Parker-Hannifin Corporation (PH) Earnings Call Transcript & Summary

Great. Well, thanks, everyone, for coming. Next up, it's my pleasure to have here Tom Williams, Chairman and CEO of Parker Hannifin. There's obviously been a lot going on at the company, with the LORD and Exotic acquisitions that closed late last year. There's an Investor Day in New York coming up in March, so we're looking forward to that. Maybe, Tom, just a couple of minutes of introductory remarks perhaps, and then we'll go into questions from myself and any from the audience, please.

Sounds good. Thank you, Julian, and thank you, everybody, for your interest in Parker, and welcome back to Barclays. It's always great to be back. Thank you for hosting and great to be in Miami. So I just want to make a couple of quick comments. First, if you look at how the company has done in the last 5 years, we're really pleased with the progress. I would kind of go back to 2015 when we launched the changes to The Win Strategy. If you're not familiar with The Win Strategy, it's really the business system of the company. And I would call it Win Strategy 2.0, building off the original Win Strategy. And I would point to 2 metrics that really signifies how well we've done over these last 5 years. First would be safety. Our safety incidents have reduced 70% over 5 years. And we now are a top quartile safety incident performing company compared to our proxy peer group, which is a phenomenal progress. The second would be margins. If you look at operating margins and EBITDA margins over that period of time, significant improvement. Probably the easiest because we've been doing so many acquisitions is to look at EBITDA because it takes -- it's easier apples to apples over the period. We've raised EBITDA margins over 5 years almost 400 basis points, so significant progress on margins. The second is what Julian was alluding to. We've been very strategic in putting the balance sheet to work and looking at transforming the portfolio. And we've added 3 great companies over the last 5 years. Added acquired revenues of $3 billion of CLARCOR, which is a filtration business; LORD, which is an engineered materials business; and Exotic, an aerospace business. So we're very happy with how they're doing and that kind of speaks to the portfolio. So we are the global leader in motion control. So we are $14.3 billion and our space is about $130 billion. So we have lots of opportunities to grow within this space. But this portfolio has been very thoughtfully put together because we have 8 motion control technologies, and these 8 motion control technologies are our significant competitive advantage versus our peers. So we are not competing against competitors -- we compete against competitors that are just typically single-line product lines. And we get to bring multiple technologies, which is a big value proposition for customers, a big opportunity to drive value and take total cost of ownership down. The stat that I'd like to tell people that -- it's not just me saying this, 60% of our revenue comes from customers that buy from 4 or more of these 8 technologies. So our customers see the value of this interrelated, interconnected portfolio. I guess the other 2 things I would close with is one, the financial performance of the company during downturns. So if you look at us through the last 5 recessions, we continued to raise the floor on performance of the company. We're now at 16.2%. That's our guidance, and that's even with Exotic and LORD's amortization in there, and that would compare to around 14.5% the last downturn. If you go back 5 years ago, we were -- we would have killed to be at 16.2% in good times. And here we are with about a minus 7% volume drop, delivering that kind of margins, so really improved resilience on the company during downturns. And then lastly, I would just say there's lots of opportunities to go forward with this. We're launching -- we've launched Win Strategy 3.0 at the end of September, and that will be the centerpiece of IR Day next month, launched our purpose statement. And these short-term issues that we've got going on between the coronavirus and some of the headwinds we have on the macros and the 737 MAX are going to play through. When they play through in combination with the momentum we've already had and then when you add Win Strategy 3.0, I'm pretty bullish about where we can take the business and build on what we've had already.

Great. Thank you, Tom, for those remarks. I guess following up, as you said, we are in a revenue downturn right now for Parker and many other companies at the conference. You have seen a number of downturns over time. Just how does this one compare with prior industrial recessions or soft patches when you're thinking about amplitude or longevity? Maybe just any differences or commonalities with other downturns that you've seen?

So if I would characterize it looking at order entry, when order entry goes negative, saying "Okay, that's the start of a downturn," and it's the sales, but -- when the orders go negative, so our guidance right now is that this would be 6 quarters of negative order entry. So if you look at us historically last 20 years, our downturns have tended to be in that 12- to 18-month range, so this would be towards the longer end of a downturn. I think the coronavirus -- I'm not trying to forecast into FY '21 for us, but the one uncertainty is the coronavirus and how will that extend this over. Because I would have said without that, we were finding bottom and would have -- FY '21 should have been a year where we would start to see some inflection or some other. With the coronavirus, that's a bit of an unknown that might make this go a hair longer. But -- so I think it's a little bit longer than normal. And in general, I think it's a little broader based as far as end markets.

And then just -- you mentioned coronavirus. On that point within Parker itself in China, maybe just give any update that you can around production sites, how satisfied you are with how the supply chain is evolving and adapting on the ground.

Yes. So a couple of comments. I had a meeting before this. I'm going to update anybody who was in that meeting so they get the latest data because I just got a text. I mean this is how fluid the situation is. I'm very pleased with what's happening so far. I mean it's obviously very challenging. This is not normal business. But we have 3,400 people in China and knock on wood, everybody's healthy. That's the first and foremost, in taking care of our people, we're following all the provincial hygiene requirements and all that. We've got all the things we need in all the plants. We have 19 locations, and all 19 -- this is the change from anybody who was meeting with me this morning -- all 19 are now up and running. Before I got this note, 17 of the 19 were up and running, and they were kind of in that 50% to 75% utilization. But actually with everything that's going on, I'm pretty pleased with that percent utilization given the dynamics. The 2 plants that just came online within the last 24 hours, they're obviously a little bit lower than that. Logistics are a little bit challenged, but that's still factored into that 50% to 75%. The key thing I would remind people is that we're not in China to export around the world. We're in China for that region. We're in country for the country. And 60% of what we do in China is produced locally in those 19 facilities, and the other 40% is imported in from either Europe or North America. So that supply chain obviously is not interrupted, other than trying to get things to clear customs, which eventually will. So it's -- there's a degree of uncertainty. We try to forecast some of that into the earnings when we updated everybody with our recent earnings call. It's very fluid. So we gave you the best information we had. Hopefully, there's enough in there to cover things. We won't know really until we see -- get through the whole quarter though.

And you mentioned at the beginning that in this downturn, your -- the management of decremental margins has, I think, surprised many people, including myself. Maybe just help us understand what has led to those decremental margins being much narrower. How is the company able to protect profitability in a downturn that, as you said, is fairly broad based versus many prior ones?

I would say the work on performing good in a downturn starts years in advance, and you got to work on creating the right kind of structure. So it really started between '14 and '16, we did a significant amount of restructuring in the company, targeting those high fixed cost type of areas to create a more agile organization, be able to flex more elastically to demand. So that was a big change. Win Strategy 2.0 in 2015 created a lot of changes around engagement and simplification, those type of things again creating more capacity to flex. Win Strategy 3.0, while we haven't been quite as public, it's coming next month, we've also been implementing some of that already in advance, started in September. And a lot of our Kaizen activity that we did really started about a year ago, and that's built some momentum. I also think our team continues to get better at being able to do those things that you got to do when you flex when the demand changes. So what Julian was referring to is our guidance is around mid-20s decremental. And our last quarter was kind of low 20s, and that's pretty good if you think about what's going on. These are some pretty unique times between that broad base of a macro impact, taking the MAX completely out of the guidance, and the coronavirus, which -- those things don't happen all that often. And for the team to power through, deliver that kind of decrementals, I'm very pleased with what they're doing.

And when we look at the -- whenever the revenue upturn comes, what type of incremental margin are you expecting the business to be able to generate? Is there a sense in which you have lower decrementals but maybe lower incrementals as well because of some changes to the nature of the business model? Or are you still expecting, no, we'll get good operating leverage when the sales turn?

Yes, I think we'll get good leverage when the sales turn. So typically as we continue to just have better cost structure and better flexibility, when volume picks up -- and some of this is volume dependent depending on how sharp the incline is, if it's kind of flat incline versus a sharp spike. But in general, that -- those first several quarters, we would probably typically see something 40% or better incrementals, and then you would glide down to a 30% over that cycle. I think for those of you that are modeling Parker and you want to model revenue change, a 30% incremental is still a best-in-class number, as well on the downside a 30% decremental. As we've studied other companies, which we do as we continue to benchmark ourselves against the best, that's still a world-class type of performance.

And you talked about the 3 large acquisitions in recent years. Maybe give us some impression around how are those performing in the current environment, CLARCOR, LORD and Exotic, particularly I guess CLARCOR that you've had in the business now for 3 years.

So we don't typically disclose how individual segments are doing versus the whole company. But I would just characterize it, Julian, that they are performing better than the base business, which is what our strategic rationale is. We're one of the 5 companies that are more resilient, that had better growth rates, better margins than the base business and they're doing that. We saw that with CLARCOR. CLARCOR now is in the late innings of integration and pretty well that's completely done. We'll finish the synergies this year. And I'm very happy with what's happened there. And this is -- we're all one team now. We took Parker gold and Parker blue and it's all green now. You put the 2 together, it's all together. But LORD and Exotic are off to a great start. And even with the dynamics of what we've seen there with -- because they're not immune to the -- obviously the MAX impacts then and the coronavirus. But we've seen LORD kind of in low single digits and compare that to -- I'm talking about growth, compare that to the base, what we forecast our guidance, at minus 6.5% organically. So that's what we wanted. We wanted something that was going to perform different than the base business. Their EBITDA margin is significantly higher than ours. And actually their EBITDA margins are coming in better than we had planned because the synergies are better than we had planned on LORD. On Exotic, the Exotic team can't help what's going on with the MAX, but there's still -- if I took -- if the MAX had continued at the rate it was before, Exotic would be growing 10%. So it -- all the other programs are doing great. Their EBITDA margins are holding in the mid-20s, and that's pretty good given the MAX not being there. And I'm very pleased with what's happened. Actually ironically, I wouldn't plan it this way, but the MAX coming out temporarily here is allowing us to redeploy and accelerate revenue synergies on Exotic. So we are accelerating our ability to take care of customers on the F135, which is a good thing. We've always wanted to do that. We've redeployed people doing that. And we have enough capacity to take some of those people that are working Kaizen in Exotic, that when the MAX comes back, which is going to come back at a slower rate, we don't need to hire any more people. So we're going to get the benefit of supporting Boeing when the MAX comes back. And we've supported our F135 customers, Pratt in particular, with a higher line rate, which is what they wanted. And we'll continue to look at repairs and those types of things in the interim too. So I'm actually -- it's not how I would've designed it, but it's going to turn out okay over the next couple of years.

And you mentioned margins, a very good performance in this downturn on the P&L side. Free cash flow, I think, has also been improving at Parker and tends to be quite resilient in a downturn. How much opportunities there are left, you think, to keep pushing up free cash margins, whether it's around supply chain or working capital or some of those non-P&L aspects?

So free cash flow for us in the last couple of years has been in that 11% to 12% range of sales, and we'd like to continue to bump that up higher. Now the properties we just brought on, CLARCOR, LORD, Exotic, would be mid-teens free cash flow, so they're going to help us with that. As we continue to improve margins, that's number one, still the biggest number on free cash flow. And we still want to grow those margins. We still want to get to 19% operating margin, so that's -- in round numbers, it's going to -- that's a 200 basis point lift there on margins. And we still have an opportunity with working capital to take and we continue to do Lean better and Kaizen better. We'll continue to take working capital. So I -- we want to be -- we -- and Julian, I mentioned this, we have been historically very resilient on cash flow. If you look at our -- our CFOA for the first 6 months is an all-time record for the company, even with what's going on. Good times or bad times, we've been double digits, over 100% free cash flow conversion for 18 consecutive years. But we really want to be top quartile free cash flow because it allows us many opportunities on behalf of our shareholders to drive better TSR. And that's what we're going to try to do. We're going to continue to be top quartile in free cash flow. We are pretty much there today. We're close, and we have opportunities to get it better.

Within Win 3.0, there's a lot of further sort of margin efforts and productivity efforts that you've cited. How much should we expect a revamp of kind of organic growth rejuvenation within that strategy?

Yes. So that's a big part of what we want to do, and that's going to be a big centerpiece. I'm not trying to make a commercial for IR Day. It seems like -- I'm like a broken record in finding people to IR Day. But -- so I think what people demonstrated is seen over the years, a company that's very cash flow resilient and high cash flow margins. So that's -- we want to continue that obviously. Second, now I think people have taken notice and this company has demonstrated a step change in operating margins, EBITDA margins and has the ability to continue to drive that up even higher. So now what we really want to build on is can we grow differently, can we be a little less cyclical than we had been in the past? And I think that's going to take a combination, and we've been working on that. It's not like 3.0 is the first time. It's going to be what we've been doing portfolio-wise. So we're buying companies that are more resilient like the last 3 that we did, that grow faster than the market, better margins. So we'll continue to look at that as cash is available, but then there's performance things we can do. And 3.0, to your point, Julian, is geared a lot about how we do those type of things. So simple by design versus a big initiative underneath simplification where we design things simpler. And you think, "Well, how does that help customers?" But it allows speed to market, better customer experience. And we'll design things that are going to have better reliabilities, and I'll go through this a lot more in detail. We have a lot of work on innovation. And we've got a whole new initiative around the front end of innovation, which is making sure we're connected close with the customer and the end user. We don't want to be innovating things because you and I think -- happen to think this is a great idea. We want to be innovating things because our customers and the end users think this is a great idea. And this process is called new product blueprinting, and we'll go through that in our IR Day as well. We're going to continue to drive international distribution, which is a big part of how we continue to grow differently because distribution tends to be more stable and have higher margins. But take international distribution for us. 5 years ago, it was 35% of our sales and we went direct on 65%. Today, it's now 40-60. So 5 points of mix improvement there, about 100 basis points each year. You might say, "Well, how did you do that?" Well, we took a playbook out of North America. And how North America became really good at distribution is we took a lot of Parker leaders and we moved them into distribution, either in a leadership position or as a part owner in distribution. And we moved 165 people over 5 years. I don't like losing people, but having people go to our distributors is a fantastic thing for us and fantastic for our distributors. We've added almost 500 distributors, I'm talking just international only. So we want to continue to do that, and we'll talk about that. Lee will cover that in IR Day, that we think we want to do about 100 bps a year on that and continue to build that out. So that's a long-term plan that continues to change the mix profile internationally, again growth resilience there because it's more tied to the aftermarket and margin enhancement because the distribution channel has higher margins than the direct channel. There's a lot of things going on there under 3.0, and we'll spend more time on it. But it's going to be a combination of what I'll call portfolio changes and performance changes, things we need to do internally as well as the portfolio.

And around the top line effort, many companies here talk about digital and what they're trying to do there internally or customer-facing. I understand that you'll keep it, customer pool, it sounds like rather than just going out and buying a software company or something. But maybe help us understand how you think about IoT, how much can Parker benefit from that rising tide?

Okay. So I'll talk about IoT, but I want to lift it up a second and talk more about our digital strategy in general, and that was a big part of 3.0. So the first thing and the most important thing is to have a great digital customer experience, and that turns -- that's your website. So having a best-in-class website because that is how people perceive your company, that's how they're going to -- their impression of your company. So we want to continue to have a best-in-class website. We're not there yet, so that's a big thing we got to work on. We do want to have digital products, to your point. Not every product needs to be digitized. We want to make sure we had the right products and create value where our customers see the value. Most of that digital products will sit in aerospace, motion systems and the filtration. So we are doing them as we speak. But I see less of a new subscription revenue stream. There might be some of that. But it's again just more of a differentiator. Again, we have these 8 motion control technologies. We can create a lot more value. Now if I can have digital insights around that -- there's a difference between one of our competitors that might just have a valve. If they're digitized, it's on or off. Versus our subsystems and systems, there's a lot more insightful data that we can provide. The other leg of this is digital operations. So this is internal. We will use some IoT, but just taking Lean and digitizing -- a digital day by the hour boards for our team members, digital problem-solving, et cetera. And the last one, which is probably on all that list, they're all equally important. The one that really has a lot of excitement and energy for me and the executive team is AI, the use of artificial intelligence, machine learning. And I would tell you we've been trying to do Lean in the office for a long time. We started Lean in 2001, and we still have a big journey to go on Lean. But as we try to do Lean in the office, it's much more complex because you can't see flow, you can't see product, you can't see processes. But with machine learning and AI, it's basically Lean for data, and machine learning can take your information to find patterns of it. So we have identified 7 use cases that we're piloting. We're about 4 months into it. And I can tell you that the productivity that we're seeing is going to be very impactful. So I'm excited about what it can do just as far as our ability to give better information to all of you as shareholders, better information to our customers and internal productivity. So this is a margin enhancement as well as a customer experience enhancement. But actually when I think through the whole digital platform that I just went through, that one has a ton of power behind it.

Switching to the balance sheet perhaps, you have LORD and Exotic in the portfolio for several months and that obviously took the leverage up somewhat.

Yes.