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Parker-Hannifin Q3 2022 Earnings Call Transcript


Listen to Conference Call View Latest SEC 10-K Filing View Latest SEC 10-Q Filing

Participants

Corporate Executives

  • Todd M. Leombruno
    Executive Vice President and Chief Financial Officer
  • Thomas L. Williams
    Chairman and Chief Executive Officer
  • Lee C. Banks
    Vice Chairman and President

Presentation

Operator

Good day and thank you for standing by. Welcome to the Parker Hannifin Corporation's Fiscal Year 2022 Third Quarter Earnings Webcast and Conference Call. [Operator Instructions]

And now it is my pleasure to hand the conference over to your first speaker today, Todd Leombruno, Chief Financial Officer. Thank you. Please go ahead.

Todd M. Leombruno
Executive Vice President and Chief Financial Officer at Parker-Hannifin

Thank you, Paul. Good morning and thanks to everyone for joining. This is our fiscal year 2022 Q3 earnings release webcast. As Paul said, this is Todd Leombruno. I am Chief Financial Officer. And as usual, with me today are Tom Williams, our Chairman and Chief Executive Officer; and Lee Banks, our Vice Chairman and President. Today, we are going to discuss forward-looking projections and also, we will discuss some non-GAAP financial measures. Slide two in our deck details our disclosure statement on these areas. Actual results may differ from our projections due to uncertainties listed in these forward-looking statements, and those are detailed in all of our SEC filings. Reconciliations for all the non-GAAP measures, along with this presentation, have been made available under the Investors section on parker.com, and those will remain available for one year. I'd like to remind everyone before we begin that we are still bound by the requirements of the U.K. Takeover Code in respect to discussing certain details of the pending Meggitt transaction. As for the call today, as usual, we'll start with Tom discussing some key items for the quarter. I'll follow up with some additional color on our Q3 results and detail the increase to our guide that we issued this morning with all of our press releases. We'll finish the call with any questions you have for Tom, Lee or myself.

And with that, we are now on slide three. And Tom, I'll hand it over to you.

Thomas L. Williams
Chairman and Chief Executive Officer at Parker-Hannifin

Thank you, Todd. Welcome, everybody, to the call today. Appreciate your participation. It was a record quarter, record quarter for the quarter and record quarter for all time in a lot of key metrics and was delivered against very difficult circumstances that required exceptional agility and performance by our global team. I know we all lived through it, but just as a refresher of what happened in Q3, we had the Omicron spikes, which drove absenteeism; we had supply chain challenges; inflation; China COVID shutdowns; and the Ukraine war. So just your basic average quarter. Obviously, I'm being sarcastic, but obviously, not ideal conditions. And what was remarkable against that backdrop, we turned in a number of all-time records, as I mentioned. And my thanks to the entire team for this great performance and resilience in these times. So a couple of comments about the quarter on slide three. Safety is our top priority. We continue to be top quartile when you look at our performance on safety incidents versus our peers. We're doing that through our high-performance teams, which is how we run the factories and the warehouses, and a culture of Kaizen. And as I've mentioned before to shareholders, there's a very strong linkage between safety, engagement and business performance. If you look at those three metrics for us over the last seven years, they're all going in the same direction. Our sales growth was 9% versus the prior year. Organic was a positive 11%, so that was very nice.

We eclipsed $4 billion in sales for the first time in the history of the company, first time over $4 billion in a quarter. That was a great milestone. We had strong demand against virtually all of our end markets. Segment operating margin was 20.3% as reported or 22.7% adjusted. That was 130 basis points better than prior year. So expanded margins, 130 basis points in the kind of conditions that I started the call with, just remarkable performance. We increased the quarterly dividend 29%. That is the largest increase in our history and clearly signals the confidence that we have about Parker for the future. We have some temporary things, which we highlighted in the future slides here, that Todd will go over about the Q4 impact related to China COVID shutdowns. The comment here I just want to make is that that's a temporary thing. How long it goes, it's hard to predict, but we expect to come up to full production sometime in Q1, and that will make up this delta that we're experiencing to Q4 during the course of the rest of FY '23. And maybe to clarify, if you're looking at our -- what we're talking about China versus what some of our peers are, we only have 60 days left in our fiscal year. So it's very hard for us to make that up in rest of the fiscal year, but we clearly feel confident that we'll make it up in FY '23. If you look at these results, it's the Win Strategy, as the portfolio changes, it's the fact that the company is now much longer cycle and a better performing company.

On slide four, what drives us is really three things: living up to our purpose, which is enabling engineering breakthroughs that lead to a better tomorrow; being great generators and deployers of cash; and being a top-quartile performer. And I want to give you one example on slide five, probably our purpose in action related to clean technologies. As the world migrates to a more carbon-friendly environment and applications, we're going to be there to help. One very topical and current area given the inflation pressures in the Russia-Ukraine war is the topic of energy and the availability of energy and inflation of energy prices around the world. And as the world moves from brown sources of energy to greener sources of energy, it's pretty clear that we're going to need to use all shades of color between brown to green as we walk to that cleaner tomorrow. And clearly, a big part of that bridge to that cleaner tomorrow is going to be natural gas. And we wanted to talk about really natural gas, where we play in it, and just how we're going to be able to help society, our purpose and action here. So upstream -- there's four main components here: upstream, midstream, liquefaction, storage and regasification and power generation. On the bottom of this slide, you see the six Parker technologies that we utilize to go into there and a couple of anecdotal comments for each one.

So in upstream, we've got fluid power controls for the rig equipment. We have instrumentation. Valves and controls in there as well. And midstream is primarily gas filtration. On the liquefaction, storage and regasification, that will be our pumps, our valves, ceiling technologies, glucan vance. And this is all under cryogenic conditions, so ultra-low temperatures. And then power gen, I'm going to cover on the next slide. So a lot of what we do for society on compressed natural gas and liquid natural gas is going to be directly applicable as the world moves to hydrogen, which is on slide six. So that last value chain as part of natural gas that incurred was the power generation piece. And clearly, what's obvious here and what's really helpful for us, and I think our customers, is all the technologies that we have on CNG and LNG are directly applicable into hydrogen. You can see in the middle of the page, the applications, those five bullets we have in the middle. On the right-hand side are our various technologies and similar technologies for both fuel sources. With the exception of our sealing technology, will need to be even more sophisticated and which we're working on as we speak to be able to seal hydrogen, which is a smaller molecule and more difficult to seal. But we'll be a big part of this bridge with natural gas, and we'll be there to help when society's ready for hydrogen as well. If you go to slide seven, which happens to be one of my favorite slides.

And while you may be tired of me showing this slide, I think it's the simplest way for shareholders and people that maybe aren't familiar with us to understand how different the company is over the last seven years. It's been our people, which is really their engagement, their ownership, those top-quartile results that we see from our people driving top-quartile performance. So in the portfolio, and I would just summarize it, we're going to -- when we close Meggitt, we will deploy $20 billion of money into acquisitions, reshaping the portfolio. We will have doubled engineered materials, doubled aerospace and doubled our filtration businesses over this period of time, dramatically reshaping the company and the future of the company. And then on the strategy side, you have the Win Strategy 2.0 and 3.0 now over this period of time. And you've seen what it's done to margins. EPS are just phenomenal. This is high into the right type of metrics on this page, which is hard to do. I can assure you that. So hopefully, you see from this progress, in addition to the alignment we have with the positive secular trends in aerospace, digital electrification and clean tech, that our business is poised for a very promising future over the next five years. I wanted to close my opening comments with giving you an update on slide eight with where we stand with the regulatory clearances regarding to the Meggitt transaction.

So on the antitrust side, we have already cleared without any conditions from the following countries: so Australia, China, Saudi Arabia, Singapore and Turkey. Brazil has given us unconditional approval subject to their usual 15-day waiting period, so that's in good shape. We've received conditional antitrust clearance from the European Commission, subject to our commitment to divest of our aircraft mill and brake business, which is in process. And then on the foreign investment side of things, the transaction has been cleared by Australia, Denmark, Germany and Italy. So probably the simplest way for me to describe it, what remains and what's left are antitrust clearances for the U.S. and the U.K. and the national security clearances for the U.K. and France. So we're making good progress, and we continue to expect the transaction will close sometime during Q3 of this calendar year. And we're very excited. We're going to put two great companies together. We're going to double the size of aerospace, and we're going to have great synergies as we work together. And we're going to do all this at the beginning of an aerospace recovery, so the timing is perfect.

With that, I'll turn it over to Todd to give you more details on the quarter.

Todd M. Leombruno
Executive Vice President and Chief Financial Officer at Parker-Hannifin

Okay. Thanks, Tom. I'm going to start on slide 10. This is just a year-over-year comparison of our Q3 financial results. And Tom mentioned this, really all the credit goes to our team members, really demonstrating stellar execution to generate a number of record results in a quarter that, as Tom mentioned, had a lot of disruptions. Sales increased 9%. We did eclipse $4 billion for the first time in our history. Organic growth was 11%. Currency was a drag at two points. So that's how we get to the 9% growth. I just want to make a comment. Our backlog levels are unbelievably strong. They're up 25% from this time last year, and over 90% of our end markets are in growing state. We continue to see all regions perform extremely well. Commercial aerospace and really all of the North American markets are really the most robust, but it is broad-based across the company. Tom mentioned this, but we did expand segment operating margins, 130 basis points in the quarter. We finished at 22.7% on an adjusted basis. And I'll go through the segments in a couple of slides, but really, every segment, every region contributed to this performance. The inflationary and supply chain issues, they are persistent. They remain. Yet our team members are really showing their resiliency as we leverage the Win Strategy to really achieve our goal, which is top-quartile performance. When you look at EBITDA, our EBITDA margins expanded 70 basis points. We finished at 22.6 for the quarter. And net income -- adjusted net income grew by 16% in the quarter, and we finished at $630 million or 15.4% return on sales. Net income grew 16% versus prior year. Very, very impressive.

I think we've mentioned this multiple times before, but Tom was talking about Meggitt. The currency deal contingent hedge we have, pound to dollar, requires mark-to-market accounting treatment. Due to what's going on with currency rates and really the strengthening of the dollar versus the pound, we did record a pretax noncash charge in the quarter of $247 million, and that really accounts for the major difference between the as-reported and the adjusted numbers this quarter. When you look at EPS, we did $4.83. That is $0.71 greater than prior year. That's up 17% from the $4.12 we did last year. So just really solid performance across the board. And again, I can't thank our team enough. If you go to slide 11, what we did here is we just put a graph together that displays really the elements of that $0.71 or 17% increase in EPS. And again, once again, this quarter, we continue to outperform. It's really driven by volume. Of course, the margin expansion that Tom and I talked about. But really, what I like about this is it really displays our solid operating performance. The majority of the change, all of it is showing up in segment operating income. $0.75 of the $0.71 increase is all segment operating income. If you look at everything else, that's the $0.04 of a drag, but really proud that we were able to not only improve EPS but do it at the operating line. If we jump into slide 12, this is our segment performance. Growth continues to be broad-based across every segment and every region. Demand is -- continues to be robust. Our orders are up 14%. The team has taken prudent actions to manage the inflationary environment.

And that really has positioned us to continue to maintain margin-neutral on all of these price cost issues that are fairly well documented across the world. That and the operating execution that I talked about really allowed us to improve margins in every segment. If you look at our incrementals, 37%, we've talked about this a couple of times, but we still are going up against pandemic-level comps. We had $25 million of discretionary savings in Q3. If you account for that, incrementals would have been 44% for the quarter. So just really solid incremental performance. It really highlights the power of the Win Strategy, and it demonstrates the transformation that we spoke about at our Investor Day just at March 8. If you jump into the segments, North America surpassed sales of $2 billion, organic growth was almost 15% versus prior year, and adjusted operating margins expanded by 100 basis points and reached 22.9% for the quarter. That led the company this quarter, right, which is really impressive. North America has certainly had challenges across the supply chain. It's great to see them rebound and lead the company again. Their incrementals improved in the quarter, and they're the best incrementals they generated all fiscal year. And even more importantly, order rates accelerated to 23% and backlog, of course, grew even stronger. Just very great execution, broad-based demand in the North American segment. If we move to international, sales were about $1.4 billion.

Organic growth there is almost 9% from prior year. EMEA and Latin America combined was mid-teens positive, and Asia Pacific was low single digit, but all regions are positive in the international segment. Again, here, operating margins expanded 110 basis points in international and finished really at a high level of 22.7%. Really satisfied to see the consistent performance our international teams continue to post. And we've talked about this. It's been a long-term effort for a long time. And I'm really happy that we're seeing the results out of our international segment. Order rates in international are plus 9%. If we look at aerospace, aerospace continues to rebound. Sales were $632 million. Organic growth was almost 6%. Very strong demand in our commercial markets, both OEM and MRO. And operating margins, great expansion here, 250 basis points of improvement, came in at 21.9%. And I just want to remind everyone, with this great margin performance, we are still operating at below pre-COVID at baseline, when it comes to sales. Orders in aerospace are minus 4%. But if you remember, we talked about this last quarter. There were a few large military orders in the prior period that really just kind of make a tough comp in aerospace. If you exclude those items, aerospace orders were positive 20. And again, aerospace dollars in the quarter are the largest dollar level that we've had in the last four quarters. So it just really gives us confidence in the aerospace recovery.

Really proud to be able to share these results across all of our segments. And like Tom says, it really demonstrates the power of the performance and portfolio change that a lot of -- all of our team members have been working on for some time. So if we go to slide 13, cash flow generation, right? Tom talked about being great generators and great deployers of cash. Year-to-date, we've exceeded $1.5 billion in cash flow from operations. That's 13.3% of sales. Our free cash flow is about $1.4 billion. That's almost 12% of sales. And our year-to-date conversion is 117%. We continue to still manage this diligently in a growth environment, right, which is not the easiest thing to do. If you look at year-to-date, working capital is a use of cash of about 3%. Versus last year, it was a source of cash of about 1.2%. Q4 is our strongest quarter for cash. If you followed us for a long time, you know that. We still continue to forecast mid-teens CFOA. And obviously, greater than 100% conversion when it comes to cash flow conversion. Tom called out the 29% dividend increase that we announced. This really reflects the confidence we have and our ability to generate cash, not just in the short term but in the long term as we look out to achieving those FY '27 goals. Just a few notes on leverage. Our gross debt to EBITDA was 2.8 times. Our net debt was 2.6 times. But if you remember, we have about $2.5 billion of cash in escrow to pay for the Meggitt transaction.

We are classifying that as restricted cash. If you exclude that $2.5 billion, our net debt to EBITDA would be 1.8 times. Now let's look at the guidance. If I go to slide 14, on the guidance, we obviously announced an increase to our guidance this morning. I'm going to give it to you on an as-reported and adjusted basis. We're raising full year EPS by $0.10. Last quarter, we were projecting $18.05 per share. We are now at $18.15 per share at the midpoint. We've also narrowed the range to $0.15 on either side. Sales growth for the full year is forecasted to be about 10%. We did increase the organic guide 50 basis points from 10.5% to 11%, so 11% full year organic growth. And while currency remains a headwind in the quarter, for the full year, we think it will be about a 1% drag to the top line. Just a reminder on currency, for our guide, we are using March 31 rates to calculate our estimate. If you look at the segment operating margins, full year guidance is 22.1%. I just want to call out, if you look at that versus last year's actuals, that's a 100-basis-point increase in segment operating margins. So I'm glad to be able to speak to that. The corporate G&A interest and other is really expected to be $947 million on an as-reported basis and $459 million on an adjusted basis. And the adjusted -- we've kind of -- the adjustments, we've detailed out for everybody. The acquired intangible asset amortization is $315 million. Business, realignment charges are $20 million.

LORD cost to achieve is $5 million. And of course, we closed our Russian operations. That is a charge of $20 million. If you're curious, that was $13 million in the segment line and $7 million below the segment operating income line. Meggitt acquisition-related expenses that we've incurred to date is $84 million. And finally, that deal contingent hedge that I mentioned, on a full year basis, it's $396 million. We will continue to adjust transaction-related expenses as they are incurred, all the way up until we get to close. And a note on tax. Our full year tax rate is down a little bit. We expect that to be about 21.5% for the full year. And when you do all the math, for us, that equates to an EPS -- adjusted EPS guide for Q4 of $4.60. This quarter, we actually put another slide in here. It's a bridge on our guidance reconciliation. The Q3 performance that we had, we really outperformed our guide significantly. We beat our guide by $0.29. We've rolled that into our full year guide here. And based on really strong backlog and order rates, in North America specifically, we have increased our Q4 North American organic growth guide by 300 basis points versus what we thought last quarter. And that really is generating about $0.08 of segment operating income in Q4. Tom has mentioned this, but the COVID-related shutdowns in China are a near-term temporary headwind for us in Q4.

Obviously, Q4 is the end of our fiscal year here. We are estimating that to impact Q4 sales by $100 million. We're using a 40% decremental on this $100 million, which is greater than what we normally operate at, simply because a number of our facilities are fully shut down. So we are confident that the facilities that are operating in China and those others in the international segment are going to be able to perform, but we're using a 40% decremental on just that $100 million of near-term headwind. That equates to a $0.24 EPS headwind going into Q4. All the other items net to a slight EPS reduction of $0.03, and that really is the walk on how we get to our new guide of $18.15. So before I turn it back over to Tom, I just want to make sure everyone saw the press release that we issued on Tuesday, with Robin announcing her retirement plans after what will be almost two decades with Parker Hannifin. And Robin has really been a driving force within the company, really helping us to transform our M&A processes, our long-range planning and, of course, serving as our voice and our biggest fan with the investment community. She has put forth timeless effort to champion of Pure W, which is our first business resource group that is focusing on developing women leaders, and that will leave a lasting imprint on Parker.

So Robin, all of us here, we couldn't be happier for you, for your husband, Scott, as you transition into the best phase, the next phase of your life, and we thank you very much.

Thomas L. Williams
Chairman and Chief Executive Officer at Parker-Hannifin

So I'm going to just pile on while we have Robin blushing and embarrass her even more. She's just done a great job. I've had a chance to work with her for 20 years. If I think about her deal-making skills and what she did when she led M&A, her ability to finance all these transactions, which isn't the easiest thing. And like Todd said, the Investor Relations and you've all experienced it, her ability to be the top spokesperson for the company, just an outstanding leader. We're going to miss her. But thankfully, she's given us lots of lead time here, and she's not leaving until the end of the year. And we'll get every ounce out of her that we possibly can on these next several months. She's nodding her head in agreement. So the last slide, slide 16. We have a highly engaged team. They're the people behind these results. Their ownership, their engagement that drove the -- is driving our success. You saw the EPS and the margin expansion, just phenomenal, speaks to the Win Strategy, speaks to the portfolio changes. We are a longer-cycle, more resilient company. And we've got great alignment to the secular trends that I referred to earlier. And we're going to help the world as it moves to the clean technologies to be more sustainable. We gave you a new guide -- new feedback where we're headed for FY '27 with continued improvement across the board and really a transformed company with a bright promising future. Again, my thanks to everybody, the global team, just a fantastic quarter, fantastic year-to-date.

And I'm going to turn it back to Paul to start the Q&A.


Questions and Answers

Operator

Thank you, sir. We will now begin the question-and-answer session. [Operator Instructions] Your first question is from Scott Davis with Melius Research. Please, go ahead.

Scott Davis
Analyst at Melius Research

Good morning, everybody and congrats, Robin. I did not see the announcement. You will be missed. And we appreciate your help over the years. I wanted to talk a little bit about your results. I mean it doesn't seem like supply chains hurt you guys really at all. I mean you had 11% core growth in a 0 GDP world. So was there a tangible impact to supply chains on being able to get stuff out the door in the quarter? It sure didn't seem like it could have been much.

Thomas L. Williams
Chairman and Chief Executive Officer at Parker-Hannifin

Scott, it's Tom. Supply chain is still a challenge. I would characterize it, if I take chips out -- I'll come back to chips in a second -- that has stabilized, but stabilized still at a fairly inefficient level. It really hasn't shown much improvement over the last several quarters nor are we forecasting that. Obviously, we're not forecasting very far out here for the rest of our fiscal year. But I think it's going to be a challenge as we go into the calendar -- rest of the calendar year. What we did see worsen was chips, and that continues to be a challenge. But I think why you've seen us perform maybe better than most has been our ability to -- we're local for local. Our supply chain has been built around that for years. And while we continue to want to localize even more, we kind of had a running start against a lot of this. We've been active on trying to increase tool sourcing. And our engineers -- we spent a fair amount of time with our engineers working to develop alternative materials that would be qualified with our customers. Our materials are either more readily available, especially in the chipset, qualifying alternative chips. And some of our engineered materials products or some of the chemicals, etc., were difficult to get. We've been qualifying alternative materials there. So I would put saying doing all of the above and just an awful lot of elbow grease and work in the factories, in the warehouses to make this work. This is not the easiest environment, but the team did a great job with it.

Scott Davis
Analyst at Melius Research

Yes. It certainly seems so. The example you gave on natural gas to hydrogen was kind of interesting. And I -- it begs the question of, does the competitive landscape change as you go to the more complex hydrogen applications? I mean my understanding is that it's -- the specs have to be pretty darn tight, and hydrogen, it's a highly volatile material. But does the competitive landscape change at all? Or is it -- do you think the competitors will be there -- the similar competitors would be there?

Thomas L. Williams
Chairman and Chief Executive Officer at Parker-Hannifin

Scott, it's Tom again. I think it does change a little bit. I think it thins out because I think there's fewer people that can do the kind of things that we can do in that area. The fact that we've already developed a lot of these cryogenic solutions puts us in a running start with that. Yes, we had to look at hydrogen embrittlement to make sure that there's material compatibility, which we're doing. And then our -- the advancement we've had in engineering materials and the fact that we have that technology in addition to all the other technologies, because the big -- like I mentioned, the big challenge with hydrogen is sealing a molecule that's much smaller and prone to leaking and, to a point, volatile. And so we're doing investments as we speak. We just looked at that early this week. We had a clean tech review with all of our groups. And we're investing in that right now so we can be ready for when that does come to market.

Scott Davis
Analyst at Melius Research

Okay. Sounds good. I'll pass it on. Thank you. Appreciate it. And good luck guys.

Thomas L. Williams
Chairman and Chief Executive Officer at Parker-Hannifin

Thanks, Scott.

Operator

Your next question is from Mig Dobre with Baird. Please go ahead.

Mig Dobre
Analyst at Robert W. Baird

All right. Thank you and Robin, all the best. Congrats. Tom, I want to go back to your comments on North America. You really kind of highlighted this geography as accelerating maybe relative to the others. And I'm wondering, what are you seeing that's differentiated or special here? And let's leave the China COVID lockdowns to the side because that part is pretty obvious. And I'm curious, when we're looking at the sequential acceleration and order intake, are you actually seeing better volumes? Or is this just a function of higher pricing given everything that's happening on the commodity side?

Thomas L. Williams
Chairman and Chief Executive Officer at Parker-Hannifin

Well, I think in North America -- Mig, it's Tom. I think North America has gotten on top of the horse, so to speak. The supply chain challenges we had were the most pronounced in North America. They had more work to do; more work to do on logistics, on dual sourcing, on qualifying alternative materials versus the other regions. And I think you see the benefit of some time and good work by all the teams, which was evidenced in their MROSs improving as you go through the course of the year and then having their best ROS quarter to date and leading really all the segments. So North America clearly has gotten on top of that, made a lot of progress to that vantage point. There is good volume improvement really across the world. Obviously, I think most of that volume improvement has been in North America and in aerospace. Because aerospace, with their long-term contracts, were somewhat shielded from the inflation pressures there. So they benefit from the volume as well.

Mig Dobre
Analyst at Robert W. Baird

Okay. And then my follow-up, I'm curious, as you're looking at your international business, maybe Europe specifically, are you sort of seeing any change in the pace of business, customer confidence or whatever you want to call it as a result of this situation in Russia and Ukraine? How did April progress for you maybe relative to March? If you can comment on that.

Thomas L. Williams
Chairman and Chief Executive Officer at Parker-Hannifin

Well, on EMEA, I would say -- again, it's Tom. It's probably too soon to know for sure how the whole rush Ukraine process is going to play through. Obviously, Russia, and our hearts go out to the Ukrainian people. And we've done an awful lot of our philanthropic work has been to help all the people that are involved in there. But it's small sales for us. It's immaterial from a -- of course, the human toll is huge, but sales tolls is immaterial. But our orders for -- if I look at Q3 versus Q2, were roughly the same. They were in the low teens. I'm talking about EMEA. We do forecast sales -- sales, you break out the international piece in EMEA, was 13% for Q3. We are forecasting it to soften in Q4 to 5%. So we do anticipate some moderation there. Some of it is comp, some of it is based on what we're seeing with the orders, and that's all baked into our guide. But I think to fully understand what the second derivative is of all the Ukrainian war, I think we're going to need more time to see how that plays through.

Mig Dobre
Analyst at Robert W. Baird

Understood. Thank you.

Operator

Your next question is from Jeff Sprague with Vertical Research. Please go ahead.

Jeff Sprague
Analyst at Vertical Research

Thank you. Good morning everyone. Congrats, Robin. Just a couple Meggitt-related questions, if I could. First, Todd, on the FX hedge, are you completely economically neutral at close on this? Obviously, the dollar has strengthened a lot against the pound, which impacts the ultimate out-of-pocket. If you could just clarify that. And also, any color on whether or not your funding costs to ultimately consummate the deal have moved materially here?

Todd M. Leombruno
Executive Vice President and Chief Financial Officer at Parker-Hannifin

Yes. Jeff, thanks for that question. On the deal contingent hedge, what we did is we locked in a pound-dollar rate. I think we did that in September time period. Obviously, a lot has changed across the world and the economic landscape since then. We still are confident that, that was the right thing to do. It has made our certain fund process as we go through the transaction, certainly much clearer and much easier. Most recently, and you've seen the pound to the dollar, really the pound weakened and the dollar strengthened. That has created these accounting transactions that we have to record each quarter. So from an economic value standpoint, we're working through that right now. Obviously, there's a lot of moving pieces with the valuation of the purchase price accounting of all that stuff. But we're confident that we're going to like the results that we have. As far as the financing goes, we've done a lot of work on this with our team, with our advisers on this. And really, what we found is the increasing interest rate environment is pretty much priced into the market. So just on a high level, the way we are attaching that is really based on our strong cash flows. We are just leaning towards more of a mix of serviceable debt on the transaction. So when you look at this compared to the last large deals that we've done, the financing plan is basically using the same methodology, and they're about the same costs in total. So more to come on that, Jeff, but we feel good with where we're at in respect to financing and the pending transaction.

Jeff Sprague
Analyst at Vertical Research

Great. And then what -- thanks for the color on the approvals and what remains. Would the U.K. national security be the longest pole in the tent here? Or should we think about the remaining items as roughly equivalent and on the same timeline?

Thomas L. Williams
Chairman and Chief Executive Officer at Parker-Hannifin

Jeff, it's Tom. It's hard to predict that. But we've had a lot of discussions with the U.K. government. There's a couple of tracks there. There's economic considerations, which are really the things we had at 2.7; the national security considerations that were in [Indecipherable] in a number of discussions with them. And then you have their antitrust process as well. And I can't predict who will go first, just that the list of who's in the outbox is increasing. And this all bodes well that we're getting closer to the end. And I think you'll see them probably all kind of go roughly in about the same time frame would be my guess.

Jeff Sprague
Analyst at Vertical Research

Great. Thanks for the color. Good luck with that.

Operator

Your next question is from Jamie Cook with Credit Suisse. Please go ahead.

Jamie Cook
Analyst at Credit Suisse Group

Hi, good morning and congrats on a nice quarter. I guess, first, just a modeling question. It looks like the aerospace margins get a nice bump in the next quarter. So is there anything unusual driving that? Or I'm just trying to understand what that could potentially mean for the trajectory into 2023 as aerospace starts to improve. So that's my first question. And then I guess my second question, again, very good organic growth. Tom, the market is very concerned about a slowdown, and people are using the R word. Just wondering if you could talk to how you think your portfolio could perform in a slowdown, or some of the market share gains. Are you getting market share? And could that -- and the pricing dynamics, could that help make your sales more resilient, assuming we're going into a downturn over the next six to 12 months? Thanks.

Thomas L. Williams
Chairman and Chief Executive Officer at Parker-Hannifin

Jamie, it's Tom. So I'll start with the first one, the aero margins. Q4 is nationally our highest margin in aerospace, typically, based on shop visits and the exposure with the summer, etc., for aircraft and engines. And then also, it's been driven by the commercial MRO activity increasing as it's growing at the fastest rate. That happens to be our highest margins, which is why you see that performing like they do. Now coming back to -- this question happens all the time as far as, well, how will Parker do during the next recession? And I'm hoping if you go to that slide that I mentioned in my prepared remarks, it's my favorite slide that shows the margin and EPS expansion. That has two notes of recessions: a pandemic and, of course, everything we're experiencing today all in it. And you've seen us move pretty much at a 45-degree angle. So I think you could, rest assured, that this team has proven its resilience to weather any recession. And we'll -- if it happens, we'll weather it the same way we have in the past. But I would argue to your point that the company is significantly different. In Investor Day, we went through the longer view of the company between the Win Strategy and how the portfolio has dramatically changed. Now we doubled the size of engineered materials, filtration and aerospace, and that's going to allow us to grow differently. And when we showed you that five-year vision, if you -- those who maybe didn't see it, there was a mix of short, long and aftermarket.

'

And when we get out to FY '27, I add up the long and aftermarket, it's roughly 85% of our sales mix. So that's going to have us operate much differently. Now if you go to, say, the time, I don't care about five years. I'm worried about what's happened in the next 12 months or so. I think I would come back to our ability to perform is proven in good times and bad times. And we have the benefit of the beginning of our commercial aerospace recovery, which is going to help us. We have that linkage to the secular trends much more so than we have in the past, which, okay, they could get impact, and I'm talking about electrification, digital, aerospace and clean tech, but they're probably not going to get impacted the same as any of the traditional end markets. We have Meggitt coming on board, so we get a lift from the acquisition just from an incremental revenue there. We're going to have the synergies, etc. And we have a company that is dramatically leaner or agile proven by what we've done the last seven years. So we're ready -- the last quarter, I was being sarcastic when I was referring to it as a normal quarter. I think, if anything, we've proven to be very resilient team and the ability to be flexible, nimble and I think you'll see that going forward.

Jamie Cook
Analyst at Credit Suisse Group

Okay. Thanks and congratulations, Robin. Thanks for all the help you've been fantastic.

Lee C. Banks
Vice Chairman and President at Parker-Hannifin

Thanks, Jamie.

Operator

Your next question is from David Raso with Evercore ISI. Please go ahead.

David Raso
Analyst at Evercore ISI

Hi, thank you and best of luck, Robin. A quick question on the China getting back to full production in July. Can you just give us a little more color on your confidence in that? And then also I mean, historically, you've sort of gone through three 12 pressure curves through the key markets. Obviously, the North American orders are strong. But I'm just curious, are there any areas that you're seeing the book-to-bill or the three 12 pressure curves that you track that are starting to show those are some of the short-cycle businesses that maybe are showing a little bit of cracks? Or are we just not seeing any cracks anywhere in the North American market at this stage? Thank you.

Thomas L. Williams
Chairman and Chief Executive Officer at Parker-Hannifin

David, it's Tom. So I'll start with the full production comment in China. If you notice, we put Q1. We didn't say July. We said Q1. And the first thing I'll say is it's an educated guess. Obviously, I'm no smarter than anybody else. And only President Xi knows when those lockdowns are going to turn around. However, a couple of things. Just part of what we have to do when we forecast is use some pragmatic thinking and a little bit of history. So we go back to when China went through it, the beginning of COVID, it had a pretty rapid rebound compared to the other regions. So some of that was factoring our equation. And then just thinking about the practicality, how long can you practically keep people locked up in their apartments and their homes, and it started middle of March. And so there's a point of diminishing returns here, where people are going to have to come back, the factories are going to have to come back. And so our best guess is sometime in Q1 of FY '23. Not saying it's a lot. It could be out could be September, and I could be wrong. And I typically had to pick a time. The whole point I was making about that comment is that it's temporary. This is not a permanent situation in China. Then if we look at FY '23 and we look at China, we would make up whatever happens here in the next several months because we have another 12 months ahead of us to make up with that. Now on your comment related to end markets, we have over 90% of end markets positive. And virtually, with the exception -- everything is positive, with the exception of aerospace, military and power gen. And that's our outlook for Q4. Feels the same. And the pressure curves look good and we still feel very good about what's going on. Broad-based, I would describe it.

David Raso
Analyst at Evercore ISI

And last quick clarification. The aerospace, it's rolling 12 months. I appreciate that. When does that large order that's making for the difficult comps roll off in that calc?

Todd M. Leombruno
Executive Vice President and Chief Financial Officer at Parker-Hannifin

Yes. David, I can take that one. This is Todd. We probably still have another two quarters to get through that. If you remember, we just started calling that out last quarter. This is the second quarter we've called it out. So we've got two more quarters to go.

David Raso
Analyst at Evercore ISI

All right. Thank you.

Operator

Your next question is from Joe Ritchie with Goldman Sachs. Please go ahead.

Joe Ritchie
Analyst at The Goldman Sachs Group

Thanks. Good morning everyone. Would echo all the comments about Robin. Really, really great working with you and wish you the best. First question, on industrial, on the global business. So just looking through the guidance, it looks like you're kind of forecasting a mid-single-digit decline. And you had a pretty high decremental, call it, high 30s decremental. I know that the comps are tough in 4Q, but is there anything else that you want to call out for the 4Q number?

Thomas L. Williams
Chairman and Chief Executive Officer at Parker-Hannifin

Joe, so are you referring to sales or margins?

Joe Ritchie
Analyst at The Goldman Sachs Group

Yes. So if my math is right, it looks like sales are expected to be down year-over-year. Margins also down, call it, more than 100 basis points. I'm just trying to parse it out and see whether there's some conservatism in there or you guys are seeing something specific to 4Q for the international business.

Thomas L. Williams
Chairman and Chief Executive Officer at Parker-Hannifin

Okay. So well, margins total for the company, 22.2% is what the effective Q4 guide is. We did 22.2% last year, last Q4. And we see expansion in North America. North American markets expand. Aerospace margin expands. And then Asia, international margins expand -- declined a little bit, still coming in our implied guidance right around 21%, and that's because of the China shutdown. So really good margin expansion in the areas outside of the China shutdown. And then on the top line, Todd preferred to this that we bumped up North America organic guide by 300 bps of going prior guide to new guide, bumped up aerospace by 50. And of course, we took down international. So maybe to calibrate people, the effect of the China shutdowns, we would throw -- we would increase total guide from Q4 by 250 bps, if that was running normal. And the total international will go up 650 bps. So it's a pretty big impact, which is weighing down international.

Joe Ritchie
Analyst at The Goldman Sachs Group

Got it. Okay. That makes a lot of sense. And then also, I kind of wanted to ask about aero also, more from a near-term perspective. I recognize you guys are kind of calling for some good growth year-over-year on the margins as well. Sequentially, though, it doesn't really seem like the margins are expected to pick up in the fourth quarter just based on the full year guide. Is there anything like you would call out from a mix standpoint in the fourth quarter versus the third quarter? Or still seeing good mix coming through in 4Q as well?

Todd M. Leombruno
Executive Vice President and Chief Financial Officer at Parker-Hannifin

Joe, this is Todd. I could take that one. What we've got in the fourth quarter guide -- you're talking specifically for aerospace, right?

Joe Ritchie
Analyst at The Goldman Sachs Group

Yes. That's right.

Todd M. Leombruno
Executive Vice President and Chief Financial Officer at Parker-Hannifin

Yes. We actually are improving margins from Q3 to Q4. We did 21.9% in Q3, and we're right at 22.2% for Q4. So there is expansion there.

Joe Ritchie
Analyst at The Goldman Sachs Group

Okay. All right, great. Thanks guys. I'll get back in queue.

Todd M. Leombruno
Executive Vice President and Chief Financial Officer at Parker-Hannifin

Okay. Thank you.

Operator

Your next question is from Stephen Volkmann with Jefferies. Please go ahead.

Stephen Volkmann
Analyst at Jefferies Financial Group

Great. Thanks for taking the question. And congrats, Robin. For me, I'm very impressed with the sort of incremental margin performance accelerating here. And I'm wondering just kind of directionally how we should be thinking about that for '23. Is there some reason that it would revert to kind of a long-term average? Or do we get to enjoy a longer period of a little bit higher incrementals?

Thomas L. Williams
Chairman and Chief Executive Officer at Parker-Hannifin

Steve, it's Tom. I'm going to probably not make any specific comments about '23. I think you can appreciate there's a lot of things that changed. We're one of the first companies to get -- has the good fortune to talk about '23, and so I won't talk about it a month sooner than I need to. However, in general, when I've articulated incrementals, they tend to inflect at your highest point at the beginning of an upturn. They start to moderate. And then you use 30% kind of over-the-cycle type of number. And then once you're deeper in the cycle, it would go below 30%. So we'll see as the numbers roll up and as we forecast. But I continue to -- we gave you our five-year look. I think we had incrementals in that low 30s over the course of the next five years to get to those five-year targets. And so that's -- we need to do that consistently somewhere over the next five years to hit those five-year targets. And you've seen our track record on doing that. We are pretty good about our say-do ratio on the five-year targets. So we'll see what happens, but the company is clearly in better shape and better condition to generate those incrementals.

Stephen Volkmann
Analyst at Jefferies Financial Group

Okay. Yes. Agreed. Well, it's worth a try. Maybe I'll shift to ask you about distribution. And I'm curious if there's any interesting trends you're seeing in distribution that are worth calling out as we try to think about the direction of everything here. And maybe you can add a comment on kind of distributor inventory when you do that.

Lee C. Banks
Vice Chairman and President at Parker-Hannifin

Steve, it's Lee. Just -- so distribution as a whole, I would say, is going very well. I'll break it down a little bit. North America, all markets are very positive. There's -- for those distributors that are covering the natural resource industries, that business is coming back quickly and specifically. Internationally, we continue to grow distribution despite all the turmoil about 100 basis points a year. So we've been making great progress on that. And I would say on inventory, everybody could use more. I mean there's a great pull taking place. We're able to satisfy customers. But as a whole, distribution, if they could build more inventory, I think they would.

Stephen Volkmann
Analyst at Jefferies Financial Group

And are you seeing more price in the distributor channel relative to the rest?

Lee C. Banks
Vice Chairman and President at Parker-Hannifin

Well, we've been -- as you know, we've been very proactive on making sure we cover material cost and do the pricing that's necessary with that. And those distributors have been passing those price increases along.

Stephen Volkmann
Analyst at Jefferies Financial Group

Okay. I appreciate you guys.

Lee C. Banks
Vice Chairman and President at Parker-Hannifin

Thanks, Steve.

Operator

Your next question is from Nigel Coe with Wolfe Research. Please go ahead.

Nigel Coe
Analyst at Wolfe Research

Thanks. Good morning, and Robin, congratulations. Thanks for the help. Going back to Meggitt and some of these currency moves. The -- I'm guessing that the bulk of the functional currency for Meggitt is U.S. dollar. I'm guessing that the bulk of the cost base is sterling. Is that correct? And -- because that then implies that if we do have a sort of a structurally weaker sterling going forward, that should be helpful to margins. So just wondering if you can maybe comment on that.

Todd M. Leombruno
Executive Vice President and Chief Financial Officer at Parker-Hannifin

Yes. Nigel, this is Todd. I don't think I could comment on that. We are bound by the code. We did mention, I believe, on the call, there's a significant mix of the Meggitt business that is in the U.S. that obviously is dollar-based. So I think I'll leave it at that. But I...

Nigel Coe
Analyst at Wolfe Research

Okay. Yes. The move is significant, so it's worth exploring. And then just thinking about international. So it looks like ex China, the -- so the kind of the ex China business is low single digits in 4Q. So I'm just wondering if maybe you could just talk about what you're seeing geographically in international markets. And then would you encourage us to model the recovery of that $100 million of lost sales through FY '23 at this point?

Thomas L. Williams
Chairman and Chief Executive Officer at Parker-Hannifin

Nigel, it's Tom. Yes, $100 million, we will recover sometime in FY '23. And obviously, we'll embed that when we give you the guide here in August. But when I think about the markets across the regions, in Q3, I'll just give you the reasons. This is all organic numbers I've given you. In both North America and EMEA, in mid-teens; Latin America, upper teens; aerospace, 6%; and then Asia was in the low single digits. And Asia Pacific was impacted because of China. China was down mid-single digits. The rest of Asia was up high single digits. And that's how you got to the Asia number. But when you look at end markets, it's pretty much across the board. As I mentioned on David's question, we have strength in 90% of our end markets. The only market decline was aerospace, military and power gen. So it's very broad-based. If I looked it up even higher, distribution and industrial both growing about the same rate, and a little bit slower, but it's been across all the segments.

Nigel Coe
Analyst at Wolfe Research

Great. Well. Thanks Tom. Good luck.

Thomas L. Williams
Chairman and Chief Executive Officer at Parker-Hannifin

Thanks, Nigel. Stephan I think we've got for more question?

Operator

Thank you. For our final question, it's from Julian Mitchell with Barclays. Please, go ahead.

Julian Mitchell
Analyst at Barclays

Thanks very much. Good morning. And appreciate all the help, Robin. So yes, I guess my final question, really, just on the aerospace business. I guess two aspects. One is I think you toned down the sales guide a little bit for the year. So just trying to understand what drove that and whether you think on the revenue side, the military headwinds abate entering fiscal '23. And then the margin performance for the year as a whole in aerospace is kind of exceptional on the operating leverage this year. Is there any way you could parse out drivers within that around maybe synergies or lower R&D, just so we can sort of use our own math to get to the sort of forward incrementals next year?

Thomas L. Williams
Chairman and Chief Executive Officer at Parker-Hannifin

So Julian, it's Tom. What's driving aerospace, if I just give you the two key components, is the commercial recovery. Our growth in Q3 commercial MRO was plus 31%, and commercial OEM was plus 21%. So those two, when we get to the full year, plus 27% for commercial MRO, plus 17% for commercial OEM. And I think actually, when I look at my numbers, we bumped aerospace up 50 bps in Q4 versus the prior guide. So we see aerospace as positive. The order entry, again, once we cycle over the multiyear military order, which we've been trying to give you visibility to that, that was plus 20%. I mean the orders that we had, commercial OEM was over 100%, commercial MRO was 60%, so gigantic orders. And what you get right now offsetting that is the military piece, which everybody tracks out the companies. The military piece for supplier health, a lot of the OEMs pulled in military business into FY '21, which makes the comparable in '22 difficult. But we'll cycle through that, and military will eventually get back to kind of a low single-digit type of growth. So I'm very bullish on aerospace. Obviously, we don't have any of the Meggitt synergies and that kind of stuff into it now. But we have the same goal for aerospace as we do for everybody else, trying to get to 25% ROS over the next five years. And we've got a great acquisition in Meggitt, which we've shown what that synergies brings, that Meggitt business up to 100% EBITDA once we get the end of those synergies. So we have a lot of things that will help us with aerospace.

Julian Mitchell
Analyst at Barclays

And is there any kind of outsized mix or R&D tailwind you'd call out for the margin performance in fiscal '22 just overall in aerospace?

Thomas L. Williams
Chairman and Chief Executive Officer at Parker-Hannifin

Well, in the current quarter, it was light, mainly due to timing, nothing unique there. I would say, in general, it's a tad light or it's going to be 2.5% to 3% for this fiscal year. It's going to probably be more in that 3% to 4% range if I go over that five-year period of time. But you won't see that hit in any material quarter -- material way, like a specific quarter, a specific year. It's going to -- over that period of time, we'll grow the MRO. And we're on still the R&D. And so by historical standards, that's a pretty efficient R&D spend versus what we were at the beginning of the super cycle for aerospace.

Todd M. Leombruno
Executive Vice President and Chief Financial Officer at Parker-Hannifin

Julian, I would just add to that. If you remember, at the pandemic when we made our adjustments, aerospace made the most aggressive adjustments from a cost basis. So we have obviously benefited from that throughout this year. Those costs are not coming back. So that would be another change from this year versus pre-pandemic levels.

Julian Mitchell
Analyst at Barclays

That's great. Thank you.

Thomas L. Williams
Chairman and Chief Executive Officer at Parker-Hannifin

Yes.

Todd M. Leombruno
Executive Vice President and Chief Financial Officer at Parker-Hannifin

Okay. That concludes our Q3 earnings call. I'd like to thank everyone for joining us today. Robin and Jeff are going to be here today if you have any further questions or if you'd like to congratulate Robin personally. I would just like to make sure everyone knows, Robin will be here through December 31 of this calendar year. So you definitely have time to congratulate her, hopefully in person, as we go throughout the year, and she'll be here for the next couple of calls as well. So that is it. I'd like to thank everyone for their interest in Parker, and thanks again for joining us today. Thank you.

Operator

[Operator Closing Remarks]

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