Parker-Hannifin Corporation

Q3 2021 Earnings Conference Call

4/29/2021

spk07: Ladies and gentlemen, thank you for standing by and welcome to the Parker-Hannifin Fiscal 2021 Third Quarter Earnings Conference Call and Presentation. At this time, all participants are in a listen-only mode. After the speaker's presentation, there will be a question and answer session. To ask a question during this time, you will need to press star 1 on your telephone keypad. If you require any further assistance, please press star 0. The opening speaker for today's call is Parker's Chief Financial Officer, Mr. Todd Liam Bruno. Please go ahead, sir.
spk15: Thank you, Elaine, and good morning, everyone. Thanks for joining our FY21 Q3 earnings release webcast. As Elaine said, this is Todd Liam Bruno, Chief Financial Officer, speaking. Here with me today, our Chairman and Chief Executive Officer, Tom Williams, and President and Chief Operating Officer, Lee Banks. On slide two, you'll find the company's Safe Harbor disclosure statement addressing forward-looking statements as well as non-GAAP financial measures. Reconciliations for all non-GAAP measures are included in today's materials. These reconciliations and our presentation are accessible under the investor section at Parker.com and will remain available for one year. We'll start the call today with Tom providing some quarter highlights and some strategic commentary, and I will provide a summary of the quarter, financial results, and review the increase to guidance that we announced this morning. Tom will then close with key messages, and then Tom Lee and I will take any questions the group may have. With that, I'll direct you to slide three, and I'll hand it off to Tom.
spk14: Thank you, Todd. Good morning, everybody. Before I jump into slide three and a quarter, I want to say thank you to all the Parker team members around the world for an outstanding quarter. It's really more than just this quarter. It's really been a whole year in the performance through the pandemic and also the transformation of the company into a top quartile diversified industrial company. These results are all because of your efforts. So let's look at the quarter on top of slide three. Starting with safety, as we always do, we had a 33% reduction in recordable incidents. We're still in the top quartile. A combination of safety, lean, our high-performance team structure, and Kaizen, we're all driving high engagement and high performance. You see that show up in our results. Sales grew about 1%. The organic decline was minus 1%. But in particular, if you take out aerospace and look at the industrial only, the industrial segment grew organically almost 4%, so that was significant. We had five all-time quarterly records. You can see the net income, EPS, and the segment marks for Parker North American International. The EBITDA margin was very strong at 21.6. As reported, 21.8 adjusted a huge increase versus prior 250 basic points. Year-to-date cash flow was an all-time record at $1.9 billion and a little over 18% of sales. Then you go to the very last row of this page, you see segment operating margin on adjusted basis, 21.4%. Again, a significant improvement versus prior, plus 240 basis points. So a terrific quarter in really tough conditions. So you go to the next slide. I want to talk about the transformation of the company. You know, the old adage that a picture's worth a thousand words is And so I want to take you to slide five, and this is really the picture that speaks to the transformation of the company. Let me explain the chart here for a minute. So you've got in gold bars the adjusted EPS. The blue line is global PMI plotted on a quarterly basis. If you look at the last six years and look at that dotted green line and compare that to the blue global PMI line, you see they are much less correlated. In fact, they are diverging. And there's been a step change in performance. The EPS over this time period has more than doubled from $7 to our guidance of $14.80, so approaching $15. And what's propelled that over that time period is an EBITDA margin that's grown 600 base points. So you might ask, how? How's that happened? It's really that blue takeaway at the bottom of the page. It's our people, that focus, the alignment, the engagement that comes when you have people think and act like an owner. The portfolio, which is a combination of our interconnected business technologies and the value they bring, and the capital deployment we've done, buying some great companies that have added to the strength of the company. Then our performance, which really sits with the strategy of the company. One strategy 2.0 at kind of the beginning of this journey, and then one strategy 3.0 most recently in FY20. So this combination has really transformed the company. You see that as evidenced in this slide, and we're very proud of it. But if you go to slide six, so that's what's kind of in the rearview mirror. But going forward, we're equally excited about where the company is going to go. And I've called this a convergence of positive inflection points. So on the left-hand side is kind of those external inflection points. You're familiar with a lot of these, but the macroenvironment industrial momentum, you see that in our positive orders and positive organic growth industrial we showed in this quarter. Aerospace is going to recover. The question is just what the trajectory will be and the timing. vaccines are making progress around the world. There's going to be a significant amount of climate investment. If you put all that on top of it, I didn't write all these down, but low interest rates, pent-up capex demand, and fiscal spending, you have a very attractive environment for industrials for the next several years. On the right-hand side is really the internal things we've been doing, Winch Edge 3.0 in particular, but that last slide that I just went through spoke to all those internal actions because that's what's been propelling us. Remember that last period The last six years really had very little help from a macro standpoint. So you look at the three major things I highlight here, performance, becoming top quartile, strategies to grow fast in the market. You've seen our margin expansion, great cash flow generation consistently over the cycle. Portfolio, we've added three great companies, all accretive on growth, cash, and margins. And with the rapid debt paydown that we've done, we're positioned to do future capital deployment, which is very exciting. The technology I'll get into in the next slide, but the interconnected technologies really is distinctive for us. And then with that climate investment, we are very well positioned with our suite of clean technologies to take advantage of that. So I would tell you that my view and the team's view is this is about as good an environment as we've seen in a number of years. Go to slide seven. You've heard me talk about this page, the power that this interconnectedness of technologies brings, the value it creates for customers. What I want to do today in light of the clean technology discussion is give you four examples of how this suite of technologies helps with a more clean environment, clean technology world. So the first would be electrification. And we've got a full portfolio of technologies here, hydraulic, electro-hydraulic, pneumatic, electromechanical. No competitor's got that breadth of technologies. And we formed about four years ago the Motion Technology Center, which put the best and brightest of engineers doing motion technologies and things that fly, as well as things with wheels underneath it. So we put the motion and the aerospace teams together. And this team has come up with a great listing of products around motors, inverters, and controllers. But there's also, in addition to the typical motion opportunities, there's other challenges around electrification, like light weighting, thermal management, shielding, structural adhesives, and noise vibration. All these, through the combination of what we have as legacy and with the Lord acquisition, we're well positioned to take advantage of those. Secondary is batteries and fuel cells. They utilize most of the technology you see on this page. Third would be clean power sources, and that kind of falls into two buckets. Renewables, which we do a lot and always have done a lot on wind and solar. Then the hydrogen. We just recently joined the Hydrogen Council, and it's going to be both onboard as well as infrastructure opportunities as you go out for the next many years. And it's really building on our high pressure and our cryogenic applications that we have today. And then we've been a more sustainable company for a long time. And really the clean technology example for us that started a lot of things is filtration. And our filtration business protects and purifies assets and equipment for people for a more sustainable environment. So we feel very good about this portfolio as there's more climate investment in the future. Going to slide eight. Just wanted to remind you of our purpose statement, enabling engineering breakthroughs that lead to a better tomorrow. It's been very inspirational for our team. And I think it comes more to light when we give you examples of the purpose and action, which is on slide nine. And again, kind of following with that clean technology discussion, I'm going to highlight electrification. I'm going to highlight, in particular, electric vehicles. On the left-hand side, you see applications that have changed because of an HEV or an EV versus a combustion engine. On the right-hand side, you see the various technologies that Parker has that addresses those applications. I won't read all those underneath it, but you see the major categories, safety-related technologies, things that save weight, thermal management, and a variety of things we do for critical protection. The big opportunity for us, so we obviously are in the factories helping to make these vehicles, and we'll always do that, but the big opportunity for us is the onboard content around engineering materials. Our bill of material for an EV or an HEV is 10x what it was in a combustion engine. And it's one of the key reasons why our Lord business has grown so nicely, even despite the pandemic. So we grew 11% organically in Q3 for Lord. So we're very happy with the progress so far and our purpose and action around electrification as an example. So with that, I'm going to turn it over to Todd with more details on the quarter. Thank you.
spk15: Okay, thanks, Tom. I'll just orientate everyone to slide 11, and I'll do a quick review of the financial results for the quarter. Tom mentioned some of these, so I'll try to move quickly. Sales for the quarter were $3,746,000. That is an increase of 1.2% versus prior year. We are proud of the fact that the diversified industrial segment did turn positive organically. Industrial segment organic growth was 3.7. Obviously, that was offset by the aerospace system segment. their organic decline was 19.7%. So all in, that drove total organic sales to minus 1.0. Currency was a favorable impact this quarter of 2.2%. And just a note in respect to acquisitions, this is the first full quarter that we report both Lord and Exotic in our organic growth numbers. So therefore, the acquisition impact was zero. Moving to segment operating margins, you saw the number 21.4%. That's an improvement of 240 basis points from prior year. It's also an improvement of 130 basis points sequentially. Strong margin performance there. And that really was the result of just broad-based execution of the wind strategy. We continue to manage our costs in a disciplined manner. The portfolio additions in Clarkor, Lord, and Exotic are all performing soundly. And you've all been familiar with the restructuring activities that we've done in FY20 and in FY21. Those are on track and on planned and generating the savings that we expected. Adjusted EBITDA margins did expand 250 basis points from prior year, finished the quarter at 21.8%, and net income is $540 million, which is a 14.4% ROS. That's increased by 22% from prior year. Adjusted EPS is $4.11. That is a $0.72 or 21% increase. compared to prior year's results of $3.39. And as Tom said, it's just really outstanding performance, and I'd also too like to commend our global team members for generating these results. If you slide to slide 12, this is really a bridge of that $0.72 increase in adjusted EPS versus prior year. And the story here across the board is just strong execution from all of our businesses. This produced robust incrementals in our diversified industrial segment and really commendable decrementals in the aerospace system segment. Adjusted segment operating income did increase by $98 million, or 14% versus prior year. That equates to 58 cents of EPS and really is the primary driver of the increase in our adjusted EPS number. Interest expense was favorable to prior by 12 cents. as we posted yet another quarter of sizable repayment of our serviceable debt, and that is really benefiting from our strong cash flow generation. Other expense, income tax, and shares netted to a two-cent favorable impact compared to prior year. Moving to slide 13, this is just an update on our discretionary and permanent cost-out actions, and this is just a reminder. These represent both savings recognized in the current fiscal year from our discretionary actions in response to the pandemic and our permanent realignment actions that were taken at the end of FY20 and throughout FY21. Discretionary savings came in exactly as we guided at $25 million for Q3 and now total $215 million year-to-date. There is no change to our discretionary savings forecast for Q4. That remains $10 million, and we continue to forecast the total year to be $225 million in full-year savings. Just to note, with the increased demand levels that we're seeing from our positive order entry, our teams have really pivoted to growth and really now these discretionary actions that we knew would diminish across the calendar year have now really been based in reduced travel expenses. If you move to permanent savings, we realized $65 million in Q3. Our total year to date is $190 million. The full year forecast again here remains as previously communicated at $250 million. One item to note, we did guide that the cost of the FY21 restructuring would come in around $60 million. It's now expected to be $10 million less or $50 million, but there is no change to the expected savings that we are forecasting. Total incremental impact for the year for both permanent and discretionary savings is $260 million. And just one other thing to note, this will probably be the last quarter that we detail these items as we anniversary the pandemic-induced volume declines and really focus our attention on growth. So, the takeaway is savings are on track, no changes other than the expense will be a little bit less. If you go to slide 14, this is just highlighting some items from our segment performance for the third quarter. In our diversified North America business, sales were $1.76 billion. That is an improvement in organic sales sequentially from Q2. It still is down 1.2% from prior year. But if you look at the adjusted operating margins, we did increase those operating margins by 190 basis points first prior year and reached 21.9% for the quarter. We were able to increase these margins despite that sales decline due to our disciplined cost management, those portfolio improvements we've talked about, And really, margins in this segment are at a record level. If you slide over to order rates, another positive here. They improved significantly from plus one last quarter, and they're now ending the quarter at plus 11. Looking at the diversified industrial international sales, robust organic growth here of 11.1%. Total sales came in at 1.39 billion. And another great story here, adjusted operating margins expanded substantially and reached 21.6%. an improvement of 400 basis points for his prior year. Clearly, the double-digit organic growth coupled with the cost containment and the effort from our global team really generated this level of record margin performance as well. And again, another plus here is order rates accelerated in this segment and are now plus 14 for the quarter. If you look at aerospace systems, they continue to really perform soundly in the current environment. Sales were 599 million for the quarter. Organic sales showed a slight sequential improvement from Q2, but are still down basically 20% from prior year. Commercial end markets are still under pressure. However, there is strength in our military end markets. What's nice here is operating margins were 19.4%, 30 basis points better than prior year, despite that 20% decline in volume. And if you look at our fiscal year, that performance of 19.4 is the highest they've done all year. So we're really proud about that. Decremental margins are also impressive here in this segment. This quarter, they're 18% decremental margins. Order rates appeared to have bottomed and finished at minus 19 for this quarter. And just a reminder, that is not a rolling 12-month basis. So overall, we're pleased about a number of things this quarter. That diversified industrial segment organic growth of 3.7 is a positive. Total segment margins improved 240 basis points from prior year and at record levels. Orders have turned positive and are plus 6. And our team has really continued to leverage the wind strategy to drive significant improvements in our business and increase productivity and generate strong cash flow. So with that, I'll ask you to go to slide 15. This is just some details on our cash flow. Year-to-date cash flow from operations is now $1.9 billion. That's 18.1% of sales. That's up 45% from prior year, and it is a year-to-date record. Improved net income margin, as we've talked about before, is really a key driver in this. It's created a step change in our cash flow generation, but I'd also like to commend our team members' intense focus on our working capital metrics. Each of our working capital metrics is improving and showing positive results, and I'm really proud about that. Moving to free cash flow at 16.8% of sales, that's an increase of 630 basis points over prior year. And our free cash flow conversion is now 141%, which compares to 122 in the prior year. So great cash flow generation there. Moving to slide 16, I just want to mention some things we've done on our capital deployment. We did pay down $426 million of debt this quarter. That brings our total debt reduction to a little over $3.2 billion in the last 17 months since the Lord acquisition closed. This reduced our gross debt to EBITDA to 2.4. It was 3.8 in the prior year, and net debt to EBITDA is now 2.2, and that's down from 3.5% in the prior year. Looking at dividends, last week you saw our Board of Directors approved a quarterly dividend increase of 15 cents, or 17%. This raises our quarterly dividend from 88 cents to $1.03 per share, and extends our record of increasing the annual dividends paid per share the 65 consecutive years. And finally, as we mentioned at the Q2 earnings release, we reinstated our 10B5 program and repurchased $50 million of shares in the quarter. All right, so if you go to slide 17, I'll just provide some color to the increase in guidance that we gave this morning. Really, the strong year-to-day performance and these order trends have positioned us to increase our full-year outlook for sales to a year-over-year increase of 4.5% at the midpoint. And the breakdown of that sales change is this. Organic sales are now expected to be flat year over year. Acquisitions will add 3%, and the full year currency impact is expected to be 1.5%. We've calculated the impact of currency to spot rates as of the quarter ended March 31st, and we held those rates constant to estimate the Q4 21 impact. Moving to segment operating margins, our guidance for the full year is raised to 20.8%. and that would equate to an increase of 190 basis points versus prior year. And just some additional colors and things to note, corporate G&A interest and other is expected to be $381 million on an as-reported basis and $479 million on an adjusted basis. The main difference between those two numbers is that $101 million pre-tax or $76 million after-tax gain on real estate that we recognize and adjusted in the other income line and Q2. That's the main item. If you look at our tax rates down just a little bit, we're now expecting the full year tax rate to be 22.5%. And moving to EPS on a full year basis, our as reported EPS guidance range is increased from 1296 to 1326. That's 1311 at the midpoint. And on an adjusted basis, we're increasing the range from 1465 to 1495. and that's $1,480 at the midpoint. For Q4, adjusted EPS is projected to be $4.18 per share. That excludes $0.54, or $93 million, of acquisition-related amortization expense, the finishing of our business reliance expenses, and integration costs to achieve. If you look at slide 18, this is just the bridge of our increase to our adjusted EPS guidance. No, these results that we just reviewed, you can see the outperformance that we had in Q3. That increases our previous guide by 57 cents. The order strength that we just reviewed and really the exceptional operation and execution by our teams have allowed us to increase Q4 guide by an additional 33 cents, and that is exclusively based on increased segment operating income. This raises our full year EPS guide by about 6.5% from prior guide. And with that, I'll turn it over to Tom for some summary comments and ask you to move to slide 19.
spk14: Thanks, Todd. So we've got a highly engaged team. You see that. This was driving the results, the ownership culture that we're building. Record performance in difficult times. These numbers are historical all-time highs for us and not the best of times. The convergence of positive inflection points, we feel, points to a very bright future. And the cash generation and deployment is evidenced by the rapid debt pay down, the acquisition performance, and our dividend increase, which I would just highlight the first time we've ever been over $1 at $1.03 on a quarterly dividend, which we're very proud of. So the winning strategy, 3.0 in our purpose statement, is well positioned in addition to those inflection points for a very strong future. I'll turn it back to Elaine to start the Q&A.
spk07: And as a reminder, if you would like to ask a question, please press star 1 on your telephone keypad now. And your first question comes from the line of Jamie Cook from Credit Suisse.
spk06: Hi, good morning and nice quarter. I guess just two questions. One, understanding you don't want to talk about 2022, but I'm trying to understand the setup for incrementals. and to what degree if volumes are still there, can we have above average sort of incrementals and how the discretionary costs sort of factor back in, you know, and impact incremental margins. And then I guess my second question, you know, is regards to your longer-term margin targets, which, you know, you're already starting to beat those targets. So in particular with volumes not really showing up in your numbers, I'm just trying to think about how we position your margins longer-term potentially to be you know, at a higher structural level. Thank you.
spk14: Jamie, it's Tom. So I'll start with the incrementals. The one thing that I would point out is our guidance for Q4 is incrementals of about 30%. And if you were to do like for like and take out the discretionary savings we had in Q4 prior period, they'd be about a 50% incremental. So they'd be at the incrementals that, you know, we feel based on the cost structure and all the things we've done with when 2.0, when 3.0, that we would generate at this point in the cycle. We would continue to do 30%, I think, as we go into 22. Obviously, we're not guiding to that yet, but I think that's a good round number to use for us. But I'll highlight Q4 because it is impacted by the prior period discretionary, which we don't have now, or not as much, and that difference is pretty significant. We go from a 30 to a plus 50 incremental. So it speaks to the underlying power of the business is there. And then on your question on long-term margin targets, yeah, this is a good problem that we have, that we basically have beat our targets by about two years. Our guide at 20.8 at the midpoint and up margin is, you know, within spitting distance of the 21. And then EBITDA, if we don't guide on EBITDA margins, we'll be at the 21% for a full year on EBITDA. So we're actively working on what this new set of targets will be, and I'm sure this is a question everybody had. So we're going to disclose them at IR Day, which will be March of next year, and we think that's the appropriate form to do that. But rest assured, we're working on it, and we're not going to settle or be happy with stopping at where we're at. We're going to continue to march forward, and we'll give you that vision when we have Investor Day.
spk06: Okay, congrats. Thank you.
spk15: Thanks, Jamie.
spk07: And your next question comes from the line of Andrew Obin from Bank of America.
spk08: Hello, Andrew. Yeah, I guess I'll follow Jamie's lead. I'll ask one question, but it will have two parts. It seems you guys are getting ready for some of the best growth you've seen in a long, long time. And the two-part question that I have for you is, how do you think about your supply chain and manufacturing footprint to meet demand and meet growth over the next three, four, five years in North America? So that's part one. And part two, for the past decade at least, we didn't really have a lot of growth in North America structurally. And in terms of your distribution channel, what do you need to do to optimize your distributors for, you know, this new growth environment? Do they need to be better capitalized? You know, there's been some consolidation. Do you need to continue consolidating your dealers? So part one, you know, manufacturing, getting ready for this multi-year upturn. And part two, what do you need to do on the distribution side? Thank you.
spk14: Okay, and there's Tom. I'll start. Maybe Lee can pile on with the manufacturing structure of the company. But we feel that we're well positioned to take advantage of this growth. I mean, one of our strengths historically is when there is a spike in demand, our supply chain and the fact that we make, buy, and sell local for local and our manufacturing footprint, which is diversified around the world, has typically been more responsive than our competitors. And then what we've done with 3.0 and adding Kaizen, and I started with my opening comments, when you link the safety performance, lean, Kaizen, and the high-performance teams, think of the high-performance teams as a structure, how we run the various cells and value streams, you've got a very powerful combination. And as we do Kaizen, as we keep finding ways to free up capacity, free up floor space, free up capacity in our equipment, we're able to do what we call more simple automation, category, which uses the only free thing in life, which is gravity. And if you saw these, these are gravity-induced material handling things and simple automation in the factories has allowed us to be responsive to this demand. So I think we're well-positioned. Obviously, we're going to have to continue to invest, which we will, but we just found ways to do it more efficiently. And Kaizen has been kind of the great liberator for us to be able to do that. On the channel, The channel has been, to your point, has been consolidating over the last number of years. I think it's in a better position than it's ever been to respond. We did see nice growth in distribution sequentially, and our distributors are investing in some inventory for the future, and I think they'll be in a position to respond. Obviously, we take share through them as well as through our OEMs going direct. And we've got a great distribution team. Our partners are strong. We've got a great distribution sales force. The strippers have been investing in application engineers and been relying on us to be better at supply chain. And in their eyes, we can continue to do better, but we have made quite a bit of stride on that. So I think both of those will be well positioned to take advantage of this upturn.
spk08: Thank you, Tom.
spk14: Thanks, Andrew.
spk07: And your next question comes from Scott Davis from Melios Research.
spk02: Hi. Good morning, everybody. Thanks for including me. I'm kind of fascinated by slide nine. I know you've shown it before, but I don't think you guys have disclosed kind of the opportunity difference between the electric vehicle and potential content versus ICE. Is there any way that you can quantify the opportunity for us?
spk14: Scott, it's Tom. For competitive reasons and for sensitivities with customers, I won't get into the dollar content, which is why you heard me describe it in terms of just size versus ICE, you know, 10X, our bill of material. Our bill of material on board is primarily almost exclusively all engineered materials. So everything, when you go down that list on the right-hand side of slide nine, these are all engineered materials, and this would be a combination of, you know, a pretty strong portfolio that we had before we did Lorde, but then Lorde added quite a bit to that. And really the combination we've got there has really given us a very attractive offering for customers. And, you know, the debate is how fast it's going to grow and what percentage of the total fleet will take over. But for us, every time there's a new EV, it's an upside opportunity. Recognize, as I mentioned, the Lorde growing 11% a quarter. Lorde's a third aerospace. So Lorde's aerospace business, is doing a little better than Legacy Parkers because they have a pretty big military exposure, but it's feeling pressure just like Legacy Parkers. And for Lorde as a whole to show a plus 11% just shows you the growth we've got on the EV and the HEV side.
spk02: Okay, fair enough. And just, again, looking at slide 13 and the discretionary cost versus the permanent cost, How do you think about this going forward and kind of past the middle of the year? Will expenses kind of go back to pre-COVID levels? Is that something that you guys are starting to model in, or is there some sort of an improvement to discretionary that almost becomes permanent, if you will? Like people will travel a little bit less, or you find that you don't need to send 30 people to a trade show. You can send 20. Or is that in the numbers already? Yeah. open-ended question, I guess, Tom.
spk15: Scott, this is Todd. I'll take that question. You're right on all accounts there. When we talked about this last year, because the decline in volume came so quickly, we pulled a number of levers on discretionary expenses. A lot of this was in response to the volume declines, right? And we talked about our permanent actions and that eventually our permanent actions would right-size the business. We feel like we're there now, but we have found a new way to do business, right? I don't think we will go back to the way we did things. Travel, trade shows, those are all great examples, but there will be some, right? We're still trying to figure out what that is, but it will not be like it was before. So that will be, you know, essentially a change that will be structural going forward.
spk02: Okay, perfect. Good luck and congrats, guys. Thank you. Thanks, Scott.
spk07: And you have a question from Joel Tiss from BMO.
spk05: I'm glad you started off with the safety talk, Tom. I've got my mask and my safety glasses on, and I've got all my shots and everything. I'm ready for you.
spk15: I'm proud of you, Joel. Stay safe, Joel. Stay safe.
spk05: Can you talk a little bit about the inventories in the channel and in aerospace and just sort of maybe more generically how the industry is setting up for 22 and 23? Like what are you hearing from your customers and your distributors and things like that?
spk14: Joel, it's Tom. So on distribution, you know, we saw a really nice improvement versus Q2. So distribution came in at plus two overall for the quarter. versus a minus six in the prior period, so an 800 basis point improvement in distribution. We saw really good growth in Asia Pacific and Latin America in that 15 to 20% range. EMEA was flat, and North America was just slightly negative, low single digits. But pretty much across all our distributors, we saw a combination of actual activity, drive, and demand, and then investing in inventory in the coming months. I think the channel has turned from, you know, last quarter I talked about selective restocking. I think it's pretty much across the board, people planning for the future. And then in aerospace, you know, we still need time. You know, I think we're bouncing along the bottom there. And, you know, and we've sized the company to put up great margins in where we're at right now. We have the advantage of being very diversified in our segments between engines. military, commercial, helicopters, et cetera, going down the line. That's helped us quite a bit. We're about 50-50 military and OE. So we're well positioned. But the question mark there is, you know, just what will the trajectory be and how long do we bounce along bottom? Clearly, I think the military side will continue to be strong for us. It was strong this quarter and will continue to be strong going forward. Both OE and MRO were on the right programs there. And the commercial side will be all based on line rates from the OEMs, the air framers. And then on the MRO side for commercial, it's all about air traffic, shop visits, and new seat positives with airlines hiring pilots back. And departure rates are improving, and that will speak well to shop visits down the road.
spk05: All right. It's great. Thank you. Thanks, Joel.
spk07: And you have a question from Joe Ritchie from Goldman Sachs.
spk14: Morning, Joe.
spk11: Thanks. Hey, good morning, guys. So I'll ask a multi-part one question, but really around free cash flow, because that's been a great story for you guys as well. And so as we think about, you know, next year and the inflection that you're going to see in growth, how do we think about, you know, you having to, you know, build working capital, you know, within your own, um, you know, distribution, uh, and, and the impact that that could have on, on 2022 for cashflow margins. And then beyond that, like longer term, what's, what's kind of like the right entitlement, you know, if margins are going to be going up longer term, what, what can free cashflow margins look like longer term for the company?
spk15: Hey, Joe, this is, uh, this is Todd. I'll take that question. And thanks for, uh, uh, noting our superb free cash flow. We are really proud about that. As you know, we don't guide on free cash flow. We're really happy with our results. There has been a step change, if you look back over time. I kind of alluded to that in the slides there. It's really driven by our increased margin performance. But not only that, I mentioned our working capital. Our teams really have put intense focus on this. And that's one of the areas that... that we really have improved with these recent acquisitions, kind of bringing them into Parker-type terms and Parker-type policies. So we're not done with that. We still have room to go on that on every single one of those metrics, so we do see that improving. Will there be some pressure as growth comes? Absolutely, but it will not adversely affect those numbers. We see a positive future here for cash flow.
spk11: Got it. Okay. Thank you very much.
spk07: And you have a question from Nathan Jones from Stiefel.
spk04: Nathan. Morning, everyone. Morning. I'd like to follow up on the aerospace side. Tom, specifically on commercial aerospace and even more specifically on the aftermarket side, that's where you guys are going to see the pickup on the commercial side first. Have you seen sequentially that get any better as we're really seeing the front end of air traffic start to pick up? And if not, what's the typical kind of lag you see from when that recovery in air traffic starts to when you actually see the recovery in your aftermarket orders?
spk14: Yeah, Nathan's top. So sequentially on sales for commercial and rural, we saw a 13% improvement going from Q2 to Q3. And the lag is sometimes hard to predict, but the sequence would be, you know, increase in available sea kilometers and increase in departure rates, drive shop visits to go up at some period of time after that. And that's always the hard part because it depends on what the routes are and the cycles and the particular engine, et cetera. But those will start to improve. And then once the shop visits go up, then our flow through into commercial MRO is going to happen. So I can't give you an exact lag because if I did, I would probably be wrong. But clearly these are all positive signs, pilots being hired, departure rates going up, available sea kilometers starting to at least stabilize and starting to improve. Those will all speak to shop visits going up, and they'll drive higher content of MRO for us.
spk04: Okay, and then one on use of cash here. I think you guys had said once we get to about mid-this year, mid-calendar year, you're going to be out of debt to pay off and obviously producing a lot of cash flow here. Can you talk about your approach to the M&A market now, when we might expect to see you back into it, and what the maturity of the pipeline looks like right now?
spk14: Yeah, Nate, it's Tom again. So you're right. Our serviceable debt will be paid off this quarter. So we'll enter FY22 with no serviceable debt in our next payment, corporate buyout due to September of calendar 22. So we have opportunities, and we're The way I would always describe it, and the lessons learned from the financial crisis, is to continuously work the financial pipeline. Lee, Todd, and myself just did reviews. We do this all the time. Lee does it monthly with his presidents. And so this is something we stay on top of. We're building those relationships. So the pipeline is active, but it's always a matter of finding a willing seller and a willing buyer. And so activity doesn't necessarily always translate into success. actual properties being acquired. But we're looking, and certainly we're going to continue to buy companies with the same kind of themes that you've seen before, that either are immediately accretive or accretive within our synergy time period so they can help the growth rates of the company, help margins, help cash flow. And, you know, you'll continue to see us be the consolidated choice. We think we're still the best home with these motion control properties. but we'll also look at the other areas that you've seen this build on in the last several years. And hopefully by now people feel good about our track record. You know, the last three got a lot of fanfare. We've been good at this for a long time. We've done 80 deals in the last 20 years, and I think you'll see us continue to be active on that. You know, first and foremost for us at Dividend, we were very excited to clip that dollar mark on a quarterly basis in it. And you'll see us stay on top of that. Our net income is going to grow, and we're going to stay on top of those dividends to match that net income growth. We'll continue to invest in the company organically in productivity. And if we don't find the right properties, which our preference would be to do deals because it drives cash and EBITDA growth, we think we're a great investment, and we'll buy shares on a discretionary basis on top of the 10B51. But the pipeline's active, and more to come. on that.
spk04: Great. Thanks for taking my questions.
spk07: And you have a question from Julian Mitchell from Barclays.
spk15: Hello, Julian.
spk03: Maybe the first question around the sort of linked topics of cost inflation and component shortages and the sort of unifying factor of tight supply chains. I mean, I guess two parts. One is, do you think there's much evidence of sort of excess stocking up or accelerated stocking up by your customers or channel partners, given all the headlines around supply chain shortages? And then secondly, when you look at Parker itself, how comfortable do you feel on that pricing outlook to offset cost inflation pressures?
spk10: Julian, it's Lee. I was waiting for somebody to ask a question about material costs and pricing. I'm looking at a commodity chart right now, which has got trends year over year, quarter over quarter, going back to the last big inflation period. It's a sea of red. But the thing I would say about our team is we saw this coming early on as we did this. And as you know, we've got really two great internal processes inside the company. It's how we track our PPI, which are our input costs, and how we track our selling price index to make sure that – we always maintain this margin neutral kind of role. So, you know, we've been active with price through the distribution channel and we'll continue to do that. We're fortunate to have great contracts in place with many OEMs that have raw material cost escalators in them. But our goal on the whole pricing side is to be margin neutral. We've done that before and we'll continue to do that. On the supply chain side, I would say You know, just echo what Tom said earlier, the biggest benefit is our business model. So we design, you know, source, make, sell in the region for the region. Everything you read about in the paper, we're not immune to that. I mean, there's still things that happen on a day-to-day basis, but I would just tell you from a company standpoint, it's not material. I mean, we manage it day in and day out. So on pricing, I think we're active in a good place on the supply chain side. We're managing it. The model's set up, so I don't think we'll get hurt, and it's really not going to be a material.
spk03: Thank you. And then how about on your own sort of customers or channel partners? Do you see them kind of across the board doing any kind of accelerated stocking up because of the supply chain issues being so well publicized, or do you think that the activity is kind of normal now? for what one would expect as you see a macro inflection positive?
spk10: Listen, everybody's very, very busy right now. I would say supply chain issues aside, North America labor is very tight. I mean, you read about that, that is a fact. So a lot of our customers are doing what we're doing, you know, just really using Kaizen automation where appropriate, et cetera. But I don't, Look, every time there's a ramp, there's a little bit of a bullwhip effect, but this is no different than anything I've seen in the past. It's just people trying to manage the increase in demand.
spk03: Great. Thank you.
spk10: Thank you. Thanks, Julian.
spk07: And you have a question from John Inch from Gordon Haskett.
spk12: Thank you. Good morning, everyone. Lee, maybe to pick up on some of the themes here, what are you seeing in terms of competitive behavior, particularly given the inflationary backdrop? How are competitors jockeying, jostling, and how is that maybe modifying your own behavior in this period of post-pandemic or emerging from post-pandemic?
spk10: I think really the narrative right now, John, is around supply. I think everybody's... We're structured much differently than many of our competitors, so the issues that you read about every day maybe are not as imperative to us. But I think the narrative right now is around supply. People are looking for continuity of supply if they can get it. Everybody understands what's happening with commodity prices. So I don't really see any negative customer actions taking place. I will tell you, and we've talked about this for years, This is always an inflection point for us where we tend to do better than the market as we come out of this. It's a combination of two things. We've done a lot of work with OE customers on design during the downturn because they're looking to simplify their designs, take costs out. We do that through our application centers. We see the benefit of that as we ramp up. And then second, our internal distribution systems are really poised to take advantage of disruptions with competitors.
spk12: I was wondering, you know, like as prices go up and everybody's trying to raise, you know, in various aspects of their operations, are competitors, one of the ways a competitor might instigate a price cut to position themselves is by not raising commensurately, say, compared with other people or other companies or players. Are you seeing any of that kind of behavior, or is it still a little bit too soon to tell?
spk10: I haven't seen that kind of behavior, and I typically really don't see that. You're in this kind of a cycle. You see more of that, John, when you're at the bottom of the cycle and people are trying to fill up factories.
spk12: Yeah, that makes sense. And then, Tom, you know, simple by design, as it becomes more ingrained as what's called an operating competitive advantage for Parker, do you think it could be used to perhaps offensively target companies for M&A, picking up on the M&A theme? I was thinking it could maybe provide a bit of an arbitrage opportunity for, say, Parker to be able to go in and, maybe even bid more knowing you can drive more synergies than other bidders that don't have simplified design as part of their arsenal.
spk14: Yeah, John and Tom, so clearly simplified design, and I would just say everything that's in WIN 3.0 is part of our basket of goods that go into evaluating an acquisition. So we look at what the best practices are for the acquisition, what best practices do we bring, that combination of 1 plus 1 equals 3, generates the synergy plan. And that's, you know, the bigger the synergies, which you're alluding to with Simple by Design, the opportunity you have to pay. And what we really look for is what's the synergized EBITDA multiple when we're done. And is that something that makes sense given to where we're trading? The other part, aside from acquisitions, to get at what Lee was talking about with competitive dynamics, Simple by Design is an opportunity for share gains. As we come up with products that are simpler to make, easier supply chains, more reliable, et cetera, and maybe in some areas where we don't currently have share, it allows us to penetrate an account. Overall, we've got 11%, 12% market share of this $135 billion space. We've got lots of room to grow. Simplified sign is just one of many share gain opportunities.
spk12: Yep, makes sense. Great. Thank you, Raj.
spk14: Thanks, John.
spk07: And you have a question from Jeff Sprigg from Vertical Research.
spk13: Good morning, Jeff. Hey, good morning. Thanks, everyone. Hey, I guess two from me. Just, you know, thinking about this idea, Tom, of trying to break the gravitational pull of the PMI, actually two questions. One just kind of maybe fundamental in the business and maybe a second kind of philosophical. First, obviously, the PMI is a broad industrial benchmark, right? Have Have you considered that, you know, calling your segments diversified industrial just suggests you are an industrial proxy? You know, perhaps some kind of different earnings presentation would make sense. You know, you give us this global technology platforms, but we don't know anything about the profitability of those sub-segments. So that's more of a philosophical question. I wonder if you've thought about that. And then secondly, You know, although most of your business is short cycle, right, I would argue it's really a broad mix of early, mid, and late. And I think to some degree people confuse short with early. I just wonder if you could kind of give us some rough buckets, what percent of your business you would actually characterize as early cycle versus mid cycle versus late cycle.
spk14: Okay, Jeff, that's Tom. So those are... That's a good question, hard one. First of all, that whole PMI gravitational pull, that's one of the reasons besides I think it's just a great way to describe the company, why we did slide five. And that's the, for those of you that are not looking at your slides, that's the whole PMI versus our EPS trend. And I hope people got the point there. This company is dramatically, and I've underlined dramatically different. And yes, we'll never be completely detached from PMIs because obviously That represents total manufacturing activity, and we would benefit from that. But we didn't get much help from that over the last six years, and you've seen us double EPS and add 600 base points to hepatone margins. So we'll continue that, and hopefully people recognize that we don't need the macros to help us. We have enough self-help with 2.0 and 3.0 to keep lasting us for many, many years. The current environment is going to get better, so we are going to get some help with that. Your comment philosophically on reporting segments, yes, that's been a raging internal debate for many, many years. There's pros and cons to it. Probably a longer discussion than I could do on an earnings call. But we continue to think that representing the way we do today is the best way. Because if you go back to those eight technologies and the fact that two-thirds of our revenue comes from customers that buy from formalized technologies, that's exactly how we go to market. We don't go to market specifically with one-off technologies all the time. We go to market if you look at our commercial teams, leveraging that breadth of technology. So that's how we're representing the company to shareholders. That's exactly how we go to market. Now, the whole early versus mid versus late, I'm not even going to try to do that, other than I'm going to reinforce your point that, yes, we are a mixture. And obviously you can look at aerospace and characterize that as long. But where do you want to put EVs? I mean, EV, we're feeling that now, but EV is a long-term change that's going to happen. Where do you want to put all the clean technologies? I could add up all the things I talked about on that one slide related to clean technology, and you get a pretty significant percentage of the company. Obviously, hydrogen's long, very long cycle, what's happening there. Electrification's a little more nearer term. So I think unfairly we've been characterized as early, and maybe because of just historically how we used to report orders on a monthly basis, see those things sooner. I think we're a good mix, and I think hopefully over the last six years, people recognize we're a good bet. If you want to bet your money, bet it on this team.
spk13: Great. Thanks for that perspective.
spk14: Thanks, Jeff.
spk07: And you have a question from David Russell from Evercore ISI.
spk01: Good morning, David. I'm curious. It seemed like the January price increases you put through were relatively modest. I think kind of where we were in the cost escalation moment, it made sense. But as the quarter's gone on and we look at the fiscal 22, it seemed like the fluid connector group put out an increase. But you don't usually do a lot of increases for July 1. The setup here feels, though, more accommodative to you putting price increases through. So two questions. Is it fair to say we should see a lot more mid-year price increases than we've seen in the past? And second, is the lead time issue significant enough where distributors who would normally want to get ahead of that increase are not able to given the lead times? I'm just trying to get a sense of how much of the price increase we could think about for 22 and sales that kind of capture it versus maybe a little bit of a natural pre-buy that you see sometimes when you announce an increase?
spk10: Yeah, David, it's Lee. I'll take that question. So I think it's fair to say you'd see mid-year price increases going on through the distribution channels, not only in North America, but globally, given where we are with input costs, et cetera. And I would say, by and large, you're probably pretty correct. Lead times that a lot of pre-buying, while there's some, it's not what you would expect if the level of activity wasn't so strong as it is right now. All right, terrific. Thank you very much.
spk15: Thanks, David. You know, I know everyone's got a pretty packed schedule today, so, Elaine, we'll take one more question before we wrap up.
spk07: Okay, the last question comes from Josh Pokerswinski from Morgan Stanley.
spk15: Morning, Josh. How are you? We may have lost Josh. We may have lost Josh.
spk07: Okay, do you want to take another question?
spk15: Yeah, we'll go to the next one.
spk07: All right, the next question comes from Nigel Coe from Wolf Research.
spk09: Thanks. I'm guessing Josh is speechless by the results, so thanks for fitting me in here. So look, I think that I think Jeff hit a really good point on the sort of early cycle point. You know, the fact that you're still negative in two of your three segments, I think, is sort of proof that you're not classic early cycle. So I think that's an important point. I did want to go back to your comments about incremental margins for 2022. And I know that that wasn't guidance necessarily. But if you could do 30% incremental margins with the temporary costs coming back and perhaps, obviously, inflation pretty rampant in the back half of the calendar year – I guess what I'm trying to ask is, you know, do you think that there's a line of sight based on ways of today to hitting that 50% incremental margin for FY22?
spk14: Yeah, Nigel, it's Tom. So you're right. We are not a guidance discussion for 22. 22 is hard enough to do, and we do it in August. But I think philosophically our goal and what is best in class is to do a 30% incremental margin. And I think the evidence that we're going to do about 30% in Q4, even with the tough comps that we have with the high discretionary cost as we did in Q4 prior period, are evidence that we can do that going into 22. We'll see when we pull the numbers together, because this Q4 is probably one of our tougher comparisons. And Q1 will probably be another tough comparison, but it will get progressively easier as we go through 22 of those comparisons. But I think a 30% is still on our radar, and Q4 is good evidence. If we can do it in Q4, we can do it going forward.
spk09: And that raises the question then, if you can do it in an environment like this, presumably FY22, a mix isn't going to be that helpful, I don't think, in FY22. But once aerospace starts kicking back into gear, Do you think 35% maybe plus could be a good run rate beyond FY22?
spk14: I missed the word. What was before FY22 there?
spk09: I mean, do you think that better than 30% could be a good number to use beyond FY22?
spk14: Yeah, over the business cycle, what we've always told people, if you're modeling us over multi-years, use 30. Now, clearly in inflections, we've done better than that, you know, in the 40s, 50 range. But this, while we're in inflection now, is a little bit masked because of the prior period big huge discretionary savings. That's why I gave the number, if you took that out, it'd be 50. So typically we glide pretty high up at the beginning, 30 over the cycle, 10 to later in the cycle, you're down into the 20s. But if you're modeling multi-year, I would use 30.
spk09: Okay, that's great. Thanks.
spk15: Thanks, Nigel. All right, Elaine, that concludes our call today. I'd just like to thank everyone for joining us. As always, we appreciate your interest in Parker. Robin and Jeff will be here all day if you have further questions or if you need clarification. I hope everyone has a great afternoon, and stay safe, everyone.
spk07: Ladies and gentlemen, this does conclude today's conference call. Thank you for participating. You may now disconnect.
Disclaimer

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Q3PH 2021

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