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

All right. We'll get started here. Everyone, thanks for joining us. I'm Nathan Jones. I'm the Stifel analyst that covers Donaldson. Very happy to have Donaldson with us today. I'm going to use a bit of a different format for the conference presentation here where I'm going to present 3 bear cases, Tod and Scott and Sarika are going to tell me why I'm in idiot for presenting those 3, and then I'm going to present 3 bull cases on the stock, and they're going to tell me what a genius I'm for presenting those 3. So getting started here, and I guess I'll introduce everybody, CEO, Todd Carpenter; CFO, Scott Robinson; and IR Sarika Dhadwal.

Okay. Bear case number one, you haven't heard this one before. Electrification of vehicles is going to drive diesel engines out of the market and create secular headwinds for the engine business, driving a declining revenue base in the long run, hydrogen and other alternative fuels are not viable alternatives in the near term.

Okay. So let's talk about alternative fuels and what's taken place. First, it's important when you understand where Donaldson's revenue is, is Donaldson with related to combustion engines on passenger vehicles has 0 revenue. We do not do anything with passenger cars, has not done -- have not done that for decades and decades and decades, which means we are meeting heavy-duty diesel engines, which means construction, agriculture, mining and long-haul trucks, period, okay? And so when we look at that space, you really need to understand about energy density necessary to do a large combine in an agricultural application, for example, and you look at the potential outcomes of anything from a hybrid, which is what used to take that 15-liter engine, we'll go to a 10-liter engine and be in series to a battery. That outcome for Donaldson Company is fine. Our market doesn't change at all. We'll continue to expand and grow. If you go to hydrogen as the first alternative fuel situation, if you follow Cummins and what Cummins is attacking, they're going after the same way they did 10 to 15 years ago when natural gas was going to replace diesel and natural gas was going to be in the combustion engine, but they're doing it now with hydrogen because it's a cleaner burn and better for the environment. So if hydrogen goes into the combustion engine, you still have moving parts of the engine. You still have fuel. The fuel is hydrogen rather than a liquid, what do you need to take out of the fuel, particulate and water exactly as you do with diesel. There's no change within the fuel sources. We actually happen to have the best technology to take particulate and water out of both gases and liquid. And then you also need air for the combustion source. So that -- in that situation, if Hydrogen wins to be the combustion fuel source, our market continues to expand and we win because we're everywhere in the globe with strong OE relationships. If it goes into fuel cells and fuel cells are not created equal. So we are working with a number of OE-related partners today. Some OEs have to take sulfur dioxide out. Some have to take mercury out. Just because of the term fuel cell is being used, I can tell you they're all being engineered very different because everyone is trying to get bigger energy density and be able to apply for maximum usage. What that ends up meaning is you need great chemical absorption capabilities and you need material sciences such that the overall gases and whatever you're trying to take out, could be absorb while being porous enough to get through. In short, you have to supply that source pristine gas, not like combustion where it's clean. This has to be pristine which means overall gas source will have a higher content for filtration need and then the air-to-air revenue based goes up. So Donaldson is in good shape there. It does remove the movable parts of an engine, which is the lubrication filter and the lubrication filter is the most commoditized filter in our entire market. Now if you think about it, when you change fuel -- when you change lubrication in your car, you go to Walmart, when you used to change it yourself anyway. You look at it and cost you $2.10, no different in a particular combine or whatever it is. It's just keeping a big stuff out of that lubrication. That goes away, we're fine with it. But the fuel source will go away. That one would be a little bit of a headwind to us. However, the air would offset. It's about a push, maybe slightly from overall market expansion situation, maybe slightly down low single digits as far as market expansion. And then the last one, of course, is battery. If it does go full battery, the way to think about that in today's battery content with a large combine straight from a large agricultural source in the company. I actually thought the battery technology would allow combine to work 4 hours in a farmer's field today, and he corrected me and told me I was wrong, it's 45 minutes. And so if you just look at that and you say, where are we with battery technologies. As we sit here, you're going to have to have 1, maybe 2 tranches of improvement relative to energy density within batteries to be able to have it then start to be designed in going forward. So where will the outcome of batteries. Batteries can still win, but it's going to be a long time before batteries win because as soon as you then have the solution, millions and millions and millions of vehicles need to fail everywhere in the world in order to start eating into the aftermarket and replacement cycles. So it's certainly longer than 10 years and the technology is still being worked on to replace diesel engines. That's the reason why Donaldson will not have headwinds in the short term. And in fact, we only have 15-ish percent of the Mobile Solution's marketplace, which is another way to say, we do not have or we have opportunity to go win 85%. So we have good growth opportunities within this market space.

Okay. Bear case number two. Filtration products have limited differentiation as evidenced by the number of copycat producers in the Aftermarket. It isn't possible to create real moats around the Aftermarket business as intellectual property lacks real protection.

About 15, 20 years ago, Donaldson changed this strategy. This was the likely scenario as everyone viewed and we viewed ourselves. 15, 20 years ago, Donaldson said, "Listen, we've got complex customer problems. What we're going to do is we're going to create proprietary technology-based solutions to solve those complex customer problems, proprietary razors, if you will, which will then allow us to sell greater replacement parts or razorblades." Our current business in the mobile solutions side is 65% replacement parts. We do that same model in our industrial-based businesses and indeed, across the entire corporation. So where we're 65% replacement parts of the company and 35%, call it, first-fit or CapEx-based programs or projects. That shows you the technology is really driving us on the replacement parts activities. And when you look at what we really try to do to build a moat, what makes us unique is a lot of filtration companies will go and buy store bot-based media solutions from wet laid-based manufacturers, so people who make paper. Donaldson Company has a paper mill on our corporate headquarters that we play with all the time because our engineers are responsible for understanding the particular or the challenge source from the customer and coming up with a media-based recipe that will provide the solution. we patent, and we own all of our recipes. So we are really strong at the material science. That's the first level of patent that we have. Then we decide what shape do we need it to be. You complete it, you can put it in a power core shape and there's a lot of engineering that goes into that. So we call that the conversion piece. So on the converting piece, we actually have patents at that step. So the second layer. And the third layer is on a lot of the sealing activities because how you seal depends upon the pressure of the overall system that you get. And believe it or not, industrial-based applications sometimes can run much higher pressures than the engine side, et cetera. So you have to have a third patent level there and the last will be the application. So we have multiple layers of patents. So we work very hard in our patent families to go and create strong moats. In fact, since our last Investors Day in 2019 to our current one, which we just held roughly 4, 5 weeks ago, Donaldson Company has released over 2,600 patents. So what that means is, since our last Investors Day, somewhere in the world, Donaldson has been granted a patent every day. We take technology seriously. We can build moats and we do it constantly.

It is -- if you look at the end product for the filtration, it doesn't look like there's a lot of technology in it. And if you see how it's manufactured and created, you will realize how much technology there is.

If I showed you a power car element, you'd look at it and go, "I don't get it. It's corrugated cardboard." And then you have to look deeper into the [indiscernible] shapes and it's incredibly complicated.

Can you just talk a little bit about the retention in the Aftermarket for proprietary versus nonproprietary products, how long you stay at the very high retention rates in proprietary versus nonproprietary and how that creates value, not just for Donaldson, but for your customers?

Sure. So what we tell our customers is if you just enter the particular name is if we put a proprietary product out into your application, we want you to have 100% of your Aftermarket as well. We don't have to take it through the independent channels. We don't have to add the added costs. We can continue to invent really cool things. And so that's how we would like to go forward. So we really try to give them that leg up so that they can have their replacement parts business because, of course, if they have it, we have it. And so we really look to that direction. From time to time, we will have somebody really get creative enough and get around our patents. That's when we'll throw it open to our independent Aftermarket, the OEs understand that, and we'll go after it. In fact, we also then fast-follow some others such as Cummins has vertical integration on their liquid-based applications. So they don't use Donaldson filters, they use their own. We have filters for every one of their applications. It's the reason why in our Mobile Solutions aftermarket, 60% of our revenue is actually in the independent channel and 40% is within the OE channel. It's important to understand that 40% because that 40% really represents a lot of technology and a lot of patents in order to help our OEs. And it gives you a sense of how the model works.

And if there's any questions that you've got along, feel free to throw your hand up. Third one. Gross margins have been in a pretty narrow band around 34% for most of the last decade. There's no real pricing power in the model with OEMs having most of the pricing power and the relationship. Scott's favorite subject.

We've had a tough run with the inflationary costs that we faced. And it's really forced the company to really think a lot differently about pricing. And so no OE wants to get price increases. But when your costs are going up significantly, it gives you the chance, the requirement, the opportunity to have to increase your prices. And I really think, while it's been painful, it's been really good for our company to go through that process to have to go to our big customers and say, "You know what, we've got to increase your prices. And they say, "No, you're not going to do that." And we say, "well, then we're going to have to shift your allocation to somewhere else." So it's been a good experience for us for the last several years, 3 probably years now to have to really take a significant run at pricing. It's also given our employees with us pushing more confidence in the value that we provide because we have yet to lose a customer on pricing. We had a recent Investor Day that Todd mentioned. And over the next 3 years, we're planning to bring our operating margin up over 100 basis points, and that's due to better pricing. And investing in higher-than-average margin opportunity. So I would say we're committed to higher levels of profitability on higher sales. So we need to continue that march to drive up our operating margin and gross margin and pricing is one key component of that. So I still feel like there's plenty of room for Donaldson to increase its operating margin. We've given a target that we're going to do over 100 basis points over the next 3 years. And I think we have great opportunities to get there. So I think we were stuck in a pretty narrow band for quite a while. But I think we've worked to work our way out of that band, and we are forecasting increasing margins over the next 3 years.

There's probably a few things structurally that help gross margins over the next few years. Faster growth in higher growth margin businesses is definitely one of those. So maybe you can talk about the gross margin differential in the Life Sciences segment and the expected growth in that business and how that kind of plays in to gross margin expansion.

It grows across the whole business and Life Sciences is a great example. We want to invest and have plenty of opportunities to invest in higher-than-average margin opportunities to mix the company up. And we've been doing that for years now. And some of those investments that we've made are starting to get bigger where we're having an impact. So when we put that along with a little added pricing muscle, I think we have good opportunities for margin growth. Nathan referenced Life Sciences. We are investing in Life Sciences. And those margins are double what we get in the engine business. If you can grow that business at a faster rate, you're going to mix the company up. And we see plenty of opportunities to really mix the company's margins up, which will give us just tailwinds going forward as we invest in those opportunities.

Okay. Now you get to tell me how smart I am. China is a long time very large opportunity for Donaldson to penetrate. Historically, the market has used lower technology products where Donaldson doesn't really participate but with the shift of OEMs to exporting to Western markets and requiring Western technology, the market is coming to Donaldson, which creates a lot of growth opportunities.

So within Donaldson, we entered China, much like everyone else on the backs of the multinational companies. We had technology so we went in there with the who's who of Japanese-based OEs, U.S.-based OEs because they were using that as an overall manufacturing source. We've now shifted. We still have the multinationals, but we're winning at the national base companies, [Falun Gong], [The Long King], [indiscernible] et cetera. And so Donaldson technology is being accepted. Now PowerCore is actually on Chinese Belt trucks and Chinese built combines. I mean excavators and construction-based equipment. And so we're doing quite nicely. Now clearly, China has had a tough run over the last couple of years, but we're coming off low single-digit share, and we already have in our pocket, these wins. And we've already built even doing in COVID, never been done before. We built a brand-new manufacturing line through videos with our Chinese engineering teams. And now we are local able to build it all within 1 of our 4 factories in China. And it's important to understand that the way we go after our world-class operations that we believe is a strength for our corporation is that we go build within region to support that region. 75% of our over $3 billion worth of revenue is built within region. China is no different. China has had that strategy for decades for the company, and we're now continuing to expand it into the mobile solutions opportunity. So we are on ground in country to be able to build for the Chinese-based manufacturers leading technology. That's the reason why when we look as it continues to open up, we continue knowing that we're winning on those programs, and we'll build it local. And so we have runway in China to grow. It should be a very nice opportunity for us. It's pretty interesting. I was walking through a diesel engine manufacturer in China just prior to COVID when they were having a tough year. And I was looking at the 10-liter engine and said, "Gosh, how many of those do you build a year?" It's really a bad year. It's really tough, really horrible. And took me about 4 tries to get it out of them and says, "Yes, but how many do you build?" Well, we're only going to build about 360,000 this year. That's the entire Class 8 truck market of the United States, one engine. China is big, and China is a great opportunity for Donaldson Company.

How do you think about protecting intellectual property in China?

So we've had tremendous success. We've actually won a number of pushbacks where people have come into and tried to get some copy infringement. Typically, for example, when they are trying to go after a PowerCore element or something like that in China, it doesn't really perform like ours does, but we go after them and stamp them out anyway. We've had terrific success. It's no different, our success in China than it is in the United States today. People try to break into our technologies, just the same here with fast followers as they do there. And so we would tell you at this point in time, with China-based technologies that we're building there, we have had good success at defending our patents.

You mentioned you've got low single-digit market share in China. What do you think a reasonable long-term goal for market share in China as Donaldson?

Yes. So it's a fantastic question. We debate this internally all the time. But we've been at the Mobile Solutions business worldwide for quite some time. It's very different depending upon region. If I just look at Western Europe versus the United States, it's different from on-road trucks between the two, it's different in agriculture between the two and construction. So really, it looks as though where you're probably at is probably somewhere between 15% to 20%, and you'd be really rock solid. But that 15% to 20% numbers, those are really big numbers.

Geopolitical risk in China? How do you view that? How are you kind of factoring that into your plans?

Always present. We have -- we did -- we never went into China as a mass sourcing strategy in order to export out of China to build in other regions for low cost. We just didn't do that. We do have some materials, some things, a couple, handful that we do get out of China and push over into Europe for consumption, but that's not really a large concern for us relative to the supply chain. Relative to the geopolitical, they've been there for a long time. They'll probably be there going forward. Certainly, we've sound terrific agility during the COVID shutdown situation. We showed -- our company showed tremendous resilience all the way through that. And yet again, now even with China being tougher, we just reported another record sales quarter and a record earnings quarter. We know how to go through those situations. And we'll just remain agile and keep our ground in China. We have strong relationships, particularly with the city government of Wuxi and we'll continue to work those.

Okay. Everybody's favorite topic when it comes to Donaldson, Life Sciences. Life Science is still relatively small for Donaldson, but fast growing with you guys at the Analyst Day having targeted 20% organic CAGR over the next 3 years. As life sciences increases in size, its contribution to enterprise growth will become more significant.

Yes. So the way to look at us, what we're doing as a corporation, again, we just last week, we reported record third quarter revenue, record third quarter profits. We told everyone for the fiscal year, which ends July 31, we're going to have record revenue, record profits. And our responsibility is to continue to grow the company and invest back into the company, which has always been part of our story is saying our #1 priority with capital is invest back into the company. So we're investing back in to grow the Life Sciences business. That means it's going to be a little bit lumpy. We took that portion out, which has been in the industrial piece, and we said, look, we're going to put this out and create a new segment, and we're going to put this out because this is our strategy. We want to be transparent and you should hold us accountable. So we put it out there knowing that it's not going to be linear. Why? Because as we go and buy companies, the overall amortization cost as happened in this last quarter could create headwinds within that smaller segment but we're doing exactly what we said we'd do. We go buy companies on the M&A side. We continue to invest organically in order to bring those opportunities to market, to leverage those going forward. The growth rates will be greater than company average. Over time, 20% CAGR on average is the targets we gave out last month at our Investors Day. We still believe in those. And on top of that, we'll continue to do more M&A. So what will happen is as we do more M&A in order to be able to grow that, you could get a lumpy outcome if you just continue to focus in on the Life Science activity, but we understand where we're going, why we're going. We know exactly where in the Life Sciences segment that we are attacking with the overall current product portfolios that we're bringing to markets. Now chromatography and biologics are really important spaces to us. We have new products. We have better value propositions for the customers. We'll press that forward, and we'll look to buy 3 types of companies. One, free revenue companies, just like we did 2 of them that bring new technologies forward that we had likely in our laboratories or complement very nicely the direction that we're going. That obviously would be amortization and you put one together and you look to make 3, but it will be a little bit of time. The second one will be more of an established base life sciences company that's really doing quite nicely that will add to our overall strategy and our portfolio, maybe brings customer relationships at a particular process that we desire. You'll probably pay higher for that than some of the other base multiples. Our net debt to EBITDA is 0.7, we could do it. And then the third one is really important, and it's foundational based activities of filtration chemistries or converting techniques that you need into the life sciences space. Those are more established companies, some of them actually probably are too broad, and we're buying it for a piece of it or things like that. But they are important to be able to finish out the full polymer-based chemistry activities and converting opportunities that go into Life Sciences. And so those are the tryout of M&A opportunities that we think in Life Sciences. But again, we look at this on aggregate. And if you attack solely the story of the Life Sciences, then I would say, hey, let's all go and look down at the total company. We just did on aggregate record profits, record revenue, and we're expanding the corporation by investing it back in with our capital, our #1 use of capital.

Record revenue, record earnings, all while the Life Sciences business is having a bit of a tough year this year. Certainly, Disk Drive business obviously is impacting that and some timing of some revenue in some of the other businesses. Maybe you could just address the softness that you're seeing in the Life Sciences top line this year and also the softness in the bottom line that's maybe due to investments and timing and things like that, that are not related to the Disk Drive deleverage.

Yes. So within the Life Science piece, people say, why the heck did you put the Disk Drive business into the Life Science business and I'll tell you why. Expanded polytetrafluoroethylene, Teflon. We're one of the best in the world that do it -- does it. And it's used in the Disk Drive business, and it's used and made us #1 in the world, and we use expanded PTFE with chemical-based absorbents to go in to Disk Drive to protect data around the world anytime you have moving parts and data storage. But it's expanded polytetrafluoroethylene. ePTFE is what you use in medical-based devices. We already have been using it for a very long time in ostomy bags, in hearing aids, in other applications. And if we're going to continue to go deeper into overall Life Sciences spaces, it's polymers that does it. It's polyether cellphone. It's ePTFE. It's PVDF. All of these are characterized by polymers that need to go and create products to go up into the end markets and come down. Many of you say, you're in Life Sciences. You look at the top and you come down and say, why? We look at the bottom and the overall materials resources, and the materials chemistries that you need to be able to make solutions for the complicated problems within the market. So we look bottoms up, acquire the bottom, get the conversion portions of it, and then we go to the end market to see where the customer problems are, and we meet in the middle and expand and go. And so that's a little bit misunderstood piece of how the filtration industry works, but it's incredibly, incredibly important. Then why is Disk Drive into the Life Sciences cycle because we already use it in other life science based applications such as ostomy bags, et cetera, but it is really important as you go forward and you answer the call within other biologics-based applications.

Okay. quickly, last one. Balance sheet is in very strong condition, as you mentioned, 0.7x leverage at the end of the fiscal third quarter, which can be used to accelerate your strategic move into process and life science filtration markets, diversifying end market exposure and continuing to mix revenue away from the engine business and into higher growth and higher margin markets.

Yes. So we're blessed with a very strong company and in strong cash flows over a very long period of time, which have really allowed us to build the business while returning pretty significant cash to shareholders. For the last several years, we've bought back 2% of our outstanding shares. We've been paying a dividend for over 60 years, increasing it for over 25 years. Last quarter, we increased the dividend another 8%. So we have strong cash flows and a relatively low debt position, and that's even after buying a few companies. So we feel like we're in a very strong position to go out and execute our strategy and have the cash flows available to support that. We think hard about our invested capital. We have about $1.9 billion of invested capital in the company, and we want to manage the return on that and manage the level of invested capital. And I think over the long term, we can both increase the return on invested capital as well as increasing the invested capital while still having a pretty significant return of cash to shareholders.

And that's buying about 2% of the stock each year.

That's correct.

Is that something that we should expect to continue as you're going forward? Will there be more of a shift towards M&A? Or can we continue to expect that kind of balance? I mean obviously, you're not going to be the one breaking the streak of raising the dividend.

No, I can't do that.

But can we expect that kind of balanced capital allocation into dividend, share repurchase and M&A?

So the priorities are: one, invest in the company organically or inorganically; two, pay dividend; and three, buyback shares. With the cash flows that we've experienced the last several years, we've been on a 2% share buyback for a long time. We're committed to at least 1%, which offsets the impacts of share-based programs for employees. And when there's available cash, and you sit at a debt level like this, we'll continue to buy back 2%. So we have that flexibility, but we look to continue those track records into the future.

Excellent, right on time. So thank you, everyone, for coming. Todd, Scott, Sarika.

Thanks very much.

Thanks for having us.

Appreciate it.