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

[Audio Gap] From a new company to a longtime standard for this conference, Donaldson Company is here. Donaldson is based in Minneapolis, Minnesota. It is a global manufacturer worldwide of filters and filtration systems that has really moved towards the idea of grabbing its customers and holding them for the aftermarket through its technological development. We've been very fortunate to have Tod Carpenter, the company's Chairman and CEO, present for us in person today. He joins us from Minneapolis, and we're excited to hear what he has to say about the exciting developments at Donaldson. Just to go through the cap table, the company is about 124 million shares, trades around $59, $7.4 billion equity cap, great balance sheet, about $300 million of net debt against about $500 million plus of EBITDA. So we got about $7.7 billion total enterprise value business. Tod is going to walk through some slides about Donaldson, so I'll cede the virtual floor to him. Tod, thank you very much for being with us, and we'll let you take it away.

Thanks, Brian. Appreciate being with everyone here today. With me today on video is our Sarika Dhadwal. She is our Director of Investor Relations. And sitting next to me here in Minneapolis is Scott Robinson. He's our Chief Financial Officer. Go ahead, Sarika. Just safe harbor statement, I won't read it. All of you understand that we keep the lawyers busy. I want you to walk away with 5 takeaways from -- about Donaldson Company: first, that we're a technology-led filtration company with deep customer relationships. So frankly, we're just a bunch of technology filtration-led geeks, and we invent cool things every day. Next, we're a diversified set of businesses with expanding opportunities of revenue globally. Third, we're an experienced management team. Myself, I'm 26 years with the company. We're also very experienced at the Board of Directors. And we're committed to our long-term strategic goals. Fourth, we're everywhere where the customer wants us to be both in sales, in production and distribution. And then last, the fifth thing is we are owners of the company. My -- for example, my ownership requirement is 10x my base salary, which is significantly above industry standard. And we do that across all the officer team as well as the Board because we like to say we act as owners, not managers of the business. Next. So we are a 106-year-old company. We are $2.85 billion. In the pies down in the bottom, we have 2 reporting segments. We're 69% Engine, so medium and heavy-duty diesel engines; and about 31% Industrial. That did switch as a result of COVID because the engine-based business last year really popped much more significantly than the Industrial, which lags the overall construction, mining and agricultural recovery. By product, most importantly, we're 64% recurring revenue or replacement parts. And you can see we're global by region, 38% in the United States, 30% within Europe, the Middle East and Africa and around the wheel. Interestingly, on the right side, within the bars, we break out our first-fit and replacement parts for you. But interestingly is that our top market is an engine-based business. But the second largest market equivalent there is our industrial air base business, which is in the Industrial segment. Next slide. Our net sales, you can see that COVID did take us down, but we bounced all the way back. And that bounce really represents -- our fiscal year is August 1 to July 31. So when we bounced, we really started bouncing late in the fiscal year last year, and we ended up with a 10.5% growth rate. Within that growth rate, we also expanded our operating margin by 80 basis points. And you can see our free cash flow -- strong free cash flow measures and diluted EPS at an all-time record of $2.32. Go ahead. Our guide for this year is we'll be over $3 billion, so growing 7.5% this year after 10.5% last year, with our overall operating margin in the mid-14% range. So we'll expand operating margin while having our gross margins flat to slightly down as a result of the inflationary pressures that all corporations are experiencing. We will again set a record with our EPS. We play in a $65 billion filtration market. We're $16 billion in our Engine Products segment opportunity. So you can see $16 billion -- we're about $1.9 billion of $16 billion. So we have nice market share, but more importantly, we have quite some runway ahead of us. In the Industrial segment, we're $6 billion in our traditional industrial air. We've expanded into the $3 billion service by connecting -- service opportunity by connecting our Industrial Products. And then that darker slice of the food and beverage piece is about a $2 billion slice of food and beverage. And we have entered that space now organically about 4 years ago, which takes our industrial opportunity up to about $11 billion. The darker piece is -- the darker gray of food and beverage of specialty chemicals and then also the black one of medical and pharmaceutical is where we're heading technologically. We have a number of products organically within our laboratories. And so we are focused on expanding and over time, creating a third segment to our corporation. All of those are foundational technologies being built within our company. But we also felt that now was the time to build some muscle. And so we've created the acquisition team, and we're focused on entering the life sciences segment and that whole filtration space within -- through expedited acquisition processes. So overall, we really focus on 3 execution pieces: expanding technologies and solutions or frankly, just inventing cool things; extending our market access, so extending into underrepresented geographies where we have opportunity; and as I discussed, executing on strategic acquisitions. We cut the overall corporation down into 4 pieces of the portfolio: Advance and Accelerate. Advance and Accelerate would receive a disproportionate amount of investment across our corporation. They are what we believe should grow above company average. Critical Core is likely the most cyclical piece of our company. They do get a healthy investment, but that is where we will see overall cyclicality across the major OE platforms that are built. Mature markets are -- you can push that as cash cow. And fix and reposition, we'll talk on the next slide. So if you look then and apply these to our corporation in the next slide, this is how we break down our entire company. You can see the Advance and Accelerate, Critical Core/mature on the top right-hand bracket, how we break down the whole company. What's really important is that 61% of the company is in the Advance and Accelerate. And think of -- those are the razor blades. So our strategy is to sell proprietary razors so that we can get that recurring revenue or razor blades. And each one of those is in a razor blade-based business or a consumable-based business with high turn. What's also important and interesting is you can see in the lower right, over a 3-year period, and this includes about 1.5 years of the whole COVID world, we still were able to grow our Advance and Accelerate businesses even though the overall corporation was feeling a headwind. So clearly, this chart in the lower right changes pretty dramatically next year when we rack out the COVID year and move forward. But it just shows the power of opportunities that we have within growing our company in the Advance and Accelerate pieces. Next slide. The last slide I want to touch on is really our ESG culture. Within -- on the left side there, in environmental health and safety, we launched an EHS framework in the corporation. We now publish a sustainability-based plan for our company. And we're doing some really exciting things. Some of them, we don't really -- we haven't really publicized. We'll be putting a better effort toward marketing what our successes have been. For example, we now have solar cells on top of Donaldson buildings in Australia, in Belgium. We just finished and went live with a $3.5 million investment in Illinois, putting solar panels within a field. And we continue to look at alternative ways of energy. Additionally, really exciting, this year, we're changing -- 11 manufacturing plants of our total of 46 manufacturing plants, all the lighting base will be changed out, and we'll save 6,000 metric tons of CO2 emissions just through this particular project and being environmentally conscious. Our employee and community engagement, we're very proud of what we have accomplished. Without -- with -- throughout the pandemic, we really focused on 3 main things. One is the protection and health of our employees. Second is take care of the customer. And third is doing our part to stop the spread of COVID. But most importantly, we have a Donaldson Foundation, and we are very focused on education. And particularly, really, we have a reach wherever Donaldson has a presence. So think of a manufacturing plant or here in the Minneapolis area and we do about $1.2 million worth of annual grants to help try to improve lives everywhere that we can. Interestingly, we were able to hold for our employees COVID vaccination clinics in India, for example, and had everyone vaccinated before the country was vaccinated, in Mexico and a number of other places. So we really take this very seriously in this whole safety environment. Strong governance. We have a strong governance culture. It's always been part of our culture. 20% of our Board of Directors, for example, is female, 20% is minorities. We'll look to advance that future -- in the coming years as opportunities present. And you can see we have a long tenured independent director but a nice mix particularly of thought-provoking, really, participants. Go ahead. So just wrapping that up. I really tried to give you -- touch on really the macro pieces of our company. And so I'd throw it open to Brian for questions.

Great, Tod. Thank you very much. So I want to start with just a broader theme of electrification. We've seen a material push towards electrification not only in light vehicle markets but also within the commercial vehicle and off-highway space. Can you discuss this particularly given your exposure to internal combustion engines and how that -- how you expect this to develop and potentially impact Donaldson over the long term?

Sure. So we have a couple of people every day on staff in our corporate technology, a couple of quants that build a very detailed model. They go through all of our OE-based customers, and so we understand all the platforms across construction, agriculture and mining as well as long-haul trucks. At this point, I'd like to remind everyone we have 0 revenue on passenger cars, 0. So we are not on combustion engines for passenger cars, and we are not, therefore, exposed to what's taking place at this point in time. But within those medium and heavy diesel engines, we know exactly where they are in the development. And we can tell you that the battery technologies of today are not really of the kind of metric really or unit of work that, for example, takes you to plow a field, that a farmer is really going to latch on to. And so hybrids are really kind of the order of the day. So if you had a 15-liter diesel engine, now it's a 10-liter diesel engine with a battery in series but there's still a diesel engine. And longer term, we're working with many, many customers around the world with hydrogen-based solutions. And what's interesting about hydrogen is that if you look at what the challenges are for hydrogen, it's particulate. You've got to take particulate out of that gas, but you also have to take other chemicals out of the gas. And so you have to be absorbent to make sure that it has a clean hydrogen-based gas. Donaldson is #1 in the world at particulate removal within the fuel-based activities. And we're actually extremely heavily focused on chemical absorption and have been for decades. And we get that technology out of the Disk Drive market. That chemical absorption, taking things like mercury, et cetera, out of the streams, we've been doing for a long, long time, which is the reason why the customers come to us. Something that people don't really talk about is that not all fuel cell-based technologies or hydrogen technologies are the same. There's 1 OE that wants mercury taken out of it because that would be the most detrimental to their particular solution. Others take other type of things out of -- and we have the capability to do that. So I'd like to have people understand that a diesel engine takes clean air, hydrogen-based solutions take pristine gas, and we can really answer that call. So therefore, we have good opportunities longer term.

Yes. I think that, that goes a long way into my next question, which we look away from the negative and really towards the positive. Talk about your engine business and maybe some of the other really exciting technologies that you have coming down the pipe that -- to put in your words and from past years, how you capture that aftermarket afterwards. So talk about some of those technologies.

Sure. I'll talk about some. And just generally, our engine-based business, even though it's $1.9 billion, that says we're in mid-teens to high-teens share. We've got a long runway, which I remind people of. That means we don't have 85%. Let's go get it. And so consequently, where we are, if you look at one of the coolest technologies we came out with in the last 2 years, we built a brand-new test bench. And this test bench allows you within diesel fuel to bring any platform -- be it in construction, mining, agriculture, we can map how that engine performs as it's plowing a field, as its digging dirt and we'll put that on this test bench and give you real-life data through our Donaldson-based fuel filtration. That fuel filtration removes particulate but it also removes water. We've always been the best in the world at particulate. Now we're the best in the world with water. And now we prove it to the engineers in our laboratories to the extent, for example, with the large OE we won yet again 3 weeks ago, over a $100 million contract that will be spread over 10 years. I'm sure it will go longer, but that's a proprietary Donaldson's media that we invented. And then we proved that we're the only ones in the world that are actually showing people how it's applicable in their particular platform. We do that on a consistent basis. Next, one of the other really cool things is we're digitizing the overall engine-based platforms and putting sensors with proprietary patented Donaldson algorithms, things such as hydraulics as well as fuel. We can now tell you when you should change your hydraulic oil. That's brand new. And so we're really pushing the whole IoT theme across the OE base. So those are the 2 really cool things on the Engine segment that keep us really in a leading position.

That's very exciting. Sticking with engines. Emission standards are set to become more stringent over the course of the next decade, they have already, both in developed and developing markets. Can you discuss maybe some of the examples in the past or maybe some that are coming down the road that -- where these step changes and emissions standards leads to considerably more content per vehicle for you?

Yes. What's really great about every time they make a regulation change is, typically, that means more has to go on the engine to have the engine perform to meet that regulation, which they always take a look at us and say, "Can you make your filter smaller?" And Donaldson has been making the overall solution for them smaller on a pretty consistent basis over the last couple of decades, thus giving us a brand-new razor to drive those razor blade solutions. What's also interesting is in developing economies such as China, they're now probably a couple of turns legislatively behind the developed economies. But that's brought them into view enough so that they're pulling Donaldson technology, for example, in China. PowerCore is now winning with Chinese-based nationals in China so much so we put a line -- a PowerCore line in China 1 year ago. It's now sold out. We'll be putting our second line in shortly as soon as we can assimilate it here in the U.S. and ship it out over. So it shows that in China, we're really gaining momentum, and that's really in the on-road sector primarily because we already have had good momentum in the off-road sector.

Just staying with that. It begs the question, any changes in how you look to protect your IP with -- as you grow in China?

China for us has actually not been any different than the United States. People in the United States try to go around our IP as well, and they end up with court battles. We have won court battles in China. Our IP sticks quite well. We can tell you with PowerCore though, within our manufacturing facility, it is a rather unique facility, whereby we have divided it up such that no one can see the entire line. And we have high security-based devices to go work in there. So we are taking extra measures as a just in case.

Excellent. Staying with the near term, you spoke on your last call about labor as a particularly challenging thing for you. Discuss some of the pinch points as it relates to what you're experiencing and talk about how difficult talent retention is in this environment.

Yes. We have enjoyed at Donaldson Company low attrition rates for a long, long time. There's a lot of loyalty in both salary and non-salary employees. However, within this environment -- so within, say, our manufacturing plants, you would say that we're about a mid-single-digit base attrition rate. Now we're at least double that. And I'll give you just 1 example [ with our talent ]. We're the #1 employer in this town because a lot of our plants are in small towns -- small town America. And there was a plant -- there was a company that went bankrupt, had 137 employees, hourly employees. We called them up. We said we'd hire them all. They said, "Well, hey, that's great, but you're going to be one of multiple companies." We were 1 of 31 in this job fair, 31 companies, including large multinationals. And these people were going to make a good living. They can choose which ones to work for. 25 people showed up to the job fair. Why did they do that? Okay. It's a different environment in the United States in having people come to work these days. We are pulling all the levers relative to, obviously, salary, our competitiveness, benefits, being far more creative relative to working hours. A lot of people don't want to work overtime anymore, work-life balance. We're being very creative relative to all of those things. Fundamentally, we have a choice to make. We build a new manufacturing plant every 2 to 3 years. Right now, it's hard to see how you build in the United States of America. I'm actually concerned for the country.

It's a [ prescient ] discussion. Apart from labor, supply chain remains a challenge. You have roughly -- we'll call it, a very significant portion of your business is an aftermarket business. So maybe talk about the engine aftermarket. Discuss some of the issues you're seeing from independent customers as well as the OE channel. And maybe talk about whether there's some supply, some -- or restocking opportunity ahead for that industry as supply chain works itself out, hopefully, over the course of next year.

So just generally, supply chain and how it's going to -- how we see it formulating then, Brian, is that really where you're at with that?

Well, supply chain and then its impact on the aftermarket -- your aftermarket business.

Yes. So supply chain, we have the headwinds that everyone has in the supply chain. We're doing okay with it in ebbs and flows. Our top 3 commodities are steel. We are very pleased with the administration's decision in Europe to actually remove tariffs on European steel. We think that could help. Right now, it's tough acquiring steel in the United States. So steel is #1, media is #2 and petroleum-based products is #3. We ebb and flow through those 3 depending upon where we are in the country, but it's largely a United States problem. It's not a problem elsewhere in the world. We've been able to be fine. Now the reason why that is for us is because our strategy is to build within region to support the regional base customers. So we break the world out in APAC, Europe, Middle East, Africa and then the Americas. So the Americas is the one that's really having the problem. The other 2 regions are generally okay. And it's really a U.S.-based problem. How we think this will really play out is it's going to need more time. It's probably going to be, give or take, on a particular commodity here or there throughout, I think, at least until next summer. But we're doing okay. We're certainly doing better than we were 6 and 7 months ago.

Your -- I appreciate that. Your industrial filtration business, the IFS business, you touched a lot of different end markets. Maybe some -- provide some color for those in the room and those joining us via Zoom, maybe some pockets of strength you're seeing and those that you carry the most caution.

Yes. So when you look at our industrial filtration business, the largest piece of that, between $400 million and $500 million, is our Industrial Air Filtration. So think of anytime you create a fuel, a mist or a particulate off of an industrial-based process, we go and we collect that for you. We protect either the environment, the machine or really workers within a particular setting, anything from pharmaceutical dust, where it will be 100% stainless steel, to weld fumes, so everything in between. What has happened is the progression has gone through about 1.5 years ago on industrial base, if a machine broke, the dust collector broke, they would just fix it. So then we went to if it broke, they would replace it, which was really good for our business. We started to see things pick up. And then it went to not only break/fix, it also went to capacity expansion. And so now you're really starting to see the overall -- the order cycle really compress. And we really have now a healthy business. Industrial has been lagging the overall engine recovery. And if you just look at our industrial utilization, for example, in the United States, you know that, that is really uptick. That also helps our razor blade business there in that business, which we'll see some nice growth this year because that's all replacement parts as well.

One thing we haven't touched on is inflation and your ability to pass on price. You've spoken to an ability within your Advance and Accelerate business. Maybe talk about these end markets and the value proposition you provide that you're able to pass along price to your customer versus maybe some of the others where it might be more of a challenge.

Yes. So that's why they kind of look at it as -- remember, we're 65% replacement parts, 35% OE. On that 65%, we can control pretty much all of that through independent channels as well as the project-based businesses. The project-based businesses take a little bit more time to wash through. So like on our dust collection business, on a CapEx base, you'll quote it at what you know. But then if inflation continues to climb as it has, it will take 1 or 2 quarters to wash that through to get the new pricing. So it has felt like it's been a little bit of catch-up even though we were very aggressive. But we're aggressive with multiple pricing actions in those cases. We've actually taken them. The piece that has been traditionally lagging for us is that OE piece, especially the large OEs. But this time -- this is the best environment for raising prices in the OEs that I've ever felt in my Donaldson career of 26 years. But you have to split it in 2 ways. You have to go 80% of the smaller multinationals and then 20% of the large ones. And you know the names in construction and ag and mining. Okay? And so with the 80%, we've had terrific success, very cooperative environment, moving. That 20%, we're having more success than we've had in the past, but it's still a bit more elongated. We'll get it. I know we'll get it. They even say we'll get it. It's a matter of we're just talking about the number. And in the past, the number was always 0, so it will happen.

Terrific. I've got time for one more question here, Tod. You mentioned new markets that you're entering, food and beverage being one. Talk about maybe the use of your balance sheet to accelerate into this space through M&A. How do you look to acquire maybe to get a toe in the door versus having to grow organically?

Yes. So we've got a lot of organic projects in flight, but those are all obviously pre revenue. The sales cycle on some of those, for example, in the medical world, could be 7 years -- 6, 7 years. And so consequently, we've been working on those for some time. And so it really becomes an opportunity for our strong balance sheet. As a reminder, our net debt-to-EBITDA ratio is about 0.7. So we have a strong balance sheet. We're going to put it to work. We're going to accelerate the growth in life sciences. We really strengthened our muscle there. We added Cory Padesky as Global Strategy Lead. He used to lead the life sciences strategy for 3M. He's now joined Donaldson. And we added a Vice President reporting to me, Dave Wood. Dave is a clinical oncology therapy -- therapeutics specialist, a PhD, where he worked the first 10 years in the laboratories and the last 15 years in PE. So we took him out of this PE world. And now he's helping us accelerate into that space and use our balance sheet to the best of our ability to do that as quickly as we can. So that's how we're looking at it. We've got some good organic opportunities. And now we've got good muscle to go after it from an acquisitions point of view, and so we're going to press that.

Great. A great company with a lot of great options on a go-forward basis. We're bumping up against time here, Tod. And Scott, I see you there. So thanks for -- I'm sorry I didn't get anything for you.

That's all right.

In any event, thanks so much for being here virtually with us. We greatly appreciate it. We -- and we'll see you very soon either in New York, in Las Vegas or in Minneapolis. And so my teammates and I thank you very much for your continued support of our event.

Absolutely. Thanks, everyone.

Thanks. Take care.

Okay. Bye.