Flowserve Corporation (FLS) Q1 2022 Earnings Report, Transcript and Summary

Good day and welcome to the Q1 2022 Flowserve Corporation Earnings Conference Call. Today’s conference is being recorded. At this time, I would like to turn the conference over to Jay Roueche, Vice President, Investor Relations and Treasurer. Please go ahead, sir.

Thank you, Sarah and good morning everyone. We appreciate you participating in our conference call today to discuss Flowserve’s first quarter 2022 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 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 May 3, 2022 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 our 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.

Thanks, Jay and good morning everyone. Thank you for joining our first quarter earnings call. I want to start with an overview of our bookings and then quickly turn to our global operations in the first quarter results. Clearly, the highlight of the first quarter was our success in capitalizing on the improving demand environment, including the award of several midsized projects, which contributed to Flowserve achieving its highest bookings level since the second quarter of 2019. First quarter bookings of $1.09 billion increased 15% over prior year and about 18% on a constant currency basis. This level was also up 12% sequentially compared to last year’s fourth quarter, which was the highest bookings quarter of 2021. As a later cycle company, we are encouraged by the demand improvement that we have seen in our served end-markets this year and our ability to profitably win those opportunities. Based on the trends we are observing today, we believe that these market dynamics will remain strong in the coming months. Let me now turn to our global operations. The first quarter was significantly more challenging than we had anticipated in mid-February. Throughout the quarter, the global operating environment got worse and inflation accelerated. The combination of supply chain constraints, logistics disruption, labor availability headwinds and significant inflation inhibited our ability to serve our customers and recognize revenue. As a result, increased under-absorption and higher costs eroded the margins in the quarter. The Russian-Ukrainian situation added further complexities to our operations. Together, these factors, combined with general volatility, drove our backlog conversion performance significantly below historical norms. In the quarter, our conversion fell to just 41% with all regions and facilities impacted at similar levels. To put that number in context, our 2021 backlog conversion averaged 46%. We are taking significant actions to restore our revenue conversion rates to historical levels and improve our overall margins. Everyone in our organization, including myself, is fully focused on working through this challenging situation. We have implemented revenue cadence meetings at all levels of the operation, created tighter teams for problematic categories and other procured items, enhanced our planning capabilities, accelerated our recruiting to fill open positions, and finally, implemented our second price increase of 2022, which is now in effect. Additionally, we have removed distractions and delayed internal programs to allow our operational teams to remain completely focused on running the business. While the challenges are large and the external environment remains highly dynamic, I am confident in our ability to work through these issues. We have a talented team who had been working tirelessly to support our customers and our company. I want to personally thank the Flowserve associates for all of their recent and future efforts for their commitment to Flowserve during this volatile time. Let me now return to the details of our first quarter results, starting with bookings. MRO activity was solid during the quarter, which supported our delivery of 18.6% year-over-year growth in aftermarket bookings. The $542 million of aftermarket awards we obtained in the first quarter marked the highest quarterly bookings level we have secured since 2014. The growth in aftermarket bookings represents a positive contribution to our full year financials and it comes with – as it comes with higher margins and shorter cycle times than our original equipment work. Last quarter, we have discussed the significant opportunities presented by larger projects that had been placed on hold by our customers due to COVID-related impacts in volatile commodity pricing. We are pleased that Flowserve was awarded several midsize projects in the first quarter of this year, each about $30 million in size, plus a larger award of around $50 million. These projects spanned across several of our traditional end markets, including LNG, mid and downstream oil and gas and nuclear power. The return of this more normalized market environment, coupled with our efforts to capture the available opportunities, drove our original equipment bookings growth to 11.5% or $544 million. We also generated bookings traction through our new 3D growth strategy, which we launched at the beginning of the year. This strategy was implemented to take advantage of the changing landscape and to accelerate Flowserve’s growth. It is our focused effort to further diversify our end markets, assist our customers on their decarbonization journey, and capitalize on the digital movement within Flow Control. We made great progress in the first quarter as our dedicated teams capitalized on each aspect of the strategy. Looking ahead, I am confident that we can deliver improvement in our traditional end markets as well as accelerate Flowserve’s growth through the new 3D strategy. I will speak further to this strategy in some of the progress we have made on it later in my prepared remarks. This quarter’s strong bookings generated a quarter end backlog of $2.2 billion, which is the highest level we have had since the third quarter of 2015 and is up 18% year-over-year. Further, we are encouraged by the level of MRO aftermarket 3D and traditional project opportunities that we see on the horizon. Taken together, we believe these factors position Flowserve well for revenue growth and improved financial results moving forward. Looking now at our bookings performance by end market. In our largest served market, oil and gas, first quarter bookings were up over 36% year-over-year. This improvement was driven by over $120 million of project bookings as well as several awards from our 3D growth strategy. Power bookings were solid increasing over 65% compared to prior year and included some fairly significant nuclear aftermarket and OE project awards, representing bookings in excess of $70 million. Water bookings, a key part of our diversification plans, also provided year-over-year growth of 12%. General industry bookings were down 6%. And finally following last year’s strong performance, chemical bookings were essentially flat year-over-year. From a regional perspective, our first quarter bookings growth was driven primarily from the Middle East and Africa, Europe and North America, which were up 51%, 45% and 9%, respectively. Asia-Pacific was essentially flat, while Latin American bookings declined 12% versus last year. Turning now to first quarter results and operations. As you will recall, we indicated on our last earnings call that the quarter would be soft and it was. We faced a very challenging operating environment driven by further supply chain, logistics and labor availability headwinds and costs, all of which were exasperated by continuing COVID impacts. We experienced a number of significant direct and indirect COVID impacts in the quarter. First, roughly 20% of our associates contracted the virus in the first 6 weeks of the year. This was a higher infection rate than we had seen in each of the full years of 2020 or 2021. While the Omicron variant’s severity and duration of illness was much lower than what we experienced in prior years, the effect on our and our suppliers, employees and facilities, particularly in North America and Europe, rippled through our supply chain and operations. In addition, with the higher number of our associates impacted, we authorized significantly more overtime for those available, adding further costs. We also utilized much more heavy airfreight than normal to minimize the impact to our customers. While we took as many extraordinary actions as possible, the combined factors disrupted our ability to complete and ship product at our typical cadence. Omicron subsided in North America through March and April. However, our cases in Europe currently remain high, particularly in Germany, where they reached their highest level in April since the pandemic onset. Also, the current lockdowns in China are impacting our local Chinese operations and a large percentage of our supply chain, which further exasperates the issues with global sea freight as the Shanghai ports remain closed. The conflict in Ukraine began right as we were reporting our fourth quarter results. Since that time, it has continued to add further complexity to our operating environment. Our team has dedicated significant time and effort in addressing the issues arisen by it and the various impacts it has on our business. Amy will cover the financial details, but we made the decision to permanently cease the operations of our Russian subsidiary. We have also stopped accepting new orders for Russia entities and canceled or suspended fulfillment of existing orders in our backlog. In addition to the financial impact of these challenges, there will be an ongoing opportunity costs associated with lost potential new awards, revenue and profit, but we are firm in our decision to end our activity in Russia. While Flowserve does not operate – or have operations in Ukraine, we have provided humanitarian support through our contributions and the actions of our European associates. In addition to these ongoing issues, global logistic lead times and availability deteriorated throughout the quarter even as the transportation costs were increasing on higher energy prices. The rapid inflation we saw in the first quarter has led us to increase our full year inflation expectations by nearly 50% above what was originally planned at the end of the year. We now expect the full year cost to procure items to increase in the high single-digit rate year-over-year with the electronics, motors, raw materials and freight being the most impacted. Over recent weeks, I have visited at least a dozen of our sites to review the operations and ensure teams are best prepared to navigate the current environment. Flowserve is particularly complex as we operate in over 50 countries, have a significant supply chain presence in China and other parts of Asia and move products and components from site to site within the Flowserve network. As I stated before, we are 100% focused on unlocking the revenue available from our highest backlog level since 2015 and improving our margin performance. We have the work under contract already, and we are determined to mitigate the current conditions, shift the product and recognize revenue. Before I go into the outlook for the remainder of 2022 and the details of actions we are taking to support revenue growth and to deliver improved margin performance through the remainder of the year, let me first turn the call over to Amy to address our financial results in detail and our updated guidance.

Thanks, Scott, and good morning, everyone. As Scott just discussed, we are pleased with our success capturing awards in the current strong demand environment and building our highest backlog level since 2015. With that said, we continue to face a number of challenges in the first quarter that impacted our financial performance. Let me walk you through some of the key drivers of our results. Our adjusted EPS of $0.07 in the first quarter was primarily impacted by lower-than-expected revenue of $821 million and the related under absorption. The light revenue was due primarily to continued supply chain and logistics headwinds and labor availability disruptions, driven by COVID absenteeism and pockets of tight regional labor markets. The Russian-Ukraine situation and the current lockdown in Chinese ports further impacted our ability to ship in the quarter. On a reported basis, our loss per share this quarter of $0.12 reflected $0.16 per share impact related to our decision to fully exit from Russia. We also adjusted for below-the-line FX losses of $0.04 and very modest realignment gains. As we described in our 10-K filing and press release, we are taking actions to close our Russian QRC as well as terminate our contractual obligations in the country, resulting in a predominantly non-cash charge of $20 million. Associated with this action, we also removed about $25 million from backlog on existing contracts we have or anticipate we will cancel. As Scott highlighted, our comprehensive flow control portfolio, combined with our strong customer relationships were key in supporting our ability to leverage the end market improvement we’re seeing. This combination drove nearly 15% bookings growth year-over-year or 17.6% on a constant currency basis. FPD’s strong bookings growth of over 20% in both original equipment and aftermarket orders was the primary driver, including our capture of several delayed project orders in the oil and gas and nuclear power markets. FCD contributed modest constant currency bookings growth. And as you may recall, FCD typically benefits from project work a quarter or two later than FPD given its comparatively shorter lead times. Additionally, you will recall that FCD saw a nice recovery last year in its MRO business. So it represents a more challenging comparative period. Flowserve’s first quarter revenue declined 4.2% or 2% constant currency, impacted by the previously discussed operating headwinds and included low single-digit declines in both FPD and FCD. While we clearly have the work available in backlog, supply chain and logistics issues as well as the labor constraints limited our ability to ship and record revenue. Both segments’ top line declines were geographically driven by Asia Pacific and the Middle East, Africa and Europe, while the Americas contributed high single-digit revenue growth in both FPD and FCD. From a sales mix perspective, OE shipments, as would be expected, were more impacted by the operational headwinds with both FPD and FCD down mid-single digits. Shorter cycle aftermarket sales were less affected, down a modest 2.8%. Aftermarket accounted for 53% of sales in the first quarter of both years. Turning now to margins. First quarter adjusted gross margin decreased 370 basis points to 26.7%, with FCD and FPD contributing 510 and 290 basis point decline, respectively. The decrease was primarily driven by approximately $26 million of expense related to under-absorption due to lower revenues as well as the previously discussed material and logistics inflation and labor shortages as well as the frictional costs we incurred to minimize disruptions to our customers. On a reported basis, first quarter gross margins decreased 380 basis points to 25.5%. This was due to the headwinds discussed earlier, plus the $10 million of charges related to our exit of Russia, which together offset the $9.6 million benefit of decreased realignment activity versus prior year. First quarter adjusted SG&A was largely flat with prior year on continued tight cost management but increased 130 basis points as a percent of sales to 23.9% due to the lower revenue levels. Our improved cost structure has Flowserve well positioned to leverage the expected near-term growth that we plan to deliver as we work through labor and supply chain headwinds and increase our backlog conversion rates. On a reported basis, first quarter SG&A increased a modest $8 million year-over-year, which included $10 million of Russian-related charges, partially offset by the $4 million decline in realignment expenses. First quarter adjusted operating margins of 3.3% decreased 480 basis points year-over-year with both FPD and FCD down roughly 350 basis points driven primarily by the decline in adjusted gross profit. First quarter reported operating margin decreased 560 basis points year-over-year to 0.9%, where the previously discussed challenges and Russian related charges of $20 million were partially offset by the $14 million reduction of realignment spending. And on taxes, our first quarter adjusted tax rate of 22.2% was in line with our full year guidance of 20% to 22%. Turning to cash and liquidity, as we had forecast on our last earnings call, first quarter operating cash was the use of $27 million primarily due to a build in working capital of $64 million. With the $226 million in sequential backlog growth, we used roughly $50 million for additional inventory and net contract assets and liabilities to prepare for the new work and to increase our safety stock as we work to capitalize on the strong demand environment we are seeing in our served end markets. As a percent of sales, first quarter working capital improved to a modest 20 basis points year-over-year to 29.4%. And while the strong bookings environment and backlog growth has driven increased inventory, I am pleased that our focused inventory management drove sequential and year-over-year decreases in total inventory, including net contract assets and liabilities as a percentage of backlog by 130 and 740 basis points to 32.2%, the lowest level since the second quarter of 2019. In spite of our seasonally lower first quarter cash flows we maintain a strong liquidity position, including $576 million of cash and $384 million of available credit facility capacity. Finally, other significant uses of cash in the quarter included a discrete foreign tax payment of $30 million, dividends of $26 million, capital expenditures of $14 million and term loan amortization of approximately $8 million. Turning now to our revised 2022 outlook, we are adjusting our guidance ranges based on a number of factors, including the ongoing supply chain and logistics challenges, hiring challenges in certain key locations, the opportunity cost of lost Russian work and the continued COVID-related lockdowns in China and the disruption it’s causing in their ports and global supply chain. The headwinds are partially offset by what we expect to remain a stronger demand environment. As a result of these factors, we now expect full year adjusted EPS in the $1.50 to $1.70 range on full year revenue growth of 5% to 7%. The revised revenue range is not only impacted by the loss of expected revenue from Russia but also by the impact of the strengthening U.S. dollar. Clearly, our revised guidance represents a significant improvement compared to our first quarter results. Key assumptions to our outlook include modest progress towards our historical backlog conversion rates as well as the impact of our latest price increase beginning to benefit us in the third quarter. Supply chain-driven delays are also expected to stabilize as we exit the second quarter and then eases further through the second half of the year. Additionally, we expect shipping conditions to improve and gradually return to normal, including at the ports in China, which are currently impacting our customer and supplier shipments as well as our internal site-to-site supply chain. The adjusted EPS target ranges exclude $20 million of charges related to our exit of Russia and our expected modest realignment expenses of approximately $10 million as well as potential future items that may occur during the year, such as below-the-line foreign currency effects and the impact of other discrete items, such as acquisitions, divestitures, special initiatives, tax reform laws, etcetera. Including the Russian exit charges, expected realignment spending in the first quarter below the line FX impact, we now expect our reported EPS in the range of $1.25 to $1.45 per share. Both the reported and adjusted EPS target ranges also assume current foreign currency rates, reasonably stable commodity prices, the continuation of current market conditions, no significant improvement in the Russian-Ukraine conflict and expectations for our customers to continue to release larger project work in the second and third quarters. We also continue to expect net interest expense in the range of $45 million to $50 million and an adjusted tax rate between 20% and 22%. You can find all of our guidance metrics in our press release and earnings deck. In terms of phasing, considering Flowserve’s traditional second half-weighted earnings and cash flows, our results in the first quarter, we now expect this pattern to be more pronounced than our initial guidance assumed as supply chain, logistics and labor availability issues are expected to improve throughout the third and fourth quarters. And as our revenue conversion accelerate, absorption levels improved and frictional costs are reduced, we expect to exit the fourth quarter with operating margins in the low double digits to low-teens. As such, due to both the expected ramp in volume and sequentially improving margins, we are forecasting nearly 80% of our full year earnings range will be generated in the second half of the year. Turning to our expectations for major planned cash usages during the year, we continue to expect to return over $100 million to shareholders through dividends. We also intend to further invest in our business with capital expenditures in the $60 million to $70 million range, including the continued build-out of enterprise-wide IT systems to further support our operational and productivity improvements. Additionally, we will continue to invest in our 3D strategy to diversify, decarbonize and digitize, where we delivered solid Q1 bookings progress related to energy transition and other targeted markets. Let me now return the call to Scott.

Thanks, Amy. I want to first provide an update on our progress delivering on our 3D growth strategy and close my remarks with our commitment and actions to meet the revised 2022 financial targets. As I outlined last quarter, our strategy to diversify, decarbonize and digitize or the 3D growth strategy supports and aligns directly with Flowserve’s long-standing purpose statement to provide extraordinary flow control solutions to make the world better for everyone. To be clear, we continue to fully support our customers in the traditional markets, where we continue to expect long-term growth. Our 3D strategy is designed to allow us to capitalize more broadly on the opportunities available within the entire flow control space by addressing our customers’ increased focus on efficiency and providing the flow control solutions that enable the energy transition journey. We believe this strategy will help us deliver accelerated and outsized growth while also providing improved resilience for Flowserve’s business model through various end market cycles. Before highlighting the progress we have made in each of the strategic pillars, I want to note the passion and support for the strategy I’ve seen from our associates and our customers. The diversified leg of the strategy includes aggressively targeting and expanding the reach of our offering in previously underserved regions and markets that exhibit attractive long-term growth prospects like water, specialty chemical and other general industries, where we maintain strong capabilities. Specifically in the first quarter, we supported a specialty chemical manufacturer in China by supplying a variety of Flowserve valves to be used in the production of engineered plastics for automotive and electronics industries. We also formed a partnership with Gradiant, a developer and supplier of advanced water, wastewater and desalination systems. Flowserve is supporting Gradiant with flow control technology and products to provide efficient and reliable water systems. The partnership is designed to provide us opportunities in previously underserved regions and positions us extremely well in various water markets and project opportunities. Next is our decarbonized strategy. This is an effort to capitalize on and assist in our customers’ carbon and energy reduction efforts. Flowserve is uniquely positioned to enable the full control aspect of decarbonization, CO2 emissions reduction and flow loop energy efficiency. As an example, we were recently awarded a project in Europe utilizing Flowserve’s pumps and the recycling of plastic waste into sustainable chemicals for use. Upon completion, the facility is expected to convert over 1 million tons of plastic waste annually into sustainable chemicals. Flowserve is also supporting carbon capture and storage, which is an area where we have supplied flow equipment to oil and gas operations for decades. The increased use of this technology in other industries over the coming decades is expected to play a significant role in the world’s decarbonization efforts. We were recently awarded a contract to supply our control valves for a portion of Norway’s first cross-border and open-source carbon capture and storage facility. This is an exciting project, and it is the first project to capture and permanently store CO2 at a large scale. Flowserve will apply our flow control knowledge and expertise to this project and leverage this experience on future CCUS projects. Finally, the digitization effort represents our focus on the growth opportunities driven by our RedRaven IoT platform and the value it creates for our customers. While the offering has only been in the market for a little over a year, we continue to gain traction with new and existing customers. We are currently operating in 45 customer sites across our core end markets. We have now intubated nearly 1,500 pumps, valves and seals with RedRaven. In the first quarter alone, the system provided over 4,000 alerts or notifications to customers, which triggered incremental aftermarket product and service opportunities for Flowserve. In one example, we recently deployed our RedRaven technology on an offshore application in Malaysia. As part of a long-term service agreement with a major oil and gas customer, we are instrumenting 56 pieces of critical flow control equipment across 12 of their offshore platforms. We will continue to focus on instrumenting our existing installed base as well as new equipment with the goal of converting our solution to a profitable recurring revenue stream providing increased pull-through of aftermarket opportunities. Turning to our market outlook for the remainder of the year, as I mentioned earlier, the global macro picture in our pipeline of run rate and project opportunities supports our expectation that we will continue to see strong demand from our customers as we move forward in 2022. We believe the improved project environment we delivered on in the first quarter will continue for at least the second and third quarters. However, should inflation and interest rates increase beyond current expectations, project investments and awards in late 2022 and 2023 could become pressured. Regardless, we do expect utilization rates of our oil and gas and chemical customers to remain high, providing strength to our aftermarket and MRO business. We will also continue to capitalize on energy transition investment and 3D opportunities, which are driven by climate change targets and ESG commitments as well as an increasing significant desire for energy independence. The conflict in Ukraine and Russia sanctions has only accelerated the desire for energy independence in both traditional energy markets as well as new cleaner energy sources. We continue to have more discussions and have seen new projects added in this space as the world repositions away from Russia into a more secure source. We are now attracting over $450 million of energy transition opportunities in 2022. This amount does not include the significant ramp we have seen in proposed LNG opportunities or in the potential growth in nuclear we see over the next couple of years. Flowserve’s broad flow control offering supports our customers’ energy transition ambition as well as provide for flow control technology to support the goal of energy independence. Significant energy investment is expected in the coming years, and Flowserve is well positioned to capitalize on this growth regardless of the energy source. Before closing, let me confirm that our most urgent near-term priority is converting our strong $2.2 billion backlog at a more normal conversion rate while expanding the realized margins. As Amy and I both indicated earlier, the decline in the percentage of backlog conversion to revenue, coupled with the frictional costs we incurred to work through the many recent challenges had a significant impact on profitability in the first quarter. As we exited 2021, we were roughly price/cost neutral following several price increases and surcharges. With the rapid inflation we experienced in early 2022, the 5% price increase that we implemented to begin the year was not adequate to cover the increases in incremental cost we expected to incur in 2022. To return Flowserve back to at least neutrality, we recently announced and implemented our second price increase of 2022, which we expect will begin flowing through in our third quarter financials. However, we would note that only about half of our sales are price list driven and benefit from these increases, while the other half of our work is typically either priced under a cost-plus model or under long-term agreements. We are also repositioning and expanding our supplier base where appropriate to mitigate the expanded lead time environment and provide more certainty around delivery predictability. We are further updating our planning tools, enhancing our strategic inventory with forward purchases and expediting critical materials and components. In closing, while the first quarter was a truly unprecedented operating environment for Flowserve, we are working with a sense of urgency to address the challenges facing the business. We continue to expect that Flowserve will deliver solid bookings in this market, and I’m confident that our leadership and operating teams are prepared to navigate through the current market headwinds impacting our operations. We expect to drive substantial sequential quarterly improvement in our financial results, which should position us for a strong back half of the year and to enter 2023 with strong momentum. The second quarter is a critical first step, and I feel confident that our team will deliver meaningful progress in the second quarter. Most importantly, we have the highest level of backlog in years, so the work is there for us. We have a strong leadership team and dedicated associates committed to delivering for our customers and for our shareholders. Additionally, the near-term demand outlook remains strong for our traditional markets, and we believe our 3D strategy progress will only accelerate our growth trajectory. In short, the market fundamentals of our served end markets remain strong and Flowserve is well positioned to drive long-term value for our associates, customers and shareholders in 2022 and beyond. Operator, this concludes our prepared remarks, and we’d now like to open the call to questions.

Thank you. [Operator Instructions] And we will take our first question from Deane Dray with RBC Capital Markets.

Thank you. Good morning, everyone.

Good morning, Deane.

Hi, first, congratulations on the order growth and a couple of questions there. Did you get a sense that there were any share gains in winning those orders? And can you take us through, qualitatively if you could, the embedded margins in backlog today parse between OE and aftermarket? Thanks.

Sure. Thanks, Deane. Yes, we’re excited about the bookings level in Q1. And like we said, there is a nice mix of both aftermarket and projects. What I would say on the pricing side or the embedded margins on both sides of these, on the original equipment, we’ve been very focused on making sure that our pricing does accommodate the latest cost increases. And so I think we’ve seen – we will see a nice progression there. And now what we’ve got to make sure is that, that frictional cost of delivery doesn’t erode those margins. And so again, I think we priced it well. We’ve just got to execute and streamline that execution without some of the frictional costs that we saw in Q1. And then I’d also say the mix of projects and we spotlighted this, like LNG and nuclear and other type of work, does contribute higher margins in some of the other end markets. And so again, we feel pretty good about the margins that we booked in Q1 certainly on the project side. And then on the aftermarket side, we feel good about the margins in backlog there. That should be up as we think about what’s happened in that product and it is much shorter cycle. So typically, on the aftermarket side, we’re delivering anywhere between 2 and 6 weeks and so our ability to price for that accurately and minimize the disruption in the operations feels really good right now. And then with $540 million of aftermarkets, we get a nice tailwind on the mix as well. And so net-net, we’ve got to execute. We’ve got to eliminate some of the frictional costs. But if we do that, that gross margin in the product should be there and should drive higher margins as we think about 2022.

And do you think you gained share?

Yes. Sorry, I didn’t answer the share one. Look, yes, it’s hard to say in one quarter for when you’re losing on share. But those were very competitive projects that we won, and we feel good about taking that and taking that work. And so that part, we feel good, and we certainly won the work that we targeted. And then on the aftermarket side or the MRO side, I think at $540 million, that level does suggest that we’re winning share in both our seals and the valve MRO. And so we feel good about our ability of winning share in those two parts of our business.

Got it. And just as a follow-up question, where is the weakest link in the sourcing side for you all today? Is it concerns about China and the shutdowns? Because the extent to which you’re moving product, sourcing product, is that the area of base concern?

Sure. It really is, and it’s primarily around Asia, Deane. And so Flowserve has a large percentage of our supply chain is tied to China and Greater Asia. And so as we think about that and not only trying to get products out of there to support our existing businesses in Asia but actually exporting that product around the world, it becomes really difficult for us. And so we have an extended supply chain there. The current disruptions of Shanghai in that region are certainly impacting our ability to get that product into our sites and our operations. And so that’s really the challenge. And what we’re working on is repositioning to more local or regionalized suppliers. We’re now qualifying new vendors that are closer in proximity to our operations. And then we are working hard to get product out of China. And that’s, right now, unfortunately, very, very difficult. But we’re finding ways to get different aspects of product out of there. And within China, I think there is a couple of key components that are really important to us. The first would be electronics. And so a lot of the electronics are coming out of China. Secondly is motors. And while we’re buying our motors predominantly from big name European and U.S. type companies, a lot of the subcomponents in the motors are coming out of China. And then third, we’ve got a large portion of our castings tied to China and India. And so that longer supply chain on castings, which is basically the foundation for all of our product in pumps and valves, becomes a source of concern as we’re moving that product over a longer and extended routes into our manufacturing in North America and Europe.

Thank you for all that color. Appreciate it.

Thank you. And next, we will move on to Andy Kaplowitz with Citigroup.

Good morning, everyone.

Yes. Hi, good morning, Andy.

Scott, you had mid-teens bookings growth in Q1 versus the guidance for the year. I think you had was high single-digit bookings growth. Do you see the rate of bookings growth in Q1 continuing or could even accelerate from here? And I know you mentioned inflation as a possible headwind on awards. Are you hearing that from customers? And then obviously, your oil and gas bookings and your power bookings took a nice jump in terms of percentage of bookings in the quarter. So maybe you could give us some more color into how you’re thinking about LNG, nuclear power opportunities going forward.

Yes. Andy, we’re in a really interesting time here on bookings. We feel really good about the activities out there. And clearly, Q1 was a nice start to the year. We’ve got great visibility to projects. And so we’ve had that now for a couple of quarters. Some of those kind of slipped a little bit more than we expected. But we’re now starting to see those line up. And part of that is that underinvestment we’ve seen over the last 2 years. And so I feel good that those projects continue to move forward. There is many that are very close to FID. And then you couple that now with what’s happening in Russia and Ukraine and this strong desire for energy independence. And so this is going to drive LNG – well, I’ll say it will accelerate LNG dramatically, and we’re seeing that. We saw awards in the first quarter, and we expect more awards in the back half of the year. In fact, our pipeline in LNG just for Flowserve products is over $300 million. It’s the largest we’ve seen in a very long time. In addition to that, we saw nuclear work in the first quarter, and we expect further nuclear work in 2022. Our pipeline on nuclear is up as high as we’ve seen in over a decade. And so I think this desire for energy independence is absolutely going to help us on the booking side. The concern, and I put this in the prepared remarks, is that at some point, the inflation in interest rates factor into the viability of these larger projects. And what I don’t know right now is when do we start to see that. What I’ll say is our customer discussions right now are not indicating any slowdown. They indicate that the business continues to move forward and they continue to spend money. But at some point, the price of putting one of these large-scale projects together will overcome the returns when you’re in an inflationary environment of high single digits and change that we saw in the first quarter. And then let me also address the MRO and aftermarket. We had a really nice number there in Q1. And I think the current utilization rates of both the refining and the chemical sector as well as the other aftermarket MRO work that we do, I don’t see that going backwards here throughout the year. I’m not sure it accelerates dramatically, but I certainly think we can hold this level of aftermarket business as we progress through 2022.

Scott. That’s very helpful. And then let me ask you a follow-up to Deane’s question. He asked about China, but let me just ask you in general about the second half earnings ramp. You mentioned modest progress in terms of backlog conversion, but are you assuming conversion gets back close to normal levels at some point in the second half? And I think your frictional costs, you called out, were almost $20 million in Q1. What’s your expectation for how frictional costs will trend in the second half of the year?

Yes. I’ll let Amy answer that. She’s got the bridge on our forward look for the year.

Yes. So I think as we think about that earnings ramp up, a couple of things to keep in mind. I mean, one, generally, Flowserve is typically between 55% and 65% second half weighted from an earnings perspective. So certainly, getting out of the gate with $0.07 of adjusted earnings is automatically going to weight our earnings more than that towards the second half of the year. We are not assuming that in the back half of the year that things get back to normal. But we are assuming a couple of things happen as we look at that. One that, the supply chain situation stabilizes and improves modestly. So, we are going to see lead times get back into the – stabilized during that period of time. And we also suspect that logistics will stabilize and improve slightly. From a conversion rate perspective, we are not anticipating that we get back to historical levels. But once again, we are expecting modest improvement in those conversion rates. So, even with what we are anticipating in the back half of the year, particularly in the fourth quarter will be well below our historical rates. From a frictional cost perspective, there are two things that we can do that will be incredibly impactful for us in terms of limiting those frictional costs going forward. The first is, as we mentioned, the COVID absenteeism and those pockets of regional labor shortages, getting that labor to a more stabilized level in those areas. And the second is around cost choices with logistics. So, our ability to stop expediting everything and choosing the most effective way to transport materials to our sites will be important. We are anticipating that with this last price increase, we are going to largely cover any other inflationary impacts that we are seeing over the course of the year. And then the last comment I will make and a really long answer, I recognize, is that as we have talked about these large project bookings increasing and that OE mix – and that OE market returning, that’s incredibly helpful to us in terms of having our plants to operate at a more optimal level. So, did some of the under-absorption issues that we have seen both last year and that were exacerbated this quarter by some of the supply chain issues and the labor shortages. We are going to see those improve sequentially over the course of the year, which is going to help us expand our margins.

Appreciate all the color.

Thank you. Next, we will take our question from John Walsh, Credit Suisse.

Hi. Good morning and thanks for taking the questions. Good morning. Maybe first question, appreciate the H1 to H2 earnings commentary. Can you help us understand what the sales split that’s associated with that is just so that way, we can calibrate how you are thinking revenue growth sequentially from the first quarter?

Sure. So, certainly, sales similarly are going to be second half weighted, but not to the extent of earnings. So, as we start to see things normalize or stabilize, maybe a better word over the second half of the year, we are anticipating that those incremental margins improve sort of in excess of that revenue growth as we see stabilization.

Great. I mean I guess maybe if I ask it differently, do you see sales sequentially growing each quarter as you go through the year? Is that how we should think about the revenue cadence?

Yes. So, I mean I think you could draw a line. Second quarter will be more than first quarter and third quarter the same. And fourth quarter, as is traditionally the case, will be our highest quarter of the year. That’s traditionally been the case. That was the case in 2021. And we will see that pattern continue. I will say at the fourth quarter revenue levels, it’s certainly levels that we have operated at in the not-so-distant past. And we feel confident that we should be able to deliver on.

Great. And then maybe just a question more broadly around managing supply chain. Can you just remind us as an organization where you are managing that from? Is it at the corporate level? Is it down at the business level, the segment? And then kind of maybe any kind of cadence on meetings that would go up to the C-level?

Yes, for sure. John, I would say we are – like we manage our supply chain like many others. We have got a group that runs the central supply chain that’s at the corporate level. It’s not an incredibly large group, but what their job is to set the strategy on supply chain. They also do category management and they do supplier quality as well. And so when you think about like adding suppliers or managing our large partner and preferred accounts, then that team would do that activity. And then embedded in each of the divisions is their own supply chain organization. That would be responsible for executing at that divisional level. And then really, the more tactical procurement and management of the orders resides at our manufacturing plants. And so we have got it kind of tiered. And then I would say from a meeting cadence standpoint, we went from 2 years ago, where I would never have to sit in on these type of meetings to where now we are doing a weekly meeting with the Presidents and the Head of Operations and Supply Chain to make sure that we are working through this as efficiently and as effectively as possible. And so we have got a ton of visibility to where we are challenged. And we are putting different programs and things in place to start to restore that. We put a slide in the deck that talked about the short-term and the long-term things that we are doing and the initiatives to focus on supply chain. But I would say, really, it’s – everything is on the table. We have put more resources towards expediting. We put more resources to category management. We formalized some of the things that were, I would call, maybe not as formal as it used to be. And then we have actively qualified new vendors that are closer in proximity to our different regions where we operate. And then on the longer term, I would say this – we have been working on this now for six months to nine months. But on the long-term, we know we have got to reposition our supply chain to more regional focus. And so that won’t happen overnight. But it’s an area that – we know that we have got to do this. We have already started to reposition and create more redundancy and resiliency in the supply chain. And then secondly, we have got to enhance our strategic relationships and our partnerships. And we did a lot of this work in Flowserve 2.0 to create what we call partners and preferred suppliers. And essentially, that’s just having more of a partnership under managed spend rather than having reactionary purchase orders. And so we are expanding that. we are basically now really looking at how do we have even deeper relationships and partnerships with the right suppliers. And so all of those things are going. And then finally, the other big thing is just continuing to advance or enhance our planning tools and competencies. And so in an uncertain environment, planning becomes absolutely critical as a competency that Flowserve has made good progress over the last 5 years on, but it’s something we have got to continue to invest in and get better in. And so we are spending a lot of time talking about how we plan our work and planning for the future.

Great. Appreciate the detailed answers. Thank you.

Thank you. Next, we will take our question from Nathan Jones with Stifel.

Good morning everyone.

Hi Nathan.

You have got the whole situation going on with China at the moment. And I think we probably have barely even started to see the ripple effects of what that’s going to do to supply chain in 2Q, 3Q, 4Q today. You are talking about stabilization and maybe some modest improvement in supply chain in the back half of the year. Is there anything that you are seeing at the moment that lead you to that conclusion, or is that just an assumption that you are building into the way you are guiding investors out there at the moment?

So, Nathan, I would say, clearly, we are seeing some stability. Amy put this in her comments and one of the answers. Stability is probably the first step that will allow us to do what we think we can do to improve revenue and drive better conversion. We are seeing that in parts of the world and in some of our commodities, where things are – it’s not necessarily getting a lot better, but they are getting more predictable. And we are not seeing the changes in lead times, and we are seeing the more accurate deliveries from our suppliers or from the logistics side. So, I do think things are settling down. We definitely need that to progress as we go forward. The single biggest concern for us right now is China and the unlocking of the Shanghai area. So, today, our facilities in Suzhou remain open. However, it’s very difficult to transport product or people anywhere within – in that region in China. And so there is definitely additional risk if we don’t see China open up at some point in Q2. So, our assumption is that we do open up in Q2. We have got good visibility to what we need in the orders and the demand in there. If it doesn’t open up in Q2, then we have additional risk in the back half of the year.

And just to give a little bit more color on that. With respect to our segment reporting, FCD, in particular, is exposed to China in terms of the product that they produce, both internally at Flowserve sites and from a supplier perspective. The same is actually true with India. And although the situation in China remains what I would call uncertain at best, we do see the situation, particularly from a logistics perspective, out of India improving and providing a bit of a tailwind for that particular segment.

And then a follow-up question on pricing. The short-term MRO kind of business is not the focus here. It’s on some of the perhaps project business that was priced last year under a cost-plus model. What’s your ability to go back and extract price out of that, or are we just expecting as those projects deliver here that the margin is going to have been eroded by inflation in those projects? And are there any kind of counter measures that you are embedding into new contracts to try and counteract the potential for further inflation?

Yes. No, it’s a good question. So, just for everyone’s benefit, our project business, where we do cost plus pricing, that’s an area that we have been very focused on to make sure that we can deliver the margins that we look at. And so the first step is before we booked the project, we do secure pricing from our prime suppliers. And so this would be our big castings, our motors and the big components there. And so at the time of booking, we feel very good that we have locked in that cost profile for the large projects. Where we get – where we have seen some erosion here recently in the last six months has been on a lot of the smaller things that we normally wouldn’t have to worry about from an inflationary environment. Now, those make up a smaller percentage of the cost, but they are certainly offsetting some of that margin potential. And so the things that we are doing within the projects, one is our quote validity has now shortened substantially. And so if we do see things change on a general basis, we are able to adjust that and make sure that we can get that pricing into the project. Secondly, we are now putting inflationary metrics into those quotes on the very large projects. Now, what I will say is that it’s difficult to do on the smaller projects. But on the bigger projects, we are starting to see success with the ability to put an inflation metric on there. And then outside of that, the only other mechanism to get additional price is just to really aggressively manage that project. And if there is a change in the project that we make sure that through the change order management process, that we are getting increased margin in that project itself. But those projects are – for us, it’s a fixed price and going back in and trying to open that up and change the price is really not going to happen.

What you are saying is that most of your cost is already locked in at the time you booked that project?

Yes. There is – certainly, all of our big costs, Nathan, are absolutely locked in. So, motors, castings and other things are firm costs from our supplier before we book that work.

Great. Thank you.

Thank you. And next, we will move on to Joe Giordano with Cowen.

Hey guys. Good morning.

Good morning.

Hi Joe.

So, on the revenue guide, the headwinds that you have to revenue from incremental FX and from the 1Q coming in below your expectation and the exit of Russia is more than the reduction in the guide. So, effectively, you are raising the confidence in the rest of the year from a top line. And look, I know that bookings this quarter were definitely better than people were expecting and your backlog is at all-time high, but backlog was high last quarter and you came in under. So, what gives you the confidence that backlog alone can drive backlog actually clearing? Because at some point, backlog could be like infinity. It almost doesn’t matter, right? So, what gives you confidence that you can more than offset the 1Q headwinds here?

Yes. No, I think – I mean, Joe, you said exactly what it is, right. The bookings in the first quarter were higher than we expected. A lot of that’s on the MRO side that will absolutely shift within the year. And then secondly, the backlog is there. And at some point, we have got to work through that and ship it. And we also believe, back to the MRO, we believe we are going to have a strong second quarter on MRO that was higher than our expectations. And again, most of the work that’s booked in the second quarter on MRO and aftermarket will still ship in the year. But the big challenge is we have got to convert the backlog at a more normal pace. And as Amy said before, we are not going into these optimal levels, if you will. We are showing, what I will call a gradual increase in our ability to convert throughout the year. And we think with some stability in the end markets, then our teams are willing to do this. And as I have gone to all of our sites, I have gone to 12 sites there recently in the last couple of weeks. We see a lot of products stacked up. We know exactly what’s missing. We know what the shortages are. And we have got some pretty good ability to start to convert that. And I think, Amy, why don’t you touch on just the percentage of completion of the projects?

Sure. So, I think the other point is just on these larger OE projects that we are booking. This is not sort of one and done in terms of revenue recognition. This is revenue that we are recognizing over the life of those projects as we clear milestones. So, some of the challenges that we see in the current situation, certainly, we still have the supply chain constraints that we need to work through. But some of the issues in terms of customers, arranging logistics and the like were not dependent on with respect to POC bookings. So, having a nice mix of POC with this point in time revenue recognition on the aftermarket and MRO sales actually adds to some of the predictability of our revenue versus detracting from it.

And then just to follow on the – I think you mentioned many times on the supply chain, the expectation for the rest of the year is that it stabilizes and does improve. I feel like that seems reasonable. But also I feel like every time we think we are done – like inflation is easing or COVID is easing, it just keeps getting worse. So, like I guess do you have some sort of edge on visibility that gives you the confidence to do that, or why not just guide as if none of this stuff gets any better whatsoever and then give – then we have like a comfort level that, under almost any circumstance, they can deliver this? Now there is some sort of embedded improvement maybe in the supply chain that maybe we are just hoping for to some extent?

Yes. And I think it goes back to stability and the volatility, right. And so with the volatility and things continuing to move, that’s where we really struggle to provide shipments. If we start to see any stabilization, then as lead times get pushed out or things start to change, we are able to actually catch up and deliver to that new extended lead time. We have got a lot of products in the system. You can see that in our WIP numbers in the inventory. And so at some point, we start to relieve that as we get the right components in the door. And so again, we feel confident that we have got the visibility there. We have performed a lot of this work. And it’s sitting on our shop floors or in WIP right now. And we have the ability to convert that as we start to unlock these different supply chain vehicles. And so we just believe that as we continue to work through the year, that this stability starts to help us unlock and grow our revenue to something that I will say is that not even at our, what I will call, a normal conversion rate, but something that makes sense and we have confidence in doing.

Just a couple of data points. We did see receipts, for example, in the month of March increase versus what we had seen in the previous month in the quarter. We have seen our on-time delivery, our on-time delivery performance from our vendors stabilized. It’s not where we want it to be, but it’s stabilized. And when you have the double-whammy of that declining and lead times increasing, it doesn’t work well. And again, we are seeing a little bit of relief on the logistics side, particularly out of India, which provide us some data points in terms of certain levels of improvements. And then I think it’s about where – trying to foresee where the next issues are popping up, and there will be challenges for sure. But in the categories that we are looking at that have been really, really impactful to us over the last couple of quarters, we feel like we are starting to see signs of stabilization in those particular categories.

Thanks guys.

Thank you. And next, we will move on to Joe Ritchie with Goldman Sachs.

Thanks. Good afternoon everyone.

Hi Joe.

So, maybe just starting off, this – you guys have been pretty clear for the last several quarters that the under-absorption issue in OE has been impacting your margins. I guess what I am trying to engage from here is what kind of margin improvement we should start to expect when you start to see the OE orders get fulfilled? And if I take a look at your order rate, your order rate has been above 400 now for several quarters. And it seems like we are probably troughing at like sub-400 revenue number this quarter. So, like how do we think about either incremental sequential margins from here on OE coming through or just margin improvement across the businesses as you start to ship some of these volumes?

Yes. So, even we are anticipating as we look at the fourth quarter of the year that we are going to exit at sort of a 12% to 14% OI level. We will see – that will be as a result of sequential improvement over the course of the year. And as you probably heard us say multiple times, that’s not the system working at optimal level in the fourth quarter, but getting some stabilization. I think that you are absolutely right that where we are seeing the largest amounts of under-absorption are certainly in the FPD segment. And it’s oftentimes at large ETO type facilities where we have got specialized labor in place and we have got line of sight into bookings coming in that require – that we continue to have that expertise on site. And so as we start to deliver on some of these larger project bookings that we see coming in, in the first quarter, we anticipate that, that absorption level is going to be much better based on the 23% increase that we saw in OE bookings in the first quarter.

Got it. That’s helpful. And maybe just a follow-on question there. So, if your exit rate is 12% to 14%, I am assuming that’s in FCD, correct me if I am wrong there, maybe it’s at the total segment level. That would be…

That’s actually at the company level.

At the company level, okay. So, you – so at the company level, I mean that would be several hundred basis points better than the exit rate last year. And I fully recognize there is seasonality in your business as well. I mean is that – is it fair to say we should be kind of carrying that forward then as we think about the type of margin improvement we should expect then next year, assuming nothing really kind of changes from current – from what’s happening currently? Is that the right kind of like starting point for next year?

We expect that we will continue to see seasonality in our business, Joe. So, we oftentimes see the first quarter be relatively weak from a margin perspective. So, I don’t want to guide prematurely to sort of no degradation from those fourth quarter levels. But what – the thing that I would say is that we do anticipate that, that 12% to 14% margin exit rate is something that we intend to build on. We don’t necessarily think that that’s the system working exactly as it should. So, as we move into 2023, we will be working to continue to improve our performance and specifically around the rate of revenue conversion as we look for 2023 financial performance. So, I would anticipate that 2023 margins will be, in total, higher or at that exit rate or better.

Okay. Thank you.

Alright. Thank you, everyone, for joining today’s call. In closing, we faced a challenging and volatile operating environment in the first quarter. Our teams are actively working through these challenges, which will position us to successfully convert on $2.2 billion of backlog. The strong bookings in the first quarter, combined with the increased spending we expect in our traditional and 3D growth markets give us confidence that Flowserve is now entering a growth phase. We have a talented team of associates, and I am confident that you will see revenue and margin improvement as we progress throughout the year. Thank you for your interest and support of Flowserve.

Thank you. That does conclude today’s teleconference. We do appreciate your participation. You may now disconnect.