Flowserve Corporation (FLS) Q2 2017 Earnings Report, Transcript and Summary

Welcome to the Flowserve 2017 Second Quarter Earnings Call. My name is Paulette, and I will be your operator for today’s call. [Operator Instructions] Please note that this conference is being recorded. I will now turn the call over to Mike Mullin, Director of Investor Relations. You may begin.

Thank you, operator, and good morning, everyone. We appreciate you participating in Flowserve’s call today to discuss our second quarter 2017 financial results. Joining me this morning are Scott Rowe, Flowserve’s President and Chief Executive Officer; Jay Roueche, Interim 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, in 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. Also as we indicated in our Form 8-K and press release yesterday, during the 2017 second quarter, the company identified certain immaterial accounting errors in prior period financial statements, which began in 2013 and continued through the 2017 first quarter. In the interest of transparency and to improve comparability of financial information, the company is amending its 2016 Form 10-K and the March 31, 2017 Form 10-Q to reflect these revisions. Additionally, the company determined material weakness existed in our internal control structure at year-end 2016 and continued through the 2017 second quarter to which we are instituting remediation plans. 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, 2017. 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, including our Form 8-K filed yesterday, 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 Scott Rowe, Flowserve’s President and Chief Executive Officer, for his prepared comments.

Thanks, Mike, and good morning, everyone. Let me begin with a few comments on our second quarter performance before discussing our view of the marketplace. Jay will then provide a financial overview, and I’ll return with my observations after my first 4 months at Flowserve and then close with our plans for the remainder of the year. As we indicated in our press release, Flowserve’s second quarter results were below our expectations and they certainly do not represent what the business is capable of or should be delivering. Additionally, we had accounting errors in the past periods dating back to 2013. They were disclosed in our press release and 8-K filing. Let me just say that this is unacceptable to me. As I talk about getting back to basics in the later portion of my comments, accounting control standards are at the forefront of running a successful business. While our operational financial performance this quarter is disappointing, the fundamental attributes that attracted me to Flowserve remain, including knowledgeable and committed people, a broad portfolio of quality products and services, a customer-focused mindset and a global aftermarket service network that is second to none. While performance across our sectors – segments this quarter was below plan, we did achieve modest sequential adjusted gross and operating margin improvement in both EPD and IPD, which is a trend we expect to continue through the remainder of the year. IPD remains very much in a turnaround mode, and we’re pleased to see a continued reduction in its lead time during the quarter, resulting in the second consecutive quarter of both sequential and year-over-year bookings growth, which is a positive sign of recovery. We’re being deliberate in our actions and recognize that the operational improvements needed to support the turnaround of IPD will not be as quick as we had originally anticipated. With that said, I’m confident in the team that we have designated to lead this initiative and the defined actions we have placed that will drive systemic and sustainable improvement. I’m also encouraged by our positive bookings performance. While this quarter did not include any particularly large award like we saw in the first quarter, bookings were up sequentially as well as year-over-year on a constant currency basis. Revenues were softer in the quarter than were previously envisioned due in part to the pull-forward timing benefits received in the first quarter as well as customer delays and pickup of certain finished products In total, constant currency revenues decreased 13.6%, impacting our absorption of cost and ability to recognize profit. We generated a book-to-bill of 1.1, with backlog growing to $2.1 billion. It’s also worth noting that the previously announced divestiture of our Gestra business had roughly a 2% year-over-year impact on the comparison of both bookings and revenue. Turning to our bookings by end market. On a constant currency basis and excluding the impact of Gestra divestiture, bookings were up modestly, driven by General Industries, which was up approximately 9%, including growth across all segments and primarily by heightened distributor activity within IPD and FCD. Our initiatives to drive the distribution channel for IPD are gaining traction, and we’re particularly strong this quarter in North America. Oil and Gas bookings were essentially flat year-over-year, with solid activity in EPD and FCD, offset by decreased levels in IPD. Aftermarket remained stable in the Oil and Gas sector, including support from North American refinery turnaround activity. However, we continue to see weak spending in maintenance deferral with our international customers. We’re also seeing significant growth at our upstream North America land business, but it doesn’t have the volume at this point to have a meaningful impact to our overall numbers. Our chemical markets were also relatively flat, down less than 1% on solid run rate activity. While chemical demand continues to grow globally, utilization remains relatively low to drive significant capital investment in the near future. Opportunities are progressing in Asia, but remain very competitive and the second wave of North American ethylene crackers continue to move forward at a deliberate pace. Power bookings decreased approximately 2% as increases in FCD and IPD were mostly – more than offset by EPD’s decline. For EPD, it was a challenging compare period as the second quarter of 2016 represented the segment’s highest power bookings of the year, accounting for nearly 1/3 of the full year bookings. Regionally, we delivered bookings growth of over 40% in Asia Pacific, which included several small project awards across the refining, chemical and power sectors. Following 4 consecutive quarters of year-over-year bookings growth, Europe was down approximately 15% in the second quarter. In Latin America, challenges continue with bookings down approximately 37%. Finally, North America, the Middle East and Africa were fairly stable, with both down less than 2%. We are seeing traction in most, if not all of our markets. However, the landscape remains highly competitive due to the excess capacity in the peer group. Our approach will be more focused around the work that we can win at margins that represent the value that we deliver. While the level of uncertainty varies by industry and region, we are not planning for a meaningful market rebound in the second half of 2017, but rather improved overall market stability. Let me now turn the call over to Jay to discuss our second quarter in greater detail. Jay?

Thank you, Scott, and good morning, everyone. As Mike mentioned in his opening comments, we revised certain prior period financial statements, including those of 2016. So my comparisons this morning will be utilizing the revised figures. Starting with EPS. Reported and adjusted earnings per share were $0.32 and $0.22, respectively, which were below our expectations. Our adjusted results were negatively impacted due to a higher adjusted tax rate, slower progress [indiscernible] turnaround effort and a lower sales level, primarily due to delays in product acceptance in the second quarter and further impacted by the pull forward of shipments in the 2017 first quarter that were initially expected to occur in the second quarter. On a reported basis, EPS saw a net benefit of $0.10 a share, driven by a $0.62 gain on the sale of Gestra, which was largely offset by $0.20 of Brazil impairment, $0.18 of realignment, $0.9 of inventory reserve and $0.5 for below-the-line currency effects and PPA. As Scott mentioned, we were pleased with our bookings level. At over $970 million, we achieved modest constant currency bookings growth of 0.8% against the second quarter of 2016, which was last year’s strongest quarter. Through the first 6 months, Flowserve has delivered a book-to-bill of 1.11 and grew constant currency bookings 2.9% year-over-year. With these results and with backlog up from year-end levels, we are on pace to drive improved second half 2017 revenue levels as compared to the first half of the year. Despite the modest sequential increase, second quarter sales of $877.1 million were lower than anticipated and represented a 13.6% decline versus prior year on a constant currency basis. Our lower starting backlog entering 2017 as well as the factors I previously mentioned were the key issues behind the decline. Aftermarket sales as expected were less affected, down only 3.6% on a constant currency basis and represented about 49% of our total revenue for the quarter. As we indicated in our prior guidance, we expect revenue to increase sequentially in the third and fourth quarters, supported by our first half 2017 backlog growth of 12.4% versus year-end levels and seasonal fourth quarter strength. Looking now at our gross margins. At 31.5%, our adjusted gross margin was down 90 basis points versus the prior year second quarter. Loss of sales leverage and the related under absorption combined with competitive pricing was only partially offset by realignment savings and a 5% mixed shift towards higher-margin aftermarket. On a reported basis, including realignment charges of $14.1 million and an inventory reserve of $16.9 million, our gross margin declined 330 basis points year-over-year to 27.9%. We continue to make progress on our disciplined cost management initiatives as adjusted SG&A, which excludes realignment and other items, declined over $10 million year-over-year or 4.8%. Reported SG&A, however, was elevated in the second quarter primarily due to the fixed asset impairment charge of $26 million in EPD and realignment expense of $17.6 million. The impairment charge was related to our manufacturing facility in Brazil, and given the current environment in that country, we have scaled-back certain of our operations. In the interim, we will primarily be focused on the aftermarket opportunity available in that region. In addition to our previous plans, realignment expense also includes new actions to aggressively target our SG&A cost structure. This will continue as the near- term focus for us to further streamline our expenses. Considering the significant decline in sales year-over-year and the loss of top line leverage, second quarter adjusted operating margin declined 330 basis points to 8.1%. On a reported basis, however, operating margin increased 530 basis points to 14.4% due to the large gain on the previously announced sale of the non-core Gestra business. Both reported and adjusted tax rates significantly exceeded our guided range due to losses that occurred in certain foreign countries where we don’t receive a tax benefit, and we incurred a 38% tax on our divestiture gain. As a result, our second quarter reported tax rate was approximately 59.1%, and on adjusted basis, it was 46.3%. For the remaining quarters of the year, we expect our adjusted tax rate to return to its normal range. Turning to cash. Operating cash flow for the quarter and the first half improved $32 million and $36 million, respectively, as working capital improvements more than offset declines in net income. Cash costs associated with our realignment program were roughly $12 million this quarter, and we now expect the total of approximately $100 million for the full year. We also remain committed to returning capital to shareholders while simultaneously investing in our business to drive long-term, profitable growth. In the second quarter, we returned $25 million to shareholders through dividends and invested $13 million in capital expenditures. Our cash balance at quarter end was over $0.5 billion. Additionally, in the second quarter, we amended our senior credit facility, which will provide greater flexibility and a solid access to liquidity going forward. So we very much appreciate the support of our banking partners in that agreement. Turning now to our 2017 outlook. Based on our first half results and our expectations for the remainder of the year, on a reported basis, we increased our full year EPS target range to $0.85 to $1.05 per share and reduced our adjusted EPS guidance to $1.30 to $1.30 per share. We also tightened our full year revenue expectations to a decline of 6% to 10% versus 2016, which now reflects minimal currency impact that are roughly 2% headwind as a result of the Gestra divestiture. We further expect full year realignment charges of approximately $120 million, including the $42 million spent in the first half of 2017. As in past years, our 2017 adjusted EPS guidance excludes realignment expenses as well as below-the-line foreign currency effects and the potential impact of other discrete items such as the second quarter’s gain on the divestiture of our Gestra business as well as the asset impairment and inventory write-down. We also continue to expect net interest expense in the $60 million to $63 million range and to return to an adjusted tax rate of 30% to 31% for the remaining quarters of the year, following the second quarter’s elevated level. With regard to cash usage in 2017, in addition to the anticipated realignment spending, we are also planning for approximately $100 million in dividends for our shareholders, capital expenditures to be in the $80 million to $90 million range, $60 million for scheduled debt repayments and global pension contributions of around $25 million, mainly to cover our ongoing service costs as the U.S. plan remains largely fully funded. With that review, let me turn the call back over to Scott before we open the line to your questions.

Thanks Jay. Now let me update you on my observations and actions following my first 4 months in Flowserve as well as what to expect from Flowserve in the second half of 2017. Just over 100 days, I’ve had the chance to visit many of our global facilities and meet with most of our leaders and a broad range of employees and customers. Let me start by highlighting several opportunities that we identified and are beginning to pursue. First, as some of you understand, Flowserve is currently a fragmented and decentralized organization built through a combination of roll-ups. While our 3-year realignment program is an important step in consolidating our physical manufacturing footprint, there is more work we can do to building a more focused, agile and responsive platform. We will continue to evaluate our global manufacturing operations to drive further efficiencies and cost effectiveness and cost effectiveness to best serve our customers. Likewise, our vast product portfolio introduces a significant degree of complexity within the organization. We will continue to streamline our products and divest nonstrategic businesses such as Gestra and Vogt, which are both closed in the quarter. As we work to improve the operating platform, transformational acquisitions are not a near-term priority, but we will continue to evaluate bolt-on product lines and fill critical geographic distribution gaps. While our scale is a great advantage, narrowing our focus to just two strategic areas where we can best compete and win will enable us to better leverage the scale that we have. While we have made significant progress on our cost structure, again, our work here is not complete. We will commit to driving efficiencies in every function that we perform with a continuous improvement mindset. I have no doubt that this effort will produce an appropriate cost structure for the current and future environment as well as improve support to our customers. Finally, we need to improve our ability to deliver predictable results. While Flowserve admittedly operates in cyclical markets, the variation quarter-to-quarter and the sense of urgency to require to address these conditions must improve. As we execute on these and other opportunities, I expect to deliver increased value to our customers and shareholders with a culture of accountability that consistently meets or exceeds expectations. We have already begun the change process at Flowserve. Let me review a few of the actions that we have already taken and are underway. The first step was introducing a cadence, calendar and KPIs that are laser-focused on the basics, the blocking and tackling necessary for driving sustainable results. On-site plant reviews, platform reviews and KPI review sessions. We need to create a culture of accountability and more focused on achieving results. With an eye towards simplification and cost reduction, we have also already taken steps to flatten the corporate organization and accelerate some SG&A reductions. We have reorganized certain functions to strengthen our market, customer and product focus, and we continue to simplify and stabilize our operations. Finally, our top 100 global leaders spent a few days last week participating in a leadership summit to achieve alignment on operational expectations going forward and commit to how Flowserve will operate in the future. After 4 months at Flowserve, I’m even more confident in the opportunities ahead. The passion and commitment of the associates I’ve met on my travels, coupled with the strong foundation we have in place, will enable us to continue to seize opportunities available to profitably grow our business and drive value for our shareholders. But the absolute first step in successfully [indiscernible] products and service company like Flowserve starts with restoring the focus on basic operations. Our top priority is blocking and tackling to create the foundation we ultimately need to grow. While my initial activities over the last few months have been almost exclusively customer and internally focused, I do look forward to regular interactions with the financial community and meeting many of you in the months ahead. Please always know that you have my commitment that every action we evaluate or ultimate take will be focused on the end goal of driving long-term customer and shareholder value. Despite a challenging quarter, I fully believe the future for Flowserve is very bright. Operator, we’d like to open the call now for questions.

[Operator Instructions] And our first question comes from Andrew Kaplowitz from Citi. Please go ahead.

Hi, good morning guys. So when we step back and think about the macro, the global investor brand has continued to improve generally over the last 3 months. We know you’re [indiscernible] in Oil & Gas and Chemicals, which have been weaker as you talked about, but your bookings have also improved. So can you give us more color on why your sales and margin generally relate across really all of your businesses? I know you mentioned customer delays. Does your global realignment really caused a step back even outside of IPD to deliver product effectively? And when do you think you can improve your efficiency?

Yes. So I mean, essentially the comments we said, we are seeing relative stability in the markets that we play in. And so we expect that to continue in the back half of the year. We don’t expect massive growth or anything extraordinary in terms of upside, but we’re getting traction. And so what we need to do is capitalize on that traction. And clearly, we weren’t able to do that in the second quarter. What I would say is we did see a heightened awareness or a heightened activity level in terms of customers not accepting product. And it think essentially, this is projects and EPCs that quite frankly didn’t need our product at that time and weren’t ready to receive it. And so they didn’t want it sitting in the yard, and it sat on our docks and in our factories rather than moving to their EPC yard that they’re doing the fabrication. We’re not sure how that continues going forward, but we’re aggressively talking to them and trying to get that product moved. And then on the margin side, I think we’re going to be – the volume levels and the underabsorption certainly hurt our margins and the IPD turnaround absolutely hurt our margins. But when we look at our standard margin, we’re getting the margins in the bookings that we expected. And I’m not going to say the pricing is good, but I would say pricing is relatively stable. And we are talking in very certain areas about increasing price. And so I don’t have a concern there, I have more of a concern in our ability to execute in driving the margins that we need on the operating side.

Scott, is there anything you can do to protect the company from those customer delays that you’re talking about? I mean, they seem to come out every time that we to get a little bit of a blip in oil prices. Is there anything you can do to protect yourself from holding sort of excess inventory in working with customers?

Yes, I wish the answer was yes, but unfortunately with the downturn, we’re accepting terms and conditions that we normally wouldn’t like or we would prefer not to have. And so we’re kind of stuck at this point with that. If the market dynamics change, we’ll push for better Incoterms that will ultimately allow us to do recognize revenue much easier.

Got it. And then last quarter, Tom said that you were about 70% through with your lead time – where your lead times need to be from a market perspective to compete effectively in IPD? Take another few months to get closer to normal. Has that time line been slowed down? And if so, can you talk about what’s holding you back from better delivery rates. And then structurally in IPD, have the markets just become more competitive? It was always – the concern there was that the markets are a little bit more commoditized. Has that happened or what are you doing to protect yourself from that?

Yes. The lead times in the second quarter in IPD did improve. So we are seeing improvement there. Obviously, we can always get better, and we want that as low as possible. But we feel reasonably good about where those – where the lead times are. And we saw that the distribution channel for IPD actually come up substantially in the quarter and our bookings were at a pretty good number. So I think that side is okay. Now it’s really the structural operation side and delivering that product. And that’s where we failed in the second quarter. Our passthrough backlog grew in IPD, which was certainly not expected. We’ve got to get that product out. We’ve got to streamline our operations. We’ve got to simplify that approach to get back to where we need to be.

Our next question comes from Charley Brady from SunTrust. Please go ahead.

Hi, thanks. Good morning.

Good morning.

I want to go back on IPD because I just really want to better understand the timetable of what’s going on with the turnaround there. What is – what wasn’t foreseen that is causing the pushout in the timetable of getting that business turned around? And can you quantify at all kind of what your time line that you’re thinking? I get the volumes aren’t there and you need volumes to come back to make it all work? But that aside, all things being equal, when does it get to a point where you want to get to?

I mean, in my world, we’re never at a point that we wanted to be at so I’ll just say we’re keep, with passion, to try to continue to improve at all cost at all time. But it’s – what I’d say is IPD is we were more aggressive in the turnaround than we probably should be. We’re much more optimistic. Unfortunately, I’ve gone through turnarounds with facilities and manufacturing products. And when you get into a situation where you become significantly passthrough and can’t deliver to your customers, the whole system, the MRP system just gets really out of whack, and you lose the ability to control and plan what you need to do. And that’s essentially what happened at two of our IPD facilities. It’s not the entire IPD business. And so it’s a limited number that got in trouble, and we’re now working through that. We have a designated team in place. I’m actually meeting with them regularly. I’m confident in the plan that we put there. I visited both of these facilities in the second quarter. But what I’d say is, it’s a turnaround, and it’s not going to change immediately. We should see sequential performance growth in the third quarter and the fourth quarter. But again, it’s not going to be – it won’t be incredible jumps in terms of ability to improve, but it will be systematic And what we’re after is a sustainable business that we’ve improved the internal process to where we continue to build quarter-over-quarter.

Okay. And just if I could kind of touch on Andy’s question on the acceptance – customer acceptance of equipment, is that a function of the timetable from the customer change from the time they place the order or – I’m trying to understand, was this a surprise or was this customer coming back and saying, "No, we told you this date, but now it’s going to be this date," maybe?

I mean, it really was a handful of projects. I don’t want to get into too many specifics with the customers but a handful of products or projects. And as you know, in the life of a project, there’s lots of – there’s some changes and there’s some other things, and we have an original customer commitment and there’s change orders and things like that, and we had finished the work, and we had it on our shipping docks to move forward and given the Incoterms, the customer had to recognize and pick that up. And their project was delayed for one reason or the other, did not pick up that product and thus, we’re not able to recognize revenue. Now that’s not going to stay there in perpetuity, and we fully expect to start to get those out of our possession and recognize revenue here in the third quarter.

Okay. And just on your comment on sequential revenue improvement in Q3 and Q4, I know you don’t give quarterly guidance, but you did comment on that. Do you see that across all 3 segments? Because it sounds like EPD that might be a struggle for that to happen.

Well, without getting into specific guidance, Charley, I think the fact that our backlog is up 12.5% versus year-end levels, that really is what provides us the confidence that we’re going to be able to push that work out the door and generate improved second half revenues vis-a-vis first half. Again, don’t want to get too specific into segment by segment, but we do feel good about our overall revenue level improvement for the second half.

Our next question comes from Robert Barry from Susquehanna. Please go ahead.

Hi guys, good morning. So could you give us just what you think a reasonable expectation would be for IPD margins to track to you over the next 12 to 18 months?

I think, I mean, so we’re essentially flat to 0 margins right now. And I’ll just say, again, the goal would be in 12 months would be the high single digits. And it’s just going to be a steady progression to get to that level. And ultimately, this needs to be a teens business.

Got you. And could you update us on what you’re seeing in terms of turnaround activity, particularly in North America refinery turnarounds?

Yes. No, we’re seeing some turnaround activity in North America certainly not at the levels we’ve seen historically. But it’s there and it’s holding our aftermarket business at a foundational level. What I’d say is on the international front, we’re not seeing the same level of activity.

It sounded like last quarter, there was some distributors stocking in the Gulf that may be there was kind of growing optimism that, that activity could be picking up. Has that continued? Or has that kind of flattened out?

Yes. No, we did see significant distribution pickup for us. And the 2 – but the 2 areas for that were primarily IPD and our Flow Control Division. Some of that is clearly supporting refineries, but it’s that base business of just valves, pumps and seals that are going in to replace anything that’s worn out or potentially upgrading the existing product. So I’d say that is a very positive sign. It’s the foundational and – that base business that we want to see grow and historically, that’s been a leading indicator for us for better things to come in the future.

Got you. And it did continue in Q2 or…

Yes. No, we increased in Q2. Jay, the number was 9% up, right?

Yes.

Yes, so Q1, Q2 is 9%.

Our next question comes from Joe Ritchie from Goldman Sachs. Please go ahead.

Thanks, good morning everyone. So Scott, maybe just following up on that comment on IPD margins for a second. When you think about kind of like high single digits in any environment that you’re in today, how much do you need volume to come back to get there? And then also, you talked in your prepared remarks about additional cost-out opportunities. And I just – if you can maybe shed some more light on timing beyond what the current plan is from a restructuring perspective.

So I’d just say IPD specifically, we would love to see volume improve here, but given the current macro context, we’ve got to be able to drive margins with the volume level that we have. And so I believe we can do that, right? And again, we’re getting price that’s at the – not a great level by any stretch of the imagination but at a reasonable level, and we’re giving it away with poor execution. So we’ve got to fix our execution problems. As we do that, we start to walk margins up. As the markets improve, we start to push price up. What I’d say is in general industry, we do have ability to drive price in IPD, and we are focused on doing that now. So I do think there are things there that we can do to – self-help activities that’s quite frankly very long list, to drive margin improvement. And then just on Flowserve overall on cost, I’ll just kind of – we’ll walk kind of top to bottom here. I discussed in my opening comments on just the fragmented nature of Flowserve. And so what that – with the fragmentation and a lot of control at the local level, we’re really not leveraging the scale of Flowserve almost at all. And so I think over time, and this certainly isn’t going to show up in ‘17 and probably not the first part of ‘18, but we’ve got to be able to capitalize on the scale that we have. And when I say that, I mean, that’s our supply chain, it’s a shared services approach on all of our back office functions, from engineering to finance to HR. And then ultimately, we need to get the SG&A in line with where the business is. And so that’s going to be a multi-quarter effort here. We did accelerate some of those actions here at the very end of Q2 and really the beginning of Q3. And we need to get that SG&A back into a level that makes sense. So I really think from a margin standpoint, we’ve got a lot of self-help activities. We’ve got to figure out how to leverage the entire Flowserve enterprise. And as we start to do that, we’ve come a lot more efficient with our ability to drive better margins.

Okay. That’s helpful, Scott. And maybe kind of as my follow-up question, can you maybe just touch on some of the accounting issues that you saw this quarter, specifically around internal control you saw really kind of the past year and what you guys are doing to address it?

Yes, I’ll let Jay start with that, and I’ll close that out.

Hey, Joe. Certainly, as you know, Flowserve takes its internal control assessment very seriously, and we are absolutely committed to a strong control environment. In short, we believe we have the material weakness, ringfenced to one location in Europe. Because we had several years of immaterial journal entries that weren’t caught by the site’s own control structure or by our compensating control, we concluded, obviously, that those controls failed. And while the amounts were immaterial to prior periods, the concept of how large could it have been was really what made us conclude that the control structure had material weakness. Obviously, we are going to be amending our 2016 10-K as well as the first quarter Q and management is actively developing remediation plans, which will be part of our revised filings to ensure that this doesn’t happen again. I don’t know if that fully answers your question or if you have any follow up on that.

Yes, let me just jump in. As I said in the opening comments, it’s just – it’s not acceptable when running a business like Flowserve. And so we’ve taken it very seriously. I’ve been impressed with the team in terms of our response to this. As you know, right, it’s been – we spent a lot of time and it’s been highly distracting in the second quarter to work through this. But we’ve also looked at the entire Flowserve organization, and I’m reasonably confident that we’ve got – it was isolated to a single facility, and we’ve got good controls around the world at other facilities and our other operations. And so we’ll work through this and we’re going to work through it aggressively. And we will improve our controls environment as we go through this process.

Our next question comes from Scott Graham from BMO Capital Markets. Please go ahead.

I have 2 questions for you, Scott and Jay. The first one is the backlog, the gross margin in the backlog. Can you comment on that? It looks like from your comments, Jay, that backlog gross margin was not one of the factors on why the gross margin declined this quarter. But would you guys be able to tell us if the margins and the gross – in the backlog are above or below kind of where we’re at now?

No, what I would say is that pricing – when we first saw the oil collapse in late 2014, pricing in 2015 first quarter is really when we saw the shock. And as you know, we burned our backlog fairly quickly here. As Scott alluded to earlier, pricing has been generally stable. Our margins have been fairly stable since 2015. We’ve seen some points to where we can drive a little bit of price. But in the aggregate, I would say that the pricing has been pretty stable since early 2015, all the way through now. And so it shouldn’t be a big tailwind or headwind going forward.

Great. The other question is – and this is maybe more directed at you, Scott. The current realignment, the expectation there was to lower rooftop and employee count by something a little north of 20%. And I think what the prior regime talked about was that, that will not – that would include no loss of revenue-generating capacity. Yet here we are with oil capital spending significantly reset. I’m just wondering if part of your comment is that you need to look at your manufacturing footprint, again, is in fact that we don’t need a company capable of generating $5 million – $5 billion in sales, that the number perhaps should be lower still and the expansion of the realignment should – another one is required. Am I framing your thinking correctly?

No, I wouldn’t say – I’m not at that conclusion right now. And honestly, I’m in the fourth month, that’s really hard for me to determine what that is. What I would say though is, to me, when you look at facilities and manufacturing and roofline and capacity, that’s something we should always be doing. And so I don’t think it’s ever done, right? And so we’re always needed to be looking at that and ideally if we’re in a continuous improvement mindset, all of our plants should be expanding capacity every single year because we’re improving our efficiencies and our ability to utilize our labor and the assets that we have. And so it really is a dynamic and moving issue. What I would say is I have looked at the realignment program. I’ve been involved with – I had several meetings on it. I like the current state of it. In terms of 2017, we’re continuing with our actions. We actually closed and completed 2 facility – complete closures this quarter. The process that we followed was very disciplined, and the results of those closures have gone very well. We did announce another one in the quarter, and we’ll continue to move forward deliberately in 2017. What I would say is, all of the future plans I am absolutely reviewing, and we’re making adjustments accordingly and as needed. But I’m just – I’m not at the point right now to say, does it expand drastically or more or do we limit it. But what I will say is, it is an ongoing effort for me, and that’s something that’s in our job scope that we always need to be focused on.

Our next question comes from Andrew Obin from Bank of America Merrill Lynch. Please go ahead.

Just sort of going back to the question. Scott, you have a reputation among investors to sort of getting things right. I think what caught people by surprise no pre-announcement. You did talk about experiencing customer delays, but sort of superficial check on my other companies sort of seems that you are the only one sort of citing it for the miss. So the question is, first, are you going to get back the revenue that you missed in the second quarter because of this customer delays? And then the second thing, how do you know that something is not broken inside Flowserve, right? You’ve restructured IPD and now, we’re having issues in IPD. We’re restructuring EPD right now, which is sort of the crown jewel of the company. What gives you the confidence? I understand that your backlog is up 12%, but seemingly, backlog is not an issue converting backlog into cash, i.e., being able to sort of deliver stuff to customers seems to be a much bigger issue. I know it’s a long question, but just want to understand what you’re thinking. I know you’ve only been there 100 days.

Well, that’s how I’m going to start with my answer to that. Yes, I’m in month 4, and so let’s make sure we’re grounded on that first. But what I’d say is it’s been an unbelievably busy 4 months, right? And I visited – I don’t know, I should have the exact total, but I would say nearly 20 manufacturing and aftermarket locations. I visited with our leadership teams, we’re doing reviews. And so I’m really trying to assess that competency and the skill set of the organization. And I would say my assessment right now is while we certainly have challenges, right, we’ve got to make improvements overall. And I’ve said that and we had problems in Q2. We’ve readjusted back half of the year for guidance. I certainly don’t take that lightly. The team doesn’t take it lightly. And right now, given everything that I see today, we feel confident in our ability to deliver what we’re committing to, which requires improvement quarter-over-quarter. And so we’ve got to do that. We also need to make that work, we need IPD to turn around, and we need to have a solid bookings in Q3 in which we expect to have. But again, 4 months in, I’ve done a lot, we’ll continue to keep assessing. But what I’ll say just overall and closer, I mean, back to the fragmentation and just the disparity within the operations, we’ve got lots of opportunities here, right? If we can drive consistent and systematic results, if we can improve our systems and process, then it’s going to allow us to do a lot of things differently and grow our margins here.

Thank you. just another question. Sort of you highlighted blocking and tackling. Does this mean that growth is delayed until you guys have a better operational plan?

No, I don’t think – we’re not going to delay growth, right? I mean, so I think we’re clearly going to try to capitalize on the markets and I think – I actually thinking I haven’t talked about this One of the other issues that I see here is that we’re not very market focused. And what I mean is, we haven’t really done the defining the markets that we want to play in and the true market segmentation. And so I think by becoming much more market focused and really trying to exploit attractive aspects of our market and making sure that our products are aligned with that market and the selling effort follows, there will be pockets of growth, right? I mean, we’ve got just a massive product portfolio and we play in almost every single space that we have. And so what we need to do is start to define what’s attractive from a market standpoint, where the competition is and then aggressively move into spaces and be agile about doing that. And so I think we’re not going to shy away from growth. We absolutely want to grow. We want to be a growth company. We need to take with the markets give us, but we need to do a lot more self-help in taking market share and growing in the attractive aspects of the markets that we’re in today.

Scott, thank you so much for your answer.

Our next question comes from James Picariello from KeyBanc. Please go ahead.

So just looking at engineered OE bookings, you had an $18 million China refinery order in the first quarter, and you still managed to keep bookings sequentially flat. Can you just talk about what drove this quarter’s demand?

Yes, it really was – there was no one thing. It’s really just the base business, which is actually a very nice sign. And so I think our largest bookings in the quarter was certainly less than $20 million. And it was all base. And so just a lot of hard work, a lot of smaller orders, and just that foundational group of activities that’s a positive indicators to go forward.

Okay. And then within general industry, you guys did call that out. Bookings up 9%, you have some several subverticals within that. Can you just talk about what pieces of that drove the order’s improvement?

Yes. We mentioned earlier about the strength that we were seeing in the distribution channel. And a lot of our distributor activity goes through GI. And so that would have been the key driver behind the improvements there.

Okay. And then just one last one here on clarification. So if I take a look at your prior core or constant currency guidance versus your revised one that now takes into account the 2% Gestra impact. You actually are baking in slightly better core sales, down 5% versus down 6% at the midpoint. Is that the right way to think about it, that Gestra was not included in the prior, and now 5% is about the number at the midpoint?

That’s correct. In the previous guidance, we were expecting 2.5% of FX headwinds. The currencies have gone our direction, but with the divestiture of the Gestra business, we picked up 2 % of new headwind, and so I think the way that you’re calculating the math is accurate.

Thanks.

Thank you.

Our next question comes from Steven Fisher from UBS. Please go ahead.

Hi, thanks good morning. Since you guys offered the medium-term margin target for IPD, can you provide a similar target for EPD and FCD? I mean, can you get EPD into the teens and FCD into the upper teens? And I know that those don’t have the same challenges that IPD has, but just trying to see what you’re hoping to do with these businesses.

No, Steve, similar to the question I gave earlier, I don’t think we’re going to want to try to get into giving guidance by individual segments. That’s a challenge in and of itself. I think the real key for EPD was, seeing this quarter having strong year-over-year OE bookings, up 14% and then we also have the largest amount of aftermarket in EPD as well. So if we can get those OE bookings to help fill our factories and absorb cost and continue with that foundational level of aftermarket work, EPD ought to be just fine. And FCD, obviously , has been a gym performer within the valve space, and we think it continues to operate as a pretty well-oiled machine.

Okay, thanks John. And Scott, you talked about market stability. I understand that you don’t anticipate a lot of growth, but what are you seeing in the medium-term pipeline or alternatively in the strategic agenda that gives you confidence that the revenues don’t have more downside after you get through the digestion of the 12% backlog growth in the near term?

Yes. No, I mean, we’ve got lots of metrics in terms of our quoting levels, our activity levels, projected CapEx and spending like that. And as I said in the opening comments, while there’s not any incredible excitement in any one of our industries that we’re at, it’s significantly depressed from where we were in 2014, and we just think we’re now at a relatively stable position. And so, are we completely at the bottom or near the bottom? We’re not exactly sure. But I mean we’re seeing traction at the levels that we’re at. And I just – at this point, everything that we’re seeing doesn’t show a massive move backwards there, but it does, again, it doesn’t show a heightened response here in the back half of the year.

And does your pipeline – you mentioned some bolt-ons – I mean, are there enough of those that should you see a pullback in some of these markets that offset it, say single digit?

Yes. No, I think – look, there’s always – it’s an incredibly dynamic landscape right now. So there’s a lot of moving pieces out there. And what I’d say is we’ve got a reasonably short list of things that we’re very interested in. And if we can make some of those work then we’ll try to capitalize on them. But again, I think just the self-help activity for us is going to be the major focus. I want to demonstrate that we can execute and perform before we try to tackle some major integrations.

Great. Thank you.

Our next question comes from Deane Dray from RBC Capital Markets. Please go ahead.

Thank you, good morning every one.

Hi Deane.

Scott, when you listed out your 4 key – or excuse me, 3 key actions in your first 100 days: Meeting leaders and visiting facilities, talking about streamlining the organization, I was listening carefully for whether cash flow was going to be set as a priority because in our view, that’s one of the sore spots right now in the quality of earnings. It was 62% conversion. And it puts you in like the fourth quartile of the industrials. Where is this in terms of priority? What has to change in the organization, whether it’s working capital, whether is the product streamlining that you’re focused on? But where is free cash flow conversion as a priority for you?

Yes. It’s – I said in my last call, so it’s very important to me. Cash is king and we need to be able to convert our EBITDA to cash flow, and we need to be able to do it effectively. And so, obviously, we’re not doing that well. It’s primarily working capital. So we’ve got opportunities both in the receivables side and on the inventory side. And so what I’m trying to balance right now quite frankly, is pulling – receivables we’re on and we’re taking action and we’re making sure that we’re laser focused on that. Inventory is a little bit longer term in terms of doing the right things there. What I would say is, with the delay in customer pickup and our increase in passthrough backlog, that’s not helping us on inventories So those will relatively quickly get unwind and be in a better place. Just – but systemically and sustainably, right, we’ve got to bring our inventory levels down. We need to be quicker in terms of our inventory efficiency. So that’s a big one. And then, as you know, right, the first thing we need to do is to get margins where they’re the supposed to be, then cash flow is going to follow. But no, it’s super important to me. It’s going to be a part of our long-term incentive plan for sure that we’re not going to change that. And we’re – as we talked about these review meetings and sessions, cash flow is now being incorporated in all of those discussions.

Got it. That’s good to hear. And then just going back to Scott Graham’s question on the restructuring actions. This quarter’s slide deck, you did not include the restructuring program overview that we had last quarter. And I wasn’t sure when Jay was stepping through the expectations for restructuring for the year, if it was either $100 million or $120 million because the plan had previously been $155 million. And Scott, you said you’d make adjustments as needed, so maybe this is a bit more dynamic versus what we were looking at before?

Yes, I’ll let Jay answer the question, but just don’t read anything into the removing it from the presentation. It’s just we’re trying to – I keep pushing Jay to get that deck a little bit simpler and that was one that we decided to take out. But Jay, you want to answer the question specifically?

Sure. Deane, one of the things that we’ve been relatively pleased with is that we’ve been getting more savings for each dollars spend that we incur. And it did come down just a little bit. Last quarter, we guided to $140 million of cash for the year. We think now that the cash cost will be around $100 million. Last quarter, we got it to $155 million of expenses, and now, we’re thinking the expenses are going to be around $120 million.

Got it, such a helpful Jay thanks.

Sure. Deane

Our next question comes John Walsh, Vertical Research. Please go ahead.

So a lot of ground covered already. Just had a couple of cleanup questions. Building off of Deane’s question with the restructuring. For 2017 I think $17 million was the incremental number we were looking for. Is that still the right number to use? Or is that moving around?

John, similar to my comments earlier about us getting more savings for the dollars we’re spending, I think we’re now looking a little bit above the $70 million level and probably will end the year at a run rate of over $200 million versus the $187 million we were quoting before.

Okay. And then, I guess, one larger picture for Scott. I mean, I’m taking away, obviously, there’s a lot of focus internally, it looks like in terms of acquisitions, right, bolt-on product lines, smaller stuff to digest. But as you get the margins to where you want across the portfolio, do you think that Flowserve has kind of entitlement or maybe a different word to consolidate the industry? Because it does still feel like there is a decent amount of excess capacity out there. Would just be curious longer term, kind of how you view that.

Yes, I do think in terms of – our long-term view would certainly be to grow. And I would hope that we can do some transformational acquisitions here because it’s a highly fragmented space, right? I mean, look at valves, look at the pump side and – I mean there’s a ton of opportunities. And so I think getting this industry more consolidated will help everybody, and I would love to be the one that can drive that consolidation at some point in time.

Great thank you.

Our next question comes from Joseph Giordano from Cowen. Please go ahead.

Hey guys thanks for my taking.

Hey Jo, how are you.

A question on the aftermarket. So bookings have been pretty stable for a while now in that like 450-ish range. But for the last 6 months , you’ve seen the revenue conversion on those bookings be on those bookings be decently below that. And I would think those would be pretty contemporaneous. So is there – I understand the commentary about customers not taking shipments on the OE side, but what’s going on there in terms of aftermarket? And why would revenues not be reflective of the booking levels.

They will be over time. What you have, Joe, is occasionally, when people are ordering new original equipment, they’ll order a complete set of parts to go with it and sometimes that is a longer delay from the time the booking is achieved until it’s recognized. The positive news is those products are still in our backlog. And what we saw as a $20 million increase in aftermarket backlog that we would expect to be realized over the coming quarters.

So in essence, the lag – the delays you’re seeing in OE are – those themselves are impacting the aftermarket as well because they’re related? Okay, that makes sense. Were those delays getting progressively better or worse during the quarter? I guess, it all boils down to, is 2018 really – I know you’re not going to give guidance here, but like those are your thought process about 2018, really, have to change a whole lot because you’re probably coming in at order rates above where people were thinking. Is the question of does this kind of delaying conversion impact the typical amount of your current year orders that we’d expect to flow through sales 6 months from now?

I wouldn’t think so. At the end of the day, after market turns relatively quickly, I mean there’s some things like nuclear parts repairs that take longer, but generally, when we get an aftermarket order, our customers absolutely need the product or spare parts or the service in a fairly timely basis.

Okay, fair enough. And just last for me. How confident are you – like if these delays persist, how confident are you that the tax rate won’t spike up again if those again if those areas that are kind of maxed out on end up losing money? Like how comfortable are you with your visibility in those regions that you’ll be at the level of profitability that allows you to soak up some of the DTA.

Joe. It really wasn’t the delays that related to the elevated tax rate this quarter. We had some losses at some of the plants that we had spoke about within our script, and that Scott had visited that are in jurisdictions where we no longer receive a tax benefit for them, and that was really the reason for the elevated tax rate. As we look at our forecast going forward, we don’t expect that magnitude of losses from those regions in the second half of the year.

Thank you.

I will now turn the call back to Mike Mullin for closing comments.

We appreciate everyone’s participation in today’s call, and we look forward to seeing many of you at upcoming investor events. Please call Jay or me if you have any additional questions. And operator, this concludes today’s call. Thank you.