Flowserve Corporation (FLS) Earnings Call Transcript & Summary

Good morning, everyone. I'm Nathan Jones. I'm the covering analyst at Stifel for Flowserve, and we're very glad to have Amy Schwetz, CFO of Flowserve, here from the company today. Before we get started, a couple of housekeeping items. I'm going back to the bull case, bear case format this year. We abandoned it last year because of the singular focus on COVID. I'll present 3 bear cases and then 3 bull cases. Management, Amy, will have the opportunity to respond, and then we'll dig into each topic with questions. Feel free to ask questions on any of the topics through the chat box on the conference portal. I welcome questions from Investors, which I'm sure will be much smarter than any of the questions I would ask. So please do ask any questions that you may have. And thanks for joining us Amy. With that...

Thanks for having us, Nathan. And thanks for starting off by saying my last name correctly. You started the morning off right.

There you go. It's probably the only thing I'll do right today. We're going to begin here with the bear cases. And the first 1 I have here is 40% of the business is directly tied to oil and gas spending, with another 10% from mostly fossil fuel power generation. These markets are going to grow slower than GDP and could see outright declines in investments over the long term. Growing faster than GDP for Flowserve is going to be challenging.

Yes. Thanks for -- thanks for starting off with an easy 1 there, Nathan. But you know our business well. I'm not sure that everybody on the call will. A little over 1/3 of our business is tied to what we define as oil and gas. And virtually all of that exposure is related to long-term assets that are in place, like refineries or LNG plants and pipelines. So I'll start by saying we think that we're years away from gasoline, jet fuel, asphalt and other refined products going completely away. And Flowserve is about 2/3 international. So we know that the world is on a different trajectory or a different pace as it relates to energy transition. So against that backdrop, kind of what are we seeing? And I've probably heard Scott Rose a dozen times at this point in time that 18 months ago, energy transition was what he was considering the biggest risk to our business. And I think at this point, we've really shifted that to say, energy transition is actually the biggest opportunity that we have in Flowserve's business. And I'm going to throw a couple of numbers, actually, that when I wrote them down for the first time, were a new nomenclature for me because I actually had to pull out the capital T in terms of dollars to be spent. But according to Irena, about $60 trillion with a T, $60 trillion is going to be spent on energy transition between now and 2030 by the energy sector. And $110 trillion by 2050 on energy transition. And I think what's exciting for us at Flowserve is not just that this touches a lot of areas that we're focused on. But in part, because there's a significant amount of that spending that relates to energy efficiency of existing assets. So how can we help our customers address their carbon footprints. So in the past, there's really been no economic reason for customers to address that, either carbon or other emissions that didn't have a dollar cost or government regulation associated with them. And we think that, that is going to change rapidly. Companies are making public commitments. There's potential costs and regulations. Society is changing their expectation related to what it means to be a good corporate citizen. And we think that we're exceptionally well positioned to assist our oil and gas customer base in a number of areas, and that could be anything from carbon capture and sequestration, flare gas recovery, reconfiguring flow control networks to be more energy efficient, converting older, less efficient refineries to biodiesel fuel facilities. And equally important in this conversation, I would say that we believe our flow control expertise can provide us new opportunities in other industrial markets that have large carbon footprints as well. So it's clearly a major theme. Energy transition is clearly a major theme in the world at large. And we think that we're pretty well positioned for it, and it's entering into conversations that we're having internally and with customers now on a daily basis. And so I think that if we look at this and say, the spending is really still in its infancy. And our traditional markets actually are in a position right now to have room to run for the next couple of years as we see mobility return and we were talking a little bit about that. I think you're getting on a plane later this week. I'm going to be doing the same. And as crude oil approaches $70 a barrel at its highest level since 2014, our oil and gas customers should have money to both reinvest in the business, but also reinvest in some of this technology that is going to assist them in the future in terms of staying relevant.

Thanks for that. I'll jump on to the next 1 in the interest of time. There is too much capacity in the flow control industry, chasing too little volume currently, particularly on OEM projects which is going to make pricing challenging as the market recovers and lead to disappointing incremental margins as backlog turns into revenue.

Yes. So I think this is a question that is probably plagued Flowserve and other flow control providers for a number of years, regardless of the environment. And Scott flagged on our fourth quarter earnings call that we do expect flow control pricing levels, particularly on original equipment and projects to be aggressive as work returns to the market and as we start to build our backlog. And even in the best of times, that large project OE work that tends to make our bookings really frothy, is our lowest margin offering. But there are 2 key aspects really to that type of work. First, as we look at our manufacturing footprint, it absorbs costs in those facilities that might otherwise negatively impact our bottom line and, frankly, have for the last 12 months. And second, it creates new installed base for us. And that installed base, then in turn needs parts, need services and needs repairs for decades to come. So again, to level set everyone on the call, large project work generally represents 10% to 15% of our revenue stream. And around 85% of our revenues are actually tied to the aftermarket and replacement MRO or -- maintenance, repair and operations. So in the grand scheme of things, really, Flowserve is much more tied to operating budgets of our customers than we are to capital budgets for those companies. And there the good news right now is really we're seeing a significant amount of pent-up demand in this space for MRO and aftermarket work. We went through COVID, and obviously, demand was down, and there post -- we had our oil and gas customers that were postponing turnarounds and traditional maintenance activities. We're starting to see that shift as we move our way through 2021. And furthermore, distributors who have really been embarking on what I think is somewhat of a historic de-stocking exercise that occurred that started pre-COVID and continue during -- has continued during the pandemic, it's going to have to reverse at some point for them to remain relevant. And we've started to see in the first quarter already this year, some improvement in our MRO bookings. And for both aftermarket and MRO, those have significantly higher margins than our OE work. So back to my comments on kind of thinking about that mix, the margin we deliver is going to be mix dependent, but I like the way we're trending based on seeing that aftermarket and MRO, those markets returning more to more normal and sustainable levels.

We've seen a little bit of I guess inconsistency over the years in this MRO aftermarket work returning as we come back into a cycle. I know you weren't around then, but I covered Flowserve back in 2009, 2010, 2011 when the aftermarket did rebound pretty well. And then in '15 and 16, where it didn't. Maybe you could just talk about the differences between what you're seeing in the market now versus at least what Flowserve saw in '15 and '16, where customers really did continue to defer that pent-up market wise.

So I'll start with a couple of things. I mean, I think, one, on the aftermarket side in 2020. The declines that we saw in that area of the business, were certainly less dramatic than what we saw in the original equipment side. So we are starting-off of a slightly higher base. But what we're hearing from our customers at this point is clearly that COVID offered sort of a two-pronged concern for them. I think the 1 which was present in previous cycles was that they wanted me to save money. But the second was really different in that we did not have access to certain sites. And so as we have discussions with our customers, what we are saying -- what we are hearing from them is that they do actually intend to restart those activities as we make our way through 2021. And certainly, the bookings that we saw in the first quarter of this year indicated that, that was the case. On the MRO side, that was a different story last year. And really, even in the last couple of quarters of 2019, where we saw de-stocking was clearly happening. We saw from some of our -- some of our public distributors that, that de-stocking continued into the last quarter of 2021 to where inventories are really at historically low levels. And I think that I'll kind of go back and touch upon a comment that that I made earlier. For distributors to stay relevant, inventory is a pretty important thing in the mix. So we've started to see small indications that recovery is occurring in that space, just based on our MRO bookings, but it's also clear to us that distributors are going to eventually need to invest in some working capital in order to serve their customers the way that they need to.

I'll vouch for that in saying as I cover the yard to U.S. distributors. On to the third 1 now. Technology, sensors, IoT, predictive analytics, might not be revenue accretive for Flowserve. The addition of all these technologies has the potential for customers to extend asset life and time between services, which could reduce aftermarket and replacement revenue for Flowserve?

Yes, you're actually playing really nicely off your last question in terms of how we think about this. And in IoT, you're referring to a product launch that occurred earlier this year that we're exceedingly excited about, our RedRaven IoT offering. We've been really pleased today in the market's interest and demand for the RedRaven technology. This is going on our pumps. It's going on our control valve that's going on our seals. I think we can -- reasonable people can disagree about whether or not over the long run that IoT is going to be considered like a car radio or it's going to actually be a differentiator in the market. And I think that your point is that data collection is easy and can be replicated pretty quickly. I think what we see as our differentiator in this space is the amount of data that we have and what we can do with that data. So the fact that we have the ability to install this and monitor this across flow control systems, and the fact that we have a bank or we have access to a significant amount of data and expertise in order to interpret that data on behalf of our customers really makes our product different to the market. This is not just an idea that we're collecting data. We are truly providing a service here in terms of monitoring and predicting what can happen with flow control devices that are in the field. And so if we think back to where we really liked the margins in our space, it's on this aftermarket side of the business. So services and replacement equipment in the mix. And so not only does this put us in a spot where we may be able -- where we're going to be able to develop a recurring revenue stream from a service, but it also puts us in a position where we're closer to the customer in terms of those aftermarket needs. And so we have the opportunity to not only serve our customers but serve our customers in a really proactive and exceptional way in the aftermarket to make that relationship closer and a better relationship for both the customer and Flowserve.

Thanks for entertaining the bear questions. At the halfway point, we'll switch to the good one.

Now, let's get to the fun part.

We're doing the good ones now. The heavy lifting of the Flowserve 2.0 transformation is nearing completion and should have laid a solid foundation for Flowserve to drive better than historical incremental margins as revenue growth returns in 2022. Depending on the strength of the recovery, the targeted 15% to 17% operating margins are in play for 2024 and 2025.

Yes. So I'm going to start by saying, Nathan, you're not going to trick me into giving any new guidance here. So I'm going to be trying to be circumspect as we work our way through this.

I'll definitely not do this.

. But I think that as we make our way through 2021, you are going to hear us referring less to the transformation as a project and more about how it has become embedded in our processes in terms of how we do business at Flowserve. . It's been heavy lifting for the last several years for sure. But I think this has now really taken root both at an operational level and at a functional level within the organization. In 2020, there is no doubt that as we looked at those transformation efforts, we reprioritized and put a focus on those efforts that were related to cost control. It is -- it's what we needed to do. And so as a result of those actions, we've now had 4 quarters in a row where we had our SG&A expense at sub $200 million levels. And last year, that piece really helped us drive decrementals under 30%, including just 14% in the fourth quarter of 2020. So we've got a really solid foundation to build off of. And to your point, incremental performance should be stronger than it was in past recoveries because this has been done in a more sustainable way than it's been done in the past. So of course, as we work our way through this, product and service mix associated with that growth will largely determine what that incremental margin is going to be. So we're going to see -- we may see some sloppiness between quarter and quarter as we see OE and aftermarket work fluctuate a little bit in terms of that mix percentage. As we indicated on our fourth quarter call, our target is operating margins between 15% and 17%, and we're going to provide a new date on that. And how quickly we get back to that wheeler or how quickly we get to that really depends on where that mix goes, how quickly the market recovers? And when does that mix kind of settle down and go to a sustainable level. So I don't want to create new guidance here as I started out with. So I'm going to deflect on the timeline question, but we're committed to these goals. And bottom line is that we think that the actions that we've taken on the cost side. And now with our 2021 focus, really returning to that growth aspect of the transformation. And that's set against the backdrop of a recovering marketplace and our committed associates, we think that we've got a really great foundation to build off of in 2021 and going forward towards these goals.

I definitely understand the avoiding the timeline kind of thing there because it definitely depends on how the volume returns and what that mix looks like at any given time. Maybe if I can...

And I can tell you, it is front of Scott and I's mind and Jay's and Mike's as well, to be more transparent with respect to those targets over time as it becomes more apparent.

Maybe I could frame a follow-up question like this. In 2018, you guys set that 15% to 17% operating margin target. Obviously, we've had a small disturbance in the global economy on the way to that time frame. Is there anything structurally within the company that you guys have found as you have rolled these initiatives out that would have struck you from getting to that 15% to 17% other than all the volume disruptions that we've seen?

So I think the volume disruption is without a doubt, the most significant element in the piece. We've touched upon the aggressive market. There's no doubt that the OE marketplace is probably a little bit -- I'll use the term scrappier than it might have been 24 months ago. But I think overall, we're holding our own with productivity movements in that space. And I think the other thing that we're really watching out for and ensuring that we're understanding is as we're bidding on things, is just the backdrop of inflation. And to date, we've seen sort of improvements in our supply chain space, really be able to offset that inflationary pressure. But interestingly, sort of the ramp-up out of the pandemic is creating a new set of issues for us to manage. But to date, I think they're ones that we've managed quite well.

If it was easy, everybody to be able to do it. On to...

Exactly.

The balance sheet is in good shape with net debt of 1.3x trailing 12 months EBITDA, improved cash flows and increasing EBITDA likely to come in the recovery here is going to add to that deleveraging and lower leverage. This gives Flowserve the ability to diversify its end market exposure away from fossil fuel markets and into areas with better long-term growth potential?

Yes. And clearly, we feel good about improvements that we made on the cash flow side. And no doubt, we think that the de-leveraging that we've seen on a net basis is going to continue as we make our way through 2021 through -- in 2 ways: one, improving EBITDA, but also improving cash generation and cash generation that's going to come on to the balance sheet over that period of time. So I always appreciate questions or commentary on the strong balance sheet. I think there aren't many movements across fluids and gases over the last 200 years of our existence that we've not been involved in. And so we do try to make sure that our movements are market led. I think as we went through the bear cases, we talked a lot about the fact that we see pretty significant opportunities in our traditional space around energy transition. And so I would want to push back against the notion that probably that, that space becomes less important to us over time. It actually will remain exceedingly important, but we'll be looking to help our customers in different ways. That being said, there are certain markets that are very attractive to us and will be in coming years, and I specifically touch on there sort of the water market. And the Specialty Chemical markets as well. And we're really excited about opportunities that may be available in that space. But as we look at the oil and gas space, that work is predominantly downstream. It's followed then by some midstream opportunities. These assets are not going to go away. They're long-term type assets. But we know that those owners are going to be interested in having them run more efficiently, and that's both from a cost and a carbon footprint perspective. So it's really going to be a huge opportunity for us in the long run. And so we talked about some ways that we are going to be able to play in that space over time. And we think that those discussions are not occurring with customers 3 years from now or 5 years from now, those are the type of conversations that we're actually having today with customers. So I think to make this long comment short, if I can, I think, one, we've got to actively pursue these growing markets that we talked about, water, specialty chem. But we also need to understand how our existing markets can operate or can offer growth opportunities for Flowserve over time. And as we think about investment in this space, it's not just about -- it's not just about diversification. It's about how do we round out the portfolio to be a strategic fit with energy transition as well. And on all inorganic growth opportunities, we have to be very sure that they offer great financial returns to our investors.

Maybe I could ask 1 follow-up there on your appetite for M&A, Flowserve hasn't done much M&A over the last few years. Is the company looking to get back into M&A markets for inorganic growth? Is there going to be some other outlet, share repurchase for capital deployment? And now that you've got the balance sheet in pretty good shape here, and certainly improve the cash flows, how is the company thinking about capital deployment?

So as we think about capital deployment sort of in terms of commitments, and then strategic opportunities. And so our commitments are obviously that the debt that we have on our balance sheet, it's our dividend. We view that as a commitment to our shareholders in the mix. And then any other opportunities that we have in the bank and whether or not that's internal investment, inorganic growth or share repurchases, we're trying to align that versus the next best opportunity. You've seen us use share repurchases in the past. We've got about $100 million of firepower available to us. And certainly, we have been out of the inorganic space for a while. That's partially because I think we had it -- well, we had a large amount of sort of pent-up integration to do within the system in the form of the transformation. As we're making our way through that and become more confident in our ability to integrate, I think we would entertain inorganic growth more than we would, call it, 24 months ago. But again, I'll go back to my last commentary on the previous question, which is it's really got to offer exceptional value to our shareholders. So that means that the financial returns need to be there and the strategic fit needs to be there. Otherwise, we'll look internally for those investments.

On to the last one. Speaking of cash generation, it has improved significantly in recent years with 96% conversion of adjusted net income over the last 4 years. And that having averaged 66% for the prior decade. Improvements in working capital, structural and sustainable and Flowserve should generate solid cash flow going forward?

Yes. We agree that those improvements are structural and sustainable. And I would actually throw into that capital discipline as well and how we are viewing capital investment in the company in that mix as well. That working capital journey, I can't take credit for it. As you know, it started well before my arrival at Flowserve, but there's no doubt that we are running the business more efficiently. But I'll tell you what is exciting about it from my perspective, is there's still opportunities for improvement in this space. And so you still hear us reference working capital in our commitment to continuing to reduce that investment in working capital over time. So as we look at the first part of the -- first couple of years of the transformation journey, it was really focused on AR improvements. And we've got small and incremental improvements to make in terms of collection activities. But really, this year, we are very focused on our inventory management. And what we can do to reduce that over time. And so we'll get a little bit of a headwind as the market grows this year from an inventory perspective and an AR perspective, but I see the opportunity to really bring that primary capital or primary working capital usage down from where we're at today and sort of the high mid-20s, to something more to the mid- to low 20s over time, and that's what we're focused on doing.

Your predecessor described their working capital improvement is more brute forced than anything else in the initial improvement. I know you guys were looking to invest in IT systems and to codify those improvements, so they would be more sustainable. Can you talk about what's been done more than just calling customers and we're asking them to pay their bills, to actually have that structurally built into the way the company operates?

I would say we've got -- had the luxury of becoming a little bit more finesse in our approach with respect to working capital management. So 1 of the things that I'd point to specifically this year is really how that inventory management has become much more of a process embedded within our operations. There's tools that are available to those with influence on this. And that's from our sales team, our sales team, working with our operators to forecast demand and to understand what are those critical supplies that need to be on-site and when. I'd say there's -- maybe you start with brute force, and now we're more moving on to the diplomacy efforts around working capital. But that being said, they're no less impactful in terms of the results that they can deliver.

Great. Well, I see we're up on time. So Amy, thank you very much for your time today. We appreciate it. And thanks for everybody for joining us on the line.

Great to be on the line, Nathan. Thanks so much.

Thanks, Amy.

Bye.