FLS - Flowserve: Offers More Than The Cyclical Oil And Gas Exposure It's Best Known For

2023-10-28 13:00:00 ET

Summary

• Flowserve is leveraging its strong process industry backlog to deliver better-than-expected revenue (+23% this quarter) and margin level.
• Healthy oil prices should support ongoing capex in 2024, but chemical capex is likely to be more restrained as debottlenecking projects reach completion.
• The company has leverage in new growth markets such as LNG, hydrogen, and carbon capture, and is pursuing margin-improvement initiatives.
• Valuation and growing addressable market opportunities do lend support to a long-term bullish stance, but I'd prefer a bigger margin of safety given potential market slowdowns emerging in 2024.

These are still good days for process end-markets like oil/gas and chemicals, and Flowserve ( FLS ) is reaping the benefits as the company continues to generate strong growth from its backlog, as well as ongoing aftermarket demand. Beyond this near-term momentum, the company has leverage to several new growth markets, including LNG, hydrogen, and carbon capture, and management has actively been pursuing new applications for its technologies (like vacuums for the semiconductor market), while also pursuing margin-improvement initiatives.

Flowserve has done well even in the context of healthy process end-markets, outperforming the overall industrial sector by a wide margin over the past year and comps like ITT ( ITT ) and Rotork (RTOXF), both of which have also outperformed the industrial space. Valuation isn’t great and there are valid concerns about how much steam is left in the company’s primary markets at this point, but it’s an interesting name all the same.

Strong Results As The Company Delivers From Its Backlog

After years of liquidity and market-driven skimping on capex, the oil and gas industry has been making up for lost time, and chemical companies have likewise been active in greenfield and brownfield debottlenecking projects. All of that drove significant backlog growth for Flowserve in recent times, as the company just couldn’t keep up with orders (supply constraints as well as capacity limitations).

Now the company is delivering on those booked orders, and revenue is exceptionally strong. Revenue in the third quarter rose more than 23% in constant currency terms, beating by about 6%, which is even better in the context of prior performance driving higher expectations.

The pump business (aka FPD) grew 26% in constant currency, with original equipment sales up 40% and aftermarket sales up 19%. The controls business (aka FCD) grew 16%, with similar underlying drivers in both segments. Overall, combined original equipment sales rose 26%, while aftermarket was up an impressive 20%.

Gross margin improved 230bp year over year to 29.7%, while adjusted operating income more than tripled, with margin up 630bp to 8.7%. At the segment level, profits rose about 85% (margin up 350bp to 11.1%), with FPD up 119% (margin up 420bp to 10.2%) and FCD up 47% (margin up 270bp to 13.2%).

This was a clean and pretty comprehensive beat, with revenue and segment profits above expectations in both businesses, better gross margin, and lower corporate-level expenses.

What Goes Up Eventually Comes Down … But Not Necessarily At The Same Rate

Bookings declined 14% in organic terms, with a book-to-bill of just under 1.0x. Adjusting for a large order in the year-ago period, bookings would have been up more than 5%, and aftermarket orders were still up 5%. It’s reasonable to be skeptical of “well, if you look at this other number…” adjustments, I think it’s fair in this case as large project-driven orders can give a false sense of the underlying business conditions.

While core bookings growth in the mid-single-digits isn’t bad, I do see some slowdowns in some of the company’s markets. General industrial markets have definitely slowed, with other companies reporting lower activity in food/beverage, pharma, HVAC, and electronics. Collectively, this is maybe 15% or so of the business mix at Flowserve. I’d also note that most chemical companies that have commented recently on capex have basically declared intentions to stand pat with capacity after current projects complete, and I wouldn’t expect a strong auto capex environment in 2024.

On the more positive side, oil/gas activity remains quite healthy, as do prices, and historically there has been pretty strong correlation between oil prices and Flowserve’s stock price. Given pricing, as well as expansion in areas like LNG, I’m still bullish on this market going into 2024. I’m likewise bullish on water (around 4% of the business) and metals/mining (around 10% of the business). Power, like the chemicals market, is looking solid now, but I expect softer results in 2024 ( General Electric ( GE ) reported 9% year-over-year organic growth in its power business in Q3, with orders down 1%).

All told, I still think at least half of Flowserve’s business is in good shape heading into 2024 where ongoing growth is concerned. And even businesses that are likely to see slower OE demand growth (chemicals, for instance), should still see healthy aftermarket momentum.

New Opportunities Add To Current Strength

Eventually, this oil/gas capex cycle will end, as all prior cycles ended. That’s created above-average volatility for Flowserve in the past, but I do think there are some new opportunities not far off on the horizon that can drive a different path after this current oil/gas expansion phase ends.

LNG is the most obvious near-term driver, as Russia’s war in Ukraine has put some strong support under LNG projects that were previously looking wobbly. Flowserve has talked about addressable opportunities with $1B in LNG over the next five years, though I do expect lumpiness given how project-oriented this business is.

Beyond LNG are newer, less certain, opportunities like hydrogen, carbon capture, and renewable plastics. In all cases, Flowserve has attractive use-cases for its pumps, seals, and valves, and in markets like carbon capture where there are multiple competing approaches (post-combustion, pre-combustion, and chemical scrubbing), Flowserve can sell into any approach. I also note that carbon capture is, for now, being led by larger energy companies and Flowserve has meaningful existing relationships with many of them.

As part of its “3D strategy” (Diversify, Decarbonize, Digitize), Flowserve is also looking at opportunities to reapply/extend its technologies into new markets. The first major such opportunity is in semiconductors, where the company has already entered the vacuum market. This is an attractive market over the long term, and while there are significant competitors in place (like Atlas Copco (ATLKY)), it’s an attractive incremental opportunity.

Flowserve also has a self-help driver on the margin side. Management is looking to boost operating margins to 14%-16% by 2027 (from around 10% this year), and the main drivers are productivity and cost-out initiatives as well as enhanced product mix. A mid-teens margin is a big ask relative to what Flowserve has historically achieved/sustained, but the plan is coherent and doesn’t seem to require a lot of major transformation.

The Outlook

I’m expecting close to 6% long-term growth from Flowserve, and that’s not a conservative number relative to what the company has historically done across cycles. The oil and gas markets will always be cyclical, but I do see longer-lasting growth opportunities from markets like specialty chemicals, pharma, food/beverage, mining (especially as more activity goes underground and becomes more process-driven), and water treatment. I also am a believer in LNG, hydrogen, and carbon capture as long-term opportunities for the company’s technologies.

I should also note that the 6% long-term growth rate includes the significant near-20% growth the company should log this year – my growth rate using 2023 as the starting point would fall to a less ambitious 4%, which compares well to management’s estimate of long-term growth of 3.3% in its traditional core markets, with 10%+ growth from 3D markets bulking that up.

I’m still more conservative than management on margins, but I do think the low end of that 14% to 16% target will be reached by 2027. With that, EBITDA margins should comfortably reach the mid-teens over the next five years. I’m looking for FCF margins to get to 6.5% in FY’27 and 8.5% in FY’32. These model outputs may be too conservative, but the company has never had two straight years of 7.5%-plus FCF margin (or at least not since 2002), and I don’t want to get too far out ahead of the company’s margin improvement story.

Perhaps because of that conservatism on margins, the shares look pretty marginal on a discounted cash flow valuation. Margin/return-driven EV/EBITDA is more accommodating, and I can get to almost $41 (11.5x) without much strain. Getting to 14% operating margin would boost the fair multiple to 12.5x, with more upside beyond that if 16% margin comes into play.

The Bottom Line

I think good things are happening at Flowserve, but valuation already reflects a lot of that and may be underestimating how much cyclicality is still in the business. I also think this is definitely a name to watch, but I do worry that there could be a 2024 shift from outperforming process stocks toward shorter-cycle names. Those shorter-term concerns shouldn’t dissuade long-term investors, but I don’t see quite enough margin of safety here to add this to my own holdings.

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