Parker Hannifin's Value Still Invisible

Parker Hannifin (PH) has spent the last decade retooling and renovating its portfolio, allowing for a stronger foundation for cash generation and growth. This effort has largely gone unrewarded by investors, with the firm currently sporting the lowest forward P/E ratio in our diversified industrial coverage universe. We think this oversight by the Street provides an opportunity to invest in a top-notch, narrow-moat firm with durable competitive advantages.

A Lean Machine
In 2001, newly minted CEO Don Washkewicz laid out the company's "win" strategy, aimed to improve the company's financial performance, customer experience, and profitable growth platforms. The brunt of this work was done during two recessions, but Parker has managed to move out of the bottom of the operational pack in the last decade.

One area where Parker seems far in front of the field in terms of manufacturing execution is developing repeatable and sustainable processes for product development and launches. Similar to the various stages a startup company goes through with venture capital firms, new products must meet various requirements in order to continue to receive additional corporate funding. This enables the firm to both cast a wide net at the early stages of a product's development and also allocate capital wisely as products mature in the pipeline. This leads to lower overall project costs and higher returns for shareholders, while maximizing growth potential.

This concept also extends to emerging markets, where Parker developed an incubator strategy in which several different product lines share back-office support and run limited manufacturing lines. This helps the business keep costs down as it learns the market and develops its own demand. As the business matures, it will move out of the incubator to be self-sufficient, with a clearer focus and a proven concept.

A Case of Mistaken Identity
Clunky segment reporting hides a fair amount of important distinctions within Parker's portfolio. Underneath the bland segment labels of "Industrial North America" and "Industrial International," Parker houses a billion-dollar filter business and a solid seals business, shaking the notion that this is a rather plain vanilla manufacturer. With comparable filter units at Pall and Donaldson (DCI) commanding nearly 20 times earnings, we think Parker is sitting on a very valuable asset that has the potential to help the firm shift from a cyclical industrial frame to something more similar to other prominent diversified firms. Importantly for investors, Parker has not built this business through pricey acquisitions, but rather by working from within, piecing together otherwise disparate business units to create solutions that customers value.

Parker's new hybrid hydraulic system for heavy trucks is an example of intercompany collaboration. Combining technology from the hydraulics group, valves group, and filters group and leveraging customer relationships fostered companywide has helped create not only a product, but also easy access to a primed market. This collaboration exemplifies Parker's recent effort to shift from being a component manufacturer to being a solution/system provider, enabling growth at higher incremental returns.

Narrow-Moat Material
Parker's narrow economic moat is derived primarily from the high switching costs that customers would incur if they opted for a competitor's product. In the case of the aerospace segment, even if a competitor offered a better technology for free after the airframe has been designed and is in production, it is nearly impossible for Parker to be unseated. This is simply because it would cost the airframe equipment manufacturer (and the entire supply chain) too much to alter the engineering after a proven design works, especially if it's FAA certified. One only needs to look at the production of the Boeing 787 to see the havoc raised by an unstable supply chain.

While not as powerful as the aerospace example, Parker's highly engineered valves and filters also are generally tightly integrated in the design of a larger system that would make alterations uneconomical, though not impossible. To this end, in the last few years Parker has made a point of becoming more of a system integrator or solution provider as opposed to a component supplier. This gives Parker more engineering control over the project and a larger portion of its bill of materials.

Over time, we also have become more impressed with the scale of Parker's distribution network. Through a franchise model, Parker has built a network of more than 12,000 stores over 60 years. Within these distribution centers, Parker holds typical maintenance and repair inventory as well as engineers. These engineers are able to fix equipment on site or can be deployed to customer locations. This level of service helps build customer relationships, keeping Parker on a manufacturer's short list of preferred vendors. In-house engineering talent also has become valuable since the recession, as a number of firms let go of their own engineers to cut costs; equipment requires maintenance, so this gives Parker another opportunity to capture revenue. While it is conceivable that a competitor could replicate this strategy, Parker has refined this concept over time, making it difficult for a newcomer to steal economic profits swiftly.

Earnings Volatility the Likely Culprit
For all the things that Parker has diligently set about fixing within its portfolio, the company really hasn't added much that would damp the impact of a weakening economy. During the last recession, Parker's earnings fell from a peak of $5.69 per share to a trough of $1.74, a 70% drop over a five-quarter period. It essentially took 10 quarters for the company to get back to the previous peak.

Even for relatively patient investors, it can be challenging to wait this long once the firm's earnings drop off. Other diversified firms have mitigated this inherent cyclicality by simply reallocating the portfolio into businesses like health care that are less cyclical and by incorporating more recurring revenues into the mix. While slow in the making, Parker has been building a formidable filtration business organically with the goal of mimicking others' push into the less-cyclical health-care world. The steady flow of consumables and the recession-resistant demand for health-care equipment has the potential to balance out Parker's earnings stream at relatively high returns and make it more immune to drastic earnings-per-share swoons in the next downturn.

Stock Price Reflects a Recession Repeat
In arriving at our downside scenario, we use the 2008-10 period as a template for the next three years. This reflects the material drop in revenue and earnings, as well as a quick recovery for the firm. For Parker, this translates to a 20% drop in revenue and a 50% drop in earnings for the next two years. Revenue would not return to 2011 levels until June 2014. Undoubtedly, this is a dire scenario, but surprisingly generates a fair value estimate of $76 per share in our discounted cash flow model, all else equal. This valuation is far closer to current price levels than our current fair value estimate of $100 per share, indicating to us that the market still believes this is a more viable scenario for Parker. Given that the recession of 2008-09 was the toughest period we have seen since the Great Depression, it takes a leap of faith to believe that an event of this magnitude will happen again in the next several years. That said, even if you think that is going to happen, Parker is essentially trading at this pessimistic-case evaluation today.

During the last two quarters, Parker has bought back nearly $1 billion of its own shares, or roughly 10% of its own market capitalization. The share repurchases have been accretive to our valuation. It is difficult to ignore a company that elects to pass up competitively bid acquisitions to purchase its own cheap stock. Moreover, having the discipline to pass on inflated acquisitions marks a mature management team geared toward creating value for shareholders.