Donaldson Company, Inc. (DCI) Earnings Call Transcript
September 15, 2026
Earnings Call Speaker Segments
Okay. Thanks, everyone, for joining us for those who don't know me, Angel Castillo, Head of U.S. Machinery and Construction here at Morgan Stanley. Appreciate your time and appreciate Brad Pogalz, CFO of Donaldson as well as Sarika Dhadwal, Head of IR at Donaldson, joining us today. Thank you both so much.
Happy to be here. Thank you.
Yes. Maybe before we just get started, just a quick disclaimer for important disclosures, please see Morgan Stanley research disclosure website at www.morganstanley.com/research disclosures. If you have any questions, please reach out to your Morgan Stanley representative.
And with that, Brad, if we could just dive right in. I think the best place that I was hoping we could kick off the discussion is just you've been in your seat now for nearly 2 years, and Rich has also been in his seat now CEO for a little bit. Just can you talk about how the strategy has evolved or changed now that Rich has had more time and yourself to kind of settle into your seats and really absorb where the business is headed and whether you decide to make changes on the strategy. Where do you see the opportunities to invest, to optimize, to change the direction, if at all, if you could just talk about that.
Sure, sure. And maybe a bit of the background on it. I've been with the company for 11 years. Rich has been with the company for more than 20. So one thing with the strategy. Rich has been a direct report of the CEO for decades and definitely had a role in this strategy. I think what we're really optimistic and encouraged by is that our strategic priorities are largely unchanged how we execute them and some of the focus areas, which I'll go to are things that we're going to evolve. But as far as where we sit today, Donaldson is a leader in technology filtration. We have an underpinning of capabilities that gives us access to lots of markets using the filtration know-how, and then availability and scale and customer relationships are a core part of how we drive value. We're in good markets. So it's about continuing to look for those opportunities. The evolution, I think, is going to be on our portfolio and analysis and really the granularity of how we get into things. So as we think about the next 5, 10 years for the company, it's about ensuring that every business has its role in the portfolio and everybody -- every business earns its place in the company. Some of that looks like classic prioritization work, 80/20 and really managing long tails of things, focusing on the regions that make the most sense for the specific markets that we're in. The good news is Donaldson touches pretty much every corner of the economy. So our access to the world is very high, then it's about prioritizing choices within that. And I think a combination largely organic growth, but also inorganic as we look for opportunities like the recently acquired facets and getting more into aerospace and defense, making sure that we dig deeper or go deeper into the markets that are exciting for us.
No, that's very helpful. And I think -- I mean you put it next year, right, Donaldson touches every aspect of the economy, and I think that's with so much macro volatility. That's 1 thing I wanted to ask about, right? A lot cross wins from early sense of cyclical recovery with PMIs, et cetera, as well as just challenges around macro with interest rates, geopolitics. So can you just remind us with so much exposure to the broader economy, like ultimately, what are the factors or the aspects that you're watching most closely that are going to ultimately dictate or that are more important to track in terms of real implications to how your business ultimately performs.
Sure. The place to start on this that I think is important for the group is the composition of the company. About 2/3 of our revenue is recurring revenue. So a version of an aftermarket part across 3 segments. In our mobile solutions, things we watch are any measure of activity. So think about freight index or truck miles driven farm activity, anything like that, that helps drive aftermarket, which is about 80% of the Mobile Solutions business. and then new equipment production. We are in ag, mining, construction and transportation. So to the extent that new equipment production is going up, that favors us well. And of course, right now, as probably everybody knows, it's looking better than it has in a while across all of these markets, especially with ag and transportation. In the industrial space, again, any unit of activity is important. So IP is a very good measure that we tend to watch. About 50% of our industrial segment is some recurring revenue. And the places that I'm really focused on right now are more the cap goods and the project side. What I do want to delineate though is you almost have to look at our industrial businesses as data center versus nondata center right now. The data center side, things like power generation are doing very, very well. and we all see that. And then the other part of the business, new projects and new factories, brownfield, greenfield, those are the places that, again, look for industrial CapEx.
That's very helpful. And maybe if we could -- you touched on it a little bit, but I guess hoping you could dive a little bit deeper into ultimately how the business was so much aftermarket tends to perform in a cyclical recovery. As you think about specifically the Mobile Solutions business to the extent that you do start seeing more first fit, what are the implications? Do you tend to see a slowdown in the aftermarket? How does that typically behave in that part of the cycle? And what are the implications in terms of your margins, your business financially?
Yes. This is an important question. the OEs that we support, especially in mobile solutions, tend to be -- have a much more volatile production cycles on up cycles tends to go up maybe 10 or 20 or even 30 in discrete periods. So to the extent that we're at a recovery like that, what we tend to see is a bit more gross margin pressure that gets leveraged on SG&A. So earnings, cash earnings growth, but we might have a margin pressure there. I think what's important to note is, in the last several years, we've changed our posture on pricing with -- so we used to in the 20 teens, being more of a price down type of cycle. We haven't had a real -- I'm going to put the post-COVID recovery side. That was nuanced. So the last time we had more of this type of normal economic recovery pre-COVID we would have seen more deleveraging as a result of that OE growth with pricing, productivity, I think we're in a better position today as a result of that.
No, that's very helpful. And I think we'll touch on it a little bit more, I guess, down the line. So I do want to ask a little bit more on pricing, but just -- in terms of the -- maybe diving deeper into the power generation side, taking it by kind of segments, I guess, that's obviously, to your point, an area of tremendous investment, a lot of -- a big topic of conversation. Can you just unpack where do you actually sit in terms of the value chain, how filtration intensity changes the size and complexity of these systems. And just as this increases and ultimately, how has that changed the economics for your company?
Sure. Our power generation is about mid-single digits, I think, roughly 5% of total revenue. And I think the breakout that's important is about half aftermarket, half new equipment. So to your question on the new equipment side, where we sit on the value chain or how we work with our customers is for large turbine systems, think basin peak power to a grid as an example there. we're the filtration system that works with turbine manufacturer, that's our customer. And we're filtering the ambient air going into that turbine where we tend to succeed and where we compete very effectively is higher technology needs in applications that are just, frankly, more difficult from an operating environment. So think coastal areas, desert, high heat, some sort of difficult environmental challenge requires a more complex solution to manage the air going into that turbine. We also sell into what we would call the small turbine systems, but think about this as more -- they've typically been used in oil and gas. Of course, there's some more localized power with things like data centers now. And then again, the replacement parts, which is very sticky in this business as we work with the OEs on that turbine install.
And maybe just as we think about that installed base opportunity that will come with turbines, I guess, as all this equipment ultimately gets installed, how should we think about the potential for kind of replacement revenue and a percentage of first fake should we still be thinking about it as 50-50 or that aftermarket? How much does that ultimately continue to expand, especially if more of this is kind of behind the meter and perhaps running more regularly?
Yes. The replacement cycle for these is maybe 2 to 4 years, so they're a longer replacement cycle than some of the other products we have. But you're absolutely right that there would come behind these installs, this wave of replacement. The balance it will really depend on the time that 50-50, if you think about a new turbine installation, that can be well into 7 figures. So the filter content on that, of course, is much lower. These are really expensive systems. So to the extent that, that new install growth starts to moderate a bit from where we've been, then you would see that percent of aftermarket tick up.
Got it. Okay. And then just in terms of Donald and eventually, I guess, as you think about the projection, the demand here, how are you positioned in terms of demand -- or sorry, capacity in terms of being able to meet that opportunity both now and over time? Like is there any need for incremental investments? If you could just touch on that.
Sure. We've made some -- no, just to be talking Power Gen , we've made some investments in Power Gen. Think about it as throughput and managing the base today. But it is a place where we would be approaching capacity constraints. The order books are full for this year and then into next. I think the question for us is to what extent do we chase or just manage the capacity we have with again, throughput types of investments. This is a market that has quite a long history with Donaldson, we've been in it for decades, and it tends to be a boom and bust type of market. So I would say that I'm also a bit tentative on just chasing today's demand with new footprints. We would want to manage the capacity within the 4 walls to the extent we can and then grow responsibly from there.
Got it. And I do want to remind the audience, if anyone has any questions, we have mics in the back, so feel free to just raise your hand, and we'll get a mic to you. But if there's none right now, I'll continue down that line. I wanted to just also ask about like you've had the -- so if you think about the move into Mexico in terms of the production and the broader footprint, we're running kind of at the same time. Just what has been harder about the transition? Any surprises in terms of -- versus what you originally expected? And what can -- what have you kind of learned from that process?
Sure. The move that Angel is referring to is the last few quarters, we've talked about standing up production for certain large turbine systems in a facility that we already had in Mexico. Our center of gravity for these large systems in production is Abu Dhabi, and we moved that over at the specific requirement of a customer needing source of supply in North America. It's turbines we've made before, customers we worked with before, so nothing new in that regard, but a new capability for this facility. And frankly, it just hadn't gone to plan. It is a different type of labor than we've typically employed in that plant. So there's a level of scale on certain applications that we didn't already have there. We have skilled labor there, but they're doing different things. And then on top of it, turnover and the competitiveness of this environment have effectively just challenged the cost side of it. Turbines are going out. We're working with the customer and meeting that demand, but it's much tougher on the cost side. We expect to be through that over the course of the next couple of quarters, so midway through this fiscal year. At that point, will repurpose that capacity and effectively sell that out more to the midsized turbines that, again, are also growing really nicely and then refocus in Abu Dhabi.
Got it. Okay. That's very helpful. And as we think about getting to the kind of middle of mid-fiscal year and just your margins normalizing after some of these challenges, I guess, ultimately, what's the right way to think about the opportunity for the business from a margin standpoint once we kind of get beyond that?
Yes, the industrial margins, we would expect a spring back to the high-teens pretax profit margin, where we were a year and change ago. And then building on that with some savings from cost optimization projects we did. We've closed 4 facilities over the last couple of years with 2 big ones even in the last 2 quarters. And so now we're at the point of leveraging the start-up -- or excuse me, leveraging the new capacity in the new home, getting through startup. And we expect that to be annualized savings of about $10 million once we get to run rate.
Got it. And then maybe just outside of data centers, you've talked about improvements in quote and order activity, just in dust collection and other project-oriented industrial businesses. Just would you characterize that as kind of industrial CapEx recovery rather than just kind of improvement from a soft in terms of how you look at the cycle and just underlying demand that customers are telling you?
Yes, I'd love to be able to confidently say it's CapEx recovery. I think maybe it remains to be seen on that. our teams are out quoting. We have no indication that we're losing the tenders. It's more about the conversion to the PO that's been the harder part for us in this business. And these are projects specifically, not recurring revenue. And I think the thing that seems to be hanging over it is almost economic uncertainty. It's kind of this cloud of where to invest. We saw it really kick in a bit in the early part of last calendar year. Tariffs slowed some global expansion plans. People were uncertain to where to go. There's been the steady stream of things that keep people cautious, and I think that's what's coming into our business. But again, over the last couple of quarters, quoting activity has increased, and we're feeling optimistic about the trajectory. Just needs to play out a bit more. And as you think about the -- what you're waiting or waiting to hear or see is it specific verticals? Is it specific quoting or turning to actual orders? Like what are the kind of the checkpoints that you're watching ultimately? It's really that conversion to order quoting activity, of course, needs to remain strong. So that's the leading indicator on this. But we watch orders and backlog in this business pretty closely. And that's where, again, we have confidence that as we're heading into this year, we're contemplating some recovery in that. but it needs to play out.
Yes. And I guess, I know you're at the tail end in terms of reporting and you're a little bit different fiscal year, but the extent that you've seen the evolution continue over the last month, I guess, anything to note there in terms of that quoting activity versus what you were kind of seeing at the time that you reported your fourth quarter?
Not much. We reported just a few weeks ago. So no big change there. I mean our view is, though, this conversion, to your question, I think that's the stat we're watching pretty closely.
Understood. Again, if anyone has any questions, raise your hand. But if not, I wanted to move to aerospace and defense. So I guess one of the strategic ideas behind facet was just the downstate have customer relationships. Technologies that the other one doesn't necessarily have. So where are you in terms of seeing some of those tangible opportunities to bring those to the portfolio together and integrate and take advantage of that?
Yes. Facet was a really exciting opportunity for us. It was the company's largest acquisition. The business itself is about $110 million in turnover at the time of close with about 80% of that going to aerospace and defense markets. The opportunities that we see are about where in their prior ownership structure, they had limited ability to compete with other portfolio companies. So we're evaluating synergies across those. Now of course, the curtains are open and they can compete across any of these markets, especially in the industrial spaces. And then the other place is looking for synergies within Donaldson in places like our industrial hydraulics businesses. And sharing references and quotes. I think it's too soon to say on this, but it is a place where we didn't model revenue synergies in the deal. It was unclear at the -- through the diligence process, we need to be getting a little bit more to understand and I think to your point, it's a very complementary business. Facet sells to places like airports for the fuel storage and we sell to the OEs for cabin air systems or something. So we needed to understand that a bit more, but I would say there's optimism inside the company. Something we got to report on as we understand more. We've had it for about a quarter and change, but feeling good about it.
Absolutely no. And I think as part of that, can you just help us remind us in terms of the accretiveness of the deal, without -- including revenue synergies, it was expected to be accretive, I think, by year 2. But just remind us of the progression of what's kind of baked into your expectations? And then it sounds like there may be potential upside there from revenue.
Yes, I think -- I'm glad you asked that. Thank you, because I think we have a clarification opportunity on this. So the deal on an EBITDA basis about double the company average. And in that regard, accretive immediately. We closed on the fourth of May. On a cash basis, so the business profit from facet, less interest expense associated cash basis accretive this fiscal year, fiscal '27 and then full accretion with amortization in year 2. The path on this, I think, is about continued growth driving. This is part of how we get there. And I think and maybe we come to it. But the balance also of share repurchase relative to paying down debt. We're going to repurchase about 1% of shares this year, which is bit lower relative to our historic average with the goal of not necessarily a target leverage ratio, but more about get faster to accretion, total all-in accretion as quickly as possible.
Got it. I think that makes a lot of sense. And just in terms of -- I will go back to capital allocation because I think that's another area that I want to touch on. But just -- maybe last one, just if we think about the business over a much longer period of time, a lot of the equipment you serve is becoming more sophisticated, contamination seems to be -- keep getting tighter. Just across areas like turbines, aerospace, semiconductors and advanced industrial processes. I mean are you seeing a structural increase in the amount of complexity that flotation requires per asset? How meaningful could that be in terms of -- is there a step change in the growth algorithm for Donaldson over time or the industry overall consolidation? Just how talk what you think about that setup in terms of the structural?
Yes. This is a really important part of our strategic view is we've over decades, chosen places where technology is valued. So that means we aren't under the hood in a passenger car. We focused on more heavy duty. The opportunities as things get tighter, as things get better performing, fuel economy standards, 15 years ago as a change with over-the-road truck that gave us a new leg of growth and technology for those engines because the engines couldn't absorb as much particulate as they could before. So filtration plays really well in the environment that you're describing, more tech, tighter tolerances. In terms of a step change to the growth algorithm, I think we'll see pockets in certain places. I don't know if it will average out. I think mid-single digits is kind of a stable place for us over a cycle. But the opportunities in places like disk drive right now. Obviously, the growth data centers is driving that up. But part of what's giving new life to movable driver is increased level of technology that has a significantly more complicated set of filters on it than the legacy technology. Those are the places where we see continued surging of market-specific opportunities. So this is where filtration is a really exciting spot overall.
And what does that do in terms of margin mix? And given that you provide more and more value to the customer in that operation, I guess, does the business have more pricing power in that vertical -- in those verticals? And as you see faster growth there to that allow for more of a margin mix up? How should we think about that?
Yes. Margin mix is part of the story as we go ahead. So we've talked openly about operating margins pushing much higher from where we are today. This year, we've guided a midpoint around 70%, I think, 16.9% exactly. The opportunity as we look ahead is growth from gross margin with mix being part of that, higher margin markets plus pricing on top of it.
Maybe that's a good transition to what you mentioned earlier in terms of a shift in the pricing strategy, right, particularly in the legacy business or with some of those OEMs or kind of that first fit -- can you walk us through that transition, when did it start to take place? When should we start to see it flow into the business? And what are the implications in terms of your go-to-market strategy to really kind of pivot away from price declines to trying to be -- making sure you're getting the value.
Yes. The very early innings of that were in the early 2020, so I think '23 -- '22, '23. And where we saw that was largely with the OEs in our Mobile Solutions business. And we want to have fair relationships with our customers. What we're finding is that with the old price-down model, it was getting tougher and tougher to offset that with cost. We could do that in the early 2000s, but lean, low-cost manufacturing, all of that has sort of played out. So it was much more difficult to offset that pressure. So in the early part of the 2020s a real push on pricing with the OEs. And this was kind of a, I'd call it, a less granular or less sophisticated approach of looking at the portfolios, the accounts and really here's what we need to reflect our value better. And then the next step for us that we're early innings on is more about the granularity of it and really getting into the details. So we think there's another leg up in terms of pricing capability, but it's about understanding the details versus just the chunks of the accounts. And this is a place where 10 years ago, our pricing algorithm for the company looked way different than it did today. And we report it in our disclosures, and you can see price has been a positive contributor. I do want to say is just sort of an astric on that. Organic growth is a priority growth through pricing is not but we will manage pricing to ensure gross margin expansion.
Maybe to that point because you are making ultimately a decision when you're making sure to be more disciplined on price that you might make some trade-offs in certain cases, right, in terms of volume. How should we think about -- or what are you seeing in terms of the competitive response or discipline to equally have again, more of a pricing structure versus others trying to undercut in any way?
Yes, I think the -- we're fortunate that we compete in fairly rational markets. So the competitive response isn't much different than it has been previously. I think the opportunity for us is this refinement that I mentioned, but -- our competitors are well known to us. They're very consistent with who we've competed with a long time even with some consolidation or 1 of them going public. It's not a different environment than we're used to. So I think we understand that well. And we know that in certain places, it's about locally competitive and we compete on availability. That's really true of our aftermarket parts. We can get priced because we can also say, we'll have it to you tomorrow. So there's different dimensions versus just raise the price. Again, it's important for us and especially with OEs that we have a fair relationship because we like being on those new platforms of tractors and excavators and transfer over-the-road trucks. We want to be on those because we sell more aftermarket and we get on those 2. It needs to be 2 ways, though.
And should we think about this as a little bit of a structural shift in terms of the pricing strategy and how you go every single year? Or is this a catch-up in terms of some of the costs, given how inflation has been so challenging. How would you kind of characterize across.
Yes, I would say that the big chunky work that we did a few years ago was a catch-up. And you saw a step change over the course of 4 to 6 quarters in our Mobile Solutions business, several points of margin improvement. The next is going to be more iterative. I will say, though, that we've got new muscle new discipline around the idea that if something changes in the market, we're agile. So we'll price for that accordingly. If there's a change in cost as a function of the Middle East conflict, we'll react to that. We won't just say price increase in January and wait. We want to be real time on it, too.
Got it. Yes, I was going to ask is -- are these more kind of annual or are they multiyear? Like how often do you get a chance to kind of reset versus maybe a surcharge related to Middle East or something?
Yes, much more annual. That's kind of the rhythm to it.
Got it. All right. And then maybe just one to kind of bridge the gap between price cost and market share, which I want to touch on. Just to what extent has the shift or the focus on kind of domestic for domestic? Has that had any implications on your ability to either compete cost-wise, or vice versa take share in any particular bucket?
Yes. This is a really important part of our footprint that I think we were able to market, I guess, to some extent, 1 year ago. So about 75% of what Donaldson makes in the world stays in that part of the world. For the most part, it's about supporting our customers and this availability and access that I mentioned before. So if we make something in China, it was about keeping it in that region or make something in the Americas that's keeping it in that region. In the time of tariffs, that created quite a bit of insulation. Tariffs were immaterial to the total company much less than 1% of total revenue, and we're able to navigate this. And I think to your question then, our ability to supply our customers reliably. And there was definitely a tariff impact, but more on a muted basis. I think that helps us. Now for certain of our competitors, I don't know if that -- I don't think that gave us a material advantage. But what it did allow us to do is to maintain the reputation and the relationships that we've had without having a disadvantage in the situation.
And maybe how would you just frame the market share opportunity broadly in terms of across first aftermarket, the different verticals of your products, I guess, is there pockets or opportunity versus less. And just like what is what's the we need to do to get that.
Sure. I think there's the classic it depends the answer on this. But let's start this way. If you think about the maturity of our operating segments, the mobile solutions has much more specific opportunities, whereas you move through industrial and life sciences and greater opportunities as a function of their relative maturity. In Mobile Solutions, I think for us, it's about continued expansion with new technologies that help really grow their part business. So they look for proprietary parts. They look for meeting some sort of performance backs. And again, we compete in heavy-duty markets. We're not in the light duty. So they're looking for to Angel's question earlier, better performing engines that require better filtration less of a market share gain and more about maintaining and incremental growth. In industrial, it's about expansion and thinking about it as content under the roof of a factory. And one of the things that we did a few years ago was reorganized the industrial group to have a head of aftermarket and services. This is a place where we recognized we were underpenetrated and each of the business units was doing their own focus on aftermarket. Well, recurring revenue growth is an important part of the strategy. And so we've reorganized around that. There's a lot of share opportunity there because of the fragmentation in this space. And then life sciences, where we're less mature places like again, food and beverage, disk drive very mature, high market share, but the rest of it, a lot of market share opportunities.
Understood. And maybe just switching over to capital allocation. I think still ample kind of flexibility or firepower in your balance sheet. So is it more that you want to integrate this and then go look for more opportunities? How should we think about the timing or the appetite as well?
Sure. We are definitely interested in doing more. And of course, the timing is hard to predict on these types of deals, but a facet like deal in terms of the company characteristics are things that we would absolutely consider. So higher growth and very good durable markets where the customer is sticky, margins that reflect that, low capital intensity. And again, this is aerospace -- last several years, we've bought 4 smaller bio companies. These still need to mature. So the place where we're probably more out of the market is on any sort of new tech that's a pre rev bio company, we're thinking more commercial access established organization at this point.
Understood. And then maybe from a leverage standpoint, I guess, how would you kind of frame your longer-term target, but also just your willingness to lever up for potential acquisition?
Yes. Definitely, I willingness to lever up provided it's do more, and we would do more like that. I would be very cautious on something that was a transformational deal. It's never say never, but it would have to absolutely be a strategic bullet markets we understand markets that we want to pursue.
Understood. No, I think that makes a lot of sense, and that's good. Capital spin is always a good thing. Maybe just last 1 with the last 2 minutes here, just you wanted to make sure, I guess, don't want you to, I guess, to your own thunder from Investee, but as you think about having an Investor Day potentially in the future, I guess, what are the aspects that you think ultimately you want to try to communicate in terms of broader topics or anything like that? Again, no need to go into details, but just curious like are there specific aspects that you think is important that people understand about the business that you feel like you need to unpack a little bit better as you have your investor conversations.
Yes. I think the topics that you raised today are good setups for that. So it's, first, what is that growth algorithm. And which markets are the ones we're pursuing a as I mentioned before, portfolio management is a really critical part of the work we're doing right now. So answering that question of what does it mean and how should all of you think about it? And then where does that leave us in terms of margin expansion, not just that margins get better, but what's the algorithm on that as well. and examples of the types of work we're doing to push that up. And then I think it's also, as we think about the next even 5 or 10 years, how do we and pushing that and again, helping all of you understand what it means and how to think about that in terms of modeling our opportunities.
Absolutely. We're looking forward to it. And if there's no other questions, I think that brings us to the time. So I wanted to make sure, again, thank you again for the time and looking forward to again investor day.
Thank you. Good questions as always. Really appreciate it. Thank you.
Thank you.
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