This is a follow-up to my original recommendation for Flowserve, which I posted about a year ago. Although the stock has appreciated meaningfully during the interim, I believe one can earn a solid return at the current stock price. Within approximately two years, FLS should be able to improve its operating margin from an estimated 11% in 2007 to 15% through enhanced pricing, operating leverage and a significantly higher proportion of aftermarket business within the company’s overall sales mix. At this level of profitability and conservatively assuming the company pays down debt with the interim FCF, I calculate earnings power to be $8-$8.50 per share by 2010. Given the company’s exposure to the global pent-up demand for infrastructure (oil/gas, power, heating, water) and the growing contribution of its annuity-like aftermarket business, I believe the market will realize these earnings are very sustainable and will value them accordingly.

(Please refer to my earlier writeup and the company’s 10k and investor presentations for a complete review of the company’s businesses and background.)

As a reminder, FLS is a leading manufacturer of flow control products, including pumps, valves and seals, and a provider of related aftermarket services to the oil & gas, chemical, power and general industrial markets. The company has 40% end-market exposure to oil & gas, 19% chemical, 12% power generation, 22% general industrial and 7% water treatment. Approximately 60% of the company’s sales come from EMEA, Asia Pacific and Latin America, where the demand for global infrastructure (oil/gas, power, heating, water) has been and is projected to be extremely robust for the foreseeable future. Bookings started to jump dramatically in the second half of 2005 and all of their markets have remained strong since then. Bookings (ex currency) grew 16% in 2005, 23% in 2006 and they are projected to grow 14% in 2007. It takes roughly 1 year for a booking to convert into a recorded sale, so the bookings growth in one year approximates the sales growth in the following year. Using this rule of thumb, sales growth in 2008 should be well into the double digits and I have sales growth moderating to the mid-high single digits in the out years.

One reason why sales should continue to grow nicely in the out years is the expected acceleration in aftermarket work that has already surfaced but should begin in earnest sometime during 2008. One of the management team’s main priorities has been to increase its aftermarket penetration within the pumps and valves divisions. Historically, they have captured around 35% of the aftermarket within their installed base, compared to 90% for the seals division. Although pump and valve products are more subject to third-party parts replicators, management firmly believes their aftermarket penetration should be much higher than where it is now. The seals group has revolved their business model around building service centers near their customers’ facilities, allowing them to quickly respond to customer aftermarket needs. Management is keenly focused on increasing the aftermarket capture rate within pumps and valves. For example, the company has started to jointly sell pumps along with its seals to better position themselves to earn the pump aftermarket business. And with some very modest capital expenditures, the company is now able to service all three of their products in the majority of their service centers. Their efforts have already started to pay off in 2007, with aftermarket sales within the pump division growing 19% YTD. Based on history, the aftermarket business is an annuity that on average grows in the mid single digits. The accelerated growth YTD has come primarily from market share gains and leveraging its long-installed base of pumps.

It is important to note that the acceleration in growth has not come from the aftermarket work associated with the recent boom in pump installations since the back half of 2006. On average, there is an 18 month warranty period once the pumps are installed. Given that the boom in sales started at the end of 2006 and throughout 2007, I expect this inflection point to begin some time during the latter half of 2008. In addition to being an annuity stream, the aftermarket work is done at very high margins. On average, original equipment sales have a 15% gross margin and the aftermarket work has a 45% gross margin. The implications of aftermarket penetration on profitability is evident by looking at the division operating margins. Seals has operating margins consistently in the 20% range. Pumps and valves have margins in the 12-13% range. In terms of other margin drivers, the company is enjoying significant pricing power with their OE work, and the company should enjoy significant operating leverage over its SG&A base in the years to come. In anticipation of the robust demand environment, the company invested significantly in engineering and sales headcount over the past year and a half, and future investments in such resources are expected to be limited. The company has a stated target of getting to 15% consolidated operating margins by the end of 2009, and the executives’ LTIP is tied to this goal. With the increased aftermarket penetration, pricing increases and general fixed cost leverage, I believe this goal is very achievable. As an aside, the current management team has been on board since 2005 and their focus on metrics and accountability was and remains a key component to my thesis.

		2007	2008	2009	2010
Sales		$3,679	$4,133	$4,463	$4,776
% Growth		20%	12%	8%	7%
Operating Profit		$404	$524	$616	$716
% Margin		11%	13%	14%	15%
Interest Expense		(59)	(54)	(37)	(13)
Other		3	3	3	3
Pretax Income		$348	$472	$582	$706
Income Taxes		122	154	189	229
Tax Rate		35%	33%	33%	33%
Net Income		$226	$319	$393	$477
Shares O/S		57	57	57	57
E.P.S.		$3.96	$5.58	$6.87	$8.33
Free Cash Flow
Net Income		$226	$319	$393	$477
D&A		75	79	82	85
Stock-based Comp		27	27	27	27
Working Capital		(138)	(50)	(36)	(34)
Capex		(95)	(95)	(95)	(95)
Other		0	0	0	0
FCF		95	279	370	460
Dividends		(26)	(34)	(34)	(34)
FCF after Divs		$69	$245	$336	$426
Debt Paydown		$69	$245	$336	$426
Reduced Int Expense	7%	5	17	24	30

With the FCF generated, I conservatively assume that they pay down debt. In reality, I believe management will announce a new share repurchase program sometime in the beginning of 2008. If one assumes FCF is used to repurchase shares, then the earnings power per share would be even higher. Note the significant use of working capital especially in 2007. Given the robust backlog levels and long sales lead times (around 1 year), the company needs significant inventory investment. FLS is mitigating this by requiring customers to fund deposits to secure a spot in FLS’s production schedule. My assumption is that the net working capital as a % of sales stays constant throughout.

While some may disagree over what an appropriate multiple ought to be for this type of business, my view is that it should certainly trade at a premium to the market. FLS represents a very nice way to participate in the pent-up demand for global infrastructure. In addition to oil, the power and water markets will be huge growth drivers for FLS over the next decade. In many cases, the wealth created by oil is allowing nations to finally deploy capital to refurbish their aging infrastructures, and FLS has a key presence in every geographic region. In addition, the aftermarket business is a very profitable, annuity like business that should do extremely well over the next 3-5 years due to the internal initiatives underway as well as from servicing the equipment placed during the past few years (during the most recent surge in OE orders, FLS has in many cases tied up the aftermarket business in connection with the original equipment sale). Currently, about 40% of the company’s sales are aftermarket sales and this percentage should grow significantly over the next few years. Finally, on a relative basis, the E&C companies (Fluor, Foster Wheeler, Jacobs Engineering, Shaw Group) trade at ~25x 2008 earnings. These companies are tied to the same macro drivers (they are all big customers of Flowserve), plus they have no recurring/aftermarket component to their sales mix.