Parker-Hannifin Corporation (PH) Q2 2011 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Second Quarter 2011 Parker Hannifin Corporation Earnings Conference call. My name is Katelyn and I will be your operator for today. [Operator Instructions] I would now like to turn the presentation over to your host for today, to Ms. Pam Huggins, Vice President and Treasurer. You may proceed.

Thank you, Katelyn. Good morning, everyone. This is Pam speaking just as Katelyn said. I'd like to welcome you to Parker Hannifin’s Second Quarter Fiscal Year 2011 Earnings Release Teleconference. Joining me today is Chairman, Chief Executive Officer and President, Don Washkewicz; and for the first time, Executive Vice President and Chief Financial Officer, Jon Marten. For those of you who wish to do so, you may follow today's presentation with the PowerPoint slides that have been presented on Parker's website at www.phstock.com. For those of you not online, the slides, they’ll remain posted on the company's Investor Information website, again at www.phstock.com, and they'll be on there for one year after today's call. So at this time, if you'll reference Slide #2 in the slide deck, this is the Safe Harbor disclosure statement addressing forward-looking statements. No different from prior quarters. If you haven't already done so however, please take note of this statement in its entirety. This slide, as required, indicates that in cases where non-GAAP numbers have been used, they have been reconciled to the appropriate GAAP numbers and are posted on Parker's website. To cover the agenda for today, on Slide #4, the call will be in four parts, as usual. First, Don Washkewicz, Chairman, Chief Executive Officer and President, will provide highlights for the quarter. Second, I'll provide a review, including key performance measures of the second quarter concluding, of course, with what you're most interested in, which is the revised 2011 guidance. The third part of the call will consist of the standard Q&A session. And for the fourth part of the call today, Don will close with some final comments. So at this time, I'll turn it over to Don and ask that you refer to Slide #5 titled Second Quarter Fiscal Year '11 Highlights.

Thanks, Pam, and welcome to everyone on the call this morning. I'd like to start off by pointing out that this is Jon Marten's first call as Chief Financial Officer of the company, and we're very excited to have him participate in this meeting this morning. Jon has been with Parker for 24 years and has distinguished himself as a leader within our organization with extensive experience throughout our operations. Jon also has worked closely with our senior leadership team, which has prepared him well for this next step. He is very much looking forward to meeting many of you in the coming months. And as I understand it, Pam will be introducing Jon to many of you in their travels this coming month. So to start the call, I'd like to take a moment to point out some of the highlights of the quarter. Maybe just an intro comment, I think we had just an outstanding quarter for the company. We set quite a few records. I'll cover some of those with you now. Sales were a second quarter record and increased 22% from the prior year quarter. Orders increased 29%, indicating that the economy continues its recovery across many markets. You can see obviously that we're building backlog and that 29% is greater than the 22% increase in sales in the quarter, so that bodes well for the future. Also, a little later in the call, I'll touch on some of the markets and what we are seeing in some of the various markets and regions around the world. Net income was a second quarter record at $232 million and it really basically doubled compared with last year's second quarter. And diluted earnings per share was a record as well at $1.39 and well ahead of our expectations.…

Thank you, Don, and welcome to everyone on the call. I just wanted to take a few moments to tell you how excited and honored I am to be leading the financial strategy at Parker. I've spent 24 years at Parker and I can tell you that there's never been a more exciting time to be a Parker employee and an even better time to be in a position where I get to tell our story on a regular basis. I'm very much looking forward to getting out to meet more of you in the next month or so. As Pam will highlight for you in a moment, this quarter marks yet another quarter where we have been able to demonstrate consistent execution and performance against our objectives. We have tremendous management talent within the company, and have a long track record of being able to deliver on our commitments that extends over the past decade. That same team, helped by all Parker employees, has allowed us to both perform better and recover more quickly from the past recession than in any previous recessionary period. Secondly, I would like to point out that the company has tremendous opportunities for growth well into the future. We have a growing pipeline of very exciting new products and technologies that is being developed. We are making investments in emerging markets, which will allow us to capitalize on all of our growth opportunities, and we have the financial flexibility to invest in acquisitions that can enhance our already strong position in our markets. Perhaps most importantly, we have a focused strategy that helps bring us direction to our efforts. The Win Strategy has set clear expectations for performance across our organization. The Win Strategy provides our businesses with the tools that allow them to be successful and it is a primary reason that we have been able to deliver such consistent revenue growth, margin expansion and returns over time. Once again, I'm excited to take on such a critical leadership role in Parker. And now, I'll hand things over to Pam, who will run through the details of the quarter. Pam?

Thanks, Jon. So at this time, please reference Slide #6 and I'll begin by addressing earnings per share for the quarter. Earnings per share for the second quarter increased $0.75 from same quarter a year ago and came in at $1.39, which is on the press release this morning. This represents an increase of 117%. On a sequential basis, their earnings per share of $1.39 exceeded expectations and compares to $1.51 last quarter. Realignment expenses in the quarter were only $2 million, $1 million net of tax or $0.01. And this compares to $7 million, $4 million net of tax or $0.03 for the same quarter a year ago. Incremental marginal return on sales was 31% for the quarter and just as a reminder, marginal return on sales is the difference in segment operating profit divided by the change in revenue for the quarter on a year-over-year basis. So now if we can move to Slide #7, laying out the components of the $0.75 increase in earnings per share from $0.64 to $1.39 for this quarter, and this is on a segment basis. The significant puts and takes are as follows: revenues increased 22% in the quarter, largely driven by the Industrial segment and Climate and Industrial Controls. However, increases in revenues were seen in all segments of the business. As a result of higher revenue, operating income year-over-year was significantly higher in across all segments, generating a positive EPS impact of $0.71. This significantly higher operating income produced record second quarter margins in North America, overall Industrial and for the corporation in total. As Don said, year-over-year, margins increased to 14% from 10.4% for the same quarter last year. While corporate, general and administrative expenses increased year-over-year due to incentives and impacted EPS by $0.03, the percent of sales…

[Operator Instructions] Your first question comes from the line of Nigel Coe of Deutsche Bank.

Don mentioned normally that margins are weaker Q over Q in 2Q and certainly history suggests that. But please explain conceptually why when revenues are higher Q on Q why the margins will be down?

Between what quarters are we talking about?

Well, I'm just saying that normally, we see shutdowns and lower revenues in 2Q versus 1Q but your revenues are actually higher this quarter but your margins were down over 100 basis points. So I just want to understand why the margin would be so much lower?

Typically, the second quarter is our worst quarter for the company. And as we're coming out of this recession -- too, of course, you have the holidays in there, we have a lot more expense in there, a lot of extraordinary things going on and not a whole lot of activity in the quarter. So when we come in with margins like this -- by the way, this 14% margin that we had in the second quarter really was only beat by 1/10 of a point and in fiscal '08 at our peak when we were going to full steam ahead. So we are popping champagne corks here when you’re we’re coming at these kind of numbers in the second quarter, because typically, this is a lousy quarter for us because of all the expenses and that. But we're happy with that. We still came in with a incremental margin of 30% overall for the company. And with a high --International group, actually, came in at almost 40% incremental so we're pretty excited about that. So all-in-all, I think a lot has to do with the extraordinary cost in the quarter and that's typical in the second quarter. As then as we climb out of this recession, we're seeing a higher percentage of OEM business as a percentage of after-market business because the after-market has been doing fairly well all along. Still continues to do well, but the OEM is starting to come back stronger now across many of our market segments. Hopefully, that gives you a little bit of color on that.

It does. And just a clarification, the International, and North America Industrial margins diverged this quarter. I'm actually wondering if you can give some color to that and maybe talk about how capacity utilization looks especially in Europe versus North America right now.

One of the things that we saw this quarter is that typically, international will lag or Europe will lag North America. And so when you look at this quarter and you really dissect it, what you see is that international is coming on. They're finally seeing what North America saw a little while ago. So when you look at just Europe's income versus their sales in this particular quarter, the income was very strong. And then of course, Asia continues to do very well. So we're starting to see the effects of Europe coming through, which we knew we would. Typically, when we come out of a recession, Europe will always follow North America and now we're seeing that happen.

Your next question comes from the line of Eli Lustgarten of Longbow Securities.

Can I get one clarification on this tax rate of 27% for the rest of the year that says that the second half is like 28%, 28.5%, and as it continues to 2012, I mean, you're R&D tax credit I assume that’s driving most of it.

Yes, Eli, what really took place as far as the tax rate, the tax laws, you know what happened. I mean, we had the enactments and there's two components of that. The first component is obviously the research and development. So there's a catch up on that because you're really getting six months from last year and then you're getting the six months of this year. So that's when you look at the 24% tax rate in the second quarter, that's playing into it. The other part of it is the subpart aft or what we call look-through provision on income overseas and we also had some benefit from that. So those are the two areas that really are affecting the tax rate. We had 29% and we brought it down to 27% this year for the full year guidance year-over-year.

This continues into next year? This will be the same thing next year?

We think so, but you never know. I mean, you never know what's going to happen. What I’d prefer to say is we'll look at that when we get to the beginning of the year. When we come up out our guidance, we'll make sure that we give you good numbers on that.

Looking at the volume particularly in North America, Industrial and International Industrial, order patterns have been much stronger for the last two quarters than the revenue number actually came in. You're only getting a 22% North America volume in this December quarter when your last couple of quarters have been 26% and 31% in orders. Were the orders coming in late? Is there something happening? And the incremental margin in North America only being 22%, is that cost being felt or is that just the timing of the seasonality?

I don't think there's anything happening in the orders, other than the fact that people are very much -- they're much more comfortable with this recovery. And I think as people become much more comfortable with the recovery, then they're willing to put orders out there. So the lead times, they're just willing to give us longer lead times, and everybody's not rushing to get everything today just to get it out, just to keep the customer happy. If you remember, we were getting a lot of orders, very short lead time in the beginning and now I just think people are comfortable with the recovery and so they extend them out. I don't think there's anything unusual.

And the incremental margin in North America being 23%, is there a cost versus price aspect there or is it just seasonality?

Eli, that's pretty much what we had said earlier. That's more of a mixed situation. We did have some additional cost involved with some of our innovation programs that we've got going on so we've funded them a little bit more because we're ramping up production especially on energy recovery type systems. So we’re pouring more development costs into that area to ramp that up. So it's really mix; it's innovation. And I think what I'd point out is don't get too focused on the one quarter because if you look at the rest of the year, you know that 22% turns into 25% and then 33%, so it builds out throughout the balance of the year. We end up in North America at about 31% incremental for the year, which is still above our target of 30%. So this is just a one month. And typically, the second quarter is typically lower performance anyway. But those would be some of the reasons for that.

Your next question comes from the line of David Raso of ISI Group.

Just trying to understand the guidance. You've got orders up 29% right now for two quarters in a row. You just put a sales growth of 22%, but the back half of the year, the sales growth guidance is only 12% for the whole company so I'm just trying to square that up. And probably the more importantly, the incremental margins just came in at 30%, 30.5% to be exact and you're planning the back half of the year to accelerate to 35%. And obviously Aerospace, you've run into the numbers, is the biggest driver. But can you give us a little more comfort on why as your sales growth slows should I believe your incremental margins get better?

David, let me tell you. When you're coming out of a recession like this and orders are accelerating the way that they are, I mean, there's some noise in there because people are really trying to -- we just went through a huge restructuring effort, the worst recession that we've ever gone through. And so people are trying to ramp up to be able to supply the demand. So really, they're struggling to meet the demand in a restructuring environment to some extent. And so there is some noise in there. They're going to work through this because as you can -- we bring temporaries back, we're bringing employees back and we're right in the midst of where we're bringing those people back to be able to satisfy the demand. As we get out into the second half it's going to be a much stabler environment.

Can you help us with some quantification now, what were some of the inefficiencies in this quarter that get alleviated? And I also know in the channel, you put a pretty healthy price increase through January 15. So can you at least help us in some regard what hit the second quarter that was a little bit one-time in inefficiency? And how we should think about price versus cost and improved efficiencies going forward again to believe incrementals get better as sales growth slows?

Just a couple of things in the second quarter. As we really look at that data, as we continue to ramp up, and as you noted, sales are sequentially up in Q2. But as we continue to ramp up from a very, very deep recession, there are some one-time type costs that would always be incurred: additional overtime; additional shipping expenses; trying to get an efficient network built back up from a supply chain standpoint. And in any upturn of this magnitude and you’ve got to remember how far down we were two years ago, any upturn, we're going to -- as we stretch the supply chain, as we try to make sure that we are -- have all the efficiencies in the network, every once in a while, we will have some lift. And this is historically true. So you've got those one-time efficiencies in Q2 that come up. But just as importantly, as Don said, there is a, and always has been, a seasonality effect in our Q1 to Q2 sequential margins for the company. And although our revenue is up this time, normally it is not down that much in the prior periods either. Now you're also right in terms of the second half. The second half is going to include those price increases that we're seeing worldwide throughout the channels, and that is going to help with our margins here for the second half and really going to help drive our MROS, too.

Is there any way to quantify that second quarter inefficiency? I mean, if I look at a $25 million hit from inefficiency, that would get me to the quarter. It would've been 35% incremental, say a little bit more worth impulsive thinking.

I would hate to try to quantify that for you because there's more than one real issue there. There is some inefficiencies, there's the mix that Don talked about and there's several other factors too. So in trying to answer your question, it's hard to really kind of give you a specific number there. But in considering everything that is happening, and considering all the dynamics with the marketplace and what's happened in Q2, we took all of that into account as we put our guidance together. And so we feel like the second half is very fair. And we feel like we've got it all baked into the second half guidance.

If the revenues, for argument's sake, are conservative, Don and Jon, everybody, if the revenue did surprise the upside versus the 12% guidance for the back half, which at the moment, given the orders and other things, say, maybe it could, should I expect that to flow through to even better incrementals? Or are you going to keep having to add incremental bodies or whatever incremental costs where that incremental margin guidance is what it is and if there's revenue upside, there's not an incremental margin upside because you’re literally at par.

Yes, David, right now, we are giving you for the year, 35%. And I would say that if we increased business, I think our targets here and what we've got the entire organization geared to is a 30% number. And I would feel very comfortable that we're going to do 30% overall as a company on increased volumes. So if you want to project higher volumes than we're giving you here, that's certainly something you can do. But I would use something around a 30% incremental. I think that would be fair and I think that's very achievable.

Your next question comes from the line of Terry Darling of Goldman Sachs.

Don, I wonder if you could start talking about the M&A landscape, a little bit obviously the balance sheet, you've got yourself in a position to do some things there, but it's been still pretty quiet this past quarter. Where do you see the pace of activity there as we evolve through 2011?

We don't forecast the acquisitions. We did a couple earlier in the year. We did one recently. We've got about $65 million or so in sales, new sales volume coming on. Of course, we'd like to do a lot more than that but we're going to be prudent as to what we actually pursue and then how much we pay. So there are a number of them. I can say throughout the entire organization, every one of our operating groups and many of our divisions are involved with looking at a variety of different opportunities. We've turned down some, obviously, some bigger ones because we just weren't going to pay what they wanted for them. We were able to land some of these smaller ones, which were very strategic and more of what I consider tuck-in type of acquisitions. We're looking at more of those. So it's hard to say. But I can say this, we're definitely looking and we've got the entire organization geared to bringing on more acquisitions before the end of the fiscal year and then on beyond that.

Don, appetite for larger deals, are you still thinking more bolt-ons or is there a potential to do some larger deals?

Our sweet spot would be, I would say, up to maybe $250 million. We've done some that were larger than that on occasion, rare. But say, $50 million to $100 million to $200 million would be kind of a sweet spot for us. When we say large around here, it's going to be $1 billion or more. I'd say that the appetite for those would be less and would have to be very strategic for us to consider and culturally, it’d have to be a perfect fit before I’d take that kind of risk. That's not to say that we wouldn't look at it. We would, but a lot of things would have to be in alignment before we would pursue that. So I think more what you’d be hearing from us would be up to the $250 million kind of levels.

On dividend, any thoughts there? Your payout ratio quite a bit below, where others in the peer group are. You focus more on acquisitions. Obviously, that's been a good strategy for you. But any change in taking out a dividend?

Yes, we're definitely looking at the dividend. As you know, we've increased it the last several quarters and we'll be reviewing that again. And as, of course, the stock price goes up, we want to make sure the percentages stay in alignment as far as the yield. So we will be looking at that. And I would anticipate that there would be some change in the dividend going forward. And like I said, we'll have a board meeting coming up this next week and we'll be making those decisions then and you will hear from us. But we are focused on the dividend. We want to make sure that we're about at the median of the peer group as far as payout and yield. And over the cycle, we'd like to pay out about 25%. So right now, it's a little bit low. When things were bad, it was a little bit over that so we're trying to maintain that discipline. So I think to answer your question, you're going to see some changes there going forward.

And might as well ask you about buyback while we're going through all of those capital allocation items.

Yes, we're buying back -- as you know, we are buying back some every quarter. We buy back about 20 million, do about 80 million a year in buyback; we're active at all times in that respect. Our focus as far as the cash deployment goes is going to be more on acquisitions if we can possibly do them, maintaining of course the dividend, like I had mentioned just earlier, and then shoring up any pension shortfalls that we might have. We want to make sure that the pension is in good shape and putting money into growing the business. But that's kind of where our priorities are going forward.

Your next question comes from the line of Jeff Hammond of Keybanc Capital Markets.

Pam, I was wondering if you could quantify the sequential growth in the order rates and maybe just speak to a couple of end markets or geographies that would be driving that acceleration?

Sure.

I said I would give you a little bit of a market overview earlier and I can kind of run through some of what we're seeing here. I think what obviously we're all seeing is that the economic recovery is really kind of in full swing here. And for us, it's really kind of unique in that all segments pretty much across the company and all regions around the world are seeing a very nice turnaround. And that's pretty much evidenced by those order rates that you saw in our press release, I mean, it’s pretty much uniform across the board. Just a little bit of regional growth commentary, North America, of course, is still accelerating. Europe, as you may recall, lagged North America coming out of the recovery but we're seeing greater improvement in Europe and in international versus North American in the second quarter, and we expect that to continue going forward. Latin America slowed a little bit from a high rate that we had in earlier periods, but they were one of the first ones to really bounce back pretty strong. But they're still doing -- I don't anticipate anything negative coming from that region of the world. I think it's still going to be doing just fine going forward. Asia has continued to be one of our strongest regions. We're expanding there; we're adding more capital and putting more fixed assets in Asia: in China and in India particular. The backlogs we talked about, backlog, right now, is up 7% over the prior quarter and it's up 14% over the first half. So we've got a pretty strong backlog in place. Talk a little bit about the ISM. I know some of you track the ISM. The ISM index has been very favorable and North America…

And Pam, did you have the sequential growth in orders?

Yes, I do. First quarter to second quarter is up 3%, international, leading the pack. Of course, they're all pretty much similar. Aerospace, you really can't look at first quarter to second quarter because as you well know, the Aerospace business is pretty lumpy. And that's why we report it on a rolling 12 when we report the orders. But first quarter to second quarter for the corporation, 3%.

Your next question comes from the line of Stephen Volkmann of Jefferies & Company. Stephen Volkmann - Jefferies & Company, Inc.: I just wondered if we could tunnel into Aerospace just a little bit, that was quite a bit stronger than what I was expecting obviously. It does seem to be turning. But given that it's a 12-month trailing, should number -- the quarter must have been very strong on the order front, what do you think is driving that and how should we think about that going forward?

I'm going to let Jon Marten. Jon Marten, his background, he worked at Aerospace so I'm going to let him answer this.

Stephen, I think you're right in that there is a recovery being reflected in the numbers there. Orders, of course, on the 12-month lag, are showing very good trends. Revenue passenger miles were showing by our analysis up more than 5%. Available seat miles are showing up more than 5%. So we're seeing growth really throughout the commercial revenue streams here that we have in Aerospace. That's being led right now by the maintenance repair, the overhaul and the spares that we're shipping commercially and that we're projecting to ship commercially. So we are seeing a turn there and we're seeing very positive trends when we look at that sector of the Aerospace business. Stephen Volkmann - Jefferies & Company, Inc.: I guess the flip side of this is I was a little disappointed in the CIC margins, the incrementals are pretty de minimis there. It feels like we've just been trying to get that business on track for so long. Is there a point at which we sort of fish or cut bait there? Or is there something that needs to be done that's sort of bigger than what we've been doing? Or how do we think about that?

We've certainly been working hard on it. We still have some segments that are down. If you look at the incrementals, the first quarter wasn't bad. We're at about just under 25%. Second quarter, we're at about 9% and, of course, that was impacted by some of the turnaround in their markets since, of course, the second -- the turnaround and of course trying to keep up with some of the turnaround is what I meant by that. They are also impacted by the housing starts. Of course, no one's building houses right now that I know of. We are still restructuring in that group and you will see the improvement that we're showing throughout the balance of the year. I think we'd go on a third quarter guidance is around 18% incremental and then we get up to fourth quarter is a big incremental. It's about 80% incremental. So we're going to average in that group about 23%. Not to where we'd like it to be. We'd like it to be 30%. But considering all the restructuring that they have been through and the reorganization that they've been through, it's respectable. It's not, like I said, 30% but it's approaching those kind of levels. Stephen Volkmann - Jefferies & Company, Inc.: I guess what I'm hearing is no appetite for potentially finding another owner for certain parts of that business.

Well, right now, we're staying focused on trying to build the business. And we consider the majority of that group as very strategic for the company and we have an industrial Valve business embedded in there. We think the Refrigeration business is strategic for us. So yes, I think we're going to stay in -- for the most part, we're going to stay in the key components of that group for the extended foreseeable future.

Your next question comes from the line of Alex Blanton of Clear Harbor Asset Management.

I'd just like to say before I ask my question that it strikes me that the 30% incremental margin level, when your actual overall margin is 15% is quite good, and I disagree with the comments that have been critical of that as not being enough. But let me ask a broader question. What is your sense of your customers' willingness to order and your own willingness to invest in order for expansion of the business? Given the change in the political climate that's taken place since the elections and the indication that there might be a somewhat more business friendly environment in Washington going forward in 2011, what's your sense of what your customers are thinking?

I think what's happening, Alex, is a very good point. I think, and we talked a little bit about this in last quarter's call that the elections were ahead of us. I think there's a lot of upbeat discussion going on right now. There's a lot of positive commentary about the future. I think our customers are expressing that. I think that's being witnessed or evident in the order trends that we're seeing. I think there's a lot more interest in investing in the business. And I think that's translating into more business for us and that's pretty much across the board. So I think it's been a positive event. November was a positive event. And I think it's going to continue strong going forward, and I think that's what we're pretty much seeing and that's what's in our guidance here.

Alex, I think you bring up a good point. I think across the corporation, we're really seeing where people really are willing to spend. The balance sheets are extremely strong. People have a lot of cash on the balance sheet. I can see it in some of our product lines that typically when the OEMs aren’t ordering were down; those are coming back. Very anecdotal but I just heard of a situation the other day where someone was ordering 1,000 machines basically just to produce the iPad. So yes, I think that we're seeing it across the corporation everywhere you look. So yes, I think you're exactly right.

Who is ordering 1,000 machines?

I'm not going to say. I just said that was very anecdotal and I've heard of someone, but I prefer not to mention who that is. I don't think that would be fair.

But Alex, you did hit on a very good point when you just started out and maybe I'll just reiterate that point. If we do what we just projected that we want to do for this year, it'll be the first time I think in history that we hit 15% operating margin for an entire year, the first time in the history, in the 100-year history of this company. So what you said earlier, I guess, I wasn't even thinking along those lines, but I just thought I'd to point that out that with this guidance that we just gave, it’s 15% operating margin with a 35% incremental; we think that's pretty strong.

Your next question comes from the line of Henry Kirn of UBS.

Could you talk about where OE versus non-OE margins stand today, and maybe what that impact was, quantified in the second quarter, and what we should expect going forward for the mix shift?

Henry, we really can't quantify that for you. That's very difficult for us to do, just the way that we're structured, the way we're organized, the way that we report. But we know; we obviously are talking to our group, talking to our customers. It's a very difficult thing. I think that in the last downturn, if you recall, when we first came out of the recession, it was the mobile market that came back fast and furious. This time, a little bit different. Industrial came back first and now we're just seeing the mobile market and the OEMs in connection with that really taking hold.

Typically what we've used in the past, this is Don, is about a 10 point delta. That's just kind of a rough cut. You go to any particular OEM and any particular after-market product is going to vary. Remember, we’ve got one million products to track and 500,000 customers. But you can use kind of a rule of thumb that our after-market business brings about 10 margin points more higher margin then OEM business, if that'll help you.

I guess in your head, how much of a negative impact do you see that in the forecasted second half margins?

In what, the OEM portion?

How much of a mix shift negative impact is in your head as you come out with the second half margin guidance?

We're looking at the second half margins, actually the margins are getting better. So the mix is going to be overall with our cost structure and the sales trends that are going on, our margins are going to be improving from that 14% to, I think, 14.5% in the third quarter and almost 16% in the fourth quarter. So I'm not thinking we're going to have a big headwind because of OEM margins. I think, again, because of the second quarter is traditionally our worst quarter as far as margin because of all the additional costs. And of course, the OEM is picking up steam here a little bit, but that's going to get washed out as we go forward. And I think if we finish at 15.9% in the fourth quarter, it's going to be a pretty nice year for us.

Your next question comes from the line of Andy Casey of Wells Fargo Securities.

Back on the implied second half incremental margin commentary, I'm still trying to understand how Parker is going to maintain the incremental margins, which to Don's earlier point, is really a changed response for the corporation than what has happened in past cycles. So I'm hoping you can comment on some of the headwinds outside of the one that you just talked about with Henry that may offset the channel pricing commentary referred to earlier.

Andy, let me just say something about the incremental. When you look at the second half incremental margins, you have to remember, Aerospace is coming in extremely strong on the incremental margin side. So it's boosting that somewhat. And I think we can all agree that Aerospace is coming on pretty strong. When you look -- if you break it down by the segment, and as I talked about, International is coming on now. So Aerospace is the strongest, which is really boosting up the 35%, then we have International. And then North America, quite frankly, is a little bit below the target. So you got to keep in mind, when you're looking at the 35% second half margins, that a lot of it is being boosted by Aerospace.

Externally, we are also seeing some potential upward pressure on input cost trends and spot conditions, maybe some supply chain issues related to market demand acceleration.

Andy, we're seeing all of that. There's no question. We're seeing from a pricing input standpoint, we're seeing increases pretty much across the board. But nothing different than what we saw in FY '07 and FY '08 as we're ramping up and reaching those peak levels of output, and we managed those very effectively. Now it doesn't mean that isn't a challenge for us; of course it is because we have to be right on point as far as raising prices and passing those increases on. We've done it extremely effectively in '07 and '08 when we went through this. I think what you're going to see is probably some surcharges on some materials if the materials get too out of hand in between price increase, difficult times when we had raise prices, we're going to have to probably go back to the surcharge route because we're not going to absorb these increases, that's for sure. We can't absorb them and we're just going to have to pass them on and we're going to have to be really diligent about that like we were when they came up -- when they were ramping up the last go around. And we managed that pretty well back then if you recall, back in '07 and '08 when these raw materials were increasing pretty readily. So I think we're going to be able to manage it okay and I think we're going to be able to maintain these margins appropriately.

Andy, the other thing to be aware of is we do have $0.07 of restructuring in the third quarter and there will be some benefits that flow through into the fourth quarter. So we've had $0.02 in realignment year-to-date; we're having $0.07 in the third quarter and then $0.02 in the fourth quarter. So there will be some benefits as a result of that.

Your next question comes from the line of Jamie Cook of Crédit Suisse. Jamie Cook - Crédit Suisse AG: It is correct to assume when we think of your incremental margin forecast in the back half of the year relative to what we were seeing last quarter. Now we're hoping for mid-30s; whereas before, we were thinking of incrementals north of 40. So to be clear, the inefficiencies and price stuff -- headwinds that we saw in the second quarter, we expect to some degree to that to continue to the back half of the year. Because we're inherently lower incremental margin forecast, aren't we or...

No, that is true, Jamie. You're right about that.

When you look at the incremental margins, let's just kind of walk through them: North America, second quarter, 22.7%; third quarter, 24.9%; fourth quarter 33%. So that's kind of climbing up. International, 39.6%; second quarter, 35.1%; third quarter, 34.9%. Pretty flat between third quarter and fourth quarter at International so that's hanging in there pretty good. For our total Industrial going from 31.5% in the second quarter to 34.1% so actually going up. Aerospace, we mentioned that was strong. Aerospace is going from 38% to 73% in the third quarter to 59% or almost 60% in the fourth quarter. And then the last one would be CIC going from 8% in the second quarter. And we've mentioned that earlier that they're actually on the low side here. We’d like to see it much higher; going to 18% and then 84% in the fourth quarter. So actually, the margins are going back up, the incremental margins. We're going to finish the year at 35.3% which is pretty strong. Jamie Cook - Crédit Suisse AG: I know but the incremental margin forecast, things have gotten where your ability to pull through…

You mean because they're not 40%? Jamie Cook - Crédit Suisse AG: Well, that's what you guided to last quarter.

When we got up in the 40%, 50%, a lot of times what you're seeing, just like what you're going to be seeing here with the CIC group is that they had a lot of restructuring. Well, when you're doing the restructuring, you have a lot of costs that you're absorbing in that period when they’re doing the restructuring and the benefits come in the subsequent quarters. That's what we have seen in the past. When we had a lot of restructuring going on, obviously, that hurt that quarter but we benefited in subsequent quarters. I think you're seeing some of the same thing going on here. Jamie Cook - Crédit Suisse AG: And just the price increases, the catch up, is that materially impacting the fourth quarter more than the third quarter? That's the way to think about it?

Yes.

Yes.

Your next question comes from the line of Mark Koznarek of Cleveland Research.

On the Aerospace part of the business, very impressive acceleration in the margin here in the quarter. And there was some mention about recovery in costs or lower expenses of some of those reimbursable R&D dollars. Can you comment on that a little bit more about sort of whether just kind of clarify that a little bit more? I mean, obviously we see what the margin target is for the full year and I'm just curious as to whether the improvement was largely due to this MRO shift that was mentioned earlier? Or what kind of benefits are we getting from that reimbursement?

Let me try to answer that question here for you. First of all, we did mention that NRE reimbursement last quarter and in fact, we did get an NRE reimbursement that was recorded in the month. But we also had other transactions that really ended up going the other way on us like we do every quarter. And so I will not say that, that one transaction really has a major material impact here on the quarter. One of the things that we were focusing on is if you really look at the margins and the recovery in Aerospace, it is really kind of being driven by the commercial after-market. And so with that improvement, and with the relatively flat nonrecurring expenses to support all the wins and all of the businesses that we've gotten over the last several years totaling $18 billion, those nonrecurring expenses we're seeing starting to flatten out here over the year and be relatively close to how we actually look at the year at the beginning of the year. And so when I look at the returns at the operating level, we go from 10 in Q1 to a little over 13 in Q2. And then we're really in the 15 range in the second half and that's what implied in our guidance. And so we just see a continuing trend upwards there. I would think that's the real pattern there that we're seeing that is very, very important to us.

Jon, you have pretty good visibility on those nonrecurring expenses. And as we sit here today, would a reasonable assumption be that they're going to be going forward pretty flat in dollars but start to moderate as a percent of sales?

I think that's a very good analysis. And in fact, that's the way that we're looking at it, Mark. So I think you're dead on there.

Your next question comes from the line of Robert McCarthy of Robert W. Baird. Robert McCarthy - Robert W. Baird & Co. Incorporated: Just really clarifications of stuff that's been handled, can you help us with the allocation of the $0.07 in the third quarter realignment across the segments?

International. Robert McCarthy - Robert W. Baird & Co. Incorporated: All of it?

Yes. Robert McCarthy - Robert W. Baird & Co. Incorporated: I want to ask the question about profitability guidance a little bit differently. You've strengthened your industrial outlook significantly. The overall full year margin outlook didn't change a lot. Some of that is apparently execution, I mean, compared to prior guidance, is proving a little bit more challenging than you hoped it would be. But you're also identifying very specifically stronger OE outlook and it sounds like a lot of that's in Europe. So in terms of where your guidance assumptions were a quarter ago, can you highlight the two or three OE markets that have accelerated or are showing faster acceleration than you were willing to bet on a quarter ago?

Robert, I think I wouldn’t pick any one or two. I listed, I think, six or seven of that are all coming back pretty strong. So I think OE in general was stronger than what we anticipate. I think that would be the way I would answer that question. And the other thing I would just mention on the guidance, I think, you were getting at our guidance and so forth. Our guidance for the second quarter was $1.20. We came in at $1.39. And take tax out, we're $1.27. So I think we feel pretty comfortable. We exceeded our guidance. The only thing I can guarantee on this guidance is that we're going to be wrong. We're going to be high or we're going to be low, but we're just not going to ever hit it on the head, but that's the only thing I can guarantee. But we felt pretty good coming in at $1.20 and then delivering $1.39. We thought that was pretty good even… Robert McCarthy - Robert W. Baird & Co. Incorporated: You should, Don. It was absolutely a good quarter. But when the elements of the forecast change, people, we just all want to understand that.

That's fair. Another thing is that Tim was sitting here last quarter and I think you may recall when Tim says, if you can remember the words he’s used, pray/go; all in. So let's not get ahead of ourselves here. And I think that the message was we increased the guidance tremendously last quarter and we just didn't want anybody get up too far ahead of us on that. And I think we still came out very well against where the Street was at, against where our guidance was at and we get paid for managing tax just like we get paid for managing everything else around here. So I think it's important to keep that in mind too.

Yes and what I would do is look at the two quarters together and look at what we said last quarter and then look at this quarter. And I think if you look at the two quarters together, you'll have a much better picture and I think you'll feel a lot more comfortable. I mean, we feel very comfortable that we're right; that we'll be able to make this guidance. So Don, let's just close, you had some closing comments.

Just to wrap it up, just a few closing comments. I want to, first of all, thank everyone that's on the call for joining us this morning. I also want to take the opportunity since a lot of our employees would be listening in as well to thank our global team for the record performance that we posted this fiscal year and for their hard work and all of their dedication in executing the Win Strategy, delivering the kind of results that we're delivering here. I'd also like to thank them for their continued commitment to serve our customers. As you know, everyone on the call knows how critical this is at this point in the cycle. This is where we gain market share typically, Parker Hannifin does because we respond to our customers' needs and that's so important today. And our employees are doing a great job of that. Our service levels are 90% plus, which is not easy to do when you're ramping up as fast as we are. So very excited about that, very pleased and I think the entire organization is doing a great job. So with that, I just want to, once again, thank everyone for participating in the call. And certainly, thank you for your interest in the company and Parker. And Pam will be around the balance of the day for any questions that you might have. Feel free to call in and she'll be happy to answer those for you. So goodbye, and have a great day. Thank you.

Thank you.

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Have a great day.