Parker Hannifin Skids, But Conditions May Be Bottoming

By Stephen D. Simpson, CFA | August 07, 2013 AAA

It's not too much of a stretch to say that Parker Hannifin (NYSE:PH) makes industry move. Although the company doesn't give much in the way of end-market breakouts, hydraulics, seals, valves, and connectors are vital to a host of markets ranging from vehicles to energy to basic machinery, and Parker counts customers as diverse as Caterpillar (NYSE:CAT) and McDonald's (NYSE:MCD) in its roster.

Orders haven't been very good for a while now, and that has basically mirrored the malaise in the wider industrial market. Although Parker's fiscal fourth quarter performance was not very strong (and guidance likely disappointed many investors), flat orders and management's commentary about signs that the economy is bottoming could make this a stock to watch again.

Closing A Tough Year On A Whimper
Those investors who follow heavy/commercial vehicle manufacturers like Caterpillar or Terex (NYSE:TEX) already know how challenging these past few quarters have been, and likewise for companies like Illinois Tool Works (NYSE:ITW) with more “general industrial” exposure. Even so, this wasn't a good performance for Parker Hannifin.

Revenue was down 2% on an organic basis, with Climate / Industrial Controls down 16%, Industrial North America down 6%, and Industrial International down almost 1%. Aerospace was the lone bright spot, as revenue improved almost 10%.

While revenue was close to the sell-side target, margins came in quite weak. Gross margin declined by a point, while segment profits declined 6% (an 8% miss relative to the sell-side). Although earnings in the Climate/Controls business were flat (leading to about two points of margin improvement), Industrial North America and International were down 10% and 5%, respectively, and Aerospace was barely up. Accordingly, these three businesses saw unit margins down around one point to 130bp.

I can't say that management's explanation helped much. I can appreciate the impact of lower volumes in North America and expenses tied to acquisitions, forex, and inventory reductions, but the disappointment relative to the revenue performance is still surprising.

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How Much Better Is Better?
Not surprisingly, I've seen some bullish sell-side analysts already coming to Parker's defense, citing the more or less flat order performance as a “meaningful improvement” from the declines of recent quarters. Still, I think it's worth noting that management's guidance for revenue growth next year seems to top out at around 4%, and that's hardly “full-blown recovery”. Likewise, a reduction in guidance of about 9% on a like-for-like basis is not what you expect to see if the economy is bottoming and about to turn.

Still, I can appreciate management's caution. Orders in the industrial business were quite a bit better (down 5% in North America, up 3% International) than the 12% decline seen in Eaton's (NYSE:ETN) hydraulics bookings, but with the recovery in China's construction market very uncertain and Caterpillar's management seemingly taking a “you'll know when we know” tone of uncertainty, there's a lot of doubt out there. All told, while I do think Parker will see better demand in commercial aerospace and improvements in markets like industrial automation, off-highway vehicle demand and conditions in the energy markets are still very uncertain at this point.

The Bottom Line
If you believe that off-highway vehicle demand will improve, not to mention general industrial/machinery demand, Parker Hannifin could be back to a point where the shares are interesting again. I'm only looking for revenue growth of about 4% over the long term against 7% historical growth (of which, only about one-third has been organic), and I am looking for ongoing margin and cash conversion improvements to generate free cash flow growth in the mid-to-high single digits.

With that, I'm thinking fair value for Parker Hannifin is in the neighborhood of $110, even after this disappointing guidance. Likewise, EV/EBITDA and ROE/PBV suggest further upside from here. Although I think Parker's stock could be vulnerable to further pessimism regarding the global industrial economy, the stock is at the very least undervalued in a market where so few industrial stocks are.

Disclosure – At the time of writing, the author did not own shares of any company mentioned in this article.

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