Donaldson Company, Inc. (DCI) Earnings Call Transcript & Summary

Well, good morning, everybody. I'm pleased to welcome Donaldson for a fireside chat presentation here. With us, we have Tod Carpenter, CEO; Scott Robinson, CFO; and Brad Pogalz, IR. There is a chat box in -- at the bottom of your webcast screen to ask questions. If you type the questions in there, I will ask them to Tod, Scott and Brad as we go along.

I'm going to start on the first-fit side of the engine business is getting the double hit now as we were already expecting a cyclical downturn in On-Road and soft industrial activity to drive a slowdown in Off-Road as well and then we got the coronavirus shutdown that just brought production to a halt in April and May. Can you talk about how you think the reopening progress, not so much from an underlying demand perspective. I know that's pretty uncertain. But just from the logistical perspective of how long it takes the OEMs to figure out what they're going to make and how much they're going to make? How much inventory they want to hold, destock? What they don't want, et cetera, and get back to just ordering at a level that's in line with real demand? Does that happen in June in your view? Or does it take into the third calendar quarter or even longer than that? Just any thoughts you have on -- from that perspective?

Sure, Nathan. This is Tod. So it's obviously a little too early to tell relative to when things will open back up from an OE production standpoint of view. We do not believe that it will happen in June. We think that, that's a bit further out. The recovery, as we start to see things pick up, will happen as it always does in our business with vehicle utilization across any of the end markets. So construction, mining, agriculture, over-the-road truck. Vehicle utilization will drive our aftermarket forward. And when the aftermarket starts to really feel a little bit of a lift, then you'll follow with the OE-based production. This one feels different in that people are being cautious and the OEs didn't want to run out of inventory. So they stock up, if you will, and they drove a change in our percentages relative to on the aftermarket, OE-based aftermarket versus independent aftermarket, and the OE aftermarket went from 40% to 45%. And so that's quite different from our behaviors. And really also -- really dictates and shows how the OEs are going to struggle. I feel as though you'll have more fits and starts on the OEs as they maneuver through this one. Maybe a false start or 2, and it's clearly later in the calendar year before we get a little bit more clarity on all that.

Okay. How long -- or do you have any kind of opinion on how the OEMs might react in the short term here? You've talked about you think they're carrying a bit of excess inventory for their own safety and security. Now I would imagine that they're probably going to have that mindset for a while, right? I mean we're not sure that the economies are going to stay open. We could go back into a closedown. Do you think that the OEMs are likely to run a bit of an elevated level of inventory here for at least a few months, if not a few quarters, that might help you kind of avoid what you would otherwise expect to be a destocking cycle at the OEMs?

Yes, Nathan, that's possible, surely. As with every company in the world right now, the balance sheet is important and cash is king. And so consequently, if you have a strong balance sheet, and you're not really sure of what kind of outcomes lie ahead of you, whatever the curve is, it is a V, W, who knows, you're going to play a little bit defensive and make sure you're not walking out or going to stock out and use the strength of that balance sheet. And therefore, you can hold a little bit of inventory until you find that new normal and maybe walk it down rather than as we've seen in previous, say, recessionary periods where the recession was obvious, the curve was obvious and so you get an acute destocking. I think this will be more of a trickle-based effect as they find their normal. And they have the power of the balance sheets to be a little bit more cautious with the way they'll behave.

Does that concern and balance sheet strengths being important, give you guys the option to maybe use your balance sheet a little bit in terms of holding a little bit of excess inventory in order to supply people who are running thin inventories, I guess, particularly in the independent aftermarket channel to look to gain some market share that way?

Yes, that's absolutely happening already. We see some of that across Latin America and some, to a lesser degree, in other parts of the world. But clearly, we have discussed that inside our company, and we will take and use the strength of Donaldson's balance sheet to do that whenever possible.

Okay. You have said that you think the independent aftermarket has destocked inventory. Do you have any opinion on how long that may take when those inventories are rightsized and you'll at least be shipping to real demand to them?

So we don't have a strong opinion on that. Obviously, we continue to model it, and we continue to look at daily order intakes and continue to reach out to our dealer partners. We did see a move across the independent channel that was significant in the last 3 months and then it was also exacerbated by the collapse of the oil and gas markets here in the U.S. And so you really feel as though -- we really feel as though that we've had a lot of headwinds within that marketplace. Now are we done? And are we at the level of the pull through? Tough to say, really. And that's the reason why we always look towards those economic factors of vehicle utilization across the end markets which will give us the best sense of when we can expect that bounce.

Okay. Does the shift to people doing less shopping in-person and more shopping online provide any tailwinds to the business? Do we need more Class 8 trucks to move stuff around and more vans to deliver it to our houses over time? More trucks and delivery vans on the road, or working harder creates additional aftermarket demand for you guys?

Yes. So any transportation movement is helpful to us, just simply because we do enjoy a good share across those transportation end markets. But it's the long-haul portion of that business that we really enjoy, and we would like to see more, more so kind of what's called or termed as that last mile of transportation, if you will, that small and medium-duty trucks. They have a lower dollar content than Class 8 trucks. And so consequently, it wouldn't be quite as large of a help or a lift to Donaldson Company. So we looked at that long-haul heavy-duty Class 7, Class 8 type of trucks that really move us. So long way of explaining, not so much on the economic of whether e-com really drives a lift for us just simply because of the small- and medium-duty trucks and that last mile won't move the needle too much for us.

Okay. On the earnings call last week, you commented that the truck markets were weak, but that you thought you did better than the market. Knowing that you have a higher share in the U.S. already, I assume that comment was talking more about China. In my view, one of the bigger opportunities for you guys over the next 5 to 10 years is gaining market share in China. Can you talk about the changes in China that enable you to penetrate more of that market over time?

Sure. So just maybe a quick comment on the U.S. The comment also reflects how market outperformed in the U.S. as well. So if you look at ACT truck production numbers, yes, we were down relative to our On-Road sales, but less so than ACT production level. So we really outperformed overall OE-based production everywhere in the world. And in China, of course, clearly, we are gaining share, and we're gaining share with our proprietary technology, PowerCore, and that's really where we want to be. We've been after that strategy for quite some time now. And we feel as though we have good momentum to the point of where we are installing a PowerCore manufacturing line in the country of China to support the local customers and the programs that we have won in over-the-road trucking.

Do you have any view on how the geopolitical strife with the U.S. and Chinese government right now might impact that opportunity?

Yes. So we have not seen that directly on Donaldson Company. You have to remember that China is looking to be an export-based company -- country, if you will, and meeting western-based standards with whatever the equipment, be it On-Road or Off-Road. And to do that, they need higher technology of filtration, and that really plays to our hand. And so the strength of our technologies, which will really drive the share gain as they look to export, is really helping us quite nicely. In addition, the Blue Sky initiative that they have over there is also helping Donaldson Company, not just on the engine-based side of things but also on the industrial side of things. And specifically, we're talking about worker protection in a manufacturing-based environment, air quality in a manufacturing-based environment. And we have proprietary technologies where we are advancing and winning to support that Blue Sky initiative in China. So we've got good momentum in China. And really, the geopoliticalness of China, for example, is -- has not had a negative effect on us. To the point of even we have been able to get some tariff relief by the country of China with the equipment that we're bringing into the country because we do support where the country is going.

Okay. Speaking of things like PowerCore and proprietary products, I know driving penetration of those proprietary products has been possibly the biggest driver of market share gains over the last number of years. Can you describe briefly how the retention in the aftermarket specifically drives longer-term growth out of those products?

Sure. So within the filtration business here, Donaldson Company for now over a decade, we have had a strategy of razors to sell razor blades. So our proprietary technology drives our aftermarket retention. And what we like to do is to solve our OE-based customers, be it in an industrial business or an engine business, we like to solve that customers concern or problem with a proprietary first-fit filter. And when that happens, of course, we sell the razor because our technology is valued. We actually sell that razor for a profit and then we -- that drives -- in turn drives our aftermarket retention. And we'd like to do that through the OE, so that the OE can then now win a greater share of their aftermarket. And so we have a good partnership with them because now OEs across the world, be it all across the United States and even in China, are now very keen on improving their replacement parts business. And so with our model that we have been working for a number of years, they can achieve that objective to drive that aftermarket -- that positive aftermarket performance and drive stability across their corporation. And so this is very meaningful and gathering more and more momentum across the world.

And so we've seen on the chart that you presented in some of your materials and at the Investor Day, the retention is close to 100% for proprietary and drops pretty quickly down to about 20% for the nonproprietary products. Is it fair to say that each OEM part generates about 4 to 5x the aftermarket revenue over its life, if it's proprietary versus nonproprietary?

That is fair to say. I think that's good math, Nathan. And when we look at the models that we have continued to evaluate on our technologies going forward that's been validated clearly and especially that retention rate, while it may not always be 100%, it is considerable. It's way up there.

And how penetrated are you on these kinds of proprietary products? Can you talk about the runway to increase that penetration? Any targets you might have for that to get to over time?

Sure. If you just step back and look at our engine business, proprietary parts of our first-fit engine business are roughly about 20% of our total aftermarket or about 25% of total engine. And so you can see how we still have quite a bit of runway to go, even though we've been at this for a decade, we still continue to win share in places like Latin America and Eastern Europe where proprietary hasn't yet caught on and really gotten depths throughout the overall business model. And so while we might get a nice leap forward on the nonproprietary side, the proprietary is a bit more of a lengthy process in order to get a new vehicle released and then you start to populate that opportunity for razor blade out there. And so we'll continue to press on that independent channel and the nonproprietary because all those products are available to us, and that's where we get a good presence in that particular new geography where we're gaining share while all the time continue to press the proprietary solutions and driving that forward. So we have a lot of runway opportunity with the proprietary model, and it is continuing to gain a lot of momentum worldwide.

Just one last one on the engine business. Are you seeing any green shoots out there in terms of improving demand?

Pretty uneven still. Really tough to say, Nathan. I would say, June and July, we continue to look forward and to those months to see exactly what ordering patterns will be. We've already talked greatly about what we have seen in the month of May. And May was, from a revenue standpoint, to be very tough. And so pretty uneven at this point.

Fair enough. Moving over to Industrial now. The industrial filtration business has a few different pieces in it. The biggest piece is obviously the dust collection business, which is pretty tightly tied to industrial production. As we start back up here, should we expect to see the aftermarket part of the business to ramp up back up in line with industrial production while maybe the capital spending piece lags until capacity utilization comes back up?

Yes, that's exactly the model. It's the same on the engine side as it is on the industrial side, where you look for vehicle utilization on the engine side, you look for industrial-based production, be it whatever region of the world to pick up. And when industrial production picks up, then, of course, the aftermarket really starts to play. And you gain that confidence across the industrial-based models, and you'll see the OE piece -- or sorry, the CapEx-based pieces of our business then start to gather momentum. And it will vary by region and end market in the world, but that's exactly how the model opens up.

I guess we have seen industrial production come back up in China. Can you talk about maybe how your business in China has reacted just on the aftermarket dust collection piece? As we've seen China open back up, China's industrial production has bounced back pretty nicely.

It has indeed bounced back nicely. In fact, coming out of -- they led the world into COVID right and so clearly, you hear all the stories of a post-COVID type of an environment in China happening. And we're experiencing that. So we have seen a lift in China, a nice bounce. And then particularly on the industrial side of things, we are seeing that CapEx-based type businesses get some momentum. It did start with aftermarket. Now we're starting to see more project-based activities across China. But I do want to caution on the industrial side and say, we can give you some very nice impressive percentages, but we still have quite a bit of share gain to have on the industrial side to get in China. So I have to be careful with percentages there, though, all things being equal, when you look at quoting logs, things like that, we're really pleased with the momentum that we have in China. And again, for the industrial side, a large part of that, particularly in our Industrial Air Filtration businesses, Blue Sky initiative-driven.

Okay. Can you just maybe talk a little bit about the market structure on the dust collection side? Are there opportunities for you to gain share coming out of this pandemic from weaker competitors or use the balance sheet, say, on inventory or something like we were talking about on the engine business as you're coming out of these shutdowns to drive some share gains?

Sure. There clearly is, and we'll continue to do that. We've, for example, set up a new model of aftermarket within Europe. We've continued to drive forward, even though we were in this pandemic and things were a bit more uncertain. We felt it necessary to continue on with our strategic plan. And so we stood up this aftermarket model where we continue to press more aggressively across Europe for our Industrial Air Filtration business. The dust collection aftermarket piece is about 25% of Industrial Filtration Solutions, that larger piece. And so we see good opportunities to press forward in there. And we do that, frankly, through inventory management, having the part available and then also maximizing our customer touches. Within process filtration, it's about 8% of our Industrial Filtration Solutions, or IFS business, that's growing high single to low double digits. So we have good momentum there. We have good opportunity to take share and use our balance sheet, particularly hold inventory and be able to quickly turn inventory to the needed place wherever it is in the world, and so we've got good momentum there. And then also our Connected Solutions piece of our Industrial Filtration Solutions business. We continue to press on that piece. Insignificant revenue today, but we are continuing to connect the dust collectors for all kind of end markets. We are live in the United States and recently went live now with a European-based approved product electrically. And so we will -- we are now selling those into Europe. And we continue to do that. Just think about the fact that we'll be connecting those products, really getting deeper to that customer relationship, which will again help us drive that aftermarket-based model. Those are some of the offensive, say, play offense moves that we're making across the company.

I know connecting some of these products has been a growth initiative for you guys. Can you talk about the value proposition to the customer for connecting these things?

Sure. So there's a couple of things, especially when you don't want to go out of your office these days, you can see how your dust collector is working, frankly, on your tablet or your phone. And you'll get pressure drop readings, you'll be able to have oversight by some of our engineers that take a look at it. We have had instances where we have called the maintenance person and said, "Hey, you're not operating as efficiently as you need to. So go and change this setting and this setting." And then suddenly, they're in really good shape and not having to worry about shutting down their production line and losing output as a result of somebody not really providing the necessary oversight to the dust collector. Additionally, we recently put out a new sensing device, and we're adding it to all the connected that will measure some of the contaminants that are going out the exhaust stack for lack of a better description. And so that dirty air stack which will help people measure and turn reports for EPA-based standard needs will drive even a greater value proposition to those customers. And we have a few other new sensors and connection devices where we'll continue to engineer those and expand that. So that maintenance person and that business will really have the best operating collector as well as a safe one.

Okay. Moving on now, I'd like to ask some questions about the capacity additions that you've put in to relieve some bottlenecks that are starting to look like they're getting to completion here. When we talk to investors, the first question we always get about those capacity additions is, well, aren't they just adding capacity at the top of the cycle that you're not going to need. So maybe you could just start with addressing that concern from investors?

Sure. We love where we are. We are so happy where we are. And the reason we are is because we didn't change our playbook as a result of the bump that we had on the top line. We did accelerate that a little bit forward. But look, we know where we want to prune the tree in order to always continue to expand our gross margins and do the cost structure work. This is work that is on our slate and part of the 5-year operations plan, that's always been there. We know our next move, and things are continuing down that path. And so we actually feel that all of the expansions that we have done in the past 2 years and that close to $300 million worth of investment directly into the company is really well-timed for us to really take advantage of the next moves that we have always had to make. So we're very pleased about where we are.

Okay. That capacity was supposed to be a solid contributor to the 120 to 200 basis points of margin expansion that you guys targeted at Investor Day for 2021. Understanding that 2020 had a black swan event and your 2021 actually starts in just a couple of months. So those targets aren't probably valid anymore. Can you talk about the structural changes you've been making in the business to drive margins? And how you feel about the execution on those projects?

Sure. So the structural changes specifically what we've had here are a couple. So the factories that we have added and that capacity we've added were really in lower-cost countries, which really allows us to then -- because we had about a $700 million bump over that 3-year period, it's really allowed us to renormalize the internal supply chain in order to really optimize the cost structure across our corporation, and so that's been really well-timed. When you look at our forward-looking gross margins, what's interesting about that is, clearly, we're doing very well on gross margin performance at the moment, and we expect that to continue. However, what will put pressure on us is when that OE-based business does come back, that will put some mix pressure on us a little bit while we find out whatever their operating rates are going to be. Still, all the work that we have done really gives us confidence that we can get our gross margins back to where they need to be. We're well on that path and as well as our operating margins back to where they need to be.

Okay. Just a couple on the balance sheet. It's obviously in very good shape, right on about a turn of net debt. And you have been a consistent repurchaser of your own shares. You're taking the fourth quarter off from repurchase. If we continue on the same trajectory we're on now from a macro perspective, continued gradual reopening, would you see that as likely to be a 1 quarter pause on the share repurchase or are you looking to look after liquidity for a bit longer than that?

Yes. So let me toss that question to Scott. And Scott, could you maybe take that one?

Yes. So as Nathan pointed out, we had a target of 2% this year, also 2% last year. We completed 2% last year. This year through the end of the quarter, we had reached 1.6% outstanding share repurchase on the target for the year of 2. So we were basically 3 quarters of the way through the purchase. And when everything kind of went haywire we just thought it was prudent to stop. We actually -- we drew $100 million on our credit facility just to kind of make sure that we could exercise that muscle. We also, in May, added an additional 364-day facility for $100 million. So I mean everybody was talking liquidity and we were as well, and we wanted to make sure we were being prudent and admittedly very conservative in managing the company's balance sheet, not having a massive amount of confidence in the future. And so therefore, we thought it was a good time to stop share repurchase. So we haven't given guidance for next year. The company has a very long history of share repurchase. If you look at our Investor Day chart, you can see that number just kind of slowly marches down. So that's a trend we're proud of and would like to continue. And so we'll look at that when we come out of the fourth quarter, and we come up with our plan for next year. So we said we were going to stop for the fourth quarter. I'd like to continue the trend of a slow, steady decline. We're committed to purchasing 1%, which offsets any dilution from our share-based employee compensation programs. So we're committed to that 1%. And then additional repurchases are governed by our current liquidity position and our other opportunities to deploy capital elsewhere.

Okay. And how are you guys thinking about the M&A markets right now? It's pretty tough to put a valuation on a business that the buyers and the sellers can agree to at the moment. When do you think we get to a position where you can figure out roughly what EBITDA is and what kind of multiples you want to pay on those kinds of things? How you make the appropriate ROIC? When do you think we get to a point where the M&A markets can open back up?

So just want to emphasize that M&A remains one of our 3 strategic pillars. We continue to do the work; we continue to work our list, if you will; continue to knock on doors; continue to talk to owners and prospective targets. Tough to say when it starts to open up. There, obviously, has been a change in the overall markets relative to valuations. And so people can -- have become a little bit more cautious right now. Tough to say when it opens up, Nathan. Clearly, it's in the weeks ahead. I don't think it's in the months ahead. It's clearly in the weeks ahead. And also, we continue to really think through if there's any opportunities out there that now present themselves as a result of the economic conditions that have happened that didn't present themselves in the past. So we'll evaluate everything, and we'll continue to focus on that.

Does this cycle -- with the black swan event and probably a disruption nobody really thought was possible, does that change your approach to valuation or leverage targets? Do you think there's going to be more or less or the same number of deals to be done on the other side of this?

Yes, that's a great question. Tough to say, filtration and the type of businesses or technology that we're looking for are still very coveted because filtration is a very interesting space for frankly, all of our competitors as well as people looking to get into the space. So it doesn't feel like there's going to be a tremendous opportunity. We just want to be making sure that we're doing the work, supporting our strategy, taking that long-term view, and we'll just continue to do that. And so should one pop its head and give an opportunity, of course, we'll be there for it.

Okay. Well, there's no questions on the line, and I think our time is up now. So I will thank you guys very much for your time, and I will look forward to catching up with you later in the day.

Thank you. Thanks, Nathan.

Okay. Thanks, Nathan. Take care.

Thanks very much guys.