Description

In my view, Flowserve (NYSE:FLS) is currently undergoing a transformation that will span several years and position the company for greater growth stability and higher returns over the long term. I have faith in the management team’s ability to execute this plan and believe that the upward trend in commodity prices will support its progress. Encouragingly, despite the lack of major projects, 4Q22 orders for Flowserve have remained steady, indicating that the transformation is starting to yield positive results. Furthermore, while margins have already improved, I believe that there is still potential for further expansion once supply chain challenges are resolved.

Particularly notable were increases in demand from the Oil and Gas [O&G] (up 30%) and from Other industries (up 14%). In light of the $220 million order placed in the previous quarter, the less-than-anticipated sequential decline in O&G suggests that the smaller size and reduced competition of the orders being placed now make them more sustainable and profitable. As for General Industries, I think that there has been a trend in recent years of low inventory across most industries, so I don’t think this coming quarter results to be particularly reliant on stock level. That said, the increase in backlog to $430 million in FY22 was the highest in over a decade.

On margins, management has a cost plan in place to counteract incremental inflation and other headwinds, so I expect margins to continue to improve. The year will be more in the hands of management than the markets and will be starting from an easy base as the benefits from cost optimization will be mostly felt in FY23. As for the Velan deal, I think FLS’s 3D growth strategy will benefit from it, and FLS will see further cost optimization by consolidating resources.

Overall, I think FLS is a buy given the strong backlog to support growth and upside potential to earnings if management executes well.

4Q22 results review

Adjusted operating profit for FLS was $112 million, and adjusted EPS was $0.63. Organic revenue growth of 18.6% contributed to this result. Segment wise, FPD achieved organic growth of 19% and an adjusted operating margin of 12.3%. FCD achieved an organic growth rate of 16.6% and an adjusted operating margin of 12.6%. While orders were down 10% quarter-over-quarter, they were up 14% year-over-year and 19% organically, totaling a solid $1.11B.

Demand outlook

The fact that bookings have increased by 14% year on year to $1.11bn across all core end markets is the thing I am most pleased about.

The fact that bookings have increased by 14% year on year to $1.11bn across all core end markets is the thing I am most pleased about. However, Chemical is a mixed bag, with the world’s chemical output growing by 3% in 2023 thanks to investments in the Middle East and Asia but slowing in Europe and North America. Power, on the other hand, benefits from the push for energy independence and security, which has led to the construction of new nuclear plants in India, Europe, and Asia, as well as the acceleration of nuclear life extension programs. For General Industries and Water, the distribution channel remains active, and the outlook is bright for investments in these areas as well as in wastewater treatment and flood prevention. Finally, the energy transition business has grown by >60% over last year, demonstrating the continued strength of the decarbonization effort. It is also encouraging that management has pointed out that the chemical and general industries markets, which are driven by GDP, are likely to be the only ones affected by a potential recession.

Velan acquisition

The purchase of Velan makes good strategic sense, as I anticipate it will contribute to FLS’s 3D expansion plans. In my opinion, the anticipated $20 million in run-rate cost synergies will be realized as a result of the consolidation of human resources, supply chain, product rationalization, and footprint. These synergies, according to management, can be realized within two years of the acquisition. In addition to the anticipated benefits from synergies in management, I also expect to see MRO and aftermarket revenue opportunities as a result of the merger, which could generate further synergies.

Cost saving plan update

Through streamlining and optimization, FLS has saved between $5 and $10 million annually, out of a total $50 million savings target. By 2023’s end, management hopes to have saved $50 million in run rates. Importantly, management has stated that additional savings in 2023 will act as upside to the guidance, despite the fact that the guidance already accounts for run-rate savings of $5-10m.

Guidance

FLS guides to 9-11% growth in revenue and adjusted EPS of $1.5-1.75 for FY23. Realignment charges of $20 million are not included in the guided EPS range, nor are the effects of foreign exchange rates or other possible discrete items. Notably, management emphasizes that the increased backlog and continued end market strength support their confidence in FY23 guidance. I believe when it comes to expanding profit margins, the essential factors are the shrewd execution and the implementation of pricing measures. Furthermore, the expected contribution from the acquisition of Velan is not included in the guidance, which could serve as an upside surprise.

Summary

FLS’s 4Q22 results were great, in my opinion, and the company’s management provided an adjusted EPS guide for FY23 that was in line with my expectations. To me, the most notable aspect of this report is the robust backlog that will undoubtedly contribute to top-line growth, thereby validating the 9% to 11% total growth guidance. I believe that better execution and the reversal of some of the items that impacted 2022 results will be the most important factors in determining whether or not the guidance turns out to be conservative. For its part, FLS has revealed that it will acquire Velan, a maker of highly engineered industrial valves. I believe the deal makes sense because of synergies with FLS’s FCD business. Management estimates that $20 million in cost synergies can be realized over two years; however, this does not account for potential gains from aftermarket sales.

Overall, I find 4Q22 results encouraging, and I think it positions FLS well to deliver solid EPS growth in 2023, although this will ultimately depend on the company’s ability to execute.