Monte Carlo Simulation Techniques Show 9% Total Return For Donaldson Company Inc. During The Next 5 Years

Aug.26.14 | About: Donaldson Co (DCI)


Donaldson Company Inc. is a great and stable company based on different financial metrics in the last decade.

The company is diversified in their markets and products. They have stated ambitious goals to increase sales to $3 billion in FY 2016 and $5 billion in FY 2021.

Monte Carlo simulations have shown that on average 9% annual return can be expected at current prices.

Dividend growth of 10% seems sustainable, even with lower than expected sales. Free cash flow payout ratio increases slightly from 35% to 41%.

Investing in Donaldson at a P/E-ratio of 20 instead of 23 improves your expected annual return by 3.2 percentage points to 12.3%.

In one my past articles, I mentioned that boring companies can post stellar results. Donaldson Company Inc. (NYSE:DCI) seems to be one of those companies. Donaldson is a manufacturer of filtration systems and replacement parts. They operate worldwide and their product mix includes air and liquid filtration systems and exhaust and emission control products. But more on that later.

Frank Donaldson founded Donaldson Engineering Company in 1915. The company name would eventually be shortened to Donaldson Company Inc. As of today, Donaldson conducts business in over 50 countries and employs more than 12,000 people. Donaldson is a dividend champion with 28 years of consecutive annual dividend raises.

This article provides an overview of the company, its products and markets and the financial stability. Furthermore, a financial model has been made to construct a pro forma income statement and balance sheet for the next 5 years. Monte Carlo simulation techniques have been used to determine the sensitivity of various outcomes and scenarios. These scenarios give potential investors a better understanding of what he or she can expect from an investment in Donaldson Company Inc.

What products does Donaldson manufacture?

Donaldson is divided into two segments: Engines and Industrial. The Engines segment (62% of sales) manufactures and sells filtration and exhaust systems for off-road and on-road vehicles but also for aerospace and defense clients. The Industrial segment (38% of sales) is geared towards gas turbine filters or more generally, filtration systems on an industrial scale. Their client base includes construction, mining, agriculture, aerospace, defense, and truck markets.

Where does Donaldson do business?

In its annual reports, Donaldson lists three geographic markets: Americas, Asia-Pacific and Europe. The Americas accounts for 48% of sales, Europe 30% and Asia-Pacific 22%. Donaldson is already a geographically diversified company. It is their stated objective to further grow Asia-Pacific sales to 33% of company wide sales in 2021. To show that the company is serious about these objectives, they recently acquired Northern Technical L.L.C., which is the largest manufacturer of gas turbine air filters intake systems in the Middle East. This acquisition is estimated to add $22 million to the top line.

Their diversified portfolio provides exposure to many different end markets and regions that typically are cycling up or down at different times. This means that even though sales in one particular segment decline, the other segments might enjoy positive sales growth. This diversification works much like a regular stock portfolio.

What are future drivers of sales growth?

One of the most important trends or initiatives that should drive sales growth in future years are emerging economies such as Latin America, Southeast Asia, India, China and Eastern Europe. Donaldson entered these regions more recently so market penetration is lower than in more mature markets like North America, Western Europe or Japan. Donaldson foresees pretty significant organic growth opportunities. As an example, here's a short section from their latest quarterly presentation:

For example, in our Engine Aftermarket business, we added 94 new distributors and over 600 new part numbers in the quarter. By having more of our product offering available locally, supported by local distributors, inventory and sales people, we have shown time and time again we can grow our business. As we noted earlier, our global Engine Aftermarket business was up globally 11% in the quarter; in these emerging economies, it was up 19%.

Another important trend is increasingly stricter diesel emission regulations in developed areas like North America and Europe. This forces OEM manufacturers of heavy duty equipment to launch new products with the latest engine technology. This provides Donaldson with new sales opportunities for their best products and also for their replacement business when the heavy-duty equipment gets out into the field.

Finally, Donaldson is constantly improving their products. The PowerCore technology is ramping up sales. In addition to the PowerCore, they are now launching another new air filtration technology called PowerPleat. They've already won some programs with that product which should be noticeable in FY 2015 results.

Recently, Donaldson has received a Master of Quality award from Daimler Trucks for three of their operating facilities. According to Vehicle Service Pros:

The annual program - now in its 27th year - recognizes outstanding suppliers that have received high scores on their quality, delivery, technology and cost performance as measured on a Balanced Scorecard. These suppliers demonstrate an ongoing commitment to continuously improving the quality of their products and overall performance of their businesses.

…The Masters of Quality award winners represent the 'best of the best' amongst our suppliers and their work is crucial to our enduring success.

It's the first time Donaldson received one of these awards from Daimler but it shows that clients value their products and performance.

Finally, Donaldson requires a certain share ownership from their executive officers and directors. 15% of the company is owned by employees (current and retired) and directors. (Source: Investor presentation, May 2014). Does it get any better than this as a shareholder? This means that the interests from employees, management and shareholders are aligned perfectly. As a shareholder, you can expect that everyone at Donaldson will do everything in his or her power to reach the stated sales objectives.

Financial overview

Let's take a look at the financials of the company. In short, they look amazing and really show the financial stability of Donaldson. To summarize:

  • Increasing revenues (6% CAGR) and EPS (11% CAGR) in the last decade.
  • Increasing free cash flow to return to shareholders via dividends and repurchase of common stock.
  • Profitability ratios are stable in the last decade, which means the company makes consistent profits.
  • Liquidity and financial ratios show the fact that DCI is a solidly led company (slight conservative maybe, but that is fine for this type of industry).
  • Annual dividend has grown 18% per annum on average in the last decade. Payout ratios based on EPS or free cash flow are quite low at only 30%.

Down below are 5 figures, which demonstrate these points. The data come from Morningstar.

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What's important to understand is that Donaldson is a rock solid company. Every graph shows that management knows what it's doing. Based on these kinds of graphs we can expect solid performance and execution from management in future years. The question then remains what kind of revenue Donaldson can expect in the next 5 years.

Outlook for next 5 years (2015 - 2019)

In order to estimate what an investment in Donaldson Company Inc. might look like, I have constructed a pro-forma income statement and balance sheet for the next 5 years. Monte Carlo-simulation techniques are used to determine the sensitivity of the total return during this period as a shareholder with regards to various assumptions about sales growth, dividend growth and current P/E multiple.

First off, I'll explain the financial model and which parameters and assumptions I have used. Then I present the base case scenario and what kind of total return a shareholder can expect, coupled with some other financial statistics. Finally, I will show what the effect is of some changes in the assumptions behind the financial model.

Parameters and assumptions of the financial forecasting model

The following parameters are used in the financial model:

  • N(x, y) = Normal distribution with average x and standard deviation of y
  • U(l, h)= Uniform distribution with lower range l and upper range h

Income statement




Sales growth


N(9%, 1.5%)

Management expects around 9-10% sales growth.

Cost of goods sold

% of sales

N(66%, 1%)

Historic range in last 5 years is 64-68%


% of sales


Historic range in last 5 years is 2-3%, in line with future estimates of management

Selling, general and administrative

% of sales


Historic range in last 5 years is 18-20%. This entry also included depreciation and amortization.


ST + LT debt


Historic range in last 5 years is 4-6%

Other income

% of sales


Historic range in last 5 years is 0-1%


% of taxable income


Historic range in last 5 years is 27-29%



N(23, 3.5)

5-yr range is between 16 and 30. This normal distribution is within these boundaries around 95% of the time.

Balance sheet




Total cash


22% of sales - 228 million

Linear regression of past 5 years, R^2 = 0.82. Obviously, this function does not apply to low sales because it results in negative total cash on the balance.


Days receivable

U(60, 70)

Historic range of days receivable is 55 and 71 with an average of 65.


% of sales


Historic range is between 9 and 12% with an average of 10.

Net property, plant and equipment

Capex and depreciation

Last year NP&P plus Capex minus depreciation = new year's NP&P


Intangible assets


Amortized from $41 to $14 million

Annual report provided amortization charges for future years.

Other long-term assets


Constant at $62 million


Accounts payable

Payables period

U(24, 34)

Historic range of payables period is 24 and 34 with an average of 29.

Accrued and other liabilities

% of sales


Historic range is between 7 and 10% with an average of 8.5%.

Deferred taxes liabilities


Average of last 5 years

Between $11 and $14 million.

Other long-term liabilities


Average of last 5 years

Between $79 and $87 million.

Depreciation & amortization

As % of PP&E

Constant at 15%

Historic range is around 15-16 with an average of 15%.


% of sales

Constant at 3.9%

Upper range of last 5 years. Slightly conservative.

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There are some items I didn't mention (e.g. goodwill, deferred income taxes, prepaid expense, other long-term liabilities) because these items are constant or have 5-year averages. Most of these items are also small in value, which makes them less important. Of course, there are some drawbacks to this financial model. Let me mention a few:

  • The assumptions are "static" which means that they don't show fundamental improvement (i.e. management improves efficiency or cuts costs). The same of course holds true that the assumptions can't do worse than specified. In real life, something could happen to business operations that would fall outside of the pre-assumed range of outcomes.
  • Other material changes like big acquisitions or macro-economic events can't be modeled, at least not with any reliability.
  • The buyback percentage is slightly overestimated because normally a certain amount of dilution takes place. This model assumes a 100% buyback with the money based on the average yearly stock price. On the other hand, all the available free cash flow is used for the buyback, even at higher P/E-ratios. In reality, management would know better when to repurchase shares.

Base-case scenario

The base-case scenario is calculated with the assumptions, which I have explained above. The Monte Carlo simulation technique I have used performs 1,000 runs where each of the variables is drawn again. This provides me with 1,000 possible outcomes after 5 years.

One of the most important assumptions is the sales growth. I stated earlier that I use a N(9%, 1.5%) distribution in order to simulate annual sales growth. I based this distribution on management expectations that have been shown in an investor presentation. Management expects 9-10% sales growth, based on:

  • Global GDP +3%
  • Filtration market+2%
  • Market share gains+2-4%
  • Acquisitions +1-3%
  • Total +9-10% sales growth

The base-case scenario assumes a dividend growth rate of 10%. If cash is needed to pay for this dividend or to raise the cash needed for next year, debt is issued for the shortage of cash. If free cash flow is enough to cover the dividend and the cash for next year, common stock is repurchased with the remainder of the free cash flow.

These rules result in the following output:

  • Average total return (including reinvested dividends) = 9.1%.
  • Around 95% of the possible outcomes are in the range of 1-16%.
  • Chance of loss = 1.8%
  • Average annual sales growth = 9.0%
  • Average EPS in 2019 = $2.53
  • Average FCF% payout in 2019 = 41%
  • Average LT Debt/equity-ratio in 2019 = 0.09
  • Average annual buyback % = -1.9%

These simulations show that on average a decent rate of return of 9% can be expected. Only in 5% of the possible outcomes, you would lose money (before inflation) on your investment. To visualize these results, I've used two graphs. The first is a histogram, which shows the distribution of outcomes in terms of annual return. The second graph shows how the annual sales growth influences the annual total return.

Distribution of total return

Annual sales vs annual total return

(Source: graphs by author)

What you see in the second graph is that annual sales growth is definitely not the only indicator influencing annual total return. Even with higher sales growth (>9% per annum), a relatively low total return can occur, even some negative values. On the other hand, even with lower than expected sales growth, it's possible to achieve excellent returns of more than 10% per year.

But what about different scenarios?

But what happens if we change some of the key assumptions?

  • Lower and slightly more volatile sales growth of N(7%, 2%) instead of N(9%, 1.5%)
  • Dividend growth rate of 20% per year instead of 15%
  • Current P/E-ratio of 20 instead of 23 (13% correction based on current price)


Base case

Lower sales

Higher DGR

Lower P/E-ratio

Average total return





95% interval for total return

1 - 16%

-1 - 14%

1 - 16%

4 - 20%

% of loss





EPS in 2019





FCF% payout in 2019





LT D/E-ratio in 2019





Annual buyback %





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In this article, I tried to convey that Donaldson Company Inc. is a great and stable company based on different financial metrics in the last decade. The company is diversified in their markets and products. They have stated ambitious goals to increase sales to $3 billion in FY 2016 and $5 billion in FY 2021. The Monte Carlo simulation has shown that on average 9% annual return can be expected at current prices. The dividend growth of 10% seems sustainable, the free cash flow payout ratio increases slightly from 35% to 41%. Even with lower sales, a 10% dividend growth rate seems completely possible. A higher dividend growth rate of 20% is less plausible; the payout ratio would rise to 65% while only increasing total return by 0.4 percentage points. In terms of total return, it's better to wait for a market correction. Investing in Donaldson at a P/E-ratio of 20 instead of 23, improves your expected annual return by 3.2 percentage points to 12.3%.

Whether anyone would want to invest in Donaldson right now depends on the individual investor. Are they willing to accept total returns of 9% per year? If not then they are better off waiting for a correction. If so, then Donaldson is definitely an investment worth considering.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.