Donaldson Q3 Conference Call

Donaldson DCI reported its third quarter earnings on Tuesday, May 19. Shares of the company traded down 7.89 percent, or $3.39, to $39.55. Below are some key takeaways from the company's conference call.

Bill Cook, Chief Executive Officer

• Our other businesses were up 6% in aggregate year-over-year despite the fact that the economic conditions in many of their end markets remained flat. For example, we had double-digit percentage revenue increases in our On-Road and Engine Aftermarket businesses.

• We also had an 8% increase in our Industrial Filtration business, with much of that driven by growth in the replacement filters. While the pace of this industrial recovery remains weak and uneven across many of our end markets and can be very frustrating, we are focused on those things that we can control to grow our business, expand our margins and deploy our capital in order to return superior value to our shareholders. We are very proud of how our company is operating.

• We delivered a 14.9% operating margin in the quarter and during the quarter returned a $120 million in value to our shareholders between our quarterly dividend and share buybacks. And our sights remained fixed on our long term objectives of building our company to first $3 billion in the sales and then $5 billion. Despite the temptation to cut expenses in the short term, we continue to make the strategic investments that will make us into a larger and even stronger company in the long run.

Tod Carpenter, Chief Operating Officer

• Our reported sales increased 1% from last year's third quarter. Foreign currency translation had a minimal impact at a consolidated level. However, that is a summary result of larger offsetting swings across the region. For example, our European business had a 5% benefit from translation while our Asian businesses had a 5% headwind from translation.

• As a reminder, you can find a detailed analysis of currency translation by business unit and region on the Investor Relations homepage of our website. The rest of this review we'll discuss local currency results. Within our Engine Products segment, our OEM sales increased 1%. Our On-Road OEM sales increased 13% with strong local currency growth in both Europe and Asia-Pacific.

• Our Off-Road OEM sales decreased 5% as the slowdown in new agricultural equipment began impacting sales in both Europe and the Americas while continued softer mining and construction equipment demand in our OEMs drove a sales decrease in Asia-Pacific.

• Based on our customers commentary, we believe the mining equipment market will remain soft until sometime next calendar year and that the agricultural equipment is in the beginning stages of a gradual weakening. We continue to see improving conditions in our Engine Aftermarket, where we supply replacement filters through both our OEM and independent distribution channel.

• Our Engine Aftermarket sales increased 11% in the quarter with strong sales in all of our major regions. We attribute this growth to the combination of improving equipment utilization in the field and our market growth initiatives. We are continuing to seeing a strong replacement filter sales growth in developed markets from our OE customers dealer organization and are benefiting from our increased Aftermarket penetration with independent dealers and distributors in emerging economies.

• Aftermarket is our earliest cycle end-market, and the improvements we have seen over the last few quarters provides evidence that diesel equipment in the field is being used at an increasing rate and that is generally what drives Aftermarket demand. This higher utilization will result in improving demand for new equipment.

• This is beginning to show up in the On-Road truck market and in the construction equipment market, although at different rates regionally. Finishing my review of our Engine Products business, our aerospace and defense sales decreased 12% as the slowdown in defense spending for ground based military equipment continued in this quarter.

• Sales in our Industrial Products segment decreased 6%. In our Industrial Filtration Solutions business, our sales increased 8% as solid levels of manufacturing activities drove record demand for replacement filters of our Torit dust collectors, and our compressed air systems. This aftermarket growth was enough to offset continued weak manufacturing capital spending levels in North America, which has reduced demand for our new industrial dust collectors.

• In our Special Applications business, our sales increased 4% on continued growth of our integrated venting products, an increase in disk drive filter sales and an upturn in our semicon, imaging product sales. Offsetting these increases was the anticipated decline in our Gas Turbine sales, which decreased 40% from last year's record third quarter.

• During last year's sudden OEM and industrial contractions, the downturn was softened by our late-cycle Gas Turbine business and by some of our emerging regions. Now, we're seeing incremental improvement in our early cycle replacement filter businesses across both our Engine and Industrial end markets. At the same time, we're seeing a variety of improving, stable and weakening conditions in our first-fit end markets. All of these combined to offset this quarter's decline in Gas Turbine system shipments and deliver a 1% sale increase.

Jim Shaw, Chief Financial Officer

• Our gross margin was 35.8%, which was the same as the gross margin that we reported in last year's third quarter. As we noted in our press release, there were pluses and minuses in the gross margin this quarter which offset each other. One of the drivers was the lower number of large Gas Turbine shipments in the quarter, which were a headwind to our gross margin in fiscal 2013.

• We also benefited from a higher percentage of replacement filter sales, which were 56% in the current quarter, compared to 51% last year. In many of our end markets, the utilization of the existing equipment in the field is good, and that helps our replacement filter sales, which carry a higher margin.

• Overall, product mix had a positive 40-basis point impact on gross margin. In addition, our ongoing Continuous Improvement initiatives benefited our gross margin by approximately 60 basis points, compared to last year. Offsetting these benefits was the 70-basis point impact on margin from higher compensation and indirect costs as we've made investments in engineering and management in our operations. We've also had a higher incentive compensation costs compared to last year.

• Our operating expenses increased by $8 million compared to last year's third quarter. As a percentage of sales, operating expenses increased 110 basis points. Higher incentive compensation expense, incremental expenses related to our Global ERP project, and increased travel and entertainment expenses impacted operating expenses by 150 basis points.

• Our effective tax rate was 28.5% in the quarter versus 29.8% last year. The decrease compared to the prior year was primarily due to changes in the mix of earnings between tax jurisdictions. Based on our projected global mix of earnings in fiscal 2014, we now forecast our full year tax rate to be between 28% and 29%. Our third quarter CapEx was $23 million.

• Looking at our forecast for the balance of fiscal 2014, we continue to expect to spend approximately $90 million on CapEx over the full year. The breakdown of the $90 million spend is projected to be approximately 20% related to capacity expansion, 30% for our technology initiatives, which includes our Global ERP project and our R&D lab expansion project. Another 30% is for tooling for new products and 20% will be related to cost reduction activities through our continuous improvement initiatives.

• We repurchased 2.4 million shares in the third quarter for a $100 million. Year-to-date, we've purchased 4 million shares or 2.7% of our diluted outstanding shares for $166 million. Our share repurchase target remains at 4% of our diluted outstanding shares in fiscal 2014. We expect interest expense in fiscal 2014 to be between $9 million and $10 million and our balance sheet remains very strong at $391 million of cash and short-term investments, which is almost entirely held outside of the United States.

• For our total company, we're now expecting a slight increase in sales for the full year with sales of between $2.44 billion and $2.48 billion. Based on our nine month performance and forecast for the fourth quarter, the midpoint of our guidance range is a 20 basis point improvement in our operating margin over fiscal year 2013. We also adjusted our full year tax rate guidance slightly lower due to a larger than anticipated second quarter benefit and a more favorable mix of earnings in our third quarter. The net of all these factors is that our updated EPS range is now $1.69 to $1.77, the midpoint of which would represent a 5% increase over last year.