Flowserve (FLS) Mark Blinn on Q4 2015 Results - Earnings Call Transcript

| About: Flowserve Corporation (FLS)

Flowserve Corporation (NYSE:FLS)

Q4 2015 Earnings Conference Call

February 18, 2015 11:00 AM ET

Executives

John Roueche - Treasurer and Vice President, Investor Relations

Mark Blinn - President and Chief Executive Officer

Thomas Pajonas - Chief Operating Officer & Executive Vice President

Karyn Ovelmen - Chief Financial Officer & Executive Vice President

Analysts

Andrew Kaplowitz - Citigroup

Mike Halloran - Robert W. Baird

Charley Brady - SunTrust Robinson Humphrey

Nathan Jones - Stifel Nicolaus

Joseph Ritchie - Goldman Sachs

Phillipe Forlorne - Susquehanna Financial Group/SIG

Chase Jacobson - William Blair & Company

Jim Foung - Gabelli & Company

Jonny Wright - Nomura

Brian Konigsberg - Vertical Research Partners

Operator

Welcome to the Flowserve 2015 Fourth Quarter Earnings Call. My name is Paulette, and I will be your operator for today's call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session.

I will now turn the call over to Jay Roueche, Vice President, Treasurer and Investor Relations. You may begin.

John Roueche

Thank you, operator. And good morning, everyone. We appreciate you participating in Flowserve's fourth quarter and full year 2015 earnings call.

Joining me this morning are Mark Blinn, Flowserve's President and Chief Executive Officer; Karyn Ovelmen, Executive Vice President and Chief Financial Officer and Tom Pajonas, Executive Vice President and Chief Operating Officer. Following our prepared comments, we will open the call to your questions. And as a reminder, this event is being webcast and an audio replay will be available.

Please be aware our earnings materials do, in this call will, include non-GAAP measures. Please review the reconciliation of our adjusted metrics to our reported results prepared in accordance with Generally Accepted Accounting Principles, which can be found in both our press release and earnings presentation.

Please also note that this call and our associated earnings materials contain forward-looking statements, which are based upon forecasts, expectations, and other information available to management as of February 18, 2016. These statements involve numerous risks and uncertainties, and many that are beyond the company's control. And except to the extent required by applicable law, Flowserve undertakes no obligation and disclaims any duty to update any of these forward-looking statements.

We encourage you to fully review our Safe Harbor disclosures contained in yesterday's earnings materials, as well as our other filings with the Securities and Exchange Commission, which are all available on our website at flowserve.com in the Investor Relations' section.

I'd now like to turn the call over to Mark Blinn, Flowserve's President and Chief Executive Officer, for his prepared comments.

Mark Blinn

Thank you, Jay. And good morning, everyone. We'll quickly recap our fourth quarter and full year 2015 results this morning. Additionally and more importantly, I'll outline the actions we are taking to improve our operating and financial performance.

Let me begin by saying that overall I am pleased with our fourth quarter financial performance which delivered full year results in line with our expectations discussed last quarter. The downturn in our served markets during 2015 was more severe, widespread and persistent than we and the industry at larger originally anticipated a year ago. The sharp declined that began in upstream oil and gas spread across the industrial complex as year progressed. Compounding the challenges in our served industries, the strong dollar was also a major headwind throughout the year. And regionally petroleum driven economies in most emerging market such as Latin America remain more challenged.

Against this market backdrop, I'm pleased with how our organization responded. Our employees remain committed to our customers and continued to deliver quality products and services through our strong operating model focused on execution. Importantly, we've taken definitive, proactive measures to better competitively position Flowserve for long-term growth and value creation. While we anticipate ongoing headwinds in the coming year, we are confident that the actions we implement in 2015, and the expanded program and growth indicatives we will discuss today, provide us with a solid foundation to drive profitable growth through the market cycle.

As we look to the future, global macro fundamentals suggest that Flowserve's end markets will continue their longer term secular growth patterns confirming we serve the right strategic industries. Population growth in an emerging middle class will drive energy demand. And aging infrastructure in energy, power, chemical and general industries will require refurbishment or replacement. Our end markets are inherently sound over the long run. Although, they are currently cyclically challenged. While we can't control the near-term cyclicality, Flowserve is well equipped to weather period of volatility. And our track record demonstrates that we are well positioned to capitalize on long-term industry growth drivers. Even as we plan for a lower for longer environment in the near term.

Let me dive into some of the actions and opportunities we are pursuing. While leadership and technology products and services are fundamental tenant of our competitive model, the markets we compete and demand that we are also competitive with our cost structure. In 2015 and continuing into 2016, the actions we are taking are transformational for Flowserve. In essence, we are structurally repositioning Flowserve for the future. First, we are aggressively taking actions to align our SG&A cost structure to market realities. These decisions are difficult and we consider our options thoughtfully before acting. We are not taking these actions lightly as they impact our most valuable asset namely Flowserve associates.

In addition, we believe the current cycle creates the right environment to accelerate the structural changes we've addressed in prior calls. These actions are critical to leveraging our global operating model and establishing a flexible, responsive manufacturing network that addresses the need of market and customers. Against both of these objectives, we've made significant progress against our previously announced $125 million realignment plan. In the fourth quarter, we executed over $50 million of activities bringing the full year 2015 investment approximately $80 million. This investment includes the closure or repurposing of seven manufacturing facilities and a few redundant QRCs, while reducing over 5% of our workforce since first quarter of 2015. Beyond this announced program, we also made significant stride in integrating SIHI and achieving the synergies we expected to date as part of our transaction economics. Our ability to execute on our diverse set of initiatives during 2015 has provided us the confidence and the ability to accelerate even more of our longer-term plans. We developed these actions over a number of years and initially expected and extended timeline to implement. However, current market conditions provide the opportunity to act now.

As such we are now expanding the previous $125 million realignment initiative which we expect to execute over two year period. We now envision a total investment of around $350 million including about $50 million of expense that is below the operating income line. With expected annualized savings of approximately $215 million once completed. With approximately $80 million of realignment expense realized in 2015 excluding SIHI initiatives, this leaves us $270 million remaining to execute over the next two years.

While some of our initiatives are in respond to volume reductions in the current market, a majority of the actions we are taking are structural in nature, focused on capacity optimization, product rationalization, supply chain optimization and developing a low cost manufacturing base for competitive positioning. Together this will fundamentally change our engineered business. We've demonstrated, proven success in our ability to transform manufacturing capacity and permanently reduce cost.

During 2016, we plan to accelerate the closure or repurposing of eight facilities that were part of our longer term plan. Additionally, we will further delayer the organization which is intended to increase accountability and performance.

In summary, when our expanding program is complete, we expect to reduce our manufacturing footprint by approximately 30%. Improved plant and machine utilization and significantly increase our manufacturing capabilities and labor hours in low cost region. We expect to realize savings of approximately $125 million in 2016 and $185 million next year. We've a proven record of reducing cost and are confident that we can deliver on this plan.

In addition to our ability to drive further cost out of the system, I'm equally encouraged by growth opportunities that are available to Flowserve. For instant, we see significant upside for growth in aftermarket and MRO. We have a QRC network that is well positioned globally. Our core aftermarket activities of parts, repair and service have shown the resiliency we expect even in 2015. And while we won't predict the timing, we do realize there is a building aftermarket tailwind coming from last year's deferred maintenance activities.

As we've seen in the past, the longer facilities continuously run, the greater the workload is available to us when customers do catch up. And while much of our MRO sales were classified as run rate OE, this activity demonstrate substantial aftermarket attributes.

In short, a significant majority of our annual revenue is brownfield in nature serving existing infrastructure that is permanent and need regular attention, which we believe provides opportunities to improve our share of the customers operational spending. For Flowserve and our shareholders, this work forms an attractive recurring revenue stream created from decade of our installed base. And we intend to increase our focus on this aspect of our business with a number of initiatives.

We are also committed to remaining a significant, competitive supplier into new, large product opportunities that make sense for our business. The logic is simple. Project work absorbs cost in our manufacturing facilities and keeps Flowserve as a technological leader and innovator in our industry. Additionally, custom and highly engineered products inherent in our EPD segment create a new installed base and provide a competitive advantage for future aftermarket and MRO opportunities.

We believe with the manufacturing and product optimization strategies we are implementing that Flowserve will remain a strong competitor in the marketplace, while the quality of our products brand and operational excellence remain key selling point. We also see sizable opportunities in our industrial business. IPD is done an admirable job of lowering cost to drive margin performance in recent years. But the priority had is growth. We've recently named a new leader for this segment that brings proven track record of the success to drive IPD forward.

One of the unique opportunities available to us is to drive increase sales through the distribution channel. Our valves business recognizes about 40% of its revenue through distributors. IPD has a number of products that are applicable to this avenue and we are pursuing it aggressively. Additionally, our acquisition of SIHI has enabled alternative, go-to-market method with a greater focus on run rate business, which we can incorporate with existing IPD products. Additionally, we now have a more extensive portfolio that we can better leverage as a result of the Innomag and SIHI acquisitions. Both of which primarily serve the chemical industry. Even in the challenged market, we believe IPD is positioned for stronger growth long term.

In fact, we see opportunity to gain share in the marketplace across our strategic product line. With a depth and breadth of our unparalleled flow control product and service offerings, Flowserve is well positioned to continue adding value for our customers. Likewise, this frame agreements, multiyear performance contracts and preferred supply arrangement and traction in the industry, Flowserve compete very effectively as we currently have over 400 such programs predominately with substantial customers. And we believe there are still opportunity in our customer focus initiative and end user strategies.

Lastly, Flowserve continues to demonstrate operational excellence and a continuous improvement culture that drives result. We continue to lower the cost of poor quality, pursue outsourcing opportunities and leverage our supply chain and logistics, all in an effort to drive out cost. At the same time, we are committed to producing innovative products and enhancement for the industry and we'll continue to demonstrate discipline in our pursuit of new work.

Before turning it over to Karyn, who will cover our recent financials in detail, let me finish by saying that while our end markets remain challenged and maybe for sometime we are in top of it. Flowserve is and will remain a strong competitor with the ability and culture to drive performance.

Let me now turn it over to Karyn and I'll return afterwards for my final comments.

Karyn Ovelmen

Thanks Mark. As we indicated in our preliminary release several weeks ago, 2015 fourth quarter adjusted earnings were in line with the expectations we conveyed during the third quarter call. A stronger performance this quarter leveraged strong shipment levels consistent with our traditional seasonality. Our adjusted fourth quarter EPS of $0.89 excludes realignment expenses of $0.31, negative below the line currency impact of $0.06, $0.02 for the non-cash valuation allowance and the Latin American deferred tax asset and SIHI impact of $0.01. Partially offsetting these items is a $0.05 benefit from the reduction of contingent consideration related to a 2013 acquisition. All in reported EPS was $0.54.

In our preliminary release early this month we indicated our fourth quarter adjusted EPS would exclude the reserve established for in at-risk customer. As we've shown today, we did not add back the $0.06 incurred since we view this as part of our business and wanted to be consistent with prior quarters. But to compare on an apples-to-apples basis with our preliminary release, our results were at the high end of our expectations.

The reserve in question is related to an at-risk customer and includes the write-down of inventory, work in process and receivables from European company that has formally indicated it needs to rework its liabilities and if unsuccessful is at risk for insolvency. When market conditions get challenging we recognize we will see the occurrence periodically. While Flowserve generally does not have customer concentration issues, we do strive to take all the steps we can to protect Flowserve assets.

Turning to our bookings. On a constant currency basis, they declined 24.8% in the quarter excluding SIHI's contribution of $54 million. As a reminder, both the 2014 fourth quarter and full year had record levels of bookings which created tough comparisons. Looking further at our bookings profile, original equipment orders were down 32.4% or organic aftermarket bookings declined 13.6% in constant currency. As Mark mentioned, our core part services and repair aftermarket business has largely shown the resiliency we expect during 2015.

While we have experienced some maintenance delays, the larger headwinds we face from reduced level of CapEx driven aftermarket projects such as efficiency upgrade as well as few parts tied to new units. Similar to all of 2014, our end markets during the fourth quarter continue to be impacted by low and volatile oil and gas prices. A strong US dollar and emerging market weakness. Certain end markets even deteriorated further in the quarter as oil drifted lower and uncertainty increase.

For instance during the first three quarter of 2015, our bookings in power, chemical and general industries held at better than we experience in our oil and gas markets. The trend changed a bit in the fourth quarter as we saw these markets taking additional step down as customers deferred capital investment and pulled in their maintenance budget conserving cash. Likewise in our regional basis the Middle East and North America were better performers through much of 2015 but this trend did not continue in the fourth quarter.

However, Europe produced some relative improvement and activity levels versus the first three quarters of the year. Latin America, our most challenged region throughout 2015 remains extremely soft with delays occurring in nearly all projects with our important customers in Brazil, Venezuela and Argentina. Considering the quarterly volatility in our served end markets and region we experienced this year, our visibility heading into 2016 remains limited.

From a sales perspective we generated $1.3 billion in the 2015 fourth quarter, an increase of 1.2% on a constant currency basis including $76 million from SIHI. This was also a 17.4% increase sequentially again reflecting Flowserve's normal seasonality. Excluding SIHI's contribution, sales declines 4.3% in constant currency compared to last year. Again our aftermarket business held up better as sales increased 2.2% on an organic constant currency basis. For the full year 2015. Flowserve's constant currency revenues increased 2.4% including $294 million from SIHI.

Looking at our margins, even with Q4 revenue declines in over 12% in tough pricing environment, adjusted gross and operating margins declined only modestly demonstrating Flowserve's strong operating performance, a shareholder alignment and focus on cost. Additionally, the increased mix of aftermarket sales and some savings from our realignment actions also contributed.

Considering we are at a challenging part of the cycle we are focused on effectively managing our SG&A expenses. Our fourth quarter SG&A declined $23 million year-over-year, or 9.1% excluding the impact of SIHI, realignment and the benefit associated with the reduction in acquisition related contingent consideration. The decline is primarily due to lower variable composition and modest realignment benefits.

Our fourth quarter and full year adjusted tax rate of approximately 29.3% and 29.1% were in line with our full year guidance rate of 30% to 31%. On a reported basis, the fourth quarter and full year tax rate is elevated as a result of accrued exit taxes for site closures and a non cash valuation allowance we took on certain deferred tax assets in Latin America.

Turning to cash flow. Flowserve generated total operating cash flow of $286 million in the 2015 fourth quarter or approximately $2.18 per share. Capital expenditures were $43 million in the quarter as we continue to make discipline investments in our business to support long-term growth.

We also repurchased approximately 1.2 million Flowserve shares during the quarter. And for full year 2015 we returned almost $400 million to shareholders through dividends and repurchases. Approximately $160 million remained available under our current share repurchase program at yearend.

Turning to our 2016 outlook and EPS guidance. We are reaffirming our full year adjusted EPS guidance of $2.40 to $2.75 a share which includes approximately $0.10 of above the line currency headwinds. Our 2016 adjusted EPS target range expects total revenues to decline 7% to 14% including a 2% currency headwind. Additionally, it reflects yearend 2015 foreign currency rate, commodity prices and market conditions. Guidance further assumes net interest expense in the $63 million to $66 million and a tax rate of 30% to 31%.

We also expect the quarterly phasing of our guidance to follow our typical seasonal trend. Although the first quarter is likely to be slightly pronounced after challenged Q4 books an improvement should follow. Our 2016 adjusted EPS guidance includes the operational performance of SIHI, quality through its realignment expenses, SIHI purchase price accounting and integration cost, below the line foreign currency effects and the impact of potential other discreet items. We also expect that 2016 capital expenditures will be reduced versus in elevated 2015 level where we increased manufacturing capacity in Asia Pacific and purchased a license enabling increased aftermarket opportunities.

We also plan to continue contributing to our pension plan to cover service cost even as the US plan is largely fully funded currently.

With that review let me turn the call back to Mark for his remaining comments.

Mark Blinn

Thanks Karyn. In closing, Flowserve expects near term market visibility to remain limited as customers calibrate around the persistent macro uncertainties. We expect this will result in continued delays in investment decision. However, as you have heard the near term market challenges provide us the opportunity to focus on cost take out, our operational performance and growth opportunities while remaining disciplined in our bidding. We believe Flowserve is well positioned with its extensive portfolio and consistent operational excellence. We've demonstrated success through prior cycles, controlling what we can by leveraging our one Flowserve initiative performance culture and comprehensive product portfolio to drive profitable growth.

As we've articulated today, we are aggressively pursuing the sizable opportunities available to us to optimize our manufacturing portfolio and footprint. And we will pull the necessary levers to not only manage through the current market but to position Flowserve continue to deliver long-term value to our customers and shareholders.

Operator, we would now like to open the call for questions. Thank you.

Question-and-Answer Session

Operator

[Operator Instructions]

And our first question comes from Andrew Kaplowitz from Citigroup. Please go ahead.

Andrew Kaplowitz

Hi, good morning, guys. Mark, so as you know Flowserve's overall business tends to be relatively late cycle. So how do you guys get a read on energy CapEx cuts which I know you know have accelerated over the last couple months when you are setting guidance? More specifically, how much concern do you have for additional pressure on your midstream and downstream oil and gas businesses? Really end markets like pipeline, LNG, even refining given relatively recent CapEx cuts?

Mark Blinn

Yes. Thanks Ande. So a lot of cuts that you talked about are typically been with the multiple nationals. We do still see project activities with some of the state owned company around the world particularly in the Middle East. But to your point a portion of our business primarily in EPD is what you call late cycle. And as we talked about before and you started to see this happen in the middle part of 2014, they start to curtail their CapEx expenditures, you've seen this with the multinationals trying to protect their dividend. And the fact is as those things can go off the drawing board, get pushed a little bit and they don't come back real quick from -- primarily from the multinationals so they don't decide necessarily over night to bring it back online. But typically these are in their long-term plan. So this is part of the reason if you take a step back and looks why we primarily focused on our engineered business with some of these realignment activities. We've been looking at these for years. If you look at what is occurred over time and it's important that people understand this, we came through a strong cycle in 2008 and in 2009 we adjusted to market and they picked up relatively quickly. There were still quite a bit of activity in the Middle East. But more importantly what we did as we started setting up a lot of our SPO facilities in India, China, enhance the one we had in Mexico, built up more capabilities and our LPO/SPO strategy is designed to start to qualify these, so that ultimately we can move the product and work to those locations. So we had these things on the drawing board for a while. What this late cycle component does is gives us time to go ahead and execute the backlog that we've had for the last year, year and half and we still have backlog and there are projects that would still come into backlog but for the most part we execute that and then start moving those capabilities to these low cost regions of the world. If you look at around some of the pipeline and other activities, some of those are on some of our run rate business and that's not as late cycle. And a lot of that is we talked about earlier some brownfield activity. So there is still some good brown field activity because what happens is lot of these facilities continues to run and they still need repairing and upgrade. So it kind of walking through it what the market environment does allows to do and this is why we are doing it as it allows to plan and execute and accelerate some of our what we call transformational activities around restructuring primarily in our engineered segment.

Andrew Kaplowitz

Got it, that's helpful, Mark. Okay, so let me ask you about the aftermarket in the context of you mentioned last cycle, obviously the last cycle, very different cycle but the aftermarket was flat in a difficult market. Aftermarket bookings in 4Q were down 11%, so the question is how do we think about your aftermarket business in the context of some of these big customers seemingly continuing to pull back on maintenance spend? Do you think you can maintain or increase the level of aftermarket bookings from the mid-$400 million range that you had this quarter or could it go lower still in the current environment?

Mark Blinn

Well, if you look back to the prior cycle we saw something similar in that there was a -- they defer their spend as long as they could. But it came within the year back at towards the end of 2009, some of the spend activity. First of all, you talked about Q4 and the year-over-year compare we had about $550 million of bookings in Q4, 2014. That was a very, very strong quarter. That had a lot of parts tied to new unit. It also had a lot of upgrade projects. So those are small projects within the aftermarket portfolio. If you strip that down and you look you can see that our run rate base maintenance was down only slightly year-over-year both on a quarter bases and on a year-over-year basis, consistent with what we saw back in 2009. So we'd expect that to stabilize unless there is any kind of disruptive event that occurs out there. I mean what our industry saw across the board was very little activity in Q4 particularly on the project and even on the run rate side. That was reflected in our bookings. But we've seen some stability in the aftermarket business. My comments earlier are some of the deferred maintenance will need to come back and come back online. What we are looking for is to see where the efficiency upgrades come back in and while the rationalizing CapEx that may take some time. So that's market driven. From our standpoint, what we need to is to continue to execute on some of our end user strategies. I talked about this before but frankly we don't know where all of our installed base, we are working with some of our teams to increase in inventory where that is so we can call on those customers. They want to us help them; we just need to know that they are in and call on them. So we are going to continue to execute end user strategies like that in an attempt to grow the aftermarket business in any environment. And in fact if you look over the last 7 to 10 years, you've seen a fairly consistent strong growth through cycle. Most of that is not the net incremental and installed base. A lot -- there was a base amount of net installed base that went it. But the fact is the growth rates were higher than that. And that was primarily from executing these end user strategies. But when you look at our business, when you have volatile moves in oil, it takes everything with it. Everything tends to move in tandem when things tend to stabilize and normalize out even at lower levels then you can get what I would say is differentiation in your end user strategies. And any other strategy you want to execute.

Andrew Kaplowitz

Right. So if I'm hearing you correctly, as soon as oil stabilizes if it has stabilized you should see more normal aftermarket behavior. Is that fair?

Mark Blinn

That's fair. I mean if you think about customers they are trying to figure out what the number is. And they make investment decisions, capital decisions all around that. So I think that's part of what you see in the industry is that volatile moves and we saw it when oil moved up by the way back in 2007 so rapidly, volatile moves tend to increase the correlation of bookings and all other activity to that movement in that underlying resource. When things tend to stabilize then end users can start making investment decisions that are more longer term but when the short term is so volatile it's just tough to make a decision. That's why everybody is.

Operator

And our next question comes from Mike Halloran from Robert Baird. Please go ahead.

Mike Halloran

Good morning, everyone. So first just kind of finishing rounding out that last thought, it doesn't sound like you think that there's a shift going on in the customer base in the aftermarket side between insourcing that type of work or outsourcing it to providers like yourself. So maybe you could just touch on that a little bit and if there's any change in trend line there if it's pretty normal relative to what you would have seen in previous cycles.

Mark Blinn

Yes. I don't think there is any significant shift. If you think about it Mike you look at the complexity of the equipment of that goes in. That tends to lead to more outsourcing because a capabilities internally for the complex work. They are always going to look to absorb their fixed cost and good times and bad. So the trends that are occurring is the equipment is becoming more complex that is certainly one, also a lot of the resources internally to our customers are aging and retiring. And they would prefer to outsource that work. And then you add to that some of the capabilities we have around the end user. And this is going to be an opportunity. It's not just amount -- it's not just maintaining repair and servicing but its how do we get more efficiency out of those products. We haven't seen a lot of that recently, but that will -- that trend will continue. But short term Mike in fairness everybody looks to cover any of their fixed cost. So I can't say that didn't happen on the margin. But that's not a long-term strategy for refinery or any kind of processing plant. It's just trying to bring that in internally. Short term maybe some of the things I'll do but on the complex equipment they will tend to let the experts do it.

Mike Halloran

Yes, that makes a lot of sense. And then on the IPD plan to move towards that distribution market, I guess a question on balance, how do you balance moving new products into that market versus an ability to maintain a margin profile, and speaking more on the idea of the level of engineering and aftermarket that's going to go through the distribution channels a little lower. So just talk about how you can protect the margin profile if not even do better than that as you move into new channels there.

Mark Blinn

Simply answer I point FCD, I mean they have done thing, same thing. You can make money through your distribution channel. I think if you take a step back and look at IPD, our focus was on improving the operations and the margins which we've done. If you look at all the adjustments and take out at-risk customer, we were over 16% in the fourth quarter. So from our standpoint mission accomplished in terms of the margin improvement but some of my comments earlier were this group broke out of engineered business and we've a real opportunity to improve how they go to market. Various channels configure to order on electronically in terms of been able to response. Some of these pieces of equipment are couple hundred dollars, $500, $600, $1000, $1500; the customers aren't as price sensitive. They just wanted it and they wanted it now. So if we can execute through our online capabilities and improve those or through a distribution channel, typically you can command margin because they need these for their brownfield activity. So I think part what we are lining out for you is this is a segment of our business and we frankly we've learned a lot from the SIHI acquisition. This is a segment of our business which has some great opportunity. We just need to improve it. We need to improve the way we go to market and how we execute into the channels. And Mike you've always known me I'll say if things aren't operating the way they should be, I'll tell you this is one that has real opportunity for improvement on the top line.

Mike Halloran

Great, I appreciate the time, Mark. Take care.

Operator

And our next question comes from Charley Brady from SunTrust Robinson Humphrey. Please go ahead

Charley Brady

Thanks and good morning. Yes, hi, Mark. The commentary on EPD, on the bookings in the quarter obviously really heavy aftermarket weighting 72% or so which is I think probably unusually high for that business. You kind of understand why given that that's a large project business. But I'm wondering can you maybe talk about the margin impact on that significant mix shift and aftermarket versus OE, when you tie that in with obviously you've done some absorption because the OE is just dropping off I guess my question at the end of the day is what level can you maintain the margins with aftermarket to offset the absorption issues you're hitting on EPD?

Mark Blinn

Yes. You are trying to find a math of what's kind of the inflection point but you are right with low level bookings in the project business you will have an absorption issue which can get pretty expensive. And part of the reason not necessarily just the Q4 bookings but part of the reason we are addressing that net segment. Charley, we had looking back to 2014 and folks would have considered that a decent market and a good year for us. We had about $150 million of under absorption in our business. And a lot of that was in that engineered segment. That's what put us on the path toward what we -- at that time it was going to about a five or six years transformation of that business. You never get your under absorption down to zero but you certainly can get it to run $50 million to $70 million in your business. So I just wanted to make that point around that engineered segment because that's a lot of the reasons we are taking those actions is to help it variablize and be much more competitive and not have to deal with under absorption. It had an overhang coming into this downturn and so part of that is we need to attack that. Once we attack that I think you are going to need to see higher levels of project bookings. In Q4, there were lot of projects that were right there in front of us and they got pushed. And that's not a typical because the customer can wait a couple of quarters and see where market settle out and it's very, very competitive. And it's to their advantage to wait over a short period of time. So I think what you are going to see is as we start to address that we'll deal with the under absorption, the after market mix will help but there is a lot of large expensive facilities in this division. So it's going to need project work but will offset that by starting to take cost out. That's also some of the facilities we took out last year. So I don't have the exact math because part of it is how we get to the cost both in terms of the gross margin line under absorption and the fixed cost as well as we mentioned earlier we are taking action in some of those areas as well. And then where the aftermarket business comes in.

Charley Brady

Okay, thanks. And just my follow-up here is on M&A just quickly, I guess does the current market environment as lousy as it is in oil and gas change your thinking directionally on where you want to look towards M&A as you look out to your pipeline and maybe does it move you toward areas that maybe a year and a half, two years ago you might not have been thinking a strongly about?

Mark Blinn

Right. Well, let me tell you one of our biggest cash M&A opportunities is this restructuring. It's got a great return but Charley, no, we had our line aside on certain industries which we find attractive and the real question is at what time do they make sense. I think what you don't want is for us to decide all a sudden to go in a left hand turn direction into some area that's not core to us, just because it may be viewed as relatively cheap. So it's fair to say that we are still focused on the areas where we think we make money. The chemical industry, we've talked for years around the opportunity around upstream, additional downstream or service capabilities. We made a small service acquisition last year. So we are going to stay focused on where we think we make money long term. There were a couple of things we need to think about. One is we don't want anything to conflict with these restructuring activities because this is a high return on our investment and we need to executing very well because our customers are relying on that. The other thing to think about is just we need to make sure we are very thoughtful with our cash both in terms of the restructuring and our shareholders as well. There is always opportunities use your stock as currency but we have to look at that relatively to the asset that we are looking at. So we are clearly opportunities may come in this type of environment especially for company like ours that has a very strong operating platform. But we need to always balance that against other priorities and what I'll tell you is when we can return $215 million, a lot of it is going to be permanent in our business with $350 million of spend, that's pretty compelling.

Operator

Our next question comes from Nathan Jones from Stifel. Please go ahead.

Nathan Jones

Good morning, everyone. I'd like to just ask a couple of questions about working capital and perhaps get Karyn's take on this now that she's been there for a while. You ended the year with core working capital about 35% of 2015 sales which has gone up considerably over the last few years. What tactics are you guys using to get that down? What's a long-term target look like and how long does it take to get there?

Karyn Ovelmen

There are several things going on. First on the account receivable side, we are seeing slower payment in particular Southern Europe and Latin American customers. They are continuing to pay but albeit just slower. Accounts payable is down with inventory up, majority of those increases in inventory are in working capital. So adding cost but not necessarily in purchase parts, it's more labor and less payable associated with that inventory. Also in terms of accounts payable negotiating the terms with suppliers. We'll pay according to terms and all through 2015 there is an emphasis to actually paying on time. We've a lot of local suppliers so paying on time helps the timing and on time delivery as well as directionally pricing. We have been focused locally at the site in terms of improving working capital. As I mentioned on the third quarter earnings release call, we are stepping back and looking at this now going forward on a more global perspective. And really looking to implement in global standardized procedures around billings and cash and collection as well as order and purchasing. So those are the type of things we are going to look at those types of programs to take time. I think in addition with the realignment going on, we will see improvements ultimately when we get through this process. It will take a couple of years but as we consolidate and streamline our sites, we should see improvement in working capital but in near term don't expect any significant swings.

Nathan Jones

Understand that. If you think longer term is there a number that you think Flowserve's structure should operate in terms of a percentage of sales in working capital or working capital turns or however you would like to frame it? Because it does seem like there's probably several hundred million dollars in working capital that you could free up to put to better use.

Karyn Ovelmen

We do believe there are some values there. We don't have specific target at this point like I said we are going to look at this in a more standardized global perspective so versus really at the local site. But yes we do believe there is some improvement there but we don't have specific target at this time.

Nathan Jones

And Mark, I think you mentioned in response to one of the last questions that there were a few projects right there in front of you in the fourth quarter that got pushed. Are those things that got pushed significantly or are they imminent? Could those orders come through in the first half of the year or have they been pushed further out at this point?

Mark Blinn

No. These were fairly well down the road and they just seemed to move. But they can move from quarter-to-quarter. We've seen this happen before but we did see they moved in. And Nathan they can move still another quarter or two easily. We still have confidence they are going to come online but remember they are very competitive. We will response but only to a point because if you remember back in 2009, 2010 and 2011 we had a lot of backlog they didn't have value to it. And that doesn't accomplish anything for us. So it is a competitive environment. These things tend to push. We have confidence some of them particularly in the Middle East are going to go forward. But just remember environment is very competitive.

Operator

And our next question comes from Joseph Ritchie from Goldman Sachs. Please go ahead.

Joseph Ritchie

Thanks. Good morning, everyone. So I guess my first question is on the restructuring plans, Mark. Maybe you can talk a little bit about the magnitude and the cadence of the restructuring in 2016? And then specifically, is it fair to assume that a lot of the actions or a disproportionate amount of the actions are occurring in EPD?

Mark Blinn

Some of the large transformational one in the large plant are in EPD, yes, Joe. And a lot of these as you -- as we talked about are in OECD countries and quite a few in Europe and they take time. You got have a long planning process in terms of just dealing with your constituencies but generally what my comments were is we expect to see about $125 million benefit this year, $185 million next year. So all other things being equal you get an earnings lift next year from just these restructuring activities. And then we will see the run rate in 2018 which will take us up to $215 million.

Joseph Ritchie

Okay and then from a cost perspective you're incurring about $150 million this year, is that kind of ballpark-ish the right number?

Mark Blinn

I think that's number yes that we talked about earlier, yes.

Joseph Ritchie

Okay. And then maybe my one follow-up is really around pricing. It looked like your gross margins in the fourth quarter decelerated a little bit versus the rest of the year. Just curious to hear what you're seeing on the pricing environment. Have things have gotten worse? And given that you have seen significant CapEx cuts to start the year from some of your customers, I'm just curious to hear what you're hearing from your customers today.

Mark Blinn

Well, some of those margins in the fourth quarter had these two customers issue right that we talked about it. And so if you -- in a lot more up in the gross margin line but in general we are actually pleased that our margins held up relatively well. But what you will see in the gross margin line is the pricing environment and to the extent we can offset by some of the restructuring activities. Because lot of those fit into gross margin line to the extent they impact manufacturing facilities. It's just going to be the timing in terms of one week and execute them, some of that is outside of our control. But we are seeing from customers and just remember we didn't have a really strong pricing environment in 2013 and 2014. It was okay versus the last cycle we had a tremendous pricing environment in 2007 and 2008. So but we are certainly seeing it down get competitive at that point in time. The other thing that we will have to deal with is the top line goes down is under absorption. And how quickly we can offset that with some other restructuring as well. But pricing environment is competitive. We saw this back in 2010 primarily because a lot of the project activity in 2010 was in the Middle East and that is always competitive in just about any environment. Typically you have Korean engineering and contracting firms there, they tend to be very competitive on price and demand out of their suppliers. So we are starting to see a very competitive environment. The real question Joe is how long this is going to last because the late cycle part of our business which is the projects which as we talked about has been well less than 20% of our business. It tends to-- the opportunities tend to move out quick and move back slowly.

Operator

And our next question comes from Robert Berry from Susquehanna. Please go ahead.

Phillipe Forlorne

Good morning, guys this is Phillipe Forlorne [ph] on the call for Rob today. So first question, going back to the restructuring, I mean the benefit of course looks up nicely versus the previous target but the return on the investment looks lower. Is that the message that incremental savings are becoming harder to find and is there any potential upside to these numbers if the environment were to get worse?

Mark Blinn

No. The numbers are really reflective of the type of restructuring that you have. I mean when you $125 million for $125 million is pretty much one for one payback or one year payback. You don't typically see that in Europe. It cost more but the fact is those savings are permanent. An also what you saw was a lot of the initial part was what I would call volume related headcount reduction as opposed to permanent closures of facilities. But when you close a facility anywhere but particularly in any OECD part of the world and particularly in Europe, it cost more than the savings but the savings are permanent. I think the important thing to think about when you take a step back is if you look at our business, lot of heritage capacity going back 10 years was in very expensive parts of the world. And we are changing that. And so what that all mean is even some of our OECD facilities are going to be have higher load levels and higher engineered equipment in them, and we are going to get more advantage of some of our low cost manufacturing around the world. So that's why we are trying to emphasis this is permanent. This is the kind of thing that would have addressed that $150 million of under absorption back in 2014. And not only would that have significantly improved margins once executed. So as you think about us moving through the cycle and more margins have been this is something that will all other things being equal relative to last and we think that things are going to -- some things are going to change. But the fact is if we had this type of manufacturing profile four five years ago, our margins would have been a lot higher.

Phillipe Forlorne

Okay, that makes a lot of sense. And then on your 2016 outlook does that imply any recovery in refining MRO spending? And what's the latest outlook there given your discussion with customers?

Mark Blinn

Well, there is an assumption that there will be some stabilization in some investment in some repair and maintenance in the business. But we are not really expecting the aftermarket upgrade and certainly not the tied units to come back during that period of time. But it does have some of our initiatives around improving the go-to-market strategy in IPD within that. So it's not matter of us just sitting back and letting the market deal what they are going to deal. We have to go and execute some of our strategic initiatives to achieve our guidance.

Operator

And our next question comes from Chase Jacobson from William Blair. Please go ahead.

Chase Jacobson

Hi, how are you? So Mark, you talked about increasing the aftermarket sales and doing a better job tracking where your equipment is going. But you also talked about more sales going through distribution which I thought would maybe make it harder to track the products and capture the aftermarket. So I guess one, can you address that? And two, as you do try to track the products better and capture the aftermarket are you putting more people on the ground or are you doing something where you're adding more technology to your products?

Mark Blinn

Yes to both. Nobel technology to the products some monitoring capabilities, boot on the ground but also technology system to track our installed base. Going back to your earlier question, the distribution channels, those are out and present there, we are just not taking full advantage of them in our industrial product segment. And these distributors they can carry multiple product line and are responsive on one or two product basis to a customer that need it fairly quickly. The end user strategies are really designed around where there are substantial installed based. If you look at some of refineries around the world, there are hundreds of pumps that are out there. And all over the world, if you look at our heritage brands going back many years, there were literally some pumps that were installed in the 70s that were still supplying parts to in remote parts of the world. So it's really around getting our hands around that, inventorying it, making sure we are calling on the customer. So one of the things that we've done this year and you alluded to a little bit is really increased our focused on our sales organization and how we get out to customers on account basis. And get more share of their wallet. Well, part of it knows what customer to call on and on what product they have in their facilities. So we will be the first to tell you. We can do a better job on that. That is one of our key strategic end user initiatives this year. So if you think about how we rolled it out over the last couple of years, we've increased our QRC network and we will continue to do that. We've worked with systems and some end user strategies to help them develop and understand how they can bring more efficiency out of an existing facility. Because even right now they are looking for higher yields out of their processing facilities. The other element now is making sure that we have the right people calling on the right customers, not just out of QRC but our sales people and that's a separate and distinct strategy from using the distribution channel. Distribution channel has been very powerful for our valve business. We just haven't levered it on the IPD side. But your point is fair. A lot of this is OE that goes through distribution as opposed to service and repair work. But a distributor, they want to get certainly margin as well but what we found and you've seen in our valve segment is we can still get good margin on product that goes through distribution because keep in mind what the customer is looking for is they are looking for that product there very, very quickly. These aren't multimillion dollar pieces of equipment. These can be in hundreds or even in low thousand. So time is of the essence.

Chase Jacobson

Okay, that's helpful. And then when you do your due diligence on some of the larger prospects, I mean it seems like always and especially in this environment the customers tell, whether it's the E&C company or the equipment suppliers they tell you that the projects are going forward until they are not. So I guess what is Flowserve doing differently now to make sure that you're putting more resources after the projects that are actually going to go forward versus the ones that are just always out there and always getting pushed?

Mark Blinn

Well, if you think about it, when we interact with these customers we are doing a lot of the design work for these products, for these facilities, working on standardization. Some of our large customers we have quarterly meetings with them to go through exactly what they are planning. It's in nobody's interest that the both sides don't understand what's going to happen. And what I mean by that is a customer -- if they are going to go forward with the project they have reasons, long-term reasons to do that. They may push it a couple of quarters. So once the project starts moving down the road, we have pretty good sense it's going to go forward sometimes, it get cancel. We saw that last year some projects that we thought really were going to forward they get cancelled. It was by a multinational that was very focused on short-term capital. But we see projects drop off or the one that are in the ideation phase that are going on the drawing board. And as people look for visibility around the underlying value the resource they may put them off at that point in time. But I think what I want to explain to you is there is a lot of work that's done before these things are bid. So in doing that we get pretty good visibility.

Thomas Pajonas

Yes. And I would add to that we do take a look at, is the financing in place with the project, and is the projects have off take agreement in place for the commodity that they are producing. We also have different levels of activities so something that is in their earlier stages we would deploy a budget level of resources. If all these things that I mentioned and Mark mentioned are in place then we will deploy more elaborate resources in order to go after that potential proposal. So we have a pretty good system for weeding out those are in early stages versus those that are more firming up and getting ready for real proposal activity.

Operator

And our next question comes from Jim Foung from Gabelli & Company. Please go ahead.

Jim Foung

Hi, good morning everyone. So I just wanted to maybe you could size up the opportunity in terms of selling the industrial pumps through distribution. How large is that opportunity for you? I presume it would be incremental to what you're doing now.

Mark Blinn

It is incremental. If you look at our valve business approximately 35% to 40% of their business goes through distribution and we are sitting probably less than 10% on the industrial side. So if -- and in fairness I would say that 30% differential is all incremental because part of what we need to do is have disciplined around what products go through our sales force and what goes through distribution because frankly a sales organization would want to have all other products at their disposal to sell, but the fact is they are only really focused on selling a few and we've seen that. So but a lot of that is going to be incremental in the business if we get it up to the right that our valve business is operating at.

Jim Foung

So net you're in the distributive -- you're in a lower margin through the distributors, net-net your bottom line would improve from just the higher volume.

Mark Blinn

Well, you do get higher volume but as I mentioned earlier time is the essence and so it's while distributors can make good margins, we make decent margin on products that go through distribution. If there was a significant margin differential, companies like ours would go direct to market. But the fact is there is a lot of value in our distribution channel. And Jim we are not talking about big, big projects going through distribution. Again this could be $1500 pieces of equipment and where the distributor add value is they carry an array of products tha they can serve the customer fairly quickly, often times they are proximate to him and so I am not saying a customer is price sensitive but they are really focused on getting that -- having that product available along with some other products that we may not serving to that customer, getting response quickly and getting their facility up and running.

Thomas Pajonas

And Jim if you look at distributors, there are many different types of distributors that add value. Some are just buy and resale, some will add content to it, some will add an engineering value added to that. So that distributor is really a route to market that we choose based on the value added that distributor can bring to that product in the territory region that the customer is in.

Operator

And our next question comes from Jonny Wright from Nomura. Please go ahead.

Jonny Wright

Good morning, guys. On the restructuring if we can just look at that from a different angle, so I think historically in the valves you always hear a lot about increased competition from low cost Chinese competitors. You guys are now looking to kind of pivot the manufacturing base away from developed economies into places like China. How do you maintain the Flowserve brand whilst doing that with your customers? And also how do you think about avoiding passing that price, passing the cost discounts on to the customer in the form of just lower prices and becoming more of a like-for-like competitor with the low cost Chinese guys?

Mark Blinn

Well, you keep in mind low costs Chinese are typically are in lower tier products. So some of these are very, very highly engineered piece of equipment. And we don't necessarily see a lot of competition from Chinese suppliers. These are high end controlled valves actuation, highly engineered pieces of equipment. But here is the important thing. The way we do this is with the permission of our customer. So part of what we've been working on over the last couple of years through the LPO/SPO strategy is working with our customers to qualify some of the manufacturing in low cost parts of the world. And don't just mention China because labor rates are gone up quite a bit there. We are talking about various parts of the world, India, Mexico. But the other thing to remember with our customers as well is often times they want to deal with the OECD facilities so sometimes what we do when we talk about repurposes, we'll make that facility engineering assembly in test, it will still be the front end but a lot of the activity around the value add to the piece of equipment will be done in a lower cost part of the world. So I am not suggesting customers on highly engineered pieces of critical equipment are wholesale moving everything to low cost parts of the world. That may occur over time and we are prepared to move with them and doing that. But I think the important thing these aren't commodity sold by the pound type equipment that typically get fully converted over to a low cost region of the world. And we don't expect that to occur over the short term. But we expected to occur faster than what it occurred over the last 10 years which is why we are taking these actions, one of the reason we are taking these actions.

Operator

And our next question comes from Brian Konigsberg from Vertical Research Partners. Please go ahead.

Brian Konigsberg

Good afternoon. Just a couple of quick questions, most have been answered, but can you just give a little bit more clarity on the restructuring or the spend you're doing below the operating income line? What are you targeting specifically and what type of savings is associated with that action?

Mark Blinn

Yes, I mean below the line typically those are going to be exit taxes, any non cash asset write-downs or certain things that are sitting below the line but lot of those are going to be exit taxes in the business. It's just not easy to move from OECD countries.

Brian Konigsberg

Okay. So is there a payback associated with that or is it just spending that needs to be done because of the move?

Mark Blinn

It needs to be done as part of the move. I'd look at it holistically and just take a step back and say we are spending -- we are going to spend $350 million, most of it is cash, there is some non cash component to that, most of it is cash to get $215 million of savings all of which is cash. It's still a great payback.

Brian Konigsberg

Yes. And also just maybe can you expand a little bit upon just the customers from you had a bad customer expense in the quarter, obviously there's stress really across the globe in the oil and gas space. Do you see -- what do you see from the rest of the customer base? Are there other accounts that are particularly stressed at this time where you might have to take similar actions over the course of 2016? Any color on that would be really helpful.

Mark Blinn

Well, I mean things could have been typically a lot of our customers are -- we don't have high customer concentration in terms of sales. But they are certainly at risk parts of the world. If you look at Latin America, they are certainly things that are going on down there. I mean we don't typically have -- we serve a lot of large customers and but these things going to occur, I mean one of these was a relatively medium sized distributor or small size distributor that went out of business. So you typically when we you see the strain in our industry, it typically occurs in the first 18 months maybe two years. We don't supply necessarily a lot of the upstream, smaller upstream type companies E&P companies that you are hearing about. A lot of the companies that we serve are large names or ongoing process capabilities. But we watch this very carefully.

Brian Konigsberg

If I could sneak just one last quick one in, just on free cash flow, so I understand you had high CapEx in 2015 associated with the move presumably? But even if you normalize that, we haven't seen net income equal free cash flow really since 2007 at this point. I know there's a question on working capital previously. But can you just maybe conceptually just talk about where you think this business should be on a run rate basis from a free cash flow conversion perspective. And I don't think you gave 2016 expectations. I assume that's going to be trailing as well. But if you could talk around that subject it would be helpful. Thanks.

Karyn Ovelmen

Yes. So going forward from a cash flow perspective, first quarter they are generally is more cash outflow from our operation associated with taxes, those types of things that we have in the normal first quarter cadence. Our capital expense will be significantly lower. We had approximately $180 million in CapEx in 2015. Our expectation is that's going to be more in line with around $110 million in 2016. So in 2015 we had higher than normal CapEx that are licenses and carryover CapEx work in 2014. Generally speaking on the working capital like I said with this market it's little tough. We don't expect significant swings in our inventories to go forward. And like I said over the course of the next few years as we execute on the realignment, we do have expectation that we will be able to bring working capital down but don't see any significant levers in the short term.

Brian Konigsberg

Do you think that net income and free cash flow will be able to converge sometime over the next couple of years? It just seems to have been to so well below net income for an extended period of time, I'm just trying to get a sense of should we be expecting this business as it's it runs and you expect it to be run to be converting into free cash flow in line with the net income?

Mark Blinn

In part of our reducing complexity is designed to that. It should start approaching it. It's going to take a while. I mean we are going to consolidate facilities then Karyn in the years out has initiatives that we start driving shared service models and things that help really drive more efficiency across the system. But let's keep in mind we are fairly distributed company across multiple countries and multiple facilities but no question that as we take out 30% of our capacity and doing some of the reductions in complexity which we think our customers are going to demand long term. We should get better free cash flow in our business. We've been as frustrate as anybody else has in terms of trying to seek that goal but we are determined to get there.

Operator

Ladies and gentlemen, we have reached our allotted time. This concludes today's conference. Thank you for participating. And you may now disconnect.

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