Parker-Hannifin's organic revenues are expected to drop in fiscal 2020 versus fiscal 2019 levels due largely to exogenous headwinds.
Short-term headwinds aside, stellar free cash flow conversion rates and margin expansion opportunities paint a promising long-term growth outlook.
In this article, we analyze Parker-Hannifin's intrinsic value and dividend coverage.
By Callum Turcan
Industrial firm Parker-Hannifin Corporation (PH) has been on an epic run since late 2015, but we think there’s room for shares of PH to shift higher still if management’s ambitious financial targets are met. As of this writing, Parker-Hannifin trades near our fair value estimate of $197 per share, with the top end of our fair value range indicating shares of PH could move up towards the $230s. Shares of PH yield 1.8% as of this writing. You can read more about the enterprise valuation process in the book, Value Trap: Theory of Universal Valuation, so we won't spend much time on the nuts and bolts in this piece.
Our fair value estimates are derived through our rigorous discounted free cash flow analysis, or spoken plainly, Parker-Hannifin’s estimated future free cash flows discounted by its estimated weighted-average cost of capital, adjusted for the balance sheet. We define free cash flows as net operating cash flow less capital expenditures, a common and traditional metric (we use enterprise free cash flows in our valuation process, but the gist is the same). In the graphic down below, from our 16-page Stock Report, we highlight how we arrived at our fair value estimate (specifically for the baseline scenario, under more optimistic assumptions that are still reasonable, we see Parker-Hannifin carrying an intrinsic value up to $236 per share). Note the fair value distribution below.
Image Shown: Most of the value of Parker-Hannifin’s equity comes from the expected discounted free cash flows during the mid-cycle and perpetuity part of the business cycle.
Please note Parker-Hannifin’s free cash flow conversion rates have simply been stellar at over 100% of net income (defined as free cash flows divided by net income in a given period). Companies with strong free cash flow conversion rates are prime dividend growth opportunities, as that paradigm indicates the level of investment (namely capital expenditures) needed to maintain ordinary business operations is tame enough to allow for a good chunk of company’s net operating cash flows to filter down to its balance sheet. That “excess” cash (free cash flows) can then be used for dividend payouts, share buybacks, net debt reduction, acquisitions, and other endeavors.
Companies that have poor free cash flow conversion rates are either undergoing periods of significant expansion (meaning their conversation rate is being artificially held down), or require high levels of continuous investment that could indicate the business model isn’t as strong as net income generation would have it appear. In the graphic down below, Parker-Hannifin highlights its first quarter fiscal 2020 (three month period ended September 30) free cash flow conversion rate of 118%. Which again, is simply stellar.
Image Shown: Parker-Hannifin’s business model is appealing due to its ability to generate “excess” cash for investors. Image Source: Parker-Hannifin – First quarter fiscal 2020 IR earnings presentation
We see Parker-Hannifin’s forecasted free cash flows over the next five full fiscal years, less its net debt position, fully covering its estimated dividend payouts and then some as you can see in the graphic below (from our two-page Dividend Report). While we expect some changes as we update our report in the coming weeks, this suggests the dividend is on pretty solid ground.
Image Shown: We like Parker-Hannifin’s dividend coverage.
Margin Expansion and Short-Term Headwinds
Parker-Hannifin posted a total segment (non-GAAP) operating margin of ~17% in fiscal 2019 (ended June 30), up from ~15% in fiscal 2017. While management is still targeting long-term improvement, Parker-Hannifin’s segment operating margins are expected to come under fire in fiscal 2020 as indicated in the graphic below.
Additionally, please note the company is expecting flat sales growth on an annual basis in fiscal 2020. Furthermore, that guidance is heavily influenced by two major acquisitions closing recently. Parker-Hannifin’s all-cash $1.7 billion acquisition of Exotic Metals Forming Company (maker of motion and control technologies) closed in mid-September, and its all-cash $3.7 billion acquisition of LORD Corporation (manufacturer of adhesives, coatings, vibration control technologies, and motion control technologies) closed in late-October. Remove that uplift from the picture, and Parker-Hannifin’s organic revenues are expected to shift meaningfully lower this fiscal year.
Image Shown: Parker-Hannifin’s fiscal 2020 performance is feeling the pressure from a massive slowdown in global industrial activity of late, including in the US. Image Source: Parker-Hannifin – First quarter fiscal 2020 IR earnings presentation
Management had this to say on Parker-Hannifin’s fiscal 2020 guidance during the firm’s first quarter fiscal 2020 conference call:
“Now switching to the outlook, we advised guidance for FY ‘20, we have seen a market shift within the last 90 days as reflected in [weakened] order entry, primarily driven by macro conditions and trade certainties. So when you look at total sales for Parker in FY ‘20 are expected to be flat year-over-year at the midpoint. With guidance now, these midpoint numbers at minus 6 organic, minus 1 for currency and plus 7 on acquisitions. Segment operating margin guidance is now at 15.2% as reported at the midpoint and the adjusted midpoint is now 16.3%.”
Longer-term, management sees the two aforementioned acquisitions (and others, given Parker-Hannifin’s acquisitive streak over the past few fiscal years) driving margin expansion and sales growth. Once temporarily business integration costs are out of the way, that should provide a nice tailwind for future margin expansion. If a deal trade, a concrete one, materializes between the US and China, that would really behoove Parker-Hannifin’s short- and medium-term trajectory. Here are some more key comments from management that were given during Parker-Hannifin’s latest conference call;
“Synergy savings from CLARCOR [a previous all-cash $4.3 billion acquisition that closed in February 2017] are still estimated to achieve a run rate of $160 million by the end of fiscal 2020, which represents an incremental $35 million of year end savings. In addition, guidance on an adjusted basis excludes $27 million of integrated costs to achieve for LORD and Exotic and $200 million of one-time acquisition-related expenses. LORD and Exotic are expected to achieve synergy savings of $15 million this fiscal year.”
Expected synergies should have a powerful impact on Parker-Hannifin’s medium- and long-term growth trajectories, especially as it relates to growing its free cash flows. Short-term headwinds aside, which are largely outside of the company’s control, Parker-Hannifin’s growth prospects still look quite strong. Parker-Hannifin is seeking growth in the aerospace industry, with that segment’s (non-GAAP) operating income growing by 45% from fiscal 2017 to fiscal 2019. Synergies enhance that upside by keeping costs contained and enabling Parker-Hannifin to build up the scale required to be competitive in the space.
Parker-Hannifin is a quality company targeting growth in industries where free cash flows can be quite dear; however, exogenous shocks cloud over its short-term outlook. We’ll be keeping an eye on Parker-Hannifin going forward and think the firm’s longer-term outlook justifies its current share price with room for significant upside if cost synergy targets and ultimately margin expansion are realized.
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.
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