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

Good morning and thanks for joining us for the final presentation that we have here at the, certainly, the final industrial presentation here at the Wolfe Transport and Industrials Conference. I do want to say thanks for all the corporate attendees at this conference, so really appreciate it. And finishing off for us, I guess, leaving the best to last would be Parker Hannifin. And very pleased to welcome back to the Wolfe Conference Chairman and CEO Tom Williams. Tom, great to see you, thanks for being with us.

Nice to see you, too, Nigel. Glad to run the final leg of the lap here for you. It's been a good 3 days for you, I hope.

Yes, pretty good. I think CEOs still feel pretty constructive about the environment, obviously, 1 or 2 challenges potentially in the background. But yes, I think the feedback has been pretty, pretty good. So it's gone very well. Thanks, Tom. So this is a fireside chat, virtual. We're going to obviously lean very heavily on Q&A. But I'm wondering if you've got any open remarks you want to kick off with and then we can go from there.

No. I think you can jump right in, Nigel.

Cool. Okay. Let's do that. Okay. So let's start off top of the mind for a lot of folks here is Meggitt. I know that there's not a whole lot you can say about Meggitt because there's a very sort of rigid regulatory environment with the London Stock Exchange. But you've got the closure planned for third quarter calendar this year. Just give us an update in terms of what you're seeing in that process and then go from there.

Yes. The process continues to go well. You probably saw we announced this week on Monday the divestiture of our wheel and brake business, which that was one of the items that the European Commission had put their conditional approval on. And so that transaction was announced and that will be contingent on our closing of Meggitt. We'll then close that transaction. That was an important step. So basically, we're down to, we have all the approvals. What's left is the U.K. and the U.S. for antitrust. On national security, you've got the U.K. and France. But I can't necessarily get into those discussions. They'll conclude when the regulatory authorities are comfortable in concluding them, but the discussions have been constructive and positive, and we still feel good about that third quarter of this calendar year for closing with Meggitt.

Yes. Yes. And is there one of those regulatory actions as a precondition for others to follow suit? Because oftentimes we see that there's one very important approval that then is precedent for others to follow suit.

Yes. Obviously, I think the U.K. and the U.S. will run their own processes, but they certainly look, there's a lot of discussions that they have with their counterparts in other parts of the world. The European Commission was, all the other approvals were approved as is. The European Commission was the only one that had a stipulation, the divestiture of our wheel and brake business. And I think by doing that, I think if there were any possible concerns, that probably helped alleviate a lot of it.

Yes. I thought the price you got for that wheel and brake business was actually pretty good. Sometimes with these regulatory-driven divestitures, sometimes the price reflects the fact it's a forced sale, but I think you got a great price.

We were very pleased with the price. We're pleased because it's ending up in a strategic buyer that we think is a great home for the business. I think part of what helped us in price, it's just been a fantastic property. I would not have wanted to sell it. But obviously, selling a $70 million business to get a $3 billion business makes a lot of sense. You do that all day long. But Kaman is getting a fantastic business. And they saw how it's been just a steady performer, high margins for a long period of time. It fits nicely with their portfolio and that was a factor in their pricing decision.

Yes. And again, I know you're somewhat constrained by what you can and can't say around Meggitt. But it's now been, not quite a year, but certainly 9 months since you announced the transaction. How much ability and scope have you had to do additional due diligence around the whole situation and get more comfortable with the plans once you get full ownership of that company?

Yes. We have done more due diligence. That stopped. We've started high-level integration discussions with the team. And I would characterize them as, I would probably underline the level, not getting into anything that we're not supposed to get into. But everything that we've looked at continues to be very positive. And the opportunity to buy a company at the beginning of a commercial recovery with the kind of synergies that we've got planned that the 2 teams could do, that are synergies that are, I would characterize very similar to how we looked at with LORD. They're not really plant consolidation. But to contrast CLARCOR and LORD, the last 2 big deals. Exotic was a big deal, but it was a stand-alone division that fit in the aerospace. CLARCOR is heavy plant consolidations, 20 plant closures, highly complex. LORD was more Win Strategy, SG&A, and I think you're going to see Meggitt be more like the LORD playbook. So I think the degree of risk is much less because more complementary technologies. There's not a lot of overlap in plant capabilities. You're going to keep those capabilities. And I think that will make the integration smoother.

Yes. And perhaps maybe this is a good point to actually take the example of LORD, which is and was a great company when you acquired it. And you've obviously made it even better company through Win. Maybe just some common examples in terms of where Parker was able to bring to bear quality improvements in the process for LORD in terms of product kind of development, product delivery, manufacturing, et cetera?

I think LORD was great on application engineering, the commercial relationships that they had. The talent that was in LORD was extremely high. And I think that the benefits as far as what we brought were the disciplines within The Win Strategy around Lean, supply chain, pricing, Kaizen, Simple by Design, all of those type of things that's in The Win Strategy. And you put those, this whole theory of acquisition, and part of why our integrations have gone so well, we're going to take the best of what Meggitt does, the best of what we do, and this 1 plus 1 equals 3. And that's what we did with LORD. And we've taken some best practices from LORD around application engineering and their commercial structure, and we're now translating that across the rest of the company. So it's been very much a two-way street, and this will be the same when we handle Meggitt.

Yes. Okay. Now I imagine you're deep in the plan process for I think about FY '23 given your June year-end. And I'm not going to ask you for FY '23 guidance. But certainly, we'd really appreciate your perspective on the cycle as you see it because right now the market has seen a lot of shadows, consumers getting heavy legs, et cetera. How do you see the cycle at this point, 2 years out of COVID, well, from the COVID lockdowns in the U.S., how do you see the cycle progressing from here?

I think one of the things I would say, it's going to be difficult to predict. You've got an environment where interest rates are going, going up. You've got a quantitative tightening. You've got inflation. You haven't had all those together at one time in a long period of time, if ever. However, most economists and most people would try to pretend like they knew what was going to happen are typically wrong. And most of the time, we figure out we're in a recession about 9 to 12 months after we're actually in the recession. So my comment around what's going to happen is more about how I feel about the company being different about this next period of time for us. I think our top line is going to act materially different as far as, if there is some kind of geopolitical extra event or a macro event compared with the past, you just plot our top line over the last 20 years, you'll see our top line has progressively been less disruptive, less decline. We blunted the declines and we've become less cyclical over this period of time. Now just taking the last 7 years, we've done 3 now, a fourth acquisition pending that will double filtration, double engineered materials and double aerospace. We've never had that kind of portfolio going into a down cycle before. Those are all really great things. You take a company that was already working on sustainability before it became sexy to have sustainability. That whole ESG equation has just been an adrenaline shot for our portfolio, clean tech and the electrification piece. And so that linkage to secular trends around aero, digital, clean tech and electrification all have bigger bill of material for us, 1.5x to 2x a traditional bill of material, combustion bill of material, growth rates that most people would argue are probably going to do well despite what happens on the macro side. And it doesn't mean we'll be impervious to a down cycle. I just think you'll see this down cycle, if it happens, which I think there's still a question on if it would happen, that we'll perform better. And that's why you saw us change our growth rates to that 4% to 6% that we think we are less linked to PMIs and global industrial production because of the portfolio change, because of the secular changes, the things we've done organically on The Win Strategy that we'll grow differently. And exactly what we'll do next year? You know I'll reserve opinion to telling you that in August. And I still feel good about next year. We have 90% of our end markets still growing. It's not like I feel like there's some impending recession. But the one thing I've learned is to design a business model that is more responsive, more resilient, has higher capabilities and then you can weather whatever gets thrown your way. And I think that's the best plan you can do as a CEO.

Hope for the best, but plan for the worst, I guess, that's really true. I do want to come back to long-term targets in a moment. But coming back to all of the factors you discussed, you described, the ESG dynamics, electrification, all of that stuff. We got infrastructure coming through theoretically next year. I mean, normally, when consumer catches a cold, the industrial side will get pneumonia. Do you think that this time could be in some ways different? I mean, again, not immune, but do you think the industrial side can hold up better because of these structural factors?

I do. And you're right. I think, in general, consumer is going to drive the GDP because it's 70% of GDP. However, if it's influenced because of inflation and people cutting discretionary spending, our customers buying Parker products and the end users buying our customers' products is typically not a discretionary purchase. I need this for my equipment. I need this for this application. You do have infrastructure spend, to your point, government support there. You have a, if you look at the CapEx for industrials the last decade, probably most of them at about depreciation rates or even less. So there's a need to kind of get CapEx back to more normalized levels. You're going to need CapEx to fix some of the supply chain issues. I can't be the only CEO in the world that looks at supply chain and I'm going to invest in more regional capabilities that's going to create the second and third derivative around that of infrastructure works. We play in all of that. You've got a distribution channel that's not at the stocking levels that they would like to be at. And then you've got the portfolio and you got the cycle. You have a lot of things that makes me feel very good about this. We should weather this. I actually think if and when something happens, the consumer side gets impacted much more so than industrial piece.

Right. You just said something very interesting about you're not the only CEO talking about investing in regional capabilities. I always think that Parker as a very localized company. You're local for local. You don't do a lot of cross-regional manufacturing. So just curious where do you need to do work to better align your manufacturing supply chains with customer demands?

Yes. Less to your point, Nigel, on local for local because we've been doing a lot of that for years. And a good barometer, remember when the tariffs came in during the Trump administration with China, our impact was basically immaterial because we don't do a lot of China into the rest of the world. That being said, what we're focusing on is creating more competitive tension and more capabilities locally. So looking at the percent dual source that we have across our spend. Now it's not rational to say, I'm going to go to 100% dual source in every single thing I buy. But we have every group looking at that. We have targets by group, by division and we're tracking that. And so that will require not necessarily CapEx from us, but it will require us qualifying other suppliers to create that competitive tension, derisk suppliers. And then the other aspect we're going to look at is we're going to track how many miles of ocean and air transportation that we do. We're going to try to cut it in half because those are the 2 more disruptive logistics. Truck and rail means by definition that you're in the region. So the air, obviously, you can do regional air work, but air is very expensive. And then ocean clearly is a longer lead time. So we're purposely trying to create more competitive tension, derisk and reduce the logistic miles that stuff travels. And even for us as a local for local player, historically, there's opportunities for us to keep doing better on that.

That's a big number, 50% reduction. That's meaningful. Well, you've done a great job, I think, relative to some of your peers on managing supply chain. You've managed through it very well. I don't want to curse you. But certainly, to date, you've done a great job. But where are the pressure points for you right now in terms of material supply, I don't know, labor productivity, et cetera? What keeps you up at night in terms of the supply chain pinch points?

I think the supply chain, I mentioned this on the call, has stabilized. It's still not at what I would call normalized levels of efficiency, but at least it hasn't gotten any worse. The exception was we felt chips got a little worse during the quarter, and that's where most of our energy is. There's some raw materials that will go into some of our engineered materials that we're keeping an eye on. But the bulk of our activity is making sure we've got qualified alternative chips. So we're doing a lot of work. Our engineering teams are doing a lot of work with our customers to just make sure we qualify as many chips as we practically can to just be there to help ourselves and help them. And so a lot of energy going around that. I don't think it's getting any worse now but that's not a quick solution, and we'll continue to work it.

Okay. Not getting worse, not getting better, which I think brings us on to China. That's obviously an area where there's some big pressure points right now. Not a huge market for Parker, but you put out a very specific target in terms of the $100 million of sales impact at a 40% decremental margin. Maybe just describe, Tom, what you're seeing real-time in China relative to kind of like when you report results end of April, beginning of May and what you saw through May?

Yes. So when we gave the guidance it was around, just to give some details, we have 18 facilities in China. And at the time we gave guidance, we had about half of them running, what I would call, close to normal and half of them being shut down with different government shutdowns. That has now moved to where there's a few that are shut down. Most of them all sit in the Greater Shanghai area. They're at various levels of coming back up. If you're not familiar, the government has what they call kind of closed-loop production, where they're allowing you to bring in a certain number of people into the facility, but those people can't leave the facility. So obviously, that's not a normal life for people. Our people are volunteering to do that. And we're feeding them and providing them places to stay in the building. So we're getting, production is coming up a little bit as a result of that. That's part of what we factored into our $100 million guidance. We do roughly 6% of our revenue in China. So that's to provide context of how big China. So it's a fairly good sized market for us. The 40% decremental is a realization when you take 9 plants and you have 0 volume going through there, it's pretty hard to manage that. Most times, you hold the decremental and you've got 10%, 15% volume decline and you manage your variable cost over those fixed costs to hold it. When you have no variable volume and all you got is fixed cost, you're kind of stuck with that thing. So what I see is a gradual upturn of production coming online, dependent on when the government releases levels of employment going in there. And then I think the question mark will be just how well does the supply chain recover? Raw materials and logistics within China, how well do they do because they're going to do the same things that we're going through. I think that this all gets worked out as we go into FY '23. And that $100 million, we'll add that $100 million on to whatever we're going to do in FY '23. How long that takes? I don't think it takes terribly long, but it's going to go into our first quarter. And when we get to August, obviously, we'll have a lot more intelligence on how that's going and how the supply chain is going. I think it's a little too soon, but that gradual reopening is happening and we'll just have to see how it goes.

Yes. Okay. That's great. But I think you said a few facilities at this point still impacted by the lockdowns?

Yes. Probably of the 18, we probably still have 7 that are impacted, but they're not down to 0. They're at various levels of coming back up.

Okay. That's great. Europe is top of our mind as it is for a lot of investors. It seems that the trends in Europe, generally speaking, are okay. How would you characterize the state of the customer in Europe?

I think Europe is still pretty good. I mean, I won't get into where we were post the earnings call, but our order rates volume-wise were very consistent through the quarter, including all the way up to the earnings call. And so the difference we see on the percent of sales, we guided to a 5% sales for EMEA in the quarter, is really just because it's a tougher comp in the prior period. Our order rates were kind of in that low teens for the quarter, and they were stable in that period of time. Now we just have to see what happens if there's a knock-on effect from the war, a knock-on effect from energy costs within EMEA. That's, I think, yet to be played through. But at the time we did the call, we haven't seen that yet.

Okay. That's great. Let me give the room a chance to ask any questions. If you got any questions, please raise your hand. No? I guess, I'll carry on. Inventories, obviously, inventory has got scope to add a bit of noise and short-term swings. I mean, any thoughts on where channel inventories are right now, Tom?

Yes. I think our distributors are under where they'd like to be. They would like to have more inventory. And I would say are probably frustrated that they can't get to a better inventory position. And so I think regardless of what happens macro-wise, our distributors will treat this as an opportunity to get into a better position. So I think that's a good thing for us as we go into '23 that they will want. I contrast that to when you go into a pandemic and there's all these unknowns around a pandemic. Obviously, people were very conservative, managed cash, very abrupt and taken things down. This is going to be, whatever happens, this is not going to be like that. I think they're going to take this opportunity to invest. And so that's a good thing as we go into '23. I think our OEMs are pretty much, they have more inventory than they want, same as we do, but it's because they can't get all the right pieces of the pie to put their equipment together. They are very much metering our demand, call it, demand fences there. We have an order, but they are telling us, here's what we want you to ship and when because they don't want to bring anything extra in if they're waiting for something else to put their piece of equipment together. I think you'll see that continue. And once things stabilize, supply chain, our OEMs typically have relied on us. And they're not going to carry the inventory. They want us to carry the inventory to meet their demands. I don't see their strategy changing unless they see an opportunity to take advantage of beating one of their competitors out by putting in some more selective inventory. But I think they'll rely on us, which is what they've historically done.

Okay. That's great. Certainly, that gels with what we're seeing as well. Moving on to the long-term targets. You obviously refreshed the strategic plan back in March. As you mentioned, you now have a 4% to 6% sort of hard range for growth. The first time, I think, you've done that. You've normally been GDP tied. So what gave you confidence, Tom, to go with a hard target like that? And 4% to 6% would certainly be well north of what we've seen in the past. And do you think, is that because you see a stronger industrial cycle or is it because you see opportunities for Parker to outperform that industrial cycle?

I think it's going to be a mixture of all of the above, Nigel. You, first of all, got some of that channel restocking that I talked about in distribution. You got the conversation we just had on supply chain, and I think the need for all of my peers to strengthen their supply chain, which creates this knock-on effect on infrastructure and CapEx, either equipment or buildings, that's going to help us. We've changed portfolio more dramatically than we've ever done. You look at the last 7 years, we've doubled engineered materials, that portion of the company. We've doubled filtration. And when Meggitt closes, we'll double aerospace. We've never ever done that in this sort of a time frame ever. So you got the portfolio dramatically different. The secular trends and all the things we've been doing on sustainability are really going to drop into a higher gear. So I think it's adding all the, it's the CapEx, it's the channel inventory work, it's the portfolio is distinctly different than before and the secular trends on clean tech, electrification, digital and aerospace are all at early days of a long cycle. It's why that one pie graph that we showed is how we move from being a company that was more short cycle than long in aftermarket to where our vision is we're going to be 85% long in aftermarket, only 15% short. And as a result of that, that mixture, and then you put in the equation and all these moves in electrification or clean tech, our bill of material goes from 1.5x to 2x bigger than our legacy bill of material. So as you're hitching your wagon to a faster growing secular trend with a bigger bill of material all spells that you ought to outpace the market. So that's why we wanted to change this. The company, I was reflecting on, so I'm in my eighth year, and I said, why didn't I talk about this in my first year. Well, we hadn't changed the portfolio. We hadn't changed, we hadn't lined up to secular trends. We hadn't done the things in The Win Strategy to expand margin, weren't in a position to have this kind of dialogue. We now are. What will industrial activity be over the next 5 years? I think that's a guess. Nobody is perfect. If you look at kind of traditionally, it's going to be in that 2% to 3.5% range. Even with a recession, whatever is going to happen, let's say, it's somewhere in that strike zone. Our 4% to 6% says that, hey, you're going to be distinctly different for some reason. And those reasons are what I just went through. Remember that the deals we've done, CLARCOR, LORD, Exotic and now Meggitt will all be faster growing and accretive to what legacy Parker has done. That's part of why if analysts and shareholders go plot our downturns over the last 20 years, you'll see that our downturn on the top line has gotten less and less sharp. And pretty much our margins in the last 8 years ignored the downturn, just grew margins through the downturn. So I think you'll continue to see us expand margins, but you'll see a top line that is materially different from. Whatever happens, I'm not predicting a recession, I think we're going to be fine. But whatever comes our way, our top line is going to act different than it has historically.

Yes. Well, since you mentioned that, I wasn't going to talk about decremental margins in a recession. But since you mentioned it, let's go there.

You were going to talk about it anyhow.

Well, I didn't want to get too doom and gloomy here, but it's remarkable how you have managed to hold margins through COVID, through 2015. And again, if we go into some kind of mechanical downturn in 2023, are you confident you can continue to hold the line on margins?

Yes. I think we'll do great on margins. I think best-in-class is still that 30% decremental. Now we clearly did way better than that. In most cases, we were favorable. We didn't even have any decremental. We did have some distinct one-offs that helped us in the pandemic, and we all took a wage reduction for myself at 50% to everybody else at 10%. If you go through what I'll call a more normal type of adjustment versus a pandemic adjustment, you're not going to do that. That would not put you as market competitive on talent so we wouldn't do that. And then we took travel and living, travel and entertainment from pre-pandemic to almost nothing, okay? So we're not going back to that level but we're also not going to have that one-off 100% to 0. So you have a couple of unique things that made it unusually good. But I think you'll still, because of the structural things we've done, the fixed costs are dramatically lower, the margins are higher. The acquisitions blunt a lot of those stuff. You'll see us do better than we have historically. Can we have no decremental at all? I think that's tough to repeat but we'll see.

Okay. I want to touch on your FY '27 margin targets. Is your plan to be CEO in FY '27? You've been 8 years in the job now and you're not close to retirement age. So I'm just wondering if you can still be CEO at that time.

More likely not because we have a general rule of thumb, though there is not a hard and fast retirement for CEOs as far as an age. But when you get to 65, past precedent is you step aside. But you got to recognize, this is a team sport here and the team has done an absolutely fantastic job. I didn't think about it on my first day on the job. But I can tell you, within my first couple of months, I've been thinking about who could be my successor. And we've been making career development, talent development things for the last 8 years to position that. And believe it or not, I've been thinking about my successive successor because this is not a job that you fall out of bed and do. You've got to build people to be able to do this and give them kind of experience in that position. So we're building people that I think they can be our successive successor. And I feel very confident since I'm a large shareholder myself that we'll be in good hands if and when I decide to step aside. But that's obviously a Board decision. The Board will work that at the right time. But this was a team effort in deciding these goals. It wasn't me deciding the goals. The Board weighed in. And we feel good that we'll get this as a team, regardless of who's CEO.

Okay. Okay. So let's finish off on your margin targets because I think that's the defining hallmark, if you will, of Parker is the margin progression through your tenure and even before your tenure. You're now looking at 25% EBITDA margins by FY '27. You haven't had a lot of help to be fair. You haven't had very conducive end markets. So a lot of this has been done through portfolio transformation, cost reduction and excellence. How much help do you need though? How much of that target do you think going forward is contingent on getting 4% to 6% organic growth and how much do you think is really making your own luck?

Yes. We don't need to get the 4% to 6% to get to those margin numbers. We can't get to a 0 either. And I haven't necessarily extrapolated that number we need to have. But we typically try to build these margin targets relying on almost all of the effort ourselves. That's how we've done all the last several targets so that we could look everybody in the eye and say, we can get there without needing the water and the boat to lift the whole thing up. And we have enough things between Kaizen, Simple by Design, our zero defect process, innovation, et cetera, and The Win Strategy that we would not give you a target that we didn't feel very good that we could do it in even just bare minimal type of growth environment. I don't think that's going to happen. I think the next 5 years, to your point, Nigel, we've gotten little help the last 8. I think the next 5 just by statistical odds will be better than the last. And I think that will help us a little bit more, but we're not relying on that.

Okay. Very clear, Tom. Well, we're out of time. I don't know if you want to close off with any remarks, Tom, closing remarks.

No. I just appreciate everybody's interest in the company. And hopefully, with some of these longer-term questions that Nigel asked, the company is quite different and our best days are ahead of ourselves, and I appreciate your conference.

Great. Thanks, Tom, appreciate it.

Take care.

Yes. Thanks.