福斯 (FLS) 2018 Q1 法說會逐字稿

Welcome to the Flowserve 2018 First Quarter Earnings Call. My name is Christine, and I will be your operator for today's call. (Operator Instructions) Please note that this conference is being recorded. I will now turn the call over to Jay Roueche, Vice President of Investor Relations and Treasurer. You may begin.

Thank you, Christine, and good morning, everyone. We appreciate you participating in our call today to discuss Flowserve's first quarter 2018 financial results. Joining me this morning are Scott Rowe, Flowserve's President and Chief Executive Officer; and Lee Eckert, Senior Vice President and Chief Financial Officer. Following our prepared comments, we'll open up the call for your questions. As a reminder, this event is being webcast and an audio replay will be available.

Also note that our earnings materials do, and this call will, include non-GAAP measures. You can review the reconciliation of our adjusted metrics to the reported results prepared in accordance with generally accepted accounting principles in both our press release and earnings presentation.

Finally, this call and our associated materials also contain forward-looking statements, which are based on forecasts, expectations and other information available to management as of May 11, 2018. These statements involve risks and uncertainties, many of which are beyond the company's control. And 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 fully encourage you to review our safe harbor disclosures contained in yesterday's earnings materials, which are available 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. We appreciate you joining today's call. Flowserve's first quarter financial results were in line with our expectations and provided a solid start to the year. I am pleased that we booked and delivered a high level of aftermarket activity and ended the quarter with a total book to bill greater than 1. We also continued our journey to reduce complexity, accelerate growth and streamline Flowserve's operating model for the future.

Before updating you on our Flowserve 2.0 activities, let me start with a financial update. In the first quarter, we delivered adjusted earnings per share of $0.27 on sales growth of 6.2%. As I mentioned, these results align with our expectations and guidance.

Aftermarket revenues accounted for 50% of our total and were up 11% year-over-year, and aftermarket bookings were up both sequentially and year-over-year. We're also pleased with our solid and broad-based total bookings this quarter of $929 million, driven by growth in our general industries, power and chemical markets.

As you will recall, in the first quarter of 2017, our bookings included an $80 million refinery project award, which skews the year-over-year comparison as we did not have any large project awards this quarter. Additionally, we sold 2 businesses in mid-2017 that are included in the 2017 first quarter comparative results.

Turning now to our segments. IPD's turnaround showed modest progress in the first quarter, but we expect to gain further traction and achieve improved financial results as the year progresses. In the quarter, we delivered revenue growth of 11% year-over-year, which helped drive an improvement in adjusted gross and operating margins of 40 and 120 basis points, respectively.

Reducing past due backlog from the current elevated levels remains a priority. The shipments of this lower-quality backlog will present margin headwinds as it's delivered throughout 2018. However, I am confident in the IPD leadership team. They are aggressively driving actions to improve the overall operating performance of the platform.

We continue to expect to exit the year delivering mid- to high single-digit adjusted operating margins for IPD as improvements take hold throughout the year. At this level, we still will not be delivering to our full potential, and I remain optimistic in the longer-term profile for this business.

EPD also delivered double-digit revenue growth in the quarter compared to the prior year. As Lee will discuss, adoption of new accounting standards accelerated recognition of some lower-margin original equipment revenue, which more than offset the 10% increase in aftermarket activity. As a result, adjusted gross and operating margins in EPD declined 90 and 50 basis points, respectively. We are committed to improving EPD's manufacturing performance on original equipment products, which will include a number of facility closures this year to better leverage our highly engineered capabilities.

FCD achieved its highest dollar value of bookings since the fourth quarter of 2015. On a reported basis, the segment's revenue declined 1% in the quarter as a result of the noncore business divestitures we completed mid last year. Excluding these divestitures, FCD would have realized revenue growth of approximately 8%.

The segment's adjusted gross and operating margins declined 260 and 220 basis points, respectively, year-over-year. The decline in margin was primarily the result of product mix and timing. I am confident this is a timing issue and not indicative of a trend. FCD has consistently delivered solid operating performance, and we anticipate that full year 2018 will be no exception.

I want to provide a little more color on our bookings and end markets. While we received no large products -- projects in the first quarter, we did win a number of $3 million to $8 million awards, driven by our base or foundational business. This solid performance helped partially offset the impact of the tough prior year comp, which included divested businesses and the large refinery booking. Additionally, based on our improved visibility and solid quoting activity, we are optimistic about our near-term market environment and believe we can deliver sequential bookings growth in the second quarter.

Furthermore, with the cycle turning, we are determined to begin recovering some of the industry-wide original equipment pricing declines that occurred in recent years. Since the beginning of the year, we have initiated 2 price increases on our base business to help improve margins, offset cost increases and mitigate the impact of a changing and dynamic global trade environment.

Additionally, we have moved our margin threshold higher in our EPD original equipment business to begin the margin recovery journey in this platform. We believe this pricing discipline and approach will deliver value for our shareholders over the long run.

Our aftermarket franchise has proven resilient throughout the cycle. In the first quarter, we delivered aftermarket bookings of $482 million, our highest level since the third quarter of 2015. Our discussions with customers continue to suggest they are increasing focus on improving efficiency within their facilities, indicating the potential for increased turnaround activity and the return of smaller project and upgrade investments.

Turning now to our first quarter bookings by end markets and starting with oil and gas. Bookings decreased approximately 19% year-over-year, driven by challenging comparison due to the EPD large refinery award in 2017. FCD's bookings were up modestly, including enhanced onshore North American activity, while IPD decreased by approximately 40%, also driven by a challenging comparison.

A number of run rate awards in EPD and IPD, primarily in Asia Pacific and the Middle East, coupled with the improving commodity price, indicate improved conditions for oil and gas markets. Our confidence is supported by the strong pipeline of pre-FEED and FEED activities that has continued to expand.

In the chemical industry, our bookings increased approximately 3%, driven by FCD's and IPD's low double-digit growth on short-cycle activity, while EPD declined approximately 9%. Overall, chemical demand continues to grow globally, driving additional ethylene investments in Asia, the Middle East and North America where the second wave of the crackers continues to move forward with 3 projects now in E&C hands and several others in various stages of planning.

Flowserve's power bookings increased 10% year-over-year, driven by strong performance in EPD and IPD and included nuclear awards in Asia Pacific and a desalination project. The power industry is the most challenged industry that we serve, and we're not counting on significant near-term growth in this space.

General industry bookings increased over 17%, driven by strength in EPD and FCD and a modest increase in IPD. The increase was largely driven by distribution, including strength in Asia Pacific, Europe and the Middle East.

From a geographic perspective, we had strength in the Middle East and Africa, delivering 15% growth and saw mid-single-digit growth in Latin America, which continues to be our most challenged region. These improvements helped offset declines in the rest of the world. Due to the large refinery award last year, Asia Pacific was down 13%, while North America and Europe were also down by low single digits.

In summary, while we expect our markets to be somewhat choppy quarter-to-quarter, we continue to believe the multiyear downturn in the cycle has started to reverse course, and we anticipate an improved marketplace ahead. We believe global economic conditions are supportive. Oil prices have shown stability at higher levels. The tax reform package and regulatory environment are beneficial in the U.S., and the global project pipeline is growing.

While we remain disciplined and realistic in terms of our outlook, we do anticipate solid steady growth in our markets, and we expect to see sequential growth in the second quarter. We believe the combination of improving marketplace and our internal initiatives that we are taking to strengthen and transform the company will position Flowserve to deliver value for our customers and shareholders.

I'll now turn it over to Lee to discuss our financial results in greater detail, and then I will return for a few closing comments before we open the call to Q&A. Lee?

Thank you, Scott, and good morning, everyone. As Scott mentioned in his comments, at the start of the 2018 first quarter, Flowserve implemented a new revenue accounting standard, ASC 606. From a Flowserve perspective, implementation of this new standard had numerous moving parts, primarily due to the significant increase in contracts requiring percentage of completion accounting, also referred to as POC, or over time. While I don't intend for this call to become an accounting lesson, let me highlight some of the significant changes.

We implemented ASC 606 under the modified retrospective approach. Under this methodology, certain contracts which have remaining obligations as of the effective date, are recognized in retained earnings at January 1, 2018. The impact on Flowserve is that $237 million of year-end 2017 backlog, equating to $0.15 of EPS, was recognized in retained earnings under the new standard.

With 23% of our revenue this quarter now coming from contracts under percentage of completion compared to just 3% in the first quarter of 2017, the new standard increased our revenues recognized this period as compared to the former standard. These POC revenues of $71 million were primarily timing related and were dilutive to our reported gross profit margin that's mostly related to larger OE projects. Since very little SG&A was applied to the incremental amounts, the revenue was modestly accretive to our operating margins and our EPS.

Our balance sheet now has 2 new line items called contract assets and contract liabilities that are essentially for our projects in process. The amounts in these new categories came primarily from what previously -- what is shown in receivables, inventory and accrued liabilities.

To wrap up this topic, let me reiterate that we knew this new accounting standard was coming, so our expectations and guidance were based on it. It was a major accounting effort due to the number of contracts affected, new locations doing POC for the first time, the multiple ERP systems that exist within the company and, most significantly, closing the books and reporting using both the new and prior accounting standards.

I am proud of our team for getting this done. We do expect, however, that our financial reporting will occur a little later in the cycle for the remaining period of this year, similar to this quarter's timing.

Let me now return to why we're here, which is discussing our financial results for the quarter. Flowserve delivered adjusted earnings per share of $0.27. Again, very much in line with our expectations we discussed on our last call and the guidance given. On a reported basis, earnings per share of $0.12 included realignment expense of $0.07 and $0.05 of global line currency impact and $0.03 of discrete corporate items.

First quarter sales increased 6.2% to $920 million. In addition to the new accounting standard, we incurred roughly a 2.5% headwind as a result of the divested businesses Scott spoke about earlier, which were offset by approximately 6% of currency tailwinds on the weaker U.S. dollar. Aftermarket sales increased 11% to $455 million, representing 50% of our total revenue for the quarter.

Looking now at our gross margins. Our adjusted gross margin of 30.3% was down 130 basis points versus the prior year's first quarter. Lower-margin original equipment revenues, including the impact of the new revenue recognition standards, more than offset our incremental cost saving and a 300-basis point mix shift toward higher-margin aftermarket activity. On a reported basis, which included increased year-over-year realignment charges, our gross margin decreased 160 basis points to 29.5%.

Adjusted SG&A was basically flat in the first quarter as our continued incremental cost savings initiatives largely offset the impact from the weakened U.S. dollar. As a percentage of sales, adjusted SG&A decreased 110 basis points with improvement across all segments. Reported SG&A increased due to the currency headwinds despite cost efforts and lower realignment spend.

First quarter adjusted and reported operating margin declined 30 and 100 basis points to 6.8% and 4.9%, respectively. As Scott discussed, we delivered modest improvement in IPD's adjusted operating margin, which were offset by FCD's 220-basis point decrease as a result of timing and shipment mix. You will note we are no longer adjusting for IPD's PPA related to the SIHI acquisition, which was about $1.25 million in the first quarter.

Our reported effective tax rate was high in the first quarter, primarily related to losses in certain regions where no tax benefit was realized. On an adjusted basis, the effective tax rate for the quarter was 27.5%, which is in line with our full year expectation of 27% to 28%.

Turning to cash. Although our total operating cash flow was a use of $121 million, reflecting traditional seasonality, our cash balance remained strong. We finished the quarter with over $0.5 billion of cash and cash equivalents, more than $200 million above March 31, 2017. In the first quarter, we returned $25 million to shareholders through dividends and had capital expenditures of $13.5 million, down about $2.4 million from a year ago.

While the first quarter tends to be seasonally weak, as I've discussed before, our working capital performance is still not where it needs to be and remains a priority to reduce. In 2018, the company is focused on implementing sustainable improvements [to support] working capital processes. We are changing the foundation of all aspects of our order to cash and sales and operational planning processes. We expect the initial benefits of these changes to begin being recognized in the second half of the year. Looking forward, our clear expectation is to deliver stronger cash flow performance.

Turning to our 2018 outlook. With our first quarter results in line, which kept us on pace for the full year, we reaffirm our full year EPS target range of $0.95 to $1.15 per share on a reported basis and $1.50 to $1.70 as adjusted. We also confirmed our expected revenue growth of 3% to 6%, including a 2% full year currency benefit and roughly a 1% negative headwind from last year's business divestitures.

The adjusted EPS target range excludes the 2018 expected realignment and transformation expense of approximately $90 million as well as below-the-line foreign currency effects and the impact of potential other discrete items which may occur during the year. Both the reported and adjusted EPS target range assume year-end FX rates and commodity prices, current backlog, expected booking levels and market position and a minimal impact from the adoption of the new accounting principles as new awards coming in are expected to offset the loss backlog.

Net interest expense is expected to -- expected in the range of $58 million to $60 million with a tax rate of 27% to 28%. Additionally, we expect traditional earnings seasonality, although for it to be more pronounced in the second half of the year.

We also expect to use approximately $100 million of cash in 2018 to pay dividends to our shareholders. We will remain disciplined in capital expenditures but plan to invest in some enabling technologies for Flowserve 2.0, which should bring full year CapEx to the $80 million to $90 million range. We expect to pay down approximately $60 million in debt and contribute approximately $30 million to our global pension plan mainly to cover our ongoing service costs as the U.S. plans remain largely fully funded.

Now let me turn it back to Scott for his closing remarks.

Great. Thanks, Lee. I'll conclude the call with an update on our internal initiatives designed to transform our business model to better serve our customers, engage our associates and reward our shareholders. We call the initiative Flowserve 2.0, and we're taking the best from our past, improving on it for the future.

In the February call, I discussed the initiative in some length and highlighted our recent completion of a full-scale internal assessment across 6 key areas: operations, commercial, growth, aftermarket, G&A costs and working capital. Since that time, we've gone from assessment to now taking action.

It is still early days, but we have now formed a fully dedicated transformational office with some of Flowserve's brightest associates. We are augmenting this team with third-party expertise where needed. The singular focus of this group is to accelerate and drive sustainable and value-creating change to improve our operating model. We're changing the way we think, act and operate to better drive growth and reduce costs.

The transformation office is currently focused on scoping and sequencing different initiatives that are intended to ultimately reduce the complexity of Flowserve, better leverage our enterprise scale and accelerate growth. These projects fall under broad work streams that are underway in various planning stages.

Here are some examples of what we're attempting to do: improving our focus on select core markets; developing a methodical process to set and govern pricing decisions; rationalizing product lines and employing design-to-value principles; improving efficiency and effectiveness of our selling functions; driving operational excellence and consistency across our global manufacturing footprint to reduce lead times, improve on-time delivery and reduce our nonmaterial cost of goods sold; optimizing our supply chain activities across the enterprise to reduce material costs; driving increased growth and profitability across our aftermarket platform; structurally reducing G&A costs while improving efficiency and effectiveness; driving to common operating systems and process automation tools and becoming a people-first organization that embraces a common strategic vision.

As I've said before, a transformational change like we're pursuing is not easy or accomplished quickly. We are not trimming around the edges, but we are pursuing a comprehensive change to our business model that will deliver long-term benefits to our stakeholders. I am confident that these actions will increase our ability to effectively support our customers, create a more meaningful workplace for our employees and drive significant long-term value for our shareholders.

Operator, that concludes our prepared comments, and we'd now like to open the call for questions.

(Operator Instructions) Our first question is from Mike Halloran of Baird. We'll move on. The next question is from Charley Brady of SunTrust Robinson Humphrey.

A couple of questions here. Just on FCD, can you just elaborate a little bit more on the timing issue that impacted Q1? And as kind of a follow-up to that, in line with that, as you're looking towards your visibility, you commented you expect sequentially improving bookings in Q2 from Q1. Is that confidence a function of what you've seen bookings through April and May? Or is it just more quotation activity that you think hasn't hit yet but likely will?

Yes. Let Lee do the FCD part, and then I'll take on the outlook on bookings.

Yes. So hey, Charley, this is Lee. FCD had a record fourth quarter to finish the year. And a lot of that performance pulled some of their shipments from the first quarter into the fourth quarter. So they basically performed as expected, and I think a lot of the results of this quarter were really impacted due to their strong fourth quarter.

Yes. So I'd just say -- I mean, to add to it, we've got a very strong FCD team. We're confident that, that starts to get back into a more normal operating margin level. On the Q2 bookings, we feel pretty good. So we had solid April bookings, and we've got visibility to refining and petrochemical work in the near term. And we've got clear line of sight that we believe that Q2 is going to be higher than Q1.

Are those ethylene plants that you mentioned that have gone to -- the 3 ones that have gone to EPCs, are you on those plants yet? Has those -- equipment been awarded?

Some have and we're participating and others are still in the pipeline.

Our next question is from Andrew Kaplowitz of Citi.

Scott, so when you think about Flowserve 2.0, can you give us an update -- obviously, I think last quarter, you talked about at some point setting out official targets. You talked today about improving efficiency in the factories, optimizing the supply chain, among other things. But is it -- are you ready at some point to give us a time frame of when you think you might be able to say that the company is more simplified? And how do you think investors should judge you on Flowserve 2.0? Should we see meaningful improvement in performance by the end of this year?

Sure. Yes, so I think the best way to think about it, I said a little bit in the prepared remarks, is the way we're using Flowserve 2.0 is it's the vehicle to accelerate our transformation. We're not satisfied with the performance of the company, both operationally and financially, and we know we've got to do things differently. And as I kind of worked through the back half of last year, it was -- what was -- we had to do something as a catalyst internally to start to drive significant change. And so that's why we've created this initiative. And as we talked about, we did a very holistic assessment in the -- that launched in the fourth quarter. It completed in the first quarter. And just basically, where we are is that assessment is now completed. We've staffed this transformational office here with a pretty large number of associates at the -- dedicated Flowserve associates that are leading that transformation. We've got the 6 work streams that I commented to on the script, so we've got commercial, growth, aftermarket, operations, working capital and then our cost structure or G&A cost.

And then we're augmenting that team with third-party help, where we just don't have the skills or the talent or we can't assess best practice to bring into Flowserve. And I'd just say, the potential prize and initiatives are defined, and we're now turning that into actions, time line and sequence. And we recognize that this is a significant effort with massive process improvement and -- which is driving success and change for the long run. The majority of the prize will be 2019 and beyond, but we fully expect to start to see benefits and achieve results in the back half of 2018. It's going to continue to require investment in our people, our process and our systems. And while we would love to come out and say here's the potential of Flowserve and here's the prize, I just think at this point, we're not ready to do that. We're still sequencing things. We're still committing to action. And quite frankly, I want to get some wins under our belt and get some traction and get more confidence in the program here. But I do think, at some point, we'll need to talk about what we see as the holistic potential for Flowserve. But I think right now, it's more of a milestone story, and it's -- let's get a win or 2 under our belt. And then we'll come out holistically with the program, the actions and what we think is the -- kind of where we think Flowserve can go on some high-level metrics.

Scott, that's helpful. And then either for Scott or Lee, we know that Flowserve -- I mean, you mentioned that you usually have seasonally weak free cash in the first quarter -- but negative $134 million. And the problem is rev rec, I guess, has muddied the waters a little bit, but you had a $64 million increase in contract assets. So can you talk about revenue in excess of billings, why it's higher in the quarter? And maybe talk about the second half improvement that you expect in working capital. If we look at the numbers, working capital as a percentage of sales were 27.9% last Q4. Should we see better than that by the end of this year? And how should we look at working capital itself?

Yes. So yes, the accounting, clearly, has changed the formula a little bit. One thing that I should mention in contract assets, that represents cases where we have not billed the customer for the work that's performed. So included in that, there is some profit that is part of the adjustments that we disclosed in the Q. But just stepping back, we made tremendous progress in the fourth quarter in driving working capital performance. Unfortunately, a lot of it was just -- it was very manual and a lot of, I would say, management intensity. Coming out of the year and in the fourth quarter, trying to get the Flowserve 2.0 running, trying to get the new accounting running, we could not provide the same, I would say, management intensity around all these areas. So working -- on AR, we did not make as much progress as I would like. We're in the process of putting in more systematic fixes to drive that and to understand what's preventing us from getting collections.

On the inventory side, as we talked about on the last call, we've been working hard and driving our past due backlog performance. We did not make as much progress as we would have liked, and that's providing some overhang. And then, I guess, the third part I would highlight is that what -- in Scott's remarks and my remarks, we talked about building our -- what we call our S&OP processes. That is a major change from how the company historically has been run. And we're in the process of implementing these -- the right processes around forecasting, buying inventory and executing production. And so that's going to take some time during the course of the year. Scott has added individuals who are extremely skilled in these areas, but it's taking time to start to get the pilots running and starting to institutionalize that effort. So in a nutshell, we're not pleased how the first quarter played out, but we feel that we can turn the corner and drive improvements through the balance of the year.

Yes. I think just to summarize it -- what Lee said, we're not happy with where cash flow and working capital are. We've been doing it a little by brute force and management attention, and we're turning that now into a much more elegant, systematic approach that's systemic and can drive long-term results on this. So we're adding resources. It's a major part of the Flowserve 2.0, and we do expect to achieve progress during the back half of '18 on working capital.

Okay. Lee, just clarifying one thing, you had $0.03, I think, of benefit from ASC 606 in the first quarter and you said it was timing. Does that mean that, that impact sort of recedes as the year goes on? Any more clarity there on how to think about it in the rest of the year?

So in our guidance, we said adjusted $1.50 to $1.70. Through ASC 606, we effectively lost $0.15 from the restatement that went into retained earnings. What we've gone out and what we've communicated is that we believe that's going to be other pull-in from '19 into '18. So net-net, we don't think there's any impact. Where there is potentially some impact is timing during the year. And so it was difficult to figure out when -- how this was going to get sequenced. But we feel that for the year, the $0.03 effect that we got this quarter, is going to be offset in other quarters. And over the course of the year, it should be balanced.

Our next question is from Scott Graham of BMO Capital Markets.

So in EPD, could you unbundle the bookings there, a little bit some of the commentary you made, Scott? Was oil and gas in EPD down because of the comp? Or when you remove the comp, was it still down? And why was chemical down?

Yes. So on EPD, OE specifically, we had the large comp, the $80 million award in refinery or oil and gas in first quarter last year. If you remove that, oil and gas was actually up slightly when we look at kind of apples-to-apples excluding that. And then on the chemical side, I don't know, Jay, do you have the exact number on the year-over-year on chemical?

Sure. The chemical bookings were actually up on a dollarized basis. They were down slightly on a constant currency basis. And I would suggest that it is predominantly timing because, as Scott mentioned during his prepared comments, we are fairly optimistic about the outlook for chemical going forward.

And then I would just say, just more generally. We're not really excited about where the OE pump bookings were in the quarter. There was a lot of work out there. And so we've got to get a little more rifle shot approach on these things. We do have visibility to a much -- a stronger Q2, and so we're looking forward to that. But also, just -- it -- especially on the EPD side is, and I said this in the prepared comments, but we ratcheted up our margin expectations, probably at the end of Q3 and Q4. And what we saw is those kind of tenders went through the cycle and started to materialize in Q1. We probably overshot a little bit on pricing. And so we know we've lost some work in Q1 that we potentially could have won had we not been pushing that. And so we're continuing to look at pricing. But also, we also feel strongly that this business commands and should get higher pricing than what's out there today. And so we're going to be pretty disciplined about what we take into the system and make sure that what we take, we can generate the value that we deserve in these awards.

Got you. Just a follow-up on the Flowserve 2.0, and I'm going to maybe make some phrases up here. I'm assuming that of the 6, some of it is like Flowserve 2.5 and some of it is Flowserve 1.5. And by that, I mean all 6 don't have -- don't require the same level of intensity by the company and you guys in that room. Could you kind of tell us of the 6, maybe which 2 or 3 are areas where you have to be more intensive and maybe which one's maybe a little bit less? I'm assuming that working capital is on the more 2.5 side. But can you see where I'm going with this question? Because the old Flowserve had some things wrong with it, but a lot of that stuff happened in the last couple of years when the markets went really bad on them. It seems to me that there's some of these areas where they're not as bad as others. Maybe you can kind of lay some of that out, Scott.

Sure. I'm not going to use your 1.5 to 2.5 because that's going to confuse all of my 17,000 associates here. So what I would say is, obviously, there's different varied -- different and -- intensity across the 6 initiatives, but I'll just go through it. But clearly, aftermarket -- or sorry, let me start with working capital. Working capital has got to get significantly better. And so that's an area that we've already added resources and we're moving into systemic process change. Under operations, supply chain is another significant area of focus. And so if we go back to the problem statement, you've got originally lots of different acquisitions. [Sites] basically made a lot of decisions and were not leveraging the scale that we have at Flowserve. And so supply chain should really -- as we start to consolidate our supply chain, centralize process, we should be able to get some nice wins here this year. And that's a big prize if we can do it correctly.

And then the third one that I would say would be on kind of the top-3 list of value creation immediately with a little more intensity is aftermarket. And so while the aftermarket franchise is absolutely fantastic, right, and I continue to be impressed with our breadth, the seals business and kind of what we can do, if I look back over the last 3 years, we haven't really grown aftermarket in the way that we need or should grow it. And our installed base continues to grow, and yet we've been relatively flat on aftermarket. And so one of the big areas that's getting a lot of initial attention and focus is how do we really start to unlock and grow the aftermarket more than we have here in the last couple years. So I'd say those are the 3 areas that are coming with a lot of intensity, and we expect to see relatively quick rewards in the back half of '18 and early '19. But all 6 are critical, and we'll have actions and initiatives and we have leaders across each of those work streams.

Understood. And if you could just maybe -- one quick mention on when you expect to start announcing the plant closures.

Plant closures? Is that what -- is that correct?

Yes, yes.

Yes, so we've actually -- we announced some in the fourth quarter, and we announced 3 here in the first quarter of this year. And so that is ongoing and kind of, I'll just say generally, on the restructuring, right, we haven't changed our course there. We do expect to complete largely the original program at the end of this year. But we added a few in the first quarter that weren't part of the original program. They were relatively smaller, I would say as cleanup that was desperately needed, and we did announce those in the first quarter. So we're still continuing to press this. We believe, from a capacity standpoint, that we have plenty of roofline and we can expand capacity significantly with productivity. And we're going to continue to refine that footprint.

Was that a news release or was that an internal announcement? Because -- I apologize if I missed that.

Yes, just internal. We're not -- we don't do that externally.

Our next question is from Steven Fisher of UBS.

You guys explained the timing part of the FCD margin before. Can you just give us a little more color on the mix headwinds you experienced? And when do you think you'll see the FCD margins return to improving year-over-year?

So this is Lee. So the key issue in the first quarter, like I said, is we moved a lot of -- I would say, parts and services got really pulled in into the first quarter. Like I said, we've put a lot of pressure on them to deliver and they exceeded our expectations. My expectation is going to the second, third quarter, we should start seeing those margins going back to where they've historically been.

Okay. And then in achieving your IPD margin targets, to what extent is this going to be more a result of gross margin improvements versus lower SG&A? I'm not sure if past backlog -- past due backlog, is that just directly a gross margin thing? Or how should we think about that dynamic?

Yes. The progression on IPD is primarily on the gross margin line. There will be some SG&A savings and work there, but it's really around execution performance. And so we've talked quite a bit about the pain in IPD and some of the sites that are causing us concerns. Those now have a pretty significant past due backlog. And what I would say is in the first quarter, they did not get worse. They didn't get significantly better, but we're in a stability mode right now. And so we've kind of stabilized the platform, if you will. And now we've got to really start to transition and focus on optimizing it for the future. But I think you'll start to see the improvements more on the gross margin line. And we do feel confident that we start to make progress in the second and third quarter of this year.

Okay. And on the past due backlog, should the ultimate target for that be 0? And if not, why not?

Yes. So it'll never be 0. And really, it's a balance of our commitment to our customers and lead times. And so in an ideal world, right, you're running a past due backlog at kind of a 2% to 3% of total backlog. But probably what's -- more importantly is that we're focused on our lead times and getting those as short as possible. And then when we make a commitment to our customers, what we don't want to do is -- if we miss a delivery, we want that the days late to be 1 week or maybe 2 weeks. We don't want the days late to be months or even quarters, which is kind of some of the situation we're in today. And so past due backlog will always be there, but it's going to -- what we want to be doing is driving lead times down aggressively and really tightening up our variability and our ability to execute.

Our next question is from Joe Ritchie of Goldman Sachs.

Maybe just sticking on the past due backlog for a second. Is it -- do you guys have like liquidated damages that are going through at all? Or is this just a function of just extra cost to serve? Is that -- I'm just trying to understand what's going through your margins right now.

So look, past -- delivering late is not good, right? It causes concerns with customers, it's revenue, it's working capital. We do have liquidated damages. There's receivables and collection issues, inventory. So it is bad. And so you don't want a large past due backlog. And so what I would say is we didn't have any major surprises in the quarter, but we didn't bring down working -- or we didn't bring down that past due backlog in Q1 and it grew. And IPD was relatively flat, but it grew in both EPD and FCD. And we've got a -- we're continuing to focus on operations and our performance to drive that down.

And one of the things, and Lee touched on this, is we've got a lot of issues there. But one of the big things that we're really focused on -- or focusing on is manufacturing planning. And so we're introducing the S&O peak process. We're investing in production planning and material management which, quite frankly, are just basics to manufacturing. But if you don't do these really well, then you'd get a lot of the issues that we're facing today. And so this is under the Flowserve 2.0, and we've already added and strengthened our competency and our people in that space. But it's an area we've got to get significantly better at.

Joe, one thing I would add to that is when we identify liquidated damages, or the potential for liquidated damages, we record them once we realize that, that product's going to be late. So we did not necessarily incur a bunch of liquidated damages this quarter because a lot of the timing of shipment was known last quarter and the quarter before.

Got it. That's helpful, Jay, and I appreciated the color on that as well, Scott. Scott, maybe just -- we've talked a little bit about the organic bookings being down year-over-year and why they were, but they were also down sequentially. And I know that there's an expectation for a sequential improvement in 2Q. But I take a step back, I look at the oil backdrop right now, it's very strong. I guess, I'm wondering, like when can we get back to $1 billion per quarter in orders, just given that the backdrop has strengthened? And then secondly, do you guys have the right capabilities in place today to actually deliver on that kind of backlog? Or is it going to take some time to fix things internally before you would take in those types of orders?

Yes, yes. So we did come down sequentially. What I would say is the FCD grew and had actually -- if you exclude the Gestra divestiture, we were up 15%. We added $482 million on aftermarket, a really good number. And so we had some bright spots in the quarter. We had a hard comp year-over-year with the Hengli award and some of the divestitures. But no, I think everything we're doing is focused around growing, and we would really like to see $1 billion on the top line at the quarterly level. And that's kind of what we're lining up and focusing on from a sales team and execution strategy. And I don't know if we're going to get to $1 billion, but we do have confidence that the Q2 will be higher than Q1.

And then just on the ability to execute, what I would say is, we're being -- back to planning and understanding where our capacity is and where our problems are, we're being more deliberate about making sure that the work that we do bring in, that we can actually execute and deliver throughout the system. And so a lot of the past due backlog, we do think, is starting to clear, and we're being selective as where do we put that work, in which facilities and making sure that we could execute. So I'm confident that what we're chasing today, we will be able to execute. But we've got to continue to progress our operational capability.

Got it. And maybe if I could sneak one more in for Lee. Lee, how should we be thinking about cash flow then? I know you guys don't have like a cash flow guidance for the year. But do the accounting rules change anything? What's the -- what should be the expectation from either free cash flow generation or conversion for you guys?

Right. So the new standard does not really impact cash flow. It obviously puts it in different buckets. So our expectation is that we are driving down working capital. We are improving the velocity of receivables, velocity of inventory. Under the new accounting, some of it -- what used to be in inventory, now sits in contract assets. So we need to come up with some better metrics around that. I mean, we're still getting comfortable with just how the accounting worked, but we need to drive more transparency around how quickly are things going through the facilities and how well are we collecting. But again, the accounting doesn't impact cash, but it does put it in different balance sheet accounts. And the expectation is we're going to reduce our investment in working capital.

But do you guys have like a bogey? You have to have at least an internal bogey that you'd like to hit from a cash flow perspective for the year, I would think.

Well, we've not gone out with cash flow guidance, but the expectation is that we're driving improvement in operating cash flow year-over-year.

Our next question is from Jeff Hammond of KeyBanc Capital.

Just on the -- I guess, in the order of pacing. One, can you just talk about what you're seeing on pricing, what you're doing differently as you get better -- a better environment to drive price? And then just comment on how the funnel is starting to build or visibility is building for larger projects.

Sure. Yes, on pricing, I talked a little bit on the prepared remarks. We did come out at the beginning of the year with a very general price increase on certain industry items. And then in the end of Q1, we followed that with a much broader price increase on the back of steel's import tariffs. And so we've got 2 out there this year. I would say the second one is a little too early to tell in terms of traction and making sure that, that's going to work. The other thing that we did was on EPD specifically, so EPD OE, is we did ratchet up our margin expectations. A lot of that work is a cost-plus model rather than a list price. And we did that in the Q -- third quarter -- Q4 of last year. And what we saw is, we had mixed results.

And so our bookings probably could have been higher in Q1 had we been a little less aggressive on that pricing. And so we're kind of feeling our way through what we believe should be an increased pricing environment, but yet we're struggling to get that traction. But we do want to be on the front side of this and be a leader in price. And given some of the operational challenges that we talked about before, we want to make sure that we're a little bit more selective, we're bringing the stuff that we can work on and when we do it, we actually get rewarded for the work that we do.

And then larger project visibility?

Yes, larger project visibility. I would say our funnel of projects is probably better than I've seen in the last 12 months. On the larger ones, though, we're not seeing anything at that kind of large size, at the $100 million, where we had 1 or 2 last year or in the last 12 months on. But we're seeing a really healthy pipeline at kind of that $10 million to $20 million range. And so I would expect to see more of those in Q2 and Q3 as we complete the year.

Okay, great. And then just back on past due backlog. So I think you said it was stable this quarter. And I just -- I want to kind of get back to the big gating factors of kind of making improvement, particularly as you start to get a pickup in demand like -- that you can kind of continue to make progress.

Yes. So I'll just -- I want to be super clear on past due backlog. So IPD was reasonably stable in the quarter. Where it went up was on the FCD side and the EPD side. And so we actually grew past due backlog in Q1, which is certainly not what we wanted to do. And then in terms of fixing this, one, we talked about it, but we've really got to change and strengthen our competency around planning and manufacturing process improvement. And so that's the focus. We've got that within the Flowserve 2.0 umbrella. And we're basically systematically going through large plans on ability to plan and execute our work. And so while Flowserve has had a lot of success historically, planning and delivery have never been a real strength. And so it's something that we're taking a very comprehensive look at in making sure that we've got strong competency around planning and manufacturing execution.

Our next question is from Deane Dray of RBC Capital.

I might have missed this, but I was hoping to get some color around the reference about 2 price increases that you've put through. Just what's the cadence of those? What's been the reaction of the customers? What kind of yield are you getting on that pricing? Just any color would be helpful.

Yes. Deane, I talked it about a little bit. I'll certainly go into it again. We did one at the very beginning of the year, and what I would say, is on select items and it was discrete. And we've got some data now that's saying that, that was reasonably successful with a relatively nice uptake and didn't get the pushback or the losses that we were worried about. And so that one went through reasonably well. The second one was on the back of the import tariffs on steel. And so we did that at the end of March, and we're just too early to tell on that one. And so those are the 2 that have happened this year that are more across Flowserve generally.

And then just what I haven't talked about yet is price is something that we're very much looking at in the commercial work stream for Flowserve 2.0. And what I would say is, we really haven't utilized analytics to really drive more intelligent pricing decisions. And so that's something that we're absolutely jumping on and we think we've got opportunities on, where we've got like parts pricing, our aftermarket service pricing and then some of our more standard type products. We're making sure that we don't have disparate pricing and that we're able to move that up progressively and done with some logic and intelligence.

Got it. And then for Lee, how does this translate into price/cost for the year? I don't think you've got a specific goal here, but where does that stand if you had to draw the line in the sand today on how you're tracking on price/cost on a net basis?

Yes. So right now, we're kind of assuming the 2 offset each other. We'll see how that plays out. I mean, Scott didn't go into a lot of detail. Even on the cost side, we have a supply chain group that is -- we're looking at who we buy from, trying to consolidate suppliers, trying to be proactive on some of the inflation. So our assumption is that it's pretty consistent with the guidance. We assume there's going to be inflation, and we also assume there's going to be some price. And then the changes since the beginning of the year, we're assuming that net outs to be pretty consistent with what we assume -- that we assumed originally in our guidance.

Our next question is from Joe Giordano of Cowen.

So Scott, on the pricing and the loss of maybe some work that's been out there, I guess, how strong is your stomach on this? How long are you willing to remain firm and sacrifice orders to kind of try the lead the market into a more disciplined scenario?

Yes. It's a good question, Joe, and it's something we talk about quite a bit between our commercial officer and our platform president and myself. You know, look, I think we went pretty strong, hoping to get more traction than we did in Q1. And it's something that we're evaluating on a regular basis. And so I would say we're not going to be completely dogmatic and we're going to do it very rationally. We understand that we want to drive growth in the business, and so we're not going to jeopardize that. But at the same time, we're not going to take work that doesn't -- we're not going to take it for practice, right? We want to take work that we know we can make money on. And we're very focused and committed to work that gives us a long-term aftermarket annuity. And so I'd say we're getting much more methodical about our pricing, and we've got a more deliberate and more visible planning cycle that allows us to have rich discussions early in the cycle and early in these project pursuits. We're not going to do anything crazy on this, right? I mean, we know it's a balance. We've got some underabsorption in some areas, but we've got past due backlog in others. And so we're pretty good about what we want to win and we're going to be more targeted.

Is this like a handful of bad actors just willing to do things for 0? Or is it -- or are you guys kind of an outlier with your thought process right now?

Yes, I -- well, I'm not going to say we're an outlier. And obviously, as you're bidding these large projects and tendering things, it's a pretty dynamic environment, right? So we'll get signals, and we can move our price down as we need to. But what I would just say is, I mean, look, we've been 3 years in a down cycle. Everybody has excess capacity and I think folks were eager to fill their capacity. And what we've said is yes, we want to make sure we minimize our underabsorption, but at the same time, we want to be the ones that are moving the market up here.

Okay. And then on the past due backlog, I hate to keep bringing the same questions up. But I understand why maybe it didn't go down as much. But I'm a little -- why did it actually go up in EPD and FCD in this environment?

Yes. Good question again. I think systemically, we don't have the planning and we don't have that true operational focus that we need. But what I would say is in the quarter, it really was isolated to a very large project -- 1 or 2 projects that we just didn't deliver on time. And the good news is these aren't going to be a quarter's late or significantly late. They're probably in the range of 30- to 60-day late. And so we do expect to clear some of this in Q2, and it remains a significant focus on us to improve our operational excellence.

All right. And if I can just sneak one in for Lee. Regarding EPD and FCD margins, given 1Q performance, do you think that you could be up year-on-year for the full year in those 2 segments?

Yes. I mean, that's our expectations. I mean, I think, again, what I said a little bit earlier in my prepared remarks is some of the new accounting pushed down the margins. EPD would have been [160] basis points higher if we had used the old accounting. And so some of it -- comparing that to prior periods, it would have been a very competitive margin. So our expectation is to drive margins throughout the year.

But you didn't like -- using this structure that we're currently booking for 1Q, do you think that it's still possible for those 2 segments to be up year-on-year versus what we booked for last year in margin?

Yes.

Our next question is from Robert Barry of Susquehanna.

So I just wanted to pick up on the comments earlier about providing the long-term targets. Scott, when you say you want to wait to get 1 or 2 under your belt first, like what exactly does that mean? Because it sounds like it might be a while before we get some midterm targets. And I think a lot of investors are just trying to kind of get their hands around the finding of reasonable midterm earnings number for Flowserve.

Sure. No, I understand that and I get it and we do think we want to talk about what the potential of Flowserve is in the long run. We -- if you go back to where we are in the transformation, the assessment got completed at the end of Q3 -- or Q1. We have now formed the team. The team's preparing the sequencing. We've got things in the pipeline. We want to get a couple wins and make sure that we've got something that we'd commit to. And the last thing I want to be doing is throwing out this large prize number and then having to talk about that when we haven't really got the process or the program in place. And so, look, we're moving very quickly with this. And I would say we do expect to be able to talk about what we think the future of Flowserve is reasonably soon.

Got it. I mean, just big picture. If I look back over the last decade, say, the margins, the op margin has peaked out at around 15%, 16%. I mean, directionally, do you think for now that's a good target? Or do you think, just given all the restructuring you've done already and what you have planned, that it's reasonable to assume a base case that's at least a little bit higher than that?

Yes. And I'd just say, again, not ready to go fully into this, but we're going to be incredibly ambitious on what we're trying to do here. And we've got a team that's focused and they're energized about doing things that are -- would be top quartile in the space and exceeding margins that have ever been done at Flowserve. But we've got to give it a little more time before we're ready to commit and show what -- how that program leads to what the future looks like.

Got it. And maybe just finally for me. I just wanted to clarify a little bit about the end market perspective, especially in oil and gas. I know you have very little upstream, so perhaps limited direct impact of higher oil. But as oil has moved up here, can you talk about kind of connecting the dots on what some of the secondary or tertiary impacts of the higher oil has actually been on the business?

Yes. I think obvious -- oil price does a lot of things in energy. And so stability above $60 and touching $70 now is definitely a positive to our industry and certainly our business. And what it does, it just gives operators confidence in their ability to start to spend money on larger projects. What I would say is, and you said it and it's really important, our exposure to the upstream side of oil and gas is relatively small. And probably worse is that our exposure to upstream land is really around FCD, and we don't have a giant pump offering in oil and gas upstream land.

And so there's things that we're looking at in our product portfolio to make sure that we're driving product into the markets that we see are attractive and growing. But overall, $70 oil is doing a lot of good things, and we're seeing smaller projects internationally start to move forward where we do participate. And for us, certainly on the pump side and the valve side, what we like are critical service type projects, FPSOs are good, production platforms and big kind of production systems that have harsh environments are -- is when customers come to us for both pumps and valves. And so any of that, that comes through the system is positive, and the new price stacking kind of stability here is helpful.

And thank you, ladies and gentlemen. We have reached our allotted time for today's call, and we'll now conclude. Thank you for participating. You may now disconnect.