No Need To Rush On Donaldson

When investors can find a company that earns a great return in a pervasive but low-key industry, they should hang on tight. That certainly would seem to apply to filtration company Donaldson (NYSE:DCI). Not only has Donaldson managed to produce double-digit returns on invested capital on a consistent basis, but the company has also managed to exploit leverage on the free cash flow line; generating a decade of double-digit compound growth off of single-digit sales growth.

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The Quarter That Was
Like a lot of industrial companies, Donaldson had a very solid summer quarter (the company's fiscal fourth quarter). Revenue jumped 22%, as the company's engine product segment grew even faster (up 35%). Profitably was likewise solid across the board - gross margin improved by more than a full point, and the company more than doubled its operating income from the year-ago level.

The Road Ahead
Although Donaldson did deliver a good performance, the company's initial guidance for the next fiscal year was a bit soft relative to analysts' prior expectations. To some extent, this does not really seem like a surprise. Military demand should ease up with the end of active operations in Iraq and the construction equipment industry (which is normally a significant percentage of Donaldson's business) is really not definitively back on its feet. On top of that, there has been a general pause in new gas-fired generation projects and the outlook for new industrial equipment (which would consume more aftermarket filters) is pretty mixed right now.

The good news, though, is that when the recovery comes (for good), Donaldson will be ready. The company has been aggressively cutting costs recently, emissions standards keep getting stricter and the company's aftermarket opportunity is not going away. On top of that, Donaldson has a high-quality and diverse customer base that includes companies ranging from Caterpillar (NYSE:CAT), to Deere (NYSE:DE), to Boeing (NYSE:BA) and IBM (NYSE:IBM). Moreover, it is difficult to look at the next few years ahead and not see solid demand in sectors like agriculture, mining, defense and aerospace - and if local, state and the federal government find the funds for infrastructure projects, that should be a boon for the construction sector as well. (For more, see Playing Rising Industrial Production.)

The Bottom Line
The biggest negative on Donaldson's stock is arguably the one that management has the least ability to control. At today's price, Donaldson does not look like any particular bargain. It is not overpriced per se, nor are rivals like Cummins (NYSE:CMI) or Pall (NYSE:PLL) noticeably any cheaper, but there just is not that margin of error discount that would seem especially necessary when thinking about buying an industrial stock amidst widespread fears of a double-dip recession.

With a fair value close to the current price, but a reasonable expectation that this company could deliver 10% free cash flow growth in the coming years while maintaining high returns on capital, this is definitely a stock to watch for any dips or pullbacks in the future.

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