Trading On margin

Donaldson stock: Growth prospects look good (NYSE: DCI)

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Investment thesis

Donaldson (NYSE: DCI) sales growth should benefit from strong end-market demand in the near term. In addition, the company raises its prices to compensate for cost inflation in the market, which is benefiting the growth of the company’s sales and margins. The company is diversifying its business portfolio to meet the needs of its current and future customers. This will be done organically by investing in R&D and inorganically through acquisitions. The company recently acquired Solaris in the first quarter of FY22 and Purilogics in June 2022. On the margin front, the company is expected to implement price increases if the current inflationary environment exists, which should support growth. margins. Additionally, the company resolved a supply issue related to one of its raw materials, which should result in sequential improvement in margins.

Donaldson Q3 2022 Results

Donaldson recently announced mixed financial results for the third quarter of 2022, with better-than-expected sales and lower-than-expected earnings. Net sales for the quarter were $853 million (up 11.5% year-on-year), beating the consensus estimate of $823.99 million. Adjusted EPS in the quarter was flat Y/Y at $0.67 (vs. consensus estimate of $0.72). Y/Y sales growth was driven by 6% higher sales volume and a 9% price contribution, partially offset by 3% headwinds. However, operating margin in the quarter declined 130 basis points year-over-year to 13% due to gross margin pressure. Due to rising raw material, freight, energy and labor costs, gross margin fell 220 basis points in the third quarter of FY22. This resulted in to flat Adjusted EPS from a year ago, which fell short of the consensus estimate.

Revenue Growth Outlook

In Q3 2022, the company tackled supply chain headwinds and inflation in raw material, freight, energy and labor costs with pricing, global footprint usage and inventory investments. Pricing was the main driver of sales during the quarter, and the company expects to continue to implement these price increases if cost inflation continues in the market. While dealing with supply chain challenges, the company has leveraged its global footprint by sourcing products from different regions and supporting its customers. The company has proactively increased inventory levels and used its balance sheet effectively to meet customer needs. Inventories at the end of Q3 FY22 increased $30 million sequentially and $150 million year-over-year to $510 million.

Company sales are expected to continue to reflect stronger demand in end markets. The strong backlog and lower inventory levels in the distribution channel should support the company’s sales growth in the near term. Along with this, the company’s sales benefit from the incremental pricing actions. In the first half of FY22, price increases contributed 450 bps to revenue growth, while in Q3 FY22 it accelerated to 900 bps, showing prices play an important role in sales growth. Due to strong end-market demand and additional pricing benefits, management raised its FY22 sales guidance from 11%-15% to 14.5%-16.5%, including an impact negative 3% in currency translation.

In the long term, the company plans to expand its business in China and slowly gain market share in the region. The China region contributed about 6% of total sales and about 31% of APAC sales in Q3 FY22. The company is winning programs in China using PowerCore technology, which should benefit it in gaining market share in the region. PowerCore technology focuses on providing flexible air filtration solutions in different conditions and configurations. The company is setting up a second PowerCore line in China. The Chinese market is currently experiencing some weakness due to Covid-related lockdowns which have led to OEM shutdowns, supply chain constraints and reduced working hours. However, DCI’s longer-term prospects in this market are good as it continues to gain market share.

Apart from this, DCI has diversified its business organically and inorganically to meet the needs of its current and future customers globally and has cemented its position as a technology-driven filtration leader. On the organic side, the company invests in R&D to develop new products and inorganically. The company recently acquired Solaris Biotech in the first quarter of FY22 to expand into the life sciences and food and beverage end markets. Solaris is a designer and manufacturer of bioprocessing and filtration equipment used in the food and beverage, biotechnology and other life science markets. This should benefit DCI as it can leverage Solaris technology and customer relationships to advance its capabilities in this area. In June 2022, the company acquired Purilogics to further expand its life science business portfolio. Purilogics is an early-stage biotechnology company that leverages a novel technology platform to develop membrane chromatography products.

DCI margins

Gross margin increased sequentially but declined year-on-year due to continued rising raw material, freight, energy and labor costs. Operating margin in Q3 FY22 declined 130bps year-on-year to 13% due to continued gross margin pressure. Other more temporary headwinds, such as manufacturing inefficiencies due to a severe supply problem of a petroleum-based chemical, also affected margins in the quarter. This chemical goes into about 90% of all air-based products the company manufactures and due to the supply issue, the company experienced significant downtime. However, the company has now resolved this issue and margins are expected to improve in the fourth quarter of FY22 and beyond. Additionally, the company expects to take additional pricing in the fourth quarter of FY22, which should improve operating margin sequentially.

Donaldson Adjusted Operating Margin and Adjusted Gross Margin

Donaldson Adjusted Operating Margin and Adjusted Gross Margin (Company data, GS Analytics Research)

The company invests organically in higher margin products and over time it should improve the mix of the company. The company also plans to leverage its infrastructure to reduce operating expenses, which should ultimately boost operating margins. Due to margin underperformance in the third quarter of FY22, the company lowered its full-year 2022 guidance range by 50 basis points, resulting in a decline of 150 to 200 basis points. year-to-year basis. The company expects to pay 14% more year-over-year for raw materials, which is expected to impact the company’s gross margin in FY22, as well as additional headwinds from labor, freight and energy inflation and manufacturing inefficiencies. Due to gross margin pressures, the outlook for the operating margin range decreased from 14% to 14.4% to 13.5% to 13.9%. Over the long term, the company expects an operating margin of over 15% as the mix of the product portfolio improves towards higher margin products.

Evaluation and conclusion

The stock is currently trading at a P/E of 17.19x the consensus FY22 EPS estimate of $2.69 and 15.10x the consensus FY23 EPS estimate of 3, $07. This is below its five-year PER average of 23.54x. End-market demand is expected to remain strong in the near term, which should support the company’s sales growth. The company is raising prices across its entire business portfolio, which should support both sales and margin growth. Additionally, margins are expected to improve sequentially as the supply issue related to a key raw material is now resolved. Cheap valuations and good prospects for revenue and margin growth make DCI a good buy.