Donaldson Delivering, And Updated Guidance For FY’23 Could Be A Catalyst (NYSE:DCI)

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.

FQ1 Should Be Setting Up For Upside

I may well end up eating these words, but I think Donaldson is set up for a beat when it reports fiscal first quarter results later this month. Industrial activity has remained healthy, with industrial air players like Ingersoll Rand (IR) and Atlas Copco (OTCPK:ATLKY) reporting healthy demand, and while I’m concerned about declining conditions for the trucking industry, I believe miles driven for Donaldson’s recently-completed quarter should be quite healthy. Likewise, I have some near-term concerns about construction and mining, but activity has remained healthy and Donaldson is primarily (around 60%) an aftermarket business.

Donaldson got a 12% boost to sales growth last quarter from pricing and I don’t see why there’d be meaningful sequential erosion (though year-ago comps are certainly stiffer). Working against the company, forex will likely have a bigger impact than has been modeled (though analysts have had a chance to adjust expectations after seeing third quarter earnings from other companies), and there could also be some headwinds tied to discontinued business.

With many companies reporting some easing in input cost inflation and component shortages, I expect some healthy sequential leverage in gross margin (around two points), and I think healthy revenue and gross margin should drive an operating beat.

Guidance Will Get Interesting

Management surprised analysts and investors last quarter when it guided FY’23 growth meaningfully below expectations… +3% at the midpoint versus a Street expectation of +6%. While aftermarket business was expected to be healthy (up mid-single-digits), management was looking for weakness in first-fit heavy machinery and weaker results in parts of the Industrial segment.

The outlook for heavy vehicle new-builds is still looking pretty healthy. Still constrained by limited component availability (and in some cases, labor), many heavy machinery manufacturers are going into 2023 with sizable backlogs that should at least support the first half of the year. I do think there will be a sharper correction in truck orders as the year goes on, and quite possibly one in construction as well, but I’d expect demand for agricultural and mining equipment to hold up fairly well given the age of the existing fleets and supportive commodity prices. Aerospace and defense should also provide some strength given ongoing recovery in flight traffic, but this isn’t a particularly large part of the business.

On the Industrial side, I do expect weaker demand in core industrial end-markets as short-cycle industries roll over. New growth opportunities in food/beverage, life sciences, and process filtration should offset that fairly well, but I think it’s reasonable to be a little cautious.

Margins should be a source of strength. Business is pretty sticky for Donaldson, and while there will eventually be pressure on prices as input costs ease, I don’t think those pressures will be particularly large in 2023, so I expect the company to leverage healthy pricing against an improving cost structure, helping drive a point or more of EBITDA margin improvement.

Many Options For Further Growth, And A Clean Balance Sheet To Fund It

Donaldson has continued to add pieces consistent with its stated strategy of pursuing growth in new filtration markets like life sciences, acquiring Purilogics back in June. This is a small company, but I like their membrane-based approach to chromatography and this could prove to be a valuable building-block over time. For readers not familiar with biochemistry and bioprocessing, chromatography is a key step in the production of biologics, as it is used to purify and separate target molecules like mRNA, plasmid DNA, antibodies, or proteins out of their production media.

I continue to see a significant runway for Donaldson in life sciences, to say nothing of other end-markets that have high-end filtration needs (like semiconductors). A recent partnership with Wildtype underlines this – the two companies will collaborate to design specialized bioreactors for Wildtype’s cultured/cultivated seafood production needs. This is, in effect, growing seafood in a controlled lab/industrial setting using bioprocessing tools and techniques. I’d have to call this a long-shot opportunity today, but I think it does illustrate how Donaldson could ultimately see growth from unexpected markets and not just traditional biologics production.

The Outlook

Donaldson’s FY’22 results were a bit better than I’d expected (revenue and EBITDA beat by about 2%), but I’ve tempered my FY’23 expectations a bit. My long-term revenue growth estimate is slightly lower (down to around 5% to 5.5%) with the model moving forward a year, and I do still see strong long-term opportunities outside of the company’s core served markets.

Given good pricing leverage, I’m expecting better EBITDA margins now, and I’m looking for about one point of improvement in FY23 and about two points of improvement over 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 long-term potential annualized returns of a little more than 8% at today’s price. Using my margin/return-driven EV/EBITDA formula, I think Donaldson can trade at over 13x forward EBITDA, and I’d note that filtration companies (particularly those with exposure to life sciences) have often traded at 15x or higher multiples, so rerating in the future is a possibility.

The Bottom Line

Given my opinion of the company, management, and the strategic plan here, I’d like to be more bullish on these shares. As is, though, I don’t see an especially strong call on fundamental undervaluation unless Donaldson posts a strong beat and a raise quarter. I lean bullish for now mostly just because I have found that good companies have a way of “growing into” valuations that may look high, but I’d really prefer to pick up shares on a pullback if possible.