Summary
- Parker-Hannifin’s transformation into a top-tier long-cycle industrial company is underappreciated by the market.
- Management has invested in expanding the company’s filtration and engineered materials businesses to leverage secular growth trends such as digitization, electrification, and clean technology.
- The company’s recent acquisition of Meggitt increased its exposure to an aerospace market that is in the early stages of recovery.
- Whiles shares may seem unattractive after their 20+% rise year-to-date, the stock is trading at a P/E of just 16.3x. Parker has re-rating potential, which could result in another 25% upside.
Recommendation
We are recommending shares of Parker-Hannifin ([[PH]] or "Parker") even after the stock's significant run year-to-date. Parker is benefiting from investments that have been made over the previous six years to reposition the company and tap into secular growth trends. Economic recoveries in China and Europe should help to offset any weakness in the U.S. economy, which still remains strong. Finally, the company's recently completed acquisition of Meggitt increased Parker's access to the aerospace industry that is just starting to recover.
In our opinion, this stock deserves to re-rate to a 20x earnings multiple, which is more in line with other industrial companies with similar growth profiles and end-market exposures. If the stock trades to a 20x P/E multiple, then PH has another ~25% upside. On a longer-term basis, Parker is a high quality Compounder and has the potential to produce 14% to 16% annualized total returns over the next 3 to 5 years.
Summary/Background
Parker-Hannifin was founded by Arthur Parker in 1917 in Cleveland, Ohio. The company's original products included pneumatic brake systems for trucks, trains, buses, and industrial machinery, as well as leak-free fittings for planes. Today, the company produces hundreds of thousands of individual products with no single product making up more than 1% of total net sales.
Parker-Hannifin Investor Presentation
In 2015, the company appointed a new CEO and a new President, Thomas Williams and Lee Banks, who over the last 7 years implemented an impressive organic and inorganic growth strategy, while at the same time dramatically improving margins. Since 2016, EPS is up 2.5x, and the stock is up 250%.
Mr. Williams retired from the company at the end of the most recent fiscal year. However, he laid the groundwork and implemented systems and strategies that have positioned Parker to be successful long into the future.
Mr. Williams remains executive chairman of the company, and he was succeeded by Jennifer Parmentier, who had been serving as COO for 2 years prior to becoming CEO. Ms. Parmentier has been at Parker-Hannifin since 2008, serving as a VP of several divisions.
Parker is well positioned to benefit from recovering economies in Europe and China and the recovering aerospace market. Additionally, investors still seem to be under-appreciating Parker's recent transformation, which we think provides the potential for the stock to re-rate.
Key Investment Themes
Economic Recoveries in Europe and China
Parker is positioned to benefit from the expected economic recoveries in China and Europe. Parker-Hannifin's International Diversified Industrial Segment makes up ~30% of sales. Management just increased their outlook for the company's fiscal 2023 as the business has been performing stronger than expected.
Parker-Hannifin 2nd Quarter Earnings Presentations Parker-Hannifin 2nd Quarter Earnings Presentation
Recoveries in China and Europe provide potential for additional upside to EPS in 2023. China just really opened its economy towards the end of Parker's fiscal second quarter, and management has yet to take into account any improving trends into their guidance for 2023.
Meggit Acquisition benefitting from Aerospace Recovery
Parker's recently completed acquisition of Meggitt PLC doubled the size of the company's aerospace business. After a rough couple of years post-pandemic, the aerospace industry is in the early stages of a multi-year recovery, and Parker is now well-positioned to benefit from the rebound.
Meggitt is a leading provider of proprietary airframe and engine products to aerospace OEMs and aerospace aftermarkets. The company has key electrification and low-carbon technologies to position it well for growth. Meggitt also has a strong presence in blue-chip OEM's premier programs. This deal is expected to add more resilience to Parker's business as the aftermarket will go from 35% of Aerospace sales to 40%.
Meggitt should prove to be accretive to Parker's overall sales growth, EBITDA margins, cash flow generation, and EPS.
Parker-Hannifin Investor Presentation
The Meggitt deal was well-timed because the aerospace industry is in the early innings of an upcycle. Parker's business is now further diversified in Aerospace and should benefit over the next several years due to the long cycle nature industry.
Investors are Not Fully Appreciating Parker's Transformation
In 2015, Parker's management presented an update to the company's Win Strategy ("Win"). The key pillars of Win are like those of the Danaher Business System ((DBS)). The DBS is often referred to as the "compounder model" because the strategy has proven to generate top-tier performance and growth for companies who implement it.
While Parker's management may not actually allude to adopting the Danaher Business System, it seems that they are at least in part copying this business model with the Win Strategy. Comparing the graphics illustrating the Win Strategy and DBS, one can see there are many similarities between the two.
Parker-Hannifin Investor Presentation Parker-Hannifin Investor Presentation Danaher Investor Presentation
Business strategies that focus on exceeding customer expectations and achieving market leadership, lean operations, and continuous improvement tend to be ones that generate market-beating shareholder returns over time. The Win Strategy has been a significant driver of Parker's performance and may be underappreciated by investors.
The below graphics illustrate how dramatic Parker's transformation has become. The company has become more exposed to longer-cycle end markets and is positioned in important secular growth industries including aerospace, electrification, and clean tech.
Parker-Hannifin Investor Presentation Parker-Hannifin 4th Quarter 2022 Earnings Presentation
Based on Parker's multiple of just 16.5x forward EPS, it seems that the market is still not fully appreciating the step up in quality Parker's business has delivered over the last 6 years. Industrial companies with steadier earnings profiles and exposure to longer-cycle end markets receive significantly higher multiples than what Parker currently trades at. For example, Honeywell, Rockwell Automation, and Quanta Services have P/E ratios of 22.5x, 26x, and 24x, respectively. If Parker-Hannifin gets just a 20x multiple on its blended forward 12-month earnings, then the stock has 25% more upside.
Key Investment Risks
U.S. Economic Weakness
While the U.S. is yet to enter a recession, many leading economic indicators are pointing towards a weakening economy. Parker has a significant portion of its business in the U.S. and has historically been sensitive to the state of the U.S. economy. While recoveries in Europe and China as well as in the aerospace industry should offset some of the possible stateside weakness, a recession in the U.S. could result in pressure on Parker's profitability. A U.S. recession could also leak into other economies where Parker operates as well.
M&A Risk
Parker has executed several large deals over the past few years. Acquisition integration is challenging and presents numerous executional risks. Meggitt just closed in late 2022, and the integration is still in the early innings. If the integration of Meggitt does not go as smoothly as management believed it would or the synergies are not as large as management's initial expectations, it could result in the deal destroying shareholder value and a decline in the shares.
Shape of China's Recovery
The recent news around the re-opening of the Chinese economy has been great for Parker's stock price. However, the shape of China's recovery does present an unknown. For example, a surge in covid cases could lead to worker absences or other supply chain delays. The recovery in China is important not only to the sentiment for industrial stocks overall, but also to the financial performance for Parker-Hannifin.
Valuation/Return Forecast
The upside over the next 12 months could be as high as 25%. The short-term downside is ~25%. Longer-term, Parker has the potential to produce 14% to 16% annualized returns, which is well above the market's long-term average.
Conclusion
Parker-Hannifin is a solid Compounder that has shown resilience over multiple industrial cycles. Based on our 2023 forecasts, PH will have grown EPS by almost 3x in only 7 years (2016 to 2023). We like market multiple equities that have grown earnings by over 2x the market.
The recent changes at the company have only strengthened its position in key markets. This is a smart management team that has and will likely continue to generate strong results for investors via M&A and margin improvement as well as organic growth. We would highlight too the track record of 50+ years of dividend increases.
Overall, while the stock has run and could pull back in weak tape, a starter position seems warranted at current prices. We would be significant buyers on a 10% to 15% pullback, with our bear case/pound the table buy levels in the $250-300 range.
For further details see:
Parker-Hannifin: Dividend King With Massive Upside Potential