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

I'm Dillon Cumming. I'm the machine ran construction analyst here at Morgan Stanley, and I'm very pleased to have up here with me today, Donaldson Corporation. We've got Tod Carpenter, Scott Robinson; and Sarika Dhadwal, CEO, CFO and Head of IR from Donaldson. So guys, thanks for being with us today.

Thanks for having us.

So first, I've got 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 here, Morgan Stanley representative. I'll pass it to Sarika to read a disclaimer for the round.

Yes. So thank you, everyone, for joining us today. Just wanted to mention that we did report our fourth quarter and fiscal '22 results on August 31. So anything we talk about today will be time stamped as of that date. And with that, Dillon, we can go forward.

So yes. We'll kick it into questions and answers, but we'll open it up to the audience in the middle of presentation in case anyone has any questions.

But just to start, I wanted to ask a question on guidance, right? I have the benefit of having you guys here pretty closely after you reported your last quarter, you initiated 0.3 guidance for sales growth up 1% to 5%. And why don't we can kind of start there first to kind of go through what you had embedded in that outlook in terms of momentum by end market.

Sure. Typically, what we did within the guidance. We have the good fortune of at the half year, being able to guide because our fiscal year, as a reminder is August 1 to July 31. So we got the reset now. However, the bad part about all of that is timing because of the uncertainty near the end of our fiscal year. Others will guide in January. We guide now. So that's a little bit of a tougher moment. As we look out through the first half of this fiscal year, it looks quite nice. So we baked that within our guidance and our overall model. But then we also just try to take a more balanced risk approach relative to a potential recessionary pressures that we may see in the marketplace. And what we've done in order to consider that specifically within our model, there's a couple of areas that we wanted to be sure about and that is China. We're not sure when China will actually open up and continue to move forward. We had great momentum prior to COVID. In China, we continue to win new programs in China. But when that economy will open up, and then actually we start to realize the benefit of all those wins. We took a more measured approach on that. And then additionally, over in Europe and the worry relative to a whole energy crisis going on throughout Europe and will that give us headwinds relative to those particular markets. So far in 2012 through 2018 in Europe, the commodity super cycle time when our overall end markets had a little bit more headwinds we were more balanced. Europe never really fell tremendously heavy, if you will. They were say, plus or minus 1%, 1.5%. They still feel very comfortable at this point in time, but we did take a more measured approach relative to getting into, say, a year from now. And we just want to take that into consideration. As the U.S. goes, U.S. feels comfortable, and then we also likely have some overall tailwinds within the United States to consider that we think would protract the steady pace that we're in today. One is the infrastructure bill that was fast. Clearly, while that's been allocated, it has not been spent. And as a reminder, we're not in construction house -- we're not in housing or residential type of markets. For us, it's about roads and bridges and things like that. So we feel as though we'll get some tailwind from that type of an activity. And then last, it's about inventory. Within the inventory portion of the United States across our end markets, we were not able to see as a collective filtration base on inventory buildup across the channels. And in fact, it's much more muted than it has been prior to any potential recession of the past. And because we didn't have a huge buildup likely that we saw in 2016, where we had the obvious step down coming into that recession, we likely will not see that type of a behavior just simply because there's not that much inventory out there to step down and feel the headwind from. So overall, we took a more balanced approach with what we know. We baked it all into the guidance, and that's how we determine the model.

Yes. No, that was a great overview. I think you alluded to the kind of 2 areas where you're potentially adopting a more cautious approach vis-a-vis China and Europe, right? When you think about the path of your guidance last year, I think you ended up having revenue come in close to double where you originally guided. How would you kind of characterize the overall guidance for this year? Would you say it's conservative, somewhat conservative? How would you kind of characterize that?

Yes. I think it's balanced. It's clearly -- we feel real comfortable, confident relative to getting all the way to the end of the calendar year. But it's really, as you get into what would be our fourth quarter, which is typically our best quarter, you think about when our planting season is for agriculture, when construction projects or roads and bridges start opening up around the world. So the cyclicality naturally for our business will be in the fourth quarter, which is May and June, July, we'll see a usual pickup there. And so we just tried to take a more balanced measured approach this year. Last year, it was record backlog never seen before record late supply chain issues. If you were able to deliver it, you can really continue to grow your business. And I would tell you that last year's guidance really was more about supply chain. This year is more about the potential end market movements.

Yes. Makes sense. The one other dynamic that was in the guidance was about 1 point of headwind from product line exits, right? And that kind of comes after you exited some other truck-related business last year. I guess, first of all, can you just remind us what catalyzes the decision to exit those product lines? And then secondarily, to what extent you're planning for more of a recurring evaluation of the portfolio going forward?

Sure. So we have strong relationships with our customer base. And the particular product line that we exited, it was really a pass-through product because we have the strong relationship we were doing. Frankly, we were managing the supply base for this particular customer. It wasn't even a filter product. It's called the DEF tank. It holds the [ ads ] for those of you with the on-road experience that holds the AdBlue that goes into the dosing to help the combustion engine actually to have less particulate out to exhaust. So we were doing that DEF tank for a large over-the-road type of a customer. But because it was supply chain concerns, we weren't making any money on it. It was time to actually exit and let them take it over. And so we work 9 months to 12 months with them to have them take it. And so we've now exited that business. It was a frankly, a very natural decision for all of us. They understood it. We'll never dessert our customer, but certainly handing it off, we completed all that. That said, taking a look at the balancing of our portfolio and the products that we actually build, we take a look at that on a pretty regular basis. It's standard work for us to now look at where we have products that are losing money and really action those to press forward and get paid for our technology or get paid for those products. Typically, we find those products are 20 or 30 years old, where now we're still the supplier to large OE. And so we continue to work those. We'll continue to work those going forward. It will just be standard work. We don't see anything in the near term that is as large as what we just exited with the DEF tanks.

Yes. Makes sense. Maybe switching the conversation over to the margin side, right? I think the outlook that you guys put out for fiscal '23 was one of the highlights of the quarter, right? It was pretty supportive after a year that obviously, we had a lot of margin challenges in 2022. Can you just remind us what was embedded in the outlook in terms of price cost, supply chain improvement and particularly for the areas that have been challenging margins over the last year, labor freight, et cetera?

Sure. Let me maybe talk that to Scott.

Sure. So we worked hard throughout the year to manage our price versus cost throughout the last fiscal year. And you saw our margins gradually coming up as we were able to implement more price increases to offset the cost increases that we had experienced. So we expect that to continue this year from the fourth quarter of last year. For the first quarter of this year and into this year, we expect the margins to be improving as a result of catching up on costs. In our guidance this year, there's actually 6% associated with price increases, primarily from the last year that will lap over this year. That will give us basically equilibrium on price cost. So we still feel like we'll be recovered. And back to Tod's comment you just made about the rationalization. We spend a lot of time on individual products and their pricing. And we're going to drive back to a reasonable gross margin on our products. And if we can't get it, we're not going to sell those products. And so we feel like we've really made good progress on our margin and on our pricing. And we continue to focus on both our margin and our costs to make sure they're at the appropriate level.

Yes. I think that makes sense. And you mentioned you're targeting a more balanced equilibria on price cost for '23. When you think about kind of scope for further pricing actions, right, I think you just said that you've only embedded the carryover plus a more normalized annual year price increase, is there any scope in the market to kind of go out there with more ad hoc price increases? Or do you feel like we've kind of hit the upper bound of that?

I mean we have our traditional price increase in, say, our independent aftermarket business that we will continue to implement this year and that are -- as part of that 6%. But we really just want to make sure we have reasonable commercial relationships with both our customers and our suppliers. And so we need to have a reasonable gross margin. But we're not looking to really push pricing further than what it should be. We want to have good relationships with our customers, and we want them to understand that we're going to push price to the extent costs have increased. We feel like we can increase our overall operating margin on the company by managing our costs, by leveraging our infrastructure and by investing in higher-than-average margin products. We believe we can continue to have higher levels of profitability on higher sales, and that's what we're committed to.

And maybe I'll just add that within our guidance, you can see in the last couple of quarters, we've had gross margin expansion. We look to continue to expand our gross margin in the quarters ahead. Then I just want to maybe make the point while other companies will look to maximize their overall operating margin. What we're trying to do and what Scott's alluded to is we're trying to optimize it. We're not trying to become -- have the next quarter and be a singular story. We're trying to become the greatest filtration company that's 200 years old, and we're 107 right now. So consequently, we take a long-term view at this. And so the optimization of the operating margin, we still have opportunity to expand it, and we're going to continue to pursue those and press as hard as we can strategically, but that's how we view that whole conversation.

Yes. That's clear. Maybe switching over to the supply chain side of things. Like I said, you guys have had to deal with a lot, not just yourselves, but really the entire industrial complex over the last year or so. We think about things like freight inflation, broader material availability, labor, how those supply chain kind of buckets improved or deteriorated relative to the last few quarters?

Yes. So transportation, clearly, over the last couple of years has been quite problematic. Now I do want to remind everyone, our strategy within manufacturing is build within region to support region. So we consider that the Americas, Europe, Middle East, Africa and Asia Pacific. We have the United States, as a reminder, is still a net exporter for Donaldson Company. So we aren't bringing a lot of product from across the other side of the world into the country. However, we still do when we had that much demand, we still try to take care of our customers. And we look to make sure we can supply it using all of our capacity and therefore, that suboptimizes some of our internal supply chain, and we're looking to renormalize that now, which will only give us a tailwind looking forward due to execution. We've seen a bit more stabilization in the markets relative to transportation. Donaldson is also doing less premium freight than they have had to do in the past year. So that will also help. We bake that within the guidance looking forward. And then I would tell you, as far as raw materials and supply base, a year ago from today, I'd tell you, we were probably chasing 100 different suppliers and the phone calls were constant. I would even sit on those relative to the projects and where we would have to go in order to try to help. It was so tough that I even visited a gasket company. The product costs $0.03, but we need millions of them, and we needed our fair share. And so consequently, we needed to go there in order to really fix that. But that was a year ago. I'd tell you today instead of hundreds of problems, we're probably less than 10. Now those ton are very important to us, very large customers. And that feels a whole lot closer to more normal. It's never 0 for us, but it feels a lot closer to normal.

Yes. Makes sense. Maybe kind of rounding out the conversation on the cost dynamic, European energy concerns, electricity cost inflation, right, very top of mind for investors. Can you discuss what you're seeing on the ground there with regards to kind of gas availability, your exposure to that kind of dynamic? And then any just broader kind of electricity cost inflation you've seen in the region, how impactful that can be.

Yes. To the extent the energy problem in Europe continues and actually been ways to create an overall recession in Europe. Again, that would be different than its previous recessionary behavior where it didn't have large swings. That clearly would hurt us because the end markets in GDP would go down. Clearly, we'd cycle down in Europe. There's no question about that. What the bigger worry for me on Europe rather than the GDP side, because I do think, for example, agriculture in the Ukraine will likely be replaced by agriculture in Western Europe that perhaps wasn't planted in the past. And so there's some normalization goes on it. It seems to me, Europe continues to do all their construction projects, and these are the markets that we're in. So I think for us, Europe could still be muted even if they go into a pretty tough recession. But the worry more than anything would be there's a large petroleum-based plant that makes raw materials that go into urethane-based products for Donaldson Company as well as many others. It's located in Germany, and it has a direct pipeline from the direct energy source from the Russian pipelines. And so should that get cut off and that petroleum-based refinery, which, again, is the largest in Europe, if they can no longer produce, it's not just Dalton Company. That would really hurt economically across all of Europe. I'm sure you've probably heard about that before. But for Donaldson Company, that would cause problems.

Yes. Got it. And then I guess on the fourth quarter call as well, you had mentioned a brief detailed approach to potentially softer macro environment next year. I guess, first of all, what kind of catalyze you to discuss that and develop the approach that you mentioned just because when all across your end market mix, right, maybe putting inside Europe for a second, it does feel like a lot of your end markets are still pretty super bingo next year, right? So when you think about that approach to potentially softer macro backdrop, what incentivizes you to create that strategy now?

Yes. Kind of interesting. I think if you look overall at China, should China continue to pick up, it's only good news for us, right? Because we've worked through and almost lapped now all of the bad news. In the United States, again, it does not feel as though the U.S. has turned toward a really tougher step down at this point in time, industrial production and our industrial side, which is more of a CapEx project-based business. Still, the order cycles are good. The quote cycles are good. quote to order, hasn't elongated as it typically would happen when people become a little bit more dated. So it still feels as though the overall cycles do not appear to have changed direction at this point with any appreciable movement. So everything still feels okay, I would say. But again, we're trying to read the tea leaves 12 months out, and so we did take a more balanced risk approach.

Yes. The other thing that helps us with quite a bit is when we think about our revenues, we also think about our costs, right? And the cost plan is directly associated with the revenue plan. And so we maybe have a conservative or a balanced revenue plan gives you a conservative or balanced cost plan. And we work hard to make sure we're managing our costs consistent with the level of activity and volume we can expect and make sure we're saving up expenses for our growth initiatives. And so that helps a lot. And we rather chase revenues then have to bring everything down, including expenses because ultimately, it helps our incremental margins by holding your expenses and having that growth. And so it gives us a really good solid plan that I'm comfortable with in terms of our expenses for this year.

Yes. So let's maybe just balance that as well. So we talked about. We're very comfortable with what we're seeing, et cetera. But let's play the more tougher story, right? And so what happens to the Donaldson if the world goes to recession, et cetera. And frankly, we're a very proven playbook here. So clearly, what we do is we continue to work on our backlogs, which still are very high. Our late position to customer request dates are still very high. They're very uncomfortable as a company. So we continue to work those down. Then we'll continue to press hard into the markets for our replacement parts business, which are usually a counterbalance to recessionary based measures. So we would continue to sell. Remember, we're a proprietary filtration company we sell razors to sell razor blades, but we do it in the filter market, technology led. So we'll continue to sell those razor blades and we'll press that out on the replacement parts. And then as Scott alluded to, frankly, it's standard work for us on the overall cost controls and the operating expense cycles. So clearly, we know how to do that work. It is unpleasant work. But we do that work. We actually do it whenever is necessary. But we also do it without jeopardizing the future. And so we'll continue to look with a strong balance sheet at executing all portions of our strategy organically and inorganically while making sure we continue to adjust to the realities of what become.

Yes, absolutely. Maybe we can move on to the more attractive elements of the [indiscernible] story. At our 2019 Investor Day, right, you outlined a very detailed strategy about how you're going to get into new markets, primarily food and beverage and life sciences, right? Can you maybe give us an update in terms of how those initiatives have progressed. You made some M&A acquisitions on Life Sciences side. But for both of those markets, at least, what are the efforts there encompassed.

Yes. So what we talked about here recently across the sectors and where we're headed strategically is we've got 2 legs to the corporation. We're looking to build a third one. And if you just think about how we view this, filters can be made out of multiple raw materials. They are cellulose, they are glass and they are polymers. We are world-class at cellulose, world class at glass and we're gaining ground on polymers. But what that means is when we become a polymer-based specialist, that allows you to take the fibers of polymers and put them up into end markets for example, in the life sciences as well as what we currently have, which are special applications like food and beverage and disk drive in those areas. So we'll expand upon those particular markets. And -- and so overall, we have an organic growth focus on that life sciences and specialty applications like that we look to build out. But we also have an inorganic focus on that. And the inorganic piece, you've seen us do 2 acquisitions, 1 in Italy called Solaris. Solaris builds bioreactors and fermenters. Bioreactors allow us to get into the growing of protein. So for example, they now sell bioreactors that help a particular company grow salmon. And so food growth is a huge market opportunity. But it's not just about the bioreactor for us. It's about the pre-filtration that goes in. We already have all those products and the filtration of the solution post the growth that we have to filter that out to allow them on all that waste application. So for us, it's really quite a comprehensive system that gives us great opportunities. The other opportunity for us is chromatography. And in chromatography, again, it's pre and post. We bought a company called Purilogics. Purilogics is in North Carolina to show you how we look at acquisitions. This is a pre-revenue company. So we'll buy revenue clearly established companies, but we also look at the technologies where we can get an entry point. And in chromatography, if you are unfamiliar with it, you'll take what's called the column. So think of a glass cylinder. You put all the solution inside a solution, let's say, 1,000 liters of whatever it is, you want only one protein out of that. You pack that with think of maybe marbles. We call them [ peers as a kid ]. They had cracks in them like looking. Okay, these resin beads will have that and they're coded with something and they attract the protein of choice, protein A, right? And then you watch all the old solution out and then you have something that allows you to collect the protein of choice and maybe get about a gallon of product out of that. What Purilogics does is take away the resin beads throws it all the way. And now you just take the entire solution, you pull that through the overall cassette Purilogics and you collect all your protein. It's 10x faster than anything currently out in the market. And so what we're looking to do and why we think Purilogics is a wonderful addition to our company is because, first of all, they need some help. And we have a strong balance sheet. They need some investment. They don't have to be playing with banks or private equity or anybody else anymore. We can go fast. And we will -- we believe that they have a really solid customer base that we'll be looking to expand that. And over the course of the next years, we believe Purilogics will be a huge win for the company. So again, we have organic based projects inside that life sciences sector that we've been working on for 3, 4, 5 years that we look to bring to market, but we also look to come over the top on the inorganic piece. And maybe at this time, is a great opportunity to plug that. Our last Investor Day was April about 3 years ago, in April of 2023. So this coming April, in Bloomington, Minnesota, we welcome all of you to come to our headquarters and we'll have another Investor Day more to come out about that where we'll reestablish targets, et cetera.

Yes. And we're definitely looking forward to it and hearing updates of the strategy. Since you mentioned it, right, or thousands of great quality that you can go fast to market, right? Some of these new products that have compelling technology, you can take it, flow through your platform and really commercialize it quickly. For those 2 products and those 2 companies, right, what does that path look like? And how quickly can you kind of get to a point where the revenue might actually be meaningful enough to kind of call out?

Well, I can tell you that we bought Solaris and I won't say all the numbers, Solaris was a $6 million revenue company. We just got 1 order worth $7 million. But we did that just simply because of the fact that we put a company that had really great products, really terrific talent and the strength of Donaldson's balance sheet and people trust and we put them together. And now there is really great momentum there. So it will take time to grow it to a larger space, but it shows the power of being able to leverage that opportunity. As far as Purilogics, we've got to get our production lines built. That's probably going to take 1 year to 1.5 years. so that we can scale that up and then we'll press but even with that, not just talking about scaling it relative to getting it available in the marketplace. We are working with many companies already. It's in laboratories. It's being tested has been proven. And maybe just one other point. Within our inorganic strategy, we looked at dozens of these type of corporations and tested them in our own laboratories. -- before we found one that we loved. And that was Purilogics and so we bought Purilogics. And so we go forward because we tested it in our laboratories. And so we believe it has a winner. It will take us a bit of time to get it more production ready, say, 1 or 2 years, but then we would expect it to really kick off.

Got you. And then I guess last question on head of the Process filtration side. As you've gotten into these markets, both food and beverage and life sciences a little more heavily you've often talked about the razor blade model being quarter the [indiscernible] philosophy, and it gives you more resiliency from an aftermarket perspective. How does the replacement cadence and the kind of razor blade portion of those end market kind of compared to what you've normally done in Engine and Industrial?

Yes. What's happening over into the life sciences based spaces, there's a lot of pot of those particular overall build applications are going to single-use type of products. And so single use is kind of music to our ears, right? And so for us, it really allows us to have more of a consumable-based mentality into those markets. which once we get proprietary and then you overlay that with the consumable type of mentality in the marketplace, we really see good things over time.

Got you. I have a few minutes left. I want to open up for questions, if there are any from the audience. Maybe we can just wrap up with two questions on China in that case. I think that's another region where you've been developing a pretty coherent shared strategy. You've won some new platforms in recent years. I think more recently, it's really started to materialize in terms of your outperformance versus the market. Can you just update us on what initiatives you have that are still ongoing there? How much of the business has been kind of outperforming the underlying end markets and what is the kind of growth outlook is for the next few years?

Yes. So China, specifically, we're doing really quite well. Even in the COVID times where you have more of a headwind with the shutdown and the uncertainties, we still continue to win new business in China. Now it takes longer to get the revenue completed or start realizing the revenue in China than it did say, 5 years ago, it was almost instant in the pre cover China. Now it does take a little bit of time for it to throw on through. But we continue to win. And I would tell you, 10 years ago, where we win in China is with the multinational companies, so think of Deere and CAT and all the rest of them, and that's how we entered the country. Now where we win is in the off-road sectors and in the on-road sectors with Chinese national-based companies. And so you can see our region to support region and for us, it's manufacturing in China to support China. And in fact, we have enough wins. We put a PowerCore line. I think we've talked about that in the past. We built a PowerCore line in China and they're building PowerCore now for that market, and we need a second one. So we will expand that based upon the wins that we have. So those are huge initiatives in both the on and the off road sector. We have less taking place over into the life sciences side because we wanted to focus more on Western Europe and the United States, where we are. But on the Industrial side, on the project base, and the replacement parts side on the Industrial. So think about project-based things for collecting well dust, I mean, well fumes, missed or any kind of an industrial dust, we do quite well there. And that business has been growing double digits for a number of years. We'll continue to press on that opportunity as well.

Got you.

The other place I'd like to just mention about where we have good growth opportunity geographically would be India. And so we have really good, both on and off-road opportunities within India. But also there is where that whole life science opportunity may present itself more aggressively than we have considered in the past. And so we're continuing to look at that hard as well.

Got you. Maybe the last question from my side. Donaldson's position overall kind of the EV ecosystem has been kind of point of investor focus as well. When you think about the trade-off between biologic versus hydrogen fuel cell. Can you just remind us of your own exposure to the energy transition, right, what the kind of content nuances are between those technologies? And then what opportunities Donaldson has got within each bucket of those technologies?

In 10 seconds...

Don't worry, feel free to...

Okay. All right. So really, when you take a look and consider what we have relative to electric vehicles, what has to happen, I was talking to a large agriculture Board member, a company board member, and I had considered that the battery technology for a combine would last actually about 4 hours before they would have to recharge it again. And this person corrected me and said it's actually 45 minutes. So the better technology clearly has to have leaps and bounds for it to go into the markets that Donaldson plays in. Again, we are not in passenger cars. We are in medium and heavy-duty diesel engines, agriculture, construction, mining and over-the-road truck. So that's just how long would it take for them to have that battery breakthrough. I'm not sure. But in the meantime, a number of people are chasing alternative fuels. So it would be a hybrid. So what used to be a 15-liter engine, might be a 10-liter engine, put in series with a battery. That would work, but it still doesn't hurt Donaldson Company. It's quite nice. And then hydrogen has become more of the opportunity. And so in 2 forms. One, you see Cummins as well as in the upcoming bauma show. We know we've worked with companies that will actually also introduce an engine that's a combustion engine just of hydrogen. And that's good for Donaldson as well. Why? Because you still have the intake air, which is what we do today. The fuel source is different. It's hydrogen. It's no longer a liquid diesel, but it's still about taking out condensate and it's about taking our particulate. But now it adds the third challenge, which is take out things like sulfuric acid mercury or whatever else necessary to make it a more pristine gas. So that would be very positive for Donaldson. The other one is fuel cells and fuel cells clearly would not have the liquid-based applications. It would also not have the combustion portion but the filter to actually do hydrogen-based fuel cells on the input would actually have about the same vehicle input as our current, and we're working with everyone who is exploring that as an opportunity as well.

Great. Well, this is a great discussion. So Tod, Scott and Sarika, thanks for the time, and we look forward to the Analyst Day.

Thanks, Dillon.

Thank you.

Thanks, everyone, for your interest in our company.

Thank you.