Flowserve Corporation

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

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

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

Thank you. If you would like to ask a question, please signal by pressing star one on your telephone keypad. If you're using a speakerphone, please make sure your mute function is turned off to allow your signal to reach your equipment. Again, that is star one. If you would like to ask a question, it will pause for just a moment to allow everyone an opportunity to signal for questions. And we'll take our first question from Dean Dray with RBC Capital Markets.

Thank you. Good morning, everyone.

Good morning, Dean.

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

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

And do you think you gained share?

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

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

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

Thank you for all that, caller. I appreciate it.

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

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

Yeah.

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

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

Yeah, I'll let Amy answer that. She's got the bridge on our forward look for the year.

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

Appreciate all the color.

Thank you. And next, we'll take our question from John Walsh, Credit Suisse.

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

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

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

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

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

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

Great. Appreciate the detailed answer. Thank you.

Thank you. And next, we'll take our question from Nathan Jones with Spifle.

Good morning, everyone. Hey, Nathan. You've got the whole situation going on with China at the moment.

I think we probably have barely even started to see the ripple effects of what that's going to do to supply chain in 2Q, 3Q, 4Q today. You're talking about, you know, stabilization and maybe some modest improvement in supply chain in the back half of the year. Is there anything that you're seeing at the moment that leads you to that conclusion? Or is that just, you know, an assumption that you're building into the way you're guiding investors out there at the moment?

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

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

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

Yeah, that's a good question. So just for everyone's benefit, our project business where we do cost plus pricing, that's an area that we've been very focused on to make sure that we can deliver the margins that we book at. And so the first step is before we book the project, we do secure pricing from our prime suppliers. And so this would be our big castings, our motors, and the big components there. And so at the time of booking, we feel very good that we've locked in that cost profile for the large projects. Where we've seen some erosion here recently in the last six months has been on a lot of the smaller things that we normally wouldn't have to worry about from an inflationary environment. Now, those make up a smaller percentage of the cost, but they're certainly offsetting some of that margin potential. And so the things that we're doing within the projects, one is our quote validity is now shortened substantially. And so if we do see things change on a general basis, we're able to adjust that and make sure that we can get that pricing into the project. Secondly, we're now putting inflationary metrics into those quotes on the very large projects. Now, what I'll say is that's difficult to do on the smaller projects, but on the bigger projects, we're starting to see success with the ability to put an inflation metric on there. Outside of that, the only other mechanism to get additional price is just to really aggressively manage that project. And if there's a change in the project, that we make sure that through the change order management process that we're getting increased margin in that project itself. But those projects are, for us, it's a fixed price. And going back in and trying to open that up and change the price is really not going to happen.

What you're saying is that most of your cost is already locked in at the time you booked that project.

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

Great. Thank you.

Thank you. And next we'll move on to Joe. Donald with Cohen.

Hey, guys. Good morning. Good morning.

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

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

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

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

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

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

Thank you. And next we'll move on to Joe Ritchie with Goldman Sachs.

Thanks. Good afternoon, everyone.

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

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

Got it. That's helpful. And maybe just a follow-on question there. So if your exit rate is 12% to 14%, I'm assuming that's in FCD. Correct me if I'm wrong there. Maybe it's at the total segment level. you know, that would be... That's actually at the company level. Oh, at the company level. Okay, so at the company level, I mean, that would be several hundred basis points better than the exit rate last year, and I fully recognize there's seasonality in your business as well. I mean, is it fair to say we should be kind of carrying that forward then as we think about, you know, the type of margin improvement we should expect then next year, assuming nothing really kind of changes from what's happening currently. Is that the right starting point for next year?

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

Okay, thank you.

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

Thank you, and that does conclude today's teleconference. We do appreciate your participation. You may now disconnect.