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

Thank you for the mic. So really excited to have the CFO of Parker Hannifin, Todd Leombruno. And also Jeff Miller, we all know from Investor Relations. Thank you, Jeff, for helping arrange Parker coming. And a special guests who I'm meeting for the first time today.

Yes.

Yan. But I'll let Todd do the introduction, give a little background on Yan.

Well, David, thank you. It's a pleasure to be here. It's a beautiful day in New York. It feels like things are kind of back to normal, so we couldn't be happier to be here today. I did a good job. Next to me as Yan Huo. Yan is our newly minted Director of Investor Relations. Yan has been with the company for 16 years, mainly in a lot of operational finance roles, but she's also worked in our compliance and our audit function. So she knows the company extremely well, and we're pleased to have her kind of take this new assignment with Jeff and myself. And I think a lot of people do know, Jeff, but Jeff is our Vice President of Investor Relations. He just took that role starting in January. So Jeff now is leading the program with Yan as the Director, and we're really excited to have people learn more about Parker Hannifin.

That's great. Well, on that note, I think most significantly in the last 5-plus years is from my covering Parker, where there were just numerous small acquisitions and then kind of went quiet on acquisitions for a bunch of years. The last 5.5-plus years you've probably turned over about 50% of the portfolio. I mean really increasing the size of filtration and aerospace and even engineered materials.

I'm curious now that we're 5 years in. I think some of the investors initially got a little skittish on the leverage with Meggitt thinking where we were economically. But overall, the comfort level with your cash flow, the ability to deleverage who would even attack this deleveraging probably even little faster than people thought right out of the gates. Just curious, now that it's been 5-plus years, remember Tom always saying, I spend as much time working on a $200 million deal as a $6 billion, [indiscernible] I find the synergies there by looking the bigger deal. Just curious, lessons learned, kind of skills honed over the 5-plus years and how that sort of influences that? How should we think about you going forward with all that?

It's a great question, David. Obviously, the company is not the same company it was 5 years ago, 10 years ago, 15 years ago. I do have a few slides. Maybe I'll just jump into these real quick, and I'll answer your question. The company, as it sits today, is a little over $18 billion in sales. When you look at the makeup of the company, 47% of that is in our North American industrial businesses. About 30% of that is the industrial businesses that are outside of North America. And then according to our Aerospace segment, it's about 23% of our business is in the Aerospace Systems segment. If you think about the portfolio exposure to aerospace, it's really about 30% when you look at certain aerospace technologies that are in our industrial technologies, things like filtration, things like ceiling, things like composites, all sit in those industrial segments. But the company is fiercely decentralized. We will always be decentralized. We love that. We have 95 individual P&L owners. These are our general managers that are responsible for being entrepreneurial and running the business and that is something that we are fiercely passionate about. The technologies put us #1 in the motion control space. That is a vital component. The interconnectedness of these technologies make us something special. So much that 2/3 of our revenue comes from customers that buy from 4 or more of those technologies. So it really is a complete package when it comes to motion control. When you look at our performance, David, this is a little bit of your question, what has happened over the last 7 or 8 years. Clearly, we've been active with capital allocation. The vast majority of that has gone to building out the portfolio with some fantastic acquisitions. But when you look at our performance, our performance has extremely accelerated. If you look at what we've done with EPS, we've almost increased EPS by a factor of 3x. And when you look at our adjusted EBITDA margins, we've increased those by $810 million basis points over that time period. When you look at those numbers, about 80% of that EPS improvement has come from really the base business getting better, right, executing the Win Strategy, both version 2 and version 3, all around operational excellence, all around value, all around margin expansion. About 20% of that increase came from making those acquisitions higher margin, higher EPS accretion, and we're really happy with that. We're really poised to grow differently than we have in the past. We know that this is something that we have to prove to our shareholders, and there's a whole number of secular trends that the portfolio is kind of levered on and that we're looking forward to growing that way. We've been talking about moving from a shorter cycle industry. And we've done this for -- this has been a long-term plan over a very long period of time. And if you look at what's happened with the acquisitions, with those secular trends, where we've assigned our resources, where we've spent investment money on the organic side of the business, we have grown in those areas that are really levered to our higher margin and higher growth. So we're really happy about that. We think by the time we get out to FY '27, more than 50% of the company will be more levered towards longer cycle and these secular trends. When you think about the future, that 810 basis points that we saw margin expansion, we're very proud of it, but we have new targets. Our target for FY '27 is 25% adjusted segment operating margins. So we have another roughly 300 basis points that we're looking to achieve going forward. And really, right now, when you think about it, there's a lot of concerns, David, you mentioned about Meggitt. We're very happy with the way Meggitt came into the business. We are 100% committed to delivering those $300 million of synergies over that 3-year time period. We will get Meggitt to 30% adjusted EBITDA margins. And we're not going to give up on that base of the business. If you remember, 80% of our improvement came from the base business, Win Strategy 3.0 will accelerate that. We do think the portfolio is levered to grow differently than it has in the past. We changed our target from a market-driven target to an organic 4% to 6% over the cycle, and we're very well positioned for that. And we're going to still continue on this top quartile performance. We think that, that has been a galvanizing item across the culture of the company, and that's something that we're not going to stop. So let me get to your question, David. What did we learn on these acquisitions? We learned quite a bit, right? When you think about what the company was before CLARCOR. If you go back to FY '16, we were a little over $11 billion in sales. We were doing about 15% adjusted EBITDA margins. We generated about $1.7 billion in cash EBITDA dollars. If you look at our guidance today, we're going to be well over $18 billion. We will be roughly 23% EBITDA margin, and we'll do over $4.2 billion of EBITDA cash this year. So that is a dramatically different company than it was in that time period. And that really has allowed us to think about capital allocation differently, right? Now I don't want anyone to think that the acquisition, the next acquisition needs to be bigger than the Meggitt transaction. What we really believe is it's got to fit in the motion control space. It would have to be growth accretive. It would have to be margin accretive, and it certainly would have to generate cash and returns for our shareholders. So that's really our portfolio as we look at it, and that's what our plan is as we move forward. We are very much focused on delevering the company. We have made countless commitments to that. And David, you'd kind of mention this. If you look at what we've done, the last 3 times, we had a large acquisition, we delevered in about 2 years. So that is our plan for Meggitt is to delever as rapidly as we can, 100% of our free cash flow outside of the dividend, outside of CapEx and outside of the little amount that we have for the 10b5-1 program will be allocated to paying back that Meggitt debt.

The success you had with the synergies being achieved on these recent deals. And then you said accretive in many different metrics, but of course, what you think you can do on synergies to make something accretive.

Absolutely.

What you've seen in the last 5 years, can we think of you as somebody more willing -- I don't want to use the expression of fixer-upper. But are you more comfortable buying something with margins that could be half or 1/3 of Parker because you feel you can improve the margins that quickly? Or are you saying we are going to be margin accretive year 1, year 2? Just kind of curious how much of a fixer-upper could you.

Well, I guess what we'll do is let's talk about CLARCOR, let's talk about LORD and let's talk about Exotic. Those 3 acquisitions were margin accretive out of the gate. Now we knew we could improve them. We knew that we could leverage The Win Strategy. We knew that there were synergies of putting those 3 companies in the Parker Hannifin portfolio, but they were margin accretive outside of synergies.

Without synergies.

Correct.

I am not sure how comfortable are you getting Oh no, we feel comfortable enough on synergies, we'll buy something at 10% margin, we can turn into 25%.

That might be a stretch. But if you look at Meggitt, Meggitt was not -- is not margin accretive out of the gate, right? So there is a significant amount of synergies. We think we got them in a perfect timing in the aerospace cycle, where it's kind of at a trough. We see that growth continuing well out into the future. But that is a story of an acquisition that is slightly margin dilutive to the whole company. But we have a clear path on those synergies and the growth that made us feel comfortable doing that.

Because your margins are so much higher now, the bogey to find something that's margin accretive out of the gate is getting challenging, right? Many businesses...

Well, correct. I mean that's why we're so focused on top quartile performance is because we know every great company is improving their margins and driving forward. And we believe we can be part of that. And we are true believers that the Parker strategy, the Parker operating system, The Win strategy can drive any one of those targets even higher.

Okay. You mentioned your commitment to deleveraging.

Yes, it was last year.

The deleveraging, is there anything out in the marketplace right now that you're seeing or even could envision saying that would change that deleveraging focus. Is there something from M&A? Or just curious as -- can we just sit here for the next 6 quarters and go, Oh no, they're going to delever. There's no question.

Yes, David, that's a great question. We've been fully committed to delevering, right? We've done that the last 3 transactions. We're firmly committed to doing that again with the Meggitt transaction. We continue to work the pipeline. If you look at all 4 of those transactions, CLARCOR, Meggitt, LORD, Exotic, these are companies that we have followed for decades. These are companies that we had relationships with for decades. These are companies that we competed with for decades. So we have a long list of targets that fit right into those same categories. And we continue to build relationships, monitor what's going on in the space. And all I can tell you is we'll be ready for whatever comes next. But we're not going to overstress the balance sheet just because some kind of timing is coming on the horizon. So I would tell we would be disciplined in our approach.

Okay. We speak to this is not your father's Parker, structurally different company. I assume as the CFO, you've had to sort of stress test that. So if you can indulge us a little bit, and I think people think of orders, in particular, and I know there's a little bit of science to it, but also a little bit of magic maybe. When you think of the order downturns that we've seen in the past, I'm not even saying you can predict what this macro downturn could be. But when you stress test and go normally like in North America, we'd have runs of when especially when you did it monthly, right, you'd be like 12 months in a row of orders down double digit. The same macro environment, when you go back and try to stress test that now, we're bigger filtration and aerospace. How have you quantified for the Board? This is paying off in dividends with returns on capital but also the reduced cyclicality. Can you help to quantify a little bit for us?

Yes, David, you said it very well. This is not your father's Parker Hannifin. If you go back to Great Recession. I know you had mentioned that, that's now 15-plus years ago. We had some fairly steep declines in orders. You look at every cycle since then, that order decline has been muted. I mentioned earlier, the company is now 30% levered towards aerospace, right? Certainly longer cycle exposure in those markets. And remember, there's a good chunk of that aerospace business in that industrial North American and international business. So where we've invested, where we've put our resources not just via acquisition, but organically, that has really changed that profile, right? Those secular trends that we mentioned on the slide earlier are early days in many of them. So those are helping that order pattern go. And if you look at just the sheer math, we know at some point, just based on the past years of double-digit growth, there could be a decline. We're still committed to growing through that. We think we can operate from an EPS and margin standpoint better than anyone in any type of environment. So that's what we feel really confident about. When you look at -- internally when we look at it, we really do feel that there has been a detachment from the PMIs to orders and from orders to organic growth. We see that across our business. One stat that we talk about is, how much of our backlog what percentage of that represents our forward 12-month sales. And if you go back to FY '15 to FY '16, it was high teens percentage Today, it's about 35%. So it's nearly doubled our visibility in our backlog, and that's what makes us feel positive. So we are cautiously optimistic about the future here. We've had a great first half. We've given our guide for the second half. We're cautiously optimistic, and we're following it very closely.

I'm trying to get a little quantification out of you. Great financial crisis. Let's hope we don't see that again. Orders were down 25%, multiple quarters, right? But since then, those many dips of 2013, '16, I don't want to call the pandemic a mini dip, but officially, it wasn't down that long. Those were sort of in that down 4 to 7 total company order declines. Your comment and committed to grow through this. Can you put that in context of down 4 to 7s in the past. Does that mean your orders can grow? Or just trying to get some...

Well, I don't know if I want to put an exact number on that, David. But we feel very confident in the aerospace business growing. No matter what happens on the industrial side of the business. And we're really committed to those secular trends, which we think will help. Backlogs are extremely strong. We haven't felt much shuffling within the portfolio. So we have confidence in what we've given in our guide.

And speaking of the backlog as being strong. In simple terms, if you think of the supply chain pre-COVID, we'll make it easy here. Scale of 1 to 10. That was a 10, life was normal.

Yes. I don't know if it was at 10, but...

I have to start the index. And let's the worst of the pandemic, it was a 2. Where are we today getting back toward that 10?

Well, it's certainly normalizing. I would say anything outside of chips. Labor is kind of still a challenge, but not anywhere near it was in the pandemic. So I guess I would put it at a 6, just kind of given a number. I think there still is room to improve. There still is challenges every day that our team is fighting through. But we're really proud of our performance over the past 2 years. I don't think you heard us call out supply chain in a significant way, on any of our earnings calls, right? So we've been pretty much dedicated to making sure there's continuity of supply for our customers and working to streamline that as best we can.

Not typical for Parker to have as many intra calendar year price increases as the last 2 years.

Correct. Yes.

Not every component -- not every part in logistics are down, but you are seeing a little, say, uptick in hot roll steel, for example.

Sure.

If there's a little wave of inflation here that might kind of surprised us a little bit to the upside. Your ability to go back to the market for price. I'm not saying you explicitly told your distribution channel. Hey, that's it for January, that's all. But just can give us a little feel what you've been saying a little bit lately on some input costs and your ability to kind of go back to the market again after the last 18 months of abnormally frequent.

You're absolutely right. The last 18 months have been clearly abnormal and they've been chaotic. It's been kind of unprecedented. The rate and the amount of cost increases that everyone has seen across the supply chain. David, you've followed us for a long time. Our pricing ability and analytics, it's been a long-term skill of Parker Hannifin going back To The Win Strategy 1.0. And I would tell you that we exercise that muscle extremely well as soon as we started to sense, something was a miss in the supply chain. And to your point, we went off cycle, and we did that immediately. We have this long-standing goal to be -- to remain margin neutral on a price-cost relationship. In normal times, we hold ourselves accountable for productivity and efficiency improvements that kind of absorb and drive our margins higher without having to pass that on to the end customer. But things like freight and energy and labor and obviously, materials really increased in ways that they never had before, and we went off cycle, and we did it as much as we needed to do in order to remain margin neutral. So we hope to not have to do that again. But to answer your question really simply, yes, we would go off cycle if we need to. If that was driven. I go back to the decentralization of the company. 95 individual P&Ls, 95 pricing teams, 95 supply chains working on input and output. Input costs and output prices every single day in the business. So there is no lag on that kind of stuff. We do it when we need to, and we do it immediately.

But right now, the incremental costs we've seen, just maybe steel in particular, hasn't necessarily required maybe a rethink for...

Yes, correct. That hasn't bubbled up to conversations that I've been in, but -- not to say that, that's not happening on individual areas where it might be more prudent.

And also, I mean, when you think of the organic sales cadence, right, your fiscal first quarter in September, 14% December quarter 10, right? And we're basically saying in the second half, meaning this calendar first half is all the way down to 2%. And given pricing is clearly year-over-year more than 2%, is the volume clearly down? Or is there it's evolving as we sit here down really down volume, I guess, is what I'm alluding to.

Yes, it's a very valid point. To your point on pricing, we hit that early. It's been over 18 months. So we don't have as much of a year-over-year pricing lift as maybe others do because we did it so much earlier. But you're right, we started the year off extremely strong organically. When you look at what we guided to, we did double our North America organic guidance from 2.5% to 5% for Q3. But our concerns around the second half really centered around what was going on in Europe, what was going on in Asia Pac, specifically China. So kind of cautiously optimistic and we've been watching that. So you look at North America, extremely strong. Aerospace, still growing very well. Some concern around Europe. And our hope is that Europe would be flat to slightly positive. And then Asia Pac would be flat to maybe slightly negative depending on how quick the COVID ramp up materializes.

Well, you sold part of my next question because maybe I'll thank Jeff, if you -- the driver of providing the geographic splits last quarter. I haven't seen that in about 25 years covering the company. So thank you for the organic geographically in the quarter. EU was up 11% last quarter. I'd say it's fair to say so far this year, people have been pleasantly surprised about Europe's resilience. Obviously, nat gas price is coming down as we're providing some relief. Can you give us some sense of that 11% last quarter and how to think about Europe?

Well, yes. I mean there certainly were concerns around Europe depending on what was going on with the Russia-Ukraine conflict, there's no doubt. I think things have turned out better than feared for sure. I don't know if I'd want to make any comments about our third or fourth quarter with Europe, but we just continue to monitor it and the team keeps working. And like I said, before what we've proven certainly over the last 4 years is that from an incremental operating performance standpoint, we think we should be able to perform well in any type of environment. So that's what we're holding our teams accountable for, and that's what they are working to deliver for us.

And then when it comes to Asia, the 53 PMI, a, first question. Do you feel 53 PMI on the ground.

Yes.

And then second, when they put out the 5% target the other day. How do you react to that, maybe your people on the ground how do they react?

Yes, it's a great question. So obviously, China is an important region for us. There's no doubt. When you look at that -- the breakup of the company, 30% of the company is coming from international locations. And when you look at that, it's about 60% of that is coming out of Europe. About 40% of that is coming out of Asia Pac. China is about half of Asia Pac. So it's a significant piece of the business for us. We have been watching all the data out of China very, very closely. We talk with our leadership team daily. I wish Lee Banks was here because he is really doing that on a daily basis. And what we're hearing back is positive feedback, right? So the numbers that you mentioned, our team is agreeing with that. And it really now is more of a timing issue. When will the stimulus come in place, when will the customers start to pull that demand. But again, we think it's more of a timing issue from a long-term standpoint, we think they'll have it figured out.

That 53, you would say your people on the ground corroborate that 53?

Yes. I mean most people. I would say...

What's positive in what time, what strong as in 10 years, so we just trying to...

Yes. What we're hearing is I'm hearing more positive than negative, right? It's been bumpy, right? We've had a couple of starts and stop, all COVID-related shutdowns, but it feels a little bit different this time that maybe it's ready for launch.

Any end markets you can be helpful with that of China. [indiscernible] plastic manufacturing, [indiscernible] domestic consumption, any?

Across the board, things have been good. And Asia Pac outside of residential construction. And believe it or not, a little bit of semiconductor softness just based on timing of these new investments being made. But across the board, really, when you look at not just Asia and China, but really the whole portfolio, I think we had a statement that 90% of our markets were still in the growth mode. So outside of military OEM and some construction markets, everything is kind of a positive for us.

And can you shed any light on the portfolio change could help differentiate your order patterns from PMIs, right? How much would you also ascribe to there's something unique what's going on with this downturn from how supply chains are being handled. Just curious as much as I know you want to take credit for the portfolio change and rightfully said. Just from a macro perspective, this decoupling of PMIs and orders have been -- It's been pretty unique.

Yes, it really has been pretty unique. I do think the largest part of that has been our portfolio change, not just with the acquisitions, but where we've invested, some of our innovation and our new products have been focused around those longer-cycle end markets. There's no denying it, right? The supply chain challenges over the last 1.5 years, 2 years have changed order patterns. I kind of had the statement that what we see in our backlog is now 2x what it's historically been. And we've challenged our teams to vet that to make sure that it is valid. And what we're hearing back is it is valid. So we are -- again, we're kind of cautiously optimistically watching that as we go through the months here.

We have only a few minutes left. So happy to open it up to anybody who has a question for Parker. Yes, you're very shy crowd when we were on the phone. But now all of a sudden you're really shy in a larger setting. But...

I guess maybe what we talked a little bit about Meggitt, but I could also talk about our CEO transition, right? So Jennifer Parmentier, Jenny is our new CEO, and I would tell you it is a no-drama transition. It's been now, I guess, we're 2-plus months in the seat. And I would tell you, it's not a surprise within the company. Obviously, everybody loved and respected Tom. He has stayed on as Chairman of the Board for the year. So he's still very much connected with the company. But Jenny is the CEO. And I would tell you that she's doing great for 2 months into the role. She's really focused on, obviously, Meggitt that is the #1 priority for us outside of safety and making sure we continue with our commitments to our FY '27 goals. Jenny is an operator at heart, and I think we've prided ourselves on being great operators. She wants to make us greater. And there's nothing wrong with that. And I would tell you that the team is behind her, and we're really excited to see what's next for us.

That's a great way to end it, but I'm not done, got few questions.

We got one more.

Your initiatives for building out Parker distribution internationally, obviously, a margin improvement, even the ParkerStores.

Correct.

And again, we just spoke of maybe Europe better than fear. But I'm just curious, that build out, how would you rate that on the pace of what you hold? I mean you were assuming a little more skittish macro lease interest rates. You would think it's maybe a little behind plan just given the macro lags. But can you give us...

David, I would tell you, I would say it was -- it's on track, right? We set a target of growing international distribution by 100 basis points a year. And we've done that. I think we've done that now, Jeff, 5 years in a row roughly. We still think that there's room to go on that, and we will continue that, not just in Europe but also in Asia. So we believe that our distribution network is second to none in the space. There's over 17,000 different outlets for it. And you're right, the ParkerStores are one vehicle for that as well. And what we found is that, that still has room to grow, and we feel really good about it.

And lastly, the product vitality index to go from 20% of your sales from products sold in the last 5 -- or produced in the last 5 years, to 25%. It's not immaterial. I think you are saying...

It's a big step change. Yes, big change.

But I don't think we see it -- I mean, your R&D numbers aren't reported every quarter with the release.

Correct.

But the R&D doesn't feel like it's been highlighted as it's taking a big step function. So can you match those 2?

Correct. Well, we've always taken the approach on R&D that we wanted to be customer driven. We want to be in the operations and we don't want to have a big center of R&D that just becomes a cost center. So we've been -- just like we do with really every expense, we manage that very, very closely. What I would tell you is that bridge from 20% to 25%, a lot of that is going to be clean tech. A lot of that will be aerospace. A lot of that will be all those secular trends, electrification, a big driver for us. And I would tell you, the company has never felt more positive about the prospects of growing differently than we do now.

It was that extra 5% despite, of course, you think of it as I can outgrow my market. I assume you're bringing to market higher-margin products. So the idea of margins higher, it's made it a lot easier with new product than just trying to play price cost.

Correct. We used to joke around what's the best metric for innovation, and it would be gross margin, right? And if it's higher than your existing product portfolio that must be something that's bringing value to your end customers, so I'm watching closely.

Real pleasure. Thank you.

Well, it's a pleasure being here. Thank you, everyone. Great to see everyone in person again.

All right. I appreciate it. Thank you.