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

All right. Thanks, everyone. This is Todd, you were the last before lunch.

That's great pleasure. Yes, really happy to have the team from Parker and I appreciate all your support over the years from the company sitting in the front here, Jeff Miller and Yan Huo from the IR team. And to my right, Todd Leombruno, who is a kind of a rookie at Parker.

Correct. Yes.

30-some years.

30-some years.

Good. Well, thanks again for coming. I always appreciate it. And I think before we get into Q&A, we'll turn it to you for some comments. And then as we go along, if anyone has any questions, if assuming I can even see you, just raise your hand and we'll try to answer that questions.

Well, Tim, it's a pleasure to be here. Thank you. We appreciate all the help that Citi has given us over the years as well. So it's a pleasure to be here. As Tim said, I'm Todd Leombruno. I'm with Parker-Hannifin. I have been with the company 31 years. It's hard to believe. And the company has never been larger. We've never been more profitable. We have never generated more cash, and it's a pleasure to be here today, and I'll just share some of the highlights with the team here. I see a lot of familiar faces, so we'll go quick through these slides, and we'll take as many questions as we can get to. But the company is going to guide to $20 billion this year in sales. We have the #1 position in a very, very large market, a $135 billion marketplace. We have a goal to reach 20% market share in our space. And you've seen we've made some big improvements in that goal over the last couple of years with our organic growth and also where we've spent time with acquisitions. The company is really a combination of 8 core technologies. It really allows us to solve solutions and challenges for our customers in ways that other companies cannot. We are fiercely decentralized. We have over 85 divisions that are P&L owners. Those divisions roll up into 5 business groups, and then we externally go out in 3 segments. We are driven by a few main things. One of them is being a great generator and a great deployer of cash. And we are bound by our business system, which we call The Win Strategy. We're on version 3 of that. And like I said, the company has never been performing better, and we've -- we're really proud of where we've been, but we're also really excited about where we're going. If you look at what we've done over the last couple of years, this is just a look pre-COVID. So you take out all the noise with COVID and the supply chain ramp and all that kind of stuff that's been through here. You look at -- since FY '19, we've grown sales in a CAGR of roughly 70%, which we're really proud of. Margin expansion has been robust, 570 basis points of margin expansion over that same time period, and we've grown EPS at a CAGR of 13%. And probably the number that we're most proud about is we have more than doubled the dollars of cash flow that we've generated as a company. This year, we're expecting to grow cash flow to just over $3 billion. So it's really been a stellar time period with the company. But like I said before, we are really excited of where we're going. We have a stated goal of achieving $30 of earnings per share by FY '27. That's a 25% increase from where we're at today. And likewise, that $3 billion of cash flow will grow to greater than $3.5 billion. How are we going to do that? We're going to do that by all the things that got us here, making sure that our people, our portfolio and our strategy drives this performance. We have really been focusing the company on becoming more exposed to longer-cycle businesses. And that has helped us through some pretty volatile times over the last 5 years, and that's going to continue to expand as we get growth from all of the secular trends, aerospace, the mega cap projects, digitization, electrification and clean tech. And that's really how we're going to try to have organic growth grow 4% to 6% over the cycle. So that's all we prepared, Tim. I know you've got some questions, so we can take them from anyone in the audience if that works as well.

Good, good. Let me start with the -- so the industrial segment, North America and International. Obviously, you mentioned, what, 8 groups that roll into that. But specific to the industrial piece, there's the engineered materials, which I think you had some oversight back in the days as well as filtration, 2 areas that if you line up the growth rates over time, both organic and inorganic. I think they've been kind of outsized growers. And I think what gets lost a little bit in Parker is just when you -- within industrial, again, a lot of different markets and the competitive dynamics aren't the same across the board. So maybe just to highlight just for folks that maybe haven't been focused those 2 segments alone what makes them unique in...

Yes, certainly. Yes. So the glue that binds the company together is really these 8 technologies that we define as a motion control technologies. These would be things like you said, filtration, engineered materials. It also would have fluid conveyance, it would have electromechanical. There would be some climate control in there. Hydraulics, of course, would be a big one. What's unique about the company is whether you're in the aerospace business or you're in the industrial business, it really is the application of those technologies to our customer applications that really tied together. We feel it's a critical element for us. Over 2/3 of the sales that the company generates are from customers that buy 4 or more of those technologies. So it's meaningful for us. I think we see it with the way our customers interact and by the way they spend their purchasing dollars. So it's important to us. So your question on the industrial side of the business, that's roughly 75% of the company. That part of the company has things like our Motion Systems business, our Flow and Process business and our Engineered Materials and Filtration business. Those businesses, specifically, we have been acquisitive with, our Engineered Materials and Filtration. CLARCOR more than doubled the size of the filtration business, LORD more than doubled the size of the Engineered Materials business. What we like about those businesses is, first, I'll start with Filtration. It is a clean tech business, right? Filtration is making everything cleaner, whether it's water, whether it's fuel, whether it's air -- it is making the world a better place, and that is part of our purpose statement. And we also love the fact that there is significant aftermarket within the Filtration business. So that has kind of helped us as demand ebbs and flows. The aftermarket remains fairly constant. So that's kind of a nice growth element in the business. On the Engineered Materials side. This is really a material science business. So this is a business that is really using chemistry to apply technologies across a wide range of market spaces. There's aerospace business within our Engineered Materials business. There is Electrification business within our Engineered Materials business. So we like that, that business is also levered towards these secular trends. And quite honestly, it is a business that fits perfectly with all the technologies within the company, it's just become a really nice fit. Those businesses were smaller in scale before the acquisitions, and it's kind of like made them more significant part of the portfolio.

When you think of the fluid power space just generically, okay, well, how Parker's hydraulic new managed business. Well, what the Deere or CAT or Parker say, would be historically how you can think about that? And now as you think about just how that business data centers probably have more hydraulic content and more EV? I mean there is -- to your point about these mega trends. How has that shifted the opportunity?

That's a great question. It is really a diverse-end market application. And you're right. I think historically, people would say, hey, how Deere goes or how CAT goes, that's how Parker is going to go. But when you look at the portfolio and the changes we've made, there's over 30% of the company is now exposed to aerospace. If you look at our top 10 customer list, over 70% of those customers are aerospace customers. So those large mobile OEMs are still extremely important to us. They're just a smaller piece of the total company as they -- versus what they were 5, 10, 15 years ago. When you look at the way we apply these industrial technologies, what's also kind of a unique element is over 50% of the sales in that industrial business goes through our distribution network. And our distribution network is second to none in the space. And this is something that we've been working on for over 80 years now. And what makes it very unique is the fact that because we have the broadest breadth of offering -- product offering in the motion control space, there's very little competition within the distribution network from competitive sources. Our distributors are either end market specialists or application specialists. They're really an extension of our engineering expertise across the platform. They're not just ordering product from us and delivering it to a customer. They're really applying our technologies to whatever situations the end customer may need.

Yes, to that point, it's a segue. Just in terms of the role of the distributor, as the technologies evolve, you think about the fluid power, it has cloud services, automation, electronic controls. I mean, it's not selling hoses. So what -- how much investment or -- to the extent that the distributor network needs to keep up with how...

Yes. I mean they're really -- it's a great partnership that we have with our distributors. We have a team that supports them specifically, but really what we've done within innovation across the company is as we've made sure that we've focused our resources, our people, our investment spend in areas that there are higher growth opportunities that there is an appreciation for the value that our engineering expertise brings and that obviously, it brings a margin along with that. When you look at our distribution network, sales that go through that distribution network on average, are between 10 and 15 gross margin points higher than direct business. So what we're seeing in these distributors are depending on what's happening with mega projects is a great example in whatever region of the world they are in, they are an extension of our reach and that really helps with new things like precision cooling and data centers and clean tech type applications; hydrogen would be another example.

As you -- you're talking about transforming the business, having more of that long-cycle exposure now, you're -- in the industrial business, your backlog coverage used to be like in the -- like mid-teens, call it, you're now in the 30%... What does that afford the company in terms of presumably you have better ability to manage the factory floor when you have more and just talk to that journey.

Well, yes, it gives us some comfort. So yes, the total numbers, you're absolutely right. If you look at the total company, our backlog coverage is around 55%. That's the entire company. Aerospace is over 100%. I think it's 120%. The number you mentioned, the 30% is the industrial business, 30% coverage. That -- all of those metrics are roughly 2x what they used to be. We like that because what that signals to us is this shift to longer cycle business is working, it is meaningful. It has remained at those levels throughout the last 1.5 years, which has been very promising because we've been in a period of destocking, we've been in a period of negative order from a year-over-year comparison standpoint, but that backlog has remained very resilient. So it does give us a little bit better window of time. That is a focus. Where we've always prided ourselves is on delivery, on quality and making sure that there's an engineered aspect to every one of these products. One of our big focus areas is on doing that even better from a demand and capacity planning standpoint. And we really do think that, that brings value to our end customers and that that's going to help us grow that 4% to 6% organic over the cycle in the future. We have pressure tested that backlog. It is real. We have gone through that constantly. And again, it just gives us confidence that there's a little bit more visibility than we had in the past.

Got it. Maybe we can just talk about what kind of -- what you're seeing on the ground, what you're hearing from distributors and you start in North America, to your point, you were talking about -- well, almost a year ago when we sat here behind us that wasn't on the radar, but you could kind of see it that we were maybe getting towards that.

Yes. We were just now, it's been 4 quarters. So it's been almost a year now of really destocking. We've looked at this historically. That period has been 6 quarters. We're through 4 quarters of it right now. So I'm not here to officially call a bottom or anything. But if we look at over time, it's been 6 quarters. We're through 4 quarters of it right now. Our International businesses have been a little bit longer. They have been 5 quarters of negative order growth. But I would tell you, what I think is different about the company today versus where we've ever been is, is that historically, when those orders would have turned negative, we would have either that very quarter or the very next quarter, we have been -- we would have been forecasting and delivering a negative organic growth number. If you look at what we're doing this year, we're forecasting a 1.5% organic growth. So that is, to me, pretty impressive after 4 quarters of negative order growth that we're still forecasting 1.5% growth. That speaks a little bit to the backlog that we just talked about. But it also speaks to the long-cycle nature of the company. A lot of that growth has been held up by aerospace businesses, which has been by design to be quite honest with you. So we feel really good about that. We have started to hear some positive sentiment from customers. I think we talked on the earnings call we just had our large North American distributor meeting just in Texas in December, and there were some positive offshoots from that. So I think we're through the majority of this and that I'm hopeful that we only have a few quarters left of this rebalancing and destocking.

So Todd Leombruno calls...

I said historically, we've got 2 more quarters left...

And just in the International markets, focus on Europe and China being the 2 big ones, maybe...

Well, like I said, Europe and our International businesses have been in it 1 quarter longer. Really, Europe has been -- if you look at all the macro indicators, they have been stagnant for some time. If you look at Germany, the production out of Germany has been low. So we're monitoring that very carefully and we're adjusting our businesses, and we're making sure that we are focused on new opportunities, new applications but serving the customer business that we have right now. Asia really has been driven by just some choppiness out of China specifically. The recovery has been slow. There's been some tough comparables with the COVID starts and shutdowns. But that's something that's been slower than we had expected. Surprisingly, the second quarter was actually a little bit better than we had forecasted that surprised us a little bit. And if you look at the orders, the orders did get a little bit better in the International segment. We actually did raise our guide for the second half of the year, just really driven off of the strength in Q2. So what I really am positive about is, is that, again, we've had a significant number of negative order activity year-over-year, but it's at such a high level that if you look at this, this is still near record levels. And the other thing that's been really nice is we've been able to expand margins during all of this activity. We are very proud of our margin expansion. We are not done yet. And quite honestly, if you look at our guide, we've expanded that margin expansion into the second half even on a soft top line.

Yes. Going back to International, I remember maybe it probably a decade or so ago at this point, a lot of the -- your domestic OEMs going to build out their infrastructure, bringing suppliers like Parker with them. A lot has changed since. And now you see a lot of those domestic OEMs in China that help saying our whole market is soft. So we're going to try and look at export markets. I mean how is...

We've always been proponents of what we call local for local supply. We like to produce, deliver service in the local currency in the local economy. That has been a method that has worked for us extremely well. I think it helped us fare better than most through the supply chain noise that was prevalent in the last 2 years. And we feel that, that's the right exposure. We have done that. You're exactly right. That's how we kind of grew the business globally. We've started to gain share with local suppliers as well, and that's what the team is focused on. So I don't think -- I don't see a big shift in our strategy as far as that goes. What we're trying to do is we're trying to capitalize on this whole reshoring and near-shoring activity, which, for the first time, it really does feel weird. We're seeing our customers do it. We ourselves are doing it, and it is meaningful for our business.

The nearshoring?

Yes, absolutely.

It's just the jury is kind of all over the board on that in terms of...

Well, yes, I think this is -- we've heard these terms before in the past. This time, it really does feel real. I think we learned a lot through the supply chain challenges that initially, it was maybe difficult to get product, but once it became an issue where you couldn't deliver to your end customer, I think that's really what's driving a lot of the investment.

Just sticking with the industrial and we will shift over to aero, but if you look at the margin performance, as you've discussed this multiple times, but Americas versus International used to be this big gap...

Correct, yes.

And you look -- just use the German economy, for example, versus the U.S. And over the last 5 years, there's been -- it's been down and Americas continues to grow and yet and the weakness in China despite all those factors...

Well, it's been -- Tim, it's a great question. It's been a long-term focus of ours. -- because the technologies are what they are. And our feeling has always been there's no reason why we shouldn't have similar margins in our International businesses than we have in our North American businesses. So I will tell you, this has not been an overnight surprise. This has been many, many years of looking at the cost structure, looking at the customer base, shifting that distribution mix. We used to have -- obviously, North America has a much higher distribution versus OEM mix. That was totally inverse in the international markets. We have increased that mix by 100 basis points a year for the last 8 years, right? So it's now 43% of the mix of International business goes through distribution. We've been very vocal with this. Our distribution business 10 to 15 gross margin points more profitable than direct shipments. And that has helped that balance out that International margins. But the team has really done a great job. We have done multiple simplification efforts. We have worked on our processes. And everyone likes winning. Our strategy is called The Win Strategy for that very reason. And our international team members have proven to themselves that they can achieve the same or better margins than our like businesses in North America. So it's been really rewarding to see that. If you look at our margin expansion, that 570 basis points that I showed on that slide, it has been equally generated across North American businesses, across our International businesses and across our aerospace businesses. So -- and we've looked at this in depth internally. 80% of that improvement has come from core businesses and only 20% has come from the businesses that we acquired. So that's kind of almost an equal mix of what those percentages of sales have been. And it's just proof that we can expand margins in every one of our businesses, and we feel really confident about not just where we've come, but also where we're headed.

I'll pause there for a second. Does anyone have any questions? Good. As we're thinking about that maybe shift to aerospace. As you look at the build rates, at least what their plan from Boeing and Airbus, you should see a nice increase. The expectations that retirements will accelerate as that happens. Think about the impact of that in terms of the commercial OE growing. How do you -- how should investors think about the potential margin impact of that mixing down -- is the OE piece, take out defense...

Yes. Well, the big thing, if you don't know where we're at today, I think I said it earlier, but 30% of our end market exposure is now aerospace businesses. It's never been a larger part of the company, which is fantastic. The other thing is that our aftermarket OEM mix has never been higher -- this last quarter, it was 47% aftermarket. On a normalized basis, we think 45% is the right number, but you could just see how much bigger it was just specifically in Q2. So we like that mix. Part of what made Meggitt attractive was it increased our aftermarket mix by 500 basis points. So that was one of the elements that made us so attractive to bring in Meggitt into the Parker family. So when we look at that, we don't -- we're on all these major programs. We know that the OEM business is ramping. But it also helps us with efficiencies within our facilities. It helps us on the supply chain side. So I'm not here to say that we're not going to have any pressure, but it will be minimal pressure as that aftermarket mix reverts back to a 45% number from 47%. And we think it's all upside on the OEM side of the business.

One of your peers in that market spoke earlier and talked about how the supply chain on the commercial side continues to kind of stay for growth. I know you guys just raised your aero guidance. But what are you seeing there in terms of...

Yes. I mean, it's true. The aerospace supply chain is still under pressure. There's no doubt about it. I think the industrial supply chain has kind of normalized. I wouldn't say it's back to normal, but it is normalized and our teams are reacting to it. With the aerospace business, we're guiding 12% organic growth this year. So that's a much different situation than the industrial businesses that are at least flattish. So I think there's still some time that it's going to take aerospace to get back to a normal standpoint. There are some chips involved there, a lot of electronics that are also making it a little bit more complicated, but we're still not through normalization on the aerospace side of it. So to answer your question, you're right. Once that normalizes, I think that will release a little bit more volume.

Does that require you investing in the supply chain?

We're working with our suppliers. Obviously, it's a partnership. -- especially with the aerospace business, it's long nature. But I wouldn't say there's no outsized investments required. It's really just working the process. There's a lot that we can do better from a -- we call it demanded capacity forecasting that I think helps our end customers and our suppliers as well.

And maybe a minute on Meggitt. Obviously, you've front-loaded some of the synergy realization. What's there? I mean I know that there was a lot of opportunity to kind of Parkerize Meggitt when you took it over, where are you in terms of...

Well, listen, we couldn't be happier with Meggitt. It is going unbelievably well. It is the largest deal we've ever done. We have been aided by this unbelievable growth that's happened within the aerospace business. So that has been very, very helpful. But the other thing that's been really unique about Meggitt is -- this is now the fourth large acquisition that we've done in the last 8 to 10 years. So we've taken lessons learned from CLARCOR, from LORD, from Exotic and we have applied all of those to Meggitt. Meggitt is a company with a long history. This is a company that we have admired, competed with. It is very, very familiar. The cultures, the values are very similar to Parker. And it has been unbelievably smooth, and I think you see that in our results, right? We committed to generating $300 million of synergies by year 3. We've committed to make that $200 million by the end of this fiscal year. It is all across the board, there's obviously a significant number of cost out opportunities. But really, it is basically applying the tools of The Win Strategy that are helping drive that forward, right? So better supply chain, better operationally, better pricing methods. And all of that has been part of what has made this so successful. We're really bullish on it.

Were there -- in terms of pricing, were there like long-term agreements that have -- about two or will roll off that you're able to get...

Yes. I mean, there's obviously -- aerospace is a little bit of a different business when it comes to pricing, but there's a significant amount of aftermarket, right? We're now 47% aftermarket. So there's some of that. There is the contracts that we have addressed. What we've talked about is we've talked about this last 1.5 years, 2 years of unbelievable inflationary pressure, coupled with unbelievable demand in the aerospace markets. And ultimately, we have to make sure that we get value for those products, whether there's a contract or not. And I think our teams have worked really hard to make sure that we're not getting taken advantage of and that we're getting value for our services.

Yes. So the margin point, rightfully so was highlighted earlier, it looks like you're -- not to jinx you -- but that 25%...

We are getting close.

It's in -- it's in sight. What -- I mean, what factors are still left in terms of -- I mean, there's been such a significant run here over the past decade, what[indiscernible] single magic bullet...

Well, listen, what we -- yes, it's been a lot of hard work by a lot of people for a lot of time. What we pride ourselves on and what we drive ourselves to be is top quartile performers. And every metric we look at, margins are one of those metrics, we are not at top quartile performance today. We believe we can get to top quartile performance. So I would tell you that 25% is certainly in sight. That is not the end destination by any stretch of imagination. I have full confidence that the team is going to be able to continue to expand margins. And if you look at this year, I think based on our guide, we're guiding 140 basis points of margin improvement, and that's with a 1.5% organic growth top line, right? So it is just proof that the margin expansion machine is real within the company, and we look at that every day across every one of our businesses. And we feel really strong about our ability to continue that.

I think one of the things that Jenny mentioned on the call was that demand better -- I don't know what I mean it was just forecasted...

What that does is that really takes a lot of noise out of the business. And we're early days on that yet. So we have a lot of opportunity on streamlining that and getting even better with that. But we do believe that, that is a way that we can win over even more customers and grow even better than we have in the past.

So the price cost discussion [ versus loans have covered ] Parker, it is how he comes up, and it's how he is, just you manage right through it, but.

Well, we certainly don't like to use it as an excuse, right? I mean I think that -- we have been focused on pricing for decades. We have an organization that prides itself on making sure we get value for the product, and that's what it really comes down to. The world has been unbelievably volatile that has caused us to go off of cycle. And I think we've been successful with that. But we've done that because we've had to do that for our shareholders. to make sure that we're not slipping. So I think we're past all that. I think we're now back to a normal pricing environment, and we will remain that way unless we have to pivot based on whatever happens to input costs.

Yes. And obviously, having that distributor network...

It is really a science within the company, and we monitor it, measure it consistently in every one of the businesses, and we hold our team accountable for it.

Got it. Maybe in the last couple of minutes and see if anyone has any questions out there?

Could you talk about the opportunity for Meggitt top line synergies and any of those starting to come through?

It's a great question. What's happened with Meggitt that's been unlike any other acquisition that we've ever done is if you look at our top 10 customers within our aerospace business, we have gotten larger with every single one of those customers. That has made us more important to those customers, that has brought us in on deeper discussions with customers. The amount of issues that we could solve has been expanded. And I think longer term, that is going to be great for top line opportunities. The way the aerospace business works now is that's more of a longer benefit in the future. We're certainly seeing it with -- on the aftermarket side of the business. And I think we'll see some near-term gains there. But certainly, longer term, that's going to be important.

One of the things, Todd used to highlight was this whole notion of instead of selling widgets to an end customer, you're going to design the whole system, that absolutely brings together all the different groups that we highlighted. Where are you in terms of along that?

Yes. I mean that shift continues. I mentioned that stat, 2/3 of our revenue comes from customers that buy 4 more technologies. That means those technologies are integrated together. They work better when they're integrated together. We can offer a better performance when we know that we've designed that system, and we know how that works and what the issues may be with it. But I would say that, that continues on. We are not competing on commodities. We're not competing on price. It really is an interconnected solution that has a ton of engineering IP wrapped around it.

Turning to the balance sheet. So with the debt paydown that you're forecasting by the end of June, you'll be back to right around that 2x of leverage -- where -- what should investors think in terms of what -- where the priorities are?

Yes. I mean we're ahead of schedule. So we're doing better than what we initially laid out, which is fantastic. This has been in the playbook on the last couple of deals. So what we've targeted as we've targeted June to be 2x net debt to adjusted EBITDA, that is our immediate focus. But I would tell you the acquisition pipeline, it has just never gone cold. We have continued to work that pipeline. We've continued to build relationships. We have continued to track activity. And I would tell you that while our main focus is to get to that 2x leverage, if something needed to happen before that, I think we've got the credibility that we could do that. And I will say the one thing that we've learned over the last couple of years is, you have to be active with the balance sheet, and we will do that. If there's something that doesn't make sense from the acquisition standpoint, there's other levers that we can pull, and we wouldn't be afraid to do that. We're not trying to do a deal that's larger than Meggitt. We're trying to do the right deal for the shareholders, the right deal for the company, and we're going to be disciplined on that.

All right. May be so just to kind of sum everything up. So if we fast forward the industrial economy, we have all kinds of fits and starts over the last couple of years. Who knows where we go. But let's fast forward to August, and you're giving an early read into FY '25. Your call earlier that the short cycle is bothering you...

Well, like I said, I don't know if I made that call, but I would tell you, on the aerospace side of the business, we feel very bullish about that. So for the foreseeable future, we see high single-digit growth within aerospace. Industrial, I'd like a little bit more time before we do that. Hopefully, we'll have some better information by the time we get to August. But I would tell you, we've never felt better about the prospects for the company with not just our performance, but -- the way these technologies are really levered to the secular trends and these capital projects. We've never felt more bullish on our prospects for growing.

Excellent. I just -- as a plug, we're doing a launch on that theme on megatrend with Rockwell training and Symbotic.

Excellent. We will be there.

So thanks again, Todd. Thank you.

Thanks, everyone. Thanks for your interest.