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

All right. Good afternoon, everyone. Thank you for joining us. My name is Mig Dobre. I'm the Baird analyst covering machinery and diversified industrials, which include Parker-Hannifin. As all of you know, Parker-Hannifin is the global leader in industrial and aerospace motion process control and materials technology as well as filtration. To update us on Parker's current strategy and opportunities, we are joined by Tom Williams, CEO. I know Tom has got some brief prepared remarks, after which we're going to do some Q&A. So Tom, the floor is yours.

Thank you, Mig, and good afternoon, everybody. Thank you for your interest in Parker. And we'll go through the slides pretty quickly here and turn it back to Mig. So if you go to the next slide, this is our forward-looking statement, which I think you're all familiar with. You can read at your convenience. If you go to Slide 3. There's really 3 things that drive the company. It's living up to our purpose, being great generators and deployers of cash and being a top quartile company. Next slide. And part of that living up to our purpose is fulfilled with this breadth of technologies. You see the 8 motion control technologies along the top there. On the left speaks to the inter-connectivity, kind of the relationships we have with our customers and the value proposition we offer, the fact that 2/3 of our revenue comes from customers that buy from 4 or more of these 8 technologies. So it speaks to how we help them solve problems. On the right, these technologies are very intimately ready to go for clean technology to helping our customers on their sustainability journey as well. And then 2/3 will gradually evolve to 100% of the portfolio if you think about it over the next 20, 30 years. So that takeaway in a bottom, increasing our customers productivity and profitability is really our brand promise, and we do it in 2 ways: one, through the interconnected nature of the portfolio and then through our clean technology offering. Next slide. This is one of my favorite slides. I think it kind of speaks to how the company has changed over the last number of years. We showed it just last week at the earnings call. On the left-hand side is our adjusted EPS growth over this period of time. We've included the FY '22 guide on this. Then on the right-hand side is adjusted EBITDA margins. So you can really see on both of these, both of them growing at about a 45-degree angle speaks to what we've done for the company. And if you ask how, how did that happen? It's really the top heading that you see is our people, their engagement, their empowerment, their ownership of the company, the portfolio changes that we've done with the various acquisitions, and I'll speak to that momentarily. And then the strategy, Win Strategy 2.0 and 3.0 have really enhanced the performance of the company. Go ahead. Next slide. Now lastly for me, 3.0 really focused and obviously, 2.0 did as well. What can we do to grow differently and expand margins. So on the left-hand side, portfolio changes more speaks to the capital deployment changes we've made. And I've got Meggitt on there, even though it's not closed. But if you add up these 4 acquisitions, we're buying companies that are longer cycle, accretive on growth rates, accretive on cash, accretive on margins kind of makes the company more resilient for the future. Big changes to the portfolio by adding these 4 companies in there. Then on the performance side, think of this as the things we can do organically around operational excellence and commercial excellence and design excellence to improve growth and improve margins. So our simplification program, 80/20 + Simple by Design. The change that we've made to innovation to make innovation a bigger portion of our portfolio, digital leadership between customer service all the way to artificial intelligence, growing our distribution to make it a bigger part of the company, especially internationally. Kaizen, we launched as part of 3.0, but if we put Kaizen with our high-performance teams, lean and really the focus on safety, that's really how we've created this culture of engagement, culture of ownership, culture of continuous improvement. And then lastly, we're changing our annual incentive plan to go from return on net assets on an annual basis to our new cash incentive plan, which will be targeted on revenue, cash and earnings with each division, respective division, and for the company as a whole. So this future is really going to be a combination of what we've done in the portfolio and we'll continue to do with portfolio changes via capital deployment, the things we could do performance-wise. You add that to some of the secular trends that are going to be very positive to the company around ESG, electrification, digitization and aerospace, the future is quite bright. And with that, I'll turn it back to Mig to start the Q&A.

Thank you, Tom. The message from you, I think, has been pretty consistent over the past couple of years. You're building a company that's more resilient to cycles that is better able to grow and deliver improved returns. So at least that's the message that I have heard time and time again. And I do want to explore each one of these subtopics, if you will, in our discussion today. And where I would like to start is to maybe get your view in terms of what the cyclical backdrop looks like for your company. Because I think the struggle here has always been that you have been viewed as a sort of a PMI-related play, right, once PMI peaks growth moderates. But one could argue that the current circumstances are a little bit different in part because of the amount of stimulus that we're seeing. Over the weekend, obviously, the big news was the infrastructure stimulus had finally passed the house. So can you give us your thoughts as to how you think your end markets will progress as you look medium term? And I'm talking about your industrial business specifically, let's kind of leave aerospace to the side based on, again, all the things that I kind of mentioned.

Yes. So I feel really positive about what the future is going to hold as far as the business environment. And maybe just to characterize a couple of things. What you're seeing right now is what I call a rebound off the COVID bottom, which is what we would expect. The next leg of growth is the replenishment of inventory because today, OEMs and distributors do not have the normal levels of inventory in the system. So you're going to have the rebound, add replenishment of inventory as the next step. If you look at industrials over, say, the last decade, it's probably fair to say they've been underinvested from a CapEx standpoint. If I just look at our company because of 2 industrial recessions and a pandemic, if I could just compare to where we were traditionally, CapEx, it's probably slightly below normal levels. So I think there's a CapEx reinvestment tied to a more growth dynamic in the future. And then this whole phenomenon that we're experiencing now, the supply chain disruptions. If I would just contrast that to the tariff activity that happened, say, 2, 3 years ago, and all of us talked about, I think, Mig, even you and I talked about this whole reshoring potential never really came to a head because with the tariffs, you could still get product, it just cost a little bit more. Now it's costing you more, but you can't get the product, you can't get it on time. So it's going to drive, I think, a greater sense of urgency around localization. And for us, that means there's going to be more infrastructure needs region by region to facilitate that, which are placed right into Parker's hands. If you put that -- so those are all things, I think, are happening in the near term to midterm. And then those secular trends I talked about in my last slide are still there that kind of underpin us for a longer period of time. So those changes I showed on that one slide on EPS growth and EBITDA margin were with no help from a macro environment, absolutely no help. And so the future I just described even if I'm slightly off, it's going to be more constructive in the next 7 to 10 years than it was, say, the last 7 to 10 years for industrials, which is a very positive thing for Parker.

Yes. I think I understand where you're coming from on this one. You also highlight on one of your slides, I don't know if we can put it back up, but I'm sure people have seen it before that 2/3 of your customers buy 4 or more technologies from Parker. And I guess, 2 things come to mind. First is how is this different relative to, say, 5 or 10 years ago? And why is it that this is an important statistic for investors to keep in mind? What does it mean economically for your business to have people that buy 4 or more Parker technologies?

Yes. So it's a great question. So we did pull up the slides so people could refer to it. The value here is that when we compete against people, we're not just competing on a singular technology or a singular product. Imagine if you're a salesperson and you're trying to sell just a filter element or just a valve, and you can't put together a total offering, which is what we can do, which can -- so this total offering, this comprehensive value proposition allows us to drive quality improvements for customers, reliability, productivity on their equipment, weight savings, assembly savings. It's I can do a lot more for a customer. And if all I've got in my bag of tricks is a valve then I'm kind of limited at what I can do. Now if these technologies didn't complement each other and they were apples, oranges and grapefruits, then there's no synergies for the customer. Do you think our customers for a second would buy from multiple technologies if they didn't see the value? No, I couldn't have the step, the step would be -- I have 5% of the company of revenue people buy from multiple technologies. Our customers see the value and that's why they're doing this purchasing pattern. So it's really enhancing our value proposition. Now to your point, I went back 10 years ago, it probably was in the upper 50s, and now we're approaching upper 60s. So it continues to -- this complementary nature, let me just take, say, the LORD acquisition, what it brought on industrials, aerospace and automotive and especially the electric vehicles is very complementary. Let's just take the EV offering. So that all sits within our Engineered Materials technology, which was traditionally sealing and shielding technologies. Now it has coatings, adhesives, vibration control, all kinds of technologies. Hence, why you see a picture of recharging connection here. All technologies are helping with a more electric, in this case, an automobile, but a more electric anything, a more electric construction piece of equipment, a more electric mining equipment. It needs a lot more thermal management, a lot more vibration control, the batteries of fuel cell, as you name it, needs these technologies.

So one of the differentiations that I have heard, I think, in the past is this idea that migrating from selling components to selling systems. And I'm curious, within that sort of a framework. What does that mean for you as a supplier partnering obviously with your OEM customers, right? Presumably, this leads to stickier relationships. But does it also lead to some economic benefit other than just incremental sales? Meaning do you have better pricing over time? Do you have better margins over time? Is that part of what has allowed you to expand margins through cycles?

It's one of it. I would characterize as it's the portfolio, it's the Win Strategy. But part of when you go to a customer and they're looking for help from a productivity standpoint. And all you've got is a singular product, singular technology, it ends up just in a price reduction discussion. Whereas if I can take their bill of material instead of it being 60 items, and it's now 40 items because we've redesigned the bill of material, I can save a lot more money for them versus just getting into a pricing discussion. So it basically avoids the pricing discussion, it gets into a cost of ownership, total cost of ownership, which would include quality, reliability, how easy is it to assemble for them in the factory. And we like working both ends of it. We like the component technologies because great systems are made up of great component technology. So you have to invest in both of those things. But when you get into a subsystem or system, it creates a level of stickiness because a customer is not really all that open-minded to want to redesign the system because it is a requalification cost and an element of risk for them. And then it also then tends to lock in the aftermarket stream, downstream they're going to tend to replace those items with the original manufacturer.

I see. One of the things that stood out to us was the way you've kind of managed through the various supply chain disruptions over the past, call it, 6 to 9 months. And I'm sort of curious if experiences that you've been through in the past year has have in any way changed the way you were thinking strategically about your footprint, some of the decisions that you make around that. And then I kind of have a follow-up to this.

So I think it has reinforced the strategy and made us want to go faster. So in particular, if I just focus not necessarily on our customers because they have their own supply chain challenges, but really, you're referring to how we're managing our suppliers.

Your supply chain.

Right. In our supply chain, all along, we started this philosophy more from a customer experience standpoint that we wanted to be local to support them, and we felt we could do the best to make, buy, sell local for local. And then if we outservice our customer experience to our competition, we would win. And so we kind of designed our supply chain around that 3. So that is not a new phenomenon. But to your point, what it is accentuated today is to have more dual sources. And that maybe over time, when we looked at supplier aggregation and try to leverage spend over a smaller list of suppliers, some of that is good, but you have to have the right number of complementary suppliers as well to minimize supply risk, to minimize logistics and lead times. And so what we've done is each one of our groups that own those 8 technologies is defining what they want from a dual source standpoint. It's not practical to say we're going to have 100% dual source in every single thing we buy. But there is an optimal number, and it will vary by group. And so you'll see us invest more on creating more dual sources.

Yes. And you're anticipating kind of the substrate of my question because many companies that I cover have gone through this process of leaning out their supply chain to generate volume discounts. And one would argue that, that adds a layer of risk. So as we're kind of going in, we're, to some degree, undoing some of this work and creating dual sourcing, is there an argument to be made for some dyssynergies on the cost side related to this?

I think there's a sweet spot there instead of maybe aggregating your spend and having it single source where you have 100% going to 1 person, you probably can get, say, 75%, 70% with that 1 person still get pretty much the same kind of leverage that you'd hope for and then the other 20%, 25% is with somebody else. And that -- and there's also the advantage of constructive tension. The people that are single source kind of know they're single source. And if you -- if they know they've got a competitor B over here, it will create honesty in the pricing dynamics.

Maybe last question on this topic. Your challenges seem to be mostly downstream. Your customer is being disrupted by their own supply chain issues. But your availability from what I understand has been pretty good. Is that, in any way, allowed you to either gain share or make an argument for, hey, I'm a more reliable supplier than so and so. Thus, I probably need doing your business long term?

I think, yes, that argument is being made. Part of what we're doing is we take on new business is getting a commitment for keeping that business. So right now, capacity is limited and capacity is a precious resource. So we're not going to just dole out any extra capacity to just anybody. So normally, I would never talk that way because capacity was not necessarily a constraint. But in this case, as capacity is something you have to be conscious of not only our own but our suppliers, we're going to connect the dots. As we take on more business, we're going to ask for that comment that it stays for a period of time or hopefully forever. But that has always been part of our game plan is when we get into tough times because we tend to have a little better -- now we are not immune. I don't want anybody -- we are having a supply chain challenge. Everybody is having it. Nobody on the planet is not experiencing this. But I think we're navigating it fairly well, and it does give us an advantage. And that's why we went to that strategy I described earlier to make, buy, sell local for local. We thought that would be a share gain opportunity for us.

Understood. I want to talk a little bit about margins, which were much better than I think many of us expected in the first quarter despite all the headwinds that we're experiencing. And look, I mean, asking a question again that was asked on the call. Was there anything unusual? And especially as we look at international, international margins are running at levels that I think none of us really anticipated not that long ago. So walk us through maybe the puts and takes as to what is all happening here and how sustainable international margins are.

So they're definitely sustainable. So if I go back to some of the systemic things that are helping international and, Mig, you followed the company along, international has lagged North America for years. And we've always wanted to get them to converge on the same kind of performance. And of course, now we're seeing it. So it's been a restructuring that we did probably from 15 years ago and really all the way up to today to make, in particular, Europe, with lower fixed costs, simpler, take some of the country-by-country infrastructure and make it more pan-EMEA and so a lot of that work happened. Win Strategy 2.0 and 3.0 lifted everybody up. And then right now, international is feeling less supply chain challenges. So they're getting the benefit of less supply chain challenges to North America. So North America is feeling the brunt of what we just were talking about. And the international team is not feeling nothing, but nowhere near what North America is going through.

So on a normalized basis, arguably speaking, North America is under earning and international is earning what it's supposed to at least looking at the last quarter you reported?

Yes. Our margin targets are really we want both of those segments to do basically the same number, whether it's targets A, target B. As we move forward, we keep raising. The other part I missed, if you remember about 2.0, we have put a big focus and it continues today on growing the mix shift for international. International was lower aftermarket. It was around 35% distribution, 65% direct. And now it's -- I don't have the latest numbers, it went to 40% and probably in the low 40s. So that's a mix improvement, which has been adding 500 distributors and moving Parker team members into distributors is a big part of the change, too.

Yes. No doubt about it. But your international is still lagging in terms of mix with what you're doing in North America, which is more distribution based, which is why the margin performance can't totally be explained by mix. There has to be something else in there, which I guess you commented on. I know everybody asked about the long-term margin targets for your business. And I know you're probably going to tell me that you're going to defer that question for the upcoming Analyst Day. But maybe the way I would ask to get something out of you. Is...

Good luck, Mig. Good luck.

Yes, right. Good luck. I'm going to ask you this way, when you sort of think about Simple by Design, which is what feels to me like the incremental element and the strategy here in terms of what we have left to drive margins even further. What's the right way to think about this initiative, right? Is this something that is incremental rather than a step function because I sort of feel like the things that you've done over the past 3 to 4 years were really more of a step function in the margin. Do we have to see sort of a full product life cycle and product redesign that might take 5, 6, 7 years before Simple by Design really makes an impact to -- a full impact to the bottom line or is there another way to think about this initiative and other things that you're working on that might be more meaningful and drive the margin?

Yes. So I'll come back to Simple by Design, but I want to -- for your benefit and really everybody that's listening in. There's more to our long-term margin trajectory than just Simple by Design. Obviously, Simple by Design probably has the most power to propel it, but Kaizen was introduced with 3.0. And in my opening comments, I talked about linking 3.0 with safety, with lean, with our high-performance teams and think of high-performance teams how we have the plants organized. There's a direct linkage between engagement scores and margin. And you can plot all of our divisions and in the upper right-hand corner, high engagement equals high margin. And the only reason I'm going through this discussion is that if you plot our Kaizen activities and our engagement activities are going on in the same parallel path because they're driving, and what happens when we have in a Kaizen event, it makes the operator the boss. So even when I go to the plant, and I'm at a Kaizen event, wherever that value stream, that team of people, they are the people we're working for, for that day or for that week. Imagine if you're -- a CEO of your firm came into your office and said, they're going to spend a day. Of course, they may not want to spend a day trying to help you be more productive, higher quality, all that. It is liberating for people because most of their career, they've never had somebody to do that for them. So don't underestimate, Kaizen is very important margin enhancer as well as lead times, et cetera. The other part that we don't talk much about on 3.0 is constant strategic positioning. Now the power of the Win Strategy is it leverages all these best practices, both inside and outside the company across 84 divisions. But the part that we recognized Win Strategy to being so powerful as an operating system is sometimes the division general managers defaulted to that being their divisions strategy. It's a big part of your division strategy, but it does not define how you're going to position yourself to win versus the competitors, which means what's your technology road map, your channel road map, your product development, et cetera. And so we added this part of Win 3.0 and call it strategic positioning. And every month, we take 3 divisions. And the office of the chief executive reviews the strategic position for the general managers. And what it's doing is it's changing the general -- they now become the strategic owner for their business, whereas maybe they defaulted to the Win Strategy before it didn't truly own how they're going to position their products, et cetera. So that's a very powerful concept that drives margin, drives a lot of other things. The innovation of things we've been doing, I've not disclosed this because I don't want to get into having to do this every quarter for the rest of my life. But if you look at innovation as a percent of our revenue, it's 2x what it was just 7 years ago. So the percentage of our products that we sell that are new to the world, I mean commercialized within the last 5 years is double what it was 7 years ago. Why should shareholders care about that? Well, it's easier to sell and it's easier to price and the margins are all better. So these are all -- and then the last one is zero defects. So we've rolled out a zero-defect process. Think of it as design for Six Sigma with, I think, a few more elements tied to it, in particular, focusing on those groups that have the highest technical content and the highest quality, reliability content with the customer. And when you design things for zero defects you save a lot of money internally as well as you save your customers a ton of money. So it is a comprehensive suite. It's not just we're bringing a Simple by Design horse and that's the only horse we're going to ride. But Simple by Design is an extremely powerful concept. I think there's very few people talking about design excellence. I think about my whole career has been on commercial excellence and operating excellence. So how do we sell things better? How do we make and buy things better? With -- and I'm a former engineer with almost no time spent on how do we design things better. And design costs are 70% of what we do. So to get to your point, it will be incremental, but it won't be tied to all 100% new products. So every new product that we launch will go through Simple by Design. It's embedded into our innovation process. But we're also doing an 80/20 cut of our existing products and taking the next best one that should go through that as well. Now that will take time. And the new ones happen automatically. The existing ones you got to get the customer to agree to requalify the product. But in a lot of cases, we're seeing anywhere from 10% to 50% product cost reductions. And in that case, you can make it very interesting for a customer to want to look at this. So it's going to be a whole bunch of things. We'll announce the targets on IR day, but our best days are in front of us. We can continue to do more on margins. We're not tapped out and there's a lot of exciting things that we can do.

I appreciate the color, and I'm going to be looking forward to that investor event. I think we have time for 1 more question. And I saved it on aerospace, maybe get you to comment a little bit on sort of your vision for this business longer term. And I know you're somewhat confined in terms of what you can talk about as far as Meggitt is concerned. But just putting it out there, look, a skeptic's view would be that this is an expensive acquisition. You're spending $10 billion and almost -- doesn't matter how you flip it, the cash-on-cash returns mathematically seem to be somewhere in the mid-single digits. Presumably, you're seeing something different. And I'm curious as to what that would be and how this acquisition strategically fits long term with the company and [ plays out ].

So let me talk about the return part first, and we'll come back to how it fits. So the returns are very similar to all the other deals we've announced most recently, so CLARCOR, LORD, Exotic, high single-digit ROIC in year 5, EPS accretive. It will be margin accretive, growth accretive. So Meggitt's legacy growth rates were higher than legacy Parker aerospace. When we put the synergies, you got to bring Meggitt back to pre-COVID because I think looking at any aerospace business right now, all the multiples are inflated because of given the depression of revenue. If you go back to pre-COVID, a little over 16x. So a little bit less than what we paid for CLARCOR. And then the synergized EBITDA multiple, which is the key multiple is -- what is it from a synergized basis? Is 10.9%. So it's well less than what we're trading at now. It's very similar to LORD and CLARCOR as far as large deal comparisons. And the leverage, the starting leverage is going to be pretty much the same as where we were starting off with CLARCOR, plus or minus a hair. The reason why that is, is because of that slide I showed earlier, EBITDA margins growing 650 bps. EPS growing by 2.5 factor. Our EBITDA is so much bigger that we can do a deal that's twice what CLARCOR was and start off with the same leverage. So it has great returns. I mean this business, if you add the $300 million on a pre-COVID basis, it's going to be a 30% EBITDA business. We like 30% EBITDA businesses that are long cycle, that's a fantastic thing to bring to the portfolio. So it's going to double the size of the business. It's going to add 500 bps of recurring revenue because they're 45% aftermarket. We're 35% aftermarket, 70% sole sourced. And their technologies are all complementary. Their braking systems, the safety and fire suppression systems, the more electric capabilities, thermal management, the sensing capabilities that they have, it's all hand in glove. Think of it as very much like LORD, hand in glove technology comparison that will make us a stronger supplier to our aerospace customers.

All right. That's a great spot to end it. Tom, thank you for the presentation, for attending the Baird conference once again. And for the folks online that would like to continue the conversation, there's going to be a virtual breakout session following right after. Thank you again, Tom.

Thanks, Mig. Thank you everybody else for listening in.

Bye.