2023-10-19 09:21:46 ET
Summary
- Parker-Hannifin Corporation has had a very strong long-term financial performance and targets further growth with operating leverage.
- The company sells control systems in industries such as construction, logistics, oil and gas, and aerospace.
- Despite the great financials, PH stock currently seems overpriced - the Aerospace Systems' future growth should be questioned and my DCF model estimates a significant downside.
Parker-Hannifin Corporation (PH) sells control systems in multiple industries. The company has had a fantastic run in terms of long-term financials. In addition, Parker-Hannifin's future for at least the medium-term seems quite good - the company ambitiously targets to repeat its long-term average growth with further operating leverage. Although Parker-Hannifin's financials seem great, I still have a sell-rating for the stock for the time being - at the current price, I believe that too much organic growth is priced into the stock.
The Company & Stock
Parker-Hannifin sells parts related to hydraulics, pneumatics, and automation technology. The company's offering revolves around industrial use cases, as Parker-Hannifin's customers include construction vehicles, logistics vehicles, oil and gas, industrial machinery, and aerospace systems along with numerous other industries. The company's parts include ones such as adhesives, aerospace cylinders, medical device components, EMI-protecting products, and industrial filters.
Parker-Hannifin divides its business into three parts - Diversified Industrial North America, Diversified Industrial International, and Aerospace Systems. It seems that the company wants to underline the Aeroplane Systems segment's performance as the segment is separate from the two others, as the segment has had a good amount of growth relating to geopolitical conflicts - the Aerospace Systems segment grew by 16% year-over-year in Q4/FY2023:
Parker-Hannifin Q4/FY2023 Investor Presentation
Although the growth has been good in recent quarters, I don't believe the performance is on a very sustainable basis - the Aerospace Systems segment has seemingly grown as a result of the war in Ukraine along other geopolitical instability. The company communicates that the segment's growth has been achieved as a result of military OEMs' return to growth. I believe further growth in the segment would imply that the conflicts spread into a more prominent event globally; Parker-Hannifin is in part a political pick on global events.
The stock has performed very well. In a year, the company's stock has appreciated by 44% on top of a small dividend yield of 1.47%. On a long-term basis, the stock performance has been good as well as Parker-Hannifin's 30-year CAGR for the stock is 13.3% excluding dividends.
1-Year Stock Chart (Seeking Alpha)
Financials
The company has achieved a good amount of growth considering Parker-Hannifin's large scale. From FY2003 to FY2023, the company's compounded annual growth rate is 5.7%:
Author's Calculation Using TIKR Data
A good amount of growth seems to be ahead as well. Parker-Hannifin has targets for FY2027 that target 210 basis points of operating leverage and an EPS growth of around 40% from FY2023, as Parker-Hannifin plans to capitalize on market trends.
FY2027 Targets (Parker-Hannifin Q4/FY2023 Investor Presentation)
Looking at Parker-Hannifin's EBIT margin trajectory is a beautiful sight. The company has been able to grow the margin on a mostly consistent basis from a margin of 6.2% in FY2003 into a current trailing EBIT margin of 18.3%, and as stated before, is looking for further operating leverage. Although I do believe that Parker-Hannifin can achieve the outlined FY2027 margin, further operating leverage seems quite improbable as Parker-Hannifin's trailing gross margin is 34.5%. Further leverage of a lower SG&A to gross profit ratio seems quite challenging to achieve.
Author's Calculation Using TIKR Data
Parker-Hannifin has leveraged debt. The company's balance sheet reveals around $1.8 billion in short-term borrowings and $10.8 billion in long-term debt, of which $2.0 billion is in current portions. Compared to Parker-Hannifin's market capitalization of around $52 billion, the debt balance seems to still be on a reasonable level - the debt represents around 24% of the market capitalization. In addition, the company has around half a billion dollars in cash and equivalents.
Valuation
Parker currently trades at a forward P/E ratio of 17.8, around the company's ten-year average of 17.0:
The P/E ratio alone doesn't tell the whole story as Parker-Hannifin has a very good cash flow conversion, but also does partly operate on somewhat cyclical industries as industrial investments can often be highly cyclical. To put the valuation into a further context and to estimate a fair value for the stock, I constructed a discounted cash flow model in my usual manner.
In the model, I mostly follow Parker-Hannifin's FY2024 guidance and FY2027 targets - I estimate a growth of 5.5% for FY2024, representing the upper range of the 3-6% growth guidance for the year. After the year, I estimate the growth to accelerate slightly into 8% in FY2025. Beyond FY2025, I estimate the growth to slow down in slow steps into a perpetual growth rate of 2.5%. The DCF model estimates represent an organic revenue CAGR of 4.9% from FY2023 to FY2033.
As for the revenues, I model in Parker-Hannifin's financial targets into the DCF model - the EBIT margin rises by two percentage points from FY2023, compared to Parker's adjusted operating margin expansion target of 2.1 percentage points. After FY2027, I only model in a further EBIT margin leverage of 10 basis points - I don't believe that a significant amount of further operating leverage is likely. I model in a good cash flow conversion, as Parker-Hannifin has proven the conversion to be very good in the company's history.
The mentioned estimates along with a weighted average cost of capital of 11.32% craft the following DCF model with a fair value estimate of $247.81, around 36% below the price at the time of writing:
DCF Model (Author's Calculation)
The weighted average cost of capital is derived from a capital asset pricing model:
CAPM (Author's Calculation)
In Q2, Parker-Hannifin had around $157 million in interest expenses. With the company's interest-bearing debt balance, the company's interest rate comes up to 5.01%. Parker-Hannifin uses debt well to its advantage. As I believe the current ratio to be quite accurate to a sustainable one, I estimate a long-term debt-to-equity ratio of 25%.
On the cost of equity side, I use the United States' 10-year bond yield of 4.89% as the risk-free rate. Professor Aswath Damodaran estimates the US' equity risk premium to be 5.91% as of July. The beta of 1.48 is Yahoo Finance's estimate using monthly data from a period of five years. Finally, I add a small liquidity premium of 0.2%, crafting a cost of equity of 13.84% and a WACC of 11.32%.
Takeaway
Parker-Hannifin's financial performance has been very good in both the company's long-term and short-term history. The company seems to perform very well when it comes to margin management, while the company continues to pursue moderate organic growth. I still don't think the current price reflects a good entry point - the Aerospace Systems segment has seen a good amount of growth due to current global events, and the growth doesn't seem to be on a sustainable level in the industry.
Further political instability or a better-than-expected growth could still prove my bearish thesis wrong. Also, the beta of 1.48 could be proven too high as Parker-Hannifin's performance in the current economy has been very good despite instability. As my DCF model estimates a significant amount of downside for the stock, though, making Parker-Hannifin's current risk-to-reward quite poor in my opinion for the time being.
For further details see:
Parker-Hannifin: Tailwinds Already Priced In