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

Okay. We'll go ahead and get started. Thank you all for coming. I'm Brian Drab, the industrial technology analyst at William Blair. I've covered Donaldson Corporation since 2008 at this point. I was -- it's amazing this stat. I woke up this morning and realized this is my 19th conference, including if I go back and conclude my internship. So in 5 years, I'll be able to say that I've attended half of the William Blair conferences if I have my math right. So today, we're lucky to have with us CEO of Donaldson, Tod Carpenter; CFO, Scott Robinson; and Head of Investor Relations, Sarika Dhadwal. Donaldson, as I think probably most people in the room know, is a global leader in industrial filtration, specializing in engine filtration, specifically air intake filtration is one of the specialties, but any type of filtration, fluid, fuel, et cetera, and also a heavy focus on industrial businesses, dust collection. I really shouldn't say too much because then you're going to get up here and say you don't have. So I'll stop. I'll let you talk about bioprocessing. Also, I have to mention that you can find a full list of research disclosures on our website, williamblair.com. And we have a breakout session for those of you that would like to continue the conversation in the Maher Room on the second floor. At this point, I'll turn it over to Tod. Thanks for being here.

Thanks, Brian. I appreciate that introduction. Thanks for all of you -- to all of you for being here and your interest in our company. With that, we'll dive in. So the main takeaways that I'd really like to give to all of you today is that Donaldson Company is the leader in filtration technology. We're $3.4 billion. And technology is our strategy. We want to be the leader in all of the filtration activities that we have and be the technology leader such that we have proprietary razors to sell razor blades. Next, we are everywhere that the customer wants us to be, with deep customer relationships. And we are, therefore, an enabler of the green modern economy, meaning that our filtration technologies help our customers meet their targets and the relationships relative to ESG that they have put out. Also, we have a clear strategic balance within the growth strategy that we'll go through here very quickly, both penetrating new markets as well as pushing forward to gain share into markets where we already enjoy a strong position. And last, we are on a journey to add a third leg to our company, which is in the Life Sciences segment. We'll give you a little bit more look into that here in the presentation as we progress. So covering some foundational metrics of exactly who we are. We are born in 1915 by Frank Donaldson, so we are a 108-year-old company, roughly over 14,000 employees, 140 locations. Very importantly, we have 2,700 active patents. That's what's been created since the last time we had an Investors Day in 3 years. So if you just do the math very quickly on that, over the time since pre-COVID and the Investors Day that we had about a month ago, Donaldson Company somewhere in the world released a patent every day. So when we say we are a technology-led filtration company, we're very serious about that. And we have had tremendous success continuing to push forward our solutions. We -- our last fiscal year reported record earnings and record EPS. We are roughly 65% of razors or replacement parts and 35% proprietary solutions. Importantly, our strategy from around the world is to build within region to support those region-based customers. So you can see we're roughly 40% in the United States or across the Americas. We are 30% in Europe, 10% in Latin America, and 20% in Asia Pacific. But it is important that 75% of what we produce is within region. So we are not pushing parts all over the world, but with our strong presence within region, it allows us to be where the customer wants us to be to meet their cost obligations as well as their supply chain obligations. So we do quite well internationally with that regard. Along the bottom, you can see our top markets. Clearly, construction, on-road trucking and industrial air, the darker portion would be that first fit portion or the first-fit vehicle or project based in the case of the industrial application, and the lighter portion is the replacement parts. And you can see how our markets lay out there. While it's true we gave record earnings and record revenue last fiscal, we just reported our third quarter and reconfirmed our guidance for this fiscal year, which will end on July 31. And what we guided is, again, record revenues and record bottom line for our company. So we continue to do quite well across our corporation. We look to expand our operating margin this year by over 100 basis points. And then our midpoint, it's about $3.03. And you can see the nice trajectory that we've had, growing EPS here as shown over the last 4 years. Our strengths as a corporation, when we really look deep inside ourselves, why do we win? Because we have those deep customer relationships and we solve complex problems for our customers with proprietary technology. We have a long history of filtration technology. And in all of our markets, we look to use that proprietary razor to sell razor blades. We are diversified with a whole host of businesses that I'll get into a little bit later when we talk about the segments. And we are an enabler, as I talked about earlier, of the greener economy that continues to progress throughout the world. We have best-in-class operations. Throughout the pandemic, even though we suffered supply chain issues much like everyone in the world, we continued to hear throughout that entire time, "Wow, you're really doing better than everyone else." Very little comfort to us since we knew we were disappointing customers, but it really showed the class of our organization. And today, we have returned back to normalcy through our supply chain as well as through our manufacturing cycles. We also have a very high aftermarket retention level, as I said, with 65% of our revenue being the replacement parts. We have 3 reporting segments. Within the last 6 months, we created and broke out for you our third segment, which is Life Sciences. The most established portion of our company is Mobile Solutions. So think of that as medium and heavy-duty diesel engines there, liquid-based filtration for all applications on construction, agriculture, mining and long-haul trucks. It's important to realize that we are #1 in the world. However, we still feel as though we have in mid-teens share, which is another way to say, we have 85% more market share to go win. And we are focused on that in order to continue to grow into underrepresented geographies for our corporation. Our Industrial-based businesses, there's a host of different businesses for industrial infrastructure type applications. Our largest piece is industrial air. Within industrial air, think of things like weld fumes, wood chips, even pharmaceutical dust and even gold dust for jewelry manufacturers. Why? Because we can actually collect the smallest particles and help them reclaim it. Our technology surface loads it and allows it to get away from the particular application better than anyone in the world, and we continue to win in the whole host of industrial-based applications as a direct result. We also have inside this Industrial Solutions, power generation applications and other businesses. Our newest segment, our smallest segment in the neighborhood of $240 million, we broke out this year is Life Sciences. And we broke it out because we wanted to actually tell you that, listen, we are doing this. And we want to give you all the metrics to have you watch our progress. We have an excellent strategy that we formulated. It is a strategy combined of organic opportunities as well as acquisition, but that is our third leg as we continue to grow the company on our journey to become $4 billion over the course of the next 3 years. Digging deeper into each of those, you can see within the Mobile Solutions market opportunity, it's $14 billion. We're roughly in the neighborhood of about $2 billion, $2.4 billion or so. Within the Industrial Solutions, we are playing in a $15 billion market. We're about $1 billion. And the interesting growth opportunity that's taken place within that particular market is we are digitizing applications, which means on your cell phone, you'll get alerts to tell you how the dust collector is working, and you'll also soon be able to press a button and order replacement parts from us. And they'll go directly through the Internet, and we'll ship it to you. We've long been shipping same-day replacement parts, if you order before noon. We've been doing this for decades. And now we're going to make it easier, so you can press a button and order. We're on that journey to digitize and hook up all of our industrial-based applications, be it in hydraulic applications, industrial applications, power generation applications, compressed air applications, and we're on that journey. And we will then allow ourselves to go deeper into the service-based portion of that in order to complete the circle, if you will, of the customer relationship and really have a closer customer relationship than ever before. So we are digitizing that. It's going quite well, and that's one of the primary growth engines that we have within the company. Within the Life Sciences business, we now -- it is a large opportunity. You can see we are very early in the journey, $21 billion opportunity. We're only at $250 million or so, but we do have good opportunities inside there with the organic products that we do have as well as acquisitions that I'll talk about shortly that we have completed. When you look specifically at the Life Sciences piece and where we're focused and how we're going after it, you can -- inside the major pieces, you look at food and beverage, alternative proteins, which means we're helping companies grow alternative proteins, salmon, for example, one inside our bioreactors. We bought a company. You could see that down on the bottom called Solaris. Solaris makes bioreactors. We, Donaldson, has filtration. We combined the 2, we help this particular company now grow salmon-based proteins in the bioreactors for human consumption. The FDA has approved chicken for human consumption. Salmon, we believe, will be next. And this is a good opportunity for Donaldson Company because if you start to think about just overall seafood-based consumptions in the world, if you take 1% of all the seafood combined and now you grow it in bioreactors, there is not enough bioreactors in the world to produce 1%. And we're in the bioreactor business and also all the filtration opportunities around the bioreactor. So think of that as a systems-based approach, which we, as a company, are very comfortable with. We do that every day in our industrial-based applications and now, we'll be doing that over in the Life Sciences-based applications. That's the alternative protein type of application where you put Donaldson and Solaris together. The other is the bioprocessing opportunity. And you can see Purilogics, Isolere Bio, Solaris and Donaldson. So the 3 obviously added to Donaldson help us go directly into that area. And I'm going to talk just very briefly about why we believe we will win. If you think in chromatography, a chromatography column, when you're making, say, biologics, a particular protein of choice, a chromatography column will be, say, 3 feet in diameter. It will be 5 feet tall. And you put a solution or mixture inside that particular column. Inside the column, though, then you want only 1 protein. So you pack it with resin. The best way for the lay person to think about this, I think, is if you remember the marbles that are clear that looks like they have cracks in them, that's what a resin bead looks like, but they're really small. The cracks are coated with something that attracts the protein of choice, and then you get rid of all the other solutions, then you release the protein of choice. It takes a long time. Within Purilogics, you do not need -- it gets rid of the resin beads, and it takes the solution after you mix it up within the column, and you take it directly through the Purilogics cassette. It's 10x faster than anything in the world. And it also goes and allows you to increase your yields. So Purilogics in this membrane-based solution, we actually were working on this organically inside of our laboratories. Purilogics was just better than we were -- we acquired Purilogics. The founder still remains with Donaldson Company. We're using the strength of Donaldson's personnel, our engineers, strength of our balance sheet and continuing directly into this market. And it shows you the skills and how we're looking at expanding the overall product portfolio. Take Donaldson strength, the acquired strength, put them together, expand the product portfolio, go in there and change those particular markets because we have a good strong value proposition. And then within the medical device applications, we've been in medical devices for quite some time. You probably don't know or we don't talk a lot about the fact that we are in ostomy bag filtration and have been for many years. We're also in hearing aid devices. And so medical devices for us is pretty common, and we'll continue to go directly into that space and where that space really comes from and our opportunities is within our disk drive business, our expanded PTFE membranes, which allows us to take that into shapes, go more directly into the medical device application. And we do have programs that are Class III-based programs that we are working on with our membrane-based solutions. So this helps, hopefully, you understand where we're headed within our Life Sciences initiatives. We have given targets where we -- this particular portion of our company will grow at roughly 20% CAGR over time and by fiscal '26 or in 3 years, we will be double, roughly double the size of the business at about $450 million. Switching now just a little bit. Now we've showed you where we're going from a segment standpoint of view. And I just want to talk about the strength of the balance sheet and the strength of the company. Within the last 3 years, we have put $1.1 billion to work within our company. You can see the breakdown as shown on this slide. Our overall capital priorities are: first, organic growth, to invest back in the business, to continue to press on our growth opportunities. That remains absolutely our clear focus to go organically. Second, to buy companies. We have added 3 acquisitions within the last year or within the last 2 years. We continue to work that cycle now. And I would tell you that our overall acquisition pipeline still remains strategic, robust, and we remain very focused on that portion of our strategy, and we look to continue to execute, as we did with the prior 3 acquisitions. Third, we are a very, very proud member of the Dividend Aristocrats Fund, meaning we have raised our dividend every year for at least 20 years, and we've been paying a dividend out for over 60, and we continue to have that as a significant priority for our company. And so Scott always likes to say as the CFO, "I'm not going to be the CFO that messes that up." So dividends are very important to us, and we'll continue to look to remain as a proud member of the Dividend Aristocrats Fund. And then last is a consistent share repurchase approach where we look to buy back at a minimum 1% on an annual basis to offset dilution. We have, over time, actually been able to buyback 2%. This year, we're on a path, we have told you that we would buyback 2%. And so overall, again, the way we look at it is just to offset dilution. But that's our fourth priority and probably the most variable one, should it be muted. So as you look at our company, we have a very strong balance sheet. Our net-debt-to-EBITDA ratio is less than 1x, actually 0.7x at current. Our free cash flow -- our cash conversion rates is very strong. We'll be over 100% this year. We believe over the next 3 years, it will be roughly around 85%. That's our target. And you can see that we have $800 million currently available to us. Clearly, given the strength of our balance sheet and the performance of the corporation, clearly, we could get more, but this is our current position. But I do also want to point out that we are an acquirer of choice. And acquisitions are an important part of our strategy, but will also continue to be strategic and selective about them to make sure that we are executing the plans that we have laid out. So we are an acquirer of choice, and we will be good stewards of the capital. So if you wrap all that up, this is what we shared with you as our targets for our Investor Day. We look to grow to become a $4 billion corporation by our fiscal '26, remembering that our fiscal '23 ends July 31, okay? So we will begin this 3-year journey to get to $4 billion. We look to expand our operating margin from the current high 14% to be in midpoint at 16%. And over the cycle, we would look for our incremental margins to be plus 20%. So very strong. Within the 3 segments, you also see more specific numbers. I won't call them out specifically, but you can see we have a good plan. We have overall capital that we need in order to execute this plan, and we are really doing quite well operating as a corporation, having just reported yet again record top line and record bottom line. So with that, Brian, maybe I will leave this slide up and throw it over to you.

All right. Thank you very much, Tod. So we have 7.5 minutes for Q&A here. And I misspoke earlier this is the last presentation of the day. So the break-out room is actually this room. So we can talk for 37 minutes and 20 seconds, if you want in this room or you -- and I'll let you all know when the 7 minutes is up and you can go on. So the Life Sciences business, maybe talk about that first, and then we'll open it up, obviously, the Q&A from everyone. But the Life Sciences business is in the very early stages. I think it's very exciting that you're embarking on this journey of growing in a new business. What -- can you just remind me what you said at the Analyst Day in terms of the target -- in terms of I think, I don't want to say the number because I can't remember at the moment, dollars of revenue that were kind of embedded in the target, the longer-term target from Life Sciences, how you grow to that amount? And who you're competing with, and how hard is it going to be to get there?

Yes. So overall, our Life Sciences business is roughly about a $240 million business. We would expect our CAGR to be over the next 3 years a 20% CAGR. Likely won't be linear, but a 20% CAGR, we would expect our overall op margin on that to be well above company average. That will also likely not be linear because of the investments that we'll make, but we do expect that to be roughly in the 20% range within the op margin of that piece of our corporation. So we have a good plan. We have good opportunities organically. All of the numbers that I've told you about the targets do not include any acquisitions. So that would be with the hand that we currently play, so we will be able to add on top of that should we execute or when we do execute further acquisitions. People that we play with or people that we compete with. If you look at Purilogics, it would be all the who's who that makes resin beads in chromatography space, okay? So it's really the Thermo Fisher, Pall, Danaher, the rest, but it's because we're not trying to do what they're doing. We're trying to actually have a better technology-based solution in order to be able to go into that marketplace and beat them. We're not going in -- we are a technology-led filtration company and a technology-led media-based company. We're going in with technology in order to improve processes for our customers as we do in every particular piece of our company. And so that's how we look at it. And we'll continue to press forward within the Life Sciences space with that mindset.

Got it. So the number I had in my head was $70 million. That's what I calculated after the Analyst Day that I just pull out my notes. So based on the slide that you put up and knowing how much is disc drive, et cetera, in there, you're growing it from basically like $5 million in revenue to $70-ish million, does that sound in the ballpark? Just for the new Life Sciences, the 3 acquisitions you made collectively today growing to that kind of ballpark in the future?

I'll be disappointed if it's only $70 million.

Great. That's the strategy, poke them with a number and get them to respond like that. Are there any questions from the audience, please?

Is electronic vehicles. Are investors exaggerating the threat there? And can you just talk about what's going on?

Sure. The question for everyone in the room, electronic vehicles, are investors exaggerating the threat there, and can we talk about what's going on? So 3 particular types of outcomes relative to electric vehicles. First, I want to remind everybody that Donaldson does not sell to car, automobiles for combustion engines. We do not have any air filtration or any liquid filtration. And that's very, very important because then what happens with EV solutions has to happen for Donaldson to have headwind in construction, agriculture, mining and long-haul trucks. So that makes the challenge much more significant because of the energy density needs of a battery, okay? Just to give you an understanding of the challenge of that, I was talking to a large agricultural Board member. And I thought that on a large combine, batteries we're to a point of about 4 hours before they have to be charged. And I was corrected, it's actually 45 minutes. And so consequently, there is really a leap that has to happen before we start to see the head winds. So then what's the other potential outcomes? Well, you have those that are making diesel engines and like they did with natural gas 10 to 15 years ago into the combustion engine, they're going to put hydrogen, okay? And so when hydrogen comes forward, what happens to Donaldson? Our market expands because it still needs air for the combustion process and hydrogen fuel, you have to take out particulate in water exactly the same thing that you have to take out for diesel. We happen to be the best at taking out particulate in water, okay? And we also happen to be the #1 air manufacturer. So from hydrogen into the combustion solution, which is the closest to market solution? And the one that comes and this is happening, that's good for us. Go to fuel cells, not all fuel cells are created equal. So I understand the term fuel cells would suggest they are, but sometimes you need to take sulfur out. Other times, you need to take mercury out. It depends upon how you're designing a fuel cell, but the important part from a filtration standpoint of view is that hydrogen has to be pristine for a fuel cell to work. That's beautiful for us because we understand how to do the chemical absorption activities. We have on program like that around the world. We're very -- it's very, very early innings. We would lose the liquid commoditized lubrication piece, but overall, the rest would be just sound. And then the last piece is, if they decide to go with a combustion engine in series, so you go from a 15-liter down to a 10-liter and you put it in series with a battery, obviously, that doesn't hurt us either, right? So what do we think is going to be the outcome? The logical outcome is going to be a mix of these things over time. And if you believe that there's a battery breakthrough that comes forward before Donaldson feels headwind, it has to be implemented across all the vehicles that are made across our markets. And then every vehicle, the millions of them across the world have to fail and be replaced. It's going to be a while, right? It's going to be a while because you have to have this breakthrough technologically if it goes all EV, and there's absolutely no question if the world finds a way to go EV, we will lose, and we have headwinds on that portion of the business. We will replace it with other venting-based applications because we also make the membranes that go between the battery separators and a number of things that go in batteries. We have the #1 patented vent application for batteries to help them get rid of the pressures. But all of those things would not be able to replace the revenue that we currently enjoy. But we see it as a mix, and we see it as actually a terrific opportunity for Donaldson to grow our company through alternative fuels.

So you're not at medium duty, just long haul?

We have some medium duties. Medium duties, we'll see some headwinds in that too because that will probably like buses are already there. Garbage trucks, things like that, will likely go. But that's not the largest portion of our revenue. No.

Okay. We'll have to break there. Thank you very much, Tod, Scott and Sarika. Thank you, everyone, for attending. As I mentioned, if you want to sit around for the breakout session, maybe some people can come over here to chat, so you can see from the other side of the podium. Thank you very much.