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

Good morning, everyone. I'm Nathan Jones. I'm the covering analyst at Stifel for Donaldson. We're very glad to have CFO, Scott Robinson; and former peer and competitor and now in IR at Donaldson, Charley Brady with us today. Before we get started, a couple of housekeeping items. I'm going back to the bull case/bear case format this year. We abandoned that last year because of that singular focus on COVID. I'm going to present 3 bear cases and then 3 bull cases. Scott's going to have the opportunity to respond, and then we'll dig into each topic with questions. Feel free to send your questions on any of the topics through the chatbox on the conference portal. I welcome questions from investors, which I'm sure would be much smarter than any of the questions I'll ask. So please do ask questions if you have any.

With that, let's begin on the bear cases. First one here, electrification of vehicles is going to drive diesel engines out of the market and create secular headwinds for the engine business driving a declining revenue base in the long run.

All right. Well, hello, everyone. This is Scott Robinson here, coming to you live from beautiful Bloomington, Minnesota. So I'm sorry, I couldn't be with you all today. But hopefully, this video experience will go well. So in regards to the first case, which is electrification, certainly, that's something we are -- we hear about a fair amount, and we spend quite a bit of time studying electrification. We have a couple of folks in our engine business who spend quite a bit of time studying future power generation ideas, and certainly electrification is one of them. We often talk to our larger OEs and have had some of them into our Board of Directors to talk about their plans for future power generation. And certainly, electrification is something that the company needs to be cognizant of and is certainly gaining traction, especially with consumer -- with automobiles. And just to be clear, in terms of automobile engines, Donaldson does not have any product, any filtration on your typical passenger vehicle. So that's clearly where it's starting. And we think about that, moving forward, there's certainly a lot of debate about what will win. There is certainly electrification; there's hybrid vehicles, which is batteries combined with an engine; there is hydrogen fuel cells, which we are seeing a lot more interest in recently; and there's also e-fuels, which is a combination of hydrogen and CO2, to create some sort of methanol synthesis, which creates a carbon-free gasoline, which is gaining traction, especially in Germany at this point. So in terms of electrification, certainly, it's happening in passenger cars. And we believe it will move to lighter-duty vehicles such as your garbage trucks that come through your neighborhood, or your city buses, or things that run a pretty specific route and have a return to base approach where they can be recharged every night or twice a day as needed. We have a pretty small exposure to medium-duty, say, 4% to 6% of our total first-fit and aftermarket sales, and we could see that gaining traction. When it comes to heavy-duty, there's still a lot of debate about heavy-duty equipment in long-haul trucks and can electrification really sustain in those applications. And that's certainly something one can debate. We feel like the engine business has quite a long run in front of it. It's doing quite well. And keep in mind that we work with our large OE customers on their new platforms. And we want to be involved with those platforms in the beginning to understand their needs and help make sure we have solutions that they're interested in selecting. And so we'll see and understand when they're switching their powertrains. I think, personally, it has a long, long ways to go decades. And I also think some of these other things, hybrid solutions have been around for decades already. The largest mine haul trucks have been hybrid for years in that they have a large diesel power generator in the middle, powering four electric wheels. So that's certainly something that is in existence, and I think will continue to be. And the market is out. We have a position that electrification is a long ways off. And certainly, you're open to your own opinion. And the other thing I would add is that fuel cells are becoming with our customers more and more available and being studied harder, and I think also being invested in. So I think hydrogen fuel cells is certainly a viable option. We have a hydrogen fuel cell. It's different than a combustion engine. In terms of filtration, the air filtration on a hydrogen fuel cell becomes much more stringent and technical and more along the lines of our disk drive filters. So the air that you need going into a hydrogen fuel cell is really pristine air, we would say versus an engine needs clean air. And so that would actually be an increase. The offset would be the liquid filtration would go away on a hydrogen fuel cell. So our engine business, I think, has a very long runway. We continue to invest more heavily in our industrial and life sciences applications because we want to continue to leverage the company's technology as we've been doing for 106 years away from engine and to add -- continue to add additional product lines and additional revenue opportunities for the company. So we're going to continue to optimize the profits in the engine business for the long term and invest as many of those profits we can in new generate -- new revenue-generating opportunities. So that's kind of a synopsis of how we feel about the electrification. Certainly, we're not afraid of electrification, and it's something both the company and its investors need to understand.

Maybe one quick follow-up on that. Investors are always worried that electrification is going to drive diesel engines out of the market tomorrow or a couple of years from now. You mentioned working on platforms with OEMs. When you're in the -- when they're in the development stage and talking to Donaldson about those, what's that typical lifespan of that engine as an OEM product?

Sure. So I mean that's -- one thing that will give us great visibility is the life cycle development. So I mean if you're starting today as a big OE, a new platform, I mean, that's years in development. It could be 2, 3, 4, 5 years of development work that's happened. And one of the things we've seen with COVID is I think the programs have been stretched out. And so people have slowed down their development and kind of really focused on what they have with all the issues that have come up with COVID and supply chain. And the programs that we were working on, I would say, for the most part, have been stretched out. But when you have a new program coming, that can be, as I said, several years in the making. And then production starts with the first vehicle. And that production can last years where they run that category of tractors, or whatever piece of equipment they're building. And then once the production stops, you still have the aftermarket where those pieces of equipment are out in the world, and many have several different owners as they move through the product's life cycle. So it can easily be 20 years from when a piece of equipment is for start off of until its end -- its retirement. So you have a very long case and revenue stream that you're going after, and we want to win those revenue streams with proprietary Donaldson filtration technology to help secure that revenue stream over the life cycle of that product.

Speaking of proprietary, let's go onto the next one. Filtration products have limited differentiation, as evidenced by the number of copycat producers that are in the aftermarket. It isn't possible to create real moats around the aftermarket business as intellectual property lacks real protection.

Yes. So I mean that's something that we -- our engine business is quite focused in the company for that matter as we want to develop our core filtration science, we want to protect that science via patents, via trade secrets and via our production methods, and we want to sell proprietary products. And the company's engine business is split into the OE business and the aftermarket business. And to Nathan's point, certainly, there have been successful -- some successful companies, one in particular, that only sold aftermarket products and didn't invest in really new technology. It was focused on delivering aftermarket products and having a full product line. And Donaldson does that as well. But our OE business wants to create proprietary solutions. As OEs have become more interested in their parts business, we want to sell them proprietary products that guarantees, for the most part, the aftermarket business for both them and for us. And we tell them, if you take a proprietary product, we're not going to release a cross-reference in our independent business and compete against you, we'll only sell that product for you. Donaldson has invented PowerCore, as an example, many, many years ago. And we're in on our fourth generation of PowerCore. And to this date, there really hasn't been anyone who's been able to get around the technology moat and sell replacement filters for that. So we keep reinventing ourselves. And I would submit, we've been able to retain a very high market share of our proprietary products based on our portfolio of patent protection and our other methods to secure those products. And our proprietary -- our PowerCore products have always grown faster than our overall business, which means that the proprietary products are slowly gaining market share. And we believe that will continue over time. And we'll get to China here later, but I'll talk a bit more about China and the opportunities there for proprietary products as we get further into the presentation. And we've done this with many things with our iQ with some of our new dust collection products. So we put that strategy throughout the company, not just in the engine business, and I believe it helps secure Donaldson's long-term future and really optimize the total profits that we get out of one particular product line. So I think we have a good history of doing that, and I think we'll continue to do so.

Maybe just for those who are not aware of the change in market share from proprietary or from nonproprietary to proprietary in the aftermarket. Maybe you could just briefly talk about the elongation of high market share for proprietary products versus nonproprietary?

Yes. If you go -- if you -- I mean if you go back to our Investor Day presentation, there's I can -- I have it right here in front of me, I can see that, but there's actually a slide in there that shows the market retention for proprietary versus nonproprietary products. And what you'll see, and I can explain it very easily, is that if you look at the proprietary products, we maintain a very strong curve, above 90% throughout the life of those products. And with the nonproprietary product, after 3 or 4 years as the number of pieces of equipment for that particular filter have increased, that's when the copycats will come in. And we do the same thing to other people's filters if they're nonproprietary. And the market share will drop considerably because there'll be enough pieces of equipment in the world for other filtration companies to make the investment to tool up those products and cross-reference the product and have an available filter for that particular piece of equipment. So you'll see the retention curves on a proprietary product stay very high, nearly 100% over a very long period of time. And you'll see the nonproprietary products that will start at 100%, but then 3 or 4 years in, you'll see that come down to 30%, 40% as other suppliers kind of jump into that particular game. And so I think that's good evidence of our ability to leverage our proprietary products and protect those products for both us and the OE who selected that product.

I'll jump onto the third one. Segment margins have been in a narrow band in the range of 13% to 15% for most of the last decade. With margins approaching the top end of the range in fiscal 2021, there's not much further upside to margins, particularly in the current highly inflationary environment as pricing is hard to get in the OEM channel.

Certainly, the tagline that I always say is we're committed to higher levels of profitability on higher sales. So we have to continue to leverage the company up. We can do that by investing in higher-margin products that mix the company up. We can do that by growing industrial faster than engine, which is not happening now, but over the longer term, which has higher margins. We can continue to do that by leveraging the company, leveraging our OpEx, leveraging our production facilities and managing the profitability of the business. So the current midpoint of our guidance is 14%. As Nathan pointed out on our last call, why is that the way it is, well, we certainly, along with everyone else, are experiencing headwinds from raw material input increases that we're experiencing right now. The longer-term targets is to continue to improve that. We had a 15% goal in the Investor Day from 2019. We pushed that guidance away, but we still feel like that profitability target is reasonable for the company. And I believe for the next few years, we can continue to increase our margins, and we'll do so with increasing volumes and the other things I just mentioned. And so it's not easy. It's hard to get pricing with OEs, but we continue to work our fast price relationship and make sure we're managing that appropriately. And we continue to invest in high-margin opportunities that will mix the company up over time. So we feel like we have to continue to do that. And we feel like there's enough dollars to invest in growth opportunities, while still leveraging the P&L with the operating margin increasing over time. So yes, Nathan is correct when he says we've been in a range of 13% to 15% for the last decade, but we're committed to continuing to grow that and we've been working hard to invest to allow those opportunities for the company to increase its margins. So I think it's possible. I think we're going to continue to push for that. We're going through our planning process right now, which is pretty dynamic in light of everything that's going on. But I feel like there's opportunity. We said we expect our margins for the back half of this year to continue to increase, and we would expect that they would increase for next year. So that's something we're working hard on, and we're looking forward to having the opportunity to prove that to you.

When you guys set goals in 2018 for the margin level, I mean, obviously, there's 2 really big things that have changed there. One is volume due to COVID. And the other one is the raw material price inputs that you've got into the business. Outside of those, internally with all the initiatives that you guys have, have all of those initiatives been implemented? Are they performing the way that you would have expected them to perform? And outside of the volume and price or cost inputs that you've got here, would there have been any reason why you wouldn't have achieved those goals?

Yes. So I mean, COVID kind of threw a wrench in everything, but we continue to, I would say, take a prudent investment approach. And we have many different things that we've invested in e-commerce, our iQ connectivity, our engine connectivity, venting solutions, process filtration and several others where we're making bets. And we try to expect a reasonable growth curve. And I would say those bets are kind of slow and steady winning the race. And so we're not going to expect something to grow from 0 to 200 million in a year, but we are going to expect it to grow. And I think process filtration is one of our best examples. I mean you probably heard Tod say this many times, Nathan, but we've taken that sales forward over several years from 0 to 120. And we built the business with process filtration, which is our LifeTec filters in the food and beverage market. And I think that's a good example of a slow and steady strong growth with higher-than-average margins. And so as that gets scale and grows bigger, that will help mix the company up. And we're doing that with Venting Solutions, and I think we've had good success in e-com and some of the other initiatives that we've worked on. And we're going to continue to try to carve out as many expense dollars as we can to put behind those initiatives, while continuing to grow the company's profitability. So we have to manage the calculus on the P&L, but I feel like as we grow revenues, there's enough dollars to leverage the P&L and invest in our growth opportunities, and that's why Tod and myself are really focused on our expense management because we want to run the company as efficiently as possible and therefore, allow dollars to be put on growth initiatives and continue to grow the profitable opportunities, while increasing our profitability and increasing sales.

Nate, I would just add to that point that a few years ago, we put in an Oracle system across the firm. And we've got a significantly greater granularity on where we're spending money -- where we should be spending money. And I think a lot of these operational improvements and the expense takeouts that we're doing do get a little bit masked by some of the external factors, like pricing and freight, things like that. So you don't necessarily see the full benefit of that because it gets kind of buried under the noise, but our ability to really target expense reduction internally is significantly better than it's been if you look over the past decade or so.

We'll go on to the good ones now. Speaking of China, China is a long-term, very large opportunity for Donaldson to penetrate. Historically, the market has used lower technology products where Donaldson doesn't really participate. But with the shift of Chinese OEMs to exporting to Western markets and requiring Western technology, the market is really coming to Donaldson, which creates a lot of growth opportunities.

Yes. So I mean we're -- as I mentioned earlier, we're very excited about China, and then I think India coming behind China. But Donaldson has been in China for decades. So we have 4 factories there. We're building a new line there to support some of our engine products. We're headquartered in Shanghai. Our operations are in Wuxi, which is about 1.5 hour, 2-hour drive from Shanghai. And so we have very good relations with the local community, the long-term employer, and we feel like we're well positioned in China. And we've been there supporting our Western OEs. As they moved to China, they wanted us to be there, and we built a good business operation. That's our headquarters for our Asia businesses located in Shanghai. And what we're seeing is China has really come a long way in their production and is interested in kind of competing in the world markets with their equipment, and they build a significant amount of the world's equipment. And as they're interested in increasing their standards in exporting, that provides a great opportunity for Donaldson to be there with our technology. And so I would say, 10 years ago, they weren't really interested in our technology. In the last several years, they've been interested in our technology, and we've been winning programs with large OEs and engine producers in China, and they're interested in proprietary solutions because, again, they want to compete. And so we've gone to win programs. We've been increasing our market share, and we have still a small market share in China. And we think as those programs mature and more programs come to light, we'll have great opportunities to be a supplier of choice. And so I think China is a very long-term opportunity for the company. And I think we're going to win in China. I think we're well positioned. And I think that's going to give us revenue growth there for a long, long time to come. China is currently, kind of bounces around 7% to 8% of the company's revenues. And I think that will increase significantly over time as the growth in China outpaces the rest of the company's growth based on new programs. When the programs kind of have some fits and starts, we have to make sure I tell Andy Dahlgren, our leader of our Asia business, that we only want to have profitable growth. So we have to be confident in the profitability we're taking out with new programs, and we don't want to win programs at lousy margins. And so we have to be smart about our margins and the revenues we're going to take on because there's plenty of business there for us and we want to grow profitably. And that's really the mission for China. And I'm optimistic about our opportunities over the next decades.

If you look at all the dynamics of the Chinese market, can you maybe comment on where your market share in China is now? And over the long term, maybe 10, 20 years in the future, what you think your entitlement is in terms of market share?

Yes. So I would say it'd be in the single digits, so less than 10% of the market right now and growing. And when you think that China produces, it depends on the year, but 1/3 to maybe more of the world's equipment, there is a massive market there. And every time we win a program, that just layers into Donaldson. So we should be able to slowly achieve market growth there. Year-over-year, as new programs are awarded, and I think we have a long, long runway, in these programs, like I said earlier, a program can be 10, 20 years, right? So when you win one, especially if it's proprietary products, that's a long stream of revenue you get. And so I think it can be a significant portion of Donaldson as we go forward.

Okay. Onto the next one. Donaldson is the clear leader in this space from a product development and technology perspective and has long-standing deep customer relationships with OEMs. This creates a significant moat around the OEM business that competitors will find difficult to penetrate.

Yes. So I mean we talked about that a bit already. But I think we have over like 1,400 U.S. patents. So the company continues to work on its core filtration technologies. We have just invested last few years in new materials research center, which is just to the north of the building I sit in on our campus here. That's coming up to speed, and I think that provides great opportunities for the company. So Donaldson is probably the only diversified filtration company, at least from a public perspective left in the world. And we really have the ability to leverage our technology. So we have many good competitors. But generally, we compete with our competitors on an individual product line, either an engine or industrial or in the different applications we have. And Donaldson has been around for 106 years, leveraging its technology. So we started in a field in Utah, where Frank Donaldson invented an air filter for a tractor. And we have been leveraging our technology into different products ever since. And we continue to do that today. And that's how we get into things like disk drive filters, or ostomy bag filters, or venting solutions. So these are technologies that we've developed that we see as giving us a great opportunity to move into a market. So we don't necessarily think about what products we have -- we want to have. We think about what technologies do we have and where can we leverage those into existing products. And as I mentioned, the disk drive technology, I think, will help us really, really well here in the fuel cell technologies, right? So if you weren't into disk drives, you're at a disadvantage on fuel cells because it's a very similar technology that will be in play there. And so Donaldson continues to expand its core science and leverage that, and that's how we got into food and beverage with LifeTec. That was some learnings that had happened years ago and that was pressed forward. And so that's how the company will continue to thrive over the long term. It's really a technology-led filtration company. And we have to continue to build on that science to make sure we can continue to bring new products into the future. And that's what the new materials research center is all about. That was a $15 million investment that is now complete. The facility is done, and the employees are in there, fine-tuning the machinery. So we're excited about the next stage of our research and development. And our R&D team does a great job. We have many long-term engineers that really understand filtration and come to work every day excited about coming up with the next great thing. So that's the life brand of the company, and I think we have great opportunities to go forward. We said we want to increase our spend in R&D, and we'll continue to do so.

Thanks, Scott. In the interest of time, I'll jump on to the last one. The balance sheet is in very strong condition, with net debt just 0.7x at the end of the third quarter, which you can use to accelerate Donaldson's strategic move into process filtration markets and diversifying end market exposure and continuing to mix revenue away from the engine business.

Yes. So I mean, we pride ourselves on a strong balance sheet. We've been able to maintain that. Our net debt-to-EBITDA ratio is around 1. So we're a little bit under that right now. We've had extremely strong cash flows this year with very good cash conversion. So the cash flows of the company are strong and have allowed us to pay a dividend for 65 years and increase that dividend for over 20 years. So we're proud of our history there and certainly a 20-year -- 20-plus year of dividend increases is not something that I want to be the guy to mess up. So we want to maintain that balance sheet. It does give us powder to invest if we see opportunities. And as Tod has said, we're looking for opportunities to invest both organically and inorganically. So we feel like our balance sheet is in a good position to continue to diversify and strengthen the company, and we look for opportunities to do so. And in the interest of time, I think I'll stop there.

Just I'll do follow-up question on that. I know you guys have brought in some resources to look at life sciences markets. Can you talk about when it comes to inorganic growth, where the focus is? And how we should expect you to proceed there?

Yes. So we brought in Dave Wood and Cory Padesky , 2 very strong individuals that I think are doing an excellent job screening opportunities, and that's something they come to work here every day, really focused on life sciences. And they are focused on understanding our pipeline and determining where the best options are for Donaldson. So we've said for a couple of years now, we're moving our strategic pinwheel. And we've added some resources to help with that and improve our expertise in that regard. And we continue to work the pipeline. And as soon as we have something that we can complete, we'll let you know right away.

Great. Well, I see we're up on time. So Scott, Charley, thanks very much for your time today. We appreciate it, and thanks to everybody on the line who joined us.

Thanks, everybody, and I wish you well. Take care.

Thanks.