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Parker-Hannifin Corporation (NYSE:PH)

F2Q10 Earnings Call

January 19, 2010 10:00 am ET

Executives

Pam Huggins – Vice President, Treasurer

Donald Washkewicz – Chairman, President, Chief Executive Officer

Timothy Pistell – Executive Vice President, Chief Financial Officer

Analysts

Jamie Cook – Credit Suisse

Nigel Coe – Deutsche Bank Securities

Andrew Casey – Wells Fargo Securities

Eli Lustgarten – Longbow Securities

Alex Blanton – Ingalis & Snyder

[Robert Cornell – Barclays Capital]

[Mark Cosmeric – Cleveland Research]

David Raso – ISI Group

Ann Duignan – J. P. Morgan

Jeffrey Hammond – Keybanc

Robert McCarthy – Robert W. Baird

Operator

Welcome to the Parker Hannifin Corporation’s second quarter 2010 earnings conference call. (Operator Instructions) At this time I would like to turn the call over to Pam Huggins, Vice President and Treasurer.

Pam Huggins

Good morning everyone. It’s Pam Huggins speaking. I hope we can get through this call today. We just had a power outage here, a general power outage not Parker specifically so we’re hoping that we make it through the call.

I would like to welcome you to Parker Hannifin’s second quarter fiscal year 2010 earnings release teleconference. Joining me today is Chairman, President and Chief Executive Officer Don Washkewicz and Executive Vice President and Chief Financial Tim Pistell.

As usual, I need to address a couple of administrative matters prior to beginning with the actual earnings release. First, for those of you online you may follow today’s presentation with the power point slides that have been presented and for those of you not online, the slides will be posted on the IR portion of Parker’s web site at ph.com.

Second, as customary, I’d like to call your attention to Slide 2 which is the safe harbor disclosure on forward-looking statements and ask that if you haven’t already done so, please take note of this statement in its entirety.

Third, moving to Slide 3, this slide is required and indicates in cases where non-GAAP numbers have been used, they have been reconciled to the appropriate GAAP numbers.

Moving to the agenda on Slide 4, the call will be in four parts today. First, Don Washkewicz, Chairman, President and Chief Executive Officer will provide highlights on the quarter. Second, I’ll provide an overview including key performance measures of the second quarter, concluding with the revised outlook for fiscal year 2010.

The third part of the call will consist of our standard Q&A session and for the fourth part of the call today, Don will close with some final comments. At this time I will turn it over to Don and ask that you refer to Slide 5 titled Second Quarter Fiscal Year 10 highlights.

Donald Washkewicz

Thank you Pam and welcome to everyone on the call. I want to start with just a few highlights for the quarter.

First, our results in the second quarter demonstrates that the actions taken over the past year to restructure our operations in response to the severe recession are certainly paying off. While our comparisons to the prior year are still negative, comparing our performance to the first quarter of this fiscal year shows significant improvements across many measures.

In particular, our margin performance this quarter and our cash flows are very strong. On the demand side, we’re beginning to see signs that we believe to be a recovering end market demand. We are monitoring orders across all of our markets and are proceeding cautiously.

Early indications are that the early signs of a recovery are coming from multiple regions and a range of markets, and I’ll give you a little bit of a color on that a little bit later in the call. These are certainly good indications for future growth.

Our near term objectives remain the same as they have been during calendar year 2009. We want to continue to manage for cash as we have been, maintain a strong balance sheet. We want to target a 30% MROS or incremental on the upside or downside of 10% operating margin. And then of course, we want to prepare for future growth.

I am pleased to report that we are exceeding our objectives. We’ve generated $346 million in operating cash flow in the quarter or 14.7% of sales. For the first six months we are 13.2%. Both of these are well above our 10% target.

For the past 12 months, we have been able to reduce inventory by $336 million. Our intention is to continue to maintain a strong balance sheet. In the past year we have reduced outstanding debt levels by $1 billion. That brings our commercial paper down to above zero right now, and our debt to equity ratio below 30% at the end of the second quarter. These actions are helping us maintain of course our strong credit ratings and balance sheet.

I’m also pleased that we were able to generate segment operating margins of 10.4%, exceeding our full year goal of 10% and equaling our margin performance in the same quarter a year ago. Our debt to margin return on sales, MROS in the quarter was an impressive 10.6% which far exceeded our target of 30%, and that’s on the down side of course.

Parker employees throughout the world have responded remarkably to this downturn and importantly have positioned us very well to benefit fully from the recovery as it develops. In our markets we continue to see somewhat of a mixed picture, but generally we are witnessing improving trends.

Although order comparisons are easing, we are encouraged that order trends have improved sequentially for the past two consecutive quarters, indicating that the worst is behind us. Regardless, our focus will continue to be managing for cash and maintaining strong margin performance for the foreseeable future, and this will put us in the best possible position to benefit from the recovery.

Reflecting the benefits of restructuring actions and improving market conditions, we are increasing our guidance for fiscal 2010 to the range of $2.40 to $2.80 per diluted share. Our previous range was $1.55 to $2.05 and that’s a mid point of about $1.80. This represents a 44% increase on that midpoint.

I might also draw your attention to the fact that when we started this fiscal year, we started at a guidance of $1.50 at mid point and our current guidance now represents a 73% increase from that starting point. So with that, I’ll turn it back over to Pam.

Pam Huggins

Thanks Don. For more detail on the quarter, reference Slide 6 and I’ll begin by addressing our earnings per share for the quarter. Consistent with what you saw in the press release this morning, earnings per share came in at $0.64 and this compares to $0.96 for the same quarter a year ago.

Included in the $0.64 is $0.03 in realignment charges for the quarter and the $0.64 in earnings per share for the quarter exceeds guidance provided last quarter due to higher sales in all segments of the business other than Aerospace and higher operating profits across all segments other than Aerospace. However, it should be noted that Aerospace met the guidance on sales and operating profits for the quarter.

SG&A expenses were lower as a result of execution of a strong budgetary control environment including lower incentive compensation, and all of these were offset by higher other expense due to benefit plans, FX and asset write offs. We also had a higher tax expense due to higher income, but a slightly lower tax rate.

Detrimental margin return on sales was a respectable 11% for the quarter, and as a reminder, this is the difference in segment operating profit divided by change in revenue for the quarter on a year over year basis.

Moving to Slide 7, and laying out the components of the earnings per share decrease in the quarter versus the same quarter a year ago, and this is on a consolidated basis. Let me just run through the puts and takes for you.

A 12% decrease in revenues in the quarter, revenues were lower versus last year in all segments. On a sequential basis, sales were higher in North America and International. As a result of the lower sales versus last year, operating income was lower in International and Aerospace only.

North America and Climate and Industrial Controls, even with lower sales posted higher operating income. Again, this favorable outcome is obviously the result of the realignment and cost controls put in place last year and this year as well.

Realignment expenses were fairly comparable year over year at $7 million, $4 million net of tax or $0.03 this year, and that compares to $9 million, $6 million net of tax or $0.04 for the same quarter a year ago.

Selling, general and administrative expenses declined $27 million, again due to tight budgetary control, lower incentive compensation. Interest was lower by $5 million due to less outstanding debt and higher other expense, and again this is on a consolidated basis of $8 million, was mainly due to asset write offs and pension expense.

Lower tax expense of $5 million, again due to less income, but the tax rate was slightly higher due to normalized tax R&D credits and more shares outstanding impacted earnings by $0.01.

So moving to Slide 8, and looking at the top line revenues for the quarter, decreased 12% to $2.4 billion from $2.7 billion last year. Of the 12% decline in revenues, acquisitions had no impact. Currency translation increased revenues by 4% and the currency impact was mostly due to the International Industrial segment, mainly the Euro against the dollar, and the organic or core decline in revenues was 16%.

Now moving to Slide 9 and focusing on segments starting with Industrial North America, North American revenues declined 15% in the quarter versus the same quarter a year ago. The majority of the decline was base revenues as acquisitions didn’t impact revenues this quarter and currency translation was a favorable increase in revenues by 1%. The net results as you see is the base revenue declined 16%.

In spite of the decline in revenues for the quarter versus the same quarter a year ago, operating income was positive and actually increased 6% resulting in a favorable marginal return on sales. Operating margins were 270 basis points above the same quarter last year and operating margins increased sequentially from 9.7% in the first quarter to 13.5% this quarter.

So continuing with the Industrial segment, moving to International, revenues declined 11% in the quarter versus the same quarter a year ago. Currency translation was in addition to revenues in the quarter of 8%, and this is versus a deduction of 3% in the first quarter. Acquisitions had no impact on revenues and the net result was a base revenue decline of 19% for the quarter.

Second quarter detrimental marginal return on sales was 29% and this includes the effects of acquisitions, realignment charges and inventory reductions. Operating margins increased to 8.9% in the quarter from 7.3% last quarter.

Now, focusing on the Aerospace segment, Aerospace revenues declined 15% in the quarter versus the same quarter a year ago. Margins decreased 250 basis points from the first quarter, but as expected and in line with the projection and what was discussed on the last call. Revenues declined as a result of commercial business, mainly regional and business generally aviation as well as spare parts in the aftermarket.

Now moving to Slide 12, the Climate and Industrial Control segment, as mentioned I think on every call, softness in North America automotive, heavy duty truck and residential air conditioning does affect this segment. Base revenues declined 5% for the quarter year over year. Currency translation was in addition to sales of 3%. The net result, the sales were down 2%.

Margins as a percent of sales were 3.5% for the quarter versus a loss of 7.2% for the same quarter a year ago, and in spite of a decrease in sales, operating income increased, resulting in a favorable margin return on sales for the quarter.

At this time, moving to orders for the quarter, Slide 13, as you note details orders by segment. These numbers represent a trailing three month average and are reported as a percentage increase of absolute dollars year over year, excluding acquisitions and currency except for Aerospace. Aerospace is reported using a 12 month rolling average.

As you can see from this slide, orders are down 7% for the December quarter just ended. This compared to minus 25% last quarter and minus 20% a year ago.

North American orders for the quarter just ended declined to 3% year over year, and this compares to a minus 27% last quarter and a minus 18% a year ago, so good improvement.

Industrial International orders were flat year over year, and this compares to minus 25% last quarter and minus 28% a year ago. Aerospace orders are down 27% for the quarter which compares to a negative 23% last quarter and a positive 2% a year ago.

In the Climate and Industrial Control segment, orders are up 6% for the quarter, up from negative 17% last quarter and a negative 28% a year ago.

Now moving on to the balance sheet, just to review a few items; Parker’s balance sheet remains solid. The cash on the balance sheet at quarter end was $234 million and as Don mentioned, no commercial paper was outstanding and this is down from $166 million last quarter.

Inventory has been reduced by $336 million since last year. Currency however, added $49 million, so the net decrease was $287 million. Accounts receivable in terms of days sales outstanding is 48 and this is down two days from the same quarter a year ago.

Weighted average days payable outstanding increased three days this fiscal year, so good working capital improvement.

Moving to the operating cash flow for the quarter was $346 million and as Don mentioned earlier, represents 14.7% of sales. And of this $346 million, $31 million was utilized for capital expenditures in the quarter, 1.3% of sales. $45 million was returned to the shareholder through share repurchases of $5 million and payment of dividends of $40 million, and debt was reduced by $203 million this quarter.

No acquisitions closed in the quarter, and on Slide 16 you can see that the debt to total cap ratio is down to 29.9%, and on a net basis, 27.3%.

So now moving to guidance, fiscal year 10 guidance, revised guidance; it’s on Slide 17 through Slide 19. On Slide 17 is the guidance for sales and operating margin by segment has been provided, and on Slide 18 guidance has been provided for items below segment operating income.

Slide 19 summarizes the guidance on an earnings per share basis and as you can see from this slide, the guidance for fiscal year 2010 for earnings per share is projected to be $2.40 to $2.80, up from $1.55 to $2.05. Please remember that the forecast excludes any acquisitions that may be made in fiscal year 2010.

Let me just talk about the guidance for a moment. The full year revised guidance assumes the following; decreased revenue year over year of approximately 5% to 8%, and this is an improvement over previous guidance of a decline of 8% to 12%.

Segment operating margins as a percent of sales, approximately 10%, and this is an improvement over previous guidance of 8.3%. Corporate administration costs are assumed at the mid point to be approximately $140 million. Interest expense is assumed at the mid point to be approximately $100 million and other expense is assumed at the mid point to be $150 million.

So if you take all those below the line items, they total to about $390 million and we’ve given a range of plus or minus 3% on that.

The tax rate is projected to at 29% and just to clarify for you and give you a little bit more color, third quarter revenue incorporates a 5% sequential increase over second quarter and fourth quarter incorporates a 5% increase over third quarter.

EPS for the quarter is approximately 10% over the EPS for the second quarter and EPS for the fourth quarter, again approximately 10% over the third quarter.

Realignment costs will be higher in the third quarter versus the fourth, particularly in International and below the line items have been adjusted to basically reflect the run rate of the first half.

Just to clarify a little more, the split in terms of first half, second half are 48%/52% and the earnings per share again is more heavily weighted in fourth quarter versus the third quarter.

At this time we’ll commence with the question and answer session. Just as a reminder, the call will be limited to one hour so please honor the request of one question and one follow up should clarification be needed. By adhering to this courtesy, everyone will have a change to participate. So at this time we’ll begin the Q&A session.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Jamie Cook – Credit Suisse.

Jamie Cook – Credit Suisse

Good morning and congratulations. I guess my first question, not to beat a dead drum because I feel like you get this every quarter, but can you just walk me through again margins on the International front were quite impressive. I know last quarter you were expecting more restructuring in Q2 relative to Q1, so how did that shake out relative to your expectations. And then I think you said in your prepared remarks, Q3 will have more restructuring and Q4, what segments does that hit?

Timothy Pistell

Unfortunately once again in Europe, protracted discussions with the Works Council could not get everything done that we wanted to get done in this quarter, so there is going to be about $17 million. Initially we had hoped, we gave you $16 million in expense for the year to generate $60 million in savings, and we thought the cost would be roughly $30 million in the quarters and so forth.

So then it does appear as I say that we are now going to shift over from the second quarter into the third quarter about $17 million. The problem with that, along with that shift in the $17 million in cost from Q2 to Q3 is of course, we can’t start realizing the savings from doing that and so some of those savings won’t all be captured in this fiscal year and will be pushed out into next fiscal year.

So instead of realizing the full $60 million that we hoped for in this year, we’ll probably only realize about $40 million. Having said all that, we are proceeding. We will get it done. It will be done in this year. The benefits will accrue, and interesting when you take a look at the analysis, I think with the updated projections that we’ve given you here today, it’s quite interesting because you’ll see that on volume, we are projecting our volumes to be down $600 million plus this fiscal year versus the prior fiscal year, about $650 million.

And yet we’re giving you a segment operating margin that’s virtually the same. Now on our math, that $650 million would cost us close to $200 million in operating margin and the reason we’re coming in the same is we told you last year that we were going to generate some substantial savings, $120 million in savings from those actions. The additional savings this year is what’s causing that great marginal impact.

So a long winded answer but kind of get all the numbers out there.

Jamie Cook – Credit Suisse

First half is doing much better than I think I anticipated in total. Is there any price material cost benefit that we get in the first half that we don’t get in the second half or any mix issues that I should be aware of outside of you talked about restructuring, but any MRO versus ROE, end market or geographical or material cost price. I’m just trying to think if there’s anything unusual in the first half versus second half.

Donald Washkewicz

I would say don’t factor in much in the way of any benefits from pricing as far as the earnings are concerned. What we’re trying to do is try to maintain parity there. We’re trying to make sure that whatever cost increase that we incur, that we’re promptly passing those on.

We’ve had some minor increases of late into the market that reflects some raw material increases. I’ll just give you a little color on raw material because you might find this interesting.

Copper for instance is at a 16 month high. Aluminum is at a 14 month high. Zinc is at a 24 month high, so for zinc castings and things like that. Steel is going up. So we’re out there with increased today to basically cover cost increases but not to expand margin per se. So I think you’re going to see those becoming pretty neutral. We hope to cover all the costs but I don’t think it’s going to benefit the margin at all.

Operator

Your next question comes from Nigel Coe – Deutsche Bank Securities.

Nigel Coe – Deutsche Bank Securities

The first question would be if you could give us a little bit of color on some of your major markets and perhaps the mobile equipment markets lagged the industrial markets in the last quarter. Maybe you could just make some comments on that, maybe December and January.

Donald Washkewicz

I’ll just kind of run you through some of the markets and some of the trends that we see. First of all, I think pretty clearly we’re seeing that we’re coming off the bottom and the bottom as far as we’re concerned was the fourth quarter of 2009. So we’re seeing continual improvement from that, and gradual improvement.

We think there’s going to be gradual improvement from here going forward obviously based on our guidance we’ve given you.

Looking at regional, our regions around the world, just to give you a little flavor of what we see there, the U.S., we see recovering at a steady pace; nothing spectacular, but a steady pace. We would say Latin America would fall into that same situation, recovering at a steady pace.

Asia is extremely strong, so it’s coming back very strong. Europe is recovering slower, at a slower pace than either U.S. or Latin America. So that’s kind of how we see it regionally in the major regions around the world.

For those on the call that are familiar with the ISM indices, I’ll just give you a little flavor of what we’re seeing there. The ISM for North America in November was 54 and in December was 56. So those are some pretty good numbers and it’s the fifth consecutive month basically where we’ve seen growth in the manufacturing sector, so that bodes well.

The new orders index was 66 and that’s the highest number that they recorded since 2004, so that’s another very, very good input. Inventories appear bottoming. We’re seeing that throughout all of our end markets. Of course that’s going to create demand.

Europe’s ISM is barely over 51. That’s still positive and it’s still a positive trend, but it’s certainly weaker than what we see in North America.

Just a little bit about some of the countries in Europe, France and Germany look stronger right now. Italy and Spain somewhat weaker growth and the U.K. is fairly flat.

We’ve talked about our order trends that we monitor here pretty closely, what we call our 3/12 trends and our 12/12 trends, and I just thought I’d give you a little run down as to what we see there.

Our 3/12 would be the last three months orders over the prior year the same three months, and the 12/12 would be the last twelve months orders divided by the prior period 12 months. So that will be what we call our 3/12 and 12/12.

Industrial North America we see gradually increasing in both of those metrics, in the 3/12 and the 12/12. Europe fairly slow increased but still positive in the 3/12 and the 12/12. Asia is a very strong uptick in both the 3/12 and 12/12. Latin America a very strong uptick in the 3/12 and the 12/12.

The interesting thing now is as we’re entering this part of the cycle and we’re hoping to see this, is that our distribution, we’re starting to see life coming back out of our distribution channel with stronger 3/12, and that’s going to bode well for our 12/12 going forward.

Heavy duty truck, the 3/12 was strong. Somewhat erratic, and I think that had to do with the free buy situation and so forth. It’s still positive, but it’s bounced around quite a bit, but still good.

Refrigeration is strong 3/12. Semiconductor is extremely strong in both of those indices in both the 3/12 and the 12/12. Process is strong 3/12. Aerospace is flat. That’s the one that we would say is roughly flat right now is the Aerospace on both the 3/12 and the 12/12, and that’s pretty much indicated in the numbers that Pam had given you earlier.

Positive, now let’s talk a little bit about sequential market trends from quarter to quarter, what we see going sequentially. Oil and gas, these would be some positive trends, positive markets out there; oil and gas, power gen, alternative energy, marine, farm and ag, military and aerospace aftermarket, not the OEM but the aftermarket positive, general and industrial markets are positive, cars and light trucks, semiconductor, of course I already said was very strong.

Light construction equipment, not so much the heavy right now, and I think getting to your questions, I think it’s going to be a little while yet before we see the heavy side of that coming back and that of course affects our hydraulics part of our business. But certainly on the light side we see some positive light there.

I mentioned heavy trucks and then certainly distribution. So those would be the positive sequential market trends that we’re seeing. The flat sequential trends would be Life Sciences. Some of these however, keep in mind are at a fairly high level already. With these Life Sciences, mining is relatively flat. Military and aerospace OEM, flat but at a pretty decent level.

Residential air conditioning and refrigeration of course, we know the situation with the housing market out there, and machine tools are relatively flat.

On a negative sequential basis, commercial Aerospace OEM and commercial Aerospace aftermarket are both negative trends as Pam indicated earlier, and then the commercial air conditioning and refrigeration segments being negative trends.

The only other thing I would just mention here is that just to keep this in the back of your mind that Europe, when we talk about Europe, as we talk about Europe with our operating groups, Europe has had in many of the major customers over there have had major shut downs, extended shut downs from the period of December 18 through in some cases through January 11, so pretty extended shut downs.

That of course impacts our second quarter as well as somewhat our third quarter so it will be interesting as they come back in to see what picks up going forward in Europe. The only other thing that’s going to be affecting us a little bit in the third quarter, and it’s already in our numbers, embedded in there is the Chinese New Year which this year is February 15.

So that entire period of time tends to slow down somewhat in China, but it’s coming in February this year. So I just thought I’d pass that on for what it’s worth. So that’s a little bit of color on some of the different markets and trends.

Nigel Coe – Deutsche Bank Securities

I think you mentioned light construction positive sequential and heavy construction lagging behind. Obviously it varied in January, but any signs of the mobile OEM channel is improving into January.

Donald Washkewicz

There’s some specific business that is going on out there that we’ve picked up and some of the specific customers, but broad based, no. We don’t see a broad based major recovery on that side yet. I think we’re a little ways off yet. I think it will come, but we’re not seeing a major improvement at this time.

But there are some customers that have captured certain business that we’ve enjoyed or will enjoy going forward and that’s been a positive. But again, not across the board.

Operator

Your next question comes from Andrew Casey – Wells Fargo Securities.

Andrew Casey – Wells Fargo Securities

Just a quick follow on to the market color that you provided, are you seeing any inventory restocking in any of your distribution channel at this point?

Donald Washkewicz

Our distribution is up on the order trends, but frankly I don’t see that happening yet. I think they’re still being very cautious. What we’re seeing is what they’re bringing in, they’re shipping out. So I don’t see a restocking going on. I think that will be what will come down the road here a little bit as their confidence improves over what they’ve been through the last 12 to 18 months here. But nothing major at this point.

Andrew Casey – Wells Fargo Securities

In your outlook for the second half, it doesn’t really appear as if you’re building any significant restocking assumption in there. Is that accurate?

Donald Washkewicz

For our own inventory?

Andrew Casey – Wells Fargo Securities

No, the inventory restocking in the industry.

Donald Washkewicz

In the channel, that’s correct.

Timothy Pistell

I think that after what we’ve just lived through here; I think that you’ll find everybody through the whole channel being extremely cautious. Some people were caught with a fair amount of inventory. And we’re a long way to go to get back to where we were, so I think that as Don said, what we’re seeing is pretty much hand them out if you will.

People order what they need and it goes right through their organization right out to whomever it’s needed.

Operator

Your next question comes from Eli Lustgarten – Longbow Securities.

Eli Lustgarten – Longbow Securities

Can we talk about the guidance? The improvement in sales forecast in both North America and International, particularly International which you sort of came from down 10.5% to 11% to down 4%. With Europe being slow, where is that coming from? Have you put a change in currency? Does that include currency? Currency is now positive. Can you give me some idea of what’s going on with that?

Timothy Pistell

We never try to predict the currency. We’re really kind of; we’re going off where we sit today. So we will not project whether we think it’s going to go up or down. We tried that before and we didn’t get it right.

Right now, what we assume is the currencies will stay where they are. That isn’t probably what will happen, but it’s the best we can do.

In terms of the improvement, you’re right. We are clearly surveying everybody throughout our organization. Everyone is projecting these modest steady increases to continue, but in point of fact of course, we do not have the orders in hand. So as Pam has given you, we do have the orders have picked up and we’re expecting as I said, those trends.

But if we only carry six to eight weeks of back log in the industrial side, so who’s to tell? We will have to see. Asia and Latin America without a doubt are doing quite well. We’re seeing it here and there in the U.S., not universally. Europe is a bit problematic, but starting to happen here or there. So we’re giving you our best trajectory.

Now, we do pick up work days as well. In fairness we have to declare that we pick up, we always pick up a few extra work days in the second half over the first half, so that helps somewhat.

Eli Lustgarten – Longbow Securities

Just to help me on the International number particularly, you had an 8% currency benefit in the second quarter. Is that what you’re assuming now for the rest of the year? What is your assumption of currency now in that number?

Timothy Pistell

Basically in our outlook going forward that’s basically what could be there. Now it could be more, it could be less. But that’s about what we would assume; the same effect in the quarter that we just had.

Eli Lustgarten – Longbow Securities

It’s so much bigger than the first quarter. Is the bulk of the change between the second quarter guidance and the first quarter guidance, mostly currency or is that just some real churn. That’s what I’m trying to figure out.

Timothy Pistell

In terms of the top line?

Eli Lustgarten – Longbow Securities

The top line, right.

Timothy Pistell

That clearly helped. There’s no question about it. That clearly helped on the top line. As you know it had a very nominal impact on the bottom line. There is impact plus or minus, but clearly that did help on the top.

Eli Lustgarten – Longbow Securities

That’s the biggest portion of going from the mid point of International was down 10.6% and now it’s down a little under 4%. But the biggest portion of that is change in currency.

Timothy Pistell

Right. And again, there was a gain there. There would be a slight gain on the operating margin level but of course it would be fairly nominal at that level.

Eli Lustgarten – Longbow Securities

Do you think most of your sales improvement is overall market improvement or do you think you’ve gained a lot of market share, because I don’t see the industry as being quoting as strong numbers as you’ve been showing?

Timothy Pistell

We let other people try to figure out. I don’t know how anyone figures out market share month to month or quarter to quarter in the channel. You can only figure that out over much longer times. I think it’s really more reflective of what’s going on in the markets. I think that’s the good news. It is reflective of what’s happening in the markets.

Operator

Your next question comes from Alex Blanton – Ingalis & Snyder.

Alex Blanton – Ingalis & Snyder

You mentioned earlier in the call that you saw the end markets improving. How do you define the end market for your company?

Timothy Pistell

How do we define the end markets?

Alex Blanton – Ingalis & Snyder

Yes. You said the end markets are improving. What do you mean? What market is that?

Timothy Pistell

Let’s talk industrially, and as you know industrially about half of our business goes direct to customers and half goes to distribution.

Alex Blanton – Ingalis & Snyder

So the end markets that you’re talking about are the equipment companies that buy your stuff that go into their machines, right?

Timothy Pistell

It is equipment companies with machines, but it’s also a lot of other people who don’t build machines. This could be going into Life Sciences, etc. But those would be the end customers. We have what we call customers and we have distributors.

Alex Blanton – Ingalis & Snyder

But let’s suppose that you’re selling something in the construction equipment. You’re talking about the construction equipment companies. You’re not talking about the construction markets out there or the things that drive those things.

Timothy Pistell

Our end customers are the construction people. In that case too, especially with most of the larger construction people they control their aftermarkets as well. So they get both the OE sales and the aftermarket.

Alex Blanton – Ingalis & Snyder

So if Caterpillar reduced its components that it buys from you last year, the stuff it has in inventory, and reduced their order rate because they reduced inventory, they could be ordering twice as much right now from you even though their markets haven’t improved at all.

Timothy Pistell

That is correct.

Alex Blanton – Ingalis & Snyder

So when you say the end markets are improving, you’re really not talking about the ultimate end market. It’s you’re direct end market.

Timothy Pistell

That might be true but you assume that just putting inventory on the shelf, what we said earlier is that no one’s putting inventory on their shelf.

Alex Blanton – Ingalis & Snyder

But they reduced it last year so now just to get enough components to maintain production, never mind replenishing inventory, just to maintain production, they have to increase their orders to you.

Timothy Pistell

I can’t speak for Caterpillar. I think there’s a lot in the public domain though about them having a lot of inventory when things slowed down that they caught with a lot of inventory. They worked them down significantly and you guys know these numbers better than I do, and that they did, a lot of these people were writing that they were going to have to order a whole bunch of components just to kind of get their plants back up online.

I don’t know any of those numbers. I’ve heard those stories too. Caterpillar aside, and people telling those stories, we do not see any customers carrying a bunch of inventory.

Alex Blanton – Ingalis & Snyder

But if they reduced it last year they have to increase their orders. Forget the inventory replenishment. That’s not even a factor yet. Second question, the detrimental margin, very good in North America 11%. It’s almost as if most of your costs were variable here and yet overseas it was 29% or the rest of the world negative, so that’s a lot worse. Why is there that big a difference? Is it charges? You mentioned there were some of that in foreign, but why is there a big difference there?

Timothy Pistell

First of all, 29% in International is outstanding. Remember our guideline here is 30%.

Alex Blanton – Ingalis & Snyder

I’m not saying it isn’t, but I’m saying your North America was even more outstanding and there’s a big difference between them.

Timothy Pistell

It’s a very good question and it gets right at the crux of what I was talking about earlier, and that is that in North America we were able to mobilize and execute our restructuring and get that behind us and done and realize the savings. All of the restructuring in North America is done, as in Asia, Latin America and we’re seeing those come through.

There has been a tremendous lag in getting that restructuring done so the costs have hit, haven’t hit, are going to continue. And the savings aren’t all coming through.

The wonderful news is they have done a lot. I don’t want to take anything away from them. They have done a lot and there are already less than 30% and we’re going to push on we’ll make that even better.

Operator

Your next question comes from [Robert Cornell – Barclays Capital]

[Robert Cornell – Barclays Capital]

Just expanding on the one point you mentioned back in December that a lot of the big mobile customers were saying be ready, be ready. What are they saying now?

Donald Washkewicz

Pretty much the same. We’re starting to see some, so it’s not like we’re not getting anything, but we’re not getting the big surge. Historically we’ve talked about this before, historically coming out of one of these things, those guys would be in pretty strong and ordering heavily, and we’re not seeing that. We are seeing increases.

Pam Huggins

I just want to add on about this mobile thing a little bit because I really get down and dig into these numbers from an orders perspective and look at them. In mobile in fact, if you just look at the second quarter sequentially to the first quarter, actually mobile increased more than the industrial.

But that hasn’t been the case up until this last quarter, and when we talk about mobile, we’re talking about a lot of different markets. We talk about cars and light trucks. We talk about heavy trucks, ag, there’s a lot of things that we include in that mobile number.

So it’s not to paint a dire picture here because if you just look at the percentage improvement, it’s actually more than industrial. But that hasn’t been the case up until this last quarter.

[Robert Cornell – Barclays Capital]

Maybe I missed it but I didn’t hear you talk about the LIFO gain in the quarter. I think you were expecting one.

Pam Huggins

No, actually we did not have a gain this quarter. It went the opposite way, a little over $1 million.

[Robert Cornell – Barclays Capital]

I don’t know whether you think about it this way, but in terms of the benefit to margins, companies typically have temporary benefits. You have price costs which you did mention, and then you have permanent restructuring costs take out. Have you thought in terms of segregating the positive impact on margins between the temporary benefits that may reverse over the course of the next so many months, one price cost being something else. You still are implying your net green and then permanent restructuring.

Timothy Pistell

In terms of the price costs we talk about this every business unit. Every manager has their sales price index. They have their purchase price index, and they are charged with the responsibility of keeping that at least neutral or get ahead of it. And again, we don’t get down into the minutia on that, but they do that.

I think we do separate these down, but again I do think we’re looking for a lot of these. Improvements have been made through this horrible period to in fact sustain. We want to raise the ceiling out here so we can raise the floor, and that’s how you do it. But without getting more specific, we do track all that.

But we do try to push it down to the business unit level. Give them key metrics, and let them run their business.

Operator

Your next question comes from [Mark Cosmeric – Cleveland Research]

[Mark Cosmeric – Cleveland Research]

In answer to a question a little bit earlier about some of the costs actions and the benefits from that, one thing that was left out is the temporary furlough program that I think last quarter you mentioned was delivering something like $100 million on an annualized run rate, but there was a presumption that at some point you’re going to have to bring those people back to full hours and reinstate whatever other cost freezes and things like that. So when does that occur? Was that a January 1, or are you still on furlough and reaping those benefits?

Donald Washkewicz

What we’ve done now is we’ve basically eliminated the reduced work weeks for some of the corporation, the administrative part of the corporation, and the rest are either still on a 10% reduction depending on the activity in their business. Some have gone down to a 5% reduction and some are on even more than that because their business is still real soft.

So it’s really a mixed bag right now. We have eliminated for some of the organization, some portion of the organization, but some of the operating units that are really still down, have decided, and we let them do this one on one, have decided to maintain reduced work week schedule.

[Mark Cosmeric – Cleveland Research]

So if we were getting a benefit of say $25 million, just a quarter of that $100 million you talked about last time, if that came through in this quarter second half it sounds like you won’t be getting quite as much.

Donald Washkewicz

That’s correct. That’s all factored into the guidance Pam gave you.

[Mark Cosmeric – Cleveland Research]

Another follow up on currency issue, the currency, you’re getting 4% to revenue that we talked about in the new outlook. What did that do to earnings and what’s the expected full year benefit from currency on an EPS basis?

Donald Washkewicz

I can’t give you that number, but it’s again nominal. It’s simple math. If it’s international and we’re making 10%, if I pick $100 million up in sales, I’m probably going to pick up $100 million in operating margin, attached to the fact that it’s going to be $6.5 million and then whatever EPS that is.

That doesn’t work all the time. It’s just a rough approximation. So it could be a couple penny plus per quarter but not much. Of course that’s all contingent upon all the rates staying where they are today.

[Mark Cosmeric – Cleveland Research]

What’s the CapEx outlook and did that change from last quarter?

Timothy Pistell

CapEx outlook has really not changed. People have been extremely cautious and conservative there and so the outlook really hasn’t changed. We don’t expect people to be cranking anything up right now.

[Mark Cosmeric – Cleveland Research]

What’s that number?

Pam Huggins

It’s $30 million for last quarter which is fairly consistent, so it’s about 1.3% of sales.

Timothy Pistell

We could get up to 1.5% or 1.6% but we’re not going to be above 2% on CapEx.

Operator

Your next question comes from David Raso – ISI Group.

David Raso – ISI Group

Just thinking bigger picture about the cash flow strength of late, where the balance sheet is, it looks like you have no acquisitions from revenues going forward. The last deal I believe was back in December of ’08. Can you give us a little bit of an update on how you’re thinking about proceeding with growth? Typically you’re good for on average 4%, 5% to 6% revenue growth versus the prior year sales, that’s kind of baked into your idea of growing the company.

Donald Washkewicz

What we’ve been doing here of late of course is all of that excess cash has gone to pay down that $1 billion in commercial paper and paid for the acquisitions we did at the first half of last fiscal year. So we’ve got that house in order pretty well there.

What we plan to do is maintain our dividend record. We’ve talked about that before. We have 53 years now. We’re going for 54 not just paying dividends but increasing every year for 54 years. And that’s going to continue so that’s the next priority in line.

And then the third one is exactly what you’re talking about. We want to finance growth. Some of this is coming in the direction you’re already seeing in Aerospace. We’ve gone from a non-recurring engineering type investments of $100 million to now $175 million a year covering a lot of the new programs we’ve got going.

So we’re investing in new growth in that regard. We’re investing in growth in other areas with respect to new product development and activity. Right now we’re basically reconnecting with opportunities or potential opportunities out there with respect to acquisitions. So as we see our leverage drop to where it’s dropping to, we’re certainly going to use that balance sheet to help growth the business.

David Raso – ISI Group

I know you can’t indicate anything really imminent that’s about to close, but are there enough things on the docket where we should expect to see some continued revenue from acquisitions? I don’t remember the last quarter you’re going to even have a dollar from acquired revenues.

Donald Washkewicz

I think what you’re going to see is we’re going to ramp up to about the level that we were at at a run rate prior to that which is going to be on a compound, not any particular year, but over a five year stretch, we’re going to average about 10% growth, half of that being acquisition. That’s our target and we intend to continue that.

David Raso – ISI Group

Last downturn it took you 11 quarters in North America to get the margins back up to double digits. Now it only took you three. So you mentioned the idea of raising the floor to hopefully raising the ceiling. I know it’s a big picture question, but are you willing to talk a little bit about the North American margins which have historically peaked around 15%? What are you thinking this time?

Timothy Pistell

I talked about this just recently to a group of folks in New York. We want to average 15%. The only way we can do that is clearly we’ve got to get these margins to 16% or 17% when times are good and then not let them get below double digit when times are poor.

So I think we definitely have raised that and we’ve got to continue to do that so you’re absolutely right. We can’t get to 15% and be happy and complacent. We need to push on and try to get these to 16% to 17% to do this thing.

I think it’s what we’ve been working a long, long time to achieve and I think we’re on the cusp of doing that.

Donald Washkewicz

The one area that will affect that a little bit as you recall, when we weren’t doing much in the way of new engines, we’re always doing engineering, but winning new programs on our Aerospace side of our business, we peaked out at 18%. Now I think that we’re down around 11%. Of course we’re in a soft market condition here.

So the other wild card here is how many new programs are we going to take on and how much are we going to have to invest in those new programs. As you know, had we not taken on any new programs here, we would have at least $75 million more earnings flowing through that group than we do today, but again, like I said earlier in the call, we want to invest in the future and that’s what we’re doing regardless of what it does to the margins within a certain relative range.

David Raso – ISI Group

That said, is the hybrid transmission, the hybrid technology in the fiscal second half or is that a decision of control?

Donald Washkewicz

We have some business in the second half factors and we have a lot of costs from additional R&D effort that’s factored in there as well.

The last point that I would point out, and it’s good to kind of go over this now and then, is as we get back into an acquisition mode, I’m not trying to downplay how our margins are going to be lower because Tim said it just about perfect that we’re going to try to get to 16% to 17%.

But another thing that does impact that is the fact that as you’re bringing acquisitions on, you’re amortizing the intangibles early on that has a negative drag on the margins. But what it does in a very positive way, it throws off a lot of cash, and that’s the reason why we’ve been emphasizing cash flow here, because at the end of the day, the cash is what we’re going to be plowing into these acquisitions.

So we might sacrifice a little bit on the operating margin, but you’re going to like the cash side of the equation as you have hopefully this past year. You’ve seen what we’ve been able to do with all that cash that we’ve generated.

Operator

Your next question comes from Ann Duignan – J. P. Morgan.

Ann Duignan – J. P. Morgan

Hopefully you’re not cutting back on costs so much or spending so much that you’re not paying your utility bills. My question, kind of building on David’s question actually, my understanding is your goals are 15% and EBIT is company EBIT at 15%. I guess my question is it looks to me like structurally, CIC is going to have a real hard time contributing to that and not continuing to be a drag. Can you talk a little bit about what your strategy is for CIC long term? Will you have to do a large acquisition in order to get scale in that business and get that up to company average?

Donald Washkewicz

We like the CIC business. The direction that we’ve been headed as you know, the focus has been more towards refrigeration, more towards the valve side of that business, the industrial valve side and de-emphasizing somewhat the automotive side, so we like that trend in what we’re doing.

Of course they’ve been really impacted in a great way here of late because of the housing situation and the car market, everything being down. The one thing that we look at CIC, we look at all the operating units the same from the standpoint of one metric, and that is return on net assets.

The real key driver in the company is return on net assets and the one thing that we’ve seen in that business in particular is that the asset intensity is not as great as some of the other businesses we have. So to get to the return on net asset metric that we have internally which is 21% pre tax, we can get there with a lower than 15% margin in that business.

You have to keep that in mind too. Really we talk about ROS and operating margins because that seems to be what the street likes to talk about, but the bottom line internally in this company, the real driver is return on net assets at the end of the day.

So to answer your question, we think the margins there will be a little bit less than other groups in the company. I think in some areas we may have groups that are a little bit higher. On average though, we’re saying that as a portfolio, we want to hit those kind of numbers that Tim talked about earlier.

Ann Duignan – J. P. Morgan

Do you think you can get to those and closer to EBIT margins without a large acquisition to give you some scale?

Donald Washkewicz

Yes.

Ann Duignan – J. P. Morgan

Just a quick follow up on your guidance, I’m just trying to back into the numbers. Correct me if I’m wrong, but I think you said sequentially revenues up 5% in Q3 and another 5% in Q4?

Timothy Pistell

That’s correct.

Ann Duignan – J. P. Morgan

And EPS up roughly 10% in Q3 and 10% sequentially in Q4?

Pam Huggins

Yes, a little more than that in the fourth quarter, but yes.

Ann Duignan – J. P. Morgan

What I was going to ask is, but embedded in your Q3 is $17 million in restructuring which should not be there in Q4, so why wouldn’t we expect Q4 EPS sequentially to be up more than 10%?

Pam Huggins

You have to remember we had $80 million of carry forward from the prior year, and so it’s also dependent on the break down on that, how that plays out from quarter to quarter.

Timothy Pistell

And the savings that we won’t get this year that will push into next, FISCAL YEAR ’11.

Ann Duignan – J. P. Morgan

You’re going to push savings to fiscal ’11 I understand that, but you’ll not have the $17 million spent.

Pam Huggins

We do have some in the fourth quarter. We do have some restructuring, but like I said, we also have that $80 million coming from the prior year in the breakdown and that is affecting the third and fourth quarter as well.

Ann Duignan – J. P. Morgan

So you don’t expect the $17 million restructuring spill over will all be in Q3. Some of it will spill into Q4. Is that how I should read it?

Pam Huggins

That’s right.

Operator

Your next question comes from Jeffrey Hammond – Keybanc.

Jeffrey Hammond – Keybanc

Just a quick question on Aerospace. You have it looks like a 10% sequential increase, and just listening to Don’s commentary around the trends, it feels like that business is still getting worse. Can you comment on how you’re looking at the back half relative to the first half of that business?

Pam Huggins

I don’t think we see it getting worse. Just as a reminder, we’re pretty much consistent with the guidance we gave last quarter. They met the guidance that we really put out last quarter for them and the guidance remains consistent, so I don’t think things are really getting worse.

I think we had projected that the commercial aftermarket side of things would be down, but we said that there would be some offset in the second half due to retrofits. So the story is the same. It’s pretty much the same. We think that commercial market will be down. It will continue to be down in the 4% to 5% range once you factor in the retrofit which is offsetting some of the commercial aftermarket.

Jeffrey Hammond – Keybanc

And the sequential uptick; is that just backlog driven on the EO side?

Pam Huggins

We have a little better military MRO than what we expected. Now you know military though is very lumpy and tends to even itself out over a longer period of time, and very hard to project as well. So we’re being consistent with what we said last quarter.

Timothy Pistell

The other thing is people are starting to fly again. Not like they used to, but people are starting to fly again. We took our furloughs back and we expect everybody, we’ve got those work days back and people are out there working again and travelling a little bit. So there’s a little help coming there.

Operator

Your next question comes from Robert McCarthy – Robert W. Baird.

Robert McCarthy – Robert W. Baird

I too would add my congratulations on a really terrific quarter. With profitability in the Industrial segment, I think you can be sure well above what anybody was forecasting, and the reason I think you’re getting a lot of questions there is it’s hard to see how you engineering the sequential improvement from the prior quarter.

But I’ve been running the numbers on what you’re implying for the second half and Industrial North America where you just did 13.5% margin on a 15% sales decline, you’re looking at second half up almost 10% with operating margin no better than the December quarter. Similarly, International, the mid points would lead you to profitability that would be roughly the same as the December quarter.

And that I think you all know would be as unusual as the kind of sequential comparison that you just had in the December quarter. So what are we looking at? Are we looking at something that was truly unusual and can’t be repeated in the quarter or are we looking at very conservative forecasting on profitability?

Timothy Pistell

We really think that most of what we’ve done is sustainable. I think again, the one thing we’ve talked about, there was a certain amount of International, a certain amount of restructuring didn’t get done.

Robert McCarthy – Robert W. Baird

But those are all small.

Timothy Pistell

Right. Those are all relatively small. We think it’s sustainable, but on the other hand we think it was pretty darn good in performance, a pretty stellar performance. So to project a huge upside from there, we already have a very strong MROS. We talked about the kind of MROS we’re going to have in the second half.

We’ve done a tremendous job in this first half on the down side on the detrimental. We are going to be in the positive numbers in Q3 and Q4 and I think we had originally given you like plus 45%. We’re much higher than that right now.

Robert McCarthy – Robert W. Baird

The Industrial North American number is 69%.

Timothy Pistell

Exactly. So I think we’re about as far as we want to go on this. We’ve said it had an improvement. We put improvement. We’re doing well. So I think we don’t feel like we’re being conservative. We think we’re being realistic. We think we can deliver these numbers but we’re not going to push any harder than that.

Robert McCarthy – Robert W. Baird

Again we’re talking about aspirational operating margin or return on sales numbers and I think it would be useful, since you haven’t established a single fixed objective for the company, I think it would be useful to make sure that we understand exactly what you’re talking about. These averaging 15% operating margins, this is a number for the average of the segments I believe not an all in corporate number?

Donald Washkewicz

It’s for total Parker.

Pam Huggins

Segment operating income.

Robert McCarthy – Robert W. Baird

So would it include unallocated corporate expenses?

Pam Huggins

Corporate expenses would be below on a segment basis.

Robert McCarthy – Robert W. Baird

So it really is just the average of the segments.

Pam Huggins

That’s right.

Robert McCarthy – Robert W. Baird

Because as you know you don’t report an operating income number on the income statement per se, so there’s a little bit of disagreement on what we’re. So the relevant question for me with corporate expenses running around or unallocated expenses by our calculation running around 3% of sales, is there some possibility of cutting into that number as well as a means to improve? I don’t know what all is in there besides good will and amortization.

Pam Huggins

There are a lot of things that play into that number below. On corporate expenses, obviously we always try to keep it to no more than 1.5% of sales. But then you get into that other category and there’s things that can vary in there.

For example, this year you have pension expense which is in there which you know, that can swing pretty quickly.

Robert McCarthy – Robert W. Baird

How big is the negative impact of that year over year for this year?

Pam Huggins

I think just year to date it was about $24 million. For the year it will be about $50 million. And so next year, as you look out, that can swing pretty heavily as interest rates go up and as the market comes back, so that could have an impact. If you look last year, that was only about $58 million for the year. So that’s one of the things that unfortunately can swing on us.

Donald Washkewicz

Just a couple of comments on your initial question. We have been at the 15% or better North American in the past. We’ve been at that number or higher. In fact we’re up to 18% on Aerospace in the past. We have been at that number or higher in Asia in the past and Latin American in the past.

And as you know, the big drain or drag has been Europe in the past, and that’s what we worked on this last period between 9/11 2001 and today to try to get Europe up to where it needed to be. And frankly, we’ve had a 14% plus change in Europe before the whole collapse here. So we are working.

We think we’re going to pick up. Of course we’re not going to fall all the way back down to where we were. We’re going to pick up where we’re at and we’re going to keep driving that up which we can’t get there without Europe. We recognized that in early 2000’s and that’s why we up all the work and effort there.

Robert McCarthy – Robert W. Baird

So you’re trying to raise the floor there.

Donald Washkewicz

Exactly. So as we do that, there’s nothing here that I think is not possible. I think it’s very achievable, something that we’re all committed to do. This entire organization, as we talk about it a lot and we make sure that we’re measuring to that, and I think you’re going to see us back there in short order.

Pam Huggins

The big opportunity is right where Don is talking about. You can talk about these below the line numbers but really the opportunity is at the operation.

So at this time, we’re going to turn it over to Don for just a few closing comments.

Donald Washkewicz

Just a couple of comments for you. First of all I’d like to thank everyone for the nice congratulations. We’re pretty excited about the quarter. we’re excited about the way the year is developing and of course any time we can raise guidance that gets up pretty excited as well.

But what’s most important I think is the fact that we see these market segments and the order trends and the regions really starting to come back to life a little bit. Certainly we would love to see it come back stronger, but the good news is that it’s in a positive direction. So we’re encouraged, and we think it’s going to continue. We don’t think this is a short term aberration here.

So we’re going to continue to stay focused as a company on maintaining a strong balance sheet. We’ve been committed to that and I think we’ve done a great job. We’re close to 40% debt as you may recall. Our leverage at the beginning of the year, being down below 30% and almost 27% on a net basis is pretty remarkable in this very, very difficult time period.

So we’re going to continue to manage for cash and also we’re going to continue to on as we mentioned earlier with the restructuring activities. With respect to dividends, I mentioned this but I’ll just mention it again. Of course we’re coming up on a dividend increase, so we’re going to be reviewing that here shortly within the next quarter.

So we’re going to have to come out with something in the way of an increase on dividends. So that’s something we’re very excited about as well, the fact that we were able to make it through this very difficult period and still be able to increase dividends year on year.

So I think with some bright spots on our horizon, we’re certainly poised to emerge from this recession stronger than we’ve ever been before.

I want to thank everybody for their participation. We certainly appreciate your interest in our company, in Parker, and I’d also like to thank on the call, I know there’s a lot of Parker employees on the call, thank all the employees around the world for their continued commitment to serving our customers.

If you have any additional questions, Pam will be around for the balance of the day and so I’ll sign off and just wish you a good day. Have a great day.

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Source: Parker-Hannifin Corporation F2Q10 (Qtr End 12/31/09) Earnings Call Transcript
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