Management’s Discussion and Analysis of Financial Condition and Results of Operations set forth in this Item 7 reflects the restatement of our 2003 and 2002 consolidated financial statements as discussed below, and all amounts for these prior periods and prior period comparisons reflect the balances and amounts on a restated basis. In addition, the following discussion and analysis reflects certain events that occurred subsequent to the original due date for filing this Annual Report, including, but not limited to, the completion of our refinancing during the third quarter of 2005 and updates to recently issued accounting standards. The following discussion and analysis is provided to increase the understanding of, and should be read in conjunction with, the accompanying consolidated financial statements and notes. Please see “Risk Factors” and “Forward-Looking Statements” sections for a discussion of the risks, uncertainties and assumptions associated with these statements. Unless otherwise noted, all amounts discussed herein are consolidated.

EXECUTIVE OVERVIEW

      We are an established leader in the fluid motion and control business, with a strong portfolio of pumping systems, valves, sealing solutions, automation and services in support of the power, oil and gas, chemical, and other process markets. These products are mission critical in the movement, control and protection of fluids in our customers’ critical processes, whether it is a refinery, a power generation facility or a transportation pipeline. Our business model is heavily influenced by the capital spending of these industries for the placement

of new products in service. The worldwide installed base of our products is another important source of revenue where our products are expected to ensure the maximum operating time of the many key industrial processes. The aftermarket business is generally a higher margin business and a key component to our profitable growth.

      We have experienced steadily improving conditions in 2004 and 2005 in several core markets, including oil and gas, chemical, and numerous general industries. The rise and continued elevation of the price of crude oil and natural gas in particular has spurred capital investment in the oil and gas market, resulting in many new projects and expansion opportunities. Although feedstock costs are increasing in the chemical market, greater global demand is allowing companies to pass through pricing and strengthen the global market. The opportunity to increase our installed base of new products and drive recurring aftermarket business in future years is a critical by-product of these market conditions.

      We have six key strategies that have been well communicated throughout the business. One of our key strategies is the globalization of our business. See “Our Strategies” section of this Management’s Discussion and Analysis for a discussion of our six key strategies. We currently have approximately 14,000 employees in more than 56 countries. We continue to implement new Quick Response Centers (“QRCs”) to be better positioned as near to our customers as possible for service and support, as a means to capture this important aftermarket business. Our markets have improved and we see corresponding growth in our business, much of which is in non-traditional areas of the world where new oil and gas reserves have been discovered. We and our customers are seeing rapid growth in Asia, with China providing a source of significant project growth. We have a strategy in place to increase our presence in China to capture the aftermarket business with our current installed base as well as new projects and process plant expansions.

      Along with ensuring that we have the local capability to sell, install and service our equipment in remote regions, it becomes more imperative to continuously improve our global operations. Our global supply chain capability is being expanded to meet the global customer demands and ensure the quality and timely delivery of our products. Significant efforts are underway to reduce the supply base and drive processes across the divisions to find areas of synergy and cost reduction. In addition, we are improving our supply chain management capability to insure we meet global customer demands. We continue to focus on improving on-time delivery and quality, while reducing warranty costs across our global operations through a focused Continuous Improvement Process (“CIP”) initiative. The goal of the CIP initiative is to maximize service fulfillment to our customers (such as on-time delivery, reduced cycle time and quality) at the highest internal productivity. This program is a key factor in our margin expansion plans.

RECENT DEVELOPMENTS

      We have restated our results for 2002, 2003 and the first quarter of 2004. The restatement of our annual 2002 consolidated financial statements, our annual and interim 2003 consolidated financial statements and our 2004 first quarter consolidated financial statements is collectively referred to as the “2004 Restatement.”

      This Annual Report includes our consolidated financial statements as of December 31, 2004 and for the year then ended and our restated consolidated financial statements as of December 31, 2003 and for the years ended December 31, 2003 and 2002. We will file restated condensed consolidated financial statements in an amendment to our Quarterly Report on Form  10-Q for the period ending March 31, 2004 at a later date. The impact of the 2004 Restatement on periods prior to January 1, 2002 is reflected as a decrease of $13.7 million to beginning retained earnings as of January 1, 2002. Information in “Item 6. Selected Financial Data,” however, is presented on a restated basis for all of the periods presented, and the impact of the 2004 Restatement on periods prior to January 1, 2000 is reflected as a decrease of $2.8 million to beginning retained earnings as of January 1, 2000.

      The 2004 Restatement corrects errors made in the application of accounting principles generally accepted in the United States (“GAAP”), including errors with respect to inventory valuation, long-term contract accounting, intercompany accounts, pension expense, fixed assets and intangibles, financial derivatives,

unclaimed property, tax matters, and other adjustments from unreconciled accounts. The 2004 Restatement is more fully described in Note 2 to our consolidated financial statements included in this Annual Report. The cumulative net reduction in net earnings for the 2004 Restatement was $35.9 million. This includes the $13.7 million reduction to beginning retained earnings at January 1, 2002, the total $19.1 million reduction in net earnings to 2003 and 2002 results of operations discussed below, and the $3.1 million reduction in net earnings to the first quarter of 2004 results of operations.

      The impact of the 2004 Restatement decreased sales for 2003 by $7.4 million and increased sales for 2002 by $2.6 million, decreased net earnings for 2003 and 2002 by $8.4 million and $10.7 million, respectively, and decreased total assets, decreased total liabilities and increased total shareholders’ equity at December 31, 2003 by $120.1 million, $121.8 million and $1.7 million, respectively. The decreases in total assets and total liabilities are due primarily to the proper netting of deferred tax assets and liabilities. The net increase in shareholders’ equity at December 31, 2003 is due primarily to an increase in currency translation adjustments, net of tax included in accumulated other comprehensive loss, partially offset by the cumulative $32.8 million decrease in net earnings through December 31, 2003 discussed above. Diluted net earnings per share decreased by $0.16 and $0.20 per share for 2003 and 2002, respectively.

      As a result of the 2004 Restatement and the new obligations regarding internal control certification under Section 404 of the Sarbanes-Oxley Act of 2002, or Section 404, we were unable to timely file with the Securities and Exchange Commission (“SEC”) this Annual Report and our Quarterly Reports on Form  10-Q for the quarterly periods ended June 30, 2004, September 30, 2004, March 31, 2005, June 30, 2005 and September 30, 2005. We will continue to work toward becoming current in our quarterly filings with the SEC as soon as practicable after the filing of this Annual Report. We will not, however, be able to timely file with the SEC our Annual Report on Form  10-K for the year ended December 31, 2005 and our Quarterly Report on Form  10-Q for the quarterly period ended March 31, 2006.

      The 2004 Restatement follows our earlier restatement, announced on February 3, 2004, of annual results for the years 2000 through 2002 and quarterly results for 2003. We refer to the prior restatement as the “2003 Restatement.” The 2003 Restatement was completed on April 26, 2004 and principally related to inventory and costs of sales adjustments resulting primarily from reconciliation issues at two of our reporting locations due to difficulties associated with the conversion to new computer systems. The 2003 Restatement also included corrective adjustments relating to the computation of our income tax provision, classification of certain balance sheet accounts and other account reconciliations.

      As part of our assessment of internal control over financial reporting under Section 404 and our 2004 Restatement, we performed additional analyses and other procedures to ensure that our consolidated financial statements included in this Annual Report were prepared in accordance with GAAP. These procedures included, among other things, expansion of our year-end closing procedures and dedication of significant internal resources and external consultants to scrutinize account analyses and reconciliations at a detailed level. We conducted expanded assessments of customer shipments at certain of our locations for revenue cut-off; analyzed certain long-term sales contracts; analyzed pending litigation matters; analyzed leasehold improvements for proper classification and amortization; analyzed our inventory reserves, including our obsolete and slow moving inventory calculations and estimates; assessed our non-U.S.  actuarially determined pension obligations and related liabilities; analyzed our liabilities associated with unclaimed third party property; analyzed our equity investments; analyzed our accounts receivable factoring and securitization arrangements; analyzed our accounting for financial derivatives; analyzed our purchase accounting for acquired businesses; performed expanded procedures on the existence, depreciation and disposals of fixed assets; performed expanded analyses of our intercompany, income tax and foreign currency translation accounts; and conducted site visits at selected locations to perform additional account balance examinations. As a result of these and other expanded procedures, management believes that the financial statements included in this Annual Report present fairly, in all material respects, our financial position, results of operations and cash flows for the periods presented in conformity with GAAP.

      We have incurred significant costs in 2005 in connection with the 2004 Restatement and financial statement audit, Section 404 assessment and Internal Revenue Service (“IRS”) tax audit, which is discussed

below. We expect that the professional fees expensed in 2005 for external advisors relating to the 2004 Restatement and the IRS audit, together with the fees for the audit of our 2004 consolidated financial statements and internal controls in compliance with Section 404, will be approximately $48 million. In 2004, we incurred approximately $22 million in professional fees related to the 2003 Restatement, 2004 and 2003 financial statement audits, Section 404 assessment and deferred tax analysis.

      On February 4, 2004, we received an informal inquiry from the SEC requesting the voluntary production of documents and information related to the 2003 Restatement. On June 2, 2004, we were advised that the SEC issued a formal order of private investigation into issues regarding the 2003 Restatement and any other issues that arise from the investigation. We continue to cooperate with the SEC in this matter.

      On February 7, 2006, we received a subpoena from the SEC regarding goods and services that were delivered to Iraq from 1996 through 2003 during the United Nations Oil-for-Food Program. We are in the process of reviewing and responding to the subpoena and intend to cooperate with the SEC. We believe that other companies in our industry (as well as in other industries) have received similar subpoenas and requests for information.

      During the quarter ended September 30, 2003, related putative lawsuits were filed in federal court in the Northern District of Texas (the “Court”), alleging that we violated federal securities laws. Since the filing of these cases, which have been consolidated, the lead plaintiff has amended its complaint several times in the action. The lead plaintiff’s current pleading is the fifth consolidated amended complaint (“Complaint”). The Complaint alleges that federal securities violations occurred between February 6, 2001 and September 27, 2002 and names as defendants Mr. C. Scott Greer, our former Chairman, President and Chief Executive Officer, Ms. Renée J. Hornbaker, our former Vice President and Chief Financial Officer, PricewaterhouseCoopers, LLP, our independent registered public accounting firm, and Banc of America Securities LLC and Credit Suisse First Boston LLC, which served as underwriters for two of our public stock offerings during the relevant period. The Complaint asserts claims under Sections 10(b) and 20(a) of Securities Exchange Act of 1934, and Rule  10b-5 thereunder, and Sections 11 and 15 of the Securities Act of 1933. The lead plaintiff seeks unspecified compensatory damages, forfeiture by Mr. Greer and Ms. Hornbaker of unspecified incentive-based or equity-based compensation and profits from any stock sales and recovery of costs. On November 22, 2005, the Court entered an order denying the defendants’ motions to dismiss the Complaint on the pleadings in their entirety. The case is currently set for trial on March 27, 2007. We continue to believe that the lawsuit is without merit and are vigorously defending the case.

      On October 6, 2005, a shareholder derivative lawsuit was filed purportedly on behalf of our company in the 193rd Judicial District of Dallas County, Texas. The lawsuit names as defendants Mr. Greer, Ms. Hornbaker, and current board members Hugh K. Coble, George T. Haymaker, Jr., William C. Rusnack, Michael F. Johnston, Charles M. Rampacek, Kevin E. Sheehan, Diane C. Harris, James O. Rollans and Christopher A. Bartlett. We are named as a nominal defendant. Based primarily on the purported misstatements alleged in the above-described federal securities case, the plaintiff asserts claims against the defendants for breach of fiduciary duty, abuse of control, gross mismanagement, waste of corporate assets and unjust enrichment. The plaintiff alleges that these purported violations of state law occurred between April 2000 and the date of suit. The plaintiff seeks on behalf of our company an unspecified amount of damages, injunctive relief and/or the imposition of a constructive trust on defendants’ assets, disgorgement of compensation, profits or other benefits received by the defendants from us, and recovery of attorneys’ fees and costs. We strongly believe that the suit was improperly filed and have filed a motion seeking dismissal of the case.

      We have recently concluded an IRS audit of our U.S. federal income tax returns for the years 1999 through 2001. Based on its audit work, the IRS has issued proposed adjustments to increase taxable income during 1999 through 2001 by $12.8 million, and to deny foreign tax credits of $2.9 million in the aggregate. The tax liability resulting from these proposed adjustments will be offset with foreign tax credit carryovers and other refund claims, and therefore should not result in a material future cash payment, pending final review by the Joint Committee on Taxation. The effect of the adjustments to current and deferred taxes has been reflected in the consolidated financial statements for periods covered by the 2004 Restatement.

      During 2006, the IRS will commence an audit of our U.S. federal income tax returns for the years 2002 through 2004. While we expect that the upcoming IRS audit will be similar in scope to the recently completed examination, the upcoming audit may be broader. Furthermore, the preliminary results from the audit of 1999 through 2001 are not indicative of the future result of the audit of 2002 through 2004. The audit of 2002 through 2004 may result in additional tax payments by us, the amount of which may be material, but will not be known until that IRS audit is finalized.

      In the course of the IRS audit of 1999 through 2001, we have identified recordkeeping and other material internal control weaknesses, which caused us to incur significant expense to substantiate our tax return items and address information and document requests made by the IRS. We expect to incur similar expense with respect to the upcoming IRS audit of the years 2002 through 2004.

      Due to the recordkeeping issues referred to above, the IRS has issued a Notice of Inadequate Records for the years 1999 through 2001, and may issue a similar notice for the years 2002 through 2004. While the IRS has agreed not to assess penalties for inadequacy of records with respect to the years 1999 through 2001, no assurances can be made that the IRS will not seek to assess such penalties or other types of penalties with respect to the years 2002 through 2004. Such penalties could result in a material impact to the consolidated results of operations.

      During the past two years, following resignations of several of our senior executives, we hired Lewis M. Kling as our Chief Operating Officer and subsequently appointed him as our Chief Executive Officer, hired Mark A. Blinn as our Chief Financial Officer, Richard J. Guiltinan, Jr. as our Controller and Chief Accounting Officer, Deborah K. Bethune as our Vice President of Taxes, Thomas L. Pajonas as our President of our Flow Control Division, Linda P. Jojo as Vice President and Chief Information Officer, and Joseph R. Pinkston, as our Vice President of Human Resources, appointed Mark D. Dailey as our Chief Compliance Officer and Paul W. Fehlman as our Treasurer, and created and staffed new positions responsible for accounting policy and procedures, financial reporting, tax compliance and internal audit. To promote continuity of senior management, in March 2005 our Board of Directors approved a Transitional Executive Security Plan, which provides cash and stock-based incentives to key management personnel to remain employed by us for the near term. As a result of this plan, we recorded additional compensation expenses in 2005 of approximately $3 million. See “Transitional Executive Security Plan” in “Item 11. Executive Compensation” of this Annual Report for a detailed discussion on this plan.

      During 2005, we made a number of modifications to our stock plans, including the acceleration of certain restricted stock grants and outstanding options, as well as the extension of the exercise period associated with certain outstanding options. These modifications resulted from severance agreements with former executives and from our decision to temporarily suspend option exercises. As a result of the modifications, we recorded additional compensation expenses in 2005 of approximately $7 million based upon the intrinsic values of the awards, primarily related to severance agreements with former executives, on the dates the modifications were made.

      As a result of the severance and executive search payments related to the management changes of approximately $2 million, expenses under the Transitional Executive Security Plan described above and stock

compensation expense resulting from the modification of our stock option plans described above, we recorded total incremental compensation expense of approximately $12 million in 2005.

      On June 1, 2005, we took action to extend to December 31, 2006, the regular term of certain options granted to employees, including executive officers, qualified retirees and directors, which were scheduled to expire in 2005. Subsequently, we took action on November 4, 2005, to extend the exercise date of these options, and options expiring in 2006, to January 1, 2009. We thereafter concluded, however, that recent regulatory guidance issued under section 409A of the Internal Revenue Code might cause the recipients’ extended options to become subject to unintended adverse tax consequences under section 409A. Accordingly, effective December 14, 2005, the Organization and Compensation Committee of the Board of Directors partially rescinded, in accordance with the regulations, the extensions of the regular term of these options, to provide as follows:

      These extensions are subject to our shareholders approving certain applicable plan amendments at our next annual shareholder’s meeting, tentatively scheduled for April 2006. If shareholders do not approve the plan amendments as currently posed in our proxy statement, these extension actions will become void. If such plan amendments are approved at our next annual shareholder meeting, the extensions will be considered as a stock modification for financial reporting purposes subject to the recognition of a non-cash compensation charge in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 123(R), “Share-Based Payment”. Our actual charge will be contingent upon many factors, including future share price volatility, risk free interest rate, option maturity, strike price, share price and dividend yield.

      The earlier extension actions also extended the option exercise period available following separation from employment for reasons of death, disability and termination not for cause or certain voluntary separations. These separate extensions were partially rescinded at the December 14, 2005, meeting of the Organization and Compensation Committee of the Board of Directors, and as so revised are currently effective and not subject to shareholder approval. The exercise period available following such employment separations has been extended to the later of (i) 30 days after the options first became exercisable when our SEC filings have become current and an effective SEC Form  S-8 Registration Statement has been filed with the SEC, or (ii) the period available for exercise following separation from employment under the terms of the option as originally granted. This extension is considered for financial reporting purposes as a stock modification subject to the recognition of a non-cash compensation change in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” of approximately $1 million in 2005. The extension of the exercise period following separation from employment does not apply to option exercise periods governed by a separate separation contract or agreement.

      In the third quarter of 2005, we refinanced our 12.25% Senior Subordinated Notes and indebtedness outstanding under our then existing credit facilities with the proceeds of borrowings under our new credit facilities. Further, we replaced the letter of credit agreement that guaranteed our European Investment Bank (“EIB”) credit facility with a letter of credit facility issued as part of the new credit facilities. The new credit facilities are comprised of a term loan of $600 million expiring in 2012 and a $400 million revolving line of credit, which can be utilized to provide up to $300 million in letters of credit, expiring in 2010, hereinafter collectively referred to as the “New Credit Facilities.” We recorded a total loss on extinguishment of approximately $27 million in 2005. As a result of the refinancing and based on the current interest rate

structure and amounts borrowed, we expect to reduce our interest expense by more than $20 million on an annual basis. For additional information on our New Credit Facilities, see the “Liquidity and Capital Resources” section of this Management’s Discussion and Analysis and Note 12 to our consolidated financial statements included in this Annual Report.

      In October 2004, one of our wholly owned subsidiaries entered into an accounts receivable securitization whereby we could obtain up to $75 million in financing by securitizing certain U.S.-based receivables with a third party. Our subordinate interest in receivables sold was $83.5 million at December 31, 2004. In October 2005, we terminated this accounts receivable securitization facility. In connection with the termination, we borrowed approximately $48 million under our New Credit Facilities to repurchase our receivables then held by such third party. See the “Liquidity and Capital Resources” section of this Management’s Discussion and Analysis and Note 12 to our consolidated financial statements included in this Annual Report for further discussion on our securitization arrangement.

      In the first quarter of 2005, we made a definitive decision to sell certain non-core service operations, collectively called the General Services Group (“GSG”) and engaged an investment banking firm to commence marketing. As a result, we reclassified the operation to discontinued operations in the first quarter of 2005. Sales for GSG were $116 million in 2004. Total assets at December 31, 2004 ascribed to GSG were approximately $63 million. We performed an impairment analysis of long-lived assets on a held and used basis, and concluded that no impairment was warranted as of December 31, 2004. GSG was sold on December 31, 2005 for approximately $16 million in gross cash proceeds, subject to final working capital adjustments, while retaining approximately $12 million of net accounts receivable. We used approximately $11 million of the net cash proceeds to reduce our outstanding indebtedness. In 2005, we recorded an impairment loss of approximately $31 million related to GSG.

      In November 2004, we sold our Government Marine Business Unit (“GMBU”), a business within our Flowserve Pump Division, to Curtiss-Wright Electro-Mechanical Corporation for approximately $28 million, generating a pre-tax gain of $7.4 million after the allocation of approximately $8 million in goodwill and $1 million in intangible assets. GMBU, which provided pump technology and service for U.S. Navy submarines and aircraft carriers, did not serve our core market and represented a small part of our total pump business. We used net proceeds from the disposition of GMBU to reduce our outstanding indebtedness. As a result of this sale, we have presented the assets, liabilities and results of operations of GMBU as discontinued operations for all prior periods included.

      In March 2004, we acquired the remaining 75% interest in Thompson, Kelly & Lewis Pty. Ltd. (“TKL”) for approximately $12 million. TKL is a leading Australian designer, manufacturer and supplier of centrifugal pumps, railway track work products and steel castings. Prior to the acquisition, we held a 25% interest in TKL. As a result of this acquisition, we strengthened our product offering in the mining industry, broadened our manufacturing capacity in the Asia Pacific region and gained foundry capacity. TKL had total assets of approximately $24 million at the time of this acquisition and sales of approximately $36 million in 2003.

BUSINESS OVERVIEW

      We believe that we are a world leading manufacturer and aftermarket service provider of comprehensive flow control systems. We develop and manufacture precision-engineered flow control equipment, such as pumps, valves and seals, for critical service applications that require high reliability. We use our manufacturing platform to offer a broad array of aftermarket equipment services, such as installation, advanced diagnostics, repair and retrofitting.

      We conduct our operations through three business segments:

      Our product portfolio is built on over 50 well-respected brand names, such as Durco, IDP, Valtek and Durametallic, which we believe is the most comprehensive in the industry. We sell our products and services to more than 10,000 companies, including some of the world’s leading engineering and construction firms, original equipment manufacturers (“OEMs”), distributors and end users.

      Our products and services are used in several distinct industries: oil and gas, chemical, power generation, water treatment and several other industries that we collectively refer to as general industries.

      Demand for most of our products depends on the level of new capital investment and maintenance expenditures by our customers. The level of capital expenditures by our customers depends, in turn, on the general economic conditions and conditions in their industries, which affect their profitability. The level of capital expenditures by our customers also depends on their liquidity, whether through cash flows from operations or access to financing.

      The oil and gas industry represented approximately 32% of our sales in 2004. High petroleum prices generally spur additional investment in upstream petroleum projects, and high prices in 2004 contributed to an increase in bookings for projects, particularly in Asia, Africa and South America. In the Middle East, however, the Iraq war and the post-war unrest softened the level of capital investments and demand for our products and services, notwithstanding the historically high crude oil prices. In contrast to their effect on the upstream petroleum projects, high crude oil prices often reduce the demand for our products and services from crude oil refineries and natural gas processors as they seek to take advantage of favorable refining margins by operating at high levels of capacity utilization and deferring maintenance. Clean fuel regulations, particularly in the U.S., led to some project business from crude oil refiners. The profitability of such projects, however, is typically lower than for maintenance related products and services.

      While high oil and gas prices are generally good for our oil and gas customers, they are generally adverse for chemical companies, since crude oil and natural gas are critical inputs in the manufacturing of their products. In 2004, the price of natural gas in the U.S. increased almost 25% from 2003. This significantly affected our chemical customers, who faced high feed stock costs. However, greater global demand is allowing companies to pass through pricing and strengthen the global market. If the economy improves, and demand for chemical-based products increases, we expect to see some improvement in the demand for our products in the chemical industry. Further, this industry’s improved profitability could spur new investment in other parts of the world such as Asia, and we would expect to benefit from those investments as well. In 2004, the chemical industry represented approximately 18% of our sales.

      Increased natural gas prices also diminished the profitability of many power generators that in recent years made significant investments in power plants that generate electricity from natural gas. While they have been able to recover a portion of their higher costs through rate increases, their liquidity is still challenged due to overinvestment in these power facilities in recent years. However, a number of nuclear power generators are planning significant maintenance activities. We have seen an increase in our orders for this area and it has been a positive contributor to 2005 orders, sales and earnings. In addition, there are several coal-fired power plants planned for the U.S., and we are actively pursuing the flow control opportunities for these projects. The revenue opportunity for our products at a coal-fired plant typically can be three times that of a natural gas power plant. The power industry represented approximately 16% of our sales in 2004.

      Worldwide demand for fresh water and water treatment continues to create demand for new facilities or for upgrades of existing systems, many of which require products that we offer, especially pumps. We believe

that we are a global leader in the desalination market, which is an important source of fresh water in the Mediterranean area and the Middle East. This is a significant market for our pumps and valve actuation products. In 2004, the water market represented approximately 6% of our sales.

      General industries represents a variety of different businesses, including mining, pulp and paper, food and beverage, steel and heating, ventilation and air-conditioning (“HVAC”), none of which individually represents more than 5% of total sales in 2004. General industries represented approximately 28% of our sales in 2004. Some of these businesses, such as mining, pulp and paper and steel, appear to have experienced troughs in 2004. Other industries, such as food and beverage, were relatively stable. HVAC was somewhat weaker due to a decline in the commercial real estate market. In 2005, some of these businesses that are tied to the economic recovery, particularly mining, have shown improvement.

      Our customers include engineering contractors, OEMs, end users and distributors. Sales to engineering contractors and OEMs are typically for large project orders, as are certain sales to distributors. Project orders generally have lead times in excess of three months. Project orders provide product to our customers either directly or indirectly for their new construction projects or facility enhancement projects.

      The quick turnaround business, which we also refer to as the book and ship business, is defined as orders that are received from the customer (booked) and shipped within three months of receipt. They are typically for more standard products, parts or services. Each of our three segments generates this type of business.

      We use our manufacturing platform to offer a broad array of aftermarket equipment services, such as installation, advanced diagnostics, repair and retrofitting. Timelines of delivery, quality and the proximity of service centers are important considerations for our aftermarket products and services. In geographic regions where we are positioned to provide a quick response, customers have traditionally relied on us, rather than our competitors, for aftermarket products relating to our highly engineered and customized products. However, aftermarket competition for standard products has increased. Price competition tends to be more significant for OEMs than aftermarket services and generally has been increasing. In the sale of aftermarket products and services, we benefit from our large installed base of pumps and valves, which requires maintenance, repair and replacement parts.

      Our reporting of trends by product type, customer type and business type are based upon analytical review of individual operational results and our knowledge of their respective businesses, as we do not formally track revenues by any of these categories. These trends are analyzed as a secondary reporting mechanism that is not derived directly from our general ledger system.

      Our overarching objective is to grow our position as an integrated solutions provider in the flow control industry. Sustainable, profitable growth is being driven using six strategies that are communicated throughout our company. These strategies include: organic growth, globalization, process excellence, portfolio management, organizational capability and technology. The key elements of our strategies are outlined below.

      Organic growth is a key initiative to grow our revenues. Our goal is to grow revenues through the development of new products and services and customer partnering initiatives to maximize the capture of the aftermarket business.

      We seek to capture additional market share by creating “win-win” opportunities for us and our customers through sourcing and maintenance alliance programs pursuant to which we provide all or an agreed portion of a customers’ parts and servicing needs. Our customer alliances enable us to develop long-term professional relationships with our customers and serve as an effective platform for introducing new products and services to our customers and generating additional sales.

      We additionally seek to continue leveraging our substantial installed pump, seal and valve base to expand our aftermarket services business, as customers increasingly use third-party aftermarket service providers like

us to reduce their fixed costs and improve profitability. The aftermarket services business provides us with a steady source of revenues and cash flows at higher margins than original equipment sales and allows us to be in frequent contact with our customers, building our knowledge of customer needs and providing cross-selling opportunities. We have been installing Flow Solutions QRC’s globally to provide the immediate parts, service and technical support required to effectively manage and win the aftermarket business from our installed base.

      New product and service development is driven through our Product Management organization working in concert with engineering, operation and sales. Our goal is to increase our revenues from new products and services developed over the last five years. Our new product development process has made significant progress in demonstrating a pipeline of new and modified products and services. We expect our research and development costs to increase beginning in 2006 to support our goal of increased revenues from new products and services.

      The globalization initiative of our business has several facets that include:

      We believe there are attractive OEM opportunities in international markets, particularly in South America and Asia Pacific, and we intend to continue to leverage our global presence to further penetrate these markets. Our recent successes in these markets include contracts worth more than $40 million for the supply of pumps and related equipment to the Nanhai petrochemicals project in China, and contracts worth more than $12 million for the Shenhua coal liquefaction project in China. In our aftermarket services business, we seek to strategically add sites as our customers and our customer base grow in order to provide our customers with rapid response, fast delivery and onsite field repair.

      We are focused on shifting, as appropriate, certain of our manufacturing and engineering functions to, and increasing our supply of raw materials and components from, lower cost areas such as India, China, Mexico, South America and Eastern Europe. In 2004, these areas accounted for approximately 17% of our direct material spending, compared to approximately 5% in 2001. We are also focused on utilizing supply chain management to reduce our procurement costs, including by expanding purchases through raw material auctions, further consolidating and standardizing our purchasing to receive higher quantity-based discounts and creating procurement alliances.

      In addition, we have expanded our China presence with additional sales people, new management, and growth plans that include acquisition or development of new capabilities that will enhance the penetration of programs in China for oil and gas and power projects as well as provide a base for the export of products.

      The process excellence initiative encapsulates ongoing programs that include:

      We seek to increase our operational efficiency through our CIP initiative. It utilizes tools such as lean manufacturing, Six Sigma methodology and constraint management to improve quality and processes, reduce product cycle times and lower costs. Recognizing that our employees are our most valuable resource in

achieving our operational excellence goals, we have instituted broad CIP training, and to date over 800 of our employees are CIP certified or trained “black belts” or “green belts”, deployed on CIP projects throughout our company. As a result of our CIP initiatives, we have developed and implemented processes to shorten our engineering and manufacturing cycle times, improve on-time delivery and service response time, lower inventory levels and otherwise reduce costs. We have also experienced success in applying “best practices” achieved in any one of our businesses to our other businesses, and continue to look for opportunities to apply successful practices across our businesses.

      We seek to continue to improve our working capital utilization, with a particular focus on improving the management of our accounts receivable and inventory. See further discussion in the “Liquidity and Capital Resources” section of this Management’s Discussion and Analysis.

      The continued management of our portfolio of products and services is critical to our company’s success. We will continue to pursue selective acquisitions and rationalize our portfolio of products and services to ensure alignment with our shareholders and customers.

      We intend to continue to evaluate acquisition and investment opportunities as we seek to broaden our product portfolio and operational capabilities and to expedite our expansion into faster growing Asian, African and South American markets. In that regard, our additional investment in TKL in March 2004 strengthened our product offering in the mining industry and broadened our manufacturing capabilities in the Asia Pacific region, which includes China, Japan, Singapore, Korea, India, Australia, New Zealand and Thailand.

      We are seeking to divest operations that we consider non-core to our overall business, such as operations that do not serve our core customer base or provide limited synergies with our other businesses. For example, as discussed above, in November 2004 we sold GMBU and in December 2005 we sold GSG.

      There are several elements to building an enhanced organizational capability:

      A multi-year agreement with the LRN Company was completed in 2005 to distribute electronic learning packages in multiple languages for the Flowserve Business Code of Conduct and other compliance programs globally throughout our company. This will be expanded to include export compliance, and regulatory compliance (U.S. and foreign), as well as other programs around harassment and employee behaviors. The emphasis on ethics and compliance was significantly strengthened in 2005 as a core organizational capability with a new Chief Compliance Officer.

      In 2005, we installed a Learning Management System (“LMS”) that allowed the development and tracking of the delivery of electronic learning systems. This system allows us to track our employees’ compliance and policy understanding through electronic means. LMS also permits the on-line enrollment for customer training as a means to share and improve their intellectual capital.

      Additional initiatives aimed at change management are evidenced in such programs as our Standardization, Teamwork And Results (“STAR”) initiative. STAR is aimed at developing and implementing an

information systems architecture that will be employed over a multi-year period. It will upgrade older enterprise resource planning applications to enable standardization of our processes and controls.

      The infusion of new product technologies has become a core requirement as we look to improve the development of new products and services. Our internal goal is to improve the percentage of new products as a function of revenue over the next five years. The investment in technology will continue to increase in 2006. A cross-divisional technology council will ensure that the technologies developed are available for wide use across all divisions to maximize the investments.

      The development of an intelligent pumping system showcases the technologies available to maximize uptime and proactively identify anomalies before they become major issues. We were the sponsor for a national energy summit in 2005 that brought together major companies in the pursuit of energy management initiatives. The technologies available to decrease the energy usage for our customers are being infused into new services for customers.

LIQUIDITY AND CAPITAL RESOURCES

      Cash generated by operations and borrowings available under our existing revolving line of credit are our primary sources of short-term liquidity. Our sources of operating cash include the sale of our products and services and the reduction of our working capital, particularly accounts receivable and inventories. Our cash balance at December 31, 2004 was $63.8 million, compared to $53.5 million in 2003 and $49.0 million in 2002.

      The increase in cash flows provided by operating activities in 2004 primarily relates to a net reduction in working capital, primarily as a result of increases in accounts payable, accrued liabilities and retirement obligations and other liabilities. The decrease in cash flows provided by operating activities in 2003 as compared to 2002 primarily relates to pension contributions, income taxes and outflows related to the IFC integration. In 2003, contributions to U.S. pension plans were $27.0 million, compared with $4.6 million in 2002. We increased our pension contributions in 2003 as a result of an increase in the number of employees due to the acquisition of IFC and increased funding requirement due to the underperformance of underlying plan assets in 2002. Contributions to our U.S. pension plan were $15.3 million in 2004. In 2002, we also benefited from receipt of a $23.2 million U.S. income tax refund compared with $4.9 million received in 2003. Cash outflows related to the IFC integration were $27.2 million in 2003 compared with $19.3 million in 2002.

      Working capital reductions provided operating cash flow of $152.5 million in 2004, compared with $70.1 million in 2003 and $120.6 million in 2002. The reduction in working capital for 2004 reflects increases of $46.6 million in accounts payable due to deferred payment of invoices at year-end in 2004, and $32.1 million in accrued liabilities due primarily to an increase of approximately $44 million in the bonus accrual for 2004. The reduction in working capital for 2004 also reflects our continued emphasis on improving accounts receivable collections and reducing inventory. Accounts receivable reductions in 2004 generated $39.4 million of cash flow compared with $23.8 million of cash flow in 2003 and $67.8 million in 2002. The improvement in accounts receivable primarily reflects improved collections and the impact of the accounts receivable securitization of $48.7 million discussed below. In addition, incremental factoring of certain non-U.S.  receivables used $3.4 million in 2004, and contributed $15.5 million in 2003 and $32.1 million in 2002.

      Our goal for days’ sales receivables outstanding (“DSO”) is 60 days. For the fourth quarter of 2004, we achieved a DSO of 66 days as compared to 70 days for the same period in 2003. Including the effect of the securitization, DSO improved to 60 days at December 31, 2004. For reference purposes based on 2004 sales, an improvement of one day could provide approximately $8 million in cash. Inventory reductions contributed $25.5 million of cash flow for 2004 compared with $29.4 million of cash flow for 2003 and $36.4 million in 2002. The majority of the inventory reduction was in project-related work in process inventory required to support shipments of products in backlog, offset in part by an increase in raw materials. As a result of inventory reductions, inventory turns were 5.2 times at December 31, 2004, compared with 4.5 times and 4.4 times at December 31, 2003 and 2002 respectively. For reference purposes based on 2004 data, an improvement of one turn could yield approximately $65 million in cash.

      Cash outflows for investing activities were $14.1 million and $26.6 million in 2004 and 2003, respectively, due primarily to capital expenditures. Cash outflows of $557.2 million in 2002 primarily represent the acquisition of IFC for $535 million, net of cash acquired.

      Cash outflows for financing activities were $250.6 million in 2004 compared with $162.8 million in 2003 and with inflows of $327.6 million in 2002. The change in 2004 results primarily from increased mandatory

repayments of long-term debt triggered by the GMBU divestiture, the issuance of the EIB credit facility and accounts receivables securitization. The change in 2003 results from the absence of equity offerings in 2003 as compared with 2002.

      Our cash needs for the next 12 months are expected to be substantially similar to 2004, except for a decrease in debt payments required under our New Credit Facilities partially offset by an increase in pension contributions. We believe cash flows from operating activities, combined with availability under our revolving line of credit and our existing cash balances, will be sufficient to enable us to meet our cash flow needs for the next 12 months. However, cash flows from operations could be adversely affected by economic, political and other risks associated with sales of our products, operational factors, competition, fluctuations in foreign exchange rates and fluctuations in interest rates, among other factors. We believe that cash flows from operating activities and our expectation of continuing availability to draw upon our revolving credit agreements are also sufficient to meet our cash flow needs for the periods exceeding the next 12 months.

      We generated $6.8 million and $16.9 million of cash flow related to the exercise of employee stock options in 2004 and 2002, respectively, which is reflected in financing activities of the consolidated statement of cash flows. Amounts generated from the exercise of employee stock options in 2003 were not significant.

      On May 2, 2002, we completed our acquisition of IFC for a contractual purchase price of $535 million, subject to adjustment pursuant to the terms of the purchase and sale agreement. A reduction of $2.2 million was agreed to and settled during the fourth quarter of 2003, which yielded a final contractual purchase price of $532.8 million. The reduction related to the finalization of balances at the date of acquisition for cash, related party activity and tax payments. In addition, we incurred $6.1 million of costs associated with consummation of the acquisition, including investment banking, legal, actuarial and accounting fees. The total purchase price including such costs was $538.9 million. After acquiring IFC, one of the world’s foremost manufacturers of valves, actuators and associated flow control products, we believe that we are the world’s second largest manufacturer of valves. We financed the acquisition and associated transaction costs by issuing 9.2 million shares of common stock in April 2002 for net proceeds of approximately $276 million and through new borrowings under our senior secured credit facilities.

      The purchase price was allocated to assets acquired and liabilities assumed based on estimated fair value at the date of the acquisition. We substantially completed the purchase price allocation of IFC during 2003 and expect no further revisions. These final allocations included $45 million for amortizable intangibles, $25 million of indefinite lived intangible assets and $304 million recorded as goodwill.

      The operating results of IFC have been included in the consolidated statements of operations from May 2, 2002, the date of acquisition.

      We regularly evaluate acquisition opportunities of various sizes. The cost and terms of any financing to be raised in conjunction with any acquisition, including our ability to raise economical capital, is a critical consideration in any such evaluation.

      In March 2004, we acquired the remaining 75% interest in TKL for approximately $12 million. We paid for the acquisition with cash generated by operations. Prior to the acquisition, we held a 25% interest in TKL. As a result of this acquisition, we strengthened our product offering in the mining industry, broadened our manufacturing capacity in the Asia Pacific region and gained foundry capacity.

      Capital expenditures were funded primarily by operating cash flows and, to a lesser extent, by bank borrowings. For each of the three years, capital expenditures were invested in new and replacement machinery and equipment, information technology and acquisition integration activities, including structures and equipment required at receiving facilities. In each year, capital expenditures were less than depreciation expense due to excess capacity and the upgrading of equipment through integration processes. Capital expenditures in 2004 include approximately $5 million for the purchase of a building we previously leased for the manufacture of valves. In 2005, our capital expenditures focused on new product development, information technology infrastructure and cost reduction opportunities and are expected to be approximately $45 million to $50 million. Certain of our facilities may face capacity constraints in the foreseeable future, which may lead to higher capital expenditure levels.

      Debt, including capital lease obligations, consisted of:

      On August 8, 2000, we entered into senior credit facilities comprised of a $275.0 million Tranche A term loan, a $475.0 million Tranche B term loan and a $300.0 million revolving line of credit, hereinafter collectively referred to as our “2000 Credit Facilities.” In connection with our acquisition of IFC in May 2002, we amended and restated our 2000 Credit Facilities to provide for (1) an incremental $95.3 million Tranche A term loan and (2) a $700.0 million Tranche C term loan. The proceeds of the incremental Tranche A term loan and the Tranche C term loan were used to finance a portion of the acquisition purchase price and to repay in full the Tranche B term loan.

      Borrowings under our 2000 Credit Facilities bore interest at a rate equal to, at our option, either (1) the base rate (which was based on the prime rate most recently announced by the administrative agent under our 2000 Credit Facilities or the Federal Funds rate plus 0.50%) or (2) London Interbank Offered Rate (“LIBOR”), plus, in the case of Tranche A term loan and loans under the revolving line of credit, an applicable margin determined by reference to the ratio of our total debt to consolidated EBITDA, and, in the case of Tranche C term loan, an applicable margin based on our long-term debt ratings.

      On August 12, 2005, we entered into New Credit Facilities comprised of a $600.0 million term loan maturing on August 10, 2012 and a $400.0 million revolving line of credit, which can be utilized to provide up to $300.0 million in letters of credit, expiring on August 12, 2010. We used the proceeds of borrowings under our New Credit Facilities to refinance our 12.25% Senior Subordinated Notes and indebtedness outstanding under our 2000 Credit Facilities. Further, we replaced the letter of credit agreement that guaranteed our EIB credit facility (described below) with a letter of credit issued as part of the New Credit Facilities.

      Borrowings under our New Credit Facilities bear interest at a rate equal to, at our option, either (1) the base rate (which is based on greater of the prime rate most recently announced by the administrative agent under our New Credit Facilities or the Federal Funds rate plus 0.50%) or (2) LIBOR plus an applicable margin determined by reference to the ratio of our total debt to consolidated EBITDA, which as of September 30, 2005 was 1.75% for LIBOR borrowings.

      On April 14, 2004, we and one of our European subsidiaries, Flowserve B.V., entered into an agreement with EIB, pursuant to which EIB agreed to loan us up to € 70 million, with the ability to draw funds in multiple currencies, to finance in part specified research and development projects undertaken by us in Europe. Borrowings under the EIB credit facility bear interest at a fixed or floating rate of interest agreed to by us and EIB with respect to each borrowing under the facility. Loans under the EIB credit facility are subject to mandatory prepayment, at EIB’s discretion, upon the occurrence of certain events, including a change of control or prepayment of certain other indebtedness. In addition, the EIB credit facility contains covenants that, among other things, limit our ability to dispose of assets related to the financed project and require us to deliver to EIB our audited annual financial statements within 30 days of publication. In August 2004, we borrowed $85 million at a floating interest rate based on 3-month U.S. LIBOR that resets quarterly. As of December 31, 2004, the interest rate was 2.39%. The maturity of the loan is June 15, 2011, but may be repaid at any time without penalty.

      Additional discussion of our 2000 Credit Facilities, New Credit Facilities, and EIB credit facility is included in Note 12 to our consolidated financial statements, included in this Annual Report.

      We have entered into interest rate and currency swap agreements to hedge our exposure to cash flows related to the credit facilities discussed above. These agreements are more fully described in “Item 7A. Quantitative and Qualitative Disclosures about Market Risk.”

      In 2000, we issued a principal amount of $290 million U.S. dollar tranche and € 100 million Euro tranche of our 12.25% Senior Subordinated Notes, with an original issue discount resulting in a 12.50% yield. In 2001, we repurchased $101.5 million of the US dollar tranche notes and € 35.0 million of the Euro tranche notes with the proceeds of an equity offering. As discussed above, in the third quarter of 2005 we repaid all of the remaining Senior Subordinated Notes, together with accrued interest thereon and a prepayment penalty, using the proceeds of borrowings under our New Credit Facilities.

      The following summarizes our repayment of indebtedness obligations under our 2000 Credit Facilities:

      Under our 2000 Credit Facilities, we were required to use the proceeds of asset sales and new debt issuance, among other things, to pay down the principal amount outstanding. In addition to mandatory repayments, we made optional prepayments of principal from excess cash generated from operations. Further, under our 2000 Credit Facilities, we were required to use a portion of our excess cash flow generated from operations during any fiscal year to repay term loans outstanding thereunder. Based on the annual calculations performed as of December 31, 2004, 2003 and 2002, no repayments were due with respect to excess cash flow for the years then ended due to the high level of optional debt prepayment during the respective years.

      The loans under our New Credit Facilities are subject to mandatory repayment with, in general:

      We may prepay loans under our New Credit Facilities in whole or in part, without premium or penalty.

      We incurred $9.3 million in fees related to the new facilities, of which $0.3 million were expensed in 2005. Prior to the refinancing, we had $11.8 million of unamortized deferred loan costs related to the 2000 Credit Facilities and the Senior Subordinated Notes. Based upon the final syndicate of financial institutions for the New Credit Facilities, we expensed $10.5 million of these unamortized deferred loan costs in 2005. In addition to the total loan costs of $10.8 million that were expensed, we recorded a charge of $16.5 million for premiums paid to call the Senior Subordinated Notes, for a total loss on extinguishment of $27.3 million recorded in 2005. The remaining $9.0 million of fees related to the new facilities were capitalized and combined with the remaining $1.3 million of previously unamortized deferred loan costs for a total of $10.3 million in deferred loan costs included in other assets, net. These costs will be amortized over the term of the New Credit Facilities.

      In October 2004, Flowserve US Inc., one of our wholly owned subsidiaries, and Flowserve Receivables Corporation (“FRC”), a wholly owned subsidiary of Flowserve US Inc., entered into a receivables purchase agreement (“RPA”) with two third party financial institutions whereby FRC could obtain up to $75 million in financing on a revolving basis by securitizing certain U.S.-based trade receivables.

      To obtain financing, Flowserve US Inc. transferred eligible receivables to FRC, which was formed solely for this accounts receivable securitization program. Pursuant to the RPA, FRC then sold undivided purchaser interests in these receivables to the third party financial institutions. Flowserve US Inc. continued to service the receivables for a servicing fee of 0.5% of the average net receivable balance. No servicing liability was recognized at December 31, 2004 because the amount was immaterial due to the short term average collection period of the securitized receivables. FRC has no recourse against Flowserve US Inc. for failure of the debtors to pay when due. As of December 31, 2004, FRC had secured $60 million in financing under the program. The proceeds were used to repay $16 million and $44 million of Tranche A and Tranche C bank term loans, respectively, outstanding under our 2000 Credit Facilities. At the time the purchaser interests were sold, $48.7 million of the receivables transferred to FRC were removed from FRC’s financial statements, and FRC further recorded short-term debt of $11.3 million. Borrowings under the RPA in excess of $11.3 million are excluded from our debt balance as presented in the consolidated balance sheets, but included for purposes of covenant calculations under the 2000 Credit Facilities.

      On October 31, 2005, we terminated the RPA. In connection with this, we borrowed approximately $48 million under our New Credit Facilities and repurchased outstanding receivable interests from the third

party financial institutions. See additional discussion of our accounts receivable securitization program in Note 12 to our consolidated financial statements included in this Annual Report.

      Through our European subsidiaries, we engage in non-recourse factoring of certain accounts receivable. The various agreements have different terms, including options for renewal and mutual termination clauses. Under our 2000 Credit Facilities, such factoring was generally limited to $50 million, based on due date of the factored receivables. The limit on factoring was raised to $75 million under the New Credit Facilities entered into in August 2005. See additional discussion of our accounts receivable factoring program in Note 6 to our consolidated financial statements included in this Annual Report.

      Our 2000 Credit Facilities that have now been refinanced, the letter of credit facility guaranteeing our obligations under the EIB credit facility, and the agreements governing our domestic receivables program each required us to deliver to creditors thereunder our audited annual consolidated financial statements within a specified number of days following the end of each fiscal year. In addition, the indentures governing our 12.25% Senior Subordinated Notes required us to timely file with the SEC our annual and quarterly reports. As a result of the 2004 Restatement and the new obligations regarding internal controls attestation under Section 404, we did not timely issue our financial statements for the year ended December 31, 2004 and the quarterly periods ended June 30, 2004, September 30, 2004, March 31, 2005, June 30, 2005 and September 30, 2005, and were unable to timely file with the SEC our Annual Report on Form  10-K and Quarterly Reports on Form  10-Q for such periods. Prior to the refinancing of our 2000 Credit Facilities and the replacement of the standby letter of credit facility, we obtained waivers thereunder extending the deadline for the delivery of our financial statements to the lenders under our 2000 Credit Facilities and the letter of credit facility guaranteeing the EIB credit facility and, as a result of such waivers, were not in default due to the delay in the delivery of our financial statements. We did not seek or obtain a waiver under the indentures governing our 12.25% Senior Subordinated Notes with respect to our inability to timely file with the SEC the required reports and, prior to the refinancing of our 12.25% Senior Subordinated Notes, were in default thereunder. However, our debt is properly classified as non-current in our balance sheet as we have demonstrated our ability and intent to obtain new long-term credit facilities in August 2005.

      We have determined, utilizing our restated financial information, that on multiple occasions we did not comply with some of the financial covenants in our 2000 Credit Facilities, which are no longer in effect. We believe that we could have undertaken readily available actions to maintain compliance or obtained a waiver or amendment to the 2000 Credit Facilities had the new restated results then been known. We have complied with all other non-financial covenants under our 2000 Credit Facilities. We believe that these covenant violations have no impact on our New Credit Facilities and that the amounts outstanding under the 2000 Credit Facilities are properly classified in our consolidated balance sheet.

      Our New Credit Facilities contain covenants requiring us to deliver to lenders leverage and interest coverage financial covenants and our audited annual and unaudited quarterly financial statements. Under the leverage covenant, the maximum permitted leverage ratio steps down beginning with the fourth quarter of 2006, with a further step-down beginning with the fourth quarter of 2007. Under the interest coverage covenant, the minimum required interest coverage ratio steps up beginning with the fourth quarter of 2006, with a further step-up beginning with the fourth quarter of 2007. Compliance with these financial covenants under our New Credit Facilities is tested quarterly, and we have complied with the financial covenants as of September 30, 2005. Delivery of the December 31, 2004 audited consolidated financial statements is required by December 31, 2005 and delivery of the December 31, 2005 audited financial statements by May 30, 2006. We have received a waiver from our lenders to deliver the December 31, 2004 audited financial statements by February 28, 2006. Further, we are required to furnish within 50 days of the end of each of the first three quarters of each year our consolidated balance sheet, and related statements of operations, shareholders’ equity and cash flows.

      Our New Credit Facilities also contain covenants restricting our and our subsidiaries’ ability to dispose of assets, merge, pay dividends, repurchase or redeem capital stock and indebtedness, incur indebtedness and guarantees, create liens, enter into agreements with negative pledge clauses, make certain investments or acquisitions, enter into sale and leaseback transactions, enter into transactions with affiliates, make capital expenditures, engage in any business activity other than our existing business or any business activities reasonably incidental thereto. With the waiver for delivery of the December 31, 2004 audited financial statements, we are currently in compliance with all debt covenants under the New Credit Facilities.

COMMON STOCK OFFERINGS

      During 2002, we financed the acquisition of IFC and associated transaction costs with a combination of bank financing and net proceeds of approximately $276 million received from the issuance of 9.2 million shares of common stock during April 2002.

      The following table presents a summary of our commercial commitments at December 31, 2004:

      We expect to satisfy these commitments through performance under our contracts.

PENSION AND POSTRETIREMENT BENEFITS OBLIGATIONS

      Our pension plans and postretirement benefit plans are accounted for using actuarial valuations required by SFAS No. 87, “Employers’ Accounting for Pensions,” and SFAS No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions.” We consider accounting for retirement plans critical because management is required to make significant subjective judgments about a number of actuarial assumptions, including discount rates, salary growth, long-term return on plan assets, retirement, turnover, health care cost trend rates and mortality rates. Depending on the assumptions and estimates used, the pension and postretirement benefit expense could vary within a range of outcomes and have a material effect on reported earnings. In addition, the assumptions can materially affect accumulated benefit obligations and future cash funding.

      We and certain of our subsidiaries have defined benefit pension plans and defined contribution plans for regular full-time and part-time employees. The defined benefit pension plan in the U.S. is the Flowserve Corporation Pension Plan and the defined contribution plan is the Flowserve Corporation Retirement Savings Plan.

      Approximately 64% of total defined benefit pension plan assets and 55% of benefit obligations are related to the U.S. plan as of December 31, 2004. The assets for the U.S. plan are held in a single trust with a common asset allocation. Unless specified otherwise, the references in this section are to total plans (i.e., the U.S. plan together with international plans).

      Benefits under our defined benefit pension plans are based primarily on years of credited service and on participants’ compensation. Assets under our defined benefit plans consist primarily of equity and fixed-income securities. At December 31, 2004, the fair market value of plan assets for our defined benefit plans increased to $276.3 million from $233.0 million at December 31, 2003. Assets were allocated as follows:

      The projected benefit obligation for our defined benefit pension plans was $488.7 million and $420.3 million as of December 31, 2004 and 2003, respectively.

      None of our common stock is directly held by these plans.

      We sponsor defined benefit postretirement health care plan covering most current retirees and a limited number of future retirees in the U.S. This plan provides for medical and dental benefits and is administered through insurance companies. We fund the plan as benefits are paid, such that the plans hold no assets in any period presented. Accordingly, we have no investment strategy or targeted allocations for plan assets. The benefits under the plan are not available to new employees or most existing employees.

      The accumulated postretirement benefit obligation for our defined benefit postretirement health care plan was $88.7 million and $92.2 million as of December 31, 2004 and 2003, respectively.

      Consistent with the requirements of SFAS No. 87, we account for pension benefits using the accrual method, recognizing pension expense before the payment of benefits to retirees. The accrual method of

accounting for pension benefits necessarily requires actuarial assumptions concerning future events that will determine the amount and timing of the benefit payments.

      Our key assumptions used in calculating our cost of pension benefits are the discount rate, the rate of compensation increase, and the expected long-term rate of return on plan assets. We, in consultation with our actuaries, evaluate the key actuarial assumptions and other assumptions used in calculating the cost of pension benefits, such as discount rate, expected return on plan assets for funded plans, life expectancy of participants and assumed rate of wage increases, and determine such assumptions on December 31 of each year to calculate liability information as of that date and pension expense for the following year. Depending on the assumptions used, the pension expense could vary within a range of outcomes and have a material effect on reported earnings. In addition, the assumptions can materially affect accumulated benefit obligations and future cash funding. Actual results in any given year may differ from those estimated because of economic and other factors.

      The assumed discount rate used for determining future pension obligations is based on indices of AA-rated corporate bonds, except for two foreign locations which use government bonds. The assumed rate of compensation increase used for determining future pension obligations reflects an estimate of the change in actual future compensation levels due to general price levels, productivity, seniority and other factors.

      In 2004, net pension expense for our defined benefit pension plans included in income from continuing operations was $22.9 million compared to $20.0 million in 2003 and $14.2 million in 2002. The postretirement benefit expense for the postretirement health care plan was $3.8 million in 2004 compared to $4.1 million in 2003 and $5.5 million in 2002.

      The following are assumptions related to our defined benefit pension plans for the year ended December 31, 2004:

      The following provides a sensitivity analysis of alternative assumptions on the U.S. qualified and aggregate non-U.S.  pension plans and U.S. postretirement plans.

      Effect of Discount Rate Changes and Constancy of Other Assumptions:

      Effect of Changes in the Expected Return on Assets and Constancy of Other Assumptions: