2023-10-19 16:11:16 ET
Summary
- Parker-Hannifin is a well-positioned stock that may benefit from rising production costs in the renewable energy sector.
- The company's business model combines sound margins, high entry barriers, and promising growth prospects in various industries.
- The discounted cash flow analysis suggests that the stock is currently undervalued and presents a buying opportunity.
For multiple reasons, Parker-Hannifin ( PH ) stands out as an intriguing stock option. Those familiar with my analyses know that I primarily focus on stocks related to the climate transition. Recently, there's been significant buzz around the substantial impact of inflation on production costs, especially in the renewable energy sector. This prompted me to seek out stocks that might benefit from these rising prices throughout the supply chain, leading me to component suppliers like Parker-Hannifin.
Given its status as a sizeable, established company with a rich history spanning over a century and a strong dividend track record, I find the discounted cash flow model to be the most insightful tool to analyze this entity. My DCF analysis suggests that the stock is currently very favorably priced by the market, albeit based on a rather generous discount rate. Consequently, considering the uncertainty stemming from the energy market and interest rates, I believe such a stable, well-positioned stock that promises shareholder value is a definite BUY.
Business Model of Parker-Hannifin
Parker-Hannifin's business model is commendable as it effectively amalgamates three pivotal elements: sound margins, high entry barriers, and promising growth prospects. The company specializes in components for industrial machinery, particularly minor components that integrate into more intricate products like rotors, control mechanisms, valves, cylinders, actuators, and the list goes on. This versatility enables them to cater to a plethora of industries, allowing them to stay abreast of market trends, pulling out of declining segments and investing more into burgeoning ones.
Parker-Hannifin's products are highly sought-after in the transport, aerospace, energy sectors, industrial machinery, and most notably, in the realm of renewable energy and green hydrogen.
Each component's market size tends to be modest. For instance, Parker-Hannifin offers 80 different varieties of electrically conductive heat shrink boots for electromagnetic shielding systems. The company's strength lies in its extensive product mix, which confers three advantages:
- Leveraging their expertise and scale of production, they swiftly tap into new markets and seize fresh opportunities.
- The narrow market size for each product, combined with the initial investments required and the challenge of competing against Parker-Hannifin's economies of scale, deters potential competitors.
- By discouraging competition and focusing on niche products, the company manages to maintain robust profit margins across its product range.
Interestingly, the escalating trade tensions between China and the USA serve as a boon for Parker-Hannifin, an American company. This deters competition from Chinese manufacturers who could potentially rival in production costs. Despite operating across 45 countries and distributing to over 19,000 locations, its operational headquarters are predominantly in the USA and Germany.
Opportunities and Threats
Given that Parker-Hannifin caters to a myriad of industries worldwide, their business model boasts commendable diversification concerning industry trends and geographic areas. The primary potential risks encompass:
- The emergence of significant Chinese competitors capable of producing at lower prices—though current geopolitics seems to mitigate this risk.
- Declining demand from the longstanding oil and natural gas sectors, both of which have been lucrative clients for Parker-Hannifin.
- The possibility of a recession which would, at least in the short-term, stunt the company's growth rate.
On the brighter side, opportunities abound:
- For years, Parker-Hannifin has been making a name for itself as a premier supplier of components for photovoltaic and solar energy. The company has recently ventured into products tailored for the green hydrogen market, aligning itself with potential major growth trends.
- The rise of novel industrial sectors needing machinery—like EVTOLs, EVs, and drones—will in the long run augment Parker-Hannifin's Total Addressable Market in my view.
- The company is perfectly poised, both competitively and in terms of size, to acquire smaller entities dealing with components that can enrich their overall product mix.
All in all, I believe the opportunities are more tangible and are likely to materialize. The threats, however, appear more speculative and broad-brush, reinforcing my optimism.
DCF Analysis
The crux of my analysis hinges on the discounted cash flow ((DCF)) analysis, which I've structured based on the following assumptions:
- I projected the financial statements up to 2031, after which I added the company's terminal value.
- The terminal value is computed by multiplying the projected 2031 earnings by the current P/E ratio of 17.80.
- The formula to determine the unlevered FCF is uFCF = EBIT (1 - tax rate) + D&A - Capex - Change in NWC.
- For the risk-free rate used in calculating WACC, I referred to the 10-year Treasury yield.
- I hypothesized that the growth rate would gradually decrease to a long-term rate of 5%.
- D&A, Capex, Tax Rate, and Change in NWC were averaged over the last 6 years. For the Change in NWC, a trimmed mean was used to eliminate two extreme values.
- For WACC computation, I used the average 5-year Beta as a measure of the stock's volatility.
Firstly, let's consider the WACC calculation, which is crucial for discounting the projected future cash flows:
Total debt | 12,902.50 |
% debt | 55.55% |
Cost of debt | 5.50% |
Tax Rate | 24% |
Equity | 10,326.00 |
% Equity | 44.45% |
Cost of Equity | 9.14% |
Risk free rate | 4.70% |
Beta | 1.48 |
Risk premium | 3% |
TOT (Equity + Debt) | 23,228.50 |
WACC | 6.39% |
Now that we have our WACC, here's how the cash flow projection for the upcoming years looks:
2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | |
Revenue | 22553.7 | 26252.0 | 30058.1 | 33845.0 | 37466.0 | 40762.8 | 43575.3 | 45754.0 |
Net income | 2188.8 | 2697.0 | 2945.5 | 3444.0 | 3742.2 | 4100.4 | 4360.0 | 4601.6 |
Interest Expense | -416.58 | -500.28 | -601.77 | -663.58 | -751.25 | -848.51 | -857.14 | -909.14 |
Earnings Before Taxes | 2895.6 | 3441.3 | 3757.0 | 4405.2 | 4781.9 | 5274.4 | 5608.1 | 5890.8 |
Tax rate | 23.77% | 21.45% | 21.40% | 21.60% | 21.49% | 21.99% | 21.95% | 21.64% |
D&A + | 390.52 | 462.71 | 524.75 | 581.69 | 651.16 | 708.99 | 758.59 | 794.53 |
CapEx - | -285.3 | -326.9 | -347.1 | -369.9 | -382.8 | -471.2 | -494.2 | -508.7 |
Delta NWC - | 712.0 | 833.7 | 1060.2 | 1401.1 | 1727.0 | 1997.3 | 1773.7 | 1786.5 |
Unlevered FCF | 1582.0 | 1999.1 | 2063.0 | 2254.6 | 2283.7 | 2340.9 | 2850.7 | 3100.9 |
Discounted FCF | 1487.0 | 1766.1 | 1713.0 | 1759.7 | 1675.3 | 1614.1 | 1847.5 | 1888.9 |
TOT Unlevered FCF | 13751.5 |
We can now adjust the results based on the cash on hand and PH's total debt as of the latest quarterly report.
Sum of DCF 2023-29 | 13,751.54 |
Terminal Value | 81908.5 |
Present value of TV | 49,894.73 |
Debt (-) | 12,902.50 |
Cash (+) | 483.60 |
Intrinsic Value | 51,227.37 |
Finally, let's relate all of this to the company's current valuation and stock price.
Mkt cap today | 51,020.00 |
Calculated intrinsic value | 51,227.37 |
Stock Price today | $22.40 |
Intrinsic value of the stock | $22.49 |
Upside (downside) potential | 0.41% |
The reason I consider this stock as a good buy is that I employed a 3% risk premium over the already high current risk-free rate. Given the current high discount rates and our expectation of a return 3% above Treasuries, we can be quite content with a stock that has such financial prospects and yet poses such low actual risk tied to the company's core business.
Dividend Policy
Parker-Hannifin has historically been among the top dividend payers in the S&P 500. Quoting from the press release accompanying the latest quarterly dividend announcement of $1.48 per common share:
This is the company's 293rd consecutive quarterly dividend. Parker has increased its annual dividends per share paid to shareholders for 67 consecutive fiscal years, among the top five longest-running dividend-increase records in the S&P 500 Index.
Here's a look at the dividend history over recent years (source: Seeking Alpha).
Year | Amount | Adj. Amount | Dividend Type | Frequency | Ex-Div Date | Record Date | Pay Date |
2023 | - | - | - | - | - | ||
1.4800 | 1.4800 | Regular | Quarterly | 08/25/2023 | 08/28/2023 | 09/08/2023 | |
1.4800 | 1.4800 | Regular | Quarterly | 05/11/2023 | 05/12/2023 | 06/02/2023 | |
1.3300 | 1.3300 | Regular | Quarterly | 02/09/2023 | 02/10/2023 | 03/03/2023 | |
2022 | - | - | - | - | - | ||
1.3300 | 1.3300 | Regular | Quarterly | 11/10/2022 | 11/14/2022 | 12/02/2022 | |
1.3300 | 1.3300 | Regular | Quarterly | 08/26/2022 | 08/29/2022 | 09/09/2022 | |
1.3300 | 1.3300 | Regular | Quarterly | 05/12/2022 | 05/13/2022 | 06/03/2022 | |
1.0300 | 1.0300 | Regular | Quarterly | 02/10/2022 | 02/11/2022 | 03/04/2022 | |
2021 | - | - | - | - | - | ||
1.0300 | 1.0300 | Regular | Quarterly | 11/10/2021 | 11/12/2021 | 12/03/2021 | |
1.0300 | 1.0300 | Regular | Quarterly | 08/26/2021 | 08/27/2021 | 09/10/2021 | |
1.0300 | 1.0300 | Regular | Quarterly | 05/06/2021 | 05/07/2021 | 06/04/2021 | |
0.8800 | 0.8800 | Regular | Quarterly | 02/09/2021 | 02/10/2021 | 03/05/2021 | |
2020 | - | - | - | - | - | ||
0.8800 | 0.8800 | Regular | Quarterly | 11/05/2020 | 11/06/2020 | 12/04/2020 | |
0.8800 | 0.8800 | Regular | Quarterly | 08/27/2020 | 08/28/2020 | 09/11/2020 | |
0.8800 | 0.8800 | Regular | Quarterly | 05/07/2020 | 05/08/2020 | 06/05/2020 | |
0.8800 | 0.8800 | Regular | Quarterly | 02/06/2020 | 02/07/2020 | 03/06/2020 | |
2019 | - | - | - | - | - | ||
0.8800 | 0.8800 | Regular | Quarterly | 11/07/2019 | 11/08/2019 | 12/06/2019 | |
0.8800 | 0.8800 | Regular | Quarterly | 08/27/2019 | 08/28/2019 | 09/13/2019 | |
0.8800 | 0.8800 | Regular | Quarterly | 05/09/2019 | 05/10/2019 | 06/07/2019 | |
0.7600 | 0.7600 | Regular | Quarterly | 02/07/2019 | 02/08/2019 | 03/01/2019 | |
2018 | - | - | - | - | - | ||
0.7600 | 0.7600 | Regular | Quarterly | 11/08/2018 | 11/09/2018 | 12/07/2018 | |
0.7600 | 0.7600 | Regular | Quarterly | 08/27/2018 | 08/28/2018 | 09/14/2018 | |
0.7600 | 0.7600 | Regular | Quarterly | 05/09/2018 | 05/10/2018 | 06/01/2018 | |
0.6600 | 0.6600 | Regular | Quarterly | 02/08/2018 | 02/09/2018 | 03/02/2018 | |
2017 | - | - | - | - | - | ||
0.6600 | 0.6600 | Regular | Quarterly | 11/09/2017 | 11/10/2017 | 12/01/2017 | |
0.6600 | 0.6600 | Regular | Quarterly | 08/24/2017 | 08/28/2017 | 09/08/2017 | |
0.6600 | 0.6600 | Regular | Quarterly | 05/08/2017 | 05/10/2017 | 06/02/2017 | |
0.6600 | 0.6600 | Regular | Quarterly | 02/08/2017 | 02/10/2017 | 03/03/2017 |
Upon analyzing the payout ratio, it is observed that it consistently hovers around 30-35%.
Jun 2017 | Jun 2018 | Jun 2019 | Jun 2020 | Jun 2021 | Jun 2022 | Jun 2023 |
35.09% | 34.42% | 27.05% | 37.71% | 27.18% | 43.27% | 33.76% |
While the company remains growth-focused and keen on reinvesting liquidity where needed, PH's management also consistently rewards shareholders with the surplus cash that the company doesn't require. From this standpoint, I believe the management is performing commendably.
Conclusions, Final Thoughts, and Potential Risks
Upon analyzing the discounted cash flow, I believe that Parker-Hannifin shares are a sound investment at this time. We're looking at a company that seems fairly priced by the market when using a 3% risk premium in the discounting of future cash flows. This premium seems generous given the well-established and steady business model of the company. Furthermore, the growth rate I've indicated might easily turn out to be on the conservative side; as always, I've aimed to stay prudent in my DCF analysis.
For further details see:
Parker-Hannifin's True Value Unmasked Through A DCF Perspective