Summary
- Parker-Hannifin has continued to execute well, and the Street has become more confident in the company's long-term ability to generate above-market growth and margin leverage.
- Short-cycle markets still matter, though, and I expect to see weaker end-market demand as 2023 progresses.
- Parker-Hannifin offers an excellent track record and good growth, but the valuation largely reflects that.
I was bullish on Parker-Hannifin ( PH ) when I last wrote about this industrial for several reasons. I liked the company’s arguably underappreciated leverage to automation and electrification, its growing exposure to aerospace, and its excellent track record of margin improvement across multiple cycles. I also liked the transformation that was underway that I believe will make this business less cyclical over time – short-cycle markets (and the extent to which PMI reflects activity there) will always be important to Parker-Hannifin with its current business mix, but it’s no longer just a cycle play.
Since then the shares have appreciated close to 25%, handily beating the broader industrial space, as well as high-quality names like Atlas Copco ( ATLKY ), Dover ( DOV ), Eaton ( ETN ), Honeywell ( HON ), and Rockwell ( ROK ). Only a handful of quality names, like Lincoln Electric ( LECO ) in my regular coverage list have done better.
At this point, I still love the company, but I’m not as bullish on the stock. Valuation is similar to Eaton, but I think Eaton has even more powerful underlying growth drivers over the next three to five years. If I owned the shares, I’d consider my defensive strategy at this point (using stops or options, for instance), and this is a name I’d look to revisit on the next pullback.
A Pretty Typical Multi-Industrial Quarter
The long-term operational superiority I see in Parker-Hannifin wasn’t necessarily evident in fiscal second quarter results which I’d characterize more as typical for the space. Likewise, I expect ongoing questions and concerns about how short-cycle markets will develop over the remainder of 2023 and how the stock multiple/sentiment will respond to likely weaker order trends.
Revenue rose 22% as reported, while organic growth came in at 10% - pretty much spot on with the overall group, and about 5% to 7% better than expected (different reporting services had modestly different average sell-side estimate numbers). The North American Diversified Industrial business remained very strong, growing more than 13% (beating by 5%), while the International segment grew almost 9% (beating by 8%). The Aerospace business grew about 5%, beating by 4%, as the company’s military business was soft and that tempered the benefits of ongoing growth in the commercial aerospace business.
Gross margin improved 80bp year over year and declined 80bp quarter over quarter to 34.1%, and results were actually a little better than expected here – a rarity among the industrials. Operating income rose 20%, with margin down 40bp to 19.6%, while segment profits rose 22%, beating by 5% (about $0.33/share), with margin down 10bp to 21.5%.
By segment, North American Diversified rose 21%, with margin up 50bp to 21.8%, while International fell 2%, with margin down 50bp to 21.9%. Aerospace was up 84%, boosted by the Meggitt deal, with margin down 10bp to 20.6%.
Orders Are Decelerating And Inventories Are High… But Demand Is Holding Up
Like the large majority of industrials, Parker is going into 2023 with a record backlog $10.5 billion in this case), but is also seeing deceleration in its orders, with second quarter orders up 3% after growing 5% in the prior quarter. While North American industrial orders decelerated modestly (from +3% to +2%), International orders weakened more significantly (from +6% to down 4%), and that’s broadly consistent with commentary about weaker conditions in Europe and China. Aerospace orders remain hot, rising 22%.
There’s ample evidence that short-cycle markets are decelerating, and likewise ample evidence that inventories are now robust after an extended period of supply chain issues led to inventory-building. Now demand appears to be decelerating when you look at metrics like PMI, loan officer surveys, business confidence surveys, and so on.
Yet, Parker management stated that 90% of their end-markets are still growing, with only life sciences and military declining, and the former has the burden/headwind of difficult comps. On the other side, commercial aero, commercial and military aftermarket, EV passenger cars, and oil/gas are all strong, growing 10% or more.
Looking further into the numbers, I have no real concerns about aerospace. There’s some modest risk that a weaker global economy will impact air travel demand (hitting aftermarket/MRO sales), but I’m not too concerned at this point. Meanwhile, commercial narrowbody production will continue to recover, defense should be stronger in 2023, and commercial widebody production should improve starting next year. Defense could, perhaps, also offer some upside depending upon what the U.S. and its allies do with the situation in Ukraine. That’s around one-quarter of the business sorted.
Looking at mobile equipment, I’m fairly bullish on autos (particularly EVs) and agriculture, and that’s something around 10% of the revenue mix. I’m not as bullish on trucks, though I think the first half will be strong, nor construction equipment in general, but Parker is more skewed to vocational trucks (cement trucks, garbage trucks, et al) and aerial work platforms, and I think those will be stronger.
I’m less bullish on non-residential construction and have some concerns about HVAC, and that all totals around 10% to 15%, but power (especially renewables) and oil/gas should remain strong. The broad “general industrial” market that makes up about a quarter of the business is the big unknown – I’ve said many times that I expect a slowdown over the coming quarters, but a lot of shorter-cycle stocks (including Lincoln Electric, Illinois Tool Works ( ITW ), and Parker) aren’t trading as if that’s much of a concern, and indeed this downturn could prove to be shallower and shorter than I expect.
The Outlook
I have no use for “dividend aristocrat” idiocy, but I will note that Parker-Hannifin has an enviable track record where dividends are concerned, and dividends remain the top priority for capital with management. Debt reduction is likely to be a high priority for the next few years, but I think there’s visibility on improved dividends and buybacks (as well as smaller, more strategic M&A) over the next three to five years.
I expect long-term revenue growth from Parker in the 4% to 5% range, and I view the company as “PMI-plus” – the company as currently constructed will never be independent on short-cycle moves, but there’s more longer-cycle business here than in the past and the company has shown that it can and will outgrow its markets (“GDP-plus” or “PMI-plus”) over a full cycle.
On the margin side, I expect ongoing improvement, albeit likely at a somewhat slower pace. Management has done a good job of upgrading the value-add of its offerings, and that can drive improved margins from increased content in areas like precision motion (life sciences, electronics, et al), automation, and electrification. I’m looking for EBITDA margins to improve toward the mid-20%’s over the next four to five years, and for free cash flow margins to improve into the high teens from recent levels in the mid-teens, driving high single-digit FCF growth.
With the outperformance in the shares, I don’t see the value that I saw before. At this point, DCF-based long-term prospective returns look to be more on the order of the mid-single-digits, and a 13.5x forward multiple on EBITDA (more than fair relative to the company’s margins/returns) gets me to “fairly valued” today.
The Bottom Line
“Let your winners run” is good advice, but “the best offense is a good defense” is also good advice and it pays to have an exit strategy in mind for all of your holdings. I wouldn’t rush to sell, and if you’ve decided to make Parker-Hannifin a one-decision long-term holding and you’re willing to withstand the ups and downs, that’s perfectly fine.
At this point, though, I’m skeptical as to whether the multiple can expand much more on top of likely shrinkage in orders. The macro environment could certainly outperform my expectations, and Parker stock can absolutely outperform whatever macro comes, but I’m more inclined to wait for a pullback than chase the shares today.
To read my recent articles on other tickers mentioned, please click here (Atlas Copco), here (Dover), here (Eaton), here (Honeywell), here (Lincoln Electric) and here (Rockwell).
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The 'New And Improved' Parker-Hannifin Now More Evident In The Valuation