DONALDSON Co INC Q3 2026 earnings call

Good morning. Thank you for joining Donaldson's third quarter fiscal 2026 earnings conference call. With me today are Rich Lewis, President and CEO, and Brad Pogalz, Chief Financial Officer. This morning, we will provide a summary of our third quarter performance and our outlook for fiscal 2026. During today's call, we will discuss non-GAAP or adjusted results. For third quarter 2026, non-GAAP results exclude pre-tax charges of $9.8 million, including $9 million of restructuring and other, and $800,000 of business development charges. This compares to prior year pre-tax charges of $65.8 million, including $4.2 million of restructuring and other, $800,000 of business development charges, $62 million for the impairment of intangible assets, and a $1.2 million gain on the sale of fixed assets.

A reconciliation of GAAP to non-GAAP metrics is provided within the schedules attached to this morning's press release. Before I turn it over to Rich, a quick note on our recently completed acquisition of Facet Filtration. Facet performance will be included in our consolidated fourth quarter earnings results reported in the Aerospace and Defense business unit within Industrial Solutions. With that, 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. I will now turn the call over to Rich.

Thanks, Sarika, and good morning, everyone. Third quarter was a strong quarter for Donaldson Company and, as expected, marked a significant step-up in performance from our second quarter results. I am proud of our team, whose hard work resulted in the company's strongest quarter to date with respect to sales, adjusted operating margin, and adjusted EPS. We successfully navigated macro uncertainty, including uneven cyclical dynamics and the ongoing conflict in the Middle East. To that end, I specifically want to thank our team in Abu Dhabi, whose dedication and resolve have been on display over the last several months. Our leaders have ensured employees feel as safe as possible and that our local operations continue.

Globally this quarter, we continue to serve our customers through our expanded product portfolio and high on-time delivery rates, including in the higher margin Mobile Solutions aftermarket business, food and beverage, and our disk drive business. We made further progress on optimizing our cost structure as we close the last two plants identified within our footprint optimization initiative. We are now focused on ramping up production in the receiving sites, which puts us on the path to delivering incremental efficiencies in the future. Lastly, subsequent to quarter end, we closed our acquisition of Facet Filtration, adding high performance fuel and fluid capabilities to our expanding Industrial Solutions product portfolio.

Facet increases our exposure to durable growing end markets, including aerospace and power generation, and strengthens our aftermarket position with approximately 70% of revenues driven by recurring, regulated replacement part sales with highly accretive margins. We welcome the Facet team to the Donaldson and integration efforts are underway. As demonstrated this quarter, Donaldson is committed to delivering for all 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 multiple end 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 continue to win. I will cover some third quarter highlights. Brad will discuss the quarterly financials and full year guidance in more detail. I will return for some closing remarks. At a high level, sales were a record $995 million, 6% above prior year, driven by currency translation, net pricing benefits, and volume growth. Operating margin was 16.6%, up 30 basis points over prior year, and an increase of 260 basis points from second quarter. Expense leverage on higher sales was partially offset by gross margin pressure from production shifts to support customer-specific requirements in power generation within Industrial Solutions. Adjusted earnings per share were $1.06, 7% above 2025. I'll cover some highlights by segment. In Mobile Solutions, sales were $630 million, up 8% inclusive of strong volume growth.

Aftermarket sales were $498 million, up 8% with growth in all regions and in both channels. We grew double digits in our independent channel, where our product availability, reliability, and consistency continue to drive share gains. This quarter, we had a large competitive win with a major North America fleet operator, supplying a mix of air, lube, and fuel products. These types of programs allow us to strengthen our future dealer relationships and create meaningful future pull-through opportunities for incremental sales. On the first fit side, off-road sales were $104 million, an increase of 9% versus prior year, led by strength in construction. On-road sales of $28 million increased 5% as truck production began to ramp, particularly in EMEA. Touching on China within Mobile Solutions, sales were up 6% due to strength in off-road. Performance in China has been encouraging.

The growing export market is supporting demand for our technology-led solutions. In Industrial Solutions, sales were $282 million, down 1%, driven by volume declines, partially offset by net pricing and currency benefits. IFS sales of $237 million grew 2% from net pricing and power generation volume growth, primarily in EMEA, where sales of new equipment more than doubled as we continue to benefit from the super cycle. Partially offsetting this favorability were volume declines in new equipment sales for industrial gases and dust collection. Importantly, we are encouraged by the positive macro indicators we are seeing for our CapEx-based businesses, including strengthening industrial production and capital expenditures in certain regions, including North America and APAC. This more supportive backdrop, combined with our new product introductions, gives us confidence in our ability to win in these markets.

Last month, we launched our Stratos Mist Collector as part of our dust collection product portfolio. With modern machining operations, elevated levels of smaller mist particles and contaminants need to be captured. We are solving this customer problem through Stratos's reliable, continuous duty filtration, which comes in a space-efficient footprint and supports multiple industries. Early indications are positive, including strong customer interest and quoting activity. Switching over to Aerospace and Defense, sales were $45 million, down 14% versus 2025 due to weaker new equipment sales. Volumes were pressured by ongoing supply chain constraints and project timing. In Life Sciences, sales of $84 million increased 13%, largely as a result of robust new equipment volume in food and beverage and ongoing strength in disk drive.

Momentum continues in our food and beverage business, where sales grew over 30%, supported by new equipment sales and with a growing installed base driving consumables demand. We are excited about the customer and channel partner reception to our new technology-led offerings and continue to build out our portfolio. In March, we expanded our LifeTec product line by introducing our most advanced high-loading performance filter, largely for use in bottled water filtration applications. This product is built with Donaldson membrane manufactured in our own material research center and is designed to improve efficiency and filter life, driving lower total cost of ownership and value to our customers. In summary, I am pleased with our third quarter results. We exited the quarter with robust order volumes, elevated backlogs, and focused execution.

Giving us confidence in delivering on our record organic guidance ranges, inclusive of record sales of over $3.8 billion or a 4% increase over prior year, driven by growth in several key high-margin businesses, operating margin expansion versus 2025, earnings per share roughly 8% above prior year, and free cash flow conversion of approximately 90%, important as we remain committed to returning value to our shareholders. 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. The topic we had been discussing with many of you since our last report was our plan to drive a strong sequential improvement in operating margin. We're pleased to say on that point, we delivered. While the operational work is not yet done in our Industrial Solutions segment, our Mobile Solutions and Life Sciences segments performed very well, all complemented by sharp prioritization of initiatives across the company. I want to thank my global colleagues for their diligence and commitment as we propelled the company to new records for sales, operating margin, and EPS. As I detail third quarter results, note that my profit comments exclude the impact from the non-recurring charges Sarika referenced earlier. Total sales increased 6%, and adjusted EPS of $1.06 grew 7% over the prior year.

Third quarter operating margin of 16.6% was up 30 basis points from the prior year and at an all-time high. Versus second quarter, operating margin increased 260 basis points due to both gross margin improvement and expense leverage. Breaking down the components of the year-over-year operating margin expansion, expense leverage remains a consistent strength at Donaldson Company. Third quarter operating expense as a rate of sales was 17.8%, an improvement of 40 basis points from the prior year, showcasing the structural expense discipline that affords us the latitude to make investment choices while driving margin expansion. Third quarter gross margin was 34.4%, down 10 basis points from 2025, as benefits from pricing, volume, and mix were more than offset by about 100 basis points of headwinds from short-term operating inefficiencies in our industrial segment.

More specifically, we realized about 80 basis points of pressure from the production shifts to Mexico for large turbine systems in our power generation business. We're seeing improved delivery performance and operational alignment. We view third quarter as the low point and expect to be fully recovered midway through fiscal 2027. Footprint optimization initiatives added a little under 20 basis points of pressure due to costs associated with plant closures and transfers of production. These initiatives were designed to improve our cost structure, and the last two plant closures were completed during the quarter. The work is now transitioned to ramping up productivity in the new locations. We expect these industrial-based initiatives to generate annualized benefits of about $10 million once we hit run rate productivity during fiscal 2027.

I want to take a moment to recognize the teams that have been working on these projects. It has been an incredible effort, and we're in the final stages due entirely to their commitment, collaboration, and resilience. The work being done strengthens Donaldson's foundation for long-term success. I want to especially thank everyone involved in this massive undertaking. In terms of profitability by segment, the gross margin impacts from power generation and footprint optimization drove pressure on the pre-tax margin in our industrial segment, which was 13.4% in the quarter versus 18.1% in the prior year. The margin was lower than we anticipated but did step up from the second quarter. We expect that trend to continue in the fourth quarter, driven by higher sales and improved operational performance.

In our other two segments, we were pleased with the profit performance. Mobile Solutions margin was an all-time high of 20.2%, 210 basis points above prior year, primarily due to volume leverage and favorable mix related to aftermarket sales strength. Life Sciences pre-tax margin was 8.1%, up 30 basis points from the prior year. Importantly, last year's profitability benefited from an earn-out reversal from the Purilogics business. Excluding this prior year one-time benefit, pre-tax margin would have increased more than eight percentage points. Volume leverage and favorable mix from our higher margin food and beverage and disk drive businesses, combined with a focused expense structure, drove the improvement. As of the end of the quarter, the company remains in a strong position, with robust orders, record backlog, and notable progress made on the footprint projects.

All of that factored into our revised outlook for fiscal 2026, which contemplates another sequential step-up in sales and margin, and we will also have Facet included in our results for the first time. Given the newness of Facet, I want to break out our guidance in terms of organic performance and then lay out the impact Facet will have on some key measures. With that, our consolidated organic sales are expected to grow between 3% and 5%, with the midpoint being about 1% higher than prior guidance due to sales strength in our Mobile Solutions and Life Sciences segments. Additionally, pricing and currency translation are each expected to contribute a little more than 1% to growth.

In Mobile Solutions, sales are expected to grow between 3.5% and 5.5%, slightly above our prior guidance, driven by an improved but still mid-single-digit increase outlook in aftermarket sales as a result of share gains and higher vehicle utilization rates. In our first-fit businesses, off-road sales are projected to grow mid-single digits from improvements in select end markets. On-road sales are expected to decrease low double digits versus flat previously as global truck production remains tempered. In Industrial Solutions, organic sales are forecast to be between flat and up 2%, with the midpoint of this range consistent with the prior guide. IFS sales are expected to grow in the low single digits, driven by robust volume growth in power generation and favorable currency and pricing in dust collection.

Aerospace and Defense sales are projected to decline mid-single digits due to the timing of certain programs as we continue to navigate supply chain issues. In Life Sciences, we project sales to increase between 9% and 11%, up from 5%-9% previously, reflecting continued volume strength in food and beverage and disk drive. With our focused expense structure, we expect full-year pre-tax margin in the mid to high single digits. Driven by our year-to-date performance and reflective of another margin step-up in the fourth quarter, our organic operating margin guidance is now forecast between 15.8% and 16.2%, versus 16%-16.4% previously. The current range implies full-year organic operating margin expansion between 10 and 50 basis points, with expense leverage being partially offset by gross margin pressure.

It's worth reiterating that our fiscal 2026 margin performance will be at a record level despite dealing with temporary operational inefficiencies, which we advanced meaningfully in the quarter and have a clear path to eliminating. With the strength of our underlying business, I am confident we will get past these headwinds and generate more meaningful margin expansion in future periods. I'll give a few points on Facet's impact to what I just laid out. We expect fourth quarter sales between $25 million-$30 million, adding around 70-80 basis points to the full year growth rate. The impact on operating margin is likely immaterial this year, as robust business performance is offset by amortization costs. Debt incurred from the transaction will add about $9 million of interest expense in the quarter, with the net dilution to EPS of about $0.03.

Excluding Facet, adjusted EPS is projected between $3.94 and $4.01 per share, with the midpoint reflecting an 8% increase from the prior year, about double the rate of our sales growth. 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 segments. Rich highlighted several new product introductions earlier. We intend to continue leading in the area. We project cash conversion in the range of 85%-95%, an improvement versus 2025 and consistent with historical averages. Our balance sheet remains a strength. Including Facet, our leverage ratio is approximately 1.8 times net debt to EBITDA, still leaving us ample financial flexibility to thoughtfully invest for future growth.

Integral to the Donaldson story is our capital allocation strategy, how we build for our future and simultaneously return value today. Our priorities in that regard are unchanged. First, reinvest back into the company. We're committed to maintaining our position as the leader in technology-led filtration. We do this through our R&D investments in strategically important, high growth, high margin areas where we have a clear path to win. We're proud to have a portfolio of patent protected products and have nearly 3,000 active U.S. and international patents, with over 120 patents awarded in calendar year 2025. In addition to R&D, we think critically about our investments in working capital and capital expenditure, investing for efficiency today and growth for tomorrow by ensuring we meet our customers' needs. Our second capital deployment priority is disciplined M&A.

We will continue to pursue opportunities that strengthen our portfolio and meet our strategic and financial criteria, with Facet being an excellent example. The financial strength of Donaldson is evidenced by our ability to invest for profitable growth and still return cash to shareholders. Our third capital allocation priority is dividends. As of the end of calendar 2025, we have paid dividends for 70 years in a row. We've also increased our dividend for 30 years in a row and recently announced an additional 7% dividend increase. We're committed to remaining as a proud member of the S&P High Yield Dividend Aristocrats Index. Share purchase is our fourth capital deployment priority. Share purchase is our variable lever, and as we indicated last quarter, we have paused our repurchasing activity to focus on paying down our Facet-related debt.

Thanks, Brad. While I've been a Donaldson employee for over two decades, my first 90 days as CEO have been remarkable. I've had the chance to meet with countless employees, customers, and investors around the globe, and I am increasingly proud of the work we have collectively done to fulfill our mission of advancing filtration for a cleaner world. Our deep technical expertise, strong culture, track record, and financial position have allowed us to operate from a position of strength, and I take great pride and responsibility in building upon that success. For more than a decade, our strategic investments have driven the growth and diversification of our high-performing company, and there is ample opportunity for us to further enhance our performance.

We are continuing to invest in attractive markets where we have a clear path to win, while also critically evaluating our existing portfolio of businesses, ensuring each business has earned a place in our portfolio. With this rigor, our foundation becomes stronger, positioning us to deliver value for all of our stakeholders. I am excited about the journey that lies ahead and humbled by the opportunity to lead such a talented organization through this next phase of our evolution. I look forward to reporting on our progress. With that, I now turn the call back to the operator to open the line for questions.