Flowserve Corporation (FLS) Earnings Call Transcript & Summary

[indiscernible] Flowserve session today. Joining me on stage here is Scott Rowe, but we have Amy, Jay and Tarek in the crowd here as well. We're just going to do some prepared remarks. So Scott is just going to give a quick overview, talk about the Analyst Day and some of the really good things they put out there. And then we're going to have a lively Q&A session. So if you have any questions, please reach out, raise your hand, send an e-mail to the session and we'll make sure we incorporate all your questions into the Q&A session. So please with that, Scott, floor is yours.

Yes. First, I'll just say thank you, Mike. Your conference is always fantastic. It's one of the best ones in the year, and so we appreciate you having us, and thank you, everyone, for joining us today. I'll just start with a few prepared remarks on Flowserve and where we're at. As a reminder, we just did a big Investor Day in New York City last month. And so if you haven't seen those slides, I encourage you to go and look at the content in there. But I'll give you kind of the takeaway, and then I know Mike is going to drill it and we'll hit all kinds of topics here. But just in short summary, I've been the CEO now for 6 years, going on 7, we've made a lot of progress in many areas, but we've also gone through a lot in terms of industrial recession, COVID, supply chain crisis and all that. What I would say is, today, I feel better than ever about our positioning as a company when we look internally and externally. On the internal side, we did something called Flowserve 2.0 back in '17, '18 and '19 to drive processing consistency across the organization. And now that's embedded in, and we're starting to see the operational results from that. Additionally, we did a big reorganization at the beginning of this year to realign our business to support our strategy, and I'll come to the strategy in a second. And now we're seeing the fruits of that labor, and we've seen consistent results throughout this year. every quarter going up and driving positive momentum from an execution side and an operational side, translating into much better financials than we've seen in the last couple of years. And then on the 3D strategy, we launched that at the beginning of last year. It's to diversify, decarbonize and digitize our business. We've made good progress on that. We're seeing outsized bookings with our diversify and decarbonize and again, Mike, I know we had some questions, so I don't want to go in too much detail there. And then finally, we launched long-term targets. And so we set long-term targets for Flowserve. On the organic side, we said we could grow at 5% a year from this point forward into 2027, equating to a $5 billion revenue business in 2027. We also said we see a substantial step-up in our operating income margin percentage going from where we are today at roughly 10% to something closer to 14% to 16% range. And we've got good visibility on how to get there. And again, we'll hit that in Q&A. And then finally, that translates to doubling our EPS from this year to 2027 and generating $4 a share. And so that's what we laid out. And again, if you haven't seen the slides on the content, I encourage you to take a look at that. And it's all in the Investor Relations site within our website.

Great. Thanks, Scott. Again, if you have questions, let me know, we're going to go pretty linearly here, talk about some of the transition go through the demand outlook, cadencing margins, et cetera. So we'll hit it pretty linearly for everybody. Let's start though with the journey a little bit, because it took some time to get to this point and we could feel the confidence building. There's some fits and starts last year. This year, it's been very consistent. As you said, the Analyst Day targets were pretty attractive, particularly from a profitability perspective. So maybe put in context why you're that much more comfortable today? What had to come together? Is it -- some of it is just what the demand outlook now is good enough that it's allowing some of the things you've done to pull through and really be able to see it. Is it the operational changes coming together? Maybe just give a little context to the confluence of forces.

Let me start with internal and then I'll go to external, but they definitely go hand-in-hand. and we feel confident on both sides of that. On the internal side, again, we started this Flowserve 2.0 journey to really go from an incredibly decentralized business to something that we can leverage the scale that we have. And just as a perspective, we operate in over 50 countries. We have a massive manufacturing footprint, and we've got lots of products and SKUs on the pump side, the valve side and even in the mechanical seal side. And so there's just a lot to work with. And when I got here, there's definitely a need for a cleanup in driving process adherence, defining process, kind of setting a structure that we knew we could grow and scale on. And we made tremendous progress on this in 2017, '18 and into '19. and -- I would say the maturity level wasn't where it needed to be to work through the dynamics of COVID and then the supply chain crisis at the end of 2021 and into 2022. And quite frankly, it caused some problems for us. And we had to work through that. And I'd say, had we made more progress faster on the Flowserve 2.0, we would have been able to work through some of these dynamic down and up in 2020 and 2022. But we're in a good place now, and we've done the restructure where we created 7 business units more aligned to the end markets in our channel to market. We've redone how we go to -- how do we support these business units at the corporate structure? We've doubled down on operational excellence, which is showing tremendous progress. And again, we've now had 4 quarters in a row of continued growth and strong operational progress. And then we've made some changes in some of the people and the capabilities. And so internally, I'm far more confident than ever before on our ability to execute and drive results than I've seen at Flowserve in my 7 years. And then if we go to the external view it's a similar story. We do what we call a market model. And again, this is in the slides for the Investor Day. And in our traditional markets, our market model is showing 3.3% growth. And while that doesn't sound super exciting, if you look at that against the last 6 years, that would be the second highest growth rate that we've seen, and it's 100 basis points higher than what we had last year. And these would be our traditional markets. So in oil and gas, it's the refining side. We've got chemical in there. We've got power, we've got general industry. It's all stuff that I would say would be the legacy industry in typical CapEx and OpEx. And we do our market model with a collection of input from third-party sources, and then we also add a proprietary lens of like what do we think and who we're talking to get those -- to get what we think. Then you take our strategy, the 3D strategy and add particularly the diversify and decarbonize. So on the diversify, what we're trying to do is get into markets that have more sustainable growth, less cyclicality. And so think about like our vacuum technology that goes into very specific manufacturing of special industries, think about water, think about our seal business getting migrated into specialty chemicals and things like that, and we're seeing outsized growth in diversify. And so we feel like that's an adder to this 3.3%. And then secondly is the decarbonization lane. And so within decarbonization, we're seeing energy security and decarbonized drive a lot of activities into nuclear, LNG, hydrogen, carbon capture, recyclable plastics, I'm going to go on and on. But we think our strategy delivers at least 10-plus percent growth. We've seen that now over the last 2 years. And so we think that, that trajectory stays as we go forward. And so the combination of the market model 3, 3 plus this 10% with our strategy, we feel really good about 5% growth. And so back to kind of confidence, the internal side is taken care of. We're making good progress. We've got good people. We've got good process. We're building on our culture, which we believe is excellent, and now we're layering in strategy and market growth. And we just -- we feel good about where we're at today.

So a lot to unpack there. Why don't we start with where you ended on the 3D strategy and pieces of it? The decarbonization piece, I'm sure you get this. But traditional energy companies, when they start bringing up decarbonization concept, a lot of people's original thought is okay, but your traditional energy company. I don't see how you can really help with this process. But you're very confident that you've got the right toolkit and the right product category and the right to play in that space. So maybe you can talk about what products you're offering? Why you are in the space? What you offer? And why the customer base keeps coming to you for help with the transition.

Yes. I won't give customer names, but we'll talk and figure out what it is. One of our biggest customers, so large integrated oil and gas operator around the world. They have upstream assets, they have downstream assets. We'll just use their example. So when they have a complex of downstream assets, there's typically a refinery and a petrochemical plant in near proximity. All of their assets, their commitment is how do we do something on the front end to make it a cleaner operation than it is today? And so in the chemical side, they're recycling plastics to put into feedstock into that plan. On the refining side, they may be converting parts of that business to a biodiesel or a sustainable aviation fuel or something like that. All of those process require flow control equipment changes to make that work. And so there's nothing new from our side. It's our traditional pumps, traditional valves, the same type of seals. We're already there in the installed base. They're typically coming to us first. And if we're able to work with them, we get that work straight away. So that would be on the front side. Then when we think about the asset itself, just like everybody else, right, they've signed up for ESG commitments. They've got government regulation issues. They have to drive their energy consumption down and they've got to drive their CO2 emissions reductions down. And we come into play in several places there. One is, we have a consultative offering called Energy Advantage where we come in and we look at the critical service pumps, we look at their control valves. We look at isolation valves. We look at the flow loop in its entirety. and we talk to them about how do we drive more efficiency within that flow loop. We're the only operator that has the energy input, which is pumps and the ability to control the flow loop with our valve offering, and so we can come in and help them diagnose things. and what we found is in a traditional flow loop in an existing asset like a refinery or chemical plant, we're seeing opportunities to reduce the energy consumption by 20% and 30% every time we do it. We now have 50 studies ongoing with our customers, and we're working through those. And then what happens in practice is once we commit the study, we demonstrate the savings, then we come in, we typically retool our pumps, so we'll take them out. We'll do a revamp or recertification on that pump changing out impellers and veins and making them more efficient, then we change out the trim on the control valve and sometimes they're adding different full control elements in there. And so these are good contracts for us. We get the aftermarket, we get parts and then we'll typically get some sort of recurring revenue as we're monitoring that asset going forward. So that would be one with Energy Advantage. And then secondly, on the back end, we have technology. And again, it's nothing new. It's things that we've been doing for a long time to start to capture carbon at their flare gas or their flue gas emissions. And so we've got the technology with a liquid ring compressor and the module that we construct to help them capture that and either reinject back into process or move that off-site and inject underground. And again, so we can help capture, we can transport carbon and we've got the pumps for injection as well. And so on decarbonization, we play front end, we play the asset itself and we play on the back end with the carbon capture. And so incredibly well positioned with competency, the installed base and the domain expertise and then the products that they've seen before and used before to solve some of their biggest challenges on their decarbonization side.

Yes. I mean, to your point, I mean, a lot of this is just the market coming to you as opposed to something drastically different that Flowserve had to do to serve that emerging trend.

Precisely.

So on the diversification side of things, how do you think about what the process is internally to identify the attractive areas to diversify into how to leverage the existing base? And also, how does that inform what the innovation cycle looks like as you start looking at some of the tangential opportunities you want to play in?

Sure. Yes. So diversify is a big lane for us. And essentially, what we're trying to do is get further away from kind of the cyclicality of the upstream oil and gas business. And so everything that we're trying to do is shorter cycle, faster, more resiliency from a market standpoint. And exactly what you said, Mike, what we've done is that we've canvassed the different markets that have flow control. We've looked at the total available market, the market attractiveness, the growth rates in the future and we've selected just a handful that we're absolutely focused on in putting product development money to an R&D money and then hopefully, acquisition money to do inorganic growth. And so the lanes that we talk about publicly and that we're super excited about is vacuum technology, which works in industrial manufacturing. So I think like solar power, so thin film and the solar power application, they can do chip manufacturing as well and other very special manufacturing. And so as countries are looking to reposition this supply chain and bring that technology closer primarily into Europe and the United States, there's a lot of build-out in this type of stuff. And so we've doubled down on our vacuum technology and our products. and we're opening the aperture to make sure that it's positioned well.

Is that SiHi? Or is that something...

Yes, exactly. So we go to market with a brand called SiHi. They work out of Germany. It is an incredibly high-quality and highly engineered. The SiHi dry components are recognized as a market leader. What we haven't done is get it positioned into some of the growth markets like the semiconductor industry. So now we've done some new product development to do that. We announced a great win in the third quarter, getting one of the first big semiconductor facilities here in the United States with our equipment embedded in the process. And so that's one. We like the water markets, but the water market is very, very broad. And so there are parts of water that we really, really like, and there's parts of water that we won't participate in but we continue to move the valve portfolio primarily on actuation and our pump portfolio into the more attractive parts of water. And then last, that we talk about pretty regularly is the seals business. And the mechanical seal is just a barrier between the pump and the motor. It's an important component, though. It's what wears out the fastest with the run rate, and it's an environmental protection issue. And so we've done really, really well in the traditional markets. And what we're trying to do now is make sure that, that's diversified into some of the new things. We really like the minerals and mining market with seals, and we like the specialty chemical aspect of seals as well. And so we're repositioning and making sure that we can participate in that attractive market. So those would be kind of 3 examples where we're doing some good things. We've done new product development, but probably more important is opening up the channel to market with our sales force and our distribution partners to make sure that we can participate.

So a question from the audience that relates to the water commentary you made. Can you just comment on the opportunities you see at the intersection of water and resource security, as you outlined in your Investor Day? And how much focus do you place on growing these when compared to some of your other segments?

Yes. Again, we like water. We know it's growing. I would say water is -- it's a challenging application to make good money on. And so we've got to be really careful on where we put water. We like wastewater a lot. We like industrial recycling of water. We like flood control. We sometimes like desalination. We think the desalination market is going to take off. I'll tell you, it's very difficult to make money in desalination right now. And so we're being cautious about what we do and how we move into desalination. But it's an area we can't ignore, and we continue to move the right products in there to take advantage of the growth rate. Some of the places that we don't like, like in the municipal water has a lot of competition and if you're not bringing more of a systems and a package approach to it, it's really, really difficult. And so the other aspect of water for us, especially in industrial and waste is adding RedRaven to our products to make sure that we've got more of a digital overlay, and we can provide more than just a pump or valve. We can help them at a systems level, reducing waste or -- reducing their waste where they've got water leakage or driving productivity in their flow loop itself.

You actually jumped to where I wanted to go next. Maybe talk about what the adoption curve has been like for your digital product, RedRaven? Are you seeing people pull it? Or is this still something you're pushing to the market? And talk about it in terms of return savings, would that benefit for the customer base is?

Sure. Yes, I'll start just overview. RedRaven is our IoT offering. We can instrument our pumps and valves, we can collect data and the whole concept here is prevent unplanned downtime, so helping our customers with reliability, monitoring their assets on a continuous basis and then ultimately moving more to flow loop optimization. So helping to drive productivity. The adoption, I say this publicly many times, it's much slower than I would like. The industry is moving slower than I think anyone would like. But the more assets that we have instrumented, we see this -- the momentum building. And so the flywheel is turning. We're getting a lot of repeat order. So back to the push or pull originally, I think I've sold like 3 or 4 of our early systems because it took an incredible top-level cell to get this in. That's starting to change. Where we've been embedded in assets before, we're now seeing a ridiculously high return, adding different assets to existing sites. And so the return bookings are really, really high, and we're expanding that. And so we are getting pulled into sites that we've worked with in the past because they like the technology. And then what do they get out of this? They get continuous monitoring that's very different than what they would have with their control system. And then they get prediction with our algorithms and our AI helps them to predict unplanned downtime primarily on the pump side. And then again, what we're trying to get to, though, when we instrument a control valve and a pump, now we've got to look at the whole flow loop and what we're seeing is the ability to drive optimization and kind of similar to the energy advantage when we do this even with RedRaven, almost inevitably, we see somewhere in that range of 20% to 30% efficiency savings by just doing something differently or changing out the impeller of a pump or changing out the TRIM within that control valve.

And then maybe let's talk more cycle dynamics and not short term, but you're very excited about what the cycle can bring on an upcoming basis. Part of it is level of underinvestment. Part of it is some of the thematics you already talked about. But maybe talk about the level of excitement you have and why you think that there's more sustainable legs to this cycle for your businesses even if there is a broader slowdown from an economy perspective.

I'll start first by saying with diversified and decarbonize, we are trying to get the business less cyclical. And so those are 2 areas that would help us on the cyclicality of the business. The other one is the aftermarket. And so the more aftermarket we can get in the bigger mix of the business, the more consistent we will and the less sensitive to up and down cycles will be at. With that said, we also believe we're at the very beginning of a substantial kind of original equipment or new CapEx build-out cycle. And back to energy security, decarbonization and underinvestment over the last 3 years, we see right now, our internal funnel of projects is substantially strong, it's grown pretty healthily throughout this year. It's higher than what it was last year, and we see tremendous activity. And so parts of them will go regional first and then kind of what industries this is. But the Middle East is -- I've been working in the Middle East since 1994. This is by far the single biggest kind of investment boom I have ever experienced. And so, you have countries like Saudi, the UAE, Qatar, Oman, Kuwait, all now taking a lot of money that they've earned with their commodities and plowing that back into infrastructure to diversify what they're doing. And so, we're participating in Saudi in hydrogen projects, in chemical projects and refining projects and not just that traditional upstream oil or natural gas production. And then we're seeing significant build-out of infrastructure like water and chemicals and other stuff throughout the whole region. But again, this is the single biggest build-out I've seen. They've made a -- all of the countries have made substantial commitments to economic growth and to how do they support that through capital investment. And so, we think that outlook is tremendous, and everything that they're doing has a full control element to it. So Middle East, by far, the single fastest-growing and biggest market for us. Asia Pacific continues to build out in lots of different ways. I would say, from a newbuild perspective, in Europe and in the United States, we see it on the energy transition. And so think about like hydrogen, carbon, recyclable plastics, not so much in refinery or new chemical plants, although the U.S. has just built out pretty substantial capacity in chemicals over the last 2 years. So -- and then the other one is the emerging markets in Latin America. So again, substantial underspend over the last 3 years. Their economies are starting to get a little bit healthier than what they did through COVID, and we're now seeing a lot of discussion in kind of uplift in the bookings out of those countries. And then from an industry perspective, I'd say I'll just kind of go across where we participate downstream oil and gas, the refining side, no greenfield operations in the U.S. and Europe. Greenfield expansion in Asia Pacific and the Middle East for sure. Chemical is a similar story. Build-out in Middle East is massive. Further build-out in Asia Pacific, maybe nothing new in Europe, nothing new in the U.S. at this point. There is some stuff in the U.S. but more a little bit gradual, but there is definitely specialty chemical applications all over the world that we feel pretty excited about. So smaller in scale, maybe a little bit smaller in our bookings, but definitely growth there. On the power side, we are very excited about nuclear. We've got a tremendous portfolio that supports nuclear. It's a big part of our business today. And we see 2 things. One, we see life extensions of existing assets in North America and in Europe. And any time they do a life extension, we get a substantial uplift to our installed base where we're essentially either putting new products in or re-rating the existing products. We see that in Europe as well. But then we're seeing new build-out in France, in Eastern Europe, some of the Scandinavian countries. India has got plans for massive nuclear growth, and we've got the technology to support that. And then we see continued investment in Asia Pacific on the nuclear side. And so we like power. And then there's other sides of power, if we booked coal-fired power plants in Germany, which I wouldn't have expected this year. And so that was a little bit of a surprise. We see that concentrated solar power, small modular nuclear reactors is moving forward. So lots of opportunity there in power. And then on general industries, we feel reasonably well positioned to see continued growth in 2024 and beyond with the portfolio. And that goes a little bit back to that diversification play that I talked about earlier.

I mean, so commentary was backlogs in a tremendous spot. Front log, you feel very good about the opportunity set as you see it today. I mean you would say the front log is as high as it's ever been right now?

Exactly. Yes.

Right. So let's use that as a segue point then to how to think about the margin profile on a forward basis. First, how do you feel about the margins in your backlog relative to what you're putting up today? Is that part of the reason why you see a pretty healthy progression from here?

Yes. So in the Analyst Day, we committed to basically -- a soft guidance for 2024 of 100 basis point improvement. And then we showed the 14% to 16%, which is a substantial uplift from where we are today. And you said it, like, one, we have confidence in 2024 because of the margins and backlog that we have right now. And so that -- if we think about that year-over-year, it's up healthily. And we feel good that we can execute and deliver the margins that are in that bid process or in the backlog itself. And then on the forward look beyond that, there's kind of 3 levers that drive margin expansion. The first one is just with the revenue growth come scale opportunities and the ability to leverage not only our fixed assets on the manufacturing side, but then leveraging the SG&A as well. And so we get some healthy and significant leverage. And you can look historically when Flowserve grows, our incremental margins are always historically very healthy. And so we feel confident in our ability to deliver that. And then in the Investor Day, we talked about 2 specific areas. One was operational excellence, delivering 100 to 200 basis point improvement. While we've made great progress on process and discipline on operational excellence, there is still significant room to run here. And we've got roofline consolidation opportunities still. We've got productivity opportunities still. So, there's still more meat on the bone in terms of operational excellence. And then the second one -- or the third one, sorry, is product management and product portfolio. And I would say of all the good work that we've done over the last 5 years, we haven't really attacked this as well as I would like. And so we doubled down on this in the new organization. And now we've got a very disciplined product management process, we've got a dedicated organization, we've elevated that organization in terms of visibility within the organization and we've set up structure and control on product management. And so we believe there's another 100 to 200 basis points by just doing the right things. I'll give you an example. We just announced, I don't think we announced it, but it's out there publicly that we're divesting an asset. We're selling it. It's something that we shouldn't be involved in. It's not material on a revenue basis. The margins aren't accretive. It took us a little while to get it out of the portfolio, but it's now out. And so that's going to be a nice uplift in the valve portfolio. And we've got more of those opportunities just on general cleanup. And then when we think about the products or the services that we really like, it's like, okay, these are the good ones. These are the winners. How do we double down and invest in those and change that growth trajectory? So we've got a far more formalized approach on product management, and we feel really good about that delivering kind of 100 to 200 basis points.

And the flip side of the -- you're shedding assets that don't fit. Obviously, the Velan deal did not work out, which is a shame across the board. But the free cash flow characteristics are improving, balance sheet is still in a very good spot. How do you look at the target environment for you right now to be able to bring in some of these assets that fit where you want to bring the portfolio as it sits here today? And what's the actionability level?

Sure. Yes. So we really like programmatic M&A as an opportunity level for us to grow in a way to redeploy our capital. And so that's the focus. I think kind of $100 million to $300 million, maybe $400 million in that range. Velan was a great one. We announced it earlier this year. It didn't get through the French regulatory approval because of the nuclear technology, which is very sad to me and disappointing However, the funnel on M&A for programmatic M&A is large. There's a lot of things out there. And so it's a relatively fragmented space within Flow Control. We've got a healthy kind of opportunity set that we're progressing through our funnel. And I'll just say I'd be disappointed if we can't demonstrate something in 2024. And so, we've got confidence in our ability to integrate now, the balance sheet is in a better position, the org design and the operational excellence are improving every quarter. And so now is the time to really kind of lean in. And we like the environment, it will support our 3D strategy, whatever we do, and we believe we've got the team in the process now to start doing this on a regular basis.

And I think that's the key, right? All the work you did over the last chunk of years here positions you both from a free cash flow working capital perspective, but also from an organizational perspective to bring these assets in and more efficiently leverage them. Last question, pricing dynamics, you feel pretty good about the industry pricing? All else equal?

Yes. I mean much better than last year, better than it was 3 months ago. We just announced our price increase for 2024. We went out with 3% to 5%. That will kick off January 1. And so we think we'll probably be net positive for price cost in 2024. Some of the big attractive projects still get undisciplined players out there. And so I don't love that. But overall, substantially better than what we've seen in the past, and we're being more selective given the backlog in our outlook to make sure whatever we put in the backlog has the margins that we deserve.

Well, great. Please join me in thanking Scott and Flowserve team for their time today.

Thank you, Mike. Thank you, everybody.

Management will be available just upstairs to the Chestnut room 13th floor for a Q&A session. Thanks again, everybody, for your time.