福斯 (FLS) 2018 Q4 法說會逐字稿

Welcome to the Flowserve 2018 Fourth Quarter Earnings Call. My name is Paulette, 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.

Thanks, Paulette, and good morning, everyone. We appreciate you participating on our call today to discuss Flowserve's fourth quarter and full year 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 will open the call for your questions. And as a reminder, the event is being webcast and an audio replay will be available.

Please also note that our earnings materials do and this call will include non-GAAP measures and contain forward-looking statements. These statements are based upon forecasts, expectations and other information available to management as of February 21, 2019, and they involve risks and uncertainties, many of which are beyond the company's control. We encourage you to fully review our safe harbor disclosures and the reconciliation of our non-GAAP metrics to our reported results, both of which are included in our press release and earnings presentation and are available on our website at flowserve.com in the Investor Relations section.

I'd now like to turn the call over to Scott Rowe, Flowserve's President and Chief Executive Officer, for his prepared comments.

Thanks, Jay, and good morning, everyone. Thank you for joining today's earnings call. Flowserve finished 2018 with a strong fourth quarter. We continued to build on the operating improvements from prior quarters, delivered enhanced earnings and grew the business with our third consecutive bookings quarter over $1 billion. I am pleased with the progress we are making in our Flowserve 2.0 transformation journey and the increased engagement of our associates. We have better visibility, a defined improvement plan called Flowserve 2.0, operational momentum and we are beginning to execute at a higher level company-wide.

Let me begin today by providing some comments on our fourth quarter and full year results, our operations and our end markets. For the fourth quarter, we delivered adjusted EPS of $0.58, which represents growth of over 16%, both on a year-over-year and sequential basis. For the full year, Flowserve delivered adjusted EPS of $1.75, which is at the high end of our revised guidance, representing approximately 29% growth compared to full year 2017. We successfully avoided the operational issues that were encountered in 2017, and we improved the performance in each of our segments throughout the year.

One area of intense focus in 2018 was margin expansion. For the quarter, we increased adjusted gross and operating income margin by 300 and 170 basis points, respectively. For the full year, we delivered a 90 basis point improvement in adjusted gross margins and 100 basis points in adjusted operating margin. Our progress with margin expansion is driven primarily by our actions within the transformation program and specifically from the commercial and operations work streams.

Turning now to our markets and bookings. The overall conditions in our end markets remained generally stable in the fourth quarter despite the volatility in commodity prices. While the quarter did not include any individual large projects, we did book a number of $5 million to $15 million awards across each of our end markets and again saw growth in our aftermarket bookings. Bookings of $1.05 billion were the highest level we've delivered since 2015. Year-over-year, it represents an increase of 6%, including headwinds from currency and divestitures of approximately 4%. For full year 2018, bookings were over $4 billion and were up 5.7% compared to 2017. The general health of our markets, coupled with the growth initiatives we've implemented thus far as part of our transformation, are key drivers of these results.

During the quarter, we delivered strong results in our aftermarket franchise, with the highest level of bookings since 2014, representing growth of nearly 15% year-over-year or over 18% on a constant currency basis. This quarterly performance helped drive full year aftermarket bookings to a year-over-year increase exceeding 10%. The commercial intensity program embedded within Flowserve 2.0 has our aftermarket organization focused on growth and further capturing the opportunity inherent in our large global installed base.

Additionally, our customers appear more focused on facility maintenance, facility efficiency in meeting regulatory requirements than we have seen in the past few years, leading to additional opportunities for growth.

Turning now to our bookings by end markets and starting with our largest market, oil and gas. Bookings in the fourth quarter increased 14% year-over-year driven by EPD where we continue to capture downstream investment, including highly engineered products critical to refining modifications for clean fuel production. Additionally, one of our strike zone initiatives that we've discussed previously is our focus on North American pipeline projects. In 2018, this commercial focus drove several wins across segments, including roughly $20 million in the fourth quarter. And we have good line of sight into a number of additional opportunities in the first half of 2019.

For the full year, oil and gas bookings were up 8%. Based on our customer discussions and the status of their pre-FEED and FEED activities, we expect increased investment in 2019 for both upstream and downstream oil and gas despite recent oil price volatility.

In chemicals, our quarterly bookings increased approximately 3% year-over-year on 18% growth in FCD and a 3% increase in IPD, which more than offset the decline in EPD. On a full year basis, we delivered growth of 6%, with all segments contributing. We remain confident in the North American ethylene project pipeline, and we also expect increasing investment in Asia and the Middle East as oil majors and national oil companies increasingly pursue integration of the petrochemical value chain.

The power market remains our most challenged industry, where fourth quarter bookings declined 17% year-over-year, although EPD was essentially flat. For the full year, power declined about 11%, with only IPD delivering growth. We continue to have muted expectations in the power markets near term due to industry-wide headwinds. Fossil opportunities in Asia remain challenged and competitive. Nuclear build in Asia continues, while Western nuclear new-builds are limited and most of the opportunities lie in extending the life of existing facilities, operates and maintenance. However, concentrated solar power continues to be a niche opportunity for Flowserve in a growing renewables market where we have a differentiated technical offering.

General industry bookings increased 13% year-over-year this quarter, primarily driven by FCD's growth of over 40% and strong distribution activity. EPD also contributed nearly 11% growth. This end market includes the mining and pulp and paper industries, which contributed quarterly bookings growth of 50% and 30%, respectively, although both markets represent less than 5% of our overall mix. For 2018, general industry grew over 12% year-over-year.

Lastly, the water industry, which represents the smallest category we break out on a stand-alone basis, declined 19% year-over-year in the fourth quarter, representing 3% of our total bookings. For all of 2018, water increased approximately 3% compared to 2017 due to strong performance in EPD with several larger flood control awards.

Looking at bookings by geography. We delivered solid quarterly and full year growth in most regions. Compared to the 2017 fourth quarter, North America was up 11% while the Middle East and Africa increased 16% and Asia Pacific was up 21%. Europe decreased 6% while Latin America decreased 15% off a very low base. For the full year, North America, Europe and the Middle East and Africa increased mid- to upper single digits while Asia Pacific and Latin America each contributed 3% growth.

Let's now turn to our performance by segment. I'll start with IPD where we continue to make good progress. The segment delivered reported and adjusted operating margins of 9.6% and 10.2% while making significant strides on the operational turnaround and the reduction of past due backlog. We are encouraged with this step-up in performance but recognize that much work remains to drive the consistent operational excellence, on-time delivery and customer experience that is needed and expected. We believe that continuing to improve our performance will get us closer to achieving the desired mid-teens operating margins from the Industrial Product portfolio. While the quarter's results were buoyed somewhat by fourth quarter seasonality, we are encouraged with IPD's progress and continue to believe we are on the right path.

EPD also had a solid fourth quarter. Bookings in the segment increased 12% year-over-year, including 20% aftermarket growth. Additionally, we made meaningful progress on past due backlog and improved adjusted gross and operating margins by 200 and 250 basis points respectively, year-over-year. We are fully focused on leveraging the full capability of our engineered pump portfolio to better serve our customers and ambitiously grow our business.

FCD continues to perform at a high level. This segment has consistently delivered strong operating performance, including this quarter's adjusted gross margin expansion of 100 basis points to 36.3% even as revenues declined 5% on a challenging compare.

Throughout 2018, we improved our ability to deliver predictable financial results and limited much of the quarterly operating income variability that we've seen in the past. We have an extensive valve portfolio, and we are well positioned to take advantage of the expected increase in project activity during 2019.

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

Thanks, Scott, and good morning, everyone. Looking through our financials that Scott highlighted, we delivered adjusted earnings per share of $0.58 in the fourth quarter and $1.75 for the full year, in line with our revised guidance we provided as part of our third quarter results. On a reported basis, fourth quarter EPS was $0.48, which includes realignment and transformation expense of $0.13, $0.01 of below-the-line currency impact and $0.04 of benefit related to U.S. tax reform.

Fourth quarter sales of $987 million decreased 4.6% versus prior year, which included approximately 4% of headwinds from currency and divested assets. Sequentially, fourth quarter revenues increased 3.6%. As we've discussed previously, our traditional seasonality, marked by a strong fourth quarter top line, was muted somewhat in 2018 due to the new accounting standard implemented at the beginning of the year. For the full year, revenues were $3.8 billion, an increase of 4.7% compared to 2017, with all segments contributing to year-over-year top line growth.

Turning to our margins. Fourth quarter adjusted gross margin increased 300 basis points versus the prior year to 33.7%, which is the highest quarterly level since 2015. IPD's 830 basis point year-over-year improvement represented over half of the increase. Additionally, as our transformation initiatives are taking hold, we continue to focus on project execution, disciplined cost control and improving the quality of our backlog. On a reported basis, the 300 basis point gross margin increase was driven by essentially the same factors as realigned expenses were roughly $11 million for both 2018 and 2017 fourth quarter.

For the full year, adjusted gross margin improved 90 basis points year-over-year to 32.3%. Fourth quarter adjusted SG&A increased a modest $3 million due to elevated corporate cost for discrete litigation accruals and expenses, sales commissions and medical claims. On a reported basis, fourth quarter SG&A was further elevated due to transformation expense, which we expect to see decline in future periods. For the full year, however, adjusted SG&A as a percentage of sales declined 20 basis points to 22.8%.

With strong gross margin improvement and an ongoing focus on cost control, Flowserve's fourth quarter adjusted operating margin increased 170 basis points year-over-year to 11.9%. IPD's significant 950 basis point improvement, coupled with EPD's 250 basis point increase, more than offset FCD's decline and higher corporate costs. On a reported basis, operating margin increased 80 basis points where improved operating performance more than offset an $8 million increase in adjusted items, primarily related to transformation costs. For the full year 2018, adjusted operating margin improved 100 basis points to 9.8%.

Our reported effective tax rate of 18.1% benefit from the true-up associated with last year's U.S. tax reform accrual. On an adjusted basis, the effective tax rate for the quarter was 26.1%. For the full year, our adjusted tax rate of 27.1% was in line with our guidance of 27% to 28%.

Turning to cash. Our fourth quarter operating cash flows were again seasonally strong at $164 million, primarily due to working capital improvement and building upon the progress of the preceding 2 quarters. Our free cash flow in the quarter was $130 million or roughly $1 per share, representing a conversion rate well above 100% of our reported and adjusted net income. Capital expenditures for the quarter and year were $34 million and $84 million, respectively.

We continue to pursue IT investments in the quarter that support and enable our Flowserve 2.0 agenda, and we continue to invest in various growth and restructuring initiatives.

For the year, we returned approximately $100 million to our shareholders through dividends and repaid $60 million of term debt.

With our strong fourth quarter cash flow, we ended the year with solid cash balance of $620 million, an increase of $90 million from the end of 2018 third quarter. As I mentioned, we delivered modest primary working capital improvements during the fourth quarter with working capital as a percentage of sales of 27%, representing both year-over-year and sequential improvement of 90 basis points and 190 basis points, respectively.

As I shared with you at our Analyst Day in December, free cash flow conversion and growth is a significant opportunity for Flowserve. We certainly acknowledge much work remains to achieve the consistent level of cash flow conversion that we believe Flowserve can and should ultimately deliver. A number of our Flowserve 2.0 transformation initiatives are focused on obtaining the systems and process improvement tools directed at all aspects of both the order-to-cash and sales and operational planning processes. We expect additional progress in 2019 and beyond as we continue to target our longer-term aspiration of 100%-plus free cash flow conversion.

Turning to our 2019 outlook. We are targeting full year adjusted EPS of $1.95 to $2.15 a share on expected revenue increase of 4% to 6%, including approximately 2% of expected headwinds due to currency and divested businesses. This level of performance would very much keep us on track with our longer-term 2022 targets we laid out in December. The adjusted EPS target range excludes expected realignment and transformation expense of approximately $65 million as well as below-the-line foreign currency effects and the impact of potential other discrete items which may occur during the year, such as acquisitions, divestitures, tax reform laws, et cetera. Our outlook assumes that volume, price and productivity will offset the potential incremental headwinds in 2019 due to inflation, FX, merit and the unplanned increase in research and development and IT investments.

Both the reported and adjusted EPS target range assume current FX rates and commodity prices. Our expectations are based on 2018 year-end backlog, anticipated booking levels and the continuation of our current market conditions. Net interest expense is expected in the range of $55 million to $57 million with a tax rate of 26% to 28%. Additionally, we expect traditional back half-weighted seasonality, similar to the 2018 quarterly phasing of cash flow and earnings.

From a 2019 cash usage perspective, we expect to return approximately $100 million through dividends to our shareholders. Capital expenditures are expected in the $90 million to $100 million range. We also expect full year debt repayment of approximately $60 million and to contribute approximately $20 million to our global pension plan, mainly to cover ongoing service costs as the U.S. plans remain largely fully funded.

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

Thanks, Lee. As we wrap up, I would like to spend a few minutes on our 2019 outlook and the progress of our transformation efforts. Many of you joined us at our Analyst Day in December when we laid out our transformational initiatives and the longer-term expectations in greater detail. For those who may have missed it, the presentation and audio from the event are still available in the Investor Relations section of our website.

To summarize the key takeaway. We are executing our multiyear transformation with a sense of urgency. We're changing the culture, improving employee engagement, simplifying our processes and creating an operating model that will weather different market conditions. Our long-term focus at Flowserve is to grow the business, expand our margins, improve return on invested capital and enhance the organizational health of the company. As our fourth quarter results demonstrate, our actions are beginning to bear fruit. While we're improving, we still have a long way to go, but we are committed to implementing lasting change to create sustainable long-term value.

As we've previously announced, beginning January 1 of this year, we combined our IPD and EPD segments into one Flowserve pump division. This new operating and reporting segment further simplifies and standardizes our operating model. While we do expect to drive modest cost savings as a result, the real catalyst for the combination is to drive productivity and value for our customers. The initial response from our customers has been very positive. We fully expect to see this new organization will greatly enhance our customers' experience with Flowserve.

Turning to our expectations for 2019. We remain confident in the stability and continued growth of our end markets. Our growth-oriented transformation initiatives provide the opportunity to outperform the underlying markets while our cost and operational initiatives can further drive margins. We believe that we have the opportunity to grow adjusted EPS nearly 20% again year-over-year when we use the midpoint of our guidance. The transformation activities that are underway give us confidence that we can produce a sizable improvement. With the traction we gained in 2018 on our operational improvements, we are confident that we can deliver on our 2019 targets.

While we have delivered some initial financial benefits from the transformational program, we are still in the early days. With each quarter, we expect to gain momentum, which will put us on the path to reach the longer-term targets we laid out in December. I am very pleased with the progress that we have made, including the ongoing engagement and commitment of our associates. We are taking the right actions to build a performance- and accountability-driven culture to create value for our customers and our shareholders alike.

Operator, we have now concluded our prepared comments, and we'd like to open the call to any questions.

(Operator Instructions) And our first question comes from Jeff Hammond from KeyBanc.

So just maybe you could talk about the disparity between aftermarket growth and OE and how you think those trends, as you look at visibility, shape up as you move through '19.

Sure. Let me start with aftermarket and then I'll hit the OE. We're really pleased with the growth and what's happening in the aftermarket program. And as I talked in December at the Analyst Day, we've launched what we're calling commercial intensity. And essentially, what that is -- and we went through it again in December. But what that is, is really looking at what do we have from an installed base perspective, where our QRCs are and really maximizing the opportunity at each of those locations. And we launched this in December of last year, and we're really seeing very positive results. We've now done pilots in each of the major geographies. We're pretty much in place and live across all of North America, most of Europe, and we've just started in Asia Pacific. And so this commercial intensity program is really helping us to grow the business. On top of that, we're seeing some macro trends that are helping us in the aftermarket side as well. And what that is, is just after several years of delayed spending on maintenance and the focus on reliability, we are seeing a renewed effort and renewed spending in maintaining equipment and making sure that they're using our parts and our service. So the aftermarket growth has been really positive, and we definitely expect that to continue as we go forward. On the OE side, it really hasn't been bad. It's just lower than what we're getting with the aftermarket side. And what I would say is as we transition into 2019, our OE visibility, particularly on the project side, is significantly higher than what we had at the beginning of last year. So our project pipeline is reasonably full. What we're seeing from the big customers that report externally is that their capital is at or above what they're stating for -- at or above for '19 over what it was in '18. And then when you look at the EPCs, their backlogs are higher than they were over last year as well. And so our project pipeline remains really healthy, and we feel good about the MRO in the aftermarket side. So we're encouraged about our growth activities and prospects in 2019.

Okay, great. And then it sounds like you're making progress on past due backlog. Can you just give us a sense of where you're at in kind of getting that fully caught up and kind of fully behind you from here?

We are making progress on past due backlog. And in the fourth quarter, we made significant progress. And so I'm not going to say we're completely out of the woods here because we're not. We would have liked to make a little bit more progress in the fourth quarter than we did. But what I'd say is on the IPD and the EPD side, we took a big chunk of past due backlog down. We hired a new Vice President of Operations in July. We formed a new manufacturing organization in 2018. And all of that reorganization, the talent improvement and the focus is absolutely driving the right results. And as you know and most people listening to the call, the past due backlog was really a headwind and hurting us in lots of different ways. It's hurting our customer relations. It's hurting us on revenue. It was incurring more costs and hurting on the gross margins. And then it hurt us on the working capital with built-up inventory and delayed receivable collection. And so getting this behind us is a huge focus. And what I'd say is we're in a substantially better place than we were in 2018. And while we're not quite to the level that we expect or we want we're actually really close to where we need to be. And so as we go forward, really, we'll shift our -- we're not going to let up on the focus of past due backlog and on-time delivery, but we're really going to start focusing on lead times for our products and making sure that we can be extremely competitive getting our products in front of customers at the time they need it.

The next question comes from John Walsh from Crédit Suisse.

So I guess, could you talk a little bit about what you're seeing out there in terms of pricing and maybe provide some context around material costs? I know, obviously, you talk about productivity in there as well and there's general inflation, but maybe just trying to isolate pricing by itself and kind of the price/material cost equation.

Yes, sure. Let me just make general comments and I'll get real specific on the pricing side. Generally speaking, and as you saw throughout 2018, we were able to grow our margin because we were on the right side of the price/cost curve. And so as I discussed before, we did several price increases at the beginning of '18, which offset the inflation and tariffs and other headwinds that we had in the global environment. And so we feel really good that we've got the right focus and the attention on that. Now as we switch to pricing for 2019, we announced our price increase actually in December of last year. And it is fully in place today across all of our products. And what -- the big question now is just how sticky is that and how much can we get. But what I would say is, at Flowserve, we're in a privileged position of having great brand recognition and being on AVLs around the world. We've got to translate that into better pricing. And so we're going to be pretty aggressive on the pricing side as -- again, as evidenced that we've already announced our price increase and we're locked in. And then the other thing we've done is in the Flowserve 2.0 transformation office, one of the work streams is focused and is all about pricing. And so when I talk about general price increases, that's great, but it's really there to stay current with inflation and what's going on. On the strategic side of pricing, we're getting a lot more analytical and sophisticated about making sure that our price distribution internally is where it needs to be and that we're capitalizing on all the opportunities that we have. And so that work is now starting to come through, and we're seeing positive results of the analytical aspect of pricing within the transformation. But I would just say, for 2019, we feel really good we're going to be on the right side of the price/cost equation. What I would say is it's still a volatile environment in terms of tariffs and trade and things like that. And so it's obviously something we're staying very current on and we're staying abreast of. But right now, given everything we know, we're in a good position with our newly announced pricing, and we'll move forward. And then just the last thing I'd just say, just like when we think about our competitors, it's still not an environment that I really like. And we're seeing other competitors not necessarily follow suit. And so when we see that, we're prepared to walk away from some of the business that doesn't make sense for us or doesn't give the margins that we want. And I think that's a little bit of a change from where we were certainly in 2017 or maybe 2018. But I also believe that the marketplace, in general, is moving in the right direction on pricing. And I think we're moving into a good spot for 2019.

Great. That's good color. And then maybe just a follow-on here. As we think about the incremental margin that you're expecting in 2019, I guess, at the segment level, you've been executing in like a low 40s the last 2 years. Is that still the right ZIP code to think about for 2019?

Well, we don't give guidance on the segment level. And so I think what you can look at is the general 2019 guidance on the revenue side and the EPS. And it implies that we are continuing to expand margins through 2019. And so with the transformational activities around supply chain and cost takeout and the pricing that we discussed, we fully expect to increase gross and operational margins throughout the year.

Our next question comes from Deane Dray from RBC.

Maybe just a follow-up on that price/cost discussion. Scott, when you talk about having put price increases in December, did you think the fourth quarter benefited at all from some pull-in form the first quarter? We've heard a number of companies seeing that, people trying to avoid those price increases. Any sense that, that happened this quarter?

Yes. No, Deane, it's a great question. And it's actually what we expected, and it didn't happen. So we were fully expecting to see a little bit of an uplift, particularly on the valve side, on the FCO side, with some pull-in business. And it just -- it didn't materialize. Now we gave more than the December window, and so we're getting some benefit of that in January but certainly have not seen an outsized uplift because of the price increases going in place.

So how -- that's really interesting. So how precisely can you gauge whether an aftermarket order is coming in? I guess, would be -- would it be because it's coming in at the old price? Or it's just that -- is there any way that you can be more precise in knowing an order's coming in like organically into the fourth quarter as opposed to trying to avoid a price increase?

Yes. It's a really good question. This is one of the reasons we set up the pricing work stream and the transformation was because we didn't have the analytics and the visibility to really understand this as well as we wanted. So what I'd say at Flowserve is we're getting a lot better at understanding the nuances on this. Where we can really see it, though, is with our distributors and the ones that -- particularly the ones that stock product, right? And so there, we've got some history with them, and we can see what they've historically done when we announce price increases. And that's both on the valves, new and the aftermarket. And we can get a little bit of that with our parts business with your preferred partners. But what I'd say is that the visibility isn't as good as what we'd want, and part of that transformation effort is to really get more sophisticated and analytical with our whole pricing.

Got it. That's a really helpful answer. And that just begs the question of how has the first quarter started out in January, if you could.

Yes. So right now -- I mean, we wouldn't have gone out with the guidance that we did if we didn't have a good data point here in January. And so I would say, normally, we would expect a slowdown in January on bookings a little bit. But right now, out of the gates, things look pretty good, both on the aftermarket and the OE side. And we feel reasonably confident in the first half of the year that we'll continue to grow the business. I'd say the only concern that I have for '19 is -- and I talked about this before, the project business we have good visibility on, and we see projects being awarded and our bookings for projects going up throughout the entire 2019. Where the concern could be is on the MRO or the base of the aftermarket business in the second half of '19. And so that's what we're watching really carefully. But right now, at least the preliminary signals at the beginning of the year are still positive that the base business or the MRO business is still continuing at a healthy rate.

Good to hear. And just last question for Lee. I hate to put you on the spot, but working capital as a percent of sales in that 27% range did not improve year-over-year. Scott mentioned that you've got that drag from past due backlog is still inflating some of your receivables. But what is the target? And how quickly can you ramp down that percent of working capital for 2019?

So you definitely put me on the spot, Deane. And it's an area that continues to be a frustrating area for all of us. As we've talked about at the Analyst Day and what we've talked about on every earnings call, it is a significant focus. We're very focused on cash -- working capital on cash flow during the year. One of the things that we are doing is changing our incentives to drive better working capital performance. During the year, historically, a lot of our incentives were more year-end focused. So you'd have this big push at the very end. But during the year, you would not have the intensity around it. We've expanded our incentive plans to include more leaders around working capital. So we are, I think, pulling all the levers that is required to do it. But as we've talked about at the Analyst Day, there are a lot of challenges given our systems and our processes. And a lot of the Flowserve 2.0 is about putting plans in place to address those and put systematic fixes in place. So we're not going out with a percentage of how much working capital we're taking out. But I will tell you, it is -- we have internal aspiration and targets that we are going to make major steps in driving reduction both in -- I'd say both in inventory and receivables.

Our next question comes from Scott Graham from BMO Capital Markets.

I've got some -- a couple of questions around the sales guidance, which organically looks like up 6% to 8%. And I guess, what I'm wondering is there's a reason that you went out with a number that large, and certainly understand the last couple quarters' bookings. But also, if you take a peek at the fourth quarter sales, those probably could have been a little bit better, whether that's a shipment issue or what have you. So I'm just -- 2 questions around the revenue guidance is: number one, what kind of gets you to the high end versus the low end? And number two, there's an assumption in there of significant amount of book-and-ship business, and I'm just hoping you can give us some data points around that assumption.

Sure, Scott. Yes, no, it's a great question. And I think where we get confidence is our backlog is up year-over-year. And so we had good bookings in Q3. We had good bookings in Q4. A lot of the bookings that came in, in Q4 were a little bit further in the quarter, like booked in late November and December rather than the beginning of the quarter. And so we've got pretty good visibility for revenue growth in the first half of 2019. And so I feel good about that. And kind of like the market -- the comments that I just said is we're tracking some good project work in 2019. And additionally, the health of the MRO business, which is very much a book-and-ship business throughout the year, has started off 2019 in a healthy place. And the last kind of data point here is while we have made significant improvement in past due backlog, there's more work to come. And by clearing that and getting to the place that we need to gets our revenue into a place that gets right there within the guidance. And so we feel reasonably good about the revenue guidance. The upside would mean we need to book some projects earlier in the year. And then with the new accounting standard, the overtime or percentage of completion accounting, we're picking up that revenue earlier than what you would have historically done with the units of completion accounting. But I think if we can get some of the -- and when I say larger projects, I'm thinking kind of $15 million to $30 million ones. If we get those secured, then there's some real nice revenue uplift throughout the year there. And that would put us on the high side.

And you are working on those projects? Is that on a pre-FEED or FEED basis?

Yes. No, I think, as I said before, we feel really good about the project pipeline right now. And so a lot of these are into FEED. They're at the EPCs. And quite frankly, a lot of them are out in the tendering, and we're bidding on them right now. And so we've got a healthy list of projects. And again, these aren't the mega -- we're not looking at a $100 million big project like we've announced before, but we're seeing a robust list of anything between kind of $15 million and $30 million with a few that are between the $30 million and $50 million range. And securing a few of those will put us more to the high side of that revenue guidance.

That's great. And then if I could just ask a second question about our old friend, IPD, which really surprised me, I suspect others. I'm sure that it wasn't all pushing out the past due backlog for the delta in the margin. Could you give us a couple of things that really went right in the business beyond the past due backlog reduction?

Scott, it's a really good point. And we delivered the 10% adjusted OI. It was kind of what -- we had communicated publicly kind of mid- to high single digits. So this is above kind of what we expected. What I would say, though, is that the IPD team, with David Wilson leading the charge here, has just done a really good job throughout the year putting the systemic and the structural things in place to move our margins back into somewhat acceptable territory. And a lot of that is the past due-backlog reduction, but a lot of it is we took some hard cost-reduction activities in -- throughout the year, but particularly in Q2 and Q3. We also divested a business that, quite frankly, was not performing well and was in a high-cost region. And the effort and the cost to turn it around was not worth the time or the effort and the distraction to do that. And so I think the combination of cost reduction, clearing the past due, the divestiture in the business and then just -- what I'd just say, and it's going to sound probably not -- it's not the most sophisticated answer, but this is -- it really is blocking and tackling. And so we've got some really, really good products within the IPD portfolio. And it's how do you capitalize on those products and make sure we're getting them to our customers and getting the margins that we deserve, and how do we deemphasize some work that wasn't making money and not doing the right things and so moving away from that and really starting to focus on the place that we can create value and make money for Flowserve and for our investors. And I'd just say David brings that great perspective and the balanced approach that allowed us to move margins forward throughout the year. Now what I would say is I do want to caution, right, we're probably not going to have a -- I'll say we will not have a Q1 that we're going to generate 10% adjusted operating margin, but we're not going to be back to the levels that we had in 2018. And so we have made a step-change improvement for the year. We do expect to go forward. Our target in this business remains a mid-teens-type business. That would generate the proper return on invested capital in the industrial space. And in order to achieve that, there's still some operational work that has to be done. There's further cost reductions. We've got to move the consolidation in the pump platform together and get some other cost takeout. We've got to be more disciplined on our pricing and our order execution, and then we've got to continue to improve the operational controls at the manufacturing side and the operational locations within the business. But great progress in the fourth quarter. And while margins will come down a little bit in Q1, we fully expect to capitalize on this momentum and keep moving the IPD business forward.

Our next question comes from Andrew Obin from Bank of America.

I just want to clarify if I've heard it correctly that you guys said that you have more confidence in large project orders in 2020 versus MRO sustainability into the second half? Is that correct?

Well, in 2019, right? So for 2019, yes, we feel -- no, we feel really good about the pipeline and the projects. And again, the large operators have communicated publicly their capital spending. And you can see in the EPC's backlog that those projects are through FID, and they're starting to move forward. And so we're in the middle of transacting and quoting for a number of large projects, and we feel pretty good about the health of these projects. Now that can change, and things do change. But everything we're seeing today, I would say that '19 -- that the '19 project portfolio is better than where we were at in 2018 at this time. And then just to be super -- just, I want to finish on the MRO side. What I said on the MRO side is we currently -- fourth quarter and our January data point look really good. And so what we're seeing is continued MRO spend. And like the MRO spend can be cut off immediately. And so if we have risk, what I'm concerned about is a potential slowdown in the MRO business in the back half of 2019. But right now, everything we see and where we were at the end of Q4 and what we've seen at the beginning of this year all looks good that the MRO spending is relatively healthy. And combine that with our internal initiatives, then we should be able to grow the MRO spend as well.

I guess, the reason I ask because one of your competitors sort of highlighted the fact that they actually expect bookings to accelerate into 2020. And I guess, they felt quite a bit better about MRO, but I think they were highlighting sort of petchem and LNG into 2020. Can you just talk about how much visibility you have on a longer-term basis? Because these are very long-winded cycles, and I'm just wondering if you guys could actually see acceleration in bookings on OE work into 2020, if that's a possibility.

Yes. I really -- we're very focused on '19 here at Flowserve. And I would just say, our lens and window is not as great as it needs or should be. But I will answer the question. And again, right now, what we're seeing, and I would say on the oil and gas side, primarily refining and the midstream space, plus the chemical space, there are a lot of project opportunities that go from '19, '20 and into 2021. And what happened is there's been a significant underinvestment over the last 4 years. And so at some point, that catches up. We showed this in our pressure curves in the December Analyst Day. And so if you believe the pressure curves and this kind of underspending theory and that demand stays somewhat constant or grows a little bit, then you get increased capital into 2020. Now what I would say is I'm not going to go 100% and commit that 2020 is going to be a great number. But right now, the project portfolios look pretty good and things are lining up to continued health in bigger projects and infrastructure spending for '19 and '20.

And how are you thinking -- just to follow up because the same competitor highlighted the fact that they sort of need to hire more engineers and field technicians. I would imagine you have plenty of sort of roof capacity to meet the growth. But do you have the people? And where do you get them?

Yes. So right now, we're communicating a reasonably moderate growth level of 5% to 7%. We have plenty of people. We've got plenty of capacity, and that is not a concern for us right now. There are some very niche aspects in our business that have grown at an outsized -- outsized than others. And so that's an area where we've got to do some selective hiring. But in general, this is not a concern for us at Flowserve.

And I'll just sneak one more in, I apologize. Just in terms of the mix, OE and aftermarket, are you guys being more selective on OE in Q4? Is that part of what happened in Q4?

No, I would say we started being more selective on the OE earnestly at the beginning of last year. And so what I would say is we have been selective. I don't think it's necessarily a cause for a little bit lower OE. I'd say some of that was just timing of orders. And some of it could be due to just selectivity. So we have raised our margin expectations and we've raised our price. And when those things happen, then we're not going to win some of the awards that potentially could have come our way.

Our next question comes from Brett Linzey from Vertical Research Partners.

Just wanted to come back to the aftermarket, I mean, very solid bookings in the quarter. I mean, historically, those aftermarket bookings tend to ship in the quarter. But yet you had sales only up modestly. So just trying to understand the disparity there. It's been wider than it has been in quite some time. Is it the nature of the work? Are customers ordering further out? Preorder ahead of price? Any color would be helpful.

Yes. So again, the MRO bookings and the aftermarket bookings in the fourth quarter were fantastic. What I would say is a lot of that came in a little bit later in the quarter, and so we didn't get to do the book-and-ship that we wanted. But the backlog's up, and we feel very good at converting that. It's typically very short-cycle work within -- like you said, it's within a 3-month window. And so I would expect us to convert on the backlog and see nice growth in the aftermarket side of our business.

Okay, good. And then maybe just shifting back to free cash flow, specifically working capital inventory on the asset side. It sounds like plans are underway. You guys are making progress there to address some of those issues. But you are guiding for fairly strong sales for the year, which typically requires some working capital build. So I guess, in that context, do you think that working capital assets can be a source of cash this year given that balance?

I'll let Lee take this one.

So Brett, what we're modeling right now is we're really driving to improve the velocity of those. At a minimum, it would be nice to keep it at least somewhat flat, but it could be slightly a burn depending on where the sales end up. So we are focusing on, as I said, the velocity and the turnover of both AR and inventory and obviously managing our payables correctly. So it would be nice to drive the growth and minimize the cash burn associated with that.

Yes. So really what we're trying to do is if we can bring down the velocity on those 2, then it will offset the need of working capital build with the growth of the business. So I would say it's probably not going to be a source of cash, but this is a huge opportunity for Flowserve. We've got a lot of attention and focus on it. What I would say is in some of the numbers that we didn't necessarily show this we've actually made tremendous progress in the back half of 2018. And so we fully expect to continue on that progress. And then the other thing I want to highlight, and Lee said this earlier, historically, at Flowserve, we've been very focused on working capital at the end of the year. And while that's wonderful for one data point, it really doesn't drive what we want to do. It doesn't get the cash freed up throughout the year, and it really doesn't help you on your long-term return on invested capital metric. And so we have really put the attention and focus of doing better on working capital throughout the year. And in fact, we're changing our incentive plans for 2019 to be an average rather than an endpoint. And so I think we should see demonstrated improvement quarter-over-quarter on the working capital metrics throughout '19.

Okay, great. And then maybe just one housekeeping. You mentioned in the release normal seasonality of the business, but it does sound like the savings maybe feather in towards the back half. Is there any framework you can give us or guidepost, be it percent of the year, first half, second half to help us kind of calibrate things here for Q1, Q2?

Sure. So what we've said, and I'll just reinforce, is that -- I would use 2018 as the guidepost for earnings and cash. Our expectation is that year-over-year, each quarter, you'll see an improvement. And I' would use that as the baseline. The other thing I would just kind of maybe highlight from a modeling standpoint, and Scott hit about this -- hinted on this a little bit earlier, is we acknowledge that the first quarter of 2018 we did not have -- we had a horrendous cash working capital quarter. We know that going into the first quarter of this year, there is some seasonal build, but we don't expect it to be to the full extent that it happened last year. We are -- as Scott mentioned, we put quarterly targets in place. We have an eye on it. We talked about it in January, we're talking about it in February that we cannot have this huge outflow of cash in the first quarter like we did last year.

Our next question comes from Nathan Jones from Stifel.

Going back to a few questions here on the bookings. Aftermarket bookings at nearly $550 million in the quarter is pretty close back to previous peak levels on the aftermarket bookings side. You guys have talked about commercial excellence initiatives to try and drive better penetration into your current installed base. Can you maybe talk about if you're seeing any benefit from that or if getting back to this level is purely market lift and potentially there's some further upside from these commercial excellence initiatives or if that's already started to be embedded in this bookings number?

Yes. So the initiative within the transformation is called commercial intensity. And we are definitely seeing an uplift due to commercial intensity. So it's both the internal efforts with -- combined with some release of MRO and maintenance spending at these large installations. So I don't know -- it's hard to say, is it 50-50, is it 70-30, but it definitely is a combination of the internal efforts and the market. And what I'd say is we've got really good visibility. And I showed this as an example in December, where we have a pilot in a target account. We are tracking to -- the uplift that I shared in December at those specific sites, which is a mid-teens-type growth improvement. So we validated that this commercial intensity program is incredibly effective. And like I said in December, there's really nothing novel or innovative about this. But it really is providing structure and process for our leaders out in the field to make sure that we're fully capitalizing on our installed base and in our service capability. So just by doing that and putting this operating system in place, we're seeing this healthy uplift. Now we're not going to get that across every single location. But for the sites that we've designated as this is an opportunity, we are seeing the demonstrated kind of a mid-teens growth. And so I would expect that to continue throughout 2019. And I said this a little bit earlier, but North America, we've gone live. We've now gone live in Europe, and we're probably at about a 60% deployment. And we've just started the process in Asia Pacific and the Middle East. But we're getting good uptake. The team is incredibly focused. And I think really what it does is, is it puts that aftermarket group now very focused and aligned to growth rather than just focusing on the margins and the delivery.

Okay. So that sounds like you think that there's upside on the aftermarket side to where the previous peak levels came in. On the OE project side, I mean, when we're in 2016, when you start getting these $5 million to $15 million or $15 million to $30 million projects, there's generally not a whole lot of margin associated with those and they absorb fixed costs. As we're coming out into a better demand environment, are you starting to see that the margin profile that you can bid these projects at improved? Are you starting to see pricing on these things improve? Do we still need to soak up more industry capacity before you can really start to see those move?

Yes. No, it's a really -- it's a fair and a good question. And historically, right, on large projects, you attract a lot of different -- a lot of attention, and there's a lot of different bidders through the EPC forcing the pricing down. Again, I said this a little bit earlier, we are very focused on moving our margins up. And we're not afraid to walk away from something that's not going to meet our margin threshold or the margin that we think we deserve when we're booking and executing these larger-type work. And so we've turned work away, and we're going to target areas and we're going to target partners where we know we can make the margins that we need to make. And when we look at the project portfolio and the things that we're tracking to in 2019, they all have a higher margin than what we've accepted over the last couple of years at Flowserve.

Okay. Then maybe just a quick one on the backlog quality. I'm sure you don't want to talk about what the exact margin and the kind of things are in backlog. But could you maybe talk a little bit about how much better the margin that's in backlog are now than -- at the end of '18 than they were at the end of '17 and if you expect that quality in backlog, that margin profile in backlog to continue to improve as we go through '19?

Yes. I'm not going to give any numbers on that, but it's certainly implied in the guidance, right? And so you can see in the guidance that we're uplifting the margin percentage with where we landed on the EPS guidance. And I said this a little bit earlier, but we really started to be selective and focused on margin in our backlog and really focused on pricing at the beginning of '18. And I would say throughout the year, we got better and better. And so every quarter, we've been able to get more confident in building that margin in backlog. And so we've got some pretty good momentum here. And I would say this really -- what I'm talking about is it really applies more on the pump side than the valve side because the valves have historically kept reasonably good margins even throughout the cycle. But on the pump side, we definitely expect to continue to expand margins given what we've booked thus far. And I don't see that changing here at the beginning of 2019.

Our next question comes from Charley Brady from SunTrust.

Just kind of back on Nathan's questions on large projects out there. I guess, more kind of medium-sized projects, is the -- we're just hearing that the pricing competitiveness is still really, really tough out there. And relative to what a normal margin might be considered, it's still maybe anywhere from 500 to 700 basis points delta. I'm just wondering, is that something you're still seeing? Is that pressure lessening at all? Or is it more confined to certain areas and in other areas, you're really not seeing that sort of pressure?

Yes. No, there's definitely pricing pressure out there. And what I would say is when you get an EPC that's launching 5 different bidding process and we've got a bunch of people competing, then the margins are not going to be very good. Where we have some proprietary technology and we're able to leverage that and then selectively add in other pumps and valves around that, then our margin profile moves up. And it's in a much better place. And so part of our efforts within the transformation is to really get more proactive about our planning. And I've talked about sales and operational planning before, but we've implemented now a CRM system. We now have global visibility to demand, and we've got a much better understanding of where our capacity is. And so we can make more informed decisions and be more selective about what we want to take and not want to take. And so while some of these projects are going to command -- or get a lot of attention from our competitors and drive prices down, we're not necessarily going to compromise on that. And we're going to go find the ones where we think we can make the right money and where we can provide either the right solution or the right technology that brings Flowserve the value that it deserves in these projects. Now the other thing I'd say is when we look about -- and I'm thinking more on the pump side here. If we look across the peer group and where folks are, we are starting to see some capacity fill up. And I would expect that pricing should continue to improve throughout 2019. But what I would say is there are still projects and some activity out there that is not what I would have expected because I would have expected more discipline on pricing with the peer group here at the end of '18 than we saw.

That's really helpful. And then just one more for me on IPD. So I guess, the margin obviously in the quarter was a lot higher than we expected, and I know you commented on that. I'm just trying to understand, how much of that, I guess, margin lift was due just from flushing out the past due backlog versus, I guess, the core business operations, for lack of a better term?

Yes. And I don't want to get in too many specifics. But I mean, it was a combination of all 3 things, right? It was the margin improvement. There was definitely some seasonality with the fourth quarter, just, in fact, that we're still focused on end of year rather than all quarters. So you had a little bit of that, and then we've got some operational improvement. And then we have this divestiture that was a low-margin to losing-margin business that came out of the system. And just the combination of all of that and then back to what I said earlier, just the blocking and tackling and the basic fundamentals of running a business in a proper manner is allowing us now to get our margins into a much healthier place. What I'd say is 10% was better than we had expected, right? We have been saying kind of mid to high single digits. And so we definitely had some wins in the quarter, but we feel really good about the sustainability in '19 over the full year to continue to grow the full year margins within that platform.

Our next question comes from Joe Giordano from Cowen.

So I just want to start on cash. In the quarter, I think some of the -- on the operating cash flow side, some of the variance versus where many of us might have been seemed to be on like the accrued liabilities paydown rather than like a traditional working capital account. So one, is there anything like we should note in that account going forward? And then, Lee, just on your longer-term 100% conversion, how should we think about that? It's obviously a big move from where we are today. Like how linear should that kind of be? Or is it going to be kind of a step change towards -- as we get closer to 2022? How do you kind of foresee that?

So let me answer the second question first. And so I think one of the things on cash conversion that we're trying to improve upon is, I would say, is first the gap between reported and adjusted earnings. As part of my prepared remarks, I highlighted that right now we have roughly adjusted -- adjustment's roughly around $65 million, that is significantly lower than where it's been. And so one of the first things is really trying to improve the quality of earnings and have fewer adjustments. So it's an area -- so that's part of it. The second part of it is obviously the working capital performance and just continue expanding our margins. So I wouldn't necessarily say it's linear, but we expect to do significantly better in '19 than we did in '18. And just having fewer adjustments is a step in the right direction. And as I talked about earlier, improving our working capital performance is also another step in that. So we hope to get to there sooner. We're not waiting for 2022 to get to 100%, but we're going to be -- we are looking to make, I would say, a relatively step-function improvement in '19 and '20.

Okay. And was there anything in that accrued kind of category that we need to...

Yes. I mean, there were some adjustment around pensions. The discount rate changed, and that lowered some of our liabilities. But it really didn't have, I would say, an immediate P&L impact. The discount rate lowered that liability. And there has been some adjustments around some environmental accruals and so forth. So I wouldn't point to something that is significant.

Okay. And then on margin, I mean, 2 things here. One on IPD. Obviously, we don't want to be in a situation where it's a big surprise positively in 4Q and then it sets up to be a surprise negatively in 1Q just given where we're coming from on a comp basis. So historically, it looks like a 200, 300 basis point kind of sequential move from 4Q to 1Q. It seems like an average before things kind of went haywire. How would you kind of handicap that now? And then like broadly with margins, I just want to get a sense of what kind of savings are you baking in into your 2019 from the restructuring efforts? I guess, the incrementals, inclusive of savings, seem fairly modest given that kind of organic growth. I'm just trying to gauge the conservatism in that margin number.

Yes. So let me talk about the first quarter first, and Lee kind of said this earlier, right? I think as you think about our earnings and revenue over the different quarters, I think using 2018 is a good go-by in terms of what to think about. On IPD specifically, it was a big quarter. It was above what we had expected, and Q1 will not be as good. And so it's going to come down. I'm not going give you an exact number, but it will definitely come down. But when we think about year-over-year, we do expect to continue to grow the IPD margins, and quite frankly, all of the platform margins. And then the second half of the question was -- remind me, what did you want in the second half there? Was it more on the full year, right?

Yes. Just curious, like in your earnings guidance, how much like savings are you baking in from the restructuring efforts that you've done in '18 and you're planning on doing in '19? And just like incrementals seem even at the high end, below 40% or so, which seems conservative based on a 6% to 8% organic growth for you guys. I'm just trying to gauge...

Yes, that's a fair question. Look, I'll just say the way I look at it is -- I look at EPS from 2018 to kind of what we're guiding at the midpoint, and it's a 17% growth. And so that doesn't feel conservative at all to me. I get where you're going on when you kind of back into that incremental margin and what the basis point improvement is. But what I'd say is, look, we feel pretty good about the guidance. We think it is aggressive, but we also think it's achievable. And we said this a little bit last year, right? We're not going to put something out that we don't think we can make. And quite frankly, our internal plans and everything that we're trying to do would be higher than what we're putting out in the guidance for 2019. But we've got a lot of good momentum. We're doing the right things. And if we can move margins up higher and at a faster rate, then we're not going to let off of that. And everything's wired around the transformation program, right? So the pricing work stream, the operational work streams around supply chain, cost takeout and the other things are all in full motion. And we're going to execute those as fast and as fierce as we can throughout the year in 2019, and we're making good progress on this.

Our next question comes from Josh Pokrzywinski from Morgan Stanley.

Scott, a lot of grounds have been covered already. But I guess, one thing that sticks out on some of your aftermarket comments here is that I think we came off a pretty strong second half in '18 in terms of turnaround activity in refineries. The calendar looks good for the first half of '19 as well. But I would imagine, at some point, you hit tough comps. Is that part of some of that second half apprehension in the MRO sustainability?

Yes. I think that's certainly factored in. And just quite frankly, I mean, we just don't have the long-term visibility on MRO spending, right? We don't get a lot of communication here, and it's hard to track it. And like I said earlier, what we hope, though, is that the market and the spending levels increase. And then what we do know is that our commercial intensity program are going to drive your growth above what we've had historically and expand our market share of the -- what we have from the installed base. So we've got that working for us. And quite frankly, just the question is, from the customer standpoint, how much spending and availability is there in the back half of '19.

And I guess, that's kind of the kernel at the center of the question is do you -- are you getting a sense in the marketplace that customers have caught up from unsustainably low levels of spending to where they're overspending near term and growing from this level is not as obvious?

No, no, that's not what I'm saying. Yes, let me be really clear. Everything we're seeing right now points to continued growth, right? The fourth quarter was good. The data point in the first quarter's solid. And so we fully expect that MRO spending maintains or continues to grow. What I'm just implying is like if there were risk and it were pulling us down to the lower side of what we guided, then it could potentially be a slowdown in the '19 MRO -- back half of the year MRO spending. But right now, we're not seeing that. That's not -- we're not seeing it, but we just don't have that visibility to -- that it continues in the back half of '19.

Got it. That's helpful. And then just one cleanup question for Lee around free cash. Lee, if I assume that you guys are, call it, working capital-neutral, which would be some good progress given the level of growth that you're expecting in '19, just between restructuring and pension that it kind of brings you down to somewhere in the neighborhood of 75% conversion. Is that a good starting point? Or is there anything else on discrete line that we should be aware of?

I think our aspiration is to be better than that.

Thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating, and you may now disconnect.