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Investment View

Parker Hannifin (NYSE:PH) is intended as along term hold, as I believe this firm is a stable grower with a strong competitive advantage and its intrinsic value will be realized over a multiyear holding period.

Business Overview

Parker Hannifin is a manufacturer, distributor, and retailer of industrial goods involved in the motion and control of fluids. This includes an array of different products, including but not limited to pipes, tubes, pumps, filters, and hydraulics. We can think of Parker as a maker of goods used to move fluids, which can be used in a wide range of industries, including but not limited to manufacture of chemicals, food and drink, oil and gas, and the operation of airlines, in addition to a diverse range of firms that use hydraulic products.

Edge

Parker's competitive advantage or "economic moat" is its distribution and retail system. It operates 3,000 stores globally, many of which are open 24 hours a day and 365 days a year. The result of this wide distribution and retail network is that stores always have parts on stock. If a factory suffers a product break, it needs to be replaced immediately, so the firm can neither afford to wait for parts to be shipped, nor is it very price sensitive. However, with Parker stores, one can walk into a store and be assured that the desired part will be in stock. This well developed network also allows Parker to quickly integrate a new product or acquisition into the business.

This competitive advantage makes more sense when we look at the nature of its competition. Parker's products operate in markets with many competitors. However, there is no single firm that competes with Parker across the broad range of its business and array of products. So its tubes, filters, and hydraulics might be in competitive markets, however no firm will compete against Parker in all of them at once. Thus Parker can put many different product lines in one convenient location, which is very difficult for competitors to replicate as they may not be in many of these industries.

Financial Statements

Parker's sales growth has been strong and stable over the past decade, and grew at slightly more than 7% annualized. Gross profit, however, grew at nearly 12% annualized over the same period. Using a longer time frame of twelve years, in order to account for an uncharacteristic drop in income in 2001, we see that net income has grown at nearly 10% annualized over the past twelve years. With growth rates in the range of 7-10% annually, it appears to be a firm with moderately strong and healthy growth rates.

In addition to Income Statement item growth, gross, operating, and net margins have all grown over the past ten years, the only decline being during the recession, which is expected due to the lower sales and similar fixed costs at that point. Growing margins are very important as they indicate the growing ability to pass on costs to customers and are indicative of pricing power and an economic moat showing the business is strengthening over time.

One metric of firm performance are the efficiency ratios of Return on Equity (RoE) and Return on Assets, (RoA). Conventionally we use these to determine how efficiently a firm is using its assets, but more importantly, they show how a firm is reinvesting its capital and are a verdict of management's ability to reinvest money back into the business. In the case of Parker Hannifin, both RoA and RoE have not only been strong, they have been growing strongly over the past ten years.

As noted earlier, Parker is both a manufacturer as well as a retailer, hence, analyzing its inventory management capabilities is necessary as well. A firm that manages inventory well is one that carries enough inventory to meet needs without any excess on hand. So we look at the Inventory Turn-Days Ratio, ITD. The number of days has consistently declined over the past ten years, indicative of a firm that is managing inventory well, and thus, can keep a smaller amount of inventory on hand to meet sales obligations.

Using Average Payment Period to estimate the time taken to pay suppliers, we see an increase from 30 at the beginning of the decade to approximately 45. This increase can be both strength and a weakness. It is a weakness as it would appear that the firm is not able to meet its payments. However, as Parker is operationally sound, rather than weakness, the growing payment period indicates that Parker is choosing to pay its suppliers more slowly, indicating strength. In the language of Porter's Five Forces, Parker appears to have resisted against the Bargaining Power of Suppliers, and as a result we see that the firm is strengthening its position in the industry, both among customers as demonstrated by rising margins, and against suppliers, as demonstrated by APP.

My estimate of Intrinsic Value, conservatively estimated, is nearly 50% higher than what the stock is trading at currently, I estimate IV to be: $120. I believe it is a firm that has a durable competitive advantage of a respected name and a strong distribution network, and it makes critical components for industry. It is not an exciting stock, but I believe it will create value over the long term for patient investors.

Source: The Case For Parker Hannifin