Flowserve Corporation (FLS) Earnings Call Transcript & Summary

Well, welcome, everybody. Glad to have Flowserve here this afternoon and very glad to have CEO, Scott Rowe here with us today. Scott is going to make a few introductory comments before we start jumping into Q&A. So Scott, it's all yours.

So first, Nathan, just thank you for having us, and thank you to Stifel. This is a great conference, and we're happy to be here in Boston. Just for perspective for those in the room and the audience that are connected online, Flowserve is a flow control company. We have pumps, valves and mechanical seals. We operate in over 50 countries, and we've got a very diverse portfolio from oil and gas upstream all the way through kind of food and beverage on the general industry side. And I'd say for those that know our story well, it's been a little up and down over the last couple of years, last year being down and not where we needed to be. But I would say, we're in a really, really good position right now. And so we've got record backlog at $2.8 billion. We had a really strong fourth quarter. We had a really strong Q1. We're building on that momentum. And there's still a lot of things that we can do, there's a lot of things that we're working on, but our growth is fantastic on the booking side. We'll hit the 3D strategy for sure, which is diversified, decarbonized and digitized. And we just feel like we're in a really good place compared to any time since the COVID downturn. So we'll just do that. I didn't want to straight -- dive in straight to the bear case, Nathan, without kind of saying we are in a good place and we're operating well, but we're happy to walk through some of the down scenario before we get to the bull case.

Yes. And for most of the people who have been in here today know I'm going to present 3 bear cases on Flowserve stock. Scott's going to tell me why I'm an idiot for presenting those 3. And then I'm going to present 3 bull cases, and Scott is going to tell me why I'm a genius for presenting those 3. So we'll jump straight into those. So first bear case, EBITDA margins have been in decline since -- the last peak in oil price in 2014. And despite multiple rounds of restructuring, much of which happened before you arrived, and the Flowserve 2.0 transformation, 2022 margins were the lowest in 25 years. The 15% to 17% operating margin targets that were outlined in 2018 are not credible, and it's difficult for investors to have confidence in sustainable margin expansion.

Sure. Well, let me just start by saying that the long-term guidance that we put out, that was in 2018 it's not fresh. We know we have to do something new there. We're going to do an investor event in the third quarter of this year and put out new near-term guidance on different targets across the financial metrics. So we'll update that in the third quarter, and we -- we're very excited to host that. We look forward to some of you guys participating in that meeting. And then if we just think about like what's happened at Flowserve, there's been 2 kind of really big upcycles, right? The kind of 2006, '07, '08 run and then the run up from kind of 2012, '13 and '14. And then both times, we've had significant downturns. But in those upcycles, the business was upwards of $5 billion of revenue, and we're not near that now. And post COVID, we had a pretty substantial pull down in bookings at kind of 20%. The OE original equipment business was down 30%, and we're now roughly at $4 billion. And so what I'd say on just this journey and I started in 2017 is when I came in, we put these targets out in '18. We made really good progress in '18 and '19 going toward those targets. We didn't get to the 15% operating margin but we started to get -- moving in that direction at a pretty reasonable increase every single year, and we still have visibility certainly to the low side. And so I think it's achievable and there's a path to getting to something in that range. Now then COVID hits us, we go down pretty hard on the bookings side. And then for our business, it's heavy in the manufacturing. There's lots of absorption there. And then there's the -- we've got -- the pricing has a major impact in these down cycles, and that's primarily on a lot of the engineered pump side and the bigger projects. And so as we think about or as we stand today in 2023, we're in a far better position than we've been ever since I've been here in terms of driving sustainable margin expansion. And so, again, we did that over the last 2 quarters. We're now laser-focused on getting back into the 2019 or the pre-COVID levels. And roughly, that's 33% gross margins and kind of 11% in the operating income. We're -- Q1, we did 30% on the gross margin and just under 10%. And that's, as you know, Nathan, the first quarter has always been a real challenge for Flowserve. And so we feel like we started the year right. We feel like the external environment to operate is really good right now in terms of labor availability, logistics, supply chain stability and things like that. It's so much better than any time in the last 3 years. And so given that backdrop of stability and then you combine that with our price increases, the internal changes we've made over the last 2 years, we feel like from where we are today and looking forward, we're in a really good position to drive margin expansion.

So -- I mean, '22 was obviously a very challenging year. A lot of that, I think, had to do with supply chain and frankly just costs...

Cost disruption, right.

A lot of that has kind of resolved itself. Is there any way to quantify kind of what it cost you last year? I mean, containers were 6x the pricing that they were in '21, if you could find one. I know you guys will put your pumps on planes and...

Yes, we were flying stuff around the world. Yes.

Is there any way to quantify or qualitatively talk about the impact that, that had on margins this year and kind of the, I don't have to do anything to get that back in '23, right? Those kinds of costs have just gone away. Containers are back down -- gone to where they were in '21 and pre-COVID. A lot of those costs have kind of worked themselves out of the system?

Yes. So the best compare is the Q1 results, right? And so if you take Q1 this year versus last year, and then last year, 2022, Q1, we put a bridge there talking about frictional costs. That frictional cost for us was roughly $25 million. And I would say, while there was some frictional cost in Q1 this year, it was basically 0. And so that's the number. And then throughout the year last year, that frictional cost did get lower and lower as we progress through the year. The third quarter was obviously the ERP issue, but the frictional cost did walk itself down throughout 2022. And so again, with that now gone in the external environment reasonably stable, we're in a position now to drive productivity, to do the right things operationally, to deliver the margins that we price against. And so we feel really good. And then, Nathan, I didn't say this at the beginning, but I'll hit it now, the other big thing is just -- I touched a little bit on pricing, but our longer cycle piece of the business gets really impacted in a downturn in an upcycle. And so in 2021, we booked some work at, what I'd call, the trough of the margins, and that's now -- was coming through the system in 2022. There's still some of that work in the backlog today, but it's substantially better than where we were last year or a year ago. And so when we think about the incremental bookings coming in and that margin pricing certainly on the big projects, it is a big, big gap. And then on our base business, which is the largest part of our business, we've actually had pretty consistent margins there. And we feel like we're now in a really good place on price cost with the inflation last year. And we feel like the price increase at 5% at the beginning of the year allows us to continue to drive that gross margin forward.

Well, I'm just going to go over to here, seeing as we're talking about it already because it sounds like this bear case might actually be a bull 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. It sounds like from what you're saying that that's already happened, and we're starting to come out of the other side of that, which is what I have questions on here about. So with the commentary that you just made that some of that lower-priced backlog that you took in 2020 and 2021 is now working its way out, maybe you can just talk about the pricing that's coming out of backlog today versus what was coming out yesterday. And the price of -- pricing on what's going into backlog today versus what was going?

Yes. And just for the group here, this is important. This really pertains to about 10% to 20% of our business. So this would be the big projects, so think EPCs and then us putting engineered pumps and engineered valves into those big EPC projects. And I'd say, it's more, the variability is higher with the pump business than it is on valves. And so valves, we have relatively consistent margin, although we've had pressure over the last 3 years on the downside there. So it does apply that it's cyclical and moving up. But the pumps is where we see the biggest variation. And then just to answer your question specifically, we're now kind of in year 2 of an upcycle. We have a significant backlog. The peer group all has reasonably large backlogs. There is substantial capacity taken out of the system back in this kind of -- the industrial recession of kind of 2016 and '17. And then there was more capacity taken out in 2021. And while I'll say, it is not perfect by any stretch of the imagination on competitive pricing, we're in a substantially better place than we were a year ago. And for Flowserve specifically, even though we still see some kind of poor behavior out there, behavior that we wouldn't want to see, with our backlog where it's at and where our utilization rate is within our facilities, there's no way we're chasing low-margin big projects. Like it's just not going to happen. And so we're in a pretty good place right now as we think about second year of growth to be very, very selective on the projects that we bring in.

So the pricing on these large OEM projects is less set by the customer and mostly set by you all and your competitors, right? Because you're talking about projects where -- for -- to simplify it, you write a number on an envelope and the customers go and open all the envelopes and lowest price sometimes, right? Well, then they give you some feedback. And so the pricing is set by what margin you are bidding on that work and what margin you can bid at is set by how low your competitors are prepared to go. So as you fill that capacity up, everybody starts writing higher numbers on those envelopes and that's how the pricing improves. So this is not really dictated to you by the customer. It's dictated by how full backlogs are and how rational the competitors are.

I think that's fair. I mean, typically, at the beginning of this, there's a target price and they say, look, we have to -- we're not going to move this project through funding if you don't get to this level. And we make up a reasonably good size of the spend on the flow control equipment. So there's some leverage there. But your point is valid, right? At the end of the day, there's usually 3 to 5 bidders on these. And typically, it's lowest price wins. I mean, sometimes you get some technical benefit or in Saudi Arabia you get a multiplier for your In-Kingdom content and your local content. But for the most price, it's lowest price. But as capacity fills up, everyone starts to move forward. And just recently in the Q1 earnings call, we've seen a lot of our competitors talk about their capacity and their ability to be more disciplined. And so I feel like we're in a -- well, I know we're in a better place than last year because our backlog is in a good spot. But I feel like the market dynamics are far better than we've seen before. And on the other side of the business, the other 80%, we typically don't see this type of fluctuation. And the price increases, we've been able to -- I'd say, we got a little bit behind at the beginning of last year on inflation with material prices like most people did, but by the end of the year and certainly into this year, we're price/cost positive on that side of business.

And you talked about on putting a 5% price increase through. So that's -- we're less talking about the large OEM project bids there. We're talking about more bids...

Yes, more of the...

Yes, [indiscernible] pumps, valves that are going through distribution after market. How have you -- how has the traction been with that 5% price increase? Are you getting through what you expected to get through? Markets accepting that kind of price increase given the growth in the market, just a little bit commentary on it?

With all of the discussion on inflation last year, this has been -- they've been reasonably easy. I mean, obviously, there's always a discussion. There's always some pushback. But for the most part, it's been very, very sticky. I'd say, the 2 price increases last year plus this one, I'd say, we're realizing kind of 70% to 80% of that.

And your distributors are kind of your best friend when it comes to that, right?

We like the distributors. We typically will have a price list with them, and they're very happy to pass that on to their customers.

Putting a gross margin mark up on it. As long as they can pass it along, they're happy to have...

It's a win-win relationship most of the time.

Okay. I'll jump on to the next bear one. Growth in energy transition and 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, this is a big concern. And I would say, from a strategic standpoint at Flowserve, we started looking at this in 2019. And not that we're smarter than others or anything like that, but we knew there was going to be pressure on the hydrocarbon space and we highly leveraged that. And just -- as background for some people, most of our business on oil and gas is the downstream side of the refining, but then we've also got a big midstream piece, a small upstream piece. But typically, oil and gas is a big driver of Flowserve. And so, in 2019, we presented to our Board in February of 2020 of this kind of we've got to do something different to address this less dependent world on oil and gas and hydrocarbons. And so we started with all these different names, and I don't want to make them public because some of them were kind of funny. But we had a strategy. We changed it a little bit even through COVID and into 2021. But ultimately, what this led to was our 3D strategy. And the 3D strategy is diversified, decarbonized and digitized. And it was deliberately put in place for exactly this, right, to offset what we thought was a substantial kind of gap in bookings or revenue for us 10 to 20 years out. And that was the -- actually, we looked at a 20- and 30-year horizon. And so the 3D strategy is intended to fill that gap. And we're very excited. We're seeing success on that. But what I would say is we haven't seen the decline in oil and gas that we anticipated -- that we would have thought. Now in the COVID year, the oil and gas project side pulled back significantly. It was a 40% reduction for us on bookings. We're just now seeing that start to come back to kind of pre-COVID levels. But in addition to that, what we're seeing is the oil and gas, I think, refining, right, or even the midstream folks, they're very interested in maintaining -- one maintaining their asset. We'll talk about the aftermarket bookings in a second. But two, meeting their ESG commitments and filling their government regulations. And so I think your refinery now is focused on carbon capture. They're focused on energy efficiency. They're focused on this carbon -- overall carbon reduction of their total footprint, we can help them. And so any time they're retooling, whether they're converting to a biofuel or a sustainable aviation fuel or driving a carbon capture project or putting recyclables on the front end, it's a flow control change. And so we're seeing substantial order activity even though we're not seeing this vast amount of greenfield projects or new refinery spending. And so I feel like today, if we kind of were to weigh this, right, the 2 big growth pillars for us are energy security and energy transition. And we feel like that offsets this longer-term kind of less dependence on hydrocarbons or potential for recession.

Yes, we've definitely seen in the short term, there's no problems with the energy markets, which is good. So I'm going to jump forward here onto the bull cases. Thanks for entertaining my bear cases. 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, nuclear, and decarbonization spending, driving investment in energy efficiency, biogas, carbon capture, utilization and storage and hydrogen. So there are a number of positive demand drivers here. And even I think on the oil and gas side, in the short term investment there is good. We are under investment for a decade and people are catching up. So maybe you can talk about these opportunities, how meaningful they are to Flowserve and what the outlook is for these various markets?

Yes. So I'll start with the energy security and then we'll go to some of the decarbonization and the new energy stuff. But on energy security, it's substantial. And one data point is we were booking work this year for a German coal-fired power plant, which you would not have expected 2 years ago or even 12 months ago. And so folks are -- different parts of the world are very, very focused on maintaining energy security. And so they've got to find a way to make sure that they're providing energy for their people and whether that's a nation state or a region or even a company. And so we're seeing all kinds of different things here. And so for Flowserve, anytime there's a flow control aspect, then we're putting pumps and valves into that application. And I'll start with kind of the bigger markets, and I'll work my way down. The nuclear -- kind of renaissance in nuclear is substantial. The EU is now considering that green. And so we're seeing substantial investment in France. France will have greenfield. The rest of the Europe is pushing for life extensions. And so when they do those things, they're adding pumps and valves, they're replacing things. They're upgrading with their aftermarket. This is a big business for Flowserve. It's roughly $300 million today. And the nuclear side, it's growing substantially. Our funnel is up 40% to 50% year-to-date. And the Velan acquisition on the valve side adds to our valve nuclear portfolio substantially. And so we like what's happening in Europe. India is moving forward as well. China is continuing to progress. And then North America, it's all about life extensions, which is aftermarket nuclear for us. And so we see substantial growth there. We don't see anything that jeopardizes or changes that trajectory at this point and we really like the nuclear space. On the LNG side, so very similar, right? This is -- obviously natural gas in Europe with the Russia and U.K. in conflict, they cut off access in Europe from Russia, and they're very focused on getting natural gas. And so we've seen substantial growth in our LNG business. We've got a big cryogenic offering on the valve side to date, so control valves. We've got Butterfly Valves that are cryogenic, ball valves that are cryogenic and support the application. We haven't, to date, had a pump that supports a cryogenic application. We do the non-cryogenic in LNG, but we will be coming to the market with the cryogenic pump by the end of the year. And so we're really excited about our ability to do that. And this is something that we continue to see growth in our outlook, and we feel really good about the sustainability of LNG. And then just other things on energy security, it's driving green energy, like -- and I'll get to the hydrogen, but concentrated solar power and then just investment in refineries to make sure that they're up and running and then just energy source on whether it's coal-fired power plants or the natural gas-fired power that we're seeing spending across the board, mostly in maintenance and making sure that they can produce at the highest levels. And so I don't see anything that slows down this energy security or energy independence in terms of spending. And then on the decarbonization space, again, it's this combination of regulation and let's say, the incentive structure in the U.S. is fantastic with the Inflation Reduction Act. Canada has just passed something recently that's in a similar kind of incentive structure. And then Europe has got a bunch of different programs as well. But we're seeing substantial spending around those incentives. And then you have companies trying to meet their ESG goals as well. And so that combination, again, is driving investment. And -- I'll start with existing infrastructure and then we'll move to some of the new stuff. But on the existing infrastructure, again, refining, petrochemical, steel mills, power plants, anything they can do to one, capture carbon, and two, reduce their CO2 footprint by driving energy efficiency down, then that works for us in our favor. And we've got a bunch of different ways to help our customers do that. And so we're excited about helping the customers we have today through this energy transition and helping them with their goals and objectives. And then on the new stuff, we talked about like biodiesel conversion, sustainable aviation fuel, any time they're repiping or replumbing, we get to participate in that. The carbon capture side, we're really, really excited about. It's probably -- of the 3 things, it would be hydrogen, carbon capture, and then the recyclable plastics would be the third big one. Those are the 3 that we like the most. And so carbon capture, you've got the ability to capture the process fluids upfront. We do that with pumps and valves, then there's a carbon pipeline. That's our pumping technology. And then typically, you're injecting into a well and again, they use our pumps on that. So we participated in the 3 flagship projects already, one in Norway, one in the U.S., and then recently the direct air capture project with Occidental, and we see that continuing to grow at a substantial rate. And then on the hydrogen side, we like hydrogen a lot. Today, our valve portfolio is migrating to that. We've won a couple of big green hydrogen programs there. And then you can also produce hydrogen through the blue and the gray ways and they've been doing steam methane reforming now for over a decade. And so we've got pump technology there. And so again, we continue to look at our portfolio and making sure that we can participate across these lanes. But we feel like we're really well positioned. And again, that energy security plus the decarbonization we feel offsets any slowdown.

Very early innings in a lot of these things that will last for a long time.

Yes, long term growth.

And there are a lot of these large projects out there that would order Flowserve equipment later on in the project planning. So there's a lot of projects out there that haven't got to the point yet where they would be ordering stuff from you. So you're likely to see some of the large LNG plants that are under planning or opportunities for Flowserve, that are -- those projects are there, they're going to get completed, but they haven't got to you yet.

Yes. Right. So you can see this with the EPC backlog, right? And so the EPCs, the backlogs are up and there's a lag time from the time they get awarded and we get awarded. And so the future projects are there. And then our project outlook funnel, and we talked about this on the Q1 call, we see it slightly up from last year, and last year had some really big projects in it, but it continues to grow.

Okay. The next one is on the 3D strategy. I think we've probably diverse [indiscernible] decarb, so then we'll talk about digitization here. And you've outlined it, so I don't need to read through this. But I guess the piece that we probably haven't touched on while we're talking today is the digitization piece. So maybe if you could talk about the opportunity for digitization, how that benefits your customers, how that benefits Flowserve, how that benefits the shareholders?

Yes. So our digital offering is called Red Raven and essentially what we're doing is instrumenting our pumps and our control valves and then think you like the processing around that like a seal system. And so we instrument that, we collect the data. We're able to see it, our customers see it. And then what that does is it allows for monitoring and then we can do prediction. So things like mean time between failure or when do you need to take a pump out of service to drive maintenance, we can help them with that. And so today, we've got roughly 2,000 assets instrumented out there globally. The penetration is slower than I would like. It's incredibly frustrating but our product is really, really good. And the more data we can collect, the better our service becomes. And so ultimately, we want to see this as a subscription style business. That's how we sell it today. But for us, this is -- what this does for us, having the data, having the ability to understand the flow loop with the control valve and the pump, it allows us to be a better solutions provider for our customers. And so we believe that with this, it allows us to migrate from our aftermarket offering today, which is a lot of parts and services to ultimately helping folks really drive productivity, uptime, unplanned downtime avoidance and things like that. And so we've been having some really good discussions at a higher level with our customers. And we believe that having the data enables us to unlock this capability. And so again, over time, the desire here while we want to be digital, and it's fun to talk about IoT and prediction and all that good stuff, ultimately, we just want to be able to provide a better service and solution for our customers. And this puts us in a front row seat as we're now talking about enabling them to operate their flow better than they've ever done before.

It would seem to me that digital on flow assets, particularly on pumps, would be something that customers would be looking to adopt. I mean, the cost of failure is very high. The loss of productivity as those things wear is fairly high. What do you credit the -- I mean, the slower than -- you said very frustrated, and it's not slower, not faster uptake. I mean, I would have thought that, that would be something that customers would be pretty keen to get on. What is it that you credit the slow adoption rate to?

We're being very creative in how they do this and drive it faster, but it's really about -- so think about a refinery. And so a refinery has got their own -- they've got their own data system. They've got their own IT infrastructure. And so they really don't want you coming in with something new that could interfere with that. There's massive cyber risk, there's government regulation, and so all of that is driving this cautiousness with this. But when we put it in, and we've done this in big refinery installations, the feedback is fantastic. And so I just think it's a matter of getting it in, getting more use cases and being able to go out and sell this a little differently than we have before. But the upside is substantial. And I'm convinced the world is moving in this direction, like it's not going to go the other way. And so we'll get the adoption up. We'll continue to make progress here and allow us to be in a better position for solutions.

Okay. Let's jump into the last one. Cash generation had improved significantly in recent years with 95% conversion over the 4 years, '18 to '21, having averaged 66% for the prior decade. I'll leave out '22 because I think that's...

I appreciate that.

Improvements in working capital are structural and sustainable, and Flowserve should be able to maintain this improved free cash flow conversion going forward after the disruption in 2022 that's related to COVID, enabling capital deployment opportunities that have been absent the last few years?

Yes. No, I appreciate you pointing this out. And it's been a big win. Historically, this business hasn't done well with cash. We were moving that up nicely into this kind of 95% range. And I'd say where we're at today and our path forward, that's the target. And it just depends. If we're growing substantially, working capital is going to build as we grow. And it might be 85%. But if it flattens out or comes down, we can generate over 100%, which we were doing before. So there's a massive focus on receivables and collections. I think we've got that dialed in tight. We've got a shared service center. It's working around the world. and I'm not worried about that. Our challenge of late has been on the inventory side. And so with lead times extending from our foundries, motor suppliers and people like that, it's just been harder and we're in a growth environment. But I think our targets for working capital as a percentage of revenue were in kind of the mid- to high 20s. We're just now coming under 30%. I feel like we'll continue to make progress there. And then that will allow us to convert free cash flow at this kind of 85% to 95%. And so then what that does, and to the last point here is, now it puts us back on our front foot thinking about capital allocation. And so I touched on at this Investor Day in the third quarter. In the third quarter, we'll come out with a very formal capital allocation policy. But I feel -- I'm just excited to be able to talk about it. I wasn't able to do that last year and we know that's an important part of what investors want from us. And so we'll come out with a very thoughtful approach to how we redeploy capital. But again, we're fortunate to be in that position now right now.

You've got a good backlog, margins going up. So you've got EBITDA increasing. You've got cash coming in. So you've got the debt decreasing, which is getting you into a position where leverage is going to be at a spot where you can deploy more capital. Maybe you can talk about Velan a little bit. And then what the strategic priorities are for capital deployment?

Sure. I'll touch on Velan. So we announced a transaction with Velan. It's a $400 million revenue valve business out of Montreal, Canada, but a big international business. Purchase price was just over $200 million, and so we like the ability to get $400 million of revenue at that price. I was just up there yesterday. The team is super excited. We're working through the regulatory process in Europe right now, but we very much expect to close this and we're excited about it. It rounds out our valve portfolio. They've got a heavy nuclear position and then they've got a cryogenic position for LNG and hydrogen. And so we really like how it fits the 3D strategy. And we're excited about the team, their customer -- they've got good customer relationships, and they're very technical in what they can do. And so it fits really well. And then on capital allocation, again, we'll get real tight on this in the third quarter. But I'd say, to start on a positive, we kept our dividend through the COVID, through the recession, through everything. And so we see that as a commitment to our shareholders. Traditionally, we would buy back shares at a minimum to offset dilution. And over time, we've done a lot of share repurchases. So we'll get back on the -- at a minimum, offsetting dilution and then evaluating additional share purchases. And then the other one we think about would be the M&A. And so we like these bolt-on M&A. We like the more programmatic. So anywhere in that range of kind of $200 million to $500 million of revenue makes a lot of sense for us. And so that would be the balance of additional share repurchases versus programmatic M&A. But again, we're just excited to be back in that position to do this.

It's been a while.

Yes, it's been a while. And then I'd just say, additionally, we do like investment grade, and so we always have to balance that in terms of what the balance sheet looks like to maintain investment grade to keep our debt payments where we would like it to be. But overall, again, we're in a good position to start thinking about capital deployment.

Awesome. Well, we are up on time. So thanks everybody who joined us this afternoon, and thanks, Scott, for being here. Appreciate it.

Yes. Appreciate it.

Thank you.

Thank you for having us.