Flowserve Corporation (FLS) Earnings Call Transcript & Summary

Great. Well, we now get to change the opening script, and I'll be saying good afternoon now. So once again, we're delighted to have Flowserve here. We have Scott Rowe, Flowserve's CEO; and also Jay Roueche of Investor Relations. I think Scott is going to make a quick introduction. And then we're going to hedge straight into the fireside chat. So with that, let me turn it over to Scott.

Yes. John, thank you to you and Crédit Suisse for having us here today, and thanks for everyone in attendance. Flowserve, we're still on a journey. And we're working through all the COVID issues. And just as a general update, we launched our Flowserve 2.0 agenda in 2018. We've made really strong progress to that. And even in the world of COVID and work from home, we continue to transform our company to a much better place. And so while we have been impacted by the downturn associated with COVID, we still believe that through the transformation and some of the things that we're starting to do on a strategic level, we've got a long-term outlook and a lot of opportunities to grow our company and create value for shareholders. So John, I'll keep the opening comments real short. I know you've got a bunch of questions here and happy to answer whatever you have.

Okay. Great. Well, I guess one of the things we've been doing is just kind of giving each company an opportunity to provide any kind of Q4 update if they'd like. I know you guys have kind of had a sales and order goalpost out there. Anything to kind of report on trends post the last time we talked on the earnings call?

Sure. I'll just reiterate what we said on the earnings call just to be clear with everyone. And so what we said on -- in our Q3 earnings call is that Q4 bookings would pretty much be in line with Q2 and in Q3. So we don't anticipate an upward inflection in Q4 but we also don't anticipate any step-down or anything getting lower. We are somewhat optimistic that at some point in the mid- to late year next year, we start to see an inflection point. And we believe we'll see that first in aftermarket orders and then potentially in our OE orders. But right now, just given what's happening in COVID and investor confidence or our customers' confidence in spending big money, we just don't think things are going to change here in the near term. And then on the revenue side, we just said that like other years, we're just traditionally seasonally up in the fourth quarter. And you'd see something similar to that in this fourth quarter. And then we also provided a little bit on the margin, saying that our decrementals would be in kind of that 20% range. That's what we've been tracking to in Q2 and Q3. And that's really driven by the quick cost actions that we took in May. As soon as our orders started to come down, we were pretty decisive in taking cost out of the company. And so our decrementals look pretty good. We expect that to continue in Q4. And then we also said on cash that we do expect that we're going to improve working capital and that we can drive about $100 million of Q4 free cash flow. So nothing new from what we said in the Q3 earnings call. But we still feel good about how we're tracking.

Great. Maybe just attack kind of one of the questions we often get asked. It's a little bit hard to parse this out but would love to get your perspective. When we think about the downstream energy markets, clearly, there's a piece that's cyclical. Think about miles driven. But then we are seeing these refiners either shifting some of their capacity or taking it down. And there's some concern there might be some kind of secular pressures there as well. What do you make of that market? And how are you positioning Flowserve?

Sure. Yes. So I'll just stay with refining and petrochemical in kind of the downstream space. And clearly, with COVID, you saw unprecedented demand destruction or demand just stopping with the quarantines. And I think what's happened is all of the operators have now kind of relooked their portfolio and really trying to figure out what the long term is and, really, what is the implication on COVID for refined products over the next decade. And a lot of folks are making strategic decisions. And so what we've seen with some of the public ones that are out there, Shell and Marathon have announced permanent closures of some assets. And really, what we're seeing is a lot of older infrastructure getting shuttered and will not come back or they'll make a decision to switch that to a biofuels facility. But then we're also seeing on the flip side of that is investment into newer, more efficient, more productive assets. And so think about Asia Pacific or the Middle East, where they've got something there. And they're adding to that capability and that capacity for the growing market in those regions. And so I don't know like exactly what will happen in this shakeout. But I would say, at the end of 2021, there will be less refineries. I don't think it's dramatically less but you can say kind of 10 to 20 out of the system. But I also think there's going to be continued investment on some of these bigger ones to continue to improve their productivity and continue to improve the volume that they can produce. And then just on the MRO side, back to kind of my comment before, we do know across the entire network, and this really applies globally, is it's been very difficult for our customers to be able to service and do all of the things that they've needed to do to keep that asset as productive as possible. And so they're doing the regulated stuff and they're doing that as well as they can. But we definitely know that there's some pent-up demand for parts and services. And so I've talked -- I tried to talk to as many of our top customers as I can at the C-suite level and just get a general sense of how they're thinking about things. And what we're getting is a pretty good read that at some point in time, they've got to spend more, like they're not -- they don't like the spending level. And they do feel like it's impacting their ability to be productive when they need to be productive. But no doubt the lower utilization is in the 80 percentage range, which we're kind of tracking right now or -- it's not great for us, right, when they track in the meantime between failure and run rates and things like that. And so operating at a lower level definitely hurts. But there's also some pent-up demand that we think we get an uplift from in mid- to late 2021.

Yes. And I think we've actually heard a couple of other suppliers into that space talk about this kind of pent-up MRO demand. I mean is there any way to kind of ballpark the size of what this could actually ultimately be, your customers spending a certain percent below normal?

No, it's a great question. In my C-suite discussions with other customers, I have to ask the same thing and I do not get a good answer. So I'm going to pass. I don't have that answer. And I think it really depends on what happens with COVID and whether or not they're able to do -- does it keep getting postponed? And does it build up even bigger? And it just depends like when folks are getting on site and as they bring people back and kind of what their confidence is that [indiscernible] capability starts to return to normal. I think the positive, as you said, kind of what's the most optimistic scenario is you start to -- COVID starts to subside here in kind of late Q1, early Q2. You start to see a lot of the mobility numbers start to come up both on air and ground travel. Our customers start to get optimistic that they're going to return to utilization rates that make more sense. And as they're trying to go from 80% utilization to 92% utilization, they've got to spend some money to do that. And so I think if that kind of all plays out, then I think we could start to see an uplift on our MRO stuff in Q3 and Q4.

Great. And I wanted to get into a bigger conversation around some new product development but something you said around bringing more efficiency and productivity to their -- some of their more efficient asset base. A lot of times, as we think of that, automation is what comes to mind and some different suppliers in that field. But can you just remind us how Flowserve -- or what you can do from your products that you're getting part of that productivity spend at the customer if that's where they're allocating their CapEx dollars?

Sure. Yes. I mean a great example is our seal business, where we have what we call life cycle agreements or LCAs. And essentially, the life cycle agreement is where we come in and we partner with an asset and with their team, right? The reliability engineer, their productivity folks and their general management. And we align on what good metrics are for meantime between failure and kind of how much they want to spend on repairs and new stuff. And then in a lot of these contracts, we're willing to take a performance-based risk to say, "We're going to help you move from X. Decrease it by 10% or 20% or whatever it is. But if we do that, we want to share in the upside as well." And so we're confident that when we partner with an asset team that we can improve their uptime, we can improve their maintenance cost and we can talk more about technology. But as we start to instrument this stuff as well, we can start to predict failures. And so by having a partnership, sharing information, instrumenting and really looking at the data together in a collaborative fashion, then we're willing to put a little bit of skin in the game. And when we do that, we can see tremendous results in helping them with their productivity and uptime.

Very interesting. I guess kind of another thing you've talked about and there are, right, some public distributors in this space. Obviously, they've been drawing down inventories, right? And we're living through that now. But if you chart their behavior through cycles, right, on the other side of the cycle, they build inventory. Is there any reason why you think that we wouldn't see that kind of normal behavior out of the distributors this time around? Or are we just now waiting for that recovery to see them start to build inventory again?

Yes, John. It's a good question. I really just think it's a matter of time. And just for the audience here, our stocking distributors are primarily on the valve side. And there are some public ones out there where you can see their inventory levels. But I mean they have dropped their inventory in a significant fashion. And I don't know if we're at the bottom, but I'm not sure how long they can go at the levels that they're at. And so let's just assume that they keep their inventory levels flat. Then theoretically, that's going to be an uplift for our business because they're -- every time they ship something out, then we're getting an order, where over the last kind of 6 to 9 months or even further, really, this started about 12 to 18 months ago, they were just -- they weren't doing any orders as they were reducing their inventory deliberately. So I think we get a little bit of tailwind. I don't know when that happens, though, John, like is it Q1, Q2, Q3? Not quite sure but, again, if you just assume that they're at the bottom on the inventory levels, then our orders should start to come up, not dramatically but moderately. And then as soon as they start to see some growth symbols, then that's when they've got -- we'll get not only the market growth but we'll also get growth that had been building that inventory back up. So in an up cycle, our business works really well. And we just need to see that inflection point, which we haven't seen yet that.

Great. Maybe in your opening remarks, right, you commented on the Flowserve 2.0 journey. I think we've been hearing over the last couple of quarters that maybe you're at a point in the organization where we could think about additions. Just wanted to get your thoughts on where would be -- or how should we think about your capital allocation priorities now that we've gotten to where we need to be on kind of some of the heavy or early blocking and tackling.

Yes. So we've been at Flowserve 2.0 since the beginning of 2018. And a lot of internal focus, a lot of kind of cleanup, a lot of integrating, a lot of the past acquisitions and really trying to create an operating system at Flowserve that, one, we could leverage and, two, can kind of work in an up cycle or a down cycle. We've made tremendous progress on that from enterprise-wide IT systems to our operational playbooks to some of the back office and functional things. And really, kind of the beginning of 2020 would be the first time that I was ready to say, okay, kind of green light to start looking at inorganic growth and acquisitions. And it was really the first time that I had confidence that if we were able to do something, we could actually integrate it effectively and properly. And so I still feel that way. And even in COVID and work from home, we've continued to progress our transformation. We can continue -- or we have continued to get better both operationally and from an IT organizational side. And so I'm confident that we can do an integration. At the same time, what I would say is we've got to make sure that we've got something that makes sense, right? We're not just going to go out and buy anything. We got to make sure that it's at the right price, that we know we can create value for Flowserve and for our investors. And then we're not going to get over our skis in terms of doing something incredibly complex that takes the whole organization off some of the work that we still need to do. And so in an ideal world, right, we'd do more of a programmatic or systemic approach, where we're doing kind of 1 or 2 deals a year, nothing outrageous or overly complex and starting to build back some of that DNA on how to do this. But I'm really confident in our team. We've got a great leadership team. We've done a lot of really good work and hard work through this whole COVID 2020 issue. And we're prepared to start to add things on. But we're going to be methodical about it. We're not going to be crazy. And then just the last point I will say is you've got to have a willing buyer and a willing seller and it's got to be at the right price. And so even though we're saying this is something we want to do, a lot of things have to align before we're going to pull the trigger on something. And so we've got a long-term plan in terms of areas that we're interested in and things that we're looking at. And we're starting to have some dialogue about potentially doing something.

Great. And maybe that's a segue here. One of the things I wanted to talk about was really -- and we've talked to several companies about this is kind of the clean energy transition, right, that's in front of us. I guess maybe from a high-level perspective, how do you think Flowserve is positioned to play in that? And then is it going to be a combination of kind of organic and inorganic paths?

Good. So I think it's definitely organic and inorganic. And a lot of the things that we did on the new product development front here and talked about in Q3 are around some of the energy transition issues and so more of a natural gas-type product. We're also looking at products around carbon capture and carbon sequestration. We've got stuff in the works around that can work on the hydrogen side. And we've been involved in hydrogen for a long time in the different refining processes. And so this is something that we do think -- we don't have our heads in the sand on energy transition. We know what's going to happen. We know it probably got accelerated with COVID in 2020. But we've got things that work there. And I'll just -- I'll give you a couple of examples. We participate in concentrated solar power. And while it's not a massive market for us, it is something that's growing and it's pretty exciting. And we've got partnerships out there with some of the leading institutes on concentrated solar power. We've got a valve product that works as good or probably better than anybody else's and we're in a preferred position there. We're trying to align some of our pump portfolio to make sure that we can be there as well. And again, that's not going to be -- it's not as massive a market but it's a great growth opportunity and something that we want to participate in. And so when we think about our business, we've been around for over 200 years. And we've got products that have pretty much solved any flow control problem or issue that's been out there. And so we're pretty confident that we can take our valves and our seals and our pumps and apply it to the latest thing or the latest application of flow control. And so we're going to continue to work that. We're going to continue to work inorganically -- or sorry, organically with our portfolio and our new product development. We'll probably continue to spend more money there. But we'll also look for bolt-on acquisitions and technology that can round out our portfolio.

Great. And so you brought up your kind of new product introductions last quarter. I mean one of the things I've been trying to understand is I think you had 5 new products, 6 upgrades. But I was trying to really understand what does that mean. Is that an acceleration of what Flowserve would have been doing a couple of years ago? Is it a step function change? Is it -- is there some way to put context around what you're doing there?

Sure. Yes. No, it's a good one. And so part of Flowserve 2.0, one of the big aspects was the new product development process. And I'd say we're not spending more money than what we have in the past but our outcomes are substantially bad, right? So now we've got an outcome-based process. We've worked really hard about understanding at the very beginning, right, defining attractive markets, looking at the competitive landscape, leveraging our know-how and putting these ideas into the funnel or into the product development process. And then the other thing we did was really tighten that process and making sure we have the right milestones, the right gates, the right checks. Are we validating the business plan? Are the assumptions still valid as we go through this? And then really tracking at the output is, okay, how long did it take us to develop the product? What is the year 1 revenues? What's our year 2 revenues? And so we've really formalized this approach. And it's not rocket science. A lot of good companies are already doing this. But we weren't as rigid and as formal in the process as we should have been. And so while -- if you look at our external financials, you're not seeing a big increase in R&D dollars. But I'm super confident that our output is substantially better than what it was 2 years ago or 3 years ago or 5 years ago. And so now what we want to do is now that we're getting things -- we're confident in our process, we're getting things through the system is we want to really focus on the idea generation and putting more into that. And so as we go forward, what you should expect is seeing increased dollars but also seeing more stuff come out on the other side. And so I feel really good about our teams here and the work that they've done. And we're going to continue to invest and continue -- go back to 200 years of product history here. We've got some incredible engineers, some great folks that have worked with customers and incredibly challenging applications. And so it's taking that knowledge and know-how and making sure that we can solve the current problems today. And we feel really good about our ability to do that.

Yes. I guess if we can go back to something we talked about a little bit earlier, that shift maybe to a renewable diesel plant or something that a refiner might be doing. How do we think about what the opportunity is for Flowserve in something like that? Or what's your kind of calorie content if somebody wants to do a switch? Are you -- I'm assuming you'd be involved just given your breadth of product.

Yes. Right. So let's assume that -- and there's a couple of examples that are out there today. But assume it's one that we've got installed base for pumps and valves already. They make the decision. They're moving from diesel to biofuel or whatever it is. We'll typically -- our sales engineers will get involved in the process. And what they're doing is kind of rewiring and replumbing that facility for the new process that they're going to involve. And so I'd say the good news is if the asset stays up and running, then we're going to continue to get parts, seals and continue to do services. So that for us is probably the biggest thing is if it's staying, even if it turns to biodiesel, it's still operating and we're still going to get aftermarket. It might be slightly reduced but it's not dramatically reduced. When they shutter and close permanently, that's when we lose out pretty significantly. And then what I would say is, as they're switching to this new process, we will get some opportunities. But it's certainly nothing like putting in a new module or a major upgrade or some massive capacity expansion. And so they might need a couple -- call it, 10 to 50 new valves that are going to have a different flow rate than what they had before, or they might get a control valve that's a slightly different spec than what's happening or they might need a new pump that's going to provide a different flow rate. So -- but it's not going to be wholesale. A big -- you're not going to see it on our top 10 project list on any quarter. But again, it's not bad. We'll get some investment from it and then, probably most importantly, as we continue to get that aftermarket in our seals and our valves in the pump side.

Great. And I guess earlier, you said to kind of expect to watch the aftermarket orders turn positive first followed hopefully by OE. You have really good geographic breadth, right? And I think there were some news articles, right, that China oil demand is already back to pre-COVID levels. So can you talk to us a little bit about what you're seeing in China? And should we expect that pattern that in China kind of goes to the rest of the world? But I just want to get your thoughts on that, what you're really seeing in China.

Yes. So I mean our China bookings and kind of the aftermarket side there look really good. And so -- and you said it right. Oil demand and mobility in China is back to pre-COVID levels. And so as that returns, then our bookings in our business follow that the same way. I would say it's really hard to project that to the rest of the world. And the Chinese do a really good job of when they say quarantine and stay home, then everybody stays home and quarantines. And so they've been able to lock down and return to a more normal state a lot easier than some of these other countries have. And so I just think it depends. And it's kind of a country by country and it really depends on virus eradication. And my personal belief is as the therapeutics and the vaccine gets out, that's what's going to start to change things for the rest of the world. But yes, I mean the 2 things to look at would be mobility data. And so as mobility goes up, demand for refined products goes up. And then ultimately, you're going to see demand for oil go up as well. But we track the mobility numbers pretty closely. And I'd just say, right now, you're seeing clampdowns in Europe. You're seeing clampdowns in North America. So that probably goes lower before it comes back up here permanently. Well, I say permanently but certainly into Q1, into Q2 as we hope the world return to a more normal place.

Yes. And then obviously, when you gave longer-term guidance targets, right, the world was kind of a different place. I think you've been very upfront that at some point, you plan to update those. But just from a high level, trying to understand both the margin and the -- so the improvement in the margin and the improvement in the free cash flow that you were forecasting, should those move together? Or are we going to see one move ahead of the other as we're thinking about that?

Yes. It's a good question, John. I think we can keep making progress on free cash flow regardless of the environment, right? So if our business is even coming down a little bit, our free cash flow conversion should continue to increase. And so we're making good progress on working capital efficiency and doing good things and becoming a more cash-focused company. And as you know, you've covered us a long time, we haven't been good at that in the past. And so we're making really nice improvement. And I would expect us to continue to improve there. On the margin side, we showed that as yellow last year at the end of the year in terms of our Red-Yellow-Green scorecard. And what we saw last year at the end of '19 is we had overbooked on the OE side. And that was -- that growth rate was higher than the growth rate of our MRO bookings. And that margin differential was kind of holding back the margin percentage. And so that's why we showed yellow. What I would say is as we turn the corner into 2020, right, the business has come down. It's really difficult to grow your margins in a decreasing environment, where revenue is coming down and we're starting to get price pressure. And so what we're doing is trying to offset that pricing pressure and some of that leverage on the overhead with all the good things that we're doing in Flowserve 2.0 around productivity and the manufacturing side, some of the lean stuff and then taking aggressive cost actions like we did in May. But I would say that's going to be -- getting up into that 15% to 18% on the OI side is going to be a challenge. It's something that I'm still not ready to give up on because I think a business like ours should -- an industrial business with kind of the assets that we have really should be in that kind of mid-teens margins. And so we're still focused on that. And we'll get real tight on what our guidance is here when we do our fourth quarter earnings call in -- at the beginning of 2021.

Great. And then I guess when you think about a solution we're hearing a lot more about, remote monitor, right, of assets. COVID seems to be accelerating the customers' desire for that. I think you have put that on top of -- I don't know if you can share, 1% of your portfolio, that you have some type of remote monitoring or sensor smart offering on top of. But if a customer decides they're like -- they want to go and put this out into -- and deploy it, what does that mean for Flowserve in terms of maybe a margin profile of that sale? Or do you more frequently attach some type of service or performance contract on top of that? Can you help us understand that a little bit?

Sure. Yes. And so we're doing a lot of work on our IoT offering. And I'd say stay tuned. There's going to be a lot more to come here in 2021 than this. But just to answer your question specifically, we've been working on this -- I mean it's been well before I've been here and probably upwards of 10 years now. And so we're well down the path of being able to have our equipment with the sensors and kind of smart equipment now. And so that's valves. It's on our seal systems and also on our pumps. And then what we've been trying to do over the last 2 years is we've been really -- we've kind of ratcheted up our efforts here and really focused about working with our customers to understand the problem statement and making sure that we have the right technology to, one, collect the necessary data but, two, to do something with the data. And the prize is really on what you do with the data rather than collecting it. And so we believe with our history of flow control experience that we can really add value because we look at a lot of different applications. We see a lot of different customers. We can add value with that data in understanding the data. So we've invested pretty heavily on data science and making sure our algorithms can, one, understand what's going on with our equipment but, two, understand the flow characteristics. And then, three, we're starting to be able to predict failure of our pumps, which is a huge plus to our customers if we can give them a warning before they go down an unplanned event. And so we're pretty far down the path here. And we're excited about our offering. When we think about business models, though, there's a lot of different things that we can do. And I'd say this is the space that will continue to evolve. But the current thinking is we want our equipment instrumented. We want to be involved there, at least the ability to see the data. And then we're -- back to my discussion before, we're kind of open to -- if we're partnering with a customer or an asset, we're open into a more performance-based contract, where we take some risks in terms of what we're willing to commit to and committing to making sure that they don't have unplanned downtime or reducing their mean time between failures on the seal side or something like that. And so I think the space is going to evolve pretty fast. And I'm pretty excited about what we've got. And again, we're going to talk a lot more about this at the beginning of 2021 from Flowserve.

All right. Great. Well, we look forward to that. And I see here we're at our allotted time. So I want to take this opportunity to thank Scott and Jay for being with us. And with that, we'll look forward to catching up again soon. And we hope that everyone stays well and safe.

Great.

Thank you, John. We appreciate you having us, and thanks, everyone, that participated today.

Great. Take care, everybody. Thank you.