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

All right. Good morning, everyone. We're very excited to continue with Parker Hannifin and CFO, Todd Leombruno. Thank you so much for joining us today. We're going to walk through sort of Q&A. But before we do that, we're going to go through a few prepared remarks and then we'll go onto the discussion. So I'll turn it over to you, Todd.

Excellent Joe, thank you so much for having us. It's been a great conference so far. We're happy to be here in person. It feels really like we're kind of back to normal. So I appreciate all your time and attention. So as Joe said, I'm Todd Leombruno, I'm the CFO of Parker-Hannifin. I just have a few slides here. I know most of you are familiar with the company. But if you look at where we're at today as a company, we're going to be over $19 billion in sales this fiscal year. Our fiscal year ends just in a few days, June 30 is the end of our fiscal year. We've had a record year. We've closed our largest acquisition ever, Meggitt PLC out of the U.K. We did that in September, and that is moving unbelievably well. You look at the company, we've never been larger. We've never been more profitable. We've never generated more cash, and we're very pleased with where we are in our market space. We are in the middle of a CEO transition, right? Jenny Parmentier has become our CEO. She's in her 6th month. It is the biggest no drama CEO transition that I have ever seen, and the company has never been more aligned. So I'm happy to be here and happy to answer any questions you have about where we are as a company. These are just a few of the things that we feel special about the company. We are the leaders in the motion control space. We have unbelievable breadth of technologies. It's an engineering powerhouse of technologies. We now have 30% of our business levered towards aerospace markets, which is a big change for Parker, if you followed us for a long time. We have an unbelievable distribution network that helps support the industrial side of our businesses, and that is getting stronger globally as we continue to progress with our strategy. And we really have 3 main things that we are driven by. One is living up to our purpose. Two, generating top quartile performance. And three, which I love the most is being great generators and great deployers of cash. So if you look at our history, we're very proud of our history. This is just a snapshot of the last few years. And you can see our transformation is real. It is working, and it is meaningful. You can see we've grown our EPS 3x, a Factor of 3x over the last number of years. You can see almost 900 basis points improvement in EBITDA margins. And the last couple of years have been really difficult, right? There's been 2 recessions and the pandemic. And what we love about this chart is it's really hard to point out where those recessions and where that pandemic was. So it's really the accumulation of a lot of effort of our 65,000 team members around the world. And our goal here is to continue making these charts go up and to the right. What's different for us now is the unbelievable trend of the secular movements, right? I talked about aerospace. It is the biggest part of our portfolio than it's ever been. We are experiencing a great growth from commercial markets. Our military business is strong as well. But you look at these other things, this movement towards clean technology, towards electrification in a big way and really all things digital. The company's portfolio is totally levered towards taking advantage of these secular trends. And we're starting to see that as you look at our performance, not just in those last slides, but as we look forward to our FY '27 targets. A long focus of the company has been trying to move our portfolio from shorter cycle to longer cycle. If you look at where we're at today, it's about 1/3 levered towards aftermarket exposure, about 1/3 that is shorter cycle and about 1/3 that's longer cycle. As we look out into the future, in the not-so-distant future in FY '27, we see that we can get almost half of our business levered towards more longer cycle business. That's obviously aerospace growth, but it's also those 3 secular trends that I talked about. And we're making meaningful progress on that as we speak. When you look out forward, we're proud of our history, but we're even more excited about our future here, and we are committed to generating over $30 of EPS. That is obviously 50% plus growth from where we're at today. And we see a clear path to another 250 basis points of margin expansion and the team is fully committed to making sure that is achieved no matter what happens in the macro. So I don't want you to think that, that's volume-centric. Those are plans that we are committed to no matter what happens in the top line. And that's really that's just a quick overview. So Joe, I'll let you ask any questions or if anyone in the crowd has any questions, will be glad to do my best to answer them.

Terrific. No, thanks for that, Todd. Yes. I'll pause periodically raise your hand if you'd like to ask a question and we'll weave it in. I guess to start, let's just start big picture on the macro. I think you sort of periodically made comments about over 90% of your end markets growing, but if you can just kind of talk us through a little bit of what you're seeing out there regionally and market-wise.

Yes. So the first place I'd start with aerospace, I guess I just mentioned that. But when you look at our Aerospace segment, that's about 25% of our business. And if you look at our Industrial businesses, there's about another 5% of end market exposure that is Aerospace specific. Those markets are growing robustly. And you look at the order activity, you look at the backlog within our Aerospace business, it is at all-time highs, and it is strong and it continues to grow. We expect that to grow high single digits for the foreseeable future. I did kind of highlight commercial markets are unbelievably strong. The MRO is bouncing back with all the air traffic activity. The OEM markets are strong, but still below their pre-pandemic peaks. So we still have a way to go to get build schedules back to where they were, and we're confident that, that is going to occur, and we're ready to continue to support our customers as that happens. Military is negative, low single digits negative, but it's really coming off a tough comp from a lot of pull forward that we had throughout the pandemic and then military MRO continues to grow, but those pieces of the business are extremely strong. When you look elsewhere, if you go more or so into the industrial segment i know a lot of people are concerned because our orders did turn into negative last quarter but they are negative on some unbelievably tough comps, so our comment about over 90% of our market still in growth mode, if that is still very true and we're very impressed with that a lot of that has surprised people because obviously the external indicators have been red for a while but we continue to post and we continued it to forecast positive organic growth in that segment. It is broad based -- it is a broad based growth across really most of those end markets North America has really surprised us in the positive, the resiliency of the North American market has been great and i would also tell you in Europe, you know fearing the worst with Europe as we started the fiscal year and that has proven to not be the case. The winner has been less harsh the demand has been better than we expected and the team continues to excel and Asia has been probably the most bumpy still performing at a very high level but dealing with soft instruction market dealing with some noise in the semi-con market and obviously just the start since the starts and stops from COVID, we're committed to region for the long term and our team continues to do everything they can with what they can control and i think if you look at the margin performance its impressive really across the board.

Maybe to dig into a couple of those. So first, the comments around Asia and if we focus on China. Just anything that you're seeing in those trends sort of year-to-date stimulus measures that seem to be gaining any traction sort of how you're seeing that market move.

Yes. So obviously, we've been in Asia for a long time. We've been in China for a long time. I would tell you, we are watching that. We would like to see more stimulus. There hasn't been as much as we were expecting. There's starting to be some trickling out, which we think will be a positive impact, but it is lower than what we were expecting. I think the thing with the semi-con is just a matter of time. It's certainly not a long-term trend. And then ultimately, probably the biggest challenge we'll have there is just when construction starts to get back to normal or at least normalize. But across the board, we continue to see good activity in China and really in all of our Asia Pacific exposure countries.

And then thinking about sort of North America and international, if we look at sort of the growth trajectory kind of pre-pandemic to now, right? You look 2019 to say what's trending in 2023. You've actually seen pretty similar organic revenue trends. So I think North America would be like 16% above, international's like 18% above. We hear a lot about like what's going on in terms of structural growth in North America, but international has actually grown more. Can you talk about kind of that distinction and maybe what you're doing in international where you might be outgrowing?

Yes. Some of that has been -- our portfolio is much different than it was years ago. The additions of LORD, the additions of CLARCOR have brought different exposures to the company that we didn't have in the past. The other thing that I would highlight about the international businesses is our distribution network, which is an unbelievable competitive advantage that we have across the company was extremely strong in North America for many, many years, second to none. And not that we were bad in Europe or Asia Pacific, but we knew that we could leverage some of those strengths that we had in North America. So we have been growing the mix of our international distribution business by 100 basis points a year for the past 7 years. So that has been a nice growth trajectory for us. Some of those secular trends that I mentioned, as far as clean tech as far as electrification, have also been supportive in the European region. So that has also been a nice change for us.

And some of those same trends, if we think about in North America and a lot of focus on investments around semi fabs and battery electric vehicle plants. Can you start by just talking about your content? And I don't know if you can sort of put it in the context of you've got a $1 billion plant, you've got this much in it, but just to kind of understand what part you are supplying in this.

Yes. So it's a great question. We've heard comments about reshoring in the past. And quite honestly, maybe a slight impact, but not nearly what the headline said. We are feeling that these projects now are real. There's a significant amount of announced projects. There's a significant amount of projects that are in various levels of funding, and that is a big plus for us. So the way we benefit from that really is unique because we benefit when the construction project starts. We benefit as the facility has stood up. We benefit as machines come into that facility because we're all over that content. And then, of course, as that facility starts running, we benefit from the MRO products that goes through that. That is another advantage that our distribution network has is because they are embedded close to these facilities, and it helps drive growth as those projects materialize. So it's hard to give you a number on what a facility brings, but we think that, that is one of the things that will differentiate our growth algorithm this time than maybe past cycles.

And just the go-to-market approach, and so one of these large fabs is announced in terms of the distributors role, your role, are you specking things out? Are they flowing through them? Just kind of talk through that process.

Well, we go to market in a number of different ways. Really, it's the best way that we can get closeness to our customers. So we have market-facing teams that attack each one of these secular trends. And then some of our businesses that are more levered towards things like semicon kind of take the charge and actually build those relationships and it kind of pulls the entire Parker portfolio along with it. But again, I don't mean to oversell the distribution network, but this is an unbelievable extension. 17,000 outlets around the world that are out in the communities, in these projects, building growth for us by being close to those projects.

And just how are you thinking about the growth opportunity there? I presume that you've seen some order activity related to these because we see the put in place spend dollars going up tied to them. Those spend dollars are far above where they were Pre-pandemic, but I don't know how to...

It's 1 of the reasons that we've changed our target from a market factor to a 4% to 6% organic over the cycle. We really feel strong not just about these mega projects and the reshoring activity, but also all of those secular trends. So that gives us confidence that we feel good about a 4% to 6% number over that cycle period.

And the reshoring piece is interesting because I think 1 of the advantages for Parker is you're a very localized model, right? So you're currently in a position where you need to make a lot of reshoring investments necessarily.

Yes.

A lot of the companies I focus on, they say we're local for local. So it's like at what layer is this happening? Where are you seeing it?

Well, our local-for-local model is real. We globalized over a long period of time. And really, in many cases, it was following our customers as our customers became more global. And we knew that we would win if we had a local source of supply. We also would benefit from the various cost differences around the world. So that was really the driver for our local-for-local model. And it really is real. I think that's why we fared better than most through these well-documented supply chain challenges and that we kind of outperformed expectations from having that local-to-local model. So it really is -- for us, it's real, and we feel the closer we could be to the end customer, the more intimate that relationship is.

Is there more that you're trying to do on getting suppliers?

There's certainly more, I would say, more North America-centric based on where those demands are coming from. And then I would say one of the things that we're doing on the supply chain excellence side is making sure that there is adequate dual sourcing capabilities across the portfolio. So that's probably getting the most attention across the company today.

And then going to switch to backlog, and then I'll open it up if there are any questions in the audience. But we think just the industrial backlog is over $5 billion. We look at it as being over $2 billion of excess backlog relative to what would have been kind of normal. Can you parse that at all in terms of backlog that might be tied to long lead times versus this is backlog tied to some of these structural tailwinds?

Yes. So it's a great question. I think it's -- there's never a silver bullet on these things. It's really a combination of our portfolio change. If you think about that movement from short cycle to aftermarket and the mix of longer cycle stuff. There's an element of our backlog increase that's related to that. There's no denying that what the world has gone through over the last 2, 3 years, has been a growth driver in backlog demand. People are trying to get their spot in line, so that it's -- there's more sight. We have done an unbelievable job getting that backlog, making sure it's real, making sure that it's not double booked. And our teams around the globe feel really good about that. I would tell you the pull from our customers is still as strong as it's been. So that also gives us confidence. So I think we feel confident that the backlog is real. We're proud with the increase in coverage that we've made. We've -- we talked a little bit about that on the last earnings call. But I think it's really a mix. It's a little bit of the portfolio change. It's a little bit of the needs of the customer. And I think it's overall just all those markets growing, some of that is from those secular trends.

And what's your view of like a $2 billion excess backlog? Do you -- in terms of I think you've talked about are going to have higher but...

I don't know if I like the word excess because that's -- I'm thinking maybe more in accounting terms, it sounds like that's a bad thing. We look at it as a good thing. And I would tell you, it has been one of the reasons why we've been able to deliver positive organic growth really across all of our businesses, even in light of orders, softening in comparable periods and obviously, the macro indicators being red.

And when you talk about that incoming activity remains robust. Has anything changed in the nature of those conversations, for example, customer -- it's taking a little bit longer to convert to an order or they're sort of testing the waters to see when they can get things, but they're not ordering.

Yes. I can't say that I have seen anything on that yet. I haven't heard any conversations where that has worked. I would tell you, the supply chain is easing outside of anything electronic and anything chips. And I don't know if it's getting better or if everyone is just more used to dealing with the issues that are out there today. We've seen some rebalancing in certain end markets and in certain regions. We have seen a little bit of inventory management in some areas of the distribution network. But I would tell you, no major cancellations, no significant pushouts and still really a robust pull for demand.

Any questions? Let's talk sort of PMI mystery. And if you could explain this, we'd appreciate it because we're accustomed to seeing trend in similar directions. How do you think about that 7 months of PMI sub-50 and just no indication of that what we're seeing in your end...

Yes, it is a great mystery. I would tell you it's something that the company is focused on for years, right? Whether it has been our organic investments, whether it has been the way we have challenged our businesses to strategically position themselves within their markets and within their application spaces. It has been a process that we have used to help generate those charts that you saw, right, everything up and to the right to drive more focus and more opportunities on where we can win using our competitive advantages. But it's also been the portfolio change that has been very purposeful. That has helped with that. So it hasn't been a surprise to us because we have been living with broad-based demand for some while, and we're glad to see it happen, to be honest with you.

And so if we think about it as a very broad-based short-cycle indicator that would be telling you that things are slowing and they're not for your business. Where are the disconnects? What is the sort of the PMI reflecting that's just not representative of...

It's a good question. I don't know if I have an answer for you on that. All I could tell you is that we're making sure we're doing everything we can to make sure we're serving our customers in the way that they need to be served. And demand remains broad-based, right? It is something that we're watching very closely. We have all kinds of tools and techniques within the business to make sure that we are putting our resources in the right spot. And I would tell you the comps are at least on our orders, the comps are still very, very difficult, and I think they're going to remain that way for a while just at high levels. So I think that's a plus for us.

And maybe touch on some of those tools, what resources you have today to sort of stay on top of demand business planning cycles and how that compares to the past?

The first thing I would tell you is everything AI. I know it's kind of become super popular recently. But we've been using AI tools within the business for some time now. And what's very powerful about those tools is that they take out a lot of bias that you have internally within the company. They do use external factors. And I would tell you that's probably the most powerful set of tools that we have from a forecasting standpoint, from a demand standpoint, from a supply standpoint that is making our business run a little bit differently. So that has been really great. And then obviously, there's the tools of Lean, all of these items that are part of our Win Strategy that we think are very powerful. If you listen to Jenny talk, she has been very clear about wanting to drive supply chain excellence. So demand and capacity planning has been a big focus for us across the company. And we think that, that's also a -- not just a driver of us becoming more efficient, that's also a huge driver of growth because it allows us to deliver even better to our customers.

And related to some of that efficiency, if we touch on channel inventories. What -- what tools do you have to track that? Sort of what's your assessment of what channel inventories are?

Yes. This is -- you're talking through the distribution network. So obviously, it's an incredibly close relationship we have with our distributors. For the most part, we make up the majority of their cost of goods sold just because of the breadth of our portfolio. So we have a dedicated sales team that is very close with them. Obviously, they're very key to all of those industrial divisions that are driving activity through there. They do report back to us sales. We track that against our sales into them. So we have a ratio of sales versus purchases, if you will. And it's really kind of a hand-in-glove type relationship. So I would tell you, we're very close to what's going on in that broad base of the distribution network and really globally around the world. So we feel like we have a good linkage to what the real demand is there and what their needs are. I would tell you for the last 3 years, it was a challenge for distributors to get inventory levels where they felt comfortable with them, that they could consistently supply their end customers. And I feel like we're kind of that equilibrium there. So we feel pretty good about where those sit.

And I think maybe there's been a little bit of de-stock over the past couple of quarters.

Yes, just maybe recently, over the last, I'd say maybe 1 quarter, maybe some rebalancing in our second quarter, maybe some de-stock in our Q3. But I would say minimal and that would probably be region and end market specific.

And what's the time line of that? Is it kind of like it happened in Q3 and it's done or a couple of more quarters?

I guess I don't know if I have a total feel for that. I mean we're watching it closely. Clearly, our order intake is one driver of that. We look at our backlog levels, which still remain extremely elevated. So that's kind of a plus. And we haven't seen any signs that show that, that is making a meaningful move one way or the other for what's its been.

So then shifting to Aero sort of thinking about the cycle and kind of a type of view of it. But I think if you compare it to pre-pandemic still organically mid-single digits below where that was. How you're thinking about sort of the commercial side, OEM or MRO, how you're thinking about military, those growth trajectory is the next...

Yes. So if you look at our business today, Commercial is about 65% of the mix. Military would be about 35%. We still have a long way to go to get Commercial back to prepandemic levels. We do believe it will get there and more. That's why we were so confident on the exotic acquisition, so confident on the Meggitt acquisition. So we feel really good about that. Commercial MRO is growing fast and we expect Commercial MRO to continue and follow that. On the Military side, the OEM business is slightly negative, low single-digit negative compared to prior year. But again, that was really on some pull-ins that were really military-based that I think really helped keep the supply chain healthy on the Military side of that. The MRO activity is really kind of going as expected. So it really is kind of a Commercial story at this point. What's nice is that we've got a broad exposure to a number of platforms are on virtually all the important platforms. And now we have Meggitt that's obviously benefiting from that as well.

And what's been the revenue experience with Meggitt through sort of the early integration effort? Are you seeing sort of an acceleration where customers were waiting or just how you're going to market in many different ways?

I think, obviously, it's still early days, right? We're only a few months into the Meggitt integration. That Meggitt business is obviously benefiting from the rebound in commercial aerospace. If you look at their history, they did dip a little bit further than us in the pandemic. So they're kind of growing faster than us now. They're just kind of getting back to where they were. What's nice is this really is an unbelievable pairing. If you look at our top 10 aerospace customers, the overlap with the top 10 Meggitt aerospace customers is uncanny. So we've gotten bigger with every 1 of our top 15 customers by bringing Meggitt into the fold. And that has really driven different conversations, right, with a more meaningful element of every platform that we're on, and we're in different areas of the plane, but all of a sudden now the wallet is much larger. So if I listen to my Aerospace team, it is driving different conversations. It is driving different value propositions, not just on the existing business, but on what's to come, whether that's sustainable aviation or whether that's product repairs and improvements, and we feel really good about that. The other nice thing about Meggitt was, it significantly increased our aftermarket portion. And obviously, that is a portion of the business that is extremely growing now. So we think we'll benefit that for some time to come in the future.

And you've talked about synergies trending ahead of initial expectations. Can you sort of dig into that a little bit for us what you've been able to do?

Yes. So it was a unique process that we went through on Meggitt. Obviously, it was during COVID, it was U.K. publicly held company, and there was some unique process things that were part of the acquisition. We have known Meggitt for years. We have competed with them. We've admired them. You look at the business, over 70% of that business is U.S.-based. There is a huge presence. So that is in California. That's where our Aerospace business has a huge presence. So this is a company that we knew for a long period of time, and we were pretty sure that this was going to be a great pairing. It's turned out better than we expected. The synergy number that we worked into our model was $300 million, which was roughly about 10% of pre-COVID sales. And we're tracking on that very well. We actually just increased our stub year from $60 million to $75 million. We expect $150 million next year, so $75 million of incremental synergies next year. So you'll see that when we talk about FY '24. And I would tell you the team is really doing a great job on this. This is the biggest deal that we've ever had. We have put our best people on the integration team, and it really has been a marriage that has worked unbelievably well. I know it's only 9 months, but the initial signs are unbelievably positive. We feel really good about it.

And so when you think about FY '24, just talk a little bit about sort of guidance philosophy. What you're looking at right now, what unique challenges are out there? What -- I mean backlog's got to be at a bit of an advantage. How you're thinking about setting that up?

Yes, those are all factors that go into play here. Obviously, we are fiercely decentralized as a company. So we look at every 1 of these businesses in a unique manner. We roll up a forecast that's generated from our teams. I mentioned a little bit earlier about our AI tool. We use that, then it's been extremely accurate for us. But we look at it and we look back at that exposure, 30% aerospace exposure. We expect that to grow mid- to high single digits for the foreseeable future. So that's kind of something that we're looking at for next year. If you look at the rest of the business, 70% and with the strong backlogs and with what we see happening with the secular trends, we feel positive about it. But we'll take a look at that as we get a little bit further into the summer and see what's happening in the macro and making sure that we do our best to give you an idea of what we think we can do and deliver on for FY '24.

And then I wanted to touch on pricing. This has been an environment that's required some pretty dynamic pricing, but just talk through sort of what your approach to pricing now, how that would have compared to sort of pre-COVID.

Yes. So our team has been I would say experts on pricing for some time. And that has been a big element of our Win Strategy going back to original version of the Win Strategy in the 2000. What we saw different as we've got into this beginning of inflationary pressure was, is that we've always focused on making sure we had precise control and analysis of our material input costs. And we felt that with our lean strategies, with our efficiencies, with our productivity that we could cover wage and normal increases just by our Kaizen culture and basically implementing our Win Strategy. That changed when we got into these inflationary times where wages kind of went out of whack, freight went out of whack, energy obviously increased, and we very quickly pivoted those teams into inflation cost coverage instead of just material cost coverage. And these were real costs. And by the way, we tracked them, we knew that they were real and we were able to communicate those with the end customers. And it was hard to debate it because it was just clear costs that we're moving. So we moved fast and we moved frequently. And what we did is we didn't wait until it became untenable. We did that multiple times throughout the inflationary period. So it was really crucial for the company to do that. And we weren't trying to increase margins by doing that. We were really trying to make sure that we stayed margin neutral when it came to covering all those increases. So the team did an unbelievable job. We have a pricing organization throughout the team that's embedded in every one of these 95 divisions and they've done an unbelievable job on it. So I think that's what we did differently. And because we have that distribution network, I don't want to say it's easier, but it is less difficult to pass on price in that distribution network. But with the OEM customers, it was hard to ignore these conversations, and we made sure that we were very clear and transparent with them. So it was a positive for us.

And so if we think about that from a price cost perspective. You went down and you sat down with OEMs and you said, here's what's happening with cost, price went up. What do you foresee? Are you going to -- they're going to bring you back the table and say, here's what's happening to the cost and the price...

What we really kind of do on pricing, especially when it comes to product improvements, retrofits, new products, we really kind of focus on the value that we're bringing, not just the cost that is in the product. So there's an element of value pricing to that, but also if it does get to a situation where costs do decline and for whatever reason, we have to give some price back, I think we would be fine with that because that means our input costs are going down. So again, it really is the goal is to stay margin neutral on this, not to drive increases in margin just from pricing. It really is the same. So I would tell you it's something that we're watching, and we're not going to let that be a reason why we don't continue to have these churns go up into the right.

I think I have time to maybe get one more in. Just on labor and in terms of what you're seeing in terms of labor tightness. And are you still adding labor in your manufacturing facilities?

Labor, again, just going back through the pandemic, there was some real challenges with getting labor. What we really did -- 1 of the first things that we did throughout the pandemic was to make sure that we kept all of our team members safe. So 65,000 team members across the company. We would not be producing product, making the sales numbers without those team members coming in every day, making sure that we were delivering to our customer demand. It has gotten better. It's certainly not to the peak of where it was. We have been focusing on simple automation. We've been focusing on some more detailed automation to make sure that labor does not become a challenge going forward. I would tell you in some parts of the business where we're growing, Aerospace would be a great example. We are still adding labor where necessary in other areas where maybe it's not growing as fast, we would be rightsizing it. So we don't do this in a vacuum. We don't try to do this from Cleveland. We really let the decentralized team manage that. And again, it's just the tools that we have. We know where we need to make adjustments, plus or minus.

Todd, I think that brings us to the end of our time. So thank you very much.

Thank you all for joining. Appreciate your interest in Parker.