Flowserve Corp Q2 FY2022 Earnings Call

Good day, and welcome to the Q2 2022 Flowserve Corporation Earnings Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Jay Roueche, Vice President of Investor Relations and Treasurer. Please go ahead.

Thank you, Tina, and good morning, everyone. We appreciate you participating in our conference call today to disclose our second quarter 2022 financial results. On the call with me this morning are Scott Rowe, Flowserve's President and Chief Executive Officer; and Amy Schwetz, Senior Vice President and Chief Financial Officer. After our prepared comments, we will open the call for questions. As a reminder, this event is being webcast and an audio replay will be available. Please note that our earnings materials discussed in this call include non-GAAP measures and contain forward-looking statements. These statements are based upon forecasts, expectations and other information available to management as of July 28, 2022, and they involve risks and uncertainties, many of which are beyond the company's control. We encourage you to fully review our safe harbor disclosures as well as the reconciliation of our non-GAAP measures to our reported results, both of which are included in our press release and earnings presentation and are accessible on our website at flowserve.com in the Investors Relations section. I would now like to turn the call over to Scott Rowe, Flowserve's President and Chief Executive Officer, for his prepared remarks.

Great. Thank you, Jay, and good morning, everyone. Thank you for joining our second quarter earnings call. We are pleased with our second quarter performance, which modestly exceeded the outlook we provided on our last call. The $0.30 of adjusted EPS that we delivered in the second quarter keeps us on pace to deliver within our full year adjusted EPS guidance range. Q2 benefited from top-line growth in the quarter as our incremental adjusted operating margin was nearly 60% on a sequential revenue increase of 7%. Our end markets remain supportive, and we delivered strong bookings of $1.04 billion, primarily driven by aftermarket and MRO activity that is now above pre-pandemic levels. The overall operating environment was challenged in the second quarter, but signs of stabilization appeared late in the quarter, giving us renewed confidence in our second-half outlook. During the quarter, bottlenecks remained for certain procured items such as electronics, soft goods and motors. Supplier lead times were still extended but have begun to stabilize, providing us more certainty to incorporate their delivery dates into our production schedules and our customer commitments. China lockdowns continued to be a headwind for most of the second quarter, with lockdown easing and logistics improving late in the quarter, allowing our facilities and suppliers to start the process of restoring their production. Additionally, our global suppliers continue to be impacted by labor availability issues and an inflationary environment across many commodities and raw materials. While we are seeing evidence that pricing for some items may have peaked and could be starting to moderate, particularly as it relates to logistics, the two price increases that we have implemented so far in 2022 will support us in maintaining price-cost neutrality for the year. The first increase began to show benefits this quarter and our most recent increase will deliver incremental benefits in the second half of the year. I was fortunate to visit many global manufacturing locations during the second quarter and saw the impact of these challenges firsthand. To say the least, it is an incredibly difficult environment to operate in, and I want to thank our dedicated and devoted teams for their passion and commitment to serve our customers and drive success for Flowserve. With this operational backdrop, the results we delivered reflect the resolve and dedication of our associates around the world. Our teams adapted and found ways around the challenging environment by placing a high level of focus on mitigating the disruptions and minimizing the costs that we had incurred in recent quarters. We worked hard to qualify new suppliers where needed and aggressively repositioned and expanded our supplier base. Where appropriate, we spent cash to build inventory with forward purchases and expedited critical components and materials. These efforts helped ease the extended lead-time environment and increased our ability to more accurately predict delivery times. We'll continue these operational actions as we build resiliency in our supply chain, strengthen our planning capabilities and staff our operations for the growing demand environment. The organization is focused on converting our strong backlog into revenue growth and margin expansion. The second quarter continued a trend of solid bookings and I couldn't be more encouraged by the strength and demand for our products and services that we saw in the quarter. In this quarter, our $1.04 billion of bookings represented growth of 10% year-over-year despite the strengthening dollar. The growth was primarily driven by our aftermarket and run-rate businesses with several large projects in our funnel into the second half of the year. The high utilization rates at our customers' facilities and the impact of deferrals that took place in 2020 and 2021 drove aftermarket bookings of $526 million, which delivered constant-currency year-over-year growth of 4.5%. From an original equipment perspective, bookings increased 21% from the prior year to $518 million. While we did not repeat the amount of large work that was in the first quarter, primarily due to timing, we did receive roughly 15 orders in the $5 million to $20 million range across all of our major end markets. Additionally, our MRO-related original equipment bookings remained strong. While we saw several projects progress to funding in the second quarter, a few of the orders that we had expected to book in the quarter shifted into Q3. In some cases, already booked projects had later milestone timings than originally anticipated. Our project funnel for large project work over the next 12 months continued to grow in the second quarter with good visibility into opportunities across LNG, nuclear, oil and gas, water and several desalination projects. Finally, development markets and our committed partners in our distribution channel provided strong booking tailwinds which should continue during the remainder of the year. With both solid OE and aftermarket bookings in the quarter, our backlog topped $2.3 billion, reaching the highest level since 2017. Several work packages are under contract and, with our expectations of a supportive demand environment, we are well positioned to deliver strong growth and margin improvement as we move forward. As I've mentioned in prior calls, I am increasingly confident that we are at the beginning of a multiyear growth cycle driven by a number of factors, including aging existing infrastructure pressured by utilization, which will require ongoing investment to maintain capacity, increase efficiency and reduce emissions. Energy security and energy independence is a rapidly growing theme driven by the war in Ukraine, and it will require significant investment across our traditional markets, including increased LNG capacity and renewed interest in nuclear power. Continued growth in consumer demand will also drive investment in our chemical, water and general industry markets. The global focus to decarbonize and meet CO2 reduction commitments will further support investment opportunities. I would also like to highlight that our Diversify, Decarbonize and Digitize strategy contributed to bookings in the second quarter. In particular, we saw strength in areas where we utilized our flow-control expertise to support customers' decarbonization efforts. Our energy-transition funnel has increased since the beginning of the year. Looking now at our performance by end market and on a constant-currency basis given the strengthening dollar: Chemicals represented the strongest market year-over-year with bookings up over 20%, including two small project awards totaling $12 million. The oil and gas industry bookings were up over 20%, driven by project work in the $5 million to $20 million range. Water bookings were up 37% with two projects totaling more than $10 million, including a desalination project in the Middle East. Finally, our power bookings were up roughly 3% on a relative basis compared to the prior year that included a large nuclear award. From a regional perspective, our second quarter bookings growth was driven primarily from North America and Asia Pacific, which were up 19% and 27%, respectively. Europe delivered 9% growth and the Middle East and Africa were essentially flat. Finally, Latin America bookings were down roughly 10%. Let me now turn the call over to Amy to address our financial results in more detail.

Thanks, Scott, and good morning, everyone. We are pleased with our second quarter financial results, which exceeded our prior expectations as well as the sequential progress we made. While the current operating environment continues to pose many of the challenges we faced in recent quarters, including supply chain issues, logistics and other frictional costs, we are encouraged by the modest improvements in these industrial bottlenecks that we began to see late in the second quarter. Considering these recent positive trends, we continue to anticipate additional stair-step progress in the quarters ahead. That said, I'd like to reiterate Scott's commentary that the major catalyst for the sequential growth we delivered in the second quarter was the hard work and unwavering dedication displayed by our associates. Their initiative and efforts to mitigate the challenges in the current landscape were integral to our performance. In the second quarter, we reported reported EPS of $0.34, which exceeded our adjusted earnings per share due to $10 million of below-the-line foreign currency gains. Adjusted EPS of $0.30 excludes the FX gain as well as a $3 million non-cash impairment and modest realignment charges of about $0.5 million. Both our reported and adjusted EPS results demonstrate the impact of what top-line leverage can deliver to Flowserve's results. Further, our quarter-end backlog is up to $2.3 billion, an increase of 15.6% since year-end, driven by a year-to-date book-to-bill ratio of 1.25x. This solid foundation and our outlook for constructive end markets support our expectation that revenues will continue to increase in the coming quarters. As Scott highlighted, we are equally encouraged that demand for our comprehensive portfolio of flow-control products looks to remain strong across all of our core end markets and within our 3D strategy. Specifically within that 3D strategy, we drove solid bookings in targeted markets, including decarbonization, specialty chemicals, energy transition and water during the second quarter. The combination of tailwinds from our traditional end markets and accelerated growth from the 3D strategy drove a bookings increase of nearly 15% on a constant-currency basis year-over-year. This bookings growth was primarily driven by improvement in our original equipment orders which were up 21% or 27% on a constant-currency basis, with both FPD and FCD in that range, as small projects move forward and distributors began to restock. In particular, we saw solid contribution from FCD's distributors where the channel represents roughly 40% of the segment's business. Aftermarket bookings were over $500 million for the third consecutive quarter. Despite the strong dollar, we continue to remain at or above pre-COVID levels as operators look to catch up on previously deferred maintenance, and our sales engineers continue to add value for our customers. Flowserve's second quarter revenue declined 1.8% year-over-year, but increased 2.8% on a constant-currency basis. The constant-currency growth was driven by aftermarket in both segments, reflecting the strong MRO and aftermarket environment of the last several quarters and stabilization in our operations. On a sequential basis, sales improved 7.4% with contributions from both aftermarket and original equipment. As I mentioned, deliveries of original equipment have continued to be impacted by supply chain and logistics headwinds as well as labor disruptions. And while each product category within our supply chain will stabilize and improve on a different timeline, we began to see modest improvements in many of these areas at the end of the quarter and are expecting the positive trends will continue. Regionally, North America's constant-currency revenue growth of over 13% included 23% and 10% growth in FCD and FPD, respectively. Middle East and Africa contributed 20% growth driven by FPD's strong 32% increase. However, growth in these regions was partially offset by low double-digit sales declines in Asia Pacific and Latin America as well as a 2% revenue decrease in Europe. Looking now to margins: Second quarter adjusted gross margin decreased 300 basis points year-over-year to 28.4%, resulting in a 170 basis point improvement sequentially. The year-over-year decline was primarily driven by material and logistics inflation, ongoing temporary frictional costs, actions to drive supply chain management improvement and increased under-absorption, which were partially offset by a 100 basis point shift to aftermarket and the impact of our pricing increase. While we continue to expect to see modest progress in the overall industrial landscape on these issues during the second half of the year, we are not banking on a significant improvement in these underlying global challenges. Similar to the second quarter, our associates will work hard to minimize the macro challenges to deliver to our customers. These efforts, improvements that we expect in the supply chain and associated costs, the impact of the second price increase of 2022 taking hold and the expected positive benefit that higher original equipment sales volume will have on absorption will contribute to higher gross margin for Flowserve going forward. On a reported basis, second quarter gross margins decreased 270 basis points to 28.3% due to the headwinds discussed earlier, partially offset by a $3 million decrease in realignment charges. Second quarter adjusted SG&A decreased $18 million to $192 million, marking our fourth consecutive quarter at or below $200 million, as a result of our disciplined cost management and a modest FX benefit. As a percentage of sales, adjusted SG&A decreased 160 basis points to 21.7%. The adjusted SG&A was roughly flat despite the 7% revenue increase over the first quarter, demonstrating the leverage we expect to deliver as we continue to grow in the second half of this year. On a reported basis, second quarter SG&A decreased $60 million year-over-year, including the impact of an asset write-down of $3 million partially offset by the reduction in realignment charges of roughly $2 million. Second quarter adjusted operating margin decreased 130 basis points year-over-year to 7.2%, with FPD down 200 basis points and FCD down 80 basis points, driven primarily by the decline in adjusted gross profit, partially offset by our SG&A management. On a sequential basis, adjusted operating margin improved roughly 390 basis points, producing a sequential incremental margin of 60%. Second quarter reported operating margin decreased 120 basis points year-over-year to 6.8% driven by the previously discussed challenges. Our second quarter adjusted tax rate of 20.3% was in line with our full year guidance of 20% to 22%. Turning to cash flows: Second quarter operating cash was a use of $45 million, primarily due to a build in working capital on continued backlog including investment in inventory buffers as well as the timing of certain accrued liabilities. We have used roughly $95 million in the first half of the year for inventory, including net contract assets and liabilities, to support the $313 million increase in backlog year-to-date. The combination of strong bookings growth and improved project environment and the frictional issues delaying shipments has pressured our working capital as we look to capitalize on this environment. As you would expect, the growing backlog and shipment delays have also impacted working capital as a percent of sales, which in the second quarter picked up 50 basis points to 29.9%. Despite this, I am pleased that for the seventh consecutive quarter, we have lowered total inventory, including net contract assets and liabilities, as a percentage of backlog, which now stands at 32%, our lowest level in three years. Lastly, other material uses of cash in the quarter included dividends of $26 million, capital expenditures of $70 million and term loan amortization of approximately $8 million. As most of you know, Flowserve traditionally uses cash in the first half of the year, but then delivers strong cash generation in the second half. We expect these seasonal dynamics to again play out in 2022. Turning now to our outlook for the remainder of the year: Based on our second quarter performance, we affirmed our target range for the full year. However, if the U.S. dollar remains at its current strong level, we believe our financial results will likely be at the low end of the range for both our revenue and adjusted EBITDA. Even with this expectation, substantial year-over-year sequential growth for both revenue and adjusted EPS for the second half of the year are still implied. In terms of phasing, we expect the third quarter to be a modest improvement over the second quarter and then to finish the year strong in Q4, positioning us to enter the new year with increased momentum. Our view is based on expectations for incremental stabilization and modest ongoing improvement in the supply and logistics challenges we have faced for a year now as well as better cost absorption coming from longer lead-time original equipment currently underway at our sites. We are not forecasting a significant backlog conversion rate change, but we do expect a combination of our strong and growing backlog, our ongoing operational progress and the continued efforts by our associates in planning and supply chain management as well as the impact of our May price increase to support the sequential financial improvement for the remainder of the year, including an expected fourth quarter adjusted operating margin in the 12% to 14% range. The full year adjusted EPS target excludes our $20 million charge to exit Russia, the modest expected realignment expense of approximately $10 million, the second quarter asset write-down of $3 million as well as potential future items that may occur during the year, such as below-the-line foreign currency effects and the impact of other discrete items such as acquisitions, divestitures, special initiatives, tax law changes, et cetera. Including the adjustments incurred in the first half of the year and the expected second half realignment spending, we now expect our reported EPS to be in the $1.25 range. Both the reported and adjusted EPS ranges also assume current foreign currency rates, reasonably stable commodity prices, the continuation of current market conditions, no significant improvement in the Russia-Ukraine conflict and expectations for our customers to continue to release larger project work in the second half of the year. We also continue to expect net interest expense in the range of $45 million to $50 million and an adjusted tax rate between 20% and 22%. Turning to our full year expectations for the major planned cash usages, we continue to expect to return over $100 million to shareholders through dividends in fiscal 2022. We also intend to invest further in our business with capital expenditures in the $60 million to $70 million range, including the continued build-out of wide IT systems to further support our operational and productivity improvements. Additionally, we'll continue to invest in our 3D strategy to Diversify, Decarbonize and Digitize where we delivered solid Q2 bookings progress related to energy transition and other targeted markets. Let me now return the call to Scott.

Thanks, Amy. As I mentioned earlier, we are encouraged by the strength of our traditional markets as well as the opportunity to further accelerate our growth as we execute our Diversify, Decarbonize and Digitize strategy. Our 3D strategy aligns directly with Flowserve's long-standing purpose to provide extraordinary flow-control solutions to make the world better for everyone. The success we have had targeting opportunities in Diversify, Decarbonize and Digitize in the first half of 2022 demonstrates that this is the right strategy for the current environment and for years to come. During my travels to the Middle East, Europe and the Americas, my discussions with customers have validated our expectations of increased investment in these areas and our view that capitalizing on their increasing investment will deliver a more robust growth profile than just our traditional markets. One thing that became very clear from these discussions is that decarbonization is a consistent priority across the globe and is now appearing in all of our end markets. Currently, our energy-transition funnel for the next 12 months stands at $675 million versus $415 million at the beginning of the year. This growth supports our conviction that Flowserve's products and services are well positioned to serve this growing market. Let me now discuss our strategy for each of the 3Ds and provide some recent wins in these areas. Beginning with Diversify, we are aggressively targeting and expanding our offering in previously underserved regions and markets that exhibit attractive long-term growth prospects, like water, chemicals and other general industries where we have strong capabilities. In the second quarter, we were pleased to be awarded a project providing pumps to a specialty chemical manufacturer in Asia for the world's first integrated polylactic acid facility. Flowserve is helping to meet the increasing demand from diverse markets, including 3D printing, hedging products, flexible packaging and food service ware. Decarbonize is expected to provide opportunities globally, and Flowserve is uniquely positioned to enable the full control aspects of decarbonization, CO2 emissions reductions and flow-loop energy optimization. Additionally, we are very focused on providing flow-control technology for energy sources. For example, Flowserve was recently awarded a contract to supply over 2,000 control and ball valves for what will become the largest commercial green hydrogen plant in the world based in the Middle East. Upon expected completion in 2026, it will produce over 650 tons of hydrogen daily and 1.2 million tons of green ammonia, which will eliminate the equivalent of 3 million tons of CO2 emissions per year. Finally, the Digitize effort focuses on growth opportunities driven by our RedRaven IoT platform and the value it creates for our customers. Since RedRaven was launched in early 2021, we have gained increasing traction with new and existing customers and are currently operating in 49 customer sites across our core end markets and have instrumented roughly 1,500 pumps, valves and seals with RedRaven. As an example of recent success, a leading electric power generating company in East Africa was experiencing an issue with one of its pumps. Working closely with the customer to resolve the issue, we presented RedRaven as an opportunity to improve operability and we implemented the IoT solution with RedRaven's real-time digital monitoring capabilities. We've empowered this customer to take an active approach to diagnose and prevent equipment failure. Going forward, our plan is to continue to focus on instrumenting our existing installed base as well as new equipment, significantly growing this recurring revenue stream and providing additional pull-through aftermarket opportunities. While we are enthusiastic about the opportunities available from our Diversify, Decarbonize and Digitize strategy, Flowserve's responsibility to ESG is truly embedded in all aspects of our business. On June 30, we released our 2021 environmental, social and governance report, outlining our ongoing commitment to create extraordinary flow-control solutions that make the world better for everyone. We believe this focus will not only enhance our own ESG efforts but will allow Flowserve to play a critical role in supporting our customers build a better tomorrow. I encourage everyone to review the entire report available on our website, but I am particularly pleased to highlight our strong safety performance, our continued progress to achieve our 2030 carbon emissions reduction goals and the commitments we've made to the communities we serve through Flowserve Cares, where we supported over 150 charitable organizations last year. Our ESG progress was recognized last year by third-party publications and Newsweek Magazine ranked Flowserve as one of America's most responsible companies for the third consecutive year. We are proud of our achievements and the third-party recognition, but we are really only at the beginning of our ESG journey. Flowserve will continue to prioritize ESG and make additional progress in the years to come. In closing, I am confident that Flowserve is making progress. I remain impressed by our associates' passion, commitment and expertise. With the solid progress we made in the second quarter, I'm convinced that we're doing the right things to work through the challenging environment and position us for growth ahead. As we look to the remainder of the year, I am very encouraged by the health of our end markets and our ability to capitalize on these opportunities through consistent execution and customer focus. We expect further conversion of our strong $2.3 billion backlog, improving our operational execution and advancing our growth strategy to position Flowserve to exit 2022 with significant momentum. Together, we believe this focus will enable Flowserve to deliver solid long-term value for our associates, our customers and our shareholders. Operator, this concludes our prepared remarks, and we'd now like to open the call to questions.

And we'll take our first question from Joe Giordano with Cowen.

Can you maybe kind of scale some of the opportunity in Europe, like with nuclear and gas being considered green now and the size of LNG? Like if you were to take all of that, what is that now for you guys? And what can that potentially be over a retooling of the European power situation?

Sure. Obviously, the situation in Europe is significant as they get less and less natural gas from Russia. And so what we're seeing is renewed interest in both nuclear, LNG, natural gas and then other forms of energy. These are all traditional markets we've serviced for decades. We've got an incredibly strong team in Europe. We have great capabilities and great products for those markets. So we're really encouraged about what's happening there and our ability to help Europe secure energy for the future. And just as a reference, year-to-date in nuclear, we booked about $140 million. That's substantially more than we've seen over the last couple of years, and that funnel continues to build. We are positioned very nicely for nuclear. There will be significant spending there, and we're already seeing a lot of that, both on some of the expansion side, but also on extending the life of those assets. So we believe this is an area of growth for us as we go forward. In the coming quarters, we'll continue to improve our execution in terms of success there.

And I noticed in one of the slides when you were just going through the financials of FPD and FCD, the gross margin was the same and SG&A was significantly less at FCD. So what's the natural gap there? And how should we think about that going forward?

So generally, if we think about SG&A between the two segments, FCD normally would have a little bit of a lower run rate from an SG&A perspective. In part because of how we allocate R&D costs between the platforms, but I think that's a shift that you would expect to see continue going forward.

So the gap that we saw this quarter was that magnitude of gap pretty normal for what you'd expect?

I wouldn't say it was out of the ordinary in terms of what we saw this quarter or what we would expect going forward.

Okay. Great. And then just lastly, if you can maybe just comment on your working capital outlook for the rest of the year. I know you'll deliver more cash in the second half like you always do, but just your view on some of the key working capital accounts.

Sure. So I would start with inventory. As we think about pushing working capital performance in 2022, we are not focused on driving down the inventory below where we're at today. We recognize that there are some investments that we need to make with respect to inventory coming into our plants in order to stabilize the supply chain. In addition to that, as these large bookings come in we will see growth in our assets moving forward. So where we need to continue to push from a working capital perspective is with respect to collections and obviously our own payables, and we'll continue to do that. Receivables is an area where we put quite a bit of focus as a company through the transition projects, and we'll continue to work to drive collections improvements. Frankly, the mix that we see with strong MRO sales should help us do that. And from an AP and vendor perspective, we'll continue to work with our vendors to push on working capital. But overall, we're at 29.9% this quarter. Scott and I continue to have a goal of driving primary working capital as a percentage of sales down to the mid-20s. I would anticipate that this year, any improvement that we see over where we're at in the second quarter of this year will be relatively modest.

We'll take our next question from Nathan Jones with Stifel.

Maybe just following up on the working capital question there. Typically, you're going to consume a little bit more working capital when the business is in growth mode, which clearly with the order rates growing and backlog growing, it's going to be. Does that target get a little bit more difficult to achieve in 2023 or 2024 as a result of potentially needing to support the growth in the business with working capital?

So I think two things will occur over time. Certainly, as the business grows, we see pressure from a receivables perspective and an inventory perspective, and that would include, obviously, our contract assets and liabilities. What I will say that is going to be a tailwind going forward as we work through the supply chain and fixed challenges: many of which are causing us to carry inventory at levels above where we would traditionally be at. As we think about 2023 and 2024, frankly, that will continue to moderate and we'll be able to carry inventories at safety stock levels that are more normal for the industry. So although it's a challenge today, I think as we move forward 12 and 24 months, it actually becomes an opportunity for us.

Great. And I wanted to ask a follow-up on the decarbonization project funnel. I think it was $675 million versus low $400 million at the beginning of the year. Can you give us some more color around that project funnel, how quickly do these projects age, how quickly do they get awarded, what kind of win rate do you have on the funnel that you're tracking? Just some more details you can give us around that?

Sure. Yes. The decarbonization side is something we're really excited about. And what we're seeing—as I said in the prepared remarks—is that across all of the end markets, everyone is doing something to reduce their CO2 emissions. We're seeing that either with energy reduction, the amount of energy needed to run their assets, electrification of assets, carbon capture and sequestration, and lots of opportunities around biodiesel or bio-conversions. We're also seeing activity in green energy, whether that's concentrated solar power or hydrogen. What we're seeing is that this is happening in our traditional markets and it's also happening with the new energy sources. This area is growing faster than any of our other markets, and I would say that continues to grow as we move forward throughout the next couple of years. We are well positioned for that. Our offering—both in pumps, valves and seals—works for a lot of different applications, and we're continuing to invest in new product development and R&D to make sure that we're well positioned for success as these markets continue to expand.

Are your win rates on those kinds of projects different from your traditional projects that you track?

I think they're slightly higher than our traditional win rates. A lot of these projects we work directly with the end users. Some of them are through EPCs. But when we can work directly with an end user, demonstrate our ability to help them in front-end design and engineered solutions, then we've got a much better chance of success. I wouldn't say we're double the win rate of our normal markets, but we're certainly doing better than in our traditional markets.

We'll take our next question from Damian Karas.

So should we go ahead and model the 60% incremental margin in perpetuity? Does that seem reasonable?

I wouldn't recommend that, but we do expect to continue to see incremental improvements in our margins as we progress.

Yes. So maybe you could just talk a little bit more about the backlog conversion and how that's trending. I think last quarter you maybe threw around a 46% number. What are you assuming for the rest of the year? And I guess, thinking about the 12% to 14% margin where you plan to exit, does that basically assume you're kind of back to normal on that conversion ratio?

No. As we look at conversion rates, we saw some modest improvements in our valve portfolio in terms of conversion rates moving from the first quarter to the second quarter. But really, the improvement that we saw between Q1 and Q2 was some reduction in those frictional costs and improved marginality in the products that we shipped during the quarter. So as we move forward in the year, we're not anticipating a resumption of that roughly 46% average conversion rate of backlog moving forward; the fundamentals in the supply chain and our markets are just not there for the remainder of the year. But as we think about that fourth-quarter exit rate, one thing to note is that the fourth quarter is traditionally Flowserve's biggest quarter of the year from a revenue conversion, operating income and cash flow generation standpoint. The operational bottlenecks that we've seen year-to-date really exacerbated that trend. So the fourth quarter is going to be big. In fact, we would think that the fourth quarter could produce roughly half of our full-year adjusted EPS, and that's in part because of a pretty weak Q1. As we think about the third quarter, realistically, the second quarter and the third quarter oftentimes look pretty similar for Flowserve. While this year, we would expect incremental revenue and earnings improvement based on the size of the backlog itself and not necessarily conversion rates. Our ability to fully capitalize on that backlog is somewhat limited by summer holidays in the Northern Hemisphere. By contrast, in Q4 not only do we have the backlog in place, but our capabilities to manage them are improving. The pricing increases will be fully embedded and our SG&A, which we've done a nice job controlling, will be fully leveraged in the quarter.

Got it. That's quite helpful. And then Scott, you spoke pretty favorably earlier about the LNG and some of the demand you're seeing there. I'm just curious how competitive you're finding these LNG opportunities? How are you thinking about the profitability there as you bid on these projects? Any additional color on the types of wins you are seeing?

Sure. We are doing well in the LNG space. We did approximately $30 million in the quarter on LNG awards, which is half of the $46 million we did in Q1. We believe, both on the pump side and the valve side and our mechanical seals, we've got a great offering for LNG. LNG is somewhat favorable to our overall mix because fewer suppliers can play in the cryogenic side and require the specialized technology that we have. So we like this market a lot and we see significantly strong growth over the next 12 months. In fact, our opportunity funnel for LNG for the year is over $400 million in the next 12 months.

We'll go to our next question from Andy Kaplowitz with Citigroup.

Scott, orders have been relatively consistent over the last couple of quarters, both in aftermarket and OE. But you did mention some projects are moving to Q3 from Q2. Do you still see a potential positive impact from large projects coming over the next couple of quarters? And I know you've talked about some risk to the strength and duration of the cycle from inflation and/or potential recession. So what are your customers saying to you at this point in the middle of the year?

Sure. The large projects are always interesting because it's very difficult to predict timing on a quarterly basis. Over the last two years, 2020 and 2021, many projects were put on hold, and we're just now seeing a lot of those start to move and get funded. While slightly lower in Q2 compared to Q1, we still have significant visibility to large projects. In fact, our project funnel is up 13% since the beginning of the year, and we continue to be very optimistic in our ability to get projects in the second half of the year. As we talked about in the first quarter, we had four large awards that were over $20 million. In Q2, we had no awards over $20 million, but we had 15 awards from $5 million to $20 million. We saw a couple that we expected to book in Q2 slide into Q3, and some of those have already booked in July. So for the back half of the year, we have a lot of visibility and are well positioned for success in winning these large projects. Looking forward, while macro issues such as recession and inflation are considerations, our customers are focused on securing energy and advancing projects. In my customer conversations in the second quarter, I did not hear people talking about moving projects out or delaying them; they were confident in continued funding and execution of these large projects.

Very helpful, Scott. And then maybe could you give us a little more color into what you're seeing on price versus costs? I know you mentioned the two big price increases this year, but are you seeing any improvement as you bid on these larger projects yet? Or is there still slack in the system where you need to wait to see more significant improvement?

Yes. We talked about this in the first quarter and it really hasn't been a dramatic change. Larger projects attract more competition and absorption rates aren't where they need to be consistently across peers, so pricing is still challenged on the largest projects. I feel good about our margin in backlog continuing to move up. We feel the first price increase at the beginning of the year is making its way through the system and the May price increase will start to show up in the back half of the year. The price increases are more effective on our assemble-to-order or configure-to-order work; engineered-to-order work tends to be on a cost-plus basis. Our team is incredibly focused: as our bookings have improved and we've got better visibility to capacity filling up at sites, expectations of margin in backlog are moving up. We're not in a perfect environment on pricing yet, but we are starting to see improvements. From a price-cost standpoint, we feel we're at least neutral or moving ahead as we exit the year. Areas we still need to work on include improving absorption and reducing frictional costs, as Amy discussed, and as we fill up and minimize those frictional costs, we'll see margins progress through the year.

We'll take our next question from Deane Dray with RBC Capital Markets.

Can we circle back on China? It sounded like that was an area of concern last quarter and the de-bottlenecking that you would hope would happen seems to be going through. Just some additional color: is it back to normal? How soon does it come back to normal? Any other repercussions?

Sure. We have a presence in China with both our pumps and valves facilities in Suzhou, and our supply chain is significantly leveraged there as well. As China locked down, it had a significant effect on Flowserve. What we saw in the second quarter was an easing of lockdowns really at the very end of the quarter, which was a positive development. As we move forward, we expect stability to continue and progress to more normal operations. Right now, we're not operating at 100% but more in the 70% to 90% range depending on the week and local situations. Generally, the supply chain there is not fully back to 100% normal, but it's substantially better than what we saw in early Q2. I anticipate that Q3 and Q4 will be reasonably stable, but it's hard to predict and I don't want to overstate the certainty around China at this time.

Understood. And then follow-up: if you step back and categorize your total orders this quarter within the context of 3D, what percent of the orders would fall within Diversify, Decarbonize and Digitize?

Just as a reminder, the 3D bookings are Diversify, Decarbonize and Digitize and represent additional opportunities. To answer directly, roughly one-quarter to one-third of our total bookings would fall in those categories. We had about $275 million of bookings in the second quarter alone that fit in the 3D categories. As we track projects, about two-thirds of the overall project funnel were in that category. Our organization is very much leaning into this strategy; our incentive plans are aligned to grow these areas, and customer feedback has been very positive, validating that we are on the right path. This doesn't mean we're walking away from traditional capital markets—gas, power, etc.—but it gives us additional growth acceleration.

Good. And related to Diversify: when you go into an underpenetrated sector like water and chemicals, do you need to compete more on price to build out presence and market share? Might that be lower margin initially, or does it not play out that way?

It depends by product and market. For example, we had a product that historically did well in water but we had de-emphasized it. We sent that product through our design-to-value center and were able to take out roughly 20% to 30% of the cost, reconfigure and simplify the offering, reduce part numbers, improve manufacturability and significantly lower cost. In that example, our margins actually increased and our competitive position improved. There are times when we may make pricing compromises to gain initial entry and build a track record, but overall I would not expect margin deterioration from our Diversify strategy. We focus on improving design and cost to compete effectively without sacrificing long-term margin.

We'll take our next question from John Walsh with Crédit Suisse.

Wanted to circle back to the Q4 exit rate, the 12% to 14%. I was just wondering if we could talk about the buckets that drive that and maybe put any numbers around it, meaning it sounds like you've got visibility with margin in the backlog, OE-aftermarket mix, what that's doing in Q4. Any of those big buckets to give people more confidence that that's actually the right exit rate?

I'll start by saying a large component of that exit rate is driven by volume. As we think about drivers, volume gives us more leverage over our fixed costs at a site level. From an SG&A perspective, we're not anticipating major increases. The absorption improvement comes in two ways: first, because our OE is filling up and we now have work — particularly in our large engineer-to-order shops — and second, because we get more certainty around the supply chain. When we have certainty, we can get the materials we need on the shop floor to progress work and absorb the hours from our workforce. So really, volume is a significant driver of the 12% to 14% improvement. Logistics has also been a big factor: in Q1 a lot was expedited across the board, but as we moved into Q2 we were able to better identify the materials that needed expediting and make more efficient transport decisions, such as switching some shipments to ocean freight where feasible or using contracted road routes, which reduces costs. We saw some improvement in logistics costs in Q2, particularly in the valve space, and would expect that to continue. Those logistics improvements are embedded in inventory, so they work quarter-over-quarter as inventory is drawn down. So again, the exit rate improvement is largely volume-driven, supported by absorption improvements and reductions in frictional logistics and supply chain costs.

Great. And then maybe just a follow-up around price/cost. You've done a lot of pricing initiatives over the last several years. If commodity input costs snap back, how do you think you'll be able to hold price? How much of this was surcharge versus actual price for the value you're delivering customers?

We used surcharges in some cases, primarily on fuel costs, but we also implemented broad price increases: a 5% at the beginning of the year and an 11% increase in May. We believe that for our direct product costs—materials and labor—we're in a relatively good place on price-cost. This year, the pressure came from under-absorption in our facilities, which is something we are focused on correcting. Amy described how absorption and logistics impact margins quarter-to-quarter and into Q3 and Q4. If things proceed as we expect, we feel we're in a reasonable position on price-cost that will translate to higher margins in the back of the year.

One thing to note with our price increases: throughout 2021 and the first price increase of 2022, those were somewhat catch-up increases to get us back to where we needed to be from a price-cost perspective. I think the May price increase was more anticipatory given what we expected for the year. So we believe we're now in a good place where we're matching what has happened with what we anticipate in our major spend categories.

We'll take our next question from Josh Pokrzywinski with Morgan Stanley.

So Scott, or Amy, what does fourth quarter try to tell us about the backlog or maybe the margin profile over the medium term? There hasn't been what you'd call a normal year in some time, but Q4 margins tend to be sort of 2 to 2.5 points above maybe what the following year averages. Is that a fair starting point? Given all the tailwinds from new markets, particularly decarbonization, how is Q4 pointing to future margins?

It's a really good question. Let me start and then I'll hand it to Amy. The environment is challenging and volatile, as you can see in our results and across other manufacturers. What I would say is we're seeing signs of stability externally and progress internally. If that stability continues, I'm confident the actions we've taken as part of Flowserve 2.0 will come through the system. But it's volatile, so it's hard to predict. Amy, why don't you walk through the details on Q3 into Q4?

Sure. As we've discussed, we need a couple of things to happen to see the progress that results in the exit rate: we need materials on the shop floor and we need the hours available from our labor force to push product through. We really see Q4 as our opportunity to catch up on longer lead times that we've seen and deliver in the way we traditionally deliver in Q4 at Flowserve. While the last three years have been abnormal, as we look at this exit rate for 2022, we're talking about momentum-building. As we go into 2023, without giving guidance today, we think we'll have a strong backlog and can start to return more to a traditional year for Flowserve. That doesn't mean Q4's margin is the margin for Q1, but it does reset the baseline from which we want to build in 2023.

And as there are no further questions, this will conclude today's call. Thank you for your participation. You may now disconnect.

Great. Thank you.