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I liked the filtration specialist Donaldson (NYSE: DCI) for a while now, and not only have the stocks been up about 15% since my last update (easily beating the broader market and industrial sector), but they’ve continued to beat the market (and the industry group) since my initial writing for Seeking Alpha. The thesis then and now was to maximize the value of legacy heavy machinery and industrial filtration businesses while exploring opportunities to extend these core competencies to new markets such as food/ beverages, life sciences and other process markets where filtration matters (and gaining new, complementary, skills via M&A along the way).
I’ll be very curious to see what management says about the guidance when it releases its fiscal first quarter results later this month. The initial guidance for FY’23 in August surprised the street with its conservatism, and recent earnings/advice calls from heavy machinery companies have been relatively good. Additionally, at a time when many short-cycle businesses are beginning to revitalize, many heavy machinery businesses have good order books through 2023 and underlying business/utilization is still healthy.
With the performing stocks, I don’t see as much undervaluation here. I think stocks are still valued for long-term annualized returns in the high single digits (around 8%), but the near-term upside appears to be capped at around $60 with no stronger outlook. There’s worse than owning a good business at a reasonable price, but there are now more options for investors and I’m not as keen on chasing after Donaldson.
FQ1 should be set up for the upside
I might just end up eating those words, but I think Donaldson is ready for a beating when he releases fiscal first quarter results later this month. Industrial activity remained vigorous, with industrial air players such as Ingersoll-Rand (RI) and Atlas-Copco (OTCPK:ATLKY) reporting healthy demand, and while I’m concerned about declining conditions for the trucking industry, I think miles driven for Donaldson’s recently completed quarter should be fairly healthy. Likewise, I have some short-term concerns with construction and mining, but business has remained healthy and Donaldson is mostly (about 60%) a spare business.
Donaldson got a 12% increase in sales growth last quarter on price and I don’t see why there would be any significant sequential erosion (although the comps from a year ago are certainly stiffer). Working against the company, the forex is likely to have a bigger impact than expected (although analysts had a chance to adjust expectations after seeing other companies’ Q3 earnings), and there could also be headwinds related to the abandonment of activities.
Given that many companies are reporting some easing in input cost inflation and component shortages, I expect healthy sequential leverage on gross margin (about two points), and I think Healthy revenues and gross margin should drive a pace of operations.
Advice will become interesting
Management surprised analysts and investors last quarter by guiding FY23 growth significantly below expectations… +3% mid-term vs. +6% expectation. While aftermarket activity was expected to be healthy (up mid-single digit), management was looking for weakness in OE heavy machinery and weaker results in parts of the segment. industrial.
The outlook for new heavy-vehicle construction still looks quite healthy. Still constrained by limited component (and in some cases, labor) availability, many heavy machinery manufacturers enter 2023 with significant backlogs that should at least sustain the first half of the year. I think there will be a sharper correction in truck orders over the course of the year, and most likely one in construction as well, but I expect demand for agriculture and mining equipment to hold up fairly well given the age of existing fleets and favorable commodity prices. Aerospace and defense should also provide some strength given the continued recovery in air traffic, but it’s not a particularly big part of the business.
On the industrial side, I expect weaker demand in key industrial end-markets as short-cycle industries turn over. New growth opportunities in the food/beverage, life sciences and industrial filtration sectors should offset this quite well, but I think it is reasonable to be a little cautious.
Margins should be a source of strength. Business is pretty tough for Donaldson, and while there will eventually be pricing pressure as input costs come down, I don’t think those pressures will be particularly significant in 2023, so I expect that that the business is leveraging healthy pricing against an improving cost structure, helping to drive a point or more of EBITDA margin improvement.
Plenty of options to pursue growth and a healthy balance sheet to fund it
Donaldson continued to add elements in line with its stated strategy of continued growth in new filtration markets such as life sciences, acquiring Purilogics in June. They’re a small company, but I like their approach to membrane-based chromatography and it could prove to be a valuable staple over time. For readers unfamiliar with biochemistry and bioprocessing, chromatography is a key step in the production of biologics, as it is used to purify and separate target molecules such as mRNA, plasmid DNA, antibodies or proteins from their production environment.
I continue to see a big lead for Donaldson in life sciences, not to mention other end markets that have high-end filtration needs (like semiconductors). A recent partnership with wild type highlights this – the two companies will collaborate to design specialized bioreactors for Wildtype’s cultured/cultured seafood production needs. It basically involves growing seafood in a controlled laboratory/industrial environment using bioprocessing tools and techniques. I should call it a long-term opportunity today, but I think it illustrates how Donaldson could ultimately see growth in unexpected markets and not just traditional organic production.
Perspectives
Donaldson’s FY22 results were a little better than I expected (revenue and EBITDA beat about 2%), but I tempered my expectations a bit for FY23. My long-term revenue growth estimate is slightly lower (at around 5% to 5.5%) with the model moving forward a year, and I still see strong long-term opportunities outside the main markets served by the company.
Given good pricing leverage, I expect better EBITDA margins now, and I’m looking for about one point improvement in FY23 and about two points improvement in the next four years. Longer term, I expect Donaldson to generate low double-digit free cash flow margins, supporting normalized FCF growth of around 10%.
Discounted cash flow modeling suggests potential long-term annualized returns of just over 8% at the current price. Using my margin/yield driven EV/EBITDA formula, I think Donaldson can trade at over 13x EBITDA going forward, and I note that filtration companies (especially those exposed to life sciences) have often traded at multiples of 15x or more, so rerating going forward is a possibility.
The essential
Given my opinion of the company, the direction and the strategic plan here, I would like to be more bullish on these stocks. As it stands, however, I don’t see a particularly strong call for fundamental undervaluation unless Donaldson posts a solid pace and an upside quarter. I’m pretty bullish at the moment, mainly because I’ve discovered that good companies have a way of “growing up” towards valuations that may seem high, but I would really prefer to buy declining stocks if possible.
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