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

Okay. So joining us today, we have Tod Carpenter, Chairman, President and CEO of Donaldson; as well as Scott Robinson, CFO; and Sarika Dhadwal, the Head of IR of Donaldson. So thanks for joining us today.

So I guess I'd like to kick it off with some questions on -- so I think yesterday, you guys reported first quarter earnings, and you updated the guide. So I think overall, you reaffirmed your guidance, but there were some different nuances. For example, I think volume growth was kind of assumed to maybe lower. And sales in the Engine segment was higher and Industrial segment was maybe weaker. So I just wanted to kind of get your -- the thought process behind your updated guidance.

Sure. So what we reported yesterday and really in the outlook of the guide, we felt like we took a balanced approach to what we're seeing in the marketplaces. We had a wonderful first quarter. Our Engine business continued on the pace that we would have expected when we gave our full year guide 90 days or so ago. The Industrial business also was on a good pace. So everything shaped up in the quarter the way we would have expected it. And so as we've built out the balance of the fiscal year, we say we took a balanced approach. And looking at things, when you look at the macro economics of the potential tailwinds or potential headwinds, the uncertainties in the second half of our fiscal year, reminding everyone that we started our fiscal year August 1, so that was our first quarter, we felt like the guide was a balanced approach. Geographically, every region in the world was up, and so we really benefited from that. And we also benefited from the incredibly hard work that all of our people did relative to pricing. We had told everyone that we expected our gross margins to go up in the quarter. They did. We're very proud of the fact that incremental was -- gross margins, they were up 100 basis points. That has been work that has been ongoing for quite some time. And so consequently, you wrap all this in macro economics and where we see our company backlogs and incoming orders, and we felt as though while people may believe we'd be at the high end of the guide, we still felt like we're in the guide and we're very prudent and balanced on our approach.

Okay. Great. So you were mentioning you might -- there's more uncertainty in the second half, obviously, of the year. So in your volume guide, do you assume more growth in the first half and maybe some decline in the second half?

Typically, our company is about 48% or 49% in the first half to 51% to 52% in the second half. And that's just typical because in our second quarter, which we are in now, November, December and January, the typical cyclicality of some of our end markets happens. There's more holidays, but then also there's less construction projects in Western-based economies. There's also less agricultural movement in Western-based economies. And you wrap that all up, so you see a downturn in this particular quarter that we're living, but then you'll also see the pickup in the second half. And so our guide is just more of a return to more normal behavior relative to what we've seen over the decades in our company.

Okay. Great. And then in terms of geography, you touched on it a little bit. But I think Europe probably represents like 30% of your sales. And China is also an important market, but it's impacted by lockdowns again, obviously. So I was wondering what's embedded in your guide in terms of those 2 geographies.

So when we look at China, what -- where we're at with China at this point is we have lapped all of the initial downturn when the overall COVID shutdowns started happening in China. And so when you do the comps, we feel as though we've taken a lot of that downturn, it's behind us. Now sure, it could go down further, should China really become even more aggressive on lockdowns. However, we feel as though it will kind of bounce along. The uncertainty for China for us in the immediate is where will they go with lockdowns and when will the economy open up. However, when the economy opens up, what will happen to us is we've been winning more programs with Chinese national-based companies with proprietary technologies, for example, with PowerCore. And so when they open up that particular marketplace across China, either in the On-Road or the Off-Road sectors, we feel like we'll get some tailwinds. Now when will they really surface? We're not sure about that. It feels as though we may get a little bit of fits and starts, so we may get a little bit of ups and some downs, ups, downs, before we actually find our feet and keep going forward. And I think that's just probably how China starts to open up over time.

Yes, makes sense. And then more on the macro, so I know you mentioned you're seeing some weakness in disk drives. But given your broad end market exposure, are there any other pockets of weakness that you're seeing across your end markets?

Not really at this time. I would tell you that when we look at our ordering patterns, how we experience things through the overall quarter, we had a more seasonal base reaction that happens in this quarter for us. So things typically, on the order intake, slow down just a little bit prior to coming into the quarter. We did see that. We saw some OE behavior a bit more aggressively pulling down some of the service channel ordering than would be typical, but it wasn't everyone. It was a couple of points, and so we think that's not really a trend. That's just a couple of folks managing inventory balances. And so overall, it feels pretty good, feels more normal in its behavior. On the Industrial side, we have had a bit more cautious on some of the capital-based projects that we would see. So you get a little bit more carefulness on going quote-to-order cycles within our Industrial Air Filtration business, for example. Bit elongated but overall, a real nice momentum still continues there as well.

That's really good color. Thank you. And then on your organizational redesign, so yes, I was just wanting to ask, how big is the Life Science business today that you're going to split off into a third segment? And what was your thought process behind breaking out that segment now?

So we're going to hold an Investors Day in early April.

Yes, in spring.

In early April, in Minneapolis, we invite all of you to attend. We'd love to welcome you to our campus. The snow should be gone. It will be a little warmer, so we'd love to have you. We're going to give you all those details at that time. Life Sciences, as you know, is a very important part of our strategy going forward. And we look to really build that business at above company average growth rates and above company average operating margin rates as well. So we'll give you more details and targets and things like that in April.

Okay. Yes, that makes sense. So maybe this is also what you're going to talk about in April, but are the investments in the Life Sciences business currently weighing on your margins as a whole company?

Yes. So when we look at overall capital deployment, we -- Scott and I go through a very rigorous process where we look to strategically invest in portions of our company that can outgrow those that cannot. Obviously, the Advance and Accelerate portfolio of our company, et cetera. And so we do that quite well. Within Life Sciences, that's been identified as a place that will get an above company average level of investment, and we'll look to press the accelerator as hard as we can to really go forward. Now what's happening at this current moment inside Life Sciences is very exciting to us because we have 2 businesses that we acquired, specifically in the last year, and one of them is Solaris Biotech. That is getting strong capital investment because of the growth opportunities that we have there. And then also, Purilogics. And they both play in related but a little bit different opportunities for our company. And when you look at Purilogics, it's a pre-revenue company. And our muscle, the talent that we have, is really figuring out the manufacturing lines. And so you'll see us invest quite significantly in that business as necessary to be able to scale it up, put it into production and get it out to market. And all of that work is happening today across our company. And so you'll see us really make sure that Life Science is getting everything it needs to be able to accelerate its growth as quickly as possible.

Great. So would you -- is it fair to characterize that your investments will be more geared toward inorganic versus organic for the Life Sciences segment or balanced?

It's both. We -- so I talked about the 2 acquisitions and that we're looking to scale those as quickly as we can. But we have organic projects in the company as well. So we'll put our food and beverage business into the Life Sciences segment. But the reason why we will do that and the common denominator relative to the Life Sciences segment, when we come out with that here in second quarter, we'll give you all of those kind of numbers for -- just to get your mind around the way we think about that, is it has a common base of technology. So it's all polymer-based chemistry solutions across multiple end markets, largely Life Science end markets, but also food and beverage type of markets. And so if you recall from earlier meetings that we've had, our food and beverage business is already a $100 million business. And so that will go into Life Sciences because it will feed technology that allow you to go into some of the other medical-based applications as well. Purilogics, Solaris will also go into there. And so that's how we look at it, that those chemistries that we're building organically in things like this Materials Research Center that we invested in about 3 years ago, are good indications that we're also vigorously attacking this organically.

Okay. That's great. And sorry, one last question on Life Sciences. But I was just wondering how you think of your confidence to be competitive in a new market that you're just beginning to participate in when there are incumbents in the business.

Yes, it's a great question. We're a technology-led filtration company. We have technology that could be applied across a host of end markets. Life Sciences happens to be one. We believe we have the technology to win. We have the right to play and we can continue to go and invest in our corporation and do an excellent job and meet new value propositions or the value proposition that our customers would require in there. So we're very comfortable with that. It's why we've chosen this strategy. This is the culmination of years of work in order to identify where is best for Donaldson to play as quickly as possible. And so Life Sciences really was chosen because we just feel good about our opportunity.

Right. Is the cyclicality also a little less than the other parts of your business?

Significantly less. Life Sciences is a lot stickier than some of our other businesses. And so diversifying the overall corporation, if you go back and look at our investors deck for years and decades, diversifying the company has always been part of our strategy. And so Life Sciences is the next step in doing that. It will always be part of our strategy. It has been part of our strategy. And so it's just a natural extension for us.

Okay. Great. Thank you. Going back to some near-term questions, but I was just curious to know how the channel inventory is today and where you expect it to be exiting fiscal year 2023. And also, I wanted to get a sense of the supply chain and what you're seeing in terms of like on-time delivery rates and backlog versus normal.

Sure, inventory first. So across the overall buildup in the last couple of years, demand was so high that as we solve the supply chain-based issues, this is going to be a different outcome, we believe, than previous recessions. In previous recession, as you go into recession, you'll see our revenue take a hit and probably step -- take 2 steps down. This time, it will be less than that because no one was ever able to fill the channel fully in the past. So you'll see a little bit of a walk down likely, but the OEs -- now for the most part, we're not able to get their channels [ fulled ] to the level that they wanted. The independent channels were not able to fill. And while we are absolutely confident based upon all the customer inputs that we've received that we perform better than our competitors through this cycle relative to supply, we're comfortable and confident in saying that, it was also difficult for us to really meet all the customer demand. So with that as the backdrop, it's the reason why we feel as though should a recession happen across the United States or Western Europe, the drop will be less this time. It will be more muted, and it will likely be a little bit more careful on its walk down, if you will, rather than a huge acute move that we have seen in the past. That's kind of the inventory in the channel where we're at. We feel comfortable that we're still at pull-through levels all the way through the channels at this point. As far as supply chain, about a year ago, I would tell you we were probably chasing about 110 suppliers. And it was all hands on deck. I had to visit one supplier, for example, it was a $0.03 part that we were chasing. We need millions of them but to get our share, it took a little bit more interaction, let's say, in order to be able to do that. Well, all those days are gone now. Now we're back to more normalcy. Where it was 110 people -- the suppliers in the past, now it's kind of our typical 10. We always worry about 10. It will never be 0, right? But we're back to a more normal internal supply chain activity there. And so we feel good about where we are. That said, our delinquent backlog, so our lates to customer position, we always have some, one year ago, it was at an incredibly historical uncomfortable level, embarrassingly uncomfortable. It is significantly improved. It's not back to normal, but it's close. And so we feel very comfortable and confident that we're doing a good job for our customers.

Okay. Yes. That's great. So in the supply chain, so you mentioned you probably managed better than your competitors. So has that enabled you to gain share?

Yes. So we're comfortable we were able to gain share, but we were also honest in saying, we couldn't take all the share we wanted because we couldn't -- even though our customers were calling and saying, hey, will you become my filtration supplier? We said, look, our priority one is the customers we have. And so now we feel comfortable those folks will also -- the ones that we said, hey, look, we would love to but we can't, because there were instances like that, we did win some share, but we turned down some share. But now they're coming back because of the strong customer relationships we have. The integrity with which we operate and try to really prioritize the customer really served us well throughout this whole period. And we just believe in that in having strong relationships, and we believe that, that will serve us well in the future as well.

Yes. That's great. And now turning to price/cost. So I think you're expecting 6% for the total company for 2023, but can you break that out, Engine versus Industrial?

Yes, it's a little bit more tilted towards Engine. Our Industrial business, much of it is more on a quote basis, so that pricing gets updated based on the most recent quote. So we plan for 6% pricing this year, which is a big part of the revenue growth. And that builds on what we did from last year. So the comps, the pricing is more significant in the first half of the year than in the latter half of the year. The gross margin progression over the last 4 quarters has gone 31.1%, 31.5%, 32.9%. And now this quarter, we did a 33.9% gross margin. And so that pricing is obviously coming into the income statement and catching up with the cost. And so we're pleased to see a 33.9% margin happen for the first quarter. Our year-over-year margins will show improvement all year because that price is building in, and we're expecting relatively flat costs this year.

Okay. Great. So in which areas is it harder or slower for you to pass through costs? And also, as material costs come down, which areas do you think are stickier?

So if you think of the Industrial side, there's more independent aftermarket or distribution channels or quote-to-order products. So on those prices or in those products, we can update the prices as we see fit based on our existing cost estimates. In the independent engine aftermarket, we have latitude to change pricing there with just a short notice period. And we want to be competitive in the markets, but we certainly are going to pass on the cost we see. When it comes to the larger OE, we have to negotiate prices on the Engine side with them, and that takes the longest. And that was the reason that our margins kind of came up slowly, as I just mentioned. And most of those negotiations are now complete, so we're comfortable with where we sit today. In terms of costs, like I said, we expect them to be relatively consistent this year. So we wouldn't expect much trading happening, right, in the next several quarters with regard to costs. But we just want to have reasonable commercial relationships with both our suppliers and our customers. And we're certainly not looking to kill our suppliers. So we want to be fair to them, and we want to be fair with our customers. And so we need to make a reasonable profit and have a reasonable commercial relationship, and that's how we really look to operate.

Okay. Great. So I think you mentioned you expect price/cost positive in the call yesterday. So I was just wondering, is there still more to do to achieve that price/cost positive? Or is it like already in your backlog?

I would say the majority, there's still a little bit left to do. But we keep layering in costs, right? And so those are catching up to the cost. So that's why we expect quarter-over-quarter to be margin positive this year when comparing to weaker quarters last year.

Okay. Makes sense. Okay. Perfect. And then I wanted to ask about the Advance and Accelerate portfolio, which the Life Sciences business is included in that. But it's -- in total, it's about 60% of your revenues. And so how do the -- overall, how do the organic growth rates and maybe margin profile and maybe market share in those -- in that portfolio differ versus like your other Critical Core mature or the fix-and-reposition markets?

Yes, it's a great question. So they definitely differentiate themselves with the fact that Advance and Accelerate is 60% to 65% of our overall portfolio. We look for that to be above company average growth. And the way we think about it is the company could be mid-single digit in aggregate, and the Advance and Accelerate is expected to be higher than company averages. When it comes to overall operating margin, it is also expected to be higher than the other -- than other components. There are pieces in Advance and Accelerate that will be at company average, but there's still great opportunities to grow because we would be underrepresented in some of those businesses. And so we'll keep on pressing those. But Advance and Accelerate is really an important part of our company to be able to strategically grow and press forward. And you're right, Life Sciences is part of that. We will, looking forward, pull Life Sciences out, really talk about Life Sciences as Life Sciences and talk about the great things that we're doing in that segment specifically to highlight it more consistently.

Okay. Great. And then on the other side, you're also exiting some low-margin programs in Off-Road and On-Road, but I was just wondering how we could think about the margin profile of the Engine business once that's all behind.

When you -- there's really kind of a 4-box model to it, right? So there's an On-Road and an Off-Road, and then there's replacement parts and first-fit, okay? So if you just think about this, the On-Road is less margin than the Off-Road and the replacement parts is higher margin than the first-fit. And so the complexity of all those is really how you build the model and how you look at our company. It might be intuitive, but it really needs to be pointed out for people as they build their models and have expectations for our company.

In conjunction with some of the work we did last year to rationalize certain products and what we've put in the forecast this year, we just want to make sure that our company knows if we have products that are not at acceptable profitability levels, we need to address those. And we need to talk to our customers about that and say, costs have gone away up or pricing has fallen on these products, and we can't continue to supply at these levels of margin. And so we're giving our employees and our company permission to let go of those products. And we'll work with the customers to help them resource those products to someone else. We're not going to just cut them off right away, but we want to continue to prune the business or tell the customers we have to raise prices on these specific products or we're not going to continue to supply them. And that's just a process that we think is healthy for the company. And we want to plan for that, so we're not stressing our business units to chase these poor products. We want to give them the freedom in the plan that allows them to do that. And when you pull out poor margin products, inherently, your margins are going to mix up. And that's really what we're looking to do. And we did that with a larger piece of a pass-through business last year, where we pulled that out and we resourced that with one of our key OEs. And now we don't have those lousy margin products anymore.

So it's like a continuing process that you're working out with businesses around that?

And now with the costs that have moved up so far in certain categories, if we're not going to be able to get pricing to compensate us for that, then we're not going to deliver those products. And the customers need to know that, and we're not trying to be difficult about it. We just need to be paid for our technology. And if a certain customer or a certain product can't achieve that, then we're not going to do that.

Makes sense. Maybe this is something that you're going to address at your Analyst Day in the spring, but I was just curious, you're adding to Life Sciences and you're exiting your -- you're constantly looking at the portfolio. And so what -- how should investors think about how your portfolio should look maybe 5 years from now?

That's a great question. I don't think anything changes about our approach. Looking forward today than it did 5 years ago looking forward, I do think that we have maybe more of an accelerated approach in that we're more focused on building out a third leg and really advancing that. But 5 years from today, we'll be talking about more diversification in the corporation because in the filtration space, there is many applications out there where Donaldson filtration technology can apply. And so we'll just continue to pursue those, continue to press forward. The portfolio should be stronger on the Life Sciences sector for sure, 5 years from today. We should be talking about the next large entry point for the corporation, and the other businesses will have continued to grow. Our Mobile Solutions business will continue to grow. Our Industrial business should continue to grow. Overall, we will continue to press that strategy. We have a number of opportunities in underrepresented geographies that we'll continue to press forward and continue at the same time, to add -- so you'll add depth to those businesses that we have, and you'll add broadness to the overall corporation.

It sounds really exciting 5 years from now. And then maybe shifting a little bit to the competitive landscape. So Cummins announced their intention to spin the filtration business. I was just curious what that -- how that will impact your business.

It's a great question. It's interesting. We're all going to learn how this plays out over time. But I would tell you that Donaldson's strategy, our #1 choice is to be a technology-led filtration company. We have been developing new filtration technologies for decades, actually, for 107 years, okay?

That's a long time.

And so consequently, we feel good about our ability to compete because our company is more broad than say Cummins -- coming out of Cummins. And so we feel as though we have a head start into many of the markets that they also talk externally about. We're comfortable with the cards we're playing. We're going to continue to press our strategy. We're very comfortable with our strategy. We're committed to it. The Board of Directors is committed to it. The officer team is committed to it, and we feel good about the hand we're playing.

Okay. Great. And then -- so this is also something that may be addressed in April. But back in 2019, you set long-term targets. And the sales are already there, but the margins are a little bit below, I think. So I was just wondering what's -- like understanding the supply chain and raw material costs are weighing on margins, what's kind of preventing you from achieving those targets?

So we just reported yesterday that our first quarter for this fiscal year was 15% op margin, which is the low end of that guide from 2019, which means we have now checked all the boxes from the last investor guide. Now clearly, we have to carry that out through the balance of the fiscal year, and our guide is sitting at 14.8%, 14.9%, kind of in there. We feel comfortable about our ability to play out a lot of uncertainty in this year, but we're on a very good glide path in order to be able to get the gross margin -- or sorry, the operating margin to where we had said at Investors Day. And then, of course, in early April, when we have that new Investors Day, we'll come out with new targets. We're really, really proud of the fact that all the targets that we set in 2019, given COVID, there was a 1-year lag, okay? I will absolutely embrace that, and we own that. But we feel very proud that we once again as a corporation said what we were going to do and did what we said.

Yes, that's great. Thank you. And then, yes, we have like 3 minutes remaining. But I quickly want to touch on -- so the U.S. is -- obviously, there's concerns it's going to go into a recession next year. And your business is 50% aftermarket, so which makes it really resilient in a downturn. But how should we think about your earnings power in a recession? And are there any unique nuances this cycle that -- you mentioned channel inventory earlier. But also maybe like some secular end market tailwinds that will kind of support your earnings versus the broader macro?

Yes. So at the core of who we are, we invent cool things, right? And they happen to be in the filtration market, but we invent proprietary razors to sell razor blades. We do it in infiltration. That razor blade business for us is 65% of the company. The OE portion is about 35%. And so what we will typically see if we end up going into a recession is the first-fit build side will slow. You'll see some elongated quote-to-order cycles in the CapEx-based businesses. You'll see the OE build rates start -- on the Mobile Solutions portion to start to tame a little bit. But we don't believe that we'll see a dramatic inventory adjustment across the independent inventory channels because they didn't get filled. We will absolutely see some. We will see some adjustment. But it won't be as acute it was in the past is our view. Overall, that's how we're looking and planning our company going forward. As far as offsets, if you just look at the vehicle utilizations and really the unevenness of the world today relative to the economic cycles that it is in, that is a wonderful hedge for our company because of the fact that we are so global, keeping in mind that only 35% of our revenue is in the United States. And so that gives us some natural offsetting nuances to the larger cycles. And then also, we have a very, very broad portfolio of businesses. And I understand people always talk about On-Road, but that's single digits revenue of our company. So there's many other businesses that help us also lessen the cycles.

Okay. That's great. And with one minute remaining, I just want to squeeze in one more on the alternative powertrain, which is about the On-Road that you were just talking about but also Off-Road to, I guess. But so your competitive positioning, investors are really interested and like curious about this. But in alternative powertrain and how your content is different, hybrid, battery electric, hydrogen electric versus diesel.

So potential technology outcomes, as we -- as a world, move away from diesel engines. If you believe the solution is hybrid, so in other words, a 15-liter diesel engine goes to a 10-liter diesel engine in series with a battery, I would tell you, bet on us. The reason you bet on us is because we have the best technology in the world for that current state of business, and we have the deepest customer relationships. The next possible outcome, a bit like Cummins is doing, where you take the combustion engine, similar to what they were doing 15 years ago where they were going to use natural gas, but now they're using hydrogen for the combustion-based process, nothing appreciably changes. The overall fuel source is different. But from a filtration stand point of view, it's just particulate and it's condensate water that you have to keep out. That's what we do in the current fuel source. That's fine. You still have moving parts. So your overall lubrication is the same and your air intake is the same. So if you believe that's the way it's going, I would tell you bet on us because we have the best technology and the deepest customer relationships. If you believe it's going to be fuel cells, lubrication will go away, which is fine because that's the most commoditized. And the overall fuel source will need to be pristine gas, and we do that and have been doing that for years in our Disk Drive business. Sometimes, you have to take out carbon dioxide. Sometimes, you have to take out other chemicals. Not all fuel cells are created equal. We are working with all the OEs that are chasing that type of a solution as well. So if you believe fuel cells are going to be the answer, I would tell you, bet on us. The reason is because we have the deepest customer relationships. We're working with all the engineers and we have the best technology. So overall, what do we believe the outcome will be? It will be a mix. And so therefore, we tell you that being a technology filtration company, we stand in a strong position to be able to win as those alternatives come forward.

Okay. That's great. Amazing. So with that, we're out of time. So thank you so much for joining us today, and thank you for joining us this Industrials Conference.

Thanks, everyone.

Thank you.

Thank you so much.