Flowserve has recovered dramatically from the lows it experienced at the end of the manufacturing recession in 2002, but the distraction of accounting irregularities (and lack of audited financials as a result) and management turnover have kept a lid on the stock's valuation. New CEO Lewis Kling (former Group President for SPX and hired as COO of FLS in July 2004) and new CFO Mark Blinn (former CFO of FedEx/Kinkos) are leading the charge in expanding company margins to 15% at the operating level (within 3-5 years). Once the company's restatement is complete and financials are available, investors will realize FLS's earnings potential and accord it an appropriate multiple. With our projected EPS of $4.03 in 2007 - based on 5% top-line growth in 2006 and 2007 and an operating margin of 12.7% in that year - FLS should trade to at least $50, a return of 29% from today's levels. If the multiple expands to what we believe is a defensible peer multiple of 15x EPS, FLS should trade to $60 by 2007, providing a 55% absolute return.
FLS is the recognized world leader in supplying pumps, valves, seals automation and services to the power, oil, gas, chemical and other industries. Mgmt is keen to point out that while it has a number of competitors in various of its business lines, no other company provides an integrated pump/valve/seal solutions package. Competitors include (in pumps) Weir, Sulzer, ITT and Idex; (in valves) Crane and Tyco; (in seals) AES and John Crane.
FLS's end markets are allowing it to grow its top-line strongly and organically - it just reported in November that in the first 9 months 2005, organic bookings were up 13% vs the prior year (and up 22% for Q3 yoy!). In our model, we have assumed top-line revenue growth of 4.2% this year, and 5% in both 2006 and 2007 (should be conservative projections).
Peer company Idex - granted, a much better operator heretofore - reports incremental margins of 30-35%. FLS should get a similar benefit in additional sales, and if the revenue growth roughly flows through from the bookings growth, the company has a much less daunting task ahead to get to 15% operating margins. Fortunately, mgmt is highly focused on the cost side of the ledger and is not taking high incremental margins as a given. A key cost component is obviously COGS, and CEO Kling has discussed in a number of venues the use of reverse auctions and strategic sourcing. To get a sense of the potential savings, assume that COGS is 50% materials (as opposed to labor, energy, etc). Assuming 10% savings on half of those items that FLS purchases, the savings would be between $45-50mm (~ $1.9bn of COGS). The CEO claims that only 15% of the company's sourced items were considered low-cost, and recounts numerous examples where they have been able to save 15-20% from reverse auctions. Of course, while this is a bit "fun with numbers", it gives a sense as to where the low-hanging fruit is.
In addition, analysts seem to be ignoring the impact of operational turn-around at the plant level. FLS mgmt has discussed a specific plant that lost $54mm in 2003 - that plant is now profitable, and was driven by a change of plant leadership. This kind of swing, no doubt partly driven by materials cost reduction as discussed above, nevertheless should help drive company margins upwards.
Warranty expense: While FLS will not quantify much prior to its having audited financials available, the company did recently show a chart (with no #s) depicting warranty costs as a % of sales dropping dramatically to levels below that in 2002. In 2003, warranty reserve was $19.4mm, up from $16.1mm at end of 2002…FLS reported increased warranty expense of $7.2mm that year; not a huge $ opportunity, certainly, but every million counts.
Surely, this is one of the principal reasons that FLS has had a lid on it, and reasonably has led the market to discount the company's credibility. The company's latest update "reconfirmed that it still expects to report that it had material weaknesses in internal controls as of Dec. 31, 2004", and, "While improvements have been made, the company does not expect that all of the noted weaknesses will be fully remediated by Dec. 31, 2005," (which was the previously anticipated deadline for resolution). In addition, "The company also said that the length of time needed to complete its 2004 financial statements will cause it to be unable to meet the deadline for its 2005 Form 10-K filing, which is due March 2, 2006, although with less expected delay compared with its counterpart 2004 filing." The restatement and controls issues relate to lack of integration and proper accounting for a number of acquisitions dating back to 2000. We assume the final hit will be below $50mm in restatement to earnings (no cash hit) plus the additional compliance costs that the company is dealing with as a result.
As the market has had little hard data to go by, it is no wonder that few analysts are willing to give FLS the benefit of the doubt, but it's our contention that this issue has masked a fundamentally solid and improving company and once resolved, will remove the ambiguity surrounding the company's earnings power, which we believe is $4+ in EPS.
We also take it as a positive signal that FLS was able to complete a $1bn refinancing in August of this year - clearly, the banks (BofA and Merrill) were satisfied with the inside information they were provided. FLS replaced its Term A and C loans with a new 7-yr $600mm Term B loan with an interest rate equal to LIBOR+175, lower than the previous borrowings at LIBOR+248. More importantly, part of the proceeds were used to redeem both tranches of the company's outstanding 12.25% Senior Sub Notes (face values of $188.5mm and eu65mm). This will result in annual savings of at least $20mm (or pre-tax $0.36/share).
While we have an incomplete picture of the company's cash flow situation, they characterize it as "strong". In Q3, debt was up by only $6mm in spite of "one-time" items of $32mm pension contribution, $31mm of call premiums, fees, etc related to the refi, and $8mm related to compliance/restatement fees (for the YTD, these cash uses, plus incentive compensation which was paid to stem the flow of employees, totaled $145mm; net over the 3 quarters, debt appears to be down $1.5mm). This implies FCF of $65mm for the quarter, and keep in mind that incremental sales consume working capital (15-18% for FLS, according to the CFO). The most bullish analysis would annualize this figure to come up with a 12% FCF yield. While probably aggressive, even cutting this in half and assuming the company's interest savings flow to the bottom line as expected, the number is close to 7% FCF yield. The true number is probably somewhere in between. Not too bad in light of the margin opportunities and revenue growth that FLS has ahead of it.