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

Greetings, and welcome to Donaldson Company Webinar as part of the Intellisight 2020 Virtual Conference. [Operator Instructions] It is now my pleasure to introduce your host, Tod Carpenter. Thank you. You may begin.

Good afternoon, everyone. It's a pleasure to be here today. We'll be going through the deck, and we've taken a little liberty with the typical decks that we have talked about in previous years, and we've added some COVID-based relationship to it. And I think this will help you understand how our company has performed throughout the COVID experience to date. So without further ado, we'll jump in. First slide is the obligatory safe harbor. I'll not read it all. You know -- just know that it's in there, although it does seem to be getting longer every year. But it is there. Most important is that we are at a bit of an interesting moment. We reported our third quarter on June 2. And so the majority of references I may make in this would be calling back on the materials during that time. We are scheduled to report our fourth quarter earnings on September 3. So we'll give you a lot of detail on what would be our fourth quarter and full year at the September 3 call. There is a reference to a business update that we did put out on August 6, and I'll call on some of that material as well. So I want to talk about our value proposition in the corporation and just put a little bit of context of COVID-19 in there as well. And so if you really take a look at 3 classifications, if you will, of information. One is that we have clear priorities. I want you to walk away with these 3 things: clear priorities, we have engaged employees and we have disciplined execution. We've talked about it a number of times in the past, but specifically, it's working quite well at Donaldson Company. By clear priorities for COVID-19, I want to say that we have 3. We established these way back in February as the outbreak was unfolding. They've not wavered. We're doing quite well. They -- and they are the health and safety of our employees, taking care of our customers and then really doing our part to lessen the spread of COVID-19. And some have asked what was our -- what has been our company exposure? We've had roughly about 30 to 40 confirmed COVID-19 cases across the 12,500 employee base that we have. So we believe we're doing excellent on these priorities and taking care of our employee population as our experience would be somewhere below 0.3% of any kind of instances in the company. So we're doing really well, very proud of the way that we're handling this as a corporation. With regards to the engaged employees, we've got excellent global coordination and collaboration going on. We always talk about collaboration as being -- as something we're very proud of in the corporation. And right now, it's working really excellently in order to help take care of our customers. We set up -- we were not a big work-from-home type of a corporation. As the pandemic came on, I would tell you that we switched to a work-from-home environment in roughly about 14 days worldwide. We did have that flow through the corporation and starting in China, we actually closed the first half of the year or January close, if you will, in China, the month of February. We did that with our entire finance organization in Asia working from home, and it went just perfectly. And we've taken what we've learned in Asia, and we've just rolled that throughout the corporation. And we've done excellent. Additionally, we have a -- we really owe a lot of gratitude to our dedicated frontline employees. When you think about that, people in the distribution centers, people in our plants, we've done really excellent. And they've done a great job at following all the protocols. We do things such as taking breaks every 2 hours and having every employee wash their hands and really making sure that we promote those safe protocols. And all the while, we're doing all of this, we're very proud of the execution that we've had across the corporation. So our customers and our suppliers, we've maintained strong communications with them. Things are going quite well. We went into this year saying we need to expand our gross margins. As we talked to you in the third quarter, that's clear. That is happening across our company, all under this umbrella of controlling what we can control, and specifically our discretionary expenses. And in our business updates we have provided to you, we have given you all the statistics on how we continue to maintain a strong financial position. So as a corporation, we're really doing excellent navigating COVID-19. Clearly, we all wish we were done with it, but we do feel as though we have good protocols and good things in place to continue on a positive vein in navigating this. The next slide, you have clearly seen this slide before. We start our presentation with it, with the top 5 things, messages that I want you to take away from our corporation. But I'm going to do this a little bit differently this time and come back and touch these a little bit in regards to COVID. And so we'll break it down a little bit further. So if you specifically look at #3 and #5, we have an experienced management team and engaged Board of Directors. And that management team really has the experience and leadership across our corporation allowed us to do things like pivot and go to work-from-home in 14 days everywhere in the world and really allowed us to continue to talk all around the world. What we learned in China, we quickly transferred that over into, for example, our plant in Poland and then down throughout Latin America and the U.S. And it's really worked quite well. The other point we want to make in #5 is that we always like to describe ourselves culturally as a say what we do and do what we say type of a corporation with a disciplined capital structure. And we maintain that. We take great pride in that. And so that's something that's really the fabric of who we are as a corporation. Within this next slide, you see that leadership team and the point here to bring out is that we have over 200 years of combined Donaldson experience across myself and my direct reports. And then just moving forward, each of those individuals as well as every officer in the company has a stock ownership requirement. And what's important to note here is that the common market practice, for example, for a CEO level is about 5x base salary. And at Donaldson, I'm required to hold on to 10x. And you can see every officer in the company is required to hold above market. And we do that because we think it's really healthy to align with our shareholder interest that we have our longer-term skin in the game. And additionally, you can see the paper -- the performance base pay is really a larger portion of the total compensation of the individual. As you, as a shareholder, do well, we obviously do well. And maybe the takeaway from all of this is we do this because we want our officer group, our leaders in this corporation to act like owners and not merely just managers. If we then go back and have that touch point of items #2 and 4 to take away, we'll go through. And on #4, specifically, I want to note that we are a global company. We are global in our production and distribution. We are -- we always like to say that we are a region to support a region's needs. We do that quite excellently. The pandemic has actually emphasized that strength in our corporation and given us a strategic advantage as a result of -- we have not had to move a tremendous amount of product around to different facilities out of necessity of things being shut down, for example, by a particular country here or there. What's important to note for us is that every plant in Donaldson Company, every country in the world has deemed Donaldson Company's plants as critical in the essential businesses. Now we did have to go through some steps in regards to that. In a country here or there where we were forced to shut down until we met those needs and went through the governmental regulations for, say, a week or something. But once that came -- once we worked that process, we were deemed essential everywhere, including specific country government visits to the shop floors, et cetera. So we are global. We are local and global at the same time, and it's really been very positive. And our operations teams have navigated this choppy waters exceptionally. Next, I want to say that we always talk about we want to solve our customers' problems with proprietary filters that help us drive replacement part sales or proprietary razors to sell razor blades. 65% of our company revenue is replacement parts. That gives us a solid foundation even during the pandemic that while you hear first-fit equipment or they'll build less trucks or less CapEx, et cetera, sure that puts 35% of our comprehensive company revenue under pressure. The fact that they're still building things and they're moving inventory and helping through transportation also gives us a more solid foundation as a corporation, and that's at 65% of replacement part that's doing quite well. In addition to that, in our Advance and Accelerate type of portfolio, we are penetrating new markets, such as food and beverage. And those type of markets where we are strategically pushing forward and making investments, such as food and beverage and such as China with air for proprietary products, are growing above the overall company average and growing above the end market averages for those businesses. So doing quite well. On August 6, we put out a business update. And what we said in that business update is that our fourth quarter sales, the sales that we will be reporting more in-depth on that September 3 date, we said it would be down roughly 15%. The important thing is that sequentially, as we went through the quarter, we started -- the lowest point was May. June was higher than May. July was higher than June. So sequentially, we continued to expand. You can see the relationship where Americas had the toughest quarter, and APAC had the best quarter. For point of reference, we are 100% back in office everywhere in Asia with the noted exception of Australia is -- has teetered. They were fully back into office and now we backed down a little bit on that. And Japan was fully back into office, and we backed down a little bit on that. Everywhere else in Asia is 100% in office, including India. Replacement parts, as I noted, are larger than first-fit and the new markets are outgrowing, as I talked about. As far as the quarter-to-date gross margins, our gross margin, again, I talked to, we wanted to expand our gross margins. Within this fiscal year in that quarter, that absolutely happened. And for the full year, that happened. And then our quarter-to-date expenses, it's important under that label of controlling what we can control, we're doing an excellent job. So dollars for dollars year-over-year, we have 15% reduction on sales, but we also have a nice reduction on expenses. All the discretionaries are under tight control. Clearly, it's easy to bring travel down these days because no one is getting on an airplane, but it's more than that. It's things that we have choices to spend on inside the corporation. We're doing a very nice job. The other point that I want to point out about that is, even though we are down appropriately on the expenses, we are not pulling back on any of our strategic investments to press forward on that longer-term portion of our portfolio. So that continues on positively. And when we look at our fourth quarter CapEx, we told you at the end of the third quarter we'll be slowing down a bit now. Over the previous couple of years, we had accelerated OpEx. We were working at renormalizing our internal supply chain. That has gone very well. All of our capacity expansion projects are either now finished or we have a couple that are really just very short term, now weeks from being done. And so as we look forward to next year, of course, we will clearly have a reduced CapEx year-over-year. I'll talk about that here in a couple of slides. So CapEx is down, as we planned it. And really, you sum up what we did with CapEx, actually our timing couldn't have been better on some of the expansion choices that we made. It's worked out quite well as we now look to normalize that supply chain and continue to expand gross margins. We typically start with this important takeaway, and that is we are a technology-led filtration company, and we try to solve customer problems with proprietary solutions. And so I want to make the point that we continue to invest in technology. We have not pulled back at all. Our new research center in Bloomington is doing well. We will wrap that project up and turn it over to all the scientists and engineers here in a matter of weeks. And that we continue to prioritize as a percent of sales our R&D investments. Remember, we are on a path from 2% to 3% of sales to 3% to 4% of sales. But I also want to make the point that clearly, we -- with the growth we've experienced in the last couple of years, we were not into that 3% range as we thought we would have, but that was only because we experienced wonderful growth. We'll likely come closer to 3% here as we close out this fiscal year. But I want to assure you that we've increased R&D by double digits every year for the last 3 years. They are getting everything that we feel that they need as we go forward here. So stepping back, we play in a $65 billion filtration market. Our engine business, which means aerospace and defense, stationary hydraulics and medium/heavy-duty diesel engines, plays in a $16 billion market. It's roughly about $1.8 billion to $1.9 billion of company revenue. Our industrial business plays in a $6 billion market. And about 2 years ago now we opened that up, and the darker slice of food and beverage is about $2 billion of food and beverage. We have now entered that. That's the piece we continue to talk about accelerated growth. And we are connecting all of our industrial products with digital-based data sets, if you will, which will then allow us to pivot and go into servicing all of that as well. So you throw that together now, and our Industrial Products segment now addresses $11 million (sic) [ $11 billion ]. We'll continue down around that wheel, if you will, from food and beverage and the specialty chemicals and electronics and into medical as we expand on our technology base. And that is an additional roughly $11 billion opportunity. We have -- we looked at a materials research center to help us make that journey and continue to work to understand and learn, get a deeper learning in all of those markets. We will expand into those particular end markets by expanding technologies. As we talked about, we need to get into medical and pharma. And so we're looking to add technologies to our company to be able to do that to extend in underrepresented geographies or market access and to execute strategic acquisitions. This is my favorite slide always, and it shows you how we look at our portfolio. And we break it down into Advance and Accelerate. Think of that as we're really investing more disproportionately there than other areas in order to accelerate the growth opportunity. Critical Core would be just as it says. We believe that we can grow, say, 1 or 2 points above what the end market does -- what the end market grows, just simply because we have that proprietary technology that answers the customer solutions. Mature, think of that as more of a cash cow. And fix and reposition is as it says. We've got work to do to get that up to company's standards. Then if you look at how that is broken down. 55% of our portfolio is Advance and Accelerate, and then from '17 to '19, you can see our Advance and Accelerate is above -- grew above company average. Critical Core is at company average. And the fun part is mature as well as fix and reposition have grown -- really outperformed what we had thought they would do during that time frame. We had some real positive share gains in a couple of those businesses, and that really explains that. Now I want to really highlight defense and gas turbine systems within this because this portfolio analysis that I've been talking to here now for a couple of years, you are all very well aware of the fix and reposition of gas turbines, but gas turbine business has really done an excellent job. And so today, I want to let you know that gas turbine is now moving to the mature bucket. It has done wonderful in its execution, in its rightsizing the business. Its profitability is now really on path to where we're very happy what the team has accomplished, and we see valuable aftermarket opportunities. Within the defense business, we have, well, one more program. It's a very, very long-cycle business. But we're moving that down to the Critical Core business. We have one program that will be coming online this year. For example, the largest helicopter, the AH-53K (sic) [ CH-53K ] helicopter will come on to production this year. We have a strong engineering team that continues to work on those programs. And so we'll look for more measured growth, but it is Critical Core. We like the margins in that business. It's executing very well. And so it's really not a cash cow base business. It is a growth business, albeit much slower than other portions of the balancing portfolio. So 2 quick moves in how we're taking a look at the company. As far as disciplined capital deployment that I referred to earlier, again, our priorities have not changed. The first is reinvest back into the corporation for growth. The second is dividends. The third is share repurchases. And regards to M&A, we look at that as investment back into the company. So it's organic or M&A. Our CapEx was elevated through fiscal '20. Now we will have 1 to 2 years of below what we think the average is. And when we return to the average, it will be at about 3% of sales. So I'll talk about the next 2 pieces in the following slides. As you can see in our dividend growth, we're very proud of the fact that we've been paying a dividend for every quarter for over 60 years. And we're also proud members of the Dividend Aristocrat Fund, and we look to remain consistent in our behavior relative to dividends. With regards to share repurchases, we have a consistent set of actions on how we behave relative to share repurchase. Our annual -- we look to offset our annual dilution of 1%. You can see over time, we've been able to reduce it by 2%, but we're a consistent story here. We're not a market timer or things like that. We would potentially take the opportunity, should something be way out of whack. But we are really -- the operative word here is we're a consistent story on share repurchases. And so the last slide that I want to leave you with is, this -- is this slide, and really it, in summary, captures who we are as a corporation. Our purpose is to advance filtration for a cleaner world. Our company is built on a strong foundation of 6 principles: act with integrity; engage and empower our people; deliver for our customers; cultivate innovation -- in other words, invent cool things; operate sustainably and safely; and enrich our communities. Inside that, we talk about our technology-led filtration company. We are world-class in our material science, and we continue to expand with digitally intelligent solutions. Our businesses -- our company is diverse in its set of businesses. We grow organically, and we do strategic acquisitions. We have an excellent performance, have a global presence with deep customers and very tied customer relationships with excellent operations and talent management. So with this as the backdrop, I would leave this slide up and open it up for any questions that you may have.

This is Brad Pogalz, Director of Investor Relations. We have no questions at this time. [Operator Instructions] We'll leave it for another maybe 30 seconds and then close it down. I think we'll turn it back to the operator, and that concludes the call.

Yes. So thanks, everyone. Appreciate your interest in Donaldson Company, and appreciate you connecting today. Oh, we have one question.

We got one.

We do have one. Hold on. Okay. During 2019, you laid out a margin expansion -- okay. We have to read them out. Yes. Sorry, I did move it. During 2019 Analyst Day, you laid out a margin expansion target. Can you bridge the margin expansion for us? What is the margin expansion contribution from optimization initiatives, mix, raw materials and others?

Yes. I'll start. This is Brad, Investor Relations, again. Thanks for submitting the question. And when we laid those out, we expected about $20 million of, let's call it, fall to the bottom line improvements from our operations initiatives. And then we would also expect to get some mix and pricing benefits from the segments that would net out to the operating margin targets we laid out at our Investor Day. With COVID, we've pulled those off. But I would say that the framework for growth and improvement is still intact. So over the course of this last year, as Tod mentioned, gross margin is up. We haven't precisely quantified the benefits from each of these categories. But I would say it's -- there is a reasonable split in our gross margin improvement. So it's definitely not all coming from mix. And with raw materials, the costs are going down, but we're also benefiting from procurement initiatives. Renegotiation of contracts, improvement of terms, things like that, that are helping our overall procurement, get savings for the company. Pricing is a slight positive for the year, which we feel really good about in this environment. And then finally, these initiatives with regard to capacity and optimizing the cost structure, a lot of that is coming online now. So that's improvement that we still expect to be in front of us. So overall, we would continue that -- or expect to continue that in '21. And we did note that in our business update press release that benefits from these initiatives should continue to flow through over the coming year. Scott, I don't know if you'd want to add anything to that.

No. I was just going to say the other thing that we talked about quite a bit during that day was our operations team had quite a bit of initiatives really focused on our costs in our plants and our supply chain and our operations. And I think they've done well, and you can see proof of that by looking at our gross margins throughout the year because they've been pretty strong, even in light of pretty tough volumes that they've had to face. So those margin improvements that we talked about, I think, you can see delivered this year and into the near future by looking at our gross margins.

Okay. The next question comes from [ Lee Neiber ]. Are you seeing any disruptions from suppliers giving you materials you need? The answer is no. We've -- our supply teams and purchasing teams have done an excellent job being able to really get everything that we need. We have had a little bit of worry in some places in Latin America, here recently of some small suppliers about potential bankruptcies and such. But we've had 0 disruptions so far. Our teams are really doing an excellent job, and this is where our region to support region strategy really is helping us in this type of an environment. So we have not seen disruptions, and we're on solid ground there. Next is by [ Jared Platt ]. I hopped on late. But as it relates to COVID, are you experiencing any labor constraint headwinds in manufacturing driven by stimulus and people wanting to stay home? So it's really a U.S.-based question with that. And we have 11 plants in the United States. And the answer is no. We have not experienced anything like that. I will tell you that our protocols are pretty good. And what we experienced, for example, down in Mexico was, there's -- roughly, in any given week, there's 1,500 man-days, if you will, as the pandemic was really hot and heavy. And the amount of man-days missed on 1 week was 1. So one person missed one day. And then the next week, it was 3. So it started to tell us that we could be really proud of the fact that we have good protocols in place, but also government-based regulations and things that are happening. I think you hear the phenomenon of people staying at home, not coming to work more in the construction-based industries. But based upon what we pay people, that has not been a concern for us. The next question, Bob -- Yes, the next question comes from [ Peter Rob ]. Address the challenge of the emergence of the electric vehicle market. So electric vehicles on Donaldson Company. I want to remind everyone that we do not have any revenue in our corporation on passenger cars. The electric vehicle market is clearly a passenger-car type of an emergence at this point in time. And if you really look at the energy density of what batteries can do now, it's an energy density issue for off-road based vehicles. So think of large combines and also excavators as well as mining vehicles, and the battery technology is just not there at this point in time. And so electric vehicles have not given an immediate threat. We are very close to all the engineering groups across our customers within those end markets. And we understand if they have any electric vehicles being engineered or ready for sale. And I can tell you that we're very comfortable with our position that, at least for the next 10 years, we'll not see any degradation. If you really think about what has to happen is, first, they have to solve the battery problem, bring that online, then they have to solve the infrastructure issue. And at this point, the battery technology is such that a farmer can plow their field with a combine for about 4 hours and then they have to charge it for another hour. And that's just not going to be the type of work or the way they work in a farmer's field, for example. Additionally, once they do have a technology that would go forward, let's say, they exponentially solve the energy density issue, you have to think about the millions and millions of vehicles across the world that we're selling to across our replacement parts, which is more 65% of the company that would then have to have an end-of-life event before we start to see something. So we can comfortably say with the deepness of our tentacles into the OEs and where we are as a model that we're comfortable that for the next 10 years, we do not see a threat. Another question has come in. Can you give us an update on the Exhaust and Emissions business? So with the Exhaust and Emissions business, we had reached an agreement with a potential buyer earlier in this fiscal year of ours. So last calendar year, actually. And given everything that has taken place in the world with COVID, you have emissions regulations now pushed out for a full year in Europe, we were not able to find a path forward. And so it was just better at this point in time to depart and go our separate ways. We have both done that. And so now we're tucking our Exhaust and Emissions business back into the company, and we will run it efficiently and look forward to get up to company-based profitability. So we are refreshing the screen one more time.

I think we're good. And I thank everyone.

That's it. Yes, I think we're out of time as well. So thank you, everyone, for your time and your interest in our company, and wish you all the best.

Thank you. This does conclude today's webinar. You may disconnect at this time, and thank you for your participation. And have a great day.