Parker-Hannifin (PH): 60 Straight Years of Dividend Increases and a Strong Growth Runway

In the world of income investing dividend aristocrats, S&P 500 companies that have raised payouts for 25+ consecutive years, are often relied upon for creating the bedrock of a safe, long-term portfolio.

 

However, there is another group of dividend growth stocks that is even more highly prized and rarer (there are only 22).

 

These are the venerable dividend kings, which have truly stood the test of time and shown an incredible commitment to long-term enrichment of shareholders with at least 50 straight dividend increases.

 

Let’s take a look at Parker-Hannifin (PH), one of the oldest dividend kings with an incredible 60 years of dividend growth to its name, to see if this little known blue chip is a reasonable investment idea for an income portfolio.

 

Business Overview

Founded in 1917 in Cleveland, Ohio, Parker-Hannifin is a global industrial conglomerate specializing in motion control systems, specifically electromechanical, hydraulics, and pneumatic components such as valves, pumps, filters, motors, etc.

 

Parker-Hannifin operates 292 manufacturing plants, 88 distribution centers, and 154 offices in 39 states and 49 countries. The company has two main operating units that serve virtually every significant manufacturing, transportation, and process industry: diversified industrials and aerospace systems.

 

Diversified Industrials: 80% of 2016 sales and 79% of operating profits, 55% of which was from North America. This segment manufactures and sells a wide range of motion-control and fluid systems and components across Parker-Hannifin’s automation, engineered materials, filtration, fluid connectors, hydraulics, and instrumentation company groups.

 

Note that after the acquisition of Clarcor, 54% of industrial sales will come from the higher margin aftermarket business, in which Parker partners with more than 13,000 global distributors to earn recurring revenues.

 

Aerospace Systems: 20% of sales and 21% of operating profit in 2016.  These products are used on commercial and military airframe and engine programs.

 

In recent years, Parker has successfully differentiated itself from being merely a supplier of quality industrial components, moving up the value chain by creating a strong systems-focused business.

 

This integrates its components for customers based on individual needs and helps them to maximize their returns on investment. In 2016 about 25% of sales came from Parker-Hannifin’s systems division, which means future sales and cash flow should be less volatile.

 

Business Analysis

Being an industrial conglomerate, one that services many cyclical industries such as the oil & gas sector, means that Parker-Hannifin’s sales and earnings growth can be rather lumpy.

 

However, what’s important to focus on is the company’s impressive ability to maintain strong profitability in good industrial environments and bad. You can see that Parker-Hannifin’s margins and return on capital metrics have been much more stable than its sales and earnings growth over the years.

 

 

In fact, Parker has been very successful in using industrial recessions to streamline its supply and manufacturing chains, as well as acquire smaller rivals through disciplined and well-executed acquisitions.

 

As a result, the company’s profitability has improved during each of the last several end-market downturns.

 

 

For example, during this most recent global industrial recession, which was caused by both the worst oil crash in over 50 years as well as slowing commodity demand in China, Parker focused on improving its systems-based business lines, investing in the internet of things, and buying filter manufacturer Clarcor for $4.3 billion.

 

In the short-term, the acquisition costs (including added interest expenses from $3 billion in new debt) have resulted in a temporary decline in profitability to slightly below industry averages (see below).

 

However, the company’s returns remain impressive (a sign of strong capital allocation), especially its return on invested capital (ROIC) and free cash flow (FCF) margin, which is ultimately what supports and grows the dividend.

 

 

In fact, Parker has a great record of generating more FCF than net income, which is due to the company’s clean accounting and lucrative aftermarket businesses, which throw off gobs of reliable cash, especially during market downturns (see 2009 and 2010 below).

 

 

Parker-Hannifin’s aftermarket business, which accounts for a little over half of its sales and an even greater share of profits, is very important for the company’s long-term outlook.

 

While Parker-Hannifin’s top and bottom lines are somewhat cyclical, the company’s meaningful maintenance, repair, and overhaul (MRO) business provides a strong source of stability and entrenchment with customers.

 

Unlike OEM parts, aftermarket parts and services are necessities when equipment wears down, making the MRO business less cyclical.

 

Parker-Hannifin’s strong market share in this business is reinforced by its distribution network, which boasts over 13,200 locations around the world and is larger than any of its competitors’ networks.

 

When equipment breaks down, it needs to be serviced immediately. Customers would prefer to work with a company like Parker-Hannifin that has a distribution network in close proximity that can quickly get the machinery back up and running.

 

Parker-Hannifin’s distribution network has been in development for more than 50 years and would take competitors decades of time and substantial financial costs to replicate.

 

Maintaining a global network that covers numerous technologies and geographies also helps Parker-Hannifin win business with large multinational customers, which need to be reliably serviced around the world.

 

Another important factor to consider is the quality of the management team. After all, running a global industrial conglomerate is highly complex and that’s why shareholders pay management to do it on their behalf.

 

Above average returns on capital are a good proxy for quality management. Part of that is being smart when it comes to acquiring rivals, either through bolt-on deals or major, needle-moving purchases.

 

When we look at the Clarcor acquisition, we see a prime example of why Parker-Hannifin has managed to do so well over the past century and grow its dividend with such clockwork consistency.

 

Specifically, Parker’s decision to buy Clarcor was based mainly on two key factors. First, it greatly strengthens Parker’s position in the filter market, with an additional 137 facilities in over 20 countries.

 

But more importantly, the vast majority of Clarcor’s business is in the aftermarket, meaning both higher-margins and recurring revenues to provide the combined companies with even greater resiliency over the coming years.

 

 

In other words, after the Clarcor acquisition, which closed in late February 2017, Parker-Hannifin is well positioned to enjoy higher profitability and more consistent sales, earnings, and cash flow.

 

You can see that the combined businesses are even more diversified and benefit from having 54% of their total sales from aftermarket applications, providing nice stability compared to OEM sales.

 

 

A large part of Parker-Hannifin’s success is also driven by its culture of lean manufacturing, which really began in the early 2000s. The company’s efforts to improve profitability, generate more cash, free up working capital, improve product quality, and raise on-time delivery rates have reinforced the company’s global positioning as a powerhouse.

 

Going forward, the company’s lean expertise will help it gain greater revenue efficiencies (e.g. use fewer part numbers, reduce overhead cost, use more ecommerce, pricing strategies, etc.), consolidate divisions, and more.

 

Even if end markets continue stagnating, Parker-Hannifin can be relied upon to continue improving its competitive position and margin profile in anticipation of better times ahead.

 

In fact, thanks to the expected $140 million a year in operating synergies from the Clarcor deal, as well as ongoing cost-cutting efforts based on Parker’s growing economies of scale, management expects to steadily improve its profitability going forward, including an improvement in operating margins from 14.5% to 17.0% between 2015 and 2020.

 

 

 

Further good news for Parker comes from the fact that it appears the global industrial recession may be ending, as seen in steadily rising Producer Manufacturing Index (PMI), a key economic indicator for industrial demand, in Parker’s key markets in recent months.

 

 

In the first quarter of 2017 this improvement in global PMI translated to a strong recovery in organic growth (excludes acquisitions) of 6%.

 

Add to this the fact that, despite being a leading provider of motion control solutions, Parker-Hannifin is still a relatively small player in a very large market (10% to 11% overall market share). As a result, the company’s growth runway remains very long as it continues playing the role of market consolidator.

 

 

Despite its relatively small share of the total pie, Parker-Hannifin has about 20% share in most of the markets it competes in, which partially explains the firm’s higher profitability metrics compared to peers that we reviewed earlier.

 

However, there is more to the story. Parker-Hannifin also has the broadest technology platform in the market, allowing it to help customers create more systems and subsystems than any of its competitors. While most competition competes on one or two technologies, about 60% of Parker-Hannifin’s customers buy from four or more of its seven operating groups.

 

Most of these technologies have patents or trade secrets protecting them and focus on mission-critical parts of the products they go into. By focusing on high-margin niches and offering a greater breadth of protected technologies, Parker-Hannifin is able to maintain strong returns on invested capital.

 

And thanks to the company’s steady use of its FCF to buy back shares (historically 2% to 3% per year reduction in share count), management has leveraged Parker’s rising sales into even stronger EPS and FCF per share growth, which they pass onto dividend lovers in the form of higher payouts over time.

 

 

The bottom line is that Parker Hannifin’s world-class management team has a long track record of excellent capital allocation and an ability to steadily improve the company’s profitability; a trend that it expects to continue in the next five years.

 

That’s why Parker expects its earnings and FCF to increase at around 8% annually over the next five years, which bodes very well for its continued dividend growth prospects.

 

 

Key Risks

There are three key risks to consider with Parker-Hannifin.

 

The first is that, while the company enjoys a growing moat, courtesy of its unique branding via ParkerStores and its Hosedoctor 24/7 customer support, this is still largely a commoditized industry. And given how highly fragmented it is, with numerous rivals competing for market share, it’s not a guarantee that management can continue improving its margins or even maintain them.

 

That in turn would mean that Parker’s bottom line growth, and the growth of its dividend, could end up disappointing because the overall industrial sector generally only grows at the rate of global GDP and can be highly cyclical.

 

Historically Parker has been able to grow slightly faster (1.5% above the industry’s growth rate), but the overall earnings and dividend growth potential is highly dependent on Parker continuing to build its brand, pricing power, and margins.

 

The other risk to keep in mind is that much of Parker’s future growth will come from overseas, from faster-growing emerging markets. However, that will expose the company’s earnings and FCF per share growth to higher currency risk.

 

Or to put it another way, because Parker will be selling products in exchange for local currencies, a strong U.S. dollar, which is likely if U.S. interest rates rise, could result in growth headwinds.

 

Finally, it’s worth noting that Parker-Hannifin’s business, despite its high aftermarket mix, remains sensitive to short-term trends in economic growth.

 

The business is most sensitive to manufacturing activity, aircraft miles flown, and construction markets. Not surprisingly, Parker-Hannifin will be impacted by trends in the broader economy and is cyclical.

 

However, with hundreds of thousands of individual products (none greater than 1% of total sales) and about 445,000 customers, Parker-Hannifin operates a well-diversified business model that won’t be brought down easily by any single factor. The company’s sturdy balance sheet and free cash flow generation add further protection.

 

Parker-Hannifin’s Dividend Safety

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

 

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

 

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

 

 

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.

 

Parker-Hannifin has a Dividend Safety Score of 83. This indicates its dividend is very safe which isn’t surprising given its 60-year dividend growth record, which is among the top five longest streaks of all S&P 500 companies.

 

 

Note that the apparent lack of dividend growth in 2015 and 2016 is due to the timing of Parker’s dividend increases. Specifically, the dividend growth is based on annual amounts each fiscal year (not calendar year like the chart above), and the recent industrial recession has forced the company to hold off some of its payout increases for up to seven quarters in order to responsibly maintain the dividend growth record.

 

The key to Parker’s incredible dividend growth consistency is mainly due to two factors. The first is management’s disciplined approach to growing the dividend.

 

Specifically, management likes to keep its EPS and FCF payout ratios low (30% of earnings is the current policy) in order to provide a strong buffer against the cyclical nature of the company’s EPS and FCF per share.

 

Even despite the slump in many industrial and energy markets, Parker-Hannifin’s EPS and FCF payout ratios remain at healthy levels of 38% and 33% over the trailing 12-month period, respectively.

 

 

In other words, by paying out only around a third of earnings and FCF as dividends, Parker maintains strong financial flexibility. This allows the company to both invest in its business, as well as buy back shares if they are undervalued. All while still providing dividend growth investors with the safe and steadily growing payouts they’ve come to expect, even during industrial recessions.

 

The other major protective factor is the company’s strong balance sheet. For example, the strong current ratio (short-term assets/short-term liabilities) and strong free cash flow generation makes it easy to service its debt and liabilities.

 

 

And don’t forget that the industrial sector is highly capital intensive. That means that we need to keep the company’s leverage ratios in perspective with those of its peers.

 

For instance, while it’s true that the company’s leverage ratio (Debt/EBITDA) has increased above the industry average (due to the debt taken on to acquire Clarcor), Parker-Hannifin’s overall debt levels remain in line with its peers, and the interest coverage ratio remains highly safe at over 12.

 

 

That explains why Parker has a very strong investment-grade credit rating that allows its to borrow at an average interest rate of just 2.7%. This provides it with plenty of low cost capital with which to both grow the company for the long-term, while maintaining its impressive dividend growth.

 

Overall, Parker-Hannifin’s low payout ratios, excellent cash flow generation, and strong balance sheet make its dividend payment one of the safest in the market.

 

Parker-Hannifin’s Dividend Growth

Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

Parker-Hannifin’s Dividend Growth Score of 82 indicates that investors can likely expect long-term dividend growth to be in excess of the S&P 500’s historical 5.7%. That’s despite the slower pace of recent dividend growth, which has been affected by the global industrial recession.

 

However, Parker’s likely ability to generate 8% EPS and FCF per share growth means that investors can expect around 7% to 8% payout growth longer-term. While that is slightly below the company’s impressive 20-year annual growth rate of 10.9%, it’s still a very solid number, especially given the highly secure nature of Parker’s payouts.

 

 

Valuation

Parker-Hannifin shares have been on fire over the past year, outperforming the S&P 500 by about 25% as oil prices rebounded and the outlook for global growth continued moderately improving. Unfortunately, that means today’s share price might not be a bargain.

 

For example, PH’s forward P/E ratio of 18.3 is slightly higher than the S&P 500’s 17.7 and significantly higher than the company’s historic 15.7 multiple.

 

At the same time, Parker’s dividend yield of 1.7% actually trades right in line with its 22-year average of 1.7%. In fact, over the past two decades Parker has only offered a higher-yield 41% of the time.

 

It’s hard to argue that the stock is excessively priced given its largely in line valuation multiples, and long-term investors have potential to generate annual total returns of around 8.7% to 9.7% (1.7% dividend yield + 7% to 8% annual earnings growth).

 

While such potential returns may not be headline grabbing, they do represent a fair return, especially for such a fundamentally sound company.

 

Conclusion

Parker’s strong performance over the past year means that much of the economy’s recent good news (such as the end of the global industrial recession) is likely priced into the stock.

 

However, given the company’s impressive track record of rewarding patient dividend investors and its long-term growth potential, Parker-Hannifin seems to represent a solid core holding for almost any diversified dividend growth portfolio.

 

Income investors seeking more yield should review the 30 high dividend stocks here.