Q3 2022 Donaldson Company Inc Earnings Call
Creating relief efforts with the Ukrainian Red Cross sell.
Several of our local teams in Europe have also contributed by creating various donation drive to help the communities where they operate.
These actions exemplify our commitment to corporate responsibility, which has always been an important part of Donaldson.
To that end this quarter. We also published our fiscal 2021 sustainability report in which we outlined our commitment and efforts in reducing our environmental impact engaging and empowering our people and maintaining our strong corporate governance.
I look forward to reporting our progress in future initiatives over time.
Now I'll turn to our third quarter results.
Donaldson had another quarter of record sales at $853 million up 12% year over year.
As expected pricing was the largest sales driver and I'm pleased with the agility of the organization to increase these efforts as cost inflation has continued to outpace our projections.
Material freight energy and labor costs were up significantly year over year negatively impacting our profitability.
Consequently, third quarter EPS increased to 67.
<unk> 66, a year ago.
This quarter, we made progress in meeting demand and saw some leveling in our backlogs, which remain at or near historic highs.
While inflation supply chain challenges and labor shortages continued to be our biggest headwinds we are not immune from newer increasingly impactful factors such as FX, our business disruptions, including those from the COVID-19, Lockdowns in China and the conflict in Eastern Europe.
Touching a bit more on the impact of the COVID-19, Lockdowns in China.
China is a strategically important area for us over the long term.
We have been continuing to wind platforms, using our power core technology and are confident in our ability to gain share in this market.
This quarter, we felt primary and secondary supply chain and market impacts from the COVID-19 Lockdowns. These.
These included OEM shutdowns logistics issues and a decrease in working hours.
Year over year total sales in China declined about 16%.
However, our current exposure is somewhat limited.
To size this third quarter, China sales were about 6% of total company sales and this compares to 8% a year ago.
Going back to the overall company this quarter to combat the headwinds we are facing we made progress in the following areas.
Pricing, we realize the benefits from our pricing actions.
And as costs continue to rise we will continue to implement increases.
Utilization of our global footprint, we leveraged our global footprint to circumvent certain supply chain challenges for example, while facing constraints in one region, we have been able to pivot and tap into a different region to support our customers' Ali.
Also in some geographies where demand has exceeded capacity, we have sourced product from out of region plants that have sufficient capacity.
Inventory investments.
We have followed through with our commitment to utilize our balance sheet and proactively increase our inventory levels as we make every effort to meet the needs of our customers.
While this fiscal year has been full of unforeseen challenges. The Donaldson team has not lost sight of our longer term strategy.
We continue to focus on gaining share within our current and future end markets, including life Sciences.
Through our investments in R&D and acquisitions, we are cementing our position as the leader in technology led filtration.
The ongoing integration of the Soliris and pace acquisitions is going well and we are focused on scaling these businesses.
Looking ahead, we expect sales to reflect continued high levels of demand and incremental pricing benefits, partially offset by negative currency translation.
With that we are increasing our sales expectations for the full year.
However, we continue to see gross margin pressure, mainly driven by inflation.
Despite this challenging backdrop, we are making progress in offsetting these headwinds through the previously mentioned efforts of the Donaldson team.
As such we are forecasting another sequential gross margin uptick and improved incremental margins in the fourth quarter.
As a net result of these factors and with increased visibility we are narrowing our EPS guidance range to be between $2 67.
And $2 73.
When compared to our fiscal 2021 adjusted results. This reflects an approximate increase of between 15% and 18%.
Scott will elaborate on the details of our fiscal 'twenty two outlook later in the call. So I will now provide some context on third quarter sales.
Total sales were $853 million up 12% from last year.
Pricing contributed roughly 9% and currency translation was a headwind of approximately three percentage points.
In engine total sales were $601 million up 13% due to sales growth in both our first fit and replacement parts businesses.
Sales in off road of $108 million were up 13% with growth in all major regions, except China as high levels of equipment production continue.
We also saw ongoing strength in our exhaust and emissions business in Europe . As a reminder, these sales come at a lower margin presenting a modest mix headwind.
On road sales of $36 million were down 9% from the prior year.
Global customer supply chain challenges, including chip shortages continued to limit near term growth in this segment.
Also negatively impact the results where the discontinued sales of some directed by equipment to a large OEM customer in North America.
Excluding this impact total on road sales were flat globally and up 12% in North America.
In engine aftermarket sales were $425 million, an increase of 15% as end market demand for our replacement products continues.
Sales in both aftermarket channels were up double digits.
In the OE channel of aftermarket proprietary products are again contributing to our growth.
Power core sales in aftermarket increased about 35% over prior year.
Another quarterly record.
In aerospace and defense sales of $31 million were up 29% year over year as we benefited from the strengthening commercial aerospace industry and market share gains.
Now turning to the industrial segment.
Industrial sales increased 12% to $252 million sales.
Sales of industrial filtration solutions or ISS grew 9% to 179 million, mainly driven by industrial dust collection and with growth in all regions, except APAC.
Continued strength in process filtration also contributed to the results.
Third quarter sales of gas turbine systems, or GTS were approximately $31 million, reflecting a 19% increase due to new equipment sales in Europe and the U S.
Sales of special applications were $43 million down 4% as the COVID-19 shutdown in China negatively impacted disk drive sales.
Also within special applications sales of venting products were up as customers expand the use of our high tech events for batteries and powertrains in the auto industry.
This is a key strategic area for Donaldson, given the strong pipeline of opportunities in this rapidly expanding market.
Overall I am proud of the excellent work the team has done to meet underlying demand execute on pricing and work through the macro challenges to deliver another quarter of record sales.
Now I'll turn it over to Scott for more details on the financials Scott.
Thanks Todd.
Morning, everyone. This quarter, we were pleased with the top line results, however, inflation and supply chain challenges were greater than our expectations negatively impacting our profitability in summary.
Third quarter sales grew 12%.
Operating income was up 2%.
And EPS of <unk> 67.
Was a penny above last year.
Operating margin this quarter of 13% was down 130 basis points year over year on continued gross margin pressure.
Gross margin, while up sequentially was below our expectations, mainly due to the continued step up in raw materials freight energy and labor costs.
Either more temporary headwinds such as manufacturing inefficiencies driven by an acute supply issue of one of our key raw materials was also a factor in the quarter.
Operating expense as a percentage of sales was 18, 5% favorable by 90 basis points over prior year, driven primarily by sales leverage we continue to actively manage our expenses by strategically investing in growth areas, such as our advance and accelerate portfolio.
Now I will touch on segment profitability before turning to the balance sheet and cash flow statement.
Third quarter engine pre tax profit margin was 14, 8%.
Down 110 basis points year over year.
The decline was driven by the timing lag of pricing realization as we catch up to cost.
Unfavorable sales mix also negatively impacted margin.
Industrial margin was 15, 4% down 70 basis points year over year. There are two things I would highlight on the industrial margin first the recent integration of the Soliris and paced acquisitions into the industrial segment has resulted in additional expenses. This quarter. Overall, we are pleased with the progress.
We have made in integrating these businesses and expect them to be margin accretive over time as they scale, excluding the acquisitions industrial margin was flat to prior year.
Secondly, unfavorable sales mix also negatively impacted results now.
Now turning to the balance sheet and cash flow statements are free cash flow continues to be negatively impacted by our elevated working capital, which is primarily due to increased inventories.
We ended the quarter with inventories up $30 million sequentially and $151 million year over year inflation, our deliberate approach to increasing our positions and supply chain challenges, both internally and externally where the drivers.
As we have talked about before we made the proactive decision earlier this year to increase our inventory product availability in this type of environment is highly valued and we are committed to being as prepared as possible to answering the call.
Also negatively impacting working capital in the quarter was a higher accounts receivable balance due to our increased sales.
Third quarter capital expenditures were $23 million, mainly driven by investments in capacity expansion, including for power Corp.
Returning capital to shareholders is always a priority and this quarter, we returned $65 million in the form of dividends and share repurchases.
Last week, we announced a quarterly cash dividend increase and year to date, we have repurchased 2% of our shares outstanding already reaching our initial fiscal 2022 target.
Our balance sheet continues to be an important asset, allowing us to have a proactive approach towards managing our capital and investments. We ended the quarter with a net debt to EBITDA ratio of <unk> nine times.
Now I'll walk through our updated fiscal 'twenty two outlook starting with sales.
We are increasing our fiscal 2022 sales guidance to a range between 14, 5% and 16, 5%, which includes a negative impact from currency translation of about 3%.
This increase from our previous guidance of 11% to 15% is driven by our third quarter engine business performance and outlook our expectations for the industrial segment are unchanged for both segments from a geographical standpoint, we expect stronger results in the Americas and Europe to offset.
APAC softness.
For engine, we expect an increase of between 16 and 18% up from our previous forecast of between 12% to 16% driven by off road and aftermarket year to date results combined.
With additional pricing realization expected in the fourth quarter.
And off road, we are now forecasting growth in the mid Twenty's versus our.
<unk> guidance of high teens.
And your aftermarket sales are now expected to be up in the high teens up from our previous low teens estimate.
We are maintaining our guidance for on road and aerospace and defense on rates sales are expected to be down low single digits, given continued customer supply chain challenges, including chip shortages and the discontinuation of the low margin product line in North America.
Aerospace and defense sales supported by year over year strength in the commercial aerospace market are projected to increase in the low twenties.
In the industrial segment, we expect sales growth of 10% to 12%, but the midpoint of this range in line with prior guidance.
Sales of IAF S are projected to increase in the low double digits as sales of new equipment and replacement parts, particularly for dust collection and process filtration continues to grow.
Moving to GTS, we expect fiscal 'twenty, two sales to be up high single digits led by aftermarket and large turbine sales.
Special applications growth is forecasted to be up mid single digits versus prior year with growth in most business units.
Now I'll touch on our margin outlook.
Looking to the fourth quarter as mentioned, we do anticipate another quarter of sequential gross margin improvement. However, given the underperformance in the third quarter, we are lowering our full year guidance range by 50 basis points.
Resulting in a year over year decline of approximately 150 to 200 basis points.
Digging a little deeper on the gross margin outlook, we expect to pay over 14%.
More year over year for our raw materials or between 400 and 450 basis points.
Adding to this pressure or additional headwinds, including freight energy and labor inflation as well as more temporary pressures, including manufacturing inefficiencies.
Driven by the decrease in gross margin outlook for the year. We are now forecasting an operating margin range between 13, 5% and 13, 9% down from our previous 14.0 to 14, 4% range and below last year's adjusted operating margin of 14%.
<unk>.
Based on our updated forecast, we revised our EPS outlook to a range between $2 67.
And $2 73.
First our previous guidance of $2 66 to $2 76.
Moving to our balance sheet and cash flow outlook capital expenditures are forecasted to be between $90 million and $100 million versus our previous expectation of 90 million to $110 million given longer than expected project lead times as a result of ongoing supply chain issues in.
Terms of free cash flow.
Now expect conversion to be about 50% to 60% for the year down from our previous guidance of 70% to 80%. This.
This is primarily due to working capital investments related to inventory build along with the previously discussed higher receivables.
In summary, while the macro challenges that are out of our control have weighed on our near term financial results. We have been aggressive in controlling what we can and thoughtfully investing for the future laying the foundation for increasing profits on increasing sales over time.
I would like to thank my colleagues around the world for all they do to ensure our successful future.
Now I'll turn the call back to Todd.
Thanks Scott.
We've talked a lot over the past few quarters about the difficulties we have faced operating within this extremely volatile.
An inflationary environment.
I want to extend my sincerest gratitude to the hardworking Donaldson employees, who have showed up every day with a commitment to the organization our customers and our shareholders I.
I would also like to thank our customers and suppliers as we jointly work through these challenging times.
At Donaldson, we have a clear vision and a path to achieving our long term goals and I know we are taking the right steps in achieving our purpose of advancing filtration for a cleaner world.
We will reap the benefits of the investments, we're making now for years to come.
Within our existing businesses, we are committed to providing our advance and accelerate businesses with the capital required to increase sales and market share and optimize margins.
We are also expanding our new product portfolio through our R&D and inorganic investments.
On the acquisition front, we completed our first life Sciences acquisition with Soliris in the second quarter and continue to look for ways to expand our reach in this sector.
Looking beyond the fourth quarter and into fiscal 2023, we are encouraged by the resiliency of the team and know that we have the right people.
The right investments and the right strategy in place to profitably grow the company.
Now I'll turn the call back to the operator to open the line for questions.
Thank you as a reminder, if you'd like to ask a question. Please press Star then one on your telephone keypad.
Our first question is from Brian Drab with William Blair. Your line is open please.
Hey, Good morning, Hi, Todd Thanks for taking my questions Hey, Scott.
Morning.
Good morning so.
Just want to make sure that I have this right and this is probably.
Our risk to ask this question since we're kind of updating the model.
As we speak here, but.
Did you make a comment specifically about fourth quarter.
Operating margin because to get to the midpoint of the guide I think I'm getting something in the 15 and a half type of range for operating margin in the fourth quarter I just want make sure that that is.
What youre implying.
Well, we gave the updated guidance for operating margin.
For the full year of $13 five to $13 nine and Thats.
10, 10 license payments down on the high point.
Paired to last year.
But.
Back into that math, I think you'd have to get over 15% for the for the fourth quarter as you calculate.
Yes, Okay. So yes, im getting over 15, I just wanted to confirm that.
Math right so.
And then.
Here's here's a question I guess, you won't want to answer it I'm just curious what you think about this.
As you look forward from there.
Is this.
Is that kind of a one.
Top because pricing.
Now caught up and just the dynamics of this all of this volatility with input costs and pricing.
A level.
That we can extrapolate.
And anyway.
Well I mean first of all I would say our fourth quarter is always our generally our seasonally strongest quarter and I think if you look back historically has pretty good margins, but we do expect.
In a year over year margins will continue to improve as we said we had a.
A bit of a tougher quarter on gross margin this quarter and that was.
Driven by factors.
Whereby our pricing.
Increases are lagging our material cost increases we had a big supplier issue. This quarter. That's now behind us. So we would expect our margins to continue to improve or are always committed to higher levels of profitability on higher sales and we're investing for that and so we feel and are not the greatest about them.
Margin performance.
This quarter, but we do expect continued improvement on a year over year basis.
As we move forward.
Okay, great. Thanks, and then I was wondering if you could just touch on a couple of areas, but if you could just update on what kind of growth youre seeing.
In the advance and accelerate as you.
Segment of the business and how you think about it.
Years ago.
What are you seeing in some of the higher growth advance and accelerate.
Markets and specifically I'm wondering also about some of the newer markets.
Getting into the water filtration et cetera.
Right sure. So when you take a look at our advance and accelerate.
Portion of the portfolio, while we experienced in the third quarter is mid teens growth across that portion of our portfolio.
In the core we would suggest to us mid single digits.
So you can see how advance and accelerate really is significantly more than other portions of our company. So we feel good about that.
Okay.
Okay I'll follow up it's more of that and thanks for taking my question.
The next question is from Laurence Alexander with Jefferies. Your line is open.
Hi, This is actually Kevin on for.
Laurence Alexander Thank you for taking my question.
I just had one about I guess the mix between price and volume contributions for the increase in the midpoint of your top line outlook and I guess I'm just wondering if it's largely price or would it likely is.
I guess I'm just wondering.
Thought about.
Demand destruction from those pricing actions and I guess I just wanted to get your thoughts behind that.
Yes.
In the third quarter.
Pricing impacted revenues by by 9% in volume was 6%.
Offset by currency headwinds of 3%.
In the fourth quarter pricing will be even a larger impact.
And so we.
We're layering these price increases Ann.
We don't feel like it's impacting demand.
We're trying to have reasonable commercial relationships with our customers. They are raising their prices. They certainly understand that costs are up and we have to pass those cost increases.
One receive them from our suppliers and then to pass them on to our customers and we're going to continue to do that to maintain reasonable margins as our part of the profit pool as long as costs continue to grow up so we do hope and expect that.
Cost increases, we're seeing will start to level off in and hopefully neutralize here at some point relatively soon.
But right now I don't think its affecting demand I mean demand is very strong.
I think we continue to slowly gain market share through our our program wins with proprietary technology and we continue to invest in the company and work hard on our strategy, even light of signing some challenging conditions that are out there.
Great. Thank you.
Again that is star one to ask a question. The next question is from Rob Mason with Baird. Your line is open.
Hi, yes, thanks for taking the question.
Wanted to go back around the commentary on your gross margin outlook.
For gross margins to be up sequentially.
As you said teasing out fairly healthy sequential increase I'm, just curious as to provide a little visibility on that.
Gross margins exit the quarter or how as they played out thus far.
In the month of May.
Relative to the 31 five in the third quarter.
Yes, Hi, Rob this is tod, so maybe I'll start and then I'll, let Scott get a little bit more detailed one thing that really happened to us in the third quarter was we had an acute supply issue Scott referenced that in his prepared remarks that was pretty significant for us we did not see that coming into the quarter, but it presented.
Significant headwinds relative to the gross margin on our execution across our multiple manufacturing plants. It was a.
Petroleum based chemical.
Suddenly became an obtainable.
And it goes in about 90% of all the air based products that we manufacture of the company.
As a result of that we lost a significant amount of Av.
Plant shifts.
And between 25 and 30 shifts of work were lost.
And as a direct result of that that did affect our margins in the third quarter. We have solved that issue now we have enough material clearly to get through the third quarter et cetera, but that that was a significant action to us in Q3 that should not repeat so I'll, let Scott manav.
In terms of pricing Robyn I said, we had a.
A 9% price impact on revenues in the third quarter.
We expect we will have a larger impact in the fourth quarter as we layer in additional pricing mechanisms and all the plants are crank back up we have additional <unk>.
Rising that we're gonna cat share as we move forward each month, and so we feel pretty good.
Back to Brian's original question about the.
Sequential operating margin improvement pick up in the fourth quarter as well as a reasonable gross margin pickup in the fourth quarter, certainly third quarter margins were we're behind our expectations based in part on what Todd just mentioned and we expect to recover that and improve from there so and our committed to.
Increasing that margin in the fourth quarter and into next year on higher levels of sales.
Yes, Scott in your earlier commentary you reference margins higher I thought year over year that that would apply to the fourth quarter operating margin does that apply to the fourth quarter.
Gross margin as Wes.
Yes, okay. Okay.
It just <unk>.
A follow up question last year on the third quarter call you did make some preliminary commentary around your I'll just call. It <unk>.
Calendar second half.
View, a peek into that I'm, just curious if you have any any thoughts.
For this calendar second half as you look.
And particularly around maybe seasonality given your backlog.
It sounds like they are still elevated.
Yeah that causes any changing your seasonality.
Yes, I mean, we still expect fourth quarter to be in our best quarter and you can kind of back into that based on the guidance provided I mean last year, we had.
Call that kind of madness. So we felt obligated to try to give a little bit more guidance in the <unk> like you said the early part of next year I mean.
We feel good about our growth prospects.
And our demand continues to be strong as we said the backlogs are high.
Channel inventories are still in a <unk>.
At low levels and so we feel like there's plenty of demand there at least for what we can see.
Reasonably well into the future and we're as I said committed to higher levels of profitability on higher sales.
If you think about next year with all of this pricing that we've had to layer in.
That comes in month by month quarter by quarter there'll be a tailwind next year and next year's revenues based solely on the price increases that were layering this year and so we would.
To put that in the mid single digit range, one offsetting factor as currencies to that in our currencies were a headwind this.
This quarters certain Atlanta, if they stay at this level they would be a headwind.
Into next year. So I think overall, we feel pretty good we're working through our planning process.
The finance teams are cranking away along with our business partners as we speak to come up with a good solid plan for next year, and we look forward to coming back to you.
With that in about 90 days.
Very good I'll get back in the queue. Thank you.
The next question is from Nathan Jones with Stifel. Your line is open.
Yes. Good morning, this is Adam Farley on for Nathan.
I wanted to first talk about the engine aftermarket channel.
Continues to show very robust growth are you seeing any channel inventory build.
Yes. So this is tod so when you really look at the overall aftermarket there have not been inventory builds we within the quarter took the opportunity to visit a number of different distributors.
And so we know firsthand that the levels that we're at at this point in time, our pull through.
We have not seen the channel build what also gives us confidence that the current levels.
Would continue as Scott mentioned.
Talked about in the fourth quarter.
Okay. Thanks for that and then on the free cash flow guidance.
I understand the higher inventory and accounts receivable.
In fact, Youre working capital maybe.
Maybe looking ahead into 2023.
Would you expect the return of cash from working capital or would you run higher inventory levels in the near term.
Well as I said, our trustee finance team is cranking away on the plan, but we would certainly expect cash conversion to improve next year, we'll have to make a call on what we want to do with inventories based on the.
The supply chain situation.
But we would expect cash conversion will improve.
I would say, while we're not willing to commit to this I would expect our raw material balances to start to trend down.
As we hopefully catch up things seem to be improving slightly right now and we're hoping that those things will continue.
But certainly we would expect to see cash conversion improve next year, yeah, just maybe a little bit of color going into the fourth quarter.
I would say that our supply chain.
Issues that we've been experiencing as compared to going into the third quarter. We've seen some slight improvement on that clearly we had that acute issue in the <unk>.
Unforeseen in the third quarter that hurt us.
But again that has been solved we do see that we have been gaining on supply chain based issues.
And so we'll be we'll be making a call as to as to when to put the pressure to bring the inventories down.
Okay. Thank you for taking my questions.
Thank you.
Sure.
We have no further questions at this time I will turn it back to the presenters for any closing remarks.
Thanks, Chris that concludes the call today, thanks to everyone, who participated and I look forward to reporting our fourth quarter and full year fiscal 2020 to result in late August Goodbye.
Ladies and gentlemen, this concludes today's conference call. Thank you for participating you may now disconnect.