PH - Parker-Hannifin Corp.

[Palantir]

Business Overview

 

Parker-Hannifin is a manufacturer, distributor, and retailer of industrial goods involved in the motion and control of fluids. This includes an array of different products, including but not limited to pipes, tubes, pumps, filters, and hydraulics. We can think of Parker as a maker of goods used to move fluids, which can be used in a wide range of industries, including but not limited to manufacture of chemicals, food and drink, oil and gas, and the operation of airlines, in addition to a diverse range of firms that use hydraulic products.

 

Edge

 

Parker’s competitive advantage or “economic moat” is its distribution and retail system. It operates 3,000 stores globally, many of which are open 24 hours a day and 365 days a year. The result of this wide distribution and retail network is that stores always have parts on stock. If a factory suffers a product break, it needs to be replaced immediately, so the firm can neither afford to wait for parts to be shipped, nor is it very price sensitive. However, with Parker stores, one can walk into a store and be assured that the desired part will be in stock. This well developed network also allows Parker to quickly integrate a new product or acquisition into the business.

 

This competitive advantage makes more sense when we look at the nature of its competition. Parker’s products operate in markets with many competitors. However, there is no single firm that competes with Parker across the broad range of its business and array of products. So its tubes, filters, and hydraulics might be in competitive markets, however no firm will compete against Parker in all of them at once. Thus Parker can put many different product lines in one convenient location, which is very difficult for competitors to replicate as they may not be in many of these industries.

 

Financial Statements

 

Parker’s sales growth has been strong and stable over the past decade, and grew at slightly more than 7% annualized. Gross profit, however, grew at nearly 12% annualized over the same period. Using a longer time frame of twelve years, in order to account for an uncharacteristic drop in income in 2001, we see that net income has grown at nearly 10% annualized over the past twelve years. With growth rates in the range of 7-10% annually, it appears to be a firm with moderately strong and healthy growth rates.

 

In addition Income statement growth, gross, operating, and net margins have all grown over the past ten years, the only decline being during the recession, which is expected due to the lower sales and similar fixed costs at that point. Growing margins are very important as they indicate the growing ability to pass on costs to customers and are indicative of pricing power and an economic moat showing the business is strengthening over time.

 

One metric of firm performance are the efficiency ratios of Return on Equity (RoE) and Return on Assets, (RoA). Conventionally we use these to determine how efficiently a firm is using its assets, but more importantly, they show how a firm is reinvesting its capital and are a verdict of management’s ability to reinvest money back into the business. In the case of Parker-Hannifin, both RoA and RoE have not only been strong, they have been growing strongly over the past ten years.

 

As noted earlier, Parker is both a manufacturer as well as a retailer, hence, analyzing its inventory management capabilities is necessary as well. A firm that manages inventory well is one that carries enough inventory to meet needs without any excess on hand. So we look at the Inventory Turn-Days Ratio, ITD. The number of days has consistently declined over the past ten years, indicative of a firm that is managing inventory well, and thus, can keep a smaller amount of inventory on hand to meet sales obligations.

 

Using Average Payment Period to estimate the time taken to pay suppliers, we see an increase from 30 at the beginning of the decade to approximately 45.  This increase can be both strength and a weakness. It is a weakness as it would appear that the firm is not able to meet its payments. However, as Parker is operationally sound, rather than weakness, the growing payment period indicates that Parker is choosing to pay its suppliers more slowly, indicating strength. In the language of Porter’s Five Forces, Parker appears to have resisted against the Bargaining Power of Suppliers, and as a result we see that the firm is strengthening its position in the industry, both among customers as demonstrated by rising margins, and against suppliers, as demonstrated by APP.

 

My estimate of Intrinsic Value is more than 50% higher than what the stock is trading at currently, I estimate IV to be: 155. I believe it is a firm that has a durable competitive advantage of a respected name and a strong distribution network, and it makes critical components for industry.

[FrankArabia]

Good write up Palantir!

[bmichaud]

Love this company and their focus on buying back stock - I actually just reviewed it last week and came up to about $109. On page 7 of the 4Q12 conference call the CEO indicates he believes it's worth $105 - "....we look at Parker stock like we do any other investment where you'd do a DCF. And we start at the full value being $105....".

[Palantir]

Could you elaborate a little bit on 107? That seems pretty low....given that their CFO has been historically greater than NI...

[bmichaud]

Could you elaborate a little bit on 107? That seems pretty low....given that their CFO has been historically greater than NI...

 

I tried to smooth out their earnings given it is relatively cyclical, so I may be overly conservative....

 

1. 2007-2012 average total asset turnover was 1.16X - FYE 2012 total assets were 11,170, so "normal" sales are 12,957.

2. 2007-2012 average net profit margin (I use net income as a proxy for free cash flow to equity) was 7.22% - 7.22% times "normal" sales is 936MM.

3. Shares out are about 150MM, so EPS (again, a proxy for FCF to equity per share) is approximately $6.24.

4. Given returns on equity north of 20%, I give it a 17.5X fair value PE - so FV per share approximately $109

[FrankArabia]

10 year average ROE is ~15%. extremely decent.

[Palantir]

Could you elaborate a little bit on 107? That seems pretty low....given that their CFO has been historically greater than NI...

 

I tried to smooth out their earnings given it is relatively cyclical, so I may be overly conservative....

 

1. 2007-2012 average total asset turnover was 1.16X - FYE 2012 total assets were 11,170, so "normal" sales are 12,957.

2. 2007-2012 average net profit margin (I use net income as a proxy for free cash flow to equity) was 7.22% - 7.22% times "normal" sales is 936MM.

3. Shares out are about 150MM, so EPS (again, a proxy for FCF to equity per share) is approximately $6.24.

4. Given returns on equity north of 20%, I give it a 17.5X fair value PE - so FV per share approximately $109

 

Thanks for your response, I think the discrepancy is primarily due to me simply using a higher income figure and higher multiple, mostly because I replaced Income with CFO which has been higher....hmm definitely will have to review assumptions.....I used a fairly conservative growth rate in valuation...but it was too simple of a model I suppose...

[boilermaker75]

PH earnings came out this morning,

 

http://www.reuters.com/article/2012/10/19/parkerhannifin-brief-idUSWEN792320121019?feedType=RSS&feedName=marketsNews&rpc=43

 

and the stock is down 7% in pre-market trading.

 

Buying opportunity?

[Palantir]

PH earnings came out this morning,

 

http://www.reuters.com/article/2012/10/19/parkerhannifin-brief-idUSWEN792320121019?feedType=RSS&feedName=marketsNews&rpc=43

 

and the stock is down 7% in pre-market trading.

 

Buying opportunity?

 

That was brutal. Earnings this quarter were indeed disappointing. But I feel that their long term prospects have not changed one bit. They are still the dominant provider in their sector, have a huge distribution chain, and can comfortably grow market share via acquisitions. I won't be adding to my position right now because it is already 10% of my portfolio, but when I add money to my account next year, I will consider it then.

 

My portfolio has gotten raped last few days. GOOG, MSFT, PH...

[FrankArabia]

just touched inappropriately....i know the feeling...though GOOG shouldn't be considered raped by any sense...the thing was up quite nicely over the quarter....you can't expect to bag kim/kourtney/khloe all in the same night

[Palantir]

True...Google had a runup, but I was expecting a target of 800+...But even in long term growth stories, there are major declines after runups so can't rule anything out.

 

I'm sitting on 20-25% cash at the moment. If the market declines substantially I'll have that to go in I guess.

[boilermaker75]

I am short October 75- and 80-strike puts. So I may have a position after today at a cost basis just below 79. Though PH is not too far from the 80-strike price. So if I don't get put to I will write November puts, probably the 75-strikes, to possibly get a starting position.

[Palantir]

^What's your estimate of intrinsic value? I have roughly 115-120ish...

[LC]

just touched inappropriately....i know the feeling...though GOOG shouldn't be considered raped by any sense...the thing was up quite nicely over the quarter....you can't expect to bag kim/kourtney/khloe all in the same night

I would think Google's drop is exactly the same feeling as bagging all the kardashians in the same night... :)

[boilermaker75]

^What's your estimate of intrinsic value? I have roughly 115-120ish...

 

I have not done an estimate of IV. I was just looking at the enterprise value to TTM FCF, $13.6B to $1.3B, to figure below $80 might be a good entry point. Now that it looks like I will have some shares after today, I'll be inspired to do a more thorough job of due diligence.

[Palantir]

This was my first major decline as an investor. I feel like I'm finally becoming a man.

[tombgrt]

This was my first major decline as an investor. I feel like I'm finally becoming a man.

 

7,xx% is a major decline? :p

 

But thanks for the write-up, will look into it.

[FrankArabia]

i haven't invested for all that long myself, but a 7% decline or permanent loss is really nothing in the overall scheme of things.

 

when i look at other greats portfolios, lots of times they have holdings down north of 25%....

[tombgrt]

Jup, but even 25% is not that much really.

 

Look at what Munger has to say on the subject. I absolutely agree.

 

 

"If You Can’t Stomach 50% Declines In Your Investment You Will Get The Mediocre Returns You Deserve."

 

[Palantir]

I was in at 82.75 and after depressing me for a few mos it has finally started rising for reasons unbeknownst to me, and is up 10%, likely thanks to analysts suddenly liking this stock. Earnings out tomorrow, my estimate of IV is about 115-120.

[Cigarbutt]

i’ve been cleaning up old files and came up with a newspaper clip from 2012 and a summary that had taken me 5 minutes to make then concerning PH, recently decided to do a deeper dive and, before putting away for later, checked this site to see if the company had been discussed. There were several learning gains on my part so I decided to share in case this is helpful for anybody.

First, kudos to Palantir who presented this idea nicely in 2012. Also, apologies for the critical (constructive) comments that benefit from hindsight.

The following is spread over two Acts. The first Act covers the period from September 2012 to June 30th 2019. The second Act covers what happened after. There are multiple analytical reasons to do this but, for the purpose of this post, I assume Palantir bought around September 2012 and sold around June 2019.

 

First Act

Those interested about the company fundamentals can read for hours but they are basically a leading global industrial manufacturer with a wide distribution network. From the perspective of the initial 2012 presenting post, Palantir expected further growth in sales (CAGR about 7% per year) and improving margins with expected net income growth (CAGR about 7-10%) and tagged an IV that evolved significantly over a short period (around 115-120 when last mentioned) with shares trading in September 2012 around 80 (PE about 11).

The opening poster reports that he was stunned by before market price movements due to the company not meeting the expected quarterly numbers which, as usual long after, looks like incredibly insignificant noise from a long term perspective.

 

Going to June 30th 2019, the investment thesis, in terms of outcome, turned out to be confirmed but not for the reasons that Palantir mentioned (more on that later) and holding this investment after 2012 required some patience as the business fundamentals (and share price) did not make any significant progress until 2016. Overall, the company applied a ‘strategy’ that has worked for many which involved various cost initiatives, relatively low capex essentially to maintain existing capacity, increasing financial leverage to fund acquisitions and increased capital ‘returned’ to shareholders through dividends and buybacks. The following analysis takes the perspective of a reasonable value investor who would have bought this in September 2012, would have been patient and would have sold around June 2019 when intrinsic value was reached. From hindsight and forgetting what happened after for now, choosing June 2019 is tricky because numbers (profitability measures) looked significantly better than the years before and could have meant either an unusual and non-enduring bump or an early manifestation of new profitable trends, let’s look at some numbers.

 

The NPM went from 8.8% to 10.6% (difference=+1.8%). Decomposed, the NPM, of the 1.8%, major components: 1.0% came from COGS, 0.8% came from SGA, 0.3% came from taxes. Interest expense % increased from 0.7% to 1.3% (a difference of 0.6%), more on that below.

 

During that period (2012-2019), PH’s share price compounded at about 11.8% per year and the dividend yield hovered around 2%. Assumption: shares sold at around 175.08.

The CAGR 11.8% can be decomposed ( 1.2+2.7+4.8+3.1=11.8 ):

From growth in sales: 1.2%

From growth in NPM: 2.7%

From growth in PE: 4.8%

From reduction in share count: 3.1%

 

Growth in sales over the period was relatively low and was mostly due to a significant acquisition made in 2017. Growth in the net profit margin was concentrated mainly in the 2019 year (some in 2018 also but unusual tax movements hid the NPM improvement). It is interesting to note that PH paid (income statement) about the same absolute amount in taxes in 2012 compared to 2019 (421.2m vs 420.5) even if revenues increased 8.9% and pre-tax income increased by 22.9%. Interest expense increased as a % of sales (x1.9) but debt increased more, proportionately. Debt levels in 2019 increased ++ but are not representative as the company was gearing up for major acquisitions. Normalized debt for 2018 and 2019 suggests that debt levels were multiplied by about 3 over the period which, by itself, is not a bad thing.

A major part of the compound return (unlike what Palantir had expected) came from multiple expansion (more on that below) and from a decrease in share count. The effect of decreasing share count as well as dividends reinvested needs to be analyzed from a longer term perspective and using intrinsic value as a guideline but increasing prices over a specific period help to boost returns, whether the increase is fundamental or sentimental. Taking the IV value framework put in place by Palantir in 2012, the buyback of shares made in 2016 was below trend line. Of course, the IV value trajectory over time may change, both up and down as new info is integrated. A humbling aspect is that, for the same period, the S&P 500 total return (CAGR with div. reinvested) comes to about 13.5%, and the CAGR of PE expansion for the index comes to about 4.0%, implying that it’s not PH that ‘re-rated’ compared to the market but more that the multiple re-rate simply followed general trends. Before somebody shouts that interest rates work like gravity please note that the 10-yr Tr. yield was at about 1.65% around September 2012 and at about 2.0% around July 2019.

 

An aspect which is interesting for valuation, if interested in the value of book value (tangible or not), is that the strategy of buying competitors for growth results in a recognition of value which is absent compared to conventional capex for expansion, which is somewhat equivalent to the IFRS (compared to GAAP) allowing revaluation according to fair value. I think this is just something to be aware of, for example, when assessing return on capital measures (also debt to equity measures).

 

In this case, in 2019, return on capital measures improved, compared to the previous few years but remained at interesting levels compared to what they were in 2012, when the NPM was lower, implying that PH is paying up for growth (and is using debt to do so).

In 2012:  ROA(avg)=10.4%    In 2019:  ROA(avg)=9.2%

In 2012:  ROE(avg)=22.4%    In 2019:  ROE(avg)=25.6%

 

-----)Learning gains

-It’s hard to predict the future but you may end up with a reasonable result if changes in key assumptions cancel each other.

-Patience may be required and timing remains a difficult task.

-It’s hard to beat the market.

-Thank you Palantir (if you still exist) for the deep (at least for me) thought process that you triggered.

 

-----

 

Second Act

Of course what is even more interesting is what came after June 2019. The company completed two major acquisitions in the fall of 2019 and Covid came. Enthusiasm remained until February 2020 when shares hit about 215. Towards the end of March, it was possible to buy below 100. Like much of the rest, there’s been a V-type rebound and the last trade on Friday was at 267.12. I didn’t perform a deep enough analysis of the last two major acquisitions but, assuming more of the same, the company is trading at an about 20-22 “normalized” PE. Opinion (given the time spent lately): i would say the company is likely to disappoint from a return point of view going forward as return to the mean forces may play out. Looking back to the March period, i wonder (if this would have been on a watchlist) if i’d have bought. i think not and wonder if this is wrong.

 

[Spekulatius]

Thanks for taking the time to write a post Morten. I have also followed PH (didn’t invest though) and it is interesting to look at how things panned out vs the expectations years ago.

For me the most striking point is that PH has performed well, despite very subpar organic growth and some badly (in retrospect) timed acquisitions. This is a company that came from a history of mediocre profitability, but a CEO a decade or so ago took measure on pricing and getting closer to the customer to boost margins, as I recall and this has contributed significantly to its outperformance. I don’t really see a similar tailwind going forward unless there is another transformation that led it boost its financial performance even more so.

[Cigarbutt]

^At this point (based on today's valuation), expectations of 'high' returns require a special set of (optimistic) assumptions. There's also been recently more emphasis on financial engineering.

However, PH has a very long history with some intrinsic cycles and quite consistent over-performance compared to the S&P500 over most previous longer term periods. Even 1.5-2% excess performance does add up if held long term (i'm presently thinking to invest in a small basket of stocks in my children's accounts to be held for 30 years or something and TRV, JNJ and now PH are candidates).

Of course, the fun is to try to build upon that by introducing some kind of trading decisions. The buying decision is easier than the sell decision. For PH, investing after general economic downturn has shown to be good idea even if it's impossible to invest at the exact bottom.

This time around, more leverage is involved and there may be less flexibility if ever a real downturn occurs.

In retrospect, a great time to invest was in around 2002 when PH was going both through a general downturn and through an intrinsic cycle with a new CEO about to help return the operations to their longer term potential (Mr. Don Washkewicz).