Parker-Hannifin Offering Short-Cycle Leverage, But A Whole Lot More Too

Writing about Parker-Hannifin (NYSE:PH) in August I highlighted the efforts that management has been making to transform a business historically driven by short-cycle industrial markets into a more diversified, higher-margin, better overall industrial company. Since then, the shares have added another 40%, more than doubling the return of the broader industrial sector.

“It’s different this time” are words that should always worry investors, and I do have concerns about valuations across the broad industrial group. That said, I do believe that Parker-Hannifin is a different company today than five, 10, or 20 years ago, and I’m not going to just assume that the shares are doomed the underperform now that the PMI is closing in on 60. I am not all that excited about the prospective returns I see here today, but I would still very much agree with a “best among its peers” argument in favor of choosing Parker-Hannifin if you had to buy an industrial.

 

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Parker-Hannifin Offering Short-Cycle Leverage, But A Whole Lot More Too

Applied Industrial Technologies Starting To See The Slowdown

Wall Street hates uncertainty and there’s plenty of that when it comes to distributors in general and Applied Industrial Technologies (AIT) in particular. With two-thirds of Applied Industrial Technologies’ verticals still growing and macroeconomic metrics like manufacturing capacity utilization, PMI, and industrial production still favorable but weakening, there’s plenty of uncertainty as to just how well the U.S. (and global) economy will perform in 2019.

AIT has done a lot to build up its business, and particularly its higher-margin fluid power business, and this a company with a strong ROIC record. I’m concerned about slowing momentum in 2019 and the possibility of further revisions to near-term guidance, but I do see a path for mid-single-digit revenue growth and double-digit FCF growth that can support a higher share price from here.

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Applied Industrial Technologies Starting To See The Slowdown

Eaton Outperforming And Still Undervalued, But Mind The Cycle

Calling out Honeywell (HON) and Eaton (ETN) as preferred names earlier this year has worked out alright, as these two diversified multi-industrials have continued to do well over the past year, year-to-date, and three-month periods, with both really standing out over the industrial sector over the past three months.

Despite Eaton’s outperformance, the shares still look undervalued. I share some of what I assume are the markets worries about the Vehicle and Hydraulics businesses (about 20% of sales), but the business as a whole seems to be on good footing and I believe the shares are undervalued on very modest long-term growth expectations.

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Eaton Outperforming And Still Undervalued, But Mind The Cycle

Margin Leverage Can Drive Parker-Hannifin Higher, But The Outlook Is A Little Murky

Like many industrial stocks, Parker-Hannifin (PH) seems caught in that tug-of-war between good present-day results and growing worries about the prospects for continued growth as 2018 moves along. Although Parker-Hannifin's orders have remained pretty strong, shrinking ISM new order numbers are a warning sign and expectations may be too high for incremental margins in the next few quarters.

Parker-Hannifin management has done alright with segment-level margins in recent years, and I like the opportunities the company has ahead in filtration, aerospace, and engineered materials as well as its core motion and flow/process control operations. The shares do look undervalued if Parker-Hannifin can deliver on its long-term margin targets, but I wouldn't say that expectations are at a can't-miss level.

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Margin Leverage Can Drive Parker-Hannifin Higher, But The Outlook Is A Little Murky

Smiths Group Looks Poised For Better Results

Over time Smiths Group (OTCPK:SMGZY) (SMIN.L) has built up a well-earned reputation for always coming up a little short. Although this U.K. conglomerate's historical performance wasn't bad in terms of margins or ROIC, the cash flow generation was weak and it was the sort of story where there was always something a little off. Likewise, while Smiths shares performed okay relative to other U.K. conglomerates, the gap with American industrial conglomerates like 3M (NYSE:MMM), Illinois Tool Works (NYSE:ITW), and Parker-Hannifin (PH) has been sizable.

Quite a bit has changed recently, as new management has returned to a philosophy of active portfolio management and R&D/innovation-driven growth. Although the results aren't showing up just yet in terms of organic revenue growth or margin expansion, I believe Smiths is on the cusp of better results that should make this a solid market-outperformer for the next couple of years.

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Smiths Group Looks Poised For Better Results

Is It Too Late For An Early-Cycle Name Like Parker Hannifin?

Investors have an uncanny knack for swinging between worrying about nothing and worrying about everything. In the case of Parker-Hannifin (PH), it would seem that poorly-communicated, near-term margin issues are disappointing investors who favor margin improvement stories within the multi-industrial space, while worries about where Parker-Hannifin sits in the short-/mid-/late-cycle ecosystem are troubling other investors.

Although I do have some concerns about growth with Parker-Hannifin, I think the stock's valuation is interesting on both an absolute and relative basis, particularly given acceleration in orders and high valuations in the peer group. To me, the shares look priced for high-single-digit to low-double-digit total returns, and you could make an argument that a fair value in the $220s or $230s wouldn't be ridiculous.

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Is It Too Late For An Early-Cycle Name Like Parker Hannifin?

Eaton Lacks Sizzle, But The Valuation Is Interesting

It's hard to work up a lot of enthusiasm for Eaton (ETN). The company is frequently a middle-of-the-pack grower, and while the company's efforts to restructure and improve margins have helped, it's not exactly a standout on profitability, nor is it really a clear leader in the markets that really set institutional investors' hearts aflutter these days.

Now, before the Eaton fans light their torches and grab their pitchforks, understand that I have *no* problem with a "boring" company. In fact, a lot of my best-performing investments have been in companies that lack a lot of buzz. What's more, I am intrigued by Eaton's valuation. Unless I'm really missing something, it looks like these shares are offering nearly double-digit total annualized return potential on long-term growth of just 3% or so. In a generally expensive stock market, and with many end-markets improving, I'm warming up to Eaton as a late value-driven play.

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Eaton Lacks Sizzle, But The Valuation Is Interesting

Crane Seeing A Choppier Recovery

Crane (CR) has always been a little different relative to its multi-industrial peers, so I can't say that I'm all that surprised that this company's recovery has followed a different trajectory. Not that this has done the share price any harm - Crane shares are up about 100% over the past two years, better than Parker-Hannifin (PH), Dover (DOV), Emerson (EMR), and many other peers that have seen sharper boom/bust cycles.

While the recent Crane & Co. ("Crane Currency") acquisition should pay off well over time, the near-term outlook for Crane is relatively tepid, with the company expecting decent (but not market/segment-leading) growth across its businesses in 2018 and not a lot of margin leverage. Some investors may find that Crane shares still make sense on a relative value basis, but I'm not inclined to chase these shares.

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Crane Seeing A Choppier Recovery

Real Recoveries Are Flowing Into Parker-Hannifin's Numbers

Despite its reputation as a high-quality short-cycle play, not to mention one with significant self-help potential through business simplification and the integration of CLARCOR, Parker-Hannifin (NYSE:PH) has cooled off a bit since my last update. Although these shares have outperformed Eaton (NYSE:ETN), a fellow player in hydraulics, they've lagged other industrial stocks like Honeywell (NYSE:HON), Emerson (NYSE:EMR), and Illinois Tool Works (NYSE:ITW), as well as the S&P 500.

With fiscal 2017 in the books and improving trends across a large swath of its end-markets, Parker-Hannifin may be worth another look now. I'm worried about the overall health/valuation of the market, and I don't think Parker-Hannifin would be immune to a wide correction, but mid-single-digit revenue growth and mid-to-high FCF growth can support a fair value around $160, suggesting a high single-digit annual return even from these levels.

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Real Recoveries Are Flowing Into Parker-Hannifin's Numbers

Eaton Offers An Interesting Valuation, But A Lot Of Uncertainties

Despite a good overall run in the industrial space, Eaton (NYSE:ETN) hasn't really kept pace, as the shares have actually lagged the S&P 500 over the past year, not to mention peers like Parker-Hannifin (NYSE:PH), Honeywell (NYSE:HON), and Schneider (OTCPK:SBGSY) (Emerson (NYSE:EMR) has more or less traveled in step with Eaton). Eaton management has been relatively less upbeat than some in its peer group, and the company's organic growth has trailed its peer group for a while now. 

Eaton's above average cyclicality is an “is what it is” sort of thing, and I don't believe management is likely to undertake a major restructuring that would see it sell or spin off an entire vertical. Likewise, I don't like large-scale M&A is especially likely. Although the company should be in place to benefit from several improving end-markets, weakness in commercial construction and passenger vehicles is a concern, as well as uncertainty regarding U.S. tax and trade policy. Eaton shares look like a rare undervalued option in the industrial space (assuming 6% long-term FCF growth), but the lagging revenue growth could be a headwind for a while longer.

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Eaton Offers An Interesting Valuation, But A Lot Of Uncertainties

IMI Group Working On Self-Improvement Through Still-Challenging Markets

Seemingly every company is looking to streamline its supply chain, improve manufacturing efficiency, and reduce its operating overhead, but the self-improvements at IMI Plc (OTCPK:IMIAY) (IMI.L) are a little more urgent. While declines in the oil/gas, power, petrochemical, industrial automation, and commercial vehicle markets have certainly hurt, IMI also saw some self-inflicted damage from under-investment in capex and R&D, too many non-strategic assets/businesses, and a lack of integration and operational efficiency. Credit, then, to CEO Mark Selway who has been tackling these issues in recent years while also dealing with serious market headwinds.

The opportunities for self-improvement and market recoveries haven't gone unnoticed, as IMI's shares are up about 25% over the past year - less than the likes of Weir Group (OTCPK:WEGRY) and Parker-Hannifin (NYSE:PH), but on par with Rotork (OTCPK:RTOXY) and SMC (OTCPK:SMCAY). My expectations for recoveries in downstream oil/gas and power may be too conservative, but I'm looking for mid-single-digit growth in revenue and FCF from IMI. That supports a mid-to-high single-digit return at today's level, which is not bad on a relative basis but arguably not enough for a company that still has some work to do on the self-improvement front.

Readers should note that IMI's ADRs are not very attractive from a liquidity standpoint, but the London-listed shares offer ample liquidity and most quality brokerages now offer such market access.

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IMI Group Working On Self-Improvement Through Still-Challenging Markets

Parker-Hannifin Pumped Up On Recovery In Industrial Markets

I've been bullish on Parker-Hannifin (NYSE:PH) for a while, but the company and the stock have managed to exceed my expectations along the way. With the shares up close to 30% since my last piece, handily beating the likes of Eaton (NYSE:ETN), Dover (NYSE:DOV), and Illinois Tool Works (NYSE:ITW), the shares continue to reflect a strong recovery scenario - a scenario that admittedly seems a little more realistic now given the generally healthy calendar first quarter results in the sector and Parker-Hannifin's own 8% reported order growth.

Parker-Hannifin's performance has been solid even without Clarcor, a deal that although expensive is likely to prove worthwhile over time, and underlying conditions are getting better as Parker-Hannifin management sees improvement in a wide range of end-markets. Although these shares are (finally) above my fair value and the reaction to first quarter earnings suggests high expectations, the valuation is not so unreasonable on a relative basis and these shares could still have some appeal for investors who want to continue playing the industrial recovery theme.

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Parker-Hannifin Pumped Up On Recovery In Industrial Markets

ESCO Technologies A Tough Mix Of Potential And Past Performance

Industrial conglomerate ESCO (NYSE:ESE) strikes me as another investment Rorschach test, as how you arbitrate between ESCO's high-potential collection of businesses and its uninspiring historical performance says a lot about whether you trust past performance as a good predictor of future results or whether you believe businesses should be valued based upon what they can do in the future.

ESCO's track record in terms of margins, free cash flow generation, returns on invested capital, and tangible book value growth doesn't inspire much confidence, and I don't think that the performance issues of the smart meter business (Aclara divested years ago) fully excuse it. On the other hand, it's hard not to like a good filtration/fluid control business and a collection of other business with good market shares and the potential for improved growth and margins. Today's valuation isn't absurd on the basis of what ESCO could become, but for my own personal investment approach, I demand a wider margin of safety unless/until management shows this "new and improved" ESCO really is here to stay.

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ESCO Technologies A Tough Mix Of Potential And Past Performance

Carlisle Companies Taking A Familiar Road To Growth

With over $3 billion in revenue and $7 billion in market cap, I'm surprised Carlisle Companies (NYSE:CSL) isn't a little better-followed than it is. While this conglomerate is heavily weighted toward construction, Carlisle's target markets are looking pretty healthy going into 2017 and management has done a good job of meeting and raising long-term growth and margin targets.

Following in the footsteps of companies like Danaher (NYSE:DHR), Illinois Tool Works (NYSE:ITW), and Parker-Hannifin (NYSE:PH) and with a clean balance sheet, I think Carlisle has a lot of options to add businesses through M&A in the coming years and improve them by applying its Carlisle Operating System. Although the stock looks rich now, that's a common issue in the market today and investors may want to run through due diligence with an eye toward adding shares if/when the market cools.

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Carlisle Companies Taking A Familiar Road To Growth

Parker-Hannifin Looking Ahead To Better Days

When I last wrote about Parker-Hannifin (NYSE:PH) I absolutely underestimated the market's willingness to look past a rough calendar/fiscal 2016 and start hoping for a strong V-shaped recovery in 2017. I thought Parker-Hannifin offered value back in January, but I definitely didn't expect the 40%-plus move in the stock - in-line with Eaton (NYSE:ETN) and Atlas Copco (OTCPK:ATLKY), but still on the high end of the range of the industrials I follow more closely.

A healthy skepticism bordering on paranoia is a good asset for investors, and that's particularly true when you think a stock is worth meaningfully more than before a big run. I don't think a long-term expectation of 4% revenue growth or 6% FCF growth is that bullish (and my expectations for FY 2025 are about 4% lower than that last article), but with a weak year rolling out of the model, it does support a fair value of about $125 today.

That's not a big premium to today's price, but there aren't many quality industrials trading at a discount today, and as I said, seeing any discount after the big run makes me wonder if I'm missing something.

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Parker-Hannifin Looking Ahead To Better Days

Eaton Seems Ready For A Protracted Recovery

With the shares near a 52-week high, it would seem that the Street is not sleeping on Eaton (NYSE:ETN). Although tough times continue in businesses like Hydraulics and Vehicle, most investors seem to believe these businesses are troughing and that more industrially-focused businesses like Electrical Products and Systems can do better in the near term.

I do think Eaton belongs on a watchlist of high-quality diversified industrials, and its relatively greater cyclicality (compared to names like Honeywell (NYSE:HON) or 3M (NYSE:MMM)) could make it a relative outperformer when (if?) that recovery comes. I do have concerns about Eaton's expectations for very modest organic growth in the coming years. My concerns are stemming from the fact that Eaton hasn't always had the greatest success in driving lasting margin improvement.

Right now, I think Eaton is priced for high single-digit to maybe low double-digit returns. That's not bad, though I do think there could be some risk to the underlying free cash flow growth rate assumptions. I'd prefer to buy at a somewhat lower price, but this doesn't look any worse than a hold to me today.

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Eaton Seems Ready For A Protracted Recovery

Seeking Alpha: Parker-Hannifin: Good Company Meets Bad Markets

Parker-Hannifin (NYSE:PH) isn't a flawless company, but this leader in motion and process control has a pretty solid record of generating attractive full-cycle margins. What's more, the company is uncommonly diversified across its end-markets and generally eschews splashy moves in favor of just consistently doing a good job.

Unfortunately, Parker-Hannifin is caught up in a global butt-kicking of industrial equities and the company is facing a lot of demand weakness across its many markets. I believe that the company can generate long-term growth of over 3% and that the shares are probably too cheap today, but investors considering buying on this pullback have to have patience and a long-term vision to offset the near-term risks that weakness in oil/gas, off-road vehicles, and general manufacturing will get even worse before turning around.

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Parker-Hannifin: Good Company Meets Bad Markets

Seeking Alpha: Storm Clouds In Front Of Parker-Hannifin

Parker-Hannifin (NYSE:PH) hasn't been a terrible performer since my article back in January, but I think investors should generally aim higher than "not terrible". I continue to believe that this diversified motion and fluid control company is well-run and a credible long-term hold, but the near-term outlook has gotten pretty scary lately and I think the odds favor that the company will underwhelm with its upcoming fourth quarter earnings release and guidance for the upcoming fiscal year.

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Storm Clouds In Front Of Parker-Hannifin

Seeking Alpha: Realistic Expectations And Improving Performance At Eaton

Based on fourth quarter results, I would argue that Eaton (NYSE:ETN) belongs on that list of diversified industrials that are doing pretty well given the circumstances (a list that includes 3M (NYSE:MMM), Honeywell (NYSE:HON), and arguably Parker-Hannifin (NYSE:PH)). The company's exposure to off-road vehicles and oil/gas will be liabilities in 2015, but exposure to aerospace and vehicles should offset it and Eaton's leverage to construction should also be a net positive.

I don't expect to find large, well-covered stocks like Eaton trading at major discounts to fair value and I don't believe that is the case here. That said, I like Eaton's prospects for "self-help" through margin leverage and asset leverage and I think these shares are slightly undervalued today.

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Realistic Expectations And Improving Performance At Eaton