Flowserve Corporation (FLS) Earnings Call Transcript & Summary

Okay. Next up, we have Flowserve. Flowserve is a world-leading manufacturer and aftermarket service provider of comprehensive flow control systems. The company has 131 million shares outstanding. The stock trades around $42, $5.4 billion market cap, $700 million net debt, $26 million of minority interest, $6.2 billion total enterprise value. Joining us today is Mr. Scott Rowe, President and CEO. Thanks, Scott.

All right. Thank you, Brett. Welcome, everyone, and thank you for your interest in Flowserve today. We are also webcasting this and then for -- so just for those that are on the webcast, I just want to say thank you for joining us today. We're at the Gabelli Pump, Valve & Water Systems Symposium here in New York City. And then Brett, just want to say, personally, thank you for having me and letting me present today. And I think Mario stepped out, but to Mario as well in G.Research. We do appreciate the opportunity to come and present in front of investors and potential investors. So for today, I'm going to go through the slides really quickly. And I think Brett's got some prepared questions, but we would love to get questions from the audience. And so I'll probably do this in 10 minutes, and we'll keep 20 minutes for Q&A. So real quickly, here are some of the highlights at Flowserve. And just as background, I'm going into my -- I've been here just about 3 years at Flowserve. And we're definitely on a path of moving forward and transforming our organization. But if we step back first, we've got a long history. We've been doing flow control for over 225 years. It started with Simpson & Thompson and Worthington literally 225 years ago. And we've got an incredibly diversified group of products that are in pumps, valves and then mechanical seals, which is the barrier between a pump and the motor itself. We've restored and returned to growth, and so we've now been growing for over 3 years. After the industrial recession in 2015, we went down in '15 and '16, and now we've returned to growth. We also have a significant installed base, which drives 50% of our business and revenue comes from our aftermarket. And as you can imagine, that aftermarket is higher margin than the overall margins at Flowserve. And then we've been transforming the business since I've been here, and I'll go through that on one slide, but we've launched a formal transformation called Flowserve 2.0. We've completed 2 years of that, and we anticipate to go 1 more year with the formal transformation metric. And really, since 2017, we've now just start to unlock some of the value returning to growth. We've had margin expansion. Our returns are much higher. And I'll show you some of the progress that we're making there. And then also, we've got a disciplined, yet opportunistic approach to capital. We're happy to take that in Q&A. I'm not going to cover it in the slides. So quickly, just overview of Flowserve. We've got 17,000 employees. We operate in over 50 countries, 52 to be exact. We've got over 50 leading brands across valves, seals and pumps. We've got 5 million assets in our installed base. And so one of the big challenges for us is identifying that asset and making sure that we're getting the parts and the service and the overhaul work and really driving the growth in the aftermarket business. And we do that through the 171 Quick Response Centers that we have all over the world. And so what we try to do is position these small facilities very close to our customer installations and provide that response, a very quick response to serving their needs for the aftermarket business. And then we touch about 10,000 customers annually. And I'll touch a little bit on customers in this slide. But you can see we're very diversified in the markets and the geographies that we play in. We're 41% in North America, 20% in Europe, 20% in Asia Pacific. Middle East and Africa makes up 11%. And just as most businesses in the industrial world, the Asia Pacific and the Middle East are growing faster than anywhere else. You can see on the right, we're heavy on the pumps versus the valves, about 70-30 pumps to valves. And then on the bottom there, you can see the end markets. And so oil and gas makes up 40%. Of that, about 80% is in the downstream side. And so that's refining and LNG on the downstream side. We do a little bit in kind of midstream, so think big midstream liquid pipelines. And then we've got a little bit of our business in the upstream, which is predominantly in the valves business. 20% is chemicals, and that's been a growing market for us. So that's both petrochemicals and base chemicals, and we anticipate growth for the next couple of years there as well. Power is about 11%. That's the one that's been a little bit challenged for us at Flowserve, but still a market that we want to participate. A lot of our installed base is in power facilities. And then we're also participating in new power with concentrated solar power and some of the new ways to produce energy. And then we've got a big bucket called general industries, which is really a whole host of other things. We've got agriculture in there, food and beverage. We also -- the biggest portion in here is what goes through our distributors, and we don't necessarily know the end markets. And so we throw it in the general industries category. And then water is at 4%. That's a growing form of market for us. Where we participate is desalination and flood control, primarily. And then we're also moving more into wastewater and some other aspects of water itself. In the bottom right, and I've already touched on this, we've got 50% of our business from aftermarket and 50% new. And so this is what we call the power of the pure-play within flow control. And basically, all we're saying is we're one of the only -- we're actually the only ones that combines pumps, valves and seals and the ability to help our operators and our customers think about optimizing their flow control solutions. One of the things that we are working on, and we can hit this in Q&A, is really trying to make our products more smart than they are today. And so in the valve space, we have electric actuators, and we have the ability to collect data and information on that. We also have control valves, which control the flow within our operators' installation and that is digital and the ability to collect data as well. And we're just now beginning to start to instrument our pumps and collect that information. And as we start to stitch this together, we believe we can help operators optimize their flow control. And we also know, and we've now proven out some of our analytics, and so we can predict some of -- on the critical pumps, we can predict failures. And we're working with our operators on uptime and preventing unplanned downtime in their facilities as well. And so that's power of the pure-play. And again, we can hit that in Q&A. A little bit of history here on Flowserve. In the post-financial crisis from 2010 and on, we're in, really, what I would call, hyper-growth time. You had major investment in upstream. You had major investment in downstream oil and gas. Chemical investment and power investment were all going really well. The company was highly decentralized. And so we had a lot of folks in the kind of wearing the general management hat. We didn't have a really strong integration across the different facilities and locations that we had. We were making a lot of independent decisions. And so that worked really well in the upcycle. But you can see there in the industrial recession, it didn't work very well in the downturn. And so the problem statement was essentially, we couldn't leverage the scale that we had, and we had difficulty taking cost out as our markets moved down with us. So I've been here since 2017. We returned to growth. And one of the big things that we're really trying to do is really think about Flowserve as an enterprise, drive enterprise-wide systems, drive enterprise-wide thinking, leverage the scale that we have and make better decisions at the Flowserve level rather than the product at the independent level. And so we're doing that through what we call Flowserve 2.0 transformation, and we're making good progress on that, and you can see a little bit of that on the slide here today. If we move forward, this is kind of the -- what I found when I came into the business, unfortunately, I had the need to stabilize it. We weren't performing how we should, and we were continuing to move in a downward direction. We got through stabilized pretty fast. We launched what we called the transformation. We did that at the beginning of 2018. Obviously, 2 years into that, and you can see the work streams that we focus on. So it's growth, it's capitalizing on our aftermarket, it's the commercial side and really making sure that we connect better with our customers and capitalize on the opportunities that are in front of us. We've got to focus on our cost structure. And you can see that in the numbers that we continue to work that down and expand our margins. And then operations and working capital are 2 big areas that we've made progress on. But I would say we still have a bigger prize as we go forward. And on the operations side, it's the normal stuff for a manufacturer, right? We're focused on manufacturing productivity. We're focused on our planning and MRP and resource planning there. We're focused on our supply chain. And we've launched a Flowserve Lean systems to drive waste out of our manufacturing processes. On working capital, same thing. It's been a little bit harder because of our disparate locations and disparate systems. It's been harder to get that information and really start to drive results. However, we've moved working capital from 31% of revenue now down to 27% of revenue. And we know there's a big prize here as we start to move into the low 20s on working capital. So again, we're going to go forward full steam in 2020 with our transformation. We got a designated PMO or project office that manages this. I'm involved very regularly in biweekly meetings. Every site I visit, we talk about the transformation and where we're at. And then the other important thing on this is we're very focused on the performance of Flowserve, but equally as important to us is the health of our organization and the employee engagement with our associates. And so we've done a really good job moving the needle with our culture. We've launched a purpose statement. We've got core values. We have values that we live and lead by. And what you see now in our employee engagement results is tremendous progress in winning over kind of the hearts and minds of the 18,000 associates that we have around the globe. And ultimately we'll transition to the optimized space. We're not quite there yet, but we're moving in that direction. And we know if we keep pushing on the transformation, we're going to be in a better place next year and the year beyond that. So at the end of 2018, we did an Investor Day, and we rolled out our long-term goals here. And we did it in the framework. So if you look at the red boxes, the framework we used was growth, margin expansion and capital efficiency. That's what's really important to us on the performance side. And then on the bottom, we had organizational health and then really starting to drive enterprise-wide IT systems. And so you can see that there, and that's embedded by the data science, the master data management and just really doing a much better job structuring and using the data that we have been collecting for over 200 years. And then in the blue boxes in the middle, you can see our targets. And so what we want to do is grow 2% than -- more than what the markets give us. And so we know we can't necessarily control the markets, but we certainly want to be taking market share and growing faster than the peer group every year. And then at the bottom left, we've got operating margin expansion. And so we want to get into the 15% to 17% on our operating margins. And I'll show you on the next slide, we've made good progress toward that, but we're not quite at our goal. We also want to convert our cash flow at 100% of net income. Again, we've made good progress, but we're not there, and I'll show that on the next slide. And then we know we want to get our ROIC into that 15% to 20%. And again, good progress. And then the box on the right is really important, because this was kind of what didn't happen in the last downturn. We want to create an operating model and an operating system that's going to allow us to leverage the scale that we have, become far more flexible, far more nimble, quicker to make decisions and be able to react regardless of the market. And so I think we're making really good progress on that, but we still have some ways to go. But I know for sure, Flowserve is in a far better place today than where were 3 years ago. And then here's the last slide and just -- this is just kind of the scorecard '17 to '19, on our progress. And you can see, we grew the business nicely in 2018 and '19. If you adjust that for FX, the numbers even come up further. On adjusted operating margin, we're making good progress there. So we've got nice margin expansion. A lot of that's been done on the cost side, some of it on the pricing. And again, we still have a lot of opportunities on the manufacturing side. And so we feel confident we can keep moving that closer and closer to 15%. We put a yellow checkmark there, just because if you drew a straight line from the time we released this to the 15%, we're a little bit lower than what that linear projection is. And one of the reasons for that is, in 2019, we grew our original equipment or our new equipment business 4x faster than our aftermarket. And so if you think about the margin differential in our new business versus the aftermarket, it's significantly more. And that's just the headwind that we didn't anticipate. We're not giving up on the 15%. And the way we kind of describe it now is we're probably on the lower end of that if the mix stays where we think it is. If the mix adjusts more to normal, we should be able to get up higher than that. But the takeaway is we've got lots of opportunities still to expand margin. Most of it's with our manufacturing, and we'll continue to push that in 2020 and beyond. And then on free cash flow, you can see we made nice progress there in 2019, converting 85% of our net income or adjusted income to cash flow. And then finally, on ROIC, this is probably where we've made the most progress, and this is obviously where working capital comes into play. So with the margin expansion, the working capital improvements, you see a 540 basis point improvement from '17. And so we're very proud of the performance, but we're not quite to the targets that we're laying out. And the targets, again, are for 2022, but we're very confident that we can continue to make progress in 2020, 2021 and beyond. And so, Brett, that's really it on the slides, and we can -- I'll sit down here, we can do Q&A.

Terrific. Scott, as you noted, you've been at the helm a little under 3 years, obviously seeing the improvement show up in the financial results. I want to ask on the organizational health piece of the transformation. Where did things stand when you joined in terms of employee engagement and ability to attract and develop talent? Where are they today? And what's your vision for where you'd like the organization to go?

So with the culture, it's always a journey, and we need to continue to evolve. But what I'd say, when I started, we weren't in a healthy place. And so we've been able to move employee engagement up about 9% in the 2 year -- really we started measuring 2 years ago. But in the 2 years, we're up about 9%. We'll do another survey here in the spring. And then on the organizational health, we used a third-party on that. When we did the initial assessment, we were in less than the bottom 5%, which is not where you want to be. Just say, I'm happy to report that we're kind of in that kind of third quartile. We need to move that up into the second quartile. And then probably most importantly, what we saw as we started to segment the data and look at it, the leadership team, the top 100 leaders were the least engaged population at Flowserve. And that is not good, right? So for anybody that does employee engagement or understands this, you really want kind of a cascading pyramid and the top of the house should be your highest engaged population. The good news now is we've moved the -- that group of leaders are now in the 90-plus percentage. They are the most engaged. And they're truly carrying the messages that I want to drive. They're cascading down our plans and our philosophy and the transformation. And I feel really good about bringing that group along. And so we've made incredible progress on the culture. And we're now a purpose-led organization. We live and lead by our values. And then we have behaviors that we now -- we do our annual performance reviews, and we use the behaviors. And what we talked about is the results are important, but how you get the results is equally as important as the results themselves. And so that's a big change from what we had before I joined.

Great. And then on the most recent earnings call, you noted that project funnel is still healthy. We've heard similar comments from peers. I guess, could you discuss, by end market and geographically, where you're seeing the most opportunities for projects moving forward?

Yes. So we still feel like we can grow this business. What I'd say is every day, with the coronavirus and things going on, it's been a dynamic situation. But what we haven't seen is big delays in the large projects. And so think refineries or petrochemical plants or things like that. And so they typically will move around and when they get funded. But overall, we feel really good about the large project pipeline that we're seeing. And so the opportunities for us are in the refining space. We see that in Asia Pacific. We see it in the Middle East. We also have opportunities on the chemical side. And so chemical, we've got a North America build-out that we're pretty confident continues to move forward. We feel very good about chemicals in Asia Pacific and chemical plants in the Middle East as well. We also feel good about LNG. And so we've got a healthy valve portfolio that plays in the LNG projects. We also can bring our pumps into that as well, but the entitlement there is not as big as on the valve side. And we know that LNG moves forward in 2020 and 2021 as well. And so I think there's still opportunity to grow, and we're confident with the initiatives within the transformation that we can continue to take market share as well. And so we've got what we call a strike zone initiative. We have a commercial intensity initiative. So we've got a lot of things that we think are self-help on the growth side. And so even a kind of a flat CapEx environment, we still think we can grow the original equipment.

Great. I guess moving to the margins piece, I want to ask about one of the opportunity within your 4 walls, there, the design-to-value initiative. And can you kind of talk about what stage of implementations that program is at and what may be the potential prize is ultimately there?

Okay. So I wish it was further. I'll start with that. But for those that don't know what design-to-value is, it's taking a rigorous approach to relooking the design of our products and designing it with the latest tools in place, right? So the latest CAD/CAM technology, the latest computational fluid design technology and then really bringing in our manufacturing folks, our supply chain and doing that cross-function collaboration to design the best products. And a lot of our products are -- you saw the history, 225 years old. We don't have any products that we're selling today that are 225 years old. But we have designs out there that are 50 years old or 30 years old. And so with the new tools and the new collaboration approach, what we're seeing is, on average, kind of a 20% to 40% cost reduction when we do these type of initiatives. And then what we're also seeing is the ability to take substantial part numbers out of the product itself. And so we're reducing complexity. And then as we build it back up into a more configurable product, we're using a lot of the similar part numbers, but we're also configuring different shapes, size and performance using the same geometry or the same approach, in which -- so it really does streamline our quality. It streamlines the quoting process, and it streams like our -- streamlines our ability to produce. The problem with this is it takes a lot of resources to do it properly. And so we've gotten kind of 2 or 3 major product lines through it. We have a long way to go. And what we're trying to do is expand that bandwidth with our designated center to do more of this. But the opportunity is tremendous. We just need to really commit and get more resources focused on getting more products through the pipeline.

Great. And you all have made good progress on working capital. If you were to adopt some of these IT and technology enablers, could we see more of a step-change improvement in working capital performance? And how do you manage that without causing disruptions to the existing operation?

Yes. So on the progress, I don't think you're going to see a 300 basis point improvement. I think it would be more gradual. And the reason, even with the improvements in the IT systems, we can't go out and hit every facility at once. And so we've got 18 facilities that we're very focused on. It's about 80% of the revenue. And when we typically do a rollout, we'll do like 2 or 3 facilities at a time, make sure they're up and running and doing what we want, and then we'll shift to the next one. And so you've seen that progress here in 2019. You'll continue to see it 2020. But I think the kind of the slope of the progress in working capital would be a good trajectory to project forward. And then in terms of disruption, I don't think we're going to have disruption. And so as we go out, and I'll talk primarily about inventory, because that's where you get potentially a manufacturing disruption. Really we're just doing what most good manufacturers already do. And so things like setting up your reorder points, making sure you optimize your inventory levels to the right levels and then really using the tools in your MRP system. And so none of this is very sexy or very advanced. It really is blocking and tackling and very basic manufacturing concepts that we just weren't using. And so I don't feel like we're going to disrupt our operations or disrupt the potential ability to deliver to our customers. I think we're just going to get better and better about getting components on time when we need them to produce our products and services to our customers. And so this is an area that we've made good progress. We're at 31%. We're at 27% now. And I do think we see steady improvement here in a couple of years to come. Good companies in our space can be below 20%. We're not committing to that, but we do think we can be in the low 20s in a reasonable period of time.