Flowserve Corporation
Q2 2013 Earnings Call Transcript

Published: 25 Jul 2013

[Operator:]

Welcome to the Flowserve Second Quarter 2013 Earnings Conference Call. My name is Vanessa, and I will be your operator for today's call. [Operator Instructions] I will now turn the call over to Jay Roueche. Mr. Roueche, you may begin.

[John E. Roueche:]

Thank you, operator, and good morning, everyone. We appreciate you participating in today's call to discuss the financial results of Flowserve Corporation for the second quarter of 2013, which we announced yesterday through our press release and Form 10-Q filing. Joining me on the call this morning are Mark Blinn, Flowserve's President and Chief Executive Officer; Tom Pajonas, Chief Operating Officer; Mike Taff, Chief Financial Officer; and Mike Mullin, our Director of Investor Relations. Following our prepared comments, we will open the call to your questions, and instructions will be given at that time. Before turning the call over to Mark, I would like to remind you that this event is being webcast and an earnings slide presentation is available, both of which are accessible through our website at www.flowserve.com in the Investor Relations section. An audio replay will also be available on our website approximately 2 hours following the conclusion of the live call. Both the audio replay and the slide presentation will remain on our website for a period of time over the next few weeks. Finally, please note that today's call and the associated earnings materials contain forward-looking statements that are based upon forecasts, expectations and other information available to management as of July 25, 2013. These statements involve numerous risks and uncertainties, including many that are beyond the company's control. As such, we encourage you to fully review our Safe Harbor disclosures contained in yesterday's press release and slide presentation, as well as our filings with the Securities and Exchange Commission, for more information. These documents are accessible on Flowserve's website under the Investor Relations section. Please note, except to the extent required by applicable law, Flowserve undertakes no obligation and disclaims any duty to update any of today's forward-looking statements. I would now like to turn the call over to Mark Blinn, Flowserve's President and Chief Executive Officer, for his prepared comments.

[Mark A. Blinn:]

Thank you, Jay, and good morning, everyone. I am pleased with the operating and financial results for the second quarter, as our dedicated employees continue to deliver on targeted improvements across our operations. Each segment contributed to solid earnings growth, demonstrating the leverage of our diverse and stable business profile, and the propensity for ongoing operational improvement is significant. Our continued focus on delivering on our customer commitment, operational excellence, thoughtful cost control and capital structure efficiency are returning value to our shareholders, drove EPS growth of 27% year-over-year. We believe this formula of improving operations and reduced share count will produce our solid earnings growth for 2013 and provide leverage over the coming years as we prepare for more meaningful expected growth. As we progress through 2013, we are capturing internal opportunities by improving the operations, positioning the company to more efficiently integrate and leverage future inorganic bolt-on acquisitions, optimizing our capital structure efficiency through returns to shareholders, and preparing the business to maximize earnings potential of large project work, which is expected to reach award stage later this year. While this summer appears to be more stable than the last several years, economies around the world are recovering at different rates. Europe seems to have stabilized, albeit at low levels. We believe North America has good opportunity ahead on the strength of gas and chemical projects. While macro growth in Asia Pacific is mixed, our objective is to further increase Flowserve's presence in the region. Latin America should see increased customer spending over the next few years. And Russia and the Middle East will require increased investment to expand and update capacity. As we have previously mentioned, large orders shifted to the right and none were booked again this quarter. This is nothing new, but we remain optimistic in our core energy markets and the significant build-out expected in North America and the emerging regions. Given the current market environment, we are pleased with second quarter bookings of over $1.2 billion. This amount represents a 1.3% increase year-over-year and a 3.3% increase sequentially, reflecting the continued strength of our run rate original equipment and aftermarket business. Over the last few years, we've grown this type of work into a strong, recurring franchise. In the aftermarket business alone, execution of our global end user strategies drove solid bookings this quarter of over $500 million, which is encouraging, considering the seasonality of our business and some ongoing deferrals of scheduled maintenance in certain regions due to strong refining margins. Looking at margins. Our focus over the last year on driving improvements within the 4 walls of Flowserve drove a solid increase in gross margins. In particular, IPD and FCD realized significant improvement in gross and operating margins. Additionally, EPD gross margins were able to overcome an unfavorable mix shift through higher sales and operational initiatives to show an increase as well. Our One Flowserve initiatives and other investments and operational excellence, including quality, project management and other company-wide programs focusing on the customer, are positioning the business to drive profitable growth. In addition, solidifying an expense management culture remains a top priority, which will effectively support our operations as we generate strong leverage on these costs. Looking briefly at segment performance. EPD's continued focus on operational excellence improvements and disciplined project pursuit has grown the top line and is steadily improving the quality of the backlog in this traditionally late cycle business. IPD's operational improvements delivered impressive margins of 12.8%, demonstrating substantial progress towards achieving this segment's target range for operating margins of 14% to 15% by 2015. FCD's strong and consistent operating performance was driven by operational excellence and increased leverage on investments to support the oil and gas markets. Looking forward to the second half of 2013, we expect to build on the momentum of the first half. And with another quarter of solid operating improvements behind us, I remain confident we are focusing on the right areas and taking the right strategic actions needed to deliver on our commitments to our customers, while profitably growing the business and delivering value to our shareholders. Let me now turn the call over to Tom for his operational review.

[Thomas L. Pajonas:]

Thanks, Mark, and good morning, everyone. As Mark discussed, we'll continue to focus on the customer and internally, on our operations and costs, as we build on the momentum gained last year. I'm proud of the substantial progress we have made towards our operational improvement targets and the return earned on our investments to strengthen our leadership and optimize our operating platforms. Impressive margin improvement, particularly in FCD and IPD, validates our customer focus strategy as well as our efforts to improve our on-time delivery, reduce cost of quality, and our ongoing investment in and development of our employees. Our One Flowserve initiatives are also generating solid returns, as we leverage global competencies across our operating platforms in the areas such as project management, low-cost sourcing and research and development. We continue to be excited about the propensity to improve our core business fundamentals, which include leveraging our global sales force as we focus on the customer and overall growth. The success of these efforts is evidenced, in part, by our strong margin improvement. On a consolidated basis, gross margin increased 150 basis points year-over-year. At the segment level, FCD delivered impressive leverage by continuing to operate on a high level by focusing on quality, cost reduction and low-cost sourcing. In addition, FCD also benefited this quarter from a mix shift towards aftermarket sales. IPD's margins expanded again this quarter as well, with operational excellence initiatives beginning to take hold as we progress towards our targeted operating margin target of 14% to 15% by 2015. Looking at our new work. Bookings this quarter were up nearly 2% year-over-year on a constant currency basis, driven by run rate original equipment orders and aftermarket. This result demonstrates the value of our diverse exposures, and strong bookings in FCD more than offset decreased IPD bookings and relatively flat EPD bookings. While our core reoccurring aftermarket and run rate activity essentially comprised all of our bookings, we do remain confident that a number of large projects are in the pipeline, and that they will begin to be released in the second half of the year. Our approach to bidding will remain disciplined. While the first projects released during a market upturn typically tend to be very price competitive, I want to emphasize that we will continue to be selective. The story in our markets and regions is very similar to the last few quarters. Our core run rate, OE and aftermarket activity has been stable as we prepare for the release of these larger-sized OE projects. Considering the value we bring to our customers on the front end of major projects, our visibility into their progress continues to give us confidence that these projects are nearing the bidding stage and on the path towards ultimate release. The chemical market, in particular, is exhibiting strengthening conditions. Increased competitiveness of the U.S. upstream and downstream chemicals are changing the dynamics of global competition. Nearly 100 shale gas-related investments have been announced in North America with a value of over $70 billion, the majority of which are for ethylene and ethylene derivatives. The Middle East is also maintaining their drive towards downstream diversification, and the chemical strength in India and China continues within these countries as they drive towards energy and manufacturing security. Moving to the oil and gas market. Oil prices remain at levels necessary to encourage major investment and a positive long-term outlook for this commodity contingents. Saudi Arabia, Kuwait, China and Russia are planning low sulfur fuel refinery projects, while North America is maintaining strong growth in pipeline construction, refinery upgrades and gas processing and gas-to-liquid plants to capitalize on the advantaged natural gas and oil supplies. Additionally, we are seeing a shift in the coming opportunities in North America, as Western contractors prepare to execute oil and gas projects that will remain here, particularly along the U.S. Gulf coast. Floating production and storage operations, FPSOs, opportunities also remain steady in Brazil, Africa and Asia Pacific. Additionally, proposed growth in LNG production and export terminals in North America and import terminals in Asia Pacific seemingly offset the slowdown in Australia, impacted by a slower China, national elections and a high cost of local project execution. Finally, Saudi Arabia, China, India and Brazil continue to drive major refinery projects. We see the power market as growing. China and India continue with their coal-based initiatives, while the Middle East is signaling strong future growth in both conventional and solar power. North America and Europe remains slow, due to conservation and low growth in energy demand. Nuclear power is still in transition, although even Japan is considering restarting a number of plants. And globally, we see an increased focus on natural gas fuel combined cycle plants. The available power industry projects, however, continue to be driven by fixed price turnkey terms, where pricing is the major consideration. Our efforts to build capability in our Coimbatore, India facility will help provide support to this market. And while aftermarket opportunities are also available on power, they are not as uniform globally, due to the shift occurring from coal to natural gas generation. In general industries, we are experiencing strong growth in global fertilizer opportunities. Mining companies are investing more carefully of late, but we see good levels continuing in parts of Southern Africa, Latin America and North America. We are also seeing encouraging signs in the desalinization market, as industry experts expect new plant orders to rise over the next couple of years. Finally, our distribution business was solid, driven largely by order supporting oil and gas projects globally. As we move into the second half of the year, I'm encouraged by the progress we have made over the last 1.5 year and the propensity in the organization to continue this momentum as we look to capitalize on additional opportunities. With that overview, let me now turn it over to Mike Taff.

[Michael S. Taff:]

Thank you, Tom, and good morning, everyone. Following Mark and Tom's operational overview and business outlook for the remainder of the year, let me discuss in greater detail our financial results. We continue to gain momentum in the second quarter, with strong leverage of solid revenue growth of 4.8%. Our year-to-date revenue growth of 4.2% on a constant currency basis is consistent with the low end of our 2013 revenue growth target of 4% to 6%. The consolidated OE aftermarket sales mix was consistent with last year. I was particularly pleased that gross margin improved 150 basis points to 34%, driven by impressive margin expansion in FCD and IPD of 280 basis points and 190 basis points, respectively, reflecting progress on our operational improvement initiatives. EPD's 20 basis point improvement was also a solid performance, considering the headwinds from SG&A and business mix as compared to the 2012 quarter. This overall gross margin improvement demonstrates the impact of our discipline and selectivity in our bidding process, which we will maintain during the expected ramp in large project releases. Turning to SG&A. We saw an increase in SG&A as a percentage of sales of 50 basis points, driven by a few discrete charges this year, totaling $4.1 million and a $3.9 million legal benefit last year that did not recur. Adjusting for these items, we saw a 20 basis point decrease in SG&A as a percentage of sales, driven mainly by thoughtful cost control and solid leverage. We will continue to focus on our longer-term goal of driving additional leverage from these costs, as we target SG&A as a percentage of sales to be consistently in the 18% range. I'm confident that the initiatives we are executing currently have us on pace to deliver on this commitment. The strong leverage in our business was demonstrated with an 11.3% increase in operating income coming off the 4.8% revenue growth. Shifting to operating margin. An impressive improvement of 90 basis points to 14.8% was driven by 270 and 250 basis point increases in FCD and IPD, respectively. We continue to believe that we are on target to achieve our consolidated operating margin objective of 100 to 200 basis point improvement by 2014, as well as IPD's targeted margins of 14% to 15% by 2015. It should be noted, however, that margins quarter-to-quarter can be volatile and difficult to forecast. On last quarter's call, we indicated that we expected this quarter to face margin pressure from an unfavorable mix, which did not occur. But now, we expect that impact to affect Q3. Below operating income, a relatively calm foreign exchange environment resulted in minimal impact from the sequential mark-to-market of our currency hedges and balance sheet items in nonfunctional currencies. As many of you know, this is a pleasant change from recent quarter's earnings volatility as a result of this line and continues to be an area of focus as we work to dampen the impact of foreign currency volatility on our results. In the meantime, we will continue to monitor FX closely. However, a strengthening dollar typically is a headwind for us. Our tax rate for the quarter was 29.4%, and we expect to be in the 30% range for the remaining quarters of 2013. Turning to cash flows. We generated $75 million from our operations during the quarter. Capital expenditures were $27 million. And we repurchased $150 million of our shares, effectively completing our $1 billion share repurchase program announced last year. We have $536 million remaining on our current buyback program, and we'll continue to execute on our strategy to efficiently deploy the balance sheet and return value to our shareholders. As in prior years, we expect to generate a significant portion of our operating cash flows in the second half of the year. Additionally, we continue to focus on our working capital as we methodically implement initiatives to address identified opportunities for improvement and work towards our goal of consistently generating annual free cash flow near our net income level. Turning to primary working capital. We saw some improvement in the quarter compared to the 2012 second quarter, with a reduction in DSO by 3 days to 78 days. Inventory turns were essentially flat with the 2012 second quarter. Again, seasonally, these only modest improvements are not surprising. And we are still very much focused on our working capital goals of mid-60s DSOs and inventory turns of 4x to 4.5x. We believe these targets are achievable with our continued effort. As I discussed last quarter, I'm confident that we are taking the necessary steps to achieve this level, and we expect continued progress to occur in 2013. Moving to our EPS guidance and outlook for the second half of the year. We are reaffirming our 2013 split adjusted earnings guidance of $3.20 to $3.53 per share following our strong first half results, continuing operational improvements and the solid performance of our run rate and aftermarket business. We continue to expect full year sales growth between 4% and 6% on a neutral FX basis after achieving the low end of the range in the first half. Turning to our spending priorities. As I mentioned earlier, we will continue to return value to our shareholders and remain committed to our disciplined approach to capital deployment. Importantly, we will continue to invest in our business to deliver profitable growth and solid organic returns, forecasting 2013 CapEx of $120 million to $130 million to further increase our worldwide capabilities. Other uses of cash, we expect this year, include pension contributions and scheduled debt repayments. But even combined, this amount is modest in comparison to the other priorities. We believe our capital allocation approach, with a targeted debt-to-EBITDA between 1x and 2x, provides a flexibility to grow the business organically, return capital to shareholders and invest in strategic bolt-ons and we'll continue to produce solid returns for our shareholders. With that, I'll turn it back over to Jay.

[John E. Roueche:]

Thank you, Mike. We have concluded our prepared remarks this morning. And, Vanessa, if you're ready, we would like to begin the Q&A session.

[Operator:]

[Operator Instructions] And our first question comes from Hamzah Mazari with Crédit Suisse.

[Hamzah Mazari:]

The first question is just on margins. You spoke of some margin pressure shifting into Q3. Could you give a little more color? Is that projects that are being delayed that are shipping out later? And was that an EPD? Any color you can give there?

[Mark A. Blinn:]

Yes, I mean, we've talked about this before. If you look at the run-off in our backlog over the last year, a lot of that has been some of what I'd call the projects we took before the One Flowserve initiative. And some of those are still there. And so it's really those that are running off, they'll be primarily in EPD.

[Hamzah Mazari:]

Great. And then just a follow up on margins. Maybe if you could talk about, after putting the COO structure in place a little over 1 year ago, maybe talk about what you've done, what's behind you already? What's yet to come in terms of IPD getting to that 15% margin rate? FCD, it looks like most of the low-hanging fruit is behind you. EPD, it seems like there's still some legacy backlog to cycle through. Any color you can give on what's behind you, what's yet to come?

[Mark A. Blinn:]

Yes, I mean, I'll try to just do it at the high level, maybe terms of innings as people talk about it. FCD has been performing at a very high level for a long period of time. And our COO, in fact, was running that. So I'd say 7th inning in that business. There are certainly still opportunity but the focus there, Hamzah, is on growth. And so you've seen that. We'll tell you what we're focusing on and hopefully, that's what we're going to be delivering. You've seen growth in FCD. That has been our priority. In the earlier stages, in both EPD and IPD, as we've talked about before in IPD, we got off to a slower-than-expected start but we're pleased with the progress. But there's -- our priority there is on improving basically the throughput in our facilities and the efficiency to take advantage of growth. And you've certainly seen the progress there, third or fourth inning, probably the same in EPD as well. EPD also has another aspect of being kind of a late cycle business that there will be a market aspect to it. But a lot of it is still what I'd call within our control. So that's probably a good way to frame it up. These things certainly take time, especially in the longer cycle segments. So really, if you think about it, we put the COO structure in place in the first quarter of last year. A lot of the processes were put in the second and third quarter. So we're starting to see the benefits of that. But they're working their way through it. And I think that's one of the areas why we're encouraged is when we look forward, we still have a lot of propensity in this business. We have a lot of opportunity to improve the operations. And again, FCD is a great example of that.

[Hamzah Mazari:]

Great. And just a last question from me, I'll turn it over. If you could just touch on the competitive environment that you're seeing out there. Some of your European competitors are going through some restructuring. Other players being disciplined. It seems like you have a good opportunity to take share. Any comments on the competitive dynamic environment you're seeing out there?

[Mark A. Blinn:]

Well, yes, I mean, it's -- there are various things going on with competitors. But I think what you're seeing consistently, which we think is an endorsement for our industry, is a focus on Flow Control. And that really benefits the industry altogether. But you're seeing various things that are occurring. For the most part, what we are seeing relative to 2010 and 2011 is a thoughtful competitive environment. And thoughtful doesn't mean anything other than everybody is certainly focused on margins, everybody is focused on what they put in backlog as opposed to where it was then. And that's typically what you see when you start emerging from these cycles. Keep in mind, the long cycle business has been basically in a soft patch since, really, the middle part towards the end of 2008. So these are the way these things certainly cycle through, and you're certainly seeing that in the competitive landscape.

[Operator:]

Our next question comes from Charlie Brady with BMO Capital Markets.

[Charles D. Brady:]

Hey, just on the margin pressure that's kind of moved from Q2 to Q3. What -- can you quantify that in any way as to what that might hit EPD yet?

[Mark A. Blinn:]

Well, I mean, I think this will really go back to our statement, we're not a quarter-to-quarter business, and for a whole host of reasons. Some of these things can move as they did even from this quarter from one to another. I think, for the most part, a lot of the, what I'd call, pre-One Flowserve initiative backlog has run off. As I said, if you look at the year-over-year 8% decline, more than that amount is representative in some of the pre-Flowserve backlog, pre-One Flowserve backlog. But as we look forward, there are -- I mean, I think -- let's start from the framework of where we are right now. We have a better margin profile than we did last year. And the fact is, really, when the timing of some of these things come through, but what we don't want to do is start parsing here over the next couple quarters where the margin impact would be. Just look at the general trends. You can see the underlying efficiency and throughput is improving. I mean, we had this quarter, year-over-year, 70 -- almost 70% contribution margin at the gross profit line on basically flat mix. That's indicative of an improving margin environment here. But these things can move -- Charlie, in order of magnitude, you can think about $20 million, $30 million of a project that comes through it at little or no margin. You can do the math as to what the margin impact will be.

[Charles D. Brady:]

Right, right, that's helpful. And just your commentary on the large projects that are kind of moving into pre-FEED theme [ph] into evaluation bid stage. Would you expect -- I know you think you're going to book some in the second half, would you expect some of that -- is some of that stuff short enough that you recognize the revenue? Or is this really all kind of 2014 work that we're looking at?

[Mark A. Blinn:]

You could, yes. I mean, you could see some revenue, maybe some engineering work, some early stages. But remember, these -- although, I would say lead times are shorter than they were in 2007 and 2008, for the most part, you're still seeing lead times that are approaching a year on some of these things. So that would give you an order of magnitude of when we'll start recognizing the revenue. I think the focus, and it was in our comments, this year is really around improving the platform, moving some of the backlog through the facilities. And then, to a certain degree, share count. That's what's really driving earnings this year.

[Charles D. Brady:]

Okay. And can you give any more color on what types of projects these are? So end markets or geographies of where you're seeing the bulk of this?

[Mark A. Blinn:]

Yes, I'll let -- Tom, can you turn your mic on? Tom will comment on that.

[Thomas L. Pajonas:]

Yes, just a quick overview. Maybe start with -- just by region. I mean, in South Africa, the solar opportunities look pretty good. I'll just quickly go through each one and highlight the big points. Latin America, looking like FPSOs. It's a good mining and aftermarket opportunity. Asia Pacific looks like FPSOs. Power opportunities, obviously, in the combined cycle gas area as well as refinery. Europe, we have some good aftermarket business versus last quarter, but I wouldn't say it's returned to the levels. Good Russian opportunities in power and oil and gas. I would say FPSOs in the Netherlands, in the European area there, is -- has been good in Q2. Middle East, we still look at those decell opportunities, as well as the power and the downstream chemical that go with the product diversification. In North America, as we've indicated in Q1, the pipeline business is good, good chemical business, as everything is shifting now to shale gas. And then, I would say, in Europe, overall, via chemicals, I mean, there is a general migration on the chemical side to Middle East, Asia and China. Although we're seeing some stabilization on the chemical side of the business relative to some of the economies in Europe improving. So I would say that's a quick overview. And then, lastly, nuclear. There's a lot of, I would say, ups and downs in nuclear, but Russia is pretty active with 9 reactors going on. Sweden announced it's upgrading its nuclear fleet. However, in the U.S., some businesses have announced the move to gas, although we are looking at building a couple of nuclear plants in the U.S. And then, obviously, China, Russia, as well as India, proceeding on their nuclear units. I would say that's a very quick regional overview.

[Operator:]

Our next question comes from Kevin Maczka with BB&T.

[Kevin R. Maczka:]

Wanted to touch on the projects again and the visibility in the second half. Your -- you commented, Mark, on the thoughtful competitive set, but yet now, we're also saying that the competitive bidding on these early jobs, it may be more competitive than maybe we were previously thinking. I'm just wondering, it sounds like your visibility and the way these projects are advancing is still there, which gives you comfort in the second half. But I'm just wondering if your visibility and your ability to win those jobs has changed at all because you're so disciplined with price and margin, which I think we all appreciate.

[Mark A. Blinn:]

Yes. No, the competitive nature of these projects, as it starts to cycle back, is not new news. I think what we've seen and, obviously, we've been bidding on some of these things, that's what gives us confidence is they're going to come. It's just to remind you, when, and I think we talked about this on the last call, when these projects start to come back and there's available capacity out there, it tends to be competitive around filling that capacity. And then they start to use price to rationalize that capacity. It's the way every cycle works. So this is not new news.

[Kevin R. Maczka:]

Just one more. On the aftermarket bookings that were relatively flat this quarter, have you seen any change at all that you can detect in customer behavior there? Are there any deferrals in any way? I know you were up against kind of a record comp there, but any more color you can give on your aftermarket booking trends?

[Mark A. Blinn:]

No, no. I mean, it's relatively flat, but we're talking about $0.5 billion bookings. And just look at the rolling 4 quarters and you can see that we're growing the business in excess of what the net installed base globally is coming online. So we still feel like we're getting good penetration and executing well. As you've seen in the past, any 1 or 2 quarters and compared to the prior year, flat or slightly unfavorably. And I think we were talking about this in 2009. People were worried that it was going to start to tail off. And in fact, what you've seen is a solid good mid-to-high single-digit growth over that period of time on a CAGR basis.

[Operator:]

And our next question comes from Brian Konigsberg with Vertical Research.

[Brian Konigsberg:]

I just wanted to actually touch on the recognition of revenues again for the large projects. I think previously, when we talked about it, you noted it was likely to be on a percentage-of-completion basis, given the size of these and how you have to work through the engineering. So if you are booking awards starting maybe late '13 and maybe that slips into '14, who knows, but is this be going to be recognized more on an S-curve type fashion, where maybe the first, I don't know, 12 months or so, you're recognizing very little revenue and then it spikes higher? Just trying to get a sense of how those will actually ramp.

[Mark A. Blinn:]

They ramp with your cost. I mean, it's really -- as you build cost into the project, you had your standard margin to that as you go through it, and that's basically how it builds up. You do make an adjustment at the end. But that's how percentage of completion works. And keep in mind, percentage of completion taking a step back runs at or less than 10% of our overall revenue.

[Brian Konigsberg:]

Right. So it should be more linear rather than an S curve like we saw with EPCs?

[Mark A. Blinn:]

Well, I means, they go with cost. Costs aren't necessarily linear. So it's -- as you start to build cost, I mean, you may have some engineering work and then do some spec design with the customer. And then you start to order some castings. When the castings come in, the motors come in, as you can imagine. And keep in mind, and as we talked about before, in some of these big systems, 40% to 50% of the cost of that, the revenue base comes from other suppliers, like a big motor. So when that motor comes in, when you have a cost associated with that, obviously, you'll have a revenue component. So I wouldn't necessarily say it's linear, but it definitely lines up with the project.

[Brian Konigsberg:]

Okay. And then just maybe over to Mike -- I'm sorry, Mike Taff. So just talking more about free cash flow. You guys' conversion has certainly lagged net income for many years now. So you guys are working quite diligently on your working capital accounts. I'm just curious, at what point should we anticipate that you actually do achieve net income type of conversion? You actually -- I would think you should exceed that type of 100% conversion for some time. It looks like that's probably not going to happen in '13. But starting potentially next year, should we anticipate you start exceeding that level and then you level off around net income thereafter? If you could just give maybe some more definitive timeline as far as when we could anticipate that type of improvement.

[Michael S. Taff:]

Well, I think as we said in our prepared comments, we've got a lot of initiatives underway. I think we're focused in the right areas and certainly, working with Tom's group, we're focused on the biggest components being receivables and inventories. But I think you'll see some of that benefit starting first half of next year and then continue through there. So I mean -- but long-term, as we get into 2014, that's certainly our goal, is to have a consistent cash flow that's near our net income level.

[Mark A. Blinn:]

If you think about it from an order-to-cash standpoint on any project, with One Flowserve initiative, what we did is start it on the front end of the process. And frankly, working capital will tend to be what comes towards the end there. So what should give you confidence that we're going to get there is now you -- look now at the contribution margin and the gross profit line that is indicative of improving operations and execution. We do still have work to do on our operations. I definitely want to call that out. But then, that should give you confidence it's going to lead the working capital efficiency.

[Brian Konigsberg:]

If I could just slip one last one. Just, Mike, I think you also said -- Mike Taff. Again, sorry. I think you did say you're working on other initiatives to neutralize the impact of FX. Can you just comment on that? Are there some plans in place where we can start to see that transaction swing quarter-to-quarter and start to mitigate at some point?

[Michael S. Taff:]

Well, certainly, we're pleased with the results this quarter, where we had essentially a minimal effect there. There are a number of things where we are working towards continuing to look at different hedging strategies and all and also, looking at whether there's ways to account for our hedging programs differently that would really just try to eliminate as much volatility as possible.

[Operator:]

Our next question comes from Nathan Jones with Stifel, Nicolaus.

[Nathan Jones:]

If I could start with a clarification. I think, Mike, during your comments, you said 100 to 200 basis points margin improvement by 2014. I think in January last year, the goal was 150 to 250 basis points. Is that a change or are you basing that over a different timeframe?

[Michael S. Taff:]

It's over a different timeframe. We -- remember, when we put the 150 to 200 basis points, that was 1 year ago, January. So it was coming off of 2011 results.

[Nathan Jones:]

Okay. So it's up 2012 results?

[Michael S. Taff:]

Yes. Yes, we improved about 50 basis points in 2012.

[Nathan Jones:]

Okay, cool. Mark, thinking a little longer term and a little more strategically, it seems like we're getting the portfolio into better shape, One Flowserve's having its effect. When you think about M&A, obviously, Flowserve has not been very active for quite some time. Thinking about potentially larger deals or adding another platform or something more major in the M&A front, can you talk about what your appetite for that might be and what kind of timeframe you might think about?

[Mark A. Blinn:]

Well, I mean, the timeframe is probably dictated more by the market than anything else. But I will say this. I think our focus is, if you consider the size and scale of our business, we don't feel at this point that we need to go and make a huge consolidation play in the industry. Consolidation be it more where you're taking capacity out, consolidating costs, basically, substantial integration. Frankly, what we've done between 2009 and 2012, with all the changes we made in our business, was almost like a large acquisition. And so we're very focused on continuing this momentum. Having said that, there have been, and the opportunity set is certainly a little light right now in the industrial space, but there have been and we think will continue to be opportunities of size that we would classify as a bolt-on, a bolt-on being where we bring in as a business and leverage our results platform, our aftermarket platform, certainly, our leadership team that we have in place right now, or even take something on the adjacent side that is focused around rotating equipment where we can drive our end-user strategies. That's how we think about it. And I can tell you, as we continue to improve operations, it gives us increasing confidence of being able to integrate one of these bolt-on acquisitions. So I think, from our standpoint, if you look at it, we want to make sure we maintain capital structure flexibility to take advantage of opportunities. But we also want to make sure that we drive improvement to this platform and don't do anything to set it back. But from a huge transformational industry consolidation play, we just don't see that that makes sense at this point.

[Nathan Jones:]

Okay. And one for Tom. Tom, orders in Flow Control have bounced back nicely after some negative growth last year. Is that growth coming short cycle through distribution or more at project basis? Does this feel like a bit of an early cycle period for Flow Control, and could we see that continue for a few more quarters?

[Thomas L. Pajonas:]

Well, in Q2, the aftermarket business was up in Flow Control. So that's one area. But I would say, in general, it's the larger projects, the FPSOs in Brazil and out of Korea and off the European coast, as well as we've seen some good nuclear parts business for North America and Southeast Asia. And then, I would just say, long gas projects in the Middle East. Those are the main areas.

[Mark A. Blinn:]

What you're seeing from that is, I think to your point, is a little bit of an early cycle read. And you're seeing it with other process companies as well. But I don't want to -- you said we haven't really made -- been too active in acquisitions. I mean, we acquired Valbart 3 years ago to get our presence in the oil and gas industry. And we consistently see the benefit of that acquisition in our results over the last few quarters.

[Nathan Jones:]

So just in terms of distribution in Flow Control, how has that been over the last couple of quarters?

[Thomas L. Pajonas:]

I mean, that distribution business was up in this last quarter. It was basically in the oil and gas area and the chemical market. And again, a little distribution increase we also saw in China based on the last 2 or 3 years' worth of the OE projects that we started to place down in there. And then we've had just a small amount of distribution on the U.S. power market. But that was up in Q2.

[Operator:]

Our next question comes from Scott Graham with Jefferies.

[R. Scott Graham:]

I wanted to ask on the cash flow side, Mike, I'm looking at the cash flow statement on the press release end. The year-to-date investment in inventory and receivables certainly have improved. It seems to me that more of the working capital issue is matching, at least in the first 6 months of this year, of what you're doing on the asset side versus what you're doing on the payable and liability side. That's just a number. Is that a fair statement? And maybe what are you thinking on that? What's the plan to improve that?

[Mark A. Blinn:]

Well, certainly, I mean, I think on the accounts payable side, you saw some usage on accounts payable. But I think that's just more timing than anything, Scott, on that same point. The accrued liabilities side, it kind of matches with what we've been talking about. One of the large users year-over-year, and for the first 6 months was deferred revenues. And as we talked about the lack of the large project bookings over the last several quarters, more on the run rate business and aftermarket business, you just tend to have less of that deferred revenue and upfront payments and all. So that kind of makes sense with where the bookings have been the last several quarters. I think as we get -- the long cycle business starts to increase into the second half of this year. And next year, you'll see that turn and be a bit more positive.

[R. Scott Graham:]

Got you, okay. And I also wanted to maybe talk again about the projection of -- your guys projection of when these things start to -- these projects start to get released and when you can start to bid on them. And maybe this is more of a question for you, Mark, than anyone. But also, I'd certainly -- any chiming in would help from the 2 EPC guys in the room. Is the turn, the potential bottoming of steel prices something of a catalyst for when projects get released? Essentially, where I'm going with this is do end-users say, "Okay, steel isn't declining anymore; maybe it's starting to turn the corner." Certainly, it has bottomed. Is that a potential catalyst for projects?

[Mark A. Blinn:]

No, it's -- I mean, we -- if there's a view of ramp and increase or extreme increase in material cost, like you saw in '07 and '08, people were hurried to get their capacity in place to process that, like you saw in the mining industry with some of materials. But steel may be an indicator of kind of general economic outlook, which will play through. But at this stage, where these projects are, steel prices, in and itself, are not going to drive what brings them this quarter, the next quarter. You think about some of these projects that we're talking about that we see on the horizon do going into commission in 2015, '16 and '17. And so, if you take a step back from there, they already, in a sense, kind of have their timeline that's built out. They need that capacity online, power, refinery or whatever it may be in those periods of time. That's why they can move a couple of quarters as they move through it. But steel, and you see that with any natural resources. Because of the lead times on this capacity, and sometimes, where we are in this stage with the pre-FEED and the FEED work done, the amount of investment that's already in it, that steel price or a marginal move in gold, a marginal move in oil, anything like that is not going to really change the pace of which these things go out.

[R. Scott Graham:]

That's fine. That's really all I had with the, I guess, maybe the one I don't think that you guys called out any types of gains or discrete losses on disposals or anything like that. You would have called that out, right? So I'm assuming none this quarter?

[Michael S. Taff:]

The only thing --, yes. No, we didn't. The only thing that we talked out discreet, I think, was in our press release. Pretty minor.

[Operator:]

Our next question comes from Jamie Sullivan with RBC Capital Markets.

[Jamie Sullivan:]

So, Mark, your commentary around the cycle. I just had a quick follow-on there. You sort of mentioned the cycle has its pattern, this one's no different. What does seem different is Flowserve and the discipline and selectivity that's been happening. So I guess the question is whether -- are you going to participate at the same level at this cycle or are you going to pick your spots at certain points of the cycle? I'm just wanted your thoughts on that.

[Mark A. Blinn:]

Well, I think, in general, as a company, our -- where we were versus the last cycle, far more disciplined and, certainly, improved execution. So I think you should expect that to continue. Having said that, I look at commentary from some of our competitors. And I think they're talking about increased discipline as well. So we wouldn't underestimate them by any stretch of imagination. But I think in general, if you're asking what's changed? Yes, there's certainly going to be more discipline. And if you look at -- there's a lot of changes this cycle versus the last. One Flowserve being one of them, the disciplined approach, the way we can utilize our capacity in our lead product, secondary product, we actually, in effect, have more and more efficient capacity to deal with project opportunities. Obviously, we're in different locations around the world where the opportunities are. So there's -- it's a long conversation. The next time I'll see you, I'll be happy to have with you around what's changed during that period of time. But you should expect continued discipline from us through this cycle. A lot of the reason is, if you look at what has really been carrying us for the last 3 or 4 quarters, it's been the aftermarket and run rate franchise and the improving operation is driving earnings growth. Great leverage on the gross margin line now and even all the way through the operating line.

[Jamie Sullivan:]

That's helpful. I'll follow on with the free cash flow discussion getting to near net income. Mike, I just wondered if you do win these, some of these large projects, let's say, in the back half of the year, early next year, knowing some of the working capital requirements on the project business, do you still feel you can hit 100% of net income next year with that mix shift?

[Michael S. Taff:]

Yes, I mean, the key there, Jamie, is just really focusing on our terms and conditions. And that's part of our -- this month's [ph] activity. It's not just the margins we're putting in the job terms, the conditions are very important. And with that comes building milestones and things of that nature. So that's something that we continue to stress with the organization. And it's just important to stay in line with the customer there with our cash flow requirements on these big projects.

[Jamie Sullivan:]

Great. And then one last quick one, if I could. EPD, there's a mention of a bad debt expense increase. Could you add some color there, magnitude of what the driver was?

[Mark A. Blinn:]

Well, it was just -- it was one customer, and it's basically all taken care of. So it's not something that you'll see that would recur.

[Jamie Sullivan:]

And so that might actually help margins play into the third quarter?

[Mark A. Blinn:]

Well, I mean, certainly. I mean, I'm not sure we'll get recovery from that one particular item. But it's relatively small. But it was a development project that we're working on and all. But it is taken care of.

[Operator:]

Our next question comes from Steve Fisher with UBS.

[Steven Fisher:]

Tom, you gave a nice outlook on the regional opportunity set. Do you have any sense of which regions are more advanced in their award process and may come in sooner versus those that are maybe going to be a bit later?

[Thomas L. Pajonas:]

Well, I mean, certainly, if I looked at Europe, I would just say in general, Europe is, I would say, moving out of some of the economic situations that they've had over the last 18 months. But then, I would say in other regions, it's very dependent upon the type of product within the industry. So for instance, and obviously, in the U.S., you have pipelines, which is maybe different than, say, your coal-fired power plants, which is going through some changes and certainly, FPSO seems to be, I would say, prevalent at, certainly, in different parts of the world, Brazil and off the coast in Europe and so on. I would say it really depends upon a number of different factors.

[Steven Fisher:]

Okay. So it sounds like it's still fairly wide open as to where these first projects would come from.

[Thomas L. Pajonas:]

Yes, I would say the good news on the power side is that we're seeing a lot of power activity different than what was there in the past as one of the first, I would say, of these type of projects that previously were in FEED and pre-FEED, we're seeing them transition now to a -- an active bidding/further potential buying stage after this bidding stage that we're going through right now.

[Mark A. Blinn:]

I think the answer to that question and the way we go through it, there's probably some general regional overlays. But the way Tom goes through these things specifically should highlight why we -- and we know and have an understanding when these projects are going to come on, because they're very specific to the type of activity that's going on. But in general, I mean, I think our commentary around the regions was Europe is stable at low levels. North America, you're going to see -- they keep talking about a manufacturing renaissance. And relative to Europe, I do want to point out, 4 years ago, the commentary around North America was manufacturing was leaving. It wasn't going to ever recover. Things weren't going to be the same. And here we are, and it's quite different. I wouldn't expect anything too different out of Europe.

[Steven Fisher:]

Okay. And then in the second half, I guess, a question along the same lines. I mean, are you thinking that these awards have come to the market, it'll be just kind of one-offs or might it be a more robust flow of projects coming to market? Or is that more of a 2014-type situation or is it just too hard to tell on the timing of these bigger projects?

[Mark A. Blinn:]

Probably fairly to really say that more general project activity will be 2014. I mean, they're all on-off, frankly, the way we work them. But I think more of a general project-type activity is going to be, across the board, is going to be 2014.

[Operator:]

And our next question comes from William Bremer with the Maxim Group.

[William D. Bremer:]

This morning, one of your competitors had to adjust their guidance due to pretty much similar commentary from you guys in terms of a lack of large-scale projects, and some of them shifting to latter periods impacting the remainder -- remainder of '13. Should we be expecting, based upon your guidance, that we should be more towards the lower end due to this, at this point?

[Mark A. Blinn:]

Bill, yes, I mean, we don't -- we certainly don't give guidance within the guidance. And my comments earlier around this year was the increased efficiency, which you commented on at the beginning, and share count is really what drives earnings this year. But one other thing relative to that competitor, who has got a great presence in oil and gas. They're more vertical across the oil and gas industry. We're more diversified across different sectors than they are.

[William D. Bremer:]

Well, that's a given. Agreed. My second question is, has there been any type of repricing or cancellations in the backlog currently?

[Thomas L. Pajonas:]

Repricing again is -- if you think about it, we have firm contracts when we go into these things. That's typically not a big issue. The pricing activity occurs before you get the contract, not necessarily after. And cancellations haven't been anything out of the ordinary.

[William D. Bremer:]

Good to hear. And then, Tom, you mentioned you called out some of the pipeline activity. Can you give us a sense of primarily, is it shales? We really haven't seen too much on long haul pipe, especially here in North America as of yet. But maybe just give us an idea of the content of the pumps involved and your exposure to pipelines in general, just a nice little overview, if you may?

[Michael S. Taff:]

Yes, I would say, generally, you're correct. It's not necessarily the long overhaul pipeline business that we're talking about. Most of this is associated with the shale and the liquids business. In a lot of cases, it maybe operates to an existing facility also on the aftermarket side of the business. So I would say, it's some new and it's also operates through existing systems on the pipeline business.

[William D. Bremer:]

And would you -- how would you characterized your year-over-year in terms of this particular segment? I mean, would you say you're running 20% or 30% higher year-over-year at this point?

[Thomas L. Pajonas:]

I would say the run rate business, pipeline business, I would say, is very similar and has been -- it grew nicely last year and the same thing this year, overall, as an industry. So I would say it's staying at the same levels in terms of the overall industry itself year-over-year.

[Operator:]

And our next question comes from Joe Radigan with KeyBanc.

[Joseph K. Radigan:]

Just one question. Tom mentioned $70 billion in shale investment on the radar. Are you similarly able to quantify the magnitude of projects you're tracking on an overall basis globally, just to give a sense of order of magnitude for the opportunity that's ahead here. And then how do you think about capture rate, either historically, or what your target going forward?

[Mark A. Blinn:]

Well, I mean, we do track all that. But we don't this discuss that necessarily publicly. I mean, the general information around project opportunities is from third-party sources, which we use as well as available. But in terms of what we're targeting, there's certainly plenty of opportunity over the horizons over the next couple of years, but we don't go into that detail.

[Operator:]

And our next question comes from David Rose with Wedbush Securities.

[David L. Rose:]

Two final questions. I was hoping that if you think about the -- your commentary around revenues for next year or at least this year was a year of, really, a year of execution and discipline and then next year is a year of growth. This year, you were talking about 4% to 6% top line growth. You indicated, Mike, that you're at the bottom end of that. So in order for you to exceed that number next year, what sort of bookings expectations do we have to see for the back half of this year on a year-over-year basis? That's one, and then I have a second follow-up.

[Michael S. Taff:]

Well, I mean, for -- obviously, for growth next year, with some pickup this year or next year in the order book will drive revenue growth in the projects. But also, and I think equally or more important, continued growth in our run rate and aftermarket business like you've seen. One thing to keep in mind with these projects, when we book them, is that's revenue you take over a longer period of time. And -- but the shorter cycle run rate and aftermarket business, that tends to manifest itself in revenues quicker. So my point is, a company can have a significant increase in big project work that goes into their backlog but may cover revenue over 1.5 year. So that growth will be muted over that period of time relative to the booking growth in any one period. But the run rate business and the aftermarket business can grow quicker. And that's why we stay very focused on it. If you look at, over the last couple of years, we've grown those businesses. Those tend to be more stable margins. Aftermarket is high-margin business. So hopefully, that will give you some color.

[David L. Rose:]

That helps. I mean, obviously, you had difficult comps as noted in your aftermarket business. So we would need to see a progression of that aftermarket growth along with stable OE bookings. Is that pretty fair in order to see growth above this year?

[Michael S. Taff:]

Yes, that's fair, yes. And just don't look at any one quarter. Because again, going back to the aftermarket, this is over $0.5 billion of aftermarket. We weren't anywhere near this size of aftermarket business 4 or 5 years ago.

[David L. Rose:]

Sure. And the other question is, the IPD margins were very impressive. And again, this goes back to your point about the aftermarket business. The bookings were down significantly, both on OE and then they were down for the aftermarket for that business. So you lose some of that operating leverage you have. You're obviously executing better. So is it intuitive then at the margins, you sort of take 2 steps forward, 1 step back on the margins that is sequentially, maybe it's a third or fourth quarter, we should see some decline in that margin on a sequential basis?

[Mark A. Blinn:]

Well, as you're -- I think the way to look at margins, you're 2 step forward, 1 back may be when they're operating more efficiently and that the marginal impact of mix is really the primary driver of margin impact when you're improving your operations from where they are. I mean, believe me, they've got a ways to go. It's going to be more about your throughput and your execution, which has been a priority. So if you look year-over-year, we focus them on the run rate business. They had a couple of what I'd call medium projects in the second quarter last year that came through their bookings. But really, it's been around making sure that they're most efficient in taking good care of their customers. So I think over the near-term, as we continue to improve this business, I think more of the margin profile is going to be over improving the operations and getting better efficiency. And then, down the road, we'll get to the discussion of OE aftermarket mix, OE growth, aftermarket growth, that will start impacting margins. That's where we want to be with the business. If we get all of our businesses that way, like we are in the Flow Control division, then it's a different discussion.

[David L. Rose:]

So then, I shouldn't expect the IPD business margins to decline, given the decline in the bookings number?

[Michael S. Taff:]

In and of itself in the bookings, no. They can have mix issues. They can certainly have things from quarter-to-quarter. We're going to 14% to 15% in this business over the next 1.5 year, 2 years. That's still a ways to go. One quarter to the next, things can change. We keep telling you, be careful to try to evaluate this on a quarter-to-quarter basis.

[Operator:]

And that was our final question. Ladies and gentlemen, this concludes today's conference. Thank you for participating. You may now disconnect.