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

Okay. We'll go ahead and get started. Thank you all for coming to the Donaldson presentation. I'm Brian Drab, the industrial technology analyst at William Blair. I've covered Donaldson for 17 years now. So today, we're happy to have with us CEO, Tod Carpenter; CFO, Brad Pogalz. It's not Pogalis, Pogalz. Okay.

Pogalz.

See every detail, and I blew one of them. And Sarika Dhadwal, who is the Senior Director, Investor Relations and ESG. So thank you all for coming to the presentation. Donaldson, as many of you in the audience will know, is a world leader in filtration, specifically in engine markets, heavy-duty engine, on-road and off-road, also many different industrial applications. And most recently, the company, over the last few years, has been expanding their presence in the medical, bioprocessing markets, and we'll get an update there. Of course, that's a very challenging end market right now. Everyone who has exposure to life sciences has been having some challenges. So maybe we'll have some questions on that. I know it came up on the earnings call. But at this point, I'll turn it over to Tod. Thank you very much for being with us today.

Thanks, Brian, and thanks to all of you for being here. We want to start, of course, with our forward-looking safe harbor to satisfy all the lawyers across the world, I suppose. But we are in an enviable position right now, having reported earnings on Tuesday, typically. We have to always reach back a number of months, but all the information then we'll talk about today is very fresh. So that will be a very nice timing. Five key points that I want you to take away from this presentation and about our company. So our strategy is to be a technology led filtration company. We are a leader in filtration around the world for all the markets that we serve. Second, we have best-in-class technology where we solve very complex customer problems, which gives us deeper relations to the customers. And that kind of relationship is very important in our company model. Third, those customers are global in nature, and we are everywhere that the customer wants us to be, particularly important in this time of tariffs, and we'll talk a little bit more in the presentation about that, that we have a clear strategic growth strategy. It's very balanced organically as well as M&A. We'll talk about that. And then [ fifth ], we are progressing toward life sciences type of business where our products that we are inventing organically to go into there as well as the M&A, the acquisitions that we have done our differentiated products. They are also disruptive products that we bring into those spaces. So specifically, Donaldson is a 110-year-old technology-led filtration company. You see our revenue breakout in the lower left. We have 3 reporting segments: Mobile Solutions is 62%. Industrial is 30%, the balance is Life Sciences. Very importantly, we sell proprietary razors to sell razor blades. We do it through our filtration businesses. We do it in every business that we have. And therefore, roughly 68% of our revenue is razor blades. The balance being first-fit or in our Industrial based businesses, we would say that would be first-fit equipment using our proprietary filtration technologies. Our overall results, you see each of the last 4 years there, we continue to grow. Everything you see with regards to revenue and adjusted earnings per share are all records for each of the prior 4 years. When I say we are a technology-led filtration company, you say that we have over 3,000 active patents between our Investors Day in April of 2019 and our Investor Day of April of 2023. That means somewhere in the world, on average, Donaldson was granted a patent every day. We're serious about our strategy. We continue to invent cool things. I often say, I should be wearing a black turtleneck, but that gig has been taken. We really have some cool technologies within our company. Very important in this time of tariffs. Our particular model has 44% of our revenue in U.S. and Canada, 28% Europe, 10% or so -- 10% or 11% in Latin America and 17% in Asia. Important is that 75% of all of our revenue is built within the region that it is consumed. That gives us a really good advantage within a natural hedge of the tariff activities going on and obviously, the constant movement of that. We are able to shift quite nicely. The U.S. is a net exporter for Donaldson Company. We have roughly 150 locations around the world. We have about 65 manufacturing plants. They're in every region of the world. And so that allows us from a supply chain standpoint of view as the economics make sense to shift from 1 region to the other to build it if we are not completely in that region. And so we have a nice way of moving that 25% around. It's the reason why on Tuesday, we said that with the current tariff situation, what's implemented the headwinds that we have in the company are about $35 million roughly, and we have ways to offset all of that either through supply chain, pricing, we'll use surcharges, et cetera. So relative to tariffs, our story is pretty straightforward. We feel pretty comfortable that we can offset it all. The one thing we do want to mention with that is we're looking to offset the dollars, that doesn't mean we get profit on tariffs. So there will be slight gross margin pressure as a result of that, obviously, because you're not able to roll that all the way through. We are with tariffs looking to have very fair relationships with our customer base. It's working out quite well so far that as a company, we're able to flex quite well so far with everything that's taking place. Along the bottom, you see our end markets, how we really are comprised within our business units and the split within each of those business units are first-fit or, say, proprietary first-fit and then the lighter blue is the replacement parts. Here, you see our financials and giving -- including the guidance that we have out for this fiscal year. This fiscal year expects to turn with 1 quarter remaining, so we are through 3 quarters of our fiscal year just reported on Tuesday of this week, which means 1 quarter left. We fully expect to have record revenues and record earnings this fiscal year yet again. You see all of that. Our adjusted operating margin is -- for this year, is 15.8%. We have given guidance for fiscal '26, which would be next year, early guidance that our midpoint is to get to 16.2%. We continue to expand our operating margin as you see here over a number of years. We will come out with guidance at -- when we give the full year report here in about 90 days. Again, we are the filtration leader with many durable competitive advantages. We have a long history of filtration technology leadership, as I talked about. We do have the deep customer relationships. You see the balance, but I do want to emphasize that we have best-in-class operations. We are everywhere that the customer wants us to be. So that's -- we get close to them when we have the volumes necessary. We expand our manufacturing footprint or do what's necessary to get that customer taken care of, and we're very, very proud of how we go to market that way. And that allows us, one of the many reasons, technology as well as deep customer relationships to have a high aftermarket retention that you saw at 68% on that first slide. We have 3 reporting segments: Mobile Solutions, Industrial Solutions and Life Sciences. The Mobile Solutions is medium and heavy-duty diesel engines, construction, mining, agriculture, long-haul trucks. That we have been the traditional -- that's how our company started. We've been the traditional leader in that particular space. We remain the leader. We are working on alternative fuel solutions with customers. Recently, we announced that we have won the fuel cell program at Daimler, for example, where we'll help them do all the filtration. Now it's interesting to understand on the alternative fuels, if you're moving away from diesel fuel oil, and let's say you're going to go to hydrogen, there's 2 ways. You can do it in a fuel cell, you can do it as the combustion engine portion. Either way, you still need air filtration. And the fuel itself actually has to take particulate and water out of it, which is exactly what you do for diesel fuel, and we are best-in-class to be able to do that. However, there's also a third need particularly in fuel cells, and that is you have to take out some of the other concentrates such as sulfur dioxide or mercury because you need more of a pristine type of a fuel, especially on fuel cells. We are excellent at that. We've been doing chemical absorption within other business units within Donaldson for decades. So we can tailor make that for the particular customer, and that's the reason why we've been winning in the alternative fuels relative to hydrogen. It's very important to really understand that not all fuel cells are exactly the same. One customer fuel cell may have to have sulfur dioxide, but the others may take -- may be more susceptible to a different type of a contaminant, and so we'll be able to absorb that out for them. So it's -- it's very broad range type of spectrum. Good growth opportunities within the Mobile Solutions opportunity segment. We're growing very well in our aftermarket business as we reported this week, we are low single-digit growth even in an environment where a lot of our first-fit vehicle end markets are -- have headwinds. They're a bit troubled at this point. We continue to grow in the Mobile Solutions space. In Industrial, we have a number of different applications within that space. What we are doing, if you have a process where it's an industrial dust, a mist or a particulate of some sort, we will filter that out for you to either make your environment better, have the machine protected, anything that you need. And additionally, we have a power generation business inside there. So think of base and peak load power stations, oil and gas type of power stations all around the world. We filter out the ambient air, make that proper. So the gas turbine can actually do its job and create power in the national grids around the world all the way to industrial hydraulics and a number of other diverse businesses in that particular segment of industrial. It is growing nicely. It also has a good operating margin of 18. Our strategy within that segment to grow it is to digitize it. So much like you have seen in a car with OnStar, we now have when we send your dust collector out, we now have it when you turn it -- plug it in, it will actually tell how it's operating back to Donaldson Company, and we can call the maintenance person and say, "hey, go do this to your dust collector, so you don't shut down your production." It's really giving us, again, deeper relationships with the customer. You're seeing our aftermarket business grow there. I would tell you, as much as 7 or 8 years ago, our aftermarket in that business used to be about 30%. Our first-fit was 70. We've gotten good momentum with this strategy. Now it's about 50-50. So you can see our aftermarket business is really going quite well within there, and we expect good things going forward to help us drive growth within that segment. Within Life Sciences. Life Sciences, we entered that segment as a new segment that's small for our company, $250-or-so million. We like the space because of the difficult challenges of filtration that the space actually allows us to help solve for our customers. We are not going in on a me-too type of a basis. We did do acquisitions. We did pre revenue-based acquisitions. We also have some really cool inventions in our laboratories. Each of those will be rolling out over time in order to grow it. As we entered that space, that particular market did start to create some new headwinds, particularly on the bioprocessing side, you see that within those end markets. It's going to take us a little bit more time than we had hoped for sure, to be able to grow into that particular space. But make no mistake. We really like the space. We like what we're bringing forward. We really have some differentiated products, and we'll be talking more about that here in the months and quarters to come. Here are the acquisitions that we have done. Our addressable market in Life Sciences large $21 billion, traditional Mobile Solutions segment, we are roughly about $2.2 billion to $2.3 billion currently in revenue of the $14 billion in that segment. Again, that segment likely could grow if hydrogen goes to be the winner in that space, and that looks to be more the direction that, that particular market is heading. Within Industrial Solutions, it's $15 billion, we're about $1.2 billion to $1.3 billion within that space. You see the 5 acquisitions that we have done across the Life Sciences space. Our most recent one, Medica out of Italy, where we now own 49%, brings a brand new technology to our company. It's called hollow fiber membranes. If you think about your hair, your hair is about 10 to 15 microns in diameter. What this does is give you almost like an extruded straw, if you will, kind of oversimplifying this. And it's important to understand the wall structure, the pores of that wall structure. Your hair again, is 10 microns will be 0.2 microns in order to be able to get into the bioprocessing spaces and help with the drug applications. That's why we bought it. It's another really cool technology add to Donaldson Company, and we're really excited about the future that, that can help us bring for our company. As far as balanced capital allocation, our first priority is to invest back into the company organically and through acquisition. Third is dividend. We raised our dividend this week -- or sorry, last Friday by 11%. It is the 30th year in a row we have raised our dividend. We are a proud member of the Dividend Aristocrats fund. That means you have to have raise your dividend 20 years or more in a row. As I said, we are at 30 years. Dividend is very important to us and for our shareholders. We continue to prioritize that. And then the fourth one is share buyback. You can see our -- how we've used capital over the last 3 years for share buyback. Important to note that in this quarter, we did -- we ended the quarter at 0.9%. Roughly 1% of shares bought back. Our guidance was midpoint, 2.5% on the buyback. As we stand here today, based upon what was going on in the last quarter, we saw opportunity. We took it. We are now at 3.3% bought back. So we were above the guide. It just made sense for us to do that. Yes, that means I feel like the company was undervalued and so we did it. And looking forward, we gave a guide of between 3.5% to 4% as far as share buyback. But again, we'll invest back in the company organically. We'll buy companies through M&A, dividends and then share repurchases. Those are capital allocations. And over the last 3 years, we gave -- we allocated $1.4 billion in that fashion. When you look at our balance sheet and you look at the model, what it brings roughly, our debt ratio, we like to operate at about 1. Today, we sit at about -- in the neighborhood of about 0.8. So we're in a strong position there. Free cash flow of roughly about 85%. That's right about our guide today. And we have available to us $800 million worth of capital, which means that we can be an acquirer of choice. So on that acquisition piece, we still do look for targets that we continue to work across our strategic pipeline and feel very good about. So again, going back to the 5 points. We are a leader in filtration. We are best-in-class in technology. We've got a lot of really, really cool things. We do help our customers solve very, very complex problems for themselves. And we have a good strategic and clear balanced growth plan and we are progressing into the Life Sciences segment, a little slower than we would want due to the end market moves, but we still love the space and what it can bring to our company. So with that, I will open it up for questions.

Yes. Thanks very much, Tod. And it's great to have you here, Brad and Sarika, of course. But Brad, I'm looking at some of my notes from Donaldson from 10 years ago and conversations that we had. I don't know if you, Brad, just want to -- I know that the investment community at large is familiar with you and you joined -- took the CFO role on recently, but some of my clients might not know your background. Do you mind just saying a couple of things in the opportunity from your perspective as well?

Yes. I joined Donaldson 10 years ago. I started as Head of IR and the role Sarika has today. I was in that job for about 5 years. I moved during COVID to Belgium to head up and be the CFO of our EMEA finance region. And so I was there for the last 5 years. During that time, I also took on Global Head of FPA for the company. And then in the last -- I was named CFO and took over First of November and now here since. So opportunity, I do want to take a moment on that. The thing that impressed me about Donaldson when I joined and continues to be part of our conversation is what Tod said about technology-led filtration. So I think when I came on, it was a retail background, and I really didn't realize where all the filters were in the world, and I thought about my furnace in my car. We don't sell on any of those things. It's low tech. We make different choices at the company. And I think what gives me a lot of optimism and part of where I'm happy to be in this chair and grow more with Donaldson is as the world gets more complicated, regardless of what happens with AI or robots and manufacturing, these things still get manufactured or equipment is still moving around. So with complicated problems in the world, there's more need for filtration, not less. And I really do think that creates an exciting opportunity for us as a company.

Even robots need filters, It's a beautiful thing.

Do you want to elaborate on that, Tod? Even robots need filters, you said.

They have to have vent filters because they actually breathe relative to how it operates. So there's a lot of venting applications across a lot of the machinery that you see, particularly like EVs, for example, headlamps, a lot of different applications, and we do that extremely well.

In a conversation that you and I had this year, you were talking about margin expansion potential in longer-term margin potential. And you said some -- I don't want to put -- I'm not going to say a number, but can you talk about what you see as the long-term margin potential? Where can operating margin go for Donaldson over the long term and why?

Yes. So we're currently coming out this year at 15.8. I think 5 or 6 years ago, we'd have been down at 12, high 12s, maybe something like that. Our Investor Day, we set a target at 16. Clearly, next year, we'll be above 16. We have programs in place to continue to expand our operating margin, 17 is clearly in sight. We have a path to be able to get to 17. And then you say, well, okay, well, how about 18, it's a sure and so we do believe we'll continue to expand our operating margin. It will take time. We're not going to just go cut the middle out so hard that we get the operating margin and hurt the company. That's not the way we do business. We do take our customer relationships very, very seriously, but there's obvious efficiencies that we can gain. For example, we're currently shutting down 2 manufacturing plants, 1 in England, 1 in California. There are other opportunities to really help optimize our footprint. There are other efficiency plays that we have. Important to understand that our company is now 97% of our revenue goes through one business system. So we've gone through all of that metamorphosis. The only thing that really isn't done right now is Brazil. It will go live later this calendar year, maybe January or so. That means we'll be 100% on the business system. That allows you to take this distributed model of certain business processes and centralize them, wherever in the world you want to centralize them in order to become more efficient and control processes and drive cost reduction as well as now pricing-based models that we have coming out of the supply chain situation. We have really done a good job at resetting all the pricing activities in the company. And now we have a much fairer relationship with our customer base, and that's how we talk to them and really embrace that challenge collectively. We are not trying to maximize our overall pricing with the customers, we're just trying to optimize it because remember, every razor blade we sell, we get the razor -- every razor we sell, we get the razor blade. And so that's an important type of significance to that. So we're trying to optimize the overall gross margins and the pricing with fair relationships with customers. But we use all of these macro-based opportunities and you roll it all up, and we clearly have room to expand our operating margin, and we will.

And on that pricing note, one thing that has happened at the company, and you correct me if I'm wrong, but for the 2008 to 2020 period as I was following the company, it seemed that every year, for most of your business lines, especially on the engine side, it's kind of prices down 1 point. How do we become more efficient in the operation to get that back. But that's different today, right? And this is one of the things that, from my perspective, gives you that potential to...?

Yes. When -- we're a 110-year-old company, and so we got our beginning in many of the large OEs in construction and agriculture and mining and those relationships had gone a little bit more to the favor on the OE, whereby we would start every year with the price down. So we would start negative 1 or negative 2 in business segments and have to make that up with cost reduction on an annual basis. In the supply chain disruptions, that was just not tenable for anybody, for them, for us. And so consequently, we were able to get rid of all those clauses, make all those contracts reset and really now have a much more fair relationship. And in fact, we get price increases on a number of those particular relationships on an annual basis. Now as appropriate based upon inflation and all the rest. So it was a massive undertaking for the company. The company now has, I think, a lot more confidence in our relationships with our customers that they're more fair and proper and really set for a long-term opportunity.

Yes, I just think that's a huge structural change in the business that really is important going forward. If there are any questions from the audience, please raise your hand. Otherwise, I'll ask a couple more. We have 4 minutes here. One of the other things that you talked about earlier this year in a conversation with me was the potential for some of these end markets that are under pressure right now to bounce back, like we've seen in the past when the engine market comes back, it's not up 5%, right? What do you see for these businesses over the next few years?

Well, it's actually simple straightforward. I'll just go back to this 1 slide here, okay -- clear. Okay. That's what we've done in the last 4 years in spite of the fact that our major end markets have headwinds. Construction, agriculture is legendary. You hear it from John Deere. All of those people are our customers. It continues to walk down. over-the-road trucking, just walk down again in the last 90 days. They thought it was going to be between, say, 250,000 and 300,000 trucks. Now they're more down to between 200,000 and 250,000 trucks from a year or 2 years ago, roughly 330,000 trucks. That's a significant market for us. That's down. Every one of those OE markets, those first-fit vehicles and the equipment build right now are down. And yet our company is performing like this. So my point to Brian is when those markets bounce, they don't bounce low single digits, they bounce double digits and sometimes over 20. So that's what gives me confidence that we'll leverage even more to the operating margin when we get the volumes back on the first-fit side of our company. Our gross margin will come down a little bit because of mix, but the overall operating margin will go up because we'll leverage that through the organization. It gives me confidence that we can expand our operating margin and that our company is an excellent, excellent shape to take advantage of that next economic upturn around the world.

And one of the reasons that those results have been so resilient is that you have such a strong aftermarket revenue stream, right? We've talked about this over the years. There's sometimes an impression that on-road truck is going to be -- is weak, so that -- it's 3% of your revenue, though right? You have 60% plus of your sales in the aftermarket, which also are somewhat higher margin products as well, too.

So the other important piece about our company and a lot of people will tag a particular end market and say, wow, that one's down. So your company is going to have a little bit of trouble. The diversity of our -- of the businesses, the portfolio of businesses that we have in our company give us some natural hedges on some of that activity. If you take a look, our company is growing and yet we have multiple end markets facing headwinds, right? Why? Because we have other ones that don't have those headwinds and they're doing really well, power generation being one that's helping offset some of those kind of activities. So the diversity of portfolio really helps us go forward and gives us confidence that look, our company is going to be less cyclical. We work very, very hard to make our company less and less cyclical coming off of 110 years, and that's work that will never end for us. But we're doing okay from that perspective, I would say. I'm a little biased.

Great. Well, we're just about out of time, so I think we'll wrap up. Thanks very much, Tod, brad, Sarika. Thanks for coming here.

Thank you.

Thank you, everyone.

Thanks, everyone.