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

Good morning, everyone. My name is Kevin Estok. I'm on the Chemicals team here at Jefferies. With us today, we have Tod Carpenter. He's the President, Chairman and CEO of Donaldson. He will be presenting to you today and with his team. So without further ado, I'll let you begin.

Thanks, Kevin. With me today, to my left here, is Scott Robinson, Chief Financial Officer of the company; and Sarika Dhadwal, she is our Director of Investor Relations. So Sarika?

Sure. Thank you, everyone, and thanks for your interest in Donaldson Company. I just wanted to mention that our last earnings call was on June 1, 2022, it was our third quarter. And any comments or statements made today will be as of that date. And we will be reporting our fourth quarter and full year fiscal '22 results on August 31. So we will talk more about fiscal year '23 and our go-forward guidance at that point.

Yes. So we're in a pretty interesting moment, right, where we've just closed the fiscal year on July 31. So we'll be referring back. Thanks for your interest in our company and for being here today. With notification here, I just want to call out the safe harbor agreement is contained in the slides. So we satisfy all the lawyer-based requirements, and we can now get to it, as far as an overview of our company. I want to leave you with 5 takeaway messages today. First, we are a technology-led filtration company, that technology that we have and enjoy allows us to have deep customer base relationships. Second, we are a diversified portfolio across multiple end markets of our filtration space, roughly a $65 billion market, and we have expandable opportunities in many geographies. Third, we are a very experienced management team as well as the Board of Directors, and we're committed to our overall growth strategy as a corporation. Four, we are everywhere the customer wants us to be. So we are global in nature with 46 manufacturing plants, 11 distribution centers. And we act locally, very close to our customers so that we can have those deep customer relationships. And five, we are owners in the company. We act like owners. You don't want us acting like as management, you want us acting like owners. And we take great pride in the fact that we often say our culture is say what you do, do what you say. And you want that out of us so that we continue to act as owners of the corporation. So presenting overall company, we are $2.85 billion last fiscal year. Again, we'll report at the end of this month, 2/3 our Engine Products segment, 1/3 our Industrial Product. We are 65% replacement parts. Our strategy as a technology-led filtration company is proprietary razors to solve that customer's filtration need so that we can sell proprietary razor blades. And we do that all across our end markets in filtration. You can see our region breakdown here now. In the right side of this, on the bars, you'll notice, even though we're 2/3 engine, 1/3 industrial, actually, our largest markets are construction, which is in the engine products, and industrial air. So think of that as any kind you have a dust, a fume or a mist created in an industrial application, that is in that space. Those are the largest 2 pieces of our corporation. The dark blue bar represents the replacement parts piece of that -- I'm sorry, the dark blue is the first-fit side, and the lighter blue is the replacement parts piece of that. We have many laboratories across the world, again, with that emphasizing that local presence. And we have roughly now 15,000 employees and over 2,000 patents with more every single year being created. Our recent financial performance is record sales with record earnings and strong adjusted free cash flow in the most reported year. If you just take a look at the guidance that we have, which is here, you will again say, as we get ready to report, our guidance has told the world that we'll continue to set records both in revenue as well as in EPS. So we will cross the $3 billion threshold in revenue for the first time in our company history. We'll be between $3.2 billion and $3.3 billion. Our operating margin will go into the high 13%, still with a long-range vision of getting into the 15% range. And our EPS will continue to expand to roughly about that $2.70 level at midpoint, range $2.67 to $2.73. We do have strong end market demand bouncing out of COVID, as Donaldson typically does out of every recession. And if you look back to where we were at about $2.58 billion, call it, $2.6 billion, should we meet this guide, Donaldson would have added roughly over -- just over $700 million worth of revenue in a 24-month period. So strong end market growth. Our gross margin story, we will see a bit of a compression on operating margin, 10 or 20 basis points, somewhere in there. However, it is really much as you've been hearing throughout the world. It's an inflationary story. Our #1 commodity used is steel. Our #2 is media. And the third is petroleum-based products. So people are surprised about the petroleum-based, but the petroleum is essentially the binders that hold our fibers together as well as other urethane-based products and glues. On the steel side, the steel is still used in many elements because of the structural integrity it gives you to really be able to hold up that element and that filter-based solution. And that's really been the headwinds that we have been experienced. Everyone knows what the steel indexes have been doing. Pulp and paper, the same. And urethane, everybody knows oil. I won't bore you with all those details. But we have also felt transportation. I do want to remind everyone that the United States is still a net exporter for Donaldson Company. So many of the headwinds in transportation that other companies are feeling, we have felt as well, just not to the magnitude. But when they come, they really hurt. We have an operations strategy of region to with -- we build within region support that region customer. So for example, we build in China to support Chinese-based customers. But we do that when we get enough volume within that region to be able to invest and build that manufacturing plant, get close to the customers and take care of them. That's the reason why we have 46 manufacturing plants all around the world in order to really stay close to that customer relationship. So at the macro, what our strategy and capital deployment strategy as a corporation, here you see we play on the left side of that chart, in a $65 billion to $70 billion filtration market. Our engine-based business, which is 2/3 of the company, just over $2 billion is -- $2 billion of a $16 billion opportunity. So you can see it's another way to say, we still have a lot of share we can go get across the world. And that's when we talk about expanding in those geographies. In the Industrial segment, we have recently, in the last couple of years, expanded that to an $11 billion opportunity. And our traditional $6 billion industrial air, we've now gone to digitize those as many people have on their first-fit-based systems. So you can now get how your dust collector is running on your cell phone, for example, and we'll send you alerts to tell you go fix this or that. The reason we do that is because of the fact that if your system goes down, you will lose industrial output production. But we could actually -- you'll lose it for hours, but we could actually prevent that by having you down for only 10 or 15 minutes if you take care of that alert. So that's allowing us to press into the overall services piece, and you see that in that $3 billion slice. And then the third -- the second add would be the food and beverage slice. So not the entire food and beverage market at this point. We just said we're going to go after the $2 billion filtration piece of it. Later, we'll evolve into more systems base but we went after the $2 billion piece, and we're doing quite well with our growth rates in that segment. Longer term, looking ahead, we also now have started our journey down into that gray and the black box, if you will. So food and beverage, the balance of food and beverage. And then in the specialty chemicals and eventually into medical, and I'll talk a little bit more about that here in slides to come. So people ask, so why was food and beverage first. If you just think about it from a filtration, right, we're a bunch of filtration geeks and we look at the technologies and say the polymer-based chemistries that you use to create filtration-based needs and end solutions in the food and beverage market are the beginning of the quality step-up that allow you to get into medical. So it was a natural entry point for us as we continue to then get better and better in world-class and polymer-based chemistry solutions, and now we're heading over into the medical and pharmaceutical. I want to focus on the right side, in the strategic acquisitions that we have done first in this chart with our latest acquisition to really help you understand and link that back to that previous chart. The most recent acquisition that we just completed is Purilogics. Purilogics is a pre-revenue technology-based acquisition for the company. But again, it's these polymer-based chemistries that specifically goes into chromatography. When you build virus-based solutions or vaccines in chromatography columns, you have these things called resin beads. And these resin beads go into the column, they call it pack the column inside there, they're coded inside kind of the cracks of the beat with a particular item that allows you to absorb the protein of choice out of that, okay? It takes a long time, et cetera. Purilogics has come up with a creation with a filter media-based solution that allows you to go 10x faster than traditional technologies in chromatography-based vaccine creations, separate the protein of choice. And this allows us -- we had things going on in our laboratories. They were ahead of us. We just asked them to join the Donaldson Company, and we will now then build out that business going forward. It allows us to get into the prefiltration of chromatography, which we have those products now in directly into the column, and then all of the waste of chromatography-based solutions. And that's why we acquired Purilogics. Solaris Biotechnical out of Italy is a company that we acquired also in this last fiscal year, And we did that to help that project-based solution within food and beverage, but also to get into the biopharmaceutical and bioreactor based chemistries. And for example, now Donaldson Company, if you think about what we've traditionally done in our dust collection market, we've always built these big blue boxes and then control all of the aftermarket space. And now we'll be looking to do that within bioreactors and invent cool things along that. So for example, Donaldson is helping grow proteins now with across customer base, things such as salmon, for example, or other type of meats within our bioreactors. And then the third is that industrial services piece that I talked about. We acquired P-A Industrial Services to be able to accelerate that model to test model-based choices that we have made strategically, really drive those to fruition and really then make some mistakes, frankly, and continue to then go build that model out across the United States. And so you'll look for us to continue to build on this acquisition that we also closed in this fiscal year, all looking at the digitizing and then having the service component to that industrial space that we currently have. We break our portfolio of businesses down as shown on the left. Advance and Accelerate, meaning they will get a disproportionate amount of investment because we believe we have the best opportunity to grow. Critical core, they are the most cyclical within our business, but they also have excellent opportunities over time to grow because we have good technology within them. Mature markets, many of you, all the textbooks would say, it's more cash cow. That's how we how we look at that. And then fix and reposition, and those would be less than company average operating margin type of base businesses that we look to fix. So we break our portfolio down this way. Within the fiscal year that we just enjoyed, you can see our investments and our focused investments are paying off because the Advance and Accelerate exactly what we're trying to grow, represents 61% of the corporation, and it grew above company averages. Critical core. We're in one of those positive cycles right now in construction, agriculture, mining. That's growing. In fact, all the businesses grew. You can see there how we designate them across those categories on the upper right. And even when you look back in the COVID years, for a 3-year period, it's interesting because in the lower right, we grew our Advance and Accelerate businesses. Sure, low single digits, but they grew low single digits in the face of a significant COVID downturn where many people had felt that. So it just -- we show you this to illustrate the opportunities across the corporation and why we're excited about our future. Capital deployment. We have deployed over $1.1 billion over the last 3 years. You can see how it breaks down. We prioritize those usages of cash. One, invest back into the corporation, invest organically or through inorganic, through M&A activities. You could see we closed those 3 acquisitions in the last year. Second, would be -- second use would be dividends. And third would be share repurchases. And so speaking about dividends, we have paid a dividend for 66 years in a row. We have raised the dividend for the 25 years in a row. We are a very proud member of the Dividend Aristocrats fund, and we continue to hold this as an important part of our capital strategy. As far as buybacks, before I get into this slide, as far as buybacks, we do buybacks on a consistent basis. We typically look to buy back about 2%, and then that helps offset the net dilution that we have on the internal programs by about 1% annually. Last, touching on ESG. We have a strong ESG program within our environmental focus. We now have solar panels on the roofs of Donaldson manufacturing facilities in places like Australia, Brugge, Belgium. We had built a solar field in Illinois, and we changed the majority of our manufacturing plants out to new lighting technologies, all removing 5% of ESG -- of greenhouse gases within the last 12 months. We are a strong employee and community engagement. Our Donaldson Foundation gives back $1.2 million annually, but we also reach out in times of need. For example, one of our largest plants in Poland. With the Ukrainian war going on today, there has been a number of people in that area that we have decided will help the Red Cross, and we made donations to the Red Cross to just help in that area where we possibly can, including the floods across Europe and also the disasters that we had in Minneapolis in the last year. We have a strong governance culture across our company. And with that, I would open it up for questions.

I was wondering if you can talk a little bit about your innovation pipeline. What's your focus on ESG...?

Yes. So the question is, can we talk a little bit about our innovation pipeline, and specifically, link that maybe a little bit back to the ESG activities. I'll talk about our innovation pipeline. The way we look at this is we certainly have 2 types. We have one is the incremental improvements that we have in current based technologies, and you see that across our PowerCore platform. We first started PowerCore. It reduced the current technology down by 40%. We had incrementally now, when you go back to that what it replaced, we're up to a 60% smaller package with the same filtration type of capabilities. So that would be a great example of an incremental continuous improvement opportunity in our corporate technology groups. But we also have breakthrough technologies. And in the breakthrough technologies, we look to always have at least 10 great ideas in flight that can all become $100 million businesses when we launch them. Sometimes we'll buy those, as we did with Purilogics, right? But that's the type of work that we have going on across the corporation. And I can tell you that I'm really pleased with our technology pipeline. We've really got some good momentum. You have heard me talk about the last 3 years how we'll continue to increase our investments in technology, and we're going to continue to do that. We have raised the technology investment each year for the last 5 years. We'll do that again in the next fiscal year. And we'll continue to look to build out that technology pipeline, all looking for the breakthrough opportunities, perhaps is entering a new overall market. And the way just to think about this is, I'm going to try not to be too filter geeky for you, so just tell me to stop if I get out of hand here. But we look all the way down to the raw materials, right? And so at the raw material level, we have to make fibers. And then when we look at the fibers, you could do that, you can do solutions in cellulose where we are world-class. In glass, we're world class, or in polymers, okay? We're an A- maybe. We're headed toward world-class because we've been really gaining momentum here in the last 3 years or so. And so that, when you think about the inventions that we're looking at, are all intended then to take those technologies, create something really cool, right, and then introduce it to the end market to solve a customer's problem. We have a lot of really cool technologies out there. I know I should probably be up here with a black turtleneck or something. I'd even look skinnier or something. But that's the way we look at it. It's really, really cool stuff that excites us. And that's how we look at our technology-based pipeline.

As you continue moving into new end markets and more specialty -- sorry. As you continue moving into new end markets and more specialty capabilities, do you feel there are parts of your, I think you call it mature or cash cows or even geographic markets, where you have a facility that you built out to serve a certain customer base that may become less of a focus for you?

Yes, clearly, yes, we look through the portfolio on an annual basis. The way we do budgeting, it's really, really important for you to understand that Scott and I, when we teamed up 5, 6 years ago, one of the things we are doing is probably being a little bit too more -- too generous to those opportunities. And so the one thing that we both don't like is peanut buttering, right? And so literally, on an annual basis, we go around the world and we look at all over 1,000 cost centers in the company and make sure the investments are going, where the investments need to go. And we do that. It's a very painstaking process, but we take the airplanes. We go sit across the desk from people, and we get the work done just to make sure that we also deemphasize where it needs to be deemphasized but emphasize where we need to. And that's the reason why we can say that we feel comfortable that, that Advance and Accelerate group is really getting the attention that it needs to get.