Parker-Hannifin Corp
NYSE:PH
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Parker-Hannifin Corp
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Thank you for standing by and welcome to the Parker-Hannifin Corporation Fiscal Year 2022 Second Quarter Conference Call and Webcast. At this time, all participants are in listen-only mode. After the speakers' presentation, there will be a question-and-answer session. [Operator Instructions] As a reminder, this call may be recorded.
I would now like to introduce your host for today's program, Todd Leombruno, Chief Financial Officer. Please go ahead, sir.
Thank you, Jonathan and good morning everyone. Welcome to Parker's fiscal year 2022 Q2 earnings release. As Jonathan said, this is Todd Leombruno, Chief Financial Officer speaking. Tom Williams, our Chairman and Chief Executive Officer; and Lee Banks, our Vice Chairman and President, are both with me here today for the webcast.
I'd like to direct you to slide number two, which details our disclosure statement addressing forward-looking statements and non-GAAP financial measures. Reconciliations for all non-GAAP financial measures are included in today's materials. Those materials, those reconciliations, along with this presentation, are accessible under the Investors section at parker.com and will be available for one year.
As usual, today, Tom is going to begin with highlights of the quarter and a few comments on the company's transformation. I'll follow-up with a brief financial summary and review the increase to our full year guidance that we announced this morning. Tom is going to handle closing comments, and then we'll open up the lines for your questions.
Two comments before we begin today. First, as a reminder, regarding the pending Meggitt acquisition, we are still bound by the requirements of the UK Takeover Code in respect to discussing certain transaction details.
And secondly, we are announcing a date and time change to our upcoming virtual Investor Day due to a scheduling conflict with another company's Investor Day. Our meeting will now be held on Tuesday, March 8th, from 9:00 A.M. to 12:00 P.M. Eastern. It will be a virtual event, and among the topics that we'll cover will be the release of our new long-term financial targets.
So, with that, I'll ask you to move to slide three, and I'll turn it over to you, Tom.
Thank you, Todd and welcome everybody. Thanks for your participation today. I want to start with the title of this slide, which is exceptional execution in a challenging environment. When you look at the performance of the company in aggregate safety, sales growth, the margin expansion, EPS, it was an extremely strong quarter. This is against arguably one of the most difficult operating environments that we've all faced in our careers when you add up the cumulative effect of inflation, supply chain challenges and the Omicron virus. My thanks to the global team for just a great job execution in this quarter and really the execution for many, many quarters as we go through this presentation.
Let's start with the first bullet. Focus on safety continues. It is our number one goal. We're leveraging our high-performance teams, the combination of the natural work teams that we have in our plants and warehouses as well as the Star Point teams and kaizen. And it's really this combination this team structure plus kaizen that is driving an ownership culture within the company. So, ownership of safety, but also ownership of quality, cost, delivery and engagement.
Sales growth was 12% year-over-year. Organic growth was 13%. It was nice across all the external reporting segments as well as every region participating. Total sales was the second quarter record as well as total segment operating margin.
EBITDA margin was 18.2% as reported or 22.7% adjusted. It was 180 basis points. It's a big move versus prior year. Robust demand environment continues. We had over 90% of our end markets in the growth phase, which we're very excited about. And this execution, what you're seeing is really the cumulative effect of One Strategy 2.0 and 3.0 driving this kind of performance. When you add the strategy changes on top of the portfolio, things we've done, adding those great acquisitions that we've done over the last number of years, and a powerful secular trends that I'm going to talk about it here momentarily, we see a future as a much longer cycle and more resilient and faster growing.
So if you go to the next slide, slide 4. I've touched on this before. This kind of frames all of our thinking and our strategies for the company to around trying to achieve these three key drivers; living up to our purpose that higher calling, that North Star that we're driving for; to be great generators and deployers of cash, to be a top quartile performer versus our proxy peers.
If you go to slide 5, which is the little expression that picture is worth a thousand words. This kind of sums up how the company has changed over the last number of years. We've updated this slide for FY 2022 numbers. And I'm going to just reframe the slide for you. On the left-hand side is adjusted EBITDA -- adjusted EPS, and on the right-hand side is adjusted EBITDA margin. So if you look on the left, and you go to FY 2016, so we work real hard as a company for 100 years to get to $6.99 EPS. And then the last six years, we've grown it by 2.5 times to a little over $18 in our current guide.
If you just look at the gain that we've had since the pandemic, FY 2020 to FY 2022 guide, it's almost another $6 just in those two years. It happens to be, and I don't think it's coincidental although we launched Win Strategy 3.0 at the beginning of FY 2020. And you can see what it's doing to propel performance.
If you look on the right-hand side, we don't guide on EBITDA margin, but we put in our EBITDA margin year-to-date to 22.4%. If you look at that from FY 2016 to that, it's 770 basis points improvement, just remarkable improvement. Really the how behind these results, it's been our people, portfolio changes that we've done and has been, again, a cumulative effect of Win Strategy 2.0, 3.0.
So if you go to the next slide, give you a quick update on the Meggitt transaction. We continue to make progress. There's really four main work streams that we're working. There's two -- the economic and national security review that we're working on with the UK government. I would characterize those as constructive and positive and on track. And then the antitrust and FDI filings are proceeding as we had anticipated. We're still anticipating a Q3 calendar 2022 close and we're really excited about this. This is obviously a compelling combination. It doubles the size of our aerospace business, highly complementary technologies. And we're at the beginning of a commercial aerospace recovery with great synergies as we put these two companies together. Again, coming -- bringing this on with everything else we've been doing, a much longer cycle, less cyclical, faster growing companies.
And then on slide 7, in addition to the strategic acquisitions that we've been making, we are uniquely positioned with our eight motion control technologies to benefit from the four secular trends that you see on this page. Now I touched on aerospace and the recovery and momentum of Meggitt plus Parker. But if you look at electrification, ESG, digitization, what you have here, our long-term multiyear growth enablers and content growth for us is going to grow both on-board as well as infrastructure. And we're excited this is going to be a big part of what we'll talk about at Investor Day, and we look forward to sharing more about these secular trends on March 8th with you.
And with that, I'm going to turn it over to Todd for more details on the quarter.
Okay. Thanks, Tom. I'll ask everyone to move to slide 9, and I'll start with our FY '22 Q2 results. As Tom mentioned, this was just an outstanding quarter. Just another reminder that our operations leaders are really driving the company to significantly higher levels of performance. Our sales increased 12% versus the prior year. We did hit a record level of $3.8 billion. Tom mentioned this, but organic sales were very healthy at 13%. Currency was about a 1 point drag on sales. That's how we got to the 12% reported sales increase.
Demand just remains robust. Our backlogs are healthy. Our growth remains very broad-based across all of our industrial businesses. If you look into the Aerospace business, commercial demand continue to trend positive. And we talked about this before, but the acquisitions of CLARCOR, LORD and Exotic continue to outperform our expectations.
When you look at the segment operating margins, it's a Q2 record on an adjusted basis. We did 21.6% segment operating margin, that's 120 basis points improvement from prior year. And our teams are really managing through the well-documented supply chain issues, the inflationary environment. I really just want to commend them on our team's swift actions to manage these costs and inflationary actions, still while achieving record sales in the quarter.
Tom mentioned this, but adjusted EBITDA margin was 22.7%. That's up 180 basis points from last year. Both our adjusted net income and our adjusted EPS has improved by 29% versus prior year. Net income is $582 million or 15.2% return on sales. And adjusted EPS was $4.46. That's $1.01 increase versus the prior year of $3.45, just a really solid quarter.
If we jump to Slide 10. This is just a bridge on adjusted EPS, and I'll just detail some of the components that generated the $1.01 increase in EPS. And as you can see, really, operating execution is the major driver in this increase. Adjusted segment operating income did increase by $132 million. That's 19% greater than prior year. And that really accounts for 80% of the increase in our EPS this quarter.
We did have some other favorable items that was $0.19 favorable. There were some currency gains that were favorable. We did sell a few facilities that we restructured those closed in the quarter, and we do have reduced pension expense versus prior year. All of that added up to $0.19. And then you could see the other items on the slide that all netted to $0.04 favorable. But really, the story here is just a very strong operating quarter.
If we go to Slide 11, I'll make a few comments on our segment performance. Tom mentioned those secular trends, we are seeing growth from those trends across our segments. Every single one of the segments has a record adjusted segment operating margin this quarter. We did maintain a cost/price neutral position. We're very proud of that. Incrementals were 32% versus prior year.
I just want to remind everybody that is against a headwind of $65 million of discretionary savings that we had in the prior year. If you exclude those discretionary savings, our incrementals were 48%. So really fantastic performance across the board from our teams. It really highlights the power of the One Strategy and really demonstrates our ability to perform through this current climate.
If you look at orders, orders are plus 12 and really the demand continues to be robust across our businesses. Just a little color on Diversified Industrial North America, sales reached $1.8 billion. Organic growth in that segment was 15% versus prior year. And listen, we're really pleased with the performance in this region. We've talked a lot -- I've read -- I know everyone is familiar with the well-documented supply chain issues. Tom mentioned the Omicron spike, we are not immune to that. But we did keep operating margins at a very high level of 21.3% in this segment and we're proud of that.
Order rates continued to be very high at plus 17. Our backlog is strong. And Tom mentioned this, 91% of our markets are in growth mode. So great things in the North American businesses.
Industrial International is a great story. Sales are $1.4 billion. Organic growth is up 14% in this segment. And I want to note that across all the regions within our International segment, organic growth was mid-teen positive in every region. So really robust activity there.
Maybe more impressive is the adjusted operating margins, 22.4%. This is an increase of 210 basis points versus the prior year. And certainly, we have volume. We've talked a lot about our growth in distribution internationally. We are benefiting from some product mix. And really, the team is doing a great job controlling cost.
And this has been a really long-term effort over a long period of time from that team. So I'm really happy that they're able to put up these continued high level of margin performance. Order rates there were plus 14%, ample backlog and really solid international performance.
If we look at Aerospace Systems, really continued signs of a rebound there. Sale were $618 million. Organic sales are positive at almost 6%. And we did see very strong demand in our commercial OEM and MRO markets. Great margin performance here as well. Operating margins have increased 270 basis points that finished the quarter at 20.7. And again, I just want to remind everyone that, that is still at pre-COVID volume levels. So great margin performance from our Aerospace team.
Aerospace orders on a 12-month rolling rate did decline 7%. But one item I want to make clear for everybody is, we did have a few large multi-year military orders in the prior period that really created a tough comp, just in Aerospace. If we exclude those orders, Aerospace orders would be plus mid-teens positive.
So we're seeing continued signs of steady improvement in Aerospace. Our order dollars in Aerospace in the quarter were at the highest level they've been in the last three quarters. So great quarter out of Aerospace.
But if you really look at the segments, it's really outstanding operating performance. We've got positive growth, strong order dollars robust backlogs, record margins and really just solid execution across the board. So great segment performance.
If I take you to slide 12 and talk about cash flow on a year-to-date basis, we did exceed $1 billion in cash flow from operations. That is 13.3% of sales. Free cash flow is $900 million or almost 12% of sales and conversion on a year-to-date basis is now 107%.
We still continue to diligently manage working capital across the company. We really are just responding to these increased demand levels that we have. The working capital change did improve in the quarter as we forecasted. In the quarter, it was a 1.9% use of cash, versus last year it was a 4.1% source of cash.
So for the full year, I just want to reiterate, we continue to forecast mid-teens cash flow from operations and free cash flow for the full year will exceed 100%.
If we go to slide 13 now, I just want to make a few comments on our capital deployment activity. I'm sure many people have seen this, but last week, our Board approved a dividend declaration of $1.03 per share. That is fully supportive of our long-standing 65-year record of increasing dividends paid.
And I want to give an update on the Meggitt financing. We continue to make progress on our financing plan. Our plan is flexible. It is efficient, it is risk-mitigating. I did mention on the last call that we secured a deal contingent forward hedge contract in the amount of £6.4 billion. Accounting rules require us to mark those contracts to market. That impact in the quarter was a non-cash charge of $149 million. We booked that in the other expense line, and we are treating that as an adjusted item.
We now have $2.5 billion US dollars of cash deposited in escrow to fund the Meggitt transaction. That is listed on our balance sheet as restricted cash. And that was funded from a combination of commercial paper and some cash on hand. A result of that, our gross debt-to-EBITDA ended up being 2.7 times in the quarter. Net debt was 2.5 times. If you account for the $2.5 billion of restricted cash, net debt-to-EBITDA would be 1.8.
Okay. So if we go to slide 14, I just want to give some details on the increase to guidance that we announced this morning, and of course, we're giving this on an as-reported and an adjusted basis. Full year adjusted EPS is raised by $0.75. We did guide to $17.30 at the midpoint last quarter. We have moved that to $18.05 and that is at the midpoint. We've also narrowed the range.
Range is now $0.25, up or down and sales is also raised. We're raising the midpoint to a range of 10% at the midpoint. We've got a range of 9% to 11%. And the breakdown of that sales change at the midpoint is organic growth is 10.5%. Currency will be about 1 point unfavorable. And of course, there's no impact from acquisitions. As Tom said, we don't expect Meggitt to close in our fiscal year.
If we look at the full year adjusted segment operating margin, we're also raising that 20 basis points from the prior guide. Full year now, we expect that to be 22.1% at the midpoint. There is a 20 basis point range on either side of that. And corporate G&A and Other is expected to be 6.56 on an as-reported basis, but 4.35 on an adjusted basis.
So of course, there's a couple of adjusted items in there. The acquisition-related intangible assets that is a standard adjustment, the realignment expenses, standard adjustment, lowered cost to achieve, standard adjustment, but we are adjusting these transaction-related expenses for Meggitt.
Year-to-date, we've got $71 million worth of transaction costs, and of course, that $149 million non-cash mark-to-market loss that I just mentioned. We're going to continue to adjust for the transaction-related expenses as they are incurred.
If you look at tax rate, tax rate is now going to be slightly lower than what we had forecasted just based on first half activity. We expect that to be 22% now. And finally, guidance for the full year assumes sales, adjusted operating income and EPS all split, 48%, first half; 52% in the second half. And just a little bit more color, Q3 – FY 2022 Q3 adjusted EPS guide, we have at $4.54.
So with that, Tom, I'll hand it back to you for closing comments, and I'll ask everyone to go to slide 15
Thank you, Todd. We've got a highly engaged team around the world living up to our purpose, which is enabling engineering breakthroughs that lead to a better tomorrow. You've seen what 3.0 has done as I referenced in that EPS that's driving our current performance what's going to drive our future performance. It's early days of Win Strategy 3.0, and I would characterize it as having long legs, lots of potential ahead with Win Strategy 3.0. The portfolio transformation continues. We've acquired three great companies, are in the process of a fourth that will make us longer cycle, more resilient. And if you put that on top of the secular trends that I highlighted, we feel very, very positive about the future.
So it's been our portfolio changes. It's been the strategy changes, but it really starts with our people, 55,000 team members that are thinking and acting like an owner, so 55,000 owners that are driving this transformation. So my thanks to all of them for what we did in the quarter, but really for what we've done in the last number of years.
And then I'm going to hand it back to Todd for a quick comment just to set up the Q&A before we get started.
Yeah. Jonathan, I just wanted to ask the participants on the call, just as a reminder to ask one question, a follow-up, if needed, and then jump back in the queue. Just so we can try to get everyone on the call to have a shot at answering the question. We do appreciate your cooperation.
So Jonathan, I'll turn it over to you for Q&A.
Certainly [Operator Instructions] Our first question comes from the line of Joe Ritchie from Goldman Sachs. Your question please.
Hi. Good morning everybody. Nice quarter.
Thanks Joe.
So Tom, you mentioned in your prepared comments that 90% of your end markets are growing. I think that there's still some concern just around like this like hyper growth that we're seeing this year, and that we’re kind of closer to peak. Can you maybe just tell us a little bit more about, kind of, like the sustainability of growth even beyond this year and maybe some commentary around inventory balances as well?
Yeah, kind of, what I would characterize as some rebound off the bottom, Joe, but you've got a lot of things that are positive. The secular trends that I mentioned during my prepared remarks, aerospace recovery, ESG electrification, digitization, are all what I would call longer cycle. I mean the whole electrification trend is going to be years, you could suggest decades. It's what's going to happen to the, ESG, digitization, et cetera. The content that we've seen and the potential bill material changes, both on board and then adding the infrastructure that's going to be needed to support that is big, and it's going to allow us to grow differently, I think, than in the past.
You've got a couple of other things that are going to underpin, I think, a more constructive industrial business cycle going forward. You've got, I think, the CapEx needs where -- are two-fold. One, you're going to need to reinvest in areas that you haven't invested in the last 10 years, because I don't think we're any different than most of my industrial peers, especially the last eight years, where we've had two industrial recessions in the pandemic. You typically probably underinvested during that time period because there's a need to catch back up to that.
And then there's also the need around supply chain. Everybody is going to need to put a more robust supply chain systems, add multiple sources, et cetera, that's going to require infrastructure, extra equipment, et cetera. So you're going to have kind of two bites of the apple on CapEx needs that's going to happen. And then you're going to need to get back to normal inventory levels in the system. And today, inventory is basically nonexistent outside of the suppliers like us. But when you go into our customers and take larger distributors, you're going to need an inventory replenishment cycle. So there's a lot of things that are going to foreshadow a much more constructive future. Then, if you look at what we – the companies we've been buying, we've been buying companies that are longer cycle with accretive growth rates than what we've done historically.
So again, you have the things we've done with the balance sheet, capital deployment help ourselves as well. So I think this is a different cycle. I mean, it clearly feels different to me. There's always all of those unknowns, the geopolitical unknowns and the virus, et cetera. But I think, if you – if we look at it, we were able to look forward, the next seven or eight years is going to, I think, be better for industrials in the last seven or eight.
Yeah. That's super helpful. Thank you, Tom. Maybe my follow-on there is again, stand out from a margin standpoint, this quarter was Aero, and it seems like we're still so far off the bottom in that business. I'm just – I'm just curious, maybe just kind of peel back the onion a little bit on what's really kind of driving the strong margins and then sustainability of those margins moving higher from here?
The big help with Aerospace is twofold. One, we were very aggressive in establishing, again, Joe, it's Tom. Establishing a fixed cost structure that was going to be designed to withstand to current conditions and flexible enough to withstand the commercial recovery. So we've done that. And we were – probably, I'd say, one of the more aggressive and quick to do that of our other peers are in the aerospace industry. So we have a fixed cost structure that is in a great position to leverage this additional volume.
And then in the near-term, you're seeing significantly higher volume from commercial MRO. And that piece is obviously more higher margins. I mean, commercial MRO in the last quarter grew 47%. So those would be the two big things. We had moderate R&D in that low 3% type of level. So you get additional volume over a great cost structure and additional volume being the higher-margin piece of the portfolio is driving the margins.
Just for people, I mentioned this in the last quarter, but it's even more pronounced now. We're guiding to 21.4 for the full year and that's against an all-time peak pre-COVID of 20.5. So that's fantastic. It's 90 bps higher than our previous high, and we're nowhere near previous high on revenue for Aerospace. You've got – so what's going to help, Joe, going forward, you've got ASKs, they're going to recover. You got departures, they're going to recover.
Omicron is probably the silver lining to helping all of us get out of this pandemic. And the Aerospace industry will be the first to recover and you can look at – there's a lot of different people forecast in the future. When we get back to pre-COVID, I think you can say anywhere from 2023 to 2025 calendar year. If you kind of look at the median – middle of that, what most forecast were saying that puts you kind of in 2024. But there's a – you're going to have a lot of positives going forward. You've got the recovery, we've got Meggitt, and the continued good things we're doing in aerospace as a whole, so we're very positive. If we weren't so positive, we obviously wouldn't have bought Meggitt. We think there's a great space to invest in.
Makes a lot of sense. Thanks, Tom.
Yeah. I appreciate the questions, Joe.
Thank you. Our next question comes from the line of Nigel Coe from Wolfe Research. Your question, please.
Thanks. Good morning. Hi, guys. Just wanted to maybe just pick up on your investment comments, Tom. You talked about CapEx, but I'm just wondering about OpEx investments. And so just wondering if there's a need to catch up on engineering spending, R&D within aerospace, any comments there would be helpful.
Yes. Nigel, it's Tom. I think on the OpEx part of things, I think we're in good shape. What we've learned over the time is that innovation is not a function purely a dollar. Yes, you need to invest enough there. It's more a function of org structure, the talent and the processes that you put in place to drive that innovation.
So, we think we're at a very good level. We're focusing a lot of our R&D, if I just take aerospace as an example, more on future component technologies and additive and trying to be ready for our customers when the RFPs come out.
If you wait for the request for proposal to come out and start to do your R&D, you're too late. So, you have to look at where the market is going and anticipate those type of things.
Our simplify design process is allowing us to innovate much more efficiently. Every new product that we develop is going through the simplify design process so that's going to help us as well. I think you weren't asking about CapEx. I think we'll have to add a little CapEx, but it will be immaterial. It would be probably just getting us into the upper 1s or closer to 2.0 on the CapEx side for productivity, for organic growth and all those kind of things.
And a good example of this and how this has been happening, and I don't disclose the total numbers. But if you look at -- we added a new metric with One Strategy 3.0 called PVI, product vitality index, and it's the percent of our sales that are coming from new products, new technologies that have been developed in the last five years. And that percentage, in the last -- I'd go five years, has doubled.
So, the percent of the portfolio that is more innovative is doubled. It's one of the things that's going to help us with sustainable growth. And it's one of the things that is helping us with margins because the new products are designed with a more attractive value proposition and higher margins. And so that's -- I think that's a good indicator, Nigel, that as long as you invest efficiently, you can get nice rewards for that.
Okay. So, it sounds like no big investment cycle on OpEx. And then just my follow-on is Industrial versus North American -- International versus North America Industrial margins. Having covered Parker-Hannifin for a long time, Industrial has always lagged North America. And within the guide, international 50 bps above North America. So, I just wondering, going forward, do we think that international and North American structural margins will be very similar going forward?
Yes, Nigel, it's Tom again. Yes. Yes. I mean they're there now, and we think they basically should run the same. And they're great positive about this and for all my international colleagues that are listening, this has been years in the making, a fantastic run rate really from all the regions outside of North America have contributed to this. We're seeing margin expansion across all three regions. And the short answer, Nigel, is yes, North America and international, should basically be about the same as we go forward.
Great. Thanks Tom.
Thank you. Our next question comes from the line of Joel Tiss from BMO. Your question please.
Joel -- welcome, Joel. Congratulations on your retirement. Glad you made it.
Thanks. Well, you see, after I ask my question, you might not feel that way. No, just kidding. So, I have one short-term, one about net pricing for 2022? Do you think that's going to be positive, or you think it's going to continue to be neutral?
Yes. Joel, it's Lee, also congratulations. Maybe just taking a step back for everybody on the call. I think the one thing that we've established inside this company is a great culture of value-based pricing. So always pricing products for kind of the – how we make or save money for our customers. When we have times of inflation, we've got great processes internally to gauge pricing, but also what's happening with material costs.
And as you know and I've said in the past, our goal is always to be margin-neutral, and we've been able to accomplish that for a long period of time. I will tell you what's happening now is just looking at material cost is not enough. Inflation is incredibly broad-based. And we've just had to take a very comprehensive look to maintain that margin neutrality. And we're very active in this last quarter. I mean, we saw things ramp up quickly. But to answer your question, I expect to maintain that margin neutrality going forward.
And then a longer-term question, probably maybe beyond Tom's scope or whatever, one we're on Wind 5.0. Do you think by 2030, we could see 30% EBITDA margin potential? And the reason, I'm asking the question is maybe just a little bit of thought process about some of the some of the big strides, you have in front of you to get the margins higher than where they are now?
Joel, it's Tom. And I'll add my congratulations as well. And I'm going to maybe just expand for a second. We have always appreciated your honesty, your intelligence and your sense of humor, just like you started this -- your questions. And that's refreshing. And it's not always -- you don't always get that. And so on behalf of all of us, we thank you and congratulate you for a great career.
On the long side, so 23, you're right, that will be beyond my time. But we're not a company that views that there's any kind of mile marker we can't go past. And so, I won't say that, that's a number we could never achieve. We're going to give you the first look at our 5-year when we get together on March 8. And I think that will give you visibility of where we think we can take the company.
But just as you've seen that chart at the beginning of my remarks, what's happened with EBITDA margin, it's at like a 45-degree line. And as long as, we keep developing technologies and products that create the distinguishing value that Lee referenced, we can attract that kind of margin attainment. So that's not an overnight and you weren't suggesting it's an overnight at 2030. But I view this as we go down the highway of continuous improvement there's no exit ramps. We're just going to continue to go and keep trying to get better and aspire -- as I mentioned at the beginning, aspire to be the best industrial company that we can.
Thank you very much.
Joel, we greatly appreciate it. You have a wonderful retirement.
Our next question comes from the line of Jamie Cook from Credit Suisse. Your question please.
Hi good morning and congrats on a nice quarter. Tom, I guess, my question, again, it relates to the margin performance in the first half of the year and what's implied in the back half of the year. I'm just sort of wondering, while you're putting up better margins than everyone expects, can you sort of talk through the supply chain, the labor inefficiencies, some of the headwinds that you're seeing in the margins, because it just makes me think, obviously, the underlying margins could be much stronger as some of these short-term issues go away. And I guess, as I think about that, does that set up Parker to put up above-average incrementals as we think about 2023, assuming sort of the world goes back to normal? Thanks.
Yes, Jamie, it's Tom. I'll start, and Lee can tag on, because Lee's leaving us as we speak. I mentioned this in the beginning that arguably the toughest environment in my career, and I've been around a long time. This is really a tough environment.
If you're a general manager, you're an ops manager, supply chain leisure between inflation, COVID supply chain disruption, really difficult to schedule the shop. It's difficult to schedule your suppliers. It's difficult to schedule your team members and apply them. Omicron has been -- well, I think it's going to be a blessing overall, has been a blessing if we didn't have any of this. It's going to get us out of it. It's really kind of peaking in January, and will start to decline, hopefully, here as we go through February, but it has impacted absenteeism rates significantly. We felt some of that in the second quarter. We're feeling much higher absenteeism rates in the beginning of Q3.
The reason why I go through that, is it just to your point, Jamie, it underlines how impressive these numbers are. If you run a factory and you're trying to hire a bunch of people, train them, and you've got absenteeism significantly higher than you used to, and you're having to redeploy people, retrain them, cross train them. You can imagine how difficult it is in any given day you’re not sure whether the material you want is coming in, you can just guess how hard that is.
And so these numbers are impressive, to your point, as we get through this and it becomes more normal times, that's helpful, and we'll kind of indicate that when we get to IR day. But the implied guidance in our second half is quite a bit better than the first half. So 22.3 is what we're implying for total op margin in the second half. We did 21.8 in the second half of 2021. So it's a 50 bps higher than prior year. And ironically, it's the same 50 bps higher than what we did in the first half. So you see some of that sequential growth.
I would just help to remind, you guys cover so many companies. We came out of the -- when we started the pandemic, we were very aggressive on taking out cost. And so it kind of fall no good decost and punished. We were one of the best companies putting up MROSs at the beginning of the pandemic. But we now have to compare against those years, and we've been trying to give you apples-for-apples. This last quarter, the apples-for-apples was a 48% incremental. The guidance for the second half is around 40% for Q3. This is making apples-for-apples taking out those discretionary costs in Q4 around 35, again, a full year, not counting those things, it turned out to be 30.
I think that's a great number. In this kind of environment that you can put up a 30 incremental, you're doing some spectacular work. And again, I want to emphasize, Todd said this earlier, a big thank you to Lee and Jenny and all the group present and all the people around the world that did such a great job run our factories. But we'll get more, Jamie, into what we think we could do in a more normalized world and show you the targets in IR day.
Okay. Thank you. I appreciate it.
Thanks, Jamie.
Thank you. Our next question comes from the line of Mig Dobre from Baird. Your question please.
Thank you. Good morning, everyone. Tom, I remember on the last earnings call, you were talking about supply chain disruptions, maybe not so much impacting you, but impacting your customers and their ability to frankly produce and thus, purchase or get deliveries of components from you.
I'm wondering if you can maybe give us an update here in terms of how things have evolved. And as you're looking at the back half of your fiscal year, how you think your own customers’ output/throughput is going to progress?
Yes, Mig, it's Tom. Yes, that is still the case. If you look at the whole value chain, our customers, us, our suppliers and our suppliers' suppliers, everybody is feeling it. Everybody's feeling it.
I would say our customers are feeling it the worst, because they're at the top of the food chain, our customers or the OEMs, they have a more complicated build material. They have more ship dependency. And so they have more difficult time. And so, that is still -- while everybody is feeling it, and we are clearly not immune, we're feeling it as well and our suppliers are feeling it, the long pole in the tent is still our customers and their ability to manage a more complex build material coming their way.
That's part of what makes forecasting sales difficult for us, is we look at our own inputs, our AI model and feedback from customers and divisions and, et cetera. But we do have to factor in, our customers are careful that they're not able to take everything that we could provide them because -- and I understand why they would do this, why would they want to take our material, if they can't put it to use. We're doing the same with our suppliers.
That really hasn't changed much since our last conversation. I think, in a lot of cases, the chip issues, at least the chips that our industry, our customers and our products use are still feeling the pinch point. As a matter of fact, probably got to hear worse as we started Q3.
We're not forecasting any help on that. Of course, we have the benefit being a different fiscal year company. We've only got five months left to talk about, but we don't see any help within our fiscal year. And if it helps going to come on that, it's going to be more towards the end of this calendar year.
Understood. You talked earlier about the robustness of this industrial cycle. But, I guess, one of the concerns out there is that, the robust orders that you've seen thus far could potentially be a factor of customers trying to make sure that they do have available components in an environment in which there are shortages out there. So what is your science as to whether or not this resulted in some unnatural boost to demand or double ordering, however you want to characterize it?
Yes. Again, Mig, it's Tom. I would say that from what we can tell, is still predominantly all underlying demand and not people trying to worry about getting in line or double ordering to your point. Is that happening? I would guarantee, it probably is happening somewhere because there's no way we can 100% predict that.
But my comment is the beginning of the Q&A was more longer term, this industrial cycle feels like it has stronger legs from just the recovery dynamics, CapEx and the underlying -- for us, the underlying linkage of those secular trends.
I think most of what our customers are doing now is just trying to be pragmatic. They're laying in orders that are over multiple time periods than they historically would have done, which I think net-net is a good thing for the whole supply chain.
Thanks for the call.
Appreciated it, Mig.
Thank you. Our next question comes from the line of David Raso from Evercore. Your question, please.
Thanks for the time. One question a little longer-term and one more near-term. With the meeting coming up, last meeting, the margin expansion was really focused on simplification and then a better mix as distribution grows. And within simplification, obviously, we had org structure, operational complexity and particularly simple by design. I was just curious, can you give us at least a little insight on how to think about approaching this meeting? Is this the ability to drive those initiatives further, get a further update on those? Are there other things that we should consider? And then I'll follow up with my near-term question.
Yes, David, this is Tom. It's going to be a combination of what were the latest on 3.0 and really keep updating on all the changes to 3.0. It's very hard in an earnings call and just even a normal roadshow that we might be doing to take people through all the different elements of Win Strategy 3.0. So we're going to try to do a more comprehensive job of taking you through that and how it can help both growth and our margin expansion.
Talk about some incentive changes that we've made, they're going to help change the behavior and motivation for our team. We're going to give you an update on the secular trends, which are really unique. I mean when Lee and I started our respective jobs, this whole ESG phenomena, the electrification, digitization, they were there, but not at the same kind of extent with the same kind of momentum and CapEx investment that's going to happen around there.
And we really -- and we want to try to give people a better understanding of how our portfolio is going to change and how the content changes because of those trends. So there will be a lot of time on that. And then it will all come out in a forecast of what we think the five-year goals are going to be. So that's a not show kind of the high-level time line of our agenda for the meeting.
That's helpful. Thank you. And just real quick, I know the guide, we can debate conservative or not on the revenue. But in particular, the international revenues for the back half of the year implied only growing 1% despite the order it just came in 2014. And I suspect some of it's currency weighing on it. But anything we should be thoughtful about on why if you look at where the guide in the back half seems a little, at least raises an eyebrow, why would international slow that much?
Okay, David, it's Tom and Todd, tag on if I missed something here. So I'll give you what I have. I don't know where you're getting to 1%, but I'll give you what we're seeing for the second half. I'm going to give you the organic numbers. So we are raising the guide, it was 6% for the second half, all-in total company to 7%. And just to kind of provide context, that 7% is against the 10% that we did in the prior second half.
So again, it's kind of the two-year stack, it's 7% on top of 10%. But if I split out the segments for you to get to the 7% North America second half is around 8.5%, International is 5%, so it's not 1%, it's 5% organic. And then Aerospace is approaching 7%, and that's how you get to the total number of 7%. I don't know, Todd, do you have to...
Yes, Dave, I would just add, you're right. You mentioned currency. We're forecasting between 3.5 and 4 points of negative impact in the International segment just from where the currency rates are today. We're not trying to forecast those going forward. It's just a year-over-year comparison. To kind of put that in perspective, we had less than one in the first half. So that's probably a little bit of a –
So that's the gap between the five and one essentially?
Correct. Yeah.
Okay. I appreciate it. Thank you so much.
Thanks, David.
Thank you. Our question comes from the line of Jeff Sprague from Vertical Research. Your question please.
Thank you. Good morning.
Good morning, Jeff.
Good morning. Hey, Todd, you laid out how your FX hedge on financing for Meggitt. Could you just update us on what, if any, interest rate risk you have just on the actual financing cost itself?
Yeah. We've got a very flexible plan here. We've talked a little bit about that. It's going to be a mix of commercial paper, a mix of cash. We did take out a deferred throughout term loan, and then the remaining of that is yet to be determined. We've looked at it. We feel good with the rates that we're seeing. So I guess, we could give you more info that as we get a little bit closer to taking action on that. But we've got the team looking at it, and we feel really good with the total cost of debt for this transaction.
You're not proactively locking anything else in front of the transaction?
No, we've looked at that, because the close timing is uncertain, the breakeven on that just becomes a little bit challenging.
Understood. And then, Lee, you mentioned we need to think more about raw mats and I totally agree. I just wonder, if you could address labor a little bit more? Tom mentioned how hard people are working in the factories and the like. Can you just maybe give us a little bit of a context of how significant labor is in terms of your direct cost in COGS or any other kind of way to frame up the labor component of the cost structure?
Yeah, I'm not sure I can be that specific for you. But I think the one thing I was thinking about when Tom was talking, the one reason we've been able to come through this two years of pandemic is really the culture around our high-performance teams driving all these processes that are embedded inside the company around lean, talent, supply chain, and the way there is just this culture of ownership. And what's been rewarding for me to see is we have had a spike in absenteeism rate, but our teams figure it out. They prioritize what needs to get done.
Our local teams figure it out. There's certainly an increase in cost in different markets, inflation – to sum it up in one number, I can't do that for you. But I can tell you, costs are going up and all the support costs that go with it. But bottom line is it's really our team that keeps working all the way through this to help us achieve these results.
Thanks a lot. I’ll leave it there.
Appreciate it, Jeff.
Thank you. Our next question comes from the line of Joe O'Dea from Wells Fargo. Your question, please.
Hi. Good morning, everyone. I wanted to start on supply chain and experience over the past few months, and your confidence in kind of stabilization of peak pain, if you think we see that kind of this past quarter and the quarter we're in right now? Anything you have in terms of visibility on things getting better? And then within that, any characterization of differences you see on the North America side versus the international side on supply chain?
Yeah, Joe, it's Tom. I would say that, I don't see it getting better, as I mentioned earlier within the fiscal year. If I had to say, it's probably this current quarter we're in, is probably the toughest that we're going to experience. At least, I'm hoping, it's the toughest with all things considered. I think we've weathered it pretty well and probably the best indicator of our ability to weather has been that incremental margin conversion and our margin expansion that's really the punch line.
Are you able to digest inflation, supply chain disruptions, absenteeism, everything. It all ends up in, well, how are you doing on margins? Are you expanding margins? Are you converting incremental revenue at the right kind of pace? And we've been able to do that.
Part of our success on supply chain is historical. We've taken the approach historically that we want to make, buy, and sell local for local. Yes, we have global supply chains, and we look at augmenting local sources. But we've always been, from a service and a customer experience standpoint, trying to be local, too, and speed-to-market, et cetera.
So, that localization has helped us a lot and a lot of -- because a lot of the pain points are tied to logistics as we're all aware of. And then we've had a pretty good risk mitigation strategy around dual sources, but we're spending a lot of time on that. So, I would tell you going forward, we're going to add more dual sources, which I'm not the only CEO in the world that's thinking that.
So, that's a good infrastructure thing for us, equipment needs, et cetera, building needs. We're going to do that. We're also going to be deploying simplify design at our suppliers because as we help them with designs that are easy for them to make, obviously, that makes it easier for them to produce and at a better cost, et cetera. North America is more challenged, in general, because it has tougher logistic challenges. That would be first.
And then second, it has tougher labor challenges. I think Europe in particular, did a better job of retaining people during the pandemic. There are various different number of programs that they had varied by country, but where they didn't people off and retain people and we did a lot of that as well. And so I think their labor availability and their logistics are running smooth in North America, and that's how we'd characterize the differences.
Got it. And then a related one on the incrementals when you talk about adjusted incrementals and a stronger first half of the year than the back half of the year, what within that change is operational versus how much of that is more a function of comps and mix and factors like that, that we would consider more non-operational elements of a step-down in the incremental in the back half?
Well, incrementals are -- incrementals based on operating margins. So, they're all operating. The difference would be what I mentioned to one of the questions was we put out some incredible incrementals in that first reset -- of pandemic. If you could go back at benchmark, we were clearly top quartile, maybe not one of the best incrementals of any industrial company. So, we're comparing against that. So, that's a difficult comparison.
And then of course, we've tried to take you through making an apples-to-apples. We had description one-offs that we've savings all the people taking pay cuts beginning to pandemic is not repeating. And so the apples-for-apples, I mean, our first half this year is in the upper 40s. When you do apples-for-apples incrementals, which is absolutely fantastic. That's fantastic in normal times and everything is running smoothly and to do it in these kind of times is just incredible.
Yes, Joe, I would just add, it does get -- because those discretionary savings kind of ramped down as we went back to normal operations. The adjustment does get lower in the second half. So, we're -- the comparable is $25 million in Q3 and goes down to $10 million in Q4. So Q1 was $125 million. Q2 was $65 million. So, you could see that start to ramp down there.
But you're not saying that there's something about supply chain that's getting tougher or that labor is driving some meaningful change within those incrementals in the back half?
No.
All right. Thank you.
Thank you. Our next question comes from the line of Scott Davis from Melius Research. Your question please.
Good morning. Congrats on a great -- another big result here.
We appreciate that.
I've got from -- I got a couple of things. First, just hearing all these questions, I mean it kind of raises the -- your question, I mean is working capital needed almost be permanently higher the next 2, 3, even potentially 4 or 5 years because of all these dislocations and such? And that kind of threw a little bit of a monkey wrench into some of your traditional lean practices?
No, Scott, we don't believe it is. We believe that this is a short-term response to the spike in demand. If you look at us over the longer period of time, you can see that we have done a wonderful job managing working capital. It still is early days on some of the recent acquisitions. So, I do think we have some upside there as well.
But the other thing I would say is, if you look at our second half, historically, the second half is really where we've started to get a little bit more leverage from the working capital side of the fence, and that's exactly what expect to see in the second half of '22. It's always a little bit tougher in a growth environment, but that's a good problem to have. And I'm really happy with the way the teams are managing this across the entire company.
Scott, it's Tom, if I would add on, our inventory levels right now we have lots of opportunity. And as we go forward, that will be a source of cash for us once we get through the more normal supply chain conditions.
Okay. That's helpful. And then this is kind of a little bit big picture. I mean, if you went back and you looked at your original deal models in CLARCOR, LORD and Exotic, I mean where -- I hate to have you rank your children, but where have you been most kind of pleased with the upside? I know there's a little bit different duration on each of these, so it's a little unfair to compare it. But when you think about trying to normalize the trajectory, I mean, what's standing out? Anything in particular that you would note on those 3 big deals?
So Scott, I'll try -- I'm recognizing them up against the time, but we try to be quick with this. We could not be happier with all 3. You're right, it's kind of like, well, picking for your 3 children, what you deal like best, you like them all. They've all achieved their margin targets that we wanted, have all done, we would expect as far as growth resilience and being accretive to growth.
I think LORD, in particular, brought some unique best practices around how we do commercial strategies, which we're applying across the company. And they've all been accretive on growth, accretive on margins and accretive on EPS. And so the design intent when we started, they lived up to their billing. A lot of times, it's not the case. So we are happy about that.
Yes. Jonathan, just to be respectful of everyone's time, I don't think we have time for another question, so I apologize to those that didn't get on the call. This really concludes our FY '22, Q2 earnings webcast. As always, Robin and Jeff are going to be available for the rest of the day. if you need any clarifications or questions. And I just ask everyone that try to stay warm, stay safe, and have a great afternoon. Thanks for your interest in Parker and thanks for joining us today.
Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect. Good day.