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

Welcome, everybody. Thank you so much for joining us, Evercore ISI's Industrial Conference, our 13th annual. I'm David Raso, Head of Industrial Research at the firm. And really excited to have Parker-Hannifin as our next presenter. [Operator Instructions] As I mentioned, Parker-Hannifin, obviously, Tom Williams, the CEO, has done a great job in the transformation of the company over the recent years, in particular. So excited to hear about that story, Tom, and we can dive into the details. But I know you had a few slides you wanted to go through to start. So I'll turn it over to you. And again, thank you very much for participating, and then we'll pick it up after the slides.

Sounds good. And thank you, David, and welcome, everybody, good morning. So I have a few slides. Like David mentioned, we'll turn it back to him for Q&A. So the next slide is the forward-looking statements you're all familiar with. I won't belabor that, you can read it at your leisure. Go to the next slide. This really is a slide is kind of our strategy summary on a page. On the left-hand side, think about that as the competitive advantages of the company, our strategic positioning, it's why we win. And on the right-hand side is where we're going as a company. And what I'm going to do today, since we don't have a lot of time, I'm going to take one item on the why we win side and will take Win Strategy 3.0 on the where we're going and talk a little bit more about that. But it's really a combination of these 2 things that's going to position us to be a top quartile company. Go to the next slide, you can see our breadth of technologies, and this is really one of the reasons why we win today is unmatched versus our competition. It creates a distinctive value for our customers. And 2/3 of our revenue comes from customers that buy from 4 or more of these technologies. And that's why we win. It creates that advantage versus the competition. Go to the next slide. On this slide, I think if you had only one slide to remember from this morning and one slide that kind of symbolized the improvement of the company transformation, and why we're different, it'd be this slide. So let me just orientate you for a minute. The blue line on this slide is the global PMI, plotted on a quarterly basis from FY '08 to today. And then the gold bars is our adjusted EPS over this period of time. And you can see when we launched the Win Strategy 2.0 in FY '16 in the course and 3.0 in FY '20, you see a distinctive different trend on EPS versus what we've been doing in the history. The green line, basically, virtually a 45-degree continuous improvement on EPS. PMIs went up, went down over this period of time, and we kept plowing forward with significant EPS growth over this period of time. One of the things underpinning that was if you look at FY '16's EBITDA margin to the EBITDA margin we're running at year-to-date, you see an almost 600 basis point improvement in margin over this period of time. So the question might be how? Why did this happen? Why is the company performing significantly different? I would say about 80% of this is tied to the strategy changes of the company at 2.0 and 3.0. And then about 20% is tied to the portfolio transformation and the capital deployment things we've done on buying great companies, CLARCOR, LORD and Exotic that were all accretive on sales, accretive on the margin, accretive on cash flow, and that's created a step change you see in EPS. Go to the next slide, spend a moment on where we're going forward, on Win Strategy 3.0. There's a lot of changes on this, and I'm only going to try to highlight a few on this slide. If I look at simplification, we're going to continue the 80/20 work on revenue complexity. We've now added Simple by Design, which recognizes that 70% of your product costs are tied up in how you design the product. And so we're going to work with design principles, the use of AI and a complexity assessment, all in a package to create design excellence in addition to operating excellence. It'll help fuel speed, it will fuel margins into the future. On innovation, we've made 2 distinct changes to our innovation process, which we call Winovation. The first one was a new metric, PVI, product vitality index, which measures the percent of new products we've commercialized over the last 5 years as a percent of the total revenue. Obviously, we're looking to grow that year-over-year. And then we put in a new process called New Product Blueprinting. So you may not be familiar with that. But basically, what that is, it's a process where we've trained our engineers to do a better job of interviewing, observing, listening to pain points for customers and end users to create better ideation, better ideas coming into the innovation funnel. Digital leadership is a 4-prong strategy around digital customer experience, products, operations and digital productivity. And under digital productivity, well, we have AI. And then distribution continues to be a strong suit for us. It's a carryover from 2.0. We're going to continue to expand that. A big part of 3.0 was the introduction of Kaizen. And I would tell you that our use of Kaizen is fairly distinctive because it links our high-performance team structure, which is how we're organized around the company, the use of lean and safety to create this deep engagement of our people and create an ownership culture of continuous improvement. We're going to continue to do the acquisitions that you've seen us do over the last number of years, where we'll be the Consolidator of Choice and look to be -- continue to be assertive with the use of the balance sheet. And we're introducing a new incentive plan called ACIP, annual cash incentive plan. We're going to target 3 metrics. Those 3 metrics that have the highest correlation to TSR, that will be revenue, cash and earnings. We'll do that division by division, and we'll be rolling this incentive out over the next 2 years. So it's really 3.0 and our Purpose Statement is going to be the powerhouse behind our future. Then my last slide is really just final messages for you. We've got a highly engaged team, really creating that ownership culture. We have top quartile engagement scores around the company. The interconnectivity, the strength of the portfolio, it sets us apart versus the competitors. We're going to continue the portfolio transformation buying great companies that are accretive on sales, cash and margins. And performance over the cycle, hopefully that EPS slide was good objective evidence. So things are different, and we're going to continue to go along that path. And then Win Strategy 3.0 pound per pound is stronger than 2.0. If you put that together with the Purpose Statement, we feel very confident in our ability to drive performance into the future. And with that, David, I'll turn it back to you for the Q&A portion of the meeting.

Yes. Thank you. I mean, you put that slide up, it does show the earnings have been able to decouple from the PMI. You're still going to probably have to prove it on this next -- the next wave, right? People are still going to hold on to, can I see them decouple as the ISM eventually drifts from 60 back down to 50. And I think while you can show it quarter-to-quarter, obviously, an acquisition is a step function way to show, look, we are now able to execute on these acquisitions in a way we weren't able to or willing to before. And given the balance sheet, the deleveraging should be there by the summer, I'm curious, and again, covering the company for a long time, there was always small acquisitions and then there was a dearth of acquisitions. Now in the last few years, clearly, it's about your confidence in getting synergies. Deals that you used to walk away from as a company, you feel because of your synergy capabilities that multiple headline might seem high, but post synergies is rather attractive. But when I think about the LORD acquisition, the CLARCOR acquisition, even Exotic, the synergy numbers are literally 10% of the acquired revenues, 12%. I mean, they're big synergy numbers. So what's changed in your ability, your confidence even, to get the synergies because at that kind of savings, a lot of deals that look very expensive, in fact, really aren't post synergies. So kind of what changed and what actions are taking place that this model can be replicated with those kind of synergies?

Yes. So I'll address that in a second day. I just want to make a comment back to your first comment about the PMI decoupling. Hopefully, people have seen over 6 years, it's decoupled. And 6 years is not 6 months, and we've proven them for 6 years, and I would -- I have a lot of confidence that we'll continue to prove it over the next 6 years and going forward. Now getting back to your question on the M&A. A couple of things changed. First would be how we view the balance sheet. And we looked at the balance sheet, maybe historically, being underutilized or maybe not put into play as much as it should have been. And our cash flow is -- we're fortunate at very significant cash flow that we should put this more into use. So that was the first step, a sign to be more assertive at the balance sheet. The second was opening our kind of our aperture to looking at larger deals in addition to the small ones. I think the takeaway that we have as a management team and with our Board was that if you create a difficulty was actually at times worse with a small deal because if you had one little slip, you had trouble making your synergies. And with a large deal, you had a little bit more latitude. I think the other thing we went into it with a much more aggressive integration plan. We were more aggressive with how we wanted to integrate it. We had, I think, better strategies with 2.0 and 3.0, which captured synergies faster than maybe the original strategy. We organized with more talented integration leaders. And we put much more emphasis on full-time people going into integration. We put project managers in charge of integration. And then we had a quarterly cadence with myself and the senior team and a quarterly cadence with the Board to track how we were performing. So that was what we did with the first deal, and then the success of CLARCOR just gave us renewed confidence, and we feel very strong that we can keep doing these deals. But you made a good point here that it's the synergized EBITDA is the key thing you look at is can you get synergized EBITDA down to a manageable level and within a reasonable period of time with your synergies. And that was kind of a new way of looking at things. We -- in the past, we may have looked at the headlines and so that's too big. But now with our synergies, it's much more digestible. And our EBITDA keeps growing, which makes our ability to do deals better each time we enter the field.

But that's -- I mean, it sounds like you're throwing more talented people at it, you're more focused on it in the sense of the integration process. But where have you found the largest savings usually? Is it, look, we just bring scale to the procurement side, or the ability to run it through our distribution, and those are the kind of opportunities. We're just sending it more through distribution than just OE, obviously, brings a better mix because you have one of the better distribution networks out there. I'm just trying to understand, if you had to characterize the 1 or 2 things, talent and focus, but where are you finding -- and also if you help us understand when you look for the next deal, what might be something you're looking at? Is it the procurement? Is it running it through your distribution that maybe the acquired company didn't have? Again, the savings numbers are pretty significant. So I'm just making sure we understand your ability to replicate it.

So it's a little different deal by deal, but the one common thread is the Win Strategy. So the Win Strategy brings a lift in the operating system. Now on any kind of acquisition we're trying to take the best of the prior company and the best of Parker, put it together, so 1 plus 1 equals 3. So we're very respective of the team we're bringing in, and we involve them and help them create the synergy plan. Obviously, we create the synergy plan based on what we think and the knowledge of diligence and what we review with the board, but we involve them in creating that plan as well. So that's part of the empowerment. It becomes their plan, not just acquirer -- us -- our plan. But the Win Strategy would be the common thread. But if you look at the differences, CLARCOR was much more of a heavy footprint consolidation based on that outline where they were and where we were, and LORD is more on the SG&A side. But the common thread is that we see Win Strategy savings, so that would be the bulk of it and then you kind of customize deal by deal, whether it's more plant consolidation, more sourcing. Sourcing is kind of a common thread that cuts through all of them as well.

And I just had a question in that I was going to ask later, but I'll ask it now. Somebody's asked me about the compensation structure change. When we had the old North by Northwest, it seemed to be a little more sensitive to the capital, the return on net assets. How does return on invested capital fit in now given the changes [indiscernible] a little growth here or a little more cash flow? Can you just help us understand the priority of return on invested capital today under the new comp structure, which is still being rolled out as we speak versus the old deal format?

Okay. So return on invested capital is still in our incentive plan. That's on the long-term side. So long-term incentive in raw numbers -- take myself, it's 1/2 on [ TSRs ], 1/2 on long-term performance units. Long-term performance is tied to 3 metrics of: ROIC, EPS growth and revenue growth. And that will be all relative performance, relative performance versus our peer group. So if you perform better than the peers, which obviously investors are looking at those type of things, then you have a better chance on your path. So we still have a return on invested capital. The change for the company was on the annual incentive. And we have returned to net assets on the annuals. And what we felt like is we were doubling down on the return metrics. And it was not -- our return on net assets is basically a long-term measure, not a short-term measure. And we already had that with ROIC in the LTI program. So we wanted to move something that was more elastic, more reflective of what's happening on an annual basis, and we wanted to be aligned to the TSR. And we made that change. We did a lot of study on this, a lot of benchmarking. And so we think it's the best pull forward. We still have ROIC, which is important. And now you've got things that are more elastic tied to near-term results.

Yes. I would argue the short-term change gives you a little more of a growthy angle of how the business is run.

Absolutely. And we did that because [indiscernible] was somewhat inflexible to growth. If you had a good asset-to-sales ratio, which is good, you could be somewhat impervious to what's happening in the top line. And we didn't want that. We wanted people to feel closely aligned with the top line, and that was the big reason why we made this change.

Within the Win Strategy, the Simple by Design is what I'm most interested in, in the sense of, look, what -- I mean, what inning or what percent of the product has gone through that simplification process, right? Now I would think that's going to provide a lot of savings throughout the evolution. But what percent would you say the product has gone through the simplification process?

Very low. I would give you a baseball analogy since spring training is starting. We're still in the first half of the first inning. So we've now trained all our engineers in this technique. It starts with 4 design principles. And this is design principles that our engineers were part of creating. So designing with forward-looking. So thinking about how you design it to be iterative as things change environmentally and with customers, et cetera; design it to be reused, to reuse other materials that you've already designed or we've designed somewhere else in the company; design it to reduce the bill of material; and then design for flow. And I would tell you that these are principles that maybe our engineers thought of opportunistically, but not on a steady standard work type of basis. So we've designed kind of standard work around these 4 principles, we've trained everybody in that. Now design to reuse or design to reduce the bill of material would be very hard if you didn't use AI because about half of an engineer's time is tied up in trying to find things. I need a seal for this design. Can I find a seal that Parker has designed already? Well, I can't -- this is too hard. I'd spec a new seal as an example or a new valve, et cetera. So the use of AI allows you to see all that. The other thing it does to help you on design for flow, it allows you to model various manufacturing techniques. So I could try this part with AI with additive, I could try it with the forging, the process, casting, et cetera, and I can see what it might look like. Then we had the complexity assessment, which today, our new products go through there, we just do a technical assessment, is it ready for the market. Now we're doing a complexity assessment, which forces a cross-functional review of the product to make sure it's easier to design and easy to produce. So all these changes are under fold. We are tracking it. I got my first look at the pipeline, it's building faster than I probably thought it would build. But this will be something that we'll be working over many years. I mean, I think investors and shareholders and analysts would think of this as something that's going to -- it will start having a minor impact in FY '22, but it's probably a 10-year journey as we do this. And we will not just do it for new products as that's the easiest as you launch a new product, but we'll do an 80-20 cut of existing products and talk to customers about whether they're willing to redesign. In some cases, they're not. The platform's coming to an end, doesn't make sense with them, et cetera. That's why this will take time. But this will be the gift that gives for many years, David.

Yes, that's what's interesting. I mean the gross margin potential here seems pretty powerful. Now it's early in the channel. I don't hear anybody complaining about they're cheapening the product or they're -- Simple by Design, sounds nice, but it's making the product less competitive. It's early, as you said, top of the first inning. But at the moment, so far, I haven't heard anybody grumble about the product quality coming out of this new technique of Simple by Design. So...

Yes. Our quality standards are not changing. The value we create is not changing. It's just how we create that internally. If you think about a product last -- we're fortunate, a lot of our products last for decades, we might spend weeks or months designing it, then we spend the next 30 years trying to make, buy and sell it. So we just spent a little more time thinking thoughtfully on how to design it differently. We still want to create the same kind of distinctive value for customers and the quality that they expect. I think you'll see what it will do for us is there's a lot of end markets and customers we can't penetrate today because maybe we're not competitive enough. And we're going to design products that allow us to get in there and the margins that we want at a price point that customers will entertain. So I think this is not only as a margin management. It's a share gaining for us to tackle accounts that maybe we couldn't penetrate before.

I do want to get your perspective on what you're seeing in the end markets. But the one grumble off here, and it's not necessarily Parker's fault at all, but the digital strategy. I think what it's done for your factories, right, enhanced automation and robotics, that's not a question. The lead time, and somebody always grumbles about lead times. But in general, I don't think people are seeing as much as a factory impact. But on the customer experience in the digital side, there is some issue with like, look, we're an engineering company. And the internet is more of a retail experience, and it's just not being leveraged or utilized by customers as much as maybe the distributors would like, and it maybe doesn't even really warrant a big investment right now. The return on investment is not there. How do you view that digital experience with the customer and is that really the case? I mean, that's the whole thing, right? You're trying to differentiate. You're not just trying to sell a hose. And the Parker store is great, the HOSE DOCTOR initiatives are great, but the commodity aspects of the business is not why your margins are going up, right? It's about getting more of an engineered solution. How does that digital experience fit because some of the distributors will tell me, it's just bargain hunters kind of going on our digital platform and trying to figure out how they can -- they can price against our competitor.

Yes. So the digital experience is a top priority for us as a company. We now have an online LTR, so [indiscernible]. It's our version of Net Promoter Score. So we have that for the total division and for the company. And then we also have just the online experience specifically. Most of our customers do not have a desire to buy online. They're going to look for information to help them as they spec things, and we've negotiated long-term agreements and other -- they have other vehicles to negotiate pricing with this versus -- now we do offer an e-commerce vehicle, but it's not really to use that often because that's not how our products are typically purchased. The main purpose of our website is drawings, specs to understand applications. And so it's navigation and content that we're focused on. We also offering e-chat version for our divisions. And everywhere we offer that, we have very high LTR scores. The customers love that, the distributors love it. But it's very high on our list to create a better experience. But most of that experience will be on content and navigation and not so much on purchasing. And what we do -- we do purchase will fulfill through our distribution channels. No sense. We already have the best channel in the world, we don't need to recreate that fulfillment channel.

Can we dive into the end market color right now, just sort of what you're seeing? I mean the uplift feels fairly broad, but can you highlight for us as the year is playing out? And then maybe kind of weave in, of course, your ability to ramp up to serve it when it comes to price cost and all the constraints we hear out there on the supply chain, be it logistics or just pure input -- input materials?

Yes. So I don't want to say a comment about intra-quarter type of things, but if I just go back to our comments on the earnings call. We think we hit our first turning point for us to get to neutral on orders and positive on industrial, was a nice turning point for us. And we see for the second half, industrial sales in that 6% to 7% range if you kind of blend North America and international and aerospace, and a minus 11% with aerospace. On the anniversary of the pandemic, we think that they'll be about flat. So that's good signs. And we've got roughly 30% of our end markets in accelerating growth and 2/3 of them in decelerating, they're climbing, and they're starting to turn the corner to showing growth in the next phase for them. So it's outside of aerospace, commercial and oil and gas, every end market is neutral or turning positive as we speak. And I think it's a good sign for, obviously, this second half, but it's a more important sign probably for FY '22 that you're going to go into '22 with that kind of positive momentum.

Is your confidence in the recovery, and again, your ability to get the product produced, are you looking to have the company in a little stronger or higher inventory level to start fiscal '22? You would think inventory is going to be a weapon here at some point as you hear the channels constrained. We don't -- some of your competitors are historically the ones that are just reticent to add that second shift or build the next factory at the top of the cycle, which might prove wise over the whole cycle, but it does give you at times, and I won't name the companies where you've been able to take share in those moments. How are you approaching the confidence in the cycle and willingness to add a little inventory going into '22?

Yes. So we don't have any problem having inventory where it makes sense. I would just remind people that when you do lean right, inventory is a waste, and inventories typically does not help you with lead times in your factory. That being said, we were responding already. The use of AI and having us have better visibility to demand changes into the future, being able to model that, is helping us today. And so we're doing a plan for every product with our supply chain, with our factories using AI to help us with sales forecasting and demand planning for our supply chain. And this has been a historical strength. We're not perfect on the upswing, and I think nobody is entirely perfect. We tend to do better than our competitors. Our lead times are better, our responsiveness is better. And this is an opportunity, to your point, for us to take share during this time period. So we will not hesitate to add people and/or change our demand planning to respond.

When it comes to the M&A environment, again, we had this conversation about synergies, are you finding similar-type opportunities where, again, maybe the headline EBITDA multiple looks high, but your confidence in the synergies can make it a more palatable net multiple? And maybe the arenas you're looking at, I know you've mentioned in the past, instrumentation or filtration, aerospace, engineering materials, can you just take us through what you're seeing?

Yes. So I think -- want to come back to a comment I missed on your very first question. One of the things we learned on the acquisition pipeline is never stop work in the pipeline, that work, those relationships have your strategic vision of where you want to go for your respective technologies, understand the competitive landscape, where are the best matches, and do you have a relationship with those people. And we do that. And our M&A team is not just myself and a handful of people at corporate, it's every one of those division general managers. So we have an M&A team that's like 150-people strong that are working this. There's 3 things we look at: want to be a Consolidator of Choice in our space. It doesn't mean we'll swing at everything, but we want to be the Consolidator of Choice. We only have 11% market share in $135 billion space. Secondly, the 4 businesses you referenced, David, instrumentation, aerospace, filtration, engineered materials, all things being equal, we've only had $100 million of spend, and I probably would lean towards those properties. The third area would be any kind of natural adjacencies. A natural adjacency years ago was us getting into filtration. It was a natural for us to have a filtration technology in our power system, of course, then we moved it into air and lube oil and process filtration, water, et cetera. So that's a great example. So we want to continue to look for those natural adjacencies. I would say valuations haven't really changed much from the pandemic. There's still industrial valuations, maybe by historical standards are fairly elevated. But the key point is what we talked about earlier, can your synergies get you to an EBIT -- a synergized EBITDA that makes sense, and that's what we're focused on.

Yes. Of those 4 categories, in engineered materials, a sort of a broad category. But instrumentation seems to be a place where you're not the market leader, that seems to be more of where you can bulk up a little bit. And there's a lot of small players. Obviously, there's one large private player. But are the opportunities presenting themselves there as much as the other 3?

They have been, we just haven't found the right property. So I've been fairly transparent. I said there's deals we want go do, and we've been doing them, and we've been looking at instrumentation both in process control and climate control, we just haven't found the right property. And we're #2 in that space, and there's an opportunity for us to continue to grow there. And we would like to. It's a good space. But we'll see. It all depends on -- you need a willing seller and a willing buyer to make it work.

Sure. And real quick. I don't know if there are [indiscernible] questions right now. So we only have a minute left, but so I'll ask a question here. We've seen private equity get up to maybe 20% ownership, roughly of your North American distributors. How is that altering how you think about the consolidation we've seen over time? Is that something that you encourage, because you like the scale, you're trying to be more of an engineered solution than just selling a commodity? I go back far enough where any distributor getting of any size that has made Parker a little bit anxious. And then quickly tie in that the international build out, are you finding the growth in your international being in existing principles that you're giving more territories to? Are you finding new pods of capital to build out that international? Because that's a big effort right now to get that mix up higher to distribution internationally.

So on the North America front, that transition, you've seen the consolidation with some PE firms coming in, has been with our orchestration, our guidance, our support, and we've been working on with our distributors, really 2 succession plans we do, ownership and leader succession following our distributors. And so this has been under our guidance, our purposeful hand and finding PE firms that want to own distribution for long term and where they'll want to invest, add scale to it, invest in people add system applications here. So I think it's been a win-win. We've kept that close intimate relationship, and we now have owners that may be at a little more scale and capital to invest in it. On the international side, I don't see so much PE people that have global capabilities or some that have. But most part of international, it's a combination of taking -- converting competitors' distribution, but more so for us, adding distribution and adding talent. We've moved about 170 Parker people into our distributors, and we've added about 500 distributors over this period of time, just in international. So it's coverage as well as competitive alignment.

Well, I can speak to you all day, but we're out of time. So yes, I really appreciate it. Have a great day with the meetings, Tom. We really appreciate you participating. So thank you. And thank you, everybody, for listening.

Yes. Thanks for your attention.

Have a great day.