Parker-Hannifin Corp (PH) — Q4 2019 Earnings Call Transcript

Thanks Liz. Good morning. Welcome to Parker Hannifin's fourth quarter 2019 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 and 3, you will 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 4. We'll begin with our Chairman and Chief Executive Officer, Tom Williams, providing comments and highlights from the fourth quarter and full fiscal year 2019. Following Tom's comments, I'll provide a review of the company's fourth quarter and full fiscal year 2019 performance together with guidance for fiscal year 2020. 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 5, and Tom will get us started.

Thanks, Cathy. And good morning, everybody. Thanks for your participation. Looking at slide 5, we had a strong fourth quarter and completed Parker's best year ever in our history. But before I jump into all the results, I wanted to just pause for a minute and reflect on the remarkable transformation of our company. Parker is a very different company now, delivering record performance and better able to perform through market cycles. We have a stronger portfolio of businesses following the three transformational acquisitions we've done in the last three years. If you look at performance and go back to last five years, adjusted operating margin percentage improved 280 basis points and adjusted EBITDA margins improved over 300 basis points. We are better performers over the cycle. We've always been good on cash flow over the cycle, but we're now much better on EPS and margins over the cycle. Particularly if you note, our margin performance during the '15 and '16 industrial recession and our margin performance just in the last quarter Q4, a negative order growth, they all point to the improved performance that I was referring to. On the three acquisitions, they're going to lift the company up on two levels, portfolio and performance. On the portfolio side, we wanted to add to Filtration, Engineered Materials, and Aerospace. These are parts that we've talked about on the air because of the resilience over the cycle. On the performance side, we're adding three great businesses that are accretive to growth and the margins. Our goal here through the Win Strategy and our Capital Deployment strategy is to build a better business that generates higher growth, margins, and cash flow through the business cycle, and you're seeing evidence of that already. Ultimately, this is going to result in Parker being a best-in-class company. So my thanks to all the Parker team members who are listening in, for all their hard work last year, but really over the last several years to get us to this point. If you turn to slide 6, part of what is transforming the company is our business model and the competitive differentiators that make us special. We'll just talk through these bullets on this page briefly. The Win Strategy, it's our business system, it is the engine behind our results. Our decentralized divisional structure really drives an entrepreneurial spirit in the company. The motion and control technologies that we have really create the breadth of our portfolio and strategically positions us to have a big advantage versus our competition. And recognizing the fact that I've talked about before, 60% of our revenue comes from customers that buy from all of those technologies. That's good evidence that our customers value that breadth of technologies. Our strong intellectual property, 85% of our portfolio, and typically what we ship has some element of intellectual property tied to it. We have long product life cycles, decades long as it goes, balanced OEM and aftermarket, and we have arguably the best distribution channel in the motion control space. We have low CapEx requirements. Our lean transformation has really driven low CapEx to drive our business, and that enables us to have a very robust capital deployment process. And we're great generators and deployers of cash, and you've seen us in action over the last five years in that regard. So if you turn to slide 7, some highlights from the fourth quarter: Safety continues to be our top priority. Our reportable incidents for the quarter were down 24%. Our high-performance teams are helping to drive these results. Our goal is zero incidents. That's not an aspirational goal; it's really an expectation of how we're going to run the company. The ownership culture that's created from the high-performance team process and the start of a safety will also be applied to quality, cost, and delivery, which will naturally lift up the performance of the company. All-time quarterly records for the fourth quarter include total segment operating margin, total Industrial segment operating margin, net income, and EPS. A couple of notes on the quarter, sales were down 3.5%, that was composed of a negative 2% organically and a negative 1.5%. Our currency orders declined 3% against tough comparables, and we had a fourth quarter record on Industrial International segment margins as well. My thanks to the International team for a great job in the quarter. So now, I want to turn to the full-year results for FY ‘19. We had a number of all-time records; of course, we only do records on a reported basis, so they are sales, total segment operating margins, net income, EPS, and operating cash flow. A couple of highlights for the full year, we came in on organic growth of 2.6%, organic sales outpacing global industrial production. We had excellent improvement in segment operating margin and EBITDA margins versus the prior year. Adjusted EBITDA margins, if you go back to when we acquired CLARCOR, we were 14.7%. We're now at 18.2%. From an EBITDA dollar standpoint, we were at $1.7 billion, and now we are at $2.6 billion. That growth in margins, that growth in EBITDA dollars has really helped enable us to do both LORD and Exotic acquisitions that we've recently announced. We achieved 17% segment operating margins, a year ahead of our original target. For the first time in our history, we reached 17%, a number that we are extremely proud of, and obviously we're not stopping there, but that was a huge milestone for us to reach. Tremendous cash flow generation resulted in $1.7 billion in operating cash. When you do it on a percent basis, we came in at 12.1% CFOA, and excluding the pension contribution, that will be 13.5%. Switching to cash and capital deployment, the goal, and you've heard me talk about this, is to be great generators and deployers of cash. So, on the cash generation side, we ended FY ‘19 at 115% free cash flow conversion. That makes 18 consecutive years of free cash flow conversion credit of over 100%. On the deployment side, it was a big year. Dividends, our stated target is to pay out 30% to 35% of net income. As a result of our growth in net income, we increased annual dividends paid out by 13%. We had our 63rd consecutive year of annual increases in dividends paid out, a record we're very proud of as well, and one that we intend to keep. We announced two transformational acquisitions. On the share repurchase side, we did $200 million on our 10b5-1 program, and we purchased $600 million on a discretionary basis. Debt reduction is going to be a higher priority going forward. Our target within three years is to get a 2.0 multiple from a gross debt to EBITDA multiple, and we'll pause the M&A activity until we get there. Just a few comments on the acquisitions that are really going to generate great value for our shareholders. We announced in the last 90 days, the acquisition of LORD Corporation and Exotic Metals; transformational to our portfolio, adding to our Engineered Materials business and on the Aerospace group with high growth and high margin businesses. When you look at the pro forma EBITDA margin, take legacy Parker with LORD and Exotic in your forecast set out for five years, we're going to improve EBITDA margins by more than 400 basis points over that five-year period. That's really going to help propel us to be in that top quartile company that we desire, and both of these companies I am referring to, LORD and Exotic, are both great cultural fits, and we expect a seamless integration. Now turning to the outlook, we are issuing guidance for FY 2020. We've got moderating market conditions. We're forecasting sales to be down 3% to flat, so minus 1.5% at the midpoint, and I'll talk more about that during the Q&A. I think the effectiveness of the Win Strategy is really being observed. When you look at our FY '20 guide, historically on negative organic growth, we would be reducing margins, But with this guidance, we're expanding segment operating margins and we're posting a record EPS. Adjusted EPS is at $11.50 to $12.30 or $11.90 at the midpoint, with a business realignment of $20 million, and we did not include LORD or Exotic in this FY '20 guidance. We will, of course, update guidance after they close. So going forward, really if you look at the FY '19 results, FY '20 guide, coupled with the momentum that we have with the Win Strategy in our recent acquisitions, we're well on our way to achieving our FY '23 targets. Just to remind people, those targets for FY '23 are sales growth of 150 basis points greater than global industrial production growth over the cycle, segment operating margins of 19%, EBITDA margins of 20%, free cash flow conversion greater than 100%, and EPS CAGR over that time period of 10% plus. The actions we're taking and the dedication of our global team members are really helping to generate strong returns for our shareholders. And with that, I'll hand it back to Cathy for a more detailed review on the quarter.

Thanks, Tom. I'd like you to now refer to slide number 8. This slide presents as reported and adjusted earnings per share for the fourth quarter and full year fiscal 2019 compared to 2018. Adjusted earnings per share for the fourth quarter increased 3% compared to the prior year, reaching $3.31. Adjustments from 2019 as reported results totaled $0.14, including business realignment expenses of $0.04 and LORD acquisition and integration expenses of $0.10. This compares to fiscal 2018 adjustments of $0.60 for business realignment expenses, CLARCOR costs to achieve, and a net loss on sale and write-down of assets and a US tax reform adjustment. For the full year, adjusted earnings per share for fiscal 2019 was $11.85, an increase of 14% compared to fiscal 2018. Adjustments from the 2019 as reported results totaled $0.37. This compares to fiscal 2018 adjustments of $2.59. The details of all of these adjustments are included in the reconciliation tables for non-GAAP financial measures. Moving to slide number 9, you'll find the significant components of the $0.09 walk from prior-year fourth-quarter adjusted earnings per share to $3.31 for the fourth quarter of this year. We gained $0.04 from lower corporate G&A, interest expense and other expenses. Lower income tax expense accounted for $0.06, and lower average share count contributed $0.11. Offsetting these gains, segment operating income decreased by $0.12 as a result of lower volume, with sales down 3.6% versus the prior year quarter, and also as a result of higher development costs incurred in our Aerospace segment. Moving to slide 10, you'll find the significant components of the $1.43 walk from adjusted earnings per share of $10.42 for fiscal 2018 to $11.85 for this year. The largest improvement came from segment operating income. This accounted for an increase of $0.79, with total segment margins improving by 100 basis points year-over-year. $0.14 came from lower interest expense. Lower income tax expense accounted for $0.19, and reduced average shares contributed $0.31. Slide 11 shows total Parker sales and segment operating margin for the fourth quarter and full year 2019. For the fourth quarter, organic sales decreased year-over-year by 1.9% and currency had a negative impact of 1.7%. Despite a decline in sales, the fourth quarter total segment operating margin on an adjusted basis improved to 17.6% versus 17.5% last year. This improvement reflects productivity improvements and the benefits of synergies from acquisitions, combined with the positive impacts from our Win Strategy initiatives. For the full year, organic sales increased by 2.6% and total segment operating margins increased 100 basis points to 17.2%. Moving to slide 12, I'll discuss the business segments starting with Diversified Industrial North America. For the fourth quarter, North America organic sales were down 3.2%. Even with lower sales, operating margin improved nicely for the fourth quarter to 18.4% on an adjusted basis. North America continued to deliver improved margins, which reflects the hard work dedicated to productivity improvements as well as synergies from acquisitions and the impact of our Win Strategy initiatives. For the full year, North America organic sales increased 1.8%, and adjusted margins increased 30 basis points to 16.9%. I'll continue with the Diversified Industrial International segment on slide 13. Organic sales for the fourth quarter in the Industrial International segment decreased by 4.1%. Currency also negatively impacted the quarter by 4.5%. Despite the lower sales, operating margin for the fourth quarter of 2019, on an adjusted basis, improved 30 basis points to 16.4% of sales. This margin performance reflects our team's improved operating cost efficiencies from realignment initiatives and the benefits of the Win Strategy. For the full year, organic sales for Industrial International increased 1.1% and adjusted operating margins increased by 110 basis points, finishing the year at 16.4%. I'll now move to slide 14 to review the Aerospace Systems segment. Organic sales increased 6.5% during the fourth quarter, primarily due to commercial and military OE growth, along with growth in commercial aftermarket. Operating margin for the fourth quarter decreased by 200 basis points due to higher development costs in the quarter and a lower mix of military aftermarket sales as compared to the prior year. For the full year, our Aerospace Systems segment delivered great organic sales growth of 8.5% and an impressive 210 basis point improvement in adjusted segment margin, finishing the year at 19.4%. On slide 15, you'll find the differences in fiscal year 2019 earnings per share between our full-year guidance going into the quarter compared to the actual results from the outperformance in the fourth quarter. Final full-year earnings per share on an adjusted basis was $0.25 higher than previously guided. At the operations level, segment operating income finished $0.01 higher than expected, driven by productivity improvements despite the lower-than-expected sales. Lower corporate G&A, interest, and other expenses resulted in an additional $0.06. We benefited from $0.16 in lower income tax expense due to discrete tax adjustments and additional benefits resulting from new regulations related to US tax reform recognized in the quarter. Lastly, we benefited $0.02 from lower average shares. On slide 16, we report cash flow from operating activities. We had strong cash flow this whole year. Full-year 2019 cash flow from operating activities was a record $1.73 billion. When adjusted for a $200 million discretionary pension contribution made during the first quarter, cash flow from operations was 13.5% of sales. This compares to 11.2% of sales for the same period last year. On slide 17, we show a history of Parker's free cash flow conversion rate. For the 18th consecutive year, Parker generated a free cash flow conversion of greater than 100%, finishing fiscal year 2019 at 115%. Parker is great at cash generation even during growth periods. We're very proud of our team for their good management of working capital. Moving to slide 18, we show the details of order rates by segment. Total orders decreased by 3% as of the quarter ending June. This year-over-year decline is a consolidation of minus 4% within Diversified Industrial North America, minus 8% within Diversified Industrial International, and a positive 10% within Aerospace Systems orders. The full year earnings guidance for fiscal year 2020 is outlined on slide 19. Guidance is being provided on both an as-reported and an adjusted basis. Total sales for the year are now expected to decrease to 1.5% compared to the prior year, within a range of minus 3% to 0%. Anticipated organic growth for the full year is forecasted in approximately the same range at a midpoint of minus 1.5%. There is no prior-year acquisition or divestiture impact, and the currency impact is expected to be minimal. We've calculated the impact of currency to spot rates as of the quarter ended June 30, 2019. We've held those rates steady as we estimate the resulting year-over-year impact for fiscal year 2020. You can see the forecasted as-reported and adjusted operating margins by segment. At the midpoint, total Parker adjusted margins are forecasted to increase approximately 20 basis points from the prior year. For guidance, we are estimating an adjusted range of 17.2% to 17.6% for the full fiscal year. The full-year effective tax rate is projected to be 23%. For the full year, the guidance range on an as-reported earnings per share basis is $11.38 to $12.18 or $11.78 at the midpoint. On an adjusted earnings per share basis, the guidance range is $11.50 to $12.30, or $11.90 at the midpoint. The adjustments to the as-reported forecast made in this guidance include business realignment expenses of approximately $20 million or $0.12 per share for the full-year fiscal 2020. The associated savings are projected to be $10 million. Some additional key assumptions for full-year 2020 guidance at the midpoint are: sales are divided 47% first half, 53% second half; adjusted segment operating income is divided 46% first half, 54% second half; adjusted earnings per share, first half, second half is divided 45%, 55%. First quarter fiscal 2020 adjusted earnings per share is projected to be $2.66 per share at the midpoint, and this excludes $0.04 of projected business realignment expenses. On Slide 20, you'll find a reconciliation of the major components of fiscal year 2020 adjusted earnings per share guidance of $11.90 per share at the midpoint compared to the prior year of $11.85 per share. The increases include $0.07 from corporate G&A, $0.55 from other expenses, and $0.13 from lower average shares. Other expenses include $0.35 of interest income from the proceeds of the bonds that we issued in June 2019, which are being held for the LORD transaction. The remainder in other is primarily related to numerous unusual charges incurred in fiscal 2019 that are not expected to repeat in 2020. Offsetting these increases is a $0.04 per share decrease from segment operating income. The operating income impact from the drop in sales volume will be partially offset by margin improvement throughout the year. The remaining decreases are $0.30 from higher income tax expense and $0.36 per share from higher interest expense. The decrease due to higher income tax expense is from discrete tax items in 2019 that we do not forecast in fiscal 2020. The change in interest expense includes an additional $0.47 in interest cost from the bonds issued in June, partially offset by anticipated lower commercial paper outstanding as compared to fiscal year 2019. This forecast does not include any results from our announced acquisitions of LORD Corporation or Exotic Metals Forming Company. We ask that you continue to publish your estimates using adjusted guidance for purposes of representing a more consistent year-over-year comparison and that you do not include the pending acquisitions until we are able to close the transaction. This concludes my prepared comments. Please turn to slide number 21. I'll turn it over to Tom to provide summary comments.

Thanks, Cath. So, just a couple of quick comments. We're very pleased with our continued progress, projecting record year of earnings in FY '20, and we're well on our way to delivering a top quartile company and being that best-in-class company that we are aspiring to be. My thanks to the global team for all their hard work, their dedication, and the results from FY '19. We're looking forward to a bright future together. And with that, Liz, we're happy to start the Q&A portion of the call.

Hi, good morning. Nice quarter. I guess just first question, Tom, if you could just provide some context around how you're thinking about the organic growth drive for 2020, what's implied for sort of first half versus second half? And then you know, what you’re seeing in terms of, you mentioned channel inventory before, how long that continues to weigh on results versus clearing the channel? So I guess start there and then - yeah, I guess, why don't we start there? That's fine.

Okay, Jamie. It's Tom. I'm glad to address that since it’s likely on everyone’s mind. Let me explain our assumptions. We were one of the first companies to discuss the prospects for 2020, and we gather insights from customers, distributors, and our own economic models. The organic growth we mentioned for the midpoint is at minus 1.5%, which translates to minus 4% for the first half, reflecting our current order entry. For the second half, we expect a slight improvement at plus 1%. This suggests a bit better volume and easier comparisons. Looking at the minus 1.5% organically by region, North America shows minus 1.5%, international reflects minus 4.5%, and Aerospace is at plus 4.5%. While this isn’t a concrete predictor of our future, it's important to consider our pressure curve history. Over the last decade, when the 3, 12 curve has dipped below 1, it typically remains under that threshold for about 12 to 18 months, depending on the business cycle. Currently, our pressure curves have been under 1 for about 7 months. This guidance is based on the expectation that the 3, 12 curve will return to above 1 roughly 15 months after it initially fell. Now, regarding the markets for fiscal year 2020, I’ll outline what we believe will influence the second half. I want to clarify that my comments refer specifically to how Parker is expected to perform in the market rather than the overall market conditions. On the positive side, we see prospects in Aerospace, forestry, and life sciences. Neutral sectors include agriculture, construction, distribution, modern tariffs, material handling, oil and gas, power generation, refrigeration, semiconductors, telecom, and ground military and defense. The negative outlook applies to automotive, engines, heavy-duty trucks, machine tools, marine, mills and foundries, mining, rail, and tires. Several factors are affecting the markets in the second half. Easier comparisons will help, as you noted earlier regarding distribution. The destocking we’ve observed early in Q3 and Q4 is expected to continue into the first half, albeit at a diminishing pace, eventually stabilizing in our view as we enter this calendar year. This should shift to a slight positive in the second half. Life Sciences and power generation are expected to have a positive impact in the latter half as well. Moreover, some markets that are currently negative might shift to neutral in the second half, reducing their negative impact, although they won’t provide a strong tailwind. These include construction, oil and gas, semiconductors, automotive, machine tools, mining, rail, mills and foundries, and tires. I’m optimistic because while the 3, 12 curves are below 1, they are beginning to flatten, which is a positive sign. About two-thirds of our markets are in Phase 3, which is the accelerating decline phase of a four-phase business cycle. This suggests we are progressing through the soft patch, and the next phase will be a decelerating decline, indicating movement towards growth. We believe there’s significant potential for improvement, and although the positive effects may emerge later in fiscal year 2020, they will provide some small tailwind. Our Win Strategy is yielding margin expansion even amidst negative organic sales. The two transformational acquisitions, LORD and Exotic, are anticipated to enhance growth and margins. By the time we fully integrate these acquisitions, we expect the markets to start rebounding, providing slight support. I’m confident about 2020 and believe we are well-positioned for the cycle. We will continue striving to be a best-in-class company. So Jamie, do you have a follow-up?

No, I mean, I think I guess, just if I can have a follow-up. The implied margin resilience that we're going to see in the North American markets in 2020 even with the sales decline, just any color in particular on that and then I'll get back in queue.

Yeah. So we have North America going up about 20 basis points versus '19. It's really going to be a continued win strategy efforts, the productivity that we've got, the kaizen activity that we have is all creating the capacity for us to be more resilient on the margin side. North America's volume being down, not as bad as International, they are able to hold up the margins and in fact expand margins because of that.

Thanks, Jamie.

Good morning, everyone. So Tom, I want to go back to your comments early on, when you talked about the transformation of the business. This is something that we spent some time speaking to investors about. And one of the questions that I think we often get that maybe you can help us with is when you're looking at your business mix and you look at what traditionally have been perceived as your key customers and key drivers, heavy machinery OEM build, how is your business looking today, especially when you count in LORD and you are counting in CLARCOR as well as Exotic versus, say, the way it looked in fiscal '15 in the last cycle or even the cycle prior to that? Because there is a business mix aspect here that I think is perhaps underappreciated even by me.

Yeah, I think you're right. I mean that was, as you know, Mig and everybody else that's been listening on the call, almost all of my investor presentations, when I talked about capital deployment, start talking about we're going to be the consolidator choice in this space because we like the space and we are number one. We want to continue to add that. But all things being equal, we'd like to invest a little heavier in filtration, aerospace, engineered materials, and instrumentation. You've seen us do three out of the four so far. And we are on purpose trying to balance out that density that you referred to that we traditionally had maybe in the Fluid Power side of the company on our fluid connectors and our motion technologies and add filtration, which is now one of our largest groups. With Lord, Engineered Materials would be one of our larger groups, and add to Aerospace which balances out the short cycle nature of the company with a high margin business with a great growth trajectory. So clearly that portfolio, since we've added $3 billion of revenue in roughly three years, that goes into those targeted parts of the portfolio that will make us clearly more resilient. You can't ever be - not have any reaction to the business cycle; everybody feels it. But can you dent the lows versus what you had in the past. And I think you see evidence of that. We held margins almost virtually flat during the industrial recession of '15 and '16 on the margin performance in Q4. Those are pretty phenomenal results and that was even before, of course, Q4 had CLARCOR in it, but it's before adding LORD and Exotic. So the mix is going to continue to help us and the Win Strategy is going to continue to help us too because we're not stopping at 17% operating margin.

I see, okay. And then if I may ask a question on Industrial International, obviously your full year guidance implies organic growth decline. I'm presuming you're sort of thinking that orders kind of keep in line with your organic guidance. Two years in a row now of contraction in International, so from your perspective, what sort of environment are you really baking into your outlook? And I am to some degree surprised that you're not announcing some kind of restructuring of sorts, addressing basically the second year of volume decline here. Maybe you can comment on that and how your cost structure has changed in international with everything that you've done? Thank you.

Yeah, so on the restructuring side, we have been restructuring International since FY '14 and we've been on a very aggressive restructuring getting International margins almost to the levels of North America, if you look at last year, 16.4% versus 16.9%, and a lot of either falls for a long time. Never thought we could ever do that. So International has been moving because of the restructuring that we've been doing, and we've been creating a much more agile organization and the mix of improving distribution versus OEM. So that's been helping International. So we don't feel the same need at least at these levels of sales decline to trigger some new level of restructuring. We've got the organization to where it needs to be; obviously, we will do the normal variable cost reductions in temps and over time and voluntary lack of works, those types of things. But we think we've really done a great job internationally and that's why you see the margins what we've had. I'm not sure I hit everything you wanted to cover, Mig, then.

No, you kind of did. I guess I'm wondering, in some ways, it's a little bit unusual to see two years in a row of, say, orders or volume decline here. That's actually worse than what happened in 2015, right? So I'm trying to understand kind of that dynamic and also trying to understand if your cost structure here has become more variable than it's been in the past. That's kind of where I was going.

International experienced a decline of at least 1% last year, being the first segment to drop. The organic decline was significant, compounded by a currency impact of minus 5.5%. We expect International to show a decline of about 8.5% in the first half, but we anticipate it will approach a neutral position by the end of Q4. Although it was the first to decline, I believe it will recover, and our guidance for International is realistic.

Thanks, Mig.

Thanks, good morning.

Good morning, Joe.

So I guess my first question and just it's going back to the inventory comments from earlier. I guess as you think about the next couple of quarters, it sounds like you're expecting destock to continue. I guess in that context, have you heard or have you experienced any distributor-like price adjustments or how are those conversations with your distributors occurring on the pricing side just given the backdrop?

So let me - I'll start with the inventory, and let Lee chime in on the pricing side of things. So with at least North America, we do have good visibility into that sales out and sales-in that I referred to in the last call. And so we look at North America, we see about a flat growth organically with about 200 basis points of destocking. So North America came in at about a minus 2% on distribution growth. That was about minus 300 bps of destocking in Q3. So we saw a little bit of improvement, about 100 basis points of improvement. And that's really was our thinking as we go into the first half of '20, so we have about another 100 bps every quarter, hence six months to get through the destocking. And that's obviously through conversations that we have with our distributors and then we were plotting, like I referred to last quarter, for plotting that sales-out, sales-in, so we can get a little better visibility of the trend. I'll let Lee comment on the pricing side.

Just commenting on distribution. Speaking about North America, I would - as Tom said, it was mixed during the quarter, really depends on the region and destocking continues. I'd say on the pricing side, if you're asking if there still pricing power in the channel, I'm not quite sure exactly what you were asking. We're still in a slightly inflationary environment. I would say that there is still pricing taking place, and which is still promising through, there's still a lot of CapEx activity taking place at this point in time, which is a good indicator that, and I'm speaking mostly of North America, that there's still a lot of positive momentum going on.

Yes, Lee. My comment was more around like whether your distributors were pushing back on price at all in this backdrop. And really kind of trying to understand whether that has any implications on the leverage in your North American business.

No, there is really none of that taking place right now.

Okay, got it. And then maybe just my follow-on, and just thinking about the trajectory of the aero business, the aero obviously continues to do well from an order perspective. If you take a look at the growth expectations for 2020, and they seem a little light based on the trends that we've been seeing. And so maybe some commentary around that as we head into 2020?

Okay. Joe, it's Tom. So on orders, remember, orders are long cycle or 12 months, and they tend to be lumpy and you don't always translate the due dates directly out into the next fiscal year, but we were plus 10% like you've seen. That composition was minus 5% on commercial OE, plus 42% on military OE, plus 13% on commercial MRO, and plus 24% on military MRO. So some of the things that really drove some of the big spikes were F-35 on the military OE. On the commercial side, it was 737 and 787, and really kind of a mixture of A 220 a pretty nice broad base mixture on the MRO side. And the military MRO, a lot of fighters F-18, F-119, F-101 is a bomber, but some pretty good progress on orders there. For sales, our forecast is about 4.5%, that composition is commercial OE at plus 3%, military OE at plus 2%, commercial MRO at plus 4%, and military MRO at plus 10%, and that's our best view at this moment.

Appreciate the color.

Thanks, Joe.

Hi, good morning. Yes, my question focuses on the sensitivity of your margin guidance to volumes. What's striking me is in the first half of the year, you have total company sales down 4% to 5%, but implied margins up 10 bps. The second half of the year, your revenue is up and the margins are up 30 bps, not terribly differently. It doesn't seem like there's much volume sensitivity to the margin improvement. Now I do appreciate the year-ago comp, mix, you know, currency can mess with the analysis a bit, but I'm just trying to understand is that accurate that where you see your margin improvement coming from really isn't that volume sensitive?

Well, if I take a tour of Parker, I'm just doing total MROS, so we're in that minus 15% to minus 20% range for the first half. If I look at the second half, it's like plus over 70%. Again, it's the loss on numbers, you got relatively modest sales increase. So, you are seeing some pretty nice lift in that second half as far as MROS go.

I see it differently, Tom. You would expect the latter half of the year to significantly boost margin improvements, particularly since your distributors aren't reducing their stock as much. With revenues on the rise, it’s improving your volume overhead absorption. What’s interesting to me is that you're suggesting it’s possible to grow margins regardless of volumes. While I wouldn’t necessarily call it impressive, it certainly is remarkable if you can achieve higher margins with lower volumes as well as with higher volumes. It’s quite intriguing, and if you genuinely can manage this without being heavily impacted by volume changes, it enhances the credibility of your projections. I just want to confirm if I’m interpreting this correctly; I’m confident in my calculations, but I’m looking for clarity on other significant factors contributing to this year’s margin improvement that you would say is not dependent on volume. You seem to suggest we can still grow margins even when sales are down, which is what I’m gathering from your comments about the first half.

You're absolutely reading it right, and that's part of the transformation that I spoke to at the beginning of the call. The combination of all the things we've been doing on lean, the kaizen activity really started heavy for us in the fall of last year, the Win Strategy simplification, all those types of things, the inefficiencies that we've worked through, the CLARCOR synergies that are really kicking in. All those things and of course, the portfolio shift as far as things we're adding to the portfolio, are enabling us to be better our margins when we have softness on sales. So yes, we feel good about that.

I wasn't certain, but part of the reason might be that pricing is particularly advantageous over the next few quarters due to the lingering effects of previous price increases. Now, with lower costs, we may see a more even situation in the second half of the year. It appears there hasn't been much of a price hike in the channel as of July 1, so I'm uncertain about the extent of price benefits you might see in your fiscal second half. However, the impact from the prior price increase should still be felt for the next six months, alongside possible advantages from reduced costs. While I'm not endorsing it entirely, it's notable if you can achieve this without being sensitive to volume. I'm trying to understand your perspective, as it seems you believe there's comfort in the few categories that are not dependent on volume. We are aware of our price costs and know that there are still some inefficiencies from CLARCOR that weren't present in the first half of fiscal '20. That's the point I was trying to make.

Yeah, I think you're right, you hit on all the buckets. The inefficiencies that we have at CLARCOR were clearly more pronounced in the first half of '19. And so that helps us as we look at '20. Some of the carry over on pricing is a little bit better in the first half. In general, if I was to do the total pricing for the year, it would be margin neutral, but we do get a little bit of help more in the first half. So I think you're right.

Thanks, David.

Yeah. Thanks, good morning.

Good morning, Nicole.

So, I just wanted to start with the first quarter. So the color between the first half and the second half was really helpful. But if you guys could give us a sense of what's baked in from an organic and a margin perspective in that $2.66 midpoint guidance for 1Q that would be helpful?

Sure, Nicole. I'll help you here. We're anticipating organic decline of about 3.5% for the first quarter with just a minimal impact from currency, say 0.5 point of 0.5% currency. But as you look at the margins, we're expecting year-over-year for North America to see improving margins year-over-year. Again, that relates to some of the inefficiencies we saw in the first half of last year that are improving. International, with the decline, will have lower margins than last year, a nice decremental though there, and Aerospace will see improving margins.

Okay, got it. That's helpful. Thank you. And then secondly on Aerospace margins, it looks to me like you've embedded about 50% incrementals in 2020 guidance. Just curious how much R&D maybe contributes to that, the factors driving the pretty substantial year-on-year increase in margins to about 20%.

Yeah. A lot of that or a good portion of that has to do with the development costs and what we incurred in fiscal '19 compared to what we anticipate in fiscal '20 and especially what we incurred in the fourth quarter. So in the fourth quarter of this year, our development costs were 7.5% of sales. That was pretty high. Our overall average for the year was 5.6%. In fiscal year '20, we expect development costs to be less than that and we're forecasting in the range of 4.5% to 5%. So lower development costs are driving some of that incremental margin improvement, along with other continuous improvements the teams are making to implement productivity and Win Strategy initiatives and just improving the processes in the shops and getting more productive.

Okay, got it. Thanks, I'll pass it on.

Thanks, Nicole.

Yes, good morning.

Good morning, Andrew.

Can we just touch, just going back to the strategy question, can we talk about internal capital deployment? And it's really a two-part question. A, how do you think deploying capital in terms of sort of capital and labor, and specifically on capital, if you could talk about stuff sort of implementing robotics, 3D manufacturing, how much money are you spending, how much impact is it making? And the second question is, given all the trade tensions, how are you guys thinking about deploying capital by geography, North America, the rest of the world, and what are you seeing in your supply chain? I know, it's sort of an expansive question, so that would be the only one from me.

It's Tom. To start with capital expenditures, a good estimate for our CapEx, including funds for organic growth and productivity, is around 2%. We are actively engaged in robotics and additive manufacturing. Our strategy for automation is to focus on kaizen first. We believe in not automating waste; instead, we are streamlining processes and optimizing our current operations before automating what remains. There is a learning curve with automation, but we are collaborating with excellent partners and have held several summits with our manufacturing engineers. The team is very enthusiastic about this approach. I believe our emphasis on kaizen is contributing positively to our margins as these activities are beginning to show results. We will continue to invest in robotics, which will fall within that 2%. Thanks to our lean transformation, we require fewer dollars, allowing us to redirect some of our traditional spending toward CapEx for robotics. On the additive manufacturing front, this is significant for us. We have three centers of excellence, strategically deciding not to establish many centers for every division. We have two for Aerospace and one for the entire company that serves as an incubator for all Industrial divisions and Aerospace. We are focused on developing proprietary material powder blending and processes. We are close to producing our first parts for both industrial and Aerospace applications using additive manufacturing. Additionally, we are working on design processes tailored for additive manufacturing, crucial for creating the next generation of products in this context. Regarding our supply chain, we traditionally prefer to make, buy, and sell within regions. About China, we maintain a positive outlook. We haven't over-extended ourselves there and still have cost-effective centers that we are pleased with. China remains vital for us, and we need to maintain our presence to ensure service. I don't anticipate significant shifts in CapEx, such as building multiple plants in Indonesia, as we have the necessary footprint with only minor adjustments to production lines expected, which will be immaterial.

And I'll just sneak in one more follow-up on collaborative robotics. I know that you had a big rollout program, I believe you did. Where are you in that in terms of kaizen versus actual physical rolling out of capacity?

Heavy on the kaizen activity, early days still in the collaborative robots. We have several, lots of them in all of our factories, but we particularly strategically emphasized kaizen's first. You talk to most sensibilities that are experts in this kind of transformation, they will encourage to do the same thing. It's a lot faster dollars to the bottom line and much more CapEx friendly. Collaborative robotics is really CapEx-friendly as well. It's going to be a light touch on CapEx. I don't see that as an issue, but the thrust has been, let's do the kaizen, let's get the processes right first.

Really appreciate it. Thank you very much.

Thanks, Andrew.

Yeah, hi. Most of my specific questions have been answered, but Tom, maybe I'll throw this one at you. If you look at where your end markets are today versus where we were when we went into the industrial recession in '15 and '16, it strikes me that as we look at the number of end markets that are down or negative right now, it's much more broad-based. Do you worry at all that heading into calendar year 2020, we're facing a much broader decline when you include automotive, heavy-duty truck, you take the impact of Boeing 737 MAX, if that production schedule declines? It looks to me like we've got a pretty broad-based set of end market declining.

Okay. Ann, it's Tom. I'll make a comment, let me touch on the MAX real quickly for a second. So the MAX for us, in our guidance we put in 42 months, and because it's first fit and most of our content there is very low margin, it's immaterial to us pretty much that schedule is to change, but I just want you to know we put it in at 42. I think we're in good shape on that. But I think your characterization is pretty accurate. This is a more broad-based, but not as deep type of softness. The '15 and '16 industrial recession was a sharp contraction in natural resources. So you had all the natural resource related end markets, as we all remember, went down significantly and so that was more isolated. This is a little more broader based, and my comment earlier on that we have two-thirds of our markets in accelerating decline is an indicator that we have some pockets that are unusually down, things like semiconductors, power generation. But we're hopeful on power generation, that's starting to find a bottom, and that we are also hopeful actually on semiconductors, it's starting to find a bottom as well.

And yes, I just wanted to follow up on the Boeing 737. Isn't there a risk that again that becomes more broad-based? It's not just about what you supply onto the airplane, but there are a lot of kind of second derivative impacts that could impact your business.

I'm not exactly sure what you're referring to, because it would just be reflecting our bill of materials there. You are talking about the general supply chain that supports Boeing?

Yeah. I am just thinking about the impact of pulling down the schedule at one large manufacturing facility and how that might impact some of your industrial distribution businesses.

Okay. I see what you are saying. I think that would be very minor. Basically, you won't be able to find it. They shut down the plant at Redmond for 20 days or whatever on a temporary basis. It would be immaterial to us as far as the implant, things that we do on the industrial side.

Okay, I'll leave it there. I appreciate that. Thank you.

Thank you, Ann.

Thanks. Good morning, guys.

Hi, Nigel.

Yes. So I just want to touch on international orders. We saw the year-over-year deteriorating from last quarter on an easier comp. So I'm just curious if you maybe just talk about geographically where you saw the incremental weakness? And then I've got a follow-up.

Yes, Nigel, it's Tom. Regarding international performance, the composition of the minus 8% included both EMEA and Asia Pacific, which experienced high single-digit declines, while Latin America showed slight growth, though it's small and not significant enough to impact overall results. In the quarter, Asia Pacific saw a downturn in May, but remained stable in June. May's performance dropped from April, but both May and June were relatively flat. Europe remained consistent, maintaining a high-single-digit decline throughout the quarter without significant changes from April to June. In Latin America, we noted some fluctuations, but overall there was mild growth.

And then in Europe, have you seen any signs of a bottom there or is it still very consistent?

I think my description of the markets earlier on that I went through is a pretty good indicator for Europe as well. So that's how we would characterize here. The only difference in Europe will be maybe a little weaker distribution channel than we have in North America, but that will be the key difference.

And then my follow-up is really maybe just touching on what Ann was digging into. Going back to '15 and '16, we saw North America negative 12%. And certainly, the order numbers don't support that kind of deterioration. But maybe just take a step back and characterize what you're seeing today, what you're hearing from the field from your channel partners and characterize what you're hearing today to what you saw in '15 and '16?

Yeah, Nigel, this feels very different, I mean, distinctly different. '15 and '16 was a commodity-driven reduction. If you remember, the commodity prices weakened dramatically. The only equipment that went in there, the demand dried up. We had oil and gas prices drop dramatically. So it was a very different type of downturn. This one is, like I mentioned earlier on, is broader based. I think our forecast was realistic. Part of why we studied those pressure curves was just look at what history has shown us going back, data back 10 years and the financial crisis today, and that 12 months to 18 months interval was fairly consistent over those cycles. But the big difference for me is sharp spike down and natural resources before, this one a lot more broader based across a broader base of end markets, but not as severe.

Okay. Thanks.

Thanks Nigel. Liz, I think we have time for one more question.

Good morning, everyone.

Good morning, Nathan.

Thanks for fitting me in. First question, I just want to follow up on this conversation about the shallowness of this pullback and perhaps its duration. Tom, it sounds like a lot of your outlook for when we recover from this is based on historical correlations and historical outlooks for the businesses. You did say this is a difference of '15 and '16. Do you need some kind of trade resolution here in order to see that recovery? Do you need to avoid a hard Brexit? Are there geopolitical things here that maybe they don't make this decline any deeper than it is that you're projecting but maybe it makes it longer than you're projecting and just how you're thinking about those kinds of things?

Yes, Nathan, it's Tom. I want to clarify in case my comments were misunderstood. We're not relying on a pressure curve history to predict future sales. It's just one data point alongside insights from our customers, distributors, and divisions. It's merely an addition to our regression models, but I wanted to share this element. Regarding our forecast, it does not assume any trade resolution. If there were a positive trade resolution, that would be favorable to us, but this doesn't consider that, nor does it factor in the resolution of Brexit, which isn't significant enough to affect our results. We are always subject to unforeseen geopolitical events, but I can't predict those. Let's not expect any upside from trade; our forecast reflects the current order entries for the first half and also takes into account improvements in comparisons. As we analyzed the markets, we identified those expected to shift from negative to neutral or from neutral to positive, and we monitor these end markets as they progress through four phases. When two-thirds of these markets are in Phase 3, it suggests an impending turnaround, and that’s reflected in our forecast. We examined the situation from various angles, and as you know, the accuracy of the forecast depends on the most current data. We will update you every quarter with hopefully improved information.

Okay. My follow-up questions, a little more longer-term on Aerospace in the margins. You guys said 5.6% in engineering expenses in 2019, 4.5% to 5% in 2020. Does that continue to decline going forward? And then maybe you can comment on the mix as we go out a few years. I think you're fairly heavily on commercial OE at the moment, and that should switch as we go forward to a little more commercial aftermarket and clearly those are at opposite ends of the margin scale. So just any qualitative commentary you could give on how you think margins should progress in Aerospace over the next few years.

Yeah, Nathan, it's Tom again. We feel very good about margins in Aerospace in the future. The current mix of OE to aftermarket for Aerospace is 64% OE, 36% aftermarket. And you're right, that won't necessarily change much over the next three to five years. But once you start going beyond that and we start having shop visits, and you're looking at the engine content and the airframe content, that is going to gradually start to move, a point or two movement on that is a big deal to us from a margin standpoint. The NRE, that 4.5% to 5% of our guiding for FY20, I think is a pretty good future number to use as well. The other advantage that Aerospace has, besides the mix you referred to is that it still has ample opportunity just like the rest of the company on the Win Strategy. It's got opportunities on kaizen. It has additional opportunities, and that all the entry into service part that they are doing today, which your first pump versus your 100th pump versus your 500th pump. We're going to work down that learning curve, and we will have some cost advantages, not in this next 12 months, but as you work through that, we're going to have cost advantages on entering to service learning. So it's a business we're very bullish on from a margin expansion.

Very helpful. Thanks for fitting me in.

Okay, thank you, Nathan. All right, this concludes our Q&A and our earnings call. Thank you everyone for joining us today. Robin and Jeff will be available to take your calls should you have any further questions. Everybody have a great day. Thank you.