to injunctions against future conduct or suffer other penalties which could potentially materially impact our business, financial statements and cash flows.

 

Legal Matters

 

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 C. Scott Greer, our former Chairman, President and Chief Executive Officer, Renée J. Hornbaker, our former Vice President and Chief Financial Officer, and current board members Hugh K. Coble, George T. Haymaker, Jr., Lewis M. Kling, 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 certain of the purported misstatements alleged in the federal securities case filed on September 30, 2003 and described in Note 13 to our consolidated financial statements, included in this Annual Report, 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 behalf of us 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 intend to file a motion seeking dismissal of the case.

 

For additional information regarding other pending securities class action and derivative lawsuits, see “Item 3. Legal Proceedings.”

 

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 appears that some product transactions and technology transfers may technically not be in compliance with U.S. export control laws and regulations and require further review. With assistance from outside counsel, we are currently involved in a systematic process to conduct further review, which we believe will take approximately 18 months to complete given the complexity of the export laws and the scope of our investigation. Any potential violations of U.S. export control laws and regulations that are identified 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 potential violations or the nature or 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 affect on our business, including our ability to do business outside the U.S., or on our financial condition.

 

IRS Audits

 

We have recently concluded an Internal Revenue Service (“IRS”) audit of our U.S. federal income tax returns for the years 1999 through 2001. 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, and therefore should not result in a material future cash payment, pending final review by the Joint Committee on Taxation. We anticipate this review will be completed by December 31, 2006. The effect of the adjustments to current and deferred taxes has been reflected in previously filed consolidated financial statements for the applicable periods.

 

During 2006, the IRS will commence an audit of our U.S. federal income tax returns for the years 2002 through 2004. While we expect that the upcoming IRS audit will be similar in scope to the recently completed examination, the upcoming audit may be broader. Furthermore, the preliminary 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 be material, but will not be known until the IRS audit is finalized.

 

In the course of the IRS audit of 1999 through 2001, we 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. We expect to incur similar expense with respect to the upcoming IRS audit of the years 2002 through 2004.

 

The IRS has issued 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 our consolidated results of operations.

 

Management Changes and Other Employee Matters

 

During the past two years, following resignations of several of our senior executives, we hired Lewis M. Kling as our Chief Operating Officer and subsequently appointed him as our President and Chief Executive Officer, hired Mark A. Blinn as our Vice President and Chief Financial Officer, Richard J. Guiltinan, Jr. as our Controller and Chief Accounting Officer, Deborah K. Bethune as our Vice President of Taxes, Thomas L. Pajonas as our President

of our Flow Control Division, Linda P. Jojo as Vice President and Chief Information Officer, and Joseph R. Pinkston, as our Vice President of Human Resources, appointed Mark D. Dailey as our Chief Compliance Officer and Paul W. Fehlman as our Treasurer, and created and staffed new positions responsible for accounting policy and procedures, financial reporting, tax compliance and internal audit. To promote continuity of senior management, in March 2005 our Board of Directors approved a Transitional Executive Security Plan, which provides cash and stock-based incentives to key management personnel to remain employed by us for the near term. As a result of this plan, we recorded additional compensation expenses in 2005 of $2.6 million and an expense of approximately $2 million will be recorded in 2006. See “Transitional Executive Security Plan” in “Item 11. Executive Compensation” of this Annual Report for a detailed discussion on this plan.

 

Divestitures

 

In an effort to better align our business portfolio with our core strategic objectives, in the first quarter of 2005, we made a definitive decision to divest the General Services Group (“GSG”), non-core service operations which provide online repair and other third-party services, and we engaged an investment banking firm to commence marketing. As a result, we reclassified the group to discontinued operations in the first quarter of 2005. Sales for GSG were $103 million and $116 million in 2005 and 2004, respectively. Total assets at March 31, 2005, ascribed to GSG, inclusive of approximately $12 million of allocated goodwill, were approximately $60 million. We performed an impairment analysis of GSG at March 31, 2005 on a held for sale basis and, after the allocation of goodwill, we recognized an impairment charge of approximately $6 million during the first quarter of 2005. The initial estimated fair value at March 31, 2005 was based upon investment banker’s valuation of GSG’s estimated fair value as well as initial bids received from potential purchasers. As the year progressed, the number of potential buyers diminished to one potential purchaser and the business underperformed due to the pending sale. As a result, the lone bidder reduced its initial offer and accordingly, we recognized additional impairment charges aggregating approximately $24 million throughout 2005, for total impairment charges in 2005 of approximately $30 million. GSG was sold on December 31, 2005 for approximately $16 million in gross cash proceeds, subject to final working capital adjustments that remain under negotiation, while retaining approximately $12 million of net accounts receivable. We used approximately $11 million of the net cash proceeds to reduce our outstanding indebtedness.

 

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.

 

We conduct our operations through three business segments:

 

 

Our product portfolio is built on over 50 well-respected brand names, such as Durco, IDP, Valtek and Durametallic, which we believe is the most comprehensive in the industry. 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 Markets

 

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

Demand for most of our products depends on the level of new capital investment and maintenance expenditures by our customers. The level of capital expenditures by our customers depends, in turn, on the general economic conditions and conditions in their industries, which affect their profitability. The level of capital expenditures by our customers also depends on their liquidity, whether through cash flows from operations or access to financing.

 

The oil and gas industry represented approximately 35% and 32% of our sales in 2005 and 2004, respectively. High petroleum prices generally spur additional investment in upstream petroleum projects, and high prices in 2005 and 2004 contributed to an increase in bookings for projects, particularly in Asia, Africa, the Middle East and South America. In contrast to their effect on the upstream petroleum projects, high crude oil prices often reduce the demand for our products and services from crude oil refineries and natural gas processors as they seek to take advantage of favorable refining margins by operating at high levels of capacity utilization and deferring maintenance. Clean fuel regulations, particularly in the U.S., led to some project business from crude oil refiners. The profitability of such projects, however, is typically lower than for maintenance related products and services as these are generally large projects obtained through a competitive bidding process.

 

While high oil and gas prices are generally good for our oil and gas customers, they are generally adverse for chemical companies, since crude oil and natural gas are critical inputs in the manufacturing of their products. In 2005, the price of natural gas in the U.S. increased almost 50% as compared with 2004, and increased 25% in 2004 as compared with 2003. This significantly affected our chemical customers, who faced high feed stock costs. However, greater global demand is allowing companies to pass through pricing and strengthen the global market. The demand for chemical-based products appears to be increasing, so we expect to see some improvement in the demand for our products in the chemical industry. Further, this industry’s improved profitability could spur new investment in other parts of the world such as Asia, and we would expect to benefit from those investments as well. In 2005 and 2004, the chemical industry represented approximately 19% and 18%, respectively, of our sales.

 

Increased natural gas prices also diminished the profitability of many power generators that in recent years made significant investments in power plants that generate electricity from natural gas. While they have been able to recover a portion of their higher costs through rate increases, their liquidity is still challenged due to overinvestment in these power facilities in recent years. However, a number of nuclear power generators are planning significant maintenance activities. We have seen an increase in our orders for this area and it has been a positive contributor to 2005 orders, sales and earnings. In addition, there are several coal-fired power plants planned for the U.S., and we are actively pursuing the flow control opportunities for these projects. The revenue opportunity for our products at a coal-fired plant typically can be three times that of a natural gas power plant. The power industry represented approximately 14% and 16% of our sales in 2005 and 2004, 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 that 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. This is a significant market for our pump and valve actuation products. In 2005 and 2004, the water market represented approximately 7% and 6%, respectively, of our sales.

 

General industries represents a variety of different businesses, including mining, pulp and paper, food and beverage, steel and heating, ventilation and air-conditioning (“HVAC”), none of which individually represents more than 5% of total sales in 2005 and 2004. General industries represented approximately 25% and 28% of our sales in 2005 and 2004, respectively. We started to see some improvement in these businesses in 2005, most notably mining and steel, after they experienced what appeared to be troughs in 2004. Other industries, such as food and beverage and HVAC, were relatively stable.

 

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 provide product to our customers either directly or indirectly for their 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. They are typically for more standard products, parts or services. Each of our three segments generates 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 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 for standard products is very competitive and price competition has generally been increasing. Price competition tends to be more significant for OEMs than aftermarket services and generally has been increasing. 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.

 

Our reporting of trends by product type, customer type and business type are based upon analytical review of individual operational results and our 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 an 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. 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 communicated throughout our company. These strategies include: organic growth, globalization, process excellence, portfolio management, organizational capability and technology/innovation. The key elements of our strategies are outlined below.

 

Organic Growth

 

Organic growth is a key long-term initiative to grow our top line revenues. This goal is to develop and launch new products and solutions as well as 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 who can offer our customers a differentiated option of not only products and services, but can also offer an additional option that includes any combination of products and solution support packages across our portfolio. Our combined pump and seal end user teams have been particularly successful in delivering new solution programs and increasing organic aftermarket growth.

 

We seek to capture additional market share by creating “win-win” opportunities for us and our customers through sourcing and maintenance alliance programs pursuant to which we provide all or an agreed portion of a customers’ parts and servicing needs. Our 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 additionally seek to continue to review our substantial installed pump, seal and valve base as a means to expand our aftermarket services business, as customers increasingly use third-party aftermarket service providers like us to reduce their fixed costs and improve profitability. The aftermarket services business provides us with a steady source of revenues and cash flows at higher margins than original equipment sales and allows us to be in frequent contact with our customers, building our 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 our installed base.

 

New product and service development is driven through our Product Management organization working in concert with engineering, operations and sales. Our goal is to increase our revenues from new products and services developed over the last five years. Our 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 beginning in 2006 to support our goal of increased revenues from new products and services.

 

Globalization

 

The globalization initiative of our business 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 we intend to continue to utilize our global presence to further penetrate these markets. Our recent successes in these markets include contracts worth more than $40 million for the supply of pumps and related equipment to the Nanhai petrochemicals project in China, and contracts worth more than $12 million for the Shenhua coal liquefaction project in China. In our aftermarket services business, we seek to strategically add sites as our customers and our customer base grow in order to provide our customers with rapid response, fast delivery and onsite field repair.

 

We are focused on shifting, as appropriate, certain of our manufacturing and engineering functions to, and increasing our supply of materials and components from, lower cost areas such as India, China, Mexico, South America and Eastern Europe. In 2005, these areas accounted for approximately 20% of our direct material spending, compared to approximately 5% in 2001. We are also focused on utilizing supply chain management to reduce our procurement costs, including by expanding purchases through reverse auctions, further consolidating our 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 that 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. This initiative includes:

 

 

We seek to increase our operational efficiency through our CIP initiative. It 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 our employees are our most valuable resource in achieving our operational excellence goals, we have instituted broad CIP training, and to date over 900 of our employees are CIP trained or certified as “Green Belts” or “Black Belts”, deployed on CIP projects throughout our company. As a result of our 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 businesses and deployed to another Flowserve business, and we continue to look for opportunities to apply the CIP tools for improved performance.

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

 

Portfolio Management

 

The continued management of our portfolio of products and services is critical to our company’s success. We will continue to pursue selective acquisitions and rationalize our portfolio of products and services to ensure alignment with our customers and shareholders.

 

We intend to continue to evaluate acquisition and investment opportunities as we seek to broaden our product portfolio and operational capabilities and to expedite our expansion into faster growing Asian, African and South American markets. In that regard, our additional investment in Thompsons, Kelly & Lewis Pty. Ltd. (“TKL”) in March 2004 strengthened our product offering in the mining industry and broadened our manufacturing capabilities in the Asia Pacific region, which includes China, Japan, Singapore, Korea, India, Australia, New Zealand and Thailand. See further discussion of the TKL acquisition in “Our Results of Operations” section of this Management’s Discussion and Analysis and in Note 3 to our consolidated financial statements, included in this Annual Report.

 

We are seeking to divest operations that we consider non-core to our overall business, such as operations that do not serve our core customer base or provide limited synergies with our other businesses. For example, in November 2004 we sold our Government Marine Business Unit (“GMBU”), and in December 2005 we sold GSG. See further discussion of these discontinued operations in Note 2 to our consolidated financial statements, included in this Annual Report.

 

Organizational Capability

 

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

 

 

A multi-year agreement was completed in 2005 to distribute electronic learning packages in multiple languages for the Flowserve Code of Business Conduct and other compliance programs globally throughout our company. This will be expanded to include export compliance, and regulatory compliance (U.S. and foreign), as well as other programs around harassment and employee behaviors. The emphasis on ethics and compliance was significantly strengthened in 2005 as a core organizational capability with a new Chief Compliance Officer.

 

In 2005, we installed a Learning Management System (“LMS”) that allowed the development and tracking of the delivery of electronic learning systems. This system allows us to track our employees’ compliance and policy understanding through electronic means. LMS also permits the on-line enrollment for customer training as a means to share and improve their intellectual capital.

 

Technology/Innovation

 

The infusion of new product technologies has become a core requirement as we look to improve the development of new products and services. Our internal goal is to improve the percentage of new products as a function of revenue over the next five years. The investment in technology will continue to increase in 2006. 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 development of an intelligent pumping system showcases the technologies available to maximize uptime and proactively identify anomalies before they become major issues. We were the sponsor for a national energy summit in 2005 that brought together major companies in the pursuit of energy management initiatives. The technologies available to decrease the energy usage for our customers are being infused into new services for customers.

 

OUR RESULTS OF OPERATIONS

 

As a result of selling GSG, which was included in FCD, in December 2005, and GMBU, an FPD business, in November 2004, we treated these dispositions as discontinued operations and reclassified the financial information reported for all periods presented. 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 GSG, which is more fully discussed in Note 2 to our consolidated financial statements, included in this Annual Report.

 

Sales

 

 

Sales in 2005 increased by $164.5 million, or 6.5%, excluding currency benefits of approximately $8 million, as compared with 2004. The increase in sales is attributable to all three of our segments. These increases are due primarily to continued growth in the oil and gas industry, which has positively impacted our Flowserve Pump and Flow Solutions Divisions, and the continued recovery and strengthening of major valve markets.

 

Sales in 2004 increased by $159.8 million, or 7.1%, excluding currency benefits of approximately $114 million, as compared with 2003. Currency benefits were the result of the strengthening of international currencies, particularly the Euro, against the U.S. dollar. The increase in sales includes new sales of $35.2 million resulting from our acquisition of TKL in March 2004, increased activities of our core markets served, including oil and gas, power and chemicals, and strong growth in the Asia Pacific region.

 

Sales to international customers, including export sales from the U.S., were approximately 65% of sales in 2005 compared with 68% of sales in 2004 and 60% of sales in 2003. Sales into the Asia Pacific region were approximately 14%, 14% and 9% in 2005, 2004 and 2003, respectively. Sales into Europe, Middle East and Africa (“EMA”) were approximately 39%, 43% and 40% in 2005, 2004 and 2003, respectively. Excluding currency translation impacts, 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, South America and Africa.

 

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. Amounts presented above include bookings related to discontinued operations of $95.4 million, $136.8 million and $159.5 million for 2005, 2004 and 2003, respectively.

 

Bookings in 2005 increased by $396.5 million, or 15.7%, excluding currency benefits of approximately $10 million and discontinued operations, as compared with 2004. Bookings for 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 EMA for our Flowserve Pump Division and improved bookings in Asia Pacific for our Flowserve Pump and Flow Control Divisions. Establishment of customer alliances has resulted in increased bookings in our Flow

Solutions Division as described below. Bookings have also been positively impacted by continued strength in the oil and gas industry and recovery of major valve markets.

 

Bookings in 2004 increased by $141.6 million, or 6.3%, excluding currency benefits of approximately $115 million and discontinued operations, as compared with 2003. Bookings for TKL, which was acquired in March 2004, were $40.5 million in 2004 Increased bookings were due to increases in the oil and gas industry, one of our primary served markets, which was spurred by increased crude oil prices.

 

Backlog represents the accumulation of uncompleted customer orders. Amounts presented above include backlog related to discontinued operations of $0, $11.2 million and $34.1 million for 2005, 2004 and 2003, respectively. Backlog at December 31, 2005 increased by $235.5 million, or 28.5%, excluding negative currency effects of approximately $67 million and discontinued operations, as compared with 2004, primarily attributable to the strong bookings performance in 2005, as well as an increase in large oil and gas project orders in EMA for our Flowserve Pump Division. By the end of 2006, we expect to ship over 94% of this backlog. Backlog at December 31, 2004 decreased by $14.5 million, or 1.8%, excluding currency benefits of approximately $33 million, as compared with 2003. The decrease is due to improved customer delivery time.

 

Gross Profit and Gross Profit Margin

 

 

Gross profit margin of 32.0% in 2005 increased as compared with 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.

 

Gross profit margin of 30.1% in 2004 decreased slightly as compared with 2003. Gross profit margin in 2004 was positively impacted by operational improvements attributable to our CIP initiative, which resulted in cost savings, synergies and a higher mix of aftermarket business, which generally has a higher margin. These were offset by a significant charge to cost of sales for the increase in the reserve for obsolete and slow moving inventory in our Flow Control Division, as discussed below, and a $14.1 million increase in incentive compensation as compared to 2003.

 

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

 

 

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, and at least 10% of SG&A consisted of professional fees, which includes audit, legal, contractor and consulting fees. SG&A in 2005 increased by $71.6 million, or 12.0%, excluding currency effects of approximately $3 million, as compared with 2004. 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 stock 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 8 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 Section 404 compliance.

 

SG&A in 2004 increased by $64.4 million, or 12.6%, excluding currency effects of approximately $21 million, as compared with 2003. The increase is due to a $29.9 million increase in annual incentive compensation and a $21.7 million increase in professional and consulting fees related primarily to the restatement of our consolidated financial results for 2003 and prior years, 2004 and 2003 financial statement audits and compliance with Section 404.

 

Integration and Restructuring Expense

 

 

The integration and restructuring expenses relate to the integration of Invensys’ flow control division (“IFC”) into our Flow Control Division. In conjunction with the acquisition of IFC in 2002, we initiated a restructuring program designed to reduce costs and eliminate excess capacity by closing some existing facilities, and reducing sales and related support personnel. We did not incur integration or restructuring expenses in 2005 or 2004 as we had largely completed our restructuring and integration programs related to IFC during 2003, except for final severance payments and payments for other exit activities primarily related to European integration activities. Approximately $4.0 million and $0.7 million of integration and restructuring expenses, respectively, for the year ended December 31, 2003 are included in discontinued operations in the consolidated statements of operations and are related to GSG facilities affected by the restructuring program. See Note 7 to our consolidated financial statements, included in this Annual Report for further discussion on integration and restructuring expenses.

 

Operating Income

 

 

Operating income in 2005 increased by $28.6 million, or 17.7% as compared with 2004, primarily as a result of the increases in gross profit margin, partially offset by the increases in SG&A discussed above. Currency had a nominal effect in 2005.

 

Operating income in 2004 decreased by $5.6 million, or 3.6%, excluding currency benefits of approximately $14 million, as compared with 2003. As discussed above, SG&A costs increased in 2004 as a result of increased incentive compensation and increased professional and consulting fees. The increase in SG&A costs is partially offset by the reduction in integration and restructuring costs.

 

Interest Expense and Loss on Repayment of Debt

 

 

Interest expense decreased $6.3 million in 2005 as compared with 2004 primarily as a result of the refinancing of our 12.25% Senior Subordinated Notes with the proceeds of borrowings under our New Credit Facilities. See further discussion of our refinancing in the “Liquidity and Capital Resources” section of this Management’s Discussion and Analysis and in Note 11 to our consolidated financial statements included in this Annual Report. Interest expense decreased $3.3 million in 2004 due primarily to lower prevailing interest rates and reduced debt levels associated with optional and scheduled debt paydowns since the acquisition of IFC, as well as lower

borrowing interest rate spreads associated with the renegotiation of our revolving line of credit in April 2002. At December 31, 2005 approximately 62% of our debt was at fixed rates, including the effects of $410 million of notional interest rate swaps.

 

Interest income increased $1.5 million in 2005 as compared with 2004 due to significantly higher average cash balances. Interest income decreased $2.2 million in 2004 as compared to 2003 due to lower average cash balances.

 

During 2005, we incurred a charge of $27.7 million as a result of debt repayments and extinguishment related to the refinancing. Expenses incurred as a result of the refinancing are more fully described in the “Liquidity and Capital Resources” section of this Management’s Discussion and Analysis. Under the 2000 Credit Facilities (as described in Note 11 to our consolidated financial statements included in this Annual Report), we were required to use the proceeds of asset sales and new debt issuance, among other things, to pay down the principal amount outstanding under the credit facilities. In addition to mandatory repayments, we paid optional prepayments of principal from excess cash generated from operations. During 2004, we incurred a charge of $2.7 million on debt repayments and extinguishment related to the accelerated write-off of unamortized prepaid financing fees 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 European Investment Bank (“EIB”) credit facility ($85.0 million) and receivables securitization ($60.0 million). In 2003, we incurred losses of $1.3 million related to the accelerated write-off of unamortized prepaid financing fees resulting from $163.1 million of optional debt prepayments throughout the year.

 

Other Expense, net

 

 

Other expense, net decreased $5.7 million in 2005, from an expense of $14.1 million in 2004 due primarily to a $2.6 million decrease in unrealized losses on forward contracts and foreign currency transaction losses. Other expense, net increased $9.7 million in 2004 from a loss of $4.4 million in 2003 due primarily to a $9.2 million increase in unrealized losses on forward contracts.

 

Tax Expense and Tax Rate

 

 

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 primarily from approximately $85 million in foreign earnings repatriation to pay down U.S. debt.

 

The 2003 effective tax rate differed from the federal statutory rate of 35% primarily due to ETI exclusion benefits of $2.5 million, changes in valuation allowances of $5.5 million primarily relating to foreign tax credits and the net impact of non U.S. operations of $2.8 million.

 

We have operations in European and Asian countries that provide various tax incentives. In 2003, we were granted an indefinite preferential tax rate of approximately 10% in Switzerland for certain sales and marketing activities. 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 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 2007 and 2011, 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 2005 tax rate, 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 applies for the years 2006 through 2008, and may apply to certain of our related party payments.

 

We expect our effective tax rate in 2006 to be similar to or lower than 2005 due to lower levels of U.S. income inclusions from our low taxed foreign subsidiaries. Our effective tax rate is based upon current earnings, estimates of future taxable earnings for each domestic and international location and the estimated impact of tax planning strategies. 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, 2005 we have foreign tax credits of approximately $21.3 million, expiring in 2010 through 2015 against which we recorded no valuation allowances. Additionally, we have recorded U.S. net deferred tax assets of $111.8 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 increased $20.3 million in 2005 to $46.2 million, or $0.82 per diluted share, primarily as a result of the factors discussed above regarding operating income. Net earnings declined in 2005 as compared to 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. Earnings per share in 2005 were negatively impacted by a 1.7% higher average diluted share count.

Income from continuing operations decreased $24.6 million in 2004 to $25.9 million, or $0.46 per diluted share. In addition to the factors discussed above regarding operating income, 2004 income from continuing operations was also impacted by increases in the effective tax rate, as compared to 2003, and losses on derivative contracts.

 

The 2005 and 2004 increases in average diluted shares reflect the issuance of stock awards and the dilutive effects of increases in our stock price.

 

Other Comprehensive Income (Expense)

 

 

Other comprehensive income declined to expense of $63.7 million in 2005 from income of $15.1 million in 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 devaluation of the Euro and the British pound versus the U.S. dollar during 2005. Minimum pension liability 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.

 

Other comprehensive income declined to $15.1 million in 2004 as compared with 2003. The decrease is primarily a result of a decrease of $36.5 million in currency translation adjustments as compared with 2003. The decline in currency translation adjustment income is due primarily to the devaluation of the U.S. dollar versus the Euro and the British pound during 2004. In addition, the minimum pension liability decreased $16.7 million as compared with 2003, primarily as a result of a slight decrease in pension plan asset returns.

 

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 excluding special items, such as restructuring and integration costs related to the IFC acquisition. We believe that special items, while indicative of efforts to integrate IFC in our business, do not reflect ongoing business results. We believe investors and other users of our financial statements can better evaluate and analyze historical and future business trends if special items are excluded from each segment’s operating income. Operating income before special items is not a recognized measure under GAAP and should not be viewed as an alternative to, or a better indicator of, GAAP measures of performance. 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, distribute and service engineered and industrial pumps and pump systems, replacement parts and related equipment, principally to industrial markets. FPD has 27 manufacturing facilities worldwide, of which nine are located in North America, 11 in Europe, four in South America and three in Asia. FPD also more than 50 service centers, which are either free standing or co-located in a manufacturing facility. In March 2004, we acquired the remaining 75% interest in TKL, a leading Australian designer, manufacturer and supplier of centrifugal pumps, railway track work products and steel castings. 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.

 

 

Bookings in 2005 increased by $233.4 million, or 17.4%, excluding currency benefits of approximately $3 million, as compared with 2004 due to increases in all regions: EMA bookings increased approximately $139.2 million, excluding currency effects; North and South America bookings increased by $42.5 million and $19.7 million, respectively and excluding currency effects, due to several large engineered projects; and Asia Pacific increased $33.1 million due primarily to TKL. The increase is also attributable to continued growth in the oil and gas industry.

 

Bookings in 2004 increased by $74.0 million, or 6.1%, excluding currency benefits of approximately $58 million, as compared with 2003. The increase is due to additional bookings of $40.5 million resulting primarily from TKL, and an increase in aftermarket bookings. Aftermarket bookings represented 46.3% of total FPD bookings in 2004 as compared with 44.3% in 2003, as our primary served markets for the oil and gas and chemicals industries experienced growth and operated at near capacity levels due to continued increases in crude oil prices.

 

Sales in 2005 increased by $65.1 million, or 4.9%, excluding currency benefits of approximately $4 million, as compared with 2004. Sales in North and South America increased by $20.8 million and $14.2 million, respectively, and excluding currency benefits. In North America, higher sales were primarily attributable to an improvement in general industrial products as well as in parts and service in the U.S. and Canada. Asia Pacific increased $16.7 million due primarily to TKL. Of the $1.4 billion of sales in 2005, approximately 49% were from oil and gas, 18% power, 12% water, 8% chemical and 13% general industries.

 

Sales in 2004 increased by $105.8 million, or 9.1%, excluding currency benefits of approximately $59 million as compared with 2003. Sales improved in all regions and were most active in our core oil and gas markets. Water projects, especially those focusing on desalination, improved and chemical markets remained strong despite increasing feedstock prices. Of the 9.1% increase, 3.0% was directly attributable to increased sales from TKL. Offsetting these favorable sales was decreased business in our North American water market, where our sales were $14.5 million lower than the previous year as FPD was more selective in bidding opportunities. Of the $1.3 billion of sales in 2004, approximately 43% were from oil and gas, 20% power, 10% water, 8% chemical and 19% general industries.

 

Gross profit margin increased to 27.9% in 2005 as compared with 25.7% in 2004 and 24.3% in 2003. The increase in both years is primarily a result of the increase in sales, which favorably impacts our absorption of fixed costs, a higher mix of historically more profitable general industrial products and services and increased productivity. In 2004, these positive effects were partially offset by an increase in incentive compensation of $7.4 million included in cost of sales.

 

Operating income in 2005 increased by $35.7 million, or 32.4%, excluding unfavorable currency effects of approximately $1 million, as compared with 2004. The increase is primarily a result of the increase in gross profit margin discussed above.

 

Operating income in 2004 increased by $17.2 million, or 20.0%, excluding currency benefits of approximately $7 million, as compared with 2003. In addition to the increased sales and gross profit margin discussed above, operating income also increased due to $2.9 million in operating income from TKL and a gain of $8.5 million from the involuntary conversion of patterns that were lost in a fire at one of our foundries. These were slightly offset by an

increase in incentive compensation of $7.4 million included in cost of sales as discussed above and an incremental increase in incentive compensation of $9.1 million included in SG&A.

 

Backlog in 2005 increased by $179.8 million, or 31.2%, excluding negative currency effects of approximately $52 million, as compared with 2004. The increase 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. In addition, FCD leverages its experience and application know-how by offering a complete menu of engineered services to complement its expansive product portfolio. FCD has more than 4,000 employees at its manufacturing and service facilities in 19 countries around the world, with only five of its 22 manufacturing operations located in the U.S.

 

In 2005, focus on execution coupled with strong operational performance in FCD’s key end-markets, yielded financial results above prior years. In an effort to better align our business portfolio with our core strategic objectives, FCD made the decision to divest GSG, which provides online repair and other third-party services. Effective December 31, 2005, we sold the assets of GSG to Furmanite, a unit of Dallas-based Xanser Corporation. We believe this divestiture allows us to continue our focus on our core end-user objectives.

 

 

In 2005, FCD bookings increased by $81.5 million, or 9.6%, excluding currency effects of approximately $3 million, as compared with 2004. This growth 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 FCD’s core end-markets including the oil and gas, power and chemical industries. Bookings in 2004 increased by $41.8 million, or 5.5%, excluding currency benefits of approximately $45 million, as compared with 2003. The increase is a result of strengthening in the chemical and the oil and gas segments of the market.

 

FCD sales in 2005, increased by $53.4 million, or 6.4%, excluding currency effects of approximately $2 million, as compared with 2004. 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 performance 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. Of the $894.3 million of sales in 2005, approximately 38% were general industry sales, 32% were sales to chemical companies, 15% were oil and gas industry sales and 15% were sales to power industry customers. Sales in 2004 increased by $37.6 million, or 5.0%, excluding currency benefits of approximately $43 million, as compared with 2003. The increase is primarily attributable to many of the major valve markets beginning to recover from several years of decline. Increased customer demand for valve products and services in the power, chemical and general industrial markets helped drive the 2004 sales increases. Of the $838.7 million of sales in 2004, approximately 43% were general industry sales, 26% were sales to chemical companies, 16% were oil and gas industry sales and 15% were sales to power industry customers.

Gross profit margin of 31.9% in 2005 increased as compared with 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 with a more favorable mix of aftermarket sales, which typically have a higher margin, positively impacted gross profit margin. Gross profit margin of 30.1% in 2004 decreased as compared with 2003. This resulted primarily from a $14.1 million charge to cost of sales for the increase in the reserve for obsolete and slow moving inventory, which resulted when a comparatively large portion of inventory purchased in our acquisition of IFC in 2002 did not sell at anticipated rates, thus triggering recognition of additional obsolescence reserves.

 

In 2005, operating income (before special items) increased $23.2 million, or 35.6%, excluding currency effects of less than $1 million, driven primarily by the increase in the gross profit margin discussed above. Operating income was negatively impacted 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. Operating income (before special items) in 2004 decreased by $7.2 million, or 10.6% excluding currency benefits of approximately $4 million, as compared with 2003. The decrease results primarily from a $14.1 million charge to income for the increased provision for obsolete and slow moving inventory, as discussed above, plus an incremental $7.6 million increase in incentive compensation included in SG&A. Special items during 2003 were associated with the acquisition and integration of IFC into FCD.

 

Backlog in 2005 increased by $36.5 million, or 16.9%, excluding negative currency effects of approximately $12 million, as compared with 2004. The increase is primarily attributable to the strong bookings performance in 2005.

 

Flow Solutions Division Segment Results

 

Through FSD, we design, manufacture and distribute mechanical seals, sealing systems and parts, and provide related services, principally to industrial markets. FSD has seven manufacturing operations, three of which are located in the U.S. FSD operates 64 QRCs worldwide, including 25 sites in North America, 14 in Europe, and the remainder in South America and Asia. Our ability to manufacture engineered seal products within 72 hours from the customer’s request — through design, engineering, manufacturing, testing and delivery — is a significant competitive advantage. Based on independent industry sources, we believe that we are the second largest mechanical seal supplier in the world.

 

 

Bookings in 2005 increased by $64.5 million, or 16.3%, excluding currency benefits of approximately $4 million, as compared with 2004. Bookings in 2004 increased by $22.5 million, or 6.2%, excluding currency benefits of approximately $11 million, as compared with 2003. This bookings growth 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.

 

Sales in 2005 increased by $47.0 million, or 11.9%, excluding currency benefits of approximately $3 million, as compared with 2004. The increase is due to the following: 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. Of the $443.6 million of sales in 2005, approximately 33% was from oil and gas, 26% from chemical and 41% from general industries. Sales in 2004 increased by $25.2 million, or 7.0%, excluding currency benefits of approximately $11 million, as compared with 2003. Continuous improvements focused on our end user customer business, as well as meeting our strategic growth initiatives, led FSD to increased shipments in all regions in 2004. Of the $394.0 million of sales in 2004, approximately 30% was from oil and gas, 27% chemical and 43% general industries.

 

Gross profit margin increased to 43.6% in 2005 as compared with 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. Gross profit margin for FSD decreased to 43.2% in 2004 as compared with 44.8% in 2003, primarily due to a $4.1 million increase in annual incentive compensation included in cost of sales, increases in worldwide metals pricing, and a charge to cost of sales resulting from an increase in the reserve for slow moving inventory.

 

Operating income in 2005 increased by $12.8 million, or 17.6%, excluding currency benefits of less than $1 million, as compared with 2004. The improvement in 2005 reflects increased gross profit margins discussed above and greater control of SG&A. Operating income in 2004 decreased by $3.7 million, or 5.0%, excluding currency benefits of approximately $2 million, as compared with 2003. The decrease in operating income is primarily a result of the decrease in gross profit margin discussed above and an increase in SG&A, resulting from an increase in annual incentive compensation of $4.1 million.

 

Backlog in 2005 increased by $19.7 million, or 45.1%, excluding negative currency effects of approximately $2 million, as compared with 2004. The increase is primarily attributable to the strong bookings performance in 2005, as well as one significant contract in which the final shipment is not due until 2008.

 

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 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, 2005 was $96.5 million, compared to $63.8 million in 2004 and $53.5 million in 2003.

 

The cash flows provided by operating activities in 2005 primarily reflect an increase in 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. The increase in cash flows provided by operating activities in 2004 primarily relates to the implementation of the accounts receivable securitization agreement and increases in accounts payable, accrued liabilities and retirement obligations and other liabilities. In 2003, we also benefited from receipt of a $4.9 million U.S. income tax refund. Cash outflows related to the IFC integration were $27.2 million in 2003.

 

Further, operating cash flows in 2005 reflect increased funding of pension plans of approximately $30 million as compared with 2004. The reduction in working capital for 2004 reflects increases of $46.6 million in accounts payable due to deferred payment of invoices at year-end in 2004, and $32.1 million in accrued liabilities due

primarily to an increase of approximately $44 million in the bonus accrual for 2004. The reduction in working capital for 2004 also reflects our continued emphasis on improving accounts receivable collections and reducing inventory. The improvement in accounts receivable in 2004 as compared to 2003 primarily reflects improved collections and the impact of the accounts receivable securitization of $48.7 million discussed below. In addition, incremental factoring of certain non-U.S. receivables contributed $0.7 million in 2005, used $3.4 million in 2004 and contributed $15.5 million in 2003.

 

Our goal for days’ sales receivables outstanding (“DSO”) is 60 days. For the fourth quarter of 2005, we achieved a DSO of 58 days as compared to 59 days for the same period in 2004. For reference purposes based on 2005 sales, an improvement of one day could provide approximately $8 million in cash. Inventory reductions contributed $4.7 million of cash flow for 2005 compared with $25.5 million of cash flow for 2004 and $29.4 million in 2003. The majority of the inventory reduction in 2004 was in project-related work in process inventory required to support shipments of products in backlog, offset in part by an increase in raw materials. As a result of inventory reductions, inventory turns were 5.6 times at December 31, 2005, compared with 5.1 times and 4.4 times at December 31, 2004 and 2003 respectively. For reference purposes based on 2005 data, an improvement of one turn could yield approximately $55 million in cash.

 

Cash outflows for investing activities were $39.3 million, $14.1 million and $26.6 million in 2005, 2004 and 2003, respectively, due primarily to capital expenditures.

 

Cash outflows for financing activities were $53.3 million in 2005 compared with $250.6 million in 2004 and $162.8 million in 2003. The change in 2005 is primarily a result of the debt paydown. The change in 2004 results primarily from increased mandatory repayments of long-term debt triggered by the GMBU divestiture, the issuance of the EIB credit facility and accounts receivables securitization.

 

Our cash needs for the next 12 months are expected to be substantially similar to 2005, except for a decrease in debt payments required under our New Credit Facilities partially offset by an increase in pension contributions and increases in capital expenditures related to information technology infrastructure and capacity expansion. 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, 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 generated $1.1 million and $6.8 million of cash flow related to the exercise of employee stock options in 2005 and 2004, respectively, which is reflected in financing activities of the consolidated statement of cash flows. Amounts generated from the exercise of employee stock options in 2003 were not significant. Stock option shares are not currently exercisable due to the temporary suspension of our stock option exercise program, as a result of which current employees, including executive officers, qualified retirees and our directors are unable to exercise their vested options. The stock option exercise program was temporarily suspended due to the fact that we were not able to timely file our annual and quarterly periodic reports with the SEC, which made it impossible to issue registered shares upon option exercises.

 

We have a substantial number of outstanding stock options granted in past years to employees under our stock option plans which have been unexercisable for an extended period due to our non-current filing status of all our SEC financial reports. These outstanding options include options for 809,667 shares held by our former Chairman, President and Chief Executive Officer, C. Scott Greer. Given the significant increase in our share price during the period in which optionees have been unable to exercise their options, it is possible that many holders may want to exercise soon after they are first able to do so. We will reopen our stock option exercise program and allow optionees to exercise their options once we become current with our SEC financial reporting obligations and have registered the issuance of our common shares upon exercise of such stock options with the SEC. We currently expect this to occur in 2006. If the holders of a large number of these options promptly exercise following such reopening, there would be some dilutive impact on our earnings per share. We anticipate that a significant number of stock option exercises at one time would positively impact our cash flow, however, we are still evaluating the extent of such

impact and alternatives to satisfy our obligation under the stock option program, up to and including repurchasing shares on the market to offset some or all of the dilutive impact on our earnings per share which could negatively impact our cash flow. The impacts on our cash flow and earnings per share are dependent upon share price, number of shares and strike price of shares exercised.

 

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.

 

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 were funded primarily by operating cash flows and, to a lesser extent, by bank borrowings. In 2005, our capital expenditures focused on new product development, information technology infrastructure and cost reduction opportunities. In 2003 and 2004, capital expenditures were invested in new and replacement machinery and equipment, information technology and acquisition integration activities, including structures and equipment required at receiving facilities. Capital expenditures in 2004 include approximately $5 million for the purchase of a building we previously leased for the manufacture of valves. In each year, capital expenditures were less than depreciation expense due to excess capacity and the upgrading of equipment through integration processes. In 2006, our capital expenditures are focused on capacity expansion, enterprise resource planning application upgrades (Project STAR: Simplification and Teamwork Accelerates Results), information technology infrastructure and cost reduction opportunities and are expected to be between $70 million and $75 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:

 

 

New Credit Facilities

 

On August 12, 2005, we entered into New 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 used the proceeds of borrowings under our New Credit Facilities to refinance our 12.25% Senior Subordinated Notes and indebtedness outstanding under our 2000 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 New Credit Facilities.

 

Borrowings under our New 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 New 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, 2005 was 1.75% 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 million, with the ability to draw funds in multiple currencies, to finance in part specified research and development projects undertaken by us in Europe. Borrowings under the EIB credit facility bear interest at a fixed or floating rate of interest agreed to by us and EIB with respect to each borrowing under the facility. Loans under the EIB credit facility are subject to mandatory prepayment, at EIB’s discretion, upon the occurrence of certain events, including a change of control or prepayment of certain other indebtedness. In addition, the EIB credit facility contains covenants that, among other things, limit our ability to dispose of assets related to the financed project and require us to deliver to EIB our audited annual financial statements within 30 days of publication. In August 2004, we borrowed $85 million at a floating interest rate based on 3-month U.S. LIBOR that resets quarterly. As of December 31, 2005, the interest rate was 4.42%. The maturity of the loan is June 15, 2011, but may be repaid at any time without penalty.

Additional discussion of our New Credit Facilities, the EIB credit facility and other debt instruments no longer in effect as of December 31, 2005 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 New Credit Facilities are subject to mandatory repayment with, in general:

 

 

 

We made a mandatory debt repayment of $10.9 million in January 2006 using the net cash proceeds from the sale of GSG and we will make a mandatory repayment of $0.9 million in July 2006 using excess cash flows.

 

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

 

We incurred $9.3 million in fees related to the New 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 New 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 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 New 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 New Credit Facilities using the effective interest method.

 

Accounts Receivable Securitization

 

In October 2004, Flowserve US Inc., one of our wholly owned subsidiaries, and Flowserve Receivables Corporation (“FRC”), a wholly owned subsidiary of Flowserve US Inc., entered into a receivables purchase agreement (“RPA”) with two third party financial institutions whereby FRC could obtain up to $75 million in financing on a revolving basis by securitizing certain U.S.-based trade receivables.

 

To obtain financing, Flowserve US Inc. transferred eligible receivables to FRC, which was formed solely for this accounts receivable securitization program. Pursuant to the RPA, FRC then sold undivided purchaser interests

in these receivables to the third party financial institutions. Flowserve US Inc. continued to service the receivables for a servicing fee of 0.5% of the average net receivable balance. No servicing liability was recognized at December 31, 2004 because the amount was immaterial due to the short term average collection period of the securitized receivables. FRC had no recourse against Flowserve US Inc. for failure of the debtors to pay when due. As of December 31, 2004, FRC had secured $60 million in financing under the program. The proceeds were used to repay $16 million and $44 million of Tranche A and Tranche C bank term loans, respectively, outstanding under our prior credit facilities. At the time the purchaser interests were sold, $48.7 million of the receivables transferred to FRC were removed from FRC’s financial statements, and FRC further recorded short-term debt of $11.3 million. Borrowings under the RPA in excess of $11.3 million are excluded from our debt balance as presented in the consolidated balance sheet as of December 31, 2004.

 

On October 31, 2005, we terminated the RPA. In connection with this, we borrowed approximately $48 million under our New Credit Facilities and repurchased outstanding receivable interests from the third party financial institutions. See additional discussion of our accounts receivable securitization program in Note 11 to our consolidated financial statements included in this Annual Report.

 

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. Under our previous credit facilities, such factoring was generally limited to $50 million, based on due date of the factored receivables. The limit on factoring was raised to $75 million under the New Credit Facilities entered into in August 2005. See additional discussion of our accounts receivable factoring program in Note 5 to our consolidated financial statements included in this Annual Report.

 

Debt Covenants and Other Matters

 

Our New 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. Under the leverage covenant, the maximum permitted leverage ratio steps down beginning with the fourth quarter of 2006, with a further step-down beginning with the fourth quarter of 2007. Under the interest coverage covenant, the minimum required interest coverage ratio steps up beginning with the fourth quarter of 2006, with a further step-up beginning with the fourth quarter of 2007. Compliance with these financial covenants under our New Credit Facilities is tested quarterly. Delivery of the December 31, 2005 audited financial statements is required by May 30, 2006. We have received a waiver from our lenders to deliver the December 31, 2005 audited annual financial statements by July 31, 2006. Further, we are required to furnish within 50 days of the end of each of the first three quarters of each year our consolidated balance sheet, and related statements of operations, shareholders’ equity and cash flows.

 

Our New Credit Facilities also contain covenants restricting our and our subsidiaries’ ability to dispose of assets, merge, pay dividends, repurchase or redeem capital stock and indebtedness, incur indebtedness and guarantees, create liens, enter into agreements with negative pledge clauses, make certain investments or acquisitions, enter into sale and leaseback transactions, enter into transactions with affiliates, make capital expenditures, engage in any business activity other than our existing business or any business activities reasonably incidental thereto. With the waiver for delivery of the December 31, 2005 audited financial statements, we are in compliance with all debt covenants under the New Credit Facilities.

CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS

 

The following table presents a summary of our contractual obligations at December 31, 2005:

 

 

 

 

The following table presents a summary of our commercial commitments at December 31, 2005:

 

 

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.

 

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 57% of benefit obligations are related to the U.S. plan as of December 31, 2005. 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, 2005, the fair market value of plan assets for our defined benefit plans increased to $311.6 million from $276.3 million at December 31, 2004. Assets were allocated as follows:

 

 

The projected benefit obligation for our defined benefit pension plans was $520.6 million and $488.7 million as of December 31, 2005 and 2004, 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 $73.8 million and $88.7 million as of December 31, 2005 and 2004, respectively. The decrease is primarily a result of plan amendments in 2005 that reduced our obligation from full coverage to a capped amount at two facilities and a higher than expected decrease in plan participants.

 

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.

 

In 2005, net pension expense for our defined benefit pension plans included in income from continuing operations was $26.5 million compared to $22.9 million in 2004 and $20.0 million in 2003. The postretirement benefit expense for the postretirement health care plan was $0.8 million in 2005 compared to $3.8 million in 2004

and $4.1 million in 2003. 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, 2005:

 

 

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:

 

 

Effect of Changes in the Expected Return on Assets and Constancy of Other Assumptions:

 

 

As discussed below, GAAP provides that differences between expected and actual returns are recognized over the average future service of employees.

 

At December 31, 2005, we lowered our assumed discount rate for the U.S. plan from 5.75% to 5.50% consistent with decreased 10-year bond yields and our average rate for non-U.S. plans from 5.12% to 4.43%. We maintained our average assumed rate of compensation increase at 4.5% for the U.S. plan and slightly increased the assumed rate of compensation increase to 3.19% for non-U.S. plans. The reduction in the discount rate had the

effect of increasing the present value of benefit obligations and, accordingly, increased pension expense for 2005. We lowered the expected rate of return on U.S. plan assets from 8.75% for 2004 to 8.25% for 2005, primarily to reflect reduced expected long-term equity returns. Further reductions to the assumed discount rate and expected rate of return will have the effect of increasing pension expense for 2006.

 

We expect that the net pension expense for our defined benefit pension plans included in earnings before income taxes will be approximately $4.4 million higher in 2006 than the $26.5 million in 2005, reflecting, among other things, the decrease in the assumed discount rate and expected reduction in the rate of return on plan assets. We expect the 2006 expense for the postretirement health care plan to be $0.8 million.

 

We have used the same assumed discount rates of 5.50% and 5.75% at December 31, 2005 and 2004, respectively, in calculating our cost of pension benefits and our cost of other postretirement benefits for U.S. plans.

 

The assumed ranges for the annual rates of increase in per capita costs for periods prior to Medicare were 8.0% for 2005, 9.0% for 2004 and 10.0% for 2003, with a gradual decrease to 5.0% for 2007 and future years. If actual costs are higher than those assumed, this will likely put modest upward pressure on our expense for retiree health care.

 

On December 8, 2003, President Bush signed into law the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the “Medicare Act”). The effects of the Medicare Act are reflected in 2004 net periodic postretirement benefit cost (a reduction of $0.7 million) and accumulated postretirement benefit obligation at December 31, 2004 (a reduction of $4.5 million).

 

Delayed Recognition of Actuarial Gains and Losses

 

At December 31, 2005 and 2004, unrecognized net actuarial losses for our defined benefit plans were $163.0 million and $132.2 million, respectively, based on the fair market value of plan assets. These unrecognized net actuarial losses primarily reflect in large part the steady reduction of the weighted-average discount rate over the years.

 

SFAS No. 87 provides for delayed recognition of actuarial gains and losses, including amounts arising from changes in the estimated plan benefit obligations due to changes in the assumed discount rate, differences between the actual and expected returns on plan assets, and other assumption changes. SFAS No. 87 requires that unrecognized net actuarial gain or loss, determined based on the market-related value of plan assets (which differs from fair market value and is a calculated value that recognizes changes in fair value in a systematic and rational manner over five years), be amortized in pension expense for the year to the extent that such unrecognized net actuarial loss or gain exceeds 10% of the greater of the projected benefit obligation or the market-related value of plan assets at the beginning of the year. These net gains and losses are recognized as pension expense prospectively over a period that approximates the average remaining service period of active employees expected to receive benefits under the plans to the extent that they are not offset by losses and gains in subsequent years.

 

At December 31, 2005, the unrecognized net actuarial loss for the U.S. plan subject to amortized recognition, determined based on the market-related value of plan assets, was $105.8 million. This amount exceeded 10% of the greater of the projected benefit obligation or the market related value of plan assets by $77.0 million. Unless offset by future unrecognized gains from higher discount rates or higher than expected returns on plan assets, amortization of this unrecognized loss is expected to increase pension expense for each of the following 13 years by approximately $6.0 million per year, which amount is reflected in the higher expense expected in 2006.

 

In the event the fair market value of pension plan assets of a particular plan is less than the accumulated benefit obligation for such plan at year-end, GAAP may require an additional minimum liability, and in such circumstances, a reduction in shareholders’ equity or an establishment of an intangible asset. At December 31, 2005, the fair market value of our defined benefit pension plan assets was $311.6 million and the related accumulated benefit obligation was $501.9 million. We recognized an additional minimum liability of $137.4 million at December 31, 2005, which was recorded as a $93.2 million charge in other comprehensive income included in shareholders’ equity, a $43.5 million deferred tax asset, and a $0.7 million intangible asset. At December 31, 2004, the fair market value of our defined benefit pension plan assets was $276.3 million and the related accumulated benefit obligation was $473.6 million. We recognized an additional minimum liability of $97.4 million at December 31, 2004, which

was recorded as a $62.1 million charge in other comprehensive income included in stockholders’ equity, a $34.6 million deferred tax asset, and a $0.7 million increase in the intangible asset.

 

Plan Funding

 

Our funding policy for defined benefit plans is to contribute at least the amounts required under applicable laws and local customs. We contributed $53.1 million, $23.4 million and $34.7 million to our defined benefit plans in 2005, 2004 and 2003, respectively. In 2006, we expect to contribute approximately $36 million to our qualified U.S. pension plan, and we expect to contribute approximately $8 million to our non-U.S. pension plans.

 

For further discussions on retirement benefits, see Note 12 to our consolidated financial statements included in this Annual Report.

 

OUR CRITICAL ACCOUNTING POLICIES AND ESTIMATES

 

The process of preparing financial statements in conformity with accounting principles generally accepted in the United States of America requires the use of estimates and assumptions to determine reported amounts of certain assets, liabilities, revenues and expenses and the disclosure of related contingent assets and liabilities. These estimates and assumptions are based upon information available at the time of the estimates or assumptions, including our historical experience, where relevant. The most significant estimates made by management include timing and amount of revenue recognition, allowance for doubtful accounts, inventory costing and related fair value allowances, deferred tax asset realization, restructuring charges and expected payments reflected in related reserves, legal and environmental claims estimates, warranty provisions, pension and postretirement benefits obligations and the fair value of indefinite-lived assets (including goodwill) and other long-lived assets. The significant estimates are reviewed quarterly by management with oversight by our Disclosure Control Committee, an internal committee comprised of members of senior management, and the Disclosure Control Committee presents its views to the Audit Committee of our Board of Directors. Because of the uncertainty of factors surrounding the estimates, assumptions and judgments used in the preparation of our financial statements, actual results may differ from the estimates, and the difference may be material.

 

Our critical accounting policies are those policies that are both most important to our financial condition and results of operations and require the most difficult, subjective or complex judgments on the part of management in their application, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. We believe that the following represent our critical accounting policies. For a summary of all of our significant accounting policies, see Note 1 to the consolidated financial statements included in this Annual Report. Management and our external auditors have discussed our critical accounting policies with the Audit Committee of our Board of Directors.

 

Revenue Recognition

 

Revenues for products and short-term projects are recognized based on the shipping terms agreed to with the customer and fulfillment of all but inconsequential or perfunctory actions required, which is generally the point of title transfer. If the customer order requires formal acceptance, revenue is not recognized until formal acceptance has been received. For contracts containing multiple products, each having separable value, we generally recognize revenue on individual product shipments equal to the shipped products’ pro rata share of the contract’s fair value upon the fulfillment of all but inconsequential or perfunctory actions of the individual product shipment. For multiple deliverables under a single contract or arrangement, such as product delivery and installation, we separate the fair value of the product from the installation and recognize revenue on each element independently upon fulfillment of all but inconsequential or perfunctory actions. Our estimates mainly relate to the fair value determination of the underlying services or products. Revenue on service contracts is recognized after the services have been rendered and accepted by the customer. All revenue for products, short-term projects and service contracts require, prior to recognition, the persuasive evidence of an arrangement, a fixed or determinable sales price and reasonable assurance of collectibility.

 

Revenue for certain long-term large contracts is recorded on the percentage of completion method calculated on a cost-to-cost basis, in instances where reliable cost estimates exist. Percentage of completion revenue represents

less than 5% of our consolidated revenues for each year presented, and is most prevalent in FPD. The percentage of completion method of revenue recognition requires us to prepare estimates of costs to complete contracts in progress, and in doing so we make judgments to evaluate contingencies such as potential variances in scheduled delivery and the cost of materials, labor costs and productivity, the impact of change orders, potential warranty liabilities and liquidated damage claims, contract disputes, and achievement of contractual performance standards. Changes in total estimated contract costs and resultant contract losses, if any, are recognized in the period in which they are determined.

 

Revenue generated under fixed fee service and repair contracts are recognized on a straight-line basis over the term of the contract. These contracts can range in duration, but generally extend for five years. Fixed fee service and repair contracts represent less than 5% of our consolidated revenue for each year presented, and are most prevalent in FSD.

 

In certain instances, we provide guaranteed completion dates under the terms of our contracts. Failure to meet schedule or agreed upon delivery dates can result in unrealized incentive fees or non-recoverable costs. In instances where the payments of such costs are likely, we perform project profitability analysis using such costs to reduce revenues realizable, which could cause estimated project costs to exceed projected revenues realized from the project. In such instances, we would record reserves to cover such excesses in the period they are determined, which would adversely affect our results of operations and financial position. In instances where the reduced revenues still exceed costs, the incurrence of the costs generally reduces profitability of the project at the time of subsequent revenue recognition. Our reported results would change if different estimates were used for contract costs or if different estimates were used for contractual contingencies.

 

Allowance for Doubtful Accounts

 

We maintain an allowance for doubtful accounts based on estimates of the amount of uncollectible accounts receivable. The amount of the allowance is determined principally based upon the aging of the receivable, as well as on customer credit history, significant customer disputes, outstanding industry and market segment information, economic trends and conditions, credit reports and customer financial condition.

 

We consider our collection history and specifically known uncollectible accounts in establishing our allowance. Customer credit issues, customer bankruptcies, general economic conditions or other matters largely beyond our control can affect the collectibility of our accounts receivable. If our customers’ financial conditions worsened or if customer disputes increased beyond levels currently provided for, we might be required to recognize additional allowances or incur additional write-offs, which would adversely impact our results of operation, cash flows and financial position.

 

Our credit risk may be mitigated by our large number of customers across many different geographic regions. For all of 2003 and most of 2004, we had a credit insurance policy for many of our European subsidiaries, whereby we were entitled to remuneration from the third party insurer, net of deductible, in instances where customers covered by this policy were unable to pay. We cancelled this policy in late 2004 due to minimal claims sought.

 

Inventories and Related Reserves

 

Inventories are stated at the lower of cost or market. We primarily determine cost for the majority of our U.S. inventories by the last-in, first-out method and for other inventories by the first-in, first-out method. We estimate the market value of our inventory based on an assessment of recent or committed sales prices, and provide for excess and obsolete inventories based on historical usage, estimated future demand and related pricing. In determining excess quantities, we consider recent sales activity, related margins and market positioning of our products. These estimates are generally not subject to significant volatility, due to the long life cycles of our product lines, except for product rationalizations generally associated with acquisition integration programs. However, factors beyond our control, such as demand levels, technological advances and pricing competition, could change from period to period. If such factors had an adverse effect on us, we might be required to reduce the value of our inventory, which would adversely affect our results of operations, cash flows and financial position.

Deferred Taxes and Tax Valuation Allowances

 

We recognize valuation allowances to reduce the carrying value of deferred tax assets to amounts that we expect are more likely than not to be realized. Our valuation allowances primarily relate to the deferred tax assets established for certain net operating loss carryforwards for U.S. and non-U.S. subsidiaries, and we evaluate the realizability of our deferred tax assets by assessing the related valuation allowance and by adjusting the amount of these allowances, if necessary. We assess such factors as our forecast of future taxable income and available tax planning strategies that could be implemented to realize the net deferred tax assets in determining the sufficiency of our valuation allowances. Failure to achieve forecasted taxable income in the applicable tax jurisdictions could affect the ultimate realization of deferred tax assets and could result in an increase in our effective tax rate on future earnings. Implementation of different tax structures in certain jurisdictions could, if successful, result in future reductions of certain valuation allowances.

 

Tax Reserves

 

The amount of income taxes we pay is subject to ongoing audits by federal, state and foreign tax authorities, which often result in proposed assessments. Significant judgment is required in determining income tax provisions and evaluating tax positions. We establish reserves for open tax years for certain positions that are subject to challenge by various tax authorities. The consolidated tax provision and related accruals include the impact of such reasonably estimable losses and related interest as deemed appropriate. We believe we have adequately provided for any reasonably foreseeable outcome related to these matters, and our future results may include favorable or unfavorable adjustments to our estimated tax liabilities. To the extent that the expected tax outcome of these matters changes, such changes in estimate will impact the income tax provision in the period in which such determination is made.

 

Restructuring and Integration Expense

 

Restructuring and integration expenses have generally been recognized in conjunction with our acquisitions. Such expenses reflect many estimates including costs pertaining to employee severance payments, fulfillment of outstanding contractual obligations and other matters associated with exiting a facility. Restructuring costs related to facilities and employees of acquired businesses generally become a component of goodwill, whereas non-acquisition related restructuring costs are recorded as restructuring expense in the consolidated statements of operations. Integration costs are recognized as a reduction to the results of operations as a component of current earnings. Reserves created for each restructuring plan are assessed quarterly and adjusted for any revisions of cost estimates or other changes in planned restructuring activities. Prior to January 1, 2003, we recognized restructuring reserves when the related restructuring plans had been both approved and communicated to affected employees. In conjunction with adopting SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” on January 1, 2003, we now record restructuring reserves as the related liability is incurred.

 

Legal and Environmental Accruals

 

The costs relating to legal and environmental liabilities are recorded when it is both probable that a loss has been incurred and such loss is estimable. We have a formal process for assessing the facts and recording any required reserves on a case-by-case basis. Assessments of legal and environmental reserves are based on information obtained from our independent and in-house experts, including recent legal decisions and loss experience in similar situations. The recorded legal reserves are susceptible to changes due to new developments regarding the facts and circumstances of each matter, changes in political environments, legal venue and other factors. Recorded environmental reserves could change based on further analysis of our properties, technological innovation and regulatory environment changes.

 

Warranty Accruals

 

Warranty obligations are based upon product failure rates, materials usage and service delivery costs, an analysis of all identified or expected claims and an estimate of the cost to resolve such claims. The estimates of expected claims are generally a factor of historical claims and known product issues. Warranty obligations based on

these factors are adjusted based on historical sales trends for the preceding 24 months. Changes in claim rates, differences between actual and expected warranty costs, sales trends, and facility rationalization activities could impact warranty obligation estimates, which might have adverse effects to our consolidated results of operations and financial position.

 

Retirement and Postretirement Benefits

 

Determination of the value of our retirement and postretirement benefits liabilities is based on actuarial valuations. Inherent in these valuations are key assumptions which are assessed annually in the fourth quarter and which include:

 

 

We evaluate, in conjunction with our professional advisors, prevailing market conditions in countries where plans are maintained, including appropriate rates of return, interest rates and medical inflation rates. Specifically for our U.S. plan, we assess such market factors as changes in the cash balance interest crediting rate, borrowing rates for investment grade corporate and industrial companies, assumptions used by Fortune 500 companies, our actual wage increases in recent years, expected rates of return for each targeted asset class held by the plans and return premiums generated by active investment management. For the non-U.S. plans we perform similar analyses, but also factor in local laws and requirements. We also compare our significant assumptions with our peers and discuss our key assumptions, prior to their incorporation into actuarial calculations, with the Finance Committee of our Board of Directors. We evaluate the funded status of each retirement plan using current assumptions and determine the appropriate funding level considering applicable regulatory requirements, tax deductibility, reporting considerations, cash flow requirements and other factors.

 

Valuation of Goodwill, Indefinite-Lived Intangible Assets and Other Long-Lived Assets

 

Our business acquisitions typically generate goodwill and other intangible assets, which affect prospective amortization expense and possible impairment expense we might incur. We test the value of goodwill and indefinite-lived intangible assets for impairment as of December 31 each year or whenever events or circumstances indicate such assets may be impaired. Impairment losses for goodwill are recognized whenever the implied fair value of goodwill is less than the carrying value. Impairment losses for intangibles are recognized whenever the estimated fair value is less than the carrying value. The test for goodwill impairment involves significant judgment in estimating projections of fair value generated through future performance of each of the reporting units, which correlate to our operating segments. The test of indefinite-lived intangibles involves significant judgment in estimating projections of future sales levels. In calculating the fair value of the reporting units using the present value of estimated future cash flows, we rely on a number of factors including operating results, business plans, economic projections, anticipated future cash flows and market data used in discounting those cash flows. Inherent uncertainties exist in determining and applying such factors. The discount rate used in the projection of fair value represents a weighted average cost of capital of 8.65%, which is applicable to our company and industry based on published data. The net realizable value of other long-lived assets, including property, plant and equipment, is reviewed periodically, when indicators of potential impairments are present, based upon an assessment of the estimated future cash flows related to those assets, utilizing methodologies similar to that for goodwill and indefinite-lived assets. Additional considerations related to our long-lived assets include expected maintenance and improvements, changes in expected uses and ongoing operating performance and utilization.

 

Due to uncertain market conditions and potential changes in strategy and product portfolio, it is possible that forecasts used to support asset carrying values may change in the future, which could result in non-cash charges that would adversely affect our results of operations and financial condition.

ACCOUNTING DEVELOPMENTS

 

We have presented the information about accounting pronouncements not yet implemented in Note 1 to our consolidated financial statements included in this Annual Report.

 

OUTLOOK FOR 2006

 

We experienced strengthening in our markets in 2005 and we remain optimistic about our markets and our performance in 2006, considering that the economic opportunities in many of our geographic and core industrial markets continue to be strong. As a result of these factors, our revenues are expected to increase from 2005, excluding currency fluctuations. For additional discussion on our markets, see the “Business Overview — Our Markets” section of this Management’s Discussion and Analysis. Our bookings have increased 23.3% for the three months ended March 31, 2006 as compared to the same period in 2005. However, as a booking represents a contract that can be modified or canceled, there is no guarantee that the increase in bookings will result in the same increase in revenues.

 

We expect our operating income to increase in 2006 as compared with 2005, although there are a numbers of factors that could have a significant impact on our operating income in 2006. Our 2006 operating income should continue to benefit from a number of operational improvement programs, including the procurement program and the CIP initiative, as well as other operational improvements in several of our facilities. In addition, continuation of our end user strategy, selective contract bidding and an increase in our quick turnaround products, which are historically more profitable, should also positively contribute to our operating income in 2006. However, a number of significant costs and certain other expenses will negatively impact our operating income in 2006. These include selected investments in technology infrastructure to consolidate our ERP systems; enhancements to our CIP initiative; professional fees incurred in the development of tax strategies and enhancement of our compliance programs; an increase in research and development spending; a continued high level of professional fees primarily related to the restatement of our financial results for 2002, 2003 and the first quarter of 2004, and the 2004 and 2005 audits, including Section 404 assessments, which were all completed in the first half of 2006; initiation of the 2006 audit and Section 404 assessment; non-cash stock compensation expenses primarily related to the adoption of SFAS No. 123(R), “Share-Based Payment” and re-measurement and modification of certain stock options; and higher wage and benefit costs due to inflation. In addition, we may experience capacity constraints at several of our plant locations in 2006 which could cause delays in shipping and payment of liquidated damages.

 

If these factors occur as we have described, we expect net earnings and net earnings per share to improve in 2006. There is potential for the exercise of a significant amount of stock options in 2006 which will become exercisable after we become current with our required filings with the SEC. The exercise of the stock options could have a dilutive effect on net earnings per share. See the “Liquidity and Capital Resources” section of this Management’s Discussion and Analysis for further discussion.

 

Following the refinancing of the 2000 Credit Facilities and the 12.25% Senior Subordinated Notes in August 2005, 100% of our debt carries a floating rate of interest. As of December 31, 2005 we had $410 million of derivative contracts to convert a portion of floating interest rates to fixed interest rates to reduce our exposure to interest rate volatility. As a result of our refinancing and lower levels of debt in 2006, we expect our interest expense will be lower in 2006 as compared to 2005. However, because a large portion of our debt carries a floating rate of interest, the debt is subject to volatility in rates, which could negatively affect interest expense. In addition, we do not expect to incur losses on debt extinguishment in 2006 as were incurred during the re-financing during 2005.

 

We expect to generate sufficient cash from operations to fund our business, capital expenditures, pension plan contribution obligations and costs of compliance, and continue to reduce debt levels. We expect to improve working capital utilization by reducing DSO and increasing inventory turns. However, the amount of cash generated from working capital is dependent on the level of revenues and other factors. In 2006 our capital expenditures are focused on capacity expansion, enterprise resource planning application upgrades, information technology infrastructure and cost reduction opportunities and are expected to be between $70 million and $75 million, before consideration of any acquisition activity. Currently, no significant acquisitions are imminent. While current pension regulations allow us latitude in the amount of contributions, we currently anticipate that our contributions to our qualified U.S. pension plan will be between $35 million and $40 million in 2006. We currently anticipate that our

contributions to our non-U.S. pension plans will be approximately $8 million in 2006. We have no scheduled repayments in 2006 under the New Credit Facilities, however we made a mandatory repayment of $10.9 million in January 2006 using the net cash proceeds from the sale of GSG and we will make a mandatory repayment of $0.9 million in July 2006 using excess cash flows. We expect to comply with the covenants under our New Credit Facilities in 2006. See the “Liquidity and Capital Resources” section of this Management’s Discussion and Analysis for further discussion of our debt covenants. The potential exercise of a significant amount of stock options in 2006 (see preceding paragraph) could generate a significant amount of cash in 2006.

Market risks associated with financial instruments

 

We have market risk exposure arising from changes in interest rates and foreign currency exchange rate movements.

 

We enter into forward contracts to hedge our risks associated with transactions denominated in currencies other than the local currency of the operation engaging in the transaction. Our risk management and derivatives policy specifies the conditions under which we may enter into derivative contracts. At December 31, 2005 and 2004, we had approximately $236 million and $139 million, respectively, of notional amount in outstanding forward contracts with third parties. At December 31, 2005, the maximum length of any forward contract currently in place was 20 months.

 

Certain of our forward contracts do not qualify for hedge accounting. The fair value of these outstanding forward contracts at December 31, 2005 and 2004 was a net liability of $2.3 million and a net asset of $3.4 million, respectively. Unrealized gains (losses) from the changes in the fair value of these forward contracts of approximately $(5.2) million, $(2.5) million, and $1.6 million, for the years ended December 31, 2005, 2004 and 2003, respectively, are included in other (expense) income, net in the consolidated statements of operations. The fair value of outstanding forward contracts qualifying for hedge accounting was a net liability of $7,000 and $2.3 million at December 31, 2005 and 2004, respectively. Unrealized gains (losses) from the changes in the fair value of qualifying forward contracts and the associated underlying exposures of $(35,000), $(0.2) million, and $0.5 million, net of tax, as of December 31, 2005, 2004 and 2003, respectively, are included in other comprehensive income (expense) in the consolidated statements of shareholders’ equity.

 

Also as part of our risk management program, we enter into interest rate swap agreements to hedge exposure to floating interest rates on term loans. At December 31, 2005 and 2004, we had $325.0 million and $125.0 million, respectively, of notional amount in outstanding interest rate swaps with third parties. At December 31, 2005, the maximum length of any interest rate contract currently in place was approximately three years. At December 31, 2005 and 2004, the fair value of the interest rate swap agreements was a net asset of $0.9 million and a net liability of $3.4 million, respectively.

 

During 2004, we entered into a compound derivative contract to hedge exposure to both currency translation and interest rate risks associated with our European Investment Bank (“EIB”) loan. The notional amount of the derivative was $85 million, and it served to convert floating rate interest rate risk to a fixed rate, as well as U.S. dollar currency risk to Euros. The derivative matures in 2011. At December 31, 2005 and 2004, the fair value of this derivative was a net liability of $2.8 million and $15.9 million, respectively. The unrealized gain (loss) on the derivative, offset with the foreign transaction gain on the underlying loan aggregate to $0.2 million and $(5.1) million for the years ended December 31, 2005 and 2004, respectively, and are included in other (expense) income, net in the consolidated statements of operations.

 

We are exposed to risk from credit-related losses resulting from nonperformance by counterparties to our financial instruments. We perform credit evaluations of our counterparties under forward contracts and interest rate swap agreements and expect all counterparties to meet their obligations. We have not experienced credit losses from our counterparties.

 

Our earnings are impacted by changes in short-term interest rates as a result of borrowings under our credit facilities, which bear interest based on floating rates. At December 31, 2005, after the effect of interest rate swaps,

we had approximately $253.5 million of variable rate debt obligations outstanding with a weighted average interest rate of 6.36%. A hypothetical change of 100-basis points in the interest rate for these borrowings, assuming constant variable rate debt levels, would change interest expense by approximately $2.5 million.

 

We employ a foreign currency hedging strategy to minimize potential losses in earnings or cash flows from unfavorable foreign currency exchange rate movements. These strategies also minimize potential gains from favorable exchange rate movements. Foreign currency exposures arise from transactions, including firm commitments and anticipated transactions, denominated in a currency other than an entity’s functional currency and from foreign-denominated revenues and profits translated back into U.S. dollars. Based on a sensitivity analysis at December 31, 2005 and before consideration of any outstanding forward contracts, a 10% adverse change in the foreign currency exchange rates could impact our results of operations by $11.7 million.

 

An analysis of the estimated impact by currency follows (in millions):

 

 

Hedging related transactions, recorded to other comprehensive income (expense), net of deferred taxes, are summarized below: