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

Great. Good afternoon, everyone. My name is Dillon Cumming. I'm with the machinery team here at Morgan Stanley, covering the space together with Courtney Yakavonis. We're going to keep things moving along here with Donaldson, which is a worldwide manufacturer and global leader in filtration systems and replacement parts across a wide variety of industrial end markets. But before we begin, I'm going to read one quick disclaimer. For important disclosures, please see the Morgan Stanley research disclosure website at www.morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative. So with that out of the way, I'm very pleased to have with me here today Tod Carpenter, Chairman and CEO of the company; Scott Robinson, CFO; and Charlie Brady, who's the Director of Investor Relations. Guys, thanks for being with us today.

Thanks for having us.

Thank you.

So we'll go ahead and kick it right to Q&A. I would just encourage any investors who have any questions from the company to please submit that via the webcast browser, and I'll relay that to the team. But just to start, this is a unique kind of thing for Donaldson that you just guided a couple of weeks ago, so we're lucky to have you here now. But you obviously initiated top line guidance for fiscal '22, total sales growth of 5% to 10%. Just at a high level, if you can kind of start by taking us through what's embedded in that outlook in terms of end market growth assumptions, where you're most optimistic and then maybe more conservative about the end market level for next year?

Sure. The 2 reporting segments that we have are the Engine Products segment, where we guided a 5% to 10% range. And then our Industrial Products segment, where we are 6% to 11%, therefore, really comprising companies overall 5% to 10%. When you look at the end markets across the Engine business, they're really strong in every region of the world. And really, we would talk to you then about construction, agriculture and mining and then over-the-road trucking. The one area that in the last quarter, we saw a little bit of slowdown would be China, and that's likely to kind of bounce along here into the next quarter as well with a little bit of a slowdown. However, we offset that with some strategic gains that we've had, share gains in China. And so we'll look for China to come back here over the next couple of quarters, even if they do feel some compression on the GDP or the growth rates across China. So overall, Engine products, our end markets are doing quite well. On the Industrial sector, we would tell you that led by the U.S., we've also felt a bounce. Our largest business in the Industrial sector is industrial dust collection. So think of Industrial capacity utilization, they've expanded that all across the world, particularly in the U.S. So we're seeing a real nice bounce there. And then we've gone through the 3 cycles of CapEx where, first, it was if a system broke, you fix it. Then if a system broke, you replace it. Now we're still -- we're seeing that as well as capacity expansion. So we're getting new projects. So the quote-to-order-cycle in CapEx-based projects are -- has really compressed. You see that in the overall growth that we saw in that business and the order income that -- incoming that we have, particularly in the United States and Western Europe, is really quite strong. And so we have a lot of tailwinds really across both segments. What we also baked in the guidance is the supply chain issues that we're experiencing led by the United States. Supply chain in Asia Pacific is fine. Supply chain in Europe is a little bit choppy, but still we're able to execute and keep on driving through it. Supply chain in the United States is incredibly difficult. And by that, we mean it's led by labor-based shortages. We have pulled all the levers and continue to pull levers to try to get people on -- hired on board. In the United States, it's very difficult to do that. And then once we get past the labor-based conversations, it is really -- our 3 largest raw materials are steel, media that we make our filters out of and then petroleum-based products. It's long been a steel-based conversation for us. Steel has somewhat lightened up, although tin in the United States is under heavy demand and frankly, is undersupplied to our country. We're doing fine on media. We're doing okay across our supply base, but the new pressures that we're seeing are in petroleum-based products. And the threats of hurricane post the weather event that we had within the last year in Texas, the threat of hurricane in Texas, when the refineries go down, people think of gasoline supply to the United States, but for us, they make other chemicals than just gasoline. And those chemicals go into our urethane-based products and that puts tremendous pressure on the supply chain. Today, we are flying plastic pellets in from outside the United States into the United States to keep our factories rolling. There is a cost to that, obviously, especially with the premium freight that we're seeing. So there's pressure across the company on the gross margin and the supply chain. We are happy that Ida didn't have a dramatic effect, but we also hold our breath and November can't come quick enough to get past the hurricane season here in the United States. And so we baked all of those risks and all of those tailwinds that we are experiencing, and the tailwinds are healthy across the entire corporation. We bake that all in and therefore, we have the guidance.

Yes. No, that was a very comprehensive overview. But if I can just unpack some of the things you mentioned on the price cost side, which is where I'm guessing you're getting the most investor questions till. But you kind of alluded to the level of inflation that you're seeing across those 3 big commodity buckets, but you've also taken a significant level of price, I'd say, over the past few quarters and probably plan to over the future quarters. So just curious if you can speak to that, how that kind of plays into the price cost equation for the balance of the year as well?

Yes, maybe Scott can take that.

Yes, I'll take that one -- so yes, in the earnings release, we talked about 8% to 10% increases in commodity costs, which translates into about $80 million to $90 million of additional cost or 2% to 3% of a gross margin headwind. So we've been working ahead of that last year to raise prices wherever we can, and we're continuing to work through that through the balance of this fiscal year, which is why we indicated to you our margin start would be a little bit tougher in the first half than in the second half because it takes a while for the pricing to catch up to the cost, especially for the prices we have not yet raised. And so we're working and really focused on our gross margins this year. We said our gross margins would be hopefully flat to just slightly down and the leverage at the midpoint of our guidance of 40 basis points of operating income percentage comes from additional leverage on our OpEx because we're growing our sales much faster than we're growing our OpEx.

Yes. No, that's a very helpful overview. And maybe if you can just discuss some of the nuances between the pricing actions you've taken and the independent aftermarket distribution channel versus the OEM pricing mechanisms. I know you've been more conservative in terms of the OEM side, but you're obviously in a much more robust inflationary environment. So maybe those conversations are easier to have. But any detail you can kind of give there in terms of how you expect those OEM pricing negotiations in particular to progress through the balance of the year and into next year?

So those are obviously -- just like Donaldson, our big customers don't want to see price increases. But I think at this point in the cycle, everyone pretty much realizes that's a reality. So we're working customer by customer with the big OEs, and having our discussions with them about the cost increases we're seeing and discussing how we can pass those costs on. And that's a customer-by-customer program, and we're complete with some and still working on others. In terms of the Independent Aftermarket, that's a little bit easier, but we still have to be competitive in the market. So we can pass prices on the independent aftermarket on probably a relatively faster basis with maybe a 30, 60 or maybe a 90 delay notification period. And then those prices are really live in the market. And we just want to make sure our distributors are competitive so they can continue to push through our product. But that's a bit of an easier process, and we have to be mindful there of the market dynamics that are present with our competitors.

Maybe just add a little bit of color on that OE cycle here for you, Dillon. So this was the best, maybe the most receptive OE environment that, in my 25-year career at Donaldson Company for price increases that we've had. I would tell you we've had, if you basket them into the large multinationals and then all others, even small strategic accounts, things like that. In that smaller strategic account basket, we've had a lot of success with the OEs. We've kind of implemented and those moved on, on the large multinationals, we still have work to do there. They are receptive. They understand. It's really about negotiating and finalizing it all.

Yes. That's very helpful color. And maybe we can talk -- and one of the more positive elements of the margin story for you guys is you put a lot of capital into the capacity investments over the last cycle. If you're going to speak to how the Donaldson of today compares to the Donaldson of the past in terms of incremental capacity. You have the service, the current industrial up cycle. What you would expect the level of profitability to be for the new Donaldson? And yes, any kind of color you can give in terms of why this time is different in terms of the margin profile?

About 3 years ago, we made a strategic decision to invest back heavily into the corporation to expand capacity to regionalize where we had volume opportunities into the 3 regions. So region to support region. So we increased capacity in Asia Pacific. We increased it in Europe, Middle East, Africa and then also across the Americas. And then we looked wherever possible to regionalize that to service to review customers. And we put $300 million back into the corporation, which is above typical average run rates over -- just over a 2-year period. and we expanded our capacity aggressively. As far as I know, we're the only one in this marketplace that did that. Then COVID hit. And of course, wow, it really put pressure, the additional depreciation, et cetera. But we were playing a long game. And then now coming out of COVID, of course, we're doing quite well. So we would tell you that we got that strategic expansion really well placed. Today, it's serving us very, very well. If we didn't have supply chain problems, to be honest with you, we'd be crushing it with all of the overall capacity expansion. Now that said, I would tell you, we're going to put additional capacity expansion into the corporation this year. We've signaled that we'll do another $120 million of CapEx basically in the company approvals. And what that does is, given the growth that we have, some of those regional-based projects. And I want to remind you that the United States is still a net exporter for Donaldson Company. And so given the overall growth that we're seeing in Asia Pacific and Europe, that means we can regionalize that because those projects now make sense as investments. And so we'll continue to expand within those regions. So for example, we have one new PowerCore line in China already running. It's producing product and shipping. We'll put a second one in there this year because of the program wins that we have in China with PowerCore. And we'll continue to put liquid in Poland and so on and so forth on those. So you'll see us continue expansion. And as soon as we continue to work through these supply chain issues, we'll continue to do it well -- do well, and we would expect good growth across all regions.

Yes, it definitely makes sense. And I do want to get over to China. Just one last question on the margin side before moving on. You did kind of call out labor as a concerning kind of factor on growth and something that you're still working to overcome. I'm just curious how confident you are in reaching a resolution in terms of labor shortages over the next few months, whether or not you see that kind of mitigating or moderating, I should say, through the balance of the year? And what really is the primary holdup at this point in terms of this cycle versus last in terms of why labor availability is such an issue?

We have no labor issues over into Asia Pacific. We have no labor issues over -- across Europe, Middle East and Africa. We have no labor issues -- in fact, it's very wonderful in Mexico. And into South America, the labor issue I speak of is a singular-focused United States issue, and it is significant. Just to give you one example. There's a company close to one of our plants that went bankrupt, had 147 personnel that needed to find jobs. We were 1 of 31 companies that quickly got a work fair together. And in that work fair, we were -- basically all of those people could have had a job and 27 people showed up to that fair. So why is that happening in our country? I don't know, but where we are now, a U.S.-based exporter, that actually puts pressure on us overall to perform. So this labor base problem that we have that I speak of is truly a U.S.-based problem.

Got it. Okay. Well, let's move on to some of the more exciting stuff for Donaldson. I want to start on the new market entry side. Obviously, increased penetration of the food and beverage and Life Sciences markets are 2 key priorities for you. You've been growing the process filtration part of your business. Just maybe first starting with the food and beverage side. Can you discuss how initiatives in that market have progressed, any kind of recent product wins or factory wins and what you're kind of doing to grow that part of the business?

Yes. So if you look at when we started this initiative, first started talking about it 4 to 5 years ago, we were mid-single digits. So call it between $5 million and $10 million worth of sale. That's how we were. And then we continued to invest in this. We built out our sales team. We're over 100 sales personnel now. We've built a factory to build our products. We've expanded our product offerings, et cetera. Last year, we grew another 15%, roughly mid-teens. We would expect that to be mid-teens to low 20s next year. And that would put that business in just 5 short years to between $80 million and $90 million. And so you can see that we've really had great success pressing forward in that particular business. We would expect to continue our investments in that and get that business well over $100 million.

Got it. That is certainly encouraging. And maybe we can shift over to Life Sciences. There's been a lot of commentary, I think a much more aggressive posture from you guys in recent quarters. We're coming up on about a year now. You've made some recent personnel hires in that area. But just to start off, is that still primarily inorganic effort for you guys? Are you still planning to get more aggressive on M&A? And then related to that, I think in the past, you've expressed more of a preference for kind of a string of pearls approach versus a single shot. Is that still the right line of thinking?

Yes, thanks. So when we set the strategy about 4, 5 years ago, we knew that the entry point to the technology for the filtration technology, which is polymer-based solutions was the overall food and beverage markets. So we knew we wanted to go inorganically there to add the technology foundation to the corporation. We would then learn more and really grow muscle in that particular area. And then we would overlay that with the M&A portions. We're talking externally now about the M&A piece, but it's always been part of the playbook. We feel as though we are now to the point where we have the skill sets internal to go organic. And so we'll now look to aggressively pick up the entire Life Sciences sector through acquisition. The 2 folks that joined us, we're 8 months or so into the journey. Dave joined us roughly last January or so. Cory was a couple of months before that. And so we -- I would tell you that we're working in that particular channel on the acquisition very hard. We have a good pipeline of opportunity. They're very -- so it's very robust and it's strategic and we'll continue to work on it. And I look forward to having success there.

Yes. That's definitely good to hear. And maybe if you can just kind of dig into the implications of the company as a whole. I mean, because it is a new market for you guys, can you just speak to a little bit -- or speak a little bit about how the replacement cadence in these end markets compare to the Donaldson average and what the margin implications of growth of these revenues are over time as well?

Yes. When you add Life Sciences overall to the model, basically, it's less cyclical, for example, then you see the company go through on the Engine cycles that we experience from time to time. And so consequently, that will smooth the company out a little bit better, obviously. But also, it's higher than company average margins. And so we'll look to mix the company up through entering into these -- to primarily the whole Life Sciences sector across semiconductor, medical and then food and beverage. So both of those outcomes are really a wide entry point.

Got it. And maybe just for those who aren't as familiar with this kind of new market as well, I mean, who are you actually displacing in this competitive side? Is it your traditional competitors that you can do with on the Engine and Industrial side? Is it more nicher players? I'm just curious on who you're kind of coming up against in those regions.

Yes. So we went into food and beverage knowing that when we had to have that organic muscle as I talked about, but also because it was an easier entry point because people like Sartorius and Paul and those folks, they were headed more towards the medical, to stick with medical plays. And so it was a little left for the taking. And once we had the product families, we would aggressively go after that. And then do what Donaldson does every day, which is care for our customers, love our customers, take care of our customers. And by being there and being there every single day, we felt like we would have a good opportunity to grow and that's proven to be very true. And so those are the type of customers. Then as you pivot over to deeper into the Life Sciences and the medical sector, those are the names that you hear about. You hear about the Pauls and the Sartorius and the Millipores, those kind of names, and we would look to get into those types of spaces.

Got it. That's definitely helpful. We've got about 10 minutes left. So just want to remind the audience, if you do have any questions for the management team, feel free to submit it through the webcast browser and I'll pass it along. But maybe switching over to some broader kind of cycle questions. I think you kind of alluded to it. Sometimes the Engine segment does go through some cycles. And I think you obviously saw some exposures vis-a-vis ag, construction, mining. But just curious how you would kind of view the kind of current cycle in those 3 areas, markets in particular? Do you feel like there's a multiyear runway for those 3 areas? Are you more bullish on one versus the other? I mean kind of -- and you alluded to this in your capacity investments answer. But does -- how you're positioning the company in terms of the length of the cycle within Engine?

Yes. So when you look at Engine today, clearly, we have really high backlogs, but we also have high delinquencies due to the lack of ability to get raw materials. And so consequently, when you talk about some of the allocations, what's happening here is people are out trying to, let's say, get their inventory increase and just to rebuild the stock positions. But they're not really capable of doing that because of the raw material shortages. And it's not just Donaldson, it's all across the industry. And I would argue we're doing quite well compared to our competitors as we talk to our customer base throughout the industry, we're faring quite well. However, when you look at the fact that we can't even meet all of our customer demands, what that's saying is people are even ordering up in order to hopefully get a higher percent -- a higher quantity because 80% of, say, 200 is more than 80% of 100. And so that's the way they're thinking about it. Now will we ever get this typical stock filling of the channel? Not this calendar year. I can't see that taking place. And then if you push on top of that an infrastructure bill by the current administration that's been working on that. I think that further elongates the elongated cycle that will at least last for the next until, say, mid next summer at minimum. We can see that far, it's going to last. Then if you put an infrastructure bill on that, then this could be a multiyear, 2-, 3-year type of a cycle for sure on our Engine business. And given the programs that we have and continue to have every single day, which we track very, very tightly of what's going on across the world because winning those proprietary razors is our strategy. Knowing that we're winning that future growth suggests that over the course of the next 2 to 3 years, Donaldson is in strong position.

Yes. And maybe that's a great segue into my question on China, which you kind of alluded to in terms of the razor-razorblade model, and that it's been a big priority for you to get new platform wins in that region. PowerCore has been very well received as the OEMs in that region and move up the quality curve. So just curious, you're really seeing some good outperformance there versus the end market. You called that out last quarter, a lot of the Chinese excavator markets and truck markets are rolling over. Revenues were up. So just curious to the extent you're really seeing more material outperformance as a result of share gains, what the outlook is over the next 1 to 3 years in terms of incremental platform wins as well.

So as China continues to advance the regulations to catch up to the Western world, say, Western Europe and goes through Euro VI and Euro VII as they climb that ladder, they turn to Donaldson Company because they know we can meet those needs. And because we're local, we've had a very good presence in China for many, many years. We take PowerCore, for example, which is flagship technology and we localize that. We build it in country now and we'll build even more of that in country. The wins that we have in the Off-Road sector have been really wonderful, but now we're winning also in the On-Road sector. In fact, I can tell you that we have a future revenue in the On-Road sector to the point of with the wins we have, even this calendar year, we'll now be up on the first-fit vehicle side, at least as high as vehicle production in the United States in, say, a down year. So if you start to think about what we have won, that revenue isn't down Donaldson books yet today. And that will take, say, 3 quarters or 4 quarters to hit. But when it hits with China, we'll also start to see a step. And so we're very proud of the work we're doing in China. I can tell you with PowerCore first-fit programs, we bid high teens in quantities of projects and we've won them all. And there's a reason for that. And it's -- we take care of our customer, we offer the best technology and we're local. We're there with them. We're with them in all the meetings. And we'll continue to do so in China. We couldn't be more proud of the Chinese team and the work that they've done for our company over there. They've really had a lot of success. And the revenue, a large part of it is still ahead of us.

Yes. It's definitely encouraging to hear. And maybe just looking outside of China, any other kind of emerging geographies that you would say are well suited to your kind of product offering and the razor-razorblade model on lines of quality as well?

Yes, Eastern Europe, we continue to gain momentum and do quite well in -- within Eastern Europe. But then really, I mean, you can never stop talking about the United States and the quantity of wins that we continue to have, replacing ourselves with proprietary technology sometimes from nonproprietary technology and giving them to the latest and greatest as well as Western Europe. And those teams continue to do quite well. We've also had not many significant wins in Brazil. Now Brazil is going to be a very small portion of the company. But it continues to suggest that the global-based OEs really looked at Donaldson Company to really meet the overall regulatory needs.

Got it. That's definitely helpful. Maybe if we can pivot the conversation quickly over to the kind of EV and hydrogen fuel cell side of the Engine business. I know we've discussed this in the past, but just if you can remind investors of what the filtration content differences are on a BEV versus an ICE versus hydrogen fuel cell? Any kind of platform as you could speak to on the fuel cell side. And any kind of color you can give there in terms of how you see adoption progressing across your major end markets?

Yes. So when you really look at those 3 options, right? So a combustion engine, obviously, has both air intake and it has engine liquid. So that would be the lubrication piece, that's a commoditized part of our business. They would also have the liquid fuel. Both the liquid fuel and the air intake are technology-based opportunities for us. When you pivot over to hydrogen, hydrogen really has an energy density that's more equivalent to diesel. And so that's why it's getting a lot of runway right now. But what we like about hydrogen as a solution is it doesn't necessarily bring with it all that engine-based lubrication piece, which is the commodity piece that goes away. So those liquid opportunities away. But the air that's needed for liquid -- for hydrogen-based is got to be pristine. So we say that a combustion engine, it has to be clean. For an overall hydrogen in our gas-based solution, it has to be pristine. And so that actually allows us, at Donaldson, an opportunity to have higher air-based content. That's where we're #1 in the world. We also have great customer relationships. So that's a good opportunity for us. And if the lubrication first-fit piece goes away, I'm not going to be sad about that because it is commoditized much like the oil filter on your car. And then consequently, if you then go to a comprehensive electric vehicle. While then clearly, you don't need air filtration or liquid filtration. I would suggest to you, though, that the energy density that we're seeing, even being put out on the over-the-road truck, for example, it doesn't compete with hydrogen or a combustion engine. There's a return to base vehicle. I just got off the phone with folks in Las Vegas at the mining show, and it's a truck manufacturer. I won't tell you which ones, but that they have an EV vehicle there. The battery is 4,000 pounds to be able to go 200 miles, okay? And you start to think about what your limitations then on what you're being carrying and so on when it's that kind of kind of a situation. It really limits you. And so the battery technology for the markets that we're in, and I remind everyone, we are not in the passenger car market for Engine intakes. That's just not what we do. We're in Off-Road and we're in long-haul trucks. And so the EV will likely have success in the return to base trucks. So I think of rep use UPS trucks, those kind of things. But the long-haul trucking, it's not there. And so we would tell you that our models conservatively say that for the next 10 years, we won't feel any pressure inside Donaldson company. We say 10 years, our models say more than that because people can get their brains around 10 years. So we're very comfortable with where we are.

Yes, that definitely makes sense, and it's a very comprehensive view of the world. Maybe just a last question here since we're up against time. Maybe this is a totally fair question to ask, but I feel like it needs to be addressed in some sense. The Investor Day targets that you put out back in 2019, you obviously had the margin range of 15% to 15.8%. Yes, you're probably not going to be there by the end of the year. And again, it's not totally fair because we've come through COVID, we've come through the supply chain disruptions. So you've faced a lot of pressure since that target was put out. But just curious, in your view, what you need to see in order to hit that margin range? Is that still the right target for the company over the long term? And when would you see that as maybe feasible to achieve over the next, call it, 1 to 3 years or beyond?

Yes, I'll take that. So I do keep the Investor Day presentation with me at all times because people do ask and we took the guidance off the table, but we still feel that these are our main targets for the company. So the Investor Day targets were to 15.0% to 15.8%. This year's guidance at the midpoint is 14.4%. So we're committed to higher levels of profitability on higher sales, right? We should always be able to leverage our OpEx on sales growth. So that gives us an apparent win. We're going to mix the company up. And we're still shooting for this -- to get into this 15% range. And so we said we're not going to get there in FY '21. But we feel that this is something we need to achieve in the next 1 to 2 years. We need to get into this range with continuing to grow our revenues and leveraging the company and managing the gross margin. This year, we're in a tough period with rapidly escalating raw material and supply chain costs. We have a bit of a headwind that slowed us there. But we still feel like longer term, these targets are achievable, and we're going to get there.

Okay. Great. That's definitely good to hear. So with that, we're going to go ahead and wrap it up. I want to thank Tod, Scott and Charlie for your time. It's been great having you out here. Hopefully, we're in person next year. And thanks for the time, and we'll go ahead and leave it there.

Thanks, everybody.

Thanks for having us.