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

Everyone. We're going to stay on schedule here. So we have the team in from the Twin Cities from Donaldson here with us, been great and loyal supporters over the years. So I appreciate all that. Sarika Dhadwal runs IR, does a great job there. Brad Pogalz, the CFO; and then Rich Lewis, day 3 in the CEO's seat. So should have some good conversation there. I think we'll start with some slides and then get into Q&A. So thank you again, Rich, and over to you.

All right. Thanks. Well, welcome to Donaldson Company presentation. My name is Rich Lewis. I'm the President and CEO, day 3, but I've been with the company 24 years. So we'll be interested in hearing your questions. And thanks for joining us today. So I know you've seen this before, our safe harbor statement. Everything we talk about today will be as of our Q2 fiscal year '26 earnings, which was just released last week. Let me start by just telling you a little bit about Donaldson. We'll get into these points in a little bit more detail. But if you take away 5 things, these are the things I'd like you to take away. So we are the global leader in filtration. We've been solving our customers' toughest problems for over a century. We lead and invest in innovation, and we deliver best-in-class technology. That is one of our main differentiators. We use that technology ultimately to deliver value for our customers in 2 ways. The filtration is a small part of the cost structure of the vast majority of our customers, and we're protecting their most valuable assets, their products, their people and their processes. Secondly, we enable them to make more money using our products than the competitions. We allow them to lower their overall total cost of ownership. We have a balanced growth strategy. It's anchored in delivering growth in our core markets, where we've invested heavily over the last century and have durable competitive advantage, while we're laying the foundation for the next century of growth through expanding our addressable market share. And then finally, to that point, if you look at our Life Science business, that really is around high-purity filtration that spans advanced industrials all the way into bioprocessing. We are laying a foundation of technology that can be used in multiple applications and multiple market segments. At our core, that is Donaldson. So this is a good lead behind. You can look at this later. If you want to know a lot about Donaldson, it's a lot of information on one page. I'm not going to drain it. I'll just give you a couple of data points. As I mentioned, we're a 111-year-old enterprise. We operate in 3 reporting segments. We've continued to deliver top line and bottom line growth through all 3 of those segments. Our anchor is innovation. We have 3,000 active patents, and we have 2/3 of our revenue in recurring revenue. So sticky through innovation and a lot of recurring revenue makes us a very resilient and reliable business. We operate throughout the world. We leverage our investments in both operations and in innovation across multiple markets, multiple applications and we do that throughout the world. We have our in-region for-region strategy. We manufacture 75% of our products in the regions that it's consumed, which also makes us resilient to global disruptions, which we've had, obviously, plenty of those here lately. We talk a lot about our growth. Historically, we have been growing mid-single digits. In F '26, we have a top line growth projection of 3%. We'll grow EPS 8%. Our goal is very simple, on higher levels of sales, we want to expand margin and grow our bottom line faster. I want to talk a little bit about Q2. So we just released Q2. As you can see on the chart, coming out of last year, we were running at record operating profit levels. Q1 was pretty much in line with that. And then we had a step down in Q2. Q2 is always a little bit of an anomaly for us. We have a lot of customers that manage their balance sheet at the very end of the calendar year, which would be their fiscal year. We also have significant holiday periods, where we have customer shutdowns. So Q2 is always a bit of a little bit of a wildcard. But if we look at this year, we had a step down that was actually not just due to those issues. We had 3 specific short-term issues that we're working through. So the first one was we have a significant ramp-up in our power gen business. So when we think about data centers, we have multiple products that touch those, the power gen business being the most significant one. All of our customers are ramping up capacity. We're ramping up capacity to help satisfy them and get in-region content. We moved a significant product line from a facility in the Middle East to a facility in Mexico. We've hired -- we've basically doubled our workforce going through the learning curve and the training on that new product. Second item was timing issues on orders, specifically in our OE business and our Aerospace and Defense business. Backlogs in both of those businesses are very strong right now coming out of the shutdown, our OE backlog stepped up double digits. And after Q1, our A&D backlogs are at significantly higher levels. So incoming orders are good. Backlogs are good. We expect those to be significantly better in the second half. And then lastly, we had a lot of footprint optimization work. In the last couple of years, we've accelerated our gross margin expansion initiatives. One of those initiatives was closing several plants. We're in the throes of that right now. We saw a lot of cost pressure from that in Q2. 2 of those plants are closed. We'll continue to ramp up in the new facilities here coming up in the second half and 2 more closed this quarter. They'll close here in the next 60 days. As we look forward, we expect those short-term issues to moderate. And you'll see in our guide, we're expecting sizable increases in the second half. So when we're done with the year, we'll have record sales, we'll have record operating profit margins, and we'll have record levels of EPS. Talk a little bit about our durable competitive advantages. These span pretty much all of our markets. If you think about how we go in, we tend to go into industries very early on. We solve very difficult problems and we start to build trust. The moats that we create in almost every one of our markets are pretty consistent. We have a deep innovation bench. So we have technologies that span multiple applications. We develop the engineering expertise. If you think about some of the markets we're in, our sales force are essentially trained engineers that are out selling because the applications are so technical. We have that deep application experience. And then around that, we invest globally to support our customers all around the world with very, very broad product portfolios, and it's all underpinned by a very strong culture of operational excellence. So it's not really one item that is our differentiator. It's really linked and stacked competitive advantages that, frankly, are hard to replicate. As we look across all of our segments, we have headroom and opportunities to grow in each one of these. If you think about our mobile business, we've been investing for over a century in that business. We're continuing to harvest those investments. We're clearly the leader in that space. Industrial, we've acquired significantly in this space over the last 30 or 40 years. We have opportunities to continue to scale and drive synergy in that business. And we're seeding our Life Science business with investments that really broaden the addressable market and our technology base. A little bit on capital allocation. We're going to continue to have a disciplined approach. We expect that we'll continue to invest aggressively in organic and inorganic growth, and then we'll return cash to our shareholders. We've been increasing our dividends for the last 30 years. We'll continue to do that, and we'll use share buybacks as a temporary lever depending on how our M&A work is going. Maybe I'll just end here, talk a little bit about Facet. We just announced our largest acquisition. This has not closed yet. We're going through the regulatory process as we speak. Facet is one of just a small handful of companies that do fuel filtration in the aviation space. It's a highly sticky, highly regulated, highly safety-driven industry. Facet brings margins growth rates higher than Donaldson company average. I think EBITDA is 2x our company average and growth rates in the high single digits. It also brings broad adjacencies for us as they go from the refinery to the wing of the vehicle in filtering the fuel in multiple stages, sometimes up to 7x. We also have products that can sell into that from our other industrial businesses. And then if you look on the vehicle, they're very strong in fixed wing and naval applications. We're strong in ground vehicle and commercial aircraft. And so there's a very complementary product portfolio from our products and theirs. So we're really excited about Facet joining the Donaldson family. We hope to close this over the next quarter or 2. This is margin accretive, cash accretive year 1, and it will be accretive to EPS in year 2. So maybe I'll just end here because then we'll get to the Q&A. But just the 5 points that we just talked about, leader in filtration, high degree of innovation and technology, really solving our customers' main priorities, which is giving them peace of mind, protecting their assets, while we help them lower their cost of ownership. Growth opportunities across all 3 segments, harvest, grow and seed across the 3 segments. And then finally, we're laying the foundation for higher margin, higher growth opportunities in the heavy industrial or specialized industrial and life science space. So that's Donaldson in a nutshell. I think I kept it on time, Tim. So yes. So we'll let you switch.

Yes. It's good. Maybe that's a good way to start us off. Rich, maybe just think about at a high level. So Todd put a number of initiatives in place under -- during his leadership. You've obviously worked with him for a number of years. As you think -- are there areas of emphasis or initiatives within the organization that maybe you'll take a different slant towards or anything that investors should think about in terms of where you want to -- maybe want to put a little different stamp on how you lead the company?

Yes. So we'll -- we're going to have an Investor Day later this year in New York. We'll clearly lay out our strategy and very good depth at that point. I think if you look at the foundation of the company, the strategy is not fundamentally going to change. We're going to lead with technology, lead in innovation, try to find markets, where those technologies make a difference in the way our customers do business. I think where we press maybe as far as the aggressiveness of the investment, that may pivot somewhat because it really is harvesting the growth and the investments in our mobile business, which we are clearly the market leader as we scale up our industrial business to drive greater operational efficiencies, while we're seeding our long term. So all 3 of those will continue to be part of the strategy. Where we press from a financial standpoint and management attention may shift a little bit. But fundamentally, it's not a major change.

Got it. Got it. Maybe this is probably more relevant to the Mobile Solutions business. But one of the themes at this conference is amongst industrial companies and even just to broader cyclicals or in general, is just this idea of starting to see a little bit more green shoots in the market. You have certain aspects and certain pieces of mobile that presumably would be more on the front end of that. Maybe just talk to what your conversations with OEM and distributor customers, what you're hearing.

Yes. So I think if you think about the replacement side, that business is north of 70% recurring replacement parts, strong utilization rates across all 4 markets. really nothing has changed there. We continue to grow our market share. Pricing has been good. So really stable performance on the replacement side. The first-fit side, I think construction and mining sort of mid-cycle build rates. I would expect that to continue. The possible green shoots are on the ag and on the commercial truck side. We are seeing some early signs. We get long-range forecast from our customers, sometimes 12 months of EDI signals through when our computers talk to each other. And we're seeing expected build rates in the truck market in the summer. We'll see if that comes to fruition. And we're actually seeing actual orders in some of our ag customers that are elevated over what they had been in the last couple of years. So I would call them early indicators of maybe there's some positivity, but I would not suggest that we're there yet.

Yes. Okay.

And Tim, as you know, I mean, when these markets come back, they come back fast. So that's why we're watching really carefully because we want to be prepared. We have the capacity. So we're going to lever well, when it does come back. But the main thing is making sure they can build all their vehicles and supporting them.

Yes. On the mobile side, the aftermarket being obviously such a big piece for you. You've outperformed in the last couple of years and on a handful of at least what you've provided externally in terms of some big customer wins. But maybe underneath that, talk about -- is there something you've kind of pushed through the sales arm in terms of the outgrowth has been pretty notable on the aftermarket side. So maybe talk about that.

Yes. That business is -- it's a business we've been doing for a long time from a commercial, operational and product side. It's a very robust, very capable business. As you said, part of the market share gains that we've seen in the last couple of years is coming out of COVID, there was significant supply chain disruptions. We performed very well in that. We used -- there was a point in time where we had spent a lot of money investing in inventory just to buffer our customer service levels. What we saw was not everybody performed well, and there was some upset customers and they wanted to change. And so we picked up a lot of share due to competitors struggling. That was probably a onetime -- that doesn't happen every day. The more basic daily share gains are really selling our technology. And we bring a lot of value to our distributors because we go out and we help train them so they can go out and grow their business. So they really are partnerships. And the better we train them, the better they can grow their business.

Got it. On one of the charts that sometimes gets a little bit overlooked or forgotten is just the globality of Donaldson and sub-50% of the business in North America. Maybe talk about trends outside North America, maybe where you're more or less optimistic, maybe focus on Asia and Europe?

Yes. So Europe and Asia have been strong points for us for some time now. We mentioned in our earnings call, 6 quarters in a row of growth in China. We probably haven't been sort of over flagging that because it would have been a while since we've seen growth there. But really, we're seeing really strong economic performance in Europe and Asia. And frankly, most of the weakness has been in Latin America and a little bit in the U.S. on some of the CapEx. So when you think CapEx, I'm going out and I'm building a plant, I need a new dust collector, a new industrial hydraulic system. Those have been a little bit muted.

Yes, which I think is interesting because if you pull 10 companies on that idea of -- or that notion of maybe we're starting to see early signs of an industrial renaissance and reshoring all these buzzwords that we talked about within industrials and that's kind of throws a bit of cold water on that. So is it just the idea of just hitting the pause button, waiting for more clarity. What do you hear from here?

Well, I think 2 things. I think there's a lot of uncertainty out in the market. And so the quoting activity for some of our capital projects, I think, if you're on the data center side, it's just full steam ahead. So our power gen business is just cranking along the non-power gen side, a lot of quoting activity. Utilization rates are okay. Our aftermarket businesses continue to grow there. So they are using the equipment in the field. But as far as new projects or retrofitting old systems, I think everybody is just sort of pushing their decisions out. The reshoring, I think, is very narrow. It's in targeted industries where there's support from the government to essentially -- we have to build these capabilities up. Some of those play in our favor. If you think about trying to become more independent in semiconductor manufacturing. Well, we have a business in Asia that supports that industry, and we sell to all the chip manufacturing companies, but as far as general manufacturing, yes, we haven't seen it. And overall, the economic conditions are a little depressed right now.

You touched on it a little bit, but the data center exposure for Donaldson, I know that can be a little tricky because you have the kind of second or third derivative impacts. But how do you size it? And how would you say your -- how would you kind of frame your competitive positioning across the relevant?

Yes. So we're touching it multiple ways. We have businesses that sell into micro chip manufacturing. So the computers that go in there, we support that through them. The vast majority of the hard drives go in there have a Donaldson filter on them. So through those OEMs, we're seeing strong demand. We're seeing data centers convert from air filtration, which we don't participate because it's more HVAC in nature. Over to water filtration, which we have products, and we're seeing an uptick in interest there. And then finally, and the main piece of it is on the power gen side. So a lot of the power gen customers, the small turbine, they're essentially taking the natural gas from source to point of demand. So there's -- they're using the turbines to compress the gas and move it. We have a good position there. That business is in strong demand. And then because the data centers don't have enough ability to tap into the grid, there's a lot of peak in baseload systems being put on site with the data centers until that becomes available. So that would be on the larger turbine side. But yes, there's -- we're really -- we've got 4 access points to that market. And I'd say the power gen is significantly the largest.

Yes. So ballpark, single digit kind of...

Yes. We talked about this in one of our one-on-ones earlier. It's probably -- it's going to continue to grow. And I would say if our customers put on a tremendous amount of more capacity, they would surge in demand. I think how many -- how much capacity they want to bring on is yet to be proven. But I do think we're seeing an elongated up cycle for sure. So instead of maybe a couple of year up cycle, we're talking multiyears of very, very high demand with incremental sort of think mid- to maybe high single-digit growth rates as they incrementally expand capacity.

Within the Industrial segment, something we talked a lot about with Todd a year ago was just how you're working to connect more of the assets, connect more of the machines in the factory. Maybe spend a minute on that. There can be a pretty powerful driver, I would assume, in terms of if those are your machines, you have visibility into the filter life, you kind of get the first shot in terms of that replacement sales. So talk about kind of the interplay between the OE side versus what that brings from an aftermarket standpoint.

Yes. Connected Solutions, it really is part of our overall strategy in industrial, which is to increase customer intimacy. So if you think about some of our OEM businesses, we're interacting with our OEM customers every day, all day long. Power gen is an OE business. Our disk drive business is an OE business. Our mobile business is a large portion of it's an OE business. So you have a natural customer intimacy. Some of our industrial businesses, they'll do a project and they'll buy replacement parts every 2 years. They might buy a new system every 10 years. And so you lose that connection with the customer until they have a need. We're trying to recreate the same level of intimacy we have with the OEs, #1, with data. So we've connected their solutions. That allows us to monitor their system, which helps us design better systems in the future. The long-term outlook would be to use that data to optimize how their system is running at any given moment because a little bit of change in how the system runs can save them a lot of money in electricity. The second piece of that is that data allows us to have reach out points to the customers, hey, look, we see a problem with your filter, your system, can we come out and check it for you? And when we come out and check it for you, not only do we sell filters into our systems, but we can also sell it into our competitors' systems. So it's really a holistic strategy to improve the first-fit design, have more touch points. We started as a subscription model. We were trying to sell the data, and we quickly realize that's not the value. The value is that customer intimacy, and we see higher win rates. When we sell -- when we are out touching customers that are connected and we service their units, when they need first-fit systems, our win rate is probably 15 points higher, and we see a much higher retention rate on replacement parts. So it's a long-term strategy. We've put a lot of money and time into it. We bought several service companies, and we're really doing a full evaluation now that we've been into it for 3 or 4 years. But we continue to press forward. We should connect another -- we're in the thousands on the number of assets that we have collected, and we should keep increasing that at a rate of about 500 to 1,000 a year.

Relative to what's the big denominator, I mean...

Well, I think you're talking -- if you think -- if you go back 50 years, there could be 100,000 units out there. But if you think about the percentage of new ones that are going in the field that are connected, it's ratio. So I think over half.

Yes. Maybe I'll put Brad in the hot seat here on the chart that you showed in terms of the operating margin bridge, pretty sizable pickup there implied in the back half of the year. Maybe talk through your confidence level in terms of that these issues are -- will be more short term in nature. And then as you think about that, I think it implies something like a 36-ish percent gross margin in that neighborhood as you exit the year. And then you've got -- you bring Facet online, you've got some of these savings. So maybe just talk to like at a high level, kind of how we should think about maybe puts and takes on that margin side?

So I want to underscore a point Rich made that the second quarter, there were a few issues in the quarter that we would view as more temporary, short term in nature. So the second half is bouncing back a bit from that. The part that I think is important is there's 2 dimensions to that increase. If you think about the step change of 1H versus 2H, a big portion of it comes from this gross margin improvement that you're mentioning, but also a decent portion from operating expense leverage. So we have typical seasonality in our business where the second half steps up. It's more activity, especially in some of our mobile markets. And that normal seasonality is what's baked into our guidance. There's nothing heroic about the sales. We would expect our OpEx to stay at about the levels that we've seen in the last couple of quarters. So we'll get a nice leverage on top of that. The gross margin, the first thing that Rich touched on, the volume, that was something very specific to the first -- or excuse me, second quarter, first half. And we have the backlog, we have the orders. So we have a level of confidence that coming in. There's some execution things there that we'll need to get that product out the door, especially with our supply chain in the aerospace and defense business, but that's something that we can work through. And then the projects that we're working on and especially this Power Gen, I mean these are things that we're doing right now to try and improve the outcome for the second half. So exiting the year, you're in the neighborhood. I think we'll come out of the year with a gross margin much stronger than we had in the second quarter. Obviously, the things that we're going to watch are not just the execution, but what's happening in the market. As the OEs start to rebound, a typical impact we see in the company is the mix pressure from large OEs, especially first-fit new equipment production that's got a lower-than-average gross margin, but it's something that we pick up with SG&A leverage and earnings growth. So there's some dynamics to think about for '27 that my hope would be a year from now, we talk about the resurgence in the OE markets and everything is going well, but that's something we'll watch in the meantime.

Yes. The savings from the footprint realignment, is that -- have we seen any -- I mean, is that still on the come there?

It's still on the come. So we'll -- we've closed facilities, and we're going through the start-up phase in some of their new homes, and then there's facilities still to be closed mostly in this quarter, third quarter.

Got it. And is the right way to still think about operating leverage in the kind of low-20s as -- I know there's interplay between OE and aftermarket, but is that still kind of the right framework to think about?

Yes, that's certainly in the ballpark, too. That's been our historic levels. The second half, we're expecting it to be well north of that for the reasons I mentioned.

Got it. Okay. Maybe just in the final minute, Rich, what -- from your lens, what do you think folks miss or under appreciate about the Donaldson story?

Yes. I think -- it's interesting because I think it's -- if you look at the products we sell, I think the first assumption is it's a commoditized product. And there are portions of the market, if you think about your HVAC filter that goes in your home HVAC system, that's pretty commoditized. Where we sell into filtration matters. It drives a lot of value for our customers, and it's much more technologically deep than most people would understand. I think the resiliency of the recurring revenue, which just continues to grow as a percentage, insulates us from a lot of the cyclicality of the markets, if I can say that properly, the cycles. And I think the long-term growth prospects across a lot of our markets are really untapped at this point. We still -- even though we're the leader, our market shares are not 40%, 50%. I mean there's upside in a lot of these markets and then lastly, I would say, if you just look at our incremental margins as we grow, we still have a lot of upside on the operating margin profits.

Yes. So think of it -- I mean, the way you started with, these are revenue-generating assets that filter in my house is not -- I'm not generating revenue on my house. Is that just [indiscernible] simple way to think about.

Well, I think when you go to buy your -- not that you're not a savvy consumer. When you go to buy a filter for your HVAC system, it's like whatever you can buy off Amazon. When you're protecting a $500,000 vehicle that makes you x dollars a day that it's operating, it's important that you know what's going in there.

Excellent. All right. I think we'll close it there. Thank you, guys. Appreciate it.

Thank you.