Flowserve Corporation (FLS) Q4 2017 Earnings Report, Transcript and Summary

Welcome to the Flowserve 2017 Fourth 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 Jay Roueche, Vice President of Investor Relations and Treasurer. Please go ahead.

Thank you, Paulette, and good morning, everyone. We appreciate you participating in our call today to discuss Flowserve's fourth quarter and full year 2017 financial results. Joining me on the call are Scott Rowe, Flowserve's President and Chief Executive Officer; and Lee Eckert, Senior Vice President and Chief Financial Officer. Following our prepared comments, we will open the call up to your questions. And as a reminder, the event is being webcast and an audio replay will be available. Also note that our earnings materials do, and this call will, include non-GAAP measures. You can review the reconciliation of our adjusted metrics to our reported results prepared in accordance with generally accepted accounting principles in both our press release and earnings presentation. Finally, 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 February 16, 2018. 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, 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, Jay, and good morning, everyone. We appreciate you joining today's call. I am pleased overall with the progress we made in the last nine months of 2017. The new leadership team is performing well and is committed to the Flowserve transformational journey. As we look forward into 2018, we believe our served markets have turned positive, which will give us the foundation that we need to drive profitable growth for the coming years. Our near-term focus and priority is transforming Flowserve into a more simplified and streamlined operating company. Flowserve has significant potential, and we are committed to unlocking it through a comprehensive program that touches each of our functions and all of our business processes. In short, I believe the opportunities at Flowserve that I envisioned when I joined last April are even larger today, and our number one priority is to capitalize on these. I will discuss more on our Flowserve 2.0 strategy shortly, but let me first provide some comments on our end markets and our results for the period. Starting first with our quarterly results. Fourth quarter adjusted earnings per share of $0.50 were delivered on a revenue decline of 3.4%, both of which were generally in line with our expectations. We were pleased to achieve better-than-expected bookings of $985 million, up 8.5% year-over-year and 10.3% sequentially on strong general industry and chemical activity. Turning to our performance by segment. I am proud of our FCD team. They delivered a strong fourth quarter with both sales and operating margin growth. They achieved this growth despite the distraction of divesting two noncore businesses during 2017. For the year, FCD's reported bookings were essentially flat and sales were down modestly. But on a true comparison basis, bookings would have been up approximately 9% and sales up 4%, excluding the sold businesses. Additionally, the segment delivered strong adjusted operating margins of 16.4% for the year despite continued pressure in the trough of the cycle. FCD has performed well through the cycle, and we will invest both organically and inorganically to build out this platform. By contrast, IPD is still in turnaround mode. While we delivered positive adjusted operating income in the fourth quarter, we remain committed to more meaningful improvement as 2018 progresses. We continue to expect our 2018 exit rate for this business to be in the mid- to high single digits for adjusted operating margin. The new leadership team under David Wilson is making progress and taking the necessary actions to improve the overall health and performance of this platform. While IPD's 2017 financial performance was disappointing for us, I am encouraged by the outlook and possibilities of this business unit. The performance of EPD is somewhere in the middle of the other two segments. EPD bookings were better than expected in the quarter, driven by stronger original equipment bookings. As a longer-cycle business, these bookings were needed to replenish our backlog and help offset the original equipment sales decline. The margins in our OE business in the fourth quarter underperformed our expectations, partially due to a 300 basis point sequential increase in OE mix, but we also struggled to execute a project in one of our Latin American manufacturing locations. We completed a number of realignment activities in EPD during 2017, and we will see additional large facility rationalization this year as we conclude our 2015 realignment plan. I believe there is substantial room for profitability improvement in this segment, particularly within the original equipment space. This segment represents the majority of our aftermarket work, which continues to perform well in both activity levels and profitability. Before discussing our markets and bookings in detail, I would highlight that we believe most of our served end markets have turned more favorable in the last 90 days, and we expect short-cycle investment in both FIDs and project FIDs to increase in 2018 as the cycle progresses. While it's still early to quantify the opportunity at this point, our customers are saying, either directly or through public means, that the improved macro environment, a relatively stable oil price at higher levels, improving U.S. regulatory conditions and the recently passed tax reform, are some of the factors supporting their expected increased spending levels. So we are encouraged at the prospects of having reached an inflection point in this cycle. Now moving to our bookings for the quarter. Our bookings were higher than expected, driven by our base or foundational business. And we did not book any large projects in the period. The largest award in the quarter was $15 million, but we did obtain a number of $3 million to $8 million projects, which combined to produce solid year-over-year growth of 8.5%. Additionally, we continue to improve our discipline around pricing and order selectivity, and we are pleased with the order quality in the fourth quarter. With this total level of bookings, our backlog grew nearly 7% versus year-end 2016 levels, providing us with a stronger foundation for growth in 2018. Aftermarket resiliency continued in the quarter, with modest year-over-year and sequential bookings growth. While we remain at the foundational level of aftermarket bookings for some time now, essentially, the $450 million per quarter level, we are optimistic that our aftermarket franchise will return to better growth rates following three years of rolling deferrals and limited investment in discretionary upgrades. Our recent discussions with customers indicate that they now anticipate higher turnaround activity and an increased focus on efficiency, starting in 2018, potentially driving an increase in small project aftermarket work, which has been largely absent for several years. Turning to our fourth quarter bookings by end market, and I'll start with oil and gas. Bookings at our larger-served market increased approximately 3% year-over-year, driven by EPD. FCD bookings were essentially flat, while IPD decreased by approximately 5%. EPD saw bookings included several small project awards in Europe, in Asia Pacific. Looking forward, we expect that oil and gas industry to continue to gain traction, evidenced by our pipeline of pre-FEED and FEED studies that continue to expand. Additionally, we expect many of our refining customers to increase their maintenance spend over the minimal levels that we've seen in recent years. In the chemical industry, our bookings increased over 21%, driven by EPD and FCD on strong short-cycle bookings, while IPD was essentially flat year-over-year. Overall, chemical demand continues to grow globally, especially with project opportunities in the U.S., Asia and Middle East. The second wave of North American ethylene crackers continues to move forward, albeit slowly, with two projects now in E&C hands and several others in various stages of planning. Power bookings decreased 6%, driven by FCD, more than offsetting IPD's strong growth, which include a small nuclear project award in Europe. Newbuild fossil opportunities remain but are very competitive, particularly in Asia. Nuclear buildout continues in China, but the opportunity is partially offset by a decline in the installed base in U.S. and Germany, where fuel switching to combined cycle natural gas provides economic rationale. Finally, we expect growth in concentrated solar power opportunities, an area where Flowserve is well positioned. General industry bookings increased over 13% versus last year's fourth quarter, which was the lowest since 2016. The increase was largely driven by distribution activity across all segments. From a geographic perspective, all regions delivered bookings growth with the expectation - or with the exception of the Middle East, which was down 17%. North America and Europe delivered 15% and 8% growth, respectively, driven primarily by FCD and EPD. Asia Pacific increased 4%. And even our most challenged region, Latin America, grew its bookings by over 50%. Now let me turn to Flowserve 2.0 and my expectations for progress during 2018. Late last year, I laid out the central elements to streamline and simplify the company while transforming our operating model. While I plan to capitalize on the foundation the company has built over the last 20 years, we believe an improved operating model will provide more value to our key stakeholders, our customers, our employees and our shareholders. As I've discussed in the past, transformational change, like the one we're pursuing, is not easy and it won't be accomplished quickly. Flowserve 2.0 will be a multiyear journey that focuses on improving the culture, the health and the performance of Flowserve. While the journey will take time, we are actively implementing and driving change. I want to highlight some of the progress that we made in 2017. We implemented a flatter corporate organizational structure and added many new leaders to the team. We created a marketing and technology organization to ensure that we are market-led and customer-focused, moving us to be more proactive with our product development and R&D efforts. We centralized our supply chain efforts and began the journey to leverage our global scale and capitalize on our buying power. We installed an operational excellence team and standardized our operational KPIs to drive improved and more consistent performance, and we reduced overhead costs and streamlined corporate reporting and requirements to accelerate our business simplification ambition. All of those changes were implemented in 2017. In addition to those changes, over the last couple of months, we conducted a complete diagnostic evaluation of how Flowserve is currently operating and organized with a top to bottom examination of ourselves, essentially equivalent to conducting a robust due diligence review to fully assess our capabilities and to better identify our long-term opportunities for value creation. We conducted this assessment across six key areas, operations, commercial, growth, aftermarket, G&A or cost structure and working capital. This full-scale assessment is now complete, and we are creating detailed action plans and a timeline to deliver this value. In January, we conducted a leadership summit with 100 of the top Flowserve associates. In this session, we launched the value creation and value capture journey. Earlier in my time at Flowserve, it became clear to me that we had to address the culture and better engage our associates around the world. A large part of the leadership summit was devoted to the foundational aspects of running a company for the long term. We launched a new purpose statement, new core values, a new vision for the future, and we spent time addressing the human side of driving change. We need each and every Flowserve associate to understand why they come to work and how they can impact our long-term success. In addition to these foundational elements, we also rolled out a global organizational change that will drive enhanced accountability and drastically simplify our organization. As I have previously indicated, Flowserve's past operating model was more intricate than required with too many P&Ls, systems and processes. The new organizational changes in the Flowserve 2.0 initiatives will significantly decrease this complexity to better leverage the vast scale that we have in the business. The entire company will be run on a similar manner with consistent operating model. We will be leaner, faster and better informed to make proper business decisions for our long-term success. We're essentially breaking down the silos that have been present within Flowserve for many years. As I discussed last September, this is a multiyear endeavor, but we do expect to see progress each and every month. The price and the potential at Flowserve is enormous. In fact, it's larger than I originally expected. However, in order to capture this value, we had to start with some of the foundational elements to address our people and our culture. 2018 will mark a significant step in our journey towards excellence. As we continue to progress with Flowserve 2.0, we look forward to sharing additional details with the financial community on the initiatives that we'll be taking and if it's derived in quantifying these opportunities. While I fully expect the benefits of our transformation are material, we anticipate offsetting much of this year's costs associated with driving these important changes by reprioritizing investments and redirecting some of our key savings. I'm confident that the actions we are taking will increase our ability to effectively support our customers, creating more meaningful workplace for our employees and drive significant long-term value for our shareholders. I'll return shortly for some closing comments, but let me now turn the call over to Lee to discuss our financials in greater detail.

Thank you, Scott, and good morning, everyone. Looking through our financials. As Scott highlighted, we delivered adjusted earnings per share of $0.50 in the fourth quarter of 2017, generally in line with the expectations we discussed on our last conference call. On a reported basis, loss per share of $0.81 included discrete tax items of $1.21, primarily related to the impact of the recent U.S. tax reform. For Flowserve, this discrete tax expense will be noncash as repatriation tax is offset by existing tax credits. The remaining impact from legislation is a benefit related to the adjustments of deferred tax items to the lower tax rate. Additional adjustments include realignment spend of $0.06 and $0.04 comprised of a small asset impairment, below-the-line currency impacts and PPA. Total sales were $1 billion in a seasonally high fourth quarter, sequentially delivering a 17.1% increase. Year-over-year fourth quarter revenue declined 3.4%, which included a 370 basis point currency tailwind on the weaker U.S. dollar and roughly a 2% headwind on divestitures. Aftermarket sales were $502 million, representing 48% of our total revenue for the quarter and were essentially flat with prior year. Looking now at gross margins. At 30.5%, our adjusted gross margin was down 230 basis points versus the prior year's fourth quarter. Loss of sales leverage, lower-margin shipments from backlog and the challenged project at EPD more than offset our incremental cost savings and a 100 basis point mix shift towards higher-margin aftermarket activity. On a reported basis, which included a reduction in year-over-year realignment charges, our gross margin decreased 120 basis points to 29.4%. Both reported and adjusted SG&A were down modestly in the fourth quarter. Continued incremental cost actions were sufficient to offset impact from the weakening U.S. dollar and other headwinds. Fourth quarter adjusted operating and reporting margin declines of 310 and 130 basis points to 9.8% and 8.3%, respectively, were primarily driven by loss sales leverage, EPD's Latin America project and IPD's performance. 2017 reported operating margins did benefit from lower realignment expense. Our reported effective tax rate was high in the fourth quarter, primarily related to U.S. tax reform act in certain valuation allowances. On an adjusted basis, the effective tax rate for the quarter was low at 24.8%, primarily due to favorable resolution of older tax issues. While we saw substantial quarterly volatility in our tax rates during the year, for the full year of 2017, our adjusted tax rate was very much in line with our initial guidance at 30%. Despite the substantial reported tax expense we recorded during the quarter, we believe the Tax Reform Act will prove beneficial to our customers, end markets and future results. Considering Flowserve's approximately 2/3 international, our effective tax rate in 2018 will not decline as much as U.S.-centric entities since we still record taxes in the foreign jurisdictions that are generating income, but the ability to move international cash back to the U.S. without incremental tax increases our financial flexibility. With current global growth rates, the tax bill, reduced regulation and relatively stable oil prices, we believe the conditions are set for inflection in many of our served markets. Quickly looking at our full year 2017 results. Revenues were $3.7 billion and our adjusted EPS was $1.36, down 8.3% and 36.2%, respectively. This is clearly not the level of performance we expect in the future. It is consistent with the third quarter guidance we provided. Turning to cash. Strong fourth quarter operating cash flow of $239 million improved $70 million year-over-year, primarily due to $148 million reduction in working capital in the fourth quarter. For the year, our $160 million working capital reduction helped generate a $71 million increase in cash flow from operations to $311 million. While we are pleased to achieve the year-over-year operating cash flow improvement, our working capital is still not where it needs to be and remains a priority to reduce. Moving to the realignment program. Cash costs were roughly $26 million this quarter, bringing the full year total to approximately $79 million. In the fourth quarter, we returned $25 million to shareholders through dividends. During 2017, we were very disciplined with our capital expenditure spending, even as we properly invested in and maintained our core business. For the quarter, capital expenditures were $21 million, which brought the full year to approximately $62 million, the lowest level in over a decade. As a result of our strong quarterly cash flow, we ended the year with a cash balance of over $700 million, a quarterly increase of $200 million sequentially. Turning to the 2018 outlook. We are targeting full year adjusted EPS of $1.50 a share to $1.70 a share on expected revenue increase of 3% to 6%, including approximately 2% of expected currency tailwind, which will more than offset an approximate 1% headwind from divested businesses. The adjusted EPS target range excludes the 2018 realignment expense of approximately $90 million as well as below-the-line foreign currency effects and the impact of potential other discrete items, which may occur during the year such as acquisitions, divestitures, tax reform law, et cetera. Our outlook assumes volume, price and productivity to offset the incremental headwinds in 2018 due to inflation, merit and the annual reset of performance-driven broad-based variable compensation plans. Both the reported and adjusted EPS target range assumes current FX rates and commodity prices. 2017 year-end backlog, expected booking levels and market conditions and minimal impact from the adoption of the new accounting principles. Net interest expense is expected in the range of $58 million to $60 million with a tax rate of 27% to 28%. Additionally, we expect traditional seasonality in the quarterly phasing of earnings, although with it being more pronounced in the second half weighting. In addition to the anticipated realignment spending, which will complete the 2015 program, other expected full year cash usage includes approximately $100 million in dividends for our shareholders. We will remain disciplined in our capital expenditures but plan to invest in some enabling technologies for Flowserve 2.0, which will bring full year CapEx to the $80 million to $90 million range. We will pay down approximately $60 million in debt and expect to contribute approximately $30 million to our global pension plan, mainly to cover ongoing service costs as U.S. plan remains largely fully funded. Next week, Scott and I will participate in the Gabelli & Company's pump valve and water systems conference in New York City. Additionally, Jay and Mike will attend Citi's International Conference in Florida next week as well. We hope to see many of our shareholders at these events, and Scott's session will be webcast for those who would like to listen. While Flowserve can't realistically participate in all the opportunities available to us, we do look forward to maintaining active engagement with the financial community again this year. Let me now turn the call back to Scott for his closing remarks.

Thanks, Lee. I will close with a few comments on our guidance and why I'm uncomfortable with it. Clearly, we did not deliver the profitability in 2017 that was originally expected. We don't intend to repeat falling short again. I would also note that our internal aspirations exceed these levels, but we believe this guidance range is realistic, considering we still have significant issues to overcome an incremental annual headwind. I am more confident in the overall marketplace and that we have seen an inflection point in most of the markets that we participate in. Additionally, Flowserve has a healthy backlog to begin 2018. I also have confidence in David and the IPD team that the past performance issues are contained and fixable and that the segment will contribute in a more substantial way in 2018. While our work this year is not forecast to unlock Flowserve's full potential, we expect it will position us well for 2019 and beyond. Our guidance for 2018 doesn't include the full productivity enhancements that we expect longer term and the benefits from Flowserve 2.0 will be more meaningful in later years. Nevertheless, we are pleased to initiate guidance for 2018 with a positive trajectory after several years of forecasting declining revenues and earnings. This year represents a new beginning for our company and one we expect to drive significant long-term value for our shareholders. Like Lee, I look forward to seeing many of you as the year progresses. We value our shareholders in every action we have and we'll take is with our owners in mind and the expectation to deliver value. Operator, this now concludes our prepared remarks. We would like to open the call to questions.

[Operator Instructions]. And our first question comes from Charley Brady from SunTrust.

Just on IPD and kind of the margin progressions through the year to get to that exit rate, how much of that, getting to that rate, is volume-dependent versus internal, fixing what's wrong-dependent?

Yes, no. Good question, Charley. It's really - it's internal focus. And so we've got the volume. In fact, in the fourth quarter, we had a nice number there. The first quarter, from a seasonality perspective, will be lower. And so we've got a little bit of some headwinds just on the scale in overcoming that. But we feel good about the bookings level and the revenue, and it really is just focusing on operations and testing what we've done. And one of the big things, and I talked about this a little bit before, is we've got a pretty substantial past due backlog. And as that backlog ages and sits there, we're adding cost to it via expediting additional inspection of the redundancies. And so until we get the past due backlog fully cleared, it just is a headwind to driving profitable growth and expanding that margin. But I'll tell you, David and the team, they're doing a good job. And I think he's in month five now on the job, and we're - we reorganized the entire platform in January. We're upgrading our people. And then probably more importantly is we're really focusing on disciplined manufacturing and operational process and process adherence, but we're at the starting line on that. And so it's going to take time. We've got to clear the past due backlog. We've got to get that process and procedural adherence in place. And I think when we look at the year, kind of the big things, we're going to continue to take cost out, both product cost and overhead cost. There's more restructuring to be done in the platform, and so there'll be some realignment activity that continues in 2018. And then we've got to get more focused on our pricing discipline and capturing the value that we deserve in that platform. But we're still committed to mid- to single high operating income margin at the end of the year, the fourth quarter. But I would just say, first quarter is not going to be great. And as we progress, it just gets better throughout the year.

Can you just comment on if we back out any kind of restructuring one-off costs as we go forward, what kind of incremental margins should we be assuming across the three segments?

Across all three?

Well, I guess, obviously, there's a different margin profile for each of the segment. So I guess, I'd like to - by segment, I guess, what's your thinking on...

Yes, I can give - I mean, I'll give a little color. I don't want to get into exact one-offs. But I'd just say IPD, we just talked about, right? So we'll progress IPD. Q1 won't be great. We should improve in Q2, Q3. We exit the year at mid- to high single digits. And while that's not where we want it to be, it should be a mid-teens business, we'll continue to drive that progress in progression. On the EPD side, we talked about the fourth quarter margins not being where we want it in the prepared remarks. And I think - so if we back that out, you get back into some normal operating margins there that we think we've got improvements on. And then FCD, I think we're at a pretty good place. And I'm not saying they don't get better, but I think it's just slow progression on the FCD side as we kind of progress and continue to do good things in the valve platform.

Our next question comes from Andrew Kaplowitz from Citi.

Scott, there was - I think you talked about the fact that there still was a fair amount of noise in the quarter. We knew about IPD margin already, but EPD margin was relatively weak based on the project execution issues. So maybe stepping back, you've been in the seat now for a few quarters. Outside of realignment, should we begin to see the noise level start to go down here pretty significantly in '18? I mean, you already talked about IPD, but sort of these little nicks and surprises, have you been able to sort of get to the point where you feel pretty on top of this stuff and we should see less noise in '18?

Yes. Andy, it's a great question. And honestly, it's what's been bothering me every quarter that I've been here. So every quarter, right, we've got something that's an issue or some nick that's driving our margins down. And what I'd say is it is isolated to - at this point, at least, isolated to our original equipment on the pump side, right? And so it's been IPD. And then we had an issue on the EPD original equipment this quarter. But everything that we're doing, right, the new organizational structure and how we think about Flowserve 2.0 in terms of defining process, procedural adherence, the right KPIs, the right metrics, everything we're doing is to just drive consistency in operations. So I do think that gets better. But unfortunately, right now, we've got a large past due backlog that's accruing cost. We've got to move that out in the first half of next year, and then we've got to start to drive more consistency in operations. Again, that is our focus. I do expect that to get better in '18, but unfortunately, this is a journey. And I keep getting surprised by things even this quarter. That shouldn't happen. And so we've just got to - we've got to get the right organization in place, the right process, and we've got to be maniacally focused on delivering that new equipment.

Okay. That's helpful color, Scott. So just focusing on aftermarket for a second. You kind of talked about it, but the aftermarket bookings have been creeping up again, 4.60 you mentioned has been the range for the last couple of years. And the thing is versus a couple years ago, right, short-cycle energy; certainly, short-cycle industrial are better than they were. You mentioned deferred maintenance and the absence of small projects. But why haven't they come back already for you guys? And are you more confident that we really should break out of this range in '18?

Yes. I think - so obviously, we've been at 4.50. We've been hitting that every quarter now for almost 2, 2.5 years. And then we've got a little bit of an uptick in the Q4, but I would say nothing to be too excited about. But as we turn into '18, the discussion and the view toward the turnaround is better than what we've seen in the last two years. And so there is optimism there, but I would just say I would be - I would say cautiously optimistic because it hasn't happened yet. And we've had this optimism a year ago, 1.5 years ago, and it hasn't come through. And what I'd say, it's kind of twofold. One is there's absolutely this pent-up demand for maintenance and focus on reliability and making sure that things don't break. But there's also a little bit of prevailing trend that's saying, okay, we've now gone this long without spending this type of money on our maintenance program in maintaining these facilities, and they're not completely breaking. And so what we're trying to do is come in with a much more proactive approach. We're trying to provide technology into our solution and being more predictive about how we go forward. And so I guess, in aggregate, what I would say is that I'm optimistic about aftermarket and starting to see growth and more sustained growth in 2018. We do have more visibility to our turnarounds, particularly in Asia Pacific and North America, but I'd love to get some wins early in the year in Q1 and Q2 to get more confidence that operators truly are spending in this space.

Just a really quick one for Lee. How much is the swing in incentive comp from '17 to '18 so we can think about underlying incrementals there?

So Andy, it's a relevant number. But historically, correct me if I'm wrong, Jay, we've not given that number out as far as - but it's meaningful. But we have not been that prescriptive on it.

And our next question comes from Scott Graham from BMO Capital Markets.

I was hoping for some help on the gross margin here as well. Could you help us understand the project situation's impact on the gross margin? And then maybe by extension, we've heard the prior regime talk the word selectivity on bookings for years. And I understand that shipments out of the backlog are only a part of the equation for any one quarter. But so the gross margin, despite what they've said, continues to come down, suggesting that the pricing on the run rate business continues to come down. Could you kind of put that together for me, Scott, as well as maybe quantify the impact from the nick from the project?

Yes, let me - I'll start with kind of - I'm not going to go way back, but I'll talk about what we're doing about pricing and where we are in gross margins. I'll turn it over to Lee to kind of hit what's happening there. But I would just say right now, and really probably put this in earnest in Q3 of this year, is a much more robust kind of philosophy around trying to get the value that we deserve on these larger projects. And I'm really speaking about pump OE, right? So both industrial and on the engineered side. And so I feel pretty good. Certainly, in Q3, we did better. And then in Q4, I feel pretty good about our selectivity on the pricing and the ability to deliver the orders that we brought forward. And so that's going to help us as we go forward. And I think - and I'm going to let Lee go into details, but a part of the problem on the gross profit is the underabsorption and our inability to execute as well as we should. And that, quite frankly, these variances in the manufacturing side are really hurting our ability to drive higher profits. Lee, you want to touch more on maybe Q4...

Yes, so just to kind of talk about the margins going forward. So Scott and in my comments, we talked about the headwinds. So between paying our people 2.5% for merit and the AIP adjustments and inflation, that provides pretty significant headwind as most businesses. I think what's maybe somewhat unique to Flowserve's current situation, as Scott also alluded to, is the past due backlog. And so that's also a meaningful number. That's going to be sales that I was going to say is going to have low margins, which compress it. So that's going to come through. Our belief is that's going to come through the first half of the year. At the same time, we are implementing robust continuous improvement programs around supply chain, around our productivity for our facilities and also continuing the realignment programs. So unfortunately, some of that work is being muted by some of the headwinds. When you normalize for that, we are driving margin expansion. But right now, it's being a little bit masked by cleaning up what's currently in the plants.

So the fact that the prior regime said, and I'm sorry to keep harking back to them, but that's a relevant set of statements from them regarding the backlog, right? So the prior regime kind of held to the fact that the gross margin in the backlog has essentially been flat for a while, but your comment on - just now, one of your comments suggest that, that's not the case.

What I'm saying - well, let me just clarify. The issue with the backlog is the past due backlog. So this is product that we are late on, and for a number of reasons. And the reality is in order to get that - we've had - as Scott has talked about earlier, the facilities are not running at efficiencies that many of us are used to. And so in order to get the product out to meet our customer requirements, it's coming at an incremental cost. We believe that the stuff that's currently - the new - I wouldn't say the new versus the old, but a lot of the new orders, should we have attractive margins associated, the issue we're having is we are late on product, and that product - our focus is to reduce the past due backlog. When that gets flushed out, it's going to be at low margins.

Again, I don't want to go back and talk about what the prior management said. But what I'd say is in this past due backlog, right, there's now - the margin has declined from the as-booked margin or the expected margin. So there's variances to what the original belief was. And it's just the definition of this work is hanging around our facilities longer and it's collecting costs, both people and material cost, that's now lower - bringing the margins down lower as we move it out of the system.

That makes a ton of sense. Last question is this. Last quarter, you indicated that your expected pace from initially taking over on reducing SG&A needed to kind of slow to make sure you were cutting in the right places because the systems were not helping you ensure you were cutting in the right places. Could you kind of update us on where SG&A reduction progression stands today?

Yes. No. Yes. I appreciate you bringing us back to this topic. It's important. So we did some pretty healthy cuts in the end of - right in that Q3 time frame. In Q4, we paused to really focus on process and making sure that we weren't - we could cut more in 2018, but what we wanted to do was make sure that we're focused on the right things and that we could create long-term value and not completely break things as we look forward. And so we now have done - in my prepared remarks, we talked about this pretty significant assessment and this due diligence upon ourselves. And so now, what that's doing is starting to highlight this path forward to say, Okay, yes, we can start to achieve more savings. But to do that, we've got to put process in place. And so what I would expect is that as we transition through 2018, we start to get much better on our ability to leverage our cost structure in the second and third quarter of this year.

Our next question comes from Robert Barry from Susquehanna.

Just to follow-up on some of the Flowserve 2.0 commentary. Is there a point, and when is it, when you think you'll be in a position to kind of lay out the midterm plan for where you think you can take this business?

Look, it's a great question. I thought you guys were going to ask this first today, honestly. We know we have to provide some more color about what the opportunity is, what the potential is and when we can get there. And really, I wish I could have come out early with the big price and put a number out there, and I would have loved to have done that. But for me, it's really about putting something out that I'm 100% confident that we can achieve. And quite frankly, where we are is we know the price is there. We know the buckets. [Indiscernible] six buckets earlier in terms of where our big opportunities are. And the issue is more around how fast can we do it. And so when I look at Flowserve and we go around the world and talk to people and look at our execution, what I'm concerned about is just our ability to drive these changes as quickly as we should. And so right now, we're kind of sharpening our pencils saying these are the actions we need to take. These are the initiatives. Here's how we resource them. And are we going to break the organization by doing all of this at once? And how do we sequence it? And so we're pretty close to getting that all pulled together. And then what I need to do after that is come out publicly and start to talk about the prices. This - here's the progression of the price, and here's how we're thinking about it. So I'm not going to give you a date on when we're going to do that, but I know I have to do it, and I know the clock is ticking there. So give us a couple months.

Got it, got it. That sounds reasonable. How big is the past due backlog?

Yes. We don't disclose exactly what it is, but what I would say is it's meaningful. It's probably twice as large as it should be. And we've got to get it - we've got to clear it out the system because it's causing a lot of problems. But we're not going to give a specific number on that.

Got you. And just lastly on the seasonality of the earnings. Can you just remind us what is the typical level and maybe just a little bit more color on what it will be this year?

Yes, Jay, do you want to kind of go typical...

Yes, no. Typically, first quarter is high teens to 20% of what the full year expectation would be. Again, with - as we indicated earlier, with some past due backlog coming through in Q1, it'll probably be towards the lower end of our progression. And then second and third quarters, take time trying to be the second best quarter. And then as we saw this quarter, the fourth quarter always tends to be the strongest. I'm sure you've got the model, Rob, where you can look at the past few years and confirm how those shake out. But that's the trend, weak first quarter, strong fourth quarter.

Yes. So I expect, what, 60% to 75% or 60% to 65% will be second half-loaded?

Yes, traditionally.

Our next question comes from Nathan Jones from Stifel.

Scott, I wonder if you could talk a little bit about I guess how expected the past due backlog and difficulty getting that out of the door. You're now looking at having revenue growth in 2018. How comfortable are you allowing the company to actually grow under these circumstances to go after orders, to look to grow orders given that the operational challenges that you had - have. What is the risk there? Do you know stacking growth and stacking volume on top of this actually creates more problems?

Sure, Nathan. Thank you. It's a complex problem, and it's something we're looking at regularly. And unfortunately, recently, with some of the problems in Latin America that I alluded to, we've had to move orders out of that facility and into others. So I would say it's a complex problem. And the good news is we've got - we still, despite all of our realignment efforts, have a pretty robust network around the world, which does give us some flexibility to move things around. And so what I'd say is when we look at the 2018 growth numbers and kind of what we've said on revenue, I have no concern at all in our ability to meet that and potentially go up if the markets were to give us a little bit more. But I'd say we've got to get this - we've got to get our house in order, and we've got to do a much better job with our productivity at each and every one of our manufacturing locations to start to grow in earnest in 2019 and '20. But in '18, I have - I don't have any concerns, but it is something that we're actively managing. And again, unfortunately, we're moving orders around from plant to plant to make sure that we can truly execute and meet our customer demands.

And then my follow-up question's going to be on working capital and cash flow, which has been relatively poor at the company for several years here. You had a very good fourth quarter cash generation quarter, even much better than you do seasonally usually in the fourth quarter. Can you talk about anything that was maybe one-off that helped you there? Any kind of processes that you've put in place to help manage that? And Lee, if you've had a chance to identify what a target kind of working capital is percent of sales number would be over the longer term?

Yes, let me - I'll talk generally, and then I'll turn it over to Lee. But sure, we did have - we had a nice progression there in the fourth quarter. And I've shared this both in the meeting that we did in September and then a little bit on the third quarter call. Right now, it's been brute force, right? So it's just been heavy lifting and a lot of focus. I'd say as Lee came in, and just basically I said, Lee, we got to get this moving in the right direction. And so we set up a cadence on how do we just manually push the right levers here to drive working capital. And so right now, it's just been heavy, heavy effort and focus, and it generated very nice results in fourth quarter. We now need to transition to systems and process, particularly on the inventory side. But Lee, do you want to talk about just some of the nuances in working capital?

Yes. So Like Scott said, fourth quarter was management attention and brute force. So as we go into the year, we need to have a much better enterprise solution. So for - it's kind of area by area. So on the AR side, our DSO is far from where it needs to be, and it's going to take total authorization to have much more ownership around that. So we are looking at processes, ownership. With people talking about bonuses, and one of our bonus metrics is improving working capital. So everybody's invested in that result. We're looking at some of our policies to drive better behavior. So it comes down to insight, behavior, ownership and accountability. On the inventory side, as Scott's talked about, having the facilities run much more efficiently. So that's an area through better planning, better execution, getting these past due backlogs out, all will drive better inventory turns. But again, as a business, we are far from where we need to be on inventory. And then on payables, we're currently looking at our supply chain and renegotiating all our terms to get back to where we think the market is on payment. So from a couple - we're probably very tactical. At the same point, as Scott mentioned, from our Flowserve 2.0 conversation, this is also a major area that we're looking for a transformational improvement. And it's clearly, we have made a large investment in our working capital, and so there's a lot of value that can be freed once we fix that.

Yes. And to continue the discussion, because it's such a big point. And just - Lee said, we're not near where we want to be, right? And I said that there - I've said it a couple times, there's a price of a couple hundred million dollars here, and we're not backing off of that. And when we think about 2018, we don't think we need to grow our working capital to deliver the business that we put forward in our guidance. And so we just have a lot of work to do, and part of our operational excellence organization that we've stood up includes a planning - central planning function, and we've put planning now at each of our platform levels. And so we've got a big attention on this. We're starting to put the right people that understand how to do this, and we're now putting the process in place to drive this down even further.

Have you had time to sufficiently look into this to be able to evaluate what the appropriate level of working capital for the business is?

No. I think we'll roll all that out when we talk about the Flowserve 2.0 price. But again, I've said it before, and I'm not - we won't change that. There's a couple hundred million dollars of opportunity here.

And our next question comes from Jeff Hammond from KeyBanc.

So you talked about some quality orders coming in. Can you just speak to how you're feeling about the margins on the orders that are coming into the backlog? And then just as you start to see this improvement and larger projects come through, what you think you're doing structurally to kind of ensure those margins hold up as we recover?

Sure. I'll repeat a little bit of what I said in the prepared remarks and in an earlier question. But we feel good about what we did in the fourth quarter in terms of quality of orders coming in, and that's both on price and the ability to execute or deliver those orders. So for me, it's really twofold, right? It's one, making sure that we get the price; and then two, making sure that we can execute them because that's what's hurting us today, is our ability to execute. And so what we saw in the fourth quarter was a nice inbound number in terms of orders. We did well across each of our platforms, and we believe that the quality of those orders in the fourth quarter is quite good. And so as we go forward, we don't expect to change that, right? In fact, we believe that we should only get better about our ability to execute. Our [indiscernible] and fees are in a level that we're very comfortable with, and our pricing is at a level that we believe we can expand our margins. And so I feel pretty good about that, basically, where the market is and our ability to do this. Now obviously, we have a long way to go to restore pricing back to the 2013 and '14 levels, and we need to continue to walk that up as the market starts to get a little bit tighter than it is today. So I'd say overall, we feel good about that environment, and it is very much a focal point for us. And what we really have to just turn our focus to is as we get the larger projects in the door, we've got to make sure that [indiscernible] and not get the - have the variances that we saw in the fourth quarter down to Latin America or some of the issues that we faced in other divisions. And so when we think about some of the things that we put in place, we talked about KPIs in process, in program management, is that we've also put in a very robust project tracking in terms of how we measure progress, how we measure our estimates execution and making sure that we're progressing these larger orders, how we should in getting them out the door at the margins that we booked them at.

Okay. And just on it seems like you're still getting smaller projects coming in. Can you just speak to what your customers are saying or what visibility you're starting to see on the larger project front?

Yes. I'd say what's - the really good thing in the fourth quarter is that we didn't have many large projects. We had one that was 15, and we just had a whole bunch [indiscernible] that kind of $3 million to $5 million to $8 million bucket. And quite frankly, we can make more money on those and they can get out of our system faster. So ideally, that's the work that we want to fill our shops up. That's the base of the foundational level. And we're pretty excited about the quality of those orders again. On the bigger ones, the bigger they are, the more visibility there is. And quite frankly, it attracts more of our competitors. And it's quite hard to make the margins that we deserve, which is contrary to the complexity and the technology that we're bringing to that solution. So yes, we want to talk about big orders, but I would say more foundational and more important for us is getting this base level of work in that's got some nice calories to it. Now with that, we are seeing in our pipeline, we're seeing more of the large orders in 2018 than we have even at the beginning of 2017. And so we've got a mix of projects. And I would say if we think about regionally, a lot of those are going to be Middle East and some in the - in North America. And when we think about what type of markets they are, we're seeing a lot in the refining space. We're seeing it increase in petrochemical, and then we've got some in the power side as well. And so we're seeing bigger work, new greenfield projects or large expansions now across each of our major served markets.

Our next question comes from John Walsh from Vertical Research.

So I just wanted to come back to the incremental margin question. And if I look at my model, and you guys have been growing sales historically, the gross margin's kind of been in the 35% to 36% range. Obviously, you've done restructuring. We all understand that 2018 has this incentive comp headwind. But when we think about going forward on a more normal basis, is 35% to 40% the right range, a little bit better than where that gross margin was historically? Or could it be something higher or lower than that? How do you kind of think about it relative to your gross margins when you're growing sales?

Yes. So this is Lee. I think what you'll see, and it's going to be a little - when it gets reported, it's probably a little different than what the underlying numbers are. What I mean by that is until we burn through this past due backlog, it's going to be depressed. Once we, I think, clear through that, I think - my view is 33% to 35% at this juncture is probably the right number. Obviously, I think going forward past '18, that number - we should continue to challenge that number and grow that number. But from a top-down standpoint, until we burn through - we'll have a bunch of revenue with very little profit on it, so it gets burned through. It's going to be more kind of in the 30% to 32% range versus the 32% to 35% range.

And the cost headwind is also something that we're dealing with this year.

Yes, Right. Good point. Right.

Yes. And just to add to it, and again, we owe you guys more color on what the future looks like for us. But what I'd say is when we go back to those six categories on where we're going to focus our efforts, supply chain and operations are two of the largest buckets in terms of prices. And so we know there's a large price when we centralize our supply chain and start to get - start to leverage the scale and get better costing on our inbound materials. And so that's one big bucket that we've got to attack that's going to help gross margins, and then the other one is the productivity within the manufacturing. And so that is - we're still having variances there. We have too many people. We've got a lot of things that are just taking too long and costing too much as we think about the manufacturing process. And so again, we'll articulate those buckets in what the price are and what we're doing about it at a future time. But there is significant potential on the gross margin side.

Got you. That's helpful. And then just as a follow-up, as we think about the portfolio and some of the things you're trying to do, is this cut - I don't want to use the word cut, but should we think about continued pruning portfolio actions going forward? And is that kind of part of a new normal?

Sure. I think - if we think about acquisitions and portfolio, we've got to do some things to make sure we've got the right products that are - provides some synergy or integration in terms of - with what we're trying to do in the future. And so with the valve side, we cut out two product lines that weren't core and didn't facilitate what we wanted to do in the long run. So we'll continue to do that, right? We've got - we're looking to move some other product lines out. We've got some opportunities to bring things in. At a general or a higher level, what I would say is right now, flow control is performing well, and I'm confident in that management team and what we're doing. And that's the one we're kind of greenlighting to bring in products or tuck-ins, both on the product development side and then potentially, the inorganic growth side. We've got to fix our ability to deliver new pumps, both in IPD and EPD, before we start to do anything on adding products to that portfolio.

And our next question comes from Josh Pokrzywinski from Wolfe Research.

Scott, I think people have tried to ask this question may be a few different ways, but I know that you don't want to call out incentive comp and it's kind of a cost to doing business, so calling out that discreetly, I respect. But should we think that ex noise with restructuring savings coming and some you've already done, incentive comp probably some other puts and takes from 2017, discrete items that go away, what's the base incremental margin you think this business is at today? And how should we think about that on kind of a pure volume price cost basis?

So this is Lee. We'll try to take another attempt to this one. So again, I think after the noise, and there is a lot of noise, I think - my view is on an aggregate basis, I think 32% to 35% is where we're at right now. But that's - I would say that's a clean number. It goes back to - so we clean up what's currently in our back - the past due backlog, it's going to be muted. And like every business, we're not unique to the standpoint, is every year, you got to deal with inflation, you got to deal with merit, and you got offset that with productivity. And our goal is to obviously have more price, volume and productivity to offset the headwinds. But right now, we're still relatively in that inflection point.

Yes. And just to add, we just provided 2018 guidance. We feel that, that's very realistic guidance, and that's what we're prepared to deliver this year. We owe the investment community what the price is, and when we take these actions, what the potential is. And so we know we've got to do that. And I just said, give us a couple months and we'll come out with what that looks like.

No. I think that's great. And that - the 32%, 35% is really helpful kind of as a clean starting point to calibrate off of. And then just as a follow-up on the - some of the questions on free cash flow and working capital management. I guess, I missed that, and maybe you said it. Is there a target for conversion in 2018?

We did not publicly put a conversion target out.

Safe to say that you guys are targeting something better than in recent years? It seems like working capital is starting to...

Yes. What I said before, it's a huge price, and we know there's opportunity there. We will continue to get better. There's no doubt about that. And just unfortunately, it's all been manual brute force and a lot of heavy lifting from an effort standpoint. And we've got to get a lot smarter about how we attack that. And so we just - as we transition into '18, it's going to be focused on process, systems, tools. We're going to keep that cadence of brute force because that's the way we're managing it, and we'll start to see more improvements in the back half of '18 on our working capital.

Yes. So we're looking at velocity, how quickly are these assets turning. And so for our sales pick up, obviously, there's typically a working capital element to that as sales go up. But we are looking towards to increase the velocity and reduce the investment on working capital.

Yes. And then just to add, again, we've got these six buckets that we disclosed. Working capital is one of the buckets in that the really big focus for us is inventory. We've got a lot of inventory. We've got to figure out what it is, what we're doing with it and then how do we have a much better and robust planning process, both in our facilities and at the platform level. And that's really what we're driving toward in the first quarter of this year.

Our next question comes from Joe Giordano from Cowen.

So I think, obviously, a big part of the story here going forward I think has to be that EPD does not devolve into like a problem that in itself needs to be fixed. So Scott, to your point earlier about we feel good about what we're doing, but there's always been like a thing that pops up. And we've had write-downs in Latin America. We got a project this quarter that went south. So how do we - what gives you confidence that, that is not something that keeps happening every quarter in that business?

Sure. No, it is a real issue, and it's what I'm most concerned about of - what I'd just point to is that we've got a lot of focus and attention on that OE and our ability to deliver work. And the big thing that we did in the beginning of 2018 was this reorganization. And so we've now put an operational manager at each of the platforms to drive consistency across that platform. So EPD now has a Vice President of Operations that is focused on project delivery and execution. And then we also raised the P&L up to a much higher level. And so I've talked about before closer of having kind of 300 general managers and P&L and a lot of complexity. And so for EPD specifically, where we're putting the emphasis in [indiscernible] is on three bigger P&Ls that are regional-based. But what it does is it allows - and I'll just use Americas, for example, what it does is allow that Americas General Manager to provide the right stewardship and consistency across that network of operations. And so those two things, in addition to our project reviews and project trackings in our operational KPI, give us confidence that we move forward. But again, every quarter, I've been surprised by something either on the new equipment with IPD or EPD, and we've got to get that out of our system. And so those are the things that we're doing to get that out. And I'm getting more confident. But again, we're not where we need to be on our ability to execute orders at this point.

And then last for me. The CapEx is going to go up next year off of like a pretty low number. Are you guys - what gives you the confidence that you're spending enough to stay ahead of like the R&D curve? And it's a tough balance when you're cutting and trying to get things in order, but in a very competitive market where small incremental benefits on the tech might win the day. So how do you kind of weigh those decisions and where do you stand...

Yes. It's a good question. We didn't disclose our R&D and where we're at. But let me just start on kind of the '17 CapEx. And so on the '17 CapEx, we basically just stopped spending, right? So when I came in, I wasn't really happy on where we're spending or how we're spending money in the process of our capital improvement. And so we clamped down pretty hard, and that's how we got to this pretty low number in 2017. As we transition to '18, we want to be able to basically keep that maintenance capital in place, and so we've kind of built that foundation of what we think is needed to maintain the level of our business and enterprises. And now, where we're spending - where we moved the capital up in 2018 has been - is all about productivity. So we're doing it with our enterprise-wide IT solutions. And so we're launching enterprise-wide now systems of that are going to start to drive a much more uniform approach and standardization across all of Flowserve. In addition to that, the R&D number does come up. And so a little bit of that improvement in capital has some of the things that we're building from an R&D perspective. The rest of R&D is in expense, and we move - we actually pushed up our year-over-year spending on the expense side with R&D. And so I've talked about this in the original tenets of Flowserve technology or in Flowserve 2.0, but that was the creation of our marketing and technology function. And so we've got a strong leader there, we're spending more money and we've got a much better process of linking where we're spending product development and research money, and combining that with the market outlook and what our customers need. And so I feel really good about our ability to drive forward on technology. So it was a key tenet of the first Flowserve 2.0 discussion. We're not backing down from that. And we're actually spending more money in '18 versus '17.

Our next question comes from Walter Liptak from Seaport Global.

Just to be clear on the Flowserve 2.0, the KPIs, those have been rolled out to the employees now? And are those going to be tied to incentive compensation at like the local level for 2018?

Yes. So what we did - the difference in the incentive plan from '17 to '18 is we made it much more at the business unit and the local level, and we're adding operational performance to the mix. And so while it's super important to have the top line overall operating income and some of the other metrics, we're now pushing down working capital, on-time delivery and revenue and operational income to the local facilities and what they control. So I think that's going to get us aligned in terms of an incentive standpoint, and it follows kind of the KPIs and how we're starting to run the business. And so we made that change for 2018, and it's in place now.

One thing I'd highlight, Scott, we've also simplified the process. Before the - I would say the AIP program was extremely complicated. I'm not sure the deliverables align with investors' interest. And we've completely simplified it to focus on what I think is important to you all, earnings, cash and growth. And so it was a major change of what was done in the past, and I think it's going to correlate more with your interest.

All right. That sounds good. Money can be a good motivator.

Thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating, and you may now disconnect.