Flowserve Corp
NYSE:FLS
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Flowserve Corp
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Welcome to the Flowserve 2018 Third Quarter Earnings Call. My name is Paulette, and I will be your operator for today's call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. 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, Paulette, and good morning, everyone. We appreciate you participating in our call today to discuss Flowserve's third 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 will open the call for your questions. As a reminder, this event is being webcast and an audio replay will be available. Please note that our earnings materials do, and this call will, include non-GAAP measures. A reconciliation of our adjusted metrics to our reported results prepared in accordance with Generally Accepted Accounting Principles is available in both our press release and earnings presentation.
Finally, this call and our associated earnings materials contain forward-looking statements. These statements are based upon forecasts, expectations and other information available to management as of November 8, 2018, and they 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 encourage you to fully review our Safe Harbor disclosures contained in yesterday's earnings materials, which are all available on our website at flowserve.com in the Investor Relations section.
I would now like to turn the call over to Scott Rowe, Flowserve's President and Chief Executive Officer, for his prepared comments.
Great. Thanks, Jay, and good morning everyone. Thank you for joining today's third quarter 2018 earnings call. Flowserve delivered solid operational and financial results in the quarter; with strong bookings, revenue growth, and continued margin expansion. At a high level, I am pleased with the progress we've made to improve our visibility in oversight across our operations. This was the second consecutive quarter that each of our segments delivered on their targets and avoided the type of unforeseen issues that negatively impacted earnings in the past.
Our confidence in our ability to set expectations, drive results, and deliver value for our customers, and shareholders has continued to grow with our progress. We believe we are building momentum heading into next year, as highlighted by our ability to deliver two consecutive solid quarters. As a result, we increased our full year 2018 adjusted EPS guidance range to $1.65 to $1.75. We will go into this in more detail later in the call.
We are encouraged by our progress, but recognize that we still have a lot of work in front of us. We're still in the early months of our multiyear Flowserve 2.0 initiative to transform our operating model, and we are now moving full speed ahead with our efforts to build a performance and accountability-driven culture that will drive the enhanced value that we believe is inherent within Flowserve.
Let me briefly touch on some of the highlights of the quarter before going into greater detail. Our adjusted EPS of $0.49 was up 20% sequentially and 30% year-over-year. Revenues grew almost 8% compared to the 2017 third quarter, with improvement in both adjusted gross and operating margins. Bookings growth across all segments drove our overall book-to-bill ratio to 1.06 for the quarter, highlighted by strong original equipment and aftermarket bookings. Our end markets continue to strengthen and we now fully expect to capitalize on the opportunities that are in front of us.
Turning now to the detail on bookings. For the first time since the third quarter of 2015, we produced bookings over $1 billion in consecutive quarters. Overall, we delivered broad-based bookings growth in all industries we serve, with the exception of the power sector. Bookings grew 13.2% year-over-year, which includes a 2% headwind from currency and divestitures. Our bookings were primarily from smaller original equipment awards of less than $5 million and are focused on the aftermarket. Additionally, we were awarded some larger original equipment work in the refinery space that was driven by the change in regulation for refined shipping fuels.
After three years of constrained maintenance spend, we have seen increased MRO spending over the last three quarters as our customers look to properly maintain their facilities. Our third quarter aftermarket bookings of $507 million represents the highest level since 2014 and was up nearly 12% year-over-year. An important aspect of our transformational efforts is to further capitalize on our significant installed base and our vast network of quick response centers. While we continue to see large projects move toward FID, Flowserve is a late cycle beneficiary of larger project work. We remain encouraged by the increased visibility we have into those opportunities and believe that many of these will come into fruition in 2019 and 2020.
Over the last several months, our confidence has increased regarding what is in the pipeline and when we'll likely to see increased project bookings. While forecasting any one quarter of bookings is always a challenge, we are optimistic our approved end markets, active quoting funnel, and solid capture rate will continue to support increased bookings for the fourth quarter, generating a healthy backlog going into 2019.
Looking now at the third quarter bookings by end markets, and starting with our largest market, oil and gas, bookings increased 27% year-over-year driven by EPD's 34% increase. We continue to expect increased investment by our customers based on their pre-FEED, and FEED activities, and projects progressing towards FID. Flowserve has also had success with, and provides a unique offering of highly-engineered products that are well-suited to enhance the processes critical to cleaner fuels. We anticipate that many of our downstream customers will pursue this type of investment due to the ongoing regulatory changes such as IMO 2020. FCD's oil and gas bookings contributed nearly 20% growth, including several small, mid and downstream awards, while IPD's oil and gas bookings were roughly flat.
In chemicals, our bookings increased approximately 4%, with all segments delivering growth. IPD led the group with a 12% year-over-year improvement, EPD contributed 4% growth, while FCD's bookings grew 1%. Both FCD and IPD orders benefit from participating in a North American chemical project where we expect to see continued investment both near and long-term. Our project pipeline includes significant expected ethylene investment in Asia, the Middle East and North America as these projects progress towards FID.
Flowserve's power bookings decreased 27% year-over-year, and remains our most challenged market. Each of our segments' power bookings this quarter declined year-over-year by about the same percentage. We continue to have muted expectations in the power markets near-term. There are a few fossil fuel and nuclear opportunities in Asia, but Western nuclear and traditional power generation markets remain challenged and competitive.
General industry bookings increased 3%, driven by strong distribution activity. FCD's bookings grew over 24% and was partially offset by EPD's 18% decline, while IPD contributed roughly 3% growth. The efforts in the distribution channel delivered strength from all regions, with the exception of the Middle East. Mining, food and beverage, and pulp and paper were all up over 5% on solid broad-based market activity, but these markets only represent about 5% of our business. Lastly, the water industry, which represents the smallest category we break out on a standalone basis, was up 67% year-over-year and represented about 6% of our total bookings. While this is a small market for Flowserve, the growth rate is encouraging.
Geographically, Europe and Asia Pacific grew 27% and 26%, respectively. And Latin America continues to improve, up 14%, its third consecutive quarter of growth. North America was up 3%, while the Middle East and Africa declined 6% versus its highest quarter of bookings in 2017.
Turning now to our performance by segment, IPD's performance continued to improve in the third quarter, delivering a 320-basis-point improvement in adjusted operating margin, leveraging a modest 5% revenue increase. While IPD is making progress, margin improvement again was restrained by the shipment of low margin past due backlog that we are continuing to clear. We also completed the previously announced divestiture of two non-core and low margin product lines early in the third quarter, which negatively impacted IPD's revenue by about 5%.
We expect another meaningful step in the fourth quarter in our efforts to deliver our target of mid to upper single-digit operating margins. While progress in IPD's turnaround has been slower than we would like, the structural and sustainable improvements we are pursuing are critical to achieving its full potential in mid-teens margin business over the longer term. EPD delivered 10% revenue growth in the quarter compared to the prior year on strong original equipment and aftermarket shipments. That included a 2% sales mix shift towards lower margin original equipment shipments. Continued improvement in EPD's manufacturing process drove an adjusted gross margin increase of 10 basis points despite the mix shift headwinds.
FCD continued its solid operating performance driving significant incremental margin improvement on 6.4% sales growth. Adjusted gross and operating margins increased 210 basis points and 290 basis points respectively year-over-year. FCD's 18.6% operating margin included increased fixed cost absorption, positive product mix shift and continued strong cost control. From an overall market perspective, we are optimistic that our improved visibility to the growing project pipeline provides meaningful late cycle growth opportunities to complement our foundational run rate and aftermarket business.
As we pursue this growth, we intend to continue our focus on better execution, which will result in improved product costs and lower overhead costs. Our transformation actions and operating improvement initiatives position Flowserve to better capitalize on the market recovery, while delivering 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'll return for a few closing comments before we open the call to Q&A. Lee?
Thank you, Scott, and good morning, everyone. For the third quarter, we delivered adjusted earnings per share of $0.49, modestly above our expectations coming into the quarter. On a reported EPS basis, we earned $0.21 per share, which includes adjusted items comprised of $0.20 of realignment and transformation expenses, $0.04 of charges related to previously announced divestitures, and $0.03 of below-the-line FX expense.
Third quarter sales of $953 million, increased 7.8% versus prior year, which included a modest benefit from the new accounting standard that was largely offset by the approximate 2% headwind from currency and divested assets. We do believe the new revenue accounting standard and the associated increase in our POC accounting has helped to mitigate some of our traditional earnings seasonality. Breaking down our revenue by mix, our original equipment sales increased 11.8% as compared to the 2017 third quarter, while aftermarket sales increased 3.9% to $457 million, representing 48% of our total revenue for the quarter.
Looking now at gross margins. At 33.2%, our adjusted gross margin was up 130 basis points versus the prior year's third quarter and reached the highest level we've seen in nearly two years. Volume leverage, better execution as well as our cost initiatives are key drivers behind this improvement. We are also confident that the quality of our backlog has increased during the year. We know, however, that there are more opportunities ahead on these fronts. Continued tight cost control and improved sales leverage drove a 30-basis-point decrease in adjusted SG&A as a percentage of sales to 22.6%, more than offsetting compensation headwinds. On a reported basis, SG&A is elevated due to the quarter's transformation expense which we expect to see decline in future periods.
Third quarter adjusted operating margin increased 160 basis points to 11% driven by strong 320-basis-point and 290-basis-point improvements in IPD and FCD respectively, which are partially offset by EPD's 40-basis-point decline and a 2% sales mix shift toward lower margin OE versus prior year. On a reported basis, operating margin decreased 200 basis points primarily related to transformation costs at corporate. Our reported effective tax rate of 33.6% was elevated in the third quarter primarily due to losses in foreign operations for which there was no tax benefit. On an adjusted basis, the effective tax rate for the quarter was 28.8%, again, modestly above our full year adjusted guidance range.
Turning to cash, operating cash flow for the quarter were $83 million, representing a substantial increase of $57 million compared to the 2017 third quarter, driven by an improvement in working capital. This marks the second consecutive quarter with meaningful year-over-year improvement. Our free cash flow in the quarter was $65 million or $0.49 per share and was up over $50 million from the prior year. This total amount represents a conversion rate of over 100% of our adjusted net income. At September 30, we also continue to maintain a strong cash balance at over $0.5 billion. Capital expenditures in the quarter were $80 million, up about $7 million from a year ago. The increase is primarily related to enabling technology investments as part of our Flowserve 2.0, as well as some increased spending on ongoing restructuring initiatives. We also returned $25 million during the quarter to shareholders through dividends.
We are pleased with the quarter's total working capital improvement of approximately $50 million over last year, especially considering our 2018 revenue growth. We know much work remains ahead to achieve consistent level of cash flow conversion that we believe Flowserve can ultimately deliver. While the company has understood the need for working capital improvement for several years now, Flowserve 2.0 will serve as the catalyst to impact lasting change. We are investing in systems and process tools, directed all aspects of our order to cash and sales and operating planning processes. Obtaining a sustainable fix won't be quick or easy but it's an effort worth pursuing given the substantial opportunity available. I look forward to sharing additional detail on our efforts with you at our upcoming Analyst Day.
Turning to our outlook, for the remainder of 2018, our solid results and the momentum gained over the last two quarters positions Flowserve well as we look ahead. Accordingly, we now expect 2018 full year adjusted EPS in the range of $1.65 to $1.75 per share on revenue growth of 5% to 7%, including a roughly 1% FX tailwind, largely offset by approximately 1% negative impact due to divestitures. Due to the new accounting rules, we don't expect to see the traditional seasonality in the fourth quarter as in years past.
As our guidance implies, however, we do expect to end the year with another solid quarter. From a 2018 cash usage perspective, we expect to return approximately $100 million through dividends to our shareholders. Capital expenditures are now expected in the $70 million to $80 million range. Although our expected 2018 CapEx guidance is down slightly, we do continue to invest in technology to support Flowserve 2.0 as we saw this quarter as well as improving our manufacturing productivity. We also expect full year debt repayment of approximately $60 million and to contribute approximately $30 million to our global pension plans, mainly to cover our ongoing service cost as the U.S. plans remain largely fully funded.
Let me now turn us back to Scott for his closing remarks.
Great. Thank you, Lee. As we wrap up, I'd like to spend a few minutes updating you on the progress of our transformational efforts. Shortly after I joined Flowserve, I laid out the case for organizational, operating and cultural improvements that were necessary to simplify and increase the effectiveness of our business model. Under the Flowserve 2.0 transformation program, we now have major initiatives underway to drive value and improve across six key work streams: operations, commercial, growth, aftermarket, cost structure, and working capital. We have a designated and full-time team leading this effort, and we brought in external advisors to help us build our capability and assist with skill set gaps and world-class thinking.
The team has built our value capture plan and is running the program with the tools that you would expect from an initiative with this scale. While we're beginning to see some initial financial benefits impacting our results, we are still in the early stages of the transformational program. We are confident that Flowserve's performance will improve in 2019 and beyond, and that our efforts will result in significant financial improvement in the coming years. I'm very pleased with the current transformation progress, the engagement and commitment of our associates, and our focus on taking the proper actions to drive value.
In addition to the performance aspect of the transformation, we are also highly focused on the health of the Flowserve enterprise and the engagement of our associates. I truly believe that an informed, engaged and empowered workforce is critical to driving the systemic change that we are seeking for Flowserve. When I joined, our associate engagement levels were not where they needed to be to undertake this type of transformational change. We have seen a marked improvement in this metric and our employees are committed to the change we are pursuing together. The transformation is serving as the catalyst to fundamentally change the way we think, act and operate at Flowserve.
We are clearly gaining traction and momentum, but it's important to remember that we are still early on this journey. I am truly optimistic on what Flowserve can become and the value we can deliver to our customers, our associates, and our shareholders. Flowserve will be hosting an analyst event on December 13 in New York City. We'll provide additional details on the event later this month. We certainly hope to see many of you there as we share additional details on the Flowserve 2.0 and our expectation for value creation going forward.
Operator, we have now concluded our prepared comments and would now like to open the call to any questions.
Thank you. We will now begin the question and answer session. And our first question comes from Charley Brady from SunTrust Robinson. Please go ahead.
Hey, thanks. Good morning, guys.
Good morning, Charley.
Hey, just the commentary on the working capital and the systems you're putting in place, can you get a little more granular on kind of what you guys are doing specifically to drive that working capital improvement you're expecting over the next year or two, I guess?
Sure. Let me start and then I'll let Lee go into some of the specifics, but I talked about this before, working capital clearly isn't where we want it to be and we knew we've got to do a lot of things to fix it. Unfortunately, with the decentralization at Flowserve when we started, it's been more difficult than I expected to drive the systemic processes and the systems that ultimately get us to where we want to be. We put this within the Flowserve 2.0 and what I'd say is, in the last kind of year, it's been a lot more around visibility and brute force and we're getting some improvement around that. And now, we're really switching it into a much more of a process focus and the system enhancement. So, Lee, you want to add anything?
Yeah. I'll speak a little bit more about A/R. I mean, we are pleased with the improvement at DSO year-over-year and sequentially, but we know we have a significant amount of work to do. I would say a lot of our progress to-date has been manual and with a lot of intensity. For example, I do a weekly cash call. We've given cash targets to our business and we track how much cash we should collect every week through the quarter, but very manual and very intense. Going forward with 2.0, our aspiration is to have a more systematic fix, so it does not take as much time for management.
Yeah. Then on the inventory side, which is probably the biggest prize, we've made progress and we're doing reasonably well and as revenues go up, we've been able to hold our inventory levels. But there's still a lot more work to be done here. We've got an organization now in place that's focused on planning and materials management. And now, we're moving to the process and systems side to really start to drive that in a better fashion than we have in the past.
Thanks. And just one more from me, on the refined fuels regulations that are coming into play, it sounds like you guys are seeing some decent pickup in work on that. I'm just wondering if you can maybe expand on the level of activity that you guys specifically are seeing and do you expect any of that to carry – how farther into 2020, or is it more 2019, just given the timing of when the stuff has to get shipped and then installed?
Sure. So, we've got a really nice product mix on the pump side for taking the refined fuels and making them a little bit cleaner than they are today. And so it is a sweet spot for us. We've got some bookings last quarter and then we saw a pretty significant uplift this quarter in that level of bookings. And we expect that to continue for the next at least two quarters, maybe even three. So, we feel pretty good about this area and what we're trying to do is use some of the technology that is preferred and then start to bundle that with some of our valves and other pumps as they're building out and expanding their existing refineries. So, this is a good space for us and we benefited in the quarter and we very much expect to see future work here in 2019.
Great. Thanks, I appreciate it.
Our next question comes from Andy Kaplowitz from Citi. Please go ahead.
Hey. Good morning, guys.
Hey, Andy.
Hey, good morning.
Scott, OE bookings up 15% year-over-year is the best you've seen this cycle. You already mentioned IMO 2020 bookings. But can you talk about the conversations you're having with your customers? There's obviously a lot of cross-currents out there, maybe more difficult U.S.-Saudi relationship that's (24:23) tariff tension. But it seems like you're still seeing improving activities. So, would you generally characterize your customers as constructive here with getting projects over the finish line? And you did say last quarter that there would be projects that could get to FID by the end of the year. Have you seen these projects begin to move forward?
Yeah. I think constructive is probably the best word to use. As you know and you said it, there's a lot of challenges. There's a lot of headwinds out there. There's political issues. There's geopolitics and other cost issues, but I think overall, I think the environment is reasonably good for moving forward the big projects. And so, while I think everyone has an air of caution, I think the commodity markets and the political environment is stable enough to where folks are willing to step forward and commit things into FID and move forward. And so, all the discussions I've had points to a 2019 that should be pretty solid in terms of projects and we should see another nice growth from 2018 into 2019.
Okay. That's helpful. And just on the topic of 2019, I know you don't want to go into too much color at this point. But could you give us some of the puts and takes when we look at your margin and specifically focused on your adjusted incremental margin. If we assume the base in 2018, it looks like it's something in the mid-20% range. When we look at 2019, I think you've already said that you expect to see better absorption and incrementals, even if OE mix increases a bit, given Flowserve 2.0. So, if I think about that, if I think about price versus cost, I don't want to put words in your mouth, but maybe a net modest positive even though there will be tariff noise. And then incentive comp, I think it's higher in 2018, right, so maybe it's flattish in 2019. So, is there anything I'm missing there as I think about the puts and takes? And so, would incrementals rise then in 2019 versus 2018?
Yeah. So, I'll just start with we're not ready to give guidance yet for 2019, but we will be doing that. And we're currently in our budgeting process. But I mean you've hit all of the big things that we ask, and are challenging our platforms to deliver. Now, the only thing I would say is in addition to that, we've got the transformation program across these work streams that, in theory and as we've seen this start to work, should be driving outsized benefit than just what we see from the macro picture. And so, my expectation is that we move forward in each of the categories, and that 2019 is a pretty good year for us. But what I'd say is, yeah, we'll do the investor event in December, and we'll outline the bigger picture. We probably won't go in the 2019 details during that session, but then quickly in the new year, we'll provide guidance for 2019.
Okay, and just one quick follow-up on this year's guidance. You mentioned last quarter that your aspirations for performance were higher than your guidance. Is your new guidance closer to your aspiration at this point or your aspiration is still higher?
Yeah. I would say we're definitely closer. There were some things in the quarter that I wasn't pleased with, and I'd say it's more around the past due backlog and the working capital. But I think on the revenue and the cost side, we're progressing as I would have liked and kind of toward our internal targets there. I think probably the biggest thing in the quarter for us is – in my first few quarters here, we would have a pretty major surprise each and every quarter. And for the last two quarters, we've eliminated and not had those big negative surprises, so that is definitely a positive step. But I think we're starting to perform like I would like and expect, but we've got a lot of work to go and it's a journey for us.
Thanks, guys. Appreciate it.
Our next question comes from Scott Graham from BMO Capital Markets. Please go ahead.
Hey, good morning. Nice quarter you, guys.
Yeah. Thanks, Scott.
So, I was hoping you could give us a little bit more on past due backlogs by segment particularly what you saw in the September month.
I'm sorry in the September month or in the quarter?
Yes. Well, in the quarter...
Yeah.
...but speaking with the gents last night, it seemed as if and maybe I mistook this but it sounds as if like there were some things that maybe went in the wrong direction in September into...
Yeah. I'm sorry, let me just talk about as a quarter and you'll get a general idea here. I just said this, I'm not as pleased as I would like to be on our progress on past due backlog and there are a lot of reasons for that. But I'll just start, again, we didn't have a major negative surprise or a significant event that changed our thinking and our progress there. And I will say, we are making progress on past due backlogs but it is not as meaningful or step changes as I would have liked.
And so, basically, if we look at kind of what's going on is we had some large more challenging orders that we took at the end of last year and at the beginning of this year. And for whatever reason, they've been constrained in our system and we're working through that. The previous issues that we've talked about due to realignment are for the most part behind us. And now, we kind of fixed some of those problems and we're addressing some of the bigger projects that didn't come out. And then when you look by a platform basis, IPD did progress which was a very good sign, and we're happy to see that. EPD and the valve business did not progress and actually went backwards just a little bit.
And so when we look at it in the quarter, July and August, we were making progress. We did take a step backwards in September and then what I would say is I've gotten the preliminary numbers for October and we've already cleared a lot of the stuff that we saw that got stuck there at the end of September for us. But look, this is one that we've got to fix. And unfortunately, it's not a quick fix because it really goes down to planning and materials management, and it's just not been a focus or a competency at Flowserve. And so we stood up this new manufacturing department. We did that in February with designated resources, and we created a central planning office here in the headquarters building. And then we've hired a new VP of Operations that started in July.
And so what we've now done, we've got the people in the organization in place, we've put a very structured process, and we're really moving toward a robust sales and operational planning process that will launch in 2019. And then we're going to really get focused on the production planning and materials management side. And so I'm very confident that we are making progress. It's not at the pace that I want to, and I do think by 2019, this will not be an issue for Flowserve.
Got it. Thank you. My follow up with that would be around really the fourth quarter implied sales guidance, which is I guess maybe a little bit confusing because on a full year basis of 5% to 7% revenue growth, my math says plus 4% to minus 4% and I know that there's FX going the other way on you and now there's this divestiture going the other way on you. But could you kind of give us a little bit more color on that range which not only is wide but also has half of it is on the negative side of the ledger?
Yeah, sure. We'll let Lee do it. He's got a bridge here that can clarify.
Yeah. So our implied fourth quarter guidance is roughly flat on a reported basis, reflecting the smoothing of our historical fourth quarter seasonality due to revenue recognition. That's the big thing you need to remember is in 2017 fourth quarter increased 17% versus third quarter and we're not expecting that type of transition. So, the other thing I would highlight is organic growth is roughly around 3% in the fourth quarter when you include that roughly 2% currency headwind and 1% of divested businesses. So right now, the big change I think this quarter versus prior quarter is the accounting basically smoothes our revenue during the year. So as I mentioned earlier, what we think is based on our guidance is that revenue will be roughly flat versus last year.
That's really helpful, Lee. Thank you. And if I can just sneak one more in here, and you were talking about earlier that you see a good or reasonably good operating environment. I was just wondering if you could kind of bring that same sort of thinking, a comment to bear on the emerging markets, which is a good chunk of your business and if you could just give us an idea as the quarter progressed how bookings in the emerging markets went for you? Thanks.
Are you talking about Q3, Scott?
Yes, yes.
Yeah, in Q3, we had healthy bookings primarily in Asia, and we're seeing a lot of activity both in Asia and the Middle East. And so I'd say as we go forward, those are the two areas that probably drive the biggest growth on the project side and it's something that we're very focused on and we've got good teams there. And so in Q3, we got pretty much what we wanted in terms of the opportunities on projects there. And then from an aftermarket standpoint, we're doing really well in emerging markets and we expect to continue to do that with our large presence with QRCs and focus in country.
Great. Thanks a lot.
Our next question comes from Josh Pokrzywinski from Morgan Stanley. Please go ahead.
Hi. Good morning, guys.
Hi, Josh.
Just want to jump in on some of the mix within EPD. I guess, given how bookings have generally trended solid, Scott, I think it's on your prepared comments talked about aftermarket being solid and coming in well. I would think given the pretty wide spread there between the OE side of the business and the aftermarket particularly seal that we start to see a bit more of a pickup there on margins. Is that something you expect to start happening going forward? Can you just give us any context for mix both in the quarter and kind of looking out over the next several?
Sure. Yeah. So, the EPD margin in the quarter actually, we were relatively pleased with where we ended up. And so when you look at the year, we've been moving margins up quarter-over-quarter through the year. I think when you look at it against last year, we were down slightly.
But I think there was an aftermarket mix there. And then in addition to that, we had some increased SG&A in that platform and a lot of that was around incentive comp and then also higher R&D. And so, I would say in the engineered side, it's an area that we've under invested in our product portfolio and it's a place that we actually really need to spend more money and make sure that we've got the right products for the right solutions and really have a refreshed product out there as we're competing against some of our more hungry peer group.
And then, the other thing I just want to remind you. If you remember last year in the fourth quarter, EPD's margins dropped substantially. And so what we're really focused on and trying to do is make sure that we're avoiding that step backwards. And at this point, I think fourth quarter will be a similar trajectory as to what we saw our margins in Q3.
Got it. That's helpful. And just shifting over to FCD, kind of the other side of the equation, clearly very strong quarter and these have popped up from time-to-time where it just surprises everybody to the upside. I mean, what's your sense for the cadence there? Does that smooth out and is some of that revenue recognition related that would cause that smoothing? Just trying to get a sense for any visibility you have there on what that could look like, especially with the tough comps.
Yeah. All right. So let's start – we'll just say, FCD had a great quarter and that team is highly focused, they're doing everything that we expect. They're ahead on the price curve side. We've got price increases that really took hold earlier in the year, and then the facilities for the most part are operating at a pretty high level. And so they're just doing solid fundamentals and running the business how we would expect and want them to run that.
I would say third quarter was a high margin quarter but when you go back and look at 2017 in the fourth quarter, they really had an outsized quarter there. And what I would say is we don't expect that big jump again in fourth quarter. But I think if you kind of look at Q2, Q3 and say – and take an average there and say that's a run rate, then that's probably a good number to look at as we go forward.
Perfect. And then just one more, I want to make sure I'm clear on Lee's revenue recognition comment. Was there any positive effect of that smoothing in the other three quarters as 4Q gets kind of smoothed to the downside? Just want to make sure we're clear on that?
Yeah. So you may recall on the first quarter, we recognized roughly $70 million. There was a difference between ASC 606 and ASC 605 of about $70 million. Second quarter, it was about $10 million, in this quarter it was about $24 million. My expectation is that that should flip in the fourth quarter but we'll find out.
Got it. Thanks for the clarification.
Our next question comes from Deane Dray from RBC Capital Markets. Please go ahead.
Thank you. Good morning, everyone.
Hey Deane.
Hey. Good morning, Deane.
Hey. I would like to get an update on price cost, where you expect to come in for the year. You just gave that shout out to FCD that they're ahead of the game. But broadly, what the challenges have been. I know you don't give a lot of detail on price but just if you aggregate price cost where that stands and what tariff impact that you've seen so far?
Sure. Yeah. So obviously, it's been an incredibly dynamic environment and a lot of changes this year. So let me start with inflation. I'll hit tariffs. But on the inflation side, we are seeing inflation on the material and on labor and so that's an area that we're very focused on. We're trying to neutralize and protect against that.
And then on the tariff side, we are being impacted but what I would say is it's a relatively small number for all of Flowserve. And so, while they're out there and we watch it very carefully and we're watching it closely, at this point the tariffs have had a minor impact to our total cost structure.
And then on the pricing side, if you remember, we did two early price increases. We did a general one at the beginning of the year and then we did a tariff specific one right as we ended the first quarter and into the second quarter. And then the other part of that would be the engineered-to-order business. And on the engineered-to-order business, this is where we're building the cost stop at the time of the proposal. And on that side, we can definitely make sure that we've got inflation and tariff impact priced into that bid.
And so right now across the board in all of our platforms, we feel that we're on the positive side of the price cost curve. And you're seeing that in our gross margins as we've kind of been able to keep that and actually progress it each quarter this year. And so, we're obviously turning the quarter now and we're looking at next year. We are concerned about inflation and we're concerned about other things that could change in the geopolitical landscape.
But I don't think that changes next year in terms of being ahead of the curve and so we're looking at what our price increases should be and we'll probably be pretty active in getting that out there and ultimately we want to be a price leader here, right. So we want to be in front of it and driving that as we go forward.
And about tariffs?
Yeah. So tariff, again, tariffs were a minimal impact for us and so it's out there and what we've been able to do is, we've neutralized it with price but then our supply chain has also been able to migrate out of certain countries and into others to where we neutralize that impact.
And so again, we feel we're on the positive side of any tariff impact. And while it's a concern and it could change any day and it's something that we watch incredibly closely. At this point, we feel good about our position and we're in a good place and we'll continue to monitor and we will adjust in 2019 if needed.
Got it. And then, just as a follow-up on the end market discussion given how well you've done in oil and gas for this quarter. There were some competitors who struggled and it just seems like you've also taken some share this quarter. Is that a fair assessment and can you give any color there please.
Sure. No. I would agree we took share in the quarter. There were also some things that we missed in the quarter as well. But I think oil and gas for us has done really well. It's primarily in the downstream side and so most of our orders there were downstream and, quite frankly, were refineries. And so in that space, we've got a pretty unique product offering that does very well. And so, we got our share of the awards and certainly did better than what we've been doing in the first half of this year or even last year. So, that's a nice spot for us. And any time we've got brownfield expansions where we've got an installed base, we typically do pretty well.
Great. Looking forward to the meeting in December. Thanks.
All right. We'll see you there, Deane. Thanks.
Our next question comes from Joe Ritchie from Goldman Sachs. Please go ahead.
Thanks. Good morning, guys.
Hey, Joe.
So, maybe just kind of following up on that point. Obviously, like big focal point here are the oil and gas orders coming back. Just can you maybe just talk a little bit again around like the pricing discipline around the orders and what you're seeing in the marketplace today? Any color there would be helpful.
Yeah. Sure. So, I'll say oil and gas specifically will stay there. And again, primarily that was refinery and refining for us in the quarter. And we've got a pretty good basket of products that fit that market really well. And so, we feel good about the margins that we achieved in Q3.
Now, what I would also say is when we don't have a preferred offering or we don't have the installed base in that existing site and it's a greenfield tender, we are still seeing really competitive prices on our engineered pump side. And I would say it's a little bit surprising with me, given the uplift in the market activity now for the past couple quarters. And I fully expect that that pricing should improve across the peer set here as we go into 2019. But it's still competitive. And then, if I apply that onto the valve side, the engineered valves is still an incredibly competitive space for pricing.
That's helpful, Scott. I mean, have you found yourself walking away from some orders because of this pricing dynamic in some of the segments, sub-segments that you talked about?
Yeah, so I touched on that a lot after the Q1 or in the Q1 earnings call. And what I would say is our team is very focused and we're not afraid to walk away from work that doesn't make sense for us. And we obviously need to look at it holistically and we need to look at what the aftermarket brings in all of that. But there are jobs and there are orders that we walked away from this quarter because we weren't there.
Yeah. That's helpful. If I could ask one more. Just on the dynamics with revenue recognition and seasonally not seeing the same kind of step up into 4Q, are there any impacts that you would see to cash flow as well? So I'm just trying to understand like how we should think about the cash flow number for the year specifically because 4Q tends to be a big quarter for you guys?
Yeah. I'll let Lee jump in on that one.
Yeah. So our expectation is that we'll have really strong cash flow in the quarter. Typically, what's happened is there's obviously a lot of shipments that happen in the quarter, a lot of stuff, as Scott's talked about in the past, as we clear up past due backlog. So what I suspect was going to happen is we're going to see a lot of shipments go out, we're going to be invoicing a lot of customers. I think you'll see a mix between assets going out of contract assets into receivables, and we're going to work hard to collect those receivables. But our expectation is that we're going to have a strong cash quarter.
Last year was really strong. We did, I think over $200 million of operating cash flow in the quarter. I'm not sure if we're going to do that high but I suspect we're going to be pretty strong versus third quarter.
Yeah. And then just to clarify, right, the 606 accounting really is around revenue recognition and should not impact what we expect on cash flow in Q4.
Okay. Thanks, guys.
Our next question comes from Jeff Hammond from KeyBanc Capital Markets. Please go ahead.
Hey. Good morning, guys.
Hi, Jeff. Good morning.
So, I think you've had two really strong order quarters, but larger projects have been largely absent. What are you just seeing from a visibility as you move into 2019 on some of the larger projects?
Yeah. I think what I'd say is, we didn't get any large ones that were – the Hengli and Dangote size. But we did get a handful of projects, primarily in refining, that were more than what we had been seeing over the last couple quarters. And so, we felt good about the projects that we got in Q3.
And then as we look at 2019, our pipeline and kind of what we see out there at our customers that are either in-FEED or pre-FEED activities is definitely higher than what it was at this time last year. And so, we feel pretty good about the project pipeline.
And again, although, there's a lot of kind of dynamics out there in the geopolitical sense and we've got oil prices coming down a little bit here in the last month, I think our customers are still willing to move forward with some larger projects, just because they haven't really done that now in the last four years. And so, we see projects next year at higher level than what we have this year in 2018.
Okay. Great. And then clearly, some progress on Flowserve 2.0 and seeing better trends, just as you kind of see yourself shifting maybe from defense to more on offense, just how are you maybe refreshing on M&A, and capital allocation in terms of maybe starting to return more cash to shareholders through buybacks? Thanks.
Yeah. That's a great question. And no, quite frankly, I'm not ready to make that transition to offense. And I love the analogy, but clearly right now, we're focused on blocking and tackling. We're focused on execution. We're focused on generating more cash flow. And so, what I'd say is our heads are down right now and we're really trying to stabilize and improve our margins and improve our operating consistency and our operating performance.
With that said, at some point, we've got to switch gears here. And I don't know when that happens and obviously having two relatively good quarters and solid performance starts to give us more confidence. But what I'd say is we're not quite there at this point.
Okay. Great. Thanks, guys. See you next month.
Sounds good.
Our next question comes from Steven Fisher from UBS. Please go ahead.
Thanks. Good morning.
Hey, Steve.
Hey, Jay. Just wanted confirm, you guys said on the last conference call that you were supposed to clear a pretty large past due project from EPD in the third quarter. Is that the one that you said on this call cleared in October?
Yeah. I didn't want to get into specifics on certain projects but, yes, we thought we're going clear in September. It didn't and we've got – we now have visibility and that's gone in the month of October.
Okay. And I think you also said on this call that the margins in EPD in Q4 would be similar to Q3. I'm just wondering if that's a lower margin project because it's past due, would that naturally just depress the margins in that segment, or is there something that you're offsetting that with and if so, is it cost structure, is it more just the better margins that are coming through backlog.
Yeah. No. I think – again, Q3 margins for EPD weren't bad, right. If you look at the year-over-year, they weren't great, but I mean you had a mix shift and we had more incentive comp, but we had higher R&D which are all things that needed to happen in that platform. And we've moved margins up every quarter in 2018, and we fully expect to continue to expand margins for EPD. But if you look back to what happened in the fourth quarter of last year, we had a really bad step down in gross margins and operating income.
And what I was saying is we don't expect to have that drop back in this fourth quarter of this year.
Got it. And then just on the power side of things, you listed in your slides a few drivers, be it thermal solar, nuclear upgrade. Are these big enough to stabilize the bookings, and if so, when do you think we could see those bookings kind of stabilize on a year-over-year basis?
Yeah. I would love to say the answer to that is, yes, but it's no. We've got a – those were the only green shoots we could find in the power industry out there. And so we do have a unique and a preferred offering for concentrated solar power. We just don't have a big project list there to overcome the declines in the rest of the power market. And then on the nuclear side, we're getting aftermarket and there's a few things, but it's just not enough to give back. And I just think power is a – it's a very challenged market. I think it will remain challenged in 2019 and hopefully we'll start to see some improvement there in 2020 and beyond.
Great. Thanks a lot.
Our next question comes from Joe Giordano from Cowen. Please go ahead.
Hey guys. Good morning.
Hey Joe.
Good morning, Joe.
Hey. So on the past due backlog, I know we talked a lot about it. But are you confident that you've identified like the root cause of these things? I'm a little surprised to hear that it's coming from stuff you booked late last year. Like is this a business problem where you shouldn't have been taking these projects at all or is it more of a behavioral issue? Do you feel like you're pricing them appropriately given the complexity? Maybe you can give some color there.
Sure. Yeah. It is – unfortunately, it's a broad comment and there's not one issue and each of our plant has slightly different issues. And again, what I'd say is we've got a lot of attention and focus on this that really wasn't the case two years ago or even a year ago. And we stood up this manufacturing group that started in February. So, we've got BP as the manufacturing and operations in each of our platforms, and we've got a planning organization that is now really focused on the blocking and tackling of production planning, and improving longer-term planning with sales and operational planning.
And so, I actually feel that we've made progress. It just didn't come through in the quarter. I think we'll see a nice drop here in the fourth quarter. And I'd say by kind of mid into next year, this will not be an issue for Flowserve. And so, we've got organization in place. We've started to put the proper processes in place to make sure we're doing the right things.
And then ultimately, we switched the systems, tools and visibilities that make sure that this is – doesn't go backwards as Flowserve continues to grow. And so, I do think we made progress, but again, it's been a painful area for us, and it's one that I'm highly focused on, and I spend a lot of time in our facilities talking through the challenges and what they need to do to get this corrected as we go forward.
Okay. That's fair. On the CapEx side, are you surprised to be cutting CapEx numbers here? I know you're being very targeted in where you're putting capital on the far side, which is good. Are there bottlenecks to deploying growth capital as you kind of go through the process here?
No. I really think it's more just being really, really disciplined. And last year was the first year when Lee and I kind of went through this process, and there's a lot on the wish list from our group, and we weren't sure kind of what was real and what was needed. And so, what I'd say is, I'm actually pleased that we've restrained the spending this year, and it's not going to impede our ability to grow. And what I would say is the investment focus this year has really been around enterprise-wide systems to fix systemic problems like past due backlog and ability to work things across our enterprise.
And so, most of the spending this year was in IT and around enterprise systems. We actually – we just went live with our enterprise-wide CRM system this month – or in October. And we've now – we're in the process of putting an enterprise-wide PLM or engineering system and we've just launched our ERP program and projects on this. And so what I'd say is, we'll get into a little more detail in December about what our strategy is around systems and really trying to drive an enterprise focus.
But back to capital, I'm actually pleased that we're able to be a little more discrete on what we spend our money on. The number makes sense and what I'd say for next year is we'll need to move that up a little bit as we start to really sharpen our pencils on the needed things around our operations and around growth. But we'll nudge that number up in 2019 and continue the investment on enterprise-wide systems.
Just last for me and kind of an extension on that. As you've gone through this, have any parts of the business come up, later where you're saying, well, now you have a better understanding of what you're going to need to do to spend to make them successful, that maybe we're not the right owners, that maybe things that weren't up for divestiture six months ago, now you're realizing that it's not where we want to deploy capital?
Yeah. No, I think it's a great question, and the more I learn about our business and the more I learn about what we can do really well and the things that we can't. We're constantly reevaluating our portfolio and what we want to take forward. So what I'd say is there's no major divestiture plans at this point, but there's probably a handful of things that are relatively small that are more of a distraction and could probably be better suited in somebody else's hands. But these won't be big needle movers but it'll actually allow us to be much more focused on the things that we do really well on, and focus more on servicing our customers and providing profitable returns.
Thanks, guys.
Our next question comes from Walter Liptak from Seaport Global. Please go ahead.
Hi. Thanks, guys, for taking my question. I wanted to ask about the bigger jobs that you talked about growing FID and it sounds like there's a couple of buckets of refined fuels and LNG. Is there anything else that you're kind of looking at?
Yeah. I think the two we're most excited about are LNG and the IMO 2020 upgrades on refined fuels. So, those would probably be the two biggest categories into 2019. The other thing is, yeah, we're starting to see some green shoots on the upstream production side. And so, we've historically done well on production facilities, and that's been an incredibly depressed market here for the last four years. And so that would be an area that we would hope to increase as we go into 2019 but it'll probably be in the back half of 2019.
And then the other area that we are getting more and more excited about is just the North American midstream. And so with that, I think interstate pipeline and then terminals and storage. And so, there's clearly a build-out there. And what I would say is, we kind of looked away from that market historically and now it's one that we've now turned more of an attention to, and there's a lot of capital being spent in 2019.
And then I'll just go through all the markets, right. So, chemical also, and so we've had pretty good growth here in chemicals over the last two years, but we definitely see a continued build-out on both greenfield and brownfield on the chemical side.
So, kind of back to my earlier comments, I feel reasonably good about our customers spending money on infrastructure in 2019. And so, we're tracking lots of projects and some will get pushed out, but for the most part we feel good about what comes into FID and our ability to win that work.
Okay. Yeah. It sounds like you got a lot in front of you. So, going into the refined fuel and the LNG projects, as you have your line of sight on these, would you expect orders in the – or these FIDs going in the first half, or the second half, or more second half weighted, what do you think about the timing for these bigger projects?
Well, if I can answer that question, I should be in a different job because that's a difficult one. And so, we've been surprised this year at FIDs that actually got pulled up ahead of expectations, and then, we've been surprised to the opposite side and moving right. It's really, really hard to predict when things come into FID. And unfortunately, it's lumpy and that's going to sway our bookings.
But what I can say is our guys are talking to the right folks with our customers. We're in their offices. And we're trying to really get diligent about predicting when the bookings come in and allowing our operations to plan appropriately, so we don't get in trouble like we did this year on some of the past due stuff.
Okay. And on the early ones that could happen next year and go FID, are you guys designed into those already, so it's sort of you're locked and loaded or are these things where they go FID and then jobs go out to bid to you?
Yeah. There are very, very few opportunities where we get spec'd in. But what I'd say is we're highly competitive in what we provide and what we offer. And so, we're not afraid to compete with the peer group, and we're going to win our share. But no, it is a competitive landscape, both from the valves and the pump side. But we feel good about our ability to win when we're targeted and focused on winning that work.
Okay. And then, just a last one for me. What's – and it's probably a tough one too. But what's the timing on like FID to when you start shipping, or you have the booking and then the shipment goes out? Like what's – is it the bid cycle a six-month cycle or a year cycle (59:07).
It really depends on whether its pumps or valves and it depends on what type of project it is. And so I would say on like a big greenfield LNG, you're going to see significant delays between FID and order placement in our delivery on things that have our equipment installed base there between FID and order placement on the pump side should be relatively fast and we can deliver in kind of six to nine months.
So it's a real kind of mix in terms of when those deliveries are and what we're tracking, has kind of all three flavors in there right now.
Okay. Great. Thanks for the detail on this.
Okay.
Thank you, ladies and gentlemen, we have reached our allotted time. This concludes today's conference. Thank you for participating and you may now disconnect.