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

All right. Good morning, everyone. Welcome to Donaldson. We are very pleased to have CEO, Tod Carpenter; CFO, Scott Robinson; and Vice President of Investor Relations, Sarika Dhadwal. I believe Scott's got something to say to me before we start.

Well, we did have a bet, Timberwolves versus the Denver Broncos for $1. And I just want you to know that the Timberwolves won, but I have not received my dollar yet.

Denver Nuggets.

Sorry, Denver Nuggets.

Yes. Well, I'm sure the Timberwolves would have beaten the Bronchos at basketball. But you will receive your dollar, never fear. All right. So as is typical with todays presentations, I'm going to present 3 bear cases, Tod, Scott and Sarika are going to tell me why I am an idiot. And then I'm going to present 3 bull cases at which point they're going to tell me what a genius I am.

So jumping into the bear cases, 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.

We've been answering this question for quite some time, probably 6, 7, 8 years. It's been interesting the evolution of the investor community and the outsiders looking into the company, how they've actually come to our view, which we haven't changed in all that time. And that view is it will likely be a mixed outcome within our end markets. It's -- you need to be reminded that we do not have any revenue at all on passenger cars within the diesel engine or any type of combustion engine. We have some in the automotive space for filtration in different type of applications, more battery-based applications, things like that. But we do not -- we are not affected in the automotive sector. So what really is the overall thesis here is energy density within our medium to heavy-duty diesel engine markets, really has to have another step to 2 steps up to be able to come forward to have a single-based solution. If you have a hydrogen-based solution where you do what Cummins. If Cummins wins with our strategy, such as combustion engine goes with hydrogen, that's actually going to expand down to companies' markets because you still need air intake solutions and overall hydrogen as the fuel source rather than diesel. What we do with diesel today is we're the best in the world at taking particulate and water out of diesel. When it comes to hydrogen, it's the same thing. You need to take particulate and water out of the fuel source. So consequently, that plays to our strengths and our markets and opportunities would just expand overall in that -- if that is the outcome. If it's fuel cells, which we have [ one ] fuel cell-based programs at OEs around the world already. They're very early innings. They're in laboratory spaces, things like that. What has to happen is, overall hydrogen has to come in, but it's not like going to be used in the combustion engine because this hydrogen has to be pristine. And you have to take out all kind of particulates but also gases. So you have to take things out like mercury or sulfur dioxide or things like that, so that it can do its magic in fuel cell application. That really has quite some runway based upon where we see all of our customers before it is really going to have some mass adoption in order to come forward. And then, of course, you have the full battery solution. If it's a full battery solution, it likely has to have 2 or 3 or even 4 turns of technology stepping forward. There's not a breakthrough out there yet ready, but it's really about energy density. The current state of batteries, as was told to me from a large agricultural company is that in a large combine, a battery will last about 45 minutes out in the field using a large combine. And so consequently, it just shows you that, look, there's a runway that has to happen, some serious breakthroughs before it would threaten us. So we have a long-term view that we talk about the next 10 years and will we face some headwinds within our markets because people can get their brains around 10 years. And it's also within the window of you actually start to create a new diesel engine, it takes you about 6 years to bring that to market. So 10 years seems fair with the technology with kind of flowing in. But even after they -- let's say they have some breakthrough and something coming forward. You have to have an end-of-life event of the millions and millions of vehicles out there that actually start bringing this forward. And so our aftermarket pressure is really even further than 10 years out. But certainly, we will not feel any headwinds over the next decade.

What's the difference in content for hydrogen versus diesel for Donaldson?

So 2 types of hydrogen to remember, right? So if hydrogen becomes the overall inside the combustion engine, like Cummins, again, the content actually is about the same. It could go up a little bit. The overall air intake system, it's exactly the same. The -- if you have to take some other materials out besides particulate and water, such as sulfur dioxide out of the hydrogen, then our content would go up. And then, of course, the most commoditized piece of that filtration answer is the lubrication and that's just -- that's already commoditized and cheap stuff that doesn't change. So really, that could go up, but certainly we don't see it going down. If it's fuel cells, you walk away from the liquid piece that commoditized piece, we're fine with that. And then the fuel source becomes actually hydrogen, you lose the combustion. But now that hydrogen is really, really specialized, and so consequently, we'll only have something like a 5% to 10% drop on vehicle content because it is hard. Not all fuel cells, people don't quite understand this, but not all fuel cells are created equal. How one company is doing a fuel cell is different than another. This one might be susceptible to one particular chemical. This one would be susceptible to a different chemical. And within Donaldson Company, the reason why we believe we have a technological leg up is because we do things like our Disk Drive business. Our Disk Drive business is doing chemical absorption for the last multiple decades and we're #1 in the world at that. And so we're bringing across from other businesses, the absorption chemical technologies into now this new space of mobile solutions as they continue to develop those opportunities.

So I'll go on to the next one. 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?

Yes. This is as a filter geek, which we all are, the question doesn't even -- the premise doesn't even resonate with us. If you pick on the lubrication filter for Mobile Solutions, for example, okay? That filters oil. We could make that filter last 1 year, 1.5 years. You don't want to pay for it, right? So that's why it's commoditized. If you pick on that, I agree with this premise. But that filter only filters out big things, [ rats and rain ], something like that, okay? It doesn't really do any big time job. It just keeps your oil last until the next change. But you get into other specialized applications that we are with our diversified portfolio as a company. And you really see the power of what we do. We go all the way down. What makes us unique is we go all the way down to the fiber-based solutions. And if you come to our Bloomington corporate headquarters, we'll show you the paper mill, for example, we have on site, where they are playing with recipes and trying to find out what is best to handle a particular challenge that a customer has given us and we'll take any type of fiber-based materials and we'll mix those into solutions and come out with controllable recipes, and that's at the lowest level. So we have fiber-based specialists that then create recipes of [indiscernible] based solution. And then when we have that patented because we control all of our recipes and patent them, then you go to the next stage of how you make a filter, a filter could be pleated, a filter can have numerous shapes to it in order to meet the application. If you look at on-road highways, the trucks today, for example, you'll see older trucks, which have the two stainless steel canisters on the outside of those. We make those in Greenville, Tennessee. The only reason they exist is because the trucker wants to look cool, okay? In reality, the rest of the trucks, okay, that are made across the U.S. have a more aerodynamic contoured front and the filter is Donaldson's and it's under -- gives you the -- under the hood and it gives you the exact same performance as those two much larger canisters. And these days, we've reduced that size by 70%, allowing it to go under the hood. That's all patented. So it's the shape and then it's -- lastly, it's the sealing to whatever the application is, and then the application particulate how we make the [indiscernible]. So we actually have a multiple layered moat with multiple patents around our mobile solutions and really taking that all the way through our product portfolios into our industrial-based businesses, into ostomy bags, into hearing aids, into everywhere we are. And we look for technological foundational pieces to be used across different end markets in order to create really difficult customer solutions.

If you could just talk about PowerCore and the ability to retain the Aftermarket with that product versus the standard product or the nonproprietary product.

So PowerCore is a particular type of filtration solution to us. If you look at it, you'll think it's corrugated cardboard, it kind of looks like that. But actually, the [ fluid ] shapes inside that particular filter is very different dependent upon the particulate and application. So it's different in industrial than it is in mobile solutions, and it's all patented. And it has years of study into where we continue to shrink that envelope and give the same performance out to our customer base. Our ability to retain PowerCore remains in the high 90s. We do have some people that have found ways to get around some of our patents and put it in the hole, but those patents are now 22 years old. And so those are the very, very first ones. And so they can go after that because they're now run out. We still retain the aftermarket really high levels within those because it's really hard. It's an incredibly challenging application. And so there have been some customers that tried other solutions, and then they come back to us because it's just simplified, you don't want to take risk of dusting your engines or dusting your other based application. So PowerCore has a huge retention value, and it's -- but it doesn't happen at Donaldson Company with just PowerCore. That happens across our entire technology portfolio. We're a technology-led filtration company. We're very serious about that. And if you take a look at our overall patent portfolio, Donaldson Company between our Investor Day of April 2019 at our Investor Day of April 2023, on average, somewhere in the world, Donaldson was granted a patent every day. We're serious about our technology. Filtration does have an opportunity to be patented, and we continue to press that [indiscernible].

Thanks. Onto the next one, gross margins have been in a narrow band around 34% for most of the last decade. There's no real pricing power in the model with OEMs having the pricing power and the relationship.

I'll take that one. So we're -- we've been on a journey with our gross margins. We're pleased for the last 3 quarters of this year, we've been in the 35%. So we've kind of broken out of that 34% zone. And we've been working on this for a while. And I really think the massive inflation that kind of the world experienced was actually good for Donaldson because it gave us a chance to kind of reset some of our relationships. And we battled pretty hard with some of the big OEs, but we just need to have reasonable commercial relationships with our customers. And we're going to deliver them technology, and we need to receive a fair price for that. And so we've worked hard to adjust a lot of those prices to account for all the inflation that has occurred around the world. And we've been slowly mixing the company up in terms of investing in higher-than-average margin opportunities. So we feel pretty good about being in the 35s. If prices go up another 10% or if they go down another 10%, then we're going to need to adjust prices accordingly to have reasonable commercial relationships. But at this point, I think the inflation has subsided. Some costs are coming down. Some costs are still going up. We've provided an estimate of 2% pricing impact on our revenues this year and through 3 quarters, that's generally holding true. And so we think we're in a much more reasonable band of pricing at this point. We're back to normal pricing activities and we feel that we should be able to hold that 35% and continue to make improvements from here.

Donaldson had some troubles in the early parts of the inflationary period during COVID, getting pricing through to some of your OEM customers? Now that you're starting to see maybe a little bit of deflation on the other side, is turnabout going to be fair play when it comes to pricing?

I think the important thing is what Scott said, we just want a reasonable relationship with our customers. We actually have reset in the past when we really had a problem at the beginning of the headwinds on the inflationary pressures, we had long-term contracts that actually had price downs based on volumes on an annual basis. That's gone. That's one of the major resets within the Donaldson model. So now we have a far better working relationship with our OEs. This whole premise, though, and how we had to deal with it really represents 35% of our company revenue. The 65% didn't really have that kind of a headwind because we were more agile relative to pricing with the aftermarket replacement based businesses, or our project-based businesses where the old pricing flowed through and we were able to immediately price up. So we're talking about the large mobile solution-based OEs when we talk about things like this. And those contracts have reset. And even to the point of where for the first time, there are some OEs where we just don't have contracts with anymore. We're on a PO-to-PO basis because it's right. They understand it. We understand it. And our relationships are in a far better place at this point in time.

That seems like it should provide increased leverage, increased gross margins for you over time, if you're not -- if those contracts with the annual price downs are gone?

The way to look at this, though, for us is, sure, if we want to go squeeze everybody and maximize our margins and squeeze every dime out of it, I suppose we could do that, but we're not trying to do that. We're trying to optimize it so that we can actually continue to create more holes over time and have a larger share of the holes created so we can sell more razors to be able to get the razor blade business. And you see that exactly happening in our company today with our Aftermarket business up 11% in the most recent quarter. We're gaining share. The overall razor to sell razor blade business model is working. So we're not looking to really maximize and squeeze every dime out of the OEs. We're having -- we're trying to have a reasonable customer relationship so that we give them technology, we continue to sell the razors, drive our razor blade business and overall the model works.

Okay. On to the bull ones. Perhaps not such a great market today, but China is a long-term very large opportunity for Donaldson to penetrate. Historically, the market has used lower technology products where Donaldson doesn't 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 in the future.

Yes. The whole premise of the question is absolutely spot on. It is happening. It's true. China is, however, remains in a pretty slow period relative to industrial-based production. And so China is still pressing for us. You see that in the quarter we reported yesterday, China was a little bit of a tougher new stories. But longer term, China certainly has a lot of upside. We've won with proprietary technology in China. But this whole question really talks about our mobile solutions type of the business. And I want to highlight also another opportunity in China, and that's in our industrial-based businesses and our strategy within industrial-based businesses, where we're winning in China. And our strategy of create, so that's kind of like create the hole with an overall first-fit production system within our industrial-based businesses. We connect it, so we can send now alerts on how your system is working to all your maintenance people's phone, and we have algorithms to tell you, hey, you should order this or that. So we create, connect and then we sell replacement parts. So we have software now that allows you to actually press buttons and just order directly from us. And now you see within this last quarter, we just added another very small service company where we're going to be servicing all that activity, giving us deeper customer relationships, really making sure our products essentially run kind of trouble-free for our customers, if you will. But deepening that customer relationship, what we have found when we connect particular progress or contracts is we have a greater aftermarket return than if it's not connected. So a small sample, early innings, probably about 1,000 collectors is what this data is from, but we'll get 20% to 25% more replacement business from a connected collector than from a non-connected collector. And so overall, it really is validating our strategy. And so we're racing to connect as many as we can, as quickly as we can, again, deepening those customer relationships and bringing that forward. And the exciting news is that in the last quarter we just lit up China, Thailand and India with that same kind of the solution. And so now we're going to go forward with that type of an answer. So where it's going to be? It's a global-based solution. This is not just Western Europe and the United States. This is the world. And we like to say when we get connected product and get that data back, the next application or quote that we'll have will be even more properly sized and therefore, give our customers the advantage on the OE side. And frankly, we're just turning the world into our laboratory.

I guess I'll take this opportunity to ask a question about your guidance for fiscal 2024. Donaldson reported earnings yesterday. And the industrial business was -- revenue was increased 2 or 3 points from where it was previously. So maybe you can just talk about what's driving the upside to that in the short term? While a lot of other businesses, frankly, are seeing headwinds in their industrial business.

Our industrial based solutions business, that strategy of create and connect a replacement service is really working. It's taking hold quite well. It's allowing us to win more market share. The business overall, while pressured in China, for sure, is doing quite well in the United States. It's kind of bouncing along in Europe. It not really had much swings. We've got quote-to-order cycles just a little bit, maybe a week longer, typical quote-to-order would be 8 to 10 weeks, something like that. Now it might be a week longer, but the larger project, so capacity expansion or capacity replacement to make sure you can continue to operate is continuing to happen. So we believe that our strategy is working, allowing us to catch more market share, and you see that within our results. And clearly, we're ahead of our Investors Day targets within our Mobile Solutions business, within our Industrial Solutions segment and we're building a business out in our Life Sciences. So we're a little bit behind there, but we're above in 2 out of 3. So we'll step back, take a look here in the quarters to come and see, gosh, are we going to have to adjust a little bit. If you take our industrial-based business that you're talking about, we're clearly ahead of the operating margin already that we expected to achieve 3 years from now. We're already there. We believe that's sustainable even as we continue forward. And so we'll adjust looking forward. But we're excited. We're really pleased about the execution in the company on our industrial-based businesses, and we'll continue to press that strategy forward.

The other thing I would just add about the industrial guidance is, we report our Aerospace & Defense business within Industrial, and that's been performing really well this year and supported for sure by the strong end market in Aerospace.

Second one, the more exciting piece. Life Sciences is still relatively small but fast growing with a targeted 20% organic CAGR over the next 3 years. As Life Sciences increases in size, its contribution to enterprise growth will become more significant and margins in this segment are currently depressed with low volume and could ramp up significantly.

So we're early innings. On Investor Day, we had a $240 million business. We said our target was about $450 million. We have a full table of opportunities and we continue to press those. We have seen some bioprocessing based projects move out a little bit, which is -- so we have projects that are CapEx-based bioreactor-based projects, so large systems, things like this to -- for cell and gene therapies in our Univercells Technologies businesses. Those are 7-figure type of projects. Those have moved pressuring a little bit in the near term. But then when you really look at the whole table of opportunities that we're pressing, there are multiple hockey stick opportunities inside that particular vertical for us. We talked about one actually in a conference here in Boston just about 3 weeks ago. And we didn't present our technology, our customer partner did, and that brought a lot more of the big names coming to our table. And specifically, it's solvent reclamation. So it may not be sexy, but in GLP-1 drugs, which all of us hear about, they actually use a solvent called Acetonitrile. You get Acetonitrile from China or Western Europe, you bring it into the United States, you truck it over to the West Coast, you actually [ prefer ] chromatography column, you can create up to about 2 million liters worth of waste that you have to incinerate and no one has been able to reclaim the solvent past about 85% purity, except when you want to reuse it, you have to be 95% to 99% purity dependent upon what drug that you actually make. Donaldson can now do 99%. We're the only ones in the world. We have been granted the patents for it. It's a hockey stick opportunity for us. It will take a little bit of time. How quickly could we build systems, things like that has been received in the markets very well. We have finally disclosed all of that information within the last month. It's just one of a stable of opportunities within this business that we're pressing. And we'll come out and tell you more about those. But we want to be a little bit further down the road on some of these with our customers and have that customer-based endorsement rather than just Donaldson Company talking about it. But that's a good example of a real-life opportunity for us, and it was exciting. I just -- you almost had to kind of hold back the line a little bit of people that really have inquired about that.

I think those will be large opportunities when they're really commercialized. Maybe just to touch on the guidance from yesterday. You did take the Life Sciences segment guidance down a little bit. It was -- growth was forecasted to be about 20%. You took that down to mid-teens. Is that primarily just the bioprocessing pushouts that you were talking about there? Is there anything else that contributed to that?

No, that's it really. That's the primary reason. So you see some of those projects actually push a little bit. But then also you can now see incoming orders on the bioprocessing side, really, really slow and the degree to which that happened, caught us a bit off guard. And so therefore, we took down that particular guidance. It's a small part of the company. Not -- obviously didn't hurt us because we still put up record top line, record operating margin, record earnings. It happens when it's small and you're building out a particular business. That particular market, obviously, within bioprocessing is well written, that it's a bit troubled. And so we finally for the first time in this quarter actually felt a little bit about that. And so we adjust it.

Last one, the balance sheet. Very strong net debt about 0.7x. I guess that was at the end of fiscal second quarter. I wrote this before you reported yesterday, which can be used to accelerate Donaldson's strategic move into process and Life Science, filtration markets, diversifying end market exposure and continuing to mix revenue away from engine and into higher growth and higher margin markets.

Scott and I talk all the time about capital deployment. I want to remind everybody that our capital deployment strategy remains unchanged. First, we want to invest back into the company organically or through M&A. Next, we want to pay dividends. We're 60, whatever the heck quantity years, and been paying the dividend. We are a member of the Dividend Aristocrats Fund, where we have been increasing the dividend for well over 20 years. We would expect to keep that. That is a priority of ours. And then last, we are a consistent buyback story. So we try to take it about a 1% buyback and whether there's an opportunity will go minus 1. We've been doing 2% buyback on an annual basis. But all that's just normal stuff. If you pick up on where we are within the M&A-based strategies, we certainly have been acquiring companies in order to build out a Life Sciences based business, but also smaller service-based companies in support of our industrial-based strategies. Those you saw one, a very small one in LaGrange, Georgia in this past quarter. That's really to continue to press that opportunity that I talked about. Our overall M&A pipeline remains full, robust, opportunistic, particular to the strategies that we're targeting, and we continue to work those. We're excited. We do have work ahead of us in order to complete the Medica-based transaction because they are partially private, about 20% of Medica is private on the Italian Stock Exchange. So we have to bring them to be private. So 20% is public, sorry. And so we'll bring them private and then complete the 49% of the transaction in the months and maybe a couple of quarters ahead. But we are super excited for them to join the company that gives Donaldson a new technology, hollow fiber membranes, also goes into the bioprocessing space when we have had a joint venture -- not a joint venture, a joint development agreement with them that we have been working to be able to bring those bioprocessing products. So if you think about what has to happen on separating those cells out, your human hair for those of you, unlike me, who have some, is about 10 microns in diameter. So the structure within that particular product is about 0.2 microns in order to do the proper bioprocessing applications, and they'll do it in kind of an extruded straw, but it's much more -- you can get your mind around straw, but it's much more elongated than that and highly technical, that now comes to Donaldson Company and is applicable across a host of spaces of medical-based applications and brings new filtration technology to Donaldson within [ polyether ] cell phone type of -- and [ polyether ] cell phone type of technology. So we're really excited about that, gives us a bigger foundation, and we'll continue to press that opportunity.

Awesome. Well, we are up on time. So thanks, everybody, for joining us this morning and Tod, Scott, Sarika, thank you. Thanks for joining us as well.