Richard Pzena, the founder and co-CIO of Pzena Investment Management, has been beating the general market for a long period of time. Since inception in 1996, its small cap focused value has managed to deliver an annualized return of as much as 14.6%, much higher than the S&P 500's annualized return of only around 6%. In the second quarter 2013, Richard Pzena purchased nearly 2.4 million shares in Parker-Hannifin Corporation (PH). Should we follow Richard Pzena into this stock? Let's find out.
A cash cow industrial business with a strong balance sheet
Parker-Hannifin is considered a global manufacturer in motion and control technologies and systems, selling to a diversified customer base of around 465,000 customers. It has three main operating segments, including Industrial, Aerospace, and Climate & Industrial Controls. Most of its operating income, nearly $1.63 billion, or 81.4% of the total operating income, were generated from the Industrial segment while the operating profits of Aerospace and the Climate & Industrial Controls were only $290.1 million and $84.3 million, respectively.
What I like about Parker-Hannifin is its consistent positive free cash flow. In the past ten years, Parker-Hannifin has managed to produce growing free cash flow, from $399 million in 2003 to more than $1.3 billion in 2012. In the past twelve months, its free cash flow came in at $964 million. Moreover, Parker-Hannifin has a strong balance sheet. As of June 2013, it had $5.74 billion in equity, $1.78 billion in cash and only around $2.8 billion in both long and short-term debt. It also booked more than $1.37 billion in pensions and other postretirement benefits.
Because of the consistent free cash flow generation, Parker-Hannifin could pay out consistent increasing dividends to its shareholders. Its dividend increased from $0.49 per share in 2003 to $1.54 in 2012, with the payout ratio fluctuating in the range of 14.8% to 32%. In 2012, its payout ratio stayed at 20.7%. Looking forward, the company expects to have decent organic growth, by focusing on high growth emerging markets, including China, South East Asia, India and Latin America. Moreover, it keeps expanding its distribution network globally, with more than 13,000 outlets, and improving the retail channel with nearly 2,100 stores around the world. It expects to deliver around 13.4% - 14% in operating margin and generate around $7.75 per share in fiscal 2014.
The cheapest among its peers
At $104.10 per share, it is worth $15.50 billion on the market. The market values Parker-Hannifin at 9.7 times its trailing EBITDA (earnings before interest, taxes, depreciation and amortization). The dividend yield stays at 1.70%. Compared to its peers including Emerson Electric (EMR) and Honeywell International (HON), Parker-Hannifin has the cheapest valuation among the three.
Emerson Electric has a bit higher valuation. It is trading at $61.90 per share, with the total market cap of $44.70 billion. The market values Emerson Electric at 9.9 times its trailing EBITDA. Emerson is one of the global leading diversified technology companies, operating in several segments including Process Management, Industrial Automation, Network Power, Climate Technologies and Commercial & Residential Solutions. Recently, the company agreed to divest its 51% stake in the embedded and power business to Platinum Equity, for around $300 million in cash. It still retains 49% non-controlling interest in the business. Interestingly, the company will increase share repurchase value to $600 million to offset earnings dilution from the divestment. The deal will allow Emerson Electric to focus on its core business, but also benefit from the upside from repositioning the embedded computing and power business with its remaining 49% stake. For the full year 2013, Emerson expects to generate around $3.4 billion in operating cash flow and $2.7 billion in free cash flow. Emerson Electric pays the highest dividend yield among the three, at 2.60%.
Honeywell International is the most expensively valued among the three. At $83.30 per share, Honeywell is worth $65.40 billion on the market. It is valued at around 12.7 times its trailing EBITDA. Honeywell pays a good dividend yield at 2%. Honeywell is the diversified technology company, operating in four main segments: Aerospace, Automation and Control Solutions, Performance Materials and Technologies, and Transportation Systems. Honeywell has seen that the macro environment would benefit the company in the future, with significant investment in long-term oil & gas opportunities, and stable demand in Advanced Materials end market.
The company has been undergoing a business restructuring for improving efficiencies and cost reduction. In the period of 2013-2014, Honeywell estimated that it could generate an additional $90 million in savings, from $130 million in 2013 to more than $220 million in 2014 in savings, driving its operating margin higher. Moreover, the potential acquisition integration with cost synergies adds to the potential benefits for Honeywell in 2014 and beyond. The company estimated that it would generate around $4.85 - $4.95 EPS for the fiscal 2013.
A Good Long Term Buy
Parker-Hannifin seems to be a good long-term industrial pick for patient investors, due to its strong cash flow generating capability, the lowest valuation and a conservative balance sheet. The expansion in emerging markets could also deliver good return and growth to the company. Despite the lowest dividend yield, its payout ratio is also the lowest. If Parker-Hannifin offers its shareholders an equivalent payout ratio to Emerson, at 80%, the dividend yield should be quite juicy, at more than 5%.