2023-08-14 17:40:39 ET
Summary
- Parker-Hannifin continues to thrive despite industrial recession risks, thanks to strong revenue and margin growth and strategic acquisitions.
- Industrial North America and aerospace systems are safe growth areas with international markets set to rebound from currency headwinds.
- Reshoring manufacturing and Meggitt look to be major industrial drivers in the long term.
Despite an uncertain future due to industrial recession risks, Parker-Hannifin ( PH ), or Parker, continues to shrug off any concerns. The strength of its core business's revenue and margin growth, combined with strategic acquisitions, has allowed the company to become an earnings powerhouse.
This has translated to solid cash flow generation, seen by the dividend aristocrat's ability to increase its annual payout for 67 consecutive fiscal years . Parker’s rare combination of growth, profitability, and balance sheet management makes it a potential winner for industrial investors.
Current State
Diversified Industrials
Fig. 1 shows Industrial North America continuing to be Parker’s core driver, growing revenues 15.7% y/y, but international markets came in soft at 4.3% y/y growth as currency headwinds ate into low double-digit gross revenue growth.
While we have seen a similar story unfold for the past few quarters, JP Morgan’s outlook shows that we have rebounded from the dollar’s staggering decline in late 2022 - early 2023, and those levels in key European and Asian pairings are likely here to stay.
I believe American companies operating internationally want to see the dollar rise in value vs other currencies (e.g. the EUR/USD pair to rise) or for the other currency to fall in value in an opposite paring (e.g. USD/JPY pair to decrease), and both should hold true coming into the year-end. This should help the segment realize more of its earning potential moving into FY 2024, especially as unadjusted operating margins managed to grow 10 basis points despite all the headwinds.
Parker also bucked the "imminent" global recession fears that were supposed to cause major cyclical slowdowns. The Q3 2023 10-Q , however, showed that across the 3 major geographies (North America, Europe, and Asia-Pacific), end-user demand grew for the agriculture, construction, mining, automotive, semiconductor, telecommunications, heavy truck, material handling, machine tools, mills, and oil and gas sectors, representing 58% of their total sales mix. Latin America was the only detractor for the industrial, construction, and trucking market, but it only makes up ~2% of diversified industrial revenues.
Aerospace Systems
Fig. 1 also shows the aerospace systems segment's expectedly mixed results following acquisitional costs related to Meggitt. Rapid expansion into the commercial original equipment manufacturing (OEM) and aftermarket spaces translated to 73% y/y revenue growth, but it came with a 700 basis point decline in unadjusted operating margins.
These should rebound after clearing short-term integration hurdles, but the real spotlight is on the segment's future growth, driven by OEM and aftermarket demand .
Boeing (BA) and Airbus (EADSY) are transitioning from widebody aircraft to focusing on more efficient narrowbody aircraft, ramping up the production battle between the B737 and A320. This should be music to the ears of Parker who is a critical supplier for both.
Deferred maintenance, repairs, and overhaul ('MRO') spending during COVID is also now coming to fruition, putting pressure on the aftermarket to meet aircraft equipment needs. However, this gives suppliers like Parker all the power in the market - a favorable position to be in during a demand boom.
While the latter half of aerospace & defense (A&D) didn't play as major a role in the total 73% y/y revenue growth, Parker continued its military contract wins, most recently in May, securing a five-year agreement with the US Army’s Aviation and Missile Command.
These are positive signs amid a tense geopolitical environment where the US continues to weaponize Ukraine - with Biden asking Congress for ~$20B more in aid - monitor the Chinese-Taiwan area across the South China Sea, and must replenish its military stockpile at home. Defense looks to be one of the safest growing areas for the company, especially with lawmakers in Capitol Hill willing to hold up debt limit talks over spending.
Post-Acquisition Balance Sheet & Cash Flows
If growth is one side of the equation for Parker, breaking the balance sheet is on the other. But even though the Meggitt acquisition significantly inflated Parker’s Gross Debt/EBITDA leverage, management has a history of committed debt reductions.
They were able to achieve massive two-year leverage reductions seen in Fig. 2 following the Clarcor (3.6x to 1.9x) and Lord and Exotic Metal (4.0x to 2.1x) deals. We already see evidence of this in Fig. 3, as leverage jumped to ~3.9x following the deal’s closure in Q1 2023 but is already down to 3.23x by the fiscal year's end.
Parker can achieve this because these deals significantly improve earnings, allowing the firm to grow cash flows from operations that help pay off debt. We can measure this in Fig. 4 through cash flow coverage (raw ratio of operating cash flows/gross debt) and by measuring the spread between the gross debt and CFO, which shows us if gross debt is being paid down (smaller bar height instead of taller bar height) or if CFO is just growing (starting height of the bar is higher).
We find that after the Clarcor deal, FY 2018 cash flow coverage reached a new high of 0.33x, driven by a 23% increase in cash flow from operations and a 17% decline in gross debt, as indicated by the smallest gross debt-CFO spread. Similarly, after the Lord and Exotic Metal deals, FY 2021 cash flow coverage hit a new high of 0.39x, driven by a 24% jump in CFO and 21% lower gross debt, seen through the second-smallest gross debt-CFO spread.
If Parker can immediately drive CFOs post-acquisition and then control debt to lower leverage for three consecutive deals, we are confident management will be able to do it a fourth time.
Dissecting Future Multi-Year Drivers
Industrial Reshoring
Reshoring is the act of companies bringing operations back to their home country. With numerous supply chain disruptions that continued well into 2023, this became a focal point for many management teams, especially with spending and subsidies the US government was willing to provide.
Accelerating American reshoring efforts isn’t just going to help US GDP figures and companies’ efficiency, but creates a structural tailwind for Parker as well. Fig. 5 shows the top-to-bottom manufacturing solutions the company can deliver, enabling them a one-stop-industrial-shop for the many plants and factories set to be constructed across American soil.
Motion systems and flow and process controls are set to be the biggest winners as they feed into secular automotive, AI-semiconductor, and power generation trends. This should improve growth for the segments from high single-digit amid a poor economic backdrop to ~10-15% in a more positive spending environment. It also feeds into Parker’s FY 2027 vision in Fig. 6 of moving away from shorter-cycle markets and moving into longer-cycle ones.
Meggitt's Importance
I believe Meggitt can transform into Parker’s most consequential acquisition due to its similar strategic fit into longer-cycle trends.
Mckinsey's report on winning in the A&D industry outlined a 3-step process to securing longer contracts and creating higher margins in commercial OEM and aftermarket segments:
- Have unique assets and solid financials to support innovation as it creates high switching costs for your customers in the aftermarket during maintenance. Meggitt focuses on sustainable and technology-oriented solutions that enable it to have a unique breadth of engine and airframe products which should expand Parker’s reach seen in Fig. 7.
- Have a robust and mature customer base. The company has a decade-long partnership with Boeing and contracts with Airbus, Embraer, and General Dynamics (GD). It also supplies engine parts to the top 4 engine manufacturers in Pratt & Whitney, Rolls Royce, SAFRAN, and GE Aviation.
- Have the right corporate expertise and contract execution to prioritize the customer experience. As an established player, Parker already excels in this and Meggitt should only further it.
There is a long runway for revenue growth and earnings appreciation as Meggitt’s expansion of Parker’s commercial OEM and aftermarket look to become significant contributors in the coming fiscal years.
Model
Fig. 8 shows the results of our joint 3 statement and DCF models driven by a variety of key assumptions.
Assumed high-single-digit revenue growth and margin expansion through FY 2027 due to an industrial bull cycle led by government manufacturing investments and reshoring trends, but the steam slowly starts to run out by FY 2028.
Assumed WACC of 10.92% using a 3.65% coupon rate on Parker's $1.4B international bond issuance in 2022 as the pre-tax cost of debt, 10-year treasury bill as the risk-free rate, and 5.70% as the market risk premium. The terminal EV/EBITDA multiple of 16.07x was derived by averaging competitors' multiples, including Parker itself.
We arrive at a $512.81 price target, representing a 23% upside from the most recent close. Given the current market conditions and economic backdrop, the target is set for the end of FY 2024, when I think we are well past any recession chances and deeper into the bull cycle.
Risks
With a plethora of growth opportunities and a sound financial state for the company, its biggest risk, aside from the general business cycle and international market risk, might be its management team.
In the past seven years, we’ve seen an aggressive management team make 4 massive deals, including the company’s record-high Meggitt acquisition, which was more than double the previous record of the $4.3B Clarcor acquisition. Fig. 9 shows the company has an additional $5B-$10B in capital deployment optionality, a bulk of which will go towards another acquisition by FY27 keeping in line with trends.
This may cause the balance sheet to become too over-levered across the short-medium term. It will take time to digest the Meggitt deal given that the $10B cost is financially uncharted waters for the company. Further, debt will not be cheap to come by in the likely event that cash flows stagnate or decline, especially as Fitch affirms their BBB+ rating for Parker, albeit revising their outlook from negative to stable.
Fig. 10 does note that the company was further committing $2B in debt paydown by the end of FY 2024 on their already ahead-of-schedule Meggitt-related debt. In addition, they are targeting a 2.0x leverage for FY 2025, meaning its next major acquisition would likely take place late 2025 - early 2026. Sticking to this schedule allows management to get the best of both worlds, placing less stress on the balance sheet by waiting to pay off debt, while also expanding the business in the future.
Conclusion
Parker-Hannifin has every making of an industrial stalwart, creating a profile that exposes you to continued growth in diversified industrials, recovering growth in aerospace systems, and new clean energy and automation verticals. Management has shown the ability to carefully expand into each area through acquisitions, and then subsequently improve cash flows to support future investments and their long-standing dividend. With numerous multi-year industrial trends, including a government that has doubled manufacturing spend since 2021 , Parker is primed to take advantage of this bull cycle in my view.
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Parker-Hannifin Is An Industrial Gem