July 2 - Fitch Ratings has upgraded Flowserve Corporation's (Flowserve) Issuer Default Rating (IDR) and senior secured bank facilities to 'BBB-' from 'BB+'. The Rating Outlook is revised to Positive from Stable. Approximately $719 million debt is affected by the rating action. The rating upgrade reflects improved clarity surrounding Flowserve's financial policies following the company's recent adoption of an updated capital structure strategy. The strategy includes a target range for leverage, defined as gross debt to EBITDA of 1.0x - 2.0x. Leverage was 0.7x at March 31, 2012 which is lower than most other 'BB+' peers. Fitch's previous 'BB+' rating for Flowserve incorporated Fitch's view that Flowserve could potentially move toward a more aggressive financial strategy involving a material increase in leverage. Under Flowserve's updated capital structure strategy, leverage can be expected to increase, partly reflecting plans to accelerate the return of capital to shareholders through a new share repurchase program. However, Fitch believes the risk of a sustained increase in leverage above 2.0x is lower than in the past. At the current 'BBB-' rating, Flowserve's target leverage would still be considered somewhat low, but other considerations constrain the ratings including cyclicality in Flowserve's long cycle infrastructure markets that can occasionally pressure operating cash flow, and concerns about global economic trends. The current ratings and outlook take into account the company's newly drawn $250 million term loan; $300 million accelerated share repurchase program; and the board's approval to repurchase up to additional $700 million worth of common shares over the next several years. Fitch notes that the company has a financial flexibility in issuing additional debt before leverage increases to the 2.0x level. As Flowserve adjusts its capital structure, Fitch may eventually consider an upgrade depending on where leverage and other credit metrics stabilize and depending on the company's future cash deployment, operating margins, and competitive position. A negative rating action is unlikely but may be considered if Flowserve significantly exceeds its leverage target by making a large debt-funded acquisition or by debt-funding share repurchases in addition to the announced $1 billion program. The ratings are supported by Flowserve's strong operating performance including historically positive free cash flow (FCF); good liquidity; growth opportunities across all segments of the company; more than one third of revenues from the higher margin and more stable aftermarket business; well-funded pension liabilities for the qualified U.S. pension plans; and a sizable backlog. In addition, Fitch notes Flowserve's technological capabilities, global presence and aftermarket services which give the company a good product diversification and a strong competitive position. Flowserve generated approximately $41 million FCF in 2011, down from $190 million in 2010. The lower FCF was largely driven by an increase in working capital as the company reported higher inventory and receivables (AR) due to higher orders and an increase in the past due backlog, although Flowserve decreased its past due backlog during the first quarter of 2012. The high AR balance was also affected by extended AR terms on long cycle projects booked during the 2009 - 2010 economic recession and is expected to decrease as the company delivers these projects. The company generated negative $154 million FCF during the first quarter of 2012, however its operating cash flow is seasonal and historically, the company has produced consistently positive FCF on annual basis, averaging $200 million over the past five years. Fitch expects Flowserve to generate from $250 Million to $350 million FCF annually over the next several years driven by improvements in working capital and higher sales in all of its segments. Fitch expects the company's annual operating cash flows to support moderately-sized acquisitions; increasing capital expenditures; growth in dividend payout; and sizable share repurchases. The company contributed $27.0 million to domestic and foreign qualified pension plans in 2011 and expects to contribute approximately $20 million to $25 million to U.S. pension plans and approximately $10 million to foreign plans. The net underfunded status of Flowserve's plans was $164 million ($37 million in the U.S.; $126 million outside the U.S.) at the end of 2011. Gross pension obligations totaled $659 million, with U.S. obligations accounting for $387 million (90% funded) as of December 31, 2011. Many of the Non U.S. defined plans are unfunded in accordance to local regulations; however they are long term liabilities and Fitch does not expect this to be a major cash outlay for the company in the near future. Much of the deterioration in the funded status of the plans was attributable to lower discount rates. Rating concerns include Flowserve's cash deployment which focuses on share repurchases and possible acquisitions; declining margins due to higher raw material costs and the impact of project delays; seasonal cash generation; heavy cash requirements to support large swings in working capital; and competitive pricing pressure throughout the industry. Fitch expects Flowserve's revenues to increase by the mid-single digits in 2012 due to improving demand in the industrial and utility end markets. Margin should remain depressed over the next several quarters before rebounding in late 2012 or early 2013 driven by the deliveries of the lower margin past due backlog and slight unfavorable sales mix shift from aftermarket to original equipment. During the first quarter of 2012, FLS's revenues grew approximately 7.8%, reflecting growth in most of its end markets. Economic weakness and challenging financial markets in Europe are not expected to have a material impact on the company's performance. At March 31, 2012, liquidity was comprised of $173 million of cash and a $346 million available in $500 million bank revolving credit facility that matures in 2015. A large portion of Flowserve's cash is invested outside the U.S. and the company does not plan to repatriate any funds that may result in adverse tax payments. The company has a conservative debt structure, with no significant maturities scheduled before 2015. Fitch upgrades Flowserve's ratings as follows: --IDR to 'BBB-' from 'BB+'; --Senior secured bank facilities to 'BBB-' from 'BB+'. The Rating Outlook is Positive.