Parker-Hannifin (NYSE:PH) is the world's leading diversified manufacturer of motion and control technologies and systems, with approximately half of its business coming from maintenance, repair, and overhaul operations, mitigating the cyclical nature of its end markets served to a degree compared to other industrial companies. We're big fans of the firm's free cash flow generation and return on invested capital, as it has generated more than $1 billion in free cash flow in each fiscal year since 2010. Free cash flow conversion has been nothing short of incredible, with the company consistently generating free cash flow greater than 100% of net income. A focus on productivity initiatives such as simplification and strategic supply chain improvements are expected to help expand operating margins to 17% by fiscal 2020 from 14.5% in fiscal 2015, and this margin expansion is anticipated to fuel an 8% CAGR in EPS through 2020.
Even though Parker-Hannifin's MRO revenue offsets the cyclicality of its end markets served to a degree, investors must be cognizant of the fact that such cyclicality exists in the source of demand for the firm's products. Weakness during the trough of economic cycles could impact Parker Hannifin's free cash flow generation. We're not particularly fond of the company's robust share repurchase program, in which it bought back ~$1.4 billion in shares in 2015 and ~450 million shares thus far in 2016, considering shares are not exactly attractive to us at recent price levels (remember buybacks are only value-creating when they are executived at a discount to the company's intrinsic value). We feel this cash may have been better returned to shareholders in the form of dividend increases, which the firm has plenty of capacity for.
Parker-Hannifin's dividend track record is already something few other companies can lay claim to; the company has raised its dividend for ~60 consecutive years, placing it in the top 5 for longest records in the S&P 500. It has increased its payout an impressive 150% in the past five years, and now has an attractive yield of ~2.2%. The firm's dividend potential is exemplary, and we are anticipating healthy growth in the payout moving forward. Income investors may want to pay very close attention.
Parker-Hannifin's Investment Considerations
• Parker-Hannifin is the world's leading diversified manufacturer of motion and control technologies and systems. There remains ample opportunity for growth in this $120+ billion global market. The firm has increased its annual dividends paid to shareholders for nearly 60 consecutive fiscal years. It was founded in 1918 and is headquartered in Cleveland, Ohio.
• When it comes to industrial entities, Parker-Hannifin is among the strongest. It has 20% share in the markets it serves and boasts top quartile performance in free-cash-flow generation and return on invested capital. There aren't many companies better positioned.
• Parker-Hannifin is expecting continued end market weakness in fiscal 2016, and sales are projected to drop in the year. The firm's business realignment expenses will negatively impact adjusted earnings per share from continuing operations by ~$0.60, resulting in guidance in a range of $6.20-$6.40. Our forecasts are in line with management expectations.
• Parker-Hannifin generates roughly half of its business from MRO (maintenance, repair, and overhaul), which is a less cyclical and higher-margin channel. The company is targeting 17% segment operating margins by fiscal year 2020. Its free cash flow conversion (free cash flow > net income) is consistently fantastic.
• Investors should keep a close eye on Parker- Hannifin's operating margins, which have expanded nicely as of late due in part to the firm's Win Strategy. Adjusted segment operating margins near 15% during the third quarter of fiscal 2016 were noteworthy.
Economic Profit Analysis
In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.
The gap or difference between ROIC and WACC is called the firm's economic profit spread. Parker-Hannifin's 3-year historical return on invested capital (without goodwill) is 22.8%, which is above the estimate of its cost of capital of 9.9%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT.
In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Companies that have strong economic profit spreads are often also solid free cash flow generators, which also lends itself to dividend strength. Parker Hannifin's Dividend Cushion ratio, a forward-looking measure that takes into account our projections for future free cash flows along with net cash on the balance sheet and dividends expected to be paid, is 2.4 (anything above 1 is considered strong).
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Parker-Hannifin's free cash flow margin has averaged about 8.2% during the past 3 years. As such, we think the firm's cash flow
generation is relatively STRONG.
The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Parker-Hannifin, cash flow from operations increased about 9% from levels registered two years ago, while capital expenditures fell about 19% over the same time period.
Through the first three quarters of fiscal 2016, Parker Hannifin reported cash from operations of ~$681 million and capital expenditures of ~$111 million, resulting in free cash flow of over $570 million, a nearly 10% decrease from the comparable period of fiscal 2015.
This is the most important portion of our analysis. Below we outline our valuation assumptions and derive a fair value estimate for shares.
We think Parker-Hannifin is worth $104 per share with a fair value range of $83-$125. Shares are currently trading at ~$112, in the upper half of our fair value range. This indicates that we feel there is more downside risk than upside potential associated with shares at the moment.
The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance.
Our forecasts for fiscal 2016 are consistent with management's guidance for sales to be down materially due to continued end market weakness. Earnings are expected to drop at a slower rate than revenue in the year as optimization initiatives should mitigate bottom-line declines. In the following years, we are anticipating a rebound in both revenue and earnings as Parker Hannifin's end markets begin to balance.
Our model reflects a compound annual revenue growth rate of -0.5% during the next five years, a pace that is higher than the firm's 3 - year historical compound annual growth rate of -1.1%. Our model reflects a 5-year projected average operating margin of 13.6%, which is above Parker-Hannifin's trailing 3-year average.
Beyond year 5, we assume free cash flow will grow at an annual rate of 2.3% for the next 15 years and 3% in perpetuity. For Parker-Hannifin, we use a 9.9% weighted average cost of capital to discount future free cash flows.
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $104 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.
Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Parker-Hannifin. We think the firm is attractive below $83 per share (the green line), but quite expensive above $125 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Parker-Hannifin's fair value at this point in time to be about $104 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Parker-Hannifin's expected equity value per share over the next three years, assuming our long-term projections prove accurate.
The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.
The expected fair value of $133 per share in Year 3 represents our existing fair value per share of $104 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we 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.