Flowserve Corporation (FLS) Earnings Call Transcript & Summary

Hi, everyone. My name is Mike Halloran, industrial analyst here with Baird. And we're pleased to welcome Flowserve back with us to our conference. Joining us today is Amy Schwetz, CFO, as well as Senior Vice President. Mike and Jay are wandering in the background as well. But we're going to do what we're doing for most of these, which is a pretty conversational fireside chat Q&A session. And we're going to dive right into it. So if you have any questions that you want to make sure that I get to, e-mail me or use the portal. My e-mail is [email protected]. I think we're going to start high level with strategy, moving demand and cycle commentary, think about pricing margins and maybe some capital deployment. So that's the quasi order we're going to go through here. And any questions that you all send us, I'll make sure we weave them into that conversation. So Amy, thanks a lot for joining us.

The #1 question I think I'm getting from investors nowadays, besides cycle type commentary and when the cycle is going to pick up, which we'll talk later on. It's specifically how does Flowserve participate in this strategic shift that's happening through some of these heavier industries, right? You guys have talked about decarbonization, digitization, diversification. So maybe we start high level and touch on those points with a series of questions. And so from your perspective, how do you guys feel like you can aggressively participate in this energy transition theme?

Sure. I'll start just by saying, Mike, thanks for having us here. Thanks for the coverage. As I said before we got on camera or on wide camera, which we were live with you in Chicago, but we hope to see you next year in person. So moving on to energy transition, I think it's an interesting topic because it's something that COVID really forced us to think about at a more detailed level probably more quickly than we thought that we needed to. We saw what happened in 2020 extremely quickly, where we really saw 2 things occur. One, the demand side from an oil and gas perspective just was shaken so heavily by mobility, then it really got us to thinking about, okay, what does this look like? We thought that this is what it would look like 15 years from now, not what it was going to look like in 2020. And so as we started to take a look at our business and determine whether or not we needed to do massive pivots from a diversification standpoint or whether or not there was something that was more obvious, it became glaringly obvious what we needed to do. And that was from an oil and gas perspective, we needed to be in lockstep side-by-side with our customers in terms of helping them through energy transition. And this really means a couple of things, and it starts out with environmental goals and how do we do what we're doing today but we're doing it better, we're doing it in a more environmentally friendly way, and that starts with helping them achieve some of their carbon reduction goals with their existing products and with their existing processes. And as we look at the suite of products that Flowserve provides, the thing that became interesting to us is that really the pump is the epicenter of energy usage from a flow control perspective. And so what we can provide and the insights that we can provide in terms of how to make that flow control loop less energy intensive is really valuable to our customers over time. And of course, we've got products that last a really long time within the assets of our customers, and we've gotten a lot better at making them over time as well. So a pump that we're building in 2021 is much more energy efficient than one that we built in 2000. And so just that upgrade alone can be pretty impactful from a customer standpoint. And then that obviously shifts into the other industries as well as they look at meeting their environmental goals. And then it becomes about what are those gateway fuels. So things like LNG in terms of advancing the usage of LNG. We've got products in that space that are extremely competitive particularly in our valves business. And so how do we really ramp up the activity with that transitional fuel. And then finally, how do we play longer term in greener energy, so blue and green hydrogen, what are we doing for the solar space as well. And so thinking about energy transition through those -- that lens, and I would call it kind of today, tomorrow and next decade, it's really helping us formulate a long-term plan in terms of how do we address that existing part of our business which is significant and make sure that there's -- that, that continues to be a meaningful element of the business going forward.

So lots to unpack there. It certainly makes sense that from an efficiency perspective with the existing footprint that you have, that you can make, iterative upgrades when people are looking for it as well as more wholesale upgrades when that replacement cycle starts materializing. What about -- what you can do to help with the decarbonization efforts, whether it's at a coal plant to help reduce emissions versus making the process cleaner? Are there things that you're helping out around the edges on that side as well? And then maybe also touch on there, are there areas of investment that you can make internally or externally to help accelerate that curve?

Yes. So we're very interested obviously in the player gas recovery and what we can do in that space. And we've got products that are very well positioned to address that in terms of our vaccine pumps. And that's actually an area of our business where we're not just at capacity but we're expanding capacity. So as we think about some of the efficiencies that we've gained over time with Flowserve 2.0, we now have a product that was primarily produced out of Germany, served out of Germany that we're thinking about, okay, how do we bring that to the Americas as well to ensure that we can both build and service that product from different spaces. Our steels are used -- are pretty important part of methane reduction in terms of emissions, and so that's another key player that I would point to in terms of reductions. And then I maybe finish with carbon capture and storage, which is something that has become -- going to become more and more important but looking at that in terms of what we can do on the front end in terms of the carbon capture itself, in terms of pumps, but then also how that feeds into pipelines and how our products can play into that over time as well. And then I'd just make a little bit of a plug here in terms of what we're doing from a digitization perspective with RedRaven and how that move to the next...

That's where I want to go next to, so that's perfect. Great.

Exactly. So when that feeds into as we're putting these products in place, which we think are going to be more energy efficient, how are our customers able to measure the results, how are we ensuring they're getting what they want, how are they tracking what they want. And frankly, when it's not working the way that they want, how do they know that it's time for maintenance or replacement. And so it really all goes hand in hand, and the story is pretty fluid in terms of how we can help out. And I think that we've got as we think about our product line, again, being a pure play in flow control, having the pumps, the valves and the seals and ultimately, this digital backdrop really places us uniquely to help our customers in this space.

So maybe talk a little bit about that RedRaven offering. It was launched last year?

January. January of 2021. Yes.

Yes. No, we listened into the call. It was really interesting. And so what does this offer that customers have been craving? And then how does this compare to what they could get elsewhere? So what is differentiated about it and that's unique in the marketplace?

Yes. So I think to start with, one of the interesting things about RedRaven is it's OE agnostic. So it can go on Flowserve equipment. It can go on other equipment as well to help monitor. What is interesting is that we have predictive capabilities in this space. So as we look at data, as we look at the large universe of installed equipment that we have, we're able to use that OE base to perform predictive analytics on behalf of our customers. So we think that, that does a couple of things for us. I mean one, it helps our customers. Predictive analytics allow them to think about maintenance in a little bit different way. It also allows us to be positioned well for maintenance and repair going forward, so allowing us to have that pull-through revenue from an equipment standpoint.

What's the adoption look like? It certainly felt like when we heard customer reaction, customer questions, that there was certainly a very high level of interest. I mean we've talked a lot in the past in general about how there's 2 ways to go up this digital strategy, right. One, are we having the software; the other is having the product base that can really help inform the other. And your approach is you have this great product base, you've got a lot of expertise and engineering skill set that you can leverage them into the broader digital offering. Has that resonated? And what have the clients said? What's the adoption look like?

Yes. So we've been happy with the adoption that we've seen so far. So we continue to book about one new contract a week. We've got over -- we've got nearly like 5,000 assets that are connected. And that's across all of our product lines, so across pumps, valves and seals. So we're not seeing just adoption in one place to the business. The revenue at this point in time, I wouldn't call it particularly meaningful, but we think that we're in a good position to grow. And the thesis that I would say that we've seen around pull-through has been very accurate. So what we've been able to do from a subscription revenue standpoint has been less than what we've been able to see be pulled through from an aftermarket revenue perspective. I think one of the things that we view as probably the best time with adoption is that customers who have placed 1 asset or 3 assets with us have been quick to add on to that over time. So we're seeing repeat customers in this space, which we see as a key element of success. And frankly, we're learning a lot about how to sell a product like this. This isn't the traditional sale. This isn't just talking to a plant manager. You're talking to a plant manager. You're talking to an IT manager. You may be talking to a VP of Ops in terms of what you can do. So we're learning about how to best position our sales team to make those sales going forward. And we think the value proposition is pretty compelling. We have some customers who quantify that they think they saved over $20 million with the product. We're also getting areas of our business probably more involved than they've been in the past. So our Chief Information Officer, for example, has been on calls with customers to sort of explain how this is working, how does it fit within the Flowserve system, making sure that security is where they want to be. So it's been a full-on push this year, but there's been a lot of activity going on in this space that we think really positions us well into 2022 and 2023 to get this business to a meaningful level.

No, that makes sense. I mean there's certainly an entitlement on your side to be able to capture some of that if you can marry it with the installed base and the products you're already offering. So that makes a lot of sense. So switching gears here, maybe talking a little bit about -- can you still see me? I think we might have lost the Flowserve team. Hi there, team, I just want to make sure you guys can hear me, whether or not you've got any insight into Flowserve and what happened with their connection. Thanks. [Technical Difficulty] Hi, everyone. Sorry for that. We lost Flowserve. Technical difficulties. So we've got Amy by phone. Unfortunately, you still get to look at me, but we got -- we have Amy by phone. So Amy, why don't we pick up kind of where we left off and maybe more think about the diversification strategy that you guys are thinking about? And one question I get a lot from folks is we get why they want to continue to make sure they service the core but then diversify into some higher growth, more interesting potential areas. Can they do that quickly enough to make a difference depending on how the cycle plays out in the traditional markets? And so maybe you could talk about that 2 ways. One, what that diversification effort looks like; and then secondarily, maybe a little bit on the timing.

Sure. So the interesting thing about diversification is I'd say at this point, it's already been pretty effective in terms of what we're seeing. We've identified the areas that we're really interested in playing in, and we're continuing to try and work to increase our exposure to those areas. So if you look at an area like water, we've seen pretty significant growth in water bookings both year-on-year and on a year-to-date basis from that perspective. Same with the specialty chemical business, it's an area that has been growing pretty substantially. And whether or not you look at that, there's a wide range as you think about chemicals all the way from pharma to less sophisticated things. But as you think about the space, we're already seeing that being a pretty significant component of our bookings going forward, I would say we also are focused on where do we need to grow from a geographic standpoint. And a great example of that is India. We've had a significant physical presence, manufacturing presence in India for several years now both on the pumps and the valve side. But we've just recently gotten more focused on India for India strategy and how do we really play in that market in a way that serves that market and doesn't just think about it as a way to reduce our cost going forward. So I think that along those lines, the idea is to identify areas that are growing faster than our -- what might be viewed as our core market and ensure that we start playing there in a pretty significant way.

That makes a lot of sense. Let's transition then to some kind of the tie that brings that all together or maybe just a wrap-up question, probably a better way to put it. When you think about all the efforts you're making, you talked a lot about the organic part and how you guys are investing internally and driving this. When you look out, do you feel like you need to augment that with some inorganic opportunities to really accelerate the curve? And what does that funnel or pipeline look like?

Yes. So I'll start with a little bit of an internal plug around R&D. And the fact that even though we cut back on R&D spending in 2020 as we move through the pandemic, we started to increase that a little bit as we've moved into 2021, and I think you'll see that continue into 2022. And what I would -- the important thing about that spending is that we've gotten very focused and ruthless about how we're spending it and ensuring that it really aligns well to 1 of those 3 Ds, decarbonization, digitization, diversification. And as a result of that, you're starting to see more in terms of product development and product launches out of Flowserve than certainly the market would have seen at some time. So that needs to be part of the conversation. And then the second area is whether or not we would consider augmenting that in inorganic ways. And the answer to that is yes. And that could be a range of possibilities. It could be joint ventures. It could be purchase of IP. It could be acquisitions over time. The piece of that, that is the first question that we're asking internally as ideas come our way is do they fit the strategy. So does this align to decarbonization, digitization or diversification? And I just want to point out that as it relates to decarbonization, that does not always mean that it's moving away from oil and gas specifically, but it is -- does it help us meet our customers' goals at the end of the day around decarbonization and does it fit well with our product portfolio. So we see this as a way to perhaps enhance the product offering that we have for our customers and ensure that we can provide something that others in the space cannot in terms of being a pure-play flow control provider. And I just want to state the obvious around anything that we could do inorganically, which is we have pretty tough requirements as we look at this from a financial perspective. And that goes from the quantitative to ensuring that this makes financial sense for Flowserve and its shareholders, does it help us meet our financial targets over time, and then we also have qualitative criteria that we look at in terms of strategic fit but also our ability to integrate on anything that would come our way.

Makes sense. Another big line of question, I got a couple in my inbox on the same kind of thought process, I'm going to kind of layer together here. When you think about the opportunity in the traditional oil and gas space, first, what's the percentage of revenue? But secondly, I think what people are interested in is you've got the majors talking about spending less capital dollars, far more focused on returns. You've got a really good aftermarket service business, which helps augment that. But how do you think about how this recovery curve can work in that market if they're going to be a little bit more careful at how they spend their capital dollars? And where do you see the risks? Where do you see the opportunities?

Yes. So oil and gas just overall is, in any given year, kind of between 35% and 40%. And that doesn't include the -- what goes through distribution for us, which could increase that total in any given period of time. No doubt, it seems as if the oil and gas producers are very focused on providing returns to their shareholders. Certainly, despite oil prices that we've seen that are really constructive, we don't hear a lot about capacity expansion at this point. That being said, we have seen our aftermarket business continue to be robust in this space. And that's despite some limited access to site during COVID and also certain assets running a little bit lighter, which has made certain elements of our aftermarket business slower to return particularly on the parts side, where we see customers working down inventories before they reorder. So I think from that perspective, we see that as an opportunity going forward. We do see in the space that upstream continues to be challenged. They need to be focused on the things that you would expect, and that's around maintaining dividends, repurchases maybe, debt reduction for some in that space. From a downstream perspective, we see that market position better. And I think it's also important to remember in this space that we're 2/3 international, so some of the conversation that's occurring in the U.S. is occurring differently in those areas of the world. And really in some areas around the Middle East, they're investing. And so I'm going to get to the -- and so I think that, that provides an opportunity for large projects going forward. That being said, going back to the energy transition conversation we had earlier, I think what's exciting about that space is you can really -- that you've got 2 opportunities for a sale in this area because it's about targets that may be something other than financial as we think about environmental targets. It may be -- it may be a ticket to entry versus a nice to have in terms of meeting regulations or meeting public commitments. But then the other piece of that is it can be about lower operating costs. And so regardless of where you're at in the cycle, the idea of margin improvement capital with relatively quick payback will make sense to customers, particularly if they have excess cash on hand.

So last one here. We're almost out of time. Just how do you think about the structural margin profile moving forward? Obviously, short term here, you had all the supply chain challenges that impacted the margin profile in 3Q, pushed some of that into 4Q. You've got price/cost capture that's going to continue to happen here, and so there's a migration as you get a little bit more of a flattening or normalization out. But when you think beyond that, obviously, the drive to get towards kind of historical peak margins has been one of Scott's and your goals. Is that still on the table? And what's the path to getting there? What do we need to see?

Absolutely. I'd say is that still on the table, and the answer is absolutely. There's not a day that goes by that we don't have a discussion about how do we work to achieve levels of margins that we want to be at for this business. The interesting thing about where we're at right now is, as we plan Flowserve 2.0, obviously, the goal was to get to some sort of through cycle margins that are attractive to our shareholders. What our assumptions around Flowserve 2.0 clearly didn't contemplate was a 20% drop in bookings in any one year. I'm really proud of how we address the cost structure in 2020. We took some decisive actions. In 2021, there has been a need as we've started to see that project funnel grow again. There has been a need in certain areas to either add or keep resources in the business that if the downturn was prolonged, we might not have done. And so now we really look at our business as kind of in 2 buckets. You've seen the aftermarket and the MRO piece of it grow at a really nice pace in 2021. And that tends to be a really good margin component of our business. So that is a mix tailwind. What we are seeing is on that large project side, and this is a handful of facilities that we have, they are nowhere near optimal levels. And so we need a couple more of those large projects to start coming through the funnel on a quarterly basis to really get to where we want to be from a margin perspective and to be at a spot where we feel like we can start to build again. That being said, where we're at from a bookings perspective right now sort of in -- and where we're guiding to for the full year and into 2022 is going to be in the area where we're pointing to revenue growth in 2022, and we start to see better absorption of that fixed base of SG&A costs. So from where we're at now, OI margins will grow regardless of whether or not we see that project work return in full force or not.

Makes sense. Well, we're out of time, unfortunately. Thank you so much, Amy. Hopefully next year, we can do this in person.

Yes, thank you very much.

Very generous with your time. Session 1 next is Colfax. Session 2 is Rev Group. Session 3 is Stoneridge. Session 4 is Douglas Dynamics. Itron is Session 5. Commercial Metals is Session 6. And Genuine Parts is Session 7. Thanks again, Amy. Thanks again, Mike and Jay.