Parker-Hannifin Corporation

Ladies and gentlemen, thank you for standing by, and welcome to the Parker-Hannifin Fiscal 2020 Fourth Quarter and Full Year Earnings Release Conference Call. At this time, all participant lines are in a listen-only mode. After the speaker's presentation, there'll be a question and answer session. To ask a question during the session, you will need to press star, then one on your telephone. Please be advised that today's conference is being recorded. If you require any further assistance, Please press star, then zero. I would now like to hand the conference over to your speaker today, Kathy Seaver, Chief Financial Officer. Please go ahead.

Thank you, Sarah. Good morning, everyone. Welcome to our teleconference this morning. 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. In slide number two, you'll find the company's safe harbor disclosure statement addressing forward-looking statements as well as non-GAAP financial measures. Reconciliations for any reference to non-GAAP financial measures are included in this morning's press release, and are also posted on Parker's website at phstock.com. Today's agenda appears on slide three. We'll begin with our chairman and chief executive officer, Tom Williams, providing an update on Parker's response to COVID-19. Tom will then discuss highlights from the fourth quarter and full year. Following Tom's comments, I'll provide a review of our fourth quarter performance together with guidance for fiscal year 2021. 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 calls we can today. Please refer now to slide four, and Tom will get us started.

Thank you, Kathy, and good morning, everybody. A couple comments from me before we start slide four. First, I hope that everybody listening in that you and your families are safe and healthy, and I'd like to extend our thoughts to those affected by this crisis. and our deepest sympathies go out to those that have lost loved ones as a result of the virus. I have a special thank you for all the Parker team members that are listening in for their hard work and their dedication in really delivering two high-level accomplishments. First, we delivered outstanding performance during unprecedented times, as you saw by the quarter and by the four-year results, and we're living up to our purpose. We're providing products and technologies that are helping society through the crisis, and we're helping to do our part to create a better tomorrow for people. So on slide four, we talk about our response to the pandemic. It starts with safety. That's the first goal in my strategy, and really when we made that change in 2015, it provided a great foundation for us to respond to this pandemic. We're helping society through the crisis. Our technologies are essential. What was interesting with all the government orders that came out, almost every one of those deemed us as an essential manufacturer. Our purpose and action is more clear than ever, and I'll give you a few examples of that. and our manufacturing capacity has stayed near normal levels throughout the pandemic. The governing principle has really been the takeaway on this page, which is our two safest places that we want for our people is to be at work and at home, and we're doing everything we can to live up to that. So in slide five, the performance during this health and economic crisis, and the confidence in the results that you saw in Q4 really come from this list that you see. I want to just touch on the very last bullet, the engaged people, This is a big change that we made in one strategy 2.0, 2015, and we recognized the strong correlation between safety, engagement, and business performance. We are now top quartile in safety, top quartile in engagement, and you can see the significant progress we're making towards being top quartile on our financial performance based on the results that we just turned in. If you go to the next page, I'm going to talk about the strength of our portfolio and our purpose in action, and on slide seven, is the unmatched breadth of technologies that we have, those eight motion control technologies. They are our competitive differentiator. It's how we bring value to customers. And our customers see it. Sixty percent of our revenue comes from customers who buy or perform more of these technologies. Go to slide eight. Our capital deployment strategy has been thoughtful, and we've been transforming this already great portfolio through these strategic acquisitions. by acquiring Clarkor, Lord & Exotic. This is $3 billion of acquired sales. We bought three great companies, the three largest in our history, and they've increased our resilience because of their technologies and because of their aftermarket content. And you've seen in the results, they are accretive to growth, margins in cash, and this was especially evident during the crisis. And we've been able to equal or beat our synergy goals despite the macro conditions. Slide 9 is our purpose statement, enabling engineering breakthroughs that lead to a better tomorrow, which has really acted as our compass and our guiding light and provided a lot of inspiration to our team. On slide 10, just some examples of that purpose and action. On the left-hand side is the food supply. We're basically from the farm all the way to your kitchen table. Transportation, whether it's truck, air, or rail, we're helping the world move products and goods around the various customers. In the middle section there, on life sciences, we're helping patients, whether it's in the hospital or in the ambulance. And probably the poster child for us and the one that's probably the signature of the purpose and action for the last quarter was the work we did on the ventilator. So six of those eight technologies that I showed on the prior page or two are in ventilators. And we saw dramatic, as you might expect, ramp up in production needs based on what was happening in society. with existing customers, and we took on a lot of new customers. I could not find suppliers that could keep up with this production demand. And in some cases, we went from zero to full production in weeks, and it was really a remarkable job by the divisions involved. On the right-hand side and the upper right, we are an essential manufacturer, as I mentioned earlier. And basically, if you look at any plant in the world, you can probably find a Parker Park somewhere in that plant. So we're an essential manufacturer because we're needed by everybody else. Then in power generation, whether it's traditional renewables, we're there to help customers with their energy source. Moving and shifting to really the summary of the quarter and the full year, on slide 12, it was outstanding. It was, you know, a difficult time, probably the most difficult in the history of the company. The organic growth came in at a 21% decline, so we felt that impact, but we paid down debt by $687 million. That was on top of what we did in Q3. And when you look at margin on the two different categories we're going to look at here, it was just terrific performance. On operating margin, it's better to look at it without acquisitions, given the acquisitions we've got and don't have in prior periods. But if you look at the adjusted growth there, 18.1% versus 17.6%. So a 50 pips increase in Q4 is a 16% detrimental, which is fantastic, actually. on the company. And then without acquisitions, EBITDA is a good way to look at this, apples to apples. If you go down to the last row, 20.4%, 160 base point improvement. Probably the first time, at least in recent memory, that we've elipsed 20% EBITDA margin. So this is really a combination of the base business performing well, the wind strategy, the prior period restructuring, and bringing on acquisitions that are accretive on the margins. If you go to slide 13, quick summary of the full year, we made continued progress. I would just remind people that we were already in an industrial recession before the pandemic hit. So these accomplishments really are up against a pretty stiff headwind. And on safety, 35% reduction in recordable incidents. This puts us in the top quartile. And I would just contrast five years ago, we were in the fourth quartile on safety, and we're now in the first quarter. So remarkable progress there. Cash flow from operations from a dollar standpoint is an all-time record. So that's an all-time record in the history of the company, $2.1 billion. If you've got to hit a record, cash is a good place to hit a record on. You can see the CFOA margins at 15.1%, pre-cash flow conversion on a 52%, and then just some debt metrics, leverage metrics there. You can see that we improved on a gross debt down to 3.6, 3.8 times, then on a net debt standpoint, this is a 3.3 from 3. And FY20 was $1.3 billion, approximately 25% of the transaction debt. So in just a little over eight months of acquisition ownership, we paid off a quarter of the debt that we took on to acquire the company. So just a great job by the teams here. Then moving on 14 to the full year, again, just great margin performance for that. So the full year organic was down about 10%. And, again, same methodology without acquisitions. Look at the operating. which is very hard to do on a volume drop, and came in at a 17% decramental, which is a best-in-class performance. With acquisitions, looking at EBITDA adjusted, we raised it to 19.3%, again, showing the combination of the wind strategy and acquiring companies that are creative on margins to help out the total business. So if you move to the transition here, so the Parker transformation, it's happening. Those numbers that you saw in the prior pages don't happen just by accident or by luck. So what have we been doing to drive that? So if you go to page 16, all roads lead to the wind strategy. And I would say it's the combination of our decentralized divisional structure with the wind strategy that drives this unique ownership culture that is really putting up these kind of results. If you go to page 17, just elaborate a little bit more on what's different. You know, we started off this time period with the major restructuring activities really starting at like 14. And if you look at the cumulative restructuring we did for those three years, it was approximately $270 million of restructuring. So that really set us on a path of putting the right kind of cost structure in place. We built upon that with on simplification in 2015. And remember simplification on a broad standpoint is structure and organization design, on 80-20, and on simplified design. But just from a structures third of the divisions of the company. And we made two major updates to the Parker business system, which is the one strategy. Building on the success of the original one strategy, we did 2.0 in 2015 and, of course, 3.0 just recently. And we're very excited about that because we have a ton of potential. We just launched it and has a lot of runway in front of it. We talked about the power of the companies that we acquired. And you see that resilience coming through in the business cycle. And I'm going to give you two slides coming up that will show you that resilience. looking at both margins and growth. But don't underestimate the takeaway. The purpose statement has really provided creative alignment and inspiration. And there's a big difference between being at work and being inspired by your work. And purpose does that for you. And that's what our people feel about that. So on slide 18, talk about the margin side. And I showed you this last quarter. And this is looking at the last five manufacturer sessions. And I would argue FY20 It's actually got two separate recessions in it. The industrial recession we were already in and the pandemic that came in in March. But you can see whether you look at it on an as reported basis or adjusted, you can see the significant step change in performance over these manufacturing recessions. Something we're very proud of and something that we intend to keep doing. And if you go to 19, this is a look at top line resilience. And go to 19. Okay. So I recognize that the Great Recession and COVID-19 is not the same, but these are two examples of significant shocks to the system. My view of COVID-19 is worse. You look at the GDP reduction across the world in the last quarter, it dwarfs any kind of GDP reduction that happened in the Great Recession. Well, let's just say for the sake of argument that the organic, that the environment was the same. happened to be Q4 as well, and FY09 was down 32%. And then what did we do last quarter? We did minus 21. Now, hopefully, that'll be our worst quarter. Time will tell, but we think it's going to be the worst quarter. So why is it better? There's some distinct structural reasons why it's better. First, the clarifier acquisition is now part of our organic performance, and it has 80% aftermarket, so that's more resilient. The percent revenue that we get from innovative products And the way we calculate that is percent of revenue that's new to the world, new to the market, divided by our total revenue. That, over the last five years, that has more than doubled over this period of time. Innovative production, more resilient, they grow faster, better margins. And then you've heard us talk about how we've changed the mix in international distribution by raising that by 500 pips over this period of time. And we've had better customer experience. We're not there. We have lots more to do on customer experience, but that's been another contributor. So the top line, we're not immune to the cycle. We felt it, obviously, but it is better than we were before. And there's distinct reasons why it's better. And it's only going to get better in the future because Lord and Exotic are not yet in our organic numbers. And you can see by the results we showed so far, they are performing better than Legacy Parker. Moving to slide 20, something we're very proud of, our cash generation history. I mentioned the CFOA record at $2.1 billion. And then we've just been very, very consistent. Good times and bad times, you see 19 consecutive years of double-digit CFOA and greater than 100% pre-cash flow conversion. So I want to move to FY21 and the outlook. And we decided to reinstate guidance. And you can make good arguments as to why not to give guidance with the uncertainty. And we're not trying to pretend that we're any smarter than anybody else because we're not. However, we're four months smarter than we were at the last earnings call. And we've proven that we can operate safely and with strong results. And while the future is uncertain, we felt we are in the best position to communicate to shareholders and provide them the insight as to where we're going. And hence, that's why we decided to do guidance. Of course, it's an opportunity we'll have every quarter, and we'll certainly get smarter as order entry comes in, and we'll update your thoughts as we go through, and certainly we'll go through this in more detail in the Q&A portion of the call. But I wanted to give you that context as to why we decided to guide before Kathy executes some specific numbers. So then if you go to 22, a big part of our success in Q4 was our actions on costs. This is a combination, as I've mentioned, of prior period restructuring, the wind strategy, and all the things we've been doing for years, and then the speed and agility of our pandemic response. But what you see here in contrasting between what we did in Q4 and what we're going to do in FY21 is a strategic shift in the cost to a more permanent cost-action basis. So you can see the little donut chart in Q4 of FY20, 12% permanent, and that's going to move to 55% permanent in FY21. If you look underneath the donut for Q4, you see permanent actions. These are all savings with $25 million. That was spot on what we told you last quarter. And you see the $175 million of savings that was less than what we told you. We told you the range of $250 to $300. And it was lower because our volume was better, which was a good thing. You know, we didn't necessarily give you specific guidance last quarter, but we had our own internal planning. We were projecting a 30% decline in volume. And hence, that's why we gave it a range in discretionary. It came in at minus 21, which we were grateful for, and we didn't need to do as many discretionary actions. We needed people to work more hours, which was a good thing. Then when you move to 21, you see discretionary at $200 million. That'll be mostly in the first half, and we'll gradually wean off of that as we go to the first and predict predominantly in how the balancing plant powers the demand. But then you see the permanent action rising to $259. And if you look at when COVID hit, and you take the second half of FY20, and add to all of FY21, and look at our restructuring costs. So we did $65 million. We're proposing $65 million of restructuring in FY21. We did $60 million in the second half of COVID-related restructuring that's going to generate just $250 million of savings. So that might seem a little more efficient than normal, and the reason for that is it's going to be an asset-light restructuring plan. We will have very few plant closures as a result. That's why it's a lot more efficient than normal. So with that, I'm going to hand it back to Kathy for more details on the quarter.

Okay. Thanks, Tom. I'd like you to now refer to slide 24, and I'll summarize the fourth quarter financial results. This slide presents as reported and adjusted earnings per share for the fourth quarter. Current year adjusted earnings per share of $2.55 compares to $3.31 last year. Adjustments from the 2020 as reported results netted to $0.28, including business realignment expenses of $0.37 and lowered acquisition, integration, and transaction expenses of $0.05. These were offset by the tax effect of these adjustments of 9 cents and the result of a favorable tax settlement of 5 cents. Prior year fourth quarter earnings per share had been adjusted by 14 cents, the details of which are included in the reconciliation tables for non-GAAP financial measures. Moving to slide 25, you'll find the significant components of the 76 cent walk from prior year fourth quarter adjusted earnings per share to $2.55 for this year. With organic sales down 21%, adjusted segment operating income decreased the equivalent of $0.61 per share, or $99 million. Decremental margins on a year-over-year basis were 19%. Decremental margins without the impact of acquisitions were just 16%. demonstrating excellent cost containment and productivity by the teams. Offsetting this decline, we gained $0.07 from lower corporate GNA as a result of salary reductions taken during the quarter and tight cost controls on discretionary spending. Interest expense cost an additional $0.15 of earnings per share as debt is currently at a higher level because of the acquisitions. Income taxes accounted for an additional $0.08 of expense because we had fewer favorable discrete tax credits in the current quarter. Slide 26 shows total Parker sales and segment operating margin for the fourth quarter. The fourth quarter organic sales decreased year-over-year by 21.1%, and currency had a negative impact of 1.1%. Acquisition impact of 8.1% partially offset these declines. Total adjusted segment operating margins were 17.4% compared to 17.6% last year. This 20 basis point decline is net of the company's ability to absorb approximately 100 basis points, or $33 million of incremental amortization expense from the acquisitions. On slide 27, we're showing the impact Lord & Exotic had on fourth quarter fiscal year 20 on both an as-reported and adjusted basis. Sales from the acquisitions were $298 million, and operating income on an adjusted basis were $32 million. The operating income for Lord & Exotic includes $35 million in amortization expense. I'd like to point out that the improvement of 50 basis points in legacy Parker operating income, despite the $818 million drop in sales, the great work the teams did on controlling costs resulted in a 16% defermental margin for the quarter within the legacy businesses. Moving to slide 28, I'll discuss the business segment, starting with diversified industrial North America. For the fourth quarter, North America organic sales were down 24.7% while acquisitions contributed 7.6%. Operating margin for the fourth quarter on an adjusted basis was 16.5% of sales versus 18.4% last year. This 190 basis point decline includes absorbing approximately 60 basis points or $9 million of incremental amortization. North America's legacy businesses generated an impressive defermental margin of 24%, reflecting the hard work of diligent cost containment and productivity improvements, a favorable sales mix, together with the impact of our wind strategy initiatives. I'll continue with the diversified industrial international segment on slide 29. Organic sales for the fourth quarter in the industrial international segment decreased by 15.4%. Acquisitions contributed 5.4%, and currency had a negative impact of 2.9%. Operating margins for the fourth quarter on an adjusted basis increased to 16.8% of sales versus 16.4% last year. This 40 basis point improvement is net of the additional burden of approximately 110 basis points, or $12 million of incremental amortization expense. The legacy businesses generated a very good defermental margin of just 9.8%, again reflecting diligent cost containment, a favorable mix, and the impact of the RIN strategy. I'll now move to slide 30 to review the aerospace systems segment. Organic sales decreased 22.3% for the fourth quarter, partially offset by acquisitions contributing 14.3%. Declines in commercial OEM and aftermarket volume were partially offset by higher sales in both military OEM and aftermarket. Operating margins for the current fourth quarter increased to 20.4% of sales versus 17.9% last year. This is net of the incremental amortization expense impact of approximately 190 basis points, or $12 million. A favorable mix, proactive realignment actions, cost containment, and lower engineering development costs contributed nicely to the quarter. 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 31, we're showing the impact Lord and Exotic has had during fiscal year 20 on both an as reported and adjusted basis. Sales from the acquisitions for the year totaled $949 million and operating income on an adjusted basis contributed $114 million. The Lord team was able to pull forward synergy savings reaching a run rate of $40 million by the end of the year. These savings plus a great deal of hard work by the teams on integration, productivity, and adjusting to lower volume due to the pandemic, helped the acquisitions be $0.04 per share accretive for the year after absorbing $100 million of amortization expense. Adjusted EBITDA from Lord & Exotic is 26.3%. With this meaningful contribution from acquisitions, fiscal year 20 total Parker adjusted EBITDA has increased to 19.3% as compared to 18.2% for fiscal year 2019. Note that the legacy Parker business was able to improve EBITDA margins 60 basis points to 18.8% despite lower sales of nearly $1.6 billion. On slide 32, we report cash flow from operating activities. We had strong cash flow this year, resulting in record cash flow from operating activities of $2.1 billion, or 15.1% of sales. This compares to 13.5% 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 is 13.4% of sales, and the conversion rate to net income is 152%. Moving to slide 33, I'd like to discuss our current leverage and liquidity position. Based on the continued strong free cash flow generation and effective working capital management, we made a sizable $687 million reduction to our debt during the quarter, which brought our full-year debt reduction to $1.3 billion, which is approximately 25% of the debt issued for the Lord & Exotic metals acquisition. I apologize for a typo on the slide. The second bullet should be $1.3 billion rather than $1.3 million. With this reduction, our gross debt EBITDA leverage metric at the end of the quarter was 3.6 times, down from 3.8 times at March 31st, despite the drop in EBITDA. Our net debt to EBITDA reduced to 3.3 times from 3.5 times at March 31st. We've continued to suspend our 10b51 share repurchase program, and we remain committed to paying our shareholders a dividend, and we intend to uphold our record of annually increasing the dividend paid. Moving to slide 34, we show the details of current order rates by segment. Total orders decreased by 22% as of the quarter ending June. This year-over-year decline is a consolidation of minus 29% within Diversified Industrial North America, minus 21% within Diversified Industrial International, and minus 5% within Aerospace Systems Orders. Just a reminder that we report the Aerospace Systems Orders on a 12-month rolling average. The full year earnings guidance for fiscal year 21 is outlined on slide 35. Guidance is being provided on both an as-reported and an adjusted basis. Beginning with this fiscal year 21, guidance, as we've previously announced, we are revising our disclosures for adjusted segment operating earnings and adjusted earnings per share. With this guidance, we will now start to include acquisition-related intangible asset amortization expense in our adjustments. We think these adjusted results will provide a better representation of our core operating earnings year over year. In the appendix of today's slides, you can find the impact of the acquisition-related asset amortization expense on fiscal year 19 and fiscal year 20. In today's pandemic environment, total sales for fiscal year 21 are expected to decrease between 10.7% and 6.7% compared to the prior year. Anticipated organic decline for the full year is forecasted at a midpoint of 11.3%. Acquisitions are expected to benefit growth at a midpoint of 2.7%, while currency is projected to have a marginal negative 0.1% impact. We've calculated the impact of currency to spot rates as of the quarter ended June 30, 2020, and we have held those rates steady as we estimate Estimate the resulting year-over-year impact for fiscal year 21. You can see the forecasted as reported and adjusted operating margins by segment. At the midpoint, total parker adjusted margins are forecasted to decrease approximately 80 basis points from prior year. For guidance, we are estimating adjusted margins in a range of 17.8% to 18.4% for the full fiscal year. The full-year effective tax rate is projected to be 23%. For the full year, the guidance range on an as-reported earnings per share basis is $7.41 to $8.41, or $7.91 at the midpoint. On an adjusted earnings per share basis, the guidance range is $9.80 to $10.80, or $10.30 at the midpoint. The adjustments to the as-recorded forecast made in this guidance at a pre-tax level include business realignment expenses of approximately $65 million for the full year fiscal 2021, with the associated savings projected to be $120 million in the current year. We anticipate integration costs to achieve of $19 million. Synergy savings for Lorde are projected to hit a run rate of $80 million. and for exotic, a run rate of $2 million by the end of the year. And, in addition, acquisition-related intangible asset amortization expense of $321 million will be included in our adjustments. Some additional key assumptions for full-year 2021 guidance at the midpoint are sales will be divided 47% first half, 53% second half, Adjusted segment operating income is divided 43% first half, 57% second half. Adjusted earnings per share, first half, second half, is divided 40%, 60%. First quarter fiscal 2021 adjusted earnings per share is projected to be $2.15 per share at the midpoint, and this excludes $0.67 per share, or $115 million, of projected acquisition-related amortization expense, business realignment expenses, and integration costs to achieve. On slide 36, you'll find a reconciliation of the major components of fiscal year 2020 adjusted earnings per share compared to the adjusted fiscal year 21 guidance of $10.30 at the midpoint. Fiscal year 20 adjusted earnings per share was reported as $10.79, To make it comparable to the fiscal year 21 guidance, which includes an adjustment for acquisition-related asset amortization expense, we show the adjustment of $1.68 to get to a comparable $12.47. With organic sales down over 11%, adjusted segment operating income is expected to drop approximately $1.95. This would result in decremental margins of 27% on a year-over-year basis. Corporate DNA and other expense is projected to negatively impact earnings per share by 36 cents because of gains achieved in fiscal year 20 that are not anticipated to repeat. Offsetting these declines, interest expense is projected to be 29 cents lower in fiscal year 21. An income tax rate of 23% will reduce earnings per share by $0.10 year over year. And the assumption of a full year of suspending share buybacks is projected to result in a $0.05 dilution due to an increase in average shares outstanding. We ask that you continue to publish your estimates using adjusted guidance, which should now include adjusting for acquisition-related amortization expense. This concludes my prepared comments. Please turn to slide 37. I'll turn it back over to Tom.

Thank you, Kathy. I thought we would close with what is probably an obvious question on most people's minds, is how do you feel about the FY23 targets that you just outlined on IR Day, given the pandemic and what it's done? And the short answer is we're still committed to them. We've made tremendous progress on margins, and our top line is clearly becoming more resilient. While the top-line revenue that Cathy articulated in IR Day was $16.4 billion, that will be very hard to hit, but we can still grow faster than the market, which is our intention. So these targets you see in this page, growing faster than global industrial production index, the margin targets at 21% of the out margin in EBITDA, free cash flow conversion in EPS. Barring a recession in FY23, and recognize that we have three full fiscal years left to get here, And provided we get some modest growth as we go in FY22 and 23, we believe we're going to hit these numbers. So, again, I want to just close by saying thank you to the Parker team. Especially thank you for keeping each other safe and for what you've been doing on all of our safety protocols and for the great results that we had in FY20. And I'll turn it over to Sarah to start the Q&A.

Thank you. As a reminder, to ask a question, you will need to press star then 1 on your telephone. To withdraw your question, please press the pound key. Our first question comes from the line of Nicole DeBlaze with Deutsche Bank. Your line is now open.

Yeah, thanks. Good morning, guys. Good morning, Nicole. So maybe starting with the expectation for decremental margins, saw on the slide that you guys are anticipating 30% decrementals. I think that's inclusive of the cost savings plan you laid out. So I guess just maybe frame for us why decrementals should step up from here since the performance this quarter was so impressive.

Yeah, Nicole is tough. So I'll start first. Our decrementals, if you look at the quarters for FY21, our projection, float in a range of 25 to 30%. So still best in class type of performance. The difference between, say, where we were in Q4 and that is a couple things. One, in Q4, we had a little bit of help with mix. We had a lot less mobile business than we had in the past. And that business is typically a significantly lower margin than distribution industrial. disproportionately higher than it normally is. So that is not going to sustain itself. It's going to go back to more normal levels as mobile comes back as we go through the four years. So that will become a headwind. The other part in Q4 is we had, as you saw from the results, a terrific performance by aerospace, which was helped with some seasonal help on the international military MRO. We had a very sharp increase versus prior periods, and that's very high margins that comes with it. So those would be the two key and I looked at all of our peers before we came into this, would still put us in the top quartile position.

Yeah, absolutely. Thanks for that, Tom. And just as my second question, I know you guys have said that you didn't see a ton of improvement from April to May when you spoke previously, but can you maybe characterize what you guys saw in June and anything quarter to date in July?

Yeah, so I'll continue on, Nicole. So through the quarter quarter, We saw industrial North America in the national bottom in May. Improved in June. And July's orders are indicative of what I'll give you kind of how we feel what the first and second half splits for our guide. And then aerospace weakened through the quarter. And I'll do more color on aerospace here in a second. So when you go to the full year, you saw our guide at minus 11. Now that minus 11 is made up of our first half of minus 19. and a second half of minus 3. So what was our thinking as we thought through that? So if you look at it by segment, North America, and I'll start with how Q4 ended, and kind of parlay that into how our thinking about the first half. So Q4 in North America ended at minus 25. Based on the orders we saw in June and July, we see some modest improvement going into the first half. We forecast that at minus 21 for the first half. Then it gets to flat for the second half of 5.21. International came in at minus 15 organically, again, based on order entry in June and July. We had that going to a minus 12, modest improvement, and going to almost flat in the second half as well. The narrow space was minus 22, helped a little bit because of that high international military MRO. We see that weakening a little bit in the first half at minus 26, and then improves, but still So again, you get the first half at minus 19, second half at minus 3, but we get to Q4 when we anniversary the pandemic and we show high single-digit positives. The thing that I would point out, our view on this, and our thinking behind the whole guidance, is that the industrial recovery has started, but it's going to be uneven and there's going to be a fair amount of demand uncertainty, and I think that that improvement is going to follow More or less, it lagged behind how the virus improves. And that's hence why we forecasted a modest improvement in the first half, and we still had aerospace declining as it's a longer cycle, taking a while to adjust out those orders. In the second half, we see things slowly starting to build. And what I would say is positioning for a really good Q4, but really positioning ourselves for an excellent FY22, Industrials are obviously going to outpace aerospace here as far as performance, and Asia is going to run fast with North America and India. So that's just a little color so far on what we think for the guide.

Got it. That's really helpful. I'll pass it on and let someone else ask. Thanks, Tom.

Thanks, Nicole.

Thank you. Our next question comes from the line of Jeff Sprague with Vertical Research. Your line is now open.

Thank you. Good day, everyone. Also, maybe a little clarification on how the cost actions work through, if we could, Tom or Kathy. It's the nature of my question. First, just looking at slide 22. So should we think of discretionary actions then as a headwind in the first quarter of, you know, roughly $125 million? So we're going from 175 in Q4 to 50 in Q1 and running 50 a quarter through 21 to get to that 200?

Jeff, it's Tom. No. Most of the discretionary things will continue in Q1 and we'll start to slowly meter them off in Q2. And so most of it's going to happen. So Q1 will look a lot like Q4 or less. and Q2 will have a small amount, and then you'll have just a very little bout that might trickle into the second half of 21. That portion is hard to predict because it will be very much sensitive to demand, just like how you saw what we did in Q4, how it flexed based on demand. It will flex based on what happens on demand as we go forward. But we're going to continue the discretionary, pretty much full steam for Q1. but the permanent starts to compensate for that based on what we did in the second half and what we're doing in FY21 to cover those total costs that need to come out, plus at the same time our volume is starting to get better as we move through those quarters.

Yeah, so on the permanent then, Tom, sounds like those build over the course of the year. Can you give us a little color on that trajectory, and is that a – Is that indicative of the run rate also as you exit, or do you actually exit at a higher run rate than that 250?

Well, the splits on the 250s, approximately 57% in the first half, 43% in the second half. And so part of what's making up the 250 is we've got $130 million that's carryover from FY20s actions. $65 million of cost that we're incurring in FY21. So it's a combination of the two coming in there.

And just one last one, if I could. On cash flow, greater than 10% now doesn't sound like a real high bar, but are you assuming now, given the performance that you've put up recently, but are you assuming – you know, some kind of negative working capital swing into next year that would be muting the cash flow?

No. Again, Jeff, it's tough. We don't want to go backwards on that percent. The dollar has become tougher, you know, because we're forecasting $1.2 billion less revenue. However, from a percent standpoint, CFOA margin, and recognize that was a really great year at 15%. I'm not saying we can always do that every time. But I can tell you I would not be happy if it came in a 10. So we're going to be looking to be well north of that. And when we come in, we'll see what happens. But the expectation is we will continue to work the working capital. We have opportunities still on inventory. We have opportunities with our acquisitions on inventory. And we're going to work receivables and payables like we normally do. So I would see it being a team effort on the cash flow, just like we've always done.

Thank you.

Thank you. Our next question comes from the line of Joe Ritchie with Goldman Sachs. Your line is now open.

Thank you. Good morning, everybody.

Good morning, Joe.

So, Tom, maybe just digging in a little bit further into the end market trends, and I know a lot of your business is short cycle, so there isn't a tremendous amount of visibility, but it seems like If I heard you correctly, the modest improvement in both North America and international, I mean, there's a way to think about it that July then, you know, for North America was down, let's say, north of 20%, international still down double digits, mid-teens. And then I guess the second part of the question is really as you talk to your distributors, you know, what are they saying about inventory levels and the potential for restock?

Yeah, so let me start with a restocking question. So right now we're forecasting that distribution will continue to probably have some mild destocking for the first half, not as much as what we saw obviously in Q4 with some mild destocking. To maybe give you a little bit more color on the markets, so the minus 11 at the midpoint is North America at minus 11. International at minus 7, aerospace at minus 20. But I want to give you a little bit more insight on international. So we're forecasting EMEA, and these are obviously put a plus or minus on these numbers, at minus 10, Asia-Pacific at flat, and Latin America at minus 10. It's a small part of the portfolio. But we have a number of markets that if I just give you – I'll give you a couple comments, and I'll try not to make this too lengthy – Our view of end markets for the FOA 21, and again, my comments are not trying to position the entire market. I'm just speaking on how Parker's going to do. But what we saw as positive is life sciences, and we're going to continue to see a pretty good first half on that based on the ventilator, but that will decline as we go into the second half. Power generation coming off the bottom still being positive. Semiconductor being positive. And then we'll have aerospace and military OEMs. and aerospace, military, MRO being positive about mid-cycle digits, and automotive actually being positive for a full year. Now, automotive will be negative for the first half, but it turns to be a positive for the second half as we see both the combustion engine volume and, in particular, our content on EV and HEV being such a strong bill of material there that that will drive a lot of growth for us in our engineering materials in the business. And in the neutral category, we've got clean, material handling, mining, ag, telecommunications, refrigeration, and forestry. Then on the negative portion for RFY 21, we've got distribution now. We think distribution has reached bottom, and it started with a slight recovery except for those distributors that support plant gas. I mentioned my comment about the stocking. So it'll be down probably – high single digits in that 5% to 10% range in the first half. Some regions could be worse, turning positive in K4. But we look at Asia being positive for distribution for the full year. And then on the aerospace, which is probably where people have a lot of questions, what do we assume on the aerospace side? So commercial OEM, we assumed a minus 25 to 30, something in that range for the full year. And how we came up with that is we took current anticipated production rates, so the rate that you see published by the air framers and the engine makers, and times our bill of material. Obviously, that's subject to change, but that's based on current production rates that we know of right now. And then on commercial MRO, we forecasted that down at minus 35 and minus 40. And recognizing that that tends to follow available sea kilometers, and so we got our first half being obviously more stressed on commercial MRO at minus 50 and the second half of minus 20 to minus 30. And then rounding out the negative markets of the construction and truck, machine tools, along gas, rail, tires, and mills and pounders. So that's a quick spin through the end markets and how we came up with the guidance. And I would tell you that our process, we use a process which is similar to what we've done in the past, When we take all the in-markets, the top 20, we look at external forecasts, and we build it up kind of by in-markets. We take our divisions and groups and build it up. We also take our customer and distributors. But this year we built an AI model, which is the first time we've ever done this, and we used the last 10 years with the data in our history to help come up with what are the interdependencies on the things that would predict our future forecasts. Now, recognizing we never had a pandemic in the past 10 years, so that's new. And while the AI model was helpful, until we have more months of the pandemic in there, it will continue to be refined. So there was a fair amount of science, but I would just tell you this is a forecast. We all know what happens with forecasts. This is our best effort at this point to tell you what we think is going to happen.

Thanks, Tom. That was very helpful. And my quick follow-up, apologies if I missed it because I got cut out of the last question. I think Jeff asked this question. But just thinking from a quantification perspective on the cost-outs, I just want to make sure it's clear. So, for fiscal 21, you've got $450 million in cost benefits. Are we netting that number against the $175 in discretionary actions from fiscal year 20? or what's the right number to think of it as a net benefit in fiscal 21?

So maybe I can help you out a little bit. We're keeping the permanent savings separate from the temporary action savings, so they're independent of each other. We did about the total year of fiscal year 20 had about $76 million of costs, And we see carryover savings into fiscal 21. A lot of those costs came through the fourth quarter, and we see the benefit coming into 21. So of the savings you see in fiscal year 21, some comes from the actions we already took. The rest will come. About $120 million will come from the actions we plan to take in fiscal year 21. Those actions will be heavily weighted into the first half. About 75% of the dollars will come through the first half and 25% in the second half. So you'll see, you know, most of the savings coming into fiscal year 21 from those actions.

Okay. Got it. Thank you.

Thank you. Our next question comes from the line of Nigel Cole with Wolf Research. Your line is now open.

Thanks. Good morning. And lots of great detail. So no free cash flow forecast for FY21. So should we take, you know, the cash EPS as the best estimate for free cash flow? But, you know, we do have cash restructuring to think about. And I guess my real question is, do you think that Wharton Capital will come down in line with sales? Or are we getting to a point now where we have to start rebuilding? some June 2nd half of fiscal.

Good question, Nigel. Yeah, you can expect that what we like to say for our target is more than 10%. As Tom described, 10% only would be disappointing for us at this point. If sales decline as we're projecting, then we would expect working capital to come out, you know, just accordingly as we typically do. We're very good at pulling that working capital down. as the volume comes down. The improvements that we talk about in the second half or in the fourth quarter, keep in mind, is talking against some pretty low comparables. So it shows improvement year over year, but it's not a significant dollar increase in terms of volume. So it would not require significant working capital in the fourth quarter.

Great. Thank you. And my follow-on is on price. It doesn't feel like there's a lot of price pressure across cap goods right now, and clearly your margin performance suggests you're not seeing much price either. But commercial aero is an area where there are some concerns. I'm just curious if you are seeing some price concession requests or some get-backs to your OEM customers in commercial aero.

Nigel, it's Lee. I would, you know, maybe I'll just couple that with commodity material inflation. We do see some modest material inflation across the channels. But, you know, our goal always has been from a cost price standpoint to be margin neutral. And we still expect that to happen this coming fiscal year.

Okay. Thank you.

Thanks, Nigel.

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

Yes, good morning. Good morning, Andrew. Great quarter, by the way. Just the first question, I guess, on supply chains, A, both global and North America. A, have you seen any disruption? shipping stuff from Asia to North America and also Mexico to the U.S., and have you made any adjustments to your supply chains post-COVID, or are you thinking about making structural adjustments? Thank you.

And your eyes, Tom. So I would take you back to really our strategy, which has been a long-term strategy on supply chains that we make, buy, sell local and local. It helps us a lot on this in that we do not have a tremendous amount of you know, cross-continent type of activity. We've not seen any disruption that's been material of nature. The supply chain team has done a really great job, and part of our protocol is always we look at risk mitigation, and we look at the solvency of suppliers and their ability to deliver, and we always look at that and make sure that things are in good shape, and we don't see any major things to worry about there. But this is an opportunity for us as our customers look at this, and they may have supply chains that are disengaged, and I've not really seen it from any material standpoint yet, that will provide a revenue opportunity for us as they move plants or relocate things. We have an opportunity since we have a global footprint to satisfy them as they move.

Ken, I guess a follow-up question on inventories and the channel and both distributors and sort of OEs. A, you know, we really, since the great financial crisis, we really haven't seen a big restocking cycle. Do you think we're going to get one after COVID? And I know you said people have sort of destocked a little bit, but are we going to see anything material coming out of it? And second thing, what can you tell us about sort of the bullwhip effect in your OE customers, how much this sort of distorts sales and what you see in the channel? Thank you.

Andrew, I can start. If Lee has anything to add, he can head on it. I think what you see with both of you, a lot of your question, the answer will be the trajectory of any kind of recovery. At this point, based on what we're just giving you as guidance, we're projecting a modest recovery, not some sharp type of recovery. If it's sharper, then I do think you'll see some restocking type of opportunities. But based on what we're projecting, I think you're going to see just normal recovery. So we saw pretty major destocking in Q4. We think some of that will continue at a lower rate in both OE and distribution in the first half. But I think the restocking opportunity, we're not projecting or counting on any of that right now. But if the trajectory of the recovery was to be a lot more sharp, then obviously I think people would be looking at that as something they need to do.

Thank you.

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

Hi, good morning. I'm trying to better understand the margin guide for the year. Now you're looking at the guidance with amortization excluded. So you're guiding 18.9 goes down to 18.1, which, you know, that seems, let's say, reasonable. A given amortization this year is going to be a lot more helpful to the margins than last year. Last year, it added 210 bits. Given your sales guide, it adds 260. So when you strip that away and we have more history looking at before this change of how you're reporting, you're implying that the margins before amortization, you know, being pulled out at 15.5. And That's on a $12.5 billion sales base. The last time you had margins that low, revenues were a billion or half a billion less than what you're guiding. And just given the improvement the company's been showing on margin, I'm just making sure, is that what we're trying to suggest? That the margins, the old way you used to report it, before you pull that amortization, the margins are going to be down at 15.5? That just seems... half a billion or a billion less than some years back when you were doing 15A or 14A. I'm just trying to understand why would the margins be that low? I mean, aerospace, mix issue a little bit. But can you just help us level set why it would be lower than even years ago when revenues were even lower?

David, this is Tom. I'll start. I'll let Kathy add on. First of all, it's a little bit difficult. You do have to back out acquisitions because acquisitions, off the MROSs a little bit. And we can share this with you more privately in a one-on-one you'll have with Robin and Jeff. But the decrementals without acquisitions, and we kept them in when they lapped, are in that 25% to 30% range. For a guidance in uncertain times, that is a really good guide on MROSs. So the MROSs come out to be appropriately positioned. When you look at the respective segments, so North America at 18.9 versus 93. Again, this is making apples to apples. Amortization put back in both years. We had 11% volume drop, and we have a mobile mix headwind. So that seems, you know, dropping 40 pips seems reasonable. International, we've gotten lower volume, and so that's dropping 30 pips, 17.1 versus 17.4. And aerospace droughts the most, which is what helped a lot here in FY20, 20.5 to 17.9. And the big difference there is the international military MRO that we had, which really gave us a strong fourth quarter. And then they had the most severe volume drought for the full year at 20% organically. So I think, you know, these are really good numbers. The MROSs for an August guide or best-in-class as far as what we would guide to, I can tell you we've never ever guided to a 25% to 30% MOS. We've always typically guided to higher to that 30% range. So we are reflecting how the business has gotten better, but we're also forecasting into a very uncertain period of time, hence why we didn't go down to the teens because that's a difficult thing to repeat.

Yeah, I think, Tom, when you strip out the change, and you look at a pre-adding back amortization, what really sticks out is international, which just put up margins year over year pre-amortization add-back. And last year in total did 15.9. You're guiding around 14.8 with a decremental of around 40. I'm just trying to understand if there's something unique going on internationally. Pre-adding back you know, more amortization. Is something going on internationally with the mix? Is there something I'm missing?

Yeah, for me, international is a lot less amortization that's getting allocated. You've got to look at both years with amortization in, and that's why I was articulated to FY20 with amortization all in. It's 17.4, and it's only dropping to 17.1, so it is not much of a drop at all for international, and it matches what you would expect with the kind of volume drop.

Okay, we'll talk offline about the ADVACs by second.

Yeah, you're throwing in international amortization as if it adds to the bulk of the amortization. The bulk of the amortization will reside in North America.

Yeah, I'm just taking the quarter you just reported and timesing it by four, essentially keeping it as a run rate by quarter. So maybe Robin or Kathy offline, we can get the exact ADVAC by second for 21 would be great.

Yeah.

Okay, thank you so much. Appreciate it.

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

Good afternoon, everyone. I guess it is now. I've got one that's probably from Lee. Can you guys talk about, you know, what kind of friction you're seeing in your own operations from safety protocols that you've you know, had to put in as part of your processes, whether that's, you know, changing how the U-shaped cells are laid out or anything like that or additional costs that you've incurred and if that's meaningful to your results. And then are there plans for you to be able to improve those processes and eliminate some or all of those frictions as we go forward?

Well, Nathan, that's a great question. Thank you. You know, first off, because I know there's a lot of team members listening, I can't say enough about what our worldwide team has done in putting in these safety protocols. We've been audited by a lot of outside governments, and they've always applauded what we're doing internally to separate things out and keep our workers safe. But, you know, yes, there's a cost. It's not material to put things up. But it's remarkable what our teams continue to do, in terms of reconfiguring ourselves, still getting the same productivity flow, but, you know, separating our workers from each other, giving them the space, giving them the, in many cases, you know, plexiglass separations, and just organizing a production system that, you know, is consistent with our lean production system that gives us excellent flow and keeps everybody safe. So, Nothing meaningful to talk about. He's doing a great job, and the results, I think, prove it out.

Fair enough. Thank you for that. Maybe on capital allocation, Tom, we're getting down to net debt in the low three. Probably by this time next year, it's going to be in the two and a half, maybe a little bit better than that even, depending on how the recovery goes. How are you guys thinking about, you know, when to reenter the M&A market in a meaningful fashion? What kind of leverage metrics do you need to get down to before you look at that? And how is the cultivation of the pipeline going in the meantime?

Nathan, I'm going to start with that and then I'll turn it over to Tom. I'd like to recalibrate you a little bit. Keep in mind that EBITDA is dropping, so the denominator gets a little bit more difficult. I think two and a half times next year is a pretty aggressive projection, and not what we're anticipating we'll be able to do. So, Tom, you want to comment? Yes.

So we are probably going to be still north of three when we finish, but obviously we're going to do it, and then we pause. We can't just solve the pace of debt reduction we did last year. But on acquisitions, we continue to always build those relationships and look at those strategic targets and have those discussions. But we're not going to enter into those until we get the M&A, get the leverage down into those low twos. And we're going to work very hard to see how we can get there.

Fair enough. Thanks for taking my questions.

Thanks, Nathan.

Thank you. Our next question comes from the line of John Inch with Gordon Haskett. Your line is now open.

Thank you very much. Good afternoon, everybody. Hi, Kathy. Could you comment a little bit on the first quarter expectations for core growth? And obviously the genesis of my question is, you know, you've got North American orders and international orders much worse than the core growth you just put up, and then an outlook that shows a substantial top-line rebound, right, in all of fiscal 21. So I'm assuming we're heading to a pretty tough next quarter or two. Is there anything you could say about that?

John, it's Tom. So similar to what I mentioned when I went through the first half, the first half is going to be minus 19 for the total company. And North America is going to get a little better, minus 25 last quarter to minus 21, and international minus 15 to minus 12. So we see that gradual improvement. It'll be a little bit in Q1 and a little bit more in Q2. The only thing that will weaken will be aerospace. Aerospace is a longer cycle. We'll be finding bottom probably most likely kind of in the middle of the year is when aerospace finds bottom.

And do you expect these businesses to good turn positive by the end of fiscal 21, just as part of your guide, or still hovering negative?

No, yes. We got in Q4, it'll be probably plus high single digits on the industrial portion. Got it. I was still trying to get back to you.

Yeah, apologies if you went over this before. There's just a lot of moving parts. I wanted to ask you, Jim, as a follow-up, the structural actions. I guess I was under a bit of an impression that the company was not looking to take structural actions based on all of the work that you've done before. So, Tom, I'm wondering kind of what perhaps maybe I got that wrong, but was there something that did trigger your thought process to go ahead and take structural actions like you think the outlook merited it as the quarter proceeded. And can you tell us anything about sort of how you're allocating these actions across, say, aerospace versus international versus the domestic ops?

Yeah, I'll give you kind of more of a strategic piece. I can let Kathy comment as far as within the segments. But, you know, when we looked at it, John, we looked at aerospace, oil and gas, going to be down for long, and so we needed to take structural actions there. And we also just looked at the trajectory here and the opportunity between all the things we've been doing for even more continuous improvement regarding the structure of the company. So that's why we're looking at permanent. If this was to bounce back sharply already, we would not be doing it, but based on the fact that this is going to be a little longer trajectory and we have certain markets that are down for probably several years, we wanted to take the actions now to get in the right position. And we really felt that way as we were going through it at the end of Q4, and that's why we took those actions. So the actions we took in Q4 are really helping us springboard into FY21 on the savings. I don't know if Kathy wants to add on as far as how it's going to split between segments or not.

Yeah, for FY21, John, the split will be about half of the costs will be through the international operations, and then the remaining... 50% will be fairly evenly split between aerospace and North America. And keep in mind that these actions are more workforce-related than they are asset-related.

I guess I would just add on to one thing that we did by structuring about a 50-blend, a permanent discretionary, is it gives us the flexibility to move depending on what happens on demand.

I'm sorry, I don't understand. A permanent discretionary gives you the flexibility to what?

To move based on demand. As an example, if we just made all permanent action, you probably have a little less flexibility by doing a mixture of both. We've got a little more flexibility. And we're not taking out assets, which gives you even more flexibility. You can obviously have people back in.

Yeah, no, the numbers are definitely impressive on the paybacks. Thanks very much. Appreciate it.

Thanks, John. Okay, in respect of everyone's day, we're going to take one more question and then let you go.

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

Good afternoon, and thanks for taking the question. I guess it dovetails with John's last question on the concept of you know, workforce versus assets within the restructuring. Can you comment on, you know, as other companies may have done similar things, whether your experience with this pandemic has accelerated stuff you've already had in the pipeline, and what sort of things might those be?

Annie, it's Tom. So we always look at how to continuously get better as far as our people and how we deploy them. And that's a combination of lean and Kaizen and simplification, all those type of things. So I would say we always have a pipeline of those type of ideas, the groups and the divisions do. And when you run into where volume is down, if this volume is going to be down for longer, some of those things get accelerated. Clearly, when we look at the most distressed end markets, that is causing us to take more aggressive action in there because we don't expect them to come back. Aerospace is an example anytime soon. But we always look at how to get better on the structure of the company. And, you know, I would say that this is that plus our response to the end markets that are being the most distressed.

Okay, thanks, Simon. And then the last question, there have been quite a few questions around this, but If I take the midpoint of the first half, second half framework that Kathy put out, the decremental margins with all the adjustments are slightly above 30 in the first half and then kind of high 20s in the second half. Is that difference – I know I'm splitting hairs a little bit, but is that difference – really NICS-related and the impact of acquisitions, or is there something else?

No, Andy, you summarized it. Because when you take out the acquisitions and only have them when they've lapsed, for example, apples to apples, the decrementals are in that 25% to 30% range that I've been saying. So that's pretty good because, to your point, NICS is not going to help us next year as well.

Okay. Thank you very much.

Okay. Thanks, Andy. Sarah, this concludes our Q&A and our earnings call. Thank you, everybody, for joining us today. Robin and Jeff will be available to take your calls should you have further questions. We appreciate your time this morning. Enjoy the rest of your day.

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