Filtration is a pretty good business to be in – there have been several high-multiple acquisitions in the space over the years (often at mid-to-high teens multiples of EBITDA), with companies including Danaher (DHR), 3M (MMM), and Parker Hannifin (PH) among those that have paid up to get into the space.

For Donaldson (DCI), it’s been a cyclical business, but one that has generated healthy double-digit returns on capital for over a decade and annualized high-single-digit FCF growth for over 20 years. And now Donaldson is looking to address even more of the market, with targeted expansion into areas like food & beverage, specialty chemicals, and pharma that offer both higher growth rates and less cyclical growth than the core engine filtration business.

I like Donaldson quite a bit, but the valuation has rarely been all that attractive to me. With the Street unimpressed with the last quarter and selling the shares off, though, there looks to be a window of opportunity here. I see a high single-digit to low double-digit annualized total return potential at today’s price, which I think is a pretty good entry price for a proven performer in an attractive space.

Lackluster Results Against A Higher Bar

In a quarter where many industrial, particularly heavy machinery, companies posted healthy revenue beats and very impressive earnings beats, Donaldson really didn’t do either. Instead, the company beat by about 3% on revenue, a little less on segment income, and by just a fraction of a point on segment margin. Moreover, investors were not very impressed with the sizable margin miss in the Industrial Products business.

Revenue declined 14% in organic terms, which was definitely on the better side of average relative to the company’s addressed markets (on/off-highway vehicles, industrial air, et al). Here again we see the value of an aftermarket-driven business, as actual usage of vehicles, air compressors, and so on didn’t decline as much as sales of new equipment.

Gross margin improved slightly (20bp), while segment income declined 21% with a one-point decline in margin.

The Engine Products (or EP) business reported 14% organic revenue contraction, with Off-Road down 23%, On-Road down 43% (against a drop in new builds closer to 60%), Aero/Defense down 3%, and Aftermarket down just 9%. Segment profits fell 14%, with margin up 20bp to just under 14%.

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In Industrial Products (or IP), revenue fell a similar 14%, with Industrial Filtration Solutions down 18%, Gas Turbine down less than 7%, and Special Apps down about 9%. Segment profit plunged 33%, with margin falling 340bp to 12.7%. The weak margin was blamed on mix, volume deleverage, and internal investments – the latter of which certainly makes sense given the company’s efforts to expand into new addressable markets.

The Outlook Remains Uncertain And Fragile

At the risk of oversimplification, Donaldson’s business is driven by underlying economic activity – the more trucks that are trucking, the more combines combining, and the more air compressors compressing, the more demand for the company’s aftermarket parts. Likewise, more demand for “first fit” products with new equipment sales.

Trucking activity is already improving, with positive recent trends in freight tonnage. Off-road has been more mixed; mining and ag equipment utilization is improving and construction has stayed healthy, but the near-term outlook for construction is a little less certain. I’m far less concerned about the industrial air opportunity; as overall business activity improves, so too will this market – air compressors are used everywhere, but most significantly in “general manufacturing”. While I think the next few quarters could still be soft (year-over-year declines), I think Donaldson will see growth again in the March quarter (fiscal Q3’21).

Still, the watchword of the day is “uncertainty”. Most industrial companies have expressed pretty healthy confidence that they’ve seen the bottom, but there’s been a wider dispersion of performance in July and August, and the recovery has been a little shallower than bulls might have been hoping to see. With the uncertainties of the U.S. election cycle, the continuation of stimulus, and COVID-19, there’s still a lot of room for the 6-18 month outlook to change.

Pursuing A Cogent Growth Strategy

Donaldson has a strong business in providing air and liquid filtration systems and aftermarket components to powered vehicles – selling air filters, fuel filters, hydraulic filters and so on to the OEMs of commercial trucks, ag equipment, construction equipment, mining equipment, and so on. Donaldson shares the market with rivals like Parker Hannifin and Cummins (CMI), but has certainly carved out a strong place for itself with double-digit market share (versus global mid-single-digit share for the IP business).

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That’s a good business, and the company is pursuing incremental growth opportunities. Companies like Caterpillar (CAT) and Deere (DE) want to grow their own aftermarket parts businesses, and Donaldson is happy to ride-along, benefiting from the aftermarket filtration contributions from these efforts, as they work with the OEMs to design the products.

It’s a good business, but it’s also cyclical, and management has an underappreciated and arguably underdeveloped expertise in designing new filtration technologies (media, etc.) that can be applied elsewhere. To that end, management has launched a transformation initiative that involves entering new end-markets like food & beverage, specialty chemicals/electronics, and pharma/medical.

There will certainly be competition waiting for them – 3M’s filtration business and Danaher’s Pall come immediately to mind – but the market opportunities are large. These markets can add about $11 billion to Donaldson’s addressable opportunity (currently estimated by management at around $27 billion), and the margins in some of the more specialized areas can be considerable indeed.

I expect Donaldson to start with lower-hanging fruit; the food & beverage industry has already been identified as the first priority, and the product demands there will be pretty familiar and more easily addressed. Getting into areas like life sciences, where the company will face off more with Pall, Sartorius, and so on, will take considerably more R&D spending and product development work, but the growth opportunities in bioproduction (and the margins) are worthwhile. Likewise in the specialty/electro-chemicals market, where ongoing volume growth in chip production and increasingly sophisticated and rigorous production technologies will require more advanced filtration needs.

This growth opportunity comes at a cost, and I mean that quite literally. Donaldson has been accelerating its R&D spending, as well as its expanding its sales infrastructure, and R&D is likely to remain elevated if management really wants to target the high-margin opportunities in biopharma and electro chem.

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The Outlook

I do believe that Donaldson will find success in these growth initiatives, and I also believe the company will benefit from a cyclical recovery in its industrial and vehicle markets. All told, I expect long-term revenue growth of around 7%, and that’s not a modest target for a company of Donaldson’s size even if the starting point is a bit artificially depressed by the first half of the COVID-19 recession. As Donaldson targets higher-margin markets, I do eventually expect margin leverage as the benefits of the new business outweigh the increased spending requirements, and I expect FCF margins to move into the low double-digits over the next few years, driving a longer-term FCF growth rate of closer to 10%.

I’m going to get on my soapbox for a moment now. A long time ago, I used to write about Donaldson more often, and I frequently lamented the high valuation and warned investors that high valuations always matter. That message wasn’t received with much enthusiasm, with many Donaldson investors pledging their long-term loyalty to the stock. As it so happens, I wrote an article on Donaldson almost 10 years ago to the day (a couple days removed) flagging the valuation risk. Since then, Donaldson shares have generated an annualized total return of 9.2% – below the S&P’s 14.4% return over that same period. Valuation always matters.

The Bottom Line

As it happens, while I don’t think Donaldson is a screaming bargain here, I think it is undervalued, and that’s a rare thing with a company of this quality and with the growth opportunity I see in the business. Between discounted free cash flow and margin/return-driven EV/EBITDA, I believe the shares are priced for a high single-digit to low double-digit return, and I think this is a stock that looks really interesting well into the $50’s.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.