Donaldson Company, Inc. ($DCI)

Hello. Welcome, everyone, to the 21st Annual Oppenheimer Industrial Growth Conference. Next up, we have the Donaldson team, represented by CFO, Brad Pogalz; and Head of IR, Sarika Dhadwal. Good morning to you both. Thank you for your time.

Good morning, Bryan. Hi, everybody. Thanks for the time. Brad Pogalz, CFO of Donaldson Company, and we've got a few slides to go through, and then happy to do a Q&A. Looking forward to it. So before we get into it, of course, the fun stuff, our safe harbor forward-looking statements carry risks and uncertainties. But one thing that I think is an important relevant note is our fiscal year ends 31st of July. So we've just closed our fiscal third quarter, which puts us in a spot where comments today will harken back to our second quarter report and the earnings recap and release that we did late February. So a few months on from that. Happy to answer any questions, but keep that in mind that there's a caveat to that. So as you think about Donaldson, the few key points for us, and I want to go through this with kind of the CFO lens today. And I'll touch on this, and again, Bryan, happy to do Q&A on anything. But for us, starting with a leader in filtration. We're 110 years old, and we serve really the most prevalent global names for our OEM businesses and then lots of aftermarket partners, dealers and distributors and customers along the way. Best-in-class technology. So we are a filtration company. And for us, what that means is that we start with the core capabilities of filtration and then extrapolate and leverage those technologies to support customers in really specific ways across markets. So we can invent a technology in disk drive filtration that helps us do membrane filtration for another application or technology that does diesel fuel filtration that we can leverage for filters in a power gen environment. Things like that are at the core of Donaldson. Customers helping them meet their evolving environmental and operational goals. As equipment becomes more high-performing or more advanced in what it's protecting or producing, that almost always lends to better filtration, higher filtration requirements. So for us, and when we think about our opportunities, as the world keeps evolving, this is going to be a good place for us because we focus on advanced filtration. We have very limited exposure to markets that are lower tech and in some cases, we've almost entirely moved away from them. For example, we don't sell engine air filters for passenger cars. And this was a choice of management over a long time and this is who we are today. Strategic and balanced growth strategy. So for us, this legacy position that we've got, we're 110 years old, especially in the OEM markets, using that technology and those relationships and capabilities to go into newer markets, high-purity applications in industrial processing, for example. And then life sciences market leadership. So looking at trends and again, thinking about our legacy filters where we've built technology to support tractors in the field and the dust that comes with that down to viruses and bacteria and filtering that out of a process, food and beverage, pharmaceutical production, things like those. So a lot of opportunities across Donaldson. And I would say that at the bottom of all of this, we're a durable company that has many different markets underpinning of technological capabilities. So a quick overview. Again, 110 years old, 111 this year, 1915, about 14,000 employees. In the middle of the top, 3,000 active patents. This is what really speaks to our technological capabilities. And as we think about funding our R&D group, it's about white space and gray space where we're looking at next level of filtration in different markets and with different materials. On the bottom left, a diversified revenue base. We have 3 reporting segments. Mobile Solutions is 62%. And think about this as diesel engine filtration, air, fuel, lube, hydraulics and it's across heavy-duty applications. So off-road and on-road, but again, heavy duty. Industrial Solutions, this is a wide range of markets. It's about the factories. It's about power gen and it's about aerospace and defense. And then Life Sciences, 8%. Most of this business are businesses we've been exploring for many, many years. And there's a small, small part of it that was more about R&D into biospaces. So a few acquisitions, 2 of them pre-revenue, but again, expanding our technological capabilities. On the right, you can see our revenue and earnings per share growth over the last 4 years. And this year, we've got a guidance for further increases in both of those measures, sequential records for the last 4 and again, anticipating that for this fiscal year. The historical financial highlights then, if we look at the far right column on each of these, you can see what we're targeting. So fiscal '26, midpoint of our guidance, as I said that we provided a couple of months ago. Fiscal '26 sales growth, 1% to 5% on top of the record in '25. Adjusted operating margin or EBIT margin, 16% to 16.4%. This would be a historic record for the company as well. And decent improvements as a function of gross margin and expense leverage. And then adjusted earnings per share at the bottom, the historic CAGR of about 10%. This year, growth of about 8%, following the 8% up from fiscal '25. And then finally, I want to call out return to shareholders, $465 million in fiscal '25, and I'll come to capital deployment in a moment. One thing that's been on a lot of people's minds since we reported second quarter that we're working to elaborate on is the run rate over the course of this fiscal year. So this is our operating margin trends. Fiscal '25, the 15.7%, which you can see ties to the slide I just mentioned. First quarter 15.5%, second quarter 14%. And this was lower than our expectations. It resulted in a modest guide pull down for our full year operating margin. And the reason we call it out this way is I think it's important to note that there were some very specific things that were driving this. First off, all of the decline is related to gross margin. Year-over-year, it was about 150 basis points decline in gross margin. Where that came from? Volume deleveraging due to the timing of orders in our second quarter. Second quarter is kind of a challenging analytical quarter for us because it includes a decent amount of holidays and then calendar year-end, fiscal year-end for a lot of our customers. So the second quarter is November, December, January. And the volume was very volatile over the course of the quarter, and we had some deleveraging. Part of that was due to a comp issue from 1 year before. We had a pretty notable benefit from it. So we expected a step down, just not to the extent that we had. The other couple of things are really specific to our Industrial segment business, operational efficiencies due to power generation. And we have a power gen business that's maybe mid-single digits of the total company sales. This is a business that is driven by natural gas turbines, large, so the large OEs in the world, we filter the ambient air going in and then some smaller turbines. So think reciprocating oil and gas. In the large turbine business, over the course of this fiscal year, we had moved production to a facility in Mexico as a function of customer-specific requirements where their source of supply had to include some percentage from North America. We make most of these systems today in Abu Dhabi. We moved as a function of this customer, not chasing capacity, but leveraging capacity to meet the customer expectations. And the start-up phase of that had just taken longer than expected due to a variety of things. So there was margin pressure in this business due to that move. The other side is the footprint optimization. And we've got a pretty big initiative that have happened over the last couple of years, and we're nearing the end of plant closures. We've got 4 facilities that by the end of this fiscal year will be closed, 3 already closed. And over the course of this fiscal year, we are finding ourselves in a place where kind of the competing pressures or dual pressures of ramping down productivity in the closing facility and layering on the productivity ramp-up in the new home for this facility. Those 2 things are stacking in the middle of this fiscal year. We anticipated that coming in. We're just calling that out. And the reason we spent a little more time on second quarter and why I wanted to elaborate with all of you today is we expected the second quarter was a dip and that we have a bounce back for the rest of the year. The volume deleveraging, we expect to be more transient and that backlogs and orders at the end of second quarter signaled a very healthy position. So we would expect to get that back. We'll still be working on power gen and footprint optimization again, the stacking, the pressure from that gets reduced. So all in, a more meaningful step-up in the second half of fiscal '26 as a function of the comments on the slide. So I'm going to switch now a little bit to a higher level again. But when we think about our durability in the market, a couple of things I want to add on this. I already talked about the history of filtration, excuse me, and with that comes some very deep customer relationships. But I think the couple that I want to highlight for the group diversified business with global scale and high aftermarket retention. So the diversified business, this has been a very strong part of how we've managed through cycles. So as many of you probably know, some of our OE markets like agriculture and transportation have been under a lot of pressure in recent years. And despite the pressure we're seeing on that side of the business, we're still growing in our Mobile Solutions business as a function of diversification and how we work with our customers. That allows us to have resiliency in many markets, and it gives us a chance to sort of mute some of these very dramatic trends that can exist in any one market, and we can handle it with scale as a function of our technology and footprint. The other point I want to make on this part is I'm going to pull from the word diversified. Tariffs have been the topic of the conversation over the last year. And Donaldson since the implementation and post liberation day have talked about tariffs being a more immaterial part of our overall business, less than 1% of sales, $25 million, give or take, headwind from tariffs, which we would expect to anticipate offsetting via pricing. The reason we're more insulated is because we have built a company that has a diversified manufacturing footprint to go with our business. So we are where our customers need us to be. And consequently, that means that about 75% of what we make in a region stays in that region. So we have very little manufacturing footprint where we've built a place in China to bring it back to the U.S. or build something in Mexico to bring it somewhere way outside of the region, going to APAC or Europe. Most of our operations are Americas, EMEA and Euro -- excuse me, APAC. And that gives us a lot of power because then we can handle things like tariffs in a meaningful way without having significant pressure that we need to go back and get pricing with our customers. And then in terms of the aftermarket retention, aftermarket today for Donaldson is approximately 2/3 of total revenue. So of our $3.8 billion, about 2/3 of it is some sort of recurring model. We win in aftermarket through a variety of things. First is, especially with OEs, they want to maintain their part of business. So in a lot of cases, the OEs, especially large OEs and mobile solutions, they're looking for lock and key solutions. They want to have proprietary products so they can retain their part business. Of course, that's very good for us, and it plays incredibly well to our strengths in terms of technology, form factor, applications engineering and then delivery. But on the other side, we also win with availability and how we support our customers. And we really see this in many of our independent dealer distributor channels, where if they order a Donaldson filter today, they can get it very quickly, next day maybe. And for them, that's incredibly valuable because now they're supporting their end customer. They don't have to tell them to go away. Those 2 components are a big way we not just build but maintain loyalty with our customers on the aftermarket side. So continuing to expand aftermarket via this retention mechanism is a really high priority for us strategically and, of course, then financially. Capital allocation. So over the last 3 years, center of the donut chart, we've given $1.6 billion to the 4 buckets you see on the screen, 18% M&A, that's a bit larger than what we've done in the past as a function of moving into some bio businesses, R&D and start-up, as I mentioned before. I want to come to a slide about a newly announced acquisition called Facet. Share repurchase moving around is about 40%. Share repurchase for us is something that we use as a lever depending on our other priorities, dividends and then organic investment. So now I want to prioritize it. First for me is investing for growth in the company. So it's about putting our money to work where we can drive organic opportunities and especially given our product portfolio and our footprint. M&A would be the next lever for growth. Third priority is about our dividends. We've paid a dividend for 70 years, and we've increased it annually for 30. Remember, the S&P High Yield Dividend Aristocrat Index, and this is an important part of our construction of capital deployment. And then as I mentioned, share repurchase would be the lever on that. So in early February, we announced an acquisition, and we have not yet closed but it's of a company called Facet. And this is a business that is about $110 million of filtration sales. So you can see the stats at the top, $108 million in there last year, an EBITDA margin approaching 40% and 70% of that $108 million are consumables. So some sort of recurring revenue. You can see at the bottom, the composition, commercial aviation, 48% military, so defense is another 26% when you put them together and then other. And this other is industrial applications, power gen, things that are very adjacent to places where we play Donaldson. But what's exciting about this business is, again, if you look at the donut chart on the left, about 80% of this is aerospace and defense. These are great markets, and we serve the critical applications that go into these markets. I'll skip over sales by geography and then some of the highlights on the side. Facet designs and manufactures the filters for these markets. And it's really about meeting very, very strict regulatory standards. Facet has 1 of 2 labs in the world for testing these standards or testing the performance against these standards. And what the standards do is make it very sticky for the customers. They're much more interested in our ability to maintain the high level of integrity we have in the filters now and maintain delivery. 236 employees, 7 countries, manufacturing sites, they have in Oklahoma, that's primary and then a smaller place in Spain. And then you can see our TAM here is about $8 billion across these markets. So within the business case for Facet, we anticipate some cost synergies, largely procurement. These are filters. We know how to make them. But on top of it, as soon as we close, I'm sure our commercial teams are excited to get in and start working with that group on understanding what our opportunities to coordinate and drive synergies will be. It's an exciting business for us. Again, the stats at the top of the page. It's a higher growth company. And I feel really, really excited about the fact that we get to bring this into the portfolio at some point. So I'll end where I'll begin, and maybe I'll just leave these on the screen for the Q&A. But I think the real takeaways here are this leadership in filtration and how we leverage technology to drive customer loyalty, connection, we're very deep with our customers. And I think this is a great opportunity for Donaldson and especially as we look ahead, more filtration, not less is probably what we're looking at in the world. So that's it, Bryan. I'll turn it over to you for any questions.

Excellent walk-through. Thank you. Before we dig in on the operating trends, I think it would be interesting to hear your thoughts on Donaldson's CEO transition. Tod was at the helm for quite a while, had a long successful run. What do you see changing under Rich's tenure? What remains the same? Just any high-level thoughts on that front.

Sure. Rich Lewis, our new CEO, took over right at the beginning of March. For the group, he has been with Donaldson more than 20 years, and he literally started in one of our plants and used manufacturing. As he worked his way up, his last big focus on operations was Head of Global Ops and named in the 20 teams, holding that role for about 8 years until he took over as President of our Mobile Solutions business, so moving on to the commercial side. After that, he did President of Life Sciences. And then just over -- or excuse me, just under 1 year ago, he took over as COO before becoming CEO. And I bring that up because Rich has also been part of the senior team for the last decade. And in a lot of ways, he was at the table as the architecture of our strategy came to bear. So Bryan, to your question, I think we're -- it's not as though we become a different company. I think the opportunities with Rich are as we look ahead and the new opportunities with new filtration technologies, some of what Tod really did a great job pushing us down the road of. We've had very good capabilities with, I would call it, more traditional filter media. And when I talk about filter media, it's like it's the paper, the filter paper, combinations, form factors, understanding of the chemistries. We had incredible capabilities with this. Tod really during his tenure, pushed us into more membrane and polymer-based filtration, which goes to a much, much higher level of filtration for different particulates. And as we look ahead, industrial applications, high purity, more advanced industrial processes, we're ready to start pursuing things like that. And I think that's where Rich is really focused. Another thing as we think about our growth is this push into expansion in industrial. And we'll talk about things like more customer intimacy in the industrial space where we understand our end customers better. We're more connected to our end customers, all with the goal of increasing our aftermarket parts. Several years ago, in the industrial segment, aftermarket was maybe 1/3 of the revenue. Today, it's about 50% of the revenue. We want to keep growing industrial aftermarket as a function of these connections to our customers. And Rich is really involved in that part of driving investment and consequently, the results and strategy that come with that. And of course, with Facet, that's a big opportunity for us that all of the team here is really excited about. And that's not going to consume Rich's career at Donaldson, but it's certainly an exciting first place as we think about how to integrate and grow that business.

Sarika, anything you'd add there from things we've talked about or you've heard over the years?

No, I think that's exactly right.

Okay. All makes sense. Definitely want to get back to Facet in a few minutes. That's a big deal, literally and figuratively, so worth spending some more time on. I guess to level set a bit more, perhaps recap the puts and takes of 1H experience for Donaldson, you did mention some of the moving parts there, but walk us through that again and the setup going into the back half, specifically industrial margin, the inflection implied and the full year guide, that's a rather healthy step-up. So I just want to make sure that we have all the moving parts understood.

Yes, absolutely. So the experience in the first half, I would say, from a revenue perspective, felt all right. We have experienced some FX tailwinds. That was part of the guide change at the 2H point. But by and large, outside of the capital projects for industrial, things were going in line with where we expected and even a bit better. We raised our Life Sciences business as a function of some organic improvements. But the important part here was the margin step. And obviously, I spent a lot of time on that. So I can dig in if there are specific questions. I won't repeat my point. But I will say that the thing that Sarika and I have tried to do as we communicated second quarter is kind of this point at the top, if you see my cursor moving around is that we view this as more of a temporary step back. So Bryan, to your comment about the 2H ramp, obviously, it looks substantial in terms of the absolute numbers. And anybody can do the math. We've got a 1H actual full year guide, so you can solve for a 2H number that is a pretty meaningful step-up from what we had in the first half. About half of that comes from expense leverage and then also gross margin improvement. So with the step-up in the second half, the expense leverage is about our continued discipline. We have been really active in managing headcount. One year ago, we did substantial restructuring in the businesses, especially Life Sciences to really prioritize. It wasn't everybody in every department in the company goes down x percent. It was a very surgical approach to focusing our efforts and all about prioritization. Typically, we get a second half sales step-up. So if you think about our guidance, it's maybe 52% of the full year revenue lands in the second half, 48% in the first. A couple of dynamics there, but that sales step-up in the back usually lands with nice margin leverage in our second half historically. So more than 52% of our profit tends to be in the second half as a function of that step-up and leverage. The gross margin improvement is what I mentioned. It's sort of building on that and that the volume challenge is something that based on our backlog and orders we said should abate. We still have some work to do on the industrial process in terms of both power gen and the footprint. But overall, that will contribute to the step-up and progress will contribute to the step up.

Okay. That makes sense. I guess the only related question, again, just to level set would be the gross margin pressure experienced in the fiscal second quarter, we have the categories there. Can you size each? We know going forward, half volume leverage, half -- improvement to get back where you expect.

Absolutely -- what's that.

I can take that one.

Yes. Fire away.

Okay. So if you think about the gross margin compression, about 60 basis points of that was due to the volume deleverage. The second piece was the power gen, which was about 40% of the deleverage. And then footprint was about 30%. So you have 100 -- you have the bulk of the differential there. And then there was some mix headwinds in there, too, but that's the majority.

Okay. Understood. You framed tariff exposure and the relatively strong position that your team is in and why. Are there any changes in terms of the new framework that we should keep in mind positively or negatively? Or is the net impact reasonably similar for your team?

Yes. It seems to be about a wash from these moving pieces. The new 232 that happened at the beginning of April seems to have more of a specific impact on small part of our portfolio due to the metal content. The day after the Supreme Court ruling, the incremental 10% that went into effect sort of washes away the benefit from what IEEPA might have had if those go away instantly. So probably like everybody on the phone and all your companies today is we're actively watching this to see what happens in terms of both next leg of tariffs, if there are any and then also the refund side of it.

Okay. Understood. Now let's circle back to Facet. I'm very intrigued by that. Maybe offer a little more color on what makes the asset so unique, the deal rationale for Donaldson and how we should think about the impact or influence on your team's strategy going forward once you do have the asset in the fold?

Sure. Well, I think what makes it so unique is that the markets that Facet support are so highly regulated and/or mission-critical. So the quality of fuel being stored for military ships and the quality of the fuel being used on those ships, of course, is paramount to success that cannot fail. And the same would be true for jet fuel, commercial airliners or private or any military aircraft, anything in the sky, the fuel quality needs to be exactly right. So Facet has -- there's a line that I've used a lot and if anybody is on that's talked to us before, you would have heard it. It was a good concept that we pulled out as part of our due diligence is they serve on aerospace refinery to the wing. So Facet is kind of this interesting thing and that we talk about it as an aerospace and defense market, but it's really about almost the industrial process to support that market, which is includes many touch points on that journey of refinery to the wing where Facet has a solution for it. So it's the movement of the fuel, the storage of the fuel in one location, the storage of the fuel at another location, selling to airports. All of that journey has quality standards, regulatory standards. And what we learned about the customer base as part of that process is they really, really want the integrity of the product to stay. And I can almost say it's sort of like some of the drug development workflows and that the switching costs, it's not worth the risk. This isn't about cost. It's about we can't risk some sort of change that compromises the quality of this fuel. So Facet is a really interesting business in that because the moat sort of expands as a function of multiple things. It's not any one thing. It's that this is a place where it ends up being a spec-in solution with very sticky customer bases. So as we start to get into it, I think it's about exploring where the opportunities are for commercial synergies. An example I like to give on Facet is power gen. We sell ambient air systems to large turbines to bring in the air, to run the turbine and which converts to energy, of course, Highly complicated systems that we do. Facet is on power gen, but they're more at liquids at or on or around the turbine. So 2 different places in this location. Now these are things we have to explore, but it's things like that, that are part of what's exciting about this business. It's already high growth, and it puts us in a place where we have these complementary or adjacent types of products or solutions that we can look at how to build on our total portfolio.

Got it. That's exciting. It will be very interesting to see what happens over the coming quarters and years. Maybe offer a quick update on life science strategy, specifically bioprocessing. Your team has been upfront about the commercialization path being delayed relative to what you had initially pursued, hoped for. Has there been any meaningful changes in terms of the strategy itself? Or is it just time line? How should we think about that progression?

Sure. Well, for the group, just a bit of background on this. We started entering these bio spaces via acquisition in the earlier 2020s. We bought 4 companies, 2 that are upstream and it's about -- it's bioreactors, so cell cultures and development. And then 2 downstream that are more pre-revenue and they're about purification separation. So think of it as potential substitutes or chromatography process. The focus of the entry into these spaces was about niche technologies that we could apply to very specific cases. It wasn't just a generic push of let's get into life sciences. We have this sort of subset of the subset of the subset market in mind that we're not on commercial applications. So to Bryan's point, this takes a long time, preclinical, clinical and then commercialization. We have to run that cycle. So the focus for us has largely been product development and get as many shots into different trials as we can via different mechanisms. The timing, of course, is where -- I don't know if I call it a learning, but as Bryan mentioned, we've been pretty open. This hasn't gone to plan. We've gotten the early 20s and a lot of the funding for our space is there dried up as a function of the post-COVID sugar rush ending. Where we are today, milestone-based. So it's about meeting the objectives. Each business has its own. And then I think, Bryan, just to put the point on as we think about acquisitions going forward, we're much less inclined for more pre-revenue tech companies than we are for things like Facet, with the scale of Facet aside, but more robust businesses, clear route to market, some aspect of commercialization. We need to see through what we've got in the bio space before putting more capital in there.

Understood. We have about a minute left. The path forward for Donaldson under new leadership, yourself included, still relatively early days leading the finance team. What's the most exciting prospect for your team? You're exposed to a lot. The fact that you have such vast institutional knowledge of filtration, growth vectors are quite broad. Are there any opportunities, 1 or 2 that you would call out as being truly the most exciting if we look forward 3, 4 years?

Yes. I think it's a little bit of what I touched on. Our capabilities in membranes and polymer-based filtration, we're really getting our footing now. This is something that we stood up a material research center in 2020, 2021. And the things that I think we'll be able to produce as a function of that are it unlocks new markets or expands existing ones. And I think these are places where we're going to find a lot of applications, and they're high growth, high margin. So this idea of mixing the company up into the higher support or higher-margin businesses is really important. And then the other thing that I think is really exciting is changes to industrial processes that give us new opportunities sort of the new factories, the standards increasing, the process, precision engineering. There's a lot of places where advanced filtration becomes more important. So I think we're well situated there. And I just want to say the mobile business is a machine, and we continue to expect mobile solutions to be a big part of the company for a long time. This is a place where with the OEs, we can generate a very nice return on invested capital because of the capabilities that we have and the volumes they bring to the company is a function of really, really, really deep relationships. So I continue to be optimistic about what we can do there.

Excellent.

I can't rank my myself, maybe that's the way to say it.

I would just add one more kind of like as a foundation for the things that Brad just talked about is just the heightened operational rigor that we've been talking about a lot within our walls here at Donaldson. I think there's a lot of energy and excitement behind that.

Yes. Good point.

So that will ideally lead to additional leverage and margin expansion, and we're all looking forward to seeing that play out.

Yes.

Very good. I know we're past time. Thank you both for your time this morning and all the great color.

Thanks, Bryan. Appreciate it.