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

Okay, I think we can get started. Perfect. Thanks, everyone, for joining us today. So my name is Angel Castillo. I'm the Morgan Stanley machinery analyst. And with me today, it's my pleasure to have Tod Carpenter, Chairman, President and CEO of Donaldson Company. We also have Scott Robinson, CFO; and Sarika, Senior Director of IR and ESG. So thank you for joining us. I'll start quickly with a disclaimer and then we'll get right into the fireside chat. So for important disclosures, please see the Morgan Stanley research disclosure website at www.morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley representative. So Tod, again, thank you for joining us today.

Thanks for having us.

Of course. So maybe just a quick place to start. For those in the audience that are not as familiar with Donaldson, would love to just start with a quick overview of the business. Just maybe start there and we can kind of set the stage for the fireside.

Sure. So Donaldson is a 109-year-old company. We have roughly 14,000 to 15,000 employees. We are global. We're $3.6 billion. We just reported our fiscal year a couple of weeks ago, like another year of record top line and record bottom line. We have 3 reporting segments: They are Mobile Solutions so medium, heavy-duty diesel engines. Think construction, mining, agriculture and long-haul trucks. We have 0 revenue on internal combustion engines of any type for passenger cars. The second segment is the Industrial segment so it's the most probably product-diverse. It ranges everything from Power Generation, so filters that go in front of a gas turbine powerhouse space and peak load power stations around the world. Those would be our largest filters, to our smallest filters in the company for aftermarket-based activities within a whole host of, say, dust, mist, weld fumes, things like that. We even get into pharmaceutical dust and actually gold dust as well in order to be able to collect that. And then in our third segment, our newest segment that we're entering to further diversify the company is our Life Sciences segment. And there, we also have another very diversified portfolio of businesses, have some traditional base businesses. The thing that's really the common thread across all of those is the overall polymer-based solutions or membrane-based solutions that we use across all of those particular applications, everything from the polytetrafluoroethylene in our Disk Drive-based business. That goes into medical-based components as well and bioprocessing-based filters. We have been acquiring -- we look to acquire within that space and in the industrial space. We have had a host of acquisitions in the last several years. So our story really at the macro is we continue to put up record top line, record bottom line, continue to look to diversify the company, diversify the portfolio. Our strategy is to be a technology-led filtration company. And over a period of 4 years from our Investor Day in 2019 to our Investor Day in 2023, on average, somewhere in the world, Donaldson was granted a patent every day. So we're very serious about our strategy and we continue to invent cool things.

That's an amazing overview. Appreciate it. And maybe we can start right there in terms of the M&A side of things, right? So you mentioned you've been investing in the Life Sciences business. You also have a lot of firepower in terms of your balance sheet, a lot of flexibility there. So maybe just to start, as you think about the next 5 years of Donaldson, right, what does the portfolio look like over that time frame? Where are you thinking about investing more of your money, particularly right now with, we've seen a little bit of a slowdown because of macro around maybe how quickly Life Sciences might move forward, et cetera? So just -- yes, just maybe start there with the next kind of 5 years for strategy.

So for us, the outlook, we step back and we look at the technology, filtration-based technologies and the raw material-based technology sciences that we have in the corporation and we look to really build that out, and then what end markets really are most beneficial where we deserve the right to win and enter. And so for us, right now, that's within the Life Sciences, particularly in the bioprocessing-based space, we do look to continue to acquire new technologies. And for us, it's -- we just completed an acquisition where we now own 49% of a company out of Italy called Medica. What Medica does is kidney dialysis filtration, and that's what you would see at the end market. However, for us, it's hollow fiber membrane technology. Hollow fiber membrane technology, if you think about it, you'll look at it, it'll be -- the inside diameter will be smaller but you'll think about it as a straw, and you're producing these straws but the wall thickness -- the straw has a porosity. Your hair is about 10 microns in diameter. The wall thickness is 0.2 and that allows you to do kidney dialysis. And more importantly, when we change the configuration, that allows us to get deeper into bioprocessing filtration and really serving that particular portion of the market and that unmet need and continues to then, because of that technological advantage, really go into that market deeper for us. And so we look at acquisitions that way. Five years from today, I would believe our Life Sciences-based business is certainly bigger. Donaldson continues to diversify. We have many new market opportunities. We'll look to acquire new technologies or organically invent new technologies and continue to broaden the base corporation portfolio to help us with our cyclicality that we see from time to time.

That's very helpful. And I want to remind everyone in the audience that if you have any questions, feel free to just raise your hand and we'll get a mic to you. But maybe just to continue down the idea of M&A. One aspect is I mentioned the balance sheet, the flexibility that you have. I think in the past, you've said you were open to more transformative deals, right? And you mentioned not only Life Sciences, but there's -- it's been more kind of tuck-ins or smaller acquisitions. So are you still open to transformative deals? Where would that be within Life Sciences if one were to come there? Maybe just talk about the pipeline, right, from that perspective maybe more from the...

Yes, maybe I'll start and then let Scott pick up the rest. So at the macro, yes, we are open to larger deals. Specifically, they would be really within our main space, either diversifying the company, adding technology. We continue to work on the pipeline every day. We would tell you the pipeline feels good. It's still strategically focused. A number of opportunities, it's full. We understand that we have some power out there, and we expect to execute on our inorganic portion of the strategy. And as far as transformational, I'll let Scott take it.

Sure. So we've completed several acquisitions over the last few years and continue to pay our dividend and buy back shares. And you see our debt-to-EBITDA levels kind of slowly drifting down. So we're generating quite a bit of cash certainly more than we've invested in the last few years. And we bought back 2% of our outstanding shares in the last several years. This year, we guided 2% to 3%. So we look at our amount of invested capital and want to manage that. As Tod mentioned, we would look at a bigger deal. The majority of the deals out there are of a smaller nature, but we would look at a bigger deal. And then if we did, then we would obviously have to take the debt levels up and come up with a plan on how we're going to work that back down. Our stated target for net debt-to-EBITDA right now is 1.0x and we're at 0.5x so we're below that. We have increased our share buyback guidance for this year from 2% over the last several years to 2% to 3% for this year in recognition of our current debt levels. We do look to deploy capital. We have to do it smartly. And it's hard to predict exactly when acquisitions will occur, but we do continue to look to invest.

And maybe when you think about diversifying, what does -- what do you kind of define that as in terms of moving? Is it more growing Life Sciences as a percentage of revenue? Is it entering other adjacencies? How do you kind of think about that?

Yes. So for us, it starts with technology. And so if we can acquire new technology, as we just did with Medica, with the hollow fiber membrane-based activities, we look for that to really broaden our overall technology in either raw material sciences or how you make a filter or how you make fibers, which would ultimately go in to make some kind of a media-based solution for filters. So we look at it that way. So if we can acquire technology, it's great. There are times where we will acquire access into a customer base that may be a bit more mature, et cetera. That's probably the quickest way to get into that end market. We don't often stand and look at the end market and say, "We like that one. Now let's figure how to get in." For us, it's a bit more bottoms up and then top down to make sure that we have a right to play and that there's an unmet need that we feel like we can bring some value into a particular end market. So we look at strategically in that sense and therefore, why we would acquire, again, starting with technology, sometimes it's access and so on.

Perfect. Maybe pivoting a little bit to the fundamentals. So could we talk about Mobile Solutions and what you're seeing, just kind of more broadly from a demand perspective there?

Yes. So Mobile Solutions, again, is construction, mining, agriculture, long-haul trucks, so we would tell you that the agriculture story is well written. Obviously, headwinds are pretty broad-based no matter where you are in the world. We would tell you the construction story started to see a little bit more headwinds in the U.S., a little bit of more slowdown. The new one in the last quarter, though, would be mining. You heard that Caterpillar talked about mining being down, a little bit more headwind. So we did see that within the mining side. And then the long-haul truck side is a little bit more muted. But I do want to remind everyone that we make proprietary filters to sell aftermarket, so proprietary razors to sell razorblade. And so no matter how many first-fit vehicles they're actually producing, we're populating out there new razors. And so that's the reason why over time, we're going to continue to go forward and grow our aftermarket and why we believe we can grow more than GDP. And you see that within our tremendously positive aftermarket, we're winning share and we're also having that model grow. And within the quarter, you saw us, although we had the headwinds that we talked about in that Mobile Solutions first-fit portion of our business, our aftermarket was up double digits. Share gain, natural order of things where we're selling proprietary filters, all of that, we're gaining real positive momentum with.

And I'm glad you brought that up because that's one thing I wanted to talk about is just the market share gains and the differentiation where you were outperforming the business, right? And this is clearly the more attractive part of your business, the aftermarket side. So what's allowing or what's driving that market share gain? How do you see that progressing? It was clearly a big driver this year. As we go into next year, is there kind of more market share? Does that kind of continue or just how should we think about the market share dynamic?

Yes. So as we look into this forthcoming fiscal year, clearly, what we saw, it will continue and we did bake that within the guidance that we gave you this fiscal year. And so we would expect to grow in the Mobile Solutions business. Even though that first-fit-based pressure will continue throughout the balance of the fiscal year, we would expect to grow. What's driving that really is kind of an interesting phenomenon. The person who has the best catalog wins or at least gives the opportunity to play in that, and we have the best catalog. We have our proprietary-based entries, but we also have all the necessary piece parts for the markets that we play. An interesting phenomenon that happened during the COVID activity when no one really could supply all the demand that was out there is we've had new customers call us up and say, "Hey, we'd like you to be our customer. How about we give you, whatever, a 7-figure order, et cetera?" And we turned many customers down actually because we said, look, we're going to take care of the customers that we have because something else that's very important to us in our strategy is our customer relationships. We're very proud of our customer relationship. We really take care to make sure that they're taken care of. And so we said, look, we're going to take care of our established relationships. Well now, a lot of supply chain has actually come around and kind of muted out and we're back to a little bit more normal. We are seeing opportunity where people say, "Hey, we like what you did there. Now and with your expanded capacity, could you take care of us?" And so that's helped us continue to grow, gain some share. And it's kind of the whole model of things. It's technology, it's our proprietary, it's our customer relationship, it's our ability to ship and take care of the customers no matter where you are because we are located very close to the customer base. They talk about 24-hour shipping and things like that. We've been doing Amazon since the '90s. We've been doing it out of Rensselaer, Indiana. You order from us before noon, we'll ship it same day. So that's kind of old hat to us and it's an important part of our model.

That's very helpful. And maybe just could you help us quantify what is your market share today? What do you kind of envision that could be over the years sort of longer term in terms of the aftermarket?

In terms of the aftermarket? So if you just kind of step back and look at what we have as far as the share, we actually debate this all the time. We're probably, say, low teens to mid-teens kind of share gain -- current share. So we have a lot of runway there and we expect to go get it. We have a higher share in the United States. The next higher share would be in Latin America and, next, probably Europe and then trailing inside Asia Pacific. So a lot of opportunity for the company globally.

And maybe could you talk about -- because one of the things that has maybe come up a little bit and more on the OEM side is maybe weakness on the parts businesses. And sometimes the question that we get is whether that's going to impact Donaldson. But instead, you've actually had the opposite where you saw destocking last year. You're lapping that. You're seeing good market share growth, again, good outperformance. So could you talk about some of the nuances that you're seeing in terms of parts demand and maybe how the environment maybe that we're in today impacts aftermarket demand?

Yes, it's a great question because people read too much into all of that. It was not a normal cycle. It was not a normal period. You come out of the supply chain difficulties that you had. What you had is every OE because, again, we're proprietary razors who sell razorblades. We can't shut those OEs down, right? Because they don't have anywhere else to go and get the razor. There, our strategy is pressured. So therefore, we're not going to shut them down. Therefore, the OEs actually win in that sense and build up a lot of inventory. The independent channel never had the chance to build up inventory during that time. So as the renormalization and the destocking happened within the OE side, it was just normal. They actually had some headwinds from the first-fit side, and they also had too much inventory as the supply chains kind of repaired. So none of that is really, really foreseen to repeat. But we did have to work through it. So we have lapped now the OE destocking. It's clear that that is now behind us. And the independent channel continues at the pull-through levels that it was in the past. So we would tell you that we're at pull-through levels on the OE side. We're at pull-through levels on the independent side and the inventory across the channels feel comfortable.

And one thing I would add is just is that we consistently hear from the OEs that they're very interested in their parts business. And that's an important revenue stream to them, that they want to try to secure that revenue stream and they really want to invest in it. So that's good for us because we want to sell through the OEs and help them achieve their goals.

No, that's very helpful. And maybe to the kind of last point on to wrap this up is just the margin side of it, right? So aftermarket is clearly more attractive margin for your business. You recently raised your target there around the margin opportunity for this business as well. How should we think about some of the underlying drivers? Is it just kind of just gaining share? Or are there other aspects of what you're doing, initiatives to drive greater profitability in the business?

Yes, sure. So we took the -- our Investor Day targets up a little bit for our margin guidance. So we are pleased to be able to increase those targets, but we want to continue to deliver higher levels of profitability and higher sales. So we have several actions that we take to do that. One is we continue to invest in higher-than-average margin activities. One is our higher-margin businesses continue to grow at faster rates, and we continue to leverage the strength of a 108-year-old company. So we feel pretty confident in the fact that we can drive our operating margin percent up over time as the company grows. And we've been able to do that the last several years. We expect to do it again this year. And with our Investor Day targets, we expect to do it again the following year. So we feel like we're in pretty good position to drive that operating margin slow and steady up in the future as we go forward.

That's very helpful. And any questions from the audience? If not, I want to move over to Industrial Solutions. So you mentioned this is where you have a little bit of a broader end market. I think one of the ones that comes up quite a bit is on the Aerospace side. So if you could just talk about the backdrop that you see there in terms of demand across those key end markets.

Yes. So the 1, say, supply chain that had not corrected is the Aerospace and Defense supply chain. And you hear that with the Boeings and the Airbuses and the rest. It's no different for Donaldson Company. Within that Aerospace and Defense business, we're 60% Aerospace, 40% Defense. You'll see really excellent growth rates, almost 40% within the quarter. But we would tell you it's lumpy, okay? And what happened is we've been working that supply chain for the entire year. We were able to get past a number of those things, which really then allowed us to get a lot of the products out that were hung up. If you just look at our Aerospace and Defense business over time, say, take a 10-year cycle, we would tell you it's more of a mid-single-digit growth business. We do everything from stationary aircraft to rotorcraft. And then on the overall Defense side, we're largely ground-based vehicles. So think M1 tanks, things like that.

And then maybe on the IFS side, how does that kind of compare in terms of the growth drivers just overall? I think you kind of alluded to a little bit there, but just...

Yes. So IFS, within our Industrial Filtration Solutions business, what we have in there is -- you look at a capital-based project. Any manufacturing process that creates a fume, a mist or a particulate, we actually capture that for you in order to help the overall manufacturing environment. And what's new, what we're bringing forward strategically on that in order to, again, to apply that proprietary razor to sell razorblade-based model is we're digitizing that entire space. So if you're a maintenance person and you have a new dust collector, the most important thing you want is to not stop production. And therefore, you really don't want to talk about the dust collector. You just want it to work. So for us, we're now -- we have a number of different patents, believe it or not, to talk about how much filter life is in a filter. It used to be red or green. It still has life or change me. Now people want to know, hey, is it 32% remaining? And what day do you think I'm going to have to change it? And so believe it or not, that's incredibly difficult to come up with. We actually have patented the algorithms and particular sensors and embedded new sensors to be able to do those kind of things. So we send those alerts to the maintenance person to say, "Hey, go look at this dust collector," and for example, they have a big hopper that collects all the particulate. Go empty it or you're about to shut down your production line. And so we have thousands of these collectors now hooked up and we'll continue to press forward in order to be able to do that. We now ship our new dust collectors in an [indiscernible], for lack of a better description, type of methodology where they plug it in, it will start to work that way. We have found that when we connect a dust collector digitally, we will actually increase our overall aftermarket opportunities because it won't be late on the reordering of parts or replacements and their line is actually kept up more frequently. So strategically, that's what we're doing across our entire Industrial portfolio. And then we're adding over the top of the service component to say, hey, look, if you want us just to take care of it, we'll do that, too. And so you see strategically really a great opportunity. We have growing aftermarket within that space. We have really shown that the overall model works. And so where we're laser-focused is to make sure we're connecting as much of the product as we possibly can. Important to note we can connect anyone's product, not just ours. Our patents and our products allow us to go and retrofit anybody's dust collector, not just Donaldson Company, and then we'll take over the overall aftermarket opportunity as well. So we see good opportunity long term for growth in the Industrial business, and you can see it in our performance to date.

Yes. And you raised your targets there as well and the margin dynamic there as well. So maybe, again, any questions from the audience? If not, I want to make sure that we have time to talk about Life Sciences. That's a business where there's been a little bit of a pivot in terms of the growth opportunity, maybe more near term as you think about maybe shifting from 18% to 22% but still attractive, right? It's still 12% to 16% growth that you're guiding to there. So can you talk about maybe what's transpired there, how you see that evolving? And is it -- over time, do you expect to get back to that 18% to 22%?

Yes, I'm going to give you an example, let's just try to create that picture for you. The reason that we moved that out a little bit is in our traditional base businesses in Mobile Solutions and Industrial, when a project moves out, it will move out a quarter or 2. But in Life Sciences, when it moves out, it will move out a year or 2. And so consequently, if you just take a look at what we have, I'm going to give you 1 example. In overall GLP-1 drug manufacturing, you have this solvent used for every chromatography column. So chromatography column is after you've grown the cells, you need to polish it. You use this solvent in order to help clean it, if you will. And in 1 chromatography column with our customer in Southern California, they'll create 2 million liters of waste per year every -- so acetonitrile is either brought in from Europe or Western Europe or China. So their supply chain for acetonitrile is boated across the ocean, drive it across the country, use it, and every week 5,000 liters go into a tanker truck, driven to Mexico and incinerated. And then they have to buy more. No one's been able to reclaim acetonitrile above 85% purity, but their process needs 95% or above. We now have been granted all the patents and we've invented to be able to get it reclaimed to 99% purity. It's so good of a product. At the Boston Life Sciences base conference, our customer presented the product. They were really excited about it because they're helping their sustainability targets. And so now we are receiving all kind of inquiries from everybody, as you can imagine. It's more than just GLP-1 drugs. It's all -- it's the single largest solvent used across the overall industry. So acetonitrile reclamation is a big project for us. Now that we have this, now we need to make the system. And the system manufacturing actually moved out 12 to 18 months. We thought we would be able to start to monetize that with the first large system. We will save on every chromatography column and there are thousands, we will save on everyone, our customers, millions of -- per year, millions of dollars per year. And of course, Donaldson will do just fine as well. So if you look at the overall model and what we're doing, that's just one of the products that we're looking at. Why did we come up with that? Honestly, we're technology-led. We're just a bunch of filter geeks and the technical description of this thing would be, first, you got to filter it, then you got to filter it, then you got to distill it, then you got to filter it again, but all those filters are really hard to do. And so we were able to accomplish that and get that done and we'll push it forward. But there are others as well that we continue to chase. And so it's just taking more time for us to continue to leverage that forward in our growth opportunity, and therefore, we're realistic and embraced that reality.

And maybe just for the last couple of minutes, any way to kind of quantify the opportunity longer term as we think about, for instance, 12 to 18 months when that starts to get monetized, what's kind of the contribution from a margin or a revenue top line perspective?

The way to think about it is everything we're doing is above company average. It will -- strategically, we're looking to mix the company up by entering the Life Sciences, we have -- we actually have confidence that that's going to continue. Everything that we see with everything that we're able to execute, that thesis actually has been proven for us, and now we just need to continue grinding through it and monetize it.

Maybe outside of bioprocessing within Life Sciences, you have Disk Drive and other businesses. What's kind of happening there and what's kind of the outlook as you think about 2025?

So our Disk Drive-based business, so the way to think about it is whenever you have moving parts within a disk drive, so think Seagate, Western Digital, et cetera, we make filters that actually will be chemical absorption or filter particulate and that helps protect the disk drive itself. Otherwise, you could lose data. And depending upon the chemicals that you need to absorb, we could do that. We've been doing this for decades. We're #1 in the world. But the important point of why that is in our Life Sciences-based business is polytetrafluoroethylene, and it's expanded, okay? And we use that across all medical-based applications and other activities and it starts and everything comes out of our Disk Drive-based business. Our Disk Drive-based business, last year, faced tremendous headwinds. It halved in a matter of months so we adjusted. That business was close to 3% of company revenue. It went way down way fast. And so you see that headwind in that Life Sciences-based report as well. That's now behind us. It is moving forward again. Why? Simply because of the overall large cloud-based farms, all those kind of activities is helping with more -- with the world becomes more digital, that's helping grow that particular business because now in those larger-based applications, the filters that we used to make, we used to make 1 million a day in Rayong, Thailand, for example. They'd be as big as your little fingernail. Now they're about half the size of your thumb. And so the content for a drive for us is much larger. And it's actually -- for us, it's a full decimal point larger when you look at it. So the business is going to be just fine. It will never be back to its heydays when computers -- when every computer and flash drive wasn't out there. It will never be back to that level but it will still be very powerful and comfortable.

Perfect. Well, that brings us to the end of time. So again, Tod, Scott, Sarika, I appreciate the time. Thank you.

Thank you. Thanks for your interest.