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

Good morning, and welcome to the Wolfe Research Global Transportation and Industrials Conference. This is the Parker-Hannifin Corporation Fireside Chat hosted by Wolfe's senior analyst covering electrical equipment and multi-industry, Nigel Coe. [Operator Instructions] And now I hand the call over to Nigel.

Thanks, Allie. Yes, good morning, and thanks for joining us. I'm very pleased to be hosting Tom Williams, Chairman and CEO of Parker-Hannifin. Tom has been CEO for 5 years now and has been really instrumental in transforming the portfolio and the operating system of Parker-Hannifin. Tom, I think the last time we had a chat, I think was way back in 2011 at the old Deutsche Bank conference. So that feels like a long time ago, and it was a long time ago, so I'm very grateful for your time today. The format of the session is going to be Q&A. I'll direct the questions. I will pause to see if there's any questions from the audience. [Operator Instructions]

So Tom, before we get into maybe a quick discussion of the current macro environment, I'd like to take a step back and maybe just review the progress you've made as CEO of Parker-Hannifin, and maybe talk about what you're most proud of in terms of your accomplishments so far and give us a little glimpse of the road ahead for you.

Well, Nigel, thank you for hosting, and welcome to everybody that's listening, and we appreciate your participation today. A couple of things, I think when Lee and I started in early 2015, we were fortunate to be taking on a company that was already very successful and had a great foundation. But there are 2 things we really focused on that we wanted to change for the future, one was the strategy of the company and the other was capital deployment. Now the strategy of the company was well-established, the Win Strategy, which started in 2001, very successful, but we recognize that it'd become the business system of the company, which was a good thing. But if you wanted to change the performance of the company, we had to change the business system as well. So I think the changes to the business system and the performance have been some of the things we've been most proud of over this period of time. A lot of changes that we did in 2015, were Win Strategy 2.0, which were around the whole engagement of our people, high-performance teams and focus on safety. On customer service, we moved that to customer experience, and we have focused on being easier to do business with e-business, and we rolled it out at the first Net Promoter Score like metric, we call it Likely To Recommend. We moved into focusing more on a dynamic metric on organic growth or profitable growth growing versus the market and a focus on international distribution in particular. And in our net financial performance, we launched a simplification initiative, and that was very impactful for the company back then as well as all the way to today. Then over for the last 4 years in 2019, September of last year, we have learned a lot with Win Strategy 2.0 and said, "Hey, there's an opportunity to continue to take our game up, and then it's 3.0, which we share with everybody externally in March." And some of the highlights for that is really on engaged people. We saw the power of linking Kaizen, Lean, high-performance teams and safety. And that was really going to create an ownership culture for us, and so that was a big part of our success there. On customer experience, we wanted to expand our thinking on digital to be more than just digital customer experience. We wanted digital products, digital operations, digital productivities, the use of AI and IoT and all those type of things. Earnings growth, we really expanded our view on innovation to be more outside-orientated with the new product blueprinting, and then our product vitality index is a metric to measure how well we're doing that. And then we launched Simple by Design, which we try to give some good examples with all the analysts and investors at IR day. And over this course of period of time, you've seen, I guess, if I had to tell you 2 metrics that I'm most proud of, one would be the safety performance of the company, which is more from fourth quartile to first quartile. And then the margins of the company have improved dramatically over that period of time. You would remember from the earnings call, in one of the slides we had that stair-step that showed our performance over the last 5 recessions. The fact that we did 19.3% EBITDA and 17.3% operating margin on the base business, not kind of the acquisitions, the EBITDA is with the acquisitions. In this kind of environment in Q3 really speaks to the cumulative effect of all the work that's happened over the last 5 years. So maybe a longer answer than you wanted, but that's what we're proud of so far.

No, I think that fairly, to my mind, the most visible success is to see what's happening to margins, and I know there's a lot of work because [ beneath that ]. But what are the hallmarks of Parker-Hannifin in June '15, '16 time frame. I think what we're seeing right now is as your debt on margins are much, much lower than the past. Maybe just talk about what's changed in terms of responsiveness to the change in demand conditions and your fixed cost base to enable you to maintain margins, set definite margins in that mid- 20s?

So what I said this many times, but to get ready for the current recession, you work on it a year before this recession. Obviously, there's things you can do in the current climate to respond rapidly, but you've really got to get prepared years in advance. So I would say the restructuring that we've done, the restructuring we did in '14 and '15, and then all the Win Strategy changes 2.0, 3.0. If you look at our fixed cost, we tend to look at fixed costs go to be traditionally defined via property equipment as well as your salaried personnel because it tends to be somewhat fixed or more difficult to move. And that's come down very nicely over this period of time. The number of divisions we've consolidated, outsourcing just our productivity in the facilities. That's helped us dramatically, and I would just give lots of credit to our operating team. We were in much better shape, so we were leaner and more productive coming into this downturn. But then the responsiveness, globally, all of our team members, with a combination of structural actions we took as well as what I describe as discretionary, which were things we could flex with order entry. And basically, if you look at our hours worked, we have flexed them to match order entries, so we've been able to get more elastic than we've ever been in any prior downturn. And the credit goes out to everybody, all the team members, the works councils, all of our leaders working in a very collaborative fashion to respond to this crisis in a fashion like we've never responded to anything before.

That's great. And then we get up a lot by investors. How important is the Parker stores, the distribution strategy, how it differs from some of the competition? And then maybe internationally, what you're doing to broaden that footprint internationally? So maybe a good way to -- maybe you can de-socialize this, how important is this? How is it? And what is your investment strategy?

Okay. So maybe a little bit how we're different than certain competitors. I would say we're more balanced on direct versus distribution. A lot of our competitors probably have a more direct model. That's maybe an over characterization, but it's probably -- and we're all close. Our distribution strategy, and I'll get to the store element part of it, is what mix do we need to have of multi-technology distributors. So there's a certain number of those, we're going to have system capabilities, application experience. So we call them multiple technology distributors, single-line distributors, which are focused on a specific technology, the Parker stores, all the whole retail part of it, Parker containers, close [indiscernible] or mobile, that becomes the comprehensive distribution strategy as a whole. Now the stores, when you look at the stores, they are geared more to your aftermarket to break/fix. That relationship that a person has, an equipment owner has with the person behind the counter because that person helps troubleshoot the issues how to get that part for a store to replace very quickly, and so that becomes a lifeline to their equipment uptime. What we see with those stores is they tend to outperform the rest of distribution. So when distribution goes down x, the stores go down about 1/3 of that. So they tend to be 3x more resilient than the regular channel, and that would make sense to you because it's all the pure aftermarket is what the stores are doing. Now on international, that was a big part of our strategy back in 2015 as we wanted to shift that mix. It's part of why you see margins for international basically coming right up to North America because we've solved some of that mix issue. We've solved a lot of restructuring, cost structure for international. And you see those margins basically coming together. But so we shifted from 35% to 65%, that's just 35% distribution, 65% direct, to now 40% to 60%. And we mentioned in R&D Day, we'd like to keep doing that about 100 basis points a year improvement, and what we really did was -- we did a couple of them, we put a leader in charge of that globally as an initiative. We put more emphasis to make sure we had the right kind of channel managements. We have global OEM account management, national OEM account management, then we have distributor account management. And I think when we went internationally at times, we did not have that clear line of sight for sales leadership on those particular 3 elements. So we did that. But then we -- the playbook out of North America was -- we moved Parker people into the distribution to help facilitate that change. And so over these 5 years, we've moved 165 Parker people into international distribution, either working for a distributor or maybe they have a part equity position as well. And I don't like losing any talent, but I'm happy to have them migrate into distribution because they're as close as a family member they could be without being part of partner. And it really has helped -- we've added almost 500 distributors internationally over this period of time. And the commentary of all that is let's move that mix from 35% to 40% distribution. And we'd like to -- we'll get increasingly get maybe a little bit harder, but I think we're going to keep migrating to that 50-50 blend is ideally what we want to get to.

Okay. One more question on execution before we get into the trading environments. Given that you have a unique Parker store network. Does this mean that when you acquire in like CLARCOR, that is much easier to generate revenue synergies than perhaps a company that has a general distribution strategy? Is that the right way to think about it?

I think we've always tried to utilize both, because sometimes we acquire a company that has a great distribution channel, and so we want to leverage that channel as well as ours. I think what we do really well is we're good channel partners. We managed -- we have a lot of experience in doing that, and we understand the sensitivities about managing distributors versus OEMs. And so I think we do a good job of either keeping the channel like we've kept a lot of CLARCOR's distributors because they tend to call on different sets of customers. We wanted to keep that channel. There were areas where it was obvious where we could co-mingle products between both channels. But I think our strength is not necessarily, hey, everything we buy goes automatically into the Parker distribution channel, is that we are a good channel management company. And so we do the best of both channels. So if that channel is great, we keep it. If our channel is better, we keep ours, in some cases, we've cut both and then leveraged both of them.

Okay, great. Thanks, Tom. Okay. So can we move to the current environment? Obviously, we've heard from you in respect -- so I'm not expecting an earth-shattering change in additions. But obviously, additions are not quite dynamic right now. We have heard it from one company that hasn't truly reduced the 2Q sales guidance to a much smaller decline. Are you seeing any changes as we go into May that makes you more optimistic on the outlook at this point in time?

Not yet. I mean, I would say that what we gave you as far as what happened in April did happen in April that 30% to 35% decline, and that was stabilizing. And so far, May has been basically about the same. I recognize that as you still need time for the OEMs to come back up, a lot of the plant closures are just now starting to kick in. I think we haven't seen that yet. We have seen Asia turn like we thought it would, and Asia did snap back in March and had a pretty good April. I would tell you that because of their Labor Day work, it fits in May, they used a little bit in our customer extended holidays that first week in May. So I think for Asia, as soon as we'll get a good indicator of what I'll call real demand, will be June. Because I think March, April, you see kind of that pent-up snapback from the downturn of February, March. That was good. But I don't know that -- I'm not sure that's enough to add to say that's an indicator of underlying demand. May's influenced a little by their May holidays. So I think for us, it's going to be more June. But I would fully expect that this -- our sense right now is that this is hopefully our low point quarter-wise, and then all indicators would be we would start to gradually move up. And what I've described before is that's the great unknown is what does the trajectory of that look like. There's not enough data to know that answer.

And by the time we get to the end of this month, do you think that the majority of your OEM customers will be back online?

I think by the end of the month, yes. And the question is there's still rent, what line rates they're going to start the lines.

Right. And then your channel, we be talking about distribute and destocking for quite some time. So I mean, it's not like we came into this with overstocking. But what's your sense on sending the sellout trends right now?

I think our distributors are like most good business people. You can't run your own business without being a pretty smart entrepreneur, and that's what I would say our distributors are, but they're being conservative on cash. And so they're making sure that they don't overextend themselves, liquidating what inventory they do have where they can. So I think that's why we saw demand. That decline we saw was pretty equally distributed in OEM and distribution, maybe slightly, not quite as bad in distribution, but I think they are being very cautious on inventory. Nobody is going to get too far out at [ others' skis ] too soon. And I think that makes sense. Cash management is critical, and that's what our distributors are doing.

Yes. And then maybe just touch quickly on how LORD is performing. We've seen pretty good outgrowth from LORD now for some time. Is that continuing to in this environment? How was LORD comparing to that down 30% or so type performance?

LORD -- both LORD and Exotic, and I would characterize CLARCOR, too, we don't report CLARCOR separately where it's all fully integrated in the filtration. But the strategic rationale for all 3 of those deals is holding up. One, they're more resilient. They're growing, or in this case, they're declining less than the base business, and their margins are accretive basis. That's how we got to EBITDAs of over 19% in the third quarter. So CLARCOR is doing that for our filtration group. So if you look at filtration as a whole, it's more resilient than the rest of Parker, legacy Parker. If you look at LORD, it's about half the decline of what we're showing you for April. And Exotic in -- at the end of Q3 came in down low single digits versus total company, we're down 7.5% organically. So I would look to see all 3 will continue to be more resilient. The one thing that's really helping LORD is it's fairly balanced. It's a 1/3 industrial, 1/3 automotive, 1/3 aerospace, and its aerospace business is 60% military, which helps as the military piece is doing well, and it has a large exposure to helicopters, which are holding it better than fixed plane. The other part that's really done well with LORD is the synergies we've been able to pull them in faster, and it's mainly been accelerating in the SG&A portion of those synergies. So if you remember, we went from 0 this year to $18 million, now we're at $30 million. And we've taken the SG&A down by 500 basis points or lower, which has been excellent. And Exotic, we've taken the opportunity to ramp up the F135, and that's helped us. And again, that business, ironically, it's the same number, 60% in military as well, and so that's helping its resilience. And obviously, the commercial side of that is going to come back, but it's going to take longer. And Exotic is going through the same kind of mixture of permanent restructuring as well as discretionary actions that legacy aerospace is doing, and the indicator is the EBITDA margins that we showed you last quarter for both businesses. Exotic is in the upper 20s, 27%, give or take, and Exotic's around 24% to 25%. So really nice job in a pretty tough environment to actually Exotic -- actually LORD's EBITDA margins have grown significantly since we acquired them. That's because of the synergies, even with no help on the top line.

Great. And you mentioned the military exposure of Exotic is 60 of% sales?

Military, yes.

Makes sense. Okay. And the bulk of that is JSF.

Yes.

Okay. Great. So another proper question that's coming in right now is how do things change post-COVID? Obviously, there's things that will be good, better and things that might not be. So how are you viewing the post-COVID role at this point in time? And how well do you think Parker's portfolio is in that world?

I like the portfolio. So 8 motion and control technologies that we have still feel very good in a post-COVID world, and the solutions that we can provide to customers and the ability to create a clear competitive advantage versus people that are single line technology. I think the real change in post-COVID will not necessarily be to our portfolio, it will be to how we work. It will be looking at productivity and the balance of what we do remotely versus what we do in an office or a factory environment, and the productivity will get from a travel standpoint and just being more efficient with customers or with each other, with distributors. They're still no substitute for doing things in person, and I'm a big believer that you can't necessarily sustain a culture with 100% remote work. You've got to have people that can get together. And I think to really drop things into what I would call fifth gear, you got to have enough people together to be able to do that. You can't be in fifth gear with everybody in their own house, their own study, it just doesn't quite get there. You can be very efficient, but it's maybe in a third or fourth gear, but not the ultimate overdrive that we want the company to be at. So we'll find that right mix, we're in the process of doing it as we speak. And obviously, we've made products, we're not like Twitter or something like that, where we're a software -- complete digital company, we're a digital industrial company. And we make products and so we need factories and we need that environment, so we'll continue to have that environment. I think it's just going to build on the productivity. That's why I was so jazzed up with AI and what it do for us. To me it was like Lean in the office. This is another element that they build it to be more efficient and taking Lean Enterprise to the office environment.

Okay. Within that subject, the U.S. manufacturing renaissance comes up in a more manufacturing and supply chains coming back to the U.S. and Mexico, but certainly away from Asia Pacific. You would benefit probably a little bit from that because I've seen some of the automation businesses and some other business groups. But how -- are you a believer in that trend? Are you seeing any signs of that happening right now?

I think it's probably too early to see too many signs, but I am a believer that, that will happen. I think there's a lot of examples where, from a national security and just from maybe an economic security, it would benefit the U.S. to have a little bit more of a local supply chain. For us, personally, you won't see us moving plants because our supply chain strategy has been to make, buy, sell local for local. We don't have a lot of cross-border traffic going. However, to your point, Nigel, we support a lot of our customers in their factories. So if they move their factories and they have to retool and they need factory infrastructure, workload filtration all the way through all of our motion technologies, we'll be able to help them. And so when that movement -- you go back one year ago, when that movement went into China, and we saw the big globalization of companies, we benefited from that. So if that happens, and it's more of a localization movement as well, we'll benefit from that again, maybe on the reverse side of it. I would still say that China is going to be a huge economy. It's going to be the second and largest economy in the world, and will eventually fight to be the largest economy in the world. So we're in China to support China with a great local team. And part of why I always coach that team is don't get caught up in all the dynamics between the governments, that's not -- that's above all of our pay grades. But take care of customers and do the right thing for Parker, and that's what we try to do in every country around the world.

Above my pay grade, Tom, I'm not sure about yours. But certainly above my pay grade. [Operator Instructions] We won't take any questions from the software competitors unless they are very good questions, which case I want to deal. So Tom, it sounds like you're pretty happy with the portfolio positioning into post-COVID. I think there's been some surgical portfolio business in the past in terms of disposals. Anything -- I mean, would you rule out any further disposals at this point? And given the outlook for aerospace right now, are you happy to cap the exposure at these levels?

Yes, so we -- just for everybody that's listening and watching, we do a robust portfolio review every year formally. And we reviewed that with the Board because you have to earn your right to be part of the team every quarter, every year. So we look at it, and we look at several key metrics, but the technologies themselves all still make sense to us. The combination of those 8 technologies, the fact that when we think about how we win and the fact that 60% of our revenue comes from customers that buy from 4 or more of those technologies, it's a huge competitive advantage for us. So we don't want to get to where all we make. I'll just exaggerate all we make are fittings because how could -- you can only offer so much value to the customer if that's all that you do. But we continuously look at that, and we challenge ourselves to make sure we got the right portfolio and that you had to be earning your way every day. There are no exceptions for loss leaders. Everybody's got the same ROS target, the same kind of performance metrics, and that's why we do what we do because we don't have 1 business that's way up here. Everybody else is way down. Now for aerospace, we like the portfolio. We like the fact that it's so balanced as far as the various platforms that it's on. It's got a nice mixture of aftermarket as everybody knows. And it's a good military exposure. It's got 33% military, and so that will act as the shockers over for us as well. But we're not naive in the aerospace section. We're going to reshape aerospace, which is what you're seeing us do. And we took a significant 20% structural change there as well as the discretionary things because commercial is not going to last forever at the current levels. It's eventually going to start to very slowly come back up. And we had the same MROS expectations for aerospace as everybody else just because their end markets are a little bit more stressed than others, they don't get a pass for that. So I've gone through this before many times. In aerospace is obviously probably a little more severe. But if you got clock commercial traffic over the last 40 years, you'll see these downturns where it takes the market 3 to 5 years to get back to where it was, and you got to respond to that. We had a very nice long run. This will still be one of our most profitable businesses, even with this downturn with good return on invested capital for shareholders. And I feel very good about where we already are with the reshaping we've done, but we'll continue to do any kind of actions we need to, based on what we see that trajectory for aerospace in the future.

Great, Tom. So we're getting a little late in the stage here, so I think this is my last question. Free cash flow conversion has been super strong, well, in the past several years and certainly this year. Do you see enough working capital benefits and balance sheet liquidation opportunities to keep cash flow at these kind of levels, $4.8 billion of free cash flow into 2021 despite what the earnings does. I mean if earnings are down, I don't know, 10% to 20%, it'll still be pretty stable?

Yes. So I won't necessarily comment on -- because I think what you're referring to Nigel are dollars because I don't want to necessarily talk about FY '21 yet. But the part that we do feel very comfortable with, which is what I think you alluded to, we've got 18 years in a row of CFOA greater than 10% and free cash flow conversion greater than 100%. So I feel very good that we will continue that trend into FY '21. Now can we hold the same kind of dollars based on what kind of revenue declines? I think that's a little bit to be seen, we'll hold the margin piece of that to percentage, and our working capital typically has been a huge engine for us. So we do a very good job of managing that during these kind of times, receivables, payables, inventory, and while maybe income comes down as it might hold the decrementals, it will come down, working capital has tended to fill that hole. I won't comment to the dollars, but for sure, we feel very good about the percentages. We're not going to break that. We're 18 years, it's going to be 19 next year. We're going to keep doing that. We've got the cash-generating capabilities to do that. We'll see how the dollars turn out.

Okay. So it was worth a try, wasn't it? So well, Tom, I think that's a good summary. Any closing remarks before we say goodbye?

No, I would just say thank you to all of the shareholders and the people that are interested. We appreciate your ownership, we appreciate your confidence in us. And the company is going to keep getting better. We have a lot of self-help. Win 3.0 is just starting. Better days are ahead.

Well, that's a great way to end the conversation. Thanks, Tom. Thanks for your time. Good luck and stay safe. Thank you very much.

Thank you. Bye-bye.