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Flowserve (NYSE:FLS)

Q3 2012 Earnings Call

October 30, 2012 11:00 am ET

Executives

Mike Mullin - Director of Investor Relations

Mark A. Blinn - Chief Executive Officer, President and Director

Thomas L. Pajonas - Chief Operating Officer and Senior Vice President

Michael S. Taff - Chief Financial Officer and Senior Vice President

Analysts

Michael Halloran - Robert W. Baird & Co. Incorporated, Research Division

Charles D. Brady - BMO Capital Markets U.S.

Hamzah Mazari - Crédit Suisse AG, Research Division

R. Scott Graham - Jefferies & Company, Inc., Research Division

Brian Konigsberg - Vertical Research Partners, LLC

Nathan Jones - Stifel, Nicolaus & Co., Inc., Research Division

Robert Barry - UBS Investment Bank, Research Division

Sid Panda - RBC Capital Markets, LLC, Research Division

David L. Rose - Wedbush Securities Inc., Research Division

William D. Bremer - Maxim Group LLC, Research Division

Operator

Welcome to the Flowserve Q3 2012 Earnings Conference Call. My name is Kim, and I will be your operator for today's call. [Operator Instructions] I will now turn the call over to Mr. Mike Mullin. Mr. Mullin, you may begin.

Mike Mullin

Thank you, operator. Good morning, and welcome to Flowserve's Third Quarter 2012 Earnings Conference Call. Today's call is being webcast with our earnings presentation via our website at flowserve.com. Simply click on the Investor Relations tab to access the webcast and the accompanying presentation. The webcast will be posted at flowserve.com for replay approximately 2 hours following the end of the call. The replay will stay on the site for on-demand review over the next several months.

Joining us today are Mark Blinn, President and CEO; Tom Pajonas, Chief Operating Officer; and Mike Taff, Chief Financial Officer. Following our commentary today, we will begin the Q&A session.

Regarding any forward-looking statements, I refer you to yesterday's earnings release, 10-Q filing and today's presentation slide deck for Flowserve's Safe Harbor presentation statement on this topic. All of this information can be found at Flowserve's website under the Investor Relations section. We encourage you to read these statements carefully with respect to our conference call this morning. And now I'd like to turn it over to Mark to begin the formal presentation. Mark?

Mark A. Blinn

Thank you, Mike, and good morning, everyone. As everyone is likely aware, Hurricane Sandy continues to impact the upper East Coast of the United States. At Flowserve, our #1 priority is always safety. Many of our associates and operations are located in and near affected areas. Likewise, we know that a large portion of the financial community and many of you participating in today's call are facing these difficult conditions as well. We sincerely hope that everyone remains safe and out of harm's way. We want everyone on the East Coast to know that we are thinking of you and your families and wishing you well.

Let me now begin our prepared remarks. I am pleased with our solid third quarter results, driven by operational progress resulting from our One Flowserve initiative, as well as the steps we have taken to improve our capital structure and ultimately, increase shareholder value. I am proud of Flowserve's strong culture of customer commitment and our employees' dedication in positioning the business to target and grow bookings in our diverse end markets. While our current outlook is somewhat cautious due to the soft macro conditions in Europe as well as moderating growth in Asia, which together have increased uncertainty in our end markets, we continue to focus on the items we can control to best position Flowserve to capture the infrastructure investment that is needed around the world, including our successful aftermarket business.

This quarter, we delivered solid earnings growth in spite of significant currency headwinds. Mike will provide further details, but as you know, a strengthening dollar materially impacts our reported results since nearly 2/3 of our business is outside the U.S. and subject to currency translation.

Our bookings growth of 2.3% or 9% when adjusted for currency, included our first large project order of the year. IPD booked over $90 million of original equipment orders to support offshore oil and gas development. We remain optimistic about the medium- to long-term infrastructure investment opportunities in our energy end markets, particularly in North America, the Middle East and Brazil.

Additionally, our focused end-user aftermarket strategies continue to produce positive results. We were recently awarded a 5-year service agreement with Dow Benelux to perform maintenance of its rotating equipment and general machining in its Dutch facility. Our commitment to localization includes the buildout of a QRC to support Dow, as well as other customers in the area. This is a great example of the types of programs our end-user strategies target and the value we can add as customers increasingly look for a trusted partner to help improve the efficiency of their facilities and better manage their smaller service vendors.

Operating margins improved sequentially and year-over-year, in spite of the overall mix shift to lower-margin original equipment. Margins were also negatively impacted by shipments of lower-margin legacy backlog. Our improved margins reflect the operational excellence progress that Tom and his leadership team are making, as they drive on-time delivery, lower past due backlog, manage costs, improve the supply chain and reduce the cost of quality throughout the business.

We believe that we are gaining share in many of our markets, while we simultaneously increase the discipline and selectivity of our bidding process. Also, we continue to see steady progress in IPD as it moves towards its 14% to 15% margin goal. Simply put, I am pleased with the progress of Tom's team, but opportunities remain for further improvement.

Our solid backlog of nearly $2.9 billion, up over 7% since year end, has us well positioned to deliver on our financial targets for 2012 and beyond. We are particularly pleased that the quarter-end aftermarket backlog exceeded $700 million for the first time. And I'm proud that we've been successful in consistently growing our aftermarket franchise, even through difficult market conditions in 2009.

Turning to our business outlook, softening economic conditions in certain regions may push out the timing of some previously expected later-cycle large project investments. We remain confident that these projects will go forward since these investments are needed by the increasing global urban populations. Market uncertainty and volatility highlight the importance of Flowserve's diverse global platform and its ability to mitigate risk, especially through our aftermarket end-user strategies.

During the quarter, we also executed our long-term strategic initiative to improve the efficiency of our capital structure by taking advantage of our investment-grade status and attractive debt markets. We also continue to execute on our previously announced $1 billion share repurchase program, which we expect to complete next year.

Even as we improve balance sheet efficiency, our commitment to increasing shareholder value through profitable growth remains, both organically and through bolt-on acquisitions. We will pursue opportunities to fill product, geographic and technical gaps in our portfolio using a disciplined process, focused on growing long-term value for our shareholders.

Looking forward to the fourth quarter and full year 2013, I'm confident, as evidenced by our strong year-to-date performance through the third quarter, that Flowserve's combination of operational improvements, the diverse end markets and geographies we serve, and almost $2 billion annual aftermarket run rate position us well to continue to capture profitable growth, margin improvement, share gain and create long-term value for our shareholders, even while considering the continuing uncertain and sometimes volatile macroeconomic environment.

With that, I'll turn it over to Tom.

Thomas L. Pajonas

Thanks, Mark, and good morning, everyone. As Mark discussed, we are pleased with our third quarter results, with bookings of $1.19 billion, up 2.3% versus prior year, despite the impact from a stronger U.S. dollar and the economic challenges facing Europe. Our consolidated book to bill was 1.02, driven by a solid aftermarket book to bill of 1.04. While we continue to see elevated levels of feed and pre-feed activity through the third quarter versus prior year, we now anticipate the larger megaproject orders shifting to the mid to second half of 2013.

Turning to our year-to-date bookings by end market. We saw strength in the oil and gas, and chemical industries, along with modest growth in the general industries and water business. Regionally, the improvement has been concentrated in North America, Asia Pacific and Latin America, partially offset by lower bookings into the Middle East/Africa and to a lesser extent, Europe. Overall, the oil and gas business continues its broad-based, positive long-term outlook with North American pipeline business positively reacting to increased oil and gas transport activity.

Other areas of pipeline project developments showing promise include the Middle East, Argentina and Colombia, with offshore platform work continuing in Brazil. In August, we had a grand opening of our $37 million Rio plant investment that allows Flowserve to expand our existing footprint in the Brazilian market, including a state-of-the-art test facility.

In the power market, coal-fired plant opportunities in China and India remain on the horizon, as well as the potential for coal-to-gas conversion opportunities in the U.S. for both full and partial conversions. With the abundance of shale gas, combined cycle plants will bear the brunt of providing new capacity requirements.

The chemical market has seen good growth year-to-date, particularly in China and the Middle East. Additional shale gas finds in the U.S. and the abundance of existing shale gas will allow new chemical production to take place competitively in the U.S. for the global marketplace. Fertilizer plant opportunities also continue to drive the market. The mining sector has been mixed with concerns about overcapacity and demand, particularly in Europe and to a lesser degree, in China, which have dampened the short-term outlook.

Turning to the year-to-date sales mix by region. We grew the top line 5.5% or 11.2% on a constant currency basis. We have seen strong activity in Asia Pacific and North America and an increase in Latin America, which more than offset European weakness.

Now let me discuss our segment results for the third quarter. The Engineered Product division bookings decreased $14 million to $554 million, down 2.4%, but up 4.1% on a constant currency basis. Oil and gas bookings increased in the quarter, along with improvements in the water bookings in North America offset by a decrease in power. Regionally, we saw higher bookings in the Middle East and North America more than offset by decreased bookings into Europe, Asia Pacific and a slight decrease in Latin America. Sales decreased $7 million to $568 million, down 1.2% but up 5.3% on a constant currency basis, driven by lower original equipment sales and decreased sales into Europe and Latin America, partially offset by higher activity in Asia Pacific and North America. Aftermarket sales increased 2% or 7% on a constant currency basis. Gross margin increased 30 basis points to 33.9%, positively impacted by some shipments of higher-margin backlog as compared to the first half of 2012, as well as a mix shift to aftermarket sales and the benefits of lower cost associated with operational execution improvements. Operating margin declined 70 basis points to 15.3% due primarily to higher SG&A on increased sales-related expenses. EPD signed a 5-year services contract with Dow Benelux to provide maintenance and machine shop functions in the Netherlands to support Dow's local rotating equipment population of around 7,000 pumps. This maintenance agreement effectively outsources this work to Flowserve.

Bookings in the Industrial Product division increased $60 million to $284 million, up 27% or 34.6% on a constant currency basis, driven by improved activity in the oil and gas industry. This was due in large part to original equipment orders in excess of $90 million to supply thrusters over the next 5 years, which are used to stabilize and position offshore oil and gas platforms. This strength in Latin America, combined with increased North America pipeline activity, were partially offset by some softness in Europe. Chemical orders were also up. Sales increased $28 million to $244 million, up 13% or 18.6% on a constant currency basis. Strength in Asia Pacific, North America and Latin America was partially offset by lower sales into Europe. Original equipment sales were up 23% versus prior year or up 29% on a constant currency basis, as the sales mix shifted 600 basis points from prior year to 70% original equipment and 30% aftermarket.

Gross margin increased to 70 basis points to 24.3%. The improvement reflects continued traction on the IPD operational plan as we improve operational excellence, our on-time delivery, the supply chain and focus on disciplined cost management. Operating margin improved 320 basis points to 10.9% as a result of improved SG&A leverage, increased sales volume and the overall improvement in gross margin due to contract execution. IPD is realizing the benefits of our 2011 realignment activities, ongoing continuous improvement initiatives, on-time delivery, SG&A expense control, disciplined pricing policies and overall contract execution. I remain confident that we have taken the necessary steps to reach the targeted 14% to 15% operating margin by 2015.

The Flow Control division had a tough quarterly comparison to prior year. Bookings decreased $29 million to $381 million, down 7% as reported or down 1.1% on a constant currency basis. While most end markets were down, we did see improved bookings in the power industry, resulting from increased aftermarket nuclear activity in Korea and in Europe. Regionally, bookings improved into Europe and more specifically in Russia as a result of increased repeating [ph] orders, but this improvement was more than offset by declines in the Middle East/Africa and Latin America.

Sales increased $26 million to $395 million, up 7.2% or 14.2% on a constant currency basis versus prior year. Sales growth was driven by original equipment sales in the oil and gas sector resulting from regional strength in Asia Pacific, North America, Middle East and Latin America, which more than offset decreased sales into Europe and Africa. Gross margins decreased 30 basis points to 35.4% due primarily to a shift in product line mix and a mix shift to original equipment. Operating margin was unchanged at 17.3%. Although operating income was up 7.1% or up 14.9% on a constant currency basis due to higher sales and cost control. SG&A as a percentage of sales was down 60 basis points to 18.2% as we continue to drive operational efficiency in the Flow Control division.

In summary, we are pleased with our progress of our initiatives in supply chain, on-time delivery, contract execution and quality improvements as we drive towards greater operational excellence. Looking forward to our end markets, the oil and gas markets continue to see long-term growth prospects in the upstream, production and transport areas, with large megaprojects in the downstream area shifting to the mid to the second half of 2013. Power should continue at its current levels over the short term. The chemical market is beginning to show signs of softening to some degree, while mining appears to be mixed in the short term based on concerns about overcapacity and demand brought about by the world economic picture.

With that, I would now like to turn it over to Mike Taff.

Michael S. Taff

Thank you, Tom, and good morning, everyone. Over the last several months, I have met with many of you to discuss our earnings risk profile and the benefits derived from our diverse end markets, geographies and short cycle and long cycle exposures. We view this diversified lower risk profile as a key differentiator for Flowserve that allows us to constantly make and meet commitments and return value to our shareholders. As we look at year-to-date bookings, our focus on end-user strategy and our critical application engineering solutions for our customers has enabled us to drive organic growth above market growth. This is evident in our growing bookings despite a challenging macroeconomic environment.

Overall, year-to-date bookings increased $109 million, up 3.1% or 8.4% on a constant currency basis. We are pleased with this growth as we increased our aftermarket capture and grew our installed base above market growth. The increase was driven primarily by the oil and gas and chemical industries, which more than offset decreased bookings within the power industry.

When we look at year-to-date sales numbers, the mix shifted 1% in favor of original equipment, which generally carries a lower margin than the aftermarket business and can pressure the margin profile. Sales increased $178 million over prior year, up 5.5% or 11.2% on a constant currency basis. At the end of last year, we had guided to top line revenue growth of 5% to 7% over 2011, and I am pleased that we are tracking in that range despite the stronger-than-expected currency headwinds through the first 9 months of the year.

Turning to the financial results. Sales for the third quarter increased 3.9% year-over-year or almost 11% on a constant currency basis. The sales increase was primarily driven by original equipment sales in IPD and FCD. Gross margins were down 20 basis points in the third quarter versus 2011, due to a mix shift towards original equipment partially offset by operational improvements. Similar to the first half of the year, there were approximately 200 basis points of margin impact due to low-margin projects flowing through earnings. While we anticipate shipping the majority of the remaining legacy backlog in the fourth quarter, we expect to see margin improvement on increased volume and better fixed cost leverage, which should more than offset this legacy impact. SG&A as a percent of sales in the third quarter decreased 60 basis points to 19.5% over the prior year, primarily due to better cost management. Operating margins in the third quarter were up 40 basis points to 14.2% on lower SG&A, partially offset by lower gross margin I discussed.

As we look at other expense income line, we continue to incur negative currency impacts due to the volatile U.S. dollar. The $0.12 loss below the line is primarily related to balance sheet revaluations in Mexico, the Eurozone and India. Additionally, the stronger dollar versus the third quarter of 2011 resulted in an above-the-line translation impact of $0.18. So on a year-to-date basis, we have experienced $0.85 of currency-related headwinds when compared to 2011, with approximately $0.45 above the line and $0.40 below the line. Our effective tax rate for Q3 was 26.1%, which is below our structural rate of 28% to 30% but was still above last year's unusual low third quarter rate of 22.9%. We continue to expect the full year 2012 rate to be at the lower end of the 28% to 30% range.

Turning to cash flows. We had another strong quarter as we remain focused on improving cash flow conversion. We generated $63 million in operating cash flow in Q3 or $123 million year-to-date, which is a $273 million improvement over prior year. CapEx in the second quarter (sic) [third quarter] was $27 million. We have invested $84 million year-to-date and continue to expect capital expenditures to be in the $125 million to $135 million range for the full year.

As Mark mentioned, we made progress in the quarter on our long-term capital structure strategy as we move towards our targeted debt-to-EBITDA ratio of 1x to 2x. We issued $500 million of 10-year public notes and executed a new $1.25 billion bank credit facility. At the end of the quarter, total debt to EBITDA was 1.2x. The total financing activity resulted in fees and a write-off of deferred financing costs totaling approximately $1.4 million. This more efficient capital structure will continue to provide us with the flexibility necessary to grow the business organically and through strategic bolt-on acquisitions with room to return capital to shareholders.

During the quarter, we repurchased $101 million of shares, which brought our year-to-date buyback total to $534 million. Our $1 billion share repurchase program has $524 million remaining, which we expect to complete next year. We also returned $18 million to our shareholders in dividends in the third quarter and $56 million year-to-date.

I would like to spend some time on how we view allocation of shareholder capital. This slide visually shows the systematic process the management team and our board contemplates when determining how best to use capital. We are committed to profitably growing our business, both organically and through strategic bolt-on acquisitions that provide a tight fit and available synergies. However, when making the decision to deploy capital, our larger goal is to allocate capital to the most attractive alternative that provides the highest risk-adjusted return to our shareholders over the long term.

Turning to working capital. Improving our performance in cash conversion metrics remains a priority of mine. Earlier in the year, we engaged a specialized consultant in this area to work with our Black Belts to evaluate working capital activity at several of our largest sites around the world. The results and recommendations from this work were beneficial and are now being used to drive improvements to the company's working capital efficiency.

In the third quarter, DSO increased 3 days versus prior year to 85 days. We typically see a slight seasonal increase in DSO in Q3. That said, I still see an attractive opportunity with our disciplined focus on cash collection and the improvements we are making on the front-end bidding process to drive DSO into the mid-60s over the next 9 to 15 months. As it relates to inventory, turns decreased marginally to 2.7x versus prior year at 2.8x. With Tom's focus on, on-time delivery, reducing past-due backlog and cost of quality, we believe we will reach our long-term target of 4 to 4.5 turns over the next 15 to 21 months.

As I have stated previously, working capital is receiving a significant amount of my attention, and we will remain committed to this area until we drive these metrics to the targeted levels. So as we take a look at the remainder of 2012, we expect strong performance despite the expected negative impact of currency and the planned shipment of the remaining lower-margin legacy backlog. We believe increased volume and absorption and the effects of our share repurchase program will more than offset the currency headwinds in legacy projects. As you know, we have seen significant foreign currency volatility with the strengthening U.S. dollar during the first 3 quarters versus 2011. We are now estimating a full year currency headwind of approximately $1 to $1.10 versus 2011, slightly higher than the $1 we estimated at the end of Q2 and the $0.50 impact we forecasted at the beginning of the year. This foreign currency headwind should be partially offset by approximately $0.30 of net benefit related to share repurchase activity in 2012, although somewhat offset by higher borrowing costs related to the increased leverage. So all told, we are narrowing our 2012 EPS guidance range to $8.20 to $8.70.

Finally, I would like to welcome Jay Roueche to the Flowserve team as our Vice President, Treasurer and Investor Relations. Most recently, Jay served a similar role for McDermott International. I've had the pleasure of working with him in the past and look forward to getting out on the road with him and meeting many of you again soon. With that, I will turn the call back to Mike.

Mike Mullin

Thanks, Mike. Operator, we're ready to open the line for Q&A.

Question-and-Answer Session

Operator

[Operator Instructions] And at this time, we have a question from Mike Halloran from Robert Baird.

Michael Halloran - Robert W. Baird & Co. Incorporated, Research Division

So on the deferrals and the pushouts that you were talking about, could you discuss kind of the end markets that those are the most prevalent in? And how much of it is you're seeing the deferrals already versus expectations for deferrals based on customer commentary and things like that?

Mark A. Blinn

It think it's more of the latter in terms of -- we note -- we stay in close contact with these customers. You've seen a lot of these projects, oil and gas, some in the power, even some on the chemical side getting booked into the EMCs. But as that process goes along in the feed work and it moves to final bid stage, in talking to customers, you can just see they get pushed out a quarter or 2. This is -- we're not in a situation where we were when we talk about looking forward back in '08, not even close. But it's the same thing. You just kind of continue to have a dialogue. You know these things are coming forward. There's been a tremendous amount invested in them, and so we just stay in touch with our customers.

Michael Halloran - Robert W. Baird & Co. Incorporated, Research Division

And if we would have talked last quarter, maybe the quarter before that, you would have said first half next year with some of these larger projects getting led out on the marketplace, it sounds like that's more mid to late next year expectation at this point?

Mark A. Blinn

Yes. Coming in last year about this time, we were targeting right around the end of this year, and then we saw them slip to Q1, and now we've seen them slip another quarter. So all in all, they've slipped 2, maybe 3 quarters since we started looking at these things last year.

Michael Halloran - Robert W. Baird & Co. Incorporated, Research Division

That makes a lot of sense. And then an update on the One Flowserve concept and specifically, on some of the cost of quality initiatives that Mike and the team are pushing through with Tom, could you just provide an update there and specifically what the acceptance level looks like in the EPD and IPD pieces where a lot of the focus was being pushed?

Mark A. Blinn

Well, if you take a step back in general, these things certainly do take time, and that's why I made a comment, in my opening comments about work remains to be done. But I think what you've seen in IPD are some of the early signs of the impact of, really, Tom's leadership and his team. I think in general, if you look across our overall margins and our SG&A, you're starting to see some of the impact of the One Flowserve in our -- in that line in terms of fixed cost leverage overall in our business. But in looking forward, I'd still think driving through EPD as we get the legacy backlog and start getting the benefit from some of the discipline that they brought in, that is yet to come. Obviously, there's -- we see more margin improvement for IPD as well. And then also, if you look back and think around the FCD business starting to be able to leverage some of the capabilities we've seen over in IPD and EPD, that is yet to come as well. So there is definitely still work to be done. I think Tom spent a lot of time with the -- his organization that he laid out for you in the Analyst Day. They're getting a good cadence and getting some good momentum.

Michael Halloran - Robert W. Baird & Co. Incorporated, Research Division

Makes sense. The last one for me then, just tax rate guidance, low end of the 28% to 30% range is where I think Mike said it was going to come in for the full year. That -- is that the -- I guess, the question's twofold. One, for the fourth quarter, if you're going to get a full year range in that low, low end of that range, it implies something north of 30%, so maybe just clarification on whether the fourth quarter guidance on the tax rate is closer to that low end and then also, what the appropriate level to think about is as you work through '13, '14 and beyond.

Mark A. Blinn

Yes, yes, I'd say, Mike, the lower -- for the fourth quarter, we'll be at the lower end of that tax range, that 28% to 30% range.

Michael Halloran - Robert W. Baird & Co. Incorporated, Research Division

And then for 2013?

Mark A. Blinn

Yes, I'd -- we'll comment on 2013 in a quarter or so. Just remember, a lot of that, Mike, is driven by mix, domestic versus foreign. So last year, when you saw that higher tax rate, that was because we had strong performance in the United States. As we understand it now, the U.S. has now the highest tax jurisdiction.

Operator

Our next question comes from Charlie Brady from BMO Capital Markets.

Charles D. Brady - BMO Capital Markets U.S.

Just back on the project pushouts, I just want to make sure I'm clear. The projects, some of it has been pushed out. Is there any of that in the current backlog or bookings now or is that just stuff that has not been let that you thought was going to be let but now is pushed out?

Mark A. Blinn

Right, it's the latter. It's yet to be booked. So when we talk about -- when we're talking about project opportunities, that's remarks around future bookings.

Charles D. Brady - BMO Capital Markets U.S.

Okay. Thanks for that clarification. And just on the EPD, because I know you -- in the prepared remarks, you said the legacy projects impacted margin by about 200 basis points or so. Can you just spell that out just for the EPD business itself? Because you, obviously, had pretty strong year-over-year flip on the OE aftermarket mix, which sounds like it's being masked -- the margin improvement is being masked by this legacy stuff.

Mark A. Blinn

Well, I think I'll jump in real quick. Mike's comments were -- most of the impact is in EPD but there is some in IPD as well, and even a small amount in FCD. If you recall, back in late 2010, early 2011, there were quite a few projects, big projects, that were led out in the Middle East that were very, very competitive, and all 3 of our units had participated in those. So that's some of what's coming through. And I'll remind you from my comments on the last earnings call, don't associate these with bad projects, associate them with the time in which they were bid and look forward and think about the aftermarket opportunities that they represent.

Charles D. Brady - BMO Capital Markets U.S.

Right, right. On the dollar-to-dollar patent headwind, obviously, $0.15 to $0.25, obviously, in the fourth quarter of that. Can you split that between how much you're seeing those above or versus below the line in Q4?

Michael S. Taff

Charlie, I'd say a majority of that's above the line, 80-plus percent.

Charles D. Brady - BMO Capital Markets U.S.

Okay. So one more and I'll get back on the queue. On the DSO, driving that to the mid-60s. If you were to get to that level, or when you get to that level, I guess, how much -- can you quantify how much additional cash generation that implies?

Michael S. Taff

It's about $13 million, $14 million a day.

Operator

Our next question comes from Hamzah Mazari from Credit Suisse.

Hamzah Mazari - Crédit Suisse AG, Research Division

Just first question, you talked about the pushout of these projects not being similar to 2009. Maybe if you could talk about how investors should view current excess capacity in the marketplace. And if you do see these projects, maybe continue to get pushed out maybe early 2014, what do you think the impact on the pricing environment could look like?

Thomas L. Pajonas

Well, it is as you -- our capacity will look multiple years out, and we see these project opportunities as we've talked about before in infrastructure being available over the next couple of years. That's different if you're referring to back to 2009 as to when we didn't know when the cycle was going to abate. We've been through kind of a lower cycle over the last couple of years, and there is need for investment. So that's how capacity is going to look going forward in terms of the project opportunities. It's not going to -- capacity, especially on a long-cycle project, the focus is around 12 to 18 months in terms of being worried about absorption. And if so, if these things push out a quarter or 2, that's not going to have a significant impact. If the market were to come to a view that it could been over an 18-month period, then on the margin, that could start to impact pricing. But we don't see that at this point.

Hamzah Mazari - Crédit Suisse AG, Research Division

That's very helpful. It makes sense. And then just a follow question on the aftermarket side, are you beginning to see more customers outsource? And maybe talk about what is driving that change from some of these customers doing this in-house and just your view there.

Mark A. Blinn

Yes, I mean, it's a long discussion, but I'll try to summarize it. Complexity, increased complexity, so the capabilities of customers, local machine shops and everything relative to that complexity is not there. And I think the second thing is you do have an aging population of engineers, particularly in the United States, where they are going to be looking to outsource that bandwidth to companies that can address the complexity and be a responsible rolling a business and then reliability in terms of responsiveness as well. So those are trends you're seeing in the aftermarket business. And you add to that a lot of our end-user strategies. This is moving way beyond where it was 20 years ago in terms of break, fix or just providing quick turn parts into efficiency, quality, reliability of these big, big projects. That's becoming increasingly important. And so as you look around the world, installed base is just that. It is there and permanent, and unless they shut it down, they always need to seek a way to optimize that capacity. And that's really where our end-user strategies are targeted.

Thomas L. Pajonas

Hamza, I would also add that as we start to see more maintenance monitoring taking place on these large projects in plants, we're going to see more of this trend continuing going forward.

Operator

Our next question comes from Scott Graham from Jefferies.

R. Scott Graham - Jefferies & Company, Inc., Research Division

So I was wondering where you are seeing weakness in chemical. Is that North America and Europe?

Mark A. Blinn

Primarily, over in Europe. I mean, what you're seeing in Europe, even relative to where we were a year ago, is weakness almost in all of our sectors as they kind of work through their financial issues and their uncertainty themselves. In the United States, you still have a market, a chemical market, that's out there, but we're lapping pretty tough compares. There was a big growth last year in the U.S. chemical industry. So as we look forward, there certainly is softness, but there's opportunities to bid projects. There's one in the Middle East. There's opportunities here in the United States that are going to give us opportunities going forward.

R. Scott Graham - Jefferies & Company, Inc., Research Division

Okay, great. Could you also give us an update on where some of the Korean EPCs are showing up around the world as you go out and bid?

Mark A. Blinn

Well, they're -- they bid very actively in the Middle East in '09, '10, '11, and it actually consumed quite a bit of their capacity, so we don't see them moving as quickly as they did before. And you're starting to see that more in the Westerns now that they're reporting some of their project opportunities. They are still fairly active in the power industry. They have been. We expect they will continue to be.

Thomas L. Pajonas

For instance, we're seeing some of the Koreans now looking at the U.K. nuclear market and potentially getting into that market also.

R. Scott Graham - Jefferies & Company, Inc., Research Division

All right. That's helpful. So the year is tracking pretty much as you guys said from the beginning, which is great. I'm just wondering, the fourth quarter guidance is still kind of, why, and I'm wondering what kind of -- the thinking is behind the lower end, the things that transpire there versus some of the things that come to fruition on the higher end, is it something internal? Is it timing of shipments? Maybe you can lay that out a little bit for us.

Mark A. Blinn

I'll summarize real quick. I mean, the big thing is currency, Scott. You saw $0.30 impact in this quarter, 12% below the line. You saw 17% below the line in the second quarter, and then there is volatility in our tax rate. I think what you've seen has been pretty consistent in our performance this year, it's good leverage on our sales in the operating income line.

R. Scott Graham - Jefferies & Company, Inc., Research Division

Right, okay. But then, to that end, since it is -- if it is internal, then if we were to just stay status quo from here on currencies, not that they will, of course, but the guidance that Mike provided there on what you guys are expecting for the fourth quarter, does that land you -- if it stays status quo, does that land you toward the higher end, toward the lower end or is that something going right in the middle?

Thomas L. Pajonas

Well, I mean, Scott, we're not going to comment on a precise number there. I mean, I think that's really the kind of the purpose of the range. I will note, obviously, that the midpoint did increase $0.05, so we do feel good about the year. We think Q4 will be a strong quarter as it has traditionally been for the company. But as Mark said, if you ask me what was one of the things that surprised me in Q3, it would have been currency. We certainly weren't forecasting $0.12 below the line, much less $0.18 above the line. So I'd say the $0.50 range just gives us a little bit of cushion for some potential volatility, not only in the euro, but other currencies that we're seeing in Mexico, Latin America, in India and other regions of the world where we operate.

R. Scott Graham - Jefferies & Company, Inc., Research Division

Great. Last question, a simple one, could you give us the end-of-quarter share count?

Michael S. Taff

End-of-quarter fully diluted share count was 51 285. On the phase of the 10-Q as of October 23, it was 49 9.

R. Scott Graham - Jefferies & Company, Inc., Research Division

Wait, well can you just-- maybe I'm misunderstanding. You're saying the end-of-quarter share count versus the phase of the 10-Q -- oh, I see. I'm sorry for the optional share. I get it, sorry.

Michael S. Taff

No, no. The Q has to bring down the share count to the date of the filing, which is beyond the end of the quarter, which would've included some share repurchasing activity in the first 23 days of October.

Operator

Our next question comes from Brian Konigsberg from Vertical Research.

Brian Konigsberg - Vertical Research Partners, LLC

Just back to the project slippages, just trying to get a sense, I don't know if you said, but where -- within which markets exactly are you seeing the slippages? I think you were insinuating that it was downstream, but I was curious if there was other markets that are showing some of that slippage as well. And also, on the downstream, particularly in the U.S., I know some of these petrochem projects are starting to hit EPC. Are people -- I'm just kind of curious, the nature of the pushout, is it people reconsidering the economics of these projects, is it really logistics, because of the size of the projects? If you could just a little more color on that, it'd be appreciated.

Mark A. Blinn

Yes, I would say, first of all, primarily on the oil and gas side of the business, and even though the long-term trends are looking good, it's more on the refining business than on the upstream production and transportation. The upstream production and transportation business is not where that pushout is occurring. The pushout is occurring for a couple of different regions -- reasons, just we probably got a little bit of a pause going on relative to what's going on with the oil prices worldwide and project financing and a few other issues. But we're talking about the oil and gas business and on the refining side of the business. But as we mentioned, we're still confident these things are going to go forward. There's been a tremendous amount invested in them.

Thomas L. Pajonas

Brian, I'd say just spending the last 6-years-plus before coming to Flowserve in the EMC business, that's something we see routinely. So the EMCs are-- similar to what you're hearing from EMCs as well, not unusual for these large multi-billion dollar projects to move to the right as they're just going through their pre-FEED and FEED activity. So I'd say no cause for alarm, just wanted to update you on when we thought we would be seeing some of these projects going to market and actually hitting our books. Before we're saying Q1, now I think what we're saying is Q2, Q3 timeframe next year.

Brian Konigsberg - Vertical Research Partners, LLC

Got you. And just on EPD, you talked about higher selling costs, maybe just a little color on what that entails. And is that likely to continue into Q4 of next year. If you could quantify it, it'd be good.

Thomas L. Pajonas

I think it's more just an investment -- primarily, around our end user strategy and some of the aftermarket business, we've had some investment in selling costs. And to some extent, Lawrence had some selling costs within -- being in the consolidated results for our full year.

Brian Konigsberg - Vertical Research Partners, LLC

Can you quantify the amount of headwind you saw in the quarter? And is that expected to continue or no?

Mark A. Blinn

It wasn't headwind. I think what is was saying is we had some increased selling costs to support our aftermarket business and our seal business. And then also, you're just seeing the add of Lawrence Pumps in there, too, year-over-year.

Brian Konigsberg - Vertical Research Partners, LLC

Okay, I got you. And then just lastly for Mike, so you guys did raise a lot of debt during the quarter, obviously, allocating it to buyback. At $1.2 billion, are you kind of settled with that debt balance for now or do you anticipate you might have some increase in the next few quarters or so?

Michael S. Taff

Well, we're -- I'd say we're at the lower end of our target range of 1.2x debt to EBITDA. As you know, we said we want to operate in that 1x to 2x range. So we will continue to monitor that. I mean, at the end of the day though, as we talked about, we firmly believe our job is to allocate capital to the most accretive method possible and all, and that's really a decision we'll make quarter in and quarter out.

Operator

Our next question comes from Nathan Jones from Stifel, Nicolaus.

Nathan Jones - Stifel, Nicolaus & Co., Inc., Research Division

Could I just get a clarification on the share count there? You said 51 285 was the end-of-quarter diluted share count. The 49 9 on the cover is a basic share count, correct?

Michael S. Taff

That's correct.

Nathan Jones - Stifel, Nicolaus & Co., Inc., Research Division

Okay. So I was just making sure you hadn't bought back 1.3 million shares in the last 23 days.

Michael S. Taff

I don't think so.

Nathan Jones - Stifel, Nicolaus & Co., Inc., Research Division

Okay, cool. And I guess a question for Tom, FCD has had a couple of negative order quarters in a row. I know a fairly large portion of that goes through distribution. Have you seen any impact there from distributor de-stocking or OEM de-stocking, for that matter?

Thomas L. Pajonas

The distribution business has held up quite nicely in the year-over-year compare and sequentially. I would say that the distribution is one of those businesses that is more prone to more GDP-type changes in the marketplace, but it's held up quite nicely. As a matter fact on the sales side, the sales distribution business was up very slightly year-over-year.

Nathan Jones - Stifel, Nicolaus & Co., Inc., Research Division

So what do you attribute the bookings weakness in FCD then?

Thomas L. Pajonas

I mean, we had a very tough compare. I mean, we have one of the highest bookings last year. It's almost $409 million, so that's one of the reasons. But with some softening on the chemical side of the business, we did have, as I mentioned, some good district heating in Russia. We did, again, have some good aftermarket business on the nuclear side. And then the oil and gas business on the -- let's say, shorter-term business was down slightly.

Nathan Jones - Stifel, Nicolaus & Co., Inc., Research Division

Great. And Mike, on that balance sheet, you're talking about 1x to 2x gross debt to EBITDA. But at the pace you're going to complete this buyback by the second half of next year, you're only going to be spending about as much cash flow as you're generating, if that much, and your net leverage is probably down closer to 0.5 turn or something like that. Isn't it more realistic to focus on what your net leverage is?

Michael S. Taff

Well, I mean, I think you can focus on multiple metrics. I think we just -- we chose to focus on the growth metric. But I will tell you that there's a lot of opportunities out there for investments, and we continue to monitor those inorganic or bolt-on type opportunities out there. We're seeing various deals on a quarterly basis. Obviously, we haven't done anything this year, to date, but that doesn't mean we won't and all with the right fit, with the right synergies and all. So we'll just -- as I said before, we'll continue to monitor capital deployment in the most accretive ways.

Mark A. Blinn

Nathan, one of the reasons we don't look at it net is there is a frictional element to cash that's overseas.

Nathan Jones - Stifel, Nicolaus & Co., Inc., Research Division

Okay, that's fair. And I guess seeing as we're talking about M&A, how is the pipeline looking at the moment?

Mark A. Blinn

Well, I mean, we're active out there looking for things that fit. I mean, we like things like Lawrence Pumps that we had last year. It's something we can integrate fairly quickly and provide a return to our shareholders, so it's good. You've seen some assets change hands in the marketplace, and so we certainly keep an eye out for things. But what we want to do is make sure we evaluate all of these things in terms of what's the best return for our shareholders.

Nathan Jones - Stifel, Nicolaus & Co., Inc., Research Division

Okay. And if I could just slip one more in, I'm going to see if I can get anything out of you about next year. I understand currency has been a significant drag on the actual dollar bookings numbers. Year-to-date, orders are up about 3% over last year and backlog's up about the same amount. Is that 3% order in backlog growth rate kind of the way we should be thinking about an organic revenue growth as a baseline for 2013?

Mark A. Blinn

I mean, there's a lot of our business that comes in during the current year, particularly as you look at our aftermarket business and some of our shorter-cycle business as well. So it's not necessarily all long lead time type projects that you can use that to map revenue for next year. And some of it, as you look next year, is going to be what the impact of currency is. It could still provide an additional headwind to us next year. But our focus is on, and I made this in my comment, the market growth opportunities that are out there in general and how we participate. One of the things that we talked about was we see opportunity in oil and gas, power relatively stable and the chemical markets some softness, but with opportunity in there. And then what we do to drive share gain in those particular sectors as well and then the benefit that we expect to see in terms of some of these larger long lead time projects that are out there. So keep in mind, if we book a big project towards the end of the next year, typically we won't see the revenues until the following year. But that's -- probably the best way to think in terms of our revenue is what our markets are going to provide, driving our aftermarket growth, as you've seen us do up to this point and focus on share gain. We also have the benefit -- we'll get the incremental benefit of Lawrence Pumps growing some of our other acquisitions, some of our product introductions as well. We've been spending money on R&D. So what you're getting a very short synopsis of kind of how we go through our planning process and think about how we're going to grow our business next year.

Operator

Our next question comes from Robert Barry from UBS.

Robert Barry - UBS Investment Bank, Research Division

I just want to comment in the deck about expecting the legacy backlog to be removed as a margin issue in 2013. I mean, just order of magnitude, is that about a 200-basis-point tailwind?

Mark A. Blinn

Yes, we've talked about it during the course of the year, 100 to 200 basis points if we walk through. And I think Mike's comments for this quarter were 200, so it's a good way to think about it.

Robert Barry - UBS Investment Bank, Research Division

And just given the way it's tracking, I mean, would it be fair to say that the biggest year-over-year delta from that stress would be kind of weighted to the first half, where the absence of that stress on the margins?

Mark A. Blinn

No, it'd actually be more towards the end because you're -- it started out and actually, the pace of shipping, it has increased during the course of the year. And then also, we talked about, on the last call, some of these things were waiting on basically some supplies from some suppliers, if they don't come in, in the end of year, it could go over into the first quarter of next year. But for the most part, we will have executed on this legacy backlog in 2012.

Robert Barry - UBS Investment Bank, Research Division

Okay. Another question on margins in EPD, I think there was some mention of higher selling-related expenses there, and I just wanted to drill down on what that was, if that was sales force investment or what it is and then how long it's going to stay elevated.

Mark A. Blinn

Well, it is a couple of things. When you talk about these long lead time projects that are -- we expect to see next year, you have to start building some of the capabilities to support bidding those and executing on those, so that's one area. Another area is we've seen good growth in our seal business, and a lot of that is because of the sales force we've dedicated to it as well. And then finally in our end-user strategies aftermarket, a lot of which is in EPD, we've invested in some resources and including QRCs, folks basically on the ground to drive that business as well, and I think the last thing in the SG&A line is just the inclusion of the Lawrence Pumps' SG&A year-over-year.

Robert Barry - UBS Investment Bank, Research Division

Got you, got you. Okay. And then just a couple of housekeeping items. The interest expense, of course, that surprisingly tracked higher this quarter. I mean, just for modeling purposes going forward, is the 3Q level or maybe a little bit higher kind of level we should be using quarterly?

Michael S. Taff

Yes, and I think it's pretty fair. But the range we're at for this quarter is directly in line with what you'll see kind of in future quarters.

Mark A. Blinn

You did have -- as Mike mentioned, you did have that deal cost in there. Just keep that in mind, Robert.

Robert Barry - UBS Investment Bank, Research Division

I'm sorry, how much was that?

Mark A. Blinn

$1.4 million.

Michael S. Taff

That's $1.4 million, but also you'll have a full quarter of the volumes in there as well next quarter, so kind of I'd say directionally where we are for this quarter would be where we will be for Q4 as well.

Robert Barry - UBS Investment Bank, Research Division

Okay. And then just finally on the repo activity, I think you did just over $100 million this quarter. Is that what the expectation would be for fourth quarter as well?

Mark A. Blinn

Yes, I think we'll be in that. We may be slightly higher. I'd say we'll kind of be in that 120 to 140 range or so for Q4.

Operator

Our next question comes from Sid Panda from for RBC Markets.

Sid Panda - RBC Capital Markets, LLC, Research Division

The first question I had was regarding the share buyback. Earlier, you had said that it will be completed in the 6 to 12 months' timeframe. And now the press release says 2013. So has there been some moderation in the plan to buy back shares in 2013?

Mark A. Blinn

No, I'd say no moderation. I mean, we're pretty much right on schedule. We talked about last quarter in the conference call that we'd be in the 200 to 240 range for the next 6 months. This quarter, we purchased $101 million. And as I just mentioned, I think next quarter or Q4, you'll see us in the 120 to 140 range.

Sid Panda - RBC Capital Markets, LLC, Research Division

Okay. And the next question I had was on the DSO and working capital targets. Could you give some specific examples of steps being taken to reach the DSO goals? You talked about an expert being brought in and some steps being implemented. Could you elaborate on that a bit?

Mark A. Blinn

Yes, I'd say overall as it relates to just the working capital project in general, we did have a specialized consultant work with us this quarter with a number of our black belts and go out and visit several of our large sites. I'd say the results and findings were kind of threefold. One was revising some of our existing processes, implementing some new procedures and also, just some cultural issues among the operations and all. I think we addressed those overall. You'll start seeing some improvements. So now we're kind of going from the assessment phase to the implementation phase. We'll start that in the latter part of the Q4, and that will carry us through a longer period of time into next year as we implement these recommendations.

Operator

Our next question comes from David Rose from Wedbush Securities.

David L. Rose - Wedbush Securities Inc., Research Division

I think virtually everything's been answered. I have 2 follow-up ones, though. One, just to be clear, no orders have been canceled. Is that correct?

Mark A. Blinn

That's correct.

David L. Rose - Wedbush Securities Inc., Research Division

Okay. Secondly, the cash flow statement implies, based on the third quarter, that about $3.7 million was the FX impact -- noncash FX impact. You'd mentioned the balance sheet valuation has an impact below the line. So that $3.7 million, how much of that was below the line?

Mark A. Blinn

Mike?

Michael S. Taff

I'm not sure...

David L. Rose - Wedbush Securities Inc., Research Division

Or maybe I can rephrase that. On the balance sheet revaluation or the below 9 -- below-the-line number, how much of it was actually a noncash impact for you?

Michael S. Taff

On below the line, I mean, typically when you're marking the balance sheet or any one of your hedges, it's noncash.

David L. Rose - Wedbush Securities Inc., Research Division

Right, so virtually all of it's noncash.

Michael S. Taff

Yes. Think of it as noncash. David, let me clean something up from earlier. We do have, from time to time, immaterial cancellations in our projects. They're very, very, very small.

David L. Rose - Wedbush Securities Inc., Research Division

Okay, and the market hasn't suggested a material change?

Michael S. Taff

No, no, no.

David L. Rose - Wedbush Securities Inc., Research Division

Okay, perfect. I just wanted to clarify that. Okay, so we can look at that -- of $3.7 million noncash item then, how would that be divided between above the line and below the line?

Michael S. Taff

I'm not sure, David. Let us -- we'll get back to you on that.

David L. Rose - Wedbush Securities Inc., Research Division

Okay. And then lastly on that FX front, with the new treasurer in place, what sort of steps can we see to kind of control that volatility in the below-the-line number? I mean, can you intimate what you plan to do for next year?

Thomas L. Pajonas

That's a great question. That's something we're going to look at. I mean, that's certainly a big challenge we have when you have really 2/3 of your business that occurs outside of North America, and so we are going to review our overall hedging policies and make sure we're doing everything we can do to preserve all the economic value possible in our interim business.

Mark A. Blinn

Keep in mind, David, I mean these hedges are designed to actually reduce cash flow volatility and cash earnings volatility. The reason the volatility is created is typically the hedged asset is sitting in backlog, and you have to mark the hedges every quarter, that's just the rules. So when the accounting rules changed 10 years ago to where you -- around hedge accounting, you had to start marking your hedges every quarter. So what I want to definitely convey is we do -- we run these programs to mitigate risk and to basically hedge the economics of a project that can take 1 year to 1.5 years for us to process through and ultimately collect the cash. So it's -- I think there's going to be volatility typically, and you see it in other companies as well, as long as you see there's tremendous volatility of dollars relative to foreign currencies.

Operator

Our next question comes from William Bremer from Maxim Group.

William D. Bremer - Maxim Group LLC, Research Division

You called out the pipeline business, specifically in North America, as favorable for not only Lawrence Pumps, but your valve division as well. Can you provide some additional color there and really your exposure to underlying pipe, primarily long haul?

Mark A. Blinn

Well, I think, I mean, what you're seeing is a tremendous amount of investment in midstream. The legacy piping business was typically around natural gas, but increasingly now what you're seeing is increased piping into the liquid parts of the world. That's gas to liquids are actually oil movement around the world, larger storage facilities. And this investment, which is installed based on the midstream side, presents opportunities. Really, broad-based opportunities in the valve business, to your comment earlier, because whether it's gas or liquid, we have the opportunity on the valve side. But as there's more investment on the liquids, that's where you have rotating equipment.

William D. Bremer - Maxim Group LLC, Research Division

Got you. And then given the midstream going into downstream, which is your bread and butter, if these potential projects that you're talking about continually do get pushed out, is it possible, maybe in a quarter or so, if we don't see them really come to fruition, that we do get an announced increase in -- announcement on additional restructuring initiative?

Mark A. Blinn

I mean, no, we're -- we don't want to certainly comment on anything like that at this point in time. What we're doing here is we're sitting here thinking about how to invest in our business. We'll always look for ways to improve it, Bill, always in any instance. But what we see right now and we're still confident that these projects are going to move forward.

Operator

We have reached the allotted time for the question-and-answer session. I will now turn the call back to Mr. Mike Mullin for closing remarks.

Mike Mullin

Thank you, operator, and thank you, all, for joining us today.

Operator

Thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating. You may now disconnect.

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