Parker-Hannifin Corporation

Ladies and gentlemen, thank you for standing by, and welcome to the Parker Hannifin Fiscal 2020 Second Quarter Earnings Conference Call and Webcast. At this time, all participant lines are in listen-only mode. After the speaker's presentation, there will be a question-and-answer session. To ask a question during this session, you will need to press star, then 1 on your telephone keypad. Please be advised that today's conference may be recorded. If you require any further assistance, please press star, then 0 to reach an operator. I'd now like to hand the conference over to your speaker today, Ms. Kathy Siever, Chief Financial Officer. Please go ahead, ma'am.

Thank you, Liz. Good morning, and welcome to Parker Hannafin's second quarter fiscal year 2020 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 materials and are also posted on Parker's website at phstock.com. Today's agenda appears on slide number three. We'll begin with our chairman and chief executive officer, Tom Williams, providing highlights from the second quarter. Following Tom's comments, I'll provide a review of the company's second quarter performance together with the revised guidance for the full year fiscal 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 four, and Tom will get us started.

Thank you, Kathy. Good morning, everybody, and welcome to the call, and thanks for your interest in Parker. Let me start with some strategic highlights, first of all, and we are very pleased to report that despite challenging macroeconomic conditions, our margins and our cash flow are at all-time highs relative to previous downturns. I think the best way to compare this, the best way to do it apples to apples, is look at the base business without lowering ZOIC, and compared to prior downtrends. When you look at our second quarter FY20 adjusted operating margin without acquisitions, that came in at 16.1%. This compares to our previous best recession performance, which was in FY16, and that Q2 adjusted operating margins were 13.5%. Both of these recessions had about similar organic sales declines, and this represents a 260 basis point improvement, comparing that to our best previous recession performance. Really remarkable performance and really my thanks to everybody around the world for doing such a great job. In addition to the margin improvement, cash flow from marketing activities was an all-time year-to-date Q2 record. This performance demonstrates that we are building a more resilient business that is poised for accelerated earnings growth as the market returns. Strong FY20 margin performance and cash flow generation so far are really a reflection of the improvements driven by the WIN strategy and the strengthening of our portfolio by buying companies that are creative to growth and to margins. So we are excited about where we are, and we're excited about where we're going to go in the future. Shifting to safety, we had a 25% reduction in recordable incidents in Q2, really making great progress there. My thanks again to everybody for their effort on this and their dedication to safety. Our recordable incident rate, and what that is, for people that aren't familiar with it, that is the number of safety incidents we have for 100 team members. That is now top quartile versus our proxy peers. And there's a very strong linkage, you've heard me talk about this, between safety and business performance. If you were to plot our safety metrics and our financial metrics, you'll see them moving in tandem in a positive direction. So some summary comments on Q2. Sales were our second quarter record as acquisition revenue offset soft organic sales. Organic sales declined as we expected with improvement in international organic sales versus our guide. The 737 MAX issues impacted our aerospace business. as Q2 airframe and engine orders were slowed in advance of the production pause. Strong adjusted EBITDA margins were significantly higher than they were during the last recession. We came in at Q2 adjusted EBITDA margin of 18.5%, again, really strong performance. Earnings in the quarter were excellent, and adjusted EPS exceeded expectations. Order rates in the quarter continued to be negative, impacting organic growth, and the portfolio additions that we have made are certainly going to help our organic growth over time, We've acquired businesses that are more resilient with higher organic growth rates than Legacy Parker. We're well positioned for excellent performance in the second half of FY 2020 and beyond that. I want to move now to year-to-date cash flow. You've heard me talk about how this is such a strategic priority for us. We want to be great generators and employers of cash to drive excellent returns for our shareholders. We've achieved the best ever cash flow from operations of any first half in our history. And given the current market conditions, that's really commendable. Free cash flow to sales is above 10%, and we're expecting to achieve our 19th consecutive year of cash from operating activities as a percent of sales in excess of 10% for FY20. The year-to-date free cash flow conversion was excellent at 130%. Moving now to the outlook, we're increasing EPS guidance for FY20 on roughly flat sales to the prior year. This reflects strong Q2 performance, which is being offset by the 737 MAX. and slightly weaker organic sales in the second half versus our prior guide. Our guidance assumes no additional 737 max sales for the balance of FY20. We are very excited about the future. We feel we're well positioned for growth with excellent margins and cash flow as the macro conditions improve. Some of the factors that are driving this feeling of confidence would be, first, launching of the one strategy 3.0, which is going to drive a further step change in the performance of the company. really building on the momentum from the previous updates that we've made to the One Strategy. Second would be the portfolio strengthening that we've done through the strategic acquisitions that have come on board. We're very happy with how Lord and Exac integrations are progressing, and we can comment more about that in the Q&A. And we recently had the leadership teams from both businesses here at headquarters talk about incorporating the One Strategy 3.0, their integration plans. It was a great session, a lot of good teamwork there. And then third would be the launch of the purpose statement, which is enabling engineering breakthroughs that lead to a better tomorrow. This statement is a real source of pride for organization, and we recognize that it takes being a top quartile performing company to live up to that higher purpose. Parker is transforming as evidenced by the higher level performance that we're doing in a very difficult part of the business cycle with lots of opportunities to drive earnings growth beyond FY20. Switching to the next slide, you'll see a reminder of our winning formula, what we've characterized as our competitive differentiators. And I've talked about these before, so I'm not going to say highlight each one specific. I would just tell you this listing in aggregate is what makes us special. This is why customers come to us, and this is why shareholders should think about investing in Parker. If I had to reference one in particular of these competitive differentiators, I would point out one strategy 3.0 and what we're the momentum and the performance enhancements that it's going to create over time, and a lot more discussions will happen on that as we move forward. So my thanks to all the global team members for their continued and dedicated effort in creating a top quartile company. With that, I'll hand it back to Kathy for more details on the quarter and the guidance.

Okay. Thanks, Tom. I'd like you to now refer to slide number six. This slide presents as reported an adjusted earnings per share for the second quarter. Adjusted earnings per share for the second quarter were $2.54 compared to $2.51 for the same quarter a year ago. Adjustments from the fiscal year 20, as reported results, totaled $0.97, including before-tax amounts of business realignment charges of $0.08, acquisition costs to achieve of $0.05, and acquisition transaction expenses of $1.14. These were offset by the tax effect of these adjustments of $0.30. Prior years, second quarter earnings per share had been adjusted by $0.15, the details of which are included in the reconciliation tables for non-GAAP financial measures. In slide number seven, you'll find the significant components of the walk from adjusted earnings per share of $2.51 for the second quarter of fiscal 2019 to $2.54 for the second quarter of this year. Starting with the net decrease of 13 cents in segment operating income, for Legacy Parker, a $260 million decline in sales contributed to a 34 cent reduction in operating income. The Legacy Parker teams did a good job of controlling costs on this lower volume by sustaining a decremental margin of 23% for the quarter. The acquisitions contributed $0.21, partially offsetting this reduction. Lower corporate G&A contributed $0.16 due to gains this year compared to losses last year on market-adjusted investments tied to deferred compensation. Incremental interest expense on the debt borrowed for the acquisitions resulted in a $0.20 year-over-year decline in the current earnings per share. Lower other expense of $0.07 benefited from interest income earned on the bond proceeds prior to the closing of the Lord acquisition. We gained $0.10 from a lower tax rate, primarily due to favorable discrete tax benefits. And a lower share count benefited the current quarter, $0.03. Slide number eight shows total Parker sales and segment operating margin for the second quarter. Organic sales decreased year-over-year by 7.1%, and currency had a negative impact of 0.4%. These declines were more than offset by the positive impact of 8.2% from the acquisitions. Total adjusted segment operating margins were 15.8% compared to 16.6% last year. This 80 basis point decline equals the incremental amortization expense from the acquisitions. With the help of the wind strategy tools, the legacy Parker businesses managed to achieve good decremental margins of 23% on their lower sales volume. On slide nine, we're showing the impact Lord and Exotic had on the second quarter fiscal year 20. These results reflect a partial quarter of contribution from Lord since the acquisition closed on October 28th and a full quarter of Exotic, which closed on September 16th. Sales from the acquisitions during the quarter were $286 million, and operating income on an adjusted basis was $36 million during this stub period. Moving to slide number 10, I'll discuss the business segments, starting with diversified industrial North America. For the second quarter, North American organic sales were down 8.5%, while acquisitions contributed 7.3% to the segment. Operating margin for the second quarter on an adjusted basis was 15.4% of sales versus 16% in the prior year. Incremental amortization of 75 basis points in the quarter more than accounted for the change in margins. North America's legacy businesses generated a good decremental margin of 24%, reflecting the hard work of diligent cost containment and productivity improvements, together with the impact of our wind strategy initiatives. Moving to the diversified industrial international segment on slide number 11. Organic sales for the second quarter in the industrial international segment decreased by 9.4%. Acquisitions contributed 4.5% to the segment, and currency had a negative impact of 1.4%. Operating margin for the second quarter on an adjusted basis was 14.6% of sales versus 15.7% in the prior year. Incremental amortization was 30 basis points in the quarter. The legacy businesses generated a very good detrimental margin of 23%, which was partially offset by contributions from the acquisitions. I'll now move to slide number 12 to review the aerospace systems segment. The aerospace systems sales increased $111 million, or 18%, from acquisitions and 1.3% from organic sales. Growth in military OEMs and commercial aftermarket sales were largely offset by lower commercial OEM sales and military aftermarket sales. Operating margin for the second quarter was 18.5% of sales versus 19.7% last year. Incremental amortization expense of 160 basis points more than accounted for the change in margins. Good margin performance from Exotic and hard work by the teams on productivity improvement helped contribute to the strong performance in the quarter. On slide number 13, we report cash flow from operating activities. Year-to-date cash flow from operating activities was $826 million, or 12.1% of sales. This compares to 10.7% of sales for the same period last year, after last year's number is adjusted for a $200 million discretionary pension contribution. That's a year-over-year increase of 11%. Free cash flow for the current quarter was 10.4% of sales, and the conversion rate to net income was 130%. Moving to slide number 14, we show the details of order rates by segments. As a reminder, these orders' results exclude acquisitions, divestitures, and currency. The diversified industrial segments report on a three-month rolling average, while aerospace systems are based on a 12-month rolling average. Continued declines in the industrial markets resulted in total orders dropping 3%. This year-over-year decline is made up of a 7% decline from diversified industrial North American orders, and a 6% decline from diversified industrial international orders, offset by a positive 12% increase from aerospace systems orders. Moving to slide number 15, the full year earnings guidance for fiscal year 2020 is outlined. This guidance has been revised to align to current macro conditions and includes the impact of the lowered and exotic acquisitions. Guidance is being provided on both an as-reported and an adjusted basis. Total sales for the year with the help from acquisitions are now expected to be flat compared to prior year. Anticipated full-year organic change at the midpoint is a decline of 6.4%. Currency is expected to have a negative 0.5% impact on sales and acquisitions will add 6.9% to the current year. We have calculated the impact of currency to spot rates as of the quarter ended December 31, 2019, and we have held those rates steady as we estimate the resulting year-over-year impact for the remaining quarters of fiscal year 2020. Considering the uncertainty of the regulatory clearance of the 737 MAX, We have now excluded all 737 max sales for the balance of the fiscal year 2020. For total Parker, as reported, segment operating margins are forecasted to be between 15.1% and 15.5%, while adjusted segment operating margins are forecasted to be between 16.0% and 16.4%. We have not adjusted the incremental amortization expense of approximately $100 million we will incur in fiscal year 20 as a result of the two acquisitions. The full year effective tax rate is projected to be 22.5%. The second quarter tax rate was favorably impacted by discrete items, which we don't forecast for the balance of the year. We continue to anticipate a tax rate from continuing operations, of 23.3% for the remainder of the year. For the full year, the guidance range for earnings per share on an as-reported basis is now $8.78 to $9.38 or $9.08 at the midpoint. On an adjusted earnings per share basis, the guidance range is now $10.25 to $10.85 or $10.55 at the midpoint. The adjustments to the as-reported forecast made in this guidance include business realignment expenses of approximately $40 million for the full year of fiscal 2020, with the associated savings projected to be $15 million this year. Synergy savings from Clarkor are still estimated to achieve a run rate of $160 million by the end of fiscal year 20, which represents an incremental $35 million of year-end savings. In addition, guidance on an adjusted basis excludes 27 million of integration costs to achieve for Lord and Exotic and 185 million of one-time acquisition-related expenses. Lord and Exotic are expected to achieve synergy savings of 18 million this fiscal year. A reconciliation and further details of these adjustments can be found in the appendix to this morning's slides. Savings from all business realignment and acquisition 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 2020 guidance at midpoint are sales are divided 48% second half, Sorry, 48% first half, 52% second half. Adjusted segment operating income is split, 49% first half, 51% second half. Adjusted EPS, first half, second half is divided 50%, 50%. Third quarter fiscal 2020 adjusted earnings per share is projected to be $2.36 per share at the midpoint. and this excludes $18 million of projected business realignment expenses, $7 million of integration costs to achieve, and $19 million of one-time acquisition-related expenses. On slide 16, you'll find a reconciliation of the major components of revised fiscal year 2020 adjusted EPS guidance of $10.55 per share at the midpoint compared to the prior guidance of $10.50 per share. During the second quarter, stronger than guided sales, together with meaningfully higher segment operating margins from the industrial segment, generated a net $0.17 operating income beat. Strong gains in market-adjusted investments tied to deferred compensation and lower than guided interest expense contributed a benefit of $0.08. and favorable discrete tax benefits during the quarter helped to contribute $0.07, totaling to a $0.32 EPS beat in the quarter. Updates to the second half guide result in a $0.04 increase in operating income, offset by a $0.30 negative impact to operating income from the elimination of 737 MAX shipments in the second half. Updates to the below-the-line items result in a net $0.01 decline. This results in a net five cent increase to the fiscal 2020 full year guided earnings per share at the midpoint. On slide 17, we show the impact the acquisitions will have on both an as reported and adjusted basis for the full year. On an adjusted basis, the acquisitions lower operating margin to 16.2% for total Parker from 16.6% for legacy Parker. impacted by the 100 million, or 70 basis points, of full-year FY20 incremental amortization expense. For the adjusted EBITDA margins, the acquisitions provide 50 basis points of improvement, moving from 18.1% for Legacy Parker to 18.6% for Total Parker. If you'll now go to slide 18, I'll turn it back to Tom for summary comments.

Thanks, Kathy. We're pleased with the continued progress. We are performing well through this downturn, as demonstrated by our cash flow performance and our ability to raise the floor on margins. We're well on our way to delivering top quartile financial performance as a company. I just want to remind people what we're trying to drive to as far as we're laser-focused on our FY23 targets, and those are sales growth at 150 base points greater than global industrial production growth, segment operating margins at 19%, HIPAA margins at 20%, pre-cash flow conversion greater than 100%, and those would all culminate in driving an EPS CAGR over that period of time at 10% plus. So thanks again to the global team, everybody around the world for all your hard work. And with that, I'll hand it over to Liz to start the Q&A portion of the call.

As a reminder, to ask a question, you will need to press star, then 1 on your telephone keypad. To withdraw your question, press the pound key. Again, that star, then one, if you'd like to ask a question at this time. Our first question comes from the line of Meg Dobro with Baird. Your line is now open.

Yes, good morning, everyone. Good morning, Meg. Maybe just very quickly some clarification on what's embedded at segment level for organic growth, especially in your industrial business.

Meg, it's Tom. So what we assumed, I'm just going to give you for the second half what the new guide was North America at minus seven, international minus 12, aerospace at minus a half, gets to the second half at a minus seven and a half. And that compares to the prior guy was minus six. Big difference there being a little bit of weakness in North America, but the big difference was the shift in the max.

Understood. Then if I may, on international, You know, I think you said negative 12 for the second half.

Yeah.

If I'm comparing that with what you've done in the first half, there's some deceleration there, and obviously your orders are looking a little bit different in that regard, being less bad, if you would. So can you help us understand kind of how you're seeing it and what's going on there?

Yeah, so our thinking on Our thinking on the orders and then sales for international, first of all, you're right. So, orders came in at minus six. They did improve in Q2. But that was driven mainly by Asia. And from what we can tell, a lot of that was influenced by some Polans in advance of China's New Year. So, we feel these order rates may be a little bit overstated or maybe not entirely reflective of our underlying market conditions. And then given the uncertainties of the coronavirus, and the fact that the Chinese government has extended Chinese New Year by one week, we actually had our Asia team, just within the last 48 hours, redo the second half forecast on what they thought. And their latest thinking, which is obviously very fluid given what's going on there, is now reflected in this new guide. And ironically, it came in about the same as what we had before. We were minus 11.5 before. We were minus 12. But that was our thinking, is that The combination of the orders are a little bit over-enhanced from the pull-ins, and our current intelligence, based on what's going on, is reflected in this guide.

I appreciate that. Not to put too fine a point, but as we're sort of thinking about Q3 specifically in India, in China, how do we think about that in terms of the negative 12 for the back half of the year?

Thank you. Yeah, so I'm not going to split it out necessarily by region, but we have international – for Q3 at about minus 16. So the worst of it hitting in Q3, you got the Chinese New Year, the extension of that, there's some obvious reasons why Q3 might be impacted worse.

Great. Thank you, Tom. Thanks, Meg.

Our next question comes from Nathan Jones with Stifel. Your line is now open.

Morning, everyone.

Morning, Nathan.

Maybe I'll just start with a question on pricing. I mean, you're kind of getting to the peak of the negative comps in this part of the down cycle. Are you guys seeing any pricing pressure coming from customers, any kind of aggressive or irrational behavior from competitors in the market out there? I know you guys are always targeting being price-cost neutral. Are you still able to maintain that at the moment, and do you think you can maintain it for the rest of the year?

Yeah, Nathan, it's Lee. The answer to your question is yes. As you know, our goal always is to be price-cost neutral, margin neutral. And I think why we're so resilient in doing that are the processes that we have. You know, we follow the input costs through our purchase price index, and we have our selling price index that we track at all the different locations. But in our forecast and what we're expecting is to be price-cost neutral, margin neutral.

Okay, you guys have also, I mean, you've taken the margin expectation in aerospace down, which I think is fairly straightforward, right? You've got less volume from the max, so you're not going to see the leverage on that. You did take the margin expectations in both North America and international up. Can you talk about what's gone on there, whether it's internal productivity or what else has led to an expectation of better margins for the full year? than you had previously baked into guidance?

Nathan, this is Tom. I think what we're experiencing, and you saw a lot of that in the first half, by taking North America as an example, we had some benefits from Lord Synergy pulling in from what we had originally expected, the wind strategy and everything we're doing there. We've seen a lot of help from Kaizen activities at all of our plants. On international, we had Very strong Q2, driven somewhat with higher volume versus our guide. But the same thing for international. Kaizen activities, the wind strategy, we had the benefit of prior restructuring that is playing through for us there. And I think it just gave us confidence that when we looked at our second half, that we could continue that in the second half. The organic growth is slightly different, slightly worse than the prior guide. but we didn't think it was enough. We thought we had enough other positives to offset that and to improve the margins.

Okay. Thanks very much for taking my questions. I'll pass it on.

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

Thanks. Good morning, everyone. Good morning, Joe. Tom, I just want to clarify the max comment that you made. I think you said that it impacted 2Q. And so if it did, like what kind of impact did it have on 2Q? And then secondly, as you think about the zero for the second half of the year, is it just fair to assume that airframers have inventory on hand and that's why the MAX is going to zero and 2H?

Yeah, so let me just – Joe, this is Tom. I'm glad you asked because I wanted to give a little bit of color as to why we did what we did on the MAX. First, given Boeing's public comments about the ungrounding occurring sometime in the middle of the year, We felt that, hey, there's a lot of uncertainty there. Even Boeing doesn't fully know exactly what's going to happen with that once suppliers will turn back on. And that we really wanted to de-risk the guidance for the rest of the fiscal year by taking the max out. I also felt that it wasn't fair to our shareholders to have it in and then be guessing at what it's going to be and what kind of ramps it could be. I thought it was a disservice to our shareholders and that it would be much better perceived stronger by taking it completely out and trying to demonstrate the guidance that we have here, even without the MAX. So what we did is the production pause officially started January 15th. However, when you look at what hit us in Q2, there was some minor slowing of orders, both on the airframe and the engine side. It was approximately $5 million in Q2. The total amount for us was a full year. including Q2 in the second half, is $150 million impact for the max and $50 million of earnings. Obviously, lower volume and the lack of absorption associated with that. But obviously, Boeing, as well as all of our customers, are really important to us. We're going to be there to support them whenever the production returns. If it happens to return soon to what we have in this guidance, we'll be there for them. And in the meantime, we're reallocating our team members to other programs as much as possible. to help with backlog and potentially accelerating schedules if our customers permit that. So that's really the strategy and the thinking behind the MAX.

That's super helpful, Tom. And then maybe if you could just kind of talk about the North America weakness in a little bit more detail, just parsing out, like, what you're seeing from a distributor perspective versus what you're seeing on the heavy industry side and how you expect that to play out in your fiscal second half.

Okay, so, Joe, what I'll do is I'll go through North America, but I'll just maybe run through the whole company on markets because it's typically a question people want. But our thinking on North America, you know, we're guiding 100 bps lower than we had the prior guess. It was minus 6. Now it's minus 7. I'm just talking about the second half because obviously that's what's left. Orders were down from 100 basis points from Q1 to Q2, so that's probably the most direct linkage there. We had distribution weaker. We have the December ISM at 47.2, and all those factors, plus obviously every time we do this, we do a bottoms-up. We re-look at what our thinking was there. I went through international, but I wanted to make a comment about distribution when I think about North America. So distribution for the whole company was down mid-single digits, about 400 basis points worse than Q1. And this declined pretty much sequentially through the quarter and really was broad-based from an end-market standpoint. International distribution was worse than North America, but about all the regions went down equally approximately going Q1 to Q2. In North America in particular, we think the holiday timing hurt. You had two Wednesdays involved there for Christmas and New Year's Day. And really what we saw with end customers is that drove extended plant shutdowns And our distributors, as a result of this broad market-based decline and the extended shutdowns, took the opportunity to resize their inventory. So if you think about down mid-single digits on distribution, our best intelligence, and again, this is an estimate, was about half of that was destocking. Half of it was tight end markets. Maybe if I go back to just total end markets, I'm just going to list off the positives and the negatives, and I'll give maybe a little more color on the specific end markets. But On the positive side for the quarter, Q2 total parker, aerospace, mining, semiconductor, lawn and turf, and marine. And then minus was distribution, which is what I was just talking about. It's not a market, but an important channel to us. Mills and foundries, refrigeration, machine tools, tire and rubber, power generation, telecom, life sciences, oil and gas, automotive, heavy-duty truck, construction, ag, Forestry and rail, this is too long a list on the negative side. But let me give you some color if I was to kind of lift it up to the major segments. So I talked about distribution. So now if I just characterize industrial end markets. For those maybe not familiar, all of our industrial markets are basically things without wheels, things that don't move, equipment that doesn't move. That improved. So industrial end markets went from minus 9 to minus 6.5. Again, total company. The positive side to there was low single-digit improvements in mining and semiconductor. Semiconductor is starting to come back. On the negative side, low single-digits, I'm just going to kind of give you buckets. Low single-digits was mills, oil and gas. Mid-single-digits was refrigeration, power, general industrial, and things greater than 10% declines for machine tools, rubber and tire, telecom, and life science. Then on the mobile side, again, equipment with wheels. saw us go from minus 6.5 in Q1 to minus 14. So that was the big shift. A lot of that was driven in North America. And the positives there was mid-single-digit improvements in lawn and turf. And then on the negatives, kind of two buckets here, high single-digit decline in forestry. But then almost all of them and markets with mobile were kind of in that 10% to 20% decline range, automotive, construction, heavy-duty truck, ag, rail, and material handling. I think Kathy alluded to in her comments about aerospace, I'm rounding to the nearest half, up plus 1.5. We had commercial OE minus 3, military OE plus 2, commercial MRO plus 15, and military MRO down 5. That headed up to 1.5. So that's kind of the spin through the end markets, Joe, if you have a follow-up to that.

No, I think I'm all good. Thanks, Tom. Thank you, Joe.

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

Yeah, thanks. Good morning, guys. Good morning, Nicole. So I guess maybe focusing on the North America orders, we already talked a little bit about what happened in international, but, you know, what's your view on whether or not order activity has bottomed and maybe thinking about how January has trended, you know, as a way to characterize that?

Nicole is Tom. So if I was to kind of do what I did, and I won't go into that same kind of detail for North America, but if you look at North America industrial, it went Q1 and Q2 basically about the same, minus 5.5, minus 6, so basically the same quarter over quarter. The mobile is what declined the most, went from minus 5 to minus 16, and all the same end markets that I just described for the total company is what we saw there. And then on distribution, that went from minus two to about, it was flat in North America to about minus four or so in Q2. So that was 400 pips in North America alone that we went down. So that was kind of how we look at North America. I think in general, when we think about organic growth for the year, we're really, in our guidance, we're reflecting really Q3 as kind of our bottom from what we see at this point.

Okay, got it. That's helpful. Thanks, Tom. And then just a quick one on the deals. I think you guys said that you're expecting 18 million of synergies up a little bit from your prior guidance. Can you just say what you realized in synergies in the second quarter and what's remaining for the second half?

Yeah, we saw a little bit of the synergies for Lorde pull into the second quarter. The timing moved ahead for us. We got them sooner than we anticipated. And so we're then factoring that through the rest of the year as well. So a small amount in Q2 with $18 million for the full year effect.

Got it. Thanks. I'll pass it on.

Thanks, Nicole.

Our next question comes from the line of Ann Dinan with JPMorgan. Your line is now open.

Hi. Good morning, everybody. Morning. Morning. Tom, would you just comment on the notion that while you've taken the downturn in aerospace because of the 737 MAX, couldn't that also spill over into your industrial business more broadly just from the supply chain and the supply base as they have to shut down production?

Yeah, and as Tom, we did factor that in because people who don't realize that we have a fair amount of work that goes that's aerospace related. and engineer materials and filtration that goes into that. So the $150 million includes the industrial piece in that. And just in round numbers, about 10% of that is industrial, and the other 90%, as you might imagine, the bulk of it is in the aerospace segment. But we did factor in the amount of onboard type of work we did. And then I think the other part you're referring to is the things that might be in the factories of our suppliers. That's factored into the guide we have for the rest of the business.

Okay. I appreciate that. And then just circling back on the same topic, can you give us a breakdown of the $150 million? How much of that is legacy Parker and how much is exotic?

So exotic is $60 million of the $50. Of the $150, sorry. $60 of the $150. $60 of the $150. Yes.

Okay. And that includes both direct shipment content on the aircraft as well as shipments to the engine?

Yes.

Okay. I appreciate that. I just wanted to get that color, and I think you've given us most of everything else we need, so appreciate it.

Good.

Thanks, Dan. Our next question comes from Jamie Cook with Credit Suisse. Your line is now open.

Hi. Good morning. A nice quarter. I guess two questions, Tom, you know, just in terms of, you know, as we exit 2020, potentially, you know, comps get better when we start to see organic growth reignite again. Based on what you've done with the acquisitions and when, should we be thinking about incrementals any differently? And I'm wondering if there's a difference on how to think about things, you know, industrial versus aerospace, I guess. And then just, you know, my second question just relates to your portfolio, given some of the announcements recently. you know, one, do you see any change in the competitive landscape or could that be a positive for you with Eaton selling their hydraulics business? And just, you know, your view of the, you know, is there any change in your view, I guess, of your portfolio in terms of potential divestitures? Thank you.

Okay, Jamie, it's time. So I'm going to work backwards on the questions. I'll start with, I think what you're referring to is the Danfoss Eaton portfolio. I would first say we weren't surprised given, I think, the portfolio that Eden has and I think some of the, you know, our inclinations as to what they might do with it. We have a lot of respect for both Danfoss and Eden. And in our view, you know, strong competitors make you a better business. So, we welcome, you know, we welcome the challenge. We like our chances. We believe that the breadth of our technologies The breadth that we have with the motion control technologies and the wind strategy is going to allow us to compete effectively with any company in our space, and we're confident going forward. Obviously, when you have these kind of transitions, having done a lot of these types of acquisitions ourselves, we recognize that there's stress in the system when that happens, and there's maybe potential opportunities to look at share gain. And so we will obviously be doing everything we can to optimize that and and take advantage of that and, you know, good competitive tension in the system. So if I move back to maybe your other two comments on incremental MRS is kind of looking forward, I still think, you know, a plus 30 in general is a good number if you're doing it over multiple years. But clearly coming out of a downturn, as we have talked about in the past, you would expect to see that be north of a plus 30 because you're going to get some help as as that volume comes up, and you're going to be only adding incremental variable costs and doing it very efficiently as you do that. So I think, you know, the first couple of quarters coming out tends to be stronger than what I would say you'd see over a whole cycle. And then the whole goal of these acquisitions, and they will, but maybe I could just comment in general about them. I'm extremely pleased with the progress. You know, we've acquired great progress in technology, but the best thing that we've done It's the talent that's come into the organization from these two businesses. It was on full display when we had the leadership meeting. We had about 80 people from both businesses in together. And if I look at LORD, LORD is ahead of what we had hoped for, low single-digit growth, and that compares to a minus 6.5 for total partners. So it's doing what we wanted. It's more resilient. And what we're seeing from the aerospace, thermal management, and structural adhesives part of LORD is really doing quite nicely. We were very confident on the $125 million of cost synergies, and we pulled in the synergies into this year. Then with Exotic, the team is doing a great job. The 737 MAX is out of everybody's hands. That's something we can't control, but that team there has effectively redeployed everybody that was on the MAX, and we've re-deployed them to the F-135. and we've got to do some minor capex to help facilitate that, but we have them on F-135. We also have the repair depot starting up on F-135. And then we've got one of the big synergies, which we didn't really disclose on our revenue side, is the fact that we have this well-established aftermarket organization, customer support operation that's part of Legacy Park and Aerospace, that can help with the commercial efforts of Exotic to go capture those legacy engines and to look for spares and repairs for the type of products that Exotic does, and we're going to do that. We're going to try to pull them in. Now, everything I just described on that is not going to really help so much Exotic and FY20, but it's really positioning for FY21, and the MAX will come back, and so I think we have the benefit there is potentially a one-two punch with Exotic. MAX comes back, and then we've also got additional people trained. Now, some of the F-135 will depend on Our customer allowing us to accelerate the schedule, I think they signal that they would, but obviously if some other supply becomes a constraint for them, they might slow us down. But that's an opportunity to accelerate the F-135. So that was kind of a long-winded answer on acquisitions, but if you think about them in aggregate, they're coming in, they're going to grow faster than the legacy Parker, and that was the whole reason why we acquired them. You see the incremental EBITDA, what it's doing for us in one of the slides that Kathy had, So we're still very positive. The max is a short-term blip on the path to a pretty strong future for them.

Thank you. I appreciate the caller.

Thanks, Jamie. Our next question comes from Jeff Sprague with Vertical Research. Your line is now open.

Yes, thank you. Good day, everyone. Just a couple things for me. First, just back to Lord Tom. Can you address how it's performing kind of in the automotive markets and – You know, you had pointed to kind of the ability to outgrow through thick and thin. We've heard a lot of, you know, the kind of negative automotive comments out of the 3Ms and DuPonts here this earnings season. I just wonder how things are really progressing for that slice of the business. Yeah, so without getting into specific numbers, I'll just take the three major buckets. Aerospace is a pretty strong growth for us, and then the industrial piece would be slightly negative. and automotive would be neutral to slightly positive. And what's really happening there is the technologies we have there that are more electrification type of technologies, which would be thermal management and structural adhesives, are offsetting the weaknesses that we have in the traditional adhesives and coatings that might be more supplied into the internal combustion engine. So I'm really happy with what they're doing, you know, coming in at low single digits. And that's even factoring in some – you know, weakness in Asia tied to the coronavirus. So that's obviously a new element, and that's an unknown still and yet to be determined. But I'm really happy with what they're doing out of the gate. Then I was curious, back to the MAX situation, you provided a little detail on the redirect to the F-135, et cetera. But have you actually, you know, shut down MAX-related production, or are you – you know, continuing at some low rate to kind of keep the line warm? How do you kind of manage that operationally to make sure you are, you know, ready to go if you get the signal? Well, obviously, that's a balancing act. So we redeployed the people, so we haven't lost that skill set for the most part. There's some we could not retain, unfortunately, but we've retained most of them. So we have the skill set people-wise. Obviously, we'll make sure we maintain any of the equipment that needs to be maintained so we're ready to go. And, you know, with our supply chain, we're making sure that they're ready and able to supply to us when we need to. So if we need to carry a little extra inventory to be ready, we'll do that. Our suppliers will be on the ready, too. But I thought it was prudent for us and for our shareholders to not be trying to chase and guessing when the max is going to start back up. So we didn't build it into guidance. But obviously, internally, we're going to make sure we've built a supply chain that can respond Obviously, Boeing needs to give us some lead time, and they recognize that, and they will. But we will be there to respond when Boeing gives us a signal. Great. Thank you.

Thanks, Jeff. Our next question comes from Joel Tiss with BMO Capital Markets. Your line is now open.

Hey, guys. How's it going?

Morning, Joel.

We've gotten a lot of good information here. So just a couple of, like, whatever, clarifications, I guess. Are you guys giving any updates on your debt to EBITDA? Like, where do you expect to be by when? Or is that more for the analyst day?

I can talk about that for you, Joel. As we finish the quarter, considering that we don't have a full 12 months of EBITDA from the acquisitions in there, we're currently at a gross debt to EBITDA as is of four times. And our net debt is 3.6 times. We expect by the end of the year, we'll have the gross debt down to 3.7 and the net debt down to 3.3. Again, that only has a sub-period of EBITDA for the acquisitions in there. So it actually, next year, will quickly look a little better once we get 12 months of EBITDA.

And is there a target before you look at acquisitions again? Do you need to be closer to two, or is it more two and a half?

Yeah, Joel, it's Tom. You know, I think 2.0 is what we'd like to get to, but obviously as we start to glide closer to that, obviously our interest is going to get more keen. The key thing on what we've learned, and it's not a new lesson over the years, is you have to continually work that business development pipeline. We are working it now today as we speak, building those relationships, understanding the the strategic fits to our company. So we'll continue to do that even though we're not ready to action anything. We'll continue to work that pipeline. But yes, we need to get closer to before we get back in the game.

Okay, and just one last quick one you Jamie asked about PLS and and you didn't really you missed that part of the question. I just wondered, are there any kind of bigger chunks that you guys are seeing that that that could accelerate the restructuring? or everything's pretty much as you expected and we just, you know, keep the incremental improvement.

Joel, help me with PLS.

The product line simplification, so looking at individual product lines and hiving them off or finding a better owner for them.

Okay, good. So, yes, that's going to be a big – we will talk a lot about that at IR Day, but the cliff notes is that's still a really big part of our strategy going forward And we've added to it with simplified design. So it's still looking at what I'll call organizational or structural change, number of divisions and groups. But that has played through for the most part, but we continue to look at that. But the other part of that that we'll look at is just within the divisions, do we have the right staffing elements, what we call competitive staffing analysis, looking at that versus best-in-class examples. So that's item one. Item three is I think what you were using, what we would call 80-20, and that's still early days. We have lots of opportunities, and that's a big part of how we're trying to simplify things, revenue complexity, and the processes and structure that services that. And the third element is simple by design, which gets at that approximately 70% of the product cost is tied up in how we design things in the first place. So you can have the most fantastic lean system and Kaizen and doing all these other simplification things I just talked about, but a lot of your cost and and your speed within your factors and your speed of service customers is stuck in concrete based on how you design the product. So we'll go through that in a lot more detail at IR Day. And we think we're one of the first people thinking differently in how we want to do that. And there'll be a combination of process and software things that will elaborate more in detail. And that's obviously that's a little bit longer term because you've got to do that as you design new things. There's some things we can do going backwards with existing designs. But that will set us up nicely for margin expansion and really, I think, speed in the future. Okay, great.

Thank you very much.

Thanks, Joel. Our next question comes from Julian Mitchell with Barclays. Your line is now open.

Hi, good morning. I think, Tom, you'd said that destocking was about a two and a half point drag on sales in the fiscal second quarter. So just wondered what your guidance implies for that destock aspect in the second half, please.

You know, that one is really hard to predict exactly how destocking goes and doesn't go. To be honest, I would not have expected, given where we were trending before the quarter, to have it step down about 200 bps. In round numbers, we're about minus 100 destocking in Q1, and it's now around minus 300 in Q2. That has to eventually find equilibrium, and based on probably the Q3 being our bottom, our hope is that the destocking would hit bottom in Q3, and then everything else from our distribution channel would be end-market related as we go into Q4.

That's helpful. Thank you. And then my second question, just on the international industrial segment, you gave a lot of good color on the top line pieces moving around there. I just wanted to ask on the margins, because it looks as if, you know, in terms of the margin rate, you're fully a guide for margins and international implies a step down. sequentially in the second half from the first half or second half versus Q2, even though the revenues just in dollar terms should be going up. So I just wondered if there's something around mix or something with the Asian production impact that you were talking about earlier that dragged down the margin sequentially even with that higher revenue.

Yeah, you hit the nail on the head. So percentage-wise, organic goes down 11.5 to minus 12 for international. But I think in particular what you're seeing there is we've got our assumption is a little weaker decremental. We go from a decremental in the low 20s in the first half to kind of the low 30s in the second half for Asia, really influenced by how we looked at what the risk associated and the uncertainties around the particular age of the coronavirus and just the unknowns there, recognizing that as you extend Chinese New Year shutdown, you know, nothing's happening there. Then when you start back up, it's going to be much more inefficient, our belief on this startup than in previous times coming off of Chinese New Year. So that's really the difference, Julian.

That's great. Thank you.

Thanks, Julian. Our next question comes from Andy Casey with Wells Fargo Securities. Your line is now open.

Thanks a lot. First question on Europe. It doesn't seem like that's trending any different than you expected, but we're seeing some improving macro stuff. Are you seeing anything on the ground that would follow that?

It is, Tom. We saw some slight improvement in Europe. If I look at EMEA as a total region, industrial went from minus 13% to minus 11 at Q2. So, you know, still soft, but, you know, got a little bit better. There was no particular end market that kind of lifted up sand. That was what drove it. It just was kind of really the whole breadth of it getting a little bit better. Mobile was basically the same, minus 13, slight improvement, minus 12.5. I'm rounding to the nearest half. So, I would say fairly consistent with some minor, minor improvement.

Okay. Thanks, Tom. And then, I think last quarter you called out phase three, phase one, or sorry, phase three, phase four being 28% and 48% respectively. It sounds like North American distribution had a little bit of a leg down. Could you kind of help us with how phase three and phase four trended in Q2 and how that may change if you exclude the North American distribution piece?

Yeah, Andy, so that distribution, as distribution goes, it really influences these four phases. I think what we've seen now in looking at these phases, things can move kind of jockey back and forth between Phase 3 and Phase 4, depending on what's going on, and that's what we saw in this last quarter. Distribution went from Phase 4 in the prior quarter to Phase 3, and distribution being like 37 points that are, you know, excluding aerospace, you know, it influences quite a bit. So if I just contrast for you, phase one, that's accelerating growth was plus three. I'm talking about the current quarter. Decelerating growth phase two is plus 17% of our sales. Accelerating decline phase three was 72%. And that main reason why that moved higher was because distribution moved into there and automotive moved into there. Automotive was in phase four. the balance being 8% of our sales was in Phase 4, a decelerating decline. So the big shift predominantly was distribution and automotive moving from 4 to 3.

Okay, thank you. And then one last one, and this is an attempt, because irrespective of what you say, I'll be at the investor day. But should we expect any significant changes in the longer-term goals that you've previously outlined? outside of potentially EBITDA margins, which are, you know, look on track to maybe exceed it. You know, given the big slug of amortization that you're carrying now, the EBIT margin seems like it might be more of a challenge. But anyway, your lineup looks great. It looks like you're going to be providing a lot of detail. But at the end of it, should we expect significant changes in the longer-term trajectory?

And yes, Tom, you're very perceptive. Obviously, the amortization headwinds, you know, Kathy gave numbers by segment. If you look at that on a steady state around numbers, you know, it's about 100 pips of headwind that we now have with amortization that we didn't have before we set those goals. But the short answer to your question is no, you should not see any big changes. but obviously EBIT needs to be looked at given what's happened, and we will look at that. And we're looking forward to seeing everybody because I think you're going to see an excited team with an exciting lineup with, I think, more information than we've ever shared with you. And we're going to get a chance to talk about the Wind Strategy 3.0 and a lot of things that I think are going to be very compelling to people wanting to be excited about our current shareholders and then hopefully future shareholders to want to own Parker Hanifin.

Great. Thank you very much.

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

Our last question comes from the line of Stephen Walkman with Jefferies. Your line is now open.

Wow. Just slid it in. Thank you. Good morning. Can I just ask Tom to go back to something you were talking about earlier when I think Joel was asking you about product line simplification and you talked about 80-20 and You know, from a lot of other companies who have instituted this, you know, a big part of the process was, you know, hiving off a fairly chunky size of revenues that might be underperforming or might just not have the potential to perform over time that you might have thought you've made lots and lots of acquisitions. So I guess I was just trying to get a little more clarity there. You know, can you picture Parker going through a process of divesting a significant chunk of revenue to kind of, you know, prepare the ship for higher returns and higher growth going forward? Or is the portfolio kind of where you want it and there might be some tweaking but nothing major? Yes, Steve, it's Tom.

So that's a good question. And actually, that's probably what Joel was getting at and I didn't completely answer him. I think the short answer is no, you're not going to see any major chunks come off. You might see some minor tweaks. The big difference between, say, how we're deploying 8020, we're deploying it the same way that people that you've seen do it before, like ATW, et cetera. The difference is our portfolio. Our portfolio is built with a lot of complementary interconnectivity there. And with 60% of our revenue coming from customers that buy from four or more of our technologies, our revenue on the tail is very much linked to other revenue throughout the company. So, it requires a little more thoughtful approach. We can't just lop off those tails saying, hey, that's the end of it because the tail for one division might be an A item for a different division. So, we're doing that from a very thoughtful standpoint. We will still get the same kind of speed and margin improvements. You're not going to see really any kind of revenue changes on that. We don't see it as a headwind to revenue. It'll be neutral on the revenue side. you might see some minor things that we do on that. But most of it is going to be just helping customers through different ways to deliver it, different pricing things. There's different things we can do on alternative part numbers that satisfy their demand. We want to still take care of our customers and create a great experience for them. We're just going to find more efficient ways to do it.

Great. Good color. I appreciate it. Thanks.

Okay. Thanks, Stephen. Okay. This concludes our question and answer session and the earnings call. Thank you, everyone, for joining us today. Robin and Jeff will be available throughout the day to take your calls should you have further questions. Thank you. Enjoy the rest of your day.

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.