Parker Hannifin

Parker Hannifin reported fiscal fourth-quarter organic sales growth of 8.0% year over year. For the full year, Parker grew its top line 8.3%, and over 100 basis points of operating margin expansion amounted to 18% adjusted earnings per share growth.

Why it matters: For a few years, Parker's aerospace business did most of the organic growth work. We think its industrial business is finally benefiting from the booming US construction activity driven by trends like the energy transition, reshoring, and the artificial intelligence-focused data center buildout. The industrial North America segment grew 5% organically year over year while industrial international grew an impressive 6.5%. We believe Parker deserves to trade at a premium valuation to its past, but we argue that its underlying cyclicality is being masked. Heavy industrial end markets, in which even maintenance spending can be delayed, still represent nearly two-thirds of consolidated sales.

The bottom line: We maintain our $680 fair value estimate for narrow-moat Parker. We consider the shares to be overvalued. Our model assumes over 300 basis points of operating margin expansion over the next five years and over 7% long-term operating income growth, but we still struggle to justify Parker's current market price.

Between the lines: In May, Parker announced the acquisition of Circor's commercial and defense aerospace business for $2.55 billion, which represents nearly 10 times the target's forward sales. We view the purchase price as exorbitant. Optimistically, Parker has a history of realizing synergies, and Circor fits nicely in its aerospace motion and flow control portfolio. The market may be underestimating integration and leverage risk from two large debt-funded acquisitions in Filtration Group and Circor. We estimate net debt/EBITDA at over 3 turns if both deals close.

Our $680 fair value estimate equates to around 20 times our 2027 adjusted earnings estimate.

Parker has generated returns on invested capital averaging in the low teens for numerous decades. Returns for the aerospace segment were injured first from end-market weakness due to the covid-19 pandemic and then from the questionable acquisition of Meggitt. We model improving returns as we expect demand for new aerospace equipment and aftermarket sales to remain well above GDP for the foreseeable future on the heels of continued growth in global travel and a sizable narrow-body plane shortage.

The company is well positioned to take advantage of a number of secular trends. The growing electronic content in vehicles and industrial machinery and the continued development of emerging economies should provide durable growth in demand for many of Parker’s products. We also think a portion of the firm’s growth stems from cross-selling its wide array of products to existing customers.

We model mid-single-digit revenue growth over the next five years, which we believe can translate into low-double-digit earnings per share growth from margin expansion due to an improving revenue mix, acquisition synergies, product line and supply chain simplifications, and manufacturing efficiency gains. Long-term, we think Parker can grow at a mid-single-digit clip and generate a segment operating margin in the mid-20s. The firm’s operating leverage and exposure to cyclical downturns can make its margins fluctuate during large economic swings.

We assign Parker Hannifin a Narrow Morningstar Economic Moat Rating based on switching costs and intangible assets. Parker generates lower returns on invested capital than many of its close peers and wide-moat industrial companies. Its returns have also fallen close to its cost of capital a few times over the last decade and dropped below it in two out of the last three global economic crises, 2001 and 2009. Nevertheless, we think the firm can outearn its cost of capital over the next 10 years.

Parker Hannifin separates its business into two segments: diversified industrials and aerospace. The firm holds number-one or -two share in many of its markets, summing to create one of the widest breadths of industrial components globally. We think the diversified industrials segment, representing around two-thirds of the firm’s revenue, merits a narrow economic moat rating derived from switching costs and intangible assets. The segment generates normalized returns in the low teens and margins in line with close peers such as Donaldson, Emerson, Ingersoll Rand, and Spirax.

The diversified industrials segment houses a diverse array of product lines such as hydraulic, pneumatic, electromechanical, sealing, and filtration components that are installed in steering, braking, suspension, exhaust, HVAC, and fuel systems in passenger and commercial vehicles, agricultural and construction equipment, and industrial plants. Parker’s components are critical to the system in which they are installed but represent a small fraction of the equipment’s overall bill of materials. Its components are designed to last decades, which we think further shifts the customer’s focus away from price and toward factors such as defect rate, performance, and customer support.

We think it is difficult for a customer to switch suppliers once Parker’s components are designed and installed in a piece of equipment. Vehicles like freight trains and ships can transport millions of dollars of goods per day, and each one takes several years to design. Once a base design is specified, it can be used for several decades. Suppliers like Parker become the default for replacement parts and upgrades and have a high participation rate in newly designed models. We think Parker’s switching costs are reflected in its aftermarket sales, representing around half of diversified industrial revenue.

Parker has garnered a reputation for quality built through a century of innovative, time-tested solutions. We think this acts as an intangible asset that is difficult for competitors to replicate. Parker has a stable of over 70 brands, most of which were acquired. Other well-known Parker brands include Racor, which has built a reputation for high-quality fuel filtration systems over the last 50 years; Lord, which was founded in 1924 and is a trusted provider of sealing, vibration control, and thermal management products; and Autoclave, which makes high-performance valves, fittings, and tubes in industries that require precise pressure and temperature control.

Parker’s product lines are designed to perform best when working with one another, which we think raises switching costs. Over two-thirds of Parker’s customers buy four or more Parker technologies. Parker’s industrial plant products illustrate this dynamic. Within robotic arms, Parker's pneumatic actuators provide linear force motion control, its pneumatic valves control the airflow that powers its actuators, its sensors monitor the performance of the pneumatic system, and its servo motors and drives are located at the arm’s joints to provide precise motion control.

Supporting the diversified industrial segment are over 17,000 independent distribution outlets across the globe. Because Parker’s components are highly engineered, only experts with Parker-specific knowledge are able to service customers. Parker and its distributors thus become the preferred providers of maintenance and troubleshooting work, giving the firm an informational edge over peers and increasing the likelihood of winning future aftermarket business.

We think Parker Hannifin’s aerospace segment merits a wide moat derived from switching costs and intangible assets. The segment historically generated returns on invested capital in the low 20s, but recent end-market weakness and the acquisition of Meggitt have greatly hampered returns. The segment’s return profile now matches those of peers Moog, TransDigm, and L3Harris. Nevertheless, we think it is more likely than not that this segment can continue to outearn its cost of capital over the next 20 years.

Parker sells largely the same component types in its aerospace segment as it does in its diversified industrials segment, but they are instead tailor-made for commercial and military airplanes, helicopters, and jets. Commercial and military aircraft markets have massive regulatory hurdles that govern suppliers. It costs considerable time and money to meet the demanding conditions set forth by regulatory bodies such as the Federal Aviation Administration, and in some cases this naturally caps the number of suppliers. Sole sourcing is quite common as a result, which we think raises switching costs above those of Parker’s other markets.

The FAA mandates the maintenance and replacement of aerospace parts, usually based on flight hours. Systems that experience high wear and tear, such as engines and brakes, are replaced many times over the course of a plane’s life, which can exceed 30 years. In addition to stricter regulations, redesign costs are immense in this segment because the design stage for aircraft can take close to a decade. We think this is reflected in Parker’s strong aerospace aftermarket business, representing almost half of segment sales.

Lastly, Parker has a long history of working closely with militaries and aircraft manufacturers to design components, forming a strong intangible asset.

Parker works closely with its customers, which gives it an informational edge over peers, raises the efficiency of its R&D budget, and drives future growth.

Adding complementary product lines to the portfolio strengthens Parker's offering, as customers value a one-stop shop.

The firm has a rich heritage and phenomenal corporate culture that are difficult to replicate. Its leadership team is incentivized to maximize long-term shareholder value through an appropriate compensation plan, in our view.

Parker’s diversified industrial segment will struggle to grow above GDP as it is exposed to many highly cyclical end markets with weak secular drivers.

The firm may need to rely on unmaintainable methods to outperform the market, such as cost-cutting or entering unrelated, higher-growth markets.

In recent years, Parker has made large, infrequent acquisitions, and we are skeptical that its most recent purchase of Meggitt will create value.