Flowserve Corporation: 2018 Q3 Form 10-Q Summary
Business context and reporting period
Flowserve is a global manufacturer and aftermarket service provider of pumps, valves, seals, automation and related flow-control systems serving oil and gas, chemical, power-generation, water-management and general industrial markets. Operations are organized into Engineered Product Division (EPD), Industrial Product Division (IPD) and Flow Control Division (FCD). The filing covers the three and nine months ended September 30, 2018; financial statements are unaudited.
Flowserve employed approximately 17,000 people in more than 50 countries and operated 174 Quick Response Centers. Aftermarket sales generally carry higher margins than original-equipment sales.
Key financial metrics
| Metric | Three months ended Sept. 30, 2018 | Three months ended Sept. 30, 2017 | Nine months ended Sept. 30, 2018 | Nine months ended Sept. 30, 2017 |
|---|---|---|---|---|
| Sales | $952.7 million | $883.4 million | $2,845.8 million | $2,626.8 million |
| Gross profit / margin | $308.5 million / 32.4% | $268.0 million / 30.3% | $866.0 million / 30.4% | $782.5 million / 29.8% |
| Operating income / margin | $62.2 million / 6.5% | $74.8 million / 8.5% | $154.3 million / 5.4% | $252.3 million / 9.6% |
| Net earnings attributable to Flowserve | $28.2 million | $47.6 million | $56.6 million | $108.5 million |
| Diluted EPS | $0.21 | $0.36 | $0.43 | $0.83 |
| Operating cash flow | Not separately provided | Not separately provided | $26.3 million | $72.4 million |
Third-quarter bookings were $1,010.4 million, up 13.2% year over year; nine-month bookings were $2,974.5 million, up 5.5%. Backlog was $1,854.5 million at September 30, 2018, including approximately $1,354 million of unsatisfied or partially unsatisfied performance obligations and $501 million of generally cancellable orders.
Cash and cash equivalents were $529.9 million at September 30, 2018, compared with $703.4 million at December 31, 2017. Total debt was $1,504.0 million, including $67.3 million due within one year and $1,436.7 million due thereafter. No revolving-credit borrowings were outstanding; available revolving capacity was $416.5 million after letters of credit and covenant limitations. The company was in compliance with its debt covenants.
Nine-month investing cash flow was an outflow of $49.6 million, including $50.0 million of capital expenditures. Financing cash flow was an outflow of $133.2 million, including $74.5 million of dividends and $45.0 million of debt repayment. The company expected 2018 capital expenditures of $70 million to $80 million and believed cash, operating cash flow and available revolver capacity would meet its cash needs for the following 12 months.
Material changes versus the prior comparable period
- Sales increased 7.8% in the quarter and 8.3% year to date, supported by higher bookings, stronger original-equipment activity in the quarter and higher aftermarket activity year to date.
- Gross margin improved to 32.4% from 30.3% in the quarter and to 30.4% from 29.8% year to date, reflecting better fixed-cost absorption, higher-margin projects and lower realignment charges.
- Operating income and earnings declined despite higher sales. Third-quarter operating income fell 16.8%, primarily because of higher SG&A, a $7.7 million loss on the IPD divestiture and the absence of a $9.9 million 2017 gain on the sale of Vogt. Year-to-date results also lacked the $141.2 million gain from the 2017 Gestra and Vogt divestitures.
- SG&A increased 17.4% in the quarter, partly due to Flowserve 2.0 transformation costs and higher incentive compensation. Year-to-date SG&A increased 4.6%.
- Operating cash flow declined to $26.3 million from $72.4 million, primarily because contract assets, inventory, accounts payable and other working capital consumed cash.
- Foreign-currency translation produced a $52.9 million year-to-date other comprehensive loss versus an $84.8 million gain in 2017.
Guidance, outlook, management commentary, risks and unusual items
Management reported stabilization in business conditions and early recovery in large-project markets, supported by improved oil prices, with expectations for continued customer maintenance and short-cycle investment during 2018. No formal earnings guidance was provided.
Flowserve adopted ASC 606 on January 1, 2018 using the modified retrospective method. The adoption increased retained earnings by approximately $20 million and changed the timing and classification of revenue, contract assets, contract liabilities, inventories and backlog. ASC 606 increased reported sales by approximately $23.7 million in the quarter and $104.9 million year to date. Approximately 21% of third-quarter revenue and 22% of year-to-date revenue was recognized over time, versus 5% and 4%, respectively, in the prior periods.
The company launched the Flowserve 2.0 Transformation and recorded $24.0 million of related expenses in the quarter and $27.4 million year to date, primarily in SG&A. Realignment Program charges were $11.1 million in the quarter and $43.3 million year to date. Total realignment charges since inception were $338.2 million, against an anticipated total investment of approximately $360 million; most remaining charges were expected by the end of 2018. Management estimated approximately $192 million of year-to-date cost savings and eventual run-rate savings of approximately $230 million.
Flowserve completed the divestiture of two IPD locations and related product lines on August 9, 2018, recording total year-to-date pre-tax charges of $25.1 million, including the $7.7 million third-quarter loss. Argentina became hyperinflationary effective July 1, 2018, with limited consolidated exposure of approximately 1% of sales and assets.
Key risks include project cost overruns, customer cancellations, dependence on oil and gas and other cyclical industries, raw-material costs, foreign-exchange volatility, international political and regulatory risks, slower receivable collections, litigation and asbestos claims, environmental liabilities, cybersecurity, supplier performance, goodwill impairment, pension obligations and execution of transformation and cost-saving initiatives. The company also continued to cooperate with the DOJ and SEC regarding a potential Foreign Corrupt Practices Act matter, which management did not expect to have a material financial impact, although penalties remain possible.
The company estimated that tax audits and related matters could reduce tax expense by approximately $14 million within the next 12 months. No material changes to previously disclosed risk factors were reported. Disclosure controls and procedures were deemed effective as of September 30, 2018.
Most important facts for investors to verify
- Assess underlying earnings excluding the 2017 divestiture gains, 2018 IPD divestiture charges, transformation costs and realignment charges.
- Reconcile reported growth and backlog under ASC 606 with results under the prior revenue-recognition standard.
- Monitor conversion of the $1,854.5 million backlog, including cancellable orders and the timing of the $1,354 million performance-obligation balance.
- Verify whether operating cash flow improves as contract assets and inventory convert to cash.
- Review debt maturities, including scheduled term-loan repayments, revolver availability and covenant headroom.
- Track execution costs and realized savings from Flowserve 2.0 and the Realignment Programs.
- Evaluate exposure to foreign exchange, Argentina hyperinflation, asbestos and environmental claims, and the DOJ/SEC compliance matter.