How Much Is Already In The Pipeline With Flowserve?

By Stephen D. Simpson, CFA | May 03, 2012 AAA

One of the realities of the stock market that frustrates less experienced investors is that the Street often foresees growth well ahead of its appearance in the financials ... and when it shows up, the stock is already generously priced. That looks to be a risk with Flowserve (NYSE:FLS) these days. While this industrial company is well-positioned to benefit from ongoing capital spending in oil and gas, power and chemicals, to say nothing of future projects in water, the current valuation already presupposes quite a lot of future business.

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A First Quarter More or Less In-Line
Flowserve had a solid open to the 2012 fiscal year, but largely did as expected. Revenue rose about 8% as reported (or 10% on a constant currency basis), with very strong results in the Industrial Products segment (up 21%), weaker results in Engineered Products (up 2%) and nearly 8% growth in Flow Control.

Flowserve also managed to show some additional operating leverage. While gross margin dropped 150 basis points, and dropped more in the Engineered and Industrial segments, operating income grew 9%. Despite the gross margin pressures, operating margin improved in two of the three segments and declined only modestly in the Engineered segment.

SEE: Understanding The Income Statement

More Business on the Way
Bookings are a closely watched number for companies like Flowserve, Tyco (NYSE:TYC), General Electric (NYSE:GE) and Emerson (NYSE:EMR), and Flowserve showed continued growth here. Although booking growth (7%) trailed revenue growth, the book-to-bill was still above one overall and in every single segment.

All in all, Flowserve's basic operating environment is still favorable. Exploration and production companies continue to drill and build out the gathering infrastructure they need to move oil and gas to the markets. Likewise, while the United States power industry is still trying to navigate new regulatory realities, overseas markets like China continue to push on with nuclear plant projects.

Can the Backlog Smooth out Performance?
One of the downsides to the Flowserve story is that its fundamental financial performance shows more volatility that the industry as a whole. While Flowserve periodically does post attractive returns on capital and free cash flow margins, it has never done so on a sustained basis. As the backlog continues to fill, analysts are more optimistic that the company can finally deliver a more consistent performance, but investors should keep in mind that the Street pays a premium for stability (and likewise punishes volatility).

SEE: 5 Must-Have Metrics For Value Investors

The Bottom Line
Flowserve seems to have its businesses on track, and the company is one of a relatively small number of players that can service demanding markets like nuclear power and LNG. Unfortunately, the Street is already incorporating a lot of expected improvement into the valuation. Even if the company grows its free cash flow at a compound rate of nearly 10% over the next decade, the stock is less than 10% undervalued. Given those demands and the alternatives in the industrial sector, investors can likely find better candidates to buy today.

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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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