Flowserve Corporation (FLS) Q3 2022 Earnings Report, Transcript and Summary

Good day and welcome to the Q3 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 Treasury. Please go ahead.

Thank you, Elena, and good morning, everyone. We appreciate you participating in our conference call today to discuss Flowserve's third 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 note that our earnings materials do and this call will include non-GAAP measures and contain forward-looking statements. And these statements are based upon forecasts, expectations and other information available to management as of November 1, 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 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.

Thanks, Jay, and good morning, everyone. Thank you for joining our third quarter earnings call. Let me start by saying that no one is more disappointed than I am about the performance in the third quarter. Our results this period do not reflect what Flowserve is capable of delivering nor are they representation of what we expect going forward. The third quarter was impacted by a number of items, some of which are self-inflicted, some were strategic decisions, and other were onetime events that came to fruition in the quarter. As a result, we delivered third quarter adjusted EPS of only $0.09. In addition to the $0.19 of ERP systems issues and corporate expense items that was disclosed in our September update, we also incurred other unexpected costs and headwinds in late September that further deteriorated our margins and earnings, such as higher-than-expected bad debt and under-absorption expenses as well as project true-up costs coming from inflation-related impacts in our highly engineered businesses. Our results were also impacted by an increase in R&D expense that we believe to be a very positive long-term growth driver for Flowserve. Late in the third quarter, we commenced a formal partnership with Chart Industries related to hydrogen fueling pumps. As part of the agreement, we acquired their in-process research and development technology, and its purchase was immediately expensed in our third quarter SG&A as noted in our Form 10-Q. Despite the negative impact to the quarter's adjusted EPS, we moved expeditiously to close this agreement given the benefits derived to both companies, including a 5-year agreement to supply Chart with these pumps upon commercialization. We believe having this technology will further increase our capabilities in hydrogen, and we also expect that the opportunities available to Flowserve in the high-growth hydrogen markets extend well beyond this initial agreement. While the impact to our results for the quarter for these items was significant, we believe most of these items will not impact future performance. First, the North American enterprise systems issues that impacted our highly profitable operations during the third quarter was remedied by mid-September. Since then, we've continued to operate at or above pre-conversion levels, and we do not expect this headwind to persist going forward. And the corporate expenses were also distinct to the third quarter and should not reoccur in the fourth quarter. Likewise, the purchase of the hydrogen technology investment we made is clearly a quarter-specific charge that we do not anticipate repeating. And lastly, the elevated bad debt charges in the third quarter are expected to subside. Those are certainly the easy ones to identify. Additionally, from an operational perspective, I am encouraged that many of the supply chain and personnel challenges that plagued us for the last year and impacted our ability to plan and meet lead times have continued to stabilize and improve. Part of this improvement is a direct result of the targeted actions we have taken to improve our supply chain management and build greater resiliency and redundancy in our facilities to support our customers and meet their expectations more consistently. Our efforts are not complete, and we continue to see opportunities to improve lead times for certain procured items, such as electronics, motors and some castings. As we continue to make progress with planning and lead times become more predictable, we expect our revenue conversion and margins to improve. Let me assure all of our shareholders that we fully recognize that Flowserve's recent performance has not met our own expectations or those of our shareholders. We have to significantly improve our execution and our ability to work through the challenges of today's complex environment. While we have made a lot of changes and improvements to how we operate, our execution in the third quarter overshadows that progress that we are making. We fully expect to deliver better results going forward. Combining the discrete items that are not expected to recur with our strong backlog and overall healthy in-market environment, we do see a clear pathway to delivering improved results. We know we must execute to get there, and this management team and I are committed to doing just that. Let me now turn to our third quarter bookings. We capitalize on high activity levels and delivered third quarter bookings of $1.2 billion, which is the highest quarterly level since 2014, and it represents a year-over-year increase of 34%. These strong bookings were anchored by two large project awards totaling approximately $250 million. Additionally, our traditional run rate bookings in aftermarket and MRO as well as our continued success with diversification, decarbonization and digitization awards remained healthy throughout the period. Despite increasing economic uncertainty, we continue to have a strong funnel of project opportunities at levels very similar to a year ago driven by energy transition activities and the global need for energy security. Some of the larger projects we were awarded in this quarter included a roughly $220 million award to supply highly engineered and industrial pumps to support the Jafurah Gas development project in Saudi Arabia. We have a well-thought-out execution plan with strong project management in place, and we are excited to be part of this significant development. Additionally, in our water markets, we booked over $30 million of engineered pumps for a pipeline that facilitates the use of desalinated seawater for copper mining activities in Chile. With the continued focus on energy security and independence, we have participated in the resurgence in the nuclear power markets and booked a handful of pump and valve orders in North America and Korea primarily for nuclear maintenance, upgrades and life extension activities. Finally, we were awarded numerous oil and gas orders in the $5 million to $10 million range primarily in emerging regions to improve energy security and efficiency. Given the size and duration of the Jafurah award, I'd like to provide some additional color on the project in our partnership with Aramco. This massive natural gas processing facility is expected to produce 2 billion cubic feet of gas per day by 2030 as well as provide feedstock for hydrogen and ammonia production. Our long-standing pump frame agreement with Aramco helped secure a significant amount of this award -- this work. We have improved our project quoting process and enhanced our project management capabilities to ensure that we deliver the margins that we are entitled to for this large project. With our success on Jafurah as well as a number of other large projects, both of original equipment bookings increased over 60% versus prior year to $680 million, which represents our highest OE bookings level since 2014. Despite the strong dollar, we generated $544 million in aftermarket bookings, which represents a year-over-year increase of almost 10% and over 16% on a constant currency basis. Our aftermarket and MRO bookings have remained strong all year, and we help -- as we help operators maintain higher productivity and output levels of their existing assets. Turning briefly to our bookings performance by end market and on a constant currency basis given the continued strengthening of the U.S. dollar. Our oil and gas bookings were up nearly 80%, reflecting large project awards and continued strength in the upgrade and revamp environment. Power bookings increased over 19%, supported by nuclear maintenance and life extensions and a nice hydropower award. Both chemical and general industries were up 15%, while our water bookings roughly doubled on the large water pipeline award I highlighted earlier. From a regional perspective, our third quarter bookings growth included all regions. The Middle East and Africa was up over 160%, again driven by the large award in Saudi Arabia. North America, Europe and Latin America delivered healthy growth of 20%, 31% and 41%, respectively. Finally, Asia Pacific bookings increased a modest 7%. I am encouraged by the activity levels we've seen thus far in 2022 in both our traditional end markets as well as with the success we've delivered through our 3D strategy. We believe that the outlook going forward remains promising. We will continue to support long-standing customers, while at the same time, targeting energy transition opportunities in previously underserved markets where we expect higher growth. Near-term visibility supports our view of continued year-over-year bookings growth in the fourth quarter in both MRO and project work, and we expect to secure another quarter of over $1 billion in orders. The combination of this improved global demand environment and the disruption of energy supplies in Europe has driven significant activity around energy security, particularly in our traditional oil and gas, nuclear and LNG markets. Additionally, the ongoing focus on decarbonization of existing assets as well as clean energy solutions continue to provide incremental opportunities targeted by our 3D growth strategy. The concerns and uncertainty around a prolonged inflationary environment and the increased probability of recession risk somewhat softened our outlook for growth. These conditions are most prevalent in Europe driven by the significant increase in energy costs and energy security risks as well as a weakened currency. We expect the impact of a potential recessionary environment would primarily impact our GDP-driven markets, including chemicals and general industries, where we have seen solid year-to-date constant currency bookings growth of 12% and 7%, respectively. However, based on our visibility into continued strong booking opportunities in other markets, including increased investment in energy security and decarbonization activity, we feel reasonably well positioned for growth in 2023. Looking forward, the strong OE and aftermarket bookings we delivered in the quarter produced a backlog that exceeds $2.6 billion, reaching the highest backlog level since 2015. This level of work under contract, combined with our expectations of a continued supportive demand environment, provide us with the opportunity to deliver strong top line growth and margin improvement as we move forward. With that, let me now turn the call over to Amy to address our third quarter in more detail and our expectations for the fourth quarter. I will conclude the call with remarks on our 3D strategy and comments on positioning Flowserve for success in 2023. Amy?

Thanks, Scott, and good morning, everyone. First, I would like to start by echoing Scott's sentiment that we are acutely aware our third quarter results are not acceptable, and they are further obscured by the previously disclosed discrete expenses, including the purchase of in-process R&D and some other items which we do not expect to recur. Absent these items, our third quarter would have looked much more like our second quarter results, and it would have been even better had we not seen a pickup in bad debt expense as well as headwinds from an increase in estimates to complete certain projects. In the third quarter, our reported EPS of $0.29 exceeded our adjusted earnings per share primarily due to $30 million of below-the-line FX gains. Excluding the FX gain as well as the $2.7 million benefit from cash collected on a previously excluded asset write-down, our adjusted EPS was $0.09. With another strong quarter of bookings, our backlog at September 30 was up 30% since year-end to $2.6 billion driven by a year-to-date book-to-bill ratio of 1.3. If not for the continued strength of the U.S. dollar, backlog would have been even higher by approximately $140 million. This solid foundation, coupled with our outlook for supportive end markets, provides the foundation for our expectation that revenues and earnings will improve in the coming quarter and in full year 2023. As Scott highlighted, we are encouraged by the combination of tailwinds from traditional end markets and the accelerated growth from our 3D strategy, which delivered a constant currency bookings increase of over 40% year-over-year. Original equipment orders, which were up 63% year-over-year or over 70% on a constant currency basis, drove the increase with FPD's OE bookings more than doubling versus prior year on the return of large project orders. FCD also contributed with a 24% constant currency increase that included particular strength in power, where booking -- where total bookings were up 66% in this end market that included nuclear orders totaling $16 million. Aftermarket bookings were $544 million, up 16% on a constant currency basis. Both segments contributed solid growth with FPD up 14% and FCD up 28%. Despite the stronger dollars, the third quarter marked the fourth consecutive quarter with aftermarket bookings exceeding $500 million as operators continue to catch up on previously deferred maintenance and avoid costly unplanned downtime while still running their facility at high -- facilities at high utilization rates. In fact, despite the strengthening U.S. dollars, this quarter's aftermarket bookings were the highest quarterly level since the fourth quarter of 2014. We are pleased that for the first time in two years, Flowserve delivered year-over-year growth in reported revenues. Excluding the effect of the strengthening U.S. dollar, revenues were up 7.2% on a constant currency basis. This growth was driven by the aftermarket with both segments up in the 10% range, reflecting the strong MRO and aftermarket environment over the last year and stabilization in our operations. FCD also contributed 14% constant currency OE growth, while FPD declined roughly 5% on the same basis. Regionally, North America's constant currency revenue growth of roughly 13% included 23% and 9% growth in FCD and FPD, respectively. The Middle East and Africa contributed 30% growth on FPD's strong 39% increase. Europe also contributed solid growth of 10% with FCD up 15% and FPD up 8%. However, growth in these regions were partially offset by declines in Asia Pacific and Latin America at 8% and 18%, respectively. Turning now to margins. Third quarter adjusted gross margin decreased 220 basis points year-over-year to 27.4%. The decline was driven by the third quarter-specific disruption in our highly profitable North American seals business due to the ERP system conversion, which resulted in roughly $5 million of unabsorbed costs and deferred an estimated $30 million in revenue and associated margins. The adjusted gross margin was further impacted by a $1 million non-cash lease accounting adjustment. Other contributors to the margin challenge included an approximate $2 million project write-down primarily on aged backlog; almost $3 million related to the effects of increased costs on our estimates to complete certain large projects; and higher freight costs, which were partially offset by a 200 basis point shift in mix to aftermarket and the impact of our price increases earlier in the year. Third quarter reported gross margins decreased 190 basis points to 27.4% due to the headwinds discussed earlier, partially offset by a $3 million decline in adjusted items. Third quarter SG&A increased $23 million to $224 million due to certain discrete items of roughly $18 million, primarily for incurred but not reported expenses related to our annual actuarial assessment, the non-cash lease accounting adjustment and the in-process R&D technology investment. This unusual activity led to inflated adjusted SG&A as a percentage of sales with the calculation increasing 250 basis points to 25.6%. On a reported basis, third quarter SG&A increased $20 million year-over-year, including the impact of the charges I just mentioned, partially offset by the reduction in adjusted items of $3 million. Third quarter adjusted operating margins decreased 460 basis points to 2.4% year-over-year due to FPD's decrease of 420 basis points, while FCD's adjusted operating margin was flat with the prior year at 10.5%. The margin was further impacted by the elevated corporate costs and SG&A that I just discussed. Third quarter reported operating margin declined 380 basis points year-over-year to 2.8% as the previously discussed challenges were partially offset by a $6 million decrease in adjusted items. Our third quarter adjusted tax rate of minus 63% was due to a benefit from the mitigation of tax liabilities recorded in prior periods and this quarter's low levels of pretax income. Turning to cash flows. Third quarter operating cash was a use of $38 million primarily due to increased working capital of $75 million to support our strong backlog growth and the shipment challenges in certain of our facilities. We have invested nearly $150 million of cash year-to-date for inventory, including net contract assets and liabilities to support the roughly $600 million increase in this year's backlog level and to assist in minimizing any future supply chain concerns. The combination of strong bookings growth and improved project environment and the frictional issues delaying shipments, including the impact of the ERP conversion, has impacted our working capital as we look to capitalize on the strong demand environment. As you would expect, the growing backlog and shipment delays have also impacted working capital as a percentage of sales with the third quarter ticking up 230 basis points sequentially to 32.2%. Despite this increase, I am pleased that we continue to lower the total inventory, including net asset and contract liabilities as a percentage of backlog, which now stands at 29.5%, our lowest level in over five years. Lastly, other material uses of cash in the quarter included dividends of $26 million, capital expenditures of $15 million and debt reduction of approximately $8 million. As most of you know, Flowserve traditionally delivered strong cash generation in the fourth quarter, and we expect this seasonal dynamic to again play out in Q4. Turning now to our outlook for the fourth quarter. We expect revenue growth of 8% to 10% year-over-year. This higher level is supported by our increased backlog, a reasonably stable to improving operating environment in our facilities and resumption of normal operating levels in our highly profitable North American seals and aftermarket business. The revenue forecast also includes a 2% to 3% headwind versus our prior fourth quarter expectations due to the increased strength of the U.S. dollar since our previous outlook. Based on the improved shipment levels and the $0.22 of items impacting the third quarter that are not anticipated to repeat in the fourth quarter, we expect to close the year with reported and adjusted EPS of at least $0.40, which would imply adjusted operating margins in the 8% to 10% range. This margin level is less than we anticipated earlier in the year. The decline in expected margins is attributed to lower absorption in our engineered facilities due to the timing of large project bookings that we had anticipated occurring earlier in the third quarter, which would have allowed for more absorption, revenue recognition and associated margins in the fourth quarter. Additionally, lower margins on percentage of completion backlog and the continued strength of the U.S. dollar have moderated our expectations. And while we fully expect our North American seals business to perform at first half shipment levels, we are not anticipating the fourth quarter ramp in shipments that was incorporated into our prior thinking. However, we continue to believe that the strong sequential fourth quarter movement that we are expecting will position us well as we look to improve financial performance in full year 2023. With the modest realignment planned in the fourth quarter, we expect our reported EPS to look very similar to adjusted EPS. Both the reported and adjusted EPS target range also assume current foreign currency rates, reasonably stable commodity prices, the continuation of our current market conditions, no significant improvement in the Russia-Ukraine conflict and no disruption due to European energy supply constraints. Although we are expecting substantial sequential revenue and earnings growth in the fourth quarter, we do not expect this growth to carry our full year results. And we are not willing to let the shortfalls of this year carry over into 2023 without taking actions. I'll now turn the call over to Scott to discuss our progress on strategy, our outlook and planned actions to improve our performance in 2023.

Thanks, Amy. Before closing with our outlook for the remainder of the year, let me provide an update on the progress of our 3D growth strategy focused on diversification, decarbonization and digitization, which aligns exceptionally well with today's market environment. I am pleased with the progress and momentum our 3D strategy has provided, where bookings in these targeted markets have exceeded our expectations. I would like to spotlight a few 3D awards from the quarter. In the diversified category, we won a water pipeline project in Chile, providing water from the Pacific Ocean to a large copper mine, which is 195 kilometers and more than 4,000 vertical meters away. This project will preserve the freshwater natural resources in the Andes Mountains. Shifting to the decarbonization leg of the strategy. Flowserve's extensive capabilities and vast installed base position us well to support our customers' CO2 reduction and energy transition plans. The increasing government incentives to reduce carbon emissions are having a significant impact on the overall growth in this market. We have seen our energy transition project funnel grow roughly 70% since the beginning of the year. Flowserve continues to lead in CCUS as well, where we are seeing the uptake on our technology gain further traction. Flowserve is participating in a number of these projects around the world, and we expect continued activity in this area for the foreseeable future. As an example, Flowserve was recently awarded contracts to supply pumps and valves for a large project to capture CO2 from 32 methanol plants across the Midwest and transported to North Dakota for permanent storage. Another example of decarbonization is in Hawaii, where Flowserve is providing equipment in the West Kauai Energy Project for a comprehensive integrated renewable energy and irrigation. Flowserve pumps will enable the hydropower and pump storage components of this project, supporting Hawaii's path to 100% renewable energy. Finally, on digitized, we continue to make good progress in the third quarter, where we instrumented roughly 125 assets and now have over 1,625 assets instrumented around the world. Other significant advances include the instrumentation of CE vacuum and liquid ring pumps and the ability to monitor sealing systems and control valves. In one recent example, we installed RedRaven, one of the world's largest desalination plants in the Middle East, where we instrumented 22 critical process pumps. The latest commissioning represents the third desal facility we are now supporting with RedRaven technology. Before closing, I would like to highlight another recent technology development we are excited about as well as some additional comments around the hydrogen pump technology acquisition. In the third quarter, we brought our FLEX isobaric energy recovery device to the market following nearly a year of extensive field testing. With its proven efficiency and compact envelope, the combination of FLEX with our high-efficiency pumps and valve offerings represents a comprehensive product offering to support the growing desalination market. While initially designed for desalination, we believe there are other industry applications for the FLEX technology that we will pursue in due time. We are enthusiastic about the opportunity to leverage the R&D efforts that Chart commenced on hydrogen distancing pumping technology and expect that we will be able to bring the product to commercialization in the second half of 2023. This Chart product will be a critical piece of the equipment for liquid hydrogen fueling stations and allows Flowserve to build out other related products across the hydrogen value chain. As we look toward 2023, we believe Flowserve is well positioned to convert on our existing $2.6 billion backlog, which currently sits at $600 million more than the beginning of the year. Even with only modest book-to-ship assumptions in 2023, Flowserve's revenue should grow at approximately 10% year-over-year. While we will see a meaningful shift back to more original equipment revenue, our aftermarket backlog remains high, providing significant opportunity to convert this high-margin business to revenue within the year. To address the persistent inflation that we have experienced throughout 2022 and the potential recession concerns in Europe and the United States, we are putting together a roughly $50 million cost-reduction plan that includes both variable and structural costs. We intend to provide more details of this program and the timing of execution during our fourth quarter earnings call, but we are planning for a large percentage of the savings to be executed within 2023. Our strong backlog should enable revenue growth of approximately 10% in 2023, and the cost-out program will ensure that we capture the margin expansion and incremental margins that we have historically come with top line growth. We are currently in the middle of our 2023 planning process. And as usual, we will provide full year 2023 guidance on the next earnings call. In summary, our third quarter performance did not meet our expectations. We are confident this quarter's discrete items will not continue and fully believe we will make meaningful progress in our ability to execute. We expect to see significant improvement in the 2022 fourth quarter with the derisked plan that we shared earlier in our prepared remarks. Further, as we achieve higher levels of conversion on our robust backlog, we should be in a strong position to grow our margins and return to a more normal level of profitability. I'm confident in our team and our ability to move beyond the third quarter to begin to grow both our revenue and our profitability. We have the right building blocks in place, and it is on us to deliver. Operator, this concludes our prepared remarks, and we'd now like to open the call to questions.

[Operator Instructions] We will take our first question from Deane Dray from RBC Capital Markets. Please go ahead.

Thank you. Good morning, everyone. Maybe we could just start to get these out of the way to address the unexpected discrete items in the quarter. And maybe we can just separate what's self-inflicted and not. So when I look at the Chart deal, the capitalizing R&D, that's fine. I mean that's -- it sounds like a great opportunity on the hydrogen side. You're supposed to do that every day. The FX, everyone is up against this. That's not self-inflicted. So I'll just take those off the table. But on the profit margin, on the percentage of completion and the aged receivables, both of those strike me as a bit of a forecasting issue. You might have known that you were a bit aggressive or the chances of those aging more and not being paid this quarter could have happened. So how much of this is a forecasting for those two items? And any kind of action plan to address that? And maybe we start there.

Sure. Yes. Thanks. I'll start and then I'll let Amy hit a couple of things that I miss here. But the previously announced and the one-time items are clearly the ERP conversion, the corporate onetime expenses, all of those were preannounced, and then the R&D acquisition. And then the other late-quarter items, like you said, are the bad debt expense and the project true-up costs. I'll hit the project true-up. I'll let Amy fill in any blanks there, and then she can address the bad debt. But on these projects, especially in the engineered environment, they're long-cycle projects and what we've seen is an inflationary environment all year. So whether that's materials, labor, energy costs in Europe, those have continued to go up. And in a lot of our projects, we review these every month. We do quarterly reviews and assessments on our estimate at completion, and we typically do a good job forecasting what that cost model looks like. And then, unfortunately, we did this later in the quarter. And what we saw was more inflation primarily in Europe, but also some of our North American projects as well come in. And given the inflationary environment and the concerns in the future, we bumped up the cost for a lot of these projects. Amy, do you want to add anything else on the projects? And I'll let you hit bad debt.

Sure. I think as we've said before with respect to large projects, we do try and lock in as much of the cost as we can. And unfortunately, in the current environment, we have seen some of the costs that we can't necessarily lock in the areas where we've seen high inflation, and that's what's being addressed in some of these adjustments in the third quarter. In -- with respect to the aging items that are reflected, I think we try and do a real bottoms-up forecast of cash collections each quarter. That happens at a site and at a platform level. In some instances, we had customers that had promised to pay fairly large receivables. That didn't happen at the end of the quarter. They're high-quality customers. We believe that it will, and in some cases, has already happened in the fourth quarter. So this is unfortunate that it was something that snuck up on us in the third quarter, but we don't anticipate that's going to continue in the fourth quarter and beyond.

Okay. All right. Let's just shift over on to the positive side here. And on the third quarter bookings, can you give us a sense of the implied margins? And just are there any challenges and confidence in the conversion and timing of the conversion of these orders?

Sure. So obviously, the $1.2 billion is a big number for us. There is a significant amount of projects that were booked. And I'd say we're excited about the profile of those projects. I would say the environment around pricing on projects is still competitive, and so we are being selected. Obviously, the deferral one, which I hit in our prepared remarks, is a very large project. We've been working on that now for 9 months. We had lots of focus on making sure our costs were correct. We've got a margin position in there that we're excited about, and we put substantial contingency for inflation in that project as well. And so I feel reasonably good about the project bookings that are in there. I would say, Jafurah is a multiyear project. That's going to take two years to execute. But a lot of these projects are relatively standard in terms of the product configuration. So not a heavy engineering mix, not a lot of technical risk and things that we can execute reasonably quickly. And so overall, we're excited about what we booked in the quarter. And then kind of going back to your previous question, Deane, we're really focused now on securing the price of the bought-out items early in the project life to make sure that there's no risk there. And then we've been putting more and more contingency in the projects themselves to make sure that we can offset the inflationary environment. So I feel better about the work that we booked today than what we booked last year in terms of how we go forward.

Great. I just have one specific question, the follow-up, the FLEX isobaric system is getting a lot of attention. People were talking about it at the WEFTEC conference. Is this a replacement to the DWEER technology? Or is it complementary to it?

Yes. So it's a good point, and I'm glad you brought this up and recognize that we do have pressure exchange out there with DWEER. And so that's been a legacy technology. It's a linear technology, and FLEX is a rotating or rotary technology. And so these are complementary, and we can use both in conjunction to get the best efficiencies. And so we really like this portfolio now. So FLEX offers a very compact, highly efficient rotary pressure exchange device. DWEER is a little bit bigger, but it's linear and can be used in different applications. And then when you combine that now with our high-efficiency pumps and RedRaven, we really believe we've got something that can differentiate us in large, highly efficient energy-dependent water markets like desalination. Now obviously, we want to move beyond desalination, and there's other areas like industrial wastewater, refrigeration, HVAC, that we also believe we can expand the pressure range technology to. So we're really excited about our capabilities and what we could do here.

That's great to hear. Best of luck.

We will take our next question. Please go ahead from Michael Halloran from Baird.

Morning, everyone. Thanks for taking my questions. So on the margin side of things, kind of a 2-parter. First, wide range, 8% to 10% fourth quarter margins on the EBIT side. Maybe talk about what the iterations are to get to the upper end of that range and what would have to happen to get to the lower. And then how should we think about what the right stepping-off point is here? Obviously, a lot of these disruptions should go away. You're confident in the profitability of the profile, in the backlog to be executing on a cost improvement plan as you work through next year. So any help you could provide on how to think about the jumping-off point for margins would be helpful as well. Amy B. Schwetz Flowserve Corporation – Senior VP & CFO Sure. So a few items just to highlight in terms of that margin range that -- or maybe expand on from my remarks. So we talked about those large order bookings that we saw in the third quarter. It did occur later in the third quarter than we'd originally anticipated. So some absorption that we had anticipated coming through in some of our ETO plants as well as delays in recognition of revenue and profit on the POC costs has -- is one of those items that brought our expectations down. We've talked about the U.S. dollar a fair bit. It's a headwind for us as we make our way into the fourth quarter. And then some of our costs on these POC projects that we're seeing creep up over time. I will comment just around conversion and the fact to get to that kind of upper end of the range or to exceed our $0.40 a share. What we really see need to happen is improvement in conversion rates around our North American seals business, and frankly, other businesses in the mix. So we're anticipating in the third quarter -- or in the fourth quarter some improvement in our valves conversion rates on par with what we saw last year in the fourth quarter. They've been very stable in the second and third quarter from a conversion standpoint. And on their higher backlog, we've seen that translate into higher revenue. We're anticipating a bit of an uptick, but a relatively small one as we move from the third quarter into fourth quarter. And then we're anticipating that our seals business performs in line with how it did in the first half of the year. So we would normally anticipate that we'd see a nice uptick in the fourth quarter, that seasonality, that fourth quarter surge within our business. And given what we experienced in the third quarter, we've tempered our expectations around that uptick. I think we're all interested in delivering on the expectations that we've set out there, and so we've tried to derisk this plan pretty substantially to make sure that we've got a number out there that we can hit. As we think about the movement going into 2023, Scott touched on some of these items in terms of how we're trying to think about large project orders in the future. That shift to OE is going to provide us some opportunities to really increase our absorption in some of our larger facilities. That generally comes at slightly lower margins, but we're anticipating that absorption should be a real benefit for us over the course of the year. And obviously, we have been impacted in 2022 by a number of discrete items or a number of items associated with the operating environment that we expect should get much better in 2023. We're working through those numbers now and are excited to give guidance in early 2023 in terms of what that improvement will look like.

And then just some comments on the front log side of things. Obviously, really nice orders. Good to see the progression. You certainly feel optimistic about the backdrop. What are the customers saying at this point? Are you seeing any real movement in the front log or trend-wise one way or another, people pulling things in, people pushing things out? And then as you think about end-market variability on a forward basis, any kind of thoughts underneath the hood about where there's a little more risk or a little bit more opportunity looking forward?

Sure. And I'd say the front log is always dynamic, and there's no change or nothing is different today. With that said, we feel reasonably confident about our path forward. In my prepared remarks, we talked about Q4 bookings being at over $1 billion again, which will be four quarters in a row for us, and we're excited about that growth. We see continued strong MRO and aftermarket in the fourth quarter as well as some projects. Obviously, the projects won't be as big as Q3 with some of the larger awards, but we continue to feel really good about that. As we move forward, we get concerned about some of the GDP-based business. And so this is our chemicals and general industries business. We're worried about Europe more than anywhere else. And so some of those large chemical customers are already talking about concerns on their demand. And so we know that, that side slows down. The offset for us and the positive is energy security and decarbonization. And so on the energy security side, we're seeing a global ramp-up of traditional energy sources. So this is oil and gas, potentially coal; other types of energy, including LNG; but then also the unconventional energy and the new energy sources as well. And so we feel that these will continue to go forward and potentially offset any concerns on recessionary fears. And so we're already seeing a revamp in all of the traditional forms of energy, including nuclear. And then the decarbonization lane is substantially active. And so we've seen a 70% increase in decarbonization activities. And so we just -- we think energy security plus the decarbonization offset any concerns of the GDP-based recessionary-type risk.

Great. Really appreciate it. Thank you.

We'll take our next question from Andy Kaplowitz from Citigroup. Please go ahead.

Good morning, everyone. Scott, just maybe following up on that last comment. You already talked about Q4 bookings and this trade-off between energy transition bookings and maybe slower chemical general industries. Do you think the trade-off is positive enough where you could keep book-to-bill over 1 over the next several quarters? And then just you booked this large Middle East project. Is that more of a one-off? Or are there a handful of these larger projects that you still see over the next several quarters?

Sure. Yes. So I'd say right now, Andy, we do expect bookings growth. Will book-to-bill be greater than 1? Not sure. It depends how high we can push our revenue because we have substantial backlog. And so we'll provide that guidance on the fourth quarter earnings call when we go full year guidance. But then back to kind of these trade-offs, the energy security is substantial. And there's a lot of activity going forward on that. We do have visibility to larger projects, some in the nuclear space, some traditional oil and gas and other things. I would say $200 million is a really large award for us. I don't anticipate that happening next year, but I can certainly see some larger projects in the $50 million to $100 million range next year as they come through the system. And so there are big projects out there. There are big developments, again, mostly around energy security and bringing a localization in security to energy in different parts of the world. And then on the decarbonization side, we're seeing so much activity. Most of these are smaller projects, but nobody is going to go backwards on their decarbonization and their ESG focus. And a lot of that is driven by government regulation. So previous regulation in Europe is helping to start that movement. And then the Inflation Reduction Act in the United States is now generating all kinds of activity around CCUS and hydrogen. And so we're pretty constructive about the outlook there. And again, the 2 drivers for us will be energy security and the decarbonization line.

Very helpful. And then, Scott, you talked about the contingencies put in Q4, but can you go into a little more detail into what you're doing or what you can do as CEO to cut down on the noise that seems to be quite frequent when you report quarterly earnings? Can you change the reporting structure in some way to even help you see problems faster were they develop? And how concerned should we be about continuing ERP transition?

Sure. So let me just start with the forecasting and our ability to be more predictive of our financial results. And obviously, we have not done a good job of this. We are putting a lot of efforts into how do we get better at predicting and understanding our results. And so a lot of this is really around doing the right things at the plant level and then at the project level. And so we've changed how we're doing that throughout this year. We're doing more direct monthly plant reviews that have a very strict protocol in how that happens. And now we're reviewing all of the larger projects on a regular basis at the corporate level. And so I think as we kind of work through this dynamic and challenging time where lead times on a lot of our components have extended more than 2x, we're getting -- I do feel like we're getting better visibility. It's not showing up yet in our results. But I believe with the stability in the supply chain, our increased focus, we start to get far more accurate about what we can predict in understanding what we can do to deliver the results. And then additionally, we're starting to put a lot more contingency in our plans. We talked about the derisk plan in the fourth quarter. We've talked about project contingencies. And so we'll continue to hedge back to make sure that we do deliver on what we commit. And then on the ERP side, we talked -- well, we preannounced and we talked about it in September, that was roughly about $30 million of revenue that was glossed in primarily July, but some in August as well. The September numbers were really good and were back to pre-conversion activity levels, and the October print was essentially the same run rate as September. And so we feel good about continued progress there. We still need to catch up the $30 million that was lost in the quarter. We believe we can potentially get some of that late in the fourth quarter, but we didn't commit to that in our guidance that we put forward, but certainly by the first half of 2023. And so the team is doing a lot to continue to expand capacity with the North American seal business. We're throwing a lot of resources at it, and we're confident we'd get through this. And just as a reminder, and we talked about this before, this is not necessarily a systems issue. The system is working fully. It's more around the training and uptake of how to use the system. And as a reminder, we've converted other parts of the seal business this year incredibly successfully. We did it in Q1 in Asia Pacific, Q2 in Europe with no issues. And so it's really getting the North American team more comfortable in equipping them with the training and the tools to use it properly. So we're confident that we've turned the corner there. We don't go backwards. We've got to continue to ramp up capacity, though, as we turn the corner into 2023.

Yes. And Andy, I think some of your question might have been also related to how should we think about future implementations. And certainly, we will be looking at this and are looking at this really closely to develop lessons learned. This is the single-largest implementation that we could have done at this point in time. And so as we move forward, we're certain -- or we feel good about our ability to deliver on future implementations in a way that both incorporates learnings from this one, but also will come with less risk than this particular conversion had.

Appreciate the color.

We will take our next question from Saree Boroditsky from Jefferies. Please go ahead.

Thanks for taking my questions. You mentioned that you expected to see another $0.25 billion in bookings to be the fourth consecutive quarter. This seems to imply potentially higher than 10% sales growth into next year. So could you talk about how much of your backlog should convert into 2023? And maybe is there any conservatism in that number?

So I'll start. I think Scott has talked about the fact that certainly, as we make our way into 2023, we have an interest in increasing the velocity at which we're converting our backlog into revenue. The makeup of our backlog is a little bit different than what it looked like last year at this time with a higher percentage of the backlog related to OE projects. And some of these OE projects will span the 2023 calendar year. So we're beginning to see from our traditional -- or our traditional backlog conversion rates in 2021 and 2022, we're going to see lower conversion rates just based on the makeup of that backlog as we make our way into 2023. But we certainly will be pushing our improvement on conversion rates moving forward.

Great. And then I guess assuming that 10% revenue growth into next year puts you almost $3.8 billion in sales. If I look back historically, that's similar to what you did in 2018. So do you think you can get operating margins to approach that 10% level? And how do I think about the impact from cost savings since that time?

So we're going to -- we'll obviously give detailed guidance with respect to 2023 as we move into next year. What I would say is Scott has highlighted what we think that we need to do from a cost-savings perspective. We know going into next year, we're going to continue to see certain headwinds, and those headwinds are in the form of a strong dollar environment that we don't necessarily anticipate changing. We also see inflation, particularly in certain pockets around the organization, being at relatively high levels. Part of what our goal is for the fourth quarter of this year is to really get those operating margins in that 8% to 10% level. So we've got the opportunity to have a strong jumping-off point going into 2023 to expand margins beyond that.

Great. Thanks for taking my question.

And we'll take our next question from Nathan Jones from Stifel. Please go ahead.

Good morning, everyone. I guess maybe following up to some of Saree's questions there on maybe some color on '23. You guys have incurred a number of frictional costs this year related to increased inbound freight early in the year, some of the things that happened during the third quarter. If you were to think about the net impact on your results this year, those kinds of things that maybe shouldn't recur in 2022, how much would the aggregate impact have been to '22's results that maybe shouldn't repeat in '23?

Yes. No, it's a really good question. And we're going through the budget process right now for 2023. And again, we'll put guidance out at the end of the fourth quarter. But as you said, there's just been a number of things that have impacted us in the year. And so at the beginning of the year, in Q1, we had COVID-related shutdowns. We had frictional costs on logistics, where we're paying 3x to ship things around the world. We had overtime. There's all kinds of stuff. And then obviously, the ERP conversion and the one-offs in the third quarter, we've clearly called that out as discrete items. And so I think, Nathan, you can build a bridge relatively easy to get to some nice margin improvement if we can get beyond all of the things that happened to us in 2022. And so these are the discussions we're having right now with the teams. It's kind of like what's the implied revenue. We know we're doing the right things on execution. We know we like the quality of the backlog. And so we've got to commit in our plans to drive margin expansion as we move beyond the friction and the noise of 2022.

Okay. I guess I'll stay tuned for February then.

Yes. Again, we'll provide that -- yes, we'll provide that in the fourth quarter earnings call with the guidance.

No worries. Maybe a couple of questions around the Saudi project. Flowserve has had large project orders, maybe not quite this big historically, but has had large project orders. And I think the project management around those kinds of things has probably been less than perfect historically, and they haven't realized the margins that have been baked into the pricing. Can you talk about any changes that are being made to how projects like that are being managed to ensure that you actually do realize the margins that have been priced into that bid?

Yes. It's a really good question, Nathan. And this is something we've been working on now for, gosh, probably 3 or 4 quarters. We've had visibility to this project since the beginning of the year. And given our relationship with Aramco, we knew we were -- part of the frame agreement, we knew some of this was coming to us. And so early on, we really strengthened our project tendering team. And so we put some of our best people on this to make sure that the quoting process was accounting for all of the costs and that we are making sure that we would put the execution plan in place as we put the tender together. And I'd say, to your point, this has not been a strength of Flowserve. We typically let one team do the project tendering and then another team do execution. And in this one, we brought forward some of our best folks to really work on the execution plan prior to award. And I would just say, Amy and I have done a monthly project review on this project now for six months. And so it's getting unbelievable scrutiny and attention. And then as we shift to execution, we've bolstered the execution team. We've changed our project management reporting to highlight risk in the project -- progress in the projects and critical milestones. And so Amy and I continue to do a monthly review now our project execution. And I'm not going to say that this project is fully derisked, but I feel far better about our ability to execute this than any projects that I've seen historically. And just a couple of data points. We booked this primarily in September, some of it happened in August, but the majority of the long lead items are already now on purchase. We've got contingency in the project, which we typically don't have a significant cost contingency in there. And we're executing to our plan thus far. And so I think we're doing everything right early. I get that early planning on execution, the contingency in the project, focusing on the right things and having a fully designated project management team. And so we'll continue to provide updates on this. This project will last probably two years for us to finish the last shipments. But we're really excited about our ability to deliver this and support Aramco, but also to deliver the margins that we deserve on this big project.

This project by itself probably absorbs a reasonable amount of capacity, particularly on the engineered pump side, industry capacity as well as your capacity. Do you think this enables the industry to be a little bit more aggressive with pricing and maybe realize a little more margin on pricing on projects going forward?

Yes. I sure hope so, Nathan. It certainly does that for us. And so we're in a much better position on capacity. We're going to be even more selective as we go forward in terms of what we take and making sure that we can move our pricing and margins up. But I would say we're seeing similar things with our peer group and competitors in terms of their bookings and backlogs coming up. And so I'm hopeful that 2023 has some better and more constructive pricing and discipline in the system.

Thanks for taking my question.

We will take our next question from Joe Giordano from Cowen. Please go ahead.

Hi, everyone. Well, I think we've been kind of dancing around and talking about this a little bit, but with all due respect, there does seem to be some sort of like breakdown of internal control somewhere. I appreciate that you're taking more contingency on stuff at the management level on what you're hearing from the field, but is there some sort of like breakdown as to how things are being dealt with at the field level that needs to be structurally changed or like -- or how the people there are incentivized or how they're kind of going about their day to day?

Yes. Look, we haven't forecasted as well as we should. And so there's no doubt that we've got to tighten up our ability to forecast our results. I'll just say the external environment has been incredibly challenging, and it's been very frustrating for Amy I as we go forward. But I'd say these are things that we've got to do better. We continue to work with the organizations on how to predict and what to forecast. There's not a breakdown on internal controls, like that's not happening. We're confident of that. Part of our cost-out program is really going to be driving organizational efficiency and having better role clarity and accountability. And so those things, we're definitely looking at as we look at how do we take cost out given the backlog that we have. But I'd say this has been frustrating, right? We've got to make sure that we can deliver on our commitments. And we believe that we're getting better. Sadly, the third quarter kind of masked some of the underlying improvements that are there. And so we've got a derisked plan in Q4 that we're very confident of achieving. And I think you see our execution start to improve dramatically as we turn the corner into 2023.

When you talk about the cost-out actions, the $50 million you're talking about, obviously, you have a sprawling enterprise that's been built up through a lot of acquisitions over a long period of time. Is there anything like more fundamental that needs to be considered to address the operational structure going forward?

Sure. No, it's a good point and it's a true statement. There's still a lot of complexity in our overall organization and the number of sites. And so we continue to look at taking facility consolidation and rationalization. And so we're -- that's part of the plan is to make sure that we can have scale at the large sites that we have and making sure that they stay absorbed. And then that goes back to driving simplification, right? If we can get to a lower number there, then we've got the ability to focus and improve results on a few set of sites rather than a very broad spectrum. And then the other thing that we continue to look at and part of the transformation that was very successful is the product portfolio and making sure that we've got a more rationalized and simplified set of products. And so that has been ongoing now for over 1.5 years. We continue to push forward to a more configured set of products. And we're not afraid to make decisions not only on customer projects where we don't get the margins that we deserve, but also on our offering and our product portfolio. And so if something doesn't make sense anymore or that market has changed dramatically, then we'll look at potentially moving out of that product line and focusing where we believe that we can get better margins and more predictability.

And if I could just sneak in one quick clarification. Like can you just size what your expectation is for orders for hydrogen and nuclear this year?

Sure. Let me -- I'll start with nuclear. And so this year, we booked over $150 million year-to-date on nuclear. There are about $20 million of work in the quarter. And so the nuclear market is looking good, and we expect to see continued work as we go forward on the nuclear side. And I'd say 2023 will bring an equal amount of opportunities for us on nuclear. On the hydrogen side, that is a really small part of our business today. We have booked a lot of valve work that we announced in the second quarter on hydrogen, and that's beginning to gain more progress. Obviously, our partnership with Chart is going to help us on the pumping technology and get us more into the distribution side of hydrogen. And then historically, we've always participated on the downstream side where we've got gray hydrogen. And so that work is still there, but most of that today is on the aftermarket side. But we see the green hydrogen moving forward quickly. We're trying to evolve our portfolio to make sure that we can support that. And the step with Chart is the first step on the pumping side to make sure that we can participate fully in hydrogen.

[Operator Instructions] We will take our next question from Josh Pokrzywinski from Morgan Stanley. Please go ahead.

Hi, good morning. Thanks for taking the call. This is Toby on for Josh. So wondering for second quarter, how would you normalize 4Q guidance for noise? I see that it still annualizes below where you expected EPS to be not that long ago. So it seems like it's probably got some project accounting or lingering ERP issues or something else want to get back?

So just a couple of things related to 4Q along those lines. So generally, we would see a ramp-up in sales volume in that seals portion of the business. We are anticipating that in the first -- in the fourth quarter that we're delivering more at first half rates in that area of the business. So through the noise of the third quarter there, but not really accelerating that conversion from what we saw in the first half of the year. We anticipate some of the issues that we saw in the first half of the year in terms of under-absorption still working their way through the system in the fourth quarter as we think about the timing of those large project bookings. And we still deal with some under-absorption as we ramp up work in the plants in the fourth quarter of this year. And then I'd just kind of point out what we've stressed throughout the call, which is we are definitely presenting a plan for the fourth quarter that we feel confident that we can deliver. So we have derisked this plan in terms of trying to understand what those additional costs could be, whether or not that's inflationary or frictional cost in the system and really trying to ensure that, that is built into our estimate as we make our way into the fourth quarter.

It appears there are no further questions at this time. I would like to turn the call back over to Scott Rowe for any additional or closing remarks.

Thank you. We have no closing remarks. Thank you for participating on today's call, and we look forward to discussing other things in future investor events and on the fourth quarter call. Thank you.

That will conclude today's conference call. Thank you for your participation, ladies and gentlemen. You may now disconnect