Flowserve Corporation: Q2 2017 Form 10-Q Summary
Business context and reporting period
Flowserve manufactures flow-control equipment and provides aftermarket services through its Engineered Product Division (EPD), Industrial Product Division (IPD), and Flow Control Division (FCD). The filing covers the unaudited quarter and six months ended June 30, 2017, compared with revised prior-period information for 2016.
Key financial metrics
| Metric | Q2 2017 | Q2 2016 | Six months 2017 | Six months 2016 |
|---|---|---|---|---|
| Sales | $877.1 million | $1,027.4 million | $1,743.4 million | $1,973.6 million |
| Gross profit | $245.0 million | $320.7 million | $513.4 million | $625.8 million |
| Gross margin | 27.9% | 31.2% | 29.4% | 31.7% |
| Operating income | $126.1 million | $93.8 million | $176.0 million | $164.7 million |
| Operating margin | 14.4% | 9.1% | 10.1% | 8.3% |
| Net earnings attributable to Flowserve | $41.9 million | $54.4 million | $60.9 million | $88.2 million |
| Diluted EPS | $0.32 | $0.42 | $0.46 | $0.67 |
Six-month operating cash flow was $46.6 million, compared with $10.7 million in the prior-year period. Capital expenditures were $29.4 million, and 2017 capital expenditures were expected to total $80 million to $90 million. Cash and cash equivalents were $505.2 million at June 30, 2017, compared with $367.2 million at December 31, 2016.
Total debt was $1.591 billion, including $89.8 million due within one year and $1.501 billion due thereafter. The company had no borrowings under its revolving credit facility, $710.3 million of available capacity after letters of credit, and was in compliance with applicable covenants.
Material changes versus the prior comparable period
- Sales declined 14.6% in the quarter and 11.7% year to date, primarily because of lower original-equipment sales, continuing capital-spending weakness in oil and gas and other industrial markets, and foreign-currency effects.
- Bookings were broadly stable in the quarter at $971.3 million and increased 1.7% year to date to $1.928 billion. Backlog increased 12.4% from December 31, 2016 to $2.134 billion; approximately 30% was aftermarket.
- Gross margins declined because of lower fixed-cost absorption, lower-margin projects shipped from backlog, and a $16.9 million inventory charge on a Latin American oil-and-gas platform contract. Aftermarket sales increased to approximately 49% of quarterly sales and 48% year to date.
- Operating income benefited from a $131.3 million pretax gain on the sale of the Gestra business. Excluding this unusual gain, operating performance was pressured by lower gross profit, a $26.0 million Brazil facility impairment, the $16.9 million contract charge, and restructuring costs.
- IPD reported operating losses of $28.7 million in the quarter and $42.5 million year to date, compared with operating income of $2.9 million and $6.6 million, respectively, in the prior-year periods. EPD operating income also declined materially, while FCD operating income benefited primarily from the Gestra disposal gain.
- The effective tax rate increased to 59.1% in the quarter and 51.8% year to date, from 35.2% and 34.5%, respectively, primarily due to foreign operations, losses without tax benefits, and taxes related to the Gestra sale.
Outlook, management commentary, risks and unusual items
- Management expected weak capital spending and pricing pressure, particularly in oil and gas, to persist through 2017 despite relative stability in oil prices.
- Realignment programs are expected to require approximately $400 million of total investment, with approximately $264.8 million incurred through June 30, 2017. Management projected approximately $230 million of annualized run-rate savings at completion and expected most remaining charges to occur in 2017.
- Management estimated approximately $93 million of cost savings for the first six months of 2017, compared with $43 million in the prior-year period, and expected approximately $215 million of savings during 2017.
- Flowserve agreed to sell its FCD Vogt product line for approximately $28 million, with closing expected in the third quarter of 2017 and an estimated gain of approximately $10 million.
- Foreign-exchange losses contributed to other expense, which was $8.8 million in the quarter and $19.9 million year to date. A 10% change in foreign-exchange rates was estimated to affect six-month net earnings by approximately $17 million, excluding the effect of hedges.
- The company identified accounting errors at two non-U.S. sites and revised prior-period financial information. Management concluded the errors were not material to any prior annual or interim period, but the revisions reduced December 31, 2016 total assets by $33.8 million and revised second-quarter 2016 net earnings downward by $8.6 million.
- Disclosure controls were deemed ineffective as of June 30, 2017 because of material weaknesses in internal control over financial reporting. Management described remediation measures involving enhanced reviews, risk-based controls, and additional ethics and controls training.
- Key contingencies include asbestos-related claims, environmental remediation at five former disposal sites, a self-reported potential Foreign Corrupt Practices Act matter under DOJ and SEC review, tax examinations, foreign-exchange exposure, potential goodwill impairment, project cost overruns, backlog cancellations, and dependence on cyclical industrial markets.
- Management stated that existing cash, operating cash flow, and revolving-credit availability should be sufficient for the next 12 months, but noted that operating cash flow could be affected by economic, political, operational, currency, interest-rate, and customer-credit risks.
Important facts for investors to verify
- Reconcile reported earnings with the $131.3 million Gestra gain, Brazil impairment, Latin American contract charge, restructuring costs, and elevated tax rate.
- Monitor whether bookings and the $2.134 billion backlog convert into revenue at acceptable margins, particularly in IPD and EPD.
- Assess progress, remaining costs, workforce reductions, and realized savings under the realignment programs.
- Review the material weaknesses, remediation progress, and the effect of the prior-period accounting revisions on future filings.
- Track leverage, scheduled term-loan repayments, covenant headroom, foreign cash balances, and the availability of the revolving credit facility.
- Follow the Vogt divestiture, expected gain, tax consequences, and the continuing impact of the Gestra disposal on revenue and earnings comparability.
- Evaluate exposure to oil-and-gas capital spending, pricing pressure, foreign currencies, Brazil and Venezuela, litigation, environmental matters, and the DOJ/SEC investigation.