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

Good morning, and welcome to the 22nd Annual CL King Best Ideas Conference. I am Tom Hayes, Senior Industrial Analyst, here at CL King. We're very pleased to have the management team at Donaldson with us today for a fireside chat. Representing the company, we have Scott Robinson, CFO. Good morning, and again, thanks for joining us. [Operator Instructions] So with that, again, Scott, appreciate you participating today. I know you have a slide presentation, so we can jump into that.

Yes. Thanks, Tom. Good morning, everyone. I have about 10 introductory slides to Donaldson. So I'll run through those and then we can move to the Q&A. So starting with Slide 1. In terms of Donaldson, there's always 5 things we think are important to remember. And so I'll run through those quick. One is Donaldson has been around over 100 years. We are a leader in filtration. We are a technology-led filtration company, and we want to sell solutions that are built on our technology of filtration. We believe we have best-in-class technology. So we've been developing some of these technologies for decades and decades. And we work every day to add to our core science of filtration, which is really the lifeblood of the company. We have 2,800 active patents and we work to create and protect new technology every day. We believe we are an enabler of the new green modern economy really by helping our customers achieve their goals through advanced filtration. We believe we have a clear strategic and balanced growth strategy and so we have two very strong businesses that have been around for decades and decades, and a new life sciences business that is penetrating some new markets for us. And lastly, we are making progress on our Life Sciences business. So our engine business has been around since day one of the company. We now call that mobile solutions. Our industrial business has been around since the 70s, and now the next move is really into Life Sciences, and I'll explain that a bit later as we move into the presentation. A little bit of history on Donaldson. Like I said, we were founded in 1915, over 100 years ago, 14,000 employees, 140 locations, nearly 2,800 active patents, a long-term dividend CAGR of 12%. We've been paying a dividend for over 65 years and increasing that dividend for over 25 years. So Donaldson is a member of the S&P High Yield Dividend Aristocrats fund, and that's a record that we're obviously proud of and something I want to make sure we keep going. If you look at our businesses, you can see we're split 62% Mobile Solutions, 30% industrial and 8% Life Sciences, and our model is really razors -- to sell razor blades, and we are 66% replacement products and 34% first-fit products. You can see our revenues have grown from $2.8 billion in '21 to almost $3.6 billion in FY '24. I'll remind you our year-end is July 31st. So we are just now embarking on FY '25. We'll get to the guidance here in a moment. And you can see earnings per share adjusted $2.32 in '21 in all the way up to $3.42 in FY '24. So a nice 4-year run for the company with strong revenue growth and also strong earnings per share growth. And I'll show you the operating margin growth here in a bit, ut the financials have, I think, trended nicely for Donaldson Company. If you think about Donaldson and our worldwide organization, we're very blessed to be around over 100 years and blessed to have a global business, a global footprint, global distribution, global manufacturing, we generally produce in region to support region and that's been built up over 100 years. So we really have a good ability to leverage our footprint, as revenues grow, we really don't need to add any subsidiaries or any shipping channels or any production facilities. So we're blessed to be in good shape there. If you think about our markets, you can see we span a large diverse set of markets, but the biggest would be construction. Next is on-road truck, industrial air, mining, agriculture and then on down the line. So we span many different markets, which serves to really stabilize and diversify the company. A little more on financial highlights, including this year's guidance. So again, we're projecting the record levels of sales and record levels of profits after records of the last several years, you can see our revenue at the midpoint is expected to grow 4% in the $3.7 billion range. Operating margin is something that we've really been focused on, we always say, we're committed to higher levels of profitability and higher sales. So that means we have to merge that operating margin percent up as our revenues grow. And you can see we've had a nice run over the last few years, and we expect to continue to increase the operating margin again this year after strong growth last year. And we'll get to our longer-term targets, but we expect to continue to do that the following year. And that brings you to EPS growth. You can see good EPS growth over the last 3 years. And we expect continued EPS growth again this year on higher sales. A little more on Donaldson, and you think about really our attributes. As I said, we've been around for 100 years and Frank Donaldson invented the first air filter for a tractor. He worked for Bull Tractor Company, believe it or not, 100 years ago. And his tractors kept dying. So he basically formed an air filter to stop the field dust from going into the engine, and that was really the introduction or the birth of Donaldson Company. We are expanding, as I said, in the opportunities in life sciences. As the world becomes more green and we're all worried about how we treat the planet, filtration is just really a super place to be for that because we can help remove harmful products. We can help the equipment run more efficiently, we can help equipment use less energy. So filtration really plays right into the heart of that. Aftermarket is always a very strong attribute of Donaldson. We want to sell first-fit systems to capture the aftermarket. And like I said, 2/3 of our business is really replacement parts. So we've been around a very long time, and we have the confidence of our customers that they know our products and have a very strong brand reputation. So that aftermarket really supports the Donaldson financial model as we slowly gain market share, it just slowly drives the company. In terms of customer relationships, we've had some of our OE customers for 75 years, and we are willing to work with them every day to help determine what sort of problem they're trying to solve. And we want to bring our solutions to them really long before it gets to some sort of procurement situation. We want to help them develop their new lines and make sure that our filtration solutions are ready to serve them. So when it does get to the bid time, we have a strong leg and being awarded that business. As I said, we're very diversified, blessed to have a very global footprint and a very broad geographic reach and customer presence. And lastly, we have our 50 manufacturing facilities. Many have been around for a long time. They really are spectacular at building filters and making sure we're building the best and lowest cost filter that's possible, I'll maximize our pricing to our customers. And that's the long history of Donaldson and cost improvement activities. If you think about our portfolio, there's maybe a few points about each. We had mobile solutions, and we want to continue to improve the efficiency of the equipment and make it run more cleanly, more efficiently, generate more power, utilize less resources on the input side, and we have great opportunities, continue to have opportunities in construction, agriculture, mining as the world kind of continues to grow up, especially in places like maybe China and India. Industrial Solutions, we're really focusing there on connecting our products. So we want to make sure that we can help our customers and their factories with connected solutions such that we can help them maintain that equipment and make sure it's running at its optimal point. We can help them ensure they're managing energy consumption to help them with their footprint reduction ideas. And there's just always a strive or a drive to improve efficiency, reduce cost and in our filtration solutions kind of thing we help that. And finally, in the life sciences, there is a great opportunity for Donaldson to bring some of our filtration expertise into this. And we're not really looking to compete with existing processes. We're looking to leverage filtration into many of these processes where we think we can improve yields, improve productivity and help our customers really manage their cost and improve their production output. In terms of -- we sell some filters into [indiscernible] cloud storage facilities, and that's just ever growing in terms of microelectronics and disk drives. Life Science is a bit more on. So you can see listed here, there's a $21 billion market and those are the acquisitions that we've completed to help increase essentially our technology that we have to offer. And we've invested about $370 million into this business to help drive it for. We feel like we're sitting in a good position with good technologies. There is a time period to ramp those businesses, but we feel like we really have some good technologies that we can leverage and we have some existing products that we brought into that portfolio, and then some new products that we've acquired, which has really given us a great opportunity long term for the company to really increase our TAM, and provide technology, filtration solutions into this life sciences sector. So we feel pretty good about that. We want to leverage the science that we have and continue to add to it. So we really don't look or think about what product we want to sell. We look at what core science or what filtration technology are we really good at. And then we think about working with that and help. And so we just got to continue to slowly expand our near adjacencies into our near adjacencies and really capture those sales. If you think about capital deployment, we've invested or deployed about $1.4 billion over the last 3 years. And you can see the makeup of that investment. So it's pretty well balanced. Donaldson is a very strong cash generator. So we're kind of lucky to have that, and we're able to buy back shares, pay dividends while investing in the company. We think we can easily manage our CapEx to be approximately 3% of sales, even with the adding of life sciences. So there's plenty of cash. We've been able to buy back 2% of our shares over the last several years. And you might have noted this year's guidance is actually 2% to 3%. Our net debt-to-EBITDA ratio currently sits at 0.5. So it's been slowly trending down even after some of the recent acquisitions. So you have kind of recognized that and increased the share buyback from 2% target the last several years to 2% to 3% this fiscal year. A little more on the balance sheet. Our general net debt-to-EBITDA ratio, we generally say our target is 1 right now, we're at 0.5. So we've made some acquisitions and still, the debt has driven down due to profit growth as well as strong cash conversion. You can see 85% is our long-term average of cash conversion. We've been above that the last few years with strong working capital management and just good performance on behalf of the company. We do have quite a bit of liquidity available if the right larger acquisition really were to come along, we would certainly consider that, and we certainly have the balance sheet strength to be able to take a run at something big if it was the right fit for Donaldson. Here's our long-term targets, which is our last slide. So we did modify these a little bit with our last year-end. The biggest reason was, you could see our Mobile Solutions and Industrial Solutions were significantly ahead of our 26 operating margin targets. So we brought those up to kind of recognize the strong progress that we've made. We expect those operating margin targets to continue to ramp up, albeit a little slower rate after the really strong growth over the last couple of years. You can see we get the sales flat from Mobile Solutions and Industrial. So 2% to 6% for mobile or 4% for midpoint and 4% to 8% for industrial or 6% for the midpoint. Life Sciences, we still feel like we have really good growth opportunities there. And that profitability story is really a scaling story. So as the revenues grow, the operating margin will increase. We did buy two pre-revenue companies. So obviously, they have no profit, just expense. But as their revenues start to kick in, that operating margin will come. And so we backed those off a little bit, but still feel really good about our life sciences investment. And personally, I think 10 years from now, that will be a very strong return for the capital that we put into it because we have pretty good growth prospects. We're over -- we're involved in over 140 drug trials or drug activities. So we feel like that's a good base and we're building it. Obviously, it can take a long time to ramp, but we need to continue to increase that every day because as those products, some percentage of them come to light that strong revenue growth for Donaldson. So we are investing in life sciences now. We said it's going to be just above breakeven for the year, and as revenues scale in that profit will come into play. So the last few years, we've generated record levels of sales and record levels of profit while investing in Life Sciences. So certainly, our profit could be higher if we weren't investing in any life sciences. But it's just such a natural adjacency for Donaldson that I feel it's important to continue to capitalize on those adjacencies and bring our technology to market even if it takes a little bit. And I feel especially good about that while we're still generating record levels of profit. So that's my dog and pony show. Hopefully, that gives you a little bit of background on Donaldson. And at this point, we'd be glad to take a few questions from the group.

Scott, that was a great overview. I appreciate it. Just wanted to go back to one of your earlier or first comments that you said you're a technology-led filtration company. How does that allow you to kind of win in the marketplace? And what does it mean for your customer base?

Yes. I mean that's -- I would say, that's is a little life bread of our company is our technology. And if you walk around here, you get a chance to go through our labs, I think you'll quickly pick up on the number of amazing people we have that are really either in an existing businesses like mobile solutions, where they're making sure they're meeting with our big OEs to understand what solution they need or generating new breakthrough research and development ideas. So we want to make sure that when a customer comes to us with a filtration solution or a filtration problem, then we have a solution for them. And if we don't, we certainly think about could we develop that. And so I really think that's critical to the company. I think it ensures our long-term success. We look to protect that. As I said, we have almost 2,800 active patents around the world. So I think that's evidence of the amount of technology the company has under its umbrella, and we're really the only global diversified technology-led filtration company in the world. So we have many strong competitors that we'll compete with in an individual business line. But we don't often compete with the same competitor across three different lines, for example. And Donaldson, I think, gets the benefit of opting learning something in one business that we can leverage in another business. For example, the technology in our disk drive business will really be the technology that we deploy, if someone is interested in building a hydrogen fuel cell for heavy-duty piece of equipment. And so we get this ability to leverage our technology across our lines, and we want to have that technology ready. So when customers come to us, we have just been waiting for them.

I think along those roughly same lines, I think one of your pillars was as supporting the movement towards more sustainable solutions, kind of the greener view. Can you just remind me how you guys win along that vertical as well?

Yes. Maybe I'll let Sarika start with that one. She's actually the leader of our ESG group, along with Investor Relations, she's doing a great job. So maybe I'll let her start there.

Sure. So just inherently, our mission as a company is advancing filtration for a cleaner world, being a diversified filtration company that is just part of the ethos of everything we do, our products and how we operate -- when we did our Investor Day in fiscal '23, we laid out some 2030 ESG ambitions. One was to reduce Scope 1 and Scope 2 greenhouse gas emissions by 42%, and we are well on our way to doing that. We also, from [indiscernible] an S point of view, with the social piece have goals of increasing the number of women in leadership positions, growing health and safety and then also charitable giving through -- just consolidated giving from a Donaldson Company point of view and through our foundation. And then I think we have various different product examples of how we try and enter into the market from a sustainable point of view. We have an alternative power program within our Mobile Solutions business, where we think about fuel cell technology in our Life Sciences business, we think about battery electric vending for those types of vehicles. And obviously, within cell and gene therapy and drug development, there's just filtration for a thriving in cleaner world, inherent in those products and services as well. So it is definitely a part of Donaldson and it's part of everything that we do.

I appreciate that. That's helpful. Maybe, Scott, maybe provide a little bit more color on your most recent acquisition. You took a 49% stake in Medica. Some additional color on how that fits into the broader life science business?

Yes. So we've known Medica for several years now, gotten to know -- the family who owns it very well. The leadership team very well. We've been collaborating with them on certain technologies. In fact, in December of last year, we signed a joint development agreement. So we became attracted to Medica because of some of their very strong technologies that they have. And the biggest one would be the hollow fiber membrane. So we have a materials research center that we've put up just to the north of the building I'm sitting in here that you might have seen. And that's been really working on our membrane technologies. And Medica is really good at some of these membrane technologies and especially how fiber membranes. They do -- they have some technologies for dialysis that are very impressive. And we've been working with them on some joint development agreements and have always been very impressed with them. So we recently acquired a 49% stake in that company. Their management team is very motivated and driven to continue to succeed and we're excited about them, and we want them to be very successful. And so we bought 49%. We have an option to purchase the remaining 51% in about 4 years based on a predetermined EBITDA calculation. So we wish them well. We currently hold a 49% stake and are very excited about. Some of the technologies that brings it to Donaldson, we think -- when we look at some of our strengths and we look at some of their strengths, we're pretty excited on what that can bring in the future for our Life Sciences segment.

Maybe building on that a little bit. In your slide deck, you mentioned that in the Life Science business, you have some revenue-generating companies, you got some pre-revenue-generating companies, I guess a 2-part question: One, your strategy going forward if you decide to add more companies to the Life Science business? It doesn't sound like you have a preference, whether it's revenue generation or pre-revenue; But secondly, is there the ability -- like I'm assuming you can in your other segments where you have technology sharing across the businesses that you put in the Life Science businesses?

Yes. So when we sat back and we did a bit of a redesign for the company probably 2 years ago now, whereby we wanted to really create this third segment, and we wanted to go public with it to give our investors information about it and really push the company further in this direction. And so what we did is we sat back and looked at what pieces of our business do we already have that we think could play. And one thing we came up with is we had a lot of membrane-based businesses, okay? And in these membranes and these technologies, some we just talked about with Medica are really important to the Life Sciences business. And so we took all the membrane-based activities, and we put them in life sciences. And we had a lot of organic things going on. We had ostomy bags that we sell filters into. We have disk drives that are membrane-based technologies. We have a lot of different venting application. As Sarika mentioned, the new battery electric vehicles have a lot of venting requirements for the batteries of the transmissions. We have a food and beverage business, which sells membrane-based filtration products into food and beverage. So we had a lot of different businesses that were already strong in those technologies. We took all of it out of industrial. They were sitting in industrial. We moved them over into Life Sciences to get Life Sciences at core. Now they're building on that through acquisition and through organic development. And I think it did two things. It really gave the Life Sciences business unit to start with, say $240 million of revenues. But I think it also helped our Industrial Business because you took some of these small pieces and you move them out. So they can kind of focus more on their true core industrial applications. And so to me, it was kind of a win-win. I think industrial has done better as a result, and you can see their strong performance. And we created this third seg with some really good technologies and that's kind of how we're sharing kind of happens here. Like I said, we'll still share a crush even the disk drive filtration will be used in advanced power for hydrogen fuel cells. So it's still all sorts of share.

No, that was great. Maybe shifting gears a little bit to the industrial product side. I think you mentioned that some of your technology is allowing you to connect the products together on a digital in nature. Maybe you could expand on that a little bit and how that is a value helper for the clients, customers.

Sure. So we've been working on this for the last several years. And at this point, if we have a dust collector that is connected and any sort of dust part you might think of in a factory organization, we really have a very strong ability to understand how that dust collector is operating and help the operator. With this knowledge, they could never have owning one or a handful of dust collectors versus a company that's been selling them for 60 years and has hundreds of thousands of them out in the field. So we've accumulated that knowledge over a long time. And now really, what we're doing is when we sell new dust collection equipment, it is sent out into the world with embedded technology. So you can think of it like when you get your car and it comes ready with OnStar, right? And it's already on, you get 3 months free. We're kind of doing a similar thing with our equipment, which is just to send it out with the module. So when it gets turned on, unless the customer says they don't want it, okay? It will automatically start feeding information back. So we give the option to the customer. But at this point, our customers are generally choosing to lead that in. And then we get a chance to work with the customer, and they get to see how that works. And what we find is the customers generally are pleased by it, and want the rest of their equipment connected. So it starts to kind of grow on itself, either our equipment or other people's equipment. And we think that's a really good strategy for the company because we end up with more revenue when we get connected solutions.

Okay. That makes sense. Maybe going back to your legacy, the Mobile Solutions business. I think as you reported in Q4, you talked about maybe some headwinds from the slow sales of new vehicles, which may impact your first-fit business. Could you remind what you communicated in regards to that level of activity and your expectations for this year in your guidance?

Yes, sure. So you can see our guidance as OnRoad down low double digits and Offroad up just low single digits. And so we see some headwinds on some of the first-fit production. But again, remember, we want to sell proprietary solutions. So every time another piece of equipment comes off a line, that's future sales for Donaldson. And the aftermarket service parts really drive that business because that's a significant portion of the total business. And if first-fit goes up or down, that's going to happen, right? The deers, the cats, the [indiscernible] goes, they're going to cycle as they go. But as we sell proprietary solutions, we're always planting new seeds. So maybe it's less than last year, but the total is still going up because the new seeds being planted. And so we try to work to forecast the first-fit piece of our business the best we can and give you that guidance. And you can probably correlate that guidance with some of the really big customers, the names of which you all know. And it's really the aftermarket that we're trying to drive.

Okay. That makes sense. Maybe kind of staying on the outlook for a moment. Certainly, the last couple of years, great performance on the op margin performance. And what are some of the drivers that continue top performance baked into the outlook?

Yes. I mean we -- like I said, we're blessed with the very strong company and we've been around quite a long. So there's many things that help us drive the operating margin up and give us confidence that we can do so. One is we've got to leverage the company, right? We can't grow our expenses as fast as regard our revenues. We don't need new subsidiaries and many things to grow revenues. So I can give you leverage, right? We want to invest in higher-than-average margin opportunities, one of which is life sciences, okay? And so as the higher-margin businesses grow faster, we can mix the company up. So we're really focused on only putting capital or any significant amount of capital in higher-than-average margin opportunities. And we feel like that gives us the opportunity to leverage the company up. And now that kind of COVID has died down and supply chain things are dying down, we can get back to our traditional routes of cost reduction. So we need to invest in cost reduction activities to make the company more efficient and reduce our cost structure to help our gross margin. In the fourth quarter, we announced some charges associated with our footprint and cost optimization program, and we need to kind of continue to push back to that. And so the world is slowly coming back to normal, still a few supply chain problems, but we feel like now is the time to really pivot back to our historical activities of cost reduction versus supply chain in COVID days and shortage that. And that will give us an opportunity to drive the operating margin up.

Okay, that's fantastic. Maybe just kind of wrap it up, I know you had a pretty extensive slide on your capital allocation strategy. But maybe just on the organic part of that because I think that was about 1/3 of what you were looking at. How do you think about spending internally as far as -- because cash is certainly not a constraint for you guys?

Yes. I mean we're -- I'm always very interested in capital deployment. It's kind of one of my favorite things to talk about. And our strategy one is invest in the company, right, either organically, inorganicall 2 pay dividends, 3 buyback shares, right? So the share buyback is what can be variable to help manage your debt levels. We want to invest monies where we can get a good return, and we have a lot of projects where we can kind of easily see the returns, and that's a strong driver for the company. We got to be smart about the total invested capital we have in the company, and we think about that a lot. And if you look over the last several years, it's gone up, but not that significantly because we're paying dividends and buy back shares. Almost equal to our profit. And so we want to invest money, but we think we can live with approximately 3% of sales, and that really funds the needs of the companies. And so when you generate a 20% return on invested capital, you just got to be smart about where you invest. But as we keep the real spinning with -- you're going to have small returns in the beginning, then they ramp over time, that's truly how the company operates, and we want to be smarter on our invested capital and continue to invest but do it smartly.

I appreciate it. I can talk to you guys all day, but our time here is up, but it's great to learn about a very fascinating story. So thank you again for participating and hopefully have the good rest of the day.

Thank you very much, everyone. I appreciate your interest.

Thank you.