Motion and control technologies company Parker-Hannifin (NYSE:PH) is somehow emblematic of investing in the industrial sector right now. The company recently gave its first-quarter earnings for fiscal 2020, and lowered its full-year 2020 guidance. But the stock continues its positive run in 2019 -- it's now up more than 33% year to date -- as investors have shrugged off disappointing earnings results and a deteriorating near-term outlook. Let's look at what's going on and what it might mean for other industrial stocks.
Parker-Hannifin lowers full-year guidance
The company is only one quarter into its full-year 2020, but given the deteriorating end-market outlook, it's already cut its full-year guidance.
Back on the fourth-quarter presentation in August, management guided toward full-year 2020 organic sales growth in the range of a 3% decline to flat and adjusted EPS of $11.50 to $12.30 (excluding the impact of two acquisitions). Jump ahead to the recent first quarter, and management is now predicting organic sales to decline 4.5% to 7.5%, and EPS to be just $10.10 to $10.90 -- and those EPS figures include the impact of its recent acquisitions.
During the earnings call, when asked to explain the dramatic cut in guidance, CEO Thomas Williams highlighted the usual slew of negative industrial data, such as survey data from the purchasing managers index (PMI) in the U.S. and China (a reading below 50 indicates a contraction in the industrial economy), and Germany's IFO index -- a leading indicator of business sentiment in Europe's leading industrial economy.
Williams also discussed Parker-Hannifin's weakening order trends, saying: "August and September were about the same, but they were weaker than July," and "we saw further softening from that August and September rate" in October. All told, orders declined 2% in the first quarter, and the weakening trend led him to cut revenue guidance. The midpoint of full-year organic sales guidance now calls for a decline of 6% compared with a previous expectation of a decline of 1.5% at the midpoint.
Will a guidance cut lead to a stock price rise?
Frankly, this doesn't appear to be a company-specific issue, as a host of industrial companies have seen deteriorating end-market conditions lead to guidance cuts. For example, the writing was on the wall for multi-industry company 3M (NYSE:MMM) before it gave earnings and consequently cut guidance. And the same can be said for construction machinery company Caterpillar (NYSE:CAT) -- yet all three stocks have risen following the guidance cuts. What's going on?
Why the market shrugged off the guidance cuts
The answer comes down to a combination of two highly related factors. First, the market could have foreseen the declines in business surveys, economic indicators, and earnings from companies in highly cyclical sectors like the railroad industry, and it was obvious that a cyclical stock like Parker-Hannifin could cut guidance -- investors were prepared.
The second reason is that investors have decided to shrug off the current weakness in the economy and are pricing in a recovery in the future. This line of thinking can be seen in how the market reacted to Parker-Hannifin's guidance.
For example, although Williams said organic sales would decline 6% for the full-year 2020, he also said they would decline 6% in the first half and then 6% in the second half (all figures are on a year-on-year basis). Given that the decline in the first quarter was just 3%, it implies that "the bottoming out of Parker is somewhere between Q2 and Q3 in this guidance," according to Williams on the earnings call.
To be clear, this doesn't mean sales growth will be positive in this period, but it does mean the decline will get smaller and then hopefully turn positive in the future.
Is Parker-Hannifin stock a good value?
If Parker-Hannifin's 2020 does indeed turn out to mark a trough, then there's reason to believe the stock is a good value now. For example, the company has converted more than 10% of its revenue into free cash flow (FCF) for 18 consecutive years, and on the earnings call, Williams said, "We fully anticipate to do double-digit cash flow from operations for the full fiscal year."
Based on guidance, the company should have $14.4 billion in revenue in 2020, meaning a minimum of $1.44 billion in FCF. Based on the current market cap of $25.5 billion, that means a price-to-FCF multiple of around 17.7 times. That's not an unreasonable valuation for a stock that should be looking ahead to earnings and FCF increases in 2021.
A similar argument applies to Caterpillar, where management believes the company won't generate less than $4 billion in FCF at the trough of its earnings cycle -- a figure that covers its current dividend payout of some $2 billion by two times. Dividend investors take note: Caterpillar is saying its near 2.8% dividend yield is safe.
The bottom line
All told, the market is already braced for a decline in many industrial companies' underlying earnings in the near future, but if some sort of trough occurs in 2020 -- meaning a recession is avoided -- then there's a case for buying ahead of it. That's the view the market has taken with Parker-Hannifin for now, and investors should start looking at industrial stocks with a view to profiting from this investment theme.