Flowserve Corporation (FLS) Earnings Call Transcript & Summary

All right. Thank you. With our final presentation today, I'm tongue-tied because it's been a long day, but we're excited to have Flowserve here with us today, Amy Schwetz, who's been the CFO, who's been at Flowserve now for 3-plus years. And this is our first time meeting, Amy. So it's great to meet you in person.

You as well, Joe.

Yes. So look, you joined right before the pandemic. I'd love to just start with the last 3 years and how you think the company has evolved since you joined. So why don't we start there and then we'll go through the rest of the questions after.

Sure. So as you pointed out, I joined Flowserve in February of 2020, which was interesting timing with the benefit of hindsight, kind of moving into lockdowns around COVID within my first month on the job. And so whereas I anticipated my first year would be really busy with travel, learning our business and, frankly, a little bit more outwardly focused as well, starting to understand our investors and meeting with the investor community, it was really a pretty inwardly focused year. So focused on kind of doing what we needed to do during the pandemic, to reduce costs while trying to get to know my team remotely and other members of the management team at Flowserve. But what I will say is there's kind of nothing like a crisis to get you in the swing of things quickly. And so I think it actually was a really interesting time to get to know the business. So as I shifted into my second and third year, I've tried to be a bit more outwardly focused after that time of introspection. And I think one of the things that I'm most proud of during my time with Flowserve is really the advent of our 3D strategy and introduction of that, both internally and externally, to the market. And obviously, that was a team effort led by Scott. But what's exciting about it from the role of CFO has really been trying to dovetail how are we allocating capital, how are we spending R&D, how are we thinking about inorganic opportunities and really trying to wrap that around the 3D strategy and making sure that we're actually kind of walking the talk there.

Yes. No, that's great. And so maybe let's get into the strategy, right? For folks that aren't as familiar with the 3D strategy, so diversified, decarbonized, digitized, what does that actually mean, right? How much progress have you made? I think you rolled it out about a year ago. So maybe just kind of talk to us about what you're expecting to get out of that strategy? And how much progress you've made?

Sure. So as Flowserve was looking at the future, in 2019 and 2020, we recognized that a large portion of our business was tied to traditional oil and gas. And clearly, energy transition is a mega trend that we are aware of and wanted to make sure that we were strengthening the business in the right way and ensuring that we were positioned to grow in the future. And so as we looked at kind of what we could do, we recognized the value in our existing portfolio, so recognized that we have a lot of expertise. We had -- we have strong relationships with our customers. And so we had the ability to not sort of move away from them during energy transition but actually lean in and really help them through energy transition. And that's how the decarbonization, so the second d, of the 3D strategy evolved with the recognition that regardless of what industry that you're in, you're looking for ways to consistently reduce your carbon emissions. And so that means we lean into our oil and gas customers and help them think through ways that they can reduce their emissions. We look at our nuclear portfolio and understand how we can grow that business, both organically and inorganically. We look at transition fuels, like LNG and hydrogen, to help grow those areas of the business. And then diversification it's really about our reach and, again, where do we have expertise, so where can we continue to grow that. So it's both a market standpoint and a product standpoint. So looking at areas like specialty chemical and growing that business water. Also thinking about high-margin products like seals and figuring out where we can continue to cascade that product through our original equipment base and gain share of that aftermarket. And then finally, the digitized trend is around -- started with our IoT offering, which is called RedRaven, which is a way for our customers, which is actually -- I say customers, but it's equipment-agnostic to get real-time data on their equipment and is an opportunity for them to look at ways to both monitor for maintenance but also monitor for emissions as well. So some exciting things there. And I think over time, the goal is really to move digitization to be not just the RedRaven product but also how we serve our customers and thinking about how we continue to move to the way our customers want to do business from a digitization standpoint.

Yes. So it sounds like ultimately, more recurring revenue streams, higher growth rates. Interestingly, on your last comment, I just thought probably smaller aftermarket footprint. Is that how you're kind of thinking about things longer term? It's like if you do kind of move a lot of your installed base and connect your installed base, is there an opportunity also to take down your fixed cost structure?

So it's an interesting point. I think there's -- proximity to our customers, I think, is always going to be part of our customer service model. I think it's been a real hallmark of Flowserve and one of the ways that we've gained that customer intimacy, which has helped grow that part of our business that our customers really value and they're willing to pay for. I think with the advent of RedRaven and the more of our installed base that we get on that product line, there's certainly a way to anticipate what our customers need in a better way. And ultimately, that may provide an opportunity for us to look at our fixed cost footprint. I think that's an opportunity that also exists within our manufacturing base as well. And it's something that we do on a routine basis. Actually, even over the last couple of years, we quietly shift production and look to close off production facilities where we can because that footprint certainly adds to the complexity of the businesses and is the way that we can look to reduce our structural costs.

For sure. So speaking of structural costs, you guys put a plan in place. In the third quarter of last year, I think it was a $50 million structural cost-out plan. Flowserve in the past, even before you got there, had a few restructuring programs. And I'm just curious, how does this plan differ from previous plans and ultimately get you to make the progress that you want to make to get to those kind of like mid-30s gross margins.

So I think that probably what's a little bit different about this cost optimization plan is that the genesis of it was really operating performance in 2022. And 2022 was a difficult year. We had some internal issues. Certainly, the macro environment presented challenges, which exacerbated things. And as a leadership team, we wanted to be somewhat introspective around those challenges. And so this cost-out plan or optimization was really almost more of a genesis around how do we operate more effectively, how do we position ourselves to better deal with challenges that we might face externally. And so a byproduct of that is we think we're going to save some costs as a result. So it's about streamlining the operations and the organization in a way that allows us to make decisions quicker, that kind of allows messaging to filter up in a quicker way within a complex organization and allow for more shared resources within the organization. So an example of that is really more tightness between our aftermarket and our original equipment. In many instances, we're sort of basing our selling decisions based on aftermarket and ensuring that we're really looking at life cycle profitability when we're making those decisions about how we bid certain jobs. So it's really about simplification. The benefit is going to be some cost savings as well. And I think we're well on our way to success there. So through the first quarter, we've taken action on about $13 million of run rate savings. And so we're excited to continue to put wins on the board there.

Yes, it seems like you're ahead of plan there. That's great. And it seems -- so if I understood it correctly, you're removing some layers?

That's right.

Yes. Okay. That makes sense. So I think Scott referred to it -- to this on the call. He mentioned that you guys have a long-term target that's out there for margins. He mentioned potentially owing the investment community a new target. Does that mean that we should expect some target at the next Investor Day, maybe sometime later this year, any comments you can make around that?

So I think overall we've got a lot going on within Flowserve right now and a number of things that we are excited about. Whether that's the 3D strategy, how some of our investing decisions are playing into that, cost optimization and, frankly, longer term targets. So we feel like we've got a lot to talk about. And so kind of owing the investor community, I would say, is around long-range targets but about the strategy in general and where we're going. And so I'd anticipate you'll see that in sort of near-term form. In terms of cost targets, again, I would say coming out of last year, the Flowserve 2.0 targets are still out there in our mind and are still things that we're working towards. But we recognized, as we ended last year at kind of 6% operating margins, that we were a long way from that mid-teens that we had talked about in 2018. And so we were hearing from our investors in some ways, "Okay, tell me how you get to 30% and 10% and then we can talk about how you get to 35% and 15%." And I think that's part of the building blocks that we want to deliver is what are the levers that we see -- now that we're at 30% gross margins, what are the levers that we see near term to get to margin levels in addition to where we think we can be at longer term. So...

That's helpful. And then maybe just thinking about the near term, so a nice start to the year. The -- I know that you gave some commentary around 2Q, 3Q and similar -- for it to be similar to 1Q. I'm curious more like if you try to bridge from last year, about $1.10, to the new guidance of $1.65 to $1.85, maybe just walk us through some of the key components of the bridge and what puts you at the high end versus the low end of range for the year.

Sure. So I'll start with just commenting on the first quarter of the year because I think that the groundwork was really laid in the second half of 2022. And we recognize that we have a tremendous asset in our backlog. And so the general seasonality of Flowserve to kind of start the year small and stair-step our way up there, it didn't necessarily have to be the case in 2023 given where our backlog was at. So we asked our platforms to really think about that and plan around ways that we could accelerate some of that movement, and we saw that pay off in first quarter of the year. So 2022, we had some significant headwinds that came into play. And so I'll start with frictional costs. And frictional cost to me, I define as really maybe 4 buckets. So logistics costs, particularly in the first half of the year were quite high. Absorption -- or under-absorption throughout the year was a problem based on -- in some parts of the world due to absenteeism from still COVID lockdowns and the like in the first half of the year. And then we had supply chain challenges in terms of elongated lead-time inflation that came into play there. And then in pockets, labor availability, that became an issue for us and is something that improved pretty significantly in the back half of the year. And then we obviously had the operational issue in the third quarter that we needed to address. And so those issues have largely subsided. I would say, from a labor standpoint, we're in a good place right now. Those frictional costs have all moderated and are improving pretty significantly over time. And lead times have largely stabilized and the supply chain, in some cases, have gotten better. So we feel good about where we're at that now, although I would still say lead times are extended, both for our suppliers and for Flowserve, in comparison to where we've been at historically. So those headwinds are removed. In terms of -- and I would say the tailwinds that we have are really around, one, the backlog; two, finally beginning to realize some of the pricing elements that we saw, that we enacted over the course of 2022; and then what we're working through is really the mix. And so last year was a big year in terms of the return of the large project, particularly in the third quarter, with the Jafurah award that we received. And so just kind of working through that large project mix and the impact that, that has on our overall return. So you saw us raise guidance in the first quarter of the year, and that was largely putting our first quarter results in the bank. And so we feel like those are definitely permanent to the year. As we look at where we were during the pandemic in '20 and 2021 and then some of the challenges that we experienced in 2022, it's pretty important for us to put out a guidance target that we've had a lot of confidence in that allowed us to kind of not everything to go perfect, and we would still be feel quite comfortable within that range. And so that's where we're at. We're taking this year quarter-by-quarter. We think we've got a lot of opportunities. Obviously, revenue conversion is an opportunity for us. I think we're continuing. In the first quarter, we saw better productivity out of our sites than we'd anticipated. So we saw some growth on the top line that we didn't expect, and we saw some improvement in margins that we didn't expect. And then we also have really some benefits from the cost optimization program that we could see in the latter half of the year.

So you're confident in the high end.

I am confident in our guidance range at this point in time.

All right. So it's interesting, really interesting, what you said. A lot of it was, but the first part of it about being able to plan better and to maybe make your year a little bit more linear than it normally is, that means that the supply chain has to be working a little bit better for you. It sounds like that's like -- so you've seen gradual improvement. And then as you think about the rest of the year, you've got the backlog, right? You've had over $1 billion in bookings in the last 5 quarters. So do you have a lot of control over when you are able to ship versus, let's say, 3 or 6 months ago?

I would say certainly, versus 6 months ago, our ability to deliver on our backlog has improved substantially. And I think that there's some of it that the supply chain generally has improved, and there's some of it that our ability to maneuver within the supply chain has improved significantly. There are a couple of areas where we continue to stand up sort of additional resources versus where we were at 1.5 years ago, and it's really around motors and electronics. And so we continue to see those as areas that we need to work closely with our suppliers, we need to look for resiliency, so additional suppliers in that mix, and just make sure that we're keeping our plants running as smoothly as we can. And truthfully, over time, I think that's one of the unlocks that we have, particularly in the Flow Control Division, as we look at some of our higher-margin products, is to continue to smooth out that supply chain so that production is as orderly as it can be, and I think that's going to benefit our margins longer term.

Yes. So what's interesting is that they're such -- project businesses tend to be lower margin than the aftermarket business. That said, when the project business goes away, there's lot of under-absorption in your facilities. Is there a way to -- I don't know if there's fixed costs that are associated with like, let's say, the pumps business, that you could potentially think about outsourcing to make your business flow a little bit more variable costs. Like, any thoughts around that, specifically on how you go to market today versus how that could change over time?

Sure. And I think that make versus buy is -- continues to be a decision that we have to assess internally. What was interesting during COVID, and I would say particularly out of our operations in Europe, is we didn't have a lot of flexibility due to government programs to take out variable costs. So we needed to handle it in a slightly different way than what we might have under unusual circumstances or if it was a company-specific under-absorption issue that we were dealing with. So actually, during that time, we ended up insourcing more of the activities than what we traditionally would have to ensure that our workforce was more fully deployed. Over time, we'll actually take that opposite -- have the opposite response and continue to see whether or not there are buy-versus-make decisions that we can make to lean out the manufacturing and reduce our costs over time.

Makes sense. I'm going to go to the audience in a minute, but before I go to the audience, one quick question just around the bookings. Just I know that oil and gas was roughly 40% of your 2022 bookings. Just talk to us about what types of projects are you booking, how much work are you already seeing from an LNG perspective, any color around that would be helpful.

So I think what's exciting about where we're at this year, particularly given kind of general economic uncertainty, is that our end markets have been quite strong. And so our funnel is actually larger than it was last year at this point in time. Our LNG funnel is actually double where it was at last year at this point in time. Our nuclear funnel is double where it was at last year at this point in time. So we're feeling pretty good about that business going forward. I think the interesting thing about oil and gas is the way that we word it. That's where energy transition lives. And so over time, we need to think perhaps about the way that we label that. But that is about how are we moving forward with energy transition, how are we helping our customers. Just like chemicals, petrochemicals is also recycled plastics. And so these are energy activities that are existing within our end markets that were previously associated, I think, with different activities than what's going on now. I think we have -- we think that we've got a great opportunity to maintain book-to-bill over 1 over the course of 2023. And really, what that -- how that sets us up as a company is confidence in revenue growth in 2024. And really, as we look at the opportunities as they exist out there is really this being part of a multiyear cycle of growth in revenue and earnings for Flowserve.