Parker Hannifin: Buy, Sell Or Hold?

Parker Hannifin

Parker Hannifin (NYSE:PH) has performed very well in 2013 as its stock gained 40%. This is not surprising considering the overall equities market performance during that time. Many companies' stock increased at similar or higher rates resulting in many companies with high valuations that are unjustified when analyzing fundamentals and future potential growth. Lets get into Parker's fundamentals to see if their stock price is justified and see where the stock is headed in the future.

Aerospace:

In 2013 Aerospace total sales of $2.3 billion was 17% of PH's total sales, but due to high engineering development expenses related to acquisition and integration, operating margins are well below desired levels. Over the past few years commercial aerospace made several "WIN's" (business agreements) amounting to about $30 billion in future sales. This along with current contracts will be a catalyst for significant sales growth going forward. Also, as engineering development costs decline, operating margins will also increase to an estimate of 16%. The following is an example of growth for Aerospace in the next five years assuming a 16% operating margin and 8% growth rate.

Note: Sales and income in millions

Note: Assuming PH continues to buy back roughly 1.4% of shares.

Aerospace 2013 2014 2015 2016 2017

Net Sales

$2,268 $2,449 $2,645 $2,857 $3,085
Operating Margin 12.36% 16% 16% 16% 16%
Operating Income $280.29 $391.86 $423.21 $457.07 $493.63
EPS from Segment 1.88 2.66 2.92 3.20

3.51

Click to enlarge

Based on the information from Parker's latest financial report I expect earnings per share from Aerospace to increase at a 9.6% growth rate which could be a low estimate considering their new business deals and expected reduction in operating costs going forward.

Diversified Industrial:

Starting in 2014 the Climate and Industrial control and Industrial segments consolidated as the Diversified Industrial segment. This segment is separated further between North America and International. The North American segment has been the major success for PH in the past. Accounting for 45% of total sales in 2013, the North American industrial segment has an operating margin of 15.78% including climate and industrial control. However, sales only grew 0.2% in 2013 but are expected to increase at a much higher rate going forward. Parker made several acquisitions in 2013 to position itself to enter new markets and develop more innovative products.

One market Parker is increasingly becoming more involved with is energy, specifically natural gas. Parker is a leader in hydraulics, fluid and gas handling, climate control, sealing and shielding and many other motion control technologies. As the U.S. becomes more energy conscious, demand for efficient and effective excavating equipment will grow significantly. PH is already involved with engineering certain equipment for hydraulic fracturing that is much lighter and easily mobile. Exporting natural gas overseas has already been approved and is likely to start in 2015; once the U.S. begins to export its produced natural gas, demand for Parker's engineered products will be high. This will be a large business for Parker in the future because there will always be a demand for a more efficient piece of equipment that meets the needs of output demand and the general publics' safety concerns. These products carry margins well above Parker's highest levels.

The international segment experienced declining sales growth and operating margins in 2013. International operating margins have always been a concern for investors as costs overseas continue to increase. During 2013 Parker Hannifin divested several plants in Europe and implemented other synergies to increase operating margins. This is great news for investors as international sales are more than 37% of PH's total sales.

The following is an example of North American Diversified Industrial growth:

Note: Sales and income in millions

Note: Assuming an 12% growth rate and a 0.5% increase in annual operating margins

North American 2013 2014 2015 2016 2017

Net Sales

$5,880 $6,586 $7,376 $8,261 $9,253
Operating Margin 15.77% 16.27% 17.77% 18.27% 19.77%
Operating Income $927.45 $1,072 $1,200 $1,344 $1,506
EPS from Segment 6.22 7.29 8.28 9.41

10.69

Click to enlarge

The following is an example of International Diversified Industrial growth:

Note: Sales and income in millions

Note: Assuming an 4% growth rate and a 1.2% annual increase in operating margins

International 2013 2014 2015 2016 2017

Net Sales

$4,868 $5,062 $5,265 $5,476 $5,695
Operating Margin 11.99% 13.19% 14.39% 15.59% 16.79%
Operating Income $583.75 $667.85 $694.56 $722.34 $751.24
EPS from Segment 3.91 4.54 4.79 5.06

5.33

Click to enlarge

PH Stock Price:

What does this all mean for the stock price? Well even though Parker had a weak financial performance in 2013 compared to 2012, it still enjoyed a 40% gain in the stock market. This gain was mostly attributed to the momentum in equities market as well as the future potential investors saw with PH's 2013 activity. Going forward the momentum from 2013 is not sustainable; but Parker's potential financial performance along with its future potential will keep the stock rising and investors happy.

So lets crunch the numbers. Not including other expenses and taxes Parker's operating earnings per share in 2013 was $12.01 per share. This represents a P/E ratio of 10.2 on its operating earnings. Below is the calculation of EPS, P/E ratios and stock price for the years 2013 through 2017.

Note: Estimated P/E is assuming current stock price at future earnings to represent the discount in the stock price if it continues trading at current levels.

Parker Hannifin 2013 2104 2015 2016 2017
Operating EPS 12.01 14.23 15.41 16.70 18.08
P/E 10.20 8.61 7.95 7.33 6.77
Estimated Stock Price 122.45 147.74 163.03 180.16 199.12
Click to enlarge

The stock is currently trading at a P/E ratio of 18.14 which is in the top quartile of the diversified industrials industry. Before 2013 Parker was undervalued and with the run its had over the past year it will require organic growth to continue making large gains. I believe PH will deliver on its promises to perform well and grow at 12%. This analysis was made under the assumption that PH has a growth rate of less that 12% and sustains the same growth through 2017. This model could be adjusted to anticipate increasing returns over the years which means the stock price targets I provided are low. Currently the stock is trading at its justified value and has had a nice run this past month; therefore, I would like to see a pullback of 3-5% before I buy. I will continually add more to my position as the stock dips lower and as momentum pushes the stock up from my original purchase price.

2013 was a pivotal year for Parker as they reorganized segments of their business either through acquisitions or divestitures. Parker also won new projects in both its Aerospace and Diversified Industrials segments as mentioned in this article. 2013 wasn't the strongest financial year for Parker but they positioned themselves well for the future. Expect large growth in this the Diversified Industrials industry in 2014 led by Parker Hannifin's investment in the future.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.