2023-12-31 05:25:31 ET
Summary
- Parker Hannifin's stock price has recently reached all-time highs following strong Q1 performance and a market rally fueled by the expectation of rate cuts by the Fed in 2024.
- The company is growing its top and bottom line through a combination of organic growth and strategic acquisitions as it shifts its product mix toward products with longer cycles.
- Parker has an impressive dividend growth history and high potential for continued dividend growth of at least 10% per year, making it an attractive investment for long-term DGI investors.
- Share buybacks are expected to resume soon, which will further reward shareholders.
- I rate PH as a Buy on merit of being a wonderful business at a fair price.
Thesis
Parker Hannifin's ( PH ) stock price has soared to all-time highs after an outstanding Q1 2024 Earnings Report followed by the market's recent rally fueled by the expectation of rate cuts by the Fed starting in 2024. The company showed strong Q1 2024 top and bottom line growth largely driven by the integration of its September 2022 acquisition of aerospace company Meggitt. For FY 2024 the company is guiding for 2.5-5% Y/Y revenue growth (1.5% organic) and adjusted EPS of $23 midpoint which would represent 11.3% Y/Y EPS growth aided by synergies from the company's ongoing restructuring and its integration of Meggitt.
The company also increased its quarterly dividend by 11.3% to $1.48 per share back in June 2023, marking the 67th year that PH has increased its dividend and retaining its spot in the prestigious Dividend Kings group. The company's 5-year dividend growth rate is now 14.44%, which combined with a relatively low payout ratio of 24.73% makes it a stock of interest for DGI investors such as myself.
However, the market has taken notice and shown much respect to Parker's performance as evidenced by the stock's ~57% gain over the past year:
PH One year stock price change (Seeking Alpha)
This prompted me to revisit PH's fundamentals along with my DCF analysis to determine whether Parker is still a good investment at its all-time highs. In this article, I will explain that while the bargain prices have left the runway I still believe that PH is still a Buy for long term DGI investors and total return investors alike.
Background
Parker is a well-diversified designer and manufacturer of motion and control technologies for OEMs and aftermarket companies in a wide variety of industrial markets and applications in 43 different countries. Its two primary business segments, Diversified Industrials and Aerospace Systems, both operate in growing markets: the former is expected to grow at a 5.83% CAGR through 2027 and the latter at a 5% CAGR through 2032 .
Diversified Industrials business (2023 10-K)
Growth of Aerospace Systems Business
While Diversified Industrials has historically been the core of Parker's business, the Aerospace Systems segment has grown substantially due to a major acquisition in this space: Meggitt in September 2022 . According to the company's 2023 10-K , Aerospace Systems now constitutes approximately 23% of the business.
One of the most attractive aspects of the Aerospace business is that it is far less cyclical than Diversified Industrials. Products have relatively long life cycles, and customer demand tends to be steadier, more predictable, and generates a larger backlog. Furthermore, Parker has also concentrated on shifting its Diversified Industrials portfolio to longer cycle products as well. As was shown in the Q1 2024 Earnings Presentation , Parker's metric of Backlog as a Percentage of Next 12-Months Sales has doubled since FY16, and its overall product portfolio has shifted more toward a longer cycle mix which is expected to continue through FY27:
Aerospace growth strengthens PH's backlog (Q1 2024 Earnings Presentation) Lengthening business cycle driven by growth of Aerospace business (Q1 2024 Earnings Presentation)
Looking at the company's backlog as of Q1 2024, the backlog for Diversified Industrials decreased $0.3B from June 30 to September 30, but the Aerospace Systems backlog increased by $0.1B during the same time frame. While this represents a very small percentage of the company's overall backlog, I will be watching for this shift in future earnings reports to see if this trend continues and by how much. The total backlog of Diversified Industrials was $4.5B as of September 30 while Aerospace Systems was $6.3B.
Forward business opportunities continue to be diversified: the company states in its 10-K that its primary areas of focus in coming years are "in the areas of energy, water, food, environment, defense, life sciences, infrastructure and transportation". These markets are all necessary, practical, diversified and not going away anytime soon.
Decentralized Business Model
Another thing I like about Parker is that its business segments and operating divisions are largely decentralized from an operational perspective. I believe this is important for a company like Parker which boasts a large, diversified portfolio of products and technologies across a wide variety of applications. Local management can focus on the products, technologies, and markets that it knows best while operating under the guidelines of the company's Win Strategy 3.0 which drives the company's culture and values:
Parker Win Strategy 3.0 overview (Company website)
Profitability
Parker has demonstrated excellent efficiencies and operating leverage: as its revenue has grown, so have its gross margin and operating margins:
PH gross and EBIT margins (Author's analysis)
Note that EBIT was lower in FY23 due to higher SG&A costs associated with the acquisition and integration of Meggitt. I expect EBIT to soon rise over 19% and eventually 20% as the integration is completed and further synergies are realized.
Parker's recent income statements do contain some large one-time costs related to the acquisition of Meggitt which had a material impact on the GAAP net income. These costs do not raise any red flags for me personally, and I am happy to see the gross margin and EBIT rising as the business grows.
Q1 2024 results looked fantastic for margins. Gross margin increased to 36.1% while EBIT of $876M hovered just above 18%. The lag in EBIT is not a surprise as the company continues to incur expenses related to business restructuring and the integration of Meggitt, but as mentioned earlier I expect this to start rising again by at least FY 2025, and likely by the second half of FY 2024. Net income rose to a healthy 13.4%, partially aided by a lower effective tax rate but primarily driven by higher revenue and gross margin:
Free Cash Flow
As an investor I look closely at cash flows because cash is ultimately what drives the business and shareholder value. In the case of PH, there isn't much to criticize: Free Cash Flow has generally been quite consistent with earnings with its most recent FCF/Share coming in at $21.64 which translates to a ~4.7% FCF Yield and more than covers the company's $5.92 dividend (a 27.3% payout ratio based on FCF).
Parker's CapEx target is 2% of sales which is attractive given the company's margins and translates to approximately 12.5% of Operating Cash Flow. The company generates ample cash to pay its debt obligations (more on that soon), pay increasing dividends, and use excess funds to consider additional acquisitions or to buy back shares.
Dividends
PH has been one of my core Dividend Growth Investment stocks for years, and I have appreciated the company's commitment to rewarding shareholders with annual dividend increases which have averaged 14.44% over the last five years . Parker is a Dividend King with 67 years of consecutive dividend increases. Looking at the company's financials and expected growth, I expect its high dividend growth to continue.
As covered earlier, Parker's dividend payout ratio is only 27.3% of FCF and 24.73% of EPS. This provides a significant margin of safety against dividend cuts and also provides the company with plenty of room to increase its dividend. Furthermore, the company expects to increase its earnings at least 10% through FY 2027 per its 5 Year Targets , and I think it is probable that 10% annual growth will continue beyond that. Thus, I expect the company to continue to raise its dividend by at least 10% each year and likely higher than that.
The current dividend yield of 1.28% is not very exciting, but for long term investors such as myself it is still attractive when I consider the expected long-term dividend growth of 10%+ as well as stock price appreciation that I expect from the company's overall performance.
PH 10 Year Dividend History (Seeking Alpha)
Share Buybacks
Parker has a history of rewarding shareholders via an increasing dividend as well as share buybacks that have reduced the outstanding share count approximately 14% over the last decade. Buyback activity has slowed down in recent years due to the company's acquisitions of LORD in 2019 and Meggitt in 2022 which required substantial cash. Unless the company makes additional strategic acquisitions to boost its revenue growth and earnings I expect share buyback activity to resume to levels seen in 2014 to 2018. Either way, PH shareholders should benefit nicely.
PH Shares outstanding - 10 year history (Author's analysis)
Balance Sheet And Leverage
Parker's balance sheet is good, but not great. The Current Ratio of 0.89 and Quick Ratio of 0.46 could be better, but the company does generate consistent, reliable cash flow which prevents it from needing to hold large balances of cash on its balance sheet to meet its current obligations.
Long term debt is $12.19B, and the principal due over the next five years averages around $1B per year as shown below:
PH long term debt obligations (2023 10-K)
While Parker only has $457M in cash on its balance sheet, its Operating Cash Flow which now exceeds $3B per year should easily cover these debt obligations and leave plenty left over for investments, dividends and share buybacks. I am comfortable with Parker's leverage, and so are creditors: according to its 2023 10-K PH has an investment grade credit profile of BBB+ per Fitch Ratings and Standard & Poor's.
Parker's stated goal is to maintain a mix of 60% fixed rate debt and 40% variable rate debt. According to the Q1 2024 10-Q , the company's "debt portfolio included $700M of variable rate debt, exclusive of commercial paper borrowings." Thus the debt portfolio currently leans much heavier than 60% toward fixed rate debt, but this has been a positive during a time of increasing interest rates. With rates now expected to start decreasing in 2024, I would expect the company to start taking more variable rate debt to get closer to its stated 60/40 goal. According to the Q1 2024 10-Q, a 100 bps change in rates translates to an incremental $24M of interest expense which is not very material to Parker's overall results.
The company has recently been utilizing its revolving credit agreement program which is set at variable rates. As of September 30 its commercial paper notes outstanding was $1.6B of its allowed $3.0B. This is historically high and is related to its Meggitt acquisition, but the company is already working to reduce this balance with $175M principal paid in Q1. With interest rates more likely to decrease than increase, I do not see Parker's historically high revolving credit use as a concern.
So Parker should be able to satisfy its debt obligations comfortably. However, its relatively low cash balance will prevent the company from making any additional major acquisitions in the near future unless it takes on additional, incremental debt. I think this option could be on the table if the right opportunity presents itself.
DCF Valuation
I've covered why Parker is a very attractive business that I own and would like to own more of, but let's take a look at its valuation to see if it is a good time to buy at current prices:
DCF analysis for PH (Author's DCF Analysis)
My DCF model returns a fair value of $450.48, which is approximately 2.1% less than the market price of $460 as of the time this article was written.
Here are some of my key assumptions:
Revenue Growth
I assumed 3.8% for FY 2024. Management's guidance for FY 2024 is 2.5% to 5%, which tends to be conservative. I will be closely watching Q2 results to see whether revenue is trending closer to the 2.5% or 5% end of the range.
Management's guidance through FY 2027 is 4-6% revenue growth. I used 5.5% which I think is fair considering the expected 5-6% CAGR of the markets that PH operates in. I used a 3% terminal rate which might be on the low side for PH, but it provides some margin of safety in the DCF.
Gross Margin
I forecast that Parker's gross margin will continue to improve as the company realizes synergies and cost containment initiatives in addition to realizing economies of scale as the business grows. Forecast terminal gross margin is 37% which I don't think is unreasonable given that PH had a 36.1% gross margin in Q1 2024. I would need to see that margin sustained for another quarter or two before I adjust this metric in the rest of the model.
EBIT
I expect SG&A as a percentage of sales to decrease back to 6% in the next couple of years as the expenses associated with acquisition costs and business restructuring wind down barring any additional major acquisitions. Over time I believe Parker should be able to get this down to 5% by continuing to demonstrate effective operating leverage as the business grows.
Interest Expense
I expect this to increase modestly as the company refinances debt at historically higher rates over the next couple of years, but with the Fed expected to start cutting rates in 2024 I don't expect a dramatic effect to Parker's average debt expense.
WACC
I assumed a 4% risk-free rate based on the approximate yield of 10 Year Treasuries as of this writing. If yields continue to drop then the resulting decrease in WACC could provide some further upside to Parker's fair value, although an increase in yields (in the case that inflation starts to rise again) would have the opposite effect. Estimated WACC is 8.8%.
Valuation
PH often trades at a premium due to the high quality of the business, so a ~2% premium over my DCF estimate is not unexpected in my opinion. And I did try to incorporate some margin of safety into my DCF model, though I estimated revenue growth at the higher end of management's own guidance for the next few years which I do believe is conservative as noted earlier. The stock still looks like a Buy even at its all-time highs, although the margin of safety that existed a month or two ago is now gone.
Recommendation
Even at the price of ~$460 per share as of the time of this writing, near an all-time high, Parker still looks like a Buy for long-term DGI investors and growth investors alike.
PH can be a volatile stock prone to strong pullbacks especially during recessions (which historically have provided wonderful buying opportunities for PH investors), so patient investors might be able to find better buying opportunities upon pullbacks. However, such a pullback may or may not ever happen, especially as the company's product mix continues to shift to longer cycles that should make results less vulnerable to recessions.
For these reasons, if you choose to invest in PH, I would consider taking a dollar averaging approach. This has been my personal approach to buying PH stock over the past several years, and it was rewarded me very well. There have been a few times that my new shares have been in the red, but they did not stay in the red for long.
As Warren Buffett has famously said, it is better to buy wonderful businesses at fair prices as opposed to fair businesses at wonderful prices. I believe Parker falls under the wonderful business at a fair price category. As a long term DGI investor who doesn't mind short-term volatility but instead looks to long term dividend growth and income as well as total return, PH checks all of my boxes.
Seeking Alpha's Quant Rating
Seeking Alpha Quant Rating for PH (Seeking Alpha)
Seeking Alpha's Quant Rating system rates PH as a 4.63 "Strong Buy" due to it's very strong Profitability and Momentum as well as its good Growth and analyst earning Revisions as well. The only poor score is Valuation which gets a D due to lack of margin of safety in today's market price. However, as explained earlier I think long term investors in PH will fare well even at today's price. I would personally give PH's valuation a C and would rate it a B if the price pulled back to $440 or lower, and an A if it pulled back to $420 or lower. At $420 or lower, I would rate the stock as a Strong Buy as well.
Risks
The key risks for Parker are:
Recession
Parker's revenue has historically taken a big hit during recessions, and even as more of its product mix shifts to products that have longer cycles and are less prone to recession, Parker would still not be immune to its effects. A recession would temporarily reduce orders and sales, consequently reducing the amount of money that Parker can return to shareholders since it would need a higher percentage of its Operating Cash Flow to cover debt obligations. This could also temporarily reduce the company's ability to invest in its growth either organically or via acquisitions.
Tight Labor Market
As a design and manufacturing company, Parker relies heavily on labor to produce and sell its products. While it continues to invest in efficiencies that reduce its headcount requirements, a tight labor market makes it challenging for the company to acquire and keep the labor it needs without significantly increasing the average cost of labor per employee. Parker has weathered the existing tight labor market well thus far as evidenced by its increasing gross margin, but if labor costs continue to increase at elevated rates then this will impact Parker's gross margin and EBIT.
Competition
Parker operates in highly competitive markets - it must effectively continue to compete on value, innovation, quality and cost. A significant portion of Parker's competitive moat is its intellectual property - it must continue to innovate successfully and retain top talent in order to sustain this moat. Many of Parker's products are not widgets; they are designed for specific applications which generally commands a higher margin than commodity type widgets. However, there is still risk of competitors with global operations in regions that can manufacture at low costs taking business away over time. Parker has managed these risks well thus far but will need to continue to do so.
War and Conflict
Parker operates globally, and while the wars in Ukraine and the Middle East have not had a material impact on the company thus far, additional tensions and conflicts around the globe could potentially disrupt the company's supply chain or demand for its products.
Conclusion
I rate PH as a Buy for long-term DGI investors and total return investors alike. My estimated DCF fair value is $450.58 which is slightly below the current market price but likely still a good entry point for long term investors. I would consider $420 or less a great entry point, and I think that investors who bought shares earlier this year at such prices will fare very well. The current dividend yield of 1.28% is low, but I expect the dividend to continue to grow by at least 10% per year. Additionally, I anticipate that PH will resume its share buybacks and reduce its outstanding share count barring any additional major acquisitions. I expect share price appreciation of at least 10% per year (on average, and certainly not linear) as well as a fast-growing 1.28% dividend which will generate Alpha compared to the broader market.
For further details see:
Parker Hannifin: This Dividend King Is Still A Buy Near All-Time Highs