Parker-Hannifin Corp

NYSE:PH

Earnings Call Transcript 2023-Q4

[Operator]

Hello and welcome to the Parker Hannifin Corporation’s Fiscal 2023 Fourth Quarter and Full Year Earnings Conference Call and Webcast. At this time, all participants are on a listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Todd Leombruno, Chief Financial Officer. Thank you. Please go ahead.

[Todd Leombruno, CFO]

Thank you so much, Donna. And good morning, everyone, and thank you for joining Parker Hannifin’s fiscal year ‘23 fourth quarter and full year earnings release webcast. As Donna said, this is Todd Leombruno, Chief Financial Officer speaking. And with me today for the webcast is Jenny Parmentier, our Chief Executive Officer; and Lee Banks, our Vice Chairman and President.

I think everyone knows we released our results and all of these slide materials this morning. Our comments today will address forward projections and non-GAAP financial measures. On slide 2 of this presentation, you will find specific details to the disclosures that we are making in respect to both, non-GAAP financial measures and forward projections. And just as a reminder, actual results could vary from what we speak about today in this presentation based on all of the items listed here in these disclosures. Our press release, this presentation and all reconciliations are available under the Investors section at parker.com, and those will remain available for one year.

Today, we’re going to start with Jenny addressing some of the highlights of our strong fourth quarter and really what was a transformational fiscal year for Parker. She is also going to reiterate some reasons that show why Parker is so well positioned for the future. I’m going to follow up with just some color on how the quarter wrapped up and provide some details around our initial FY24 guidance that we released this morning. Jenny will wrap up the call with some key messages, and then we’re going to open up the lines for Q&A for Jenny, Lee or myself.

So, now, I’ll ask you all to move to slide 3. And Jenny, I’ll hand it over to you.

[Jenny Parmentier, CEO]

Thank you, Todd. Good morning to everyone, and thank you for joining our call today. Q4 was a quarter of outstanding performance across all of Parker.

Starting with safety. We remain in the top quartile with a 20% reduction in recordable incidents. Safety has been and will remain our top priority. We had record sales of $5.1 billion in the quarter, a 22% increase over prior year with organic growth of 6%. This is our second quarter above $5 billion in sales.

We achieved record adjusted segment operating margin of 24%, a 110 basis-point increase over prior year. And as we discussed last quarter, our backlog coverage remains resilient at 55% and has increased 1% sequentially. The Win Strategy and portfolio changes have delivered a strong finish to a great year. Next slide, please.

A great and transformational year. On the right side of the page, you can see highlights from fiscal year ‘23. Again, it all starts with our team. Top-quartile safety and engagement delivers these results. We now have approximately 30% of the portfolio in aerospace and defense, and we couldn’t be happier with the progress of the Meggitt integration. The team is exceeding our expectations. And a record $3 billion operating cash flow, 22% higher than prior year, allowing us to make great progress in paying down debt. Todd will give you a few more details on this in his upcoming slides. Next slide, please.

Many of you have seen this slide before. As you know, over the past eight years, we have strategically reshaped the portfolio to double the size of aerospace, filtration and engineered materials. I’d like to draw your attention to the middle of the page for the FY23 update.

The dotted line represents where we originally forecasted our longer-cycle and secular trends revenue to be at the end of the year. The arrow and new solid line represent that we have realized a bigger shift to longer-cycle revenue. The combination of the portfolio changes and secular trends is already and will continue to create a profound shift in our revenue mix. We have high confidence that by FY27, we will have approximately 85% of the Company in long-cycle end markets and industrial aftermarket. This mix shift is further reason why we will grow differently in the future. Next slide, please.

Diving a little deeper into our future sales growth drivers. The five buckets on this slide will allow us to achieve our FY27 target of 4% to 6% organic growth over the cycle. The Win Strategy is our business system. It delivers growth and financial performance. Every tool in this system expands margins.

CapEx reinvestment is addressing the last decade of underinvestment as well as investments to strengthen and develop the supply chain. This will result in increased equipment spend and higher levels of automation. And under innovation, our new product blueprinting tools and Simple by Design principles have increased our product vitality index, that is the percent of sales from new products. This enables faster growth and support of the secular trends.

The acquisitions we have made are great companies with higher growth rates, aftermarket and accretive margins. We continue to benefit from the growth related to secular trends. We expect multiple years of solid growth in aerospace driven by both commercial and defense. And we are enjoying an increased bill of material on all electric passenger vehicles and continue to partner with our mobile customers on electrifying their equipment and helping them to achieve their carbon-neutral goals. And today, two-thirds of our portfolio enables these clean technologies. Again, all of this giving us high confidence to grow differently than we have in the past and achieve our 4% to 6% organic growth over the cycle. Next slide, please.

As a reminder, living up to our purpose, top-quartile performance and being great generators and deployers of cash is what drives Parker. This slide provides an update on living up to our purpose, enabling engineering breakthroughs that lead to a better tomorrow. We are committed and on track to be carbon-neutral by 2040 and achieved a 20% carbon reduction in fiscal year ‘23. And we are proud to be in the first quartile of the Carbon Disclosure Project on climate change.

Post pandemic, our teams were anxious to get back into the communities where we work and volunteered over 10,000 hours in fiscal year ‘23 to help serve others. And again, our clean technologies are critical in helping our customers achieve their carbon-neutral goals. Next slide, please.

The combination of our growth drivers and living up to our purpose points to a very promising future for Parker. We are committed to our FY27 targets of growing EPS from $21.55 to $30 and achieving 25% adjusted segment operating margin. Growth from secular trends, continued transformation of the portfolio with Meggitt and continuing to accelerate our performance with Win Strategy 3.0 will drive top-quartile performance and organic growth of 4% to 6% over the cycle.

We have entered fiscal year 2024 on a solid foundation. The guidance that we are sharing with you today reflects continued progress to these FY27 goals. Todd will go through the quarter and the guide, and then I will be back with more comments on our guide assumptions and why we are still very bullish about the future and the 4% to 6% organic growth over the cycle.

Over to you, Todd.

[Todd Leombruno, CFO]

Thank you, Jenny.

If everyone’s following, I’m going to start on slide 10. And I’m really proud to say once again, every Q4 number highlighted in this gold box is a record for the Company. It was really just an unbelievably strong finish to the fiscal year.

I’m going to try to move quickly because Jenny already spoke to the 22% sales growth and the 24% segment operating margin. But in respect to sales, organic growth was 6%. When you take a look at the Meggitt acquisitions and the divestitures that we did in FY23, the net addition for the quarter was 16%. And the good news here is on currency, the headwinds have moderated. It’s now was just a slight a headwind of 0.4% in the quarter.

One thing I do want to note is adjusted EBITDA margins, 24.4%. That’s an increase of 130 basis points versus prior year. And if you continue down the page, both net income and adjusted earnings per share did increase by 18% versus the prior year. Our adjusted net income was $791 million or a 15.5% return on sales, and adjusted EPS was $6.08 in the quarter. That is an increase of $0.92 or 18% versus prior year.

Internally, we always stress how important it is to finish strong. And really, these results are just really a testament to the resilience of our global team. So, thank you to everyone for a great Q4 and a great fiscal year ‘23.

If you move to slide 11, this is just a bridge on how we generated that $6.08. This is a $0.92 walk. And I’m proud to say, again, you could see the biggest bar on this page is increased segment operating income. If you look at that, we increased segment operating dollars by $264 million. That’s nearly 28% increase year-over-year. That added $1.63 of EPS to our total for the quarter.

There were a few headwinds below the segment that are really no surprise. Obviously, that interest is 100% related to Meggitt. That’s consistent with what we’ve seen in past quarters. And income tax was favorable this year in the quarter. Even though we did finish favorable, it was a headwind of $0.19 compared to what we did last quarter. And if you think about that, last quarter, we did have a few onetime items that were related with the acquisition that were favorable and some higher discretes last year. Those were obviously non-repeating issues this year. So the story on the walk is just really strong operating execution, and it’s really across the board.

If you move to slide 12, just some details on the segment performance. Every segment delivered positive organic growth this quarter, but they also delivered positive margin expansion, you can see across the board here. Incrementals were very strong, and all of these margins are records.

And I’m also proud to say, even with the challenging comparisons, orders did increase from last quarter to a plus-3% versus prior year. And our backlog did increase 1% sequentially and did reach a record, $11 billion. So this is really the result of robust aerospace activity but also the changes to the portfolio that we spoke to throughout the year.

Just jumping into the North American businesses. Sales were very strong, $2.3 billion. That was 5% organic. That’s really right in line with our guide. Adjusted operating margins did increase 60 basis points to 23.5%, really just driven by excellent execution across those North American businesses. Incrementals also did improve sequentially, and that helped drive our margin expansion.

One thing to note, orders did turn negative to 8%, but that really still is against tough comps. We still have strong backlog coverage that we believe will continue to support growth. And customer sentiment overall remains positive in North America. So, all-in-all, a great quarter and a great finish by our North American team members.

If you look at the international businesses, sales were $1.5 billion; organic growth, nearly 4%. Organic growth did remain positive in all of our international regions, really led by Asia Pacific, 8.5%, almost 8.6%. Latin America was 2.5% positive. And even EMEA, which we’ve seen some softness, did post a 1% positive organic growth.

Even with all that said, margins did increase 90 basis points, finished at 23.3% versus prior year and really still continue to reflect consistent performance, productivity improvement, good cost controls and that increase in distribution mix that we’ve talked about periodically.

Orders in the international business did improve from last quarter. They are still negative 1, but it is a nice improvement from last quarter. And again, from our international team members, great consistent performance, and I’m glad to see these results.

If you move to aerospace, this is really the story of the quarter, really a standout, just fantastic results all around. Sales are $1.3 billion, 16% organic. Total sales are a 90% increase versus prior year. That’s really obviously benefiting from the Meggitt acquisition. But if you look at the business, commercial OEM and MRO continue to be very strong. Both of those businesses are growing at plus 20% versus prior in the quarter.

The military OEM business did return to growth this quarter with high single-digit organic performance. That was really nice to see. And operating margins, a new record high, really increasing an impressive 160 basis points to 25.8%. Those strong margins reflect that growth in the commercial aftermarket businesses and really notably a nice favorable mix of spares versus repairs.

So, you can also see the addition of Meggitt has also increased our aftermarket exposure. That was one of the compelling aspects of that acquisition. We’re glad to see that materialize in the results.

The aerospace team is really doing a phenomenal job, obviously, dealing with growth. The integration is ahead of schedule and on track, and these results are really fantastic to see. It’s really truth that Parker and Meggitt are really better together.

If you look at aerospace order rates, plus 28%, continues to be robust and then obviously, it’s helping our backlog. Great performance across the segments.

If I jump to slide 13, I just want to highlight our cash flow performance. We finished the year with extremely strong cash flow. It was a record in FY23. We increased cash flow from operations 22%. We reached a record $3 billion of cash flow from operations. That’s 15.6% of sales. Free cash flow, also very strong, $2.6 billion or 13.6% of sales. Our CapEx came in right where we were forecasting, 2%. And just as a note, because this was the closing of Meggitt, we did have some transaction-related expenses that were a drag to cash flow that was about 1% of sales. So those obviously aren’t going to repeat next year. And we have set ourselves up extremely well to be great generators of cash.

If you look at conversion, free cash flow conversion for the year, 125%. And I just really want to thank our teams for the great work on working capital. We strive to be great generators, great deployers of cash, and reaching this $3 billion milestone is really the result of significant effort from our team across the globe.

If you go to slide 14, you can see what we did with all that cash. We reduced debt by $850 million in the quarter. Since we closed Meggitt just this fiscal year in September, we have reduced our debt by $1.4 billion. Since announcing Meggitt, way back in August of 2021, we have already paid down approximately 35% of the total consideration of nearly $10 billion. So, very impressive work across the board by our team.

If you look at leverage, gross debt to adjusted EBITDA finished the year at 2.8%, and net debt to adjusted EBITDA finished the year at 2.7 -- excuse me, 2.7 times. We’ve spoken about our great track record of how we are so dedicated to quickly deleveraging after the deals. And since closing the transaction in September, we have already reduced leverage by 1 full turn. So we’re proud of that.

Looking forward to next year, we expect to generate significant cash flow. We think we can reduce debt by an additional $2 billion in FY24. And we are targeting leverage of 2 times in early FY25.

Okay. So moving to guidance and putting FY23 to bed. You could see what we are looking at here is slide 15. And I’ll start with the top line. Reported sales growth for the year is forecasted to be in the range of 3% to 6% or 4.5% at the midpoint. That equates to approximately $19.9 billion in total sales. If you look at the split, the first half is 49% and the second half is 51%.

Speaking specifically to organic growth, for the full year, we expect it to be 1.5% at the midpoint. In respect to aerospace, we’re expecting high single-digit growth in aerospace, a little over 8%. North America organic, we expect that to still be positive at plus 1%. And international, we are forecasting slightly negative at 2.5%. Those are all full year numbers.

The backlog that I just spoke of earlier does support our growth, so we feel confident in these numbers. And if you look at the breakdown, the guidance does assume acquisition sales, roughly $500 million from Meggitt, offset by $400 million of the divestitures that we did complete in FY23. So, the net impact is $460 million or about 2.5% of our total sales.

I mentioned currency earlier based on spot rates as of June 30th. We do expect currency to be a slight tailwind of 0.5% or roughly $100 million. So, that is based on currency rates as of June 30th. We still see margin expansion this year, 30 basis points is what we’re forecasting for FY24. That is all based on continuing to accelerate our performance across all of our businesses using the Win Strategy and, of course, delivering on Meggitt synergies that we have communicated.

If you look at adjusted segment operating margin, our guidance is 23.2% at the midpoint, and there is a range of 20 basis points on either side of that midpoint. If you look at operating income dollars -- segment operating income dollars, the split is 47% first half, 53% second half. And for the full year, we are forecasting incremental margins of 30%.

Few other items in respect to guidance. Corporate G&A is $240 million. That’s a full year number. Interest expense is $525 million. That is a $40 million reduction from where we finished in FY23, really just based on our strong debt pay-down. And other expense is $25 million. Full tax rate, we’re guiding at 23.5%. That is without any discrete items that is really a continuing rate from operations, 23.5%. And finally, we expect full year as reported EPS of $18.55 or on an adjusted basis, $22.40. The range -- those are both midpoint numbers. The range on either side of those is $0.50, plus or minus. And the split is 46% first half, 54% second half. And just specifically for Q1 of FY24, we are forecasting adjusted EPS to be $5.10 at the midpoint.

Looking at cash flow. Full year free cash flow is expected to be between $2.6 billion and $3 billion. So, will be mid-teens free cash flow, and our conversion will be over 100%. Also included in the appendix is subsegment guidance details and some other specifics that you might find helpful.

If I move to slide 16, this is just a bridge and really highlights as follow, again, very similar to what’s happened throughout this fiscal year. The organic growth, the acquisition sales, margin expansion and the $75 million of incremental Meggitt synergies for the year translate to an increase in segment operating income of $1.47. We will have less interest expense next year based on that debt reduction that we’ve done, but -- and that will add $0.23 to EPS.

Our forecasted tax rate of 23.5% is a headwind of $0.26. But remember, we had a lot of favorable items in FY23. We’re not forecasting those to continue. We also had lower interest income. If you remember, we prefunded those -- the Meggitt transaction in June of last year. So, we had interest income in the first quarter of last year. That was about $35 million.

Just to note, that is reported in the other expense/income line on the business segment statement. That was a one-off benefit that obviously will not repeat in FY23. That’s a $0.21 headwind. The rest is just a forecasted $0.20 unfavorable to EPS, and there’s just some really some non-repeating items in there. And obviously, share count is also a $0.10 headwind that we hope to make up. So, that’s a walk from FY23 to FY24. EPS at the midpoint is forecasted to be $22.40.

So with that, Jenny, I’ll hand it back to you and ask everyone to move to slide 17.

[Jenny Parmentier, CEO]

Thank you, Todd. Just a few key messages to close this out.

So, FY23 was a tremendous year with record performance. We have top-quartile safety and engagement, and that continues to drive results in our business. We truly have a great team. We have a proven track record, and we’re going to continue to accelerate our performance with the Win Strategy 3.0.

The transformation of the portfolio is clearly delivering on longer cycle and more resilient portfolio, and this will allow us to achieve our FY27 targets and continue to be great generators and deployers of cash.

So before we go into Q&A, I’d like to give you a few of our assumptions and comments on the guide. So obviously, aerospace is a real growth differentiator for Parker in fiscal year ‘24. We are projecting total aerospace growth at 17% with the acquisition sales from Meggitt and organic growth of 8%. We see strong mid-teens growth in commercial and mid-single-digit in military. Good story all the way around.

We have now had two years in a row of double-digit growth for industrial. But having said that, as Todd mentioned, industrial orders have been negative for the past two quarters. However, in North America, backlog coverage is still above 30%, which is roughly double what it has been in the past, and it will support the growth we have in the first half.

We do expect some destocking to continue, but overall sentiment from our customers is positive about steady demand and future growth. Obviously, there’s more macroeconomic uncertainty for the second half, and we’ll update you on that in future calls.

While we did see an improvement in international orders from Q3 to Q4, this does include a benefit coming from some of those multi-period, longer-cycle orders and an easier comp from last year’s China COVID shutdown. Again, the backlog coverage remains above 30%. But as Todd said, we are forecasting negative growth for the first half and full year.

Since the last time we talked, we’ve seen some signs of Europe slowing. Customers are returning to those seasonal shutdowns where they do maintenance in their facilities, and we’re starting to see some softness in some of the end and geographic markets as well as some weakening macroeconomic indicators. And although China had stronger growth in Q4 than Q3, recovery is slower than anticipated, and then we will face a tough comp in Q1 against prior year China COVID rebound.

So in summary, this is our thinking right now: strong aerospace growth, strong backlog on the industrial side, some near-term uncertainties and tough comps, but the future growth drivers that I went through on the earlier slide remain intact, and activity is at a high level. We are still very bullish about the future and our 4% to 6% organic growth target over the cycle.

So now I’ll hand it back to Donna for Q&A.

[Operator]

[Operator Instructions] Today’s first question is coming from Julian Mitchell of Barclays.

[Julian Mitchell, Barclays]

Maybe just wanted to start off with the industrial businesses. Maybe give us a bit more color on the assumptions for international. It sounds like you’ve got a down first half organic sales and also down second half organic sales in the guide. So, are you sort of assuming heavy negative orders pressure there for the coming six months or so? Just wanted to check that. And broadly on destocking, any regions or markets to call out in particular where that’s most severe?

[Jenny Parmentier, CEO]

So first of all, your question on international, like I was talking about earlier, obviously, the backlog is still strong. It’s above 30%. But those customer shutdowns that I mentioned, that takes weeks out of the schedule that we hadn’t seen previously. So, a return to that is one of the reasons.

And then obviously, since the last time we talked, we’ve seen a slowing in Europe. We’ve seen the demand not be as strong in certain regions. And then the China recovery is -- we haven’t seen the rebound from the stimulus that had been previously anticipated. So, that is all weighing in there as well.

[Julian Mitchell, Barclays]

I see. And maybe just following up on the sort of the destocking comments you’ve made. Any more color on markets or geographies most affected?

[Jenny Parmentier, CEO]

So, we did see destocking happen in Q4, and we just expect that to continue through the first half. I’ll let Lee comment a little bit on the specifics of some regions and markets.

[Lee Banks, Vice Chairman and President]

Yes. Julian, it’s Lee. I think destocking, mostly at the distribution level, there’s -- it’s been going on for a couple of quarters. They were holding more inventory than usual. But I would tell you the sentiment is still strong. So, we’ve seen destocking across our European distributors and in North America.

Maybe too, just a little more color on Europe, as Jenny was talking about, the biggest softness really is around the DACH region. So that would be Germany, Austria, Switzerland. I think it’s a couple of things. It’s -- the China export market is a big deal for them. And China has not rebounded like we all expected it would.

And then, I think when you pivot to Asia, with China, the property woes continue to weigh heavily on the business community there. So all the stimulus we read about really hasn’t trickled down to any significant economic activity. I’m still expecting that to change going forward, but those are the plus sides as we move forward.

[Todd Leombruno, CFO]

Hey Julian, this is Todd. I would just add, we don’t have this really first half-, second half-weighted. We are forecasting international in total to be about 2.5% for the full year. And if I look across the year, there’s no real weighting there. It’s about an even split.

[Operator]

The next question is coming from Joe Ritchie of Goldman Sachs.

[Joe Ritchie, Goldman Sachs]

Thanks. Good morning, guys. And nice end to a year.

[Todd Leombruno, CFO]

Thanks, Joe.

[Jenny Parmentier, CEO]

Thanks, Joe.

[Joe Ritchie, Goldman Sachs]

Maybe just -- hey, just wanted to maybe talk a little bit more about North America. Obviously, you’ve got this little order deceleration, the destocking commentary. Just maybe talk a little bit more about what your expectation is for orders going forward or any comments you can make about how this fiscal first quarter is trending, that would be helpful.

[Jenny Parmentier, CEO]

Yes. Thank you, Joe. So obviously, we’ve already talked a bit about what we expect to see, a continuing destocking and just kind of a softening in orders despite a very positive sentiment from the customer. So in the first half, in North America, we’re projecting 2% growth and overall for the year, 1%. So, we think that there’s some macroeconomic uncertainty in the second half. But in the first half, we fully believe that this strong backlog is going to support what we have in the guide.

So, the backlog, again, above 30%, a little bit down, about 2% down, from last quarter but very strong. And in talking with our customers, we continue to constantly pressure test this and analyze it. And we’re not really seeing any major pushouts or cancellations, so we feel good about the guide we have out there.

[Joe Ritchie, Goldman Sachs]

Okay, great. And then maybe just focusing to aero. I guess it’s funny, like you’re expecting 8% growth -- good growth. But why is 8% the right number? It feels like it could be better than that and then -- particularly with military inflecting. And then also, would love to get any color around where the integration is going better than expected with Meggitt.

[Jenny Parmentier, CEO]

Sure, sure. So, the first half for aero is 12%. So obviously, we’re going to see some nice growth here in the first half. And in the second half, we have 5%. And the comps get pretty tough in the second half. So, we feel good about that 8% organic number right now.

So obviously, we’re seeing really nice growth in commercial OEM. We see those narrow-body rates increasing. Wide-bodies are starting to recover, but really, it’s a story about narrow-body rate increases.

And then MRO, as Todd mentioned earlier, the Meggitt acquisition has really increased our aftermarket exposure. And it’s been really strong with the air traffic recovery, especially with those narrow-bodies.

And we’re pleased to see military OEM return. Obviously, the military budget increase is going to drive mid- and long-term growth. F-35 is nearing peak delivery. So all good news there. And then, same thing with military MRO. I mean, there’s a focus on retrofits and upgrades as the fleet ages. So really good outlook for all of aerospace going forward.

So, you questioned about Meggitt integration. I mentioned in the slides, we couldn’t be happier with the progress of that integration. We’re forecasting another $75 million in synergies in FY24. Team did a great job in FY23 of pulling some actions ahead and allowing us to increase those synergies by $15 million. So really just a positive outlook for aerospace.

[Todd Leombruno, CFO]

Hey Joe, this is Todd. Just one thing I would add. If you remember a year ago, when we did the Meggitt post-close call, we said that we felt Meggitt could add $0.80 of EPS on a full year basis. We are ahead of that schedule. So that should give you some comfort too, that it is adding EPS to the bottom line as well.

[Operator]

The next question is coming from Andrew Obin of Bank of America.

[Andrew Obin, Bank of America]

Just a question on price and cost. Companies are starting to talk about disinflation, maybe some deflation. What’s the view on the Company’s pricing power into next year and also ability to actually extract price concessions from supply chain?

[Lee Banks, Vice Chairman and President]

So, we’ve -- you’ve covered us a long time. I mean, the one thing I think we’ve got a good handle on inside the Company is kind of price/cost and the ability to push cost in the price. Every one of our facilities is embedded in our Win Strategy. We look at costs constantly, and we look at price.

I would say pricing has become much more normal now. We’re not in that rapid inflationary period. But our goal is always to keep things margin-neutral, and we’re working that. And we’re working the cost side on the supply chain side, too. So I’m comfortable that kind of the price/cost scenario we have is baked into our margin forecast.

[Andrew Obin, Bank of America]

Excellent. And then, the other question, you sort of talked about seeing Europe slow down, specifically Germany and the DACH region. If you read the newspapers, economists, politico, a lot of articles about sort of structural slowdown in Germany, right, because exports to China, cheap energy from Russia. Could you give us a slowdown as an opportunity to sort of reconfigure your manufacturing footprint and supply chains in Central -- I would call it, Central Europe or just Western Europe in general? What are your thoughts? And is it too early to say?

[Lee Banks, Vice Chairman and President]

Well, so first off, we’ve been reconfiguring our supply chains and our manufacturing footprint in Europe for the last 8 or 10 years. I mean, you remember when Tom and I took our roles, we had a big initiative…

[Andrew Obin, Bank of America]

I absolutely do, absolutely do.

[Lee Banks, Vice Chairman and President]

So -- and I would just tell you that that is always ongoing. So, we never stopped with that. And we take every opportunity we can to just continue to be better, and we’re doing that today.

[Jenny Parmentier, CEO]

Yes. We don’t wait for an event, Andrew. It’s something we’re always working on.

[Todd Leombruno, CFO]

Andrew, this is Todd as well. I think Lee brings up a good point. We’ve been working that initiative for a long time. And if you look at the margins that I just ran through for Q4 and really what we’re guiding for FY24, you’ll see that those international margins are similar to every other piece of our business. So, that has been a great success.

[Lee Banks, Vice Chairman and President]

Great European team with great leadership, doing great things, they really are.

[Andrew Obin, Bank of America]

No, I appreciate you’ve certainly been doing something right. Thanks a lot.

[Lee Banks, Vice Chairman and President]

Thank you.

[Jenny Parmentier, CEO]

Thanks, Andrew.

[Operator]

The next question is coming from Nathan Jones of Stifel.

[Nathan Jones, Stifel]

Question on the margin guidance in aerospace. Jenny, you just mentioned $75 million of additional synergies for Meggitt in 2024, which I think is about 150 basis points. And the margin guidance is up about 60 basis points. So maybe just some commentary on the core, I guess, margin decline in 2024. Is that really just a function of increasing commercial OEM as part of the mix or is something else in there?

[Jenny Parmentier, CEO]

You just answered the question, right? We expect those narrow-body rates to go up, and it’s definitely a matter of mix.

[Nathan Jones, Stifel]

Okay. Fair enough. That’s helpful. And then, I guess, just on the M&A outlook now. I mean, you guys have obviously done a sensational job paying down debt post Meggitt back to towards 2 by the end of the fiscal year, early in ‘25. What are kind of your criteria for getting more materially back into the M&A market and the shape of the pipeline? I know you guys continue to cultivate that even when you’re out of the market. Just commentary on plans there?

[Jenny Parmentier, CEO]

Yes. So, we’re committed first to pay down our debt. That is our number one priority and our focus. We’re always working in the pipeline. We have long-standing relationships with people we talk to now as we have in the past. So, that’s not something that we ever let go stale or dry. It’s a continuous pipeline. So, for now, we’re focused on paying down debt, and we expect to get in the range of about 2 times by fiscal year 2025. And I’m sure we’ll talk about it in the future.

[Operator]

The next question is coming from Jeff Sprague of Vertical Research Partners.

[Jeff Sprague, Vertical Research Partners]

Just wanted to follow up on your comments on price/cost margin-neutral. I believe you got yourself the price/cost margin-accretive through this period. Kind of correct me if I’m wrong on that. But should we kind of expect that trend back to neutral to occur here in ‘24, or can you actually maintain some kind of positive spread?

[Lee Banks, Vice Chairman and President]

Well, I think, Jeff, again, you followed us, we’ve always maintained some kind of positive spread. We’re always looking at the portfolio. We’re sunsetting products. We’ve got different strategic pricing initiatives. But I would tell you, we deal with a lot of core tough customers, and pricing is very competitive. It’s really what we do with the balance of the portfolio that helps us out. And as we’ve talked about in the past, one of the great strengths of this company is the distribution base we have, which gives us a great opportunity to kind of price into that market.

[Jeff Sprague, Vertical Research Partners]

Understood. And then, Jenny, just back to aero. Can you be a little bit more explicit about what your aero commercial aftermarket assumption is inside the guide? And is the growth similar at legacy Parker aero and Meggitt on those metrics?

[Jenny Parmentier, CEO]

I guess, I would say, first of all, that it is very similar. But obviously, the Meggitt acquisition, as we’ve mentioned, has meaningfully increased our aftermarket exposure. So it’s mid-teens is what we’re projecting right now. And again, that air traffic recovery, especially with the narrow-bodies with this high domestic traffic, is that really what’s going to help that into the fiscal year.

[Operator]

The next question is coming from David Raso of Evercore ISI.

[David Raso, Evercore ISI]

On the margins industrially that you had them up despite in aggregate, your industrial organic sales are down. Just want to make sure I understand, the destocking that you’re referring to, I think that probably is distribution, which would be a challenging mix if that’s your destock. Are you also referencing, though, maybe a more balanced destock? It’s at OEs as well? I’m just trying to get a sense of the ability to have margins up when you’re destocking distributions, a heavy lift. So, I’m just curious if you could color on that.

And maybe the -- what’s in the backlog? It sounds like the backlog will help carry the first part of the fiscal year. Although margins particularly positive, what will be coming out of the backlog? Just trying to get a sense of the margin progression and how to have margins up if organic is down industrially for top line.

[Jenny Parmentier, CEO]

Yes. So David, primarily when we talk about destocking, we are talking about distribution. But we’re just seeing a kind of a moderation of growth across all of our customers. So, don’t worry about margin degradation. We’re not going to allow that. We have all the right things in place to make sure that we hit our margin targets.

So really, it’s about -- we’re just continuing to see the benefit of this transformed portfolio, right? We’re continuing to see the power of the acquisitions that we’ve done over the last several years.

[Todd Leombruno, CFO]

Hey David, this is Todd. I would just add to that. Jenny is absolutely right. We do believe that we can expand margins both in the North American businesses and the international businesses. It really is a testament to the power of the Win Strategy. But if I’m looking at the numbers here, it really is a smooth glide path, very similar to what we’ve done historically with our normal seasonality. So, it’s not weighted in any -- one way or the other. I gave a little color on the splits of segment operating income, but the margin expansion is a nice glide throughout the year.

[David Raso, Evercore ISI]

And maybe I missed it, just a clarification. The first quarter in North America particularly has a hard comp. Are we saying margins could be up every quarter in North America, or is it just for the full year and the first quarter is down and then it’s up from there?

[Todd Leombruno, CFO]

No, we see margin expansion in every quarter this fiscal year.

[Operator]

The next question is coming from Josh Pokrzywinski of Morgan Stanley.

[Josh Pokrzywinski, Morgan Stanley]

Jenny, you referenced the backlog here a few times. I think for most folks, they don’t really think about backlog when they think about the industrial pieces of Parker. Clearly, that’s changing, but maybe some more kind of breakdown of how long does that backlog extend out? Is there a particular set of end markets or channel mix? Like I would assume more OEM, maybe more project activity. Just any kind of color you can give us on the nature of that backlog and really the duration over which it ships. Is it kind of one to two quarters, three, four or something like that?

[Jenny Parmentier, CEO]

So the backlog, as I’ve said, is at 55% right now, and it went up 1% sequentially. So that -- we talk about that backlog being so strong and especially, obviously, aerospace is in there. But in industrial being above 30% is roughly double what it was in the past. So we were sitting around 15% to 17% coverage in the past, and now we have 30%. So that’s really coming from the acquisitions we’ve done, the higher aftermarket, the longer cycle. So we’re seeing a more resilient and longer, I call it the demand horizon, a longer horizon on that backlog. So, we feel very strongly about it.

Now we know from the past that backlog isn’t bulletproof, but we are constantly pressure testing it, analyzing it, talking to our customers, which is really a great benefit of us being so decentralized because our divisions can have real-time conversations to make sure that that backlog is strong.

So I wouldn’t be able to break out all the details that you were just asking about between the channel and the OEMs, but I would tell you that over 30% coverage in industrial is a good place to be right now. And that’s why we feel good about covering the growth we have in the first half.

[Josh Pokrzywinski, Morgan Stanley]

Got it. That’s helpful. And then -- oh, yes, please go ahead.

[Todd Leombruno, CFO]

Josh, this is Todd. I was just going to add to that the other thing to keep in mind is when we talk about the Company having 30% aerospace exposure, 5% of that exposure does come from our industrial businesses. So, that is also a plus there as well.

[Josh Pokrzywinski, Morgan Stanley]

Understood. That’s helpful. And then just pivoting to something I’ve heard a lot of your peers talk about, particularly this quarter, on U.S. mega projects or, I guess, North American mega projects and near-shoring. Obviously, you folks play in all stages of that, I guess, new products that are being developed here as well as the construction of maybe some of these facilities themselves. Open-ended question, but is that something that in Parker’s, I guess, more kind of component- and subsystem-type business that you’re actually seeing yet, or is it just a little too early and maybe we see that more kind of later in ‘24?

[Jenny Parmentier, CEO]

We are seeing some of it through our customers and our distributor partners. And you’re right, there’s just been a massive amount of announced CapEx. I mean, some industry sources are citing over $500 billion.

Some key examples of that where we will get into the game is the semi fabs and the electric vehicle battery plants that are now breaking ground. So, we win -- Parker wins when the job site is prepped, when the factory is built and when the machines go into the factory. So, it’s early days, but Parker is winning and will continue to win in the future.

[Operator]

The next question is coming from Joe O’Dea of Wells Fargo.

[Joe O’Dea, Wells Fargo]

Todd, I wanted to circle back. You talked about Meggitt trending ahead of that $0.80 that you had given about a year ago. Just any sort of color on what you think the all-in Meggitt contribution is this year?

[Todd Leombruno, CFO]

Yes. I would say it’s slightly above that $0.80 that we really forecasted for the first full 12 months. So, we’ve only owned them 9.5 months, but it’s been a fantastic 9.5 months. We’ve talked about the synergies being ahead of schedule, but the other thing is they are benefiting from the secular trend in aerospace. So, their growth has exceeded expectations every quarter since the close. So, we feel really good about that. I’m really happy we got the deal done.

[Joe O’Dea, Wells Fargo]

All right. Got it. And then, Jenny, I wanted to circle back the macro CapEx investment sort of drivers that you talked about, kind of the three main buckets with underinvestment, supply chain, megaprojects. Can you just talk about sort of within those buckets, sort of if you can rank order what you’re seeing is sort of like the biggest growth drivers for you, but also just what you’re seeing in terms of kind of the evolution of them, maybe where things are accelerating, where things have played out a little bit more?

[Jenny Parmentier, CEO]

Well, I don’t know that I can rank them right now, but I would tell you that I see activity in obviously, all three of them. If you start off just thinking about the CapEx, investment because of the reinvestment over the last 10 years, we’re seeing some -- just some upgrading of factories, a lot of work being done to really develop the supply chain and increase capacity. So, that ties into the investment, a lot of machinery and a lot to help really that supply chain development.

A lot of folks that got burned during the pandemic are going to dual source this. So that drives a lot of investment. And as I mentioned just a few minutes ago, the mega projects, we’re starting to see some of that. We’re hearing about involvement in that from some of our distribution partners. And it’s still early days, but there’s a lot out there for us to go win.

[Operator]

The next question is coming from Jamie Cook of Credit Suisse.

[Jamie Cook, Credit Suisse]

Congrats on a nice quarter. I guess most of my questions have been asked, but I guess just to -- you wouldn’t know this from looking at your results. But in 2023 or 2022, is there any way you can handicap the inefficiencies running to your earnings, whether it was related to supply chain, employees not being back, et cetera? And I’m just wondering, for if any of this is an opportunity for 2024 potential tailwind that’s not implied in your guide.

And then my second question, Lee, I don’t think you said this yet. I know you walked through some end-market color. But last quarter, you told us like the percent of the portfolio that was growing versus not growing. I think last quarter, 90% of the portfolio was still in growth mode. Can you give us an update just on your portfolio percent, flat versus growing versus negative?

[Lee Banks, Vice Chairman and President]

So Jamie, it’s Lee. I guess, I’ll start on a couple of things. One, in terms of -- we’re always striving for productivity and continuous improvement. So certainly, things coming out of COVID were chaotic. Some of that chaos is settling down. So those are opportunities for us, but productivity is increasing. You see it in our numbers and kind of the inefficiencies that were going on are getting better. It’s not perfect. There still are supply chain issues out there, but it’s a far cry from what it was before.

I would say when we look at our markets from the backlog that we have, all our markets are still growing at different levels. I mean, it’s kind of interesting, nobody talks about oil and gas anymore, but that’s been incredibly strong, land-based oil and gas here and even offshore here and in Europe. Everything in aerospace is great, and forestry and automotive is still great. North America, anything around electric vehicles is doing really well, and we share a lot of content in those areas.

And then, construction equipment is still steady throughout all that as is ag. I think some of the areas have softened, and you’ve seen it with public announcements as the whole area of HVAC is down. I think that’s short term. That will come back. And semicon is soft. And life sciences really just tough comps coming out COVID, things were really going there. The sentiment is it’s just tough comps. So, it’s getting better as we kind of cycle through the comps.

[Todd Leombruno, CFO]

Hey Jamie, this is Todd. I would just add to that, on your 90% question, if you look at our total orders last quarter, they were plus 2. They did move to plus 3. So there really hasn’t been a material change in that percentage of end markets that continue to grow.

[Operator]

Thank you. The next question…

[Todd Leombruno, CFO]

Hey Donna, this is -- sorry to interrupt you. This is Todd. I think we have time for one more question. So, whoever you have next in the queue, that will be our last call.

[Operator]

Okay. The next question is coming from Jeffrey Hammond of KeyBanc Capital Markets.

[Jeffrey Hammond, KeyBanc Capital Markets]

Just a couple of quick questions. Supply chain in aero has kind of been a problem point. Just wondering what you’re seeing there and how that kind of informs kind of the growth rate and how much it’s may be holding the growth back.

[Jenny Parmentier, CEO]

Yes. So, it’s interesting. I’ve been talking to a lot of people about supply chain, as always. And the aerospace supply chain is really experiencing what the industrial side of the business did 18 to 24 months ago. So just -- it’s a little bit tough. There’s constraints responding to the high rate increases and demand. But, I would tell you that outside of chips and electronics, we’re starting to see some lead times moderating. But overall, I would say it’s still a constraint for aerospace. So again, we work closely with our suppliers. We’re investing in developing suppliers, especially in aerospace, because obviously, with it being a third of our portfolio, it’s very important to us that we can deliver these orders.

[Jeffrey Hammond, KeyBanc Capital Markets]

Okay, great. And then, I think as was the case with LORD, Exotic, the deleveraging process is pretty swift here and seems maybe a little bit ahead. Just level set us on when we start to shift away from debt pay down.

[Todd Leombruno, CFO]

Hey Jeff, this is Todd. Obviously, Jenny mentioned it earlier. We are fully committed to debt pay down. So if you look at what I mentioned earlier, we expect to pay down another $2 billion of debt in this fiscal year, FY24. We don’t expect to get to 2.0 times till early FY25. So, we talked about the portfolio. We never stop looking at it both from an addition and a subtraction standpoint. But our main focus really is still for FY23 is to continue that debt pay down trajectory.

[Todd Leombruno, CFO]

Okay. This concludes our FY23 Q4 webcast. As always, we fully appreciate everyone’s interest in Parker, Jeff Miller, our VP of Investor Relations; and Yan Huo, our Director of Investor Relations, are available if anyone needs any further clarifications or has any questions on any of the materials we covered this morning. I want to really thank everyone for joining. We appreciate your support. Thanks.