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Donaldson Co Inc. (NYSE:DCI)

Bank of America Merrill Lynch Global Industrials & EU Autos Conference 2013

March 19, 2013 11:30 am ET

Executives

William M. Cook - Chairman of the Board, Chief Executive Officer and President

Analysts

Andrew Obin - BofA Merrill Lynch, Research Division

Andrew Obin - BofA Merrill Lynch, Research Division

Good afternoon. Andrew Obin, BofA Merrill Lynch's Multi Industrials and E&C analyst. We are starting, the end of the day is near, so that's good. But with us we have Donaldson, global manufacturer of filtration products. I guess I've covered the company for many, many years, and I have to say it really is one of my favorite companies to cover. So I'm very pleased that I get to cover it even in my new capacity, very excited about that. So with us we have Bill Cook, the company's Chairman, President and CEO; and we also have Wim Vermeersch, company's Vice President of Europe and Middle East.

And with that, I'll let Bill speak. Thank you very much for being here.

William M. Cook

Great. Thanks, Andrew. Thank you all for your time and attention. I'm not sure if he says that to all of his companies about being the favorites or not, but I do appreciate that. So Arnold, does he say that to everybody else, too?

Unknown Attendee

No.

William M. Cook

No? Okay, right. Well, anyway, it's a pleasure to be with you all, and we'll have some time for questions and answers at the end. And also, I put copies of the slides outside if you're interested at the end to pick those up.

So before I get started, my general counsel makes sure I always have to say this that there are forward-looking statements in this presentation, so the actual events may be different than what we present today.

So who is Donaldson Company? We are a filtration company. We've been in business for almost 100 years. And really, what we aim to do is to be the technology leader in our markets and then use our technology to build out a diversified portfolio of businesses around the world. We weren't always like that. Up until about 25 years ago, Donaldson Company was mostly in North America, mostly focused on heavy trucks and off-road equipment and mostly first-fit. And what happened in the early '80s, and this is isn't a picture of me, I was never this cute. But I just want to pull your attention to the blackboard, we've been using this slide because it really represents what Donaldson did in the middle '80s. In '83, some of us probably remember there was a twin recession, and Donaldson Company lost money for the first time since the Great Depression. Frank Donaldson, who is our Chairman, and his CEO at the time decided to change the model of the company. So they said, mostly North America, mostly heavy equipment, mostly first-fit. Let's diversify the company, make it a more stable platform for both the customers, the employees and the shareholders. And so that's the journey the new Donaldson has really been in the last 25 years in terms of this journey of growth through diversification.

So what do we do today? We have 2 reporting segments, the first is Engine Products, and this is really part of where we started back almost 100 years ago, but we've expanded it. So today in the Engine Products, we sell air filters, liquid filters and exhaust and emission products. So the way to think about Donaldson in this area is we clean the air going into an engine, diesel engine; we clean the liquids around it, the fuel, the oil and hydraulic systems; and we treat the gas that's coming out of it for particulate or noise.

And this would be some of the typical applications that you would see. So we're on-road heavy trucks, off-road construction, ag, mining, defense. And then we do have an Aerospace and Defense business, which is both military vehicles, and the aerospace part is both commercial and civil aviation.

The other reporting segment is Industrial Products, and these are the newer businesses in Donaldson, the ones that we've been really focused at growing to help provide that diversification. And there's a couple of different product lines or businesses in here that I'll cover. So the first is Industrial Filtration Systems. So this is all types of manufacturing products found in a manufacturing plant. So this is an industrial dust collector that would clean the air in a plant. So it might collect welding fume, it might grinding particulate, particles from a woodworking operation. Whenever there's a particulate fume or mist that's generated that has to be cleaned up, that's what we're doing there.

The largest filters we manufacture are for gas turbines. This is probably the size of about a 4-storey building. You can see a stairs there on the platform. This is the filter. The turbine is actually back here. So we design and fabricate those filter houses, and in there could be hundreds or, in some cases, thousands of replacement filters.

And the smallest filters we manufacture are for hard disk drives. So in a laptop, there's a hard disk drive or on a server PC, and there's 2 or 3 filters in there cleaning the air in the drive.

You might be thinking, what's the common thread between these 3? It really gets back to the technology. We invest centrally in our R&D, and then we find ways of leveraging that across as many different markets as we can looking for growth and diversification as we do that. So even though these are very different, the -- some of the base technology is the same, how they capture and retain particles. And we can leverage that.

So we look at diversification in a couple of different dimensions, so this is split between Engine and Industrial. So the newer businesses, the Industrial businesses, now represent about 37% of our sales. By geographic mix, we've actually made the most progress. So I mentioned that 25, 30 years ago, we were mostly in North America. You can see that actually the U.S. is about 40% of our business, with Latin America it's -- Americas is 47%, but you can see over 50% of our revenues now are outside of the Americas between Asia Pacific and Europe. And as Andrew mentioned, Wim is responsible for our European, Middle East and North African businesses.

Next to mention is the split between first-fit and replacement parts. Again, we were mostly first-fit 25 years ago. So almost everything we sell on a first-fit has a replacement part component. So almost every -- whether it's a truck filter, a gas turbine filter, a dust collection filter, those need to be replaced, and they might be -- they're going to be replaced for the life of that equipment, which in some cases can be 20 or 30 years. So it's that classic razor-and-blade analogy. And what we want to do is capture as much of the blade business as we can.

So there are really 2 key slides that if you're not paying attention to anything else I say that I ask you to look at. So this is the first one. So this plots a 20-year CAGR and share price appreciation through the '70s and '80s. That's back when Donaldson was a very cyclical industrial company. The CAGR was about 6%. I mentioned that we changed -- started changing the model here. By 1990, we actually got traction on that in terms of being more stable business, and you can see what's happened to the share price CAGR. So about 3x what we did over the previous 20 years, and our goal is to continue that. To me, this validates the change in the model, that what Frank Donaldson decided to do in the mid-80s and what we've been implementing for the past 25 years really did work for our shareholders.

So the new Donaldson starts about 1990, where those blue boxes started. Since then, including the recession, we've grown sales at an average CAGR of 8% and earnings at about 2x out of 15%. This is almost all organic. The organic piece of that is over 7%. So we're mostly an organic growth story, which really fits our model of delivering more consistent financial performance.

We'll talk about revenue growth, earnings growth. The third metric we use to run our business is ROI. We set a target for the company of 15%. And you can see over that 23-year period, 21 out of the 23 have been at 15% or higher. The 2 that were slightly below were between 14% and 15%.

Now the word consistency is something you hear a lot about Donaldson. Some people call us boring, okay? But I don't know whether they're talking about me personally or about our performance because it's boringly consistent. But our dividend policy has been consistent for over 20 years. We pay out between 25% and 30% of the average of the prior 3 years' EPS. So as earnings have grown, so have the dividends of 14% CAGR.

We've had a consistent share repurchase philosophy. So we don't commit to doing an exact amount each year because it's obviously subject to other uses of the cash and the share price. But historically, we've said we want to target to repurchase 3% of our outstanding shares, which after new option grants should result in a net 2% reduction. And you can see that the decrease in the bars isn't equal, but that's actually what we've averaged over that 23-year period, is a net annual reduction in shares of 2% per year. I think during this period, we've had 4 stock splits -- 4 or 5, I can't remember. But that's -- this is another great way that we see of returning value to our shareholders.

Another thing that was put in place in the middle '80s was our compensation system, so it's all around the numbers. So our annual incentives is based on really 4 components. It's revenue growth, operating margin, return on investment and earnings per share. We don't get paid on the earnings per share component unless we're over record. So it's not related to plan or budget. It's you have to be over the previous record in order to get into the range. And then our long-term incentive is it's got the revenue growth and ROI. So we got ROI in both our short or annual and our long-term plans really to help manage the quality of the earnings and the revenue growth.

Another thing that was sort of fundamental to the execution of this diversification strategy was share ownership requirements. So the officers of the company are required to hold between 5 and 10x their base salary in Donaldson stock. That does not include options. So that's in holdings. We're given 5 years to get there. And then -- so mine is 10x my base salary in Donaldson stock. Once I got to that, I still have to retain 25% of my -- any options I exercise. So actually now my target, I think, it's about 15x my base salary, I'm there. But I mean, it's part of the model of making sure the management is thinking about the long-term value creation, and that we're not speculating or trading in and out of the stock. So it's about holding the stock until we retire or leave the company and building that perspective in the management team. In addition, we did an ESOP in the late '80s for many of the employees in the U.S. So about 15% of the company today is owned by employees, officers or directors. And we think even for beyond the management, having the general employees own the stock builds in that sense of ownership and long-term value creation.

So we're a July year end. So this is our fiscal second quarter results, which we announced about a month ago. So we had -- the second quarter was -- our sales were -- it's actually record sales at about a little bit under $600 million for a second quarter, up about 3%. But it's certainly not what we had planned when we started the year, sort of this -- the economic weakness that we started to see in September and then the destocking that we saw in -- near the end of the calendar year sort of suppressed us from -- in terms of comparisons to where we were last year and that's -- the year-to-date numbers are on the right in terms of year-over-year for the first 6 months.

As we look forward, so for the balance of -- for the full year of fiscal '13, which ends in July, we see our Engine sales decreasing slightly from last year. Our Industrial sales driven by our strong Gas Turbine segment should be up between 1% and 6%. And so the company will be approximately equal to the $2.5 billion record we set last year. The operating margin, we're looking at between 13.9% and 14.7%, so the high end of that range would be equal to the record we set last year, an EPS of $1.61 to $1.81, so they're bracketing what we did last year.

So we're in a period of economic weakness for many of our end markets. But as we look forward, we have a strategic plan that we've been working on for the past 7 years. And our goals are to build our company into a $3 billion filter company by fiscal '16, and then $5 billion by fiscal '21. When we ended last year at $2.5 billion, we were actually ahead of the pace to do that. So we're ahead of plan. This year, at flat sales, it's going to take us back maybe closer to the original plan. But despite the economic weakness that we see, we still clearly see the opportunity to do this over time. The filtration market provides great opportunities for us, and we're well positioned to execute. And how we're going to do that is really through further diversification. So as you look out to what Donaldson Company is going to look like in fiscal '21, it's going to even be more international it is today, more industrial, more replacement filters in all the markets where we have that opportunity and more liquid filtration. And I'll talk about each one of these a little bit more.

Just starting at the global filtration market. It's estimated by experts at being about $50 billion in size, and we're really targeting about 40% of that. So about $20 billion is what we're going after where we either have products today or the technologies that we can convert into products that allow us to differentiate. And typically, we target markets not only where we have a technology differentiation, but where there's a technology requirement for better filtration and customers are willing to pay for it. So not included in the targets that we're looking at are segments like auto. We're not in that because it's not a technology-driven market for us, where the customers aren't willing to pay for it. But we see the sum of these being about $20 billion. And so if we're $2.5 billion this year, you can see we have lots of runway, we believe, to grow into the $3 billion and the $5 billion strategic targets that we have. So if you build up, looking forward, how we think we're going to get to the $3 billion and the $5 billion, in normal times we assume that GDP will get back to about an average 3%. The filtration market grows at 100 to 200 basis points faster than GDP. It's just a function of the market, the need for cleaner and cleaner filtration environments. Historically, we've averaged 2% to 4% per year in share gains. So that's actually what we've done over the past 20 years, so we think we can continue to do that. And then acquisitions would add 1% to 3%. Now we haven't done that. So that's the one change from what we can take a look at over the last 20 years, we want to step up our acquisitions slightly. So if we took the midpoint of that, that would be 2% per year. At our current size, that would mean we'd have to add about $50 million in acquisition acquired growth each year. So it's not that big, but it's typically bolt-on acquisitions in markets that we're currently in. And the sum of all that gets to the 9% to 10% that we're targeting going forward.

A lot of our model is built on this razor-and-blade analogy. So you think about -- we want to design a unique razor, create the hole, so to speak, and then sell the replacement filters, that annuity that goes on for 10, 20 and 30 years, and then use the profits from the aftermarket to reinvest back into the first-fit to create more holes. So just the continued razor and blade, and just keep working that circle over and over again.

And we're doing that through technology. So if you've followed Donaldson for a number of years, we've always been the technology leader in our markets, but we tended to let the technology get stale. And if we design a new filter, on Day 1, when that piece of equipment, whether it's a truck or tractor, is out in the field, we start out with our OEMs at about 100% share. But if it's not designed with proprietary technology, you can see it starts to degrade our market share pretty quickly. And so maybe by the end of the fifth year, you're at 20% to 30%. So our model changed in terms of how we think about this to saying if we're designing the first-fit system, why don't we make it really hard for people to replace us, to [indiscernible] us. And working with our OEMs, they have the same model now because they want to retain that replacement parts business as well. So what we're doing is using new technologies, and I'll show you an example in a second, like PowerCore, where through patents, through trade secrets, we can keep that proprietary for maybe 3 to 5 years, so close to 100%, and then it starts to degrade. So essentially what we're doing is we're picking up all that blue area of that curve incrementally over the way that we were doing it in the past.

So this is an example of how we do that. This is a technology Donaldson designed about 20 years ago. It was really -- it was pretty innovative at the time but we left it out there for about 12 years. And over time, sort of that -- it followed the red line. So this is PowerCore Generation 1, which we released about 8 years ago, has the same performance, same life, same efficiency as this, half the size. So we can shrink the size of the entire system by about 50%, which is on a first-fit application is a big deal, less space, less weight. And then for us and our OEMs, because it's a smaller system, this type of technology, they could try and put something in there but it'll plug. It won't work. So this is what we get when we do the proprietary technology, we get the blue curve.

The other change is we said we're not going to leave this out there for 10 or 12 years waiting for somebody to knock it off before we start inventing the next generation. When we released this, we started working on the Gen 2. So this has the same life and performance, all 3 of them. It's about 1/3 smaller. So again we can shrink the size of the system, and nothing else will fit in there for a period of time. So you keep raising the bar in a more frequent basis. That's the model. We released Gen 2, we're working on Gen 3 already. So that's the change in the model to give the OEMs better value on the first-fit, but really to protect that aftermarket. This is one example. We have lots of examples on both the air and liquid side of how we're doing that.

So as we look out to fiscal '21, this is how we think the company will look. And again, we'll be $5 billion in size at that point. And I should mention, these aren't aspirational plans that I came up with. These are the culmination or summation of really the detailed plans by business and by region. So we have the action plans to execute this. We think we'll be close to that 50-50 split between Engine and Industrial, which has been a long-term target. We're actually very close to 48% for Industrial. Geographically, we see Asia Pacific growing very significantly over the planning horizon. So by fiscal '21, each of the regions will be roughly 1/3 of the total pie.

I should note all regions are growing. It's just that Asia Pacific is growing faster. Replacement parts currently 50-50. We think that'll be 55% or higher. We think maybe it could get as high as 60%. Both parts of the business are important, the first-fit and the replacement parts, but our market shares in the replacement parts are lower, so it should grow faster. And then liquid filtration is currently about 18% of our business. So as I mentioned earlier, we're selling oil filters, fuel filters and hydraulic filters for diesel-powered equipment. We think we can essentially triple that over our planning period to 25% of our sales, about $1.2 billion.

I showed you the PowerCore. Here's a larger depiction of what we're trying to do. We've already sold 19 million units. We have about a 90% win rate when we offer this technology, so very, very well accepted. The G2, we've started introducing that, 1/3 smaller, and we're working on G3.

So the idea is just to continue to refresh this. This -- you might think, "Well, what's the big deal if you reduce this by 1/3?" But this is for a very small application. I did this because I'm old, and I don't like to carry big filters around, okay? If you think about a truck filter, a gas turbine filter, each one is about this big. So that -- we're still talking about a very significant benefit from size reduction when maybe the G2 is still like this big. So we see that we have a runway to do this at least through a couple more generations.

We've also taken that technology, the PowerCore, and applied it to industrial air filtration, so dust collectors. This is a competitor baghouse on the right, and this is our system on the left. And you can see the size difference. So again same advantages, tremendous reduction in size, space, easier to maintain and proprietary replacement filters. So we lock up the blade business.

On liquid filtration, we're leading with technology there as well. These higher performance, new higher performance diesel engines are running at higher fuel injection pressures in a common rail system. So they need better filtration particles at lower pressure that weren't a problem or are a problem in higher pressures. So we have a new filter media, the membrane that actually does the filtering called Synteq XP, and we've already won 8 OEM platforms with that technology.

So that supports that growth rate that I mentioned a minute ago in liquid filtration.

So I just -- to wrap up, I just want to offer some conclusions, the journey that we've been on the last 25 years. I think we've done a good job of diversifying product lines and geography so far, but we're not done. We're very deeply integrated in the global economy. We have 40 plants around the world serving our customers, 24 of those outside of the U.S. So we are -- have invested where our customers are going and need us to be. We have a, we think, a very balanced business model between growth, ROI and earnings growth, and we're committed by virtue of our incentives and shareholder -- and shareholding requirements to growth and financial performance. So this is the other second important slide. So again, I'd just call your attention to this. This is plotting our return to our shareholders over the past 23 years versus the S&P 400. And our goal is to continue to increase the spread between those 2 lines, and we have the business model and the strategic plan, which I believe will -- allows us to do that.

That was the presentation. Andrew, do we have time for some questions?

Question-and-Answer Session

Andrew Obin - BofA Merrill Lynch, Research Division

Sure. Any questions? Okay, I'll ask the first question. Thinking about your outlook for the year, right, the beginning of the year was somewhat slow and disappointing. I think you're expecting some acceleration in the second half of the year. Given what you're seeing in the order book, what you're seeing from your customers, what gives you comfort that we will see the acceleration in the second half of the year?

William M. Cook

Yes, it's a good question. Things have changed a lot over the -- for us in the last 9 months. So we started the fiscal year in August, and we had plans to grow 9% this year, and we're not going to do that. What happened very quickly in September and -- middle of September is that basically like somebody dialed the switch back. Everybody started to ratchet back production and then destocking. I think a lot of the destocking on both equipment and inventory is behind us now. So that's a headwind that we're not going to -- we're not facing now with the possible -- with the exception of China. There's a lot of equipment that's been built up in China that has to be worked through, but I think the rest of the world, the destocking is behind us. We're watching the same indicators all of you are. We're seeing sort of sequential improvements. They're not maybe heroic, but we're seeing better numbers, things like PMI. We're talking a lot with our customers about what their outlooks are. Caterpillar being our largest customer, so we talk a lot with them. And so we're -- and we get some seasonal lift, typically, in the second half of our year versus our first half. So that was the basis for the guidance. The customer comments, feedback, the seasonal uptick, the absence of the destocking, really that's what we're looking forward to. We don't have tremendous amount of visibility in our order book. I mean, people are waiting for the last possible minute to order. So I mean we're -- we see some encouraging signs, and we're just going to have to see how it plays out.

Unknown Analyst

[Audio gap] do you think you have in China?

William M. Cook

We don't have a lot of inventory. It's our customers. So there's a lot of -- depending on what type of vehicle, whether they're talking about wheel loaders or excavators, it could be months of inventory. I know Caterpillar has talked about actually trying to export equipment out of China to other parts of the world to sort of sop that up. So I think a lot of people are trying to do that, is work that inventory down as quickly as they can.

Unknown Analyst

What's your sense -- because you guys also have a sense of the aftermarket business, you have a sense of utilization. So destocking versus utilization, have the 2 disconnected? Meaning is utilization data from the field is better than what you would see just based on the new orders because of destocking? Is that what's driving the optimism?

William M. Cook

Well, the destocking actually sort of was noise in the whole thing, okay? So in spite of what was happening with utilization, say, the last calendar quarter, the people between us and the users of the equipment were taking stock out, they weren't ordering from us. So that part is behind us. I think the demand that we're seeing now is more representative of what we actually think is being pulled all the way through to the field. And we're seeing ton-mile indicator as we look at different industry indicators that sort of talk about how equipment is being used. Those are all improving. So that supports an uptick. It's just going to be -- it's a question of how strong it is so -- but the absence of destocking is going to help us quite a bit.

Unknown Analyst

Given what the environment is doing in terms of the top line, if I look at your CapEx plans, and historically, you guys have some sort of internal capital allocators, you spend it internally for growth. I mean, your CapEx does imply capacity additions. In FY '13 CapEx, I think, is going to be up 20% or something. So where are you adding capacity? Why are you adding this year? And how does it fit in the long-term plan?

William M. Cook

We are not in a burn-the-furniture mode, okay, because we have a strategic plan. So we want to get to the $3 billion and $5 billion, and we -- it's a long lead time in terms of starting the capacity far enough in advance of when you actually need it, okay? And also we see some opportunities in parts of the world that are actually still growing, like Latin America, very well for us. So what we have done, our original capital guidance was like $130 million for this year, we dialed that back to $90 million to $100 million. Some of that is carryover from last year when we started to slow down some projects, but it's down. But we are doing some capacity expansions, very targeted where we really need it. So we have a -- I was -- grand opening for a new -- for expansion of our distribution center in Mexico in December, so we doubled the size of Mexico because our Latin American business was out of capacity. So I mean that's a good type of thing to be doing. In some cases, we've also dialed back some capacity like some of the capacity we're planning for China, we've now deferred further out because we are going to need it, but we're not going to need it as quickly as we thought. So the capacity expansions are less than we had originally planned. They're -- what we're not doing now, we're deferring, we know we're going to need it eventually, but we don't need it as quickly, and where we're adding it is because we literally need it to support the current business.

Unknown Analyst

On your plan, your outlook, can you talk about your biggest concerns of you -- why won't you get there? Is it doing these acquisitions? Is it your GDP forecast of 3% might be too high? What's your -- what's the biggest risk to your long-term plan?

William M. Cook

Well, Wim and I were asked this question like what keeps us awake at night. And there's a couple of things. I mean, one is if we're stuck in sort of this very slow or no growth mode. It's going to change the year as to when we get to the $3 billion and the $5 billion, okay? I mean, it seemed like we came out of the recession. We did a lot of good work in the recession on our operating margin, sort of had a step function improvement. But now really we're set up for growth. And that could change the year, and so we might not be able to get to 9% to 10%. But it's a question of whether we get stuck or not. I think we can still grow because there's the share opportunities that we can take, but it's probably going to be harder to get to the 9% and 10% if we're seeing 1% GDP growth. I'm hoping that's not the case, but I worry about that. But I can't control that, okay? So what we're doing is focusing on the things within our business that we can control. Typically, when our growth slows down a little bit, we really ratchet up our Continuous Improvement initiatives to really try and wring as much as we can out of our margin. It's a good time to do it. We're also working on a lot of new customer platforms, which aren't going to generate sales now, but they're going to generate sales 2 or 3 years out, so that's around market share. So we shift the balance of what we're focused on. Really, we're trying to get that balance between protecting our financials in the short-term, while not missing any long-term opportunities. I worry about sort of competitors. They all see what we're trying to do in terms of being the technology leader. And so I'm sort of -- I'm paranoid about somebody trying to steal the technology leadership, and that's why we're doing what we're doing with the successive generations of technology. That's -- again I can't control what they're going to do, but I can -- we can control what we can do, and that's to assume that they're going to try and catch up. If they don't, then we're pleasantly -- then we're ahead of them even further. If they do, we're ready with an answer. So those are the 2 things that I tend to think about. The filtration market is over -- is going to grow because the need for filtration is really driven by the need for cleaner and cleaner environments, whether it's in a disk drive or it's in a new diesel engine. Take a look at the emerging markets and how much -- how old a lot of their technology is on their vehicles. So OEMs in China, in India, in Russia that wouldn't talk to us 5 or 10 years ago now want our technology. And our market shares are very low. So even in a low-growth environment, we have those type of opportunities. So I mean, I see -- I don't see any question of getting to the $3 billion or $5 billion, it's just whether we have to moderate the years depending on GDP.

Unknown Analyst

Can you elaborate on the competitive nature of

[audio gap]

[indiscernible]

William M. Cook

Yes. When we offer a new technology, we are not pricing it as a premium. Where we're typically offering it is sort of the same price or same value proposition as what it's replacing. And we've been asked, "Well, why wouldn't you ask more? It's really different or unique." But what we really want to do is accelerate the adoption rate. We don't want to give a buyer a reason not to try it, okay? They already might be a little bit concerned because it's different enough, okay? But if we say it's the same price, and you get to retain your aftermarket because for us it's all about that aftermarket. Getting this -- in many cases, we're replacing ourselves on the first-fit, okay, because we have a high market share on air -- heavy duty air filters, but it's all about winning the aftermarket. I mean, we give them a better value proposition because it's smaller and lighter but in terms of taking that 20% or 30% that I showed on the red line, up to 100% for a period of time. And that's good for both of us. So it's a premium product but not priced as a premium because we want to maximize adoption.

Andrew Obin - BofA Merrill Lynch, Research Division

Can you tell us, Bill, maybe just to give people a sense of, let's just use North America

[audio gap]

what was your market share historically on OEMs going back maybe 10 years ago? What was your market share of the aftermarket? And as you have started to focus on aftermarket, where is your aftermarket [indiscernible]?

William M. Cook

Yes. I think the -- so we released, probably maybe 7 or 8 years ago, a platform for one of the U.S. -- or it's actually a U.S.-based global truck manufacturer, and we used a technology like this. So as I mentioned, this was introduced in the early '90s. So it's very, very proven technology. It works very well. And it was okay. I mean, okay for the application. But within 1 year, that literally, that chart that I showed, it went from 100% for us and for them down to 25% or 30%. So we sold these razors. It was a new truck but we used old technology that was easily copied. And so we went back to them and said, "Look, here's the missed opportunity." So really rather than waiting for the next generation of truck platform to design, they asked us to do a redesign, so we could do something to increase the capture rate. So most of our OEMs get it now. I mean, 10 years ago, they were probably, "Well, just give us whatever is proven and works." But they all want to keep their parts business now as well. So we can take that 25% up to 100% to keep it there for maybe 3 to 5 years, and then it starts to degrade. So it's very powerful, and it's really just leveraging 2 things. One is our technology investments, and two is our long-term OEM relationships. These are the -- these people trust us, and we have the relationships, so we should leverage that position to introduce technology that's going to keep the business for both of us.

Andrew Obin - BofA Merrill Lynch, Research Division

Could you talk about [indiscernible] talk about it but the pie chart for the end market? You already -- you sort of [indiscernible] as $20 billion right now. That was in a pie chart several years ago. It was [indiscernible], which was 1/4 of that market. Tell us why have you decided to focus on that? And where could this thing be in 5 to 10 years?

William M. Cook

Yes. I think the -- we did a lot of self-analysis coming out of the last recession. So the diversified model had -- we'd gone through other downturns in the previous 20 years. We had 19 consecutive years with earnings records through some good times and some weaker times from the early '90s up until the last recession. In the last recession, almost all of our end markets got hit at the same time, and that was sort of unprecedented. A couple didn't. Gas turbine didn't, but not enough of them that our sales didn't go down. We still had a good year. It was our third best earnings year ever, but it was not a record year. So out of that, we said, "Let's do, sort of, a post mortem. What happened?" I mean, the diversification sort of worked, but not as well as we hoped or I hoped. And we said, well, we took a look at the end markets that we're in, and we took a look at end markets that other people are in, and looked at how they operated through the recession. One of them was like food and beverage, and that didn't cycle either as dramatically or at the same time as sort of all the industrial markets that we're in. So we have a small business, as Andrew mentioned in there, it came as part of another acquisition. So we think we've got some products and some technology, and what we're trying to figure out now is whether there's a way to scale that up to build that out. Now we haven't announced any specific plans. We do have a small business, but it's interesting because it's a big market. There seems to be parts of it that are really driven around technology, and it seems to cycle differently. We have some other ones that we're also looking at also in terms of diversification that we think might offer some cycle to add to the cycle diversification for us. My goal is that the next time we go through a recession like the last one that we have more slivers in that pie that they're cycling differently, so that we can go through it without losing a lot of our sales very quickly in most of the end markets. So it's around adding to diversification, that's why food and beverage is up there.

Unknown Analyst

Can you help us think about how margins will progress going forward? I mean, on the gross margin side, is it predominantly aftermarket progression or are some of these new platforms that you guys are pursuing on a mix effect basis perhaps higher or lower margins? And also just the degree of operating levers that we should be thinking about?

William M. Cook

Yes. I think it's a great question. When we released our strategic plan in 2006, I think our operating margin was 11% or something like that. And I think we talked about, through the planning period over the next 10 years, trying to get to an operating margin of 15%. We went through the recession, and as I mentioned earlier, in times of slower growth, we ply a lot of our resources or more of our resources on business improvements within the business. So we had a step function in terms of operating margin. So last year we were at 14.6%. So we're basically, I guess, 4 or 5 years ahead of -- roughly, ahead of our pace. That step function we don't see sort of repeating every couple of years. I think, looking forward, what we want to get to is a sustainable 15%-plus operating margin in good times and bad. So our guidance would be from where we are now, we're looking at probably on average about a 20-basis point improvement annually, not -- and the reason is, is that we're -- while we get operating leverage, we want to also invest back into our business. So we're trying to grow, as I mentioned a few minutes ago, at sort of 2x the filter market, the filter market, say, 8% or -- excuse me, 4% -- between 4% and 5%, and we're trying to grow at 9% to 10%. That requires an investment back in the salespeople and technology systems to do that. So our model is we want to try and optimize operating margins not maximize them because we want to try and optimize them with their growth. So the sustainable 15% is where we want to -- plus percent is where we want to get to.

Andrew Obin - BofA Merrill Lynch, Research Division

By the way, when I think about [indiscernible] and how it's modeling, about 11% now compared to 10 years ago.

William M. Cook

Oh, I'm not always right so...

Andrew Obin - BofA Merrill Lynch, Research Division

Thank you very much.

William M. Cook

Yes, thank you all for your interest. If you have any follow-up questions or want my card, please stop by.

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Source: Donaldson Company's CEO Presents at Bank of America Merrill Lynch Global Industrials & EU Autos Conference 2013 (Transcript)
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