DONALDSON Co INC: Form 10-Q for the period ended Oct 31, 2024

Overview

Founded in 1915, Donaldson Company, Inc. is a global leader in technology-led filtration products and solutions, serving a broad range of industries and advanced markets. Donaldson’s diverse and skilled employees at approximately 150 locations on six continents, 77 of which are manufacturing and/or distribution centers, partner with customers - from small business owners to the world’s largest original equipment manufacturer (OEM) brands - to solve complex filtration challenges. Customers choose Donaldson’s filtration solutions due to their stringent performance requirements and need for reliability.

The Company’s operating segments are Mobile Solutions, Industrial Solutions and Life Sciences. The Mobile Solutions segment is organized based on a combination of customers and products and consists of the Off-Road, On-Road and Aftermarket business units. Within these business units, products consist of replacement filters for both air and liquid filtration applications and filtration housings for new equipment production and systems related to exhaust and emissions. Applications include air filtration systems, fuel, lube and hydraulic systems, emissions systems and sensors, indicators and monitoring systems. Mobile Solutions sells to OEMs in the construction, mining, agriculture and transportation end markets and to independent distributors and OEM dealer networks.

The Industrial Solutions segment is organized based on product type and consists of Industrial Air Filtration, Industrial Gases, Industrial Hydraulics, Power Generation and Aerospace and Defense products. These products are further organized by the Industrial Filtration Solutions and Aerospace and Defense business units. Within our industrial portfolio, the Company provides a wide product offering in the market to industrial customers consisting of equipment, ancillary components, replacement parts, performance monitoring and service globally, that cost-effectively enhances productivity and manufacturing efficiency. Industrial Air Filtration, Industrial Gases and Industrial Hydraulics products consist of dust, fume and mist collectors, compressed air and industrial gases purification systems, hydraulic and lubricated rotating filtration applications as well as gas and liquid filtration for industrial processes. Power Generation products consist of air inlet systems and filtration sold to gas compression, power generation and natural gas liquification industries. Aerospace and Defense products consist of air, fuel, lubrication and hydraulic filtration for fixed-wing and rotorcraft aerospace applications and ground defense vehicle and naval platforms. Industrial Solutions businesses sell through multiple channels which include OEMs, distributors and direct-to-consumer in some markets.

The Life Sciences segment is organized by end market and consists of the Bioprocessing Equipment and Consumables, Food and Beverage, Vehicle Electrification and Medical Device, Microelectronics and Disk Drive markets. Within these markets, products consist of micro-environment gas and liquid filtration for food and beverage and industrial processes, bioprocessing equipment, including bioreactors and fermenters, bioprocessing consumables including chromatography devices, reagents and filters, polytetrafluoroethylene membrane-based products, as well as specialized air and gas filtration systems for applications including hard disk drives, semiconductor manufacturing, sensors, battery systems and powertrain components. Life Sciences primarily sells to large OEMs and directly to various end users requiring cell growth, separation, purification, high purity filtration and device protection.

The Company’s results of operations are affected by conditions in the global economic and geopolitical environment. Under most economic conditions, the Company’s diversification between its diesel engine end markets, its global end markets, its diversification through technology and its OEM and replacement parts customers has helped to limit the impact of weakness in any one product line, market or geography on the consolidated operating results of the Company.

Consolidated Results of Operations

Three months ended October 31, 2024 compared with three months ended October 31, 2023

Operating Results

Operating results were as follows (in millions, except per share amounts):

Geographic Net Sales by Origination

Net sales, disaggregated by location where the customer’s order was received, were as follows (in millions):

21

Net Sales

(1) The impact of foreign currency translation was calculated by translating the first quarter of fiscal 2025 foreign currency net sales into U.S. dollars using the average foreign currency exchange rates for the first quarter of the prior fiscal year. The impact of currency translation does not change the underlying drivers of revenue shown in this chart.

Net sales by segment (in millions):

Net sales for the three months ended October 31, 2024 increased $53.8 million, or 6.4%, from the three months ended October 31, 2023, reflecting higher sales in the Mobile Solutions segment of $32.4 million, or 6.0% growth, the Industrial Solutions segment of $11.4 million, or 4.6% growth, and the Life Sciences segment of $10.0 million, or 16.6% growth. Foreign currency translation increased net sales by $7.1 million compared to the three months ended October 31, 2023, reflecting increases in the Mobile Solutions, Industrial Solutions and Life Sciences segments of $3.3 million, $2.2 million and $1.6 million, respectively. During the three months ended October 31, 2024, the Company’s net sales increase was driven primarily by volume increases primarily due to strong underlying market growth.

Gross Margin

Gross margin as a percentage of net sales for the three months ended October 31, 2024 was 35.5%, a decrease from 35.6% for the three months ended October 31, 2023. The decrease in gross margin as a percentage of net sales was primarily due to restructuring expenses of $1.1 million associated with a continuation of the global footprint and cost optimization actions.

Selling, General and Administrative Expenses

Selling, general and administrative expenses for the three months ended October 31, 2024 were $166.1 million, or 18.5% of net sales, compared with $155.0 million, or 18.3% of net sales, for the three months ended October 31, 2023, an increase of $11.1 million, or 7.2%. The increase in selling, general and administrative expenses as a percentage of net sales was primarily due to restructuring expenses of $2.2 million associated with a continuation of the global footprint and cost optimization actions.

Research and Development Expenses

Research and development expenses for the three months ended October 31, 2024 were $22.7 million, or 2.5% of net sales, were generally flat as a percentage of net sales compared with $21.3 million, or 2.5% of net sales, for the three months ended October 31, 2023.

Non-Operating Items

Interest expense was $5.5 million for both the three months ended October 31, 2024 and 2023.

Other income, net for the three months ended October 31, 2024 was $5.2 million, compared with other income, net of $3.8 million for the three months ended October 31, 2023, an increase of $1.4 million, which was driven primarily by higher income from joint ventures.

Income Taxes

The effective tax rate was 24.2% and 25.1% for the three months ended October 31, 2024 and 2023, respectively. The lower effective tax rate was primarily due to an increase in discrete tax benefits.

The Organization for Economic Co-operation and Development (“OECD”) released the Model GloBE Rules for Pillar Two on December 20, 2021, which defined a 15% global minimum tax. Since the model rules have been released, many countries have enacted or continue to consider changes in their tax laws and regulations based on the Pillar Two proposals, some of which became effective for tax years beginning after January 1, 2024. We are continuing to evaluate the impact of these proposed and enacted legislative changes as new guidance becomes available. The Company does not expect Pillar Two to have a material impact on the Company’s financial statements as most jurisdictions in which the Company operates have an effective tax above the 15% threshold.

Net Earnings

Net earnings for the three months ended October 31, 2024 were $99.0 million, compared with $92.1 million for the three months ended October 31, 2023, an increase of $6.9 million, or 7.5%. Diluted EPS were $0.81 for the three months ended October 31, 2024, compared with $0.75 for the three months ended October 31, 2023, an increase of $0.06, or 8.1%.

Segment Results of Operations

Net sales and earnings (loss) before income taxes were as follows (in millions):

(1) Corporate and unallocated includes interest expense and certain corporate expenses determined to be non-allocable to the segments, such as restructuring charges and incentive compensation.

Mobile Solutions Segment

Net sales and earnings before income taxes were as follows (in millions):

(1) The impact of foreign currency translation was calculated by translating the first quarter of fiscal 2025 foreign currency net sales into U.S. dollars using the average foreign currency exchange rates for the first quarter of the prior fiscal year. The impact of currency translation does not change the underlying drivers of revenue shown in this chart.

Three months ended October 31, 2024 compared with three months ended October 31, 2023

Net sales for the Mobile Solutions segment for the three months ended October 31, 2024 were $572.4 million, compared with $540.0 million for the three months ended October 31, 2023, an increase of $32.4 million, or 6.0%. Excluding a $3.3 million increase from foreign currency translation, net sales for the Mobile Solutions segment increased 5.4%. All business units were positively impacted by foreign currency translation.

Net sales of Aftermarket increased $43.7 million, primarily due to volume increases driven by favorable market conditions, inventory destocking in the prior year and market share gains. Net sales of On-Road and Off-Road decreased $5.7 million and $5.6 million, respectively, primarily due to a decline in global equipment production driven by weak end market conditions, including agriculture and transportation.

Earnings before income taxes for the Mobile Solutions segment for the three months ended October 31, 2024 were $104.7 million, or 18.3% of net sales, an increase from 17.1% of net sales for the three months ended October 31, 2023. The increase was driven by higher volume, favorable product mix related to the sale of replacement parts and select lower input costs.

Industrial Solutions Segment

Net sales and earnings before income taxes were as follows (in millions):

(1) The impact of foreign currency translation was calculated by translating the first quarter of fiscal 2025 foreign currency net sales into U.S. dollars using the average foreign currency exchange rates for the first quarter of the prior fiscal year. The impact of currency translation does not change the underlying drivers of revenue shown in this chart.

Three months ended October 31, 2024 compared with three months ended October 31, 2023

Net sales for the Industrial Solutions segment for the three months ended October 31, 2024 were $257.6 million, compared with $246.2 million for the three months ended October 31, 2023, an increase of $11.4 million, or 4.6%. Excluding a $2.2 million increase from foreign currency translation, net sales for the Industrial Solutions segment increased 3.7%.

Net sales of Aerospace and Defense increased by $9.6 million due to ongoing strength in the aerospace and defense end markets. Net sales of IFS increased $1.8 million, reflecting higher sales volume in power generation driven by the timing of projects.

Earnings before income taxes for the Industrial Solutions segment for the three months ended October 31, 2024 were $41.0 million, or 15.9% of net sales, a decrease from 17.6% of net sales for the three months ended October 31, 2023. The decrease was driven by higher operating expense from investments for future growth and the impact of negative product mix.

Life Sciences Segment

Net sales and losses before income taxes were as follows (in millions):

25

(1) The impact of foreign currency translation was calculated by translating the first quarter of fiscal 2025 foreign currency net sales into U.S. dollars using the average foreign currency exchange rates for the first quarter of the prior fiscal year. The impact of currency translation does not change the underlying drivers of revenue shown in this chart.

Three months ended October 31, 2024 compared with three months ended October 31, 2023

Net sales for the Life Sciences segment for the three months ended October 31, 2024 were $70.1 million, compared with $60.1 million for the three months ended October 31, 2023, an increase of $10.0 million, or 16.6%. Excluding a $1.6 million increase from foreign currency translation, net sales for the Life Sciences segment increased 13.9%. The increase was driven by strong market demand and market share gains in disk drive and strong food and beverage markets in EMEA and APAC.

Losses before income taxes for the Life Sciences segment for the three months ended October 31, 2024 were $5.3 million, or 7.6% of net sales, an increase from losses before income taxes of 7.0% of net sales for the three months ended October 31, 2023. The increase was driven by the expected impact from investments made in the Company’s recently-acquired businesses.

Liquidity, Capital Resources and Financial Condition

Liquidity

Liquidity is assessed in terms of the Company’s ability to generate cash to fund its operating, investing and financing activities. Significant factors affecting liquidity are cash flows generated from operating activities, capital expenditures, acquisitions, dividends, repurchases of outstanding shares, adequacy of available credit facilities and the ability to attract long-term capital with satisfactory terms. The Company generates substantial cash from the operation of its businesses as its primary source of liquidity, with sufficient liquidity available to fund growth through reinvestment in existing businesses and strategic acquisitions.

Cash Flow Summary

Cash flows were as follows (in millions):

26

Operating Activities

Cash provided by operating activities for the three months ended October 31, 2024 was $72.9 million, compared with $138.0 million for the three months ended October 31, 2023, a decrease of $65.1 million. The decrease in cash provided by operating activities was primarily driven by an increase in working capital requirements during the current quarter, including purchasing additional inventory to increase on-time deliveries, partially offset by higher earnings in the current quarter.

Investing Activities

Cash used in investing activities for the three months ended October 31, 2024 was $96.0 million, compared with $23.2 million for the three months ended October 31, 2023, an increase of $72.8 million. The increase in cash used was primarily due to the equity method investment in Medica.

Financing Activities

Cash provided by financing activities generally relates to the use of cash for payment of dividends and repurchases of the Company’s common stock, net of borrowing activity and proceeds from the exercise of stock options. Cash provided by financing activities for the three months ended October 31, 2024 was $9.8 million, compared with cash used in financing activities of $78.9 million for the three months ended October 31, 2023, an increase of $88.7 million. The increase was primarily driven by a debt repayment of $73.8 in the first quarter of the prior year.

To determine the level of dividend and share repurchases, the Company considers recent and projected performance across key financial metrics, including earnings, cash flow from operations and total debt. Dividends paid for the three months ended October 31, 2024 and 2023 were $32.4 million and $30.2 million, respectively. Share repurchases for the three months ended October 31, 2024 and 2023 were $74.4 million and $53.3 million, respectively.

Capital Resources

Additional sources of liquidity are existing cash and available credit facilities. Cash and cash equivalents as of October 31, 2024 was $221.2 million, compared with $232.7 million as of July 31, 2024. The Company has capacity of $501.9 million available for further borrowing under existing credit facilities as of October 31, 2024, which includes $327.0 million available on the Company’s $500.0 million unsecured revolving credit facility that expires on May 21, 2026.

The Company believes the liquidity available from the combination of expected cash generated by operating activities, existing cash and available credit under existing credit facilities will be sufficient to meet its cash requirements for the next 12 months and beyond, including working capital needs, debt service obligations, capital expenditures, payment of dividends, share repurchase activity and potential acquisitions.

Financial Condition

Short-Term Borrowings and Long-Term Debt

As of October 31, 2024, total debt, including short-term borrowings and long-term debt, represented 29.4% of total capitalization, defined as total debt plus total stockholders’ equity, compared with 26.5% as of July 31, 2024. As of October 31, 2024, the Company was in compliance with its financial covenants.

Long-term debt outstanding was $563.6 million as of October 31, 2024, compared with $508.4 million as of July 31, 2024, an increase of $55.2 million, primarily due to proceeds from long-term debt received during the three months ended October 31, 2024. As of October 31, 2024, there was $327.0 million available and $165.0 million outstanding on the Company’s $500.0 million unsecured revolving credit facility that expires on May 21, 2026.

Working Capital

In order to help measure and analyze the impact of working capital management, the Company calculates days sales outstanding as the average accounts receivable, net for the quarter, divided by net sales for the quarter multiplied by the number of days in the quarter. The Company calculates days inventory outstanding as the average inventories, net for the quarter, divided by cost of sales for the quarter multiplied by the number of days in the quarter. The Company calculates days payable outstanding as the average accounts payable for the quarter, divided by cost of sales for the quarter multiplied by the number of days in the quarter. The Company calculates net cash cycle as the sum of days sales outstanding and days inventory outstanding, less days payables outstanding.

Off-Balance Sheet Arrangements

The Company guarantees 50% of certain debts of its joint venture, AFSI, as discussed in Note 16 in the Notes to Condensed Consolidated Financial Statements included in Item 1 of this report.

Critical Accounting Estimates

There have been no material changes to the Company’s critical accounting estimates as disclosed in the Company’s Annual Report on Form 10-K for the fiscal year ended July 31, 2024.

New Accounting Standards Not Yet Adopted

For new accounting standards not yet adopted, refer to Note 1 in the Notes to Condensed Consolidated Financial Statements included in Item 1 of this report.

Safe Harbor Statement Under the Private Securities Litigation Reform Act of 1995

The Company, through its management, may make forward-looking statements reflecting the Company’s current views with respect to future events and expectations, such as forecasts, plans, trends and projections relating to the Company’s business and financial performance. These forward-looking statements, which may be included in reports filed under the Securities Exchange Act of 1934, as amended (the Exchange Act), in press releases and in other documents and materials as well as in written or oral statements made by or on behalf of the Company, are subject to certain risks and uncertainties, including those discussed in Part I, Item 1A, “Risk Factors” of the Company’s Annual Report on Form 10-K for the fiscal year ended July 31, 2024, which could cause actual results to differ materially from historical results or those anticipated. The words or phrases such as “will likely result,” “are expected to,” “will continue,” “will allow,” “estimate,” “project,” “believe,” “expect,” “anticipate,” “forecast,” “plan” and similar expressions are intended to identify forward-looking statements within the meaning of Section 21E of the Exchange Act and Section 27A of the Securities Act of 1933, as amended, as enacted by the Private Securities Litigation Reform Act of 1995 (PSLRA). In particular, the Company desires to take advantage of the protections of the PSLRA in connection with the forward-looking statements made in this Quarterly Report on Form 10-Q. All statements other than statements of historical fact are forward-looking statements. These statements do not guarantee future performance.

These forward-looking statements speak only as of the date such statements are made and are subject to risks and uncertainties that could affect the Company’s performance and could cause the Company’s actual results for future periods to differ materially from any opinions or statements expressed. These factors include, but are not limited to, challenges in global operations; impacts of global economic, industrial and political conditions on product demand, impacts from unexpected events, effects of unavailable raw materials, significant demand fluctuations or material cost inflation; inability to attract and retain qualified personnel; inability to meet customer demand; inability to maintain competitive advantages; threats from disruptive technologies; effects of highly competitive markets with pricing pressure; exposure to customer concentration in certain cyclical industries; inability to manage productivity improvements; inability to achieve commitments related to ESG; results of execution of any acquisition, divestiture and other strategic transactions; vulnerabilities associated with information technology systems and security; inability to protect and enforce intellectual property rights; costs associated with governmental laws and regulations; impacts of foreign currency fluctuations; and effects of changes in capital and credit markets. These and other factors are described in Part I, Item 1A, “Risk Factors” of the Company’s Annual Report on Form 10-K for the fiscal year ended July 31, 2024. The Company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, unless required by law.

The Company’s market risk includes the potential loss arising from adverse changes in foreign currency exchange rates, interest rates and commodity prices. To manage these risks, the Company employs certain strategies to mitigate the effect of these fluctuations. The Company does not enter into any of these strategies for trading or speculative purposes.

The Company maintains significant assets and operations outside the U.S., resulting in exposure to foreign currency gains and losses. A portion of the Company’s foreign currency exposure is naturally hedged by incurring liabilities, including bank debt, denominated in the local currency in which the Company’s foreign subsidiaries are located.

During the three months ended October 31, 2024, the U.S. dollar was generally weaker than in the three months ended October 31, 2023 compared with many of the currencies of the foreign countries in which the Company operates. The overall weaker U.S. dollar had a positive impact on the Company’s international net sales and net earnings because the foreign denominated revenues translated into more U.S. dollars in many regions around the world. The estimated impact of foreign currency translation for the three months ended October 31, 2024 resulted in an overall increase in reported net sales of $7.1 million and an increase in reported net earnings of $0.9 million.

Derivative Fair Value Measurements

The Company enters into derivative instrument agreements, including foreign currency forward contracts and net investment hedges, to manage risk in connection with changes in foreign currency. The Company only enters into derivative instrument agreements with counterparties who have highly rated credit. See Notes 11, 14 and 15 in the Notes to Condensed Consolidated Financial Statements included in Item 1 of this report.

Foreign Currency Forward Contracts - Cash Flow Hedges and Derivatives Not Designated as Hedging Instruments

The Company buys materials from foreign suppliers. Those transactions can be denominated in those suppliers’ local currency. The Company also sells to customers in foreign countries. Those transactions can be denominated in those customers’ local currency. Both of these transaction types can create volatility in the Company’s financial statements. The Company uses foreign currency forward contracts to manage those exposures and fluctuations. These contracts generally mature in 12 months or less, which is consistent with the forecasts of the related purchases and sales. Certain contracts are designated as cash flow hedges, whereas the remaining contracts, most of which are related to certain intercompany transactions which offset balance sheet exposure, are not designated as hedging instruments. The total notional amount of the foreign currency forward contracts designated as hedges was $66.9 million and $32.3 million as of October 31, 2024 and July 31, 2024, respectively. The total notional amount of the foreign currency forward contracts not designated as hedges was $190.1 million and $249.7 million as of October 31, 2024 and July 31, 2024, respectively.

Net Investment Hedges

The Company uses fixed-to-fixed cross-currency swap agreements to hedge its exposure to adverse foreign currency exchange rate movements for its operations in Europe. The Company has elected the spot method for designating these contracts as net investment hedges.

The total notional amount of net investment hedges as of October 31, 2024 and July 31, 2024 was €80 million, or $88.8 million. The maturity dates range from 2027 to 2029.

Based on the net investment hedges outstanding as of October 31, 2024, a 10% appreciation of the U.S. dollar compared to the Euro would result in a net gain of $8.0 million in the fair value of these contracts.

Interest Rates

The Company’s exposure to market risk for changes in interest rates primarily relates to debt obligations that are at variable rates, as well as the potential increase in the fair value of long-term debt resulting from a potential decrease in interest rates. As of October 31, 2024, the Company’s financial liabilities with exposure to changes in interest rates consisted mainly of $165.0 million outstanding on the Company’s unsecured revolving credit facility, €80.0 million, or $86.9 million, of a variable rate term loan and ¥2.0 billion, or $13.1 million, of variable rate senior notes. As of October 31, 2024, variable short-term borrowings outstanding consisted of $70.8 million. Assuming a hypothetical 0.5 percentage point increase in short-term interest rates, with all other variables remaining constant, interest expense would have increased approximately $0.4 million in the three months ended October 31, 2024. The Company has no interest rate hedging agreements. Interest rate changes would also affect the fair market value of fixed-rate debt. As of October 31, 2024, the estimated fair values of fixed interest rate long-term debt were $266.8 million compared to the carrying values of $300.0 million. The fair values are estimated by discounting the projected cash flows using the interest rates at which similar amounts of debt could currently be borrowed.

The interest on cash and cash equivalents will vary as short-term yields change. Assuming a hypothetical 0.5 percentage point increase in yields, with all other variables remaining constant, interest income would have increased approximately $0.3 million in the three months ended October 31, 2024.

Commodity Prices

The Company is exposed to market risk from fluctuating prices of purchased commodity raw materials, including steel, filter media and petrochemical-based products including plastics, rubber and adhesives. On an ongoing basis, the Company enters into selective supply arrangements that allow the Company to reduce volatility in its costs. The Company strives to recover or offset all material cost increases through price increases to its customers and the Company’s cost reduction initiatives, which include material substitution, process improvement and product redesigns. However, an increase in commodity prices could result in lower gross profit.

Bankers’ Acceptance Notes

Consistent with common business practice in APAC, the Company has subsidiaries which accept bankers’ acceptance notes from their customers in settlement of certain customer billed accounts receivable. Bankers’ acceptance notes represent a commitment by the issuing financial institution to pay a certain amount of money at a specified future maturity date to the legal owner of the bankers’ acceptance note as of the maturity date. The maturity dates of bankers’ acceptance notes vary, but it is the Company’s policy to only accept bankers’ acceptance notes with maturity dates no more than 180 days from the date of the Company’s receipt of such draft. As of October 31, 2024 and July 31, 2024, the Company owned $6.7 million and $8.4 million, respectively, of these bankers’ acceptance notes and includes them in accounts receivable on the Condensed Consolidated Balance Sheets.

Evaluation of Disclosure Controls and Procedures

Management of the Company, with the participation of its Chief Executive Officer and its Chief Financial Officer, evaluated the effectiveness of the Company’s disclosure controls and procedures as of the end of the period. Based on their evaluation, as of the end of the period covered, the Company’s Chief Executive Officer and Chief Financial Officer concluded the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) were effective. The Company’s disclosure controls and procedures are designed so information required to be disclosed by the issuer in the reports it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s (SEC) rules and forms and such information is accumulated and communicated to management of the Company, with the participation of its Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.

Changes in Internal Control over Financial Reporting

No change in the Company’s internal control over financial reporting (as defined by Rule 13a-15(f) under the Exchange Act) occurred during the fiscal quarter ended October 31, 2024, that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

There are inherent risks and uncertainties associated with the Company’s global operations that involve the manufacturing and sale of products for highly demanding customer applications throughout the world. These risks and uncertainties could adversely affect the Company’s business, reputation, financial condition or results of operations. The “Risk Factors” section in the Company’s Annual Report on Form 10-K for the fiscal year ended July 31, 2024 outlines the risks and uncertainties the Company believes are the most material to its business.