Donaldson: Attractively Valued With Good Progress Prospects (NYSE:DCI)

Funding Thesis

Donaldson Firm, Inc. (NYSE:DCI) inventory has traded flattish since my previous coverage in September. The corporate has reported combined Q1FY24 outcomes since then with its flattish gross sales lacking estimates whereas EPS coming higher than estimates. I proceed to see good development potential for the corporate. Within the coming quarters, Donaldson’s income development is well-positioned to learn from simpler year-over-year comparisons, good end-market demand and market share positive factors within the Industrial section, aftermarket stock destocking finishing within the Cell Options section, and restoration within the Disk Drive market within the Life Sciences section. Other than natural development, the corporate has a wholesome stability sheet and is well-placed to do bolt-on M&As.

On the margin entrance, the corporate ought to proceed to see positive factors from pricing actions, value deflation, working leverage, and elevated plant productiveness. The corporate’s Life Sciences section is at the moment posting unfavourable working margins as it’s investing in scaling its current acquisitions however administration expects sequential enchancment because the yr progresses. This must also assist total working margins within the coming quarters. The valuation is engaging when in comparison with its 5-year historic averages. This, mixed with good development prospects makes DCI inventory a purchase.

Income Evaluation and Outlook

Put up-pandemic, DCI’s gross sales development benefited from robust, broad-based end-market demand and better pricing. Nevertheless, in current quarters, the corporate’s gross sales development was negatively impacted by the advance in world provide chain circumstances which drove its OEM clients to normalize their stock, resulting in decreased aftermarket gross sales. As well as, the weak spot within the disk drive market additionally negatively impacted the gross sales development.

Within the first quarter of 2024, the corporate’s Cell Options section gross sales declined 2.7% Y/Y on account of a quantity decline in its Off-Highway and Aftermarket companies, partially offset by a pricing profit of three%. Weakening world end-market circumstances, significantly in China and the agriculture markets within the Americas and India, led to an 8.7% Y/Y decline in Off-Highway gross sales. Aftermarket gross sales decreased 1.9% Y/Y because the OEM buyer destocking continued in response to normalizing world provide chain circumstances. Nevertheless, On-Highway gross sales grew 5% Y/Y attributed to elevated on-highway tools manufacturing, particularly in China.

Within the Industrial Options section, gross sales elevated by 7.2% Y/Y pushed by robust demand in most of its geographic areas and a 2% contribution from pricing. Robust mud assortment and energy era gross sales drove a 7.4% Y/Y gross sales development for the Industrial Filtration Options (IFS) enterprise. Aerospace and Protection gross sales grew 6% Y/Y because of the continued energy in Protection enterprise.

The Life Sciences section continues to face headwinds from ongoing softness in Disk Drive market demand, which brought about its gross sales to say no 4.1% Y/Y within the first quarter.

On a consolidated foundation, internet gross sales of $846.3 million have been primarily flat Y/Y as decrease volumes within the Cell Options and Life Sciences segments have been offset by quantity development within the Industrial Options section and a 3% contribution from pricing.

Trying ahead, the corporate’s income outlook is optimistic.

If we take a look at the corporate’s quarterly gross sales development trajectory within the final fiscal yr, Q1 FY23 gross sales have been up 11.4% Y/Y, after which they noticed a leg down with 3.2% Y/Y development, 2.6% Y/Y development and 1.2% Y/Y decline in Q2, Q3, and This fall of FY23 respectively. So, the income comparisons have gotten meaningfully simpler from the present quarter onwards.

Segmentwise, the Cell Options section’s aftermarket enterprise, which accounts for ~75% of the section’s gross sales and was below stress from stock destocking, has now began seeing a stabilization so as patterns. This bodes properly for the section’s gross sales which ought to see sequential in addition to Y/Y enchancment within the coming quarters.

The corporate’s Industrial section ought to proceed to do properly pushed by finish market energy in addition to market share positive factors. In my last article, I defined how the corporate’s linked providing with real-time info and knowledge analytics concerning the state of the filters put in on the buyer’s location in addition to an e-commerce software for substitute components helps it win market share. On its latest earnings call, administration famous that aftermarket gross sales development from linked clients in FY23 is outpacing that of non-connected industrial clients validating the customer-centric method of this mannequin which helps them win share. The corporate launched its linked mannequin in India, Thailand, and China final yr and remains to be within the early part of realizing the advantages of this mannequin. I’m anticipating continued energy ultimately markets and market share positive factors from linked options providing to drive development on this section.

Within the Life Sciences section, the weak spot within the disk drive market has impacted the corporate’s gross sales over the previous couple of quarters. Nevertheless, this market is probably going close to the underside. Speaking about this market on the Q1 earnings name, the Firm’s CEO Tod E. Carpenter said:

We’re seeing early indicators of a gradual demand restoration and anticipate a sequential enchancment in disk drive gross sales via fiscal 2024 as knowledge heart and cloud computing demand recovers.”

So, a recovery in this market should help the segment’s growth in the coming quarters. Life Science segment sales should also benefit from the company’s focus on growing its bioprocessing and filtration offering for the alternative protein market where management is investing significant resources.

Overall, I expect a good acceleration in Y/Y revenue growth helped by easing comps, good execution and market share gains, and recovery in aftermarket and disk drive businesses. The company also has a healthy balance sheet with a net debt-to-EBITDA ratio of 0.7x at the end of the last quarter. So, I expect the company to remain active in the M&A area as well, and any bolt-on acquisition can add to overall growth.

Margin Analysis and Outlook

In Q1 2024, the company’s adjusted gross margin saw a 170 bps Y/Y expansion to 35.6%, mainly driven by benefits from pricing, lower freight costs, strong plant productivity, and favorable material costs and mix. However, operating expenses as a percentage of sales increased by 100 bps Y/Y due to increased hiring and Life Sciences’ acquisition-related expenses. The operating expense deleveraging more than offset the Y/Y gross margin improvement, resulting in the adjusted operating margin contraction of 30 bps Y/Y to 14.7%.

Segment-wise, the EBT or Pretax profit margin improved by 260 bps Y/Y and 120 bps Y/Y, respectively in the Mobile Solutions and Industrial Solutions segments. While Life Sciences’ EBT margin declined Y/Y due to incremental investments in acquisitions and lower Disk Drive volumes.

Looking forward, I am optimistic about the company’s margin growth prospects. The company’s gross margin should continue to increase Y/Y benefiting from pricing improvement, cost deflation, and good plant performance as supply chain conditions improve. Seasonally, Q2 is usually lower because of holidays and we can see a sequential decline in Q2 FY24 as well but I won’t be reading too much into it and Q3 FY24 and Q4 FY24 should be strong.

In terms of operating margin, the company has seen some headwinds as it is making incremental investments to scale recent life science acquisitions. Usually, life sciences EBT margins have been above the company average but have turned negative in recent quarters due to these investments. However, the good news is that they are sequentially improving with Q1 FY24 better than Q4 FY23 and management expects this sequential improvement to continue as the acquired businesses scale. For the full year, management expects the segment to post above breakeven margin indicating meaningful improvement ahead as the year progresses.

In addition, the company’s operating margin should also benefit from volume leverage from sales growth acceleration in the coming quarters. So, I am optimistic about the company’s margin growth prospects.

Valuation and Conclusion

DCI is currently trading at a 19.19x FY24 consensus EPS estimate of $3.20 and a 17.38x FY25 consensus EPS estimate of $3.53, which is at a discount versus the Company’s 5-year average forward P/E of 22.28x.

The corporate has good development prospects supported by easing Y/Y comps, good execution, and market share positive factors, restoration in aftermarket enterprise within the Cell Options section and disk drive enterprise within the Life Sciences Options section, and future M&As. The margin development prospects are additionally engaging with gross margin benefiting from pricing enchancment, value deflation, and elevated plant productiveness. As well as, a sequential enchancment in Life Sciences section profitability together with working leverage from greater gross sales ought to profit the corporate’s working margins within the coming quarters. Given the great development prospects and engaging valuation, I proceed to have a purchase score on the DCI’s inventory.