Description

At 14x NTM earnings, Parker Hannifin (PH) is not getting credit for improving business mix toward less-cyclical (longer-cycle) products nor the strong accretion to follow its acquisition of Meggitt (expected to close in 3QC22).  We forecast 5 years of above-consensus earnings growth and modest multiple expansion toward a $500+ target price by CY2025. 

Parker Hannifin manufactures motion control products such as fluid power systems and electromechanical controls, as well as fluid purification, process instrumentation, and electromagnetic shielding products. Historically, investors have viewed PH through a very narrow lens – a cyclical, short-cycle company heavily levered to changes in the ISM. However, PH has made meaningful changes to its portfolio in recent years that move it away from short-cycle and towards longer cycle businesses with much of its revenue stemming from recurring aftermarket sales. PH should no longer be viewed as a play on ISM (because it’s not) with new 2027 targets implying $30+ EPS and attractive margins, deserving of a higher multiple of at least ~17x (vs. current mid-teens), which implies a price target >$500 (should be trading in the mid-$300s today).

Beyond the current perception issue, we believe investors are ignoring PH’s growth drivers including the recovery in auto, aerospace, and easing supply chain issues; Meggitt acquisition synergies; continued margin expansion; clean technology and electrification applications –and are too focused on the near term industrial cycle.

The transition away from short-cycle industrials to longer cycle + secular trends. 2027 sales mix (incl. Meggitt) is expected to be 50-55% of sales in longer cycle vs. 15% shorter cycle and 33% industrial aftermarket

Projected end market breakdown in 2027

Business Overview

PH is the leader in the $135B motion & control industry, with an 11% market share (goal to reach 20%). A simple way to view PH is as a technology powerhouse of interconnected solutions, with a global network of 17,000 distribution outlets that generates ~50% of Industrial revenue. 2/3 (up from 1/2) of revenue is derived from customers who buy 4 or more Parker technologies and 2/3 of the portfolio enables clean technologies. The OEM/Distribution revenue split is approximately 55%/45%, with North America Industrial near 50%/50%, International Industrial at 60%/40%, and Aerospace at 65%/35%.

The distribution channel at PH is multi-channel and consists of:

• Multiple technology, systems-focused: This is high capital investment, specifically in engineering where a lot of systems integration work occurs. This network handles connectors, pneumatics, motion systems solutions, etc.
• Single technology-focused: This occurs in any trading area and these distributors have expertise in one vertical. Includes end-market solutions that are vertically integrated such as engineered materials and instrumentation.
• Product-line focused: These distributors typically come to Parker through an acquisition. Sometimes they stay that way in a single product line focus, but they usually transition into becoming a multiple technology distributor.
• Market-focused: Focused on a specific market such as underground mining.
• MRO-focused: These are companies like Applied Industrial Technologies and MSC. 

Parker’s distribution network is independently owned and operated. “Multiple technology, systems-focused distributors” are viewed as the greatest revenue contributor, in which PH products typically represent 70-80% of the operator’s cost of revenue. Parker’s margins through distribution are about 10pts better than direct to OEM sales. The company is also able to pass on price through this channel more efficiently. PH is looking to achieve a 50%/50% sales mix in OEM/Distribution in its International Industrial business, with about 100bps in annual improvement, leading to margin accretion.

Diversified Industrial Segment is broken out into North America and International. This segment sells products to both OEMs and distributors who serve the replacement markets in manufacturing, packaging, processing, etc. Main product categories include motion-control and fluid systems, such as high temperature metal seals, sterile air filters, and industrial hoses. Total Industrial is ~85% of total revenue, with North America over half of Total Industrial. Total Industrial EBITA margin is ~22%, with North America and International both at similar levels.

Aerospace Segment sells products primarily in the commercial and military aerospace markets to both OEMs and end users for spares, maintenance, repair, and overhaul. Main product categories include airframe and engine programs, such as engine exhaust nozzles, fluid metering, and hydraulic systems. Aerospace is ~15% of total revenue and EBITA margin is ~21%.

Parker is leaning on its Win Strategy 3.0 that focuses on engaged employees, customer experience, profitable growth, and financial performance. Simple by Design, one of the components, is a critical way for PH to reduce product cost, which ultimately enhances its competitive profile. In fact, 70% of product cost is influenced by product design, highlighting its importance. One example is a 20% product cost reduction for PH’s spin-on filter, a fuel water separator filter that provides protection for engines – by reducing product overlap and consolidating head designs from 9 to 4, Parker eliminated over 45 assemblies and 130 components. As the name suggests, this is the third phase, with the prior two having focused on consolidation and increased scale, and simplification of products through SKU reductions and GTM efforts, respectively. This third phase revolves around simplification of design to lower SG&A and material costs. Overall, this evolving strategy underscores the quality and foresight of management to derive the best possible employee/customer experience and financial performance.

Differentiation in PH’s business stems from the Win Strategy, decentralized business model, technological breadth and interconnectivity, long product life cycle, low capital intensity, and its global distribution network.

2027 targets are 4-6% organic growth, 25% adj. segment op margin, 25% adj. EBITDA margin, 10% adj. EPS growth, and 16% FCF margin. The organic growth guide is notable because PH has not historically provided a specific number range, highlighting management’s confidence in its transformed portfolio and greater visibility. The FCF margin target is also noteworthy because PH has typically guided to >10% margins.

On capital deployment, PH expects to deploy $30B over the next six years and after accounting for Meggitt ($10B) and capex/dividends/buybacks ($9B), the company has about $5-$10B of additional capacity to deploy. Put shortly, Parker has a lot of capital flexibility, which it should be given some credit for given past M&A success.

M&A History

Acquisitions are and have been an important part of PH’s transformation. The Exotic Metals and Lord acquisitions furthered PH’s effort to shift its platform exposure towards Aerospace, Filtration & Engineered Materials. They also upscaled the quality of the total portfolio ($1.5B of combined sales at 25% margins vs. base PH with 18% margins in 2019).

For the three completed acquisitions (Clarcor, Lord, Exotic), PH has paid less than <11x EBITDA and met/exceeded synergy targets for each. For Clarcor, PH achieved Y3 cost synergies of $160M (vs. the $140M target); for Lord and Exotic, PH achieved $125M / $13M in cost synergies in Y2 / Y3, a year early for Lord and in-line for Exotic. This has helped margins rise from low teens to over 20% in the past 5 years. 

Now, onto Meggitt (expected to close 3QC22) – this is a leading provider of airframe and engine products, with 55% end market mix tied to OEMs and 45% aftermarket, and a 54%/46% split between commercial and military. Combined PH/Meggitt will have 60%/40% OEM and aftermarket/MRO exposure, and nearly an even split between commercial and military. The deal will add complementary technology and nearly double PH’s Aerospace Systems exposure, thus help reduce cyclicality. Meggitt’s sales are ~90% from A&D, so it will increase PH’s exposure to an attractive end-market. Meggitt has ~5,000 suppliers, so the combined company should be able to realize synergies on the cost front, leaner productivity, and SG&A reduction. PH does not have advanced sensor products, which Meggitt does; thus, the deal will accelerate PH’s aspirations on digitization. Note, Meggitt is one of the few remaining pure play, scaled A&D assets remaining in the industry. Interestingly, the new long-term outlook at the investor day included Meggitt – while this thinking may end up being futile, we believe this at least points towards management being confident in its approval, a positive.

Based on our calculations, we see accretion of ~$1.40 in FY23, ~$2 in FY24, and ~$2.50 in FY25 with the assumption that PH delivers $300M in synergies by year 3. We do not believe much, if any, of the accretion is priced into the stock, wherein lies the opportunity.

M&A history success. Meggitt is next, which is severely underappreciated

Conclusion

At PH’s current valuation, we believe the market is giving little to no credit on the portfolio transformation to longer-cycle assets.  With the evidence of the portfolio transformation, management execution, and major benefits of the Meggitt deal, it is difficult to argue the other side. We acknowledge that management has typically been unable to effectively tell its story, but we view the latest investor day as a sign of renewed vigor from management to solve this perception issue, which they vehemently disagree with.

We think the clean technology and electrification applications are also being underappreciated given Parker-related content per vehicle increases 1.5x-2.0x from ICE to EV/hybrid. PH also benefits not only from the electrification of passenger vehicles, but also tractors and heavy on-road trucks. PH has favorable technology in solar, wind, and hydrogen production/storage/dispensing that positions the company well for the energy transition.

We see the path to $30 EPS in FY27 as fairly conservative, especially considering the amount of capital deployment optionality (if the $5-$10B of additional capital is fully allocated to repurchases, it implies $4-$10 incremental EPS upside to the target) and that PH has built a track record of exceeding prior targets.

One can debate exactly what multiple this new look company few years from now deserves, but what’s clear to us is that a mid-teens fwd EPS multiple is too low and that closer to ~17-18x is more justifiable (we think comps such as ITW and HON make sense). In addition, putting all of this against the backdrop of a very rocky and uncertain multi-industrial environment today, we view the PH’s risk/reward as one of the most attractive that we have come across.

Excluding Meggitt, we arrive at $27.73 EPS in 2027 and ~$2.50 accretion from Meggitt (assuming $500M repurchase) and thus believe PH is highly undervalued at current levels. We recognize that the summer might show some macro volatility, but have strong conviction that those pullbacks (and today) should be bought for investors with longer duration.

Catalyst

- PH’s underlying business mix transformation to longer cycle and secular becoming better understood

- Meggitt deal synergies

- Capital deployment flexibility