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

Welcome, everybody, to the Parker-Hannifin session, and very pleased to welcome Todd Leombruno, who is the Chief Financial Officer. He'll have a few slides to sort of level set us, and then we'll do some general Q&A, would love to have as much participation as we can. So with that, Todd, welcome. Thanks for coming.

Well, thanks for having me. This is my first time at this conference, so I appreciate the hospitality. It's great to see such a great turnout. I know many in the room are very familiar with Parker-Hannifin. I just have a few slides that I'll go through for those that might not be so familiar. This is the way the company looks today at a glance. We have been focused on what we call the motion control space for well over 100 years. This is our FY '24 financials, which just finished in June. June is our year-end. And nearly $20 billion in revenue, you could see that's kind of split across really 3 distinct businesses that we share externally. Our North America diversified industrial business is roughly 44% of the company. Those businesses that are based internationally are about 30% of the company. And aerospace, specifically our Aerospace Systems business, the segment itself is about 27% of the business. A little bit of further color is we break our revenue into technology platforms. And you could see Aerospace Systems is the same as it is 27%. But we have really 3 platforms that make up our industrial business. That's Motion Systems, that's Flow and Process Control, and that's Filtration and Engineered Materials. Over a longer period of time, our focus on the company has been to expand our aerospace exposure, our filtration exposure and our engineered materials exposure. So this is what the chart looks like as of FY '24. If you know the company from years ago, that would have been a much different mix. Really, the thing that ties all of these businesses together is our operating strategy, we call it The Win Strategy. It was named that because as humans, we all want to win, and that was a strategy that was set out for the company years ago. We're on our third iteration of that. The company is really a collection of unbelievable engineering technologies that we use to apply customer challenges in the most unique ways possible, and that's how we drive value. One of the key things that we love about the company is, if you look at the industrial part of the business, which is roughly 70% of the company, 50% of that business goes through our independent distribution network. So that is really important because we have the widest technology offering in the space, and that allows our distributors to really have a leading position when it comes to serving both the aftermarket and small regional local OEMs around the world. And we're fiercely passionate about our decentralized operating structure and driving decisions in the business that are close to customers and close to product issues. Some people get confused about the business because it is such a diverse end market mix and such a wide range of technologies. We love the market space that we're in. We label it as about a $145 billion market space. We've tried to simplify this for digestion. And if you look at this, over 90% of our revenue comes from what we've identified as the 6 market verticals. Aerospace and Defense is now 33% of the company. You may say, geez, Todd, you just showed us 27% on the last slide. We do have aerospace business that resides in our industrial businesses. And those are technologies around filtration, around sealing and shielding and vibration control. So we put those technologies where the technology experts, are and just like any other end market, they serve aerospace from those business. Next biggest market is what we call in-plant automation and industrial equipment. It's about 20% of the company. And then we move to transportation, both on and off-road, that's 15% of the company. And then off-highway, this would be things like ag and construction, 15%. And then a nice bit of energy, oil and gas exposure there and then refrigeration, air conditioning and cooling is about 4% of the company. Add that all up, and that's our $20 billion worth of business. What is unique about us is all of these technologies, all of these applications are based in technology offerings, and then our application engineers just apply our best solutions to whatever our end customer needs. Just a snapshot on what we've been doing over the last 5 years. We're really proud of this. We've been able to grow revenue at a CAGR of 7%. This is going back pre-COVID. We have grown adjusted segment operating margins by 630 basis points. We nearly hit 25% last fiscal year. Our target -- our previous target was 25%, that was for our FY '27. So we accomplished that many years earlier. We feel really good about that. We have grown earnings per share at a CAGR of 14% over the last 5 years. We finished over $25. It's the first time in the history of the company we've been able to generate earnings per share at that level. And probably one of the things that I'm most proud about is we've doubled our free cash flow generation. So back in FY '19, we were generating about $1.5 billion of cash flow. Last year, we did $3 billion of cash flow. So that's the performance of what the company has been. It really is a combination of our team members around the world, our strategy and these changes that we've made to the portfolio. And we believe that we are not done yet. Just last May, we introduced new long-term targets, 5-year targets. So this takes us out to FY '29, starting in FY '25, which we're in as I speak right now. And we raised our margin targets. We raised our segment operating margin targets by 200 basis points. We now target 27% segment operating margins. EBITDA margins, we raised a little bit higher, 300 basis points to 28%. And we raised our cash flow, free cash flow margin 100 basis points from what was 16% to 17%. We still believe we can grow earnings per share at a CAGR greater than 10% over that time period. And probably one of the more challenging goals we set for ourselves, which remains the long-term goal that we've had for the company, is to grow organically with a 4% to 6% CAGR over the period. So that's where we're going in the future. I will remind everyone that if you do all that math, if you look at where we're at today, that would generate earnings per share of greater than $35. But what it does not take into account is optionality we have with the balance sheet. We just did the largest transaction in the history of the company. It's only been 24-ish months since that's closed. Our leverage is back to our target at 2.0x net debt-to-EBITDA. And because of the growth of the company, because of the cash flow generation, because of that margin expansion, we see no issues with continuing to grow our dividend, to continuing to invest in the company and to keep our share buyback program going. What is exciting for us is we've got options. And we've got options that are somewhere in the range of $20 billion to $26 billion over the next 5 years. Our focus would be to deploy that on M&A like we've done in the past. But I know I'm sure you'll have some questions about that and where we're focused. And the short answer is it's going to be more the same. But none of those targets that I just talked about take into account this $20 billion to $26 billion of optionality. So Steve, I think that's all I had.

Great. All right. So let's kick off Q&A then. If anybody has a question, you can just raise your hand and we'll work that in. I'll just start off. I think, Todd, one of the most striking things that's happened at Parker since I started covering you guys, I remember an IR guy that looked a little like you.

Yes, it was me.

So 20 years ago or so. But...

Not that long. It wasn't that long.

One of the most striking things is that we've heard a lot at this conference about a bit of a soft patch in short-cycle industrial. That used to be kind of what drove Parker-Hannifin. It doesn't seem to be driving it any longer. You just gave guidance for FY '25 that was kind of ahead of what the Street was expecting. Talk about how that's changed and how much visibility you have, and what gives you confidence of setting that sort of higher guidance for FY '25?

Yes, Steve, you gave me a flashback here on some of those meetings years ago. You're absolutely right. Parker was pegged as a short-cycle company. There's no doubt the markets we serve, they are cyclical. They will always be cyclical. What our focus has been over the last many years has been to kind of level out that cyclicality and lean the portfolio towards more what we call longer-cycle business. That acquisition strategy has been a big driver of that. We doubled our aerospace business. We doubled our filtration business. We doubled our material science, our engineered materials business, and that has been extremely powerful. That's what we've done on the acquisitive side of the business. But internally, we have focused our teams on innovation metrics, on product vitality metrics. Our investments, our resources have been directed on businesses that lean applications, that lean themselves to more visibility, more longer cycle. That short-cycle element of the company is still there. It is a critical piece of the company. It's important to our technology offering. It's important to our distribution base, and we are committed to that. What we have seen here just last year, if you look at FY '24, was it -- it was a muted industrial environment. There's no doubt about it. What really saved the day for Parker-Hannifin in FY '24 was aerospace continued to outperform, and that more than made up for the softness that we were seeing in the industrial sides of the business. Your question about guidance is very true. We just gave our annual guidance a little over a month ago. And a lot of thought, a lot of analysis, a lot of data went into that. And it's going to be more of the same. We're going to see aerospace carry an outsized portion of the growth for the company in FY '25. We guided to a midpoint of 8.5% organic for aerospace. That's 11% in the first half, obviously softer in the second half. And then on the industrial side of the business that you're asking about is, it is soft. We have guided for negative organic growth in the first half of our fiscal year, and that's been driven by what we have called continued softness in off-highway. Ag is double-digit declines that has been ongoing and continues to be a sign of negative growth in the areas. So what we are hopeful for is, we are hopeful that when we get to the second half, there will be a gradual, very gradual return to growth, also helped by some easier comps coming off of FY '25. So what you're going to see for us again this year is strong growth, strong performance out of aerospace, and we're going to manage that industrial business like we always have through these ups and downs. And our goal is to still drive margin expansion no matter what happens on the top line.

Okay. And you guys don't talk in a lot of detail around pricing, but any broad comments you can give us in terms of what you can...

No, I would say we're going to do pricing like we always do. Coming off the last -- whatever it is, 2, 2.5 years, it's been a very dynamic inflationary environment. We've all lived through that. We've all seen everything that we purchase increase in price. We have a pricing organization that I think is the best pricing organization in the industrial space, lots of data analytics, lots of process expertise throughout the organization and really a drive to act frequently and quickly. So that's what we did when we saw the inflationary pressures come into place, and that's what we'll continue to do. Pricing in general has moderated back to a normal environment. But we're still in an inflationary environment. It's not as bad as it was, but it's still worse than it used to be. And I would say that's probably even more so on the aerospace side of the business, right? A little bit different than the industrial side of the business. But aerospace is still working through significant supply chain challenges and obviously double digit, high single-digit to double-digit growth, depending on the platform. So we're making sure that we keep margins neutral. You're not going to hear us ever get on an earnings call and complain that price/cost was a factor in us not meeting our commitments.

But is it fair to say that price/cost has been a tailwind? I mean you guys have grown margin a lot over the last 10 years.

We certainly have. We certainly have. And I think it's been an element of it, but I would tell you, the main drivers of our margin expansion has been the changes in the portfolio, the organic investments that we've made, really implementing all the tools of our Win Strategy, which I know we've got a full room here, I won't go through that whole list of things. But when you look at that, we have really focused on being the most strategic on the supply chain side, the most value-based on the pricing side. We continue to refine our lean skills that you know we've been doing for over 30 years now, and we're still learning on that. We are no way experts in that area, but we could continue to learn and drive that forward. And we're really focused on making sure we can grow differently. That is -- from an organic standpoint, that is one of the things that we have not accomplished. So that is a goal that still sits out there, and that's what's driving the team's focus.

Okay. Let's look at orders a little bit. I think historically, for you guys sort of a cycle is 5 or 6 quarters of negative orders. Where are we in that?

Well, we have looked at that. You're exactly right. The average, when order year-over-year comparisons on a quarterly basis, when they turn negative, the average has been 6 quarters of negative activity. And that varies a little bit. Sometimes the international is a little bit different, maybe a quarter or 2 longer. The longest we've ever been has been in the financial crisis and the recession/COVID period, and that was 7 quarters. So we just released orders for June. We were really happy to see the North America orders returned to flat, which -- flat was kind of a positive for us. And international looks still negative but less bad. So we were happy with that. We felt comfortable with that. But we're not -- if you look at those last downturns over the history of time, certainly, the portfolio of the company was different. And every one of these downturns has got a little theme within itself. But what we saw on this last downturn was not as steep of a decline. So we're not expecting that steep of a return. And we're all following all the same external metrics that this room follows, and we expect it to be gradual at best. Where I draw positivity at is from our aerospace business and some signs of life in some of those smaller categories. Refrigeration, HVAC has returned to positive growth. There is activity in the energy markets that has been positive. We're not expecting a rebound in those major off-highway markets or really in-plant and industrial equipment yet.

And you guys, I think, have worked some new processes around AI and forecasting. Does that give you longer visibility now than you used to have?

Yes, it certainly does. We've talked about this externally. Our backlog coverage is much higher than what it used to be. Obviously, the aerospace business is clearly a longer cycle business. We have over $6.7 billion of aerospace backlog. It's the highest it's ever been. Obviously, it's the highest percentage of sales of the company that it's ever been. So we feel really good about that. But if you look solely at the industrial side of the business, back in 2015, we would have had maybe 15% backlog coverage. Today, that's high 20s. So it's down from where it was like in the peak of the supply chain stuff, maybe 3 or 4 basis -- 100 basis points lower than what it was, but still significantly higher than where we were before. And I think that's a factor of our portfolio change. It's a factor of customers being more focused on making sure they have continuity of supply. And that has been a nice buzz for us. And to your point, all kinds of analytical tools that help us look forward that we didn't have historically.

So are these higher levels of backlog kind of what the new normal should look like, or do they continue to moderate?

Well, on aerospace, we expect that to be the new normal for sure. On the industrial side of the business, this slight decline, this slight moderation is not a surprise to us. And we think it probably is where it will remain going forward. But we just got to get through this little soft patch of demand.

All right. We'll come up for air. Any questions from -- can I get it one in the back?

Just on the M&A side, if you don't mind, are you guys thinking more aerospace or are you thinking more the industrial businesses? And aerospace -- it seems like there's a lot of folks out there looking for assets. Almost every sort of aerospace company here is looking for assets. Can you just talk about how -- why you would win?

Yes. We love the aerospace business. There's no doubt about it. We made a big swing with Meggitt. Before that, we did Exotic Metals Forming. That has more than doubled our exposure to aerospace over the company's history. And it has been transformational for our performance. We would like to get more aerospace. There's no doubt about it. We don't have a target. We're not chasing a particular number. What it really comes down to for the M&A space is, we want to add companies to the portfolio that will help us grow differently, that we have a clear path to margin expansion, doesn't have to be margin accretive immediately, but through a synergy period, it has to be margin accretive. It's got to be accretive to EPS, and it has to help us grow cash. We have set a ROIC target in year 5 that's got to be very high single digits. It's got to exceed our cost of capital. And we feel that if we find a transaction that fits from a cultural standpoint, fits from a technology standpoint and meets all those criteria, that's how we win within Parker-Hannifin. What we have been successful at over the last 4 large transactions has really has been, I would call it, world-class integration and world-class synergy realization. And Meggitt is a prime example of that. It had the benefit of lessons learned from CLARCOR and LORD and Exotic, the last 3 acquisitions the company has done. And what we learned was move quickly, move with precision and take care of the customer, take care of the technology and treat the people right. And we like those results. So I think where we win versus others is our ability to integrate, capture real synergies that are visible in the financial statements. And part of that is in the selection process and the relationship building of all of these targets. So we are very much focused on it. If you look at our capital allocation history, we have been much highly levered towards spending all that optionality on M&A. We like what that has done with the company, and we plan to do it again. We're not trying to do anything bigger than what we did with Meggitt. It's going to have to be the right deal. We're not going to be rushed to do it, and we're going to remain disciplined like we have in the past. So we like our track record, and we like what the pipeline looks like.

Good. Do you have any views on like if aerospace is 50% of the company? Is that fine if it's the right asset?

That would be totally fine. It's over 30% today.

And you mentioned this earlier, I was going to get to it, but you've recharged the balance sheet. You're kind of where your normal debt to assets or EBITDA coverage should be. How much are you willing to flex up if the right deal came along?

It all depends on the deal and the size. As the company gets larger, as our margins get higher, as our free cash flow gets larger, it really changes the dynamics on what we can do and how quickly we can delever. We like where the company is positioned in respect to that. So we would not be afraid to do exactly what we did in the past if it was the right transaction.

And one thing that struck me recently is that you actually announced a reasonably chunky divestiture, which hasn't really been part of the track record.

Yes. That is feedback that we've got from many people like this in this room. And it's something that we've taken a harder look at. That is actually the ninth division business, product line divestitures that we've done over the last, I think, 6 years. So some of them have been small, but what they have done is they have simplified the business. They have allowed management to focus on our core technologies on businesses that we like. The business that we just divested, you're right, it was -- it's been the biggest that we haven't been required to divest as part of any other acquisition agreements. But a very sound business, a great business, a little bit outside of our core technology. And while that has been part of the Meggitt integration, we really came to the conclusion that it probably wasn't going to achieve above company average operating margins, and we found a best owner for it. So you've heard us talk, we go through this process every year with every single one of our businesses. We make sure that they earn their right to stay in the portfolio and we've been more active on moving ones out that might find better success elsewhere.

Great. Maybe the final one on M&A. The Meggitt process was a little more drawn out.

Oh, yes. Yes. Aging.

That's exactly what the reaction I was looking for. So the question is, would you do something like that again? I mean there's a lot of approvals in the divestures and...

Yes, that process was probably the most complex process that we went through ever in the history of the company. It's hard to say we would not do that exactly again, based on the results that come from it. Each one, as you know, is different within itself. Each one has a different set of complications. But I would tell you, the team has taken each one of these transactions, put it into our toolbox and we're ready to execute on whatever complexities could be out there. What is nice about a longer process is, it does allow us to -- and what was the Meggitt case was we were able to prepay down a lot of that purchase price before we had closed. So there was almost $2 billion on that purchase price was applied towards the purchase of Meggitt before we closed, and we've now done nearly $4 billion since. So that puts the company at a nice rinse and repeat optionality, which we like. And Meggitt has been fantastic. We are really glad that we got to yes on that.

And a lot of companies have sort of come at this at a different angle from you, which is to do it more in small chunks, but more of them. Is that also on the table?

That is also on the table, yes. It does not have to be bigger than Meggitt. It doesn't have to be bigger than LORD. It doesn't have to be bigger than CLARCOR. Exotic was a fine example of a midsized acquisition, historically, what would have been on a larger scale for Parker-Hannifin. And it just has to be the right business for us, and it's got to be -- fit all those criteria that I went through earlier, and we just want to make sure that we remain disciplined on it. We don't want to have to come here and explain why synergies aren't showing up in the P&L or why the returns aren't what we expected. And I think a lot of that we control based on the pipeline reviews, the relationships that we've had over many, many years with all of these potential targets, and really what I can't stress enough is a world-class integration process.

Anyone else? Yes?

Just on the guidance for this year in longer-term. You got the aerospace business, which is round numbers, 30% of your portfolio probably growing at 12%. So you're almost hitting the bottom end of your midterm guide -- you near-term guide just with aero. So it sounds like -- and there's no M&A in there. So it sounds like you're sort of assuming that the industrial businesses don't really pick even though the orders seem like they've kind of inflected. So can you flesh that out a little for me?

For FY '25, you're speaking specifically? Yes. So our guide, midpoint guide for aerospace growth organic is 8.5%. The total company is a range of 3% to 5%, right? So we are expecting aerospace to -- certainly, the orders to moderate just based off of 2 years of double-digit growth. And we're watching that very highly. It's at very high levels. That supply chain is still very stressed in aerospace. We just came off a double-digit organic growth in aerospace. So right now, we're guiding to 8.5%. On the industrial side, we're expecting it to be negative first half. So first 6 months of our fiscal year, we're expecting that to be negative with a gradual rebound in the second half. That coupled with the aerospace growth gets us to that 3% to 5% range for the guidance.

Could you just elaborate on the stress in the aero supply chain? And why it's still there? And if Boeing is ever able to increase production, what does that do to the supply chain from where we are today?

Yes, that's a good point. Yes, it's a unique supply chain. It suffered worse than the industrial supply chain through the COVID and resulting supply chain challenges after that. But they've also been dealing with really now 3 years of pretty positive organic growth. So I think it's just been a combination of severe impact during COVID and then really 3 years of prolonged growth. And of course, that is -- it's a complex supply chain. So it's better than it was, it's just not healed yet. And we expect that to really still take some time to continue on that healing process. And what was the second part of the question?

[indiscernible] Boeing at some point?

Yes, yes, yes. Well, yes, all the large manufacturers, Boeing, Airbus, that will put more stress on the supply chain. What we're trying to do is make sure that we are delivering to those customers well ahead of the rate that they need today. We don't think that there's a big enough bubble there that would have any kind of inventory pushback. And we're just making sure we're ready, right? That's what really -- what our focus is. We'd love to see those rates increase.

With that, I'm afraid we're out of time. I'm sorry. We want to keep on schedule time. Thank you.

Thank you so much.

Really appreciate it. Great seeing you.

Thanks, everyone.