Flowserve Corporation (FLS) Earnings Call Transcript

[ Audio Gap ] Mike Halloran here with Baird, and we're pleased to welcome Scott Rowe and the Flowserve team with us today. We've got a couple [indiscernible] the stragglers in the audience as well. But what we're going to do here is pretty standard format. Scott is going to give some prepared remarks not very long, and we're going to do a pretty lengthy Q&A session. So if you have any questions, please raise your hand, let me know. Send me an e-mail, happy to respond to the e-mail on here and make sure we [indiscernible] any of your questions into the conversation with that. Scott, thanks for coming for [indiscernible].

Yes First, Mike, just thank you for having me. Thank you for Baird for setting the conference up. It's always 1 of the best conferences of the year. So we are happy to be here and tell the Flowserve story. Maybe I'll just start as a quick backdrop, and then we'll jump into Q&A. Flowserve is always on a journey. We're always aspiring to do bigger and better things. I'd say Q3, we just had -- we did our earnings call 2 weeks ago. We had a very strong third quarter. The bookings were fantastic at about [ $1.3 billion ], record backlog, record aftermarket. And so we feel like our end markets are moving in the right direction and providing support. And then the business from the operating system that Flowserve has the business continues to perform. And so we've seen continued margin expansion. We're now at several years of margin expansion in the business. And both the pumps and the valves are making tremendous progress. And so we put out long-term guidance and long-term targets at the end of the fourth quarter last year, mid-single-digit revenue growth into 2030, 20% operating income by 2030 and then double-digit EPS growth. And I'd just say right now, we still feel very good about our long-term targets, everything is setting up structurally to continue to support that. And we look forward to working with their customers and the end markets that make sense to drive that growth and profitability.

So maybe we start at the high level before we dig into all the moving pieces going on right now and for sure there are a lot of them, Right?

I kept it very open at the intro.

You know what, it makes my job easier, right? So why don't we start with the margin journey? And then we'll talk about the confidence in the revenue framework because I think we can then dovetail that in some of the shorter-term revenue dynamics from there. But this has been 100 basis points a year kind of margin story. It was a race to 16% EBIT margins. You've surpassed that. Now you're on a path for that 20% plus over this time frame. What are the pieces we're working on today to get to that 20%? How much is volume dependent, but more importantly, what are the structural pieces you're trying to drive to get to that level?

Yes, for sure. Yes. So the last 4 years, every year, we've made tremendous progress here. This year is no different. We're moving in the right direction. We've got to get to 20% plus in 2030. That's our goal. The last 5-year plan we had, we delivered that early. And so we're always leaning in. We're always trying to do things as best we can as an organization. If we go back a little bit and then we'll answer what we're doing today, the Flowserve Business System, we kicked that off about 3 years ago. So 2023, we launched that. It has a pillar of operational excellence, portfolio excellence. We've got commercial excellence, people excellence and then innovation excellence. But the first 2 are the ones that are driving margin. So operational excellence and portfolio excellence. And so on the operational excellence side, it's really driving productivity at the manufacturing sites. And so we're really focused on getting the variances down, reducing our cost per standard hour, doing all the right things within the manufacturing side. We've made great progress there. . On the portfolio excellence, it's 80-20. And so the 80-20 journey has also helped us drive margins really nicely. And so by definition, with 80-20, you're cutting out products that might be lower margin or you're exiting customers that might not be supporting your business in the best way, and you're focusing your resources on your A products and your customers. And we're now in the third year of that, and we're seeing tremendous results. And so those 2 things alone are really driving nice margin expansion. And then the third pillar, while it's not necessarily in the Business System, it's getting supported by the Business System is the aftermarket. And so we've seen tremendous aftermarket growth. Aftermarket for us has higher margin content than our OE or original equipment work. And what we're seeing is the ability to drive that historically now over 3 years, we're driving it kind of mid- to high single digits, outpacing the revenue from our OE. And so we're getting a nice help with the aftermarket margins. And so we'll continue to do that. If we now say we're about 16% here in Q3. As we look forward to 20%, we need to deliver another 100 basis points every year to get to the 2030 target. The actions in front of us. We've got to continue the operational excellence journey. Just I see modest improvement will continue there. the 80-20 is still something that we believe will drive margin expansion. And so we kind of think of that framework about 100 basis points a year on the original equipment type margin. We've got a pricing initiative that we're kicking off or have kicked off already, and we believe that, that will start to drive margins. And then the other one is with the effectiveness of the operational excellence and the improvement in productivity and leaning out our manufacturing facilities, combined with the complexity reduction of 80-20, we're freeing up capacity within manufacturing. And so now we're going to pick up something we've always done kind of 1 or 2 facility consolidations a year. We're now starting to see more meaningful consolidations. And when we do that, we see substantial margin increase as we eliminate that manufacturing overhead and really drive scale into our best manufacturing facilities. And so we think that's a really nice lever for us as we go forward. And so I'd say, overall, we have confidence in our margin progression. We've demonstrated it now for 4 years in a row. We've got to keep going, but we've got plans that we're executing to across the business.

And it really sounds like most of that's in your control versus depending on what the environment looks like?

Yes. I think obviously, revenue growth helps us there, right? But I think we've got -- our plans are predicated on things that we can control and what we can deliver anything on the margin growth will drop through very nice incrementals and only help us on our journey.

And the M&A piece seems to be margin accretive as well based on what you've done so far?

Yes. So recently, we closed the Trillium Valves acquisition. We closed that deal at the end of the second quarter. The margins right now are slightly below our blended margin, but with synergies and what we're going to do with 80/20, we have a high degree of confidence in the ability to get the margins above and really gives our FCD business more levers to pull in terms of what to do to drive margins and grow the business. And so we're pretty excited about what Trillium brings for us. It's highly oriented to the power markets, both traditional power and nuclear, and so we're excited about that growth space and the ability to drive synergies through the integration execution.

So why don't we pivot to the mid-single-digit growth framework? And I'll just open end the question why are you confident that that's the right target over the next 4 years?

Yes. I think -- well, one, mid-single digits doesn't appear that aspirational, but it's something that we haven't demonstrated a couple of years now. And so while we put that in the range of kind of 4% to 6%, like we are gaining more and more confidence to deliver that. What we've seen this year is some downward pressure because of the 80/20 actions. And so as we're calling out that portfolio, cutting things by definition, those are out of the system now and the revenue come down a little bit. So we've got a little bit of a headwind that we've got to offset there. We'll see a lower headwind in Q4 less than 2027. And so that starts to abate as we turn the corner into 2027. With that, we're at record backlog right now at the end of the third quarter, and so a substantial backlog for us as we think about the forward look and our end markets are really good right now. And so if we kind of walk through the biggest end markets for us, we've got energy security is playing a big role in what we're trying to do, and we're seeing more and more bookings around kind of the global energy space kind of retooling as a result of the Middle East, but even -- some of this was happening before then. And so there's a lot of activity around new pipelines, where the refining network is, some of that midstream downstream activity. Power has been a great tailwind and it will continue to track for us both on the traditional power side and the nuclear side. So we feel really good about continuing to drive growth in the power sector. And then general industries has been good, right? And so if we think about water, we've got mining, we've got pharmaceutical in there. There's a handful of others. But all of those sectors seem to be growing at a pretty nice pace. And so -- and then maybe last, we'll just say the aftermarket side, right? We've grown the aftermarket business at kind of this mid- to high single digits. We're gaining market share with our installed base or a different way to say that is improving our capture rate that's continued to go up. The teams are focused, and we feel good about our ability to continue to drive growth. And so I'd just say the actions over the last couple of years have been tremendous. The team is working really hard, and we're getting more and more confidence to drive growth over the long term at [indiscernible].

And if I broaden that out to a 4-year view to get to that 2030 framework, I mean, it feels like there's a point or 2 of price embedded in that.

Yes. For sure it's all initiatives.

You're going to have increasing contribution from the nuclear backlog and the power backlog that you've built. And so it feels like you're not asking for a particularly large GDP base or end market base outside of that to get to that number from a volume perspective. It's fair we think about it.

Sure, absolutely.

Yes. All right. So maybe we talk a little bit a bit then about what you're seeing from an order perspective. obviously, this year has had some moving pieces associated with it on the geopolitical side, in particular. Maybe talk through how you've navigated through this and how the dynamic has changed for you in terms of what your project expectations were, what your turnaround expectations were, yet still putting up $1.3-plus billion per quarter of orders, which is pretty dynamic, how those are all interrelated.

Yes. Yes, that's -- this is a complicated answer, Mike, as you know. We'll start in the Middle East, and then we'll talk about some of the implications of the conflict in the Middle East and how it resonates around the world. So Middle East, for us, roughly 15% of our overall business. It's an important business for us. We do a lot of work there. It is highly aftermarket. So we win big projects, and we'll talk about the projects in the Middle East. But where we make the most money is in the aftermarket, and we've got a tremendous installed base in most of the countries in the region. And so when the war kicked off, a lot of that normal run rate MRO-type work has come down. We publicly put that in the Q2 and Q3, it's roughly $100 million of impact year-to-date, and that's now -- that's down. And at the current levels, it's staying down and it's really a result of some of the conflict, the inability to get to the site and then just general utilization levels being at kind of a lower number than what you would see on a normalized basis. Also, there was a project funnel at the beginning of the year in the Middle East that we are pretty optimistic about. We've seen roughly half of those projects move out and get pushed into 2027 and beyond. And then there's damage and reassessment. So I think like as we think forward about what can happen in the Middle East, you've got the ability to get utilization back up, that aftermarket starts to kick off and gets us back into where we were before. You've got some repair and rebuild work that's coming. We put a number out in Q3 that says more than $50 million of repair work that we have visibility to. We think it's higher than that, but we just can't get access. And we're not having -- it's still a very dynamic environment right now to get a granular response there. . And then the other factor would be some form of resiliency or redundancy in the network. And so think about parallel pipelines or increased storage or different terminals or even capacity in different parts of the region. And so we think that will happen, that's probably '27 or '28 type of impact. So I'd say, overall, right now, Middle East is down. We can't predict the timing of when it comes back up. But I think stability or any kind of cease fire in the Middle East, we start to see a very constructive environment for us and going forward. And then the Middle East, because you couldn't get product through the Strait of Hormuz and output is down across all the whether it's crude or natural gas or LNG or whatever it is, the rest of the world has stepped up. And so the dynamic that we've seen, particularly, and I'll stay in the U.S. and we'll stay refining, what we're seeing on the refining side is incredibly high utilization rates on the back of a lot of profitability with the [ cracks pad ]. And so what's happening there as they're very busy. They're delaying -- some operators are delaying their spending. They're delaying their turnarounds. And so we believe that there's some pent-up demand around the maintenance side. With that said, our numbers in the U.S. have been reasonably good or North America has been reasonably good. We're getting more replacement-type work, so pumps and valves that will come in that they can change out quickly as a replacement. Our parts business is slightly down. The service business is slightly down, but we're also getting some emergency work as well. But we believe that given where the levels of maintenance and spending are, we think there's some tailwinds for us in 2027 because they can't go this long without doing the proper maintenance on those sites. And then maybe the other piece with energy security is everyone's kind of relooking where they're getting energy from and whether that's the crude oil, the refined product or the natural gas, we're seeing different movement on -- think about terminals in different areas or LNG liquefaction facilities, regasification facilities, different types of pipeline. And so we have seen an uptick in our energy business outside of the Middle East as a result of some of the conflict.

And it's been interesting to see how many of these moving pieces still floated your way despite this one pretty major challenge. And it's not like Europe is a particularly strong market at all, right?

Europe has been relatively stable for us, not necessarily growing, but it certainly hasn't declined. But yes, Middle East is a big part of the business. And when that goes down, it's just been interesting to see the offset in other parts of the world, primarily North America, we've seen some in South America. We've seen some in Africa. We've seen a pickup in Asia Pacific as well.

So then maybe talk about the funnel as we think about going into next year. Do the areas that the funnel shift particularly much? It feels like maybe there's a little bit more conversion opportunity in the Middle East. I don't think you have very different views on what's going to happen in Europe at this point. So maybe kind of talk about the composition of opportunity.

Yes. Yes, I think for us, middle -- Europe is roughly flat. There's a heavy chemical mix for us in Europe, and I just don't think there's not major investment in chemicals, certainly on the big side. It's very much an aftermarket business right now. And so I'd say that's relatively flat. Middle East, we've talked about, we do think there's upside. The timing to predict the timing is very difficult right now. But when things settle down, there will be a lot of spending significant investment in our -- the project funnel has actually increased. We just have to convert on those opportunities they have to move forward. . North America funnel looks really good. I'd say it's a mix of -- we've got a lot of power projects in there. You've got other general industries, and then some of the refining stuff is now moving into project type work, which I wouldn't have expected before. And so there's been a recent acquisition of 1 of the refinery players to buy a dormant refinery, and they're going to invest significant money to get that up and operational. There's a greenfield refinery on the books in the U.S. that, quite frankly, I didn't think was going to go forward and now it looks like it will probably go forward. And so there's nice project activity there. But I would say, just overall, our funnel is elevated on a sequential basis. And so we feel pretty good about the visibility of big projects, certainly into 2027 and beyond that, but it is the markets that we just talked about, right? Power is definitely the 1 leading it you've got some on the energy security side and then we've got some general industry stuff that looks pretty good as well.

How do you think about the '27? Turnaround season this year, certainly had a lot of pushouts and delays as people are running their equipment hard because of where crack spreads have been at?

I'd say still a little early to tell. They're still running flat out. We just had our team together. We talked about this yesterday. We really needed to start to work and lean in on the planning side. I think the spring one might be kind of a little bit lighter than what I would say normal but I think the fall on, they've got to do a lot of activity. But we'll see how it plays out. I'd say under any scenario that we really believe that 2027 starts to walk up on the maintenance spending in the refining space.

Are you seeing kind of an offset to the softer turnaround this year with higher maintenance and higher kind of emergency break fix [indiscernible].