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Donaldson Co Inc. (NYSE:DCI)

Credit Suisse 15th Annual Global Services Conference

March 11, 2013 5:30 pm ET


James F. Shaw - Chief Financial Officer and Vice President


Hamzah Mazari - Crédit Suisse AG, Research Division

Hamzah Mazari - Crédit Suisse AG, Research Division

[Audio Gap]

James F. Shaw

All right. Thank you, Hamzah. I will jump right in. First, I'll start off with the Safe Harbor statement. As you know, this presentation does include forward-looking statements, which are current views but not necessarily reflective of what could happen in the future and that could impact these results. So, just -- I think most of you are somewhat familiar within Donaldson. But, who we are, it seems kind of obvious. We're a filtration company. But we really are -- we believe, compared to our competitors, a different kind of filtration company. We want to be the technology leader in all of the markets we serve. So that causes us to maybe look away from some filtration markets where our technology isn't valued or where we can't make as big of a difference to our customers in terms of innovative solutions. We also are a very diversified portfolio of global businesses. And you'll hear, throughout my presentation, the reemphasis in terms of the global nature and the diversification nature of our business.

We're organizing into 2 reporting segments. One is the Engine business, and within the Engine, which is diesel engine primarily, we provide air filtration, liquid filtration and exhaust and emissions product. When we say liquid, we sometimes get questions, what you mean by liquid? It's hydraulic filtration, lube or oil filtration and fuel. Those are the 3 primary components when we say liquid on the Engine side. In terms of the end markets on the Engine side, we participate in the off-road market, which is comprised of ag, off-road heavy construction, as well as mining. On the on-road heavy truck, as well as the off-road, we participate both in the first-fit solution, designing the OEMs' solution to help with their first-fit solution and then participate in the aftermarket in terms of the replacement parts.

We also participate in the Aerospace and Defense business, about 2/3 of that is defense or military applications, about 1/3 of that is commercial aerospace, in terms of fixed or rotary ring -- rotary-winged aircraft.

On the other side of our business, the Industrial Products Group. Very diversified, in terms of the types of end markets we serve. The first is the Industrial Filtration Systems business. The picture here is an example of a Torit dust collector, which is the -- dust collector is the biggest piece of this Industrial Filtration business. This would be a dust collector outside a factory, outside a -- maybe some grain handling, anything where there's particulates to be removed from an industrial workspace.

The largest application we sell is a gas turbine inlet filter. This system here is multiple stories high. We will design and build, through subcontractors, that housing and then inside the housing, on that intake side, there's hundreds of filters there that are cleaning the air prior to it reaching the turbine, gas turbine, for electrical production.

And then, purposely, we go from our largest application to our smallest. We also provide filtration in hard disk drives, both to take out moisture, as well as other contaminants that could affect that drive. So great diversity terms of the end market applications and even the size of the filter solution.

Today, we're a very diversified portfolio. The Engine business makes up 63% of our business. The Industrial, 37%. In terms of geographic mix, we're greater than 50% outside the Americas, and the Americas includes Latin America, so even more so outside the U.S., 23% Asia-Pacific and 30% in terms of Asia.

In terms of the mix between our first-fit and aftermarket dollars, we're 50-50 right now, in terms of first-fit solutions versus replacement parts. And we think this diversification that I've just been talking about really does work. Back in the early 80s, we were primarily a diesel engine, North America, first-fit-focused company. And we went through a lot of ups and downs in terms of the cyclicality of that market. And as you see, once we started to focus -- the new management focused on how do we diversify more international, more replacement parts, more industrial other than diesel engine. And once that started to kick in the early 90s, you see, previously, we were 6% compounded annual growth rate. Since then, we've been 18% compounded annual growth rate, which really emphasizes that, that has worked.

During that same period, which included the recession, our sales have grown 8%, including the impact of '08 and earnings up 15% during that same 23-year period.

We also focused on the quality of our earnings, not just growing, but growing well. We have an internal threshold of 15% ROI. We've hit that, as you see here, since 1990, every year except 2 on that chart, and some cases exceeding that fairly significantly.

This chart -- we also invest significantly in the business because we see a lot of opportunities for growth here over the next, really, the next decade. This chart here, on the top line, is capital expenditures as a percent of sales since 1990. We've historically been between 3% and 4% of our revenues, sometimes it ticks up a bit higher in terms of -- maybe we're adding a significant piece of capacity. Sometimes, like through the recession years, '08, '09, we did dip a little bit below that, but we've been ticking up. So, generally, we're between 3% to 4% of our revenues in terms of CapEx.

In R&D, we've been between 2% and 3% over the most recent period of time. And that's while our revenues have grown 8%. So on a real dollars standpoint, we're continuing to invest a lot more in R&D.

We've also consistently been able to raise our dividend. Our stated dividend policy is that we will pay our dividend based on 25% to 30% of the trailing 3 years earnings per share. So that's resulted in a 14% compounded annual growth rate. And also resulted in about a 1% yield over the most -- past few years.

In addition to dividend growth, we've also been believers in a consistent share repurchase philosophy. Over the period since 1990, we've reduced our share count 2%. Over the last 5 years or so, we've changed our repurchase philosophy a little bit. We used to buyback 3% on a gross basis, which gave us a 2% net after dilution from things like options. Over the last several years, we've been buying back -- or had our stated target be 2% gross, 1% net. But we're opportunistic, depending on whether we have a lot of acquisition opportunities, whether the market dictates. But, over time, we've stayed at 2% gross to get a 1% net.

We also think we're quite a bit different in terms of the management compensation and stock ownership requirements that we have. So our management philosophy, in terms of annual incentive comp, is 2 pieces. One is we have an annual incentive, which is based on sales growth, operating margin, ROI and EPS. That's sort of the framework. It's pushed all the way down to even the plant levels, and they'll have pieces of this, but then they'll also have things like safety and things that are particular to a plant. But on the management team, many of these goals only start with what we call a record. So EPS, our EPS last year, was $1.73 for fiscal year '12. The 0 point is $1.73. So unless we set a new record on things like sales or EPS, we don't get a payout. So it's encouraging us, in terms of record, is the mentality. And you'll see, over time, we've had records every year except for '08.

The other piece of it is the long-term incentive. We have a 3-year rolling plan where management is compensated based on sales growth targets, as well as ROI. So that balances it out. Not just any sale, it has to be quality sales in order to hit both the sales and the ROI targets.

In terms of ownership requirements. We think we're as high or maybe the highest of industrial companies that -- we think we're unique in this regards, in terms of the requirements of officers having 5x to 10x their base salary rate in stock. Directors, 5x their retainer. And then we have also have requirements that once you reach those levels, and exercise options, you're also required to hold a percentage of those option exercises. So our CEO see, for example, is well in excess of then 10x.

We also have 15% of the company owned by employees. So, by employees I count both current and retired, as well as our directors. So we think that really adds to a culture of this -- not only are we shareholders -- not only do we act like shareholders, we are shareholders in terms of how we think and how we act for a large portion of the employee base.

I'll spend just a minute on the most recent quarter. Before I turn to, some maybe longer-term views. We've had a challenging year. We started out our fiscal year, which is July year end. So we started in August with a lot of high expectations that we're going to go back on the 8% to 10% growth path. And I think as we got to the fall, we were really probably surprised a bit in terms of how some of the industrial production really slowed, a lot of focus on inventory corrections that really impacted us during our first quarter, and then our second quarter, and we've been able to adjust in terms of our headcount, in terms of our spending, in terms of some of our discretionary spending. So we're up 3% on revenues this quarter and down slightly on our EPS. Our first quarter was little bit tougher because that decrease in demand from some of our OE, both on-road truck and off-road, hit us quite quickly and we weren't able to adjust to some of the absorption. So off a little bit more on a year-to-date. But now, as we look forward, we think most of that inventory de-stocking is behind us. Not all of it, but most of it, especially on the aftermarket side. So we're projecting, for the rest of this fiscal year -- or for the full fiscal year, is that our Engine sales will decrease slightly from fiscal '12. That does assume -- that's mostly related to the slow first half, so it does assume some improvement in our second half of the fiscal year. Our industrial sales are now projected to be up 1% to 6%. The big driver there is our Gas Turbine business, that's a business we have a lot of visibility to, in terms of the lead times and the orders. So we feel pretty comfortable in terms of how the Gas Turbine business looks for the rest of the year and that's up 27% to 32% for the year. So it's an example of how our diversification model really does work when one business is down, another one is able to pull through and help that out. So we're looking at the full year guidance to be approximately equal in terms of revenue to fiscal year '12. And we struggle with that a little bit because we're always looking for the 8% to 10%. But a flat with a record year in a pretty tough environment is -- we'll reset this year and look forward to next year to get back on track for the normal growth patterns. So what that looks like is $2.5 billion, $1.61 to $1.81 EPS. We were $1.73 last year.

Turning a little more long term. We have set strategic goals out to fiscal '16 and fiscal '21. And they're not just pulled-out-of-the-air type goals. We've challenge all of our businesses, in each region, to build up their detailed plans. Obviously, things will happen differently than that. But we've really challenged everyone to build up. Where are the opportunities? Where can you grow and how can we get there? We really do believe we can get to be a $3 billion company in fiscal '16 and a $5 billion in fiscal '21. And the way we’re going to do that is, essentially, more of the same. We need to be more international. We have a lot of opportunities for market penetration outside the U.S.. More industrial. We want to continue to grow the industrial businesses faster than the Engine businesses, even though we're going to continue to grow the Engine businesses. More replacement parts, and I'll talk a bit about some of the strategies on that. And more liquid. This is one of the newer pieces to the diversification portfolios, to focus more on growing our liquid businesses.

If we think about the filtration market, it's about a $50 billion market. And we don't participate, by design, in some of these markets. I mentioned at the outset, we don't do automotive or water, there's different reasons for that. Maybe automotive, it's something that the technology isn't doesn't quite as valued, you're not protecting as significant of an investment as maybe you would be a $300,000 piece of mining equipment. In water, we often get asked why are we not in water? It's really not a technology, that we have, that we can bring a big differentiation to the market today. So what we've decided to do is focus on $20 billion of this $50 billion market. And by doing that, we think -- only -- we're about a $2.5 billion company today, so we have a lot of runway, we have a lot of technologies that we believe we can take from the portfolio and apply those to other areas within this section, a cross section of the market. So these are the industries that we're focused on, and we think there's a lot of opportunity for us to make further penetration there.

In terms of our sales growth objectives. We often get asked, how do you look at or how do you expect to continue to grow 8%, 9% or 10%? First, in terms of longer-term -- I know, obviously, this year -- maybe this isn't the case. But GDP, over time, has grown about 3%. Some, higher in certain economies, less in certain others. The filtration market has grown about 2% higher than GDP, and that's historically, and we think that will continue as more expensive equipment, more automation requires more sophisticated filtration solutions, more applications in some of the developing world that continues to expand that market.

Market share gains. We've grown 2% to 4% over time, and we believe both from emerging market, more penetration into areas we're not as strong, as well as further retention on the aftermarket we think we can continue to grow that through things like PowerCore. And acquisitions are sort of icing on a cake. We look at acquisitions for either adding the technology that we don't have, may be accelerating some of our organic growth. But generally, we are an organic growth company. But we look to acquisitions as more bolt-ons, average 1% to 3% from a revenue growth over time. And that adds up to the 9% to 10% growth.

In terms of our model. It's fairly, fairly simple. But it helps to reinforce to everyone especially within the company where our priorities are. First, create the whole to work with our OEM customers to help solve the problems they have to design unique, first-fit applications, which helps us to sell the replacement parts, which then helps us take the penetration, the market, the profitability, we are able to develop on replacement products and create additional reinvestment in the integrated technologies, new first-fit solutions.

In terms of how an innovative first-fit solution helps us gain additional market penetration in the aftermarket. If we think about a non-innovative, not PowerCore, not maybe our SELECT fuel solution, where it's maybe not unique in the marketplace that somebody else could come out with a competing solution fairly quickly, we, historically, have gotten down to about 20% aftermarket retention after a couple of years. In situations, now, we've been focusing more on the innovative type first-fit solution. We essentially take that 20% up to close to 100% in terms of the aftermarket retention. And that's a win for us and it's also a win for our OEs, because we're selling the OE's this replacement part and they can sell that through their channel as well. So it helps them with their focus on their aftermarket.

So, looking forward, in terms of what our portfolio objectives are. We'd like to grow the Engine business faster than -- I'm sorry, the Industrial faster than Engine. So that would represent pretty aggressive growth on the industrial side by fiscal '21. We want to continue to expand our growth outside of the United States. So this chart shows Asia-Pacific up to 33%, which is almost tripling the Asia-Pacific business over the planning period. So pretty significant growth objectives there. And same thing on first-fit versus replacement. We want to grow replacement to 55% while still growing the first-fit.

And the one we've added, over the last couple of years, is drilled liquid. Our liquid businesses about a $400 million business today. We want to take that to over $1 billion by the end of our planning period. So significant growth targets there as well. Maybe take the last couple of minutes just to talk about a couple of the more unique technology solutions that we think will help us to grow that replacement part business.

PowerCore is probably the most obvious one where we even thought quite a bit about PowerCore. On the left here is that the conventional cellulose filter that has been on the market for many years, that's probably an example of where our retention goes down to maybe 20%. One of the key problems for our customers has been with some of the new emissions requirements, there's been a premium for space under the hood. So they wanted a smaller solution in terms of the housing and the filter and we've been able to design PowerCore, which shrinks the footprint of the filter housing considerably and also allow both us and our OEM customers to have a higher percentage of the aftermarket replacement parts and now, recently, we've introduced PowerCore G2 or Generation 2, which is 30% smaller than the first ones. We're continuing to reinvent ourselves as we move forward and innovate and help shrink that space, an example of solving the customers problem.

This is an example of taking PowerCore to the industrial side of the business. On the right is a dust collector, that is a -- -- I'm sorry, a baghouse, which was taking contaminants out. Baghouses were a market that was hard for us to penetrate because there's not really a unique way to make a better felt bag. So what we've done is, with PowerCore, introduce a solution that's 50% to 70% smaller, a technology that's much easier, cleaner to change out, so the factory isn't down as much. And a much more unique solution that gives us another market opportunity.

And the last one is SELECT fuel. So over the last several years, there's been changes in the fuels in terms of bio-diesel creating new problems, as well as some of the newer engines having higher requirements for contaminants that maybe could get through before and not cause a problem but now with some of the higher injector pressures could really cause a problem on the fuel injectors, to the extent those contaminants got through. So our new product, SELECT fuel, has allowed us to capture all of those new contaminants or higher requirements but last just as long or longer than the existing filter. And that was the problem that the OEs challenged us with is they don't want to have to change out these filters so often because of the new requirements. And we've won 8 new programs on that, that'll go in over the next couple of years.

So, in conclusion, we continue -- we use the word diversify a lot. We are a very diversified company, diversified product lines, deeply integrated with the global economy. We feel we have a very balanced business model and continue to committed to both growth and financial performance. And I think this last slide is probably one of our favorites because it sort of says it for us, in terms of -- that the strategy is working. If we look back to fiscal year 1989, $100 invested in Donaldson, which is the one on the top, versus the S&P 400 on the bottom, really has expanded that gap in terms of return to shareholders over time, and our goal is to continue that separation as we move forward and execute on our strategy. So with that, I think there's like 1 minute left. I don't know. Any quick questions?

Question-and-Answer Session

Unknown Analyst

[indiscernible] As you look at the 2016, 2021 goals, especially given that kind of product shift in there, what are you look at for margins?

James F. Shaw

What we've looked at for margins is not maximizing the margins as we move forward but incrementally improving those over time. So we need to continue to invest back in the business on things like our R&D, our -- expanding our distribution, especially overseas. So what we've said is we should get margin expansion by a higher penetration of the aftermarket. And also just leveraging some of our fixed costs, aftermarkets generally 100 to 200 basis points better on an operating margin standpoint. So what we've said is probably about 20 to 30 basis points improvement year-over-year is our target. This year it's going to be a little more challenging just given some of the things that happened to us in the first half of the year. But on a normal growth year, that's what we're targeting. All right.

Hamzah Mazari - Crédit Suisse AG, Research Division

On the engine side, you've spoken about your visibility being much lower. And so you had to cut guidance based on OEM production ramp up slower than usual. It seems like the truck numbers have come in better. I know you're mostly off-road versus on-road. But are you confident that you guys have got numbers enough and Engine seems to be now improving based on new data points?

James F. Shaw

Yes. With the on-road truck, we are seeing some encouraging build rate numbers creeping up. So I think that's encouraging. I think we're still optimistic on ag. I think we have a little more concern right now in terms of maybe some of the mining in terms of where that's headed. So we feel like we're in the 50%, greater, or less likely. But it does assume, especially in our fourth quarter, some recovery on the engine markets.

All right. Thank you.

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