Parker-Hannifin Corporation

Good day, ladies and gentlemen, and welcome to the Parker-Hannifin Fourth Quarter 2019 Earnings Conference Call. At this time, all phone participants are in a listen-only mode, so if anyone should require assistance during the call, please press star, then zero on your touch-tone telephone to reach an operator. Later, we will conduct a question-and-answer session, and instructions will follow at that time. As a reminder, today's conference may be recorded. I'd now like to introduce your host for today's conference, Ms. Kathy Siever. Executive Vice President, Finance and Administration, and Chief Financial Officer. Please go ahead. Thanks, Liz.

Good morning. Welcome to Parker Hannafin's fourth quarter 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 slides number two and three, 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 number four. We'll begin with our Chairman and Chief Executive Officer, Tom Williams, providing comments and highlights from the fourth quarter and full fiscal year 2019. Following Tom's comments, I'll provide a review of the company's fourth quarter and full fiscal year 2019 performance, together with guidance for fiscal year 2020. Tom will then provide a few summary comments, and we'll open the call for a question and answer session. Please refer now to slide number five, and Tom will get us started.

Thanks, Kathy, and good morning, everybody. Thanks for your participation. Looking at slide five, we had a strong fourth quarter and completed Parker's best year ever in our history. But before I jump into all the results, I wanted to just pause for a minute and reflect on the remarkable transformation of our company. Parker is a very different company now, delivering record performance and better able to perform through market cycles. We have a stronger portfolio of businesses following the three transformational acquisitions we've done the last three years. If you look at performance and go back the last five years, adjusted operating margin percent has improved 280 basis points, and adjusted EBITDA margin has improved over 300 basis points. We are a better performer over the cycle. We've always been good on cash flow, over the cycle, but now we're much better on EPS and margins over the cycle. In particular, if you note our margin performance during the 2015 and 2016 industrial recession and our margin performance just in the last quarter, Q4, on negative order growth, they all point to the improved performance that I was referring to. On the three acquisitions, they're going to lift the company up on two levels, portfolio and performance. On the portfolio side, we've wanted to add to filtration engineering materials and aerospace. These are parts that we've talked about, wanted to add to because of their resilience over the cycle. On the performance side, we're adding three great businesses that are accretive to growth and to margins. Our goal here through the wind strategy and our capital deployment strategy is to build a better business that generates higher growth, margins, and cash flow through the business cycle, and you're seeing evidence of that already. Ultimately, this is going to result in Parker being a best-in-class company So my thanks to all the Parker team members that are listening in for all their hard work last year, but really over the last several years to get us to this point. If you turn to slide six, part of what is transforming a company is our business model and the competitive differentiators that makes us special. I want to just talk through these bullets on this page briefly. The win strategy, it's our business system. It is the engine behind our results. Our decentralized divisional structure really drives an entrepreneurial spirit in the company. The eight motion and control technologies that we have really creates that breadth of our portfolio, and this strategically positions us to have a big advantage versus our competition. And recognizing the fact that I've talked about before, 60% of our revenue comes from customers that buy from four or more of those technologies, that's a good evidence that our customers value that breadth of technologies. Our strong intellectual property, 85% of our portfolio, and typically what we ship has some element of intellectual property tied to it. We have long product life cycles, decades long as they go, balanced OEM and aftermarket, and we have arguably the best distribution channel in the motion control space. We have low-cap X requirements. Our lean transformation has really driven a low-cap X to drive our business, and that enables us to have a very robust capital deployment process. And we're great generators and employers of cash, and you've seen us in action over the last five years in that regard. So if you turn to slide seven, some highlights from the fourth quarter, safety continues to be our top priority. Our recordable incidents for the quarter were down 24%. Our high-performance teams are helping to drive these results. Our goal is zero incidents. That's not an aspirational goal. It's really an expectation how we're going to run the company. And the ownership culture that's created from the high-performance team process that has started with safety is It's going to be applied also to quality, cost, and delivery, and that will naturally lift up the performance of the company. All-time quarterly records for the fourth quarter, total segment operating margin, total industrial segment operating margin, net income, and EPS. A couple of the notes on the quarter sales were a negative 3.5%. That was composed of a negative 2% on organic and a negative 1.5% on currency. Orders declined 3% against some tough comparables. And we had a fourth quarter record on industrial international segment margins as well. My thanks to the international team for a great job in the quarter. So now I want to turn to full year results for FY19. We had a number of all-time records. Of course, we only do records on a reported basis so that they are sales, total segment operating margins, net income, EPS, and operating cash flow. A couple other highlights for the full year. We came in on organic growth at 2.6% organic sales. outpacing global industrial production. We had excellent improvement in segment operating margin and EBITDA margins versus the prior year. Adjusted EBITDA margins, if you go back to when we acquired Clarkor, we were at 14.7%. We're now at 18.2%. From an EBITDA dollar standpoint, we were at $1.7 billion, and now we're at $2.6 billion. That growth in margins, that growth in EBITDA dollars, has really helped enable us to do both the lowered and exact acquisitions that we recently announced. We achieved 17% segment operating margins one year ahead of our original target, and the first time in our history, 17%, a number that we're extremely proud of, and obviously we're not stopping there, but it was a huge milestone for us to reach. Tremendous cash flow generation, resulting in $1.7 billion in operating cash. When you do it on a percent basis, we came in at 12.1% CFOA, and excluding the pension contribution, that would be 13.5%. Switching to cash and capital deployment. The goal, and you've heard me talk about this, is to be great generators and employers of cash. So on the cash generation side, we ended FY19 at 115% pre-cash flow conversion. That makes 18 consecutive years of pre-cash flow conversion greater than 100%. And on the employment side, it was a big year. Dividends, our stated target is to pay out 30%, 35% of net income. And as a result of our growth in net income, we increased annual dividends paid out by 13%. We had our 63rd consecutive year of annual increases to dividends paid out, a record we're very proud of as well, and one that we intend to keep. We announced two transformational acquisitions, and on the share purchase side, we did $200 million on our 10B51 program, and we purchased $600 million on a discretionary basis. Debt reduction is going to be a high priority going forward. Our target within three years is to get 2.0 multiple from a gross debt to EBITDA multiple, and we'll pause an M&A activity until we get there. Just a few comments on the acquisitions. They're really going to generate great value for our shareholders. We announced in the last 90 days the acquisition of Lord Corporation and Exotic Metals, transformational to our portfolio, adding to our engineer materials business, and the aerospace group with high growth and high margin businesses. When you look at the pro forma EBITDA margin, take Legacy Parker with Lorde and Exotic, and you forecast that out of five years, we're gonna improve EBITDA margins by more than 400 basis points over that five year period of time. That's really gonna help propel us to being that top quartile company that we desire, and both of these companies I'm referring to, Lorde and Exotic, are both great cultural fits, and we expect a seamless integration. Now turning to the outlook, we're issuing guidance for FY 2020, We've got moderating market conditions. We're forecasting sales at a negative three to flat, so minus 1.5% at the midpoint, and I'll talk more about that during the Q&A. I think the effectiveness of the wind strategy is really being observed when you look at our FY20 guide. Historically, on negative organic growth, we would be reducing margins. But with this guidance, we're expanding segment operating margins, and we're posting a record EPS. Adjusted EPS is at $11.50 to $12.30. or $11.90 at the midpoint. Business realignment of $20 million. And we did not include Lorde or Exotic in this FY20 guidance. We will, of course, update guidance after they close. So going forward, really, if you look at the FY19 results, the FY20 guide, coupled with the momentum that we have with the wind strategy and our recent acquisitions, we're well on our way to achieving our FY23 targets. And just to remind people, those targets by FY23 are sales growth of 150 basis points greater than global industrial production growth over the cycle, segment operating margins of 19%, EBITDA margins of 20%, free cash flow conversion greater than 100%, and EPS CAGR over that time period of 10% plus. The actions we're taking, the dedication of our global team members are really helping to generate strong returns for our shareholders. 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 eight. This slide presents as reported and adjusted earnings per share for the fourth quarter and full year fiscal 2019 compared to 2018. Adjusted earnings per share for the fourth quarter increased 3% compared to the prior year, reaching $3.31. Adjustments from 2019 as reported results total $0.14, including business realignment expenses of $0.04 and lowered acquisition and integration expenses of $0.10. This compares to fiscal 2018 adjustments of $0.60 for business realignment expenses, Clarkor cost to achieve, a net loss on sale and write-down of assets, and a U.S. tax reform adjustment. For the full year, adjusted earnings per share for fiscal 2019 was $11.85, an increase of 14% compared to fiscal 2018. Adjustments from the 2019 as reported results totaled 37 cents, This compares to fiscal 2018 adjustments of $2.59. The details of all of these adjustments are included in the reconciliation tables for non-GAAP financial measures. Moving to slide number nine, you'll find the significant components of the $0.09 walk from prior year fourth quarter adjusted earnings per share to $3.31 for the fourth quarter of this year. We gained $0.04 from lower corporate G&A interest expense and other expense. Lower income tax expense accounted for $0.06, and lower average share count contributed $0.11. Offsetting these gains, segment operating income decreased by $0.12 as a result of lower volume, with sales down 3.6% versus the prior year quarter. and also as a result of higher development costs incurred in our aerospace segment. Moving to slide 10, you'll find the significant components of the $1.43 walk from adjusted earnings per share of $10.42 for fiscal 2018 to $11.85 for this year. The largest improvement came from segment operating income, This accounted for an increase of 79 cents with total segment margins improving by 100 basis points year over year. 14 cents came from lower interest expense, lower income tax expense accounted for 19 cents, and reduced average shares contributed 31 cents. Slide 11 shows total Parker sales and segment operating margin for the fourth quarter and full year 2019. For the fourth quarter, organic sales decreased year-over-year by 1.9%, and currency had a negative impact of 1.7%. Despite a decline in sales, the fourth quarter total segment operating margin on an adjusted basis improved to 17.6% versus 17.5% last year. This improvement reflects productivity improvements, and the benefits of synergies from acquisitions, combined with the positive impacts from our wind strategy initiatives. For the full year, organic sales increased by 2.6%, and total segment operating margins increased 100 basis points to 17.2%. Moving to slide 12, I'll discuss the business segments, starting with diversified industrial North America. For the fourth quarter, North America organic sales were down 3.2%. Even with lower sales, operating margin improved nicely for the fourth quarter to 18.4% on an adjusted basis. North America continued to deliver improved margins, which reflects the hard work dedicated to productivity improvements, as well as synergies from acquisitions and the impact of our wind strategy initiatives. For the full year, North America organic sales increased 1.8%, and adjusted margins increased 30 basis points to 16.9%. I'll continue with the diversified industrial international segment on slide 13. Organic sales for the fourth quarter in the industrial international segment decreased by 4.1%. Currency also negatively impacted the quarter by 4.5%. Despite the lower sales, operating margin for the fourth quarter 2019 on an adjusted basis improved 30 basis points to 16.4% of sales. This margin performance reflects our team's improved operating cost efficiencies from realignment initiatives and the benefits of the wind strategy. For the full year, organic sales for Industrial International increased 1.1%, and adjusted operating margins increased by 110 basis points to finish the year at 16.4%. I'll now move to slide 14 to review the aerospace systems segment. Organic sales increased 6.5% during the fourth quarter, primarily due to commercial and military OE growth, along with growth in commercial aftermarket. Operating margin for the fourth quarter decreased by 200 basis points due to higher development costs in the quarter and a lower mix of military aftermarket sales as compared to the prior year. For the full year, our aerospace systems segment delivered great organic sales growth of 8.5% and an impressive 210 basis point improvement in adjusted segment margin, finishing the year at 19.4%. On slide 15, you'll find the differences in fiscal year 2019 earnings per share between our full year guidance going into the quarter compared to the actual results from the outperformance in the fourth quarter. Final full year earnings per share on an adjusted basis was 25 cents higher than previously guided. At the operations level, segment operating income finished one cent higher than expected driven by productivity improvements despite the lower than expected sales. Lower corporate G&A interest and other expense resulted in an additional $0.06. We benefited $0.16 from lower income tax expense due to discrete tax adjustments and additional benefits resulting from new regulations related to U.S. tax reform recognized in the quarter. And lastly, we benefited $0.02 from lower average shares. On slide 16, we report cash flow from operating activities. We had strong cash flow this whole year. Full year 2019 cash flow from operating activities was a record $1.73 billion. When adjusted for a $200 million discretionary pension contribution made during the first quarter, cash flow from operations was 13.5% of sales. This compares to 11.2% of sales for the same period last year. On slide 17, we show a history of Parker's free cash flow conversion rate. For the 18th consecutive year, Parker generated free cash flow conversion of greater than 100%, finishing fiscal year 2019 at 115%. Parker is great at cash generation, even during growth periods. We're very proud of our team for their good management of working capital. Moving to slide 18, we show the details of order rates by segment. Total orders decreased by 3% as of the quarter ending June. This year-over-year decline is a consolidation of minus 4% within Diversified Industrial North America, minus 8% within Diversified Industrial International, and a positive 10% within Aerospace Systems orders. The full year earnings guidance for fiscal year 2020 is outlined on slide 19. Guidance is being provided on both an as-reported and an adjusted basis. Total sales for the year are now expected to decrease 1.5% compared to the prior year within a range of minus 3% to 0%. Anticipated organic growth for the full year is forecasted in approximately the same range at a midpoint of minus 1.5%. There's no prior year acquisition or divestiture impact, and the currency impact is expected to be minimal. We've calculated the impact of currency to spot rates as of the quarter ended June 30, 2019. We've held those rates steady as we estimate the resulting year-over-year impact for fiscal year 2020. You can see the forecasted as reported and adjusted operating margins by segments. At the midpoint, total Parker adjusted margins are forecasted to increase approximately 20 basis points from prior year. For guidance, we are estimating an adjusted range of 17.2% to 17.6% for the full fiscal year. The full year effective tax rate is projected to be 23%. For the full year, the guidance range on an as-reported earnings per share basis is $11.38 to $12.18 or $11.78 at the midpoint. On an adjusted earnings per share basis, the guidance range is $11.50 to $12.30 or $11.90 at the midpoint. The adjustments to the as-reported forecast made in this guidance include business realignment expenses of approximately $20 million or 12 cents per share for the full year fiscal 2020, with the associated savings projected to be $10 million. Some additional key assumptions for full year 2020 guidance at the midpoint are sales are divided 47% first half, 53% second half, Adjusted segment operating income is divided 46 percent first half, 54 percent second half. Adjusted earnings per share first half, second half is divided 45 percent, 55 percent. First quarter fiscal 2020 adjusted earnings per share is projected to be $2.66 per share at the midpoint, and this excludes 4 cents of projected business realignment expenses. On slide 20, you'll find a reconciliation of the major components of fiscal year 2020 adjusted earnings per share guidance of $11.90 per share at the midpoint compared to the prior year of $11.85 per share. Increases include 7 cents from corporate G&A, 55 cents from other expense, and 13 cents from lower average shares. Other expense includes 35 cents of interest income from the proceeds of the bonds that we issued in June 2019, which are being held for the Lord transaction. The remainder in other is primarily related to numerous unusual charges incurred in fiscal 2019 that are not expected to repeat in 2020. Offsetting these increases is a four cent per share decrease from segment operating income. The operating income impact from the drop in sales volume will be partially offset by margin improvement throughout the year. The remaining decreases are 30 cents from higher income tax expense and 36 cents per share from higher interest expense. The decrease due to higher income tax expense is from discrete tax items in 2019 that we do not forecast in fiscal 2020. The change in interest expense includes an additional 47 cents in interest cost from the bonds issued in June, partially offset by anticipated lower commercial paper outstanding as compared to fiscal year 2019. This forecast does not include any results from our announced acquisitions of Lord Corporation or Exotic Metals Forming Company. We ask that you continue to publish your estimates using adjusted guidance for purposes of representing a more consistent year-over-year comparison and that you do not include the pending acquisitions until we are able to close the transaction. This concludes my prepared comments. Please turn to slide number 21. I'll turn it over to Tom to provide summary comments.

Thanks, Kathy. So just a couple quick comments. We're very pleased with our continued progress. We're projecting a record year of earnings in FY20, and we're well on our way to delivering being a top quartile company and being that best-in-class company that we are aspiring to be. My thanks to the global team, all their hard work, their dedication, the results from FY19, and we're looking forward to our bright future together. And with that, Liz, we're happy to start the Q&A portion of the call.

Ladies and gentlemen, if you'd like to ask a question at this time, please press the star, then the number one key on your touchtone telephone. If your question has been answered or you wish to remove yourself from the queue, you may do so by pressing the pound key. Our first question comes from the line of Jamie Cook with Credit Suisse. Your line is now open.

Hi, good morning. Nice quarter. I guess just first question, Tom, if you could just provide some context around how you're thinking about the organic growth guide for 2020 and what's implied for sort of first half versus second half and then, you know, what you're seeing in terms of, you know, you mentioned channel inventory before, how long that continues to weigh on results versus clear the channel. Sure. So I guess start there, and then, yeah, I guess why don't we start there. That's fine.

Okay, Jamie. It's Tom. Happy to do that because that's obviously probably top of mind for everybody. So let me take you through our assumptions. And obviously this process that we do is we're one of the first companies to start talking about calendar 20. We take a lot of input from customers, distributors, our divisions, of course, and our own economic models. So the organic growth that we talked about at the midpoint at minus one and a half, That turns into a first half at minus 4, which really mirrors our current order entry, and a second half of plus 1. So on the second half, we have slightly better volume, a little bit easier comps. If you look at that minus 1.5 organically on a regional basis, it's North America at minus 1.5, international at minus 4.5, and aerospace at a plus 4.5. I'm kind of rounding to halves here as I go through it. You know, while it's not a predictor of our future, there's another important data point that we've looked at, and that's our pressure curve history. If you look at the last 10 years, any time the 312 curve has gone less than one, it tends to go down to less than one for a 12- to 18-month duration, depending on where that particular business cycle is. Our current pressure curves have been less than one for about seven months. So this guidance assumes that the 312 curve crosses one approximately 15 months from when it started. So not too different from what we had seen in other cycles. Of course, and that's our best estimate at this time. Let me take you through the markets that we see for FY20, and I'll give you a little color as to what we think's driving the second half. I'm gonna make just a clarifying comment like I usually do. I'm gonna list markets in positive, neutral, and negative. This is our forecast for the market. Don't take my comments as I'm speaking about the entire market. This is just how Parker's gonna perform in the market. So on the positive side is aerospace, forestry, and life sciences. On neutral, which is a pretty big section, agriculture, construction, distribution, long-term, material handling, oil and gas, power gen, refrigeration, semi-con, telecom, and ground, military and defense. On the negative side is automotive, engines, heavy-duty truck, machine tools, marine, mills and foundries, mining, rail, and tires and rubber. So what's driving the markets in our view in the second half, besides some help on easier comparables, will be the one part, which is what you were alluding to earlier, Jamie, on distribution. The destocking that we were seeing early in Q3 and Q4 will continue for the first half, but at a diminishing rate. And then we'll be pretty much at equilibrium in our view on the distribution channel come into this calendar year, and that turns to a slight positive for the second half. Life sciences will be positive for us in the second half, as well as power gen turning from negative to positive in the second half. So that's one category, things that we see moving to positive in the second half. There's another big category of markets that are currently negative that we see as going to neutral in the second half. So they don't necessarily provide us tailwind, but they become less of a headwind, obviously. The negative, the neutral ones, first half to second half, I'm just going to list these out, are construction, oil and gas, semi-con, automotive, machine tools, mining, rail, mills and boundaries again, and tires. So I'm pretty optimistic. When you look at the 312 curves, you know, they are less than one, but they're flattening. So that's a positive indicator. When you look at our four phases of the business cycle, we have about two-thirds of our markets that are in phase three. phase three being the accelerating decline phase of a four-phase business cycle. And what that signals to us is that we're moving our way through this soft patch because the next phase after accelerating decline is decelerating decline, which means you're starting to move out of that, and then the next phase after that is growth. So in our view, there's lots of self-help here. The markets are going to turn, and they're going to start to help us, albeit a little bit later, and FY20, but we'll start to provide some small tailwind. The wind strategy is producing margin expansion for us in a negative organic sales environment. We've got the two transformational acquisitions in Lord and Exotic that bring in higher growth and margins. And just about the time that we close these deals and really get the integration really up and running is also going to be about the time these markets start to come back and start to give us some some slight tailwinds, so I think that all is going to align very nicely. So I feel good about 20, and I think, you know, it all comes back to the message I started the call with, that we're positioned well for the cycle, and we're going to continue to try to be that best-in-class company. So I don't know if you have a follow-up, Jamie, or not.

No, I mean, I think, I guess just if I can have a follow-up, you know, the implied margin statement, You know, resilience that we're going to see in the North American markets in 2020, even with the sales decline, just any color in particular on that, and then I'll get back to you.

Yeah, so we have North America going up about 20 basis points versus 19. It's really going to be the continue to win strategy efforts, the productivity that we've got, the Kaizen activity that we have is all creating the capacity for us to be more resilient on the margin side. and North America's volume being down not as bad as international, they're able to hold up the margins and, in fact, expand margins because of that.

Okay, thanks. I'll hop back in queue.

Thanks, Jamie. Our next question comes from the line of Meg Nobra with Baird. Your line is now open. Thank you.

Good morning, everyone. So, Tom, I want to go back to your comments early on when you talked about the transformation of the business. This is something that we spend some time speaking to investors about. And one of the questions that I think we often get that maybe you can help us with is when you're looking at your business mix and you look at what traditionally have been perceived as your key customers and key drivers, heavy machinery OEM builds. How is your business looking today, especially when you count in Lorde and you're counting in Clarkor as well as Exotic, versus, say, the way it looked in fiscal 15 in the last cycle or even the cycle prior to that? Because there's a business mix aspect here that I think is perhaps underappreciated even by me.

Yeah, no, I think you're right. I mean, that was... As you know, Meg, and everybody else that's been listening on the call, almost all of my investor presentations when I've talked about capital deployment, I start talking about we want to be the consolidator of choice within the space because we like the space and we're number one, so we want to continue to add that. But all things being equal, we'd like to invest a little heavier in filtration, aerospace, engineering materials, and instrumentation. You've seen us do three out of the four so far. And we are on purpose trying to balance out that density that you referred to that we traditionally had maybe in the fluid power side of the company on our fluid connectors and our motion technologies and add filtration, which is now one of our largest groups, and with lowered engineered materials will be one of our larger groups, and add to aerospace, which balances out the short cycle nature of the company with a high margin business that's got a great growth trajectory. So clearly that portfolio has changed. We've added $3 billion of revenue in roughly three years that goes into those targeted parts of the portfolio that will make us clearly more resilient. You can't ever not have any reaction to the business cycle. Everybody feels it. But can you dent the lows versus what you had in the past? And I think you see evidence of that. You know, we held margins almost virtually flat during the industrial recession of 15 to 16 in the margin performance in Q4. Those are pretty phenomenal results. And that was even before, of course, Q4 had Clarkor in it, but it's before adding Lord and Exotic. So the mix is going to continue to help us, and the wind strategy is going to continue to help us, too, because we're not stopping at 17% operating margin.

I see. Okay. Okay. And then if I may ask a question on industrial international, you know, obviously your full year guidance implies organic growth decline. I'm presuming you're sort of thinking that orders kind of keep in line with your organic guidance. Two years in a row now of contraction in international, so from your perspective, what sort of environment are you really baking into your outlook? I am, to some degree, surprised that you're not announcing some kind of restructuring of sorts, addressing basically the second year of volume decline here. Maybe you can comment on that and how your cost structure has changed in international with everything that you've done. Thank you.

Tim Stenzelman Yeah, so on the restructuring side, we have been restructuring international since FY14, and we've been on a very aggressive restructuring. getting international margins almost to the levels of North America. If you look at last year, 16.4 versus the 16.9. And a lot of you that followed us for a long time never thought we could ever do that. So international has been moving because of the restructuring that we've been doing and we've been creating a much more agile organization and the mix of improving distribution versus OEM. So that's That's been helping international. So we don't feel the same need, at least at these levels, sales decline, to trigger some new level of restructuring. We've got the organization to where it needs to be. Obviously, we'll do the normal variable cost reductions and temps and overtime and voluntary lack of work, so those type of things. But we think we've really done a great job internationally, and hence that's why you see the margins on what we've had. I'm not sure I hit everything you wanted to cover, Mike.

No, you kind of did. I guess I'm wondering, it's in some ways a little bit unusual to see two years in a row of, say, orders or volume decline here. That's actually worse than what happened in 2015, right? So, you know, trying to understand kind of that dynamic and also trying to understand if your cost structure here has become more variable than it's been in the past. That's kind of where I was going.

Yeah, so, Meg, I agree. That was a part of your question I missed. Yeah, international did grow at least minus 1% last year, but it was the first to start to go down, and so it felt a little bit sooner. So international didn't decline organically last year. Of course, it had a lot of currency, minus 5.5% currency, but we do – I think we've been realistic with international. We've got international down about 8.5% the first half and then started to work its way – by the final time we exit Q4 – you know, to almost a neutral type of position in Q4. So it was first to go in, and, you know, I think it will be fine. And I think the guide is pretty realistic on what we have for international.

All right. Thank you.

Thanks, Meg. Our next question comes from Joe Ritchie with Goldman Sachs. Your line is now open.

Thanks. Good morning.

Good morning, Joe. Good morning.

So I guess my first question is just going back to the inventory comments from earlier. I guess if you think about the next couple quarters, it sounds like you're expecting VSTOX to continue. I guess in that context, have you heard or have you experienced any distributor, like, you know, price adjustments? How are those conversations with your distributors occurring on the pricing side, just given the backdrops?

So I'll start with the inventory. I'll let Lee chime in on the pricing side of things. You know, so with at least North America, we do have good visibility into that sales out and sales in that I referred to in the last call. And so we look at North America, we see about a flat growth organically with about 200 basis points of destocking. So North America came in at about a minus two on distribution growth. That was about minus 300 bps of destocking in Q3. So we saw a little bit of improvement, about 100 base points of improvement. And that really was our thinking as we go into the first half of 20. So we'll have about another 100 bps every quarter, hence six months to get through the destocking. And that's obviously through conversations that we have with our distributors. And then we're plotting, like I referred to last quarter, we're plotting that sales out and sales in so we can get a little better visibility of that trend. I'll let Lee comment on the pricing side.

Just commenting on distribution, speaking about North America, as Tom said, it was mixed during the quarter. It really depends on the region, and destocking continued. I'd say on the pricing side, if you're asking if there's still pricing power in the channel, I'm not quite sure exactly what you're asking. We're still in a slightly inflationary environment. I would say that there's still pricing taking place. And what's still promising, too, there's still a lot of CapEx activity still taking place at this point in time, which is a good indicator that – and I'm speaking mostly of North America – that there's still a lot of positive momentum going on.

Yeah, Lee, my comment was more around, like, whether your distributors were pushing back on price at all in this backdrop and – and really kind of try and understand whether that has any implications on the leverage in your North American business.

No, there's really none of that taking place right now.

Okay, got it. And then maybe just my follow-on, in just thinking about, you know, the trajectory of the Aero business, the Aero obviously continues to do well from an order perspective. You take a look at the growth expectations for 2020, and they seem a little light just based on the the trends that we've been seeing, and so maybe some commentary around that as we head into 2020.

Okay, Joe. It's Tom. So on orders, remember, orders are a long cycle. They're 12 months, and they tend to be lumpy, and you don't always translate the due dates directly out into the next fiscal year. But we were plus 10, like you've seen. That composition was minus 5 on commercial OE, plus 42% on military OE, plus 13 on commercial MRO and plus 24 on military MRO. So some of the things that really drove some of the big spikes were F-35 on the military OE. On the commercial side, it was 737 and 787, and really kind of a mixture of A220, a pretty nice broad-base mixture on the MRO side. On the military MRO, a lot of the fighters, F-18, F-119, F-101 is a bomber, but, you know, some pretty good progress on orders there. For sales, our forecast is about 4.5%. That composition is commercial OE at plus 3, military OE at plus 2, commercial MRO at plus 4, and military MRO at plus 10. And, you know, that's our best view at this moment. Okay. I appreciate it, Collin.

Thanks, Joe. Our next question comes from David Raza with Evercore ISI. Your line is now open.

Hi, good morning. My question focuses on the sensitivity of your margin guidance to volumes. What's striking me is in the first half of the year, you have total company sales down 4% to 5%, but implied margins up 10 bps. The second half of the year, you have revenues up, and the margins are up 30 bps, not terribly differently. It doesn't seem like there's much volume sensitivity there. to the margin improvement. Now, I do appreciate the year-ago comp, mix, you know, currency could mess with the analysis a bit. But I'm just trying to understand, is that accurate, that where you see your margin improvement coming from really isn't that volume sensitive?

Well, if I take total Parker, I'm just doing total MROS. We're in that minus 15 to minus 20 range for the first half. And if I look at the second half, it's like plus over 70% now. Again, it's the loss of all numbers. You've got a relatively modest sales increase. So you are seeing some pretty nice lift in that second half as far as MROSs go.

Well, I'm not just saying the opposite, Tom. I'm saying you would think the second half of the year has got to really carry the load on the margin improvement because your distributors aren't destocking you the same way. You have volume overhead absorption that's improving because you have revenues up, not down. But that's what strikes me as interesting, that you're almost saying I can grow margins, not saying regardless of volumes, but it's, I don't want to use the word impressive, but yeah, if you can do it, it's impressive that you can have down volumes, up margins, and up volumes, up margins. I mean, it's just interesting to see, because obviously, you know, if you really can do it without that much volume sensitivity, it makes the credibility of the guide improve. So I'm just trying to understand, am I reading it right? I mean, I know I'm doing the math right, but I'm just trying to figure out Are there clear things on the margin improvement this year that you would say, yeah, it's really not tied to volume at all? You know, have confidence that we can grow margin even when volumes are down, because that's what you're implying in the first half.

Yeah, no, you're absolutely reading it right. And that's part of the transformation that I spoke to at the beginning of the call, that the combination of all the things we've been doing on lean, the Kaizen activity really started heavy for us in the fall of last year. the wind strategy, simplification, all those type of things, the inefficiencies that we've worked through, the cloud core synergies that are really kicking in, all those things, and, of course, the portfolio shift as far as things we're adding to the portfolio, are enabling us to be better on margins when we have softness on sales. So, yes, we feel good about that.

Yeah, I wasn't sure. Maybe part of the reason is the price cost is, particularly helpful the next couple quarters because you still have some lag benefit from prior price increases, but now you get the benefit from the lower cost, and that kind of goes more neutral in the second half. It doesn't seem like in the channel you put much of a price increase, if any, through July 1, so I'm not sure how much benefit maybe in your fiscal second half you'll have on price, but the carryover from the prior price increases should still be there the next six months, and then maybe you benefit from some lower costs. So I'm not I'm not blessing it here, but it's impressive if you can do that where you're not that volume sensitive. I'm just trying to get a handle on it. It seems like you believe it, just were there a couple buckets to make us feel good about that's not volume sensitive. We know what the price cost is, or we know we have some inefficiencies that were still lingering at Clarkor that aren't there in the fiscal first half of 2020. That's all I was driving at.

Yeah, no, I think you're right. You hit on all the buckets. The inefficiencies that we had at Clarkor were clearly more pronounced in the first half. of 19, and so that helps us as we look at 20. Some of the carryover on pricing is a little bit better in the first half. In general, if I was to do the total pricing for the year, it would be margin neutral, but we do get a little bit of help more in the first half, so I think you're right.

All right. No, I appreciate the call. Thank you.

Thanks, David. Our next question comes from Nicole DeBlaise with Deutsche Bank. Your line is now open.

Yeah, thanks. Good morning. Good morning, Nicole. So I just want to start with the first quarter. So the color between the first half and the second half was really helpful. But if you guys could give us a sense of what's baked in from an organic and a margin perspective in that 266 midpoint guidance for 1Q, that would be helpful.

Sure, Nicole. I'll help you here. We're anticipating organic decline of about 3.5% for the first quarter. with just a minimal impact from currency, say half a point of half a percent currency. But as you look at the margins, we're expecting year over year for North America to see improving margins year over year. Again, that relates to some of the inefficiencies we saw at the first half of last year that are improving. International with the decline will have lower margins than last year, but a nice decremental though there. And aerospace will see improving margins.

Okay, got it. That's helpful. Thank you. And then secondly on aerospace margins, it looks to me like you've embedded about 50% incrementals in 2020 guidance. Just curious, you know, how much R&D maybe contributes to that? the factor is driving the pretty substantial year-on-year increase in margins to above 20%.

Yeah, a lot of that or a good portion of that has to do with the development costs and what we incurred in fiscal 19 compared to what we anticipate in fiscal 20, and especially what we incurred in the fourth quarter. So in the fourth quarter of this year, our development costs were 7.5% of sales. That was pretty high. Our overall average for the year was 5.6%. In fiscal year 20, we expect development costs to be less than that, and we're forecasting in the range of 4.5% to 5%. So lower development costs are driving some of that incremental, along with other continuous improvements the teams are making to implement productivity and wind strategy initiatives and just improving the processes in the shops and getting more productive.

Okay, got it. Thanks. I'll pass it on. Thanks, Nicole.

Our next question comes from Andrew Obin with Bank of America. Your line is now open.

Yes. Good morning.

Good morning, Andrew.

Can we just touch, just going back to the strategy question, can we talk about about internal capital deployment, and it's really a two-part question. A, how do you think deploying capital in terms of sort of capital and labor and specifically on capital, if you could talk about stuff sort of implementing robotics, 3D manufacturing, how much money are you spending, how much impact is it making? And the second question is given the all the trade tensions, how are you guys thinking about deploying capital by geography, North America, the rest of the world, and what are you seeing in your supply chain? I know it's sort of an expansive question, so that would be the only one from me.

Andrew, it's Tom. So let me start with the CapEx side. So I think a good round number to think about is on CapEx, and this would be for the fund organic growth as well as productivity is around 2%. And we are very active on robotics and additive. I would just tell you that our strategy on automation robotics is to do Kaizen first. We believe that let's not automate waste, that we're going to do Kaizen, we're going to streamline the processes and optimize what we have, and then we'll automate the remaining processes. And so there's a little bit of a learning curve on learning all the automation. We've got a lot of great partners that we're working with, and we've had a number of summit sessions with all of our manufacturing engineers, and I would say the organization is really jazzed up about it. And I think this is a good strategy. We're putting Kaizen first, then automation. And that's part of why I think you've seen the margins do as well as they have is the Kaizen activities are just starting to gain traction. So more robotics coming forward, but we will invest in that. That will be in that 2%. And because of our lean transformation, we don't need as much dollars. We can divert some of that, what we've traditionally done, into more CapEx choice robotics. On the additive side, that's a big deal to us. We've got three centers of excellence. We've decided strategically that we're not going to have, this is not the kind of process you're going to have 80 of them, like one for every division. So we have two centers of excellence for aerospace, and we've got one for the entire company. And that one for the entire company really acts as an incubator for all the industrial divisions as well as also for aerospace. And we're working on proprietary material powder blending and processes. So there's a lot of good work there. We're very close to having our first production parts, both industrially and aerospace, to make it into the field utilizing additive. I'll tell you the other thing on additive is is designing for additives. So we have a program working on designing for an additive world because it's very important to design the next generation of products thinking about an additive manufacturing process versus designing it in the subtraction world. Now, you're asking about supply chain. We've always been our view on supply chain is that we like to make, buy, and sell in the region, for the region. So maybe you're asking about China. Do we feel still good about China? And we really do. I mean, we've not over- position ourselves in China where we think we're overextended. We still have low-cost centers there that we're very happy with. China is still a huge country for us, and we need to be there to service that. So I don't think you're going to see us doing much big capex shifts like building a bunch of plants in Indonesia. We have the footprint we need, and there will be maybe just a minor tweaking of lines, but it will be immaterial.

And I'll just sneak in one more follow-up on collaborative robotics. I know that you had a big rollout program. I believe you did. Where are you in that terms, you know, sort of Kaizen versus actual physical rolling out of capacity?

Heavy, heavy on the Kaizen activity. Early days still in the collaborative robots. We have several, lots of them in all of our factories working. But we particularly strategically emphasize Kaizen's first. You talk to most sense eyes that are experts in this kind of transformation. They will encourage you to do the same thing. And it's a lot faster dollars to the bottom line and a lot more CapEx friendly. And the collaborative robotics is really CapEx friendly as well. It's going to be a light touch on CapEx. I don't see that as an issue. But the thrust has been let's do the Kaizen. Let's get the processes right first.

Really appreciate it. Thank you very much.

Thanks, Andrew. Our next question comes from the line-up. Ann Deignan with J.P. Morgan. Your line is now open.

Yeah, hi. Most of my specific questions have been answered, but Tom, maybe I'll throw this one at you. If you look at where your end markets are today versus where we were when we went into the industrial recession in 15 and 16, It strikes me that as we look at the number of end markets that are down or negative right now, it's much more broad-based. Do you worry at all that heading into calendar year 2020, we're facing a much broader decline when you include automotive, heavy-duty truck, you take the impact of the Boeing 737 MAX, if that production schedule declines? It looks to me like we've got a pretty broad base set of end markets declining.

Okay, and it's Tom. I'll make a comment. Let me touch on the max real quickly for a second. So the max for us, in our guidance, we put in 42 a month. And because it's first fit in most of our content there, it's very low margin. It's immaterial to us. Pretty much that that schedule is to change, but I just want you to know we put it in at 42. So I think we're in good shape on that. But I think your characterization is pretty accurate. This is a more broad-based but not as deep type of softness. You know, the 15 and 16 industrial recession was a sharp contraction in natural resources. So you had all the natural resource-related markets, as we all remember, went down significantly. And so that was, you know, more isolated. This is a little more broader-based. My comment earlier on that we have two-thirds of our markets in accelerating decline is an indicator that we have some pockets that are usually down, things like semiconductor and power gen. But we're hopeful on power gen that that's starting to find a bottom, and that we're also hopeful actually on semiconductor that's starting to find a bottom as well.

And, yes, I just wanted to follow up on the Boeing 737. Let me see. Isn't there a risk that, again, that becomes more broad-based? It's not just about what you supply onto the airplane, but, you know, there are a lot of kind of second derivative impacts that could impact your business.

I'm not exactly sure what you're referring to because it would just be reflecting our bill of material there. You're talking about the general supply chain that supports Boeing? Yes.

Yeah, I'm just thinking about the impact of pulling down the schedule at one large manufacturing facility and how that might impact some of your industrial distribution businesses.

Oh, okay. I see what you're saying. I think that would be very minor. Basically, you wouldn't be able to find it. So if they shut down the plant at Redmond for 20 days or whatever on a temporary basis, it would be immaterial to us, you know, as far as the implant things that we do on the industrial side.

Okay, I'll leave it there. I appreciate it. Thank you. Thank you, Anne.

Our next question comes from Nigel Coe with Wolf Research. Your line is now open.

Thanks. Good morning, guys.

Nigel?

Yeah, so I just want to touch on the international orders. You know, we saw the year-over-year, you know, deteriorating from last quarter on an easier comp. So I'm just curious, you know, if you may just talk about geographically, where you saw the incremental weakness, and then I've got a follow-up.

Yeah, Nigel, it's Tom. So on international, that composition of that minus eight, we had both EMEA and Asia Pacific at about the same, that high single-digit declines, and we had Latin America low single positive. Remember, Latin America is small, so it's not really enough to move the needle. And the way that trended in the quarter was is that Asia-Pacific weakened in May but stayed stable in June. So May stepped down from April to May, but May and June were pretty well flat. And then Europe was pretty consistent. It was in that high single-digit level the entire quarter. So no real variation going April to June. And in Latin America, we saw some variation, but in general slight growth.

And then in Europe, are you seeing any signs of a bottom there, or is it still very consistently bad?

I think my description of the markets earlier on that I went through is a pretty good indicator for Europe as well. So that's how I would characterize Europe. The only difference in Europe would be maybe a little weaker distribution channel than we have in North America, but that would be the key difference.

And then my follow-up is really maybe just touching on what Anne was digging into and Going back to the, you know, 15, 16, you know, we saw North America, you know, negative 12%. And certainly the order numbers don't support that kind of, you know, that kind of deterioration. But maybe just take a step back and characterize what you're seeing today, what you're hearing from the field, from your channel partners, and characterize what you're hearing today to what you saw in 15 and 16.

Yeah, Nigel, this feels very different. I mean, distinctly different. 2015 and 2016 was a commodity-driven reduction. If you remember, the commodity prices weakened dramatically. All the equipment that went in there, the demand dried up. We had oil and gas prices drop dramatically. So it was a very different type of downturn. This one is, like I mentioned earlier on, is broader-based. I think our forecast was realistic. Part of why we studied those pressure curves was to just look at what history has showed us Going back, we only had data back 10 years from the financial crisis today, and that 12- to 18-month interval was fairly consistent over those cycles. But the big difference for me is sharp spike down in natural resources before. This one, a little more broader-based across broader-based event markets, but not as severe. Okay.

Thanks, Nigel. Liz, I think we have time for one more question.

Our last question will come from the line of Nathan Jones with Stifel. Your line is now open.

Good morning, everyone.

Good morning, Nathan.

Thanks for fitting me in. First question, I just want to follow up on this conversation about the shallowness of this pullback and perhaps its duration. Tom, it sounds like a lot of your outlook for when we recover from this is based on historical correlations and historical outlooks for the businesses. You did say this is different to 15 and 16. Do you need some kind of trade resolution here in order to see that recovery? Do you need to avoid a hard Brexit? Are there geopolitical things here that Maybe they don't make this decline any deeper than it is that you're projecting, but maybe it makes it longer than you're projecting, and just how you're thinking about those kinds of things.

Yeah, Nathan, so I want to clarify in case anybody took my comments the wrong way. We're not using a pressure curve history as to how we predict future sales. It's just one data point on top of our customers, our distributors, our divisions, et cetera. Okay, so it's just one of many in addition to the regression models we have. But it's just another element that I wanted to share. You know, I think that, you know, as far as this forecast, it does not assume any kind of trade resolution. So if we had some kind of trade resolution and there was a, you know, really positive on that, that would be upside to us. Obviously, this doesn't, and the resolution of Brexit or however that happens, that'll be immaterial to us. It's not big enough to to move the needle. And we're always subject to if there was something geopolitical event out of our control. But I can't forecast those type of things. Let's not assume any kind of upside on trade. It's really mirroring the current order entry we have for the first half. And then we get some help on comps. And as we went through the markets, I listed all those markets that we think are going to go for you from negative to neutral. or from neutral to positive. And then we track all these end markets and where they are in those four phases. And when you have two-thirds of them in phase three, that's an indicator that you're going to start to turn. The next phase is going to be DeSAR in decline, and that's what we put in the forecast. So there was a whole bunch of different angles. We looked at it. As you know, a forecast is only as good as the most current data, and we'll update you every quarter and hopefully give you even better information.

My follow-up question's a little more longer term on aerospace and the margins. You guys said 5.6% in engineering expenses in 2019, 4.5% to 5% in 2020. Does that continue to decline going forward? And then maybe you can comment on the mix as we go out a few years. I think you're fairly heavy on commercial OE at the moment, and that should switch as we go forward to a little more commercial aftermarket and clearly those are at opposite ends of the margin scale. So just any qualitative commentary you could give on how you think margins should progress in aerospace over the next few years.

Yeah, Nathan, it's Tom again. So we feel very good about margins in aerospace in the future. The current mix of OE to aftermarket for aerospace is 64% OE, 36% aftermarket. And you're right. I mean, that won't necessarily change much over the next, three to five years, but once you start going beyond that and we start having shop visits and you're looking at the engine content and the airframe content, that is going to gradually start to move. A point or two movement on that is a big deal to us from a margin standpoint. The NRE, that 4.5% to 5% that we're guiding for FY20, I think is a pretty good future number to use as well. And so the other advantage that aerospace has besides the mix you referred to is that it still has ample opportunity, just like the rest of the company on the wind strategy. It's got opportunities on Kaizen. It has additional opportunities in that all the entering into service part that they're doing today, which, you know, your first pump versus your 100th pump versus your 500th pump, we're going to work down that learning curve, and we will have some cost advantages, not in this next 12 months, but as you work through that, we're going to have cost advantages on entering into service learning. So, It's a business we're very bullish on from a margin expansion.

Very helpful. Thanks for fitting me in.

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