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

Welcome, everyone, to the 19th Annual Oppenheimer Industrial Growth Conference. Next up, we have Donaldson Company led by CFO, Scott Robinson; and Head of IR, Sarika Dhadwal today. Thank you both for being here.

Thanks for having us.

To kick things off, and I can't see you or some technical issues, I think, are [ result ]. To kick things off for those a little less familiar with Donaldson Company, perhaps offer a little bit of background, history of the business, key drivers. And most importantly, what you think really differentiates Donaldson at this point?

Sure. So I think we have a few slides that we'll just jump into and then we can certainly jump into Q&A after that. And so -- before we start, I just wanted to put up this forward-looking statement safe harbor, which most of you have seen many times. And I also wanted to point out that we will be reporting our third quarter fiscal '24 earnings results on June 4. Just probably not here in a couple of weeks. So anything we talk about today will be backdated as of our second quarter fiscal '21 earnings release. With that, I will turn it over to Scott Robinson, Chief Financial Officer.

All right. Good morning, good day, everyone. So I have just 6 slides that hopefully provide a bit of an education on Donaldson to address Bryan's points there. The first slide is kind of 5 key things I would like you to be able to take away from this presentation about Donaldson. But certainly, Donaldson has been around for 108 years and has focused that entire time on filtration. We are a technology-led filtration company. So we really want to be a leader in filtration. We want to have best-in-class technology. We really spend a lot of energy on our core sites of filtration. And I really think that ultimately is the lifeblood of the company. We have the ability to leverage our technologies across our business units into new technologies or new products or new ways to help solve our customers' filtration problems. And I think Donaldson has long been looked to by our customers as a partner that really wants to help them solve their filtration problems. As an economy in the world has really moved into a greener, more clear or clean environment, that plays right into Donaldson and we want to enable a more green economy, by utilization of our technology-led filtration solutions. So that is just a great thing for the world and a great thing for Donaldson. We really think about our capital deployment and our strategic in our growth strategy, making sure we're deploying capital to places that will help us grow, again, through -- in expanding our technologies. And the last one is really the next natural progression for Donaldson and we've been working on this for years and talking about it for quite a while is to further expand into Life Sciences. And I think we have some good technology that we've built internally. We have some good technology that we've acquired. And we're just starting on the journey there, but I think we have certainly permission to play in some good technologies that we can bring to the market. Moving to the next page, an overview of Donaldson's, you can see founded in 1915, 14,000 employees, 140 locations in thousands of patents in pretty good revenue and adjusted EPS growth over the years. In the last 4 years, you can see, including this year, we're going to be adding about $1 billion of revenue into the company from 2.5 to 3.5 plus and we've taken our EPS $2 to $3. So pretty steady growth over time. You can see on the bottom left side, that we are -- we really want to be -- to sell razor blade company. So 36% first bid products and 64% replacement and then you can see the split of our 3 disclosed segments. Life Sciences has been disclosed for the last couple of years. So that's a new segment for us. And that's where we're really focusing our next opportunity for the company. In terms of Donaldson's approach to the market and our competitive advantage, we have been around for over 100 years, and we really do truly have a long history of filtration leadership with very deep customer relationships. I mean many of our OE customers we've had for 60, 70 years as customers, and we really want to work to help them protect their equipment, make their equipment run more efficiently, more cost effectively and help them fulfill their missions. I talked about the green economy and how things are moving that. I mean, that is permanent for a filtration company and in finding ways to help protect the world. We are very global. So over 50 manufacturing facilities around the world. So we have the supply chain, the production capacity all around the world where we need it which really gives the company a great ability to serve our customers and be where they are. We want to be a technology-led filtration company with a razor to sell razor blade approach. And that's why we have a very strong aftermarket business and aftermarket retention, which really helps to stabilize the company over the long term, having that replacement parts business. And we -- like I said, we have more 50 manufacturing facilities. We really have good operations on commitment and a long approach to the cost optimization and having a very strong operational footprint. So when we report in 3 segments, a Mobile Solutions segment, an Industrial Solutions segment, and then recently, a Life Sciences segment. But I'll start maybe with Life Sciences. So really, we completed -- the company redesigned a couple of years ago whereby we went to straight business unit focus. For the past 40 years before that, we had a matrix organization where we had kind of 2 segments. And it was engine or Mobile Solutions and Industrial and we have a geographic split. And so with the redesign side, we put everybody into a business unit. So one of the 3 business units, and we created a separate Life Sciences stand-alone unit. I think that's been a great move for the company. And basically, when they thought about Life Sciences, what we really thought about was the opportunities we have, but we also thought about the technologies we have. And lowest of these technologies and Life Sciences are more of a membrane-based approach. And we've put all of the membranes in the Life Sciences. And that way, we can leverage that technology out into the market. I think it also 3 industrial solutions from having some of these traditional Donaldson businesses and now Industrial is able to better focus. So I think we -- we did Industrial favor, and we created a whole third business unit for the company, which now we report, obviously, you can all see how we're doing, we guide upon, we gave Investor Day targets for. And so I think that that's been a great move in the company. It was not easy to redesign. And we did take quite a bit of a regional cost out, but we are essentially able to reinvest those in our new Life Sciences unit. So that's a full business unit now with P&L accountability and some great opportunities as we move forward. And the Mobile business has always been there, and we still have opportunities in the Mobile business, and we'll continue to capitalize on those. In terms of a little bit more about the balance sheet and cash flow generation, a very strong history of cash flows. We have a net debt-to-EBITDA target of one, we're running slightly under that, even after investing some dollars in our Life Sciences acquisitions, and paying out a dividend and buying back 2% of our shares for the last several years. So a very strong ability to continue to invest. We want to be smart about how we invest. We have very strong returns to the company, and we have to keep that in mind when we're making acquisitions because you're not going to get a 20% return on day 1, but we do want to invest and deploy capital into the company where it makes sense. Our free cash flow conversion has averaged 85% for the long S3. Last year and this year, we'll do over 100% or right around 100%. So we continue to generate strong cash. We've paid a dividend for over 60 years. We've been increasing that dividend for 25 years. So we're now in the S&P high-yield dividend aristocrat's fund. We've been buying back 2% of our shares for the last several years. So we have strong cash generation that really puts the company in a position and we have quite a bit of available liquidity. If it were needed, either in terms of another pandemic or terms, hopefully, maybe on a larger acquisition. So the company is in a very strong position. And certainly, we are holding power available for acquisitions, and then we'll see how that goes in the future. Last slide, we did an Investor Day in April of last year, and we did give out targets 3-year targets. So you can see the midpoint of Mobile on 4, Industrial has 6, and Life Sciences at 20. So we're growing all of our business units the highest margin business is growing at the fastest rate, and that would be an average of 6% growth for the company over 3 years on an annual basis. We want to continue to increase the operating margin company. For the company, I would say we're committed to higher levels of profitability on higher levels of sales. So we gave a midpoint of operating margin guidance of 16%. We just bumped up our operating margin guidance for this year at a midpoint of 15.2%. So that's growth in operating margin this year. That means if we can hit the 15.2%, we would need any voice points of operating margin improvement over the next 2 years. We feel like we're well positioned to deliver that, and we have to continue to increase the company's level of profitability in percentages on increasing sales. And finally, we have to leverage. So 20% to 24 -- 20% to 24.4% incremental margins will obviously increase that operating margin over growing revenues. So that completes the slides. I think Sarika will take them down. And yes, and Bryan, maybe you could move into your Q&A.

Yes, absolutely. Thank you, Scott. Good walk through. We have been the foundation kind of in place for discussion. With that being the case, how should we think about your forward growth path? Your high level, the most attractive new opportunities to continue to scale the business and improve the profitability. No doubt we'll get into Life Sciences on that front and to balance discussion. What are the biggest risks that your team faces looking forward? There's always discussion some degree of pushback from investors on secular headwinds in Mobile. Very debatable in terms of time frame. But how has your team view those? How are you positioned relative to the potential spectrum of next-gen engines has it all net in terms of forward outlook, the fiscal '26 targets that you've had and beyond?

Yes. So I mean, I feel like we're pretty well positioned and pretty lucky to have -- at all the people who have come before us to deliver the company to this point. So we have very strong technologies at the core of all of our businesses, especially in the Mobile Solutions and Industrial businesses. We are blessed with a global company, with a great footprint and great manufacturing and really well-positioned assets. So we should have the ability to serve our customers in a very strong position for lease to grow from. We continue to add new technology into the company every day. And I think, ultimately, that's what pushes the company forward. And so we feel like we're in a good position. We've been putting up record sales and record profits for the last few years. So we're definitely heading on a good trajectory, and we've been doing that for a while. We've been investing in Life Sciences. So it's not like our profitability -- our profit has declined. We continue to generate record levels of both operating margin percent, operating margin dollars, EPS, while we're investing in Life Sciences, which will certainly serve the company well in the longer term. In terms of headwinds and maybe you mentioned electrification. I think clearly, the -- everyone can have their own opinion there, they certainly have that right. But clearly, the narrative about electrification has changed from several years ago where it was very binary. It's either going to be electric or internal combustion to really a range of outcomes that are moving through the system today, albeit at a very slow pace. So we want to help facilitate that more green economy. We want to help our customers bring solutions to market, and we're working with many of our large customers on their future platforms, whether they be hydrogen fuels or synthetic fuels are different things along those lines -- and so that's there. I think ultimately, we would say we feel very comfortable that we can grow Mobile Solutions for at least the next 10 years. Probably long beyond that, that we will be involved with our customers and their solutions. And obviously, there's going to be a range of outcomes, all the way from electrification and continued internal combustion and everything in between. So we feel like we're in a pretty good position. Certainly, people have the electrification question, but we feel like we're in a pretty good position to address that.

I appreciate all the color. And just to level set on, I guess, what would be worst-case scenario in terms of engine adoption that everything goes battery electric, including large offered vehicles which seems unlikely, but just claims [indiscernible]. What would the aftermarket stream big for you? Because I seen that would still remain quite attractive for you. So a decade plus of growth, but just the [indiscernible] tension, you still have a lot of cash.

Yes. I mean the company is -- in Mobile Solutions is essentially 2/3 replacement parts. So I mean, if some -- if you could suddenly snap your fingers and create or convert everything to 100% electrification. First of all, we still do have venting applications, and we have some things to help battery-powered equipment operates. So we add sales there. But you have the whole aftermarket business. So you have all these pieces of equipment in the world -- and I don't if this happens country by country or suddenly magically in the world all in one place. But you have all the equipment that can live for 20, 30, 40 years into the future. So you're [ expecting ] to have aftermarket or replacement parts that are going to be needing to satisfy those products as they continue to operate while these hypothetical, electrified equipment comes to the market. It just seems like such a long ways away. And we wanted to put a stake in the sand. And so we talked about what stake we wanted to make at our Investor Day. And we actually have a model whereby we use our R&D team to help us, and we basically have every platform in the world in existence and we also forecast future platforms that are coming. And so we know all the equipment in the world and we could project the business we're going to get from the existing equipment and for future programs. And so we have the benefit of working with our OEs, so we know that they work out next internal combustion platform, which buys quite a while because it will take years to come into assistance. So we do get kind of a first-hand view into what our customers are working on to satisfy their customers. But at the end of the day, our Investor Day statement was [indiscernible]. We expected to be able to grow Global Solutions revenues for at least 10 years, and that's kind of how we see it.

Understood. Very, very helpful color. And circling back to Donaldson Catalysts, the build-out of Life Sciences that is attracting more attention appropriately so. And the string of pearls kind of a strategy that you're utilizing is pretty intrigued. Maybe walk us through each of the pieces that you put in place so far, the kind of portfolio role of those assets and how that -- it has helped to build the momentum that your team very confidently speaks to?

If you want me to get on that slide?

I don't know if you can get [ qualified ]. And the way I think about this is the way we've presented it on Investor Day, and it's actually Slide 100 in the Investor Day deck. And it is basically a puzzle, which shows all the different opportunities in Life Sciences. And first of all, I just want to say, we've been working on a lot of these membrane-based technologies for many, many years. And so we had a lot of organic activities ongoing. And when we did the redesign, which I mentioned, we pulled all those into the Life Sciences segment. But in terms of the puzzle, you can see, and this is kind of how I look at it is if we have an asset that we're looking at, where does it fit into the puzzle? And we don't have to fill all of the whole puzzle. We just want to be very smart about where we're going to play and what a new asset would bring to us and we've done some things organically, and we've acquired 4 companies, Solaris, Purilogics, Isolere Bio and U Tech. And we recently announced an opportunity we're working on an Italian public company called Medica. So we continue to invest in this area to fill out our portfolio and to bring new technologies into the company. I think we have very good technologies here that will gain traction as they scale into the future. It's not going to be immediate, and it's a small business, say, $240 million, $250 million right now. But we think we have good opportunities to continue to grow that in ways to deploy capital that bring a return relatively quickly. You're not going to do a 20% return on day 1 of the investments. But we think longer term, these margins are very high, and we'll have strong returns for the company as we scale them and bring them together and fill out this puzzle, we feel like we're in a good position. In the meantime, we're able to generate record levels of sales and record levels of profit while making these investments. Our debt is 0.7%. So it's not like we've leveraged up the company to get there. and we feel like we're in a good position.

Yes, absolutely. And circling back to one of your earlier points, hopefully, the dry powder that you have and the flexibility is utilized for growth investment as opposed to we're responding to another pandemic or anything along those lines.