FLS - NYSE

Good day everyone, and welcome to the Q1 2023 Flowserve Corporation Earnings Conference Call. Today's conference is being recorded. At this time, I'd like to turn the conference over to Jay Roueche, Vice President of Investor Relations and Treasurer. Please go ahead, sir.

Thank you, Linda, and good morning, everyone. We appreciate you joining our conference call today to discuss Flowserve's first quarter 2023 financial results. On the call with me this morning are Scott Rowe, Flowserve's President and Chief Executive Officer; and Amy Schwetz, Senior Vice President and Chief Financial Officer. Following our prepared comments, we will open the call for questions. As a reminder, this event is being webcast and an audio replay will be available. Please note that our earnings materials do, and this call will, include non-GAAP measures and contain forward-looking statements. These statements are based upon forecasts, expectations and other information available to management as of May 2, 2023, and they involve risks and uncertainties, many of which are beyond the company's control. We encourage you to review our safe harbor disclosures as well as the reconciliation of our non-GAAP measures to our reported results, both of which are included in our press release and earnings presentation, and both are accessible on our website at the Investor Relations section. I would now like to turn the call over to Scott Rowe, Flowserve's President and Chief Executive Officer, for his prepared comments.

Thanks Jay. And good morning, everyone. Thank you for joining Flowserve’s first quarter earnings call. I am pleased to report strong results for the first quarter, which provide us with a very solid start to the year. First quarter adjusted EPS came in at $0.40, supported by year-over-year revenue growth of nearly 20%. Thanks to the efforts of our associates across the company, we continue to build on the positive momentum created in the 2022 fourth quarter driving further operational improvements while performing for our customers. The first quarter has historically been our most seasonally impacted period in any given year, but we have taken action to moderate this trend and drive more consistency in our results. Our first quarter performance was a great start in this effort. In the fall of last year, we challenged the team to not only deliver a strong finish to 2022, but also to ensure that we are maximizing our opportunities to begin the year strong. The team's efforts paid off as both segments delivered outstanding results exceeding their revenue margin and bookings commitments. The first quarter results have us well positioned relative to our previously announced full year guidance and provide a solid foundation to build upon throughout the year. We remain optimistic about our end markets and are encouraged by the growth in value creation opportunities ahead of us. I am increasingly confident that Flowserve is well positioned for 2023 and beyond, and I believe we are differentiated from many others in the industrial landscape. Our end markets remain healthy, and we secured solid bookings above $1 billion for the fifth consecutive quarter. In fact, our project funnel is now at its highest level since 2019, including projects across all industries driven primarily by two key catalysts. First, there is an increased focus on energy security around the globe, which is driving heightened levels of activity. For example, we are seeing significant investment in nuclear, LNG, fossil power plants and regional oil and gas developments, as countries look to become less dependent on unreliable foreign suppliers of energy. Today, our nuclear and LNG project funnels are up significantly from where they were a year ago. The second primary driver of our expected growth is decarbonization. We believe spending in this area will continue to expand through 2023 and accelerate beyond this year as our customers look to meet their ESG commitments and comply with regulatory changes. This investment is supported further by various government incentives, including the Inflation Reduction Act in the United States. Our project funnel and decarbonization doubled in 2022 and has risen nearly 25% since the beginning of the year, and now includes activities like hydrogen, carbon capture, sustainable energy like wind and solar, as well as projects to decarbonize existing infrastructure. Flowserve is truly at the intersection of energy security and energy transition. These two major global themes leverage both our traditional end markets and our 3D strategy of diversification, decarbonization and digitization. This backdrop, combined with Flowserve's, late cycle exposure and the direction of our customers capital spending, support our expectations for continued positive order momentum in 2023. Additionally, we have taken significant actions over the last year to drive further operational improvements to better execute in the current environment, we have focused on accountability, streamlined decision making, and improved processes across our manufacturing platforms and supply chain functions. We believe the combination of the supportive market environment with improved operational execution will enable us to continue to build on the momentum of stronger operating results as seen in these last two quarters. Flowserve delivered revenues of nearly $1 billion this quarter, our highest first quarter sales level since 2015. We leveraged this top line growth to deliver adjusted gross margins of over 30%, an important hurdle for Flowserve's progression towards price cost and absorption improvement. Additionally, we produced incremental adjusted operating margins of 34% in the quarter. Notwithstanding our strong revenue performance, our first quarter book-to-bill was 1.08 and drove a sequential increase in our backlog, which now sits at $2.8 billion. This solid foundation, the strongest since 2014, positions Flowserve for expected revenue growth in the remainder of 2023 and 2024. Finally, we expect margins in our backlog to further increase as we replace lower margin project work that was booked primarily in 2021 with higher margin business, we are winning today. We should also benefit from the impact of our January 1 price increase in future periods as it works its way through the system. Let me now provide some additional color on our first quarter orders. Bookings remained strong in the first quarter at $1.06 billion, while last year's bookings benefited from four projects sized between $30 million and $50 million. Our bookings this year were driven by higher margin MRO and Aftermarket awards. Today, MRO and Aftermarket bookings are close to record levels, supported by strong growth in FCD and our seals business across all geographies. Many of our customers have been running their assets at high utilization rates over the past year, which requires ongoing maintenance spending to ensure their facilities remain operational and productive. We expect to see solid activity in this space, including turnaround, general maintenance and efficiency focused upgrades throughout 2023, and at this point, we see no signs of it slowing down. This quarter's largest project bookings included three midsize awards in the $10 million to $20 million range, which were primarily in the oil and gas markets for both pump and valve equipment. We also booked several smaller projects in the $5 million range that represented virtually all of our core end markets and regions and included a record level of energy transition bookings of nearly $50 million. As a result, we delivered 11% constant currency bookings growth in our chemical and general industries markets, while our power and oil and gas markets were down 32% and 4% respectively. Due to the tough compare of last year's first quarter large project bookings which included a $55 million nuclear award. We are in the second year of what we continue to believe is a multiyear upcycle. We fully anticipate delivering bookings this year at a similar level to 2022 with the potential for additional growth. This comes despite the headwind of the large $220 million [inaudible] project that we booked last year. Later cycle project investment, increased EPC backlogs and continued MRO and aftermarket growth are expected to drive our full year book-to-bill over 1.0 again this year, resulting in increased backlog that should position Flowserve for further revenue growth in 2024. Again, we are pleased with our first quarter results and we remain confident in the outlook. Our performance over the last two quarters affirms that we are pursuing the right initiatives, including the implementation of our 3D strategy and supporting our traditional customers. Energy security is critical in the near term and we believe the 3D strategy is well aligned with the expected energy transition and decarbonization investments of tomorrow, creating visibility to long-term growth. With that overview, let me now turn the call over to Amy to address our first quarter financial results and our expectations for the remainder of 2023 in greater detail. Amy?

Thanks Scott and good morning, everyone. Looking at Flowserve's first quarter financial results in greater detail. We are pleased that both segments exceeded our prior expectations for the period, thanks to the sustained momentum we established in the fourth quarter and our team's efforts to deliver these results. Our adjusted EPS of $0.40 on revenue of nearly $1 billion demonstrates the improved stability and operational execution that drove better shipping cadence and top line leverage as we delivered on our near record backlog. At Flowserve, the last month of any quarter traditionally has a disproportionate effect on that period's results. This trend was even more announced in March of this year, which represented 45% of the quarter's revenue and over 60% of the first quarter's adjusted operating income. This monthly contribution will aid our efforts to obtain better balance in adjusted EPS between quarters in 2023. On a reported basis, our earnings per share for the quarter was $0.20, primarily impacted by realignment and FX charges totaling $0.15. Velan acquisition costs and discrete noncash asset write-downs accounted for the balance. First quarter revenue increased over 22% year-over-year on a constant currency basis, with both OE and aftermarket revenues increasing over 20% versus prior year. FPD contributed OE and Aftermarket growth of 29% and 22% growth, respectively, while FPD delivered growth of 18% and 11%, respectively. Revenue increased across the globe on a year-over-year basis, with notable strength in the Middle East and Africa region as well as in Latin America, where sales were up 58% and 37%, respectively, while all other regions were up in the mid to high teens. Shifting now to margins where we delivered solid improvement. Adjusted gross margin increased 370 basis points to 30.4%, including FPD’s 310 and FCD’s 410 basis point increases. Benefits from our enhanced volume leverage, last year's pricing increases and an improving supply chain environment were partially offset by the recognition of lingering lower margin backlog that was booked in 2021, as well as increased compensation expense based on our strong year-over-year performance. We are pleased to have delivered 30% plus gross margins earlier in the year than we did originally anticipated, and our actions and initiatives are designed to maintain and improve this level of gross margin performance. On a reported basis, first quarter gross margins increased 480 basis points to 30.3% where, in addition to the items mentioned previously, the 2022 first quarter included $10 million of Russian related exit charges and gross margin that did not recur in 2023. First quarter adjusted SG&A increased $25 million to $222 million, primarily due to increased compensation expense accruals, R&D investments and discrete legal charges. As a percent of sales, adjusted SG&A decreased to 130 basis points to 22.6% as we successfully leveraged our higher revenues. On a reported basis, first quarter SG&A increased $38 million to $244 million or 24.9% of sales. In addition to the items mentioned previously, the quarter also included realignment charges of $16.7 million, $3.1 million of costs related to the Velan acquisition and $2.9 million for the non-cash write-down of a discrete asset. Partially offsetting those items is $10.2 million of SG&A expense that was also related to our exit from Russia last year, which did not recur in 2023. Our first quarter adjusted operating margin increased 500 basis points to 8.3%, driving a solid incremental adjusted margin of 34%. Both FPD and FCD contributed to the improvement with 540 and 380 basis point increases, respectively. First quarter reported operating margin increased 490 basis points year-over-year to 5.8%, where significant operating leverage was partially offset by the $4 million increase in adjusted items versus prior year and FX headwinds of roughly $7 million, Our strong start to the year has Flowserve well positioned for further success in 2023. Our first quarter tax rate [Tech Difficulty] supply change, additionally, our previously mentioned strong March revenues contributed to accounts receivables cap fees of $26 million. From an inventory perspective, we delivered an improvement versus the prior year where inventory, including contract assets and liabilities for the first quarter was a use of $34 million, versus the prior year use of $52 million. As a percent of sales, primary working capital ticked up of modest 40 basis points to 32.8%, supporting our continued solid bookings and sequential backlog growth. While our backlog increased over 25% since this time last year, our inventory, including contract assets and liabilities as a percent of backlog, dropped 290 basis points to 29.3%. As our supply chain continues to improve and as we further enhance the inconsistency and predictability in our operating performance, we believe the opportunity exists to reduce working capital investment to a level below 30% of sales. In addition to working capital, other significant uses of our cash in the first quarter included $26 million in dividends, $15 million in capital expenditures, and a $10 million term loan debt reduction. Turning to our outlook for the remainder of the year, we expect to continue our recent operating momentum, capitalizing on supportive end markets and delivering sequential adjusted operating margin and EPS improvement through the year. Additionally, we remain committed to the $50 million cost reduction plan that we announced last year to address both variable and structural cost. We executed several actions during the first quarter and are finalizing our plans to take the necessary steps needed to ensure we achieve this target for annualized savings by the end of the year. With our near record backlog of $2.8 billion, we now expect to deliver revenue growth in the 10% to 12% range, including a modest currency benefit given the weakening of the US Dollar since the year began. We also increased our full year 2023 adjusted EPS to the $1.65 to $1.85 range, which incorporates the first quarter outperformance and would represent a year-over-year adjusted EPS increase of 59% at the midpoint. As we highlighted last quarter, we expect to ship roughly 80% of the $2.7 billion backlog we began the year with. We typically ship roughly 90% of our beginning backlog in any given year. However, due to the return of large project awards and last year's significant increase in OE bookings, coupled with ongoing issues with an extended supply chain, our quoted lead times remain elevated. A further note, our revenue and adjusted EPS ranges do not include any impact from the expected acquisition of Velan, which we now expect to close in the third quarter as we continue to work through regulatory approvals, primarily in Europe. Our targets also exclude anticipated realignment expenses of approximately $25 million, as well as potential items that may occur during the year, such as below the line foreign currency effects, and the impact of other discrete items such as acquisitions, divestitures, special initiatives, tax reform laws, et cetera. Excluding the expected realignment spending and other first quarter adjustments, we have reaffirmed our reported EPS range of a $1.40 to $1.65. Both the reported and adjusted EPS target range also assume current foreign currency rates, reasonably stable commodity prices, no significant geopolitical disruptions and expectations for the end market environment to remain supportive at levels similar to 2022. We also continue to expect net interest expense in the range of $55 to $60 million and an adjusted tax rate between 18% to 20%. Finally, in terms of phasing and given our strong start to the year, we now expect Flowserve second and third quarter adjusted earnings to be more in line with our first quarter performance. And we continue to anticipate our traditional strong fourth quarter performance with both elevated revenues and earnings. In summary, we believe our full year guidance is balanced. Our updated range reflects the positive momentum we have created over the last two quarters, but incorporates some of the uncertainties that still exist in the current environment. Most importantly, we believe that Flowserve is on the right track, and we're confident in our ability to execute within that enhanced guidance range. Let me now return the call to Scott.

Great. Thank you, Amy. I'd like to provide a brief update on the Velan transaction. Our integration planning efforts with Velan are progressing well. The more we interact with Velan's Associates and sites, our confidence only increases that this is the right acquisition for Flowserve to create substantial shareholder value. We are eager to begin the integration of the Velan associates, products and sites into Flowserve. We are meeting many committed and talented associates around the world with a passion for providing solutions into challenging applications like nuclear, defense and severe service. We continue to believe significant opportunities exist with the combined portfolio, and we remain fully committed to delivering at least $20 million of annualized cost synergies to be achieved by the end of year one. Additionally, we expect the transaction to be accretive to our adjusted EPS in the first full year following close. While we are making significant progress with the regulatory approvals, there are certain agencies in Europe that are taking longer than our original expectations, and we now believe that we'll close the transaction in the third quarter versus our prior expectation of closing late in the second quarter. Turning to our 3D strategy, as we enter the second year focusing on diversification, decarbonization and digitization, we are encouraged by the higher growth rates we have experienced in the 3D targeted markets, and we fully expect that trend to continue. We remain committed to diversifying our portfolio with new technology and products while substantially capitalizing on the decarbonization initiatives around the world. These include significant opportunities in hydrogen, CCUS, recyclables and partnering with our existing customers with our energy advantage offering to increase the efficiency of their operations, reduce their energy usage and lower their carbon footprint. The first quarter again produced solid 3D bookings. Let me now highlight some of our indicative 3D wins starting with the diversified pillar. We are rapidly expanding our dry gas seals offering for all gas applications, including hydrogen, where our differentiated sealing technology works extremely well in this stringent application. In a recent example, Flowserve's dry gas seals were chosen for an Eastern European facility expansion and modernization project. In an effort to support hydrogen compression, our seals enable the customer to meet strict environmental standards while improving their overall operability and uptime. Shifting to decarbonize, Flowserve supplying pumps, valves and seals for the world's first large scale direct air carbon capture project based in Texas. Following the project's expected completion in 2025, the facility will be the largest of its kind and capture up to 500,000 metric tons of CO2 annually. Once the pilot plant is operational and proves that this concept can have a significant impact on the environment, we expect this technology to be leveraged globally. Finally, on digitize, we continue to make progress deploying RedRaven, our IoT offering, where we are instrumenting and monitoring our installed base with customers around the world to provide predictive analytics and improve data for their assets. Entering its third year of commercialization, we are now receiving contract renewals for monitoring and prediction services, which demonstrates that we are creating value for our customers by enhancing their ability to avoid downtime and drive overall productivity of their assets. We were pleased to receive renewal contracts from four power plants in the US. And even more encouraging is that each customer is increasing the number of assets monitored by our technology. In closing the strong first quarter results were an important step forward in our progress to delivering the type of performance that we expect in 2023 and beyond. Going forward, we plan to convert on our healthy backlog and drive sustainable returns and value for our shareholders. Our end markets remain supportive and we fully expect that our 3D strategy will provide opportunities to continue to grow the business for years to come. Our internal efforts are paying off and I believe that this team will deliver strong performance in 2023 and beyond. We are excited about the pending Velan acquisition and look forward to completing the transaction and recognizing its benefits. In summary, I believe Flowserve is rapidly heading in the right direction to drive enhanced shareholder value. Operator, this concludes our prepared remarks and we'd now like to open the call to questions.

[Operator Instructions] We'll take your first question from Josh Pokrzywinski from Morgan Stanley.

Hi, team. Congrats on the great quarter. This is Toby on for Josh. So how should we think about seasonality and throughput for the rest of the yea, given the strong 1Q? Would there be any drag from past due backlog along the way?

So as we look at our first quarter performance, we were pleased to be able to execute a little bit better on our backlog than we'd anticipated starting the year, which really resulted in revenue exceeding what our expectations initially were for the first quarter of the year. That being said, it doesn't create a drag on revenue for the rest of the year, just given the strength of our backlog where it's at today. So in fact, the goal is to continue to plan and convert and improve productivity as we make our way through the years. And from an EPS expectation, however, we would anticipate the second and the third quarter, given where we landed in the first quarter of the year, to look more like how we started the year, but with our expectations for the fourth quarter of the year continues to be quite strong and delivers an EPS above what we've seen in the first three quarters of the year.

Yes, and just to add, the operating environment is improving, so supply chain is more stable, the logistics environment is better. And so as those challenges subside our operational performance and planning and productivity get better, it's allowing us to deliver more on the revenue side. So to Amy’s point what we expect is Q2 and Q3 to look a lot like Q1. We did a lot of great work in Q1 to unlock our capability and our capacity, and we expect to not go backwards as we progress through the year here.

Thank you. That's really helpful. And then from a margin perspective, with some of the headwinds and friction subsiding, are we closer to thinking about margin targets for the cycle? Should it be in like the prior mid-teens range on the table?

Sure. Yes, we had that out. We put that out several years ago. And we definitely owe the investment community new targets. So I would just say let us get through Q2 and we'll talk about what we want to do for long term targets, but we definitely know that we need to do that and we anticipate putting out new targets sometime this year.

We'll hear next from Andy Kaplowitz from Citi.

Good morning, everyone. Scott, bookings, as you said, were over $1 billion again, and you suggested you weren't seeing any signs of economic weakness impacting bookings. But last quarter I think you had mentioned that you could still see growth in bookings of the $4.4 billion you posted in ‘22. And I know today you said bookings maybe more flattish versus last year. Is there anything in terms of incremental conversations you're having with customers that are giving you pause and/ or do you still see solid bookings continuing in April?

Sure. The only pause or concern is that we had a giant award in the third quarter of last year, the [inaudible] award, at $220 million. And so the question just is, can we overcome that big number? And I would say right now our plans are to be at the same kind of rate that we were at last year, if not higher. And so if we kind of break that down we're seeing record MRO and aftermarket bookings and so that's a really good sign. We're at $550 million in the quarter and we expect that to continue as we go forward and so that provides the basis for what we need and then it just really is about projects. And so on the project side, we've got great visibility to our project funnel. In fact, it's at record level in terms of looking out 12 months into the future. There are a handful of larger projects there. But what I would say is we are now incredibly selective about what we're going to take, right. And so with a $2.8 billion backlog it allows us to be more selective in providing the right work into the right facility and getting the margins that we believe we deserve as we're executing these complex jobs. So I feel pretty good about our outlook and whether we'll be right at the number of last year or above will just depend on the project activity and what we determine to go forward. And so I think there's a real good chance to exceed it. I think we're really positioned well and then back to the drivers, the energy security side and the decarbonization are the two lanes that we see the most growth this year.

And Scott, I wanted to follow up in terms of last quarter, I think you said that recession could impact general industries and chemicals. And I think even you said European chemicals are down 5% in January. But you just told us that general industrials and chemicals were up, I think 11% year-over-year in bookings in Q1. So what are you seeing specifically in those end markets, particularly chemicals as you probably are aware, some peers out there have been talking about a little bit of a weaker chemicals market. So what are you seeing?

Yes, so that's a little bit of the concern would be the GDP based markets like chemicals in some of our general industries. But our quarter print was strong on a year-over-year comparison. We've seen growth in chemicals now. Gosh. I think it's been almost six quarters where we've seen chemical booking growth. And so that's the area that we're watching out for. I would say Europe chemicals would be the biggest concern from a GDP kind of driven recession perspective. General industries would be second. But today in our Q1 numbers, we haven't seen any slowdown yet, and so we're cautious about it. We're preparing and planning for a potential slowdown there, but net-net, we think the decarbonization and energy security bookings will offset any slowdown that we could potentially see. But again, we haven't seen that slowdown at this point.

We'll move next to Mike Halloran from Baird.

Hey, good morning, everyone. Maybe following up on the flip side of Andy's questions there, maybe talk about your confidence level in the energy cycle disaggregating from maybe the over economic cycle if there is some softness. Obviously, Scott, you spent a lot of time in the prepared remarks talking about the strategy behind the transition that's going on in the energy space, but would like to also hear some perspective on the ability for that to decouple in your mind in the more traditional side of the energy space.

Sure. I'd just start by saying we've seen this decoupling in prior cycles. Sometimes it's aligned and other times it is decoupled. And so I think we're decoupled from what we'll call a general GDP/ industrial slowdown. And again, the two biggest drivers are energy security and decarbonization. The third one would be just the lack of significant investment in 2020 and 2021. And so given the long cycle nature of our business, we're now just now seeing a lot of those big projects that were either on hold or delayed, starting to move through the system. And when you look at the oil and gas side, you've got natural gas pricing in the US off a little bit, but we continue to see strong LNG and we see significant international activity on the oil and gas upstream side. And so I just, I don’t see, I think, again, we might have some slowdown on our GDP type business. Again, it'll probably show up in chemicals and general industry, a lot of that's potentially oriented to Europe. We're not seeing that yet. But I believe that this energy cycle with the security aspect of it, the ESG and decarbonization component, combined with the late cycle nature of our business, I believe that we're going to see continued growth, certainly 2023 and 2024. And, yes, when you look at our business and if you run through the cycles, right, typically our cycles are anywhere on the upside from kind of three to up towards seven years. We feel like we're in year two of this, and I just don't see it slowing down for several years.

Well, thanks for that. That was helpful. And then the backlog margins maybe just are we at the point where the margin profile that you see in the backlog is being reflected in the margin profile that's being reported on a quarter-to-quarter basis? If not, when do you think that starts normalizing out and being more reflective?

Sure, I'll take a stab at that one, Mike. We are definitely seeing margins in backlog improve and that actually started at some point kind of midway through last year, but that profile is only getting better. So we've referenced these large projects that we booked at kind of the low point in the cycle that are making their way through the system throughout 2023. And simply the roll off of those projects and the replacement with pricing that's more indicative of the environment that we're in today is very helpful. And the other thing that I would comment on is that the strength of our aftermarket in MRO business in the current year and actually going back into last year is very constructive in terms of improving those margins as well. And the last comment that I would make is just in general, our extended lead times had resulted in some of the pricing actions that we've been pretty proactive about throughout 2022 and even early into 2023 finally starting to take hold. And so that's been really helpful in terms of bringing our margins through. We've talked about this 30% as kind of that hurdle rate that we wanted to get to. We did get there a little bit quicker in 2023 that we'd anticipated, but we view this as a jumping off point, not necessarily the end goal.

We'll hear next from Joe Giordano from Cowen.

Hey, guys. Good morning. I was hoping, Scott, you mentioned that you expect orders this year kind of flat with next year, which is a good number. If we were to just kind of extrapolate that forward, right. Let's just say in a scenario where revenues next year are flat versus where you're guiding today just because orders are the same, let's just assume that. Like what kind of margin uplift would you expect without any benefit of volume? Just given like where you plan on exiting your guidance this year into next year?

I'm not ready to provide guidance for 2024. I do appreciate the question, though, and I will say it will be up from where we are today. Look, I just say we've got two really good quarters in a row. We delivered a Q1 in a historically challenged environment. And the teams are just laser focused now on Q2 and Q3 and building that. If we look from a higher level, though, and we'll build on what Amy is saying, right, the book-to-bill is really strong, right. We're now 1.1 again, if the MRO stays where we think it is, the project cycle funnel is where it's at. We have a lot of confidence of revenue growth in 2024. And then when you think about margin drivers, right, Amy hit on price cost. We've done like, five price increases now in 18 months, we've got the latest one effective January 1. We're more selective on project bookings than ever before in terms of margin threshold. And so you get a lot of accretion with the new backlog every single quarter that works its way through. And that MRO price difference from our OE is pretty significant. So the higher that MRO is, the better it comes through. And so I think we're shaping up for obviously we've committed to very strong improvement both on the revenue and margins for 2023. And at this point, I don't know if it continues, if the trajectory of improvement continues at the same pace, but 2024 is shaping up to be better than 2023, for sure.

Fair enough. And I had to ask. I appreciate all the commentary about the backlog, the margins, and being disciplined. I just think the industry has proven that discipline exists until conditions suggest that you need to be aggressive. So like how, what controls are in place to like ensure what you're saying happens in practice? Like how high up the chain are these decisions going so that if things do get kind of tight and project activity wanes, we're not, like, chasing things that we shouldn't be chasing?

Sure. We've always had good discipline on pricing approvals and so we've got it. Like most companies, we've got a nice kind of grants of authority on who can approve what. We've got some margin thresholds on the low side that say we can't do that. But there's also work strategically that we want to take, whether it's the right application or amazingly strong aftermarket that we're focused on. But I'm not too worried about our ability to govern and take the right work. Amy and I see big projects and we get very involved on what those numbers should look like on anything that's in what we'll consider large projects. But our division presidents and the head of our VP GMs have great visibility and are the approval process there. And so I don't see us getting undisciplined in this area. And then again, our discussions with our senior management team, we have the backlog. We're at a really good place in terms of absorption and capacity and so we're now at a place that we can be far more selective than ever before. And so those are the types of discussions that we're having with our salesforce and our VP GMs about what do we want to take, how does it fit within the facility, and making sure that we can commit to the right slot in the manufacturing profile and then really making sure that we can get the value out of those orders that we deserve, especially in the complex engineered products.

Andrew Obin from Bank of America.

Hey, you have Sabrina Abrams on for Andrew Obin. So I know you guys talked about reaching gross margins over 30% earlier than you were talking about and it sounds like you still have the incremental drag. More competitive projects that you booked in 2021. I think that headwind gets smaller as you move through the year. So how are you thinking about gross margins considering they were above 30% in 1Q?

Sure. So I think there were some drags that we knew were occurring with respect to gross margins in 2022 and we've talked a lot about frictional costs, labor absorption and supply chain challenges. I think those are all starting to dissipate and we fully anticipated that those were going to continue to get better sequentially as we made our way through. We've also talked about pricing, which is really starting to be a nice driver in that margin maintenance element of performance. I think where we want to continue to focus and ensure that we're really leveraging the top line which has the ability to grow throughout the year, is really in the areas that planning matters. So making sure that we're converting revenue on the schedule that we want to, making sure that we're getting the right product at our plan. So if you look at our guidance, we're not anticipating any big outperformance from a margin perspective as we make our way through the year. However, if we can maintain margins at this level, we should start to see better operating margins drop through via SG&A leverage and our continued work with respect to our tax rate.

Great, thank you. And can you talk a little bit about 1Q coming in ahead of expectations? And what specifically in March drove better operations in the quarter? Is it just supply chain sort of getting better?

Sure. The general environment was definitely better, right. So we got the supply chain issues are now subsiding, the logistics issues are gone, we've got the labor in our facilities where we need it, and so that general environment allowed us to execute at a higher level. The other thing I would say is just general planning. And so we started talking about Q1 back at the end of the third quarter and really focused on finishing ‘22 strong, but also starting the year off in the right direction and doing the things necessary to make sure that we had a good Q1. I just say the combination of a much better environment, enhanced and improved planning, and just a general commitment to say we're going to have a good Q1 and get the year started right across all of the operating units. And so we're excited about what we were able to do. We've got a lot of discussions with our team to make sure that we can continue to take out some of the cyclicality between our quarters and make sure that we can drive more consistent results, but we're definitely on a really good path to do that.

Sabrina, let me just add on to that a bit. In the fourth quarter, we talked about really wanting to minimize that drop off between the fourth quarter and the first quarter in terms of margin performance and really minimize that impact. And that's what we did. And actually, then what I think we saw in terms of the overdrive in margins in the quarter was the ability to convert our backlog and to bring revenue in the quarter. But frankly, to do it in a way where we still have a strong backlog in place to work through that same planning and productivity cycle as we make our way through 2023 and into 2024.

[Operator Instructions] We'll move next to Deane Dray from RBC Capital Markets.

Thank you. Good morning, everyone. How does deal size impact this quarter on the implied margins going into backlog? When you start seeing, I think you had some outsized deals before. It looked like the mix, you had more like mid-size wins coming through. Do these tend to be better margin projects? And so just give us some color around deal size.

Sure. I'll talk generally, and then I can go into a little bit of the specifics, but generally speaking, the larger the award, the more attraction to the competitive landscape there is. And so typically, the largest awards have lower margins. And then as we kind of move down into that $5 million to $10 million range, we get some really good margins on that. And then obviously, indeed, you know this, right, but the MRO and the aftermarket have the highest margins in our mix of equipment, and certainly the seals business would be at the highest end of that. And so what we saw in Q1 was relatively few larger projects. In fact, only three in that kind of $10 million to $20 million range. And then we had a really healthy mix of this kind of $5 million to $10 million type work, which, quite frankly, we really like. Those come at higher margins. They're also a little bit easier on the execution side and a lot less time within our facilities, and we're able to turn them quicker on the lead time. And so the Q1 bookings were really good from a margin mix perspective for us. Again, the high aftermarket and MRO projects that we like. So some of the exceptions on the margin side, there are bigger projects that work really well for us. So the nuclear business, like last year in Q1, we booked a $55 million nuclear award. Those come at really nice margins for us. There's some specific technology we have in the refining space that also contributes to large margins, and those are typically big projects. And then I'd say even some of the bigger ones, we've gotten more sophisticated about minimizing the cost inflation aspect of it and preserving what we call higher margins relative to what we've traditionally taken. And then just the other aspect of some of these projects is we always look at the aftermarket entitlement and if we believe that we are locked in for the long term aftermarket support, providing the seals into that application, pull through on valve products and other stuff, then we're willing to go a little bit less on the front end, knowing that we're going to get a large aftermarket entitlement. But overall, we feel very good about the margin, certainly booked in Q1. And then as we think forward and what we're bidding on and what we're looking at now, those margins are better than what we've seen even a year ago today.

All right, that's exactly what I was looking for. And appreciate all that additional color. And just a follow up question for Amy. Ever knows we haven't had normal markets in quite a while, but for working capital to sales target, you talked about getting below 30%. What's the stretch target where if you really were able to optimize and assuming continued supply chain healing and so forth, but where does that number go?

Yes, if we could get this business to the mid-20s, Deane, it would be an incredible unlock for us from a cash perspective. And we think it's doable. And we do need conditions to normalize a bit. As we talked about mix, the one comment that I would make is the mix that Scott talked about being accretive to margins. It should also be helpful to working capital in the grand scheme of things. That tends to come with terms that we like. It tends to be manufacturing that is more standard and really allows us to maximize working capital in a way that may be more difficult with more complex projects. So there's a lot to like about the mix that we're seeing right now for a couple of different reasons.

Yes, and that was also great to see positive free cash flow this quarter as well.

Yes, absolutely.

We'll move to Saree Boroditsky from Jefferies.

Thanks for fitting me in. So there's a lot of good, great commentary on the end market and bookings. I believe the current guidance implies book to ship work is roughly flat. So just given all this positive commentary, could you talk about what is driving that assumption?

Sure. So, as you know, we've obviously guided to kind of a 10% to 12% increase in sales. And with respect to our sales guidance and really our full suite of guidance for the year, we're not counting on everything going perfectly as we make our way through the rest of 2023. So you could consider it a hedge on book to ship, you could consider it a hedge on project execution, but clearly that book to ship business that is implied in the forecast is not quite as strong as what our booking guidance is. But I think that allows us to have a number of ways to deliver on our guidance range for the full year, which we want to be both achievable from a credibility standpoint, but also create significant improvement over what we've seen in prior years from both an earnings per share and a margin perspective. I mean and that's the way we've gone about it with the sales guidance.

Understood. And then just a modeling questions, obviously, margins came in stronger in the quarter year despite corporate being elevated. So what was the driver of the higher corporate spending? And is that the right run rate for the remainder of the year? Thank you.

Sure. So I think our run rate for corporate spending, I would put it closer to where we were at in 2022 in terms of those numbers. We did have a couple of discrete items that were included in that corporate spending, the largest of which was that discrete legal settlement that approval that I had mentioned in my remarks, and that was around $5 million.

We'll hear next from Nathan Jones from Stifel.

Good morning, everyone. I'd like to follow up on some of the commentary around your ability to be a lot more selective with some of these projects. We've had plenty of commentary over the last few quarters about unabsorbed overhead. Can you talk about maybe where we are with that capacity utilization? Revenues are a lot lower than it was still at the prior peak. It's been a lot of restructuring and stuff, so maybe capacity utilization comes into that. But just any further commentary you can give us on where we are with unabsorbed overhead and your ability to really be selective on projects here.

Sure, just the first comment before I jump into capacity around the world would just be we got to remember when we compare to prior years, just the FX on the revenue side. And so overall, I would say we're in a reasonably good position on absorption. It continues to improve. And then I'd say what we're seeing in the margins is just a much more stable environment of things getting through the shop. And so we are now, our cycle times and our ability to, the velocity of equipment going through the manufacturing side is substantially better, which improves everything on the variances and the absorption side. But like always we've got a pretty large footprint and there's always a handful of facilities that aren't where we want. And so when I talk about being selective, those are the things that we're looking at. We've improved our sales and operational planning process dramatically in the last two to three years and what we're seeing the results from that are being selective on manufacturing sites that need work are getting their work directed to them, but then it's also allowing us to be more selective on the margin side. And so I'd say overall we're in a reasonably good position in terms of capacity globally. However, there's one or two sites that still need some work and we are working to, we're directing the new orders to that. And then the other thing I'd just say is if you look across the competitive landscape, we're seeing a lot of our certainly on the pump side, and well even on the valve side as well, we're seeing a lot of the peers now starting to fill up and becoming more disciplined collectively. And so I feel like we're in a far healthier position than a year ago and certainly than two years ago. And I would say we've got a really good run here for the next couple of quarters in terms of being able to be selective on bookings, getting them into the right locations and getting the margins we deserve.

Historically the competitors and yourself starting to fill up capacity has coincided with improved pricing. Do you expect to see continued improved pricing? I guess on bid margins in projects continue to improve for the industry as well as for Flowserve over the next year or so?

Yes, I think it has to happen, Nathan, right. What we've seen, even this quarter, we had some of our peers book some really big projects and they're doing the same thing we are, right. And so I fully expect pricing, certainly on these larger projects to move up substantially from where we were two years ago. But even if we compare to last year, I think these projects get priced at a higher level. Again, with our backlog and our capacity situation, we're not going to take work that we did at the margins we did two years ago. No way.