Parker-Hannifin Corp (PH) — Q1 2018 Earnings Call Transcript

Thank you, Chelsea. Good morning, and welcome to Parker-Hannifin's first quarter fiscal year 2018 earnings release teleconference. Joining me today are Chairman and Chief Executive Officer, Tom Williams; and President and Chief Operating Officer, Lee Banks. Today's presentation slides, together with the audio webcast replay, will be accessible on the company's investor information website for one year following today's call. On slide number 2, you'll find the company's Safe Harbor disclosure statement addressing forward-looking statements, as well as non-GAAP financial measures. Reconciliations for any reference to non-GAAP financial measures are included in this morning's press release and are also posted on Parker's website. Today's agenda appears on slide number 3. To begin, our Chairman and Chief Executive Officer Tom Williams will provide highlights for the first quarter of fiscal year 2018. Following Tom's comments, I'll provide a review of the company's first quarter performance, together with the guidance for the full year fiscal 2018. Tom will then provide a few summary comments and we'll open the call for a question-and-answer session. Please refer now to slide number 4, as Tom will get us started with the highlights.

Thanks, Cathy, and good morning to everybody, and thanks for joining the call. We appreciate your interest in Parker. So let me just make a few comments about general business conditions and we will talk about the quarter. First, safety continues to be a top priority for the company. Prioritizing safety is obviously the right thing to do, but the focus on safety is driving an increased engagement from our people, which is in turn driving safety improvements across the company, which is also impacting our operational improvements across the company as well, so I'm very encouraged by all of that. You saw the announcement on orders, which showed a broad-based increase across markets and regions. The organic growth was greater than industrial production growth for the last three quarters in a row, so we're excited about that. The Win Strategy initiatives continue to generate improvements in both growth and operating margins. If I would characterize business confidence in general, feedback from our customers has been very positive, so there is a nice general business confidence in the market. It has been about two years since we announced and introduced the new Win Strategy, and a lot has happened in that time. Two years ago we were in a tough industrial climate, actually our second biggest downturn in sales in the history of the company, and we performed better than we ever had in any previous downturn. If you're looking for evidence on whether the new Win Strategy is working, I think if you look at the results of the last two years, it is clear and objective evidence that the strategy is working. The good news for all of our people and shareholders is that we’re still in the early stages of implementation, so there is a lot of upside with the new Win Strategy and we're excited about that. I wanted to say first of all thank you to all the Parker team members around the world for the great progress after two years from the launch and for being a partner in creating the new Win Strategy, as they played a big part in developing the strategies that we're now rolling out. Let's move on to the quarter. It's always nice to start strong. Starting with safety, we had a 24% reduction in recordable injuries which was great performance. The key performance metrics for the quarter showed solid performance across the board, with sales being a first-quarter record for us, up 23%. Organic growth was slightly above 7%, and order rates increased at double digits, which is the highest level of order growth that we've had for a quarter since Q4 of fiscal 2011. The segment operating margins continue to improve nicely and EPS for the quarter was also a first-quarter record. EPS increased by 36% as reported and 48% on an adjusted basis, which are impressive increases. We're on track to deliver strong operating cash flow going forward. On capital deployment priorities, dividends continue to be our number one focus; we're increasing dividends and maintaining our longstanding track record of dividend increases. We're going to continue to invest in organic growth with our CapEx as it's the most efficient way to grow the company. We're maintaining our 10b5-1 plan for a consistent share buyback program and we're continuing to focus on reducing debt. Moving on to the outlook; we increased our adjusted EPS outlook by $0.60 at the midpoint from $8.80 to $9.40. This reflects the first quarter beat that we had and increased organic growth estimates that we included in the guidance. We've also increased total Parker organic growth estimates from our previous guidance of 3.7% to a new guide of 5.5% organic growth for the entire company. We're going to keep driving the new Win Strategy and I'll make a quick comment or two about each of the four goals. First is engaging people; creating an ownership culture produces accountability with respect to responsibilities, driving better results. Second is premier customer experience; we want to transition from a service mindset to an experience mindset, ensuring holistic interaction with our customers and distributors. Third is profit growth; we aim to grow organically faster than the market. Finally, our financial performance goal is maintaining a 17% segment operating margin along with growing EPS by 8% year-over-year. I’d like to comment on CLARCOR; integration is going very well, synergies are on track, and the new filtration group is functioning as one team, genuinely representing one Parker team now. In summary, we're anticipating a record year and are driving continuous improvement across the board. With that, I’ll give it back to Cathy to provide more details on the quarter.

Thanks, Tom. I'd like you to now refer to slide number 5. I'll begin by addressing earnings per share for the quarter. Adjusted earnings per share for the first quarter were $2.24 compared to $1.61 for the same quarter a year ago, representing an increase of 39%. For year-over-year comparison purposes, first quarter fiscal year 2018 earnings have been adjusted by a total of $0.14. Operating income adjustments include business realignment expenses of $0.04 and CLARCOR costs to achieve of $0.03. Last year's first quarter earnings have also been adjusted for business realignment expenses of $0.06. On slide 6, you'll find the significant components that illustrate how we moved from the adjusted earnings per share of $1.61 for fiscal 2017 to $2.24 for fiscal 2018. The most significant increase came from higher adjusted segment operating income of $0.62, attributable to meaningful organic growth, income from acquisitions, and increased margins due to our new Win Strategy initiatives. Also notable was a lower income tax rate, which led to a year-over-year increase of $0.12, while lower other expenses due to decreased pension expenses contributed $0.06. Adjusted per share income was reduced by $0.11 due to higher interest expenses and $0.06 due to higher corporate G&A expenses, primarily as a result of increased performance compensation expenses. Moving to slide number 7, total Parker sales and segment operating margins for the first quarter increased year-over-year by 7.4%. There was a 13.9% contribution to sales from new acquisitions in the quarter, while currency positively impacted sales by 1.4%. On an adjusted basis, total segment operating margins improved to 16.0% versus 15.4% for the same quarter last year. Regarding fiscal year 2018 operating margins, these include incremental depreciation and amortization from prior acquisition quarters, so a better comparison will be with the EBITDA margins, which improved to 17.0% in fiscal 2018 from 15.0% in fiscal year 2017. The increase in EBITDA margin reflects the benefits of higher volume and a positive impact from our new Win Strategy initiatives. Moving to slide number 8, I'll discuss the business segments, starting with Diversified Industrial North America. For the first quarter, North American organic sales increased by 9.7% compared to the same quarter last year. Acquisitions contributed 26.4% to sales, while currency also positively impacted the quarter. Adjusted operating margin for the first quarter was 16.7% versus 17.5% in the prior year. Next, Diversified Industrial International segment organic sales for the first quarter increased by 11.7%, with acquisitions positively impacting sales by 7.3%, while currency positively impacted the quarter by 3%. The adjusted operating margin for the first quarter was 15.7% versus 14.2% in the prior year. Moving to slide number 10, we show the Aerospace Systems segment, where organic revenues decreased by 5.5% for the first quarter. The reduced volume in OEM and commercial aftermarket sales were partially offset by strength in the military aftermarket during the quarter. Much of this reduced volume was timing-related, and increased volume year-over-year is anticipated for the rest of the fiscal year. Adjusted operating margin for the first quarter was 14.7% versus 13.1% in the prior year, reflecting a greater aftermarket sales mix and the timing of development costs. Moving to slide number 11, we display the details on order rates by segments. Parker orders represent a trailing average and are reported as a percentage increase of absolute dollars year-over-year, excluding acquisitions, divestitures, and currency. Total orders continue to show strength with a positive 11% improvement for the quarter. This year-over-year improvement included 10% from Diversified Industrial North America orders, 15% from International orders, and 4% from Aerospace Systems orders. On slide number 12, we report cash flow from operating activities, indicating a year-to-date cash flow from operating activities of $239 million or 7.1% of sales, compared to 4.2% for the same period last year. Significant capital allocations year-to-date include $88 million for dividends, $79 million or 2.4% of sales for capital expenditures, and $50 million for repurchases of common shares. The full-year earnings guidance for fiscal year 2018 is outlined on slide number 13, with total sales increases expected in the range of 14.2% to 17.8%. Anticipated full-year organic growth at the midpoint is 5.5%. Acquisitions are expected to contribute 8.3% to sales and currency is expected to positively impact sales by 2.3%. We have calculated the impact of currencies to spot rates as of the quarter ended September 30, 2017. We maintained stable rates as we estimate the resulting year-over-year impact for the remaining quarters of fiscal year 2018. Total Parker's segment operating margins are forecasted to be between 15.3% and 15.7%, while adjusted segment operating margins are forecasted to be between 16.1% and 16.5%. The full-year tax rate is now projected to be 28%, down from our previous guide of 29% due to favorable stock option tax credits realized in the first quarter. For the full year, the guidance range for as-reported earnings per share is now $8.45 to $9.05 or $8.75 at the midpoint. On an adjusted basis, the guidance range is now $9.10 to $9.70 or $9.40 at the midpoint.

Thanks, Cathy. So we're very pleased with the start of the year. I think what we have going on here is a combination of several factors; sales growth, the lower cost structure we have been focusing on, integration of CLARCOR, and the execution of the Win Strategy. All of these factors combined are driving us to project a record year in fiscal 2018. Again, thank you to the global team for all your hard work and dedication. I want to hand it off to Chelsea to start the Q&A portion of the call.

Hi, good morning, this is Adam Farley on for Nathan. It looks like one of the big changes in revenue guidance came from International Industrial, going out to 16.9% at the midpoint. What regions are driving this growth and what end markets are also driving the growth?

So Adam, let me start that and then hand it over to Lee to give you more details. What has changed in our guidance is looking at order entry over the last three months. Order entry was pretty consistent throughout the quarter, both in North America and in international markets. In particular, we saw Asia continue to be strong, and the Europe, Middle East, and Africa region was growing in the low teens, while Latin America was in the low single digits. So that combination is quite strong. Aerospace grew by 4%, which was against a tough comp of 14%. When we look at the Industrial portion, North America and Africa is about 10.5% for the first half, and then 3.7% for the second half. The second half compares to a growth of 6% that we had in FY17. The growth we're seeing is broad-based across every end market and region participating. Lee, do you want to comment further?

Yeah. Just piggybacking off Tom, I want to provide a little added commentary on the different segments. It's moving in the direction we expected from the last call. Order entry was broad-based and all regions participated. For Aerospace, we fell short of expectations for Q1, but we're still forecasting growth for the year. Weakness in commercial OEM was a headwind for us, which we regard as timing-related. We expect growth in MRO as the fiscal year goes on. On Industrial, many end markets showed significant year-over-year growth. In construction equipment, mining is very strong. Oil and gas activity continues to improve with rigs rapidly coming out of cold storage. Distributor partners are optimistic, seeing capital loosen in the economy, and project activity is increasing, which is an encouraging sign for us. So we're positive about the various end markets across the globe.

All right. That's great. Thank you so much. I will pass it along.

Can you say that if CLARCOR was accretive or dilutive to the operating margins, including the amortization?

At the beginning of the year, we guided for $0.20 of accretion from CLARCOR for the year, and we're on track for that. That includes the impact of depreciation and amortization as well as the additional interest incurred because of the deal, so it's accretive.

I meant on the operating margins, what was the change in operating margins from putting CLARCOR in there?

Yeah. They are in line with what you saw historically for CLARCOR and in line with our filtration group, so normal margins.

Okay. And I just wondered why the operating cash flow was down on a year-over-year basis?

Sure. The first quarter is typically our low quarter for cash from operations. We still expect this year to be at 10% or greater as a percent of sales. In this quarter, we're building capital to match the higher volume we're incurring. We're also building some inventory to prepare for the footprint moves related to the integration of CLARCOR, leading to a higher investment in working capital than usual. But this isn't out of our normal trends for a first quarter, and we will recover that through the rest of the year.

Was the strength in international markets all just Parker's core business, or are you seeing any traction from CLARCOR starting to gain traction internationally? And in terms of CLARCOR, should we see revenue synergies in '18, and how are we tracking to the savings plan of $140 million?

The international strength we saw largely stems from CLARCOR's end markets being aligned with legacy Parker's markets. As for revenue synergies, while we're working hard at them, I would advise not to anticipate them in FY18. Realistically, any realizations in that area will likely not be visible until FY19!

Thank you.

Good morning, everyone. First off, I want to commend you on your performance over the last several years, especially in the last 12 months. That's from someone who has been on the sidelines on the stock, so I tip my hat to your team. Now, regarding organic growth and the more difficult comps in the back half of the year, looking at your order, it seems like you're bucking those comps nicely. Can you speak to how you're considering the momentum?

Mig, on order entry, we typically have visibility for the Industrial portion of the business in the 6 to 8 week range. We have more confidence in the first half of the year, and going into January, we expect a solid outlook. For the first half, we're seeing 10.5% growth, although it reflects easier comps. In the second half, we're estimating around 3.5% growth compared to the 6% organic growth we had in the same period last year. That feels positive, give the historical context.

Understood. Could you provide more insight into the margin in Aerospace? You’ve called out things that provided support this quarter. What shifts are expected for the rest of the year to achieve your margin guidance?

In the quarter, we observed a favorable mix of aftermarket sales overall. Development costs were lower this quarter; however, we expect those will align as we incur the remaining development costs during the rest of the year.

Thank you.

Could we talk about CLARCOR and the integration? Coming into the year, there were cost cuts and costs to accelerate the integration. How should we think about achieving those $140 million in synergies?

We're still targeting the $140 million in synergies. Our upcoming Investor Day will provide a more in-depth update, as it will fall around the one-year anniversary of the acquisition.

Thank you. Could you share how significant China is to Parker overall?

Unfortunately I can't provide an exact figure, but I can say it's among our top three largest countries alongside the US and Germany. Additionally, we're seeing positive growth in the entire Asia region, not just China.

I wanted to know if you've seen any labor inflation anywhere in the world?

No, nothing out of the ordinary has been observed regarding labor inflation at this point.

Thank you.

Thanks and good morning, everybody. Given the strength of Parker in Q1, do you have any insights regarding distributor inventories today?

Currently, at the distributor and OEM levels, it feels primarily like end market pull through. Based on the rebound we talked about previously, it reflects their strong demand.

Regarding CLARCOR and synergy targets, I noticed you incurred about $6 million in costs this quarter as opposed to the full year guidance of $52 million. Is this spend schedule an indicator of your synergy expectations?

We did shift some timing on the footprint mergers we planned. As a result of that shift, several costs have moved toward later quarters. However, we expect the savings, and the projected savings are still on track as anticipated.

In general, the character of our planned closures often leads to a more conservative forecast on timing and savings. We anticipate seeing a more pronounced impact in Q2, Q3, and Q4.

What about commodity inflation? Did that impact the North America margins this quarter?

The net effect is no. We've observed some commodity inflation, such as copper, but those costs are easily manageable under our contracts where necessary.

I'd like to discuss the back half of the year regarding the sequencing and splits you've outlined. Your second-half projection does not appear to reflect significant improvement immediately, in light of the broad order book you've referenced. How should we think about pricing capabilities late in the year?

We see our segment operating margin guidance in the mid-30% range overall. Although CLARCOR's inclusion affects our ability to provide specificity surrounding legacy Parker's margins.

Why is the second-half growth rate in Industrial slower if it is primarily from annual comps?

That's about the right approach to understanding that; it reflects the broader picture and earnings from last year.

Have you seen supply chain constraints? If so, could you provide more details?

We did experience some noise with the ramp in production but nothing abnormal. We're managing through those challenges without major problems.

Our backlog has remained relatively flat despite the increases in order entry, which is a good indicator of our ability to accommodate the growth thus far.

On the Win Strategy, you spoke of multichannel selling techniques for growth. Are all aspects of the strategy still intact, or are some performing better than anticipated?

There remains considerable opportunity for us, especially regarding services, innovation, and systems development. With only about a 10% market share in motion control, we still have substantial opportunities to grow. Our aim is to consistently grow at an average of 150 basis points greater than global industrial production.

Can you comment on the pipeline for acquisitions?

Dividends continue to be our primary focus for capital deployment. We plan to invest in organic growth, maintain share buyback, and prioritize debt reduction, but we're prepared to pursue acquisitions if the opportunities align with our strategic vision.

What are the early opportunities you've identified for potential revenue synergy with CLARCOR?

At a high level, we see opportunities in channel, region, and OEM portfolio development through CLARCOR's aftermarket strengths paired with Parker's OEM focus. However, it's important not to project revenue synergies overly optimistic for FY18, as we won't realistically see returns until FY19.

Can you provide updates on the strategy progression for distribution expansion in international segments?

This has been a key initiative for us. Per our new Win Strategy, we've made great progress with senior teams dedicated to this focus in regions like Asia and EMEA.

Thank you.

What are you factoring regarding CLARCOR's organic revenue growth for this year?

We're looking at a mid-single digits expectation for CLARCOR, aligning more closely with the core business.

Thank you.

In Asia, how are facilities operating today compared to extreme low rates?

We’ve made prior investments to prep for this growth, and expansion will focus on targeted equipment rather than significant capital outlays.

Regarding group consolidation, where is the focus as we head toward FY18?

We've consolidated from 114 to about 90 divisions, but the pace will slow as we continue to seek logical group alignments that support synergy. We're focusing on strategic necessity instead of number-driven approaches.

Thank you, Chelsea. Thank you to everyone for joining us today. Our team will be available throughout the day to address any further questions. Thanks again; have a great day.