The industrial sector has always been susceptible to economic downturns and uncertainty, but certain areas within the industry provide a refuge against these business cycle fluctuations due to the diversity of end markets and the necessity of their products. One of these industries is the aerospace and defense sector, which is likely to demonstrate resistance due to the ongoing need for national security.

An investor could invest in one of these end-market A&D firms, or they could find a company that has exposure to all the resilient markets while offering strong profitability, diverse industry and aftermarket exposure, and sustained dividend growth. One such company that exemplifies these qualities, in my opinion, is Parker-Hannifin (PH).

Parker’s products find use in numerous end markets, from agriculture to transportation to A&D. The company has longstanding business relationships with many key players in these industries. Many industrial firms have revised down top and bottom line projections while seeing subsequent share price drops due to the current macroeconomic outlook remaining ambiguous with ever-present recessionary fears. In contrast, Parker-Hannifin raised its earnings outlook for FY 2023 in its latest earnings report and has returned approximately 12.5% on a TTM basis compared to -6.3% for the Industrial Select Sector SPDR ETF (XLI).

Parker-Hannifin will continue to illustrate efficient operations and prudent management, with continued top and bottom line growth, both organically and through recent M&A activity, sustained dividend increases, and defensive end markets. Additionally, the company is currently undervalued, which adds to its appeal as a defensive industrial name with a positive growth outlook.

Heightened Geopolitical Tensions & Meggitt Acquisition Will Spur Aerospace Systems Segment Growth

In 2022, Parker Hannifin’s Aerospace Systems division contributed approximately 16% of the company’s total revenue. While this segment currently represents a minority of Parker’s revenue, it counts many major US defense contractors, as well as the two largest commercial aircraft manufacturers, Boeing (BA) and Airbus (OTCPK:EADSF), among its key customers.

Geopolitical tensions, driven in part by events such as the ongoing conflict in Ukraine and growing concerns over China’s relationship with the US and Taiwan, are leading to increased global military spending. Parker is well positioned to benefit from this trend, with its fuel systems and onboard inert gas systems being used in aircraft such as the F-35. The company’s missile business, which includes thermal management systems used in air-launched cruise missiles and the control actuation system in Javelin anti-tank missiles, also has growth potential, particularly as the US looks to restock its inventory following the conflict in Ukraine.

Beyond its military end markets, Parker also produces key components for naval vessels, helicopters, and unmanned aerial vehicles. While the Aerospace Systems segment has seen rising margins over the past few years, growth has lagged behind other segments. However, Parker recently completed its $9.9 billion acquisition of UK-based aerospace firm Meggitt PLC, which will significantly expand the company’s exposure to the Aerospace and Defense sector. Meggitt supplies advanced composites, fuel systems, and weapons systems to military aircraft, as well as wheel and braking systems used in commercial aircraft like the Airbus A321 and almost all Gulfstream (GD) business jets.

The Meggitt acquisition not only boosts Parker’s defense exposure but also supports the company’s commercial aircraft business. Parker has supplied fluid and motion controls to Boeing and Airbus for their narrow-bodied aircraft, and Meggitt’s wheel and braking systems will further expand Parker’s exposure to these companies. Meggitt also supplies braking technology for almost all Gulfstream (GD) business jets, which presents another growth opportunity for Parker as Gulfstream looks to accelerate deliveries and catch up on a backlog of orders. Meggitt’s braking technology will be essential to this process.

Parker also holds an advantage in the Aerospace and Defense aftermarket sales. The rapid expansion of orders for narrow-body aircraft following the COVID-19 pandemic will sustain the need for aftermarket services and parts, as commercial airlines emphasize timely repairs to avoid operational delays. This and the fact that the Aerospace aftermarket has strong margins indicate robust demand for Parker’s products and higher profitability. As airlines continue to service older models of aircraft, Parker’s consistent aftermarket revenue in the commercial aircraft business is likely to continue.

Overall, the Aerospace Systems segment of Parker Hannifin offers a unique revenue stream and increased profitability, particularly with the addition of Meggitt. As geopolitical tensions continue to drive global military spending, and the commercial aircraft industry rebounds from COVID-19-related issues, Parker is well positioned to benefit from increased demand for its products and services in both markets.

Parker as a Whole Continues to Deliver Strong Profitability and Margin Expansion

Parker is a company that offers essential parts in industries such as life sciences and agriculture, which are not as exposed to changes in the business cycle as firms that sell directly to consumers. As a result of this, along with its broader diversification, Parker has been able to maintain revenue growth even during times of economic downturn. In Q2 2023 earnings, management reiterated a 6-8% organic sales growth target for FY 2023, demonstrating confidence in top-line gains, aided by the company’s $10.5 billion backlog.

Parker’s Win Strategy is expected to continue to spur cost savings and operational efficiencies, driving further profitability as the company leverages its economies of scale to establish itself as a market leader in each subindustry. The recent Meggitt acquisition exemplifies this strategy, as Parker has doubled its sales exposure to the aerospace and defense market, primarily in the high-margin aftermarket business.

Compared to its competitors, including Eaton Corp., Dover Corp., IDEX Corp., and Honeywell International, Parker has a competitive edge due to its efficiency in generating free cash for shareholders and maintaining high efficiency in this area relative to its peers. While Parker demonstrated an EBITDA margin of 21.3% over the last twelve months, which is similar to that of its peers, this figure likely contains growing pains as the company works to integrate the $9.9 billion Meggitt company into its operations.

Parker has announced that it intends to address the underinvestment in capital expenditures since the Meggitt acquisition, as part of its Win Strategy. Going forward, the company plans to focus capital spending on modernizing current operations and enhancing efficiency through automation and digitization. This approach is expected to lead to margin expansion and increased profitability. Parker can also take advantage of the extended life cycles of its products by directing a majority of its investment towards optimizing operations instead of constantly introducing new products to maintain its competitive edge.

Valuation Does Not Reflect Strong Business Drivers and Management’s Performance

Although Parker’s business has demonstrated resilience and strength through both organic growth and strategic acquisitions, its current valuation does not reflect these positive factors. While Parker’s forward earnings growth is the highest compared to its closest competitors, it trades at a relatively low multiple of approximately 16.4x forward earnings. However, with the Meggitt acquisition bolstering its stable aerospace aftermarket business and the Diversified segment driving margin expansion, there is little doubt that Parker will continue to exhibit earnings growth in the years to come.

Parker’s valuation appears to be lower compared to its peers, despite the company’s resilience and growth through organic growth and strategic acquisitions. Parker’s forward earnings growth is the highest among its immediate peers, yet the company trades at around 16.4x forward earnings. The Meggitt acquisition has increased Parker’s gross leverage profile to close to 3.8x, higher than its peers, and this increased leverage introduces elevated credit risk over the near term.

Parker’s lower multiple could reflect increased concern about the company’s ability to integrate the Meggitt acquisition, especially in the wake of higher interest rates and an unfavorable macroeconomic outlook for 2023 and into 2024. However, Parker’s management has a successful track record of integrating acquisitions and deleveraging. The company’s commitment to preserving the health of the balance sheet will support a higher valuation and increased shareholder givebacks via sustained dividend growth.

The company’s commitment to correcting underinvestment in CapEx by modernizing existing operations and increasing efficiency through automation and digitization will drive margin expansion and higher profitability. Parker can leverage the long life cycles of its products to allocate a majority of spending towards optimizing operations rather than constantly innovating products to maintain its competitive advantage.

Compared to IDEX, which has a similar long-term EPS growth trajectory and similar diverse customer base, Parker’s share price in the range of $430 to $470 per share seems reasonable, assuming a forward P/E for Parker between 22x to 24x. Given that Parker has increased its dividend for 66 years straight, the Gordon Growth Model provides a ballpark estimate of the per-share value of around $450 per share.

While Parker’s valuation may not fully reflect its growth potential and stability, it is important to note that the market may be factoring in concerns over the company’s increased leverage following the Meggitt acquisition. Despite this, Parker has a strong track record of successfully integrating acquisitions and deleveraging, which should support a higher valuation and increased shareholder returns. Therefore, while a higher share price may be warranted, it is important to consider the potential risks and uncertainties before making any investment decisions.

For All the Optimism, Parker Must Deliver on Expectations

Parker has some challenges to overcome despite its positive outlook. For instance, the Meggitt acquisition presents a unique challenge as the company’s revenues declined in 2020 and 2021 due to the impact of COVID-19. Parker has a history of successfully integrating its acquisitions, but it still needs to find ways to leverage Meggitt’s business. Additionally, while some aspects of Parker’s business are more recession-resistant, the company is not immune to the business cycle and may miss its top-line growth projections.

For example, sales of Parker’s products to agricultural customers could decline during economic slowing if crop prices experience a drawdown. The same applies to its transportation end markets if consumers reduce discretionary purchases. These factors present a near-term risk for Parker as it navigates a weaker market while deleveraging its balance sheet.