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

Well, good morning, everybody. My name is Andy Casey. I'm the analyst who covers machinery and diversified industrials. And I want to welcome everyone to our fireside chat with Parker-Hannifin. Joining us today are Tom Williams, Chairman and CEO; Robin Davenport, Vice President, Corporate Finance; and Jeff Miller, Director, Investor Relations. Again, welcome, everyone. Really appreciate your participation. Before we get started, for the investors with us today, your lines are on mute. It's a fireside chat format. But if you have a question you would like addressed, please send me an email at [email protected], and I'll do my best to ask it. So with that, why don't we get started? Thanks again, Tom, Robin and Jeff for joining us.

Tom, I was hoping to get some clarification on some things from your call last week. You indicated China is back up, but a little uncertain how sustainable that might be. For other regions, it sounds like we've seen stabilization in the last couple of weeks of April. But it sounds like you're planning for an L shape. Can you kind of walk us through why that is, planning purposes, and whether that's just to get the cost structure in place to deal with what you might encounter in the future?

Okay, Andy. Hi, everybody. It's Tom. Thank you, Andy, for hosting, and thank you to all the investors for your interest in Parker. So the L comment I made at the earnings call was really around our planning and our cost strategy that we wanted to plan and design a cost structure that would be kind of for a worst-case scenario, but design a flexible L, where if you -- look, think of an L, the horizontal part of the L that it could move depending on how demand moved, and that's how we design things. Now with that mixture we have of structural and discretionary, the discretionary piece could move depending on what the markets go to. Now we don't -- I don't think anybody really is spurred up to know exactly what the pattern of the recovery is so we designed a cost structure that could win in the current market and when if it doesn't move much at all. But I would fully expect it probably to not be an L, but we designed our cost structure and our planning for an L, with the key thing being a flexible cost structure, flexible ability to move.

Okay. And then just kind of turn to a concept that's out there that the recovery will potentially follow the path of the virus, China first, Europe next, then U.S. got hit. When you look at customer demand, you made the commentary about China. Is Europe getting any better sequentially? And then when you're looking at these 2 markets, Europe and North America, do you kind of expect them to follow the same sort of trends that China did? Or is it different?

So far, we've not -- don't have enough data yet on Europe to see it move. So I would say the jury is out still for that and for North America. Now I made comments about Asia on the call and China, in particular, because we had better visibility, and we had -- and they went in sooner so they have advanced information, so we could glean up from that. However, I think you can't necessarily look at Europe and North America through the same prism as China, different economies, China, more controlled, different political systems. But I do think, obviously, they're going to follow some pattern where there's a rebound and then the underlying conditions take over after that. But we've not seen it yet in Europe or North America. That's why my comments were specific to Asia only on the call.

Okay. And then when we kind of look at the short term, obviously, very challenging. You've kind of laid out some things we should consider for the June quarter, meaning targeting 30% decrementals for the legacy business in your fiscal Q4. If we look past this quarter and assume a modest recovery, what sort of incremental margin should we expect ex acquisition impact and taking some of these temporary actions that you did for Q4 out? Is it 40% plus? Or should we think more in the 30% range?

I think, Andy, a lot depends on the trajectory and what kind of increase we get. But assuming that there's not some almost invisible recovery where it's only 1%, but assuming you get some kind of normal inflection here, I would expect that if you look at past patterns for us, that we'd be north of 40% for those first quarter or 2, and that would glide down to the 30%. And as you go deeper in the recovery, deeper being a couple of years, you're going to start going to the mid-20s. But that will be a pattern I would expect for this time as well.

Okay. Great. And then the feedback I've gotten from investors leading up to this call, it's pretty evident that there's quite a bit of concern about the aerospace segment, knowing it's the smallest of the 3. But I'd like to ask questions I received from investors on that segment, because it really clearly seems to be an overhang on the stock performance. So first, a lot of investors are looking for a fairly detailed breakdown on military and commercial exposure. And then maybe looking at last year on a pro forma basis, if you could add back the acquisitions, specifically Exotic, what percent of revenue is really driven by commercial OE and MRO?

Okay. So maybe I'd start off with just a reminder to investors that approximately 20% of the company is aerospace. So I would -- from my point of view, you should not value the 100% of the company based on 20% of the business because 80% of the company is industrial and seeing different dynamics than with the aerospace businesses. But that being aside, the aerospace business is 67% commercial and 33% military. And of the 67% commercial, it's 48% OEM and 19% of MRO. And then the 33% military, it's 20% OEM and 13% MRO. And I would just, again, remind people on the military side, the military is growing nicely. It has a very stable book of business there. So that will help us weather the storm. Just to give you some insight on the platform side of things, a little bit more color here. Of the aerospace sales, 33% is engine, 28% is commercial transport, 14% would be military fixed wing, 8% business jet and general aviation, helicopters would be 8% and regional transportation is 9%. The reason why I go through all that is that we're very diversified from a platform that we've gone, and that was done on purpose over the years to make sure that we participated on the right type of platform, but that there is a good diversity depending on what happen in the aerospace cycle. So that would hopefully help a little bit on the color side for aerospace. Again, I would just remind people that while the commercial side is challenged, our military portion is nicely growing.

Okay. And if I could key up the diversification within commercial. For the content on existing and new commercial aircraft, it sounds like it's pretty widely diversified. Is it right to look at your business to kind of act like an index on commercial aero, OEM and aftermarket? Or would you point us to any concentration we should consider?

Yes. I think it'd be more appropriate, Andy, to -- and for investors to look at it as an index reflective of the total market. That's been, by design, as we've won a nice mix of business on what I would call legacy or older programs as well as new, a nice mix of single and twin, as well as military business. So I think viewing it as an index would be the more appropriate way.

Terrific. And then kind of qualitatively on margin, could you kind of rank order what might be the highest margin and what might be the lowest, and kind of where military falls in that?

So military is nice, but I'll rank it for you: commercial MRO would be the highest; then military MRO; then military OEM; and the last would be commercial OEM as far as ranking on margins.

Okay. And then when you package it all together, are you looking for -- we've talked about the 30% decrementals on the legacy business. Would the same be true in aero for Q4?

Yes. So our target, really, for all of the business groups is 30% decrementals, and that's beyond Q4. So whatever the future holds, we're designing a flexible cost structure to respond to what happens in the future. And hopefully, we move from talking about decrementals to talking about incrementals, but we feel very good about -- again, I would emphasize approximate 30%. This isn't down to an exact science, but approximate 30% decremental for aerospace and all the other reporting segments in North America and international.

Okay. And then this is a question from an investor. Kind of based on what you see out there for aerospace, are you concerned about any heightened risk for write-offs within the aero business, again, given the end market dislocation?

You're referring to goodwill impairments, Andy? Or...

Yes. Yes, exactly, Tom.

No. Don't feel -- we're in very good shape. We do that process, the review of that, continuously and more in good shape on that. We do that by business group, and all the business groups are in good shape.

Okay. And then the other concern, based on the questions coming in, seems to be leverage and balance sheet. And with respect to that, on the call, you made it very clear about intention to reduce gross debt-to-EBITDA leverage to 2 from 3.8 at the most recent quarter end. Pretty clearly, in the short term, EBITDA is probably going to take a hit, but may not have been expected when you're putting the plans together. But how should we view that goal against the prospects for EBITDA that may be lower for some period of time. I think the achievement was targeted at fiscal '23. Would that be pushed out? Or is it more -- kind of, more about the magnitude of debt reduction?

So on that target, that's an important target for us, and it was originally planned at the end of FY '23. And I think that's still a pretty good number. I mean if we're off by a quarter, it's going to be in the neck of the woods, and we have a lot of opportunities. This great shutdown that we are feeling right now is not a permanent, and you're going to eventually start seeing improvement in the great unknown as at what pace and what timing. We have the ability, with all the things we laid out at Investor Day and Win Strategy 3.0, to generate a lot of margin expansion via self-help what I would consider minor growth to support that. So you're going to see margin expansion once we eventually -- it will be post once we go down here and we stabilize at some number and you start to move off of that, and we don't know what that trajectory will look like, once you start to move off of that bottom, we should start to see margin expansion as we go out the next several years. And we still have opportunities with working capital on the legacy business to improve, and we have opportunities with working capital with the acquisitions that we acquired. So I think there's lots of opportunities to continue to improve cash flow. You've seen what we did on EBITDA margins already over the last number of years. When we -- before CLARCOR, they were 14.7%, as in the course of the last quarter, they're 19.3%. So we had big movement, but there's big opportunities still. Win Strategy 3.0 has got a lot of really impactful margin accretive type of things that we can do in a relatively modest growth environment. So we'll get there, and I think we'll get there relatively close to the original target.

Okay. And then a couple more on the leverage. And then I would like to get to The Win Strategy 3.0. One is fairly detailed. How should we consider the cash on the balance sheet with respect to being available for capital deployment? Are there any restrictions? And could you ballpark kind of percentage of free cash flow from domestic U.S. operations that could be used to fund dividends and debt reduction?

Okay. So on the cash side, and Robin, feel free to jump in on this as well. 70% of our cash generation is in the U.S., and we continuously look at ways to how to repatriate international cash. Our international cash is around $700 million. As you probably saw last quarter, we brought back $300 million. So we look at the most tax effective ways to bring that back. Now of the $700 million that's there, we need to keep about $250 million for working capital. So that would be what you would need to run the business on an ongoing basis. The balance of it is really just a matter of looking at whether there's a need to do it and the friction cost that would be incurred, which should be approximately mid-teens to do it. But I like our opportunities. We typically have not needed to do that with the kind of frictional cost. We've had enough -- strong-enough cash flow, and you've seen our track record of 18 consecutive years of greater than 10% CFOA and greater than 100% free cash flow conversion. But if we did need to, there's opportunities to do it with some friction costs, but we also continue to look for ways to do it in a frictionless process. And certainly, anytime we find a frictionless way to do it, we will bring that back for sure. Andy, you there?

Sorry, Tom, I was speaking with a mute on. One question kind of on the negative side and then one on the kind of flip side. So on the negative, it seems like a lot would happen -- have to happen to get there. But would the company ever -- would there be any effect of potentially operating Parker with high-yield ratings? And then on the flip side, once things stabilize and cash flows get better, what sort of exposure out in '23 might you be looking to potentially add through acquisition?

Okay. So I'll start on the high yield, and I see that as basically not going to occur. I mean almost 0% probability of that happening with our cash flow history, and just look at what we did in Q3 and the margins we did and the actions we've taken in Q4. So I think that's extremely, extremely unlikely. But in a hypothetical, if it did, we have 7% of our debt is already fixed, and our average interest for the entire total debt is 3.2%. So it's really not -- our debt structure could not be impacted that much if something like that was to happen. So I think that's -- again, I would put that at very virtually 0% probability. When cash gets better and we start to look at capital deployment beyond debt reduction. Our priorities are consistent with what we've talked about before the acquisitions, one would be the dividend payout and maintaining it and maintaining our increased track record, that's very important to us that's going to happen. The capital spending we do for organic growth and productivity will continue today. We're being a little conservative on that. We'd probably open it up a little bit more, and then we would evaluate whether we would -- at some point, as we collide down to 2.0, we'd look at starting up 10b5-1 again. But then as you get down to 2.0, it's then the trade-off that you look at between strategic acquisitions and discretionary share repurchase, and we'll continue to do that like we would in the past, where we try to make the best decisions on behalf of our shareholders to maximize returns. And if we went down the acquisition path, we'd be looking to do similar to what we did in the past, where we acquired companies that upgrade the portfolio and make the portfolio more resilient from a top line standpoint and are accretive on margins. And that's what has happened with the last 3 acquisitions, and that's why you've seen those EBITDA margins improve so dramatically. The base business has improved its profitability through The Win Strategy in that we bought companies that were accretive. So that's been a nice one-two punch for us. So we would continue that track record.

Okay, great. And then now Win 3.0. And you outlined your longer-term strategy with that, pretty much just as all of the COVID-19 issues were gaining momentum, is there anything you're seeing maybe outside of aero and energy markets that was kind of touched on on the recent call? Is there anything you might be seeing that might impact that goal achievement? And then within that, you really stressed developing the culture of ownership. And in the short term, how do you really balance centralized actions against fostering decentralized decision-making?

Okay. So maybe, Andy, I'll take it e at a time. First of all, goal impact with Win Strategy 3.0. The one thing that -- for our investors, who we launched this internally in September. So our team has had time to digest it and internalize it, start to get traction on this. We went externally in March at IR day because that was the right forum to do it, but we've had a running start internally on this. And I would just say, and I'm not saying this because I'm part authoring this, it was very well received internally. It had a lot of input from our team, and it was recognition of feedback that we got from Win Strategy 2.0 that we wanted to adopt the next time we were going to update The Win Strategy. So it came across very positively. And really, what people are using it now is it's very helpful to help them manage through today's crisis. You have the normal playbook, but the ownership equation is really important to help people through the current crisis. It links very nicely to the purpose statement on why we're an essential manufacturer, simple by the design, is even more important now. And as we look at -- looking at existing partners and now we take that same concept into the existing partners, Kaizen, all the things we talked about at Investor Day to highlight for you some of those changes. Our tools that people recognize, if you're running one of our divisions, they are very impactful and very helpful for you to survive in this tough environment. So I'm not worried at all about losing traction. If anything, I think this is -- the crisis has kind of spiked the interest here and the need to drive 3.0 even faster. A culture of ownership is something that -- well, first of all, culture is something the company has been working on for 100 years. And it's like the muscle membrane of the company, and it's -- it doesn't go away, I think, because of the recession. And the ownership side of things is around our high-performance team structure, which we've been working on for a while. But I would tell you that I think people have internalized ownership and our purpose statement, even more so given this crisis, because it's layered in a level of urgency and emotions around what you do every day and the impact you have on each other and impact you have on society. And I think it made Parker come to life, it made our products come to life in the eyes of our people and it reinforce where we're trying to take the company. It was like putting a giant steroid injection into the purpose statement because of the current crisis. Now that whole central versus decentralized is a normal kind of structural tension that is constructive because I think having worked in centralized type of areas and pure decentralized, I view that what we have is kind of a mixed model. It's a hybrid of both, where you have The Win Strategy, which really acts as the central business system, and is deployed locally by all these divisions, which allows us to go fast because we can make some decisions from the center, but we get a lot of input from the divisions. And then we -- it's not like I have to manage 56,000 people. We have all these division general managers that help do that, and they're the ones who are on the ground making this happen. And without them, the company is not successful. So this structure, this decentralized structure, has been one of our secret sauces. It's much more impactful to people if they can feel a closeness to customers and a closeness to the P&L. Nobody gets jazzed up to be part of a call center and some giant centralized function, and you can't tell whether you're winning or losing. So we very much have always wanted to have the company designed to know whether you're winning and losing. What do your customers think of you? And are you making money? And that's the key ingredients -- and how do your people feel? Those are kind of the 3 key feedbacks, and we track all 3 of those. And you can get that more directly in a decentralized structure, but the benefit and where we think the company took a significant notch up is when the original Win Strategy came out. We've been building on it ever since, where we layered in this central business system with the decentralized structure, that's really what -- and you saw that graph I had at IR Day, and it was in the earnings call last week, where I showed that stair-step in operating margins. That was really the best of both worlds where you leverage central and decentral.

Yes. That is an impressive chart, Tom. But -- and I guess to that, if we -- and I know '23 is a bit of a ways away, but if we go into an L-shaped recovery, do you then have to look at the goals and kind of reprioritize some just because the top line might be more challenged than you may have thought? Does the reprioritization mean more attention gets paid to the return generation? Or do you think you can hit both based on what you see?

We feel good about still hitting those FY '23 goals. I would put a little asterisk by '23 because that would be in what we would consider normal business times, not a recession. But it doesn't need to be something with a lot of tailwind. Now this immediate period of time is we've got to get through this, and that's why you saw us take such aggressive actions to make sure that we stay on top of this. But we're eventually going to stabilize at some new point, and we're going to start to grow off of that. And the big debate, of course, is what shape is that and at what pace and what timing. And I think nobody knows. But there is enough self-help at Win Strategy 3.0 between all the things we outlined that we feel very good about our ability to expand margins at what I would consider just a moderate growth type of environment. It only needs to be a couple of points of growth for us to pull that off. We purposely designed things that gave us what can we control and how can we get better internally. And obviously, what we want to try to influence how we win business, we view that as an internal process as well. But we're going to do things significantly better on how we win. On the growth side, you've already seen us become more resilient over the last several cycles and I hope Q3 demonstrates for a lot of people resilience as a company. So that's going to continue. But Win Strategy 3.0 gives us a lot of upside to continue to build on the progress we've had so far.

Okay. Terrific. And then we have a question from an investor, it's kind of a broad-ranging question. We've got 2 minutes left so I'm not sure we can address it all. But how would you characterize Parker-Hannifin's opportunity with respect to kind of the broader electrification trends that seem to be unfolding in the economy?

I'll try to be short. We like our chances a lot on that. As a matter of fact, I view that as an opportunity. We're one of the few players in our space that has multiple motion and control technologies, meaning that we can do whatever energy source the customer needs, hydraulic, electrohydraulic, pneumatic, electromechanical, and we can put all the surrounding technologies with it. So that's a big advantage that we have, that we're energy agnostic, we can do whatever is needed. Then if you look at LORD is a classic example. So when we acquired LORD, it added to our portfolio being able to help customers as they migrate from traditional energy sources to hybrids to battery-powered, because now we have a much more comprehensive with the structural adhesives and thermal management to go along with the shielding and the sealing that we have. So when we go to customers now, we have the best offering on a material science standpoint to help them with electrification as well. So its upside, our bill of materials goes up in a more electric world. So we view it as more of an opportunity than a threat.

Okay. With that, we're pretty much out of time. I'd like to thank Tom and Robin for participating in this fireside chat and for all the investors who took the time to listen in. And hopefully, everybody found it worthwhile. So with that, I'll sign off, but thank you, Tom and Robin.

Thank you. Thank you, everybody, for joining.