Flowserve Corporation (FLS) Earnings Call Transcript & Summary

Hi, everybody, Mike Halloran here with the Flowserve team. Scott Rowe is on stage. Amy, CFO, is sitting in the crowd. So I'll make sure I call on her Socratic method to make sure I have all these really detailed financial questions that no one really wants to answer later in the day. But we're going to do a standard format. Scott's going to just give a few prepared remarks here, and then we're going to dive into Q&A. So if you have any questions, e-mail me, raise your hand, either work. With that, Scott, please, the floor is yours.

Yes. So first just, Mike, thank you for having us. Thanks to Baird for putting on a great convention and conference here. And then thanks for the attendance in the audience and coming and listening in person. And so I just want to start with the Flowserve Business System. We put a slide out last week on our -- on the Internet site, Investor Relations, you can find it. But what we did is we formally launched what we're calling the Flowserve Business System. And so that has 5 components: people excellence, operational excellence, portfolio excellence, and then you move into commercial excellence and innovation excellence. And so we thought it was important and the timing was right to kind of roll out a framework of how we're going to run the business. And we organized by 7 different business units that are product family and customer-related. And this framework now is a way for all 7 business units to drive results consistently across Flowserve. And what it does is drive process to outcomes. And so the outcomes is growth, margin expansion, cycle resiliency and stronger cash flow. And it's as simple as that. We're excited about it. The other important piece is we've made a lot of progress on operational excellence over the last 2 years. We're now moving into portfolio excellence. And so there's a second slide there describing that in more detail. And so last year, in our Investor Day, we called it product management and portfolio optimization, and sorry for all the names, but now it's called portfolio excellence. And essentially, what that is, is 80/20. And so we launched an 80/20 process, very formal structured approach to looking at our portfolio. It's data-driven. And so we started with significant data analysis. Now we've segmented into quads. We're following a very standard methodology here, and we're very excited about what we see as the results. We launched 3 business units last year. The first one got kicked off in January. We launched 3 sequentially. Now we're working through the process in the back half of the year of what that looks like. And then we're going to launch 2 more product business units at the beginning of last year -- or the beginning of next year, sorry. And then last year in the Analyst Day, we said operational excellence should deliver 100 to 200 basis points by 2027. We said the same thing for product and portfolio excellence. We said 100 to 200 basis points by 2027. We feel like we've done a really nice job on operational excellence, delivering a lot of the margin expansion year-to-date. And then we start in earnest on the portfolio excellence next year, and we put a little plus by the 100 to 200 basis points because we're pretty confident that we can deliver more than 200 basis points. So with that, Mike, we'll just jump into questions.

Yes. And let's really dig into that, right? Why do you think this is the right time for the 80/20 piece? I have my own views, but they're here to hear from you and not from me. So what is it about the journey that you got to the starting point where you said the organization is now capable of handling some of the more advanced segmentation, quad work, et cetera, that would come with an 80/20 approach.

You've followed us a long time, Mike, and so you know our history well. I've been in the role now 7.5 years. We launched what we call Flowserve 2.0 in my second year. We made good progress. We were doing something called product rationalization. And I'd just say we had a lot on the go, and we really weren't as mature as I wanted to, to launch a very formal structured process. And so 2 things have changed that allow us to do this and give us far more confidence. Number one is the org design, which we kicked off last year. We wanted to do that in the COVID year but just couldn't do it given all of the nuances with COVID. Not being face-to-face with people, doing a massive org design during that time frame was just not optimal. Now we have the org design, 7 business units organized by product family, customer channel. That allows us to do 80/20 by business unit, which before would be very difficult to do. The second thing and probably equally as important is the integrity of our data was not in a place that allowed us to do something that gave us the trust and confidence that, one, the data was right, but also the ability to communicate to our associates and have confidence with the associates to drive the change management necessary. And so it takes a lot of buy-in, a lot of support. The data today is in a much better place than ever before. We've done a ton of work on consolidating ERP systems, creating data warehouse, data structure, data integrity. And now we're at a place that we can do this. So the timing is right. We've got the right people. We've got the right focus. The data is clean, and we can follow a structured process like this pretty seamlessly.

So this question that we just got kind of dovetails on that. What did you do in Flowserve 2.0 and what's different now? So I think you touched on a couple of things. One, data integrity and the organizational structure were 2 of the core components of Flowserve 2.0. Anything else in there that you would want to point to? And then what is the difference today?

Yes. I'd say when you look at it, it really has been just a natural process where we keep building on things. I'd just say Flowserve 2.0, we maybe tried to do too many things. We were focused across operations, products, customers. We had a data element of that, and we were making a thin layer of progress rather than making really deep progress across all of it. But we did drive results. In '17, '18, '19, we made substantial improvements on margins and working capital. But it wasn't enough to weather through some of the COVID and the supply chain impact. But I'd just say we're building on what we did then in the things that we're doing now with the org design and the Flowserve Business System. And so operational excellence is substantially better today than it was within Flowserve 2.0, but a lot of the tenets in Flowserve 2.0 are still what we're doing today. And so I'd just say, I think of it more as a continuity or a continuous process. But now, we're kind of all-in on the Flowserve Business System, and we're starting to see some really good results.

So let's then talk through some of the -- what we're trying to accomplish here, right? So I think traditional 80/20 type platforms, it's about segmentation, which is what you're in the midst of right now. You said you did 3 of them this year. You got a couple of them...

Yes, we've done all the data. All five business units, the segmentation stuff.

And so then the implementation curve is what starts now. And when you look at using the quad approach, however you want to do it, how would you characterize the percentage of your portfolio that really doesn't fit from the right pricing, right customers, right -- however you want to define how you want to go about that segmentation and definition?

Yes. We haven't given specific numbers, Mike, but I would just say it's an 80/20 philosophy for a reason. It's the Pareto approach. We fit the data very well, maybe a little bit more aggressive on the above the 80 side. But what we're finding is -- and this is the philosophy is that 20% of your customers are driving 80% of your business. And 20% of your product families are driving 80% of that. And we're fitting that to a T. And again, maybe it's a little bit smaller on the front end with a bigger impact on the back end, but it's really close to what we see in other industrial companies. And so again, now, the importance is the data is segmented properly. We've got to follow the process. And the process is very prescriptive. It's -- if you're in Quad 4, these are things that you don't want to hold on to or you want to raise your price to a point that the margins become acceptable and you move them into a Quad 3 or a Quad 2. And so I'd just say the team is very focused. We are using a third party to help us with process discipline, but we've lifted up within our pumps division and our valve division to high potential individuals that are leading the program across those respective business units. And that seems to work so far so good. And again, we're well down the process with one of our -- we kicked off in January with our first business unit. And so we're now running 8, 9 months into this, and they'll go through a second cycle of cutting the data next year, which is crazy to believe. It's probably 4 months out that they're into Round 2. And ultimately, we don't want this to be an episodic event. We want it as every year process that's feeding into our annual operating plan.

So how do you get the right buy-in from the teams culturally? Is this an incentive structure? Have you done any work on that side? Are there other factors that you're using to make sure the team gets that right buy-in, and frankly, just executes effectively, right?

This is -- it's a really important question, and it's important in all companies. It's very important in Flowserve. Two things I would say. First is our company, we have a lot of technical people, a lot of engineers. When you show them the data, they get it. And so a lot of skepticism upfront as we cut the data, as we show folks that here's what it looks like and we demonstrate why we want to do things and what the result could be, then our organization responds reasonably well. And so, so far, we're off to a really good start on change management. The commercial team or the sales team has bought in, the product team has bought in, operations has bought in, and we're making good progress. As we turn the corner to 2025, we will adjust incentive plans. We're going to focus more on margins. And so the group that's impacted by this more than any is our sales organization. So we have a sales incentive plan or SIP. Historically, that's been bookings only without a margin component. Now they'll pick up a margin component in their incentive plan.

Great. And then let's use that to just kind of wrap a bow on it. If I think about the 14% to 16% margin targets you put out at the Analyst Day, tracking very favorably relative to that range.

Yes. We're on track.

It feels like these new initiatives give you incremental confidence. And I think the terminology you used on the recent calls, disappointed if there wasn't some room in there. What are you looking at for benchmarks over the next couple of years relative to those targets? Or is it just execution kind of a smooth out quarter-to-quarter progression? What should we think about there?

Yes. I'd say -- I mean, quarters sometimes can be lumpy at Flowserve by saving some of the project and all that. And so I just ask folks to look beyond 1 quarter. But over time, as we're blending 3 quarters in a row or annual, like we should see significant steps up in margins. And we've done a nice job this year really on the back of operational excellence. The product and portfolio excellence really starts in 2025. And again, we feel we've got 200 plus for a reason by 2027. So I think you'll start to see some really nice uplift on margins. And then the only thing I want to add here is our business units are a little bit different, right? So we have -- let's take our Mechanical Seals business unit that sits in our pump division. It's a high-margin business today. The focus with 80/20 there is to focus on growth and focusing on our best customers. So really elevating that, channeling some of the resources that might have been stuck on the long tail and putting them to focus on growth. Isolation valves and some of the industrial pump assets, that's a margin story. And so we're really looking at the margins. We're putting more focus and emphasis on margin behind growth. But at the end of the day, if you do 80/20 properly, you should, in theory, be able to grow your business but drive margins substantially higher, and that's the focus.

And then impact on free cash flow and how do you think about capital velocity through the organization?

Yes. So free cash flow is a good story. We had a nice sprint in Q3. We continue to work our primary working capital lower and lower with complexity reduction or 80/20, right? The inventory needs to run the business go down substantially. And so we think there's a free cash flow opportunity as well. So you get the margin expansion driving higher margins, more cash flow. And then the added benefit is reducing the complexity and reducing some of that inventory that gets tied up in the system. And so there's more room on working capital. We put out the target last year of kind of mid-20s as our goal on working capital. And I'd just say that's not an end state for us. It gets us much better than where we were before when we were kind of 30 and 30-plus, but we still think there's room to improve on that.

So let's transition to the revenue side of things, demand side of things. I'll just leave an open-ended comment. How are you looking at the world, state of the union from your perspective on the underlying demand trends? And I'm sure we'll have a bunch of questions here.

Yes, there's lots that we can dig in there. I'll give a high-level overview, and we can go anywhere you want with this. We still feel -- are confident in our end markets. Last year, we put out a number of getting to $5 billion of revenue, which is essentially a 5% CAGR every year. We're on track to that. We don't see anything different. I'd say on the positive side, we really like the power end markets. So traditional power, nuclear power, renewable power, all things where we play. We can come back to that if we want, but we see a very healthy growth rate there. Decarbonization continues to work for us. That's been growing at roughly 30% a year. We see that may be slowing down in the U.S. given the administration change with the -- if there's changes to the Inflation Reduction Act, that could pull down some of the incentives that make that work possible. But I would say net-net, globally, we still see growth with decarbonization at a very healthy rate. And so we like decarbonization. The Middle East build-out has been substantial. We don't see that ending anytime soon. So essentially, what's happening there is we've got operators moving from just focusing on oil to now natural gas to petrochem, to specialty chemical to power, to water. And so the type of work that we're doing over there is changing slowly. It's moving more and more toward general industries in a kind of a GDP-type feel, but we have visibility to substantial work. And so that continues, and we're excited about that into next year. And then I'd just say this regionalization continues to be a big theme for us as well. And so as companies and countries look to reposition their assets or drive a more regional strategy, we're benefiting from that infrastructure and that build-out. And so we feel really good about our overall outlook. The projects look good. And then the other part of our business is aftermarket. And as you know, over the last 2 years, we've continued to walk that up very gradually, but that's on the back of essentially winning market share. And so what we're seeing is our capture rate on our vast installed base continues to move up incrementally, driving bookings growth there. And so that's through initiatives like quoting faster, delivering faster, being more responsive, having our service centers and service personnel on site with our customers, all of that is contributing to substantial aftermarket improvement. And I think that we can continue to grow that just on the back of these initiatives as we move forward, and I feel pretty confident of that in any economic environment.

How do you think about the funnel of activity? How has that tracked? I mean orders has been great. Funnel seems to have...

Yes, funnel is healthy. We put out some numbers in the third quarter. I'd say year-over-year, our total funnel is roughly flat. That just has to do with some projects rolling off the back end, some that we booked. But when we dig in, the decarb is up substantially. The power funnel is up 20%. Nuclear is up 20%. General industry is up. And so we really like that forward funnel. And just as reference, when we talk about our funnel, it's a 1-year outlook. And so we don't do an extended horizon. It's just what we think we can book in the year.

And maybe just go through the 3D strategy quick before we go into maybe the specific end markets.

Sure. So 3D strategy, this is something we've been talking about now for 3 years. At Flowserve, we've been heavily kind of oil and gas-oriented. And so the diversify lane is the first 3D. That's allowing us to move into more GDP type, less cyclical end markets. Think water, general industry, mining with the MOGAS acquisition, just broadening out that portfolio. The decarbonization is the second -- so decarbonization is really helping our end-user customers drive a more clean or decarbonized portfolio. And so things in there would be biodiesel conversion, sustainable aviation fuel, recyclable plastics on the front end of a chemical plant. We're doing some hydrogen work. We do carbon capture. I mean the list goes on, but there's a lot of stuff in there. We do put nuclear in there as well. And so when we talk about decarbonization growth, it includes our nuclear business also. And then on the digitized side, the last D, what that is, is instrumenting our assets. So instrumenting our pumps and valves with sensors and technology, collecting that data, lifting it up and then being able to monitor and predict. And so essentially, at the end of the day, what we're trying to do is help our customers with flow loop optimization, and we can do that through better visibility and better data management. And so we really like our RedRaven system. It's like we believe we've got the best asset management system out there for our products. What we've got to do is get that installed more with our customers and with those installations.

So let's go on a couple of things here. If I think about the first 2 Ds, I mean a lot of that is just taking your existing product portfolio and applying it to new...

Absolutely.

Right? I mean this isn't exactly like you're trying to introduce something drastically new. I'm not saying there's not innovation along the way, there is. But this is core to what you've done over the last chunk of years, right?

For sure. Yes. Diversify is essentially 200 years of pump experience, 100 years in the valve world, finding those products, using our domain expertise and moving them into areas that we don't have the concentration. So a lot of times, it's more about the channel strategy. So finding the right reps or agents, thinking about distribution versus direct, making sure we have the business development folks that can go out and do the right things there. And so it's not as much about the products. It's more about the focus and the orientation of the company. Decarbonization, a lot of that is our existing customers today, and so just helping them through this energy transition, helping them get cleaner on the portfolio, driving carbon down in terms of their emissions, reducing their energy footprint, things like that.

And then the RedRaven, what's the customer feedback from those who've actually put it in part of their installed base and started utilizing more aggressively? I know you just said we want to broaden that out. We want to get more people on it. But what's the initial feedback been?

Feedback is fantastic. I mean so we're getting -- our Net Promoter Score with the group that's using it is very, very high. They're always willing to be a reference. They're typically adding more assets that they want instrumented on the platform, and so they continue to grow. And so a lot of our growth is on the back of existing customers. We're using those case studies to go out and expand that and try to drive further growth. And I'd just say those are things -- this is something that's really important to us. We do think having this type of offering is very important in the future. I think everything is ultimately getting instrumented. You want to have a view of data. You want to be able to drive optimization. And so we're looking at kind of the whole landscape here, and we're talking about some pretty exciting things on it, right?

And who has access to that data? Can you use that data and then transfer it to other application sets? Or is the customer...

Yes. I think -- I mean data is something that's very sensitive with a lot of our customers. And so every agreement might be slightly different. But what I would say is there's an ability to sanitize the data and then we can use that data to drive optimization.

So I've got a couple of questions on this, so I might as well transition to it before we go to the end markets. How are you thinking about the M&A side of your portfolio today? Maybe the second question will be on MOGAS and what that brings. But what's the intent? What's the portfolio -- I mean, the pipeline of opportunity look like? How actionable is it? And how ready is the organization to absorb?

Sure. Yes. So maybe just a couple of pre-course. Now that free cash flow is better, we're in a much better position to deploy capital. I'd say we've been very methodical about what that looks like, very balanced, making sure that the highest value creation opportunity wins. This year, we did close the MOGAS acquisition. And so that was a $300 million purchase of about $200 million of revenue, accretive margins to our FCD platform. We bought it at a very good multiple, fits the valve portfolio very nicely. It's a premium product with technology that we didn't have, and that's very differentiated in the marketplace. So we're really excited about what we can do there. And so that, I'd say, is the first of what we'll call a series of programmatic acquisitions here. Our funnel looks really good as we look forward. We want to stay true to the 3D strategy. And so finding diverse flow control, finding things that can support us in decarbonization are all on the table. And so I just think this is a highly fragmented business. Our Flowserve business model now allows us to integrate better than ever before. And so I'd just say we're more on the front foot of looking at acquisitions to bring into the portfolio, drive accretive growth and do good things through inorganic growth.

And is the hope to be able to mix up the quality, mix up the technology and mix up ultimately the margin entitlement through these deals as well?

Yes. So I think part -- Amy talks about this really well, like one of the criteria is we want margin-enhancing opportunities. And so as we -- MOGAS is a great example. It's accretive to the FCD margins. We're looking at other opportunities that fit that. It's not to say we wouldn't find something that would be slightly lower than our blended margin, but we'd have to have the ability to extract cost and cost synergies to get into a margin that we know is enhancing. We feel like we're on a very good trajectory with our own margins. The last thing we want to do is acquire something that's dilutive or brings us down in that endeavor.

And then back to the end markets demand and the backdrop. Are you seeing any project delays? And I mean this from 2 perspectives, both funnel conversion for whatever that reason might be, but also you've already won the bid, maybe EPCs, site readiness, some of the other things are pushing out the actual conversion of orders from revenue. Are you seeing any pressures on either side of those curves?

I mean, the project world, there's always -- there's always something. There's financial delays. There might be execution. But I would say we don't see anything different today than we saw a year ago or even 2 years ago. If anything, we're seeing, compared to 2 years ago, maybe things are moving a little bit faster in terms of getting funded and certainly faster on the execution as supply chains have kind of condensed here. So we're not seeing anything different than certainly what we saw a year ago.

So I'm going to start with power from an end market perspective, which I will say in my 15 years covering you has never been the first end market discussed on stage.

But you have to go a long, long way back to find the big power build-out where it was one of our...

I mean we, for years, talked about how you got the installed base. It would be great if the market came back, but the catalyst wasn't necessarily there. Maybe talk about twofold things. One, what's the catalyst? And two, how your products specifically can serve where this market might be heading?

Yes. I mean that's a relatively simple story. Power demand in North America and Europe is now increasing. And so any forecast out there shows increased demand for power. We haven't seen that in 25, 30 years, right? So on the back of efficiency with appliance efficiency, building power efficiency, installation efficiencies, there just hasn't been this increased need for power. That's now changing with AI and data centers. And so that is the single one driver for the growth. The other driver is electrification of nearly anything, right? So automobiles to scooters to bicycles to everything else. And so you're seeing this demand now start to walk up. And we'll use North America, then we'll go to Europe. And North America, you've got the utility players, some are regulated, some are not regulated. You've got folks like Microsoft, Google, Apple going, "hey, we need power to supply our data center, and we are willing to pay a premium for that." And so the whole market is a little bit in chaos right now, but everybody knows they've got to invest into their power production and power generation. And this is why you're seeing some pretty weird stuff, right? So Three-mile Island now in the talks of being -- coming back to life, Amazon buying a take-or-pay agreement on nuclear in Pennsylvania, like these are fundamentally different. And then we're seeing the exact same thing in Europe. So no different. It's driven by electrification and data centers. Europe is the same way. And so we believe that our traditional power business grows. They're going to expand capacity or at least invest substantially in the capacity that we have. We have a massive installed base in traditional power. So coal-fired power plants, combined cycle of natural gas, nuclear power, we've got equipment and all of that. So we're pretty excited about the outlook. Last year, we had a growth rate that was relatively small. We'll publish a new growth rate as we turn the corner next year, but we're excited about the opportunity.

And is the way to think about the impact on your portfolio next couple of years?

Growth.

But the opportunity set is as you start actually getting the approvals and getting the growth and the recertification and then the incremental capacity because all these things take time.

It does take time, correct.

I mean there aren't a lot of people who have the certifications and the expertise in these areas that you have.

Yes, I think that's fair. And those are -- I mean, those comments are really on the nuclear side for the most part. And so nuclear, the handful of folks that can do this work are relatively limited. We have the certifications in essentially all the countries that we'll operate, and we're partnered with the licensors on the nuclear technology. And so we're in a prime position to capitalize on this. On the life extensions of a nuclear asset or resurrecting an asset that's been mothballed, they're not going to change OEMs there. So they're coming to us for the aftermarket. They're coming for us to extend the life of those -- that equipment. And so we're pretty much -- I'm going to say we're locked in or guaranteed. But for the most part, we've got first look if we do what we're supposed to do, then we're going to win that work. And again, we're excited about it. To your point, it's not going to -- the nuclear stuff is not going to come immediately. Those are longer life cycle projects. Typically, a new build when we get the order is 3 to 5 years. But with our percentage of completion accounting, you'll start to see revenue in the first 2 years, but it picks up in years 3 or 4. But again, our bookings have been -- if we go back 2 years, they've been walking up nice and gradually. So we're already starting to see some of the revenue from the work that we booked last year. And again, super excited about what this means. We got to continue to round out the portfolio in nuclear. And then on the traditional power, I think we're going to start to see a lot more activity about helping customers improve the asset reliability, making sure their pumps and valves are working as they're running that asset even harder.

Yes. And frankly, some people can't wait for the 7-plus years that it's going to take to...

Yes, they're not going to be able to wait.

Get for some of the nuclear work. So on the traditional -- more traditional oil and gas side of things, why the confidence in the resiliency of the cycle from here? I could probably point to a bunch of reasons. But from your -- from where you sit, we've had a decent run. Why can the run continue?

Yes. So oil and gas, first, for everyone -- oil and gas for us is really more of the downstream play. So 90% of our oil and gas is in the refining markets in the very downstream. We do midstream work as well. So think like LNG, liquefaction plants and regasification, some midstream pipeline, terminal storage and stuff like that. We do very, very little on the upstream oil and gas. And so when we think about where money is being invested, certainly in Saudi Arabia, a lot of that is now midstream and moving toward the downstream. And then in the U.S., a lot of our oil and gas bookings is really about the utilization of the refining assets. And so as that utilization remains fairly constant, we continue to serve that customer with better service levels, faster quoting, better parts delivery, then we can keep walking up our business. And so we feel pretty confident that just on our installed base, driving capture rates up that we can continue to grow oil and gas.

And then last one, you alluded to it a little bit earlier, but how do you think the prospects of this regime change matter for you more from a manufacturing footprint perspective, ability to manage the tariffs, nimbleness of the -- of your manufacturing base or anything else that you might think is relevant?

Yes. So I'd say on the positive side, everybody knows like less regulation, better environment to do work, unlocking LNG exports, like all that's positive in the U.S. The concern is the tariff side. And so that's something we've got to work through. We've seen this before with tariffs specifically on China. We have a relatively large and complicated global network. 2/3 of our business is outside of the U.S. And so -- but what I would say is in-product imported from China or India into the U.S. is relatively low. For us, it's more of a supply chain issue. And so -- we've done a lot of work to reposition our supply chain, to regionalize it, to make sure we have backup suppliers. It was challenging in the first administration. It was challenging in the supply chain crisis in '21 and '22. And so I'd say today, Flowserve is better positioned than ever before to work through some of the things that could happen.

Great. Well, please join me in thanking Scott for his time today.

Yes. Thank you.