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Executives

Pam Huggins - Vice President and Treasurer

Don Washkewicz - Chairman, President and CEO

Tim Pistell - Executive Vice President and Chief Financial Officer

Analysts

Jeff Hammond - KeyBanc Capital Markets

Nigel Coe - Deutsche Bank

Alex Blanton - Ingalls & Snyder

Jamie Cook - Credit Suisse

Mark Koznarek - Cleveland Research

Dave Raso - Citigroup

Ann Duignan - Baer Sterns

Andy Casey - Wachovia Securities

Ana Recinos - UBS

Eli Lustgarten - Longbow

Daniel Dowd - Sanford Bernstein

Robert McCarthy - Robert W. Baird

Parker Hannifin Corporation (PH) Q3 2008 Earnings Call April 22, 2008 10:00 AM ET

Operator

Good day, ladies and gentlemen, and welcome to the Parker-Hannifin Third Quarter 2008 Earnings Conference Call. My name is Stacey, and I will be your moderator for today. At this time, all participants are in a listen-only mode. We will be facilitating a question-and-answer session towards the end of this conference. (Operator Instructions). As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the presentation over to your host for today's call, Miss. Pam Huggins, Vice President and Treasurer. Please proceed, ma'am.

Pam Huggins - Vice President and Treasurer

Thank you, Stacey. Good morning everyone. This is Pam Huggins speaking just as Stacey said. I'd like to welcome you to Parker-Hannifin's third quarter 2008 earnings release teleconference.

Joining me today is Chairman, President and Chief Executive Officer, Don Washkewicz and Executive Vice President and Chief Financial Officer, Tim Pistell.

Prior to proceeding to the earnings release, please allow me to address a couple of administrative matters. First, for those of you online, you may follow along with the PowerPoint slides that have been presented. And for those of you not online, the slides will be posted on the Investor Relations portion of Parker's website at phstock.com.

Second, as is customary, I would like to call your attention to Slide number 2, which is the Safe Harbor disclosure on forward-looking statements, and again I ask you to read this statement in its entirety if you haven’t already done so.

Third, moving to Slide number 3, this slide is required, indicates that 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, the Chairman, President, and Chief Executive Officer will provide highlights for the quarter. Second, I'll provide a review including key performance measures of the quarter, concluding with the revised outlook for fiscal year 2008.

The third part of the call will consist of the standard Q&A session. And as a reminder, please ask one question at a time. You can always get back in the queue. In this manner, everyone will have a chance to participate. And for the fourth part of the call today, Don will close with some final comments.

So, at this time, I'll turn it over to Don and ask that you refer to Slide number 5 titled, Third Quarter Highlights.

Don Washkewicz - Chairman, President and CEO

Thanks Pam, and good morning to everyone on the call. Just a few comments and then Pam will return for a more detailed review of the third quarter.

First of all, I'd just like to say that I am very pleased with the strong performance this quarter. We are certainly on track for another record year for sales and earnings at Parker and by the way this is our fifth year in a row now where we have posted record sales and earnings for the company.

We see an up strength that for the balance of the year to significantly increase our guidance for the remainder of our calendar year moving our guidance to 5.40 to 5.60 per share.

Our record results this quarter again highlight Parker’s new balance. Our industrial sales outside of North America made up over half of our revenue for the quarter and today we have a better balance in sales and margins than ever making us less exposed to regional economic cycles. We are very pleased with the ongoing growth in Europe, Asia, and Latin America. All of the regions outside of North America right now are doing very well for Parker.

Our organic growth in Industrial International Segment during the quarter was about 8.4% and again that’s a very strong performance. In fact the industrial international sales grew for the tenth quarter in a row. So we are very pleased with that.

Our operating margins in the quarter for our international business continue to exceed that from North American. As you can see this has been a seven year work-in-progress for the company. Our European team has been working very hard on this for the past seven year, has done a very excellent job executing on our comprehensive margin improvement strategy. Our operating income in our Industrial International Segment increased nearly 35% compared to the same quarter one year ago.

So overall the results demonstrate that even with the challenging economic environment in the United States, we continued with our record performance. This is the result of the fundamental and structural changes we have made in Parker since 2000, when we launched the Win Strategy and which we will continue to make going forward.

It's clear to us that the Win Strategy has helped Parker make become more flexible and better able to react quickly so that we continue to perform during slower growth periods. All of this is being driven by our employees with continued execution of the strategy.

The Win Strategy of course all of you know, is a road map for operational excellence and growth at Parker and has proven effective across the economic cycle. And I think that’s most evident when you look at today's results.

Lastly, just a couple more points. Organic growth continues to be very healthy exceeding 4% this past quarter despite the markets in North America that are in recession.

Cash flow from operations remains very strong nearly 10% of sales, certainly this is going to give us the ability to continue to grow the business going forward. We are leveraging our cash flow to selectively add advanced technologies to our portfolio. Recent acquisitions that I am sure you have noticed have added about 270 million in sales and that gives us about a $0.5 billion in sales through acquisitions for the fiscal year. And that’s pretty much on target for the company. We are targeting about 5% of sales.

Earnings per share lastly are up over 25% and of course this is the main driver for our share price. So we are very pleased with that.

Just some comments on some markets; orders were up over 9%, as you have seen in the release in the quarter versus a year ago with particular strength coming from our Industrial International and Aerospace Segments.

Just another thing, I want to point out is that our distribution remains very strong and that represents about half of our industrial business and we continue to see strength in this channel and expect continued strength going forward.

Some of our North America OEM markets continue to been in recession as expected, such as automotive, heavy duty truck, light truck, residential air conditioning, semicon, light construction. We've talked about these in the past and as you have can see here they continue to be in recession. They have been performing at this level for as quite some time and so we are hopeful that once they return to more normal growth levels that we should be in a position to benefit from that future time.

So with that, I am going to turn this back over to Pam for some additional detail.

Pam Huggins - Vice President and Treasurer

Thanks, Don. For more detail on the quarter please reference Slide #6 and I will begin by addressing earnings per share for the quarter. Earnings per share for the third quarter came in at $1.49, that's represents a 25% increase over the $1.19 in the third quarter last year.

Moving along to slide #7; the earnings growth on a consolidated basis in the quarter versus the same quarter a year ago is the result of the following: First, revenues in the quarters increased 14% mainly due to the Industrial, International, and Aerospace segments with revenues up 32% and 8% respectively. Gross margins improved by nearly a percentage point over last year and selling general and administrative expenses increased as a percent of sales, declining to 10.9% from 11.1%.

Also lower outstanding shares mainly, is the result of the accelerated share repurchase program which we complete in November contribute about $0.05 in the quarter. These higher earnings as a result of these items that I just mentioned there were offsets. The offsets were lower CIC segment operating income, obviously due to the exposure in the North American soft markets such as auto, heavy duty truck and residential construction.

Higher interest expense, mostly due to the result as higher dept, due to acquisitions and share repurchase program that I just mention that we completed in November as well. As you recall some of that was finance with commercial paper. As a percent sales however, compared with last year interest expense is flat.

Higher other expense as result of income items last year that didn’t repeat this year such as gains on the sale of real estate. And then higher taxes due to increased income, which is good thing, partially offset by lower tax rate.

Just to summarize this puts and takes from the third quarter on a per share basis versus the year ago, operating income contributed $0.31. Less outstanding shares, contributed $0.05 and that was all offset by higher corporate, general and administrator expenses of $0.03. Additional interest expense of $0.01 and higher other expenses $0.02. Netting these items, you can see that the earning were quality earnings, clearly the result of better performance in the quarter.

Moving to Slide #8, addressing sales, you can see sales for the quarter increased 14% to 3.2 billion from 2.8 billion last year. Of the 14% sales growth, 4% was organic, 4% as the result of the acquisition and 6% is the result of the currency and obviously mainly the euro because of our business in Europe.

Moving to Slide #9, the strong growth in the quarter is the result of continued industrial and market strength with international organic growth of 8% and this was led by all three regions Asia, Latin America, and Europe. So distribution continues to do well and the aerospace business has continued to increase their growth rate throughout the years supported by healthy orders. And that’s up against tough comparisons from last year.

Acquisitions continue to contribute to sale of 4% for the quarter and that equates to 111 million for the quarter and 247 million year-to-date. And of course Parker continues to make progress in emerging markets.

Moving to Slide #10, focusing on segments, starting with North America. Most notable on this slide is that in spite of several soft markets North American third quarters sales are up 4%, 2% organic. This is an improvement over last quarter's organic growth of 1%. So in spite of a challenging North American economic environment, operating income for this segment is ahead of last year. This is the result of diversifying the business continuing to make successful acquisitions and of course execution on the Win Strategy initiative.

Moving to Slide #11, continuing with Industrial Segment moving international; noteworthy here is that currency is becoming the larger contributor to the sale 15% for the quarter, again due mainly to the strong euro and the weakening of the dollar. Our organic growth continues at a healthy pace 8% for the quarter and against tough comparison a year ago. Acquisitions add 9% to sales in this segment, and most notable in this segment this quarter is that margins as a percent of sale were 16.1% versus 13.8% a year ago a 230 bases point improvement. So international continues to perform well across the various markets that Parker serves. The volume improvement is broad-based across all the major regions Germany, Italy, France and the Scandinavian Countries they all continue to do well. Germany is particularly strong.

Let’s move to slide 12, and moving to Aerospace segment, margins as a percentage sales this quarter of14.5% is an improvement over last quarter, but down from last year's 15.2%. This is due to increased researched and development costs in connection with new program wins mainly, the 787 although there are many wins that we will talk about later.

Moving to slide 13, the Climate and Industrial Control Segment; as you well know in this segment, there is softness in the North American automotive, heavy duty truck and residential air-conditioning, which is affecting this particular segment. Sales are down organically 3% for the quarter and 5% year-to-date. The operating margin for the quarter of 6.5% compares to 6.9% last year.

At this time, I am going to talk about orders a little bit, so moving to slide 14. Orders for the quarter -- slide 14 details the orders by segment. Just to remind you these numbers represent a trailing three months average and are reported as a percentage increase of the absolute dollars year-over-year, excluding acquisitions and currencies except for aerospace. Aerospace as you know, is reported using a 12 month average.

So you can see from that slide, orders are up 9% for the March quarter just ended. This 9% compares to 2% a year ago. So orders continue to be strong. North American orders for the quarter are up 2%, this compares to negative 2% for the same quarter a year ago.

Industrial international orders continue to show strength at 11% this quarter and that’s on top of the 11% a year ago. International strength is supported by high double-digit growth in Asia, mid double-digit growth in Latin America and Europe remains strong tutoring on double-digit growth.

Aerospace, continues to build backlog with orders up 28% this quarter and this compares to 19% last quarter and 2% a year ago. In the Climate & Industrial Control segment, order strength as anticipated has somewhat improved. Orders were down 1% for the quarter, which is an improvement from the negative 6% last quarter and negative 4% one year ago.

Moving to the balance sheet now, Parker's balance sheet remains solid. Cash on the balance sheet at quarter-end was 182 million. We had 439 million in commercial paper outstanding. Day sales and inventory remained constant with last year at 64 mainly due to the acquisitions. Accounts receivables, in terms of DSO is flat with last year, coming in at 50 days. And the large decrease that you are seeing in other assets and pensions and other post-retirement benefits year-over-year is the result of FASB 158.

So moving to slide 16 at this time, I'm happy to report of operating cash flow for the quarter just ended with 390 million, another record for the company. For the year cash flow was 864 million versus 537 million last year. That’s an increase of 61%. Of the 390 million in cash flow for the quarter, 69 million or 2.2% of sales was used for capital expenditures. Acquisitions consumed 5 million in the quarter, the last two acquisitions Vansco and HTR Holdings Corp. in April. Dividends were paid in the amount of 35 million. Share repurchases consumed 51 million and the remaining 230 million was used to pay down commercial paper.

On slide 17, you can see that the debt to total cap ratio is 26.1% and on a net basis, 24.1%, providing the capacity to generate premium returns for our shareholder moving forward.

On slide 18 just to address the fiscal year 2008 guidance. The guidance for fiscal year 2008 is shown on slides 18 through 20. On slide 18 the guidance for sales and operating margin by segment have been provide and on slide 19, guidance has been provided for the items below segment operating income. Slide 20 summarizes the guidance on an earnings per share basis from continuing operations. As you can see from this slide, the guidance for fiscal year 2008 for earnings per share is projected to be $5.40 to $5.60 versus the previous guidance of $5.15 to $5.40. Please remember that the forecast includes acquisitions made to date, but excludes any acquisitions that we may make going forward in the remainder of the year.

So the revised guidance assumes the following: sales growth approximating 11.5%; segment operating margins as a percent of sales in the range of 14 to 14.3%; corporate admin cost 1.5% of sales and interest and other expense in the range of 180 to 185 million and a tax rate of 29%. So the EPS guidance for the year has been increased by $0.25 on the low end and $0.20 at the upper end.

So at this time Stacy, I would like to open the call to begin the question-and-answers session.

Question-and-Answers Session

Operator

(Operator Instructions). Your first question comes from the line of Jeff Hammond with KeyBanc Capital Markets. Please proceed.

Pam Huggins

Good morning Jeff.

Jeff Hammond

Hi good morning. I was just wondering if you could -- as you look at the order trends, I mean it seems like the comps get a little bit easier and you kind of held the momentum. Can you just talk about inflection points within any end markets that materially changed or where are your seen if any deceleration in the international markets and maybe just around that give us your view in terms of momentum moving into fiscal '09?

Pam Huggins

Okay. Thanks Jeff.

Tim Pistell

Jeff this is Tim. I think that in terms of the international, I think Latin American right now is really I got to kind of say red hot almost with especially from the Ag come out of Brazil. And so we don't see any let up on that and that just seems to be get stronger and stronger. So that’s the good news. Asia Pacific has just continued to be strong across the board, fairly confident at very high levels. I think there has been a lot of concern about Europe certainly and frankly we are watching that all closely too, because everyone seemed to be concerned. But for us the order rate seemed to be hanging and pretty well. There is a lot of good things happened in Europe in terms of shipping to the rest of world especially to Asia. A lot of their strength is back, but they have a lot of product own to Asia and they are also lead the role in certain other things and I mean in wind power strong market, a lot related to the oil and gas the and exploration and the ship building, et cetera. So frankly, I mean Europe has held up very, very well for us.

I think here in North America not a lot of different, I would say then going to North America going to specific markets. I think the market that we saw have been soft, remained soft. We thought heavy duty truck was going to increase, it looked like it was, but now seems that heavy duty truck is taken another whack based upon the high fuel prices and people having to park rigs and that and so. That one may not recover as quickly as we hoped, it would. The semicon seems to go on, that’s off as that came on later. It stays weak. We are thinking now that that will stay soft for pretty much the balance of the calendar year, as what we are hearing with increasing into next calendar year. I say the rest of it seems to be fairly constant. I am not sure that gave enough color or not.

Jeff Hammond

That’s good. And just maybe, just the comment on momentum and as you start think about fiscal '09.

Tim Pistell

Well, it's taking on interesting Jeff. We are right in the throws of that. We are doing our roll off of our operating plans. Our people are doing that. We don't really have a lot of that. I will be a lot smarter come the middle or end of June. So I really can't give any answer right now.

Jeff Hammond

Okay. Thanks guys.

Tim Pistell

Alright.

Pam Huggins

Thank you Jeff.

Operator: Thank you Jeff. Your next question comes from line of Nigel Coe with Deutsche Bank. Please proceed.

Pam Huggins

Good morning Nigel.

Nigel Coe

Good morning. Thanks, congrats and the great quarter.

Pam Huggins

Thank you.

Nigel Coe

I guess just on North American industrial margins you took down the guidance as to full year. I expect the MRO is stronger than -- your discretion is stronger then your OE right now and given that the higher margins in that channel, just wondering why margins are coming through are the weaker there?

Pam Huggins

Sure. Nigel, let me answer that. One of the things that happened in this quarter is because Easter fell in this quarter. We did have some under absorption in some of our plants. So that really did affect the margins. The other thing as Tim mentioned is semiconductor obviously is very slow, not expected to come back. We thought there might be a little bit of bump on that. The other thing is mobile business. When you look at the proportion of our mobile versus our industrial business, a little bit of a higher proportion of mobile versus industrial in the quarter.

Nigel Coe

Okay. And then anything on the mix between hydraulics, connectors, filtration?

Pam Huggins

No, I can't tell you that. The filtration after-market is absolutely bromine. It's doing very well. And I can't tell you that on hydraulics North America is still doing very well, but of course internationally even much, much stronger.

Nigel Coe

Okay.

Pam Huggins

And quick connectors seems to be fairly hanging in there.

Nigel Coe

Okay, great. Thanks a lot.

Operator

Your next question comes from the line of Alex Blanton with Ingalls & Snyder. Please proceed.

Pam Huggins

Good morning, Alex.

Alex Blanton

Good morning. I am concerned about the degree at which the currency is affecting your international business and the overall business as a result, 6% of your sales -- 6 percentage points of your sales increase overall coming from currency changes and almost 15% of the industrial rest of world, I am concerned about the time when the currency starts going against you. That will happen eventually. What are your thoughts on that? Would there a comparable effect on profits for example?

Tim Pistell

Alex, Tim Pistell. We've talked, I think certainly as long as you have followed us, but for somebody others, first of all people do need to understand that we naturally hedge as best we can our businesses. And so most of what we sell in a region, we are making a region, so there can be -- while there can be dramatic numbers on the revenue line that you see, which the revenue has been up 170 million roughly in the quarter on currency. The costs are all up on a proportional basis as well. Now having said all of that, certainly net of the bottom there is a gain. That's something clearly, we can't do a whole lot about in a short-term, the way we manage it in the long-term as I said is to make sure we produce where we sell and it does provide us with some opportunities to on a short-term basis, we can -- if Europe is strong and North America is softer, there maybe a certain amount of excess capacity, we have here that we can use to help out over there. But all in all, you are right. I mean, it's a big number. It's grown over the course of the year I think a little bit of our outlook in the fourth quarter we are not deploying it and frankly, we are not quite sure it would stay at such a robust level and we think it may come off a little bit. But if we were currency experts, we would be treating that and so it's hard to answer, but we just manage through it. That's what we are paid to do is to manage through it.

Alex Blanton

Well, here is what I am really talking about here. You reported a 14% overall increase in sales of which 6% was currency and 8% was the rest. Now if the currency had gone the other way, you would had a 2% sales increase.

Tim Pistell

Yes.

Alex Blanton

That's what I am talking about. Would your earnings in that case be up just the 2%? I mean, would you maintain your margins at least but certainly there wouldn't be any improvement in margins so therefore you would be hurt on the earnings side the same amount as the sales side. Will you?

Tim Pistell

Well, as I try to say, there certainly was -- there is a net benefit for us, running positive as it is. If it goes against us and runs negative, but it's not as dramatic on the bottom line and as I say again that is our job to manage through that. So yeah, that happens, that's happened before and you have got things back and forth. So yeah, you are right that is a phenomenon in connector and again we just need to manage through it and make sure that we continue to deliver the earnings on a consistent basis.

Alex Blanton

Yes, okay. Thank you.

Pam Huggins

Thanks Alex

Operator

Your next question comes from the line of Jamie Cook with Credit Suisse. Please proceed.

Pam Huggins

Good morning Jamie.

Chase Becker

Hi. It's actually Chase Becker in for Jamie. How are you?

Pam Huggins

Chase.

Chase Becker

Just two times in a row I think. My question is just circling back on North America, I just want to make sure I understand that I appreciate the comments that you gave earlier on the margin front, but if you are backing into kind of your fourth quarter numbers here, that implying about, if I am doing my math right, about 150 basis point deterioration in the fourth quarter year-over-year. Does that sound about right? And I mean, is there something else I am missing other than what you were alluding to earlier in your comments?

Pam Huggins

No, I think you are accurate. I you look at what's happening, we all tend to have a lower margin in the second half versus the first half and yeah you are right when you are comparing to the prior year.

Chase Becker

Okay. And then can you provide some color on the breakout on your aerospace orders?

Pam Huggins

Sure, you know, when you look at the 28% aerospace orders obviously the preponderance of that is falling in the OEM commercial side of the business. After-market for the most part is up about 10% and the strength that you are seeing is really on the OEM commercial side. Military after-market is up, commercial after-market is up, commercial OEM is obviously the strength that you are seeing and then military on the after-market side is flat.

Chase Becker

Okay, great. Thank you.

Operator

Your next question comes from the line of Mark Koznarek with Cleveland Research. Please proceed.

Pam Huggins

Good morning Mark.

Mark Koznarek

Hi good morning. Just a follow up to Alex's question, can you guys quantify the currency benefit here in the quarter. Do you just simply take the 170 times your international margin which would make it around $0.10 a share, or is it something less than that?

Tim Pistell

Well Mark, no you can't do that because that's just down to the margin level and again a lot of the other parts below that are over there as well and taxes etcetera. So, again it is a much smaller number when you get down to the bottom field. So, you've got to do it on a net basis.

Mark Koznarek

Okay, but my real question has to do with price versus cost, you know, raw materials have certainly become troublesome again in terms of rapid appreciation and you guys are usually pretty quick to raise prices but, you know, there is contract terms etcetera and so is some of the margin recession in North America particularly expectation of higher raw materials that you don't think you are going to be able to capture?

Don Washkewicz

Mark, this is Don, you are right. As far as the raw materials, we have seen continued escalation in raw materials in particular copper and brass have just continued to go north at us. You are never a 100% real-time as far as passing anything on, okay? Even though in many of our OEM contracts that we have, if you are about as close as you can be to real-time because you have escalation clauses tied into those contracts on these very vital raw materials but if you read that there is still some push back and you have to still get in front of the customer and present your case. There is no way he is going to give you anything for no good reason. They want an explanation and so you have to bring the facts.

With respect to the other raw materials, I would say the rubber and plastic polymers, anything oil-base related are certainly seeing the impact as well and we're trying to pass those increases on as we see those. Again, it is probably no better or worse than what we've doing over the last three or four years. We've been experiencing these escalating raw material prices now for quite some time and I would say we are in no better or worse condition than we have been in the past by just trying to do our very best to pass these on and make sure that we don't see margin erosions from that.

Just coming back to one point that Alex Blanton made earlier, I just wanted to add one comment to that and maybe it gets a little bit Mark to what you were saying earlier in this call, your first question. When we do our forecast, when we do our strategy and all and when we look at strategy and what our targets are, goals are. We target 15% operating margin as our target here is, irregardless of what the foreign exchange rates are. We just don't get into that. We expect the operating unit to make 15% across the board in any environment. So maybe that would help respond a little bit to what Alex was asking about too. And that's a global target for us. I hope that answers your questions on the raw materials.

Mark Koznarek

Yeah, thank you.

Operator

Your next question comes from the line of Dave Raso with Citigroup. Please proceed.

Dave Raso

Good morning. Two questions on the fourth quarter international revenue guidance. If you think about currencies probably act somewhat similar in the next quarter with this current quarter versus the quarter you just reported. And if you look at the acquisitions that you'll likely be benefiting your sales especially implying core growth to be most flat internationally in the fiscal fourth quarter. Can you reconcile that?

Tim Pistell

David, yeah Tim Pistell. A couple of things on the international front and again these last two acquisitions we did really will fall within North America essentially; the ones that began at the beginning of April. There are a couple of things. One is again, I think the currencies were really talking a lot was a big boost of revenue in the quarter. I think that a little bit of that has been tampered down in the fourth quarter. The other phenomenon is that one of our more recent acquisitions, which is in the Subsea business, their orders were huge and they are really lumpy, I mean big time. They had quite high revenue in the third quarter and right now it looks like it will be much lower on the fourth quarter in that business unit.

So, it is a combination of being a little cautious on the currency and the fact that we know that that unit -- now that because of its going on in gas is booked solid, I think for the next three or four years in terms of their capacity, but its just a very lumpy in terms of sales. So I think maybe that's part of the reason that we're seeing a slight decline.

I do want to look back a little bit on North America. It seems there is a lot of questions on that and I think year to year you see one picture but I'm seeing from the guidance we've just given you on the fourth quarter versus the third quarter that we just reported in this morning, in North America we've given you more sales, we've given you more margin, and we've given you a higher margin than you had before. So I think which is implied in there. We have gone through tough times in some of these markets, but we've raised the guidance and part of that is what we are say in North America, we'll actually be a little better in the fourth quarter than we would in the third.

David Raso

Parker Hannifin International though still, Scan Subsea maybe this is a little lumpy this quarter, maybe it was 50 million the next quarters, it is taken down at 10 or 15. Currencies will be somewhat similar. And the orders you setup 11% internationally, so finally squaring up, are you expecting a much slower poor growth internationally in the fourth quarter than the third quarter?

Pam Huggins

David this is Pam. Just to get in to the details or numbers a little bit, it is really just currency. We really don't forecast the currency in there so you have to add that back.

David Raso

Okay. Maybe it is something related to that. Your inventory group faster than your sales for the first time in six years this quarter except for one little difference a year ago, the fiscal third quarter a year ago. Is there anything, I should read into that we don't get your breakout of the inventory till the Q, set an office, its more problematic, is its finished goods or you kind of trying holds more raw materials upfront. How should I think about that?

Pam Huggins

Now Dave, I mean the inventory really is currency and acquisition.

David Raso

But there are very few, I mean there is really no acquisitions in the quarter, so it can’t really be that.

Pam Huggins

Yeah, but there is always adjustments that flow through as they firm things up on the acquisitions. So really in the quarter, we only grow inventory by 7 million, once you extract those other items out.

David Raso

And that's a sequential comment; 7 million right?

Pam Huggins

Right, it is down, 7 million. I'm sorry, I said down 7 million sequentially.

David Raso

So 1470 instead so it still up a little bit but, okay that's helpful. I appreciate it. Thank you.

Pam Huggins

Thank you.

Operator

Your next question comes from the line of Ann Duignan with Baer Sterns. Please proceed.

Ann Duignan

Hi good morning guys.

Pam Huggins

Good morning Ann.

Ann Duignan

Can we take a look at aerospace again just for a moment. Can you tell me if you are seeing any slowdown in commercial after-market orders, I know you said they were up 10% but what is the trend you are seeing there, I mean, we're seeing a lot of aircraft, older aircraft in particular coming out of service, high fuel prices for attaining the profitability because of the airlines. What are you guys seeing out there in commercial after-market for aerospace?

Pam Huggins

Ann actually, we're not seeing a decrease but I can understand the reasoning for your question. I mean, when you look at the airlines and you look at that fact that there is consolidation going on, you look at that fact that the airline is going bankrupt. Yeah I can feel why you answer -- you are asking that question and they are taking parts of the planes and putting them on another planes. But quite honestly, we are not seeing the decrease in our commercial after-market to this point.

Ann Duignan

Okay. Thank you. That’s helps. And Don or Tim either one, your outlook, the range of your guidance for Q4 as [Kane Island this is light of a gate], what's the hesitancy there and what are the risks, where are the concerns of you going to Q4?

Tim Pistell

Well I would think that the -- I mean we are sort of touching on many of them and again I guess is some of the issues where the markets kind of go, where is the currency. We don’t have it. I mean again there is a lot of currency concern. So, I don’t know, we could over. I don’t think it’s a lot different than what we have given on a -- we narrowed it from the second a little bit, I guess so forth. So, I don’t really know what to say there. There is a lot of [bakeries] I don’t think there is some uncertainty out there in the markets on this currency thing and so forth. So I think that’s all.

Don Washkewicz

And I think Ann this is Don. If you look at the range, I mean we did come in with very strong range revision. We picked up at the top end of the last guidance and moved up from there. So I want to read into that that we are too bearish on the balance of the year. I think we are very positive. Lets' just add, and I think we typically have also given you a range about like this in the past and that’s workout well for us. I mean it's hard to get an exact number and we are not trying to do that. So that I think the key thing resistant to see that we picked up on the 540 and went north of that and that’s probably the important as such to pick up there.

Ann Duignan

Okay. So there is no one region nor end market that you are looking at that you know, you see a cloud is developing that you are concerned about?

Don Washkewicz

No. I think that the real question is on the North American markets just how long the runs that are down now and have been down will remain down. I think we like to think that at some point or which should start seeing some movement back and especially in light of the fact that interest rates now are down at 2.25% that’s come down drastically and I think everyone realizes that’s a big move for the economy and eventually that is going to translate into better activity here. May not be in the next quarter, but hopefully in the next 6 to 9 months I think we should expect to see that. How things starts is another thing, we don’t know, I think its going to a time for that to bleed off. But all of the segments that have been down and are down now, we would expect at some point we would see a little relief. And I think going into next fiscal year, hopefully we would see some turn up in the semiconductor part of the business for sure. The question is on the automotive and on the light truck we are not sure about that heavy duty truck of course, we thought already with have turned in and has not. So we are just going to continue you know, doing what we are doing and trying to hold these margins as we have been and just hope for that at some point these lower rates are going to translate into something better down the road. But I won't read anything negative you know, going into the next several months here for sure.

Ann Duignan

Okay. Thank you very much and by the way congratulations for time. Well deserved, you've got my vote.

Pam Huggins

Thank you. Thank you, Ann. I do appreciate that.

Operator

Your next question comes from the line of Andy Casey with Wachovia Securities. Please proceed.

Andy Casey

Thanks. Good morning everybody.

Pam Huggins

Hi, Andy.

Andy Casey

I am going to believe or something, but back on the implied Q4 North American margin guidance, the expected higher rate of year-over-year deterioration when I am coming out of a 160 basis points down at the mid point versus 40 in Q3. I just want to clarify, while sequential was up a little bit is the year-over-year change all raw materials or is it being influenced by acquisition integration, because the real they implied in industrial international margin, does not appear to be falling the same pattern. I am just trying to make sure we incorporate everything as we look enough to your future?

Tim Pistell

Andy this is Tim. I think that you touched in some which I haven’t probably going to get you here and the fact that again we are looking at more sequentially frankly of course you know, well okay, that how we are going to do in the fourth quarter versus third quarter we just finished. You say there is -- if I looked year-to-year maybe it’s a bigger decrements and so forth. Yeah I think that certainly some of the acquisitions would come into play, because the preponderant here is especially these most recent ones are here. And in the first quarter generally they don’t come in earning at peak capacity. And so I want to get to that because of the accounting has changes, you got to observe a lot of cost and redeploying out that all of that’s in our numbers. I think Pam mentioned earlier the high quality of the earnings, I think we have been delivering all year and everything is in these. Guys, there is no adjustments for integration or new acquisitions. There is no adjustments for restructuring. We are not into all that. What we give you is what we report that all of those are in there. And yes, so there is a bit of that phenomenon occurring in this fourth quarter as we have added some big ones shortly. And in short-term we may bring it down a little bit, if you look at the year-to-year. Having said all that, they are coming on board and we are giving you in total higher margins in the fourth then we just did in the third. So I think it’s tremendously strong enough performance in the light of some really rough markets here. And few years ago everyone was saying well whose really cycle, whose late cycle and Parker is in early cycle and we try to say, you know, we are now early, we are mid and we are late, I think this is pretty late. And I think we are still delivering for you. And so, I am feeling good about that coming through as well. So all in all, but yeah, that’s a sort of a mystery of things. But yeah, there will be a little bit of acquisitions polling down a bit short-term.

Pam Huggins

Yeah then Andy, I just want to point out, when you look at the margins, last year in North America we ended at 14.7 in our current guidance, yet again I will add the mid point is 14.3 and that’s at the mid point not [accounting map or range]. So I think our margins are hanging in there pretty well.

Andy Casey

Okay. Thanks for that. And Don if I may, could you kind of talk about what's you are seeing, I know you finished two relatively good sized acquisitions towards the end of the, I know this is historic quarter, but what you are seeing going forward.

Don Washkewicz

Well, that’s what our target is. Our target is 5% of sales. We have pretty much set that now. This fiscal year I will say that we are looking at a number of -- and having been looking at a quite a few different opportunities. We have passed on some opportunities in the last 12 months. Of course we have made some very nice ones just recently. We have about $1 billion worth of capacity that we can use for acquisitions and still within the frame work of our debt-to-debt equity ratios that we want to maintain. So there is quite a bit out there for us to look at. We are seriously looking at a number and I would expect that you would see a continued scrambled acquisitions coming in the next 12 months.

Andy Casey

Thank you very much.

Pam Huggins

Thank you, Andy.

Operator

Your next question comes from the line of Ana Recinos with UBS. Please proceed.

Pam Huggins

Hi Ana.

Ana Recinos

Hi, good morning. Could you just give us a little bit more color I guess on what's going on in Latin America, you mentioned again in Brazil and kind of what your outlook of sales for the best of this year and is there any other areas down there that are helping you on the international side?

Tim Pistell

Tim, again. Well again, Brazil in total is Ag is certainly leading it, but we are not seeing it on all fronts, I guess, because of the wealth is being created that we see pick up in the automotive and the truck and the construction as well and it’s just spreading across, which is the good news. Argentina is really looking to step things up on the serving side and that bodes well et cetera. So I think that all in all, we are across the board, it’s pretty good. I mean then as well as a little challenging too, in this case they have now put up outside of that everything else seems to be pretty good down there. And I would say it's really spread across to many other markets.

Ana Recinos

I guess on the Asia Pacific side so you mentioned it was constantly high levels that imply that you are seeing both falling materially or what kind of worst things are you seeing there on the Asia Pacific side.

Tim Pistell

Well I think Pam had mentioned that. I think again we are in double-digits and we are into kind of mid to high double-digits over there and there is still plenty of wonderful opportunities for us there and our major customers want us there that is the wonderful thing. Because of the breadth and line that we can supply, they lover Parker to show up and so it just bodes well for us.

Ana Recinos

Great. Thank you.

Pam Huggins

Thank you.

Operator

Your next question comes from line of Eli Lustgarten with Longbow. Please proceed…

Pam Huggins

Good morning Eli.

Eli Lustgarten

A nice quarter, I said we are joining of course of nice quarter. One clarification, in the guide, you have 29% tax rate, which in order to get like the 30, 31% tax rate in the fourth quarter. Is that something happened in the fourth quarter or is it just 29% guidance for the year and you have been running about 28.5 right now?

Don Washkewicz

Yeah. I thin the way you get there anymore, I mean there is a very little long lasting things and it is all discreet tax items and planning. Part of it Eli is when we do acquisitions that presents opportunities for us. So I think yeah, I think we have been giving a sort of 29%. We have been able to do little bit better by doing a discreet thing here or there, so it's just going forward on the same basis.

Eli Lustgarten

You have been talking of bigger tax rate in the fourth quarter to get it up there?

Don Washkewicz

No. We would expect frankly again. It is hopefully more or the same, but you just never know what opportunities you are going to have.

Eli Lustgarten

That’s good. And going back to your guidance on the vision, the North America you gave the biggest sale numbers, but you talked that’s acquisition with the margins always by the mix, international was currency. Could you talked about the aerospace sector, because you said they are actually up the volume, you took down the margin forecast, which I assume is because of the investments in mix. And what the implication of that going forward in 2009, it looks like you have much more volume in the fourth quarter, because of 9% from 7 and the margins are staying down and does that continued to 2009?

Tim Pistell

Let me again and I maybe turn it back over to Don a little bit on aerospace. But you saw the wins that we have had here, huge wins on $2 billion on the Airbus 350, on top of that there is three other programs, which accumulate to another billion dollars, since $3 billion of wins tremendous for the future. But going with that and now it is into development and nonrecurring engineering. Over this fiscal year, this year, I say over last fiscal year, our R&D and non-recurring engineering is up over $30 million this year over the prior year. I mean it was already up the prior year, we are up another $30 million this year. So, again without that the aerospace space margins, you can do the math would be you know real close to 16%. While we are paying that price now and that is how we are get these big wins and that secures our future for a lot of years and decades to come. Dan, I do not know if you want to add anything to that.

Don Washkewicz

Yes, I would just mentioned that few of the wins that we had I think you are familiar with the Airbus A350, and that hydraulic system on that, which includes pumps reservoirs and all related types equals about $1 billion over the life of the program. So, we are working very actively on that. The fuel system likewise on that contract including all the fuel inheriting and measurement and management system for fuel is about $1 billion as well. So we are talking $2 billion in Airbus, a new business over a life of that program. There has been a lot of changes on the 787 that I am not going to go into, but as that has been pushed out again and there is a lot of re-working and re-engineering and re-design and re-everything in its immediate yesterday. I mean everybody wants everything yesterday, which causes a major impact on our expenses. A lot of over time, a lot of additional people brought on to try to handle that additional work. So that 787 continue to be a major R&D program for us. The Gulf Stream looks -- call it the G650, we have won the flight control actuation systems. I am not sure if we went public on this totally or not, but it may have. I am not positive. The actuation system weather controls and all of that with some auxiliary electro hydrostatic motor pumps. That was about a $390 million program again, a lot of engineering involvement in that. There is another one, which was Mitsubishi Regional Jet, where we won the hydraulic system including the engine driven pumps a lot of sensors and related type of equipment I think that was in the neighborhood of about $200 million in sale the potential I should say. The Cessna Citation Columbus 850 was another program that was flight controls as about $400 million program a lot of engineering activity going on in that area. And then another one by Cessna was which was called the SkyCatcher it’s a light sport aircraft and that’s primarily a wheel and brake system. Not quite as much value but still a lot of the engineering intensity on those so. Those would be the major programs quite of run of activity and its all abodes well for the company. In the long run of course the impact is on our short term performance which is the nature of this kind of business. You suffer a little bit now through the R&D stage and then you have a long tail as far as profits and sales going forward.

Pam Huggins

So Eli not to pile on, this is Pam speaking. But typically the OEMs versus MRO business runs 50%-50% in normal times and right now we are running about 65% OEM. And that comes in at no margin.

Don Washkewicz

And we are looking at increasing engineering expense in '09 versus '08 again because of this win I guess that’s where we were driving at.

Tim Pistell

Right now, and again our guys controlling up their plans and so we all know what there are going to bring in. But Eli I don't think there is going to be a lot more. The big programs the 350's the 787, there are already in our shops and on board and I Think at this stage I don't have the numbers, but I don't think we will -- another big increase.

Eli Lustgarten

Thank you.

Pam Huggins

Thanks Eli.

Operator

Your next question comes from the line of Daniel Dowd with Sanford Bernstein. Please proceed.

Pam Huggins

Good morning Dan.

Daniel Dowd

Good morning. Good quarter. Actually want to turn to a more macro issue, so and certainly one of the things investors in this space are worried about is what if any impact a US recession is likely to have on companies like Parker. And as I was thinking about your guidance here as I am looking at your updated orders for North America, if you believe that there's is a relatively brief US recession. It looks to me like you currently believe you're going to get through this US recession effectively without really feeling the effects of it the way you would have expected in your North American businesses? Have you amended your North American economic outlook for alternatively your North American industrial economic outlook?

Tim Pistell

That we amended ours?

Daniel Dowd

Yes.

Tim Pistell

At this stage no I think we've talked specific markets. I don't think we don't have a department of economists. So we don't, can't say that we have a one of those. I think we do it market by market and I think, no I mean outside the exceptions we mentioned heavy truck is going stay down for longer, semi-con going to stay down for longer. I don't think there is a lot of other big changes to the…

Don Washkewicz

Dan, what we like to say here, this is Don is that we're not talking about a USA recession we're saying that USA is in recession has been in recession for at least eight months now. And the good news is Parker is not in a recession. And as I stated earlier on the call is that we are pretty fairly positive here going forward is that we have six major markets segments that have been in the recession. We are talking heavy duty truck off 50% if that’s not a recession in that segment I don't now what is. The housing start and the impact that’s had on the air-conditioning side of our business is in recession. The light trucks of course goes hand-in-hand with new construction that the trades aren't buying light trucks because no ones building anything. That’s in recession. The big three automotive and domestic manufactures are certainly in recession. We seen semi-conductor bouncing off the bottom here. We think that’s going to last another year, that’s in recession.

When you look at all of these segments that we have talked about here, I never seen a situation like this in the past that we have done so very well with so many of our key target market segments doing so poorly. And again we feel like the USA is in recession has been for eight months. We've seen especially on all of these areas that the order trend is been down. We think we are bottomed out in many of these. If there is more to come, I don’t know what direct worse is going to come from. Like I said earlier, I think we are going to bounce back a little bit as a result of -- you could see our current order activity is a little bit more positive in North America. I think the interest rates are going to drive that more positive going forward. So I would say, if anything, I am a little bit more on the bullish side, but I don’t want anybody on the call thinking that we are not in a recession. We are -- Parker Hannifin is in a recession for sure. But the USA I should say is in a recession, Parker Hannifin of course, our results would indicate that we are not and again it has a lot to do with the balance of the company that you must take notice of. We have changed the balance dramatically over the last seven years predominantly outside of North America now and a much better balance of mix of products and markets that we serve, a much bigger company than we were seven years, which gives us more balance and flexibility as well. So, and of course driving all of those initiatives that we have been driving and that those are not one-time initiatives, those are ongoing initiatives that are going to continue to drive results and performance for this company going forward. So we are bullish. If more is to come in mark-to-market, we think we are going to hold up just fine and we will see what happens I guess going forward. We will give you more color on that of course at the end of the fiscal year going into next.

Daniel Dowd

And let me just follow-up then on what Tim said earlier. He said we are at late cycle and we are doing great, but obviously I am wondering actually if you imagine that all of the stimulus that has been driven into the US economy really starts to have an impact maybe in Q3, maybe Q4. Doesn’t that imply that we actually may look back at this period and view it as mid-cycle rather than late cycle?

Tim Pistell

You could be right. I think there is a lot of uncertainty, there is reasons why I can see that we are at the bottom or hit the bottom or come out of this thing. I can see we are -- know it can get a lot worse and it's just hard to call right now. So we are trying to manage and plan accordingly. But again, I think the point is we sell into so many different markets, so many places around the world that you name it we sell pretty sell into that market. So yeah we are mid, we are late, and we are working awfully darn hard out here to eliminate certain cyclicality factor here, get into a lot of the sort of secular stories and markets that do not have those cycles to it. So I think all in all, I would say kind of the pursuant if you will I think the results speak for themselves, largely we are suffering through some of these down markets and we think we are delivering the kind of performance that the investors want to see.

Don Washkewicz

And I think -- this is Don again. I think if you stay focused on the orders, the order trend would dictate that a lot of good things are happening here and there is a lot of strength, even aerospace and the non-industrial markets are very strong. So we are pretty positive. We think we have a pretty good future in store here and we are prepared for whatever is to come.

Daniel Dowd

Thank you.

Pam Huggins

Okay, Stacey, at this time we would like to take one more question, could we before we wrap up here.

Operator

Your final question comes from the line of Robert McCarthy with Robert W. Baird. Please proceed.

Robert McCarthy

Good morning everybody. Thanks for taking another question. I had a couple of clarifications I wanted to ask about, but my question first is I wondered if you could provide a little help on understanding or maybe reminding us because I think we may have talked about this in the past. How you manage pricing for distribution in a rising input cost environment because they operate catalog right, so I guess, I am solely interested in how you manage it in a general sense? And then can you talk specifically about when would be next opportunity to secure a price increase in response to what's going on with cost?

Tim Pistell

Thanks Rob. Nothing really changes depending on the environment basically speaking -- generally speaking I should say. And what I mean by that is for distribution, what we typically do is we review prices and we adjust prices if needed at one or two time periods a year, either January or July. Now, having said that, there have been cases where if we get a rapid increase in raw materials in a highly raw material sensitive product line and there are some of those in the product we are offering that we will make mid-term adjustments, okay. We would do something outside of the January or July timeframe.

Robert McCarthy

Alright.

Don Washkewicz

And we have done that in the past, but we try to stay to twice a year and the reason we do that is if you have 125 divisions, say you have 75 or 80 of those are industrial divisions and they are all changing prices at different times of the year, it drives our distributors crazy. So, what we try to do is put some sanity back and say, "Hey, we should try to keep this to twice a year." Everything that happens is frankly when you are going at a customer and if you have changed prices different divisions are different, every other month you got another division changes prices, the customer starts, wait a second, you just raised the price last month. Well, yeah, but that was X, Y, Z division, now we have got another division, A, B, C division that's raising. Well, wait a second. So, we just decided a long time ago to just have a twice a year. So nothing new and we do that regardless of the economy. We do that in growth periods with the economy, we do that in the recessions, we do that regardless of what's happening out there. We do those revisions and we pass those on as need be and make those adjustments.

Robert McCarthy

Okay. So you have got -- I mean, in fact you have a price increase coming for that piece of the business mid-year?

Don Washkewicz

Yeah.

Robert McCarthy

And the time lag between the new prices and how it affects your own results should be really short, all right, matter of days or weeks?

Don Washkewicz

Yes. In that segment, it's fairly short, that’s right. We give it a little bit of a notice and then we make the -- we do the re-printing of the list prices and so forth fairly quickly.

Robert McCarthy

And then in terms of clarification, I just want to make absolutely sure that I got this right because probably I heard two different things about currency in the international outlook. As I understand it, your fourth quarter outlook that's incorporated in the full year outlook for international has zero currency contribution in it. Is that right?

Don Washkewicz

It has…

Robert McCarthy

Comparing year-to-year, all right?

Don Washkewicz

We, again on this we would be doing at the Parker rates and that would be -- so no, there is currency in it, but there is not a big delta change in it, if you will, from the sort of standard Parker rates. So we don’t -- in other words, I guess the easy way to say it Rob is we don’t predict the movements from here. We just -- we take them as they come, but…

Robert McCarthy

I understand that, but you just had a quarter with 16% contribution or I mean, you really get a sizable contribution with high certainty or high likelihood. I am not clear on how much of the contribution you have in your number though?

Pam Huggins

Yeah, Rob, this is Pam. We don’t try to forecast the currency going forward because we don’t know whether it's going to go up or down. And so, we don’t try to make that call. So in the sales numbers, it's not in there.

Robert McCarthy

I appreciate that. But if you are not using current currency rates, which would imply a significant year-to-year benefit, then you are explicitly using a different assumption than is the current assumption…

Pam Huggins

That's right.

Robert McCarthy

And you may not define to forecast but in effect you kind of are?

Pam Huggins

That's right.

Robert McCarthy

Okay. All right. Thank you.

Pam Huggins

Okay. At this time, let's end the Q&A session and I'll turn it over to Don for some closing comments.

Don Washkewicz

Okay. Thanks Pam. Just a few closing comments. We are clearly on our way to another record year at Parker. I think that's pretty clear to everybody. This quarter we produced record quarter results in sales, net income, cash flow, earnings per diluted share, so pretty much across the board any metric that you might look at or compare, it was very positive for us.

We as a result of all of the last activity and that performance we significantly revised our guidance for fiscal 2008 from the range that it was and I would point that that was as little as 5.15 not long ago to 5.40 that was the original range, we picked up on the high end of that now, which is 5.40, we have taken that up to 5.60, so that’s a very significant increase in per diluted share.

I want to thank everyone that’s on the call for your time and the questions that you have asked. I think the results we are achieving certainly are a direct result of executing the win strategy as I indicated earlier. One of the objectives just as a reminder is that we are out here trying to maximize return on total capital, maintaining our top quartile position relative to our peer group and this will remain our top, our primary focus for the company.

We maintain a strong organic growth rate over 4% even when some key markets have remained weak. And if you look at that 4%, we have been looking at other reports coming up, that's up in the top quartile, I believe, as well from the reported numbers that we have been hearing. This 4% of course is in addition to our growth rate through acquisitions, which we continue to pursue and will for the coming quarters and fiscal year.

Lastly, we continue to reach new records generating strong cash flows and increasing earnings per share. I'd just like to say on behalf of the leadership team, I want to also thank Parker's worldwide team of employees for their accomplishments and for continuing to profitably grow our company quarter-in and quarter-out, year-in and year-out.

Once again, thank you for your participation. We appreciate your interest in Parker. Just a reminder that Pam will be around the balance of the day to take individual calls if you would like to call into her office.

Okay. Thank you very much and have a great day.

Operator

Thank you for your participation in today's conference. This does conclude your presentation. You may now disconnect and have a good day.

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Source: Parker Hannifin Corporation Q3 2008 Earnings Call Transcript
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