Company Overview

FLS is an industrial manufacturer of Pumps, Seals and Valves. The company’s products handle the flow of liquids and gas in intensive and operationally critical industrial applications.  FLS’s operating income is 75% aftermarket and 25% OEM.  Geographic exposure is 33% N.A., 23% Europe, 20% AsiaPac, 14% ME&A, and 10% L.A..  The largest end market is Oil&Gas 40%, Chemical 19%, Power 15%, Water 4%, and the rest are general industrials (pharma, food, etc).  FLS receives 45% of its revenues from downstream, 35% from midstream and 10% from upstream.  The business is late cycle and orders take up to 24 months to fulfill. About 66% of the revenues are highly customized to specific user environments and the rest are pre-configured ‘off-the-shelf’ solutions.

Business Model

Most of the profit comes from servicing the installed base of products, which have shelf lives of 40 to 50 years in the field.  Aftermarket yields above 20%s OPM while OEM is a high single digit margin.  In OEM the company operates an assembly model for the most part. Customers finance orders in advance so the cash cycle is very short at 9 days over a business cycle. FLS delivers AM service from a global network of 170 local Quick Response Centers, which are effectively light repair shops with minimal capital needs.  Net, FLS generated ROITC of 50% over the last cycle and just shy of 20% ROIC with acquisitions (with an improving trend).

The focus on aftermarket protects FLS during recessions.  In 2009-2010 organic revenues fell by less than 8%, EBITDA contracted by 12% and EPS shrank by 14%. The cycle before that was similar. In other words, while FLS operates in a space which is perceived as very volatile, the business itself is quite resilient relative to typical capital equipment providers.

Competition

Most of FLS’s markets are fragmented with the top 10 players holding 15% share. Only the Seals market is dominated by 3 players, who control 75% share (the Seals is the smallest segment).  Differentiation at the product level is limited and OEM providers do not have pricing power. FLS is the largest player in the Fluid Control Market (Pumps, Valves & Seals). It has no. 1 position in pumps, no. 1 or 2 position in seals and no. 3 or 4 in valves. While differentiation at the product level is limited, reputation and reliability are extremely important to customers as downtime is very expensive. Customers dislike change and require very compelling reasons to risk unknown products.  Therefore, market shares on new equipment sales tend to stay flat on an organic basis as customers stick to the brands they know and trust. In that respect, FLS has very good reputation for its products, with high level of customer satisfaction, so the company should be able to protect share over time. In short, the OEM competitive landscape is characterized with limited pricing power and slow change.

The competitive environment in aftermarket is different. Market share is shifting from independent service providers to OEM service providers. Drivers for this change include consolidation of end customers and higher regulatory cost of doing business. Both translate to scale advantages for OEM providers’ aftermarket units. In addition the equipment is getting more sophisticated with higher content of unique parts per OEM. The ability to delivery parts quickly is extremely important to clients. On that front the AM units of the OEMs have a natural adv. over independents as they get parts before independents. OEMs also keep certain inventory to themselves and therefore are able to commit to better response times and service level guarantees. OEMs are also taking share away from in-house repair shops.  This trend is a result of increased focus by customers on their core capabilities and outsourcing service to cheaper 3^rd party providers.  Dwindling knowledge within in-house service teams, which have been losing budgets for years exuberates this trend.

In line with the above trends, FLS has been gaining share in aftermarket.  The company is perceived as the most forward thinking provider in aftermarket and has the largest network of service centers. FLS has expanded its network of new service centers at a ~3.5% cagr during the last cycle, growing AM at a >6% cagr. It has been gaining share relative to the service market’s 3-4% natural growth.  In the past, FLS and other OEMs didn’t focus on aftermarket (as crazy as it sounds) and allowed others to service their equipment. Today FLS touches less than 40% of its install base. It has ample room to expand its network further.  Each time FLS opens a center near its customers it becomes relevant to customers who could not work with FLS in the past, as proximity is critical to quick response time. With cost and parts advantage, FLS takes share from in-house teams and independents.

Aftermarket is an attractive growth segment since it supports pricing power. A customer that faces equipment breakdown is far more focused on shortening the time to get back up again versus finding the best bid on the required parts. Further, customers tend to stick with their original equipment service provider as differences in AM offering between OEMs is limited and risk aversion is the deciding factor for end users. In addition, FLS is the only player that offers a full line of products in all three categories – pumps, seals and valves. This ability is a competitive adj for some types of customers that prefer one-stop-shop solutions. 

To sum, FLS should be able to hold its share in new equipment sales, while increasing its share in aftermarket. Gaining share in aftermarket is mostly within FLS’s control and is based on LT structural drivers. Aftermarket will continue to generate good returns.

Market

A top-down analysis of FLS’s specific TAM indicates growth of at least 6% for this cycle. This analysis bakes into account a 55/45% exposure to Developed Markets versus Emerging Markets.

A bottom up analysis supports higher growth rates for the company’s end markets into 2015: Blending end market growth assumptions implies 3.3% of total capacity expansion of volume. Adding weighted inflation expectation of 3.6% (IMF est.) argues that the “$” spend will grow by 7%. Notice that this assumes that every 100bps of capacity expansion generates 100bps of equipment spend – typically that is not the case and there is a positive multiplier for equipment.

The net takeaway from the above exercise is that a market assumption of 6% cagr this cycle appears reasonably conservative from a top-down and bottom-up analysis.  FLS expects to grow 50-100 bps above market thanks to share gains in AM.

Value Creation

Organic revenue growth of 7.5% from 2013 to the mid-cycle in 2015 implies cycle to cycle growth of 5.0%. Net OPI growth with reasonable incremental margin assumptions should be around 11% cagr from 2013 into the mid-cycle year of 2015. With leverage, this yields equity compounding of 13% before use of FCF, and over 20% after use of FCF. FLS trades for 12.5X fwd on 2013.

Risks

Emerging Markets: make up 45% of current revenues exposure (OPM are mostly similar to DM), and will contribute about 2/3 of forward growth.  The LT growth outlook for EM economies is based on fundamental drivers supported by population and GDP per capita expansion. In that respect the effort of China, India, Brazil and the like to build their energy infrastructure is motivated by strategic rationale tied to geopolitical needs. It is not just a direct economic calculation similar to a profit driven business. In other words these nations are willing to accept lower IRRs than current to secure their energy sources.

Delay in the overall cycle: similar to EM, the cycle of infrastructure build out could miss our investment horizon in DM.  The argument of cheap valuation, market share gains and limited downside applies here as well.

Power – Nuclear: The Fukushima accident on March 2011 raises the concern for FLS’s Nuclear exposed business.  Nuclear is less than 7% of FLS’s OPI.