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

Laurence Alexander with the Jefferies Chemicals team. It's my pleasure to introduce the team from Donaldson. We have Tod Carpenter, the CEO; Brad Pogalz; and Sarika from Investor Relations. Without any further ado, I want to pass it over to you. And just remember, go forward, don't go backwards.

Thanks, Laurence. With me today are Sarika Dhadwal. She is our Director of Investor Relations; Brad Pogalz, he is our Chief Financial Officer; and Rich Lewis, who will be here momentarily, is our Chief Operating Officer. So forward-looking statement, to please all the lawyers in the world, clearly is in our deck. I do want to remind everyone that we did report earnings here just last week. And so consequently, everything that I do say will be up to date. So that's really good news. Five points I want you to walk away from with is, Donaldson Company is a leader in filtration within all of the end markets that we serve. We have a history of solving complex customer problems therefore, best-in-class technology. We are helping our customers meet their environmental expectations through the solutions that we do provide. We have a clear strategic and balanced growth strategy for the company, and we continue our progression toward our Life Sciences market segment. So here we are. We were founded in 1915. So we are a 110-year-old company, about 14,000 employees. In the lower left, you will see two operating models, if you will. First-Fit is about 32% of the company revenue. And aftermarket is 68%. So you think about our particular model across our entire business is proprietary razors to sell razor blades. You can see in our 3 segments, Mobile Solutions about 60%, 30% in Industrial and 8% to 10% within our Life Sciences based business. Updating the revenue and the adjusted EPS numbers shown below as of our fiscal '25 ending, which did end on July 31. Our new fiscal year started August 1. You can see almost $3.7 billion is our revenue and $3.68. You can see the growth through the last 4 years. Every number within our revenue and EPS is a record for Donaldson Company. We continue to grow well through the cycle. Important on the patent line, I told you we are proprietary razors to sell razor blades. We now have over 3,000 active patents between our Investor Day in April of 2019 at our Investor Day in April of 2023. Donaldson was granted a patent, on average, somewhere in the world, every day. We're serious about being the technology leader. We continue to invest in R&D and press our strategy forward. We are 44 -- or 45% U.S. and Canada, roughly 30% in Europe, Middle East, Africa, 10% Latin America and 15% to 20% in Asia Pacific. Very importantly, in this time of tariffs, it's important to note that 75% of everything that Donaldson manufactures is manufactured within the region that it is consumed, which gives us that natural protection, if you will, against so much of the tariff conversation of today. Here is our guide, as of last week. Sales, we look to be a $3.8 billion company. You can see the growth rate there on our adjusted operating margin, it would be a record at 16.4%. We're very proud of the fact that over 4 years will come from roughly 14.5% to 16.5%. we always look to expand our operating margin on growing sales. That's just a belief of ours, core belief. We have done that quite nicely, as you see here on the chart, over the last 4 years. Our adjusted EPS centers on $4, up from $3.68. So the incremental margin within that plan is roughly 40%, really strong incremental margin for what we have just guided to the external world. We are a filtration leader. Here are our competitive advantages. So clearly, a long history in filtration leadership. We've been doing this 110 years. We continue to broaden the company, expand it with into new end markets, all on the strong technology foundation. We're the leader in advanced filtration because of that technology, innovation that we have and that we continue to invest in. We have a high aftermarket retention rate. As I said earlier on the slide, 68% of our revenue is now aftermarket parts. And so you can really emphasize that razor to sell razor blade model. We have deep customer relationships and our strategies, particularly within the Industrial segment really, I'll speak to that in a little bit, drive us to get even deeper with the customers and more intimate with them, diversified businesses of global sales which even though we have a number of our end markets that have headwinds today, construction, mining, agriculture, First-Fit, over-the-road trucks, all of those particular end markets have headwinds. The strength of our diversified portfolio still saw our company grow last year in spite of that. And then we have best-in-class operations. We're very, very proud of the year that our operations team just turned in. We are back to customer delivery rates, even stronger than pre-pandemic. So think of 95% on-time delivery to customer request date when they wanted to -- when they want the product. That's what our company is performing to, across a broad base of portfolios. For example, in our mobile solutions aftermarket, if you order the part before noon, we'll ship it to you same day. We've been doing that for decades. That is not new at Donaldson Company, and we are back to that type of turnaround and taking care of our customers today. So these are our strong advantages that we have within our model and that we're very proud of. We have 3 reporting segments: Mobile Solutions, Industrial Solutions and Life Sciences. Within our Mobile Solutions segment, we have been growing in our aftermarket-based products. We have proprietary technology on air and liquid, which really drives our aftermarket growth. We are heavily involved with all the OE-based, with alternative fuel-based applications. We continue to win on those type of situations around the globe. We have won things from fuel cells to hydrogen-based combustion engines, et cetera. And so we have really good growth opportunities within Mobile Solutions. Within Industrial Solutions, we are connecting our products on the largest piece of industrial. So if you think about that, we sell a proprietary First-Fit system, then we sell our aftermarket products, but we connect that first base system. So when you get a new dust collector for Donaldson Company, when you plug it in, it will have a bunch of sensors on it. The maintenance people really don't know a tremendous amount on how to make that dust collector work. They just want to make whatever product their factory produces. And they don't want it to go down. So things such as we have a thing called the hopper, really think of it as a garbage pail, you're collecting all of this particulate. Our people will send them an alert to the maintenance person's telephone to say, "Hey, go take out the garbage or it's going to ingest into their system, shut down their manufacturing process and then they'll be shut down from actually making money for 3 to 4 hours while I clean that out and reset it." Instead, we'll give them an alert. And it's a highly technical way to do that. That is actually patented now. And that they love that. When we do connect our industrial-based products, it's been proven that we sell as many as 3x to 4x more aftermarket replacement parts, getting that deeper and more intimate customer relationship and it's proven out tremendously successful. We'll look to expand the connectivity of our Industrial Solutions by roughly 30% within this fiscal year. In our Life Sciences-based businesses, it has elongated a bit more than we would have liked to when we went into this particular segment because the overall end market really found a lot of headwind and pressure within the last 2 to 3 years. So it's expanded a little bit more than we wanted to. But we do still very much like the market. We have differentiated products that we're bringing out. We have a little bit more development to go in that particular segment, but a lot of growth opportunities within that. We'll look to grow that mid-single digits this year and continue to expand that here in years to come. Use of cash, it's important that -- this slide hasn't changed in decades. It's organic investment, so invest back into the company to help the company grow. It's buy companies, do M&As. Those are the first two priorities of cash. The next one is paid dividends. We are a very proud member of the Dividend Aristocrats fund. We have increased our dividend now for 30 years. Last year, we increased it by 11%. So we're a proud member of that. Dividends are very important to us. And then share repurchases is our fourth priority. You can see the usages of cash over the last 3 years where we invested $1.6 billion across the particular cycle. Our net debt-to-EBITDA ratio stands today at about 0.7. We like to run the company at about 1. We have a very strong balance sheet, giving us a lot of strategic opportunities for ourselves. Our free cash flow is roughly about 85%. We like to run the company. That's what we guided to yet again this year. And we have more than $700 million available to us in order to really do strategic acquisitions. That gives us flexibility and agility to be an acquirer of choice based upon the strength of our balance sheet and so you can see within that second priority, which is to do M&A within our company portfolio, we look to execute that just simply because of the strength of the corporation. So again, just closing before I open it for questions, we are the leader in filtration in all of the markets that we serve. We do have best-in-class technology. I can get very geeky with you and talk about the cool things that we have in laboratories, but I'll save you that for another day. We do help our customers achieve their sustainability and environmental-based targets. And we have a very clear and strategic balanced growth plan again, with our capital priorities of invest back into the company organically, do M&As. Those are our two primary growth levers. And then we are continuing our progress and still really like the life sciences market. With that, that is a very quick summary of our company. And we can open the floor for questions.

So I guess maybe just to start, if you think about the end markets that have been more challenging, so ag, heavy-duty truck, pharma, life sciences, where are you seeing shifts in behavior that may imply a change in trend? Where are you seeing kind of optimism even if it's not yet shifts in behavior?

So if you look at the U.S., which is our biggest reason, it also happens to be the most mixed region for us. You'll see our First-Fit vehicles, so construction, mining, ag, on-road, all down within that particular region; a little bit more life in the ag market within the last quarter. If you switch over into -- well, first, staying in the U.S., the industrial segment is -- so CapEx-based projects is still very good. We are still receiving quite a few quotes there. So industrial, we're very comfortable with the progress that we have there. Switching over to Europe. Europe is actually the most stable region that we have. We see pretty broad-based aftermarket growth. The First-Fit cycles are starting to show a little bit more life more broadly than the U.S. If you go to Latin America, it is easily the most troubled market. It's pulled back everywhere in aftermarket as well as within the First-Fit vehicles. It doesn't really matter. The country, they're all very careful. It is the smallest part of Donaldson Company at roughly 10% of our revenue. And then Asia-Pacific, we have seen a little bit of life in China. That really drives the Asia-Pacific region on the First-Fit side. We saw some bump within the off-road sector and the on-road sector in China within the quarter. Does that really mean that we can call it and say, hey, China is starting to come back, we're going to be a little bit more careful about that. It's a little bit tough to say directionally where China really heads. It's more of a point than anything that you can discern and start to draw lines to, but we are pretty happy with the fact that it feels like we've troughed there. And the aftermarket continues to go quite well. So really, you step back from all that, it's a fairly complex story, but it shows the power of the portfolio of Donaldson Company with that much mix. And yet Donaldson Company grew mid-single digits within the quarter. And so that's what we talk about by diversifying the corporation, we stand ready. When construction, mining and agriculture do come back globally, those markets do not come back by, say, 5% mid-single digits. If you go back to history, the last time that we were in this type of a position, those markets come back by double digits, and it's not 10%. It's more like 15% to 25% on an annual basis. When they come back, they come roaring back. We stand poised to take advantage of that when we do see that occur. We do expect that to occur here looking forward. But even with that as the obvious headwind for our company, we continue to grow. And then this year, we guided additional growth of the company to $3.8 billion and a record EPS at $4.

And so one area that's been doing well is aerospace and defense. Can you dissect a little bit kind of how you're thinking about the growth over, say, the next 5, 7 years? How much of that is long-cycle projects where you're in qualification of new applications that will be launched? And how much of it is response to kind of shorter choppiness geopolitical needs?

So aerospace and defense specifically. So aerospace and defense is kind of an interesting story right now. You have to overlay the choppiness within that a little less from the external market-based, say, components or influences more to the supply chain portion of things. While we have gotten ourselves into a fantastic position within the supply chain and the rest of the company. With A&D, it's different because we don't get to control that. We get told where we have to buy some particular components. And to get a second qualification of a particular part is not allowed. And so we have to grind it out a little bit. That makes us very lumpy. You see that within the results of last fiscal year, quarter-by-quarter, it will continue that way. There are a handful of parts, we call them the golden screw now that when we get that, we could actually ship. So it's more of that than the external influence as the end mark of A&D and what will continue to cause us to be more lumpy. We also have some programs, some multi-decade programs now coming to end of life. So we'll have a little bit of pressure from that in this coming year, but we also have new programs coming on. So you go net-net within all of those dynamics. Aerospace and defense is a little bit more difficult because of the supply chain to really forecast going forward. But we do put it as more of a flat-based outlook year-over-year.

Can you talk a little bit about the levers you've pulled to improve Donaldson since 2023? And what do you have left to do, say, through 2030? That is, on the internal side that changes kind of the visible? Like think about it kind of the way you've outgrown the end markets. A lot of that was internal initiatives. Can you flesh out kind of what's left on the checklist?

Boy, that's a whole basket of items. There's not really one big lever that we pulled in order to expand our operating margin the way we have. It's a host of things. It's, for example, footprint optimization that we talked about on the call, where we currently are shutting down two manufacturing plants, the one in aerospace and defense business, one in our industrial base business, one in California, one in England. We have a couple of more footprint optimization programs -- projects, I mean. Looking forward, that will help us gain some more efficiency. So it's that. It's also post the redesign of the organization, now putting it into verticals. We used to be four regional based type of companies. So Europe, the Middle East, Africa, United States, Latin America and Asia Pacific. We're all like four Donaldson companies. Now we went to verticals. And so 3 years on from that type of an organization structure, for the first time in our 110-year history, we are now gaining more efficiency out of that. And really, you see that within our operating expense control year-over-year where we just are now leveraging more appropriately those type of business processes for efficiency and speed. So you'll see a little bit more tightening of the belt there. That's really more by design and tweaks to the organizational structure. You'll see more of that. We have more opportunity going forward. It's also within the supply chain disruptions that we all experienced. We went to our First-Fit customers and it was time to reset the relationships, and we wanted a more fair and balanced relationship with our customers, and we were able to achieve better pricing. We no longer have price downs to start the year out within our annual contracts. Those are all gone. So instead of starting every year negative from a pricing standpoint of view, we have tailwinds on that on an annual basis. It's just a whole host of many different things that our 14,000 employees have really worked incredibly hard at, to really drive that leveraging across the organization, and what gives us confidence to stand up here today and say, we really are committed to increasing our operating margin over greater sales.

And I just want to unpack one of the comments there about the changing away from the annual price downs. In other industries, when we've seen companies shift that way, then when the customers run into trouble and the company, who is being more disciplined on price, sticks to the new methodology. You then sort of get a lot of feedback of how the customers are disappointed out for revenge, kind of feel hurt. There's a range of emotional reactions. This seems like a significant shift for Donaldson. Can you give us some sense of what you gave the customers in exchange to sort of get that transition to stick?

Sure. So what did we give them in exchange? Technology and reliance. They can count on us to deliver, they can count on our technology to perform exactly to the difficult application challenge that they give us. Our technology answers that call. They have great comfort when they do business with Donaldson Company knowing that their application is going to be met, and we are there everywhere in the world for them. Remembering that we're in roughly 140 countries. We have between 60 and 70 manufacturing plants. We are global with a local touch. And so when the customer wants to move product around the world, we're able to do that quickly for them and manufacture it. That 75% within region where the customer consumes it is really a strong advantage for the Donaldson Company. And so that's what we give the customer. Did we experience some of those things that you talked about, Laurence? Sure, we did? Do we lose some business along the way? Of course, we do. We'll lose a project here or there, but that's not new. That's always been going on. I know you will always have you lose a project because they're not going to get 100% of their business. And so we would tell you that the environment really has not changed. We're not out to maximize with our First-Fit partners our operating margin, that's not our goal. We're just trying to optimize it. We're trying to have very fair and balanced relationships with our OEs. And I would tell you, for the first time in decades, we believe that we have done the work. We're treating them fair and that's where we sit today.