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

All right. Good morning, everybody. Joining me next on stage is Parker-Hannifin's new -- we can still say new, right? Yes, new CEO, Jenny Parmentier. Jenny, thanks for joining us. I enjoyed our sit down last week to kind of get acclimated and see what you're focused on in the business, hoping to get a redo some of that today with the bigger audience. So obviously, a lot of great things going on at Parker.

Maybe just to start off here, what are you seeing out there in the market? Obviously, a very dynamic macro environment and anything that is of a particular focus to you on the strategic side? Obviously, Meggitt it's going to be a big piece of that. So maybe that's sort of the stock answer, but anything else, I'll call it more day-to-day management that is occupying your attention. And then we'll take it from there.

Well, thanks for having us, Josh. It's great to be here. So first of all, I would say that, in general, underlying demand is positive, right? Obviously, aerospace is very strong for us. Commercial mid-teens growth, military mid-single digits. So real positive about aerospace. We're enjoying some nice growth in automotive tied to electric vehicles. So that's very positive. Some of what we're seeing, I'll talk about destocking a little bit in a minute, but we are seeing softness in HVAC, semicon, life science. We do think that, that is more temporary in nature because it is directly tied to some strong secular growth in the future. So we see that, that would -- that should turn around. When we talk about destocking, it's been a topic, a lot of questions around destocking. And we've seen that the last couple of quarters. We've seen that in the channel. But we feel good about our guide and mainly because the backlog is different with our transformed portfolio, we see a difference in the amount of backlog we have. So if you look at where we used to be across Parker, we're about mid-20s, 20%, 27% backlog. Now we're at 55%. A lot of that driven from aerospace. But if you look at the industrial side of the business, usually mid-teens percentage. Now it's 30%. So we feel really good about the guide that we have out there and continuing to have some growth there. When we look into the regions, obviously, some softness in industrial machinery, stationary equipment in the DACH region. We've seen some softness across Europe. But what we have seen there is a return to summer shutdowns, right? So a lot of the customers have gone back to taking that time off to do maintenance in their factories, something that they hadn't done for quite some time. And in China, we're just seeing a slow recovery, right. We're not seeing the stimulus or the response to the stimulus that has been there. So when you look to our guide, there's some uncertainty there, and that's what we're keeping an eye on.

You touched on something that I think a lot of folks in this room -- your team have struggled with as well over the last couple of years is this whole supply chain ripple effect creates a dislocation between, okay, what's underlying demand, what's the function of just longer lead times, what's inventory. You mentioned there was some destocking going on. You mentioned that underlying demand is still good. I guess, how do you tease out some of those points in the context of orders are down in the industrial segment, probably going to be down for a while, if I'm just following comps. But is there sort of built into your guide or even more broadly in the way you're looking at the markets and expectation that we're kind of at a smooth underlying demand calculus? Or does that inflect in one way or the other here as you think about it?

Well, I think that in the industrial side of business, the supply chain has definitely heeled. It's not back to where it was. I don't think that we're back to where we were from a demand standpoint in 2019. So we still have a ways to go there. I think that with the transformation of our portfolio, we are seeing -- like I said, we're seeing that higher backlog, and we're seeing that the supply chain is moderating, right, that we're being able to analyze that demand forecast better, schedule our factories better and really enjoy some of that, that normalizing of the supply chain. I think in Aerospace, they're going through with the supply chain went through in the industrial side of business, 18 to 24 months ago, right? There's a steep climb in demand. There's a lot of folks going through some tough times. Chips for instance, that continues to be a struggle for us, not only in just aerospace but on the Motion Systems side of the business. So definitely some healing, but definitely still some challenges. We'd like to say that we fared better over the last couple of years than others, mainly because of our local-for-local strategy. That really gave us a leg up. We weren't immune to all the challenges but we fared better. And it's 1 of the reasons that I believe and I've said one of my biggest areas of focus is investing in the supply chain.

And then I guess on the destocking front, a few different kind of target areas for that come to mind for me. Certainly, there's distribution. You have some visibility into that and particularly in North America, I think, in terms of their sell-through. But there's the OEMs, and the OEMs finished products their customers as well. So a few different constituents to be named here, where do you feel like that's most acute or where the inventory situation in those lists is maybe a little healthier?

Yes. So we've been experiencing destocking for the last couple of quarters, and we have that forecasted to continue into the first half with our distribution channel. And those -- some of those markets that I mentioned earlier that we are seeing some weakness. So we feel like, again, that the sentiment from the channel is still very positive about growth. It's just at a lower rate than it has been in the past. So they're still very positive about it. And they're, I think, more of a moderating of their inventory than something to signal a big drop in demand.

Understood. And maybe putting all that in the context of your key priorities as CEO mean not a ton of what I would call very squeaky wheels right now. Obviously, there's still a lot of lifting to be done around Meggitt and recognizing the synergies there. But as you said, we're through the worst of supply chain. Demand feels sort of stable, plenty of things to watch. But where are you spending your time?

Yes. So I would tell you that my #1 priority is the safety of our team members. And it is the very first thing and the very first pillar on the Win strategy safety is number one. Is the safety, the top quartile safety and the engagement of our team members that delivers the performance that you've been seeing and will continue to deliver the performance into the future. So Win Strategy 3.0, still very early days for us. It's a big area of focus for me. It's been there prior to me sitting in this chair, but I'd like to say my fingerprints are all over it because I've been part of the team for some time. So a really big focus. And then -- and like you said, it's making sure that we stay focused on the Meggitt integration, which is going very well. We're very happy with that, and we're committed to hitting our $300 million in synergies by FY '26. And I mentioned supply chain, investment in the supply chain, making sure that we can serve our customers at a very high level for what we see to be a period of great investment and demand. So that's a focus and really continuing the continuous improvement culture that we enjoy. It is something that is the foundation of who we are and it will help us continue to expand margins.

You mentioned supply chain is an area of focus and the benefits of local for local, which I think been a hallmark of Parker for some time, probably helps you during the supply chain crunch. But with things like near-shoring becoming a lot more popular, does it make you reconsider some of your plant base? Presumably, you benefited those customers in that investment, of course, but do you need to reshuffle where you're at?

No, I don't believe so. I mean we're in region for region, local for local. We enjoy those businesses in every region. We have very experienced team members in those regions, and we'll be there. We'll continue to be there for our customers.

Understood. On the backlog side, for industrial, where we've kind of seen the biggest dislocation. It's not a business I think most people would think of as carrying a lot of backlog, given that a lot of more components, things you can hold in your hand. How should we think about -- is -- does that ultimately mean revert to where it was before the pandemic? Or have customers kind of rewire their thinking to say, and maybe I want to have a little bit more on order at any given point in time. How is that psychology...

No, I definitely think that there's some new behaviors as a result of what we went through coming out of the pandemic. But I think the bigger story really is around our portfolio and how it has changed. I mean we are in longer cycle and higher aftermarket businesses. We're going to see that longer demand horizon as I like to call it. And while I think it will come down a little bit, I don't think we're going to go back to where we were. I think we're going to see that stronger backlog as part of our transformed portfolio.

Understood. And I guess the punchline is that all rolls up to margins have been excellent the last several years. Every target that's been out there has been exceeded pretty early and impressively despite some macro headwinds. How should we think about the big drivers from here of that next milestone, the 25% adjusted segment operating margin target?

Yes. So the beauty of it is, and I always seem to have this with me as our Win Strategy, every strategy on this business system expands margins, right? So it's never just one. If you look at our performance over the last several years, if you just look and see where we got the improvement. We had 3x EPS, almost 900 basis points of adjusted EBITDA. And through FY '22, 80% of that came from the base business. So a lot of work using the Win Strategy. When you look forward, we have this higher aftermarket mix, right? We have -- with the addition of Meggitt, aerospace aftermarket has grown 900 basis points to 45%. So that's really an indicator of higher margins. We have all of our simplification tools and our continuous improvement tools which a lot of that is -- has tremendous upside yet. We have our 0 defect initiative, which drives costs out of the business while really improving the customer experience. So a lot of levers to pull on margin expansion. And it's one of the reasons why you hear us speak confidently about hitting those targets for FY '27.

One of the areas there that I find particularly fascinating is Simple by Design. You have thousands and thousands of SKUs where I would imagine every engineer and every region wants to put their fingerprints on their version of it. Where are we in that journey? What could that ultimately provide in terms of a benefit to margins as you're able to do some of that SKU rationalization or standardization?

Yes. So we have about 3 years of Simple by Design under our belt. So I would say that it's still early days, right? I mean it's -- that tool was really an expansion of our overall simplification initiative, and it's really powerful because it's not just existing products, it's using that lens to design new products as well. So all of the principles of Simple by Design go into all of the new products. It's really thinking about designing with forward thinking, designing to reuse, not redesign another component, designing to reduce the complexity and reduce the bill of material and reduce the stocking locations, reduce the amount of times you touch material, how you manufacture it. So it's not just an engineering activity. It's an activity that goes across the enterprise and all the functions. And -- and that's how you get the cost reduction and provide the value to your customer.

And what's been the experience of that over time? I mean, when it was originally announced that sounded very interesting, certainly ambitious. In practice, has that met your expectations?

Yes, it has. We use the term business fundamental when we feel like we've fully operationalized the initiative. And we do consider, Simple by Design a business fundamental but still early days and still a lot that we can get from it.

Understood. I want to tip it over to the demand side for a bit, if we could. If I think about some of the bigger trends that have been talked about on the stage this week, certainly mega projects and whether it's near-shoring or energy transition or kind of other things in that vein. Clearly, a lot of buzz around that. Parker's diversity probably says that it's hard to really zero in on one of those. I would imagine that you guys are most excited about Aero just given woody there. But on sort of this generational moment for CapEx, what are you focused on? Where is sort of the biggest opportunity as it relates to where your business exposed today?

Yes. So we believe that there is a lot of opportunity there. When you think about everything that's been announced from business and government to build, to update, to automate, there's just a tremendous opportunity, all organic growth drivers for Parker. I mean, there's going to be not only just the demand for construction and transportation, but energy and factory automation. So a lot of upside. You're right. It is, at this point, it's early days. It's difficult to tie it out, but we are seeing examples of it. We're seeing in some discussions with distributors. I was just visiting 1 last month who happens to be located near one of the chip factories that's going to be stood up. And he has already been working with a local contractor who's working on the -- some of the prepping of the job site assumptions and he's very excited about their ability to continue to work with other local contractors and the general contractors on those projects. So our channel is starting to see it. Our divisions will start to see some of that as well. But it's early days, early days.

I would imagine it's hard to generalize given the breadth of the portfolio, but it sort of seems like you participate in every phase from pouring the concrete all the way out to filling out the factory floor. I would wager that the factory floor piece is probably the richest content. How should we think about when that could start to kick in? I mean maybe there's the historical context that you could share, but is that something that doesn't really show up until maybe a year out from when these projects really get going?

Yes. So you're right. I mean we are in every phase. We're there when the job site is prepped when the walls are stood up when they're building the factory and then the machinery that goes inside. And I would say it depends on what factory it is where we participate more. But obviously, the machinery going in the factory is a good position for us. I think with a lot of this, it's not going to be like a hockey stick. It's going to be nice steady growth over time. If you think about a semicon chip, it does -- it takes time to stand those factories up, right? So it's -- again, I keep using the term early days, but it is, but we'll continue to participate and will participate more in the future as those really get off the ground.

So I think one of the things that all of us are probably struggling with to some extent is this has been a weird cycle. It doesn't look like it's going to get any less weird anytime soon. But if I take a step back, it doesn't really look like at least in the macro indicators that volumes are materially above 2019 levels. If you look at the industrial universe as a whole. Obviously, price is up a lot. But in Parker's businesses, how do you see sort of that cycle-to-cycle benchmarking or most of the areas still within kind of last cycles? I guess, 2019 wasn't even high in some cases. But how do you feel about that progression cyclically? Do we still have runway here? Or does it feel like we've grown enough cycle to...

No, I think we still have runway. I mean if you look at Industrial over the last 10 years, it's a challenged environment. I think the next 10 years are going to be much better. I mean I think the supply chain getting better, supply chain healing is helping, but I don't think we're a 2019 level shift. I think there's still room there. If you just -- if you look at aerospace and you look at where we were at in 2019 on the 737 MAX, we were building 51 a month. We were supporting to build a 51 a month, I mean now it's 38, right? So that's just one example in one of our areas where there's still room.

So I'd like to stick with aerospace there. I think that's one of the areas as folks have kind of squared up the guide where there's probably the most head scratching going on in terms of that second half outlook more of a mid-single digit. It seems like aero is almost sold out through like the end of the decade. What would give you the pause there on what could drive you more within the range or below the range? Because it seems like you're prime to perform, you're in the right spots. But I get that there's always a desire to be conservative, but is there anything specific in forcing that?

Well, if you look at our guide, I mean, full year is 8%. First half is 12%, second half is 5%. Last year was the tale of 2 halves, right? So we had some tough comps out there, right? The first half last year was 6%. The second half that we just came off of was mid-teens. So some tough comps there. But you're correct, we are positioned well. We will perform and we're very excited about the aerospace trend.

And you mentioned earlier that supply is certainly a constraint there kind of living in the moment that some other industries live the last year. Where do you see kind of the most risk relative to your business? And maybe the ecosystem is shown under time that it's all the same. But some folks would say, okay, labor for some of the more specialized applications or shop visits are more problematic. Others would say it's material, it's the forgings casting. Where would you be most focused in terms of kind of the current supply chain risk?

Yes. Depending on the business, there's still some labor shortages and pockets, so we still experience that. But I think supply chain is our biggest opportunity to improve. And I've mentioned before that I think the aerospace supply chain is going through what the industrial did 18 to 24 months ago. So It's tough out there, right? And it's definitely a risk or can be a constraint in some areas. So it's something that we're spending a lot of time making sure that our demand, our schedules that we're putting out are well understood as well as the customers' future demand.

Understood. And obviously, using kind of that comparison to the last supply chain shock that industrial went through. Inventory probably grows somewhere. I can't imagine people are double ordering, but is there anything where folks are trying to just hold hard material as much as they can?

I don't think anybody is in that mode. I think that in aerospace, you see the airlines trying to build inventory on spares, right, making sure that they can handle what's in front of them. But I don't believe there's any double ordering going on. I think there may have been some of that early on in the industrial increase in demand. But as I mentioned earlier, we're constantly analyzing and pressure testing. What's out there, the orders and the backlog and what our customers are doing and what their schedules are. So I think right now, what's out there is pretty reliable.

Understood. And how should we think about pricing power in those businesses? Obviously, a lot more customer consolidation than you would have in the industrial side. But demand is very strong. Obviously, supply is limited. Does that afford you maybe a bit more precision on pricing than you would have had in the past?

Well, we use the same pricing tools in every business, right? So the same strategic pricing that goes on in the industrial side of the business that we've used the last couple of years. We've used the last 20 years is what we use in aerospace as well. So we're using those tools. We're having those -- in some cases, those tough conversations with customers. But it's a muscle that we have. It's a strength that we have, and we'll continue to do so. The industrial side of the business is back to more of the normal pricing schedule. So we don't see right now a return to where we've been in the last 24 months.

And then obviously, we're going to go through a mixed transition here over the next couple of years that will continue further as OE just ramps up more and more and more. Now Parker doesn't have the issue that, say, some other folks have where OE is loss-making or super low margin, but how should I think about the influence of that higher OE mix impacting overall margins? And does it make some of those margin targets a little bit more difficult even if the dollars are higher, just the percentage ends up being lower, given the growth that different.

Yes, we -- even with this year's guide, we have that higher OE mix built into the guide. And we still feel confident about our ability to expand the margins through some of the tools that I was talking about earlier. So obviously, the mix -- when it shifts, we have a shift in margin. But to counter that, we have a lot of the tools and the processes that we use to make sure we get that margin expansion.

Understood. And then, I guess, maybe just as a status check on Meggitt, big observations thus far. Obviously, deal very well timed and market is very attractive. But within the organization itself, whether it's what you've learned about them or how the 2 businesses have come together, anything that you'd point out or particularly proud of, concerned about, et cetera.

Yes. Great business. Couldn't be happier with the acquisition. The team is just a highly experienced team, great technologies, great complementary technologies for the portfolio. Just couldn't be happier with how quickly the team has embraced the Win Strategy. I recently was at the VINCI Park location in the U.K., which used to be the headquarters for Meggitt. And I walked in the front door and was created by a full wall of the Win Strategy. So a high-performance team culture before Parker and really fitting nicely. -- fitting nicely into our culture. So again, increase the synergies year 1 from $60 million to $75 million. I feel really good about the $75 million this year and the $300 million in total. We've been able to really take a look at the structure, remove some of those spans and layers of SG&A. So that is something that really helped us increase those synergies. So really, -- great acquisition, going really well.

I guess M&A more broadly has become a bigger part of Parker's DNA over the past 7, 8 years. You've done a lot in aero recently, obviously, including Meggitt but not just Meggitt. But how do we think about future priorities? I mean, motion and control, as you define it as I see it in the slide deck, is this enormous market I would imagine not every niche is interesting, but how do you think about what the priorities could be or should be from here whether it's error relative to industrial or maybe in motion and control, just given how fragmented it is and how much the world is changing around some of these bigger secular trends?

Right. So we -- we had an on-purpose strategy to make acquisitions that would double the size of aerospace filtration and engineered materials. And we've done that with CLARCOR, LORD, Exotic, and now Meggitt. So going forward, first of all, it doesn't have to be as big a deal as Meggitt. It doesn't have to be in those 3 areas. We like all the technologies. It really has to be the right deal that's focus on creating shareholder value, accretive to EPS, margins, growth tied to the secular trends, higher aftermarket. So that could be in any of the areas, but really has to be the right deal at the right time. And we keep our acquisition pipeline healthy and robust. And we keep those relationships going. So that's what it looks like for future acquisitions.

And then, I guess, on the core portfolio or the portfolio as it seems today, any pruning that needs to be done? I know there's some common technologies and areas of expertise where it's not just one particular market that you could get rid of wholesale. But are there areas of the business that do need a little bit of, call it, disposal hygiene? Are you pretty satisfied with everything you have?

We're pretty satisfied with what we have. There's been some small pruning along the way. But every year, we go through a process of who's the best owner of this business. And all of our businesses, the expectation for margin expansion and margin targets is the same. So if we don't see a line of sight to that, we address it. But we're happy with it right today.

Excellent. Jenny, I appreciate the time. It's great having you up here. And certainly, it sounds like things are going the way of Parker, so best of luck.

Thanks for having us.