Parker-Hannifin Corporation (PH) Q2 2021 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by, and welcome to the Parker Hannifin Corporation Fiscal 2021 Second Quarter Earnings Conference Call and Webcast. At this time, all participant lines are in a listen-only mode. After the speakers' presentation, there will be question-and-answer session. [Operator Instructions] Please be advised that today's conference is being recorded. [Operator Instructions] I would now like to hand the conference over to your speaker today, Todd Leombruno, Chief Financial Officer. Thank you. Please go ahead, sir.

Thank you, Gigi, and welcome, everyone, to our earnings release webcast. This is Todd Leombruno, Chief Financial Officer. And joining me today are Chairman and Chief Executive Officer, Tom Williams; and President and Chief Operating Officer, Lee Banks. Today's commentary and the slide presentation will be accessible as an on-demand webcast on our investor information website located phstock.com, and will remain available for one year. If you move to Slide 2, you'll see the Company's safe harbor disclosure statement addressing forward-looking statements as well as non-GAAP financial measures. Reconciliations for any reference to any non-GAAP financial measure, is included in today's material and are also posted on our website at phstock.com. If you move to Slide 3, you'll see our agenda. We'll begin with Chairman and Chief Executive Officer, Tom Williams, providing some strategic comments and highlights from our second quarter. Following Tom's comments, I'll provide a more detailed review of our second quarter performance and review the components of our increase to guidance for the remainder of our fiscal year fiscal year '21. Tom will then provide a few summary comments, and we'll open the call to questions from Tom, Lee or myself. And with that, Tom, I'll hand it off to you.

Thank you, Todd, and good morning, everybody. Thanks for your participation today. Now before I move to Slide 4, I want to make a few opening comments. Calendar 2020 was an extremely difficult year to say the least, for all of us, both professionally and personally, and I hope all of you are staying safe. Our global team has come together like no other time in our history and has responded to this combination of a health and economic crisis. We've rallied around our purpose, in the Win Strategy, and we've showed that Parker is an exceptional performer even in the most difficult of environments. I'd like to take this opportunity beginning here to thank our global team for just great performance. And you're going to see evidence of that over the next couple of slides. If you go to Slide 4, one of our key competitive advantages our breadth of motion control technologies. We're now up to two-thirds of our revenue. You heard me talk about this as [indiscernible] 50%. We're now up to two-third of our revenue coms from customers who buy from four or more of these technologies. As these interconnected technologies that enable us to create even more value for our customers and create a distinct competitive advantage versus our competitors. If you move to Slide 5, we just had outstanding performance in the quarter when running through some of the highlights. Top quartile safety performance, we had a 23% reduction of recordable incidents. This now makes 75% reduction for the last five years, which has been phenomenal. Sales decline was 2.5% year-over-year. You can see it was a little over 6% from an organic standpoint. This was significantly better than our guidance and about a 50%-plus improvement from where we were in Q1. Q2 was a record net income at $447 million. The EBITDA margin was a little over 23% as reported or 20.8% adjusted. You can see the significant improvement versus prior 230 basis points. Year-to-date, cash flow from operations was a record at 20.4% of sales. And then the table to bottom there has got segment operating margin both as reported and adjusted basis, I'd call your attention to the adjusted row, 20.4% segment operating margin adjusted. And again, a giant increase versus prior, plus 250 basis points. So, there's a lot of numbers on this page. We have a lot of companies to track. So, the easy way to remember this is just the quarter we put up 320s. And we happen to highlight that in gold. So, greater than 20% EBITDA margin, CFA margin and segment ARPU volume. So, we're pretty proud of that, and those are all great results during a pandemic, so just a fantastic job on the whole team. If you go to Slide 6, we're going to talk about cash flow. Big cash flow quarter, paid down $767 million of debt in the quarter. If you look at the last 14 months, it's $2.8 billion of debt. This is a little over half of the acquisition that we took on with lower excise, which is great progress there. You see the ratios in the middle of the page there. Of significance, if we go back a year ago, we were 4.0 and now we're at 2.7% on a gross debt-to-EBITDA basis. And we've now reinstated effective in this quarter of Q3, our 10b5-1 share repurchase program. So, I'll move to the next slide, which is our transformation of the Company. And hopefully, just the last two slides are indicative of how the Company is transformed. But I'd like to give a little more color and context as to what we're doing. So if you move to Slide 8. This is our strategy summary on a page, and it's flanked on the left side with why we win, which you've heard me talk about this in the past, this is a list of our competitive advantages, and I've highlighted them. So, I'm not going to talk about them this earlier today. But there are historical success factors that will continue on into the future. I want to focus most of the time for my next couple of slides on where we're going. And I've got a slide on each one of these bullets. And the output of really this historical success factors and where we're going is that we want to be a top quartile company, and we want to stand out in the crowd, and we think we're doing that. So if you go to Slide 9. The one strategy and this is 3.0. This is our business system. Pound for pound, this has been the most impactful change we've made to-date to the Win Strategy. And it's going to be Win 3.0 in our purpose statement. They're going to be the powerhouse behind our future performance. Go to 10. You've seen our purpose statement, enabling engineering breakthroughs that lead to a better tomorrow. This is a statement that everybody has really rallied around. It found very expirational within the Company, has enabled everyone to connect their efforts to this higher calling, this higher purpose of life. And really it helps answer the question, how can we help through our customers, create a better tomorrow. And I think given what's going on with the coronavirus and the vaccine, Slide 11, is probably a great highlight of our purpose and action and just how essential we are to the vaccine value chain. And the way to read this slide to go left to right and go in a clockwise fashion was turning upper left-hand corner. So, we're in a development and production phase of these vaccines, mixing, purification, filtration and dispensing. Then you got to get the product moved around. So, we are in sterile transfer containers, especially designed. And then all of our motion control technologies are in both air and ground transportation to move the product around the world. We need to be able to store it locally and that requires low-temperature refrigeration, how our refrigeration technologies are in play there. Then when you administer to the patient, again, you need on-premise refrigeration, and then stoppers and trim seals as part of our engineered materials offering. So we're very proud to be part of this value chain, and through our customers helping to create the better tomorrow than all of us, as I start this call are striving for as we try to exit the pandemic and deliver billions of vaccines to people around the world over the next quarters and years. So if you move to Slide 12. My last slide for my opening comments, want to focus on our strategies to grow faster in the market. And our proxy for the market is global industrial production growth, which is skipping that acronym. So on the left-hand side, it's a series of portfolio of things that you've seen us make transforming a portfolio of the Company buying three great companies, $3 billion of acquired revenue that were all accretive on growth, cash and margins. As a matter of fact, as an example, LORD grew mid-single digits last quarter, while the rest of the Company, total company grew minus 6%. On the right-hand side, there is a list of organic growth strategies. And what's interesting about this list with the exception of international distribution, these are all new with Win Strategy 3.0. So, I'm going to make a quick comment on each one. So strategic positioning is really our effort to focus on stronger divisional strategies. And we have a cadence with every division. We do three a month, and these are extremely productive conversations with our general managers to how they're going to position their division to win versus the competition. Second, both in our innovation, we made two big changes. One is a metric PBI, which is product vitality index. It's a measure of new products as a percent of sales, looking at a five-year period for new product blueprinting, which is that NPP, acronym there, is really a change to our ideation process to create better ideas coming into the innovation funnel. The output of what we're trying to do here is that we want our PBI context a percent of sales, to grow by 600 basis points over the next five years, a more innovative portfolio, better chances to grow, better margins, et cetera. And then simplify design. I've talked a lot about that. It's a speed initiative. It's a cost initiative. It's a customer experience initiative. It's a recognition that 70% of your costs are tied up in how you design a product. And simple by design is all about focusing on design excellence. So when you put together design excellence with operational excellence, it's a dynamic pairing. International distribution is going to continue from the success we've had with 2.0. Digital leadership is really a four-pronged attack, digital customer experience, digital products, digital operations and digital productivity, and digital productivities where we have a concerted effort on artificial intelligence and debt analytics. And then lastly, a new our annual cash incentive plan acronym, ACIP, and that's going to focus our divisions and the whole company on driving growth cash and earnings. So, it's this combination. And it's this combination that's helped us performed better on the top line organically, particularly in the current downturn, and it will be our catapult to growing fast in the market as we go forward. So with that, I'm going to hand it back to Todd with more details for the quarter.

Thanks, Tom. I'd like to direct everyone to Slide 14, and I'll just begin summarizing our strong second quarter results. This slide displays as reported and adjusted earnings per share for the second quarter and I'll focus on adjusted earnings per share. We generated $3.44 this quarter, and that compares to $2.98 last year. If you look at the breakdown of the adjustments for the FY '21 as reported numbers, it netted to $0.03 this quarter. And that is made up in the following bucket. Business realignment expenses of $0.14, integration cost to achieve of $0.02; acquisition-related amortization expense of $0.62; and as we communicated last quarter, we are adjusting out the gain on the sale of land that amounted to $0.77. And all in, the net tax impact of all of those adjustments is $0.02. Last year, our second quarter earnings per share were adjusted by $1.41. The details of which are included in the reconciliation tables for non-GAAP financial measures. If you move to Slide 15, this is just a walk from the $2.98 to $3.44 for the quarter, and despite organic sales declining 6% and total sales declining 2.5%, adjusted segment operating income increased by $70 million or $0.11. That equated to $0.42 per share. So a very strong operating beat for the quarter. Decremental margins on a year over basis are favorable, demonstrating the excellent operational execution, robust cost containment by our team members really in every segment and every region. If you continue on the slide, we had a slight headwind from higher corporate G&A, just $0.02 that was a result of market-based adjustments to investment tied to deferred comp. And as Tom mentioned, our strong cash flow allowed us to pay off a significant portion of debt on a year-over-year basis that reduced our interest expense that equated to $0.12 for the quarter. And then, if you look at the remaining items, other expense was just $0.01 slightly higher. We had a higher effective tax rate that impacted us by $0.03. And finally, slightly higher diluted shares resulted in a $0.02 impact, that's how we get to the $3.44. If you move to Slide 16, this is a savings from our cost out actions. I know there's been a lot of questions on this, just from some of the early reports. Just a reminder, these represent savings recognized in the year as a result of our discretionary actions in response to the pandemic and volume declines, plus the savings we realized from our permanent reliant actions taken in FY '20 and also in FY '21. So if you look at this, our second quarter discretionary savings exceeded our forecast and now amount to $190 million on a year-to-date basis. We are now forecasting for the full year that discretionary total will increase to $225 million or an increase of $50 million. The majority of that increase was recognized in the second quarter and roughly amounts to $35 million above our forecast. Just a reminder, as demand continues to increase and our team's pivot to support growth, we expect these discretionary savings to be lower in the second half. Permanent actions remain on track. There's no changes to what we have communicated previously. Our full year forecast will generate savings of $250 million, and that will be $210 million incremental. And we believe that this will help us generate the strong incremental margin that we have in our guide for the second half. If we move to Slide 17, this is just a walk of the total results for the Company, sales and segment operating margin. And as Tom mentioned, organic sales did decline by 6.1% this year. The decline was partially offset by the contributions from acquisitions, that was 2.6%. And currency impact of 1%. And again, despite these lower sales, total adjusted segment operating margins improved to 20.4% versus 17.9% last year. This 250 basis point improvement reflects all the positive impacts from our Win Strategy initiatives, the hard work and dedication to cost containment and productivity improvements as well as savings from those realignment activities I just spoke of and really performance of the recent acquisition, so strong execution really across the entire the Company to get these results. If we jump into the segments, if you go to Slide 18, looking at diversified industrial North America, sales there declined by 5.9%, acquisitions were a plus of 3.1% and currency only slightly negatively impacted sales. But again, even with these lower sales, our operating margin for the second quarter on an adjusted basis increased sizably to 21.3%. Last year, it was 18.2%. So again, another impressive 310 basis point improvement focused on our long-term initiatives around Win Strategy, along with the productivity improvements, diligent cost containment actions and really some increased synergies we're seeing out of the LORD acquisition. So if we go to the next slide, Slide 19, for Diversified Industrial International. Organic sales for the quarter increased by 3.1%, acquisitions added 3.2% and currency accounted for 3.5%, again, strong operating performance here. For the quarter, we reached 20.3% of sales versus 16% in the prior year. And again, same story, Win Strategy initiatives, strong synergy growth and really our teams around the world rally together in light of the pandemic. If we go to Slide 20 and talk about Aerospace Systems Segment, and again, what we'll see here is a decline of 20.9% for the quarter, acquisitions helped us by 0.4%. And again, a small currency impact of 0.1%. Really, declines in the commercial businesses, both in the OEM and aftermarket end markets were the main impact. These were partially offset by higher sales in both military OEM and military aftermarket sales. Operating margins for the second quarter was 18% versus last year's 20.2%. This resulted in a decremental margin of 28.8%, which is in line with our expectations and really the result of all the previous actions we've taken to realign the aerospace business to current market conditions, along with strong cost controls and really helping to offset the pandemic composed of a mix that we're seeing from the commercial and military businesses. Slide 21 is just some highlights on cash flow. Tom already mentioned this, but our operating cash flow activities increased 64% year-over-year to a record of $1.35 billion of cash. This is an impressive 20.4% of sales. Our global teams are really focused on this, very disciplined in managing our working capital across the world, and we're really focused on delivering strong cash flow generation. If you look at free cash flow, year-to-date, we now move to 19%. That's an increase of 78% versus prior year, and our cash flow conversion is now 1.64% versus 130% last year, so just strong cash flow performance from the team, very impressive results. If we wanted to just focus on orders real quick, moving to Slide 22, our orders came in at flat this year or this quarter, I should say, and that was really driven by plus-one in our industrial North American businesses, plus 10 in our diversified industrial businesses and minus 18 on a 12-month basis in aerospace. So all in, we came in flat. And that's the first time in seven quarters I believe that members have been not negative. If we move to Slide 23 and the guidance, obviously, we have a pretty large guidance increase. We are now providing this on an as-reported and an adjusted basis. And based on the strong performance we just spoke of in the first half, all the current indicators that we see right now, we've increased our total outlook for sales to a year-over-year increase of 1.7 at the midpoint. This includes a forecasted organic decline of 3.4%, offset by increases from acquisitions of 2.9% and currency of 2.2%. And again, just a reminder, we've calculated the impact of currency to spot rates based on the quarter ending December 30, and we held those rates steady as we look through the second half of our fiscal year. In respect to margins, for adjusted operating margins by segment, at the midpoint, we are now forecasting to increase margins 150 basis points year-over-year, and that range is expected to be 20.2% to 20.4% for the full year. And if you note for items below segment operating income, there is a fairly significant difference between the as-reported estimate of 3 88, and the adjusted forecast of 4 87. The difference is that land sale that we spoke about, that's $101 million pretax, $76 million after tax. That was recognized as other income in Q2. And since that's an unusual onetime item, we are going to adjust that from -- we have adjusted that from our results. Full year effective tax rate, no change, we still expect that to be 23%. And for the full year, the guidance range for earnings per share on an as-reported basis is now $11.90 to $12.40 or $12.15 at the midpoint. And on an adjusted per share basis, the range is now $13.65 to $14.15 or $13.9 at the midpoint. Adjustments to the as-reported forecast made in this guidance at a pretax level, include business realignment expenses of approximately $60 million for the year associated with savings projected from those actions to be $50 million in the current year. And acquisition and integration costs to achieve $50 million of expense. Synergy savings for the LORD acquisition are now projected to reach $100 million. That is an increase of $20 million from our prior stated numbers of $80 million, and that is included in our guidance. Exotic synergies remain and expected to be $2 million for the full year. Just a reminder, acquisition-related intangible asset amortization expense is forecasted to be $322 million for the year and some assumptions that we have baked into the guidance here. At the midpoint, our sales are divided 48% first half, 52% second half. And both adjusted segment operating income and adjusted EPS is split 47% first half, 53% second half. For the third quarter of FY '21, we are forecasting adjusted earnings per share to be $3.54 at the midpoint. And that excludes $0.57 or $97 million of acquisition-related amortization expense, the business realignment expense and integration costs to achieve for the quarter. So if you look at -- move to Slide 24, this is really just a walk from our previous guide to our revised guide. We had guided at $12 per share last quarter, based on the strong second quarter performance, we exceeded our estimates by $1.06. And we mentioned this, but the improving demand environment, along with the strong operational performance. Some additional extended discretionary savings, the permanent restructuring savings and increased LORD synergies, we feel confident in raising our forecasted margins, which adds $0.85 of segment operating income over the next two quarters for the remainder of the fiscal year. So the majority of this increase is based on operational performance. This calculates to an estimated incremental margin of 41% for the second half. And then some other minor adjustments to the below segment operating income lines are a negative impact of $0.01. And that's a net of interest expense income tax. So that's how we get to the $13.90. That is approximately a 16% increase from our prior guide. So, if I can direct you to Slide 25, I'll turn it back over to Tom for some comments.

Thank you, Todd. And just want to wrap things up with these great results don't happen by accident. They're driven by a highly engaged global team. Our focus on safety, high-performance team is Lean and Kaizen, is driving an ownership culture within the Company and its resulting in top quartile engagement as well as top quartile results. We talked about the portfolio. It's a big competitive advantage of us at interconnectivity, a transformation on the three acquisitions and the fact that they're outgrowing and generating more cash and margins than legacy Parker. Our performance over the cycle, but I would just reflect in the last five years and just use round numbers, our margins or up 500 basis points. In a five-year period of time, it was not necessarily the easiest five-year period of time for industrial companies. And then our one Win Strategy, at 3.0, in particular, and the purpose statement, are going to be the powerhouse behind exerting our performance into the future. So, I give my thanks to everybody for all their hard work and the great results. And to you, Jane, I will hand it back to you for start the Q&A.

[Operator Instructions] Our first question comes from the line of Joe Ritchie from Goldman Sachs. Your line is now open.

Congratulations on a fantastic quarter. Maybe just kind of just starting off. Tom, obviously, it seems like things are kind of coming off the bottom of here, you're starting to see some improvement in the order trends in your industrial businesses, both domestically and internationally. Can you maybe just like walk us through exactly like what you saw -- what you're currently seeing and what you saw kind of transpire as the quarter went on?

Sure. On the orders Joe, we saw if you look at total Parker from minus 12% to zero, North America to minus 11 to plus 1; International from minus 4 to plus 10, and then Aerospace get improved from minus 25 to minus 18. Pretty much North America and International improved throughout the whole quarter. And from our view, it looks like Aerospace is finding bottom. International piece, in particular, if you look at that plus 10, that was EMEA, plus 7; Asia, plus 13 and Latin America plus 27. So pretty strong rebound across all of the particular regions internationally. When I look at some of the higher level sub-segments, so the major buckets outside of Aerospace. Distribution get better I was minus 14 the prior quarter to minus six this quarter. Industrial, things are stationary, went from minus 7 to plus 1.5. And mobile saw the biggest improvement from minus 13 to plus 2.5. So, we saw all the sub-segments improved nicely with the largest recovery being at mobile. And when you look at our end markets in the four phases of growth, we have roughly about 30% of our end markets are in accelerating growth and about two-thirds are in decelerating in decline. So we continue to move all the various end markets into either bottoming out. And you saw our decline starting to turn for accelerating growth. And maybe I'll pause to, I don't know if you want me to go through all the end markets, but that's the color we saw. In distribution, we saw an entity, which was encouraging. Our distributors, I would say, cautiously optimistic. They are being careful. There is some uncertainty, obviously, in the next six months. And what we're seeing from distribution is selective restocking, in particular, focusing on those longer lead time type of products that they can get ahead of demand and position themselves to take share, which we're happy to help them with that. And in general, what we're seeing from distribution, in some cases, with some of the OEMs is placing a little larger stock orders with scheduled releases over the next several quarters, which are all indicators of people I think trying to plan as a few things are turning and start to get ahead of things.

Yes. That's super helpful and great to hear, Tom. If I -- can I just ask one follow-up question and really just focusing on like the sustainability of margin improvement going forward. Clearly, you've got a lot of long-term actions within the Win Strategy that are going to help. But I really want to focus on the temporary cost actions that are benefiting FY '21 to roughly $225 million. How should we think about that beyond 2021? Are you -- is that going to be a headwind beyond this year? Or are there other actions that you can take to mitigate some of those expenses coming back?

Joe, this is Todd. I'll take that one. I mean some of these things are volume related. So as volume continues to come back. We expect some of those costs to come back into the business. But really, what we saw in the second quarter was a lot of productivity improvements. This has been based on our focus on Kaizen for a long time. Many elements of our Win Strategy initiatives have helped drive that. But there's been strict cost containment by our teams really around the globe. What did surprise us a little bit was lower travel and lower discretionary expenses. That's why we increased the discretionary expenses for the remainder of the year just based on the current situation that we see in the world right now, but we do see that returning. Nowhere will it go back to the levels that we've seen in the past, but we do see it going up from where we're at now.

Thank you. Our next question comes from the line of Nicole DeBlase from Deutsche Bank. Your line is now open.

Can we start with just looking at the 3Q outlook, what's baked in at the midpoint with respect to organic growth? And if there's any big change or divergence in the incremental margins you're expecting in 3Q relative to 4Q?

Yes, Nicole, this is Tom. So if I take the top line and maybe to help with the guide for the full year. So, we reduced the guide on decline on organic for minus 7.5% to minus 3.5%. But I think what's probably the most interest to analysts and shareholders, is what do we think the second half is going to be. So the second half, our assumptions in the guide is North America and International, both in that kind of that 6% to 7% positive organic growth. And Aerospace at around minus 11% for the second half. When we look at Q3, I'm going to focus on the top, and I'll come back to the decrementals and incrementals. In Q3, we're going to see a slight improvement in the industrial portion of the Company, about 100 basis points as there's still some uncertainty. And those orders I referred to earlier on, have scheduled releases are going out multiple quarters. We see Aerospace about the same as we had in Q2. And when we get to Q4, we've got North America in that upper teens, International of around plus 10% and aerospace getting to flat and that puts total Parker in Q4 in the low teens for Q4. So again, Industrials for the second half, that plus 6% to 7% range and Aerospace at minus 11%, so when we think about the margin side of things, Q3 margins are going to be slightly less than Q2. And that's mainly from the reasons that Todd was describing, we're going to have less discretionary savings in Q2 than we had in Q3. Q3 is going to be around $25 million, and Q2 was $65 million. So you got $40 million less of discretionary savings going into Q3. We'll still have a favorable MROs, and then people aren't familiar with what that term is that's basically you have less sales and you get more earnings. So you can't really calculate an incremental, but it's favorable. And when we get to Q4, we've got approximate 30% MROS. I would just make the comment for Q4, really for the first half of FY '22, that the incremental MROS are going to be a tough comp for us. So the plus 30 this is, again, remember in Q4 prior period, we had the gargantuan discretionary cost out, all the big wage reductions at that time. If you were to make it like-for-like and take out discretionary actions from both periods, this would be greater than 60% incremental. And so, it's -- the business is performing at a very high level, you'll see margins get a little better into Q4. That will be our highest margin quarter. And if you just look at for the second half, we go from 20.1%. That's the first half total company to $20.7 million in the second half, so continued improvement and we're not going to stop there. Obviously, our goal is to keep driving this as we go into FY '22.

Got it. That's super helpful. And then maybe just as a follow-up, can you just talk about any impact you into production, supply chain with respect to COVID and the level of confidence you have as a result in ramping as this recovery does take place?

Nicole, it's Tom again. When we look at COVID and its impact, we're mirroring case rates in the local communities that we're at. We've done a great job of, I would say, almost exclusively, our case is originated from outside of work. And we've tried to take the position. We won't be able to be safe at home and save our work. But we like them to be the safest possible they could be when they're at work. We're not immune to absenteeism, type of things related to this. But it's not been a material impact to us. We've been able to keep up with demand, keep up with our lead times. And if you look at us historically, obviously, a pandemic is a unique phenomena, but we have periods of increased demand, we outservice our competitors. It's something we've proven time in and time out. I would look for us to have the opportunity to take share because our lead times and our customer experience will be better than our competitors. So I feel very good. And on the supply chain side, we purposely laid out a strategy years ago to be local for local. So we make buy and sell in the region for the region. So that supply chain strategy, that operational strategy allows us to be very flexible based on what's happening, do not have all our eggs in one basket in one particular region, not to be overly exposed on trade tariffs and those type of things. So, we feel very good about where we are in supply chain.

Thank you. Our next question comes from the line of Scott Davis from Melius Research. Your line is now open.

And I don't say this very often, but congrats on a great not just a couple of quarters, but great the last two or three years, has been just phenomenal. Impressive, but anyways, I want to talk a little bit about M&A because you've been so successful in that front, which is not -- perhaps not something folks would have expected out of Parker in the old days, you're going to be down to 2.5 turns of debt, as you said, this year. And are you ready to reload on the M&A front? Do you have an interesting backlog at all that you want to talk about?

Yes, Scott, first of all, this is Tom. Thank you for your comment and the recognition of progress it doesn't go unnoticed, and we do appreciate that. On the M&A side, what's been interesting and we're really happy about the cash flow and the ability to pay down debt is clearly ahead of schedule. And we're going to be in a position to come into this fiscal year, where all of our service with debt, the term loans and the CP that we took out with these acquisitions will be all paid off. And our next corporate bond is not due to September of '22, and it's a nominal amount of $300 million. So, we are going to be in a position with a much stronger balance sheet to look at capital deployment across all the veins. Now in particular, you talked about M&A. So the lesson learned for us historically, is to never stop working the M&A pipeline. And so we're continuing to build those relationships. We are building those relationships with across a couple of big themes. We want to be the consolidated choice within our space. We think we are the best -- we're the leader in the space, we think we're the best home, which means we'd like to be looking at anything within our space. In particular, though, if we only had a certain amount of money and all eight of the technologies that I referred to earlier on roll on the table, we like to focus on filtration, engineered materials, instrumentation and aerospace. We think those -- you've seen us focus on those to date. But I would tell you, we saw us do with the last three deals, buy companies that within very quickly or within a reasonable period of time and with synergies. Can outgrow, can outpace margins, can outpace cash flow for the base business, and that's what we did, and that's going to be the flavor you're going to see as we go forward. And if we don't find the right properties, we think we're a great investment, and we're going to invest in Parker and buy our shares.

Makes sense, Tom. Can you talk a little bit about how when you do a deal, how do you integrate it? I mean, how do you bring or how do you bring Win into an asset? Do you come in with all the tools? Do you come in with Lean first? Or is there some sort of a -- or is it case by case? Is there a playbook? I don't think I've ever heard you guys talk about that. I'm just kind of curious.

It's a good question. There's obviously, there's lessons learned that we've learned over the years and how to organize the project management office, what you're going to do on day 1. And there's really two big kind of veins that you're looking at looking at all the integration tasks, those basic tasks of putting the businesses together and then your synergy task. We've learned to make sure you've got a dedicated integration team and you put the best and prides people and those various leadership positions, put a great integration manager. But the key thing to remember is we're buying great companies. And they're bringing good things to us, and we're trying to bring good things to them as we become one team, and it's the concept of one plus one equals three. So we're going to take the best of the acquisition and the best of Parker. And obviously, we work the Win Strategy. But we do give some latitude within the respective acquisitions to how they want to implement the Win Strategy. There's no -- it's not an option that you're going to implement it, but we give them latitude as to how they want to phase it in because, obviously, certain parts might be more applicable faster for respective acquisitions. We have a real robust cadence as far as review. And frankly, I think we've gotten pretty good at this and something we want to keep doing.

Thank you. Our next question comes from the line of Andrew Obin from Bank of America. Your line is now open.

Yes. Great quarter, great free cash flow conversion as well. Just a couple of questions for me. The first one, you sort of talked about your dealers still being cautious. I mean if you look at our channel checks, if you look what are the publicly traded hydraulics companies or the ones that are still hydraulic companies, sort of talk about what they are seeing in the channel, they just sound a bit more optimistic relative to what you guys are saying and sort of our channel checks, I think, a bit more optimistic on outlook as well. Just trying to understand, is it market-based conservatism? Or are your dealers are more conservative, your channel just knows something that we just don't see across the industry.

Well, you're probably referring to one of our neighbors, and they would be much more heavy mobile than stationary and distribution. And we're not a hydraulics company. We're diversified industrial companies. So that's a big difference.

But I'm also talking about a small competitor down in Florida, I guess.

Okay. Well, our discovers still feel good but part of what they're doing is placing orders, making scheduled releases over the next couple of quarters. Now we still think that if I look at going into Q3, that we're going to go from a minus 6% to getting to probably flat on North America and EMEA, and we'll be probably in that upper teens when you look at Asia Pacific. Then when you get to Q4, we'll be very strong in North America and EMEA, probably around that plus 10%. And now China has a tough comp in that Q4 because if you remember, that's when they rebounded on the pandemic, so they're probably going to be flat on distribution. But our distributors still feel very good. And when we look at distribution for the whole second half, it will end up being a nice positive.

Got you. Second question, you sort of talked about China, and I think we've been sort of talking about hydraulics competition emerging out of China for the past 20 years. But it does seem that we finally are at a point where you are sort of seeing Chinese competitors, and particularly the fact that China is leading recovery this time around. How do you see competition in China from the local competitors this time around? And then in this upturn, how different is that? And then also some of them are talking about getting into industrial applications now, even though probably you have a bigger moat there. But just how do you think about Chinese competition coming out of this downturn in the next cycle?

Andrew, it's Tom again. That's been a question really for a while now. And I really don't see it much different coming out of this than it was when we went into it. Just as a reflection, China for us grew about 10% last quarter. So we did quite well in China, Asia Pacific overall grew about 7%. And the way we win in China is we're in China with the same or better cost structure because we have a nice density of plants in China and a very robust supply chain in China. And we have the breadth of our technology. So when we go to compete. And again, that's a distinguishing characteristic that we have around the world. We're not just competing as a Chinese fitting company or a Chinese host company, we can put the whole portfolio technology to get in that discussion with the customer, they can't beat us when we're having a discussion around cost of ownership or the weight of the product or reliability, the ease of assembly, all those type of things that you can do when you're a multi-technology. And obviously, these multi technologies are interconnected or not disparate technologies or interconnected technologies that create a big value proposition for customers. So that's been -- we can beat them on a cost because we're there. We're at the same cost structure or better, and we have a better basket to sell more products to customers.

Thank you. Our next question comes from the line of David Raso from Evercore. Your line is now open.

My question is on Aerospace, but if you could clarify first. Were you saying the fourth quarter, the fiscal fourth quarter Aerospace organic sales flat? I just want to make sure I heard that correctly?

Yes, David. This is Tom, flat to prior year.

And I'm not asking for '21 guidance, but can you take us through your thoughts on how you see the cadence of the Aerospace recovery and? Obviously, make color also how you think about M&A in the space as well? So I'm trying to tie those two together and give us a little lay of the land, if you're already at flat in calendar 2Q, fiscal 4Q, how are you thinking of the slope from there?

Yes. David, it's Tom again. So we like this space. This is all of our motion control technologies going into things that fly. We're going to things that fly because there are stationary and things that have wheels under them. And the way we look at Aerospace is that we have its size to win in the current climate. The current climate is finding bottom, and it's going to be a slow turn coming back up. But my view over the next several years is going to gradually show improvement. Now what is that pace of improvement? I think it's going to mirror the pace of vaccine deliveries and the comfort that travelers feel. And I think you'll see resident -- personal travel come back much more aggressively. The business travel will come back, but we'll probably plateau at a certain level based on just the efficiencies of digital tools. But we're positioned to win right now with the kind of op margins in this current climate, and it's only going to get better going forward. So with respect to M&A, I actually think this is a good time to look at M&A in the Aerospace arena, depending on the right property and direct pricing, obviously. But I think the future is bright. Now it's going to be -- it's a long-cycle business, so it will turn slower than industrial turn would be. But again, if you're positioned to win now and you're going to have a gradual upturn, it speaks to nice incrementals and nice positive year-over-year changes for you over the next several years.

Yes. I'm just trying to balance the dance that doesn't go on with the stock, right? The traditional crowd that looks at the ISM and says, hey, this is fantastic right now. How much better can it get? While the compounded crowd looks at your cash flow, the deleveraging and say, look, we can definitely move the ball forward here. This is not just an old ISM play. And the timing of the M&A, I think it's important to balance that -- those two crowds. And not to get inside your M&A department here, but when you listed those four categories, can you just give us some sense of -- if you had your druthers, identical kind of assets, when you think of where you're positioned, your size, the competitive landscape and then obviously, how you view the cycle playing out. Of those, I mean would you prioritize them at all between filtration and engineered materials, filtration in Aerospace?

I probably won't prioritize not to disappoint you being big and the answer, but we like all those properties. But I will come back to the very first thing and this is -- what I always remind the Board and I'll remind shareholders. We want to be the consolidated choice within our space. So those8 motion control technologies that, I believe, was on Slide 4, is the space we play in it. And we have a big advantage that we're not disparate pieces of businesses. With now two-third of this revenue comes from people that buy from these -- all these technologies for four or more, we like all those technologies. I think the thing you're going to see us look for is -- and the theme that you've seen with the last three deals is within a period of time depending on the synergies, they're going to be growth accretive, margin accretive and cash accretive. And that's a different strategy, I think, for the Company. Our tendency, we would prefer to buy things that are not ultra small. But if you just look at the histogram of the targets, it's more in the midsized category just because of the lay of the land. There's fewer of these really super large targets that you can look at. We will look at them, obviously. When I say midsize, what's changed for us versus the past is our mid-size is now bigger. A midsized target for us would be envisioned an exotic like deal, which, historically, would have been the largest deal in the history of the Company for LORD and CLARCOR. So our appetite is there. If I could go back, David, to a comment you made about the ism, which I thought was a thoughtful comment. The power of this portfolio, besides being interconnected, is that the cycle is somewhat balance each other. So yes, we will see some near term, and we'll see how long near-term turns out to be on the industrial portion of the Company that's going to have much more robust macro conditions. But then following that, the Aerospace business is going to start to be healing. And I think sequentially, that those time periods are going to be complementary to each other. The other part is that this five-year period that I envision going forward, is going to be, I think, much easier for industrial companies in the last five-year period because we went through two industrial recessions and a pandemic. I'm not going on wood here. I guess it's possible to have that happen again. But the odds are low that it would repeat. So I think it's a much better time. And we have enough self-help for all those people that I'd like you to encourage. We are no longer a short-cycle bet. We are bet over the cycle. And we have all kinds of room once Win Strategy 3.0 just started. And those FY '23 targets are not an endpoint. They're a mild market we're going to blow past.

Thank you. Our next question comes from the line of Mig Dobre from Baird. Your line is now open.

And maybe just to kind of pick up on this topic here. Tom, you've spent a better part of last year of sort of showcasing how the business is performing different than it has in prior downturns, right? Or entering an upturn, and I'm curious to get your perspective as to how this next upturn might be different than what we have seen historically?

Well, I think it's always hard to predict one cycle versus I think you will continue to see us perform very well on converting on the incremental side. Just I would caution people incrementals for Q4 this year and for the first half of next year are going to be tough comps. We're going to try to flatten the field when we give you the results. So you'll be able to see the real incrementals of the Company. But I think you would expect to see us north of 40% in the first couple of quarters and we glide down in the 30s. But we're going to be in a much -- that stair-step slide that I've showed for the last couple of quarters. Our intention is to keep raising the ceiling and raising the floor. So, this next ceiling, this next cycle, our expectation is going to be higher the last ceiling. We're doing it right now. This isn't even really a necessarily good period right now, and we're breaking records on margins. So I'm bullish because there's a lot of positive factors. If you just look at interest rates and what's happening with global industrial production forecast. In my view, of pent-up need for CapEx, given that there's been two industrial recessions in the last number of years, and Aerospace cycle that will follow an industrial cycle that you get the benefit of those not being right on top of each other, and just a tremendous amount of self help. A lot of what you've seen has propelled these margins to date as prior period restructuring in Win Strategy 2.0. Win Strategy 3.0, and I mentioned not just being biased because I'm a part author, but it's better than 2.0, hands down, and you've only seen about a year of that in play. And so 3.0 is going to get -- has tremendous legs. So we have still a portfolio of self-help. And the big thing is that we're back in the capital deployment gain. So it will be a steady diet of dividends, share repurchase and acquisitions. And obviously, that formula we're going to raise. I can assure all the shareholders listening. There will be a Q4 increase to the dividend. We're not going to break our track record. And then we'll continue to do what we've always done is look at the acquisitions purchase, share repurchase and try to make the best decision of happy shareholders for what is the best long-term return for them.

And perhaps, you're going to want to punt on this, but you're pretty close to your stated fiscal '23 targets. At what point do we expect an update to this? And I'm also curious as to how you're thinking about free cash flow margin here. I mean, even taking out the working capital benefit that you had year-to-date, free cash flow margin is quite impressive. How sustainable do you think this is, especially as perhaps we need to see a little more working capital coming back into the business? Thank you.

So Mig, I'll start on the '23 targets. I'm going to let Todd take the free cash flow one. You're right, I am going to punt. But hopefully, you recognize we've not hesitated to change these. So we've gone from -- I'm just going to use segment operating margin. We've gone from 15% to 17% to 19% and now 21%. So, we've not hesitated to update it. We just want to prove for several quarters that we're close or at it. And once we do that, we'll be prepared to give you a better vision of that. And I'll let Todd talk about free cash flow.

Yes, Mig, you're right. Our cash flow has been really impressive. And like I said, it's really the work of our global team, really focusing very quickly on working capital management. We know there's going to be some pressure on working capital as growth returns to the business. So we're well aware of that. But as Tom said, we've basically had a step change here. Our margins are a different profile than they used to be, and that obviously feeds the free cash flow. So we think historically, we're going to be better than we've been historically, and we're positive on that going forward.

Thank you. Our next question comes from the line of Nigel Coe from Wolfe. Your line is now open.

And great job. You make it look easy, but I know it's not, so well done. So we're pretty deep into the Q&A here. We haven't had the end market roll down. So it'd be remiss not to do that, but just one clarification, the lag on distribution -- distributor orders versus -- sorry, versus OE. A little bit surprised with that. Is that normal at this point in the cycle as we turned back up? Or is this a quirk of this pandemic?

Nigel, it's Tom. No, it's very normal. Mobile tends to lead, which is doing now and then industrial and then follow-up disputes. Remember, the distribution, well, we'll service some small to medium-sized OEMs is primarily the aftermarket. And so that tends to lag a hair after you see a sharp return, which is what you're seeing with some of the other end markets. And I will spin you through the end markets quickly. And I'm going to break it into the buckets like I've historically done. I'm starting with the positive end markets. The greater than 10%, this is for the total company was semiconductor, life science, power generation, agriculture, refrigeration, aerospace military OEM and aerospace military MRO. On the positive high single digits was automotive, positive low single digits was construction, heavy-duty truck. And then on the declining markets, they've got four buckets: Low single-digit decline was telecom and tires; high single-digit decline was long and turf, material long and turf, handling, mining, mills and foundries in distribution. Distribution is on a market that's we put in there. The 10% to 20% range is rail, marine and forestry; and the greater than was machine tools, oil and gas, aerospace, commercial OEM and aerospace, commercial MRO.

Great. That's wonderful. And then just on the margins between International and North America. We now have very close conversions between these margins. Is that really a function of the recovery profile mix perhaps? Or are we in a situation now where these margins going forward are going to be very comparable.

Yes, Nigel, we worked with this for many, many, many years to get those margins comparable, and I really give credit to our international team. They've made great progress. So, we're not where we want to be. We still have plans to move it forward, but we see those margins. There's no reason why those margins can't be similar.

Gigi, I think we have time for maybe one more question.

Thank you. Our next question comes from the line of Josh Pokrzywinski from Morgan Stanley. Your line is now open.

Just following up on asked a question from earlier, just on PMIP. So I guess is there anything in the business today, Tom, that you're seeing that would that would say that the PMI is maybe not indicative of where the business and your recovery, your customers are in recovery, like maybe things don't feel quite as far along as they normally would with like a 60 PMI, whether it's inventory levels, which we sort of talked about or just the types of end market leadership, anything that would make you feel like maybe this has kind of some longer legs to it than you would normally see at this point?

Josh, this is Tom. I still think that you'll see relatively this similar correlation feared to plot our orders historically against PMI is anywhere from a three to six month lag. I think that pandemic has the potential to maybe influence that a little bit, we'll just have to see as that plays through. But I would just characterize, I feel better about this next several years and I do about what happened in the last six years of leasing my time leading the Company. Because I just think about, we went through a natural resource recession, we went to the most current recession and we had the pandemic. And so, I think there is a need for industrial and infrastructure type of activities. I think Aerospace will return longer-term. So I just think there's a better -- potentially more stable macro environment the next couple of years.

Got it. That's helpful. And I agree with that. And I guess just kind of related to that, all the while bringing up the segment operating margins within striking distance of your target even with an arrow still on its back. At what point does gross margin become a limiter and you need to find yourself mixing higher on that front because the distance between the two is narrower than we see in most of our coverage. So at what point does that I mean, more differentiated growth or M&A mix like what you had with the word exotic? Just any observation you would make on what it takes to get to the steps beyond?

Yes, Josh. Again, it's Tom. One clarification, our gross margin might look different than you compare to other companies because we embed a fair amount of SG&A and/or our cost of goods sold. So our gross part has some of that in there versus other people might be booking their SG&A in different categories. But your question is stepping higher levels really. Can margins continue to grow higher? It absolutely can. If you look at what I was referring to earlier on about early days of Win Strategy 3.0 and all the initiatives we have underneath there, I feel very good about our potential there and just very strong legs and where the future can hold. You can put that in place maybe a little macro-environment, yes, you can have little more [indiscernible] leverage. And then we're coming into a period of time where we have a stronger balance sheet, so we can put that to work as well. So what I've told people before, maybe I'll close on this. If you like what's happened in the last six years in the environment we had with basically no macro help, the next several years are going to be fantastic.

All right, everyone. This concludes the Q&A portion of our earnings call. We appreciate all your comments. And as always, thank you for your interest in Parker. Rob and Jeff are going to be available throughout the day and if anyone needs any follow-ups. We thank you again, and everyone stays safe. Thanks.

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.