福斯 (FLS) 2015 Q4 法說會逐字稿

Welcome to Flowserve's 2015 fourth-quarter earnings call. My name is Paulette and I will be your operator for today's call.

(Operator Instructions)

I will now turn the call over to Jay Roueche, Vice President, Treasurer and Investor Relations. You may begin.

Thank you, operator, and good morning everyone. We appreciate you participating in Flowserve's fourth-quarter and full-year 2015 earnings call.

Joining me this morning are Mark Blinn, Flowserve's President and Chief Executive Officer; Karyn Ovelmen, Executive Vice President and Chief Financial Officer; and Tom Pajonas, Executive Vice President and Chief Operating Officer. Following our prepared comments we will open the call to your questions. As a reminder this event is being webcast and an audio replay will be available.

Please be aware our earnings materials do and this call will include non-GAAP measures. Please review the reconciliation of our adjusted metrics to our reported results prepared in accordance with generally accepted accounting principles which can be found in both our press release and earnings presentation.

Please also note that this call and our associated earnings materials contain forward-looking statements which are based upon forecasts, expectations and other information available to management as of February 18, 2016. These statements involve numerous risks and uncertainties and many that are beyond the Company's control.

Except to the extent required by applicable law, Flowserve undertakes no obligation and disclaims any duty to update any of these forward-looking statements. We encourage you to fully review our Safe Harbor disclosures contained in yesterday's earnings materials as well as our other filings with the Securities and Exchange Commission which are all available on our website at Flowserve.com in the investor relations section.

I would now like to turn the call over to Mark Blinn, Flowserve's President and Chief Executive Officer, for his prepared comments.

Thank you, Jay, and good morning everyone. We will quickly recap our fourth-quarter and full-year 2015 results this morning. Additionally, and more importantly, I will outline the actions we are taking to improve our operating and financial performance.

Let me begin by saying that overall, I am pleased with our fourth-quarter financial performance which delivered full-year results in line with our expectations discussed last quarter. The downturn in our served markets during 2015 was more severe, widespread and persistent than we and the industry at large originally anticipated a year ago.

The sharp decline that began in upstream oil and gas spread across the industrial complex as the year progressed. Compounding the challenges in our served industries the strong dollar was also a major headwind throughout the year. And regionally petroleum-driven economies in most emerging markets such as Latin America remain more challenged.

Against this market backdrop I am pleased with how our organization responded. Our employees remain committed to our customers and continue to deliver quality products and services through our strong operating model focused on execution. Importantly, we have taken definitive proactive measures to better competitively position Flowserve for long-term growth and value creation. While we anticipate ongoing headwinds in the coming year, we are confident that the actions we implemented in 2015 and the expanded program and growth initiatives we will discuss today provide us with a solid foundation to drive profitable growth through the market cycle.

As we look to the future, global macro fundamentals suggest that Flowserve's end markets will continue their longer-term secular growth patterns, confirming we serve the right strategic industries. Population growth and an emerging middle class will drive energy demand and aging infrastructure in energy, power, chemical and general industries will require refurbishment or replacement. Our end markets are inherently sound over the long run, although they are currently cyclically challenged.

While we can't control the near-term cyclicality, Flowserve is well-equipped to weather periods of volatility. And our track record demonstrates that we are well-positioned to capitalize on long-term industry growth drivers even as we plan for a lower for longer environment in the near-term.

Let me dive into some of the actions and opportunities we are pursuing. While leadership in technology products and services are fundamental tenets of our competitive model the markets we compete in demand that we are also competitive with our cost structure.

In 2015 and continuing into 2016, the actions we are taking are transformational for Flowserve. In essence we are structurally repositioning Flowserve for the future.

First, we are aggressively taking actions to align our SG&A cost structure to market realities. These decisions are difficult and we consider our options thoughtfully before acting. We are not taking these actions lightly as they impact our most valuable asset, namely Flowserve's associates.

In addition, we believe the current cycle creates the right environment to accelerate the structural changes we have addressed in prior calls. These actions are critical to leveraging our global operating model and establishing a flexible, responsive manufacturing network that addresses the needs of our markets and customers. Against both of these objectives we have made significant progress against our previously announced $125 million realignment plan.

In the fourth quarter we executed over $50 million of activities, bringing the full-year 2015 year investment to approximately $80 million. This investment includes the closure or repurposing of seven manufacturing facilities and a few redundant QRCs while reducing over 5% of our workforce since the first quarter of 2015.

Beyond this announced program we also made significant strides in integrating SIHI and achieving the synergies we expected to date as part of our transaction economics. Our ability to execute on our diverse set of initiatives during 2015 has provided us the confidence and the ability to accelerate even more of our longer-term plans. We developed these actions over a number of years and initially expected an extended timeline to implement.

However, current market conditions provide the opportunity to act now. As such, we are now expanding the previous $125 million realignment initiative which we expect to execute over a two-year period. We now envision a total investment of around $350 million, including about $50 million of expense that is below the operating income line with expected annualized savings of approximately $215 million once completed.

With approximately $80 million of realignment expense realized in 2015, excluding SIHI initiatives, this leaves us $270 million remaining to execute over the next two years.

While some of our initiatives are in response to volume reductions in the current market, a majority of the actions we are taking are structural in nature, focused on capacity optimization, product rationalization, supply chain optimization and developing a low-cost manufacturing base for competitive positioning. Together, this will fundamentally change our engineered business. We have demonstrated proven success in our ability to transfer manufacturing capacity and permanently reduce costs.

During 2016 we plan to accelerate the closure or repurposing of eight facilities that were part of our longer-term plans. Additionally, we will further delayer the organization which is intended to increase accountability and performance.

In summary, when our expanded program is complete we expect to reduce our manufacturing footprint by approximately 30%, improve plant and machine utilization and significantly increase our manufacturing capabilities and labor hours in low-cost regions. We expect to realize savings of approximately $125 million in 2016 and $185 million next year. We have a proven record of reducing costs and are confident that we can deliver on this plan.

In addition to our ability to drive further costs out of the system I am equally encouraged by growth opportunities that are available to Flowserve. For instance, we see significant upside for growth in aftermarket and MRO. We have a QRC network that is well-positioned globally.

Our core aftermarket activities of parts, repairs and service have shown the resiliency we expect even in 2015. And while we won't predict the timing we do realize there is a building aftermarket tailwind coming from last year's deferred maintenance activities. As we have seen in the past, the longer facilities continuously run the greater the workload is available to us when customers do catch up.

And while much of our MRO sales are classified as run rate OE this activity demonstrates substantial aftermarket attributes. In short, a significant majority of our annual revenue is brownfield in nature, serving existing infrastructure that is permanent and needs regular attention which we believe provides opportunities to improve our share of the customer's operational spending. For Flowserve and our shareholders this work forms an attractive recurring revenue stream created from decades of our installed base and we intend to increase our focus on this aspect of our business with a number of initiatives.

We are also committed to remaining a significant competitive supplier into new large project opportunities that make sense for our business. The logic is simple: project work absorbs cost in our manufacturing facilities and keeps Flowserve as a technological leader and innovator in our industry. Additionally, custom and highly engineered products inherent in our EPD segment create a new installed base and provide a competitive advantage for future aftermarket and MRO opportunities.

We believe with the manufacturing and product optimization strategies we are implementing that Flowserve will remain a strong competitor in the marketplace while the quality of our products, brands and operational excellence remain key selling points. We also see sizable opportunities in our industrial business. IPD has done an admirable job of lowering cost to drive margin performance in recent years but the priority ahead is growth.

We have recently named a new leader for this segment that brings a proven track record of success to drive IPD forward. One of the unique opportunities available to us is to drive increased sales through the distribution channel. Our valves business recognizes about 40% of its revenue through distributors.

IPD has a number of products that are applicable to this avenue and we are pursuing it aggressively. Additionally, our acquisition of SIHI has enabled alternative go-to-market methods with a greater focus on run rate business which we can incorporate with existing IPD products.

Additionally, we now have a more extensive portfolio that we can better leverage as a result of the Innomag and SIHI acquisitions, both of which primarily serve the chemical industry. Even in the challenged market we believe IPD is positioned for stronger growth long term. In fact, we see opportunity to gain share in the marketplace across our strategic product lines.

With the depth and breadth of our unparalleled flow control product and service offerings Flowserve is well-positioned to continue adding value for our customers. Likewise, as frame agreements, multiyear performance contracts and preferred supplier arrangements gain traction in the industry Flowserve competes very effectively as we currently have over 400 such programs predominantly with substantial customers and we believe there is still opportunity in our customer focused initiatives and end-user strategies.

Lastly, Flowserve continues to demonstrate operational excellence in a continuous improvement culture that drives results. We continue to lower the cost of poor quality, pursue outsourcing opportunities and leverage our supply chain and logistics all in an effort to drive out costs. At the same time, we're committed to producing innovative products and enhancements for the industry and we'll continue to demonstrate discipline in our pursuit of new work.

Before turning it over to Karyn, who will cover our recent financials in detail, let me finish by saying that while our end markets remain challenged and may be for some time we are on top of it. Flowserve is and will remain a strong competitor with the ability and culture to drive performance.

Let me now turn it over to Karyn. And I will return afterwards for my final comments.

Thanks, Mark. As we indicated in our preliminary release several weeks ago, 2015 fourth-quarter adjusted earnings were in line with the expectations we conveyed during the third-quarter call.

Our stronger performance this quarter leveraged strong shipment levels consistent with our traditional seasonality. Our adjusted fourth-quarter EPS of $0.89 excludes realignment expenses of $0.31, negative below the line currency impact of $0.06, $0.02 for the non-cash valuation allowance on the Latin American deferred tax asset and SIHI impact of $0.01. Partially offsetting these items is a $0.05 benefit from the reduction of contingent consideration related to a 2013 acquisition. All in reported EPS was $0.54.

In our preliminary release earlier this month we indicated our fourth-quarter adjusted EPS would exclude the reserves established for an at-risk customer. As we've shown today, we did not add back the $0.06 incurred since we view this as part of our business and want it to be consistent with prior quarters.

But to compare on an apples-to-apples basis with our preliminary release our results were at the high-end of our expectations. The reserve in question is related to an at-risk customer and includes the write-down of inventory, work in process and receivables from a European company that has formally indicated it needs to rework its liabilities and if unsuccessful is at risk for insolvency.

When market conditions get challenging we recognize we will see these occurrences periodically. While Flowserve generally does not have customer concentration issues we do strive to take all the steps we can to protect Flowserve's assets.

Turning to our bookings, on a constant currency basis they declined 24.8% in the quarter excluding SIHI's contribution of $54 million. As a reminder, both the 2014 fourth quarter and full year had record levels of bookings which created tough comparisons.

Looking further at our bookings profile, original equipment orders were down 32.4% while organic aftermarket bookings declined 13.6% constant currency. As Mark mentioned, our core parts, services and repairs aftermarket business has largely shown the resiliency we expect during 2015. While we have experienced some maintenance delays the larger headwinds we face come from reduced levels of CapEx-driven aftermarket projects such as efficiency upgrades as well as fewer parts tied to new units.

Similar to all of 2015 our end markets during the fourth quarter continued to be impacted by low and volatile oil and gas prices, a strong US dollar and emerging market weakness. Certain end markets even deteriorated further in the quarter as oil drifted lower and uncertainty increased. For instance, during the first three quarters of 2015 our bookings in power, chemical and general industries held up better than we experienced in our oil and gas markets.

The trend changed a bit in the fourth quarter as we saw these markets take an additional step down as customers deferred capital investment and pulled in their maintenance budgets conserving cash. Likewise, on a regional basis the Middle East and North America were better performers through much of 2015 but this trend did not continue in the fourth quarter. However, Europe produced some relative improvement in activity levels versus the first three quarters of the year.

Latin America, our most challenged region throughout 2015, remains extremely soft with delays occurring in nearly all projects with our important customers in Brazil, Venezuela and Argentina. Considering the quarterly volatility in our served end markets and regions we experienced this year our visibility heading into 2016 remains limited.

From a sales perspective we generated $1.3 billion in the 2015 fourth quarter, an increase of 1.2% on a constant currency basis including $76 million from SIHI. This was also a 17.4% increase sequentially, again reflecting Flowserve's normal seasonality.

Excluding SIHI's contribution, sales declined 4.3% constant currency compared to last year. Again our aftermarket business held up better as sales increased 2.2% on an organic constant currency basis. For the full-year 2015 Flowserve's constant currency revenues increased 2.4% including $294 million from SIHI.

Looking at our margins, even with Q4 revenue declines of over 12% in a tough pricing environment adjusted gross and operating margins declined only modestly, demonstrating Flowserve's strong operating performance, our shareholder alignment and focus on costs. Additionally, the increased mix of aftermarket sales and some savings from our realignment actions also contributed.

Considering we're at a challenging part of the cycle we are focused on effectively managing our SG&A expenses. Our fourth-quarter SG&A declined $23 million year over year or 9.1% excluding the impact of SIHI realignment and the benefit associated with the reduction in acquisition-related contingent consideration. The decline is primarily due to lower variable compensation and modest realignment benefits.

Our fourth-quarter and full-year adjusted tax rates of approximately 29.3% and 29.1% were in line with our full-year guidance rate of 30% to 31%. On a reported basis the fourth-quarter and full-year tax rate is elevated as a result of accrued exit taxes for site closures and a non-cash valuation allowance we took on certain deferred tax assets in Latin America.

Turning to cash flow, Flowserve generated total operating cash flow of $286 million in the 2015 fourth quarter or approximately $2.18 per share. Capital expenditures were $43 million in the quarter as we continue to make disciplined investments in our business to support long-term growth.

We also repurchased approximately 1.2 million Flowserve shares during the quarter and for full-year 2015 we returned almost $400 million to shareholders through dividends and repurchases. Approximately $160 million remained available under our current share repurchase program at year-end.

Turning to our 2016 outlook and EPS guidance we are reaffirming our full-year adjusted EPS guidance of $2.40 to $2.75 a share which includes approximately $0.10 of above the line currency headwinds. Our 2016 adjusted EPS target range expects total revenues to decline 7% to 14% including a 2% currency headwind. Additionally, it reflects year-end 2015 foreign currency rates, current commodity prices and market conditions.

Guidance further assumes net interest expense in the $63 million to $66 million range and a tax rate of 30% to 31%. We also expect the quarterly phasing of our guidance to follow our typical seasonal trends. Although the first quarter is likely to be slightly more pronounced after challenged Q4 bookings an improvement should follow.

Our 2016 adjusted EPS guidance includes the operational performance of SIHI while it excludes realignment expenses, SIHI purchase price accounting and integration costs, below the line foreign currency effects and the impact of potential other discrete items. We also expect that 2016 capital expenditures will be reduced versus an elevated 2015 level where we increased manufacturing capacity in Asia-Pacific and purchased a license enabling increased aftermarket opportunities. We also plan to continue contributing to our pension plans to cover service costs even as the US plan is largely fully funded currently.

With that review let me turn the call back to Mark for his remaining comments.

Thanks, Karyn. In closing, Flowserve expects near-term market visibility to remain limited as customers calibrate around the persistent macro uncertainties.

We expect this will result in continued delays in investment decisions. However, as you have heard the near-term market challenges provide us the opportunity to focus on cost take-out, our operational performance and growth opportunities while remaining disciplined in our bidding.

We believe Flowserve is well-positioned with its extensive portfolio and consistent operational excellence. We have demonstrated success through prior cycles, controlling what we can by leveraging our One Flowserve initiative, performance culture, and comprehensive product portfolio to drive profitable growth.

As we have articulated today, we are aggressively pursuing the sizable opportunities available to us to optimize our manufacturing portfolio and footprint. And we will pull the necessary levers to not only manage through the current markets but to position Flowserve to continue to deliver long-term value to our customers and shareholders.

Operator, we would now like to open the call for questions. Thank you.

(Operator Instructions) Andrew Kaplowitz, Citigroup.

Good morning, guys. Mark, so as you know Flowserve's overall business tends to be relatively late cycle. So how do you guys get a read on energy CapEx cuts which I know you know have accelerated over the last couple months when you are setting guidance?

More specifically, how much concern do you have for additional pressure on your midstream and downstream oil and gas businesses? Really your end markets like pipeline, LNG, even refining given relatively recent CapEx cuts.

Yes, thanks, Andy. So a lot of the cuts that you've talked about have typically been with the multinationals. We do still see project activities with some of the state-owned companies around the world, particularly in the Middle East.

But to your point a portion of our business, primarily in EPD, is what you call late cycle. And as we've talked about before, and you started to see this happen in the middle part of 2014, they start to curtail their CapEx expenditures. You've seen this with the multinationals trying to protect their dividend.

And the fact is those things can go off the drawing board, get pushed a little bit and they don't come back real quick from primarily from the multinationals. So they don't decide necessarily overnight to bring it back online. But typically these are in their long-term plans.

So this is part of the reason if you take a step back and look why we primarily focused on our engineered business with some of these realignment activities we've been looking at these for years. If you look at what has occurred over time, and it's important that people understand this, we came through a strong cycle in 2008 and in 2009 we adjusted to markets. And they picked up relatively quickly.

There was still quite a bit of activity in the Middle East. But more importantly what we did is we started setting up a lot of our SPO facilities in India, China, enhanced the one we had in Mexico, built out more capabilities. And our LPO/SPO strategy is designed to start to qualify these so that ultimately we can move the product and work to those locations.

So we've had these things on the drawing board for a while. What this late cycle component does is gives us time to go ahead and execute the backlog that we've had for the last year, year and a half and we still have backlog, and there are projects that will still come into backlog, but for the most part we execute that and then start moving those capabilities to these low-cost regions of the world.

If you look at around some of the pipeline and other activities, some of those are on some of our run rate business and that's not as late cycle. A lot of that is we talked about earlier some brownfield activity. So there still is some good brownfield activity because what happens is a lot of these facilities continue to run and they still need repair and upgrade.

So kind of walking through it, what the market environment does allow us to do, and this is why we're doing it, is it allows us to plan and execute and accelerate some of our what we'd call transformational activities around restructuring primarily in our engineered segment.

Got it, that's helpful, Mark. Okay, so let me ask you about the aftermarket in the context of you mentioned last cycle, obviously in the last cycle, very different cycle but your aftermarket was flat in a difficult market.

Aftermarket bookings in 4Q were down 11%, so the question is how do we think about your aftermarket business in the context of some of these big customers seemingly continuing to pull back on maintenance spend? Do you think you can maintain or increase the level of aftermarket bookings from the mid-$400 million range that you had this quarter or could it go lower still in the current environment?

Well, if you look back to the prior cycle we saw something similar in that there was they defer their spend as long as they could. But it came back within the year back towards the end of 2009 some of the spend activity.

First of all, you talked about Q4. In the year-over-year compare we had about $550 million of bookings in Q4 2014. That was a very, very strong quarter.

That had a lot of parts tied to new units. It also had a lot of upgrade projects, so those are small projects within the aftermarket portfolio. If you strip that down and you look and you see that our run rate base maintenance was down only slightly year over year both on a quarter basis and on a year-over-year basis consistent with what we saw back in 2009.

So we'd expect that to stabilize unless there's any kind of disruptive event that occurs out there. I mean what our industry saw across the board was very little activity in Q4, particularly on the project and even on the run rate side, that was reflected in our bookings. But we have seen some stability in the aftermarket business.

My comments earlier is some of the deferred maintenance will need to come back and come back online. What we're looking for is to see where the efficiency upgrades come back in and while they are rationalizing CapEx that may take some time. So that is market driven.

From our standpoint what we need to do is continue to execute on some of our end-user strategies. I've talked about this before but frankly we don't know where all of our installed base is. We're working with some of our teams to increase an inventory where that is so we can call on those customers.

They want us to help them, we just need to know they are there and to call on them. So we are going to continue to execute end-user strategies like that in an attempt to grow the aftermarket business in any environment. And in fact, if you look over the last seven to 10 years you've seen a fairly consistent strong growth through cycles.

Most of that is not the net incremental installed base. There was a base amount of net installed base that went in but the fact is the growth rates were higher than that and that was primarily from executing these end-user strategies. But when you look at our business, when you have volatile moves in oil it takes everything with it.

Everything tends to move in tandem. When things tend to stabilize and normalize out even at lower levels then you can get what I'd say is differentiation in your end-user strategies and any other strategy you want to execute.

So if I'm hearing you correctly, as soon as oil stabilizes if it has stabilized you should see more normal aftermarket behavior. Is that fair?

That's fair. If you think about our customers, they are trying to figure out what the number is and they make investment decisions, capital decisions all around that. So I think that's part of what you see in the industry is that volatile moves, and we saw it when oil moved up by the way back in 2007 so rapidly, volatile moves tend to increase the correlation of bookings and all other activity to that movement in that underlying resource.

When things tend to stabilize, then end-users can start making investment decisions that are more longer term. But when the short term is so volatile it's just tough to make a decision. That's the way everybody is.

Mike Halloran, Robert Baird.

Good morning everyone. So first, just kind of finishing, rounding out that last thought, it doesn't sound like you think that there's a shift going on in the customer base on the aftermarket side between insourcing that type of work or outsourcing it to providers like yourself. So maybe you could just touch on that a little bit and if there's any change in trend line there if it's pretty normal relative to what you would have seen in previous cycles.

Yes, I don't think there's any significant shift. If you think about it, Mike, you look at the complexity of the equipment that goes in, that tends to lead to more outsourcing because the capabilities internally for the complex work they are always going to look to absorb their fixed costs in good times and in bad. The trends that are occurring is the equipment is becoming more complex, that is certainly one.

Also a lot of the resources internally to our customers are aging and retiring and they would prefer to outsource that work. Then you add to that some of the capabilities we have around the end-user and this is going to be an opportunity, it's not just maintaining repair and servicing but it's how do we get more efficiency out of those products. We haven't seen a lot of that recently but that trend will continue.

But short term, Mike, in fairness everybody looks to cover any of their fixed costs. So I can't say that didn't happen on the margin but that's not a long-term strategy for a refinery or any kind of processing plant is to try to bring that in internally. Short term maybe some of the things they'll do but on the complex equipment they will tend to let the experts do it.

Yes, that makes a lot of sense. And then on the IPD plan to move towards that distribution market, I guess a question on balance, how do you balance moving new products into that market versus an ability to maintain a margin profile, speaking more on the idea of the level of engineering and aftermarket that's going to go through the distribution channels a little lower. So just talk about how you can protect the margin profile if not even do better than that as you move into new channels there.

The simple answer is I will point to FCD. I mean they've done the thing, the same thing. You can make money through your distribution channel.

I think if you take a step back and look at IPD, our focus was on improving the operations and the margins which we've done. If you look at all the adjustments and take out the at-risk customer we were over 16% in the fourth quarter. So from our standpoint mission accomplished in terms of the margin improvement.

But some of my comments earlier were this group broke out of the engineered business and we have a real opportunity to improve how they go to market. Various channels, configure to order on electronically in terms of being able to respond, some of these pieces of equipment are a couple hundred dollars, $500, $600, $1,000, $1,500, the customers aren't as price-sensitive, they just want it and they want it now.

So if we can execute through our online capabilities and improve those or through a distribution channel typically you can command margin because they need these for their brownfield activity. So I think part of what we're lining out for you is this is a segment of our business, and frankly we've learned a lot from the SIHI acquisition, this is a segment of our business which has some great opportunity.

We just need to improve it. We need to improve the way we go to market and how we execute into the channels.

And Mike you've always known me. I'll say if things aren't operating the way they should be I'll tell you, and this is one that has real opportunity for improvement on the top line.

Great. Appreciate the time, Mark. Take care.

Charley Brady, SunTrust Robinson Humphrey.

Thanks, and good morning. The commentary on EPD, on the bookings in the quarter obviously really heavy aftermarket weighting 72% or so which is I think probably unusually high for that business.

You kind of understand why given that that's a large project business. But I'm wondering can you maybe talk about the margin impact on that significant mix shift in aftermarket versus OE, when you tie that in with obviously you've got some absorption because the OE is just dropping off. I guess my question at the end of the day is what level can you maintain the margins with aftermarket to offset the absorption issues you're hitting on EPD?

You're trying to find the math of what's the inflection point. But you're right, with low-level bookings in the project business you will have an absorption issue which can get pretty expensive.

And part of the reason, not necessarily just the Q4 bookings, but part of the reason we're addressing that in that segment, Charley, we had looking back to 2014, and folks would have considered that a decent market and a good year for us, we had about $150 million of underabsorption in our business. And a lot of that was in that engineered segment. That's what put us on the path towards what we at that time was going to be about a five- or six-year transformation of that business.

Now you never get your underabsorption down to zero but you certainly can get it to $50 million to $70 million in your business. So I just want to make that point around that engineered segment because that's a lot of the reason we're taking those actions is to help it variabilize and be much more competitive and not have to deal with underabsorption.

It had an overhang coming into this downturn and so part of that is we need to attack that. Once we attack that I think you're going to need to see higher levels of project bookings. In Q4 there were a lot of projects that were right there in front of us and they got pushed.

And that's not atypical because the customer can wait a couple of quarters and see where markets settle out and it's very, very competitive. And it's to their advantage to wait over a short period of time.

So I think what you're going to see is as we start to address that we will deal with the underabsorption. The aftermarket mix will help but there's a lot of large expensive facilities in this division. So it's going to need project work, but we will offset that by starting to take cost out.

That's also some of the facilities we took out last year. So I don't have the exact math because part of it is how we get at the costs both in terms of the gross margin line underabsorption, in the fixed costs as well, as we mentioned earlier we're taking action in some of those areas as well and then where the aftermarket business comes in.

Okay, thanks. My follow-up here is on M&A just quickly, I guess does the current market environment as lousy as it is in oil and gas change your thinking directionally on where you want to look towards M&A as you look out to your pipeline and maybe does it move you toward areas that maybe a year and a half, two years ago you might not have been thinking as strongly about?

Right. Well, let me tell you, one of our biggest cash M&A opportunities is this restructuring. It's got a great return.

But Charley, no. We've had our line of sight on certain industries which we find attractive. And the real question is at what time do they make sense?

I think what you don't want is for us to decide all of a sudden to go in a left-hand turn direction into some area that's not core to us just because it may be viewed as relatively cheap. So it's fair to say that we're still focused on the areas where we think we make money.

The chemical industry, we've talked for years around the opportunity around upstream, additional downstream or service capabilities. We made a small service acquisition last year. So we're going to stay focused on where we think we make money long term.

There's a couple of things we need to think about. One is we don't want anything to conflict with these restructuring activities because this is a high return on our investment and we need to execute them very well because our customers are relying on that.

The other thing to think about is just we need to make sure we're very thoughtful with our cash both in terms of the restructuring and our shareholders as well. There is always opportunity to use your stock as currency but we'd have to look at that relative to the asset that we're looking at.

So we are clearly opportunities may come in this type of environment, especially for a Company like ours that has a very strong operating platform, but we need to always balance that against other priorities. And what I will tell you is when we can return $215 million a lot of it is going to be permanent in our business. With $350 million of spend, that's pretty compelling.

Yes, thanks very much.

Nathan Jones, Stifel.

Good morning, everyone. I'd like to just ask a couple questions about working capital and perhaps get Karyn's take on this now that she's been there for a while.

You ended the year with core working capital about 35% of 2015 sales which has gone up considerably over the last few years. What tactics are you guys using to get that down? What's a long-term target look like and how long does it take to get there?

There are several things going on. First on the accounts receivable side, we are seeing slower payments, in particular Southern Europe and Latin American customers. They are continuing to pay but albeit just slower.

Accounts payable is down with inventory up. The majority of those increases in inventory are in working capital. So adding cost but not necessarily in purchased parts. It's more labor and less payables associated with that inventory.

Also in terms of accounts payable negotiating the terms with suppliers we will pay according to terms and all through 2015 there's an emphasis directionally. It's paying on time. We have a lot of local suppliers, so paying on time helps with timing and on-time delivery as well as directionally pricing.

We have been focused locally at the sites in terms of improving working capital. As I mentioned on the third-quarter earnings release call we are stepping back and looking at this now going forward on a more global perspective and really looking to implement a global standardized procedures around billings and cash and collection as well as on order and purchasing.

So those are the types of things we're going to look at. Those types of programs take time.

I think in addition with the realignment going on we will see improvements ultimately when we get through this process. It will take a couple of years but as we consolidate and streamline our sites we should see improvement in working capital. But in the near-term we don't expect any significant swings.

Understand that. If you think longer term is there a number that you think Flowserve's structure should operate in terms of a percentage of sales in working capital or working capital turns or however you would like to frame it? Because it does seem like there's probably several hundred million dollars in working capital that you could free up to put to better use.

We do believe there's some value there. We don't have specific targets at this point. Like I said we're going to look at this in a more standardized global perspective so versus really at the local sites. But, yes, we do believe there's some improvement there but we don't have specific targets at this point.

And Mark, I think you mentioned in response to one of the last questions that there were a few projects right there in front of you in the fourth quarter that got pushed. Are those things that got pushed significantly or are they imminent? Could those orders come through in the first half of the year or have they been pushed further out at this point?

These were fairly well down the road and they seemed to move but they can move from quarter to quarter. We've seen this happen before but we did see they moved.

And Nathan, they can move still another quarter or two easily. We still have confidence they are going to come online but remember they are very competitive. We will respond but only to a point because if you remember back in 2009, 2010 and 2011, we had a lot of backlog that didn't have value to it and that doesn't accomplish anything for us.

So it is a competitive environment. These things tend to push. We have confidence some of them, particularly in the Middle East, are going to go forward but just remember our environment is very competitive.

Okay, thanks very much. I will jump back in the queue.

Joseph Ritchie, Goldman Sachs.

Thanks, good morning everyone. So I guess my first question is on the restructuring plans, Mark.

Maybe you can talk a little bit about the magnitude and the cadence of the restructuring in 2016? And then specifically, is it fair to assume that a lot of the actions or a disproportionate amount of the actions are occurring in EPD?

Some of the large transformational ones in the large plants are in EPD, yes, Joe. And a lot of these as we talked about are in OECD countries and quite a few in Europe and they take time.

You've got to have a long planning process in terms of just dealing with your constituencies. But generally what my comments were is we expect to see about $125 million of benefit this year, $185 million next year. So all other things being equal we will get an earnings lift next year from just these restructuring activities and then we'll see the run rate in 2018 which will take us up to $215 million.

Okay and then from a cost perspective you're incurring about $150 million this year, is that kind of ballpark-ish the right number?

I think that's the number that we talked about earlier.

Okay. And then maybe my one follow-up is really around pricing. It looked like your gross margins in the fourth quarter decelerated a little bit versus the rest of the year.

Just curious to hear what you're seeing on the pricing environment. Have things have gotten worse? And given that you have seen significant CapEx cuts to start the year from some of your customers, I'm just curious to hear what you're hearing from your customers today.

Well, some of those margins in the fourth quarter had these two customer issues that we talked about it. So a lot of them were up in the gross margin line. But in general we were actually pleased that our margins held up relatively well.

But what you will see in the gross margin line is the pricing environment and to the extent we can offset it by some of the restructuring activities. Because a lot of those sit in the gross margin lines to the extent they impact manufacturing facilities. It is just going to be the timing in terms of when we can execute them, some of that is outside of our control.

What we are seeing from customers, and just remember we didn't have a really strong pricing environment in 2013 and 2014. It was okay, versus the last cycle we had a tremendous pricing environment in 2007 and 2008. But we're certainly seeing it down get competitive at that point in time.

The other thing that we'll have to deal with as the top line goes down is underabsorption and how quickly we can offset that with some of the restructuring as well. But the pricing environment is competitive. We saw this back in 2010 primarily because a lot of the project activity in 2010 was in the Middle East and that is always competitive in just about any environment.

Typically you have Korean engineering and contracting firms there. They tend to be very competitive on price and demand that of their suppliers. So we're starting to see a very competitive environment.

The real question, Joe, is how long this is going to last. Because the late cycle part of our business, which is the projects which as we've talked about has been well less than 20% of our business, it tends to the opportunities tend to move out quick and move back slowly.

Thanks, Mark.

Robert Barry, Susquehanna.

Good morning, guys this is [Phillipe Forlorne] on the call for Rob today. So first question, going back to the restructuring, I mean the benefit of course looks up nicely versus the previous target but the return on the investment looks lower. Is that the message that incremental savings are becoming harder to find and is there any potential upside to these numbers if the environment were to get worse?

No, the numbers are really reflective of the type of restructuring that you have. $125 million for $125 million is pretty much a one-for-one payback or a one-year payback. You don't typically see that in Europe.

It costs more but the fact is those savings are permanent. And also what you saw was a lot of the initial part was what I'd call volume-related headcount reduction as opposed to permanent closures of facilities. But when you close a facility anywhere, but particularly in any OECD part of the world and particularly in Europe, it costs more than the savings but the savings are permanent.

I think the important thing to think about when you take a step back is if you look at our business a lot of our heritage capacity going back 10 years was in very expensive parts of the world. And we're changing that. So what that will mean is even some of our OECD facilities are going to be have higher load levels and higher engineered equipment in them and we're going to take more advantage of some of our low-cost manufacturing around the world.

So that's why we're trying to emphasize this is permanent. This is the kind of thing that would've addressed that $150 million of underabsorption back in 2014 and not only that would have significantly improved margins once executed.

So as you think about us moving through the cycle and where margins have been this is something that will all other things being equal relative to last and we think things are going to -- some things are going to change. But the fact is if we had this type of manufacturing profile four or five years ago our margins would have been a lot higher.

Okay, that makes a lot of sense. And then on your 2016 outlook does that imply any recovery in refining MRO spending? And what's the latest outlook there given your discussion with customers?

Well there is an assumption that there will be some stabilization and some investment in some repair and maintenance in the business. But we're not really expecting the aftermarket upgrade and certainly not the tied to units to come back during that period of time. But it does have some of our initiatives around improving the go-to-market strategy and IPD that's in that.

So it's not a matter of us just sitting back and letting the markets deal what they are going to deal. We have to go and execute some of our strategic initiatives to achieve our guidance.

Okay, thanks guys.

Chase Jacobson, William Blair.

Hi, how are you? So Mark, you talked about increasing the aftermarket sales and doing a better job tracking where your equipment is going. But you also talked about more sales going through distribution which I thought would maybe make it harder to track the products and capture the aftermarket.

So I guess one, can you address that? And two, as you do try to track the products better and capture the aftermarket are you putting more people on the ground or are you doing something where you're adding more technology to your products?

Yes to both. Technology to the products, some monitoring capabilities, boots on the ground but also technology systems to track our installed base.

Going back to your earlier question the distribution channels, those are out and present there.

We're just not taking full advantage of them in our industrial product segment. And these are distributors that can carry multiple products lines and are responsive on a one or two product basis to a customer that needs it fairly quickly.

The end-user strategies are really designed around where there's substantial installed base. If you look at some of the refineries around the world there is hundreds of pumps that are out there. And all over the world. If you look at our heritage brands going back many years there are literally some pumps that were installed in the 1970s that we're still supplying parts to in remote parts of the world.

So it's really around getting our hands around that, inventorying it, making sure we're calling on the customers. So one of the things that we've done this year, and you alluded to it a little bit, is really increased our focus on our sales organization and how we get out to customers on an account basis and get more share of their wallet. Part of it is knowing what customer to call on and what product they have in their facilities.

So we will be the first to tell you we can do a better job on that and that is one of our key strategic end-user initiatives this year. So if you think about how we've rolled it out over the last couple of years, we've increased our QRC network and we'll continue to do that. We've worked with systems and some end-user strategies to help them develop and understand how they can bring more efficiency out of an existing facility because even right now they are looking for higher yields out of their processing facilities.

The other element now is making sure that we have the right people calling on the right customers not just out of a QRC but our salespeople. And that's a separate and distinct strategy from using the distribution channel. The distribution channel has been very powerful for our valve business, we just haven't levered it on the IPD side.

But your point is fair. A lot of this is OE that goes through distribution as opposed to service and repair work. But a distributor they want to get certainly margin as well but what we found, and you've seen in our valve segment, is we can still get good margin on product that goes through distribution.

Keep in mind what the customer is looking for is they are looking for that product there very, very quickly. These aren't multimillion dollar pieces of equipment. These can be in the hundreds or even in the low thousands, so time is of the essence.

Okay, that's helpful. And then when you do your due diligence on some of the larger prospects, I mean it seems like always and especially in this environment the customers tell, whether it's the E&C company or the equipment suppliers they tell you that the projects are going forward until they are not. So I guess what is Flowserve doing differently now to make sure that you're putting more resources after the projects that are actually going to go forward versus the ones that are just always out there and always getting pushed?

Well, if you think about it when we interact with these customers we're doing a lot of the design work for these products for these facilities working on standardized nation. Some of our large customers we have quarterly meetings with them to go through exactly what they are planning.

It's in nobody's interest that both sides don't understand what's going to happen. And what I mean by that is a customer if they are going to go forward with the project they have reasons, long-term reasons to do that. They may push it a couple of quarters, so once the project starts moving down the road, we have a pretty good sense it's going to go forward.

Sometimes they get canceled. We saw that last year some projects that we thought really were going to go forward did get canceled. It was by a multinational that was very focused on short-term capital.

But where we see projects drop-off are the ones that are in the ideation phase that are going on the drawing board. As people look for visibility around the underlying value of the resource they may put them off at that point in time. But I think what I want to explain to you is there's a lot of work that's done before these things are bid, so in doing that we get pretty good visibility.

And I would add to that we do take a look at the financing in place for the project, does the project have offtake agreements in place for the commodity that they are producing. We also have different levels of activity. So something that is in the early stages we would deploy a budget level of resources.

If all these things that I've mentioned and Mark mentioned are in place then we will deploy more elaborate resources in order to go after that potential proposal. So we have a pretty good system for weeding out those that are in early stages versus those that are more firming up and getting ready for real proposal activity.

Jim Foung, Gabelli & Co.

Hi, good morning everyone. So I just wanted to maybe you could size up the opportunity in terms of selling the industrial pumps through distribution.

How large is that opportunity for you? I presume it would be incremental to what you're doing now.

It is, it is incremental. If you look at our valve business approximately 35% to 40% of their business goes through distribution. And we're sitting probably less than 10% on the industrial side.

In fairness I wouldn't say that 30% differential is all incremental because part of what we need to do is have discipline around what products go through our salesforce and what goes through distribution. Because frankly a sales organization would want to have all their products at their disposal to sell but the fact is they will only really focus on selling a few and we've seen that. But a lot of that is going to be incremental in the business if we get it up to the rate that our valve business is operating at.

So net you're in the distributive -- you're in a lower margin through the distributors, net-net your bottom line would improve from just the higher volume.

Well, you do get higher volume but as I mentioned earlier, time is of the essence. And so while distributors can make good margins we make decent margins on products that go through distribution. If there was a significant margin differential companies like ours would go direct to market but the fact is there's a lot of value in our distribution channel.

And Jim, we're not talking about big, big projects going through distribution. Again these could be $1,500 pieces of equipment and where the distributor adds value is they carry an array of products that they can serve the customer fairly quickly, oftentimes they are approximate to them. And so I'm not saying a customer is ever price insensitive but they are really focused on getting having that product available along with some other products that we may not serve into that customer and getting response quickly and getting their facility up and running.

And Jim, if you look at distributors there are many different types of distributors that add value. Some are just buy and resell, some will add content to it, some will add an engineering value add to that. So that distributor is really a route to market that we choose based on the value added that that distributor can bring to that product in the territory or region that the customer is in.

Jonny Wright, Nomura.

Good morning, guys. On the restructuring if we can just look at that from a different angle, I think historically in the valves you always hear a lot about increased competition from low-cost Chinese competitors.

You guys are now looking to kind of pivot the manufacturing base away from developed economies into places like China. How do you maintain the Flowserve brand whilst doing that with your customers? And also how do you think about avoiding passing that price, passing the cost discounts on to the customer in the form of just lower prices and becoming more of a like-for-like competitor with the low-cost Chinese guys?

Well keep in mind low-cost Chinese are typically in our lower tier products. So some of these are very highly engineered pieces of equipment and we don't necessarily see a lot of competition from Chinese suppliers. These are high-end control valves, actuation highly engineered pieces of equipment.

But here's the important thing, the way we do this is with the permission of our customer. So part of what we've been working on over the last couple of years through the LPO/SPO strategy is working with our customers to qualify some of the manufacturing in low-cost parts of the world.

And don't just mention China because labor rates have gone up quite a bit there. We're talking about various parts of the world India, Mexico.

But the other thing to remember with our customers as well is oftentimes they want to deal with the OECD facility. So sometimes what we do when we talk about repurpose is we'll make that facility engineering, assembly and test. It will still be the front-end but a lot of the activity around the value add to the piece of equipment will be done in a lower-cost part of the world.

So I'm not suggesting customers on highly engineered pieces of critical equipment are wholesale moving everything to low-cost parts of the world. That may occur over time and we're prepared to move with them in doing that.

But I think the important thing, these aren't commodity sold by the pound type equipment that typically get fully converted over to a low-cost region of the world. We don't expect that to occur over the short term but we expect it to occur faster than when it has occurred over the last 10 years which is why we're taking these actions, one of the reasons we're taking these actions.

Brian Konigsberg, Vertical Research Partners.

Good afternoon. Just a couple of quick questions, most have been answered, but can you just give a little bit more clarity on the restructuring or the spend you're doing below the operating income line? What are you targeting specifically and what type of savings are associated with that action?

Below the line typically those are going to be exit taxes, any non-cash asset write-down or certain things that are sitting below the line. But a lot of those are going to be exit taxes in the business. It's just not easy to move from OECD countries.

Okay. So is there a payback associated with that or is it just spending that needs to be done because of the move?

It needs to be done as part of the move. I would look at it holistic and just take a step back and say we're going to spend $350 million. Most of it is cash.

There is some non-cash component to that. Most of it is cash to get $250 million of savings all of which is cash. It's still a great payback.

And also just maybe can you expand a little bit upon just the customers from you had a bad customer expense in the quarter, obviously there's stress really across the globe in the oil and gas space. Do you see -- what do you see from the rest of the customer base? Are there other accounts that are particularly stressed at this time where you might have to take similar actions over the course of 2016? Any color on that would be really helpful.

Well things could happen. Typically a lot of our customers we don't have high customer concentrations in terms of sales but there are certainly at-risk parts of the world. If you look at Latin America there's certainly things that are going on down there.

We don't typically have -- we serve a lot of large customers but these things can occur. One of these was a relatively medium-sized distributor or a small-sized distributor that went out of business. So you typically when you see the strain in our industry it typically occurs in the first 18 months, maybe two years.

We don't supply necessarily a lot of the upstream, smaller upstream type companies, E&P companies that you're hearing about. A lot of the companies that we serve are large names or ongoing process capabilities. But we watch this very carefully.

If I could sneak just one last quick one in, just on free cash flow, so I understand you had high CapEx in 2015 associated with the move presumably. But even if you normalize that, we haven't seen net income equal free cash flow really since 2007 at this point.

I know there's a question on working capital previously. But can you just maybe conceptually just talk about where do you think this business should be on a run rate basis from a free cash flow conversion perspective. And I don't think you gave 2016 expectations. I assume that's going to be trailing as well.

But if you could talk around that subject it would be helpful. Thanks.

Yes, so going forward from a cash flow perspective first quarter there generally is more cash outflow from operations associated with taxes, those types of things that we have in the normal first-quarter cadence. Our capital expense will be significantly lower. We had approximately $180 million in CapEx in 2015.

The expectation is that's going to be more in line with around $110 million in 2016. So in 2015 we had higher than normal CapEx, we had a license and some carryover CapEx work in 2014. Generally speaking on the working capital like I said with this market it's a little tough.

We don't expect significant swings in our inventories as we go forward. And like I said over the course of the next few years as we execute on the realignment we do have expectations that we will be able to bring the working capital down but don't see any significant levers in the short term.

Do you think that net income and free cash flow will be able to converge sometime over the next couple of years? It just seems to have been to so well below net income for an extended period of time, I'm just trying to get a sense of should we be expecting this business as it's it runs and you expect it to be run to be converting into free cash flow in line with the net income?

Part of our reducing complexity is designed to do that. It should start approaching it. It's going to take a while.

We're going to consolidate facilities, then Karyn in the years out has initiatives that we start driving shared service models and things that help really drive more efficiency across the system. But let's keep in mind we're a fairly distributed Company across multiple countries, multiple facilities.

But no question that as we take out 30% of our capacity in doing some of the reductions and complexity which we think our customers are going to demand long term, we should get better free cash flow in our business. We've been as frustrated as anybody else has in terms of trying to seek that goal but we're determined to get there.

Ladies and gentlemen, we have reached our allotted time. This concludes today's conference. Thank you for participating and you may now disconnect.