Fls Week 2 Additional Research

Flowserve Corporation (FLS)

Industrials Group

Andrew Yoon

Clarification: What is Bookings? Booking: Receipt of a customer order that obligates FLS to manufacture or

perform services.

Backlog: Accumulated value of all bookings.

Using Q1 2009 as example (sales of $1.02 billion):

Bookings in Q1 2009 = $968 millionvalue of all orders received in 2009.

Backlog for Q1 2009 = $2.67 billionvalue of all uncompleted orders received over all time.

Therefore, like we discussed last time, bookings can decrease while revenues increases for a given quarter. Simply means that value of orders received in that quarter has decreased relative to the previous year.

Bookings

Recap from last time: Strong Performance

Current Ratio = 1.45 Quick Ratio = 0.93Increasing gross margin, net margin, ROA, and ROE over time2008 P/E = 9.34, 2008 EPS = 7.82

Cash Flow Statement Examination

2005 2006 2007 2008

Revenue Growth

6.85% 13.57% 22.92% 18.89%

Net Income Growth

-36.9% (extra. items)

574.87% 122.35% 72.97%

Gross Margin 32.30% 32.91% 33.16% 35.33%

Net Margin 0.63% 3.78% 6.80% 9.89%

ROA 0.65% 4.01% 7.27% 11.00%

ROE 2.00% 11.27% 19.78% 32.35%

Examination of Cash Flow Statements

*Hurt primarily by large increases in A/R, about 100 more than in 2007.

Conclusion: quite clear that strong ratio increases and operating cash flows are from improvements in net income.

Cash Flow Statement Examination

2005 2006 2007 2008

Net Income 17.07 115.03 255.77 442.41

Dep.+Amort. 69.89 71.0 77.72 81.44

Deferred Taxes -27.57 4.52 -17.68 -52.59

Non-Cash Items 73.28 3.22 -2.64 4.98

Changes in Working Capital

-5.23 -30.58 104.2 -70.22*

Cash from Operating Activities

127.45 163.19 417.37 406.03

FLS Realignment Initiative

Goals of realignment: Reduce and optimize non-strategic manufacturing facilities Reducing headcount SG&A expense reductions Accelerate continuing improvement programs

Expect to incur up to $40 million in realignment fees in 2009 ($0.50/share).

Claim to have achieved $7 million in benefits already, and expect increased benefits in 2nd half of 2009.

Believe that realignment will deliver full annual run rate savings of $56 million (assumes that things will continue as they are).

Charges of $10 million ($0.13/share) in Q1 Charges of $19 million ($0.25/share) in Q2

Indicates that most of realignment is complete (max of $0.50/share).

Restructuring

Fiasco with SEC/DOJ

Source: FLS 2007 10-K Two foreign subsidiaries delivered products to Iraq between 1996 and

2003 under UN Oil-For-Food Program. FLS hired outside counsel in Feb. 2006 to investigate – found that

“certain non-U.S. personnel” authorized payments that were not authorized under UN Oil-For-Food Program, and not properly documented in foreign subsidiary accounting records.

Without denying or admitting SEC charges, FLS settled with both SEC and DOJ monetarily.

Details are somewhat sketchy, still not completely sure what happened…

Good news is, major management seems to have changed:

UN Oil-for-Food Program

Management Profiles

Lewis M Kling (President and CEO) – Age 63 Joined FLS as COO in 2004, President and CEO since 2005. Prior, was employed by SPX Corporation for 7 years. Career began at Apollo Support department at GE Company, where he served

for 24 years in management positions.

Kyle B Ahlfinger (Vice President, CMO) – Age 45 Served as Vice President and CMO since 2007. Prior, was Vice President of Marketing for Flow Control Division from 2005

to 2007.

Mark A Blinn (Senior Vice President, CFO) – Age 46 Served in his current capacity since 2006. Joined FLS in 2004, after serving as CFO of FedEx Kinko’s.

Management

Management Profiles

Mark Daily (Senior Vice President, Human Resources and CCO) – Age 49 Served in current capacity since 2006. Oversees ethical and legal compliance of company’s policies and regulatory

requirements.

Paul Fehlman (Vice President and Treasurer) – Age 44 Has been VP and Treasurer since 2005. Joined FLS in 2000 and in the past has served as Assistant Treasurer and

Director of financial services.

Management

Could not find…

Percentage of revenue derived from servicesIf I had to make a guess based on competitor Dresser-Rand Inc, it would be approximately 50%, especially because service seems to be a bigger part of the business for FLS than for DRC.

DRC is addressed in the competitors section later.

Remaining Questions

Q2 2009 Results

Strong Q2 2009 results (compared to Q2 2008): EPS of $1.92, down $0.20 relative to record results from previous year, but this includes $0.25 in

restructuring charges (would be $2.17 without). Sales decreased 6% (4% excluding negative currency effects) to $1.09 billion. Operating income declined $14 million to $159 million, but this includes realignment charges of

$20 million (would have increased $6 million, or 4%). Operating margin of 14.6%, or 16.4% excluding realignment charges (was 14.9% in previous

year). Gross margin decreased 70 basis points to 35.4%, including realignment charges of 110 basis

points. SG&A improvement, down 40 basis points to 21.2% (this is even including realignment charges

of 70 basis points) – due to cost containment initiatives from restructuring. Bookings of $1.04 billion, down 21% (or down 12% excluding negative currency effects). Strong backlog - $2.71 billion. Backlog was $2.83 billion in Dec. 2008. Company is confident: Raised projected EPS for 2009 to between $7.15 and $7.75 (up from

$6.75 and $7.50) – this includes $0.50/share of restructuring charges.

Q2 2009 Results

Pump Division Q2 2009 Results

Most of the strong results comes from pump division: Bookings of $650 million, down 12%, or up 1% excluding negative currency effects and large

order for thrusters last year. Sales of $660 million, up 4%. Strong SG&A improvement: down 140 basis points to 15%. Operating income of $114 million, up $10 million. Operating margin improvement of 80 basis points to 17.2%, or 18.8% excluding realignment

charges.

Comforting for the following reason:Management says that in the past, pump orders tend to lead both valve and seal orders because pumps take much longer to produce – may be indication that orders for valves and seals will be stronger in the future.Sulzer, a major competitor which solely makes pumps, reported dramatic decrease in bookings for the quarter – that FLS’s were up excluding unusual factors is comforting.

Q2 2009 Results

Control Division and Solutions Division Q2 2009 Results (less strong)

Control Division (makes valves) Bookings of $274 million, down 36%, or down 30% excluding negative currency effects. Sales of $303 million, down 18%, or down 11% excluding negative currency effects. Gross margin improvement of 10 basis points to 36.0%. SG&A up as percentage of sales 150 basis points to 20.8%. Operating income of $47 million, down $16 million. Operating margin decrease of 150 basis points to 15.5%, or 17.8% excluding realignment charges. Decreases and worse performance attributed to weakness in chemical and general industries

markets.

Solutions Division (makes seals) Bookings of $132 million, down 22%, or down 16% excluding negative currency effects. Sales of $145 million, down 17%, or down 10% excluding negative currency effects. Gross margin improvement of 70 basis points to 46.4%. SG&A up as a percentage of sales 280 basis points to 27.8%. Operating income of $29 million, down $9 million. Operating margin decrease of 210 basis points to 19.7%, or 21.6% excluding realignment charges.

Q2 2009 Results

Markets were extremely happy about the news…

Q2 2009 Results

Day after earnings announcement, stock price up 12% from

$72.28 to $80.79 (P/E up from 9 to 10).

Analyst Projections for FY 2009

Ladenburg-Thalmann: Investment Rating: Buy Price Target: $100 (was trading at $64.00 as of report writing) EPS Target for 2009: $7.20 (Q2: $1.95) Believe that FLS’s QRC and geographic diversification of end-market are good competitive

advantages that should drive the price upwards.

BB&T Capital Markets: Investment Rating: Buy 12-Month Price Target: $80 (was trading at $72.73 as of report writing) EPS Target for 2009: $7.21 (Q2: $1.90) Believe that FLS is an attractive long-term story, well-positioned to withstand downturn due to

large backlogs, solid balance sheet, and aftermarket presence.

Credit-Suisse: Investment Rating: Outperform (most attractive rating) 12-Month Price Target: $85.00 (was trading at $64.61 as of report writing) EPS Target for 2009: $7.18 (Q2: $1.82)

Analyst Projections about 2009 for FLS

Top Competitors or Companies with Similar Businesses

Crane Co. (CR): Specifically, Fluid Handling Group manufactures valves, pumps, and systems.

Dresser-Rand Group Inc. (DRC): Global supplier of custom-engineered rotating equipment, operates in new units and aftermarket parts and services.

KSB AG (KSBBF): Germany-based producer of pumps, valves, and related systems. Broken into Industry and Building Services, Water and Waste Water, and Energy and Mining.

Tyco International Ltd (TYC): Specifically the Flow Control Division designs, manufactures, and sells valves, pipes, fittings, etc.

Competitors

Crane Co. (CR)

Market Cap: 1.24B EPS = 1.33 P/E = 14.15 Operates in multiple divisions: Aerospace and Electronics,

Engineered Materials, Merchandising Systems, Fluid Handling, and Controls.

Fluid Handling group split into three sections: Crane Valve Group, Crane Pumps and Systems, and Crane Supply. Order backlog of $302.7 million (much smaller than FLS); this is the largest segment of CR by sales (1.16B in 2008 relative to 2.6B in sales for whole company).

Manufactures valves, pipes, etc. serving many industries all around the world.

Competitors

Crane Co. (CR)

Competitors

2005 2006 2007 2008

Revenue Growth

9.04% 9.49% 16.05% -0.57%

Net Income Growth

-229.05% 21.94% -137.58% -316.81%

Gross Margin

31.17% 32.40% 32.19% 32.76%

Net Margin 6.60% 7.35% -2.38% 5.19%

ROA 6.36% 6.81% -2.17% 4.87%

ROE 18.06% 18.06% -7.05% 18.31%

Dresser-Rand Group Inc. (DRC) – Founded 2004

Market Cap = 2.4B EPS = 2.67 P/E = 10.94. Global supplier of custom-made rotating equipment solutions. Industries served: oil and gas (91% of revenues) – production,

recovery, processing, storage, refining, etc. Two business segments: new units (54.8% of revenue), and

after-market parts and services (45.2% of revenue). Operates globally: manufacturing facilities all over the world,

with clients in over 140 countries. 33 service centers in 17 countries (much smaller and less

established than FLS).

Competitors

Dresser-Rand Group Inc. (DRC)

Competitors

2005 2006 2007 2008

Revenue Growth

504.37% 24.28% 10.89% 31.81%

Net Income Growth

413.14% 112.29% 35.47% 85.29%

Gross Margin

23.77% 26.89% 26.96% 28.19%

Net Margin 3.07% 5.25% 6.41% 9.00%

ROA 2.24% 4.45% 5.47% 9.63%

ROE 7.21% 12.46% 13.25% 26.01%

KSB AG (KSBBF)

Market Cap = 569.18M EPS = 100.28 P/E = 3.24 Germany-based producer of pumps, valves, and related systems. Products are used in building services (Industry and Building

Services division), water utilities (Water and Waste Water division), energy sector, and mining (Energy and Mining division).

Has production plants in 19 countries, products sold in more than 100 countries worldwide.

Competitors

KSB AG (KSBBF)

Competitors

2005 2006 2007 2008

Revenue Growth

10.20% 14.30% 10.21% 12.92%

Net Income Growth

36.06% 344.56% 55.23% 60.29%

Gross Margin

59.53% 57.52% 58.63% 57.86%

Net Margin 0.78% 3.04% 4.29% 6.09%

ROA 1.06% 4.38% 6.11% 8.66%

ROE 3.42% 13.74% 17.62% 23.49%

Tyco International Ltd. (TYC)

Market Cap = 14.33B EPS = -3.34 P/E = -8.04 Operates in multiple divisions: ADT Worldwide, Flow Control,

Fire Protection Services, Electrical and Metal Products, and Safety Products.

Flow Control manufactures and services valves, pipes, fittings, etc. 2008 net revenue of $4.4B, or 22% of company’s revenue.

While company itself hasn’t been doing too well recently, Flow Control division has been increasing sales, operating income, and operating margin over time – service revenue makes up only 5% of revenue for the division.

Competitors

Tyco International Ltd. (TYC)

Competitors

2005 2006 2007 2008

Revenue Growth

-56.07% 2.41% 8.27% 9.32%

Net Income Growth

9.64% 16.03% -148.52% -189.15%

Gross Margin

35.58% 34.24% 33.88% 35.03%

Net Margin 18.57% 21.04% -9.43% 7.69%

ROA 4.95% 5.70% -5.31% 5.39%

ROE 9.49% 10.14% -11.15% 10.02%