Flowserve Corporation (FLS) Earnings Call Transcript & Summary

Hello, everyone. Welcome to the Flowserve Corporation presentation. My name is Mike Halloran, an industrial analyst here with Baird, and we're pleased to once again welcome Scott Rowe, CEO of Flowserve, to our conference to talk about the company and where it's headed. So as far as logistics go, I'll just give some brief remarks here, and then I'll hand it over to Scott, who will also give some brief remarks, and we're going to have most of the time be Q&A oriented. So if you have any questions, either click within your webcast portal there, and you'll be able to fire me an e-mail or just send me an e-mail, mhalloran@rwbaird.com. M-H-A-L-L-O-R-A-N @rwbaird.com and I'll make sure I weave everything into the presentation. And so with that, Scott, floor is yours.

Yes, great. Thank you, Mike, and I really appreciate you having us today, and thank you to Baird for hosting the conference. And then for all those participating, we appreciate your interest in Flowserve and tuning into to today. I'll just start with just a general overview of what's happening at Flowserve and how we're thinking about things. And then I know Mike's got a list of questions here that we can kind of walk through and provide some more color or probe on some areas. And so I'm now just over 3 years in my role as CEO of Flowserve. We launched Flowserve 2.0 at the beginning of 2018. And really, the whole reason we started that is we knew we had to transform our business to be successful in the long run. And I would say despite COVID, despite some of the end markets, that is still the premise and still the focus today of what we're doing. And we've made tremendous progress in all facets of Flowserve 2.0. And as just a reminder, we were looking at both the health of our company, plus the performance aspects of the company. And when you think about performance, we had growth work streams, we had cost work streams. And then we had stuff focused on free cash flow generation, like working capital reduction, inventory velocity, DSO, all of those good things. And I'd just say really, leading up to COVID and this downturn on our end markets, really pleased with the progress that we've made. And so you can see it in the numbers there from 2017 into '18 and into '19, we are making great progress toward the goals that we laid out on our 5-year goals. And I still think that we're going to be at a better place after we get through all this. And as we kind of think about 2020, right, COVID hit us real early in the year with our Chinese facilities in January. We saw it in February with our first case in Singapore. And then it really caused disruption within our operations. But then probably even more importantly, we saw what it meant to our global economic impact. And as everyone knows, COVID has stopped mobility, and mobility is really impacting our biggest end market, which is the refined product in oil and gas. And so it's had a significant impact on us. And so our bookings are down roughly 20% due to this. We feel reasonably well that we don't see another step down, but we also don't see an inflection here in Q4 or Q1. On our earnings call last week, we talked about inflecting the growth in 2021 and probably more back-half weighted. But we also feel that our aftermarket in our MRO business starts to see an uplift before our project business. And so, Mike, and to everyone out there, I don't know exactly when that is. I think it really depends on vaccine and therapeutics, and a lot of it is just psychology on when people feel like they can start to live a more normal life and when our operators can start to commit capital. And they've got to have confidence in end markets. They've got to get the psychology that the world is going to be a better place. And I think when that happens, I think we actually start to perform reasonably well, back on the bookings. And so that's kind of the just short outlook, and I know, Mike, we'll get into that more. But then on just driving initiatives and what we've done in 2020, we had to reprioritize the transformation. But I would say it wasn't fundamentally different than what we've been talking about over 2 years. We had to accelerate a lot of the cost actions because of the bookings drop at 20%, and I'm actually really pleased with our ability to execute in the downturn. And so we took costs out pretty aggressively, certainly on the SG&A side. And now as our backlog comes down, we're very focused on making sure that we've got the right cost position as our revenues start to come down if the bookings decline. But overall, really pleased with the downturn execution, the downturn playbook and leveraging the themes of Flowserve 2.0 throughout 2020. And then just my last point is, we developed the transformation to, one, change internal process, really focus on how we think, act and operate, but to make sure that we had a flexible cost structure in an organization that worked regardless of the environment. And so we are seeing success on our downturn management. Our decrementals have been better than any other downturn in Flowserve recent history, over the last kind of 12 years. And quite frankly, we're performing well against the peers and the operational metrics as well. So we feel like the program is working. We're leveraging all of the hard work over the last 2 years. And now we've got to really start to focus on returning to growth and really defining attractive markets in the flow control space that will be there for the long run and pivot our portfolio into that attractive growth. Mike, that's the general overview. And I know you'll dig in here. So…

Yes. And I think we'll start where you kind of left off a little bit, which is, let's talk about what's in your control, right? And there's a bunch of different buckets with what's in your control: the margin side, the commercial side, the R&D side and then the free cash flow side. So let's start high level and just kind of encompass everything. If you were to take a step back, what inning do you think you are as far as the transformation goes and getting the right processes, the right type of thought process and execution internally versus where you would ideally want the organization to be?

Yes. So again, we've made just tremendous progress over 2 years. I'd say your progress in COVID world is not as fast as we would have expected this year, but still incredibly pleased with that. And so if I had to kind of put a percentage on it, at the beginning of the year, we said we were roughly 50% complete. And I'd say we've made roughly 20%, 25% more progress at this point. We're not exactly where we need to be, but we're starting to get really close. And the things that I think are really important on our side is the enterprise-wide IT systems. And so we were in a really bad state when I got here. I feel really confident in our IT team and the approach that we're moving. We did our first kind of full-on wholesale ERP conversion this year to our new model and new template. And so we'll start to roll that out across the globe. We started this year, we validated the template. We'll continue that every year, putting big chunks of our business onto that. And so that's a big step forward in terms of how we operate and our ability. If we were to do an acquisition, we now have something that we can integrate into, from an IT standpoint. And then also, we've made tremendous progress on the operational front with our new kind of like -- here's the operational blueprint or playbook. And that's got a bunch of themes in it. But one is the Flowserve lean systems. We've got supply chain in there. We've got productivity work stream in there. And all of those have made progress in 2020. Still not where we need to be, still a lot of opportunity on cost reduction and productivity. But now what we have is a standard basically operating system for manufacturing within Flowserve that we've never had before. And we're seeing good results out of that. And so we're actually able to drive productivity up in a lot of our facilities despite the bookings coming down. And I'd say we're kind of 70% to 80% of the way through that. We've got the program defined, but we've got to get it fully implemented and get all of our facilities executing properly. And so I feel good about that as well. And then on the growth side, we've had to pivot a lot of the R&D and the investment in the strike zone stuff into attractive markets. And so while we've made great progress over 2 years, we've kind of not really set a reset but had to change our focus. And so there's still a lot of good work that comes from that. But what I'm really pleased with is the process and discipline of defining attractive markets, being a market-led organization and then putting our investments and efforts behind that in a disciplined manner is now all in place and will be successful for the future.

So you mentioned there, commercial intensity strike zone, some of these internal initiatives you've had. Also, cumulatively just increasing the amount of R&D and the focus more on voice of customer. I don't know if you guys are calling it exactly that, but taking customer needs in the marketplace and making sure your R&D is focused on that. Talk a little bit about what that's done in terms of how you've performed in the market in the areas where you have put that kind of attention and focus forward. And how much more can we see on the R&D side as you continue to push this paradigm through the organization?

Yes. So from day 1 of me coming to Flowserve, I knew we needed to differentiate technology. And the beauty of Flowserve is that we've got products that have been solving customer problems for centuries, where we've got 200-year old brands in the portfolio. We're pretty much in every flow control application that there is, whether it's water or food and beverage or refined products. And so really, it's about us focusing and then really putting the effort and the energy and our know-how into products that make sense. And so when we do that, we see tremendous success. And so last year, we talked a lot about midstream pipeline where we kind of exited that business. We put a lot of focus and attention on that and created about $100 million of revenue last year and into this year. And then now this year, obviously, that's not a super attractive market. It turned off a lot faster than we expected. But what we're now doing is saying, okay, well, what are those attractive markets? And how do we retool that portfolio to make sure that we can participate in different cycles across the portfolio. But I feel really good about our ability to do that. It's just -- unfortunately, it doesn't happen overnight. And so we've got to systematically look through the markets to find which ones that we are excited about and then start to retool and upgrade some of the products that, quite frankly, we're underinvested or we've walked away from to get back into a preferred position. But that's ongoing. We're doing that, and I feel really good about our ability over multiple years to create opportunities that have hundreds of millions of dollars behind it.

And when you think about the free cash flow improvement that's been very evident, it seems sustainable from a run rate perspective here. How much is left? Where do you think about the conversion on a forward basis? But I think more importantly is, when you're thinking about this portfolio repositioning, at least to some extent repositioning, how much is the better free cash flow and the ability to deploy external capital? How much is that going to help? And how focused are you on bringing in the right types of M&A in the near to medium term?

We had a phone ring in here. Sorry, Mike, I don't know. Not sure what happened there. Say the last part of the question, again. It was free cash flow, right?

Right. It was free cash flow. And then what does that do for your M&A side? And does that help accelerate? How important is the M&A piece to this product portfolio issue?

Got it. So we have -- you can see the numbers. We've made sequential improvement here on our free cash flow conversion. Working capital is probably the biggest lever that we still -- that we've been working on and that can still drive free cash flow. And I'm proud of our performance of going kind of 32 plus percent when I started, working capital to revenue. We got down to 28%. Q3 for us wasn't great, but I'm confident we've got the things in place to keep pulling that down. We're going to -- you heard Amy on the call on Friday. She's very passionate about this. So she's a great partner to continue to drive the right metrics there. And our DSO has kind of been light and kind of what we think where it should be. There's a little bit more opportunity, so we won't let up there. But the big focus is on inventory right now. And we think by just a little bit more of Flowserve 2.0, really some system enhancements following the process and the playbook that we have, we're confident that we can pull inventory levels down even further and kind of get in that 25% range of working capital. And so that starts to free up a lot of cash and puts more cash into -- in our bank account. And then some of the work that we did on liquidity and balance sheet earlier this year is -- leaves us in a very healthy position. And so then the follow-on there, Mike, is we are interested in inorganic growth. And so as we kind of look out at the landscape there, it's been an incredibly dynamic year. There's a lot of opportunities for us to look at inorganic growth and adding to our portfolio in attractive markets. And so we've looked at a couple of things this year. And just unfortunately, you got to have the willing seller and align with us on price expectations, and we've got to be comfortable on the valuation. But as I said earlier, I'm starting to feel really good about our ability on the IT side and the operations side to integrate something if we were to pull the trigger on a deal. And so that gives me a lot of confidence that we can do the right thing on -- once we acquire it, to make sure that we integrate and get it into the portfolio. And then now with the free cash flow conversion and where we are with working capital, I feel confident that we've got a kind of a virtuous cycle there to continue to bring cash onto the balance sheet and into our bank account.

So when you think about all these initiatives cumulatively and as you start seeing volume growth return at some point, maybe late next year, maybe '22, how are you guys thinking about what the incremental margin profile of the organization will look like in a more normalized growth environment once we get there?

Yes. So we had put out in 2018, we put targets out, and kind of 15% was our long-term aspiration. And I still -- I don't want to give up on that. And when I think of industrial companies and kind of what we can do and we talk about how far along on the transformation we are, and we're still working on a ton of cost stuff, at this point, I don't want to give up on that. And so we'll formalize our long-term guidance at the end of Q4. So that will come in the next earnings call. But I'd just say right now, I think mid-teens for us is the right aspiration and the right level. And I just don't see any reason why we can't get there if we do the right things. And so we don't want to change that guidance today, but we'll come out formally here at the end of Q4 and talk about what our expectation is. But again, with the transformation and what's still left out there, we've got plenty of opportunities to move the needle on margins.

Yes. It certainly feels like you believe that's on a lower, if not meaningfully lower, revenue base than when you would have been at those margin levels historically.

Yes. Even on a lower revenue base, we still think we can get there.

And kind of shifting gears here to the current landscape. Let's start on the short-cycle side. High level, you mentioned in the prepared remarks, I mean late next year, you're hoping orders can start turning a little bit more positive. Stagnant kind of sequential type thought process the next couple of quarters. The glimmer of hope there is the short-cycle side, right? The aftermarket piece that you mentioned, maybe talk a little bit about why there's confidence that you could see that pull forward a little sooner than expected. What's that customer base telling you right now?

Sure. Yes. So we're fortunate to have a nice list of customers and big companies that are going to be here for the long run. And in fact, yesterday, I was with our #1 customer and had a 2-hour session with them on what's next, what's their aspiration? What are they looking at in 2021? And pretty much, almost unanimously, everybody thinks they're going to spend more money on maintenance and just kind of maintaining operations. And so I think they would have liked to have spent that money this year. But with COVID, they just couldn't get people on-site or they couldn't do the planning that was necessary to keep that chemical plant as -- running as effectively as they want. So there's definitely some pent-up demand, mostly on the parts side, but certainly on our services as well. And so the question, Mike, is just really, when does that start to come and play through the system, right? We think it's -- we do think it's in 2021. It's hard for me to call is it Q1 versus Q2. But I would certainly start to expect by mid-2021, that we've got growth going on the MRO and the aftermarket side of our business. And so I feel good about that. All of our customer conversations are supporting that. There are risks with that. The risk would be really on the COVID side. If you start to see big shutdowns and the economy is dropping because of restricted mobility, again, I think it delays it. But I think everything we're seeing with vaccine and therapeutics, even if it gets delayed, it's not going to be delayed a year, right? It's delayed a quarter or 2 quarters before the world starts to return to normal. And so this is what I talked about a little bit earlier, but this is where the psychology comes back in. But I truly believe if we -- if operators can get folks onto their sites, they are already starting to plan for these things that I really start to think we see this MRO growth and aftermarket growth. And then hopefully, earlier next year, but certainly no later than the year.

Yes. No. A few quick ones on that. One of the things I get is, wait, CapEx budgets are coming down, everyone's saying CapEx budgets are coming down for next year. It seems to me what you're basically saying is, overall CapEx budgets are coming down, but where our exposure points are to the aftermarket, the maintenance piece, that is the piece that's going up next year, and that should be a directional benefit for you.