Introduction
Parker-Hannifin (NYSE:PH) is in a multi-year initiative to transform their business into a more resilient company that is less prone to the cycles that is a feature of their industry. The acquisition of Clarcor in 2017 increased Parker’s revenue exposure to the filtration aftermarket. The aftermarket business has different economic drivers than the OEM (original manufactured equipment) business. Generally, the OEM business is when Parker sells a component to a manufacturer. For aftermarket, Parker sells parts to the end user. With the aftermarket, customers typically have an immediate need for a specific part regardless of the business cycle or budgets. With the Lord acquisition, Parker acquired a company with a product mix that would extend the overall lead time of Parker’s business. With the Meggit acquisition, Parker increased their aerospace aftermarket business but also positioned itself to benefit from secular trends in global aerospace. Commercial aerospace is expected to see a 3.8% compound annual growth rate in revenue passenger kilometer through 2041. On the military side of aerospace, analysts expect increased defense spending globally. Parker sells a host of products to aerospace manufacturers and end users, including heat sensors, braking systems, engine valves and many others.
Notwithstanding their efforts to be more resilient, Parker is still subject to the swings of the business cycle. At the end of the day, demand for their Diversified Industrial segments is going to be driven by the level of capital spending across their markets. On this point, Parker has seen some weakness. In the Diversified Industrial North American segment, sales in the recent quarter were down 4.6% and order rates were also down 4% as compared to the same quarter last year. Destocking continued, and has been, a source of underperformance for several quarters. For the Diversified International segment, sales in the most recent quarter were down 3.1% and order rates were down 8% as compared to the same quarter last year. Incoming orders were soft in Europe and parts of Asia, notably China. For the three months that ended March 31st, backlog in both Diversified Industrial segments were down to $4,364 million as compared to $5,090 million for the quarter last year.
The Aerospace Systems segment continues to outperform. Sales in Aerospace Systems were up 17.9% in the most recent quarter and order rates were also up 15%. This is the fifth quarter of double-digit growth in Aerospace Systems. Growth in this segment was broad based and backlog increased to $6,465 million from $5,766 million for the comparable quarter last year. For the most recent quarter, the Aerospace Systems segment was 27.8% of net sales, Diversified Industrial North America was 44.0% and Diversified Industrial International came in at 28.2% of net sales.
Source: Parker-Hannifin 10-K for 2023 and 10-Q for Q3 2024
The strategy by which Parker has employed to transform their business has been through acquisitions. On the plus side of acquisitions in general, the combined company benefits by having a wider customer base that can withstand the cycles better. The combined company also enjoys benefits that accrue because of economies of scale with regard to corporate administration and the purchases of raw materials. On the minus side, acquisitions don’t always work out to the benefit of the shareholder. Some research has shown that average returns to the acquirer subsequent to a merger transaction are slightly negative.
Source: Bruner R: Deals from Hell: M&A Lessons That Rise above the Ashes (New York, John Wiley & Sons 2005). Goedhart M, Koller T, Wessels D: Valuation: Measuring and Managing the Value of Companies (Hoboken, New Jersey, John Wiley & Sons 2005). Moody’s.com
In this article, we review the record of Parker from 2014 to 2023 and measure the value that they have created for shareholders. The time period reflects their recent merger activity and capital allocation decisions. The framework we will use come from the work of Mary Buffett and David Clark in which they detail the investment strategy of Mr. Warren Buffett. We also consider the historical P/E ratio of Parker in relation to observed growth rates in earnings per share for the period. Using the framework and our inputs, we find that Parker-Hannifin is a worthwhile consideration for a long-term, value-oriented investor.
Source: Mary Buffett and David Clark, The Buffettology Workbook (2001) and Buffettology (1997). Simon & Schuster. Berkshire Hathaway Annual Reports.
Measuring Value
Parker-Hannifin’s fiscal year ends on June 30th 2024 and for this fiscal year end, analysts are expecting an earnings per share of $24.84. For the fiscal year that ends June 2025, analysts are expecting an EPS of $26.44. We shall use the fiscal year 2025 EPS as our input.
Please take a look at Table 1.
Table 1: EPS, Dividends per Share and Retained per Share | |||
Year | Normalized Diluted EPS | Dividends per Share | Retained per Share |
2014 | $ 5.94 | $ 1.86 | $ 4.08 |
2015 | $ 6.32 | $ 2.37 | $ 3.95 |
2016 | $ 5.48 | $ 2.52 | $ 2.96 |
2017 | $ 6.18 | $ 2.58 | $ 3.60 |
2018 | $ 8.21 | $ 2.74 | $ 5.47 |
2019 | $ 9.42 | $ 3.16 | $ 6.26 |
2020 | $ 8.18 | $ 3.52 | $ 4.66 |
2021 | $ 10.48 | $ 3.67 | $ 6.81 |
2022 | $ 13.16 | $ 4.42 | $ 8.74 |
2023 | $ 14.70 | $ 5.47 | NA |
CAGR | 10.59% | 12.73% | |
Cumulative Retained Earnings from 2014 to 2022 | $ 46.53 | ||
Increase in EPS | $ 8.76 | ||
Return on retained | 18.83% |
Source: Seeking Alpha
There are some items to consider in this table. The growth in EPS has been solid with EPS in 2023 being almost 2.5x what it was in 2014. The dividend per share growth rate over the period exceeds that of the EPS. Having a dividend per share growth rate that exceed the EPS growth rate supports the view that management is shareholder-oriented. On the last column, we also have the value of retained earnings per share for the periods presented. We calculate retained earnings per share by simply subtracting dividends per share from EPS. Let us consider the retained earnings per share further.
In business theory, earnings in a particular year can be attributed to all the net capital invested in the business up until just before that particular year. So, in theory, earnings for fiscal year 2023 can be attributed to all the net capital invested in the business since inception until the end of 2022. In 2023, the capital was put to use and delivered an earnings per share for the owners of the business. We are going to narrow the scope and look at retained earnings from 2014 to 2022.
From Table 1, Parker retained $46.53 of investor earnings from 2014 to 2022. In 2023, Parker delivered an EPS of $14.70 which is an $8.76 increase in EPS as compared to 2014. This amounts to an 18.83% “return on retained earnings” and is a very good rate of return. This means that dividends per share grew at a nice clip and whatever was not paid out in dividends was profitably deployed in a way that increased EPS.
In Table 2, we take the next step and include the average share price for the period.
Table 2: Increase in Share Price | ||||
Year | Normalized Diluted EPS | Dividends Per Share | Retained Per Share | Average Share Price |
2014 | $ 5.94 | $ 1.86 | $ 4.08 | $ 116.53 |
2015 | $ 6.32 | $ 2.37 | $ 3.95 | $ 120.54 |
2016 | $ 5.48 | $ 2.52 | $ 2.96 | $ 105.40 |
2017 | $ 6.18 | $ 2.58 | $ 3.60 | $ 141.13 |
2018 | $ 8.21 | $ 2.74 | $ 5.47 | $ 177.61 |
2019 | $ 9.42 | $ 3.16 | $ 6.26 | $ 168.17 |
2020 | $ 8.18 | $ 3.52 | $ 4.66 | $ 176.95 |
2021 | $ 10.48 | $ 3.67 | $ 6.81 | $ 262.91 |
2022 | $ 13.16 | $ 4.42 | $ 8.74 | $ 292.91 |
2023 | $ 14.70 | $ 5.47 | NA | $ 307.63 |
Cumulative Retained | $ 46.53 | |||
Increase in Market Value | $ 191.10 | |||
Value added per share | $ 4.11 |
Source: Share price information is from Yahoo! Finance.
We have already seen that the cumulative retained from 2014 to 2022 was $46.53 per share. Here we see that the increase in the market price of the shares from 2023 as compared to 2014 is $191.10. This figure is arrived at by taking the average 2023 share price of $307.63 and deducting the average share price in 2014 of $116.53. This means that for every dollar retained, Parker has delivered a $4.11 increase in market value. The market has reacted favorably to management’s activities. The increase easily passes Mr. Buffett’s $1 reinvestment test in how he judges management with respect to creating shareholder value. Here is the specific excerpt that describes the $1 reinvestment test.
“For a number of reasons managers like to withhold unrestricted, readily distributable earnings from shareholders – to expand the corporate empire over which managers rule, to operate from a position of exceptional financial comfort, etc. But we believe there is only one valid reason for retention. Unrestricted earnings should be retained only when there is a reasonable prospect – backed preferably by historical evidence or, when appropriate, by a thoughtful analysis of the future – that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.” – Source: Berkshire Hathaway, 1984 Letter to Shareholders.
The next item we consider is what is a good entry point for the stock? At a forward P/E ratio of 21, is this stock not expensive? If we consider Mr. Buffett’s view, the answer is straightforward. Mr. Buffett’s view is that great businesses are seldom a bargain and it is better to buy a “wonderful company at a fair price than a fair company at a wonderful price*.” Because of the wealth compounding effect of a great business, Mr. Buffett doesn’t seem to mind paying a fair price for a piece of the business – it need not be a bargain basement price. A metric that is not explicitly used by Mr. Buffett is the Price to Earnings to Growth or PEG ratio. It was popularized by another investing great – Peter Lynch, and we shall use the ratio to highlight the value in the stock. Please take a look at Table 3.
Source: Peter Lynch and John Rothchild. One Up on Wall Street: How to use What You Already Know to Make Money in the Market. Simon & Schuster 2000. *Mr. Buffett’s quote can be found here.
Table 3: Price to Earnings to Growth Ratio (‘PEG’) | |||||
Year | Normalized Diluted EPS | Average Share Price | P/E Ratio | EPS Growth Rate | PEG Ratio |
2014 | $ 5.94 | $ 116.53 | 19.62 | 10.59% | 1.85 |
2015 | $ 6.32 | $ 120.54 | 19.07 | 10.59% | 1.80 |
2016 | $ 5.48 | $ 105.40 | 19.23 | 10.59% | 1.82 |
2017 | $ 6.18 | $ 141.13 | 22.84 | 10.59% | 2.16 |
2018 | $ 8.21 | $ 177.61 | 21.63 | 10.59% | 2.04 |
2019 | $ 9.42 | $ 168.17 | 17.85 | 10.59% | 1.69 |
2020 | $ 8.18 | $ 176.95 | 21.63 | 10.59% | 2.04 |
2021 | $ 10.48 | $ 262.91 | 25.09 | 10.59% | 2.37 |
2022 | $ 13.16 | $ 292.91 | 22.26 | 10.59% | 2.10 |
2023 | $ 14.70 | $ 307.63 | 20.93 | 10.59% | 1.98 |
Average | 1.98 |
If we take the average share price for the fiscal year period and the normalized earnings figure, we shall arrive at the P/E ratio. We then scale this ratio by the observed growth rate in EPS as presented in Table 1. We find that on average, Parker trades at a PEG ratio of 1.98.
In Table 4, we consider today’s price, the earnings estimate for fiscal year 2025 and the growth rate and find that the stock is trading at about a 7% discount to fair value as measured by the PEG ratio.
Table 4: Current Implied PEG | |
Current Price | $ 515.22 |
EPS guidance | $ 26.44 |
Growth Rate | 10.59% |
Implied PEG | 1.84 |
Risks
There are risks to our thesis. While Parker’s recent record of acquisitions have been accretive to shareholders, future acquisitions may not be. Also, the weakness in the Diversified Industrial segments could be longer than we expect. While the CEO did hint that early April numbers could augur a change in the destocking trend for the Diversified Industrial North American segment, there is still the International segment that is showing softness. Lastly, Parker is betting that secular trends in aerospace will provide a source of growth for years to come. That may not materialize or if even it does, it may not be to the extent that they anticipate.
Conclusion
In this article, we have found that Parker has been able to grow earnings and dividends at a meaningful rate. Moreover, the portion of earnings that is not paid out in dividends is used in a way that increases earnings. Long-term investors have been also rewarded by an increase in the market value of the stock by a factor of $4.11 for every dollar retained. While the stock is not cheap in the conventional sense, the stock offers a reasonable entry point for long-term investors.
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