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

Fantastic. So I think we'll resume now with Parker Hannifin. It's my pleasure to have here Tom Williams, Chairman and Chief Executive.

Perhaps, Tom, if we could start out with your perspectives on, I guess, the industrial [indiscernible] outlook, first of all. I think you've been quite clear in recent presentations and calls that you do see a better backdrop to industrial demand than, perhaps, what we got used to in the past decade. So maybe sort of any updated perspectives around that to start off.

Thank you, Julian, and nice to see everybody. It's good to be back in person. So a couple of things as far as -- if I think about this industrial cycle and what potential it might hold. I view it as much more constructive than what we've experienced in the last 7 or 8 years. You've got the rebound we're all experiencing due to COVID, which you're seeing being reflected. But you've got a CapEx move that I think we're going to experience. A couple of levels: One, you're going to see CapEx to help with supplier development. CapEx to maybe cover some underinvestment in the last 7, 8 years due to 2 industrial recessions and the pandemic. You've got the acquisitions that we've done. They were a very significant change in the portfolio that were accretive on revenue and really more resilient and longer cycles. So they're going to help us going forward. You got the things under Win Strategy 3.0, which we'll spend a lot of time in Investor Day going through there. That are things we can do to help organically grow differently. You got incentive changes that we're doing. And then there's the secular trends that I see are going to be very impactful to us. I'll just give you a quick -- we're going to spend a lot of time on March 8 going through this. But you've got the aerospace recovery. You've got digitization, ESG and electrification. All these things are typically bill-of-material adders on equipment, but then also add infrastructure opportunities for us. When you put this all together in just maybe a general inventory replenishment, particularly with our distribution channel, it sure feels like the next cycle should be more constructive for industrials. And first, proof's in the pudding. We'll see how time unfolds, but I feel very good about it.

And when you look at the, say, your OEM customers, again, more on the industrial side, perhaps starting off there, and your channel partners for the distribution like business, do you still see that sort of inventories are very lean across customer, channel partner, [indiscernible]? Or do you worry about any kind of excess ordering or talking about...

Yes. No, I can never predict that there isn't a few excess orders. But we talk to our distributors all the time. We have good visibility into their inventory. In the U.S., particularly, we see their sales, what they're doing by end markets. So we have a lot of good context, and they are definitely below normal inventory levels. And they would very much like to get to higher levels of inventory. Because that's one of the competitive advantages they have, is their ability to respond with certain stocking [ positions ]. But they're nowhere near that. The OEMs typically run just in time anyhow, but they're very much below where they would normally like to be as well. Their demand is real, and I had more conversations with our customers' CEOs than probably any time in my career around the demand planning side of things. I think they're out there looking to plan a little bit longer, which is a good thing for the supply chain, but they feel very skinny as well. So I mean the people who have inventory are people like us, the suppliers that are -- we're being paced a little bit by our OEMs that have more complex bill of materials. They can't take everything we've got because the everything is coming in on a timely basis for them. And that's what's kind of having our backlog pile up, what you've seen as we've disclosed it. But it's not a indicator that there's over inventory anywhere else in the system. I feel very good about that.

And as you said, Tom, your backlog, I think, is up sequentially 5 quarters now, up in the low 20s here in December. How do you think about that playing out the next 12 months, call it? Do you worry about tough orders comps coming up, and that may drag the backlog down? Or you think it can stay at a very high level because of that strength that...

Well, I'll make a comment about orders, and I'll come back to the inventory backlog question. So orders decelerated because it can't keep going at 50%. I'd like to be CEO of a company that keep growing 50% every quarter. I'd love that, but that's not practical. What we saw from an inventory dollar standpoint, which helped kind of negate prior periods and the comparables, is we saw North America stay strong at a high level. International sequentially got stronger, and aerospace sequentially got stronger. So that felt very good. On the backlog side of things, I think as supply chain things moderate and things get better, they will glide down, but I don't necessarily see them going to all the -- to go say to pre-COVID levels. Because as I was mentioning, those secular trends, they have longer-cycle dynamics to them. And I think our backlog is going to be composed of things that are longer cycle, either through the secular trends or customers taking advantage of doing longer demand fences and signaling those, which would be a great thing for us and our suppliers. But it's not going to go all the way back to pre-COVID. It's going to be somewhere between there. And I think that would be a reflection of the strength of the company, that it's going to be a little higher than past periods.

That's helpful. And then maybe beyond those sort of cyclical gyrations, you mentioned electrification. You mentioned digitization, and we'll hear a lot about those on March 8 as well. Is there any way of kind of sizing Parker's exposure to those 2 trends?

What we're going to try to do because this is -- everybody always wants us to disclose all of our technologies and all that kind of stuff. So we're going to try to give you all a couple of cuts. We're going to take the 4 technology platforms and show you how they've changed in 2015 to today, and then with Meggitt as a pro forma. And I think without -- because I would like you all to tune in on March 8, not telling everything, it's a pretty dramatic transformation of the portfolio when you see the technology platforms and how they've changed over the period of time. The other look we'll give you is trying to characterize the company in really kind of 3 segments: long cycle, short and aftermarket, aftermarket being really our industrial distribution piece of it. And we'll try to contrast that in '15 to today. Because as you -- so those 4 secular trends, obviously, aerospace, everybody kind of gets that, what's going on and that's naturally long cycle. But what's interesting around -- you take electrification. So automotive in general would have been historically perceived as cyclical, short-to-medium type of cycle type of business. And for us, that's going to now turn out to be a longer-cycle business. Because our content on EV, being so significant and, obviously, being a small portion of the total auto production as that moves -- and that's going to move over the next 10, 20 years for a very long time period. It's going to underpin a longer-cycle auto order for us. If you take digitization, 2 end markets that were historically very cyclical, semiconductor and trucking. Now I'm not saying they're not going to be cyclical anymore, but the demand around chips and the truck -- transportation system is so important that we all buy things differently digitally, it's going to underpin kind of demand for those industries. And what we do a lot of work in semiconductor on low end process control, it's going to create a longer-cycle gyration for that. So we're going to try to take the various end markets and show you how they maybe historically were shorter cycle. And maybe not all of it, but some of it is going to map more to a longer cycle. And we'll try to give you some examples. Besides me giving you an overview of the strategy of the company and capital deployment and those type of things, we'll have Lee and Jenny -- Lee is our Vice Chairman and President. Jenny is our Chief Operating Officer. We'll take you through -- they'll take you through the 4 secular trends and give you examples of our applications and our technologies and what that means to us and try to have that come to life for you in a more illustrative fashion.

Now that sounds perfect. Just as a quick reminder, please. If you have a few seconds, open up that QR code for the audience response survey. I think, Tom, on that point on more disclosure around segmentation in the industrial side, I think that would be extremely welcome. And maybe help us understand sort of from the outside, you have that full platform disclosure of the 3 segments. Aerospace is obviously a common point [indiscernible] side of that. How do you -- when you think about sort of running the company and strategically, maybe help us understand how the sort of the 3 segments versus the 4 platforms, how does that form your discussions with all the rest of the management?

What we try to do is we're organized around technology platforms inside the company. But since most of our competition are private companies, for us to disclose margins by technology would be a distinct competitive disadvantage for us. In my view, it would be creating value degradation for shareholders to do that. We are very much organized going to market in that combined fashion. So while it looks like North American and international is combination of things, that's exactly how we go to market. And what people don't realize, and hopefully, I can help you with that, we are very much an integrated portfolio of technologies. We are not discrete technologies that stand on their own with separate sales forces. We have sales forces that represent all these technologies. Yes, we bring in domain experts and we bring in application experts. But we represent all these technologies. And that's how we have a distinctive value proposition versus our competition. We're not just selling a valve or a fitting or a seal. We put all these together in subsystems to create a stronger value proposition. And so we have a global OEM sales force and a national OEM sales force. And these are sales force that looks at all these technologies. So we represent the company in those external reporting segments, very much how we go to market commercially. But we recognize that's not always that helpful for shareholders, as it looks like vanilla ice cream to all of you, and we're trying to make sure we can give you better insight. So I think the sweet spot here is we're going to use IR Day and that platform to disclose a lot more details. For us to try to do that on an earnings call momentum, quarterly fashion would be very hard, and like I mentioned, would be a competitive disadvantage. So I think we can give you -- strike the right balance of giving you more technology platform insights, more insights to long, short and aftermarket, where we're going with secular trends, more examples. People always want to know the margins. The margins are basically identical. You take those technology platforms, they're almost the same, within spitting distance of each other. If you're trying to model the sum of the parts, you can take those technology platforms and put the same margin in theirs. This isn't that hard. All the same, we could not have -- so we've grown margins 800 basis points 7 years. We could not have done that by having one segment really stink and these other ones do fantastic. They're all improving at the same pace, and they're all within 100 bps of each other.

And if I think about the 3-segment structure for a second, the margins, I think, in diversified international has surprised people [indiscernible] good size for years now. They're up to [indiscernible]. Sounds like that's sustainable. Maybe help us understand kind of what changed structurally in international? And is there a sense in which, I don't know, if it has more -- it's had more momentum on margin, could you see it outstrip your margin?

I think in the near term, an [ XR ] guidance has international higher than North America. And that's primarily because of the supply chain challenges being more pronounced in North America than, say, outside of North America. But we're really excited and very proud -- and if my international colleagues happen to be listening to the webcast, we've worked really long time to get international margins. Well, the question used to be, Julian, is that people always tell me, when will you ever to fix international? And the fact that we've got margins equal to or higher than North America is fantastic. So it's been, I would say, 3 big things: One, there's been a mix shift in international with a higher mix of distribution versus OEM, and we'll give you the specific numbers on March 8. But the reason why that's impactful is the distribution margins are 10 to 15 points higher than OEM. So you have a mix shift going on there. The second would be we've done a tremendous amount of restructuring, as you know, Julian, that we've been after for a while. But we continue to do that even through the pandemic. And we now have the international team -- I would say we're never done on this, but we have the international fixed cost structure much more similar or competitive with the rest of the world. And then lastly, the team has done a great job with The Win Strategy and with the 2 major changes with the second version and now 3.0. The international team has really taken it to heart and done a great job with execution. And we now -- in the past, Asia stood out as being the highest-margin region. Now if you look at Asia, Europe, Latin America, North America, again, some of the technology platforms are all very close to each other, which is exciting.

Got it. And if we look at aerospace for a second, I think it's clear that the commercial side, most companies have sort of a similar outlook on recovery in line with shop visits and everything else and trying to get back to that 2019 level maybe 2 years out on commercial. Military is a lot more complicated. We heard from GE this morning [indiscernible] Honeywell, their business is down double digit. And Parker, you've had some orders bumpy. Maybe sort of help us understand how you think about that military growth outlook 12 months either side, I guess, for a second for each business.

Maybe I'd take the 4 segments, just keep kind of round numbers. So our guidance, if I look at commercial OEM, around plus 20% year-over-year -- the commercial MRO, sorry, plus 20%; commercial OEM kind of mid-teens plus. Then to your point, you get to the military side, military MRO, which was kind of soft the first 6 months, we see as being positive in the second half, kind of being flattish for a year, maybe slightly up for full year on the MRO side, more influenced by some tough comps we had in the prior period on the military MRO. Military OEM -- and the term, remind people that maybe aren't familiar with tracking aerospace specifically. When we went through the pandemic -- and I thought this was a smart move by -- all the way from the top tier customers through the supply chain, was you had some suppliers -- we didn't happen to fall into this, but we had some suppliers that were very dependent on commercial activity. And when that went to virtually 0, any military business they had to really to keep them alive, they pulled forward military demand. And so we participated in that, and we had really a, I would say, at least a year to 18 months of pull forward of demand on military OEM. So military OEM for us in our guide is probably a minus 5% to minus 10% for [indiscernible] year. Once we clear that -- and it might take a little bit into FY '23 to clear those comps, I look for military, both OE and aftermarket, to be kind of that low single-digit type of growth, which will be very attractive. We do well with that. We're on the right platforms. And then the exciting thing military-wise, which is not really in the near term, but as the new helicopter programs get decided, so those are major -- those are F-35 equivalents in the helicopter world for the future.

And when we look at firm-wide operating average, very, very good incremental margin even without kind of cost out and coming in. Based on all the work you've done on the Win program and the fact that margins across the business are like similar now, how do you think about operating leverage to sort of operating leverage in [indiscernible] out?

Yes, I still -- we benchmark companies doing this. A 30% incremental is still, over the cycle, is still a best-in-class type of performance. If I look at this, our current guidance, and what we've done so far and what we're guiding to, we've been in that kind of that low 30s. And if you take that, to your point, Julian, the prior period wage reductions that we had that aren't repeating in this period, we're in that 45% to 50% incrementals, which you might expect kind of at an inflection than an upturn, but you wouldn't expect that with the kind of inflation, supply chain disruptions that we're having. So it's really, really commendable to the operating team to put up these kind of underlying incrementals given what is arguably one of the hardest operating environments that we've experienced in our careers. And so in general, as your demand stays up, you're north of 30%. And then as you go deeper into the cycle, they start to decline. But 30%, you're modeling this over a 5-, 10-year period of time, the 30% is still a good number to model in.

And when we look at the 3 segments, I suppose it's similar across the margin rate.

Yes. Long term, they're the same. I mean this year, we're going to have higher incrementals in aerospace and international, lower in North America, primarily because of the supply chain differences. Yes, in general, you're right. Longer term, it should be about the same.

And when we think about price/costs, I think investors sometimes try and figure out, once cost inflation goes away, for those companies who suffered from it the most, get the biggest recovery effect? Or is it the companies who manage to cope it already who suddenly get a big [indiscernible] they have pricing power. To date, Parker has been in that latter camp, where you've been able to cope with [indiscernible]. How do you think about any margin impact once cost inflation...

In general, our pricing tends to be very sticky. And I'll give you a couple of reasons for that. So half of our sales in industrial, both for distribution, we have never lowered list prices. So as we raise list prices, that's not going backwards. So that -- so you take half of the sales right there. That's taken care of. On the OEMs, we maybe have 1/4 of our OEM contracts that have some kind of material clause where it self-adjusts to some kind of index that we've agreed to. And so those will adjust but you have -- the majority of them do not have that in there. And so it will still be sticky on the OEM side. The other part that we've done differently about pricing -- and I would just -- part of why we performed as well as we have on the pricing side and inflation, and to your point, Julian, it showed up in margins and incrementals, is because we look at inflation holistically. Commercially, I think most of the focus has been historically on pricing to value of new products or pricing to material changes. And today, what's going on with inflation between material, logistics, energy and wages, there's so much inflation in the system. But there's no way -- we used to be able to handle productivity to offset all these other things, inflation, and just focused pricing on innovation and material. That's not the case now. So we've been looking more at total inflation and the impact. And whilst even those OEMs that had material clauses in there, and they might self-adjust, it will be very sticky on the other elements that we negotiated, labor, energy and logistics. I also don't think necessarily you're going to see some sharp snap down the pricing. I think this is going to be very moderate and slow. And I think we're in for a bit of a time period here where things start to normalize. So I don't -- I mean we're still seeing quite a bit of inflation as we speak.

Then perhaps if we look at, I think, the last Investor Day, something that was discussed a lot was Simple by Design. I suppose the biggest impact of that is on the cost of goods sold. [indiscernible] and maybe sort of give us an update on Simple by Design and where you think gross margins. I suppose on the -- on the outside, the gross margin of Parker looks lower than peers. But there's some definitional differences around COGS. If you're looking at sort of the rate of change in the gross margin, how much upwards, how much runway is left [indiscernible].

So you nailed it as far as our gross margin -- not every company calculates gross margins the same way or books or cost of goods sold the same way. So we have some differences as far as we put a lot more SG&A into our cost of goods sold. So the best apples-for-apples comparison is to compare us at operating margin or say EBITDA, one of those other margin type of things. But I think very much so that we've got every opportunity to keep working that side of the equation. I think that price/cost will continue to work on our behalf. Go back to the first part of your question.

Yes. So it's really around the sort of Simple by Design concept, redoing some of the engineering approach.

Right. So if I could take people maybe to the birth of Simple by Design, and it wasn't a hub that -- most of the time we focus on operating excellence. How do we make things better? How do we buy things better or commercial excellence? How do we sell or price things differently? And not as much energy around design excellence. So that was an aha maybe 2 years ago around design excellence, and we've rolled out a process under our Simplification umbrella, which would include 80/20, but it includes now Simple by Design. And while 80/20 might be in the second inning, Simple by Design is clearly in the first inning of our effort there. It will be a very much a long-cycle, 5- to 10-year type of margin accretion type of thing. Maybe seen a little bit so far in the current numbers, but not that much. We'll take you through some specific examples in Investor Day to try to make this come to life for you. But in general, what we've seen is anywhere from 10% to 20% product cost reduction. That's kind of the typical range. We may have some extremes where it was higher than that. We may have some where we couldn't find anything. But in general, it was kind of in the 10% to 20% range. It allows us to design things that are easier to flow in the shops, easier as far as inventory practices and demand practices, better positioned for forward-looking changes that a customer or an end market might have. So it puts the same kind of rigor that we had on operational excellence and commercial excellence with design excellence. Because arguably -- and this is debatable, but 70% of your costs are tied up in how you design things. Think of it as pouring concrete. Once the concrete is poured, it gets pretty hard to redo the concrete. You can sit there and chip away at it with lean and strategic procurement and all those other kind of things, but the concrete itself has been cast. And if we could spend more energy on that piece of it, not just energy and time, but with standard work and processes and so we put those in place. So we'll take you through that. But that's one of those that is really yet to be unveiled in total for our shareholders. And it will be a big part of getting us to our new targets or really beyond that. I mean our new targets are going to be out the next 5 years. But Simple by Design has got that kind of staying power for a long period of time. Right now, every new product that we design is going through Simple by Design. We're methodically taking existing products through this as well. We don't want to just wait for the evolution of every new product design to find a turnover of the portfolio. We're taking the most obvious, existing products to take a look at that as well.

Great. And just as a reminder, we've got a few minutes left, so please take the time on the audience response if you have a second. I think one other area, Tom, that we'll hear about on March 8 is around cash flow. I think free cash flow margin has improved dramatically in recent years at Parker. Maybe talk a little bit about is there more room left on that if we're thinking about working capital, CapEx efficiencies? And how much of that higher EBITDA margin you generate will drop into the cash flow line?

Yes. We're going to update people on our cash flow target there. We like -- to your point, we like free cash flow margins as a metric maybe versus conversion. There's nothing wrong with free cash flow conversion, but I think margins are maybe a better indicator. And what you've seen as the operating margins and EBITDA margins of the company have gone up pretty significantly, you also see free cash flow margin mimicking that with the same kind of trajectory. We feel a little bit of near-term pressure now, as most people are, around inventory. So right now, our CFOA has been, if I took out the change in working capital, would be around mid-teens. We're around 13%, kind of absorbed about 2 points with the working capital. So I think on working capital, we have clearly an opportunity on inventory, big opportunities there. We are pretty close to being best-in-class on receivables. We'll keep working that. And I think we still have more opportunities on payables. So in general, I think working capital has more opportunities. And then as we drive margins, you'll see free cash flows move with that. So free cash flow will have 2 lifts, operating margin and working capital. And we just -- still like to get back -- I mean, we were working inventory at the beginning of The Win Strategy. It was around 18% of sales was our inventory. We got it down to 10% to 11%. Through a couple of acquisitions that had more inventory and with all the supply chain challenges that we've had, we're bumping around 15% now. So you can see the kind of working capital lift you could get if you take that 15%, maybe because of some of the deals we've done, have a little longer lead times. You might carry a little more inventory. Maybe you're not going to get back down to 10% to 11%, but you could clearly get a couple of hundred bps of working capital lift from there from where we are today. And so I think we've got some nice legs there.

And then maybe the Meggitt deal. I think the targeted close is September. I'm not sure if there's any -- you, obviously, don't give an update on the sort of regulatory process. But maybe any sort of milestones to bear in mind? I think there's something from the EU on a statement date the other day.

Right. So there's -- I wish I could disclose more, but I'll give you the 4 work streams. So there's 2 tied to the U.K. government: economic considerations and national security considerations. And we're making progress on both of them. I can't necessarily comment about that publicly. I would just say that the conversations with the government have been constructive and very positive. So -- and that's a tentative date there where the U.K. government would talk about those 2 by March 18. Now of course, they can move that date, but that's tentatively what they have now. The date you're referring to, Julian, was the EU looking at the antitrust. But -- so the other 2 work streams are antitrust and FDI filings. Those are going as planned, and the EU said that they were going to give their feedback by the end of March. I think most of the -- the entities that would probably look at it the hardest and the longest being the DOJ here, the U.K. and the EU. They're probably going to come to around the same timing, that late March, maybe into April. And then we've got some longer lead times with other countries that will take longer. So we still feel good about that sometime in Q1 of our FY '23, for everybody else, Q3, so kind of that late summer time period.

Perfect. Well, I think we're out of time. Thank you very much, Tom. And obviously, we'll look forward to hearing more in a couple of weeks.

Thank you, everybody.

Thanks for being here. Thank you.

Thank you.