RealMoney Silver - Go With the Flowserve

Go With the Flowserve
By Bill Trent
RealMoney.com Contributor
2/13/2008 2:39 PM EST

Late last year, I used the government's PPI data by industry to scout out 26 investment ideas, among which were industrial valve manufacturers Flowserve (FLS) , Crane (CR) and Curtiss-Wright (CW) . In October, I said Flowserve may be the best way to play the PPI report.

Since that column in October, Flowserve has gained more than 22.5%, while the S&P 500 has lost nearly 12%. Now the question is whether to let this winner ride or to take the money and run. For now, I think the answer is to keep on going with the Flowserve.

For one thing, they call them "industrial" valves for a reason -- there is likely limited exposure to a consumer slowdown. According to the most recent 10K, the company's customer mix by end market is approximately 43% oil and gas, 23% general industrial, 15% chemical, 13% power generation and 6% water treatment. These are industries with long-term planning needs, many of which are finding themselves behind the curve. I don't see them slowing their spending anytime soon.

This is supported by the pricing power the industry continues to enjoy. Although off the 2007 peak in the double digits, the year-over-year change in January was still far above the industry's long-term average and still indicating an overall rising trend.

12-Month Percentage Change
in Industrial Valve Manufacturing Prices

Click here for larger image.

Source: Bureau of Labor Statistics

The pricing power is also flowing through to earnings. Flowserve is set to announce earnings on Feb. 27, but they preannounced in a big positive way at the end of January, which explains most of the stock's run. Curtiss Wright shares, meanwhile, gained 7% on Tuesday when its earnings beat estimates by 9 cents a share "led by our Flow Control and Metal Treatment segments, which experienced strong organic growth of 23% and 15%, respectively, over the prior-year periods." Crane also walloped estimates when it reported last month.

All these positive estimate revisions caused Flowserve's Zacks rank to jump up to 1, putting the company among the top 5% of all companies measured in terms of earnings momentum. According to Dan Fitzpatrick, as of last Friday the technicals supported a buy (with appropriate risk controls.)

As with most stock ideas, Flowserve has some downside risk, particularly with regard to valuation levels. In particular, its 1.8% free cash flow yield is below the yield on Treasuries, meaning that a good deal of the return must come from growth. There are several names that offer similar growth and higher free cash flow yields, particularly among the software companies I look at. Still, I think there could be benefit to owning Flowserve for diversification purposes.

Its 19 times forward P/E ratio isn't among the cheapest available, and is toward the high end of the 8 to 24 times range at which Flowserve has traded over the last five years. Its price/book ratio is also significantly higher than those of its peers. I would not be at all surprised to see the valuation contract in the short term, and I am virtually certain it will contract in the longer term.

But taking the valuation ratios down to the five-year average over the next five years would knock about 4-5% per year off the return, by my estimates. Given the 20% annual expected growth rate over that period, that still leaves room for annual returns of 15% or so, which I think will far outpace the S&P 500 over that time.