Flowserve Corporation

Moat: 3/5

Understandability: 3/5

Balance Sheet Health: 4/5

Flowserve is a global manufacturer and aftermarket service provider of comprehensive flow control systems, encompassing pumps, seals, valves, automation, and related services. These products are integral to several industries, including oil and gas, chemical processing, and power generation.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Business Overview

Flowserve operates in the flow control industry, a critical part of various industrial processes, by manufacturing and servicing industrial equipment used to control and manage the flow of liquids and gases, mainly in harsh environments.

  • Revenues Distribution: FLS primarily serves two segments:
    1. Flow Control Division (FCD) produces, designs and sells control and isolation valves, actuators, and related items and accounts for about 57.4% of total sales.
    1. Engineered Pumps Division (FPD) offers engineered, end-to-end pumps and seals to a variety of industries and represents about 32.6% of sales.
  • The remainder is for corporate, service sales and other.

  • Geographic Diversification: Flowserve has a wide global footprint, with a considerable chunk of its revenues coming from North America (40% of total sales), followed by Europe (35%), Asia Pacific (15%), and Latin America, Middle East and Africa (10%). This broad geographic spread helps reduce the impact of local economic downturns.

  • Industry Trends: The flow control industry is influenced by several factors, including:
    • Cyclicality: Demand for flow control products and services is highly cyclical, rising during economic booms and declining during recessions, which significantly affect the revenue of companies in this space.
    • Energy Transition: A major trend shaping the industry is the shift towards renewable energy sources. This is creating a new stream of opportunities in new infrastructure and power generation.
    • Digitalization: Companies like Flowserve are increasingly leveraging digital technologies, including data analytics and artificial intelligence (AI), to improve their products, services, and operational efficiency. This is driving a higher degree of automation in manufacturing and service delivery.
  • Increased M&A Activity : The industry has been experiencing a surge of M&A activities, partly due to the need to scale or expand into new product niches.
  • Sustainability: Companies are increasingly focusing on sustainable and eco-friendly options for power generation, and the use of “green energy” is becoming increasingly important.
  • Margins: Flowserve’s gross margins are generally in the 30% range. Operating margins are typically around 10%. These are influenced by raw material costs, production efficiency, and pricing power. There is evidence of some margin pressures due to increased input costs and competition. Management has been actively working to improve these margins by implementing cost-reduction programs and raising prices.
  • Competitive Landscape: The flow control industry is highly competitive with numerous players. Companies such as Emerson, Xylem, and Pentair compete in specific segments. FLS’s business is impacted by the cyclical nature of its main markets. They are also impacted by consolidation in the industry, making scale an advantage. They need to adapt to new industry trends, including sustainability and digitalization.
  • What Makes Flowserve Different? Flowserve differentiates itself by several aspects:
    • Global Presence: A well-established and worldwide brand and distribution network give FLS a competitive advantage in the market.
      • Broad Product Portfolio: Their diverse product line and services enable them to cater to different customer needs across different industries, which they provide to a large customer base.
    • Aftermarket Services: They are a significant player in after-market services, as their highly specialized products require constant attention. They have the experience needed to serve such niche markets.
    • Engineering Capability: Flowserve is known for their engineering and application capabilities. They can develop new and modified products to meet customer requirements.

Financials

  • Revenue Trends: Flowserve has experienced periods of revenue volatility depending on the business cycle, with revenue heavily tied to the oil and gas industry. For the first three quarters of 2023, their revenue grew from $2,823.1 million to $3,253.3 million, but decreased significantly YoY in Q4 of 2023.

  • The revenue is affected by different markets as seen from geography-wise trends.
  • Profitability: They saw a jump in profitability through the first three quarters of 2023, with operating income increasing from $223.7 to $326.1 million. In 2022 their net profit was -$84.6 million which they returned in 2023 to 109.6 million. Their earnings are highly susceptible to economic upturns.
  • Cash Flow: Flowserve’s cash flow from operations was significantly stronger in 2023 than in the same period in 2022, showing that they are becoming more efficient in converting revenue into cash.
  • Debt and Leverage: The company has a leverage (net debt-to-EBITDA) of 2.6 in 2023, slightly lower than 2022’s 2.8. The Debt to capital ratio has decreased from 2022 to 2023. They continue to manage their balance sheet effectively.
  • Share Repurchase: Flowserve has engaged in stock buybacks over the last 2 years, spending approximately $200 million in repurchases to reduce share count and increase EPS.

Moat Analysis

  • Moat Rating: 3/5. Flowserve exhibits a narrow moat stemming from its established reputation, high customer retention rate, and extensive global network. However, commodity aspects of several of its products and strong competition create risks.
  • Justification:
    • Intangible Assets: The company benefits from brand recognition and certifications within some specific industries, particularly oil and gas and nuclear power plants. This makes switching to competitors more difficult for their customers. However, they don’t have strong brands across all their product lines.
      • Network Effects: Limited network effects are present since the company does not depend on having a large network to deliver value.
    • Switching Costs: Significant switching costs exist for some of their products. For example, if a customer integrates FLS equipment into their manufacturing system or production process, they are less likely to choose products from other competitors because it requires heavy financial outlays and changing processes. They also need to consider switching costs from servicing to another company. But, there is no clear cut evidence they have an advantage here.
      • Cost Advantages: Flowserve has some cost advantages because of economies of scale and their global footprint. This helps them optimize their operations and compete on costs. But the advantages can erode when faced with newer players with more efficient manufacturing processes.
      • Limitations: While their existing portfolio may create somewhat sustainable competitive advantages, new products are not always successful, and they will have to face competitors which can lead to them potentially eroding their profitability.

Risks to the Moat & Business Resilience

  • Industry Cyclicality: FLS’s revenues are heavily dependent on cyclical sectors, and economic downturns may severely impact their revenue. The company should seek to mitigate risks by diversifying into different sectors less exposed to economic cycles.
  • Competition: The flow control industry is intensely competitive. FLS should always maintain and upgrade its capabilities to fight off competition.
    • Global Supply Chains: The disruptions caused by the Covid-19 pandemic are being replaced by new ones, including the Russo-Ukraine war, high-interest rates, and other factors. All these can disrupt their global manufacturing base and affect profitability.
  • Technology Disruptions: Technology in the industry changes often. FLS must innovate and keep up with current trends to maintain their edge in the market.
  • Raw Material Prices: Raw material prices, like steel, can fluctuate wildly, affecting the cost structure of the company. They need to have a robust supply chain to mitigate these risks.

Understandability Rating

3/5. While the company’s business model is relatively straightforward and they have been operating for over 200 years, a detailed analysis of their business requires understanding the workings of many different industries. Also, understanding the dynamics of mergers and acquisitions in the flow control sector is complex. The company’s earnings drivers and their complicated financials also make this a little difficult to understand by novice investors.

Balance Sheet Health Rating

4/5. Overall, FLS’s balance sheet health is strong. They have moderate levels of debt and have improving liquidity and leverage ratios. They have improved free cash flow in the previous fiscal year, so they have lots of cash to reinvest in the business and pay down debt.

Recent Concerns

  • Q4 2023 Results: Flowserve’s latest report in Q4, 2023 showed that despite full-year revenue and earning increases, that quarter saw declines in both revenue and earnings compared to the previous quarters. They also offered a low guidance for future earnings in 2024, which drove down their share price. Management emphasized that this was a result of delays in large project bookings that were pushed into 2024.

  • 2024 Guidance: Management forecasts growth in their FCD division, but their FPD division is forecasted to decrease in 2024 due to delays in large project bookings. This guidance was below expectations. However, management believes that their overall performance for the next few years will improve, even if there is a near-term struggle in sales and earnings.

  • Supply Chain Disruptions: Although most supply chain issues have been resolved, management continues to monitor the global supply chain for any new problems.