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

Good morning, everyone, and welcome back to the morning session, day 3 of the Goldman Sachs Industrials and Basic Materials Conference. This is Joe Ritchie, Head of U.S. Multi-industry Coverage and very excited to have on the line now from Parker Hannifin, Lee Banks, President and Chief Operating Officer. Lee, thanks for being with us here today.

Thank you, Joe, and thank you for everybody on the call for attending.

Well, why don't we just kind of get right into it, Lee? Look, I know that you only reported 2 weeks ago, and half your business goes through distribution. But I guess folks are -- folks right now are really kind of like itching for any type of like whether it's either specific data or just where trends are kind of heading. And so I'd be curious, like you guys gave us April quarter-to-date trends, down 30% to 35%. Maybe just touch a little bit about kind of what you're seeing, specifically across regions or end markets, and then we'll just take the conversation from there.

Yes. So I don't have -- I'm not in a position to give you any guidance for the quarter, but I can give you a little color on what we said last quarterly call. I think the first thing before I even start with that, just for clarity, the 35% to 40% down, it's really important to confirm to everybody that those are 1/12 numbers at that point in time. We almost always, on the industrial business, always reported 3/12, and we reported 12/12 on the aerospace. But because we saw such a marked drop-off in the second half of March and then in April, we just wanted to be transparent what was going on with industrial and aerospace activity. The only region that I really have enough insight on to give you some color about is Asia, but I will comment at the end a little bit about how things are progressing in the other regions of the world. But just to kind of level set everybody on Asia, I mean, it's really -- it varies by country, but I think the important trend to understand is what's happened in China. So China in Q3, sales were down 30%, February, they're down 40%. And then March, they snapped back to flat on a year-over-year total. So for Q3, we were down 22%. And I would say all industrial activity in China, all facilities, by and large, are up and running, and I'll talk more about that in a second. When I think about China, Japan and Korea, we're forecasting those down about 5% to 10%. Japan's had some varied shutdowns coming back off of shutdown. And then in ASEAN, it's been slightly positive, only driven by some activity in life sciences and semiconductor India activity. In India, it's been down high teens. I think the positive side with India, when we gave the call, it was in virtual lockdown, it's coming back off of lockdown. Now just kind of swagging it, it's in that 50% to 70% capacity coming back on stream. So positive things there. So when I think about Asia as a whole, we're definitely going to be down in that 5% to 10% area. There's some other really cloudy things when it comes to Asia Pacific, though. I mean there's a lot of global trade uncertainties going on and especially impacting the China economy. And then there's, quite frankly, a lot of credit issues with small Chinese companies that need cash. So those are being resolved as we talk about going forward. But other countries that were partially shut down, I think, slowly are coming back. Economic activity in Singapore, Malaysia and Indonesia are rebounding back, as I talked about. When I think about the other regions, Joe, what is encouraging is Europe is slowly waking up. I mean, Italy, I would say, virtually all across the region, were back to manufacturing capacity now. And in North America, all facilities are running. We talked about the last -- at the call, many customers being shut down, and we expected those customers to start coming back online here in May and into June. And there's puts and takes on how that's going, but by and large, that is happening. So it's still a very dynamic situation to be sure, but that's the best kind of color I can give you on the quarter right now.

Yes. That's helpful. And I fully appreciate the fact that, like, look, we're only a couple of weeks from when you reported. And I know half of your business kind of sells through distribution. But maybe just one of the things that Tom had kind of noted was that things had stabilized over the last 2 weeks in April. Maybe you can talk about like more specifically around what was driving that stabilization? Like what were you guys really seeing, whether it was the distribution business or whether it was the direct business? Just any other color around dynamics around what was stabilizing would be helpful.

Yes. I would -- the stabilization, we saw a period of there about 2 weeks that, again, I don't have the numbers right in front, minus 40%, minus 35% on industrial. But I would say that OEM and distribution was virtually in sync on the percentage down. I know I personally did a touch call with probably, I don't know, 30 of our distributors, just to talk about markets and what was happening, and it was very much in sync with the economic -- OEM economic activity that we saw. And as you can imagine, you had -- and it's still shut down, but coming back, all the automotive facilities shut down, so they're not buying any MRO or putting any CapEx in place for new platforms. All the -- many of the truck OEMs were down. I mean you just go through the economy, a lot of facilities shut down or really, really conserving cash for only critical things. So the nutshell is OEM and distributor activity were both down equally.

Got it. Okay. But maybe just kind of touching maybe a little bit more on the commentary then from your -- the distributors that you mentioned, the 30 distributors. You're in constant contact with your customers, with the distributors. I'm just curious, like how are you thinking about where we are from an inventory perspective? This is -- as I kind of think about both North America and your international businesses, you've seen some negative growth in each of those businesses, each of the last 4 quarters. So I'm just curious, like, are we through or are inventories fairly lean? Just any color on the inventory situation would be super helpful.

Yes. So it was clear to me. No distributors were buying ahead at the end of March or beginning of April. Everybody was conserving cash and kind of liquidating what they had. I've seen these inflection points in past recessions. What will happen is there will be a quick pull-through on demand, both on the OEM level and on a distribution standpoint. I suspect on the OEM level, there probably is -- most of these OEMs are running just in time. And as they come back, they'll ramp up slowly, but that demand will pull-through from an OEM standpoint. And on a distribution standpoint, I think what you'll see if we start to get some legs behind the economy is a quick snapback in activity.

Got it. I mean that makes sense. And it's pretty consistent with what you guys have been saying even several quarters ago before we kind of hit this downturn and had this perfect storm with both COVID-19 as well as what you were seeing from a MAX perspective. So that's helpful color on the recovery. Maybe kind of shifting gears a little bit, Lee, and just kind of talking about the cost-out actions that you guys outlined. So just to level set, $250 million to $300 million in 4Q cost actions, about $25 million to $30 million in long-term structural. As you think about the $250 million to $300 million, do you think all of that comes back in fiscal '21? Or how do we think about how you can flex that number and whether there's a portion of the temporary actions that don't come back next year?

Yes. Joe, so it's a great question. And I'll be honest with you. It's like we always get this question every recession we go through. So it's a great chance to just kind of tee up some of the things we're doing. There's a slide we've showed in our investor deck, and I -- we may have showed it on the last earnings call. I think, in fact, we did. And what it is, it's a staircase of margin improvement through past recessions. So in FY '02, it shows the floor of where our margins were. And then as you can see, FY '02 was a recession, FY '09, FY '13, FY '16 and FY '20. And it just shows margins sequentially going up over that period of time. So I've been a senior operating executive in the company through every one of these recessions. And what I can tell you, every time you go into recession, there is a dramatic cost-out initiative to get capacity in line with the new realities of economic activity. But it's not a static business model. It never all comes back. And what happens is when you're adjusting on variable or fixed cost, you make different decisions on how to streamline your organization, outsource different things, just make yourself better. It really gives you a pause to rethink what you're doing to create value and how you can do it differently and more effectively. So to give you an exact number on what comes back and what doesn't come back, I couldn't do that. But I would tell you that you will see the margin expansion going forward. As we go forward, you'll see nice incremental margin improvement as we come out of this. You'll see very good cost control and decremental margin improvement as we're in this. Yes. I mean, I'll stop there, Joe, and if there's any clarification on that.

No, that makes sense. And I'm very familiar with the chart you're talking about. It's pretty impressive performance over the last few downturns. And where you guys are today than where you were 15 years ago is pretty incredible. Maybe just staying on this for a second, but I failed to mention it earlier. If anybody in the audience does have a question, feel free to shoot me an e-mail at [email protected]. And then also, you can send me questions via the web link as well. But maybe just kind of staying on this topic for a second. Lee, you guys have talked about Win 3.0 as kind of like the driving kind of like governance force but behind a lot of this, the margin expansion over time and going forward. And so maybe just talk a little bit about like how you're expecting to simplify your operations on the go-forward basis to drive stronger margins? And then has anything potentially changed in the way that you're going to be operating your business because of the backdrop that we've experienced in the last couple of months?

Yes. Thanks, Joe. So I think it's important for everybody to understand that this performance or this increase in performance of the company over the last 20 years started 20 years ago. It started with Win Strategy 1.0, if you will, when Don Washkewicz was the CEO. And we've been building on the performance of that business system through time. So -- and then when Tom and I were putting our new jobs in 2015, we refreshed the Win Strategy to 2.0 and really amplified the success we had from 1.0. And I think 3.0, it's hard for you to judge as an outsider. But internally, it's just got so much gas to it that people are incredibly excited because they've helped author it, and they can see the path going forward. One of the things that I just got off a webcast on before we hung up, which is new to Win Strategy 3.0 is Simple by Design. This is an initiative of standardizing on how we design products, but also cost out products across the enterprise. I mean when you're in a manufacturing world and you've got 300 manufacturing plants and hundreds of thousands of SKUS, complexity, just by its nature, enters into the products you design day in and day out. And this ability to standardize across the company, how to design product simply and build across and eliminate complexity is going to be a real home run for us. I know you'll ask me, well, how much is it? And I'll repeat what Tom said, it's big. And we'll build on top of this. But along with that, the power of Win Strategy 3.0 is just the enterprise as a whole and the culture of continuous improvement and innovation that this company has. I mean, I couldn't be more proud of what we've innovated during this COVID crisis on behalf of medical institutions and couldn't be more proud of the really continuous productivity this company derives through a culture of kaizen inside the company and our Parker Lean System. So I'll stop there. But there's no -- is there a -- I'd say the only pullback has been, we've been really cautious about people traveling in between facilities right now until we get this crisis stabilized. So there's been very little travel. But lots of touch points with Zoom meetings and still, myself, keeping in touch with all the kaizens going on around the organization, and Tom and I are both doing that. So I...

That makes a lot of sense. Yes. Sorry.

No, no. I was just saying, we're not hampered by executing on Win 3.0 because of COVID.

Got it. That makes a lot of sense. So it's -- I guess it's a good thing that I reached out to the audience to make sure they could send in questions because now I've gotten a few of them. So maybe just going to the audience with this specific question. Lee, what end markets are you most optimistic about and most pessimistic about over the next 12 to 18 months, assuming that the pandemic issues are mitigated?

Yes. So again, I'm probably going to repeat the color I gave you or Tom gave on the earnings call. What's really strong for us right now is the whole military market, life sciences and microelectronics. Those are all doing very well. What has been down, things you would expect. I mean oil and gas is down significantly. I'm not optimistic about oil and gas. We're taking significant restructuring, structural restructuring, things about that across the enterprise. Commercial aircraft, commercial transport, I'm not optimistic about that at all. I think it will be 3 to 4 or maybe even 5 years before we get back to the level of travel that we had. So we've had significant restructuring in those areas to kind of get ready for the new reality. Yes. I'll stop there. But I mean, other markets that are down, construction equipment is down, heavy-duty Class 8 truck is down significantly, and that was a cycle that was bound to happen before COVID hit. It was just overbuilt. And rail is down right now. But I would say the most pessimistic I would have is oil and gas and commercial transport.

Got it. And I mean, just going back to the comments you made earlier around -- because things are lean, I guess, on the factory floor is really kind of what -- the way to think about, call it, short-cycle industrial activity, you would expect to recover quicker, assuming, obviously, like these pandemic issues do kind of subside?

That's correct. That's correct.

Okay. Great. And then another question from the audience. Obviously, you made 2 big acquisitions over the last 12 months. And this person would like to know how LORD has performed over the last 2 months and then really kind of specifically really thinking about like the auto piece of the business because it does have some exposure there. But clearly, there are parts of auto that are doing okay, given EV penetration. Just any color around that would be helpful.

I'll start off just talking about LORD as a company. I couldn't just be happier with the way the integration has gone and also the cultural alignment inside Parker Hannifin. I mean you would think we've been joined at the hip for the past 103 years. I mean it's just so symbiotic the way we operate. And the other thing about LORD is just a lot of great talented executives came on board that want to be part of what we're doing as a company. They see the synergies inside the company going forward. We can talk more about the synergies we pulled forward, but let me give you just a little color on the business. So as you know, roughly 1/3 of the business is automotive, 1/3 is industrial -- I'm sorry, 1/3 is aerospace, 1/3 is industrial, 1/3 automotive. And on the 1/3 aerospace, our heavy content is really on rotorcraft applications. So that's still doing very well in this environment. A lot of military applications, commercial rotorcraft being used in commercial logistics applications, et cetera. On the 1/3 industrial, it's a mixed bag, as you could guess. I mean there are some end markets that are down. There are some that are doing just fine. And then on the automotive, yes, the combustion engine automotive has been down, although that's coming back strongly in China, but we've been very active on electric vehicle applications. And our content is up significantly on those applications. And that's held in there quite well. So I think the best way to characterize LORD from a top line, let's say, it's 50% better than what Parker Hannifin is doing and driving strong EBITDA margins in the company, 27% plus. From a synergy standpoint, we're able to pull in $30 million of synergies year-to-date. And what's so exciting about that is there's just so much more we can do. But it's mostly an SG&A play, and it's got all kinds of tools inside the company to kind of streamline what we do in front of the customer, which we're working on. And we do this lockstep with LORD management. And the other side of that is where the synergies are not on big facility rationalizations. Those are always very tough. We went through that with CLARCOR, which was a handful. We're past that today. So we're kind of off to the races. And every single day, it's just getting more and more integrated.

No, that makes sense. And it was -- that was super helpful color, breaking down LORD from an end market perspective. Obviously, the other acquisition that you guys did over the last 12 months was Exotic Metals. And look, some folks that I talked to have questioned the timing of the acquisition, just given what we've seen on the commercial aero markets. And I know, I think about 60% of your business there is tied to military. So maybe just talk a little bit about that acquisition specifically and how you feel about it now versus when you bought it and then also how you feel about it longer term.

Yes. Joe, what I think I might do is just take you a step back and just talk about aerospace as a whole, and then I'll drive down into Exotic.

That'd be great.

Because I think it's important for the audience. There's a lot of press over aerospace right now, a lot of concern on commercial transport, and it's warranted. But I think it's important for everybody to realize, it's 20% of Parker's business, 80% of what we do is industrial activity. And when you think about that 27%, 67% of that is commercial activity and 33% of that is military. On the 67% that's commercial, 48% of that is OEM activity, 19% is MRO. And on the 33% military, 20% OEM and 13% MRO. So bringing Exotic onboard, this is a company that we had courted for a long, long time, knew the family, and they've done a great job building a very strong platform around the engine, both in commercial transport but also in military. And they're on all the best programs. So what's gone away for them right now is the commercial transport, but what's very strong for them, which is 60% of their business, is military. And we're on the F135 Joint Strike Fighter doing the engine buildup on that Joint Strike Fighter. And we've got strong demand on that, and we've been able to shift some of the demand that was consumed by the strong commercial buildup to the military, which is being pulled by our customer. So it's -- if you follow the F-35, it's got a big backlog. There's plenty of opportunity to continue to grow here. So you're right. I mean none of us really foresaw the huge pandemic going forward when we did this. We did know about the MAX situations when we got into it. And we were so confident that, that would resolve itself with time. It still will, but we were very excited about the military exposure. So great company, and I can't say enough about the Exotic team.

Now that's great, Lee. And I guess just maybe just following up on Exotic and in the context of what you've said about aero, I think you talked about aero trends being down 40% to 45% in April. How did Exotic do relative to those trends? And then also, the decrementals in Exotic, is it possible for the decrementals to remain in the mid-20s? Is that the expectation?

Well, the mid-20s must be a number you backed into, Joe, because I don't think we ever gave that. But the -- what I would tell you is Exotic is not down as much because of the military exposure as the baseline arrow, which is dominated by commercial. And we operate that business under the same guys, no worse than 30% decremental, which is world-class, top quartile performance, but they're operating very well. And I think the other thing, this is a 24% EBITDA margin business that we know we can expand over time.

Got it. Okay. Great. And then -- I'm sorry, did you have something else to say?

No, no, I'm okay.

Okay. Cool. So maybe just going back to aero more broadly. Last quarter, you kind of called out about a $0.30 impact from MAX in the second half of '20. Like, I guess, how should we be thinking about the impact to the first half of '21 and then potential tailwind in the second half of '21, just given like the dialogues that you're having with Boeing? I'm just trying to understand what your base case is right now.

Yes. So Joel, we're not going to comment on '21 yet. We're going to give you guys a full update, the best we can, in I guess it's August, yes. But we're still working through that with Boeing. I think Boeing is still working through that themselves. So I think we'll make a much better position to give you better clarity. But from our operating standpoint, we pulled out 100% of the MAX, as you know, for this fiscal year. We didn't have that in any of our forecasts. And we won't put it in our forecast until we're confident that we've got good line of sight going forward with it.

Okay. Makes sense. And so Lee, I've got a couple more questions from the audience. The first one is, do you see any global supply chain changes due to the China challenges and any risk associated with it?

Yes. I get this question all the time. I think the important thing for the audience to realize for Parker Hannifin is we make in region what we sell in region. So our supply chain, by and large, tends to be localized to the region that we are selling. So what we have -- and this has been kind of a hallmark about what we've done is we don't have big supply chain issues across the company that are material. Yes, there are instances where we supply something from China for North America, but it's a very exception to the rule. So we're pretty comfortable. It's not a burning platform inside Parker right now.

Okay. Great. And then the next question from the audience is, specifically as it relates to your oil and gas business, how are you restructuring that business specifically?

Yes. So oil and gas for the company, it touches probably 7 different divisions across the company. So out of 84 divisions, there's probably 7 or 8 that touch it significantly. And we've just done significant fixed cost and variable cost restructuring there. There is no significant plant closures attached to that. It's more about just getting our support costs in line. We have adjusted support costs, fixed costs that are associated with that business. We pared back on some distribution centers that would be focused on that business. But that's how we've done it. It's kind of a spread out across the organization, if you will, a little different than aerospace.

Got it. And maybe, Lee, just kind of shifting gears a little bit, just talking more on the balance sheet and liquidity and your leverage. It was great to see the debt reduction this quarter. It's been such a focal point for your stock. Maybe kind of step -- for those that haven't been as close to it, maybe step through some of the things that you guys have done to increase your liquidity. And then also, do you expect any further reduction in debt in the fourth quarter?

Yes. So Joe, you followed us a long time. This is a strong cash-generating company. And just for the audience, last quarter, we generated $1.3 billion in cash year-to-date and a CFOA of 12.3%. And we reduced -- I think we paid down right around $611 million in debt reduction. We've got a target. Our current debt-to-EBITDA in Q3 was 3.8, and our target is 2.0 in FY '23. And I feel very confident that we'll have a strong cash generation quarter this quarter. Very confident in that. Just to think about the makeup of our cash, 70% of that cash is generated in the U.S. And I call that out because we will bring back cash internationally if we can do it in a most effective way possible. We need about $250 million of working capital internationally to support the businesses, but we brought back $300 million last quarter. Another important thing, I think, for the audience in today's environment is all our regions are self-funded. So they generate cash to support themselves. We're not paying or sending working or sending cash here to support the regions. They all do a great job. That's something we've got great discipline around. So yes, 18 consecutive years at 10% cash flow from operating activity and 100% free cash flow conversion almost 18 years, and we will not break that streak this year.

Yes. No, that makes sense. And then I guess maybe just, I guess, probably worthwhile you touching on the one financial covenant that you have and then just the results of the impairment testing? And maybe if you can even just give a little more color around how frequently you guys will be looking at your assets and doing those impairment tests. I think that would be helpful as well.

Yes. So we do those impairment tests once a year and the impairment tests are done at the group level. We rolled those up. Our coverage and the carrying cost for those businesses is very significant right now. There's no risk of impairment that we saw based on the latest rounds we just did. I think it's important to remember, we've got roughly $2.5 billion in capital headroom on the debt covenants we have in place. So I really don't see any -- this is not something I go to bed at night worried about is doing this. So I'm very confident that we've got the cash generation to meet our responsibilities going forward. I know it gets a lot of -- people talk about it a lot, but I'm very confident we'll be able to do that.

No. That makes a ton of sense. And I do appreciate that color. I'm going to end with one last question. It's a theme that everybody is talking about these days, and that's reshoring. I would just love to get your view on whether you think that is something that is potentially going to be needle-moving and whether you do expect to see a lot of investment being poured into potentially onshoring certain businesses and certain end markets and localizing supply chains globally.

Yes. So I mean, it was interesting to see TSMC putting up a new semi chip plant in Arizona. I was interested in reading that. Listen, I don't know. I can tell you from Parker's perspective, just to reiterate what I said before, we make what -- we manufacture what we need to sell in the region, and that's our strategy. It always has been our strategy. So we don't do -- we don't build plants in Mexico to export back to the U.S. or build plants in the U.S. to export to Europe. We manufacture where we need it. So from our company standpoint, I don't see any shift in our strategy. Time will tell on some of the supply base in other industries. I'm not sure I can really say with confidence how that will turn out.

That makes sense. Look, we appreciate the time today. Enjoyed our conversation. Have a great weekend. And again, just thanks for participating in our conference.

Thanks, Joe, and thanks, everybody, in the audience. I appreciate your time.