Parker Hannifin (PH) surprised the market by announcing a large deal last week. For $4.3 billion dollars, it is buying its smaller rival Clarcor (CLC) which improves Parker´s diversification while enhancing exposure to the more stable aftermarket sales segment. The deal takes place at a relative steep multiple, although large anticipated synergies make the deal look fair, but not necessarily cheap.
As a result I have a rather neutral stance on the deal, yet I worry a bit about the prospects for investors in Parker going forward. This comes after shares have run up by nearly 50% in 2016 on the back of hopes of a recovery in industrial end-markets amidst the recent recovery in commodity prices.
Motion & Control, Parker´s Core Competency
Parker Hannifin has defined its core competency in motion and control, having subdivided its activities across four segments: motion systems, flow & process control, filtration & engineered materials, and aerospace systems. As each of these segments have multiple focus areas themselves, it is evident that Parker is a very diversified business already, having exposure to many parts of the economy.
The company has made great achievements in the past, at least according to its investor presentation. The company has done so by offering premium solutions and by focusing on markets (segments) which it can dominate with market shares of over 20%.
The company is on track to post segment operating margins of 14% in 2016, a major improvement from margins of nearly 10% in 2009, and little over 7% in 2002. The company targets further gains in the coming years, as segment margins should improve by another 300 basis points towards 17% of sales by 2020. These gains should be accompanied by other goals such as growing faster than the overall market, deliver on improved return on capital metrics and continue to generate strong cash flows.
While the company points towards long term margin improvements being realized since 2002, the ten year picture shows much more modest achievements. The company is now posting sales of $11.2 billion on a trailing basis, merely 5% above revenues reported in 2007. Reported operating margins are stable at 11% on a corporate level. This suggests that actual earnings have been largely stable, although earnings per share have grown on the back of share buybacks. This comes after Parker has bought back one in every four shares outstanding over the past decade.
While Parker Hannifin has traditionally focused on organic growth, accompanied by some very small acquisitions, it has diverted from this path with the purchase of Clarcor.
Parker Hannifin has agreed to acquire the company in a $4.3 billion deal including the assumption of debt. The $83 offer for Clarcor represents a near 18% premium compared to the unaffected price, as the offer is almost double the level at which shares traded at the start of the year.
Clarcor creates mobile, industrial and environmental filtration products, generating $1.4 billion in revenues and $253 million in adjusted EBITDA in the process. The products offered by Clarcor are complementary to those of Parker, adding both international and domestic sales to Parker´s business. This includes a big aftermarket sales stream which is applauded by investors as these revenue streams are highly recurring in their nature.
Besides this strategic rationale, the deal has a financial component as well which makes the acquisition worth pursuing. Parker Hannifin aims to cut costs by $140 million a year, although it will take three years to deliver upon these anticipated savings.
These costs savings are very much needed to justify the deal which takes place at a valuation which is equivalent to 17 times trailing adjusted EBITDA. Including synergies, the multiple comes down to a more acceptable 10.9 times, still not marking a true bargain in my eyes.
Modeling The Contribution Of Clarcor
The pro-forma impact of the purchase of Clarcor is relatively limited, despite the fact that the deal tag is big in absolute dollar terms. Clarcor will add $1.4 billion in sales, expanding the revenue base of Parker by some 12%, while being slightly accretive to margins as well.
Clarcor is adding $207 million in EBIT, although that number is positively impacted by a $27 million patent litigation award, for a more normalized number of $180 million. With a $4.3 billion financing component related to the deal, I see little accretion in the short term. Assuming no synergies on day one, and using a 4% cost of debt, the deal is neutral to earnings per share in the near term.
Gradual deleveraging and realization of synergies has the potential to significantly boost earnings. Assuming a $180 million EBIT contribution and another $140 million in synergies, while working with lower financing costs of $150 million in a year or two (following deleveraging), after tax earnings could increase by $125 million by 2018. That would add nearly a dollar to the reported earnings per share.
Pro-forma sales will increase toward $12.8 billion. Parker posted $1.67 billion in adjusted EBITDA on a trailing basis. Including the $253 million contribution of Clarcor and the anticipated synergies, adjusted EBITDA is seen at $2.06 billion going forward.
Parker Hannifin has sizable cash holdings to finance the $4.3 billion deal, holding $2.14 billion in cash while operating with $3.25 billion in debt. This suggests that net debt will come in at $5.4 billion following completion of the deal, for a 2.6 times leverage ratio. If we add in $1.8 billion in pension related liabilities, leverage ratios are set to rise towards 3.5 times.
Parker Hannifin has 136 million shares outstanding which trade around $142 per share, giving the company a roughly $21 billion enterprise valuation ahead of the Clarcor deal. That is equivalent to roughly 12-13 times adjusted EBITDA. The 17 times multiple paid for Clarcor looks steep in that light, although that metric falls to 11 times including synergies, making the deal fair at best, but not necessary very cheap. It should furthermore be said that leverage ratios will be elevated following the deal, ranging from 2.6 to 3.5 times EBITDA, depending if you include pension related liabilities or not.
At $142 per share, and given that shares have already risen 46% so far this year on the back of a recovery in crude prices, the valuation looks full. Based on the outlook for 2017, which calls for adjusted earnings of $6.40-$6.70 per share, valuation multiples come in at 21-22 times adjusted earnings, amidst a balance sheet which has gotten a bit leveraged following the Clarcor deal. That said, this deal has the potential to add upto $1 per share in earnings by 2018-2019, reducing the multiples towards 18-19 times. This is still not that appealing given the recent dollar strength, leveraged balance sheet and fact that synergies take time to materialize.
The real appeal has to come from a 200-300 basis point improvement in margins by 2020, as outlined in Parker´s strategy. That should boost pre-tax earnings by some $250-$375 million if all goes to plan, having the potential to add $1.30-$2.00 to earnings per share by 2020. Using the current earnings number, assuming the Clarcor deal works out, and factoring in successful margin expansion, I see a $9 earnings per share number for 2020.
Applying a market multiple of 18 times earnings to such earnings potential, and factoring in 10-20% cumulative revenue growth, I can make the case for $10 earnings per share by 2020. That suggests fair value of around $180 per share, but leaves just 25% upside in the coming four years, not being very compelling. As such I can only conclude that shares are more than fully valued after the great run-up seen already this year.
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.