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

It's a pleasure to be with all of you today. Thanks for hosting us. So maybe we'll just try to make up a little bit of time here. So we have the safe harbor statement, just to let you know that it's all included as a quick reminder. We closed our fiscal year, which is August 1 to July 31 and reported. That's what I'll be referring to. Actually today is the last day of our first quarter. Obviously we'll not be talking about anything with regards to that. So just as a quick overview with messages that I would like to have you take away about our company. Strategies about choices, we choose to be a technology-led filtration company, we choose to have deep customer relationships. We believe that sets us apart within the industry. Overall we have a very diversified global portfolio of businesses and many opportunities for expandable businesses in markets. We have an experienced management team and an experienced Board of Directors team that all has rallied around our long-term strategic goals and targets and have our total commitment and support. Fourth, we are everywhere the customer wants us to be. So we like to say we are global with a localized footprint. And last, we have a culture of ownership. You would -- and we'd like to also have you understand that we have above industry average ownership guidelines for myself, for example. My ownership requirement is 10x my base salary, which is significantly above industry. And we do all of that throughout all the officers and the Board because we like to say, "You want us to act as owners, not as just managers." Just turning quickly and touching on ESG. Within our environmental health and safety, a portion of the activity we did cut out 6,000 metric tons of CO2 last year. So we did meet all of our targets. We recently published our whole new guide relative to where we're headed in that direction. We are strong community advocates, continuing to reach out with the Donaldson Foundation and giving back to all of our local communities of where we are. And we have a strong governance culture across our corporation with a very diverse board, as you can see, and also a nice evenly balanced 10-year board. So I'm getting a little bit deeper into the company. We are $3.3 billion. You can see our split within our 2 reporting segments, our Engine segment and our Industrial segments. But one thing that I'd like to really call attention to is that middle pie there. We are a razors, proprietary razors to sell razor blade company. We do it across all of our portfolio of businesses. And therefore 65% of our revenue is recurring and razor blades. You can see our regional breakdowns in the last pipe. Also of note in the far right, the bars there, as you can note, our top market, if you will, is on our engine business and the second largest is in our industrial-based businesses. So that speaks to the diversity that we have across our corporation. If you look at the latest metrics that we published, they tell you that we reported record revenue at $3.3 billion last year. All the way to the right, we reported record earnings per share at $2.68. And we have opportunity as you look at the 2 in the middle. In the middle, we have our operating margin is at 13.5. I'll talk to you about our latest guidance here in the next slide. But we have opportunity because it's really a gross margin story. That 35% of our business, which is heavy OE base, always lags inflationary-based responses, and this is no different. However we have had expanding gross margins over the last 3 quarters. And when we report the quarter that we're just finishing, we would expect to have expanding gross margins in that quarter, all pushing our operating margin back to where we would expect it to be, in the 14s. Our adjusted free cash flow, you'll see it down last year, that was by choice. We relied heavily based upon the supply chain problems that we were experiencing on our balance sheet, which has a very comfortable net debt-to-EBITDA ratio of below 1. And so we invested in inventory to take care of our customers. Remember that choice of strong customer relationships, and we really used our strategic balance sheet, if you will, to be able to go after that. We'll reverse that this year now as many of the supply chain challenges that we had have cleared. So you'll see that free cash flow really change in this fiscal year. Therefore our guidance is for the fiscal year that we are now in, is to set a record on the top line, to have a strong over 100 basis point operating margin expansion year-over-year and to have a record earnings per share. How we look at capital deployment? On the left chart, we play in a $65 billion filtration industry. $16 billion of our engine business is roughly just over $2 billion of our company in the industrial business is that darker blue. And you can see how we've gone into service for a $3 billion opportunity and that slight slice into food and beverage, you roll that together, that's an $11 billion opportunity. And the gray all the way to the black bar is where we're heading technologically, which through organic opportunities as well as acquisitions. We'll head down that wheel into the medical and pharmaceutical over time, really opening up roughly half of the entire filtration industry as opportunity to our company. Therefore in order to grow our company on the right side, we look to expand our technologies, our technology platforms, our solutions. We have good market opportunity to extend into markets where we're underrepresented and to execute strategic acquisitions. We look at our portfolio much as the way all of you would with Advance and Accelerate, getting the disproportionate share of investments in our corporation. Critical Core would just be probably the most cyclical portion, but it gets strong investments as well. Mature markets, many of you would say, cash cow, fix and reposition, we are in good shape there with only one business at this point in time in that particular box. I do want to call attention though to the right side, where we talk about strategic acquisitions. Purilogics and Solaris Biotech are in that medical space where I told you where we were going. We have organic projects, but specifically in the M&A, we have targeted filtration companies, both of those very unique and really help us get in a strong foothold into that particular medical-based markets. And on TA Industrials, that's really about that $3 billion service opportunity where we continue to test models in the industrial space, and it was a nice small acquisition that we allow to build on. And so you can see, strategically, we say what we do and we do what we say, and that is we're going after those particular strategic choices and our acquisitions aligned with that. Just quickly touching. You could look at this later at how we really break up our portfolio. I do want to call out that 61% of our portfolio is in the Advance and Accelerate portion of our company. Strategically, we have deployed over $1 billion over the last 3 years, as shown here, 7% to M&A, 30% to dividends. We are a proud member of the Dividend Aristocrat's fund, meaning we have increased our dividend for over 20 years in a row, and we continue to look to do that and behave in that consistency of story. 38% has been share repurchases, again, a very consistent behavior where we look to buy back a minimum of 1% to offset any dilution that we may have as a corporation. And in most years, we look to do 2% in order to bring that down by about 1% over time. Within capital expenditures, we have really gone through a reinvestment back into the corporation pretty significantly expanding our capacities, which turned out to be a strategic bull's eye for us over the course of the last 3 years because as we bounced out of the pandemic, we were able to take care of our customers better than all of our competitors. And capacity is not a concern for us, our ability to produce product. We did have the supply chain challenges as most, but we can meet all of our customer demands. So just very quickly, our priorities with capital deployment, our first invest back into the company. Next, M&A portion of our strategy. Dividends remain very important and a consistent story of share repurchases. Our dividends, Scott likes to say, we've paid them for over 66 years and he doesn't want to be the Chief Financial Officer that messes that up. I can tell you it's a very important part of our story, and we will continue to grow this corporation so that we can continue to act consistently for all of you that trust us with your investment. With that as a backdrop of our corporation, [ Brian ], I think I've made up a little bit of time here. So I'll throw the floor open for questions.

Yes. Can you hear me, Tod?

Yes, I can.

Okay. Great. And thank you. You did a terrific job of catching some tailwinds, and we've got a couple of minutes after the end of the half hour that we can go into. I want to talk -- you spoke to something that I think from a stock perspective isn't necessarily priced in. Is that 100 basis points of margin expansion that you're targeting for 2023 or your fiscal year ending in July. How much of that do you think is under your control versus external factors that have impacted you to this point?

Yes, that's a great question. We believe all of it is under our control, just simply because of the fact that we've now started to see the pace of inflation actually start to abate. While there is a little bit of inflation, it would be starting to plateau a bit, which means then what we have to do is get the pricing opportunities reflected across all of our businesses. Some of them lag, OEs are pretty fantastic at dragging their feet on that. We still have some work ahead of us. However we're very proud of the fact that over the last 3 quarters, we were at 31.1, 31.5, 32.9 on the overall operating margin, our gross margin expansion. And so we look to build on that. And we have confidence with all of our teams working around the world to get that pricing action normalized as well as our supply chain issues. I would tell you, our supply chain, one year ago, we probably were chasing between 100 and 125 very critical parts. We were looking all the time for the golden screw, I call it. We would have 9 out of 10 parts, when the golden crew came in, we produced. Now I would tell you we're back to pretty much normal. We're under 10 items that we're chasing, and they're the same 10 in more normal type of environment. So we would tell you that the majority of that is under our control.

Yes. Let's talk about this though as well from a sourcing perspective. Given the amount of aftermarket business that you have, have you changed any sort of thoughts on where you're sourcing your materials, whether they're raw, whether they're purchased, whether subcomponents, et cetera?

Yes. So we have had in order to meet this supply and demand, particularly when the horrible Texas weather event happened last year, that forced us to build things in Europe to bring it back to the U.S. And for us, normally, the United States is a net exporter. So we usually like to build within region to support that region. And with all the supply chain problems, it really pressured us to take care of our customers and do really use the available capacity where it was where we can get supply in order to do that. That is all renormalizing now. So it's another -- one of those factors that give us confidence that we can really fix our gross margins.

If we're thinking about the aftermarket component of your business, which is about 50-50, and it's one of the reasons why you're such a great company and such just terrific stock to own. It's usually one of the earlier -- earliest indicators of any sort of economic trouble or any sort of economic recovery. Can you talk about what you're seeing there and whether that really translates to any sort of thoughts on the slowdown upcoming from broader economic activity?

Yes, it's interesting, right? Because if you go and look at the previous recessions, what would happen is you'd have a significant step-down event and the destocking as a result of all of the independent and OE aftermarket channels, all the replacement parts. However, this time, it was never able to get to the inventory levels that they ever made to independent channels or the OE channel comfortable, right? So when we're looking through what we're seeing today on the order intake levels, we're suggesting that it's more pull through. And we go out and visit our -- we're back to visiting our dealers in all regions of the world, except for China. China is obviously difficult. You know all about that. But all the other regions of the world, we're able to touch our customers more. And so we would tell you that if there is a pullback, it is not going to be of the levels of step-down that we've seen in the past simply because no one was able to build the inventory to their liking.

That makes a great deal of sense. And one of the other pieces of this aftermarket business that you have is the ability to pass on price. So we've discussed maybe some of the inflationary issues on the OE side that you've had to deal with. Talk about how you've handled that from an aftermarket perspective and how that's -- go ahead.

Yes. So on the independent channel of the aftermarket, we control our own price, right? So we've been able to push the pricing as quickly as we see the need to. So you -- what we like to do is be more normal and predictable on our pricing actions, which typically take place January 1. There are businesses we had 4 pricing actions last year. As steel continued to, for example, to ramp up far quicker than anyone would expect, we went out and we changed prices 4x. So across the independent channel, we would tell you we're in good shape. We're actually back to normal in a large part of the company, whereby our pricing behaviors will go back to annual. Where we're still lagging a little bit is we still have some stubborn OEs that have not come all the way through. And frankly, what we're doing there is just telling them, listen, we're going to be reallocating our capacity to those that we feel proper and fair relative to the pricing. And so that's the way we've handled the situation. So we're almost through all of it, as you can see by the fact that our gross margins have expanded over the last 3 quarters. A little bit more work to do, but we're pretty happy with the progress. Independent channel, it's kind of business as usual right now.

There are no questions in the audience, I want to ask one about some of the growth channels that you have going forward, whether it be on the medical side or within food and beverage. The slide is terrific about what the opportunity is. Maybe talk about the pipeline of what might be behind what you've already purchased and how that blends with your strategy?