Parker-Hannifin Corporation
Q4 2010 Earnings Call Transcript

Published: 3 Aug 2010

[Operator:]

Good day, ladies and gentlemen, and welcome to the Fourth Quarter 2010 Parker Hannifin Corp. Earnings Conference Call. My name is Josh, and I'll be your coordinator today. [Operator Instructions] I would now like to turn the presentation over to our host for today's call, the Vice President and Treasurer, Pam Huggins. You may proceed.

[Pamela Huggins:]

Thank you. Good morning. It's Pam Huggins speaking as he just said. I'd like to welcome you to Parker Hannifin's Fourth Quarter and Fiscal Year 2010 Earnings Release Teleconference. Joining me today is Chairman, President and Chief Executive Officer, Don Washkewicz; and Executive Vice President and Chief Financial Officer, Tim Pistell. As normal, let me just address a couple of administrative matters prior to beginning with the actual release. First, for those of you on the line, you may follow today's presentation with the PowerPoint slides that have been presented, and for those of you not online, the slides will be posted on the IR portion of Parker's website at phstock.com. Second, as is customary, I'd like call your attention to Slide #2. This is the Safe Harbor disclosure on forward-looking statements, and after that, if you haven't already done so, please read this in its entirety. Now moving to Slide #3, this Slide, as required, indicates that in cases where non-GAAP numbers have been used, they have been reconciled to the appropriate GAAP numbers. Moving to the agenda on Slide #4, the call will be in four parts today. First, Don Washkewicz, Chairman, President and Chief Executive Officer will provide highlights for the quarter. Second, I'll provide a review including key performance measures of the fourth quarter and of course concluding with the fiscal year 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. At this time, I'll turn it over to Don and ask that you refer to Slide #5 titled Fourth Quarter and Fiscal Year '10 Highlights.

[Donald Washkewicz:]

Thank you, Pam, and welcome to everyone on the call. I want to start with a few highlights of our performance for the past quarter and also for the past fiscal year. First of all, needless to say, we're very pleased with the way Parker employees reacted to the conditions in our global markets over the past year. Their quick and decisive actions along with our focus on the WIN Strategy and on generating cash flow allowed Parker deliver very strong fourth quarter and full year results in fiscal 2010. First, I'm going to cover just a few key points for the fourth quarter, some highlights. We had our second consecutive quarter of year-over-year increases in order rates, with a 35% increase this quarter compared with the fourth quarter of fiscal 2009. This improved demand level helped us generate 26% growth in revenues for the quarter as conditions in our markets continued to improve. Importantly, our segment operating margins reached 13.9%, which is above 900 basis points above where we were just four quarters ago, representing obviously a wonderful recovery for us. Our Industrial North American segment margins in particular reached 15.7%, which is above levels we achieved in the record year of fiscal 2008. Again, this reflects our ongoing success in executing our WIN Strategy. Our incremental margins were an impressive 48%, representing the change in segment operating income as a percentage of change in revenues. Earnings per diluted share at $1.35 increased 342% from the same quarter last year, and our focus on cash generation was evident in the quarter as operating cash flow reached $377 million or 13.5% of sales, which far exceeded our 10% target. I'll make just a few comments about the fiscal '10 year. Despite being slightly down on revenues for the year, we generated increased operating margins, increased diluted earnings per share and increased cash flow from operations. As you may recall, last year this time, we projected $1.50 in earnings per diluted share, and we're certainly pleased that our actual came in at $3.40. Fiscal year 2010 total segment operating margins reached 11.4% compared with the 9.7% in fiscal 2009, so we hit that double-digit number there and exceeded our 10% target for the year. Cash flow from operations was $1.2 billion or 12.2% of sales, again, well above the 10% target that we had. Our cash flow performance really reflects our focus on working capital management throughout the year. Notably, we achieved this cash to sales ratio despite a discretionary contribution of $100 million to the company's pension plan. We used our cash to increase the quarterly dividend for the 54th consecutive year in fiscal 2010, paying out $0.26 per common share in addition to maintaining our share repurchase program. Our year-end balance sheet is very strong, with a debt to capital ratio of 28.9% and a net debt to capital ratio of about 21%, and certainly, this affords us considerable flexibility to invest in future growth for the company. So summing it up, we delivered a very strong quarter and full year for our fiscal 2010. When we look at fiscal 2011, we have issued guidance for earnings from continuing operations in the range of $3.60 to $4.40 per diluted share, and that represents about an 18% increase at the midpoint on approximately a 5% increase on sales. So with that, I'll turn it back over to Pam

[Pamela Huggins:]

Thanks, Don. For more detail in the quarter, I ask that you reference Slide #6, and as usual, I'll begin by addressing earnings per share for the quarter. Earnings per share for the fourth quarter increased $1.4 from the same quarter a year ago and came in at $1.35. That's more than a 300% increase as Don just mentioned. On a sequential basis, the earnings per share of $1.35 compares to $0.94 last quarter. Realignment expenses in the quarter were $7 million. That's $4 million net of tax or $0.03, and this compares with the $15 million, $9 million net of tax or $0.06 for the same quarter a year ago. Earnings per share of $1.35 for the quarter exceeds the earnings per share guidance due to higher revenues in all segments of the business and increased segment operating income, and this had a positive EPS impact of $0.27. Our lower tax rate was a positive EPS impact of $0.06 due to favorable settlements in connection with IRS audits. Reduced other expense was a positive impact of $0.08 due to currency and a favorable inventory adjustment and then higher corporate G&A expenses within the EPS impact of $0.07, and this was a result of higher market-driven benefit expense. As Don mentioned, incremental margin or return on sales was a respectable 49% rounding up for the quarter, and as a reminder, margin 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. Moving to Slide #7 and laying up the components of the $1.04 increase in earnings per share from $0.31 to $1.35 for this quarter, on a segment basis that is, the significant puts and takes are as follows

[Operator:]

[Operator Instructions] And our first question comes from the line of Mark Koznarek of Cleveland Research.

[Mark Edward Koznarek:]

I am just taking -- and kind of struck by the contrast between Slide 5 where you go through all the highlights, real positive highlights for this year and then Slide 19 where we've got what's pretty arguably a cautious initial outlook below consensus entirely. And the last time, setting aside last year, which nobody knew what was going on a year ago, but the last time you did that was in fiscal '09 when it was pretty clear we were rolling into a downturn, and nobody could have forecasted Lehman six weeks later, which really collapsed things. But this guidance suggests that you folks have a very cautious macroeconomic outlook, and so I'm wondering if you can review the macro assumptions that underpin the guidance here.

[Donald Washkewicz:]

Mark, this is Don. Just a couple of comments about how we go through the process of coming up with these forecasts. First of all, we do this at a group level and roll up the groups from the bottoms up. We certainly were not expecting any heroes for the day coming over a real strong forecast, just having come off a very, very difficult year and a recession. That's been the worst recession in 70 years. So we weren't encouraging that at corporate, and we didn't get that and rightfully so. So when you look at what we came in, when we're coming in with a 5% growth number and an 18% earnings per share growth number at the midpoint, I would say that we did capture the Street, not that we were trying to capture the Street, but we bracket it. And in fact, the Street I think said $4.30 something, and our top end of our range is $4.40. So in fact, the Street was a little bit more bullish on the top line, and if we add another $0.5 billion on the top line, I think we'll be at the top end of the range. We'll be right on the Street, so I think we're in sync here. I think the question is just, "How bullish do you want to get early in this fiscal year?" One thing we've tried to do here is make sure that no matter what happens, we make our numbers, and so as a result of that, if we were to come in with a high-end forecast, people would be spending day one as if we're going to make that high-end number, and that's a dangerous thing to do. So you may have seen this, and we're pretty consistent like this year after year. We don't really change our MO here, so we pretty much forecast the same way. You can call it conservative. You can -- so I think it's just prudent especially in light of the fact that we've just gone through this very, very difficult period. And by the way, the growth number, really is more like organic growth, is like 7% at the midpoint because of FX. We show 5% here, but we got a negative impact of 2% from FX. And at the high end of course, we'll obviously have that covered with the high end of our range. That would be delivering another $1 per share at the high end of our range, so hopefully, that sheds a little light as to how we go through the process and why we do what we do.

[Mark Edward Koznarek:]

I think that actually partially answers the follow-up, which is the 5% midpoint of the revenue, which you're now clarifying is really organic 7%. It just seems like your orders in the fourth quarter, 35%, you could have basically flat orders for the next nine months or so and still end up with a 9% top line number rolling into fiscal '11. So it almost seems like you're expecting the year to start strong from a revenue standpoint and then actually tip negative in the second half. Is that part of the assumption?

[Donald Washkewicz:]

No, I don't think that's what we would assume. I think we're saying that we can see out pretty clear through the end of the calendar year, and like what we said in the past, we'll update you every quarter as far as what we're seeing beyond that. But like we did this last year, we didn't have a lot of visibility last year either, but we kept updating you on a quarterly basis as things we're rolling out. So I wouldn't say that we have a negative outlook on the year at all or on the second half or anything. We just have less visibility when you get past the end of the calendar year.

[Timothy Pistell:]

Mark, this is Tim. When we give you a 48%-52% split, first half, second half, what we're giving you basically is at constant rate because that uplift from 48% to 52% we get simply from workdays. We have more workdays, and that's pretty much the math of it. So it does say that we are where we are. We've recovered collectively to -- we went from 100 down to 65. We've backed up weighted average around 90, and we're sticking at 90 right now, and frankly, that is what we're seeing there. And there are some -- the problem is, we do not know what's coming out of Washington D.C. We do not know the outcome of the elections or what else is coming out of Washington D.C. and what it's going to mean to American businesses. I go over to Europe, I got a coalition government in the U.K., may or may not hang together. We know it's parliamentary in form. We've got Merkel [German Chancellor Angela Merkel] in Germany doing the right things but under a lot of heat from a lot of people because they don't like what she's doing. So I mean I think that there is a lot of uncertainty around, and it's not just in Parker. It's everyone I talk to, so we're trying to be as prudent as we can.

[Operator:]

And our next question comes from the line of Jamie Cook of Credit Suisse.

[Peter Chang:]

It's actually Peter Chang for Jamie Cook. I had a question on the International incremental margin outlook based on your guidance. It looks like you guys are assuming something north of 75% in both the low and high end of the guidance range. Can you provide some color on what's driving that, if that was a result of the realignment cost you took this past year?

[Pamela Huggins:]

Yes, your numbers are exactly right, and I think you're exactly right. If you look back over the restructuring that we've taken over the last three years, a significant portion of that restructuring has really been in International, so you have a couple things coming on. As you move along in the year, you have the volume coming on as well as the savings as a result of all that restructuring, so you're right.

[Peter Chang:]

And do you expect that? I mean I know you're not giving 2012 guidance now, but I mean that type of incremental is probably not sustainable. What do you think would be a sustainable incremental margin going forward past this year?

[Timothy Pistell:]

Peter, this is Tim. I think we've been pretty out and open how we run the businesses here, and the expectation is for people to operate around this 30%, MROS we call them, marginal return on sales. Now in the early phase of an upturn or downturn, the percentages will be higher. You can be caught with a 50% or something, and then overtime, it will come back, revert to the mean, so to speak, and we want people to operate to that. So with that, we'll settle down in that 30% range, and that's how we operate.

[Operator:]

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

[Andrew Casey:]

On the other expense, the $160 million, is that where the pension falls into?

[Pamela Huggins:]

Actually, a portion falls in what we call below the line, and a portion falls above the line. There's about $34 million that we're going to incur next year in terms of pension expense, and there's about $12 million, I think, of that $34 million, which is above the line.

[Andrew Casey:]

And what other assumptions are you making in the delta and other, the $160 million versus what you did this year?

[Pamela Huggins:]

Well, one of the things that you have to remember in terms of other expense -- well, I want to clarify this. It doesn't answer your question directly, but I want to make sure that people understand that in the first quarter, we have more stock option expense in other. And then you were asking about the full year?

[Andrew Casey:]

Yes.

[Pamela Huggins:]

Can we go on and then I'll get back to him on that, the one -- because it doesn't change that much year-over-year.

[Andrew Casey:]

Then in terms of that guidance, it doesn't include acquisitions. You were careful to explain that. What sort of pipeline are you seeing at this point?

[Donald Washkewicz:]

Well, we're basically looking -- all the groups are looking at a variety of different opportunities out there and in various stages, I should say, of review, so, yes, there's plenty out there. We're trying to be prudent here as far as what would be best for Parker at this stage, and we're going to continue. That'll be part of our cash deployment strategy as -- trying to grow the business from some acquisitions for sure.

[Timothy Pistell:]

Yes, and if I can add on, in terms of -- because it's a natural lead into what our capacity looks like, and as we're sit here today with these statements, we're looking at about $1.5 billion capacity without violating any of the parameters with the debt rating people. We are very, very protective of our debt rating and live to that. So we have about $1.5 million as we sit here today. If we assume no acquisitions and just stockpiling cash, if you will, we will probably accumulate another $1 billion worth of capacity over the course of the year. So as Don said, all groups are active again looking, but we're, of course, going to be very disciplined.

[Andrew Casey:]

And then one last one on field, the distribution channel. Don, can you characterize what you're seeing? Is it still a deferral of restocking and keeping relatively lean inventories?

[Donald Washkewicz:]

That's kind of what we're seeing. Again, I think the OEMs have always operated in that mode. They really don't carry a lot of excess, at least with our products. The distribution, I think likewise. Everyone's cautious at this point in the cycle. They're replenishing to the extent that their orders are coming back, and our distribution is performing better now, and you know half of our Industrial business approximately is distribution. So they're performing better, so in fact, their stock levels are going up somewhat but again, not to the extent that they're trying to anticipate some wonderful growth coming forward. They're just trying to match their stock levels with the current level of activity.

[Pamela Huggins:]

Andy, before you go, I just want to answer your question with respect to the other category. We just talked about the pension going up, and I think you're talking about the $130 million to the $157 million at the midpoint?

[Andrew Casey:]

Exactly.

[Pamela Huggins:]

Yes, that really is the pension. For the most part, that's the pension going on.

[Operator:]

And our next question comes from the line of Nigel Coe of Deutsche Bank.

[Nigel Coe:]

In breakable turns what [ph] (34

[Timothy Pistell:]

Nigel, this is a day-to-day thing, I have to tell you. When we put this thing together and finalized it a couple of months ago, actually there was a lot of pretty bleakness out there. Now we were going through a lot of positive -- it's 15 [ph] (35

[Nigel Coe:]

Can we talk about the some indicators dropping off, I mean you're talking about internal Parker, i.e., orders or were you talking about just on the macro side?

[Timothy Pistell:]

Well, the Parker orders in particular and again, reflecting some of the macro. But yes, some of the markets which were recovering and quite strong and so forth, we've seen a little bit of them coming off of those increases, so I think it's hard to call. That's the problem. It's just very hard to call. We have good visibility. We feel very good about the first two quarters we're given, yes, but it's really difficult to predict those Qs three and four.

[Nigel Coe:]

On net realignment expenses, I was a little bit surprised that you're maintaining $50 million of investments in 2011, level with 2010. I mean is this something that you expect to recur going forward and, i.e., should we be modeling restructuring expenses at these kinds of levels going forward? And secondly, can you maybe describe in a bit more detail where you expect to spend that money?

[Timothy Pistell:]

This is Tim. Let me just carry on. What we have said historically before the downturn is that you can always anticipate us probably incurring $0.10 to $0.12 of restructuring every year. We feel that's just a normal part of doing business and doing what you have to do to run the company over the long term. We basically have doubled that here now through this downturn. It's going to be three years in a row where we have doubled that. Now why, do you ask, is this carrying over the next year? Because a lot of it, frankly, it is not here in North America. It is in Europe because things are -- and sometimes, they take longer to get done, and they can be expensive. But this is sort of the last round, and we hope to get it done this year. We couldn't, and so it's going to roll over into next. After next year, I think we should drop down to at the rate you've been seeing through this downturn.

[Nigel Coe:]

Other expense dropped off a lot 3Q to 4Q, just wondering why that was the case.

[Pamela Huggins:]

You're talking on a segment basis?

[Nigel Coe:]

Yes, Q-to-Q. The other expense from 3Q to 4Q dropped off.

[Pamela Huggins:]

I have year-over-year. I had don't have 3Q to 4Q.

[Operator:]

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

[Terry Darling:]

Tim, I'm wondering if you could follow on. I think you'd mentioned about $1 billion of free cash flow for FY '11. Can you just kind of take us through some of the other pieces there? What are you assuming on CapEx? What are you assuming on working capital there?

[Timothy Pistell:]

Sure. In general terms here, we still expect that we can do a little -- now there's a difference between our metrics sort of -- and then the absolute dollars, but we've done a great job on our days sales outstanding, receivables. We think there is a little bit more room to improve on that. We've done an even better job in inventory, but a lot of that is really a function of your cost of goods sold that you're calculating. But once again, we think that we can do better there. Now we think that again, some cases these dollars will go up but as a percentage of sales improve. The one thing we did this year which -- a tremendous job on is in the payables area, and that helped a lot in the working capital, and we definitely think there's some more room there. So that's kind of the three major components on the working capital. On the fixed asset, we think we'll get back up next year to a level where our CapEx expenditures are pretty well equal to depreciation, which is around 2.5% of sales. That's where we were before the downturn. Everyone pulled the horns in with the downturn, and I think this last year, we only spent 1.2%, 1.3% of sales. But I think it'll get back into a balanced-type situation of 2.5%, which is far below where we historically would run through an expansion, but that's what it looks like.

[Terry Darling:]

And depreciation, amortization all in, Tim? Is that similar versus last year?

[Timothy Pistell:]

Yes, the dollars were -- they're very close to the same. So the big difference is that the actual payout on CapEx will pop up again to around that level.

[Terry Darling:]

And that CapEx is, what, $250 million, $270 million, something like that? Correct

[Timothy Pistell:]

That is correct.

[Terry Darling:]

So the free cash flow number you called, that must be before CapEx?

[Timothy Pistell:]

Yes, the way we get measured around here is cash flow from operating activities less that CapEx. That's how we do it. We exclude dividends because sometimes our investors get sensitive of the -- they think we're going to take a bad decision that hurts their dividends. So we leave the dividends out, so it is cash from ops less CapEx.

[Terry Darling:]

And then, Don, more broadly, you can address kind of the secular side of the growth outlook, not just for '11, but longer term, going back a couple years ago to the analyst meeting where you talked about accelerating organic growth. Maybe talk a little bit about how you're feeling, where you think you're gaining market share. Maybe talk a little bit around the guidance on International Industrial revenue growth for the regions, and just maybe talk about where you think Parker is differentiating itself versus the market from an organic growth perspective.

[Donald Washkewicz:]

Well, maybe I'd start just talking a little bit about the regions. The one area that's still pretty soft for us is Europe. We're recovering pretty well in North America. If you look at our 2008 levels, we're in almost at about 95% of 2008. Looking at 2008, I think a peak [ph] (42

[Terry Darling:]

When might you expect, Don, to be able to get up to that 4% range?

[Donald Washkewicz:]

I would say we've got a few years here yet. We're probably at 2% now, just in the twos, and I would say in another two, three years, we should be at that 4%. Of course, these things, when you say innovation and you snap your finger. It takes years to develop that kind of a pipeline, and we've been working at this now for about five years so I'm happy that we're as far as we are. But we can see how we're going to get to the 4%. There's no question about it. And that's, of course, higher-margin business. When you talk about new to the industry, new to our world, you don't talk a lot of competition there, at least, in the earlier years. So this should be better business for us, higher-margin business and truly a state-of-the-art type products coming out.

[Terry Darling:]

And then just lastly a clarification on your geographic comments. In Industrial International, high-end of the organic or high-end of the revenue guidance range, 4.5%, fair to say Europe is pretty flat in that context?

[Donald Washkewicz:]

That's correct, yes. I can give you a little bit of maybe a little bit of color here on the order trends. And of course, we look at order trends in all different ways here. But I'll give you a little idea. On the 3/12 and a 12/12, when we talk about 3/12, we're talking about the last 3/12 orders, the last three months of orders over the prior year, the same three months. So that would be the index that we're talking about. And the 12/12 would the same. Last 12 months over the previous year, the same 12 months. That's a ratio. So strong or increasing trends would be in Industrial North America, Europe, as I mentioned, okay? Asian and Latin American, North American distribution, both of those trends are positive and looking strong, heavy-duty truck, of course, is, and I think everyone on the call knows about heavy-duty trucks, looking pretty good, refrigeration. Semiconductors is strong, but again, I think, they're probably at the peak, hovering, bouncing around the peak of the cycle, still at a very high level. The question is, how long will we stay at that level? The jury is still out there. Aerospace is positive, especially on the commercial side of the Aerospace business and off hire construction. The one flat area on a 3/12 and 12/12 would be off-highway farm and ag [agriculture] but on a sequential basis month-to-month, that seems like it's improving. So that would be a little bit of how we look at the orders on a 3/12, 12/12 basis. I'm just going to give you a quick rundown to show you that, there are positive things going on out there. I don't want anyone leaving this call thinking this is gloom and doom by any stretch. On a sequential basis, now these are sequential orders, it changes month-to-month as opposed to this year versus last year, these are the positives

[Operator:]

And our next question comes from the line of Alex Blanton of Ingalls & Snyder.

[Alexander Blanton:]

I just like to echo the general theme here and observe that you had a 26% sales increase in the quarter but really, it was still down 8% from the average for fiscal '08. And if your only assuming a 5% or 7%, whatever you want to call it, for this coming year, you're still going to be down below '08. With that kind of increase, including whatever acquisitions you've made since then, so it is a very, very conservative forecast. Can you just elaborate a little bit more on what are the uncertainties you see for the fiscal year we're in, and perhaps calendar '11 in total?

[Donald Washkewicz:]

Well, I think, I've mentioned the one area that's been down the most, that we're waiting to come back is Europe, okay? So when you look at a whole region, that's $3.5 billion, $4 billion of our total number. That's the one area that we're waiting to see exactly what's going to happen and fast that's going to come back. That's 80% of what it was in 2008. Most of the other regions have recovered not entirely in North America but moving in that direction. So I say that, when you say concerned, the question there is just how fast will Europe recover in this fiscal year. I'd say that would be the biggest area that we're watching very closely. A lot of the indicators are positive, like I mentioned, a lot of the ISM [Institute of Supply Management] indices and so forth, but we want to see that translate into positive orders.

[Timothy Pistell:]

Alex, this is Tim. If I could sort of step up of sort of at more macro-level. So what I'm hearing out there and I was even in New York, had a CFO conference and speaking with a lot of CFOs, not just in machinery industrial, but all sectors and it was pretty much universal and that the issue is that nobody knows what's coming. People haven't even sorted through this healthcare legislation, understand what it means to them financially. We're talking about cap and trade on energy again, and no one knows if that's going to happen or not. No one understands what they're doing on the income taxes, and are we going to let the Bush expire? Are we going to put the Bush in? Are we going to change other things? Now buried in some of these bills are some very terrible legislation. If you're a multinational company, it would severely impact those companies who have a significant percentage of their business offshore, which we do, which is sort of a strategic imperative, and I can go on and on. So we don't know, and that's the thing. And so until people cannot be optimistic or confident, which you need for recovery, a sustained recovery, people cannot be optimistic and confident until they have some certainty. That's the one thing markets hate. And we don't have certainty. And so first of all, we have to have certainty. We got to get people confident, and they got to then want to go borrow money and, of course, the bank has got to loan the money, want to loan the money, which isn't an easy thing to do for a lot of people. So I mean it really, there's a macro overhang here that has us all perplexed. And frankly, the relationships between business in Washington now are the worst I've seen in 42 years. And everyone I talk to says the same thing. And so that's the problem, that's the overhang. If you guys can give us some certainty out of Washington and I'm not saying which one would hold on an issue. It's just these are just nothing is certain and we never know what to expect week to week. And so that's the atmosphere we're dealing in, Alex.

[Alexander Blanton:]

In looking at your markets this quarter, do you have any estimate or ballpark number on how much of the sales increase is coming from lower inventory reduction on the part of your customers or dealers versus the year before? In other words, if your dealers reduced inventory less this year than last year, that would translate into a sales increase for you. So how much of the 26% is from that factor by itself, or do you have any idea?

[Donald Washkewicz:]

Alex, there are still short lead times out there today. So I don't think that we're looking at anybody restocking, or destocking, or anything with respect to -- at least, I don't see that. I think they are acting prudently and they're stocking in accordance with the level of demand that they are seeing, being cautious. We're getting orders shipped tomorrow-type things because people are just putting a lot of the inventory in. So I think that demand that we're seeing is real demand. It's not a function of people putting a lot on the shelf without any demand out there. They're being very cautious. They don't want to get hurt in this upturn if this tends to slow down. So I don't see any of that all.

[Alexander Blanton:]

And final question is for, I guess, Tim. Because Tim mentioned that normally, you would expect a 30% incremental operating margin but that would only be within a certain range of volume, would it not? Otherwise, you would approach a 30% total as methodically over time. You can't keep that up at some point, it has to go down because I'm sure the 30% is not the target for the operating margin. What is the target for the operating margin?

[Timothy Pistell:]

Well, that's a good question, Alex. And I think you're right. I mean, as I said earlier, you can start on the up or down, you can start with like plus 50 or minus 50. And then it will stay to the 40s, 30s, goes on long enough, it get to the 20s, of course, you're reverting. But the target on the operating margin, we have said, is 15%. And then we have now, we're trying to do 15% over the cycle. And we have analyzed that in order to get to 15% over the cycle, we have to do a couple of things. First thing we have to do is in the good days, not stop at 15%. We have to get to 16% or 17% in the good day. And then in the bad days, we don't want to go below 12%, let's say, all right? So you raise the ceiling, you raise the floor. Now that leaves me into something that I'm very glad you asked that question because it's all about managing cyclicality, and we talked to you before that we thought we were prepared in the downturn and that we were not going to fall off a cliff like we did before. Interesting, I just want to give you some statistics here. I went back through this period here so, okay, fiscal '08 was a boom year, great year. '09, '10, were really tough. '11, we're looking for an improvement coming out of it. And just, I went back and compared the same comparable years in the last downturn and that would be fiscals '01, '02, '03 and '04. '01 was still a boom year, '02 and '03 were struggles, '04 was a recovery. When we went in '08 that boom year, our operating margin was 230 basis points higher than it was in '01, which was the boom year before that downturn. We started that, we were 230 basis points better. In '09 when we went down, we did go down. We went from 119 to 88, but it was 320 basis points better than the first year of the downturn the time before. So this year, '10, the second year of this downturn, we generate 10.4, that's 450 basis points better than the second year of the downturn '03. And now, of course, we're looking at the recovery and we're giving enough here. So I think that we've been talking about it. If you can talk the talk, you need to walk the walk. I think that we have done that, and I am so proud of our people that they have been able to raise the ceiling, raise the floor, anywhere from 230 to 450 basis points. So I think it is -- we got to keep going, and you can't raise the ceiling if you don't raise the floor. I think we've done that. We've proven that. So hopefully onwards and upwards but I can say, right now, we're pretty confused out here.

[Alexander Blanton:]

Well, yes, back to back, over $3 of shares here, pretty good. Gasoline strategy, Win Strategy, lean, right?

[Timothy Pistell:]

Yes, sir. Lean is absolutely embedded into the Win. And the one last thing that we talked about cash and I would just, again, just the five years of the experience in '04 to '08, our cash flow from operating activities with 10.0%. That's what it average, 10%. These two years, these horrible years, the worst we've seen, they've averaged 11.6%.

[Operator:]

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

[David Raso:]

Just so I understand your 48%-52% revenue split, the first quarter, if you look at the recent order trends, you're looking at revenues up near 30% for the quarter. That half of your split is saying, then the second quarter revenues are down 9% to 10% year-over-year. Now I understand the idea of just giving your conservative guidance, but Don's comments about the next six months we have good visibility, the guidance is telling that second quarter revenues year-over-year are down. How is that consistent with the company looking to double their CapEx in the year? They're talking about $1.5 billion of M&A power. So I'm just trying to square up the commentary. And then you've just given a conservative guidance, but...

[Pamela Huggins:]

David, this is Pam Huggins talking. Just to clarify numbers a little bit, and let's talk on an organic basis. When you look at the first half of 2011 versus 2010, and I'm talking at the midpoint of course, your about 14% and you have a 14% increase. When you get to the second half, you're still almost at a 2% increase. So we saw a huge increase in the first half. The second half is relatively flat with the first half, but on an organic basis, it still has an increase.

[David Raso:]

True. But again, the second quarter, last quarter, orders were up 23%. You booked revenues, up 26%. Orders were just up 35%. Let's trim it a bit and say, revenues were up only 30% in the first quarter. That means the second quarter revenues have to be down year-over-year to be consistent with your 48%-52% split. And that's fine. You keep on saying, we don't have visibility beyond 90 days, which is fine. We're a bit of uncertain time right now at the macro-data versus what you're seeing on the ground. But I'm just trying to square up how you're thinking about it. And I know it's getting back to depreciation, Tim, but you are looking to double your CapEx in a year where you think beyond 90 days, your sales are down. So I'm just trying to square everything else here.

[Timothy Pistell:]

David, again, I'm not seeing...

[Pamela Huggins:]

Second quarter, organically, were up 9%.

[David Raso:]

So second quarter is up 9%, you're saying that this coming quarter is more like 19%, despite orders are up 35%?

[Pamela Huggins:]

That's right. But let me tell you, that 35%, you have to remember it's again tough comparisons. And if you look at actual orders on an absolute dollar basis on a three-month rolling going sequentially, last quarter to this quarter, that's not the type of increases that you see, David. So you do have to remember that there are some really -- you're up against tough comparables.

[David Raso:]

And then when it comes to the end markets, you're typically about 90 days x the Aerospace business. But when you actually look at what the caps of the world in years and wide variety of other non-mobile players, all the industrial markets, life sciences, everything, are you seeing, and I know those production schedules could change, but obviously, while your customers give you beyond 90 days with some framework, are you seeing calendar fourth quarter production schedules that are only equal to or up modestly from calendar fourth quarter '09?

[Pamela Huggins:]

Well, what I can tell you is when you look at the markets in the mobile and you look at it on a sequential basis, it's up high-single digits.

[Timothy Pistell:]

David, this is Tim. I'm really struggling here because what you're saying and what we got here because we're not giving -- I'm seeing the first quarter of next year forecast, first quarter of next year, is up considerably $400 million or so over the Q1 of the prior year. I'm seeing Q2 of next year being up like $300 million over the prior year, and I'm seeing Q3 being up a couple hundred million over and then I see Q4 of next year kind of beyond. Not a whole lot different than the Q4 of this year. But I got -- although very strong increases from year-over-year. Now...

[David Raso:]

But then the full year revenue guidance is only up $500 million?

[Timothy Pistell:]

I'm taking about year-over-year. Sequentially, if we're going off the fourth quarter of this year to the first quarter of next year, yes, it's down a bit. It is down a bit, and that's simply because of the summer months or vacation shutdown. So anyway.

[Pamela Huggins:]

But remember David, currency is in there. I mean, I know you know that but...

[David Raso:]

I know, I appreciate that. But just, again, revenue guidance for the year are all in, is up about $500 million. And you're rattling off hundreds there year-over-year where there's got to be a negative number in there somewhere in the guidance. Look, you're just doing a crystal ball thing, we don't really know beyond 90 days. So I'm just trying to square up how that's going to influence your decision on CapEx. And I know it's getting back to depreciation, but you're doubling CapEx. You obviously have an acquisition pipeline that when you read between the commentary, it sounds like we're looking to step up acquisitions. You haven't gone this many quarters about making an acquisition. I don't know how long, it's been at least a decade. So I'm just trying to make sure this conservatism doesn't actually parlay into you just sitting on a balance sheet that should be utilized right now, or really alters how you're thinking of your production schedule. I'm just trying to think commentary versus you and practice.

[Timothy Pistell:]

No, again as I say, it's the numbers that I given you were before the currency impact, which I think Don gave you which is built in and is significant. No, and as you know, when we said we are looking at things again, we have a strong balance sheet, we have capacity and we're looking at things again. But we're going to be very disciplined on what we look at and what we think about acquiring.

[David Raso:]

And from the last comment, the M&A environment, Don and Tim, you are still looking at it as these are the parts of the cycle where Parker utilizes the balance sheet in your macro-view and sitting on your wallet per se?

[Donald Washkewicz:]

Yes, that's correct.

[Operator:]

And our next question comes from the line of Steve Volkmann of Jefferies & Company.

[Stephen Volkmann:]

But just anything in the 2011 outlook with respect to raw material trends, any supplier constraints or pricing issues that you feel like we should comment on?

[Donald Washkewicz:]

Well, this is Don. We're still getting pressure on some raw materials. I'd say the ones that would come to mind would be copper, and rubber, and steel, some of the thermal plastics, and nickel and things like that, nickel-based alloy. So that's an ongoing thing, Steve. I don't see that we're probably going to get it much relief and as the economy continues to grow, I think that it'll just continue on. Our goal is to pass it on basically as to -- we'll negotiate the best we can, we push back the best we can, we do the best we can on a procurement side. And then, of course, we've got to make it up on the other side. And I think our performance over the last five to seven years proves that we understand how to get that job done. So I don't anticipate that Parker have any major shortages or anything like that going into this period, but I do think that there's going to be more pricing pressure going forward.

[Stephen Volkmann:]

So net of price for the price-cost balance, is that a net positive for you in the...

[Donald Washkewicz:]

Well, I'd say, we're going to at least offset, let's just put it that way. We will offset any cost increases with our pricing.

[Operator:]

And our next question comes from the line of Eli Lustgarten of Longbow Research.

[Eli Lustgarten:]

Quick question. I want to make sure. A clarification is, didn't, Tim, you say, initially, that you forecast the first half and then you really treated the second half as flat, adjusted for number of days. So anything can happen in the second half as far as guidance goes? And I think it's the part we're missing.

[Timothy Pistell:]

Yes, that's exactly right. And I think as Don point out earlier and we tell you that we have other bites. We'll have other opportunity come back and recalibrate this thing. But right now, that's our issue. Our real concern, Eli, is Q3 and Q4.

[Eli Lustgarten:]

But we shouldn't say, if you had a $1.50, you wound up at $3.40 and you add $3.60 at the bottom, who knows where we could go to. I'm kidding.

[Timothy Pistell:]

$8, right?

[Eli Lustgarten:]

Yes. Two quick questions, specifically. One, in the order patterns that we've shown particularly for the car [ph] business, how much of the gain was in distribution versus OEM? I mean are they up equally or there's a big difference between distribution and OEM?

[Pamela Huggins:]

Well, if your talking about on a sequential basis, distribution is, I would say, high-single digits. And it's pretty much in line -- we're pretty much seeing that going across industrial as well as mobile. When you look at it on a year-over-year basis, I mean obviously, mobile's up a little bit more than distribution and the industrial side of it. We saw the industrial come back very strong, okay, and then it kind of flattened out and then we saw the mobile take a big leap forward, okay? Now we're starting to see industrial come forward in Europe.

[Eli Lustgarten:]

I guess I'm trying to get the split between Distribution and OEM business. And the bulk of the gain right now is coming from OEMs as opposed to distribution system?

[Pamela Huggins:]

That's right.

[Timothy Pistell:]

Yes.

[Eli Lustgarten:]

And I think you talked about Aerospace because we're starting to see a lot more activity in the Aerospace, starting to hit potential for double-digit gains, and you've got very modest gains next year in Aerospace, and you have margin is not doing very much, you may have use backlog. Do you sense how -- when do we start seeing some of the leverage from Aerospace? And when do we see some of this -- how much of the increase are indicative to be next year holding down margin? At what point do we see that course over coming?

[Pamela Huggins:]

In terms of R&D, let me just talk about that a little bit. We have a slight increase next year, not much in terms of the percent of sales. R&D has been running around about 10% of sales, and that's going to continue next year. What is happening though is commercial aftermarket and the commercial OEM, that will increase next year. What's going to happen is we're going to have some decrease on the defense side, the C-17 and F-22. I'm sure your familiar with what's happening with those programs, so we're going to see some decline in the Defense side of the business, which is going to be offset by the commercial OEM and the commercial MRO, both will be increasing. And there's a pretty good increase built in for the commercial aftermarket side, which you would expect as the revenue of passenger miles are going up.

[Eli Lustgarten:]

But again, in 2012, do we start to see the breakout in both revenue and return to a more normal level of profitably?

[Pamela Huggins:]

Yes, I mean, we think this R&D is going to continue to go down as a percentage of sales. That sales continue to increase.

[Operator:]

And our next question comes from the line of Robert McCarthy of Robert W. Baird.

[Robert McCarthy:]

Pam, can I just get a couple of things clarified from the last two questioners. I think I thought I heard you say that you thought R&D as a percent of sales would be maintained at current levels because you need to keep it up. But then, I think, right at the very end of your response, you said something about R&D going down a little bit.

[Pamela Huggins:]

Yes, let me clarify you. Fiscal year 2010 to fiscal year 2011 is relatively flat as a percentage of sales, okay? So a very, very minimal increase. But as we go forward after fiscal year 2011, we think that the R&D is going to come down as a percentage of sales as revenue climbs.

[Robert McCarthy:]

And then the other one was at the end of your comment, higher pressure. Did you actually say that you're seeing improved order flow sequentially out of European distribution?

[Pamela Huggins:]

Out of European industrial. We're starting see the industrial side of the business pick up in Europe.

[Robert McCarthy:]

But not distinguishing between distribution and OE?

[Pamela Huggins:]

No, because we're seeing, and you know, in all areas, it's picking up whether you look at the mobile, or the industrial, or the distribution, all three aspects of the business are increasing. I'm just talking relative.

[Robert McCarthy:]

So then what I wanted to ask about and sorry if this seems like beating a dead horse on a couple of these issues. But I assume that given how important pricing has been to the success of the overall Win Strategy, that you are assuming some positive pricing contribution in your FY '11 guidance or put differently, would you be assuming some cost inflation?

[Timothy Pistell:]

Yes, Ron, Tim Pistell. There is a nominal -- again, when we roll it all up because, of course, it's all very specific to the situation. When you collectively roll it up, there is a modest assumption on price increase in there. Positive price increase, yes.

[Robert McCarthy:]

I mean, can you help me -- when you're saying modest, you mean like less than a percent kind of number?

[Timothy Pistell:]

No, 1% to 1.5%.

[Robert McCarthy:]

And then the other question that I asked was fairly transparent motivation is, is there any link between compensation and the accuracy of the forecast that you get from the operating units as you roll up your internal forecast?

[Timothy Pistell:]

None, whatsoever. Actually, we did see our compensation and the key components, one, is based on cash flow. Another one is based on return on net assets, all actuals. Those are the two key short term for longer term of the share price. And then at sales growth, earnings growth and ROIC. And none of that -- and that's how we do versus the peers is not how we do it to a plan.

[Pamela Huggins:]

But Rob, one of the things that I will say is at the group level, right? The President and the group controller, they look at the accuracy of that forecast on an ongoing basis.

[Robert McCarthy:]

But outside of, call it, managerial suasion, there's not really any explicit downside from submitting a forecast that later is trounced?

[Donald Washkewicz:]

No, either direction. There's no incentive to go higher or lower as far as that goes.

[Robert McCarthy:]

But Don, you said, you specifically want people forecasting numbers that you can be sure will be delivered?

[Donald Washkewicz:]

Well, we want to have a high confidence that they deliver the operating margins and the EPS, if you will, irrespective of what happens on the top line. We're going to hold their feet to the fire in getting to the bottom line, okay? And by saying that, I mean, early in the program, we don't want them just hiring a lot of people just because they forecasts some high-level top lines and how they can justify starting to spend money hiring people, spending money and so forth as if we're running at that level. We don't want them spending money at that level until we get to that level, so no. But there are, like Tim said, I think the important thing is, it's a good question that you asked, our incentives are tied to our performance against the peers for the most part, okay? They are tied to the peers. So if we get into the top quartile of performance relative to the peers, we're going to have top quartile inceptive and if we're in a midpoint, we're going to be about the middle of the pack, we'll get the middle of the pack kind of incentive. So that's how we're basically incentivized here.

[Robert McCarthy:]

And then if I can, there have been a couple of comments made about, Tim, you calculate an acquisition capacity, you talk about being back in the market, you're seeing more stuff. But in each case when you've mentioned that you said something about we're going to remain disciplined, can we infer from that, that you intend to remain more disciplined than you have been in the last couple of cycles? Or are you just trying to say, we're not in any hurry, we're not trying to meet any objective?

[Donald Washkewicz:]

Well, what we're saying is, number one, there has to be a good fit when this is done. There has to be a good fit with what we're trying to accomplish here. It has to be synergistic. And number two is the fact that we don't like the multiples, where the multiples got to at the peak of the last segment 2008. We don't like the levels that these properties are being sold at. We're not going to pay those kind of levels, okay? So if we need to have a return for our shareholders based on a reasonable price, a fair return and a fair price for the property. So what I mean is that people are still looking in a rearview mirror thinking that those EBITDA multiples are going to hang in there forever then, frankly, we're going do fewer deals at those levels. And I don't think that we're alone in that respect. Based on what I'm seeing out there, I think everyone is kind of looking at the same thing that, wait a second here, we're not going to have this euphoria as far as top line growth going double digits forever and then without backing into some kind of discounted cash flow that gives you some huge valuation. Those are the times of the past, okay? So we're going to be disciplined and we're going to be prudent. We're going, honestly, go after those things that have the most synergistic impact on the company, but we will not do it at any price.

[Operator:]

And our next question comes from the line of Ann Bugman (sic) [Duignan] of JPMorgan.

[Ann Duignan:]

It's Ann Duignan. Tim, I wanted to step back and just pause you a little bit. You compared margins cycle-over-cycle in '09, '10 versus '01, '02, '03. Can you tell us, with the outlook midpoint of the outlook that you've given us for '11, how does that compare with '04?

[Timothy Pistell:]

I think it compares well. I mean '04 was a recovery year, but it wasn't a -- and it was one that they continued, of course, into '05 and '06, a little different, but it was a nice uptick. It was around a 10% increase in volume in that case and we picked up a couple hundred basis points on the operating margin. We went from 5 9 to 7 9, and this from '10 to '11, we're looking at only a 5% increase out of '10 and we're picking up, looks like about, 100 basis points. So it seems to hang together pretty well that way.

[Ann Duignan:]

Yes, because to David Raso's question earlier, I mean, I think, it's fine when you guys are conservative and we appreciate you being conservative, particularly into calendar year '11. But sometimes, the numbers just don't add up when we go back to the drawing board. I think that was the point David was trying to make. Can you talk specifically on just also on pricing and the pricing environment in Europe in particular? Are you seeing any increase in pricing competition from Europe being competitors just as volumes recover over there?

[Donald Washkewicz:]

Ann, it's still pretty early with the levels of activity over there right now. There's really not a lot of pricing, if you will, capability in Europe at these lows because they're very, very depressed yet. And I think that's going to continue until the activity levels pickup.

[Ann Duignan:]

And is that a function of you're more exposed to OEMs in Europe versus distribution? How is it that...

[Donald Washkewicz:]

No, I think its a function of demand. Demand is so low being there about 80% of the 2008 level, that there is -- the customers are not going to be taking any price increases for the most part until they see that their demand is picking up and they can justify accepting anything there and justifying it, if you follow what I'm saying.

[Pamela Huggins:]

And, it's Pam speaking. I'd like to say that our guidance is realistic as opposed to conservative. And then just to answer a question for Nigel Coe, I think he was the one who asked about the other category, and why didn't have third quarter to fourth quarter. I can deduct from the information that I do have that it's really mostly related to inventory valuation and currency, and we can talk further off-line about those two items. So at this time, I'll turn it over to Don with a few closing comments. And thank you very much for your participation today.

[Donald Washkewicz:]

Yes, thanks. We extended the call a little bit because we got a little bit late start. So hopefully, that didn't put you in any pain with other calls that might be happening. I think you should pretty much agree that we're positioned pretty well as a company to come out of this situation a lot stronger than when we went in this recession. I think in line with Tim's comments, I'd like to just reiterate the points that we have now increased margin performance at the bottom of each of the last three manufacturing recessions and just as importantly, we have also raised the peak margins at the height of each of the last two expansions. And I think that doesn't tell the whole story either because this last recession was the worst one in 70 years. So I think having raised the bottom and raised the top in an ugly situation that we haven't seen in 70 years speaks very highly for the company. So I think that all represents or demonstrates our ability to reshape the financial performance of the company and we basically told you what we're going to do over the last five to seven years here, and we're executing, and we're doing exactly what we said we'd do so. Hopefully, our credibility is pretty well out there. It's pretty good. We're going to continue to execute all aspects of the Win Strategy as working. I think you can see what's happening. We're going to obviously focus a lot on growth and profitability as we have. We anticipate ongoing investments in R&D, international expansion. I mentioned some of the Asian region as to why we're focusing on there. Acquisitions and distribution are also going to be a focus to grow our business going forward. So with that, once again, I want to thank everyone on the call, and we certainly appreciate your interest in Parker. I also like to thank one last time the Parker employees across the world, and many of them are tuned in here for their continued commitment to serving our customers. And then just as we said in the past, Pam will be available, the balance of the day, to answer any additional questions that you may have. So with that, I'll just say goodbye and have a great day.

[Operator:]

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect have a great day.