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Avinash Gandhi

DCI AT A GLANCE

P/E ► 20.7 AVG EV/EBITDA ► 13.2 AVG ROA ► 10.3% HIGH ROE ► 18.5% HIGH Debt to Equity ► 0.937 AVG Current Ratio ► 2.26 AVG Interest Coverage Ratio ► 10.5 VERY HIGH

 

 

 

 

 

 

Donaldson is an international manufacturer of engine and industrial filtration systems. In 2007 the company increased its capital expenditures in Asia by 64% and in Europe by 46%,^[1] highlighting its growth strategy. Donaldson is hoping to take advantage of several trends unfolding in foreign markets. In Europe, the increasing popularity of diesel engines in the face of climate change has made the need for engine filters paramount, as diesel fuel, while more efficient, releases more soot and pollutants than regular gasoline. In Asia, the tremendous growth of developing nations like India and China is being powered by coal plants with archaic emissions standards - leading to over 750,000 deaths per year in China alone.^[2]

As China's national income increases, however, Donaldson is betting that the demand for industrial air and liquid filtration will rise, allowing the company to reap rich rewards - and that the Chinese government will continue to allow private companies to sell products to manage pollution. Another risk to Donaldson comes from rising steel prices, as many of the company's products use steel as an input, meaning more expensive steel would squeeze margins. Though the filtration industry is highly competitive, with many diversified manufacturers, Donaldson faces its most direct competition from Cummins, Clarcor, and Pall.

Business & Financials

Donaldson manufactures consumables, replacement parts, and filtration systems for heavy industry.

• Engine Products: Donaldson's engine filtration systems and parts are sold in three segments: 1) to manufacturers of off-road vehicles like agricultural, construction, and mining vehicles and equipment, 2) to heavy-duty truck manufacturers, 3) to aftermarket vendors that sell replacement or upgrade parts to stock engines.
• Industrial Products: Donaldson produces a variety of products for industrial use: 1) industrial filtration systems to cleanse the emissions released from power and manufacturing plants, 2) gas turbines used in the production of electricity from natural gas, 3) special applications products like membrane filters and computer emissions filters.

Worldwide economic growth has been the primary driver of demand for Donaldson's products, especially its industrial products.

The company actively acquires other engine and industrial parts and filters companies, to add to its product portfolio and thin out its competition. For example, Donaldson acquired Aerospace Filtration Systems, Inc. in March 2007, which added aerospace technology to the company's Engine portfolio. Donaldson also acquired Rawsen Equipment (Pty) Limited in June 2007, adding air & gas compression filters to the Industrial portfolio and expanding the company's South African holdings.

Donaldson sells to a number of customers, including the U.S. government; its most significant consumer is Caterpillar, who made up 10% of Donaldson's revenues in 2007.

Trends & Forces

PowerCore Filters: As Engines Shrink, Donaldson Hopes to Grow

Donaldson's new PowerCore line consists of highly efficient filtration technology (we're talking 99.98% of particulate matter removed) with half the surface area^[5]. This makes the filters smaller, thus allowing them to be incorporated into smaller engines. Vehicle manufacturers are currently trying to increase engine efficiency by making vehicles lighter, more streamlined, more compact - but with greater amounts of power. With the PowerCore filter, Donaldson is positioned to take advantage of the growing demand for smaller engine parts.

Donaldson Hopes to Take Advantage of Diesel Growth in Europe

Diesel is a refined petroleum product that is denser than gasoline, and releases about 15% more energy per liter^[6], making it more fuel efficient and, therefore, more climate-friendly. Diesel is, however, notorious for its emission of nitrous oxides and other harmful pollutants when burned, and air quality standards in many countries require that diesel vehicles use air filters - which is where Donaldson steps in. Over the past few years, the company's diesel filter market has expanded, especially in climate-conscious regions like Europe. Donaldson saw 2007 truck part sales rise 6.9% in the U.S. because of more stringent emissions requirements, and 10.4% in Europe because diesel vehicles are catching on in the region^[7]. The company is predicting that the continued adoption of diesel vehicles will drive demand for diesel filters, causing sales in the segment to grow from $50 million to $150 million by 2012^[8].

Steel Prices Affect Donaldson's Margins

As an industrial equipment manufacturer, Donaldson uses a large amount of steel as an input. Internationally, steel demand has risen over the past few years because of increasing industrial development in developing nations like Thailand, India, and China. Growth in the need for steel has outpaced global steel production, causing prices to fluctuate erratically; overall, however, the trend for steel prices has been up, with the global price of steel rising from $554/tonne in December of 2005 to $720/tonne in January of 2008^[9]. For Donaldson, rising steel prices mean rising costs and falling margins, though the international development that has caused steel prices to shoot up has also allowed the company to increase sales, offsetting any major, negative effects thus far.

Donaldson is Betting on Environmentalism to Emerge from Developing Markets

Filtration technology would have little demand without government regulation of air and water quality. Environmental laws in the United States make it necessary for industrial and automotive developers to use Donaldson's technology to keep in compliance with government regulations and avoid costly fines. Internationally, emerging markets are experiencing rapid industrial growth - especially countries like China, which provides cheap labor and manufacturing capacity to global corporations. This expansion has come at a price, however, as the use of cheap, barely-filtered coal plants to power China's manufacturing plants has caused environmental degradation on an unheard of scale; over 750,000 deaths a year are caused by air pollution and other environmental damages^[10]. It has been observed, however, that as a country's wealth grows, so too does its environmental consciousness, and China appears to be no different - in 2006, the country saw over 60,000 "public disturbances" over pollution problems, and the share of complaints submitted to the State over pollution issues has risen over the past three years from 6% to 13%^[11]. Donaldson sees potential in the expansion of international markets, and is betting more on international growth than on domestic growth; between 2005 and 2007, the company increased its capital in Asia by 64%, in Europe by 46%, and in the U.S. by only 11%^[12].

International Development Is a Double-Edged Sword

While Donaldson clearly believes that international development will carry it into a rich future, there are significant risks involved for an American company operating outside the U.S. Aside from economic regulations like tariffs, international operations risk harm from political and military events, as well as shifting social and economic currents. China, especially, deals with a number of these issues, as the country has a strong central government but is relatively new to the capitalist trade system. Foreign companies operating in China often face increased competition arising from technological theft, legal issues as rules and regulations differ from province to province, and PR issues from Chinese plant managers using child labor.

Competition

The filtration system industry is highly diversified - filters are made for a wide range of products, from residential water heaters to car exhausts. Donaldson is one of the larger players in the industry, and focuses on heavy-engine and industrial filtration. The company faces direct competition from such manufacturers as:

• Cummins - Cummins is a vertically integrated manufacturer of diesel engines, power generators, and filtration components. In 2006, the company earned 55% of its revenues from selling diesel engines, 18% from power generation systems, 17% from filtration components, and 10% from the distribution of its products^[13].
• Clarcor - Clarcor is a direct competitor to Donaldson, with an engine filters segment, an industrial filters segment, and a packaging segment operated by a separate, wholly-owned subsidiary, J. L. Clark, Inc. Unlike Donaldson, who splits engine filter sales between engine manufacturers and replacement parts vendors, Clarcor sells mostly to the replacements market.
• Pall - Pall produces filtration systems for the industrial market and the life sciences market. A significant part of its business stems from the aerospace industry, with 53% of aerospace revenues coming from military customers^[14].

Notes

1. ↑ DCI 10-K 2007, Item 8, Note J, Page 49, Percent change calculated by dividing the difference between 2005 capital and 2007 capital by 2005 capital, http://sec.gov/Archives/edgar/data/29644/000089710107002019/donaldson073861s1_10k.htm#toc12
2. ↑ The Wall Street Journal, Blog by Mark Gongloff, July 3rd, 2007, http://blogs.wsj.com/environmentalcapital/2007/07/03/in-other-papers-sweeping-chinas-pollution-deaths-under-the-rug/
3. ↑ DCI 10-K 2007, Item 8, Note J, Page 49, http://sec.gov/Archives/edgar/data/29644/000089710107002019/donaldson073861s1_10k.htm#toc12
4. ↑ DCI 10-K 2007, Item 6, Page 9, http://sec.gov/Archives/edgar/data/29644/000089710107002019/donaldson073861s1_10k.htm#toc12
5. ↑ http://findarticles.com/p/articles/mi_m0FZX/is_2_68/ai_84017250
6. ↑ http://en.wikipedia.org/wiki/Diesel
7. ↑ DCI 2007 10-K, Item 7, Page 13, http://sec.gov/Archives/edgar/data/29644/000089710107002019/donaldson073861s1_10k.htm#toc24
8. ↑ William Blair & Company, DCI Report, September 11th, 2007
9. ↑ http://www.meps.co.uk/allproducts%20steel%20price.htm
10. ↑ The Wall Street Journal, Blog by Mark Gongloff, July 3rd, 2007, http://blogs.wsj.com/environmentalcapital/2007/07/03/in-other-papers-sweeping-chinas-pollution-deaths-under-the-rug/
11. ↑ Economist.com, "Don't drink the water and don't breathe the air", Jan 24th, 2008, http://www.economist.com/world/asia/displaystory.cfm?story_id=10566907
12. ↑ DCI 10-K 2007, Item 8, Note J, Page 49, Percent change calculated by dividing the difference between 2005 capital and 2007 capital by 2005 capital, http://sec.gov/Archives/edgar/data/29644/000089710107002019/donaldson073861s1_10k.htm#toc12
13. ↑ Reuters.com, Full Description: Cummins, Inc., http://stocks.us.reuters.com/stocks/fullDescription.asp?rpc=66&symbol=CMI
14. ↑ Reuters.com, Full Description: Pall Corp, http://stocks.us.reuters.com/stocks/fullDescription.asp?rpc=66&symbol=PLL