Donaldson Looks To Spur Profitable Growth Through Investments in New Life Sciences Segment

Equity Analyst

Krzysztof Smalec

Associate Equity Analyst

Alex Medow

Donaldson, a leading manufacturer of air and liquid filtration systems, has built a narrow moat around its large installed base of equipment coupled with a razor-and-blade business model that continues to generate a relatively steady and high-margin stream of recurring revenue from aftermarket parts and consumables. The firm generates an increasing portion of its sales from proprietary solutions, which enjoy higher margins and greater customer retention rates. As a result, recurring revenue has steadily increased, from roughly 50% in 2012 to over 60% in fiscal 2022. We expect this trend to continue, as the firm continues to scale their new life sciences segment both through organic investment and acquisitions. 

Our main concern is the threat that increased adoption of electrification will pose to the firm’s engine business in the long run, though we expect the impact to be gradual for several reasons. First, Donaldson has no exposure to passenger vehicles, and we expect that the adoption pace for medium- and heavy-duty equipment to be relatively slower. For instance, battery weight is a concern for on-road vehicles, as it may reduce payload capacity, while lack of convenient access to the grid is an issue for off-road applications. Second, the growth in hybrid vehicles will still create opportunities to sell air and liquid filters. Last, even as electric powertrains begin to capture market share of new vehicles, there is a large existing fleet of vehicles with diesel engines that will continue to drive demand for aftermarket parts for many years. 

Given the long-term threat of electrification, we think management will pursue leveraging its filtration technology in new and emerging verticals to spur future growth, namely life sciences, as the company has executed several acquisitions over the past several years to jump-start the segment's growth. We believe Donaldson will be able to achieve product market fit in several high growth end markets, particularly food and beverage, bioprocessing, and medical devices.

Business Strategy & Outlook

We think Donaldson has dug a narrow economic moat based primarily on customer switching costs and secondarily on intangible assets. Donaldson is a leading filtration solutions company, manufacturing both air and liquid filtration systems. Its products typically account for only a fraction of a customer’s bill of materials but perform an important function. As such, its large installed base of equipment generates a steady stream of recurring revenue from replacement parts and consumables, as customers tend to replace components like-for-like because of the risk of product failures from switching to a less proven alternative.

Donaldson’s moat is built on customer switching costs that stem from its razor-and-blade business model. After the firm secures a first-fit sale, customers have to periodically purchase replacement parts and consumables as filters become filled with contaminants. While not all the replacement parts that Donaldson sells are proprietary (notably in emerging markets, where commoditized solutions are still more common), the firm strives to increase its sales of proprietary products under its razor-and-blade model. The key source of differentiation for Donaldson is its proprietary filter media (the filtration material), as the firm develops innovative media in-house to optimize the filters’ efficiency, lifetime, and other properties. The firm has been successful in driving higher adoption of its proprietary solutions, as those products have accounted for roughly three fourths of new wins in recent years. This is important from an economic moat perspective, as the firm’s proprietary products have a significantly greater customer retention rate than more commoditized solutions.

Although there is a risk of copycat producers reverse engineering and replicating Donaldson’s proprietary products and encroaching on its aftermarket sales, Donaldson has historically been successful in protecting its intellectual property. Additionally, the firm regularly introduces new or improved solutions that allow it to remain a step ahead of its competitors. Another key factor contributing to customer switching costs is that Donaldson’s products perform an important function but account for a small portion of customers’ total costs (for example, the cost of an air filter is a mere fraction of the cost of an engine). We believe that customers tend to be reluctant to switch vendors and risk damaging an expensive engine by using an improper filter, as the cost of failure could far outweigh the cost savings of switching to a cheaper solution. 

Donaldson’s large installed base of equipment, coupled with its razor-and-blade business model, continues to generate a relatively stable and higher-margin stream of recurring revenue from replacement parts and consumables. The firm derives over half of its sales (65% in fiscal 2022) from replacement parts tied to its installed base. This proportion has steadily increased in recent years (from 50% in 2012) because of the firm’s efforts to increase sales of proprietary products, which have higher customer retention rates. As such, each first-fit equipment sale helps grow Donaldson’s installed base and contributes to the firm’s recurring revenue stream.

We also see intangible assets supporting Donaldson’s moat, including its reputation for quality and reliability, long-standing relationships with customers, and a patent portfolio of more than 2,800 patents as of fiscal 2023. Donaldson offers highly engineered and customizable solutions, and its engineers often work with customers’ engineers to develop unique solutions, leading to sticky client relationships. For example, the firm has multidecade relationships with major original equipment manufacturers, such as Caterpillar, Cummins, and Deere. We believe this gives Donaldson a competitive advantage and inside track to win future contracts, as the firm may consult and work on developing innovative filtration solutions for new OEM product lines before they are even launched. We think the firm’s research and development investments are sufficient to protect its moat over the next decade.

Donaldson’s moat has allowed it to consistently deliver returns on invested capital in excess of its cost of capital, as the firm’s ROICs averaged an impressive 19% over the past 10 years. We believe that the firm’s inherent moat sources remain intact, and we think the firm is well positioned to continue to outearn its cost of capital and create value for shareholders over the next decade.

Narrow

Economic Moat

Donaldson

Donaldson Co., Inc. engages in the manufacture of filtration systems and replacement parts. It operates through the following segments: Engine Products and Industrial Products. The Engine Products segment includes replacement filters for both air and liquid filtration applications, air filtration systems, liquid filtration systems for fuel, lube and hydraulic applications, and exhaust and emissions systems. The Industrial Products segment consist of dust, fume and mist collectors, compressed air purification systems, air filtration systems for gas turbines, polytetrafluoroethylene membrane-based products, and specialized air and gas filtration systems for applications as well as hard disk drives, and semi-conductor manufacturing. The company was founded by Frank Donaldson in 1915 and is headquartered in Minneapolis, MN.

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Donaldson Co., Inc. engages in the manufacture of filtration systems and replacement parts. It operates through the following segments: Mobile Solutions, Industrial Products, and Life Sciences. The Mobile Solutions segment is involved in off-road, on-road, and after-market business units. The Industrial Products segment focuses on industrial air filtration, industrial gases, industrial hydraulics, power generation and aerospace, and defense business units. The Life Sciences segment consists of bioprocessing, food and beverage, medical device, vehicle electrification, microelectronics and disk drive business units. The company was founded by Frank Donaldson in 1915 and is headquartered in Minneapolis, MN.

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