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Edited Transcript of PH earnings conference call or presentation 31-Jan-19 4:00pm GMT

Q2 2019 Parker-Hannifin Corp Earnings Call

CLEVELAND Feb 2, 2019 (Thomson StreetEvents) -- Edited Transcript of Parker-Hannifin Corp earnings conference call or presentation Thursday, January 31, 2019 at 4:00:00pm 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

* Joel Gifford Tiss

BMO Capital Markets Equity Research - MD & Senior Research Analyst

* Julian C.H. Mitchell

Barclays Bank PLC, Research Division - 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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Good day, ladies and gentlemen, and welcome to the Parker Hannifin Fiscal 2019 Second Quarter Earnings Conference Call. (Operator Instructions) I'd now like to turn the conference over to the Chief Financial Officer, Cathy Suever. Please go ahead.

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

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Thanks, James. Good morning. Welcome to Parker Hannifin's Second Quarter Fiscal Year 2019 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 press release and are also posted on Parker's website at phstock.com.

Today's agenda appears on Slide 3. To begin, our Chairman and Chief Executive Officer, Tom Williams, will provide comments and highlights from the second quarter. Following Tom's comments, I'll provide a review of the company's second quarter performance, together with the guidance for the full year fiscal 2019. 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. 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. Thanks for your interest in Parker and your participation today.

So I'm going to start by first highlighting Parker's business model, which Cathy mentions on Slide 4, specifically, those competitive differentiators that really help us stand out versus other companies and versus our competition. So first on the list, and first and foremost, is the Win Strategy. It's our business system. It's a proven strategy that has a long track record of success.

The second will be our decentralized divisional structure. We like that structure because it's close to the action. We want our people close to the customers and close to the P&L so that we know whether we're making money or not.

The breadth and integration of Parker's technology portfolio really creates this combination of technologies that creates a unique customer value proposition. I think this is best demonstrated by the fact that 60% of our revenue comes from customers that buy more and more of those technologies.

We make engineered products. About 85% of our products have some kind of intellectual property wrapped around them. Our products have long product life cycles, which is a great thing. We're balanced between OEM and aftermarket, and to support this business model only requires low operating CapEx requirements, which is very positive. We've got a great track record on cash generation and deployment, and we want to continue that over the cycle going forward.

So some key takeaways for the quarter. Safety is always our top priority. We had really strong performance; 23% reduction in recordable incidents. This is building on great progress from prior quarters. My thanks to everyone for their efforts on owning safety, the leaders and all the team members of the company.

And I would just remind shareholders there's a very close linkage between safety performance and financial and customer performance. And you can see that linkage as we improve safety, seeing the performance in our customer and our financial metrics.

We put up a number of second quarter records. This was on sales, segment operating margins, net income and EPS. We reached 16.4%, as reported, on operating margins in the quarter. This is an unprecedented level of performance for the second quarter. If you were to go back years ago, it would normally be a Q4 type of performance to get what we did in Q2, a really significant job for everybody around the world.

Our organic growth came in positive at almost 6%, partially offset by currency, and we had strong cash flow and free cash flow conversion for the quarter, driven by operating income growth and good working capital management.

As a result of all this, we're increasing earnings guidance for the fiscal year, and we remain confident in our ability to reach our new guidance for FY '19 as well as FY '23 5-year financial targets. So my thanks to the team members for Parker around the world. Great progress, great results. Thank you so much.

So a couple more comments about the quarter. A strong quarter, nice earnings improvement year-over-year, as I mentioned, a number of records. From a net standpoint, our sales came in at 3%, again, with almost 6% organic, which is very close to our guidance. Spot on. Order rates moderated. It was a combination of tougher comparables as well as growth moderating. We'll talk more about that during the Q&A. Net income was a Q2 record, which included income tax expense related U.S. Tax Reform of $14 million. And segment operating margins, again, was a record 16.4% as reported. This compares, if you look what was -- the previous Q2 record was 14.4%.

So if I could just comment for a second. Most of the time, when you beat a margin record, you beat it by 10 to 50 basis points. So nominal type of beat. The fact that we beat this by 200 basis points is very significant. We almost never do something like that. That was remarkable. And of note is that this includes the CLARCOR intangibles as well as the cost to achieve. Again, a really outstanding result.

If I would switch now on an adjusted basis. Adjusted segment operating margins for total company were 16.6%, which was up year-over-year 170 basis points versus Q2 of FY '18. Aerospace had another great quarter, making 3 straight quarters with margins over 19%. A great job of aerospace team demonstrating really nice returns on the significant amount of investments that we made there over the last decade or so. And what we've done is we've built a long-cycle, high-performing business that we're excited about now, and we're excited about what the future is going to bring for the aerospace business. On an as-reported EBITDA standpoint, EBITDA margins were up 120 basis points to 17.0% or 17.2% on an adjusted basis.

So I spent a fair amount of time talking about margins. There's 3 big factors that drove margin expansion for us. Again, it starts with the Win Strategy and execution the team's doing on that. The productivity, what we demonstrated in the plants, and the plant closures improving there, and supply chain optimization.

Cash flow, switching to cash, was strong. We expect to exceed 100% free cash flow conversion and operating cash greater than 10% of sales for the fiscal year. This will be excluding discretionary pension contribution.

And then on share repurchases, we bought a total of $500 million in Q2. This is made up of a discretionary repurchase of $450 million and our 10b5-1 program repurchasing $50 million.

So now, switching to the outlook. We're increasing EPS guidance by $0.09 at the midpoint to $11.29. This is on an as-reported basis. And we're now increasing it $0.20 at the midpoint to $11.60 on an adjusted EPS basis. This reflects the strong first half that we had and the outlook for the remainder of the fiscal year. We're forecasting moderating sales growth based on our current order entry and currency impact, and this has a forecasted organic growth range of 2% to 4% for the full fiscal year.

We are in a great position, the best position we've ever been to outperform regardless of the market environment. Several factors underpin our confidence and ability to perform here. New Win Strategy is demonstrating a distinct step-change in performance. I think the best example is if you were to look at our margin expansion over the last 4 years, that's a great indicator that there's clearly a step-change of performance, and the underpinning of that is the Win Strategy.

But what really gives us a lot of confidence is that we're still in early days in the Win Strategy performance. And I would just highlight a few opportunities there. The first is our whole high-performance team process, which is all about creating an ownership culture of the company. As you have owners evolve and continue to care more and drive more engagement, you're going to see performance improve with it.

Simplification initiatives are still early days. The innovation pipeline is growing. And the combination of lean and kaizen opportunities and our supply chain strategies are going to continue to yield margin expansion as we go forward.

We are stronger as a company now than we've ever been. Our cost structure is in the best shape that it's been. And we're well positioned to manage any kind of market dynamics and softening. The combination of our earnings growth, cash flow and our strong balance sheet gives us a number of capital deployment opportunities as we continue to drive increased shareholder value.

We continue to have confidence in our ability to reach the financial targets in FY '23 -- 2023 that we communicated in last year's Investor Day. And just as a reminder what those are: to grow organically 100 basis points faster than the market, this will be over the cycle; segment operating margins of 19%; EBITDA margins of 20%; free cash flow conversion greater than 100%; and EPS CAGR over this time period of 10% plus. In sum, we anticipate another record year for FY '19, and we're making good progress towards our new 5-year targets.

And with that, I'll hand it back to Cathy for a more detailed review on the quarter.

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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, and I'll begin by addressing earnings per share for the quarter.

Adjusted earnings per share for the second quarter were $2.51, which is a 17% increase compared to $2.15 for the same quarter a year ago. The differences between the as-reported results and the adjusted results are as follows: fiscal year 2019 second quarter operating income adjustments include business realignment expenses of $0.01 and CLARCOR cost to achieve of $0.03. This compares to prior-year adjustments of $0.07 for business realignment expenses and $0.07 for CLARCOR costs to achieve. In fiscal year '18, we also adjusted other expense to exclude a net gain of $0.05 from the sale of assets and the write-down of an investment.

Income tax expense in the current year second quarter has been adjusted by $0.11 for a tax expense related to U.S. Tax Reform. This updates the initial net onetime tax reform adjustment of $1.65 adjusted for in the second quarter of fiscal year '18.

On Slide #7, you'll find the significant components of the walk from adjusted earnings per share of $2.15 for the second quarter of fiscal 2018 to $2.51 for the second quarter of this year. The most significant increase came from higher adjusted segment operating income of $0.41 attributable to earnings on meaningful organic growth, synergy savings from acquisitions and increased margins as a result of Win Strategy initiatives.

Lower average shares resulted in an increase of $0.07, and lower interest expense contributed $0.03. Adjusted earnings per share was reduced by $0.06 due to higher income tax expense in fiscal year '19, driven by higher earnings. And higher year-over-year corporate G&A expense, primarily as a result of losses in market-adjusted investments tied to deferred compensation, resulted in a $0.09 per share reduction.

Moving to Slide 8, you'll find total Parker sales and segment operating margin for the second quarter. Total company organic sales in the second quarter increased year-over-year by 5.7%. There was a 0.5% negative impact to sales in the quarter from prior year divestiture, while currency negatively impacted the quarter by 2.2%.

Total segment operating margin on an adjusted basis improved to 16.6% versus 14.9% for the same quarter last year. This 170 basis point improvement reflects the benefits of higher volume, productivity improvements and the benefits of synergies from acquisitions combined with the positive impact from our Win Strategy initiative.

Moving to Slide #9, I'll discuss the business segments, starting with Diversified Industrial North America. For the second quarter, North America organic sales increased by 5% as compared to the same quarter last year. Our prior year divestiture accounted for a 0.4% loss of sales, while currency also negatively impacted the quarter by 0.3%.

Operating margin for the second quarter on an adjusted basis was 16% of sales versus 15.1% in the prior year. This 90 basis point improvement for North America reflects the hard work dedicated to productivity improvements as well as the benefits from additional volume, synergies from acquisitions and the impact of our Win Strategy initiatives.

I'll continue with the Diversified Industrial International segment on Slide #10. Organic sales for the second quarter in the industrial international segment increased by 3.6%. Negative impact from a prior year divestiture accounted for 0.8% of sales, while currency negatively impacted the quarter by 5.3%. Operating margin for the second quarter on an adjusted basis was 15.7% of sales versus 14.2% in the prior year, reflecting increased volume, improved operating cost efficiencies from realignment initiatives, and the benefits of the Win Strategy.

I'll now move to Slide #11 to review the Aerospace Systems segment. Organic revenues increased an impressive 12.2% for the second quarter due to strength in the military and commercial OEM businesses as well as the aftermarket businesses.

Operating margin for the second quarter was 19.7% of sales versus 16.0% in the prior year, reflecting the benefits of higher volume and cost efficiencies, the impact of a favorable sales mix, the deferral of some development costs, and good progress on the Win Strategy initiatives.

Moving to Slide 12, we show the details of order rates by segment. As a reminder, Parker orders represent a trailing average and are reported as a percentage increase of absolute dollars year-over-year, excluding acquisitions, divestitures and currency. The Diversified Industrial segments report on a 3-month rolling average, while the Aerospace Systems segment reports on a 12-month rolling average.

Total orders increased by 1% as of the quarter end. This year-over-year growth is made up of flat order growth from Diversified Industrial North America, a decline of 2% from Diversified Industrial International orders, and a 10% growth from Aerospace Systems orders.

On Slide 13, we report cash flow from operating activities. Year-to-date, cash flow from operating activities was $541 million. When adjusted for a $200 million discretionary pension contribution made during the first quarter, cash flow from operations was $741 million or 10.7% of sales. This compares to 6.8% of sales for the same period last year.

The significant capital allocations year-to-date have been $200 million for the payment of shareholder dividends; $550 million for share repurchases of common shares made up of $100 million through our 10b5-1 plan and $450 million of discretionary share repurchases completed in the second quarter; and $200 million for the previously mentioned discretionary pension contribution.

The revised full year earnings guidance for fiscal year 2019 is outlined on Slide #14. Guidance is being provided on both an as-reported and an adjusted basis. We have adjusted our sales outlook for the second half to reflect current order trends and current currency rates.

Total sales increases for the year are now expected to be in the range of minus 0.4% to plus 2.0% as compared to the prior year. Anticipated organic growth for the full year is forecasted in the range of 2% to 4%, or 3% at the midpoint. The prior year divestiture negatively impacts sales by 0.4%, and currency is expected to have a negative 1.9% impact on sales for the year. This calculated the impact of currency to spot rates as of the quarter ended December 31, and we have held those rates steady as we estimate the resulting year-over-year impact for the remaining quarters of fiscal 2019.

For total Parker, as-reported segment operating margins are forecasted to be between 16.7% and 17.2%, while adjusted segment operating margins are forecasted to be between 17.0% and 17.4%. The full year effective tax rate is projected to be 23%. This anticipates a tax expense run rate of 24% for the third and fourth quarters.

For the full year, the guidance range on an as-reported earnings per share basis is now $11.04 to $11.54 or $11.29 at the midpoint. On an adjusted earnings per share basis, the guidance range is now $11.35 to $11.85 or $11.60 at the midpoint. This updated guidance on an adjusted basis excludes business realignment expenses of approximately $19 million or $0.11 per share for the full year fiscal '19 with the associated savings projected to be $10 million. The guidance on an adjusted basis also excludes $15 million or $0.09 per share of CLARCOR costs to achieve expenses. CLARCOR synergy savings are estimated to ramp to a run rate of $125 million by the end of fiscal '19, which represents an incremental $75 million of run rate savings as we exit fiscal '19.

We remain on track to realize the forecasted $160 million run rate synergy savings and $100 million revenue synergies by fiscal year '20. And finally, guidance on an adjusted basis also excludes $0.11 per share for the second quarter tax expense related to U.S. Tax Reform.

Savings from business realignment and CLARCOR 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 2019 guidance at the midpoint are sales are divided 48% first half, 52% second half; adjusted segment operating income is divided 47% first half, 53% second half; adjusted earnings per share first half/second half is divided 46%, 54%. Third quarter fiscal 2019 adjusted earnings per share is projected to be $2.99 per share at the midpoint, and this excludes $0.05 of projected business realignment expenses and $0.01 of projected CLARCOR costs to achieve.

On Slide 15, you'll find a reconciliation of the major components of fiscal year 2019 adjusted earnings per share guidance of $11.60 at the midpoint compared to the prior guidance of $11.40 per share. Increases include $0.11 from stronger segment operating income, $0.03 from lower full year tax expense and $0.20 from reduced average shares.

Offsetting these increases is an $0.11 per share decrease from higher corporate G&A than previously forecasted due to market adjusted investments tied to deferred compensation and higher other expense attributed to mark-to-market accounting of equity investments in the second quarter as well as $0.03 from higher interest expense for the year.

Please remember that the forecast excludes any acquisitions or divestitures that might close during the remainder of fiscal 2019.

On Slide 16, you'll find the components of our updated full year increased guidance relative to the outperformance in the second quarter versus our initial guidance going into the quarter. Actual second quarter earnings per share on an adjusted basis were $0.12 stronger than previously guided due to excellent operating performance, partially offset by higher corporate G&A and other expense attributable to the market investment losses previously mentioned.

For the balance of the year, we expect net incremental per share benefits of $0.08. Lower tax expense will provide $0.03, and $0.16 will occur due to the lower average shares. Offsetting these favorable items will be the impact that moderating growth will have on operating income in the second half of $0.10 per share as well as an expected net $0.01 unfavorable impact from below-the-line items of corporate G&A, interest and other expense. All of this equates to a net increase to adjusted earnings per share for the full year of $0.20.

This concludes my prepared comments. Tom, I'll turn the call back to you.

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

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Thank you, Cathy. We're very pleased with our continued progress. With the execution of Win Strategy, we're projecting another earnings record for fiscal 2019.

I just want to conclude by saying thank you to the global team for all the hard work, their dedication, and I thank our shareholders for their continued confidence in us.

And with that, James, I'll hand it over to you 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 Ann Duignan with JPMorgan.

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Ann P. Duignan, JP Morgan Chase & Co, Research Division - MD [2]

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I think maybe perhaps you could give us some color on the regions, what you're seeing in the various regions, and then the various end markets. We used to do the 3 12 and the 12 12 or the trends around the end markets and the regions. Perhaps we could start with that, Tom.

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

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Okay. And this is Tom. I'll start. I'm going to give you maybe an overall framework, then I'll hand it to Lee with more details. Let me start with the new guide, and I want to focus on organic guide. So we guided now to 2% to 4% as far as our range. And I'm going to put the regions in Aerospace into that range and give you where they sit. So on 2% to 4%, Latin America would be above that range. Aerospace is above it. North America would be right at the midpoint. Asia Pacific would be at the low end of that range. And EMEA would be flat. So that's our view on organic growth for the full year. Probably what's more important and interesting for everybody on the call is what are we seeing for the second half, so our first 6 months of the calendar year 2019. So our organic guide, I'm going to kind of round here, is approximately a little less than 1% for the second half. And the way that splits out is North America, a little bit north of 1%, international about a minus 0.5%, Aerospace at 2.5%. So now, if I split out international, that minus 0.5% is around Latin America plus 5%, Asia Pacific, flat, and EMEA about negative 1.5%. Again, these are all second half numbers for us. So maybe a little bit of thoughts from me on what's behind the second half guide. Well, let's start first with the most recent order entry, and you all saw the numbers from the press release: North America at 0; international, minus 2%; Aerospace at plus 10%; Total company at 1%. So if I could step back for a second and think back to where we were 2 years ago, we were clearly in an accelerating growth environment. That very naturally moves into a moderating growth, as most business cycles do, from accelerating into a moderating growth, and that's fully based on our last guide, what we had projected for the second half. However, if I was to give you an analogy going from moderating to really what we guided to, a slow growth, I'd have you visualize a metal spring, not spring the season, but a spring -- a metal spring. And I think that spring is our organic growth. And it's still, I think, very capable of a moderate growth environment. I don't think the dynamics have changed. However, there's been some weights put on top of the spring, and these weights would be the macroeconomic and geopolitical issues that we've all been talking about and reading about and listening to; and trade-related things, Brexit, monetary policy, the oil and gas price softening and the government shutdown. I'm very optimistic -- we are very optimistic that those weights, those macro issues, will resolve themselves, maybe not all of them, but several are going to resolve themselves. And that spring, our organic growth guide for the second half that is currently now in slow growth environment, can spring back to a moderate growth environment. The big question is when. I don't think anybody really knows the answer to that. However, our guide assumes that those macro issues are not going to get resolved in enough time to really have much support or change to what our current second half guide is. So that's a backdrop. I'm going to hand it over to Lee to give you more details on the markets.

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Lee C. Banks, Parker-Hannifin Corporation - President, COO & Director [4]

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Okay, Ann. What I thought I would do, if you don't mind, is first, just some color on Aerospace. I mean, we were absolutely pleased with the performance in Aerospace, strong organic growth. And I just thought I'd give you some color by the segments in Aerospace. So commercial OEM for us was up 11% in Q2, and we're guiding at the midpoint for 5% for the full year. Military OEM, up 24% in Q2, and a guide to 14% for the full year. Commercial MRO up 8%, a guide to 4% for the full year. And military MRO was a strong 9% in Q2 and a 3% guide for the full year. So these full year guides, obviously, some of this stuff is very lumpy, and then there's tougher comps, but that's our latest thinking right now. So we're guiding to 5.7% organic growth at the midpoint for Aerospace. On the industrial side of the business, what we did is just kind of look at this, we took all our markets in Q2, how we saw them. And this is pretty consistent with Tom's comments, how we're projecting them going forward. But we kind of put these markets in 3 buckets: growing and still stable, growing but moderating from Q1, and then soft to negative that we saw in Q2 and really was a carryover from Q1. Just reading through some of these markets that are still positive: Refrigeration is doing well. Telecom, life sciences, construction markets, heavy-duty truck in North America and Europe, fantastic; build rates still. The one area that is down significantly is in Asia, China specifically, and I'll comment on that later. Agriculture, lawn and turf, forestry, material handling, and I just talked about Aerospace. Moderating from Q1 and Q2 was distribution, mostly North America; oil and gas, mostly land-based oil and gas; and then general industrial and mining. And what we would consider soft, or you could say negative, and there's 4 of these that we would kind of put in the trade-related bucket: Mills and foundries, which is -- impacts China significantly; automotive machine tools, tires and rubber. And then there's 4 key markets that have been flat since Q1: Power gen. It hasn't gotten worse. It's stable, so I think we're bouncing along the bottom there. Semiconductor microelectronics, if you will, has gotten worse in Q2. Rail is stable. And Marina is stable at a low level. I'll just comment quickly on the regions. I think in North America, we're still pretty bullish. Our distributor base is bullish. I'd say the only moderation we saw was really distribution that serves kind of the microelectronics markets and land-based oil and gas. It definitely took a step back. And I would say that, clearly, there were some rebalancing of inventory from some of our channel partners in North America in Q2. On EMEA, you've got Turkey, Brexit, tariffs and Yellow Jackets, and they've put a lot of pressure on a lot of different areas. We're expecting slightly negative growth for the second half, although we did see some rebounding in offshore North Sea oil and gas, which was nice. And we -- continued headwinds in the machinery markets, mostly around Germany. And then Asia, 2 great years, strong comps, as we talked about. I'd say overall, Asia, we're -- as Tom mentioned, we're forecasting to be flat in the second half. So by and large, we're very encouraged. As Tom mentioned, there are some pressure on some markets, but I don't get a sense everywhere that there's going to be some precipitous pullback. I just think we're in a kind of a pause or slow-growth area right now. So I'm going to stop. I just gave you a lot, and go from there.

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Ann P. Duignan, JP Morgan Chase & Co, Research Division - MD [5]

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You did, indeed. And I don't want to hog the call, but I just -- could I just clarify, without putting words in your mouth, would North America distribution have been the one kind of that inflected the most during the quarter, and I leave it there.

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Lee C. Banks, Parker-Hannifin Corporation - President, COO & Director [6]

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It definitely pulled back North America. I would not say overall. I would say those areas, a little bit of rebalancing across the channel, and those areas are around land-based oil and gas pulled back. But that's just off the hip, right. I don't think so. I don't think the most would be a wrong way to characterize it.

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Operator [7]

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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 [8]

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I'm wondering how to view the Industrial International guidance for the second half. You're guiding the top line down a little bit. The margins are pretty resilient. And I'm just wondering, is the resilience more a function of the structural cost work that you've done for that region? Is it mainly comps? Or is it something else?

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Thomas L. Williams, Parker-Hannifin Corporation - Chairman & CEO [9]

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Andy, it's Tom. I think what you're seeing is a combination of things. You pointed to one of them. The restructuring that we've done -- and I would characterize this for really all the regions. Obviously, international, we did probably more over the last several years than we had in North America. But it's a combination of that prior period restructuring, so that fixed cost's in a lot better position than we've been. The new Win Strategy changes and that focus on simplification and the costs -- SG&A costs have come down. Our variable costs have gotten better. The productivity in the plants, we saw, continued to improve through the quarter. And our -- we've continued to feel that they'll improve in the second half, which is why we -- our margins are so resilient with a little bit of softness there. And we've done a really nice job on supply chain and sort of just optimizing all the dynamics that are going on from a material inflation, freight, et cetera. So I think the team has done a great job of executing, but there's still a lot more opportunities there, which is why we've guided to pretty good margins in the second half even with some softness in the top line.

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Andrew Millard Casey, Wells Fargo Securities, LLC, Research Division - Senior Machinery Analyst [10]

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Okay. And then -- I think you said it, but if -- investors seem to be worried about a downturn across several markets. I'm just wondering what you would expect from Parker in terms of return performance if the markets actually did go into a downturn. Are we looking at not only raised -- increased margin performance that you've already demonstrated with this record in the second quarter but also decreased return sensitivity to the changes and end market demand swings?

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Thomas L. Williams, Parker-Hannifin Corporation - Chairman & CEO [11]

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Well, obviously, and it depends on the severity of a market swing. But I would tell you, we have this continuous view on being cost leaders. Everything we're doing around the Win Strategy, the execution there, is on making us the most nimble, agile business that we possibly can be. And I think the best evidence of that is just plot our margins over the last 4 years, what's happened. You've seen significant margin improvement. And of course, in the second half, we're guiding to a little less sales [and] margins equal to or better than what we originally said in the last guide. Now, typically, over a cycle, we would expect sales would drop. That same 30% decremental, I think, is still a good rule of thumb. But what we've demonstrated over the last several cycles, go back to '02, I'm going to take a history lesson for those who haven't tracked the company a long time. 2002, we had 60% drop in earnings. '08 and '09, it was a 40% drop. The '15 to '16 industrial recession contraction was a 20% drop. And so I -- we continue to get better. Our whole goal is to raise the floor, raise the ceiling of margin performance. And while we're very proud of what we did in Q2 and very proud of -- and we're guiding for the first time in the history of the company to a 17% operating margin, we clearly, clearly have a lot more opportunity in the future. So I'm not worried at all about any kind of softness. We've been practicing for this every day, so we're ready for it.

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Operator [12]

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Our next question comes from the line of Nathan Jones with Stifel.

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Nathan Hardie Jones, Stifel, Nicolaus & Company, Incorporated, Research Division - Analyst [13]

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I'd just like to dig a little bit further into the margin in North America. I think incrementals are in the mid- to upper 30s in the second quarter North America, versus kind of that 10 to 20 that you'd guided to for the first half. So clearly, better there. And I think this is probably around the productivity improvement postclosing the CLARCOR and Parker facilities. Maybe, Tom, you could -- Tom or Lee, you could talk a bit about the improvement in productivity there, if those businesses are now running at the levels that you expect them to run, if there's further improvement we're going to see in the third quarter. Any -- just any color you can give us around that.

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Thomas L. Williams, Parker-Hannifin Corporation - Chairman & CEO [14]

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Yes, Nathan, this is Tom. I would say, first, you have a good ground-rooted improvement in productivity even regardless of the plants that were involved in plant closures because you got all the other plants that are improving as well in Win Strategy execution and all the things that I talked about earlier in sort of my opening comments. So you got a good ground-based improvement in productivity, specifically around the plants that -- and all the lines that we moved, we saw steady progress and productivity, but we have more to do. So we were pleased, as you pointed out, 37% more or less in North America for the quarter and beat what we had guided to, what we had communicated. But we expect that to continue to get better, and we're guiding to an even stronger second half. So our belief that we told you last quarter about the second half being stronger than what we feel the first half would be, that still holds true. We may have gotten a little better faster. But what we've seen is there's still lots of opportunities whatnot yet at the complete rates that we need to be, so I think that bodes well to what our second half is going to be. And really, I think signals -- not talking about FY '20 yet -- that signals that we had momentum at FY '20 as well.

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Nathan Hardie Jones, Stifel, Nicolaus & Company, Incorporated, Research Division - Analyst [15]

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Maybe then just on the order -- the flat orders in North America in the quarter. Lee talked about some maybe channel rebalancing on the distribution side. Have you seen that abate into the third quarter here? Are you seeing any channel rebalancing or any OEM channel rebalancing there, inventory there, maybe with your OEMs anticipating a little slower growth, they tend to maybe take some inventory off the shelves? Or what your expectations are in both channels for inventory over, say, the next 6 months?

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Lee C. Banks, Parker-Hannifin Corporation - President, COO & Director [16]

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Yes. Nathan, it's really hard for me to have a gauge for the OEM channel, but my feeling through the distribution channel is the rebalancing that took place is, by and large, done. I think there's real pull on demand that's taking place. And so I don't feel like there's more pullback coming given current market conditions right now.

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Operator [17]

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Our next question comes from Julian Mitchell with Barclays.

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Julian C.H. Mitchell, Barclays Bank PLC, Research Division - Research Analyst [18]

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Maybe just following up in the industrial businesses on the cadence of the order changes that you saw in the last few months. Was it in general, when you look globally, a big step-down very late in fiscal Q2? Or was it a steady deceleration since sort of early October? And related to that perhaps, how should we think about the organic growth guide in the current quarter versus the fourth fiscal quarter? Is there any particular cadence on the industrial side that you would emphasize?

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Thomas L. Williams, Parker-Hannifin Corporation - Chairman & CEO [19]

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Julian, this is Tom. Let me -- I'll start first with the order trends and I'll maybe take region by region. So North America, pretty well declined equally -- equal parts through the quarter and really mirrored the -- if you'll go back to the prior year, the increases we had. So kind of a mirror image there. I would say EMEA and Latin America was -- I'd say really all the regions were pretty sequentially equal drops. EMEA and Latin America exited flat to prior, so remember, our international was minus 2. That composition was EMEA and Latin America exiting flat, and Asia Pacific exiting slightly negative on that end. As far as the first half/second half -- in the third quarter and Q4 on organic, we have a little bit better organic in Q3, and that's mainly because of comps with Aerospace in Q4. We had a huge Q4 in Aerospace with some big MRO activity that is unlikely to repeat. And so that's probably what's weighting it down. But I would say in general, how I articulated, what we articulated as far as organic growth is not really too much different between Q3 and Q4.

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Julian C.H. Mitchell, Barclays Bank PLC, Research Division - Research Analyst [20]

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And then my second question would be around maybe switching to the balance sheet. You talked about the buyback step-up, the $500 million or so in Q2. Does the demand slowdown at all affect your appetite to undertake acquisitions, and therefore, buybacks are a more logical use of cash? Or are you still equally interested in M&A as you look out over the rest of this year?

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Thomas L. Williams, Parker-Hannifin Corporation - Chairman & CEO [21]

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Julian, maybe to start, one thing I'd like to cover the capital deployment from a comprehensive standpoint. So first is dividends. We're going to keep that consecutive increase record. And we like to target 30%, 35% of net income on a rolling 5-year average. And our dividends are going to grow because we're going to grow net income over this time period. CapEx, as you -- my opening comments about one of the things that makes us unique, we're pretty efficient on CapEx. We'll use CapEx to fund organic growth and strategic productivity. So now, to the heart of your question is share purchase versus strategic acquisitions. And we like both. We will do what the best use of this for our shareholders for the long run. I think in general, acquisitions generate incremental cash, generate incremental EBITDA. That would be the preference, provided that they meet our stringent and our disciplined view of acquisitions. Over the cycle, it's important, as far as where we are, but what's more important is it a strategic fit. Will it hit our return criterias? We would model where we were organically into the DCF, so we fact that in. So I would just say, the M&A pipeline is active. We're going to continue to look at properties, really, along 2 big things: We want to be the consolidated choice in our space if the property is a good fit. And then all things being equal, we're going to invest in engineering materials, aerospace, instrumentation, filtration; of course, you've seen our -- the big investment we did in filtration. But you saw on the last quarter, we bought shares. We didn't see a property that we could execute on that made sense, that they click. Remember, the acquisition pipeline is not 100% first-pass yield. It requires 2 people to get married. And we think we're a great value. And we know where the company's going. And we thought it was a great investment, great time to buy Parker. For that matter, it's never a bad time to buy Parker. So we'll continue to look at all those. I think in general, like you've heard me talk before, we want to have a balance sheet that is about the work. We have a great earnings profile. We have great cash flow. And we want to be great deployers, and we're going to deploy the best possible way, recognizing that the whole goal is to drive shareholder value over the long term. And every quarter might be a little different how we tweak that, but I think you'll see us continue to be active.

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Operator [22]

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Our next question comes from the line of Andrew Obin with Bank of America Merrill Lynch.

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Andrew Burris Obin, BofA Merrill Lynch, Research Division - MD [23]

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Just a question, I guess, for Tom and Lee. I remember maybe last year, you guys were sort of stressing the fact that we're still in very early innings of the industrial cycle. And I looked at your growth, and you guys have been spot on, I get it. But your peer Eaton just provide a sort of 5%, 6% organic growth for hydraulics for '19; 8%, 9% for Aerospace. Rockwell is guiding for a 7% for 2019. So I'm just wondering what has happened to the cycle, and why are you so different from other short-cycle industrials that I'm looking at in looking at '19. And have you changed your view about the long run? Sorry for a longwinded-winded question, but the difference in guidance is so stark between you and everybody else.

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

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Andrew, it's Tom. I can't comment about everybody else. I can just comment about what we see. We can -- if I take Aerospace, we continue to see Aerospace very strong. And we had robust orders. You saw order entry there. We had a robust first half. Our second half will still be very strong sequentially. It's a 7% growth sequentially. We had some pretty tough comparables in the second half, which makes it not look quite as strong, but I'd put up our Aerospace numbers against anybody in that space. On the industrial side, we do tend to probably see things maybe a tad quicker than other people, but we're giving you what we see right now, and that's all we can do. The order entry on the prior quarter, given the fact that our backlog is 4 to 6 weeks, typically, in the industrial piece, is what you're going to yield out in the next quarter. I still believe, and as you've heard me talk about before, that I still think this is a great industrial environment. I do think, though, that some of the uncertainties weighed on order demand, and I do think they'll resolve. But since our fiscal year ends June 30, I'm not sure they're going to resolve in time to influence our second half. Remember, we're guiding only for our second half or our full year, which ends June 30, versus everybody else is guiding to a full year calendar 2019. So that's how I would describe it.

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Andrew Burris Obin, BofA Merrill Lynch, Research Division - MD [25]

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No, that's very fair. And just a follow-up question. Seeing how a channel check work is picking up very, very strong pricing even though we are seem to slow down you guys are talking about. Is there anything different about the industry pricing strategy in this cycle? It's just I've been doing it for a while, and pricing seems to be as sticky as I've ever seen.

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Lee C. Banks, Parker-Hannifin Corporation - President, COO & Director [26]

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Andrew, it's Lee. As you know, I mean, we're constantly measuring our input costs using our PPI metric and using our -- and seeing what's happening with inflation. There's certainly been a lot of inflation in this cycle, some driven just by pure commodity pricing, some driven by extra things like tariffs, et cetera. So I think what you're seeing is just the ability to probably cover some of those input costs that are maybe a little different than past cycles.

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Andrew Burris Obin, BofA Merrill Lynch, Research Division - MD [27]

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What's -- right. But what's driving this fundamental ability? That's a big deal.

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Lee C. Banks, Parker-Hannifin Corporation - President, COO & Director [28]

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You mean for it to stick? Andrew, I think I lost you there. But I would just finish by saying that we were in a very rapid growth environment. I think supply was paramount for everybody. And I think there's just strong brand recognition with Parker's brand throughout the channel. So not sure I get...

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

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You guys are doing a great job in the channel. I'll follow up off-line.

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Operator [30]

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Our next question comes from Jamie Cook with Credit Suisse.

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Jamie Lyn Cook, Crédit Suisse AG, Research Division - MD, Sector Head of United States Capital Goods Research, and Analyst [31]

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I guess first question on Aerospace and margins have been very strong, in particular, over the past 3 quarters. I know you're guiding for margins to deteriorate in the back half. But can you talk about mix or whether there's upside to Aerospace margins over the next couple years, and what would be driving that, I guess, is my first question. And then my second question, just based on sort of what you're -- the uncertainty in the macro environment or in some of the slowdown in the markets you talked about, are you considering potentially additional restructuring actions at all, and how we should sort of think about that? Or what actions you're taking to prepare if there is a downturn.

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Catherine A. Suever, Parker-Hannifin Corporation - Executive VP of Finance & Administration and CFO [32]

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Jamie, this is Cathy. I'll start on the Aerospace margin. We were very pleased with the margins that they achieved in the quarter, and we do see a lot of improvements that they've worked hard at getting -- gaining in their infrastructure and their cost control. If you notice, we did raise the guidance for their margins for the year a fair amount. In the second half, you'll see maybe not as high as you would have expected, and that's going to be driven by higher development costs in the second half than what we experienced in the first half. We're anticipating development costs for the year to finish somewhere between 5 3/4 of their sales to 6 1/4. They did 5.5% in the first half, and we're expecting closer to 6.5% in second half just because of the timing of some of those development activities.

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Thomas L. Williams, Parker-Hannifin Corporation - Chairman & CEO [33]

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And then, Jamie, this is Tom. I'll take the market question he had. Again, I would just go back to we're constantly preparing for any softness by just having the best cost structure we positively can, but we will make market adjustments. We're not seeing anything yet that would warrant a change in our restructuring profile. We have a lot of levers you can pull that don't trigger that, like reduction of temporary workforce, overtime reduction, those type of things, recognizing that we have probably around 8% of our workforce total company that is temporary people. So there's a number of levers we can move that won't trigger a restructuring change.

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Operator [34]

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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 [35]

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Obviously, an important time for the stock and the company here in the sense of trying to show the evolution, how does Parker handle a slowdown differently than in the past. And I mean, this quarter, obviously, you're able to show weaker orders, weaker organics, still able to raise the guide, do a good job in the quarter. But just can you help frame a little bit thinking about, really not that far away from 6 months from now, fiscal '20 guide. We can all make our top line assumptions. But can you help us with -- when you look at the order patterns, what you're seeing right now, as you know, North America -- if you look at the comparisons and you double stack them, right, the actual North American comp gets a little harder, and then it begins to ease. The international order comps start to ease from here. Can you help us level-set -- again, I know you're not going to give us fiscal '20 guide right now, but should we be thinking the order rates in North America and International are both negative in the current calendar 1Q? And then I'd like to follow up with a question on kind of cost side items or below the line items as well to think about puts and takes '20 versus '19.

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Thomas L. Williams, Parker-Hannifin Corporation - Chairman & CEO [36]

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David, it's Tom. As you might expect, I won't get into FY '20. But I think orders are going to be reflective of what I imagine that organic guide that I gave you for the second half, meaning that a little less than 1% total company; North America, up plus 1%; International about minus 0.5; and Aerospace, the 2.5. So I think orders will mimic that. Obviously, Aerospace orders are longer cycle, lumpier, so they may not look exactly like that. But I think the industrial pieces will mirror that organic guide that I gave you. And as far as below the line, why don't you follow-up with that question.

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David Michael Raso, Evercore ISI Institutional Equities, Research Division - Senior MD & Head of Industrial Research Team [37]

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Sure. And just to be clear on your answer, so it doesn't sound like you see the North American orders -- I'm not going to try to hold you to 100, 200 bps here, but it doesn't sound like you see North American orders going maybe negative at all, let alone any materiality. And then international orders, it sounds like you also don't think that would get any worse from here. Is that a fair characterization of your answer? Just seeing what you're saying out there and knowing the comps.

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Thomas L. Williams, Parker-Hannifin Corporation - Chairman & CEO [38]

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Yes. Again, I would frac it with a little bit of a range. It's really hard to pinpoint this stuff. But I mean, the numbers I gave you is our best estimate at this point based on the current order entry.

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David Michael Raso, Evercore ISI Institutional Equities, Research Division - Senior MD & Head of Industrial Research Team [39]

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And then on the year-over-year benefits. I know you're not going to quantify them. Just if you can help us a little bit. You're obviously going to have the share count help. The full year benefit of the plant closures and some of the approved -- improved efficiencies, and I would suspect -- and we can debate the cost structure materials, but you would think of for price cost, maybe it even gets better as we look into the moment you have to give a guide on '20? Can you help us a little bit, maybe even prioritize for us, is the biggest benefit to plant closure efficiencies having that for a full year? Obviously, repo versus M&A the next 6 months, we can debate it, but it sounds like you have a nice share count health. Can you just kind of frame the puts and takes for us on those cost items and below the line items? And obviously, any other help you have on tax or anything would be great, just things that you see as of today.

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Catherine A. Suever, Parker-Hannifin Corporation - Executive VP of Finance & Administration and CFO [40]

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David, I'll start it out here. We're forecasting some of the realignment activities that we're doing this year that we'll see $10 million of savings in the year, and then that'll carry through. In terms of the integration and the synergy savings we're seeing with continuing to work on integrating CLARCOR, we've increased the run rate to up to $125 million through this -- the end of this year, and that's a $75 million incremental. And we still then think that by the end of fiscal '20, we'll be up to $160 million. So yes, we'll continue to see savings from those activities. In terms of price cost, we don't really talk about in that detail. Lee, you want to touch on that?

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Lee C. Banks, Parker-Hannifin Corporation - President, COO & Director [41]

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No, I would just say on price cost, David, you know the way we track this in our -- our goal is just to be margin-neutral as we go through these.

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Catherine A. Suever, Parker-Hannifin Corporation - Executive VP of Finance & Administration and CFO [42]

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And in terms of tax expense, we are forecasting an effective rate of 23% this year. I would expect that to be our continuing long-term rate for the next year or 2, unless things change significantly.

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Thomas L. Williams, Parker-Hannifin Corporation - Chairman & CEO [43]

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David, (inaudible) to a higher point here. I think what you're getting at is we got more room to go. We're going to end up '17, and we're on a mission to get to '19. We're not stopping there. That's just a test. We're just going to stop for a minute and congratulate ourselves and keep moving. But we are very pleased with what we're seeing, and I won't get into FY '20 because we haven't done that, but we're going to continue to grow earnings and grow margins.

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Catherine A. Suever, Parker-Hannifin Corporation - Executive VP of Finance & Administration and CFO [44]

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Thank you, David. I think we have time for one more question.

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Operator [45]

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Our final question will come from the line of Joel Tiss with BMO Capital Markets.

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Joel Gifford Tiss, BMO Capital Markets Equity Research - MD & Senior Research Analyst [46]

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Just wondering, just 2 things -- I wonder, again, just more of a characterization, but are the pieces largely in place for the 19% longer-term operating margins? Or are there more levers that have to be pulled? Or it just depends on what the volume profile looks like? And just help us get a sense of where you are there.

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Thomas L. Williams, Parker-Hannifin Corporation - Chairman & CEO [47]

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Well, it would be -- all the things -- Joel, this is Tom. All the things that we've had in the Win Strategy, all along in that infamous walk we've got that shows you from where we were in FY '18 at the IR Day to the 19%. And if I would just tell you the major ingredients without going through the numbers, the CLARCOR synergy's a big part of it. All simplification program, which we didn't talk about, is still early days. The whole 80-20 look at our revenue complexity is a big deal. We're down to 80 divisions now, 122 to 80 divisions. So 80, 8-0, we continue to work that. But I would tell you that the revenue complexity side is a bigger deal. Productivity. We have a lot of things we're doing on kaizen. We're combining lean and kaizen and some strategic CapEx investments we're making around automation. Those will continue to yield. We've done a great job in supply chain, and we've been able to optimize the supply chain in a much more efficient way than, I think, maybe historically, which we're pretty pleased with that. And we'll continue to leverage a fair amount of our spend that I think has not had as much visibility, all indirect costs side of things. And then we're going to continue to have margin enhancements around change in the mix and distribution, the innovation pipeline, those type of things. So I think you all know us well enough. We wouldn't put out a number. Even if it was 5 years ago, we don't think we had a road map to get there. So we believe in our road map. But I would just again emphasize that it's not the final destination. And we got to 17% early. I'm not saying we'll get to 19% early, but our confidence is there.

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Joel Gifford Tiss, BMO Capital Markets Equity Research - MD & Senior Research Analyst [48]

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And then just the last one in Aerospace. Is there any unusual mix that could put a little pressure on the margin progression over the next, say, 12 to 18 months?

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Catherine A. Suever, Parker-Hannifin Corporation - Executive VP of Finance & Administration and CFO [49]

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Yes, good question, Joel. We will see an increased volume of OEM activity, of entry into service as some of the newer platforms are now ramping up, and that does start out at very low margins. So that will have some pressure on our Aerospace margins. But we are confident. I mean, we're forecasting a midpoint margin for this year of 19%, 19.1%, and we -- the cost efficiencies that they've been working hard on, I think, will help balance against that mix pressure that they're going to feel the next few years.

All right. This concludes our Q&A session and our earnings call for today. Thank you, everyone, for joining us. Robin will be available to take your calls should you have further questions. Thanks, everybody. Have a great day.

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Operator [50]

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Thank you. Ladies and gentlemen, that does conclude today's conference. Thank you for your participation. You may all disconnect.