Flowserve Corporation (FLS) Earnings Call Transcript & Summary

Good afternoon, everybody. This is Nathan Jones with Stifel. Welcome to the Flowserve fireside chat. And I'm very pleased to have Scott Rowe and Amy Schwetz, CEO and CFO, with us today. I think we have Jay Roueche on the line as well. [Operator Instructions] I will jump in first.

Scott, you've been involved in energy markets for quite some time. I'd like to start just with a few high-level questions on how you view this downturn relative to others you've been through. I understand Flowserve has limited exposure directly to upstream, and what there is, is mostly offshore, but oil money does lubricate a lot of the businesses that you're in. So this one clearly has some different attributes. We already had a supply-side issue with the rise of unconventional oil supplies, particularly U.S. shale. And then we've seen unprecedented demand destruction created by COVID-19. And for a short period, we'd even seen the start of a price war between Russia and the Saudis, which may or may not have been targeting the U.S. shale market to begin with. If you could just talk about your views on the oil market, what are the things we need to have to see prices rise? What are the things that would be nice to have but your business can live without? And what are the things that you would really -- do you think would really get the energy markets moving again?

Yes. Sure, Nathan. First, just for -- thanks to you and Stifel for having us today. We appreciate you giving us the opportunity to talk about Flowserve. Yes, I've been in oilfield services and energy environment for almost 22 years now, and I think my first downturn was in my second year of -- in a drilling company called Varco that made drilling equipment. So unfortunately, I've seen more up and down than I care to admit, and I'm a relatively newcomer when I talk to some of the peers in oilfield services. But I'd say, a couple of things on these oil cycles, right, they're all a little bit different, and it's hard to go back and compare to kind of what year looks like another and all of that. But what I'd say, certainly from the 1998 forward, this one is very different than the others. And I think that the big thing, and you touched on it, is just that this is a combination of both supply and demand, and so it really started with a bit of a supply surplus and a long story with the unconventionals and the North American shale becoming productive. And then I'd also add that just the flight to capital into North America. And really, this happened before 2014, '15, when it turned down, but what was surprising to a lot of people is that the capital continued to stay into that space through '15, '16 and '17 despite the downturn in '15. And so you started with pretty much a frothy situation on the supply side, and then you've had one of the most extreme demand collapses due to the COVID-19 virus. And so there's a bunch of different estimates out there that compare 2019 to 2020 in terms of oil demand. The one that we kind of line up with is kind of a 7% to 10% down, which is pretty extraordinary. And if you go back through kind of the last 3 or 4 big downturns in the oil market, the worst case is demand was off by 1% or 2%. And so you've got a frothy supply situation to begin with now crushed with the demand situation. And so it makes for a really challenged environment in the upstream side of oil and gas. And then just to complicate things, the storage situation is essentially full. The whole logistics with pipelines and kind of the whole system is essentially at capacity. And so now you're seeing a lot of production shut in, and you're starting to see the benefits of a quick response here. But I'd just say our view is that this is going to take a little bit longer than what you traditionally see just because it is the supply and the demand. Some of the indicators that we're watching, unfortunately, we're starting to see some green shoots here as we're seeing demand come back in China relatively fast. You're also seeing some green shoots on ground transportation, which is the single biggest portion of refined products. And so I do think there's some things that are showing that we might be at an inflection point and can get the system moving. The concern is just as when does capital start to move back into the industry and when does it impact the demand for our products. Now the good news for Flowserve is only 5% of our business is in the upstream space. And so when we show the 45% for oil and gas, the majority of that is in downstream in the refining side and the petrochem side, where the installations are there. And what we know is a lot of our operators want to continue those operations. They've got to continue to invest in the maintenance of the ongoing operations, and they're committed to reliability and uptime. And so we're very focused on helping our downstream partners there. We're very focused on winning the work that is available in the upstream and the midstream, but I just do think that, certainly on the oil side and the upstream side, this is going to take a little bit of time for the whole system to work through this supply and demand situation.

It's very helpful. Maybe I'll jump down. You made this comment just there about capital flowing into and maintenance having to get done to keep things keep things rolling. And there was a comment you made on the recent earnings call that I found interesting about customers you've spoken to acknowledging they cut aftermarket spending, and this would be, I guess, primarily downstream chemical kind of area, too deeply in 2015 and 2016. And I remember being surprised back then at how long those deferrals went on. Can you expand a little bit on those discussions and talk about what customers lost in terms of productivity, what trade-offs they're making in terms of protecting their liquidity versus running at an optimal level?

Sure. So one of the things in -- when the COVID crisis hit and then some of the -- just the energy downturn is I've been really making an effort to reach out to my -- our top 10 customers and spend as much time as they'll give me in terms of understanding how they're thinking through the downturn, where they're going to invest, where they're not going to invest, some of the cutbacks that they're doing and just helping get a better understanding of the situation to help best run Flowserve and make better decisions here. And I would say -- I'm not going to say unanimously, but I would say several of the operators talked about cutting too severe in their reliability and their maintenance departments in the '15, '16 downturn, and they said that they're more committed this time than last time to preserving that maintenance money and really keeping the focus on reliability and production. And I think what they saw was just that -- in '15 and '16 is, by cutting it pretty dramatically, they ultimately ran into uptime and just ongoing productivity-type issues, and they weren't able to sustain the level of performance that they are used to doing. And so I think this time, I'm hopeful and optimistic that the focus will be on uptime and productivity. They're still going to manage their dollars and their maintenance spending pretty aggressively, but I feel confident that we're going to see continued spending there. And I -- it's come down for us already. I don't think it will be at that level of '15 and '16. And then I think what we're seeing, at least, and I talked about this in the earnings call last month, is we're seeing a lot of things get pushed out into Q3 and Q4. And in our discussions with our customers, that wasn't necessarily due to budget, but it was more due to just availability of people that could, one, plan the down -- or the turnaround or the maintenance activity; and then two, just getting people onto their sites. And so now as some of the COVID restrictions are starting to release, we're actually having more and more discussions about getting our folks on the site. And so I feel reasonably good that our aftermarket business and our in and out or MRO business is going to be down, but I don't think it will be down as much as '15 and '16. And as you know, right, that's a big part of our margins and an important part of Flowserve. And so we're putting a lot of efforts to stay close to our customers. We're putting a lot of efforts on how do we do more in that service space, how do we do more to help our operators with their uptime and productivity. I feel reasonably good about being able to preserve that business.

Okay. I guess then if we scratch out 2Q '20 because it has vastly different dynamics because people are closed down and you just can't send people out there to do turnarounds, and we've heard a lot about turnarounds getting pushed out of the fall -- out of the spring and into the fall or even to next year. So if we forget 2Q for a minute, just because of the black swan event that we're being -- have had going on here, it's your contention then that the declines in the aftermarket are not going to last as long. Maybe they'll be as deep in the short term, forgetting 2Q '20, but they won't last as long as they did in '15, '16 and probably evening a little bit into 2017. Do you think customers have learned a lesson from what happened in the last downturn and will be more apt to spend on maintenance and productivity as we go through this downturn?

Yes. I mean that's my view today. Obviously, things could change, and another wave of COVID-19 in the fall or the winter could change things. But certainly, in all of our discussions now, I'd say that's the read that we're getting, and their actions are supporting the discussions that we're having.

So a fair amount of the assets, the downstream and chemical assets, are controlled by IOCs and NOCs, who I think typically will cut spending across their portfolios in oil downturns because they're getting pinched on the upstream side of the business. Do we really need to see a recovery in oil prices even to maintain a decent level of aftermarket spending on those downstream assets, just to have enough funding from those companies in particular rather than just the independents to see that level of maintenance spending maintained?

Yes. No, I mean it's a really good point, and I think there's definitely a factor, right? And so they're making -- theoretically, in these downturns, are making more money in the downstream side than the upstream, and so they've got to balance and make sure they're supporting both sides of that. But again, I think a lot of them learn that if they don't invest in the maintenance, if they don't invest in keeping their operations up, the lower productivity actually costs them more in the long run. And so I think that's kind of the lesson learned in '15, '16, is that they were jeopardizing their ability to keep their operations at the level that they wanted to, and they're more inclined to spend more on maintenance and making sure that they can stay up. Now I think this is my theory at this point, and it can change, but I think what we're seeing and hearing right now from our customers is that they want to continue to spend on maintenance, and they're going to be very focused on the uptime numbers and their productivity.

Fair enough. A few comments from the last earnings call on current trends and expectations, I'd just like to follow-up and see whether those trends have played out the way you expected a month ago, if you've got any updates there. You said bookings in 2Q '20 might decline 15% to 25%. Would you say you're still on trend for that kind of a number?

Yes. So just as a reminder to everyone, in the earnings call, we talked a little bit about the second quarter and compared it against last year. And 2 things I'd just say, on the bookings side, Q2 '19 was our best quarter of the year. So it was a pretty high number at $1.1 billion. And then the other thing I'd say is, as usual, right, June is always our largest booking month within the quarter, and so things could change in June. But I'd say right now, no change to what we talked about a month ago, and we're still tracking in that kind of 15% to 25% down from last year.

With economies opening back up, people going back to work, you being at potentially able to get on to onto different facilities and into customers' buildings, is there any reason for us to think that June won't be better than April and May?

No. At this point, we fully expect to have better bookings in June than we did in May, and I think it's twofold: one is that's just our normal seasonality and just the way our operators behave in terms of getting bookings at the end of the quarter and then a little bit of that on the Flowserve side, where we kind of hold things and doing it more in the last minute; and then I'd just say the second trend there is just things are continuing to get better, right? And so May was a better month than April in terms of things open, people coming back to work, progressing different projects or the work that they're continuing to move forward with. And so I fully expect June to be a better month than May.

Okay. You said 2Q '20 revenue is similar to 1Q '20. I mean I think it's fair to say that the reopening of the global economy here has been going better than I think pretty much anybody would have hoped for a month ago. Potential for 2Q '20 to be maybe a little bit better than 1Q '20 in light of just how the global economy reopening has progressed?

Well I think for us, on the revenue side, most of that's in backlog, and so I would just stick with the comments that we made a month ago and say we're still tracking to that. There could be some upside. And really, for us, it's about our facilities being able to operate. And so Q1, we had some major issues on shutdown. But really, it only -- it was -- while we had major issues, it was 2 weeks out of the quarter, and it was the last 2 weeks in the quarter or the last 2 weeks in March. And then as we kind of fast forward into April, we had some major issues in India, where the country was shut down based on the government regulations. What I'd say today is we're doing a much better job about bringing our people -- or being allowed to bring our people back in and operate in that country, and so we feel good there. The other issue is in Latin America. And so you're seeing more cases in Latin America than what we saw in April and certainly in March. And so we've had some more shutdowns in Latin America, primarily in Brazil, than what we expected even a month ago. But I would say net-net, we should be tracking to exactly what we said a month ago, where the second quarter revenue will be very similar to the first quarter. And then there -- as always, right, there's some opportunities to be above that number, but then there's also some risks that are going to -- could potentially keep us at that number or slightly below.

Only it takes a few cases of COVID to shut down a plant, hey?

Yes.

And we need to avoid those. So...

Yes. That's -- I mean -- and that's -- unfortunately, that's what we're doing, right? I mean we're tracking everybody who -- we've got fever units that are measuring people's temperature, we're quarantining any suspected people. And what we're finding is when we're disciplined on our safety, when we're vigilant and we're aware, we can avoid major shutdowns. When we have some complacency or a lack of judgment, then we're having a shutdown situation. And so we're getting better as we're working through this, and we're doing everything we can to protect our associates. But unfortunately, we had to shut down a facility last week that probably could have been avoided had we been doing everything we should have been doing.

So is the takeaway there on the uptime that you're getting out of your facilities is that you've seen some additional challenges in some places, you've seen others do better, but net, you're about where you thought you were going to be?

Yes, I would say. If you compare it to a month ago when we did the earnings call, I'd say we're very much tracking to our expectations a month ago.

Okay. The 2018 Analyst Day, you guys set some financial goals, which I'm sure didn't anticipate a global pandemic, the temporary closure of large parts of the global economy and $30 oil. So I'd like to get your views on what might need to happen to get somewhere towards some of those goals, specifically starting on free cash flow, the target there was 100% plus conversion. I went back and looked. In the last 12 years, Flowserve has done that twice: once in '07; and once in 2017 as you guys made a lot of progress on working capital there. The main drag on cash flow over the years has been working capital, and a lot of that was prior to the current team arriving. And it had consumed hundreds of millions of dollars, and primary working capital sat in the mid-30s. You guys have made some really good progress on working capital down into the mid-20s in 2018 and maintaining that in 2019. I don't think you're done with the process and IT rollouts to institutionalize better working capital management. So do you see further upside to working capital to help with cash conversion?

Yes. Let me just go back. We put these targets out, gosh, 18 months ago. And to your point, we did put some assumptions around there, and we certainly didn't assume a COVID-19 global pandemic that shuts the world down. And so there are some words there around the assumptions that we did build in. And so I just -- I appreciate you recognizing that at the beginning. And like we did at the end of last year, we recalibrated and talked about our progress against those metrics that we put out. We'll do exactly that at the end of this year as well. But in terms of free cash flow and getting to 100%. I mean, Nathan, you nailed it, right? It's really working capital for us. And if we can perform well on working capital, then I'm confident that we can get the 100%. And like you said, when I first got here, we were in the 30s, and that was not ideal at all. We've made good progress here. We had a good quarter. Q1 was really solid on working capital. And I'd just say, we've got plenty of opportunities ahead of us. And so even in the downturn when terms and conditions get a little bit tighter with our customers and you're chasing the revenue down, we still feel like we've got an opportunity to unlock working capital. And so in fact, I did a meeting on this with Amy earlier today. There are plenty of opportunities for us to continue to drive this. And so I think we make progress here. I think this is one that we can still really strive to get 100% on the free cash flow conversion. And it's one that, even in the downturn, I think we can make progress on.

So you mentioned terms and conditions there, which was the next question that I had. Typically, I've seen -- I've covered you guys for like 11 years now. And typically, in these downturns, the terms and conditions that your customers impose on you and your competitors get tougher and more onerous. How do you plan to deal with that during this downturn? Is it something that you'll just have to suffer through? Are there times where you'll walk away from business if the Ts and Cs are not appropriate for you? Just how are you going to deal with that during this downturn?

Sure. So we're already seeing all kinds of requests from our customers. And so the majority of those requests are on pricing, but it gets to Ts and Cs in payment terms as well. And what I would say is -- unlike kind of 2015, '16, is we've got a robust playbook now on the commercial side that helps a lot of our sales and general managers think through the balance of margins and cash flow. And so what we won't do is take something that doesn't meet our margin profile and has horrible cash position. And so we'll balance that. And what I would say is we're going to get pressure here, but the opportunity there to continue to drive inventory down and the opportunities to do better things on receivable is still tremendous. And so even with some of the headwinds here, I think we can keep making progress.

Okay. So again, I know some of these targets are outdated, and given the pandemic, they're not likely reasonable anymore. But you had set a goal of 15% to 17% on the operating margin, obviously not set with this outcome in mind. I think you'd set that assumption of no market growth during that time horizon, and any volume leverage was going to be gravy. Typically, energy downturns take some time to roll through Flowserve's P&L, with the OEM business the last to recover, which leads me to believe the level of revenue in 2022 is probably going to be lower than it was in 2018. Under those circumstances, is it reasonable to expect Flowserve to post margins even at the bottom end of that range in 2022?

Yes. I'd just say, Nathan, let us -- we'll come back at the end of this year and kind of recalibrate, and we'll talk about the performance this year, and then we'll talk about the go forward. And so I don't want to speculate on that. What I would say is that Flowserve 2.0 is still alive, and we're still making progress. We have lots of opportunities to continue to take cost out of the business, and this isn't necessarily our people but on the product cost. And so we've got design-to-value that's moving forward. Our lean program is up and running, and we're seeing tremendous results there. And so there's still some levers for us to expand margin. And then obviously, on the other side of that equation, though, is we've got a headwind on the mix side, which we've talked about before, where our OE mix was greater than the aftermarket mix. And so that was a headwind going into the year. And then obviously, with the downturn, we're not going to be able to get the pricing that we expected at the beginning of the year. And so net-net where does that all come out? I don't know yet. I mean we're still early in working through all this. But at the end of the year, we'll certainly reconcile, and we'll talk about our guidance on margins going forward.

Fair enough. Maybe I'll just turn to the cost side then. The cost-out actions that you guys announced on the last call to me look to be pretty modest with the majority coming from variable cost reductions and reductions in CapEx. Can you talk about the decision to maybe carry some of the more semi-fixed costs here in the short-term versus being a bit more aggressive on the cost reduction side?

Yes. And just as a reminder for everyone, what we said in the earnings call a month ago was that we'd take $100 million out of our cost versus 2019. And half of those costs would be avoidance-type actions, and the other half would be coming from structural actions. And basically, all of that now is in motion, if not complete. We'll go into much more detail at the end of Q2 as we're still in some discussions with some jurisdictions that require us to talk to our employees on. But I feel reasonably good about our ability to be aggressive on getting cost aligned with where we think our revenue are, and the actions that we are taking will position us nicely for -- certainly for the rest of the year. And then I think, Nathan, what you're kind of going through is just the semi-fixed and roofline and all that. I'd just say there's still tremendous opportunities. And for those that have followed Flowserve for some time, we did a major realignment program, and that was launched in 2015 and was basically executed 15, '16 to '17. Basically, when I got here is we pressed pause on the program, and we did that for a number of reasons: one, I wasn't super confident in our ability to execute these types of moves flawlessly without losing market share and making sure that we didn't spend or lose too much money as we're executing; and then two, is I just thought getting our business process more aligned and more standardized would bring us far greater returns than closing another facility. And so we really focused on the enterprise-wide IT systems. We focused on our Flowserve lean systems. We focused on some other business practices. And what we've seen by doing that is we're actually getting significantly more productive in the manufacturing footprint that we have. And what we're seeing now is that even if there wasn't a downturn, we're freeing up a lot of capacity that we didn't think that we had. And so regardless of the downturn, we were going to resume kind of a more continuous business as usual, rationalizing our footprint in normal course of business. And now with the downturn on top of that, we're only going to accelerate that. And so kind of the end of the year, we'll go into a lot more discussion about what's happening. I don't envision a big 2015 rollout realignment program. But I do think you can see from us, we're going to take actions on these sites, we're going to continue to make the right decisions about consolidation, but we'll be doing this more as a normal business process than a giant program. And I feel really good with our team and our ability and some of the things that we've done from a systems and process standpoint that we can execute these type of changes, I'm not going to say flawlessly, but we'll do it significantly better than what we've done in the past.

I would like to follow up on that one. And I think hitting the pause back then was, I mean, clearly, the right thing to do. That whole massive realignment program that was enacted before you got there, I think it's safe to say, didn't go all that smoothly.

Yes.

Could you talk about what you think the weakness is in the organization that led to that not being executed to the level that you would hope it to be; what you've done to, I guess, embed higher capabilities into those kinds of functions that would be responsible for doing that; and what your level of confidence is that you could execute something like that or something -- those kinds of actions more effectively and more efficiently in the future?

Yes. Now unfortunately, Nathan, in my career, I've had to do more of this than I would want to do. And really, it's not a major secret, but when you -- the way you're successful about this is if 2/3 of your time needs to be planning and 1/3 of the time needs to be execution. And if you do that and you really focus on risk mitigation and you're focused on process, then those moves become a lot smoother. And I just don't think we have the competency and, certainly, the commitment to go through that planning. And so just -- if you think about a manufacturing location and you're closing one and moving it into the other, master data management and the manufacturing part numbers and the routings and the drawings are all ridiculously important, right? Your materials planning becomes like the key competency. And when you cut over your backlog and shift it to the new facility, how you do standard work and work constructions is critically important. And so all of this stuff has to be done way upfront. I mean it's like months and months ahead of before you pull the trigger on making a move or even announcing a move. And where I'm confident today is a lot of the investment in Flowserve 2.0 was around master data management and part number nomenclature and how do we go forward in making sure that we've got one version of the truth for our engineering drawings and how we remember our parts. We put a lot of focus on materials planning and building up that competency. We've done all kinds of work on what is standard work, how do we define it, how do we create playbooks and visuals to know how to build this type of pump or a valve in the event that an operator doesn't show up that day or we move it to a new location. And so it really just is that hardcore blocking and tackling of manufacturing and that investment way upfront in the planning that will ultimately make you successful when you pull the trigger and do a move like that.

Makes total sense. Maybe over to the balance sheet. The business did end at the downturn with a strong balance sheet, net leverage at 1.5x at the end of the first quarter. My model has you staying under 2x throughout this downturn. I won't ask you to bless that or not. Aside from the fact that we know my model is wrong, that does give you a lot of flexibility to invest internally or to get on the front foot with M&A as we stabilize and recover or to potentially buy back your own stock. Can you talk about how you're thinking about deploying that balance sheet, whether it be in the next few months or the next couple of years?

Yes. I'll take a stab at that one, Nathan. And I guess I'll start with saying we do think we're in a really healthy position from a balance sheet perspective at this point in time. And given our commitment to continue to generate free cash flow, we think that we're going to stay that way. So as we think about capital allocation, our structure hasn't really changed from where we were at before the downturn. We had certain capital expenditures that we view as commitments. And as we think about that that's our dividend, it's our fixed assets -- our capital expenditures that are focused on safety investments. And then we had discretionary capital in the mix, which would include strategic-type items. And we're agnostic as to how we create value, but I will say at this point, as Scott has outlined, we really felt like great returns have come from investing in the transformation efforts that we've gone through to date, and we think there's still opportunities there. So we bought back some stock in order to offset dilution from our equity plans. But I think you'll continue to see us reinvest in the business in terms of transformation efforts going forward. But we'll keep our eyes open and evaluate opportunities as they come our way because the goal at the end of the day is to create value.

Maybe a little more philosophically than tactically in the near term. There hasn't been much done on the M&A front over the last few years, and I do understand that, that's prioritizing getting your internal house in order before you want to stack businesses on top of that. Maybe you can talk about maybe when you pivot from defense and internal kinds of investment here to offense and more of an M&A focus.

Yes. I'll take that one, Nathan. Again, we've been very focused on Flowserve 2.0, very focused on the inward with looking. What I do think, though, is with this crisis, and that's COVID-19 and the energy downturn, there's going to be opportunities for us. And so what I would say is we've got a list of things that make sense in terms of rounding out the pump portfolio and the valve portfolio and really anchoring in on being a full control solutions provider. And so if those become available at the right price and we feel confident in our ability to integrate them and they fit with what we're trying to do, then I do think it's something we have to look at. And to Amy's point though, we'll evaluate those options with the internal options and really pick decisions that drive the highest returns. But I do think given a lot of the volatility and where the markets are going, there's going to be some assets that come available that could make sense. And for us, just as we're kind of moving into the -- we're moving into the ground where we've got confidence in our ability to integrate, we're executing at a better level, some of these things start to become more interesting to us than they even were 1 year ago or 2 years ago.

That sounds reasonable. Well I see we're -- we've just run slightly overtime and with no questions in the queue. Amy and Scott, I'll thank you very much for your time, and I hope to catch up with you guys soon.

Great. Thank you, Nathan. Appreciate you having us today.