Flowserve Corporation (FLS) Earnings Call Transcript & Summary

Good morning, everyone, and welcome to day 2 of the 9th Annual Credit Suisse Conference. My name is John Walsh, and I am the multi-industrial analyst here. We're very excited to be starting the day off with Flowserve, and we have their CEO, Scott Rowe, with us. Before we head into Q&A, just a reminder, if you'd like me to ask a question on your behalf, please e-mail me. It's [email protected]. And with that, let me turn it over to Scott before we start with the fireside.

Great. John, just I wanted to say thank you to you and Credit Suisse for having us today. And for those that are participating and following us, I just say thank you for your support. Today, we're going to talk a little bit about how Flowserve goes forward from here. We've been very focused on a transformation for several years. And as that transformation starts to wind down, we're now really thinking about how do we change our focus or add the focus of growth into the mix. And we introduced the concept in the Q3 earnings call around diversification, decarbonization and digitization. And that's really the approach that we're taking as we turn the corner into 2022. So John, I look forward to our discussion today. I know we'll hit on a lot of these different topics, and we'll just start with questions.

Great. Thanks, Scott. And yes, I definitely want to dig into all of those topics, and we'll certainly have time. But let me sneak in the obligatory supply chain question before we start. Just curious, as you look at your supply chain, have we seen any changes since the Q3 earnings date? Are things getting worse, better, unchanged?

Sure. Yes. I think we'll primarily focus on strategic stuff today, but I'm happy to kind of just give the update. And for those that follow us, you heard in the Q3 earnings call that we had some supply chain and logistics issues that did delay revenue. But just as a reminder, that revenue is in our backlog. And so we're confident that it turns into -- that it's in our backlog, it turns into revenue within Q4 or Q1. Unfortunately, all of the problems don't get fixed in the fourth quarter. But I'd just say, similar to what we see and read in the news and what people are seeing around the world is similar to what Flowserve is facing today. And so we're still fighting inflation issues. There's still some disruption and there's still some logistics. However, I would say that there is a modest improvement from Q3. We had a confluence of events that did impact us. We're doing everything we can to mitigate that and to expedite. Our teams are highly focused on this. It's hard to say, does it get materially better in the next 6 months or 9 months, but I think our team is working through better than where we were in the third quarter. So again, I'd say slightly positive. The one thing I would say though, or caveat is that December is always our biggest month. And what I am concerned about is some of the logistics issues as the globe is -- both retail and business-to-business is starting to ship a lot of products in the month of December. But we've been incredibly proactive. We've done a ton of risk management on the logistics side, and we're working the issues that we've been faced with. And your question just is kind of what are the new issues that pop up as we go forward. But overall, I feel a little bit better than what I did in September.

Great. No, I appreciate that color. So then maybe let's dive into some of those larger topics, particularly maybe first around energy transition. Obviously, you've started to kind of call out energy transition orders on your quarter. They're getting to be chunkier. So maybe we could unpack kind of the big buckets that you've talked about. And maybe first, we could start with carbon capture and sequestration kind of -- there's also hydrogen, there's energy storage. I think what we're trying to better understand and investors are is what is the Flowserve offering into those different categories? And how should we think about the growth going forward in those categories?

Sure. Yes, I'm happy to talk through all of that, John. I think the important one, though, really is energy efficiency. And let me start with that, and then I'm happy to talk about new construction. So what we're seeing with our end-use customers, and this is primarily oil and gas, but it's not limited to just oil and gas. So if we think about large installations, and process industries in their cost to serve. One of the big dollar items is electricity to power their facility, and pumps is one of the largest consumers of electricity in these facilities. And so as we go and talk to our end-use customers. So this could be a refining, it could be a chemical plan, it could be a steel mill, it could be a water desalination plant where the single highest cost is electricity to produce clean water. What we believe we can do, and we've demonstrated this successfully this year, has come in and say, look, we're happy to work with you and look at your energy consumption through your pumps, look at your flow loop because we have the control valve. And then we also look at the leakage rates through the mechanical seals, whether that's in a liquid form or a gas form. And so on energy advantage, it kind of opens up a bunch of different things for us. We can drive down energy cost. We -- that, in turn, reduces their CO2 emissions, right? And so that's a major topic for anybody around the globe that's offering today. And so we've got cost on energy. We've got the CO2 reduction. We've got liquid rates reductions by doing the proper ceiling of their pumps to the motor. And then we can also talk to them at the same time now about how do we keep uptime in higher productivity through minimizing disruption or failure -- early failure of a pump or potentially in that fluid. So the energy efficiency side has -- if you look at the public numbers, that's the biggest spin that we see in the energy transition movement over the next couple of months. And we believe that Flowserve is positioned better than anybody else to help our customers here because we have so many different pieces of products and expertise in that flow loop. And so we've now demonstrated this with several kind of flagship customers. We're creating what we're calling an energy advantage offering that we're taking out to all of our customers, almost like a menu to say, here are the things that we can do for you. And here's how we can partner to help you in this whole energy efficiency agenda. And then the other thing I'd say is we're getting really creative on our contracting. And so this is not a typical sell for us. This is not with the maintenance manager. It's not with even the plant manager. It's typically at the corporate level. And what we're trying to do is say, look, we can track a baseline on energy use or we could track a baseline on carbon emissions. And what we want to do is participate in the upside. And so we've had several discussions. We've got one contract that's quasi-performance based. But we believe that's the model that takes us into there. And so I think kind of recurring revenue, more committed to solutions than just providing a product or service, and we're pretty excited about what we can do in this space. So that's -- that would be the first bucket in energy transition. We're calling that energy advantage offering from Flowserve. Now if we go to the other buckets, so let's start with carbon capture and sequestration. So there's a lot of different concepts on the table. It is a little bit of a wild, wild west in terms of who's doing what. And when you think about how this has to come together, you have the emitters. You have to have some sort of a processing unit to take that emissions into a more pure medium that you can then transport. So now you have pipeline and transport players coming into play. And then you've got to have a place to put it. And so today, the likely place to do that is some sort of geographic formation that's either a salt dome or abandoned well or some storage place underground. And so that's typically some of your oil and gas players. And then you've got to have somebody that's willing to bring all of these parties together, negotiate whether it's a carbon credit or a tax advantage or whatever the form of compensation may be and pull that into a project that has some economics that make sense in all parties agree. And so it's -- my point in saying all of this is it is not easy to get one of these things moving forward. When it comes to Flowserve, though, there's a lot we can do to participate in the process. And so when you think about the emissions, you've got to take the emissions and convert it into something that's mobile. So that processing unit has all kinds of flow control technology in it, whether it's a pump, a valve or a mechanical seal, it's there. And we're working with a couple of customers on how do you make that modular and more repeatable. And so we could get recurring revenue by just creating sort of a template on how to do this for a certain type of facility. And then when it goes to the pipeline, it really depends on pressure and temperature and how they want to transport that medium in terms of whether it's a gas or liquid. We do believe that there's liquid flow in some part of the process, whether it's the pipeline or the injection into the ultimate well. And so there's a prominent role for pumps in all of this. And then on the -- whether it's gas or liquids, our valves will play throughout the entire process. So I'd say if we think -- typically Flowserve, if you think about our entitlement, it's somewhere in the range of 4% to 5% of total CapEx of fluid handling-type projects. And I would say for CCUS, it's probably in that same ballpark is a good rule of thumb. And so we're tracking several projects around the world. We're hopeful to announce and participate in one very soon, but we are connected with several different players on how to do this. So we are excited about this market. I think there's going to be a lot of traction. Obviously, every country and government is talking about this, all of the major corporations are trying to reduce their CO2. And if you can do a big production like this, you get a lot of credits and a lot of opportunities to drive our CO2 emissions down. And so it's certainly an exciting space. And then I'll go to the third big category, and I'll just -- I'll call it, biofuels for lack of a better word, but this would be your biodiesel conversions, your sustainable aviation fuel and will just roll in kind of bioplastics in here as well. It's completely different, but it's the same concept for us. And so what we're seeing is existing infrastructure getting converted to support some form of biofuel. And typically, what they're doing here is they're taking some sort of input, whether it's food waste or different biomass and then they're mixing and blending it with traditional refined product to get something more sustainable than the traditional fuel. And what we're seeing from a lot of our customers and operators is they're taking an existing refinery and converting it into this. We participated in several of these this year. We have a long list of projects that will continue here in the next year and beyond, and we have a good offering for that. Now what I'll say is when we convert an existing refinery to a biorefinery, it wouldn't be the same entitlement as a greenfield because we're modifying a lot of our equipment. But it's still a healthy -- it's a healthy win for us. It's usually in the range of somewhere between $5 million to $10 million on new equipment. But what we're also trying to do during this process is introduce the concept that I explained before on energy advantage and doing that at the same time. And we've been successful once this year in doing that where we get the equipment order, but we're also getting the energy advantage kind of performance contract. And then we also are trying to weave that into recurring revenue with a life cycle agreement for our seals and then a long-term maintenance contract for our pumps and valves. And so I think any time folks are changing or doing something different, we get a couple of different bites at the apple, if you will, in terms of creating revenue and business for us. And then the other one we're seeing in the same kind of bio space is the recyclable plastics. And so that is becoming a bigger and bigger market. We've got flow control technology to support that process, both in the vacuum side with our CE vacuum technology, the pump side, these are high water-intensive processes and then on the valves as well. And so again, several orders this year. We've got a few more projects in front of us in the coming quarters, and we're very excited about the growth potential on recycled plastics as well. And then finally, I'll go to the fourth leg here. This is the long one, John, sorry. The fourth leg is hydrogen. And I'd say this is another one where there's a lot going on. There's a lot of different competing technology. We're currently participating in the gray hydrogen. So this is the steam methane reforming. We're doing this at existing refineries today. We have the pump and the valve technology to do this. And we believe that there's going to be more and more of that going forward. And so we think that's certainly a growth opportunity for us. And then the other thing we're doing is trying to stay very close to the other technologies that move more into the blue, green type approach there. Now blue is just adding the carbon capture. And so that's you're collecting the emissions and somehow either reinjecting or storing that. So go back to my CCUS commentary, there's a processing module that we're trying to standardize that can capture that emission and then either reinject or go into some form of storage. And then on the green side, again, a little bit of a wild, wild west, but what we know is that's a heavy water process. And again, any time you're handling fluids, there's going to be valves, there's going to be pumps. And so our approach there is to stay close to the technology, stay close to some of the licensors there and then really try to find who's going to win and partner with them on their flow control needs in a processing facility like that. That was a long on, John.

No, but incredibly comprehensive. So appreciate that, definitely got a good education there. I want to come back to this energy advantage concept. So maybe 2 things. So first, what is driving the customer to want to speak to you about this? Is there some regulations that are coming down the road? Is it because of their own ESG commitments? Is it because you now are focused more on this? So your having this dialogue with the customer? Just curious what's the catalyst, right?

It's all of the above, John. And again, every operator, every country is a little bit different. So let's just take a major that's European based in a refinery that's in Europe, and you get all of the above, right? They've got corporate targets, both on ESG, carbon reductions. They've got government mandates to drive emissions down. And then we've now got this offering that we can come and talk to about. Now what I'll say is on the large pumps, this -- the technology and the approach is really nothing new. So in the past, we would call this a pump retrofit where you take a pump out of service, you bring it into our shop. And essentially, what you're doing is over the life of that asset that we're calling the refinery in Europe, the process changes, right? And so they're now blending differently or they're running different volumes through those different temperatures. And as that process changes over the years, a lot of times they don't change out the pump to make sure it's keeping up with the latest efficiency curves for that process. And so retrofits have been happening for decades. And we've been -- it's been a big part of the Flowserve business. But we haven't really been as proactive as what we could have done in the past. And so now what we're saying is look, let us look at your data, let's look at this combined with the data that we see in the pumps and the valves and look at this more holistically as a flow loop. And the fact that we've got the ability to look at the expertise in control valves and the expertise in providing the energy or the pump, we can drive further efficiencies than we've ever done before. And we are absolutely confident that we can do this at a significant rate, driving efficiencies by, call it, 30-plus percent in older refineries. And so now we can go in with a lot more confidence than we've had in the past. And again, it's a sell at a higher level. It's not with your maintenance manager, your traditional procurement person but it's saying, look, here's your investor presentation that lines out your goals, and we believe we can help you by doing these things and here's the menu of things that we're willing to do. And that usually gets us in the door, and then you go back to the performance-based contract and they go, "Well, look, we don't really have budget for this year", and we say "that's fine." We're happy to work this on the savings and will commit the resources upfront, but we want a share in the upside. And then that typically gets us another discussion. But I would just say, unfortunately, this isn't happening as fast as I would like. We're getting a lot of traction in the early discussions. It's a little bit slower once we get to the operating level. But I'm absolutely confident that this is something that will be a big part of what Flowserve does going forward. And while it sounds dramatically different, it's all things we've done before, right? We've done the retrofits on the pump to drive better efficiencies. We've got the ability to look at the flow loop. We've got really good people on the technical side that can look at computational fluid dynamics and analysis on that. We can modify control valves to drive better efficiency and process flow. And then we're really good at providing life cycle support through the life of an asset. And by doing that, we know we can drive energy down. We can drive CO2 down. We can drive leakage rates down with the proper sealing. And so we feel more and more confident about moving into this performance agreement over the long term. And we think that's going to be what will help us be successful here.

Great. And I just want to make sure I understand how this will be structured correctly. So will you actually use your own kind of CapEx and put -- and own the equipment at the customer site? Or are you going to be putting sensors on equipment that they purchased so that where you know the process because if you're guaranteeing the performance, right, you want to make sure you actually know what's happening at the customer's location? So how does that look?

Yes. And I'd say we've got a lot of different flavors of this right now. There's not one. In an ideal world, right? And I haven't talked about regulated yet. But in an ideal world, we've got our RedRaven IoT solution in place. And for those that don't know is, that's our -- that's our IoT approach, where we're censoring our equipment, both our pumps, our seal systems and valves. We're collecting data. We're able to do lots of good work with that data to provide predictive failures, but we can also look at the performance even more in depth than what you could with just a normal DCS data. So the RedRaven data, combined with the flow characteristics that the customer has from a data perspective, is what gives us the best opportunity to do this. We don't necessarily need to have our RedRaven installed to make this work. But what we found is that you just don't get the same performance aspects if we don't. So what we would really like to do is say, hey, we can come in, we're confident, we could do this. We're willing to do a performance-based contract. We like to put RedRaven in the assets that we're talking about to guarantee that we can meet these goals. And so we've been successful on that once. And another time, we weren't successful because they wanted to go with something different or they didn't want to instrument the pumps at that time. Now back to the CapEx side. Typically, this isn't capital intensive, it's more manpower intensive. And so when we think about the work that we're doing with the pump, it's -- you're typically just changing out impellers or some of the veins of the performance characteristics. We're not typically putting in a new pump. We wouldn't do that at our cost, like we would want them to buy that pump. But if it's just a minor change out or a modification to the equipment, then we're okay with that. And then the same thing with the control valves. It's usually just a change in the trimming of the control valves rather than a change out of the whole thing.

Great. Maybe just pivoting a little bit, but staying on the same topic. Free cash flow this year has certainly been a bright spot. When I think about the forward framework, you are targeting 100% conversion. As you pivot and move deeper into these energy transition technologies, do you have to take up your own R&D? Or are there things that you need to bring into the portfolio that you don't have today? Just thinking about Flowserve, your balance sheet, right, certainly, you have the ability. Just curious how you're thinking about that make versus buy?

Yes, sure. Let me just start, and I appreciate you calling out the free cash flow. It is a very much a bright spot this year, and it's something that we've been focused on since I've been here with the Flowserve 2.0 transformation. I would just say, we still have opportunities here and we will continue to maintain the 100% as we go forward. What I'll say is, as we start to move into a much steeper growth trajectory, we might see that number start to come down. But we're not going to be back in that kind of low 70s or 60s that we were historically. And we feel confident in the opportunity around working capital to continue to improve there. And so we feel very good about our ability to generate cash as we go into 2022. And then to your question, our balance sheet is reasonably healthy right now. And again, we're confident in our ability to generate cash. And so now it's really a focus of how do we deploy that cash. And as we think through the different things that we're focused on, right, we've got essential -- what we'll call more essential things and that would be looking at our commitments around maintenance CapEx, which is relatively low for a business of this size. We do want to continue the dividends. So that would be something that would be -- that we want to keep going with. And then we're buying shares to offset equity -- or equity compensation and dilution on a regular basis as well. And so that's kind of the blocking and tackling. And then as we kind of move into some more strategic dollars, what we do want to do there is start to push up our R&D even more. And so we've been walking that up like, I'll call it, very modestly every year. We do want to take another step up this year. We believe that we've got to invest in our products and our solutions to be at the forefront of the best offering for our customers. And so you'll see that number continuing to go forward. And then after that, we still have cash. And so then it's just a strategic decision around what's the best return for us. And so whether that's a debt paydown, pension funding obligation or do we move more and more into some inorganic growth. What I will say is, as we've done in wrapping up the Flowserve 2.0, we are much more confident in our ability to integrate today than we ever have been. And so we have now opened that aperture to start to look at a programmatic M&A within Flowserve. And again, I'm confident that the team we have can integrate this, whereas 2 years ago, I wasn't saying the same thing. And so we do think that this is an important part of our growth. We believe there's technologies that can advance the enterprise and our offering more strategically than what we have within the portfolio. And so I just expect us to go forward with that into 2022. We've made a couple of smaller acquisitions this year, all I would say are pretty under the radar at this point. They're not large, but we do have a nice funnel and we've gotten more formal with that approach. And I think you'll see more from us in 2022 than you've seen in the last couple of years.

Great. And maybe once again, going back to the energy advantage because that's really attacking your installed base. If I remember correctly, a couple of years ago, I think as part of the Flowserve 2.0 initiative, you were going out and actually mapping that installed base, right? So you knew where everything was. Where are we in that process? Because I would think that would -- you wouldn't have been able to do this kind of initiative without having already done that leg work previously?

Well, that's all relative -- we're never perfect, but it's complete. That was certainly part -- we had always had an installed base database. We've recommitted to using that properly. And then what we've also done is now we've got a really good segmentation of our customer base. And so we know where the installed base is. We've got a good idea through our CRM system that we call FlowForce. We've got a really good idea of where we should be targeting these type of opportunities and where we have customers that are willing to do things like this. So we know where to hunt and who to talk to. That is not a problem. It's just a matter of having those discussions and getting some of these customers to commit at the higher levels.

Got you. And then just from a kind of where this and how we'll see this as investors. Will -- well, how will this flow through the orders? So for example, are we going to see a lot of smaller orders that will then kind of build over time? Like do you go in and just do one facility and then you prove it out and then the customer says, "All right, let's bring this now to 10 more facilities?" I'm just curious how we'll see it come through....

Yes. I think what you'll see it will be in our aftermarket bookings for sure. And you're not going to see like a big pop like a $10 million order. This will be more of a recurring revenue stream if we -- it depends on how we structure the contract, but that's what it will be. And then your other point, right, when we can win one of these properly at a big operator and demonstrate at one site that this is something that as a concept that works and prove out our approach, then we fully expect that, that operator rolls it out across multiple sites. And we're in discussions now where we've been successful with one, and we're talking about how do you deploy that across a couple of different sites.

Great. And then we did get one in here. So I just wanted to ask this question. As we think about margins and, one, it sounds like all of this would be accretive to margins as you roll it out. But how do we think about the margin opportunity more near term as you think about next year? What your mix looks like and as you're filling your factories? And if there's any kind of under absorption that we should be mindful of?

Sure. Yes. I think for those that follow us, like 2021 has been a difficult year on margins. We're typically a longer cycle business. And so as we hit the COVID downturn in Q2, Q3 of last year, a lot of our project and original equipment business dropped by 30-plus percent. And so that obviously has a massive impact on our ability to fill those type of factories. We did a good job taking costs out aggressively early in the pandemic. And what we're -- we've got 2 sides of the business. That aftermarket MRO is kind of back to 2019 levels. The absorption rate in those facilities is kind of where you would want it or where you expect it. But in our project and OE business, we've got specific plants that are, quite frankly, very under-absorbed. And when you look at when does that kind of play out and hit us the worst on the P&L, it was kind of second quarter and third quarter of this year. And so we're -- I would say, we are optimistic that we're at kind of the trough here, and we're working our way out. I would say that's not a guarantee but we do feel confident as the orders start to come back as we've taken cost measures to rightsize those project type facilities, we do believe that we start to move up. And as you kind of look at, we're not -- I'm not providing 2022 guidance here, but just kind of the color on how to think about this. Our bookings are up this year. Our backlog will be up at the end of the year versus last year. The mix will be more aftermarket versus projects. And so all of those things are favorable to improve margins on a year-over-year basis. Now in the fourth quarter earnings call, we will, like we always do, provide annual guidance, and so we'll make that very transparent. What I will say is there's obviously a lot of factors going into our different divisional margins. I want to start with some of the good work that we're doing on the project management side. And so we've really -- through the transformation and even in today, we've been very focused on restructuring these product lines. And so it starts with the product rationalization, it's what do we want to keep, what do we not want to keep? And how do we restructure some of these projects or products that just haven't been touched for years? And then as we kind of simplify that offering, then we move into our design to value, which is essentially a robust, rigorous process to drive cost out of that product. And we look at that very holistically from a supply chain, design from a manufacturing perspective and really looking at how do we drive costs out of that and then go to the supply chain. And so today, we have lots of inflationary headwinds there, but we're continuing to do some really good work around consolidating our suppliers, shifting more to low-cost countries. And so there's still room for us to improve our supply chain and actually get savings and favorability. Unfortunately, a lot of that good work has been completely offset or even more than offset by the inflationary pressures that we saw in 2021. We're offsetting that with pricing. We've announced 4 price increases this year. We'll have another 5% go effective January 1. We've been slightly behind on price cost throughout 2021, just not being able to catch up with some of the inflation that we're seeing. However, we believe at the beginning of the year with the incremental 5% that we start to get in a position of at least neutrality, and we'll continue to watch this carefully. And then again, on absorption, that's kind of the last one. We've got a mix across our facilities. We've got some facilities that are struggling to keep up, and we're actively hiring labor and doing everything we can to make sure we can maximize output. And then we've got other facilities, specifically project and specifically oil and gas project facilities that, quite frankly, are not full at all, and we're fighting the under-absorption there. So a lot of different levers in the Flowserve mix. But again, go back to my first comment, as we think about 2022, everything stacks up for margin expansion into next year.

Great. Well, we will have to leave it there. Appreciate the insights and all the color as always. Look forward to continuing the dialogue and hope that everyone stays well.

Great. Thank you, John. Appreciate you having us today. And thanks for those who participated.

Excellent. Take care.