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

Great. So thanks, everyone, for being Here, it's my pleasure to have up next Todd Leombruno, EVP and Chief Financial Officer of Parker-Hannifin. Thank you, Todd, for coming. I think we'll go straight into Q&A.

So I think I guess as the question that's been very common for months has been the sort of interplay of Parker with the macro.

sure.

and I think when people look at it, they're sort of confused, you've got the global PMI sub-50 Parker's orders and revenues seem fine. The management tone is confident. So maybe just kind of talk about what you're seeing in demand out there and what underpins that confidence with the sort of macro red and yellow lights.

Yes, excellent. So Julian, thanks for having us. We're glad to be here. We mentioned this on our earnings call on the red PMIs for some time now. And really, this has been a strategy that the company has been working on for years now. We've really focused our internal investment on products that were more resilient than others historically. But really, our acquisitions, the portfolio has transformed significantly. If you go back to CLARCOR, if you add LORD in there, if you look at Exotic and now Meggitt, the company really is much more longer cycle. If you look at aerospace exposure alone, if you look at the company, it's over 30% if you look at not just our Aerospace Systems segment, but the aerospace business that's in our Filtration or Engineered Materials Technology segments within the Industrial segment. So that has been helping us. Backlogs are in a record high, and demand is fairly robust across the majority of the businesses that we have. So it's been a little bit of a bounce back from the pandemic. The supply chain has been challenged over the last 2.5 years. So that's kind of leading to the backlogs being as high as they are. But we feel really good about where we're at as a company. We really like the portfolio changes that we've made, and I think you're starting to see that throughout the businesses.

That makes sense. And if we look at, I guess, 1 concern investors always have the last year or so is that tight supply chains pushed up backlogs? And then as the supply chains ease sort of backlog and orders take a sudden lurch downwards. How sort of worried are you about that risk? How comfortable are you when you look around your distributor and sort of OEM customers and particularly on the industrial side? Aerospace, it's still supply chain problems for years ahead, probably.

Yes. So we've been through these cycles a number of different times throughout the various economic dips. We do feel really good about it. We've been kind of cautiously optimistic when you look at the company as a whole. We have seen some softness out of Europe, and we have seen some softness out of Asia Pacific, mainly in the mobile construction markets out of China specifically. But aerospace remains very robust. And there is a significant amount of industrial markets that is very positive. If you look at North America, our North America orders and sales continue to be positive organically. We did increase our North American organic growth. We doubled it with our last guide. So we feel really good about that. And that, coupled with aerospace, we think, is going to make sure that the company continues to show growth, at least for the rest of our fiscal year.

Understood. And I think if we look out, say, to the last quarter of the current fiscal year, you're sort of embedding not a lot of organic growth, volume down a bit. I think people sort of contrast that with your tone and say, is that just cushion or conservative because there's so many macro cross currents?

Julian, it's a great point. Obviously, we just came out with our Q2 results, and that allowed us to double North America. We still show positive growth for North America in Q4, and we show positive growth for Aerospace in Q4. It's really the international segment that's a little bit negative. And we're just being prudent based on what we saw in that segment, the orders did go negative. So we gave you the best look that we thought we had at that time, and we'll come out after Q3 and give you a better update. But right now, we haven't seen much push out. We haven't seen anything really material from the large OEM customers. Distribution is still very strong. and that is 50% of the industrial business. So that's really good. And that has been growing in the international segment as well. So that's also a positive.

And when you think about China sort of from here, what's your assessment of pace of recovery.

Yes. I was just in Singapore and Malaysia last week. There's a lot of positive things going on in Asia Pacific. And if you look at our whole Asia Pacific segment, those countries outside of China have really kind of held up that segment just with the noise around COVID that's been happening in China. But I think it's a short-lived issue. I think that there'll be stimulus that will work its way through China. They're just coming off of Chinese New Year. So we expect to rebound in our Q3, the rest of the Q3, I should say. And I think we'll get that figured out.

And then on Aerospace, I think one area has been sort of military OE. I think it's been under some pressure. I think partly just tough comps from COVID, maybe supply chain is in there as well, sort of how do you assess where we are on the military OE and looking ahead.

Military OE is really the one component of aerospace that is negative. And you're right, a little bit of it is the comps. We sense the pull forward in the pandemic on some of those military platforms, mainly the F-35. And that was really -- we feel it was a way to keep the aerospace military suppliers kind of intact during COVID. So we're experiencing a little bit of a pullback on that, but the F-35 program is fantastic and that will continue to grow for many, many years. We expect that maybe more in our FY '24 to kind of see that return to growth. And what is offsetting that is great strong growth in commercial OEM and then also commercial aftermarket, which we expect to continue to grow as flight miles get back to prepandemic levels, which were not still quite there yet. So we feel really good about that. And then, of course, the military MRO stuff is slightly positive, and we expect that to remain positive going forward.

Got it. And on the commercial side on OEM, a lot of companies still complaining about supply chain, slow ramp always the sort of [indiscernible] blame seems to rotate depending on the week. But how do you sort of assess your supply chain in commercial OE, your ability to get things done on time for your customers?

Well, we pride ourselves on that, right, throughout the pandemic. We really strive to satisfy customer demand as best as we possibly could. We have a local-for-local model that supports that. Aerospace has been a little bit slower to recover than maybe the industrial supply chain. So I've started to hear that throughout our businesses, but I don't think it's anything material that's going to keep us from reaching our guide or supplying customers. It's something that we pride ourselves on managing and we don't think that will be an issue.

And on the point on sort of aerospace, it's been around, I guess, 5 months now since Meggitt red got pulled in. Any thoughts around -- I noticed you took up your revenue guide slightly very early days, but how is that sort of synergy extraction looking as well?

Yes. We couldn't be happier with the Meggitt transaction. It was a long road to get to the close, but we're ecstatic that we got there. It is a great business. It is being integrated as we speak. The first 5 months have been meaningful. We did put $60 million of synergies in our fiscal year 2023 guide. We will achieve those synergies. There's no doubt about that. I would confirm the $300 million that we had in the deal. That's by the first full third year out in FY '26. So there's no issues with that whatsoever. We're going through, and we're making that a Parker like entity. And what we found is a little bit heavier SG&A than what we see in our Parker businesses. They did decline faster than our aerospace business throughout the pandemic. So we've got a little bit of a natural recovery that's going on there. We expect Meggitt to grow faster than our legacy business, just mainly because of the decline that they had. And so far, it's great. We have a location here that's nearby in Miami. So we're visiting that after the conference. But the operational pieces of Meggitt are extremely ecstatic to be part of Parker. They've seen our transformation. They've seen our performance, and they want to be part of that. So it's really been a fantastic addition to the company. I think it's going to work out great.

And more broadly, when you think about M&A at Parker, that's really something that Tom had made maybe more programmatic than was the case before. Maybe sort of where we are today. Just had a CEO change very recently. How different is the conference around M&A, maybe the way it's approached, sourced, integrated. Give us a sort of a broad sense of that.

That's a great question, Julian Yes. So Jenny Parmentier, our new CEO, and that transition has been as smooth as possible. Jenny has been with the company for 15 years. She's been part of the leadership team for some time. So you're not going to see us go high and to the right on any of these things. We've long been an acquisitive company. You're right, Tom had kind of changed the game starting with CLARCOR and then, obviously, LORD, Exotic and now Meggitt. He really wanted to focus on growing our filtration business, our Engineered Materials business, our aerospace business and our instrumentation business. and really hit home runs on 3 of those targets. If you look at the company now, it's more balanced across those portfolios. So we're not so tied to trying to grow those 4 specific. We certainly would grow those with the right targets and the right acquisitions. But we're in no rush to do the next deal. It doesn't have to be bigger than Meggitt. What it does have to do is it has to help the company grow better. It has to help the company achieve our margin targets. It's got to generate cash and it's going to generate returns, and it's got to be something that fits within our portfolio. So those are really the criteria that we look forward to. And that's something that we're not going to stray from. So Jenny is a believer in that policy, and that is what her main focus is as we go forward. Short term, we're really focused on paying down debt, right? We've made a commitment to get back to 2x debt to EBITDA in 2 years. We did that after CLARCOR. We did that after LORD, Exotic, and we're confident that we'll be able to do that again after Meggitt. So that's kind of been our focus. Obviously, from a total capital allocation standpoint, we're committed to our dividend, long-standing 66-year record of increasing our dividends. We will do that. We have increased our CapEx a bit, right? Historically, we've been about 1.5%, 1.6% of sales. We'd like that to be around 2%. We are at 2% this year. So we feel really good about that. We have $200 million for our share buyback program that we will remain committed to and 100% of everything that's left will go to paying down that Meggitt debt. And that's what the team is working on, and that's what the team is committed to.

Understood. And if we're looking at that filtration and engineered materials sort of technology platform, it's the biggest one of the 4 sales-wise. How do we think about your -- there's a lot in there. So when we're thinking about kind of where the areas Parker is particularly strong, I don't want to mention competitors necessarily by name, but just some sense of like where is the market share highest in the market, which is a global powerhouse inside Parker. Because on the outside, it's hard to people to marry the sort of technology platforms with the....

Sure, sure, sure. What marries those 2 platforms together is the material science element of it, right? So whether it's the media and the filtration business or whether it's the chemistry within the Engineered Materials business, that's really the special sauce that makes those businesses work. Those are high-margin businesses within our company. They are applications that are meaningful to the customers that they serve. They really benefit from our application expertise our global reach, our distribution network, and that's what really makes those stand out amongst their peers. When you look at the filtration business, it's really one of the largest filtration industrial position businesses that's out there. And we like the growth patterns with that, and we like the margin expansion that they've had throughout that business. On the Engineered Materials side, LORD was a game changer. It gave us -- we had a lot of sealing technologies. This really gave us adhesives. This gave us a lot of bonding capabilities. And when you look at all of those secular trends that we talk about, whether it's aerospace or clean tech or electrification, these are the businesses that are really forefront in those spaces. So we like the growth prospects for those businesses as well.

How about -- if we switch to looking at motion systems your sort of sales for various reasons have been stable for many years. Is that something that concerns the management? Are there measures in place to tweak the portfolio within Motion Systems to regear it for higher growth? How do you think about that? .

Yes, it's a great question. I wouldn't say if you're looking at those charts over time, right, there's there is 2 recessions in a pandemic in there. And those are typically our most cyclical businesses, right? So just the timing of those somehow is a little bit unfortunate on the presentation of those numbers. We did do a little bit of internal movement of businesses within or with moving out of motion systems. That's a little bit of a piece -- we did have a few small divestitures through out there as well. But we love that -- those technologies. There's no doubt about it. When you look at the core of Parker-Hannifin Motion Systems is critical, to making sure our distributors are competitive, making sure we could offer a total system solutions to our large OEM customers. So we are dedicated to that. You won't see us peel that off in any way, shape or form. There will be typical pruning of the portfolio throughout all of those businesses that we are committed to do every year, and that's part of it. There's a little bit of currency in there, too, when you look at what currency rates have done, but that admittedly affects the whole portfolio as well. But overall, we like the technologies. I think -- looking forward, what's a positive for Motion Systems is clean tech, right? When you look at anything from hydrogen to electrification, they're also levered to benefit from that as well.

And yes, on that point, I think it's fair to say that Parker sort of valuation stands out versus some others because they might have more of a secular halo attached. What are some of the longer-term growth drivers at Parker that do you think are most sort of underappreciated by investors right now?

Yes. We've focused for many, many years on really improving our margin profile, making the company less cyclical performing better throughout those cycles, and we're really proud of what we've been able to do in that space. There's no doubt. Looking forward, we do realize growth is probably the last thing that we haven't made meaningful progress on. But if you look at where we're at right now, we do feel extremely positive that there clearly is a pent-up CapEx elements that I think we will benefit from significantly. There's countless billions of CapEx projects that are announced that are in progress that will benefit Parker-Hannifin. When you look at aerospace, for example, we see a clear trajectory to growth there. That is clearly helping us this year. There's no doubt, but we see that as a longer-term growth cycle. All of those portfolio changes are all focused on companies that historically grew faster than Parker. So we feel good about that. And then the last thing I would say is all of those secular trends, clean tech and digital supply chain, they're bringing opportunities to us that we hadn't seen as we have gone through certain other cycles in the past. So our prospects are positive. We feel really good about that, and we're committed to it. That's why we changed our target to 4% to 6% growth over the cycle and that is through FY '27. So we think that, that will show that we have the capability to grow differently.

That makes sense. And I guess one element is around an operating improvement is on free cash. I think Parker has done very well even recently with a lot of working capital constraints and so forth. Should we see the free cash flow margin kind of moving up over time with operating margins and you get to that sort of mid-teens plus

It's absolutely one of the things that's critical to Parker when you look at we try to bowl down our win strategy, and we try to bowl down what drives the company. One element is being great generators and great deployers of cash. When you look at our cash flow generation, there's been a step change both in the dollars and the percentage that we've been able to generate from a cash flow standpoint. So we are committed to 16% free cash flow in our FY '27 targets, and we're positive that we're going to be able to hit that. One element that I would say that's been really interesting to watch is, we've changed our variable incentive plan program. And this is a program that 100% of the company is on. So whether you're a general manager, whether you're based in the Cleveland headquarters, whether you're a line team member or someone that works in the warehouse, everyone is on the same annual incentive plan program, and there's 3 elements of that program, sales growth, earnings growth and cash flow. So what makes me excited about it is it's the first time that we've had all 65,000 team members across the world compensated on generating free cash flow. So we expect that to be another lever that drives us to achieve those FY '27 targets. It's really -- it's certainly changed the conversations within the company, and I think we're going to like what those results bring.

Understood. I think people often ask the things that Jenny might do differently. Yes, it's not like there was an emergency to fix or something?

No, no, no. So Jenny and Tom are very similar. They have a passion for our team members that is fantastic to watch. Safety is our #1 metric across the company. So Jenny will continue that. We've always believed that if you have the most engaged, empowered team, you're going to win. So she will continue that as well. We certainly are focused on the growth elements that we just talked about. We have all those targets. We're clearly committed to meeting those targets. So we don't have to make a change with any of that. Meggitt, we talked a little bit about Meggitt. Jenny was part of that decision. She was involved in that. And between her Lee, myself and Andy and our entire aerospace team, we are fully committed on making sure that, that works and that goes extremely smoothly. So you'll see that. I think what Jenny might do a little bit different is one of her areas of strength is supply chain. And you look at what we've just come through this 2-plus years of supply chain noise. I think she thinks we can be better, right? The company certainly is better than it was 5 years ago. Our goal is to make it the best company in the world, the safest industrial company, to be top quartile financial performance. And I think what Jenny is seeing is that there's probably some tools and expertise that we can add to be even better suppliers to our customers and do that in a way that is even more efficient and even more productive. So I think that's what we'll see her focus on.

That's interesting. And I guess one element on the portfolio or growth-wise is that I think a lot of companies will try and talk to a digital or software element. There's often a lot of hype around that versus the reality of the business. Kind of how does Parker see that transition? Does it see it as something sort of it's participating. But look, it's not a step change so we don't need to.

Well, what we try to do is we try to let our customers pull that from us instead of push that to us. So there's nothing more terrible than creating a function that's not meaningful to a customer. So our customers that want to work with that, we apply those tools. We do think that there's a digital element from a product identification from an ordering standpoint, from really partnering with our distributors that we've been working on and that we can do better. And we think that that's really where we're going to make the best progress.

Cash flow is helping the speed of delevering. How quickly could Parker move back to doing acquisitions of scale? Well, I mean, a scale of a size of Meggitt, we're probably looking at a 2-year period.

Well, I mean, a scale of a size of Meggitt, we're probably looking at a 2-year period, right, just like we did between LORD, Exotic and CLARCOR. But I would tell you there's no pressing need to do one bigger than Megitt or the same size as Megitt. What we're really focused on is just making sure it's the right ship, it fits all of our financial criteria and that it makes sense and it fits within the portfolio of Parker-Hannifin. So if there's a bolt-on something that supports one of the secular trends like digitization or electrification you might see us do something like that. But again, our commitment right now is to reduce leverage.

That makes sense. And then lastly, perhaps before we go to the audience response survey, margins international versus North America and industrial, they've been similar for a while. Do you think that continues? Or it's like the progress you have made in international, I don't know do you see some chance it moves higher ....

It's a really good question. For years, our international margins were significantly lower than our North American businesses. And we always thought that those margins could and should be similar. It took us a long time to get there. But you're right, we actually had a few quarters where those international margins were actually slightly higher than our North American businesses. That's kind of flipped a little bit now with the volume changes in supply chain kind of being a little bit more North American-centric. But we don't see those going backwards by any stretch imagination. What's beautiful about what the company has done over the last 8 years is when you look at that significant margin expansion, it has been shared across the portfolio. It has been shared across the regions. And I think we've convinced a lot of our team members that it's possible, right? It doesn't matter what technology you're in, it doesn't matter what number you are from a market share standpoint that if you execute the tools of the The win Strategy, if you serve the customer, that the profitability is going to follow. And we don't see that to be any different, whether you're based in Europe or Asia or Latin America or North America. So our goals are really set upon improving from where we're on now, and that is really across the board.

Perfect Well, now we'll switch quickly to the audience response survey. I think the first question is really around ownership of the stock.

What is the question? Does the question come.

It should be here. I don't know -- So the questions around ownership, we can participate ourselves as well. And so here, it's decent more overweight than the other meetings so far this morning. The next question is around the bias to the stock, positive, negative or neutral.

We've been on a bit of a run lately. I think Meggitt has helped out a little bit, the quarter results of Meggitt. It seems good.

Yes. So positive reaction. Thirdly is around through-cycle earnings growth. I think the peers here would be sort of broad industrial or U.S. multi-industry would be the peer set to think about.

Yes, you've seen our chart on that. We're really proud of what we've been able to do there.

So people thinking above average for the most part. The next question capital deployment. So again, short term, this is -- it's very clear, it's #5 [indiscernible] meant to be a, I don't know, a 3-year view probably on what to do with excess cash.

That should be interesting. So Okay. We're actually working on that.

Very consistent. The next question is on the valuation multiple. What sort of calendar '23 PE should Parker-Hannifin trade at?

Yes. I have my opinion on this answer.

So high teens is the consensus.

Yes.

And then the next 1 is on -- the next question will be around sort of why do you own less, not more, or why does someone not own any of it? We should trade at 17x, [indiscernible] 25x and the biggest reason is core growth. So it goes back to that lack of [indiscernible].

Yes.

And then I think the last question now, ESG -- is it a positive factor or not? I think almost every company has been very similar, the answer here, which is it's about 1/3, yes, to #1; and 2/3, no; or #3. So a bit more of a skew but directionally consistent.

It seems so.

Thanks everyone for responding.

Thanks everyone for your time. Yes. It was great to be here.

Thank you for [indiscernible].

We're working on the growth. So give us some time.

Thank you.