Despite adverse global market conditions that will probably continue to affect infrastructure projects through at least 2009, we believe Flowserve (FLS) is well positioned to maintain its strong organic growth in its core end markets for both the original equipment and aftermarket businesses, which consist of oil & gas, power generation, water resources, chemical and general industry. Although oil prices continue to plunge (below $50 a barrel recently), in our view flow control opportunities are generally based on long-term investments. Major oil companies have recently noted that they plan to continue to spend billions of dollars on new projects, while power projects continue to increase in developing regions such as China, India, the Middle East, and Latin America. About two-thirds of Flowserve's business is derived outside of the U.S.
We see the company continuing to win new business via its diversified geographic mix and aftermarket strategy, and its ability, in our view, to execute on its contracts. While infrastructure spending has historically been driven by profit with the majority of the projects managed by multinational companies focusing on creating shareholder value, we believe investment drivers now include demographics, aging infrastructure, and economic growth. With more government funding available in developing markets, we think Flowserve has favorable long-term growth prospects.
The company continues to plan for market fluctuations and cyclical shifts, focusing on key strategic initiatives, including moving manufacturing, sourcing, and engineering to low-cost regions, hiring temporary employees when appropriate, using multiple shifts, expanding its research centers in India, and other cost-containment initiatives. Flowserve also continues to monitor customers, financial relationships, and suppliers. We expect global opportunities to continue for aftermarket services through changing business cycles, as the company maintains response centers close to its customers and develops long-term relationships. In our view, demand for Flowserve's products and services will continue to be driven by the need to keep oil & gas flowing, electricity on, and water and chemicals available.
Based on what we see as Flowserve's financial flexibility, diversified business model, and favorable long-term prospects in developing regions, along with our valuation metrics, we find the shares extremely attractive. The stock carries S&P highest investment ranking of 5 STARS (strong buy).
Texas-based Flowserve, which was formed through the 1997 merger of Durco International and BW/IP, is one of the world's leading providers of fluid motion and control products and services. The company manufactures engineered and industrial pumps, seals, and valves, and also provides related flow-management services. Customers use fluid motion and control products to regulate the movement of liquids or gases through processing systems in their facilities. Industries served include oil & gas, chemical, power generation, water treatment, and general industrial.
Principal markets for the company's products are oil & gas (39% of bookings in 2007), general industry (24%), chemical (19%), power generation (12%), and water resources (6%). On a geographic basis, 2007 revenue broke down as follows: North America, 39%; Europe, 26%, Middle East and Africa, 13%; Asia Pacific, 15%; and Latin America 7%. In the third quarter of 2008, original equipment sales represented 64% of sales, up from 58% a year earlier.
The company's Pump division (56% of 2007 sales) manufactures engineered and industrial pumps and pump systems, replacement parts, and related equipment. The segment's products are primarily used by companies in the oil & gas, chemical processing, power generation, water treatment, and general industrial markets. Pump systems and components are produced at 28 plants worldwide.
Flowserve manufactures over 150 different pump models, ranging from simple fractional-horsepower industrial pumps to high-horsepower engineered pumps (over 30,000 horsepower). Aftermarket services through the company's global network are provided at 76 service centers in 28 countries.
The company's Flow Control division (30%) designs manual valves, control valves, nuclear valves, actuators, and other equipment that provide flow-control-related services. These products are typically utilized within a flow control system to control the flow of liquids or gases.
The Flow Solutions division (13%) manufactures mechanical seals, sealing systems, and parts. Seals are used on a variety of rotating equipment, including pumps, mixers, compressors, steam turbines, and other specialty equipment. The division's products are used primarily by companies in the oil & gas, chemical processing, mineral and ore processing, and general industrial end markets.
In September, 2008, Flowserve was added to the S&P 500 index.
The company's key objective is to enhance its global position as a product and integrated solutions provider in the flow control industry. To achieve this, it pursues organic growth; emerging market expansion; operational excellence; portfolio management and strategic acquisitions; and enhanced organizational capability, technology and innovation. Flowserve plans to focus on opportunities that can expand its organic growth from existing customers while evaluating potential new customer-partnering initiatives that maximize the capture of the product's total life cycle.
Regarding globalization, Flowserve plans to increase its presence in emerging markets, targeting China, Russia, Africa, the Middle East, and Latin America. The company has already expanded its China presence with additional sales and supply chain professionals and growth plans, which include acquisition or development of new capabilities that will enhance the penetration of products for oil & gas and power projects, as well as provide a base for the export of products. In 2007, these areas accounted for about 15% of the company's direct materials spending, compared with 5% in 2001.
Flowserve is focused on reducing costs via further use of strategic sourcing, and continues to make progress in standardizing processes and simplifying its information technology platform. The company is also focusing on providing customers with integrated flow management solutions as opposed to just supplying point products in pumps, seals, and valves.
Despite near-term market volatility and uncertainty due to the global financial crisis and economic downturn, we believe Flowserve will be able to achieve most of its objectives based on its diverse geographic and business mix, aftermarket strategy and solid position in the marketplace. Year-to-date, bookings at Sept. 30, 2008, were $4.1 billion, up 28% (19% organically), driven by strength in Europe, the Middle East, and Africa. Backlog rose 35%, to $3.1 billion, from 2007 yearend.
Flowserve projects a 40¢ per share negative foreign currency effect to its earnings in the fourth quarter of 2008, following 20¢ in the third period, because of the strengthening U.S. dollar against the euro and other currencies. However, it believes that much of the impact will be offset by its strong operating performance and lower tax rate. The company also thinks the weakening euro provides an opportunity for its foreign operations to be more competitive in the global market long term.
The company continues to make progress toward its selling, general, and administrative (SG&A) expense target of 20% of sales or lower, with the percentage trending down from 25.6% in 2006 to 21.2% in the third quarter of 2008. Flowserve continues to focus on improving its working capital efficiency, while return on equity (ROE) has been trending upward, to 30% at Sept. 30, 2008, from 22% in 2007 and 6.9% in 2002. Meanwhile, long-term debt to capital has been reduced in each year since 2000, from 78.5% to 28% at the end of the 2008 third quarter.
For 2008, we project revenue growth of about 24% (over 15% organic), moderating in 2009 to near 10% because of a global cyclical downturn and a negative foreign currency effect. We still expect strength in the pump business, as well as demand for flow-control and flow-solutions products and services mainly in the oil & gas, power, chemical, and water sectors. Although capital spending for some projects may be curtailed by soft markets and lower oil prices, we believe any project delays will be temporary, as customers seek to complete their infrastructure upgrades within their targeted time frame.
In our view, gross margins will continue to expand somewhat during 2009, based on pricing and operational initiatives, improved fixed absorption on higher sales, stabilizing raw material costs, and a mix shift toward higher-end products leading to more opportunities in the higher-margin aftermarket business. We see EBITDA margins widening to above 16% on well-controlled SG&A expenses and higher sales.
We project a lower effective tax rate of 25% for 2008, and EPS of $7.50 (including a 38¢ tax benefit), advancing 12% in 2009, to $8.40.
Flowserve shares were recently trading at a price-earnings ratio of 5.1 times our $8.40 estimate for 2009, and an Enterprise Value-to-EBITDA multiple of about 3.9 times, both steep discounts to our projected multiples for S&P's Industrial Machinery subindustry group. Historical p-e ratios over the past five years have ranged from 11 times in 2007 to 78 times in 2004. In our view, the below-average p-e reflects adverse global economic conditions that could affect capital spending, and the company's exposure to the oil & gas and power markets.
We believe Flowserve deserves to trade at higher-than-industry multiples based on its strong balance sheet and financial flexibility, well-diversified geographic and product mix, and still robust bookings growth. Our relative metrics, including EV/EBITDA using a multiple of 5 times our 2009 EBITDA estimate (resulting in a $74 value), and p-e using a multiple of 7.5 times our 2009 EPS estimate (resulting in a $63 value), suggest a price of $68.
Our discounted cash flow (DCF) model indicates an intrinsic value of about $55. Blending these valuations, we arrive at our 12-month target price of $62.
We believe the company's corporate governance practices are sound, as the board is controlled by a supermajority of independent outsiders (making up more than 90% of the board) and the company has separate positions of chairman and CEO. Additionally, there is no poison pill, directors are subject to stock-ownership guidelines and receive all or part of their compensation in the form of equity, and the audit committee is made up solely of independent outside directors.
On the negative side, a supermajority vote of shareholders is required to approve certain types of mergers and to amend provisions of the charter or bylaws.
Risks to our recommendation and target price include significant delays and/or project cancellations due to customer spending cutbacks, especially in the oil & gas and power sectors; a shortage of skilled labor; geopolitical issues in developing regions; a weak euro; and internal control problems over financial reporting.