Thursday, March 21, 2013

Donaldson Equity Research and Analysis

In theory, filtration companies have a lot going for them. Growing regulatory requirements promulgated by environmental concerns should ensure GDP growth in the future. Moreover, the promise of long term growth from industrialization and increasing numbers of transport vehicles in emerging markets offers plenty of upside. On the other hand, they are still cyclical plays that are dependent on specific end markets. In this article I want to focus on Donaldson (NYSE: DCI) and discuss some of the reads across to other companies from its recent results.

Donaldson Earnings

The market didn’t like the recent results, and they served as a salutary reminder that the industrial market still faces challenges this year. Sales were up 3%, but operating income declined 5%. In order to demonstrate the particulars with this company I’ve broken out some numbers below. The orange segments represent Industrial Products revenues, while the blue shows Engine Products revenues.

It’s not hard to see that its key end markets are construction and agricultural (aftermarket and off road) machinery, heavy trucks (on road), industrial filtration and gas turbine filters.

Here is how the relative segments have been trending in terms of quarterly revenues.

What the Industry is Saying

In order to assess its end markets it’s a good idea to go back to Alcoa’s (NYSE: AA) recent results. There is a detailed outline of them here. The key thing to note here is that Alcoa’s predictions for its Heavy Truck and Trailer segment got progressively worse in 2012, and Europe and North America are set for declines in 2013. All growth prospects in the segment are expected to come from China.

Turning to gas turbines, Alcoa forecast 3%-5% growth for its industrial turbine sales, and it remains an area of strength. Gas Turbine revenues have been strong for Donaldson (up 79% in the quarter) on account of low gas prices causing electricity generators to run the turbines more. However, it is not all good news for Donaldson. For example, Joy Global (NYSE: JOY) is seeing ongoing weakness in its mining operations because low gas prices have reduced the demand for coal for electricity generation. Of course this is happening because gas prices have been low in the US and because growth has slowed in China. As such, Joy Global is facing ongoing challenges, and Donaldson is talking about mining not picking up until later in 2013. Construction, mining and heavy trucking remain problematic sectors for Donaldson.

Caterpillar (NYSE: CAT) is a major customer of Donaldson and is exposed to many of the same end markets. The fact that its EPS forecasts have been lowered over the last few months should have presaged the negative commentary from Donaldson on construction and mining. Much of CAT’s future growth depends on China, and Donaldson remarking that CAT was still reducing inventory in China (primarily because of weakness in construction) is not a great sign, even as others are predicting better days in China.

Indeed, just as Alcoa predicted, demand from construction and mining OEM manufacturers has weakened in Asia and the Americas. This is a consequence of lower end demand, and it will take time for this to filter through.

Donaldson a Stock to Buy?

The bullish case for Donaldson is dependent on conditions getting better in China and specifically within mining, construction and the heavy trucking industries. The market has been keen on this idea, but I think the information discussed above gives enough clues as to what to look for. If China’s construction industry is picking up you will see this in Caterpillar and Joy Global’s numbers before you see it with Donaldson. Similarly, Alcoa gives key guidance over many of its end markets, and my sense is this there isn’t enough hard evidence to get too excited yet.

Granted, China has the financial muscle to buy 7%-8% growth this year, but it is far from clear whether it will go towards the same kind of stimulus spending that it undertook in 2008. For now Donaldson is talking of reduced visibility and lowering its full year outlook. It’s probably not the time to pile in, but rather monitor what its peer group is saying first.