Flowserve Corporation (FLS) Earnings Call Transcript & Summary

Welcome to Flowserve's presentation. We're very pleased to have CEO, Scott Rowe with us today. As with all of these presentations, I'm going to present 3 bear cases on the stock. Scott is going to tell me why I'm an idiot. And then I'm going to present 3 bull cases on the stock, and Scott is going to tell me why I'm a genius. So starting with the first bear case. Margins were in decline from the 2013, '14 oil price peak despite multiple rounds of restructuring and the Flowserve 2.0 transformation, with 2022 margins the lowest in 25 years. The 14% to 16% operating margin targets look more achievable today, but it appear to be more of a peak level of margins than a sustainable through the cycle level.

Yes. Well, first, thanks, everyone, for joining us today. And Nathan, thanks for having me. The Stifel conference is always great. So appreciate you having us today. Yes. And I don't like I always start with bear case before the bull case but it's okay. I know that's the format, though.

Finish with the good ones. So we walk out feeling good.

All right. Yes. So I think the question is, can -- one, when and how do we achieve the 14% to 16%? And is that your peak margins? And is that the end? Let me first talk about how do we get there because I think that's super important. We're not there yet. We've got very good momentum in the last 2 years, and we've got a path to achieving the 14% to 16% through a couple levers. Lever 1 is operational excellence. We put a very strong program in place really over my tenure in 7 years, but reemphasizing some very important points post-COVID and supply chain disruption, and that's now generating substantial results. And we're seeing -- we're actually ahead of where we expected to be this year on the operational excellence. We've also started what we're calling product excellence now, which is essentially product management and portfolio optimization. We believe -- we said last year in the Analyst Day that, that's going to deliver at least 100 to 200 basis points of margin improvement. And now we have the visibility and the organization to deliver that. And so we're getting more and more confident in our ability to drive another kind of 200-plus basis points on the back of product management and portfolio optimization. And so I'd just say as the year plays out, we'll go into more details of exactly how we're doing that and where we're seeing the wins. But we've launched one of our business units fully into the process, and we launch another one actually next week or in 2 weeks into that process as well. And so again, we feel pretty good about that. And then there's just some cost control overhead and leverage. And as we continue to grow, we'll see that margin expansion happen just on the back of holding the cost on our overhead structure. So I'd say right now, we feel really good about the 14% to 16%. We're ahead of where we thought for 2024, and we have visibility to achieving that target. And then when we say is that your peak margins? Or is that kind of the through cycle margins? I believe it's our through cycle margin. I think 16% would be on the high side, 14% would be on kind of that downturn or pull back. And the whole -- when we set those goals out last year, we said from the beginning, we believe that's a sustainable margin. We actually think our margins can go higher than that, but I don't want to get into that yet until we get -- make the progress and get a lot closer to the 14% to 16%. But I would say right now, we believe clear visibility to doing that in what I'll call a relatively flat or stable environment, potentially in a downturn on the low side of things. And again, very clear [ levers ] between operational excellence and the product and portfolio optimization.

So product management and product project management have been a couple of areas. I don't know Flowserve has been focusing on. Can you talk about kind of where you are in that transformation? And what kind of contribution you think those initiatives can make to the margin expansion profile?

Sure. So we did a major reorganization at the beginning of last year. And I'll talk -- let me talk product first. I'll come back to project. So in the product management, we've always had product management in the company, but not a fully dedicated structure across all of our product families. And so last year, when we went to the 7 business units, we now have true accountability and responsibility with product management across the whole portfolio of Flowserve. So all 7 business unit leaders have a Director of Product Management and then below that at the product family level, we have project product managers as well. And so they have clear visibility to what they're responsible for, essentially, its growth and margin improvement and then really making sure that we're putting -- doing the proper things in the good hygiene of products of life cycle -- full life cycle, looking at the products, the channel to market, the pricing, the promotion, all of the things that you should be doing there. Then the other piece to this is really looking at Flowserve's portfolio within the 7 BUs and saying, okay, within industrial pumps or isolation valves, how are we thinking about that portfolio in its entirety? Where should we be focusing more? Where should we be cutting or moving things out? And again, we're way down the line of working through a very aggressive system on the portfolio optimization. So we feel good about that. And then project management has always been an important aspect at Flowserve. I'd say we've been doing that reasonably well. And essentially, for large projects, we have dedicated teams of project management. We put a new place -- a new system in place probably 4 years ago that's -- when we win projects, we execute them reasonably well. When I say reasonably well, it would be on time and at the margins that we bid or you're trying to squeeze out a little bit more through the change order process. And then again, with the reorganization, we've kind of doubled down on that operational excellence discipline within project management. So I feel really good about that.

Okay. I'll go on to the next one. I've gone one too far. We'll do this one in a minute. Historically, during cyclical CapEx upturns, which Flowserve are we seeing now? There is too much capacity chasing OEM project volume and pricing has been challenging, leading to lower incremental margins as backlog turns into revenue, operating leverage could be limited.

Yes. Yes. I think -- I mean, you're going way back on your -- you've been covering us a long time. So I would say in my time, typically, when we're growing the business, we're generating reasonably good incrementals, 40-plus percent. I don't think that changes. I feel good about our ability to drive strong incrementals when we're growing the business, and we're seeing that this year as well. . So back to kind of why do we believe that in potentially some of this overcapacity. Clearly, it's a highly fragmented space in the pumps and the valves side. And at times, we see -- with the larger projects, we do see players getting very, very excited about the opportunity, the potential aftermarket and they're coming in at relatively low upfront pricing. We've put in place what we're calling, and this is primarily the big pump projects. We're putting in place a process we call selective bidding. And so we're really looking at the opportunities in front of us, the partnership with that operator, do we work well with them? Can we get the aftermarket? Do we think we can be successful in the execution? And that's been in place now for almost a year. And we've actually turned away several large projects that we had the ability to win, but the margin profile wasn't what we believe we deserved for taking on the risk of that project. And so right now, we're in a position where we can grow while being incredibly selective at margins upfront that are on par with kind of the rest of the portfolio, which, as you know, Nathan, like back -- if you go back to before my time, we were taking some of those large projects at almost no upfront margin or very low margin. And we're not doing that anymore, and we don't need to do it. And what we found is while there may be a player or 2 out there doing it by doing our selective bidding, working upfront with the operator, the end user and with that EPC, we're finding enough projects to keep our pipeline full and continue to grow that business. And then the other piece of that is really making sure that the aftermarket entitlement will come through with that new sale. And so part of that selective bidding process is making sure that we're very early on in the aftermarket establishment of that, working with that customer on that specific site. So ensuring that the QRC is there, ensuring that we're there for the commissioning and we're there for that first operating session and then making sure that we can partner with the operator to make sure that they have productivity and uptime. And so I guess, is a long answer to in this cycle and where we're at, we feel really good about chasing -- selectively chasing projects that can bring substantial margins to Flowserve that are accretive to what we're doing in its entirety when you factor in the aftermarket. And right now, we continue to win with that approach. And I don't see that changing as we go forward for the next year or 2.

So we're a couple of years into an upcycle now coming out of the COVID driven down cycle. And even in this upcycle, you guys have been talking about margins going into backlog being better than margins coming out of backlog, which is understandable coming right off the early upcycle on that. Is that still the case that pricing and the margins going into backlog is still improving? Or have you reached more of an equilibrium kind of spot -- plateau spot?

Yes, it's a -- I mean we had some really big jumps last year. We're not going to see that. But today, our margins in backlog are better than what we have now.

That's a good short answer. .

100%.

Don't hit the button or I'll be another one ahead. So third one here, 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 over the long term.

Yes. So I'd say this goes to our strategy in the -- Flowserve growth strategy is our 3D strategy, it's diversify, decarbonize and digitize. And we know we've got to diversify our portfolio to avoid a potential scenario like this. What I'd say is I don't feel this is going to happen anytime soon. I'll come back to that. But as we continue to move our portfolio into more industries that are less cyclical, have a more [ GDP feel or GDP plus feel ] to them, then the better off we're going to be in terms of long-term growth. And so we put a substantial effort to pivoting the pumps and valves into markets that we feel that have this kind of long-term growth trajectory like water, specialty chemicals, some of the general industry and manufacturing, that vacuum technology support. Mining is another one that we're moving and repositioning into. And so as we continue to make that migration, then we'll see the Flowserve business less cyclical. Now with oil and gas and the cyclicality of that and decarbonization playing into that, what we're seeing now is it's -- where we play in oil and gas, as you know, it's 80% refining. So we're really -- when we talk oil and gas, it's about refineries. And in the U.S. and Europe, there's no new build on refinery, but there's substantial investment to maintain that operation and then there's substantial investment to decarbonize that asset. So either a biodiesel conversion, an energy advantage where they're reducing their energy input to it, potentially doing carbon capture on the back end. There's lots of things that they're doing to spend money on that asset. We are seeing growth on new development, certainly in the Middle East. It's a very significant and big market and growing incredibly fast. We're seeing investment in Latin America. We're seeing less investment in Asia Pacific. And so I think we're still -- we still have several years of build-out in other parts of the world outside of the mature U.S. and European market. And then you combine that with decarbonization, and we see a very healthy growth rate. And then the other one, Nathan, and you know this because you've been following us for a long time. Power has been a substantial part of our business forever. We put flow control equipment into large-scale power facilities. And this could be a coal-fired power plant. It could be natural gas. It could be nuclear. Now it's concentrated solar power. It could be hydrogen, where we participate as well. But power is $450 million of business for us every year. The majority of that today is on aftermarket. We've seen no increased demand in the United States and Europe on power demand in over 20 years, and we're now starting to see that change. And we're seeing a change because of all things electric and we're seeing it change now with the huge power demand on data centers. So we believe power is going to be a substantial growth lever for us as we go forward and could potentially offset or be at a different part of the cycle as some of the oil and gas build-out that we're seeing in the Middle East. Because I do believe the Middle East is not going to continue at this incredible rate that we've seen in the last 2 years. It will continue for another 3 to 4 years, maybe 5 years. But at some point, that starts to slow as they've built out this infrastructure. But we feel like through diversification, through our exposure to power and with the decarbonization that we can continue to grow this business in a relatively progressive fashion and less cyclical than what we've seen in the past.

You said data centers and your multiple went up 1 point. You're supposed to day AI...

AI, sorry.

To get the other point.

Well, AI is driving the growth in data centers, as you know.

So there's clearly similar excitement around power generation and we're starting to see large growth in the U.S. and other places around the world because of stuff like that, the electrification of the economy certainly, the power consumption that these data centers take. Certainly, nuclear is being talked about as a big part of that. And I think that's a reasonably decent sized piece of your power business. Talk about how you play in that and kind of what your expectations for growth over the next few years are?

Yes. We're very well positioned in nuclear. We've got a large installed base. We work with all of the major operators in the United States in Europe, Asia Pacific. In our business, it was heavy aftermarket just because there haven't been too many new builds. But what we're seeing now primarily in Europe through EDF is substantial new build projections. So this would be France and Eastern Europe. We're well positioned with the French operator there. We're also seeing build-out in parts of Asia Pacific. I think Japan, Korea, China as well, where, again, we've got equipment, both pumps and valves that service that. And then what we're seeing in the other mature markets is life extensions of that asset. And when you do a life extension of a nuclear facility, you're essentially adding 20 years of life to that, and it requires the overhaul of your pumps and valves. And so that's a really good work for Flowserve. And so we feel incredibly optimistic about the nuclear outlook in the nuclear business. We've tried to acquire a company in that space. We'll continue to work to round out that portfolio even further, but we really like the outlook in nuclear, and we're well positioned with our facilities and products to continue to grow there.

Thanks to Mr. Macron.

Yes, exactly.

All right. We'll turn to the bull cases now. Flowserve has several positive demand drivers over the short, medium and long term with high oil prices and underinvestment during and pre-COVID, renewed focus on energy independence, driving investment in oil and gas, LNG and nuclear and decarbonization spending, driving investment in energy efficiency, biogas, carbon capture and utilization and storage and also hydrogen.

Yes. And I'd say we'll just go back to the strategy, the diversification, decarbonization and digitization. And the macro themes underpinning that. One is energy security. The other one is regionalization. And so on the energy security side, this is why we're seeing such a massive investment now in energy as countries are kind of repositioning and relooking the geographical or the geopolitical landscape and saying, hey, I need to make sure that I've got energy available for my country or my region. And so we feel really good about this outlook of energy for at least a decade, and we see it on the oil and gas side. We're seeing it substantially with LNG. We have a large portfolio, both pumps and valves and the cryogenic side on LNG. So we're seeing LNG build out and making sure that countries can get natural gas and security. We just hit nuclear, which we feel very good about the outlook on nuclear as well. And then on the oil and gas side, we're starting to see more and more investment internationally on large projects. And so that would be on the large project upstream side, which ultimately gets to the downstream side as well. And so you've got regions like the Middle East that's saying, okay, we need to take one step further in diversifying our economy from just oil and gas production to now doing that processing step. And so this is the build-out we're seeing now in the Middle East is refining petrochemical and then moving into chemical production as well. And that's -- I mean, if you look at the Saudis, that's another 10 years at their 2030 program, but we're also seeing it in the UAE. We're seeing it in Qatar. We're seeing it in Kuwait, in Oman as well, where we're seeing substantial build-out to take that next step in their process. And so we feel really good about the investments in the Middle East continuing and moving forward. And I said this before, I think at some point, that slows down once they build out, but right now, we don't see any slowdown in terms of build-out. And then on the energy efficiency side, I'd say that what we're seeing there is a combination of government regulation and whether that's moving towards green energy or decarbonizing existing assets, we're seeing incentives to reduce CO2 emissions, and we're seeing incentives to green energy. And then secondly, the companies themselves are now trying to achieve their ESG targets. So a lot of them put out net zero targets. And then I'd just say just being just generally good stewards of the environment as well as that third factor. But we're seeing all major -- again, refining is probably the single easiest example to talk about. We're seeing an existing refinery where we may have 2,000 or 3,000 pumps and valves installed there and they're looking to decarbonize that asset, and they're doing that through potentially a biodiesel conversion. And when they do that, they're replacing our pumps and valves or they're looking to put carbon capture on the back end, which is a new flow loop, which we have technology and products that we can be participating in or they're saying within the flow loop itself, how do we drive down the energy to run that flow loop and be more efficient? And we have a consultative offering called Energy Advantage that helps them with that as well. And so on existing assets, we're getting multiple touches for new products, new services to help them decarbonize that asset. And then when we think about kind of the new energy side, we don't have a ton of flow control in the wind side, but there is some on the power generation of wind concentrated solar power, we participate. And then hydrogen, we feel good about, but it's still a long way out. So blue and gray hydrogen on the back of an existing asset, we're well positioned for that. Green hydrogen, we have the products. We've got the technology to participate there. It's just really slow going. And so I'd say slower on hydrogen, but the carbon capture side, we're seeing substantial growth rates. We talked about a big project that we won in the first quarter, but we feel really good about the growth of carbon capture. And then just decarbonization of itself, that business for us, if we think new energy and decarbonization, we've been growing that between 15% and 20% a year now over the last 2 years. Our forward funnel on projects is up 25% year-on-year on decarbonization.

It should be a very high-growth market. .

Very high growth market for us.

Okay. I'll go on to the next one, and we've covered a bit of this one. Flowserve has updated its strategy to focus on diversification, decarbonization and digitization. Diversifying away from traditional energy markets provides for better market growth in the long term, while digitization opens up opportunities for new revenue streams and share gains. I think we probably covered the diversification and decarbonization. So maybe we can focus on the digitization piece of this.

So our digitization offering is called RedRaven, and this is where we instrument our pumps and valves and collect that data back to our own central monitoring. And so at that point, we can do condition monitoring of that asset in our products, but we can also do prediction in there as well. And so we're using different algorithm, some AI to help us drive prediction to avoid unplanned downtime of that asset or of that flow loop. And so this offering is -- we feel it's really good. It's probably the best out there for flow control products. The adoption has been relatively slow. So today, we have over 2,000 assets that are instrumented. We're collecting that data. We're providing a good service back to our customers. We are seeing that growth rate start to inflect up. And so we feel that with this kind of knowledge in this continued ability to share case studies with other customers that we're starting to get more pull and more attraction to our offering. So we're excited about it. I'd say what we like the most is it is a subscription model, which is fantastic. But what it does is it puts us in a front row seat with that asset and that team on all of their flow control problems and challenges. And so when we see something wrong, we can immediately get the right people in there, the service engineer or that local QRC to say, hey, let's look at this pump. Let's look at this valve. We might need to replace an impeller. We might need to change the trim on the valve or whatever. But we're there helping them solve problems. And by doing that, then we get -- typically, we're getting great aftermarket pull-through when that happens, but also as they think about their next expansion or change, we're typically the first call on that. So we're already seeing the aftermarket rate increase where we have RedRaven installed and put in place. So we're going to continue to push this. Again, we're seeing a different trajectory this year than we had last year. So our growth rates up. We'll continue to move forward. But hopefully, we get to somewhere in the ballpark of 10,000 to 30,000 assets installed. We're collecting a lot of data. We're continuing to learn and we're putting ourselves more in a solutions position with our customers.

I've been surprised at RedRaven's penetration rate hasn't been faster than it has been. What do you attribute the slower kind of uptake of this technology?

Yes. I'm not going to say we made a mistake here, but we started where you would expect us to start with our preferred customers like these are big major oil and gas customers global or the giant chemical players. So that's where we started. I mean that's where I have relationships with their executive team, and they were open to -- a little bit open to saying, hey, let's test this out. But what happened with those really big sophisticated customers is as you started to work through cyber challenges or IT infrastructure? Or what are you putting on our side -- are you actually putting something that's WiFi enabled on our site that actually transmits? No, so we can't do that. . And so I'd say we started knocking on -- I'm not going to say the wrong doors, but maybe not the easiest doors to get into. Where we're seeing the success today would be on much smaller assets. So I'll give you a great example is there's a steel mill here in the United States. They've got kind of 5 large high energy pumps that drive the steam to run the steel process. And they're absolutely critical to the process. We've instrumented those with RedRaven. We've got an amazing partnership. We're pulling through aftermarket. We have services now like -- and we're now a true partner with the steel mill. And so we're getting much more success at individual sites kind of smaller scale where we know we can make a difference and there's not as much bureaucracy working through a large system there.

Should it eventually be ubiquitous on your products, like they will be -- they will ship RedRaven enabled at some point in the future? Because it would seem like particularly on the pump side of the business, that all of those products should -- well, not all of them probably not a little tiny industrial ones, but any of the larger size kind of pumps should have this kind of technology on it because it's going to optimize the asset light for the customer.

So on the ebullition technology, some of our high-energy pubs, that's what's happening today. So we ship them instrumented, ready to go, all you have to do is turn on the subscription. So that's happening in the large ones. Then also under control valves, it's the exact same way. So the control valves have a digital positioner in them today. And literally, it's just about the ability to turn it on to provide that monitoring back to a different service than what they have today. So we're doing a lot of that. And so again, I think the world, as we go forward, I mean, and everyone sees this, right, everything is getting instrumented. Like so I just -- we're not going to go backwards on this. We're going to continue to push forward. We have a great product. The feedback has been tremendous. And I truly expect to see this growth rate continue to increase.

Okay. On to the last one. Cash generation has improved significantly in recent years with 93% conversion of adjusted net income in '23, having averaged 66% for the prior decade improvement...

Appreciate your color.

You're welcome. So some of that was before you got here. Improvements in working -- I could go back further.

You can go further down and the number goes down.

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

Yes. Now you and I have talked a lot about cash. The 66% rate is sad to see that on the screen. However, when I got here, we made primary working capital focus and cash management a focus, and we made really good progress in 2018 and '19. So we got into -- we weren't done, but we would from -- gosh, I can't -- 33% primary working capital down to 27% primary working capital. So really good progress. And then the COVID disruption in the supply chain kind of turned us upside down and we didn't make progress for 2 or 3 years. We're kind of now back on our front foot here. I feel really good about what we're doing. I think the first quarter, Jay, 28% right, on working capital percentage. So I keep saying working capital percentage because it's probably the single biggest lever for us to drive free cash flow conversion. The other stuff we're doing reasonably well in terms of capital spending and doing the other things that we need to do on collections, receivables. But I feel good about this. We're not going to go backwards. We're at 28% now. We need to get into the mid-20s and then ultimately, the lower 20s. In the investor conference last year, we committed to kind of a mid-20s working capital percentage to revenue. So we still have some work to go here. But I feel like we're on a really good path to achieve that well ahead of that 2027 time line that we said. And then we'll start to move this down into that kind of lower 20s in the next step. But this is an area that we should have gotten -- it's kind of like the RedRaven, right? We should have gone faster on this, but I'd just say the COVID and the supply chain challenges messed us up more than we expected. But we're back on the program. We know how to do this. There's no reason for our working capital to be inflated. And so driving kind of this 90% to 100% cash flow conversion is well within our control, and we know how to do this, and we'll continue to moving forward with it.

I think it was pretty understandable for the disruption that happened through COVID given the length of your supply chains, the amount of stuff that you have on the ocean at any given time. So I don't think that was...

A variety of countries that we source from is...

Totally. Maybe just in the last minute that we've got, we can talk about priorities for this improved cash flow. I mean Flowserve had up and down EBITDA and not been a good producer of cash over the years, which has certainly limited the capital allocation possibilities. Now with better cash flow and with significant growth we've seen in EBITDA over the last 2 or 3 years, the balance sheet is in a place where you can deploy capital, obviously, the Velan acquisition didn't work out. But just priorities for capital allocation and what kinds of things you're looking at?

Sure. Yes, I'd say -- and again, we feel this allows us to start to do those things, and we're pretty excited about it. I'd say we're taking a very balanced capital allocation approach. We moved the dividend up modestly at the beginning of this year. We also expanded the share repurchase program and we'll certainly add a minimum buyback shares to offset dilution. But I'd say the M&A is an important part of what we want to do. And back to kind of the 3D strategy, we want to diversify the portfolio. We want to find things that can continue to help our customers decarbonize and we want to be able to digitize. And so we're going to use that framework when we think about acquisitions. I don't think we'll do anything crazy here, but we should be buying something every single year to bring into our portfolio. It's a highly fragmented place, and we feel like we can do a really good job being a steward of capital allocation in buying an asset for the right price, integrating it properly, extracting those synergies and creating value through M&A. And we haven't been able to do that for a lot of the reasons that we discussed. But we've got a very strong team now. We know how to do integration. Our IT systems are in a place that allows us to plug companies in. And so I believe every year, we should be doing something that's building out our portfolio aligned with our strategy.

Okay. And we are up on time. So thanks, everybody, for joining us for Flowserve. And Scott, thanks for joining us here today.

Okay. Thanks, everyone. Thank you, Nathan.