Parker-Hannifin Q4 2021 Earnings Call Transcript

Quartr
Provided by Quartr
August 5, 2021

There are 12 speakers on the call.

Operator

Good day and thank you for standing by. Welcome to the Parker Hannifin Fiscal 2021 4th Quarter and Full Year Earnings Conference Call and Webcast. At this time, all participants are in a listen only mode. After the speakers' presentation, there will be a question and answer session. Please be advised that today's conference is being recorded.

Operator

I would now like to hand the conference over to your speaker today, Parker's Chief Financial Officer, Todd Lambrunno.

Speaker 1

Thank you, Dawn, and good morning, everyone. Thanks for joining our FY 'twenty one Q4 earnings release webcast. As Dawn said, this is Tas Liam Bruno, Chief Financial Officer speaking. I'm here today with Tom Williams, our Chairman and Chief Executive Officer and Lee Banks, our President and Chief Operating Officer. If you could focus on Slide 2, this is the company's Safe Harbor disclosure statement addressing forward looking Statements and non GAAP financial measures.

Speaker 1

Reconciliations for any non GAAP measures are included in today's materials. Those reconciliations and our presentation are accessible under the Investors section at parker.com and will remain available for 1 year. As usual, we'll start today with Tom providing some highlights for the quarter and our record fiscal year, as well as some color on Parker's transformation. Following Tom's comments, I'll provide a brief financial summary and provide some details on our FY 'twenty two guidance that we just released this morning. I'll then hand it back to Tom for closing comments, and then Tom, Lee and I will open the lines for Q and A.

Speaker 1

And just one reminder, in respect to the announcement we made Monday Concerning the Meggitt acquisition, we are still bound by the requirements of the U. K. Takeover code. With that, I'll ask you to move to Slide 3, and I'll hand it off to Tom.

Speaker 2

Thank you, Todd. Good morning, everybody. Thanks for joining us today. This marks the end of FY 'twenty one for us, and it was a difficult year Personally and professionally for everybody due to COVID, but it was a year where the Parker team really shined. We delivered outstanding results and lived up to our purpose in enabling a better tomorrow, And my thanks goes out to the global team for just a great year, great quarter.

Speaker 2

So let's start with the quarter. It was Dynamite, Top quartile safety performance, 29% reduction in reportable incidents. The sales growth in the quarter was 25% approximately. Organic was almost 22%, and the industrial portion of the company grew at almost 27% in the quarter. We have 6 all time quarterly records: Sales, net income, EPS, segment margins for Total Parker as well as North America and International.

Speaker 2

The EBITDA margins were very strong at 21.8 percent as reported or 22.1% adjusted. That was 190 basis points improvement versus prior. On the segment operating margin, on an adjusted basis, if you go to that last row, 22.2% or a 2 30 basis point improvement versus prior. Just a great quarter and a really great team effort by everybody around the world. Go to Slide 4, we'll move to the full year.

Speaker 2

It was a year of records, and I won't read all these to you, but you can see 8 all time fiscal year records. And just that's in the history of the company, so that's 104 years to put up So it speaks to how well the team performed in this last fiscal year. Sales growth came in almost 5% year over year. Organic was flat, But clear momentum building on orders and organic growth in the second half of the year as you see from our order rates. FY 'twenty three margin targets, We hit them at full 2 years early, and we'll be announcing new targets once we have Investor Day March of next year, And we're going to go out for a new 5 year target, so we'll be going out to FY 'twenty six.

Speaker 2

We look forward to that discussion at that time. Operating cash flow was 2 point $6,000,000,000 a record. It was almost 18% of sales. Free cash flow conversion rate was 135%, And we were very pleased to be able to announce the offer to acquire Mega Plc, which greatly enhances our aerospace portfolio, and I'll touch on that So if you go to Slide 5, I want to talk about the transformation of the company, give you a little bit of color behind what's driving it and the progress we're making on the results. On Slide 6 speaks to those 3 drivers: living up to our purpose, being great generators and deployers of cash, and being a top quartile performer.

Speaker 2

I'm going to touch on each one of these over the next several slides. When it comes to purpose, enabling engineering breakthroughs that lead to a better This is something that really resonates with our people. It represents a higher calling to your work, and it acts as our North Star. In the next few slides, I'm going to talk about and highlight our purpose in action, specifically our technologies and how they're helping healthcare, How they're helping the climate and create a more clean technology world for everybody. So on Slide 8, we're going to talk about vaccine production, In particular, something that's obviously very pertinent for today, COVID-nineteen production.

Speaker 2

On the left hand side speaks The challenges that drug manufacturers have today. This is a batch process typically with extensive inventories, long lead times to produce these products. They take huge space requirements, large footprints for storage, large footprints for the manufacturing processes and very typical changeovers. Cleaning cycles between the batch processes is very complicated. So the idea here is a simple concept that most of us can relate to.

Speaker 2

All of us have been in some kind of restaurant with a soda fountain where you can pick your beverage of choice. And of course, the technology behind that is The concentrated syrup and carbonated water and you get to pick the soft drink of your choice. So the idea here is instead of soft drinks, Could we deliver sterile vaccine ingredients with a similar type of process? And on Slide 9 is that process. So it's our in line dilution system.

Speaker 2

It's a proprietary point of use process for combining the purified vaccine ingredients. So you look at that piece of equipment, you can see it's on wheels. So it's modular, Easy to move around, easy to deploy, has mixing and sensing combined, it has two way communications via the IoT enabled system, It can talk to the manufacturer's enterprise system to enable scheduling just in time. It uses very importantly Intellectual Property Protected Single Use Consumables. So instead of these massive batch processes, huge cleaning events for changeovers, This is a giant productivity improvement for the drug manufacturers on the speed of the changeover, but also just reducing contamination tied to the changeover.

Speaker 2

Then our software And automation helps control the amount and the flow of these various ingredients. So this applies obviously to COVID-nineteen, apply to other vaccines That are being developed and that we can use this for other drugs as well. So this is a really attractive business opportunity for us, but more importantly, it's a great help to customers And society is a great example of our purpose in action. Move to Slide 10, move to the climate and the clean technology portion of our purpose. We just recently announced last month new sustainability targets.

Speaker 2

You see on the right hand side of this page is our new sustainability report, which you can reach electronically. We're announcing a 50% reduction in emissions by 2,030, so that'd be Scope 1 and 2 emissions, direct and indirect. And then by 2,040, same thing, Scope 1 and Tube to be carbon neutral. So enabling a more sustainable future with what we do with our plants, Our operations, our supply chain. But in addition, if you go to Slide 11, and actually more importantly, how can we help our customers How can we help society with the sustainability journey?

Speaker 2

And so on this page, you see the 8 motion control technologies And that this portfolio, approximately 2 thirds of this portfolio is a very much part of the enabling of clean technologies for our customers. The exciting part is the expanding bill of material On automobiles, on construction equipment, on forestry, on mining, basically almost every piece of equipment, on airplanes, engines, Everything is feeling this impact for more electric applications. So there's onboard opportunities, But there's also infrastructure opportunities as the world has to build in infrastructures to support that growth. Our technologies can help And then I want to move to Slide 12, which illustrates the top quartile performance portion of those three drivers. And you can see we're using 2 metrics to illustrate this, adjusted EPS on the left and adjusted EBITDA margin on the right.

Speaker 2

That's really been our people, the strategic portfolio changes we made, the capital deployment decisions that we made over the last 7 years and the one strategy that's transformative performance. When you step back and look at this, this is just remarkable improvement. On the left is a more than doubling of our EPS, And that's hard to do. I can assure you that's really hard to do. So this is fantastic progress, a little less than $7 in FY 'sixteen and over $15 as we closed last year.

Speaker 2

And the EBITDA margin, which has clearly been propelling that from 14.7% to 21.3%, so a 660 basis point And then the last part on transformation and the drivers is cash generation and deployment. We touched on the cash generation piece in my opening comments, but clearly in the deployment, it's how to deploy capital and buying effective companies. And we're very excited to put 2 high quality companies together in aerospace combination that we announced Monday, Parker and Meggitt, Nearly doubles the size of our Aerospace Systems segment with highly complementary technologies, 70% sole source, a strong recurring revenue, Excellent growth potential, combination of commercial, aerospace recovery as well as the synergies, and this will be accretive to our organic sales growth, Margins, EPS and Cash Flow. This deal makes sense for all stakeholders, the shareholders of Parker and Megan, the team members of both of our companies, The parishioners, pensioners and of course, both of our customers. Following the announcement on Monday, we've introduced ourselves to the key stakeholders in the U.

Speaker 2

K, Reinforcing why we are the best home for Meggitt. Our long great track record in the U. K, the clear strategic rationale for the deal, Including the premium we are offering to the Meggitt shareholders, our shared interest to continue to innovate and invest, and that we are committed to being a responsible steward of Meggitt. That is why we've agreed with Meggitt to offer the U. K.

Speaker 2

Government a number of legally binding commitments about how we will operate going forward. These type of transactions take time, We are pleased with the reception so far, and we look forward to constructive discussions with the key people in the U. K. Government. And we'll keep you updated as the process unfolds And we go to the planned completion of this in approximately 12 months.

Speaker 2

With that, I'll hand it back to Todd for more details on the quarter.

Speaker 1

Yes. Thanks, Tom. I guess I would like to direct everyone's attention to Slide 15, and I'll just real quickly walk through the FY 'twenty one Q4 results. As Tom mentioned earlier, we have some outstanding results to share here. Sales increased over 25% in Q4 versus prior year And finished at $3,900,000,000 As he said, that's an all time record for the company.

Speaker 1

And we're really particularly proud of this

Speaker 2

Due to the

Speaker 1

fact that our aerospace markets are still challenged. It really demonstrates the strength of the portfolio additions that we've spoken about, CLARCOR, and really is driven by strong prop based demand across all of our industrial businesses. Organic sales are up 22% in the quarter. So basically, the majority of that 25% change is all organic. This is the first time organic sales have been positive for the company over 2 years.

Speaker 1

Currency also was favorable with a 3.5% impact to total sales. Moving to adjusted segment margins, that 22.2% is an improvement, like Tom said, of 2 30 basis points from prior year, and it's also 80 basis points improved sequentially from Q3. Just another strong quarter of margin performance as really our teams around the world pivoted to the increased demand levels Managed through a number of challenges. Very proud of our team for that margin performance. Incrementals are also commendable at 31% year over year, Really impressive considering last year was the depth of the pandemic, and our decrementals last year were fantastic at plus or excuse me, minus 13%.

Speaker 1

And if you remember, that included approximately $175,000,000 of temporary savings in that FY 'twenty Q4. So we're really happy with the 31% incrementals. EBITDA margins also expanded 190 basis points from prior year, finishing the quarter at 22.1%. If you look at that net income number, dollars 577,000,000 that's an ROS of 14.6 percent, and that's an increase of nearly 50 All of those great results translated to an adjusted EPS of $4.38 That's an increase of 1.39 share or 46% compared to the prior year number on this slide of $2.99 Just one point I want to reference to the prior year numbers, And I'm really speaking to net income and the EPS numbers only. We have been planning for some time to convert our remaining U.

Speaker 1

S. Locations That used to use LIFO for inventory valuation to standardize that across the company and move to FIFO inventory valuation purposes. We made that voluntary change in FY 'twenty one Q4, and we've retrospectively applied that change to prior years, We've attached the impact of those prior years to this press release in the table section. So impact to the previously reported quarter last year was minimal. It was only $0.04 last year.

Speaker 1

So the $2.99 on this page, if you're looking back to prior year, that would have been $3.03 in FY 'twenty. So one other note I want to make, LIFO, we've always booked this at the corporate level. This has no impact to our segment operating margins or The incrementals that I just mentioned too and now 100% of the company's inventory is valued using the FIFO method. So just one last comment on the quarter, really proud of our team globally. It's just a tremendous effort the team put forth to So if we could move to Slide 16, this Just a bridge of that $1.39 increase to adjusted EPS that I just mentioned.

Speaker 1

And what I love here is the largest bar on the page Signals the strong operating performance that the teams put together. Our segment operating income on an adjusted basis increased $250,000,000 Or 40% from prior year Q4. That accounts to $1.50 of the increase in EPS that we just Put up for the quarter of $1.39 so it's really strong execution really everywhere across the company. All the other items you see on the If you net it, it's $0.11 unfavorable. Corporate G and A income tax and shares were slightly unfavorable, but lower interest and lower other expense have partially So again, most of this is really fantastic due to comparing back to Our COVID impacted quarter of the prior year.

Speaker 1

If you go to Slide 17, just some color on our segment performance. Really, the message here is our industrial businesses delivered outstanding results across the board. We've Spoken in the past about the impact these portfolio changes have had on the company, and you could see it here in these margin numbers. Diversified North America sales were $1,800,000,000 in the quarter. Organic sales improved again in this Segment sequentially up and are up 26% versus prior year.

Speaker 1

Operating margins improved Impressive 300 basis points versus prior year and really finished at 22.5% for the quarter. Obviously, volume helps us a little bit there, but Really the disciplined operating performance and cost control really continue to drive the sizable increase to margins. Margins in this segment are a record, all time record, and incrementals also were very healthy at 34%. And again, I keep referencing the comparables back to last year, which is just a very tough comparison. If you look at order rates, order rates are robust at +50 6%.

Speaker 1

This is up sequentially from last quarter. We reported plus 11% and really just strong across the board. If I move to the international, diversified international segment, really same story here, a little bit higher organic growth of 28.5%. Sales just reached $1,500,000,000 in that segment. And again, another story here, adjusted segment operating margins expanded Growth in that volume coupled with that cost containment and productivity initiatives really generated this record margin performance in this segment as Order rates again here, tremendous, up a little bit higher than North America at plus 58% versus 14% positive in the last quarter.

Speaker 1

So really just a great performance out of our industrial business. I'll just touch on Aerospace Systems really slightly, very sound performance In the current market, sales here were $603,000,000 for the quarter, and I'm happy to report organic sales have turned positive in this segment. They are up 1%. We saw strength in commercial and military aftermarkets, with strong sequential growth again in Q4, And we're happy to start seeing rate increases from OEMs, particularly in the narrow body and business jet platforms. Aerospace orders also got less negative and improved to minus 7% this quarter on a rolling 12% basis versus minus 19% last quarter And further proof that we are seeing signs of recovery in this area.

Speaker 1

Operating margins also very strong 21.6 That improved sequentially from Q3 and really finished the year at the highest level they've had in the entire fiscal year. So very proud of our aerospace So just looking at company at whole, we're really pleased with these results. That's a solid finish to the fiscal year. Our total incrementals were 31%. I'm really proud about that.

Speaker 1

And really just a comment, if I look at just our industrial businesses, If I go back to pre pandemic FY 2019 and on a like for like basis, if I include LORD in those FY 2019 numbers, In the Industrial businesses, our sales volume has surpassed pre COVID levels. So we're really proud about that. Orders you can see in total are plus 43%. And as Tom mentioned, not only did we achieve our FY 'twenty three margin targets, but we surpassed them, And we did that 2 years ago. So if I go to the next slide, Slide 18, cash flow.

Speaker 1

We're obviously very proud of this. Tom mentioned this earlier, full year cash flow from operations was $2,600,000,000 That's an all time record for the company, 17.9% Sales, just outstanding, top quartile performance. If you look at that compared to prior year, we generated over $500,000,000 more cash. That's 24% more cash than we did prior year. And like I said, that CFOA of $2,600,000,000 is a record.

Speaker 1

Working capital, really solid performance here, and I want to just really thank our teams everywhere around the world for focusing on this. We asked them to focus on this through the pandemic, and they delivered us soundly. So I want to thank you all for your focus on that. Free cash flow, also fantastic, 16.5%. That's up 3 10 basis points versus prior year.

Speaker 1

And the free cash flow conversion for the year, 100 and So with that, this now marks the 20th year that free cash flow conversion has been greater than 100% and cash flow from operations Great than 10%, 20 years running. All of this allowed us to significantly pay down Our serviceable debt, we've been vocal about that for the last couple of months. If you look at the last 20 months, we've paid down $3,400,000,000 of debt, And our gross debt to EBITDA finished the year at 2.1%. Net debt is 1.9%. So again, Similar story here, we achieved these leverage levels, a full 1 year sooner than we originally forecast, and it's just an outstanding cash position.

Speaker 1

It's top quartile execution and really impressive considering the backdrop of the global pandemic. So 2019, I will ask you to focus on 2019, just flipping to FY 2022 and our guidance you saw that we released this morning. As usual, we're going to provide this on an as reported and an adjusted basis. And I'll just start at the top. Sales, we're forecasting sales to increase in the range of 5% to 9%, really 7% at the midpoint and really the breakdown of that sales growth is essentially all organic.

Speaker 1

We do not expect the Mega transaction to close in FY 2022. Both LORD and Exotic have anniversaried, so those are no longer Considered acquisition sales. Therefore, we are forecasting no impact to sales from acquisitions. And currency is just a minimal drag at 0.2 percent of sales. And just like we always do, we'd have calculated the impact of currency to Spot rates at the end of June 30, and we've held those rates steady as we forecast FY 'twenty two.

Speaker 1

One thing I'll note, the sales split for the guide is 48% First half, 52%, second half. The next item I'll talk about is segment operating margin. On an as reported basis, the guidance for the full year is 19.3% at the midpoint, and there's a range of 20 basis points on either side of that. But more importantly, on an adjusted basis, segment operating margin guidance for the full year is 21.6% at the midpoint, Same range of 20 basis points on either side of that. This adjusted segment operating margin guide is 50 basis points higher than what we just finished our record FY 'twenty one at.

Speaker 1

Just some color on adjustments. At a pretax level, business realignment Charges are expected to be $35,000,000 for FY 2022. Lowered cost to achieve are only $7,000,000 for the forecasted year And acquisition related intangible amortization is $320,000,000 Just a note on the split, adjusted segment operating margins 46 percent first half, 52 percent second half. If you look at the corporate G and A interest and other, $480,000,000 is our forecast. That is the same on an adjusted and an as reported basis.

Speaker 1

Tax rate, we are forecasting full year to 23%. And finally, EPS on an as reported basis, our guidance is $14.48 at the midpoint. There is a $0.40 range on either side of that, and our adjusted EPS guidance is $16.60 at the midpoint, Same $0.40 range on either side of that. Adjusted EPS split, first half is 45%, second half is 55%. And a little color on Q1, we are forecasting adjusted EPS to be $3.60 at the midpoint.

Speaker 1

Slide 20 is the bridge and again this is very similar to Q4. Main driver of the $1.56 or 10% increase To adjusted earnings per share is just our continued strong execution across the enterprise. Segment operating margin is accounting for 1.7 Of that change, and then again, just slightly higher corporate G and A tax and average shares outstanding are a little bit of a drag, But all in, dollars 1.56 increase in earnings per share increasing earnings per share by 10%. Lastly, I will just talk about capital deployment for FY 2022. We are committed to our capital deployment strategies.

Speaker 1

We have a strong 65 year of record of consistently, consecutively increasing the annual dividends paid. We're going to continue with that record. Our payout target is not changed. It remains 30% to 35% of the 5 year average of net income. And of course, we're going to continue to fund organic growth and productivity across Our global locations, we expect capital expenditures to be 2% for the year.

Speaker 1

Our 10b5-1 share repurchase program, We reinstated that this year. We are committed to continuing that in FY 'twenty two. And as I mentioned when I was talking about cash flow, we have Distinguish all of our serviceable debt, and we are now in a cash building position. So our focus for FY 'twenty two will be to So with that, Tom, I'll turn it back to you, and I'll ask the audience to focus on Slide 22.

Speaker 2

Thank you, Todd. Just closing messages. What drives these results, the engine behind the company is our people, Highly engaged team, great culture, higher levels of ownership driving this performance, very inspiring results as you've seen. Moving up to our purpose, the vaccine production is a classic example that top quartile performance, the more than doubling of EPS, The 6 60 basis points improvement in EBITDA margin over the last 6 years. Getting the margin targets that we laid out for you 2 years early, and obviously, we're going to keep improving upon that.

Speaker 2

And the strategic deployment of capital and change in portfolio with CLARCOR, LORD, EXOTIC and now Meggitt, You put that together with the Win Strategy 2.0 and now 3.0 and it really spells for a bright future and we'll continue to accelerate the performance. And with that, I'll turn it over to Dawn to open up to Q and A.

Operator

Thank And your first question comes from the line of Scott Davis with Melius Research.

Speaker 3

Hi. Good morning, guys, and congrats on a great year.

Speaker 4

Thanks, Scott.

Speaker 3

I don't always say that, but I mean it. Guys, you've

Speaker 5

had a few days

Speaker 3

for this to marinate, the Meggitt deal at least. What's been the customer response and feedback to the announcement.

Speaker 2

Scott, it's Tom. We're early days on reaching out to customers. General view is very positive. They like the fact that this is a stronger bill of material opportunity to create more value, The highly complementary technologies and really the track record of both companies. Both companies have a great reputation, Great innovators, great engineering led companies, so the response so far is very positive.

Speaker 3

Good to hear. And Not to get too nitty gritty here, but you didn't really talk much about some of the challenges out there on the cost side, supply chain, Disruptions, logistics, all of that. I mean, clearly with 31% incrementals, it couldn't have been too big of a deal for you guys, but perhaps you could help us understand How you've managed through that and how you're thinking about that as it relates to guidance over the next 12 months as well?

Speaker 4

Hey, Scott, it's Lee. I'll take a shot at answering this. I think the first thing on the supply chain side is just To kind of step back and recognize how we're structured, which is a huge benefit for the company. So as you know, we make, sell and source in the region For the regions, what allows us to be closer to customers and get away from a lot of international shipments. Having said that, we're not immune to what's going on in any of the regions, but I would characterize it internally as being manageable, But not without hard work.

Speaker 4

Now I would say the biggest challenges we're dealing with is just our customers. So I mean, I think automotive is very public on what's happening, but I probably don't have a large OEM that has Had some kind of disruption where lines have been down, people have been sent home, etcetera. So we're working with our customers to work through that. It's just creating a lot of chatter in the channel and it's just I would say best is a lot of choppy production.

Speaker 3

Yes, makes sense. Okay, thanks, Lee.

Speaker 6

Yes, you bet.

Speaker 1

Appreciate it, guys.

Operator

I'm sorry. Your next question comes from the line of Jamie Cook with Credit Suisse.

Speaker 7

Hi, good morning and nice quarter. I guess Just a couple of questions. Can you help us understand the what you assume for organic growth in the first half versus the second half and what you're assuming sort of Price versus volume. And then I guess the aerospace like the top line guide to me seemed like With what's going on, I understand we have the delta variant, but there could be some level of conservatism there as we think about sort of the top line. So if you can just help me understand what Your assumptions are on the aerospace guide.

Speaker 7

Thank you.

Speaker 2

Jamie, it's Tom. I'm going to take the guide and I'll take a few minutes I'll go through the aerospace piece. I'll let Lee touch on the price cost aspect. So this is probably the So first of all, there's a number of tailwinds, And I'll highlight some of the headwinds. But on the tailwind side, clearly, the order trends, the macro environment, I think there's a CapEx Under spend that happened for a number of years, so I think there's some CapEx demand that's coming back from manufacturing companies.

Speaker 2

Clearly, Governments being more prone to put in stimuluses, the rebound from the great shutdown and of course So, rebound of activity, the commercial aerospace recovery, which I'll touch on to answer your question here in a minute, Jamie, Low interest rates and then the Climate investment, which with our same technology portfolio is a very attractive positive for some future. On the headwind side is the delta variant and COVID, it hasn't gone away and is creating uncertainties throughout the world. The Supply chain disruptions, in particular our customers and how that might impact demand patterns, which Lee touched on, and inflation, both on the material side and on wages. But we've built a pretty sophisticated AI model over the last 18 months. It's not perfect, nothing is when it comes to forecasting.

Speaker 2

But in my time at the company, it's the best tool we've had to date. And we factored in all these inputs and came up with what the best forecast is. I'll give you a little more detail behind it. The first half that we're looking at is up a little over 9% Organically, in the second half, up mid single digits. That's how you get to the 7% overall.

Speaker 2

An important part though, if you look at the industrial piece, Both North America and industrial approximately the same, up 11% in the first half and up mid single digits in the second half. When you think about aerospace and several of the pre reports that came out, didn't have the insight that I'm going to share it with you right now. So we have aerospace With a gradual recovery up 3% in the first half, up 5% in the second half, that's where you get to 4% at the midpoint. But what's underneath that and I'll help give you some context as to why that number is what it is. On the commercial side, both OEM and MRO, That's going to grow low teens, so nice recovery there.

Speaker 2

Military MRO is growing mid single digits. What is down It's military OEM. It's down mid single digits. And the reason for that, and thankfully, our customers thought of us, our customers accelerated deliveries last We were up 19% as an example. They did this to protect the supply chain to protect supplier health Because a lot of suppliers have commercial exposure as well as military exposure, and they accelerated the military exposure to help everybody.

Speaker 2

So this year that we're in now 'twenty two is a reset of the inventory through that supply chain. So we will be down and of course then we'll go back to more normal levels In FY 'twenty three, if you take out that acceleration in the prior period, our FY 'twenty two military OEM would be about a +3. So then when you add when you would factor that in, aerospace growth would be more like 8%. So that 4% is being weighted down By the military OEM segment that reset of inventory. So hopefully that helps everybody with why the aerospace number is what it is.

Speaker 2

Just comparing that growth rate to 7% to GIPI, Global Industrial Production Index, that's going to be Within our fiscal year 'twenty two, that's a 4.8% forecast. You've heard us talk externally, we want to grow 150 basis points faster than that. So that's Our number of 7% should do that. And maybe while I've got kind of talking about guidance, I want to just touch for a second on operating margin and I'll Let me comment about price cost. So our operating margin guide is at 21.6% at the midpoint.

Speaker 2

So it's an approximate 30% MRLS for the full year. If you were to take out the discretionaries in the prior period, made this an apples to apples, the underlying MROS is a positive 50%. And a good indicator is that what we did in Q4, we did over 50% in Q4, so that was actual results. But the reason why I mentioned that Is that underlying MROS is being hidden because of the year over year comparisons being awkward and really speaks to the operational excellence from the team Because it's hard to do an underlying 50% MROS. I think everybody can appreciate that.

Speaker 2

So Lee, if you want to comment on the price cost.

Speaker 4

Yes, Jamie, I'll just Ed, I'll finish up here with pricecost. So last earnings call, the question came up and I talked about how We track all the commodities on quarterly trends and then year over year trends. And I said back then, it was a sea of red. In other words, everything was up. And I would tell you here a quarter later, it's still a sea of red.

Speaker 4

But having said that, We're able to see this coming very well because of the processes we have internally by measuring what we call our purchase price index And then also maintaining margin neutrality by our selling price index. So we're on top of it. And our goal, as we've always said, is to be margin neutral. We're actively working price, both with direct customers and distribution, but it is a There is a lot of inflation on the commodity side right now. No doubt about it.

Speaker 7

Okay. Thank you. I appreciate the color.

Speaker 1

Thanks, Jamie.

Operator

Your next question comes from the line of Mitch Dubre with Baird.

Speaker 1

Good morning, Mitch.

Speaker 8

Good morning, everyone. Thank you for taking the question. Tom, I guess I'm looking for a little more context from you vis a vis industrial order strength both North America International, I don't know what your expectations were for the quarter, but I feel you versus ours, these orders were much stronger. And I'm also looking to understand what backlog must look like at this point because Obviously, your order intake was higher than organic growth. And are there any challenges with regards to converting this backlog to actual revenues either on your side or maybe potentially your customers.

Speaker 8

So let's start with that maybe.

Speaker 2

So, let me talk about orders, it's Tom. I think just to maybe help clarify things for people, people who are doing 2 year stacks, you might say, hey, geez, it seems like the organic growth might be light compared to The one thing that you have to look at is in current period, we have acquisitions in prior period. We do not have LORD and exactly go all the way back to 'nineteen. When you do apples to apples on orders 19 to 21 and exclude the acquisitions, our industrial orders are up low teens. And I just mentioned as I was answering Jamie's question, our forecast for the first half on industrial is Low teens, 11% organic growth.

Speaker 2

So there's clear correlation between what we're seeing versus 2019 in apples to apples on order entry. And that's how we in addition to the AI model, how we laid out the year. Backlogs are increasing. Again, you got to remember in the prior periods as a uniquely low comps, so it's probably inflated number that you can't get too excited about. Our on time delivery is holding up nicely.

Speaker 2

Obviously, my customers would like to see us do better on that, But it's holding up very well compared to comparable times. And I'd say the impact that we've seen It's been more on customer push outs of schedules, particularly in automotive where the automobile OEMs are having trouble with chips as everybody knows, And they're taking really targeted shutdowns and that will push out our various orders and that impacted North America A little bit in Q4. But as Todd had mentioned, our Q4 sales were up about 10% industrialite versus Q4 of FY 'nineteen. So everything is kind of coalescing between orders and sales when you compare to 'nineteen around that low teens That type of growth rate. Okay.

Speaker 8

And then, I guess I want to follow-up on Jimmy's question on pricing And trying to see if we can get maybe a more specific answer. When I'm looking at various PPIs as some of the Product categories that you guys are involved with, it's pretty common that I'm seeing these PPIs somewhere in the plus 4%, 4.5% year over year. And I'm just sort of wondering if you're seeing a similar level of price increases in your industrial business And if there are differences at all in terms of OE versus your distributor partners? Thank you.

Speaker 4

So I would say it's a range, some lower and some higher. Whether it averages out to that or not, I can't really say. But with our OEM customers, we've got Direct contracts with many of them and what we're benefiting from is a lot of them have material clauses in them. So it allows us to capture Pricing as we go forward. On the distribution side, that's typically just a list price increase.

Speaker 4

But what you're seeing is Kind of our best guess and it's all in the guide right

Speaker 2

now. Thank you. Thanks, Mig.

Operator

Your next question comes from the line of Nicole DeBlase with Deutsche Bank.

Speaker 1

Good morning, Nicole.

Speaker 9

Thanks. Good morning, guys. Can we just maybe I know you went through the one half Dynamics, Tom, but can you just narrow that view a little bit to what's baked in to 1Q both with respect to organic growth and incremental margin? Thanks.

Speaker 2

Yes. So Nicole, it's Tom. So Q1 would be kind of Lowtomidteens for industrials, aerospace low single digits and really our first half From an MRLS, it's going to be in that upper 20s. Again, I would just point to again the comparison If you did apples to apples, it would still be in that 50% range. So it's really outstanding performance by the operating team being masked by the In prior period, all the discretionary cost savings that we had.

Speaker 9

Got it. Okay. Thanks, Tom. And then can we just clarify on the change to FIFO accounting in the U. S.

Speaker 9

I guess what was the impetus to do this now? And is there any benefit to the 2022 guidance related to the FIFO change?

Speaker 1

Yes, Nicole, I'll take that. This is Todd. We've been talking about this internally for quite some time, and it really started with the recent acquisitions, CLARCOR, Lord and Exotic, those companies always use the FIFO valuation method. We did not use it in our Aerospace business. We really only used it in our traditional U.

Speaker 1

S. Locations, all of our international By rule, I had to use the FIFO valuation method. So we took a look at it and said, hey, maybe this year is an opportunity To convert, and that's essentially what we did. We converted early in the quarter. We worked tirelessly across our teams and with our internal or excuse me, our external auditors.

Speaker 1

And we felt that was the best time to do it. There really is no impact to the quarter since we converted. We essentially reported the quarter in the FIFO method. We did go back and restate prior years Just to show you what the impact was. And I just want to make sure everybody realizes that if you look at this historically, it's a $0.01 or $0.02 per quarter, It's a very immaterial impact.

Speaker 1

We always book that at corporate, so it had no impact to our segment margins or anywhere incrementals. And it really just Now standardizes our inventory valuation across the entire company. So we're happy with the results. In respect to FY 2022, there is no there is nothing In the guidance for

Speaker 4

a benefit for converting to FIFO.

Speaker 9

Okay. Thanks for clarifying that, Todd. I'll pass it on.

Speaker 1

Okay. Thank you.

Operator

Your next question comes from the line of Nathan Jones with Stifel.

Speaker 3

Good morning, everyone.

Speaker 1

Good morning.

Speaker 6

I wanted to follow-up on the MROS comment, Tom, of 50% if you'd normalize Both years for all of the discrete costs and charges and benefits, which I think is you would normally see a Hi, MROS in the first real year of a recovery here, which would then glide back down to something more normalized. Can you talk but I think the $50,000,000 was probably higher than you would normally get in the 1st year. Can you talk about what you think that MROS Kind of progression would be over time and what a normalized average kind of incremental margin MRO would be for you guys?

Speaker 2

Yes, Nathan, it's Tom. And you're right, I think this underlying MR was at 50% for a whole year and it would be also counting Q4 and probably Q3 of last year, so 18 months will be higher and longer than we would normally expect. I think what speaks to The changes from the ONE strategy and the fixed cost changes we made and maybe the efficiencies on top of those changes that came out of the pandemic But I think going forward, especially when we get to FY 'twenty three, you won't have these anniversaries to worry about with the discretionary 1 year, not in the next year. I think and I would just use for people modeling 30%. As we've looked at it in benchmark, That continues to be a best in class number.

Speaker 2

And I think with all the changes we've made, I think that's a good number to use over a cycle to

Speaker 6

Thanks for that. I think I want to ask a question on the ESG report that you guys The other day is clearly some very significant reductions that Park has made over the last decade or so and some Good aggressive targets over the next 10 to 20 years. Can you talk just a little bit about it's probably a very long answer. Some of the mechanisms that you're going to use, some of the main initiatives that you're going to use to achieve those goals?

Speaker 2

Yes. So it's going to be a combination. So we've been working this already We've had since 2010, 44% reduction. I've got the report actually from it. I have to go find various we use different time periods That was in the report since 2010.

Speaker 2

So we've been on this for a while and it's Energy things that we do within the plants, renewables, different lighting, some of this will happen from indirect emissions as the various Utility companies change over to heating renewables, we automatically get credit for that as well. We're going to be working with our suppliers What they can do to reduce it? All the Kaizen work we do, where we just utilize the equipment better, smaller footprints, Better flow, less distances traveled, all those kind of things Help in this reduction. So we have every group signed up for their opinion. They have their respective greenhouse targets that they're working on.

Speaker 2

They know exactly where they are, And that gets cascaded down plant by plant. And then we've also had so we envision every group having a list of greenhouse gas emissions, Production is water things they're doing, recycling things they're doing. That's the only way we know how to do. We drive it down And then at the group level, we have each group on their technology roadmap developing their clean technology portfolio And how it needs to change for EVs, more fuel cell EVs, more hydrogen, etcetera. And the groups have been actively doing this.

Speaker 2

The good thing about this is we formed the Motion Technology Center about 3 years ago And for people who aren't familiar with this, this was taking the best and brightest that we could between Aerospace and our Motion Systems Taking all the motion related technology of the company and having a center of excellence for it, and in particular, focusing on electrification. And a lot of the technologies that we developed in the '90s on the F-thirty five, so the flight surfaces on the F-thirty five fighter are electrohydraulically And we've taken a lot of those learnings and applied it into the industrial portion of the company and has Developed a suite of motors and motor controllers and software that we're offering on the industrial companies, OEMs in particular, Well, there are platform changes as I look at more electric. And when you add in acquisitions like LORD on top of the engineering materials We have a really strong material science portfolio to help with that transformation as well. So our sustainability message is twofold. Things we're going to do internally, which we have good line of sight to.

Speaker 2

And we put out 2 major targets, 930 and 2040, but we're looking for year over year Things to get there and then what we're doing to help our customers because our customers at Scope 3, that's us helping our customers and we'll

Operator

Your next question comes from the line of Joe Ritchie with Goldman Sachs.

Speaker 10

Thanks. Good morning, everyone.

Speaker 1

Good morning, Joe.

Speaker 10

Todd, maybe first question on free cash flow. Clearly, really nice job this year at 16.5% of sales. Hi, guys. As you think about the free cash flow margin going forward,

Speaker 8

should we be thinking that there's going to

Speaker 10

be a little bit more of like a working Capital train going forward just given that growth is inflecting here on the industrial side?

Speaker 1

Well, yes, absolutely, Joe. There's been a step change in our cash flow I think everyone has seen that over the last couple of years. It's always a little bit tougher in a growth environment, so we'll be ready for that. I still think there's some opportunity across our enterprise. Some of the recent acquisitions, I think we've got some upside on inventory.

Speaker 1

And really, I have

Speaker 6

a

Speaker 2

lot of debt on receivables and

Speaker 1

payables Throughout the last 20 months. So I still think we've got room to grow here. So we're not expecting much of an

Speaker 10

Okay, great to hear. And then my one follow-up, Tom, obviously, clearly, big announcement this week. I'm curious, maybe on the flip side of things, are you thinking maybe a little bit more aggressively around like The portfolio divestiture side, to help with the potential deleveraging from this large acquisition and how you're thinking about

Speaker 2

Yes, Joe, it's Tom. We look at that all the time, not just when we have a large acquisition, but this is Something we have standard work around that we look at, at the Office of Chief Executive, so Lee, Todd and myself, as well as we do it annually with the Board. I would characterize that I've used this visual for people. I think the portfolio of the company has been very thoughtfully put together, think of it as a tree trunk with the various branches. 2 thirds of our revenue comes from customers who buy from 4 or more of the 8 technologies we have.

Speaker 2

So My predecessors and everybody that built this company did a very thoughtful job of putting together interconnected pieces that make sense. So when we do that portfolio analysis, There's very little that we see if we'd want to divest. It's something we look at all the time. It doesn't mean that we wouldn't divest anything, But if you use the tree analogy, it would be a small branch. There's going to be no major trunks that gets lopped off.

Speaker 2

But we look at it all the time, But I wouldn't see any big announcements from us regarding divestitures.

Speaker 10

Okay. Thanks for taking my questions.

Speaker 1

Appreciate it, Joe.

Operator

Your next question comes from the line of Joel Tiss with BMO.

Speaker 5

Hey, guys.

Speaker 1

Hello, Joel.

Speaker 5

Just a different angle on that last question. Are there any internal actions you guys can take or that would really help To get ready for the Meggitt acquisition or that's not how you work?

Speaker 2

Well, I would characterize Joel, it's Tom. Those internal actions have been happening every day since I joined the company and every day that everybody else that works here. I mean, we're all about continuous improvement. And I think the slide we showed earlier on, the 6 60 basis points improvement in EBITDA margin is what's positioned us to be able to do a deal of this size. If you think about a couple of things regarding Meggitt and just using that as an example, the multiples We're going to do are very similar or less than what we did with CLARCOR.

Speaker 2

The synergies, while the dollars are big, the percent And what's interesting is we're going to do a deal that has Over 2x the purchase price of our largest transaction, but our starting leverage will be about the same point that we were when we did lower in exotics. The question might be, well, how? The reason for that is because EBITDA has grown dramatically. The cash flow generation of the company, The EBITDA margins have grown so dramatically that we can take this size and it looks very similar to what we did in the past. And so we've been getting ready every day.

Speaker 2

And as we keep getting ready, we'll probably be ready to do something even better as we go into the future. When we update you on our FY 'twenty six targets, they're going to be higher than where we are today. And Wind Strategy 3.0 just started And it has tremendous firepower behind it to continue to propel the company. So we're preparing for the future every day and I think what we did really the last

Speaker 5

Does that take away Your kind of potential as we get to Investor Day to have some kind of bigger levers that really Drive margin forward, is it really just a series of small things? And can you give us a couple of examples of some of the things you're working on that could really

Speaker 2

Well, there's a couple of things I'd talk about on the top line. It would be the portfolio changes we've made, but there's also things organic that we're doing differently, the whole strategic positioning, which I'll try to give more color on that on IR Day, How our divisions are taking a real step change in ownership of how they position themselves versus their competitors, the innovation changes we've made on PBI and New product blueprinting, simplified design, which is a growth propellant as well as a margin engine, International distribution growth, the digital leadership and the new incentive plan change, ACIP replacing RONA, all those things are going to help on the top line, Several of those help on the margin side as well. So as the portfolio becomes more innovative, and it has over the last number of years, those Higher margins, simply by design, as some of you maybe heard me talk about, will be the single largest Margin enhancement the company has ever done and it's just started international distribution as we move that mix, that's a margin enhancement. We found with digital leadership that we continue to get more efficient with the use of AI, and then Probably last but not least and the most important, the things we've done around engagement.

Speaker 2

If I had to pick one single thing that's propelled the company, it's been the engagement of our Team members, engagement scores, the ownership, and it's hard to put a number to that. But you know when you have people that think and act like an owner, they use lean and kaizen, it's just part of their normal thinking, that spirit of continuous improvement is a big part of what's driven our You can plot our Kaizen activity and our engagement scores and they're working hand in hand. They're like on a parallel path Driving success. So it's not one single thing, Joel. It's a number of things.

Speaker 2

And I guess that one slide that we showed you earlier Show the compounding effect of improvement year over year, the compounding on EPS, doubling it to compounding on margins, And that's going to keep going. We're not going to stop.

Speaker 3

That's great. Thank you.

Speaker 1

Thanks, Joel. Hey, Don, I think we have time for one more question. So whoever is next in queue will take one more question.

Operator

Okay. We have a question from the line of David Raso with Evercore ISI.

Speaker 11

Hi. Thank you very much. I apologize. I didn't follow the order commentary. You said that the current quarter orders were running, I think said 17%.

Speaker 11

Can you first clarify that? Was that industrial? Was it the whole company? I'm just trying to understand that comment.

Speaker 2

David, this is Tom. So the comment I mentioned on orders was contrasting 2019 to 2021 where we were, if you made it apples for apples And because we didn't have acquisitions, 2 of the last acquisitions in 2019, and that has orders growing versus 2019 at around low teens. And I was just making that correlation that we had order entry coming in low teens versus 'nineteen, and we've got Sales growth in Q4 was right around 10% versus 'nineteen, and our forecast for Organic growth in the first half for the industrial piece of the company was around 11%. So they all kind of coalescing around that 10% to 11% low teen type of level.

Speaker 11

I appreciate that, but we're not really comparing it versus 'nineteen. Your guide is 2 versus 21. And if the orders were over 50% industrially in last quarter, if you look at the more challenging comps, single stack, maybe it's 17%, so the orders would be up like 40 Or you want to double stack it, it's even less of a degradation. So I'm just trying to understand what are the actual order trends right now versus a year ago? Just so we understand, are you seeing a slowdown?

Speaker 11

Or are we just confusing the commentary about versus 2019? Just to be clear, The first half industrial growth is the correlations breaking significantly versus orders leading sales and how you're guiding.

Speaker 2

Right. So what are you trying to give you back something that was more normalized activity because the year over year is what we've announced. It was over 50% plus for international and minus 7% for aerospace and plus 43%. But you can't extrapolate that Against normal conditions because that was against a quarter ago, which is when when the great shutdown happened. So you can't take that number, Extrapolated into organic growth, you got to come back to kind of some other benchmark.

Speaker 2

So we went back to when activity was more normalized And that's the data that came up with. This is where all the various inputs that we put into that. So there's a lot of science that went into this number, and I'm just trying to contrast why you can't take a 43% Order entry and so you can have a 43% organic growth.

Speaker 11

But would you be able to help us with how the orders are trending currently versus a year ago?

Speaker 2

Well, orders continue to grow through the quarter. I mean, if I take North America, it was 11% Q3 went to 56% and it sequentially got better every month through the quarter, same thing happened international. So we saw momentum building through the quarter. Things were definitely not slowing down, David. I don't want anybody to take That thought process, things built through the quarter.

Speaker 2

That's why I

Speaker 11

want to be clear. I mean, Tom, if you've got 50 in this past quarter, that usually is right, somewhat of a correlation for the next But the comps not exactly a normal comp.

Speaker 2

But the fact is, if you look at

Speaker 11

the comps, this current quarter, the industrial orders should still be up North of 30 or so. And then when you have 2 quarters running 50, then 30, it doesn't make a lot of sense to be thinking the first half industrial is kind of low teens. And I'm just I know it's a little tricky on the conversion, maybe some things are taking a little longer to ship. I'm just making sure we don't walk away thinking that's a pretty dramatic slowdown. So you're just saying you're not seeing a slowdown end of the day?

Speaker 2

I want to be very clear. There's absolutely no slowdown. You can't take a 50% order entry rate and draw linear curve there and say it's a 50% organic growth.

Speaker 11

I hear you. Lastly, for the March meeting, when we think about the comment about Simple by Design, So you feel pretty early in the journey. Any way you can frame for us how you perceive margin improvement From here versus kind of the journey we've been on the last 5 years, just to kind of frame it a little bit for us, given some of the time.

Speaker 1

Well, I've not to

Speaker 2

do that yet. I want to do that in full context, Going through all the strategies and how we're going to do it and giving you a fully baked explanation. But I would just say that we're going to continue to get better. And if the future is any if the past is an indicator, You can draw that into the future.

Speaker 11

I appreciate that. Okay, thank you very much.

Speaker 1

Appreciate it, David. All right. I just want to say thank you to everyone for joining us today. This does conclude our FY 'twenty one Q4 earnings webcast. And again, just consistent with the comments made on Monday regarding the requirements of the U.

Speaker 1

K. Takeover code and our pending Meggitt transaction, A representative of Citibank will continue to participate on all of our analyst and investor calls for the foreseeable future. Robin and Jeff are obviously available here all day if you have further questions or need any further clarification. And always, thank you for your interest in Parker, and I hope everyone has a great day and a great weekend. Take care.

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Earnings Conference Call
Parker-Hannifin Q4 2021
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