Flowserve Corporation (FLS) Earnings Call Transcript & Summary

Next up, we have Flowserve. Flowserve is a world-leading manufacturer and aftermarket service provider of comprehensive flow control systems. The company's product portfolio of pumps, valves, seals, automation and aftermarket services support global infrastructure industries, including oil and gas, chemical, power generation and water management as well as certain general industrial markets. Joining us today from Flowserve is CFO, Amy Schwetz. Amy joined Flowserve as CFO in February 2020, previously served as CFO of Peabody Energy. Prior to Peabody, Amy held multiple audit roles at Ernst & Young for more than 8 years. Flowserve has 130.4 million shares outstanding. The stock trades around $31; $4 billion market cap; $644 million in net debt; $4.7 billion total enterprise value. Amy, I know, had an earnings call today. So thank you very much for joining us. I'll turn it over to you, and then we can move to the fireside chat.

Yes. Thanks for having us, Brett. We appreciate the opportunity to be here and talk a little bit more about Flowserve. And if I look a little bit tired, I'm trying to survive the ice and post-earnings call in Dallas, but I'm ready to dive right in and talk about some of the questions that might help you and others understand Flowserve a little bit more.

Great. So wanted to start with, over the last 2 years, we've obviously seen a strong push globally away from fossil fuels towards renewable energy sources, seeing some pushback against that more recently. Can you discuss broadly how you think about the position that Flowserve plays in the industry, being able to continue to serve your major customers today as they go through transitions of their own and beyond into the future?

It's a great question, and it's probably even a more important question today than it was even a week ago in terms of the world events. But as Flowserve, as we were thinking through what our strategy should be? Our traditional customers in the oil and gas industry are a huge component of our business, 40% to 50% of our business, when you take into account the work that we do through distributors. So thinking about pivoting away from this industry, it really is not a practical option for Flowserve. And as we look at the opportunities that are available to us over time, in terms of assisting our traditional customers with energy transition. We really think the relationship that we have with them today is going to assist us in building those relationships in the future as we look to help them achieve their energy transition goals. And meanwhile, as that spending starts to ramp up, we actually see 2022 as a year of pretty strong growth in those traditional markets as capital spending, particularly at current oil prices continues to ramp up.

And geographically, can you help us think about where you're seeing the most optimism and activity with regards to potential capital projects moving forward this year?

Certainly. So if we look at our bookings profile towards the end of the year, we were really seeing the most growth in North America and in the Middle East. And I think that trend is going to continue as we make our way into 2022, especially as we see that large project component of our business really come back in a meaningful way as we make our way through 2022.

And what have you heard or seen from customers so far in terms of spring and even looking out to the fall turnaround seasons? And is there a significant deferred maintenance backlog still that some of your customers have pushed off coming through the COVID downturn as well as due to virus -- site access restrictions?

Sure. So we really did see our aftermarket business come back nicely in 2021. And really, the softness that we saw was more on the large project side. But if I think about our aftermarket business really in 3 pieces in terms of services, services that are provided at sites. If I think about our distributor business, our MRO business and then lastly, thinking about parts, which parts could be seals, it could be pump parts that we would sell to our businesses. Really, all of those elements of our business came back in a pretty meaningful way over the course of 2021 with one exception, and that was really around the spare parts element of the business. And I think during the pandemic, we saw customers really reduce the spares that they kept on site and lower those levels of safety stock. And I think that, that's really the last component that we're going to see come back around that aftermarket business. Site access was obviously a huge issue in 2020. It continued to be one in the first 6 to 9 months in 2021. But as we finished out the year and as we move into 2022, I think, like many of us, our customers are starting to see COVID as much more of an endemic than a pandemic scenario. And so things like site access have become less of a restriction to us than they would have been a year ago.

Another dynamic on the demand front. We've noticed clearly, your North American distributor customers continuing to run at very low inventory levels. What's your current expectation thinking on some level of channel restocking demand that could take place potentially this year?

Yes. We thought we started to see a little bit of that in 2022 and even in some releases we saw, we saw some financial indication that, that was happening at distributors, but we absolutely think that has to continue to occur. Distributors need stock in order to be relevant to their customers. And so this destocking phenomenon that really started pre-pandemic, there is definitely an end in sight. And I think we started to see that some in the back half of 2021, again, and that's just only going to continue as we make our way through 2022.

Now as we think about Flowserve being able to help your customers go through their energy transitions, can you talk about which products are in the portfolio today and which ones you potentially have to add either internally through development or externally? As we look across these major buckets, carbon capture sequestration, hydrogen gas, LNG, concentrated solar, lithium mining and some other, are these newer energy applications?

Sure. So one of the components of the transformation process that Flowserve went through over the last several years was actually focused on our R&D spend, and it was around making our R&D spend more relevant, connecting it to customers' needs and the platforms in a more meaningful way and ensuring that we are actually getting bang for our buck from that R&D expense. And truthfully, we have not increased R&D expense significantly over the last several years, but we've made it more impactful. And so if I look at that 2020, 2021, we actually had more new product releases in those 2 years than we had in the last decade combined. So the traction that we're getting around new product development is strong. That being said, there are different ways that we're spending money. One is ensuring that our R&D spend is linked to what we call the 3 Ds, which is diversification, decarbonization and digitization. And then the second is really around making sure that we placed our products in the best way to service our customers. And I'll give a couple of examples of that, if you'll bear with me. The first is really around our [ CE ] product portfolio, which is -- you talk about CCUS, hydrogen concentrated solar power. Our vacuum pumps have applications in each of those type of -- in each of those type of processes. And so really, our investment there is not so much around new development, but it's around the globalization of that product. So making sure that we have manufacturing capacity and are utilizing manufacturing capacity in the right geographies and also ensuring that we've got the right training and aftermarket service deployed in order to service those products once they're in use and can help our customers in the right way. And another kind of example similar to that is around water, which is obviously really key to lithium mining. And an example of that is our Byron Jackson product line. It was a brand that was -- that's been well known in the past. And they've kind of been unloved for several years. And this is a pump that we actually put through our design-to-value process over the last couple of years. We took 30% of the cost out of the production for that product. We did 30% reduction in parts involved in building that pump, so simplified our process, and we made it highly configurable, so easier to manufacture in addition to being cheaper. And it's now a product that can be used in agriculture, municipal water and other industrial processes. It was actually a brand that we owned. It was a product that we had manufactured in the past, but we just needed to upgrade and get it ready for this century of use. And that's a product that we launched in mid-2021, and we think it's a $50 million product for us over time.

Okay. Very helpful. And maybe along these lines, can you help us think about the role that Flowserve plays as well as what the project opportunities look like for some of your traditional refinery customers undertaking, say, bio diesel and renewable diesel conversions as well as maybe greenfield projects in biodegradable plastics facilities?

Yes. So we're starting to see those projects pop up 1 or 2 every quarter as we look through things. Now we're looking at our funnel of opportunity through this lens of energy transition. And each of those play a component of that energy transition funnel that we see. And as of -- as we start the year, that funnel is actually over $400 million. So a very sizable basket of opportunities that would include the items that you mentioned and other things. But ultimately, this is an area where we see opportunities really starting to pop up and grow and grow at a rate that's faster than the rest of our business. And also areas that we've got the customer relationship, and we should be able to capture our fair share or even more of that market as we move forward.

Great. And I wanted to ask about the traction you're seeing from customers for your RedRaven IoT platform as well as some of your newer holistic offerings you've been rolling out to customers such as Energy Advantage.

Yes. We're really excited about both of those 2 products that you named, and I'll start with RedRaven, which is our IoT offering. We launched it in January of last year. We currently have over 1,000 assets that are being monitored with 40-plus customers at this point in time. We've got significant growth plans for that over the course of 2022. We actually hope to quadruple that number of assets under monitoring over the course of the year. We really think that RedRaven stands apart from other IoT offerings from the standpoint that we can use predictive analytics, and we've got the benefit of having the experience with these assets that are under monitoring of arrangements. So we've got -- we're able to bring the skill set that Flowserve has to bear as we think about that product. We currently have been focused on deploying this as sort of a large project, engineered-to-order type pumps. But we've been working over the course of -- since it's been in development to really ensure that we can use this product not just in pumps and not just large ETO pumps, but deploy it into industrial applications for pumps, but also our valves and seals. And we see over time, I think as we look at 2021, and we're actually really excited about the opportunities that we have in the valves portfolio because if you think about pump opportunities, you're dealing with a half dozen or less pumps potentially in a facility. And as you think about valves, that is -- that number goes up pretty significantly if you think about the number of assets that you could be monitoring in one facility using RedRaven. So we're excited to continue to get traction, not just in -- where we started this, but in other areas of the business and make digitization a much bigger part of our portfolio over time. And the other project you mentioned was -- I'm sorry, just one -- I'll touch really quickly on Energy Advantage. And it's, again, a project -- or a product that we've launched just recently that really provides 3 offerings. Looking at efficiency, looking at carbon and carbon output and then also deploying at cost advantage. And with that product, really, what we found is important when we were initially soft launching this, Scott Rowe was actually a key salesperson as we looked at potential products or projects that we could launch with this type of product. And so we've been very focused on building up a team within Energy Advantage that has the relationships with customers so we can go in at the right level of the organization and sell this based on what their needs may be, whether or not that's ESG goals or cost advantage goals or efficiency and uptime related goals with operational performance.

Great. We'll take a question from the audience.

Yes. This one is from Zoom. Where are you on the expense curve to create global service facilities?

Sure. So one of the benefits that we think that we have with the Flowserve portfolio is our network of quick response centers. And so we actually work very hard and work with our customers to ensure that we are in places around the world where we can meet their needs the best. Those quick response centers will be able to do relatively complex repairs. But in some instances, there will be a requirement to take those to different facilities along the way. But we think that really from a cost perspective in the service side of the business and repair side of the business that we're relatively competitive. As we look at parts, sometimes as you deal with smaller operators who can be a little bit more nimble in the way they go about it, that cost advantage can shrink or not be present. But with respect to services, we feel good about where we're at.

Great. And curious, Amy, what components internally or other inputs are you all watching most closely this year in terms of availability issues as well as just general inflation?

Yes. So there's 3 areas of the supply chain that we've been most impacted in the last, call it, 4 or 5 months, and we expect to continue into the first half of this year. And the first is motors, and that's impacting both our pumps -- our pump and valves parts of the business. And the second is around electronics. And the electronics piece is not going to be any surprise. I think that's something that is heard pretty consistently amongst industrials. And then the last one is a little bit of a head scratcher, it's around soft components. So things made from fluorosilicone. So diaphragm, that sort of things that are used in both positioners and seals that we've had a challenge with respect to this year. I think what's interesting as we look at these is, overall, I'm not talking about huge motors. I'm talking about relatively small motors. So all of these items are relatively small dollar amounts but can have big impacts in terms of slowing down our conversion of backlog to revenue. So we've been very focused on that area of the business. The other one is not necessarily around product or inventory, but it's around how we're getting it to sites. So as lead times have grown exponentially, how we get products to our facilities has needed to change. So before where we might be able to choose ocean freight, as an example or trucking, we're now needing to expedite that and look more at airfreight, which obviously has a pretty significant cost differential. And the other component of that is that with trucking and ocean freight, over time, we've been able to consolidate and really, really improve our rates as it relates to those needs of -- modes of transportation. And we've not seen that same phenomenon on the airfreight side. So logistics is an area that we anticipate we're going to continue to see high or elevated costs in the current environment. But as lead times start to start to be worked into our process more, we'll be able to go back to these more traditional modes of transportation, which ultimately should remove that friction cost from our cost structure going forward.

Okay. And then as we move past the impact of Omicron, which is fairly significant across a lot of global manufacturers, what parts of the business or geographic regions are you all watching most closely in terms of labor placing stress on the organization throughout the course of this year?

Yes. I'll start -- I'll maybe stop at Omicron for just a second because it's been a really interesting start to the year. So as we look at the first 6 weeks of 2022, we've had about 20% of our workforce actually have COVID. And so that number is on par with where we were at for all of last year. So just 200 cases shy of that. So it has been a very difficult variable to manage, particularly in the month of January. As we move forward, clearly, the labor markets have gotten tighter and skilled labor continues to be a challenge in many of the areas that we do business. So machinists, for example, that's just a -- and welders. These are just areas that students aren't going into anymore. So we continue to be very focused on ensuring that we've got the right programs in place to address it. And then I think like everybody else, transportable skills are challenging in the current environment. So in the professional ranks areas like finance, HR, IT, those can be challenging to retain our staff in certain areas. Overall, though, I think that these are manageable levels, and we may have blips in little pockets. But overall, we think that our retention rates are holding up pretty well, given the current environment that is really not just focused on the U.S., but is pretty consistent with where we do business around the world.

And given the very strong balance sheet you have, what's the appetite for M&A given the industry supply constraints and operational challenges? Would you like to see those stabilize a bit more before potentially accelerating any possible acquisition activity?

Yes. We're going to continue to be active in evaluating potential acquisitions. And when I talk about acquisitions, I could be talking from anything to a relatively small acquisition of IP via licensing agreement, an investment in an emerging technology that would be of a relatively small size or a bolt-on acquisition. And we're going to evaluate them. We're going to do it through the lens that we want it to advance our 3 D strategy to ensure that it's going to be a fit for Flowserve, not just now, but 5 years in the future as we look at where the business wants to go. That being said, we have an eye for returns as we do this. So we think -- well, what we know, we've got the need to be choosy about how we do -- how we look at these things. So we need things that drive returns. We need things that drive us to be a more profitable and returns-focused companies. And ultimately, we're agnostic whether or not value is driven by organic investment and inorganic investment. We just want to make sure that it's superior value for our customers -- for our shareholders.

Great. And on the cash flow, working capital side, Amy, can you discuss some of the processes you put in place to drive improved working capital management? How you've had to adapt those in the current environment and maybe the outlook for any trends in working capital going forward?

Sure. So there has been a lot of focus and effort that's been put into working capital in the last couple of years. And at the end of 2021, on a gross basis, we have working capital actually where we want to see it at an under $1 billion mark in terms of use of cash. Our investments to date have really focused on things like centralized collections efforts for the company; dashboards that allow us to see where we're at; what customers that we need to focus on; more robust planning processes on the manufacturing side. So ensuring that our sales team is lined up with the manufacturing facility in terms of where that demand is coming from and then what the requirements are going forward. And those processes and tools have led to results that have been pretty impactful to our free cash flow in both 2020 and 2021. As we look forward to 2022, particularly given the supply chain constraints that we have, as we think internally about where we want to drive, we want to be less focused on the inventory side and more focused on improving the denominator of that primary working capital as a percentage of sales. So ensuring that our backlog is translating into revenue as quickly as we can make that happen. And so that's really the key message that we're sending to our sites over the course of this year. In terms of challenges, I think just we are going to be going through a period of growth in the business. I think that we've got the tools in place to ensure that we're responsible about that. That being said, that the area that I think we will need to think about investment as we go into 2022 is really around large projects. And so these multi-month, multi-quarter even, in some cases, multiyear projects that require that we meet certain milestones, so we get milestone payments, those are going to be ones that we're going to very need to -- going to need to very carefully manage the cash flow and those arrangements, so that, that doesn't become a drag on working capital as we make our way through the year. It's a good problem to have. It means that area of the business is coming back in a major way, but we're preparing for that.

Great. And maybe last question, obviously dynamic. But given recent developments, can you help us think about how you approach and manage geopolitical risk across the footprint?

Sure. I logged in early. So I got to think about this one for a little while, Brett, at the end of your last fireside chat. So I'll start with where we're at with Russia specifically. So we do about $50 million of business of sales in Russia each year, and it's really divided into 2 parts. We've got one, we've got a quick response center that's in country. That's pretty steady state around $15 million of sales a year. And then the balance is original equipment that may be shipped into the country each year. It's a relatively small component of business related to Russia, and we obviously are prepared and are following what's happening from a sanction standpoint and prepared to comply with those going forward. We think that we have a fairly robust compliance process and review process in terms of where we do business, how we do business around the world. And the nice thing about having a portfolio of operations that is as decentralized as Flowserve is we are not entirely reliant on one country, one region, around the world. So we are practiced in doing business in areas of the world that are less developed. But it's not an oversized risk in any of those countries where we do business.

That's very helpful. Amy, thank you so much for joining us. Really appreciate you making the time today.

I appreciate it, Brett. Talk soon.

Thank you. Take care.