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In spring of last year, I wondered if shares of Flowserve (NYSE:FLS) were nearing an inflection point. The company has seen very poor fundamentals and share price performance over the decade which followed the shale oil peak in 2014.
The company has shown signs of life again as of recent, and in combination with an interesting bolt-on deal, I believe that shares might be nearing an inflection point. This has really been seen during 2023, with the company hiking the outlook in a convincing manner, creating still an interesting set-up for the shares into 2024.
A Tough Decade
Back in 2014, Flowserve was a huge player and supplier to the energy infrastructure and industrial sector, with the energy sectors seeing a strong boom, driven by the US shale revolution. Its pumps and control solutions played a vital role in growing the domestic energy production.
A $5 billion business was posting an EBITDA number of nearly $900 million, making a $1.4 billion net debt number look very manageable. The 137 million shares of Flowserve valued equity at $9.0 billion, equal to 18 times earnings, all looking like quite a fair valuation.
With US shale production, or better said, capital investments peaking at the time, enthusiasm and spending on the sector came down in the years which followed. This hurt Flowserve in a major way as well, with shares trading in the $40s in the years which followed.
These negative returns have been “backed” up by tough operating times, as 2022 sales were down 30% from a >$5 billion number in 2014, reported at $3.6 billion. This has just in a tiny way been offset by a 5% reduction in the share count. Troublesome was that margin pressure was observed for years, with operating profits of $197 million in 2022 working down to margins of 6%. This compares to a margin profile which comfortably came in their teens a decade earlier, meaning that earnings fell to just over a dollar per share.
While net debt was down to $838 million, being down in absolute dollar terms, relative leverage ratios rose as EBITDA shrank to just $300 million. There were some silver linings, even as a 2% increase in 2022 sales numbers was not impressive. The good news was an order intake of $4.4 billion, comfortably exceeding the revenues reported, resulting in the backlog increasing in a convincing manner to $2.7 billion.
This momentum was extrapolated into the 2023 guidance, with the energy sector seeing renewed impetus from geopolitical events. 2023 sales were seen up 9-11%, with adjusted earnings seen up from $1.10 per share in 2022 to $1.50-$1.75 per share in 2023. About two-thirds of these sales are generated by the Flowserve pump division, with the remainder of sales generated by Flowserve control division, with both segments posting roughly equal margins around the double-digit line.
Trading at $35, this worked down to a 20 times earnings multiple, or a lower twenty times multiple at the lower end of the earnings range, but momentum was clearly positive. Moreover, Flowserve announced a substantial $245 million deal for engineered industrial valves’ manufacturer Velan, a deal set to add $380 million in sales and $21 million in EBITDA, although a $20 million synergy number looks quite compelling and could add on top of that.
Given all these moving factors, I recognize the potential to be at an inflection point, but the past poor track record withheld me from having conviction, which left me to initiate a modest position at $34 per share.
Trading Range Bound
Since the spring, shares of Flowserve have mostly traded in a $35-$40 trading range, now trading at the top of this range. In August, Flowserve announced a 22% increase in second quarter sales to $1.08 billion, as accelerating sales growth came with operating leverage. Operating profits rose to $96 million, with GAAP earnings of $51 million reported at $0.39 per share.
After a smaller hike in the guidance following the release of the first quarter results, full year sales growth is now seen at 16-18%, with adjusted earnings seen around $1.85-$2.00 per share.
Comforting are the midterm targets, which were announced in September as well. The company maintained the 2023 guidance, yet it already guided for a mid-single digit increase in 2024 sales, accompanied by 20-25% adjusted earnings per share growth. The company furthermore announced 2027 targets and while the $5 billion revenue number does not look too ambitious, adjusted earnings of $4 per share look quite convincing.
In October, a mixed bag of news was released. The French Ministry of economy rejected the previously announced acquisition of Velan. Later that month, third quarter results were announced, with sales up 25% to $1.09 billion, with growth in original equipment sales exceeding aftermarket sales growth.
Somewhat disappointing is that quarterly bookings of $1.07 billion were down 13%, coming in just below the reported revenue numbers, although that positive book-to-bill ratios in previous quarters make that the backlog is up 6% over the past year to $2.77 billion.
On the back of the stronger results, the company now sees full year sales up 18-19%, with adjusted earnings seen a midpoint of $2.00 per share. Net debt is now reported at $847 million, as an increase in working capital has limited the decline in net debt, although improved earnings power means that relative leverage is coming down quite a bit with EBITDA being on the rise as well.
And Now?
Heading into 2024, we see that Flowserve has seen incredible momentum, as management furthermore outlined a decent outlook, or at least ambitions for earnings growth in the years to come. This however has to come without the contribution of Velan, which is fine as deleveraging efforts have been held back by growth in 2023.
What is clear is that operating momentum has reversed as the oil & gas sector has seen a revival post the pandemic. Moreover, the early contributions from a change of product offerings are starting to pay off. This includes a greater focus on 3D technology, as well as focus on LNG, hydrogen and carbon capture, among others.
Given all this, I am happy to hold onto a modest position as the improvements have really showed up this year, and while the Velan deal rejection is a small setback, the overall outlook is good. All in all, I find comfort in the momentum and growth in future earnings, making me quite upbeat here to hold onto a modest long position.
