DCI - Donaldson Company: Still Not Coming Through My Filter

2023-07-02 10:04:23 ET

Summary

• Donaldson has seen continued growth as it continues to improve the positioning of the business.
• I like the long-term performance of the business, but still fear the positioning to old-fashioned industries.
• I continue to appreciate the long-term performance, but I do not see a reason to get involved right here, right now.

Time to pick up coverage on Donaldson Company ( DCI ) as it announced a bolt-on deal, with the previous take on the business dating back to February 2022, when I was filtering through the filtration play.

While applauding the long-term value creating track record for shareholders, on the back of a combination of organic growth and dealmaking, I was a bit careful. A 20 times earnings multiple and a modestly leveraged balance sheet were perfectly explainable, yet it was the long-term positioning of the business which stood at the basis of my caution.

Shedding Some Perspective

Donaldson is an interesting business as the exposure to filtration makes it a long-term growth play, as the significant insider ownership (with shares held by both management and workers) being an interesting combination.

Filters, which are designed and manufactured by Donaldson, are used to improve efficiency, enhance equipment life and reduce maintenance costs. With liquid, air and emission filters designed, I believed that near to medium term demand might be actually increasing on the back of higher ESG standards, although electrification might render some use cases useless in the long haul.

In September 2020, the company posted its results for the fiscal year of 2020. Sales slipped a bit on the back of the impact of the pandemic late in the fiscal year, as the business posted sales of $2.6 billion, on which earnings of around $2 per share were reported.

2021 sales rose by 10% to $2.85 billion, with operating margins improving to a solid $385 million. This resulted in earnings of $2.24 per share as net debt of $283 million was very modest with EBITDA trending near half a billion. With the company ending 2021 on a solid note, the company guided for earnings to come in between $2.50 and $2.66 per share in 2022.

This strong momentum pushed shares up to the $70 mark in the summer of 2021, but shares retreated to $55 early in 2022. The resulting 21 times multiple was reasonable, but I feared the long-term outlook related to the positioning with the engine product business (with $2 billion in sales) responsible for the majority of sales, complemented by a $900 million industrial products business, all while the company was moving in a small way into other categories like food, life sciences and biotechnology as well.

What Happened?

After voicing a constructive but somewhat cautious tone, we have seen shares trade around the $50 mark during the summer of 2022 as concerns on global industrial players were rising. Ever since then, shares have recovered and now trade in a $60-$65 range, currently exchanging hands at $62 per share.

The company continued to reposition the business as it acquired Purilogics in June of last year in a $20 million deal to add more life science exposure. For the year ending in July 2022, Donaldson grew full year sales by more than 15% to $3.3 billion, with net earnings growing at similar percentages to $333 million and GAAP earnings being up to $2.66 per share. Moreover, the company guided for earnings to advance to about the $3 per share mark in 2023.

Ever since, the company posted resilient first quarter results, as it announced its next bolt-on deal with the acquisition of Isolere Bio in February of this year, adding more life science operations. By May, the company hiked the annual dividend payouts to a dollar per share as third quarter results were solid, despite economic uncertainty.

While topline sales are only up 5% in the first three quarters of the year to $2.55 billion, the company has seen margin expansion and demonstrated on operating leverage. This resulted in net earnings over the same period being up 15% to $267 million, equal to $2.16 per share, with adjusted earnings coming in ten cents higher.

Ironically, it is the life science segment which is doing bad this year, due to weakness in the Disk Drive market. Note that life science now make up a mere 7% of sales, with the business still dominated by mobile solutions, and to a lesser extent industrial applications.

A net debt load of $435 million remains very modest as the company posted an adjusted EBITDA number of $450 million for the first nine months, as the $600 million run rate reveals a mere 0.7 times leverage ratio.

In June, the company announced its next deal to fortify the life science business. Donaldson has reached a deal to acquire Univercells Technologies in an EUR 136 million deal. The Belgium-based business provides innovative biomanufacturing solutions for cell and gene therapies and generated about EUR 10 million in revenues in 2022.

Hence, the sales multiples are very demanding at about 13 times trailing sales, but it will definitely boost the growth profile of the business and the life science ambitions. In comparison, Donaldson supports a roughly $8 billion enterprise valuation at $62 pre-deal, making that it trades at a mere 2.5 times sales multiple.

Reiterating My Take

With Donaldson on track to earn $3 per share, shares still trade at a 20-21 times multiple as leverage will continue to come far below 1 times EBITDA, even after the latest life science add-on.

Given all this, and despite the increased focus of dealmaking in life science, I am still cautious given the positioning of its end markets. I continue to appreciate the business, but need a bit of a margin of safety before getting involved.

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