Flowserve: Still Not Worth Buying

| About: Flowserve Corporation (FLS)

Summary

Flowserve is an American multinational which supplies industrial and environmental machinery and related services into the Oil & Gas, Power Generation, Chemical (and other industrial) sectors.

The company's sales exposure to Oil & Gas, which represents over a third (FY 2017: 38% of sales), has hit it hard over the past five years.

Sales have fallen almost 7% compounded since 2014 (on a TTM basis, to March 31, 2018).

Even with optimistic assumptions, it is difficult to justify the current share price and valuation. Further downside is more probable than upside.

Introduction to Flowserve Corporation

Flowserve Corporation (FLS) is an American multinational, which supplies industrial and environmental machinery to the Oil, Gas, Power and Chemical industries (among other industries).

More specifically, they supply pumps, valves, automation, and various services. Services include machinery repairs, field and support services, engineered services, and asset performance management.

Flowserve is a relatively large company. It currently generates around $3.7 billion in revenue. Its latest 10-K indicates it has around 17,000 employees.

FLS stock has performed poorly. As shown in the table below, the stock has declined -10.27% over the past twelve months.

Share Price Performance In this article, I will introduce and profile the company, and provide an indicative valuation.

Business Segments

The company operates through three key segments: (1) EPD (Engineered Products Division) which offers long lead time, custom and other highly-engineered pumps and pump systems, mechanical seals, auxiliary systems and replacement parts and related services; (2) IPD (Industrial Product Division) for engineered and pre-configured industrial pumps and pump systems and related products and services; and finally (3) FCD (Flow Control Division) which offers engineered and industrial valves, control valves, actuators and controls and related services. The business is not performing very well, hence high short interest exceeding 10%. The company has high exposure to Oil & Gas of 38% of FY 2017 revenues (FY 2016: 36%). Other main markets include mining and ore processing, pharma, pulp and paper, food and beverage (together around 24%), and chemical markets at 21% of revenues. Sales in power generation markets represented 13% of sales, and finally water management end markets represented 4% of sales.

As a percentage of sales, the mix is consistent among chemical, power generation and water management, while Oil & Gas is increasing. The exposure to Oil & Gas is what has made this company suffer. However, the entire business has suffered over recent years, with every segment taking a hit:

Flowserve Segments Geographically, the mix is also generally consistent, with North America contributing 40% of FY 2017 sales, Europe contributing 23%, Asia-Pacific contributing 19%, Middle East and Africa contributing 13%, and Latin America contributing 5% of sales.

Flowserve's Earnings

On a trailing twelve months (TTM) basis, the company generated $3,714.47m in revenue, with positive EBIT of $189.72m.

As you can see in the table below, revenues have grown at a negative rate over the past five years (-6.81% per annum, compounded, as compared to an average negative growth rate of -4.74%). This growth has been largely stable.

Flowserve Earnings The company's sales are both declining on average and trending downward over time, as are gross profits.

Gross profits vs. total assets is a useful quality ratio for assessing a business's competitiveness and efficiency. As the table above shows, the gross profit vs. total assets ratio has weakened over time (currently: 22.82%), in line with the movement in gross profits, which is quite clearly negative.

In nominal terms, gross profits have fallen over the five-year period (by -8.45% compounded, worse than the fall in revenues). The company's gross profits are about 1.6x as high as its top-line volatility. The loss of sales has given way to a seemingly more drastic fall in competitiveness.

Indeed, as sales contract across an industry, the bargaining power shifts in favor of customers rather than suppliers. As noted in its FY 2017 10-K report:

The markets for our products and services are geographically diverse and highly competitive. We compete against large and well-established national and global companies, as well as regional and local companies, low-cost replicators of spare parts and in-house maintenance departments of our end-user customers.

Multiple factors have attacked and eroded the value and competitiveness of Flowserve over the years. The crash in the oil price, and resultant loss in orders for various Flowserve products and services, is one key factor. It has become more and more of a price-taker, in an increasingly competitive space, competing not only with “large and well-established national and global companies,” but also “regional and local companies, low-cost replicators of spare parts and in-house maintenance departments” of the company's end customers.

As shown in the prior table, Flowserve Corporation's gross margin was 29.30% in the past twelve months. That is in comparison to an average of 32.21% in the past five years inclusive.

EBIT (Earnings Before Interest and Taxes), i.e. Operating Income, was +$189.72m in the past twelve months, which represents an EBIT margin of 5.11%. Flowserve Corporation's EBIT margin has clearly weakened over time. This more recent margin compares to an average five-year margin of 10.54%. This, of course, coincides with the loss of revenues and gross profits.

The company's net income was -$1.26m in the recent TTM period (a near break-even net margin of -0.03%). Flowserve Corporation's net margin has sunk more recently, just as gross profits have generally trended downward over the past five years. The company's free cash flows are better though (discussed later).

Finally, it is worth considering Flowserve Corporation's sales, general and administrative (SG&A) expenses, and operating leverage; the ability of the company to generate operating earnings from sales and gross profits. I have measured this over time, by examining the change in Operating Income/EBIT vs. the change in sales and gross profits individually.

Flowserve Operating Leverage (Note: I have “winsorized” the data to calculate the final averages for my three measures of operating leverage, which is to say I have removed any large fluctuations/anomalies.)

Operating leverage demonstrates the susceptibility of earnings to rise/fall in response to changes in sales and gross profits. In the case of Flowserve, operating leverage actually seems easier to predict/establish than many other companies.

The company's underlying operating leverage appears to be in the region of 3.25x relative to sales, and 2.50x relative to gross profits. However, operating leverage does change on a non-linear basis as sales rise or fall, and if sales do not pick up sustainably, Flowserve could struggle at a much more unfortunate pace.

If Oil & Gas revenues are able to pick up over the next few years, there could be a bull case for FLS stock hiding somewhere here. Oil prices are now back up, well over $70/barrel. A sustained recovery could see Flowserve returning to the same level of sales it saw in, say, 2015.

However, a strong recovery is by no means guaranteed, and any recovery is likely to take (or continue taking) longer than desired. And it's not as if the competition is going to die down regardless.

Flowserve's net income is especially low recently due to a large income tax provision. Operating income is still positive, at over 5% of sales. However, if consolidated sales were to decline any further (probably less than 5% further), operating income could be wiped out. Operating leverage has escalated to around 4-5x now.

As fixed costs have risen consistently relative to sales (as sales have fallen), the company is now more or less at a breaking point. Will it now bounce back, or start hemorrhaging cash?

Finally, Flowserve Corporation pays dividends. The dividend yield is currently 1.79%, based on TTM dividends paid. Net income was technically negative; in the prior TTM period, the payout ratio was 84%. If the company's performance does not bounce back, don't count on a 'price floor' based on the dividend yield. In a further-downside scenario, dividends probably won't be around for long.

Flowserve Dividends Yet dividends have actually increased in nominal terms, as the table shows. This is in light of the falling net margin, a more precarious revenue/cost structure, and falling returns on equity (ROE) and assets (ROA), even before the recent negative net income.

Quality of Flowserve's Earnings and Cash Flow

As noted, Flowserve Corporation's net margin has fallen in recent years, and so has its net income (on a nominal basis). Similarly, while net income has generally fallen, operating cash flows have fallen.

In the most recent TTM period, operating cash flows were $186.41m (vs. negative net income of -$1.26m). Before the negative net income of the last twelve months, operating cash flows were running at around 1-2x net income, which is okay considering that the business is declining.

In the table below, you can see the long-term relationship between Flowserve Corporation's operating cash flow vs. net income (which includes net income to non-controlling interests) over the long term.

Flowserve OCF vs. NI

Obviously, the so-called income quality ratio has collapsed in the past twelve months, with net income in negative territory. However, in absolute terms we can see that cash flows are at least holding up, which is positive.

Free cash flow (NYSE:FCF) can be simplistically calculated as operating cash flow minus net business capital expenditures. Flowserve Corporation's five-year average FCF is $300.10m. Its FCF is generally weakening over time, but it is at least holding up fairly well.

Cash flow margins are still clearly falling, though, and it's going to be difficult for cash flows to continue holding up without a top-line recovery.

Flowserve The company's FCF margins have worsened over the past five years, both relative to sales (TTM: 3.58%), and relative to total assets (TTM: 2.78%).

Free cash flow is important for a company's business and its investors, for valuation purposes - not just for business purposes but also for investors/valuation purposes. EBITDA, another proxy for cash flow (which is before capex) is also a useful pricing metric for the company (see the valuation commentary later).

Additionally, it is useful to examine a company's cash conversion cycle in helping to assess the quality and sustainability of earnings and cash flow.

Flowserve's Cash Conversion Cycle

Over the past TTM period, the full cash conversion cycle (CCC) has fallen from 166 days (in the prior TTM period) to 141 days (calculated for March 2018 as: DSO of 79 + DIO of 114 - DPO of 52). Further, over the past five years (a longer time horizon), Flowserve Corporation's CCC has fallen which is generally a positive sign.

Flowserve The current TTM period has been the most efficient period over the past five TTM periods (in terms of the working capital cycle). Over the five-year period, days sales outstanding have generally increased, days inventory outstanding have trended downward, and days payables outstanding have generally fallen.

These trends do actually look healthy. If a company's cash conversion cycle is improving, reduced days inventory outstanding are generally higher-quality sources of cash flow than increased days payable (i.e. stretching suppliers). Next, we will take a quick look at inventories themselves.

Flowserve's Inventories

The balance and composition of a company's inventories provide us with an additional indicator for a company's future sales growth and health.

Generally, rising raw materials (and work-in-process, if applicable) as a percentage of total inventories is more preferable to rising finished goods. Stable (or falling) days inventory outstanding is also preferable.

As the table below shows, Flowserve's raw materials have generally increased relative to total inventories, while finished goods have also increased. However, finished goods are mostly stable.

Flowserve Inventories Note: due to other factors (namely Progress Billings and excess and obsolete reserve-related adjustments, the inventory figures above differ from actual, net inventories. However, they can still show us the generally positive trend.)

Flowserve's Financial Health and Risk

Piotroski's F-score is a test for financial health. A score of 9 is perfect; 0 is the worst possible score. Flowserve Corporation's F-score is 3, which is considered bad.

Firstly, its return on assets (ROA) is negative, which is not good (note: ROA fell year over year). The company's gross margin fell, which is not good (29.3% vs. 30.6%).

Operating cash flow was positive in the trailing twelve months. Additionally, operating cash flow exceeded net income in the trailing twelve months (a good sign).

Meanwhile, leverage (debts) increased in the recent period (generally a negative sign). The company's current ratio increased, which could be interpreted positively (currently: 2.3x). The company's shares increased (generally not a positive sign). And finally, the company's asset turnover ratio (sales vs. average total assets) fell in the recent period (a negative sign).

Flowserve Corporation's F-score has worsened slightly since the prior TTM period, in which the F-score for Flowserve Corporation was 4.

Further checks can be made to produce a reasonable estimation of the likelihood that a company is manipulating its earnings or financials (a probabilistic approach). Examples include examining the growth in non-operating and/or intangible assets, the growth in receivables relative to sales, changes in depreciation rates relative to property, plant & equipment (PPE), and more.

Fortunately, Flowserve Corporation does not seem to be using aggressive accounting techniques.

In terms of its debt load: as of recent, the company's debt-to-capital ratio is 48%, while the company's EBIT-to-net-interest-expense ratio was 3.2x in the trailing twelve months (this has worsened over the past five years). The company's moderate level of debt does currently appear to be manageable, although the company would ideally reduce its debt load. (See the table in the next section.)

Flowserve Corporation's Balance Sheet

The funding of Flowserve Corporation's assets is comprised of 64% of liabilities, and 36% of equity (total assets minus total liabilities). As noted, the company's debt/capital ratio is 48% (that is, financial debts vs. the sum of financial debts plus shareholders' equity).

The company is, therefore, using a considerable amount of leverage. As shown in the table below, the company's leverage has increased over recent years, while its interest coverage has weakened (3.2x in the most recent TTM period ended March 31, 2018).

Flowserve

As the table shows, debt-to-EBITDA is around 4x, though this has quite clearly been on an upward trajectory over the years. Still, the company is technically still mostly equity-funded.

Goodwill and intangible assets represent 30.2% of Flowserve Corporation's balance sheet. This is not too high, which is preferable.

Long-term Financial Trends

The table below provides an overview of Flowserve Corporation's long-term financial performance.

Flowserve Flowserve's Recent Financial Performance

For good measure, the table below shows Flowserve Corporation's recent performance over the past eight quarters.

Flowserve

The recent growth in 2018 Q1 is promising. It is still early days, but it is good to see positive revenue growth (mostly from growth in North America and Asia-Pacific), after a string of bad quarters.

However, free cash flow also collapsed in this quarter, mostly due to a large loss of operating cash flow. We'll soon see how revenues and cash flows average out over 2018.

Flowserve's EV/EBITDA Multiple

Using the EV/EBITDA valuation measure, the company's EV/EBITDA ratio, as of Jun 12, 2018, is 15.0x. This would suggest the company either has limited upside, or is likely to grow in value at an above-average rate. See the table below for further multiples and value ratios.

FLS Value Ratios It's interesting how stubborn investors have been with FLS stock; the company's EV/EBITDA multiple of around 15x (currently) is right around (or even above) the average EV/EBITDA multiple for FLS stock over 2014-2017 (around 14x). Also, the EV/FCF multiple is now well over 40x; in prior years it was closer to 20-30x.

If a solid, sustained recovery doesn't come around the corner, I'm not sure where the upside will come from. If the price-to-free-cash-flow settled back down to its long-term average of closer to 20x, the company's free cash flow would need to double just to maintain its current value.

Next, I will outline some basic assumptions for a valuation based on possible future growth and margins (a DCF model), in light of these multiples.

Basic DCF Valuation for FLS Stock

I will now make some DCF assumptions for growth and margins. My assumption for Flowserve Corporation's compound annual growth rate for the next five years is 2% in a base case, growing at the same rate of 2% for steady-state growth (to perpetuity, beyond 10 years).

My second assumption is that the company's EBIT margin gradually moves from its current EBIT margin of 5.11% to 10.00% over the next 10 years. I am also giving the company a base discount rate of 8.00%, and I am using the same rate for the terminal value in year 10.

All said, this provides us with an enterprise value of $3,428.78m. After adjusting for cash, debt, outstanding options, etc., we find an equity value of $2,371.76m (or $18.13 per share), which represents -57.29% downside from the current share price.

Note: this basically assumes a return to an on-average, steady-state-like recovery. No fast recovery or bounce-back; just a long-term growth rate of 2% on the top line (from a cumulative 25% loss of revenues since 2014). It also assumes a doubling of the company's EBIT margin, which would be a return to a similar EBIT margin the company had in 2016 (11% on the comparable TTM period, vs. 5.1% more recently).

However, perhaps those assumptions do not give Flowserve enough credit. Alternatively, in an upside case, we could make some more optimistic DCF assumptions for growth and margins: a compound annual growth rate for the next five years of 5.00% (i.e. a sustained recovery over five years), before gradually scaling back down to a long-term growth rate of 2.00% for steady-state growth (to perpetuity).

Additionally, we could assume that the company's EBIT margin gradually rises from its current EBIT margin of 5.11% to 15.00% over the next 10 years, which is the kind of EBIT margin it saw in 2014. (A base discount rate of 8.00% would be used, and the same rate for the terminal value in year 10.)

This upside case would provide us with an enterprise value of $5,999.97m. After adjusting for cash, debt, outstanding options, etc., we would find an equity value of $4,942.95m (or $37.78 per share), which indicates -10.98% downside from the current share price.

Basically, by buying FLS stock, you're implicitly counting on a solid recovery over the next few years, with a tripling of the company's EBIT margin, roughly speaking. This is by no means impossible. But perhaps investors are being too optimistic. I think the company is currently either fairly valued, or overvalued.

Moving Averages (MAs) for FLS Stock

Finally, from a simple, technical perspective, stocks whose 20/200 MAs and 50/200 MAs are both above 1.00x, and whose 20/200 MAs exceed their 50/200 MAs, are thought to be in upward trends. If a stock's 20/200 and 50/200 MAs are both negative, and the more recent 20/200 MA is below the 50/200 MA, a stock is thought to be in a downward trend.

In respect of Flowserve Corporation, its 20-day moving average vs. its 200-day moving average is 0.99, while the stock's 50-day moving average vs. its 200-day moving average is 1.03.

Flowserve Currently, FLS stock appears to be in no particular trend. Overall, however, FLS stock could be a potential short (one simply one to avoid) worth investigating further. (Note: according to Morningstar, short interest is currently 12.81%.)

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.