Flowserve Corporation (FLS) Q2 2016 Earnings Report, Transcript and Summary

Welcome to the Flowserve 2016 Second Quarter Earnings Call. My name is Paulette and I will be your operator for today's call. [Operator Instructions] I will now turn the call over to Jay Roueche, Vice President of Investor Relations and Treasurer. Mr. Roueche, you may begin.

Thank you, operator, and good morning everyone. We appreciate you participating in Flowserve's 2016 second quarter earnings call. Joining me this morning are Mark Blinn, Flowserve's President and Chief Executive Officer; Tom Pajonas, Executive Vice President and Chief Operating Officer; and Karyn Ovelmen, Executive Vice President and Chief Financial Officer. Following our prepared comments, we will open the call up to your questions. And as a reminder, this event is being webcast and an audio replay will be available. Please be aware that our earnings materials do, and this call will, include non-GAAP measures. Please review the reconciliation of our adjusted metrics to our reported results prepared in accordance with generally accepted accounting principles, which can be found in both our press release and earnings presentation. Please also note that this call and our associated earnings materials contain forward-looking statements which are based upon forecasts, expectations, and other information available to management as of July 28, 2016. These statements involve numerous risks and uncertainties, including many that are beyond the company's control. And except to the extent required by applicable law, Flowserve undertakes no obligation and disclaims any duty to update any of these forward-looking statements. We encourage you to fully review our Safe Harbor disclosures contained in yesterday's earnings materials, as well as our other filings with the Securities and Exchange Commission, which are all available on our website at flowserve.com in the Investor Relations section. I would now like to turn the call over to Mark Blinn, Flowserve's President and Chief Executive Officer, for his prepared comments.

Thank you, Jay, and good morning everyone. Let me start with a quick overview of the quarter. First, Flowserve delivered solid financial and operating results in the second quarter. This performance, including our adjusted EPS of $0.57 per share, was generally in line with our expectations and kept us on pace to deliver within our prior guidance range for the full-year, although we did tighten our range this quarter by modestly lowering the upper end. We continue to make significant progress in our transformational realignment program to optimize our manufacturing platform and reduce our cost structure. Additionally, we are seeing early traction from some of our growth initiatives. I will review a few key highlights and then Karyn will discuss our financial results in greater detail. From an operational standpoint, our continuing focus remains to improve our on-time delivery, reduce past due backlog, ensure best-in-class quality, enhance our sales process, and project management capabilities, minimize the impact of restructuring on day-to-day activities and further leverage our supplier relationships. Our employees have supported these efforts, and I'm generally pleased with the operational execution that we've delivered, even while undertaking our realignment efforts and facing a challenging market backdrop. During the quarter, we saw less volatility in some commodity prices, most notably crude oil. While this stability is encouraging, we still expect our customers will remain cautious with their capital and operating budgets in the near term. Considering the multi-year nature of infrastructure original equipment investments, the more important criteria for our customers is stability and it will likely require several quarters of consistency before investment spending actively resumes. Despite the headwinds in many of our sectors and changing end market dynamics, our primary efforts remain on structurally improving our company, controlling our costs and positioning Flowserve for profitable growth and increased shareholder value creation. These efforts include strategically repositioning our capabilities, aggressively aligning our manufacturing presence with our served industries for the long term and responding to current market environment, while permanently reducing under absorption in our system, pursuing our growth initiatives and enhancing our value proposition for our customers. As noted earlier, we continue to make solid progress on our realignment program, delivering approximately $27 million of savings in the second quarter. To date, we've initiated actions on two-thirds of the facilities we expect to either be closed, repurposed, or sold. Importantly, we remain on track to meet our goal of reaching approximately $100 million of incremental savings which is expected in 2016. In terms of specific locations, we have ceased manufacturing and completed the product transfer at an IPD facility in the UK. And in Canada, we closed an EPD facility and also divested a non-strategic foundry. We also have initiated the process to transfer capabilities from our Dubai operations to another location in the Middle East and are nearing completion on closing a Dutch location where manufacturing has now ceased. During the third and fourth quarters, we plan to address additional manufacturing sites and continue to expect about $160 million in charges for the year. While we identify most realignment costs incurred for your analysis, it's important to recognize that our reported and adjusted numbers do include the expected negative impact on revenues and profits that have been delayed during the transition, which should materialize as the receiving sites come up to speed on the new lines. We should also see the benefit of eliminating all the duplicative costs resulting from the transition. With each site undergoing restructuring, we obtained valuable lessons learned and applied them to subsequent locations. Overall, the pace and progress of our restructuring is on track and we are confident that this realignment program will position our business for long-term success. Looking further at the market and bookings within our served industries, overall for the quarter constant currency bookings declined approximately 10% against last year's strongest quarter, as lower OE bookings and project awards more than offset the 2.3% growth in aftermarket bookings. Sequentially, our bookings increased 4%, reflecting both our resilient aftermarket franchise and normal seasonality. I spoke about the challenges of the original equipment business already, but we’re pleased with this quarter's year-over-year increase in constant currency aftermarket bookings, which is the second consecutive quarter of this growth. Our aftermarket franchise largely demonstrated the kind of resiliency we expect even in these tough markets. And while operating budgets have remained constrained, this quarter's level was also supported by increased emergency response, brake fix type activity and the return of a few small upgrade projects, which were notably absent during 2015. Overall, we remain in a period of rolling deferred maintenance where many of our customers are catching up on the 2015 deferrals, but delaying activity previously scheduled for 2016. This practice will not likely continue indefinitely and we expect to benefit as operating budgets normalize. We've also recently see more customers enquire about new or extended long-term lifecycle agreements, or LCAs. We view this activity as positive. In these agreements, we seek to add considerable value to our customers while driving volume for Flowserve. From a segment perspective, we are particularly pleased with IPD's bookings growth of 3.4% on a constant currency basis. For some time, this business had largely leveraged EPD's oil and gas project work. Under new leadership, IPD is returning to its industrial root and demonstrated some early traction in our commercial initiatives for the segment, including increasing our exposure in the profitable chemical sector and other general industries, and better leveraging the distribution channel and growing its run rate in small project activity. Additionally, IPD has benefited from the ongoing integration of SIHI's products across Flowserve's selling platform, including product pull-through across Flowserve's broad portfolio. In fact, this enabled the former SIHI entity to achieve one of its highest levels of quarterly bookings to date in the second quarter. Turning now to specific end markets and looking at bookings on a constant currency basis, oil and gas declined 20% in the quarter, which impacted each of our segment and reflected the broad based pressure on our oil and gas customers' budgets. Oil and gas is our largest served market and this industry has been challenged for over a year and a half now. Power bookings decreased approximately 9%, driven by declines in the IPD and FCD segments. EPD's bookings were essentially flat, including strong nuclear aftermarket orders in North America and Europe, and our success in shifting certain products traditionally focused on oil and gas markets towards our power customers. Going forward, we continue to expect combined cycle investment in North America, while China continues to invest in nuclear where we participate in both the Western and Chinese designs. In our general industries, constant currency bookings decreased approximately 4%. Solid IPD bookings partially offset EPD's 18% decline. As previously mentioned, IPD's distributor initiatives showed progress and we intend to utilize this channel to target previously un-served markets. Flat FCD bookings were supported by solid defense-related orders in Europe and global pulp and paper activity. Broadly speaking, distributors remain challenged. While we believe destocking is largely complete in this channel, they are now maintaining inventory at lower levels and often ordering only when they have a customer order in hand. Chemical bookings were essentially flat in the second quarter, supported by a strong increase in SIHI bookings. We continue to see some delays in the expected ethylene-driven derivative plants as well as the second wave of crackers, but we expect this development to progress in North America and the Middle East supported by low cost feedstock. To wrap up, we are confident that we’re taking the right actions to position Flowserve for the future and we are encouraged by the progress made this quarter. Although our served markets remain volatile and challenging, our first half results were largely in line with our expectations and we expect a stronger second half of the year with seasonality, cost takeout and backlog shipments as the key drivers. Aftermarket is showing resiliency during this time and if extended market stability occurs, we do expect growth in the original equipment orders to ultimately follow. Nevertheless, we expect our customers will remain deliberate near term and early projects to be very competitive. In this environment, we will remain disciplined. I’d like to leave you with a final thought. While we are very much internally focused on cost reduction and structurally rightsizing our operations in this environment and making good progress, we are also positioning Flowserve for the eventual improvement in our markets. We continue to invest for long-term profitable growth, including in the distribution channel and other industrial opportunities, as well as new product development and improvements through our disciplined R&D process. I am confident in our ability to execute our strategic vision and the extended outlook for our served markets, as well as our capabilities to drive long-term value for our customers and shareholders. Let me now turn the call over to Karyn.

Thank you, Mark, and good morning, everyone. Turning to our 2016 second quarter financials, our results were largely in line with our expectations. Bookings were highlighted by a growth in our aftermarket business, albeit still at low levels, and we also delivered sequential constant currency aftermarket and OE increases of 5.6% and 2.5%, respectively. Based on our first half 2016 results and our expectations for the year, we have tightened our 2016 adjusted EPS guidance, while maintaining our full-year 2016 revenue outlook. Second quarter adjusted EPS of $0.57 was driven by our continued operational execution and a solid level of shipments even with the challenges that come with executing significant realignment initiatives. Our second quarter adjusted EPS excludes $0.11 of realignment expense and $0.01 associated with the SIHI purchase price accounting and integration charges which were partially offset by a gain of $0.03 from below the line currency impacts. Reported EPS for the quarter was $0.48, which included an above the line negative currency translation headwind of approximately $0.01. Q2 revenues of over $1 billion decreased 11.7% or 9.7% in constant currency. Year-to-date, Flowserve's constant currency revenues decreased 6.2% compared to 2015 levels. Adjusted SG&A expenses declined 4.2% in the second quarter, but remained elevated as a percent of sales due primarily to the decline in revenues and the timing impact of expected realignment savings from our ongoing cost reduction efforts in higher cost regions. Turning to margins, second quarter adjusted gross margins were 32.7%, down 130 basis points from prior year and excluded realignment charges of $8.9 million and SIHI charges of $2.1 million. Reported gross margins were 31.6%, which were negatively impacted by lower volumes that resulted in increased under-absorption as well as work that reflected the challenging pricing environment booked over the last year and a half. Similar to the first quarter, IPD continued to be particularly impacted by under-absorption in many of its facilities in high-cost regions due to a nearly 18% revenue decline. We continue to expect margin improvement in this segment through the year from our realignment initiatives and the continued integration of SIHI. Our second quarter tax rate of approximately 29% was slightly below our full-year guidance rate of 30% to 31%. Looking at bookings in greater detail and on a constant currency basis, original equipment at bookings declined 19.4%, while aftermarket realized a 2.3% increase over the prior year. From a regional perspective, Europe's bookings increased 9.1% constant currency, while North America was down 10.6% and Latin America and Asia Pacific were down mid-teens. The Middle East was particularly challenged. Last year this region continued to invest in the downturn, but in the current environment we see limited project activity occurring and aftermarket work is being deferred. Turning to revenues, we delivered modest constant currency growth in the Middle East, which was realized from the backlog built during last year's positive booking environment. North America, Asia Pacific and Europe saw constant currency sales decline in the 8% to 12% range, while national oil company challenges in Latin America drove a constant currency decline of nearly 32% in that region. Shifting to our realignment program and the approximately $27 million of savings realized in the second quarter, this progress keeps us on track to achieving our goal of incremental savings of approximately $100 million in 2016. We expensed $20 million in the second quarter related to these efforts, bringing the first half 2016 total expense to approximately $34 million and we continue to expect an expense of roughly $160 million during 2016 as we continue to execute on a number of planned actions during the second half of the year. For the total program, we expect our $400 million multi-year investment to drive estimated total savings of $195 million in 2017, which is $70 million incremental to total 2016 program savings of $125 million. In 2018, the full annualized program savings are expected at $230 million. Turning to cash flow, through June 30, 2016, operating cash flow was down about $15 million versus a year ago as cash outflows related to realignment exceeded our book expenses. However, free cash flow improved roughly $62 million compared to the first half of 2015, due to elevated capital expenditures last year related to the purchase of an aftermarket license, and carryover investment on our new Chinese valve facility. We returned $25 million to shareholders through dividends, while our realignment program used approximately $34 million of our cash during the second quarter. As many of you know, typically the majority of our operating cash flow is realized in the last two quarters of the year and we expect that to be the case again this year likely with more weighting on the fourth quarter. Turning to our outlook for the remainder of the year, while we see continued pricing pressure and caution in our end markets, we remain confident over the longer term that our diversified end markets, comprehensive product portfolio and geographic exposures coupled with our strategic growth initiatives and transformational realignment plans position us for the future. However, there is still uncertainty given ongoing macro and political issues, including the impact of the recent Brexit vote. While we have limited direct exposure to the UK, the potential broader impact of the event on the UK, European and global economies is still largely unknown. Based on performance for the first half of 2016, our backlog and its expected recognition combined with our expectations at the current market conditions will largely persist. We tightened our full-year adjusted EPS guidance range to $2.40 per share to $2.60 per share. Due to the expected timing and margin of scheduled backlog shipments as well as our recognition of realignment savings, we expect our performance will be even more heavily weighted on the fourth quarter results compared to prior year's. On the top line, our 2016 adjusted EPS target range assumes revenues declining 7% to 14% compared to the 2015 level and this range includes a 2% currency headwind or roughly $0.10 per share of about the line impact. Guidance further assumes net interest expense in the low to mid $60 million range and a tax rate of 30% to 31%. As a reminder, our 2016 adjusted EPS guidance includes the operational performance of our 2015 SIHI acquisition and excludes realignment expenses, SIHI purchase price accounting and integration costs, below the line foreign currency effects and the impact of other potential discrete items. Moving on to cash usage for the year, we continue to expect full-year capital expenditures in the range of $105 million to $115 million, a significant reduction over elevated 2015 levels. Cash realignment expenditures are expected in the range of approximately $125 million to $150 million for the full year. Scheduled debt payments for the remainder of the year are $30 million and we also plan to continue contributing to our pension plans to cover service costs, even as the US plan remains largely fully funded. With that review, let me turn the call back to Jay.

Thanks, Karyn. Operator, we have concluded our prepared remarks and would now like to begin the question-and-answer period.

[Operator Instructions] And our first question comes from Mike Halloran from Robert Baird.

First on the IPD margins, obviously a couple quarters in a row here of some challenges there, how does that cadence look through the back half of the year? What were the pressure points in the first quarter and second quarter here? And do those start diving off a little bit when you get to the back half and how should we think about the progression?

A couple of things; three things to think about in that business. One, it's in transition from a realignment standpoint. We talked about one of the facilities that was closed in the first quarter. And also in the transition as we take costs out during the course of this year from the SIHI acquisition a year ago and then finally its transition over to more of the industrial and the commercial approach. It's working through that, and what you see is it's not getting fixed cost leverage because the outflows of the project oil and gas year over year. So when we look at that business, we know it's going to be challenged from a margin standpoint during the course of the year, but we expect to get realignment costs and the SIHI costs out toward the back half of the year and then continue to drive and get the fixed cost leverage in the business. We think we can get the margins back up in this business to good levels, but it will be much more of an industrial type business at that point in time.

So basically modest progression in the back half of the year and then more meaningful as the cost savings take over?

Yes.

And the second question just on the downstream spending outlook, a lot of conflicting thoughts there, right. On one hand you are seeing some stability emerge in the aftermarket, slight uptick in some of these larger turnarounds and obviously there's been a lot of deferrals that need to get vetted out at some point. On the other hand, you see crack spreads that are struggling a little bit right now. There's a lot of inventory and there's concerns about what the majors are going to do with their spending. How are you thinking about the downstream environment going forward next two to five quarters range and all those competing things that meld together?

Well, that's just it, I think you identified there's a lot of competing information, so we've taken a conservative view on the downstream activity. Aftermarket has shown some resilience. Some of the small projects are needed to just maintain levels of efficiency. But when you start to get the projects, we definitely take a conservative view. And, Mike, that's why if you look at our restructuring activities, we've had this view for a while. I think when you've heard us talk we said we're going to take a lower for longer approach, conservative, aggressively restructure, particularly our custom engineered business, and then when the markets come back we'll get leverage from that. So we've taken a conservative approach. Most of the costs and a lot of the benefits are in the custom engineered design towards those downstream projects, and we do know they will come back at some point in time, but we will have a custom engineered business that will be more efficient than ever.

Our next question comes from Andrew Kaplowitz from Citigroup.

Mark, so aftermarket awards in 2Q are on an absolute level; we're back to levels of the first three quarters of last year, actually, before oil and gas spending really fell off a cliff. So do you think they just level off here for a while, given still the uncertainty in the markets or could they start to move higher from here? You talked about potential for a refinery, turnarounds picking up, or simply maybe customers who previously deferred spend now actually spending, so what do you think from here?

A couple ways to look at it. I think from a market-driven standpoint – and one thing I want to make a point, a lot of our aftermarket opportunities are end-user strategies, where we go in and help people in any market improve the efficiency. We didn't see a lot of that last year because the reaction on the OpEx budgets was to constrain everything. But if you look at from a market-driven activity, I made the comment earlier we're in a rolling deferral period where you'll see an uptick there as if there's pressure that comes off the operating budgets. We don't see that over the short term. The market needs some stability. You look in the backdrop of what's occurred, the concern with the majors over having to cut their dividend has certainly abated, but they're still being fairly conservative. So from a market standpoint I think we'll continue to see the rolling deferral. But the opportunity for us is to continue to execute on our strategies, because the nice thing about installed base, it's permanent, it stays, and they're always looking for efficiency. And that's what we like relative to even what we saw in 2009. They're not shutting a lot of facilities. They are running them, and the one way you can improve your profitability is to make it more efficient. But I think from a market standpoint, we don't expect the budgets to snap back here short term. But we will continue to drive our end-user strategies. We saw a little bit of benefit of that in the second quarter.

Mark or Karyn, can you talk about how to think about EPD revenue moving forward? There are a couple puts and takes in the business obviously, stabilizing aftermarket we just talked about, but it's still weak projects business. So EPD revenue, it did turn down in the quarter, but you've got backlog down now over 20%. So should we think that EPD revenue could be down double digits at some point over the next few quarters before it starts to rebound?

Let me help kind of line out how to think about it. A big part of our aftermarket business is in that segment. And so you'll get the benefit from the market and the execution of the aftermarket strategies. Now, there's no escaping the fact that one of the biggest things that moved the needles is the projects. And I just want to make a distinction. While it moves the needle on revenue, keep in mind it doesn't move the needle as much on earnings, especially now as we start to restructure that custom engineered business, because if revenue goes down and you have a lot of under-absorption, it can impact your earnings. But as we start taking these costs out, keep in mind those projects are very competitive in good markets and bad, but it does tend to move the needle on revenues. So from our standpoint, until we see some project activity, we don't think that custom engineered business is going to see an uptick trend in its revenue, which is a component of the EPD business from a revenue standpoint. And again, that does move the needle. If you look in the aftermarket, we're encouraged by what we see in stability and sequential and year-over-year increases, that is also our most profitable business and drives a substantial amount of earnings. So, think of it two ways. One in terms of revenues and earnings, also think a third component of what we're doing with the cost structure in that project-related revenue.

Karyn, one quick clarification, it looks like last quarter you were saying that you're going to get $125 million of savings in 2016 in total. Now, you're saying you're getting $125 million by the end of 2016, with $25 million of that in 2015. Is that a different forecast? It's just a bit confusing I think.

Nothing's changed there in terms of outlook for spend as well as the savings for 2016. So year to date, the expense is $33 million and inception to date our expense is $150 million. So of the remaining $250 million to spend, about 50% of that will be in 2016. So 2016, we are expecting to have $100 million of incremental expense. So the total for 2016 will be $125 million.

Our next question comes from Scott Graham from BMO Capital Markets.

Mark, if you could answer this question it would be helpful. You've got a backlog which gives you visibility. You've got a little bit more stability in the aftermarket and we are largely through the month of July. So we know where the bookings are laying out. Would you say at this point you are in the middle of your sales range for the full-year, maybe toward the weaker end of that or toward the better end of that?

Well, I think Karyn made in her comments, Scott, and that's going to indicate where we are in the range from your modeling is a lot of our activity has and does occur in the fourth quarter. So we still have a big ramp up in terms of sales, but you're right, it is in the backlog both in the aftermarket and the original equipment. But just to be clear, there is an element of revenue during the course of the year that is still yet to be booked into backlog and will need to be shipped out.

I guess the genesis of that question is that it doesn't really look like the OE bookings improved at all in the second quarter, whereas my sense from the first quarter was that you had a bit of a bump up off of very weak levels early in the first quarter and that got better as the quarter progressed. That doesn't look like it happened this quarter. Is that a fair statement?

Now, I'm just trying to think of – we saw some OE bookings, a small project that came through in the second quarter, I think in just trying to understand your math a little bit here, Scott.

Very simply if I'm putting your numbers incorrectly, which I think I am, OE bookings in the quarter were down 22; in the first quarter they were down 17. You did face a more difficult call it stacked two-year comp, but even considering that, the OE being weaker in the second quarter on a year-over-year basis than in the first quarter, stock comp let's say maybe equalizes that but...

I got it. Yes, it does. It does equalize it. We had a real tough comp in Q2. So I wouldn't look at the year-over-year comps first quarter to second quarter. It's probably better to look in terms of what's happening on a sequential basis as we build backlog, or as backlog gets depleted. We built some aftermarket backlog, but our OE backlog particularly our big project backlog has been running down. But we did have a real tough comp in Q2 of last year.

Moving on to the backlog itself, the margin in the quarter was, as has been discussed, on the weaker side of things. I'm just wondering, I know you are really being steadfast in your discipline with bookings. The margin weakness let's say a little bit more than what we've seen certainly in the first half as well is more volume than anything that's coming out of the backlog that is really weak margin. Is that a fair statement? You know where I'm going with this, Mark.

I do.

A few years ago the legacy margin – legacy backlog that stayed with us for a lot longer than we thought, that's not what this is, right?

No, it’s not. What you're seeing is fixed cost leverage and it's mainly volume related. And it's the fact that, I think we made this point last time, particularly in the areas where we're taking costs out, we can't take it out as quickly as volume declined. The other thing, and I alluded to this in my comment, is in the margin business when you restructure a business and all the activity that's going on, think about it, we've got ultimately will impact 30% of our sites. You have sending and receiving sites; you have all types of activities that occur with that. That impacts your business negatively. That's why we want to get through this quickly because when you do that, you naturally get a lift because you don't have the distractions you have in the business. So when we look at our margin profile, we see and understand what's going on in IPD, that had an impact in terms of the integration of SIHI and the volume leverage as well. We also recognize in our custom engineered business that volumes have come down, but it takes a while to get those costs out of the business. And then generally broad-based a lot of our other costs, structural costs considering where they are take time to get out. You add onto that the fact that when you make these kind of changes, there are costs in the system that we don't call out necessarily in realignment or in our otherwise results that impact your business negatively. Anybody that goes through a major restructuring like this, and we're executing very well, has those knock on costs. We expect them, we deal with them and we know we'll get through them.

That's fine and that's extremely helpful, and that dovetails into my third and last quick one, possibly more for Karyn. When are we more through that? When is that more in the rear view mirror? Some of those duplicate costs and some of the potentially lost revenues, is that not until first quarter of next year?

As we've indicated, 2016 is the year of major shifts that we have from a manufacturing footprint perspective, so heading into the end of 2016, as well as the beginning of 2017. So it's really coming out of the latter part of 2017 when we'll start to have the sending sites have shut down. We'll start to see any losses are under absorption or inventory carry there. So it's really more towards the latter part of 2017.

Our next question comes from Chase Jacobson from William Blair.

I wanted to follow up again on the OE bookings and revenue dynamic. The OE bookings have been declining pretty steadily. I know you're coming off a tougher comp from 2014, but in total they've been coming down at a double-digit rate now for six quarters in a row. And this was the first quarter where we really saw the OE revenue decline pick up to double digits. Is that OE revenue decline going to get worse as we go over the next few quarters, just given how soft the bookings have been?

Chase, we don't break out guidance by OE and aftermarket. But what you can do is look at our guidance for the year, and you can see what stability we've had in the aftermarket business and make your own assumptions about that. But you can see – and then also the run rate business, it would tend to be more stable. And then on the margin what will impact revenue is going to be the project business. And that's what you're really seeing in terms of the revenue declines. It's primarily driven by projects that were booked in 2014 and there was good project activity there. It wasn't necessarily at a very, very high price, but it was an okay market at that point in time. Those are rolling through backlog. That's also going to be the pacing item for taking the costs out of our custom engineered business, because when a plant is full with backlog, you don't want to start restructuring the facility. So what that reduction in backlog does allow us to do that you can't see at this point because we're still executing on it is taking those costs out of that business.

And on the pricing, we've been hearing some mixed things I think from some of the other flow control companies over the last couple weeks, some talking about the tough pricing in oil and gas spreading into other markets like power and some talking about companies actually becoming more disciplined and the pricing stabilizing. I'd like to get your updated thoughts on the overall pricing environment in your industries?

Power has always been competitive. That's new not new news at all. It's always been a competitive business. Definitely on the project opportunities it’s competitive, but I can tell you that the market and the peers out there have been relatively disciplined, certainly relative to what we saw in 2010 and 2011. So there's been discipline out there and we assume a competitive environment, and that's why we go after the costs and actually increase some of our resources on the supply chain side, but no rational competitors out there at this point.

Our next question comes from Joe Ritchie from Goldman Sachs.

So I guess my first question, I fully recognize it's probably early to ask this question, we've got another five months left in the year, but maybe as we think through 2017, Mark, at this point what are your planning assumptions for growth? Do you think that you guys can grow in 2017? And the reason I'm asking the question is really because I'm trying to get a sense for how to really think about your margin trajectory for 2017.

Again, I'll go back to my statement. Remember projects are not as profitable on the margin side, especially if you don't take the costs out the business. The way we look going forward is we want to continue to execute on our commercial strategies, and we think we have growth in that. A lot of that is our OE run rate business, that's IPD. Look, you saw some traction in this quarter on IPD. That came as expected, actually a little bit earlier than we expected, also growth in our aftermarket business. Those are two contributors to our earnings and margins significant going into 2017. Then a lot of it will depend on how bookings come in in the second half of the year, both on those and any project activities. We're not seeing or expecting or planning for a lot of big projects to come back here over the short term. We think the market needs to see some stability. If they do, they might start ordering some of the long lead time items in these large projects. But I wouldn’t anticipate that we'd see that in our order book this year. Could materialize next year and to the extent there is percentage of completion on them, we can take them into revenue, but that really depends on when we start to see them.

And then maybe you touched on the aftermarket piece, it's nice to see the sequential trend the last two quarters. Based on what you're hearing from refineries today, somebody mentioned earlier there's a bunch of puts and takes, is $480 million the right run rate moving forward or do you still expect there to be some lumpiness in the trajectory of those orders over the next few quarters?

Well, a small amount will move the needle on a percentage basis. It doesn't take much in terms of our compares, but generally what we saw in the first quarter was a base level, which we were very pleased with, some stabilization. And I think one of the things just to understand our business, if you look at over the course of many years, even at the last downturn, our aftermarket bookings base resilient level are higher than they were before. The reason for that is this primarily, executing our end-user strategies, getting more penetration into customers’ facilities, more share of their wallet. We will continue to focus on that to drive what we'd see as self help growth in this business despite whatever market conditions can be.

And maybe one last one for Karyn, can you talk about the free cash flow dynamics a little bit? I know that you're more second half weighted, I think you mentioned in your prepared comments that you expected to be more 4Q weighted as well and fully recognize during this transition that you have some elevated inventory levels. Can you talk us through how to think about normalized cash for you guys and when does that start to normalize, is it a 2017 phenomenon?

Through the end of 2016, we should see some liquidation through the year, but however as you mentioned that should be potentially offset with some of the build up from realignment. So as we're transitioning through realignment, we have the potential there to have elevated inventories through 2016 as well as 2017. From a receivable perspective, we have seen some delays, in particular in Latin America. We've got full disclosure in our Q there regarding particular inventories that we're looking at and so we'll continue to work through those. Inventory, of course, is going to be reflective not only of the realignment, because it's very important as we go through the transition to ensure quality service on time to our customers during the transition. But in terms of executing our strategies, there's other strategic initiatives that could potentially result in carrying additional inventory. But of course those also result in higher margins. But we'll continue to work through that, we continue to see some delays with customers as they push out taking delivery. So market conditions are also playing there a bit. But as we go through the realignment, the expectation is that with reduction in the sites by definition we'll have more optimized product management, more optimized supply chain and of course more optimization in terms of our inventory turns. Once we get through that realignment, we'll then really start to look at it from an enterprise-level overall from our receivables, payables and inventory from enterprise [standardized] processes and going through that project to really focus on fine-tuning the metrics in the targets there. But key right now is to get through the realignment.

Our next question comes from Charley Brady from SunTrust.

Just a question on the commentary in the prepared remarks or maybe it was the Q&A, the amount of revenues that are being delayed or held up by the transitory activities of realignment and restructuring and moving stuff around, can you quantify the magnitude of what that revenue is in the pipeline but just can't get out the door because of various realignment activities?

No, we really haven't quantified. We want to just comment generally to help folks understand what happens when you realign a business, because you're moving product, you're shutting down a facility, you typically have employees in production at the sending facility and the receiving facility. All kinds of things can occur where it gets held up in the system. You work with your customers on this. Fortunately, because of our strong execution historically and the lead times, we're not a bottleneck in a product right now. As a matter of fact, we still are the point where we try to deliver to customers and they're not ready for it. I think what we wanted to do is illustrate that there are costs, revenue, working capital associated with moving one plant to another location. These are not standard widgets that we make that you shut it down a facility and you just stand up the other one, you're moving project management, engineering capability, pattern capabilities, all type of things, know-how, employees to the receiving site, and then you've got to be able to stand it up and you overlap. It's kind of like when you integrate to or switch over a very complicated system, there's a lot of overlap that you need to have.

I understand. I guess the point I was really driving to is understanding how much pent-up demand is in your internal channel that maybe is a headwind to the revenue growth this year or is in fact as you go through this, how much of that would get released this year versus having to drag it into 2017? I'm trying to get a sense from a down 7% to 14% revenue outlook for this year, the influence on that of just internal changes you're doing that's holding stuff up that otherwise would be flowing out the door.

That's fair. Let me try to answer it this way. It wouldn't move the needle on that guidance too much if it wasn't occurring. So I don't want to suggest it's anything really, really significant, but what's driving our revenue this year is primarily the market conditions offset by some of our strategic initiatives. As you've seen out there, it'd be a tougher revenue guide this year if we weren't executing on our aftermarket and run rate business initiatives.

And switching gears, if I look at the guidance, the EPS guidance and square that with revenue guidance and drill that into margins, you look at EPD with aftermarket going to 70% plus of sales in that segment or bookings in that segment, which is unusually high for that business, how much of the mix shift – you get a positive margin mix shift on a higher aftermarket percentage, but you've got an absorption issue to offset that, if you look at the back half and you look at your backlog, particularly in EPD, how much does that mix shift to a very high percentage of aftermarket, presumably it's probably going to creep up a little bit more as you go into Q3, how much of that offsets the absorption issues you're having that can drive margins higher in the back half of the year?

The absorption issues are being addressed by the cost takeout. That's the primary thing that we're doing to address the absorption in the business. Now, to your point, what allowed us to be – have the confidence in our range is going to be the aftermarket business and the run rate business, which is more profitable. But what I'd tell you is there is some impact on the absorption from the other business besides the big project business, but most of it is going to be in the cost takeout.

So the negative impact I guess as we go through the year on absorption is shrinking because of the internal realignment transformation stuff you're doing, correct?

That's right. And one point I think we made on the last one, when we looked at the beginning of 2014, and this is important, we had over $160 million of under-absorption within the four walls of our company. So, we're addressing what I'd say is under-absorption we came into this market and under-absorption caused by the environment that we're in. So there's a lot of opportunity there to take costs out.

And just one more quick one, on the aftermarket side of the business, you talked about break/fix type business. Have you seen an acceleration of that or maybe the better question is has that break/fix mentality stabilized, it sounds from your comments like maybe that still has yet to happen?

Break/fix is not market driven, it's event driven. In other words, when you run a facility flat out and you're trying to capitalize on spreads, whatever you can generate in the revenue, break/fix tends to come in and you don't plan for it. We actually try to help our customers try to avoid it. But that is what happens when you defer maintenance. You don't go to standard takedown, scheduled takedown. You'll run into more break/fix, because these things are designed to run for a period of time, and if you think about it from a flow control item if one of those goes down then basically it impacts the operation of your facility.

That's the point I was trying to get to is are you seeing an acceleration or pick up in break/fix because in fact the customers are pushing stuff out to the very limit that it can get to and sometimes it breaks sooner than they thought it was going to.

We're seeing it as a result of the deferrals. We're in a rolling deferral, so we'll see if they get back onto a schedule and stay ahead. But if they push it out, then you'll see more break/fix activity.

And our next question comes from Nathan Jones from Stifel.

Mark, if I could go back to APD and the margins for a minute, you talked about four big buckets for the margin issues that you're having there at the moment, which is absorption, increased expenses from the realignment, taking costs out of SIHI and the transition to industrial. And you also talked about the realignment taking out some of those absorption issues. So all of those four impacts should be relatively transitory. All of this stuff is planned to be finished by the end of 2017. If we held everything else constant, where do you think the margins in IPD should be in that timeframe in say 18 months once all of this stuff is behind you?

I made the comment earlier about two things. One, in IPD we think we can get it back to where the margins were before and even improving, because it will be a different business. It will be less of what I'd say the big projects; it will have fewer of those in there and more on the industrial side. It's going to take some work. I think the other thing is I commented earlier on our custom engineered business, which is primarily within EPD, plans we put in place starting in 2014 and have continued to execute are really to designed to make that more efficient than it's ever been. So when you look at two of our important components of our business, these are really designed when we get through it to make them as efficient as ever or more efficient.

So given that and given where the margins were, is it an unreasonable expectation to think that margins in that segment by the end of 2017 are going to be double digit to low teens?

I mean if I execute well and we can drive that, we'll need some top line. That's going to be important. You've got to give me the top line variable, but if we can have some market support and execute on the strategies then we can drive the margin improvement to that level. But there is going to be a fixed cost leverage component to that business.

On a little bit of a more positive note, you talked about getting some traction on some of the growth initiatives, the long-term agreements on the aftermarket picking up. Can you talk about some of those things that are going to have a more enduring benefit to the company rather than just talking about the cyclical pressures that we're under now?

A couple of things. We've seen improvement in our distribution channel. In the aggregate, it's actually gone up slightly, but that's with a fairly significant decline year over year in North America. Where we're seeing the benefits, believe it or not, are in Latin America as we bring new distributors on, rationalize some of our distribution, improvement in Europe, and looking over the horizon at Asia as well. Another one is just on our general commercial strategies, we haven't gone into a lot of detail, but how we've lined up our sales organization – we've always been very good at pursuing projects and I think we'll always be very good. We've got a great team doing that. But where we really invest a lot of time and effort is getting more share of the wallet, more around our channels to market, e-commerce and we're seeing traction there. It's very early days there is what I would say. So those are some positives we certainly see. As we move this business, we're always going to have the project side of our business. We like that installed base, but increasingly and to the credit of bringing the folks in from SIHI, we've learned a lot around how profitable that business can be and how we can grow it. So early stages there on the project business, we've always been fairly solid. It's really about being more efficient, and on the aftermarket it's continue to drive our end-user strategies.

And then on SIHI, I think one of the attractive parts of that business was going to be able to leverage your global sales force to more deeply penetrate markets with their products. Can you talk about how successful that's been, and also any color you can give on leveraging your aftermarket network to capture more of their aftermarket business?

I would say we've been slower to leverage our sales force and our aftermarket for all the right reasons. They have a really solid, capable channel to market in terms of e-commerce and sales approach that we're actually adopting in our organization. So we've gotten a benefit from that. And we have yet to really scale it globally the way we need to, both on the original equipment and on the aftermarket. It's delivered good solid aftermarket, but it's still – would say it's still fairly European-centric. But what we've done is we've been able to – really the improvement was taking what they had and leveraging it across our organization. So the better opportunities are still ahead of us with that, what I'd say, market and commercial opportunity in SIHI.

And our next question comes from Andrew Obin from Bank of America.

Just a question, you talked about your own restructuring process, and the way I see it's more focused on taking overhead out of the system versus the capacity. As we think about the industry, do you think any actual capacity is being taken out versus just overhead?

Absolutely, we're taking it out. We're going to take out about 30% of our facilities. A significant amount of the spend particularly in the custom engineered is capacity takeout.

But the way I think about it, isn't the plan that you're going to take out the manufacturing footprint but you put in more value streams in existing facilities, it's not like you're not going to be able to manufacture, you're just going to be able to manufacture with less overhead, right?

You're going to be able to manufacture in over less square footage over more efficient machines. We're going to actually leverage – in part of this we're moving some of the sub-manufacturing on non-critical items to suppliers as well. So we're pushing literally some of the manufacturers to third-party, but the key is there will be less square footage, much more efficiency. Now, if your question is are we going to get better fixed cost leverage, yes, but the biggest component of fixed cost leverage overheads, call it SG&A, is going to be volume related.

I don't think I'm making myself clear. People actually shuttering capacity, do you think when the industry is done with the restructuring, the ability to manufacture number of units is going to be the same or increased, or do you think the industry as a whole will be able to make less stuff? That's what I mean, because you will have your capacity. You'll still be able to deliver all the same products to your customers, just at a much better cost structure.

Got it. In terms of our ability to address the market, I can't speak for others in general, although I do know capacity is getting taken out. But I can tell you our approach is we actually will be able to deal with more volume. Why? Well, when you have a very efficient facility believe it or not they actually can crank out more volume, less under-absorption, it cranks out more volume, more automated machinery, leveraging third-party suppliers. So we have no concerns about being able to address industry demand at all.

Let me ask another question, what are you hearing from your customers about their access to capital, right, because I think last year people were clearly capital constrained because they had debt obligations, they had dividend obligations. This year it seems they are generating more cash. They've cut costs. What are you hearing about their ability to access capital? What are you hearing about their ability to go to banks and access capital? Are things getting better?

Well, yes. In general they absolutely are. Keep in mind a lot of our customers are big brand names and have plenty of access to capital. I think what we are seeing is that some view of stabilization, although as I mentioned earlier we need oil to be stabilized for a couple of more quarters here, but generally no concern over access to capital. What you did see was the marginal ones that we dealt with were impacted last year. There are some regional elements as you look around the world; parts of Latin America are definitely very challenged, but that's been the case for a period of time. We see that in – Brazil has certainly been impacted for a period of time. But a lot of the large ones around the world are well-capitalized. When you look at the industry in general, as you well know, a lot of them went over the last couple of quarters and secured their balance sheets. Typically if we have exposure to those folks, we would have had a letter of credit anyway, but it is good for the industry that they were able to go out and either sell some of their reserves forward or issue some equity and they did, or else also go out and raise debt. That was good for the industry, because in February there was a deal of concern, not saying that they're necessarily out of the woods, but certainly the industry is in better shape than it was four months ago.

And just last question if I have time on M&A, do you think there is opportunity to pick up some assets in this environment for you guys to be a consolidator or are you just too busy with internal stuff?

Well, make no mistake, our restructuring and realignment is an absolute priority. It is a $400 million acquisition that will yield $230 million of benefits. No acquisition can ever compare to that. Having said that, what we have seen is valuations have normalized some and we just need to be disciplined and opportunistic out there as we look at opportunities. But our priority is going to be the realignment, absolutely. But we'll weigh any opportunity against what our priorities are and we've got really good teams and people here that can do many things and do them well.

And our next question comes from Robert Barry from Susquehanna Financial.

It sounds like pricing has stabilized a bit, but I'm curious to what extent you think the P&L in the quarter is still reflecting bookings that were made under more favorable pricing? And where I'm going is I'm just curious how close you think gross margin down 150 basis points in the first half is versus where we'll end up bottoming there if pricing is actually stabilizing?

It's still a competitive pricing environment, Robert, especially on the projects. I don't think there was a lot of 2014 pricing in our revenue in the second quarter, so we're sitting pretty much reflective of market conditions since the downturn right now in our P&L. We are where we are in terms of where the pricing environment, no big uptick, no big downtick in the pricing. It's competitive on the projects, so that's going to be project by project, the backlog that we had is pretty much rolled through. So really the margin profile going forward is going to be around the cost takeout. And again, I'll mention just where a lot of these costs are, it takes time to get them out of the business. Also mix, one of the things with less project activity, assuming that it doesn't impact absorption as much is that you get more favorable mix. That's why we need to take the costs out, particularly on the custom engineered side and then what we can do on executing on our run rate strategies.

[indiscernible] guess on where we might bottom out on gross margin?

We don't want to guide on that because anything can impact gross margins in any one general quarter. And where the volumes too, Robert, that's going to be an issue as well. So don't want to guide specifically on those, but a lot of our actions are designed towards enhancing our gross margins and getting the fixed cost leverage across SG&A.

Just a quick follow up on the aftermarket and these life cycle agreements, I'm just curious whether they are a significant part of the aftermarket bookings? And where I'm going is just whether these LCAs are impacting the pace at which we think or should think about the aftermarket bookings reading out into the P&L?

They’re still relatively small, but consistent. Historically a lot of them were in our seal business, but increasingly we're seeing them a little broader based. It's still relatively small and the point I want to make is we have to go out and earn our aftermarket every day in this business. But what we did see is there are benefits in the environments that we're in, believe it or not. And that is one that customers want to tend to make sure in this environment they go with very, very solid suppliers, suppliers that can deliver on time and a good quality product, can meet the engineering specs. Another thing that's important is they're looking for cost efficiencies as well. Part of the value proposition in the lifecycle agreement is going in and saying, look, we'll work with you because we do this all the time in terms of managing your costs down over a multi-year period. So they're looking for more value and we're certainly in the position where we can deliver it to them. That's really the benefit we've seen in this environment because it goes directly to their operating budgets, it gives them visibility and it gives them more efficiency.

How does the accounting work if you book a multi-year agreement? Do you book the whole value upfront in bookings and then it reads out through the P&L?

No. You recognize the revenues as you deliver the product as you get paid. So there's nothing up front.

From a bookings perspective, though, how much...

You book it as order.

The full value of the...

Yes, you don't book everything up front.

And our next question comes from John Walsh from Vertical Research.

Thanks for fitting me in here after the hour. I wanted to ask a question about the cash expenditures for the restructuring actions into next year, so is there a range you can provide, the $200 million to $225 million of cash spending, how to think about that over 2017 and 2018?

So basically from the actual expense going out into 2017, basically you should be looking at it in the concept of approximately $160 million for 2016. Incremental to that will be in 2017 approximately $90 million for a full spend in 2018 of approximately $400 million.

And then just thinking about the deltas, I know there was a little bit in the earlier answer, but deltas around debt reduction payments, pensions, some of those items you called out on that slide as we think about 2017, the deltas if any of those become tailwinds or further headwinds?

Going forward, currently we are paying about $15 million a quarter in terms of paying down debt, so about $60 million annually. And 2017 will be consistent with that on the debt payments.

Thank you. Ladies and gentlemen, we have reached our allotted time. Thank you for participating and you may now disconnect.