Parkerís Largest Deal in Meggitt Is Value Dilutive in Our View
Parker’s Largest Deal in Meggitt Is Value Dilutive in Our View
Analyst Note| by Joshua AguilarUpdated Aug 03, 2021
After reviewing Parker Hannifin’s offer to purchase wide-moat rated Meggitt, we raise our fair value estimate to $276 per share from $272 per share previously. We fully incorporate the deal as we believe it will receive full approval given the relative lack of overlap in Parker and Meggitt’s product line. However, the fair value raise was entirely due to time value of money, as we think the deal is value dilutive by $1 per share. The purchase price is greater than the equity value implied in our GBX 610 fair value estimate. We award Parker’s acquisition of Meggitt its full 10% cost synergy target by year 3. Without cost synergies, our fair value would have fallen between 7% and 8%. That said, we think Parker deserves the benefit of the doubt in achieving these aspirations given its track record of success with its Win Strategy.
Parker is paying GBP 7.1 billion or $9.9 billion for the acquisition. The deal essentially doubles Parker’s commitment to aerospace as measured on both sales and profits, and from what we heard on the call, gives the firm a bias toward a presence on Pratt & Whitney’s geared turbofan. Parker values the deal by anchoring on 2019 historical EBITDA, including the cost synergies. The firm expects the transaction to close in 12 months. As we value the deal, we believe aerospace is capable of rising to $1.5 billion of combined EBIT with both legacy Parker and Meggitt, with synergies contributing just over $300 million by fiscal year 2025. Overall, we believe total return on invested capital will return to the 13% we're estimating in 2021 by our midcycle projection in 2025. Given the size of the deal, which is the biggest we can recall in Parker’s history, Parker will have to issue debt in order to complete its all-cash offer.
Business Strategy and Outlook| by Joshua AguilarUpdated Aug 03, 2021
Parker Hannifin is a well-run, diversified industrial conglomerate with exposure to a wide variety of end markets. Over time, we believe the firm can achieve its goals of outpacing the industrial production index by 150 basis points and margin expansion on the heels of its newest Win Strategy and large acquisitions of Clarcor, Lord, and Exotic Metals. We believe part of Parker’s strength lies in its broad range of motion and control technologies with a wide variety of applications, including hydraulics and pneumatics, fluid and gas handling, and sealing. Importantly, according to Parker representatives, about 85% of the revenue from these technologies has intellectual property protection, which we believe helps cement Parker’s competitive position given the long product lifecycles and low reinvestment needs of this business. Parker's acquisitions brought in technologies that filled in major gaps in its existing portfolio, including in filtration, engineered materials, and vibration technologies, among others. With these acquisitions, Parker gained a stronger foothold in the highly desirous higher-margin aftermarket.
Win Strategy 3.0 was borne out of CEO Tom Williams' and COO Lee Banks’ longtime experience managing and operating Parker’s various businesses. Looking forward, our Parker thesis primarily relies on Parker's ability to successfully integrate its large-scale acquisitions and improve working capital in line Parker's historic, core figures, as well as margins through initiatives like product line simplification, productivity initiatives that improve inventory turns, improved supply chain sourcing, net restructuring benefits, and finally lower restructuring in the out years of our forecast. We also expect that Parker's international business can drive similar margins to its North American business with growing strength in distribution.
These factors lead us to expect Parker to increase its top line to a near 4.5% organic compound annual growth rate over the next five years and expand non-GAAP adjusted segment operating margins (before acquisitions and corporate costs) by 370 basis points from 2020 levels by 2023 or 160 basis points over its 21% target.
Economic Moat| by Joshua AguilarUpdated Aug 03, 2021
We believe Parker Hannifin merits a narrow economic moat rating based on switching costs and intangible assets. We think the total company benefits from a large installed base of products, which according to its annual report are supplied to "459,000 customers in virtually every manufacturing, transportation, and processing industry."
Parker’s diversified industrial segment consists of sales of an assortment of various hydraulic, pneumatic, and electromechanical components, including valves, actuators, and pumps, as well as filters, hoses, and seals. In addition to Parker’s field sales employees, the diversified industrial segment’s massive quantity of approximately 15,500 independent distributor locations throughout the world-–the blade in Parker’s razor-and-blade model--heavily support Parker’s installed base. Parker has curated this distribution network over multiple decades (over 60 years). Based on Parker’s past comments, we estimate that the 10-point-higher-margin aftermarket distribution business typically represents about half of Parker’s industrial business through an economic cycle, which we believe evidences switching costs. We calculate that this segment has historically earned return on invested capital including goodwill of approximately 14% through the cycle.
Parker’s distributors help the company reach its various end markets with their highly technical level of expertise, with some customer relationships lasting for years. Less available skilled labor that can appropriately address the specific and ongoing equipment service requirements of Parker’s customers only serves to reinforce these switching costs, in our view. It is difficult for customers to find other qualified maintenance technicians given the highly specialized nature of Parker's equipment. Other factors that reinforce switching costs include the mission-critical, complicated, and long-lead-time nature of Parker’s equipment, specifically in aerospace, automotive, and other transportation applications.
A high cost of failure in some of Parker’s end markets could translate to thousands of dollars per minute of downtime if an offshore seal fails in the oil and gas industry, at best. At worst, seal failure could lead to loss of lives in the aerospace industry, for example. While a sealing solution isn’t the largest item on a bill of materials, customers tend to heavily rely on injection molders for technical expertise. While Parker's products are a small part of a customer's total project costs, they are vitally important to its success. Parker’s sealing solutions are highly engineered products based on proprietary materials and are designed to keep tight tolerance and resist higher temperatures. Parker’s tight tolerance expertise must confront several factors, including part design and complexity, material selection, tooling, and process design and control.
Designing a part is the most important factor in controlling tight tolerance. Part walls can have differential shrink rates based on the thickness of different sections. Alternatively, if a part has larger dimensions, it can make it more challenging to control and maintain tight tolerance. Sealing solutions must also withstand various temperature ranges, such as extreme heat and corrosion commonly associated with aircrafts taking off and landing, or extreme pressure from deep seawater conditions. Parker's design precision specifically leads to asset optimization, but it can also lower a company's total cost of ownership. Additionally, customers using non-Parker parts in any piece of equipment purchased from a distributor without the express permission of the company voids that equipment's warranty.
A high degree of content on a specific platform reinforces switching costs. Parker’s broad aerospace portfolio, for example, includes flight control actuation, fuel pumps and valves, hydraulic equipment for commercial airframe manufacturers on programs like the Airbus A350, Boeing 777x, and Boeing 787, military programs like the F-35, as well as engine components like on CFM’s Leap engine, General Electric’s GEnx engine, and Rolls-Royce’s Trent engine programs (specifically, the XWB, the 1000, and the 7000). For aerospace, we estimate returns on invested capital, including goodwill, have historically averaged about 22% through the cycle. Nevertheless, we think the aerospace segment merits a narrow moat instead of wide, given the bargaining power of airframe manufacturers like Boeing and Airbus and their ability to pressure price from their supply chain, as well as comparably less intellectual property protection in just under half of the segment’s portfolio.
Parker also benefits from intangible assets. Aside from technical expertise and highly engineered products backed by intellectual property like patents, intangibles include a broad breadth of technology with long product lifecycles and low investment requirements, as well as a long record of success. Over 60% of Parker’s revenue goes through customers that buy from four or more of Parker’s technological core competencies, including in hydraulics, pneumatics, electromechanical, filtration, fluid and gas handling, process control, climate control, and sealing and shielding. Furthermore, according to Parker representatives, the firm holds a number-one or -two share in many of the industrial markets it serves. The acquisition of Clarcor in 2017 not only strengthened Parker’s competitive position in the filtration aftermarket with its favorable 80% revenue exposure, but it also shored up its technology offering in the filter and industrial HVAC markets.
We can glean examples of Parker’s technology in its product portfolio. Sensors are generally critical when assessing systems that use fluids (water, oil, or gas) to either generate power or transfer liquids or gas from one point to another. Factors like pressure, temperature, humidity, and vibration are critical in these systems when it comes to producing quality. Variations in pressure materially hamper production while extreme temperatures can lead to undesirable results. The large quantity of data collected by sensors is itself proprietary, since Parker can convert that data into algorithms that identify defective equipment and can trigger corrective action before catastrophe strikes. Aside from predictive maintenance benefits, sensors also obviate the need for manual reading of equipment. Industry journals citing the U.S. Department of Energy state that minimizing downtime has been shown to increase production by as much as 25% while increasing asset availability by 30%.
Taking a specific example, trade journals highlight wireless vibration sensors. Wireless sensors can used in a manufacturing process (like power plants, food and beverage packaging facilities, or paper and metal manufacturing facilities, among others) and configured to transmit data, set alarm thresholds, and create product notifications. The design, moreover, allows for low-cost, easy installation. Other products like Parker’s hand-held meters provide portable maintenance and diagnostic data for hydraulics and pneumatics, and automatic sensor recognitions eliminate the setup time that can be both confusing and time-consuming for operators. Solutions like these are especially valuable in hazardous environments, since they allow the user to keep a safe distance from dangerous areas.
In the electro-pneumatic space, Parker Hannifin has introduced a range of pressure regulators that provide precise control and energy savings in railcar applications but are also built to withstand extreme temperatures up to negative 40 degrees Celsius, which extends its useful life. Other pneumatic applications, such as air saver units found in factor air nozzles and air gun applications, cut compressed air costs by 40%-50%. Technology leading to cost savings matters because compressed air systems require huge expenditures of energy and costs that are often overlooked when calculating a plant’s cost of production. Industry trade journals citing the U.S. Department of Energy state that the cost of air ranges from 16 cents to 30 cents per 1000 cubic feet. Yet, only 12.5 cents of every dollar spent on electricity to generate compressed air is doing useful work.
In filtration, Parker’s top-loading compressed air filters, which are designed to protect internal components of a refrigerated dryer, can remove solid and liquid contaminants up to 99%, which allow for easier replacement. These filters were previously awarded a product of the year award by Plant Engineering. In flow meters, which are within Parker’s fluid control division and monitor the flow of cooling fluid used in welding, pump seal water, or boiler feed water applications, Parker’s meters feature no moving parts to clog or wear out, which contribute to a long product cycle, but are also designed to monitor particulates with a high amount of accuracy and permits occasional overranging up to 125% of capacity without damaging the meter.
Parker Hannifin’s returns on invested capital, including goodwill, have safely exceeded our estimated weighted average cost of capital of 8.0%, at an average of 16% over the past 10 years. Ultimately, we believe it is more likely than not Parker can continue this normalized level of performance over the next 10 years.
Fair Value and Profit Drivers| by Joshua AguilarUpdated Aug 03, 2021
After reviewing Parker's proposed acquisition of Meggitt, we raise our fair value estimate to $276 per share from $272 previously. However, the raise was entirely due to time value of money, which would have resulted in a $5 raise to intrinsic value (meaning the deal decreased our valuation by $1). Had it not been for anticipated cost synergies of 10% of revenue by year 3, our fair value would have fallen considerably more--by 7% to 8% in total. We think the deal's strategic rationale is to give the firm a stronger presence in the aerospace aftermarket business, which represents a higher-margin, recurring revenue base. We value Parker at nearly 17 times our 2022 adjusted EPS expectations of $16.60. We still believe that Parker will easily exceed its long-term 2023 sales, margin, EPS, and free cash flow targets by 2023, particularly since it's apparent to us that Parker will hit its margin targets two years early.
We model about a 4.5% organic top-line CAGR through our five-year explicit forecast, which incorporates the global 2020 COVID-19 pandemic recession. In the motion systems subsegment, we think revenue growth will be driven by greater automation needs, particularly given the market’s emphasis on productivity gains and eliminating hazardous tasks. We expect Parker’s growing distribution network is well positioned to capitalize on Europe’s growing pneumatic equipment consumption, as well as faster-growing regions like Asia-Pacific. Parker should also benefit from large customers’ preference of buying from a list of preferred component suppliers, underpinning what we see as strong switching costs, as well as a robust amount of intellectual property protecting this revenue stream. Aside from increased digitization stemming from predictive maintenance needs, we believe that the flow and process control and the filtration and engineered materials subsegments will be driven by the increased importance of customers optimizing their operating costs and production, automation driven less reliance on traditional labor, and government and related compliance norms.
We believe Parker can expand total adjusted segment operating income margins safely to over 23% by 2023 from an impressive 18.9% in 2020 based on a combination of product line simplification initiatives, productivity and supply chain benefits, growth in international distribution, as well as lower restructuring in the out years of our forecast (but with net restructuring benefits).
Risk and Uncertainty| by Joshua AguilarUpdated Aug 03, 2021
Like many diversified industrials in our coverage, Parker Hannifin is exposed to a number of risks in the broad global economy, including trade disputes and the impact from tariffs on raw material costs, cybersecurity risks, and labor disputes, as well as execution risks specific to the company, including the integration of Clarcor, and finding suitable M&A targets to supplement organic growth at affordable prices.
We think the biggest risk to investing in Parker is a major slowdown in the global economy, which is heightened in the aftermath of COVID-19 and government-related closures; we point out commercial aerospace will see muted passenger demand in the near-term, and we don't expect a return to 2019 level until about three to four years from now. Parker’s margin targets to 2023 don’t presume an additional recession to the global economy. However, Parker has done an exceptional job mitigating the deleterious effects of decremental margins, holding underlying decrementals to the high-teens during the fiscal fourth quarter of 2020. During the 2001 recession, Parker’s decremental margins were a disastrous 55%-60% (which we find high given that our coverage favors moatier names), 45% during the Great Recession of 2008, and finally improving to about 20% during the Industrial Recession. In our view, this Parker's most recent performance during the pandemic-induced recession rightly puts Parker at the higher end of quality in multi-industrial land.
We think Parker's ESG risk is low. ESG risks we see include environmental liabilities tied to remediation efforts in some former manufacturing facilities, difficulty attracting skilled manufacturing labor, carbon emission regulations in aerospace operations, worker safety in manufacturing facilities, and finally, product liability due to faulty design. Of these, we would be most concerned with carbon emission regulations, though we point out that Parker's technology could be adopted for hybrid electric flight.
Capital Allocation| by Joshua AguilarUpdated Jun 07, 2021
While we have a favorable view of Parker Hannifin’s management team, we assign Parker Hannifin a Standard capital allocation rating. Parker's balance sheet is sound, with less than 25% of its debt coming due within the next three years, and its net debt/enterprise value coming in under 35%. The firm's distributions are also shareholder-friendly, with an unbroken increasing dividend for over 60 years, and management's execution is strong with its Win Strategy. That said, we think share repurchases from prices of about $305 from the third quarter of fiscal 2021 are likely mildly dilutive, and we don't see recent acquisitions necessarily increasing the firm's switching costs or intangible assets.
Thomas L. Williams has been CEO since February 2015 and assumed the chairman role in January 2016. We normally prefer that these two roles remain separate. Even so, we applaud Williams and COO Lee Banks for implementing the new Win Strategy in 2015. Both Williams and Banks have served in a variety of roles in the firm’s operating groups. Williams held key leadership positions in hydraulics and instrumentation after a stint at General Electric, while Banks (who’s known for giving a breakdown of Parker’s global businesses with his "walk around the world" during quarterly earnings calls) has experience leading multiple product groups at Parker like filtration and engineered materials, as well as regional groups like Europe, the Middle East, and Africa and Latin America.
We see the prior iteration of the Win Strategy (2.0) as largely responsible for successfully mitigating the downside effects of the most recent 2014-16 industrial recession. It helped lift segment operating income margins by about 130 basis points from 2015 to 2018 and drive year-over-year organic growth of 8% in 2018 (though Parker rose about 3% organically at the top line, it tends to outperform industrial production over time). Free cash flow conversion consistently comes in above 100% while frequently driving double-digit adjusted EPS growth and better stock performance than the S&P industrial category. While many diversified industrials claim to empower their people, we think Parker has successfully created a decentralized culture by giving each of its business groups full profit and loss responsibility while allowing its business groups to source their own materials, all while leaving most business functions in the hands of each group with minimal centralized functions, like legal responsibilities. Other aspects of the Win Strategy we like include the emphasis on customer-driven innovation, which allows the firm to spend R&D dollars in a responsible manner and is more likely to drive growth.
Other moves we approve of include expansion of the firm’s distribution network to capture more of the higher-margin maintenance, repair, and operations business outside North America. Finally, we liked the acquisition of Clarcor during the duo’s tenure. From a strategic standpoint, we appreciate how the purchase strengthened the firm’s filtration technology. From a financial standpoint, we like how it was immediately margin- and EPS-accretive while paying a reasonable price of just under 11 times EBITDA, net of anticipated synergies (ahead of management’s stated expectations as of this writing). Over the long run, we expect that the firm will continue to target bolt-on acquisitions in what it calls the motion and control technology space, particularly as its balance sheet returns to more normalized levels after the Clarcor acquisition. Our conversations with Parker representatives lead us to believe that the company looks to strengthen any holes in it technology portfolio, as evidenced by the Lord and Exotic Metals acquisitions, each of which were accretive to organic sales, margins, and EBITDA.
We credit management for continuing Parker’s historical free cash flow conversion excellence at greater than 100% (including 152% in fiscal 2020), along with a free cash flow margin in the mid-teens. This has allowed Parker to be one of five diversified industrial firms that have continuously paid an annually increasing dividend for over 60 years (the others are 3M, Dover, Emerson Electric, and Stanley Black & Decker). We expect that the firm’s payout ratio will typically be in the mid-30s, on average, as a percentage of adjusted EPS (with a greater proportion relative to EPS in the fiscal 2021 down year). Finally, we like another aspect of the firm’s shareholder orientation, which includes a propensity to repurchase shares at undervalued prices, although we think shares are overvalued at current prices (in the $310s as of this writing).