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

Perfect. Well, thank you, everyone, for joining. My name is Julian Mitchell. And it's my pleasure to have on now Tom Williams, Chairman and Chief Executive of Parker-Hannifin Corporation. Just a quick reminder, any questions anyone has, please e-mail me them, and I'll be sure to try and ask. Also, please, if you have a second, fill out the brief survey questions that you can see to the side of the screen. And so with that, I'll hand over to Tom for some quick remarks before our fireside chat.

Thank you, Julian, and welcome to everybody that's listening in. I was telling Julian earlier, it would have been nice if we were in Miami doing this, but this is the next best thing, and thank you for all your interest in Parker. I wanted to start with making a few comments on how the company has changed, in particular over the last 5 years. The word transformation is maybe overused, but clearly, there's something significantly different about the company. We'll give you some objective indicators to point that out. So the first would be, just look at how we performed during the pandemic. The last 3 quarters have been fantastic in how we've done it. Particularly, if you look at the last quarter, we had greater than 20% EBITDA margin, operating margin and CFOA margin. And so we're really proud of that. If you go back and look at how margins, EBITDA margin has done over the last 5 years, I want to use round numbers, it's increased by 500 basis points over the last 5 years. If you look at EPS, and I'm doing EPS on an adjusted basis, apples-to-apples, calculating the way we do it today, if you go back to FY '16, 5 years ago, it was around $7. And our guidance today is $13.90. So it's double -- almost double over that period of time. And the thing I would like to point out is that if you were to plot PMI over these 5 years, it'd be up, it'd be down. But the one thing that's been constant is this improvement from Parker. Margins are going up, cash flow is going up. EBITDA dollars are going up. EPS is going up. So the question might be, so why? Why is that happening? Why is it not correlated to PMI? Why -- how is this happening? And the short answer, it's performance and portfolio changes. The performance side is The Win Strategy, and it's the change that we've made with 2.0. And then most recently, 3.0, the third revision with The Win Strategy. And there's a tremendous amount of operating leverage and operating system improvements that came from both of those changes and then the portfolio changes that we made. If you look at CLARCOR, LORD and Exotic, all 3 of those deals were accretive on growth, accretive on cash, accretive on margins. And then if you put those together with what I would call our competitive advantage, kind of the strategic historical success factors of the company, which is our distribution channel, our decentralized structure, our low CapEx business model, high intellectual property, et cetera, the breadth of our technologies, that's kind of been our winning formula. And what I would suggest to people going forward is going to be the same thing. It's going to be equal to or better than what you saw before because I -- my view is the next 5 years is going to be a better macro environment than the last 5 years, and we have as much gas in the tank from a self-help standpoint as we had in the last 5 years. So we feel very good about the future, very bullish, and our best days are in front of us. And with that, I'll let Julian kick off the Q&A.

Thank you, Tom. Perhaps just starting with the top line outlook. Maybe describe briefly the differences you see by geography at present within the industrial part of the company and how you assess the need, if any, for sort of restocking at any particular segment of customers or distributor and channel partners or whether you think it's, no, it's about end demand and that's what's moving things at the moment?

So let me start with maybe the regions. What we saw in the last quarter was international was positive 3% organic growth. And we -- of course, you saw the strongest order interest in international and pretty much across all 3 of the regions, with Latin America being our smallest but ended up the highest incremental gain, Asia being very strong and Europe doing quite nicely as well. So we feel pretty good about international showing progress across pretty much all 3 of the areas, the geographies. North America was still slightly negative, minus 6, but it was half of what we thought it was going to be. So we saw a nice improvement in North America. Orders turned positive for the first time, and really industrial orders turned positive the first time since September 2018. And so those all felt very good. And it was pretty broad-based when you look at end markets. And then when I think about stock, demand, that kind of question, with our OEMs, it's pretty much all in demand. They've, over the years, moved to relying on us for our supply chain, our real-time [ compound ] service to them. So they really have very little inventory in their system. So whatever you see on the OEM side is real demand on orders. For distribution, we did see some selective restocking, but more so for those long lead time items. And the way they laid the orders and they lay them in with release dates that are out multiple quarters. So it's not -- you can't necessarily look at our order interest and say, "well, that should flow out in this quarter or the next quarter," because a lot of those orders had release dates that were several quarters out into the future. I think that's a good sign where distributors are starting to feel more bullish, in particular, investing in those longer lead times, so they can position themselves for the upturn and take share with those kind of products.

And maybe looking out beyond the very short term, Parker has seen a number of sort of dips and recoveries over the last 10 or 12 years. Very different sort of slopes depending on each one. A big bounce in '11, a shallow one in '14, then a stronger bounce in '17. How would you -- it's really early, of course. Your orders just turned a few months ago, but what are your sort of perspectives, having seen a bunch of these cycles on the shape or slope of the upcoming one, particularly in industrial? Aero has its own dynamics. But on the industrial side, in particular?

I think I feel pretty good about the industrial piece. Now exactly what the slope is going to look like, that's up for grabs here. But there's a couple of dynamics that I think are in our favor. I think there is a bit of a pent-up infrastructure need because, again, using the last 5 years as the time frame, there was 2 industrial recessions and a pandemic. So I think there's some infrastructure needs across the world. I think you got a great environment, low interest rates. You have stimulus that's already been spent. And whether it'll be more stimulus, it seems likely. But even without that, I think that bodes well. And so I like our exposure in the [ end ] markets, if you go through the various end markets. I like where we are in that cycle. And then aerospace will be a longer -- but we're sized to win in aerospace today. As it improves, we'll see nice incrementals as this improves. But obviously, industrials are going to outpace the rate of improvement with the aerospace. The reason why I feel good about it is I just look at the last 5 years and what we went through and the gains the company showed. We're going to have a better top line environment in the next 5 years. The odds are clearly in our favor to have that. Exactly what it will be, we don't know. We never try to be dependent on revenue. We try to make sure we have enough of our own self-help. And I think we could do that even with minimal revenue gains.

Perfect. And Tom, I think there's been rightly a lot of emphasis on the margin performance at Parker. But perhaps looking at the top line, there's a growth aspiration, of course, as well within whatever macro environment there is. So how would you assess the company's sort of performance relative to its markets, relative to its competitors? Are there any specific areas you think this is where Parker is doing very well on market share, for example, or big priorities for share gains in the medium term?

Yes. So we just did this for the Board. And we outgrew GIPI over the last 5 years, and we outgrew our peers over the last 5 years. But that's still an opportunity that we think we can explore more on. And if I look at the 4 breakthroughs of the company: 0 accidents, likely to recommend, growing 150 basis points greater than GIPI and growing earnings 10% year-over-year, the one I think is the one that is probably the most -- obviously, getting to 0 safety incidents is a big challenge. But being consistently growing faster in the market is one that we were focusing on. And there's a lot of things we're doing on that. So we made a bunch of changes on innovation, our product vitality index, New Product Blueprinting and training our engineers. Simple by Design will be a margin enhancement, as also speed to market, and it will allow us to penetrate some customers where we are not competitive today, where we redesign a product and get in there and be more competitive, so it's a share gain opportunity. International distribution is still an opportunity that we continue to shift that mix. Our new incentive plan around ACIP is a big deal. And so that's -- all those things together are what I can call the things we can do ourselves to improve organic growth. And then on the portfolio side, it's buying companies that grow better than what we've done historically. And so in the first year, it shows up as an acquisition revenue. In the second year, it's organic revenue. And that's what we've seen with LORD and Exotic and CLARCOR. They've helped us on the top line. And even in the down period, they've been more resilient and actually, LORD grew in the last quarter mid-single digits versus declining in the rest of the company. So portfolio changes as well as the things I said on the organic performance pieces is how we'll grow differently.

Perfect. And you mentioned CLARCOR a few years ago. More recently, the LORD and Exotic deals, as it had all been in the portfolio for some period now, maybe there's any impressions you could give us on how satisfied you are with the integration process. Any main learnings as you think about perhaps starting to go on the offense, again, reasonably soon on capital deployment?

Yes. I could not be happier with all 3 of those deals. If I maybe just take one at a time. Now CLARCOR has been completely blended in. So I'm really going to refer to filtration as a whole. But filtration has been much more resilient than the rest of the company. So the rest of the company, I would say, wherever you see the rest of the company at, filtration's half that decline whenever we go down. Now on the upside, filtration is a little more steady eddy because it's a heavy annuity revenue stream versus what CLARCOR brought, 80% aftermarket. So it will be much more of an annuity revenue stream for us, horizontal on the downside, not giant inflections on the upside. EBITDA margins well north of the total company, EBITDA margins in that kind of low to mid-20s. LORD does come in and just couldn't be happier with LORD. LORD grew mid-single digits last quarter, benefiting from really the automotive exposure it has, in particular, the EV and HEV exposure that it has and the whole electrification of everything and all of its thermal management, adhesives and coating technologies going into that. And recognize, LORD put in a positive mid-single digits with 1/3 of its business being exposed to aerospace. So it just shows you how good, how strong that portfolio is. And then Exotic actually declined a little bit better than legacy aerospace. And Exotic kind of had the worst of the aerospace decline because it had exposure on the MAX more so than legacy aerospace, and it had the pandemic. But it's done extremely well. It's 60% military, which has been huge, and it's on the right military programs. And its EBITDA margins in mid-20s. And of course, LORD's are in the upper 20s. So where can I sign up to do more of those? I mean that's -- I want a steady diet of those 3 kind of deals. And so when we look going forward, that's -- we're going to continue to look at those type of properties. We're happy to look within the 8 motion and control technologies. I think we've gained a lot of confidence in how we do our integration teams, how we form them, what works, what doesn't work. We clearly like things in the spaces where we understand the customer and the end markets. And we bring -- and the acquisition brings complementary technologies because that's -- if you think about all 3 of those deals, that was kind of the formula for all 3 of those deals.

Perfect. And I think the leverage is coming down quicker than people had expected, certainly, 9 months ago, very good cash flow. And now the EBITDA will accelerate its recovery. How quickly should investors expect that Parker might look to start undertaking transactions of size again? When do you feel comfortable sort of putting that on the balance sheet, and also putting it on to the organization at a time of very fast-changing macro backdrops?

Yes. That's a good question. Actually, the organization has an interesting perspective. I think the organization is shopping up a bit actually to do an acquisition. And it's gained a lot of confidence. When we first did CLARCOR, I think the organization was, "Wow! Okay, that's pretty big." And now people didn't bat an eye with the other 2 deals. I think we've built that muscle memory in there. I think come summer, we're clearly ready to do something like that. I'd tell you, we continue to work that acquisition pipeline. The relationships we work continuously, whether we have the dry powder or not. But our capital deployment strategy, I think the first thing you're going to see is in April. We're going to raise the dividend. We just haven't decided the amount. It's obviously up for Board approval. But we're going to raise the dividend and continue our track record of 65 years of accounting. So that's the first step, I think, you see of capital deployment. We obviously continue to do organic investments in the company. But then we'll look at the acquisitions versus share repurchase. Really in the summertime, if we've got the capacity to do either one of them, our preference is to do acquisitions because it grows cash. It grows EBITDA. But we're a great investment. And we're -- I don't feel any pressure to just buy a company for the sake of buying something. We'd be happy to invest in Parker. But we'll work the pipeline and we'll be selective. And I think you'll continue to see us buy things that fit the formula you've seen us do the last 3 deals.

And I suppose we're in a slightly different universe on valuation multiples today in the broader market than the past few years. Is that a big challenge limiting Parker's M&A funnel? Or because of the areas you're looking at, the synergies you can get from bringing businesses in that are close to what you have already, you can still find a sufficient number of attractive deals financially?

Yes. I think in general, I've not really seen, at least within our space, valuations change much over the last -- I think they've been elevated and stayed elevated, to your point. The reason why we can make these deals work is we buy things that are great strategic fits, where the combinations of 1 plus 1 equals 3. And so we can get these synergies that are at first blush are significant, but then we can execute on them, and we actually beat them most of the time, our synergies. So we get it to -- you get the headline EBITDA multiple, and then you get the synergized EBITDA multiple. As long as the synergized EBITDA multiple looks, relative to us, reasonable, then we're happy to do these, and they're accretive and have the right kind of ROICs for our shareholders. And hopefully, our shareholders feel confident in our selection process and our execution process that are based on what we've done in the last several deals.

And when you look at sort of the base business, very good performance on decremental margins over the past year or so. As we look at the recovery beyond just the next quarter or 2, what sort of operating leverage on the way up should investors expect? And do you see a big risk that in fiscal '22, as those discretionary costs come back, that acts as a big anchor on the operating leverage?

Yes, I'm glad you brought it up because I want to clarify because I think people maybe read more into my comments on the earnings call than maybe was necessary because we feel very confident that we're going to put in a 30% to 35% incremental, even with those tough comps. I'm talking about an incremental MROS, margin return on sales, with the tough comps, our toughest being in Q4, and it gets a little bit easier as we go into the first half of '22. So my point there was, if you didn't have those tough comps, you'd be experiencing incrementals like you maybe historically would see Parker put up at the beginning of the cycle, 50%, 60% incremental. And that's really what the underlying business is going to do. What you'll see externally is a 30% to 35% incremental, which are still best-in-class, as you study these over the cycle. Once you go beyond that, we'll be able to hurdle any of the costs that are coming in, still put in the 30%-plus incremental when you look at the full year for FY '22. We've got the permanent savings that are going to stick. We've got Win 3.0 that's got all kinds of legs to it. And we're already proving, as we start to glide down the discretionary, that we can put up really strong incrementals. I mean our incrementals have been favorable. We've had less revenue and higher earnings. So people haven't even been able to see these incrementals because it's -- you can't calculate it with less earnings -- I mean, less revenue.