DCI - Donaldson: Good Near Term As Well As Long Term Prospects

2023-09-14 09:44:05 ET

Summary

• Donaldson Company's revenue growth is expected to benefit from good demand across its end markets.
• The inventory destocking in its Mobile Solutions business is nearing its end, which should positively impact sales growth.
• The company's good execution and market share gains, along with a focus on growing trends like alternative fuel vehicles and alternative proteins, should support revenue growth in the medium to long term.

Investment Thesis

Donaldson Company’s ( DCI ) revenue growth should benefit from good demand across its end markets. Over the past couple of quarters, the company has experienced inventory destocking by its OE channel partners in its Mobile Solutions business. This destocking is nearing its end, which should positively impact sales growth. Furthermore, the strength in the Industrial Solutions sector, and the recovery in the Life Sciences segment, as disk drive demand rebounds, should support revenue growth in the near term. In the medium to long run, the company’s good execution and market share gains in Industrial segment coupled with focus on the growing trends like alternative fuel vehicles in Mobile Solutions segment and alternative protein ( e.g. cell-cultured meat and plant-based meat) in Life Sciences segment should further support revenue growth.

Further, acceleration in volume growth, a moderation in input costs and the carryover benefits from price increases, combined with an improving mix, should drive margin growth in FY24 and beyond. The valuation is currently lower than its historical averages which, along with promising growth prospects, makes DCI stock a good buy.

Revenue Analysis and Outlook

After seeing good growth post reopening, the company’s sales has been negatively impacted in the recent quarters as the improvement in global supply chain conditions prompted customers to normalize their inventory levels, leading to a decrease in aftermarket sales of Mobile Solutions segment. Additionally, the persistent softness in the disk drive market had a negative impact on sales growth.

During Q4 FY23, the Mobile Solutions segment's sales declined by 4.8% year-over-year to $542.5 million as customer inventory normalization continued, more than offsetting the approximately 6% pricing benefits. Consequently, aftermarket sales saw a 6.8% year-over-year decline to $401.8 million. Off-road sales also declined by 0.4% year-over-year to $103.4 million due to weaker market demand in the Americas and China. On the other hand, on-road sales increased by 5.4% year-over-year to $37.3 million, driven by high levels of global equipment production.

In the Industrial Solutions segment, sales grew by 10% year-over-year to $277.1 million, driven by robust global demand and approximately a 4% benefit from pricing. The Industrial Filtration Solutions ((IFS)) business, the largest contributor to the segment's revenue, grew by 10.9% year-over-year to $241 million, primarily due to strong dust collection sales and power generation project timing. Aerospace and defense sales also increased by 4.3% year-over-year to $36.1 million, supported by strength in the defense industry.

In the Life Sciences segment, the ongoing softness in the disk drive market and destocking issues outweighed the 340 basis point contribution from acquisitions to the segment's sales growth. This resulted in an 11.9% year-over-year decline in sales to $59.9 million. On a consolidated basis, the company's revenue decreased by 1.2% year-over-year to $879.5 million, driven by a volume decline in the mobile solutions and life sciences segments, partially offset by approximately 5% pricing benefits. The impact of FX translation was minimal in the quarter.

Looking ahead, the inventory destocking ending in aftermarket business should help sales in FY24. During the fourth quarter, the company's independent channel (~60% of aftermarket sales) remained flat year-over-year, while the OE channel (~40% of aftermarket sales) saw a mid-teens decline, indicating ongoing destocking in the OE channel. Management expects the inventory situation stabilizing in the second half of the fiscal year. This coupled with easing comparisons in this business starting from the second quarter of this fiscal year should help aftermarket sales growth in FY24. Furthermore, the first-fit business should continue to benefit from healthy end-market demand, particularly in the on-road sector, and is expected to grow in the low single digits year-over-year in FY24 as per management guidance.

In the long run, the company is strengthening its position in alternative fuel power to support customers' transition to low- or zero-emission vehicles. The company has already launched burst vent products for hydrogen fuel cells and lithium-air batteries and continues to expand its alternative power solutions portfolio to remain well-positioned to address all future engine adoption scenarios. Additionally, the company is broadening its battery vent offerings to capitalize on the growing EV opportunities.

In the Industrial segment, the strength in Industrial Filtration solutions should continue to drive sales. In addition to good end-market demand and secular trends favouring this business, the company is also benefitting from good execution and gaining market share. In this segment, the company is moving away from subscription model and now offering a broad connected service offering with real time information and data analytics about the state of the filters installed at a customer's location coupled with a digital gateway to access the company’s e-commerce application for all replacement parts not only from Donaldson-branded products but also for other manufacturers’ systems and other service needs. This offering serves as a one stop shop and help customers optimize their systems’ operations. This customer centric approach is helping the company win market share in this market and, with a serviceable addressable market ((SAM)) size of ~ $15 bn , there is an ample runway of growth.

In the Life Sciences segment, after several quarters of destocking, the disk drive inventory is lean and demand is showing early signs of recovery. Management expects a sequential improvement in the disk drive business through fiscal 2024 as demand from data centers and cloud computing recovers. The company has guided for a 20% Y/Y increase in sales in the current year, driven by the recovery in disk drive demand and geographic expansion in the Food & Beverages business.

One particularly interesting long-term driver for this segment is the trend towards alternative proteins such as cell-cultured meat and plant-based meat. According to management, the alternative protein market is a multi-billion-dollar industry growing at a 20% CAGR. With only 100 million liters of bioreactor capacity currently available for all applications, the world is projected to need 10 billion liters of bioreactor capacity for alternative proteins. This presents a significant opportunity for the company in the alternative protein business, particularly for Solaris' bioreactors. The company acquired Solaris BioTech, a designer and manufacturer of bioprocessing and filtration equipment in food and beverage and biotechnology, in November 2021 to expand its presence across several end markets. Solaris' bioreactors have already seen sales more than double year-over-year in the fourth quarter, with a record-high backlog as the company entered fiscal 2024. Furthermore, Solaris and Wildtype signed an agreement in 2022 to jointly develop a new generation of bioreactors to facilitate cost-effective large-scale production of clean and sustainable cultivated seafood. As the market for plant-based and cell-based proteins continues to expand, Solaris is well-positioned to capitalize on this trend, driving DCI's sales growth.

Overall, the company has good near term as well as long term growth prospects. For FY24, management has guided for a Y/Y sales increase between 3% and 7% as headwinds from destocking in the aftermarket and disk drive business ease. At mid-point this guidance represents acceleration in revenue growth versus 3.8% Y/Y growth in FY24. The company’s long term growth prospects also appears to be attractive driven by good execution, market share gains, secular growth drivers in the industrial and life science businesses as well as potential for inorganic growth through further M&As.

Margin Analysis and Outlook

In the last couple of years, the company's margin growth was impacted by inflationary input costs, including labor, energy, and freight costs, as well as supply chain constraints. To counter this cost pressure, the company implemented pricing actions across all its segments, partially mitigating the margin challenges.

During the fourth quarter of 2023, the company observed a stabilization in input costs, including reduced freight expenses and improvements in global supply chain conditions. Additionally, the company realized benefits from the pricing actions it had implemented. Consequently, the adjusted gross margin increased by 140 basis points year-over-year to 34.3%. However, the operating expenses as a percentage of sales rose by 200 basis points year-over-year to 20% due to increased post-pandemic hiring costs as well as lower Y/Y sales. As a result, the adjusted operating margin declined by 60 basis points year-over-year to 14.3%, with operating expense deleverage outweighing the gross margin expansion.

Looking forward, management has guided for FY24 operating margin between 14.7% and 15.3%, representing an increase from the 14.6% reported in FY23, as the company continues to benefit from the carryover impact of price increases, moderation in input cost, as well as accelerating sales growth.

Further, as aftermarket sales bottom in mid FY24 and resumes growth, it should also help margin mix as aftermarket sales have higher margins. The company is also investing in higher-margin growth sectors, particularly in Life Sciences which should improve the company’s margins in the long run. So, I have a positive view on the company’s margin expansion potential both in the near as well as long-term.

Valuation and Conclusion

DCI is currently trading at 19.48x FY24 consensus EPS estimates of $3.17 which is a discount versus the company's 5-year average forward P/E of 22.48x.

The company has good near as well as long-term growth prospects driven by inventory destocking headwinds easing, good execution, market share gains, focus on emerging growth areas like alternative fuel vehicles in Mobile Solutions segment and alternative proteins in Life Sciences segment. The company’s margin is also poised to improve with moderating input cost headwinds, benefits from price increases, accelerating sales growth and mix improvement. I believe as sales growth accelerates for the company in FY24 and margin improves, it may act as a catalyst for the stock’s P/E multiple to re-rate higher. Hence, I have a buy rating on DCI stock.

For further details see: