Parker-Hannifin Corporation

Good day, and thank you for standing by. Welcome to the Parker Hannafin Fiscal 2021 Fourth Quarter and Full Year Earnings Conference Call and Webcast. 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 the session, you will need to press star 1 on your telephone. Please be advised that today's conference is being recorded. If you require any further assistance, please press star 0. I would now like to hand the conference over to your speaker today, Parker's Chief Financial Officer, Todd Liam Bruno.

Thank you, Dawn, and good morning, everyone. Thanks for joining our FY21 QCOR earnings release webcast. As Dawn said, this is Todd Liam Bruno, Chief Financial Officer speaking. I'm here today with Tom Williams, our Chairman and Chief Executive Officer, and Lee Banks, our President and Chief Operating Officer. If you could focus on slide two. This is the company's safe harbor disclosure statement addressing forward-looking statements and non-GAAP financial measures. Reconciliations for any non-GAAP measures are included in today's materials. Those reconciliations and our presentation are accessible under the investor section at Parker.com and will remain available for one year. As usual, we'll start today with Tom providing some highlights of the quarter and our record fiscal year, as well as some color on Parker's transformation. Following Tom's comments, I'll provide a brief financial summary and provide some details on our FY22 guidance that we just released this morning. I'll then hand it back to Tom for closing comments, and then Tom Lee and I will open the lines for Q&A. And just one reminder, in respect to the announcement we made Monday concerning the MEGIT acquisition, we are still bound by the requirements of the U.K. takeover code. With that, I'll ask you to move to slide three, and I'll hand it off to Tom.

Thank you, Todd. Good morning, everybody. Thanks for joining us today. This marks the end of FY21 for us, and it was a difficult year personally and professionally for everybody due to COVID, but it was a year where the Parker team really shined. We delivered outstanding results and lived up to our purpose in enabling a better tomorrow, and my thanks goes out to the global team for just a great year, great quarter. So let's start with the quarter. It was dynamite, top quartile safety performance, 29% reduction in reportable incidents. The sales growth in the quarter was 25% approximately. Organic was almost 22, and the industrial portion of the company grew at almost 27% in the quarter. We had six all-time quarterly records, sales, net income, EPS, segment margins for Total Parker, as well as North American International. The EBITDA margins were very strong at 21.8% as reported, or 22.1% adjusted. It was 190 basic points improvement versus prior. On the segment operating margin, On an adjusted basis, if you go to that last row, 22.2% or a 230 basis point improvement versus prior. Just a great quarter and a really great team effort by everybody around the world. Go to slide four. We'll move to the full year. It was a year of records. And I won't read all these to you, but you can see eight all-time fiscal year records. And just that's in the history of the company. So that's 104 years to put up a record. So it speaks to how well the team performed in this last fiscal year. Sales growth came in almost 5% year-over-year. Organic was flat, but clear momentum building on orders and organic growth in the second half of the year, as you see from our order rates. FY23 margin targets, we hit them at full two years early, and we'll be announcing new targets once we have investor date March of next year, and we're going to go out for a new five-year target, so we'll be going out to FY26. We look forward to that discussion at that time. Operating cash flow was $2.6 billion, a record. It was almost 18% of sales. Free cash flow conversion rate was 135%. And we were very pleased to be able to announce the offer to acquire Mega PLC, which greatly enhances our aerospace portfolio, and I'll touch on that briefly here in a few minutes. So if you go to slide five, I want to talk about the transformation of the company, give you a little bit of color behind what's driving it, and the progress we're making on the results. On slide six speaks to the three drivers, living up to our purpose, being great generators and deployers of cash, and being a top quartile performer. I'm going to touch on each one of these over the next several slides. When it comes to purpose, enabling engineering breakthroughs that lead to a better tomorrow, this is something that really resonates with our people. It represents a higher calling to your work, and it acts as our North Star. In the next few slides, I'm going to talk about and highlight our purpose and action Specifically our technologies and how they're helping healthcare and how they're helping the climate and create a more clean technology world for everybody. So on slide eight, we're going to talk about vaccine production. In particular, something that's obviously very pertinent for today, COVID-19 production. On the left-hand side speaks to the challenges that drug manufacturers have today. This is a batch process typically with extensive inventories, long lead times to produce these products. They take huge space requirements, large footprints for storage, large footprints for the manufacturing processes, and very difficult changeovers. The cleaning cycles between the batch processes is very complicated. So the idea here is a simple concept that most of us can relate to. All of us have been in some kind of restaurant with a soda fountain where you can pick your beverage of choice. And, of course, the technology behind that is a concentrated syrup and carbonated water, and you get to pick the soft drink of your choice. So the idea here is instead of soft drinks, could we deliver sterile vaccine ingredients with a similar type of process? And slide nine is that process. So it's our in-line dilution system. It's a preparatory point-of-use process for combining the purified vaccine ingredients. So you look at that piece of equipment, you can see it's on wheels. So it's modular, easy to move around, easy to deploy, has mixing and sensing combined. It has two-way communications via the IoT enabled, It can talk to the manufacturer's enterprise system to enable scheduling just in time. It uses, very importantly, intellectual property protected single-use consumables. So instead of these massive batch processes, huge cleaning events for changeovers, this is a giant productivity improvement for the drug manufacturer on the speed of the changeover, but also just reducing contamination tied to the changeover. Then our software and automation helps control the amount and the flow of of these various ingredients. So this applies, obviously, to COVID-19. It will apply to other vaccines that are being developed. And we can use this for other drugs as well. So this is a really attractive business opportunity for us. But more importantly, it's a great help to customers and society. It's a great example of our purpose in action. Move to slide 10. Move to the climate and the clean technology portion of our purpose. We just recently announced last month new sustainability targets. You see on the right-hand side of this page, is our new sustainability report, which you can reach electronically. But we're announcing a 50% reduction in emissions by 2030, so that'd be scope one and two emissions, direct and indirect. And then by 2040, same thing, scope one and two, to be carbon neutral. So enabling a more sustainable future with what we do with our plants, our operations, our supply chain. But in addition, if you go to slide 11, and actually more importantly, how can we help our customers How can we help society with a sustainability journey? And so on this page, you see the eight motion control technologies across the top. And this portfolio, approximately two-thirds of this portfolio, is a very much part of the enabling of clean technologies for our customers. The exciting part is an expanding bill of material on automobiles, on construction equipment, on forestry, on mining, basically almost every piece of equipment on airplanes, engines, Everything's feeling this impact for more electric applications. So there's onboard opportunities, but there's also infrastructure opportunities. As the world has to build in infrastructures to support that growth, our technologies can help that infrastructure move. And then I want to move to slide 12, which illustrates the top four top performance portion of those three drivers. And you can see we're using two metrics to illustrate this. Adjusted EPS on the left and adjusted EBITDA margin on the right. That's really been our people, the strategic portfolio changes we made, the capital deployment decisions that we made over the last seven years, and the one strategy that's transformed is performance. When you step back and look at this, this is just remarkable improvement. On the left is a more than doubling of our EPS, and that's hard to do. I can assure you that's really hard to do. This is fantastic progress. a little less than $7 in FY16 and over $15 as we closed last year. And the EBITDA margin, which has clearly been propelling that from 14.7 to 21.3, so a 660 basis point improvement there. And then the last part on transformation and the drivers is cash generation and deployment. We touched on the cash generation piece in my opening comments, but clearly in the deployment is how do you deploy capital and buying effective companies. And we're very excited to put two high-quality companies together, an aerospace combination that we announced Monday. Parker and Megat nearly doubles the size of our aerospace system segment with highly complementary technologies, 70% sole source, a strong recurring revenue, excellent growth potential, combination of commercial aerospace recovery as well as the synergies, and this will be accreted to our organic sales growth, margins, EPS, and cash flow. This deal makes sense for all stakeholders, the shareholders of Parker and Megan, the team members of both of our companies, their parishioners, pensioners, and, of course, both of our customers. Following the announcement on Monday, we've introduced ourselves to the key stakeholders in the UK, reinforcing why we are the best home for Megan. Our long, great track record in the UK, the clear strategic rationale for the deal, including the premium we are offering to the Megan shareholders, our shared interest to continue to innovate and invest, and that we are committed to being a responsible steward of Megan. That is why we've agreed with Megan to offer the UK government a number of legally binding commitments about how we will operate going forward. These type of transactions take time, but we are pleased with the reception so far, and we look forward to constructive discussions with the key people in the UK government. And we'll keep you updated as the process unfolds and we go to the planned completion of this in approximately 12 months. With that, I'll hand it back to Todd for more details on the quarter.

Yeah, thanks, Tom. I guess I would like to direct everyone's attention to slide 15, and I'll just real quickly walk through the FY21 Q4 results. As Tom mentioned earlier, we have some outstanding results to share here. Sales increased over 25% in Q4 versus prior year and finished at $3.9 billion. As he said, that's an all-time record for the company. And we're really particularly proud of this due to the fact that our aerospace markets are still challenged. It really demonstrates the strength of the portfolio additions that we've spoken about, Clarkor, Lord, and Exotic, and really is driven by strong broad-based demand across all of our industrial businesses. Organic sales are up 22% in the quarter, so basically the majority of that 25% change is all organic. This is the first time organic sales have been positive for the company in over two years. Currency also was favorable with a 3.5% impact to total sales. Moving to adjusted segment margins, that 22.2% is an improvement, like Tom said, of 230 basis points from prior year, and it's also 80 basis points improved sequentially from Q3. Just another strong quarter of margin performance as really our teams around the world pivoted to the increased demand levels and managed through a number of challenges. Very proud of our team for that margin performance. Incrementals are also commendable at 31% year over year. Really impressive considering last year was the depth of the pandemic. And our decrementals last year were fantastic at minus 13%. And if you remember, that included approximately $175 million of temporary savings in that FY20 Q4. So we're really happy with the 31% incrementals. EBITDA margins also expanded 190 basis points from prior year. finishing the quarter at 22.1%. And if you look at that net income number, $577 million, that's an ROS of 14.6%, and that's an increase of nearly 50% from prior year. All of those great results translated to an adjusted EPS of $4.38. That's an increase of $1.39 per share, or 46%, compared to the prior year number on this slide of 299. Just one point I want to reference to the prior year numbers. and I'm really speaking to net income and the EPS numbers only. We have been planning for some time to convert our remaining U.S. locations that used to use LIFO for inventory evaluation to standardize that across the company and move to FIFO inventory evaluation purposes. We made that voluntary change in FY21Q4, and we've retrospectively applied that change to prior years And we've attached the impact of those prior years to this press release in the table section. So impact to the previously reported quarter last year was minimal. It was only 4 cents last year. So the $2.99 on this page, if you're looking back to prior year, that would have been $3.03 in FY20. So one other note I want to make, LIFO, we've always booked this at the corporate level. This has no impact to our segment operating margins or the incrementals that I just mentioned to, and now 100% of the company's inventory is valued using the FIFO method. So just one last comment on the quarter. Really proud of our team globally. It's just a tremendous effort the team put forth to put up just such a solid quarter to finish, really, as Tom said, a record year. So if we can move to slide 16, this is just the bridge of that $1.39 increase to adjusted EPS that I just mentioned. And what I love here is the largest bar on the page signals the strong operating performance that the teams put together. Our segment operating income on an adjusted basis increased $250 million, or 40% from prior year Q4. That accounts to $1.50 of the increase in EPS that we just put up for the quarter. of $1.39, so it's really strong execution really everywhere across the company. All the other items you see on the slide, if you net it, it's 11 cents unfavorable. Corporate G&A, income tax, and shares were slightly unfavorable, but lower interest and lower other expense partially offset the impact there. So, again, most of this is really fantastic due to comparing back to our COVID-impacted quarter of the prior year. If you go to slide 17, just some color on our segment performance, really the message here is our industrial businesses delivered outstanding results across the board. We've spoken in the past about the impact these portfolio changes have had on the company, and you can see it here in these margin numbers. Diversified North America sales were $1.8 billion in the quarter. Organic sales improved again in this segment, sequentially up and are up 26% versus prior year. Operating margins improved an impressive 300 basis points versus prior year, and really finished at 22.5% for the quarter. Obviously, volume helped us a little bit there, but really the disciplined operating performance and cost control really continue to drive the sizable increase to margins. Margins in this segment are a record, all-time record, and incrementals also were very healthy at 34%. And again, I keep referencing the comparables back to last year, which is just a very tough comparison. If you look at order rates, order rates are robust at plus 56%. This is up sequentially from last quarter. We reported plus 11%, and really just strong across the board. If I move to the international, diversified international segment, really same story here. A little bit higher organic growth of 28.5%. Sales just reached $1.5 billion in that segment. And, again, another story here, adjusted segment operating margins expanded 300 basis points for its prior year and finished at 22.1 percent in the international segment. Just really, again, strong organic growth in that volume coupled with that cost containment and productivity initiatives really generated this record margin performance in this segment as well. Order rates, again, here, tremendous, up a little bit higher than North America at plus 58% versus 14% positive in the last quarter. So really just a great performance out of our industrial businesses. I'll just touch on aerospace systems really slightly. Very sound performance in the current market. Sales here were $630 million for the quarter, and I'm happy to report organic sales have turned positive in this segment. They are up 1%. We saw strength in commercial and military aftermarkets. with strong sequential growth again in Q4, and we're happy to start seeing rate increases from OEMs, particularly in the narrowbody and business jet platforms. Aerospace orders also got less negative and improved to minus 7 this quarter on a rolling 12 basis versus minus 19 last quarter, and further proof that we are seeing signs of recovery in this area. Operating margins also very strong, 21.6%. That improved sequentially from Q3 and really finished the year at the highest level they've had in the entire fiscal year. So very proud of our aerospace team there. So just looking at company in whole, we're really pleased with these results. That's a solid finish to the fiscal year. Our total incrementals were 31%. I'm really proud about that. And really just a comment. If I look at just our industrial businesses, if I go back to pre-pandemic, FY19, And on a like-for-like basis, if I include Lorde in those FY19 numbers, in the industrial businesses, our sales volume has surpassed pre-COVID levels. So we're really proud about that. Orders, you can see, in total are plus 43%. And as Tom mentioned, not only did we achieve our FY23 margin targets, but we surpassed them. And we did that two years earlier. So if I go to the next slide, slide 18, cash flow, we're obviously very proud of this. Tom mentioned this earlier, full year cash flow from operations was $2.6 billion. That's an all-time record for the company. 17.9% of sales, just outstanding, top quartile performance. If you look at that compared to prior year, we generated over $500 million more cash. That's 24% more cash than we did prior year. And like I said, that CFOA of $2.6 billion is a record. Working capital, really solid performance here. And I want to just really thank our teams everywhere around the world for focusing on this. We asked them to focus on this through the pandemic, and they delivered soundly. So I want to thank you all for your focus on that. Free cash flow, also fantastic, 16.5%. That's up 310 basis points for its prior year. And the free cash flow conversion for the year, 135%. So with that, this now marks the 20th year that free cash flow conversion has been greater than 100%, and cash flow from operations has been greater than 10%, 20 years running. All of this allowed us to significantly pay down our serviceable debt. We've been vocal about that for the last couple months. If you look at the last 20 months, we've paid down $3.4 billion of debt, and our gross debt to EBITDA finished the year at 2.1%. Net debt is 1.9%. So again, it's a similar story here. We achieved these leverage levels a full one year sooner than we originally forecast. And it's just an outstanding cash position. It's top quartile execution and really impressive considering the backdrop of the global pandemic. So 19, I will ask you to focus on 19, just flipping to FY22. And our guidance, you saw that we released this this morning. As usual, we're going to provide this on an as-reported and an adjusted basis, and I'll just start at the top. Sales, we're forecasting sales to increase in the range of 5% to 9%, really 7% at the midpoint, and really the breakdown of that sales growth is essentially all organic. We do not expect the mega-transaction to close in FY22. Both Lord and Exotic have anniversaries, so those are no longer considered acquisition sales. Therefore, we are forecasting no impact to sales from acquisitions. And currency is just a minimal drag at 0.2% of sales. And just like we always do, we have calculated the impact of currency to spot rates at the end of June 30th, and we've held those rates steady as we forecast FY22. One thing I'll note, the sales split for the guide is 48% first half, 52% second half. The next item I'll talk about is segment operating margin. On an as-reported basis, the guidance for the full year is 19.3% at the midpoint, and there's a range of 20 basis points on either side of that. But more importantly, on an adjusted basis, segment operating margin guidance for the full year is 21.6% at the midpoint, same range of 20 basis points on either side of that. This adjusted segment operating margin guide is 50 basis points higher than what we just finished our record FY21 at. Just some color on adjustments. At a pre-tax level, business realignment charges are expected to be $35 million for FY22. Lowered costs to achieve are only $7 million for the forecasted year, and acquisition-related intangible amortization is $320 million. Just a note on the split, adjusted segment operating margins, 46% first half, 52% second half. If you look at the corporate G&A interest and other, $480 million is our forecast. That is the same on an adjusted and an as-reported basis. Tax rate, we are forecasting full year to be 23%. And finally, EPS on an as-reported basis, our guidance is 1448 at the midpoint. There is a 40-cent range on either side of that, and our adjusted EPS guidance is $16.60 at the midpoint, same 40-cent range on either side of that. Adjusted EPS split, first half is 45 percent, second half is 55 percent. In a little color on Q1, we are forecasting adjusted EPS to be $3.60 at the midpoint. Slide 20 is the bridge, and again, this is very similar to Q4. Main driver of the $1.56 or 10% increase to adjusted earnings per share is just our continued strong execution across the enterprise. Segment operating margin is accounting for $1.76 of that change. And then again, just slightly higher corporate G&A tax and average shares outstanding are a little bit of a drag. But all in, $1.56 increase in earnings per share, increasing earnings per share by 10%. Lastly, I will just talk about capital deployment. For FY22, we are committed to our capital deployment strategies. We have a strong 65-year record of consistently, consecutively increasing the annual dividends paid. We're going to continue with that record. Our payout target is not changed. It remains 30% to 35% of the five-year average of net income. And, of course, we're going to continue to fund organic growth and productivity across our global locations. We expect capital expenditures to be 2% for the year. Our 10B51 share repurchase program, we reinstated that this year. We are committed to continuing that in FY22. And as I mentioned when I was talking about cash flow, we have extinguished all of our serviceable debt, and we are now in a cash-building position. So our focus for FY22 will be to continue our record of strong cash flow generation and accumulation in preparation for the closing of the mega-transaction. So with that, Tom, I'll turn it back to you, and I'll ask the audience to focus on slide 22.

Thank you, Todd. Just closing messages. You know, what drives these results, the engine behind the companies are people. highly engaged team, great culture, higher levels of ownership, driving this performance, very inspiring results, as you've seen. Living up to our purpose, the vaccine production is a classic example of that. Core top performance, the more than doubling of EPS, the 660 base points improvement in EBITDA margin for the last six years. Getting to margin targets that we laid out for you two years early, and obviously we're going to keep improving upon that. And the strategic deployment of capital and change in portfolio, Clarkor, Lord, Exotic, and now Megat, you put that together with the wind strategy 2.0 and now 3.0, and it really spells for a bright future and will continue to accelerate its performance. And with that, I'll turn it over to Dawn to open up the Q&A.

Thank you. If you wish to ask a question, please press star 1 on your telephone. To withdraw your question, press the pound key. Please stand by while we compile the Q&A roster. And your first question comes from the line of Scott Davis with Milius Research.

Scott Davis Hi. Good morning, guys, and congrats on a great year. I don't always say that, but I mean it. Guys, you've had a few days for this to marinate, the mega deal at least. What's been the customer response and feedback to the announcement?

Scott, it's Tom. We're early days on reaching out to customers. General view is very positive. They like the fact that this is a stronger bill of material, opportunity to create more value, the highly complementary technologies, and really positive the track record of both companies. You know, both companies have a great reputation, great innovators, great engineering-led companies, so the response so far is very positive.

Good to hear. And not to get too nitty-gritty here, but you didn't really talk much about some of the challenges out there on a cost side, you know, supply chain, disruptions, logistics, all of that. I mean, Clearly, with 31% incrementals, it couldn't have been too big of a deal for you guys, but perhaps you could help us understand how you've managed through that and how you're thinking about that as it relates to guidance over the next 12 months as well.

Hey, Scott, it's Lee. I'll take a shot at answering this. I think the first thing on the supply chain side is just to kind of step back and recognize how we're structured, which is the huge benefit for the company. As you know, we make cell and source in the region for the region, so it allows us to be close to the customers and get away from a lot of international shipments. Having said that, we're not immune to what's going on in any of the regions, but I would characterize it internally as being manageable, but not without hard work. I would say the biggest challenges we're dealing with is just our customers. So, I mean, I think, you know, automotive is very public on what's happening, but I probably don't have a large OEM that hasn't had some kind of disruption where lines have been down, people have been sent home, et cetera. So, you know, we're working with our customers to work through that. It's just creating a lot of chatter in the channel, and it's just, you know, I would say this is a lot of choppy production.

Yeah, makes sense. Okay, thanks, Lee.

Yeah, you bet. I'm sorry. Your next question comes from the line of Jamie Coote with Credit Suisse.

Hi, good morning and nice quarter. I guess just a couple questions. Can you help us understand what you're assuming for organic growth in the first half versus the second half and what you're assuming sort of price versus volume is? And then I guess the aerospace, like the top line guide to me seemed like, you know, with what's going on, understanding we have the Delta variant, but there could be some level of conservatism there as we think about sort of the top line. So if you can just help me understand what your assumptions are on the aerospace guide. Thank you.

So, Jamie, it's Tom. I'm going to take the guide, and I'll take a few minutes to describe that. I'll go through the aerospace piece. I'll let Lee touch on the price-cause aspect. So this is probably the question that everybody's on everybody's mind, how do we come up with the guidance and some of the context behind it? So first of all, there's a number of tailwinds, and I'll highlight some of the headwinds, but on the tailwind side, clearly the order trends, the macro environment, I think there's a CapEx underspend that happened for a number of years, so I think there's some CapEx demand that's coming back from manufacturing companies. Clearly, governments being more prone to put in stimuluses, the rebound from the great shutdown and, of course, the rebound of activity, the commercial aerospace recovery, which I'll touch on to answer your question here in a minute, Jamie, low interest rates, and then the climate investment, which with our clean technology portfolio is a very attractive, positive for us in the future. On the headwind side is the Delta variant and COVID. It hasn't gone away and is creating uncertainty throughout the world. The supply chain district, supply chain disruptions, in particular our customers and how that might impact demand patterns, which Lee touched on, and inflation, both on the material side and with wages. But we've built a pretty sophisticated AI model over the last 18 months. It's not perfect. Nothing is when it comes to forecasting. But in my time at the company, it's the best tool we've had to date. And we factored in all these inputs and came up with what the best forecast is. So I'll give you a little more detail behind it. The first half that we're looking at, is up a little over 9% organically, and the second half up mid-single digits. That's how you get to the 7% overall. An important part, though, if you look at the industrial piece, both North America and industrial are approximately the same, up 11% the first half and up mid-single digits the second half. When you think about aerospace, and several of the pre-reports that came out didn't have the insight that I'm going to share with you right now, so we have aerospace companies with a gradual recovery up 3% the first half, up 5% the second half. That's where you get the 4% at the midpoint. But what's underneath that, and I'll help give you some context as to why that number is what it is, on the commercial side, both OEM and MRO, that's going to grow low teens. So nice recovery there. Military MRO is growing mid-single digits. What is down is military OEM. It's down mid-single digits. And the reason for that And thankfully, our customers thought of this. Our customers accelerated deliveries last year. We were up 19% as an example. They did this to protect the supply chain, to protect supplier health, because a lot of suppliers have commercial exposure as well as military exposure, and they accelerated the military exposure to help everybody. So this year that we're in now, 22 is a reset of the inventory through that supply chain. So we will be down 20%. And, of course, then we'll go back to more normal levels in FY23. If you were to take out that acceleration in the prior period, our FY22 military OEM would be about a plus three. So then when you would factor that in, aerospace growth would be more like 8%. So that 4% is being weighted down by the military OEM segment, that reset of inventory. So hopefully that helps everybody with why the aerospace number is what it is. Just comparing that growth rate to 7%, to GIPI, Global Industrial Production Index. That's going to be within our fiscal year 22. That's a 4.8% forecast. You've heard us talk externally. We want to grow 150 basis points faster than that, so our number at 7% will do that. Then maybe while I've got kind of talking about guidance, I want to just touch for a second on operating margin, and then I'll let Pete comment about price costs. So our operating margin guides at 21.6% at the midpoint. So it's an approximate 30% MROS for the full year. If you were to take out the discretionaries in the prior period and made this an apples to apples, the underlying MROS is a positive 50%. And a good indicator is that what we did in Q4, we did over 50% in Q4. So that was actual results. The reason why I mention that is that underlying MROS is being hidden because of the year-over-year comparisons being awkward, and it really speaks to the operational excellence from the team, just because it's hard to do an underlying 50% MROS. I think everybody can appreciate that. So, Lee, if you want to comment on the price-cost.

Yeah, Jimmy, I'll just, you know, add on and finish up here with price-cost. So, last earnings call, the question came up, and I talked about how we track all the commodities on quarterly trends and then year-over-year trends, and I said back then it was a sea of red. In other words, everything was up. And I would tell you here, a quarter later, it's still a sea of red. But having said that, we're able to see this coming very well because of the processes we have internally by measuring what we call our purchase price index and then also maintaining margin neutrality by our selling price index. So we're on top of it. And our goal, as we've always said, is to be margin neutral. We're actively working price. both with direct customers and distribution, but there is a lot of inflation on the commodity side right now, no doubt about it.

Okay, thank you. I appreciate the color. Thanks, Jamie.

Your next question comes from the line of Midge Debray with Bayard.

Good morning, Meg. Good morning, everyone. Thank you for taking the question. Tom, I guess I'm looking for a little more context from you vis-a-vis industrial order strength, both North America and international. I don't know what your expectations were for the quarter, but I'll tell you, versus ours, these orders were much stronger. And I'm also looking to understand what backlog must look like at this point, because obviously your order intake was higher than organic growth, and are there any challenges with regards to converting this backlog to actual revenues, either on your side or maybe potentially your customers? So let's start with that maybe.

So let me talk about orders, Tom. And I think this will maybe help clarify things for people. People, if you're doing two-year stacks, you might say, hey, geez, it seems like the organic growth might be light compared to the two-year stack. The one thing that you have to look at is, In current period, we have acquisitions in prior period. We do not have lowered in exact. We go all the way back to 19. When you do apples to apples on orders 19 to 21 and exclude the acquisitions, our industrial orders are up low teens. And I just mentioned as I was answering Jamie's question, our forecast for the first half on industrial is low teens, 11% organic growth. So there's clear correlation between what we're seeing versus 19% again, apples to apples on order entry. And that's how we, in addition to the AI model, how we laid out the year. Backlogs are increasing. Again, you've got to remember the prior periods as uniquely low comps, so it's probably an inflated number that you can't get too excited about. Our on-time delivery is holding up nicely. Obviously, my customers would like to see us do better on that, but it's holding up very well compared to comparable times. And I'd say the impact that we've seen has been more on customer pushouts of schedules, particularly in automotive, where the automobile OEMs are having trouble with chips, as everybody knows, and they're taking really targeted shutdowns, and that will push out our various orders, and that impacted North America a little bit in Q4. But as Todd had mentioned, our Q4 sales we're up about 10% industrially versus Q4 of FY19. So everything's kind of coalescing between orders and sales when you compare to 19 around that low teens type of growth rate.

Okay. And then I guess I want to follow up on Jimmy's question on pricing and trying to see if we can get maybe a more specific answer. You know, when I'm looking at various PPIs of some of the product categories that you guys are involved with, it's pretty common that I'm seeing these PPIs somewhere in the plus four, four and a half year over year. And I'm just sort of wondering if you're seeing a similar level of price increases in your industrial business and if there are differences at all in terms of, you know, OE versus your distributor partners. Thank you.

So I would say, you know, it's a range, some lower and some higher. Whether it averages out to that or not, I can't really say. But, you know, with our OEM customers, you know, we've got direct contracts with many of them. And what we're benefiting from is a lot of them have material clauses in them. So it allows us to capture that pricing as we go forward. On the distribution side, that's typically just a list price increase. But, you know, what you're seeing is kind of our best guess, and it's all in the guide right now.

Thank you.

Thanks, Meg.

Your next question comes from the line of Nicole DeBlaze with Georgia Bay.

Good morning, Nicole.

Thanks. Good morning, guys.

Can we just maybe – I know you went through the one-half dynamics, Tom, but can you just narrow that view a little bit to what's baked in? to one cue, both with respect to organic growth and incremental margin. Thanks. Tom Schueler Yes.

So, Nicole, it's Tom. So, first quarter would be a kind of low to mid-teens for industrials, aerospace low single digits. And really, our first half from an MROS is going to be in that upper 20s. Again, I would just point to, again, the comparison if you did apples to apples, would still be in that 50% range. So it's really outstanding performance by the operating team being masked by the prior period, all the discretionary cost savings that we had.

Got it. Okay, thanks, Tom. And then can we just clarify on the change to FIFO accounting in the US? I guess, what was the impetus to do this now? And is there any benefit to the 2022 guidance related to the FIFO change?

Yeah, Nicole, I'll take that. This is Todd. You know, we've been talking about this internally for quite some time, and it really started with the recent acquisitions, Clarkor, Lord, and Exotic. Those companies always use the FIPO valuation method. We do not use it in our aerospace business. We really only used it in our traditional U.S. locations, all of our international locations, by rule had to use the FIFO evaluation method. So we took a look at it and said, hey, maybe this year is an opportunity to convert, and that's essentially what we did. We converted early in the quarter. We worked tirelessly across our teams and with our internal, or excuse me, our external auditors, and we felt it was the best time to do it. There really is no impact to the quarter since we converted. We essentially reported the quarter in the FIFO method, We did go back and restate prior years just to show you what the impact was. And I just want to make sure everybody realizes that if you look at this historically, it's a penny or two per quarter. It's a very immaterial impact. We always book that at corporate, so it had no impact to our segment margins or any of our incrementals, and it really just now standardizes our inventory evaluation across the entire company. So we're happy with the results. In respect to FY22, there's nothing in the guidance for a benefit for converting to FIFO.

Okay. Thanks for clarifying that, Todd. I'll pass it on.

Okay. Thank you.

Your next question comes from the line of Nathan Jones. Hi, Nathan.

Good morning, everyone. Good morning. I wanted to follow up on the MROS comment, Tom, of 50% if you'd normalised both years for all of the discrete costs and charges and benefits, which I think is you would normally see a high MROS in the first real year of a recovery here, which would then glide back down to something more normalised. But I think the 50% was probably higher than you would normally get in the first year. Can you talk about what you think that MROS kind of progression would be over time and what a normalized average kind of incremental margin MROS would be for you guys?

Yeah, Nathan, it's Tom. And you're right. I think this underlying MROS of 50% for a whole year, and it would be also counting Q4 and probably Q3 of last year, so 18 months, would be higher and longer than we would normally expect. I think we're what speaks to the changes in the wind strategy and the fixed cost changes we've made and maybe the efficiencies on top of those changes that came out of the pandemic just a more efficient way of working. But I think going forward, especially when we get to FY23, you won't have these anniversaries to worry about with the discretionary one year and not in the next year. I think, and I would just use for people modeling, 30%. As we've looked at and benchmarked it, That continues to be a best-in-class number. And I think with all the changes we've made, I think that's a good number to use over a cycle to use 30%.

All right, thanks for that. I did want to ask a question on the ESG report that you guys put out the other day. It's clearly some very significant reductions that PARC has made over the last decade or so and some good aggressive targets over the next 10 to 20 years. Can you talk just a little bit about, it's probably a very long answer, some of the mechanisms that you're going to use, some of the main initiatives that you're going to use to achieve those goals?

Yes, so it's going to be a combination. So we've been working this already, and we've had, since 2010, a 44% reduction. I've got the report actually from it. I have to go find various, we use different time periods, and 50% in the report. since 2010. So we've been on this for a while, and it's energy things that we do within the plants, renewables, different lighting. Some of this will happen from indirect emissions. As the various utility companies change over to using renewables, we automatically get credit for that as well. We're going to be working with our suppliers on what they can do to reduce it. All the Kaizen work we do where we just utilize the equipment better, smaller footprints, better flow, less distances traveled, all those kind of things help in this reduction. So we have every group signed up. They have their respective greenhouse targets that they're working on. They know exactly where they are, and that gets cascaded down plant by plant. And then we've also had – Envision every group having a list of greenhouse gas emissions, reductions, water things they're doing, recycling things they're doing. That's the only way we know how to do it. We drive it down to the respective divisions. And then at the group level, we have each group on their technology roadmap developing their clean technology portfolio and how it needs to change for more EVs, more fuel cell EVs, more hydrogen, et cetera. And... The groups have been actively doing this. The good thing about this is we formed the Motion Technology Center about three years ago, and for people who aren't familiar with it, this was taking the best and brightest that we could between aerospace and our motion systems groups, taking all the motion-related technology of the company and having a center of excellence for that, and in particular, focusing on electrification. And a lot of the technologies that we developed in the 90s on the F-35, so the the flight surfaces on the F-35 fighter are electrohydraulically actuated, and we've taken a lot of those learnings and applied it into the industrial portion of the company and has developed a suite of motors and motor controllers and software that we're offering on the industrial companies, OEMs in particular, where their platform changes as they look at more electric. And when you add in acquisitions like Lorde on top of the Engineer materials applications that we had from Legacy Parker, we have a really strong materials science portfolio to help with that transformation as well. So our sustainability message is twofold. Things we're going to do internally, which we have good line of sight to, and, you know, we put out two major targets, 2030 and 2040, but we're looking for year-over-year things to get there. And then what we're doing to help our customers, because our customers, that's scope three, that's us helping our customers, and we'll be all over doing that.

Great. Thanks for taking my questions.

Thanks, David.

Your next question comes from the line of Joe Ritchie with Goldman Sachs.

Thanks. Good morning, everyone.

Good morning, Joe.

Todd, maybe first question on free cash flow. Clearly, you know, really nice job this year at 16.5% of sales. I guess if you think about the free cash flow margin going forward, Should we be thinking that there's going to be a little bit more of like a working capital train going forward, just given that growth is inflecting here on the industrial side?

Well, yeah, absolutely, Joe. There's been a step change in our cash flow performance. I think everyone has seen that over the last couple of years. It's always a little bit tougher in a growth environment. So, you know, we'll be ready for that. I still think there's some opportunity across our enterprise to Some of the recent acquisitions, I think we've got some upside on inventory. And really, on receivables and payables throughout the last 20 months. So I still think we've got room to grow here. So we're not expecting much of an impact. Okay, great to hear.

And then my one follow-up, Tom, you know, obviously, clearly, you know, big announcement this week. I'm curious, you know, maybe on the flip side of things, are you thinking, you know, maybe a little bit more aggressively around, like, the portfolio divestiture side to help with the potential deleveraging from this large acquisition, and how you're thinking about divestitures holistically, that'd be helpful.

Yeah, Joe, it's Tom. We look at that all the time, not just when we have a large acquisition, but this is a something we have standard work around that we look at at the Office of the Chief Executive, so Lee Todd and myself, as well as we do it annually with the board. And I would characterize it, I've used this visual for people. I think the portfolio of the company has been very thoughtfully put together. Think of it as a tree trunk with the various branches. Two-thirds of our revenue comes from customers who buy from four or more of the eight technologies we have. So My predecessors and everybody that built this company did a very thoughtful job of putting together interconnected pieces that make sense. So when we do that portfolio analysis, there's very little that we see that we'd want to divest. It's something we look at all the time. It doesn't mean that we wouldn't divest of anything, but if you use the tree analogy, it would be a small branch. There's going to be no major trunks that gets lopped off. But we look at it all the time, but I wouldn't see any big announcements from us regarding divestitures.

Okay, thanks for taking my questions.

Appreciate it, Joe.

Our next question comes from the line of Joel Tiss with BMO.

Hey, guys. Just a different angle on that last question. Are there any internal actions you guys can take or that would really help you to get ready for the MEGIT acquisition, or that's not how you work?

Well, I would characterize Joel as Tom. Those internal actions have been happening every day since I joined the company and every day that everybody else that works here. I mean, we're all about continuous improvement, and I think the slide we showed earlier on, the 660 basis points improvement in EBITDA margin is what's positioned us to be able to do a deal of this size. If you think about a couple things regarding MEGIT, and just using that as an example, the multiples that we're going to do are very similar or less than what we did with ClarkWare. The synergies, while the dollars are big, the percent synergies are very similar to what we did with Clarkor and Lorde. And what's interesting is we're going to do a deal that has over 2x the purchase price of our largest transaction, but our starting leverage will be about the same point that we were when we did Lorde and Exotic. So the question might be, well, how? The reason for that is because EBITDA has grown dramatically. the cash flow generation of the company, the EBITDA margins have grown so dramatically that we can take this size, and it looks very similar to what we did in the past. And so we've been getting ready every day, and as we keep getting ready, we'll probably be ready to do something even better as we go into the future. You know, when we update you on our FY26 targets, they're going to be higher than what we are today. And once you add your 3.0 just started, and it has tremendous – firepower behind it to continue to propel the company. So we're preparing for the future every day, and I think what we did really the last 10 years is what's positioned us to do the mega-acquisition.

Does that take away your kind of potential as we get to Investor Day to have some kind of bigger levers that really drive margin forward? Is it really just a series of small things? And can you give us a couple of examples of some of the things you're working on that could really continue to transform this company? And then I'm finished. Thank you.

Well, there's a couple things I'll talk about on the top line. It would be the portfolio changes we've made, but there's also things organically we're doing differently, the whole strategic positioning, which I'll try to give more color on that on IR Day and how our divisions are taking a real step change in ownership of how they position themselves versus their competitors. The innovation changes we've made on PVI and new product blueprinting, simplified design, which is a growth propellant as well as a margin engine, international distribution growth, digital leadership, and the new incentive plan change, ACIP replacing RONA. All those things are going to help on the top line, but several of those help on the margin side as well. So As the portfolio becomes more innovative, and it has over the last number of years, those carry higher margins. Simple by design, as some of you maybe heard me talk about, will be the single largest margin enhancement the company's ever done, and it's just starting. International distribution, as we move that mix, that's a margin enhancement. We found with digital leadership that we continue to get more efficient with the use of AI, and then probably last but not least and the most important, the things we've done around engagement. If I had to pick one single thing that's propelled the company, it's been the engagement of our team members, the engagement scores, the ownership. And it's hard to put a number to that, but you know when you have people that think and act like an owner, that use Lean and Kaizen as part of their normal thinking, that spirit of continuous improvement is a big part of what's driven our success to date. You can plot our Kaizen activity and our engagement scores, and they're working hand-in-hand. They're like on a parallel path driving success. So it's not one single thing, Joel. It's a number of things, and I guess that one slide that we showed you earlier showed the compounding effect of improvement year over year, the compounding on EPS, doubling it, the compounding on margins, and that's going to keep going. We're not going to stop.

That's great. Thank you.

Thanks, Joel. Hey, Don, I think we have time for one more question. So whoever's next in queue, we'll take one more question.

Okay, we have a question from the line of David Russo with Evercore ISI.

Hi, thank you very much. I apologize. I didn't follow the order commentary. You said the current quarter orders were running, I think you said 17%. Can you first clarify that? Was that industrial? Was it the whole company? I'm just trying to understand that comment.

David, this is Tom. So The comment I mentioned on orders was contrasting 19 to 21, where we were. If you made it apples for apples, and because we didn't have acquisitions, two last acquisitions in 19. And that has orders growing versus 19 at around low teens. And I was just making that correlation that we had order entry coming in low teens versus 19. And we've got sales growth in Q4 was right around 10% versus 19. And our forecast for organic growth the first half for the industrial piece of the company was around 11%. So they're all kind of coalescing around that 10% to 11% low team type of level.

I appreciate that, but we're not really comparing it versus 19%. Your guide is 22% versus 21%. And if the orders were over 50% industrially in last quarter, if you look at the more challenging comps, single stack, maybe it's 17%. So the orders would be up like 40. Or you want to double stack it, it's even less of a degradation. So I'm just trying to understand, what are the actual order trends right now versus a year ago? Just so we understand, are you seeing a slowdown? Or are we just confusing the commentary about versus 19? Just to be clear, because the first half industrial growth is the correlations breaking significantly versus orders leading sales and how you're guiding.

I was trying to give you back to something that was more normalized activity because the year-over-year is what we've announced. It was over 50 plus percent for international and minus seven for aerospace and plus 43. But you can't extrapolate that against normal conditions because that was against a quarter ago, which is when the great shutdown happened. So you can't take that number and extrapolate it into organic growth. You've got to come back to kind of some other benchmark. And so we went back to when activity was more normalized, and that's the data they came up with. This is where all the various inputs that we put into that. So there's a lot of science that went into this number, and I'm just trying to contrast why you can't take a 43% order entry and say you're going to have a 43% organic growth.

But would you be able to help us with how the orders are trending currently versus a year ago?

Well, orders continued to grow through the quarter. I mean, you know, if I take North America, it was 11% at Q3, and it went to 56%, and it sequentially got better every month through the quarter. Same thing happened international. So we saw momentum building through the quarter. Things were definitely not slowing down, David. I don't want anybody to take that thought process. Things built through the quarter.

Well, that's why I want to be clear. I mean, Tom, if you've got 50 in this past quarter, that usually is, right, somewhat of a correlation for the next quarter, but the comp's not exactly a normal comp. But the fact is, if you look at the comps, this current quarter, the industrial orders should still be up north of 30 or so. And then when you have two quarters running 50, then 30, it doesn't make a lot of sense to be thinking the first half industrial is kind of low-teens. And I know it's a little tricky on the conversion. Maybe some things are taking a little longer to ship. I'm just making sure we don't walk away thinking that's a pretty dramatic slowdown. So you're saying you're not seeing a slowdown end of the day. I'm going to be very clear.

There's absolutely no slowdown. You can't take a 50% order entry rate and draw a linear curve there and say it's a 50% organic growth.

I hear you. I hear you. Lastly, for the March meeting, When we think about the comment about simple by design, still you feel pretty early in the journey. Any way you can frame for us how you perceive margin improvement from here versus kind of the journey we've been on the last five years? Just to kind of frame it a little bit for us, given simple by design. I'm not going to do that yet.

I want to do that in full context, going through all the strategies and how we're going to do it and giving you a fully baked explanation. But I would just say that we're going to continue to get better. And if the past is an indicator, you can draw that into the future. I appreciate that.

Okay, thank you very much.

Appreciate it, David. All right, I just want to say thank you to everyone for joining us today. This does conclude our FY21 Q4 earnings webcast. And, again, just consistent with the comments made on Monday regarding the the requirements of the U.K. Takeover Code, and our pending MEGIT transaction. A representative of Citibank will continue to participate on all of our analyst and investor calls for the foreseeable future. Robin and Jeff are obviously available here all day if you have further questions or need any further clarification. And always thank you for your interest in Parker, and I hope everyone has a great day and a great weekend. Take care.