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Edited Transcript of PH earnings conference call or presentation 31-Oct-19 3:00pm GMT

Q1 2020 Parker-Hannifin Corp Earnings Call

CLEVELAND Nov 19, 2019 (Thomson StreetEvents) -- Edited Transcript of Parker-Hannifin Corp earnings conference call or presentation Thursday, October 31, 2019 at 3:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Catherine A. Suever

Parker-Hannifin Corporation - Executive VP of Finance & Administration and CFO

* Lee C. Banks

Parker-Hannifin Corporation - President, COO & Director

* Thomas L. Williams

Parker-Hannifin Corporation - Chairman & CEO

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Conference Call Participants

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* Andrew Burris Obin

BofA Merrill Lynch, Research Division - MD

* Andrew Millard Casey

Wells Fargo Securities, LLC, Research Division - Senior Machinery Analyst

* Ann P. Duignan

JP Morgan Chase & Co, Research Division - MD

* David Michael Raso

Evercore ISI Institutional Equities, Research Division - Senior MD & Head of Industrial Research Team

* Jamie Lyn Cook

Crédit Suisse AG, Research Division - MD, Sector Head of United States Capital Goods Research, and Analyst

* Jeffrey Todd Sprague

Vertical Research Partners, LLC - Founder & Managing Partner

* Joel Gifford Tiss

BMO Capital Markets Equity Research - MD & Senior Research Analyst

* Nathan Hardie Jones

Stifel, Nicolaus & Company, Incorporated, Research Division - Analyst

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Presentation

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Operator [1]

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Ladies and gentlemen, thank you for standing by, and welcome to the Parker Hannifin Corporation First Quarter 2020 Earnings Conference Call. (Operator Instructions) Please be advised that today's conference is being recorded. (Operator Instructions)

I would now like to hand the conference to your speaker today, Cathy Suever, Chief Financial Officer. Please go ahead, Madam.

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Catherine A. Suever, Parker-Hannifin Corporation - Executive VP of Finance & Administration and CFO [2]

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Thank you, Joelle. Good morning, everyone. Welcome to Parker Hannifin's First Quarter Fiscal Year '20 Earnings Release Teleconference. Joining me today are Chairman and Chief Executive Officer, Tom Williams; and President and Chief Operating Officer, Lee Banks.

Today's presentation slides, together with the audio webcast replay, will be accessible on the company's investor information website at phstock.com for 1 year following today's call.

On Slide #2, you'll find the company's safe harbor disclosure statement addressing forward-looking statements as well as non-GAAP financial measures. Reconciliations for any reference to non-GAAP financial measures are included in this morning's materials and are also posted on Parker's website at phstock.com.

Today's agenda appears on Slide #3. We'll begin with our Chairman and Chief Executive Officer, Tom Williams, providing highlights from the first quarter. Following Tom's comments, I'll provide a review of the company's first quarter performance together with the revised guidance for the full year fiscal 2020. Tom will then provide a few summary comments and we'll open the call for a question-and-answer session.

Please refer now to Slide #4 and Tom will get us started.

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Thomas L. Williams, Parker-Hannifin Corporation - Chairman & CEO [3]

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Thank you, Cathy, and good morning, everybody, and welcome to the call. We appreciate your interest in Parker.

So let me start with the first quarter highlights, and I'm going to start like I normally do on safety. We had a 25% reduction in recordable safety incidents year-over-year, which is a great start to the year. When you look at it from a safety incident rate -- so for those that aren't familiar with this, this is the number of safety incidents per 100 people. We came in at 0.46, which is a top quartile number. Top quartile happens to be 0.5. So this is the first time in the history of our company that we came in, in the top quartile from an incident rate. So we're very proud of that.

Safety for us is a core value and 0 accidents is not an aspirational goal. It's really an expectation that we're going to operate the business and lead the business in such a way that we're going to drive a 0 accident culture. And if you've seen, there's a very strong linkage between safety and business performance. And you can see that if you'd look at our numbers over the last several years and plotted safety and our financial improvement, you'll see that it went hand-in-hand.

So switching to financial results. Q1 was a strong quarter on margins and on cash against a challenging macro environment on sales. Sales declined 4%. And that composition was a minus 3% organic, minus 1.5% on currency and a plus 0.5% on acquisitions. Total segment operating margin remained level at 17.0% reported. Adjusted segment operating margins increased 10 basis points to 17.3%. On a reported basis, EBITDA margin increased 70 basis points to 18.4% and adjusted EBITDA margin increased 110 basis points and reached 19.1%. So really, when you look at it, operating margin or EBITDA margin, really excellent performance at this part of the cycle. EPS reported was $2.60 and on adjusted basis was $2.76.

We had a very strong quarter on cash flow. Cash flow from operations came in at 13.5% of sales. We had a record as far as cash flow from operations in terms of dollars at $449 million. And free cash flow was 12.0%. And when you look at free cash flow conversion, that was 118%, so really, really strong quarter on cash.

We had a number of exciting announcements in the quarter. We launched The Win Strategy 3.0. So that's the third revision of The Win Strategy. This follows the second revision we did in 2015 and we launched a new purpose statement for the company. And we closed the LORD and Exotic acquisitions. So we've been busy in the quarter. And we're really excited to welcome the LORD and Exotic team members to the Parker team. The joint integration teams have been working hard in preparation for the closings and they're hitting the ground running as we speak.

As you heard me talk about, the acquisitions are transformational to Parker's portfolio, really strengthening engineered materials and aerospace with high-growth, high-margin businesses that will definitely be more resilient over the business cycle. Our global Parker teams are very energized by all these announcements between The Win Strategy, purpose and these acquisitions so that we're excited about the future.

Now switching to the outlook. We revised guidance for FY '20. We've seen a market shift within the last 90 days. It's reflected in weakened order entry, primarily driven from macro conditions and trade uncertainties. So when you look at total sales for Parker in FY '20, they're expected to be flat year-over-year at the midpoint with guidance now -- these are all midpoint numbers -- at minus 6% organic, minus 1% for currency and plus 7% on acquisitions. Segment operating margin guidance is now at 15.2% as reported at the midpoint and the adjusted midpoint is now 16.3%.

I would just call your attention, there's 2 important impacts on there when you look at it from a partial year is the amortization of the 2 deals. From a partial year standpoint for FY '20, that impacts us by 70 basis points. When you look at it on a full 12 months, there's 100 basis points of deal amortization as a headwind on margins.

Business realignment expenses are expected to increase to $40 million. This is reflective of the current macro conditions. This was $20 million in the prior guide. And of course, our guidance now includes LORD and Exotic Metals Forming for the balance of the year. And we'll go through discussing markets and the guidance assumptions in more detail during the Q&A.

So let's switch to cash flow and margin resilience. So hopefully, you saw on the cash flow numbers in my comments just a moment ago, cash flow was very strong, record numbers. And then when you look at the operating and EBITDA margin performance, and I'm going to compare it to 2015 and '16, so the last downturn we experienced. And we'll look at this legacy Parker without acquisitions. That allows us to do an apples-to-apples comparison.

So FY '16, which would have been the worst year in that downturn, on an adjusted operating margin was 14.8%. And then FY '20 guidance is 16.6% at the midpoint. So when you look at that delta, that's an improvement of 180 basis points. On adjusted EBITDA, in FY '16 it was 14.7%. Our current guide at the midpoint is 18.2%. So that's a 350 basis point improvement. So clearly, raising the floor on margins when you compare the '15, '16 downturn to what we're experiencing now.

We fully anticipate to do double-digit cash flow from operations for the full fiscal year, like we've been doing for the last 18 years. And really, this performance is driven by a combination of factors. The new Win Strategy which we introduced in 2015 is propelling our performance. All the previous restructuring activities we've done which has positioned us to be a more agile and lean operating company.

So let's move to Slide 5 and talk about the future. We're very positive about the future. And I think we are absolutely poised to generate nice earnings growth after we clear these near-term macro conditions. A couple of things influencing our confidence on the earnings potential. The Win Strategy 3.0 and the purpose statement represents some important changes for the company, plus we've added 2 great businesses via these acquisitions.

And actually, in my view, the timing of these acquisitions couldn't be any better during the soft part of the cycle. There's clear advantage here. We have the capacity to digest these much easier than we were digesting CLARCOR as we were trying to ramp up the base business as well as digest CLARCOR. And when you look at the timing, when you look at the integration teams hitting their stride, it's about the same time the markets will start to turn for us, approximately 9 months. And both of those factors will drive earnings growth as we look into the future.

We're going to be hosting an Investor Day, March 12, 2020, in New York City. And during that Investor Day, we're going to showcase The Win Strategy 3.0 and the purpose statement, so give you a lot more color on the key strategic changes for the future. We're going to highlight all 6 operating groups. In the past, we've highlighted one group. And last time, we highlighted 3 groups. For the first time ever, we're going to give you insights to all 6 groups. You'll see the entire company. And we'll go through the 3 last acquisitions: CLARCOR, LORD and Exotic.

So just a quick reminder which is on this page that you see the winning format for Parker, our competitive differentiators. The Win Strategy, now 3.0, the third revision of that, which is our business system. You couple that with our decentralized divisional structure. In my view, that's the best of both worlds. You got a centrally led business system that's deployed locally with that closeness to the P&L. The breadth of our portfolio of technologies is very interconnected, strong intellectual property, long product life cycles, very balanced between OEM and aftermarket with the best distribution channel in the motion and control space. Low CapEx requirements to actually generate growth and productivity. And all this ends up culminating in being able to generate a lot of cash and being able to deploy it on the best behalf we can for our shareholders.

So we have a lot of confidence on our ability to achieve the FY '23 financial targets. I just want to thank all the global teams listening in for their hard work, their continued and dedicated effort.

And I'll hand it back to Cathy for more details on the quarter and the guidance.

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Catherine A. Suever, Parker-Hannifin Corporation - Executive VP of Finance & Administration and CFO [4]

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Thanks, Tom.

I'd like you to now refer to Slide #6. This slide presents as reported and adjusted earnings per share for the first quarter. Adjusted earnings per share for the quarter were $2.76 compared to $2.84 for the same quarter a year ago. Adjustments from the fiscal year '20 as reported results totaled $0.16, including before tax amounts of business realignment charges of $0.04, acquisition costs to achieve of $0.04 and acquisition transaction-related expenses of $0.14, offset by the tax effect of these adjustments of $0.06. Prior year first quarter earnings per share had been adjusted by $0.05. The details of which are included in the reconciliation tables for non-GAAP financial measures.

On Slide 7, you'll find the significant components of the walk from adjusted earnings per share of $2.84 for the first quarter of fiscal '19 to $2.76 for the first quarter of this year. We benefited $0.02 per share in operating income from Exotic Metals Forming Company since closing on that acquisition September 16. For Legacy Parker, a $166 million decline in sales contributed to a $0.15 reduction in operating income. The teams did a great job of controlling costs with lower volume by sustaining a 15% decremental margin for the quarter.

Incremental interest expense on the debt borrowed for the 2 acquisitions resulted in a $0.15 decline in the current earnings per share. Interest income from the pre-acquisition investment of that cash benefited the current quarter $0.09. Lower other expense of $0.13 came from several onetime gains in the current year and by not repeating several onetime losses from last year. Lower corporate G&A contributed $0.01 while fewer favorable discrete tax benefits in the current quarter resulted in a higher tax rate, causing $0.12 of incremental tax expense. Finally, a lower share count benefited the quarter $0.09.

Slide 8 shows total Parker sales and segment operating margin for the first quarter. Organic sales decreased year-over-year by negative 3.3%. Currency had a negative impact of minus 1.5%. These declines were partially offset by a positive impact of 0.6% from the September acquisition of Exotic. Despite declining sales, total adjusted segment operating margin improved to 17.3% versus 17.2% last year. This 10 basis point improvement reflects the operating cost improvements teams have been working hard on, combined with additional positive impacts from our Win Strategy initiatives.

On Slide 9, we're showing the small benefit Exotic had on the first quarter FY '20 results post close on September 16. You can see they contributed $21 million in sales and $3 million in operating income on an adjusted basis during this brief stub period. Exotic results are included in the Aerospace Systems segment.

Moving to Slide 10. I'll discuss the business segments, starting with Diversified Industrial North America. For the first quarter, North American organic sales were down 3.2%. Currency had a small impact on sales of negative 0.2%. Even with lower sales, operating margin for the first quarter on an adjusted basis was an impressive 17.3% of sales versus 16.6% in the prior year. North America continued to deliver improved margins, which reflects the hard work dedicated to productivity improvements as well as synergies from CLARCOR and the impact of our Win Strategy initiatives.

Moving to Diversified Industrial International segment on Slide 11. Organic sales for the first quarter in the Industrial International segment decreased by 8.7%. Currency had a negative impact of minus 3.9%. Operating income for the first quarter on an adjusted basis was 15.9% of sales versus 17.0% in the prior year, a decremental margin of 25%. The teams continue to work on controlling costs during the more difficult drops in volume by utilizing tools of our Win Strategy initiatives.

I'll now move to Slide 12 to review the Aerospace Systems segment. Organic revenues increased 8.2% for the first quarter as a result of growth in all of the platforms, with the strongest growth in military OEM and the commercial aftermarket. In addition, the Aerospace segment sales increased $21 million or 3.7% from the addition of the Exotic acquisition. Operating margin for the first quarter was 20% of sales versus 19.5% in the prior year, reflecting the impact of higher volume in all the platforms, lower development costs and good progress on The Win Strategy initiatives.

On Slide 13, we report cash flow from operating activities. Cash flow from operating activities was a first quarter record of $449 million or 13.5% of sales. This compares to 10.3% of sales for the same period last year after last year's number is adjusted for a $200 million discretionary pension contribution. That's a year-over-year increase of 25%. Free cash flow for the current quarter was 12% of sales and the conversion rate to net income was 118%.

Moving to Slide 14. We show the details of order rates by segment. As a reminder, these order results exclude acquisitions, divestitures and currency. The Diversified Industrial segments report on a 3-month rolling average, while Aerospace Systems are based on a 12-month rolling average. Continued declines in the industrial markets drove total orders to drop 2% for the quarter end. This year-over-year decline is made up of a 6% decline from Diversified Industrial North America, 10% decline from Diversified Industrial International orders, offset by a very positive 22% increase from Aerospace Systems orders.

The full year earnings guidance for fiscal year 2020 is outlined on Slide #15. This guidance has been revised to align to current macro conditions and now includes the impact of the LORD and Exotic acquisitions. Guidance is being provided on both an as reported and an adjusted basis. Total sales for the year with the help from acquisitions are now expected to remain flat compared to prior year. Anticipated full year organic change at the midpoint is a decline of 6%. Currency is expected to have a negative 1.1% impact on sales and acquisitions will add 7.4% to the current year. We've calculated the impact of currency to spot rates as of the quarter ended September 30, and we have held those rates steady as we estimate the resulting year-over-year impact for the remaining quarters of this fiscal year.

For total Parker, as reported segment operating margins are forecasted to be between 15.0% and 15.5% while adjusted segment operating margins are forecasted to be between 16.0% and 16.5%. We've not adjusted for the incremental amortization of approximately $100 million which we will incur for the remainder of this year as a result of the 2 acquisitions.

The full year effective tax rate is projected to be 23%. The first quarter tax rate was favorably impacted by discrete items which we don't forecast. We are anticipating a tax rate from continuing operations of 23.3% for quarters 2 through 4.

For the full year, the guidance range for earnings per share on an as reported basis is now $8.53 to $9.33 or $8.93 at the midpoint. On an adjusted earnings per share basis, the guidance range is now $10.10 to $10.90 or $10.50 at the midpoint. The adjustments to the as reported forecast made in this guidance include business realignment expenses of approximately $40 million for the full year fiscal 2020 with the associated savings projected to be $15 million.

Synergy savings from CLARCOR are still estimated to achieve a run rate of $160 million by the end of fiscal '20, which represents an incremental $35 million of year-end savings. In addition, guidance on an adjusted basis excludes $27 million of integrated costs to achieve for LORD and Exotic and $200 million of onetime acquisition-related expenses. LORD and Exotic are expected to achieve synergy savings of $15 million this fiscal year. A reconciliation and further details of these adjustments can be found in the appendix to this morning's slides.

Savings from all business realignment and acquisition costs to achieve are fully reflected in both the as reported and the adjusted operating margin guidance ranges. We ask that you continue to publish your estimates using adjusted guidance for purposes of representing a more consistent year-over-year comparison.

Some additional key assumptions for full year 2020 guidance at the midpoint are: a split first half, second half of 47%, 53% for all sales, adjusted segment operating income and adjusted EPS. All 3, we expect to be split 47%, 53%.

Second quarter fiscal 2020 adjusted earnings per share is projected to be $2.22 per share at the midpoint. This excludes $15 million of projected business realignment expenses and $167 million of acquisition-related expenses and costs to achieve for both LORD and Exotic.

On Slide 16, you'll find a reconciliation of the major components of revised fiscal year '20 adjusted EPS guidance of $10.50 per share at the midpoint compared to the prior guidance of $11.90 per share. Starting with just the legacy business, a $0.10 per share beat in the first quarter is quickly going to be offset by the challenging macro conditions facing the rest of the fiscal year. A drop of nearly $800 million in forecasted sales at the midpoint is driving a decline of $1.44 in operating income for the rest of the year.

Interest expense in our previous guide included the interest on $2.3 billion of bonds we were holding for the acquisitions. Since then, we have borrowed additional term loans and commercial paper to complete both acquisitions. Now that both acquisitions are closed, we've allocated $0.72 of interest expense to the acquisitions, which includes the interest on the bonds, the term loans and the new commercial paper, causing a relief of $0.29 of interest expense within the legacy business.

Also in our previous guide, we had an assumption of earning $0.35 from interest income on the cash from the bonds. That cash has now been used for the acquisition so the other expense line which includes interest income has been reduced going forward.

And finally within the legacy business, we are anticipating a slightly higher tax rate for the rest of the year, which will drop earnings per share $0.03, resulting in revised legacy Parker adjusted guidance of $10.50.

Exotic is estimated to contribute $0.28 and LORD $0.44 to operating income for the year, inclusive of the additional combined $100 million amortization expense we will be incurring. Offsetting this will be the $0.72 of interest expense related to the debt for these acquisitions. All-in, this leaves $10.50 consolidated adjusted earnings per share at the midpoint for our guide for fiscal 2020.

On Slide 17, we show the impact the acquisitions will have on both an as reported and adjusted basis. On an adjusted basis, the acquisitions lower operating margin to 16.3% for total Parker from 16.6% for legacy Parker, impacted by $100 million of amortization expense. For adjusted EBITDA margins, the acquisitions provide 50 basis points of improvement, moving from 18.2% for legacy Parker to 18.7% for total Parker. For those of you building forecast models, we've included more details regarding the LORD and Exotic impact on the total year guidance in the appendix.

If you'll now go to Slide #18, I'll turn it back to Tom for summary comments.

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Thomas L. Williams, Parker-Hannifin Corporation - Chairman & CEO [5]

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Thank you, Cathy. So we're very pleased with our progress. We are going to perform well with this downturn as demonstrated by our cash flow performance and raising the floor on operating margins. And we're well on our way to being that top-quartile company that we want to achieve and being best-in-class.

And just a reminder of where we're trying to drive to, we want to transform the company to achieve the targets we've set out in FY '23 of growing organically 150 basis points greater than global industrial production growth, segment operating margins of 19%, EBITDA margins of 20%, free cash flow conversion greater than 100% and EPS CAGR over that time period of 10%-plus.

So again, thanks to everybody, all the global team members around the world for your hard work. And with that, I'll hand it over to Joelle to start the Q&A portion of the call.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from Nathan Jones with Stifel.

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Nathan Hardie Jones, Stifel, Nicolaus & Company, Incorporated, Research Division - Analyst [2]

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Tom, it seems like you guys have taken maybe a bit more negative outlook going forward over the next 3 quarters here than some of your peers have. I think you mentioned you were planning on 3 more quarters of downturn here. Can you just maybe talk a little bit about what's going on in the end markets and your expectations around why you're thinking this downturn is as long as you guys have seemed to have built into guidance here?

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Thomas L. Williams, Parker-Hannifin Corporation - Chairman & CEO [3]

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Yes. Nathan, it's Tom. I'm sure this is the question top of mind for everybody. I'll start off with going through kind of what was behind the guide then I'll finish with a summary of end markets.

So it starts first with our Q1 orders. And you've seen that minus 2% total company, but in particular minus 6% North America and minus 10% internationally. And then you got to look at other external indicators that are typically flow-through in our orders 3 to 6 months out. Those things like the ISMs and the PMIs. So the U.S. is in that 47.8% for September. That was a 10-year low, as everybody knows. Europe's PMI of 45.7% for September. And of course, Germany, our third-largest country, at 41.7%, obviously feeling the impact of the trade-related uncertainties. Asia PMIs are weak. And so when we look, part of what influenced our forecast was the trend of orders through the quarter. So August and September were about the same, but they were weaker than July. And then as you look at October, while October is not done yet, we looked at October on a daily basis, we saw further softening from that August and September rate.

So put those factors into also our bottoms-up latest look for divisions, in our view, yielded a more challenging macro environment. So I'll peel back the organic piece a little bit more and I'll give you some of my thoughts as to why we did what we did. So you've seen organic at the midpoint at minus 6%. So that composition is North America at minus 6%, International at minus 11.5% and Aerospace at plus 4.5%. So the first half, second half organic is both minus 6%. So minus 6% for the first half, minus 6% for the second half.

And so given that organic growth was minus 3% in Q1, that implies that our low point or the bottoming out of Parker is somewhere between Q2 and Q3 in this guidance. And we also look, remember, I talked about the pressure curves last time and we had baked in about a 15-month duration. This now looks like it's an 18-month duration, the whole fiscal year. That's the difference versus the prior guide.

When we look at the 4 phases of growth that we've talked about in the past, the markets are definitely moving through those phases. The largest phase is now in Phase 4, decelerating growth at 48%. That last quarter, that was at minus 10%. So that's encouraging that they're starting to move through that. When you look at Phase 3, which is accelerating decline, that used to be 67% last quarter, now it's 28%. So that's also an important point. All these things are signaling some kind of a bottoming for us about the midpoint of our FY '20.

So maybe now just to kind of walk on the prior guide to the new guide. So the prior guide was minus 1.5% at the midpoint. Again, I'm talking about organic. And the new guide is minus 6%. So that's a 450 basis point step-down. Our orders stepped down 200 basis points. And again, I'm focused on the industrial piece where North America and International stepped down 200 basis points.

And then we had to try to project out those ISMs and PMIs I just described that are pretty negative and they're going to flow through in orders anywhere over the next couple of months to maybe a maximum of 6 months and then also looking at the October orders that weakened from what you see in September. So that kind of made up the balance. You got 200 that's already declined with orders. The balance of 250 made up by projecting those PMIs and ISMs into our future orders and what we saw in October. So that kind of gives you the walk down.

So maybe if I'd give you comments on the end markets for Q1. I'll start with the positives. Aerospace continues to be very strong, lawn and turf, forestry and marine, and pretty much all the others are negative. So probably the best way for me to summarize the others is to kind of take them into major buckets.

So distribution, I recognize, is not a market, but it's an important channel for us. Distribution actually got a little bit better. I'm talking about going from Q4 to Q1 year-over-year. It came in Q1 at about minus 2%. And in Q4, it was a minus 2.5%. That composition, North America got better, Europe stayed about the same and Asia Pacific got worse.

The industrial end markets stayed relatively the same, both were minus 9%, minus 9% in Q4, minus 9% in Q1.

And the mobile market is where we saw the step-down. Mobile markets went from a minus 3% in Q4 to a minus 6%. In particular, what stepped down in mobile was ag, construction, heavy-duty truck and material handling. So that's a quick run-through. That's at the global level, what I was describing as far as the end markets and what caused us to move the guidance like we did.

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Nathan Hardie Jones, Stifel, Nicolaus & Company, Incorporated, Research Division - Analyst [4]

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I appreciate the transparency and on the color there. Just moving away from things that are happening in the short-term here. I'm sure there'll be plenty of questions for that on you. Maybe you could just talk a little bit about what's changed in The Win Strategy 3.0 from Win Strategy 2.0.

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Thomas L. Williams, Parker-Hannifin Corporation - Chairman & CEO [5]

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Yes. And I'd be happy to do that because that's going to be very exciting for the company. And obviously, when we have you all together, we'll go through this in a lot more detail. But if I would just paraphrase the key points.

So underneath engagement, we're going to continue to expand that whole ownership concept with the idea that the more people we have thinking and acting like an owner, the better the company is going to perform. But a big change on engaged people is kaizen, and we'll take you through all the things we're doing on kaizen as far as our approach to it, who we're working with and the results we're seeing.

Under customer experience, a lot more emphasis on digital leadership. And we'll expand what we mean by that. And a new metric, which is not too dissimilar to what we had before, but we have a new metric called Composite Likelihood to Recommend, which is going to be a mixture of on-time delivery and feedback from our customers and distributors.

And profitable growth, we have this new strategic initiative called Strategic Positioning, which we'll give you more color on. New product blueprinting underneath innovation and 2 new metrics for innovation, product vitality index and gross margin for that product vitality. And we'll explain more about that when we're in person.

And then on simplification, a very new, powerful concept called Simple by Design, where we focus on simplifying the design of our products to reduce the bill of material complexity, the inventory and planning and scheduling complexity and the ability to produce it, recognizing about 70% of our product costs are tied up in how we design it.

So we will talk a lot more about that when we have you all there. We will be somewhat careful on Simple by Design because I don't want to teach all my competitors how to do that, but we'll give you enough color so that you all know that it's real and there's some big enhancements to the company, both on a growth and a margin standpoint.

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Operator [6]

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Our next question comes from Ann Duignan with JPMorgan.

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Ann P. Duignan, JP Morgan Chase & Co, Research Division - MD [7]

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I'm not sure that there are any questions left after all of that color. You gave us global end markets, industrial versus mobile. Would you mind breaking those up by region please or any notable differences across the major markets that have declined: ag, construction, heavy duty, material handling?

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Thomas L. Williams, Parker-Hannifin Corporation - Chairman & CEO [8]

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Yes. Ann, it's Tom. So I'll give you the high points by region. So North America was about 3% organic decline. On the positive side was machine tools, heavy-duty truck, forestry and lawn and turf. Flat was distribution and automotive. And then on the negative side, we had low single digits was mining, telecom and life sciences. Mid-single-digit decline, these are all declines, refrigeration, mills and foundries and tires. And then switching to more of the mobile markets, mid-single-digit declines was construction and marine and mid-teen declines was ag, material handling and rail. So again, I had mentioned that distribution fared better in North America than any of the other regions as far as how it performed.

And Europe came in about a minus 7% for the quarter. On the positive side was refrigeration, power, semicon, life science and oil and gas. And then on the negative side, starting with the industrial end markets, we had a couple that were greater than 20%, mills and foundries, machine tools. Obviously, Europe being more export sensitive, feeling the impact of trade uncertainties. Those are very trade-centric type of end markets. Mid-teen declines was mining, tire and rubber. Distribution came in around minus 4.5%, about the same as it was versus prior period. And mobile, we had low single-digit declines in construction and ag and about 10% on heavy-duty truck and auto. So actually mobile fared okay in Europe. The industrial end markets suffered worse in Europe.

And then in Asia, on the positive side, Asia came in at a 12% decline for Q1. And then on the positive side were oil and gas, mining and marine. Although it declined, distribution was down about 5.5%. And on the industrial space, we had about mid-teen declines on mills, refrigeration, machine tools, greater than 20% on some of those big, secular end markets like power gen, semicon, and of course, telecom being somewhat impacted by the Huawei challenges. And then on the mobile side is where we saw some of the steepest declines, greater than 20% in construction, ag, material handling and rail. So you can see that mobile feeling the worst in Asia Pacific. So that's a quick spin to the regions.

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Ann P. Duignan, JP Morgan Chase & Co, Research Division - MD [9]

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Okay. And then just as a follow-up, I think you've already answered this. But are you seeing any signs of -- I hate to like use the word we use every time when we're coming up -- but any green shoots anywhere?

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Thomas L. Williams, Parker-Hannifin Corporation - Chairman & CEO [10]

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Well, what has been nice is that distribution got a little bit better. So we like that. The fact that, that went into Phase 4. And we had a number of other things moving into Phase 4, automotive and life sciences and oil and gas. And actually, power gen and semicon, even though they're down mid-teens for us, the fact that they went into Phase 4. I always like when things move into Phase 4 because then guess what the next phase is, accelerating growth. So that's encouraging.

And we still had the ones that were strong and continue to be strong like aerospace. Lawn and turf is seeing some seasonal help there. And forestry, with all the paper-related goods tied to e-commerce, has continued to be strong. So those are what I would say as indicators. Again, for us, what we're signaling with this guidance is a bottom forming for us. I can't call a bottom for anybody else, but a bottom for us is somewhere in the middle of our fiscal year.

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Operator [11]

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Our next question comes from Joel Tiss with BMO Capital Markets.

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Joel Gifford Tiss, BMO Capital Markets Equity Research - MD & Senior Research Analyst [12]

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I just wonder on the last discussion and super-duper color there. Can you just give us any sense of how you take -- it feels like things are a little worse now or maybe in the next couple of month’s future because of inventory reductions. How do you take the amplification of that in the near term out of your forward guidance? I'm just curious how to think about that.

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Thomas L. Williams, Parker-Hannifin Corporation - Chairman & CEO [13]

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Yes. Joel, it's Tom again. So the destocking is always a tough question. But the one area where we do have good data on is North America distribution. And you've heard both Lee and I talk about this in the past that the destocking has been improving by about 100 bps. And that's actually what happened again. So to refresh people's memory, in Q3 of '19 it was down 300 bps of destocking, Q4 was 200 bps and now Q1 was 100 bps.

So we had guided to that we felt distribution was going to -- at least North America was going to get into somewhat of equilibrium at the end of the calendar year, so end of Q2, but we clearly are seeing destocking at the OEMs, especially the mobile OEMs destocking. And how long that takes to play through is very difficult because we don't have the kind of visibility into that, that we have with the U.S. distribution. What we're guiding to, it's very hard to split end market demand versus destocking. What we gave you is kind of our view all-in of this impact.

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Joel Gifford Tiss, BMO Capital Markets Equity Research - MD & Senior Research Analyst [14]

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And then just like a strategic question, and not so much thinking about a forecast, just thinking about, how do we think about Parker's earnings resiliency going forward, like beyond the obvious? Okay, aerospace is a bigger part of the company. But like some of the ways that you guys think about that could help us.

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Thomas L. Williams, Parker-Hannifin Corporation - Chairman & CEO [15]

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Yes. Joel, it's Tom. That's a good question. And I'm actually glad that you asked it because we've been working very hard at this, as you might imagine. And there's a number of factors. First, it would start with some of the portfolio moves that we made over the last number of years, CLARCOR, LORD and Exotic. So let me give you some, for instance.

So when we look at our order entry without getting into things that I don't want to disclose publicly. Our filtration platform is holding up much better than the rest of the industrial platform. And that was by design with CLARCOR with its density in aftermarket. So that it's living up to its billing, what we had hoped for. LORD is coming in with about a 4% organic growth. And that compares to what we just told you, are guiding to a minus 6% for Parker. And Exotic's growth is coming in around 11%. And so that's better than Parker and better than Parker Aerospace. So you got some portfolio things that we're doing that drives resilience and enhance organic growth.

And then you've heard us talk about what we have been doing on distribution, growing international distribution, in particular. And we've changed that mix from when we started with Win Strategy 2.0, we were at 35% international mix in distribution and now it's 40%. So that doesn't seem like a lot, but moving that number 100 bps a year is meaningful. That enhances margins and it provides more resilience, again, because our channel there is servicing primarily aftermarket.

We're doing a lot of things on innovation, which we'll give you a lot more color with 3.0 when we see you all in March. But the new product blueprinting, product vitality index, our gross margins that we're tracking on these products are all designed -- because when you look at our innovation growth, it is growing faster than the base business so it's going to hold up better in a downturn. The things we're trying to do to drive customer experience are really important because you can't really grow with a customer if you don't give them a good experience.

And then all the things we've been doing operating-wise, simplification, lean, supply chain, et cetera, and now kaizen to make the company more agile and just a better operating company. So those would be the things that I would say on the top line and then just from an operating standpoint, how we're going to get to those FY '23 targets.

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Operator [16]

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Our next question comes from Jamie Cook with Crédit Suisse.

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Jamie Lyn Cook, Crédit Suisse AG, Research Division - MD, Sector Head of United States Capital Goods Research, and Analyst [17]

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I guess just a couple of questions. I guess the first one, just understanding the guide, the International or the implied International adjusted margins, I guess, fall off a little more than I would have expected in the remaining 9 months of the year. Understanding there's a lot of moving parts, but is there any way you could sort of help us with what the puts and takes are there besides increasing it more.

And then just obviously the cash flow in the quarter was very strong. And as we are in sort of a slowdown here, leverage becomes more topical. So just, Tom, how we should think about cash flow for 2020, whether there's any structural improvements we should be looking for?

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Thomas L. Williams, Parker-Hannifin Corporation - Chairman & CEO [18]

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So Jamie, let me start. I'll have Cathy add on as far as debt and maybe comment on cash flow. But one thing I want to try to make sure everybody understands, this new guide has got still some really good decremental margins in it. If you benchmark companies, which I know you all do this, a minus 30% decremental is still best-in-class decrementals. So I'm just going to read to you total decrementals for the company Q2 through the rest of the year. So Q2 -- these are approximate. These are at the midpoint. There's going to be a range around these numbers -- a 27% decremental, Q3 a 28% decremental, Q4 a 23% decremental. So we end up with a full year at about a 25% decremental.

So those are really, I think, very excellent performance given that if you look at industrial, it's going to be down minus 6% North America and minus 11.5% in International. That's why International is a little bit worse on its decrementals. North America is coming in around 24% and International is at 29% and it's because it's about a 2x difference on volume. And so that's creating a lot more challenges.

And then in addition to the volume side, International has currency, which we've always struggled to identify a currency impact on financials and we've basically decided not to try to communicate that because you can't get a consistent number with it, but we do all know that when currency becomes a headwind to us, it becomes a pressure point on margins. So that's another factor for International.

On cash flow, and I'll hand it over to Cathy. I would have shareholders rest assured that, that 18 years of 10%-plus CFOA is going to turn into 19 years because we've got a proven track record of being able to work working capital. And these operating margins, like you heard me talk about in my opening comments, are 180 basis points better than our last downturn. So we have better operating margins and we'll work the working capital like we normally do. And Cathy, do you have anything to add on?

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Catherine A. Suever, Parker-Hannifin Corporation - Executive VP of Finance & Administration and CFO [19]

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Yes. Jamie, we finished the quarter end at a levered gross debt to EBITDA of 3.6. We did bring in a small amount of additional debt in the form of term loan to close LORD this past week. And so it's going to go up slightly. But if you look historically, we do have a great track record of managing the working capital very well during a down cycle. So we're pretty confident.

In addition to that, both LORD and Exotic have a history of very strong cash flow, stronger than Parker. So they will be great contributors to it. And we're confident. We would be at a level that we were with CLARCOR when we closed that deal, and we brought that down very quickly. And we feel that we can do the same even though we are seeing things slow down. Also keep in mind, we do carry about $1 billion of international cash so our net debt to EBITDA was actually 2.1 at the end of the quarter.

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Operator [20]

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Our next question comes from David Raso with Evercore ISI.

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David Michael Raso, Evercore ISI Institutional Equities, Research Division - Senior MD & Head of Industrial Research Team [21]

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Just looking at the organic growth first half, second half. Obviously, the second half, a big change from used to be up 1% to negative 6% now. Can you take us through your thoughts on how you see orders playing out underneath that decline? I mean, it seems like the second quarter you're expecting the biggest organic decline but the second half is still pretty healthy at down 6%. I mean, healthy, meaning a large decline. So I'm just trying to get a sense of how you're viewing the order patterns underneath that negative 6% in fiscal second half.

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Thomas L. Williams, Parker-Hannifin Corporation - Chairman & CEO [22]

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Yes. David, it's Tom. And that's where the forecast gets more and more challenging is the further that you go out. But we really were trying to project some of those macro indicators that I mentioned in my comments, U.S. ISM, Germany's number, Asia's PMIs, the rest of Europe PMIs, et cetera, recognizing that as we plotted those historically, they tend to lag and impact our orders 3 to 6 months out.

So we know we saw a weakening in October. That's going to influence Q2. And then these other macro indicators, 3 to 6 months out, starts to impact the second half. And so that was the thought process behind that, but it does become more challenging as we try to figure that out because our backlog outside of aerospace doesn't carry us out that far so we had to kind of look at historical trends and lagging periods between these macro indicators and what we do.

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David Michael Raso, Evercore ISI Institutional Equities, Research Division - Senior MD & Head of Industrial Research Team [23]

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Yes. I'm just trying to think how you thought about managing your own inventory through the end of the year and that interplay between, okay, the second half's a lot weaker than we thought, but we do see some bottoming process, and that's how we're managing, be it not even just inventory, but how you're thinking about pricing that usually gets announced Jan 1 and so forth. I mean, is it fair to say at this stage you're not thinking of the orders improving much in the back half fiscally? Just the comps get a lot easier. So I think for a lot of people seeing the cut to the organic is obviously not pleasant. But if you felt the orders were improving in the back half to some degree, you can call it temporary. Because the way you're speaking to the business is, it's kind of a temporary macro environment. I know it's hard to call. I was just curious, do you have some sense of where you're headed and how you're managing the company to that fiscal second half? It doesn't sound like you're planning for orders to be, say, up in the latter part of the year. Is that a fair assessment on how you're trying to manage?

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Thomas L. Williams, Parker-Hannifin Corporation - Chairman & CEO [24]

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Yes, David. I think that's fair. We would project that orders would continue to be weak because our orders, organic growth in orders are typically within a month or 2 of each other when you plot it historically. So for us, on inventory, inventory is never good. It's a waste when you're running a lean operation. So we're continuously -- whether we have volume going up or volume going down, we're looking to optimize inventory, period, all the time. And the kaizen efforts that we're doing and in unity with our Parker lean process, we'll continue to work at managing inventories down.

Obviously, when orders go down, you need to update all your planning tools, your plan for every part, which is part of our lean system. So we're doing that. And then on pricing, I'll let Lee comment on pricing, what we're doing with that.

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Lee C. Banks, Parker-Hannifin Corporation - President, COO & Director [25]

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Look, David, maybe I'll put price and cost together. I would say cost inputs, it's a mixed bag. There's some going down, some going up. But from a price/cost standpoint, as always, we just try to stay margin neutral, and that's what we're planning going forward.

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David Michael Raso, Evercore ISI Institutional Equities, Research Division - Senior MD & Head of Industrial Research Team [26]

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Okay. And just to make sure, just to wrap up here. The first quarter organic was in line with your expectations, maybe 20 bps even better. I actually thought the orders weren't even that bad in the first quarter relative to some of the fears out there. But then, obviously, you took a big chunk out of the rest of the year on organic sales and even your thoughts on orders. So the surprise, I guess, must have really been this last month that you really thought to see at least some beginning of bottoming process. So is that fair? It's really been the last month that really drove the change in the guide.

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Thomas L. Williams, Parker-Hannifin Corporation - Chairman & CEO [27]

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David, it's Tom again. So there's 2 things. You're right, October, but then also the sequencing we saw within the quarter, the fact that August and September got worse from July. So we were starting to see a weakening through the quarter, then another step-down in October. That's why we changed the guide.

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Operator [28]

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Our next question comes from Andrew Obin with Bank of America.

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Andrew Burris Obin, BofA Merrill Lynch, Research Division - MD [29]

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Just a question on cash flow, and it's not more a question. But a lot of companies that do deals have shifted to reporting sort of cash earnings. Given a massive discrepancy between your cash flow generation and reported earnings, have you guys considered moving to reporting cash numbers? And what has the feedback been from your investors?

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Thomas L. Williams, Parker-Hannifin Corporation - Chairman & CEO [30]

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Yes. Andrew, it's Tom. It's a good question. We have thought about it and we have reached out to shareholders. And it's been pretty, pretty uniform from shareholder feedback saying, don't make that change, continue to -- obviously, we will adjust for onetime costs and the things that we normally have been doing. But other than that, continue to report on a GAAP basis.

And if you think about it, it creates a bigger hurdle that the business needs to absorb to generate returns on behalf of the shareholders. And I think that was the feedback I heard from shareholders is, we want you to incorporate that bigger challenge into how you run the place. But it's a good comment. I know there's been good companies that have made that change. At this point, we've elected to stay with what we've been doing.

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Andrew Burris Obin, BofA Merrill Lynch, Research Division - MD [31]

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And then just a question. As your numbers have decelerated, what has the feedback been from LORD and Exotic? What have they experienced relative to expectations when you announced the deals?

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Thomas L. Williams, Parker-Hannifin Corporation - Chairman & CEO [32]

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Yes. So Andrew, it's Tom again. So actually, they've held up really nicely. LORD, in the outlook that we've just given you, is coming at about a 4% organic growth. And we had in our model about 5.5%. That's what I verbally said during the announcement. That was kind of our 5-year CAGR. So if you think of everything that's going on that's changed from when we made that announcement to today, that's pretty good. And again, that 4% positive compares to minus 6% for Parker. That's why we like LORD so much. That's why we bought them. It's accretive from a growth standpoint.

And then when you look at Exotic. Exotic is coming in a little lower, 11.5%. In our model that we built for the DCF, we had about a 7.5% CAGR. So that's held up nicely. I would say 2 things, a little better F-35 sales and we modeled a more conservative 737 MAX. We modeled Exotic going down to 42, but Boeing has not done that yet with Exotic and probably won't because Exotic with its long lead time for materials. When you look at what Boeing's done when they're managing the supply chain, the rest of our aerospace is, for the most part at 42, but as they've managed long lead time type of suppliers, Exotic being one of those, they've kept them at 52 because of obvious reasons. You can't ramp back up with that kind of long lead time. So that's part of why they've overproduced on the revenue.

So in a nutshell, both acquisitions holding up on revenue, both acquisitions coming in at the EBITDA level that we expected. Actually, LORD, slightly better on EBITDA margins because we pulled in $15 million. The $15 million that Cathy referred to in her comments is the synergies for LORD. And we're able to pull them a little bit earlier than we thought.

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Andrew Burris Obin, BofA Merrill Lynch, Research Division - MD [33]

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And if I may squeeze just one in. Auto exposure with LORD, you did comment that auto is bottoming. Was that referring to sort of the old Parker exposure or was that referring to LORD's exposure as well? And that will be it for me.

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Thomas L. Williams, Parker-Hannifin Corporation - Chairman & CEO [34]

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That was total Parker. That was based on Q1. So we didn't have LORD in Q1. But their auto has held up better than our auto has so pretty comparable.

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Operator [35]

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Our next question comes from Andy Casey with Wells Fargo Securities.

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Andrew Millard Casey, Wells Fargo Securities, LLC, Research Division - Senior Machinery Analyst [36]

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I just wanted to go back to the decrementals that you talked about, Tom. Were those all-in including the acquisitions or were those Parker legacy?

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Thomas L. Williams, Parker-Hannifin Corporation - Chairman & CEO [37]

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Parker legacy without the acquisitions. Andy, trying to do it with the acquisitions is apples and oranges. Acquisitions are not in the prior period. We've got the $100 million of intangible amortization. So the MROSes when you look at it all-in versus prior are basically are nonsensical. You can't really read anything into it, which is why I gave you the ones without it.

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Andrew Millard Casey, Wells Fargo Securities, LLC, Research Division - Senior Machinery Analyst [38]

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Okay. Okay. I appreciate that. And then basically, over the long term, you had talked about 30% incrementals. The decrementals you gave were lower than that, which is good. When you embed the 2 new acquisitions that seem to be a little bit similar to CLARCOR, a little bit more resilient, would the downside over the long term relative to the mid to high 20% decremental that you gave kind of even shrink further?

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Thomas L. Williams, Parker-Hannifin Corporation - Chairman & CEO [39]

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Well, I think there's definitely that potential because, to your point, they will be more resilient. They're higher margins as well so they should help us with that. And we're going to work to make them even better than they are today. The whole goal is, is to take the best of what we do and the best of -- and of course, now we is now all of us -- and the best of what the acquisitions had and make it even better. So I still think, again, for purposes of modeling, I don't want to get too far over my skis, I would just encourage you to continue to use the plus and minus 30%. It's still best-in-class. And of course, our goal is to try to do better than that.

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Operator [40]

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Our final question comes from Jeff Sprague with Vertical Research Partners.

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Jeffrey Todd Sprague, Vertical Research Partners, LLC - Founder & Managing Partner [41]

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Just 2 from me, if you don't mind. Just first, back on the acquisitions. At the time they were announced, I thought LORD's run rate sales were about $1.1 billion and Exotic was about $450 million. And when I look at what you laid out here, it looks like they're both actually kind of on an annualized basis tracking flattish, not up. Is there something in timing or do I have those basis wrong?

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Thomas L. Williams, Parker-Hannifin Corporation - Chairman & CEO [42]

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Jeff, it's Tom. I think the main thing I would add, when we gave it, it was based on calendar year over calendar year. Now these numbers are in Parker's fiscal year so the prior periods are not comparable.

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Jeffrey Todd Sprague, Vertical Research Partners, LLC - Founder & Managing Partner [43]

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Those growth rates you gave us though, Tom, were for the year in your plan or just in the quarter, those organic?

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Thomas L. Williams, Parker-Hannifin Corporation - Chairman & CEO [44]

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Yes. The growth rates I gave, Jeff, are for our FY '20. So it'd be comparing the period of time they're in part of Parker, our FY '20, and then using the same Parker fiscal year in FY '19. That is the way to go back and kind of reconstitute that with the 2 acquisitions.

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Jeffrey Todd Sprague, Vertical Research Partners, LLC - Founder & Managing Partner [45]

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And then just one other question on incrementals, if you don't mind. And perhaps it goes to the FX point you were making, Tom. But the decline in 6% organic sales decline, right, is about $650 million in sales. I think Cathy said $800 million, if I think about it on a core basis. And $1.44 of EPS headwind would gross up to like $230 million. So that's like a 35% decremental on the core business, if I think about it relative to the walk that you gave us where you showed kind of legacy Parker versus the deals. Am I missing something there or is it FX?

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Catherine A. Suever, Parker-Hannifin Corporation - Executive VP of Finance & Administration and CFO [46]

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Yes. Yes, Jeff, it's the FX differential. So the number I quoted was top line total drop that we had in our guidance for the second, third and fourth quarters. And when you're quoting organic, you're probably correct that it's closer to $600 million.

All right. This concludes our Q&A and our earnings call. Thank you to everyone for joining us today. Robin and Jeff will be available throughout the day to take your calls should you have any further questions. Everyone, have a great day. Thank you.

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Operator [47]

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