Good day, and welcome to the Q4 2022 Flowserve Corporation Earnings Conference Call. Today's conference is being recorded. At this time, I'd like to turn the conference over to Mr. Jay Roueche, VP of IT and Treasurer. Please go ahead, sir.

Thank you, Anna, and good morning, everyone. We appreciate you joining our conference call today to discuss Flowserve's fourth quarter and full year 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 February 22, 2023, 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 both 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. I'd like to start by thanking our associates around the world for their resilience and dedication to our customers and our company. In the fourth quarter, we executed well and delivered significant performance improvement across all aspects of our business, which led to our adjusted EPS of $0.63. In short, we finished the year strong. These results were achieved despite the continuation of some supply chain and labor availability headwinds. Additionally, we delivered solid bookings of $1.1 billion, representing constant currency year-over-year bookings growth of nearly 20% with continued support from our traditional end markets and enhanced 3D booking activity. With four consecutive quarters now exceeding $1 billion in bookings, we ended the year with a near-record backlog of $2.7 billion despite the impact of a much stronger dollar compared to the last time we were at these levels in 2014. We recently announced an agreement to acquire Velan, a Canadian valve manufacturer. This acquisition will be incredibly complementary to our existing FCD business and enhances our 3D strategy with growth in nuclear and severe service markets. We're looking forward to welcoming the Velan associates into the Flowserve family toward the end of the second quarter. In the fourth quarter, we delivered modest improvement in our shipping cadence, which drove year-over-year constant currency revenue growth of roughly 19% and total revenues over $1 billion, which was our highest quarterly sales level since the fourth quarter of 2019. But also note that our North American seal business is back on track as daily shipments exceeded pre-system conversion levels and we have significantly closed the gap that resulted from the third quarter's ERP system disruption. SG&A containment remains a priority, and we again delivered a quarterly adjusted SG&A below $200 million, which included the impact of a favorable settlement, but more importantly, it reflects focused efforts around cost management and improved productivity within our overhead structure. With this strong finish to the year, I am confident Flowserve is well-positioned for a successful 2023 as we build on the fourth quarter momentum and deliver our robust backlog. Let me now provide some additional color on our fourth quarter bookings. Bookings continue to be strong in the fourth quarter at $1.1 billion. This is slightly below our third quarter bookings level of $1.2 billion, which benefited from the $225 million deferral contract. While we didn't have a similarly sized contract this quarter, we did secure a number of awards in the $10 million to $35 million range, totaling over $100 million, primarily in oil and gas and chemical markets, as well as many smaller projects in the $5 million range across our end markets. Importantly, our higher-margin aftermarket and MRO markets continued to provide solid growth in all regions, further supporting our expectations for 2023 margin expansion. Full year 2022 bookings of $4.4 billion increased roughly 18% or nearly 23% on an FX-neutral basis. As the overall market rebounded nicely from prior years, we achieved a strong result despite our exit from the Russian market, which typically had provided bookings in the $50 million to $70 million range. As we highlighted throughout the year, larger project activity returned in 2022 after several years of delays and was complemented by the second consecutive year of steady growth in our run rate businesses, which together drove a 36.5% increase in backlog for the full year. But we had expected healthy bookings growth as we entered 2022, given the pandemic-driven lack of investment in new infrastructure and maintenance, we performed better than expected, driven by our customers' intention to ensure global energy securities and their increased energy transition spending. We expect these trends will continue in 2023, and we believe Flowserve is well-positioned in both new projects and aftermarket work. To provide support of these themes, our oil and gas bookings were up 35% in the quarter and up over 40% for the year, and our power bookings also remained strong on energy security concerns with fourth quarter awards up 17% and up 27% for the year. Shifting to our market outlook for 2023. We believe the current environment supports another solid year of bookings growth for Flowserve despite the potential for some macro headwinds. While we don't currently expect another project the size of last year's deferral award, we do have visibility to a robust pipeline of smaller-sized projects in 2023. In fact, our project funnel was roughly at the same level as it was this time last year. Additionally, we expect our aftermarket and MRO business to maintain its recent momentum through 2023 as we believe customers will continue to invest in maintenance, efficiency and decarbonization. Our 3D strategy is working, and we expect continued growth in 2023 from our specific efforts to diversify and capitalize on decarbonization efforts around the world. We expect energy security priorities and new energy spending will continue to be key growth catalysts for us in 2023 and beyond. The disruption of energy supplies in Europe has driven heightened levels of activity to secure reliable energy in all regions of the world. These conditions have already driven a significant investment increase in nuclear, LNG, fossil power plants as well as regional oil and gas infrastructure. We believe this trend will continue to drive capital investment in oil and gas as well as other energy infrastructure. Additionally, while 2022 decarbonization spending far exceeded our initial expectations, by delivering bookings growth of 75%, we anticipate further growth to occur in 2023. Our energy transition funnel is up more than 60% versus this time last year. This growth is supported by government regulations, corporate ESG commitments and public pressure, creating planned investments in an effort to make the world a better place. The moderating factors incorporated in our outlook include uncertainty around a prolonged inflationary environment and the increased probability of recession risk, primarily in Europe, driven by the significant increase in energy costs and the energy access issues as well as the region's weakened currencies. A potential recessionary environment would likely only impact our GDP-driven markets, including chemicals and general industries, where both markets delivered 10% growth in 2022. However, we believe continued strong bookings opportunities in other markets will overcome any softness we experienced from our GDP-based businesses. With that overview, let me now turn the call over to Amy to address our fourth quarter financial results and our expectations for 2023 in greater detail. I will conclude the call with remarks on our 3D strategy and comments on positioning Flowserve for success in 2023. Amy?

Thanks, Scott, and good morning, everyone. We are pleased that our improved operating performance, shipping cadence and sales leverage in the fourth quarter drove strong adjusted EPS of $0.63. We delivered year-over-year revenue growth of 13% or 18.6% on a constant currency basis to over $1 billion, marking our highest quarterly revenue level since 2019. On a reported basis, our earnings per share for the quarter was $0.92, well above our adjusted EPS, primarily the result of the $0.45 tax valuation allowance reversal, as well as $0.06 of benefits related to the reversals of prior expenses that were adjusted for non-GAAP measures in prior periods. Partially offsetting these benefits were below-the-line FX charges of $0.14 and charges of $0.07 to increase the estimated cost to exit our former Russian business. As Scott mentioned, we are especially pleased with the operational performance in our North American Seals business during the fourth quarter, and this area was a solid contributor to our earnings. As many of you know, we traditionally provide our quarterly and annual SEC filings in conjunction with the earnings press release. However, for year-end, the audit requirements for our 10-K that relate to the ERP issues we encountered during Q3 and our recovery in Q4 have taken additional time to complete, including our final assessment of internal controls. We expect to complete this work in the near term and fully believe our remaining work will have no impact on our financial results reported today. Looking now at our revenues. Fourth quarter original equipment sales increased 14.3% with FCD and FPD contributing 17% and 12% growth, respectively. Year-over-year, aftermarket revenues were also up nicely, 11.9% due to FPD's 15% growth, partially offset by FCD's 5% decline. In total, our full year 2022 revenue increased 2.1% or 6.8% on a constant currency basis. From a regional perspective, the increase was primarily driven by mid-teens sales growth in North America and the Middle East and Africa with low single-digit growth in Latin America. Partially offsetting this growth were declines of 7% and 15% in Europe and Asia Pacific, respectively. Turning now to margins. Fourth quarter adjusted gross margin decreased 40 basis points to 28.8%, including FPD and FCD showing a 70 and 50 basis point decline, respectively. The decrease is primarily due to the realization of some longer-dated backlog booked in tougher times, as well as materials and labor cost inflation, which we partially offset by our pricing actions earlier in the year. On a reported basis, fourth quarter gross margins decreased 60 basis points to 28.4%, including charges of $8.1 million due to our exit from Russia, partially offset by a $4.5 million settlement on previously written down assets. Fourth quarter adjusted SG&A was roughly flat compared to the prior year, but down 200 basis points as a percentage of sales to 18.4% as we demonstrated ongoing cost control that leveraged higher revenues. On a reported basis, fourth quarter SG&A increased $6.5 million to $193.6 million or 18.6% of sales and included $5.5 million of additional Russian exit charges. A gain of roughly $3 million on the receipt of cash on previously written down receivables, and a modest realignment benefit. Both reported and adjusted SG&A included a period benefit comprised of the recovery of prior legal expenses and a modest gain on an asset sale which were sufficient to more than offset our increased year-over-year incentive compensation accrual in the quarter. Our fourth quarter adjusted operating margins were 10.8%, an increase of 150 basis points year-over-year. FPD and FCD adjusted operating margins increased 340 and 160 basis points, respectively. Fourth quarter reported operating margin increased 80 basis points year-over-year to 10.1% where our previously highlighted cost management more than offset the gross profit decline, the $6 million increase in adjusted items and FX headwinds of roughly $6 million. Our fourth quarter and full-year adjusted tax rate of 10.1% and 10.4% were lower than expected, primarily due to the resolution of discrete tax items, jurisdictional profitability mix and execution of certain tax strategies. Turning to cash flow. The fourth quarter remained our seasonally strongest quarter, albeit impacted by factors continuing to lengthen our cash conversion cycle, including strong project bookings and longer lead times due to supply chain and labor availability challenges. We generated cash flow from operations of nearly $70 million, which included $55 million of cash flow from working capital due in part to the $19 million generated through inventory, including net contract assets and liabilities improvement. Turning to the full year operating cash flow, it was a use of $40 million, driven by a working capital usage of nearly $190 million to support our strong 22.7% constant currency bookings growth and 36.5% increase in year-over-year backlog, as well as required adjustments to longer lead times for certain critical materials. However, fourth quarter working capital as a percentage of sales increased only a modest 20 basis points sequentially to 32.4%, again reflecting our sales growth, which largely compensated for the strong bookings and backlog improvement. Additionally, while our backlog increased over $730 million since year-end 2021, our inventory including contract assets and liabilities as a percentage of backlog dropped 500 basis points to 28.5% versus prior year, reflecting the ninth consecutive sequential quarterly decline and reaching the lowest level in five years. In 2023, we expect improved working capital progress and significant cash flow generation as we deliver on our backlog and leverage the improved tools and processes now firmly in place to accelerate our cash conversion cycle. In addition to working capital, other significant uses of cash in 2022 included $105 million in dividends, $76 million in capital expenditure investments, R&D investments of approximately $40 million, a one-time Canadian tax payment of $30 million and roughly $16 million in contributions to our foreign pension plans. Turning now to our 2023 outlook. As Scott highlighted, we expect to deliver strong revenues and adjusted EPS this year, supported by our near-record backlog with expectations for continued support of end markets and further building off the operational momentum we established in the fourth quarter. As you likely saw in our pre-release a few weeks ago, we are targeting a full year 2023 adjusted EPS in the $1.50 to $1.75 range, which would represent a year-over-year adjusted EPS increase of nearly 50% at the midpoint. We also expect revenue to increase in the 9% to 11% range, while we typically ship roughly 90% of our beginning backlog in any given year, due to the return of large project awards to our backlog, as well as some lingering supply chain issues impacting our lead times, we currently expect to recognize just over 80% of our $2.7 billion backlog during 2023. As previously announced, our revenues and adjusted EPS target ranges do not include any impact from the expected acquisition of Velan. It further excludes our expected realignment expenses of approximately $20 million, as well as potential 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 reform laws, etc. Excluding the expected realignment spending only, our EPS is expected to be in the range of $1.40 to $1.65. Both the reported and adjusted EPS target range also assumes current foreign currency rates, reasonably stable commodity prices, no significant geopolitical disruptions and expectations for the end market environment to remain supportive at levels similar to 2022. We also expect net interest expense in the range of $55 million to $60 million and an adjusted tax rate between 18% and 20%. In terms of phasing, Flowserve's earnings and cash flows have traditionally been second half weighted, and we expect that pattern to continue in 2023. Seasonally, our first quarter is almost always our lowest, typically representing around 15% or so of full year adjusted EPS. As we move into 2023, we expect less sequential margin contraction than typical from the fourth quarter into the first, probably around 50 to 150 basis points depending on final mix. However, the reduction in revenue from fourth quarter levels that traditionally occurs will lead to less leverage of our SG&A. Conversely, we generally generate a disproportionate share of full year earnings in the second half, particularly in the fourth quarter, where one-third to 40% of full year earnings is the norm. Additionally, while we expect to continue to make progress on supply chain, logistics and labor availability issues that remain, we believe our lead times fully reflect these headwinds on our expected shipping cadence. That said, we expect quarterly revenues in both gross and operating margins will increase over the course of the year and expect to exit 2023 with gross margins of 30% or better. Turning to our expectations for major planned uses of cash this year. We expect to close the acquisition of Velan in the second quarter using a combination of cash on hand and revolver borrowings, totaling roughly $215 million. We also plan to return over $100 million to shareholders through dividends and expect capital expenditures in the $75 million to $85 million range to support our 3D growth strategy and the continued build-out of our enterprise-wide IT systems to further support our operational and productivity improvements. We are excited to begin the process of integrating the Velan organization into Flowserve following the close of the transaction, likely sometime in the second quarter.

Great. Thank you, Amy. Before closing with our 2023 outlook, let me highlight the progress we have made on our 3D growth strategy and technology developments related to our 3D product offering. We launched our 3D strategy focused on diversification, decarbonization, digitization in early 2022, which is intended to drive higher growth rates in profitable markets and products. One year in, I am even more confident in the strategy, which is incredibly well aligned with the current market environment and expected to drive continued strong momentum for Flowserve in 2023 and beyond. In 2022, Flowserve's 3D bookings grew roughly 25% year-over-year at a significantly higher rate than that of our broader portfolio. While we fully expected our strategy to deliver accelerated growth, our bookings performance last year exceeded our own ambitious expectations. Additionally, we continue to invest in new products and partnerships to further expand Flowserve's leadership position in these targeted markets. Turning to each leg of the strategy in recent awards. Let me begin with diversified. We believe our focus to diversify by targeting particular products, markets and regions will provide more stability through cycles and deliver incremental growth. The specialty chemical market, vacuum products and water markets are key for accelerated market penetration and to provide growing opportunities for Flowserve. Over the last 18 months, we have seen significant bookings growth across the diversification lane, including the recent award to supply critical nuclear vacuum compressors for the construction of a new nuclear power plant in China supporting the country's goal of replacing coal burning power plants with nuclear power. Moving to the decarbonized component of our strategy. Our energy transition funnel continues to grow and is now up over 60% versus the prior year, which should provide significant opportunities going forward. Our product portfolio and global installed base have Flowserve well-positioned to support our customers' carbon reduction efforts, including flared gas recovery, carbon capture and storage, increased Flow Loop efficiency, biofuel conversions and new nuclear investment and life extensions. Additionally, new construction recyclables and hydrogen represent Flowserve's largest decarbonization growth opportunities longer term. These initiatives are the elements needed to reduce the global CO2 footprint. Recently, Flowserve was selected as a sole supplier for flare gas recovery systems for five facilities along the U.S. Gulf Coast. Once operable, these facilities will reduce toxic volatile organic compounds in the air by 5,600 tonnes annually. Finally, on digitization, it includes our efforts to instrument, monitor and provide predictive analytics on our installed base around the globe. Flowserve's IoT offering, RedRaven, has continued to make good progress with further deployments. Although adoption has been slower than originally expected, we have more than doubled our presence at customer sites in 2022 and now have instrumented more than 1,700 pieces of equipment. We are now able to instrument pumps, valves and seal systems, providing enhanced visibility and predictive capabilities across Flow Loop operations. Additionally, we continue to update and enhance our capabilities and algorithms through AI and smart learning as we collect more and more customer data. In one recent example, Flowserve is partnering with a large U.K.-based water utility to provide digital condition monitoring services. The customer is expected to add hundreds of assets across the region in the coming years. We consider this a flagship win for RedRaven and expect more of these awards in 2023. Finally, Flowserve was also selected as a preferred provider of pump equipment, validating our expectations that our digitization strategy can enhance product and aftermarket pull-through. The combination of our IoT capability with RedRaven and our unparalleled knowledge of Flow Control puts Flowserve in a unique position to provide holistic solutions for our customers. Let me now shift to our focus on technology, new product development and partnerships to enhance our 3D offering. Last year, Flowserve launched 23 new and redesigned products. Virtually all of these were aligned with the 3D growth strategy. 2022 also saw significant activity in the partnership area. We acquired in-process R&D for hydrogen pump technology for dispensing applications. And as a result, we believe we can broaden this skill set to more areas in the growing hydrogen space. We also formed a technology joint venture for cryogenic applications such as LNG, hydrogen and other gases. And we entered into a nonexclusive partnership agreement with Gradiant to help address the most challenging problems in industrial water and wastewater treatment. 2023 is off to a fast start as well. We announced an agreement to acquire Velan, a manufacturer of engineered industrial valves, supporting the nuclear, cryogenic and defense markets, which would further accelerate our 3D growth. Velan's product offering is highly complementary to our FCD segment, and the acquisition is expected to be accretive to adjusted EPS in the first full year following close, which we anticipate by the end of the second quarter. We also signed an agreement to provide Flow Control technology in their plastic recycling operations. We are excited to be a preferred partner to Clariter and support their pursuit to eliminate plastic waste around the world. Let me close by acknowledging that 2022 was a difficult year. However, we are a more resilient and nimble company today as a result. I'm confident that we have learned from the challenges in 2022 and will build on the solid results in the fourth quarter going forward. I'm proud of our team for their hard work and dedication to finishing the year strong. We entered 2023 with a substantial backlog of $2.7 billion, which supports the significant revenue and earnings growth we expect this year. I am confident that the adjustments we've made to our operations and supply chain will position us to better navigate future challenges and improve our delivery cadence moving forward. To drive margin improvement and address expected inflation headwinds, we are progressing on the cost-out actions we communicated on the third quarter call. We remain committed and are on track to taking $50 million of structural cost out of the business by the end of the year, which we expect will largely offset certain inflationary areas. Finally, I'm confident in our teams and our ability to drive progress and improved performance throughout 2023 to deliver value to our customers and shareholders. Operator, this concludes our prepared remarks, and we'd now like to open the call for questions.

And we'll take our first question from Josh Pokrzywinski with Morgan Stanley.

Scott, you touched on there at the end some of the '22 challenges that I'm sure you're happy to put behind you. It looks like 4Q is a good kind of mile marker that that's happening. If you had to think about in the context of the guide, what is sort of the easy comp and passage of time, nonrecurring things? I think you had some COVID absenteeism earlier in the year. Obviously, you had the ERP at the end of the year. How would you add up those items in the bridge, the more nonrecurring stuff compared to the core improvement?

Yes, Josh, that's a great question. I'll begin and then pass it to Amy to explain in more detail. Last year was quite challenging, and you highlighted some issues, but there are many to consider. For instance, in the first quarter, we dealt with COVID, extreme logistics constraints, and widespread supply chain difficulties, which seemed to accumulate throughout the year. The ERP conversion in the third quarter further complicated things. However, we believe the current environment is much more stable, as evidenced by our success in Q4. We need to build on this momentum as we head into 2023. I can confidently say that our operating landscape has changed significantly. Our approach to running the company and our organizational structure for success are very different now compared to the start of last year. We're more agile and quicker to respond. While the supply chain isn't perfect, it's considerably more stable, and our operational capabilities are much improved compared to what they were. Amy, could you go ahead and discuss the details of how we view margins in relation to last year?

Sure. I think you framed it well in your question, Josh, because you talked about the fourth quarter as being kind of a mile marker for us. One of the things, as we turn the page into 2023, and I'll say we've been talking about 2023 since midway through the year, I would say, in terms of how do we start the year strong. One of the ways we're doing that is really trying to limit the amount of contraction that we see in margins as we move from Q4 into Q1. So you heard me say in my remarks that we're really targeting more of a 50 to 100 basis point contraction in margins as we move from quarter-to-quarter. That's less than what we've typically seen at Flowserve. From that, our margins are expected to continue to expand quarter-over-quarter as we exit the year at something 30% or better. As we think about the challenges that we faced in 2022, I'll just kind of rattle some off and how we're thinking about them going into 2023. So from a price cost perspective, from an inflationary impact perspective, we think that our pricing increases that we enacted in 2022 and the one that we had to start the year in 2023 are going to keep us neutral as we move through 2023. We feel good about where we're at from that standpoint. Clearly, last year, we experienced issues whether they were frictional costs, loss of volume, lower absorption rates at our plants, and productivity falling that really impacted our profitability. We're not going to see those things this year, and we're going to see a lot of improvement in that area. That will be partially offset by 2 items: One is an increase in our labor costs, which reflects the market that we're in today from a labor perspective; the second piece is really around mix. We see more of our revenues and our guide of 9% to 11% increase coming from our backlog, which means lower assumptions around book and burn. That means those revenues generally come at higher margins. So that mix impact is moderating some of our margin expansions that we'll see. I'll also say that kind of below the gross margin line, we anticipate that we're going to see higher interest expense in 2022. We'll see a slightly higher tax rate now in the 18% to 20% range as we turn the page. We still have some old backlog that's going to flow off sequentially, which leads to that sequential improvement in profitability. We'll also see slightly higher R&D as we move from 2022 into 2023.

A lot of detail that I really appreciate. I'm probably going to need to go over the transcript again to make sure I didn't miss anything.

A little longer answer than...

That might be the first time anyone has ever said that to me on a call.

That's good. No, it's good stuff. I appreciate it. Just looking over to the order side. Scott, wondering if you have any view on how you expect broader book-to-bill to go this year? And maybe on one specific market that we've heard a little bit more chatter on is hydrogen, where it seems like there's some IRA rulemaking that is going to clear up and cause some projects to kick off. How would you think about what you're seeing in those markets and how those inform your rewon orders for the year?

Sure, Josh. Let me start with hydrogen, and then I'll hit the overall market for 2023. We're really excited about hydrogen growth, and we feel that there's going to be substantial effort going forward. You hit it, whether it's IRA in the U.S. or the incentives in Europe, lots of countries are incentivizing hydrogen energy and growth there. We think this grows, and hydrogen has a significant Flow Control element. So whether it's the electrolyzer where you're creating hydrogen or transportation and distribution, there are Flow Control opportunities within the hydrogen value chain. We booked work this year, including a big project in Saudi Arabia, work in Europe, and also in the United States. Our Chart acquisition in the third quarter is around hydrogen dispensing and distribution. We're very excited about our ability to provide a pump into that part of the market, and we’re confident that we'll be able to commercialize that technology this year and start to drive orders in 2023. We need to continue to round out our valve, pump and seal portfolio to make sure that we've got multiple opportunities within the hydrogen value chain. A lot of our R&D and additionally, some of the partnerships we talked about are geared toward that market. But we see hydrogen as a substantial growth market, and we feel like we're doing the right things to position ourselves for that. Then let me just kind of step back and I'll talk about 2023 more generally. 2022 was a very strong bookings year. We had significant growth across all of the end markets, including with the 3D strategy. I don't think the growth will be as high as what we saw in 2022, but we are expecting growth in 2023. Remember, we had the big Jafurah project at $225 million. We don't have another substantial project in the pipeline, but our pipeline is at about the same value as what we started last year. We feel pretty confident that the bookings in the project side will come through. They’ll just be relatively smaller, and we'll book more of them, which actually helps us with margins as well. Secondly, we feel very good that the MRO spending and aftermarket spending remains at this elevated level. Overall, we see growth. Part of the 3D strategy includes the catalysts for this. You heard me say this in prepared remarks, but I'll reiterate it; number one is energy security. As countries look to secure their energy supplies and lessen dependence on other countries, we're seeing substantial work in LNG, nuclear and some in oil and gas. That’s a big driver. Secondly, everyone's decarbonizing existing assets and moving to clean energy. We see those as the two big catalysts that will continue to drive bookings going forward.

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

This is Kenneth Lee from RBC on for Dean today. First, on free cash flow, I'm curious about the cadence of free cash flow throughout the year. Are you expecting some sort of hockey stick in the fourth quarter? Can you maybe remind us what your expectations are for buffer inventory levels?

Sure, Kenny. I'll start with cash flow cadence and then ask Scott to talk a little bit about inventory as we think about 2023. We expect significantly improved cash flow as we move into 2023. The biggest piece of that is we anticipate that net income will improve. This improvement starts in the first quarter but is sequential throughout the year. As is traditionally the case, we expect a significant portion of our cash flow generation does occur in the third and fourth quarter. We see a significant increase in our backlog, which means working capital is going to be a factor as we move forward. That being said, we see it improving pretty significantly as a percentage of sales and certainly driving it below that 30% number as a percentage of sales. As we look at investments made in the second half of 2022, we see an opportunity in the first half of the year to target free cash flow at neutral levels or better. The last item I'd add is regarding free cash flow; we do have a cost optimization program that is ongoing. There will be some cash outflows related to realignment I anticipate toward the last three quarters of the year.

Sure. I'll touch on buffer inventory. As you've seen throughout 2022, we've been building inventory. It's twofold: one, our bookings and backlog are substantially up, driving a lot of it; two, given the supply chain challenges and longer lead times within the supply chain network, we've implemented some buffer inventory. We did this relatively surgically, but we're giving our operations the ability to stock up on additional inventory that we normally wouldn't do. This just goes back to making sure we can deliver to our customers and meet our internal commitments. We feel like it's prudent to do. I’d say that the buffer inventory level is at a reasonably good place right now. I don't expect it to go higher as we move forward into 2023, but also don't expect it to subside in the next two quarters. As things stabilize and lead times come down with our supply chain, we can start to reduce that buffer inventory in the back half of 2023.

That's great color. And then just on Europe, I guess it's left in top comp, but it seems the region was largely better than feared across this sector this quarter. Can you talk about what the conditions were like throughout the quarter for you and what you see there on a real-time basis?

Sure. We addressed this in the prepared remarks and said that there are concerns with Europe just given the currency, the inflation issues on energy and just the general state of the economy there. We watch this closely. We have a big run rate business that's tied more to chemicals and specialty chemical markets. We saw in the fourth quarter roughly about a 5% slowdown in that run rate business. Again, not a huge part of our overall business, but something we're watching carefully. As we think about Q1, we're seeing a similar roughly 5% slowdown. As we move forward in the year, as inflation subsides in Europe, we actually expect that to return to a more normalized level. Remember that’s on top of over 10% growth that we saw in the region for 2022. I don't think this is going to be a major issue for us; however, we continue to monitor it. The positives that I talked about before, energy security, decarbonization and in some of our end markets, I’m confident that we can overcome any slowness on the European side.

We'll now take our next question from Damian Karas with UBS.

You have quite a good bit of sales visibility this year stemming from that $2.7 billion in backlog. Could you just clarify as it relates to the run rate business? You're assuming that it continues to grow or at least hold steady as the year progresses, and you don't foresee any recessionary pockets coming this year?

Yes. I think our run rate business is going to be very robust. That's driven by a lot of these assets, whether it's a refinery or a chemical plant, that are running at really high levels and have been deferring maintenance since the beginning of COVID. We continue to see significant maintenance and shutdowns and turnarounds into 2023. I just don't see that subsiding. I talked about the situation in Europe, which would impact some of our run rate business, but outside of that, we're confident it’s not going to be substantial; there's moderate growth anticipated with the run rate and aftermarket business as we progress through 2023.

Got it. And then I wanted to ask you about the $50 million in cost actions. Could you give us an update on how far along you are there? And how much of the benefit realization you've assumed for your guidance this year?

Sure. I'll start a little bit on that and then maybe let Amy answer some of the timing and how it works through. We're talking about it as a cost program externally with our analysts. I want to emphasize two things: the #1 priority for Flowserve is converting the backlog, and we're not going to do anything that jeopardizes our ability to ship and get product to customers and meet our internal commitments. The program we've launched about organization optimization is truly about driving accountability as number one, and then really taking steps to simplify what I'll call a relatively complex business at Flowserve. We've been working on this since Flowserve 2.0. We made good progress but are now doubling down on business processes that need to get simplified. The $50 million cost is a result of this reorganization and the optimization we are moving forward with. Amy, please discuss some actions we've taken and when it starts to show up in the P&L.

Sure. So Damian, to date, we've exercised about $5 million to $10 million worth of run rate savings, which have been reflected in our guidance range. As we discuss the $50 million program, we expect to achieve that run rate by the end of the year. That incremental amount of savings exists today as potential upside to our guidance range, or something that's out there in case we experience more inflationary pressures than currently built in the guidance range.

We'll now take our next question from Mike Halloran with Baird.

I want to go back to his first question there. When you think about that run rate business and it being kind of modestly positive; that commentary seems a bit at odds with how strong your overall commentary is and how positive you are in the overall end markets. Are you actually seeing something that gives you pause in those markets? It doesn't sound like it. Is this just more prudency because you don't know what you don't know, comps, maybe turnarounds are more static because refineries are making money right now? Just kind of any context around that would be great.

Yes. I'd say it's just prudent. We had significant growth this year in the MRO and aftermarket, so I think it's just saying we're probably not going to grow at the rate we did in 2022. There's nothing we’re seeing to indicate that we won’t grow in 2023. Additionally, our backlog includes aftermarket and MRO. We're going to convert that big backlog as well. So you'll see revenue grow even if the bookings weren't at that higher level.

Appreciate it. And then just a second quick one. Just confidence in the margin levels that you have in the backlog and being able to execute. I'm guessing, was there still what you would see as higher margins relative to maybe the 2022 aggregate rate? Would love to get some context on that.

Sure. Amy touched on this a little bit on one of the questions, but I'll add some more color. As we think about the cycle, 2021 was the low point. We did take some work in 2021 that had depressed margins, and that's still in our backlog. It will work through the system throughout 2023. The bookings in 2022 are all incremental to margins on a year-over-year basis. From this point forward, as we're booking projects, with the significant backlog and our facilities being relatively full, we don’t have any reason to go backwards on margins. There’s still competition on pricing, but we only take work that's going to be accretive to margins going forward. So I feel really good about our backlog, the margins in backlog is substantially higher than where we were this time last year.

Yes. Flowserve has traditionally done a nice job protecting against inflationary pressure by getting POs in place quickly for equipment and negotiating price protection where possible under the contract. In 2022, we faced challenges recouping some of these frictional costs due to logistical issues and labor disruptions from COVID. We're positioning ourselves much better for 2023 by resolving these issues as we move forward, which gives us more confidence in the margins within our backlog this year versus the situation we were in last year.

We'll now take our next question from Joe Giordano with Cowen.

You guys announced a couple of leadership changes with the pre-announcement a couple of weeks ago. Can you talk through what led to those and how you're organizing the reporting structure a little differently now?

Sure. This goes to the organization optimization that I discussed earlier. As we think about this, it's really about how do we drive accountability deep in the organization and simplify what we're doing at Flowserve. One of the things we've done is we've organized internally very similar to how we report externally. Another important change is we're creating more product verticals for full lifecycle delivery. A good example is our seal business. Instead of having the seal business distributed across regions and potentially unfocused, we're creating a seal vertical and full P&L with single leadership over the global business. This is the major change. We have some other internal changes as well but its all about driving accountability with our results in our end-to-end business and simplifying some of the handovers that we had historically.

Earlier we talked about the issues you faced in 2022, some of which were within your control and others that were not. Now thatyou’re moving into M&A mode, having bought in-process R&D, what gives you the confidence that Flowserve organizationally is prepared to take on something like this that makes it a little more complicated while you're getting on your feet execution-wise?

It's a good question. I've been here six years, and we've been working on operational surety and business processes for a long time. We haven’t been very acquisitive because we were defining what the Flowserve playbook looks like and how to operate. Today, I’m confident in our team’s ability to do this. We’ve got a proven IT team that can implement systems, and our operational playbook is second to none. We need to improve process discipline in using it. Our other functions are operating in what I'll call the top quartile in terms of running big companies. When we look at Velan, it’s a publicly traded family-run business. There are opportunities for process improvement within their facilities. Applying some of the things we’re doing at Flowserve and some of the lessons learned in 2022 gives me confidence that we can have a successful integration. There are several levers for value creation, which Amy has highlighted in previous Q&As. We're confident we can utilize most, if not all, of the levers for a successful integration and complementary acquisition.

If I could just sneak one last one in quickly about China. You mentioned you won a nuclear project there. Can you give some clarity on what the competitive landscape looks like there from local Chinese players as geopolitical issues ramp up? How challenging is it for a U.S. company to take on critical infrastructure there?

We have a broad portfolio of Flow Control products, but some of our business does well in China while other parts are really, really difficult. The award I spotlighted was for vacuum technology. It's a niche product, where we have established preferred technology. When we have a technology that's hard to replicate in China, we do well. We’ve also performed well with the FCD and the valve businesses, which have grown nicely. For some of the pump business, it is really competitive; the preference for local products is becoming even more prevalent, despite our big operation in Suzhou. We’re selective about where and what we do in China. I think there will be a return to investment in China seeing as the country reverses its zero-COVID policy. I’m positive about growth in China; we just need to remain focused on what products work there and tailor our operations to support local markets. Again, we've done well in valves, we need to perform better in pumps, while continuing to position our niche technology for preferred applications in China.

We'll take our next question from Saree Boroditsky with Jefferies.

Maybe just a little bit on the acquisition of Velan. You talked about the $20 million of run rate synergies and maybe just how you're thinking about potential revenue synergies given the complementary product portfolio.

Sure. We really like this business. They have a great presence in nuclear, severe service, defense, and an impressive LNG and cryogenic offering. We believe the products are complementary to what we have today within Flowserve. We think about nuclear; now we can combine our nuclear offerings with theirs, with very little overlap. We’re excited about the potential synergies. We've discussed hydrogen and LNG earlier; their cryogenic offerings complement what we’re trying to do. Additionally, we can expand into other gaseous applications like hydrogen. There are some really interesting things we can do with a combined portfolio. Amy has mentioned in her prepared remarks that Velan's aftermarket presence is not very big, so we feel confident about our ability with the QRC network to capture the installed base and aftermarket with Velan products.

And I know it's early, but you talked about some of the longer lead time projects currently in the backlog. Could you share some details about the composition of that and the visibility it gives you beyond 2023?

It relates back to what Amy said earlier. We booked some work in 2021 at low margins. That work will work its way through the system throughout 2022. As we exit 2021, we're dealing with the fallout from 2022. By exiting 2023, all of that will move out as well. We're replacing that with higher-margin work than what was booked in 2021. We’re confident in this progression on margins since, as Amy discussed, we don't anticipate a significant drop from Q4 to Q1, like we’ve traditionally seen. We build throughout the year in 2023, allowing us to end the year at a much better gross margin position. There are several long lead items in the backlog, with nuclear awards typically spanning 1 to 3 years, while the Jafurah award will be around 18 months to 2 years. Those projects will remain with us and are part of the reason for that lower backlog conversion number that we highlighted in our prepared remarks.

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

This is Adam Farley on for Nathan. I wanted to follow up on the Velan acquisition. Could you provide more detail on the $20 million in cost synergies? What are the main buckets?

We touched on this in our remarks. With the cost synergies, we're really highlighting or targeting overhead-type expenses. Velan currently trades as a public company, so public company costs and overhead are a component of that. The combination of two industrial companies can lead to economies of scale around supply chain. We talked about the complementary portfolio; product rationalization over time will come into play, as well as footprint rationalization as we work our way through. We're certainly in the early days of planning around integration, and we're excited to get started. There’s significant opportunity here through cost synergies, but this is definitely a growth story for both the product portfolio and the Flowserve portfolio overall.

Okay. And then post-closure of the Velan acquisition, what are your expectations for future M&A? How is your pipeline of opportunities shaping up?

I'll start, and let Scott provide some color. I think that Velan is a really great example of the type of transactions that we want to do. One is that we think it makes financial sense and strategically, this aligns closely with our 3D strategy and improving our focus on growing markets in nuclear and other industries expected to grow significantly. We’ve put effort into building out a pipeline of inorganic growth opportunities. We intend to pursue it with financial discipline, focusing on enhancing our 3D strategy.

Amy summed it up nicely. That’s essentially what we're looking for; it has to fit the 3D strategy. We will be financially disciplined and confident in our ability to integrate.

It appears there are no further telephone questions. With that, this will conclude today's conference call. We thank you all for your participation. You may now disconnect.