Parker-Hannifin Corp (PH) — Q2 2021 Earnings Call Transcript

Thank you, and welcome, everyone, to our earnings release webcast. This is Todd Leombruno, Chief Financial Officer. And joining me today are Chairman and Chief Executive Officer, Tom Williams; and President and Chief Operating Officer, Lee Banks. Today's commentary and the slide presentation will be accessible as an on-demand webcast on our investor information website located at phstock.com, and will remain available for one year. If you move to Slide 2, you'll see the Company's safe harbor disclosure statement addressing forward-looking statements as well as non-GAAP financial measures. Reconciliations for any reference to any non-GAAP financial measure are included in today's material and are also posted on our website at phstock.com. If you move to Slide 3, you'll see our agenda. We'll begin with Chairman and Chief Executive Officer, Tom Williams, providing some strategic comments and highlights from our second quarter. Following Tom's comments, I'll provide a more detailed review of our second quarter performance and our increase in guidance for the remainder of fiscal year '21. Tom will then provide a few summary comments, and we'll open the call to questions from Tom, Lee, or myself. And with that, Tom, I'll hand it off to you.

Thank you, Todd, and good morning, everybody. Thanks for your participation today. Now before I move to Slide 4, I want to make a few opening comments. Calendar 2020 was an extremely difficult year to say the least, for all of us, both professionally and personally, and I hope all of you are staying safe. Our global team has come together like never before in our history and has responded to this combination of a health and economic crisis. We've rallied around our purpose in the Win Strategy, and we've shown that Parker is an exceptional performer even in the most difficult of environments. I'd like to take this opportunity to thank our global team for their great performance. And you're going to see evidence of that over the next couple of slides. If you go to Slide 4, one of our key competitive advantages is our breadth of motion control technologies. We're now up to two-thirds of our revenue. You heard me talk about this being 50%. We're now up to two-thirds of our revenue coming from customers who buy from four or more of these technologies. As these interconnected technologies enable us to create even more value for our customers, they also create a distinct competitive advantage versus our competitors. If you move to Slide 5, we had outstanding performance in the quarter when running through some of the highlights. Top quartile safety performance, we had a 23% reduction of recordable incidents. This now makes a 75% reduction over the last five years, which has been phenomenal. Sales decline was 2.5% year-over-year. You can see it was a little over 6% from an organic standpoint. This was significantly better than our guidance and about a 50%-plus improvement from where we were in Q1. Q2 was a record net income at $447 million. The EBITDA margin was a little over 23% as reported or 20.8% adjusted. You can see the significant improvement versus prior periods, up by 230 basis points. Year-to-date, cash flow from operations was a record at 20.4% of sales. And then the table at the bottom has segment operating margin both as reported and on an adjusted basis. I'd call your attention to the adjusted row, which shows a 20.4% segment operating margin adjusted, again a large increase versus prior, up by 250 basis points. So, there's a lot of numbers on this page. We have a lot of companies to track. So, the easy way to remember this is just that we had a quarter with 320s. And we noted that in gold. So, greater than a 20% EBITDA margin, CFA margin, and segment ARPU volume. We're quite proud of that, and those are all great results during a pandemic; just a fantastic job by the whole team. If you go to Slide 6, we will discuss cash flow. It was a big cash flow quarter, during which we paid down $767 million of debt. If you look at the last 14 months, it totals $2.8 billion of debt reduction. This is a little over half of the acquisition that we took on with lower excise, which represents great progress. You see the ratios in the middle of the page there. Of significance, if we look back a year ago, we had a ratio of 4.0, and now we're at 2.7% on a gross debt-to-EBITDA basis. We have now reinstated our 10b5-1 share repurchase program, which becomes effective in Q3. So, I'll move to the next slide, focused on the transformation of the Company. Hopefully, just the last two slides are indicative of how the Company is transforming. But I want to provide a little more color and context as to what we're doing. If you move to Slide 8, this is our strategy summary on one page, flanked on the left side with why we win, which you've heard me discuss in the past. This is a list of our competitive advantages, which I've highlighted. I won't talk about those in detail today, but these are historical success factors that will continue into the future. I want to focus most of my time on where we're going. Each bullet point will have its own slide. The output of these historical success factors and where we're going is that we want to be a top quartile company and stand out in the crowd, which I believe we are doing. If you go to Slide 9, this is the Win Strategy 3.0, which is our business system. Pound for pound, this has been the most impactful change we've made to date in the Win Strategy. It will serve as the powerhouse behind our future performance. Moving to Slide 10, you've seen our purpose statement, enabling engineering breakthroughs that lead to a better tomorrow. This is a statement that everyone has rallied around. It has been very inspirational within the Company, enabling everyone to connect their efforts to this higher calling and purpose in life. It truly helps answer the question of how we can assist our customers in creating a better tomorrow. With everything going on related to the coronavirus and the vaccine, Slide 11 is probably a great highlight of our purpose in action and just how essential we are to the vaccine value chain. The way to read this slide is to go from left to right and in a clockwise fashion, starting from the upper left-hand corner. We are in development and production phases of these vaccines, including mixing, purification, filtration, and dispensing. Subsequently, we need to move the product around using sterile transfer containers that are specially designed for this purpose. All of our motion control technologies are involved in both air and ground transportation to move the product globally. Additionally, we must store it locally, which requires low-temperature refrigeration; our refrigeration technologies play a vital role here. When administering to the patient, we also need on-premises refrigeration, along with stoppers and trim seals as part of our engineered materials offering. We are proud to be part of this value chain, and through our customers, we are helping create a better tomorrow for everyone as we attempt to exit the pandemic and deliver billions of vaccines to people around the world over the next quarters and years. If you move to Slide 12, this is my last slide for the opening comments. I want to focus on our strategies to achieve faster growth in the market. Our proxy for the market is global industrial production growth. On the left side, we have several portfolio elements that you've seen us make continually transforming within the Company, including three great companies we've acquired, which totaled $3 billion of acquired revenue that were all accretive on growth, cash, and margins. As a matter of fact, LORD grew mid-single digits last quarter while the rest of the Company experienced a total company decline of -6%. On the right side, there's a list of organic growth strategies. It's interesting to note that with the exception of international distribution, these strategies are all new with Win Strategy 3.0. I'll make a quick comment on each one. First, strategic positioning is our effort to focus on stronger divisional strategies. We have implemented a cadence with every division, holding three meetings per month, which have been extremely productive conversations with our general managers on how they will position their division to win against the competition. Secondly, concerning innovation, we've made two significant changes. One is a metric called Product Vitality Index (PBI), which measures new products as a percentage of sales over a five-year period of new product blueprinting (NPP), which represents a change to our ideation process to generate better ideas for the innovation funnel. The goal is to grow our PBI in its context as a percentage of sales by 600 basis points over the next five years, resulting in a more innovative portfolio with better chances for growth and improved margins. Next is the initiative of Simplify Design. I've discussed this extensively. It's a speed initiative, a cost initiative, and a customer experience initiative that acknowledges that 70% of your costs are tied up in product design. Thus, Simple by Design focuses on design excellence. When you combine design excellence with operational excellence, you have a dynamic pairing. Continuing with international distribution, we aim to build on the success we've experienced with Win Strategy 2.0. Digital leadership encompasses a four-pronged approach: digital customer experience, digital products, digital operations, and digital productivity, with a focused effort on artificial intelligence and data analytics. Lastly, our Annual Cash Incentive Plan (ACIP) will drive our divisions and the entire company towards achieving growth in cash and earnings. It's this combination that has helped us perform better on the top line organically, particularly during the current downturn, and will be our catalyst for rapid growth in the market moving forward. With that, I will hand it back to Todd for more details on the quarter.

Thanks, Tom. I'd like to direct everyone to Slide 14, and I'll just begin summarizing our strong second quarter results. This slide displays both as-reported and adjusted earnings per share for the second quarter, and I'll focus on adjusted earnings per share. We generated $3.44 this quarter, compared to $2.98 last year. If you look at the breakdown of the adjustments for the FY '21 as-reported numbers, it netted to $0.03 this quarter, which is broken down into the following categories: business realignment expenses of $0.14, integration costs of $0.02, acquisition-related amortization expense of $0.62; and as we communicated last quarter, we are adjusting out the gain on the sale of land that amounted to $0.77. All in, the net tax impact of all of those adjustments is $0.02. Last year, our second-quarter earnings per share were adjusted by $1.41, and details of that reconciliation are included in our non-GAAP financial measures. If you move to Slide 15, this shows a walk from $2.98 to $3.44 for the quarter. Despite organic sales declining 6% and total sales declining 2.5%, adjusted segment operating income increased by $70 million or $0.11, which equated to $0.42 per share, demonstrating a strong operating beat for the quarter. Decremental margins on a year-over-year basis are favorable, showcasing excellent operational execution and robust cost containment by our team members across every segment and region. Continuing on the slide, we did experience a slight headwind from higher corporate general and administrative expenses, amounting to just $0.02, resulting from market-based adjustments to investments tied to deferred compensation. Additionally, as Tom mentioned, our strong cash flow allowed us to pay off a significant portion of debt on a year-over-year basis, which reduced our interest expense by $0.12 for the quarter. Looking at the remaining items, other expenses resulted in a slight increase of $0.01. We experienced a higher effective tax rate, impacting us by $0.03, and finally, slightly higher diluted shares resulted in a $0.02 impact, leading us to the adjusted earnings per share number of $3.44. Moving to Slide 16, this showcases the savings from our cost-out actions. I know there have been numerous questions about this from some of the early reports, so I want to remind everyone that these represent savings realized during the year as a result of our discretionary actions in response to the pandemic and volume declines, along with savings from our permanent realignment actions taken in FY '20 and FY '21. Our second-quarter discretionary savings exceeded our forecast and now amount to $190 million on a year-to-date basis. We are now forecasting that the total discretionary savings for the full year will increase to $225 million, reflecting an increase of $50 million. The majority of that increase was recognized in the second quarter, roughly amounting to $35 million above our initial forecast. Just a reminder, as demand continues to rise and our teams pivot to support growth, we expect these discretionary savings to decline in the second half. Permanent actions remain on track, and we anticipate that these will generate full-year savings of $250 million, with $210 million being incremental. We believe this will support the strong incremental margin reflected in our guide for the second half. Looking at Slide 17, this presents the total results for the Company, including sales and segment operating margin. As Tom mentioned, organic sales did decline by 6.1% this year, but this decline was partially offset by contributions from acquisitions, which totaled 2.6%, and currency impact accounted for an additional 1%. Despite lower sales, total adjusted segment operating margins improved to 20.4% compared to 17.9% last year. This 250 basis point improvement reflects all the positive impacts from our Win Strategy initiatives, the hard work and dedication to cost containment, productivity improvements, and savings from those realignment activities I mentioned earlier. We saw strong execution across the entire Company to achieve these results. If we jump into the segments, beginning with Slide 18, looking at Diversified Industrial North America, sales declined by 5.9%. Acquisitions positively impacted this segment by 3.1%, and currency had only a slight negative impact on sales. Nonetheless, even with these lower sales, our operating margin for the second quarter on an adjusted basis increased sizably to 21.3%, compared to 18.2% last year. This represents an impressive 310 basis point improvement, driven by our long-term initiatives with Win Strategy, productivity improvements, diligent cost containment actions, and increased synergies from the LORD acquisition. Moving to the next slide, Slide 19, for Diversified Industrial International, organic sales for the quarter increased by 3.1%. Acquisitions added 3.2%, and currency accounted for 3.5%, demonstrating strong operating performance in this segment. For the quarter, we achieved an operating margin of 20.3% compared to 16% in the prior year, showcasing similar positive dynamics from Win Strategy initiatives and strong synergy growth, as well as our teams' collaboration worldwide in response to the pandemic. Slide 20 discusses the Aerospace Systems Segment, where we experienced a decline of 20.9% for the quarter. Acquisitions contributed slightly by 0.4%, and there was a minimal currency impact of 0.1%. The declines in the commercial businesses, both in the OEM and aftermarket end markets, were the main contributors to this performance, although we partially mitigated these impacts through increased sales in military OEM and military aftermarket. The operating margin for this segment for the second quarter was 18%, compared to last year's 20.2%. This resulted in a decremental margin of 28.8%, which aligns with our expectations and reflects our actions to realign the aerospace business to current market conditions while maintaining strong cost controls. Slide 21 outlines some cash flow highlights. As Tom already mentioned, our operating cash flow activities increased by 64% year-over-year to a record $1.35 billion, representing an impressive 20.4% of sales. Our global teams are focused and disciplined in managing working capital across the globe, driving strong cash flow generation. As of year-to-date stats, our free cash flow now stands at 19%, representing a remarkable increase of 78% compared to the prior year. Our cash flow conversion is now at 1.64%, compared to the 130% last year, showcasing impressive results from our team. Briefly focusing on orders, moving to Slide 22, our orders came in flat this year for this quarter, driven by growth in our industrial North American businesses at plus one, diversified industrial businesses at plus 10, and aerospace at minus 18 on a 12-month basis. This flat result is significant as it marks the first time in seven quarters that we've not witnessed negative performance. Moving to Slide 23 and discussing guidance, we have a sizable guidance increase to announce. We are now providing guidance on both an as-reported and an adjusted basis. Based on our strong performance observed in the first half and the current indicators we see, we've increased our total outlook for sales to a year-over-year increase of 1.7% at the midpoint. This includes a forecasted organic decline of 3.4%, offset by increases from acquisitions of 2.9% and currency forecast of 2.2%. Just a reminder, we've calculated the impact of currency based on spot rates at the quarter ending December 30, and we held those rates steady as we projected into the second half of our fiscal year. Concerning margins, for adjusted operating margins by segment, at the midpoint, we forecast an increase of 150 basis points year-over-year, with an expected range of 20.2% to 20.4% for the full year. Notably, for items below segment operating income, there's a significant difference between the as-reported estimate of approximately 3.88 and the adjusted forecast of around 4.87. This disparity is attributable to the land sale we discussed, which amounts to $101 million pretax or $76 million after tax, classified as other income in Q2. Since this is an unusual one-time item, we have adjusted our results accordingly. Our full-year effective tax rate remains unchanged, with expectations around 23%. For the full year, the new guidance range for earnings per share on an as-reported basis is now set at $11.90 to $12.40, or $12.15 at the midpoint. On an adjusted basis, the earnings per share range is now $13.65 to $14.15, or $13.90 at the midpoint. Adjustments to the as-reported forecast made in this guidance at a pretax level include business realignment expenses projected to be approximately $60 million for the year associated with savings interactions, forecasted to be around $50 million for the current year, and acquisition-related integration costs estimated at $50 million. Synergy savings for the LORD acquisition are now expected to reach $100 million, an increase of $20 million from our prior stated number of $80 million, which is included in our guidance. Acquisition-related intangible asset amortization expense is forecasted to be $322 million for the year, and we've baked certain assumptions into the guidance. At the midpoint, we observe that our sales will be divided 48% in the first half and 52% in the second half, while both adjusted segment operating income and adjusted EPS will be split at 47% for the first half and 53% for the second half. For the third quarter of FY '21, we forecast adjusted earnings per share to be $3.54 at the midpoint, which excludes $0.57 or $97 million of acquisition-related amortization expense and business realignment expense for the quarter. If you look at Slide 24, this illustrates a walk from our previous guidance to our revised guidance. We had initially guided $12 per share last quarter; however, based on the strong second-quarter performance, we exceeded our estimates by $1.06. We noted improvements in demand conditions coupled with our strong operational performance, alongside the extended discretionary savings, permanent restructuring savings, and increased LORD synergies. We are confident in raising our guided margins, which adds $0.85 of segment operating income over the next two quarters for the remainder of the fiscal year. The majority of this increase is based on operational performance. This translates to an estimated incremental margin of 41% for the second half. Additionally, minor adjustments below segment operating income lines resulted in a negative impact of $0.01, which nets interest expense and income tax adjustments, leading us to the adjusted earnings per share of $13.90, representing approximately a 16% increase from our prior guidance. Moving to Slide 25, I will turn it back over to Tom for final comments.

Thank you, Todd. To wrap up, I want to emphasize that these great results don't happen by accident. They're driven by a highly engaged global team. Our focus on safety, high-performance teams, Lean, and Kaizen is fostering an ownership culture within the Company, resulting in top quartile engagement as well as top quartile results. We discussed the portfolio, which serves as a substantial competitive advantage, achieved through interconnectivity and the transformation brought about by our three acquisitions, which is enabling them to outgrow and generate more cash and margins than our legacy Parker. Our performance over the last cycle is reflected in the fact that our margins have improved by 500 basis points over the past five years, a timeframe that has not been the easiest for industrial companies. Moving forward, our One Win Strategy, especially Win 3.0, backed by our purpose statement, will continue to drive our performance into the future. I would like to thank everyone for their hard work and these great results. And now, I'll hand it back to Jane to start the Q&A.

Congratulations on a fantastic quarter. Maybe just to kick things off, Tom, it seems like you are starting to see some improvement in the order trends in your industrial businesses, both domestically and internationally. Can you walk us through what you've seen happen during the quarter?

Sure, Joe. Looking at our orders, we observed a shift from minus 12% to zero for total Parker, from minus 11 to plus 1 in North America, and from minus 4 to plus 10 in international markets. Aerospace shows improvement, moving from minus 25 to minus 18. Generally, North America and International improved throughout the quarter, and it seems that Aerospace is finding its bottom. In particular, for the International segment, the plus 10 was driven by EMEA at plus 7, Asia at plus 13, and Latin America at plus 27, indicating a strong rebound across those regions. Sub-segment performance was encouraging, with Distribution improving from minus 14 the previous quarter to minus 6 this quarter. Industrial activity remained stable, moving from minus 7 to plus 1.5, and Mobile experienced the largest rebound from minus 13 to plus 2.5. Overall, we saw marked improvement in all sub-segments, particularly Mobile. Within our end markets, roughly 30% are in accelerating growth while about two-thirds remain in deceleration or decline. We're seeing indications that many markets are starting to bottom out, and our declines are beginning to turn towards accelerating growth. Additionally, our distributors are cautiously optimistic, selectively restocking longer lead-time products to position themselves for the expected demand. There's an observable trend of larger stock orders from OEMs, scheduled to be released over the next several quarters, indicating that they are attempting to prepare themselves for an upswing.

That's helpful, and great to hear, Tom. As a follow-up, I want to focus on the sustainability of margin improvement going forward. Clearly, you've implemented many long-term actions with the Win Strategy, but can you provide insight on the temporary cost actions benefiting FY '21? Will they represent a headwind beyond this year? Or are there other actions you can leverage to mitigate some of those expenses in the future?

Joe, this is Todd. Some of our cost actions are volume-related, so as volume continues to return, we expect some of those costs to come back. In the second quarter, we observed substantial productivity improvements, driven by our long-standing focus on Kaizen and various elements of our Win Strategy initiatives. Strict cost containment by our teams across all segments contributed to the overall strong results. We did experience some degree of discretionary savings from reduced travel expenses, which led us to increase our forecast for the remainder of the year. Although we expect some increase in expenses, it won't return to the levels we've seen in the past.

Can we start with your 3Q outlook? What has been factored into the midpoint regarding organic growth? Is there any significant change in the incremental margins expected in Q3 versus Q4?

Yes, Nicole, this is Tom. In terms of our guidance, we revised the organic sales decline from minus 7.5% to minus 3.5%. For the second half of the year, we anticipate North America and International markets to see organic growth in the range of 6% to 7%, while Aerospace is projected at around minus 11% for the second half. In Q3 specifically, we expect a slight improvement in the industrial portion of the Company, about 100 basis points, despite ongoing uncertainties. The Aerospace segment will remain similar to Q2 performance. In Q4, we predict North America will be in the upper-teens growth range, with International about plus 10% and Aerospace potentially returning to flat growth. This positions total Parker in Q4 with low teens growth. Concerning margins, it's worth noting that Q3 margins will be slightly less than Q2 due to lower discretionary savings: approximately $25 million for Q3 compared to $65 million for Q2. We still anticipate favorable MROs despite the decline, and we acknowledge that comparative margins will be challenging between quarters.

Got it. That's super helpful. As a follow-up, can you discuss any impacts from COVID on production and supply chains, and your level of confidence regarding ramping operations as recovery progresses?

Nicole, it's Tom again. Evaluating COVID's impact, we mirror case rates in local communities. We've done remarkably well, as most cases seem to have originated from outside of work. We’re focused on employee safety, ensuring the safest possible conditions are in place in our facilities. While we haven't been immune to absenteeism due to COVID, it hasn't materially affected our capabilities. We've maintained strong service levels and lead times, and I expect our position will allow us to capture market share as we are currently outperforming competitors on both metrics. Additionally, due to our strategy of local sourcing and production, we are well-positioned to navigate supply chain challenges; we have a diverse supply chain aiding our flexibility.

I don't say this often, but congratulations on a great not just a couple of quarters, but the last two or three years. It's just been phenomenal. I'd like to talk a little about M&A, as you've been very successful in that area, perhaps not something everyone would have expected from Parker in the past. You mentioned you're heading down to 2.5 turns of debt this year. Are you ready to reload on the M&A front? Do you have an interesting backlog of targets you'd like to discuss?

Yes, Scott, thank you for your acknowledgment and for recognizing our progress. Regarding M&A, we are pleased with our cash flow and the ability to pay down debt ahead of schedule. We will be in a strong position moving into this fiscal year, having eliminated service debt from term loans and CP taken on during acquisitions. Our next corporate bond isn't due until September 2022, and it's a nominal amount of $300 million. We are prepared to pursue capital deployment in various forms, particularly in M&A. Our historical lesson has been to continuously work the M&A pipeline, building relationships. We're focusing on consolidation in our space. We are the leader here and want to remain the best home for companies within our space, particularly in filtration, engineered materials, instrumentation, and aerospace. You've seen us pursue companies that we felt could be integrated quickly and outperformed margins and cash flow. This approach will continue going forward. If we don't find suitable targets, our plan is to invest in Parker and repurchase shares.

That's helpful, Tom. Can you elaborate on how you integrate these deals? What's the process to bring the Win Strategy into an asset? Do you come in with all the tools or do you approach it on a case-by-case basis?

That's a great question. Our historical experiences contribute to a well-defined integration playbook, with two key aspects we focus on: the integration tasks and the synergy tasks. We've learned the importance of having a dedicated integration team and assigning effective integration managers to these projects. Importantly, we acquire businesses that are already successful and aim to merge the best traits of both the newly acquired company and Parker, with the idea that one plus one equals three. We utilize our Win Strategy while allowing respective acquisitions some latitude on how they would like to implement it, ensuring pragmatism as we work toward a unified approach.

Yes, great quarter, and great free cash flow conversion as well. I have a couple of questions. First, you mentioned that your dealers are still cautious. According to channel checks, many publicly traded hydraulic companies seem more optimistic regarding their outlook. Is your channel being conservative, or do they know something we might not be aware of?

You're likely referring to one of our neighbors, as they are predominantly a mobile-oriented company, while we are more diversified. Our distributors do feel optimistic, but they are placing orders strategically with scheduled releases over upcoming quarters. Overall, we anticipate Q3 to transition from a -6% organic decline to flat or near-flat growth as we enter a strong second half. Our distributors recognized this positive direction and are preparing for it with larger orders.

Got it. My second question emphasized how you expect to see competitors emerge from China, particularly in hydraulics. Are you noticing significant competition from local firms, and how do you perceive the competitive landscape over the next cycle?

That's been a question we've faced over many years. I don't observe competition from China emerging any differently than in previous cycles. Historically, we maintained growth in China, particularly in the last quarter, reflecting a 10% uptick. Our operational strategy ensures we are competitive on pricing through an efficient and localized production model. We offer a distinctive portfolio of interconnected technologies that bolsters our value proposition compared to competitors. Clients recognize the combined advantages of cost, reliability, and assembly efficiency that we present.

My question pertains to Aerospace, but first, could you clarify? Did you state that in the fourth fiscal quarter, Aerospace organic sales would be flat?

Yes, David, that's correct. Aerospace sales will be flat compared to the prior year in fiscal Q4.

I’m not asking about FY '21 guidance, but could you present your thoughts on the recovery cadence for Aerospace? Specifically, how does this relate to your M&A strategy in the space?

Sure, David. We have confidence in this space, with our motion control technologies targeting aviation products. Aerospace has a considerable size to win in the current climate. We expect the recovery pace will correlate with vaccine deliveries and passenger comfort levels. We foresee personal travel rebounding aggressively, while business travel may plateau owing to increased reliance on digital tools. Therefore, we believe we're well-positioned for a gradual recovery in this sector over the next several years. Regarding M&A, I think we will consider strategic opportunities in the Aerospace sector, especially at favorable pricing, while recognizing this business typically operates on a longer cycle.

I understand the dance here — that's important in balancing the perspectives of the market. Could you provide clarity on the sector priorities for M&A? If you had to choose between similar assets, what specifics would direct your choice?

I won't prioritize sectors explicitly, although we value our position in each focus area. Our objective remains to be the consolidated choice within our space, and we appreciate our interconnected technological advantage. All sectors, including filtration, engineered materials, instrumentation, and aerospace, are appealing to us. The common theme among our successful acquisitions is seeking properties that are capable of delivering growth, margin improvements, and cash flow more effectively than our existing business. While seeking larger targets, we are realistic and heed the reality of a favorable mid-size landscape. Additionally, I'd like to emphasize the cyclical balance we enjoy through our cohesive portfolio. The current recovery is expected to be more favorable than previous cycles, as we’ve endured two industrial recessions and a pandemic, setting the stage for more stable growth over the next five years. We possess a range of self-help options to support this trajectory.

It seems you have made a significant effort over the past year to showcase how the business is performing differently compared to prior downturns. I'm curious about how this next upturn might contrast with what we have seen historically.

While it is challenging to predict precisely how the cycles will vary, we intend to convert incrementals during this period as well. That said, we acknowledge that Q4 this year and the first half of next year will present tough comparisons. Therefore, we’ll work diligently to level the playing field in our reporting. I expect those figures to exceed 40% in the first couple of quarters before stabilizing in the 30s. Our aim is to continually raise both the ceiling and the floor, which will ensure that the upcoming cycle presents higher benchmarks than in the past. We achieved remarkable records in margins, and we remain optimistic about sustained growth driven by a confluence of favorable economic factors.

You appear to be approaching your fiscal '23 targets quite closely. When might we expect an update regarding these objectives? Additionally, I’m keen to understand your thoughts on the sustainability of free cash flow margin, as even considering the working capital benefit year-to-date, your margin remains quite impressive.

Regarding the '23 targets, I’ll defer to Todd for detailed updates on free cash flow. While we've updated these targets periodically, our focus has been to verify that we are close to or have achieved them consistently. Once that has transpired conclusively, we will feel comfortable presenting new projections.

Mig, you’re correct that our cash flow performance has been exceptional, thanks to our global team's dedication to working capital management. We recognize that growth will likely exert some pressure on working capital; however, we anticipate maintaining stronger free cash flow margins compared to historical performance going forward.

It's great to see the outstanding performance, but we have yet to discuss the end market roll-down. I wanted to clarify one thing: is your order lag on distribution versus the OE a typical occurrence at this part of the cycle?

No, it's quite normal; mobile typically leads, followed by industrial, with distribution lagging as it generally aligns with the aftermarket. In our current observations, distribution has been placed into a slight decline, but the improving order rates from other segments suggest that recovery is on the horizon. To summarize, our greater than 10% growth sectors include semiconductors, life sciences, power generation, agriculture, refrigeration, aerospace military OEM, and aerospace military MRO. The high single-digit positives include automotive and low single digits include construction and heavy-duty truck. In contrast, our declining markets show low single-digit drops in telecom and tires; significant declines in long and turf handling, mining, and distribution; as well as machine tools and oil & gas metrics.

Just following up on the topic discussed previously, Tom. Your responses have been enlightening, but do you see any current market indicators suggesting that the PMI is not reflective of the actual recovery trajectory your customers are witnessing?

While there may be minor discrepancies in timing due to the pandemic, I observe a positive correlation between order trends historically against PMI indices. I believe the upcoming years will offer improved stabilization compared to the chaotic cycles of the past six years. With the anticipated need for capital expenditure and robust macro conditions, we can confidently say the outlook for growth is favorable.

Understood. Relatedly, as your segment operating margins are approaching targets, do you foresee gross margins acting as a limiting factor? At what stage might you need to pursue growth more aggressively via M&A or different market channels?

Be aware that our gross margin metrics might differ when compared to other companies due to how we classify SG&A against cost of goods sold. While our operating margins are on an upward trajectory driven by Win Strategy initiatives, there's still ample room for improvement and stabilization in gross margins. Moving forward, we're focused on capital deployment as well, incorporating dividends and share repurchases to increase shareholder value. In conclusion, I thank everyone for their valuable insights during today's call. We appreciate your interest in Parker Hannifin and look forward to our next update. Thank you.