Donaldson DCI S
December 30, 2015 - 4:40pm EST by
go2bl93
2015 2016
Price: 28.00 EPS 1.58 1.35
Shares Out. (in M): 135 P/E 18 21
Market Cap (in $M): 3,800 P/FCF 17 19
Net Debt (in $M): 426 EBIT 0 0
TEV ($): 4,200 TEV/EBIT 0 0
Borrow Cost: General Collateral

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  • Hydraulic
  • Industrial
  • Gas turbines
  • Aerospace
  • Mining
  • Agriculture
  • Trucking
  • Cyclical

Description

DCI has historically been a highly valued, well-run company with a solid competitive position and fairly stable revenue stream driven by low priced after-market parts exposure.  These types of businesses tend to hold up relatively well in downturns like these and hence generally deserve a premium valuation (it currently trades at 19x EPS when most of the rest of industrials trades at a market multiple or less).  However, recent results and data points from competitors and customers suggest that there is no longer much room to hide and that DCI may soon also fall victim to earnings downgrades and multiple compression. 

Simply, DCI makes filtration systems (air, exhaust, hydraulic, fuel, etc.) that go into engines and industrial applications along with the replacement filters for said systems.  Their primary exposures are industrial construction (large industrial plants, etc.), off-road products (mining, agriculture), on-road products (large trucks), aero & defense and gas turbines.  CAT is their largest customer at around 10% (but less than) of revs.  They compete mostly with CLC and CMI.  It is also a sleepy name in that it’s not all that well followed, doesn’t have a huge market cap and there isn’t a ton of liquidity.  I believe this is what creates the opportunity.

 

To break down what’s happened in the space over the last several months, leading up to DCI’s last print.  DCI printed its prior Q on 9/1 for the quarter ended 7/31 where they put up a beat with weak guidance, but not overly cautious commentary.  15 days later, their closest competitor (CLC) announced a huge whiff and guide down suggesting that the quarter (ended 8/31) got progressively worse into September.  This was confirmed by CMI, who showed negative trends accelerating to the downside in their Filtration division (quarter ended 9/30).  CAT has also since guided 2016 below the Street, citing revenues down 5%.  

 

    Feb-14 May-14 Aug-14 Nov-14 Feb-15 May-15 Aug-15            
CLC Revs   312.7 386.6 400.2 413.4 351.1 399.8 352.2   <<<Decelerated throughout the Q and sept
YoY           12% 3% -12%            
                             
    Mar-14 Jun-14 Sep-14 Dec-14 Mar-15 Jun-15 Sep-15            
CMI Filtration   265.0 275.0 268.0 267.0 255.0 260.0 240.0            
YoY           -4% -5% -10%            
                             
    Apr-14 Jul-14 Oct-14 Jan-15 Apr-15 Jul-15 Oct-15            
DCI Revs   624.2 668.2 596.5 596.9 568.0 609.8 538.0            
YoY         3% -9% -9% -10%            

This lead up to DCI’s last print, conveniently the day before Thanksgiving, where they missed top-line (down 10%), slightly missed EPS and guided down the year.  In that print, their aftermarket business got slightly better (from -5% YoY decline last Q to -3% this Q) and their industrial business outperformed.  Despite that and lower expectations for Q1 than any other Q this year, they still missed.  On the call, they talked down their industrial segment, saying that their order rate slowed and was lagging their revenue recognition rate, and this should turn more negative going forward.  Additionally, their on-road revenues remained bolstered driven by a strong year in truck sales in 2015, however they acknowledge that given recent order rates (ACT reported orders down 60% YoY in November, -40% in October, and most of the market expects truck sales to decline by 10%+ in 2016) pose risk to FH216 for them.  They also talked about construction starting to disappoint.  Finally, they plan to moderate share repurchases going forward given their current capital structure.

Despite this, their guidance assumes a similar revenue decline in FQ216 (10%) and a sizable rebound to flattish revenues for H216 despite most of their segments getting worse into H216.  Hence, I think their guidance for FY16 remains fairly aggressive and needs to come down:

    FY16 - 9/1/15   FY16 - 11/25/15                      
Segment   Organic FX   Organic FX   Notes         Correlations      
  Off-Road Products               Ag -20-10%, Mining -10-5%, Construction +LSD CAT, Komatsu, Joy Global, Deere, CNH, AgCo  
  On-Road Products   +LSD     +LSD     Growth in H1       CMI, PACCAR, NAV…60% HD, 40% MD  
  Aftermarket Products   +LSD     Slight Decline   Driven by retention       30% AM is Trucks = Tonnage.  70% activity in other end markets
  Aerospace and Defense Prod.               Comm up, Defense down              
Engine Products   -2%-+2% -4%   0%-(4%) -3%                      
  Indust. Filtration Solutions Prod.   +LSD     (2%)-(6%)                        
  Gas Turbine Products   -13-9%     (11%)-(15%)                      
  Special Applications Products   Slightly Down   Slightly Down                      
Industrial Products   -3%-+1% -4%   -3%-+1% -4%                      
                                   
Total Revenue Growth   -2%-+2% -4%   0%-(4%) -4%                      

 

EPS guidance is now for $1.49-$1.69 (down from $1.56-$1.76), which implies -6% to +7% growth.  I think both of these are fairly generous given the headwinds mentioned above.

In Engines, based on what CAT said, recent commentary that 2016 could be even worse for CAT and DCI’s commentary that they are seeing construction get worse, I think revenues for that portion of the business is at risk of being quite a bit worse than they projected (+LSD in construction, -5-10% in mining).  They are also expecting to be up in on-road., however recent commentary out of PCAR, Volvo and ACT suggest that NA heavy duty truck is likely to roll over pretty hard in 2016 (consensus currently projecting 10-15% declines).  Aftermarket is their biggest and most stable segment, but it rolled over pretty hard the last two Qs (-5% and -3%), and given what’s happening to their end markets, it seems plausible that this segment is at risk of underperforming going forward.

In Industrial, management admitted that things are getting worse, and the magnitude of their guide-down is reasonable, it is plausible that this segment could get worse from here given capex trends across the board in industrial land.

On Margins, decrementals in H215 became pretty severe despite restructuring actions taken beginning in FQ215.  They reportedly achieved $5M in run-rate savings in Q4 and think this will be closer to $7M through 2016, (maybe 50-100 bps incremental to FY16), but still experienced 24% decremental margins (though admittedly better than the 40% experienced in FQ315). 

Looking out into FY16, the bottom end of their range seems to assume low teens decrementals while the high end of their range assumes 50% incrementals.  Part of that is driven by the $45-50M in incremental restructuring benefits, however this is mostly offset by increase in comp expense, incremental investment and FX issues (it appears that they are potentially paying themselves a good portion of the benefit that they're receiving from implementing restructuring).  They also just recently opened a new plant in Poland to serve the on and off-road markets.  While Western Europe has proven to be a more resilient market and the impact of this is presumably baked into guidance, still somewhat of an odd time to be expanding. 

I think revenues could be closer to down 5-6% organically, driven by further weakness in ag/mining and less exciting construction growth in off-road (13% organic decline in FY16 vs. 19% in FY15), new weakness in on-road driven by declines in NA truck (5% decline vs. 12% increase in FY15), a 5% decline in aftermarket driven by broad weakness across their end markets.  If revenues are down closer to 5% organically and assuming a less onerous underlying decremental than is baked into guidance (ex. restructuring) and what they experienced last year of ~15-20%, you're probably in the $1.30-1.40 range.  The bridge is as follows:

FY15 Revs   2,371 2,371              
                     
Change in Revs   (189) (189)    -5% Organic, -4% FX, +1% acq   
% Change   -8% -8%        
                     
FY16 Revs   2,183 2,183              
                     
FY15 Op. Inc   305 305              
% Margin   13% 13%              
                     
Decrementals   (57) (75)              
Decremental Margin   30% 40%   <<<FQ315 Decremental = 40%, FQ415 = 24%
                     
Incremental Restructuring Savings   45 40              
Comp Expenses   (11) (11)              
FX Transactional   (10) (10)              
ERP System Investment   (2) (2)              
                     
FY15 Op. Inc   271 247              
% Margin   12% 11%              
                     
EPS   $1.43 $1.30              

Hence, I think it's plausible that they disappoint this upcoming Q relative to Street numbers and could potentially bring down annual guidance. 

Given that, I think the R/R is roughly this:

  • Risk:  20x midpoint of guidance of $1.59 = $32 = ~13% downside
  • Reward:  16x downside EPS of $1.30 = $21 = ~25% upside

Though I'd say that there could be some downside to that multiple if they really put up that type of EPS number (FLS, which is supposed to have a similar aftermarket-type business model, suffered a 5x multiple reduction to multi-year lows throughout 2015 as numbers kept being revised lower and end markets deteriorated).

Additionally, I am beginning to view their governance as somewhat questionable.  As I mentioned above, it seems that they're planning on paying themselves this year a majority of the cost savings being driven by the restructuring that they implemented last year, which is always fun.   They also recently had to delay their 10-K filing due to past incorrect rev rec (potentially fraud), which on the margin creates some further concern over governance.

Risks:

  • Given the short interest and liquidity, if they put together a decent Q and don't guide down for the year, we could see a squeeze 
  • Some of their businesses are lumpy, which could help any given quarter and confuse the trajectory for the year 
  • Defense budget is theoretically stronger next year...but that segment is small
I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.

Catalyst

I think it's plausible that they disappoint this upcoming Q relative to Street numbers and could potentially bring down annual guidance. 

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    Description

    DCI has historically been a highly valued, well-run company with a solid competitive position and fairly stable revenue stream driven by low priced after-market parts exposure.  These types of businesses tend to hold up relatively well in downturns like these and hence generally deserve a premium valuation (it currently trades at 19x EPS when most of the rest of industrials trades at a market multiple or less).  However, recent results and data points from competitors and customers suggest that there is no longer much room to hide and that DCI may soon also fall victim to earnings downgrades and multiple compression. 

    Simply, DCI makes filtration systems (air, exhaust, hydraulic, fuel, etc.) that go into engines and industrial applications along with the replacement filters for said systems.  Their primary exposures are industrial construction (large industrial plants, etc.), off-road products (mining, agriculture), on-road products (large trucks), aero & defense and gas turbines.  CAT is their largest customer at around 10% (but less than) of revs.  They compete mostly with CLC and CMI.  It is also a sleepy name in that it’s not all that well followed, doesn’t have a huge market cap and there isn’t a ton of liquidity.  I believe this is what creates the opportunity.

     

    To break down what’s happened in the space over the last several months, leading up to DCI’s last print.  DCI printed its prior Q on 9/1 for the quarter ended 7/31 where they put up a beat with weak guidance, but not overly cautious commentary.  15 days later, their closest competitor (CLC) announced a huge whiff and guide down suggesting that the quarter (ended 8/31) got progressively worse into September.  This was confirmed by CMI, who showed negative trends accelerating to the downside in their Filtration division (quarter ended 9/30).  CAT has also since guided 2016 below the Street, citing revenues down 5%.  

     

        Feb-14 May-14 Aug-14 Nov-14 Feb-15 May-15 Aug-15            
    CLC Revs   312.7 386.6 400.2 413.4 351.1 399.8 352.2   <<<Decelerated throughout the Q and sept
    YoY           12% 3% -12%            
                                 
        Mar-14 Jun-14 Sep-14 Dec-14 Mar-15 Jun-15 Sep-15            
    CMI Filtration   265.0 275.0 268.0 267.0 255.0 260.0 240.0            
    YoY           -4% -5% -10%            
                                 
        Apr-14 Jul-14 Oct-14 Jan-15 Apr-15 Jul-15 Oct-15            
    DCI Revs   624.2 668.2 596.5 596.9 568.0 609.8 538.0            
    YoY         3% -9% -9% -10%            

    This lead up to DCI’s last print, conveniently the day before Thanksgiving, where they missed top-line (down 10%), slightly missed EPS and guided down the year.  In that print, their aftermarket business got slightly better (from -5% YoY decline last Q to -3% this Q) and their industrial business outperformed.  Despite that and lower expectations for Q1 than any other Q this year, they still missed.  On the call, they talked down their industrial segment, saying that their order rate slowed and was lagging their revenue recognition rate, and this should turn more negative going forward.  Additionally, their on-road revenues remained bolstered driven by a strong year in truck sales in 2015, however they acknowledge that given recent order rates (ACT reported orders down 60% YoY in November, -40% in October, and most of the market expects truck sales to decline by 10%+ in 2016) pose risk to FH216 for them.  They also talked about construction starting to disappoint.  Finally, they plan to moderate share repurchases going forward given their current capital structure.

    Despite this, their guidance assumes a similar revenue decline in FQ216 (10%) and a sizable rebound to flattish revenues for H216 despite most of their segments getting worse into H216.  Hence, I think their guidance for FY16 remains fairly aggressive and needs to come down:

        FY16 - 9/1/15   FY16 - 11/25/15                      
    Segment   Organic FX   Organic FX   Notes         Correlations      
      Off-Road Products               Ag -20-10%, Mining -10-5%, Construction +LSD CAT, Komatsu, Joy Global, Deere, CNH, AgCo  
      On-Road Products   +LSD     +LSD     Growth in H1       CMI, PACCAR, NAV…60% HD, 40% MD  
      Aftermarket Products   +LSD     Slight Decline   Driven by retention       30% AM is Trucks = Tonnage.  70% activity in other end markets
      Aerospace and Defense Prod.               Comm up, Defense down              
    Engine Products   -2%-+2% -4%   0%-(4%) -3%                      
      Indust. Filtration Solutions Prod.   +LSD     (2%)-(6%)                        
      Gas Turbine Products   -13-9%     (11%)-(15%)                      
      Special Applications Products   Slightly Down   Slightly Down                      
    Industrial Products   -3%-+1% -4%   -3%-+1% -4%                      
                                       
    Total Revenue Growth   -2%-+2% -4%   0%-(4%) -4%                      

     

    EPS guidance is now for $1.49-$1.69 (down from $1.56-$1.76), which implies -6% to +7% growth.  I think both of these are fairly generous given the headwinds mentioned above.

    In Engines, based on what CAT said, recent commentary that 2016 could be even worse for CAT and DCI’s commentary that they are seeing construction get worse, I think revenues for that portion of the business is at risk of being quite a bit worse than they projected (+LSD in construction, -5-10% in mining).  They are also expecting to be up in on-road., however recent commentary out of PCAR, Volvo and ACT suggest that NA heavy duty truck is likely to roll over pretty hard in 2016 (consensus currently projecting 10-15% declines).  Aftermarket is their biggest and most stable segment, but it rolled over pretty hard the last two Qs (-5% and -3%), and given what’s happening to their end markets, it seems plausible that this segment is at risk of underperforming going forward.

    In Industrial, management admitted that things are getting worse, and the magnitude of their guide-down is reasonable, it is plausible that this segment could get worse from here given capex trends across the board in industrial land.

    On Margins, decrementals in H215 became pretty severe despite restructuring actions taken beginning in FQ215.  They reportedly achieved $5M in run-rate savings in Q4 and think this will be closer to $7M through 2016, (maybe 50-100 bps incremental to FY16), but still experienced 24% decremental margins (though admittedly better than the 40% experienced in FQ315). 

    Looking out into FY16, the bottom end of their range seems to assume low teens decrementals while the high end of their range assumes 50% incrementals.  Part of that is driven by the $45-50M in incremental restructuring benefits, however this is mostly offset by increase in comp expense, incremental investment and FX issues (it appears that they are potentially paying themselves a good portion of the benefit that they're receiving from implementing restructuring).  They also just recently opened a new plant in Poland to serve the on and off-road markets.  While Western Europe has proven to be a more resilient market and the impact of this is presumably baked into guidance, still somewhat of an odd time to be expanding. 

    I think revenues could be closer to down 5-6% organically, driven by further weakness in ag/mining and less exciting construction growth in off-road (13% organic decline in FY16 vs. 19% in FY15), new weakness in on-road driven by declines in NA truck (5% decline vs. 12% increase in FY15), a 5% decline in aftermarket driven by broad weakness across their end markets.  If revenues are down closer to 5% organically and assuming a less onerous underlying decremental than is baked into guidance (ex. restructuring) and what they experienced last year of ~15-20%, you're probably in the $1.30-1.40 range.  The bridge is as follows:

    FY15 Revs   2,371 2,371              
                         
    Change in Revs   (189) (189)    -5% Organic, -4% FX, +1% acq   
    % Change   -8% -8%        
                         
    FY16 Revs   2,183 2,183              
                         
    FY15 Op. Inc   305 305              
    % Margin   13% 13%              
                         
    Decrementals   (57) (75)              
    Decremental Margin   30% 40%   <<<FQ315 Decremental = 40%, FQ415 = 24%
                         
    Incremental Restructuring Savings   45 40              
    Comp Expenses   (11) (11)              
    FX Transactional   (10) (10)              
    ERP System Investment   (2) (2)              
                         
    FY15 Op. Inc   271 247              
    % Margin   12% 11%              
                         
    EPS   $1.43 $1.30              

    Hence, I think it's plausible that they disappoint this upcoming Q relative to Street numbers and could potentially bring down annual guidance. 

    Given that, I think the R/R is roughly this:

    Though I'd say that there could be some downside to that multiple if they really put up that type of EPS number (FLS, which is supposed to have a similar aftermarket-type business model, suffered a 5x multiple reduction to multi-year lows throughout 2015 as numbers kept being revised lower and end markets deteriorated).

    Additionally, I am beginning to view their governance as somewhat questionable.  As I mentioned above, it seems that they're planning on paying themselves this year a majority of the cost savings being driven by the restructuring that they implemented last year, which is always fun.   They also recently had to delay their 10-K filing due to past incorrect rev rec (potentially fraud), which on the margin creates some further concern over governance.

    Risks:

    I do not hold a position with the issuer such as employment, directorship, or consultancy.
    I and/or others I advise do not hold a material investment in the issuer's securities.

    Catalyst

    I think it's plausible that they disappoint this upcoming Q relative to Street numbers and could potentially bring down annual guidance. 

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