Investors have been inconsistent in their approach to industrial companies since the election and the late 2012 slowdown in the economy. One of the winners has been Parker Hannifin (NYSE:PH), as investors have bid up the shares of this leading fluid power systems provider by more than 20% since their October lows. While Parker Hannifin is likely to remain a consistent, well-run industrial company, it's hard to find an attractive risk/reward balance at this time.
SEE: Earnings Forecasts Primer
So-So Fiscal Second Quarter Results
Parker Hannifin saw ongoing deterioration in its financials in its second fiscal quarter, though results were better than analysts had expected. Revenue fell about 1% as reported, with acquisitions boosting results and masking the 4% organic deterioration. Reported revenue from the industrial business fell about 2%, while aerospace rose more than 6%. Revenue in the small climate/industrial controls segment fell about 18%.
While restructuring expenses are playing a role, margins continue to come under pressure from weak volumes. Gross margins eroded nearly two and a half points, while segment operating income declined about 17% (with corporate operating income down about 19% as well). All segments were down by double-digit percentages, with industrial down 15% and aerospace down 26%.
All told, Parker Hannifin did a little better than expected on revenue and as expected on margins (which, given the below-expectation volume is actually a little impressive), but much of the reported EPS performance came from "below the line" non-operating items.
SEE: 5 Stock Market Metrics Explained
Orders Suggest the "V-Shaped" Recovery Isn't Coming Soon
If there's going to be a V-shaped recovery after this recent slowdown, it's not likely to come in the next quarter. Orders fell 2% this quarter, with mid-single-digit drops in the key industrial business.
Parker Hannifin is just too broad-based to make many sector calls here. The company is about four times the size of Eaton (NYSE:ETN) in hydraulics and fluid power, with markets such as general industrial, autos and off-road vehicles making up about a quarter of sales. Said differently, as the general global economy picks up, so should Parker Hannifin, but it's still going to take a little time.
It's a somewhat different story with aerospace, however. Parker Hannifin saw 14% order growth here over a rolling 12-month average, consistent with low-teens original equipment growth reported by General Electric (NYSE:GE). I believe PH still has growth to be gained from the commercial aerospace cycle. But it's a modest contributor to profits, and margin leverage is still an unanswered question.
SEE: The Value Investor's Handbook
Quality, but at a Cost
Parker Hannifin has a deserved reputation for being a good quality long-term performer. But that quality is maybe not exactly what investors think it is. For instance, its operating margins have been relatively volatile when compared to others such as Eaton or Illinois Tool Works (NYSE:ITW).
What's more, much of the company's growth is bought in. Parker Hannifin has been an active acquirer, and those deals appear to be responsible for about half to two-thirds of the company's growth over the trailing decade. While there's nothing wrong with a growth-by-acquisition story per se, it's still an important detail to appreciate, particularly in the context of the company's hefty debt load.
The Bottom Line
My biggest issue with Parker Hannifin is its valuation today. The big rise in the share price since October already seems to predict improving fundamentals in key markets such as North America and China as 2013 goes on, and not much is left over.
I believe that the company can grow at around a 4% core rate in the future. Discounting that back and subtracting out the cash suggests a fair value in the mid-$90 range today. While I may not be in a rush to sell Parker Hannifin today, I'd be a little concerned about the trends in orders and margins, and I would demand a bigger discount to fair value before establishing a new or larger position.
At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.
Mutual Funds & ETFsLearn about arbitrage funds and how this type of investment generates profits by taking advantage of price differentials between the cash and futures markets.
Investing NewsWill Ferrari's shares move fast off the line only to sputter later?
Stock AnalysisHere are five stocks that pay safe dividends and should be at least somewhat resilient to a bear market.
InvestingThe further you fall, the harder it is to climb back up. It’s a universal truth that is painfully apparent in the investing world.
Fundamental AnalysisOptions market trading data can provide important insights about the direction of stocks and the overall market. Here’s how to track it.
Stock AnalysisCan these two oil stocks buck the trend?
Investing NewsAlcoa plans to split into two companies. Is this a bullish catalyst for investors?
EconomicsDiscover the four countries in the world that manufacture the largest amount of chocolate and learn basic facts about the chocolate industry.
Stock AnalysisIf you want to buck the bear market trend by going long on consumer stocks, these three might be your best bets.
Investing NewsA rate hike would certainly alter the investment scene, but would it be for the better or worse?
When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>