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Flowserve Looking To Bookings And Margins
It was just the other day that Reuters ran an article highlighting the risk that a building boom in domestic pipelines could be significantly slowed by a shortage of the enormous heavy-duty valves and pumps that such projects require. That sounds like a pretty healthy backdrop for Flowserve (NYSE:FLS) - a veritable pure-play on fluid handling equipment like pumps and valves. The question for Flowserve investors, though, is how much the company can improve its full-cycle margins and how much is already built into the price.
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Sound Second Quarter Performance
Flowserve reported a basically in-line quarter, with solid ongoing growth in its backlog. Revenue rose 5% as reported, or better than 12% on a constant currency basis. Engineered products (EPD) sales rose 13%, while industrial products (IPD) rose 9% and flow control (FCD) rose 11%. While the flow control business seems to be seeing some sluggishness tied to Europe and the oil & gas sector, petrochemical and energy demand seems solid in the other segments. Margins were a bit of a mixed bag. Gross margin fell about 30 basis points as the company continues to work through lower-margin backlog business. Lower SG&A spending counterbalanced this, though, and operating income rose 18% as reported and more than 28% on a currency-adjusted basis. Both EPD and IPD reported stronger margins, while margin in the FCD business compressed a bit.
SEE: Analyzing Operating Margins
More Business on the Way, and It's Looking More Profitable
Flowserve reported a 7% currency-adjusted bookings growth for the second quarter, with low double-digit growth for both EPD and IPD. Not surprisingly, FCD was the laggard as orders fell less than one percent. I suspect investors will like the news that aftermarket product bookings jumped 13% and now make up more than 40% of the book. Flowserve's aftermarket business is arguably an under-appreciated part of the company's story; while bears fear the company's vulnerability to large project wins (and the timing and financing risks that go with large projects), roughly 40% of the business is in more reliable aftermarket products. What's more, given the multiples historically given to aftermarket-heavy businesses like Donaldson (NYSE:DCI), Pall (NYSE:PLL) and Clarcor (NYSE:CLC), growth here could expand multiples for Flowserve.
SEE: 5 Common Trading Multiples Used In Oil And Gas Valuation
Ample Opportunities and More Responsible Competition?
Large pipeline companies like Enbridge (NYSE:ENB), Enterprise Products (NYSE:EPD) and Plains All American (NYSE:PAA) don't seem overly worried about the valve/pump shortage, nor should they be. Sulzer (OTC:SULZF), SPX (NYSE:SPW), Flowserve, Tyco (NYSE:TYC) and General Electric (NYSE:GE) may not fall all over themselves adding capacity, but none of these companies are going to let a honeypot like a major pipeline project slip away for lack of capacity.
That said, the speed with which pipelines and facilities get built is an unknown. There is a lot of need right now for more takeaway capacity in regions like the Bakken, as well as more delivery capacity for utilities in the East and Midwest that would like to switch from coal to natural gas, but have to pay significant differentials because of a lack of infrastructure capacity. And then there's still the potential for LNG-driven infrastructure build-out; LNG represents a valid way of monetizing the United States' huge natural gas reserves and getting that gas to markets that are willing to pay much more for it than domestic customers.
As I said, I don't see the major suppliers going crazy with bringing on supply. Past boom/bust cycles were driven at least in part by the actions of smaller companies to grab business while they could; there has been a lot of consolidation, though, and larger companies are usually more restrained in their capacity expansions.
SEE: Cashing In On A Commodity Boom
The Bottom Line
I like what Flowserve is doing with its operations, and I like the long-term market growth potential. The real question now is whether the company can expand its free cash flow conversion rate from a volatile pattern that averaged around 6% to something more consistently in the high single-digits or low teens. Right now, I'm willing to give the company partial credit for that transformation and a low teens forward free cash flow growth rate. Doing so suggests a target in the low $130s, which makes Flowserve a solid hold but not an especially promising new money candidate.
At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.
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Sound Second Quarter Performance
Flowserve reported a basically in-line quarter, with solid ongoing growth in its backlog. Revenue rose 5% as reported, or better than 12% on a constant currency basis. Engineered products (EPD) sales rose 13%, while industrial products (IPD) rose 9% and flow control (FCD) rose 11%. While the flow control business seems to be seeing some sluggishness tied to Europe and the oil & gas sector, petrochemical and energy demand seems solid in the other segments. Margins were a bit of a mixed bag. Gross margin fell about 30 basis points as the company continues to work through lower-margin backlog business. Lower SG&A spending counterbalanced this, though, and operating income rose 18% as reported and more than 28% on a currency-adjusted basis. Both EPD and IPD reported stronger margins, while margin in the FCD business compressed a bit.
SEE: Analyzing Operating Margins
More Business on the Way, and It's Looking More Profitable
Flowserve reported a 7% currency-adjusted bookings growth for the second quarter, with low double-digit growth for both EPD and IPD. Not surprisingly, FCD was the laggard as orders fell less than one percent. I suspect investors will like the news that aftermarket product bookings jumped 13% and now make up more than 40% of the book. Flowserve's aftermarket business is arguably an under-appreciated part of the company's story; while bears fear the company's vulnerability to large project wins (and the timing and financing risks that go with large projects), roughly 40% of the business is in more reliable aftermarket products. What's more, given the multiples historically given to aftermarket-heavy businesses like Donaldson (NYSE:DCI), Pall (NYSE:PLL) and Clarcor (NYSE:CLC), growth here could expand multiples for Flowserve.
Ample Opportunities and More Responsible Competition?
Large pipeline companies like Enbridge (NYSE:ENB), Enterprise Products (NYSE:EPD) and Plains All American (NYSE:PAA) don't seem overly worried about the valve/pump shortage, nor should they be. Sulzer (OTC:SULZF), SPX (NYSE:SPW), Flowserve, Tyco (NYSE:TYC) and General Electric (NYSE:GE) may not fall all over themselves adding capacity, but none of these companies are going to let a honeypot like a major pipeline project slip away for lack of capacity.
That said, the speed with which pipelines and facilities get built is an unknown. There is a lot of need right now for more takeaway capacity in regions like the Bakken, as well as more delivery capacity for utilities in the East and Midwest that would like to switch from coal to natural gas, but have to pay significant differentials because of a lack of infrastructure capacity. And then there's still the potential for LNG-driven infrastructure build-out; LNG represents a valid way of monetizing the United States' huge natural gas reserves and getting that gas to markets that are willing to pay much more for it than domestic customers.
As I said, I don't see the major suppliers going crazy with bringing on supply. Past boom/bust cycles were driven at least in part by the actions of smaller companies to grab business while they could; there has been a lot of consolidation, though, and larger companies are usually more restrained in their capacity expansions.
SEE: Cashing In On A Commodity Boom
The Bottom Line
I like what Flowserve is doing with its operations, and I like the long-term market growth potential. The real question now is whether the company can expand its free cash flow conversion rate from a volatile pattern that averaged around 6% to something more consistently in the high single-digits or low teens. Right now, I'm willing to give the company partial credit for that transformation and a low teens forward free cash flow growth rate. Doing so suggests a target in the low $130s, which makes Flowserve a solid hold but not an especially promising new money candidate.
At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.
by
Stephen D. Simpson, CFA
Stephen D. Simpson, CFA, is a freelance financial writer, investor, and consultant. He has worked as an equity analyst for both sell-side and buy-side investment companies in both equities and fixed income. Stephen's consulting work has focused primarily upon the healthcare sector, while he has also written extensively for publication on topics pertaining to investments, security analysis, and healthcare. Simpson operates the Kratisto Investing blog, and can be reached there.
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