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

All right. If everyone could please get situated. We are -- We have the great pleasure of having Donaldson with us again; ticker DCI; Minneapolis-based global manufacturer of filtration systems and replacement parts and have some exciting technologies in the Life Sciences business. Tod Carpenter, company's Chairman, President and CEO, is here, as is Rich Lewis, the company's COO. Hi, there. The company is about 115 million shares, trades around -- it's about a $10 billion equity cap business, about $10.4 billion total enterprise value. I had the pleasure of having Donaldson here as long as I can remember, whereas in shareholder returns will tell you that you'd probably pay attention. Tod is going to come up with a few slides, and then we'll get into some Q&A. So Tod. Thank you very much.

Thanks, Brian. Appreciate it. So safe harbor announcement here to please all the lawyers. You've all read it before, won't spend time. But the important thing here is that we actually completed our first quarter 3 days ago. So any remarks that I do make will actually be at the -- looking back to the close of our fiscal year, reminding you that our fiscal year is August 1 to July 31. So we're reporting -- we'll be reporting our first quarter at the end of this month. So 5 takeaways that I'd like to have. You really remember about our corporation strategy is simply defined as choices. Our first choice is to be a technology leader in filtration. Second choice is to be everywhere the customers want us to be, therefore, we are a global company and the third choice is to have deep customer relationships because we are technology-driven, that allows us to have best-in-class technology and 3 years ago, we redesigned a company from a regional-based company to more of a vertically based business oriented company that has allowed us to make faster decisions and be more agile. Our solutions help our customers meet their sustainability targets. We have clear strategic and balanced growth strategies across every one of our businesses. Then about 3 years ago, we actually entered into the Life Sciences segment, which we'll talk further in the presentation. This is a very important slide, probably the best slide in the pitch, if you want to understand one thing about our company. We are a 110-year-old filtration company. We are roughly at around $10 billion market capital at close market today. We have over 3,000 active patents. We said we are a technology-led filtration company. What that really means is between Investors Day of April 2019 and Investor Day of April 2023, on average, somewhere in the world Donaldson Company was granted a patent every day. So we really look to be differentiated through technology. Our model is -- proprietary filtration to sell razor blades. So razors to sell razor blades. You see that in the lower left where 68% of our products, our replacement parts, 32% are that first-fit or CapEx-based parts. If you look in the lower right, you can see coming out of COVID, and you look at our revenue, we have been putting up record after record after record after record, 4 years in a row and running, both in EPS as well as revenue, and we look to continue our growth this fiscal year, I'll show you that in a couple of slides. [ 44 ]% U.S. and Canada, 30% in Europe, 10% Latin America and 17% in APAC. It's important on the lower bars, the lighter blue is the aftermarket piece. The darker blue is that first-fit piece within each of those business segments. We are represented physically in about 80% of the countries in the world that our customers want us to be. And the second checkmark there on the right is very important in this world of tariffs. 75% of everything that we manufacture is manufactured in the region that it is consumed. That allows us great flexibility where our customers want us to manufacture. And also on our $3.7 billion worth of revenue last year, our tariff exposure was $35 million. You could see that strategy of being where the customer wants us to be and manufacturing within region has really served Donaldson Company well, allows us to be agile and flexible for the customers in this time of uncertainty. I told you about the records we put up last year. Here is our guidance that we just put out. It is yet another record. We will be $3.8 billion. We will also put up record operating margin at 16.4% at midpoint or expanding roughly 180 basis points of operating margin over a 3-year period and our EPS will also be a record at $4. Important, last year, we did raise our dividend by 11%. We are a proud member of the Dividend Aristocrats fund, meaning we have increased our dividend for at least 20 years in a row for Donaldson Company -- it's actually 30. I told you we're a filtration leader. When you look at our competitive advantages, we have a long history of solving complex customer problems. We do have deep customer relationships. We are an industry leader in all the markets that we do serve. Again, high aftermarket retention due to that razor to sell razor blade model, and we have best-in-class operations. We have now coming out of COVID and then the subsequent supply chain issues that everyone in the world suffered through. We have now taken our late positions to all of our customers even lower than it was pre-pandemic. So our supply chain issues are certainly behind us as a company. And when we talk about best-in-class operations, that's what we mean. We have 3 reporting segments: Mobile Solutions, Industrial Solutions and Life Sciences. All 3 have opportunities for growth. Within Mobile Solutions, think of all the alternative fuel opportunities as well as many aftermarket opportunities within diesel-based applications. In Industrial Solutions, we are digitizing that space and connecting all of our products, thus allowing deeper relations with our customers in driving the aftermarket back. A few years ago, when you talked to us about our industrial space, we would tell you our first-fit programs we're about 65% of that particular segment and aftermarket was 35%. And today, it's now 50-50. That shows the strategy execution that we have had. Within Life Sciences, within the Bioprocessing segment, that's elongated. It's well -- well known in the industry, that's pushed out a couple 2, maybe 2, maybe 3 years for us on some of the differentiated products that we are bringing out the market due to the end market headwinds. However, that particular segment for us is doing very good in the food and beverage which has similar technologies to the areas within the bioprocessing side. And also, as a result of cloud-based storage, our Disk Drive business continues to grow nicely. Our use of cash over the last 3 years, our priorities remain the same: invest in the company in order to drive organic growth, M&A opportunities, dividends. Again, we talked about we did raise dividend last year and then share repurchases. We are a consistent story on dividends and share repurchases. We typically buy back 1% within share repurchases in order to offset dilution. And we have guided 2.5% this year. Last year, frankly, our stock price got ridiculous. And so therefore, we bought 4%. It was really the proper move for the company at the time because actually, what that did to our net debt-to-EBITDA ratio was took it all the way up to 0.7. So we have a strong balance sheet, and that seems like the right thing to do. So we like to run the company roughly at about 1x long-term debt, 85% free cash flow and we have available to us with all the documents we have today at $700 million. Truth is we can get a whole lot more than that very quickly because of the strength of our of our balance sheet, and that makes us an acquirer of choice. So again, we are a leader in filtration. We do have best-in-class technology. We help our customers solve their complex needs. Our strategy is a balanced growth strategy along with M&A, and we have entered strongly into the Life Sciences segment. So a very quick overview of our company. And with that, I'll pass it over to Brian for questions.

Yes, great, and thank you, Tod. Go ahead.

Okay. 68% replacement, love that business, okay? But can you talk about the life of the filter and how it has changed over the years, whether it's been extended and whether or not that -- there's a threat to someone making a very long-lived filter, which would impact your sales growth?

Sure. The actual replacement cycle depends upon the application. If you look at a long-haul truck, it's going to be about once a year. If you look at a mining opportunity, for example, it could be every 2 weeks, right? So that hasn't really changed -- sorry, go ahead, okay. So that hasn't really changed. As far as extending the life, customers are looking at really driving cost down, first-fit costs more than the life opportunity. And so if you can give them equal life, less cost, they'll take it. One example, if you look at over-road trucking, and you'll see the trucks with the stainless steel cylinders on the side, very boxy. We make those in Greenville, Tennessee, but our technology PowerCore reduced that particular application by 70% with the same filtration outcomes, so exactly the same performance, but it allowed them to put it under the hood going after aerodynamics. And obviously, that gave us a leg up in the aftermarket because it's a highly proprietary technology. People look more to that rather than extending the life. We could, for example, take your lubrication filter and we could make that last 1 year, 2 years, whatever you want, but you don't want to pay for that. And so that really isn't what's driving the marketplace.

Tod, just kind of taking a step back strategically -- or to talk about strategy and Life Sciences specifically, given that maybe the drug development cycle has been slower than otherwise anticipated, how do you balance strategic priorities for both your core engine and industrial business and also life sciences now going forward, particularly from an M&A perspective?

Sure. So what we're really doing, we talked a lot about Life Sciences because that was a new entry, but we invest in our core technologies and Life Sciences organically to win where we can win. So we'll press hard where we see opportunities. And you see that strategy paying off in the market share gains within our Mobile Solutions business as well as our Industrial businesses. Those strategies are doing quite nice for us. So we press wherever we can on the organic side. Within Life Sciences, since those are new products, and 2 of the acquisitions, for example, were 0 revenue-based companies that were really pre-revenue, we were going to really drive that out to market. It's just elongated on us. We still like the market space. We will look to acquire really in -- this is part of -- maybe part of what's -- may be overemphasized on the Life Sciences. But we would buy into Mobile Solutions if there was a technology advantage, for example, in alternative fuels, we'd buy there. We'd certainly buy into the industrial space in order to help that business and do more bolt-ons. And then we're also can in the life sciences space. So our M&A strategy is really more broad based than probably understood.

Understood. Talking about portfolio evolution over the next several years, how much of what you're looking for is, we'll call it, breadth of offering versus penetration deeper into markets with customers?

Yes. So I think the evolution of the company over the next few years will really be our best opportunities more aftermarket Mobile Solutions as well as Industrial Solutions simply because the OE portions, remember, construction, mining, ag and long-haul trucks are all down right now. So that's at 32% to 35% of our company are feeling headwinds. In spite of that, every year for the last 4 years, we have grown. And when those companies come back, they don't -- when those markets come back, I mean, they don't come back by 5%, they come by 15% or 20%. And you see that in long-haul trucks, for example, they're down from 320,000 down to somewhere in the neighborhood of 210,000. That will come back. We've seen that before in the 2012 to 2016 recession. We feel this is more similar to that type of activity and expectations looking forward. So short term, our aftermarket opportunities are really going to drive us. When those other markets bounce, clearly, we'll have tailwinds because of our aftermarket opportunities and our first-fit positions with the OEs.

Spend a couple of minutes talking about what you're seeing in those off-road markets and then a couple of minutes on the on-road whether it's ag or mining or construction as far as any sort of green shoots that you might be looking for? I think you all talked about it a little bit on the last call.

Sure. Maybe I'll let Rich talk through that one.

Are we on?

Yes.

Yes. I think if you take the aftermarket side of the business, we're seeing demand coming through pretty much at pull-through levels or kind of normalized inventory. I would say last year, it was sort of region by region. So we saw a lot of strength in Europe and the U.S., some tough economic conditions in APAC and Latin America this year, we're seeing sort of broad-based improvement. So good on the aftermarket side. And then on the first-fit side, I think we're at bottom for sure, and we're looking for green shoots. I don't think there's anything clear that says it's coming back quickly. But we do feel like we have bottomed and those markets are going to bounce in the next 12, 18 months, we'll start to see some life would be expected based on past cycles may not be exactly the same as last year, but I think that's what we're expecting.

Tod, you have been very good at the razor-razorblade model and the margins, can you look -- just help us out with regards to the military and defense and aerospace, particularly in what's going on in Europe? Anything there that we should be kind of thinking about? Obviously, in Life Sciences, your EBIT margins, what do you say 5 years from now, how close will they get to the corporate averages?

So Aerospace and Defense first. So we have an Aerospace and Defense business that's grown nicely in the last couple of years, much like everyone in A&D we did expand our overall operating margin within that particular segment. We are taking actions to also continue to improve that operating margin. For example, we're shutting down a manufacturing plant in California right now. It will be shut in at the end of March, still keeping it in manufactured in the United States, but it's clear there's a better cost structure out there. It's kind of standard work for us. But within ASD, that's what's happening. As far as programs, we do have some long-term programs that actually now go away replaced by some new programs like the H53K helicopter, which is really just starting to get going, and that's all Donaldson technology. So A&D has a nice momentum. It's above company average operating margin. It will continue to expand, and we'll continue to grind out more wins there, grind that out because I say that is the single longest sales cycle of any business in the company. It is not months, it is years and it could be a decade before you see revenue on that. So then when you look at the Life Sciences, what we did within the last 1.5 years, we had a big appetite when we went into strategically, things were really going well. The momentum was real positive within that particular industry. And then a lot of inventory started happening post COVID, it really put us back on our heels. We focus that particular business so that we can then really cut down our appetite, if you will. You can't eat the whole smorgasbord, right? And so that's what we did. We now have chosen and proprietized what we believe are our best opportunities going forward. I think over the next 5 years, you'll see that whole business get up to company average. And when I say company average, we're not going to be sitting at 16.4% where our guide is. We'll continue to expand as a company. And so over 5 years, that will be to the new company average, and we see that path available to us.

You've spoken at length over the course of the last year or so about telematics and your ability to gain greater aftermarket share, particularly in the industrial side. Talk about that initiative and how that's bearing fruit.

Yes. This is really cool. So if you look at a dust collector, which us filter geeks we look at fondly. You'll drive down the road, you'll see these big dust collectors. If you have a missed a particular or a fume in a particular application of industrial, that's where our Torit based business goes in. We are connecting those so that you can send alerts to the maintenance person to say, listen, go out and change the trash, okay? So for example, that collects a lot of particulate. If you don't actually empty that trash, we call it a hopper, but it's really a trashcan, it could ingest back up into your dust collector, shut your entire manufacturing process down and you'll be shut down for 2 or 3 hours, no longer making widgets. If you just do what our alert says, it takes you 15 minutes you keep going. We went to 1 site, for example, we said, look, here's the value proposition. They said, okay, we'll try one. After a month, they called us back and say, we have 60 collectors on site, outfit all of them. So we're really getting good momentum. Why is this important? Deeper customer relationships like our strategy calls for and the aftermarket opportunity because it's so easy to do business with us at that point is about 3 to 4x more than what a non-collected dust collector is. So we look to continue to press that forward. It is part of the quiet little secret of the growth that we're seeing in our industrial aftermarket. We actually need to really hook them up faster, if you will. We look to hook up about another between 2,000 and 2,500 this fiscal year and the momentum will continue to grow.

Does that same technology translate for your engine markets?

So it's different with an engine. With an engine -- so a lot of this AI and all the conversations within filtration industries. If you just take our products, for example, and you can imagine a filter, you can't put AI in a filter, right? But within an overall system-based, you can put sensors, right? And the sensors then will give you operational data that come back to us, which allow us then to turn the world into our laboratory and our first-fit-based systems then become best-in-class applications for all of the customer base. So you can reduce the size of them and really give the customer a better experience. And that's what we're really looking to do. So it's really more of a sensor game for us rather than digitizing some other kind of application, if you will.

Talk about the last 3 or 4 years, you've done a spectacular job in your core business, driving profitability. And we're in a very fluid environment from a tariff standpoint now. So maybe what lessons from supply chain disruptions have you been able to kind of make just a part of who Donaldson is right now from an operating standpoint? And how are you a better operator now as a result of those...

Yes. Well, first, I would tell you, I think our operations team is daily. Simply put, we're good. And I know during the overall supply chain disruptions, we weren't where we wanted to be, but we were better than all of our competitors. And we had customers calling us from our competitors and saying, "Hey, can you please sell to us" and our answer was no because we're going to take care of the customers that we have. While that weren't turned out pretty interesting in today's environment because some customers are calling us back and saying, "hey, I really like what you did there. Will you take me now?" And you can see that within some of the aftermarket share gain that we have been getting strategically and our operations team is doing really, really tremendous work. We always consider standard work as taking a look at every plant, have that plant stand up on its own merits. We are currently in the process of shutting down 3 manufacturing plants, 1 in California, a large 1 in California, a very small 1 in California, which will then read us of all manufacturing in California. And then we just finished shutting down 1 in England, and we sold the land there. So we continue to focus in on where -- our cost structure is best laid, and we just consider that standard work. That's really more of who we are within our operations team, and it's really helped you can see our operation expansion here in the last couple of years.

Looking at your balance sheet, clearly very conservatively levered, but part of that is just simply due to the amount of cash that you all generate. From an M&A pipeline standpoint, anything that we should be thinking about you wanting to expand in your core engine or industrial segments.

Well, if you take a look at Industrial, we have a host of businesses within Industrial. We do everything from industrial dust. We do industrial hydraulics, right? So we're doing air and liquid across multiple applications. We look to do bolt-ons within those opportunities geographically, technologically. That is really a focus for us. If we can expand and continue to diversify the company with new industrial-based applications, filtration focus, where we have an underlying technology that gives us an advantage. We'll continue to do that. Our M&A pipeline is full. It's strategic, and we continue to work it every single day.

Your question, okay.

Are you shutting down the 2 California plants because of our rules and regulations.

Rules, regulations, costs, all of it.

Why is cost of high?

It -- really, the -- when you consider all the overheads and the cost of doing business in California, it is really problematic. I'll tell you what, we're moving this to the Hartland. We're moving that entire manufacturing plant to Illinois, the pay back 2.5 years, okay? That should tell you how bad California has gotten.

At least you could tell our government of that.

That's someone else's job. We're just trying to be a filter company. I'll leave that to everyone else.

Mario, do you have one? Okay. You went to 4% of the shares on the repo last year. Would there ever be a scenario where you just decided -- similarly when the stock got silly that it's effectively an M&A of your own company, why not even be more aggressive than that.

I don't think that's -- I don't think going private is the best use of cash for us.

I didn't quite say all that. But you said that and now it's in my head.

Look, we'll continue to be opportunistic on the buyback. But buyback is not our story. Buyback is not even our game, right? We're just a consistent buyback company. We just do 1% to offset dilution. The only reason we acted the way we did last year is, frankly, it was ridiculous, okay? We were down like $61, $62. Today, we're sitting at $84. I mean it just made sense that was the best use of cash. And because we had such a strong balance sheet. I think at the time, we were 0.6. We went all the way up to 0.8 and now we're back down to 0.7. So we returned over $400 million to the shareholders last year in the form of buybacks and dividends. It was just an opportunistic moment that we couldn't pass. That's not who we are, though.

You're victims of your own success in a very difficult environment. So I applaud performance by the operating team as well, Rich. And I thank you all for being here. It's always great that you support us every year.

Thanks. Appreciate it. Thanks for your interest.