Flowserve Corporation

Good day and welcome to the Q4 2022 FlowServe Corporation Earnings Conference Call. Today's conference is being recorded. At this time, I'd like to turn the conference over to Mr. Jay Roosh, VP of IT and Treasurer. Please go ahead, sir.

Thank you, Anna, and good morning, everyone. We appreciate you joining our conference call today to discuss FlowServe's fourth quarter and full year 2022 financial results. On the call with me this morning are Scott Rowe, Flo Service 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 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 February 22nd, 2023, and they involve risks and uncertainties, many of which are beyond the company's control. We encourage you to fully review our safe harbor disclosures, as well as the reconciliation of our non-GAAP measures to our reported results, both of which are included in our press release and earnings presentation, and both 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, Solicitor's President and Chief Executive Officer, for his prepared comments.

Thanks, Jay, and good morning, everyone. I'd like to start by thanking our associates around the world for their resilience and dedication to our customers and our company. In the fourth quarter, we executed well and delivered significant performance improvement across all aspects of our business, which led to our adjusted EPS of 63 cents. In short, we finished the year strong. These results were achieved despite the continuation of some supply chain and labor availability headwinds. Additionally, we delivered solid bookings of $1.1 billion, representing constant currency year-over-year bookings growth of nearly 20%, with continued support from our traditional in-markets and enhanced 3D booking activity. With four consecutive quarters now exceeding $1 billion in bookings, we ended the year with a near-record backlog of $2.7 billion, despite the impact of a much stronger dollar compared to the last time we were at these levels in 2014. We recently announced an agreement to acquire Valon, a Canadian valve manufacturer. This acquisition will be incredibly complimentary to our existing FCD business and enhances our 3D strategy with growth in nuclear and severe service markets. We're looking forward to welcoming the Valon Associates into the post-serve family toward the end of the second quarter. In the fourth quarter, we delivered modest improvement in our shipping cadence, which drove year-over-year constant currency revenue growth of roughly 19% and total revenues over $1 billion, which was our highest quarterly sales level since the fourth quarter of 2019. I would also note that our North American seal business is back on track, as daily shipments exceeded pre-system conversion levels, and we have significantly closed the gap that resulted from the third quarter's ERP system disruption. SG&A containment remains a priority, and we again delivered a quarterly adjusted SG&A below $200 million, which included the impact of a favorable settlement, but more importantly, it reflects focused efforts around cost management and improved productivity within our overhead structure. With this strong finish to the year, I am confident we'll serve as well-positioned for a successful 2023 as we build on the fourth quarter momentum and deliver our robust backlog. Let me now provide some additional color on our fourth quarter bookings. Bookings continue to be strong in the fourth quarter at $1.1 billion. This is slightly below our third quarter bookings level of $1.2 billion, which benefited from the $225 million deferred contract. While we didn't have a similar size contract this quarter, we did secure a number of awards in the $10 to $35 million range, totaling over $100 million, primarily in oil and gas and chemical markets, as well as many smaller projects in the $5 million range across our end markets. Importantly, our higher margin aftermarket and MRO markets continued to provide solid growth in all regions, further supporting our expectations for 2023 margin expansion. Full-year 2022 bookings of $4.4 billion increased roughly 18% or nearly 23% on an FX-neutral basis. as the overall market rebounded nicely from prior years. We achieved this strong result despite our exit from the Russian market, which typically had provided bookings in the $50 to $70 million range. As we highlighted throughout the year, larger project activity returned in 2022 after several years of delays and was complemented by the second consecutive year of steady growth in our run rate businesses, which together drove a 36.5% increase in backlog for the full year. While we had expected healthy bookings growth as we entered 2022, given the pandemic-driven lack of investment in new infrastructure and maintenance, we performed better than expected, driven by our customers' intention to ensure global energy security in their increased energy transition spending. We expect these trends will continue in 2023, and we believe FlowServe is well-positioned in both new project and aftermarket work. To provide support of these themes, our oil and gas bookings were up 35% in the quarter and up over 40% for the year. And our power bookings also remained strong on energy security concerns, with fourth quarter awards up 17% and up 27% for the year. Shifting to our market outlook for 2023. We believe the current environment supports another solid year of bookings growth for FlowServe, despite the potential for some macro headwinds. While we don't currently expect another project the size of last year's deferral award, we do have visibility to a robust pipeline of smaller-sized projects in 2023. In fact, our project funnel is roughly at the same level as it was this time last year. Additionally, we expect our aftermarket and MRO business to maintain its recent momentum through 2023, as we believe customers will continue to invest in maintenance, efficiency, and decarbonization. Our 3D strategy is working and we expect continued growth in 2023 from our specific efforts to diversify and capitalize on decarbonization efforts around the world. We expect energy security priorities and new energy spending will continue to be key growth catalysts for us in 2023 and beyond. The disruption of energy supplies in Europe has driven heightened levels of activity to secure reliable energy in all regions of the world. These conditions have already driven a significant investment increase in nuclear, LNG, fossil power plants, as well as regional oil and gas infrastructure. We believe this trend will continue to drive capital investment in oil and gas, as well as other energy infrastructure. Additionally, while 2022 decarbonization spending far exceeded our initial expectations by delivering bookings growth of 75%, we anticipate further growth to occur in 2023. Our energy transition funnel is up more than 60% versus this time last year. This growth is supported by government regulations, corporate ESG commitments, and public pressure, creating planned investments in an effort to make the world a better place. The moderating factors incorporated in our outlook include uncertainty around a prolonged inflationary environment, and the increased probability of recession risk, primarily in Europe, driven by the significant increase in energy costs and the energy access issues, as well as the region's weakened currencies. A potential recessionary environment would likely only impact our GDP-driven markets, including chemicals and general industries, where both markets delivered 10% growth in 2022. However, we believe continued strong bookings opportunities in other markets will overcome any softness we experience from our GDP-based businesses. With that overview, let me now turn the call over to Amy to address our fourth quarter financial results and our expectations for 2023 in greater detail. I will conclude the call with remarks on our 3D strategy and comments on positioning FlowServe for success in 2023. Amy?

Thanks, Scott, and good morning, everyone. We are pleased that our improved operating performance shipping cadence, and sales leverage in the fourth quarter drove strong adjusted EPS of 63 cents. We delivered year-over-year revenue growth of 13% or 18.6% on a constant currency basis to over $1 billion, marking our highest quarterly revenue level since 2019. On a reported basis, our earnings per share for the quarter was 92 cents, well above our adjusted EPS, primarily the result of the 45-cent tax valuation allowance reversal, as well as 6 cents of benefits related to the reversals of prior expenses that were adjusted for non-GAAP measures in prior periods. Partially offsetting these benefits were below-the-line FX charges of 14 cents and charges of 7 cents to increase the estimated cost to exit our former Russian business. As Scott mentioned, we are especially pleased with the operational performance in our North American SEALs business during the fourth quarter. And this area was a solid contributor to our earnings. As many of you know, we traditionally provide our quarterly and annual SEC filings in conjunction with the earnings press release. However, for year end, the audit requirements for our 10K that relate to the ERP issues we encountered during Q3 and our recovery in Q4 have taken additional time to complete, including our final assessment of internal controls. We expect to complete this work in the near term and fully believe our remaining work will have no impact on our financial results reported today. Looking now at our revenues, fourth quarter original equipment sales increased 14.3% with FCD and SPD contributing 17 and 12% growth respectively. Year over year, aftermarket revenues were also up nicely, 11.9%, due to FPD's 15% growth, partially offset by FPD's 5% decline. In total, our full year 2022 revenue increased 2.1%, or 6.8%, on a constant currency basis. From a regional perspective, the increase was primarily driven by mid-teen sales growth in North America and the Middle East and Africa, with low single-digit growth in Latin America. Partially offsetting this growth were declines of 7% and 15% in Europe and Asia Pacific, respectively. Turning now to margins. Fourth quarter adjusted gross margin decreased 40 basis points to 28.8%, including FPDs and FCDs 70 and 50 basis point declines, respectively. The decrease is primarily due to the realization of some longer-dated backlogs booked in tougher times, as well as materials and labor cost inflation, which we partially offset by our pricing actions earlier in the year. On a reported basis, fourth quarter gross margins decreased 60 basis points to 28.4%, including charges of $8.1 million due to our Russia exit, partially offset by a $4.5 million settlement on previously written down assets. Fourth quarter adjusted SG&A was roughly flat compared to the prior year, but down 200 basis points as a percentage of sales to 18.4% as we demonstrated ongoing cost control that leveraged the higher revenues. On a reported basis, fourth quarter SG&A increased $6.5 million to $193.6 million, or 18.6% of sales and included $5.5 million of additional Russian exit charges. A gain of roughly $3 million on the receipt of cash on a previously written down receivable and a modest realignment benefit. Both reported and adjusted SG&A included a period benefit comprised of the recovery of prior legal expenses and a modest gain on an asset sale which were sufficient to more than offset our increased year-over-year incentive compensation accrual in the quarter. Our fourth quarter adjusted operating margins were 10.8%, an increase of 150 basis points year-over-year. SPD and SPD adjusted operating margins increased 340 and 160 basis points respectively. Fourth quarter reported operating margin increased 80 basis points year-over-year to 10.1%. where our previously highlighted cost management more than offset the gross profit decline, the $6 million increase in adjusted items, and FX headwinds of roughly $6 million. Our fourth quarter and full year adjusted tax rate of 10.1% and 10.4% were lower than expected, primarily due to the resolution of discrete tax items, jurisdictional profitability mix, and execution of certain tax strategies. Turning to cash flow, the fourth quarter remained our seasonally strongest quarter, albeit impacted by factors continuing to lengthen our cash conversion cycle, including strong project bookings and longer lead times due to supply chain and labor availability challenges. We generated cash flow from operations of nearly $70 million, which included $55 million of cash flow from working capital due in part to the $19 million generated through inventory, including net contract assets and liabilities improvement. Turning to the full-year operating cash flow, it was the use of $40 million driven by a working capital usage of nearly $190 million to support our strong 22.7% constant currency bookings growth and 36.5% increase in year-over-year backlog, as well as required adjustments to longer lead times for certain critical materials. However, fourth quarter working capital as a percent of sales increased only a modest 20 basis points sequentially to 32.4%, again reflecting our sales growth, which largely compensated for the strong bookings and backlog improvement. Additionally, while our backlog increased over $730 million since year-end 2021, our inventory, including contract assets and liabilities, as a percentage of backlog dropped 500 basis points to 28.5% versus prior year, reflecting the ninth consecutive sequential quarterly decline and reaching the lowest level in five years. In 2023, we expect improved working capital progress and significant cash flow generation as we deliver on our backlog and leverage the improved tools and processes now firmly in place to accelerate our cash conversion cycle. In addition to working capital, other significant uses of cash in 2022 included $105 million in dividends, $76 million in capital expenditure investments, R&D investments of approximately $40 million, a one-time Canadian tax payment of $30 million, and roughly $16 million in contributions to our foreign pension plans. Turning now to our 2023 outlook. As Scott highlighted, we expect to deliver strong revenues and adjusted EPS this year, supported by our near record backlog with expectations for continued support of end markets and further building off the operational momentum we established in the fourth quarter. As you likely saw in our pre-release a few weeks ago, we are targeting a full year 2023 adjusted EPS in the $1.50 to $1.75 range. which would represent a year-over-year adjusted EPS increase of nearly 50% at the midpoint. We also expect revenue to increase in the 9% to 11% range. While we typically shift roughly 90% of our beginning backlog in any given year, due to the return of large project awards to our backlog, as well as some lingering supply chain issues impact on our lead times, We currently expect to recognize just over 80% of our $2.7 billion backlog during 2023. As previously announced, our revenues and adjusted EPS target ranges do not include any impact from the expected acquisition of a lawn. It further excludes our expected realignment expenses of approximately $20 million, as well as potential 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. Excluding the expected realignment spending only, our EPS is expected to be in the range of $1.40 to $1.65. Both the reported and adjusted EPS target range also assume current foreign currency rates reasonably stable commodity prices, no significant geopolitical disruptions, and expectations for the end market environment to remain supportive at levels similar to 2022. We also expect net interest expense in the range of $55 to $60 million and an adjusted tax rate between 18 and 20%. In terms of phasing, FlowServe's earnings and cash flows have traditionally been second-half weighted, and we expect that pattern to continue in 2023. Seasonally, our first quarter is almost always our lowest, typically representing around 15% or so of full-year adjusted EPS. As we move into 2023, we expect less sequential margin contraction than typical from the fourth quarter into the first. probably around 50 to 150 basis points, depending on final mix. However, the reduction in revenue from fourth quarter levels that traditionally occurs will lead to less leverage of our SG&A. Conversely, we generally generate a disproportionate share of full year earnings in the second half, particularly in the fourth quarter, where a third to 40% of full year earnings is the norm. Additionally, while we expect to continue to make progress on supply chain, logistics, and labor availability issues that remain, we believe our lead times fully reflect these headwinds on our expected shipping cadence. That said, we expect quarterly revenues and both growth and operating margins will increase over the course of the year and expect to exit 2023 with gross margins of 30% or better. Turning to our expectations for major plan uses of cash this year, we expect to close the acquisition of Elan in the second quarter using a combination of cash on hand and revolver borrowing, totaling roughly $215 million. We also plan to return over $100 million to shareholders through dividends and expect capital expenditures in the $75 to $85 million range to support our 3D growth strategy and the continued build-out of our enterprise-wide IT systems to further support our operational and productivity improvements. We are excited to begin the process of integrating the Volant organization into FlowServe following the close of the transaction, likely sometime in the second quarter. The transition is indicative of the type of niche bolt-on transactions that we believe can complement our business and accelerate our 3D strategy. while also demonstrating our financial discipline as a steward of capital management. The lawn will add roughly $380 million of revenue and will be accretive to the gross margin of our STD segment and flow serve overall. We are targeting $20 million of run rate cost synergies through overhead reduction, supply chain savings, rationalization of the combined product offerings, and footprint consolidation. In addition, we believe that the combination of their install base and our existing QRC network will result in logical revenue synergies with the potential for pump-pull-through opportunities as well. Also earlier this month, we completed our first amendment to our revolving credit facility, and we would like to thank our relationship banks for their continued support of FlowServe. Finally, as Scott will highlight shortly, we made significant investments during 2022 in technology, R&D, product development, and partnerships to advance our 3D strategy. We expect increased investments in these areas in 2023 as well, as we capitalize on the energy transition opportunities in the marketplace and support our customers' decarbonization and energy efficiency goals. Let me now return the call to Scott.

Great. Thank you, Amy. Before closing with our 2023 outlook, let me highlight the progress we have made on our 3D growth strategy in technology developments related to our 3D product offering. We launched our 3D strategy focused on diversification, decarbonization, digitization in early 2022, which is intended to drive higher growth rates in profitable markets and products. One year in, I am even more confident in the strategy, which is incredibly well aligned with the current market environment, and expected to drive continued strong momentum for CloseServe in 2023 and beyond. In 2022, CloseServe's 3D bookings grew roughly 25% year-over-year, a significantly higher rate than that of our broader portfolio. While we fully expected our strategy to deliver accelerated growth, our bookings performance last year exceeded our own ambitious expectations. Additionally, we continue to invest in new products and partnerships to further expand CloseServe's leadership position in these targeted markets. Turning to each leg of this strategy in recent awards, let me begin with diversify. We believe our focus to diversify by targeting particular products, markets, and regions will provide more stability through cycles and deliver incremental growth. Especially chemical market, vacuum products, and water markets are key for accelerated market penetration and to provide growing opportunities for closed-serve. Over the last 18 months, we have seen significant bookings growth across the diversification lane. including their recent award to supply critical nuclear vacuum compressors for the construction of a new nuclear power plant in China, supporting the country's goal of replacing coal-burning power plants with nuclear power. Moving to the decarbonized component of our strategy, our energy transition funnel continues to grow and is now up over 60% versus the prior year, which should provide significant opportunities going forward. Our product portfolio and global installed base have FlowServe well positioned to support our customers' carbon reduction efforts, including flare gas recovery, carbon capture and storage, increased flow loop efficiency, biofuel conversions, and new nuclear investment and life extensions. Additionally, new construction and recyclables and hydrogen represent FlowServe's largest decarbonization growth opportunities longer term. These initiatives are the elements needed to reduce the global CO2 footprint. Recently, FlowServe was selected as the sole supplier for flare gas recovery systems for five facilities along the U.S. Gulf Coast. Once operable, these facilities will reduce toxic, volatile organic compounds in the air by 5,600 tons annually. Finally, on Digitize, it includes our efforts to instrument, monitor, and provide predictive analytics on our installed base around the globe. FlowServe's IoT offering, Red Raven, has continued to make good progress with further deployments. Although adoption has been slower than originally expected, we have more than doubled our presence at customer sites in 2022 and now have instrumented more than 1,700 pieces of equipment. We are now able to instrument pumps, valves, and seal systems, providing enhanced visibility and predictive capabilities across flow loop operations. Additionally, we continue to update and enhance our capabilities and algorithms through AI and smart learning as we collect more and more customer data. In one recent example, FlowServe is partnering with a large UK-based water utility to provide digital condition monitoring services. The customer is expected to add hundreds of assets across the region in the coming years. We consider this a flagship win for Red Raven and expect more of these awards in 2023. Finally, FlowServe was also selected as preferred provider of pump equipment validating our expectations that our digitization strategy can enhance product and aftermarket pull-through. The combination of our IoT capability with Red Raven and our unparalleled knowledge of flow control puts FlowServe in a unique position to provide holistic solutions for our customers. Let me now shift to our focus on technology, new product development, and partnerships to enhance our 3D offering. Last year, Flowster launched 23 new and redesigned products. Virtually all of these were aligned with a 3D growth strategy. 2022 also saw significant activity in the partnership area. We acquired in-process R&D for hydrogen pump technology for dispensing applications. And as a result, we believe we can broaden this skill set to more areas in the growing hydrogen space. We also formed a technology joint venture for cryogenic applications such as LNG, hydrogen, and other gases. We entered into a non-exclusive partnership agreement with Gradient to help address the most challenging problems in industrial water and wastewater treatment. 2023 is off to a fast start as well. We announced an agreement to acquire Vilon, a manufacturer of engineered industrial valves supporting the nuclear, cryogenic, and defense markets, which would further accelerate our 3D growth. Vilon's product offering is highly complementary to our FCD segment, and the acquisition is expected to be accreted to adjusted EPS in the first full year following close, which we anticipate by the end of the second quarter. We also signed an agreement with Claritor to provide flow control technology in their plastic recycling operations. Claritor is a clean tech company producing green, sustainable petrochemicals upcycled from plastic waste. We are excited to be a preferred partner to Claritor and support their pursuit to end plastic waste around the world. Let me close by acknowledging that 2022 was a difficult year. However, we are more resilient and nimble company today as a result. I'm confident that we have learned from the challenges in 2022 and will build on the solid results of the fourth quarter going forward. I'm proud of our team for their hard work and dedication to finishing the year strong. We entered 2023 with a substantial backlog of $2.7 billion, which supports the significant revenue and earnings growth we expect this year. I am confident that the adjustments we've made to our operations and supply chain will position us to better navigate future challenges and improve our delivery cadence moving forward. To drive margin improvement and address expected inflation headwinds, we are progressing on the cost-out actions we communicated on the third quarter call. We remain committed and are on track to taking $50 million of structural costs out of the business by the end of the year which we expect will largely offset certain inflationary areas. Finally, I'm confident in our teams and our ability to drive progress and improve performance throughout 2023 to deliver value to our customers and shareholders. Operator, this concludes our prepared remarks, and we'd now like to open the call for questions.

Yes, sir. Thank you. And 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 reach your equipment. Once again, that is star one if you would like to ask a question. And we'll take our first question from Josh Hoeksewinski with Morgan Stanley.

Hi, good morning, all.

Good morning.

Scott, you touched on there at the end some of the 22 challenges that I'm sure you're happy to put behind you. Looks like 4Q is a good kind of mile marker that that's happening. If you had to think about, in the context of the guide, what is sort of the easy comp and passage of time, non-recurring things? I think you had some COVID absenteeism earlier in the year. Obviously, you had the ERP at the end of the year. How would you add up those items in the bridge, the more non-recurring stuff, compared to the core improvements?

Yeah, Josh, it's a good question. And let me start and then I'll hand it over to Amy to kind of walk through the bridge. You know, 2022 was a difficult year and you touched on some of the things, but it is a long list. And you just think about the first quarter last year where you had the COVID. We had crazy logistics constraints. We had supply chain challenges everywhere. And it just seemed to kind of build through the year. And then obviously the ERP conversion in the third quarter didn't help us. What I would say is we feel like the world is in a much more stable place. We demonstrated that with the success of Q4. We obviously need to build on that momentum as we turn the corner to 2023. But I'd just say we're in a very, very different operating environment. And additionally, the way we're running the company and how we're organized for success is very different than how we started the year. And I said this in the prepared remarks, and I'll say it again. We've learned a lot, and as part of this, we're more nimble. We're quicker to respond. The supply chain situation isn't perfect right now, but it is far more stable, and our ability to operate in this is significantly better than what it has been. Well, Amy, why don't you walk through the bridge a little bit and kind of how do we think about margins and compared to last year?

Sure. I think you framed it well in your question, Josh, because you talked about the fourth quarter as being kind of a mile marker for us. And so one of the things as we turn the page into 2023, and I'll say we've been talking about 2023 since, you know, since midway through the year, I would say, you know, in terms of how do we really start the year strong. And one of the ways that we're doing that is really trying to limit the amount of contraction that we see in margins as we move from Q4 into Q1. And so you heard me say in my remarks that we're really targeting more of a 50 to 100 basis point contraction in margins as we move from quarter to quarter. That's less than what we've typically seen at flow serve. And then from that, our margins are expected to continue to expand quarter over quarter as we exit the year at something 30% or better. As we think about the challenges that we faced in 2022, I'll just kind of rattle some off and how we're thinking about them going into 2023. So from a price cost perspective, from an inflationary impact perspective, we think that our pricing increases that we enacted in 2022 and the one that we had to start the year in 2023 are going to keep us neutral as we move through 2023. So we feel good about where we're at from that standpoint. Clearly last year we experienced issues whether or not they were frictional costs, loss of volume, lower absorption rates at our plants, and productivity falling that really impacted our profitability. We're not going to see those things this year. We're going to see a lot of improvement in that area. I will say that that's going to be partially offset by two items. One is an increase in our labor costs, which reflects, I think, the market that we're in today from a labor perspective. And then the second piece of that is really around mix. We see more of our revenues in our guide of 9% to 11% increase coming from our backlog, which means lower assumptions around book and burn. And so that means those revenues generally come at higher margins. And so that mixed impact is moderating some of our margin expansions that we'll see. I'll also say that kind of below the gross margin line, we are anticipating that we're going to see higher interest expense in 2022. We'll see a slightly higher tax rate now in the 18 to 20% range as we turn the page. We still have some old backlog that's going to flow off sequentially, which leads to that sequential improvement in profitability. And we'll also see slightly higher R&D as we move and turn the page from 2022 into 2023.

A lot of detail there. Really appreciate it. Probably going to need to go over the transcript again and make sure I didn't miss anything.

A little longer answer than... That might be the first time anyone's ever said that to me on a call. That's great.

No, it's good stuff. I appreciate it. Just flip it over to the order side. Scott, wondering if you have any view on how you expect broader book-to-bill to go this year and maybe on one specific market that we've heard a little bit more chatter on is on hydrogen. where it seems like there's some IRA rulemaking that is going to clear up and cause some projects to kick off. How would you think about what you're seeing in those markets and how those kind of inform your view on orders for the year?

Sure, Josh. Let me start with hydrogen and then I'll hit the overall market for 2023. We're really excited about hydrogen growth and we feel that there's going to be substantial effort going forward and you hit it, whether it's IRA in the US or the incentives in Europe, lots of countries are incentivizing hydrogen energy and growth there. And so we think this grows and hydrogen has a significant flow control element. So whether it's the electrolyzer where you're creating hydrogen or transportation and distribution, there's flow control opportunities within the hydrogen value chain. We booked work this year. We booked a big project in Saudi Arabia. We booked work in Europe. We've also booked work in the United States. And then, you know, our chart acquisition in the third quarter is around hydrogen dispensing and distribution. We're very excited about our ability to provide a pump into that part of the market. And we're confident that we'll be able to commercialize that technology this year and start to drive orders in 2023. We need to continue to round out our valve and pump and seal portfolio to make sure that we've got multiple opportunities within the hydrogen value chain. And a lot of our R&D and then additionally some of the partnerships that we talked about are geared toward that market itself. But we see hydrogen as a substantial growth market, and we feel like we're doing the right things to position ourselves for that. And then let me just kind of step back and I'll talk about 2023 more generally. Obviously, 2022 was a very strong bookings year. We had significant growth across all of the end markets and including with the 3D strategy. I don't think the growth will be as high as what we saw in 2022, but we are expecting growth in 2023. And as a reminder, we did have the big Jafura project at $225 million. We don't have another substantial project in the pipeline yet. But what I would say is our pipeline is at the same value, roughly the same value as what we started the year last year. And so we feel pretty confident that the bookings in the project side will come through. They'll just be relatively smaller and we'll book more of them, which actually helps us on the margins as well. And then secondly, we feel very good that the MRO spending and the aftermarket spending remains at this elevated level. And I'd say, you know, overall, you know, we see growth. And then I'd say kind of part of the 3D strategy in the areas that we think are the catalyst for this, and I said this in the prepared remarks, but I'll reiterate it, you know, number one is energy security. And so we think as countries are looking to secure their own energy supplies and to lessen the dependence on other countries, we're seeing substantial work in LNG. We're seeing it in nuclear. We're seeing it some in oil and gas. But that's a big driver. And then secondly, everyone is decarbonizing their existing assets and moving to clean energy. And so we see those as kind of the two big catalysts that will continue to drive bookings going forward.

Excellent detail, and best of luck to all you guys this year. Thank you, John.

We'll now take our next question from DeAndre with RBC Capital Markets.

Hi, this is Kenny Seen from RBC on for Dean today. First on free cash though, specifically curious in the cadence of free cash flow throughout the year. Are you expecting some sort of hockey stick in the fourth quarter? And can you maybe remind us what your expectations are for buffer inventory levels?

Sure, Kenny. I'll start with kind of cash flow cadence and then ask Scott to talk a little bit about inventory as we think about 2023. So let me first start by saying that we expect significantly improved cash flow as we move through 2023, or as we move into 2023, I should say. And really the biggest piece of that is we are anticipating that net income improves. And as we pointed out, that improvement will be, you know, starts in the first quarter but is sequential throughout the year. And so as is traditionally the case, we would expect that a significant portion of our cash flow generation does occur in the third and fourth quarter. We do see a significant increase in our backlog, so it means working capital is going to be a factor as we move forward. That being said, we see it improving pretty significantly as a percentage of sales and certainly driving it below that 30% number as a percentage of sales. And as we look at investments that were made in the second half of 2022, we really see an opportunity in the first half of the year to target free cash flow at neutral levels or better. And then the last item that I would add just with respect to free cash flow is we do have our cost optimization program that is ongoing. There will be some cash outflows related to realignment. I would anticipate that that will really be more towards the last three quarters of the year. Sure.

And then I'll touch on buffer inventory and As you've seen throughout 2022, we've been building inventory, and I'd say it's twofold. One is our bookings and backlog are substantially up, and so that's driving a lot of it. But in addition to that, given the supply chain challenges and the longer lead times within the supply chain network, we have put in buffer inventory. And we've done this, I'll call it relatively surgically, but we're giving our operations the ability to stock up on additional inventory that we normally wouldn't do And this just goes back to making sure that we can deliver to our customers and meeting our internal commitments. And we feel like it's the prudent thing to do. And so I would say that that buffer inventory level right now is at a reasonably good place. I don't expect that to go higher as we move forward into 2023, but I also don't expect that to subside at any time in the next two quarters. And so hopefully as things stabilize and lead times come down, with our supply chain, then we'll start to reduce that buffer inventory in the back half of 2023. Thank you.

That's a great color. And then just in Europe, I get it's left in top comp, but it seems the region was largely better than feared across the sector this quarter. So can you maybe talk about what the conditions were like throughout the quarter for you and what you see there on a real-time basis? And that will be all for my end. Thank you.

Sure. We addressed this in the prepared remarks and said that there are concerns with Europe just given the currency, the inflation issues on energy, and just the general state of the economy there. We watched this closely. We have a big run rate business that's tied more to the chemicals and specialty chemical markets. And what I'd say, we saw in the fourth quarter roughly about a 5% slowdown on that run rate business. Again, not a huge part of our overall business, but something that we're watching carefully. And I'd say as we think about Q1, we're seeing a similar kind of roughly 5% slowdown. As we move forward in the year and as inflation subsides in Europe, we actually expect that to return and come back to a more normalized level. And then just as a reminder, that's on top of over 10% growth that we saw in the region last for 2022. And so I don't think this is going to be a major issue for us. However, we're watching it carefully and we'll continue to monitor. But I think the positives that I talked about before, energy security, the decarbonization, and then some of our end markets, I'm confident that we overcome any slowness on the European side.

Thank you.

We'll now take our next question from Damian Karras with UBS.

Hi, good morning, everyone.

Good morning. Yeah, morning. Obviously, you have quite a good bit of sales visibility this year, stemming from that $2.7 billion in backlog. Could you just clarify, as it relates to the run rate business, you're assuming that it continues to grow or at least hold steady as the year progresses, and you don't really foresee any recessionary pockets coming this year?

Yeah, I think our run rate business is going to be very robust. And that's just driven by a lot of these assets, whether it's a refinery or chemical plant, one, are running at really high levels, and two, have been deferring maintenance now really since the beginning of COVID. And so we continue to see significant maintenance and shutdowns and turnarounds into 2023. And I just don't see that as exciting. I talked a little bit about the situation in Europe, and that would impact some of our run rate business. But outside of that, we feel really good about, and it's not going to be substantial, but moderate growth with that run rate and aftermarket business as we progress through 2023.

Okay, got it. And then I wanted to ask you about the $50 million in cost action. Could you give us an update on how far along you are there and how much of the benefit realization you've assumed for your guidance this year?

Sure, I'll start a little bit on that and then maybe, you know, let Amy answer some of the timing and how it works through. And I'd say, you know, we're talking about it as a cost program, you know, externally with our analysts. But I really want to say two things that are critically important. Number one is that the number one priority for FlowServe is converting the backlog. And we're not going to do anything that jeopardizes our ability to ship and get product to our customer and meet our internal commitments. And then secondly, the program that we've launched about organization optimization is truly about driving accountability as number one, and then really taking steps to simplify what I'll call relatively complex business at FlowServe. And so we've been working on this since FlowServe 2.0. We made good progress, but we're now doubling down on some of the business processes that that need to get simplified. And so that's really what's happening. The $50 million cost is basically a result of this reorganization and the optimization that we're going forward. And Amy, why don't you just talk about some of the actions we've taken and kind of when it starts to show up in the P&L.

Sure. So, Damien, to date we've exercised about $5 to $10 million worth of kind of run rate savings, and those have been reflected in our guidance range. As we talk about the $50 million program, We expect that we'll get to that run rate by the end of the year. And realistically, that incremental amount of savings really exists today as potential upside to the guidance range that we have or something that's out there in the event that we experience more inflationary pressures than what we've currently got built in the guidance range.

Great. Appreciate the call. Best of luck.

We'll now take our next question from Mike Halloran with Baird.

Hey, good morning, everyone. So I just want to go back to his first question there. You know, when you think about that run rate business and kind of being modestly positive, it seems that that commentary is a little bit at odds with how strong your overall commentary is and how positive you are in the overall markets. Are you actually seeing something that gives you pause in those markets? It doesn't sound like it. Is this just more prudency because you don't know what you don't know? Comps, you know, maybe turnarounds are more static because, you know, refiners are making money right now. Just kind of any context around that would be great.

Yeah, I would say it's just prudence, right? We had a significant growth this year in the MRO and aftermarket, and so I think it's just saying, you know, we're probably not going to grow at the rate that we did in 2022 because But there's nothing that we're seeing right now that says that we're not going to grow in 2023. Okay, great. That's great context. In addition to that, you know, even, and I just say, you know, our backlog includes aftermarket and MRO. And so we're going to convert on that big backlog as well. And so you'll actually see the revenue grow, even if the bookings weren't at that higher level.

Appreciate it. And then just second quick one, just, confidence in the margin levels that you have in the backlog and being able to execute. I'm guessing those are still what you would view as higher margins relative to maybe the 2022 aggregate rate, but would love to get some context on that.

Sure. Amy touched on it a little bit in one of the questions, but I'll add some more color. As we think about the cycle, 2021 was the low point. We did take some work in 2021 that the margins were depressed, and that's still in our backlog, and it will work its way out. through 2023. And then I'd say the bookings in 2022 are all incremental to margins, you know, on a year-over-year basis. And, you know, certainly from this point forward, as we're booking projects, you know, we're now with a significant backlog and the facility is relatively full. You know, there's no reason to go backwards on margins as we think about project awards. And so, you know, there's still some competition there on the pricing side, but, you know, from our standpoint, we only take work that's going to be accretive to margins going forward. And so I feel really good about our backlog to kick off the year and the margins and backlog substantially higher than where we were this time last year.

And just for a little bit more color on that, I think GlowServe has traditionally done a nice job getting as much protection as they can, particularly around large project orders, around inflationary pressure by getting POs in place quickly. for equipment and getting price protection to the extent that it's possible under the contract. I think in 2022, we were in an environment where it was really difficult to recoup some of those frictional costs in terms of expediting freight, the absorption levels that we were seeing, the labor disruptions from COVID. And so just seeing those work their way out of the system as we make our way into 2023, gives us much more confidence in the margin that we're seeing in our backlog this year versus the situation that we were in this year or last year at this time.

That makes a lot of sense, Amy. Thank you, and thanks, Scott. Appreciate it. Thank you.

We'll now take our next question from Joe Giordano with Cowan.

Hey, hi, everyone. Hey, Joe.

Hey. You guys announced a couple of leadership changes with the pre-announcement a couple weeks ago. So, can you maybe talk through what led to those and how you're organizing the reporting structure internally a little bit different now?

Sure. So, this goes to the organization optimization that I discussed in a previous question. Again, as we're thinking about this, it's really about how do we drive accountability deep into the organization and how we simplify what we're doing at FlowServe. And so one of the things that we've done is we've organized now internally very similar to how we report externally. And then the other important thing that we've done is we're creating more product verticals for full lifecycle delivery. And so I think the best example here is our SEAL business, Rather having to seal business distributed across regions and maybe not as focused as I would have liked, we're now creating a seal vertical and full P&L that we've got single leadership over the global business. And so I'd say that's kind of the major change. We've got some other internal changes in there as well. But again, this is all about driving accountability with our results in your end-to-end business and then simplifying some of the handovers that we had within the business historically.

All right. And then we talked earlier about, you know, the issues that you guys faced in 2022, some of which are under your control, some of which were not. You know, now that you're moving into M&A mode here and you bought in-process R&D, what gives you the confidence that FlowServe organizationally is prepared to, you know, take on something like this that makes it a little bit more complicated when you're, you know, you're kind of getting on your feet execution-wise?

Sure. I think it's a good question. I've been here six years now, and we've been working on operational security and business process for a long time. We haven't been real acquisitive just because we were defining what that full-serve playbook looked like and how to operate. Today, I'm confident in our team's ability to do this. We've got a proven IT team that can put systems in place Our operational playbook, I'll say, is second to none. We've got to improve on process discipline and using that. And then I just say our other functions are all what I'll call in the top quartile in terms of how to run big companies. And so when we look at Vilon, it's publicly traded, but it is a family-run business. There are opportunities for process improvement within their facilities. And I think applying some of the things that we're doing at FlowServe, some of the things that we learned in 2022, gives me the confidence that we can have a successful integration. And I just say, you know, with this business, there are lots of levers for value creation. And Amy kind of hit on some of those in previous Q&A. But we're confident that we can hit most, if not all, of the levers and have a very successful integration and a very complimentary acquisition here.

And if I could just sneak one last one in quickly on China. You mentioned you won like a nuclear project there. Can you just give us a little – and what the competitive landscape looks there from local Chinese players just as geopolitical things start to ramp up, how hard is it to get on critical infrastructure there from a U.S. company? Thanks.

Yeah, we obviously have a broad portfolio of full control products. And I just say some of our business does really well in China and other parts are really, really difficult. The award that I spotlighted was vacuum technology. It's a niche product, and we kind of get locked in because we've got preferred technology. And so when we've got a technology that's hard to replicate in China, we do really, really well. Additionally, we've done well with the FCD and the valve businesses, and that's grown nicely throughout the year. I would say on some of the pump stuff, it is really competitive, and the preference on local China becomes more and more prevalent. despite the fact that we've got a big operation in Suzhou. And so we're being real selective on where and what we do in China. I think there's going to be a return to investing in China as China reverses the zero COVID policy and we'll start to see investment there. And so I feel good about growth in China, certainly in the near term. We've got to continue to get laser focused on what products work in China and then tailor our Chinese operations to support the local markets. And Again, we've done that really nicely in valves. We've got to do some more work in pumps, and then we've got to continue to put that niche technology preferred product in the right applications in the China market.

Thanks, guys.

We'll take our next question from Sari Brodaisky with Jefferies.

Hi, thanks for fitting me in. Maybe just a little bit on the acquisition of Elan. You talked a little bit about the 20 million of run rate synergies and maybe just how you're thinking about the potential revenue synergies given the complementary product portfolio.

Sure. Again, we really like this business. They've got a great nuclear presence, severe service, defense, and then they've got a nice LNG and cryogenic offering. And so we believe the products are very complementary to what we have today within FlowServe. And so we think about nuclear. We now combine our nuclear offering with theirs. There's very little overlap, and we're excited about what we can do together. And then we talked about hydrogen and LNG earlier. The cryogenic offering that they have works really well with what we're trying to do. And then we can expand that into other gaseous applications like hydrogen. And so there's some really interesting things that we can do with the combined portfolio. And then as Amy mentioned in her prepared remarks, Belon's aftermarket presence is not very big. And so we feel really good about our ability with the QRC network and the focus on aftermarket and MRO within our valve business to really start to get the aftermarket with the Belon products and capture the aftermarket on the installed base that Belon has.

Thanks for that, Collar. And I know it's early, but you talked about some of the longer lead time project work currently in the backlogs. Maybe just give a little bit about the composition of what that is and the visibility it gives you beyond 2023. Thanks.

Sure. That goes to what Amy said earlier, right? As you know, we, we booked some work in 2021 at low margins that works through the system throughout 2022. And so as we exit 2020, or I'm sorry, that 2021, we work here in 2022, it's still in backlog today. But as we exit 2023, all of that is out of the system and gone. And so again, we're replacing that with higher margin work than what we booked in 2021. And we feel really good about this progression on margins like that Amy discussed. And so we don't see a big drop off from Q4 into Q1 like we've traditionally seen. We build throughout the year as we go through 2023. And then that allows us to exit the year at a much better gross margin position. And then there's some really long lead or longer lead items in the backlog. So the first would be our nuclear awards. Typically, those can span anywhere from one year to upwards of three years. And then the deferral award is roughly 18 months to two years within the backlog as well. And so those will stay with us and work through. And that's some of the reasons for that lower backlog conversion number that we called out in the slides in our prepared remarks.

Appreciate the color. Thanks.

We'll take our next question from Nathan Jones with Stiefel.

Yeah, good morning. This is Adam Farley on for Nathan. I wanted to follow up on the Belon acquisition. Could you maybe provide a little more detail on the $20 million in cost synergies? What are the main buckets of those cost synergies, and is there a low-hanging fruit you can go after?

Sure, so we touched on this a little bit in our remarks, but with the cost synergies, we're really highlighting or targeting overhead-type expenses. Vilon currently does trade as a public company, so public company costs and overhead are a component of that. The combination of any two industrial companies, I think, can lead to economies of scale around supply chains. We talked about the complimentary portfolio, but product rationalization over time will come into play on this as well, as well as footprint rationalization as we work our way through. So we're certainly in early days of planning around integration, and we're excited to get started. But as Scott has indicated, we think there's a lot of opportunity here, both through cost, but also this is definitely a growth story for for that product portfolio and for the FlowServe portfolio overall.

Okay. And then post-closure of the VaLON acquisition, what are some of your expectations for future M&A? How is your pipeline of opportunities shaping up? And what are the main focus areas for inorganic growth? Thank you.

So I'll start and let Scott provide some color. I think that, you know, Belon is a really great example of the type of transactions that we want to do. One, we think it makes financial sense. Two, strategically, this is, you know, certainly right down the fairway in terms of how we want to grow strategically within the 3D strategy and the focus on nuclear and other industries that we think are going to grow at a really nice pace in the future. We have put an effort over the recent period of trying to build out that pipeline of what inorganic growth would look like, but certainly we intend to do that with financial discipline and with an eye on enhancing our strategy.

I think Amy summed it up.

That's essentially what we're looking at. It's got to fit the 3D strategy. We'll be financially disciplined, and then we've got to have confidence in our ability to integrate.

Thank you for taking my questions. Thank you.

And it appears there are no further telephone questions. And with that, this will conclude today's conference call. We thank you all for your participation. You may now disconnect.