派克漢尼汾 (PH) 2011 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the second-quarter 2011 Parker Hannifin Corporation earnings conference call. My name is Caitlin and I will be your operator for today. At this time all participants are in listen-only mode. Later we will conduct a question-and-answer session. (Operator Instructions). As a reminder, this conference is being recorded for replay purposes. I would now like to turn the presentation over to your host for today, to Ms. Pam Huggins, Vice President and Treasurer. You may proceed.

Thank you, Caitlin. Good morning, everyone; this is Pam speaking, just as Caitlin said. I'd like to welcome you to Parker Hannifin's second-quarter fiscal year 2011 earnings release teleconference. Joining me today is Chairman, Chief Executive Officer and President, Don Washkewicz; and for the first time Executive Vice President and Chief Financial Officer, Jon Marten.

For those of you who wish to do so, you may follow today's presentation with PowerPoint slides that have been presented on Parker's website at www.PHstock.com. For those of you not online, the slides will remain posted on the Company's investor information website, again at www.PHstock.com, and they'll be on there for one year after today's call.

So at this time if you will reference slide number 2 in the slide deck, this is the Safe Harbor disclosure statement addressing forward-looking statements, no different from prior quarters. If you haven't already done so, however, please take note of this statement in its entirety.

This slide, as required, indicates that in cases where non-GAAP numbers have been used they've been reconciled to the appropriate GAAP numbers and are posted on Parker's website.

To cover the agenda for today on slide number 4, the call will be in four parts as usual. First, Don Washkewicz, Chairman, Chief Executive Officer and President, will provide highlights for the quarter. Second, I'll provide a review including key performance measures of the second quarter, concluding of course with what you're most interested in which is the revised 2011 guidance.

The third part of the call will consist of the standard Q&A session and for the fourth part of the call today Don will close with some final comments. So at this time I'll turn it over to Don and ask that you refer to slide number 5 titled Second-Quarter Fiscal Year 2011 highlights.

Thanks, Pam, and welcome to everyone on the call this morning. I'd like to start off by pointing out that this is Jon Marten's first call as Chief Financial Officer of the Company and we're very excited to have him participate in this meeting this morning.

Jon has been with Parker for 24 years and has distinguished himself as a leader within our organization with extensive experience throughout our operations. Jon also has worked closely with our senior leadership team which has prepared him well for this next step and he's very much looking forward to meeting many of you in the coming months. And as I understand it, Pam will be introducing Jon to many of you in their travels this coming month.

So to start the call, I'd like to take a moment to point out some of the highlights of the quarter. Maybe just an intro comment, I think we had just an outstanding quarter for the Company; we set quite a few records, I'll cover some of those with you now.

Sales were a second-quarter record and increased 22% from the prior year quarter. Orders increased 29% indicating that the economy continues its recovery across many markets. You can see obviously that we're building backlog and that 29% is greater than the 22% increase in sales in the quarter, so that bodes well for the future. Also a little later in the call I'll touch on some of the markets and what we are seeing in some of the various markets and regions around the world.

Net income was a second-quarter record at $232 million and basically doubled compared with last year's second quarter. And diluted earnings per share was a record as well at $1.39 and well ahead of our expectations. I want to point out that we are achieving these records on lower volume levels than we did in fiscal 2008 when sales peaked and so obviously all the hard work over the past two years is really paying off for the Company.

Total segment margins were 14%, which is -- as well. That's very strong performance, especially considering that the December quarter is traditionally a weaker quarter, actually our weakest quarter typically from a margin perspective. So in a second-quarter to come in with 14%, we're pretty ecstatic about those margins.

Industrial North America margins were strong at 15.2%, as were Industrial International margins at 14.6% and we were also pleased to see Aerospace margins improve significantly from last quarter and reach 13.8%. Now those on the call that have been on the call the last couple of calls may recall that the last quarter's call we said that Aerospace had bottomed and certainly these numbers would indicate that it has and it's on its upward climb here. So we're feeling pretty good about Aerospace going forward.

Our cash flow remained strong at 7.2% of sales and, excluding a discretionary contribution of $200 million in the first quarter, year to date operating cash flow is at 10.7% of sales and that exceeds the Company's target of 10%. So again very, very nice performance for the Company.

During the quarter we completed one acquisition and that's in addition to two we did last quarter and we certainly have more opportunities in the pipeline that we're looking at. And as you know, we don't forecast acquisitions but we are certainly actively pursuing them and pursuing strategic opportunities going forward. We're certainly very pleased that we performed so well in what has historically been a seasonally weak quarter for the Company.

Looking ahead to the full fiscal year 2011 we have increased our guidance for earnings from continuing operations to a range of $5.80 to $6.20 per diluted share and that gives you a $6 midpoint. And that number represents a 9% increase from the midpoint of our previous guidance and a 76% increase year over year. So pretty nice improvement as we go forward.

Again, I told you from the beginning that what we'll do is we'll continue to update these numbers as we go forward; as we see things developing out in the marketplace we'll give you a new look at what our guidance is and what we think we're going to do for the year.

So if we did $6 as we're projecting here that -- as a midpoint, we have a range around that. But if we say for instance if we hit the $6, that would put us at record earnings per share for the year. Our prior record was in fiscal 2008 when we hit $5.53 and that was, by the way, on more sales volume.

So our strong first-half combined with the solid order entry levels which are exceeding our sales growth in the half gives us certainly continued confidence in achieving record earnings for the year. And we're going to continue to increase, as I said -- or not increase, but give you updates on this guidance every quarter as new information becomes available.

So now, before I go back to Pam and have her go into some of the results in more detail, I'm going to hand things over to Jon just for a few moments. He wanted to say a few words of introduction this morning. So, Jon, why don't you take it from there?

Thank you, Don, and welcome to everyone on the call. I just wanted to take a few moments to tell you how excited and honored I am to be leading the financial strategy at Parker. I have spent 24 years at Parker and I can tell you that there's never been a more exciting time to be a Parker employee and an even better time to be in a position where I get to tell our story on a regular basis. I'm very much looking forward to getting out to meet more of you in the next month or so.

As Pam will highlight for you in a moment, this quarter marks yet another quarter where we have been able to demonstrate consistent execution and performance against our objectives. We have tremendous management talent within the Company that has a long record of being able to deliver on our commitments that extends over the past decade. That same team, helped by all Parker employees, has allowed us to both perform better and recover more quickly from the past recession than in any previous recessionary period.

Secondly, I would like to point out that the Company has tremendous opportunities for growth well into the future. We have a growing pipeline of very exciting new products and technologies that is being developed. We are making investments in emerging markets which will allow us to capitalize on all of our growth opportunities. And we have the financial flexibility to invest in acquisitions that can enhance our already strong position in our markets.

Perhaps most importantly, we have a focused strategy that helps bring us direction to our efforts. The Win Strategy has set clear expectations of performance across our organization. The Win Strategy provides our businesses with the tools that allow them to be successful and it is the primary reason that we have been able to deliver such consistent revenue growth, margin expansion and returns over time.

Once again, I'm excited to take on such a critical leadership role in Parker. And now I'll hand things over to Pam who will run through the details of the quarter. Pam?

Thanks, Jon. So at this time please reference slide number 6 and I'll begin by addressing earnings per share for the quarter. Earnings per share for the second quarter increased $0.75 from the same quarter a year ago and came in at $1.39, which you saw in the press release this morning; this represents an increase of 117%. On a sequential basis the earnings per share of $1.39 exceeded expectations and compares to $1.51 last quarter.

Realignment expenses in the quarter were only $2 million, $1 million net of tax or $0.01, and this compares to $7 million, $4 million net of tax or $0.03 for the same quarter a year ago. Incremental margin or return on sales was 31% for the quarter and, just as a reminder, marginal return on sales is the difference in segment operating profit divided by the change in revenue for the quarter on a year-over-year basis.

So now if we can move to slide number 7, laying out the components of the $0.75 increase in earnings per share from $0.64 to $1.39 for this quarter. And this is on a segment basis, the significant puts and takes are as follows. Revenues increased 22% in the quarter, largely driven by the Industrial segment and Climate and Industrial Controls. However, increases in revenues were seen in all segments of the business.

As a result of higher revenue, operating income year over year was significantly higher and across all segments generating a positive EPS impact of $0.71. The significantly higher operating income produced record second-quarter margins in North America, overall industrial and for the Corporation in total. As Don said, year-over-year margins increased to 14% from 10.4% for the same quarter last year.

While corporate, general and administrative expenses increased year over year due to incentives and impacted EPS by $0.03, the percent to sales for these expenses is consistent at 1.3%. Other expense decreased favorably impacting earnings per share by $0.07 mainly due to less fixed asset write-offs in this year versus the prior year and a gain on the sale of a facility. Taxes increased, which most of you noticed, due to higher income while the tax rate was actually lower due to tax law enactments.

So at this time moving to slide number 8 and looking at the top-line, revenues for the quarter increased 22% to $2.9 billion from $2.4 billion last year. The impact of acquisitions was nominal and currency was unfavorable by 1%. After taking currency and acquisitions into account the organic growth was 22%, consistent with the reported growth of 22%. There's a little bit of rounding going on here, so if you try to reconcile the numbers that I just gave you, that's just rounding.

Moving to slide 9 and focusing on segments commencing with the Industrial North America segment. North American revenues increased 23% in the quarter versus the same quarter a year ago. Currency and acquisitions each added 0.5% to revenues in the quarter; adjusting for these organic or core revenues increased 22%.

Operating income increased from $114 million to $159 million, a 39% increase, and this resulted in a marginal return on sales of approximately 23%. Operating margins increased 170 basis points over the same quarter last year. The operating margin in this segment is a second-quarter record for the Corporation.

So now moving to slide number 10, moving to the International Industrial segment. Organic revenues increased 26% in the quarter versus the same quarter a year ago. Currency was a deduction to the revenues in the quarter of approximately 3%. Acquisitions, again, had minimal impact on the revenues in this segment; therefore reported revenues increased 23% for the quarter. And in this segment incremental marginal return on sales was 40%.

Operating margins increased 570 basis points to 14.6% in the quarter and this compares to 8.9% for the same quarter a year ago, so great performance in International.

Moving to slide 11 and focusing on the Aerospace segment for a moment. Aerospace reported revenues increased 15% in the quarter versus the same quarter a year ago. Again there was minimal impact from acquisitions and currency, so base revenues increased 15%, in-line with what was reported. Margins increased 360 basis points for the quarter year over year to 13.8% from 10.2% last year.

And as you'll recall from the last earnings call, we had indicated that Aerospace would incur less research and development in this quarter versus the first, but that research and development would be slightly higher for the segment for the year in total.

Slide number 12, Climate and Industrial Control segment, let me just address that for a moment. Year-over-year total reported revenues increased 23% and for the quarter; acquisitions increased revenue 2% and currency had minimal impact. So the organic or base revenues increased 20%, again a little bit of rounding here. Margins as a percent of sales were 4.4% and for the quarter versus 3.5% last quarter.

So moving to slide 13 and addressing the orders. The numbers that we're presenting here, they represent a trailing three-month average and are reported as a percentage increase of absolute dollars year over year. And these numbers exclude acquisitions and currency, except for Aerospace. Aerospace is reported using a 12-month rolling.

So as you can see from this slide, orders are up 29% for the December quarter just ended; this compares to 29% last quarter and a minus 7% a year ago. North American orders for the quarter just ended increased 26% year over year and this compares to 31% last quarter and a minus 3% a year ago. Industrial International orders increased 29% year over year and orders were up 34% last quarter and flat a year ago.

Aerospace orders are up 37% for the quarter which compares to a positive 16% last quarter and a minus 27% a year ago. In the Climate and Industrial Control segment orders are up 26% for the quarter comparing to 23% last quarter and they were positive 6% a year ago.

I would like for you to take note that the sequential decrease in order rate improvement representing orders calculated as a percentage increase on a three-month rolling basis year over year, this is due to tougher comps and absolute dollars orders have increased sequentially quarter to quarter.

So moving on to the balance sheet, Parker's balance sheet of course remains very solid. Cash on the balance sheet at quarter end was greater than $800 million and we had zero commercial paper outstanding. Inventory increased by $66 million during the quarter, $5 million from acquisitions and DSI increased by one day. However, DSI is down 10 days versus year over year. Accounts receivable in terms of days sales outstanding is 46, down two days from the same quarter a year ago. And of course we continue to work on the weighted average days payable outstanding.

Moving to the cash flow statement, operating cash flow for the quarter was $285 million representing 10% of revenues. And on a year to date basis, after adjusting for the $200 million contribution to the pension plan that we made in the first quarter, operating cash flow is $608 million and this represents 10.7% of sales.

The major components of the uses of that $285 million in operating cash were -- acquisitions $35 million; $57 million or 2% of revenues utilized in connection with capital expenditures; $67 million has been returned to the shareholders via share repurchases of $20 million and dividend payments of $47 million.

Proceeds from the issuance of medium-term notes of $295 million was received in the first quarter and these proceeds were utilized to pay down $257 million in euro bonds outstanding which came due in November. As a result of this and some -- just a few miscellaneous items cash decreased $115 million in the period.

On slide 16 you can see that the debt to total cap ratio is 26.5%, down from 30.4% last quarter.

So now moving to the guidance, which I know that you're all interested in. On slide 17 through 19 the guidance has been presented. On slide 17 the guidance for revenues and operating margin by segment have been provided. Slide 18, guidance has been provided for the items below segment operating income or what we call below the line items. And then slide 19 summarizes the guidance on an earnings per share basis.

As you can see from this slide, the guidance for fiscal year 2011 for earnings per share is projected to be $5.80 to $6.20, as Don has already mentioned, and that represents a $0.50 increase at the midpoint from the previous guidance provided. Please remember that the forecast excludes any acquisitions that may be made in fiscal year 2011.

The full-year revised guidance assumes the following, at the midpoint -- increased revenue year over year greater than 17%, and this is up from 13% last quarter; segment operating margins as a percent of sales approximately 15%; expenses below segment operating income, or as we call below the line items, which include corporate administration, interest and other expenses, are assumed at the midpoint to be $388 million and the guidance incorporates a range plus or minus 1%. These expenses are reduced from prior guidance in large part to reflect the current run rate.

The full-year tax projection is 27% and that's down from 29% for previous guidance, again due to tax law enactments that I mentioned earlier. But a couple of points with respect to guidance -- sales first half/second half are divided 48%/52%; earnings per share first half/second half are divided 48%/52% as well.

Fiscal year 2011 -- 2011 includes higher pension expense. We talked about this on previous calls. And realignment costs for the year are projected in the normal range of $0.10 to $0.12. $0.10 to $0.12 is within the range that is defined as normal realignment costs, costs that would be expected to be incurred on an annual basis. Third-quarter earnings per share will be less than the fourth quarter and we think you as a group have the third quarter about right right now.

So at this time we will now commence with the Q&A session. As a reminder, the call will be limited to 1 hour, so please honor the request of one question at a time and follow up only when clarification is needed. By adherence of this courtesy everyone will have a chance to participate. So at this time Caitlin, would you please open the call to begin the Q&A session?

(Operator Instructions). Nigel Coe, Deutsche Bank.

Good morning. I'll keep this to one question and -- Don mentioned normally that margins are weaker Q for Q in 2Q, and certainly history suggests. But can you just explain conceptually why when revenues are higher Q by Q why the margins will be down?

Between what quarters?

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

Typically the second quarter is our worst quarter for the Company. And as we're coming out of this recession too -- of course you have the holidays in there, we have a lot more expense in there, a lot of extraordinary things going on and not a whole lot of activity in the quarter. So when we come in with margins like this -- by the way, this 14% margin that we had in the second quarter really was only beat by a 10th of a point in fiscal 2008 at our peak when we were going at full steam ahead.

So, we're pretty -- we're popping champagne corks here when coming at these kinds of numbers in the second quarter because typically this is a lousy quarter for us because of all of the expenses and that. But we're happy with that; we still came in with an incremental margin of 30% overall for the Company and with a high -- International Group actually came in at almost 40% incremental so we're pretty excited about that.

So, all in all I think a lot has to do with the extraordinary costs in the quarter and that's typical in the second quarter. And then as we climb out of this recession we're seeing a higher percentage of OEM business as a percentage of aftermarket business because the aftermarket has been doing fairly well all along. Still continues to do well, but the OEM is starting to come back stronger now across many of our market segments. Hopefully that gives you a little bit of color on that.

It does. And just a clarification. The International and North American Industrial incremental margins diverged this quarter. I'm actually wondering if you maybe could add some color to that and then maybe talk about how capacity utilization looks in -- especially in Europe versus North America right now?

This is Pam speaking, Nigel. One of the things that we saw this quarter is that -- typically International will lag, or Europe will lag North America. And so when you look at this quarter and you really dissect it, what you see is that International is coming on; they're finally seeing what North America saw a little while ago.

So when you look at just Europe's income versus their sales in this particular quarter, the income was very strong. And then of course Asia continues to do very well. So we're starting to see the effects of Europe coming through which we knew we would. Typically when we come out of a recession Europe will always follow North America. And now we're seeing that happen.

Great, thanks. I'll follow up off-line, thanks.

Eli Lustgarten, Longbow Securities.

Thank you. Good morning, everyone. Could I get one clarification on this tax rate of 27% for the rest of the year that says the second half is like 28%-28.5% and as it continues into 2012 -- the R&D tax credit I assume is driving most of it?

Yes, Eli. What really took place as far as the tax rate -- the tax laws. You know what happened, I mean we had the enactment. And there are two components of that.

The first component is obviously the research and development, so there's a catch-up on that because you're really getting six months from last year and then you're getting the six months of this year. So that's -- when you say look at the 24% tax rate in the second quarter, that's playing into it.

The other part of it is of the subpart F or what we call look-through provision on income overseas and we also had some benefit from that. So those are the two areas that really are affecting the tax rate. We had 29% and we brought it down to 27% this year for the full-year guidance year over year.

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

We think so, but you never know. I mean, you never know what's going to happen. We'll look at that --.

(Inaudible).

Yes. What I'd prefer to say is we'll look at that when we get to the beginning of the year. When we come out with our guidance we'll make sure that we give you good numbers on that.

May I ask a question -- looking at the volume, particularly North America Industrial and International Industrial, order patterns have been much stronger for the last two quarters than the revenue number actually came in -- sort of only getting a 22% North America volume in this December quarter when your last couple of quarters have been 26% and 31% in orders. Were the orders coming in late? Is there something happening? And the incremental margin in North America only being 23%, is that cost being felt or is that just the timing of the seasonality?

I don't think there's anything happening in the orders, other than the fact that people are very much -- they're much more comfortable with this recovery. And I think as people become much more comfortable with the recovery, then they're willing to put orders out there. So the lead times, they're just willing to give us longer lead times and everybody is not rushing to get everything today just to get it out just to keep the customer happy.

If you remember, we were getting a lot of orders, very short lead time in the beginning. And now I just think people are comfortable with the recovery and so they extend them out. I don't think there's anything unusual.

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

That's pretty much -- Eli, that's pretty much what we had said earlier. That's more of a mix situation. We did have some additional cost involved with some of our innovation programs that we've got going on, so we've funded them a little bit more because we're ramping up production especially on energy recovery type systems. So we're pouring more development costs into that area to ramp that up.

So it's really mix, it's innovation. And I think what I'd point out is don't get too focused on the one quarter. Because if you look at the rest of the year, that 22% turns into 25% and then 33%. So it builds up throughout the balance of the year. We end up in North America at about 31% incremental for the year which is still above our target of 30%. So this is just a one-month and typically the second quarter is typically lower performance anyway. But those would be some of the reasons for that.

Great, thank you.

David Raso, ISI Group.

Hi, good morning, everybody. Just trying to understand the guidance. You've got orders up 29% right now two quarters in a row, you just put up sales growth of 22%, but the back half of the year the sales growth guidance is only 12% for the whole Company. So just trying to square that up.

And probably even more importantly, the incremental margins just came in at 30%, 30.5% to be exact, and you're implying the back half of the year they accelerate to 35%. And obviously Aerospace, running through the numbers, is the biggest driver. But can you give us a little more comfort on why as your sales growth slows should I believe your incremental margins get better?

Well, Don, please help. But, David, let me tell you -- when you're coming out of a recession like this and orders are accelerating the way that they are, I mean there's some noise in there because people are really trying to --. We just went through a huge restructuring effort, the worst recession that we've ever gone through.

And so people are trying to ramp up to be able to supply the demand. So they are really -- they are struggling to meet the demand in a restructuring environment to some extent. So there is some noise in there. They are going to work through this because as you can -- you know, we bring temporaries back, we are bringing employees back. And we are right in the midst of where we are bringing those people back to be able to satisfy the demand. As we get out into the second half, it's going to be a much stabler environment.

Can you help us with some quantification, though? What were some of those inefficiencies in this quarter that get alleviated? And I also know in the channel you put a pretty healthy price increase through January 15.

So can you at least help us in some regard what hit the second quarter that was a little bit one-time in inefficiency, and how we should think about price versus cost and improve efficiencies going forward, again, to believe incrementals get better as sales growth slows?

Yes, David, this is Jon. Just a couple things in the second quarter. As we really look at that data, as we continue to ramp up and as you noted, sales are sequentially up in Q2. But as we continue to ramp up from a very, very deep recession, there are some one-time type costs that would always be incurred; additional overtime, additional shipping expenses, trying to get an efficient network built back up from a supply chain standpoint.

And in any upturn of this magnitude -- and you've got to remember how far down we were two years ago -- any upturn we are going to -- as we stretch the supply chain, as we try to make sure that we've got all the efficiencies in the network, every once in a while we will have some blips, and this is historically true. So you've got those one-time efficiencies in Q2 that come up.

But just as importantly as Don said, there is, and always has been, a seasonality effect in our Q1 to Q2 sequential margins for the Company. And although our revenue is up this time, normally it is not down that much in the prior periods either.

Now you are also right in terms of the second half. The second half is going to include those price increases that we are seeing worldwide throughout the channels, and that is going to help with our margins here for the second half, and it's really going to help drive our MROS, too.

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

Yes, I would hate to try to quantify that for you because there's more than one real issue there. There is some inefficiency, there's the mix that Don talked about. And so what we've -- and there are several other factors too. So in trying to answer your question it's hard to really kind of give you a specific number there.

But, in considering everything that is happening, considering all the dynamics with the marketplace and what's happened in Q2, we took all of that into account as we put our guidance together. And so we feel like the second half is very fair and we feel like we've got it all baked into the second-half guidance.

Last related to this -- if the revenues, for arguments sake, are conservative, Don and Jon, everybody -- if the revenue did surprise to the up upside versus the 12% guidance for the back half -- which at the moment given the orders and other things you'd say maybe it could -- should I expect that to flow through to even better incrementals?

Or are you going to keep having to add incremental bodies or whatever incremental costs where that incremental margin guidance is what it is and if there's revenue upside there's not an incremental margin upside because you're literally having to add cost?

Yes, David, right now we are giving you, for the year, 35%. And I would say that if we increase business I think our target here, and what we've got the entire organization geared to, is a 30% number. And I would feel very comfortable that we're going to do 30% overall as a company on increased volume.

So if you want to project higher volumes than we're giving you here, that's certainly something you can do. But I would use something around a 30% incremental. I think that would be fair and I think that's very achievable.

All right, thank you very much.

Terry Darling, Goldman Sachs.

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

Yes, well, we don't forecast acquisitions. We did a couple earlier in the year, we did one recently, we've got about $65 million or so in sales -- new sales volume coming on. Of course we'd like to do a lot more than that, but we're going to be prudent as to what we actually pursue and then how much we pay.

So there are a number of them, I can say, throughout the entire organization. Every one of our operating groups and many of our divisions are involved with looking at a variety of different opportunities. We've turned down some obviously, some bigger ones, because we just weren't going to pay what they wanted for them.

We were able to land some of the smaller ones which were very strategic and more of what I'd consider tuck-in type acquisitions. We're looking at more of those. So it's hard to say. But I can say this, we're definitely looking and we've got the entire organization geared to bringing on more acquisitions before the end of the fiscal year and then on beyond that.

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

I don't -- well, large -- our sweet spot would be, I would say, up to maybe $250 million. We've done some that were larger than that on occasion, rare, but say $50 million to $100 million or $200 million would be kind of a sweet spot for us.

When we say large around here, it's going to be $1 billion or more. I'd say the appetite for those would be less. They'd have to be very strategic for us to consider and culturally they'd have to be a perfect fit before I'd take that kind of risk.

So, that's not to say that we wouldn't look at it, we would, but a lot of things would have to be in alignment before we would pursue that. So I think more what you'd be hearing from us would be up to the $250 million kind of levels.

Okay. And then, Don, on dividend, any thoughts there? Your pay-out ratio, quite a bit below where others in the peer group are. You've focused more on acquisitions, obviously that's been a good strategy for you. But any change in thinking on the dividend?

Yes, we're definitely looking at the dividend. As you know, we've increased it the last several quarters and we'll be reviewing that again. And as of course the stock price goes up we want to make sure the percentages stay in alignment as far as the yield.

So we will be looking at that and I would anticipate that there would be some change in the dividend going forward. And like I said, we'll have a Board meeting coming up this next week and we'll be making those decisions then and you'll hear from us.

But we are focused on the dividend; we want to make sure that we're about at the median of the peer group as far as pay out and yield. And over the cycle we'd like to pay out about 25%. So right now it's a little bit low, when things were bad it was a little bit over that, so we're trying to maintain that discipline. So I think we -- to answer your question, you're going to see some changes there going forward.

And I might as well ask you about buyback while we're going through all of those capital allocation items, then I'll pass it on.

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

Okay, thanks very much.

Jeff Hammond, KeyBanc Capital Markets.

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

Sure.

Jeff, I can -- maybe this would be a good time to break and I said I would give you a little bit of a market overview earlier. And I can kind of run through some of what we're seeing here. I think what obviously we're all seeing is that the economic recovery is really kind of in full swing here.

And for us it's really kind of unique in that all segments pretty much across the Company and all regions around the world are seeing a very nice turnaround and that's pretty much evidenced by those order rates that you saw in our press release. I mean that's pretty much uniform across the board.

Just a little bit of regional growth commentary. North America of course is still accelerating. Europe, as you may recall, lagged North America coming out of the recovery, but we're seeing greater improvement in Europe and in international versus North America in the second quarter and we expect that to continue going forward.

Latin America slowed a little bit from a high rate that we had in earlier periods, but they were one of the first ones to really bounce back pretty strong. But they're still doing -- I don't anticipate anything negative coming from that region of the world; I think it's still going to be doing just fine going forward. Asia has continued to be one of our strongest regions. We're expanding there, we're adding more capital and putting more fixed assets in Asia, in China and in India in particular.

The backlogs we talked about -- backlog right now is up 7% over the prior quarter and it's up 14% over the first half, so we've got a pretty strong backlog in place.

Talk a little bit about the ISM. I know some of you track the ISM. The ISM index has been very favorable. In North America it's been around 57, the Purchasing Managers Index, anything above 50 is of course very good. That's I think the 17th period where it's been above 50. And interesting this quarter the eurozone is at 57 as well, so it's pretty much matched North America's numbers. So that's a very strong indication of what's happening there.

All the major countries in Europe are showing continued strength, leading of course would be Germany. UK, Switzerland, France and Sweden will also be strong. As I mentioned earlier, China is extremely strong for us. China's industrial growth is going to be somewhere around 10% this year -- at least that's what's been publicized -- and Parker will grow at least at twice that rate this year going forward. So we've got a lot going on there. So that's where some more activity is going to be coming from.

And I'm going to give you just a little commentary on our 3/12 and 12/12. I think most of you understand the 3/12 and 12/12. When I talk about the 3/12, it's the last three months' orders over the previous year the same three months, and 12/12 is the last 12 months' orders aggregated compared to the last -- the previous 12 months' orders aggregated. So that's kind of the index that we're looking at.

Industrial North America is increasing in both metrics, the 3/12 and 12/12; Europe is increasing in both; Asia is increasing in both; Latin America is not increasing on the 3/12, but they are very strong yet on the 12/12 and I think that's just a little bit of a quirk because of the second quarter being a little softer there and the fact that they were up so high to begin with. So all the regions pretty much are doing well.

Distribution in North America is strong in both the 3/12 and 12/12, and actually the 12/12 is increasing which is a good sign for the future, so that's an area where we're going to be getting more activity. And then just looking at some of the specific market segments -- heavy duty truck, construction, refrigeration, process, Aerospace and agriculture, as well as CIC, are all -- we're seeing strong 3/12s and 12/12s in all of those target market segments. A lot of that though, keep in mind, is OEM business for us.

So as we indicated earlier, that's of course putting some pressure on the margins a little bit, but still that's also going to be good volume coming in. The only area that's really flattening out a little bit is the semiconductor business, the 3/12 is flat, 12/12 is remaining pretty strong, but the 3/12 is flat so we'll have to keep an eye on that and see what happens going forward.

So pretty much everything as far as target markets that we have are doing well. The only soft segments now that we see is a little bit in the area of power gen, residential air-conditioning and commercial air-conditioning, those would be kind of the weaker segments. Everything else -- and I could just read down the whole list but it would be wasting time -- everything else looks pretty strong. So hopefully that gives you a little bit of input as to where some of this volume is coming from.

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

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

Thanks a lot.

Steven Volkmann, Jefferies & Co.

Hi, good morning. I just wonder if we could tunnel into Aerospace just a little bit; that was quite a bit stronger than what I was expecting. Obviously it does seem to be turning. But given that it's a 12-month trailing, December quarter must have been very strong on the order front. And what do you think is driving that? And how should we think about that going forward?

Well, I'm going to let Jon Marten -- Jon Marten, you know his background, he worked at Aerospace. So I'm going to let him answer that.

Well, Steve, I think you're right in that there is a recovery being reflected in the numbers there. Orders of course on the 12-month lag are showing very good trends. Revenue passenger miles are showing -- we're showing by our analysis up more than that 5%; available seat miles are showing up more than 5%.

So we're seeing growth really throughout the commercial revenue streams here that we have in Aerospace. That's being led right now by the maintenance repair and the overhaul in the spares that we're shipping commercially and that we're projecting to ship commercially. So we are seeing a turn there and we're seeing very positive trends when we look at that sector via Aerospace business.

Great, thanks. And then I guess the flip side of this is I was a little disappointed in the CIC margins, the incrementals were pretty de minimis there. And it feels like we've just been trying to get that business on track for so long. Is there a point at which we sort of fish or cut bait there? Or is there something that needs to be done that's sort of bigger than what we've been doing or how do we think about that?

Well, we've certainly been working hard on it. We still have some segments that are down, we -- if you look at the incrementals, the first quarter wasn't bad, we're at about just under 25%. Second quarter we're at about 9%, and of course that was impacted by some of the turnaround in their markets. And so first to second -- the turnaround and of course trying to keep up with some of the turnaround is what I meant by that.

And then they're also impacted by the housing starts. Of course no one is building houses right now that I know of. We are restructuring, still restructuring in that group and you'll see the improvement that we're showing you throughout the balance of the year. I think we've -- our third-quarter guidance is around 18% incremental and then we get up to -- well the fourth quarter is a big incremental, it's about 80% incremental.

So we're going to average in that group about 23%. Not to where we'd like it to be, we'd like it to be 30%. But considering all the restructuring that they have been through and the reorganization that they've been through, it's respectable. It's not like I said 30%, but it's approaching those kinds of levels.

But I guess what I'm the hearing is no appetite for potentially finding another owner for certain parts of that business?

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

All right, thanks very much.

Alex Blanton, Clear Harbor Asset Management.

Good morning, Pam.

Hi, Alex, how are you?

Oh, let me put you off the speaker. I'd just like to say before I ask my question that it strikes me that the 30% incremental margin level when your actual overall margin is 15% is quite good. And I disagree with the comments that have been critical of that as not being enough. But let me ask a broader question.

What is your sense of your customers' willingness to order, and your own willingness to invest and order for expansion of the business? Given the change in the political climate that's taken place since the elections and the indication that there might be a somewhat more business friendly environment in Washington going forward in 2011, how do you -- what's your sense of what your customers are thinking?

I think what's happening, Alex -- a very good point, I think -- and we talked a little bit about this in last quarter's call that the elections were ahead of us. I think there's a lot of upbeat discussion going on right now, it's a lot of positive commentary about the future. I think our customers are expressing that.

I think that's being witnessed in the -- or evident in the order trends that we're seeing. I think there's a lot more interest in investing in the business and I think that's translating into more business for us and that's pretty much across the board.

So I think it's been a positive event, November was a positive event. And I think the -- I think it's going to continue strong going forward and I think that's what we're pretty much seeing and that's what in our guidance here.

Alex, I think you bring up a good point. I think across the Corporation we're really seeing where people really are willing to spend. The balance sheets are extremely strong; people have a lot of cash on the balance sheet. I can see it in some of our product lines, that typically when the OEMs aren't ordering we're down, those are coming back.

Very anecdotal, but I just heard of a situation the other day where someone was ordering 1,000 machines basically just to produce the iPad. So yes, I think that we're seeing it across the Corporation everywhere you look. So, yes, I think you're exactly right.

Who's ordering 1,000 machines?

I'm not going to say. I just said that was very anecdotal and I heard of someone, but I prefer not to mention who that is.

Okay, thanks, Pam.

I don't think that would be fair.

Thank you.

But, Alex, you did hit on a very good point when you just started out and maybe I'll just reiterate that point. If we do what we just projected that we want to do for this year, it'll be the first time I think in history that we hit 15% operating margin for an entire year. The first time in the 100-year history of this Company.

So, what you said earlier, I guess I wasn't even thinking along those lines, but I just thought I'd point that out. That with this guidance that we just gave you of 15% operating margin with a 35% incremental, we think that's pretty strong.

Well, I think so too. Thank you.

Henry Kirn, UBS.

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

Henry, we really can't quantify that for you, that's very difficult for us to do. Just the way that we're structured, the way we're organized, the way that we report. But we know -- we obviously are talking to our groups, we're talking to our customers. It's a very difficult thing.

I think that in the last downturn, if you recall, when we first came out of the recession it was the mobile market that came back fast and furious. This time a little bit different, Industrial came back first and now we're just seeing the mobile market and the OEMs in connection with that really taking hold.

Typically what we've used in the past, this is Don, is about a 10 point delta, okay? Now that's just kind of a rough cut -- you go to any particular OEM and any particular aftermarket product it's going to vary all over the map. We've got 1 million products to track and 500,000 customers. But you can use kind of a rule of thumb that aftermarket business brings about 10 margin points more higher margin than OEM business, if that will help you.

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

What, the OEM portion?

Right. Well, how much of a mix shift negative impact is in your head as you came out with the second half margin guidance?

Well, when we're looking at the second half margins, actually the margins are getting better. So the mix is going to be -- overall with our cost structure and the sales trends that are going on, our margins are going to be improving from that 14% to I think 14.5% in the third quarter and almost 16% in the fourth quarter.

So I'm not thinking we're going to have a big headwind because of OEM margins. I think again, because the second quarter is traditionally our worst quarter as far as margin because of all the additional costs and of course the OEM is picking up steam here a little bit, but that's going to get washed out as we go forward. And I think if we finish at 15.9% in the fourth quarter it's going to be a pretty nice year for us.

All right, thanks a lot. I appreciate that.

Andy Casey, Wells Fargo Securities.

Thank you, good morning. Good morning, everybody. Back on this -- not to beat it too badly, but on the implied second-half incremental margin commentary, I'm still trying to understand how Parker is going to maintain the incremental margins. Which, to Don's earlier point, is really a changed response for the Corporation than what has happened in past cycles. So I'm hoping you can comment on some of the headwinds outside of the one that you just talked about with Henry that may offset the channel pricing commentary referred to earlier.

Andy, let me just say something about the increase. When you look at the second-half incremental margins, you have to remember Aerospace is coming in extremely strong on the incremental margin side, okay. So it's boosting that somewhat and I think we can all agree that Aerospace is coming on pretty strong.

If you break it down by the segment and, as I talked about, international is coming on now. So Aerospace is the strongest, which is really boosting up the 35%, then we have International, okay, and then North America quite frankly is a little bit below the target. So you've got to keep in mind, when you're looking at the 35% second-half margins, that a lot of it's being boosted by Aerospace.

I appreciate that, Pam, and I thank you for the clarification there. But from externally we're also seeing some potential upward pressure on input cost trends and in spot conditions maybe some supply-chain issues related to market demand acceleration. So --.

Right.

Yes, we're -- Andy, we're seeing all of that, there's no question. We're seeing -- from a pricing input standpoint we're seeing increases pretty much across the board. But nothing different than what we saw in FY 2007 and FY 2008 as we're ramping up and reaching those peak levels of output. And we manage those very effectively.

Now it doesn't mean that isn't a challenge for us, of course it is, because we have to be right on point as far as raising prices and passing those increases on. We've done it extremely effectively in 2007 and 2008 when we went through this. I think what you're going to see is probably some surcharges on some materials.

If the materials get too out of hand in between price increase, typical of times when we would raise prices we're going to have to probably go back to the surcharge route because we're not going to absorb these increases, that's for sure, we can't absorb them. And we're just going to have to pass them on and we're going to have to be really diligent about that like we were when they were ramping up the last go round.

And we managed that pretty well back then, if you recall, back in 2007 and 2008 when these raw materials were increasing pretty readily. So I think we're going to be able to manage it okay. And I think we're going to be able to maintain these margins appropriately.

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

Okay, thank you very much.

Jamie Cook, Credit Suisse.

I don't mean to beat up on the margin question, but I just want to make sure I'm clarifying. It is correct to assume when we think your margins -- your incremental margin forecast in the back-half of the year relative to what we were seeing last quarter. Now we're hoping for mid-30s, whereas before it was -- we were thinking of incrementals north of 40.

So to be clear, the inefficiencies and price stuff -- headwinds that we saw in the second quarter, we expect to some degree for that to continue into the back half of the year? Because we're inherently lower incremental margin forecast, aren't we? Or am --?

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

Well, when you look at the incremental margins, let's just kind of walk through them. North America second quarter 22.7, third quarter 24.9, fourth quarter 33. So that's kind of climbing up. International 39.6; second quarter 35.1; third quarter 34.9, pretty flat between third quarter and fourth quarter in International, so that's hanging in there pretty good. For total Industrial, going from 31.5 in the second quarter to 34.1, so actually going up.

Aerospace, we mentioned that was strong. Aerospace is going from 38% to 73% in the third quarter to 59% or almost 60% in the fourth quarter. And then the last one would be CIC going from 8% in the second quarter and we mentioned that earlier, that they're actually on the low side here, we'd like to see them much higher, going to 18% and then 84% in the fourth quarter. So actually the margins are going back up, the incremental margins, we're going to finish the year at 35.3% which is pretty strong.

I know, but the incremental margin forecast, things have gotten worse -- your ability to pull through --.

You mean because they're not 40%?

Well, that's what you guided to last quarter.

Well, here's what -- when we get up in the 40%-50%, a lot of times what you're seeing, just like what you're going to be seeing here with the CIC Group, is that they had a lot of restructuring. Well, when you're doing the restructuring you had a lot of costs that you're absorbing in that period when you're doing the restructuring and the benefits come in the subsequent quarters; that's what we've seen in the past. When we had a lot of restructuring going on obviously that hurt that quarter, but we benefited in subsequent quarters. I think you're seeing some of the same thing going on here.

Okay. And does -- the price increases, the catch-up, is that materially impacting the fourth quarter more than the third quarter, that's the way to think about it?

Yes.

Yes.

Okay, thanks. I'll get back in queue.

Okay, Caitlin, can we just take two more questions? Two more questions?

Yes.

Thank you.

Mark Koznarek, Cleveland Research.

Hi, good morning. On the Aerospace part of the business, very impressive acceleration in the margin here in the quarter. And there was some mention about recovery in costs or lower expenses of some of those reimbursable R&D dollars. Can you comment on that a little bit more, about sort of whether -- just kind of clarify that a little bit more?

I mean, obviously we see what the margin target is for the full year and I'm just curious as to whether the improvement was largely due to this MRO shift that was mentioned earlier or what kind of -- what kind of benefits are we getting from that reimbursement?

Yes, Mark, this is Jon, and let me try to answer that question here for you. First of all, we did mention that in our reimbursement last quarter and in fact we did get a reimbursement that was recorded in the month. But we also had other transactions that really ended up going the other way on us like we do every quarter.

And so I would not say that that one transaction really has a major material impact here on the quarter. One of the things that we are focusing on is if you really look at the margins and the recovery in Aerospace, it is really kind of being driven by the commercial aftermarket.

And so with that improvement and with the relatively flat nonrecurring expenses to support all the wins in all the businesses that we've gotten over the last several years totaling $18 billion, those nonrecurring expenses we're seeing starting to flatten out here over the year and be relatively close to how we actually looked at the year at the beginning of the year.

And so when I look at the returns at the operating level we go from 10 in Q1 to 13 in -- a little over 13 in Q2. And then we're really in the 15 range in the second half and that's what's implied in our guidance. And so we just -- we just see a continuing trend upwards there. And I would think that's the real pattern there that we're seeing that is very, very important to us.

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

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

Okay, great. Thank you.

Robert McCarthy, Robert W. Baird.

Thanks for taking my question.

Sure.

Hi, everybody. Two things, just really clarifications of stuff that's been handled. Can you help us with the allocation of the $0.07 in the third quarter realignment across the segments?

International.

All of it?

Yes.

And I want to ask the question about profitability guidance a little bit differently. You've strengthened your industrial outlook significantly, the overall full-year margin outlook didn't change a lot. Some of that is apparently execution -- I mean, compared to prior guidance is proving a little more challenging than you hoped it would be.

But you're also identifying very specifically stronger OE outlook and it sounds like a lot of that's in Europe. So in terms of where your guidance assumptions were a quarter ago, can you highlight the two or three OE markets that have accelerated or are showing faster acceleration than you were willing to bet on a quarter ago?

Yes, Robert, I won't pick any one or two. I listed I think six or seven of them that are all coming back pretty strong. So I think OE in general was stronger than what we anticipated. I think that would be the way I would answer that question.

And the other thing I would just mention on the guidance -- I think you were getting at our guidance and so forth. Our guidance for the second quarter was $1.20, okay; we came in at $1.39, and take tax out we're $1.27. So I think we feel pretty comfortable with it -- we exceeded our guidance.

So the only thing I can guarantee on this guidance is that we're going to be wrong, okay. We're going to either be high or we're going to be low, we're just not going to ever hit it on the head. But that's the only thing that I'm going to guarantee you. But we felt pretty good coming in what, $1.20 and then delivering $1.39, we thought that was pretty good even --.

You should, Don; it was absolutely a good quarter. But when the elements of the forecast change, people -- we just all want to understand that.

That's fair, that's fair. And another thing is that Tim was sitting here last quarter and I think you may recall when Tim says -- if you remember the words, he used [prego], all in. So, let's not get ahead of ourselves here. And I think that the message was we increased the guidance tremendously last quarter and we just didn't want anybody to get too far ahead of us on that.

And I think we're -- I think we still came out very well against where the Street was at, against where our guidance was at. And we get paid for managing tax just like we get paid for managing everything else around here, so I think it's important to keep that in mind too.

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

Robert, was that it for you then?

Oh, yes. No, I'm perfectly happy. Thank you very much.

Okay, thank you. So just then to wrap it up just a few closing comments. I want to first of all thank everyone that's on the call for joining us this morning. I also want to take the opportunity, since a lot of our employees would be listening in as well, to thank our global team for the record performance that we posted this fiscal year and for their hard work and all of their dedication in executing the Win Strategy and delivering the kinds of results that we're delivering here.

I'd also like to thank them for their continued commitment to serve our customers. As you know, everyone on the call knows how critical this is at this point in the cycle. This is where we gain market share, typically Parker Hannifin does because we respond to our customers' needs and that's so important today.

And our employees are doing a great job of that. Our service levels are 90% plus, which is not easy to do when you're ramping up as fast as we are. So very excited about that, very pleased and I think the entire organization is doing a great job.

So, with that I just went to once again thank everyone for participating in the call and certainly thank you for your interest in the Company, in Parker. And Pam will be around the balance of the day for any questions that you might have. Feel free to call in and she'll be happy to answer those for you. So good-bye and have a great day. Thank you.

Thank you.

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