EUR 850.00 For Business Accounts Only

Morningstar | We Maintain Our FVE for Parker Hannifin as the Firm Continues to Excel With Its Win Strategy

After taking a fresh look at Parker Hannifin, we are lowering our moat trend rating to stable. We had previously thought industrial Internet of Things offerings like the Parker Tracking Systems, as well as an expanding distribution network in markets outside of North America, could lead to stronger switching costs. We no longer find the first argument persuasive given that Parker is backing away from making Internet of Things an additional revenue source. As for the expanding distribution network internationally, we expect that Parker will still maintain a 50/50 sales mix between original equipment and the aftermarket for the overall firm. That said, we are keeping our $178 fair value estimate (which implies a 2019 P/E estimate of about 15.5 times and a 2019 EV/EBITDA of 10.5 times), as well as our narrow moat, stable trend, and Standard stewardship ratings.

While our new model has various puts--including slightly higher revenue and midcycle margin assumptions, offset by takes like higher capital expenditure requirements through the cycle in tandem with lower stage II return assumptions--the differences mostly net one another out. Our thesis is simple: in our view, Parker is a well-run, diversified industrial conglomerate with exposure to a wide variety of end markets. We arrive at this conclusion because we believe Parker’s significant aftermarket activities drive customer switching costs and the company’s broad portfolio of patented technologies and deep engineering know-how generate intangible assets for the firm. The company’s highly skilled executive team reinforces these structural advantages; management has expertly implemented its Win strategy, which focuses on understanding customer demand, driving lean manufacturing, and leveraging engineering expertise.

Moreover, the firm boasts a large installed base of products that touches nearly every major industrial end market like aerospace, process plant infrastructure, and oil and gas, to name a few. These products reach an impressive 455,000 customers. Aside from its high level of technical expertise, the firm’s independent distribution network of 16,900 locations benefits from customer relationships that can last for over a decade. Other factors that reinforce switching costs include the mission critical nature of the business, as well as the long product cycle nature of the business. The latter minimizes reinvestment needs and allows Parker to consistently boast a free cash flow conversion of greater than 100%.

Other factors that benefit Parker include a high degree of content on various platforms, such as those found on the big two airframe manufacturers in Boeing and Airbus, the big jet engine manufacturers (CFM/GE, Pratt and Whitney, and Rolls-Royce), as well as the U.S. military. Looking through Parker’s aerospace, we find a majority of this content is protected by a high amount of intellectual property which is hard to displace, particularly around engine components and actuators given Parker’s leading motion control technology.

We think the firm will grow its overall top line at a 3% CAGR through our five-year explicit forecast, which incorporates management’s comparably conservative top-line guidance for 2019 off difficult 2018 comps. Drivers include greater automation needs, large customers’ preference of buying from a list of preferred component suppliers, increasing digitization, robust demand from emerging markets, and less available skilled labor in North America. In the Aerospace Systems segments, revenue passenger miles remain a key driver, and we see Parker’s position in the supply chain protected by its high degree of intellectual property. We think segment operating margins can expand to 18.5% by 2022 (up 280 basis points from 2018 levels). Aside from growth in the international distribution network, we believe the firm will drive margin expansion through additional Clarcor synergies, product line simplification, and lower restructuring charges in the waning years of our explicit forecast.

Finally, the firm is notably one of five multi-industrials firms to pay an annually increasing dividend for an unbroken chain of 60 years, which demonstrates both a culture of shareholder orientation and exhibits management’s excellent cash management acumen.