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

My name is David Ridley-Lane. I'm an analyst here at Bank of America on the Multi-Industrials team. And today, we have with us members of the management from Donaldson and Corp. We have Tod Carpenter, CEO; Scott Robinson, CFO. And I think they have a slide presentation they're going to run through at the start here. So I'll turn it over to you, Tod.

Thanks, David, appreciate it. We're showing our first slide, I would imagine. I can't see the slide, so I'm going to trust what slide we're on here for everyone in the room, Charlie is actually maintaining the slide control. So welcome to Donaldson. I really appreciate your attendance today and your interest in our company. Next slide, Charlie, is just the safe harbor. By now, we've all been through this so many times. I'm not going to read everything. Just please note that there are forward-looking statements in what we have to present today, and please be aware of them. So go ahead, next slide, Charlie. Also as a reminder, that Donaldson company recorded its second quarter earnings on February 25. And as a reminder, our fiscal year is August 1 to July 31. So our second quarter ended at the end of January. We are currently in our third quarter. We did report earnings on this at the second -- for our second quarter on February 25, and that's what we will refer to. Next slide, Charlie. There are 5 messages that I want to leave you with within this presentation today, and they really describe our corporation well. First, we are a technology-led filtration company. So we use proprietary filtration to drive complex customer solutions across the world, across all of our end markets, which helps us then sell and grow faster within our aftermarket. So think of that as proprietary razor blades -- or proprietary razors to sell more razor blades. Second, we are diversified across the globalness of our corporation, where everywhere that the customer wants us to be, and we're diversified by the businesses that we serve. Third, we have a very experienced management team and a very experienced board team. I myself have been with the company 25 years, and the Board is very committed, and our leadership team is very committed to the long-term health and strategy execution of this 106-year-old company. Fourth, we are global. Again, we have 46 manufacturing plants across the world. So we are everywhere the customer wants to be. And as the world continues to talk about supply chain, it's important to know that Donaldson is where the customer wants us, and we have an in-region to support regional-based customers' manufacturing outlook and strategy, and that really allows us to normalize wherever necessary to be close to the customers. And fifth, we have a culture of strong ownership. We are a say what you do, do what you say company, and the culture of strong ownership drives all the way through even into our share ownership requirements. For example, I'm required to hold above market, which is, at Donaldson Company, 10x my base salary as far as having skin in the game and it's true with higher than above-average market of every leader in the company. And so next slide, Charlie. So we have 2 reporting segments. The very first reporting segment is our Engine business shown here is a slide within the agricultural sector, and many people take a look and say our Engine Products business is the air intake that goes into a diesel engine and the overall engine liquid, so fuel and lubrication and say, that's essentially what we are. But what we want to show you here is that we have many, many filtration opportunities across all this medium and heavy-duty diesel engine platform opportunities. The end markets we serve within here are construction, agriculture, mining, long-haul over-the-road trucks. We have a little bit of revenue in what we call return to base trucks, so waste refuge, things like that. We have 0 revenue in automotive. We do not do automotive. Next slide, Charlie. The next reporting segment that we have is our Industrial segment. It has -- what is shown here is an industrial manufacturing plant. All the blue type of applications. Is our opportunities within 1 manufacturing plant in what we call an Industrial Air Filtration business. This overall Industrial reporting segment is about 1/3 of our corporation. The business I'm showing you here is about $450 million of that to show the opportunities. We also have many other filtration products within this particular segment all the way to our disk drive manufacturing where we make 1 million filters per day in Wuxi, China, and 1 million filters a day in Rayong, Thailand, they are about as big as your little fingernail. Next, Charlie. I am going to -- I can't see the slides, but we play in a $65 billion filtration products market. I'm assuming that's the slide around, right, Charlie?

Correct..

Okay. Yes. So we play in a $65 billion filtration market you can see where I showed that agricultural example, we have our Engine segment, which plays in about $16 billion of an opportunity. And then I showed that other Industrial application. Within our Industrial application, I showed that because that's our industrial air or about $6 billion. And with about 3 years ago, we changed our strategy, and we advanced that to enter into the food and beverage opportunity, but not the entire food and beverage particular market. We're playing at about a $2 billion slice of that market. Further, we're digitizing our industrial based products so that we can then enter into a $3 billion service-based market within Industrial products. So that now opens that up to about $11 billion. So within Engine at $16 billion, industrial, it is $11 billion and the reason the gray -- you continue right around into semiconductor and then black into medical, is because the technology -- why we entered into food and beverages? The technology from a filtration standpoint of view, that it takes to get into the overall end markets of food and beverage, give you a baseline to grow and then get into semicon-based technologies and eventually into medical-based technologies. We do have projects and investments taking us into both of those markets in what we term as life science for those 3, and we are making good inroads. For example, our overall food and beverage particular business has now gone from about 4 years ago being $5 billion to $10 billion -- $5 million to $10 million worth of sales to now between $65 million and $70 million worth of sales. So you can see that we have had really good aggressive growth within that. We look to grow by, first, expanding our technology, or, as we say amongst all of us, we are a bunch of filtration geeks, and so we look to invent cool things. Next, we look to extend into under-access markets. So we have a very low share in China. We're growing nicely in China, but we still are single digits. So we have a good opportunity in China, among many other countries in the world. And then the third piece is strategic acquisitions. Go ahead, Charlie. We cut our company up into a portfolio much like many of the companies that are out there. We cut it up into Advance and Accelerate when we show you the businesses here of what part of our portfolio is in the Advance and Accelerate. What role do they play? They get an above-average investment inside the corporation, and they're expected to grow at a greater level than the overall corporation. Critical Core, those businesses, you see those typically cycle for Donaldson Company. They will get good investment in the company. They are expected to grow not as much as the Advance and Accelerate, but most importantly, they are really a strong foundation for our corporation. Then in the mature sector, those are -- think of those as the cash cow. We have very good strategy. We have good leading position in those. But those overall end markets will likely not grow, or we will choose to actually not have those particular pieces of the company grow such as our Gas Turbine business, where we have a good competitive advantage. We have good profitability in that business. We just choose not to go after that to grow it more based upon the longevity of that end market, and we'll choose to invest in other pieces of the portfolio. We have a Fixed and Reposition piece, which is our exhaust and emissions business. That is a sheet more of a sheet metal tape business, and that is below average company margins. And so consequently, we are on a fixed plan to get that back to company averages. That's how we break down our portfolio. Most importantly, when you look at the growth and the overall contribution margin to the company, 57% of the company is in the Advance and Accelerate, 28% is in the Critical Core, and you see the balance. Our portfolio and our strategic bets, our investments are acting and behaving exactly like we would want them to. You see our Advanced and Accelerate, the black line going in the lower right-hand side of this chart, is going across -- that represents company average. You can see our Advanced and Accelerate growing greater than company average and Critical Core and the balance falling right in line as well. What is important in the messaging is within the second quarter, we grew -- from first quarter to second quarter, we had a 7% sequential increase and year-over-year 2.6%. That's pretty important because that's a pre-COVID type of a moment. So that's November, December and January for us. Sequentially is an important number because first quarter to second quarter in Donaldson Company always sees a bit of a decline, just a slight decline. And this time, we were up year-over-year by 7%. So really strong comeback. Additionally, in China, you see we're up 70%. We are winning share in China in our Engine-based businesses. We are winning with proprietary based products, and we have a nice uplift there as well as in our Industrial Air Filtration business, where we're up 27%. And IFS is a conglomerate of multiple businesses, but both the Engine and the Industrial side in China has shown nice lift. We expanded -- we're very proud to expand our gross margin by 30 basis points to overall 34%. A level we told you that we were working on our gross margin expansion within the last year. We continue on that journey. We will continue it looking forward. But we're very pleased with the opportunities and the numbers that we've been putting up. We did restructure in the quarter. And you can see the numbers there, $14.8 million. We expect $8 million return, if you will, on an annual basis starting next fiscal year. But what we did has nothing to do with COVID. In fact, going into COVID, we played the long game. We told all of you, and we told our employee base that we're playing this for the long game. We did not have COVID based restructuring. We did have end market-based restructuring. The one example here that might -- you could argue, might be touching that is the Aerospace business. Aerospace is clearly affected by COVID. We would not have restructured that, but that has a longer-term comeback, maybe another couple of years before it reaches that. So we did do some things that we were looking to do anyway, and we did trim and realign the Aerospace business. The other restructuring items, frankly, were things we wanted to do to drive efficiency into the organization, and we were going to do them anyway. And so those are -- that's an important point that we have here. And then just a quick note on the share repurchase. We are at 0.7%. We did guide that we would do a share repurchase of 1% to 2% somewhere between their within the fiscal year. What I want to talk about on share repurchasing is that we are a consistent story. We buy 1%, which offsets the overall dilution on an annual basis. We have been averaging 2%, so that's a net minus 1%, but we do say that we will offset dilution, and we'll buy back the 1%. Go ahead next, Charlie. So within the last release, in F '21, you can see our guidance here. We say that the company will be up between 5% and 8%, which is a 6.5% midpoint. That was, frankly, received very well and a surprise to many people. We feel very comfortable with that number with the way the overall markets are returning. The U.S. is clearly coming back faster than other end markets at this point in time. You can see our Engine-based business at midpoint would be up 10%, and our Industrial-based businesses, which had headwinds coming into the quarter, now look to be able to get back to overall flat for the year. So that's a very positive outlook. We're very happy with that. And we see that across our factories today. Our overall margin is expected to increase 80 basis points over fiscal '20. You can see the midpoint to be at 14%. And our -- you can see our adjusted EPS, which would be up 11% on the expansion over the prior year. And then just some typical model building notes there at the end. Again, we're really pleased with where the company is at the moment. We are seeing lift across our end markets, therefore, we did reinstate guidance. We do have a more comfortable outlook here as we march toward the end of our fiscal year on July 31. So with that, I would open it for questions and toss it to you, David.

Thank you. Thank you for that overview. Maybe the first one, you did highlight China, very strong growth. I think you said 70%, which is very impressive. How much of that is more of a cyclical recovery as the Chinese economy comes back from COVID? And how much of that is structural for Donaldson with your new program wins or market share?

Yes. So the interesting thing for our company is that we've had low share in China, and we really have been targeting China for about the last 5 years. Our low share says that it was low single digits, which clearly represents that underrepresented piece and that opportunity for our company. So really, this is all share gain for us. Yes, the overall economy came back in China, but Donaldson had won those vehicle platforms prior to COVID and even during COVID and now as industrial -- as that production rate hits, we're able to ramp up and be there for those customers. So it's nice their economy came back, but this is a share gain for us.

And just for comparison, what would you say if you're currently low single-digit in China, your market share more globally? Or what's a more representative number?

Yes. So if you just look at China, we're probably low to mid-single digits in China. So we still have quite a bit of runway. But it's very, very different in the other parts of the world. I'll just say that we're very mature with strong shares in the United States. I would say, we have a growing maturity in Western Europe with good share in Western Europe. I would say we're very immature across Asia Pacific. So we have good opportunities led by our opportunity in China. And I'd say that we're growing up, say, maybe past adolescence in Latin America and doing better.

Did want to touch on something else that you mentioned in your remarks on aerospace. I think this is a pretty small piece of your overall revenue, maybe 1 or 2 points. But a lot of companies have very high margins in the commercial aerospace business given the regulations and everything. Has this been an outsized drag on your profitability? And would you expect similarly recovery that you would see outsized margin benefit from that?

Yes, sure. So clearly, the way aerospace reacted, with everything that's taking place in the industry is that it cycled down, it was very acute. And so consequently, absolutely dragged on our overall operating profits. And we had to do something. We had to do something to the point of -- that business essentially went down by 50% in a matter of weeks. And so we -- while we didn't panic, we also had to wait and take a measured approach to say when is it going to come back. Now clearly, it's not going to come back for quite some time. And so therefore, we restructured to meet where we're at. It does have above company average overall operating margin. And so -- but when businesses go down by 50%, clearly, that was a headwind to our bottom line. We do look, in the short-term, to get that back. Not all the way back. We'll need a little bit more volume to do that given our factories and some of the alignment projects we'll have. But we will be above company average margin, just not as high as it used to be. And we'll look for that to come back here in the next couple of years.

Got it. Has the COVID downturn made you think any differently about your manufacturing locations and your own supply chain? It sounds like you have a very broad global presence. And also just the topic de jure have you seen any disruptions in your supply chain as many other companies have?

Yes. So two-pronged question there. So first in the Donaldson supply chain, and how we supply our customers, actually, I think it really validated our strategy, which is region to support region and build within there with our 46 manufacturing plants. So we go into a region, we get a presence with enough volume, then we'll build the manufacturing plant, and we'll stay close to our customers in order to be able to service them. As COVID broke out, that allowed us a strategic advantage over our competitors because we were already global, and we continued to supply within the region to support region. And so I think it really validated the decades work that we have been doing and our overall strategy. So that came out very nice. As we come out of COVID, however, the overall supply chain, I would tell you that they're more pressured to meet the uptick than Donaldson Company is. And so we are having some input supply chain challenges. And the weather event in Texas that shut down all the oil refineries, people think of that as -- people think about that as the energy sector. But the reality is that, that also creates a number of chemicals that go into other products across the supply chain where those plants got shut down. And so we'll have some headwinds there to deal with. And we're working through those supply chain challenges. So we'll look to renormalize that. I would say our suppliers, as a result of everything have gone -- are having a bit more difficult time than Donaldson Company is as being a supplier to ROEs.

Got it. And then you mentioned you had a very measured response through the COVID downturn. You have taken the first $15 million restructuring charge. Did the downturn give you a new perspective on some of the opportunities to reduce fixed costs? Are there some things that you're considering going forward? Or is kind of the plan that you announced last quarter kind of represent that?

Yes. It's important to understand that we went into this mini recession, if you will, very different than the prior. The prior recessions, we always restructured, and we were very aggressive about it. And this time, we told the employee base as well with all of you, we are not restructuring because this is a short term net effect, and we're going to play the long game. So now as you look forward, what we've learned is some of the things that we were doing in order to support the business, you likely don't have to do that. So we clearly have been challenging what the proper balance of work from home and work from office is. We have canceled 21% of all our outstanding lease buildings -- leases that we had in order to save cash looking forward. We are working at work-from-home model. So there'll be some positions where there'll be a balance. There will likely be very, very few positions where you can be 100% work from home. But certainly, we will allow people to now have 1 or 2 days a week work from home. And so we are shedding some of those costs quickly as we look forward. So little things like that we have taken into account. The big one, of course, is travel and entertainment. Yes, we moved an entire manufacturing line to a foreign country, and we put -- we stood that up entirely through video, and we've never done that before. It'd be teams of people on airplanes going down there to make sure that, that happens in a positive way. You can't always do that. This line, we could do that. You can't do that with every manufacturing line. But it does beg the question of why are we spending what we're spending on travel and entertainment? Salespeople have to sell, okay? That will even happen a little bit differently. So we are challenging ourselves on the travel and entertainment type of models. And so we'll be very honest with ourselves about those type of applications going forward, where we'll look in our next budgeting cycle, which we actually begin in about 60 days. So we'll look in our next budgeting cycle to challenge ourselves to hold those opportunities down to reinvest that money then into things where they're more customer facing, where it can help us grow.

And that's a good segue into an area where you are investing more, which is research and development. You've invested in building a new material research center. I'm just kind of curious. Within that growing R&D budget, are you directing the additional dollars to new markets, something like life sciences? Or is it a little bit more broader investment in some of your core markets as well?

Yes. It's definitely a few Pareto it, it would be heavier toward the life sciences and then into some of the broad-based fundamental filtration technology needs. So the thing -- that I think the mistake people make in a filtration company is they go always top down. They look at an end market and then they said, "Well, are you investing in creating cool things for that end market. And then if so, what are they?" And with filtration, it doesn't really work that way. With filtration, you have to have overall fibers and those fibers are some type of methodology to create some media. And so what you want is a consistent poor structure for the particular application, be it in life sciences or Engine or even in Industrial. And so there's basic filtration principles that we were excellent at some of the media. So we're world-class in glass-based media. We're world-class in cellular space medias. We're world-class in pre and post Street than polymer based solutions within those. But polymers stand-alone and the methodology you can manufacture polymer based solutions, we were a solid B to B-plus. And so we're looking at taking that and which helps you get into the life sciences piece and really upping our game to an A-plus, but that also then plays back into many of the other end markets. So definitely a Pareto heavier toward the life science but also fundamental filtration capabilities, which then go across all the end markets that we play.

I do you have a question from the audience. What's causing the more muted expected growth in the Industrial segment?

Yes. That's an interesting 1 for us because coming out of recessions, we would tell you that Donaldson Company, within its portfolio, always sees the Engine Aftermarket piece come out first. Then we would tell you that it's the Industrial Aftermarket and then it would be the Engine OE, and then it would be the Industrial CapEx. But this time, it's been Engine Aftermarket, Engine OE, Industrial Aftermarket and then Industrial OE. So what's happened is, across the industrial basis, people were just being very careful with their balance sheet. And they were taking things that -- if it breaks, fix it, and they would -- we would see that kind of business. I would tell you, we progressed to, if it breaks, replace it. So now we're clearly in that cycle, and we see that lift across our Industrial businesses. We are now starting to see the beginnings of the next cycle, which, yes, you're -- if it breaks, replace it, but also, "Hey, let's expand our capacity and invest." And so when those 2 things happen and you get into that type of a characteristic, then you start to really see a nice step-up across our Industrial businesses. I would tell you also now, within the last 60 days, we would say that the quote to order cycle within our industrial businesses has started to compress just by a matter of days. So it's early innings on that. But you are seeing people now being a bit more open with investments and less protective of cash in the balance sheet. So I would expect that cycle to start picking up here as we look forward.

Got it. And then when you look at some of the market share gains that you've gotten over the years, how much of that is coming from new product introduction versus better execution on sales model? I don't know if you publicly gave out sort of vitality index and how has that trended over the last few years?

Yes. We haven't really talked about that type of a metric. But the one that we do share is that the way we've changed our overall technology in our model is, if you look back 10 years ago, if you had a solution and you were a customer that needed a solution you came to us, we would probably, 20% to 30% of the time, be offering you a proprietary solution. And now we're more like 70% to 80% of the time. So why isn't it 100? Because still, there are some economies in the world that go for commoditized solutions, go for cheap, down and dirty. And so we want to be there for the customers. But clearly, we are up in that 70%, 80%, and at times, in certain markets, we'll be 95% or so. So the behavior of winning with proprietary technology has really accelerated here within the last 5 to 7 years.

We do have another question coming in. Stay with me one second.

Charlie, we can hear all your paper movements.

Sorry, Tod.

Go ahead, Dave.

Sure. What about the transition to electric vehicles and off-road over time? How much of a threat or opportunity could that be?

Yes. So it's pretty interesting. So first, I want to remind everyone that we sell 0 revenue in the passenger cars, right? So that's the clearest threat for electric vehicles coming online. And the reason it is, frankly, because it's easy to move people. That's the reason why electric vehicles can and batteries can win in buses. But when you talk about alternative energies in the markets that we play, construction, agriculture and mining as well as over-the-road trucks, the return to base vehicles like waste refuge, things like that, they could go batteries. But the energy density within batteries is not there to be able to do large combines and long-haul trucks at this point in time. You see that being played out in the market, Elon Musk arguing with Bill Gates, right? So Elon is a little bit at stake with electric vehicles and Bill Gates is more of the environmentalist, and he talked about energy density as well. And the calculations are true. At some point in time, it used to be -- natural gas was going to be the winner, then it became batteries. But more importantly, now there is an energy density solution that is being talked about more frequently, and that's hydrogen. And within the hydrogen-based solutions that we're working with customers on, there are many, many conversations going on. Nobody has announced the new platforms. They still have years ahead. But no matter what the winner is, think about the millions and millions of vehicles that are out there. They all have to have an end-of-life event. When they have an end-of-life event, then the new vehicle will be bought, and that takes market opportunities away from us. So that's going to take a long, long time, some have said decades to be able to have that churn, decades once they start to introduce the new solution, if you will. At Donaldson, we are really happy to be working with the hydrogen-based solutions because if you think about the air intake for a diesel engine, it needs clean air. But a hydrogen-based solution, which, when you go across that, you need to take the chemicals out and you need to take a particulate out, so you need pristine air. And Donaldson really is -- really exceptional at those type of air challenges, or, in this case, gas challenges. And so we're ready to be in that solution conversation, and we're talking with all of our typical customer base and helping them with their -- really create their solutions.

Got it. And then maybe we could talk about sort of your appetite for further acquisitions. I think your leverage right now, net debt-to-EBITDA is 0.7%, below kind of 1x target that, I think, you've put out there. How aggressive -- or how full is the M&A pipeline? And how aggressively are you thinking around areas that you have a defined interest in like life sciences?

Yes. So we continue to work the pipeline as we have always defined it. We're still very happy with our opportunities there continue to work that. They're very strategic. But I want to point out that within the last 3, 4, 5 months, we have added a couple of people to our organization. So Dave Wood joined Donaldson Company, and he's the Vice President of Life Sciences, New Business Development. So Dave gets up every day to look into the life sciences sector and look into acquisitions. So why Dave? Dave actually is a PhD, immunization oncologist who, as a practicing physician then backed out and said, "I really like the financial worlds better and started to do M&A within the space for the last decade." So he's very familiar with the space. He knows the technologies. And so Dave now leads that portion of our company. And we've teamed Dave with a gentleman by the name of Cory Padesky. Cory is our Global Strategy Lead for Life Sciences, and he joins us from 3M where he had the same position. So we now have 2 people focused every day to get up and buy companies in the life sciences sector. We have the balance sheet to do it. We have the powder to do it. Given the cycle that it appears the company is on, where we're seeing lift coming out of COVID, we should be able to generate the cash to do it. We already have a strong balance sheet. And so now we add these 2 gentlemen to our team. And say, let's continue to build out that third leg, both organically with what we have going on in the company today, but also inorganically, and that's what they're doing.

Got it. Sounds good. I did have another question come in from the audience. What is the content per vehicle for your applications for diesel, hydrogen and electric? I assume there are...

Yes. So if you just take and let's just baseline things, right? If you talk about everything and say the diesel engine is $100 of content, it's more than that dependent upon the engine, but let's just to get a real number. If it's $100 there, the battery or solution would, frankly, be 0 because a battery just needs separators. We do, do the material separators in what we call expanded polytetrafluoroethylene. So we do the battery separations, et cetera. But so it might go from $100 to $1, okay, if it goes to batteries. But if it goes to -- from what it currently is in diesel engines over to hydrogen, for example, what you lose is you lose the overall lubrication filter off the engine, so engine oil, which, frankly, is no great loss to us because it's a commoditized filter. We're in it just as a -- to be a one-stop shop for our customers. So that goes away. And then the other one is the fuel piece goes away. So the 2 liquid -- but all other applications, such as the hydraulics as well as the air intake increase. And the air -- or stay, but the air actually increases because of the chemical absorption natures, and it gets a little bit difficult. So that's the reason why you lose some of the commoditized pieces. You probably go from about $100 to maybe $60 to $70 with all the applications. Some of that is still being figured out depending upon the overall fuel cell-based design because some of these designs that are out there want to remove some certain chemicals from the air versus other OEs designs. And so that could flow even higher to more than $70 or $80, but that's a little bit of work that's still ahead of us. But that's kind of the relationship of the 3. Hopefully, that answers the question well enough for you.

Yes. And then one other one. Does this mean that Donaldson is already working on hydrogen for solutions and other applications such as trains?

So what's interesting about the contracts that we have is, I would tell you, if you just focus on our current markets, which are construction, agriculture, mining, over-the-road trucks, that's where the majority of our energy is. There are certain niche markets that sure we have conversations with. But the overall solutions of what comes out within fuel cells are going to be out of those core-based markets. It's not going to be out of a locomotive or things like that because those are those are one-off -- there's not a lot of trains manufactured and bought on an annual basis. But the technical challenge is just all the same, right? So how big is it going to be the fuel cell? And what kind of pristine air do you need? We do have business on trains. We currently have filters on trains, but I would tell you that if you look for the overall next step or the breakthrough in the technology, look to those other markets.

Got it. So we want to be mindful of time. I think we're at the end of our scheduled time. So thank you, Tod, Scott, Charlie. Thank you, again.

Thanks, everyone, for your interest in Donaldson. All the best. Bye.

Take care.