Flowserve Corporation (FLS) Earnings Call Transcript & Summary

Good afternoon, everyone. It's Deane Dray back, senior analyst, multi-industry electrical equipment for RBC. We're delighted to be hosting Flowserve as our next presenting company. We have Scott Rowe, President and CEO. Scott, thanks for being here.

Thank you, Deane.

Terrific. We'd much rather be doing this in person, much rather be in Vegas, but just where circumstances are right now, this is where we are, but appreciate it.

We'll take it.

All right. Let's just jump right in. And I'll start with oil and gas because you are one of the more indexed companies we have to the sector. It has lagged. But if you listened for green shoots in your quarter, whether it was order rates, bookings, MRO, aftermarket, you saw encouraging signs. So has the corner been turned and give us your perspective, that would be a great place to start.

Yes, absolutely. So just for those that don't know Flowserve. We're about 40% oil and gas with our total portfolio. The rest is power, chemicals, general industries and water. And then of that oil and gas, about 60% of it is the downstream side. And so we're really more refinery focused or installation focused than anything else. And so as Deane said, we had a solid quarterly booking -- or Q2 was a solid quarterly bookings number for us. And what we saw was our MRO and aftermarket business performed really well. And so we're seeing that side of the business come back. And so if you think refineries and as kind of the vaccine gets out, mobility increases, both on ground travel and air travel, the refinery utilization is now coming back up. And for us, that's a really good thing. And so as refineries are operating kind of at higher levels, they're consuming more of our products, whether it's valves, pumps, mechanical seals, all of that is a good thing. And so I'd say that's been the positive news thus far this year is that the utilization rates are up, people are replenishing their -- more of their consumable items that get worn out in the process of running their big facilities. We expect that to continue. I don't expect the growth that we saw sequentially from Q4 into Q1, but we do think that MRO and aftermarket business will be at a more moderate growth rate going forward. And then, Deane, to the other part of the equation and what you asked was just on the project side. And while we're seeing a lot of activity in our funnel and a lot of discussions on projects, we haven't seen projects getting booked yet. So we had a limited project activity in Q1 and Q2. We have a lot in the pipeline and that's really the big question is kind of when do those start to come forward. There's a lot of speculation. There's a lot of data out there. There's a lot in our system and our conversations that the projects that were out there at the end of 2019 and going into COVID are still there. Very few of them actually got taken off the books are canceled, but they've just been delayed. And so there's different requirements now. There's different funding needs and they've just got to kind of work back through that whole process. And so I'm optimistic, and I said this on the earnings call, I don't know if it's -- is it the fourth quarter of this year or first quarter of next year, but they are going to come back. And so we are confident that we're going to see oil and gas projects in the future. I think it's just a timing issue at this point.

Yes. And from our perspective, those are the leading indicators that we look for when it shows up on aftermarket and your commentary about the front log, those discussions, the projects don't go anywhere until you've had that level of discussion upfront. And it's just really -- there's no way to quantify that, right? That's all just qualitative?

It is qualitative. But what we use is a CRM system, we call it FlowForce. And so we can track opportunities and we compare that year-over-year. And so we know that project activity is up substantially from last year. And so that's kind of one way to look at it. It doesn't give you exactly when these things move forward or how it looks. But we know for sure, there's more activity, there's more discussions, there's more projects in our funnel, and we're confident that these things start to come through in the coming quarters.

Could you talk about backlog and how much visibility does that give you into the next few quarters into 2022, the expected kind of conversion time? Is it any different than what we've seen historically?

Sure. Yes. So our bookings, Deane, in Q1 and Q2, we had a bookings ratio, book-to-bill of over 1. So that means we're booking -- we're building backlog. So that's really good. We're excited about that. We didn't do that in 2020. And so if we can build backlog, we get pretty excited. And so what we're at -- we finished Q2 at $2 billion of backlog. So that's a reasonably healthy number for us. And again, we grew it in Q1, we grew it in Q2. And typically, in our business, we can convert anywhere from 85% to 90% of that backlog in a 4 quarter or calendar year period. And so we've got really good visibility now into at least the first half of 2022. And quite frankly, we talked about this just in the previous comments, right, if that MRO and aftermarket business sustain even at the levels that we were at in Q2, then we're building backlog throughout the end of the year. And so we're confident that our ending backlog in 2021 is going to be higher than it was last year. And that -- what that tells you then is as we convert that backlog into revenue, we're pretty confident in revenue growing now in 2022.

Great. Hey, look, every CEO is coming through at this conference is getting asked about the price/cost conditions, just material shortages, labor. But you see all of that. Just in terms of level of severity, where -- if you're doing triage, where are the biggest pain points for you today?

Sure. I'll just start generally and then I'll hit the pain points. This is a global issue, right? And so you think pandemic and you think recovery and some industries are accelerating forward, oil and gas is lagging a little bit behind. But it's really causing a lot of challenges in the supply chain. So there's dislocation issues, there's disruption issues, there's inflation in the system. And so it's tough right now. And we are pretty public in Q2 that we were in a negative position. And that's quite frankly, the first time I've had to say that since I've been here. Our Flowserve 2.0 initiatives that were really around restructuring the company and focusing on sound business practice have really helped us put us in a good position to manage that. But in Q2, it started to pick up and a lot of that was due to India. And so for us, our supply chain is more India than China. And so India obviously got hit significantly with COVID. We had a lot of our suppliers come off-line and it was a real issue. We're seeing India start to recover, and I can talk more about that. But just the global picture, though, it's still a mess. And I don't know when it gets better. And I think you can see and you hear stuff certainly at your conference and in the news but it's still out there. And so there's a lot of challenges. And I'd say where we're impacted the most are 3 areas. It's the global logistics situation, so transport providers and whether that's air, ground or sea, it's all a mess right now. Things are getting delayed. It's hard to book, there's inflation and it's really challenging. What I'd say, the sea freight is probably the most challenging for us when we're putting big pumps or big bowls into containers and getting those moving around the world. And so we're seeing inflation on that in disruption. And then the other 2 areas, motors are a big one for us where we've seen inflation, and obviously, any time we have a pump or putting a motor with it. And then finally, on the electronics side, we've done a decent job mitigating risk there thus far, but that's a concern, and we're making sure that we've got the primary, the backup source. But I mean the global electronic situation is unreal right now in terms of finding that. And so for us, that shows up on our actuators on the valve side, in the control valves. So anything that's kind of smarter moving has got some sort of circuit board on there. And then now with our IoT and everything else, it's a big part of what we're trying to do.

Yes. Absolutely nothing you said there is surprising. What is surprising, I guess, is that I could have put 5 different or 6 different companies that I cover that would have said, here are the pain points, and they would have recited those.

Yes.

So we're not surprised, especially on the last point because no one thinks about a motor or a pump having that much semiconductor exposure, but they're all smart and drain of the semiconductor getting directed and in shortage for the auto industry affects everyone.

It is shocking, Deane. Like I would have never guessed this 6 months ago, and here we are talking about. And we -- fortunately, for us, we're using a pretty basic printed circuit board. So it's not the most complex ones, but everything is getting snatched up. And the problem now is like people know there's a shortage. And so folks are buying too much or putting stuff in inventory, and it's causing a lot of problems out there.

Good. I wanted to talk about pricing. But first, since you brought up Flowserve 2.0, and this is kind of a hypothetical, but think about if we were trying to go through all of these conditions because you're halfway through Flowserve 2.0 and the company is so much better in terms of its operating. How is Flowserve 2.0 right now making the company operate better, hold on to margins, precision on the manufacturing side? How are we seeing that in light of these really tough operating environments?

Yes. So just for those that aren't aware of what we were trying to do. Back in 2018, we knew we had to run the business differently. And so we launched a big transformation called Flowserve 2.0. And now we're a long way down that. Deane, we're probably more like 80%, 85% through the program. And at the end of this year, we'll actually disband the formal program itself. Now the results and the benefits will continue to come for years beyond the end of the year. But back to your question, had we not done this, we would have been in a world hurt through COVID. And so part of the program is what we did is we looked at all of the different aspects of our business. So manufacturing, supply chain, the commercial team, how we do financials, what do we do on enterprise-wide systems and things like that. And we've been investing heavily on rewriting the DNA and the operating system of our company to just be far more efficient than what we've done in the past. And we were getting really, really good results pre-COVID. We saw margins improve, working capital improvement, free cash flow improvement, ROIC coming up. And then COVID has kind of taken -- we've taken a step back and now we're back on the ball game. But I think as we look at the COVID year, right, our decrementals were far better than what this company has ever experienced in a downturn. We were able to act decisively and quickly with cost-out programs, closures of sites, we were able to manage the working capital reasonably well. There were some issues in Q3 last year. But overall, it was a reasonably good performance. And so I'm pleased that we did the program. The results are certainly coming through. Obviously, the pullback in bookings and revenues levels don't hurt us. But we're in a really good position today now to capitalize on growth. And so as we think about coming out of the cycle, as we start to talk about incrementals and drop-through and things like that, we're going to be well positioned to do some good things with the company.

I was hoping you'd give a little more specifics on the kind of incrementals on the upswing.

Yes. I think, Deane, we'll come out at the end of the year with kind of long-term guidance and margins and things like that. But I'd just say everything that we're trying to do is kind of better than what the company has done in the past. And so if you look at kind of the incrementals before, we think we can do things in a better fashion. And so I'd say that's a good benchmark for now. But as we come out with full year guidance at the end of the fourth quarter, we'll do the full year guidance and then we'll recalibrate back to those Flowserve 2.0 goals as well.

Good. Well, one of the other work in progress that you are showing -- work in process that you're showing progress on has been on free cash flow generation and working capital management. That was your mandate, one of the biggest mandates. We're seeing steady progress. And so give us a sense of what's been accomplished so far in terms of free cash flow generation? And what is there still to do ahead?

Yes. So historically, the company didn't do a great job converting the cash. And so for us, the 2 big opportunities were receivables, management and then on our inventory management. And so through Flowserve 2.0, we put a lot of focus on both of those and we're seeing the results. And so we're actually getting really good results in the back half of '19, kind of a little rocky in the 2 big quarters of COVID, but back on track now. And so as we really focus on collections and making sure that our DSO is in a much more normal place, which we are today, then we start to generate nice cash flow. And then on the inventory side, it's really around production planning. And so that was a competency at Flowserve that really didn't exist. And so we've put a lot of effort around manufacturing planning. And so this is sales and operational planning on the front end, but really focusing on the MRP and how do we run production at the sites. And so we've changed that dramatically in Flowserve and the results are really, really good. We have a few stragglers still in the system that we're getting back up to where we think they need to be. But overall, I'm really pleased with what we've been able to do. And I was fortunate to go to some of our European sites last week that I hadn't visited in over 18 months. And just to see the progress and the amount of the inventory velocity improvements and what we're doing there is really impressive. And so there's actually more runway here and so we're not done. And this is one -- while the transformation will formally end this year, like those tools that process are truly now embedded in our operating model and system, and we'll continue to see results and improvements throughout 2022 and beyond.

Yes. That's really good to hear. And from our perspective, that's been one of the most important areas for focus. Traction is being shown, and you can see where there's still plenty more upside. So I love hearing that. Let's circle back on pricing because you do have pricing power in specific areas across the portfolio. Just talk about how you've been able to put that through value-based pricing? And what should we know that you're doing differently today?

Sure. So again, Flowserve 2.0 pricing was one of the major work streams in there and just kind of relooking all aspects of pricing. So understanding list price management on parks and things like that, that have a list price, truly redoing the way we do cost plus pricing on some of the bigger projects for the engineer to order work. And so we've made a lot of progress there. And now it's a discipline and part of the management playbook, which quite frankly, wasn't as formal as I would have liked at the beginning. And so as we think about 2021, we did a modest price increase at the beginning of the year, but kind of -- we didn't really know the whole situation of where the business was going to go and kind of what inflation was doing. So it probably wasn't as much as we needed or wanted to. We actually did a second price increase at the end of Q2, beginning of Q3. And so we'll start to see the results of that probably around the kind of mid-fourth quarter. But we've done blanket price increases on our list price. We've adjusted our modifiers on guidance for our sales force in terms of discount levels and control there. And then we've got a higher margin expectation on our engineered order work that's significantly higher than what we've been doing in the last 12 months. So I think we're trying to offset a lot of the inflation. And I think what we've done and put in place here in Q3 is certainly enough for the current situation. We will absolutely reassess this as we turn the corner into 2022 though.

Just in terms of price increases, have they -- have these been done outside of the normal cadence that you would see? And has that been at all disruptive? And what are the sensitivities there?

Yes. So normally, we would do 1 -- we'd announced at the end of the year and go live at the beginning of the year. And that's kind of the normal cadence for most industrial businesses. A midyear increase means something exceptional happened. And again, I mean, it's not a surprise to anybody, right, with what's going on in inflation. I mean just pick up that -- any newspaper, you can read about inflation. So I think -- I'm not going to say it was well received, but I think it was certainly expected from our customers. And I feel reasonably good about the traction that we're going to get on the latest rounds of increases.

Good. Let's roll back to one of the very first topics when we talked about oil and gas. And you mentioned refiners, but there's -- conges up the whole legacy type of downstream focus for Flowserve. But there's this energy transition that is going to become a meaningful driver of growth in the sector. Can you give us a sense of how Flowserve is positioned here, what the opportunities are? What can you do organically? Where might you do some M&A, but just the energy transition theme?

Sure. Yes. So Deane, this is a big one for us. And so again, 40% of the business is oil and gas. And this is probably -- of all the industrial grouping, right, this business is under more pressure than anybody else. And as they think about carbon reduction and being greener than they were in the past. And so what we want to do is we've been with these companies for decades, if not 100 years, in some cases, and what we want to do is support them today and through their energy transition journey. And so we're not going to walk away from our customers. We've got a great business with them, and we've got installed base in their facilities. And so our approach is threefold. And the first 1 is saying, hey, if you have an asset, whether it's a chemical plant, it could be a desalination water facility, but want to stick with oil and gas. So it's a big refining plant. We know they're under pressure, right? And so whether it's somewhat out of Europe that's getting regulated through the government to do something differently or some of the ESG pressures here in the United States on ways to do things differently as well. They're under a lot of pressure. And so what we're doing is coming with kind of a menu of options to say, hey, through energy advantage, here are things that we can do because we've got pumps and valves, and we have a holistic look at your flow loop, and we think we can drive energy efficiency for you. And so what does that mean? It means optimizing their flow loop, driving down the energy content in the pump to optimize their flow loop, looking at our control valves and making sure that everything is working in unison. We also have a unique proposition with our seal business, to make sure that we're not leaking or causing harm to the environment in the ceiling itself. We have fugitive emissions in our valve side, so we can look at gas leak and things like that. So we have a lot of different things where we can come and say, "Hey, we're here to help." And then the other part of this, Deane, is if we can layer in our IoT side, the Red Raven side, where we instrument both our pumps and valves, now we've got more data to help them drive productivity and efficiency. And so we've gone out very actively in this approach. And what I would say is part of this is new, but a lot of it isn't new. And so -- in the old days, what we would call as a pump retrofit or a pump upgrade. Essentially, what we're doing is pulling that pump out of service, looking at the characteristics of flow. And then we were upgrading the internals to meet the new process conditions. And by doing that, that pump was more efficient and the motor was running less and the energy consumption was less. So we have the know-how and the knowledge and the skill set to do it. We're just applying it now at a bigger scale. And we're getting a lot of traction with our top customers. It's a very consultative sell. In fact, I've been meeting with the top refining management to try to sell this personally. But when we get in at the top level and then start working at the bottom up, we're having incredible success and traction. And what we're seeing is we can drive significant energy savings with our customers to the tune of, in some cases, $1 million a year on a small set of pumps and equating that to a carbons emissions reduction that is pretty significant. So that's one piece of the puzzle. The other is just low-carbon energy sources, right, and making sure that we're playing in the flow control aspect of that. And so that could be concentrated solar power, where we have pumps, valves and seals in there. We're leaning in on the hydrogen side. So both the blue, the gray and hopefully soon to be green. And so making sure that we've got equipment and solutions that can participate in hydrogen. LNG comes into play there as well. We've got a great offering, both in valves and pumps on the LNG side. So just making sure that we're there for kind of the energy of the future that will be less carbon-intensive. And then finally, the third leg on this stool is really around the different technologies that are going to enable this ultimately transition. And so that's the carbon capture and sequestration. It's moving to biodiesel, which we spotlighted in the second quarter, where we did a big project in conversion here in the United States. But it's also doing recyclable plastics, lithium, being on the mining side, the battery recycling side. So again, anywhere that there's flow control, we've got a good purview, a good offering, and we're confident we can do something to participate in that space. And then just to -- to just kind of close this discussion -- not close it, but I'll finish with -- if we go back pre-COVID, we were booking about $100 million to $150 million in what we'll call energy transition-related work. And this year, we've already booked in the first 2 quarters over $100 million in this type of work. And again, that's concentrated solar power. It's some carbon capture sequestration stuff, flare gas recovery. It's biofuel conversions and then it's recyclable plastics as well. And so we think we've got a really good position to capitalize on the spending here. It's a little bit of the Wild Wild West right now and trying to get my team focused on a couple of things where we know we can add value with our customers as really important but there's a big opportunity and there's going to be substantial spending in this in years to come.

Substantial spending organically -- organic investments or substantial spending by Flowserve' in M&A?

Yes. I would say it's spending by our customers. I didn't answer your M&A side. I think right now, a lot of this is internal development team, but we are looking at acquisitions that can help us kind of connect the dots and improve our offering. And so I do think that's part of the long-term equation for Flowserve is to be accretive with adding companies, adding technologies to round out our portfolio.

That's great. So as you were clicking through all the different ways on the energy transition, how you're assisting your customers to move into these opportunities that has to have a meaningful impact, positive on your ESG, your ESG rankings. Just give us -- how does that all link together? Where is ESG today? What's the mandate? What's the opportunity to move up in terms of the ratings?

Yes. No, it's a really good question, Deane. We are working hard on this. There is some low-hanging fruit that we probably didn't focus on that we needed to. And so we're making some corrections and probably -- corrections isn't the right word. We're telling our story far better than we were in the past to move us up on those rankings. And so I think we were doing a lot of really, really good things that we weren't getting rewarded for or weren't getting credit for. And so I think what you'll see in the next turn of these evaluations in these reports is you'll start to see our score move up pretty significantly. And then the part that's a little bit frustrating is we think our -- if we just say on the environmental side, we think our impact with our customers is far more significant than what we can do within the 4 walls of Flowserve. And trying to get credit for that is not very easy, you read how that is and what that true kind of handprint is that we're leaving on the world, but through our customers and our technology. And so we're going to continue to evolve that story and that messaging. And I think when ESG investors and others start to see that and truly comprehend what impact we can have on the globe through our products, through our services and through our know-how, then that's when you really see us get put in a different light than we are today.

Yes. Just on that talent. Yes. But the rating agencies are very sensitive about the benefit you bring to your customers.

Yes.

So you just have to tell the story and...

Yes.

Okay, good. Because we see it. Because distributors don't make any products. So within their 4 walls, they don't have a whole slot of story, but they're telling all about their customer side. And you obviously have a big opportunity there. We only have a couple more minutes. Just going through -- one of the things I did want to hit is not anything specific, but just your sense of inventory in the channel just -- there's this whole restock opportunity. And I'd like to check on -- take your pulse in terms of where you think that stands today.

Sure. I think we talked about in the quarter and there's really no new news or no change there. But at the end of the quarter, we talked about our distributors who are finally starting to place some stocking inventories, and I truly expect that to continue here through the back half of the year. And if you look at any of the publicly traded distributors, their inventories are at, I mean, literally record lows. And so they have to replenish or they just -- they become irrelevant and will start going straight to the end-user customer. So I'm confident that, that improves here in the back half of the year. Not quite sure what the magnitude is, but they have to come up from where they are, and we're already starting to see that.

Good. And again, we've got a couple of minutes. And I just want to make sure that -- because you did touch on it, on RedRaven. We think this is really significant in terms of the opportunity in IoT platform for Flowserve. Just where does this change your level of offerings? And how much of a benefit are we seeing today in RedRaven?

Sure. Yes. So for those that don't know, RedRaven is our IoT offering, and it's essentially where we can instrument our pumps, our valves in a seal system. And what that does is allow us to get data back on how our equipment is operating, but also on process flow. And then in return with our customers, we can provide some really great analytics and visibility in terms of what they're doing and how the equipment is working. And then we're now well down the road on predictive failures as well. And so as we think about efficiency, productivity and uptime being the big challenges for them, we think we can provide a really unique offering across their flow loop that can help them in those areas. And so we launched this in January after years of development and a lot of pilot work but we're really pleased with what's happening. And so the mantra I keep saying is, we're booking about a 1 new installation every week. We're still on track for that this week. And right now, we've been -- and again, talking to customers and traveling around last week, we're getting a lot of uptake from our customers. They're excited about this. We've got an open source kind of system that allows them to plug and play it in pretty seamlessly, which is a really big deal when you're thinking large installations that have their own cybersecurity issues, their own network issues and things like that. So this is something that we're excited about and when we think about energy efficiency, enabling that with RedRaven in data gives us a really good advantage and perspective in how to do that.

Good. And just a quick sound bite. What inning are you in, in harnessing all the opportunities with RedRaven in terms of your product offering, intimacy with your customers, aftermarket and so forth.

Yes. I mean we're at the beginning. We launched in January. So we're 7 months in. And so I think we're at the very beginning. I think there's a lot more we can do. The more we talk to our customers, the more we're adding to the platform and evolving it. So I'd say maybe the second inning right now.

Good. I was ready for warm ups, but I'll take second inning.

We're at the beginning of the game, right?

All right. Good. All right. We're out of time. Scott, this has been really helpful, really insightful. I appreciate your spending time with us today. I wish we had more time. I know we'll connect again on earnings. Best of luck with your travel, stay healthy, and thanks again for participating.

Well, thank you, Deane. Thank you for everybody who joined. We appreciate RBC hosting us today.

This concludes presentation by Flowserve. You can sign off now, everyone. Thank you for participating.