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

So good afternoon. It's Laurence Alexander with the Jefferies chemicals team. Welcome to the afternoon session of the first day of our industrial conference. It's my pleasure to introduce the team from Donaldson Company. Today, we have Tod Carpenter, who's the CEO; and the CFO, Scott Robinson. And without any further ado, I'll pass it over to you.

Thanks, Laurence. Thanks to all of you for attending today, and thanks for your interest in our company. I want to leave you with five thoughts throughout this presentation I'd like you to take with you. Donaldson Company solves complex problems for our customers. And as a result of that, we are a leader in filtration worldwide. We are a technology-based corporation, and we use our organizational strengths to drive long-term customer relationships. We are an enabler of the green modern economy, and we help our customers achieve their sustainable targets. Things such as power generation, efficiency as well as carbon capture. We have a clear and strategic, balanced growth plan, both through organic and inorganic opportunities, and we are continuing to progress with our Life Sciences-based strategy where we intend to use our technology-leading positions to be a disruptor in many of those processes. So who are we? At Donaldson, we are a 108-year-old corporation. We have over 14,000 employees. We have -- we sell -- as a proprietary-based filtration company, we sell razors to sell razor blades, and we do it across all of our filtration-based businesses. You can see in the lower left, our revenue base, whereby we have 3 reporting segments. But most importantly, our razor blade revenue is 64% of our revenue, where our first-fit is 36%. Along the bottom, you see our most recently reported year, which we talked about here just a few short weeks ago. You can see the progress across overall, our revenue growth as well as our EPS expansion. Importantly, as a technology-led filtration company, our Investors Day in 2019 was in April in New York, and we recently held another Investors Day this April. The time between those 4 years, on average, every day, somewhere in the world, Donaldson received a patent. We are a technology-led filtration company, and we are serious about inventing cool things. We are global. We are everywhere that the customers want us to be. We have a presence -- a physical presence with sales or manufacturing 80% of the countries in which we do business. Our manufacturing strategy specifically is to build within region to support that region. As a result, 75% of what we manufacture stays within the region where the customer resides. That's how we know we are everywhere the customer wants us to be. You can see that we're very diverse across the overall businesses on the bottom. The largest market that we serve is construction. And noting right there is on-road trucks and then industrial air and right on through the balance of the portfolio. Within that particular chart, notice that the lighter blue is the replacement portion of that particular revenue and then the darker blue is our first-fit or proprietary first-fit-based solutions for our customers. As I said, we recently reported over the last 3 years, from fiscal '21 to fiscal '23, we had a CAGR of 10% growth. We just guided that we will grow between 3% and 7% for the fiscal year. As a reminder, our fiscal year starts August 1 and ends July 31. Our adjusted operating margin, we will, on the guide, expand to 15% and our adjusted EPS will go at midpoint, somewhere around $3.22. Growth of roughly 5%, operating margin of roughly 15% and expansion of the adjusted EPS, everything that you see on this chart that we just guided a few short weeks ago, are new records for Donaldson Company. We just reported records for last fiscal year, and we expect to put more records up in this fiscal year. Looking at who we are, more durable-based advantages, we have a long history of filtration technology. We started on the Mobile Solutions-based market, where our company got its growth when Frank Donaldson founded us and invented cool things, and we continue to do that across all of our marketplaces today. We have deep customer relationships. Many times, our engineers talk directly with the engineers of the customer, and we like that, of course, because then we can really understand what they need, and we have a strong value proposition through entering that particular or solving that particular customer's problem with our technology. We are a diversified business with global sales. So we're everywhere that the customer needs us to be. We are an enabler of the green and more modern-based economy, and we help solve power-based consumption issues as well as carbon reduction footprint for our customers. We have a high aftermarket retention as I talked about on the earlier slide, and we have best-in-class operations. We are extremely proud of our delivery rates to our customers across the world. We have 3 reporting segments. Each of them have a strategic advantage, and each of them we expect to grow over the next 3 years. First is Mobile Solutions, our longest-storied segment within the overall company. We look to grow in our traditional portion of that, but we also look to continue to grow within a new fuel-based technologies, which our technologies inside Donaldson Company when it comes to filtering particulate, when it comes to doing gas-based cleaning or absorption out of potential alternative fuels such as hydrogen, are world class, and we will continue to go directly into those markets. And so we have good growth opportunities in our Mobile Solutions segment. Within Industrial, we have long been a first-fit provider across those particular businesses and then supporting them with the aftermarket components. And now we are providing intelligent-based solutions for our customers and digitizing the entire space, such as we're sending alerts out to the maintenance person inside the manufacturing plant directly to their phone to know when the piece of equipment is not operating at its best. And we continue to what we call light those pieces of equipment up throughout the world, and that is allowing us to parlay then a deeper customer relationship and actually servicing the equipment. We had good growth in our Industrial base business, double digits this year. We look to continue to grow by high single digits for the next 3 years. Our strategy is executing real well. We're doing quite nicely, and we look to continue a wonderful execution in that business. Within Life Sciences, we have some excellent disruptive type of technologies and opportunities to go into particular spaces. We are doing that organically and inorganically. I'll talk a little bit more about that here. When you look across our significant market expansion opportunity as a corporation, Mobile Solutions, we address a $14 billion opportunity. Inside Industrial Solutions, it's $15 billion. And now we've entered the Life Sciences adding $21 billion opportunity to the company. So our addressable market is now $50 billion. We're roughly $3.4 billion. We have good opportunity, and we have technologies to apply across those spaces. We'll enter into the Life Sciences side through acquisitions, as shown all across that outer ring there. We have acquired 4 companies within the past 2 years, but also organically, and we'll continue to do inventions of a disruptive nature, in particular processes within Life Sciences organically as well as these acquisitions. So for example, Purilogics and Isolere Bio joined Donaldson Company and they are pre-revenue companies. And why they are attractive to us is just simply because it improves the overall efficiency and outcomes of the customers' processes in this highly specialized space of cell and gene therapy and therapeutics creations. That really takes filtration to be able to do that. And so it's nice to be able to combine them, have them join Donaldson Company, where we believe 1 plus 1 equals 3. Specifically within the Life Sciences sector then, we will expect to see growth within the food and beverage activities. We have enjoyed double-digit food and beverage growth for a number of years. We expect that to continue looking forward. We also have opportunities in alternative proteins. And what that really means on the alternative proteins is inside Donaldson's bioreactors, we have customers growing cultured proteins. Think of, for example, one of the major customers that we have is growing salmon. Cultivated chicken has been approved for human consumption by the FDA. We would expect our customer to also achieve that opportunity, and it's really an FDA approval, I mean. And then that opportunity is a terrific growth opportunity for Donaldson Company, and we're helping them grow it efficiently, drive their cost down so they can compete within the marketplace. Within bioprocessing, you can specifically see along the bottom where the 4 acquisitions that we have really play and connect with the Donaldson offerings, specifically vaccines, cell therapy and gene therapy creations, and we believe we'll have terrific success within those opportunities. And then within the medical device space, probably a quiet secret, but we have been doing ostomy bags for a very, very long time. Right now, we do in the neighborhood of about 40 million ostomy bag venting filters annually. And we also have been doing hearing aids about 20 million a year. Believe it or not, hearing aids do have filters on them in order to protect them as well. So we have been in the medical device space for quite some time, and we also have programs where we continue to work on potentially implantable devices to help in this space as well. We have a balanced approach to capital allocation. You can see over the last 3 years, the numbers and how we have put our investments to work. Specifically, number one, we look at organic investment, investing back into the company, continuing to invent cool things and push them out to the marketplace. That was roughly 20%. Then we look to buy companies. We did that with 21% over that same time frame of the investments of $1.3 billion. And we have been giving a dividend for over 65 years, and we have actually increased our dividend for over 25 years, and we are a very proud member of the Dividend Aristocrats fund. You can see that was 25% used. And then I would say we are a consistent share repurchase company, where we look to buy back at least 1% annually, offsetting dilution. And lately, we've been doing, on average, 2% in order to have 1% reduction. Though very consistent, this story has not changed on the usages of capital for the company for at least a decade. Our strong balance sheet then as we look at it longer term, our net debt-to-EBITDA ratio will be -- roughly 1 is our target. We're currently under that, even while acquiring 4 companies in the last 2 years. Free cash flow will average, over time, about 85%. Our recent guide is -- for this fiscal year is 100%, and we have $800 million in capital already set up and currently available to us. I want to stress though, we are an acquirer of choice. We do our work, we create our strategy and then we acquire to the strategy. So longer-term financial targets that we gave at our Investors Day through fiscal '26. So consider this, today is our fiscal year '24. We look for growth rates across our 3 segments to yield 6% growth at our company. And Donaldson Company will become a $4 billion company. We will expand our overall operating margin to 16% as well as over the cycle, we will have incremental margin in the low 20s. We believe that we are poised and really in a great position to be able to deliver this. I should note, it was interesting in 2019, we set targets out. Yes, we had COVID in the middle, and so it delayed things by about a year. But when we stood up in front of all of you in fiscal -- in April of 2023, we had delivered in the range of all of those targets in spite of COVID. So with that as the backdrop, I would open it for questions.

I guess maybe just to start, can you dig into a little bit the growth drivers for Life Sciences? And with the CAGR you're looking for over the next 3 years, are you looking at a sprint or a marathon? So how do you think over the next 5, 7 years? And then should the growth rate be better or worse in the 2030s than the 2020s?

Yes. So when we look at our Life Sciences-based business, our current growth rates that we have put out is roughly 20% for the next 3 years. We're in the neighborhood of about a $240 million business. That puts us at $450 million in our fiscal year '26, which is 36 months from now, roughly. And so we believe we'll be able to put up those type of targets. Now it will not be linear. Some of that will be organic, but all of that does not take into account any future acquisitions that we have that maybe we can execute on. On the Life Sciences-based programs, we have a nice mix of businesses, some businesses that will continue to press forward with double-digit based growth and other businesses that will push forward with 1 million this year, then 2 million, then 3 million. And then when those programs that we're working at across the customer base hit, then we would expect a little bit of a lift on those type of a program. And so we have baked all of that into the current guide through fiscal '26. Then I would expect overall growth to continue at the type of pace that we're enjoying. We are clearly committed to growing that business to $450 million in fiscal '26. I would expect it to be much larger over time. We will not quit at $450 million. It's really, really important to understand why we like this space is because we believe we have disruptive technologies that drive efficiency into very inefficient opportunities for overall cell and gene therapies and protein-based process management that's going on within the Life Sciences space.

Can you give two or three examples for why now is the right time to be disruptive in that space for Donaldson?

Yes. It's all about technology, right? We're a technology-led filtration company. And when we invent cool things, I often say, I should stand up here in a black turtleneck and maybe people will really believe me more. But the reality is when a company puts 2,700 patents out in a 4-year period, we're committed. Some of those patents have to be within the -- happen to be within the Life Sciences-based area. And so we now see opportunity within our inventions as well as a combination now of the acquisitions to be able to scale them. And so why now? Because we have the technologies to be able to do it. We didn't enter this to wake up one day and say, "Hey, let's go into Life Sciences." We've been working on it for quite some time. We just decided now to tell you exactly what's going on within that sector, be completely transparent with it. We've been doing this work for a number of years because we feel as though, and typical to our company, we're going to say what we're going to do, and then we're going to do what we said and we want you to hold us accountable. And so we felt let's be transparent.

And then you've highlighted M&A several times. Can you talk a little bit about your screening process, when you expect acquisitions? How many years it takes to hit your return on capital? And how much of your M&A pipeline would be Industrial rather than -- or versus Life Sciences?

Yes. So maybe I'll talk about the pipeline, and then I'll toss to Scott about relative to returns, and he can explain that a little bit further. So just about our pipeline. We have completed a number of acquisitions in the recent years. We are committed to our acquisition portion of our growth strategy. We continue to work on that pipeline. We actually created an organization, asked a gentleman by the name of Dave Wood to join our organization. Dave is a PhD in oncology immunization therapies, and he also happens to buy companies and sell companies for a living because he spent quite a bit of time in that space. So he has created an organization. We now have good muscle to be able to understand and target specifically what we would like to target within our strategy. We're doing an exceptional job. I would tell you that our pipeline continues to be robust, selective, strategic, and we'll continue to work it.

And maybe just a bit on the acquisitions and their financial performance. So we think hard and long about how we want to deploy our capital. And if you look at the invested capital base over the last several years, it's been relatively flat. And so we have a strong return, almost 20% return on invested capital. And we try to be smart about how we deploy that capital. And we've completed some acquisitions recently, and our net debt-to-EBITDA ratio still sits at 0.8. So we expect those companies to ramp. We want to maintain the overall returns over the company and be smart of that. I would remind everyone that while we're investing in these Life Sciences companies, even with the amortization expense and the start-up expense that we are incurring, we're generating record levels of sales and record levels of profit. So the returns are still trending up even with the slight drags you get from some of these smaller acquisitions in the start-up phase. So we expect big things for them over the long term, and we think we can maintain our returns with managing our invested capital, but still allowing for acquisition. So our CapEx guide that we gave at Investor Day accounts for all the acquisitions that we have. So we have room within CapEx to scale them, and we think that returns will come pretty strongly as the acquisitions ramp over time. And with 20% growth rate in Life Sciences, you can see some pretty decent ramping. We expect that to continue over the next 3 years.

And then your 3-year targets, to what extent are those mid-cycle targets? That is -- I think we keep getting the sort of 2024, 2025 recession questions. And how much -- how do you see your ability to work through that if that does evolve?

So we have baked in everything that we know relative to the immediate outlook within '24, '25, '26. If the recession is long and deep, obviously, that would clearly affect us. We have not baked in any type of a deep recession really anywhere in the world. The most complicated economy right now for us is China but we've lapped all the downturn. And we're waiting for China to come pull forward, in which case, when China's economy does pull forward, that's actually a little bit of a tailwind for us. Everybody has watched or continues to watch and try to understand the United States, we do as well. We have not baked in a meaningful recession in the United States in that time. More of if the GDP can just stay in low single digits, we're absolutely fine given the expansion that we have and the share gains that we continue to enjoy.

And then just lastly, with the sustainability trends in the industrial sector, should we be looking for any acceleration in industrial in the middle of the decade? Or how is your technology fit there evolving?

The sustainability trends are pretty spotty, to be honest. I don't think you have a consistent story with a particular momentum behind it. COVID hit, and of course, everybody is going to chase 2.5 particulate inside office buildings and all the rest. And now that's gone, melted away. You have to be careful with some of the macro trends and it's really more on the Industrial space, more of a consistent story within the overall Industrial macros, and it's really more about how much are we producing? Where are we producing it? How are you located to take care of your customers? Are you inventing cool things to actually have reductions in their capital outlays and make their life easier and allow them hit their sustainability targets? It's not really one big macro trend that everybody is going to go and chase and we're all good. Anyone? We have 1 minute or one -- maybe one quick question if anyone has anything?

Well, I'll toss in the question of the day that has been in every meeting I've heard is, can you talk about sort of the destocking on the Industrial and automotive side, if you've seen any new areas of softness there?

Yes. So in our Mobile Solutions aftermarket organization, we have 2 pieces of it. We have an independent channel, but then we also have an OE-branded channel. The independent channel is 60% of our aftermarket. There has been no appreciable destocking, it's really more pull-through typical type behaviors. On the OE-branded side of things, there has been destocking. It's been going on for the last couple of quarters. However, it's not to suggest that there's some kind of a line you can draw in a particular end market. It's a very scattered diagram, it's customer specific. It's not in ag. It's not in mining. It's in a customer and then maybe the next quarter, a different customer will do it because the OEs had the most success at building up inventory as we all had supply chain disruptions. The independent channel never really enjoyed in the filtration industry the ability to bring up their inventories like they wanted to. We've got a couple more quarters to work through. Probably that's scattered diagram of specific OEs. But as long as they stretch it out and don't do it all at once, we're fine.

Okay. Great. Thank you.

Thank you, everyone.