Flowserve Corporation

(NYSE: FLS)

INDUSTRIALS GROUP

Andrew Yoon2009 GPS Fall ConferenceOctober 2, 2009

Table of Contents

i) Business Description

ii) Porter’s 5 Forces

iii) SWOT

iv) Competitors

v) Key Drivers & Catalysts

vi) Valuation

vii) Investment Recommendation

Table of Contents

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Business Description

Business Description

Flowserve Corporation is a manufacturer and aftermarket service provider of flow control systems.

Flowserve operates in three different segments, each responsible for a different product line:

Flowserve Pump Division (pumps)

Flow Control Division (valves)

Flow Solutions Division (seals)

Aftermarket servicing includes installation, repair, and retrofitting. These services are provided through Quick Response Centers (QRCs), of which there are 150 located throughout the world.

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1) Flowserve Pump Division

Business Segments

Designs, manufactures, distributes and services pumps, pump systems, replacement parts, and related systems.

Pumps are used to move fluids through piping systems.

World’s largest supplier of pumps to oil and gas, chemical, and power generation industries.

Portfolio of more than 150 different pump models

30 manufacturing plants and 79 QRCs located worldwide

Independent industry sources say FPD is 3rd largest pump manufacturer in the world.

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2) Flow Control Division

Business Segments

Designs, manufactures, distributes, and services valves, actuators (device for moving or controlling a system), and automation systems.

These products are usually custom-designed for a customer’s needs.

FCD’s products are used to manage the flow of liquids and gases by opening, closing, or partially obstructing various passages.

48 manufacturing plants and 29 QRCs located worldwide

Independent industry sources say FCD is 3rd largest industrial valve supplier in the world.

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3) Flow Solutions Division Designs, manufactures, distributes, and services mechanical seals and sealing systems

and parts.

Seals join systems together by preventing leakage.

FSD’s products are used in a wide variety of high-stress conditions, so they need constant repair or replacement.

More than 185 models of seals available.

6 manufacturing plants and 74 QRCs located worldwide

Independent industry sources say FSD is 2nd largest mechanical seal supplier in the world.

Business Segments

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Revenue Mix by Segment

 

Segment Revenue Breakdown

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2006 2007 2008 2006 2007 2008Flowserve Pump Division $1,617.70 $2,095.40 $2,514.80 52.03% 54.81% 55.27%

y/ y growth 29.53% 20.02%

Flow Control Division 994.80 1,163.20 1,381.70 32.00% 30.43% 30.37%y/ y growth 16.93% 18.78%

Flow Solutions Division 496.60 564.50 653.70 15.97% 14.77% 14.37%y/ y growth 13.67% 15.80%

Net Revenues 3,109.10 3,823.10 4,550.20 100.00% 100.00% 100.00%y/ y growth 22.96% 19.02%

Revenue % of Revenue

Operating Income by Segment

 

Segment Operating Income Breakdown

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2006 2007 2008 2006 2007 2008Flowserve Pump Division $172.70 $274.20 $391.00 44.61% 49.91% 53.07%

y/ y growth 58.77% 42.60%

Flow Control Division 115.90 163.70 218.40 29.94% 29.80% 29.65%y/ y growth 41.24% 33.41%

Flow Solutions Division 98.50 111.50 127.30 25.45% 20.29% 17.28%y/ y growth 13.20% 14.17%

Net Revenues 387.10 549.40 736.70 100.00% 100.00% 100.00%y/ y growth 41.93% 34.09%

Operating Income % of Operating Income

Geographic Revenue Breakdown

Geographic Revenue Breakdown

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2006 2007 2008 2006 2007 2008North America $1,132.59 $1,467.45 $1,565.72 37.00% 39.00% 35.00%

y/ y growth 29.57% 6.70%

Europe 795.88 978.30 1,252.57 26.00% 26.00% 28.00%y/ y growth 22.92% 28.04%

Middle East and Africa 489.77 489.15 492.08 16.00% 13.00% 11.00%y/ y growth -0.13% 0.60%

Asia Pacific 459.16 564.40 805.23 15.00% 15.00% 18.00%y/ y growth 22.9% 42.7%

Latin America 183.66 263.39 357.88 6.00% 7.00% 8.00%y/ y growth 43.41% 35.87%

Net Revenues 3,061.06 3,762.69 4,473.47 100.00% 100.00% 100.00%y/ y growth 22.92% 18.89%

Revenue % of Revenue

Industry Bookings Breakdown

Industry Bookings Breakdown

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2006 2007 2008 2006 2007 2008Oil and Gas $1,555.31 $1,684.29 $1,991.22 43.00% 39.00% 39.00%

y/ y growth 8.29% 18.22%

Chemical 542.55 820.55 867.97 15.00% 19.00% 17.00%y/ y growth 51.24% 5.78%

General Industries 831.91 1,036.49 1,174.31 23.00% 24.00% 23.00%y/ y growth 24.59% 13.30%

Power Generation 470.21 518.24 765.86 13.00% 12.00% 15.00%y/ y growth 10.2% 47.8%

Water 217.02 259.12 306.34 6.00% 6.00% 6.00%y/ y growth 19.40% 18.22%

Net Revenues 3,617.00 4,318.70 5,105.70 100.00% 100.00% 100.00%y/ y growth 19.40% 18.22%

Revenue % of Revenue

Table of Contents

i) Business Description

ii) Porter’s 5 Forces

iii) SWOT

iv) Competitors

v) Key Drivers & Catalysts

vi) Valuation

vii) Investment Recommendation

Table of Contents

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Power of Suppliers

LOW Many of FLS’s raw materials – bar stock, fasteners, motors, etc – are not custom

designed, and therefore available from a wide variety of sources.

Company is a vertically-integrated manufacturer for necessary custom parts (corrosion-resistant castings for pumps and valves are manufactured by FLS).

Minimal switching costs in moving between suppliers.

Porter’s Five Forces

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Power of Customers

LOW Sell products and services to more than 10,000 companies directly or through

designated channels.

Largest customer in 2007 accounted for 5% of revenue.

No customer accounted for more than 10% of 2008 revenue.

Customers have no choice but to repair FLS custom-designed parts to maintain production – little power to negotiate prices.

Porter’s Five Forces

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Power of Substitutes

MEDIUM Pumps, valves, and seals are absolutely indispensable parts of fluid control systems.

Only FLS will be able to repair or replace custom-made parts.

Customers cannot put off purchases or repairs in recessionary times.

However, companies could cut costs by purchasing less sophisticated parts from other manufacturers at minimal switching cost; there isn’t always a need for custom-made supplies.

Porter’s Five Forces

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Industry Rivalry

HIGH Pump Division: industry is highly fragmented, with more than 100 competitors

Control Division: top 25 global valve manufacturers comprise less than 25% of total valve market.

Solutions Division: less fragmented, larger companies tend to hold more of the market share.

In aftermarket services market, independent local repair shops can make repairs for non-customized parts due to existence of common standards.

Porter’s Five Forces

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Barriers to Entry

HIGH Much of FLS’s sales through referrals or existing relationships with clients – difficult for

a new entrant to compete against reputations of already established companies.

To build manufacturing plants and service centers, as well as hire experienced personnel, requires extremely large initial capital investment.

Trademarks and patents held by established companies make it difficult for new entrants to design competing products.

Porter’s Five Forces

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Table of Contents

i) Business Description

ii) Porter’s 5 Forces

iii) SWOT

iv) Competitors

v) Key Drivers & Catalysts

vi) Valuation

vii) Investment Recommendation

Table of Contents

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Strengths

Exposure to wide variety of end industries and countries to hedge against limited risks.

Strong manufacturing capabilities – as one of the largest companies in its space and manufacturing facilities all over the world, FLS experiences favorable economies of scale.

Quick Service Centers (QRCs) throughout the world provide competitive advantage: easy to provide quick (usually 24-hour) service to clients around the world.

All parts of FLS’s business are connected – companies building plants will likely need pumps, valves, and seals at similar times.

Aftermarket servicing is a high margin business that will likely remain stable even in times of economic downturn. These services also help FLS maintain long-term relationships with clients.

Strong and broad brand portfolio. Custom-designed products make it easy for FLS to tailor to client’s interests.

Extremely strong fundamentally: gross margin, net margin, ROA, ROE have been growing over time, and dramatically outpace competitors.

Large backlog of orders waiting to be filled.

On average, 40% of bookings in a quarter are for servicing requests, which usually need to be filled immediately.

SWOT

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Weaknesses

SWOT

Oil and gas industries represent a significant amount of revenue. Stock price has traded with oil in the past – significant exposure to the risks and cyclicality of this industry.

Backlog is much larger than it has been in the past – company may be “stretching itself too thin,” straining relationships with customers and affecting profitability.

Bookings can usually be canceled or modified at any time, so they are not necessarily a good indication of future revenue.

The company uses defined benefit pension plans, some of which is not funded (Austria, France, Germany, Sweden). Unfunded pension obligations could affect the bottom line and force the company to funnel cash from R&D, etc to pension plans.

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Opportunities

SWOT

Future demographic trends predict increased demand for FLS products from end markets:

Oil prices are projected to rise in the long term. As oil gets more expensive, companies can access harder-to-reach oil while still turning a profit; these operations will need more intricate piping and pumping.

Nuclear power is especially expected to become more popular: by 2008 end, 43 reactors under construction and 372 reactors planned or proposed worldwide. FLS’s “N-stamp” certification, required to service companies in this industry, gives it a competitive advantage here.

Water consumption has doubled every 20 years and this trend is expected to continue. With 99% of the world’s freshwater not easily accessible, will need more complex systems and pumps to reach them.

Well positioned in developing countries such as China and India, which are expected to expand infrastructure dramatically.

Contracts with a variety of well-established companies, which will help improve FLS’s brand image and recognition:

10-year supplier agreement with Saudi Aramco (world’s largest oil company) to provide products and services.

Exclusive relationship with Petrobras (world’s 7th largest oil company, recently discovered large oil deposit in Brazil).

Supplier of valves to Westinghouse Electric Company nuclear power plants in China.

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Threats

SWOT

The industries that FLS competes in are extremely competitive are fragmented, increasing pricing pressures, which may adversely affect the company’s results.

Increases and volatility in prices of raw materials could negatively impact bottom line.

65% of FLS’s sales are outside the US, which exposes the company to additional risks:

Foreign currency exchange fluctuations

Regulatory and political risks abroad

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Table of Contents

i) Business Description

ii) Porter’s 5 Forces

iii) SWOT

iv) Competitors

v) Key Drivers & Catalysts

vi) Valuation

vii) Investment Recommendation

Table of Contents

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Competitors

Parker-Hannifin Corporation (NYSE: PH): Manufactures, services, and distributes a variety of motion and control technologies and systems, including fluid power/control systems. Market Cap: 8.86B.

Pentair, Inc. (NYSE: PNR): Company is made up of two divisions, one of which, the Water Group, provides products and systems used to move, store, and treat water and other fluids. Market Cap: 3.02B.

Harsco Corporation (NYSE: HSC): HSC is structured similarly to FLS – three different divisions (Infrastructure, Metals, Minerals & Rail) which provide products and aftermarket servicing to clients. Market Cap: 2.83B.

IDEX Corporation (NYSE: IEX): Manufactures variety of industrial products, specializing in fluid and metering technologies. Market Cap: 2.31B.

Competitors

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Company P/ E, ttm EPS, ttm Net Margin, ttm ROA, ttm ROE,ttmFlowserve Corporation 12.78x $7.66 9.74% 10.42% 28.08%Parker-Hannifin Corporation 17.66x $3.13 4.93% 5.46% 10.66%Pentair, Inc. 31.84x $0.96 3.22% 3.22% 9.49%Harsco Corporation 18.86x $1.87 4.57% 4.72% 10.00%IDEX Corporation 23.95x $1.20 7.03% 6.33% 7.86%

Table of Contents

i) Business Description

ii) Porter’s 5 Forces

iii) SWOT

iv) Competitors

v) Key Drivers & Catalysts

vi) Valuation

vii) Investment Recommendation

Table of Contents

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Drivers & Catalysts

End markets will need to expand infrastructure in the coming years to obtain harder-to-reach resources, thus increasing demand for FLS products (world will need more oil, energy, drinkable water, etc).

FLS is well-positioned in developing countries like China and India (and is expanding that position by building more QRCs and manufacturing facilities in these areas). As these nations become more wealthy, they will expand their own infrastructure and manufacturing capabilities, and will likely require FLS products to do so.

Existing strong relationships and exclusive contracts with some of the world’s largest energy companies ensure that FLS can capitalize on these demographic trends.

Key Drivers & Catalysts

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Table of Contents

i) Business Description

ii) Porter’s 5 Forces

iii) SWOT

iv) Competitors

v) Key Drivers & Catalysts

vi) Valuation

vii) Investment Recommendation

Table of Contents

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Valuation Summary

52 Week Range: $37.18 – 110.74All Time High: $139.04 (May 2008)

Discounted Cash Flows:Exit Multiple (EV/EBITDA): $93.94 – 117.62Perpetuity Growth: $101.51 – 119.03

Trading Comparables:EV/Sales: $83.09EV/EBITDA: $117.22EV/EBIT: $112.24

Average of Valuation: $90.86 – 115.80 Currently Trading: $97.82

Implied ROI: (7.1)% – 18.4%

Valuation Summary

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Football Field

Football Field

Football Field

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$0.00 $20.00 $40.00 $60.00 $80.00 $100.00 $120.00

DCF - Perpetuity Growth

DCF - Exit Multiple

Trading Comparables

52 Week Market Value

Key Valuation Assumptions

Key Valuation Assumptions

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52 Week Range:P/E: 4.87x – 14.49xP/B: 1.3x – 3.88x

Discounted Cash Flow:Exit Multiple: 9x EV/EBITDA (Implied terminal growth rate – 4.95%)Perpetuity Growth: 5% terminal growthWACC: 11% (11.1% cost of equity, 5.7% cost of debt)

Trading Comparables:Companies Parker-Hannifin Corporation [PH]

Pentair, Inc. [PNR]

Harsco Corporation [HSC]

IDEX Corporation [IEX]

Multiples [median]EV/Revenue: 1.1xEV/EBITDA: 9.2xEV/EBIT: 10.0x

Table of Contents

i) Business Description

ii) Porter’s 5 Forces

iii) SWOT

iv) Competitors

v) Key Drivers & Catalysts

vi) Valuation

vii) Investment Recommendation

Table of Contents

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BUY

Thesis:

Flowserve’s business model of providing high-quality aftermarket servicing to its wide range of products has helped it remain relatively immune to the global economic downturn.

Due to demographic changes, worldwide demand for power, oil, and water will increase. Flowserve’s strong position in developing countries such as China and India and partnerships with some of the largest companies in these spaces will ensure that it remains a leader in its field.

The company is trading at 15% below its estimated fair value of $110. With FLS’s strong fundamentals, solid business model, and promising end market growth, this large discount to fair value is a rare buying opportunity. 

Key Drivers & Catalysts

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