Donaldson Delivering, And Updated Guidance For FY'23 Could Be A Catalyst

I’ve liked filtration specialist Donaldson (NYSE:DCI) for a while now, and not only are the shares up about 15% since my last update (handily beating the broader market and the industrial sector), they’ve continued to beat the market (and the industrial group) since my initial write-up for Seeking Alpha. The thesis then and now was maximizing the value of the legacy heavy machinery and industrial filtration businesses while exploring opportunities to extend those core competencies into new markets like food/beverage, life sciences, and other process markets where filtration is important (and acquire new, complementary, competencies through M&A along the way).

I’ll be very curious to see what management says about guidance when it reports fiscal first quarter earnings later this month. The initial guide for FY’23 back in August surprised the Street with its conservatism, and the recent earnings/guidance calls from heavy machinery companies have been relatively good. Moreover, at a time when many short-cycle businesses are starting to roll over, many heavy machinery companies are carrying good backlogs into 2023 and underlying activity/utilization is still healthy.

With the shares performing well, I don’t see as much undervaluation here. I think the shares are still priced for long-term annualized returns in the high single-digits (around 8%), but near-term upside looks capped at around the mid-$60’s without a stronger outlook. There are worse things than owning a good company at a reasonable price, but there are more options now for investors and I’m not as inclined to chase Donaldson.

 

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Donaldson Delivering, And Updated Guidance For FY'23 Could Be A Catalyst

Donaldson Deserves A Second Look After A Steep Decline

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.

 

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Donaldson Deserves A Second Look After A Steep Decline

Donaldson Leveraging Strong Demand And Easier Comps

 

With strong production growth in commercial vehicles and recoveries in many short-cycle industries, not to mention strong demand for freight capacity, Donaldson (DCI) isn't hurting for business these days. While component shortages are starting to crimp truck production, and are likely capping Donaldson's revenue upside, the overall operating environment is still healthy.

I'm excited to see what Donaldson can achieve by repurposing its core air and liquid filtration technologies for markets like food/beverage and pharma/life sciences, as well as markets like electronics and specialty chemicals, but Rome wasn't built in a day and this is going to be a multiyear process, likely one that requires M&A spending in what is not a cheap market.

These shares have modestly outperformed the S&P 500 and the broader industrial sector since my last update, and I think another beat-and-raise quarter is likely when Donaldson reports again in early September. Valuation is so-so. I can see some upside from here and the long-term prospective return isn't bad compared to what I think is an expensive sector, but a lot of my bullishness stems from a fundamental leaning toward "letting your winners run" and a belief that Donaldson's future growth and margin opportunities could drive even better results than I'm currently modelling.

 

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Donaldson Leveraging Strong Demand And Easier Comps

Donaldson Still Leveraged To High-Quality Revenue Growth Upside

Recommending Donaldson (DCI) back in September, I liked the company for its leverage to an eventual recovery in heavy machinery (trucks and off-road equipment) and industrial demand, but even more for the growth potential the company had in its attempts to bring its very strong filtration technologies into new markets like food/beverage and life sciences. On top of that, I saw an M&A “kicker” as many filtration companies have been taken out in the past at pretty rich multiples.

Since that last article, these shares have risen about 25%, modestly outperforming the larger industrial group and roughly doubling the return of the S&P 500 (while lagging partial peer/comp Parker-Hannifin (PH)). I don’t see quite the near-term opportunity from a valuation perspective as before, but I still like the company’s leverage to recovering end-markets, and its demonstrated desire to grow new market opportunities (hiring a new VP to oversee growth efforts in life sciences).

Donaldson looks modestly undervalued now, with a long-term total annualization potential return on the higher end of what I’m seeing these days for high-quality industrial names (6% to 8%). I also do believe that M&A remains a potential outcome, and likely at a premium multiple. I wouldn’t buy or recommend buying Donaldson as a takeover candidate, but I do think there’s still a window of opportunity here for a company that will likely trade at a higher multiple once the end-market recoveries are obvious.

 

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Donaldson Still Leveraged To High-Quality Revenue Growth Upside

A Quarterly Hiccup At Donaldson May Be An Opportunity For Long-Term Investors

Filtration is a pretty good business to be in – there have been several high-multiple acquisitions in the space over the years (often at mid-to-high teens multiples of EBITDA), with companies including Danaher (DHR), 3M (MMM), and Parker Hannifin (PH) among those that have paid up to get into the space.

For Donaldson (DCI), it’s been a cyclical business, but one that has generated healthy double-digit returns on capital for over a decade and annualized high-single-digit FCF growth for over 20 years. And now Donaldson is looking to address even more of the market, with targeted expansion into areas like food & beverage, specialty chemicals, and pharma that offer both higher growth rates and less cyclical growth than the core engine filtration business.

I like Donaldson quite a bit, but the valuation has rarely been all that attractive to me. With the Street unimpressed with the last quarter and selling the shares off, though, there looks to be a window of opportunity here. I see a high single-digit to low double-digit annualized total return potential at today’s price, which I think is a pretty good entry price for a proven performer in an attractive space.

 

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A Quarterly Hiccup At Donaldson May Be An Opportunity For Long-Term Investors

Seeking Alpha: Entegris Is Another Small-Cap Play On Future Semi Spending

Investors aren't exactly in danger of running out of ways to play expected improvements in semiconductor capital spending in 2014. I've already talked about opportunities in companies like Ultratech (UTEK) and Mattson (MTSN), and both appear to offer significant value if and when next-gen capital spending increases.

Entegris (ENTG) is a different sort of play. Unlike Ultratech and Mattson, there really isn't much of a missionary aspect to sales - semiconductor manufacturers already understand the need for contamination control and advanced material handling, and Entegris already holds solid share in its core markets. That said, more advanced fab processes should require more filtration equipment and a larger sales opportunity for Entegris. While I don't necessarily see as much upside in the Entegris bull-case scenario (compared to Ultratech or Mattson, that is), I believe there is less execution risk here and still an opportunity to generate worthwhile capital gains.

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Entegris Is Another Small-Cap Play On Future Semi Spending

Investopedia: Pall Always Gets The Benefit Of The Doubt

I'd hate to be short Pall (NYSE:PLL), as large companies in the filtration space often seem as close to bulletproof as you can find in the market. So even though sell-side analysts chronically overestimate Pall's free cash flow, investors remain happy with a company that admittedly enjoys strong share and a very lucrative channel of repeat business. While I think Pall's shares remain overvalued, I don't have any particular reason to believe that the shares will sell off dramatically, as the life sciences business should be stable and the industrial business should start improving next year.

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http://www.investopedia.com/stock-analysis/082913/pall-always-gets-benefit-doubt-pll-dci-entg-iex.aspx

Investopedia: Is Clarcor's Business Slipping Away?

Filtration has proven to be a consistently popular business with many investors and corporations. The appeal makes sense - as performance and environmental quality demands increase, so does the demand for better filtration. Filtration also tends to be a business oriented towards defensible high-margin consumables business. All of that said, Clarcor's (NYSE:CLC) business is not looking so strong right now and it's worth asking why that is.

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http://stocks.investopedia.com/stock-analysis/2012/Is-Clarcors-Business-Slipping-Away-CLC-DCI-CMI-CAT0626.aspx

Seeking Alpha: Pall Has The Quality, But Valuation Is A Stretch

Filtration has been a popular niche within industrial and life science markets, and it's not hard to see why. Once a system is in place, the vendor can usually look forward to years of lucrative disposables/consumables sales and customers are disinclined to risk their reputations or systems (to say nothing of downtime) just to save a few bucks on a competing platform.

All of that speaks to why Pall (PLL) should be a popular stock. Certainly the company has a great array of businesses, with relatively dependable markets like biopharmaceuticals and healthcare offsetting more volatile and cyclical industries like microelectronics and aerospace. That all being said, there's a fair value for every asset and Pall is going to have to deliver remarkable performance to live up to its present valuation.

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Pall Has The Quality, But Valuation Is A Stretch

Investopedia: Pall And The High Cost Of Excellence

Being a disciplined value-oriented analyst can be a real pain sometimes, as it often forces you to hold off from buying names you'd really like to own. Filtration specialist Pall (NYSE:PLL) is a good case in point. The company has appealing returns on capital, a great, broad-based filtration business, and appealing upside to internal improvements. Unfortunately, the Street knows all about this name and the value just isn't there.

A Very Solid Start to the Fiscal Year 

Pall certainly got its fiscal year off to a good start, posting nearly 12% revenue growth in constant currency terms and beating the average Wall Street guess by about 10%. Growth was led by 19% higher sales in the industrial category, while life sciences was hardly a laggard at 14%. Biopharma, energy/water and aeropower, were notable subcategories with strong growth, while performance in medical, food/beverage and microelectronics was less impressive.

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http://stocks.investopedia.com/stock-analysis/2011/Pall-And-The-High-Cost-Of-Excellence-PLL-GE-CLC-BA1213.aspx

Investopedia: Pall May Be Offering An Entry Point

Looking at the results of companies in the broadly-defined filtration business, for example companies like Donaldson (NYSE:DCI) and Clarcor (NYSE:CLC), it may be tempting to decide that the run in industrial filtration is over and it is time to move on to other ideas. In the case of Pall (NYSE:PLL), though, that may not be the wisest long-term move. While Pall is certainly not performing at peak potential, the opportunities that seem to be left in the company and stock make it a worthy consideration for a long-term investor.

A Tough End to the Year  
Pall pre-announced a disappointing fourth quarter result, so the market has already had a chance to digest the news and punish the stock accordingly. Pall reported that revenue rose 15% on a reported basis, with constant currency sales growth of about 6%. Growth was led by the life sciences business, with 8% constant currency growth. This segment is slightly more than half of the company's total sales. On the industrial side, growth was a more modest 5% (again on a constant currency basis).

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http://stocks.investopedia.com/stock-analysis/2011/Pall-May-Be-Offering-An-Entry-Point-PLL-DCI-CLC-BA-GE-TYC0919.aspx

Investopedia: Clarcor's Growth Story A Little Gummed Up

Industrial filtration is one of those "stealth growth" markets that gets little attention, but offers investors a good play on diverse themes like pollution control, energy efficiency and OEM equipment growth. Recently, though, it has started to look as though this sector has some issues to resolve. Like Donaldson (NYSE:DCI), Clarcor (NYSE:CLC) is not looking at a disastrous operating environment, but it looks like investors have to lower their expectations a little for the time being.

Disappointing Third Quarter Results  
Bucking the "beat and raise" trend that is still prevalent in the industrial sector, Clarcor actually missed its estimates for the quarter. Sales rose 8%, with double-digit growth in the industrial/environmental segment and solid results in engine/mobile filtration offsetting a decline in the packaging business.

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http://stocks.investopedia.com/stock-analysis/2011/Clarcors-Growth-Story-A-Little-Gummed-Up-CLC-DCI-CMI-HON-CYD-PH-CAT0915.aspx

Investopedia: Will China Extend Joy Global's Cycle?

In many respects it looks like the bloom is well off the rose when it comes to the industrial equipment rebound. A range of companies - Caterpillar (NYSE:CAT), Emerson (NYSE:EMR) and Donaldson (NYSE:DCI) just to name three - have posted solid results in recent weeks, but suggested that growth is going to get harder in markets like North America and Europe (where most of these companies still garner the majority of their revenue).

What, if anything, does that mean for Joy Global (Nasdaq:JOYG)? As one of the leading providers of heavy machinery to the mining industry, it is clearly a cyclical business and this up-cycle in equipment demand has been going on for a while now. Will a slowdown in economic growth lead to mining companies pulling back on projects and curtailing demand, or will acquisitions like China's IMM give it enough emerging market exposure to temper the down-cycle?

Read more of this article at Investopedia:
http://stocks.investopedia.com/stock-analysis/2011/Will-China-Extend-Joy-Globals-Cycle-JOYG-CAT-DCI-CMI-CAM-TWI-KMTUY0902.aspx

Investopedia: Donaldson Likely Looking At A Lower Gear Next Year

The trouble with good times is that in the market they always come to an end sooner or later. Like many other industrial and vehicle suppliers, Donaldson (NYSE:DCI) has had a very solid run as the economy has recovered from its worst levels. With a lot of OEM orders already in the history books, though, it looks like the pace of growth is due to slow, and it's anybody's guess as to whether shareholders will remain as loyal to the stock if growth finds a lower gear.

A Solid Cap to a Good Year  
Donaldson did well for its fiscal fourth quarter. Revenue rose 21% as reported, or about 13% on a constant currency basis. Admittedly that pales a bit when compared to the results of Caterpillar (NYSE:CAT), BorgWarner (NYSE:BWA), or Cummins (NYSE:CMI), but it was a good result and it compares well with other filtration players like Pall (NYSE:PLL) and Clarcor (NYSE:CLC).


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Investopedia: Joy Global's Mixed Quarter

With the stock markets in the middle of a "high oil prices will kill growth" snit, once-hot commodity plays have cooled off rapidly. That's not the best time, then, for mining pure-play Joy Global (Nasdaq:JOYG) to offer up a mixed quarter. While the global mining boom almost certainly still has legs, it looks like this entire sector has lost some momentum for the time being. 

A Mixed First Quarter 

Joy Global's fiscal first quarter gives investors a lot to chew on and try to interpret. Revenue was up 19% from the year-ago quarter, but down 17% sequentially and off a bit from the average analyst guess. Underground machinery and original equipment both appeared to be weaker than analysts hoped, though they were up 21% and 12% respectively (and investors should note that there is overlap in these two categories). (For more, see Joy Global A Mix Of Performance And Scarcity.)

Profitability was also disappointing on a relative basis. Gross margin was up more than a point and a half, and operating income jumped 31%, but expectations were generally higher. So while it is certainly true that operating margins in the high teens for both underground and surface equipment are not bad in their own right, the reality is that stocks trade largely on expectations and Joy Global did not meet them this time around.

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http://stocks.investopedia.com/stock-analysis/2011/Joy-Globals-Mixed-Quarter-JOYG-CAT-TWI-DCI-IR-KMTUY0303.aspx

No Need To Rush On Donaldson

When investors can find a company that earns a great return in a pervasive but low-key industry, they should hang on tight. That certainly would seem to apply to filtration company Donaldson (NYSE:DCI). Not only has Donaldson managed to produce double-digit returns on invested capital on a consistent basis, but the company has also managed to exploit leverage on the free cash flow line; generating a decade of double-digit compound growth off of single-digit sales growth.   

The Quarter That Was
Like a lot of industrial companies, Donaldson had a very solid summer quarter (the company's fiscal fourth quarter). Revenue jumped 22%, as the company's engine product segment grew even faster (up 35%). Profitably was likewise solid across the board - gross margin improved by more than a full point, and the company more than doubled its operating income from the year-ago level. 


http://stocks.investopedia.com/stock-analysis/2010/No-Need-To-Rush-On-Donaldson-DCI-CAT-DE-BA-IBM-CMI-PLL0901.aspx

Cummins Comes On Strong

Another piece recently published on Investopedia.
I definitely have a soft spot for industrial tech companies like Cummins ...

(please note: something a little goofy happened to the first paragraph in the editing process. We're working on it...)

http://stocks.investopedia.com/stock-analysis/2010/Cummins-Comes-On-Strong-CMI-TTM-DCI-CAT-ARM0428.aspx