Parker-Hannifin (PH) is a high quality industrial business with entrenched market positions and excellent cash flow generation. The company has increased its dividend for 59 consecutive years, making it a Dividend King, and offers a 2.8% dividend yield today. Its dividend has also compounded at a double-digit annual rate over the last decade and should continue putting up above-average growth, making it a good fit for our Long-term Dividend Growth portfolio.
The strong dollar and sluggish industrial activity around the world are challenging the business today, but we don’t believe these issues affect PH’s long-term earnings power.
Business Overview
PH is a global leader in motion and control technology – anything that enables motions (e.g. hydraulics, mechanical pneumatics controls, etc.) or controls the flow of fluids or gases (e.g. pumps, valves, filters, etc.). Its precision engineered solutions serve roughly 445,000 customers in virtually every significant manufacturing, transportation, and processing industry.
Business Segments: Diversified Industrial North America 45%, Diversified Industrial International 37%, Aerospace Systems 18%. Note that roughly 50% of PH’s industrial sales are from high-margin aftermarket business, which is also much less volatile than OEM revenue.
Technology Platforms: Flow & Process Control 32%, Motion Systems 28%, Filtration & Engineered Materials 22%, Aerospace Systems 18%.
Business Analysis
PH is the number one player in a fragmented $120 billion market, which provides plenty of room to grow organically and through acquisitions. The company has about 20% share in the markets it competes in and possesses profitability metrics that are in the top quartile compared to its peers.
Of course, the company has many competitive advantages. PH 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 PH’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, PH is able to maintain strong returns on invested capital.
Source: Simply Safe Dividends
While PH’s returns are somewhat cyclical, its meaningful maintenance, repair, and overhaul (MRO) business provides a strong source of stability and entrenchment with customers. MRO accounts for 50% of PH’s industrial sales and carries much higher margins than the overall business. Unlike OEM parts, aftermarket parts and services are necessities when equipment wears down, making the MRO business less cyclical.
Importantly, PH’s strong market share is reinforced by its distribution network, which boasts over 12,800 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 PH that has a distribution network in close proximity that can quickly get the machinery back up and running.
PH’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 PH win business with large multinational customers, which need to be reliably serviced around the world.
Finally, it’s worth mentioning PH’s 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.
Most recently, PH raised the margin target for the company to 17%, which is meaningfully higher than the 14.5% it ended at last fiscal year. 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 (consolidating its 115 divisions by 20-25% to gain more scale and operating efficiencies), and more. Even if end markets continue stagnating, PH can be relied upon to continue improving its competitive position.
Key Risks
At the moment, PH’s results are being hurt by the strong dollar and sluggish industrial activity around the world. The business is sensitive to manufacturing activity, aircraft miles flown, and construction markets. Not surprisingly, PH will be impacted by trends in the broader economy and is cyclical. If current global growth trends continue weakening, the stock will likely fall in the near-term.
However, with hundreds of thousands of individual products (none greater than 1% of total sales) and about 445,000 customers (none greater than 4% of total sales), PH operates a well-diversified business model that won’t be brought down easily by any single factor. The company’s excellent balance sheet and free cash flow generation add further protection.
Dividend Analysis
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. PH’s long-term dividend and fundamental data charts can all be seen by clicking here.
Dividend Safety Score
Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
PH’s dividend payment is extremely safe with a Safety Score of 97. Over the last four quarters, PH’s dividend has consumed 39% of its earnings and 42% of its free cash flow. Even if the company’s earnings were chopped in half, they would continue to more than cover the dividend.
Looking longer-term, PH’s payout ratios have about doubled over the last decade as dividend growth outpaced earnings growth. Given management’s 30% payout ratio goal, future dividend growth will likely be more aligned with earnings growth. However, there is still plenty of room for dividend increases for many years to come.
Source: Simply Safe Dividends
Source: Simply Safe Dividends
During the last recession, PH’s sales fell by 15% in 2009 but its earnings dropped by about 40%, reflecting the cyclicality of many of its end markets. The stock also underperformed the S&P 500 by 6% in 2008, falling by 42%. While PH’s low payout ratios will help it weather just about any economic storm, it’s important to be aware of the stock’s cyclicality.
Source: Simply Safe Dividends
Cash flow is the lifeblood of businesses, and PH’s cash generation has been extremely impressive. The company has generated operating cash flow greater than 10% of sales (i.e. a 10% cash flow margin) for 14 straight years – even during the financial crisis. The company’s substantial aftermarket business, massive distribution network, and leading technologies have made it a cash machine.
Source: Simply Safe Dividends
PH’s balance sheet also looks great. The company could cover its entire debt with cash on hand and less than one full year of earnings before interest and taxes (EBIT). In other words, PH has plenty of flexibility to repurchase shares (announced a $2-$3 billion repurchase plan in October 2014), increase the dividend, and make opportunistic acquisitions.
Source: Simply Safe Dividends
To conclude, PH’s low payout ratios, excellent cash flow generation, and strong balance sheet make its dividend payment one of the safest in the market.
Dividend Growth Score
Our 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.
PH’s dividend Growth Score is 64, suggesting that the company’s dividend growth potential is above average. PH has increased its dividend for 59 consecutive years, firmly securing its spot on the exclusive Dividend Kings list, which contains stocks that have raised their dividend for at least 50 straight years. However, the company is surprisingly not a member of the S&P Dividend Aristocrats Index. We are not sure why S&P does not include PH, but we guess it could be that it measures increases on a calendar year basis instead of fiscal years (PH’s fiscal year ends in June). Regardless, PH’s dividend growth is consistent and impressive.
While PH’s 2.8% dividend yield is not enough income for investors living off dividends in retirement, its dividend has grown by 150% over the last five years and consistently compounded at a double-digit clip.
Source: Simply Safe Dividends
Going forward, PH targets an EPS payout ratio of 30%, which the company is at today. In other words, future dividend growth will correlate with earnings growth, which management hopes will hit 10% per year even if end markets remain sluggish.
Valuation
PH trades at 15x forward earnings and offers a dividend yield of 2.8%, which is significantly higher than its five year average dividend yield of 1.7%. The earnings multiple appears to be very reasonable for a company of PH’s quality, likely reflecting the market’s pessimistic outlook for growth in many of PH’s end markets.
However, management believes the company can put up double-digit earnings growth even “if the industrial space for the next five years is a weed bed.” If true, the stock could generate double-digit annual returns over through 2020, barring a global recession.
Conclusion
No one knows exactly when industrial activity will begin to rebound. The headwinds caused by depressed natural resource markets, the strong dollar, and stagnant economic activity could persist for quite some time.
However, PH has the business model to survive any climate and emerge stronger on the other side. It is our expectation that the company will be larger and more profitable five years from now, and long-term dividend growth investors will be rewarded. PH remains one of our favorite blue chip dividend stocks that we are willing to stay patient with.
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