Donaldson Company, Inc. manufactures filtration systems and replacement parts for trucking, industrial and life sciences companies. The filtration systems remove contaminants from air and liquids allowing the equipment to run longer and more efficiently. As a result, the filtration system and the subsequent replacement parts play a key role in ensuring that the equipment or industrial facility is running at peak performance. Replacement parts are 65% of Donaldson’s revenue, reducing revenue volatility despite the cyclical nature of its end markets.

Donaldson is adding “smart technology” to its products which can warn the customer when the filter needs to be replaced, preventing, for example, a costly breakdown in the fuel injector. Given its filtration systems analyze the fluids running through the vehicle or facility, smart technology can also alert the customer when to replace those fluids, adding additional value.

Donaldson is also preparing for the transition to hydrogen and battery power. Hydrogen fuel needs clean air and water much like a diesel engine. In fact, from a filtration standpoint, hydrogen needs to be pristine when compared to diesel for the fuel to work. Donaldson does not sell filters in the commoditized automobile market. The heavy-duty truck and machinery market is much further from mass adoption of electric (battery) operated vehicles. However, Donaldson does have a dual battery vent offering to control temperature and pressure fluctuations in a battery pack.

Donaldson has moved into the life sciences market via a few acquisitions over the last couple of years. The end markets are different (biomanufacturing for example) but the products are still filters used for purification. Instead of purifying diesel, the products purify gas, liquid and steam for a sterile manufacturing process. Adding the life sciences segment increases the total addressable market for Donaldson as well as adding non-correlated end markets.

By providing a valuable product and consistently adding new technology, Donaldson earns high returns on invested capital and operates very efficiently. Donaldson’s returns on capital are in the high teens with an operating margin in the mid-teens. Donaldson generates steady cash flows and has a somewhat formulaic approach to capital allocation. As operating cash flow grows in the mid-single to low double digits, the company spends about 50% on dividends and stock buybacks, 25% on capital expenditures, leaving the remainder for reinvestment in core segments and acquisitions.

From a valuation perspective, Donaldson is trading within its historical earnings multiple. The upside comes from the company’s ability to grow earnings and generate strong cash flows to pay dividends and buy back stock. Given the consistent operating history and value add its products provide, we are confident this upside will play out over the coming years.