DONALDSON Co INC Q2 2026 earnings call

Good morning. Thank you for joining Donaldson's Q2 fiscal 2026 earnings conference call. With me today are Tod Carpenter, Chairman, President, and CEO, Rich Lewis, Incoming President and CEO, and Brad Pogalz, Chief Financial Officer. This morning, we will provide a summary of our Q2 performance and our outlook for fiscal 2026. During today's call, we will discuss non-GAAP or adjusted results. For Q2 2026, non-GAAP results exclude pre-tax charges of $6.7 million, including $2.9 million of restructuring and other, and $3.8 million of business development charges. This compares to prior year pre-tax charges of $6.6 million, including $2.2 million of restructuring and other, and $4.4 million of business development charges. A reconciliation of GAAP to non-GAAP metrics is provided within the schedules attached to this morning's press release.

Please keep in mind that any forward-looking statements made during this call are subject to risks and uncertainties, which are described in our press release and SEC filings. With that, I will now turn the call over to Tod.

Thanks, Sarika. Good morning, everyone. Donaldson Company achieved record sales in the Q2 as we worked hard to meet strong customer demand across all three of our segments. Our underlying business is robust, as evidenced by our high backlogs and continued strong order intake. While we face short-term execution challenges in our industrial segment, we saw strength in areas such as independent aftermarket within mobile solutions and food and beverage and Disk Drive within life sciences. We also announced the acquisition of Facet, the largest acquisition in company history, which I will discuss in a few minutes. Entering the second half of the year, I have confidence in the strength of our organization and our commitment to deliver on our updated fiscal 2026 outlook, which represents record sales of approximately $3.8 billion, with operating margin and adjusted earnings per share at all-time highs.

Throughout our history, our talented global teams have demonstrated a commitment to deliver for all of our stakeholders, including our customers, shareholders, and employees. We continually do this through our leadership position in filtration, which was built on decades of solving our customers' most difficult filtration problems, our best-in-class technology, uniquely powerful because we focus on filtration capabilities and then leverage these technologies across markets, our ability to help customers meet evolving environmental and operational goals by helping to protect equipment, processes, and people, and our clear strategic and balanced growth strategy. This is how we have and will continue to win. In late January, we announced our next President and CEO, Rich Lewis, effective next week on March 2nd.

This transition reflects a long-term succession planning process that comes at a time when we are well-positioned for the future, thanks to the talent, dedication, and discipline of our global team. Rich has been with Donaldson since 2002 and has been our Chief Operating Officer since August. On behalf of the entire organization, I wanna congratulate him, and I look forward to his future success. Before I turn it over to Rich to discuss our Q2 results in more detail, I wanna touch on our recent acquisition of Facet, which we are very excited about. This acquisition complements and expands Donaldson's product portfolio, bringing high-performance fuel and fluid filtration capabilities for mission-critical applications and broadening our exposure to durable end markets, such as Aerospace and Defense and power generation.

Importantly, approximately 70% of Facet's revenue are driven by recurring, regulated replacement part sales, a nice fit with our already large composition of replacement parts. Facet makes us stronger, adding nearly $110 million in sales, with gross margins and EBITDA margins significantly above our current company average. The company has low capital intensity and strong cash flows. We look forward to welcoming the Facet team to Donaldson and reporting on our combined performance. I will turn it over to Rich, who will talk more about the Q2 highlights, and then Brad will take us through the financials in more detail. Rich?

Thanks, Tod. Good morning, everyone. First, I'd like to thank Tod for his leadership and congratulate him on his successful Donaldson Company career, including his impact as CEO over the past 11 years. I am honored to step into the CEO role and look forward to working alongside our broader leadership team to build on our momentum and deliver for our stakeholders. I also look forward to my continued partnership with Tod as he transitions to the executive chairman position. Now I'll cover our Q2 results. At a high level, sales were a record $896 million, 3% above prior year, with growth across all three segments. Currency translation and pricing benefits were partially offset by volume declines in both mobile and industrial solutions. Operating margin was 14%, down from 15.2% a year ago as a result of gross margin pressure.

Volume de-leveraging, concentrated operational inefficiencies related to our production shifts to support higher demand and power generation, and footprint optimization costs negatively impacted gross margin in the quarter. Adjusted earnings per share were $0.83, flat versus the record achieved in 2025. Now, looking at our segments, mobile solution sales were $557 million, up 2%, driven by currency benefits. Aftermarket sales were $447 million, up 1%, with high single-digit growth in our independent channel, offset by OE channel declines. Overall, we are benefiting from share gains and increases in global vehicle utilization. On the first-fit side, off-road sales of $86 million increased 8% as we cycle against weak market conditions from prior year, particularly in agriculture. On-road sales of $23 million decreased 9% as a result of continued declines in global truck production.

Touching on our mobile business in China, sales were up 18% due to strength in off-road and aftermarket. This marks our sixth consecutive quarter of growth in China, and we are optimistic about the future opportunities in this important market. In Industrial Solutions, sales were $260 million, a 2% increase compared with 2025, driven by currency benefits. IFS sales of $223 million grew 7% from continued strength in power generation, particularly in North America and Europe, and demand for new equipment remained significant. Rounding out our Industrial Solutions performance, Aerospace and Defense sales were $37 million, down 19% versus prior year due to project timing, primarily in defense. In Life Sciences, sales of $80 million increased 16% year-over-year, largely as a result of robust growth in food and beverage and Disk Drive.

In food and beverage, our largest business within life sciences, new equipment sales grew substantially in all regions, laying the foundation for future replacement parts sales growth. We continue to win, including in areas such as liquid cooling for data centers, and we are winning with key OEMs and channel partners through our strong sales processes and technology-led products. Given our Q2 results and our expectations for the second half of the year, we are updating our margin and earnings outlook for fiscal 2026. At the midpoint of our revised guidance ranges, we continue to expect a record year for Donaldson, now inclusive of record sales of $3.8 billion and sales growth in each of our segments, consistent with our previous expectations.

Operating margin expansion of 50 basis points to an all-time high of 16.2%, including second half operating margin, consistent with our prior guidance. Earnings per share of $3.97, roughly 8% above prior year, free cash flow conversion of approximately 90%, which provides us capital allocation optionality to return value to our shareholders. In summary, I am proud of the agility and resilience displayed by the Donaldson team as we navigate some short-term operational headwinds to set ourselves up for stronger performance over the long term. With that, I will now turn it over to Brad, who will provide more details on the financials and our outlook for fiscal 2026. Brad?

Thanks, Rich. Good morning, everyone. I want to start by thanking the Donaldson team. They demonstrated tremendous agility as we work to deliver for our customers while making progress on several big projects, including the work done on the Facet acquisition. Facet will be an important addition to our company. We expect to close in the next couple of quarters. As Tod mentioned, Facet will make us stronger, strategically and financially. Beyond Facet, we're focused on delivering the strong second-half performance reflected in our guidance. First, a summary of our results. Note that my profit comments exclude the impact from the non-recurring charges Sarika referenced earlier. Total sales increased 3%. Adjusted EPS of $0.83 was flat year-over-year. Operating margin declined 120 basis points to 14%, due primarily to the impact from discrete operational issues on gross margin.

Q2 gross margin was 33.7%, down 150 basis points from the prior year and below our expectations. About 60 basis points of the total gross margin decline was due to de-leveraging from lower volume in the mobile and industrial segments. We anticipated some year-over-year gross margin pressure in the quarter, as there were certain businesses, particularly OE aftermarket and defense, with difficult comparisons from last year. The timing of orders and delivery had a greater impact than planned. For the second half of fiscal 26, we expect the volume pressures abate based on our strong backlogs and the leverage that comes with our typical second-half sales step-up. Q2 gross margin was also impacted by inefficiencies driven by changes we are making to our manufacturing footprint.

One item that spiked this quarter relates to power generation. Specifically, the production of our large turbine systems. To meet the super cycle demand and deliver on customer-specific requirements of producing in North America, last year, we began producing these large systems for the first time at one of our facilities in Mexico. The combination of a protracted startup process in Mexico and surging demand resulted in a gross margin headwind of about 40 basis points in the quarter. We have plans in place to accelerate our improvement and expect to make progress in the second half of this fiscal year. Another area where we expect improvement in the second half relates to our ongoing footprint optimization initiatives. This fiscal year is an important milestone for this work, with the most significant projects expected to be completed by fiscal year-end.

In the quarter, we had about 30 basis points of gross margin pressure as we go through the final stages of a plant closure in the U.S. and associated transfer of production. Once through this heavy lift period, we will begin to realize cost benefits later in this fiscal year and into the future. While gross margin in the Q2 was not to our expectation, the drivers of the performance reflect short-term headwinds from the work we are doing to establish long-term efficiencies in several of our most important businesses. Our forecast contemplates sequential improvement in gross margin and full year expansion. I'm confident we will deliver on that target. At the same time, our team continues to do an excellent job managing our operating expenses.

As a rate of sales, operating expenses improved to 19.7% from 20% a year ago, reflecting benefits from the structural cost optimization initiatives launched during the prior fiscal year, as well as continued expense discipline. We're prioritizing opportunities while conserving where we can, providing necessary offsets to the footprint work we're doing. In terms of segment profitability, Mobile Solutions' pre-tax profit margin was 16.8%, down 60 basis points from prior year, primarily due to volume deleveraging in the aftermarket OE channel and footprint optimization efforts. Industrial Solutions' pre-tax margin was 11.9%, down from 16.1% in 2025, stemming from the previously mentioned operational inefficiencies and footprint optimization costs. With improving plant efficiency and benefits from leverage on higher sales, we expect industrial pre-tax operating margin to step up notably in the second half.

Life Sciences' pre-tax margin improved to 9.3% from a loss of about 1% a year ago. Strong sales in our higher margin, food and beverage, and Disk Drive businesses, and benefits from a more focused expense structure following optimization programs a year ago, drove the improvement. Turning to our fiscal 26 outlook, first on sales, we are reaffirming our consolidated sales guidance of 1% to 5% growth, with stronger-than-expected sales in Mobile Solutions and Life Sciences being offset by lower Industrial Solutions sales. Our forecast assumes pricing and currency translation will each contribute about 1% to growth. Within Mobile Solutions, we're increasing our growth forecast to a range between 2% and 6%, compared with flat to up 4% previously, primarily due to favorable currency.

We are raising our guidance for aftermarket and now expect sales up mid-single digits versus our previous low single-digit forecast, primarily due to strength in our independent channel from currency, pricing, and volume. Consistent with our prior guidance, off-road sales remain on track to grow mid-single digits, mainly due to a modest rebound following significant declines in agriculture a year ago. On-road sales are expected to be flat for the year, also in line with our prior guidance, due to muted global truck production. In Industrial Solutions, sales are forecast between a decline of 1% and an increase of 3% versus the previous expectation for growth between 2% and 6%. Sales of IFS are now expected to grow in the low single digits, down from mid-single digits previously, due largely to declines in sales of dust collection and industrial hydraulics systems.

Aerospace and Defense sales are projected to decline mid-single digits versus flat previously, due to the timing of certain programs. In Life Sciences, we are increasing our sales forecast as benefits from favorable currency translation are expected to complement already strong food and beverage and Disk Drive momentum. To that end, we project sales to increase between 5% and 9% versus a 1%-5% increase previously. We expect benefits from sales leverage and continued cost discipline to generate full-year pre-tax margin in the mid to high single digits, up from mid-single digits previously. Given our Q2 performance and our outlook for the balance of the year, we revised our operating margin guidance to a range between 16% and 16.4%, a decline of 30 basis points at the midpoint from our prior forecast.

Despite the temporary gross margin headwinds in Q2, the full year operating margin forecast still reflects a record level, and at the midpoint, an incremental margin approaching 35%. With that change, we now expect fiscal 2026 EPS between $3.93 and $4.01 per share. At the midpoint of $3.97, we are projecting EPS growth of 8% on 3% sales growth. Our earnings guidance contemplates a second-half step-up in sales, supported by our strong backlogs, as well as gross margin expansion resulting from the operating improvements I discussed earlier. Onto our balance sheet and cash flow outlook. Our capital expenditures are expected to be between $60 million and $75 million, with focused investments, including new products and technologies across all verticals.

We continue to project cash conversion in the range of 85%-95%, an improvement versus 2025 and consistent with historical averages. The balance sheet remains a strength of Donaldson's, with our net leverage ratio currently at 0.7 times. Adjusting for the Facet acquisition, Donaldson would have a net leverage ratio of approximately 1.7 times, still leaving us ample financial flexibility to thoughtfully invest for our future growth. As we think about shareholder value creation for the long term, our capital allocation priorities are unchanged. First, reinvest back into the company. We are the leader in technology-led filtration and intend on maintaining our position. R&D investments in strategically important, high growth, high margin areas where we have a clear path to win will drive our success. Our longer-term efforts are also supported by ongoing working capital investments and capital expenditures.

Our second capital deployment priority is disciplined M&A. We actively work through a pipeline of opportunities. Discipline is key to our approach. We are excited about our Facet acquisition and look forward to pursuing additional opportunities that meet our strategic and financial criteria. We are creating long-term value through our growth investments, but also through the return of cash to our shareholders. Our third capital allocation priority is dividends. Calendar year 2025 was our 70th year in a row of paying dividends and the 30th in a row of increasing our dividend. We have every intention of maintaining our status as a proud member of the S&P High Yield Dividend Aristocrats Index. Share repurchase is our fourth capital deployment priority, and it has always been the variable component.

Given the pending close on our acquisition of Facet, we do not expect to repurchase additional shares in the balance of this fiscal year. Year to date, we have repurchased 1.2%, which offsets dilution, our focus now is using the strength of our business to rapidly pay down debt. Looking beyond the quarter, the underlying fundamentals of our business are strong, we have the right priorities to deliver another year of profitable growth and value creation. I'll turn the call back to Tod.

Thanks, Brad. As I sit and reflect today, I am particularly pleased with Donaldson Company's continued evolution as a premier global provider of technology-led filtration solutions, and I'm excited for the opportunities that lie ahead. It has been a privilege to be part of this organization for the last 30 years and an honor to have led the company for the last 11. I'll not be far away as I take on the role of Executive Chairman. I am highly confident in our teams around the globe who make Donaldson what it is, and who I know will reach new heights under Rich's leadership. With that, I'll now turn the call back to the operator to open the line for questions.