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

Hi. Thank you, everybody, for joining us. It's the beginning, Day 1 of the Evercore ISI Annual Industrial Conference. So really appreciate you taking the time. And I'm really trying to think of a better company given their broad exposure, the very interesting evolutionary story of the company to have kicking off the conference than Parker-Hannifin. We're lucky today to have the VP of Finance, Robin Davenport; the CFO, Todd Leombruno, to maybe give us a little bit of a quick overview, a few slides, and then we'll dive right into Q&A. So again, thank you for participating. And I'll turn it over to you.

David, thank you so much. Rob and I are very happy to be here. As we were just chatting earlier, we really wish we were in person, but this is a good substitute. So it's happy to see everybody, and thank you for your interest in Parker Hannifin. We just have a few slides here. Robin will kind of click those through us. This is just our forward-looking statement. Obviously, we're going to talk about things that are going to happen in the future. And we're going to have some non-GAAP numbers that we may discuss and we've got reconciliations on that. If you follow Parker for a long time, these are really the 3 things that drive our company. We really have been driven across our organization to live up to our purpose statement that is enabling engineering breakthroughs that lead to a better tomorrow. That has really been a galvanizing theme as we have excelled through the pandemic and as we look forward to driving the company forward into the future. We have a fantastic long history of cash flow generation. We are very proud of that. We also strive to be great deployers of that cash and generate great returns for our shareholders. And then really a theme that's kind of been elevated over the time that Tom and Lee have been in the CEO and COO role is really driving the company to be top quartile performance against our proxy peers. So just a quick overview of the company. We are the leader in the motion and control space. These 8 technologies are what powers us and what drives us. It's how we solve customer solutions, it's how we win in the market space. It is such a powerful element to us that 2/3 of our revenue comes from customers that buy 4 or more of these technologies. And coincidentally, it also sets us well up as we start to think about secular rends in the clean technology space. 2/3 of our portfolio supports the movement to clean technologies. And really, the benefit here or the value driver that we give to our customers is we are their partners to help drive their productivity and profitability. So if you go to the next slide, we're very proud of our performance. It's really been a significant step change over time. When you look at what we've done on our earnings per share, we've increased it by a factor of greater than 2.5, and we've increased our EBITDA margins by 770 basis points over this time period. And really, it's been a combination of our people, the performance initiatives that have been part of The Win Strategy, also our portfolio, changes in CLARCOR, LORD, Exotic and soon to be Meggitt that have enabled us to put up these great numbers that we're very proud of. And then I think the last slide I have is really how do we get there? This is really the performance that we've had across the companies. There is not one single thing that you could call out. It really is a combination of all of these things on what has got us here and what is going to get us in the future. And of course, I mentioned the portfolio additions. We couldn't be happier with CLARCOR, LORD and Exotic. And Meggitt is progressing as we expected, and we still see that closing in Q3 of calendar 2022. So I feel very strongly about not just our portfolio changes, but our performance. So with that, I think you could take the slides down, and we can just get right into Q&A.

All right. Sounds great. Obviously, the main topic of the day for a lot of investors trying to think through your Russia Ukraine exposure, if you can size it as direct. And then maybe think through some indirect, be it down to Tier 3, 4, 5 vendors that could be impacted. And then, of course, maybe some ramifications of obviously one clear impact are higher commodity prices, [indiscernible] the dollar is stronger as well. Just take us through your thoughts and exposure.

Yes. Yes, David, we're watching these unfortunate events that are rapidly unfolding along with everyone that's on the call here. And we are looking at that with great concern. We have -- Europe is a big region for us. It is important for us. We have team members mainly in surrounding areas like Poland and the Czech Republic, but there are families that overlap across the borders, and we are watching that. We do have a sales company in Russia. We have a sales company in Belarus. Those are open today. Those are operating today as we speak. And really, our main concern is for our team members and their families, and we hope for just a speedy resolution to this tragic event. The overall impact to us is very immaterial. It's very small when you look at the scope of the entire company or even just our EMEA performance. So it's not so much that we would be impacted from a lack of sales, it's really more a concern for our team members. Commodity prices, David, you're right, there could be some volatility with those based on whether that be energy or whether that be direct commodities. But we have always had a strong set of tools that we manage input costs. I think if you have seen our performance over the first half of the year, you've seen that we've been proud to say that we've been able to remain margin neutral. The demand environment and the pricing environment is really at a level that we have not seen, right in, certainly, most of our careers. We've expanded that to look at things outside of material cost. So we're looking at energy costs. We're looking at labor costs. We're looking at freight and logistics cost. And we're trying to capture total inflationary pressures. And like I said, it is active involvement by every one of our teams, both in the operations, in our sales and pricing functions and really across the globe. And it's something that is spoken about daily across the management team, and we are committed to make sure we do everything possible to maintain margin neutral in this time of rising costs.

And to be clear, just to quantify the Russia Ukraine exposure, would you characterize as less than 1%, 2% of revenue?

Significantly less than 1%.

Okay. All right. And those sales are small, but I mean are we stopping sales right now?

We are following all rules that have been set up as far as the sanctions go. So our team -- our customs teams were all on that last week. But David, I can't stress it is a very immaterial piece of the region and the company.

And it's a little early, but -- I mean, obviously, Germany's announcement today of further investment in the military. How is it impacting your military business?

Yes, David, I think you're right. I think it is probably a little bit too early to sense. I did do a quick check this morning, and I think the takeaway is it's probably too early to say that orders are flying in based on potential actions. If it does get to a more significant military use, it obviously would be a positive for us. But I think it's still too early to kind of go that route yet.

So no calls from customers saying, "Hey, just be on watch for incremental."

Not that I have heard yet, and I don't want to say that there hasn't been calls in the specific divisions, but that hasn't bubbled up to our knowledge yet.

Okay. And the price cost, you mentioned it's been neutral to margin, which is obviously better than most -- any company I cover. Given some of the volatility here though, are you still comfortable that price cost can be neutral to maybe accretive to margins as we move further into calendar '23?

Yes. I mean what we've tried to do with our customers, David, is we've tried to communicate with them in real time. We fully believe that you have to be active and transparent in this process. We don't want to get caught behind. We don't like to go in and ask for a significant increase. So what we're basically doing is we are passing on the costs that are increased to us, and we're doing that as often as we need to in order to remain cost neutral. We're not trying to make that a margin positive, and that has been our long-term goal, and there's been no change to that whatsoever. But we are active, we are very active when it comes to making sure that we don't take a step back.

Regarding the supply chain, have we seen any improvement? And if so, where? And if not, maybe actions taken? I know you altered some of the -- where the port activity was going from Long Beach or diverting into Houston, things of that nature. Maybe first and foremost, just are you seeing any improvement in supply chain?

Yes. I mean it's -- our teams are very active. This is really kind of the benefit of our decentralized structure, where we have teams that are in the day-to-day of their businesses, the demands of their customers, the issues with their suppliers. But what's nice is that we have a center-led team that helps direct and leverage the power that is Parker Hannifin. So we've done a lot of that. We have gone to alternative ports. In some cases, we have been active with logistics companies and freight forwarders and whatnot. It felt like Q2 was hopefully maybe the peak of those issues. I wouldn't say it's a significant improvement, but there are some signs of maybe just our teams being more apt to react and manage the situation that we're in. We think it's going to be with us for a while. But again, we clearly take responsibility for the supply chain. Those are our suppliers, and we understand that our customers need the products, and we're here to support them.

When it comes to the size of your backlog and some of the supply chain issues, it sounds like though from, when you say 2Q, right, fiscal 2Q, calendar 4Q, right? So it sounds like at least it's -- let's say it's at least stabilized. But the size of your backlog, I mean, right now, it's -- if you look at the industrial business, it's 57% of your next 6-month revenue guide for industrial.

Yes.

I mean, usually, it's 30% to 40%. So when I think of that, now you're more of a short-cycle business to be fair outside of Aerospace, but is the supply chain dynamic impacting how far you're willing to open up your order book?

Yes, David, that's a great question. I know there's been a lot of comment around that over the past few months. To be honest with you, I have not seen customers asking for a longer window of time. Certainly, if you take the aerospace business out of the equation, that certainly is a longer cycle business, especially when you get into some of the military elements of that, where it could be multiyear orders that flow through the backlog and it's lumpy. And that's why we kind of do it on a 12-month rolling versus the 3-month rolling. But what I see here is, obviously, the percentage comps are impacted based on the decline that we experienced along with everyone else through the pandemic. So our order dollars are increasing, and the backlog is very robust, as you said. I think if you went back and looked at other significant downturns, maybe the financial crisis, maybe you can do that. I don't know if we see that much different in our core business as far as the backlog changing. But also, I would also state that when you look at that, we now have certainly lowered in that industrial side of the business. There is some longer-cycle elements of that portfolio. But also the CLARCOR piece, right? And if you look at -- I know CLARCOR is now coming on 5 years old, but we've had 2 recessions and the pandemic in that 5-year period. So when I look at the backlog for that business, it is very, very strong and robust across those businesses as well. So I think it's a combination of our core businesses having that impact from a bounce back, if you will. It's our portfolio changes. And then I really just think that we've often allowed OEMs to make an annual blanket order with scheduled releases. That is still occurring. And we haven't noticed any different of it. We're very close. We're making sure that, that backlog is real. And we can tell based on our communications with customers that it is product they need, and we feel good about it.

I'd like to look at order growth versus inventory growth just to get a sense of -- and lately, I look at my model here, I mean, we saw last quarter, your inventory growth did grow a lot more than orders. Now the comp obviously plays with the numbers a little bit.

Correct.

Can you take us through maybe how you're thinking about orders versus inventory growth? And I know maybe a little more inventory right now is a bit of a competitive weapon. That might be a temporary issue. But thought process and what you're seeing on orders?

Yes, David, that's a great point. If you look at our business, historically, we do grow a little bit of inventory in the first half of the year, and then we reduce in the second half of the year. It's just part of the seasonality of the business. For years, we've had a stronger second half than we had our first half. A little bit of that is just based on a number of working days. So there is an element of that, that we do expect inventories to reduce. We think it's an opportunity for us, David. We think we can do better. There's no doubt about it. In some cases, to make sure that we had continuity of supply, we may have made some orders to -- larger orders or larger inventory orders in order to make sure that we could continue to deliver over time. And that's just based on all of the demands that are happening at various suppliers around the world. And then in some cases, there certainly are still shortages, chips get the headline, but it's really all kinds of electronic components that are a challenge. In some cases, that is keeping inventory that we have in our facilities, maybe waiting on 1 or 2 minor components in order to ship.

And the one thing I would add to that too David, is that with our customers trying to manage their inventory and their bill of materials, very, very short lead times that we've gotten in many instances in terms of them having to postpone shipments because they have incomplete bill of material, which obviously keeps our inventory a bit higher than we would have otherwise planned.

And to meld that understanding right, being a good supplier, you're willing to carry a little bit on your balance sheet while they're working through all the machines sitting, waiting for component.

Yes.

But the earlier comment that last quarter, calendar fourth quarter, was maybe the worst -- or the peak of the problems in the supply chain. Are you also seeing downstream that the amount of machines that people refer to as in-hospital missing a part? Are you seeing from your customers that it is starting to come down for them a little bit?

Yes, David, I haven't heard much of that. I know that in the conversations that I'm part of, the demand is still very robust at both our OEM customers and certainly our distributors. So when I say that the supply chain challenges hopefully hit a peak in Q2, they're getting slightly better. It's not like it's a night and day step change as we progress throughout the quarter. It's just something that is not a surprise to us anymore, and we are reacting and our teams jump right on it and get to the best solution possible as quickly as we can.

If you don't mind me asking, but as the CFO, I assume this is top of -- tip of your tongue, top of mind. What is the wage inflation that you're experiencing right now? I'm just curious, just given some of the labor contract issues we've seen and everything...

Yes. I mean, it obviously varies by country that we do business in. Our cycle -- our wage cycle usually is September through September. We just made that change a few years back. We are right in line with what you're seeing in all the news, right? It is greater than it has been in the last 20 years, but it's right in line with what you're seeing in there. So maybe 50 basis points higher than what the average has been. But it's 50 basis points higher than what it's ever been. So we are reacting to that. We have a strategy. We want to be competitively paying our team members around the world. We will do that. We will continue to do that. And we make up some of that in productivity. And we own that. We've always owned that over the entire time that I've been with the company, we don't foresee that changing in the future. But there are a number of cost input pressures, labor being one of them, that we're making sure that we get value for and we get paid for.

Looking at the growth profile, the second half of your fiscal year, calendar first half, the guidance implies a little bit below 6.5%, but 7% organic. If you look at consensus for the following year, they have sales at 7.2%. So I'd say, a little acceleration from the 6.5%. To try to think about a reacceleration, where do you see that ability to, say, accelerate a bit from the second -- fiscal second half? Is it an Aerospace acceleration? Is it -- everybody is pontificating about the supply chain, but if the supply chain loosen, you'd be able to ramp up volume beyond the current run rates, just trying to think that through.

Yes. I mean, David, I think you said it right. Aerospace is a piece of that. But across our industrial businesses, demand is broad based. You look at our international businesses, I think we stated, every one of those is mid-teens positive from an organic growth and an order standpoint. So we feel really good about that. We are managing the supply chain. There's no doubt about it. North America has robust backlog as well. So some of that is carried through of that, but also, we'll talk a little bit more about this on Tuesday with attention to these secular trends, Aerospace being one of those, but clean technology, digitization and...

Electrification.

What was that?

Electrification.

Electrification, yes, right, which is very, very big for us in our LORD business, which has really been a wonderful thing to see, and that has expanded our content on virtually every electrical platform that's out there. And not only is it expanding that, but it's longer cycle in a sense of automotive maybe used to be more considered short cycle. But with this conversion to electrification, we see that as a nice secular win that's going to take us where we want to go as we look at these new 5-year targets.

One aspect of growth in fiscal '23 versus '22 is inventory potentially needing to be rebuilt. But how would you characterize the inventory when it comes to your OEM customers, which is a broad swap, I get it, but begin to summarize. But then also on the distribution, where would you characterize the inventory versus exiting fiscal '22, starting July fiscal '23.

On the OEM -- or excuse me, on the distribution side of that, I would say there's still room to grow from a restocking standpoint, right? A lot of this activity has been very much centered on pent-up demand. Actual products that are needed from a repair standpoint. If you talk to our distributors, which I know, David, you're close to many of them, I think they would like to grow their inventories across those various channels. So that's the message that we're getting. That is what our orders are indicating, and that is the way we are working with that team. On the OEMs, I think it would be a little bit of a different situation depending on what end markets they're in. But we're not feeling like there is excess inventory in the channels as we work our way through our second half year and of course, as we look out into future years.

Can you give us a little color on China? When I think about some of your exposures there and lately, you've seen a little better auto data out of China, while the heavy cap goods, be it heavy truck or construction, is still down a lot, but maybe starting to find a bottom, maybe a post Olympic, post Chinese New Year, maybe the COVID lockdown is not as severe. Just curious if you're seeing any hint of improvement.

Yes. I mean I couldn't be more impressed with our Asia Pacific team specifically, but if you want specific detail on China, they're performing unbelievably well. I think historically, that market might have been a little bit more focused on construction equipment. But as we have built out our capabilities, as we've built out our technologies, as we have moved to localized product in China, it has grown in the other markets that we serve in that space. And of course, CLARCOR and LORD have been a big piece to that. So when you look at things like the electrification of automobiles, that has been a nice plus. So we couldn't be happier with China. It is performing just like the rest of the company at record levels. And what's nice about this is that we see that there is upside across the China businesses, our Asia Pacific businesses, our entire international segment as long as -- or as well as the Aerospace and the North American businesses.

But just to bring it more near term, nothing yet necessarily on an uptick. I mean the business is obviously taking some share with the penetration, but [indiscernible] guys on the ground?

No. I guess I would just direct you back to our guide. That's the most I feel comfortable saying.

Yes. In the quarter, we set a China growth for Q2 as being mid-single digit.

Okay. When it comes to the Meggitt acquisition expected to close maybe late this summer. I know Robin is close to it, and she's excited to tell me everything she can about it right now. I know [indiscernible] very much. We can't talk about it, but if you can just give us what you can just thinking through all the aspects of what are the -- are the pensioners happy with the situation? Is the government, at least? Because we have a lot of regulation [ road milepost ] coming up, how much of the Russia-Ukraine situation pushes that back because they're busy? Does it pull it forward because they're excited to get it done? Just curious, your thoughts.

Well, David, I would tell you, we couldn't be happier with getting to the agreement on Meggitt, right? We are working the process. It is a unique complex process, more so than if it wasn't a publicly held U.K. company. But it's exactly what we expected. So we are progressing on our time line. We clearly foresee that as a Q3 calendar year '22 close event. We're working through the regulatory filings. We're working through the economic commitments. We're working through the national security clearances. And we still feel very confident that, that is a Q3 calendar year '22 close. Culturally, very similar companies, right? This is a company that we have known for a long time, that is very complementary to our Aerospace business. We know people that have worked there. We have people that work on our team that used to work there. So it is a nice combination of talents, and we're looking forward to making a bigger, better automotive supplier for that growing market. And it's very important to us because we firmly believe in the thought of aerospace as a secular trend. So I would say, at this point, everyone is happy. We are really looking forward to progressing through the timeline and getting to meet a broader team from Meggitt very soon.

Fair to say you won't answer the question, what do you think the accretion from the deal will be? Is that something we...

Dave, when you look at our acquisition strategy, we look at -- we only look at companies, obviously, that are in our space, but they've got to be accretive to sales growth. We prefer them to be a little bit longer cycle, which this one fits. And they got to be accretion to segment margins, EBITDA margins and EPS. So this will all check the boxes on every one of those things.

We have time for one last question. And just maybe as a segue to next Tuesday when you have your annual -- not annual, I guess, would be 2 years since the last one. I think you were the last meeting, right? Or you were about to have the meeting and it went virtual...

Yes, unfortunately, we learned really quickly how to do a virtual Investor Day. Robin did a great job putting that together with about 4 days notice, 5 days notice?

A couple more.

Thinking about the margins, right? We'll get new margin targets. And the management has long stated, we look at ourselves as a 30% incremental margin business. So for simplicity, if you just did a mid-single-digit revenue growth, 20%, 30% incrementals on that will give you 30, 40 bps a year of margin improvement. When we think of above and beyond that, if we try to think about what we could hear next Tuesday, the key drivers, is it going to be Simple by Design? Building out the distribution even further in international as a mix, which is obviously a positive margin mix? And then I guess the Aerospace business, inherently, when things are really clicking, it could be very high-margin business, though your industrial margins are pretty close, how do we think about above and beyond that kind of 30, 40 bps a year from the previously stated 30% incrementals?

Yes. Yes. So David, that 30% number, we feel good that, that's the right number as a over-the-cycle target. In some times, we do a little bit better than that, sometimes it's a challenge to get that good depending on what's going on in the business. But we think that, that, from a target standpoint, that is the right target. It is not an easy target to get. It is not just volume-driven, sales go up and boom, 30% drops to the bottom line. There is a lot of work that goes into that. A lot of that work is all of these components of The Win Strategy, right? You mentioned international distribution expansion, you mentioned Simple by Design, Kaizen, Lean, 80/20, all of those things are elements that allow us to generate ever higher margins. And when you look back at what we've done, I know you followed us for a long time, we're very proud of being able to commit to an increased number and then having some confidence that you could trust us that we are going to get there. So I think that's what you're going to see next week. We like the 30% incremental target. Everything that we're doing is a component of ensuring that we get there. And I think we've learned a lot as we have progressed through the pandemic, right? We learned a lot of things that we didn't think were possible, right? Doing meetings like this are a prime example of just productivity gains that we are experiencing across our global businesses, right? And that is a big piece. Digitization and digital productivity is a big element of what we see going forward. So we're looking forward to sharing more with that with you on Tuesday, and we're really bullish about what Parker can do in the future.

Well, I appreciate you taking the time. Thanks so much, and I'll be there, at least virtually, right? It's a virtual meeting.

Yes.

I will virtually see you on Tuesday, so...

Excellent.

Thank you so much for taking the time. Appreciate it.

David, thank you. And thanks, everyone, for joining.

Have a great day.

Thanks.

Thank you.