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

All right. Good morning, everyone. Thanks for joining us. My name is Mig Dobre. I'm the Baird analyst covering machinery and diversified industrials. It is my pleasure to introduce to you today, Parker-Hannifin. As you probably know, Parker is a global leader in industrial and aerospace motion, process control and materials technologies. Here to update us on Parker's current strategy, we're lucky to be joined by Chief Executive Officer, Tom Williams; and also by incoming COO, Jenny Parmentier. So welcome to you both. It's great to have you part of the Baird Conference. I know, Tom, you have a couple of introductory remarks, and we'll do some Q&A.

Well, good morning, everybody. It's great to be back at Baird and back in person with everybody. So you're familiar with the forward-looking slide, I won't belabor that. So if you're not familiar with this, this is a great slide, Parker at a glance. It was a global leader in motion control technologies. It's about $135 billion space. We're at roughly 13% market share, with the opportunity to get to 20% market share. So as you can tell from that, it's a very diverse, fragmented space, lots of opportunities to grow organically and inorganically. We have 8 interconnected technologies that are very much linked in our offering for customers. We have about 2/3 of the portfolio aligned with clean technologies, and that will continue to grow. And about 2/3 of our sales goes to customers that buy from 4 or more of those technologies. So our customers see the integrated offering as being distinctly different, solves more problems with them, reduces weight, improves safety, their sustainability journey just changes their cost of materials with bill of materials. We are unique in that. We use 17,000 independent distributors. So we don't own any of these distributors, and they roughly make up about half of our industrial sales. It's part of our secret sauce and how we go to market and differentiate ourselves. And then we are very decentralized. So we have essentially led strategy, which is the Win Strategy, but it's deployed through 88 divisions around the world. We like that because it creates intimacy with the P&L, intimacy with our customers. We're not big fans of central overhead SG&As around the company. The takeaway you see on the bottom of the page, that's our purpose statement: Enabling engineering breakthroughs that lead to a better tomorrow. And what that's done is it's inspired our team to what they do to help society and what they do beyond just making a paycheck and earning a living. On this page, on the left-hand side is kind of a little history as far as how we've done as a company and really the transformation, which has been through our people, the portfolio and the strategy of the company. The far left is EPS change. You can see that's a 2.6x change in the last number of years. So it dramatically changed the profitability of the company. The margins have grown almost 800 basis points. On the right-hand side is really the how. In the first 2 bullets, if you look on the right, all around this engagement concept, safety is being the most important thing we do to, the engagement of our people and our leaders taking engagement seriously. Those 2 things have created what I'd like to characterize as an ownership culture, recognizing that if people think and act like an owner, they're going to perform and behave differently than they're just thinking that they're an employee. We -- our good fortune to be great generators of cash. Over this time period, our cash flow has gone from around 10% to the mid-teens. It's about 500 bps improvement in cash flow margins. We've taken that cash and been pretty effective at deploying it. We deployed $25 billion of cash, about $20 billion of it towards acquisitions, which you can see those 4 acquisitions on the bottom of this page, CLARCOR, LORD, Exotic and Meggitt totally reshaping the portfolio of the company, doubling engineered materials, doubling filtration and doubling aerospace. If you combine that portfolio change through capital deployment and our secular alignment around those 8 technologies going into aerospace, digital, clean tech and electrification, the portfolio is going to behave much differently going in the future is going to grow much differently. It's going to be a longer cycle. And if you look at our forecast going out in the future will be about 85% long cycle or aftermarket, 15% short cycle. So a dramatic shift in how the company has been designed. And then just to close, what's our focus on the continuity between Jenny and myself, Jenny is going to be a great COO, and I've been to hang around for years as Executive Chairman, and I told Jenny, I will be there as little or as much as she needs me. I should be the one driving the kind of my engagement on that. But the Meggitt acquisition, we're -- we're off to a great start. The integration is going well. We've got a great team organized there. I feel very confident in the success there. We had a great Q1. You saw the results in our earnings call, very strong results. We're forecasting records with our guidance for FY '23. The Win Strategy change that we made, 3.0 being the third major revisions of Win Strategy are still relatively early days, but the early days is continued margin expansion and to grow the company differently organically. And like I mentioned, you combined the Win Strategy with the secular trends with that reshaped portfolio, our best days lie in front of us, and we feel very good about achieving those FY '27 targets that we laid out. And with that, Mig, I'll turn it over to you.

Sure. Thank you -- thank you, Tom. A quick reminder, you can submit questions by e-mailing [email protected]. And if you don't mind, maybe going back a couple of slides, you've anticipated.

You want to go to my favorite slide, Mig?

Yes. Let's go back to your favorite slide.

We can leave this up all day long.

Well, it encapsulates your time, your tenure as CEO. And for us, it's great to have you here as you -- you've announced you're moving to the next step in your journey. As you reflect back on your time as CEO of Parker, what do you think is the most important factor to your legacy?

Well, a couple of things that happened over this time period is we focused specifically on people. And it sounds for shareholders, I mentioned, why did you do all that? Well, as the people that makes the company go. We're focused on safety, we're focused on engagement. And a combination of those 2 factors created that ownership mentality that I was referring to. We changed the strategy of the company multiple times, 2.0 and 3.0 and with a lot of different initiatives, which I won't go through now, but they changed really how we performed. We became a high-performing company, a top quartile type of company. We changed the capital deployment. We had put together a much more sort of balance sheet with more strategic prospecting of what deals we're going to do, and we're able to pull off some pretty good transactions we did a great job of integrating them. And then that purpose statement that I referred to, created that feeling amongst people that I'm doing something for society and doing something beyond just my job. And what was interesting about the pandemic, one of the very few silver linings of the pandemic was that it allowed people to understand their purpose much more clearly because if you remember in the depth of the pandemic, where you're an essential manufacturer, where you're not an essential manufacturer, why we had all of our team members coming into factories to produce the products that we do. We were able to describe that to them with our purpose so that higher calling on life, which is what we're all trying to do, really connected the dots for people. I think the part that I'm most proud of, I'm leaving behind a great team. This is a great team that's going to take us another future. This was never about a one-person show. It's always about a team of people putting together great results. The decentralized structure by nature, it creates that kind of teamwork. And as I mentioned in the earnings call, business leadership is a team sport, and we have a very deep team. So all the shareholders out there should feel comforted by the fact that there's a very deep team that's been helping to deliver these results.

Understood. Getting margins north of 22% help, too. So if you could do all of that and drive the return profile in the way you have, that certainly is a great accomplishment. So Jenny, as you're coming into the role, you're obviously an insider, you've known Parker, you worked for Parker for a number of years. What do you think -- what do you see as the biggest opportunities at this point? Is it further margin expansion, more growth, more diversification? How do you approach it?

All of the above, Mig. I think the best thing that we can continue to do with the strong team that Tom was talking about was just continue on the success of the transformation that's underway. As we saw on the last slide, integrating Meggitt, bringing them into the family is a top priority for us. We feel really good about the synergies that we published. We're going to hit those. And as Tom said, Win Strategy 3.0 is -- it's really in early innings. We still have a lot of margin growth there. We have the ability to grow organically. We can get a lot more out of Win Strategy 3.0. We just updated it for our FY '27 targets. And I feel confident. The team feels really confident about hitting those.

All right. Since you bring up margins in your comments, this is something that I usually like to ask Tom every time he comes to Baird Conference. But really important to your story, in my view, has been the expansion in gross margin that you've achieved, there's different ways to get margin expansion, getting it at the gross margin level is notable. So when I'm looking at where you are today, roughly 28% -- what do you see as the true longer-term potential of this business? Maybe that's a question for both of you.

Okay. So gross margin is actually now higher than that because we made some reclassification of costs and cost of goods sold in SG&A, which are, I think, more reflective of the way our company should be portrayed and there's a lot of diversity of practice of how you do those things. And actually, when we acquired Meggitt, we saw doing it in a different way. And actually, the prior acquisitions all do it in a different way and so we now made that change with the Q1 filing. If you go look at the Q, you'll see our gross margin is now around 35%. And so we think this is a company continue to grow both gross margins and reduce SG&A, and it will happen through a variety of things. We have Kaizen, which is still early days. Zero defects, for those you who aren't real familiar, this is the idea of having process stability in everything that you do. And when you do that, you have less rework, less scrap, less times going through the process multiple times. Think of it as an iceberg. We can see the tip, which is cost of poor quality, but all the extra work that people go into making products because things don't have stable processes is a huge cost for the business. Simple by Design is in early days, being more innovative, a new incentive plan that we just rolled out. This is the first full year that has taken effect, which will help drive simplicity and focus on cash, earnings and on revenue, so there's a lot there. This change we just made with the margin expansion as we announced the new targets was the biggest step change in targets we've had since my watch. So we were at 21%. We gave 25% as a target that we're getting to. And it's a destination. It's not the final destination. It's just a step on the way for us to being the most profitable company we can be, and we're trying to be the best diversified industrial company out there. And that's the goal until we do it consistently year in, year out, we're not going to be done.

Well, I can think of 1 or 2 with gross margins north of 40, so I'll hold you to that.

Yes, there's lots of opportunity.

That's great. Let's pivot a little bit and talk about some -- a couple of near-term issues if you were. You just reported earnings. You gave an update, but it'd be interesting to hear how you think about demand, especially in the context of the guidance that you provided for the back half of your fiscal year, that's really the first half of calendar '23.

Right. So demand right now, and I'll contrast kind of right now versus what we have in the guidance for the second half, demand right now is very robust. It's broad-based. It's 90% of our end markets are in a growth phase. When we look at the regions, we had a 14% organic quarter, every region around the world was double digits, and aerospace was at 7%. So as you go forward, aerospace continues to be strong. We've got the commercial recovery both on the OEM side and the aftermarket continues to be strong, a little bit of softness in military OEM, but that will -- once we anniversary some big business we had there, that will get back to low single digits. And what we did with the second half is we increased the second quarter guidance on organic sales. It was around 3.5%. We bumped it up to about 6.5% organic growth. But we left the second half the same at 2%. I know there was a lot of discussion on the earnings call about that. And our backlogs are very strong. They're $10 billion now. When you're throwing Meggitt year-over-year, we're up about 16%. And sequentially, they stayed flat. So that means that despite a record quarter in sales, we didn't really eat into the backlog. The only thing we were cautious about is that we'd like to see how January starts the year. So most of our OEMs are calendar fiscal year ending companies. They're all running to the finish line. They want to have a great finish to the year. We'd like to see how they start the new calendar year. Do their demand signals to us change at all, which is why we left the second half the same. So there's a chance we could do better. There is a chance also given that we do have a macro environment where we have high inflation, and we know that the Fed is going to do what it needs to do to get inflation down, that's probably going to tamp down demand. And the question is just when does it hit in our fiscal year, which would be the first half of next year? Or does it hit after that? So we're just being a little bit careful and not getting too far over our skis with how we forecast that our second half, the first half for everybody else. But there's no indicators right now that there's a problem. Everything still feels very good. We're doing things from a cost-wide standpoint. I would say we're -- we're leaning forward to this, where we're going to be on our toes versus being on our heels in case the macro changes. But we're probably going to wait till we get to that January indicator before obviously, the benefit of reporting your quarterlies, we can update you every quarter with what we see, and we need to wait for that data.

Speaking of OEMs and their behaviors, we still continue to hear from some of them that there are issues with long lead times for hydraulic components, hydraulic products. I don't know if that's you or the industry or...

It must be one of our competitors.

Yes. I'm sure it's one of your competitors. I guess my question is this, as lead times, in some cases, R&D coming down relative to what we've seen over the past 12 to 18 months, orders have moderated. People didn't need to order ahead. And I'm wondering if there is a function of that or factor that could be impacting your business as well?

Well, we were actually pretty happy with the orders. I mean our comps for like North America prior period was like a plus 32 or something. I mean we had some really high comps. First to come in at plus 5 for the quarter. We were pretty...

More of a forward-looking question on my end rather than a quarter.

Okay. Well, I see supply chain healing, but not fast enough to see any kind of demonstrable change to lead to that. So I think our planning with our OEMs is about the same lead times and the demand signals that they're giving us is about the same. I actually think, I've said in the discussion earlier with some other shareholders. If that could continue even as a supply chain heals, that would be a great thing for the industry. More long-term planning between customers and suppliers is a good thing. They can make them stronger, it's easier for us. I'm hoping, and I think that's something that they'll want to do differently once this gets better, I think they want to do planning differently in longer horizons.

And this kind of relates a little bit to this concept of this industrial cycle being a little bit different than the ones that we've experienced over the past 10 years or so. I know you talked about it in the past. I mean the rule of thumb for your industrial business has been whenever there is a downturn, you typically see 6, 7 quarters of negative order intakes. And I'm wondering if you have any sense that this time might actually be different. And again, we're all expecting some sort of a recession downturn, call it whatever you want to call it, in 2023. What's your best guess?

I think you will see us, if you were to plot prior recessions, we will be less volatile. Of course, it all depends what happens macro-wise, and that's really hard to know exactly does the Fed [indiscernible] land the economy and all that. I think all things if you look at over multiple cycles going forward, the fact that we changed the portfolio so dramatically, and our secular alignment that we had to those [indiscernible] more consistently. Because if you look at those 4 deals, CLARCOR added to the aftermarket -- 80% of CLARCOR was aftermarket. So that's more steady it. LORD was a nice balance between automotive, industrial and aerospace. And then Exotic and Meggitt were both Aerospace businesses. If you take LORD as an example, the whole electrification trend, all those things as it moves to more electric, cleaner tech, our bill of material is up 1.5 to 2x. So a combustion engine application today is 1x, something that's EV or clean tech is 1.5 to 2x. So growth rate and content is in our favor. So I see us growing differently. That's why we changed that growth target. We used to have ourselves as a x bps versus the market, and we changed that. We think we're going to grow differently than the market, 4% to 6% over the cycle. And so I look forward to Jenny talking about that. But I think that's going to happen.

Absolutely. Related to all of this, maybe we can talk a bit about whatever levers you have and the flexibility that you still have left in your cost structure. You've taken a lot of cost out. And the dynamics this time around seemed to be a little bit different versus prior cycles where labor markets are tighter, there's a little more pressure on wages, right? So do you still have the same tool set available to you to be able to manage the cost base if there is a downturn?

Yes, I still feel good about that. I bring everybody back because I get this question at a time we face a potential recession. If you look at that graph on the left, so let's talk about what happened over that period of time. There were 2 industrial recessions and a pandemic. And that's what happened on EPS and margin. So I think you can rest assured, we're going to do a pretty good job on whatever happens macro-wise. I always tell people that you prepare for the next recession over the last couple of years. If you just wake up and say, what am I going to do if the recession hits, you're too late, you're too late to the party. So you got to continuously work in your cost structure, cost of goods sold, SG&A, your footprint, [indiscernible], all those kind of things continue to be the most lean agile company that you can be. We're 20 years doing lean, and we're still early days of that whole lean journey. Yes, there are other things you can do that are more near term like producing your temporary team members. Remember, we have about -- probably you don't know that we have about 10% of our workforce that are temps. So we have very easy value we can flex on that. You can reduce over time. You can go to short work works in those countries that allow a short workweeks. You can do temporary lack of workers. A lot of things you can do to flex things -- we're being very careful on cost today. Again, this call concept of being on your toes. We're not filling salary jobs unless they're absolutely necessary. So the rule of thumb is 30% decremental. And we've historically, over this period of time, delivered those numbers, we did better than that. And I think you'll see us continue that.

Understood. And maybe one last question on this topic of margins. International, this is really something that I get asked about a lot by investors. And it goes -- there are 2 questions. How did we close this gap? How did you close this gap versus North America? Because it's not obvious that it's from business mix, right? I mean North America is still heavier mix towards aftermarket rather than OE. So that's still -- that discrepancy seems to still be there, yet that margin gap has closed. So how did you do it? And is this sustainable through a potential downturn? Or has this business been over-earning for some reason over the past couple of years?

No, it's definitely sustainable. We've structurally changed international and particularly we worked on the most was Europe, but all 3 of the regions, Latin America [indiscernible]. A couple of big changes on the cost side. So the footprint is dramatically different. There's been some shift to better cost regions, but there's fewer plants, consolidations -- if you go back to FY '14 and '15, was heavy, heavy restructuring, most of that was put into international. We've changed SG&A. So we -- as opposed to having a lot of things that were serviced SG&A by country, it's now a little bit more pan-Europe to do things, which has helped us. So the cost structure is one. The second is the mix. So yes, North America still has a heavier mix on distribution. But international went from 35% distribution to now 42%, 43%. So that's a significant mix shift over this period of time. And those 2 factors together is what's allowed us to have sustainable international margins right now, and it won't be a problem because none of that stuff is all permanently in there and it's not going backwards with the recession.

Okay. Got a question from the audience here. And this question focuses on pricing. It's really around the sustainability of pricing next year and whether or not price/cost dynamics can actually start to change as we're thinking about your fiscal '24, so the second half of calendar '23?

I'm going to start, but I'll let Jenny chime in because Jenny has been doing an awful lot of pricing work for the last 18 months as Chief Operating Officer. But I would just remind everybody that distribution is half of our industrial sales, and that's very sticky on pricing. I still think there's still inflationary pressures. While you see material moderate, you still have energy inflation, you still got wage inflation. And so you're going to still see us work the pricing side of things to offset that. Our whole goal is margin neutrality on this. And those of you who have followed us a long time, now we've been doing this for 20 years, we've got a very robust process at every division tracking sell price index versus inflation. Jenny, why don't you talk about maybe the shift from material cost recovered to total inflation?

Right. So in the past, we have always looked at what we call material cost recovery and make sure that we were adjusting price when we saw fluctuations in material costs, raw material costs and otherwise. As we started working through these inflationary times a little over a year ago, we saw the need to switch to inflation cost recovery, adding in all the input costs that we were starting to see. So anywhere from labor to logistics to now energy on top of material cost. So we -- as Tom said, we've been doing this pricing strategy for 20 years, but we sharpened our pencils and just even made it that much more robust to be able, on a real-time basis, look at all those costs and make sure that we were making the right changes, taking the right steps to have that margin neutrality. So it's been a big shift for us, but obviously a necessary one. And it's helped us to respond, I would say, faster and in the past year more frequently.

If I could just tag on, in the past, not that there was always wage inflation, energy inflation historically, but it wasn't as high. So we would use productivity to offset that, and we had to look at pricing on the material side of things. Now that's not practical at all. While, obviously, we're still doing productivity every year, but we had to look at this more holistically from a total inflation.

We have about 5 minutes left, and there's 2 other topics I wanted you to comment on. First one is this whole concept of reshoring. You talked about it, again, in prior settings, but I'm curious what that means for your business not just in terms of demand, talk about that, but in terms of how you go about investing your capital?

So I'll start with how it impacts us, and I'll talk about how it impacts our demand. So we're very conscious that we've been fortunate, our supply chain strategy has been local for local. And that's -- we're not immune to what's been going on, but we've tended to fare maybe better than others because of that local-for-local strategy. We wanted to have a supply chain that was in the region for the region, mainly from a service differentiator, and that's helped us a lot in the supply chain side of things. So we're going to continue to look at dual sourcing as much as practically. You can't 100% dual source everything, but on those products or those materials that you want to have dual-sourced, we're going to have that in play. And so we're working on that. We've got targets for every one of our businesses. Now how it impacts demand, I was mentioning to some shareholders earlier today, nothing frustrates a CEO more than not being able to get material. And that's what we've experienced in the last 18 months. And so I can't be the only CEO out there that's thinking about dual sourcing and about supplier development and adding resources here. Other people are doing the same thing. So what that means to us is if they have to add a factory somewhere in some new locations, have to buy equipment or that supply chain that supports that factory around that factory -- those are all great opportunities for Parker either in the plant around the equipment or on the product that they happen to be making as well. So that's one of the dynamics. As I think about the next 10 years. You got the portfolio changes we did. You got the secular change, but you also had this change in reshoring and then also a change in CapEx. Most industrial CEOs like myself, you look at what their CapEx spend has been, it's probably not been at the level that they need to for the next 10 years, and that will be automation. It will be productivity. It will be dual sourcing, all those kind of things. So that's one of the reasons why we're going to go through this period of time that there's uncertainties and nobody here knows exactly what's going to happen. But I feel better about the next decade. This last decade, on the screen, it was not the easiest decade for all of us. And I think there's some dynamics in our favor going forward.

But to that point, in terms of what that means for you and the way you go about investing. Does that mean that you have to think about your own manufacturing footprint differently? Is this -- and to some degree, I asked because reshoring. I mean we clearly see that it's happening in areas like tech. What does really happen in industrial where your business truly lies?

Yes. There's been some work where we're trying to localize things more, say, within North America. It's some investments we're making in all in North America. I'm not going to point out countries, I think it's kind of obvious, we'll be doing on that. But where we could just not -- if you hit dual sourcing, but one of your sources is in a spot that has very long lead times, it just creates more risk, more inventory, et cetera. So we're going to balance that out by building those suppliers more nearshore. It won't necessarily change our footprint, we like our footprint. We are adding some CapEx to add some footprint in some of those areas that helps us. We're going to add some CapEx to do more productivity, more automation. As you look at workforce demographics over the next -- there's more people like me stepping down from their jobs where you've got to make those investments to have that productivity but also just good safety, good productivity, good ergonomics for people to reduce those repetitive motion things that they're doing. So the CapEx is going to go from, say, 1.5% of sales to 2%. It doesn't feel like a big number because our -- we're pretty efficient on our CapEx spend, but that will be significant over a period of years. And again, I go -- I'm sure we're not the only company that's thinking about those slight changes in CapEx, all adds up [indiscernible] across the board.

Absolutely. Well, I could go on, but unfortunately, we're out of time. So please join me in thanking both Tom and Jenny for their presence and for their comments. Thank you.

Thanks, Mig. Thanks, everybody.