Business Context and Reporting Period
Company: Flowserve Corporation
Filing Type: Form 10-Q (Unaudited)
Reporting Period: Quarter and six months ended June 30, 2007
Business Overview: Flowserve is a global leader in fluid motion and control, providing pumps, valves, and mechanical seals primarily to the petroleum, chemical, power generation, and water industries. The company operates through three segments: Flowserve Pump Division (FPD), Flow Control Division (FCD), and Flow Solutions Division (FSD).
Key Financial Metrics
| Metric (in thousands) | Three Months Ended June 30, 2007 |
Three Months Ended June 30, 2006 |
Six Months Ended June 30, 2007 |
Six Months Ended June 30, 2006 |
|---|---|---|---|---|
| Sales | $930,677 | $752,859 | $1,734,077 | $1,406,716 |
| Gross Profit | $302,415 | $252,599 | $567,889 | $470,593 |
| Gross Margin | 32.5% | 33.6% | 32.7% | 33.5% |
| Operating Income | $96,908 | $73,358 | $164,331 | $114,480 |
| Operating Margin | 10.4% | 9.7% | 9.5% | 8.1% |
| Net Earnings | $63,205 | $33,609 | $96,819 | $52,208 |
| Diluted EPS | $1.11 | $0.58 | $1.69 | $0.90 |
| Cash & Equivalents | $47,955 (as of June 30, 2007) | |||
| Total Debt | $684,158 (as of June 30, 2007) |
Material Changes vs. Prior Period
- Revenue Growth: Sales increased 23.6% for the quarter and 23.3% for the six months compared to the prior year. Growth was driven by strength in oil and gas markets, particularly in Europe, the Middle East, Africa (EMA), and North America. Currency effects contributed approximately $38 million to quarterly sales and $72 million to six-month sales.
- Profitability: Net earnings surged 88% for the quarter and 85% for the six months. This was driven by a 32% increase in operating income, despite a slight compression in gross margins (down 110 basis points for the quarter) due to a higher mix of lower-margin original equipment sales versus higher-margin aftermarket sales.
- Expense Management: Selling, General, and Administrative (SG&A) expenses increased 14.3% for the quarter but decreased as a percentage of sales from 24.3% to 22.5%, reflecting operating leverage.
- Tax Rate: The effective tax rate dropped significantly to 24.7% for the quarter and 29.3% for the six months, compared to 46.3% and 42.1% in the prior year, due to favorable tax audit results and changes in tax law.
- Cash Flow: Operating cash flow turned negative at $(61.7) million for the six months ended June 30, 2007, compared to positive $7.9 million in the prior year. This was primarily due to a $120.6 million increase in inventory to support backlog and a $100.2 million increase in accounts receivable.
Guidance, Outlook, and Risks
- Outlook: Management believes the outlook remains favorable, citing sustained capital investment in oil and gas. However, they note that oil price volatility could negatively impact business. Backlog increased 27.3% to $2.1 billion, reflecting strong order intake.
- Capital Allocation: The company completed a $2.0 million share repurchase program. Dividends of $0.15 per share were paid in Q1 and Q2. Capital expenditures for the full year 2007 are expected to be between $90 million and $100 million.
- Debt Facilities: On August 6, 2007, the company amended its credit facilities to reduce interest margins, extend the revolving credit maturity to 2012, and eliminate mandatory debt repayment requirements.
- Legal and Regulatory Risks:
- Oil-for-Food Program: Ongoing investigations by U.S., Dutch, and French authorities regarding payments made by non-U.S. subsidiaries to Iraqi officials. An internal investigation found unauthorized payments totaling approximately €600,000. A Dutch penalty of approximately €265,000 is anticipated; U.S. and French outcomes remain uncertain.
- Export Compliance: A voluntary review of U.S. export control compliance is ongoing, with completion expected by the end of 2008. Potential penalties cannot be estimated at this time.
- Litigation: Significant shareholder class action and derivative lawsuits regarding alleged securities violations are pending, with trials set for late 2007.
Investor Verification Checklist
- Working Capital Trends: Verify the sustainability of the $120.6 million inventory build-up and the 64-day Days Sales Outstanding (DSO) to ensure future cash flow conversion.
- Margin Mix: Monitor the ratio of original equipment sales to aftermarket sales, as the shift toward lower-margin equipment sales is compressing gross margins.
- Legal Exposure: Track the resolution of the Oil-for-Food investigations and export compliance review, as fines or penalties could materially impact future earnings.
- Debt Covenants: Confirm continued compliance with the amended leverage ratio (3.25x debt to EBITDA) and interest coverage covenants.
- Segment Performance: Review the Flowserve Pump Division (FPD) specifically, as it is the fastest-growing segment but carries lower margins than the Flow Control (FCD) and Flow Solutions (FSD) divisions.