Donaldson Company, Inc. ($DCI)

I'll just give a quick introduction. I'm Brian Drab, the industrial technology analyst at William Blair, and I've been covering Donaldson since 2008. Very happy to have the whole team with us today. We've got Rich Lewis, CEO; CFO, Brad Pogalz; and Head of Investor Relations, Sarika Dhadwal. I do have to remind you, you can find a full list of research disclosures on our website, williamblair.com. This is kind of exciting for me. We've got Rich Lewis for the first time at our conference and very excited to have you. Donaldson has a track record of having some of my favorite CEOs. Bill Cook was such a nice person in addition to being a great CEO. I remember he sent me a message on the day that my twins were born in 2012 saying the importance of, like, how special it is to have daughters and talking about his daughters. And actually, in that year, in June, I had to -- I introduced Phil and then ran off the stage to go to the hospital because my wife, like, I go, "My wife is trying not to have our twins right now." And I ran off and they came like a month later, but it was like touch and go. So memories, anyway, I've been doing this for a long time. But I'm going to get out of the way. I have things to say about the company, but I've taken too much time already. I'm going to let you say everything about the company. Thank you for being here, Rich.

Yes. Thanks for having us. All right. We're on here. So again, Rich Lewis, President and CEO of Donaldson. Thanks for joining us here today, and welcome to the Donaldson presentation. So we'll do our safe harbor statement. I know everybody has seen this before. Everything will be as of our Q3 earnings release, which just happened to be this past Tuesday. So everything is very fresh with related to the company's numbers. I'll talk a lot about the company today, but I really want to use this slide to sort of set up what I would consider the key takeaways. So we are a filtration company. We focus on filtration. That's where our heart's at. That's where our DNA is at. We're a pure-play filtration company. And we've been solving some of the most difficult, challenging problems in this industry for over a century. What that's done for us is it's built really deep application expertise across multiple end markets and multiple product lines. We've also built durable customer relations over that period of time by working back and forth with our customers to understand their challenges, solving those problems, and that creates a very strong moat for us in these industries. We lead with technology. We've been setting the bar for innovation and technology and filtration. And I'll just tell you, I remember when I interviewed with the company, I was not a filter guy came from other industries back in 2002, and I went to our Bloomington, Minnesota headquarters, and I was amazed at the depth of technology. As a kid who would just change his oil filter on his cars when he was young to understand what goes into some of these filters was a different level of expertise than I had ever imagined. So we lead with technology. But more importantly, we use it to set the performance bar with us and our customers, but also for the industry. And you can see across all of our product lines, we've done that over generation and generation. So why is that important? So that's what we do and how we do it. And let me tell you about why it's important. Why it's important is if you look at what our -- where we play, we play in industries where filtration and our customers' applications are either mission-critical or they're very high value creation industries. If you think about the cost of a filter versus the total operating cost from our customers, it's a small price to pay to have the best technology. We provide them with 2 things. First, peace of mind. We are protecting their most valuable assets. We're protecting their people, their manufacturing processes and their products. We also enable greater levels of productivity. They will make more money using a Donaldson system than they can with the alternative through greater levels of uptime, greater levels of reliability, better efficiency. So greater peace of mind, greater productivity in a relatively low-cost product relative to their total operating cost. If you think about how we grow, so we operate in multiple end markets through multiple products and multiple applications. All of those have macro tailwinds to one degree or another. And then we layer in market share gains based on operational excellence and our innovative filtration technology and then pricing. That's our growth algorithm, and we deploy that across multiple end markets. We've been doing mobile solutions, so our large off-highway, on-highway business for well over a century. We continue to harvest the investments we've made over decades to continue to grow market share in those markets and those markets continue to grow. We use our strong razor to razor cell razor blade model. So we are very much consumable-driven, resilient, high-margin replacement part business, and we use the proceeds of that to expand our technology footprint. One area in particular is we've been expanding into high-purity membrane filtration. What that does for us is it gives us access to a much wider addressable market. This is the model we've been deploying and it's the model we'll continue to deploy, and this is how we win. So I won't drain this slide, but this is a good takeaway if you want to look back later and see who Donaldson is. We're a 111-year-old firm, again, purely focused on filtration. As a technology-led filtration company, we have over 3,000 patents. We deploy those across 3 operating segments: our Mobile Solutions, which is our longest tenured business, our Industrial Solutions and then Life Science, which is our high-purity filtration markets. 66% of our revenue comes from high-margin, durable replacement consumables. This is our business. We'll talk more about some of the specifics as I go through here. We're a global company. We operate with a global footprint, but we have a local touch. So if you go to all of our core end markets, we have deep application teams, sales team, customer service teams supporting those customers regionally, but it's underpinned by global scale and operational capabilities and R&D. So if you think about our technology investments, most of our technologies are deployed through multiple end markets and certainly in multiple regions. Operational capability is the same. You can go into a plant in China and see filters being made on the same production assets for mining, dust collection and power gen, and you could see the same thing on a plant in Europe or the U.S. We have global scale, but we deploy it with a local touch, which allows us to be very sensitive to local market needs. Our objective financially is very simple. We want to deliver higher levels of profitability on a growing top line. F '26, which will end at the end of July, will be no different. We'll set record levels of sales, adjusted operating profit and EPS for this fiscal year. We continue to grow the company, but we also are investing for the long haul. So these will be records across all 3 KPIs, and we continue to invest aggressively for long-term growth. Our top line this year will come in around 4% on the sales line, and our EPS will be roughly 8% growth over prior year. I want to talk a little bit about the sequencing because this has been part of the conversation as this year has progressed. We exited our fiscal year '25 with a lot of momentum. Our first quarter was very much in line with expectations and what we thought would happen based on how we exited '25. Our quarter 2, which frankly, is always a little bit analytically tough just because it covers November, December holiday period, sometimes it also covers the spring Chinese New Year type holidays as well. So we always have a little bit of noise from that. But on top of that, we had a very aggressive, I would say, a lot of our large OEM customers were managing their balance sheet towards the end of the calendar year. And then we had some deleveraging due to that, and we also had some operational challenges. We're in the midst of closing 4 plants and then ramping up one of our facilities in Mexico to support the ongoing tailwinds in the power gen business. And there was a fair bit of cost and operational challenges in the quarter related to those things. Transient in nature, but they had a meaningful impact in the quarter. So as we exited the commentary that we had out of our earnings call was, "Hey, look, there'll be a sequential step-up in Q3 as some of those costs abate and we see some of the volumes come back." Happy to say we saw a large uptick in our backlogs coming out of Q2 and sequentially increasing through our Q3. We'll exit Q3 with record levels of backlog and we saw the sequential step-up that we had expected and anticipated. Quarter 3 was a record quarter for us on sales, adjusted operating profit and EPS, a record of all time regardless of quarter. So we had a really strong Q3, and we still carry probably over a point of gross margin and operating margin pressure due to those transient challenges that we have that we'll work through over the next couple of quarters. So we expect our Industrial business to continue to expand margins as we exit this year into next year. For our guide, you can see we're expecting another step-up in Q4. That will be the first step in the recovery of some of those challenges, and we'll finish the year at record levels across all 3 of our major KPIs. So let's talk about our competitive advantages. I mentioned several of these in the opener. It's really a layered approach. We don't rely on one particular thing to give us a competitive advantage. It's several moats of strategic advantage, long-standing innovation. We have the widest technology base in the industry. We have deep application knowledge into all of our key applications and product lines, and we have a global footprint that's frankly unparalleled in this industry. That gives us scale and cost, along with the best technology with a very, very deep expertise in our end markets. This is a big part of our competitive advantage. And then when you layer in the model, which is razor to sell razor blades, it creates a very durable, resilient business. We use that to continue to expand our technology base into high-purity filtration, which is the next generation of our long-term growth would be in our Life Science business. So if you look across all 3 segments, they all have meaningful roles to play in our growth portfolio. Mobile Solutions being our core market and our most mature has been -- continued to grow through the cycle. We have two end markets that have been depressed and this business continues to grow. It's a testament to the model, the share gain and the resiliency of the replacement parts. Industrial, we continue to drive scale and synergy across this business while increasing customer intimacy. We see industrial as an opportunity for us to expand this portfolio significantly over the next decade. And then finally, Life Science, we talked about expanding our technology base, which opens up a large new addressable market. If you think about Life Sciences, the 2 largest businesses within that are legacy Donaldson businesses, our food and beverage business and our disk drive business. Both have very strong tailwinds from a market standpoint today, and both businesses are continuing to grow market share very aggressively. All 3 businesses, top line and bottom line growth opportunities with strong underpinning from the macro. Let's talk capital deployment. So we just completed the largest acquisition in the company's history. I'll talk about that here in a second. Our capital deployment philosophy remains the same. We are now 30 years of increasing dividends. We're a proud member of the S&P Dividend Aristocrat Fund. We will continue to be great generators of cash. Our first priority is organic investment. Part of those durable advantages is a long-standing repetitive, high level of return on invested capital. That is a good sign of our durable competitive advantages, but it's also how we manage our capital base. Organic investment, we'll continue to look for M&A opportunities. That asset was a great addition to our business, but we'll continue to be disciplined and very strategic about where we go into M&A. And then dividends, and share buybacks will continue to be part of our balanced structure. I'm sure there'll be a question about that here in a little while, so we'll just address that in the Q&A. Facet. Let's talk about Facet. So Facet is a great business, very high margin profile, fast-growing business relative to a typical industrial business and very, very sticky customer relationships. From the refinery to the wing in jet fuel, sometimes these filters are used 7x to filter those fluids. It's also highly regulated due to the safety nature. So this is a great business, very sticky customer relationships. They've been at this for 85 years. Frankly, they are another Donaldson, both culturally and how they think about filters. They are a great company, and we're really excited to have them as part of our portfolio. So -- let's talk about Donaldson and what we do. We are filtration experts. A lot of times, we'll say we're filter geeks because we really like filters, and we're really into the science, all the way from the fibers and the raw materials to the construction of the filters to the applications. Why that's important? We provide our customers the best-in-class technology that gives them peace of mind for value-creating mission-critical applications, and we increase their productivity, all for a low portion of their overall operating cost. We'll continue to grow all 3 segments. They all have macro tailwinds, market share opportunities, pricing opportunities. And then we'll continue to extend our technology base that opens up all the high-purity filter applications and gives us a large portion of new growth opportunities for the long haul. It's a great company and the growth algorithm, I think, has been very consistent. Our return on invested capital has been very consistent. And personally, I moved to Minnesota for Donaldson, not because I like cold weather, and I've been really happy with the company over my career. So I'm proud to be the new CEO of the company, and I look forward to continuing to protect what makes us special.

All right. Thanks a lot, Rich. I don't have microphone, so do you mind taking this, then I'll use this one. Thank you very much. We have 12 minutes in this room, and sorry about the confusion about the breakout room. I know on your schedule, it says something. I'm being told by the organizers. We are going to the Richardson room after we conclude some Q&A here. So I'll ask the first question, then we can open it up to anyone in the audience that has a question. Rich and I first met at the Investor Day for Donaldson several years ago. And at the time, I didn't know that he was going to become CEO, but I left the conversation very impressed and actually had a conversation with Tod Carpenter, the CEO at the time saying, "Man, this guy is really intense and really passionate about the company."

Nice. And I'm intense. Is that the conclusion?

So far. That's if I have to sum it -- if you're asking me to sum it up in one word. I like intensity. You can ask my boss is sitting in the back, he'll attest to that. No. So what I -- one of the main takeaways I had after talking to Rich, though, was that there was a major change at this company that had taken place really during the pandemic, I think, around that time in terms of pricing and the culture around pricing. And I wonder if you could just talk about that a little bit.

Sure. Yes. I mean we were specifically talking about the largest part of our company, which is our Mobile OEM business. So if you think about our Mobile business being 2/3 out of that, the largest portion is our Mobile OE business. A lot of long-standing relationships. And we came off a period of time, frankly, I mean, I was our global operations leader for multiple years. So I ran all of our plants and distribution centers, procurement around the world through a fairly deflationary period of time on the back of a China super cycle that went on quite some time. So we were moving footprint to low-cost countries, spending capital on automation, driving lean manufacturing. And we were able to continue to reduce costs and pass that cost along to our customers and also take some for ourselves. But there was an inflection point in the mid-20 teens where inflation and deflation equation had changed. But the relationships with the customers had not sort of caught up to that. And so after a redesign where it was much clear about accountability. So we were a very matrixed organization and we went from having multiple people accountable for certain things to, okay, we have one person who's responsible for growing that business and expanding the profitability. And so I think that was a cultural shift for us in a lot of ways that laser-focused accountability to another level. And frankly, that business had to be corrected. Otherwise, it was unsustainable. So a lot of the conversations were around how do you deploy capital to a business where the profitability and the return on invested capital wasn't to the profile that we would expect. And so we had to reset relationships with customers. It was -- we did it in a very professional, methodical way so that we would not damage long-term relationships. And Brian and I were just reminiscing about it because I said you were grilling me about whether it was a durable, but it was a good conversation. And at the time, it was unknown whether that was a durable set of price increases. Now we know. And we measure our market share gains very precisely in that business. And I will tell you, in spite of those, we are continuing to gain share. So that tells me that, that pricing was warranted, necessary and durable. And we were just talking a minute ago, I believe there's actually one more step-up in pricing, not only in that business but culturally for Donaldson. But it's less about sort of attitude. It's more about being very, very precise about the portfolio because we have a very wide range of products and the margin profiles on low margin or low-volume products versus high volume, I think we can get very precise there and see one more step-up in pricing and margin. And that will be part of our new operating model that we'll be talking about, especially as we get to our next Investor Day sometime next year.

Yes. The first roughly decade that I covered the company, one of the main messages was always when the question around price came up was we're absorbing about 100 basis points of price downs every year and offsetting it with productivity. And so this has really changed -- that's why it struck me that day. It's changed the nature of the financial profile significantly where it was 11%, 12% operating margin company for a long time, and there was step up to the 13% to 14% range, but now you've broken into the potential to go higher and price is a big part of that. What do you see as the potential for operating margin longer term? Tod was kind of open about this kind of a blue sky scenario. I don't know how much you'd like to talk about where it could go longer term.

Well, we certainly do not constrain it on the top end. And as we put together long-range plans, and we'll talk more about those in the future. But certainly, we see further expansion in operating profit and numbers that start with twos not ones. So I certainly believe that's part of our longer term. It's a combination of operating discipline, leveraging fixed cost base, but it's also around mix and where we're growing. And a lot of our growth investments are into higher margin, higher growth parts of the market. And so as the mix changes, that will mix us up. So it's less about taking more price for ourselves, and it's more about where we're going to grow, even though there is more pricing to be had.

So potential for 20% plus operating margin for the record.

Correct.

And for all the AI bots that are scrubbing the transcript.

Brad is our CFO. He does -- he's been instrumental in our long-range planning. I'll certainly let him weigh in here.

Agreed for the record. Yes.

Okay. Can you talk a little bit about -- there's so much discussion around the AI data center theme. And a couple of the areas of your business that touch that are the disk drive filtration business as well as you're in filtration for power gen and gas turbines. And so how is that affecting your business?

Yes. So maybe just to kind of level set. So we come at the data centers 4 different directions. So we have a microelectronics business where we're into providing pure, sterile, call it safe, pure air, high-purity air or chip manufacturing. So those end up in the computing power of AI. We've got the disk drive business that you mentioned on the storage side, power gen. And then finally, our food and bev business, we've been expanding into data cooling. So a lot of these data centers were using air cooling, and because of the intensity of the computing and the heat, they're moving more to liquid cooling. And the same applications and products that we use in some of our food and beverage products can actually be used for these data cooling centers. It is part of the growth story in Q3 of our food and beverage business, which, frankly, is broader than food and beverage. But the 2 big ones are disk drive and power gen. And if you look, the disk drive -- hard disk drive manufacturers are all going gangbusters. They're building at peak levels. Same thing for the gas turbine manufacturers. So we see large tailwinds, sort of abnormally good tailwinds in those markets with legs to run. We would see power gen going into the next decade. And on the disk drive side, it's really just going to come down to throughput. How much more can our disk drive manufacturers increase outputs. For us, it's not necessarily constrained by that because as the technology changes, our value and the content per drive for Donaldson is going up. So the dollar per drive for us is increasing as they shift to their next-generation technology. And so we see growth in both of those businesses for the years to come.

Can you put a finer point on that change in technology that's happening in the disk drive space?

Yes. If you think back -- if you go back to like when hard drives were the storage device of choice for notebook computers, laptops. The filters in there were like the size of your fingernail, and they were a few cents per filter. Then they went to more sophisticated technologies as they started going more into the cloud and servers, they call nearline drives, and they went up tenfold in content. And now there's this next generation, which really gives us industry legs for quite some time. It's called HAMR, it's Heat-Assisted Magnetic Recording. It was launched by Seagate, but the other drive manufacturers have their own versions -- and frankly, they're now working on the next generation past that because that's launched and starting to scale up, and that increases our content even further. So think about the nearline going up 2 to 3x in revenue per drive.

For Donaldson, your content is up 2 to 3x...

On those drives, 2 to 3x what a typical nearline. So even if the industry stays flat from a capacity standpoint, if they convert to that, it's increasing our dollar content. And it's a very, very complex technology. We are investing in that business, more clean room space to support these 2 operations. And it's also allowed us to take more market share because this technology jump has been really challenging for the industry and not all supply base meet those demands.

Yes. Perfect. Okay. We'll leave it there for now. We'll continue the discussion in the Richardson room. Thank you very much for being here.