Parker-Hannifin: Onward And Upward
Summary
- Parker-Hannifin is set to announce 2022 fiscal Q1 numbers on Thursday.
- The company is months away from acquiring Meggitt, a deal that will increase the importance of the aerospace business and set the company up for another decade of growth.
- Parker shares are fairly valued at current levels, but increased leverage from the Meggitt deal could be problematic in the event of a macroeconomic slowdown in the next two years.
- I currently hold shares in Parker, but would wait for a pullback to ~$270 before adding to the position.
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Parker-Hannifin (NYSE:PH) is scheduled to report Q1 fiscal 2022 earnings before the market open on Thursday and they are expected to report solid top line growth. The company provided guidance for fiscal year 2022 in August, with a GAAP EPS range of $14.08 to $14.88 and $16.20 to $17.00 on an adjusted basis, with organic growth of 5% to 9%. The consensus EPS forecast for Q1 is $3.78, with estimates ranging from $3.64 to $3.92. The company announced that they would have an acquisition-related intangible asset amortization charge of $320MM in 2022 and the first quarter is often one of the slower quarters for Parker, so anything over $3.70 of GAAP earning would be a reasonable result for Q1.
Parker-Hannifin earnings by quarter - from author
Competitor Collins Aerospace group, part of Raytheon Technologies (RTX), reported a 7% increase in sales versus last year in their most recent earning report last week, including a 38% increase in aftermarket parts and a 3% decline in commercial market original equipment. In addition to Aerospace, Parker has exposure to high growth areas like automation and weight reduction in transportation to help drive similar revenue growth. The company has posted four consecutive quarters of sequential earnings growth after bottoming out in fiscal Q4 last year.
Revenue Driving Cash Flow Growth
The company has a long history of driving outstanding shareholder returns, with free cash flow having increased from $960MM in 2011 to $2.37B last year, a 147% increase. The Parker has used some of the cash to reduce the number of fully diluted outstanding shares from 154,664,510 shares in 2012 to 130,834,478 at the end of fiscal 2021, a 15.4% reduction. The share price has reflected the underlying performance, having more than tripled in the last three years.
Much of the recent growth has been driven by acquisitions, starting with the $4.54B purchase of filtration company CLARCOR in 2017. CLARCOR had sales of $1.52B in 2016 and averaged $198MM in net cash from operating activities over the prior three years.
Parker made two large acquisitions in 2019, with the purchase of EMFCO Holdings Incorporated, parent company of Exotic Metals Forming Company LLC ("Exotic") for $1.7B in September followed by the $3.5B purchase of LORD Corporation in October. LORD had annual sales of approximately $1,025 million for its fiscal 2018 and Parker paid 15.1x EV/adjusted EBITDA, compared to a 12.9 EV/adjusted EBITDA purchase price for EMFCO. Parker was able to quickly deleverage after the two deals, paying down $3B in debt over the following two years.
Meggitt Next Acquisition-based Growth Driver
With the debt/EBITDA ratio back under 2.5 and credit still relatively cheap, Parker announced the acquisition of Meggitt in August for $8.8B. Meggitt, an aviation components manufacturer, had revenues of $2.3B in 2020. If the deal closes as expected by Q3 2022, the aerospace business would go from representing 19% of Parker's revenues up to 31%.
From Parker-Hannifin/Meggitt merger presentation
Meggitt anticipates earning of $232 to $260MM for 2021 and Parker is paying 16.3x EV/2019 Adjusted EBITDA. The price seems a bit rich, but Parker believes they can generate $300MM in pretax cost savings by the end of the third full year following closing by leveraging a common supply chain, reducing their manufacturing footprint, and reducing SG&A. However, the cuts will cost the company at least $250MM in upfront expenses, creating an initial headwind. The two companies have complementary portfolios with very little overlap, so there won't likely be any major divestiture necessary to achieve regulatory approval.
From Parker-Hannifin/Meggitt merger presentation
The acquisition is expected to deliver a high single-digit ROIC by year 5 and continue to increase thereafter, which would be in line with Parker's recent ROIC history. Meggitt's profit margins pre-COVID were also comparable to Parker's, so Parker is by no means sacrificing margins for volume.
Parker's margins have also been in line with peers like Eaton (ETN) and Donaldson (DCI) over the last decade and margins have been trending upward since the purchases of LORD and Exotic Metals Forming. Overall, Parker has demonstrated solid execution and my only concern would be a prolonged macroeconomic slowdown while the company is carrying a higher debt load after closing the Meggitt deal.
The deal is being funded in part by a three-year, $2B term loan with interest rates based on either a base rate (see 8-K filing) or LIBOR, plus a per annum spread between 0-0.625% for the base rate and 1-1.625% for LIBOR. Parker's short and long-term debt were placed on watch and Fitch indicated that the deal could lead to a two notch downgrade from their BBB+ rating. The interest rate might reach 2.44% if Parker's debt reaches the lowest rating levels outlined in the loan agreement. The interest rate is entirely manageable under most market conditions. However, we have seen two liquidity panics during the last two recessions, so even a remote risk must be taken into consideration.
Near-term Dividend Growth Likely Limited
The company declared a Q4 dividend of $1.03 per share for shareholders of record as of November 12, 2021, which equates to a forward dividend yield of 1.39%. Parker has steadily increased their dividend over the years and has maintained a low payout ratio. Further dividend increases may be muted for several years while they pay down debt from the Meggitt deal. The dividend payout was increased last quarter, so technically the annual payout will be increased next year even if the quarterly dividend rate remains unchanged.
Is Parker a Buy?
Parker has averaged just over $1.9B in free cash flow generation over the last three years and has a track record of steadily increasing free cash flow. Shares seem to be fairly valued currently at 16.4x trailing 12 month FCF and ~20x average FCF over the last three years.
The Meggitt deal could easily add 20% to Parker cash flow over the economic cycle, but the deal would present a near-term risk until Parker is able to reduce leverage. I currently own shares in Parker and plan on holding for the foreseeable future, but I plan on holding off on adding to my position until shares are closer to $270 to provide a margin of safety.
This article was written by
Analyst’s Disclosure: I/we have a beneficial long position in the shares of PH either through stock ownership, options, or other derivatives. 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.
This article represents the author's opinion and is not intended as investment advice. Readers are encouraged to perform their own research before making any investment decisions.
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