Donaldson Co. Stock: Improved Fundamentals, Still Not A Buy (NYSE:DCI)

Engineer checking and maintenance technical data of system equipment condenser Water pump and piping air compressor system.

Oranat Taesuwan/iStock via Getty Images

In industrial applications especially, filtration systems, whether they be for air, fuel, hydraulic purposes, or some other need, are incredibly important. What is, at first glance, a rather simple type of technology helps the modern world to function. They help air to be clear, food and beverages to be consumable and tasty, turbines to operate, and so much more. One company dedicated to producing these filtration systems and replacement parts associated with them is Donaldson Company (NYSE:DCI). Like so many other companies in recent months, Donaldson Company has experienced quite a bit of pain from a share price perspective. However, the company’s fundamentals have only continued to get better. So long as this trend continues, it will not be much longer before shares in the company deserve some upside potential. For now, I do still think that the business is a ‘hold’ candidate. But if fundamentals improve further and/or shares drop another 10% or so, I could definitely see this being a solid ‘buy’ for long-term investors.

A dichotomy exists

Back in December of 2021, I wrote my first article about Donaldson Company. In that article, I acknowledged that the company was a quality operator. However, I also made clear that while quality might exist, this does not necessarily translate into a ‘buy’ for the business. To be absolutely transparent, I do believe that the long-term potential of the business is attractive. Having said that, at the time, shares looked too pricey to make sense. As a result, I ultimately concluded that there were better prospects on the market, and I ended up rating it a ‘hold’. When I write a business this way, my belief is that its returns will more or less match the broader market for the foreseeable future. Since then, shares have performed more or less as I would have anticipated. While the S&P 500 is down 19%, shares of Donaldson Company have generated a loss for investors of 16.2%.

Historical Financials

Author – SEC EDGAR Data

Given this decline, investors might think that the company was undergoing some pain. However, that couldn’t be further from the truth. Consider the company’s top-line performance. When I last wrote about the firm, we only had data covering through the first quarter of the firm’s 2022 fiscal year. Now, we have data covering the first nine months of the year. During that time frame, revenue came in at $2.42 billion. That’s 16.1% higher than the $2.08 billion the company reported the same time one year earlier. Growth has slowed down as of the latest quarter, coming in at 11.5% year over year, with revenue climbing from $765 million up to $853.2 million. Having said this, the overall expectation for the year is quite bullish. Previously, management thought that revenue would rise by between 11% and 15% this year. That number has been revised higher to between 14.5% and 16.5%. using midpoint estimates, that should translate to an extra $71 million in sales for the year.

Financial performance on the bottom line has been mostly positive as well. Net income in the latest quarter did weaken, coming in at $83 million compared to the $84.4 million experienced in the third quarter of 2021. However, overall profits for the first nine months of the fiscal year were strong at $231.8 million. That’s 14.4% above the $202.6 million reported the same timeframe one year earlier. Other profitability metrics have also mostly improved. Admittedly, operating cash flow did worsen, coming in at $143.9 million for the first three quarters of 2022 compared to the $305.6 million reported one year earlier. But if we adjust for changes in working capital, this metric would have risen from $295.3 million to $327.1 million. Meanwhile, EBITDA for the company has also been on the rise, climbing from $362.2 million to $391.6 million.

Historical Financials

Author – SEC EDGAR Data

When it comes to profitability for 2022 as a whole, investors should know that margins will be weaker than previously anticipated. Given the inflationary and supply chain issues the global economy is experiencing, this should not come as a surprise. Earnings per share should be between $2.67 and $2.73 with a midpoint of $2.70. That compares to the range of $2.66 to $2.76 with a midpoint of $2.71 previously expected. Despite this implying that margins will be weaker than anticipated, net income should still be higher year over year. Net profits for the entirety of the year should be $331.7 million. That compares favorably to the $286.9 million reported for 2021. Guidance has not been given when it comes to other profitability metrics. But if we assume that they will increase at the same rate that earnings should, then operating cash flow should be around $464.7 million, while EBITDA should be around $571.4 million.

Trading Multiples

Author – SEC EDGAR Data

Using this data, it becomes fairly easy to value the business. Using our 2021 results, the firm is trading at a price-to-earnings multiple of 21.6. The price to operating cash flow multiple is lower at 15.5, while the EV to EBITDA multiple is 13.5. If we use the 2022 estimates, these numbers come in at 18.7, 13.4, and 11.7. Normally, I prefer to use data from the most recently completed fiscal year (or the forward-looking data if it’s worse than the most recently completed fiscal year) to value the business. However, given how far we are through the 2022 fiscal year for the company, I don’t see an issue using the forward-looking figures.

In my last article, I approximated a price-to-earnings multiple for the company, on a forward basis, of 21. The price to operating cash flow multiple was 12.8, while the EV to EBITDA multiple was 11. What this shows is that, while the company has gotten cheaper on a price-to-earnings basis, it is a bit more expensive when it comes to the other profitability metrics. also, for context, I also decided to compare the company to five similar firms. On a price-to-earnings basis, these companies ranged from a low of 5.4 to a high of 19.6. Using the EV to EBITDA approach, the range was from 3.7 to 14. In both of these cases, four of the five companies were cheaper than Donaldson Company. Meanwhile, using the price to operating cash flow approach, the range was from 7.7 to 14.8. In this case, three of the five were cheaper than our prospect.

Company Price / Earnings Price / Operating Cash Flow EV / EBITDA
Donaldson Company 18.7 13.4 11.7
Mueller Industries (MLI) 5.4 7.7 3.7
Crane Holdings (CR) 12.1 13.3 9.2
Parker-Hannifin (PH) 19.6 14.8 14.0
EnPro Industries (NPO) 10.5 12.0 8.8
Standex International (SXI) 17.4 13.5 9.7

Takeaway

Based on the data provided, it looks to me as though, operationally, Donaldson Company is still a perfectly fine and solid company. Margins will likely suffer some this year compared to prior expectations. But even so, results should be stronger year over year than they were in 2021. Relative to valuing the company based on 2021 results, shares are also looking much more attractive. However, they seem to be priced more or less in the same range on a forward basis as when I last wrote about the firm. That forward approach is becoming increasingly relevant because of how late we are into the 2022 fiscal year for the business. Because of this change, I am becoming more bullish on the business. Normally, the prices at which shares are going for would lead me to rate the business a ‘buy’. But given heightened concerns about the broader economy and inflation, I have started to become a bit pickier regarding businesses. Due to this, I have still retained my ‘hold’ rating on the company. But if the fundamental condition picks up further or shares drop from here, I could see myself upgrading the rating of the business.

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