Flowserve Corporation (FLS) Earnings Call Transcript & Summary

Well, good morning, everyone. Welcome to the Stifel Cross Sector Insight Conference. Today, we're hosting Flowserve. And with us, we have Scott Rowe, President and CEO; and Amy Schwetz, Senior CFO. Today's format, I'm going to run -- Flowserve will run through a brief presentation -- a brief overview of the company and then I'll run through 3 bear cases followed by 3 bull cases to hope you better understand the story. So with that, I'll turn it over to Scott.

Yes. Great. Thank you, Adam. And I just want to thank you, Nathan, and the Stifel team for having us. I'm joined today by Amy Schwetz, our CFO. She's been with us for 2 years. I've been at Flowserve for 5 years. I'd say at the beginning of the journey, we started Flowserve 2.0, which was really all about changing the way we operate and run the business. We made significant progress in 2018 and '19 under that philosophy in that program. COVID year took a sideways, energy markets came down and kind of really been working to try to restore that revenue base. And so what I'm excited about today is we're starting to see that growth. We had a really strong bookings in the first quarter. We're seeing our end markets begin to recover, and we're confident that we've got the right approach for what's going on in the current environment. Additionally, we launched a strategy at the beginning of the year. We call it diversify, decarbonize and digitize or our 3Ds. It's all about how we're growing given the context of their current environment. And so we can get into that with the bull case, but we're pretty excited about what we have going on at Flowserve, and I appreciate the attention and participation today.

Great. Thank you, Scott. So I'm going to start with bear cases first. It's a bear case number one. EBITDA margins have been in decline since the 2014 oil price peak despite multiple rounds of restructuring and the Flowserve 2.0 transformation. The 15% to 17% operating margin targets are not credible, and it's difficult for investors to have confidence in sustainable margin expansion.

Sure. Let me talk about the macro backdrop first, and I'll let Amy talk about the margins. Yes. So since 2014, obviously, oil has continued to decline, then we had another decline in 2020 with the COVID. And then today, we're actually seeing a significant ramp back up. So we'll talk about that in the bull case. But what I will say is our business is exposed to the oil markets. We're primarily downstream. So about 30% to 40% of our business supports refining and downstream. So we don't have a huge exposure on that front end of the full upstream side. What we are very focused on is the other part of our business in creating that more diverse industrial base. And so even -- at the end of 2020 and 2021, we started to see our industrial-type businesses grow pretty significantly and very healthy. And so as part of our diversified strategy, we want to pivot more and more into that general industry. At the same time, we don't want to walk away from our existing customers. We want to continue to support the refining operations. We want to continue to put full control equipment in the -- and capitalize on this growth in oil and gas. But Amy, why don't you talk about the margins and kind of how we're thinking about things here.

Sure. So Scott referenced the transformation and the process the Flowserve was going through early in his tenure as CEO. And really through 2019, the company had made really great progress in terms of margin expansion, improvement of ROIC, improvement in free cash flow kind of across the board in addition to seeing nice revenue growth. Certainly, the pandemic in 2020 presented some interesting challenges for Flowserve. We're a very long-cycle business. We are -- we have revenue that is driven off of our backlog. And during 2020, we actually saw our business impacted less than some of our competitors. So we worked off that strong backlog. We took aggressive action with respect to our cost structure, where we could, particularly around overhead costs, and we really beared that first year of the downturn quite well. 2021 presented some interesting challenges to us as we won dealt with a lower beginning backlog in the long cycle nature of our business. So we started in 2021 to really see an improvement and the quicker cycle elements of our business. So our aftermarket business, our repair business, our MRO business, we started to see that really return in the first quarter of 2021. But what was missing was this large project volume that was really dependent on line of sight to strong macro improvement. And so this year, as we look at where we're at from a margin perspective, we see very strong margins continuing in our aftermarket and MRO business, and we continue to struggle in this large project area where we have certain plants, large engineer-to-order facilities that are at this point under absorbed. The great news is, is with our first quarter bookings, we saw a really strong return to those large project orders, and that's really what drove our bookings to over $1 billion for the first time since 2019 in the first quarter of 2022. So although we see our margins at a low point in the first quarter, we're very confident that as we continue the year, we're going to see continued improvement in margins over the course of the year, with really limited improvement in sort of the environment that we find ourselves in, with tight supply chain, with logistics being working less than smoothly, from an operating perspective, but also pretty costly in today's environment. But frankly, volume is very, very helpful to our business. And so as we see that volume ramp sequentially, we're going to see our margins ramp sequentially. And in fact, by the fourth quarter of this year, we see our margins sort of in the 12% to 14% range this year with room to grow as conditions improve.

Great. I wanted to just talk a little bit about Flowserve 2.0. I believe it's supposed to be in the optimized phase beginning in 2020. What is the optimized phase and what does it evolve? And was Flowserve 2.0 implementation on track? Or did COVID delay it a little bit?

Sure. The optimized phase was essentially meaning that we're completing most of the tasks on the transformation and then we're running our business in normal course. I think everyone that's following us anywhere in the world knows that 2020 was anything but a normal year. And so it's hard to -- we certainly didn't optimize anything as we're fighting through the pandemic and trying to keep our associates safe. And so what -- really what was intended to happen was to capitalize on the progress of '18 and '19, we made systemic change across most, if not all, of our functions. And so I think like commercial front-end, operations, aftermarket support, and what it was all about was creating a more consistent playbook across these different elements of the business and making sure that we could run the business more consistently than what we've done in the past. And again, we are incredibly successful in the first 2.5 years of the program, COVID took a sideways. And with that, the market -- the our end markets came down at 30%. And so we really pivoted more to cost out, restructuring our SG&A and our overhead cost of the corporation and further consolidation of our facilities, both at the major manufacturing in the QRCs. Now all of those playbooks are still intact, right? And so we're still running the company under the Flowserve 2.0 transformation. Our functional leaders are leading it now instead of a designated team. And so I'm confident we start to see that margin improvement in the incrementals as our business starts to come back. And we're already seeing that in our front-end indicators with our bookings in 2021 -- I'm sorry, 2022.

One of the things I'd mention is just from a quality of earnings perspective where Flowserve is at today versus where we were at 2 or 3 years ago where we were dedicating significant amount of cash and expense to restructuring and realignment efforts. We have now fully absorbed those into the business. So as you look at our reduced SG&A costs in comparison to where we were at a couple of years ago, that's now with Flowserve 2.0 really embedded in that continuous improvement effort embedded in the various functions moving forward.

All right. Great. I'm going to move on to the second bear case. Historically, during cyclical CapEx upturns, which Flowserve is starting to see now. There's too much capacity chasing OEM project volume and pricing has been very challenging, leading to lower incremental margins as backlog turns into revenue.

Sure. So Adam, I'll start with this, and Amy can jump in. Clearly, like after any downturn, there is excess capacity in the system. And what I would say is kind of back to my first comment, we participate across a number of different industries and a number of different end markets. And so while we're experiencing capacity and absorption issues in our engineered pumps, that's primarily focused on oil and gas, both upstream, midstream -- upstream, midstream and downstream, that is an area where there's still capacity out there in the system, but we're starting to see that improve as we go forward. If you contrast that to some of our facilities that are more focused on the industrial markets or the water markets, we've actually seen tremendous growth since the pull back in March, April of 2020. And those facilities now are absolutely full. We're hiring as fast as we can to continue to expand our capacity. So it really just depends on what part of the business that we're in. But I would say overall, at Flowserve, we're seeing all of our facilities start to fill up. Amy mentioned on the part of the business that's working well, the MRO, the aftermarket, our seals business, the industrial side of the business, all of those are now approaching 2019 levels or higher. In fact, we've got parts of the business that are at the highest levels we've seen since 2014. And so that's a really positive development for us as we work through 2022, where we're not seeing this is the big engineered pump side and some of the big project opportunities in valves. But we have -- as we look forward, we see a huge opportunity for projects. Our project funnel is as big as it's been in the last 5 years. And we're confident that, that capacity in the system starts to catch up. And we see a little bit more disciplined on the pricing side. We're not quite there yet on big projects. But I do feel very good toward the back half of the year. We start to see more discipline. We start to see capacity externally start to get filled up, and then we start to be able to make decisions a little bit better than what we have in the last year or so.

And on those areas of the business that Scott referenced is doing well. We have been pretty aggressive with pricing increases over the last 9 months. So we've put in place 3 pricing increases since the fall of 2021. We recognize that the markets are changing rapidly. And I think what's interesting in those quick moving areas of the business is we've actually seen those pricing increases stick more than they have in the past. So discounts applied to those are just not happening at the rate that we would have seen at other points in time when pricing increases have been put in place. So the market is accepting them. And aside from sort of that large project business where everybody is hungry for that work right now, we're seeing the pricing environment as good as I think it's been in the last 5 or 6 years.

Yes, for sure. The only other thing I'd just add here is it just depends where you are on the cycle. And sadly, we've gone through many of these. But where we are right now is that -- kind of that beginning inflection back up and when you start to turn, there definitely is overcapacity out there. But what you can see, if you look back in history and as we kind of work our way in those up cycles, we've actually generated very strong incremental margins in the later parts of that up cycle. And that goes to the fact that a big part of our business is longer cycle and longer lead times. And so that's how it plays out from a revenue standpoint and a margin standpoint.

All right. That's great to hear. I'm going to finish up on the bear cases, growth in energy transition in other markets won't be enough to offset the secular decline in oil and gas markets, and Flowserve is likely to grow slower than GDP as a result.

Yes. So yes, I mean, this is a great question and a good one. We think about it all the time. We talk to our Board as well. And so there's no doubt that at some point, the oil and gas markets are -- will not be what they are today. I think it's anybody's guess as to when that is and when that reliance on hydrocarbons is not there. Our view is that's decades away. It's not in the near term. And certainly, what we're seeing today is a race to get energy security and the availability of oil and natural gas, and we participate in both of those. So I think, certainly, for the next 10 to 20 years, we're going to be fine with those type of markets. All of those businesses right now, we feel very strongly on the outlook. At the same time, we are really focused on the energy transition. And so back to our strategy of diversification and decarbonization, those are things that are really supporting the new energy world. And I'll just kind of walk through some of the examples. So we're a big player in concentrated solar power. We do both -- we do pumps, valves, mechanical seals in concentrated solar power. We're also participating in other forms of green energy. A lot of our new product development is going toward hydrogen right now. And we're now on several hydrogen projects around the world, most of those are smaller scale. There's things in our funnel that are substantially big, and we're focused on it. The other big part of energy transition is reducing your CO2 emissions. And we are in a very good position to help operators and our customers drive down their energy footprint, their CO2 reduction. And then we also -- and we call that our Energy Advantage program, where we've got a team that will go and do site assessments at a refinery. And then we'll look at a flow loop to drive energy optimization of that specific flow loop and we're in a unique position with our pumps, valves and seals that we can provide an offering and a commitment that we can drive down their energy footprint and while doing that drive their CO2 reduction down. And then there's other things that we continue to work on, like carbon capture and underground storage. We're now on the two first -- the flagship projects around the world, one in Norway, one here in the U.S. We're participating in both of those in a big way. And so we're really making sure that we're evolving our portfolio to support the energy transition. And I think as we kind of build that work up, we build the diversification up in over a long, long period of time as the oil and gas starts to taper off, we're confident that we can overcome that decline with the things that we're working on today.

All right. Great. And now I'm going to turn it over to the bull cases. You just touched on this a little bit, but Flowserve has several positive demand drivers over the short, medium and long term with high commodity prices and underinvestment during COVID. Renewed focus on energy independence, driving investment in oil and gas, LNG and nuclear, decarbonization spending, driving investment in energy efficiency, biogas, carbon capture, et cetera, et cetera. So is there any -- are there any technologies that need to be developed or acquired maybe to participate in these markets?

Yes. It's -- all of these are requiring innovation. And the more that we can innovate, the more efficient these different technologies will be to create energy. And so all of our R&D and all of our focus is going into our 3D strategy. It's either going to be on diversification, decarbonization or on the digitization. And the digitization aspect is really about efficiency and making sure that you use the data to operate your refinery or your petrochemical plant or your desalination plant more efficient than you are today. And so there's a lot of technology that has to go into these. We're actively partnering with lots of different organizations and players in the space. And we believe that through those technology cooperations that will lead to unlocking some of these even faster than what's happening today. And then I just -- I want to just talk about the current situation, right? And no one would have guessed at the beginning of this year that we'd have oil price where it is, the invasion of Ukraine and the sanctions on Russia are changing the energy landscape dramatically. And what we're seeing at Flowserve is a significant investment into LNG. We're seeing a renewance of nuclear power, which we participate incredibly well. And then we're seeing oil and gas developments come back on to the table that have been taken off for years. And so while we're not at 2014 levels of spending across the energy sector, we're moving in that direction rapidly, right? We haven't seen pricing like this since back to 2014. And so we feel very confident that our traditional markets, the nuclear, the LNG, the oil and gas have a very significant runway. And we are absolutely committed to those markets. We've got an incredible portfolio across pumps, valves and seals to support that. And so we're -- while some of the bigger projects will take longer, we're confident that we've got a lot of visibility to work as we go forward. And then you couple that with this drive for energy security. And so that's -- it's supporting investment in different parts of the world than you normally would see. And so energy security is playing a big part of that investment. And then the other thing that you would think that some of the new energy transition stuff would be backed off during this time. We're not seeing that at all. In fact, we're seeing an acceleration of anything that's focused on energy transition. And so I think we're positioned uniquely to capitalize what I'll call in the traditional end markets and the growth there and the future of energy with the carbon capture in underground storage, the hydrogen, all of the biogas conversions, the biofuel conversions and the energy efficiency thing. So we're very excited about our outlook right now.

And I think what's exciting about the current environment is that versus where we thought we were going to be about a year ago, we now have this renewed strength in our traditional markets, where, frankly, we've got the products to serve our customers and what they want to accomplish. And so the strength of those markets will allow us to allocate capital in a way that we might not have thought was possible 12 months ago to these areas that we see expansion in the future. And then I think additionally, some of this -- some of this work builds on itself with the strength in the LNG markets and our penetration in that area improving. That actually allows us to build our hydrogen business in the future as well. So this becomes, over time, a bit of a virtuous cycle in terms of how it can work out for Flowserve.

All right. Thanks. On to bull case number two, touch on this again. Flowserve has updated strategy to focus on diversification, decarbonization and digitization, diversifying away from traditional energy markets provides for better market growth over time with digitization, opening up opportunities for new revenue streams and share gains. So maybe you can just talk about some of your -- a little more detail on your digitization strategy, maybe the RedRaven offering. How does this work in reality? And what other technologies or products are being deployed to try and capitalize on these initiatives?

Yes. So for us on the external -- so two things on digitization. We want to further digitize our own operations and drive efficiency internally. But on the external side, we want to instrument our pumps, valves and mechanical seals to help our customers drive further efficiency. And so we've done that with our RedRaven offering. We launched this at the beginning of last year. And essentially, this is our IoT solution for flow control. And so with that, what we do is we instrument pumps, we instrument our control valves, we can instrument the seal systems. And when we do that, we not only get a better look at the flow dynamics, but we get the ability to look at our equipment. We can drive predictive analytics on maintenance and failures and things like that. And so we can drive better op time or better operability of the system and we can prevent the unplanned downtime, which is one of the biggest issues for any major installation. Then in addition to that, what we're now looking at is combining the product data with the flow -- the flow loop data and saying, how do we make that entire flow loop more efficient? And these are some of the things that we're working with some of our preferred customers with on really doing things significantly different to drive efficiency in those full loops, and we're having tremendous success. So we're very excited what RedRaven can bring. We're now instrumenting a lot of our product. We're offering on the front end. We're also offering to go in and retrofit. And then the other thing that's pretty unique to our offering is we can do this on competitor pumps and valves as well. It doesn't have to be just Flowserve. And so when we go in, we talk more holistically about how do we drive one, operability and two, efficiency of that flow loop with our customers. And so we have tremendous traction. I was in the Middle East last week talking to a lot of our big customers there. We've got a tremendous installed base and opportunities to instrument a lot of that product going forward. And so we're -- the push right now is to get more assets instrumented, get them connected, understand the data. As we do that, we drive our algorithms in a better fashion to be more predictive and help with the flow loop optimization. But we're excited about what we can do, and we think we're uniquely positioned by having the pump in the valve offering to look at that flow loop more holistically.

In addition, as we get this business to scale on -- with respect to RedRaven, it pairs really nicely with our aftermarket business. So the position that it puts us in to help us be solutions-based with our customers and be there for the service and repairs that they need is another real benefit that we see along the digitization stream going forward.

Just a follow-up. So you're digitizing products that service. There's a high cost of failure to the products that you put in. Maybe you could talk about the monetization opportunity of some of the digital?

Go ahead, Amy.

Sure. So I think one of the things that I like about the digital model is really the ability over time to drive subscription revenue and to get sort of the steady state in this recurring revenue stream in the mix. And as we've seen, I think that, that really drives a more sustainable business for Flowserve. So as we think about the COVID-related downturn, one of the challenges that we had is this long-cycle business. But as we work our way into a sustainable revenue stream along the digitization line, that creates a really more resilience in this. And it also, again, that aftermarket revenue stream that it allows us to tap into is one, that is really attractive to us and really remains in play regardless of where we're at in an economic cycle.

All right. Great. In our final bull case, cash generation has improved significantly in recent years with 95% conversion of adjusted net income over the last 4 years, having averaged 66% for the decade prior. Improvements in working capital are structural and sustainable. And Flowserve should be able to maintain this improved free cash flow conversion going forward, enabling capital deployment opportunities that have been absent in the last few years?

Yes. Let me -- I'll start and then I'll hand it over to Amy, who is very focused on this. So this is a big effort in Flowserve 2.0 is one of the work streams was how do we get better free cash flow conversion, 66% was not ideal. And so there has been a lot of efforts across reducing working capital and the different things on free cash flow of conversion. But Amy is leading this for us. I'll let her jump in here.

Yes. I mean, free cash flow conversion, I think, it's so important to a business and it's really got to be top of mind to our investors. And there's been a lot of work that's been done in this space in really all areas. We started really tackling the accounts receivable and the collection process very early on in the transformation. We've seen great improvements there through centralization of collection efforts and work that's been done to really improve the way that we work with our customers on collections. And really, over the last couple of years, we have shifted our efforts to inventory. Inventory has been an area that I would say that in the past, Flowserve has really applied sort of a blunt model to. If you're buying one thing, you're buying everything. And really, what we're looking for now is a much more nuanced model with inventory, where quick moving items, we're buying in bulk. And we're ensuring that we've got the right level of safety stock in place, but some of the slower-moving inventory, we're looking at in different ways. So inventory has been an area of focus for sure. It's one that with supply chain issues, we've needed to think about a little bit more carefully over the last 6 months. And we may see in certain areas of the business, a little bit more inventory or a little bit more working capital employed -- employed inventory as we work our way through it. But we do see these efforts as really being sustainable and ongoing. And the last thing I might touch on with free cash flow is really capital discipline. And Flowserve has been a business that, in the past, has spent $100 million plus in capital investments over a period of time. And really, the centralization efforts that took place with Flowserve 2.0 means that we're much more disciplined in terms of how we deploy capital across our operations. We, in no way, want to starve our business of capital, but we also want to make sure that we're making smart decisions. And so therefore, over the last couple of years, you've really seen us bring our capital expenditure ranges down. Some of that's been in response to the environment that we're in. And some of it's just been in terms of making better choices about how we're deploying capital at the operating level.

Yes. So this is an area we've made great progress, and we'll continue to make progress. As Amy said, though, given some of the supply chain challenges, we're very focused on strategic inventory. So you probably won't see that in this quarter or next quarter. But long term, we've got -- this wheel is turning, and we're confident that we continue to make progress here.

Yes, great. I was going to say, as these processes are institutionalized into the working capital movement, should we expect to see further improvement in cash flow conversion?

Yes, for sure. Yes. I mean we still endeavor to be in the low 20s. I would say the near-term target would be kind of mid-20s on primary working capital to revenue. And so we're not quite there. We've made good progress to get there. And so I think as we kind of get to the back half of this year as things settle down in the current environment, we start to get back on this journey into mid-20s working capital.

All right. Great. Well, we are just about up on time. So Scott and Amy. Thank you.

Yes. Adam, thanks.

Thanks a lot.