In my portfolio, I allocate 12.5% to the industrial sector. I currently own companies like Emerson Electric (NYSE:EMR) and General Electric (NYSE:GE). Currently, I am not looking for additional companies in this sector. However, if I find an attractive opportunity, I will initiate a position as I am still accumulating capital and assets. It is also important to make independent research on companies, as it helps me to be familiar with them, and be able to buy shares on short notice when they are attractively priced.
When I published my portfolio, one of the comments recommended me to look at Parker Hannifin (NYSE:PH). The first thing I did was to look at the dividend champions list made by David Fish. I found out that Parker is another example for those "boring" companies, who don't sell "sexy" products. Instead, they sell industrial products that most people don't even know where they are used. The company is doing it so successfully that it managed to raise earnings and therefore dividends for over 50 years. That gave me incentive to look into the company. The strong results published for Q2 2016, convinced to me to prioritize my analysis, and to look whether I should initiate a small position in the company.
Parker-Hannifin is a manufacturer of motion and control technologies and systems, including fluid power systems, electromechanical controls and related components. It is also a producer of fluid purification, fluid and fuel control, process instrumentation, air conditioning, refrigeration, electromagnetic shielding as well as thermal management products and systems. Its motion control technology is used in the products of its three key business segments: Industrial, Aerospace and Climate & Industrial Controls.
When I look at the fundamentals of PH, they are a little bit misleading. If I look at the past decade, there seem to be overall growth in the main metrics. However, if I look at the past 5 years I see declining revenue and EPS. This is troubling, and the reason is a turnaround process. Usually I wait for a company to complete the process as companies like McDonald's (NYSE:MCD), Procter & Gamble (NYSE:PG) and IBM (NYSE:IBM) showed us that turnaround processes can take longer than initially expected.
The graphs above show the revenue growth over the past 5 and 10 years. The numbers are pretty disappointing in my opinion. The revenue that grew quickly from 2006 to 2011 stalled, and the CAGR over the past 10 years is just 3%. Currency headwinds and the turnaround process are the reasons for that, , but CAGR of less than 1% for the past 5 years is disappointing. The growth in the Aerospace sector should be able to drive revenue forward in the future, but at the moment it doesn't look very promising.
EPS is somewhat different. The company through buyback of its shares decreased the share count in a respectful manner over the past decade. Together with cost cutting and high margins, the company managed to grow its EPS by CAGR of 6.5% over the past decade. This figure takes into consideration the 1.85% CAGR of the EPS in the past 5 years. The problem is that the decline in the EPS is a continuing process, and the outlook for 2016 shows EPS of around $6.12. The turnaround should really have its impact in 2017 as analysts predict double digits growth in EPS. However, as I said above, I take these predictions with a grain of salt as turnarounds can be hard to predict.
The reduction of the shares outstanding allowed the company to grow its EPS much faster than its revenue. In addition, the company increased the quarterly dividend at an even faster rate. The CAGR of the dividend is 12% for the past decade, and it slowed down to 7% over the past 5 years. HP has an amazing track record of 59 years of growing distribution. However, the payout ratio is climbing over the past 5 years together with the dividend yield. I believe that as long as the turnaround is in process, the dividend raises will be more modest. The company offer medium yield which is totally sustainable in my opinion.
While the company managed to reduce its share count by 25% over the past decade, and increase the dividends by over 300%, it didn't come without cost. The debt of PH grew very quickly over the past decade. The debt to equity ratio is still not too high at 0.7 which is similar to peers like United Technologies (NYSE:UTX), and lower than other peers like Boeing (NYSE:BA). However, it is important to monitor the debt burden at these levels, as the balance sheet is more levered than it used to be.
In my opinion, the fundamentals of PH are not that appealing. If I ignore that turnaround process that the company is going through, I see a great company that knows how to reward its shareholders. However, the turnaround must be taken into consideration and with the current fundamentals, investors should be rewarded with lower than peers valuation, that will justify buying the stock in the middle of the turnaround.
After I looked at the deteriorating fundamentals over the past 5 years, I am looking for a valuation that will suit a company than in the midst of a change. The current P/E ratio is 16.7 and forward P/E is 16.3. I believe that a company that suffers from declining EPS should be valued cheaper. Look at the graph below, while EPS is contracting and the trend is still in motion the forward P/E is actually expanding while the P/E ratio is only 5% that it used to be in 2011, while the company was growing rapidly.
Other metrics like P/S and P/B are also at around the same level they were back in 2011. In 2011, the stock market was much more optimistic, commodities were trading for higher prices, and the whole industrial was far more bullish on its future. Now, the industrial sector is in a worse position, and PH is going through a turnaround yet the valuation is the same. For me it doesn't make any sense.
The valuation that seems more fair to me is around where it was before the Q2 results. I think that the stronger than anticipated quarter made investors too optimistic, and it doesn't reflect the real value. The forward P/E in my opinion should be around 13.5 to 14 in order for me to initiate a position. With mediocre fundamentals and inappropriate valuation, the company must some very good growth opportunities to justify the current valuation.
The aerospace sector is a growth prospect for PH. The EPS is forecasted to decline in 2016, but the aerospace sector is performing well over the first half of 2016. PH actually managed to grow its operating income by over 15%. The aerospace sector is still pretty small, but its growth can propel help propelling the EPS of the entire firm. However, it is important to note that the amount of orders actually decreased by 10% from a year ago, and if it becomes a trend, it will be a problem.
Another important aspect is the diversification. Not only that PH has its aerospace segment, its diversified industrial segment has significant presence globally. In the past six months 45% of the revenue and operating income from the diversified industrial sector came from outside of North America. The weakness in the emerging market is felt, but PH manages to maintain large exposure to the international market. The company has some diversification globally together with diversified products.
Income seeks should also take into consideration that the company is still making close to $1 billion in FCF. If you look for income, FCF must be important for you. The firm is still a money making machine with FCF yield of over 7%. In addition, the company is highly profitable and its margins are at the same level they were a decade ago when it managed to grow its EPS. Moreover, the turnaround process that will move some facilities to cheaper countries will help PH in expanding its margins.
Another important aspect to consider is the legacy of PH. The company has been raising EPS and dividends for the past six decades. Over the years it sailed through several crises, and always managed to go forward. It is a blue chip as possible, and therefore I believe it will succeed in its turnaround process. At the end of the day, PH is a company with great legacy, that managed to grow EPS over the long run, highly profitable and create a lot of FCF, and sometimes that all we need.
Turnaround is always a risk, especially when valuation is taken into consideration. The current valuation means that investors believe that the turnaround will succeed. I think it will succeed as well, but I don't know when. If it is delayed by several more years, investors will suffer from lower than average returns, and lower than average dividend growth rate. Therefore, it can be a big risk for the returns and income in the medium term.
I stated it above, but it should be emphasized. The debt burden is much larger than it used to be. PH now has a balance sheet that carries much more debt. This debt was used to fund operations, buyback shares and pay dividends. As the FCF cannot cover both the dividends and the buybacks, debt is being used, but it cannot continue forever. The company must achieve higher FCF, or it won't be able to maintain the buybacks that support the EPS growth.
The dividends are 70% higher today than they were in 2011. However, the EPS is still at the same place it was back then. Together with the higher debt burden, and the constant need of share repurchases to increase EPS, I find out that PH is a company that is getting closer to its maximum capacity. The dividend cannot grow much more, and especially not as fast if the company is willing to maintain comfortable payout ratio of around 40%. Buybacks won't be able to continue without debt, which is already much higher than it used to be, yet they are necessary for the EPS growth. It is a pretty complicated situation, and again everything depends on the success of the turnaround and the moment when EPS will finally grow again.
The current global environment isn't very compelling for industrial companies. Like Caterpillar (NYSE:CAT), and other peers, PH suffers from the cyclical commodities market. In this market, it will be much harder for the firm to increase prices, especially in the international segment. The strong USD makes price increases almost a necessity, yet the environment will make it harder to execute.
In my opinion, PH is not attractive enough for me to initiate a position right now. The fundamentals are declining, the opportunities are there, but they rely on the success of the turnaround in 2017. The risks from continuing stagnation are not priced into the stock, as the valuation isn't fair in my opinion.
Sometimes, when I look at companies that I want to buy, I sell put options, but in that case it isn't worth. I believe that the company will be fairly valued at $85, but the premium for selling puts for January 2017, are too low for me at the moment. Moreover, I believe that UTX is a much more compelling peer, and probably my favorite choice in the sector. If I held it, I would keep it, but at the current prices, I will not initiate a position.
Disclosure: I am/we are long CAT, MCD, IBM, PG, PG, EMR.
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.