Parker-Hannifin Corporation

Good day, ladies and gentlemen, and welcome to the Parker Hannafin Fiscal 2019 Second Quarter Earnings Conference Call. At this time, all lines are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will be provided at that time. Should anyone require operator assistance during today's call, please press star then zero on your touchtone telephone. I'd now like to turn the conference over to the Chief Financial Officer, Kathy Siever. Please go ahead.

Thanks, James. Good morning. Welcome to Parker Hannafin's second quarter fiscal year 2019 earnings release teleconference. Joining me today are Chairman and Chief Executive Officer Tom Williams and President and Chief Operating Officer Lee Banks. Today's presentation slides, together with the audio webcast replay, will be accessible on the company's investor information website at phstock.com for one year following today's call. On slide number two, you'll find the company's safe harbor disclosure statement addressing forward-looking statements as well as non-GAAP financial measures. Reconciliations for any reference to non-GAAP financial measures are included in this morning's press release and are also posted on Parker's website at phstock.com. Today's agenda appears on slide three. To begin, our chairman and chief executive officer, Tom Williams, will provide comments and highlights from the second quarter. Following Tom's comments, I'll provide a review of the company's second quarter performance, together with the guidance for the full year of fiscal 2019. Tom will then provide a few summary comments and will open the call for a question and answer session. Please refer now to slide number four. Tom will get us started.

Thank you, Kathy, and good morning, everybody. Thanks for your interest in Parker and your participation today. So I want to start by first highlighting Parker's business model, which Kathy mentions on slide four, specifically those competitive differentiators that really help us stand out versus other companies and versus our competition. So first on the list and first and foremost is the win strategy. It's our business system. It's a proven strategy that has a long track record of success. The second would be our decentralized divisional structure. We like that structure because it's close to the action. We want our people close to the customers and close to the P&L so that we know whether we're making money or not. The breadth integration of Parker's technology portfolio really creates this combination of technologies that creates a unique customer value proposition. I think this is best demonstrated by the fact that 60% of our revenue comes from customers that buy four or more of those technologies. We make engineered products. About 85% of our products have some kind of elemental property wrapped around them. Our products have long product life cycles, which is a great thing. We're balanced between OEM and aftermarket. And to support this business model only requires low operating CapEx requirements, which is very positive. We've got a great track record on cash generation and deployment, and we want to continue that over the cycle going forward. So some key takeaways for the quarter. Safety is always our top priority. We had really strong performance, 23% reduction in recordable incidents. This is building on great progress from prior quarters. My thanks to everyone for their efforts on owning safety, the leaders and all the team members of the company. And I would just remind shareholders there's a very close linkage between safety performance and financial and customer performance, and you can see that linkage as we improve safety, seeing the performance in our customer and our financial metrics. We put up a number of second quarter records. This was on sales, segment operating margins, net income, and EPS. We reached 16.4% as reported on operating margins in the quarter. This is an unprecedented level of performance for the second quarter. If you were to go back years ago, it would normally be a Q4 type of performance to get what we did in Q2, a really significant job for everybody around the world. Our organic growth came in positive at almost 6%. partially offset by currency, and we had strong cash flow and free cash flow conversion for the quarter, driven by operating income growth and good working capital management. As a result of all this, we're increasing earnings guidance for the fiscal year, and we remain confident in our ability to reach our new guidance for FY19, as well as the FY23 five-year financial targets. So my thanks to the team members for Parker around the world. Great progress, great results. Thank you so much. So a couple more comments about the quarter. A strong quarter, nice earnings improvement year over year, as I mentioned, a number of records. From a net standpoint, our sales came in at 3%, again with almost 6% organic, which was very close to our guidance, spot on. Order rates moderated. It was a combination of tougher comparables as well as growth moderating. We'll talk more about that during the Q&A. Net income was a Q2 record, which included income tax expense related to U.S. tax reform of $14 million. In segment operating margins, again, was a record 16.4% as reported. This compares, if you look, what was the previous Q2 record was 14.4%. So if I could just comment for a second, most of the time when you beat a margin record, you beat it by 10 to 50 basis points, some nominal type of beat. The fact that we beat this by 200 basis points is very significant. We almost never do something like that. That was remarkable. And of note is that this includes the Clarkor intangibles as well as the cost achieved. Again, a really outstanding result. If I would switch now on an adjusted basis, adjusted segment operating margins for the total company were 16.6%, which was up year over year 170 basis points versus Q2 of FY18. Aerospace had another great quarter. making three straight quarters with margins over 19%. A great job by the aerospace team, demonstrating really nice returns on the significant amount of investments that we made there over the last decade or so. And what we've done is we've built a long-cycle, high-performing business that we're excited about now, and we're excited about where the future is going to bring for the aerospace business. On an as-reported EBITDA standpoint, EBITDA margins were up 120 basis points to 17.0%. or 17.2% on an adjusted basis. So I've spent a fair amount of time talking about margins. There's three big factors that drove margin expansion for us. Again, it starts with the wind strategy and the execution the team's doing on that, the productivity that we demonstrated in the plants and the plant closures improving there, and supply chain optimization. Cash flow, switching to cash, was strong. We expect to exceed 100%. Free cash flow conversion and operating cash greater than 10 percent of sales for the fiscal year. This would be excluding discretionary pension contribution. And then on share repurchases, we bought a total of $500 million in Q2. This was made up of a discretionary repurchase of $450 million and our 10 program repurchasing $50 million. So now switching to the outlook, we're increasing EPS guidance by 9 cents at the midpoint to $11.29. This is on an as reported basis. And we're increasing at $0.20 at the midpoint to $11.60 on an adjusted EPS basis. This reflects the strong first half that we had and the outlook for the remainder of the fiscal year. We're forecasting moderating sales growth based on our current order entry and currency impact. And this has a forecasted organic growth range of 2% to 4% for the full fiscal year. We are in a great position, the best position we've ever been to outperform regardless of the market environment. Several factors underpin our confidence and ability to perform here. New wind strategy is demonstrating a distinct step change in performance. I think the best example is if you were to look at our margin expansion over the last four years, that's a great indicator that there's clearly a step change in performance, and the underpinning of that is the wind strategy. What really gives us a lot of confidence is that we're still in early days of the wind strategy performance, and I'll just highlight a few opportunities there The first is our whole high-performance team process, which is all about creating an ownership culture of the companies. As you have owners evolve and continue to care more and drive more engagement, you're going to see performance improve right with it. Simplification initiatives are still early days. The innovation pipeline is growing. And the combination of lean and Kaizen opportunities and our supply chain strategies are going to continue to yield margin expansion as we go forward. We are stronger as a company now than we've ever been. Our cost structure is in the best shape that it's been, and we're well positioned to manage any kind of market dynamics and softening. The combination of our earnings growth, cash flow, and our strong balance sheet gives us a number of capital deployment opportunities as we continue to drive increased shareholder value. We continue to have confidence in our ability to reach the financial targets in FY23, 2023, that we communicated in last year's Investor Day, And just as a reminder, what those are, to grow organically 150 basis points faster than the market, this would be over the cycle. Segment operating margins of 19%, EBITDA margins of 20%, free cash flow conversion greater than 100%, and EPS CAGR over this time period of 10% plus. In sum, we anticipate another record year for FY19, and we're making good progress towards our new five-year targets. And with that, I'll hand it back to Kathy for a more detailed review on the quarter.

Okay. Thanks, Tom. I'd like you to now refer to slide number six, and I'll begin by addressing earnings per share for the quarter. Adjusted earnings per share for the second quarter were $2.51, which is a 17% increase compared to $2.15 for the same quarter a year ago. The differences between the as-reported results and the adjusted results are as follows. Fiscal year 2019 second quarter operating income adjustments include business realignment expenses of $0.01 and Clarkor costs to achieve of $0.03. This compares to prior year adjustments of $0.07 for business realignment expenses and $0.07 for Clarkor costs to achieve. In fiscal year 2018, we also adjusted other expenses to exclude a net gain of 5 cents from the sale of assets and the write-down of an investment. Income tax expense in the current year, second quarter, has been adjusted by 11 cents for a tax expense related to U.S. tax reform. This updates the initial net one-time tax reform adjustment of $1.65 adjusted for in the second quarter of fiscal year 18. On slide number seven, you'll find the significant components of the walk from adjusted earnings per share of $2.15 for the second quarter of fiscal 2018 to $2.51 for the second quarter of this year. The most significant increase came from higher adjusted segment operating income of $0.41, attributable to earnings on meaningful organic growth, synergy savings from acquisitions, and increased margins as a result of WIN strategy initiatives. Lower average shares resulted in an increase of $0.07 and lower interest expense contributed $0.03. Adjusted earnings per share was reduced by $0.06 due to higher income tax expense in fiscal year 19, driven by higher earnings. And higher year-over-year corporate G&A expense, primarily as a result of losses in market-adjusted investments tied to deferred compensation resulted in a $0.09 per share reduction. Moving to slide 8, you'll find total Parker sales and segment operating margin for the second quarter. Total company organic sales in the second quarter increased year-over-year by 5.7%. There was a 0.5% negative impact to sales in the quarter from prior year divestiture, while currency negatively impacted the quarter by 2.2%. Total segment operating margin on an adjusted basis improved to 16.6% versus 14.9% for the same quarter last year. This 170 basis point improvement reflects the benefits of higher volume, productivity improvements, and the benefits of synergies from acquisitions, combined with the positive impacts from our wind strategy initiatives. Moving to slide number nine, I'll discuss the business segment, starting with Diversified Industrial North America. For the second quarter, North American organic sales increased by 5% as compared to the same quarter last year. A prior year divestiture accounted for a 0.4% loss of sales, while currency also negatively impacted the quarter by 0.3%. Operating margin for the second quarter on an adjusted basis with 16% of sales versus 15.1% in the prior year. This 90 basis point improvement for North America reflects the hard work dedicated to productivity improvements, as well as the benefits from additional volume, synergies from acquisitions, and the impact of our wind strategy initiatives. I'll continue with the Diversified Industrial International segment on slide number 10. Organic sales for the second quarter in the industrial international segment increased by 3.6%. Negative impact from a prior year divestiture accounted for 4.8% of sales, while currency negatively impacted the quarter by 5.3%. Operating margin for the second quarter on an adjusted basis was 15.7% of sales versus 14.2% in the prior year, reflecting increased volume, improved operating cost efficiencies from realignment initiatives, and the benefits of the wind strategy. I'll now move to slide number 11 to review the aerospace systems segment. Organic revenues increased an impressive 12.2% for the second quarter due to strength in the military and commercial OEM businesses, as well as the aftermarket businesses. Operating margin for the second quarter was 19.7% of sales versus 16.0% in the prior year, reflecting the benefits of higher volume and cost deficiencies, the impact of a favorable sales mix, the deferral of some development costs, and good progress on the wind strategy initiatives. Moving to slide 12, we show the details of order rates by segment. As a reminder, Parker orders represent a trailing average and are reported as a percentage increase of absolute dollars year-over-year, excluding acquisitions, divestitures, and currency. The diversified industrial segments report on a three-month rolling average, while the aerospace systems segment reports on a 12-month rolling average. Total orders increased by 1% as of the quarter end. This year-over-year growth is made up of flat-order growth from diversified industrial North America, a decline of 2% from diversified industrial international orders, and a 10% growth from aerospace systems orders. On slide 13, we report cash flow from operating activities. Year to date, cash flow from operating activities was $541 million. When adjusted for a $200 million discretionary pension contribution made during the first quarter, cash flow from operations was $741 million, or 10.7% of sales. This compares to 6.8% of sales for the same period last year. The significant capital allocations year-to-date have been $200 million for the payment of shareholder dividends, $550 million for share repurchases of common shares made up of $100 million through our 10b-5-1 plan, and $450 million of discretionary share repurchases completed in the second quarter, and $200 million for the previously mentioned discretionary pension contribution. The revised full-year earnings guidance for fiscal year 2019 is outlined on slide number 14. Guidance is being provided on both an as-reported and an adjusted basis. We have adjusted our sales outlook for the second half to reflect current order trends and current currency rates. Total sales increases for the year are now expected to be in the range of minus 0.4% to plus 2.0% as compared to the prior year. Anticipated organic growth for the full year is forecasted in the range of 2 to 4% or 3% at the midpoint. The prior year divestiture negatively impacts sales by 0.4%, and currency is expected to have a negative 1.9% impact on sales for the year. We've calculated the impact of currency to spot rates as of the quarter end of December 31, and we have held those rates steady as we estimate the resulting year-over-year impact for the remaining quarters of fiscal 2019. For total parker, as reported, segment operating margins are forecasted to be between 16.7% and 17.2%, while adjusted segment operating margins are forecasted to be between 17.0% and 17.4%. The full-year effective tax rate is projected to be 23%. This anticipates a tax expense run rate of 24% for the third and fourth quarters. For the full year, the guidance range on an as-reported earnings per share basis is now $11.04 to $11.54 or $11.29 at the midpoint. On an adjusted earnings per share basis, the guidance range is now $11.35 to $11.85 or $11.60 at the midpoint. This updated guidance on an adjusted basis excludes business realignment expenses of approximately $19 million or 11 cents per share for the full year fiscal 19 with the associated savings projected to be $10 million. The guidance on an adjusted basis also excludes $16 million or 9 cents per share of CLARCOR costs to achieve expenses. CLARCOR synergy savings are estimated to ramp to a run rate of $125 million by the end of fiscal 19, which represents an incremental $75 million of run rate savings as we exit fiscal 19. We remain on track to realize the forecasted $160 million run rate synergy savings and $100 million revenue synergies by fiscal year 20. And finally, guidance on an adjusted basis also excludes 11 cents per share for the second quarter tax expense related to U.S. tax reform. Savings from business realignment and CLARCOR costs to achieve are fully reflected in both the as reported and the adjusted operating margin guidance ranges. We ask that you continue to publish your estimates using adjusted guidance for purposes of representing a more consistent year-over-year comparison. Some additional key assumptions for full year 2019 guidance at the midpoint are sales are divided 48% first half, 52% second half. Adjusted segment operating income is divided 47% first half, 53% second half. Adjusted earnings per share, first half, second half, is divided 46%, 54%. Third quarter, Fiscal 2019 adjusted earnings per share is projected to be $2.99 per share at the midpoint, and this excludes $0.05 of projected business realignment expenses and $0.01 of projected Clarkor costs to achieve. On slide 15, you'll find a reconciliation of the major components of fiscal year 2019 adjusted earnings per share guidance of $11.60 at the midpoint compared to the prior guidance of $11.40 per share. Increases include $0.11 from stronger segment operating income, $0.03 from lower full-year tax expense, and $0.20 from reduced average shares. Offsetting these increases is an $0.11 per share decrease from higher corporate G&A than previously forecasted due to market-adjusted investments tied to deferred compensation and higher other expense attributed to mark-to-market accounting of equity investments in the second quarter as well as $0.03 from higher interest expense for the year. Please remember that the forecast excludes any acquisitions or divestitures that might close during the remainder of fiscal 2019. On slide 16, you'll find the components of our updated full-year increased guidance relative to the outperformance in the second quarter versus our initial guidance going into the quarter. Actual second-quarter earnings per share on an adjusted basis were 12 cents stronger than previously guided due to excellent operating performance, partially offset by higher corporate G&A and other expense attributable to the market investment losses previously mentioned. For the balance of the year, we expect net incremental per share benefits of 8 cents. Lower tax expense will provide 3 cents, and 16 cents will occur due to the lower average shares. Offsetting these favorable items will be the impact that moderating growth will have on operating income in the second half of $0.10 per share, as well as an expected net $0.01 unfavorable impact from below the line items of corporate G&A interest and other expense. All of this equates to a net increase to adjusted earnings per share for the full year of $0.20. This concludes my prepared comments. Tom, I'll turn the call back to you.

Thank you, Kathy. We're very pleased with our continued progress with the execution of one schedule. We're projecting another earnings record for fiscal 2019. And I just want to conclude by saying thank you to the global team for all the hard work, their dedication, and I thank our shareholders for their continued confidence in us. And with that, James, I'll hand it over to you to start the Q&A portion of the call.

Excellent. Thank you, sir. At this time, all lines are in listen-only mode, so if you'd like to queue up for a question, you can press star, then 1 on your touch-tone telephone. And as a reminder for those on the phone, when you are asking your question, if you wouldn't mind placing yourself on mute after you've stated your question to prevent any background noise during response. Once again, that is star, then 1 to ask a question. Our first question comes from Ann Dwegnan with J.P. Morgan. Your line is now open.

Hi, good morning.

Good morning, Anne.

I think maybe perhaps you could give us some color on the regions, you know, what you're seeing in the various regions and then the various end markets. You know, we used to do the 312 and the 1212 or the trends around the end markets and the regions. Perhaps we could start with that, Tom.

Okay, Anne, this is Tom. I'll start. I'm going to give you maybe an overall framework and then I'll hand it to Leif with more details. Let me start with the new guide, and I'm going to focus on organic guides. So we guide it now to 2 to 4 percent as far as a range, and I'm going to put the regions in aerospace into that range and give you where they sit. So on 2 to 4, Latin America would be above that range. Aerospace is above it. North America would be right at the midpoint. Asia Pacific would be at the low end of that range. And EMEA would be flat. So that's our view on organic growth for the full year. Probably what's more important and interesting for everybody on the call is what are we seeing for the second half, so our first six months of the calendar year 2019. So our organic guide, I'm going to kind of round here, is approximately a little bit less than 1% for the second half. And the way that splits out is North America a little bit north of 1%, international about a minus half, a percent, aerospace at two and a half. So now if I split out international, that minus half percent is around Latin America plus five, Asia Pacific flat, and EMEA about negative one and a half. Again, these are all second half numbers for us. So maybe a little bit of thoughts for me on what's behind the second half guide. Well, it starts first with the most recent order entry, and you all saw the numbers from the press release. North America at zero, international minus two, aerospace at plus 10, total company at one. So if I could step back for a second and take back to where we were two years ago, we were clearly in an accelerating growth environment. That very naturally moves into a moderating growth, as most business cycles do, from accelerating until moderating growth. And that's fully based on our last guide, what we had projected for the second half. However, if I was to give you an analogy going from moderating to really what we guide it to is slow growth, I'd have you visualize a metal spring, not spring the season, but a spring, a metal spring. And I think that spring is our organic growth. And it's still, I think, very capable of a moderate growth environment. I don't think the dynamics have changed. However, there's been some weights put on top of the spring. And these weights would be the macroeconomic and geopolitical issues. that we've all been talking about and reading about and listening to. And, you know, trade-related things, Brexit, monetary policy, the only gas price softening and the government shutdown. I'm very optimistic, we are very optimistic, that those weights, those macro issues will resolve themselves. Maybe not all of them, but several are going to resolve themselves. And that spring, our organic growth guide for the second half that is currently now in a slow-growth environment could spring back to a moderate growth environment. The big question is when. I don't think anybody really knows the answer to that. However, our guide assumes that those macro issues are not going to get resolved in enough time to really have much support or change to what our current second half guide is. So that's a backdrop, and I'm going to hand it over to Lee to give you more details on the markets.

Okay, and what I thought I would do, if you don't mind, is first just some color on aerospace. I mean, we were absolutely... Pleased with the performance in aerospace, strong organic growth. I just thought I'd give you some color by the segments in aerospace. So commercial OEM for us was up 11% in Q2, and we're guiding at the midpoint for 5% for the full year. Military OEM up 24% in Q2, and a guide to 14% for the full year. Commercial MRO up 8%, a guide to 4% for the full year. And military MRO was a strong 9% in Q2 and a 3% guide for the full year. So these full-year guides, obviously some of this stuff is very lumpy and then there's tougher comps, but that's our latest thinking right now. So we're guiding the 5.7% organic growth at the midpoint for aerospace. On the industrial side of the business, what we did is just kind of look at this We took all our markets in Q2, how we saw them, and this is pretty consistent with Tom's comments, how we're projecting them going forward. But we kind of put these markets in three buckets, you know, growing and still stable, growing but moderating from Q1, and then soft to negative that we saw in Q2 and really was a carryover from Q1. Just reading through some of these markets, that are still positive. Refrigeration is doing well. Telecom, life sciences, construction markets, heavy-duty truck in North America and Europe, fantastic build rate still. The one area that it's down significantly is in Asia, China specifically, and I'll comment on that later. Agriculture, lawn and turf, forestry, material handling, and then I just talked about aerospace. Moderating from Q1 and Q2 is was distribution, mostly North America, oil and gas, mostly land-based oil and gas, and then general industrial and mining. And then what we would consider soft, or you could say negative, and there's four of these that we would kind of put in the trade-related bucket. Mills and foundries, which impacts China significantly. Automotive. machine tools, tires, and rubber. And then there's four key markets that have been flat since Q1. Power gen, it hasn't gotten worse. It's stable, so I think we're bouncing along the bottom there. Semiconductor microelectronics, if you will, has gotten worse in Q2. Rail is stable, and marine is stable at a low level. I'll just comment quickly on the regions. I think in North America, we're still pretty bullish. Our distributor base is bullish. I'd say the only moderation we saw was really distribution that serves kind of the microelectronics markets and land-based oil and gas. That definitely took a step back. And I would say that clearly there was some rebalancing of inventory from some of our channel partners in North America in Q2. On EMEA, you know, you've got Turkey, Brexit, tariffs, and yellow jackets, and it put a lot of pressure on a lot of different areas. We're expecting slightly negative growth for the second half, although we did see some rebounding in offshore North Sea oil and gas, which was nice. And we, you know, continued headwinds in the machinery markets, mostly around Germany. And Asia, two great years, strong comps, as we talked about. I'd say overall, Asia, as Tom mentioned, we're forecasting to be flat in the second half. So, you know, by and large, we're very encouraged, as Tom mentioned. There are some pressure in some markets, but I don't get a sense – everywhere that, you know, there's going to be some precipitous pullback. I just think we're in a kind of a pause or a slow growth area right now. So I'm going to stop. We just gave you a lot and go from there.

You did indeed, and I don't want to hog the call, but could I just clarify without putting words in your mouth, would North America distribution have been the one kind of that inflected the most in the quarter? And I leave it there. Thank you.

They definitely pulled back North America. I would not say overall. I would say those areas, a little bit of rebalancing across the channel, and those areas are around land-based oil and gas pulled back. But that's just off the hip. I don't think so. I don't think the most would be a wrong way to characterize it.

Okay. I'll leave it there in the interest of time. I appreciate the color. Thanks.

Thanks, Dan.

Thank you. Our next question comes from Andy Casey with Wells Fargo Securities. Your line is now open.

Thanks. Good morning, everybody. Good morning, Andy. I'm wondering how to view the industrial international guidance for the second half. You're guiding the top line down a little bit. The margins are, you know, pretty resilient. And I'm just wondering, is the resilience more a function of the structural cost work that you've done for that, you know, that region? Is it mainly comps, or is it something else?

It is, Tom. I think what you're seeing is a combination of things. You pointed to one of them. The restructuring that we've done, and I would characterize this for really all the regions. Obviously, internationally, we did probably more over the last several years than we have in North America. But it's a combination of that prior period restructuring, so that fixed costs in a lot better position than we've been The new wind strategy changes and that focus on simplification and the costs, SG&A costs have come down. Our variable costs have gotten better. The productivity in the plants, we saw it continue to improve through the quarter. And, you know, we continue to feel that they'll improve in the second half, which is why our margins are so resilient with a little bit of softness there. And we've done a really nice job on supply chain. It starts just optimizing all the dynamics that are going on from a material inflation, freight, et cetera. So I think the team has done a great job of executing, but there's still a lot more opportunities there, which is why we've guided to pretty good margins in the second half, even with some softness in the top line.

Okay. Thanks, Tom. And then I think you said it, but if – investors seem to be worried about a downturn across several markets. And I'm just wondering what you would expect from Parker in terms of return performance if the markets actually did go into a downturn. Are we looking at not only raised, increased margin performance that you've already demonstrated with this record in the second quarter, but also... decreased return sensitivity to the changes in market demand swings?

Well, obviously, Andy, it depends on the severity of a market swing. But I would tell you we have this continuous view on being cost leaders. Everything we're doing around the wind strategy, the execution there, is on making us the most nimble, agile business that we possibly can be. And I think the best evidence of that is just plot our margins over the last four years and what's happened. You've seen significant margin improvement. And, of course, in the second half, we're guiding to a little less sales and margins equal to or better than what we originally said in the last guide. Now, typically over a cycle, we would expect sales would drop, you know, that same 30% decremental, I think, is still a good rule of thumb. But what we've demonstrated over the last several cycles, go back to 2002. I'm going to take a history lesson for those that haven't tracked a company in a long time. 2002, we had a 60% drop in earnings. 2008 to 2009, it was a 40% drop. The 2015 to 2016 industrial recession contraction was a 20% drop. And so we continue to get better. Our whole goal is to raise the floor, raise the ceiling of margin performance. While we're very proud of what we did in Q2 and very proud of, and we're guiding for the first time in the history of the company to do a 17% operating margin, we clearly, clearly have a lot more opportunity in the future. So I'm not worried at all about any kind of softness. We've been practicing for this every day, so we're ready for it. Thank you very much.

Thanks, Andy.

Thank you. Our next question comes from the line of Nathan Jones with Stiefel. Your line is now open.

Morning, everyone.

Good morning, Nathan.

Just like to dig a little bit further into the margin in North America. I think incrementals are in the mid to upper 30s in the second quarter in North America versus kind of that 10 to 20 that You'd got it too for the first half. So clearly better there. And I think this is probably around their productivity improvements post-closing the Clark and Parker facilities. Maybe Tom or Lee, you could talk a bit about the improvement in productivity there, if those businesses are now running at the levels that you expect them to run, if there's further improvement we're going to see in the third quarter. Just any color you can give us around that.

Yeah, Nathan, it's Tom. I would say first that you have a good ground-rooted improvement in productivity, even regardless of the plants that were involved in plant closures, because you've got all the other plants that are improving as well, wind strategy execution and all the things that I talked about earlier in some of my opening comments. You've got a good ground-based improvement in productivity, specifically around the plants and all the lines that we've moved. We saw steady progress in productivity, but we have more to do. We were pleased, as you pointed out, 37% MROS in North America for the quarter and beat what we had guided to and what we had communicated. But we expect that to continue to get better, and we're guiding to an even stronger second half. So our belief that we told you last quarter about the second half being stronger than what we feel the first half would be, that still holds true. We may have gotten a little better faster, But what we've seen is there's still lots of opportunities. We're not yet at the complete rates that we need to be. So I think that bodes well to what our second half is going to be. And really, I think signals, not talking about FY20 yet, but signals that we have momentum at FY20 as well.

Maybe then just on the order, the flat orders in North America in the quarter, Lee talked about some maybe channel rebalancing on the distribution side. Have you seen that abate into the third quarter here? Are you seeing any channel rebalancing or any OEM in the OEM channel rebalancing their inventory there? Maybe with your OEMs anticipating a little slower growth, they tend to maybe take some inventory off the shelves. or what your expectations are in both channels for inventory over, say, the next six months?

Yeah, Nathan, it's really hard for me to have a gauge through the OEM channel, but my feeling through the distribution channel is the rebalancing that took place is by and large done. I think there's real pull on demand that's taking place, and so I don't feel like there's more potential more pullback coming given current market conditions right now.

Okay, thanks very much. I'll pass it on.

Thanks, Nathan.

Thank you. Our next question comes from Julian Mitchell with Barclays. Your line is now open.

Hi, good morning. Maybe just following up in the industrial businesses on the cadence of the order changes that you saw in the last few months. Was it in general, when you look globally, a big step down very late in fiscal Q2? Or was it a steady deceleration since sort of early October? And related to that, perhaps, How should we think about the organic growth guide in the current quarter versus the fourth fiscal quarter? Is there any particular cadence on the industrial side that you would emphasize?

Julian, it's Tom. I'll start first with the order trends, and I'll maybe take region by region. So North America pretty well declined equally, equal parts through the quarter and really mirrored if you go back to the prior year, the increases we had, so kind of a mirror image there. I would say EMEA in Latin America was, I'd say really all the regions were pretty sequentially equal drops. EMEA in Latin America exited flat to prior, so remember our international orders were minus two. That composition was EMEA in Latin America exiting flat and Asia Pacific exiting slightly negative on that end. As far as You know, the first half, second half, and the third quarter in Q4 on organic, you know, we have a little bit better organic in Q3, and it's mainly because of comps with aerospace in Q4. We had a huge Q4 in aerospace with some big MRO activity that is unlikely to repeat, and so that's probably what's weighing it down. But I would say in general how I articulate and what we articulate as far as organic growth is not really too much different between Q3 and Q4.

Thank you. And then my second question would be around maybe switching to the balance sheet. You talked about the buyback step up, the $500 million or so in Q2. Does the demand slowdown at all affect your appetite to undertake acquisitions, and therefore buybacks are a more logical use of cash, or are you still equally interested in M&A as you look out over the rest of this year?

Julian, maybe start with it. I'd like to cover the capital deployment from a comprehensive standpoint. So first is dividends. We're going to keep that consecutive increase record, and we'd like to target 30% to 35% of net income on a rolling five-year average. And our dividends are going to grow because we're going to grow net income over this time period. CapEx is my opening comments about one of the things that makes us unique. We're pretty efficient on CapEx. We'll use CapEx to fund organic growth and strategic productivity. So now to the heart of your question is share repurchase versus strategic acquisitions. And we like both. We will do the best use of this for our shareholders for the long run. I think in general, acquisitions generate incremental cash, generate incremental EBITDA. That would be the preference, provided that they meet our stringent and our disciplined view of the acquisitions. Over the cycle is important as far as where we are, but what's more important is, is it a strategic fit? Will it hit our return criteria? We would model where we were organically into the DCF so we'd factor that in. So I would just say the M&A pipeline is active. We're going to continue to look at properties really along two big veins. We want to be the consolidated choice in our space if the property is a good fit. And then all things being equal, we're going to invest in engineering materials, aerospace, instrumentation, infiltration. Of course, you've seen the big investment we did in infiltration. But you saw in the last quarter, we bought shares. We didn't see a property that... that we could execute on that made sense, that clicked. Remember, the acquisition pipeline is not 100% first pass yield. It requires two people to get married. And we think we're a great value. And we know where the company's going. And we thought it was a great investment, great time to buy Parker. For that matter, it's never a bad time to buy Parker. So we'll continue to look at all those. I think in general, like you've heard me talk before, we want to have a balance sheet that is put to work. We have a great earnings profile, we have great cash flow, and we want to be great deployers. And we're going to deploy the best possible way, recognizing that the whole goal of this is to drive shareholder value over the long term. And every quarter might be a little different how we tweak that, but I think you'll see us continue to be active.

Great. Thank you. Thanks, Julian.

Thank you. Our next question comes from the line of Andrew Obin with Bank of America Merrill Lynch. Your line is now open.

Good morning. I guess it's still morning. How are you guys?

Good morning, Andrew.

Just a question, I guess, for Tom and Lee. I remember maybe, well, last year you guys were sort of stressing the fact that we're still in very early innings of the industrial cycle. And I look at your growth, and you guys have been spot on, I get it. But, you know, your peer Eaton just provided sort of 5%, 6% organic growth for hydraulics for 2019, 8%, 9% for aerospace. Rockville is guiding for 7% for 2019. So I'm just wondering, you know, what has happened to the cycle? And, you know, why are you so different from other short cycle industrials that are looking at 2019? And have you changed your view about the long run? Sorry for a long-winded question, but just the difference in guidance is so stark between you and everybody else. Thanks.

Andrew, it's Tom. I can't comment about everybody else. I can just comment about what we see. If I take aerospace, we continue to see aerospace very strong. We had robust orders. You saw the order entry there. We had a robust first half. Our second half, will still be very strong sequentially as the 7% grows sequentially. We have some pretty tough comparables in the second half, which makes it not look quite as strong, but I put up our aerospace numbers against anybody in that space. On the industrial side, we do tend to probably see things maybe a tad quicker than other people, but we're giving you what we see right now, and that's all we can do. The order entry In the prior quarter, given the fact that our backlog is four to six weeks typically in the industrial piece, is what you're going to yield out in the next quarter. I still believe, and as you've heard me talk about before, that I still think this is a great industrial environment. I do think, though, that some of the uncertainties weighed on order demand, and I do think they'll resolve it since our fiscal year ends June 30th. I'm not sure they're going to resolve it in time to influence our second half. Remember, we're guiding only for our second half or our full year, which ends June 30th, versus everybody else is guiding to a full year, calendar year 2019. So that's how I would describe it.

No, that's very fair. And just a follow-up question. I think our channel check work is picking up very, very strong pricing, even though we are seeing the slowdown you guys are talking about. Is there anything different about the industry pricing strategy in this cycle? I've been doing it for a while, and pricing seems to be as sticky as I've ever seen. Thanks a lot.

Andrew, it's Lee. As you know, we're constantly measuring our input costs using our PPI metric and seeing what's happening with inflation. There's certainly been a lot of inflation recently. in this cycle, some driven just by pure commodity pricing, some driven by extra things like tariffs, et cetera. So I think what you're seeing is just the ability to probably cover some of those input costs that are maybe a little different than past cycles.

Right, but what's driving this fundamental ability? That's a big deal.

You mean for it to stick? Andrew, I think I lost you there, but I would just finish by saying that, you know, we were in a very rapid growth environment. I think supply was paramount for everybody, and I think there's just strong brand recognition with Parker's brand throughout the channel. So I'm not sure I can answer that.

No, you guys are definitely doing a great job on the channel. I'll follow up offline. Thanks a lot. Okay, thanks.

Thanks, Andrew.

Thank you. Our next question comes from Jamie Cook with Credit Suisse. Your line is now open.

Hi. Hi, good morning. I guess first question on aerospace, the margins have been very strong, in particular over the past three quarters. I know you're guiding for margins to deteriorate in the back half, but can you talk about mix or whether, you know, there's upside to aerospace margins, you know, over the next couple years and what would be driving that, I guess is my first question. And then my second question is, Just based on sort of what the uncertainty in the macro environment are and some of the slowdown in the markets you talked about, are you considering potentially additional restructuring actions at all and how we should sort of think about that or what actions you're taking to prepare if there is a downturn? Thanks.

Jamie, this is Kathy. I'll start on the aerospace margin. We were very pleased with the margins that they achieved in the quarter. and we do see a lot of improvement that they've worked hard at gaining in their infrastructure and their cost control. If you notice, we did raise the guidance for their margins for the year a fair amount. In the second half, you'll see maybe not as high as you would have expected, and that's going to be driven by higher development costs in the second half than what we experienced in the first half. We're anticipating development costs for the year to finish somewhere between five and three quarters of their sales to six and a quarter. They did five and a half percent in the first half, and we're expecting closer to six and a half percent in the second half, just because of the timing of some of those development activities.

And then, Jamie, this is Tom. I'll take the market question yet. Again, I would just go back to we're constantly preparing for any softness by just having the best cost structure we possibly can. But we will make market adjustments. We've not seen anything yet that would warrant a change in our restructuring profile. We have a lot of levers you can pull that don't trigger that, like reduction of temporary workforce, overtime reduction, those type of things, recognizing that we have probably around 8% of our workforce total company that is temporary people. So there's a number of levers we can move that won't trigger ever-structuring change.

Okay, thank you. I'll get back in queue. Thanks, Jamie.

Thank you. Our next question comes from David Rasso with Evercore ISI. Your line is now open.

Hi, good morning. Obviously, it's an important time for the stock and the company here in the sense of trying to show the evolution. How does Parker handle a slowdown differently than in the past? And I mean, this quarter, obviously, you were able to show weaker orders, weaker organics, still able to raise the guide, you know, do a good job on the quarter. But just can you help frame a little bit thinking about, you know, we're really not that far away from six months from now, fiscal 20 guide. We can all make our top line assumptions. But can you help us with, if you look at the order patterns, what you're seeing right now, As you know, North America, if you look at the comparisons and you double stack them, right, the actual North American comp gets a little harder, and then it begins to ease. The international order comps start to ease from here. Can you help us level set? Again, I know you're not going to give us fiscal 20 guide right now, but should we be thinking the order rates in North America and international are both negative in the current calendar 1Q? And then I'd like to follow up with a question on kind of cost side items or below the line items as well to think about puts and takes 20 versus 19.

David, as Tom, as you might expect, I won't get into FY20, but I think orders are going to be reflective of matching that organic guide that I gave you for the second half, meaning that a little less than 1% total company, North America plus one international about minus a half, and aerospace, the two and a half. So I think orders will mimic that. Obviously, aerospace orders are longer cycle and lumpier, so they may not look exactly like that. But I think the industrial pieces will mirror that organic guide that I gave you. And as far as below the line, why don't you follow up with that question?

Sure, and just to be clear on your answer, so it doesn't sound like you see the North American orders, I'm not going to try to hold you to 100, 200 pips here, but it doesn't sound like you see North American orders going maybe negative at all, let alone any materiality. And then international orders, sounds like you also don't think those get any worse from here. Is that the fair characterization of your answer, just seeing what you're saying out there and knowing the comps?

Yeah, again, I would bracket with a little bit of a range. It's really hard to pinpoint this stuff. But, I mean, the numbers I gave you is our best estimate at this point, based on the current order entry. John Aucott All right.

Thank you. And then on the year-over-year benefits, I know you're not going to quantify them. Just if you can help us a little bit, you're obviously going to have the share count help. The full year benefit of the plant closures and some of the improved efficiencies, And I would suspect, and we can debate the cost structure on materials, but you would think the price-cost maybe even gets better as we look into, you know, the moment you have to give a guide on 20. Can you help us a little bit, maybe even prioritize for us, you know, is the biggest benefit the plant closure efficiencies, having that for a full year? Obviously, you know, repo versus M&A the next six months, we can debate it, but it sounds like you have a nice share count help. Just kind of frame the puts and takes for us on those. cost items and below-the-line items, and obviously any other help you have on tax or anything would be great, just things that you see as of today.

Okay, David, I'll start out here. We're forecasting from the realignment activities that we're doing this year that we'll see $10 million of savings in the year, and then that'll carry through. In terms of the integration and the synergy savings we're seeing with continuing to work on integrating Clarkor with We've increased the run rate to up to $125 million through the end of this year, and that's a $75 million incremental. And we still then think that by the end of fiscal 20, we'll be up to $160 million. So, yeah, we'll continue to see savings from those activities. In terms of price cost, we don't really talk about in that detail. Lee, you want to touch on that?

I would just say on price-cost, David, you know the way we track this, and our goal is just to be margin neutral as we go through these.

And in terms of tax expense, we are forecasting an effective rate of 23% this year. I would expect that to be our continuing long-term rate for the next year or two unless things change significantly.

But, David, is somebody hooked it up to a – To a higher point here, I think what you're getting at is we've got more room to go. We're going to end at 17. We're on a mission to get to 19. We're not stopping there. We're just going to stop for a minute and congratulate ourselves and keep moving. But we are very pleased with what we're seeing, and I won't get into FY20 because we haven't done that, but we're going to continue to grow earnings and grow margins. All right. I appreciate that. Thank you.

Thank you, David. I think we have time for one more question.

Excellent. Our final question will come from the line of Joel Tiss with BMO Capital Markets. Your line is now open.

All right. Thank you. Just two things. Good morning. I wonder, you know, again, just more of a characterization, but are the pieces largely in place for the 19% longer-term operating margins, or are there more Are there more levers that have to be pulled, or it just depends on what the volume profile looks like? And just help us get a sense of where you are there.

Well, it would be all the things – Joel, this is Tom – all the things that we've had in the wind strategy all along in that infamous walk we've got that shows you from where we were in FOI 18 at the IR day to the 19%. And if I would just tell you the major ingredients without going through the numbers – The clockwork synergies is a big part of it. Old simplification program, which we didn't talk about, is still early days. The whole 80-20 look at our revenue complexity is a big deal. We're down to 80 divisions now, 122 to 80 divisions, so 80-80. We continue to work that. But I would tell you that the revenue complexity side is a bigger deal. Productivity, we have a lot of things we're doing on Kaizen. We're combining Lean and Kaizen. and some strategic CapEx investments we're making around automation. Those will continue to yield. We've done a great job in supply chain, and we've been able to optimize supply chain in a much more efficient way than I think maybe historically, which we're pretty pleased with that, and we'll continue to leverage a fair amount of our spend that I think has not had as much visibility, the whole indirect costs side of things. And then we're going to continue to have margin enhancements around changing the mix on distribution the innovation pipeline, those type of things. So I think you all know us well enough. We wouldn't put out a number. Even if it was five years ago, we didn't think we had a roadmap to get there. So we believe in a roadmap. But I would just, again, emphasize that is not the final destination. And we got to 17% early. I'm not saying we'll get to 19% early, but our confidence is there.

And then just the last one in aerospace, is there any unusual mix that could put a little pressure on the margin progression over the next, say, 12 to 18 months?

Good question, Joel. We will see an increased volume of OEM activity of entry into service as some of the newer platforms are now ramping up. And that does start out at very low margins. So that will have some pressure on our aerospace margins. But we are confident. I mean, we're forecasting a midpoint margin for this year of 19%, 19.1. And the cost efficiencies that they've been working hard on, I think, will help balance against that mixed pressure that they're going to feel in the next few years.

OK. Thank you so much.

Okay. Thanks, Joel. All right. This concludes our Q&A session and our earnings call for today. Thank you, everyone, for joining us. Robin will be available to take your calls should you have further questions. Thanks, everybody. Have a great day.

Thank you. Ladies and gentlemen, that does conclude today's conference. Thank you for your participation. You may all disconnect.