Donaldson Company (NYSE:DCI) released a great deal of news flow to its investors last week. The filtration business reported its first-quarter results, which fell quite a bit short compared to expectations both in terms of sales and earnings, as the company has reasonable explanations for the shortfall, which nonetheless remains disappointing.
Following the strong long-term track record, as well as the ambitious targets for 2021, I like the shares and am a buyer on slightly larger dips going forwards.
A Soft Quarter
Donaldson reported first-quarter revenues of $596.5 million, a 0.5% decrease compared to the year before. Besides weaker demand in certain end-markets, the company saw a stronger dollar hurt sales by another 2%, as the shift of some large orders into the second quarter hurt sales as well. Analysts have been anticipating growth in sales to levels around $622 million for the quarter.
Engine product sales rose by 0.4% to $390.7 million, as growth in the aftermarket products segment more than offset a rather steep decline in off-road products, which resulted from weaker conditions in agricultural markets and the Asian mining sector. Profitability of the engine business was under pressure, with EBIT falling to 13.6% of sales, down nearly 240 basis points compared to the year before.
The fact that overall sales fell resulted from a 2.1% fall in industrial business sales towards $205.8 million. EBIT of the unit came in at 13.4% of sales, a 140 basis points deterioration versus last year.
Arguably, the sales developments have been disappointing, as the lack of growth and inflation have pressured margins. Overall gross margins have been down by 80 basis points across the business, falling to 35.0% of sales. Lower production volumes was the key driver behind the margin pressure.
Operating expenses totaled 22.1% of sales, which was up 160 basis points on a relative basis. An increase in compensation expenses, the adoption of a new ERP project and the integration of the acquired Northern Technical, all resulted in an increase in the cost base.
As a result of the overall modest fall in terms of sales and margin pressure across the board, earnings have been pressured. Net earnings fell by 9.2% towards $55.9 million, despite a lower effective tax rate compared to the year before. The company has repurchased quite a few shares over the past year, limiting the fall in earnings by a penny to $0.40 per share. Analysts actually anticipated that earnings would increase by a penny to $0.42 per share.
For the current year, Donaldson sees sales increase between 1% and 5%, including a $17-$20 million contribution from Northern Technical. As a result, record sales of roughly $2.50-$2.60 billion are anticipated, which should allow earnings to increase to levels between $1.77 and $1.97 per share.
This guidance is a non-GAAP earnings metric, excluding restructuring as well as pension settlement expenses.
Solid Balance Sheet, Premium Valuation
Donaldson ended the quarter with $267 million in cash, as the debt load of $516 million yields a net debt position of some $250 million. This net debt position is very much manageable, being equivalent to a year of earnings and roughly 0.5 times reported EBITDA.
With some 141 million shares outstanding, which have fallen to $39 in the wake of last week's news flow, equity is now valued at $5.5 billion. Based on the outlook for this year's results, equity is now being valued at 2.2 times anticipated sales and 20-21 times earnings.
An Unexpected Slowdown
The 0.5% fall in first-quarter sales is an unexpected negative surprise, although Donaldson anticipates three percent sales growth on an annual basis at the mid-point of the sales outlook.
This follows years of steady revenue growth, as only in 2009 sales have been down on an annual basis over the last decade. On average, Donaldson has grown sales at a 4%-5% rate over the past decade. At the same time, the company managed to boost operating margins from roughly 10% of sales to current levels around 14%. Margins have been stagnant at those levels in recent years.
The combination of sales growth and margin expansion has allowed Donaldson to more than double its net earnings, as the company has repurchased nearly a fifth of its shares outstanding, adding to earnings per share growth, while operating with a rather solid balance sheet. These operational achievements have been reflected in the share price, with shares being up from levels around $15 in 2005 and during the crisis, to highs close to $44 earlier this year.
The company's technological advantage results from efficient filtration systems, which are small, have a long filter life and result in lower operating as well as maintenance costs. These premium offerings underlie the long-term outperformance and the strong returns on the stock market.
Investors have not been pleased with the soft first-quarter results, although the full-year guidance alleviates some of the revenue concerns. The pace of anticipated sales growth is falling behind the long-term average, as dollar strength will be a key reason why growth is disappointing somewhat.
Despite these short-term issues, Donaldson's management remains committed to double the business again by 2021, a year in which it anticipates that sales will reach $5 billion. These goals are quite ambitious, translating into annual growth rates of around 10% per annum. As a result, the long-term goals are quite ambitious, and this is probably a key reason why investors are still willing to attach a premium valuation to the company's shares. In a recent investor presentation, Donaldson stresses the 8% CAGR in terms of revenues being reported over the past 25 years, which demonstrates the ability to show long-term growth.
As a result, I am perfectly comfortable paying a premium for Donaldson's shares versus the remainder of the market, pegging the desired entry point at an earnings multiple of 18-20 times. Based on the anticipated guidance, this translates into a roughly $34-$37 entry point, just a few dollars below the current price level. As such, I will keep a close eye on the shares in the coming weeks, hoping to pick up a few shares in this long-term value creator.
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