Flowserve Corporation (FLS) Earnings Call Transcript & Summary

Good afternoon, everyone. This is Joe Ritchie, Head of Goldman's U.S. multi-industry coverage. Welcome to the afternoon of day 3. We're in the home stretch here, and very excited to have Flowserve here with us today. We have both the President and CEO, Scott Rowe, as well as Jay Roueche, Head of Investor Relations. Thank you both for being with us today.

Yes, Joe, appreciate you having us and leaning out here with the first virtual conference. So appreciate all the logistics and the work to put this on.

Yes. No. Thanks, Scott. And so, Scott, look, I guess, maybe why don't we just kind of get right into it. Obviously, you're seeing some pretty unprecedented times here. In the oil and gas markets. With negative oil prices, something that we've never seen before. You have a long history of experiencing downturns and the volatility in these markets. Maybe just characterize how this compares to maybe the part 2 that we saw really from 2014 to 2016 and then also during the Great recession in '08 and '09?

Yes. And so just as a reference for the folks that don't know my background. I started at Flowserve in 2017 and so kind of missed both of those by -- I was certainly involved in both of those downturns in the -- more in the upstream oilfield service side when I was with the Cameron International business. But I'd just say all of these downturns, and even if we go back even further into kind of dotcom issues and 9/11 and things like that, they all had different characteristics and different attributes. And I'll talk about some of the commonalities and what we need to do. But let me just kind of go to what's different this time. And so what we're seeing now is you're battling this unprecedented pandemic and virus. On top of -- for us is what is a collapse in the demand for energy in some of the other commodities where our products go. And so I think we've never had to do that before, we're so concerned about the health of our associates and making sure that we're not spreading the virus. That has been incredibly challenging just to keep our facilities operational and drive productivity when we're stopping and starting. And so fortunately, we've been deemed essential in almost every country that we operate but it's still been just incredibly difficult because we're in some of the hot spots. And so I think that part has been very challenging and very concerning. And then if you switch to kind of what I'd call more normal downturn playbook, that's the side certainly where I'm comfortable and have had a lot of experience. And I think we're starting to do all of the right things. And so on the Flowserve side, just as we kind of think through downturn. What is -- making sure that we're in touch with our employee base, and opening communication and answering questions and all that. And I'd say I'm interacting more with our associates today than ever before. And then it's the same thing with your customers, right? And so staying close to your customers, staying engaged with them, understanding their plans. And so similar with our employees. I'm actively reaching out to our top 10 customers and beyond and trying to get as good a read as I can on how they're thinking through the downturn, what they're seeing in the next steps. And then, unfortunately, it's about cost, right? And so getting the cost structure in line with what you're thinking. And what I can say is this -- the experience in the upstream side is you've got to move fast on this, you've got to be decisive and we outlined last week in our earnings call that we're going to do that and take about $100 million out of our cost structure. And so I think we're executing the downturn playbook as the best we can and I think we'll have better performance than what we've seen in the past. But the difference now is just dealing with the virus. And well, unfortunately, we're just not out of the woods on that. And so that's causing some major issues. But all in all I know Flowserve will be a better company and we'll be in a better place as we work through this, but the last 2 months have been incredibly challenging.

Yes. That makes a ton of sense. And I'm sure we'll get into all the things that you're doing from a cost-out perspective and appreciate those comments. I guess I'm just trying to think about this a little bit longer-term for your business and for your end markets as you kind of think about maybe even like the next 10 years in a world where there's some decarbonization? Like how do you think your business evolves over the next 10 years? And does your mix of business change, where your products are more oriented to potentially other end markets that you're not serving today or those end markets get bigger? I just -- I'd love to hear how you're kind of thinking about this from a -- more from like a strategic planning perspective.

Yes. And so really, I've been here 3 years now, and the first 2.5 years, we were really very focused on the Flowserve 2.0, which was all about creating a much better operational model, focusing -- getting away from a very decentralized plant-based and local GM type organization to putting a process and playbook that was enterprise-wide. And so we made great progress on that over the last couple of years. And really, in the last 6 months, we started to put a lot more effort onto the long-term strategy. And so we really began this in earnest kind of third quarter last year and into fourth quarter. And then in February of this year, we actually presented to our Board. What I would call in the next 10 years of Flowserve and how do we look at our business and how do we do things differently. And what I'd say is that a lot of the stuff that we presented in February to the Board is still incredibly relevant. But with this -- the COVID crisis and now the downturn, some of those things are going to need to be accelerated and then some are just not going to come to fruition. And I did say the way that we're thinking about it is we absolutely want to be in Flow Control technology. We know that we've got a shift more and more from products to services. We know that the technology aspect and kind of the Internet of Things and the predictive side and the ability to instrument and collect data will only be more and more important and so we're -- we feel like we've made great progress there, but we need to make even further progress. And then we know that we've got to ultimately be a better Flow Control provider and a solution provider. And so I think more risk-based contracts, more holistic services and I think the current environment only starts to accelerate those programs with our customers. And then I think as we look at the end markets, that's obviously going to change, and it was in the process of changing even before this, and so what we're doing is trying to think through where can we take the things that we do really well with and how do we apply that into something that's going to last 20, 30 years and beyond. And so we agreed to find what we think are attractive markets. And I'm not going to say we are doing a whole portfolio shift into something new. But what we are doing is looking at kind of 3 or 4 major things and saying, "does this make sense for us? And if it does, are we okay, getting there organically? Or do we need to do some smaller bolt-on acquisitions that help round out the portfolio or at least buy into some market share that allows us to grow in that area." But I'd say regardless of downturn and COVID, I feel very good about our long-term plans to take the portfolio, the products and the services that we have today. And make sure that we've got a meaningful, viable, growing business for the next 10 years, 20 years and 30 years and beyond. And I think we've got a good team. We've got a lot of thought around this. And I'd just say as we kind of work through some of the -- getting out of the disruption and the crisis mode as we kind of turn into the back half of the year and into 2021, we'll be able to start to talk about that more freely in terms of what our ideas are and direction that we're leaning.

Yes. That's super helpful color, Scott. And it makes a lot of sense, right, at this juncture, it's survive through the environment and then just make sure you're well positioned on the way out. I guess your comments around Flowserve 2.0. And when you first started, I remember you really kind of talking about like remaking the playbook. For Flowserve and what Flowserve is going to look like over the next 10 years. I guess I'd love to get some more color around where you think you are along that journey. You had also kind of set some longer-term targets during your 2018 Investor Day. Are those targets still achievable in light of the environment that we're in today? I'm just trying to get a better sense for whether there's been much shift there?

Sure. So on Flowserve 2.0, again, it was all about recreating the playbook and the operating model for Flowserve and the premise was get away from this incredibly decentralized. Everybody, do your own thing to something where we can leverage the scale and the know-how at an enterprise level, and we had work streams and all kinds of different activities. And again, we made incredible progress. And what we said at the end of the year was that we're about 50% of the way through the activities. Let's say, we're probably a little bit more than 50% now, but not much more than that. But what this crisis is doing is really taking us back to reevaluate all of the different work streams. And so we're -- we've done a lot of that already. We're still in a little bit in process in terms of relooking things. But as you can imagine, right, what we're doing now is accelerating the cost actions of that and then putting some of the things on the back burner that were more nice to have or were more on the market side or potentially on some of the commercial side. So we're doubling down on our design-to-value and the cost out. We're relooking the roofline and consolidation there. We accelerated the spans and layers around the SG&A side and really kind of accelerated that by about a year from where we were thinking into the actions that we're taking this year. And so the program is still alive and well. We're still going to progress it through 2020 and into 2021. And I feel good about the progress. It's just which areas are we accelerating and emphasizing versus others that we're deemphasizing. And then, Joe, on the long-term targets, we've put out some pretty ambitious targets that were going to last us into 2020. At the end of last year, we kind of gave some color around where we were tracking against those. And again, I think we made tremendous progress, right? And so if you remember, we kind of had a green on our growth target and our ability to grow at above -- 2% above the industry growth. We were yellow on the operating margin. Again, our aspiration was 15% to 17%. But with that -- the mix of OE versus aftermarket, we are getting some headwinds and some pressure on that. We felt pretty good about our ability to convert 100% of our free cash flow, and we had made great progress over the last year on that. And then on ROIC, we had targeted 15% to 16%, and again, made tremendous progress over the 3 years to ROIC. And so what we'll do is, at the end of this year, we'll provide another update in terms of where we are and some color around that. At this point, I don't want to say we're giving up on the targets. But at the same time, the COVID disruption is clearly impacting our margin percentage and our ROIC. Now I think once we get beyond kind of Q2 and we get hopefully into a more normal virus situation, then we can start to really get the margins moving back up, focusing on the decrementals and doing all the right things to be back on track to this. But I'd say, again, at the end of the year, we'll kind of recalibrate and say, here's our expectation for 2021. Here's where we are against the targets, and we'll have a rich discussion about that at that time.

That's fair enough, Scott. And I guess since we have been talking about some of the cost actions that you are taking, I guess, you put into effect, call it, $100 million in 2020 cost-outs that were announced this quarter, roughly $50 million of that being structural. I guess just in the context of the actions that you've already taken? Like maybe provide a little bit more color on how these cost actions differ?

Yes. So what we said last week was $100 million of cost out and that would be 2019 over 2020. And then the way we're thinking of that is the majority of that is going to be SG&A, but you've got some of the cost of goods sold in there. And then we're roughly saying half of that's coming from the cost avoidance, which would be travel and the hold on merit and some of those other things, whereas the other half are coming from structural. And then what you'll see in 2021 is that the half that's coming from structural, you'll get the benefit of a full year there. But then you're going to get some headwinds of, hopefully, increased travel and some merit and some other things like that. And so where we are with the whole program is we've already begun, and we've made announcements and actions already. And most of the geographies -- I'll be able to give a little bit more color in Q2 because there are some countries where we've got to have discussions with the various labor groups. And so I don't want to go into too much detail. But I'd say, we're in-flight on all of this and feel confident to make these numbers at this time.

Got it. And I know that you guys mentioned similar run rate in 2021. So the way to think about that is that you'll see the kind of structural cost actions like roughly -- I'm thinking like roughly, we'll see $50 million in potential savings next year. Am I thinking about it the right way? Or how are you guys thinking about that for '21?

No, Joe. So what we're saying is the $100 million is year-over-year. So the 2019 to '20, half of that is coming from structural changes, to say, roughly $50 million. And then in 2021, you're going to get a full year impact of that that number. Right? So just basically double it. And then what we've got to offset, though, as you are going to get some headwinds on the avoidance side with travel and some of the other things that start to come back into the business.

Sure. Okay. That makes sense. And then -- so maybe just kind of diving into your businesses a little bit. And clearly, I know you guys withdrew guidance in 2020 -- in I mean 2020 guidance in early April. But you also mentioned that you thought bookings could decline 15% to 25% in 2020. So I guess, I want to kind of dig into the aftermarket side of the business. Historically, I thought of that business as being kind of like a $500 million kind of like run rate-per-quarter type business. But refinery production is down a lot. So like, I guess, I'm just trying to understand how are you guys thinking about this business in the second quarter? And then like is there a potential for a quick recovery in this business as well?

Yes. So yes, let me start with what we said last week on the earnings call. And so we did rescind the full year guidance for 2020. And so that's now off the table. But I did provide color on Q2. And so the bookings commentary that we gave for Q2 is that we thought bookings would be down kind of 15% to 25%. And then the way to think about it on aftermarket is the aftermarket business is going to be less impacted, and so it will be on the lower side of that range. And what we're seeing, in Q2, is that with the aftermarket side, is a lot of the installations that we serve on a regular basis are prohibiting visitors and suppliers from coming on to their locations. And so I think Q2 gets harmed on the aftermarket side more than what we're thinking in the back half of the year in Q3 and Q4. And so what you can see at the refining and the chemical side is a lot of the turnarounds or a lot of the maintenance that you would expect in Q2 has now been deferred into Q3, Q4, potentially into Q1. And so I'd say, we're somewhat optimistic that our aftermarket business will see a little bit of a resurgence in Q3 and Q4. I think it's too early to say that definitively. But I'd say, overall, aftermarket gets less impacted than certainly our project and OE business. As you can imagine, that's an incredible area of emphasis for us. It's part of the transformation with the commercial intensity, had a discussion today with our business leaders on how do we make sure that we're staying close to our customers, making sure our lead times on parts and repairs was incredibly low. And so just really making sure we can capture all the work that's available out there on the aftermarket side.

Got it, Scott. And maybe within that context, can you maybe talk a little bit about inventory levels and whether you think that the inventory levels are lean going into this downturn or whether there's some destocking that you could see from your customer base as well?

Yes. Joe, just to be clear, are you talking about the Flowserve inventory levels or are you talking about what we're seeing with our distributors and customers?

Just -- sorry, just to be clear, what you're seeing with your distributors and your customers.

Yes. So we do -- just as background for everybody, we do have -- a big part of our valve business goes through stocking distributors. It's less so on the pump side, but we definitely have distributors and partners that will stock our pump parts and some full units as well. Really, on the valve side, we saw destocking really begin kind of mid last year. And so we're 3, 4 quarters into that now what I would say is more of that is going into the kind of the oil and gas side, midstream, upstream and some downstream. And now obviously, with the downturn, they're readjusting their levels. And so a quarter ago, I thought we'd get a little bit of uplift on this. Right now, I would say there's not a whole lot of uplift. But at the same time, they've been working their inventory is down now for 3 quarters. And so I don't want to call an inflection here for sure because I don't think we're going to inflect in the next quarter or 2. But I don't think we're going to drop off dramatically from where we are and what we're seeing in March and April time frame. And then on the pump side, I'd say it's a pretty similar type discussion there where folks were running reasonably lean in terms of holding product or holding parts. And so I think our activity will parallel the end-use activity without a whole lot of buffer in that channel.

Got it. Okay. Now that's helpful color on the destocking trends. That's interesting. I guess maybe kind of shifting gears a little bit and just talking about the original equipment business. You already saw orders down. I think it was 13% in the first quarter. Just based on the conversations that you're having with your customers, like what are you hearing about project activity and CapEx cuts specifically?

Yes. So if you go back to -- we had kind of provided some color on Q2 bookings at the 15% to 25%. The original equipment or the project side would be on the high end of that in terms of being down. And so when we've talked to our customers and kind of try to get a better understanding of what's going on there, really, they're committing to the most of the projects that are already through the FID phase or the investment phase. And so if it's been funded and it's in the -- in EPC and moving forward, we're not seeing any cancellation discussions there with only a minor couple of exceptions that are in the -- more on the upstream oil and gas side where we don't -- we've got some exposure to, but it's less than 5% of our total business. The ones that we're seeing that are getting delayed or canceled or just slowed down dramatically are the ones that are in concept or feed. And so if they haven't made it through the funding decision and they're not fully into the EPC world, then we're seeing a lot of concern on those projects. And so as you'd expect, I mean, the world's changed dramatically, and we can kind of go through the different end markets, but whether it's in the downstream oil and gas or in a chemical side or even in a general industry, everybody is reassessing their plans right now. And so I think the massive disruption due to the pandemic has caused everyone to relook their cash position, relook liquidity, really think hard about whether or not they're going to go forward with major investment plans. And I'd say we're seeing everything rescrub, whether it's a greenfield project or an expansion or even an upgrade, all of that is going to get relooked. And so I see a pretty healthy dose of things that get moved out. And then I'd say there's going to equally be a significant amount of cancellations, particularly those in the upstream side and anything that's more in that oil and gas side.

Yes. No, that makes sense. And it probably does make sense for us to kind of touch on the end markets. I like the heat map that you guys provided at earnings. I'm not sure if that was your idea or if I should be giving kudos to Mike Mullin and Jay. But it was good to see.

It was all Mike and Jay on that one.

I'm going to go with Mike and Jay is on the phone. But the -- I guess is outside of water, like which of these end markets do you think is going to kind of decline sharply but could recover quicker? Or which of your end markets do you think are going to decline sharply? And then just maybe just stay down for longer?

Yes. The ones that are doing reasonably well. We didn't -- on chemicals, right, there's 2 types of chemicals, right? You've got the petrochem and then the specialty chem. The specialty chemical side is actually doing really well. And so if you think like sanitation equipment, food and beverage, things like that, that market really hasn't come down and has grown and they're running those facilities at really high levels. So we're trying to make sure that we can continue to serve that space in even a more meaningful way than we have in the past. So I see that rebounding. We are seeing a little bit on the power side, which the -- with the concentrated solar power and some of the different renewables. And I think you'll see some acceleration on that. And then on the water side, we're really seeing pretty robust activity around desalination, wastewater and municipal water and a lot of that's driven by government spending. And as there's different stimulus packages out there. I think they'll continue to be beneficiary in the water and anything on the municipality side. I would say on the refining side, there's probably a few pockets of where we do think that there's going to be an investment more in Asia Pacific and Middle East. And so I'd say it's more of a regional type issue than an industry overall. Whereas, I think North America and Europe on the refining side is actually going to get hit pretty significantly, and the investment will be off. So I'd say those are -- the areas of probably opportunity would be Asia Pacific, Middle East on downstream refining and Petrochem, specialty chem looks really good, and then the water side is promising as well.

Got it. That's helpful, Scott. And we're getting a question from the audience. So this individual wants to know -- basically, like a lot of industrial companies right now are decentralizing and putting accountability in the business segments. And this person believes that you guys are -- it sounds like you guys are doing the opposite. And so why is that the right strategy for you?

Yes. It's a really -- it's a good point, and let me just do a clarification. We're not necessarily doing the opposite. We didn't have anything from a central perspective whatsoever. So we didn't have a common system or platform. We didn't have the same nomenclature on how do we talk about things. We didn't have the same part numbering systems. And so when we talk about running an enterprise-wide playbook, really, what we're trying to do is put the basis in that allows our local GMs and plant managers to make decisions at the local level and stay close to our customers at a local level. But not have them worry about what is the ERP system that they're using? Or how do you do product life cycle planning? Or how do you do supply chain consolidation? We're trying to take away a lot of that heavy lifting type stuff, that there's good process and structure that's best-practice around the world and really keep them highly focused on running their businesses in local markets. And staying close to their customers. And so probably the easiest way to say it is we really want that. We want decentralized decision-making, but we want to have the structure and the systems at an enterprise level that can help them do even a better job than they've done in the past.

That makes sense. Just a couple of follow-on questions that I've gotten. A big theme at this conference has been reshoring. And you mentioned your -- you mentioned changes that you're making to your own manufacturing footprint, potentially your supply chain as well. But like how are you thinking about your supply chain, your manufacturing footprint in the context of this backdrop in this pandemic? Are -- is it accelerating any changes that you would potentially be making on either the supply chain or your footprint?

Yes. So let me talk to supply chain. First then I'll hit footprint because they're a little bit different. So we've got 50 large manufacturing locations. They're scattered all over the world, and back to the kind of letting folks do whatever they wanted. We had typically had local supply chains around that different facility, and so we've got more suppliers than I care to admit, and we still have a massive opportunity to start to drive some consolidation and reduction and leverage the spend that we have. And so we're still on that path. And I'd say, really, the only change there is we've got to relook kind of from a geopolitical and then a geo kind of COVID-risk perspective, we've got to layer that on as a lens. But the direction we were going was primary and secondary supply. Proactive managed spend versus noncontract, just basic reactive spend. And so I'm very pleased with the progress we've made in about the last 12 to 18 months, and we'll continue on that journey but we might just have a different country landscape than we might have had before. But this is an area that while we want to be able to serve the local operations, if we're not leveraging the spend and the scale that we have at Flowserve, then we're not getting the best pricing and certainly the best service levels from our suppliers. And so this is a huge opportunity for us even as we go forward. And then on the roof line and the consolidation, for those that have followed Flowserve for a long time, in the previous downturn in 2014 and '15, we had launched what we call the realignment program and went really heavy on a roofline facility and consolidation standpoint. And so we made really good progress there, and we took out a big number of the facilities that we had. When I came in, we slowed the program a little bit, and it wasn't necessarily that we didn't have the opportunities, it was more that we had done a lot, and we needed our organization to kind of regroup, reconstitute, make sure that we could execute with all of the changes that we had made. Now with the downturn, this will be another part that we do accelerate. We've got a list of opportunities that are ongoing, and we're actively going to move through that. And so what I would expect from us is we're not going to announce another giant realignment program, but we'll just move forward with kind of 1 or 2 of these things a year and maybe a little bit more next year as we work down the footprint. And then the other thing that's really important as part of this is one of the big work streams in the transformation was our lean journey and the Flowserve lean systems. And so what we're seeing as we advance through our lean journey is we're actually freeing up substantial capacity that we didn't realize that we had before. And so I just -- we can just use one example. But in one of our valve facilities, just by implementing the lean process, we're actually freeing up about 30% or 40% of the roof line and capacity within that facility. And so obviously, as we do that, it creates now an opportunity to close something and move more products into that operation that's performing incredibly well. And so I think as we've made great progress on lean, we're seeing more and more productivity. We're seeing more ability to consolidate roof line, and I would fully expect from us to start seeing that move into a more normal cadence as we go through the back half of this year and into 2021.

That makes a lot of sense. And great to hear that you're getting increased capacity using the lean tools. That's super helpful. I guess one last question for you, Scott. You mentioned that I think you were cutting CapEx by, call it, roughly $30 million to $40 million. But at the same time, this whole technology road map was a pretty significant part of your Investor Day back in 2018. So can you maybe just talk a little bit about whether -- the nature of investments or your investments are changing? And where are you specifically around like your plans on IoT integrated products, predictive analytics? So any color around that would be helpful. And I guess, is the way to think about the remaining CapEx for the year? Is most of that just growth Capex?

Yes. So we're cutting CapEx down to basically $60 million, and in that $60 million, roughly half of that is going to be enterprise systems that help us with just, again, moving more to a one Flowserve type approach and then also helping us to drive the productivity that's desperately needed across some of our functions and in the platforms. And then you've got a bucket there, that would be the normal maintenance and the must-do. And then you've got a little bit, unfortunately, only a little bit, that's reserved for growth. Now with that said, that's just on our CapEx side. On the R&D and the product development side, we're cutting it a little bit. But really, what I'm asking the teams to do, the cuts are about reprioritization. And so we had some things that we were working on that, quite frankly, aren't going to make sense in the new world. And so we're stopping that. And then we're going to reposition to products that we know will serve attractive markets and help to grow our business. And so on anything that we are working on before that we think can help us on the growth side, we're not going to stop that. And then ultimately, in 2021, we've ratchet back up that full R&D spending as we repopulate our product development pipeline on some of the more attractive markets.

Scott, that makes sense. And with that, we're going to be bumping up on time. So Scott and Jay, thank you both for being with us at the conference this week. I appreciate the conversation and hope you guys have a great weekend.

Yes. Joe, thank you again for having us, and good luck for the rest of the conference and stay safe and well. Thank you.