Parker-Hannifin Corporation

Ladies and gentlemen, thank you for standing by, and welcome to Parker Hennepin's Fiscal 2020 Third Quarter Conference Call and Webcast. At this time, all participants are in a listen-only mode. After the speaker presentation, there will be a question-and-answer session. To ask a question during the session, you will need to press star 1 on your telephone. Please be advised that today's conference is being recorded. If you require any further assistance, please press star 0. I would now like to hand the conference over to your host, Chief Financial Officer Kathy Peer. Madam, please go ahead.

Thank you, Lateef. Good morning. Welcome to Parker Hannafin's third quarter fiscal year 20 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 material's 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 comments on the current environment and related actions we've been taking. Tom will then discuss highlights from the third quarter. Following Tom's comments, I'll provide a more detailed review of our third quarter financial performance. Tom will then provide a few summary comments, and we'll open the call for a question and answer session. We'll do our best to take all the questions we can today. Please refer now to slide number four, and Tom will get us started.

Thank you, Kathy, and good morning, everybody. Thanks for your participation today. Before I get into slide four, I just want to first extend our thoughts to all those who have been affected by the crisis, and our deepest sympathies go out to those that have lost loved ones as a result of the virus. A special thank you to all the health care professionals for their courageous efforts around the world. And I'd also like to thank all the Parker team members for their dedication and their support and what we have done in our own small way to help society through this crisis. I'll elaborate more about that later on in the presentation. So this is unprecedented times, and that's a word that's probably overused, but very appropriate given the uniqueness of having a combined health and economic crisis. So on slide four, our performance and our strength for both of these crises really comes from the wind strategy, which is a proven operating system, and we're now in our third and very powerful revision of that, a portfolio of products and technologies that are needed. And this has never been more evident and important in today's climate. We make things that the world absolutely needs. Our culture and our values, which is why people join and stay at Parker, And our purpose, which has been our North Star, and I'll talk more about the connectedness of our purpose to our actions later on. And we have an engaged team of people. We have top quartile engagement scores, and if you couple that with our decentralized divisional structure, that is what has enabled us to move at the speed and agility that you've seen during this crisis. So on slide five, our crisis management strategy is really threefold. First is the safety of our team members and their families. Second is how do we help society through this crisis? We are essential, and I'll talk to you more about why we are essential, and that we want to emerge stronger than ever before after the crisis is over. We have utilized a crisis response management team, and that structure we have in every key country, and we have it for corporate as well, and their focus has really been on the health and safety side of things. We've had a daily cadence with that team seven days a week, really since this all started in January. I wanted to make a comment about how the executive team has been functioning. So the executive team, say the top 20 executives in the company, have still been coming to the office, and we maintain physical distancing and do Zoom conferencing and all those type of things, but it's very advantageous to have us co-located so we very quickly can see each other, make decisions. That's been a key enabler to our speed and decisiveness as well. On slide six, we'll talk about the health and safety actions. They've been early and they've been decisive. They've been patterned off of the CDC and the WHO, as well as lessons that we've learned from China. And this is a list that you probably are familiar with as you've listened to other companies. I won't necessarily go through each one of these, but I would just point to we were early on with travel restrictions and we were early with cancellation of in-person meetings. And I would highlight two examples. First, ConExpo. We were probably one of the first companies to withdraw from ConExpo, which is a very important show. So that sent... a very strong message, I think, to everybody in our space as well as our people, the importance of what we wanted to do here, protecting our people. And then we were an early adopter of the Virtual Investor Day, which all of you were a part of, and we thought that was very successful. Not as good as in person, but it was very successful, and it was a smart move to do that. So the takeaway on this page, the governing message to all of our people has been this takeaway, that we wanted the two safest places for our people to be at work and at home And we're going to do everything humanly possible to make sure that that happens. So I mentioned that we were essential. And on slide seven, I just wanted to highlight some examples of our purpose and action. And I'm going to go through these just real quickly. But our products have helped society through this entire crisis. If you look at food supply, we have products from the farm all the way to the point of use in retail, helping patients, whether it's emergency transportation on a helicopter or on hospital beds. And we are an essential manufacturer, but we're also helping other people that are essential manufacturers. That little picture that you see in the upper right-hand corner there is a picture of a typical manufacturing plant with the roof off of it. And I would tell you that we are in almost every manufacturing plant around the world helping people make their products. So those eight motion control technologies you see in the lower right are being put to use to help society. And if you go to the next page on slide eight, A couple more examples, transportation, whether it's heavy-duty truck or air freight to give products to customers, power generation for electricity. We're on traditional as well as renewables. And I think the best example and the poster child of this crisis is really the ventilator. We do a fair amount in health care, but the ventilator in particular, we have almost doubled our sales in this calendar year of 2020, and we have six of our eight technologies on the ventilator. And we've been supporting new technologies. and existing customers as well as countries from around the world. And the divisions that have been doing this have just done a herculean job staying up with customers and just a fantastic job. My compliments to all of them. So the next slide is our purpose statement, enabling engineering breakthroughs that lead to a better tomorrow. We released this last September, and I can tell you we probably never envisioned how positive an impact it's had on our people, and it really has become a rallying cry. for our organization through this crisis. And it illuminates, I think, the purpose and what we bring to society and gives a great deal of meaning for our people and what they do day in and day out. Moving to slide 10, a quick snapshot of facility and supply chain status. And you go to that middle column, just did the major regions and total parker. So this is percent capacity versus pre-virus, using pre-virus as 100% as an example. We're virtually back to normal at 97%. There was obviously a lot of things that went on through the quarter and in April with stay-at-home orders and all that that moved this up quite a bit. Our supply chain strategy on the right-hand side has done great and very effective during a crisis. You've heard me talk about this in the past, but we make, buy, and sell in the region for the region. We've also got a very robust supply supply chain risk mitigation strategy that we've been doing for years, well before this started. So we're in very good shape on that. This is a non-issue for us. Moving to 11, I want to talk about the quarter. And I would just, if I had to summarize, I would tell you this is probably one of the best quarters that we've ever done, given the environment that we're in. It was really just remarkable performance by the team. Starting with safety, we had a 27% reduction in recordable incidents, And that yields, when you look at reportable incident rates, so that's the number of safety incidents per 100 people, we're a top quartile company, which is fantastic progress. Sales were flat year over year. Acquisitions all set to decline. We had an organic end currency. But the margins really were stellar. They really stood out. So we've got two categories here. Without acquisitions, and I would call your attention to the adjusted segment operating row, and you see we came in at 17.3% for the quarter last year. versus 17.2% in FY19, same quarter. So 10 basis point improvement, 16% decremental. And remember, this is on about a 7.5% organic decline. So just fantastic progress by the teams to pull that off. And then when you put acquisitions, it's easier to look at EBITDA to make it apples to apples. If you look at EBITDA margin on an adjusted basis, that last row, you can see we came in at 19.3%. so a 60 basis point improvement versus the prior period. And this speaks to two things. One, the base business keeps getting better and is performing better, and we acquired companies that have accretive EBITDA margins to Legacy Parker, which is helping fuel that margin expansion. One more page on highlights for the quarter on slide 12. Our EPS performance, as you saw, was very strong, exceeded expectations. We had a record Q3 year-to-date cash flow, so records mean a record in the history of the company of $1.3 billion, which was great. The CFOA margin was 12.3%, and the free cash flow conversion rate was 122%. We were very pleased with our debt reduction of $611 million. That was a very nice reduction. That helped reduce our leverage from 4.0 to 3.8 when you look at it from a gross debt to EBITDA. So you can see from these two slides and how the quarter went, we performed extremely strong. So we're going into this pandemic in a very strong financial position. So on slide 13, we have the order rates. And this is traditionally in Kathy's section, but we wanted to pull it up earlier to allow me to talk about April. Just a reminder on this page, industrial orders are a three-month year-over-year comparison, and aerospace is a 12-month year-over-year, rolling 12-month year-over-year comparison. and excludes acquisitions and currency. But I think the next, so you can see what happened there a little bit better, driven primarily by international, but it's probably a little more illustrative if you go to slide 14, where we talk about April in particular. But I just want to emphasize that while Q3 got a little better, there was a distinct drop, and we felt it in March, in the middle of the month. So on a daily rate basis, you've got to remember that the prior site is three months rolling up, When you look at a daily basis, we were clearly feeling this in March already. And so that was impacting us. The pandemic was declared March 11th, and we had IR Day on March 12th. And I think just as soon as the cameras stopped rolling, the stay-at-home orders started up pretty much around every country around the world. China had already started that. And so what you're looking at this page is a 112, not a 312. So this is April, month of date 12. versus April month-to-date of the prior period. Again, it excludes acquisitions and currency. The month hasn't closed, hence why we have ranges on here. And orders were clearly influenced by those stay-at-home orders that I referred to and extensive customer plan shutdowns that happened through the month of April and started in March, for that matter, as well. But the one positive note here is that our orders have stabilized the last two weeks. So that's a very good sign. So as a result of that, in slide 15, we've taken decisive cost reduction actions in the fourth quarter. And I would give you a hockey analogy. We are skating to where the puck was going. We saw this decline happening. We felt it in the middle of March. And we started these actions in March. And so we started right at the beginning of April. These were effective April 1st. Now, these actions are really in two distinct buckets. The first is discretionary. which will vary based on order entry, and it will flex to the amount of orders and business that we have. So that's the first category. The second is permanent structural cost actions that are predominantly SG&A, and that will be across the company, but in particular focusing on aerospace and oil and gas and markets that are low for longer that need structural actions to them. So let me just take one at a time here. So on the discretionary side, we have salary-based wage reductions, and you can see the various elements here. All of our salary team members around the world and our directors took a 10% base salary reduction. Our officers are in the 20% to 30% range, and myself at 50%. Now, this is effective April 1st, and it's effective for 90 days, and we'll evaluate whether we need to extend it when we get to Q1, and that evaluation will be dependent on how order entry is doing and how the business is progressing. The next category you see there is reduced work schedules. And that could range anywhere from a reduced work schedule of 10% to 100%. And we could take a plant down one day a week. It could go down for several weeks at a time. And it depends on really the activity in that plant. And we're very much matching work hours to order entry. And we've had terrific, terrific collaboration around the world from all of our colleagues, works councils, et cetera, too, use this as a very effective tool to adjust business to order entry. We're foregoing annual merit increases, and we're reducing travel and basically reducing everything that's not moving we're not spending. So you add up all that, that comes to a $250 to $300 million cost reduction in Q4. And then as I referred to on the structural side, those are SG&A-related reductions in force. And if I was to highlight aerospace costs, we are going to do an approximate 20% reduction of force in the number of people that we have in the aerospace group. And that yields a $25 to $30 million cost reduction for the quarter. Add that up, that's $275 to $330 million. So we're targeting an approximate 30% decremental margin. We're planning for an L type of recovery here, where the L is going to have the bottom of the L, the horizontal side is going to have some variation here. and a variation that is not known at this point. We're planning conservatively on the cost and cash side for an L, but you notice very distinctly with the way we've done in discretionary, we absolutely had the flexibility that L turned into a modified V or to a U that we could respond at a moment's notice to any kind of growth because our discretionary side is very flexible. If you go to 16 on the cash side, we're conserving capital spending, as you might imagine, We're optimizing working capital, which is a traditional strength of the company. You go through all of our past recessions. This is a legacy that we've always done extremely well in. We're temporarily suspended a 10B51 share repurchase program, and we will maintain the dividend payout and the annual record of increasing dividends paid. Just as a footnote, our annual dividends paid in FY19 was $3.16, and FY20 was $3.52. It's a record we're proud of, and it's a record that's going to continue. We're confident. You look at all these actions on the cost side and the cash side and generating a greater than 10% CFOA going into the future. So I want to close out my opening section with the transformation of the company, and it starts with the wind strategy. Whether it was the original wind strategy almost 20 years ago, wind strategy 2.0 in 2015, to today, wind strategy 3.0, this is the engine behind our success. and it's going to create a very powerful future for us. This is the highlight of Investor Day, so I won't go back through that as we just did that last month. On slide 19, this unmatched breadth of technologies is even more clear today because it's a portfolio that is unmatched and gives us a competitive advantage, but it's also a portfolio that is very much needed in society. And the fact that 60% of our revenue comes from customers that buy from four or more of these eight technologies is is recognition that our customers feel the same way. On slide 20, we've been very strategic in upgrading the portfolio. This is a list of three transformational acquisitions, adding to filtration, engineering materials, and aerospace. And even in these trying times, we see the power of these deals. Their top lines, all three of them, have been far more resilient than Legacy Parker, and the EBITDA margins have been nicely accretive. If you go to slide 21, This is the chart we showed at Investor Day, and we've got two stair steps in here. The black is as reported operating margin, and the orange is adjusted operating margin. And this is how we've done the last five manufacturing recessions, and this is remarkable progress from where we were when the original wind strategy was launched. Five recessions, and these stair steps, they really speak to the improvement that we've done over many recessions. And you get ready for your current recession. many years before. So the reason why we're performing as well as we are now is we've been changing the cost structure for the last five years, and we've been working at this for the last 20. Our Q3 year-to-date adjusted operating margin at 16.7% was already in a tough environment. I would remind you that year-to-date, if I add organic and currency together, it's about a minus 7% environment. So we are performing at remarkably high levels in a tough environment. That's an almost 900 basis point improvement from when the wind strategy was first launched. Now, obviously, Q4 is going to put downward pressure on that number, but we will still end the year significantly better than we've been in any prior recession. On 22, there's a look at cash flow, and I would just call your attention to the blue line, which is the CFOA margin line. And you can see we've been extremely resilient over many cycles, Good times and bad times, this company generates 10% or greater CFOA and 100% or greater free cash flow conversion. We've did it before. We're going to do it again. This graph hopefully speaks to the resiliency of the cash flow for the company. And on 23, the outlook for FY20, you know, the current environment is highly uncertain, as all of you, I think, can certainly understand and appreciate, making it very difficult for us to guide with any kind of accuracy or reliability, hence the or we're throwing the FY20 guidance. The portfolio and the cost structure has been transformed in the last five years. That's why we've been performing as well as we have been, and the proof is really in those slides I just showed you. We have come out very rapidly and assertively to adjust costs to the current environment, and as I just spoke to, our cash flow is very resilient. And we have a bright future. The one strategy 3.0 and our purpose are going to propel us as soon as we get through this crisis and propel us through this crisis as well. So with that, I'm going to hand it back to Kathy for details on the quarter.

Okay, thanks, Tom. I'd like you to now refer to slide number 24, and I'll summarize the quarter. This slide presents as reported and adjusted earnings per share for the third quarter. Adjusted earnings per share for the quarter were $2.92 compared to $3.17 last year. Adjustments from the current fiscal year as reported results netted to 9 cents, including before-tax amounts of business realignment charges of 10 cents, acquisition costs to achieve of 6 cents, and acquisition transaction expenses of 14 cents. These were offset by the tax effect of these adjustments of 7 cents and the result of a favorable tax settlement of 14 cents. Prior year third quarter earnings per share has been adjusted 3 cents the details of which are included in the reconciliation tables for non-GAAP financial measures. On slide 25, you'll find the significant components of the walk from adjusted earnings per share of $3.17 for the third quarter last year to $2.92 for the third quarter of this year. Starting with the net decrease of $0.07 in segment operating income, For Legacy Parker, a $329 million decline in sales resulted in only a $54 million reduction in operating income, or 31 cents. The Parker teams did an excellent job of controlling costs on the lower volume, resulting in a Legacy Parker decremental margin of 16% for the quarter. The Lord and Exotic acquisitions contributed 24 cents in operating income. Lower net corporate G&A and other expense contributed 3 cents this quarter as a result of currency gains on forward hedge contracts. We incurred incremental interest expense of 19 cents year over year. After adjusting out the benefit of a favorable tax settlement, a higher tax rate from continuing operations and less favorable discrete adjustments resulted in a 4 cent reduction from income taxes. On slide 26, you'll find the significant components of the walk from the previous third quarter adjusted earnings per share guidance at the midpoint of $2.36 to $2.92 for the third quarter fiscal year 20 actual results. Segment operating income contributed $0.43 more to the quarter than anticipated. Our guidance was developed at the start of the COVID-19 scare in Asia, and we anticipated a 16% drop in international organic sales, but actually achieved only a 10% organic decline. The aerospace segment, on the other hand, experienced more impact in the quarter than was anticipated. Our quick reactions to controlling costs and the resulting higher margins also contributed to the higher-than-expected operating income. Lower net corporate G&A and other expense contributed $0.10 due to the previously noted currency gains in the quarter. Lower interest expense due to reductions in debt and lower variable interest rates in the quarter resulted in a $0.02 per share improvement. Slide 27 shows total Parker sales and segment operating margin for the third quarter. Organic sales decreased year over year by 7.4%. and currency had a negative impact of 1.5%. These declines were more than offset by the positive impact of 9.3% from acquisitions. Total adjusted segment operating margins were 16.9% compared to 17.2% last year. This 30 basis point decline is net of the company's ability to absorb 100 basis points of incremental amortization expense from the acquisitions. On slide 28, we're showing the impact Lord & Exotic had on the third quarter, fiscal year 20, on both an as-reported and adjusted basis. Sales from the acquisitions were $343 million, and operating income on an adjusted basis was $42 million. The operating income for Lord & Exotic includes $35 million in amortization expense. Note the improvement of 10 basis points in legacy Parker operating income despite the $329 million drop in sales. The great work the teams did on controlling costs resulted in a 16.4% decremental margin for the quarter. Moving to slide number 29, I'll discuss the business segments, starting with Diversified Industrial North America. For the third quarter, North American organic sales were down 7.1%, while acquisitions contributed 8.9%. Operating margin for the third quarter on an adjusted basis was 17.1% of sales versus 16.5% in the prior year. This 60 basis point improvement is after absorbing 100 basis points of incremental amortizations. North America's legacy businesses generated an impressive decremental margin of 4%, 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 30. Organic sales for the third quarter in the industrial international segment decreased by 10.2%. Acquisitions contributed 6.2%, and currency had a negative impact of 4%. Operating margin for the third quarter on an adjusted basis was 16.2% of sales versus 16.5% in the prior year. Without the incremental amortization expense, margins would have improved 10 basis points on an overall 8% reduction in sales. The legacy businesses generated a very good decremental margin of 19%, again reflecting diligent cost containment and the impact of the wind strategy. I'll now move to slide number 31 to review the aerospace systems segment. The aerospace systems sales increased 16.7% from acquisitions, while organic sales declined 2.4%. Declines in OEM volumes, primarily commercial, were partially offset by higher commercial and military aftermarket sales. Operating margin for the third quarter was 17.4% of sales versus 20.7% in the prior year. Incremental amortization expense impacted the change in margins 160 basis points. Lower earnings were driven by the OEM volume declines, higher engineering development costs, and a less favorable aftermarket mix, Good margin performance from Exotic and hard work by the teams on cost containment and productivity improvements helped contribute to the solid performance in the quarter. On slide 32, we're showing the impact Lord and Exotic has had year-to-date fiscal year 20 on both an as-reported and adjusted basis. Sales from the acquisitions totaled $651 million, and operating income on an adjusted basis contributed $82 million. This operating income includes $65 million of amortization expense. Adjusted EBITDA from Lord & Exotic is 26.3%. With this meaningful contribution from acquisitions, total Parker adjusted EBITDA has increased to 19% year-to-date compared to 18% for the same year-to-date period in fiscal year 2019. In slide 33, we report cash flow from operating activities. Year-to-date cash flow from operating activities was a record $1.3 billion, or 12.3% of sales. This compares to 12.1% of sales for the same period last year, after last year's number is adjusted for a $200 million discretionary pension contribution. Free cash flow for the current year-to-date is 10.5% of sales, and the conversion rate to net income is 122%. Moving to slide 34, I'd like to discuss our current liquidity and credit positions. Our cash, as of the end of the quarter, was $0.7 billion. The majority of this cash is overseas, allowing the international operations to be self-financed. Our long history of free cash flow exceeding net income during growth periods as well as recessionary periods gives us strong confidence in our cash flow outlook. With additional emphasis on our well-established cash management practices, we are optimizing working capital, taking advantage of the government tax payment deferrals, and reducing our capital expenditure investments. We have temporarily suspended our 10B51 share repurchase program, but as Tom described, we remain committed to paying our shareholders a dividend and we're confident we have the cash available to do so. We have a $2.5 billion revolving credit facility readily available should we need it, and we have no major debt repayments due until fiscal year 23. We remain active in the commercial paper market, and as of the quarter end, we held $.9 billion in commercial paper debt. The only active financial covenant in place is to maintain a gross debt to total cap ratio below 65%. We are currently at 59.4%, and we have $2.5 billion of headroom where we're in need of additional debt. Our gross debt to EBITDA leverage metric at the end of the quarter was 3.8 times, down from 4.0 times at December 31. We were able to pay down $611 million of debt during the quarter, and as we build a full 12 months of EBITDA from the acquisitions, the metric will become more meaningful. As Tom mentioned, we are withdrawing our fiscal year 20 guidance due to the uncertainties we are still facing through this quarter. We ask that you continue to publish your estimates using adjusted results for a more consistent year-over-year comparison. As a reminder, we will be revising our method of reporting adjusted results to include adjusting out the acquisition-related amortization expense but we do not intend to make that change until fiscal year 21. We ask that you do not adjust for amortization expense in your estimates until we all consistently make that change. If you'll now go to slide number 35, I'll turn it back to Tom for summary comments.

Thank you, Kathy. We are confident in our ability to emerge stronger than we've ever been before, and that confidence and that hope really comes from a couple of factors, the wind strategy, the portfolio we have of needed products and technologies, our culture, and our purpose, and probably most importantly is the last page, our team of people, fantastic team of people, which we tried to show as many as we could here on this page from all around the world. And what this crisis has clearly exposed and shown is just what an important role everybody plays within the company. I would just like to, again, thank the global team for an extraordinary job, thank them what they've done to date, and thank them for what we're going to do in the future. And with that, I'll turn it over to Lateef to start the Q&A.

Thank you, sir. As a reminder to ask a question, you will need to press star 1 on your telephone. To withdraw your question, press the pound key. Again, that's star 1 on your telephone to ask a question. Please stand by while we compile the Q&A roster. Our first question comes from the line of Nigel Coe of Wolf Research. Your line is open.

Thanks. Good morning. Can you hear me? Good morning, Nigel. We can hear you well, yes.

Great. Okay, great. So, Tom, you mentioned that you're planning on an L-shaped recovery, and I'm just wondering what that means in terms of balance sheet liquidation inventories. It suggests that you're going to be very aggressive in terms of liquidating the balance sheet. So my real question is, four key guidance obviously has been withdrawn, but... Do you have confidence that you can still generate $1.8 billion of free cash flow versus the 1.3 year-to-date?

Nigel, yes, because we typically are fourth quarter, even in tough times, it's always a very strong quarter for us. And we will have the advantage of working capital generating a lot of cash for us in Q4, and that should help us quite a bit. And so we still see that that 10% or greater CFOA as percent of sales is going to continue, and we'll do a good job in Q4. I think what I want to emphasize is we're planning for an L to be conservative, but we have the flexibility with whatever shape letter it turns out to be. And, of course, nobody knows at this point, but we have the supply chain flexibility. We have the people flexibility to respond in whatever direction it works.

Great. Thanks, Bill. And then my second question is on the deck rental margins. You've obviously done a fantastic job, especially on the legacy target businesses. Your comments on the four Qs seem to suggest that there's going to be some deterioration in the run rates given the volume drop-off that you're expecting. But given the cost of talent measures you're putting in place, I'm a little bit surprised that maybe deck rentals can't be managed below 30%. So I'm just wondering what you're expecting in terms of deck rental margins based on your scenario planning.

Well, like I have on that slide that I outlined all the cost reductions, we're targeting a 30% decremental. A 30% decremental is still best in class if you benchmark other companies. And doing a 30% decremental approximately in this kind of climate is really, really good performance. Who knows what the quarter is going to turn out to be? I would suggest to the folks listening that April is probably our low point and that we would see may start to improve a little bit and then improve a little bit after that with June. But if you can do decrymentals like this in this kind of environment, that's really outstanding performance. I agree. Good luck.

Thanks, Nigel.

Thank you. Our next question comes from the line of Nick Dobrek up there. Your line is open.

Thank you. Good morning, everyone. I'm glad to hear you're doing well. I'd like to ask a question on aerospace. The color that you've given us on April is quite different than the orders prior to coronavirus becoming an issue. And I guess I'm wondering, how should we be thinking about this softness in orders playing through to fundamentals next quarter and over the next couple of quarters? How does it flow to revenues? and how should we think about decremental margins in this segment specifically?

Meg, it's Tom. So I think obviously we haven't disclosed until this time aerospace on a 112 because it is lumpy and there's a lot of multi-month, multi-quarter, multi-year type of orders that get in there. So it can sometimes be misleading either on the positive or the negative side when you look at it. But aerospace, what we're planning for is a significant change It's going to go through a tough time, and you've got the commercial side that's going to come down very strongly, but we have a really great military business. So we're basically two-thirds commercial, one-third military, and that military business is growing very nicely. So our 20% reduction in force will be in addition to those discretionary things for aerospace. So we'll do the 20% reduction in force. That's a permanent SD&A challenge to kind of reshape for this new normal, but we will continue the reduced work schedules, the salary reduction, the things I have on the discretionary page that I outlined, so that aerospace can flex as well. And we feel very good that aerospace will be able to do well in this new environment. The exotic team that's come on is performing well. They're performing well. better than Legacy Parker, and it has an over 60% military business. So aerospace long-term, long, long-term, is still a great business. It's going to have a couple years here of challenges, and we're reshaping the portfolio to win in this new reality, and we're doing it very quickly.

Understood, Tom. But is there a way to maybe talk about this business sequentially from a revenue standpoint? Just trying to make sure that we have our expectations properly gauged there.

Well, we're not guiding, so I'm not going to start spouting off what I think Q4 is going to be. But I think you can look at order entry there. And you can also recognize that we do have very strong backlogs in this business. So we have the ability to continue to work backlogs. And actually, the backlogs have held up fairly well. When I look at backlogs going from March to April to date, Commercial OEM is at about an 11-month backlog, and military OEM is at an almost two-year backlog. Commercial MRO, if you remember at IR Day, we talked about a two-and-a-half month. It's still about two-and-a-half months. And military MRO is at about a 16-month backlog. So the backlogs are holding up. I would tell you what customers are doing is they're more rescheduling quantities, and that's what we're doing is we're reshaping. our supply chain demand, and our people to that new reality.

Appreciate the call.

Thank you. Thanks, Mick.

Thank you. Our next question comes from Andrew Obin of Bank of America. Your line is open.

Sorry, can you hear me? I apologize. Yes.

Good morning. Good morning.

Good morning. Just a question. Can you just talk maybe about region-specific trends on orders? You provided great granularity on orders by segment in April, but maybe just compare and contrast how Asia, Europe, and U.S. – well, U.S. you have, but how, you know, the pace of recovery in Asia and what do you see at the end of the tunnel in terms of your China experience?

Either is time. So I'll address that. Let me start with, I'll give you the Q3. I recognize maybe a lot of you won't need Q3, but I'll give it to you for context, and then I'll go into April and China, your specific question. So you saw the orders on Q3, and the improvement that we saw before middle of March was really international. It was both EMEA and Asia, and you saw aerospace orders stay level, and that was because we had very strong military OEM orders. When you look at it by kind of subsegment, and this is organic, and you've already seen total parker at minus 7.5, aerospace at minus 2.5, but distribution was down about mid-single digits, pretty much steady versus the prior quarter. Again, this is a Q3 market summary. Industrial was down mid-single digits, a slight improvement, about 200 pips improvement versus Q2, and then mobile was down low teens. and it had a slight improvement versus Q2. The markets that were positive, we had some very strong markets that were positive in Q3. Greater than 10% was power gen and semiconductor. We had two markets that were positive, low single digits, marine and mining. And then on the declining markets, I'll just give you in various buckets, low single digit decline was mills and foundries, mid single digit declines, refrigeration, oil and gas, lawn and turf and distribution. high single-digit declines in life science and automotive, and then that 10% to 20% decline was tires, telecom, construction, heavy-duty truck, agriculture, and rail. Now to April, Andrew. So what we saw in April so far, so you saw the segments. Let me give you color on international. So on that page, slide 14 in the deck, it's 25-30 down. but Asia Pacific was down about minus 5 to minus 10, and then EMEA and Latin America down minus 35 to 40. We did have some positive in markets in April. Life Sciences, I mentioned the amount of ventilator work that we were doing, power generation, semiconductor, as well as aerospace military, OEM, and aerospace military, MRO. All the other ones were negative. The positive, as I mentioned earlier on, was that orders were, stabilized the last two weeks at these levels. So they did not continue to decline, which is kind of the first sign of healing. In May, and this is a guess on our part, is that this will be somewhat similar but slightly better as most of our customer shutdowns start back up in May. But there's been a lot of variations. This is part of why we're not giving guidances. Their start dates have moved very much. Almost every day we get a new letter from a customer moving a start date. and their levels of production have moved and really won't be finalized until they start up, and they'll start at low levels. But we expect May to be slightly better, and then June should build slightly better on that. But your point, and what we're looking at really is what you were getting to, is Asia. So Asia was the first to go in and the first to come out of this. So Asia, while maybe not necessarily foreshadowing what the rest of the world is going to do, it's illustrative to understand what happened So in particular, if I look at China, because that's really the bulk, it's half of Asia at least, in Q3, the trend there, I'm using round numbers on sales, was a minus 30 in January, minus 40 in February, and then flat in March. So we had a very sharp rebound in China orders in March. This was restocking due to the pent-up demand from January and February. And so our thoughts, and about the only region I'm going to give you thoughts on Q4 is Asia. And so I'll give you what our initial estimates might be for Asia. Again, indicative of what might happen as you think about the rest of the world subsequent months down the road is that we have North Asia, China, Japan, and Korea kind of in that minus 5 to minus 10 for the quarter, Q4. Southeast Asia is slightly positive. and then India being down probably in the high teens. Most of India is taking a very hard line in their manufacturing capacity, shutdowns, and that puts total Asia in that minus 5% to minus 10% range for Q4. I would just comment that that visibility is cloudy, clearly dependent on how global trade does and probably mostly dependent on China's economy. The same challenges that we have seen in the rest of the world on small to medium-sized companies are China has the same issue. Those companies need cash. And then the rest of Asia is still operating with partial shutdowns if you look at New Zealand, Singapore, Malaysia, Indonesia, and India in particular. So Asia is the first to start to heal, and that's the indicator that we see at this moment, Andrew.

That's incredibly helpful. And just a follow-up question. How do you gauge the financial health of your distributors, their ability to access capital, to access this environment, and, you know, what do you think financial health for your distribution stands right now? Thank you.

Yeah, Andrew, this is Lee. So, I mean, as you know, we've got incredibly close relationships with all our distribution, and we have constant health checks with them, very current on receivables, just very frank conversations on credit. and we don't have any issues looking through the channel right now to speak of.

That was simple. Congratulations. Thank you, and congratulations and a great quarter. Thank you.

Thanks, Andrew. Thanks, Andrew.

Thank you. Our next question comes from David Rassa of Evercore ISI. Your line is open.

Hi. Good morning. I'm trying to think of a setup exiting this calendar 2Q. I mean, it looks like the way the revenues are playing out, the orders, your decrementals, it seems like you're sort of wide-range EPS for the quarters, like $1 to $1.50 or so. But typically, the next quarter, you have sales down mid-single digit. I would think, just given what's happening here, it should be the opposite. They should be improving from calendar 2Q to 3Q. But I'm trying to understand the setup. When you're saying stabilization... Are you getting any indication? Is this distributor inventories low enough that they're restocking OEMs? You know, we're not stocking up before they're shut down so they have a catch-up. I'm just trying to get a better sense of how comfortable can we be that the first quarter of fiscal 21 can really leverage off that, say, dollar to dollar 50 range. I think people are just trying to get a sense of what's the earnings power after what could be a difficult calendar to keep.

So, David, it's Tom. So I probably won't surprise you. I'm not going to comment on Q1, but I'll give you maybe some thoughts on the other parts of your question. So when I make comments about being more stable, it's the daily rate stabilizing for the last two weeks. And our distributors are smart business people, and they're conserving cash just like everybody else. So they are pretty much being very careful with what kind of things they're going to do on inventory and they're managing inventory. very appropriately. I think our Q1 is going to have an advantage because our cost structure is going to be extremely lean going into Q1. What I can't predict is what's going to happen on the top line. I do think that we will progressively improve, you know, April to May, May to June. But I can't guess necessarily what the year over year is going to be because the pandemic, you have to cycle the pandemic before you start to show really positive gains in but I think sequentially you're going to start to see improvement. The big question is just the rate of improvement. You know, is this an L? Is this an L with, you know, where the bottom of the L starts to move up more aggressively than a traditional L? Is it a U? We don't know. That's why we've designed our ability to flex to that demand if it happens, but have a cost structure that can be there if it doesn't happen as well.

That was sort of the genesis of the question. Okay. If there's any reopening that can be stabilized at all, you would think your revenue sequentially would go against the historical norm. It wouldn't decline mid-single. It should improve. But from your answer, it sounds like it's more OEM right now than it is distributor. And to your point, I'm just trying to figure out the incrementals coming out, because if it's OEM over distributor, you'd argue you'd rather have distributor. But to your point, you're going to have cost outs that should not automatically come back. Right, you should have some leaned-out costs. But, again, it's more OE improving from here or stabilizing, let's say, than I should think it's the distribution. It's more OE.

Okay, so I get your question more, David. So I think you will see improvement, marked improvement, across both channels, OE and distribution, because those order rates that we showed you on that slide for April are pretty equally representative distribution and OEM. maybe slightly better in distribution, but they're pretty much the same. So you're going to see both of them come back. It won't be like, hey, we just get a rebound on OEM and distribution stays the same. You'll get both coming back.

Okay, that's helpful. I appreciate it. And lastly, anything about how you're viewing the world now that changes how you feel about what leverage you want to come down to before? And I know it never was imminent anyway, but we used to talk kind of 12, 18 months, Have you rethought at all what you are comfortable with on leverage before you would lean back forward, be it M&A or repo?

David, it's Tom again. So we still feel strongly we want to get back down to that approximate 2.0 level on a gross debt to EBITDA. That was our feeling before the crisis. It's still our feeling. Okay.

Thank you very much.

Thank you very much. Thanks, David.

Thank you. Our next question comes from Nathan Jones of Stiefel. Your line is open. Good morning, everyone.

Good morning, Nathan.

Just a question on the decrementals first. You guys have some noise going on in the decremental margins with the acquisitions folding in. Is that 30% decremental that you're targeting, including the acquisitions, excluding the acquisitions? How should we think about that?

Nathan is Tom. That would be excluding the acquisitions, the legacy business. But I would just tell you that the two acquisitions are doing extremely well, and I would just want to make one quick comment in case people might have more questions than acquisitions. Part of why you see the improvement in North America is our synergies on Lorde have accelerated. We've gone from what we told you last quarter at $18 million to and FY20 to $30 million. And we've been able to accelerate our SG&A on Lord. And so we look for that. The documental is on Legacy. But we look for the two acquisitions. Both acquisitions, as you saw, are coming in at a really nice, you know, Lord is significantly beating what we thought they'd be in EBITDA. They're approximately 27% EBITDA for Q3. And Exotic was in the mid-20s. And both of those businesses are executing the same kind of cost reductions and cash actions that the rest of the business is doing. So they will continue to be helpful. Their top line is holding up better than Legacy Parker, and their margins are better. So they will continue to help. But that decriminal I quoted was on the Legacy business.

Okay. And then on the cost-out numbers – The $250 to $300 million, it sounded like that was in place on April 1. Are you already at the run rate there? And then the $25 to $30 that's structurally coming out of the aerospace business, how long does that take before that falls into your cost structure?

The numbers that are on that page are what we will feel in Q4. So that's full quarter, you'll feel it. And it's more than just aerospace and the structural. There's oil and gas things we're doing. And there's things really across every group that we're doing as well, but clearly a lot of it is aerospace-driven.

And then just one quick one on the exotic synergies. You talked about the large synergies there. Does the large drop in the expectation for aerospace here reduce the expectation of the amount of synergies that you can get out of exotic over the next year or two?

Yeah, for exotic... We had a pretty minimal amount of synergies, if you remember, it was $13 million. And we recognized that with material savings for Exotic, you've got long supply agreements, and they really weren't going to start to kick in until year 22 and 23. And most of Exotic's synergies were productivity and the one strategy, which we feel very good about. So the $13 million, the short answer is we feel good about that. That's not changing. And I would just highlight again for Exotic, again, Their top line in Q3 was still significantly better than Legacy Parker. We're clearly fortunate that over 60% of that business is military, and we've been able to pull in and accelerate our F-135 work to kind of help cushion what's happening on the commercial side. And so for Exotic to deliver mid-20 EBITDAs, given what's going on, it's just really fantastic performance by them.

Okay, thanks for taking my questions.

Thanks, Samson.

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

Hi. Good morning and nice quarter. Thanks, Jamie. I have two questions. Tommy kept talking about the resilience of Exotic and Lord through the third quarter. Can you sort of talk about trends that you're seeing in April for those businesses? And then my second question with regards to the 30% decremental, I assume that's specific to the fourth quarter. And my question is, if we're in a prolonged sort of downturn, how confident are you with decremental margins because some of the actions you're taking seem like more short-term versus like salary cuts and stuff like that versus long-term? Thanks.

Okay, so let me start with the second part. So the 30% decremental in Q4, that will continue going forward. We'll continue to do the things we have to do to flex the business, to deliver that, And, again, I'm saying approximate, 30%, regardless of what's happening with the top line. I believe that this will eventually start to turn, so you have to be careful that you don't do too many permanent structural actions and prevent your ability to respond. So we will watch that. We obviously won't let the temporary things go on forever because that would be unfair to people, and we would then have to turn them into permanent. But we will look at that quarter to quarter and make those decisions as a team. but I think you can expect the decrementals and the resilience. Remember, the resilience you're seeing now is five years in the making. It's the work we've been doing, and I would say it's even before that. That stair steps on those margins happened because of all the actions we've done over the last 20 years. We've been building a more resilient business model for 20 years now, so this is why we're able to perform here. But specifically, you've seen the margins significantly increase the last five years, and you could point directly to wind strategy 2.0 The trends in April for Lorde and Exotic, so I don't really want to go into too much detail on this. I would just say that Lorde would be probably half as better than what you saw for Legacy Parker, at least half better. I mean half less bad. That's a way to say that in English. And I would say the same thing for Exotic. and even better for Exotic because Exotic is probably going to be able to hang in there at a high single-digit type of decline because of their very strong military business. And that's what's really helping them. We've been able to pull forward, and our customers have approved this, the F-135 work, and we just happen to be very fortunate. Thank you to the Exotic team for having such a big bill of material on one of the premier military programs really in our history.

Okay, thank you. I appreciate the insight.

Thanks, Jamie.

Thank you. Our next question comes from Nicole DeBlay of Deutsche Bank. Your line is open.

Yeah, thanks. Good morning, guys. Morning, Nicole. So I just wanted to talk a little bit more about distributor inventory levels. If you could just comment on, you know, do you think distributor inventories have right size for the current level of demand? I'm just trying to gauge how much restocking would be required as we come out of this and end-user demand increases.

Nicole, this is Lee. You know, my sense is that inventories are in line with demand. They're not buying anything. They're conserving cash. So what I think you would see is a pull-through on real demand through the channel back to Parker Hannafin.

Okay, got it. Thanks, Lee. That's helpful. And then on the leverage, is the expectation that you guys have more opportunity to continue paying down debt in the fourth quarter, or is the next tranche of that likely to be coming in 2021?

Yeah, Nicole, this is Kathy. We'll watch how things are going through the fourth quarter, but if you look at our expectation for cash flow, we will have some flexibility, I believe, to pay down additional debt during the quarter. And if we're comfortable going into next year in the position that we are, then I think we will definitely do that. Got it. Thanks, Kathy. I'll pass it on. Okay. Thanks, Nicole.

Thank you. Our next question comes from Ann Dubman of J.P. Mulligan. Your line is open.

Hi, thanks. This is John McMullen on behalf of Ann. Her question is, can you provide us a little bit more of an update of a lower discount rate environment and weaker equity returns on your pension plan funding?

Sure. This is Kathy. The discount rate that we're currently booking expense to was set last June, and we set it once a year at our June 30 timing, and we're at a discount rate of 3.28%. As we disclose in our queue, if the rate drops 50 basis points, that will have an impact of about $15 million to our expense. We're watching it. As of the June rating last year, we had no required pension contribution due until fiscal year 23. As the rate will likely drop and will have some impact on the need to fund, we don't anticipate it being any sooner than fiscal year 22. And so we have a good year plus before we have any. And that repayment we think would be a pretty minimal amount required. So no funding requirements, we don't think, for the rest of this year and fiscal 21. Okay.

Great, thank you. That's all I have. I'll pass it on.

Okay, thank you.

Thank you. Our next question comes from Stephen Volkman of Jefferies. Your line is open.

Great. Maybe if I could do a couple of longer-term questions here, and I'll just sort of take them together. I'm wondering, it's probably too early to answer a lot of this, but I'm wondering if there's any change in your long-term margin expectations, as you have laid out recently, And second to that, given that things look like they could be a little bit different going forward for some of the end markets, like you mentioned aerospace and oil and gas, does that potentially free up some businesses that might be candidates for the vestiture going forward? Thanks.

Steve, it's Tom. So the margin targets that we gave you an investor day, are still the targets. We're not moving off of those. They're still what we're striving to get to for FY23, and we still think we can do that. From the investor side, oil and gas and aerospace are still great businesses, and we are able to perform well in those end markets, and we use all eight of the technologies into those end markets. So they meet all the performance criteria to stay part of the team, And we'll get through this near-term challenges, and we're going to reshape those businesses to win in this new market. But these are really strong businesses for us, have all the right kind of returns. So, yes, they will stay part of the portfolio. Thank you. Good luck.

Thanks, Stephen.

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

Hi, good afternoon. Maybe just a quick question around aerospace again. So you've taken some fixed cost measures in that business, so the assumption, understandably, is for a prolonged downturn. Maybe just help us understand what you're thinking about aerospace aftermarket, within the commercial side specifically, and is it fair to assume, similar to peers, that decremental margins... on that aftermarket decline will be very, very severe. And then sticking to aerospace, one of the large defense contractors talked about some production choppiness for the F-35 program. Just wondered if you'd seen any of that or expecting any type of slowdown or disruption on that program on the military side. Thank you.

Okay, Julian, this is Tom. I'll start with that one. On the F-35, no, we have not seen any toughness. As a matter of fact, we are accelerating our deliveries, so everything has been fine on that. And then the commercial MRO, you're right. As you might expect, that's feeling a very sharp decline. It's probably in the greater than 50% type of decline area, and that will take a while to heal. You'll need the public to want to get back in airplanes. but they will. If you think about it over time here, I think the leisure traveler, once the right kind of safeguards and comfort are there, will come back, and who knows how long that takes, but they will come back. And the business traveler will come back, but probably not to the levels that you've seen because we've all learned that there's a lot of digital productivity that you can do, and that's why we're designing the structure of aerospace to be able to win because it might take a little while for this to heal. Nobody fully knows, but I think you'll see the leisure side heal faster. The business travel will come back, but probably not come back to 100%. But then you'll have the demographics that were there before, is that aerospace tends to follow GDP historically and tends to follow GDP at 2x GDP. So once you get through this kind of reshaping of aerospace, it will start to then follow that kind of growth rate. which is a nice growth rate, and we will continue to have this business perform well. We will do the things to make aerospace as great a business as it is now, be great in a tough environment. Great. Thank you.

Thanks, Julian. Lateef, we have time for one more question.

Yes, ma'am. That question comes from Andy Casey of Wells Fargo Securities. Your line is open.

Thanks a lot. I hope everybody's well.

Thanks, Andy.

I just was looking for a little bit more color on what you may be seeing on the distribution inventory actions. Going into the quarter, it looked like those might be stabilizing a little bit. Clearly, April, they probably fell off. But is the pattern kind of stabilization and then reacceleration? No.

Andy, I think the way I would characterize it, you're right. They were declining to stabilizing in March. I think the second half of March, you know, the channel saw what was coming. There was a conservation of cash, really not buying anything. We saw a direct impact through our divisions from distribution. And I would tell you in April, as Tom characterized, they're down about as much as the OEMs are down right now. So... I think any kind of rebound we get in demand will facilitate a rebound in demand directly to our divisions.

Thanks, Lee. And then should we kind of look at the distribution in terms of regions as similar to what Tom had laid out in terms of China getting a little bit better, you know, down less, maybe getting better, and then the other regions...

Yeah, I think the way to think about distribution is really the reemergence of the manufacturing base. So, you know, a lot of our distribution is dealing with MRO activities inside the manufacturing space, and when they're closed, they're not buying anything. So we've seen a rebound in distribution in manufacturing. In Asia, China specifically, Europe's been incredibly soft, along with North America and Latin America.

Okay. Thank you very much.

Okay. Thanks, Andy. This concludes our Q&A session and the earnings call. Robin and Jeff will be happy to take your calls should you have any further questions. Thank you for joining us today. Stay safe and enjoy the rest of your day.

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