Flowserve Corporation
Q1 2014 Earnings Call Transcript

Published: 24 Apr 2014

[Operator:]

Welcome to the Flowserve First Quarter 2014 Earnings Conference Call. My name is Ellen, 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 our call today to discuss Flowserve Corporation's financial results for the first quarter of 2014, which we published yesterday afternoon 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 flowserve.com in the Investor Relations section. An audio replay will also be available on our website approximately 2 hours following the conclusion of this 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 this call and the associated earnings materials contain forward-looking statements that are based upon forecasts, expectations and other information available to management as of April 23, 2014. These statements involve numerous risks and uncertainties, including many that are beyond the company's control. Therefore, we encourage you to fully review our Safe Harbor disclosures contained in yesterday's press release, slide presentation and in our filings with the Securities and Exchange Commission, including our Form 10-Q filing for the period ending March 31, 2014. All of these documents are accessible on our website under the Investor Relations section. Finally, 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 our operating and financial performance in the first quarter. We met our expectations for the 3-month period, which provides confidence in our 2014 guidance. I appreciate the commitment and dedication of our employees. They have continued to embrace our performance culture initiatives while increasing their focus on exceeding our customers' requirements. These efforts, evidenced by our notable operational improvements, enhance Flowserve's ability to capture the expected growth provided by accelerating market demands and aftermarket opportunities. EPS of $0.78 increased over 16% versus last year's first quarter. While Mike will discuss the details of our financials in a moment, I would simply add that our core business delivered and is demonstrating the improvements in our operating platform necessary to support anticipated revenue growth. Bookings of $1.2 billion increased slightly over last year, driven by strong aftermarket growth of over 8%. Aftermarket bookings of $517 million were at a record level for the period and highlight the success of our ongoing commitment to end-user strategies and supporting our customers. Our original equipment bookings were again driven by the recurring short cycle run rate business, which continues to provide a solid foundation of profitable work. Although we bid on a few larger projects during the quarter, these initial opportunities were competitive as expected. We remain disciplined and selective and continue to believe our shareholders will be rewarded by this approach over the cycle. With the anticipated ramp-up of energy-related projects, particularly in the Gulf Coast, we believe there is ample opportunity for near-term bookings and revenue growth on the horizon. Additionally, I would like to highlight the IPD segment. Over the past few years, it has delivered on its commitment to improve the operating platform and is now shifting focus towards higher growth. As evidence of this progress, IPD's bookings grew over 10% year-over-year, demonstrating its operational progress and customers' increasing confidence in its capabilities. These solid bookings produced a quarter-end backlog of $2.7 billion, level with a year ago, but significantly improved in terms of quality and past due levels. Compared to year end, backlog is up over $130 million or 5.2%. Despite traditional seasonality, Flowserve again demonstrated the strong leverage that exists in the business, driven primarily by improving execution, as well as focused cost control and modest aftermarket mix shift. Gross margins improved across all segments, including an impressive 280 basis point increase in FCD. Last month, we dedicated significant time during our Analyst Day highlighting the operational improvements that we have implemented over the last few years. This quarter, strong gross and operating margins are a direct result of these initiatives. However, I want to emphasize again that significant propensity remains to further enhance our business. And even as we prioritize increased growth, we will continue to focus on the customer and improving key metrics. Turning to our end markets. Several project owners have made final investment decisions on large infrastructure investments over the last few quarters, which is encouraging. A number of these energy-related projects have already been awarded to EMCs, and we are currently bidding on many of them. Our visibility into the progression of similar projects as a move towards final investment decision provides us additional confidence in an improving cycle. By region, North America shale production continues to support investment in chemical and oil and gas projects. Ongoing efficiency investments in Europe's infrastructure drove modest growth over the last year. We continue to pursue opportunities in Asia Pacific and aim to further increase our presence and market penetration in that region to support growth. Middle East investment is expected to continue as they look to capture more the value in downstream products, although it remains the most competitive market. And while political and financial instability in Latin America pose some challenges, their efforts to increase production should provide opportunities over the coming years, assuming these issues can be managed. In addition to expected near-term organic growth in our core end markets, we also continue to target technology, product and geographic additions through strategic bolt-on acquisitions. Our disciplined approach towards these opportunities requires rates of return that add value for our shareholders. Likewise, we take the same disciplined approach when evaluating our existing portfolio. If an asset is not performing to the level we expect, serving a key market or providing the appropriate growth opportunities, we will either take the necessary actions to correct it or divest the business if another party values it more highly. Our recent divestiture of Naval, a noncore district heating valve asset, is a good example of this approach in action, as we regularly evaluate our assets based on rates of return and strategic fit to drive value for our shareholders. As we look forward to the remainder of 2014, I am confident that our actions over the last few years have significantly improved our operations and ability to support customer's requirements. As a result, Flowserve is now well positioned to take advantage of the growing energy markets we see ahead. So with that overview, I will turn the call over to Tom.

[Thomas L. Pajonas:]

Thanks, Mark, and good morning, everyone. Our first quarter results have us well positioned to deliver on our full year 2014 targets. As we have discussed and detailed late, there remains substantial opportunity within the business, and we continue to focus on improving our operations. Our goal is to better align our processes with our customers' expectations, as we prepare for the improving growth expected in our key energy markets. These customer focused initiatives include

[Michael S. Taff:]

Thank you, Tom, and good morning, everyone. With our operational overview and business outlook well covered, let me discuss in greater detail our financial results for the quarter. We began 2014 with a strong operational performance and are well positioned to deliver on our guidance for the year. First quarter EPS increased 16.4% to $0.78. Included in EPS is $0.03 per share of net benefits. As we discussed in the press release, this amount is comprised of a $0.05 gain on the sale of our Naval district heating valve business, partially offset by combined $0.02 of realignment charges and below the line currency expense. Excluding these items and the $0.03 per share net benefit from discrete items in 2013, EPS increased 17.2% year-over-year. As expected, the first quarter reflected typical seasonality, with revenues down 2.6% or 1.3% on a constant currency basis. Even so, we delivered improved gross margins across each segment through strong execution, a higher quality of revenue, continued emphasis on low-cost sourcing and a 1% mix shift towards aftermarket. Turning to SG&A. Our results demonstrated focused cost control. As reported, SG&A as a percentage of sales was down 120 basis points. 2 items skewed our results, including the $12.6 million net gain on the sale of a business in 2014 and $1.7 million of joint venture transaction fees in 2013. Adjusting for these items, SG&A expense declined $4 million year-over-year. As we have indicated, our longer-term goal is to achieve full year recurring SG&A as a percentage of sales to be consistently in the 18% range. We've made substantial progress over the last few years and opportunities clearly remain. Progress will ebb and flow quarter-to-quarter, since even as we lower cost in some areas, we're also making strategic investments in others to improve our platform. For instance, over the last year or so, we've invested in quality and project management programs and personnel, increased research and development spend and reorganized our global sales organization. To be sure, our end goal is not only focused on dollars spent, but also increasing our capabilities, efficiency and productivity. We will continue to further optimize SG&A in this manner over the next few years. On a reported basis, operating margins were down 10 basis points to 15.4%. However, excluding the discrete items we previously discussed, operating margins increased 120 basis points year-over-year to 14.3%. Below the line, foreign currency had a negative impact of approximately $2 million in the 2014 quarter, but it decreased significantly from last year's $11 million negative impact, which included $4 million of Venezuela devaluation. While we continue to monitor this year's developments in Venezuela, we have not recorded a charge for any further devaluation. Our tax rate in 2014 first quarter was 26% and was lower than our previous expectations due to certain beneficial tax items. For the remaining quarters of 2014, we continue to expect a tax rate of nearly 30%. Turning to cash flows. As many of you know, the first quarter seasonally tends to be a major usage of cash and it was again in 2014. We used about $85 million in our operations during the quarter, but that was an improvement of $23 million versus last year. We also spent another $171 million combined for share repurchases, dividends, capital expenditures and debt payments, while the sale of the Naval business generated cash inflow of approximately $47 million. In the end, we finished the quarter with no borrowings on our corporate revolver and about $165 million in cash. Similar to the seasonality of our earnings profile, we also expect the first quarter to be the trough for cash flow and anticipate much stronger performance during the remainder of the year. Focus on cash flows and working capital will remain a priority, as we work towards our goal of consistently generating annual free cash flow near our net income level. We continue to execute on our strategy to efficiently deploy the balance sheet and return value to shareholders. At quarter end, we had about $275 million remaining under our authorized buyback program. Turning to working capital, it's a mixed story. Although DSOs increased 3 days and inventory turns were flat compared to a year ago, the combined dollar balance of receivables and inventory was down around $27 million from 2013 levels. And these items were cash neutral in the 2014 quarter, which is an improvement of $43 million versus a year ago. I remain confident that the working capital initiatives previously detailed will drive improvement in our metrics over the next few years, as we continue to target DSO in the mid-60s and inventory turns of 4x to 4.5x. Moving to our EPS guidance and outlook for the remainder of the year, we are reaffirming our 2014 earnings guidance of $3.65 to $4 per share. We also continue to expect revenue growth of 3% to 6% on a neutral FX basis. Turning to our spending priorities. After a couple of years of accelerated returns to shareholders to optimize our balance sheet, we expect a return to our stated policy of returning 40% to 50% of our running 2-year average net earnings to shareholders through dividends and share repurchases. Importantly, we fully intend to invest in our business for profitable growth and solid organic returns. Capital expenditures were $31.7 million in the first quarter, and we continue to expect full year CapEx in the $130 million to $140 million range. These investments include adding and expanding capacity in regions like India and China, introducing new products, and as many of you saw in Raleigh, replacing and upgrading manufacturing equipment. We believe this dual approach of capital returns to shareholders with organic and acquisitive investment in our business will provide Flowserve shareholders solid returns over time. Other uses of cash we expect for the remainder of the year include pension contributions and scheduled debt repayments. But even combined, this amount is modest in comparison to the other priorities. Lastly, I'd like to thank the many of you who attended our Analyst Day in Raleigh last month. For those of you who are unable to participate and have an interest, the presentation is available on our website. In the weeks ahead, we are planning a fairly active investor relations schedule, with investor meetings in Europe, scheduled visits to our offices here and a number of conferences over the next few months. We value our time with the financial community and our shareholders and anticipate there will be several venues available to you ahead. With that, I'll turn it back over to Jay.

[John E. Roueche:]

Thank you, Mike. Operator, we have concluded this morning's prepared remarks and would now like to open the call up to any questions.

[Operator:]

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

[Hamzah Mazari:]

The first question is just on maybe if you could give a little more color as to how you plan the balance, getting some of these larger projects that are coming in pretty competitive, as well as sort of balancing, taking a lower margin project in -- and getting the aftermarket for it. You mentioned Yanbu was pretty low margin, but now you're seeing the aftermarket for that. Do you expect the competitive environment to get better and margins to get less competitive, as some of these larger projects come online? Maybe just walk us through what your thought process there is and how selective you're going to be.

[Mark A. Blinn:]

Just your question indicates the -- really the -- how we think about it and the complexity. You're exactly right. I mean, the way we look -- first, to the first question, what happens in our industry is as capacity starts to fill up, then the industry starts to use lead times to the extent they can. But there's reluctance to do that because time is money on these projects for the engineering contracting firms. But then the industry also starts to use price to rationalize capacity. So that's a general theme in our industry. And when we talked to you back in 2010, you had a number of forces that were really driving a very price competitive market, Middle East projects, Korean contractors and the like at that point in time. Setting that aside, what we do know is we look at our capacity long term and capacity utilization, in terms of potential absorption. That's a factor you consider relative to where you see in the market cycle. And -- but you also look strategically at some of these projects. So if you've got a good foothold on the aftermarket, you want to make sure you're very competitive. Having said that, Hamzah, I can tell you, in our industry, a bad project never gets better. And so one of the things that we're always very careful with, because we had discussions with you for a couple of years about past due backlog and legacy backlog, that is not a situation that gets better and we think really provides types of [ph] returns for our shareholders. So we will balance all of that. And in the meantime, what we want to do is to continue to focus on execution because that allows us to be more competitive. So as we look at these projects, we will look over at our capacity over 1.5 to 2 years, anticipate how it's going to get utilized, look at market expectations around the world, because with our LPO/SPO, we can move work all around the world and look at the aftermarket opportunities, look at other pull-through of products because keep in mind, it's not just a certain type of pump that we're seeing, there are seals that go with it and there's valve opportunities as well. And that's how we'll consider the projects. But at this phase, and we talked about this in the first quarter, we saw some that were just very, very competitive. And yes, that could -- we could have taken a couple of those, and those may have changed the comps that we're talking about today. And that -- while that would change the discussion or the perception of the discussion, it really doesn't change the discussion because if those aren't profitable, and they go into our backlog, but they're not going to deliver value to our shareholders. So it is a very thoughtful and complex way we do that. But it's important to know, the process we use around One Flowserve really looks across all of our global capacity, all of our capabilities, our supply-chain capabilities, aftermarket, pull-through opportunities, the other products that we can bundle in, and that's how we consider how we want to take a project. What we don't want to do is fill up our capacity with projects that don't meet our economic requirements. Long answer to your question, Hamzah, but I think that's important because just the length of this answer indicates the level of detail and thought we go through when we look at a project.

[Hamzah Mazari:]

I appreciate the answer. It's very helpful. On the aftermarket side, how much of that growth is just pent-up demand or deferred maintenance relative to just underlying growth that you're seeing within that business right now? Is there a way to parse that out or think about that?

[Mark A. Blinn:]

On a percentage basis, no. But on a anecdotal basis, you heard Tom's comment around what we've seen in the Gulf Coast region with increased maintenance spend. Over the last couple of years, European production process facilities have been holding back on maintenance CapEx. So some of that is starting to come back online. That certainly contributed. Also, as we talked about, some of the installed base that we put in over the last couple of years is bearing fruit. And then there's an aspect of it where we're really executing on our end-user strategies. So if we've talked about 8-plus percent growth in aftermarket and really look at the growth over the last couple of years, there's not that much incremental net installed base that goes in around the world at that point in time. So what that indicates is we're gaining ground executing on our strategies, but there certainly will be cycles. Now what you're seeing with the opportunities in the Gulf Coast region is they're going to start putting money back in the maintenance.

[Operator:]

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

[Unknown Analyst:]

This is Patrick actually dialing in for Charlie. On the bookings side, I was just wondering, what was the tenor of that during the quarter?

[Mark A. Blinn:]

Hold on. Can you speak up? I can't hear you.

[Unknown Analyst:]

Sorry, sorry. By the way, this Patrick dialing in for Charlie. On the bookings side, what was the tenor of that during the quarter? Was there a steady uptake? And I guess, also if you can give a little bit more color on the backlog as well, how are the margins now, say, versus 2 or 3 years ago as a result of increased bookings?

[Mark A. Blinn:]

Yes. I mean, one of the things -- typically, we don't really talk about current quarter information. But in the press release, in our commentary, we talked about accelerating in some of the activity in April. Now 3 months in a -- 3 weeks in a quarter doesn't necessarily make the quarter. But we wanted to give the market an indication of what we've seen. And I think some of our competitors in our industry have seen is that towards the end of the first quarter, things started to pick up. Again, competitive on some of the large projects, and that's continued into April as well. As to the comments on the backlog, if you think about it, especially on the large projects, backlog can be around a while. We embarked on this journey a little over 2 years ago around being disciplined and focusing on execution and all the processes associated with that. What that means and has meant is that our backlog has continued to improve over time. So as we look at this year's backlog, and you heard at my comments over the last year's, you've seen growth in our aftermarket business. But more importantly, we're not having discussions really now around significant legacy or past due backlog. And that type of backlog tends to have little or no margin at the gross margin level. So that can just highlight to you that we've seen good improvement in our backlog. And we think that's important because not only does it impact margins, but it impacts working capital, it impacts our customers, it impacts our sites, it flows through the entire system. We do still have work to do. And one of the outcomes over time of this continued discipline and execution will be more efficiency in our working capital.

[Unknown Analyst:]

Got it. Can you guys -- moving on to the segments, can you guys provide a little bit more color on how much the key end markets were up or down relative across the 3 segments?

[Mark A. Blinn:]

You're going to have to speak up again. You're kind of drifting on us.

[Unknown Analyst:]

Can you provide a little bit more color on how much the key end markets, oil and gas, chemical and power gen were up or down relative across the 3 segments?

[Mark A. Blinn:]

Well, I think that what -- we need to look at trends over a couple of quarters because, for example, the decline in bookings was more focused on our FCD business, a very high performing business. We saw a pretty good level of oil and gas orders last year on some FPSO opportunities. So when you look at any quarter year-over-year compare, you got to be very careful about calling it a trend. But that's a good business. It does well. As we've indicated, oftentimes, in the first quarter, don't read that as the year for that division. It's executing at a very, very high level. But you'll -- sometimes, you'll have some challenging comps. Generally, in our industries, we've heard there's been talk around -- certainly around the E&P side in oil and gas. But keep in mind where we participate. It's more on the processing side. And what that means is when you take a hydrocarbon, when you take any kind of feedstock and you can process it in a different manner or transport it, what you're seeing increasing levels of, that benefits our industry. The other comment on the power side where you see improvement is we've been in gridlock, certainly in the United States, around fossil-based power plants, but they've gone to combined cycle. You've seen what's happened to the nuclear industry and some signs of life. As we had indicated years ago, that represents 20% of the global supply of power. There is no way to diversify away from that over a short period of time. And you look at all the aspects of what's going on around the world in energy security, and it's difficult for countries, even like Germany, that said they were going to exit it and completely exit it now because they're reliant on natural gas from Russia. So I think it's important to consider there can be pauses [ph] in certain area of the power industry. But as long as people move to urban areas and there's population growth, there's going to be demand for more power.

[Operator:]

Jamie Sullivan with RBC Capital Markets.

[Jamie Sullivan:]

Mark, a question on the run rate OE business and the opportunities there. Maybe you can just give us your view on that cycle and maybe what the growth of that market opportunity is, assuming that these large projects are going to be lumpy and sometimes competitive, as you mentioned?

[Mark A. Blinn:]

Well, some of those large projects will pull through some of what we -- more of our run rate products. If you look at EPD and IPD, IPD will tend to benefit from project opportunities because they'll supply some more of the configured order. I think, in general, when you see upgrades and retrofits of large and medium-sized facilities, and as Tom commented, when you see the distribution channel start to take in more inventory during those periods of time, and more important, Flowserve specific, as IPD continues to improve its execution, that gives us encouragement in that run rate business. I think other areas, as we talked about -- in Mike's comments, he talked about our sales force. I mean, we are making a lot of changes here at the company, but one of them is if you think about it, companies tend to like to hunt elephants. Bringing focus and comp plans around driving this run rate business is important as well. So I think there's market-driven aspects to it. There is a benefit from project activity. There's a benefit to aftermarket from project activity, because there's, I talked about these before, commission spares that go with a new project. So that's kind of the macro outside-in looking opportunity for that business. I think improving the way we execute into our distribution channel, FCD does it quite well. We can -- certainly, we've got room for improvement in IPD as well, focusing our sales organization. Improving execution will give us the opportunity to continue to drive that, more of that configure-to-order smaller run rate business.

[Jamie Sullivan:]

Okay, that's helpful. And then maybe -- you talked about the IPD, the bookings, up 10% or so. I know they had a little bit of an easy comp, but you talked about the focus on growth and some success there. Can you maybe some give us some more details on that, maybe how resources are allocated or focused now or initiatives that we don't see outside of the numbers that's making you feel good about the progress there?

[Mark A. Blinn:]

Well, the way it's operating, it gave us more confidence on executing on our acquisition of Innomag last year. If you think about it, the one thing you don't want to do is acquire an asset, a business for a company that isn't performing at the level it should because it doesn't make things better. So I think that's one great indication of the way that we're thinking about the business, is to bring in more products for them to deliver to our customers. Another thing that we talked about is just aligning the sales organization and making the investments that we have. That's one of the businesses where we've made investment on the chemical side to support the ISO standard chemical equipment. So it's going to be investment in terms of R&D, sales organization, people, talent, inorganic investment opportunities as well because oftentimes, on some of these bolt-ons, those are the type of products, those configure-to-order, that we can bring in and load onto our platform. Honestly, a highly engineered, long cycle piece of equipment, we contend to develop ourselves. And when you go out and make those types of acquisitions, you're typically just buying installed base and setting yourself up for an opportunity to consolidate manufacturing capacity.

[Thomas L. Pajonas:]

And I would add to do that, that if we look at the IPD business, bookings were up in many different areas, so not just one. So chemical was up and GI, water and oil and gas. The only one that was down a little bit was the power business, which was expected. Both the aftermarket and the OE business were up. And if you look at the regions, again, it was broad brush, up across all the regions, with the exception of the Middle East. So it was a good strength across the wide berth of both region and industries on the IPD side. And as Mark has indicated, just good solid execution on the orders that they were getting in.

[Operator:]

The next question is from William Bremer with Maxim Group.

[William D. Bremer:]

We know Flowserve's expertise on the downstream market. Can you provide us an update on what you've seen and some of the initiatives that you're doing on upstream?

[Mark A. Blinn:]

We've made a couple of comments around our participating in the thrusters for offshore platforms and also FPSOs as well. So -- and we also provide some of the -- in the firewater pump for some of the offshore platforms. So if you think about type of rotating equipment opportunities and valve opportunities, that's really where we participate on the upstream side. Now there are things we do near upstream that I would call, again, like in the tar sands, where you're right there proximate to the production facility and there's a pre-processing activity that occurs so that the product is easier to transport as opposed to hauling in large trucks and containers. So at the wellhead, there's certainly some down water injection pumps and things like that where we can participate, but it's really going to be around flow control. And that's our core competency. And then on the midstream as well, and Bill, I know you're fairly familiar with that, there's -- you have valves. I mean, the Valbart valve is critical on some of the gas pipelines, certainly, whether it's gas or liquid. If it's a liquid pipeline, you've got pumps that go on it, seals as well. And then, if you think about upstream and midstream, that means that product is going somewhere to get processed.

[William D. Bremer:]

Great. My second question, and I appreciate the color there. You called out nuclear a little bit. Can you give us a little color on what is happening on the waterfront? A little desalinization there, I know it's a very small piece. But what are you seeing in terms of some of the projects?

[Mark A. Blinn:]

Tom.

[Thomas L. Pajonas:]

Yes, the -- you want me to cover nuclear or do you want me to cover the water feeds [ph] itself?

[William D. Bremer:]

They sort of go hand in hand.

[Mark A. Blinn:]

Okay. Yes, in -- well, in the Middle East, you're right. The -- I would say the power business and the desal business kind of go hand in hand because they try to put those 2 things together. Well, we are seeing a pickup in the desal business, particularly in the Middle East, China, and I would also add India into that. We're seeing some -- a fair amount of activity in the water business itself, not necessarily desal, but water -- I mean, the simple business in the U.S. out of our industrial group. So as the financial condition changes with some of the cities in the U.S., they seemed to be moving at some of those projects. We're also seeing some Latin American countries look at desal as certain countries have mandatory requirements to use desal for mining in order to conserve some of the water supplies because they're having some shortages in Latin America. So we're seeing some good projects there. And as you've indicated, the power, and especially in the Middle East, is going along with the desal plants, particularly in the Middle East.

[Operator:]

Your next question is from Chase Jacobson with William Blair.

[Chase Jacobson:]

Just first on the capital allocation. Mark, at the analyst meeting, you gave the target for $2 billion of growth investment through 2018 on top of CapEx. You've been through the first quarter. You were still active with the share repurchases. Can you update us on the acquisition pipeline?

[Mark A. Blinn:]

Yes. It's active in terms of some of the smaller opportunities that you see out there. I mean, I think you've read out there some of the larger opportunities in the flow control industry. So there is activity that is certainly picking up. But in terms of the bolt-on, we're -- we stay very focused on looking for the types of opportunities, products, regions that are certainly out there. They just have to meet the return requirements. And then from time to time, you see assets go out to auction, but you'll see them right about the same time we do.

[Chase Jacobson:]

Okay. So I mean, is there any way to give color on if you're prioritizing technology or geographic footprint or product portfolio at this point?

[Mark A. Blinn:]

Well, I think that's just it. It's really -- we want to make sure we have the flexibility to shift across those opportunities. And that's what we're doing. So in different areas, I can tell you, we're focused more on R&D and product development and in area One [ph] because we can leverage the product technology that we have right now. We can get it to market as quickly as we'd like. And either there's no asset available out there or to acquire and integrate that asset creates more risk than taking it to market ourselves. We have spent quite a bit of capital on further penetrating the Indian and Chinese market to support those markets primarily, but also to support markets around the world. So we've opened, in the last year, 1.5 years, a new facility in China, one in India and one in Brazil as well. So I think the point here is what we're going to do is look for capital allocation opportunities to provide returns to our shareholders, and we'll look across the entire spectrum. Obviously, M&A is more opportunistic. And sure, you can create opportunities by paying up. But then the real question is, can you deliver the value to your shareholder of that acquisition over a period of time? And that's what we have to do. So we're moving certainly across all of those, not only with our CapEx dollars, as Mike talked about with our SG&A as well. One thing I want to be clear on in SG&A, this is not a matter of just going through and cutting costs. This is really a matter of how we prioritize those SG&A dollars to drive long-term value.

[Chase Jacobson:]

Okay. And then on the competition, you've been talking about it, about competitive market for a while. And I guess, we shouldn't be surprised to see it more competitive in the Middle East. But now that, that experience is behind you, are you worried about the ultra competitive environment spilling into the U.S. at all? And is the competition that you're seeing coming from Eastern or Western competitors?

[Mark A. Blinn:]

It's a lot of the same competition that we've seen before. They're good and capable companies. One thing to keep in mind in terms of competition, particularly in the United States, the more of the OECD, what customers value is quality, on-time performance and good execution. And so in the Middle East, it can tend to be oriented a little bit more towards price, although that's changing as well. Because if you think about it and if you followed some of the E&C projects from the Koreans that were executed a couple of years ago, they struggled a little bit, and that cost everybody money. So I think there's an increasing perception, especially in the critical nature of these, that quality and on time is just paramount, not at any price. We had a very strong pricing environment, '06, '07, '08. But again, what I'll tell you is that's when economies were growing at very rapid rates. And more importantly, commodity costs were rising very quickly. So when an owner would bid a project, it would come in 50% to 80% more than what they budgeted for. So that causes the market to try to grab capacity as quickly it can. It's not always a good situation. So what we see in these environments, this is typical. We go through multi-year cycles. We started the cycle down really towards the end of 2009. It got very difficult because the industry had little visibility in 2010 and 2011, but you live with that backlog and you see the opportunities start to come. This is not any different from any time before, other than the financial crisis -- was pretty rugged on all industries. So as we looked at competition, they appear to be very rational, but this isn't unusual as people start to fill their capacity.

[Operator:]

The next question comes from Ryan Connors with Janney Montgomery.

[Ryan M. Connors:]

I wanted to ask a question on the guidance, if you might. You mentioned at the Analyst Day, Mark, that the trajectory of bookings in the large projects out of the business would be a critical factor in determining whether you end up ultimately at the low end or the high end of the range. And here we are a few days from May and still at a reasonably wide range there in guidance. So can you kind of update us on how you're handicapping that relative to the comments you made about somewhat of an acceleration in bookings at the back half of the quarter and into April?

[Mark A. Blinn:]

Well, yes, let me clarify. The conversation at the Analyst Day was where we'd be in the revenue range. So I think one of the key messages that we want to make sure you take away from this -- I mean, look at the improvement in the margins, look at the improvement in the operations, the platform, that's -- you see improvement year-over-year, which, in and of itself, revenue aside, drives earnings growth in the business. So that's one thing to look at in terms of when we look at our guidance. I think the question I had at that point in time was, how will revenue growth impact your earnings outlook? And what we talked about is some of these projects, if they are competitive, still have economic value. We'll contribute some to earnings, but less so than the underlying platform in terms of growth. So I think, I want to make that distinction. That was the conversation we had at that point in time. We still think one of the biggest opportunities to drive earnings growth in this business is improving our platform. But clearly and certainly, as you take a step back relative to where you were, I mean, we've sold the business that had some revenues to it. We do need to see increased booking activity to start approaching the top end of our revenue range.

[Ryan M. Connors:]

Okay. And then my second question is just, I mean, you've kind of touched on this a few times on the call here, but just to kind of ask it more, I guess, directly, this whole issue of competitiveness to the environment, is there anything different -- can you contrast, I guess, the environment today versus the last cycle around and whether things are more or less competitive or whether this is just kind of where you would expect things to be at this stage of the cycle we're in right now?

[Mark A. Blinn:]

I think it's where we'd expect it to be. If you go back to the last cycle, I think the industry in general got caught by surprise with how economies heated up so quickly and material costs or commodity costs went up fairly quickly. This one seems to be more steadily paced. What do we mean by typical? Typical in the fact that it's understandable, these projects get delayed because people want to make sure they have their budgets right, that they know exactly what the process conditions are, that any change orders they want to consider to get this thing right, they do. So I think people are very, very thoughtful. These are 40- to 50-year commitments that these owners are making. And if you've looked at the activity back in '07, '08, they were rushing to market as quickly as they could and understandably so. This is more typical. Long-term spend, long-term commitment, it's not just any one individual's career, it's many careers that depend on the decision that these folks make. And so they're very, very thoughtful and methodical about it as they go through the process, so it's not typical. I think, over the last couple of years, what we did see, and you've seen in our industry, was 2010, 2011, there was little visibility, and that creates some more of -- we use the term choppy behavior at that point in time. That's not unusual as well, except for the fact that the industry had added capacity and was adding capacity and in '10 and '11, had little or no visibility as to how that was going to get used up. So a steep cycle, you saw, it creates a little more of a choppy environment during the trough that we've seen we getting back to more of what you see as steady state [ph] in our cycles.

[Operator:]

The next question is from David Rose with Wedbush Securities.

[David L. Rose:]

I had a follow-up question on the aftermarket business. I was wondering if you can quantify the size of the opportunity for bringing in-house some of your aftermarket support as in Dow Benelux? And was there any progress reflected in the aftermarket growth that we saw in the quarter?

[Mark A. Blinn:]

Yes. I mean, there was absolutely progress. I mean, progress in terms of market driven, we talked about earlier, but also in executing on our end-user strategies. And there's a whole array of things that we're doing to try to capture more share of the customer's wallet. We could and have quantified what the opportunity is internally that wouldn't be necessarily something I'd talk about on the earnings conference calls. But if you take a step back, Dow Benelux is one facility. Think about how many they operate, how many DuPont operate, Exxon and Shell. That really is our opportunity. And if you take a look at just overall aftermarket, I mean, again, I would say the aftermarket was up in many areas. Chemical market was doing very good on the aftermarket side. The oil and gas, we talked about the refineries on the Gulf Coast and started to spend some of the MRO business. Again, from where they were in the past, Europe oil and gas aftermarket was also up, which was a very good sign. Our general industries business was up in terms of aftermarket also. And then most of the regions fared very well in Q1. Probably, the only region that we had a little difficulty was in Latin America and Venezuela. Other than that, I think it bodes very well for the aftermarket going forward. And then the last thing, as we mentioned, the distribution business on the valve side also had a very strong Q1 in that area. And we've had a pretty good distribution business on the industrial side also in that area, so...

[David L. Rose:]

I guess, my question was related -- did you see any benefit of additional opportunities in the quarter that went in-house or went from in-house to where you were taking care of it?

[Mark A. Blinn:]

Yes, we didn't announce any during the quarter.

[David L. Rose:]

And do we expect -- even if they're small, you won't announce them anyhow, will you?

[Mark A. Blinn:]

Well, those types of relationships, we tend to, if the customer permits, let you know, because it helps you understand we're executing on our strategies. Sorry about that. I get emotional when I talk about aftermarket.

[Operator:]

Our next question is from Brian Konigsberg with Vertical Research.

[Brian Konigsberg:]

Understanding your enthusiasm for aftermarket, those type of -- with those type of margins. But Mark, I do have to push you on the guidance a little bit more. So I mean, we're standing here in Q1. Organically, you're down 1%. If I look at what Q1 has typically contributed to the full year revenue, it is trending below where we would be to hit the mid-range of your full year target numbers, about 4.5% growth range. Your backlog is flat year-over-year, yet you're talking to 3% to 6% growth. I mean, so obviously, you're assuming that there's going to be a meaningful acceleration. We're talking about EPD orders maybe coming in the back half of the year, but it's not going to contribute a whole lot this year. So how should we be thinking that? And what's really driving this and what you that confidence that we're going to get there?

[Mark A. Blinn:]

Well, one thing is we, in Q1, even on lower revenues, we delivered more earnings, and we're sitting flat backlog year-over-year, but as I talked about improved backlog, with more earnings power and backlog. I think the third thing to look at, is look at the growth in our aftermarket business, even over the last 2 quarters. We've seen good growth there. And then the trajectory of the platforms. So we're not done improving this platform as well. And I think the other thing -- the comments earlier, aside from the aftermarket is, as these project opportunities come, there's run rate business that goes with that as well. So I think you -- if you saw those things together. And honestly, Brian, there's an aspect of share count year-over-year as well that we get a benefit from. That's what, at this point, gives us confidence on our guidance.

[Brian Konigsberg:]

Yes, but just to follow-up on that, I mean, I appreciate the improved margins in the segments. But I mean, if we look at Q1, you did get a meaningful tax gain, which I don't think you were anticipating. You got the gain on the sale of the asset. So operationally, you're actually running quite a bit below, I think, where you expected the run rate to be. So I don't think your guidance initially anticipated those benefits. And it seems like top line actually would be a meaningful driver to get you operationally where you thought you would be. Is that not a fair view?

[Mark A. Blinn:]

No, if you even normalize the operating income, I mean, it improved on lower revenues. So take all the items aside, let's not even talk about the tax, and you can see the improvement driven by the improvement in gross margin and the other one, the operating and the leverage on the SG&A as well. Now to your point, especially around fixed costs, leveraging the SG&A line, do we get benefit from top line growth? Yes, because we leverage it. We can leverage it in our factories, our gross margins. So there's certainly improved benefit. But if you look, being able to improve our margins on a normalized basis, compared year-over-year on declining revenue, that shows you the power that you may not be fully observing in the improvement of the platform and just even the growth of the aftermarket bookings over the last 2 quarters.

[Operator:]

The next question is from Joe Giordano with Cowen.

[Joseph Giordano:]

Just one last one maybe on aftermarket. So we're -- last quarter was all-time high aftermarket. This quarter, all-time high for a 1Q. How do you look at the timing of conversion there? And how would you balance on a margin level maybe the -- what we expect to be a short cycle conversion from that OE? How would you balance that with expected -- sort of expected OE growth in the back half of the year at a more of like a dilutive impact to that? How would you categorize the whole -- the trend for the year on the overall operating margin?

[Mark A. Blinn:]

Well, I mean, what -- more on the gross margin than the operating margin, because if you get project-related revenues, you tend to get better fixed cost leverage in the SG&A line for that. We talked about this before. If you looked at, historically, the -- when we reported the seal business, had 40% plus gross margins in the business. And so you can see it certainly has a margin enhancement. So a mix shift in original equipment to aftermarket, all other things being equal, assuming there's no improved operations or anything like that, is 25 to 30 basis points margin. But that's it on the gross line. We want really to drive all of it. What we want to do is make sure we have profitable projects that come through in the business. Again, we can increase the bookings that you see. But if we take things at 0 profit or potentially, at a loss in the operating line, we don't think that benefits anybody at this point in time, because we're not concerned short term about absorption issues. So as you look at that, we want to continue to grow that aftermarket business. It does tend to cycle through over -- max a couple of quarters. The run rate business will tend to cycle through a little bit longer. And then projects, we do get percentage and completion accounting, but those things will tend to execute over a year, 1 year plus.

[Joseph Giordano:]

Okay. And then one question on chemicals. So we saw year-on-year, there's about a 300 basis point mix shift on the bookings there, so something like 15% year-on-year growth in chemicals. I just -- maybe if you can give some color as to where that's coming in and which segment are you seeing that kind of big increase. And is this the OE from the ethylene projects that have already been handed down to the EMCs? I think -- so that's maybe that's getting hidden in the OE decline in EPD.

[Mark A. Blinn:]

Yes. I mean, the ethylene projects are a part of it. We're starting to see those projects start to come in. But if you were to look overall, chemical is up about 15% for FLS overall. And the business, it was up in EPD quite a bit, so that was EPD, and it was up in IPD also. And chemical, and FCD was just slightly down about 2%. So 2 of the business, where the powerhouse destroyed the chemical business. And beside the ethylene projects, they're getting the shale gas finds in the U.S., driving all the chemical business, primarily in the U.S. And you're also seeing some chemical business driving in the Middle East. They, again, diversify their overall business to get into the chemical business. So I would say Middle East and North America were the 2 primary drivers, along with EPD and IPD in that basis.

[Operator:]

The next question is from Scott Graham with Jefferies.

[R. Scott Graham:]

So the pickup in bookings that you saw in March and April, one of the things that we understand is that the company's optimism on the timing of a project releases TPCs [ph] is incrementally a little bit better because of what you're seeing in Europe and the Middle East. I was just wondering if -- is that the same thing? Are you -- is your optimism on the timing of the rest of world over those areas of the world, bookings, leading, running through your bookings now?

[Mark A. Blinn:]

Let me see if I understand the question. I mean, we've talked about seeing these opportunities out there, and I think a lot of the comments have been focused around North America. And I think during the Analyst Day, Scott, we -- you saw some of the awards to some of the EMCs. And we were saying, we'd anticipate seeing some of that towards the back half of this year from the North America. If you go around the world, those are a set of different conversations that either give us optimism or concern over a period of time. For example, in the Middle East, some of the upgrade requirements we talked about in Kuwait and some of the projects that we've seen out there for a while. And in Europe, a lot of that is going to be more around the economy. And we don't expect that they're going to build any new refineries. But it will certainly support some of the run rate business, the power industry as well and some of the things that we're -- they're doing with chemical as well.

[R. Scott Graham:]

Understood. I wanted to ask you a little bit more about the run rate business, Mark, because we've been using that phrase now for a couple of quarters. You gave a couple of examples early on in the call about what that is exactly. I guess, my bigger question is, what are the signs that you're seeing there that suggest that, that can continue at the pace of growth that it's currently running at?

[Mark A. Blinn:]

Well, I mean, one is just the growth we've seen fairly consistently over the last couple of years in that business. Another one is the improved execution. Those are the kind of pieces of equipment that a customer needs quickly, on time and to operate the way it needs to operate. And when IPD wasn't executing to that level, honestly, they had to turn away some business. So I think those are some of the encouraging signs that we're seeing. The other thing that we've looked at, we talked about a minute ago, was the distribution channel. In 2008, they started destocking, that will tend to put pressure, it'll flow through into that run rate business because that, oftentimes, that's where some of that configure-to-order product will tend to go through. The other thing that we added in our commentary, Scott, is oftentimes, some of the run rate -- and this can be some of the configure-to-order process equipment will go along with projects as well. So on project opportunities, IPD does participate. If you look at the balance of plant-type investment, some of those run rate products will go in there. And I think the other thing -- frankly, one example is we told you 3 or 4 years ago that we've not probably targeted an R&D opportunity in the ISO chemical pump, got that product up and running and it's doing well. So those are some of the things. But I think really, from our standpoint, what it comes to -- externally, we looked at project opportunities, we look at the distribution channel, we do look at some of the drivers and economies because some of this run rate product goes into small upgrades or repairs or replacements in Europe and in the United States and other regions. And then, internally, we look through opportunities around how we're aligning our sales organization, the products we've developed that we've invested in and how we're taking them to market, the acquisition that we made of mag drive product that we can load on to the platform. And then at the end of the day, it comes down to execution.

[R. Scott Graham:]

Understood. The last question is this. Earlier today, a company in your space, not necessarily a competitor per se, reported that the power business -- their power business had started to accelerate in the Middle East and Africa. I was wondering if you were seeing the same.

[Mark A. Blinn:]

If you take a look at the power business, a lot of that is tied to desal business in the Middle East, and also, it's tied to the combined cycle business in the Middle East. I would say it's those 2 drivers there. And after there [ph] does have some desal business going on there. And as you know, that those plants take a lot of power in order to operate. I would say you're correct there.

[Operator:]

We have no further questions at this time. I'd like to turn the call back over to Jay Roueche for any closing remarks.

[John E. Roueche:]

We again appreciate everyone's participation today. If you have follow-up questions, please call Mike Mullin or me. And with that, Ellen, we have concluded today's call. Thank you.

[Operator:]

Thank you. Ladies and gentlemen, this concludes Flowserve's first quarter 2014 earnings conference. Thank you for participating. You may now disconnect.