Flowserve Corporation

Welcome to the first quarter 2020 earnings call. My name is Sylvia, and I'll be your operator for today's call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. During the question-and-answer session, if you have a question, please press star then 1 on your touch-tone phone. Please note that this conference is being recorded. I will now turn the call over to Jay Rouge, Vice President, Treasurer and Investor Relations. Sir, you may begin.

Thank you, Sylvia, and good morning, everyone. We appreciate you participating in our conference call today to discuss FloatServe's first quarter 2020 financial results. Joining me this morning are Scott Rowe, FloatServe's President and Chief Executive Officer, and Amy Schwetz, Senior Vice President and Chief Financial Officer. Following our prepared comments, we will open up the call for questions. And 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 8, 2020, 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 available on our website at flowserv.com in the investor relations section. I would now like to turn the call over to Scott Rowe, Flowserv's president and chief executive officer, for his prepared comments.

Thanks, Jay, and good morning, everyone. Thank you for joining today's call. First, I hope that everyone is healthy and taking the necessary precautions to to stay safe and well. The world has dramatically changed in the two and a half months since our last call. In February, we talked about the virus impacting our China and Asian operations. Since then, the coronavirus has spread through the globe, altering the way hundreds of millions of people around the world work, interact with each other, and live their day-to-day lives. This has upended the global economy, and with very few people now driving or flying, the demand for oil, natural gas, and related transportation fuels has plummeted to historic lows. The magnitude of this unprecedented crisis creates a challenging backdrop for FlowServe. However, we enter this period with a strong backlog, over a billion dollars of liquidity, no debt maturities until 2022, a trusted brand, great products and services, and most of all, outstanding people. Over our 230-year history, FlowServe has managed through multiple market downturns. While every crisis brings renewed challenges, I have absolute confidence that by leveraging the collective experience of our team and the progress we have made in the FlowServe 2.0 transformation program, we will come out of this situation a better and stronger company. We're using a four-phased approach to position FlowServe for success throughout the COVID-19 crisis and the market downturn. COVID-19 crisis management includes focusing on the safety of our people, delivering customer support in the continuity of our business, which is about restoring our capabilities, planning and executing for the downturn, and finally, positioning FlowServe to differentiate in the future. FlowServe has remained open for business throughout most of this pandemic, as the vast majority of our sites and facilities are considered essential to support the global energy, chemical, power, and water infrastructure complex. This is a responsibility that we don't take lightly, and we have done so by prioritizing the health and safety of our employees, customers, and suppliers. I want to express my sincere appreciation to our associates for their extraordinary efforts during these challenging and unprecedented times, and particularly to those employees who are on the front lines and have enabled FlowServe to continue supporting our customers. Additionally, I could not be more pleased with the efforts of our company to support our local communities. FlowServe is providing equipment to improve sanitation within hospitals, collaborating to accelerate the development and manufacturing of low-cost ventilators, and providing support to hospitals and caregivers around the world. We are doing everything we can to provide assistance during this critical time. We have been closely monitoring the COVID-19 situation since the middle of January to best position FlowServe to respond to the pandemic. We stood up crisis teams in Asia, Europe, and the Americas and leveraged our global experience as the virus spread around the world. Our leadership team is met daily on the topic to coordinate how best to protect our associates and continue to support our customers. Our emergency response teams have been operating in compliance with and on the advice from local governments as well as following CDC and World Health Organization recommendations. Furthermore, we implemented processes around personal protective equipment, appropriate social distancing through staggering of shifts, and temperature checks for all on-site associates. Where there has been a risk of infection, we have immediately begun contact tracing, quarantine procedures, and temporary site closures for cleaning. Despite all of these efforts, we have faced a significant level of disruption as COVID-19 spread around the world, causing temporary facility closures and impacting our employees at those sites. We have associates that are directly impacted by the virus, and we operate in several of the hot spots around the world, like Milan, Madrid, and India. In terms of numbers, over 90 of our facilities and offices have experienced periods of temporary closure through May 6, impacting the work routine of over 8,000 associates. In most cases, the closures were limited to one to two days, although in some cases, like Italy, Spain, China, Argentina, and India, we have experienced long periods of closure. Nevertheless, virus-related challenges delayed roughly $74 million of revenue in the first quarter. Amy will get into more of the financial impact, but clearly, idle facilities materially impacted our results. As of today, we are open for business, but we still have three significant manufacturing facilities in India that that have only partial staffing to comply with local regulations. We have made significant progress over the last three weeks and we now have approximately 95% of our operating capacity open and are operating around 80% productivity. We still expect to deliver roughly 88% of our $2.2 billion backlog that we began 2020 with during the year. Assuming the impact from the pandemic doesn't worsen and our suppliers remain stable. In the face of this challenge and disruption, we expanded our efforts to best serve our customers, working closely with them to ensure business continuity and prioritizing critical shipments. I'm extremely proud of our teams and the positive feedback received from our customers as we supported their operations. There are too many instances to share, but examples include expedited delivery of a critical nuclear valve to prevent power disruption and accelerating vacuum pump shipments for sterilization applications in healthcare and pharmaceutical industries. Our supply chain team is doing a great job managing potential delays, navigating logistics risks, and shifting to alternative vendors to maintain continuity of supply. We've established a number of hit teams and workflow processes to minimize lead times and provide assurance of materials. Presently, India is the most challenged location for our supply chain. We're resourced to roughly $150 million a year. primarily for local Indian operations and North American valve facilities. Our Indian suppliers are facing the same manpower restrictions that we are facing. Our team is assessing local viable options, but critical POs are being moved to alternative regions and secondary suppliers. We expect the supply chain disruption to continue to improve through the second quarter. Shifting to our first quarter financial results, the COVID-19 disruption in the quarter had a significant impact to our financials. As a result of some discrete non-cash charges, our reported EPS was breakeven. On an adjusted basis, our earnings were 21 cents per share. Both results included approximately 19 cents impact from the COVID-19 disruption related to delayed shipments and the cost associated with closed facilities. Constant currency revenue grew modestly while bookings declined 6.6% on a constant currency basis as our customers reacted to the crisis and access to their facilities became more limited for our service technicians. Our free cash flow improved 8% compared to a year ago on strong working capital performance. Turning to our segments, FCD's constant currency bookings and sales were both down approximately 6% and continued to be impacted by slower MRO activity in North America and Europe. The quarter's bookings included several $3 to $7 million awards across power, chemical, and defense markets. Adjusted operating margins declined 590 basis points to 10.1%, reflecting the revenue mix shift towards lower margin project work away from shorter cycle MRO, as well as the impact of COVID-19 disruptions to operations. FPD's constant currency bookings decreased 6.7%, Oil and gas project activity continued in the first quarter, including seven awards totaling over $90 million across Asia, the Middle East, and North America. Aftermarket orders of $426 million increased 1% on a constant currency basis as the seal aftermarket business performed well despite the COVID-19 challenges. Revenue increased 6.2% constant currency, driven by original equipment growth of 25%. Adjusted operating margins declined 300 basis points, which was driven by a combination of pandemic-related impacts in the 600 basis point mixed shift towards original equipment from aftermarket. FPD entered 2020 with a strong project backlog following 2019's original equipment order growth of over 20%. Turning to our consolidated bookings and served in markets, First quarter bookings were $977 million, producing a book-to-bill of 1.09. However, this amount was down 6.6% year-over-year on a constant currency basis. In March, we did have the highest level of monthly bookings for the quarter, as is typically the case, but the amount was muted by global crisis. The backlog of $2.2 billion grew sequentially 3.8% on a constant currency basis. To date, we have had one small cancellation within our backlog, which was a North American chemical project that has been delayed and descoped. We have not had any material cancellations from our backlog at this time. We have had a few discussions with mainly upstream oil and gas customers in the Americas about potentially placing certain orders on hold or canceling them, although the amounts involved would not represent a material portion of our backlog. Original equipment bookings in the quarter were $475 million, down at 14.6% compared to last year's first quarter. Aftermarket bookings in the first quarter were $502 million, flat to last year's bookings. While aftermarket bookings were generally good, customer site access limitations as well as delays in scheduled turnarounds impacted our aftermarket bookings this quarter, as a significant amount of work has been delayed until the third and fourth quarters when operators can plan and execute on-site projects and services. I would also note that while our bookings discussions with the financial community tend to lean toward big projects, traditionally 85% to 95% of our annual bookings are tied to existing operating facilities, are installed based in our customers' aftermarket and MRO budgets, where we expect to see more stability. Turning to our served-in markets and starting with oil and gas, First quarter bookings decreased 13% year-over-year on a constant currency basis, driven by FPD's 14% and FCD's 8% declines. The quarter included eight awards in the $5 to $40 million range, totaling $90 million. The first quarter bookings included multiple pump package awards to support cleaner fuel production, where we continue to benefit from emission regulation changes. On a constant currency basis, chemical bookings were down roughly 13% in the quarter, primarily driven to FCD's 21% decline. The quarter included two smaller awards totaling $10 million in Europe and Asia Pacific. In 2019, the oil and gas and chemical markets accounted for roughly 60% of our bookings. Our large customers in these markets are integrated majors, national oil companies, and the big global chemical producers. Our exposure with them is heavily weighted towards the downstream markets and their fixed infrastructure. While we expect this business to be impacted by the current situation, we believe these companies will continue to invest to keep their operations safe and productive, and we have no doubt this group of companies will be there for the long run. Only a small portion, about 5%, of our oil and gas exposure serves the upstream markets where the most severe cuts and concerns are expected. Moving now to power, our power markets saw constant currency bookings down 1%, where FPD's 3% increase, including concentrated solar power and nuclear awards, was offset by FPD's 4% decrease. While gender industries, and specifically distribution, continue to face headwinds from the MRO slowdown in North America, first quarter bookings increased 7% year over year, driven by FPD's 10% increase, including growth in mining and pulp and paper markets. Finally, representing our smallest market, water bookings decreased 9% in the quarter with no significant awards. Regionally, we saw growth in Europe and Latin America of 10% and 11% respectively, more than offsetting this growth were declines in North America, the Middle East, and Africa and Asia Pacific of 15%, 20%, and 4% respectively. I'll return shortly to discuss our path forward in Outlook, but let me now turn the call over to Amy to cover our financial results in greater detail. Amy has been with us for almost three months, and I'm pleased to have her on the team and appreciate her early contributions during this critical time. Amy?

Thanks, Scott, and good morning, everyone. As Scott mentioned, I joined the company about three months ago and am delighted to be here at FlowServe. With the spread of COVID-19, my onboarding process has been far from what I had planned or expected. Under normal circumstances, I would have been traveling to our facilities to meet with our teams and get a firsthand view of our operations and the opportunities in front of us. Luckily, thanks to video conferences and phone calls, I have been able to do much of this remotely. However, as Scott laid out, all of us on the leadership team have been primarily focused on ensuring the safety of our employees and working diligently to guide the company through this challenging time. So while this has certainly been a case of diving into the deep end, in many ways working through this crisis over the last few months has accelerated my climb up the learning curve. One of the attributes that attracted me to FlowServe and that is particularly valuable in the current macro environment is our strong liquidity position. FlowServe ended the first quarter with $622 million in cash and cash equivalents. Additionally, we have $721 million of available capacity under our revolving credit facility, which remains undrawn. Together, this makes for a strong position at quarter end, with over $1.3 billion of available liquidity. Additionally, in our seasonally weak first quarter, we delivered free cash flow of $30 million, a 7.6% year-over-year increase, despite lower earnings. I understand that this is only the second time over the past decade that FlowServe has generated positive free cash flow in the first quarter, which is an indication our focus on working capital is paying dividends, and I congratulate our team. FlowServe's current leverage primarily consists of about $1.4 billion of low-cost fixed-rate debt. We have no material maturities until 2022, and the company continues to be rated investment-grade by the major credit rating agencies. I am confident that this strong balance sheet and liquidity position, combined with an improved ability to generate cash flow, disciplined capital spending, and the actions that we're taking to manage costs, will position FlowServe well to weather the expected near-term market challenges. And as Scott discussed, we also continue to implement our FlowServe 2.0 initiative, which will produce a more efficient and flexible business model, and enhance our ability to capture opportunities and drive value creation when our served markets return to growth. Turning to the first quarter results, we delivered adjusted EPS of 21 cents on modest revenue growth. On a reported basis, first quarter EPS was break-even, including realignment and transformation expenses of 10 cents, 20 cents of non-cash tax-related valuation allowance, and $0.05 of other non-cash asset write-downs and a gain of $0.14 in below-the-line foreign currency, primarily due to the revaluation of U.S. dollar denominated items on the foreign balance sheet. As Scott mentioned, the financial impact of the COVID-19 disruption to our operations was significant. We estimate approximately $74 million of revenue was deferred from the first quarter at locations most heavily impacted by the virus, which combined with costs related to idle facilities and the compensation expense of unproductive labor resulted in approximately $33 million of impact to gross profit, or roughly 19 cents per share. With revenues deferred, first quarter sales of $895 million only increased half a percent or 2.2% constant currency versus the prior year. The strong 7.7% increase in original equipment revenues drove our growth. FPD was a primary contributor with its 4.3% growth, driven by a 23% increase in original equipment sales. Aftermarket revenues of $442 million were down 6%. primarily due to disruptions within our QRCs and limited access to our customers' facilities. Turning now to margins. First quarter adjusted gross margin decreased 290 basis points to 30.8%, including FPD and FCD declines of 260 and 330 basis points, respectively. In addition to the disruptions in our facilities, margins were further negatively impacted by a 400 basis point mixed shift towards OE, driven by FPD's 600 basis point shifts. On a reported basis, FlowServe's first quarter gross margins decreased 330 basis points to 29.7%, again due to COVID disruptions and mixed headwinds, as well as increased realignment expenses of $4 million versus last year's first quarter. First quarter adjusted SG&A as a percent of sales increased 120 basis points year over year to 25.3%, primarily due to the timing of certain expenses as well as the year over year increase in the allowance for credit losses, which was due in part to the new accounting standard implemented in January. On a reported basis, SG&A as a percent of sales increased 420 basis points, primarily due to $18.7 million of higher realignment charges, as last year's first quarter included a gain on the disposition of SPD assets. First quarter adjusted operating margin decreased 400 basis points to 5.9%, including SPD and SPD declines of 590 and 300 basis points, respectively. Again, underutilized and disrupted facilities, higher SG&A, and sales mix impact are the primary reasons for the decline. Reported first quarter operating margin decreased 730 basis points to 2.9%, including the previously mentioned approximately $20 million of increased realignment and transformation expenses and approximately $10 million of non-cash asset write-downs. While we continue to take measures to ensure the health and safety of our workforce and minimize the disruption in our facilities, we are also actively addressing our cost structure going forward to ensure it's aligned with expected market conditions. And Scott will provide more details in just a moment. Turning to cash. Our cash flow from operations increased roughly $8.8 million, including strong working capital improvement of $22.2 million Primary working capital decreased $38 million versus last year's first quarter and declined 200 basis points as a percentage of sales to 26.4%. Transformation initiatives continue to deliver working capital progress in the quarter, including our five-day DSO improvement and modest improvement in inventory returns. First quarter free cash flow increased about 7.6% year-over-year to $30 million. This resulted in significant improvement to our free cash flow conversion metrics. We had positive free cash flow despite the small reported loss versus a 47% conversion to reported earnings last year, even with the headwind of the $6.7 million of higher CapEx. Relative to our adjusted earnings, free cash flow conversion improved to almost 110% versus last year's 52%. During the first quarter, we returned about $58 million to shareholders through both our quarterly dividend as well as by repurchasing about 1.1 million shares in the open market to offset equity compensation dilution, which is similar to our approach in 2019. Driving cash flow performance will remain a top priority in 2020. With active management of accounts receivable, inventory, and supply chain embedded in our transformation initiative, as well as the reduction in working capital that traditionally accompanies market volume decline, we are confident in our ability to generate cash during this downturn. And we view the first quarter year-over-year improvement in DSO and our free cash flow performance as an affirmation that we are on the right track. Turning to our expected cash usage in 2020 and considering our near-term focus on capital preservation, We have reduced planned capital expenditures to below $60 million versus the original estimate of $90 to $100 million. Our investments here will largely consist of maintenance capex and enterprise-wide IT investments that further enable our transformation progress. With no material debt maturities this year, expected uses of cash consist primarily of realignment and transformation expenses, and the funding of expected dividends of approximately $100 million. Finally, before turning the call back to Scott for his closing remarks, I would like to mention that while my initial and current priorities have been largely internally focused, both navigating this unprecedented downturn and driving the transformation progress, I do very much value and look forward to actively engaging with our shareholders in the financial community. Again, I'm proud to serve as Low Service Chief Financial Officer, and I'm looking forward to the years ahead. Let me now return the call to Scott.

Great. Thank you, Amy. Let me wrap up my prepared remarks to outline the actions we are taking to respond to the pandemic and the downturn in our markets. I'll start with the market outlook. I've spent a lot of time over the past month connecting with customers, including virtual meetings with each of our top ten customers for direct feedback on how they are managing through the crisis. I want to start by sharing a few observations from these discussions. In general, it is expected that projects that are past FID are expected to continue to progress forward, but could be slowed or de-scoped, while projects in the feed stage will likely be delayed and many will never proceed. We've already seen many of our large customers announce double-digit CapEx budget cuts in 2020 due to supply and demand issues weighing on commodity prices. Additionally, most of our customers referenced a prolonged recovery and an extended period of reduced project investment. These customers were committed to keeping their existing facilities operational, and they do not expect significant cuts in reliability in uptime-related projects and spending. With reduced greenfield and brownfield spending, aftermarket and replacement of original equipment become an even greater priority for FlowServe. While this type of work is typically more resilient, given the severity of the demand decline and limited access to our customers' facilities, we expect that in the near term there will be reduced spending due to disruption and delayed turnarounds. Most of these facilities will continue to operate, and while timing is uncertain, the focus on uptime and productivity will lead to renewed maintenance spendings. With these market realities as a starting point, we have developed and are now executing our response plan, which includes capital preservation, cost actions, and reprioritization of initiatives, strategies, and the transformation program. We are planning $100 million of cost reductions within 2020 as compared to the prior year with a similar cost reduction number on a run rate basis entering 2021. Our near-term actions will largely be focused on variable costs associated with expected volume changes, SG&A reductions, and decreased capital spending. In addition to these structural changes, we have already deferred annual merit increases for 2020, have frozen new hiring, eliminated nonessential travel, and expect a significant reduction to annual incentive compensation. plan to substantially reduce capital expenditures to below $60 million, deliver greater supply chain savings, and will continue to right-size our workforce to current market conditions. We will continue to invest in manufacturing productivity and enterprise IT systems that can improve our ability to operate more cost-effectively. We are in the middle of this process right now, and out of respect for our associates around the world, I will not be able to provide more details until the second quarter earnings call. I can assure you that we are taking aggressive cost actions to ensure that our cost structure is right-sized to the new reality of our business. On our last earnings call, I highlighted that we were roughly halfway through our transformation journey to build a more efficient and flexible operating model. We've made significant progress over the last two years, and the transformation has driven fundamental improvement in our culture and performance. Our operational execution progress, improved cash flow, and stronger financial returns encouraged me that CloseServe is significantly better positioned today than any other time in our history to address this crisis. We remain committed to advancing the transformation agenda and the long-term vision for CloseServe 2.0. However, in light of the continuing impact from COVID-19 on our markets, we are proactively reprioritizing planned transformation initiatives. We will accelerate the cost-focused elements of the transformation and like supply chain, design to value, G&A reduction, and manufacturing optimization. We will also continue to focus on serving our customers through the commercial intensity program and a reprioritized strike zone initiative. We must ensure that we're winning the work that is available to FlowServe while remaining committed to our disciplined approach. I am confident that FlowServe 2.0 program has positioned us for success in this downturn, and I have no doubt that FlowServe 2.0 will continue to drive outperformance despite the market conditions. In short, we are focused on controlling what we can control. With the actions we are taking, we are positioning both for the present and the future. In April, we withdrew our full-year guidance due to the rapidly changing environment and the limited long-term visibility. At this time, we are not going to reinstate guidance, but I will provide some color on how we are thinking about the second quarter. We believe bookings might decline by as much as 15% to 25% year over year, primarily driven by declines in original equipment bookings and moderate declines in aftermarket bookings. We believe revenue will be similar to this year's first quarter, subject to our ability to keep our manufacturing locations open and operating. Thus far, we have had more success in April than we had in March. The cost control actions that I just discussed will have a small benefit to gross margins and SG&A in the second quarter, but will have a much bigger impact in the second half of the year. Our operating margins in the second quarter will again depend on keeping our operations open, but at this time we do anticipate operating margin deterioration. I should say we do not anticipate operating margin deterioration. I would expect that our adjusted earnings per share in the second quarter to be at or better than the first quarter, subject to our ability to keep operations open for business. In summary, I am proud of how FullServe has responded to this crisis, provided support to our customers, and worked through the difficult decisions and challenges of a significant downturn. We will continue to drive towards a more efficient FullServe operating model as we continue to build on the fundamental improvement and momentum of our CloseServe 2.0 transformation. We believe that all of our actions will position CloseServe to navigate the current market environment and capture the eventual growth opportunities as markets recover in the future. We remain committed to driving value for our associates, customers, and our shareholders. Operator, that concludes our prepared remarks. We'd now like to open the call for Q&A.

Thank you. We will now begin the question and answer session. If you do have a question, please press star, then 1 on your touchtone phone. If you wish to be removed from the queue, please press the pound sign or the hash key. If you're using a speakerphone, you may need to pick up the handset first before pressing the numbers. Once again, if you have a question, please press star, then 1 on your touchtone phone.

Okay.

And our first question comes from Mike Halloran. Please go ahead.

Good morning, everyone. Hope everyone's doing well. So first, could you put some of the comments in historical context? When you think back historically, obviously aftermarket tends to lead. Bookings take a fair amount of time to recover. So in the context of that, when you look back historically, how long has it typically been until you start seeing I don't even mean large-scale projects, just more normal project activity out there. And then also, what is the customer's ability to defer aftermarket more than a quarter or two, like you saw, say, in 15 and 16 where the deferrals were longer? My suspicion is the deferrals won't be as significant this time around, but I'd love some thoughts on that as well.

Yeah. So, Mike, let me talk – we'll talk about the 14, 15 kind of, you know, industrial recessions. That's the guideline there. Let me talk OE first, and then I'll come to aftermarket. And I just say the fundamental difference really is that now we've got a virus that doesn't allow people to, you know, interact and perform work. But let's talk OE first. And so in 2014 and 2015, you know, we saw kind of a, you know, 20% down on our overall bookings with a 25%, 30% OE reduction in 2015 and into 2016. and then started to climb out of that in 17 and 18. And what I'll say is, you know, what I saw coming in in 17 is there's probably some things that we could have done a little bit earlier to get bookings going, and we had some issues operationally during the realignment program. And so, you know, I think I don't know if that's a go-by. I think every crisis is a little bit different. What I would say is, you know, the downturn in energy on this one is significant because but at the same time, the world's reacting significantly faster than what we saw in 2014 and 2015. What you can see is production already starting to come down in North America. You're seeing rig count come down. By taking this decisive action so quickly, you hope that that duration could be shorter than what we saw in 2014 and 2015. Then on the aftermarket side, what we saw in 2015 was about a 10% decline in our aftermarket business. And so what that showed you is customers were still willing to spend money on maintenance, on reliability, on uptime. And I think that's a decent example right now. What I would say, the one caveat there is that in 15, we know that a lot of operators cut too much on their maintenance. And in some of my discussions with the customers, they said that it was too much and it harmed their ability to keep their productivity as high as they wanted to. So I don't know how that translates to what their spending is, but I think 10% is a decent number to start to think about. Now, the issue that we're having right now, though, is they can't bring folks onto their sites because of the virus in a lot of areas around the world. And so they've destaffed to minimal levels for maintenance. They're only allowing suppliers on site for absolutely critical work. And so that's definitely going to have an impact for us in Q2 and Q3, but And it really is, you know, it's a function of when does the world start to return to a more normal place where we can get people together to plan for turnarounds or plan for maintenance-type events, and then when can you actually get them on the site. What we're seeing is a lot of folks are delaying that now into Q3, and we're actually seeing a stack-up on some of those maintenance events. But I do think that some of those even get pushed out into Q4 and into 2021. But that's how it kind of compares to 15. And like I said, all of these downturns are different. And I think it's going to take a couple quarters for us to really understand how this one plays out.

That's super helpful. And then I appreciate the good call you gave on how you're reprioritizing, how you're putting your capital to work within the context of the 2.0 transformation. Could you also give a little color on what that means for any of the R&D, the innovation side of this? Obviously, you're still pushing forward with the commercial initiatives, so I'm guessing they're tied. But any thoughts on how you're thinking about that relative to the cash preservation and liquidity that you're focused on as well?

Yeah, Mike, you know, as you know and as every company is doing right now, it's a balance of what do you have to do in the near term and then, you know, making sure that you can differentiate and do good things in the future and It's no different for flow serve. And so I just say right now, you know, we're relooking everything. So we're absolutely, you know, relooking our technology and our R&D. There are some projects that still make a ton of sense and we're going to accelerate and keep those moving. There are some things that we're working on that were, you know, for the upstream market that we'll put on hold because it just doesn't make sense anymore to invest, you know, good money into that when we know that it's going to be a little bit, you know, longer until you get to commercialization. So I expect probably slightly reduced spending there, but it's more a reprioritization. And as we start to pick up other type projects, I do expect to continue the investment in technology as we go forward. And I'm still a believer that FlowServe has got some of the best products out there. I believe that by continued investment in our products and our services that we can differentiate technically. And so there's really no change to a philosophical approach there. We'll continue to put money into R&D. It's just a reprioritization given everything that's happened here in the last 10 weeks.

Appreciate it. Thanks for the context.

Our next question comes from Andy Kaplowitz from Citigroup.

Hey, good morning, guys. Hope you're well. Yeah, hey, Andy. Good morning, Andy.

Good morning.

Scott, you mentioned the down, I think, 15% to 25% in orders in Q2. Do you think that represents the bottom of demand for FlowServe? Is that what you saw in revenue in April? And if it is, is aftermarket sort of trending at that level, too, given the shelter-in-place initiatives? And I think you just mentioned, you know, evidence that there are, you know, Q3 turnarounds and major maintenance events planned. So, Despite the risk of delays, do you see sort of Q3 starting to recover from Q2 on the aftermarket side?

Yeah, and if we talk just aftermarket, I do think there's, you know, from Q2 to Q3, there's a potential uplift. But it's really hard to, like, be definitive about that because we just don't know, you know, how the world's going to be, you know, where the virus is and, you know, where the quarantine and the regulations start to get lifted. Right. I'd just say if things are progressing and regulations lifted and people are interacting and allowed onto these different sites, then I would think Q3 would be a better aftermarket quarter for us. If that doesn't progress, then that gets pushed into Q4 or even Q1 of 2021. But I think things have been pretty drastically turned off for aftermarket, certainly from the last two weeks in March. and through April, and so it's already down at that kind of 10% that we saw in 2015, and I think it really is a function of where the virus is and when people are allowed to return to different sites.

Andy, probably the one thing I would add, and I know you know this, but for the benefit of others, it is worth noting that Q2 of 19 was our highest bookings quarter last year, and it was the first time we were over 1.1 billion in a quarter since probably 2014.

Thanks for that color. And then, Scott, maybe just talking about decremental margin, I mean, this might be framey, but should you be able to achieve at or better than your gross margin, you know, which is in the low 30s going forward? You know, any color on how the $100 million of cost can ladder out over time? And maybe you could give us more color regarding the 19 cents of COVID impact in Q1. How much of that impact was just direct manufacturing or supply chain disruption that may go away in Q2 or shortly thereafter.

Yeah, let me talk decrementals first. I know it's been a subject of discussion with a lot of the industrial earnings here. And so two things. One is we obviously want to minimize decrementals as best as possible. And given all the work that we've done on ClosedServe 2.0, I fully expect closer to ultimately be better than what we've delivered in the past on decrementals. The two caveats to that are, one, we're still trying to get people into the sites and start working. And so when you've got a lot of unproductive time in your manufacturing locations like we had in Q1 and we'll have in the beginning of Q2, then it becomes really difficult to compare decrementals or quite frankly to even talk about them. And so I'd say I'm optimistic by the end of Q2 we're going to have a much better ability to talk about it. The other headwind on the decrementals is just, and it's the same thing that we talked about at the end of the fourth quarter, was this margin mix of OE to aftermarket. And so last year we had 20% growth in the OE bookings, which is now causing a mixed headwind. You can see it in the Q1 numbers. it's going to play out for the remainder of the year, and it's going to put pressure on our ability to deliver better detrimentals. On the positive side, we're taking aggressive action on costs. We talked about it on the $100 million, and so that starts to come in reasonably quickly, and that will certainly offset the headwinds on disruption and the headwinds on the mix issue as well. And then on the second part of your question was on – Go to the second part of your question, Andy.

The 19 cents in terms of, you know, once the disruptions fade, you know, does that just sort of go away? And, you know, with the cost, $100 million laddering in, you know, by Q3, is that sort of basically gone?

Yeah. Okay. So the 19 cents of COVID disruption is made up of two things. One is the revenue that we weren't able to get out and the gross margin associated with that. And so that's 14 cents of EPS. And then the other part was basically just the inability to get our folks onto site. And it's basically we were paying them, right? So we didn't want to impact them personally because of this virus. And so we're paying them while they're not doing work. And that cost us another $0.05. And so that's what the $0.19 is. You know, we had a significant amount of days of unproduction in March. What I would say on a go-forward basis is the beginning of April was not great, but where we are today is we're up and operational around the world with the exception of India. Now, unfortunately, India represents – we've got three large locations there. It represents significant revenue for FCD and for FPD. And we're mandated right now to only operate at less than 50% of our staffing. And so we're going to see some impact in Q2. Again, I'm optimistic as the virus subsides that in Q3 we start to return to a more normal place. And then what the 19 cents doesn't represent, Andy, and it's really important, is we didn't quantify just the loss of productivity from all of the kind of two-day closures and the work from home. We had a bunch of facilities, and we talked about it in the prepared remarks, where folks were in for a couple days, and then we had to take them offline for two more days, and then they came back in, and it just didn't equate to strong productivity. And so there's some other noise in there on margin disruption in Q1. What I would say is we're doing a much better job learning how to work in the new environment, and we're starting to see our productivity improve dramatically. pretty significantly here already in Q2 with the exception of our inability to get to India.

Thanks for all the colors. Stay well.

Thanks.

Our following question comes from Josh Pokrowinski from Morgan Stanley.

Hi. Good morning, guys. Good morning, Josh. He's got just a Just a quick question for you, I guess, and I appreciate you outlining the differences between now and, you know, kind of the 15-16 hard landing. You know, I guess one thing that is, you know, maybe a little bit different with no one driving anywhere, you know, kind of a, you know, lack of storage on the crude side, you know, low demand for refined product, you know, kind of out the other end of it. Anything that, you know, kind of results in an overhang because either those customers, you know, have a storage issue or, you know, just demand is so low that they're really trying to throttle back their own utilization. Is that playing into that, you know, those order comments or, you know, productivity comments, et cetera?

No, absolutely, right? And so in my discussions, you know, I've talked to a lot of downstream operators, upstream operators, the EPCs, and the whole issue here is that demand is down, you know, I mean, there's a couple estimates out there, but, you know, pick a number, 7% to 10%. on the demand for oil. And so then you look at what the production's been doing, and that keeps going. And so now you've got the whole system is essentially full, and you've got storage now at maximum levels and no place to put it, and dislocation of pricing and negative oil pricing in April. And so these are significant events that are having major implications across the whole system. And, you know, the refiners are operating at kind of 70%. We're seeing some of those already idled. And so, I mean, these are major events that are having a massive impact. You know, I feel pretty good about the Q2 numbers that I shared in terms of being down. And then I think really what the big factor is, you know, for Q3, Q4 and beyond is, you know, again, when does the virus start to subside? When do folks start on, you know, driving and getting transportation fuel going? When do you start flying again? And that really is going to dictate the timeline of return to more normal oil and gas fundamentals.

Got it. That's helpful. And maybe just a longer-term question. I mean, some of your end markets, namely oil and gas, but I guess anything in the process world right now, are now on their kind of second big shock in five years. How is that kind of tempered or altered the way your customers think is Is the three-year planning horizon for something just too far out to predict the future? Have they kind of narrowed their project scope in some of those discussions you're having just over a timeline they can more readily predict? Or is it too soon for all of that? Just any kind of thought on your end or what you're hearing from customers would be helpful.

Well, I think it's a little early, but I also think that what's really important is just kind of you've got to look at this on a geographic basis and an upstream-downstream basis, right? And so when you look at who's going to be challenged the most, the upstream operators in North America are just incredibly challenged, right? And so a three-year planning window there is very much out the window, and they're in complete crisis mode and trying to preserve costs and do the best they can during this. But if you look at kind of the downstream side, I think most of those operators are still thinking more three years, five years. The good news is that's the majority of our customer base. They're typically bigger customers who have historically operated with good cost discretion and can live in most different environments. And then on the chemical side, I think it's the same thing, where they're still working through their longer-term business plans They know the short term's not good, but they're going to be there and they're going to continue to operate three to five years from now. And so I just think you've got to really look at the different markets. You've got to look at the different geographies as you think through kind of what's going to work and what's not going to work. And so when I say we've got to reprioritize our strike zone and our R&D, that's why we have to do it, because there's just going to be a lot of different ways to operate in depending on whether you're upstream or downstream or whether you're in special chemistries or petrochemicals. And then the geography is going to be really important as well. And so we know North America will be incredibly challenged. The Middle East will probably continue to spend and move at a more robust rate than other parts of the world. And we believe that in Asia that you're going to see continued investment there, albeit at a slower pace than what we've seen over the last couple of years.

Scott, I appreciate all that. Thanks, team, and best of luck to you.

Our next question comes from John Walsh from Credit Suisse.

Hi. Good morning, and glad to hear everyone as well. Hey, John. Maybe just first a clarification. I think, Scott, in your answer to Andy's question, I might have thought as we got to the back half of the year, that the headwinds from the aftermarket mix might dissipate? Maybe I misheard the answer, or, you know, is that the right way to think about it? You know, I'm just looking on a year over year basis, the aftermarket mix, and you were at 49% in the back half of last year.

Yeah, so really you've got to look at 19 in our bookings, and we outbooked aftermarket by 20% last year. And so that headwind really is going to play in for all of 2020, and I don't expect that to get more normalized until 2021. And so as we shift the backlog in OE, it will obviously start to come down. But I wouldn't expect, you know, you're going to still see, you know, more OE than aftermarket, you know, in Q2, Q3, and in Q4.

Gotcha. Okay. Thanks for that. And then I don't think I heard it in the prepared remarks, but can you talk a little bit about your experience that you saw in China, kind of as they got on the other side of COVID, what you saw in terms of activity levels there? through the year, maybe comparing, contrasting February with April?

Sure. For us, we've got manufacturing and operations in Suzhou, which is east of Wuhan in the epicenter. We were shut down for two weeks post the Chinese Lunar New Year, which equated to about three weeks offline. We've been able to get that operation up and running, and we've essentially got our supply chain in China almost fully restored and operating in normal. And then on the customer side, we had decent bookings in Q1. We had bookings in China in February for large projects. And, in fact, one of the oil and gas projects that we mentioned was in China. And so I think for them, a lot of the planned investment that was already in the works is absolutely continuing and moving forward. What I would say is I do think you're going to see reduced spending there. I think that it ultimately slows down. But they didn't cancel anything, or at least that we were involved in, during that timeframe. Now, I'd also say that, as I think most people fully know, China was incredibly robust in terms of their precautions and their clampdown to really make sure that the virus did not get out of Wuhan and tried to contain it as best as possible. And it's been very difficult for the rest of the world to follow the model that China did. And so, I think it's going to be interesting to see how the rest of the world responds as we get to the other side of this. But I do think China will probably be one of the better examples, along with South Korea and a few others, that have done a really good job of the shutdown and then in re-implementation. But I think for us, right now, we feel good operationally that our China facility is up and going. We feel reasonably good about our ability to keep the supply chain consistent and constant and support our operations And in Q1, at least, we saw decent order rates in China itself.

Great. Thanks for taking the question.

Our next question comes from Dean Dre from RBC Capital Markets.

Thank you. Good morning, everyone, and welcome to Amy.

Thank you.

Hey, just to clarify on the second quarter bookings comment of the framework, Jay, it was nice to remind us about the tougher comp, but what about where do you think your distributors stand today, all the destocking that typically happens? Did that happen this quarter, or do you think you still see some in the second quarter, too?

Yeah, it's a good question, and I'll separate kind of our pump distribution from our valve distribution. On the pump side, it was reasonably good in Q1 as a lot of that product is going to the MRO and keeping the downstream facilities up. We did have... OK bookings on the valve side for the big stockists. And you can see the number versus Q1 last year. A lot of that was some of our natural gas products on the valve side. And then a little bit was our actuation product going more to the midstream side. The problem, though, is with everything really turning dramatically down in March and April, and you can see this with the public companies that are out there, right, D-NOW and MRC, I mean, they're really struggling right now because their business is predominantly North America and just have such a big mix to the upstream side. And so, unfortunately, unlike a quarter ago where I thought we might have some tailwinds on this destocking, there's going to be another leg down on destocking from the valve main distributors today. I think we have a few products that will do okay because they've got reduced inventory, and I'd say those would be more of our downstream valve products and more of our natural gas type products. But overall, net-net, it gets worse with our distributors before it gets better.

Yeah, that makes sense. And then just to clarify on the capital allocation front, I'm not sure I heard you say whether buybacks – are on hold or is that still open? Is it still addressing share creep? Where does that all stand?

Yeah, I think we'll let Amy take this one.

So with respect to capital allocation, there really hasn't been a change of philosophy for the company since I've joined. We did repurchase shares in the first quarter, but that was really to offset equity dilution that we had from those compensation plans and so we're not anticipating significant share repurchases over the course of 2020. We do maintain an active plan. We've got about $113 million still available under that plan, but taking into account the global pandemic, our current leverage and credit ratings, there's probably more pressing issues than share repurchases, but you can never say never.

Great, that makes sense. And just last quick one, did I hear or did we see that there was some asset write-downs in the quarter? Were those COVID-related?

So I would say that those asset write-downs, a couple of different buckets for those. First, in our adjusted EPS, you did see us record a write-down of our deferred tax asset in Italy. That was And that was about a $25 million impact or about 20 cents per share. That was expedited, I would say, by COVID-related activities in Italy and the disruption that we saw at those sites. We also had some inventory and AR-related write-downs that were specific to a certain project in Latin America. that I would say that current oil prices did have an impact in triggering that write-down as well.

And what was the amount on that one?

So about $7.5 million on the project.

Got it. Thank you.

Our next question comes from Gerald Ritchie from Goldman Sachs.

Thank you. Good morning, everyone, and welcome to Amy as well. Good morning. So my first question, maybe just kind of starting on the restructuring action, Scott, and I know you can't give us a lot of details on them today, but to the extent that you can maybe kind of parse out how much of it is temporary versus structural, and that's the $100 million, and then in the context of 2021 with the additional $100 million, Maybe you can kind of put that in the context of, like, the longer-term margin target, you know, the 15% to 17% that you guys are targeting for 2022.

Sure. Yeah, no, it's a good question. Happy to address it. I'll just start with, you know, we fully understand the magnitude of this crisis and thus the bigger number and the quicker action than you've seen in the past on, you know, in executing this. I do need to be a little bit careful because out of respect to our employees, this is an ongoing effort and we're in discussions right now with various labor groups around the world. But what I can share is that of the $100 million, roughly half of that this year would be the cost avoidance type actions with the other half coming from structural actions. I think that's probably a decent way to look at it. And then so if you think forward, right, some of the cost avoidance things come back, some don't come back, but then you're getting a full year of structural savings versus kind of six and a half, seven months of the structural savings. So that's probably the easiest way to look at it. And then just the other thing I would say is You know, this has been an incredibly fluid and dynamic environment. And so while we think this is the right thing to do right now, if things get worse, then we'll take more actions. And then the other important point is we still have $2.2 billion of backlog, right? And so we've got to get the backlog out. We've got to support our customers. And so we've got a lot of costs that we've got to preserve as we're working through that backlog to get that out. And as the backlog comes down, then we start to work out some of the labor that's directly related to getting the product out. And so I think you'll see more from us as we go forward. And really, while none of this is good and none of these decisions are good decisions, what we're firmly convinced is that this is something that we had to do given where the outlook was and what we're trying to achieve today. And then on our margin targets for the future, while we're still committed to achieve that and to be a better place than we were or where we were last year and even where we are today, there's going to be some issues as we bring the business down from a size perspective. We're going to have some pricing challenges. And so I just say let's see how this plays out over the next quarter or two And then what we'll do at the end of this year, just like the end of last year, is we'll start to reconcile kind of where we are and update where we are on a target basis for 2022. But it's just, as you can imagine, a really dynamic time. And, again, we're going to do whatever it takes to make sure that we're preserving our margins and that we've got an incredibly viable business for the future and making sure that we're prepared for the other side of this.

No, that makes a lot of sense, Scott. I appreciate the details. I guess maybe my one follow-up, you mentioned earlier that projects that are in the feed stage are basically getting deferred, but the ones that are in FID are continuing to move forward. I guess just in that vein, when you look at your pumps division and the backlog that's in that business today, Is it the expectation that you're going to be able to continue to work off that backlog throughout the year and the pumps division will actually grow in 2020?

Yeah, we have substantial backlog in pumps, and so we're going to have good revenue in that platform. I'm not going to commit to growth just because we're not sure what the book and ship numbers look like, but I did get some color on Q2 overall, and in Q2 we expect the revenue to be very similar to the Q1 revenue numbers. And then as we finish the second quarter, we'll provide some better and clearer guidance as we're thinking about the back half of the year.

Okay, fair enough. Thank you all.

Our next question comes from Joe Giordano from Cohen.

Hey, everybody.

Hey, Joe. Yeah, hey, Joe. Good morning.

Hey, Scott, I just wanted to clarify something you said earlier just to make sure I heard it right. So you meant on the operating margin, you said you do not anticipate deterioration. I assume that's sequentially. I just want to make sure I have that right.

Yeah, I apologize. I kind of stuttered on that one here. Let me walk through the Q2 outlook just so we're super clear. So first on the booking side, we expect 15% to 25% down. Color on that, OE will be down more than the aftermarket, and then FCD will probably be impacted more than pumps. And so the 15% to 25% would be a comparison to last year's Q2. And as Jay said, Q2 last year was our highest bookings quarter at $1.1 billion. And then when we look at revenue, we think Q2 revenue will look something similar to Q1. And again, it's really subject to our ability to keep those facilities open and operational. And then on the gross margin line, I would expect gross margin percentage to be a little bit better than Q1 of this year. But again, it just depends how much disruption we have. And so if we can avoid that kind of $8 million of paid time off, then our margins start to look better than what we had in Q1. And then what we were saying is on the OI or the EPS sign, The operating income and the EPS should be at least what we saw in Q1 2020. But again, subject to our ability to keep things open and operational. And then I made comments in the prepared remarks, the SG&A in Q2 will be better than what we saw in Q1, but really the full impact of those cost changes really start to show up in Q3 and Q4.

That's clear. Thanks for going over that again. I know this is not going to be something that's on your mind as much right now, but once we finally get through all this stuff, call it two years out, whatever it is, you're a company that has big leverage to markets. that have had two generational corrections in five years. So like, how do you think about that long term and how do you structurally want to be organized as a company? And do there need to be kind of more material changes to ensure portfolio resilience long term?

Sure. So obviously we have been heavily focused on closed-serve 2.0 since I've been here. What we did with the board, though, this February was rewriting the long-term strategic direction proposal. And I'll just share a couple things on that. But number one is we do want to stay committed to what we do well, and that's the flow control space. And then the second thing we really started to think through was 10 years from now and 20 years from now, what do our markets look like and where do we want to play? And so we talked a lot about diversifying. We talked a lot about how do we get in things that we know will continue to be there and We certainly didn't anticipate what we're seeing right now when we talked through that, but we've got some ideas to solidify the growth and the long-term outlook for closed-serve. We'll continue to progress on that. I'm not going to commit to anything right now in terms of directionally and what we're doing, but there were probably 10 big ideas that we walked through that if we can execute on two or three of those, it starts to put another leg in what we're doing. another leg to the stool and kind of gets us really well balanced in position regardless of kind of what the different markets are doing. Thank you.

Our next question comes from Andrew Obin from Bank of America.

I guess good afternoon. It's still morning where you guys are.

We've crossed the noon hour for you, haven't we?

First of all, I'll just join everybody in extending my welcome to Amy. Welcome on board, although times are quite challenging. So the first question I have on free cash flow, could you just talk about the challenges of releasing working capital throughout 2020 in an industry that's sort of been hit by low oil prices and maybe the nature of the supply chain just by design and contracts is very long term. So how should we think about sort of ability to release working capital in 2020?

Sure. And let me just start by doubling down on something that was in my remarks, which is we do expect to generate free cash flow in 2020. Working capital has been a huge focus of the company long before I came on board. And you really are starting to see those improvements take hold with good comparative progression DSO improvement five days better than it was in Q1 of last year. Frankly, that's despite headwinds if you think about productivity, about people working from home, and the efforts from a collection side that goes into that. Certainly the market will present some challenges, but we've moved pretty quickly to preserve cash. And so if you look at what we've done from a CapEx perspective, bringing that spending to match it with the current environment down to $60 million or less, deferred merit, eliminated discretionary spend, we think that we've taken the cost actions necessary to help us preserve that. And that's backed up by our strong backlog. So if you think about that and what we'll do from a revenue perspective over the course of 2020, that gives us some line of sight. So I think that although there are clearly some headwinds, we think if we continue to do what we're doing, With incremental focus, I think, on both inventory management and what's going on on the supply chain side, we're going to continue to see progress in the area of working capital over the course of 2020.

I'll just add on here. This is the one area I'm incredibly pleased with our progress since I've been here. We're at 26% working capital this quarter. When I started, we were over 30. We're making good progress. Most of that was through the FullServe 2.0 initiative And what I would say is the investment in systems and process is really starting to show itself. And so I don't expect us to back off. I mean, obviously there's going to be some challenges on, you know, different parts of working capital. But I do think we'll be able to release the working capital as the business comes down. And quite frankly, I'm still expecting us to improve our working capital as a ratio as we move forward.

Now, that certainly has been sort of one of the things you – did very well. And just a follow-up question, sort of longer term, you know, you sort of highlighted inability to get your text on customer sites, so a two-part question. First, maybe more color or what geographies are particularly challenging, but the second question, sort of longer term, you know, how do you think, you know, you did highlight at your analyst and consistently more investment, but sort of industrial IoT opportunity as it relates to remote monitoring. Do you think this will be sort of an impetus to accelerating this? Because we've heard from multiple companies that this online stuff is just a lot more relevant in this environment. So sort of two-part question. Thank you. Sure.

Yeah, in terms of getting people on site and to different areas in the geography, I'd say certainly North America's challenge on that is there's been broad work-from-home restrictions. In Europe, it is incredibly prevalent and still is the case where most people are working from home and there hasn't been or very little relaxation of those constraints. Asia is the part where, in China, we're allowed to get a lot of our service techs back in. I'm trying to think of another bright spot around the world, and there really isn't right now. Geographically, I'd say Europe was the worst. North America has been challenged in terms of getting people into locations. Latin America has been challenged, certainly in April, maybe not so much in mid-March. I think you've got to just follow where the virus is and where the case counts are, which tells you whether or not we're able to work there. But I do think, let's go to your second part of the question. There is absolutely no doubt that the ability to do things remotely and monitor our equipment and provide value-added insights around reliability and uptime and prediction only becomes more and more important. And we showcased our technology, gosh, a year and a half ago. We continue to make really good progress in moving through kind of next generation of that. We've got our technology up and operational on many sites around the world, and I really believe that this type of investment and this approach to monitoring assets without people on the location only gets accelerated with COVID-19.

Thank you so much. Have a great day. Thank you.

That is all the time we have. A lot of your questions. Thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating. You may now disconnect.