Flowserve Corporation — Q1 2018 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 unaudited three months ended March 31, 2018, compared with the three months ended March 31, 2017.
Flowserve adopted ASC 606 using the modified retrospective method on January 1, 2018. The adoption increased opening retained earnings by approximately $20.0 million and materially changed the timing and classification of revenue, contract assets, contract liabilities, inventory and backlog.
Key Financial Metrics
| Metric | Q1 2018 | Q1 2017 | Change |
|---|---|---|---|
| Sales | $920.0 million | $866.3 million | Up 6.2% |
| Gross profit | $271.4 million | $269.0 million | Up 0.9% |
| Gross margin | 29.5% | 31.1% | Down 160 bps |
| Operating income | $45.4 million | $50.7 million | Down 10.3% |
| Operating margin | 4.9% | 5.9% | Down 100 bps |
| Net earnings attributable to Flowserve | $15.1 million | $19.1 million | Down 20.5% |
| Diluted EPS | $0.12 | $0.15 | Down $0.03 |
| Effective tax rate | 34.2% | 21.6% | Up 1,260 bps |
| Operating cash flow | $(120.7) million | $3.9 million | Declined $124.7 million |
| Capital expenditures | $13.5 million | $15.9 million | Down $2.4 million |
Sales benefited from approximately $49 million of favorable currency translation and approximately $71 million from ASC 606 adoption. Aftermarket sales represented approximately 49% of sales, compared with approximately 47% in the prior-year quarter. International sales, including U.S. exports, represented approximately 63% of total sales.
At March 31, 2018, cash and cash equivalents were $535.7 million, down from $703.4 million at December 31, 2017. Total debt was $1.573 billion, including $71.5 million due within one year. Long-term debt was $1.501 billion. The company had no borrowings under its $800 million revolving credit facility, $81.6 million of outstanding letters of credit and $718.4 million of available revolving capacity. The company was in compliance with its debt covenants.
Material Changes Versus the Prior Comparable Period
- Bookings declined 3.1% to $928.5 million, partly because Q1 2017 included an approximately $80 million Hengli Integrated Refining Complex order that did not recur. Bookings also reflected lower activity in oil and gas and water markets.
- Sales increased primarily from higher aftermarket activity, favorable currency effects and ASC 606 revenue timing. Reported sales included approximately $23 million from FCD businesses divested in 2017 in the prior-year comparison.
- Gross margin declined because revenue was recognized on lower-margin projects, realignment charges increased and ASC 606 had an unfavorable estimated impact of approximately 170 basis points.
- Operating income decreased despite higher sales and gross profit, primarily because SG&A increased $7.4 million. Lower stock-based compensation and sales leverage partially offset higher currency-related and implementation costs.
- The effective tax rate increased substantially, principally because of the mix of foreign earnings and losses in certain foreign jurisdictions for which no tax benefit was recognized.
- Operating cash flow turned materially negative because of working-capital requirements, including a $64.4 million increase in contract assets and a $48.6 million increase in inventory.
- Backlog was $1.837 billion at March 31, 2018, down 9.7% from December 31, 2017. ASC 606 reduced opening backlog by approximately $237 million. Approximately 43% of backlog related to aftermarket orders.
Segment sales were $467.7 million for EPD, $198.1 million for IPD and $277.2 million for FCD. Segment operating income was $39.4 million for EPD, an operating loss of $2.3 million for IPD and $33.9 million for FCD. IPD materially reduced its operating loss, while EPD and FCD experienced lower operating margins.
Guidance, Outlook, Risks and Unusual Items
- Management stated that results remained challenged by cautious customer capital investment, particularly in oil and gas, and by pricing pressure. With oil prices more stable at improved levels beginning in the second half of 2017, management anticipated increased maintenance and short-cycle investment during 2018.
- 2018 capital expenditures were expected to be between $80 million and $90 million.
- Management expected approximately $20 million of U.S. pension contributions in 2018, excluding direct benefits paid.
- Realignment programs are expected to require total investment of approximately $360 million. Cumulative charges through March 31, 2018 were $306.3 million, including $11.5 million in Q1 2018. Remaining charges were expected throughout the rest of 2018.
- Management estimated approximately $59 million of year-to-date cost savings versus approximately $44 million in the prior-year period and expected approximately $230 million of eventual run-rate savings, with most expected in 2018. Management also expected an approximately 20% reduction in global headcount relative to early 2015 levels.
- Management believed existing cash, operating cash flow and revolving-credit availability would be sufficient to meet cash needs for the next 12 months, although operating cash flow could be affected by economic conditions, customer demand, foreign exchange, interest rates and operational factors.
- Material contingencies include asbestos-related claims, environmental remediation at five former waste disposal sites, a French appeal related to the United Nations Oil-for-Food investigation and a self-reported potential Foreign Corrupt Practices Act matter under review by the DOJ and SEC. Management did not expect these matters to have a material adverse financial impact, but outcomes remain uncertain.
- Key ongoing risks include oil and gas and other cyclical end-market exposure, order cancellations, fixed-price project cost overruns, raw-material inflation, foreign-exchange volatility, international legal and regulatory compliance, litigation, pension obligations, cybersecurity, supplier performance and execution of realignment savings.
Most Important Facts to Verify
- Reconcile reported sales, margins, backlog and contract balances under ASC 606 with comparable pre-adoption measures; ASC 606 contributed approximately $71 million to Q1 sales and materially affected backlog and working capital.
- Assess whether the sharp deterioration in operating cash flow is temporary working-capital timing or reflects sustained growth in contract assets, inventory and other operating requirements.
- Monitor backlog conversion, cancellations and profitability, particularly the $495.9 million of customer orders generally cancellable without penalty.
- Verify progress toward the $230 million expected run-rate savings and the remaining realignment charges and cash expenditures.
- Review debt maturities, including scheduled term-loan repayments of $15 million in each of the next four quarters and additional maturities in 2018 and 2019.
- Evaluate the sustainability of the dividend in light of negative operating cash flow, total debt and planned pension contributions.
- Follow the tax measurement-period effects of the Tax Cuts and Jobs Act, foreign tax audits and the potentially recoverable approximately $8 million of tax expense within the next 12 months.