Flowserve Corporation

Good day and welcome to the Q2 2022 FlowServe Corporation Earnings Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Jay Roosh, Vice President of Investor Relations and Treasurer. Please go ahead.

Thank you, Christina, and good morning, everyone. We appreciate you participating in our conference call today to discuss FlowServe's second quarter 2022 financial results. On the call with me this morning are Scott Rowe, the Service President and Chief Executive Officer, and Amy Schwetz, the Senior Vice President and Chief Financial Officer. After our prepared comments, we will open the call for questions. As a reminder, this event is being webcast and an audio replay will be available. Please note that our earnings materials do, in this call, include non-GAAP measures and contain forward-looking statements. These statements are based upon forecasts, expectations, and other information available to management as of July 28, 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 disclosure, as well as the reconciliation of our non-gauged answers to our reported results, both of which are included in our press release and presentation. and are accessible on our website at float.com in the investor election section. I would now like to turn the call over to Scott Rowe, Float Service President and Chief Executive Officer, for his preparedness. Great.

Thank you, Jay, and good morning, everyone. Thank you for joining our second quarter earnings call. We are pleased with our second quarter performance, which modestly exceeded the outlook we provided on our last call. The 30 cents of the EPS that we delivered in the second quarter keeps us on pace to deliver within our full year adjusted EPS guidance. Closer benefited from top line growth in the quarter as our incremental adjusted operating margin was nearly 60% on a sequential revenue increase of 7%. Our end markets remained supportive and we delivered strong with $1.04 billion, primarily by aftermarket and MRO activity that is now above pre-pandemic levels. The overall operating environment was challenged in the second quarter, but signs of stabilization appeared late in the period, giving us renewed confidence in our second half outlook. During the quarter, bottlenecks remained for certain procured items, such as electronics, soft goods, and motors. Supplier lead times were still extended, but have begun to stabilize, providing us more certainty to incorporate their delivery dates into our production schedules and our customer commitments. China lockdowns continue to be the headwind for most of the second quarter, with lockdowns easing and logistics improving late in the second quarter, allowing our facilities and suppliers to start the process of restoring their production. Additionally, our global suppliers continue to be impacted by labor availability issues and an inflationary environment that existed for most commodities and raw materials. While we are seeing evidence that pricing for some items may have peaked and could be starting to moderate, particularly as it relates to logistics and materials, the two price increases that we have implemented so far in 2022 will support our efforts to maintain price-cost neutrality for the year. The first price increase began to show this quarter, and our most recent increase will benefit the second half of the year. I was fortunate to visit many global manufacturing locations during the second quarter, and saw the impact of these challenges firsthand. To say the least, it is an incredibly difficult environment to operate in, and I want to thank our dedicated and devoted teams for their passion and commitment to serve our customers and drive success for Folkserve. With this operational backdrop, the results we delivered demonstrated the resolve and dedication of our associates around the world. Our teams adapted and found their way around to the challenging environment by placing a high level of focus on mitigating the disruptions, minimizing the costs that we had incurred in recent quarters. We worked hard to qualify new suppliers where needed and aggressively repositioned and expanded our supplier base. Where appropriate, we spent cash to build our inventory with forward purchases and expedited critical components and materials. These efforts helped ease the expanded lead time environment and increased our ability to more accurately predict delivery times. that will continue our operation as we build resiliency in our chain, strengthen our planning capabilities, and staff our operations to the growing environment. The entire organization is focused on our strong backlog into revenue growth and margin expansion. The second quarter continued a trend of solid bookings, and I couldn't be more encouraged by the strength and demand for our products and services that we saw in the quarter. In the quarter, our $1.04 billion in new awards delivered a year-long bookings growth of 10% despite the strengthening dollar. The growth was primarily driven by our aftermarket and run-rate businesses as several of the large projects in our funnel shifted into the second half of the year. The high utilization rates at our customer facilities and the impact of deferrals that took place in 2020 and 2021 drove aftermarket bookings of $526 million, which delivered constant currency year-over-year growth of 4.5%. From an original equipment perspective, bookings increased 21% in the prior year to $518 million. While we did not repeat the amount of large-scale work that was in the first quarter, primarily due to timing, we did receive roughly 15 orders in the $5 to $20 million range across all of our major end markets. Additionally, our MRO-related original equipment bookings remained strong. While we saw several projects progress to funding in the second quarter, a few of the orders that we did expect to book in the quarter shifted into free, and some of these have already been booked by. Our project funnel for large project work over the next 12 months continues to grow in the second quarter, with good visibility into opportunities across LNG, nuclear, oil and gas, water, several desalination projects. Finally, the developing markets and our committed partners in our distribution channel provide strong bookings for the first half, which should continue during the remainder of the year. With both solid OE and market bookings in the quarter, our backlog topped $2.3 billion, reaching the highest level since 2015. This level of work under contract is aligned with our expectations of a supportive demand environment position us well to deliver strong growth and margin improvement as we move forward. As I've mentioned in prior calls, I am increasingly confident that we are at the beginning of a multi-year growth cycle driven by a number of factors, including aging existing infrastructure pressured by hospitalization, which will require ongoing investment to maintain capacity and increase efficiency in reducing use. Energy security and energy independence is a rapidly growing theme driven by the war in Ukraine, and it will require significant investment across our traditional markets, including increased LNG capacity and renewed interest in nuclear power. GDP growth and consumer demand will also continue to drive infrastructure space in our chemical, water, and general industry markets. the global focus to decarbonize and meet CO2 reduction commitments will further support investment opportunities. I would also like to highlight that our diversification, decarbonization, and digitization growth strategy contributed to strong rankings in the second quarter. In particular, we saw strength in areas where we utilized our flow control activities to support customers' decarbonization efforts. Our energy transition alone has been over 60% since the beginning of the year. Looking now at our performance by end market and on a constant currency basis given the strengthening dollar. Chemicals represented the strongest market for year-over-year with bookings up over 20%, including two small project awards totaling $12 million. Oil and gas industry bookings were up over 20%, and it benefited from project work in the $5 to $20 million range. Water bookings were up 37%, with two projects totaling more than $10 million. including a desalination project in the Middle East. Finally, our power bookings grew up roughly 3% on a relatively tough $20,000 compare that included a $12,000 nuclear award. From a regional perspective, our second quarter bookings growth was driven primarily from North America and Asia Pacific, which grew up 19% and 27%, respectively. Europe delivered 9% growth from the Middle East and Asia, Africa was essentially flat. Finally, Latin America bookings were down roughly 10%. Let me now turn the call over to Amy to address our financial results in more detail.

Thanks, Scott, and good morning, everyone. We are pleased with our second quarter financial results, which exceeded our prior expectations, as well as the sequential progress we made. While the current operating environment continues to pose many of the challenges we faced in recent quarters, including supply chain issues, logistics, and other frictional costs, we are encouraged by the modest improvements in these industrial bottlenecks that we began to see late in the second quarter. Considering these recent positive trends, we continue to anticipate additional stair-step progress in the quarters ahead. That said, I'd like to reiterate Scott's commentary that the major catalyst for the sequential growth we delivered in the second quarter was the hard work and unwavering dedication displayed by our associates. Their initiative and efforts to mitigate the challenges in the current landscape were integral to our performance. In the second quarter, we reported EPS of $0.34, which exceeded our adjusted earnings per share due to $10 million of below-the-line FX gains. Adjusted EPS of $0.30 excludes the FX gain, as well as the $3 million non-cash impairment and modest realignment charges of about $500,000. Those are reported and adjusted EPS results demonstrate the impact of what top line leverage can deliver to Closers results. Further, our quarter end backlog is up to $2.3 billion, an increase of 15.6% since year end. driven by year-to-date book-to-bill ratio of 1.25. This solid foundation and our outlook for constructive end markets to continue support our expectation that revenues will continue to increase in the coming quarters. As Scott highlighted, we are equally encouraged that demand for our comprehensive portfolio of flow control products looks to remain strong across all of our core end markets and within our 3D strategy. Specifically within that 3D strategy, we drove solid bookings in targeted markets, including decarbonization, specialty chemicals, energy transition, and water during the second quarter. The combination of tailwinds from our traditional end markets and accelerated growth from the 3D strategy drove a bookings increase of nearly 15% on a constant currency basis year over year. This bookings growth was primarily driven by improvement in our original equipment orders, which were up 21% or 27% on a constant currency basis, with both FPD and FCD in that range. As small projects moved forward and distributors began to restock. In particular, we saw solid contribution from FPD distributors, where the channel represents roughly 40% of the segment's business. Aftermarket bookings were over $500 million for the third consecutive quarter. Despite the strong dollar, we continue to remain at or above pre-COVID levels as operators look to catch up on previously deferred maintenance and our sales engineers continue to add value for our customers. Closer second quarter revenue declined 1.8% year over year, but increased 2.8% on a constant currency basis. The constant currency growth was driven by aftermarket in both segments, reflecting strong MRO and aftermarket environment of the last several quarters and stabilization in our operations. On a sequential basis, sales improved 7.4% with contributions from both aftermarket and original equipment. As I mentioned, deliveries of original equipment have continued to be impacted by supply chains and logistics headwinds, as well as labor disruptions. And while each product category within our supply chain will stabilize and improve on a different timeline, we began to see modest improvements in many of these areas at the end of the quarter and are expecting the positive trends will continue. Regionally, North America's constant currency revenue growth over 13% included 23 and 10% growth in FCD and SPD, respectively. Middle East and Africa contributed 20% growth on SPD's strong 32% increase. However, growth in these regions was partially offset by low double-digit sales declines in Asia Pacific and Latin America, as well as a 2% revenue decrease in Europe. Moving now to margins. Second quarter adjusted growth margin decreased 300 basis points year-over-year to 28.4%, resulting in 170 basis point improvements sequentially. The year-over-year decline was primarily driven by material and logistics inflation, ongoing temporary frictional costs, actions to drive supply chain management improvement, and increased thunder absorption, which were partially offset by a 100 basis point shift to aftermarket and the impact of the early 2022 pricing increase. While we continue to expect to see modest progress in the overall industrial landscape for these issues during the second half of the year, we are not banking on significant improvement in these underlying global challenges. Similar to the second quarter, our associates will work hard to minimize the macro challenges to deliver to our customers. We believe these efforts, improvements that we expect in the supply chain and associated costs, the impact of the second price increase of 2022 taking hold, and the expected positive benefits that higher original equipment sales volume will have on absorption will contribute to higher gross margins for FlowServe going forward. On a reported basis, second quarter gross margins decreased 270 basis points to 28.3% due to headwinds discussed earlier. partially offset by a $3 million decrease in realignment charges. Second quarter adjusted SG&A decreased $18 million to $192 million, marking our fourth consecutive quarter at or below $200 million as a result of our disciplined cost management and a modest FX benefit. As a percentage of sales, adjusted SG&A decreased 160 basis points to 21.7%. Initially, adjusted SG&A was roughly flat, despite the 7% revenue increase over the first quarter, demonstrating the leverage we expect to deliver as we continue to grow in the second half of next year. On a reported basis, second quarter SG&A decreased $16 million year-on-year, including the impact of an asset write-down of $3 million, partially offset by the reduction in realignment charges of roughly $2 million. Second quarter adjusted operating margin increased 130 basis points to 7.2% year-over-year, with SPD down 200 basis points and SPD down 80 basis points, driven primarily by the decline in adjusted gross profits, partially offset by our SG&A management. On a sequential basis, adjusted operating margin improved roughly 390 basis points, producing a sequential incremental margin of 60%. Second quarter reported operating margin decreased 120 basis points year over year to 6.8%, driven by the previously discussed challenges. Our second quarter adjusted tax rate of 20.3% was in line with our four-year guidance of 20 to 22%. Turning to cash flows. Second quarter operating cash was a use of $45 million, primarily due to a build in working capital $104 million on continued backlog, including investment and inventory buffers, as well as the timing of certain accrued liabilities. We have used roughly $95 million in the first half of the year for inventory, including net contract assets and liabilities, to support the $313 million increase in backlog year-to-date. The combination of strong bookings growth and improved project environment and the frictional issues delaying shipments has pressured our working capital as we look to capitalize on the environment. As you would expect, the growing backlog and shipment delays have also impacted working capital as a percent of sales, which in the second quarter picked up 50 basis points to 29.9%. Despite this increase, I am pleased that for the seventh consecutive quarter, we have lowered the total inventory, including net contract assets and liabilities, as a percentage of backlog, which now stands at 32%, our lowest level in three years. Lastly, other material uses of cash in the quarter included dividends of $26 million, capital expenditures of $17 million, and term loan amortization of approximately $8 million. As most of you know, LOSERV traditionally uses cash in the first half of the year, but then delivers strong cash generation in the second half. We expect these seasonal dynamics to again play out in 2022. Turning now to our outlook for the remainder of the year. Based on our second quarter performance, we affirmed our target range for the full year. However, if the U.S. dollar remains at its current strong level, we believe our financial results will likely be at the low end of the range for both our revenue and adjusted EPS. Even with this expectation, substantial year-over-year and sequential growth for both revenue and adjusted EPS for the second half of the year are still implied. In terms of phasing, we expect the third quarter to be a modest improvement over the second quarter. and then to finish the year strong in Q4, positioning us to enter the new year with increased momentum. Our view is based on expectations for incremental stabilization and modest ongoing improvement in the supply chain and logistics challenges we have faced for a year now, as well as better cost absorption coming from longer lead time original equipment currently underway at our sites. We are not forecasting a significant ramp in backlog conversion rates, but we do expect combination of our strong and growing backlog, our ongoing operational progress, and the continued efforts by our associates in material planning and supply chain management, as well as the impact of our May price increase to support the sequential financial improvements for the remainder of the year, including an expected fourth quarter adjusted operating margin in the 12 to 14 percent range. The four-year adjusted EPS target excludes our $20 million charge to exit Russia, the modest expected realignment expense of approximately $10 million, the second quarter asset write-down of $3 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, etc., Including the adjustments incurred in the first half of the year and the expected second half realignment spending, we now expect our reported ETFs to be in the $1.25 range. Both the reported and adjusted ETFs range also assume current foreign currency rates, reasonably stable commodity prices, the continuation of current market conditions, no significant improvement in the Russia-Ukraine conflict, and expectations for our customers to continue to release larger project work in the second half of the year. 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%. Turning to our full-year expectations for the major planned cash usages, we continue to expect to return over $100 million to shareholders through dividends in fiscal 2022. We also intend to invest further 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 will continue to invest in our 3D strategy to diversify, decarbonize, and digitize, where we delivered solid Q2 bookings progress related to energy transition and other targeted markets. Let me now return the call to Scott.

Thanks, Amy. As I mentioned earlier, we are encouraged by the strength of our traditional markets, as well as the opportunity to further accelerate our growth as we execute our diversify, decarbonize, and digitize strategy. Our 3D strategy aligns directly with Closer's longstanding purpose to provide extraordinary full control solutions to make the world better for everyone. The success we have had targeting opportunities in diversification, decarbonization, and digitization And the first half of 2022 demonstrates that this is the right strategy for the current environment and for years to come. During my travels to the Middle East, Europe, and the Americas, my discussions with customers have validated our expectations of increased investment in these areas and our view that capitalizing on their increased investment will deliver a more robust growth profile than just our traditional markets. One thing that became very clear from these discussions is that decarbonization is a consistent theme across the globe and is now appearing in all of our in-markets. Currently, our energy transition for the next 12 months stands at $675 million versus $415 million at the beginning of the year. This growth supports our conviction that flow service products and services are well-positioned to serve this growing market. Let me now discuss our strategy for each of the three DPs to provide some recent wins in these areas. Beginning with Diversify, we are aggressively targeting and expanding each of our offerings in previously underserved regions and markets that exhibit attractive long-term growth prospects, like water, especially chemicals, and other general industries where we have strong capabilities. In the second quarter, we were pleased to be awarded a project providing pumps to a specialty chemical manufacturer in Asia for the world's first integrated polylactic acid facility. FlowServe is helping to meet the increasing demand from diverse markets, including 3D printing, hygiene products, flexible packaging, and food service wear. Decarbonization is expected to provide opportunities globally, and FlowServe is uniquely positioned to enable the flow control aspect of decarbonization, CO2 emissions reductions, and flow loop energy optimizations. Additionally, we are very focused on providing flow control technology and energy sources. For example, FlowServe was recently awarded a contract to supply over 2,000 control and ball valves for what will become the largest commercial green hydrogen plant in the world based out of the Middle East. Upon expected completion in 2026, it will produce over 650 tons of hydrogen daily and 1.2 million tons of green ammonia and which will eliminate the equivalent of 3 million tons of CO2 emissions per year. Finally, the Digitize effort focuses on the growth opportunities driven by our Red Raven IoT platform and the value it creates for our customers. Since Red Raven's launch in early 2021, we have gained increasing traction with new and existing customers and are currently operating in 49 customer sites, across our core end markets and have instrumented roughly 1,500 pumps, valves, and seals with Red Raven. As an example of recent success, the leading electric power-generating company in East Africa encountered an unforeseen issue with one of its pumps. Working closely with the customer to resolve the issue, we presented Red Raven as an opportunity to improve operability, and we implemented the IoT solution with Red Raven's real-time digital monitoring capabilities. we've empowered this customer to take an active approach to diagnose and prevent equipment failure. Going forward, our plan is to continue to focus on instrumenting our existing install base, as well as new equipment, with the goal of significantly growing this recurring revenue stream and providing additional pull-through aftermarket opportunities. While we are enthusiastic about the opportunities available from our diversification, decarbonization, digitization strategy, both serves responsibility to ESG truly embedded in all aspects of our business. On June 30th, we released our 2020 Environmental, Social, and Governance Report, outlining our ongoing commitment to create extraordinary flow control solutions that make the world better for everyone. We believe this focus will not only enhance our own ESG efforts, but will allow Closer to play a critical role in supporting our customers build a better tomorrow. I encourage everyone to review the entire report available on our website, but I am particularly pleased to highlight our strong safety performance, our continued progress to achieve our 2030 carbon emissions reductions goal, and the commitments we've made to the communities we serve through Closer Cares, where we supported over 150 charitable organizations last year. Our ESG progress was recognized last year by Forbes Magazine as one of the world's top female-friendly companies, and Newsweek Magazine ranked Fullserve as one of America's most responsible companies for the third consecutive year. We are proud of our achievements and the third-party recognition, but we are really only at the beginning of our ESG journey. Fullserve will continue to prioritize ESG and make additional progress in the years to come. In closing, I am confident that Fullserve is making progress. I remain impressed by our associates' passion, commitment, and expertise. With the solid progress we've made in the second quarter, I'm convinced that we're doing the right things to work through the challenging environment and position us for growth ahead. As we look to the remainder of the year, I am very encouraged by the health of our in-markets and our ability to capitalize on these opportunities through consistent execution and customer focus. We expect further progress in converting our strong $2.3 billion backlog, improving our operational execution, and advancing our growth strategy to position FullServe to exit 2022 with significant momentum. Together, we believe this focus will enable FullServe to deliver solid long-term value for our associates, our customers, and our shareholders. Operator, this concludes our prepared remarks, and we'd now like to open the floor to questions.

Thank you. If you would like to ask a question, please signal by pressing star 1 on your telephone keypad. If you are using a speakerphone, please make sure your mute function is turned off to allow your signal to re-equipment. Again, press star 1 to ask a question. We'll take our first question from Joe Giordano with Cowan.

Hey, guys. Thanks for taking my question. Morning, Joe.

Hey, can you maybe try to scale some of the opportunity in Europe, like with nuclear and gas being considered green now and the size of LNG. If you were to take all that, what is that now for you guys and what can that potentially be over the retooling of the European power situation? Sure.

Obviously, the situation in Europe is significant as they get less and less natural gas from Russia. What we're seeing is the renewed interest in both nuclear, LNG, natural gas, and then other forms of energy. These are all traditional markets. Most of it has played for decades. We've got an incredibly strong team in Europe. We have great capabilities and great products for those markets, and so we're really encouraged about what's happening there and our ability to help Europe secure energy for the future. I just As a reference, year-to-date in nuclear, we've booked about $140 million. That's substantially more than we've seen over the last couple of years, and that funnel continues to grow. And so we are positioned very nicely for nuclear. There will be significant spending there, and we're already seeing a lot of that both on some of the expansion side but also on just extending the life of those assets. And so we believe this is an area of growth for us, and as we move forward, But, you know, the coming quarters, we'll continue to see ourselves in long-term success there.

I noticed on one of the slides when you were just going through the financials of FPD and FCD, the gross margin was the same and SG&A was significantly less at FCD. So what's, like, the natural gap there, and how should we think about that going forward?

So generally, if we think about SG&A between the two segments, FCB normally we would expect to have a little bit of a lower run rate from an SG&A perspective, in part because of how we allocate R&D costs between the platforms. But I think that's a relationship that you would expect to see continue going forward.

So the gap that we saw this quarter was like a normal – that magnitude of gap is pretty normal for what you'd expect?

I don't think it was out of the ordinary. in terms of what we saw this quarter or what we would expect going forward.

Okay, great. And then just last, if you can maybe just comment on your working capital outlook for the rest of the year. I know you'll deliver more cash in the second half like you always do, but just your view on some of the key working capital accounts. Thanks.

Sure. So I would start with inventory. And as we think about pushing working capital performance in 2022, we are not focused in driving down the inventory. below where we're at today. We recognize that there are some investments that we need to make with respect to inventory coming into our plants in order to stabilize the supply chain. In addition to that, as these large products come in, we anticipate that we will see growth in our content assets moving forward. So where we need to continue to push from a working capital perspective is with respect to collections. and obviously our own tailings. And we'll continue to do that. Receivables is an area where we put quite a bit of focus as a company through the transportation projects, and we'll continue to work to drive collections improvements. Frankly, the mix that we see with strong MRO sales should help us do that. And from an AP and vendor perspective, we'll continue to work with our vendors to push on working capital. But overall, you know, we're at 29.9% this quarter. Scott and I continue to have a goal of driving primary working capital as a percentage of sales down to the mid-20s. I would anticipate that this year any improvement that we see over where we're at in the second quarter of this year will be relatively modest.

Thank you.

And we'll take our next question from Nathan Jones with Steeple.

Good morning, everyone. Maybe just following up on the working capital question there. Typically, you're going to consume a little bit more working capital when the business is in growth mode, which clearly with the order rates growing and backlog growing, it's going to be. Does that target get a little bit more difficult to achieve in 2023 or 2024 as a result of potentially needing to support the growth in the business with working capital?

So I think two things will incur over time. Certainly as the business grows, we see pressure on a receivables perspective, from an inventory perspective, and that would include obviously our contract assets and liabilities. What I will say, I think, is going to be a tailwind going forward as we work through these supply chain and logistics challenges, many of which are causing us to carry inventory at levels above where we would traditionally be at. I think as we think about this in terms of a 2023 and 2020 outlook, frankly, that will continue to moderate and be able to carry inventories at levels that are – at safety stocks that are more normal for the industry. So although it's a challenge today, I think as we move forward 12 months and 24 months, it actually becomes an opportunity for us.

Great. And I wanted to ask a follow-up on, I think you called it the decarbonization project funnel. I think it was like 675 million versus low 400s at the end of the year. Can you give us some more color around that project funnel? Kind of how quickly do these projects age? You know, how quickly do they get awarded? What kind of win rate do you have on the funnel that you're tracking? Just some more details you can give us around that. Sure.

Yeah, so the deep organization side is something we're really excited about. And what we're seeing is, you know, and I said it in the prepared remarks, is that across all of the in-markets, everyone is doing something to reduce their CO2 emissions. And so we're seeing that either with energy reduction, right, so the amount of energy that's needed to run their asset. We're seeing it in electrification of the asset. We're seeing it in carbon capture and sequestration. And then we're also seeing lots of opportunities around the biodiesel side or the bioconversions. And then as we we're seeing that now in green energy, right? So whether that's concentrated solar power, the hydrogen award that I mentioned on our call. But what we're seeing is, like, this is happening in our traditional markets, and it's also happening with the new energy sources. So this area is growing faster than anything that we, you know, any of our markets, and I would say that continues to grow as we move forward throughout, you know, the next probably, you know, the next couple years. And so we are... well-positioned to that. Our offering both in pumps, valves, and seals works for a lot of the different applications, and we're continuing to invest our new product development in our R&D to make sure that we're well-positioned for success as these markets move forward.

Are your win rates on those kinds of projects any different to your traditional kind of projects that you track?

Yeah, I think they're slightly higher than what we would say is our traditional, and so a lot of these projects we're working directly with the end user. Some of them are through EPC, but when we can work directly with an end user, demonstrate our ability to help them in the front-end design in the engineered solution, then we've got a much better chance of success. Yeah, I wouldn't say we're double the win rate of our normal markets, but we're certainly doing a better job than just in the traditional markets there.

Great, thanks for taking my questions.

Take our next question from Damian Carras.

Hi, good morning, everyone. Good morning.

Hey, Damian. So we should go ahead and model the 60% incremental margin in perpetuity. Does that seem reasonable? That would be nice.

I wouldn't recommend that, but we do expect to continue to see incremental improvements in our

Yeah. So maybe you could just talk a little bit more about the backlog conversion and how that's trending. I think last quarter you maybe threw around a 46% number. What are you assuming for the rest of the year? And I guess, you know, we think about the 12% to 14% margin where you plan to exit. Does that basically assume you're kind of back to normal on that conversion ratio?

No, as we look at conversion rates, you know, we saw some modest improvements in our VALS portfolio in terms of conversion rates moving from the first quarter to the second quarter. But really, the improvement that we saw between Q1 and Q2 was some reduction in some of those frictional costs and improved marginality in Q2. in the products that we shipped during the quarter. So as we move forward in the year, we're not anticipating a resumption of sort of that 46% average conversion rate of backlog moving forward. The fundamentals in the supply chain and our markets are just not there for the remainder of the year. But as we think about that fourth quarter exit rate, one, I would start by commenting that the fourth quarter is traditionally FlowServe's biggest quarter of the year from a revenue conversion, from an operating income and cash flow generation standpoint. And the operational bottlenecks that we've seen year to date really exacerbated that trend. So the fourth quarter is going to be big. In fact, we would think that the fourth quarter could produce roughly half of our full-year adjusted EPS, and that's in part because of a pretty weak Q1. As we think about the third quarter, realistically, the second quarter and the third quarter oftentimes look pretty similar for flow serve. And while this year we would expect incremental revenue and earnings improvement based on the size of the backlog itself and not necessarily conversion rates, our ability to fully capitalize on that backlog is somewhat limited by summer holidays in the northern hemisphere. And so by contrast, in Q4, not only do we have the backlog in place, but conditions and our capabilities to manage them are improving. The pricing increases will be fully embedded, and our SG&A, which we've done a pretty nice job controlling, will be able to be fully leveraged in the quarter.

Got it. That's quite helpful. And then, Scott, you spoke pretty favorably earlier about the LNG and some of the demands you're seeing there. I'm just curious how competitive you're finding these LNG opportunities, and how are you thinking about the profitability there as you bid in on these projects? And really, maybe any just additional color you can share on the types of wins you are seeing. Thanks.

Sure. No, we are definitely doing well in the LNG. We did approximately $30 million in the quarter on LNG awards. That's half of the $46 million we did in Q1. We believe both on the pump side and the valve side and our mechanical seals, we've got a great offering for LNG. We're continuing to be very bullish on the outlook here and our ability to win awards. From a margin or pricing perspective, LNG's a little bit favorable to the overall mix for us just because there are less people that can play in the cryogenic side and have the technology that we have. And so we like this market a lot, and we see significantly strong growth over the next 12 months. In fact, our opportunity funnel for the year is over $400 million over the next 12 months.

Great. That's a lot.

Go to our next question from Andy Kaplowitz with Citigroup.

Good morning, everyone. Hey, Andy. Scott, so orders have been relatively consistent over the last couple of quarters, both in aftermarket and OE. But you did mention some projects are moving to Q3 from Q2. Do you still see a potential positive impact from large projects coming over the next couple of quarters? And I know you've talked about some risk to the strength and duration of the cycle from inflation and or potential recession. So what are your customers saying to you at this point in the middle of the year? Sure.

Yeah, the large projects are always interesting because it's very difficult to predict timing on a quarterly basis. But what we've seen is over the last two years, 2020 and 2021, those projects were basically put on hold, and we're just now seeing a lot of those start to move the system and get funded. And so, you know, while we're slightly lower into large projects than Q1, we still have significant visibility to large projects. In fact, our project funnel is up 13% since the beginning of the year, and we continue to be very optimistic in our ability to get projects in the second half of the year. And, you know, just as a data, we talked about in the first quarter, you know, we had four large awards that were over $20 million. In Q2, we had no awards over $20 million, but we had 15 awards from that $5 to $20 million. And we saw a couple that we expected to book in Q2 have now slid into Q3, which I've already booked in July. And so, you know, I'd say certainly for the back half of the year, we have a lot of visibility, and we are well positioned for success in winning these large projects. And then I'd say, you know, and then as we kind of go forward, this is where, you know, we've got to talk about recession, inflation, and everything else in the dynamics. But I would say today I still feel reasonably confident that these large projects continue in 2023 and 2024. And it goes kind of what I said in the prepared remarks on the macro environment, right? We know there's a need for energy independence. And so you're going to get significant investment in oil and gas and LNG and in nuclear. We know that there's a continued desire for the decarbonization and the CO2 reduction, and so there's going to be significant investment in the carbon capture, energy efficiency, the biofuels, the recyclable plastics, and the hydrogen. And so I just think that the net, you know, we still think that there's a positive outlook for projects moving forward, and I had a bunch of customer conversations in the second quarter, and nobody was talking about those projects moving out or being delayed. They were very confident in the continued movement and progression of funding and ultimately execution of these large projects.

Very helpful, Scott. And then maybe could you give us a little more color into what you're seeing on price-first costs? I know you mentioned the two big price increases this year, but are you seeing any improvement as you bid on these larger projects yet, or is there – Still, you know, a bit of slack in the system, so you kind of have to wait a little bit to see more significant improvement.

Yeah, I'd say we talked about this in the first quarter, and I'd say there really hasn't been a significant change. And so the larger projects attract more competition. Absorption rates aren't where they need to be fully within our peer group. And so the pricing is challenged on the larger projects. We feel good about our margin and backlog continuing to move up. We feel good that the price increase in the first quarter is making its way through the system in the second quarter and the end of the year. And then the price increase that we did today, which was an initial 11%, we feel confident that that's going to start to show up in the back half of the year. And the price increases, as you know, Andy, are really on our assemble-to-order or configure-to-order work. The engineer-to-order work is mostly on a cost-plus basis. But I'll tell you, our team is incredibly focused as our bookings have improved, as we've got better visibility to our capacity getting filled up. We're certainly moving up that expectation of margin and backlog. And so I'd say we're not in a perfect environment on pricing yet, but we are starting to see some improvements. And from just a price standpoint, we feel good that we're watching material prices, inflation. All of the things that we would normally look at from a price-cost standpoint, and we feel like we're at least neutral or going ahead of it as we exit the year. The areas that we still have to work on and reduce are, as Amy talked about in her script, and that's the first cost. We're substantially lower in Q2 than in Q1, and the absorption side as well. As we start to fill up and as we start to continue to minimize that frictional cost, then we start to see our margins progress up throughout the year.

Appreciate all the color.

We'll go to our next question from Dean Dre with RBC Capital Markets.

Thank you. Good morning, everyone.

Hey, can we circle back on China? Because it sounded like that was an area where of angst last quarter and the de-bottlenecking that you would hope would happen seems to be going through. Just kind of some additional color. Is it back to normal? How soon does it come back to normal? Any other kind of repercussions?

Sure.

And just as background for everyone, we do have a large presence in China with both our pumps and our valves. That's part of Suzhou. And then our supply chain significantly leveraged to China as well. And so as China gets locked down and has problems, it does have a significant effect on flow serves. You know, what we saw throughout the second quarter was an easing in the lockdowns really at the very end of the second quarter. And so that was a positive development. And as we kind of move forward, we expect that to continue to be relatively stable. And we expect this to continue to progress there. I'd say right now we're not operating at 100%, but we're operating more in that kind of 70% to 90% depending on the week and the different situations. I'd just say generally the supply chain there is not, like us, is not fully back to 100% normal, but it's substantially better than what we saw in Q2 in the first two months of Q2 and I anticipate that Q3 and Q4 will be reasonably stable, but it's really hard to predict that, and I certainly don't want to bet money on the stability of China right now.

Understood completely and agree. And then follow-up question, and I might have missed this data point, but if you step back and categorize your total orders this quarter within the context of 3D, what percent of the orders would fall within, you know, diversify, decarb, and digital?

Yeah, so just as a reminder that 3D bookings, you know, are really – it's that diversify, it's the decarbonize, and the digitize. You know, some of that is stuff that, you know, we would have gotten additionally. And so we've got to be a little bit careful how we think about it. But to answer your question directly, it's roughly a third or close to a quarter of our total bookings would fall in those categories. And so obviously we are very focused on that. It was $275 million of bookings in the second quarter alone. And then what I'd say is as we track projects, about two-thirds of our overall project funnel is and our project bookings were in that category. And so, you know, our organization is very much leaning in on this strategy. Our incentive plans are aligned to grow in these areas. And then, like I said in the prepared remarks, you know, as I talk to our customers, we're getting very good feedback that we're on the right, that will drive, you know, long-term growth for FlowServe. And, you know, this doesn't mean we're walking away from our markets. In fact, we are very encouraged of the gas market, the power market, and our other traditional markets. At the same time, though, we believe that this gives us an accelerator as we move forward.

Good. And just related to this, on the diversify mandate, when you go into an underpenetrated sector, you said water and chemicals. Do you need to compete more on price to build out a presence and a market share there? So might that be lower margin either initially or does it not play out that way?

Yeah, I think it depends. I wouldn't say it's not the same for each product, each market. You know, just one example of a water offering. We've had a product that historically has done really, really well in water. We kind of walked away from that kind of 10 years ago and didn't really invest in the product line and didn't invest in the channel to market. What we did is send that product through our design to value center. We were able to take out roughly 20% to 30% of the cost. We were able to reconfigure the product and simplify that offering into something that took out part numbers, improved our ability to manufacture, took out space and weight, and then drove the cost down by 20% to 30%. And so, you know, in that specific example, our margins are actually increasing and our ability to compete is substantially better. But there are times that, you know, when we're looking at something very specifically and we've got to make some compromises on pricing to get in there and start to build a track record of success that we're able to use as a case study and talk to our customers. But I would just say, you know, I don't think we're compromising on margins to diversify categories. You know, that's certainly not the communication, the discussion with our teams. You know, it's hard to say just because, you know, we do have a broad product line to say, you know, one versus the other. But I'd say overall I wouldn't expect margin deterioration if we implement our diversification strategy.

Got it. Thank you.

We'll take our next question from John Walsh with Credit Suisse.

Hi. Good morning, everyone. Hi.

Good morning, John. Wanted to circle back to the Q4 exit rate, the 12% to 14%. I was just wondering if we could talk about the buckets that drive that and maybe put any numbers around it, meaning it sounds like you got visibility with the margin in the backlog, maybe OE aftermarket mix. what that's doing in Q4, you know, just any of those big buckets to kind of give people more confidence that that's actually the right exit rate.

So I'll start by saying that there is a large component of that exit rate that is driven by volume. And so, you know, as we think about volume, that does a number of things for us. obviously gives us more leverage over our fixed costs at a site level. From an SG&A perspective, we're not anticipating major increases in SG&A over the course of the year. And the absorption bucket we talk about really comes in two ways. It's coming because our OED log is filling up, and we now have to work at particularly our large engineer-to-order shops It's also coming as we get more around the supply chain. And keep in mind when I talk about certainty, that's not necessarily improvement. It's about the stability of the supply chain. We then have the material that we need on the shop floor in order for the grass to work through and absorb the hours from our workforce at the plant level. So really volume is going to be a significant part of that improvement of the 12% to 14%. As we think about other things that we include in the market of frictional costs, logistics has been another big story that we've seen there. And as we talked about in the first quarter of the year, literally everything was being expedited across the year. everything, but we were making pretty broad assumptions about what were the materials that needed to be expedited. As we transitioned from Q1 into Q2, we've seen more decisions put around expediting materials. We've also seen better information flow into the site level to allow us to make decisions about what is the way that we're transporting goods to a plant site. Can we use ocean freight instead of heavyweight air as an example, which leads to a significant decline in cost? Are we using a contracted route for our road shipments that allows us to use a low cost? So we saw some improvement in logistics costs in Q2, particularly in in the valve space, which we would expect to continue over the course of the year, but that's going to be a benefit that keeps working for us as we go quarter on quarter because those costs are actually embedded in our inventory. So I think when we think about the waivers around that quarter per quarter, it's volume, which will be less constrained in the fourth quarter, and it's not dependent, frankly, on as as it is traditionally on book to ship, the backlogs in place, and then that improvement that we're seeing in a and finally those frictional costs around logistics and other areas of the supply chain.

Great. Thank you. And then maybe just a follow up around price cost. So you've obviously done a lot of pricing initiatives over the last several years. Just thinking about if we snap the line on kind of certain commodity inputs, how do you think you'll be able to keep price? You know, I don't know how much this was kind of surcharged versus you actually pricing for the value you're delivering to customers. Thank you.

Sure. We did surcharge examples primarily on fuel costs, but really for us, we went hard on just doing an overall price increase. Again, we had 5% at the beginning of the year, 11% implemented in May. At this point, we believe that if we just look at our direct cost of products, so that would be our materials, our labor, we feel relatively good about where we are on price cost. What we experienced this year and in the first quarter were those costs and the underabsorption of products through our facilities. And so those are the areas that we're working on. I think Amy's described both of those in detail and how they get to Q3 and Q4. So I would say, you know, if things are going right now, then, you know, we feel we're in a pretty reasonable position on price-cost, and that will translate to higher margins in the back half of the year.

And one thing just to note with our price increases is I would say, you know, throughout 2021 and our first price increase of, 2022, those were somewhat catch-up prices in order to get us back to where we needed to be from a price-cost perspective. I think that the May price increase that we put in place is much more anticipatory in terms of what we saw happening in the back half of the year. So I think we're now at a good distance as well where we're looking at what has happened and what we anticipate will be happening

in our major spend categories. Great. Thank you.

We'll take our next question from Josh Swinski with Morgan Stanley.

Hi. Good morning. Thanks for fitting me in here. Yep. So, Scott, question for you on...

or I guess, you know, Amy or Scott, whoever wants to take it, on kind of what fourth quarter is trying to tell us about, you know, the backlog or maybe the margin profile here over the medium term. I guess there hasn't been what you would call a normal year in some time, but, you know, 4Q margins tend to be, you know, sort of two, two and a half points above maybe what the following year is, taking an average with, you know, a pretty wide range. Is that sort of a fair starting point? I mean, I know on one hand you've had a lot of volatility, but, you know, we're also kind of in year four or five of flow serve 2.0 and an awful lot of, you know, tailwinds starting to pop up from some of these new markets, particularly around decarb. So just wondering how, you know, kind of fourth quarter is pointing us into the early read on future margins.

Yeah, it's a really good question. Let me start, and then I'll hand it over to Amy to provide some more details on our progression from kind of where we are today and into the fourth quarter. I'll just start by saying that the environment that we're operating in is just unbelievably challenging. And as you can see from our results over the last couple of quarters, it is very difficult to predict what we're seeing and then how do we execute in that. What I would say is that we're seeing signs of stability externally, and we're seeing progress within our internal operations. And so if that stability continues, I'm confident the actions that we're taking, the things that we started way back in FullServe 2.0, all of those things start to come through the system. But, again, it's just such a volatile environment. You can see that in our numbers. You can see it with other manufacturers too. It's a difficult time, but we're confident we're doing the right things, and we're very confident that we're going to be able to progress. But, Amy, why don't you walk through some of the details on Q3 and then into Q4?

Sure. So just, you know, again, with our progression during the year, I think we need a couple of things to happen to continue to see the progress that we want to see to ultimately result in that exit rate. So we need materials in our shop floor and we need the hours available from our labor force in order to push that product through. And we really see the fourth quarter of this year as being our opportunity to kind of catch up on those longer lead times that we've seen from a supply chain perspective and then also deliver in the way that we've traditionally delivered before. in the fourth quarter at low serve. And you're absolutely right that as we look across really the last three years, whether it be 2020, 2021, and now 2022 with the unique challenges that we've seen in each of the years, they haven't necessarily played out as normal quarters. But I think as you hear us talk about that exit rate for 2022, we're talking about it as a momentum-building quarter and that, frankly, as we go into 2023, without giving guidance, we think we're going to have a strong backlog. And so we start to return more to... more to a traditional year for flow serve in terms of what that looks like. And so that doesn't necessarily mean that, and it doesn't mean that our exit rate of Q4 will be our margin rate in Q1, but it does mean that we're going to try and build off of that exit rate and move towards expanding margins over the course of 2023, knowing that what we delivered in the fourth quarter kind of resets the baseline of where we want to go where we want to go in 2023. Thank you.

And as there are no further questions, this will conclude today's call. Thank you for your participation. You may now disconnect.