Business Context and Reporting Period
Company: Flowserve Corporation
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: September 30, 2006
Business Overview: Flowserve is a global leader in fluid motion and control, providing pumps, valves, and mechanical seals primarily to the petroleum, chemical, power, and water industries. The company operates through three segments: Flowserve Pump Division, Flow Control Division, and Flow Solutions Division.
Key Financial Metrics
(Amounts in thousands, except per share data)
| Metric | Three Months Ended Sep 30, 2006 |
Three Months Ended Sep 30, 2005 |
Nine Months Ended Sep 30, 2006 |
Nine Months Ended Sep 30, 2005 |
|---|---|---|---|---|
| Sales | $770,757 | $649,485 | $2,177,473 | $1,956,767 |
| Gross Profit | $248,330 | $211,216 | $714,440 | $625,059 |
| Gross Margin | 32.2% | 32.5% | 32.8% | 31.9% |
| Operating Income | $60,404 | $54,811 | $170,400 | $136,939 |
| Net Earnings | $28,183 | $(9,950) | $75,146 | $3,986 |
| Diluted EPS | $0.50 | $(0.19) | $1.31 | $0.07 |
| Cash & Equivalents | $48,737 (as of Sep 30, 2006) | |||
| Total Debt | $654,564 (as of Sep 30, 2006) |
Cash Flow (Nine Months Ended Sep 30, 2006):
- Operating Activities: $14.4 million
- Investing Activities: $(43.6) million
- Financing Activities: $(15.7) million
Material Changes vs. Prior Period
- Revenue Growth: Sales increased 18.7% in Q3 and 11.3% in the nine-month period compared to 2005, driven by strength in the oil and gas markets, particularly in the Middle East and North America.
- Profitability: Net earnings turned from a loss of $9.95 million in Q3 2005 to a profit of $28.18 million in Q3 2006. This improvement is largely due to higher operating income and the absence of a $27.9 million loss on early extinguishment of debt recorded in Q3 2005.
- Discontinued Operations: The 2005 results included significant losses from the General Services Group (GSG) divestiture. In Q3 2006, the company recorded $0.8 million of income from discontinued operations related to the final settlement of the GSG sale.
- Stock-Based Compensation: The company adopted SFAS No. 123(R) in 2006. A $5.6 million non-cash charge was recorded in Q3 2006 due to modifications of stock option plans approved by shareholders.
- Working Capital: Operating cash flow decreased to $14.4 million (from $19.9 million in 2005) due to an $89 million increase in working capital requirements, specifically higher inventory and accounts receivable levels to support sales growth.
Guidance, Outlook, Risks, and Unusual Items
Outlook and Guidance:
- Management expects full-year 2006 capital expenditures to be approximately $75 million.
- A stock repurchase program for up to 2 million shares was authorized in late September 2006, expected to commence in Q4 2006 to offset dilution from stock options.
- The company anticipates continued growth in oil and gas markets but notes risks related to economic conditions and raw material costs.
Unusual Items:
- Stock Option Modification: A $5.6 million charge was recorded in Q3 2006 related to the extension of option exercise periods.
- Discontinued Operations: Q3 2006 included a $0.8 million gain from the resolution of inventory reserves related to the GSG sale.
Risks and Contingencies:
- Legal Proceedings: The company is subject to ongoing SEC and foreign government investigations regarding the United Nations Oil-for-Food program and potential violations of the Foreign Corrupt Practices Act. Additionally, there are pending securities class action lawsuits and asbestos-related claims.
- Export Controls: An internal review is underway regarding potential non-compliance with U.S. export control laws, which could result in fines or penalties.
- Tax Audits: The IRS is auditing tax returns for 2002-2004. While a 1999-2001 audit concluded with proposed adjustments, the company expects no material cash payment due to offsetting credits. However, future audits could result in material tax payments or penalties.
- Internal Controls: Management concluded that disclosure controls and procedures were not effective as of September 30, 2006, due to material weaknesses in financial reporting processes, though remediation efforts are underway.
Investor Verification Checklist
- Internal Control Remediation: Verify the progress of remediation for material weaknesses in financial reporting, specifically regarding revenue, inventory, and debt disclosures.
- Regulatory Investigations: Monitor the status and potential financial impact of the SEC and foreign investigations into the Oil-for-Food program and export control compliance.
- Stock Option Dilution: Assess the impact of the recent reopening of stock option exercises and the new share repurchase program on future earnings per share.
- Tax Liability: Track the outcome of the ongoing IRS audit for 2002-2004 and the potential for penalties related to record-keeping deficiencies.
- Working Capital Trends: Monitor the sustainability of inventory and receivable levels relative to sales growth to ensure cash flow stability.