Donaldson Deserves A Second Look After A Steep Decline (NYSE:DCI)

Writing about Donaldson (NYSE:DCI) in August of 2021, I noted that I was more concerned about valuation with this high-quality filtration company, but that I was inclined to “let the winner run” on the basis of strong near-term demand and intriguing long-term diversification and growth opportunities.

That was not a good call, as the shares have since declined almost 25% over that period. While it’s true that many industrials have been taken to the woodshed over the last six months on fears related to supply chain pressures, global macro instability, and so on, Donaldson has dramatically underperformed, trailing the industrial space by almost 20%. All the more curious is that sell-side expectations for Donaldson actually aren’t all that much lower now; margin assumptions for FY’22 have come down, but have been offset by higher revenue.

I find Donaldson much more interesting at these levels. Not only do I believe there’s a healthy off-road cycle left to leverage, but I believe the company’s efforts to reapply core technologies into new markets like food/beverage and life sciences can drive higher revenue and FCF over time. I wouldn’t call the shares “screaming buy” cheap, but I do think the valuation is more interesting for long-term investors.

A Stronger-For-Longer Off-Road Cycle

Off-road has been a strong market for Donaldson for some time now, with revenue rising 27% in the last quarter and following on +45%, +51%, +45%, +11% growth over the four preceding quarters. Growth has been pretty broad-based – while new emissions standards are definitely driving a significant amount of growth, underlying volume and price has been strong as well. Better still, I don’t believe this positive trend will end soon, even if the rate of growth does start to shrink on tougher comps.

Agriculture has seen used equipment prices soar, as strong crop prices and accommodating interest rates are improving demand for equipment at a time when OEMs are struggling to meet demand due to supply chain and labor difficulties. Given demand, backlog, and production capacity at major OEMs like AGCO (AGCO), CNH (CNHI), and Deere (DE), I believe there will be healthy demand for first-fit (that is, new equipment) Donaldson products for some time, as well solid aftermarket demand.

Construction isn’t as squeezed as agriculture, but there are positive trends here as well, particularly ahead of a recovery in U.S. non-residential construction later this year and into 2023 and infrastructure projects accelerating in 2023 and beyond. In mining, fleet age has shot up above long-term trends (around 11 years versus an historical average closer to 8.5 years), and with high commodity prices, many operators are looking to refresh and expand their fleets.

On-Road Good See A Smoother Cycle

Investors have been fretting about a potential near-term peak in heavy-duty trucks, but those peaking concerns are being counterbalanced by the reality that major OEMs simply can’t get the parts they need to fulfill their order books. With that, the outlook is shifting toward a more stretched-out upcycle that should last into 2023 as companies deliver on those delayed volumes.

Heavy-duty trucks will always be a cyclical business, but rising emission standards will continue to create opportunities for Donaldson. New standards are on the way in Europe, while the EPA has proposed newer, higher standards for U.S. heavy vehicles. There is always uncertainty with respect to details and timing on new regulations, but there is an inarguable trend across the major world markets (North America, EU, China) of stricter standards, with each generation providing new value-added opportunities for Donaldson.

I would also note that Donaldson has relatively less risk to electrification than some heavy vehicle suppliers. Full electrification of off-road and on-highway vehicles would certainly be a negative development for the company’s filtration business, but full electrification is unlikely in markets like Class 8 trucks, and the company would actually be well-placed to leverage opportunities from alternative fuels like LNG or hydrogen.

Growth Opportunities In New Industrial Markets

Donaldson’s engine business is the “steak” to the story, but the “sizzle” comes from the company’s opportunities in new markets. There are a range of industrial markets where high-quality filtration is vital to production and quality control, and management is increasingly looking to apply its fundamental technologies in filtration (including filtration media) to new markets like food/beverage, biopharma/life sciences, and specialty chemicals.

Management took a meaningful step forward in those efforts last November, acquiring Solaris Biotechnology, a European manufacturer of bioprocessing equipment like bioreactors, fermenters, and tangential flow filtration systems, for EUR 41M. While Solaris is small in terms of revenue contributions, it broadens Donaldson’s offerings for the biopharma and food/bev markets and should accelerate the company’s marketing efforts.

Donaldson has been methodical in building out these new businesses, and I expect that to continue. Process filtration has been growing at a double-digit rate, though, and I expect further expansion here to help drive a higher sustainable long-term growth rate for Donaldson.

A key unknown at this point is how far the company wants to go and how much they’ll spend to get there. The list of end-markets that need high-quality filtration is long (including markets like semiconductor manufacturing), but while the company has solid core technology that can be repurposed into new markets, it still takes time to design and validate new products and gain traction with customers in new markets – many of whom may be understandably cautious about handing over mission-critical “never fail” business to a company that is, to them, an unproven newcomer.

Acquiring established businesses can accelerate that process, but it’s not a cheap way to grow – particularly in areas like biopharma and electronics where acquisition multiples are usually quite high for process control companies. This is a primary reason why I expect a “methodical” approach from management, even if it is apt to frustrate investors with a Veruca Salt-like insistence on growth “now”.

The Outlook

Donaldson has taken a near-term hit from supply chain pressures, but I don’t see the company as faring materially worse here than other industrials. Incremental margins in the last quarter were quite low, but the company does still have some pricing power and I believe the margin situation will resolve over the next year or so. In the meantime end-user demand continues to run higher than expected.

I’m still expecting long-term revenue growth around 5% to 6%. I expect a multiyear run of above-trend growth driven in off-road vehicles and healthy first-fit demand in on-road through 2023. Over the longer term, I believe expansion into new markets can add 200bp to 300bp to the sustainable revenue growth rate.

I expect operating margin to be relatively flat in FY’22, with reacceleration in FY’23 and FY’24 as supply chain challenges ease. Working capital needs will likely depress near-term free cash flow, but I expect relatively quick reacceleration into the low double-digits for FCF margin and modest long-term expansion toward 13%, driving high single-digit FCF growth.

The Bottom Line

Discounted cash flow suggests a total annualized potential return in the high single-digits, which is good enough to make these shares interesting once again. While the valuation isn’t quite as compelling on a margin/return-driven EV/EBITDA basis, the shares do nevertheless look undervalued by this metric as well, particularly given the relative scarcity of quality filtration companies (and the healthy recurring revenue and ROICs they can generate). Below $60, I think these shares are worth a serious look.