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

Good morning, everybody. Welcome to the Stifel Cross Sector Insight Conference. My name is Adam Farley, and today, I have the pleasure of introducing Donaldson Company. With us, we have Scott Robinson, CFO; and Sarika Dhadwal, Director of Investor Relations. So for today's format, I will be doing 3 bear cases and 3 bull cases to better understand the story. So with that, I'll start with bear case #1, electrification of vehicles is going to drive diesel engines out of the market through secular headwind in revenue [indiscernible]...

So the first thing I would say about that is certainly, electrification, I mean, our focus right now is primarily passenger cars. Great headwinds there. But we don't have any sales on passenger in terms of the [ Audio Gap ]. The question is, how long will electrification [indiscernible ] will ultimately [indiscernible] when it comes to different scenarios right now. Certainly, electrification is one. Other one is hybrid engines have been around for many, many [ years ]. Think of a big mine haul dump truck right now. That's currently a hybrid engine. Another possibility that's [indiscernible] hydrogen. So it's something we spend a lot of time on and think about for our Engine business. We believe our Engine business has quite a long run in front of it. We have a very big [ Audio Gap ] cover the replacement parts on the engines currently in service today. Hydrogen fuel cells are a very interesting option. If hydrogen fuel cells either went out or take a portion of the heavy Engine business, hydrogen fuel cells provide a unique opportunity because the -- if you think of air filtration for a big diesel engine, you need pure -- clean air going into that engine. But for a hydrogen fuel cell, the filtration needs for that air filter go up drastically, and you can think of that more along the lines of our -- the filters we use today to filter Disk Drives. So we have a similar technology that's already ready that we've developed for that sort of filtration. And so that could be a great opportunity for Donaldson. I would actually, in terms of the air filter, increase the selling cost of that filter. So it's something we study quite a bit, and we have a couple of folks in our technology group that have developed models to help kind of predict all the different classes of product and what their current forecast looks like. And we think at this point, it's quite a ways off.

Thank you, Scott. Bear case #2, filtration products have limited differentiation as evidenced by the number of copycat producers in the aftermarket. It is impossible to create real moats around the aftermarket business as intellectual property likes real protection.

Yes. I mean, our main mission in life is to be a technology-led filtration company. And so we want to sell filtration products with really a razor-razorblade model. And to do that, we want to have intellectual property that protects our products, and we do that with both trade secrets as well as patents. The company has thousands of patents that we've put on our products. I would say our filtration core science is really the light bread of our company. We started 107 years ago with a farm field -- filter in a farm field in Utah and have been increasing our technology ever since. So we believe our technology matters, have products such as PowerCore that were on the fourth generation. And if a customer takes a PowerCore product in their next line of products, and when we -- when they sign up for that, we commit that we'll only sell that filter through them. But we won't release a product in the independent aftermarket, and so they get all the sales and so does Donaldson. And we're always trying to convince our customers to take that. And as customers have become more interested in their service parts business, that's a great model for them because then they secure their service parts business. Our PowerCore products continue to grow at a significantly faster pace than our normal products. And the retention has stayed very, very high for a decade on those. So we believe that we can protect our products and that our products have value to the customers, both from the actual service or quality that they provide as well as helping them protect their service business. [indiscernible] have a long history of razor-razorblade model. And I think that served the company well to grow our aftermarket business. And every time we convince a customer, they come to us and want a proprietary product, that just locks up the aftermarket for Donaldson and the customer for a long time. You think of some of these larger engines that either in a highway truck or a backhaul or a large off-road piece of equipment, I mean, the life of that truck can be 20, 30 years. And so when they select the proprietary product with a proprietary fit, you really lock up that sale for the life of the product. So that's the -- the mission is proprietary products, razors to sell razor blades. And we continue to make slow and steady progress with that. For some customers, it's not always perfect. If you don't have the perfect distribution setup, but over the history, especially in our more developed markets, that's been a pretty successful path for us and for our customer.

You mentioned proprietary fit, is there maybe some examples of how the IP lays in the equipment, maybe [indiscernible] housing? Or...

Yes. We go at it from every different angle. So we'll start with our proprietary media. So most filter companies will just buy media out of the market. We actually design our own recipes, give the recipe to the media provider, and then they'll build the media for us. So we have proprietary recipes that we use, then we had some trade secrets on how we coat the media before it goes into the filter. So we start with the proprietary recipe and we have trade secrets on how we actually build our media, and then we have patent protection in many different layers in terms of the filter and the housing that it sits in. So there can be on a -- think of a PowerCore, think of a big PowerCore filter for a dump truck that's probably this big, there might be 10 different patents protecting that in a proprietary recipe and trade secrets on how the media is made. So you can see there's a lot of different ways that, that product is protected. And we've had excellent success in protecting those products. I would say most of the competition has really not been able to really copy those products.

Bear case #3. Segment margins have been in a narrow band in the range of 13% to 15% for most of the last decade. With margins at the top end of the range in fiscal 2022, there's not much further upside to margins, particularly in the currently highly inflationary environment as pricing is generally harder to get, especially in the OEM channel.

So I mean, we're -- my mission is we're always continue to higher levels of profitability on higher sales. And so we have to continue to push that operating margin up. We continue to organically invest in higher-than-average margin products. So we don't want to invest in dilutive products. We focus our investment in our Advance and Accelerate portfolio on higher-than-average products. So over time, we should be able to mix the company up. We have a 106-year history. We have a global footprint. We have all the subsidiaries we need. We have 46 manufacturing facilities. We have all the operating subsidiaries we need. And so we can also can and should be able to leverage our infrastructure. So while we have to add for capacity, as we've experienced this massive growth, generally, we will be able to leverage our infrastructure and drive our OpEx cost as a percent of sales down. And that's with a commitment and a plan to really continue to increase our R&D spend. So we've organically invested in things like Venting applications, like Process Filtration, like e-commerce that all give us opportunities to drive sales of products with higher-than-average margins. Now Engine has experienced remarkable growth over the last few years. And oftentimes, our Industrial business would have higher margins than our Engine business. But we still want that Engine business. The ROI on the Engine business is over 20%. So while it doesn't do much for our percentage, it certainly creates economic value and drives good profit. So over time, that growth rates, I would presume, will even out. In fact, we should be able to grow Industrial faster than Engine because we're investing heavier in Industrial than we are in Engine. And so we feel like the opportunities are there for us to increase our margins. In terms of pricing, this last quarter, our revenue growth of 11.5%, 9% was driven by pricing. Now certainly, costs have gone up, and we're committed to making sure that our pricing is consistent with the inputs that we're facing. So we want to be a reasonable business partner, both with our suppliers and with our customers. And certainly, our suppliers are experiencing inflation, as are our customers. And I just feel like we want to have reasonable commercial relationships. And as long as costs continue to go up, we have to raise our prices. In my mind, it's just that simple. Now some customers aren't too keen when you go to them and tell them, "We need a 20% price increase." But unfortunately, that is the cost structure that we are facing and I think, generally, they are facing as well. They're raising their prices. And so while some customers make it a bit challenging to raise our prices to them, we're not going to stop until the price/cost equation gets balanced out. So if costs continue to go up, we're going to continue to raise prices. It's just that simple. If a customer is going to refuse a price increase, so then they're going to have a problem getting product because we have high demands right now and we can certainly shift allocation to the customers who are a bit more reasonable when it comes to pricing. In our first half of the year, we had 4.5% price in terms of revenue growth on 19% revenue growth. Third quarter, we had 9%. So you can see we continue to layer in more prices and that will continue to benefit the fourth quarter as well as next year. We expect more price increases to come into the fourth quarter. And so we think our operating margins are going to increase. We have been down because raw material prices in freight and labor and everything else is going up faster than we can raise our prices. So in periods where costs are escalating rapidly, our margins are going to dip down. That's only a temporary phenomenon. And we did a -- I mean, if you think of gross margin, it's 31.1% in the first quarter -- sorry, in the second quarter. 31.5% in the third quarter. So we came up 40 basis points. That was a little bit less than we had hoped. But if you look at our guidance for the year, when you back into the fourth quarter, you can see we expect continued improvement in the fourth quarter from a sequential basis, and we expect that to roll into next year. So we feel like the investments we've made position us well for longer-term growth and higher than average growth. So we expect to get above 15% in the future, and we expect to continue to grow as we tip the mix of the company to higher-margin products.

Right. And over to the bull cases. Bull case #1. China is a long-term, very large opportunity for Donaldson to penetrate. Historically, the market has used lower technology products where Donaldson doesn't participate. But with the shift of OEMs to exporting to Western markets and requiring Western technology, the market is coming at Donaldson which creates a lot of growth opportunities.

Yes, this is a -- it's kind of a neat story. So I mean, the question is well written. China is turning and exporting to Western markets to help their markets, either because of excess capacity or just the desire to compete on the world markets. And I've been at Donaldson going on 8 years. And I can remember when I first got here, the only sales we had in China, we had -- we've been in China for, I don't know, 40, 50 years. We had 4 plants there. We're putting in another one. So we've been there for many, many years, decades, in fact. And over time, some of the large OEs in China have begun to become interested in our technology. So they want to sell products that look like they come from the West, and that points them to the larger filtration producers for their filtration needs. And so we have won many programs in China now that are starting to ramp up. You can think of maybe -- if you think of Weichai. Weichai is the largest engine manufacturer in the world. They produce 3x the U.S. on-road truck market every year in terms of engines. So they are a big, big company. And a few years ago, we won our first programs with them. Those are coming online now. We're only interested in profitable business. And so we're not just going all out to get all growth possible. We want to have good margins on the business we win. We need to teach the customers that to get this level of product, here's the way the game is played. We're not going to give you 200,000 filters 1 month and then 0 the next. We're going to have reasonable margins in our products. And if we can't get that, then we're not going to be interested in those programs. And so we've tried to be very disciplined when it comes to the business we take on there and make sure it's reasonable because we know we're going to have to put capital in here. And we're putting the PowerCore line in China. We're putting a second PowerCore line in China. We've added another facility. Our facilities are in Wuxi, which is a couple of hours away from Shanghai. We've been there for decades and decades so we have good relationships with the local government. China right now has been tough. Our poor -- especially our colleagues in Shanghai have gone through that lockdown. They're free now and they're out. So we talk to them quite a bit and especially the finance folks there, I've talked to every couple of days, and they are very resilient people and really do a great job for us managing that business. So we think like China -- and then India will come behind China. So we think we have great, great, very long-term opportunities there to win those programs and to grow our business in China.

Bull case #2. Donaldson is the clear leader in the space from a product development and technology perspective and has long-standing and deep customer relationships with OEMs. This creates a significant moat around the OEM business that competitors will find difficult to penetrate.

So I talked about this a little bit already in terms of technology, but maybe a few more things. So one thing I think is pretty neat about Donaldson is we have many good competitors. But you think that really Donaldson is really the only public, diversified, technology-led filtration company in the world. And you think -- so we have products all the way from hearing aids and Disk Drives and ostomy bags, all the way to big engine diesel filters, right? And we cover that whole span. And we have the benefit of continuing to invest in our core filtration sciences. And like I said, that's really the life bread of the company. But it's interesting to me that we often have all these different veins of products. And when we start focusing on a certain technology, when we get really good at it, it takes us into a product. So we don't have a product in search of technology. We have a technology in search of products. And we often learn things -- like in our Disk Drive business, that's really taught us the way for future hydrogen fuel cells. That absorption technology is already being utilized in certain development programs for hydrogen fuel cells. So we get this benefit of really being able to leverage our technology. And we have very good competitors and they're good companies. But most of the time, in fact, almost all the times, we don't compete against the same competitor across many of our lines of business. So they're investing in technology as well. But they have the opportunity to get a new technology and then leverage it into their existing product lines. Versus we are working on our core science of filtration, and we have the benefit of bringing to market products and then leveraging that technology across many different product lines. And I think that gives Donaldson a great opportunity to leverage the return from its research and development. And the company's ROI runs pretty high. And I think long term, that's really just simply a result of the research and development we've been able to do that ultimately leads into products that are ran through a well-run company to drive a high return. So I really think that, that is our technology. We invested $15 million a couple of years ago in our new research facility in Bloomington. So it's right off Highway 35. If you drive by there and look to the west, you can see it. It's a brand-new building that we put on our campus, and that's really about future membrane technologies. And so we continue to want to expand our science. And one thing we're really focusing now is moving in the food and beverage and into medical, which we've talked about quite a bit. And I think some of the organic things and the inorganic things that we have going on will lead to strong businesses in the future.

So Donaldson is clearly a technology leader. Maybe you could just touch a little bit more on process filtration.

Sure.

You just mentioned areas like life science and food and beverage. Maybe just how do you go-to market? Is it similar to kind of the PowerCore, razor-razorblade?

Right. So our process filtration products are built in a city called Hann, Germany, that's right outside of Dusseldorf. We have 2 lines there. And so we bought a company called Ultra-Filter many, many years ago, and that sold many of the products that go into those customers. And we would go to those customers in the food and beverages, and they might have dryers for their hydraulic -- or sorry, for their compressors or products that are in their factory today. And that's one thing when we're -- especially with our Industrial customers, we can see the whole process and see -- and the customers will be asking us for products that are in the line that we currently don't have. And we could clearly see in the food and beverage arena that we had the ability to move into the middle of that line. So we were kind of on the front end, in the back end. And there's many opportunities in the food and beverage process to have filtration, and filtration is obviously very important when it comes to food or beverage. Our beer has to be filtered, right? And so we worked into that, and we started with a small group of salespeople. And right now, we're over 120 people in our process filtration sales group. So that business continues to grow with much higher than average margins. And so that's an example of where we were able to really leverage technology into a new line of business with higher-than-average margins. We expect ultimately or in the relatively near future, that will be a $100 million business all in, in food and beverage. And so it's organic investment and growth story that we feel pretty good about. And I think it's a good example of how Donaldson, having the size that it is, has the leverage and the opportunities to continue to expand its technology and broaden its product portfolio, which really allows us to grow the company.

Great. And we just touched on this a little bit. But bull case #3, the balance sheet is in very strong condition with net debt of less than 1x at the end of fiscal 2Q '22, which can be used to accelerate Donaldson's strategic move into process filtration markets, diversifying end market exposure and continuing to mix revenue away from Engine.

Yes. So we've historically going back many, many years, have had very strong cash flows. And if you look at our dividend, we've been able to pay dividends for, I think, 65 years without interruption. We've been able to increase our dividend for over the last 25 years, so that gets us into the S&P High-Yield Dividend Aristocrats Fund. And I think those are 2 points that we're very proud of. So we've been able to maintain that. We've also been able to maintain a relatively consistent share buyback process. So returning capital to shareholders via dividends and share buyback has been going on for decades, and we feel pretty good about that. And we've still been able to invest in the company. You can think of CapEx, historically, 3% to 3.5% of sales. And if you look at the acquisitions, we've done some acquisitions over the last 10 years, not a massive amount. But we're continuing to look for acquisitions, especially in the food and beverage and medical markets. And we purchased Solaris a few quarters ago, and that's looking like it's going to turn out to be good for us. And Solaris is another example of products we were selling into food and beverage. And we got to know Solaris because our customers were asking for their products. And so now our sales guys in the food and beverage business can sell those products right into their existing customers, and we can sell the bioreactors into certain medical applications as well. So we feel like we have an excellent position. We are looking to deploy capital while maintaining a relatively consistent return of cash to our shareholders. And I think over the company's history, the net debt, we've always said we have a target of around 1%. So we've been able to stay pretty close to that. This year, the stock was down, and we said our buyback target was 2%. We hit that at the end of the third quarter, so we did increase that to 2% to 2.5% just to provide a little room for the fourth quarter. So we're going to actually exceed our share buyback commitment for this year. We raised the dividend this last quarter, so we feel good about that. And we're going to continue to look for ways to deploy capital. We have to be smart about capital because we have a very strong return. So it's hard to start any capital investment with immediate return of 20%. But we look for investments, either capital or inorganic, that will over the longer term drive our return up and make the company more efficient or expand the company's either technology, geography or product portfolio. So we feel like we have opportunities to do that. We are, I would say, I don't know, a conservative acquirer. So we do work hard, especially in the Life Sciences business. Tod, the CEO, and I meet with Corey and Dave, our 2 gentlemen, who all they do every day is look for Life Sciences company. We meet every Monday to go through their list. And they've literally gone through hundreds of companies, and we look to develop relationships with those companies and find opportunities where we can acquire companies. We -- from an acquisition perspective, I think our best opportunities rely in companies that are not necessarily going through an auction process. We look for companies that we have a relationship with already that, hopefully, the sellers, maybe they're interested in staying with the company or they're interested in their legacy, their brand, their customers, maybe their geography in which -- their communities in which they operate. And so we try to find companies where we can build the relationship with the sellers and make sure that one of the things that we'll commit to is making sure they understand how we're going to treat the company going forward. And it's surprising how many sellers are really worried about what happens to their company after it's sold, especially if you're talking first or second-generation kind of owners where we want to find companies that align with our ethics and our morals and our approach to doing business. And so sometimes, to me, that takes a little bit longer, but that's where we find the best opportunities to be successful. And most of our companies that we've acquired, we still have the employees, the leadership from prior to the acquisition. And BOFA is a good example where we still have the same team in place. Hy-Pro, the son of the Founder still works there. Solaris, the CEO is expecting -- is still working, and we think he's great and will hopefully continue to be with us for a long time. So we're going to try to be disciplined, but we are going to try to find opportunities to deploy capital with only a 0.9 ratio of net debt to EBITDA. We have to find ways to continue to deploy capital because, ultimately, if we don't deploy any capital to the acquisitions, the debt ratio will actually start to drift down just because of the cash flows that we're able to generate. So we're able to do some investments and still maintain that kind of balance sheet. And then the perfect larger thing ever came along, that's certainly something we can look at and complete that and then still have a path to bring those debt levels back down.

All right. So we're just about up on time. With that, I'll conclude today's presentation. Scott, Sarika, thank you, and best of luck for the rest of the day.

Thanks. Thanks, everybody. Thanks for your interest.