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

Yes, competitors. Right. Those competitors would be MANN+HUMMEL out of Germany; Fleetguard out of Cummins, it's a vertical integration of the Cummins division; and then a company called Baldwin is the brand name, and that's owned by Parker Hannifin.

Got it. That's really helpful color, Tod. And maybe just switching over to kind of the margin expansion element of your strategy. Scott, you kind of alluded to this already that Donaldson had been progressing against your goals of gross margin expansion by kind of looking to grow into the more profitable capacity. And you said that you were in kind of the later innings of that strategy. I guess as we think about incrementals kind of coming out of this next industrial upcycle, should that allow Donaldson to kind of post above-average incremental margins? And how do you kind of consider the interplay between the incremental R&D spending and the sales force additions you mentioned as well?

Yes. I mean we're committed to driving the margins up on growing sales. And our gross margin improvement during the run-up was delayed, and we're seeing the benefits of it now. And it was delayed because we were committed to delivering to our customers, and we incurred additional expense to do so. And so that's why we started on the capacity expansion projects. And now those are coming to fruition, and we're seeing benefits in the renormalization of our supply chain. And so we still feel like we have room to grow or committed to higher levels of profitability on higher sales. And so we look for sound incremental margins as revenues increase. But even before that, we look for good margin improvement this year on relatively flat sales. So we feel like we have still room left in the game, innings to play and a lot of opportunities to capitalize on. And with that, I would note that the Twins, I think, are either 1 or 2 wins in front of the Yankees right now. So in terms of baseball, we're proud of our performance.

I would -- this is Tod. I'll just add a little bit more color into that. If you go back where we were as a corporation, remember our strategy, right? We invent cool things. They're proprietary to supply our customers and really solve their complex problems. And then that, in turn, allows our customers to win more aftermarket, and we get the replacement parts. But the important part about that strategy is in 2016, when our company bounced up by $700 million in 36 months, the most important part is you must never let your customers run out of inventory. And so we did take pressure and we took headwinds on, on the internal supply chain so that our customers never ran out of product. That held our gross margins down. That then, in turn, saw us accelerate our 5-year operations plan that Scott talked about. We put that footprint in place. And now we're doing that internal supply chain normalization. That's the reason why where we are in that journey, Scott refers to, we still have opportunity for margin expansion ahead of us. And it's because we're really still in that -- we have some excellent projects to be able to expand that or really normalize that internal supply chain, if you will. So we have good opportunity ahead of us.

Got it. Super clear, Tod. And certainly, appreciate you keeping with the baseball analogy there, Scott. Maybe switching over to China, it looks like mix growth there has definitely been a focus for you guys over the past cycle. And you said that you're now beginning to kind of ship against product -- projects that were won there over the past 2 to 3 years. As OEMs in China kind of continue to move up that quality curve, how large an opportunity for Donaldson do you see there versus your current business today?

Yes. So China, as a reminder for everyone, China is about 7%, 8% of the company's revenue. We've been there for decades. We went there early on to support our Disk Drive-based business. We have excellent relationships with the Chinese government in the Wuxi area. And we continue to expand there. So we're doing quite nicely. What's really fun about our China-based initiatives and our China teams right now is we went into then the engine-based business on the backs of the multinationals. So think of mostly the Japanese multinationals as well as the Caterpillars and the John Deeres, the Komatsu, the Hitachi, Kobelco, so all of those customers. But now, what we're doing is we're winning on the state-owned based company. So think the LiuGong and the Lonkings and the rest. And we're winning with technology. And we're winning with PowerCore. We're winning with PowerCore so much so that we'll be building our first line to support that local win base that we've had on those Chinese national companies. And so we're excited that we have good momentum in China. Because China, of course, produces roughly 30% of the world's heavy-duty equipment. And for us to have that kind of a momentum where they're pulling our technology forward into both off-road and on-road vehicles is very important for us. The other portion of our company opportunity in China is the industrial dust collection side of things. With the Blue Sky initiative, we are gaining good momentum, and we have a manufacturing plant where we build it locally to support the China markets. And so we're getting good momentum with our technology within China to support the Blue Sky initiatives, and we'll continue to press forward in both the engine and industrial businesses there.

Got it. I think you mentioned it there for a second there, Tod, that -- you said that you were investing in capacity to produce and ship locally from China. Do you have a sense of how much capacity, from a revenue perspective, you'd expect that facility to be able to service, so that we can kind of use as a benchmark to what maybe percentage of revenues China could represent for Donaldson over time?

Tough to say.

We're investing in our plants in China right now to bring in an additional line. So we'll continue to enhance and expand the plant operations there as we ramp up the business.

Look we -- just to remind, Dillon, we've got low single-digit share in China. Even though we're very proud of -- you know I was talking about we're planting seeds for future growth. And those program wins that we have in China, they really are only now starting to build on some of the production. So we're just now starting to see some of those low sales, and yet, we still have good growth in China. We just finished off a brand-new manufacturing plant that we look to be filling here in China over the next 2 to 3 years as we continue to grow there. Tough to say where we'll be overall as a percentage of revenue with the corporation, but we do have really high expectations from our China team, and we're investing to make sure that, that happens.

Got it. That's a helpful framework. Maybe switching over to kind of the alternative powertrains, alternative fuel debate. Can you just remind us of the filtration content differences between an ICE versus a BEV in kind of a hydrogen fuel cell? And I guess, how much of your business would you kind of characterize maybe at risk from incremental alternative fuel penetration?

Yes. So if you really look at overall the technology race out there, so you have the internal combustion engine, but you also could have a hybrid. So a hybrid would be, let's say, you have an application mining truck that used to have a 15-liter diesel engine. They might go with a 10-liter diesel engine now. But they'll put batteries at the wheels and put it in series. That already exists today. So they would call that a hybrid-based vehicle. The other opportunity would be hydrogen, of course. And then the full would be -- full electrification. So within a hybrid type of an activity, there's no real pressure on the company. The difference between the air capacity on a 15-liter diesel engine versus a 10-liter diesel engine would likely only pressure overall revenue by mid-single digits because the overall airflows become very consistent. On the hydrogen-based vehicle, what's really interesting about that is you still have the hydraulics, which we're in. You would not have the overall liquid-based fuel taking particulate or water out of fuel there, but you would have air. And the fun part about that one is, while a combustion engine needs clean air, a hydrogen engine needs pristine air. And what I mean by that is you could take particulate out of a combustion engine, but you also have to take chemical absorption and you can't let chemicals hit into the hydrogen-based vehicles because of the process in order to be able to create the energy. Hydrogen likely is going to allow us to expand our overall air revenues just simply because of that technology challenge. And what's really cool about that is we already are on hydrogen-based vehicles. We've won platforms, we've already shipped products. We don't talk about it that much, but we're working with the suppliers that are interested in that, and we're in their laboratories to do so with really high-end technology. If you think about our company, why could we do this so quickly? The reason we could do this is we're also the #1 producer in disk drives in the world, disk drive filters in the world. And what is necessary to protect the disk drive's data storage is you have to take the chemicals out of the air, so it doesn't ruin the disk drive and particulate. And so we can pivot that technology that we've been in for decades. We even bumped it up a little bit, and now we're adding that into our engine-based air for hydrogen. The other thing about -- if it goes full electrification, which we believe with the energy density at this point in time, and we have people studying it and modeling it, really statistical experts have built models, we would tell you the energy density of a battery is not there. And it has to have an exponential step up before that would win in the markets. And it's important for people to understand Donaldson does not play in the passenger car market for the powertrain. We have no revenue there. But if it does go electric, we also have technologies within the venting portions of the automotive and within the battery compartmentalization, where we actually sell to battery manufacturers some technology that helps them to compartmentalize overall battery packs, if you will. That would be significantly less revenue than the air intake system, for example, for hydrogen or combustion engines. You wrap all of that up with the complexities of all of that coming into our markets, we would tell you, we're very comfortable saying that for the next decade, we will not face any headwind pressures across the revenue as a result of new technology introduction on our engine-based markets. We -- our models actually project longer, but to say a decade is very fair.

Got it. Yes. That's really, really great color. Maybe switching over to capital allocation quickly. M&A, I think, is historically accounted for kind of a lower degree of your total capital deployment in recent years, although you've done some. Are you seeing more opportunities today in the pipeline as a result of COVID? And I guess, if that's the case, what areas of the business are you actually looking to still grow out inorganically?

Yes. So this is Scott. So I would say the -- our pipeline is relatively consistent. So we haven't seen a big flood of new companies come into our pipeline as a result of maybe COVID slowdowns. We do look to continue to complete acquisitions. We look to expand the company's technology or geographies. And so we're continuing to be active looking. We're blessed with a very tenured group of employees here who know the filtration companies out in the world and know the ones we're interested in. So we're keeping close tabs and a relationship with those companies. So we'll continue to look. Our capital deployment strategy is: one, invest in the company, either organically or inorganically; two, pay dividends; and three, buy back shares, and so we continue down that path.

That's helpful, Scott. And we're bumping up the top of the half hour here. So I'm going to wrap it up with a more thematic question. But the reshoring thematic has kind of been theme that's been kind of stooping across industrials. There are certain companies that are looking to bring supply chains back to the U.S. kind of given the level of COVID-related disruption. Considering that a significant portion of your industrial business is still kind of tied to U.S. IP and kind of keeping in mind the opportunity that you're targeting in food and beverage and pharmaceuticals, are you viewing that kind of theme of reshoring as an opportunity for Donaldson over time? Or do you feel like that's not really a significant driver?

Sure. So I'll take that. So when you really look at reshoring, Donaldson never offshored. So we're still in that exporter out of the United States. And our strategy has always been the building region to support region. So if you hear us talk about opening a new plant in China, it's because we have China-based customers, and we're looking to have enough volume there in order to pivot and make it a local supply chain for our overall customer base. And that's been our strategy for decades. It remains our strategy. And so therefore, to reshore back to the United States, I would tell you that, that's not who we are. But it's not who we are because we never acted as an offshore-based company going and chasing a lower cost type of theme to bring it back into the United States. And I would tell you that we have -- we see the world as 3 regions. It's overall the Americas. It's, of course, Europe, Middle East, Africa; and then it's Asia Pacific. So that's really important for us. The other thing that's really important is when you look at our overall strategy, if you will, from a technology-led filter company, that allows us to follow the local technology-based needs. And so you saw our products that would be far more technical, for example, in Western Europe than they would in China, but we're allowed to follow the lead of that local-based government regulation and flex it appropriately so. And that's all part of our strategy to be close to our customers and have a great supply chain for them.

So Dillon, this is Brad. If there was a bunch of new factories in the U.S. for pharmaceuticals or something like that, that obviously ends up being good for us because there's a new population to go sell to.

Yes. That's definitely helpful for that framework. Great. Well, I think we're at the top of the time here. So I want to thank Tod, Scott and Brad for your time. It's great to have you guys out here, and hopefully, we'll have you guys out in person next year. And this will conclude our presentation.

Thank you. Good job.

Thanks, Dillon.

Bye, everyone.