Flowserve Corp Q3 FY2022 Earnings Call

Good day and welcome to the Q3 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, Investor Relations and Treasury. Please go ahead.

Thank you, Elena, and good morning, everyone. We appreciate you participating in our conference call today to discuss Flowserve's third 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. Following 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 do and this call will include non-GAAP measures and contain forward-looking statements. These statements are based upon forecasts, expectations, and other information available to management as of November 1, 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 Investor Relations section. I would now like to turn the call over to Scott Rowe, Flowserve's President and Chief Executive Officer, for his prepared comments.

Thanks, Jay, and good morning, everyone. Thank you for joining our third quarter earnings call. Let me start by saying that no one is more disappointed than I am about the performance in the third quarter. Our results this period do not reflect what Flowserve is capable of delivering, nor are they a representation of what we expect going forward. The third quarter was impacted by a number of items, some of which are self-inflicted, some were strategic decisions, and others were one-time events that came to fruition in the quarter. As a result, we delivered third quarter adjusted EPS of only $0.09. In addition to the $0.19 of ERP systems issues and corporate expense items that were disclosed in our September update, we also incurred other unexpected costs and headwinds in late September that further deteriorated our margins and earnings, such as higher-than-expected bad debt and under-absorption expenses, as well as project true-up costs coming from inflation-related impacts in our highly engineered businesses. Our results were also impacted by an increase in R&D expense that we believe to be a very positive long-term growth driver for Flowserve. Late in the third quarter, we commenced a formal partnership with Chart Industries related to hydrogen fueling pumps. As part of the agreement, we acquired their in-process research and development technology, and its purchase was immediately expensed in our third quarter SG&A as noted in our Form 10-Q. Despite the negative impact to the quarter's adjusted EPS, we moved expeditiously to close this agreement given the benefits derived to both companies, including a 5-year agreement to supply Chart with these pumps upon commercialization. We believe having this technology will further increase our capabilities in hydrogen, and we also expect that the opportunities available to Flowserve in the high-growth hydrogen markets extend well beyond this initial agreement. While the impact to our results for the quarter for these items was significant, we believe most of these items will not impact future performance. First, the North American enterprise systems issues that impacted our highly profitable operations during the third quarter were remedied by mid-September. Since then, we've continued to operate at or above pre-conversion levels, and we do not expect this headwind to persist going forward. The corporate expenses were also distinct to the third quarter and should not reoccur in the fourth quarter. Likewise, the purchase of the hydrogen technology investment we made is clearly a quarter-specific charge that we do not anticipate repeating. And lastly, the elevated bad debt charges in the third quarter are expected to subside. Those are certainly the easy ones to identify. Additionally, from an operational perspective, I am encouraged that many of the supply chain and personnel challenges that plagued us for the last year and impacted our ability to plan and meet lead times have continued to stabilize and improve. Part of this improvement is a direct result of the targeted actions we have taken to improve our supply chain management and build greater resiliency and redundancy in our facilities to support our customers and meet their expectations more consistently. Our efforts are not complete, and we continue to see opportunities to improve lead times for certain procured items, such as electronics, motors, and some castings. As we continue to make progress with planning and lead times become more predictable, we expect our revenue conversion and margins to improve. Let me assure all of our shareholders that we fully recognize that Flowserve's recent performance has not met our own expectations or those of our shareholders. We have to significantly improve our execution and our ability to work through the challenges of today's complex environment. While we have made a lot of changes and improvements to how we operate, our execution in the third quarter overshadows that progress we are making. We fully expect to deliver better results going forward. Combining the discrete items that are not expected to recur with our strong backlog and overall healthy in-market environment, we do see a clear pathway to delivering improved results. We know we must execute to get there, and this management team and I are committed to doing just that. Let me now turn to our third quarter bookings. We capitalized on high activity levels and delivered third quarter bookings of $1.2 billion, which is the highest quarterly level since 2014, and it represents a year-over-year increase of 34%. These strong bookings were anchored by two large project awards totaling approximately $250 million. Additionally, our traditional run rate bookings in aftermarket and MRO, as well as our continued success with diversification, decarbonization, and digitization awards remained healthy throughout the period. Despite increasing economic uncertainty, we continue to have a strong funnel of project opportunities at levels very similar to a year ago driven by energy transition activities and the global need for energy security. Some of the larger projects we were awarded in this quarter included a roughly $220 million award to supply highly engineered and industrial pumps to support the Jafurah Gas development project in Saudi Arabia. We have a well-thought-out execution plan with strong project management in place, and we are excited to be part of this significant development. Additionally, in our water markets, we booked over $30 million of engineered pumps for a pipeline that facilitates the use of desalinated seawater for copper mining activities in Chile. With the continued focus on energy security and independence, we have participated in the resurgence in the nuclear power markets and booked a handful of pump and valve orders in North America and Korea primarily for nuclear maintenance, upgrades, and life extension activities. Finally, we were awarded numerous oil and gas orders in the $5 million to $10 million range primarily in emerging regions to improve energy security and efficiency. Given the size and duration of the Jafurah award, I'd like to provide some additional color on the project in our partnership with Aramco. This massive natural gas processing facility is expected to produce 2 billion cubic feet of gas per day by 2030, as well as provide feedstock for hydrogen and ammonia production. Our long-standing pump frame agreement with Aramco helped secure a significant amount of this award. We have improved our project quoting process and enhanced our project management capabilities to ensure that we deliver the margins that we are entitled to for this large project. With our success on Jafurah, as well as a number of other large projects, our original equipment bookings increased over 60% versus prior year to $680 million, which represents our highest OE bookings level since 2014. Despite the strong dollar, we generated $544 million in aftermarket bookings, which represents a year-over-year increase of almost 10% and over 16% on a constant currency basis. Our aftermarket and MRO bookings have remained strong all year, and we help operators maintain higher productivity and output levels of their existing assets. Turning briefly to our bookings performance by end market and on a constant currency basis given the continued strengthening of the U.S. dollar. Our oil and gas bookings were up nearly 80%, reflecting large project awards and continued strength in the upgrade and revamp environment. Power bookings increased over 19%, supported by nuclear maintenance and life extensions and a nice hydropower award. Both chemical and general industries were up 15%, while our water bookings roughly doubled on the large water pipeline award I highlighted earlier. From a regional perspective, our third quarter bookings growth included all regions. The Middle East and Africa was up over 160%, again driven by the large award in Saudi Arabia. North America, Europe, and Latin America delivered healthy growth of 20%, 31%, and 41%, respectively. Finally, Asia Pacific bookings increased a modest 7%. I am encouraged by the activity levels we've seen thus far in 2022 in both our traditional end markets as well as with the success we've delivered through our 3D strategy. We believe that the outlook going forward remains promising. We will continue to support long-standing customers while at the same time targeting energy transition opportunities in previously underserved markets where we expect higher growth. Near-term visibility supports our view of continued year-over-year bookings growth in the fourth quarter in both MRO and project work, and we expect to secure another quarter of over $1 billion in orders. The combination of this improved global demand environment and the disruption of energy supplies in Europe has driven significant activity around energy security, particularly in our traditional oil and gas, nuclear, and LNG markets. Additionally, the ongoing focus on decarbonization of existing assets, as well as clean energy solutions, continue to provide incremental opportunities targeted by our 3D growth strategy. The concerns and uncertainty around a prolonged inflationary environment and the increased probability of recession risk somewhat softened our outlook for growth. These conditions are most prevalent in Europe, driven by the significant increase in energy costs and energy security risks as well as a weakened currency. We expect the impact of a potential recessionary environment would primarily impact our GDP-driven markets, including chemicals and general industries, where we have seen solid year-to-date constant currency bookings growth of 12% and 7%, respectively. However, based on our visibility into continued strong booking opportunities in other markets, including increased investment in energy security and decarbonization activity, we feel reasonably well positioned for growth in 2023. Looking forward, the strong OE and aftermarket bookings we delivered in the quarter produced a backlog that exceeds $2.6 billion, reaching the highest backlog level since 2015. This level of work under contract, combined with our expectations of a continued supportive demand environment, provide us with the opportunity to deliver strong top line growth and margin improvement as we move forward. With that, let me now turn the call over to Amy to address our third quarter in more detail and our expectations for the fourth quarter. I will conclude the call with remarks on our 3D strategy and comments on positioning Flowserve for success in 2023.

Thanks, Scott, and good morning, everyone. First, I would like to start by echoing Scott's sentiment that we are acutely aware our third quarter results are not acceptable, and they are further obscured by the previously disclosed discrete expenses, including the purchase of in-process R&D and some other items which we do not expect to recur. Absent these items, our third quarter would have looked much more like our second quarter results, and it would have been even better had we not seen a pickup in bad debt expense as well as headwinds from an increase in estimates to complete certain projects. In the third quarter, our reported EPS of $0.29 exceeded our adjusted earnings per share primarily due to $30 million of below-the-line FX gains. Excluding the FX gain as well as the $2.7 million benefit from cash collected on a previously excluded asset write-down, our adjusted EPS was $0.09. With another strong quarter of bookings, our backlog at September 30 was up 30% since year-end to $2.6 billion driven by a year-to-date book-to-bill ratio of 1.3. If not for the continued strength of the U.S. dollar, backlog would have been even higher by approximately $140 million. This solid foundation, coupled with our outlook for supportive end markets, provides the foundation for our expectation that revenues and earnings will improve in the coming quarter and in full year 2023. As Scott highlighted, we are encouraged by the combination of tailwinds from traditional end markets and the accelerated growth from our 3D strategy, which delivered a constant currency bookings increase of over 40% year-over-year. Original equipment orders, which were up 63% year-over-year or over 70% on a constant currency basis, drove the increase with FPD's OE bookings more than doubling versus prior year on the return of large project orders. FCD also contributed with a 24% constant currency increase that included particular strength in power, where booking where total bookings were up 66% in this end market that included nuclear orders totaling $16 million. Aftermarket bookings were $544 million, up 16% on a constant currency basis. Both segments contributed solid growth with FPD up 14% and FCD up 28%. Despite the stronger dollars, the third quarter marked the fourth consecutive quarter with aftermarket bookings exceeding $500 million as operators continue to catch up on previously deferred maintenance and avoid costly unplanned downtime while still running their facilities at high utilization rates. In fact, despite the strengthening U.S. dollars, this quarter's aftermarket bookings were the highest quarterly level since the fourth quarter of 2014. We are pleased that for the first time in two years, Flowserve delivered year-over-year growth in reported revenues. Excluding the effect of the strengthening U.S. dollar, revenues were up 7.2% on a constant currency basis. This growth was driven by the aftermarket with both segments up in the 10% range, reflecting the strong MRO and aftermarket environment over the last year and stabilization in our operations. FCD also contributed 14% constant currency OE growth, while FPD declined roughly 5% on the same basis. Regionally, North America's constant currency revenue growth of roughly 13% included 23% and 9% growth in FCD and FPD, respectively. The Middle East and Africa contributed 30% growth on FPD's strong 39% increase. Europe also contributed solid growth of 10% with FCD up 15% and FPD up 8%. However, growth in these regions was partially offset by declines in Asia Pacific and Latin America at 8% and 18%, respectively. Turning now to margins. Third quarter adjusted gross margin decreased 220 basis points year-over-year to 27.4%. The decline was driven by the third quarter-specific disruption in our highly profitable North American seals business due to the ERP system conversion, which resulted in roughly $5 million of unabsorbed costs and deferred an estimated $30 million in revenue and associated margins. The adjusted gross margin was further impacted by a $1 million non-cash lease accounting adjustment. Other contributors to the margin challenge included an approximate $2 million project write-down primarily on aged backlog; almost $3 million related to the effects of increased costs on our estimates to complete certain large projects; and higher freight costs, which were partially offset by a 200 basis point shift in mix to aftermarket and the impact of our price increases earlier in the year. Third quarter reported gross margins decreased 190 basis points to 27.4% due to the headwinds discussed earlier, partially offset by a $3 million decline in adjusted items. Third quarter SG&A increased $23 million to $224 million due to certain discrete items of roughly $18 million, primarily for incurred but not reported expenses related to our annual actuarial assessment, the non-cash lease accounting adjustment, and the in-process R&D technology investment. This unusual activity led to inflated adjusted SG&A as a percentage of sales, with the calculation increasing 250 basis points to 25.6%. On a reported basis, third quarter SG&A increased $20 million year-over-year, including the impact of the charges I just mentioned, partially offset by the reduction in adjusted items of $3 million. Third quarter adjusted operating margins decreased 460 basis points to 2.4% year-over-year due to FPD's decrease of 420 basis points, while FCD's adjusted operating margin was flat with the prior year at 10.5%. The margin was further impacted by the elevated corporate costs and SG&A that I just discussed. Third quarter reported operating margin declined 380 basis points year-over-year to 2.8% as the previously discussed challenges were partially offset by a $6 million decrease in adjusted items. Our third quarter adjusted tax rate of minus 63% was due to a benefit from the mitigation of tax liabilities recorded in prior periods and this quarter's low levels of pretax income. Turning to cash flows. Third quarter operating cash was a use of $38 million primarily due to increased working capital of $75 million to support our strong backlog growth and the shipment challenges in certain of our facilities. We have invested nearly $150 million of cash year-to-date for inventory, including net contract assets and liabilities to support the roughly $600 million increase in this year's backlog level and to assist in minimizing any future supply chain concerns. The combination of strong bookings growth and improved project environment and the frictional issues delaying shipments, including the impact of the ERP conversion, has impacted our working capital as we look to capitalize on the strong demand environment. As you would expect, the growing backlog and shipment delays have also impacted working capital as a percentage of sales with the third quarter ticking up 230 basis points sequentially to 32.2%. Despite this increase, I am pleased that we continue to lower the total inventory, including net assets and contract liabilities as a percentage of backlog, which now stands at 29.5%, our lowest level in over five years. Lastly, other material uses of cash in the quarter included dividends of $26 million, capital expenditures of $15 million and debt reduction of approximately $8 million. As most of you know, Flowserve traditionally delivered strong cash generation in the fourth quarter, and we expect this seasonal dynamic to again play out in Q4. Turning now to our outlook for the fourth quarter. We expect revenue growth of 8% to 10% year-over-year. This higher level is supported by our increased backlog, a reasonably stable to improving operating environment in our facilities, and resumption of normal operating levels in our highly profitable North American seals and aftermarket business. The revenue forecast also includes a 2% to 3% headwind versus our prior fourth quarter expectations due to the increased strength of the U.S. dollar since our previous outlook. Based on the improved shipment levels and the $0.22 of items impacting the third quarter that are not anticipated to repeat in the fourth quarter, we expect to close the year with reported and adjusted EPS of at least $0.40, which would imply adjusted operating margins in the 8% to 10% range. This margin level is less than we anticipated earlier in the year. The decline in expected margins is attributed to lower absorption in our engineered facilities due to the timing of large project bookings that we had anticipated occurring earlier in the third quarter, which would have allowed for more absorption, revenue recognition, and associated margins in the fourth quarter. Additionally, lower margins on percentage of completion backlog and the continued strength of the U.S. dollar have moderated our expectations. And while we fully expect our North American seals business to perform at first half shipment levels, we are not anticipating the fourth quarter ramp in shipments that was incorporated into our prior thinking. However, we continue to believe that the strong sequential fourth quarter movement that we are expecting will position us well as we look to improve financial performance in full year 2023. With the modest realignment planned in the fourth quarter, we expect our reported EPS to look very similar to adjusted EPS. Both the reported and adjusted EPS target range also assume current foreign currency rates, reasonably stable commodity prices, the continuation of our current market conditions, no significant improvement in the Russia-Ukraine conflict, and no disruption due to European energy supply constraints. Although we are expecting substantial sequential revenue and earnings growth in the fourth quarter, we do not expect this growth to carry our full year results. And we are not willing to let the shortfalls of this year carry over into 2023 without taking actions. I'll now turn the call over to Scott to discuss our progress on strategy, our outlook, and planned actions to improve our performance in 2023.

Thanks, Amy. Before closing with our outlook for the remainder of the year, let me provide an update on the progress of our 3D growth strategy focused on diversification, decarbonization, and digitization, which aligns exceptionally well with today's market environment. I am pleased with the progress and momentum our 3D strategy has provided, where bookings in these targeted markets have exceeded our expectations. I would like to spotlight a few 3D awards from the quarter. In the diversified category, we won a water pipeline project in Chile, providing water from the Pacific Ocean to a large copper mine, which is 195 kilometers and more than 4,000 vertical meters away. This project will preserve the freshwater natural resources in the Andes Mountains. Shifting to the decarbonization leg of the strategy. Flowserve's extensive capabilities and vast installed base position us well to support our customers' CO2 reduction and energy transition plans. The increasing government incentives to reduce carbon emissions are having a significant impact on the overall growth in this market. We have seen our energy transition project funnel grow roughly 70% since the beginning of the year. Flowserve continues to lead in CCUS as well, where we are seeing the uptake on our technology gain further traction. Flowserve is participating in a number of these projects around the world, and we expect continued activity in this area for the foreseeable future. As an example, Flowserve was recently awarded contracts to supply pumps and valves for a large project to capture CO2 from 32 methanol plants across the Midwest and transported to North Dakota for permanent storage. Another example of decarbonization is in Hawaii, where Flowserve is providing equipment in the West Kauai Energy Project for a comprehensive integrated renewable energy and irrigation. Flowserve pumps will enable the hydropower and pump storage components of this project, supporting Hawaii's path to 100% renewable energy. Finally, on digitization, we continue to make good progress in the third quarter, where we instrumented roughly 125 assets and now have over 1,625 assets instrumented around the world. Other significant advances include the instrumentation of CE vacuum and liquid ring pumps and the ability to monitor sealing systems and control valves. In one recent example, we installed RedRaven, one of the world's largest desalination plants in the Middle East, where we instrumented 22 critical process pumps. The latest commissioning represents the third desal facility we are now supporting with RedRaven technology. Before closing, I would like to highlight another recent technology development we are excited about as well as some additional comments around the hydrogen pump technology acquisition. In the third quarter, we brought our FLEX isobaric energy recovery device to the market following nearly a year of extensive field testing. With its proven efficiency and compact envelope, the combination of FLEX with our high-efficiency pumps and valve offerings represents a comprehensive product offering to support the growing desalination market. While initially designed for desalination, we believe there are other industry applications for the FLEX technology that we will pursue in due time. We are enthusiastic about the opportunity to leverage the R&D efforts that Chart commenced on hydrogen distancing pumping technology and expect that we will be able to bring the product to commercialization in the second half of 2023. This Chart product will be a critical piece of the equipment for liquid hydrogen fueling stations and will allow Flowserve to build out other related products across the hydrogen value chain. As we look toward 2023, we believe Flowserve is well positioned to convert on our existing $2.6 billion backlog, which currently sits at $600 million more than the beginning of the year. Even with only modest book-to-ship assumptions in 2023, Flowserve's revenue should grow at approximately 10% year-over-year. While we will see a meaningful shift back to more original equipment revenue, our aftermarket backlog remains high, providing significant opportunity to convert this high-margin business to revenue within the year. To address the persistent inflation that we have experienced throughout 2022 and the potential recession concerns in Europe and the United States, we are putting together a roughly $50 million cost-reduction plan that includes both variable and structural costs. We intend to provide more details of this program and the timing of execution during our fourth quarter earnings call, but we are planning for a large percentage of the savings to be executed within 2023. Our strong backlog should enable revenue growth of approximately 10% in 2023, and the cost-out program will ensure that we capture the margin expansion and incremental margins that we have historically come with top line growth. We are currently in the middle of our 2023 planning process. And as usual, we will provide full-year 2023 guidance on the next earnings call. In summary, our third quarter performance did not meet our expectations. We are confident this quarter's discrete items will not continue and fully believe we will make meaningful progress in our ability to execute. We expect to see significant improvement in the 2022 fourth quarter with the derisked plan that we shared earlier in our prepared remarks. Further, as we achieve higher levels of conversion on our robust backlog, we should be in a strong position to grow our margins and return to a more normal level of profitability. I'm confident in our team and our ability to move beyond the third quarter to begin to grow both our revenue and our profitability. We have the right building blocks in place, and it is on us to deliver.

We will take our first question from Deane Dray from RBC Capital Markets. Please go ahead.

Thank you. Good morning, everyone. Let's begin by addressing the unexpected items from the quarter and distinguish between those that are self-inflicted and those that are not. Regarding the Chart deal and capitalizing R&D, that seems like a promising opportunity in the hydrogen sector, and it's something we should be doing regularly. The foreign exchange impact is something everyone is experiencing, so that's not self-inflicted. I'll set those aside. However, the profit margin issues related to the percentage of completion and aged receivables appear to be more about forecasting. It seems you may have been a bit too optimistic, or perhaps you anticipated that aging receivables might not be collected this quarter. Can you clarify how much of this is a forecasting issue for those two items? Additionally, do you have an action plan to address them? Let's start there.

Sure. Yes. Thanks. I'll start and then I'll let Amy hit a couple of things that I miss here. But the previously announced and the one-time items are clearly the ERP conversion, the corporate one-time expenses, all of those were preannounced, and then the R&D acquisition. And then the other late-quarter items, like you said, are the bad debt expense and the project true-up costs. I'll hit the project true-up. I'll let Amy fill in any blanks there, and then she can address the bad debt. But on these projects, especially in the engineered environment, they're long-cycle projects and what we've seen is an inflationary environment all year. So whether that's materials, labor, energy costs in Europe, those have continued to go up. And in a lot of our projects, we review these every month. We do quarterly reviews and assessments on our estimate at completion, and we typically do a good job forecasting what that cost model looks like. And then, unfortunately, we did this later in the quarter. And what we saw was more inflation primarily in Europe, but also some of our North American projects as well come in. And given the inflationary environment and the concerns in the future, we bumped up the cost for a lot of these projects. Amy, do you want to add anything else on the projects? And I'll let you hit bad debt.

Sure. As we've mentioned previously, for large projects, we attempt to lock in as many costs as possible. However, due to the current environment, we have encountered some costs that we cannot secure, particularly in areas experiencing high inflation. This is addressed through adjustments made in the third quarter. Regarding the aging items, we conduct a thorough forecast of cash collections each quarter at both the site and platform levels. In certain cases, customers who had pledged to pay significant receivables did not fulfill those commitments by the end of the quarter. These are reliable customers, and we are confident that payments will be made, and in some cases, they have already occurred in the fourth quarter. It is unfortunate that this issue arose unexpectedly in the third quarter, but we do not expect it to persist into the fourth quarter and beyond.

Okay. All right. Let's just shift over on to the positive side here. And on the third quarter bookings, can you give us a sense of the implied margins? And just are there any challenges and confidence in the conversion and timing of the conversion of these orders?

Sure. So obviously, the $1.2 billion is a big number for us. There is a significant amount of projects that were booked. And I'd say we're excited about the profile of those projects. I would say the environment around pricing on projects is still competitive, and so we are being selected. Obviously, the deferral one, which I hit in our prepared remarks, is a very large project. We've been working on that now for 9 months. We had lots of focus on making sure our costs were correct. We've got a margin position in there that we're excited about, and we put substantial contingency for inflation in that project as well. And so I feel reasonably good about the project bookings that are in there. I would say, Jafurah is a multiyear project. That's going to take two years to execute. But a lot of these projects are relatively standard in terms of the product configuration. So not a heavy engineering mix, not a lot of technical risk, and things that we can execute reasonably quickly. And so overall, we're excited about what we booked in the quarter. And then kind of going back to your previous question, Deane, we're really focused now on securing the price of the bought-out items early in the project life to make sure that there's no risk there. And then we've been putting more and more contingency in the projects themselves to make sure that we can offset the inflationary environment. So I feel better about the work that we booked today than what we booked last year in terms of how we go forward.

Great. I just have one specific question, the follow-up, the FLEX isobaric system is getting a lot of attention. People were talking about it at the WEFTEC conference. Is this a replacement to the DWEER technology? Or is it complementary to it?

Yes. So it's a good point, and I'm glad you brought this up and recognize that we do have pressure exchange out there with DWEER. And so that's been a legacy technology. It's a linear technology, and FLEX is a rotating or rotary technology. And so these are complementary, and we can use both in conjunction to get the best efficiencies. And so we really like this portfolio now. So FLEX offers a very compact, highly efficient rotary pressure exchange device. DWEER is a little bit bigger, but it's linear and can be used in different applications. And then when you combine that now with our high-efficiency pumps and RedRaven, we really believe we've got something that can differentiate us in large, highly efficient energy-dependent water markets like desalination. Now obviously, we want to move beyond desalination, and there are other areas like industrial wastewater, refrigeration, HVAC, that we also believe we can expand the pressure range technology to. So we're really excited about our capabilities and what we could do here.

That's great to hear. Best of luck.

We will take our next question from Michael Halloran from Baird.

Morning, everyone. Thanks for taking my questions. So on the margin side of things, kind of a 2-parter. First, wide range, 8% to 10% fourth quarter margins on the EBIT side. Maybe talk about what the iterations are to get to the upper end of that range and what would have to happen to get to the lower. And then how should we think about what the right stepping-off point is here? Obviously, a lot of these disruptions should go away. You're confident in the profitability of the profile, in the backlog to be executing on a cost improvement plan as you work through next year. So any help you could provide on how to think about the jumping-off point for margins would be helpful as well.

A few items to emphasize regarding that margin range. We noted large order bookings in the third quarter that occurred later than we initially expected. This led to some absorption in our ETO plants and delays in recognizing revenue and profit from POC costs, which lowered our expectations. The U.S. dollar continues to be a headwind as we enter the fourth quarter, and we're observing rising costs on these POC projects over time. To reach the upper end of the range or to exceed our $0.40 per share target, we really need improvements in conversion rates for our North American seals business and other sectors. We expect some improvement in our valve conversion rates in the fourth quarter, similar to last year's results at that time. They have remained stable through the second and third quarters, translating to higher revenue due to a stronger backlog. We anticipate a small uptick moving from the third to the fourth quarter and hope our seals business performs comparably to the first half of the year. Typically, we expect a seasonal surge in the fourth quarter, but given the experiences in the third quarter, we've adjusted our expectations. We're focused on meeting the targets we’ve set and have worked to mitigate risks to ensure we achieve them. As we look ahead to 2023, Scott has touched on our approach to large project orders. The shift to OE will create opportunities to enhance absorption in our larger facilities, which generally comes with slightly lower margins, but we anticipate that this absorption will be beneficial throughout the year. In 2022, we faced several challenges affecting our operations that we expect to improve significantly in 2023. We're currently analyzing those figures and look forward to providing guidance early in 2023 regarding the expected improvements.

And then just some comments on the front log side of things. Obviously, really nice orders. Good to see the progression. You certainly feel optimistic about the backdrop. What are the customers saying at this point? Are you seeing any real movement in the front log or trend-wise one way or another, people pulling things in, people pushing things out? And then as you think about end-market variability on a forward basis, any kind of thoughts underneath the hood about where there's a little more risk or a little bit more opportunity looking forward?

The front log is always dynamic, and there are no significant changes today. We feel reasonably confident about our future. In my prepared remarks, I mentioned that Q4 bookings will exceed $1 billion again, marking our fourth consecutive quarter of such performance, which we're excited about. We anticipate continued strong performance in MRO and aftermarket sectors for the fourth quarter, along with some projects. While the projects may not be as substantial as the larger awards in Q3, we remain optimistic. However, we are becoming concerned about the GDP-based business, particularly in Europe, where some large chemical customers have expressed worries about their demand. If that segment slows down, it could have an impact. On a positive note, energy security and decarbonization are promising areas. We're witnessing a global increase in traditional energy sources like oil, gas, coal, and LNG, as well as unconventional and new energy sources. We believe these will help mitigate recessionary concerns. There’s been a resurgence in traditional forms of energy, including nuclear, and decarbonization activities have increased by 70%. We feel that the combination of energy security and decarbonization will offset any worries related to GDP-based recession risks.

Great. Really appreciate it. Thank you.

We will take our next question from Andy Kaplowitz from Citigroup. Please go ahead.

Good morning, everyone. Scott, just maybe following up on that last comment. You already talked about Q4 bookings and this trade-off between energy transition bookings and maybe slower chemical general industries. Do you think the trade-off is positive enough where you could keep book-to-bill over 1 over the next several quarters? And then just you booked this large Middle East project. Is that more of a one-off? Or are there a handful of these larger projects that you still see over the next several quarters?

Sure. Yes. So I'd say right now, Andy, we do expect bookings growth. Will book-to-bill be greater than 1? Not sure. It depends how high we can push our revenue because we have substantial backlog. And so we'll provide that guidance on the fourth quarter earnings call when we go full year guidance. But then back to kind of these trade-offs, the energy security is substantial. And there's a lot of activity going forward on that. We do have visibility to larger projects, some in the nuclear space, some traditional oil and gas, and other things. I would say $200 million is a really large award for us. I don't anticipate that happening next year, but I can certainly see some larger projects in the $50 million to $100 million range next year as they come through the system. And so there are big projects out there. There are big developments, again, mostly around energy security and bringing a localization in security to energy in different parts of the world. And then on the decarbonization side, we're seeing so much activity. Most of these are smaller projects, but nobody is going to go backwards on their decarbonization and their ESG focus. And a lot of that is driven by government regulation. So previous regulation in Europe is helping to start that movement. And then the Inflation Reduction Act in the United States is now generating all kinds of activity around CCUS and hydrogen. And so we're pretty constructive about the outlook there. And again, the two drivers for us will be energy security and the decarbonization line.

Very helpful. And then, Scott, you talked about the contingencies put in Q4, but can you go into a little more detail into what you're doing or what you can do as CEO to cut down on the noise that seems to be quite frequent when you report quarterly earnings? Can you change the reporting structure in some way to even help you see problems faster were they develop? And how concerned should we be about continuing ERP transition?

Sure. I’d like to begin with our forecasting and our ability to better predict our financial results. Clearly, we haven't excelled in this area, and we are actively working to improve our predictive capabilities and understanding of our outcomes. A significant part of this involves making the right adjustments at both the plant and project levels, which we have revamped this year. We are now conducting more thorough monthly plant reviews, adhering to a strict protocol, and assessing larger projects regularly at the corporate level. As we navigate this challenging period, characterized by doubled lead times for many components, I feel we are gaining improved visibility. Although this improvement isn't yet reflected in our results, I believe that with a more stable supply chain and heightened focus, we will achieve greater accuracy in our forecasts and our ability to meet our commitments. Additionally, we are incorporating more contingency plans into our strategies. We have discussed our derisk plans for the fourth quarter and project contingencies, and we will continue to put safeguards in place to ensure we deliver what we promise. Regarding our ERP system, we previously announced a loss of around $30 million in revenue mainly from July and some from August. The numbers in September were encouraging, returning to pre-conversion levels, and October maintained the same pace. We are optimistic about ongoing improvements, though we still need to recover the $30 million lost during the quarter. We might recover some of that late in the fourth quarter, but we haven't formally committed to that in our guidance, though we expect to have it by the first half of 2023. Our team is making significant efforts to enhance capacity within the North American seal business, and we are confident we can overcome these challenges. It’s important to note that this is not fundamentally a systems issue; rather, it pertains to training and effectively utilizing the system. Previous conversions in other regions have gone smoothly, so it’s about ensuring the North American team gains confidence through the right training and tools. We believe we have turned a corner on this and will not revert to previous issues. However, we still need to continue ramping up capacity as we head into 2023.

Yes, Andy, some of your question may have been about how we should approach future implementations. We are closely examining this to learn from our experiences. This has been the largest implementation we could undertake at this time. As we look ahead, we are confident in our ability to handle future implementations in a manner that incorporates what we've learned from this one and carries less risk than this conversion did.

Appreciate the color.

We will take our next question from Saree Boroditsky from Jefferies. Please go ahead.

Thanks for taking my questions. You mentioned that you expected to see another $0.25 billion in bookings to be the fourth consecutive quarter. This seems to imply potentially higher than 10% sales growth into next year. So could you talk about how much of your backlog should convert into 2023? And maybe is there any conservatism in that number?

I'll start by noting that as we enter 2023, we are focused on accelerating the conversion of our backlog into revenue. The composition of our backlog is different from this time last year, with a larger proportion related to OE projects. Some of these OE projects will extend through the 2023 calendar year. Consequently, we anticipate lower conversion rates compared to our traditional rates from 2021 and 2022, due to this change in backlog composition as we progress into 2023. Nevertheless, we are committed to improving our conversion rates moving forward.

Great. And then I guess assuming that 10% revenue growth into next year puts you almost $3.8 billion in sales. If I look back historically, that's similar to what you did in 2018. So do you think you can get operating margins to approach that 10% level? And how do I think about the impact from cost savings since that time?

We will provide detailed guidance for 2023 as we approach next year. Scott has pointed out the necessary cost-saving measures we need to implement. We are aware that we will face certain challenges next year, particularly due to the strong dollar, which we do not expect to change. Additionally, we are experiencing high levels of inflation in certain areas of the organization. Our goal for the fourth quarter this year is to increase operating margins to the 8% to 10% range, which would give us a solid foundation to further expand margins as we head into 2023.

Great. Thanks for taking my question.

And we'll take our next question from Nathan Jones from Stifel. Please go ahead.

Good morning, everyone. I guess maybe following up to some of Saree's questions there on maybe some color on '23. You guys have incurred a number of frictional costs this year related to increased inbound freight early in the year, some of the things that happened during the third quarter. If you were to think about the net impact on your results this year, those kinds of things that maybe shouldn't recur in 2022, how much would the aggregate impact have been to '22's results that maybe shouldn't repeat in '23?

Yes. No, it's a really good question. And we're going through the budget process right now for 2023. And again, we'll put guidance out at the end of the fourth quarter. But as you said, there's just been a number of things that have impacted us in the year. And so at the beginning of the year, in Q1, we had COVID-related shutdowns. We had frictional costs on logistics, where we're paying 3x to ship things around the world. We had overtime. There's all kinds of stuff. And then obviously, the ERP conversion and the one-offs in the third quarter, we've clearly called that out as discrete items. And so I think, Nathan, you can build a bridge relatively easy to get to some nice margin improvement if we can get beyond all of the things that happened to us in 2022. And so these are the discussions we're having right now with the teams. It's kind of like what's the implied revenue. We know we're doing the right things on execution. We know we like the quality of the backlog. And so we've got to commit in our plans to drive margin expansion as we move beyond the friction and the noise of 2022.

Okay. I guess I'll stay tuned for February then.

Yes, we will provide that in the fourth quarter earnings call along with the guidance.

No worries. Maybe a couple of questions around the Saudi project. Flowserve has had large project orders, maybe not quite this big historically, but has had large project orders. And I think the project management around those kinds of things has probably been less than perfect historically, and they haven't realized the margins that have been baked into the pricing. Can you talk about any changes that are being made to how projects like that are being managed to ensure that you actually do realize the margins that have been priced into that bid?

Yes, that's a great question, Nathan. We've been focusing on this for about three to four quarters now. We recognized the importance of this project early in the year due to our relationship with Aramco and our involvement in the frame agreement. To address this, we enhanced our project tendering team and assigned some of our top people to ensure that the quoting process covered all costs and that we had a solid execution plan in place as we prepared the tender. Historically, Flowserve has not excelled at this; we usually have one team handle project tendering and another manage execution. For this project, however, we've involved some of our best team members to collaborate on the execution plan before the award. Amy and I have conducted monthly project reviews for the last six months, providing intense scrutiny and attention. As we move into execution, we've strengthened the execution team and revamped our project management reporting to emphasize project progress, risks, and critical milestones. While I wouldn’t say this project is entirely risk-free, I feel much more confident in our execution ability compared to past projects. A few key points to note: we booked most of this in September, with some occurring in August, and the majority of the long lead items are already purchased. We've included a contingency in the project, which is unusual for us, and we are sticking to our plan so far. Early initiatives like careful execution planning, maintaining contingency, focusing on the right elements, and having a dedicated project management team are all in place. We will keep providing updates on this project, which we expect to last about two years until the final shipments. We are excited about our capacity to deliver for Aramco and achieve the margins we aim for on this significant project.

This project by itself probably absorbs a reasonable amount of capacity, particularly on the engineered pump side, industry capacity as well as your capacity. Do you think this enables the industry to be a little bit more aggressive with pricing and maybe realize a little more margin on pricing on projects going forward?

Yes. I sure hope so, Nathan. It certainly does that for us. And so we're in a much better position on capacity. We're going to be even more selective as we go forward in terms of what we take and making sure that we can move our pricing and margins up. But I would say we're seeing similar things with our peer group and competitors in terms of their bookings and backlogs coming up. And so I'm hopeful that 2023 has some better and more constructive pricing and discipline in the system.

Thanks for taking my question.

We will take our next question from Joe Giordano from Cowen. Please go ahead.

Hi, everyone. I think we've touched on this a bit, but there appears to be a breakdown of internal controls somewhere. I appreciate the management's increased focus on what they're hearing from the field, but is there an issue with how things are being managed at the field level that requires structural changes? Additionally, how are the people there being incentivized, and how are they approaching their daily tasks?

Yes. Look, we haven't forecasted as well as we should. And so there's no doubt that we've got to tighten up our ability to forecast our results. I'll just say the external environment has been incredibly challenging, and it's been very frustrating for Amy and I as we go forward. But I'd say these are things that we've got to do better. We continue to work with the organizations on how to predict and what to forecast. There's not a breakdown on internal controls, like that's not happening. We're confident of that. Part of our cost-out program is really going to be driving organizational efficiency and having better role clarity and accountability. And so those things, we're definitely looking at as we look at how do we take cost out given the backlog that we have. But I'd say this has been frustrating, right? We've got to make sure that we can deliver on our commitments. And we believe that we're getting better. Sadly, the third quarter kind of masked some of the underlying improvements that are there. And so we've got a derisked plan in Q4 that we're very confident of achieving. And I think you see our execution start to improve dramatically as we turn the corner into 2023.

When you talk about the cost-out actions, the $50 million you're talking about, obviously, you have a sprawling enterprise that's been built up through a lot of acquisitions over a long period of time. Is there anything like more fundamental that needs to be considered to address the operational structure going forward?

It's a valid point and absolutely true. Our organization remains quite complex with numerous sites. We are actively exploring facility consolidation and rationalization. This is a key part of our plan to ensure that we can achieve scale at our larger sites while keeping them fully utilized. This also ties back to our goal of simplifying operations. By reducing the number of sites, we can concentrate our efforts and enhance results at a select few locations instead of spreading ourselves too thin. Additionally, we are examining our product portfolio as part of a successful transformation to create a more streamlined and rationalized set of products. This effort has been underway for more than a year and a half, and we are committed to advancing towards a more tailored product offering. We are willing to make tough decisions on customer projects where margins are insufficient, as well as on our product lines. If a product no longer makes sense or if the market has shifted significantly, we will consider exiting that product line to concentrate on areas where we can achieve better margins and more stability.

And if I could just sneak in one quick clarification. Like can you just size what your expectation is for orders for hydrogen and nuclear this year?

Sure. I'll start with nuclear. This year, we have booked over $150 million year-to-date in the nuclear sector, with about $20 million in work during the quarter. The nuclear market appears strong, and we anticipate continued opportunities in this area moving forward. I would say that 2023 should present an equal amount of opportunities for us in nuclear. Regarding hydrogen, it currently represents a small segment of our business. We have secured significant valve work in hydrogen, which we announced in the second quarter, and that is beginning to progress. Our partnership with Chart will enhance our pumping technology and allow us to engage more in the distribution aspect of hydrogen. Historically, we have participated on the downstream side with gray hydrogen, and that work continues, mainly in the aftermarket. However, we see green hydrogen advancing quickly, and we are evolving our portfolio to support this growth. Our collaboration with Chart is a key step in ensuring we can fully participate in the hydrogen market.

We will take our next question from Josh Pokrzywinski from Morgan Stanley. Please go ahead.

Hi, good morning. Thanks for taking the call. This is Toby on for Josh. So wondering for second quarter, how would you normalize 4Q guidance for noise? I see that it still annualizes below where you expected EPS to be not that long ago. So it seems like it's probably got some project accounting or lingering ERP issues or something else want to get back?

We have a few updates regarding the fourth quarter. Typically, we expect an increase in sales volume in the seals segment. In the fourth quarter, we are projecting to deliver more at first half rates in that segment. Although we experienced some challenges in the third quarter, we do not foresee a significant acceleration in the conversion compared to the first half of the year. Some issues from the first half related to under-absorption are likely to continue affecting us in the fourth quarter as we consider the timing of large project bookings. We will still face some under-absorption as we increase activity in our plants during this period. Additionally, we want to emphasize that we have drawn up a plan for the fourth quarter that we are confident we can achieve. We have mitigated risks associated with potential extra costs, be it from inflation or other frictional costs, and we have ensured these are included in our estimates as we approach the fourth quarter.

It appears there are no further questions at this time. I would like to turn the call back over to Scott Rowe for any additional or closing remarks.

Thank you. We have no closing remarks. Thank you for participating in today's call, and we look forward to discussing other things in future investor events and on the fourth quarter call. Thank you.

That will conclude today's conference call. Thank you for your participation, ladies and gentlemen. You may now disconnect.