Flowserve Corporation (FLS) Q3 2021 Earnings Report, Transcript and Summary

Good day and thank you for standing by and welcome to the Q3 2021 Flowserve Corporation Earnings Conference Call. At this time all participants are in a listen-only mode. Please be advised that today's call is being recorded. [Operator Instructions] I'd now like to hand the conference over to Jay Roueche, VP Treasurer and Investor Relations. You may begin.

Thank you, Justin, and good morning, everyone. We appreciate you participating in our conference call today to discuss Flowserve's third quarter 2021 financial results. On the call with me this morning are Scott Rowe, Flowserve's President and Chief Executive Officer; and Amy Schwetz, Senior Vice President and Chief Financial Officer. Following our prepared comments, we will open the call for your questions. As a reminder, this event is being webcast and an audio replay will be available. Please also note that our earnings materials do and this call will include non-GAAP measures and contain forward-looking statements. These statements are based upon forecasts, expectations and other information available to management as of October 28, 2021, and they involve risks and uncertainties, many of which are beyond the company's control. We encourage you to fully review our safe harbor disclosures as well as the reconciliation of our non-GAAP measures to our reported results, both of which are included in our press release and earnings presentation and are accessible 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.

Great, thanks, Jay, and good morning, everyone. Thank you for joining our third quarter earnings call. There are two key messages that we want to cover today. First, we are confident that Flowserve is on the path to growth after a dramatic pandemic driven downturn. We are optimistic about the future, the positive inflection we are seeing in cycle and our opportunities through energy transition. Second, we experienced a number of challenges in the third quarter with our supply chain logistics and labor availability. These problems had an impact on our revenue and profitability in the quarter, but we believe that we will work through the issues and restore our revenue to a more normal conversion rate in the quarters to come. Let me now move into my prepared remarks. As I just indicated, the third quarter presented a number of challenges, which we continue to navigate, including supply chain logistics and labor availability. These issues were truly global in nature and have had an impact on Flowserve and other global industrials in the quarter. Flowserve had been largely successful in mitigating these issues in the first half of the year, but the confluence of events and the combined impact of the challenges had an adverse effect on our third quarter results. I will specifically address the disruption and inflation challenges with the supply chain later in my prepared remarks. It is important to note that we remain encouraged by the healthy underlying demand that we see across many of our end markets and by the fact that many of our headwinds we experienced in the third quarter are primarily timing related. We expect that our business will return to growth and that the Flowserve team will work diligently to resolve the issues that we faced in the quarter. Let me now turn to our results. Third quarter reported and adjusted EPS were $38.29 cents respectively. The combination of supply chain logistics and labor availability shifted approximately $60 million of expected revenue out of the quarter. Our backlog remains secure and we are confident in our ability to recognize the backlog at a more normal revenue conversion rate in the coming quarters. Our third quarter bookings of $912 million represented a 13% increase over prior year continuing this year's trend of strong year-over-year quarterly growth. Aftermarket and MRO bookings during the quarter were consistent with first half levels while larger award activity continues to remain below pre-pandemic levels. Aftermarket orders of $495 million, increased 16% in our at pre-COVID levels. The aftermarket business is benefiting from the increased utilization rates of our customers assets being driven by improved mobility and increasing GDP levels around the globe. Original equipment bookings increased 9% year-over-year to $417 million. Our project or original equipment business continues to lag in the recovery with less than a handful of larger projects awarded in the quarter with only two project orders in the $10 million to $20 million range. Some of the same macro issues around logistics and supply chain are also impacting the progress of these global projects moving toward award. We remain confident in our pipeline of opportunities and we expect project work to increase from this point forward. Each of our core end markets delivered year-over-year growth in third quarter with oil and gas up 33% while chemical and power were both up 17%. Water bookings were also particularly strong up 46% and included $10 million desalination award. From a regional perspective, bookings growth was driven primarily from North America and the Middle Eastern Africa. These markets were up over 30%. COVID continues to negatively impact Flowserve's and our customers' operations in Asia Pacific, which was the only region not returning to growth thus far in 2021. We do expect our overall bookings to recover more towards our first half 2021 quarterly run rate of approximately $915 million in the fourth quarter. We saw bookings growth in each of the three months during the third quarter and we believe that September's exit rate can restore our bookings levels to those in the first half of year. Project timing will be the key variable for fourth quarter bookings levels. We believe full year bookings will grow year-over-year in the 10% range. This level of bookings growth positions Flowserve well for revenue growth and solid financial performance in 2022. I would now like to return to the operational challenges that we faced in the third quarter. Approximately $60 million of revenue and $20 million in gross profit that we had previously expected to recognize in the period was deferred from the third quarter due to supply chain issues, global logistics and labor availability. We were largely successful in mitigating these types of items during the first half of the year, but as the quarter progress we faced significant issues on all three fronts. Historically challenges like these might affect a few locations in any given period, but in the third quarter we saw a very large number of our global manufacturing facilities and to our fees impacted by the logistic supply chain labor issues. On the supply chain front, we are facing disruption and inflation across the entire value chain. We have done a good job managing our critical vendors for procured items, such as castings, forgings, machining, and large motors. And we are seeing the benefits from the supplier consolidation and the quality work that was completed in the Flowserve 2.0 transformation. However, the broad issues and extension of lead times across essential components like base materials, coatings, small motors, consumables, and electronics have impacted our ability to deliver product to our customers. We have now identified and are mitigating these extended lead times, but there is no immediate fix and we expect further disruption in the coming quarters. To address the accelerating inflation that we saw during third quarter, we have now announced our fourth price increase of the year, which will go into effect at the end of this year to continue our efforts to offset the increased costs on purchase items and logistics in the marketplace. We are in a difficult environment with inflation and cost pressure, but I feel that we've done a nice job balancing enhanced pricing and our pursuit of growth. With logistics, we are getting impacted in three different ways. First, our supply chain is predominantly out of Asia and the ability to ship product from that region to Europe and the Americas is now more costly and less predictable than ever before. Second, it is also difficult to reliably coordinate and schedule product shipments from our factories to our customers. And third, in some cases, our customers are unwilling or unable to schedule pickup or delivery of our products, which impacts the timing of revenue recognition. While we believe the situation with our customers is getting better, we are the most impacted in the latter weeks in the third quarter. Finally, it is hard to maintain staffing in productivity levels in certain parts of the world in the current environment. For example, in China, we're having to hire a significant number of new associates to keep up with demand and to satisfy the emerging local laws. In Europe, labor is especially tight in certain areas, while in the Americas we saw a large COVID quarantine rate during Delta's rise, and it is also a very tight labor market. We are pleased that the heightened COVID cases and related quarantines we saw in the third quarter across our business have consistently declined through October and we are encouraged by this continuing downward trend. We will, of course, continue to focus on the safety of our associates as we have been since the start of the pandemic. We are actively working through each of these disruptions and we expect it'll take a few quarters for us to adjust to the extended supplier, lead times, the disruption and logistics and the issues with labor availability before we return to the more normal operating model. Additionally, we have not seen nor do we expect an increase in cancellations from our backlog. So, our revenues are there for us to deliver in the coming quarters. Following our third quarter results and with the assumption that these issues will impact Flowserve in the fourth quarter and likely into 2022, we adjusted our 2021 full year guidance metrics yesterday. As we indicated in yesterday's press release, our revised adjusted EPS range is now a $1.40 to a $1.45. I will now turn, call over to Amy to cover our financial results in greater detail.

Thanks, Scott and good morning, everyone. Looking at Flowserve’s third quarter financial results in greater detail our reported EPS of $0.38 exceeded our adjusted EPS at $0.29 due to a $16.6 million discreet tax adjustment from the reversal of certain deferred tax liabilities. Partially offsetting the $0.13 gain on taxes, our adjusted EPS also excludes [indiscernible] items, including realignment expenses, below the line FX impacts and certain costs incurred in our debt refinancing. During the third quarter, we took advantage of the favorable debt markets to solidify our liquidity and financial flexibility for years ahead by pre-funding upcoming debt maturities. We amended and restated Flowserve’s senior credit facility by extending the maturity of our revolving credit facility by two years and enhancing the financial flexibility we have under it, as well as lowering the ongoing commitment fees and in including a sustainability linked options to enable further cost reductions as we progress our ESG objectives. In addition to the revolver, we also obtained a $300 million fully drawn term loan, which included participation from a minority owned depository institution in addition to most of the syndicate banks and the revolver. We sincerely appreciate the support of our historic and new banking partners in both facilities and look forward to working closely with them in the years ahead. In September, we also accessed the debt capital markets and issued $500 million in new 2.8%, 10-year senior notes. We value the confidence of investors in this offering as well. In October, we used all the proceeds from the term loan in senior notes, in addition to some excess cash together, totaling $842 million to fully redeem our senior notes with maturities in 2022 and 2023. Now I'd like to return to our third quarter financial results. As Scott mentioned, the third quarter was impacted by supply chain, logistics and labor headwinds that delays roughly $60 million of expected revenue out of the quarter. These issues primarily occurred late in the third quarter. Revenue decreased 6.3% to $866 million largely due to the deferred revenue I just mentioned. All-in, we had an 11% decline in original equipment or OE sales driven by FPD’s 20% decrease, but partially offset by FPD’s 2% increase. Beyond the challenges in the third quarter FDP continues to be impacted by its 2021 beginning OE backlog, which was down roughly 25% versus the start of 2020. Aftermarket sales remained relatively resilient in total down, roughly 1% where FPD’s 12% increase was offset by FPD’s 3% declined. Turning to margins, our third quarter adjusted gross margin, decreased 190 basis points to 29.6% primarily due to the OE sales decline and the related under absorption, particularly at our engineers to order sites in both segments. The other previously mentioned disruptive impacts as well as higher logistics costs, which increased 25% year-over-year. These headwinds were partially offset by a 3% mix shift for higher margin aftermarket sales. On a reported basis, the gross margin decreased about 160 basis points to 29.3% was driven by the factors previously mentioned and were partially mitigated by the $3 million decrease in realignment charges versus prior year. Third quarter adjusted SG&A increased $7.4 million to $200 million versus prior year, primarily due to a $3 million increase in expense related to our incurred, but not reported potential reserves, increased R&D spending and returns from travel costs, which were a temporary benefit in 2020, as well as headwinds from foreign exchange. Reported SG&A was flat with a prior period as these increases were offset by $7 million decrease in adjusted items and discipline cost control offset the return of some of last year’s temporary cost benefits. Third quarter adjusted operating margins of 7% decreased 390 basis points year-over-year as in FPD’s adjusted operating margins. Primarily due to increased under absorption related to its 20% OE revenue decline, FPD’s adjusted operating margin decreased 170 basis points year-over-year to 10.5% due to sales mix and slightly higher SG&A as a percent of sales. We expected sales volumes to normalize that margins will improve. And to that point had Flowserve not experienced the $60 million revenue deferral our adjusted operating margins would have been flat to modestly up on a sequential basis. Third quarter reported operating margins decreased 280 basis points year-over-year to 6.6% where the previously discussed challenges more than offset the $10 million reduction of adjusted items. Our third quarter adjusted tax rate of 15.2% was driven by our income mix globally and favorable resolution of certain foreign audits in the quarter. The full year adjusted tax rate is expected to normalize in the 20% range. Turning to cash and liquidity, our third quarter cash balance of $1.5 billion reflective of the debt refinancing discussed earlier, as well as solid cash flow performance in the quarter. Our net debt position of $652 million at the end of the third quarter has declined by over $300 million in the last three years. We believe a bright spot in our third quarter financial results is our continued progress on cash flow. On a year-to-date basis, through the third quarter, operating cash flow of $151 million is up nearly $37 million versus the prior year. While free cash flow of $117 million has increased 73% or $49 million over the prior year. In the third quarter, we delivered $78 million or approximately 67% of our year-to-date free cash total. This third quarter performance is up versus the comparable period in 2020, despite voluntary funding of a $20 million pension contribution during the quarter compared to no funding a year ago. We are pleased with our improved cash flow performance year-to-date. And with our typically, seasonally strong fourth quarter ahead, we are confident in our ability to stay on pace to deliver a free cash flow conversion of over 100% of our adjusted net income once again in 2021. Working capital with a cash source of $56 million in the third quarter and a $47 million increase versus last year. Accrued liability, prepaid expense and continued improvements in our account receivable process where the major contributors this quarter. As a percentage of sales, primary working capital saw a modest 40 basis point sequential increase to 29.8% due primarily to the market disruptions in the quarter. Both CSO and inventory turns were roughly flat sequentially. I would also like to highlight our disciplined inventory management. For the third consecutive quarter, our combined balance of inventory and contract assets and liabilities decreased while backlog continued to increase and despite holding elevated work and process and finished goods inventory at quarter end due to the logistics challenges. Since year end 2020 backlog has increased $115 million while inventory and contract assets and liabilities have of decline $16 million. Major usages in the third quarter include dividends and CapEx of $26 million and $11 million respectively. As I just mentioned, we also contributed $20 million to our U.S. Cash Balance Pension Plan to keep it largely fully funded. In the fourth quarter major uses expected includes a completed retirement of the 2022 and 2023 senior notes, the $26 million October dividend, and a higher level of CapEx spend. Turning now to our outlook for the remainder of 2021. Based on the supply chain and logistics challenges that arose and accelerated late in the quarter, its impact on our third quarter earnings and the expectations that these conditions will persist. Flowserve revised our full year 2021 revenue and EPS guidance ranges. We now expect a full year revenue decline of 3.5% to 4.5% and reported an adjusted full year EPS of $1.05 to $1.10 and $1.40 to $1.45 respectively. To briefly cover our thought process. We expect the revenues and income that were deferred out of the third quarter to be largely realized in the fourth quarter. However, we expect the challenges of the third quarter to continue industry wide for the next few quarters. So, we are assuming the fourth quarter has a similar deferred revenue impact to what we just experienced. This coupled with the impact of the strengthening dollar on our non-U.S. denominated sales particularly the Euro resulted in lowering our expectations for full year 2021 revenue. We do expect that the fourth quarter will have the traditional closer for fourth quarter seasonality with strong revenue conversion. However, we do not expect that revenue and the associated profit will be fully caught up at year-end. Our adjusted EPS range continues to exclude expected realignment expenses, as well as below the line foreign currency effects and the impact of other potential discrete items, which may occur during a year, such as the premium and fees to incur to retire the note. In terms of other guidance metrics our net interest expense remains unchanged at $55 million to $60 million, and we modestly lowered our full year adjusted tax rate guidance to approximately 20%. From a booking standpoint, we now expect full year 2021 bookings to increase in the 10% range year-over-year. Additionally, we continue to expect the majority of this increase will come from our aftermarket and shorter cycle MRO original equipment products. The major core categories of our full year cash usages include the October debt retirement, dividends and share purchases of roughly $120 million, capital expenditures in the $65 million range. The third quarters pension contribution and the funding of our now model three alignment programs. In conclusion, while our third quarter was impacted by supply chain, logistics and labor headwinds, we view these primarily as transitory. The backdrop for our traditional markets looks positive. There's an increasing interest in our energy transition offerings, and we continue to build momentum in our operational and cash flow progress. With a solid and growing backlog and to progress by the broader industry in managing the supply chain and logistics headwinds, we believe that Flowserve is well positioned to deliver earnings growth in 2022. Let me now return the call with Scott.

Thank you, Amy. Before addressing our outlook to the remainder of the year and some early thoughts on 2022, let me first provide an update on our strategic initiatives. While current conditions are increasingly favorable for our traditional energy markets, we are taking steps to best position the company for the energy transition that is already underway in which presents a significant long-term opportunity for Flowserve, our shareholders and all stakeholders around the world. To support our efforts, we have increased our strategic focus on three major themes: decarbonization, digitization, and diversification to accelerate our growth in 2022 and beyond. We continue to identify significant energy transition opportunities and applications where we have been supporting our customers for decades. As we focus on lower carbon energy production, we are investing in technology to advance our customers aspirations, including additional capabilities within: carbon capture, hydrogen and energy storage. We are still in the early innings of tapping into this growing market and our third quarter bookings included over $25 million of energy transition work, including: biodiesel conversions, solar power projects, and energy efficiency upgrades. Our project funnel for energy transition continues to grow, demonstrating we have the flow control products and expertise to support our customers today and through their energy transition journey. I'd like to highlight a few examples of our third quarter booking success stories. Flowserve selected to provide pumps and seals for a sustainable aviation fuel project in the Netherlands. The facility will produce sustainable aviation fuel that when compared with the fossil jet fuel has the potential to cut lifecycle emissions from aviation by up to 80%. Additionally, we will remain active on the facility for years to come ensuring the lowest total cost of ownership with the inclusion of Flowserve's lifecycle advantage aftermarket solutions. Our pumps and seals were also chosen recently for a biodiesel conversion project in United States. Flowserve helped compress the engineering and approval time from a normal 12-week – 12-month cycle to seven months supporting an earlier plant startup in delivering a faster payback. The project is expected to reduce CO2 emissions from diesel production by up to 600,000 tons per year. In addition, our vacuum pump technology was selected to support a leading provider of thin film technology for the production of solar power panels. [indiscernible] will provide equipment for new facilities in the U.S. and in India, reducing the overall power consumption, maintenance downtime in the [indiscernible] require. Finally, let me update you on the progress of RedRaven, our IoT offering launched earlier this year, which instruments pump, valves and seal systems to provide the capability to assist our customers with a data driven approach on how to improve their operations, increase asset up time and reduce associated energy emissions. We continue to expand the RedRaven instrumentation across product portfolio in the quarter and further increase access for our customers while developing the distribution channel. We are currently working with over 40 customers and have connected nearly 5,000 assets; while we are still relatively early in the rollout customer interest continues to increase. Turning now to our outlook for the remainder of the year and our positioning as we think about 2022. With bookings continuing to improve in October, we are confident in the market outlook as we close out the fourth quarter and plan for 2022. As I indicated earlier, we expect fourth quarter bookings to be roughly $950 million, depending on the level of project activity. By achieving this level, our 2021 bookings will deliver a 10% year-over-year growth rate. Based on current market conditions we also expect year-over-year bookings growth to continue in 2022, based on our discussions with our customers, EPC backlogs and our project funnel. We believe that the lessening impacts of the pandemic combined with increased energy demand, growing de-carbonization and energy transition opportunities and global economic growth create a compelling view of our markets. Additionally, with increased utilization, coupled with energy prices that are well above pre-pandemic levels, we expect that our customers will continue their aftermarket in MRO spending as well as return to their capacity expansion plans across our served end-markets. A project funnel remains well above prior year levels, providing confidence that while the timing of the return of these larger project remains uncertain. We expect that many will ultimately move forward in 2022. All of this gives us increased confidence in the flow control market striving bookings growth throughout 2022. Additionally, we believe that our added focus on de-carbonization, digitization and diversification will only enhance our growth outlook. Looking both near and longer term, energy transition investment will provide strong opportunities for Flowserve. While we continue to support our customer's traditional applications, we believe we are well positioned to support our customer's energy transition initiatives. Operationally I'm confident that we have the team and the tools to work through the third quarter challenges. Flowserve 2.0 has provided the visibility and business processes to address these issues and our teams are currently working to resolve and mitigate the issues that arose in the third quarter. Longer term, we expect the opportunities from our served in markets combined with our improved operational execution and an embedded continuous improvement culture will enable Flowserve to deliver on the longer-term targets we introduced during our last Analyst Day. In closing, we believe that with the expected return to growth and continued execution improvements, Flowserve will be well positioned to deliver stronger incremental margins and overall financial results. We believe in the company's long-term ability to achieve our original targets, including operating margins in the 15% to 17% range, ROIC of 15% to 20% and to continue free cash flow conversion in excess of 00%, which we've already demonstrated. Our focus remains on supporting our customer's, execution and capitalizing on improved markets to drive long-term value for our shareholders and our stakeholders. Operator, this concludes our prepared remarks, and we now like to open the call to questions.

[Operator Instructions] And our first question comes from Deane Dray from RBC Capital Markets.

Thank you. Good morning, everyone.

Hey Deane. Good morning.

Hey. Just appreciate all the specifics here. And maybe we start with the line of sight on that $60 million revenue push, and that's pretty consistent. We've heard from a number of your peers on just the logistics are not being able to get those products out the door. But I'm curious to hearing a bit more on the assumption for the fourth quarter kind of a repeat, is that more of a placeholder or have you really done kind of a bottom-up analysis of what you can or may not be able to ship in the fourth quarter?

Sure. I'll start, and Scott can add some color. I think to start with, one of the frustrating things about the challenge that we experienced in the third quarter is, if it did occur quite late and it wasn't with our – wasn't with our major components. So, there was an element of this that was very late occurring, which makes it somewhat difficult to plan in the future. What we do have really good line of sight on is that the $60 million of deferred revenue has largely shipped or will ship in the fourth quarter. And so, as we were looking at fourth quarter revenue projections, we thought it was prudent at this point to assume that we were going to see a similar deferral out of the fourth quarter as well, just based on general congestion in the fourth quarter in our line of sight to these continued challenges.

Yes. I'll just add on that to Amy's points, a lot of this built throughout the third quarter and really came to roost in August and late September. And so, we're still wrestling through this. We don't think we're – well we know we're not out of the woods. We know that there's still challenges ahead and we put guidance out there in the fourth quarter that's for the best of that site in the viewing that we have. We are working through all of the resolution actions right now. And every week that goes by, we get more and more certainty on what we can do in Q4 and 2022.

Got it. I appreciate that caller. And then look, one of the bright spots in the quarter is on free cash flow and appreciate the, the details being provided. And Amy, I don't know if you intentionally did this, but you said once again will be above 100% free cash flow conversion like its routine because a couple years ago it was not routine at Flowserve. And that was an area that from a quality of earnings needed to improve and the improvement is really coming through now. So, look, a lot of heavy lifting was done over the past couple of years, but Amy, from your perspective, what are the structural changes that have made this hopefully a more permanent conversion of at least 100%? Is it working capital efficiency, asset utilization just kind of take us through it? What has made this from your perspective should be more a routine that we should see from Flowserve?

Yes. I'm really proud of the efforts that the team across both platforms and functions that put into improving our working capital performance. And that has been really key in the improvement and free cash flow conversion. And so, this really started with the cash collections process with our invoicing and collections process, centralizing that, getting insight into performance where we needed to focus our efforts using standard processes and systems to do that. This year and last year the focus has really been on inventory management and that's not been without challenges, but I think that this quarter is an excellent example of the work that the team – that the team has done in trying to manage both a growing backlog and inventory management in the process. I will tell you given the deferral of revenue that we had at the end of the quarter, if you would've told me that inventory could have improved sequentially, I would've been extremely surprised, but I think it's just an indication of the efforts that the team has put into that and the process around planning from a demand standpoint and what that means on the shop floor.

Great to hear. Thank you.

Thank you. And our next question comes from Damian Karas from CBS. Your line is not open.

Hi, good morning, everyone.

Good morning.

I'm fortunate to see some of the supply chain headwinds hit you guys, but good to see on the flipside; the bookings continue to look good there. Was wondering if you could maybe give us some additional color on how the bookings are trending through October. I'm just curious thinking about the $950 million, how much project activity if any at all kind of, do you need to get there?

Sure. So right now, we feel good about the $950 million. It is dependent on projects coming through and getting booked at the end of the year. We feel really confident on the aftermarket run rate and our MRO spending and so that's been consistent all year thus far. Our aftermarket number in the Q3 was solid. And it's right at that kind of $500 million level, which is that pre-pandemic level. And so, we feel really good on aftermarket and MRO continuing, and typically at the end of the year, we see a little bit of an uptick from Q3 to Q4 there. And so, I think that will help as well. And so, it all comes down on whether these projects get booked and that operators have the confidence to move forward with those. And what I would say is, normally I would be incredibly confident with this, but as lead times are changing and as prices are continued to get adjusted, I think some of our operators are hesitant to pull the trigger on the very large projects. And so, we've got a few planned in our numbers, but what I'd say is we've risk adjusted that right now. And we believe more of the larger projects will happen in 2022. And so, it's really just a matter of, kind of this $5 million to $10 million range of projects coming through at the end of the year. We're currently optimistic on that situation. We know they have to do this work. They're committed to it. It's just a matter of will they pull the trigger by the end of the year or will it rollover to 2022?

Okay. Got it. And I guess thinking about all the moving pieces now with a decent chunk of deferred sales, which are going to show up in 2022 now and then the price cost dynamics, how should we be thinking about incremental margins when you return to growth next year?

Sure. So, with respect to margins, we do think that volume is key in expanding those margins as we make our way through the fourth quarter and into 2022. The mix that we actually currently have in our backlog is favorable to margins growth. If you go look at the mix between aftermarket and original equipment, what we'd like to see is some strength in those OE bookings. So, at our large engineer to order factories in particular, we get those volume levels up to cover some of our absorptions, and obviously that will be really helpful in expanding margins. So, one thing that, that I would say is that our SG&A performance has been solid. So, as we see those growth margins stand we're going to see a lot of that drop to the operating income line item as well. Given the work that's been done with respect to SG&A.

Okay, great. Thanks for taking my questions.

Thank you. And our next question comes from Andy Kaplowitz from Citigroup. Your line is now open.

Good morning, everyone.

Hey, Andy, good morning.

Scott, obviously we have what amounts to an energy crisis in several parts of the world. As you speak with your customers, do you think they can still defer CapEx in 2022 as they have in 2021? Then as you look at your major end markets, can you give us some more color into where you expect to see the most bookings growth in 2022? Is it chemicals, could you see a revival of L&G, being more traditional power related work? Any more color would be helpful?

Sure. Yes. Adding to your first point, Andy, I don't think operators can hold capital spending any longer, and so we feel pretty confident on the product spending in 2022. It's a little shocking that it hasn't happened already, but in talking to them, we know there's a lot of projects on the books, there's expansions and there's new projects as well. And so, I really do believe that 2022 is the year that kind of unlocked that. As we think about regions, the middle-east is certainly a big region that we'll spend lots of money and we know that there's major projects on the books that are well positioned for. We also know that Asia Pacific will move forward with additional spending in infrastructure and so we're excited about India, obviously India got hit significantly in the second quarter and I think as they're kind of reemerging from the COVID crisis that they have, they're relooking their project plans and their investment schedules. And then there's also work here in the United States, and so there's still infrastructure that's got to get built out. And then when we look at, in market – the in markets that we really like would be L&G would be one, there were no major project awards for us in the third quarter, but there could potentially be some in the fourth quarter, but also as we know for sure things will go forward in 2022. And then on the chemical side, we have seen an uptick in growth there and our products that support specialty chemicals like vacuum and some of our other smaller pumps and valves have done well this year, and we expect that to continue to go as we go forward. On the refining side, I do think there'll be investment more on the, just kind of the general upgrade's and just making sure that the assets run as well as possible. I don't expect major capital redeployed in new refineries or big expansions with the exception of China in some parts of Asia. I think overall with the – just the power situation where oil places are, where natural gas prices are, countries, customers, operators are all looking for things to invest in and move forward to solve some of the challenges that the world is seeing right now,

Very helpful color. And then can you tell us what the ultimate impact of price versus cost ended up being Q3? I know you said last quarter that you announced the price increase at the beginning of the Q3, but you also had said that you wouldn't see a benefit until early in 2022. You just announced another price increase for the end of the year here. So ultimately when do you think price versus costs could turn positive for Flowserve?

Yes, it's a really good question, Andy. And I'd say that there's a lag when we announced to when we can realize it's anywhere between a month or two pending our contracts and how we – how aggressive we can get it into our customers. But so right now, I'd say, Q2 was slightly negative. We were certainly negative in Q3. We saw a significant inflation throughout the quarter in many of our commodities and components. Now, we have announced the fourth price increase, which will go into effect at the end of the year that will be a pretty significant increase and we expect that to come through January 1, 2022. And so, I think we're doing a reasonable job, but we're probably – again, two months behind maybe kind of eight weeks to 10 weeks behind. And so, we'll catch up as the year finishes out into 2022. The other point that I do want to make is a large percentage of our business is the engineered pumps and the engineered valve and the pricing on that truly is a cost-plus model. And so, we build up the costing as we see it, and we can typically get solid quotation from our vendors and suppliers that they'll hold in a contract. And so, on that side of the business, we're actually doing well. We're tracking our margins and our expected margins, and we're confident that we've got margin improvement in the backlog as we think about 2022. So, again, overall, I think we've done a nice job on price cost, but it's just an incredibly challenging environment right now. And we're seeing some of the inflation across some of the things that we're trying to buy. It's just – it's tremendous, like what you're seeing 50%, 70% increases across commodities that you would never expect this type of inflation on. And so, we've got to stay diligent. We'll continue to work this, but overall, I feel like we're in a reasonably good position on price costs.

I appreciate it, Scott.

Thank you. And our next question comes from Josh Pokrzywinski from Morgan Stanley. Your line is now open.

Good morning, guys.

Hi, Josh.

Hi, Scott. So, one thing that we've kind of talked about over the last few quarters that has been kind of a surprising too on your size the distributor inventory. I would imagine and what have historically been kind of the IPD business where that was fairly low and you were anticipating at some point had been to restock. Maybe now is not the exact time because of the supply chain issues, but what progress, if any, were you and those customers able to make on that replenishment over the quarter?

Sure. Yes, distribution is a really important part of our channel in the market and it's exceptionally present in North America. And so, we talked to our pump distributors all the time and our valve distributors. And what I would say is their bookings have certainly increased in Q2 and Q3. And so, we're seeing that restocking happening now. As you can see it in our numbers that comes through on the MRO and aftermarket side and the general industries category that we breakout. And so, we feel good about what's happening over the last two quarters, and we're confident that there's more to come. We're looking at some of our distributor inventory levels. They're still not at that pre-pandemic level. And so, we know that they're going to continue to move their inventory levels up to support their overall business. So, I think, that's certainly a bright spot for us and it's come through and it chose up again in that aftermarket MRO and in the general industry bucket. And we expect more, more growth to come as we think about fourth quarter and into 2022.

Got it. That's helpful. And then just on 2022, I mean, obviously the macro environment has been way different than you guys would have expected a few years ago when you put out the margin targets. But project activity seems like it's been kind of the biggest surprise, I guess, like what I'm struggling with there, and maybe you can sort of help rank order the opportunities that remain, the project activity doesn't seem like it's super high margin. And yet, it's clearly had a bit of an impact on where you guys would have seen those margins come out? Can you help square up maybe, like, where do you see kind of the biggest opportunities or gaps relative to where you thought you might've been a few years ago?

Yes, let me – I'll start and then I can let Amy answer that, but it really is what we wanted strong aftermarket and MRO growth, which what we're seeing this year that does have a positive margin mix. And so that's now going to start to come through the system. And then on top of that, we want to help the project business that will be at a little bit lower margins, but what that gives us a significant absorption in our sites. And we're missing that right now. And so, we're having to deal with under absorption and it's coming through the P&L and it's definitely has a headwind in the margins as we can grow that side of the business, we feel a lot better about our ability to get the absorption in a much better place and start to see margins come up. Probably Amy has got more details on that.

Yes, I would say, Scott, spot on thematically there. I think from a margin perspective, we believe that we're really in the trough of a downturn here and it's driven by two things and mitigated by one. And so, the two things that are impacting us right now on the OE side are really the fact that the volume isn't set off in a level and this does impact us in terms of our margin performance. And the second piece is that the OE sales that we're experiencing right now were booked at the height of the downturn. So, as we think about that pricing environment, it was very competitive as we made our way through the second, third and fourth quarter of 2020. And that is – we are feeling that in our OE margins today. The mitigation of this is really the fact that the mix, as Scott has indicated, it's been quite favorable for us in 2021 in terms of both our bookings and our sales. So as this OE volume gets back to even some kind of normalized levels away from the 18% to 20% down and we built that backlog and as we will in the fourth quarter and into 2022. We are going to see margin expansion.

All right, that's helpful. Thanks team. Good luck.

Thank you.

Thank you. And our next question comes from Joe Giordano from Cowen. Your line is now open.

Yes, good morning.

Hi, Joe.

Good morning.

Hi. You mentioned earlier, Scott, that cancellations haven't happened yet, so you feel comfortable there. Just the longer that these supply chain things linger, like what gives you confidence that that's not just like the next thing that's going to happen as a logical extension of all these problems that people are just like a lot of these projects just have to go out longer.

Yes, we typically don't see a lot of cancellations in our backlogs and the delays that we're experiencing are weeks, not months. And so, I really don't expect cancellation of backlog. And so, I'm fairly confident on that. I'd say probably the bigger concern that lead times push out and costing gets higher that our customers are going to relook the project environment to make sure that it's a financially viable project. And so, I think that's kind of the risk. We haven't heard that from a lot of customers yet, but we do think that there's some concerns there that that's a potential that could happen or a risk. But cancellations in our backlog, I really don't see happening.

And then as far as the energy transition stuff, it's a nice – it's a thematic area to be, it's growing for you guys, but it's still certainly not the perception of the company. Like what's your appetite to accelerate that in like a bold way, maybe through some – like an acquisition, you have the balance sheet to do some stuff. So, how fast are you willing to move on that to make it like something that people really focus on?

Yes, so it's a really good point and it's something we're very focused on. And so, this year we're already at kind of $125 million to $150 million of bookings. Hopefully, we can finish here about $200 million of bookings in this space. And so, we're committed to this. And what I would say is our internal employees are really excited about this direction and being a part of something that can really solve the major issues around the globe. And then we're seeing from our customers that we've got a flow control operating that that really does fit in some of the things that they're doing. And so, we've spotlighted a couple of awards this quarter around the biodiesel conversion, sustainable aviation fuels, solar power. And so, what we've done now is kind of retooled all of our internal product development in R&D to make sure that we can have an offering in a full control solution in this type of atmosphere. And so, all of our R&D and new product development is now focused on either diversification, decarbonization or on the digital side. And we've been doing that now for over a year. And so, we've kind of pivoted all of that effort there and really stood up designated teams now to support our business development activities around energy transition. And so, I think, I'm not going to say we're all in on this, but we are pretty committed. We're confident that the outlook is a significant growth engine for us and will grow faster than the current markets that we're participating in. And so, we're going to continue to put the resources and the efforts there that we can capture a big share of the spending in the flow control space associated with energy transition.

And I might just touch on that from an acquisition standpoint. I think the first question that we ask as we look at any sort of opportunity it doesn't align with the strategic focus areas and there as Scott defined in his prepared remarks around decarbonization, digitization and diversification. So, it doesn't give us a bigger piece of that going forward. And then obviously as we move on from there, we have to ensure that it lines up and it is financially attractive and drives shareholder returns. So, I think that strategic question, we feel that that can be part of the answer for us going forward, but it needs to align closely with that strategy and drive the financial results that we want to see.

Thanks guys.

And thank you. And our next question comes from Joe Ritchie from Goldman Sachs. Your line is now open.

Thank you. Good morning, everyone.

Good morning.

So, I'm wondering as maybe just talk about the 4Q guide for just a second. When I kind of try to put some numbers into my model and maybe I'm doing this wrong, it seems to imply like a pretty good sequential margin improvement in both of the segments. And so just trying to understand, what's kind of driving the sequential margin improvement. I know volumes are going to be higher in the fourth quarter. But any color you can give on that, and then specifically for each of the segments, that would be great.

Sure. So, a couple of things, one you’ve heard me now probably say three or four times over the course of the call that we do think that volume is a pretty important element in us improving our margin performance. And it certainly the loss of that $60 million certainly had an impact on our margin performance in the third quarter. So, a fair amount of backings is driven by that volume increase. The other element that I would say that comes into play is this mix issue that we continue to talk about. So, as we look at the backlog and it is focused on aftermarket and that resiliency in the aftermarket booking that is driving in both of our segments some of the volume expansion quarter-on-quarter.

Got it. So, I mean it’s fair to say that sequentially incremental margin should be like 35%, 40% from 3Q to 4Q?

We see, although we're not guiding specifically on that, we're seeing margins expand quarter-on-quarter and absolutely.

Okay. And then maybe just one quick follow-up on, and I'm assuming your customers clearly understand kind of the environment that we're in. But I'm curious on some of these deferred shipments, are there any penalties associated with those shipments, just given the environment that we're in customers are kind of understand the backdrop.

Yes, sure. The penalties cause liquidated damages. What I'd say is right now with the current environment, our customers have been somewhat sympathetic to the DLDs. There are times when we've had some significant issue within our facility, that's delayed something, and those will come through the system. We had a little bit of that in the quarter, but I'd say the disruption that we're seeing right now primarily is not impacted with the liquidated damages. Most of the delays really were on our smaller products rather than some of the bigger projects that would have the formal liquidated damage provisions. And so, a lot of the delays that we saw were in our valve business on just kind of one off or two off valves in the MRO side, we saw delays in our aftermarket business and ability to get services and workout and typically that wouldn't care liquidated damages. And then we saw it in our seal business as well, that typically wouldn't carry liquidated damages. And so, a lot of this disruption has just been that kind of broader set of our more basic type of products rather than the projects that you carry that. But it's a good question. The LDs are part of the big projects, but I feel confident our ability to mitigate that just with conversations and open dialogue with what we're seeing with the supply chain and other things.

Got it. That's helpful. Thank you.

Thank you. And our next question comes from John Walsh from Credit Suisse. Your line is now open.

Hi good morning.

Good morning, John.

Good morning, John.

Hi. Maybe just first question, going back to kind of what it looks like as we go into 2022 if you hit your orders kind of guidance here as we go through the end of this calendar year, does that alone give you kind of enough visibility that we won't have any kind of under absorption issues next year, or do we need to see kind of the orders follow through into Q1 and Q2 to kind of get past any concerns that there could be under absorption on the larger project business or the engineered project business?

Yes, so I'll start there. I think we still need to see some uptick in that original equipment business in both the fourth quarter and in the first and second quarter of next year, much of that work can start it's generally under percentage of completion accounting. So, we start to, we start to be able to absorb some of those costs pretty quickly as those orders come in, despite the fact that we may not ship it for some time in the future. So, the fourth quarter is important, but the first half of next year will be important as well. And ultimately the mix of the business obviously is understood in being some of the driver of that. We want to continue to see the strength in aftermarket and MRO, but we want to see that supplemented with some of this project business coming back into play.

Yes. Just the other thing I'd just add is we're not done with our route by an optimization. And so, we continue to look at that and have some facilities and apply some of the work that we did in Flowserve 2.0. What we're seeing is our ability to enhance productivity, which in turn increases our capacity. And so, as our capacity increases at the sites that are our preferred sites for manufacturing, pumps, valves, and seals, then we can start to look at further rationalization. And so, we've been doing kind of anywhere from four to two consolidations a year. We'll continue that pace into the future, which will additionally help on the absorption side.

Great. Thank you for that. And then, almost maybe as a look back I guess you guys have been active on the governance side this year. I can go back to an 8-K earlier this year where you got rid of the super majority approval on some things. You've also put out your ESG report. It seems to be pretty active on the governance side. Could you just kind of help us understand kind of the catalyst behind some of those things?

Yes, absolutely. No, I appreciate you pointing that out. We have a slide in the presentation, and so I encourage everyone listening to go to our slide and look at some of the things that we're doing on ESG progress. This is something that's very important to me. It's important to our Board and to our shareholders. And so, we're very focused on this. And to your point, we've made great progress in our governance structure – really, since I've been here and we've done that with a broad succession, we've done it with tightening up some of the different things around our governance and making it more normal or more kind of where we would want within the governance framework. Additionally, on the ESG side, we put out what was our first ever ESG report this year. Traditionally, we had called that the sustainability report and we spoke it's really on the environmental and sustainability side. And so, in 2022, it was really last month we put it out was the first ESG report. So again, I'd encourage you to go to our website where you can find that. And we talk about, there are progress on reducing carbon emissions. We talked about what we've been doing on the social side with our employees which really is around KC, it's around diversity, equity and inclusion. And it's really taking in the community aspect of poster cares and making sure that we make a positive impression in the communities where we live and work. And then on the governance side, we've already talked about some of the things that we'd move forward with. But this is something that's in the forefront of all of our discussions with our board. And we want to make sure that Flowserve purely is doing its part with ESG and having a positive impact in the communities where we live and work.

Great. Thank you. Appreciate you taking the questions.

Thank you. And our next question comes from Andrew Obin from Bank of America. Your line is now open.

Yes. I guess good afternoon now. Thank you for fitting me in.

Right, great Andrew.

I guess it's still morning for you guys there. So more of a philosophical question, right, so how does this sort of tug of war works between you and your customers, right, because they are facing labor shortages on certain shipments and you guys are sort of saying, they're not going to be cancellations. I totally appreciate it. You guys clearly for you, there is this tug of war between absorbing volumes, absorbing fixed costs and being aggressive on pricing. So, in terms of contract structure and pricing dynamic, could you give us an insight how do you find middle ground with your customers, right, because they clearly want to make sure you are healthy and able to ship this stuff, right. And you don't want to give away your product for free. So, if you could just, what are the conversations like in this crazy environment? Thank you.

Yes. I want to start by thank you for your last comment there and pointing out that it is a crazy environment. So, we'll go back to 2020 with the COVID pandemic that hit us dramatically in February, and March and April the business was there about 20%. And the good news is we have a long list of historic customers that we have partnerships with. I had steering committee and strategic discussions with a lot of our top customers and they truly are partners. And so, I think that's probably the most important thing, is that they know and recognize the value that Flowserve brings to their installation, to their operations, into their future and we recognize the importance of them in everything that we do here at Flowserve. And so, I think, it starts with that. But the other thing I'd want to point out is like, this is happening to everybody in the space on a competitive standpoint. And so, we're not alone and we're all experiencing the same pressures. But it is an incredibly dynamic environment, right? So COVID last year and now you're still facing issues this year. And now we're seeing that the entire the supply chain shock as all companies around the world are starting to move back and re-emerged from this recession and push forward is it's causing this massive spike in a massive disruption across the supply chain. And so, our customers are sympathetic. We've got to continue an open dialogue with them. We have to be transparent with what we're doing. And I'd say we're doing a much better job of that at Flowserve than we ever have. And so, we'll continue to have those open dialogue. We'll continue to be transparent with the issues that we're facing. And at the end of the day, we're going to make sure that we do the right things that support the long-term growth for Flowserve with the partnerships, and then making sure that we can drive shareholder value over the long run.

Thank you. And just a follow-up question. I don't know if you've heard anything about it, but we've been reading that this energy crisis in China is making them reassess some sort of lower and more power consuming industries. How does that impact I guess the flow industry, right? Because a lot of, sort of more generic products coming out of China, a lot of casting in portions that coming out of there. Is there any impact from the policy? Have you had any conversations with your suppliers? Does it impact the competitive dynamic? Thank you.

Yes, we haven't seen any significant impact. We're seeing close with our suppliers there and as of now it's been okay. I mean, we're still dealing with the logistics issues and things to get product into Europe in North America, but nothing on that front at this point.

Thanks so much. Thanks for fitting me in, as I said,

Yes, thank you.

And thank you. And ladies and gentlemen, this now concludes our program. This concludes today's conference call. Thank you for participating. You may now disconnect.