Parker-Hannifin Corp (PH) — Q3 2018 Earnings Call Transcript

Thank you, Chelsea. Good morning, and welcome to Parker-Hannifin's Third 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 at phstock.com 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 at phstock.com. Today's agenda appears on slide number 3. To begin, our Chairman and Chief Executive Officer, Tom Williams, will provide highlights for the third quarter. Following Tom's comments, I'll provide a review of the company's third 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.

So thanks, Cathy, and good morning, everybody. Thanks for your participation today. We really appreciate your interest in Parker. So the combination of the Win Strategy, the CLARCOR integration and the strong growth that we saw in the quarter resulted in some very impressive results for the quarter. Thank you to the Parker team members around the world for all your hard work and dedication and the great progress that we're making. Let's jump into the quarter, starting first with safety. Our injuries were down 25%, primarily driven by our engagement initiatives, specifically the high-performance teams. About 80% of our people across the company are in these teams, which number about 5,000 teams worldwide. The goal of this initiative is to create an ownership culture that starts with safety. The progress we've seen on safety is expected to translate to ownership around quality, cost, and delivery. We achieved several all-time records in the quarter. When I say all-time records, I mean in the history of Parker. We had sales of $3.75 billion for the quarter, net income of $366 million, net income ROS of 9.8% and EPS of $2.70. We had a third-quarter record for segment operating margins of 15.8% as reported. This is especially noteworthy given the amount of depreciation and amortization we have in CLARCOR, the restructuring, the CLARCOR costs to achieve, and all the activities that occurred in the quarter. Sales increased by 20%, with 8% organic growth, which is about twice the growth rate for global industrial production. We had order entry rates increase by 11%, marking the third consecutive quarter of double-digit order entries. Adjusted segment operating margins were 16.3%, and EBITDA margins were up 280 basis points to 17.1% as reported or 17.6% adjusted. Adjusted EPS was $2.80, a 33% increase compared to the prior year. Let me switch to cash and capital deployment. As you've heard me say before, our goal is to be great generators and deployers of cash. Our priorities are, in this order; first, dividends. Last week, we announced our 15% dividend increase, which is very positive for our shareholders. This marks the 62nd consecutive year of increases in annual dividends paid. It's a track record we're very proud of and have every means to continue with. Our next priority is organic growth investment, which is the most efficient investment we can make on behalf of shareholders, and we've done a great job paying down debt. Our gross debt-to-EBITDA multiples decreased from 3.6 times at the CLARCOR close to 2.6 times at the Q3 close, showing very significant progress on debt reduction. We'll continue our 10b5-1 share repurchase program. As our debt reduces, we'll reevaluate acquisitions and discretionary share repurchases, always striving to make the best decisions for our shareholders. To provide context on our operating margin performance, I want to remind you that this operating margin for Q3, despite extensive restructuring, was the best in Parker's history. This indicates the potential upside for our margins once the restructuring costs are behind us. Our strategy is a long-term approach, and we are focused on protecting our customers during this extensive plant closure phase, which drives some short-term challenges but is the right move for our customers and shareholders in the long run. We're closing about 36 facilities, which represents 2 million square feet of floor space, a considerable undertaking. The headwinds affecting North America Industrial margins are due to mix, plant closure inefficiencies, and higher volumes. While these higher volumes are positive, they required the closing plants to stay open longer, resulting in redundant fixed and variable costs at both the closing and receiving plants running simultaneously. Fortunately, these North America headwinds are short-term issues, not structural concerns. We expect gradual improvement in North America Industrial incremental margins over the next three quarters. Aerospace had an outstanding quarter, with segment margins up 390 basis points year-over-year to 18.1% adjusted. Industrial International margins improved by 80 basis points year-over-year to 15.3% adjusted. Both Aerospace and International margins are reflecting the benefits of our extensive margin expansion efforts. As for the CLARCOR integration, it is proceeding well, and it is hard for our leadership team to believe we just reached the one-year anniversary of that integration. We have raised our synergy targets to $160 million and anticipate $100 million in incremental revenue over the first three years. The adjusted EBITDA margins have improved significantly due to the combination of our Win Strategy, CLARCOR synergies, and higher organic growth. At the time of announcement, our adjusted EBITDA margins were 14.7%. By the end of the quarter, they reached 17.6%, showing terrific progress. Looking ahead, we've increased our organic sales growth rate for the year from previously 6.5% to 7.6% and are raising our adjusted EPS guidance to a range between $9.95 and $10.15. The business realignment and CLARCOR costs to achieve have been reduced from $110 million to $95 million as we are witnessing efficiency improvements in the implementation costs and increased volume. There is no impact on forecasted savings from the restructuring in FY 2018. Overall, the momentum is positive. Our new Win Strategy, CLARCOR synergies, organic growth, and strong cash flow generation have enabled us to increase our corporate targets, which we revealed at our recent Investor Day. Our new five-year goals include a sales growth of 150 basis points greater than global industrial production growth by 2023, with segment operating margins at 19%, EBITDA margin at 20%, free cash flow conversion exceeding 100%, and earnings per share CAGR of over 10%. With that, I will hand it back to Cathy for a more detailed review of the quarter.

Thanks, Tom. I'll now refer you to slide number 5 and begin by addressing earnings per share for the quarter. You see here as-reported earnings per share for the current year third quarter of $2.70 and adjusted earnings per share of $2.80. The $2.80 compares to $2.11 for the same quarter a year ago, representing a 33% year-over-year increase. The respective adjustments for both years are as follows: fiscal year 2018 Q3 operating income adjustments include business realignment expenses of $0.04 and CLARCOR costs to achieve of $0.06. The adjustments for Q3 of FY 2017 include $0.09 for business realignment expenses and $0.27 related to acquisition expenses. On slide number 6, you'll find the significant components of the walk from the prior year adjusted earnings per share of $2.11 to the $2.80 for the third quarter of this year. The most significant increase came from higher adjusted segment operating income of $0.60 attributable to earnings from meaningful organic growth, income from acquisitions, and increased margins resulting from our new Win Strategy initiatives. This $0.60 improvement is net of incremental depreciation and amortization expense of $0.11 from the CLARCOR acquisition. Lower other expenses contributed an increase in EPS by $0.13, while a lower effective income tax rate added $0.09. Adjusted earnings per share was reduced by higher corporate G&A, equating to a $0.07 decrease, while earnings interest expense was also a $0.07 reduction in the current quarter. Moving to slide number 7, you'll find total Parker sales and segment operating margin for the third quarter. Total company organic sales increased year-over-year by 8.4%. There was a 7.5% contribution to sales from acquisitions, while currency positively impacted the quarter by 4.3%. Total segment operating margin on an adjusted basis improved to 16.3% versus 16.1% last year. Compared to last year, current quarter margins include 50 basis points of CLARCOR-related incremental depreciation and amortization expense. This overall margin improvement reflects the benefits of higher volume, combined with the positive impacts of our new Win Strategy initiatives. Moving to slide number 8, I'll discuss the business segments, starting with Diversified Industrial North America. For the third quarter, North America organic sales increased by 10.4% compared to last year. Acquisitions contributed 13.8% to sales, while currency positively impacted the quarter by 0.5%. Operating margin for the third quarter on an adjusted basis was 16.4% of sales versus 18.2% in the prior year. The current quarter includes 90 basis points of CLARCOR-related incremental depreciation and amortization expense and reflects what we believe are the peak impacts of the inefficiencies related to our footprint consolidation. The higher sales volume experienced in the quarter caused a delay in the closure of some consolidating plants to maintain service levels for customer deliveries. Our productivity improved as the quarter progressed, and we expect steady improvements in Industrial North America incremental margins as plant closures continue during the rest of calendar year 2018. I'll continue with the Diversified Industrial International segment on slide number 9. Organic sales for the third quarter in the Industrial International segment increased by 8.6%. Acquisitions positively impacted sales by 3.3%, while currency positively impacted the quarter by 11.2%. Operating margin for the third quarter on an adjusted basis was 15.3% of sales versus 14.5% in the prior year. Compared to last year, the current quarter includes 25 basis points of CLARCOR-related incremental depreciation and amortization expense. We continue to see progress in margins in Industrial International from the realignment and simplification efforts. I'll now move to slide number 10 to review the Aerospace Systems segment. Organic revenues increased 3.4% for the third quarter, demonstrating strength in all aspects of the business during the quarter, both commercial and military, as well as both OEM and aftermarket. Operating margin for the third quarter, adjusted for realignment costs, was 18.1% of sales versus 14.2% in the prior year, reflecting a favorable aftermarket sales mix, successful execution of the Win Strategy, and lower development costs during the quarter. Moving to slide number 11, we show the details of order rates by segment. As a reminder, Parker orders represent a trailing average and are reported as a percentage increase of absolute dollars year-over-year, excluding acquisitions, divestitures, and currency. The Diversified Industrial segments report on a three-month rolling average, while Aerospace Systems are based on a 12-month rolling average. Total orders continue to be strong, growing by 11% as of the quarter end. This year-over-year growth comprises 11% from Diversified Industrial North America orders, 8% from Diversified Industrial International orders, and 17% from Aerospace Systems orders. In slide number 12, we report cash flow from operating activities. Year-to-date, cash flow from operating activities was $905 million or 8.6% of sales compared to 9.2% of sales for the same period last year, or 11.8% last year adjusted for a $220 million discretionary pension contribution. Current year free cash flow of $710 million has us on track to continue our 15-year streak of 100% or more free cash flow conversion of net income. Significant capital allocations year-to-date include $264 million for shareholder dividend payments, $194 million or 1.9% of sales for capital expenditures, and $150 million for the company's 10b5-1 repurchases of common shares. The full-year earnings guidance for fiscal year 2018 is outlined on slide number 13. Guidance is provided on both an as-reported and adjusted basis. Total sales increases are expected to be in the range of plus 17.7% to plus 19.7% compared to the prior year. Anticipated full year organic growth at the midpoint is plus 7.6%, which is 110 basis points higher than our previous guidance. Acquisitions in the guidance are expected to positively impact sales by 8.1%. Currency is expected to have a positive 3% impact on sales. We calculated the impact of currency to spot rates as of the quarter ended March 31 and have held those rates steady as we estimate the resulting year-over-year impact for the fourth quarter of fiscal year 2018. For total Parker, as-reported segment operating margins are forecasted to be between 15.4% and 15.6%, while adjusted segment operating margins are forecasted to be between 16.0% and 16.2%. The full year adjusted tax rate is now projected to be 24%, down from our previous guidance of 25%. For the full year, the guidance range on an as-reported earnings per share basis is now $7.76 to $7.96, or $7.86 at the midpoint. On an adjusted earnings per share basis, the guidance range is now $9.95 to $10.15, or $10.05 at the midpoint. In addition, to a full year net loss on the sale and write-down of assets of $5 million and the net provisional tax charge of $225 million, this guidance on an adjusted basis excludes business realignment expenses of approximately $50 million for the full year fiscal 2018. Savings from business realignment initiatives are still projected to be $25 million. Additionally, guidance on an adjusted basis excludes $45 million of CLARCOR costs to achieve expenses. CLARCOR synergy savings are still estimated to be $58 million in fiscal year 2018. We continue to remain on track to realize the forecasted $160 million run rate synergy savings by fiscal year 2020 on CLARCOR, which was updated at our March Investor Day. Savings from all business realignment and CLARCOR costs to achieve, along with anticipated full year favorable effects from U.S. tax reform, are fully reflected in both the as-reported and the adjusted guidance ranges. Fourth quarter fiscal 2018 adjusted earnings per share is projected to be $2.85 per share at the midpoint, excluding $0.12 of projected business realignment expenses and $0.09 of projected CLARCOR costs to achieve. We ask that you continue to publish your estimates using adjusted guidance for purposes of representing a more consistent year-over-year comparison. On slide number 14, you'll find a reconciliation of the major components of fiscal year 2018 adjusted earnings per share guidance of $10.05 per share at the midpoint compared to prior guidance of $9.85 per share. Increases include $0.04 from higher segment operating income, $0.05 from lower other expenses, $0.14 from a lower effective tax rate, and $0.02 from a lower projected share count. Offsetting these increases is a $0.03 per share decrease from higher forecasted corporate expense and $0.02 per share from higher projected interest expense. Please remember that the forecast excludes any acquisitions or divestitures that might occur during the remainder of fiscal 2018. This concludes my prepared comments. Tom, I'll turn the call back to you for your summary.

Thank you, Cathy. We're making good progress and seeing broad-based improvement in demand across geographies. The Win Strategy initiatives are generating improvements in both growth and earnings. We're increasing our earnings guidance and are on track for record-year performance. We really have a bright future ahead. The new five-year targets we've announced put Parker in the top quartile of performance versus our peers. So I want to say again, thank you to the Parker team members around the world for all their progress and hard work. I also want to thank the shareholders for their continued confidence in us. At this point, I'll hand it over to Chelsea to start the Q&A portion of the call.

Hi. Good morning.

Good morning, Ann.

Good morning. Can we talk about the realignment costs and the CLARCOR costs? Maybe you could give us some color in terms of have the absolute costs gone up? Or are we just pushing out costs because volume is too strong, and we have duplication? And any color you can give us around quantifying how much more we're going to spend now in fiscal 2019 than we might have thought a quarter ago or a couple of months ago.

Yeah, Ann. It's Tom. We're moving some costs from 2018 to 2019. But during the quarter, we experienced what I described at the beginning about a significant amount of restructuring. We also need to protect our customers by running redundant plants and covering that with bridge builds. We track productivity at the closing and receiving plants, and we saw productivity improve during the quarter. I expect this last quarter was the worst of inefficiencies. We moved only three plant closures from this year to next year. The remainder of the footprint plan is intact, and even with these adjustments, we achieved all-time best margins and improved EBITDA margins. We're in year two of the CLARCOR integration, and our synergies, including footprint changes, are ahead of the schedule we set, so while there was some short-term noise, we expect strong progress moving forward.

Yes, Tom, can you give us any color on the cadence of the improvement of incremental profits, particularly in North America? I think what investors are focused on is the incremental profits. When will we get back to your more normal 25%, 30% incrementals?

What we've got in the guide for Q4 is a 19% incremental for North America. I'm not going to go beyond that at this point since we want to see more plant metrics in the next quarter. So I won't forecast FY 2019. We do expect inefficiencies to continue in the first half of FY 2019, but they will get better each quarter. Last quarter was our low-water mark, and we expect improvements in Q4.

Good morning, everyone.

Good morning, Nathan.

Again, following up on some of the margin questions here. I think we've seen several companies report this quarter having some trouble passing through raw material inflation. What do you think contributes to the margin drag here versus price cost?

Nathan, it's Lee. As you know, pricing for us is more than just passing through input costs. We track the price-inflation relationship closely, and while we have seen inflationary costs throughout the supply chain, I can tell you it's not contributing significantly to our North American margin incrementals. The strong margin growth in International and Aerospace gives an indication that our processes are recovering price costs. We employ strong disciplines at both division and corporate levels on pricing. Year-to-date, we have a positive spread between our selling prices and our input costs, and we've done price increases through surcharges on heavy commodity-based contracts.

So just to clarify, you were still positive in the third quarter?

Yes, we were.

Can you talk about which markets have been better than you thought as we moved into the back half?

In Aerospace, we see good demand for single-aisle commercial aircraft and increased commercial MRO driven by traffic growth. In the industrial sector, we find growth across almost all our markets and end areas, including agriculture, construction, mining, and oil and gas. The oil and gas sector, specifically, is quite strong, and we're seeing a resurgence in offshore projects. In North America, sentiment remains strong, especially with our distributors. We see EMEA continuing organic growth, and China is very active in infrastructure investment and natural resource markets. The majority of our end markets are growing.

Hi. Good morning, everyone.

Good morning, Joe.

Can you quantify the disruptive impact from CLARCOR? Was the 50 basis point drop in North America metrics all due to CLARCOR?

Joe, it’s Tom. The disruptions are not solely due to CLARCOR; there are inefficiencies related to plant closures across the company. The inefficiencies include premium freight, overtime, scrap, rework, lower productivity at closing plants, and redundant costs. We believe the worst inefficiency we've seen this time around is subsiding and gives us optimism for the upcoming quarters, but yes, it will continue to affect the first half of FY 2019.

Thanks a lot. Good morning.

Good morning, Andrew.

Do you expect to have all plants closed as you said by the end of this fiscal year?

Yes, we're on track with the 36 closures, with only three pushed into FY 2019.

Hi. Good morning. I guess my first question, based on the shrink you saw in your North American order book in the quarter, how much visibility do you have on the risk of that margin shift?

It's hard to identify that risk right now because we have a lot of end markets that remain strong. What we've experienced has been general caution in mobile equipment. Overall, our data indicates nearly all of our markets are expanding, particularly in aerospace and international industrial growth outlook. We don't see sufficient reasons yet to slow down or adjust growth expectations.

Hey. Good morning, guys.

Good morning, Jeff.

Can you talk about the core growth rates that CLARCOR is seeing? How much is tied up in working capital around plant transition?

The growth rates for CLARCOR are inline with standard increases in the filtration market, around low- to mid-single-digit. With incremental revenue synergies expected to increase that to 4.5% CAGR over time. Regarding inventory, we do have higher levels due to the plant transitions but expect that to normalize as we close these facilities.

Is the stock dislocation making you rethink buybacks?

We're in the process of continuing our share repurchase program. Once we clear some debt, we're actively looking at strategic acquisitions as well. We evaluate both options simultaneously.

Thank you.

Thank you. Good day, everyone.

Good morning, Jeffrey.

I wanted to come back to the disruptions one more time. It seems like we measure everything. Are you concerned about missing the cycle here by restructuring at the wrong time?

I think it's important to note that we are still achieving record margins. Our EBITDA margins are up significantly, and we achieved all-time records regardless of restructuring. I hope investors are committed for the long-term with us, as we continue to drive efficiencies and reduce costs to set ourselves up for future growth. The path we've chosen is designed for long-term success, and I firmly believe that.

Hi, good morning, guys.

Good morning, Joe.

I wanted to ask how you're thinking about the macro indicators impacting your business and when you would acknowledge that we might have to adjust actions given broader factors.

Currently, around 95% of the end markets are showing growth despite fluctuations in macro indicators. Until there's a significant and sustained decline across multiple market segments, we remain optimistic about our growth trajectory. The data suggests that we should continue to see opportunities without having to scale back on growth initiatives.

Thanks for the clarification on incremental costs it helps. Can you confirm if any lingering costs will flow into next year?

Yes, there will be inefficiencies and costs from the 36 plants into 2019, but those costs will be decreasing over time as productivity improves.

Thank you, Ann. This concludes our Q&A and our earnings call. Thank you for joining us today. Robin and Ryan will be available throughout the day to take your calls should you have any more questions. Thank you, everybody. Have a great day.