FLS

Business Context and Reporting Period

Company: Flowserve Corporation
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: September 30, 2004
Reporting Date: April 26, 2006 (Delayed filing due to restatement and internal control issues)
Business Overview: Flowserve designs, manufactures, and services industrial flow management equipment (pumps, valves, mechanical seals) primarily for the petroleum, chemical, power, and water industries.

Significant Restatement: This report includes restated financial statements for 2002, 2003, and Q1 2004 due to errors in inventory valuation, long-term contract accounting, intercompany reconciliations, pension expense, and tax matters. The filing was delayed to address these errors and Section 404 internal control requirements.

Key Financial Metrics

Note: All figures are in millions unless otherwise noted. 2003 figures are restated.

Material Changes vs. Prior Period

• Revenue Growth: Sales increased 13.2% in Q3 and 5.9% YTD compared to the prior year. Growth was driven by the acquisition of the remaining 75% of TKL (Thompsons, Kelly and Lewis) and strengthening oil and gas markets.
• Profitability Decline: Despite higher sales, Net Earnings decreased 35.4% in Q3 and 33.6% YTD. This was primarily due to a significant increase in the effective tax rate (62.5% in Q3 vs. 16.5% in Q3 2003) caused by foreign earnings repatriation used to pay down U.S. debt, and higher Selling, General, and Administrative (SG&A) expenses.
• SG&A Expenses: SG&A increased 12.5% in Q3 and 11.1% YTD. The increase was driven by higher professional fees ($7.7 million in Q3) related to the restatement and legal matters, and higher incentive compensation accruals.
• Integration Costs: There were no integration or restructuring expenses in 2004, compared to $3.8 million in integration expense in Q3 2003. This absence of special items contributed to the increase in Operating Income.
• Discontinued Operations: The Government Marine Business Unit (GMBU) was reclassified as discontinued operations. It was sold in November 2004 for approximately $28 million.

Guidance, Outlook, Risks, and Contingencies

Management Commentary & Outlook:

• Management expects cash flows from operations and existing credit facilities to be sufficient for the next 12 months.
• Capital expenditures for the full year 2004 were approximately $45 million.
• Backlog increased to $896.6 million at September 30, 2004, up 4.3% from the prior year.

Material Risks & Contingencies:

• Internal Controls: Management concluded that disclosure controls and procedures were not effective as of September 30, 2004. The company identified 20 material weaknesses in internal control over financial reporting, including issues with revenue recognition, inventory, and tax accounting.
• Legal Proceedings:
  • SEC Investigation: The SEC issued a formal order of private investigation regarding the financial restatement. The company is cooperating.
  • Securities Litigation: A consolidated shareholder class action lawsuit is pending, alleging securities violations between 2001 and 2002. The case is set for trial in March 2007.
  • Export Controls: The company initiated an investigation into potential violations of U.S. export control laws regarding transactions in Iraq and other regions. Potential penalties are currently indeterminable.
  • Asbestos Litigation: The company faces numerous pending lawsuits regarding asbestos exposure, though it believes most are covered by insurance.
• Debt Covenants: The company determined it did not comply with some financial covenants in its 2000 Credit Facilities based on restated results. However, it obtained waivers and successfully refinanced its debt in August 2005 with "New Credit Facilities," under which it is currently in compliance.

Investor Verification Checklist

• Restatement Impact: Verify the specific adjustments made to 2002-2004 financials and the resulting impact on historical comparability.
• Internal Control Remediation: Review the progress of the remediation plan for the 20 identified material weaknesses in internal controls.
• Legal Exposure: Monitor the status of the SEC investigation, the shareholder class action lawsuit, and the outcome of the export control compliance review.
• Tax Rate Volatility: Assess the sustainability of the effective tax rate, which was significantly elevated in 2004 due to one-time repatriation events.
• Debt Refinancing: Confirm the terms and covenants of the "New Credit Facilities" entered into in August 2005 and the company's ongoing compliance.