Earnings Call Transcript - PH Q1 2022

Operator, Operator

Good day and thank you for standing by. Welcome to the Parker Hannifin Corporation, Fiscal 2022, first-quarter earnings release, conference call and webcast. At this time, all participants are in a listen-only mode. After the speakers presentation, there will be a question-and-answer session. Thank you. I would now like to hand the conference over to your first speaker today, our Chief Financial Officer, Todd Leombruno. Sir, please go ahead.

Todd Leombruno, CFO

Thank you Rachel. And good morning, everyone. And thanks for joining our FY 22 Q1 earnings release webcast. As Rachel said, this is Todd Leombruno our Chief Financial Officer. And joining me today is Tom Williams, our Chairman and Chief Executive Officer, and Lee Banks, our Vice Chairman and President. If I could direct you to Slide 2, you will see our disclosure statement addressing our forward-looking statements and Non-GAAP financial measures. As usual, we've included all reconciliations for any Non-GAAP measures in today's materials. Those reconciliations and our presentation are accessible under the investor section on Parker.com and will remain available for 1 year. The agenda is as usual, Tom is going to begin with some highlights on the quarter. He's got a few strategic comments to you that he'd like to add. And then I'll follow-up with a very brief financial summary of our quarter and provide some color to the details on the increase in our guidance that we released this morning. Tom will close with a few closing summary comments, and then we'll open up the lines and take your questions. Just one reminder regarding the pending mega acquisition. We are still bound by the requirements of the UK takeover code and respect to discussing certain transaction details. So that's just a reminder for everyone with now, I'll ask you to move to slide 3. And I'll hand it up to Tom.

Thomas Williams, CEO

Thank you, Todd. And good morning, everybody. And welcome to the call. We turned in to an outstanding quarter and it's a great start to FY '22. My thanks to the global team for delivering such a record quarter against the backdrop of strong demand, inflation, and supply chain disruptions. A couple of highlights, safety performance continued to improve with a 17% reduction on a rolling 12-month basis. Organic growth is at 16% year-over-year. We had seven first-quarter records in sales, total company operating margin, net income, and EPS. Each reporting segment had all-time operating margin records. EBITDA margin reported at 22.1% adjusted, which is 210 basis points higher than the prior year. Segment operating margin adjusted was also at 22%, a 210 basis points improvement from the prior year. Just a great quarter. I'm very proud of the team and thank you for your hard work. Moving to Slide 4, there are really three things that drive the Company: living up to our purpose, creating generators and deploying cash, and being a top quartile performer. On Slide 5, you're familiar with our purpose statement, enabling engineering breakthroughs that lead to a better tomorrow. We've been trying to show you examples of our purpose in action after the Company comes to life. One of the secular trends accelerated by the pandemic is standardization. At Investor Day, we will highlight our content as we look at the whole digital supply chain. Examples include things like 5G, infrastructure, electronics manufacturing, clean rooms, data centers, and electronic devices. A current application we are focusing on is semiconductors, especially given the importance of chip demand around the world. On Slide 6, there is a significant amount of investment in the semiconductor space, which will drive double-digit growth for us over the next several years. Our strong expertise in semiconductor manufacturing is notable, as about a quarter of our divisions ship some kind of content in the semiconductor space. The left-hand side of the slide outlines the applications we serve, while the right-hand side displays our technologies that provide distinct value for our customers. The first segment is process controls, which involves the precise control of gases and liquids in the process. Fluid and gas handling provides cooling systems for the tools, while electro-mechanical systems assist with wafer movement. Engineering materials provide shielding and sealing that protect the wafer from issues that could destroy the chips. We are essential to this supply chain and related technologies and markets around digital. This all contributes to four major secular trends driving long-term growth for the Company: aerospace, ESG, electrification, and digitization. On Slide 7, speaking of the breadth of technologies, two-thirds of our revenue comes from customers purchasing for four or more of these technologies. This demonstrates the interconnectedness of our technologies and the value proposition we deliver. Moreover, two-thirds of our portfolio is also helping enable our customers on their clean technology journey, and this number will continue to evolve towards nearly 100% over time. An example is the seal work we did today for combustion engines in Parker sales that will eventually be replaced by sales for motors, batteries, and electric vehicles. The takeaway is our brand promise: helping our customers increase their productivity and profitability. We do that through our interconnected solutions and the value proposition we offer. Moving on to Slide 8, you can see our EPS trend has been significantly improving over the years, reflecting a tremendous amount of year-over-year growth. Our EBITDA margin is also showing continuous expansion. The how of our growth stems from our people, their engagement, the ownership they take, portfolio changes, and strategic developments. Notably, we are seeing a strong shareholder vote regarding our mega acquisition, and we continue to work with the UK government on both economic and national security matters. Our anti-trust and FTI filings are proceeding as planned, and we still anticipate a Q3 calendar 2022 close.

Todd Leombruno, CFO

Okay. Thank you, Tom. I know Tom mentioned a number of these numbers, so I'll try to move quickly. The quarter was fantastic with seven records. Sales were up almost 17% versus the prior year, finishing at $3.8 billion. Organic sales are roughly 16%, accounting for almost all of the total, with currency having a small favorable impact. Growth this quarter was driven by strong, broad-based demand across all our industrial businesses, especially a rebound in the commercial aerospace market. We also benefited from strong growth from our recent portfolio additions, including CLARCOR, LORD, and Exotic. Both segment operating margins and adjusted EBITDA margins expanded by 210 basis points year-over-year. We are proud of that achievement. Adjusted segment operating margin came in at 22%, reflecting another strong quarter of margin performance. Our teams executed exceptionally well under increased demand and well-documented supply chain challenges. Incrementals are at 35% year-over-year, a remarkable figure even considering last year included $125 million of discretionary savings as a result of our pandemic actions. Adjusted net income and adjusted EPS both rose 40% compared to the prior year. Adjusted net income sits at $557 million, which translates to a 14.8% return on sales, while adjusted EPS is $4.26, marking a $1.21 increase from the previous year. On Slide 12, we break down the $1.21 increase in adjusted EPS. This strong performance across every segment is notable, with adjusted segment operating income increasing by $184 million or almost 30% compared to the prior year, accounting for a substantial portion of the earnings per share increase. All other favorable expenses helped offset the slightly higher corporate G&A that resulted from temporary savings actions taken last year. Moving on to Slide 13, every segment generated record margins in the quarter. We maintained our neutral price-cost position across all segments, despite inflationary pressures and supply chain inefficiencies. Orders for the total company increased by 26% year-over-year. Diversified Industrial North America sales reached $1.8 billion, marking a 17% increase. The adjusted operating margins in this segment improved by 30 basis points to 21.3%, while order rates remained positive at 32%. In diversified industrial international, the team excelled with 21% organic growth, achieving just under $1.4 billion in sales and adjusted operating margins of 22.8% after a 360 basis points expansion. Aerospace Systems also performed remarkably well, with sales nearing $600 million and positive organic sales of 3.4%. The commercial aftermarket showed strong growth at 33% year-over-year, leading to a 400 basis points increase in operating margins to 22.1%. Overall, orders saw a turnaround to positive territory, which signifies a steady recovery. As for cash flow, cash flow from operations was $424 million, or 11.3% of sales, with free cash flow reaching $376 million, or 10% of sales, marking an 83% conversion rate for the quarter. Our diligent working capital management contributes to our strong performance here. The increased demand necessitated a careful response, leading to a use of cash during this quarter. Compared to the prior year, the current environment shows a significant turnaround. Full-year cash flow from operations is expected to be in the mid-teens range, while we anticipate free cash flow exceeding 100%. On Slide 15, our board approved a dividend payout of $1.03 per share, marking our 286th consecutive quarterly dividend. This aligns with our target of 30% to 35% of our five-year average of net income. Additionally, we executed share repurchases, including $50 million through our 10B51 program and $180 million on a discretionary basis. This discretionary purchase compensates for the three quarters we paused the program from FY '20 Q4 through FY '21 Q2, with the goal of eliminating dilution in FY '22. Regarding the Meggitt financing, we secured a $2 billion deferred term loan, with combined cash deposits facilitating key financing arrangements for the acquisition. As for guidance, we've recently increased our forecast. The sales range now sits at approximately 6% to 9%, with just under 8% at the midpoint. We expect an 8.4% organic growth, though we anticipate some currency headwinds in Q3 through Q4. There is no impact from acquisitions, as we do not expect Meggitt to close during this fiscal year. We are targeting Q3 of calendar year 2022 for that. The adjusted segment operating margin forecast for the full year has increased by 30 basis points. Our guidance for adjusted EPS is now at $17.30 at the midpoint, with narrowed ranges around that expectation. We anticipate adjusted EPS for Q2 to be $3.74 at the midpoint.

Thomas Williams, CEO

Thank you, Todd. A big thank you to the global team for their excellent performance in delivering outstanding results. I want to emphasize our bright future propelled by our wind strategy 3.0 and our long-term capital deployment strategy concerning our acquisitions. Thank you for your attention, and let us now proceed to the Q&A session.

Operator, Operator

Please standby while we compile the Q&A roster. Your first question comes from the line of Mig Dobre from Baird. Please proceed with your question.

Mircea Dobre, Analyst

Good morning everyone, and congrats on a very strong quarter. Tom, where I was thinking we'd start. You highlighted four big trends that benefit your business: aerospace, ESG, electrification, digitization. The first one, Aerospace, is perhaps clearest to observe. But I'm curious about the other three: can you give us some context in terms of how all of this plays into your business? How is it driving incremental growth? More importantly, are these items driven by new product introduction from Parker, or is this using the existing solutions that you have in new ways that are helping your customers achieve these goals?

Thomas Williams, CEO

Thank you, Mig. I appreciate you picked up on that comment. These are secular trends that will unfold over decades. Electrification is a subset of that, and digitization will continue to transform how we operate and interface with the supply chain. These are longer-term developments, with a focus on the infrastructure needed to support them, including both onboard equipment and additional components. Our existing portfolio is designed to respond efficiently to these shifting dynamics, and we plan to also add new innovations. At Investor Day, we will present quantifiable data on digitization, revealing significant opportunities for growth in this space. I believe we are looking at a far more constructive environment moving forward.

Mircea Dobre, Analyst

Understood. Regarding international performance, which frankly performed quite a bit better than I expected. Can you elaborate on the margins and if there are any unique factors that helped this quarter? How are you seeing the various regions develop, particularly in China?

Thomas Williams, CEO

On orders, they were strong throughout the quarter. Looking at dollar values, the overall order improvement of 26% from the previous year shows consistency. Internationally, all regions were strong, showing positive performance. As for the margin side, there's nothing particularly unique other than our standard strategies - being careful with costs and making rapid adjustments post-pandemic. International operations have faced fewer disruptions than North America, which is reflected in the margins.

Jeff Sprague, Analyst

Tom, I wonder if you could address a little bit what's going on with your OE customers. It seems they may have faced some sales slippage in the quarter, but I don't see that reflected in your numbers. Can you give some color on the OE side, particularly their inventory levels and your visibility into this trend for the remainder of the year?

Thomas Williams, CEO

With our customers, I would say supply chain challenges have been more significant for them compared to ours. They are placing longer span orders with staggered release dates to secure future supplies. We’ve seen some delivery acceptance push-outs, along with temporary plant idling, particularly in China. Overall, demand with them remains strong despite these challenges.

Lee Banks, Vice Chairman

Jeff, I can't give you an actual number, but our margin neutrality reflects a lot of hard work. We've embedded processes around pricing and supply chain for over 20 years, ensuring the whole company is aligned and driven by accurate selling and purchase price indices.

Scott Davis, Analyst

Now that we're post-COVID, can we take stock of CLARCOR and Exotic in terms of how they're performing? Are they meeting or exceeding your expectations?

Thomas Williams, CEO

We are very pleased with both acquisitions. LORD has shown resilience and faster growth than legacy Parker, performing well above expectations. Exotic's performance has also been strong given market conditions, and we're confident about strong future growth potentials as aerospace traffic begins to rebound.

Ann Duignan, Analyst

Regarding your Q2 guidance, you're guiding to $3.74 at the midpoint, while consensus is $3.86. Can you discuss the disconnect between your guidance and sell-side models?

Thomas Williams, CEO

It's mostly a top-line discrepancy. We have raised our organic growth forecast for the second half but left Q2 essentially the same due to ongoing supply chain challenges and uncertainties.

David Raso, Analyst

The international margins have been impressive and are now running ahead of North America. Can you explain the drivers of this improvement?

Thomas Williams, CEO

International margins have improved through cost structure changes and a concerted effort to expand the distribution network. All regions have embraced best practices to enhance performance, leading to increased growth opportunities.

Nathan Jones, Analyst

Has your local sourcing and manufacturing encouraged better supply chains and given you a competitive edge during this time?

Lee Banks, Vice Chairman

Absolutely, our strategy of local sourcing has indeed helped. We've also implemented a dual-sourcing strategy for added flexibility and material substitution capabilities during disruptions.

Nigel Coe, Analyst

About military OEMs, how do you see that sector developing over the next fiscal year?

Thomas Williams, CEO

We expect slight declines in military OEMs due to inventory adjustments. However, the sector should recover in FY '23 and beyond. Military MRO is projected to grow by mid-single digits for the year despite quarterly softness.

Stephen Volkmann, Analyst

Your OE customers are facing delivery delays from a tight supply chain, but what about your distributors? Are they also facing similar issues?

Thomas Williams, CEO

Distributors are struggling with inventory levels as well, indicating significant pent-up demand. We're committed to addressing their needs as supply chains stabilize and grow.

Todd Leombruno, CFO

Great work by the global team, and we appreciate everyone's participation today. We wish everyone a great remainder of the day.

Operator, Operator

Thank you. This concludes today's conference call. Thank you for participating. You may now disconnect.