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

Okay. Good morning, everyone. Thank you for joining us. My name is Mig Dobre. I'm the Baird analyst covering diversified industrials and machinery, which includes Parker-Hannifin. It is my pleasure to host Parker-Hannifin at our industrial conference today. As you probably know, Parker is the global leader in industrial and aerospace motion control technologies with very diversified set of products. To update us on Parker's current strategy, we're joined today by Chief Executive Officer, Tom Williams. Tom, welcome. I know you have some prepared remarks, so I'll turn the floor over to you, and then we'll do some Q&A.

Thank you, Mig, and thank you to everybody that is joining in. It's great to be back at the Baird conference, even if it is virtually. And to all our veterans, thank you for your service on Veterans Day, and we appreciate everything you've done for the country. I think everybody is familiar with the forward-looking statement. I won't belabor that, you could read it at your leisure. I want to spend time on the next slide on our competitive differentiators and just highlight a couple because I'm going to imagine some of them will come up with the questions with Mig. But we have a breadth of technologies and interconnectedness and complementary nature of our technology offerings. It creates a tremendous amount of value for our customers. 60% of our revenue comes from customers that buy from 4 or more of those technologies. So our customers see it. We ship about 85% of our products, have either a trade secret tied to them or some kind of intellectual property like a patent. So that gives us a lot of competitive advantage. We have the best distribution network in the motion control space. And when you add up this whole list of competitive differentiators, really, culminates in that last bullet, being a great generator of cash and great deployer of cash, which has gotten better over the years and been a historical strength of ours. Next slide. So we've transformed the company over the last number of years. I would call out 2 big things: portfolio changes as well as performance enhancements. On the performance side, it's tied to the business system of the company, which is the Win Strategy and 2 big enhancements in 2015 and most recently with Win Strategy 3.0, which I'll touch on here momentarily. We simplified the organization structure, streamlined. And we acquired 3 great companies, which you see on this slide that were all accretive to us from a growth standpoint, margins and cash flow. And you see that come on to a portion up here, our performance, which is really indicated on this next slide, which gives you probably, I think, the easiest way of evidence of how things are working. So this is a look at our operating margins over the last 5 manufacturing recessions, and you can see the as-reported and the adjusted lines there. This now includes adjustments with deal-related amortization. We're very proud of this, and we are going to continue to expand these partners, and this is really a testament to what we've done in the past and what we see going forward. And the going forward is really on the last slide. And 3.0 is going to continue to accelerate our performance going forward. It's simplification, which things that you've seen us already do with org structure, org design, this 80-20, which I think everybody is familiar with. Simple by Design, which I'll save for the Q&A portion, but I'm very excited about Simple by Design and how that changes the company's performance from a design excellence standpoint. On innovation, our innovation process is called Winovation. And that takes us from idea to launch. We made 3 important changes that we added a metric, our vitality index, which is tracking a percent of commercialized new products as a percentage of revenue and looking, obviously, for year-over-year improvement there. We added 2 process changes to that. One is Simple by Design, as you might imagine. And the other is new product blueprinting, which really drives an outside-in focus, speaking to our customers more, the end users, to bring those pain points into our value creation of the pipeline. Digital leadership, I'll save for the Q&A part, but I'm really jazzed up about that, and I can take you through that later. We're going to continue to expand distribution, especially internationally. And then our brand -- Kaizen starts with the structure of the company, which is our high-performance team structure. And those of you that may be aren't familiar with that, it's how we organize all the value streams and functions around the company. Almost everybody is in some kind of high-performance team, and it creates that ownership level more than just ownership at a division but ownership within your team structure for basic things around the company like safety, quality, cost, delivery. And that's where we embedded Kaizen, that's where we embed Lean. And so really that triangle is a very powerful triangle performance for us. We're continuing to look at acquisitions, and we're hopefully going to continue to buy great companies, like you've seen us do the last 3 times. And then we've added a new incentive plan, which is going to replace return on net assets, which is our current but we've already piled all it in the filtration group. And this will focus on 3 metrics, earnings, revenue and cash flow, which are -- have the highest correlation to TSR. It will be simpler for our people to understand. It will be more elastic and more tied to annual performance. RONA was a good metric, but it tended to be more long-term-orientated. We have a whole suite of long-term metrics that we already have. So we think this combination of continue to enhance the portfolio, Win Strategy 3.0, the performance we've had historically, gives a little bit of a turn in the macro environment. We believe strongly that the best days lie in front of us. So with that, Mig, I'll turn it over to you for Q&A.

Thank you, Tom. Before we get into Q&A, just a quick reminder to everyone that we will be hosting a breakout session after this presentation where you'll have an opportunity to interact directly with Tom. Also, if you would like to submit a question for me to ask, you can e-mail me at mdobre@rwbaird.com. So Tom, you recently reported, right? So you gave us a pretty comprehensive view on where demand stood. But I think it would be helpful, at least for me, to talk a little bit about the things that surprised you relative to your initial set of expectations, right? You've obviously well exceeded your guidance. You raised the guidance going forward. So as you think of the various end markets, where do you think were kind of the biggest positive surprises? And looking forward, where do you feel the most comfortable with the path towards additional demand improvement?

So I think, in general, on the positive surprise side, we saw industrial markets, just in general, do better than we thought. We had guided to like around a minus 19%, and we came in organically at minus 13%. And we saw improvement in North America and international. The fact that China was made a little bit stronger, and we thought China was positive and that Europe and North America were less weak than we expected. We saw more markets move from accelerating decline to decent lowering decline, which when you look at the 4 phases of growth, that's the first step of kind of moving towards growth. We had 2 regions turned positive in order entry. That was in Asia and Latin America. So that was encouraging. And I think the strength of the aerospace portfolio and the fact that we are very balanced as far as our technology platforms between engine to regional jet and biz jets, et cetera, as part of our exposure were about 50-50 on commercial and military. I think, in general, our aerospace business weathered the storm maybe better than we thought as well. As far as upside, I think there's upside pretty much across the board. When we look at the second half, all the end markets, with the exception of oil and gas and aerospace, will be either positive or neutral. I think things that are -- like semicon, telecom, life sciences, those are the things -- and then the things that are tied to kind of the digital expansion, truck, packaging, all things related to that, that supply chain turned quite nicely. But I'm looking forward. As I mentioned on the earnings call, we have a couple of quarters here that were challenged still, and with the virus activity in our Q2, Q3. But then with Q4, we have an easy comp. Obviously, we anniversaried the pandemic. We have a lot of our own self-help that's kicked in and will be kicking in more. Macro conditions are getting better. And with the vaccine and with, I think, just a more constructive industrial environment going forward, I'm pretty bullish in the future. The comment I've made in the past -- so I've been CEO for 6 years, Lee and I leading the company. And over those 6 years, we've had 2 industrial recessions and a pandemic. So I think we're due. I think the industrial environment is due. And it's more than just being wishful thinking. I think there's a lot of good indicators that are supportive of industrial activity and the need for, I think, infrastructure investment in just a good climate that I look forward to as very positively once we get into the next 6 months.

Right. I mean, at least for me, this is the part that's been so surprising, right? I mean we've all seen cycles and recessions play out before, and it's a process. It's not something that normally gets turn on a dime. But in this case, it seems that activity has essentially surprised everyone, not just folks like me, but even operators such as yourself in terms of the pace of the recovery. So I'm trying to understand what feels different to you this cycle versus the prior one? Is it pent-up demand? Is it just willingness to invest that is different on the part of customers? Or how do you interpret it?

I think longer term -- I'm not talking about the next couple of quarters, I think confidence and stability will be in a more positive state than maybe they've been in the past. You have to recognize that we were 7 quarters of negative order entry to date, and we were just about ready to turn before the pandemic started. So I think the industrial activity was ready to turn before the pandemic and now you get through the pandemic on top of that. So I think you have 2 things that you'll be rebounding from: low industrial activity pre-pandemic and then just a need to come back to normal levels after that. And then also just thinking you have a better environment going forward. So we did not forecast a V-shaped recovery. We're not necessarily forecasting that now. I think we would have guessed have been more of a very slow, like a Nike swoosh. And maybe with the vaccine and the activity we're seeing, it's going to be a little more sort of a swoosh than what we have thought.

Understood. I want to maybe change gears here and talk a little bit about your cost structure, right? And you had that slide that you've used in the past, showing your margin performance relative to other downturns. And look, I mean, $425 million of savings, right, that we're talking about for the current fiscal year. I mean that's a meaningful amount relative to your revenue. So the question that I've got is, essentially, how are you delivering these savings. Because as I look at that chart that you presented, it suggests to me that your cost structure is progressively more flexible, and perhaps you can talk about some of the drivers behind that in the sustainability.

Yes. I feel very good about the sustainability piece of it. And I think that's evidenced by -- just in my tenure, all the margins have progressed. But it all start up with, I think, really over a number of years of significant restructuring of the company. I mean starting in FY '14. As the Win Strategy changes, you can't underestimate the impact of that. That is the business system. It's how we run the company, and it's changed how we're structured. We're a much more lean organization. We're much more agile than we've been. I would like to continue to have us be even more flexible. The changes in 2.0 drove a lot of structural changes, simplification, leaning, et cetera. And then 3.0 is even more sophisticated with 80-20 and Simple by Design, going to change the game for us, the Kaizen linkage that I mentioned in my prepared remarks all bode well. We were also -- so those are what I'd call systemic things that we did. And then we were just very decisive in moving out. When the pandemic hit, we were very assertive on doing the discretionary things, which everybody did a shared sacrifice approach as far as wage reductions. And then we did not hesitate to wait for a future outcome or more order entry. We knew there are certain end markets and certain areas that we needed to take action on, and we took those actions. We also solve with the kind of the digital leadership initiatives as a company and just the acceleration of the digital, everything, that there were some structural things we could do on top of that regardless of end market changes, and we took those actions as well. And so you see, as I showed in the earnings call, that high graph of the mix of permanent versus discretionary and how you'll see us move to 60% of our savings will be permanent. And I think shareholders should like that because nobody expects people to take a temporary wage reduction for the rest of their career. I mean that's not -- it's not how things work. It's a temporary sacrifice. And you end up not being competitive if you expect people to do that. So we've -- October 1, for the most part, we've reinstated all those. But the permanent actions are there, and it will continue to provide great strength for us going forward for the rest of the year.

You talked about operating margins and EBITDA margins as well. To me at least, one of the more interesting things is the way your gross margin has progressed over the past, call it, 5, 6 years, especially since the introduction of Win 2.0. That's where we've seen nice margin expansion on the gross margin line that I think has really kind of driven your margin story. So can you talk a little bit about that? I guess what I'm wondering here, with gross margin, pre-pandemic at, call it, 26% almost, can we eventually see Parker as a business that can earn close to 30% gross margin? Do you think that's on the table based on your current business mix?

I think what you'll see is you'll see segment operating margin and gross margin move in tandem. That whatever incremental bps you'll see happens with segment operating margin, you're going to see a disproportionate amount of that happen in the gross margin front, but maybe not all of it but the majority of it showing up in the gross margin. The way we look at the income statement, as we look at the whole income statement, we just don't stop at the gross margin line, so it looks great. We look at the whole income statement, and we work on the entire income statement. And the Win Strategy addresses the entire -- all the elements that are in the income statement. The things that typically hit gross margin is how you run your factories, how you price things, how you buy materials. And those have been the bread and butter of the Win Strategy. I would say that Simplification and Kaizen have really just accelerated those bread-and-butter things that we do in the Win Strategy around supply chain, lean and pricing. The next evolution for us will be the Simple By Design and digital leadership. I think those take us to a whole another level of performance. And so that will show up in gross margin, will show up in segment operating margin for us because there's a lot of things that go into that whole equation. We like to look at the entire statement. And that -- so I think for shareholders, the best indicators look at segment operating margins, and that's -- you continue to see us make progress.

Well, no, fair enough. But I guess everybody can appreciate that there's -- in some ways, it's easier to cut SG&A than it is to drive higher gross margins, right? I mean that's where the hard work has to be done, for lack of a better term. Can we talk a little bit about the Simple By Design? Because I think this is maybe relatively new, and I'm wondering exactly what this means. And can you frame the potential impact on returns or margins, however you want to frame it really?

Yes. So let me explain and maybe for people that aren't familiar with it. So this was a realization that you would think after 40 years of work, maybe I'd come to this sooner. But if you think about where we spend all our energy as business leaders and operators, we spend most of it on trying to convert a design into a product that a customer wants. And so a lot of that energy is on about 30% of the cost structure. 70% of the cost structure gets really kind of stop buck in how you design things and that we should be a little more balanced in all of our energy and processes around design excellence as well as operating excellence. If you look at most organizations, there are disproportionate spend amount of time, processes and initiatives around operating excellence. Now don't get me wrong, we will continue to be focused on that. We want to have more focus on the design excellence. So Simple By Design addresses that. And it looks at a couple of things to help our engineers. So the first is just a complexity assessment. Today, remember, when we launch a new product, we do a technology assessment, but we don't do a complexity assessment. And so this complexity assessment will be a very simple questionnaire. It will be multifunction, cross-functional to assess how complicated is this design as we give it to the factory and our supply chain people to buy. So there'll be a more collaborative discussion and hopefully get obviously better design. We then have 4 governing principles for engineers to design products, so design for forward bookings. So what kind of requirements, what customers might need in the future, what kind of material changes that are going to happen, what kind of climate changes are going to happen, so factor that into how you design things. Design to reuse material, to reuse material around the company, design to reduce the bill of materials. How do we -- if you design a new product that has a 80-part number bill of material versus an 8-part number bill of material, it is much less complex, fewer stocking locations, easier to assemble, et cetera. And then the design for flow, how do we design things that are easier to produce, easier for our operators or assemblers to put our products together. We're going to -- all of this gets enabled by the use of AI. If you're a company of our size, with the amount of drawings that we have, the amount of part numbers, et cetera, for an engineer to do all these things just with their normal capabilities, it's impossible. But AI allows them to see all this information with these 4 governing principles that we design in a way they never could before. And we've done this enough with a few of the pilot divisions that we've seen dramatic cost reduction. So ultimately, where this shows up will be speed. We will get to market faster. We have a chance to take share because maybe there's areas we're not as competitive and that we will now design things to be more competitive in. But we're going to take costs down. We are going to measure this at the net manufacturing margin line, which is right below gross margin, gross margin minus any kind of production [ barriers ] that get you to the net manufacturing margin. That's why we're going to hold people accountable to this. I'm not going to disclose what the targets are, but we have targets on it. And I would just tell you that it's going to be the fuel that takes us past the current 3-year targets that we have out there, so it will be helpful as we get to the FY '23 targets. But it's probably a longer-term initiative because we're going to look at existing part numbers with an 80-20 kind of cut. And everything that gets designed new will go through Simple by Design. So it will be a gift that gives for years and years. And we're going to change the paradigm on how we design things. When you think about it as an engineer that used to design things many moons ago, I was never trained this way, and most of our engineers were never trained this way. But this is something that our people are very excited about and is a big game changer. And I think very few companies in the world are talking about this.

One of the things that strikes me from what you're saying is that all of this is essentially independent of volume, right? This is just on the existing base of business, doing things better and hopefully generating better margins on that. Am I to infer then that beyond previously outlined targets, we should be thinking higher incremental margins than normal if we're seeing sort of the normal volume lift, right? You have this initiative plus incremental volume and the cost absorption that, that would drive?