Parker-Hannifin (NYSE:PH) manufactures a broad line of motion control and industrial products serving a an array of end-markets across the globe. The company operates in four business segments, the size and growth of which are shown in the figure below (Parker operates on a July 31 fiscal year end):
Parker reports its industrial business in two segments: international and North America; however, the segments generally sell the same products although the mix may be slightly different. The two industrial segments are the company's largest in terms of revenue and operating profit, as shown the above figure. The international industrial business has been the company's fastest growing since 2007, logging cumulative growth of 31%. The Federal Reserve's broad dollar index has fallen about 9% over the same period, therefore it is likely a fair portion of the growth has been currency driven although international still compares favorably to domestic's 15% cumulative growth. Since fiscal 2007, the company has acquired about $1.2 billion of revenue with a large portion falling into the industrial segments. This compares with revenue growth in all segments of about $2 billion over the period, making it likely that over half the growth in industrial was driven by acquisitions.
Products in the industrial business mostly relate to the movement of fluids in order to control power in industrial processes and similarly electromechanical devices which also drive similar processes. For example, the company makes hydraulic actuators that will move a rod over a specific distance with varying amounts of force. Products are sold into a large variety of markets including oil and gas, chemicals, mining, construction and farm machinery, automotive, machine tools, aerospace, food processing, life sciences and microelectronics. About 50% of the North America segment's revenue is through distributors with the other half coming from direct sales.
Turning to the aerospace segment, the company reported a cumulative growth rate since fiscal 2007 of 18%, making the segment the second fastest growing of the company's four. Organic growth is likely higher than the international industrial segment due to less impact from currency and acquisitions. The segment generates less than one-fifth of the operating income of the combined industrial segments, therefore the contribution to the overall business is somewhat small.
Products in the segment include aircraft wheels and brakes, hydraulic systems, engine subsystems and fuel system components. Many of the products are quite similar in function to those found in the industrial segment, but are designed to aerospace specifications. About 65% of revenue is from commercial aerospace, with the balance coming from the military. Also, about 63% is OEM versus 37% maintenance, repair and overhaul (MRO).
The company's smallest segment at 8% of revenue is climate and industrial controls. The segment has been impacted by several weak end markets including automobile and residential construction leading to a revenue decline of 7% since fiscal 2007. Products are used as components in the manufacture of refrigerators and air conditioners as well as in fluid control applications.
One of the key indicators for Parker's business is the global purchasing manager's index (PMI) compiled by JPMorgan and published by Markit. The following chart shows the evolution of this index since 1998:
In October 2011, the PMI composite index hit its lowest level since August 2009 and the manufacturing subcomponent was especially weak coming in near a breakeven 50. The PMI signals expansion when above 50 and contraction when below. October was the third month in row where the manufacturing component of the PMI was near breakeven. All major regions of the world have declined from the cycle highs reached earlier in 2011 but the eurozone has been the only region in outright decline with a reading of 46.5 on the composite PMI down from 49.1 in September. Japan on the other hand just exceeded 50 for the first time since the earthquake in recent months.
The industrial weakness implied by the global PMI index is corroborated by the recent eurozone and U.S. industrial production readings of -2.0% and 0.2%, respectively for September. In China, electricity usage, a proxy for industrial activity, has steadily cooled from a peak growth rate of 16.2% in June to 9.3% in October.
Growth in revenue passenger kilometers flown serves as a good proxy for growth in the aerospace industry and in turn for that segment of Parker's business. The chart below shows the year-over-year growth rates in this metric since 2006 as reported by the IATA:
The trend is running in the neighborhood of 4% annually, although the recent recession has shown the volatility of growth. Data for September continue to show strong growth at 5.6% year-over-year. One negative for the industry is the recent modest decline in freight tonne kilometers which are no higher than the peak in 2008 and down about 2.7% year-over-year through September.
Parker's climate and industrial control business is reliant on a few key markets including automobiles, heavy trucks and new homes. Global car and commercial vehicle production peaked in 2007 at 73.3 million units before falling to 61.8 million in 2009 and then rising to 77.9 million in 2010 according to the OICA. Although there has been a significant rise, the data show production in China has more than doubled while the U.S. and Japan have shrunk. Given the higher accessory content of cars destined for developed markets, it is likely that Parker's climate business has suffered due to this trend.
Turning to new home construction, the data show a very significant falloff from the peak in 2006 of 1.28 million homes to the September 2011 run-rate of 313,000 which has been another headwind for Parker's climate business.
Parker's quarterly reported order rates, another indicator of short-term conditions, are shown in the graph below:
Growth rates in orders has been consistently slipping across Parker's segments although industrials N.A. did show a slight uptick last quarter. However, the climate and industrial controls business slipped into the negative. As of fiscal 1Q12, the company is guiding to revenue growth of 6.5% to 10% in industrial N.A., 5.9% to 9.4% in industrial international, 7.1% to 10.1% in aerospace and 1.1% to 4.6% in climate and industrial controls.
In the longer term, the general pattern of development for Parker's major markets should be along the course of industrial production and GDP. The company has benefited from the emergence and industrialization of China and other Asian countries as well as Latin America. At some point, the growth curve will flatten in those regions and Parker's growth rates will recede. However, the timing of that shift could be some years away. The company's markets will continue to follow the prevailing business cycle implying that growth will not be in a straight line.
An economic profit model will be used to put valuation parameters around Parker's stock. The following table presents Parker's adjusted invested capital:
The company's fixed assets are predominantly buildings and manufacturing equipment. Parker maintains 311 manufacturing plants, 102 distribution centers and 185 sales and administrative offices worldwide. The majority of locations or 298 facilities are in North America while 172 are in Europe, 99 are in Asia Pacific and 29 are in Latin America for a total of 598 facilities. A portion of the properties are leased and all rental expense has been capitalized.
The company's fixed asset base is well depreciated on an accounting basis. Parker does not segment accumulated depreciation by asset category, but given the long life of buildings its equipment has likely been depreciated by greater than 80%. This is not necessarily a cause for a concern, but capital expenditures should be monitored closely in the future to see if the company is falling behind on investing in its business.
Other expense capitalizations include R&D, marketing and advertising spend. R&D expenses are disclosed, but the two latter categories are estimated based on a percentage of SG&A and sales, respectively. The capitalization periods are four, three and seven years, for each category in order.
Parker's purchased intangibles are primarily customer lists although there are small amounts for trademarks and patents as well. Finally, the positive contributors to other net assets are large amounts of inventory and accounts receivable.
The following table shows a segmentation of estimated run-rate gross income:
Net income of $1,114 million million excluding investment income conforms to actual results for fiscal 3Q11 through through 1Q12 and First Call estimates for fiscal 2Q12 with a small adjustment made to account for diluted versus basic shares. In the three historical quarters of the reference period, Parker produced relatively clean earnings - there were no material adjustments made for one-time items or the like.
Within the remaining elements of gross income, depreciation is of note due to the declining accounting asset base of the company. Future years should see depreciation continue to decline implying a certain amount of growth in net income on the order of about 1% per year from this source. Capitalized expense add-backs constitute the remainder of the gross income accounts with R&D being the largest at 17% of gross income. A $12 million adjustment was made for the increase in the LIFO reserve over the past year which is otherwise deducted from net income. This adjustment also entails adding back the excess value of inventory to invested capital.
The figure below shows the inputs for the calculation of the company's returns on capital in IRR terms based on run-rate gross income and invested capital:
Parker is currently generating an IRR of 14.5% on its investments or about 2.6x the inflation adjusted cost of capital. The modified IRR of 12% assumes 45% of gross income is reinvested to maintain the existing business. Additional capital invested for growth is discussed below. For a mature business, Parker's rate of return is quite strong and likely as well as can be expected.
The following chart shows historical adjusted returns on assets for the company:
Adjusted returns on assets are currently at a multi-year peak after having fallen to about 6% during the recession. Returns coming out of the 2001 recession were similarly low, if not worse. The chart also shows that income fell by about 50% during the most recent recession, before recovering strongly.
Capitalization and Implied Income
The table below shows the current financial structure of the company, with the equity trading at $80.86:
Parker is majority capitalized by equity with debt and the company pension plan also being important sources of financing. The pension plan liability represents the projected benefit obligation as found in the financial notes, instead of the accumulated benefit obligation because the former better represents the true liability to the company, in my view. About 20% of the capitalization of the company is in debt and debt-like liabilities.
Using Parker's capitalization, expectations about future profitability can be implied from the market. Ultimately this expectation can be reduced to a future level of gross income generation given static returns on capital. However, it is more insightful to segment market expectations between the existing level of gross income, which could be referred to as the existing business and a certain growth rate over a series of years. Sometimes that implied growth will be zero and the market will either be implying no growth or a decline in profitability.
The following table shows a breakdown of value between current profitability and growth for the company:
For Parker, the value of the firm is somewhat above that which is consistent with existing profit; implying some level of future growth. With a firm value of $15.8 billion and current run-rate gross income as defined above, the company's market valuation is implying about 2.5% growth for 10 years. The company is expected to grow invested capital as defined in the model at about a 1% rate over the next year, therefore the company will need to expand returns on capital over the short-term to keep track with the growth expectation. It should be noted that the number of years of growth and the growth rate are in a sense interchangeable, whereas the company could grow for longer at a lesser rate, or for a shorter time at a higher rate.
Parker has been a major beneficiary of the expansion of global industrial production due in part to the rise of China, India and other emerging market players over the past two decades. The company has also taken advantage of the global mining boom as many of the company's hydraulic products are sold into the construction machinery industry. A final important market trend is the boom in military and aerospace, the former driven by the U.S.'s 21st century expeditionary operations and the latter driven in large part by the build out of emerging market commercial aviation fleets. Over the longer-term it should be recognized that these trends will flatten out regardless of any short-term fluctuations.
A look at short-term indicators such as PMIs, industrial production and home sales gives some cause for concern about the business outlook for Parker, although airplane passenger miles are holding up better. Another factor for Parker is the flattening of U.S. defense spending and the possibility of reductions beyond those funds earmarked for expeditionary operations as part of a budget deficit reduction plan. Finally, although still relatively strong in most areas, Parker's order rates have been flattening in recent quarters.
From a financial perspective it is clear that Parker's business is in peak form. Returns on assets are near or at cycle highs and net income is at a record. The company is generating a very respectable IRR of 2.6x its cost of capital. However, one thing that is clear from Parker's history is that it is a cyclical business and its stock should be priced as such. For the stock to be fair value it should reflect that in one of three years net income should recede to about half its peak level. Having some growth embedded in the stock is fair as long as that growth is from a more normalized earnings level, which Parker's is not - in fact the stock is fully pricing today's earnings, which are likely cycle highs.
In my view, the market had the valuation right on Parker in the August to October 2011 timeframe but at the current price, the stock is not attractive. Investors that believe future growth can be substantially greater, the cyclicality of the business will become more muted or a combination of both may find greater comfort in holding the stock.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.