Donaldson: Pricing actions to benefit revenue and margins (NYSE: DCI)

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Investment thesis

Donaldson Company (NYSE: DCI) stock is up about 10% since our last article. Company sales benefited from strong end markets and price actions in FY22. Pricing actions taken in FY22 expected to continue in FY23, which should support the company’s revenue growth. Aftermarket and Aerospace & Defense volumes should benefit from strong demand and the recovery of commercial airlines which should more than offset any slowdown in on-road and off-road activities. DCI plans to improve its profitability by focusing on higher-margin projects. This, coupled with price action and cost control measures, should help margins in FY23. Valuations are cheap.

DCI Q4 FY22 results

Donaldson recently announced mixed financial results for the fourth quarter of FY22, with EPS in line with estimates and better-than-expected revenue. The company’s revenue in the quarter increased 15% year-on-year to $890 million (vs. consensus estimate of $880.24 million). Adjusted EPS rose 27% year over year to $0.84 (vs. consensus estimate of $0.84). Sales growth was driven by a 12% price and 10% volume contribution, partially offset by a 7% negative impact from unfavorable currency translation. Adjusted operating margin in the quarter increased 40 basis points year-on-year to 14.9% as operating expense leverage offset gross margin pressure. Gross margin declined 150 basis points year-over-year to 32.9%. Improved adjusted operating margin and lower share count led to 27% year-on-year growth in adjusted EPS.

Revenue outlook

In the fourth quarter of FY22, the company saw a slight improvement in supply chain constraints, including chip shortages. This led to an 18% year-over-year sales increase in the Engine Products segment. Sales of the Off-road, Aftermarket and Aerospace & Defense activities increased by double digits Y/Y. The Aftermarket business benefited from the growth of the Exhaust and Emission business in Europe. The Aerospace and Defense business grew on the strength of spare parts as commercial aerospace recovers. However, On-road business sales fell low single digits due to weakness in the Asia-Pacific region. The Engine Products business in China was down 6% year-on-year due to the two-week shutdown of factories in China resulting from the COVID-19 related lockdowns. The company is expanding its independent channels from the Engine Aftermarket business to increase its presence in underrepresented regions such as Mexico and Brazil.

Off-road and On-road sales are expected to decline by single digits due to the strategic exit of certain low-margin programs. The company is focusing on higher-margin projects to improve profitability. This should negatively impact sales in the short term, but should improve profitability while increasing sales in the long term. Volume growth in both off-road and on-road businesses is expected to slow in FY23. In the off-road business, volumes related to the new emissions program in Europe should have peaked during FY22. This should translate into a slowdown in volumes next year. Even though supply chain constraints ease, the On-road business is expected to remain impacted to some extent in FY23. This should be offset by mid-single-digit growth in Aftermarket and Aerospace & Defense. Demand in the Aftermarket business remains robust with high vehicle utilization levels. The company’s strategy to expand its aftermarket business in the underrepresented region is also expected to help gain market share. Aerospace & Defense sales are expected to be supported by a strengthening commercial aerospace industry, which remains below pre-COVID levels. Even though the business in the APAC region, particularly in China, is still affected by Covid, I believe the situation should improve next year and the company has good long-term plans in China which should generate gains market share and growth.

Industrial segment sales were up 10% year-over-year in the last quarter, driven by growth in industrial dust collection, new equipment and spare parts. Sales of industrial filtration solutions increased by 14%, mainly driven by new industrial dust collection equipment and spare parts. DCI’s process filtration sales benefited from new program wins. Gas Turbine Systems sales increased 39%, supported by the timing of spare parts sales in EMEA. Specialty Applications sales were down 17% due to COVID-19-related shutdowns in China, which impacted hard drive sales, partially offset by sales growth in ventilation products.

In the industrial segment, sales are expected to be driven by strong demand for dust collection and process filtration products and contributions from the three acquisitions completed in FY22. In the fourth quarter, the company acquired Purilogics to expand its presence in the life sciences sector. Purilogics’ technology platform, when integrated with DCI’s technology, is expected to enable DCI to bring a broad portfolio of purification tools to market.

Going forward, the pricing actions taken by the Company in FY22 are expected to continue into FY23 and contribute significantly to revenue, particularly in the first half of FY23. The price advantage in the 2H FY22 was double that of the 1H FY22, which should translate into bigger gains at the start of FY23. The company will also implement its regular price hike which is normally done every year, but the majority of price benefits will likely come from price increases already implemented in the second half of FY22. therefore there is good visibility in terms of price advantages for FY23. The sales forecast range for FY23 is between 1% and 5%, which includes price advantages of approximately 6% and approximately 4% due to currency translation.

The company is positioning itself to weather economic downturns by using its global footprint to circumvent supply chain issues, capitalize on aftermarket business, manage costs, and use its balance sheet to seize opportunities in the “Moving Forward” businesses. and Accelerate” and the life sciences sector. . DCI consolidated its position as a technology-driven filtration leader by meeting customer demand by reducing its backlog and inventory. This bodes well for the company’s long-term growth.

Margins

In the fourth quarter of FY22, the company saw some stabilization in raw material costs and a slight easing in global logistics and labor pressures. However, gross margin for the quarter remained under pressure as it fell 150 basis points year-over-year to 32.9%. While the company compensates for raw material and freight inflation with price increases, other transitory factors such as inefficiencies, labor turnover and training costs as well as the composition of sales are dragging down margins. Operating expense leverage offset these pressures, resulting in improved adjusted operating margin.

Donaldson Adjusted Gross Margin and Adjusted Operating Margin

Adjusted gross margin and adjusted operating margin (company data, GS Analytics Research)

Going forward, the company’s margins in FY23 are expected to improve, driven by gross margin expansion and leveraged operating expenses. With the moderation of production costs, the gross margin should improve. The company is also struggling to manage its expenses and operate effectively in the recessionary environment. This, combined with the improvement in gross margin, should benefit adjusted operating margins. Additionally, the company is focused on improving its profitability by investing in higher margin projects to improve the mix. Adjusted operating margin is expected to be between 14.5% and 15.1% in FY23, which is a good improvement from operating margins of 13.5% in FY22. This, combined with a slight improvement in revenue, should help the company post good earnings growth.

Evaluations and conclusion

The stock is currently trading at 16.92x the consensus FY23 EPS estimate of $3.00, which is below its five-year average PE of 23.25x. Despite concerns over the general market downturn, the company should be able to increase revenue in the current year, helped by pricing advantages and growth in certain end markets such as secondary markets and aerospace. In addition, the company should see a significant increase in its margins thanks to its price actions. This, coupled with lower valuations, makes DCI a good buy.

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