Flowserve Corporation (FLS) Q3 2008 Earnings Report, Transcript and Summary

Good morning. My name is Christie and I will be your conference operator today. At this time, I would like to welcome everyone to the Flowserve Third Quarter 2008 Earnings Conference Call. All lines have been place on-mute to prevent any background noise. After the speakers' remarks there will be a question-and-answer session. [Operator Instructions]. Thank you. I will now turn today's conference over to Mr. Zac Nagle, Vice President of Investor Relations. Mr. Nagle, you may begin your conference.

Thank you, operator. Good morning everyone and thank you for joining us. Welcome to Flowserve's third quarter 2008 investor conference call. Today's call is also being webcast along with our earnings presentation on our website at flowserve.com. Just click on the Investor Relations tab to access the webcast and the accompanying presentation. Before we get started with the presentation, I'd like to highlight a couple of important items. First, we schedule the duration of the call for a full 90 minutes or we typically not need that much time, we're happy to go beyond our typical hour to cover prepared commentary and any subsequent Q&A. Second, for those of you who have accessed today's call through our dial-in phone number and also wish to follow along with our earnings presentation slides on our website, please select the Click Here to Listen via Phone icon on the Event Details page. I'd also like to note that our webcast we posted on our website for replay approximately two hours following the end of the call. The replay will stay on the site on-demand for the next few months. Joining today are Lew Kling, President and CEO of Flowserve; Senior Vice President, Chief Financial Officer and Latin America Operations, Mark Blinn; and Vice President and Chief Accounting Officer, Dick Guiltinan. Following our commentary, we'll begin the Q&A session. Regarding the forward-looking statements, I'll refer you to yesterday's earnings release and 10-Q filing and today's earnings presentation slides deck for Flowserve's Safe Harbor statement on this topic. All of this information could be found on Flowserve's website under the Investor Relations section. I encourage you to read these statements carefully with respect to our conference call this morning. The information in this conference call including the initial statements by management plus their answers to questions related to projections or other forward-looking statements are subject to Flowserve's Safe Harbor. Now I would like to turn things over to Lew to begin the formal presentation.

Thanks Zac and good morning. It's a pleasure to welcome you to our 2008 third quarter conference call. I am pleased to report that the third quarter was another terrific quarter for Flowserve with continued strong execution and outstanding financial results. These record results again demonstrated the improving operational excellence, continued strength in our end markets, strong leverage in our income statement and the successful execution of our key strategies. This resulted in strong organic growth in bookings and sales for both our original equipment and aftermarket portions of our business, as well as solid year-over-year gross margin and operating margin improvement. When looking at the year-to-date our strong financial results for the third quarter have increased our confidence and our ability to continue to deliver strong earnings and cash flow in the fourth quarter. As a result, even with the adverse impact from the strengthening dollar, we expect our full year earnings per share to be at or around the high end of our previously announced range of 720 to 750 per share. It is also worth noting, that a long term benefit of a stronger dollar also improves the competitiveness of our non-U.S. operations which represent approximately 70% of our global business. During next two slides, I will touch on some of the significant company highlights for both the third quarter and the year-to-date, as well as the primary performance metrics achieved during this quarter. Equally important to the reported financial results of what we are seeing in the major markets we participate in, oil and gas, power, chemical, and water. I will spend a considerable amount of time on these topics, since I know it's on the minds of many of our investors. We'll also look at some commentary about our target global markets from numerous external sources including some of our major customers, to demonstrate that our positive outlook doesn't just represent an isolated Flowserve point of view, but rather a host of views that point to what appears to be continuing opportunities for our products and services, despite the general uncertainty about the overall macro economic outlook. In light of the unprecedented shifts in the credit and financial markets, I will share some history with you, with respect to our markets during the past 13 years as I went through similar cycles from an economic point of view. And then I will review with you what we've been doing during the past few years to improve the company's performance and prepare for any business cycle. Since history tells us even in week cycles our markets may temporarily decrease but they don't go away. This discussion will provide you a better understanding of our external market outlook, and help you gain a stronger sense of the opportunities we see ahead. I also wanted to note that to-date we haven't seen any meaningful reduction of opportunities and in fact the proposal pipeline in all divisions is still extremely strong. In addition, we have also not seen any unusual cancellations of projects around the globe, but we will continue to monitor this very carefully and respond quickly to any changes in marketing conditions as neared. Slide three covers some notable highlights of the third quarter of 2008. We delivered record fully diluted quarterly earnings per share of $2.04 up over 85% versus the same period last year. Earnings per share during the quarter also benefited from tax items detailed in our 10-Q and press release of approximately $0.22, which were partially offset by foreign currency hedging activities of $0.12 in the quarter. This significant increase in earnings reflects continued success in driving improved consolidated operating margins increasing 240 basis points to 14.2%. This also reflects both continued gross margin improvement year-over-year of a 100 basis points to 35.1% and a further reduction of a 170 basis points in SG&A expense as percentage of sales to 21.2%. We also delivered our seventh quarter of bookings in excess of $1 billion, recording bookings of nearly $1.4 billion up almost 30% over the previous year including organic bookings growth of 22%. This was lead by the pump division delivering an impressive 44.3% growth in bookings in the quarter, including over 35% organic growth. We continue to drive strong manufacturing throughput in the third quarter, delivering record third quarter sales of almost $1.2 billion up nearly 26% over the previous year including over 18% organic sales growth. Based on our strong global footprint and portfolio of industry leading products to buying with our strong sales force we achieve significant growth in both our original equipment and aftermarket businesses. Even during the growing financial crisis since September, we're able to renew and increase our unsecured European letter of credit facility from €80 million to €100 million reflecting our banks strong confidence in financial position. Reflecting our continued commitment to return value to our shareholders and confidence in cash flows we repurchased approximately $100 million worth of Flowserve share during the quarter. Additionally, on September 26th based on the strength of our balance sheet we had our corporate credit rating increased by Standard & Poor's to BB with a positive outlook from BB- with a positive outlook. And just a few hours later, we were added to the S&P 500 Index. Slide five covers the key year-to-date highlights for 2008. The team delivered record earnings per share of $5.71 in the first three quarters up over 104% versus the same period last year. Bookings for the first three quarters raised [ph] a record $4.1 billion up over 28% versus a year ago including almost 19% organic growth year-over-year. Sales for the third quarter were also up sharply versus 2007 reaching a record $3.3 billion up nearly 25% including almost 15% organic growth this year. In addition, at the close of third quarter our backlog stood at healthy $3.1 billion showing solid support for 2009 revenue and earnings. And in fact we've also been taken for orders for 2010 delivery such as the Abu Dhabi Crude Oil Pipeline order received last month. Gross margins have steadily improved through the first three quarters up 220 basis points to 35.4% based on strong operational improvement, a solid pricing environment and improved fixed cost absorption on higher sales. Well SG&A cost control has also continued to show solid progress decreasing an additional 140 basis points to 22.1% as a percent of sales. Consolidated operating margin has continue to benefit from the teams success in driving effective initiatives to improve both gross margin and SG&A as a percentage of sales increasing sharply by 340 basis points to 13.7% versus the first three quarters of 2007. So as you can see, our financial performance for the first three quarters of this year posted past our previous year on all significant financial metrics. The third quarter also demonstrated that good business opportunities remain in the market and we continue to use our strong global footprint and aftermarket strategy to win this new business. And by continuing to solidly execute in these contracts, we will be well positions to keep delivering strong operational and financial results to our shareholders. Slide six outlines a traditional P&L format, the third quarter highlights I discussed on the previous slides. Since I fit most of these key financial highlights previously, I won't go to any further detail here. Moving on to slide seven, which I am sure is familiar to many of you, you can see that quarterly progression of bookings since 2004 and a tremendous growth we've driven since the back half of 2005. Slide eight highlights our sales, since the beginning of 2004 and the average conversion cycle we've talked about many times between a booking and a sale, which is averaged about 12 months. I would like to remind everyone again that this is an average conversion cycle with valves and seals normally being showed in 12 months and pumps on the average being longer. Now let's take a look at what drives infrastructure opportunities. Over the past decades, infrastructure spending was primarily driven by profit. Much of the work around the world was managed by western multinational corporations with a need to create shareholder value. Today, several additional factors increasingly drive the need to invest capital for infrastructure requirements. These drivers include demographics, ageing infrastructure, independence and economic growth. Within each of these areas are a number of motivating factors such as population movement from rural to urban cities, refurbishment needs, energy security and potential and political stability to name a few. In many cases these investments are supported by more than one of these factors and in the developing markets many are supported by government funding or guarantees not directly related to today's U.S. or European capital markets. Slide 11 begins to look at our core infrastructure markets oil and gas, power, chemical, and water from the point of view of numerous external sources including some of our major customers. In the oil and gas market which represents about 37% of our market to-date, we continue to see our global customers making investment decisions based on projected demand growth; upgrade and optimization projects, refurbishment of ageing infrastructure and economic growth in developing regions. It is important to understand that these major investment decisions by our customers are not made based on the spot price of oil but rather on longer-term product demand considerations. We have all heard the news likely that projections for demand growth in this market had softened from beginning of the year. And as of three weeks ago, the Energy Information Administration and the International Energy Agency, the two energy watchdogs for the United States and Europe did forecast a reduction in demand for oil. But that global demand was still up approximately 400,000 barrels per day for 2008 and a projected 700,000 barrels per day for 2009. In addition, as you can see we received positive announcement on the chart, news in the market continues to show planned investments over the long-term as demonstrated by companies such as Exxon Mobile, ConocoPhillips, and the major oil companies of India, China and Saudi Arabia. This news aligns with the overall general feedback we're receiving directly from our customers which includes the recent concerns raised about the Canadian Tar Sands projects. From what we are hearing from our customers, this does not appear to have any effect on the current projects but may have an effect on projects in the planning phase. Since these Tar Sand projects represent less than 2.5% of our bookings year-to-date, it should have little effect on our future results. Slide 12 illustrates a view of the global business opportunities for Flowserve based on the long-term view of oil demand. Fundamentally there is some level of opportunity for Flowserve across the full spectrum of prices for barrel of oil. However, there is also an optimal range or investments are made across all aspects of the industry. As we have discussed in the past, many of our heritage brands have earned strong customer preference over the years within the downstream portion of the oil business. When oil prices float in the optimal range, the crack spreads remain healthy which allow the downstream owners, particularly the refiners to invest in the optimization in their facilities, which include capacity increases, refurbishment and modernization, it fits well within our product offerings. Recently with the declining availability of light sweet crude oil is becoming imperative that refineries convert their current operations in order to handle the heavy oil coming to the market, where we have the right product technology to support them. Midstream or pipeline investments are made with oil prices within or above the optimal range as shown by our recent announcement of our Abu Dhabi Crude Oil Pipeline contract of approximately 85 to $90 million. As oil prices move outside the optimal range, additional investments may become feasible. For example, when the oil prices are in or above the optimal range, we benefit from the increased investment in both the development of alternative fuels in complex oil recovery systems. When oil prices are in or below the optimal range, the consuming industries such as chemical, power and what we classify as general industries enjoy lower operating cost and higher margins. Which drive investments in optimization and expansion which ultimately creates excellent business opportunities for our products and services in those target markets. The challenge occurs, when oil gets too low or too high. When it's to low, consumers expect prices to fall which leads to lower margins and lower profits for refiners thereby restricting investment in new facilities. When oil gets too high, the market reacts by reducing demand. The problem for all us is there is no absolute numbers defining the boundaries of optimum oil pricing. Each type of oil produced has different cost structures which on the basis for their optimal high and low spread. For example, typical production cost for light sweet crude relatively close to the surface run under $10 per barrels. This production cost increase significantly, as you'll move through the different grades of oil and production methodologies, such as heavy crude, Canadian Tar Sands crude and sub sea crude. As we discussed earlier, it is important to remember that major infrastructure investments are not made on the spot price of oil. These are long lead projects that are based on the projected requirements for oil usage usually years away where independent research data still shows an increased demand for oil. In addition, national oil companies which own over 90% of the worlds oil reserves, invest in oil development for many reasons other than profit, such as social programs, demographics, ageing infrastructures, security, independence and economic growth. In the power industry which represent about 15% of our business to date, the need for basic electrode it continues drive at industry forecast of significant global growth for the next several years. This need is created by growth in urban areas, aging infrastructure, new environmental standards, expansion of industrialization of developing regions and the modernization of urban areas such as the more than $300 billion plan for development in Mid East for city development. Over the past couple of months China has announced plans to add 60 gig watts of power to the nuclear grid by 2020. This is in fact incremental for their plans for coal fired and natural gas fire generating units. Announcements of also recently come out relative to the critical needs for additional power in India. It was recently reported the Indian government has allocated $95 billion to meet the increasing demand for power across the country; and as you bias their target for incremental power generation over the next five years from 79 gig watts to 90 gig watts. The world energy output report for 2007 projected that energy demand would double by 2013 from a baseline in 2005. And to our best knowledge, this projection has not been modified to date. In the chemical industry which represents about 19% of business year-to-date they continues to be a focus on investment into lower cost regions of the world as well as in developing alternatives for petroleum base products. The move into low cost developing region has continued to drive growth in new plan construction in both Asia and the Middle East. As you can see in the recent announcements, regions in China are planning major capital spends for chemical facilities such as the investment plan of $15.8 billion by China Guodian. Many of the major petroleum companies in China are continuing with their plans to build refinery and petrochemical complexes over the next several years. As for alternatives petroleum based products, there continues to be investments in development of biotechnology alternatives as well as fuel alternatives. A significant amount of attention is also being given to coal gasification investments supported by recent announcements stating that in 2009, their construction plans of $8.9 billion in North America alone. In Nevada market, which represents about 6% of our business year-to-date, the available market tends to stay steady in an upward direction. This is supported by the persistent need for water worldwide, the continuing need to refurbish ageing infrastructure and the requirement to bring older operations up to current standards. The need for water globally is challenging the available fresh water supplies and as drive your increased need for the expansion of desalination and the resource to potable water. With the advancements in technology, for sea water reverse osmosis the cost of desalination has dropped significantly, making it much more as a viable alternative. Desalination market for our segments is projected to grow more then $56 billion in the next seven years. A report from Morgan Stanley earlier this year looked into the projected water needs of the emerging economies and determined that the new infrastructure requirements to meet these needs could drive an increased amount of spending from its current estimate of $80 billion annually to a $180 billion annually over the next 15 to 20 years. From al of the emerging market requirements, the June 2008 report estimated the infrastructure upgrades, the United States alone would require $700 billion in capital investments. As urban city centers grow industrialization and modernization projects are commissioned and as population increases the need for potable water and water for industrial purposes will also grow. This growth will continue to challenge the industry to find ways to produce and deliver this water to its point of consumption. As we have discussed over the past several slides, the market in our core industries still present significant opportunities to growth. When you look at the available market for pumps, valves and seals over the past 13 years, in all our markets you can see the impact of proper economic times. What is most interesting is that the infrastructure markets both mature and developing continue to provide business opportunities throughout the various parts of the cycle. So we will continue to plan for this market fluctuation and their potential cycles while pursuing activities to increase market share and strengthen customer relationships. I believe the title this chart, we prepared is indicative of how we run our business. As a company we are continuing to focus on key strategic initiatives to enhance our ability to take advantage of market opportunities, I mean in what part of the economic cycle we are in. As I have said many times, operational excellence is a key strategic area focus for our management team. We are continuing looking for areas which strengthen our current performance as well as position us to manage through any cycle. Some of the areas we have made great strides in include moving manufacturing engineering and material sourcing to low cost regions of the world. Utilizing multiple shifts instead of any adding booking order, utilizing flexile staffing with practical, adding advance computerized machining capabilities to reduce manufacturing time, reduce labor burden and improve quality and many other cost containment initiatives. We've also continued to strengthen our ability to share and leverage knowledge to the integration of our global ERP systems, development and implication of a global engineering platform and the establishment of global engineering centers. Combining these initiatives with our key growth strategies, help position the company well for all phases of the business cycle. Slide 18, gives a high level view of the investments we have made over the past few years to strengthen our global diversification and competitiveness around the world. As you can see we have significantly expanded our capabilities in four key regions; China, India, the Middle East, and Latin America. Our approach has been to establish indigenous operations to effectively serve the local market or taking advantage of low cost manufacturing, component engineering and strategic sourcing where practical. These position us well to support our global customers from project and section through commissioning and over the life of their operations. As you look at slide 19, you can see the range and diversity of our recent global project wins. We have been successful across all our markets and regions around the globe, as our customers continue to demonstrate long-term trust in Flowserve as a dependable business partner. Slide 20 gives an overview of Flowserve's aftermarket growth strategy. The chart on the left represents our aftermarket revenues through the third quarter of 2008 and as you can see highlights significant growth in revenues since 2006. We believe that this growth is a direct result of our end-user strategy which focuses on creating greater value for our customers to expand in aftermarket services. While maintaining proximity to our customers to the use of over a 150 quick response centers worldwide, working with our customers to optimize their equipment operation of Flowserve and competitive projects... our products as well as training their people and minimizing their down turn time, we can develop long term relationships that provide continued business opportunities. This aftermarket growth strategy is truly one of the aspects of Flowserve that makes us different. And along with our global diversification positions us to continue to win business through all phases of a business cycle. Slide 21 shows a selection of strategic technologies where we've made significant investments to meet the current and future needs of our customers. And because many of these projects have been conducted in conjunction with our customers many are actually funded or co-funded by these customers. Our investments in nuclear capability and desalination are providing current business opportunities as well as helping to support future growth. Teaming with a major oil producer, we have made significant developments in pumping systems for deepwater or sub sea production operations. We believe this experience is placing us on the leading edge of technology development in this crucial future market. In the area of advanced electronic diagnostics, we've developed both intelligent pumping systems and intelligent valve systems. These two new projects are provide advanced sensing capabilities which help our customers become aware of operational performance issues and potential problem areas before they cause inefficiency or unplanned downturn. Slide 22, takes a look at many of our developments around the pursuit of alternate energy sources. There are several active projects in this area, either underway or in the advance stages of development, these include clean coal, solar power, bio-fuel and our recently announced commercialized systems for natural gas and biogas refueling stations for automobiles, trucks and buses through our Flowserve compression systems joint venture with Linde in Austria. There are also other areas in early development where we're partnering with customers on either pilot or research projects. These include geothermal power, wind power, compressed hydrogen gas fuel and ocean energy conversion. In closing, it's important to remember that history tells us that businesses made pass through several cycles overtime, however history also tells us that there continues to be investments in infrastructure development and aftermarket support during all phases of these cycles. This is driven by the need to keep oil and gas flowing, water and critical chemicals available and electricity on. As I discussed in the past, we have found that customers will continue to select companies who deliver on time, deliver an effective product and can provide a global support network even during the more challenging times. I believe that our leadership and strength come from our ability to deliver on these core customers requirements which in turn positions us could be successful during all phases of our business cycle. I would now like to turn the presentation over to Mark, to further discuss our financial statements. Mark?

Thank you Lew and good morning everyone. As Lew mentioned we are very pleased with our third quarter and year-to-date results. As we've seen strong orders in sales growth and strong margin improvements. This morning, before I review the financials, I'll cover a few topics and highlights relative to our business today. I'm going to spend a little more time on these current issues and more importantly how we're positioned. The first topic is the credit market. The world is seeing unprecedented times, in the global financial markets and it's important to note that Flowserve has a durable capital structure. And I'll review that in a moment. We're also continuing the monitor customers, financial relationships, counter parties and suppliers and we have not seen any problems. A consistent team, we have discussed for many quarters is the strength in our aftermarket business. We've seen strong execution on our aftermarket strategies reflected by 17% year-to-date growth in Flowserve aftermarket business including 20% growth in the Pump Division. As we look at cycles, aftermarket provides a sustainable high margin earnings strength. We've also seen strong operating margin expansion of 340 basis points, driven by operational excellence, a mix to higher end products, improved pricing and volume leverage, resulting in gross margin improvement of 220 basis points. We've done this, while remaining focused on cost containment, resulting in a reduction in SG&A as a percent of sales of a 140 basis points year-to-date. With respect to tax, we have seen that benefits of tax items of $0.22 in the quarter and $0.38 year-to-date and we now estimate our full year tax rate of approximately 25%. Another business indicator which has remained strong over the last four quarters is cash flow generation and the third quarter was no exception with the generation of $173 million of operating cash flow. Now let me take a moment to talk about currency and how it impacts our business. As we've often discussed about two thirds of our business is international, this means revenues, operations, people, QRCs two thirds is international. We do use foreign currency contracts, to hedge future cash flows. What I mean by this is where we secure contract in dollars that's going to be manufactured in Europe, we hedge those cash flows at time we receive the order, out to the period when we expect to receive cash and we use forward currency contracts. The impact of economics of the order, are reflected above the line and the impact of the hedging activities are below the line. If you look at the first half currency, we had a benefit above and below the line based on the strengthening of many foreign currencies, most notably the Euro from 146 to 157. Recently we've seen a dramatic strengthening of the U.S. dollar against all Flowserve [ph] significant currencies and this has created an impact. The reason I highlight all currencies, as some currencies in the first half didn't strengthen against the dollar, but we pretty much consistently seen a lot of those currencies weaken in the last couple of weeks. So if you look at our July guidance, we based it on $1.57 Euro for the second half of the year, when you consider that actual rates, for Q3 of 2008 and spot rates recently for Q4 of 2008, you can see that it's driven an adverse impact of $0.60 for the second half of the year, including an estimate of approximately $0.40 in the fourth quarter and this is above and below the line. Or if you look at our guidance, the bottom line as we've been able to counter the impact of this currency with strong operational performance and a lower tax rate. And as we mentioned one important factor is of the weakening of foreign currencies does provide a benefit to our international operations. So looking at the third quarter and year-to-date results you can see that we had strong sales and even stronger orders as Lew mentioned which provides a solid backlog for Q4 in 2009. If you look at gross margin, gross margin improved a 100 basis points in the quarter and 220 basis points year-to-date despite shifts to more original equipment in our pump and seal division. In fact, we have increased gross margin to 35.4% year-to-date. If you look at SG&A we've seen tremendous leverage in SG&A, with and improvement of 170 basis points in the quarter and a 140 basis points year-to-date. As we talked about before, over half of the increase in SG&A is selling related. We've also seen corporate expense drop down below 300 basis points as a percent of sales. When you look at the year-over-year comparison for the quarter and the year, it is important to note that we had $9 million and reduce legal cost for the quarter and approximately 18 year-to-date. We're continuing to drive SG&A as a percent of sales to 20% or below which is our target. If you look at operating margins as a result of the leverage in gross margin in SG&A, operating margins improved 240 basis points to 14.2% in the quarter and 340 basis points to 13.7% year-to-date. And contribution margin for the quarter was approximately 23% and it's almost 28% year-to-date. When you add the benefit of tax rate leverage, we're getting tremendous earnings leverage in our P&L. Now I'll turn to the divisions. The Pump Division has had a great year, highlighted by strong third quarter order growth of 44% including 35% organic growth. And strong year-to-date order growth of 33% including 22% organic growth. I highlight this year-to-date because as we look back at the second quarter, we notice that orders were... organic orders were 7.5%. This reminds us, that this is not a quarter-to-quarter business; the bottom-line is that the trends are strong. If you look at our gross margin, we've had gross margin improvement of 70 basis points in the third quarter to 30.5% despite a 600 basis point mix shift. And for the year, we've seen 300 basis point improvement in gross margin despite a 100 basis point mix shift. This has been driven by operational excellence, a mixed to more high end products, pricing and fixed cost leverage. When you combine the gross margin improvement with good expense control and SG&A you'll get a result it's a 160 basis points of margin improvement to 15.5% for the quarter and 310 basis point improvement in margin to 15.3% for the year. With a solid order book and improving margins, the Pump Division is well positioned. The next slide just shows a breakout of mix between aftermarket and original equipment and what I'll point out is that we've had strong aftermarket growth for the year of 20% in bookings and 24% in sales. This is important to note, because this is well above the market growth rate. Looking at the Valve Division; the Valve Division has demonstrated consistent improved performance for last three years and the third quarter was no exception, based on strong order and sales growth notably in the chemical and power markets and if you look at their gross margin improvement of 200 basis points in the quarter and a 110 basis points year-to-date, you can see that they are converting their opportunities in an improving operating environment. Their gross margins are running at 35.9% year-to-date. They are doing this through a good product management, R&D initiatives, lean, CIP and low cost sourcing just to name a few. They've also done a great job on cost management as they've driven SG&A to 20% as a percent of sales, while still investing in selling and R&D. Similar to the Pump Division the result is tremendous operating margin expansion, 280 basis points in the quarter to 16.7% and 210 basis points year-to-date to 16.1%. This team has really transformed this business over the last few years and there are plenty of opportunities ahead of them. The Seal Division has had had another strong quarter highlighted by continued strong orders and sales growth. They have accomplished this growth by continuing to sustain high gross margins in excess of 45% despite a shift to more original equipment. This shift results from their strategy to increase their install base where they have or more importantly plan to have an aftermarket presence. Looking at SG&A, we've often discussed that they've been investing in their business, they have invested in selling, expanding their QRC network, expanding the capabilities of their auxiliary manufacturing facility to support the global market and they have invested in engineers, systems and machineries to drive a global standardized platform. They've done all this investment while maintaining operating margins year-to-date of 19.5%. This investment will enable them to continue to take share and sustain solid operating margins. Looking at our primary working capital, the growth in receivables of 245 million include the impact of the $70 million of factored receivables that are no longer factored and also we've see an increase of approximately $100 million year-to-date in progress billings. In inventory, inventory grew a $179 million primarily driven by working process in the Pump Division. Also in these working capital numbers is the impact of the Niigata acquisition approximately $30 million. If you look at advance payments, advance payments increased year-to-date $134 million, which secures our backlog and also helps offset the working capital impact. Looking at third quarter cash flows, as I mentioned earlier, we had a very strong cash flow from operations in the third quarter of a $173 million. We continue to invest in our business with $36 million of capital spend and we returned a 114 million back to our shareholders in the form of dividends and share repurchases. The next slide is what I referred to earlier, demonstrating the strength of our balance sheet. If you look at term debt and revolver, these facilities were committed till August of 2012. We added that the cash on the balance sheet at the end of the quarter of $154 million and also as Lew mentioned we're able to upsize our European letter of credit facility. Bottom-line, is at the end of the quarter we had approximately $500 million of capacity and we're well positioned going into what is historically been our strongest cash flow quarter. Taking the chart on our drivers of EPS growth, we're well on track on our key initiatives to drive gross margin and SG&A improvement. We've also seen our tax rate and we estimate it to go to approximately 25% for the year, through planning in certain tax items. We talked about the impact of foreign currency and looking forward we now expect 2008 EPS target at around the upper end of our previously announced range. We will continue to stay focused on driving strong end... our strong end user strategy and taking aftermarket share, as this will drive sustainable high margin earnings. We'll be focused on continued cost containment to drive SG&A as a percentage of sales down. And we will maintain a strong balance sheet, available capacity and financial flexibility. As I mentioned we do expect our tax rate to be approximately 25% for 2008 and as I've always mentioned, execution is still the focus in our business. We are going to take advantage of opportunities and continue to improve the platform. We believe we are well positioned. With that I'll conclude my comment and turn it over to question and answers. Question And Answer

[Operator Instructions]. Your first question comes from the line of Michael Schneider of Robert W. Baird & Co.?

Good morning guys and congratulations on a great year so far.

Thanks Mike.

Thanks Mike.

Maybe first we can just talk about the mix in pumps because I guess even I understand of that the six point shift now towards project activity versus half the market, can you give us a sense of is this weight or is this mix sustainable in the Q4 or in the early '09 or is there some reversal that we should expect now as the cycle gets longer?

Well, as is we talked about before Mike, one of the big things that's impacted shift is our tremendous success in growing our aftermarket business. But as we talked about over the last couple of quarters and even in the last year, you've seen the bias relative to current mix to more original equipment. And so and that persisted again year-to-date and even in this quarter because we had 69% original equipment in orders in 31%. So that should indicate that there is still going to be a shift mix relative year-over-year. Having said that, I think one of the important things to note is that we continue to drive gross margin improvement, so as we talked about before original equipment is good business, so we look at in terms of absolute growth and each one of them in terms of original equipment in aftermarket.

Okay. And in fact on that topic of the gross margin benefit I think historically you said each point shift translates into about a 30 point change in gross margin. And year-to-date now are we seeing a one point shift and yet gross margins are up 300 basis points. So I'm curious how is that relationship held, just so we can get a sense as we model now at some point I guess in '09 the reversal of this mix shift. Does that reversal still hold such that, the aftermarket growth is percent of mix for each one point, we're going to see 30 basis points of gross margin benefit.

One... that is kind of theoretical application and one of the thing that has changed since we talked about that year ago is that the margins in our original equipment have gone up. And a lot of that, as we talked about is certainly pricing, but also if you look at this business over the last five, seven years, we've seen more of a migration to our higher end products, that what Flowserve offers and those tend to commend higher margins and also lead to more aftermarket opportunities. So, the 30 basis point holds roughly, it will tend to shrink down as original equipment margins to go up, often we talked that aftermarket margins are fairly stable. So, it's a good proxy for modeling, but it can certainly change relative to how many specialty pumps we may ship in the quarter and again we're seeing more and more of those.

And have the aftermarket margins risen over the last year 18-24 months?

Well... as I said they've been pretty consistent. We've see a little bit of pricing in certain parts, but service tends to hold fairly stable through the cycles, but nothing really noteworthy in terms of price increase to talk about.

Okay. And then I'm just curious, when I look at your pump and valve market sales figure its historically and I'm referring specifically to slide 20, if you look at the aftermarket it goes back to I am sorry 2004, I am curious about what the aftermarket did, at least the other data sources you use, going back to '98, '99 and then 2000, 2001, did it decline or is that all project mix that declined at least in the two or three years?

Mike its difficult really to use that data going back to that period of time because, we were not even closer of as it is today that was prior to the IDP acquisition. I can tell you... I can give you some anecdotal information, one the aftermarket strategy was much more of a break fix at that point in time. And also as I talked about, it was tend to be a higher concentration of more process pumps and product pumps we've seen a migration of more higher end products over the last couple of years. So I am not sure that information would be really relevant. What we can say is and we talked about this before is through cycles aftermarket tends to remain fairly firm. There are commission spares that sometimes during the project the aftermarket that go with the new project but for the most part, if you think about what can occur in the down cycle as they still need to maintain the facilities in a state of repair. And those will certainly be opportunities, where they are going to look for efficiency; if you think about the immediate profit pool that operators can go to, as he is going to try to maintain and increase the efficiency in his existing facility. And the other thing is, if you look at it... they will be looking for ways to get rid of fixed cost and that provides certainly the opportunity to outsource their service to us. I think a lot of those things combined with our execution, improved execution over the last couple of years, really makes us a different aftermarket business than you would have seen in 1999.

So in fact all those factors both internal and external and especially now the large install base that you put in place over the last two years shouldn't I actually argue that aftermarket say for the perceivable future continues to grow even your project activity rolls over substantially because now your servicing are significantly larger install base and your servicing more effectively?

We continue to execute and take care of our customer, yes.

Okay. And then final question on the tax rate, so 25% is the Q4 number I am sorry the 2008 number. Can you give us some sense, is that rate changed meaningfully in 2009 or is that a sustainable rate?

Well, we talked about that before, in the last call our structure rate was rising approximately 29% and that we're going continue to invest in planning opportunities. We haven't given any further guidance beyond that so that's where we're at this point but I will tell you, we're going to take advantage certainly of being a global international company, continue to invest in tax planning and with a focus of driving that down as we have a over the last couple of years.

Well I guess the core question is have you as result of all the activities during 2008 reduced your structural tax rate or are these just all one time settlements with different types authorities overseas?

We are where we were last quarter at this point; we haven't provided any additional update. Our structural rate is approximately 29%.

Okay. Thank you.

Your next question comes from the line of Charley Brady of BMO Capital Markets.

Hey thanks, good morning guys.

Good morning.

To start with, where you were in terms of capacity and particularly in Latin America you talked about that actually its down there oil and gas market, may be need some capacity, where you are on that and just in broad terms what you're doing and these are coupled with that capacity right now?

Let me answer the second question first. We do feel comfortable with our capacity not only because of the physical capacity that we have worldwide but how we're managing it, we're managing it on a global basis. On your first question around Latin America, you're right there is a lot of opportunity there. Flowserve has been there for a long time so that... we're not a new entrant into that market, but we're investing in capacity down there. First of all, we talked about this we're going to build a new facility in Brazil, outside of Rio de Janeiro. We have a facility there right now that is servicing our customer but in talking to our customer we see a lot of opportunity going forward, so we have committed some capital to build a new facility. I think equally important is around Brazil and another parts we're investing in QRCs because they have a lot of infrastructure that is being serviced by local machine shops and that's an opportunity for us. So we are investing in capacity down there, so we're going take advantage to the opportunity in Latin America.

Just going back on prior question on the gross margin increases in the phase of significant swing to the OE mix, how much of that is out of price and how much of that is just coming from internally generated better operational manufacturing?

Charles we don't break that out specifically, but I think if you look at the contributors, certainly prices provided benefit because that tends to almost flow through except for the commissions you paid to your selling organization. But we've seen a substantial benefit from operational excellence and where that really shows is you've just seen regardless of mix, you've seen good gross margin improvement really across all three of our divisions. So that's been a consistent theme. Also you see things in terms of the products that we're putting out there, we've migrated our products to some of the higher end products available out in the market. Remember in the second quarter we talked about some specialty pumps that we shift and how that impacted gross margins. So... and also we get volume leverage as well. So all those are contributing factors, but I think price is not necessarily the number one contributing factor. When we look at it we think operational excellence and where we're taking our products, is really what's driving the margin improvement.

Thanks.

Your next question comes from the line of Amit Daryanani of RBC Capital Markets.

Thanks, good afternoon guys.

Good afternoon.

I guess just a question on the cancellation side, I realized you guys talked about, not seeing the extraordinary cancellations but are you seeing OEMs maybe pushing out the deliveries schedules at this point?

We really haven't seen very much of it, we're hearing some anecdotal terms if they're if some possible delays, but as far as cancellations are concerned, we're really not seeing anything out of the ordinary, as I said, there is just some talk out there but really nothing that we can put our finger on at this point in time.

Alright. And then I guess, just looking at in terms of the capital usage going forward, you guys seem to be fairly comfortable with the amount of debt that's on the book, you should generate good amount of cash going forward? Can you just talk about what do you perceive to be the biggest priority of the cash usage, given that, I think you're about half way through the 300 million buyback program you guys have?

Yeah Amit, it's interesting how time change right because three weeks ago the order of the day was having as much cash on your balance sheet as possible, and that is the priority to us. I think it's important to note that we look at this company and our balance sheet really in the interest of our shareholders, so we want to make sure we have adequate capacity to whether whatever happens in these credit markets. But that aside and we'll continue to deploy our capital as we have in the past. We'll look at opportunities to return value to the shareholders, we bought a $100 million of share back... million dollars of shares back during the third quarter, we think that's a good way to return value to our shareholder. We've committed to the dividend, you see a lot of company's now that are pointing those down or taking them off, we've committed that because we believe in our cash flow. Also keep in mind we've been investing increasing amounts in our business in capital expenditures. You saw $36 million in the quarter; I talked about our investment in Latin America next year. We're building out our facility in the Middle East, standardizing our machinery, so we have good uses for cash. What we typically do is we'll talk about that cash and how we plan to use it going forward at the beginning of the year, but for this year just to highlight what we did, as we went off factoring program use cash, we topped up our pension plan which is good going for employee morale, so we think we've invested it wisely.

Fair enough. And I think your market... sorry I understand that, the fact that you guys bought back stock in this quarter, was about $125 per share and the stock is trading almost more than half of that right now. So I was curious of the priority to buyback stock at this point was bigger than keeping cash in hand given the uncertain macro environment.

Well couple of things Amit is the drop in the markets has been fairly precipitated over the last couple of weeks and keep in mind our window closed for repurchasing shares September 15th which is our blackout period. So we don't have the opportunity to do anything as afterwards. But even when we bought those shares back during that period of time, we looked at our cash flow generation opportunities and felt very comfortable with repurchasing those shares under our program. And again we feel very comfortable with our cash position right now.

Got it. And then just finally, could you just maybe talk about here what percent of your build in material is procured on a global basis, where do you see that percent trend over the next 12 to 24 months and also how much of the production is on the low cost regions today?

If you look at the ordered this different divisions all have a different amount. We don't really put out all those numbers, but I can tell you that in the valve side, we're probably on north of 30% in low cost areas. And a little bit lower in the pump and seal side. So we're doing a significant amount of low cost purchasing and remember most of our small parts sub assemblies a lot of that we actually build in places like India and China then we'll it ship it back into Europe and U.S. or we'll do final assembly in the low cost countries.

And we've talked about the investment in Latin America, we have facilities in Mexico, Argentina, Brazil and we see that as an opportunity to be a low cost source region over the world as well. And that's why we're making investments.

Got it. And then just a final question maybe I'll hop off after that. I think last quarter you guys at least talked about the bookings in the second half of 2008 on the pump side would be higher in the first half, given the strong bookings growth Q3, are you still comfortable with that statement?

In terms of the back half of the year? Yeah, we made the comment if you remember, in the last quarter we talked about pump bookings and the reason is just to remind you that we're not a quarter-to-quarter business, as I illustrated in my comments. We had 35% organic growth this quarter versus 7.5. So looking forward we were confident with our bookings the only thing I will say is what happens to the currency, we have seen dramatic moves in currency and that does impact our reported bookings but not necessarily our organic booking. So that's one thing that we just don't know what's going to happen to the currency because we've seen a significant move in the last two weeks.

Got it, thanks a lot guys.

Your next question comes from the line of Scott Graham of Bear Stearns.

Hey, good afternoon yeah.

Hi, Scott.

I am trying to make my questions brief and possibly get back in line. Would you guys be able to split for us on the bookings in the backlog particularly the bookings, the percentage of bookings that are actually aftermarket, I assume its pretty small but nevertheless?

You mean the back log or the bookings we kind of laid out for the Pump Division and year-to-date our booking growth has been 17%, so we do have that data. In terms of... if your question is with the backlog what percent of that is? You're right, there is aftermarket order, there are aftermarket orders in our backlog but a predominant amount of that backlog is original equipment orders.

So predominant to find as 90% plus?

I don't have that numbers specifically. And we don't provide that specifically.

And the bookings, the answer is kind of the same, yes.

Yeah, in terms of booking you can see the mix, for example in the pump business, you can see for the quarter, it's been 64, 36 is the mix I am sorry on booking 69, 31 and basically two-thirds year-to-date are original equipment one-third is aftermarket. In the seal business we have seen a little bit of a shift in their bookings to more original equipments based on their strategy, but they've historically held at about 75% aftermarket and 25% original equipment. And just to breakout in the Valve Division, the breakout is as we've reported is usually about 85% original equipment, 15% aftermarket, but as you know some of that original equipment in that 85% is really aftermarket. It goes to distributors, where they just replace the valve and it has aftermarket response times and aftermarket pricing to it.

Understood, that's helpful thanks. You have both manufacturing and quick response centers around the world that appear to be finding more and more opportunities that continue to drive your bookings and sales. Relative to the previous question about uses of cash because I think we're all pretty much modeling the same thing that, in the absence of another share repurchase program, you guys are going to have a significant amount of cash on your books by the end of 2009. So I'm wondering lets say that there is another share repurchase authorization, is there a real CapEx opportunity here to increase the number of QRCs are you considering that, or are you considering an investment in the pension plan to lower your pension quarterly expense, maybe if you can give a little bit more granular Mark to move on what those uses maybe even if you could itemize the uses of cash and prioritize?

Yeah and as I mentioned earlier Scott, this is typically something that we do on our year end call, but let me just talk generally at this point. That we'll always look at our pension plans I think you mentioned that, we did certainly top it up in the U.S. pension plan this year, but with the way the markets have responded, all assets have been have depreciated in price. So we'll certainly take a look at that going forward. We had the event of going off factoring in a sense and we're pretty much done with that, but looking forward we're going to spend a lot of money in capital this year. If you look at our investments in Dubai, in Saudi Arabia next year, we're going to spend the money to put to build our Brazilian facility and build out some QRCs, I do think there still plenty of opportunity for us to build out our QRC network. Keeping in mind that this is not like a retail chain where we build it and then try to seek customers. We work very closely with our customers to determine where the best place to put two ROCs around the globe is, but yes we do have opportunity to continue to invest, we've not completed our share repurchase program. So, I don't even want to talk about the second one until we've completed this one, but we'll be thoughtful with our cash going forward. And as always we'll take a look at how we return cash to our shareholders. But you've made the point and historically we generated a lot of cash in the fourth quarter, that's typically historically been when we generate the lot of it and that's what typically precipitates the conversation in the beginning of year, how we intend to use our cash that year.

Okay. Last question is along the lines of the, the strength in the dollar, is there really two parts of this question number; one is, are you actually seeing anything yet maybe on a short cycle stuff that suggest that lower local currency valuations or actually helping you competitively, is that something that you guys are starting to maybe measure a little bit. And then secondly, I know the mark-to-market was for the third quarter, what I'm obviously trying to do here, I suspect others are is to understand the translation piece of the $0.60 would it be fair to say that the mark-to-market in the fourth quarter will be roughly the same in the same vicinity as the third quarter and the rest is translation?

So, let me get to your second question first and then I'll we'll go back to your first one. In terms of the currency we didn't provide... we indicated an impact, an estimated impact of $0.40 in the fourth quarter. And basically what we did there was we went back and looked at our guidance on the last call and said, what would the impact have been based on what we saw on the currency in Q3 and what we are estimating in Q4. And for example the average we used is 127 for the Euro and it might be there today and it might not. So as soon as we get that estimate, its changed. But I think we didn't want to go in the much further detail in terms of above or below the line. You can see the mark going from 141 to 127 is approximately to your point or what it was in Q3. And in terms of the translation benefit you can see the benefit that we saw above the line in the first half of the year and try to estimate what it will be in the last half of the year. I think, the important point on currency is, that is something that is driven basically a translation, benefit the first half of the year and we'll have an impact in the back half of the year and also a mark on our hedge. The cash flows are hedged, that's important from an economic standpoint. And I think another thing in terms of if you look at our guidance we've been able to counter that impact with operational performance and a lower tax rate. And again... what was your first question?

Thank you for that. I suspected the same and I appreciate your granularity on that. The second question was simply, are you guys in fact hearing from your operating units that pay Hey the strength in the dollar thing is really helping us out.

Well, the change has been very, very recent, but I can tell you what we heard as the dollar was weakening with really no one [ph] side this was back last July, we actually saw some of our facilities that were starting to put currency contingencies in their bid in our European facilities because their costs were going up at such a rapid rate, they didn't know where there are going to be during the bidding process. So that's what kind of gave us the indication, that whenever these currencies move real fast, it changes things and we can respond and what we did see was that it put a lot of pressure on our bidding process in our European facilities as they became very expensive in terms of the cost structure, similar to us traveling over to Europe is as a tourist everything got very expensive there real quick.

Understood. Yeah, thanks very much. Good presentation.

Thank you.

Thank you.

[Operator Instructions]. Your next question comes from the line of Neil Khamsari [ph] of Sam's Capital Management.

Hi congratulations on a good quarter.

Thank you.

I just had a sort of a big picture question, could you expand a little bit on how you're positioned in these emerging markets relative to your competition in China, India. You spoke little bit about Latin America, Middle East, but how you're positioned relative to your competition in these markets?

If you take a look at India, we have nine factories in India plus some QRCs, most... some of those are joint venture factories in the valve area, where we have a joined venture pump facility. We have our own pump facilities, we also do in fact most of our design of seals in Chennai. So we have facilities in Bangalore, Chennai and Coimbatore. So compared to our competition, I think we're in outstanding shape in India. In China we're a little bit late getting into. We let other people get in there first, even though we've been in there probably for about 40 years, but not with manufacturing capability. So we let our competitors get in there, make the mistakes that we all make when we first enter into a country. And then we went ahead and build Greenfield facilities about a year and a half ago in the pump, valve and seal area. They are now only fairly four facilities, we also have a number of QRCs and we're planning to put a number more of QRCs into China. So right now I think we're very competitive in China, we're seeing a lot more business in fact business that we never saw when we were importing into China. In most of these countries India, China especially in Brazil, you have to be part of the economy, you have to have factories and people on the ground to really see all the large projects. They all want a certain percentage of internal workings in all their projects and now we are in all these areas, we have factories on the floor and we are very competitive.

In Latin America as Lew mentioned, we've been there for a long time, but its fair to say over the last 10 years, we'd going to lost our number one position in that region and that's why we're making the investment, because we think with our model we have the opportunity to take it back, so that's an area of focus for us.

Another question, this is on... you mentioned that there's been migration to high end products. What portion of your overall sales is... the sort of high end or specialized pumps there need the big three or four you're the big three or four competitors versus more commodity type products where there is hundreds?

Sure. And well we don't break out the specific in terms of percentages of our mix, but I can tell you generally it depends on which competitor you look at. Some of our competitors offer a high-end high energy pumps that are have sophisticated engineering but it's generally fair to say, really in all off our divisions we've been migrating our products to more of what we call the Tier five or the higher end product line. And the reason that we do that is you get paid for the engineering, you get paid for the capabilities and more importantly they really lend themselves to your aftermarket strategy. What we've done with some of our more process pumps at even though they require engineering and they do drive the aftermarket is that's a lot of the product where we moved the manufacturing or the sourcing to low cost parts of the world.

Last question, in terms of your software capabilities with some of these advanced solutions, how does that... how accepted is that as a total life cycle cost perspective from a customer standpoint. And again how long have you had sort of those tools for your customers?

That's a great point because I think in the comments earlier I talked about historically we operated in our more break fix model. And if you think about the really the purchase decision, the purchase decision was more around the capital, the cost of the equipment and then there was break fix strategy that was behind it. Where the customers have migrated is? Is right to your point to focus on total cost of ownership and what they want is they want quality, they want precision and they want responsiveness. If you think about what a system or software system can do for us, it really enables us, it allows us to engineer 24/7, it allows us to move specifications immediately to a QRC or a manufacturing facility. More importantly, it allows us to give the customer real time what they want and if you think about that these pumps, seals, valves are very highly engineered if you're off by a little bit you can substantially decrease the effectiveness or the efficiency of the piece of equipment. So I think they're seeing that, I made my comments earlier about efficiency. We see a lot about Greenfield projects out there, but you also see a lot of spend that's been driven in what I call Brownfield and that's where we're looking to make these facilities more efficient. As Lew talked about, they are un-equated [ph] and they are running less than optimal and that's our opportunity to go in and drive real value to the customer by increasing the efficiency.

And just to follow on that, how would you compare your software capabilities relative to on ITT or Sulzer or whoever?

Well, I am not really too familiar with their software capabilities to be honest with you but I can tell you, I think our capability is that we are driving and we are continuing to make investments will really position us well relative to our competitors but more importantly in the eyes of our customers.

Okay. Thank you very much.

Your next question is a follow up from the line of Scott Graham of Bear Stearns.

You have a slide in your presentation... where you talked about be prepared and I'm wondering what happens, what's the first and second levers that you pull here, when you do see the OEM bookings slowdown and you realize that operational excellence maybe needed to accelerate and other things need to happen. What are some of those first levers that you pull?

Well when we are watching, and we're continually watching, we've been doing it for years of what's going on out there, but if you take a look at leverage we have they are really listed on the chart, having multiple shifts as an example versus building brick and water, if you have to you can back off on a third shift, you can back off on a second shift. Those are important ways of removing people if that's really needed. We also have the ability to move equipment because of our processes that we have when we win a job, we can move equipment from lets say our facility in U.S. to Europe, or Europe to Asia or around the world and build it in a different location. Having temporary employees, when you have a downturn a possible downturn that's one of the original places or immediate places that you turn to, if you want to reduce your cost, but all three divisions, constantly watch costs around the world. It's not something that you just sit there and wait for a phone call saying Oh, oh things are bad what we do is monitor on a continuous basis, we make changes on a continuous basis and that's why we used the word be prepared, because we are and have been.

One thing to add to that Scott is, as Lew mentioned earlier in his comments these markets don't go away. So what we do is we drive to deliver incremental value to our customer in terms of the products that he has in his facility, but also as we've talked about the aftermarket business. We continue to grow that aftermarket business because, we're present, we're proximate to the customer, it generates sustainable earnings, but more important when that project does come up, you're there and you're ready.

The other thing is of course, we really want to drive increased market share, if when things start to go down, if they do start to go down, the ability to get market share is extremely important because you can go in there and if you are delivering on time which I've talked about many, many times, you're delivering a product that works when it gets there and you have that worldwide network to support the products, you can truly go after other business that your competitors have and drive market share up.

That's great. Thanks a lot guys.

[Operator Instructions]. There no further questions at this time. This concludes today's conference call. You may now disconnect. .