Parker-Hannifin Corporation (NYSE:PH) Q1 2024 Earnings Call Transcript

Parker-Hannifin Corporation (NYSE:PH) Q1 2024 Earnings Call Transcript November 2, 2023

Parker-Hannifin Corporation beats earnings expectations. Reported EPS is $5.96, expectations were $5.33.

Operator: Greetings, and welcome to the Parker Hannifin Fiscal 2024 First Quarter Earnings Conference Call and Webcast. [Operator Instructions]. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Todd Leombruno, Chief Financial Officer. Thank you. You may begin.

Todd Leombruno: Thank you, Diego. Welcome to Parker’s Fiscal Year 2024 First Quarter Earnings Release Webcast. As Diego said, this is Todd Leombruno, Chief Financial Officer, speaking. Thank you to everyone for joining us this morning. With me today is Jenny Parmentier, our Chief Executive Officer; and Lee Banks, our Vice Chairman and President. Our comments today will be addressing forward projections and non-GAAP financial measures. Slide 2 of this presentation provide specific details to our disclosures in respect to these areas. Actual results could vary from our projections based on the items listed here. Our press release, this presentation and reconciliations for all non-GAAP measures were released this morning and are available under the Investors section at parker.com.

And they will remain available there for 1 year. Today, Jenny is going to start with some highlights of our outstanding first quarter. She will also reiterate how our portfolio transformation, along with strong aerospace secular trends, position Parker for a promising future. I will then provide some financial details on the quarter and detail our increase to our fiscal year ’24 guidance. Jenny is going to wrap up. And then Jenny, Lee and I will take as many questions as we could fit in the hour. And with that, I would ask you to move to Slide 3. And Jenny, I’ll hand it over to you.

Jennifer Parmentier: Thank you, Todd. Good morning to everyone, and thank you for joining our call today. Q1 was a standout quarter, driven by a strong portfolio and our teams executing The Win Strategy. Starting with safety, a 16% reduction in recordable incidents. Safety has been and will remain our top priority. Record sales of $4.8 billion in the quarter, a 15% increase over prior year with organic growth of 2.3%. Record adjusted segment operating margin of 24.9%, a 220 basis point increase over prior year with all segments coming in above 24% and 26% adjusted EPS growth along with 11.4% free cash flow margin. The combination of Parker and Meggitt delivered an outstanding quarter for aerospace and a strong start to the year.

As a result of this performance, we are increasing our FY ’24 guidance, and Todd will go over this later in the slide deck. Next slide, please. Many of you have seen this slide before. The transformation of our portfolio over the last 8 years has doubled the size of aerospace, filtration and engineered materials. As a result of this, from FY ’15 to FY ’24 guidance, you can see the obvious shift to a longer cycle and secular revenue mix. We have high confidence that by fiscal year ’27, we’ll have approximately 85% of the company in long cycle end markets and industrial aftermarket. Next slide, please. The mix shift that I just spoke of is evident in our strong backlog. For total Parker, backlog remains resilient. Coverage has doubled from 27% in fiscal year ’16 to 54% today, and this has been consistent for the last several quarters.

Aerospace backlog is extremely robust. This coverage will support high single-digit growth well into the future. Industrial backlog coverage continues to be 2x what it was in the past, from mid-teens to low 30s. We now have longer-term visibility from the portfolio changing acquisitions with secular and longer-cycle exposure. Next slide, please. We have transformed the portfolio, and we have strong backlog. Let me remind you of the future sales growth drivers. The Win Strategy is our business system that delivers growth and financial performance. It is a proven strategy, and every tool in this system expands margins. Macro CapEx reinvestment is addressing the last decade of underinvestment as well as investments to strengthen and develop the supply chain.

This will result in increased equipment spend and higher levels of automation. Under innovation, our new product blueprinting tools and Simple by Design principles have increased our product vitality index, that is the percent of sales from new products, enabling faster growth and support of the secular trends. And as mentioned on the previous slide, the acquisitions we have made are great companies with higher growth rates, aftermarket and accretive margins. We continue to benefit from the growth related to the secular trends. As previously stated, we expect multiple years of solid growth in aerospace, driven by both commercial and defense. And no matter what the energy source is, from diesel to electric to hybrid, the primary Parker content that we have today increases 1.5 to 2x with electrification.

With 2/3 of our portfolio supporting clean technologies, we are well positioned today, even better for tomorrow, and we are truly energy-agnostic. Again, all of this is giving us high confidence to grow differently than we have in the past and achieve our 4% to 6% organic growth over the cycle. Next slide, please. Now 30% of our business, aerospace is a growth differentiator for Parker. And Parker and Meggitt are a powerful combination. This team has embraced The Win Strategy and is exceeding our expectations. We couldn’t be happier with this acquisition. Next slide, please. From nose to tail, we have a comprehensive portfolio of products and services. Parker has a broad product offering for both airframe and engine applications. Meggitt brought new product and system areas, including braking, fire detection and suppression, thermal management, avionics and sensors and electric power.

This breadth of technologies is enabling a more strategic relationship and discussions with our customers, both OEM and aftermarket. Next slide, please. This slide highlights the favorable aerospace secular trend we are experiencing now and will into the future. Taking a look at the sales mix at the top of the page, we are now 45% aftermarket, an 800 basis point increase with the acquisition of Meggitt. And we have a balanced portfolio with strong growth drivers in each of these 4 areas. At the bottom of the page are the macro growth drivers. On the commercial side, we are expecting double-digit growth in aircraft deliveries and air traffic. On the military side, the Department of Defense budget increases. And our military aftermarket partnerships will drive mid- and long-term growth, a very promising future for aerospace.

I’ll now turn it over to Todd to go through the summary of our Q1 results.

Todd Leombruno: Thank you, Jenny. I’m going to begin here on Slide 11 and just touch on some of the financial results. Jenny mentioned this, our FY ’24 is off to a very strong start, really speaks to the alignment across our global team. We broke several records this quarter. We set records for sales and on an adjusted basis, segment operating margin, EBITDA margin, net income and earnings per share. If you look at the sales growth, it’s up 15% versus prior year, obviously, strongly impacted by the net of acquisitions and divestitures. You look at that impact, that was a little over 11% positive to our growth. Organic growth remained positive at 2.3%, and currency was actually a slight favorable 1% impact in the quarter. When you look at adjusted segment operating margin, it was 24.9%.

That is an increase of 220 basis points versus prior year. And if you look at adjusted EBITDA margin, that was 24.8%, an increase of 150 basis points versus prior year. If you look at adjusted net income, we generated $776 million in net income. And adjusted EPS was a record at $5.96. If you look at both of those items, it’s a 26% improvement versus prior year. And we can’t say this enough, it’s our portfolio transformation and really consistent execution across the global team, just great work delivering a standout quarter here. And I’m really pleased to say that these results are consistent across all of our businesses. If you can move to Slide 12, this just kind of details the 26% increase in earnings per share, that’s $1.22 of improvement.

What I really like about this chart, the main driver continues to be standout operating performance. We increased segment operating margin dollars by nearly $250 million. That was $1.46 of our EPS growth. And while all segments contributed to growth, really the strength in our aerospace business was a major driver this quarter. If you look at income tax, that was $0.17 favorable this year. Really, that is solely based off of a few discrete items that settled in the quarter. We did have some headwinds on the other expense line of $0.27 and also the interest expense line of $0.10. But I will tell you, both of those items are simply related to timing with last year’s funding of the Meggitt transaction. We do not expect those to repeat going forward.

And finally, corporate G&A and share count were just slightly [indiscernible] at $0.02 each, and that is — really that is in line with what we guided to. So nothing of concern there. So that’s the walk to the record $5.96 in EPS, and it really is just driven off a broad-based offering improvements. Obviously, the Meggitt results are in there. The synergies are in there. And as you can see, strong record margins across all of the businesses, just great job by the team. On Slide 13, we’ll just talk a little bit about segment performance. Every segment delivered adjusted operating margins over 24%. That’s the first time in the history of the company that, that has happened. And it was really, again, just driven by strong performance, good volumes.

Obviously, Meggitt synergies helped quite a bit, and really just the global team is very aligned. If you look at incrementals, we did 40% incrementals versus prior year, really proud of that number. And orders are positive at plus 2 versus prior year. And backlog coverage, as Jenny mentioned, really remains elevated. And again, aerospace activity remains especially robust on the order line. So just great work there. And then lastly, I would just say as we celebrate that 1-year anniversary with Meggitt, we’re really very pleased that those businesses continue to outperform. It’s been a great addition to the company. If you look at North America specifically, sales volume is up 4.5%. We generated $2.2 billion of sales. Organic growth was slightly positive, just 0.5% there.

And that was impacted by some destocking and channel rebalancing that we’ve kind of mentioned throughout the quarter. If you look at adjusted operating margins, we did increase operating margins 150 basis points to 24.9%. And that was really just great execution and obviously cost controls. So great work there. And if you look at orders in North America, they did improve versus last quarter. They are minus 4. They did improve from minus 8. And backlog coverage in North America obviously remains strong as well. So great work to our North America team. In the international businesses, sales were $1.4 billion. That is an increase of about 2.5% versus prior year. Organic growth in the segment was about negative 2. So that was down. Organic growth in EMEA was positive 2, right?

So that was a plus. Latin America, also very positive at plus 8. The impact of the segment was really driven by Asia Pacific, and that was about a negative 8 organic growth. And that’s really just a result of mostly China softness that I think is well documented and also some tough comps that we had in the prior year. However, if you look at operating margins, even with that negative 2 organic growth, we expanded operating margins by 100 basis points. And the segment finished at 24.1%. So our team members there are focused on productivity, cost controls. The team really expanded margins in a very, very tough environment. So just great, resilient performance across the segment there, very nice work. Order rates do continue to be choppy. They did decline to minus 8.

Really, that is conditions driven really out of Europe and China. The standout for the quarter is our aerospace business, right? Just a stellar quarter from aerospace. Sales were $1.2 billion. That was an increase of 65% versus prior year. Organic growth, very robust at about 16%. And that was really broad-based, double-digit growth in all of the aerospace market platforms. So business is very strong there. Operating margins, unbelievable, a new record, increasing 610 basis points to 26%. Really, that was driven by healthy margins, rate increases at the airlines, strong aftermarket growth, really all those things contributing to great margin performance. I will note, we did benefit from a few small favorable onetime contractual settlements in the quarter.

And we do not expect those to repeat throughout the rest of our fiscal year. Aerospace orders, I already mentioned this, but plus 24 are very robust. Great future for the aerospace business. If you move to Slide 14, just a quick look at cash flow. Our cash flow from operations increased 42% versus prior year. Cash flow from operations was $650 million. That’s 13.4% of sales. Our free cash flow increased even more, 48% increase versus prior year, finished at $552 million for the quarter. That’s 11.4% of sales, and free cash flow was 85%. For the full year, we are committed to our strong cash flow generation profile. We are forecasting mid-teens cash flow from operations. And of course, we will extend our record free cash flow conversion of over 100% [indiscernible].

So great start to the year on cash flow. Moving to Slide 15. I just want to touch real quick on our leverage reduction. I think everybody knows we are focused on our leverage reduction commitment. We reduced debt in the quarter by $370 million. And just since the Meggitt close, we’ve reduced that by over $1.8 billion and improved our leverage by 1.2 turns. Both of those numbers are ahead of what we originally scheduled. If you look at gross debt to EBITDA, it’s now 2.6 and net debt to adjusted EBITDA is now 2.5. And of course, we are still committed to forecast over 10 — over $2 billion of debt paydown in FY ’24. So great work there that [indiscernible]. Looking forward on Slide 16, just some details on guidance. Basically, we are reaffirming our full year organic growth midpoint.

We did incorporate September 30 currency rates. And we are increasing our margin and EPS expectations for the year. Reported sales growth for the year is now forecasted to be in the range of 2.5% to 5.5% or roughly 4% at the midpoint. That split will be just as it always is, 49% in the first half, 51% in the second half. We are raising our aerospace organic growth guidance 200 basis points from 8% in our prior guide, now 10%. So that’s great to see that business performing so well. Full year organic growth is tweaked just a little bit. The company will remain at 1.5%. Currency is a small offset, which is now expected to be just a slight headwind to our prior guide. Margins, if you look at margins, we’re raising our margin expectation to 23.6. At the midpoint, there’s a range of 20 basis points on either side of that.

And if you look at what we’re forecasting on a year-over-year change, we’re increasing that expectation to 70 basis points of margin expansion versus prior year. It was 30 basis points in our prior guide. Incremental margins really just based off of the strong Q1 performance, we expect those to be around 40% for the full year. And if you look at the other items, corporate G&A, interest and other are relatively unchanged to what we guided to last quarter. Tax rate for Q2 through Q4 we expect to be 23.5. So if you look at the full year, that will equate to about 23% on the tax line. And EPS on an as-reported basis is now $19.13 at the midpoint, and adjusted EPS is $23. And the range on both of those items is $0.40 plus or minus. Split remains the same, 48% first half, 52% second half.

And specifically for Q2, adjusted EPS is now expected to be $5.17 at the midpoint. And as usual, if needed, we have more guidance specifics that are included in the appendix, and that’s all I had. Jenny, I’ll turn it back to you, Slide 17.

Jennifer Parmentier: Thank you, Todd. And now I would like to recognize our colleague and friend, Lee Banks, during his last quarter earnings call. Lee will be retiring as Vice Chairman and President effective December 31, 2023. He joined Parker in 1991, has been an officer of the company since 2006 and a director since 2015. During Lee’s tenure, sales grew at a 7% CAGR to nearly $20 billion. EPS grew from $0.36 per share in fiscal year ’91 to $21.55 adjusted per share in fiscal year ’23. Since 2015, total shareholder return was 292% versus S&P 500 industrial sector of 80%. As if all of this isn’t enough, I’d like to repeat a few of my comments from last week’s shareholder meeting when we announced Lee’s retirement. It’s obviously not possible to overstate the tremendous positive impact Lee has had on our company, our businesses and our team members around the world.

His legacy and track record is nothing short of extraordinary. From leading our largest businesses to growing our global distribution network to championing and driving operational excellence to co-creating the recent versions of The Win Strategy and probably most importantly and what he’s proud of is to recruiting, leading and developing many of our most talented leaders and beyond, Lee’s set the bar for us for what good looks like and was a key leader in the transformation of Parker’s performance and portfolio. Lee, on behalf of all of us, we can’t thank you enough. We will miss you. And we wish you and your family nothing but great health and happiness in your retirement.

Lee Banks: Thank you, Jenny. Thank you, Todd.

Todd Leombruno: Lee, we know you’re going to crush retirement just like you crushed [indiscernible].

Lee Banks: I’ve got a plan.

Jennifer Parmentier: All right. Next slide, please. A few key messages to close this out before Q&A. Q1 was a great start to fiscal year ’24. Our focus on safety and engagement will continue to drive positive results in our business. We have a proven track record, and we’re going to continue to accelerate our performance with The Win Strategy 3.0. It’s been a successful first year with Meggitt. And the transformation of the portfolio is delivering a longer cycle and more resilient revenue mix, allowing us to achieve our FY ’27 goals and continue to be great generators and deployers of cash. We have a very promising future ahead of us. Back to you, Todd.

Todd Leombruno: Diego, we’re going to open the call for Q&A. So we’ll take whoever’s first in the queue. Thank you.

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Q&A Session

Operator: [Operator Instructions]. And our first question, we have Andrew Obin with Bank of America.

Andrew Obin: Lee, congratulations. We’ll definitely miss you. But these EPS numbers are staggering when you started where you are right now. Yes, just a question in terms of guidance. If I take the midpoint of your EPS guidance and you gave us the first half, second half split, and then just subtract what you’ve printed in the first quarter, there seems to be a sort of sequential decline in EPS that would be quite a bit more than what the history would suggest. And I’m just trying to understand, is that — given that you do have Meggitt now, is that just a different seasonal pattern that Parker is going to have? Or are there onetime items in the second quarter versus the first quarter that’s sort of this — that the implied numbers are driving?

Todd Leombruno: Andrew, I’ll take a stab at that and then if Jenny or Lee’s got some color, I’ll let them add. Q2 for us has obviously got some seasonality in it. It is our lowest volume quarter of the year. But really, I would call out just a stellar performance in Q1. Every number that we talked about was a record. It’s kind of hard to keep that going into your lowest volume quarter. You’re right, we do anniversary Meggitt. So that from a year-over-year standpoint, it’s now in the base or will be in the base for Q2. So that is it. But there’s no other onetime items that are abnormal that we would expect to see in Q2. It’s really just volume and seasonality around the business.

Andrew Obin: No, that’s a good answer. I’ll take it. And the other question, just North American orders. Could you just provide a little bit more visibility by key verticals? I think they’re holding in a bit better than I would have expected. What’s coming in better than expected, what’s weaker and maybe a lot of focus on orders this quarter. Maybe just talk a little bit about the cadence of orders throughout the quarter.

Lee Banks: Andrew, it’s Lee. I’ll take this. So maybe I’ll just take a step back. I think all the reports that I’ve read, I think the narrative is right. If you look at it globally, and I’ll get into North America here in a second, but underlying demand in North America is still fairly positive. There is definitely some inventory balancing taking place, not only through the distribution channel, but I would also argue at OEM levels, too, with their customers, dealership, dealers, et cetera. And I think that’s going to continue to play out through the second half of this — into calendar 2024. But there’s a lot of — I mean, you just look at all the infrastructure spending taking place, there’s been a lot of money flooded in the economy in North America.

And I would still say it’s good. When you look at the rest of the world, really, the story is China. China, not only tough comps, but it just hasn’t rebounded like I thought it would have rebounded maybe 3 or 4 quarters ago. And it’s got — it’s probably got a bigger impact on what’s happening in Europe right now, especially in Germany would be a key market. So that’s soft. If I look at the rest of Asia, the rest of Asia, Southeast Asia, India are still strong. But if you look at Japan and Korea, they’re pretty soft, too, I think, tied to China. When I think about the North American markets, and I’ll lump aerospace in there, I mean, you can’t find any weakness. What’s going on in aerospace, commercial, military, OEM, MRO, all really strong.

And I don’t see that stopping for some time. If you look at those 3 indicators that Jenny talked about, you’re hard-pressed to find a time in history where you’ve had all those 3 indicators, available seat kilometers, DoD spend and then aircraft coming into service where they’ve all lined up that well. Land-based oil and gas in North America is still really strong. There’s less rig count, but there’s a lot of MRO activity taking place that’s keeping people busy. And again, our distribution, if you look at all the end markets, yes, they [indiscernible] on inventory, but things are not falling off a cliff. It’s still real good. So the short way telling you, I feel pretty positive about North America end markets. We just got a little bit of a balancing taking place right now.

Operator: Our next question comes from Joe Ritchie with Goldman Sachs.

Joseph Ritchie: Congrats on a great start to the year. And then, Lee, trips to Cleveland won’t be as fun. We’ll miss you. [indiscernible] retirement.

Lee Banks: Great.

Joseph Ritchie: So maybe following up on Andrew’s question, if you had to think — if you had to look across your industrial end markets today, what portion of those end market do you think are continuing to decelerate? And then as you kind of think about the destocking commentary, any color on like how long you think certain end markets will continue to destock for you guys?

Lee Banks: I’ll take a stab at this, and maybe I’ll let Jenny and Todd pile on. But I think in North America, you’ve got things like automotive are somewhat flat; heavy-duty trucks, flat; agriculture is flat. Construction in North America is really kind of flat for the most part. Again, I think there’s some dealer inventory that people are working through. But it’s still good overall demand there. I think things that were tied to COVID production, life sciences, there’s still some big overhang from the ramp-up we had during that period of time. So that’s just tough comps, and the demand is down a little bit. Yes, I’ll leave it — material handling is still really strong.

Joseph Ritchie: Got it. Go ahead, Jenny.

Jennifer Parmentier: Just to echo Lee’s comments to Andrew’s question and yours, I think with this backlog as strong as it is, although that we see this destocking continuing, we see a bit of supply chain normalizing, and that’s helping things. And as that heals, we’ll start to see, I think, a bit of a better environment. But just echo all Lee’s comments.

Lee Banks: One other thing I meant to say when I was talking, Joe, is I think what everybody forgets about, everybody is focused on aerospace and Meggitt, which have been huge positives. But don’t forget about that we bought LORD and we bought CLARCOR. And we bought those to kind of — we knew they would not be as cyclical as the core legacy Parker business. And I think you’re seeing that in the numbers. It’s panning out that way to be true.