Donaldson Still Leveraged To High-Quality Revenue Growth Upside

Summary

• Donaldson had a somewhat mixed fiscal second quarter, as certain industrial markets remain weak, but off-highway machinery is recovering nicely, process filtration is growing strongly, and guidance was improved.
• The real sizzle to the Donaldson story remains the multibillion-dollar addressable market/revenue expansion opportunities in markets like food/beverage and life sciences.
• Donaldson offers a long-term annualized return on the higher end of high-quality industrials today, and filtration companies have often traded at robust premiums in the past.

Recommending Donaldson (NYSE:DCI) back in September, I liked the company for its leverage to an eventual recovery in heavy machinery (trucks and off-road equipment) and industrial demand, but even more for the growth potential the company had in its attempts to bring its very strong filtration technologies into new markets like food/beverage and life sciences. On top of that, I saw an M&A “kicker” as many filtration companies have been taken out in the past at pretty rich multiples.

Since that last article, these shares have risen about 25%, modestly outperforming the larger industrial group and roughly doubling the return of the S&P 500 (while lagging partial peer/comp Parker-Hannifin (PH)). I don’t see quite the near-term opportunity from a valuation perspective as before, but I still like the company’s leverage to recovering end-markets, and its demonstrated desire to grow new market opportunities (hiring a new VP to oversee growth efforts in life sciences).

Donaldson looks modestly undervalued now, with a long-term total annualization potential return on the higher end of what I’m seeing these days for high-quality industrial names (6% to 8%). I also do believe that M&A remains a potential outcome, and likely at a premium multiple. I wouldn’t buy or recommend buying Donaldson as a takeover candidate, but I do think there’s still a window of opportunity here for a company that will likely trade at a higher multiple once the end-market recoveries are obvious.

Mixed Results in Fiscal Q2, As Vehicles Start To Recover

Donaldson’s fiscal second quarter was mixed, but positive on balance, as revenue and segment earnings exceeded expectations and the negative parts (the Industrial Products segments) weren’t that weak. I’d also point to healthy guidance for the remainder of the year, with the low end of guidance lifted above the prior sell-side average estimate and the midpoint about 4% higher.

Revenue was basically flat in constant currency terms at $679M, beating expectations by 4%. Gross margin was down 50bp on a GAAP basis, but up 30bp to 34% on an adjusted basis. Adjusted EBITDA rose 6%, and adjusted operating income rose 8%, with margin improving 60bp to 13.4%. Segment profits beat by 7%.

By segment, Engine Products grew 4% to $436M, beating expectations by 5%, with Off-Road up 11% on improving conditions in end-markets like construction, agriculture, and mining. On-Road declined 3%, but management believes the commercial trucking business has bottomed, and looking at trends since quarter-end (miles driven, etc.), it would certainly seem to be the case. Aftermarket sales rose 6%, while Aero/Defense was down 22% on well-understood issues in the commercial aerospace market. Segment profits rose 16% (margin up 110bp to 13.3%), beating by 12%.

In Industrial Products revenue declined 7% to $217M, missing by 1%, as Industrial Filtration Solutions (down 7%) saw weakness in dust collection and Gas Turbine Systems (down 5%) was weaker on lower project activity. Special Apps declined 11%. Segment earnings declined 25% on meaningful operational deleverage, with margin down 430bp to 11%, but was still only 3% below expectations.

Process Coming Along As New Opportunities Develop

One of the key bull theses on Donaldson is the lucrative opportunity(ties) for the company taking its core air and liquid filtration technologies (and exhaust/emissions controls) and transferring them into new-to-them markets like food/beverage and life sciences, the latter of which has supported exceptional growth for a host of companies like Danaher (DHR) and Thermo Fisher (TMO) selling into bioproduction opportunities.

In a pretty soft quarter for Industrial overall, management called out “continued momentum” in process filtration, with high teens sales growth. Management specifically mentioned “traction” in food/beverage and renewed its commitment to driving more growth in life sciences, with the company recently hiring a new VP of Business Development for the life sciences segment.

Donaldson isn’t going to become a major player in these markets overnight, but the segments of the food/beverage market that the company is targeting today add another $2B in addressable revenue, and the life sciences market is likely in the neighborhood of $5B (as would the total food/beverage be).

Generally speaking, filtration products are often designed in collaboration with customers and/or original equipment suppliers. That makes entry into new markets more challenging, and I would not be surprised if management pursued some select acquisitions to accelerate the process.

End-Markets Coming Back

While management guidance for the Industrial segment was relatively cautious (down 2% to up 2% for the full fiscal year), I’m a little more bullish. Compressor demand has been strengthening at Atlas Copco (OTCPK:ATLKY) and Ingersoll Rand (IR), and economic activity trackers have been showing a recovery that is gaining pace. As more business get back to normal (or at least “closer to normal”) activity, filtration demand will follow.

I’m likewise bullish on the food/beverage market for 2021; it won’t see the same snap-back as manufacturing end-markets as it never fell as much, but underlying demand should grow at a mid-single-digit clip and Donaldson can exceed that with product line expansion and market share growth. I’m less bullish on the turbine business given reports from other companies in power gen.

For the Engine Products business, Donaldson should see several quarters of strengthening demand. Trucking activity has picked up noticeably, and companies in the ag, construction, and mining spaces like Caterpillar (CAT), CNH Industrial (CNHI), Deere (DE), and Epiroc (OTCPK:EPOKY) have offered pretty healthy guidance for demand recovery in calendar 2021 and into 2022.

The Outlook

I’ve modestly boosted my near-term estimates on a stronger off-road vehicle recovery and better results in process filtration than I’d expected at this point, but I haven’t changed my model on a fundamental basis. My long-term revenue growth rate moves from closer to 7% to closer to 7.5%, and the FCF growth rate from 9.5% to 10%, and I am also expecting modestly better margin on improved overhead leverage from the higher volumes in my revenue assumptions.

The Bottom Line

Donaldson is now trading in line with my EBITDA-based fair value target (15x forward EBITDA, but that is based on a takeover multiple at the low end of the range of past filtration deals. On cash flow, I still see Donaldson priced for high single-digit long-term annualized total returns, and I do see near-term upside into the $60s.

Again, I’m not trying to make the case that Donaldson is a screaming bargain by conventional metrics, but rather by the standards at which filtration companies have traded in the past. There are risks here, including the impact of electrification in heavy machinery on filter demand and the uncertainties that come with targeting new markets, but relative to the growth opportunities, I still think this is a name to consider.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.