Parker-Hannifin: Good Company Meets Bad Markets

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Summary

Weakness across multiple markets, but especially in "general industrial", off-highway machinery, and oil/gas is leading to a sharp contraction in Parker-Hannifin's near-term revenue prospects.

PH has so far been able to maintain margins despite weak volume and pricing trends, and management believes it can grow at a 3%-plus pace over the next five years.

Mid-single digit FCF growth and a high teens ROE both support a fair value in the $104 to $108 area, but many other industrial stocks are on sale too.

Parker-Hannifin Parker-Hannifin (NYSE:PH) isn't a flawless company, but this leader in motion and process control has a pretty solid record of generating attractive full-cycle margins. What's more, the company is uncommonly diversified across its end-markets and generally eschews splashy moves in favor of just consistently doing a good job.

Unfortunately, Parker-Hannifin is caught up in a global butt-kicking of industrial equities and the company is facing a lot of demand weakness across its many markets. I believe that the company can generate long-term growth of over 3% and that the shares are probably too cheap today, but investors considering buying on this pullback have to have patience and a long-term vision to offset the near-term risks that weakness in oil/gas, off-road vehicles, and general manufacturing will get even worse before turning around.

Bunny Meets Wood Chipper

As management's guidance for 7% organic revenue contraction in FY 2016 (given after the fiscal first quarter report in October) would suggest, this is definitely an ugly stretch for this industrial company.

Broadly speaking, about three-quarters of Parker-Hannifin's sales are to various industrial markets, with about a third of that going to "general industrial" applications, and a similar amount going to mobile equipment (vehicles used in mining, agriculture, construction, trucking, etc.), energy, and oil/gas.

There's really no good news in the mobile side of the business. The ag and mining end-markets are likely to see high single-digit to double-digit declines in 2016 as demand for original equipment decelerates further in response to weak commodity prices. While construction equipment is looking a little better in some markets (like Europe), it is still quite weak in China. Last and not least, while Parker-Hannifin management had been seeing strength in heavy duty trucks through the last quarter, the sharp declines in North American Class 8 truck orders has to pressure that business before too long. All of this makes life difficult for the hydraulics, connector, and seal businesses for PH and its prime rivals like Eaton (NYSE:ETN) and Bosch Rexroth. Likewise, Danfoss (a sizable European player in mobile hydraulics) has been seeing weak results on persistent weakness in ag, construction, and mining.

Automation is likewise no great help to Parker-Hannifin today (nor to Eaton, Emerson (NYSE:EMR), Rockwell (NYSE:ROK), or Siemens (OTCPK:SIEGY)). Exceptionally weak oil prices has created a huge headwind in the oil/gas space, with knock-on effects in petrochemicals and other related markets. Discrete/factory automation has likewise weakened as companies have cut back on their capex spending.

Overall general industrial market conditions are likewise weak. Both Fastenal (NASDAQ:FAST) and MSC Industrial (NYSE:MSM) have reported significant weakness in U.S. manufacturing, and that threatens Parker-Hannifin on multiple levels, as MRO/aftermarket sales are very significant to the company.

A Few Bright Spots?

It may not be all doom and gloom for Parker-Hannifin in 2016. First, relative to Eaton, Parker-Hannifin has a lot less exposure to emerging markets like China and Brazil. Second, Parker-Hannifin does have exposure to some markets that should be able to grow this year.

Close to 20% of the company's sales go into aerospace. Like Honeywell (NYSE:HON), Parker-Hannifin is leveraged to growing deliveries of newer programs like the A350 and B787; management has previously indicated that the company's bill of materials is about 3x to 4x larger on these planes than its predecessors. I'm not expecting blockbuster growth in aerospace in 2016, but it should be one of the relatively few sectors to show positive momentum and Parker-Hannifin has more leverage here than Eaton (though not as much as Honeywell).

Parker-Hannifin also has some exposure to non-residential construction/renovation on the HVAC side. We're not talking exposure on par with Honeywell, Eaton, or Siemens, but there aren't a lot of sectors pointing up for the company in 2016. Last and not least, exposure auto production and power gen could both continue to be positives in 2016 - while I'm not optimistic about auto OEM capex spending, I think auto production will be okay and I think power gen will be a stronger market in 2016 (though this is by no means a commonly/widely-held opinion).

Self-Help And Quality Can Help … To A Point

In the plus column for Parker-Hannifin, I'm encouraged that the company's core operating margins and segment margins have held up reasonably well. Even with accelerating organic revenue contraction (down 7% in the fiscal first quarter after a 5% decline in the fiscal fourth quarter of 2015 and flat results in the fiscal third quarter), company-wide operating margin has stayed above 10% and North American Industrial segment margins were down less than a point on an adjusted basis in the first quarter despite a double-digit decline in organic revenue. Along those lines, while management is looking for pretty significant contraction in FY 2016, the segment margin guidance from the first quarter of 14.6% to 15% (versus 15.3% adjusted in the quarter) is pretty encouraging.

Management also has what I think are relatively reasonable expectations for the next five years and a cogent plan to get there. Parker-Hannifin is already underway with a plan to generate about $70 million in annual cost savings, and it looks like management is more interested in an Illinois Tool Works-style (NYSE:ITW) slimming down. PH has close to 120 product divisions and consolidating some of these should produce savings though eliminating redundant expenses and improving sourcing.

As of the September investor day, management is looking for organic sales growth out to 2020 to average around 150bp better than global industrial production (estimated around 1.9%). That strikes me as a very realistic goal. I was a little more surprised to hear that the company is targeting a near-doubling of its share in motion control from around 11% to 20% or better - the surprise to me is that such an expansion wouldn't generate a bigger outperformance relative to global IP. Parker-Hannifin is also looking to drive better margins, with a long-term target of around 200bp of improvement in segment operating margins (to 17%).

Re-Assessing The Value

I was relatively more pessimistic on Parker-Hannifin than the sell-side back in the middle of 2015, but conditions in general manufacturing have gotten worse since then and conditions in markets like oil/gas, heavy trucks, and so on have also gotten incrementally worse. The net impact is a 5% to 6% reduction in my revenue expectations for the next two years. I think Parker-Hannifin can get some of this back with the eventual recovery, but markets like mining may not recover for a very long time. In any case, the net result is that my long-term revenue annualized growth outlook is now at around 3%.

I do believe further margin improvement is likely, and that can support an eventual climb toward double-digit FCF margins. That's not a tremendous improvement (I'm looking for FCF margins over the next decade to be about 140bp higher on average than the trailing decade), but consistent operators like Parker-Hannifin don't usually have a lot of easy levers to pull to drive better performance. If Parker-Hannifin can hit those figures, a 5% annualized long-term FCF growth rate is reasonable, as is a fair value above $107. Using an alternative valuation approach that uses ROE to generate a "fair" price/book multiple gives me a target of around $105.

The Bottom Line

Unless this is the kickoff to a longer/deeper recession, investors look rather spoiled for choice among the higher-quality industrial stocks. Eaton and Parker-Hannifin are both down about 20% from the time of my last article on PH and there is a disturbingly long list of companies whose shares are down 20% to 30% over the past year.

Clearly there is still risk here. I'm looking for a roughly 15% peak-to-trough drop in Parker-Hannifin's revenue, but a more serious global slowdown could take that to 20% or more and take the share price down even worse. If you don't think this is the start of a multiyear period of global economic gloom (or doom), this is probably an attractive time to build a long-term position in PH, but as I said, there are a lot of choices out there now and investors should shop around a bit - given the trends in most markets, I don't think there's a need to rush to get in today.

Disclosure: I am/we are long MSM.

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.

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