FLOWSERVE CORP - 10-Q Quarterly Report

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FORM 10-Q

SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

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QUARTERLY REPORT UNDER SECTION 13 OR 15 (d)
OF THE SECURITIES EXCHANGE ACT OF 1934

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For Quarter Ended June 30, 2002 Commission File Number 1-13179

FLOWSERVE CORPORATION
(Exact name of Registrant as specified in its charter)

NEW YORK
(State or other jurisdiction of incorporation or organization)

31-0267900
(I.R.S. Employer Identification Number)

222 W. LAS COLINAS BLVD., SUITE 1500, IRVING, TEXAS 75039
(Address of principal executive offices) (Zip Code)

(Registrant's telephone number, including area code) (972) 443-6500

Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.

YES X NO
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SHARES OF COMMON STOCK, $1.25 PAR VALUE,
outstanding as of July 31, 2002 55,204,776

FLOWSERVE CORPORATION
INDEX

2

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

FLOWSERVE CORPORATION
(UNAUDITED)

CONSOLIDATED STATEMENTS OF OPERATIONS

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME/(LOSS)

See accompanying notes to consolidated financial statements.

3

FLOWSERVE CORPORATION
(UNAUDITED)

CONSOLIDATED STATEMENTS OF OPERATIONS

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME/(LOSS)

See accompanying notes to consolidated financial statements.

4

FLOWSERVE CORPORATION

CONSOLIDATED BALANCE SHEETS

See accompanying notes to consolidated financial statements.

5

FLOWSERVE CORPORATION
(Unaudited)

CONSOLIDATED STATEMENTS OF CASH FLOWS

See accompanying notes to consolidated financial statements.

6

FLOWSERVE CORPORATION
(UNAUDITED)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in thousands, except per share data)

1. ACCOUNTING POLICIES - BASIS OF PRESENTATION

The accompanying consolidated balance sheet as of June 30, 2002, and the
related consolidated statements of operations and comprehensive income/(loss)
for the three months and six months ended June 30, 2002 and 2001, and the
consolidated statements of cash flows for the six months ended June 30, 2002 and
2001, are unaudited. In management's opinion, all adjustments comprising normal
recurring adjustments necessary for a fair presentation of such consolidated
financial statements have been made. The accompanying consolidated financial
statements and notes in this Form 10-Q are presented as permitted by Regulation
S-X and do not contain certain information included in the Company's annual
financial statements and notes to the financial statements. Accordingly, the
accompanying consolidated financial information should be read in conjunction
with the Company's 2001 Annual Report. Interim results are not necessarily
indicative of results to be expected for a full year. Certain amounts in 2001
have been reclassified to conform with the 2002 presentation.

2. RECENT ACCOUNTING DEVELOPMENTS

In August 2001, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards (SFAS) No. 143, "Accounting for
Asset Retirement Obligations". SFAS No. 143 addresses financial accounting and
reporting for obligations associated with the retirement of tangible long-lived
assets and the associated asset retirement costs.

SFAS No. 143 is effective for the Company on January 1, 2003. The Company
is currently assessing the impact of SFAS No. 143 and has not yet determined the
effects, if any, it will have on its consolidated financial position or results
of operations.

In April 2002, the FASB issued Statement of Financial Accounting Standards
No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB
Statement No. 13, and Technical Corrections." The most significant impact of
SFAS 145 is to eliminate the requirement that gains and losses from the
extinguishment of debt be classified as an extraordinary item unless these items
are infrequent and unusual in nature. SFAS 145 is effective for the Company on
January 1, 2003. Upon adoption of SFAS 145, the Company will reclassify
previously reported extraordinary items as a component of earnings before income
taxes.

In July 2002, the FASB issued Statement of Financial Accounting Standards
No. 146, "Accounting for Costs Associated with Exit or Disposal Activities".
SFAS 146 requires that a liability for a cost associated with an exit or
disposal activity be recognized initially at fair value when the liability is
incurred. SFAS No. 146 is effective for the Company on January 1, 2003 and will
be applied on a prospective basis.

7

3. GOODWILL AND OTHER INTANGIBLE ASSETS

On January 1, 2002, the Company adopted SFAS No. 141, "Business
Combinations," and No. 142, "Goodwill and Other Intangible Assets". SFAS No. 141
requires that all business combinations be accounted for using the purchase
method. Additionally, SFAS No. 141 establishes specific criteria for the
recognition of intangible assets separately from goodwill. SFAS No. 142
primarily addresses the accounting for goodwill and intangible assets subsequent
to their acquisition. The most significant changes made by SFAS No. 142 require
that goodwill and indefinite lived intangible assets no longer be amortized and
be tested for impairment at least on an annual basis. Additionally, the
amortization period of intangible assets is no longer limited to forty years.

Upon implementation of SFAS 141 and 142, the Company reclassified acquired
workforce intangible assets with a net carrying value of $18.5 million to
goodwill as that asset does not meet the new criteria for recognition apart from
goodwill. The Company also determined that certain acquired trademark intangible
assets have indefinite useful lives and is no longer amortizing these intangible
assets.

Under SFAS 142, goodwill is no longer amortized and instead is tested for
impairment at the reporting unit level annually and whenever events or
circumstances indicate goodwill may be impaired. The Company has completed the
required transitional goodwill and indefinite lived intangible asset impairment
tests and determined these assets were not impaired. Amortization of goodwill,
workforce intangible assets reclassified to goodwill and trademark intangible
assets with indefinite useful lives totaled $4.8 million and $9.5 million on a
pretax basis for the three months ended June 30, 2001 and for the six months
ended June 30, 2001, respectively. Such amortization for the 12 months ended
December 31, 2001 was $19.7 million.

The following table reflects consolidated results in the second quarter of
2001 adjusted as though the implementation of SFAS No. 141 and No. 142 occurred
on January 1, 2001:

8

The following tables provide information about acquired intangible assets:

(1) Other amortized intangible assets as of December 31, 2001 includes
acquired workforce intangible assets of $18,501 that were
reclassified to goodwill upon the implementation of SFAS 141 and 142.

Amortization expense:
Actual for six months ended June 30, 2002 $3,618
Estimated for six months ending December 31, 2002 $4,180
Estimated for year ending December 31, 2003 $8,359
Estimated for year ending December 31, 2004 $8,359
Estimated for year ending December 31, 2005 $7,129
Estimated for year ending December 31, 2006 $6,669
Estimated for year ending December 31, 2007 $6,634

As a result of the acquisition of Invensys plc's flow control division as
more fully described in Note 5, the Company acquired an estimated $78.3 million
of intangible assets. Of this amount, $26.6 million was assigned to registered
trademarks that have an indefinite life and are not subject to amortization. The
remaining $51.7 million of acquired intangible assets have a weighted average
useful life of approximately nine years. The intangible assets that make up that
amount include engineering drawings of $27.2 million (10 year weighted average
life), patents of $20.1 million (11 year weighted average life) and other
intangible assets of $4.4 million (3 year weighted average life). The amounts
assigned to the acquired intangible assets arising from the acquisition are
preliminary. Further refinements will be made based on the completion of final
valuation studies.

9

The changes in the carrying amount of goodwill for the six months ended June
30, 2002 are as follows:

Other reclassifications include the allocation of previously unallocated
goodwill to the Company's reporting units and other reclassifications from
intangible assets in connection with the implementation of SFAS No. 142.

10

4. ADOPTION OF SFAS NO. 133 - ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING
ACTIVITIES

The Company adopted SFAS No. 133, "Accounting for Derivative Instruments and
Hedging Activities," and the corresponding amendments on January 1, 2001. In
accordance with the transition provisions of SFAS 133, the Company recorded a
cumulative-effect adjustment in other comprehensive income as of January 1, 2001
of $0.8 million, net of deferred tax of $0.5 million, representing the current
fair value of hedging instruments. Of the asset amount of $1.3 million, $3.4
million related to foreign currency forward contracts, offset by a liability of
$2.1 million related to interest rate swap agreements.

5. ACQUISITIONS

On May 2, 2002, the Company completed its acquisition of Invensys plc's flow
control division (IFC) for an aggregate purchase price of $535 million (the IFC
Acquisition), subject to adjustment pursuant to the terms of the purchase and
sale agreement. IFC is a manufacturer of valves, actuators and associated flow
control products, and provides the Company with a more balanced mix of revenue
among pumps, valves, and seals and more diversified geographic and end markets.
The Company financed the acquisition and associated transaction costs with a
combination of bank financing, as more fully described in Note 6, and net
proceeds of approximately $276 million received from the issuance of 9.2 million
common shares in April 2002. The Company also used $40 million from the proceeds
of the equity offering to reduce amounts outstanding under the Company's
revolving credit facility.

The purchase price has been allocated to assets acquired and liabilities
assumed based on estimated fair market values at the date of acquisition. These
allocations include $78.3 million for acquired intangible assets and $190
million recorded as goodwill.

The purchase price allocation for these acquisitions is preliminary and
further refinements will be made based on the completion of final valuation
studies. The operating results of IFC have been included in the consolidated
statement of operations from the date of acquisition.

The table below reflects unaudited pro forma results of the Company and IFC
as if the acquisition had taken place at the beginning of 2002 and 2001,
including estimated purchase accounting adjustments and financing costs.

PRO FORMA CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)

The pro forma information does not purport to represent what the Company's
results of income actually would have been had such transactions or events
occurred on the dates specified, or to project the Company's results of
operations for any future period.

11

6. DEBT

In the second quarter of 2002, in connection with the IFC acquisition, the
Company agreed with its lenders under its existing senior credit facilities to
amend the terms of such facilities that, effective as of the closing of the IFC
Acquisition, provided for: (1) an incremental Tranche A term loan in an
aggregate principal amount of $95.3 million and (2) a new Tranche C term loan
facility of $700 million, to be used to repay all of the existing Tranche B term
loan facility of $468.8 million, repay $11.3 million of the existing Tranche A
term loan and provide funds to be used to finance the IFC acquisition. The
Tranche A term loan has a final maturity in June 2006. Terms of the new Tranche
C term loan include maturity in 2009, rather than 2008 for the former Tranche B
term loan and reduced spreads resulting in lower interest rates. As part of the
amended and restated senior credit facility, several covenants were modified,
including various financial ratios to allow for the IFC Acquisition and other
matters. The senior credit facilities are collateralized by substantially all of
the Company's domestic assets and a pledge of 65% of the stock of the foreign
subsidiaries. As a result of repaying the Tranche B term loan facility, an
extraordinary expense of $6.3 million, net of tax, was recorded in the second
quarter of 2002 related to the write-off of the unamortized balance of prepaid
financing fees related to the Tranche B term loan and other related fees.

The term loans require scheduled principal payments, which began on June 30,
2001 for the Tranche A loan and will begin September 30, 2002 for the Tranche C
loan. In addition to the payments made in connection with the refinancing of the
senior credit facility, the Company had repaid $15.5 million of the term loans
(during the first half of 2002). The scheduled principal payments of the term
loans outstanding at June 30, 2002 are summarized as follows: $36.7 million in
the remainder of 2002, $78.7 million in 2003, $84.0 million in 2004, $89.3
million in 2005, $56.0 million in 2006, $100.0 million in 2007, $388.0 million
in 2008 and $194.0 million in 2009. The Company is required to use a percentage
of excess cash from operations under certain circumstances, as defined in the
Credit Facility and the indenture, to reduce the outstanding principal of the
term loans in the following year. No additional principal payments have been or
are due in 2002 under this provision.

The term loans bear floating interest rates based on LIBOR plus a credit
spread, or the prime rate plus a credit spread, at the option of the Company.
The credit spread for Tranche A can increase or decrease based on the leverage
ratio as defined in the credit facility agreement. At June 30, 2002, the
interest rates on the term loans were 4.6713%, 4.6250%, 4.6875% and 4.6250%
relating to the Tranche A term loan facility, 6.1395% related to a Euro
denominated portion of the Tranche A and 4.750% and 4.875% relating to the
Tranche C term loan facility.

Under the amended and restated credit facility, the Company has a $300
million revolving credit facility due June 2006. A portion of the incremental
Tranche C term loan was used to repay $40.0 million of the outstanding
indebtedness under the revolving credit facility. At June 30, 2002, no
borrowings were outstanding on the revolving credit facility. The revolving
credit facility allows the Company to issue up to $200 million in letters of
credit. As of June 30, 2002, $38.2 million of letters of credit had been issued
under the facility. As letters of credit issued under the facility reduce
availability, the Company had $261.8 million remaining in unused borrowing
capacity at June 30, 2002 under the revolving credit facility. In addition to
the letters of credit issued under the facility, there were $7.8 million of
letters of credit outside the facility at June 30, 2002.

The provisions of the credit facility require the Company to meet or exceed
specified defined financial covenants. These covenants include a leverage ratio,
an interest coverage ratio, and a fixed charge coverage ratio. Further, the
provisions of the credit facility and the Senior Subordinated Notes contain
limitations or restrictions on indebtedness, liens, sale and leaseback
transactions, asset sales, payment of

12

dividends, capital expenditures, and other customary restrictions. As of June
30, 2002, the Company was in compliance with these covenants.

7. INVENTORIES

Inventories are stated at lower of cost or market. Cost is determined for
U.S. inventories by the last-in, first-out (LIFO) method and for other
inventories by the first-in, first-out (FIFO) method.

Inventories and the method of determining costs were:

Inventory balances increased primarily as a result of the IFC Acquisition
and due to foreign currency translations, primarily due to the strengthening of
the Euro in June 2002. Inventory balances excluding the acquisition of IFC at
June 30, 2002 were as follows: raw materials of $76.2 million; work in process
of $206.2 million; finished goods of $241.3 million; progress billings of $76.4
million; excess and obsolete reserve of $44.8 million; and LIFO reserve of $33.4
million.

8. RESTRUCTURING AND ACQUISITION RELATED CHARGES

In June 2002, in conjunction with the IFC Acquisition, the Company initiated
a restructuring program designed to reduce costs and eliminate excess capacity
in North America by consolidating facilities. The Company's actions, approved
and committed to in the second quarter of 2002, are expected to result in a
gross reduction of approximately 450 positions and a net reduction of
approximately 225 positions.

This program includes the announced closure of six valve facilities and a
reduction of sales and sales support personnel. The Company established a
restructuring reserve of $11.0 million for this program in the second quarter of
2002 and expects the majority of the reductions and closures to occur before
March 2003. Costs associated with the closure of Flowserve facilities of $0.6
million have been charged to restructuring expense in the income statement and
costs associated with the closure of IFC facilities of $10.4 million along with
related deferred taxes were accounted for in the purchase accounting for IFC.

During the second quarter of 2002, the Company also incurred $2.0 million of
integration expense in conjunction with the program. Expenses classified as
integration generally represent period costs associated with acquisition related
reorganizations such as performance and retention bonuses, idle manufacturing
costs, costs related to the integration team and asset impairments.

Additional restructuring and integration expense related to the IFC
acquisition are expected in subsequent quarters. The impact of additional
restructuring activities will be recorded as programs are detailed, approved and
announced.

13

In August 2000, in conjunction with the acquisition of Ingersoll-Dresser
Pump Company (IDP), the Company initiated a restructuring program designed to
reduce costs and to eliminate excess capacity by consolidating facilities. The
Company's actions, approved and committed to in the third quarter of 2000, have
resulted in the net reduction of approximately 1,100 positions, which was
consistent with the plan. The program includes the closure of IDP's former
headquarters, the closure or significant downsizing of a number of pump
manufacturing facilities, service and repair centers, and reduction of sales and
sales support personnel. The Company established a restructuring reserve for
this program in the third quarter of 2000.

In the second quarter of 2001 and for the six months ended June 30, 2001,
the Company incurred integration expense in conjunction with the program of
$16.9 million and $36.1 million, respectively. The Company substantially
completed its integration activities during 2001. Expenditures charged to the
2000 restructuring reserve were:

9. EARNINGS PER SHARE

Basic and diluted earnings per share were calculated as follows:

14

Options outstanding with an exercise price greater than the average market
price of the common stock were not included in the computation of diluted
shares. Options to purchase 108,414 shares of common stock and 371,926 shares of
common stock were not included for the three month and six month periods ended
June 30, 2002, respectively. Options to purchase 435,849 shares of common stock
were not included in the computation for the three month period ended June 30,
2001. For the six months ended June 30, 2001, the computation of diluted net
loss per ordinary share was antidilutive, and therefore, the amounts reported
for basic and diluted net loss per ordinary share were the same.

15

10. SEGMENT INFORMATION

The Company has three divisions, each of which constitutes a business
segment. Each division manufactures different products and is defined by the
type of products and services provided. Each division has a President, who
reports directly to the Chief Executive Officer, and a Division Controller. For
decision-making purposes, the Chief Executive Officer and other members of upper
management use financial information generated and reported at the division
level. The Company also has a corporate headquarters that does not constitute a
separate division or business segment.

Amounts classified as All Other include Corporate Headquarters costs and
other minor entities that are not considered separate segments. The Company
evaluates segment performance and allocates resources based on profit or loss
excluding integration expenses, interest expense, other income or expense,
income taxes and extraordinary items. Intersegment sales and transfers are
recorded at cost plus a profit margin. Several valve distribution centers were
transferred from the Flow Solutions Division to the Flow Control Division in
2002. Amounts reported for these distribution centers for 2001 have been
reclassified to conform to the current business configuration.

(1) Special items reflect costs associated with the IFC Acquisition
including a negative purchase accounting adjustment associated with the
required write-up and sale of inventory of $2.6 million (recorded as a
component of cost of sales), integration expense of $2.0 million and
restructuring expense of $0.6 million.

(2) Special items reflect integration expense associated with the
acquisition and integration of IDP of $16.9 million.

A reconciliation of total segment operating income before special items to
consolidated earnings before income taxes follows:

(1) Special items reflect costs associated with the IFC Acquisition including a
negative purchase accounting adjustment associated with the required
write-up and sale of inventory of $2.6 million (recorded as a component of
cost of sales), integration expense of $2.0 million and restructuring
expense of $0.6 million.

(2) Special items reflect integration expense associated with the acquisition
and integration of IDP of $36.1 million

A reconciliation of total segment operating income before special items to
consolidated earnings before income taxes follows:

Effective July 1, 2002, the Company realigned its operating segments. Under
the new organization, the Flow Solutions Division will only include the
Company's seal operations, while the Company's pump and valve service businesses
will be included, as appropriate, in the Flowserve Pump Division and Flow
Control Division, respectively. Segment information will be reported under the
new organization structure beginning in the third quarter of 2002 when the
Company begins to operate under this new organization structure.

17

11. GUARANTOR AND NONGUARANTOR FINANCIAL STATEMENTS

In connection with the IDP acquisition and as part of the related financing,
the Company and a newly formed Dutch subsidiary, Flowserve Finance B.V., issued
an aggregate of $375 million of senior subordinated notes (the U.S. dollar Notes
and the Euro Notes). The U.S. dollar Notes and the Euro Notes are general
unsecured obligations of the Company and of Flowserve Finance B.V.,
respectively, subordinated in right of payment to all existing and future senior
indebtedness of the Company and of Flowserve Finance B.V., respectively, and
guaranteed on a full, unconditional, joint and several basis by the Company's
wholly-owned domestic subsidiaries and, in the case of the Euro Notes, by the
Company. These Notes are included in the Company's balance sheet and are
classified as "long-term debt due after one year".

The following consolidating financial information presents:

(1) Consolidating balance sheet as of June 30, 2002 and the related statements
of operations for the six months and the three months ended June 30, 2002
and June 30, 2001 and cash flows for the six months ended June 30, 2002 and
2001 of (a) Flowserve Corporation, the parent, (b) Flowserve Finance B.V.,
(c) the guarantor subsidiaries, (d) the nonguarantor subsidiaries, and the
Company on a consolidated basis, and

(2) Consolidating balance sheet as of December 31, 2001 of (a) Flowserve
Corporation, the parent, (b) Flowserve Finance B.V., (c) the guarantor
subsidiaries, (d) the nonguarantor subsidiaries, and the Company on a
consolidated basis, and

(3) Elimination entries necessary to consolidate Flowserve Corporation, the
parent, with Flowserve Finance, B.V., guarantor and nonguarantor
subsidiaries.

Investments in subsidiaries are accounted for by the parent using the
equity method of accounting. The guarantor and nonguarantor subsidiaries are
presented on a combined basis. The principal elimination entries eliminate
investments in subsidiaries and intercompany balances and transactions. Separate
financial statements for the guarantor subsidiaries and the nonguarantor
subsidiaries are omitted because of immateriality.

18

FLOWSERVE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(AMOUNTS IN THOUSANDS)
CONSOLIDATING STATEMENT OF OPERATIONS
FOR THE THREE MONTHS ENDED JUNE 30, 2002
(UNAUDITED)

19

FLOWSERVE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(AMOUNTS IN THOUSANDS)
CONSOLIDATING STATEMENT OF OPERATIONS
FOR THE THREE MONTHS ENDED JUNE 30, 2001
(UNAUDITED)

20

FLOWSERVE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(AMOUNTS IN THOUSANDS)
CONSOLIDATING STATEMENT OF OPERATIONS
FOR THE SIX MONTHS ENDED JUNE 30, 2002
(UNAUDITED)

21

FLOWSERVE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(AMOUNTS IN THOUSANDS)
CONSOLIDATING STATEMENT OF OPERATIONS
FOR THE SIX MONTHS ENDED JUNE 30, 2001
(UNAUDITED)

22

FLOWSERVE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(AMOUNTS IN THOUSANDS)
CONSOLIDATING BALANCE SHEET
JUNE 30, 2002
(UNAUDITED)

23

FLOWSERVE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(AMOUNTS IN THOUSANDS)
CONSOLIDATING BALANCE SHEET
DECEMBER 31, 2001

24

FLOWSERVE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (AMOUNTS IN THOUSANDS)
CONSOLIDATING STATEMENT OF CASH FLOWS
FOR THE SIX MONTHS ENDED JUNE 30, 2002 (UNAUDITED)

25

FLOWSERVE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(AMOUNTS IN THOUSANDS)
CONSOLIDATED STATEMENT OF CASH FLOWS
FOR THE SIX MONTHS ENDED JUNE 30, 2001
(UNAUDITED)

26

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS

The following discussion and analysis are provided to increase understanding
of, and should be read in conjunction with, the accompanying consolidated
financial statements and notes.

Flowserve produces engineered and industrial pumps, industrial valves,
control valves, nuclear valves, valve actuators and controls and precision
mechanical seals, and provides a range of related flow management services
worldwide, primarily for the process industries. Equipment manufactured and
serviced by the Company is predominately used in industries that deal with
difficult-to-handle and corrosive fluids as well as environments with extreme
temperature, pressure, horsepower and speed. Flowserve's businesses are affected
by economic conditions in the United States and other countries where its
products are sold and serviced, by the cyclical nature of the petroleum,
chemical, power, water and other industries served, by the relationship of the
U.S. dollar to other currencies, and by the demand for and pricing of customers'
products. The Company believes the impact of these conditions is somewhat
mitigated by the strength and diversity of Flowserve's product lines, geographic
coverage and significant installed base, which provides potential for an annuity
stream of revenue from parts and services.

In general, results for the second quarter of 2002 and the six months ended
June 30, 2002 were higher than the corresponding period in the previous year due
to the Company's acquisition of Invensys' flow control division (IFC) on May 2,
2002. The results for IFC subsequent to the acquisition are included in the
results for the Company's Flow Control Division. This acquisition was financed
through a combination of debt and proceeds from a common stock offering as
discussed in further detail in the Liquidity and Capital Resources section of
this Management Discussion and Analysis.

Special items incurred for the second quarter of 2002 reflect costs
associated with the acquisition of IFC including the following: integration
expense of $2.0 million; restructuring expense of $0.6 million; a negative
purchase accounting adjustment of $2.6 million (included in cost of sales)
associated with the required write-up and subsequent sale of inventory; and an
extraordinary charge of $6.3 million, net of tax, reflecting the write-off of
unamortized prepaid financing and other related fees resulting from the
refinancing of the Company's senior credit facility. Special items in 2001
include integration expense of $16.9 million for the second quarter and $36.1
million for the six month period associated with the August 2000 acquisition of
Ingersoll-Dresser Pump Co. (IDP).

Operating results before special items should not be considered an
alternative to operating results calculated in accordance with generally
accepted accounting principles.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The process of preparing financial statements in conformity with accounting
principles generally accepted in the U.S. requires the use of estimates and
assumptions to determine certain of the assets, liabilities, revenues and
expenses. These estimates and assumptions are based upon the best information
available at the time of the estimates or assumptions. The estimates and
assumptions could change materially as conditions within and beyond the
Company's control change. Accordingly, actual results could differ materially
from those estimates. The most significant estimates made by management include
the allowance for doubtful accounts receivable, reserves for excess and obsolete
inventories, deferred tax asset valuation allowances, restructuring accruals,
legal and environmental accruals, warranty accruals, insurance accruals, pension
and postretirement benefit obligations, and valuation of goodwill and other
long-lived assets. Most of these estimates are reviewed quarterly with the
Company's Audit/Finance Committee. The following is a discussion of the critical
accounting policies and the related management estimates and assumptions
necessary in determining the value of related assets or liabilities.

27

REVENUE RECOGNITION

Revenues and costs are generally recognized based on the shipping terms
agreed to with the customer and fulfillment of all but inconsequential or
perfunctory actions required of the Company. Revenue for certain longer-term
contracts is recognized based on the percentage of completion method calculated
on a cost to cost basis. Shipping and handling costs are reported in cost of
sales and amounts billed to customers for these costs are included in revenues.
Progress billings are generally shown as a reduction of inventory unless such
billings are in excess of accumulated costs, in which case such balances are
included in accrued liabilities.

ALLOWANCE FOR DOUBTFUL ACCOUNTS

An allowance for doubtful accounts receivable is established based on
estimates of the amount of uncollectible accounts receivable. The amount of the
required allowance is determined based upon the aging of the receivable,
customer credit history, industry and market segment information, economic
trends and conditions, credit reports and customer financial condition. Customer
credit issues, customer bankruptcies or general economic conditions can affect
the estimates.

INVENTORIES

Inventories are stated at the lower-of-cost of market. Cost is determined
for U.S. inventories by the last-in, first-out (LIFO) method and for other
inventories by the first-in, first-out (FIFO) method. Provisions for excess and
obsolete inventories are based on an assessment of slow-moving and obsolete
inventories. A factor of historical usage and estimated future demand provide
the basis for the estimates. These estimates are generally not subject to
significant volatility due to the relatively long life cycle of the Company's
products except for product rationalizations, which may occur in conjunction
with an acquisition.

DEFERRED TAX ASSET VALUATION

Deferred tax assets and liabilities are established based on the profits or
losses in each jurisdiction in which the Company operates. Associated valuation
allowances reflect the likelihood of the recoverability of these assets. The
judgment of the recoverability of these assets is based primarily on the
estimate of current and expected future earnings and prudent and feasible tax
planning strategies. These estimates could be impacted by changes in future
taxable income and the results of tax strategies.

RESTRUCTURING

Restructuring reserves are generally established in conjunction with an
acquisition. The reserve reflects many estimates including those pertaining to
employee separation costs, settlements of contractual obligations and other
costs associated with exiting a facility. Restructuring costs related to
facilities and employees of an acquired business are generally recorded in
goodwill whereas all others are recorded as restructuring expense in the
Consolidated Statement of Operations. Reserve requirements for each individual
plan are reassessed quarterly and could change due to revisions of cost
estimates and changes in planned restructuring activities.

LEGAL AND ENVIRONMENTAL ACCRUALS

The costs relating to legal and environmental liabilities are estimated and
recorded when it is probable that a loss has been incurred and such loss is
estimable. The Company has a formal and established process for assessing the
facts and circumstances and recording such contingencies on a case-by-case
basis. Probable legal and environmental costs are based on information obtained
from the Company's experts plus the Company's loss experience in similar
situations. The estimates may vary in the future due to new developments
regarding the facts and circumstances of each matter.

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WARRANTY ACCRUALS

Warranty obligations are based upon product failure rates, materials usage
or service delivery costs. The Company estimates its warranty provisions based
upon an analysis of all identified or expected claims and an estimate of the
cost to resolve those claims. The estimates of expected claims are generally a
factor of historical claims. Changes in claim rates, differences between actual
and expected warranty costs and the Company's facility rationalization
activities could impact these estimates.

INSURANCE ACCRUALS

Insurance accruals are recorded based upon an analysis of the Company's
claim loss history and an estimate of incurred but not recorded claims. The
estimates are based upon information received from the Company's external
insurers. Changes in claim rates and differences between actual and expected
claim losses could impact the accrual in the future.

PENSION AND POSTRETIREMENT BENEFITS OBLIGATIONS

Determination of the value of the pension and postretirement benefits
liabilities is based on actuarial valuations. Inherent in these valuations are
key assumptions including discount rates, market value of plan assets, expected
return on plan assets and assumed rate of increase in wages or in health care
costs. Current market conditions, including changes in rates of returns,
interest rates and medical inflation rates are considered in selecting these
assumptions. Changes in the related pension and postretirement benefit costs may
occur in the future due to changes in the assumptions used and changes resulting
from fluctuations in the Company's related headcount.

VALUATION OF GOODWILL AND OTHER LONG-LIVED ASSETS

The value of the Company's goodwill and indefinite lived intangible assets
are tested annually for impairment or whenever events or circumstances indicate
goodwill may be impaired. The test involves significant judgments based upon
projections of future performance of each of the Company's reporting units. The
net realizable value of other long-lived assets is reviewed periodically, when
indicators of potential impairments are present, based upon an assessment of the
estimated future cash flows related to those assets. Due to uncertain market
conditions and potential changes in strategy and product portfolio, it is
possible that forecasts used to support these assets may change in the future
which could result in non-cash charges that would adversely affect the Company's
results of operations and financial condition.

Based on a critical assessment of its accounting policies and the underlying
judgments and uncertainties affecting the application of those policies,
management believes that the Company's consolidated financial statements provide
a meaningful and fair perspective of the Company. This is not to suggest that
other general risk factors, such as changes in worldwide growth objectives,
changes in material costs, performance of acquired businesses and others, could
not adversely impact the Company's consolidated financial position, results of
operations and cash flows in future periods.

RESULTS OF OPERATIONS - THREE MONTHS ENDED JUNE 30, 2002

Sales increased 27.6% to $592.7 million for the three months ended June 30,
2002, compared with $464.6 million for the same period in 2001. The increase is
primarily associated with the IFC acquisition, which contributed $88.1 million
of sales in the second quarter, and a higher volume of engineered project sales
in the petroleum and water markets. Sales on a comparable basis, excluding IFC,
increased 8.6% to $504.6 million primarily due to a higher volume of project
sales. Currency translation had virtually no impact on second quarter 2002
sales. Net sales to international customers, including export sales from the
U.S., were 52% of sales, compared with

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