Flowserve 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. Flowserve offers an attractive way to benefit from the robust spending environment within its end markets.  On top of what should be a very healthy demand environment for the foreseeable future, the company is led by a new CEO who has an excellent track record (at SPX and Allied Signal previously) in significantly improving operating efficiencies.  In addition, the company’s current SG&A spend is temporarily bloated, as the company had to spend inordinate amounts of money on outside professional fees to restate prior financials.  As a result of these factors, the company’s near-term earnings power should far exceed the company’s current run-rate as well as the forecasts from most of the research analysts covering the stock.  According to my estimates, FLS trades at a 2007 P/E of 13x.  I believe this valuation is cheap given the strength in their end markets, the company’s significant and growing aftermarket exposure which should reduce cyclicality going forward, and the potential for much more margin improvement going forward.

 

For a complete description of the business, please refer to the company’s 10-K and the various investor presentations that are available on their website.  The company has 35% end-market exposure to oil & gas, 19% chemical, 14% power generation, 25% general industrial and 7% water treatment across their 3 main product groups: pumps, valves and seals.  The company has a new management team that has made significant progress in streamlining operations, improving service quality levels and generating margin improvements through a rigorous focus on metrics and accountability.  The improvement in on-time deliveries, product quality and profitability is coming at a very advantageous time as the company’s primary end markets are extremely robust and are forecasted to remain so for at least the next several years, particularly in the oil & gas sector.  Starting in the latter half of 2005, the company has experienced a dramatic increase in order bookings and backlog.  These bookings have just started to flow through into sales and the existing backlog of business provides a solid base of sales growth for 2007, 2008 and beyond.  The division that has shown the most impressive growth has been the pumps division, given its historically strong market share within the oil and gas sectors.  While valves has grown nicely, the recent explosion in pump orders augers well for valves, as there is typically a six to nine month lag from when customers place pump orders and valve orders for a given project.     

 

Since management’s arrival in late 2004, the company has enjoyed significant gross profit flowthrough, coming from (1) better pricing discipline, (2) the operating leveraging effects from increased sales, and (3) various cost saving and operational improvement initiatives (low-cost sourcing, capacity optimization, etc.).  In 2005, on a sales increase of 6.8%, the company increased gross margins from 30.1% to 32.0%, achieving gross margin flowthrough of over 50%.  The average flowthrough within the industry is closer to 30%.  For the first 9 months of 2006, the flowthrough has remained strong at just under 40%, improving gross margins from 31.9% to 33.2%.  The decline in flowthrough for 2006 YTD is mainly attributable to the change in business mix between original equipment for new projects (“OE”) and aftermarket parts and services.  The margin differential between OE and aftermarket can be substantial, where aftermarket margins are typically 2-4x greater than OE margins.  The company has had great success in capturing the aftermarket within the seals group with lesser success in the pumps and valves groups.  According to the company, the aftermarket capture rate within the seals group is 90% compared to 35% for valves and 32% for pumps.  The difference in business mix can be seen in their 2005 operating margins: seals ran at around 20%; pumps and valves both ran at 10%.  The big difference in capture rates is driven by the fact that both the pump and valve products are more subject to third-party parts replicators.  Plus, the seals group has done a great job of building service centers near their customers’ facilities, allowing them to better respond to customer requirements.  The new 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 many of their service centers. 

 

At any rate, the recent boom in orders and sales is coming mainly from OE work (new pumps for a refinery expansion, new valves for a new chemical plant), thereby skewing the business mix towards OE.  For example, in Q3 2005, the OE/aftermarket mix in pumps was 52% OE/48% aftermarket.  In Q3 2006, the mix shifted to 60% OE/40% aftermarket.  Ceterus paribus, a mix shift towards OE will place pressure on gross profit flowthrough.  But with the combination of much better pricing they are currently enjoying on their products, higher volumes running through the plant, and the cost-cutting and plant optimization initiatives in place, the company believes that gross margins will continue to accrete (i.e. the incremental % flowthrough will be greater than overall gross margins).  In addition, the large amounts of OE product being produced today just adds to their installed base, thereby fueling their future aftermarket business and bolstering gross margins going forward.    

 

With all this going on, the company recently became current with its SEC filings after a 2.5 year process where they had to restate its 2002, 2003 and 2004 results.  The overall impact of the restatements to net income was only $36 million and more than a third of that was for periods prior to 2002.  Ironically, the overall reduction was less than what the company spent on the internal audit.  In 2005, the company spent $70 million in financial professional fees, including $39 million in audit work, $8 million for Sarbanes-Oxley and $23 million in tax, internal audit and other services.  Over half of the fees were devoted to the restatement efforts; now that the restatement effort is complete and they are now current filers, these fees should come down significantly.  The CFO has indicated that audit fees should normalize in the $5 to $7 million range; SOX fees should be negligible as they internalized this function; and other fees should be in the high single digits to low double digits.  This implies that the current SG&A spend is temporarily bloated by $40-50 million, representing roughly 1.5% of forecasted 2006 sales.  The majority of these non-recurring expenses should be taken out by the end of this year.

 

 

It is difficult to precisely predict the translation of bookings growth into sales growth.  The company has suggested that, historically, there is a 9-12 month lag between bookings growth and sales growth.  For example, bookings growth (excluding F/X) in 2004 was 7% which matches exactly with the company’s sales growth one year later.  However, the company has recently started seeing larger customer-directed lead times on its OE-related bookings.  There are several reasons for this: (1) the growing tightness in industry capacity means customers are submitting orders to get in the queue earlier than they normally would; (2) a given project’s other components, like compressors, steel fabrication, heat exchangers, concrete, are also experiencing longer lead times or even some delays; and (3) the projects are getting larger and more complex, which means that FLS’s products may not be needed quite as early in the project’s construction process.  The end result is that some of the delivery dates have been pushed out anywhere from one to three quarters. 

 

The company experienced a significant increase in bookings during the 3^rd quarter of 2005, where order growth jumped from mid single digits to 21% on a consolidated basis.  Consistent with the year-long lag, sales growth during the 3^rd quarter of 2006 jumped from mid single digits to 19%.  Order growth has remained extremely strong since then, with Q4 2005 order growth of 27% and 9 months 2006 YTD order growth of over 25%.  In terms of sales projections, I am forecasting sales growth in 2006 of 14.5% and growth in 2007 of 14.4%.  Given that the growth in orders of 2006 YTD are over 25%, I believe my sales growth forecast for 2007 conservatively factors in the recent trends in extended lead-times.  One benefit of extended lead-times is that you have added visibility into sales for 2008 and beyond. 

 

The acceleration in sales growth coupled with the operational improvements implemented by the new management team has created some exceptional margin improvement since 2005.  Management is confident that margin improvement will continue, arising from the continued focus on metrics and accountability at the individual plant level, continued discipline in product pricing and the leveraging of fixed costs from the increase in $ sales.  In addition, the majority of the outside professional fees incurred as a result of the company’s restatement will go away in 2007.  I estimated these expenses to be $40-$50 million, which represents about 1.5% of 2006 forecasted sales.  The vast majority of these professional fees is found in the corporate expense line, which are expenses not allocated to the divisions.  In 2007, I am modeling a $30 million reduction in corporate expenses. 

 

As a result of the healthy margin flowthrough and the reduction in professional fees, I am forecasting consolidated EBIT margins to improve from 7.1% in 2005 to 9.2% in 2006 and 11.7% in 2007.  In 2005, management announced that that it was their goal to hit 15% consolidated EBIT margins over a three to five year timeframe.  In coming up with this goal, management was expecting a healthy demand environment but nothing that comes close to the demand that the company is currently experiencing.  Obviously with the current robust market conditions, management is increasingly confident that they will meet their goal within the given timeframe.  

 

 

 

 

 

 

 

 

Regarding the tax rate, the CFO believes that given the international mix of business, the normalized tax rate for Flowserve will be in the mid 30s over the course of the next several years.  In the short term, the company is taking advantage of certain deductions that historically were not utilized which should reduce the tax rate modestly.  After the company became current with its financials, the company also announced a 2 million share buyback, most of which was intended to offset potential dilution from the exercise of prior management’s options, which could not be exercised until the company was a current filer.  I estimate the fully diluted share count to be 56.5 million pro forma for the option exercises and the subsequent share buyback.

 

Flowserve currently trades at a P/E of 13x using my estimates for 2007.  While one can argue that there is a degree of cyclicality in Flowserve’s end markets, our conversations with procurement officers at the major E&C companies and other end users of Flowserve’s products indicate that the markets should remain very healthy for at least the next three to five years.  In addition, the management team has placed a huge emphasis on ensuring that the new OE products shipped today will be attached to aftermarket business in the future.  This is significant because the total aftermarket opportunity could be 3-4x the initial purchase price, and aftermarket business has higher margins by a magnitude of 2-4x.  The added emphasis on aftermarket capture should stabilize the revenue base and positively impact margins going forward.  On a relative basis, the E&C companies like Fluor, Shaw Group and Foster Wheeler all trade at 2007 P/E multiples north of 20x.  These companies are tied to the same macro drivers in oil/gas, chemical and power and are in fact large customers of Flowserve’s.   

 

Potential uses of FCF:

-         further share buybacks

-         expansion capital projects in capacity constrained areas

-         acquisitions