Donaldson Company Inc (DCI) 2002 Q3 法說會逐字稿

Good morning ladies and gentlemen.

Thank you for standing by.

Welcome to the Donaldson third quarter earnings conference call.

At this time all participants are in a listen-only mode.

Following the formal presentation instructions will be given for the Q&A session.

If anyone needs assistance at any time during the conference please press the star followed by the zero for an operator.

As a reminder this conference is being recorded Wednesday, May 29th, 2002. I would like to turn the conference over to Mr. Bill Cook.

Please go ahead.

Thanks.

Good morning and again, welcome to our third quarter conference call.

I'm Bill Cook, Senior Vice President and Chief Financial Officer.

Joining me today are Bill Van Dyke, our Chairman, CEO, and President, Rich Sheffer, Assistant Treasurer and Director of Investor Relations, and Dave Westbrook, Director of Financial Reporting.

Before we get started, I need to caution you that statements in this call regarding Donaldson's business that are not historical facts are forward-looking statements and that future results could differ materially from the forward-looking statements made today.

Actual results may be affected by many important factors including risks and uncertainties identified in today's press release and in our SEC filings.

We really appreciate the opportunity to talk with so many of you about the business and financial matters important to all of us at Donaldson.

Our earnings release was sent out yesterday and is quite detailed.

I will start out by summarizing the financial highlights of the release.

Bill Van Dyke will then comment on the business conditions we are facing and expect to see in the near term.

At yesterday's market close Donaldson company reported record third quarter diluted net earnings per share of 47 cents versus 39 cents last year.

An increase of over 20 percent.

Record net earnings of $22 million were up an equal 20 percent from $18 million last year.

Third quarter revenue was flat at $269 million.

The nine-month period Donaldson reported record diluted net earnings per share of $1.35 versus $1.16 last year.

An increase of over 16 percent.

Record net earnings of $62 million were up 17.5 percent from $53 million last year.

Nine-month revenue was $822 million down two percent from $839 last year.

Foreign currency translation reduced our third quarter revenue by about two percent and nine-month revenues by about one percent.

Now I'd like to introduce Bill Van Dyke, our President, Chairman and CEO.

Bill.

Thanks, Bill.

We have to be very pleased with the company's performance through our third quarter, especially given the economic conditions in our industrial markets.

We again produced record earnings by continuing to focus on the things that we control, that is by managing our costs and our balance sheet.

Year-to-date, except for sales we continue to show improvements on every line of our --

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Please continue, gentlemen.

So what will be different next quarter?

Next quarter, we think we will hold our phone connection through the whole conference.

Many of the details will change and we'll cover those in a moment.

Still, we see some segments of our filtration portfolio providing enough upside to counter balance the coming turbine downturn.

The overall expectation will not change, consistent, superior, financial results.

Now, let's look at some of the details.

We expect one or two more strong quarters from our gas turbine business.

Our back logs tell us sales will begin to soften late in the first quarter of our next fiscal year.

All of the gas turbine manufacturers have seen incoming orders drop for North American shipments late this year and next year.

Public comments by these turbine manufacturers suggest North American sales decreases of 20 to 50 percent in calendar '03, which spans a couple of our fiscal years.

Historically gas turbine is a highly cyclical business, though on a cycle that's divorced from anything else we do.

When the current North American market upswing began in 1999, it was characterized as a demand bubble, not a permanent demand shift.

We knew then that the market would eventually see a correction and we have remained disciplined in our manufacturing investments.

We kept a healthy share of manufacturing and subcontractors, and the capacity we brought on line during the boom will be strategically desirable post bubble.

We expect to soften the impact of the North American downturn with increased

market share in Europe, where demand is not expected to decline as in the U.S.

We are also building our share of the replacement filter market for turbines as plants built during the early part of the current bubble are starting to come due for their first filter replacements.

Finally, we are developing the next generation of turbine air intake systems, a new and dramatically different product solution which will allow us to further differentiate ourselves from the competition.

We'll talk more about this at a later date.

On another front, the North American heavy truck market appears to be in the midst of a pre-by, ahead of the new EPA diesel emission regulations set for October of this year.

First quarter incoming orders at truck manufacturers were up about 70 percent over prior year, at about 65,000 units.

However, only a small portion of those orders have delivery dates beyond October.

So far the majority of truck manufacturers have committed to spreading this volume over the next six to seven months.

Indicating an intent to manage the cost structures during the pre-buy.

This is good news for Donaldson.

We see a solid up-tick in our truck sales through the fall season, but still maintain our operating efficiencies while fully meeting our customers' needs.

The U.S. dust collection market appears to finally be turning after a two-year-long decline.

The steepest we have seen in 20 years.

Our orders bottomed out early this quarter and have improved the last two months.

Though our backlog remains below a year ago, we are expecting fourth quarter to be sequentially better than third quarter, but not better than fourth quarter a year ago.

This provides some positive momentum going into fiscal 2003.

The cautious rate of increase in manufacturing capital spending generally suggests a slow recovery for this business.

Most of our disc drive filter customers, the hard disc manufacturers, are positive in their business outlook for the second half of this calendar year.

Strong PC sales in the seconds half of 1999, prior to Y2K, have the industry anticipating a PC refresh cycle three years later.

Companies that lease their PC's will need to upgrade this year if their current PC's were released in 1999.

As noted in the earnings release there was no third quarter EPS impact from current

spending on plant rationalization.

We had previously stated that this year's spending on plant rationalization would be lower than last years.

However we view plant rationalization as an ongoing process.

We expect to continue to work to improve our long-term manufacturing base.

The previously announced closing of our old Saybrook Connecticut plant has been completed.

We've also completed the move of our dust collection production [INAUDIBLE]

in China, into our [INAUDIBLE] China complex.

While third quarter spending to complete these efforts was minimal, we will continue the pay as you go practice of absorbing these costs into current operating earnings.

Last quarter we reported our new plant in Monterey, Mexico and our new state-of-the-art clean room in [INAUDIBLE] China had been completed, and we were shipping product

from these locations.

This quarter we added a new membrain plant near Philadelphia.

We have now completed the move into this plant and are shipping product.

Finally, work continues on our new plant in the CzechRepublic.

We anticipate production in calendar year 2003.

As we have discussed over the past several quarters, operating expense management remains a priority.

We have continued to let attrition reduce our salary-to-head count which is now down about five percent from last year.

Hourly head count is flat with last April despite the new facilities opened this year.

All discreniary expenditures remain under tight control as evidenced by roughly a 50 percent reduction in North American air travel so far this year.

Our operating cash flow remains strong this quarter at almost $32 million.

So far this year, we have been using the cash to reduce our debt, paying down $44 million in debt since last April.

We expect to continue delivering strong operating cash flows going forward.

The strong cash flow, combined with low debt and high borrowing capacity, provide us sufficient liquidity to invest in the continued growth of our business.

In summary, we know the gas turbine boom will likely recede later this year.

And that will create a new set of challenges for us.

But, for perspective, two years ago our heavy truck sales dropped by $50 million and Donaldson posted a 10 percent earnings increase.

This year we are looking at another $50 million revenue drop in dust collection.

Yet earnings are on track for our 13th consecutive double digit rise.

Donaldson's people have repeatedly shown themselves to be pretty adept at solving problems.

So while we are further sobered, we are not intimidated by the prospect of yet another $50 million sales drop next year, in time in gas turbine.

Every time we see a setback, new strengths emerge from this diversified portfolio of filtration businesses we have built over the last 15 years.

As noted in the press release we are expecting a lift from trucks, dust collection and disc drive.

With that we need a low single digit revenue rise from the rest of the portfolio to fill the gas turbine drof-off.

So we look forward to next year as we have the last two, focused on managing the entire business, not just the revenue line, and intent on producing consistent, superior, earnings growth.

That concludes our prepared comments.

Operator, we can now open the call up for questions.

Thank you, sir.

Ladies and gentlemen, at this time we will begin the Q&A session.

If you have a question, please press the star followed by the one on your push button phone.

If you could like to cancel your request for a question press the star followed by a two.

You will hear a three-tone prompt following your question.

If you are using speaker equipment, please lift your hand set before pressing the numbers.

First question comes from William Jenco.

Good morning.

Merrill lynch.

My question revolves around the sustainability of the 31.5 percent gross margin that you achieved in the most recent quarter.

Was there any benefit from mix that may go away, perhaps when dust collection recovers?

Or is this a new level we should be focusing on?

Actually, if dust -- when dust collection recovers, it will actually raise the gross margin.

Our gross margin on that particular line is above the company average.

Mix is not a factor in that number.

It is the result of the work that we have been talking about for the last year or year and a half focused on just making our operations run better.

Okay.

and just, could you talk a little bit about the turbine business in terms of currently what portion of your business is outside the United States, what portion of your business is spare parts, and what your most recent experience has been on spare parts demand?

Yeah.

Roughly, I think where you are headed is what portion of the business is going to be affected by this contraction in North America?

Right.

I think about 70 percent of the total revenue.

The non U.S. Piece is 20 to 25 percent.

Of the remaining chunk you have 10 percent in parts.

So you are down to something in the neighborhood of 70 percent of the total revenue.

And then, we think the first quarter of next year will look a lot like the first quarter this year in terms of total revenue.

The backlog continues to show very strong through the first quarter.

So we are really looking at the contraction starting to bite toward the end of the first quarter.

Then it's a question of how fast and how deep.

So our model, if that's where you are going, if I can presume that's what you are trying to get to, our model is we are looking for about a 25 percent reduction in our gas turbine sales next year.

Maybe five percent of the company's revenue in gas turbine.

Okay.

That's what I was heading.

Thank you very much.

Thank you.

The next question comes from David Seeno.

Please state your company name followed by your question.

Good morning.

Gabilly and company.

Just a couple of questions.

Is there anything in the heavy-duty truck business, either the aftermarket business or production schedules going out into next month or the following month that would indicate there's any underlying pick up in demand for tractors?

I'm assuming there are a finite number of production slots through October and at some point don't you have to say well, you know, that underlying demand is picking up and some of these orders are for beyond October 1?

David, Bill Cook here.

On the heavy-duty truck, what you are -- what we are seeing there will be some pre-buy in advance of the emission regulations.

Our customers are trying not to -- are trying to spread that out.

They are not accepting -- they are spreading the orders out through October and November.

So that -- which is good news for us.

So it doesn't come through in one big lump.

So what we will see quarter-by-quarter sort of jumps around in heavy-duty truck, in our production, but not major ones.

And on a year-over-year basis we are looking for a gradual rise in '03 in heavy truck demand.

Okay.

So if there's another strong book of orders in June, then perhaps we can presume that this is more than pre-buying then?

I think right now we are looking at having a good fourth quarter and a good first quarter of next year.

And then probably some adjustment after that due to the pre-buy, the second quarter of next year.

But just on a -- if you take a look at it on an annual basis, year-over-year, right now we are looking at probably smoothing out for the pre-buy, probably a single digit increase in heavy truck demand year-over-year.

Okay.

And, just getting back to the gross margin.

Could you talk generally about pricing in the quarter?

Pricing?

Um -- you know, we are under intense pricing pressure from all of our major customers in a way that we mitigate that or jofr set that is through the cost reduction margin improvement efforts.

Bill Van Dyke mentioned before we have been very successful at offsetting that.

That's really the focus of our efforts is trying to provide the value to our customers and respond to the price decrease requests and protect our margins.

So far, we have been able to do that.

Okay.

And then the last thing, I'm just trying to reconcile the industrial products total backlog was down nine percent but the 90-day backlog was up 18 percent from the prior quarter.

Is that just timing the total backlog has the gas turbine piece in there?

It's mostly a function of the gas turbine.

And what Bill's comments earlier, we are looking at a very good, you know, good fourth quarter and good first quarter of next year.

Beyond that, it's dropping off with what's happening in the industry overall.

So the 90 and 180-day, the backlog looks very solid.

It drops off after that.

Okay.

Thank you very much.

Thanks.

Thank you.

The next question comes from Keith Hughes.

Please state your cop name followed by your committee.

Keith Hughes from Suntrust Robinson Humphrey.

Switching to the dust collection business.

The sequential improvement or sequential movement in orders, what particular end markets have you seen stronger than others in the past couple months?

The - generally, Keith we have seen some signs of life in many of the end markets.

We are not ready to declare victory on that yet.

The machine tool consumption which is one of the measures we try and track our dust collection is still way down year-over-year.

But we have seen in march it was up six percent from February.

So we are seeing some glimmers.

But it's hard to draw any firm conclusions yet in terms of what's happening in the various end markets.

Okay.

Thank you.

Thank you.

The next question comes from Richard Ethan.

Please state your company name followed by your question.

Robert W. Baird

Just a follow-up in the gas turbine side of the business.

How do you manage the outsourced piece of that business?

So when you anticipate that your revenue and gas turbine will be down 25 percent year-over-year, is that taking into account the outsourced piece of that business?

I'm not sure I understand your question, Rick.

Let's make the assumption that the industry is off 50 percent next year.

Right.

You outsource half of your production.

Right.

We end off 25 percent is that a fairly pessimistic assumption?

Um -- we are trying-shall-it's out there in the fog and everybody is trying to guess exactly what's going to happen.

If we -- we think that that's a conservative, but reasonable, we are trying to be realistic about it and prepare ourselves for whatever comes at us.

I don't think we are overstating the problem at this point, as we understand it, based on the information our customers are giving us by suggesting that turbine volume for us will drop-off 25 percent.

It's a ballpark kind of number.

We are trying to guess what's going to happen seven months out in the future.

When you sayin' to the fourth quarter, does that business stay, you know, flat-ish at the 53 million level, or does it pick up quarter-to-quarter as well?

The fourth quarter of this fiscal year?

Yes.

We are looking at a pretty good quarter in both the fourth and -- first and fourth quarters sort of comparable with the way we have been running.

There would be a seasonal improvement if nothing else over the fourth quarter?

If you expect fourth quarter gas turbine to look similar to fourth quarter last year, I think you would be pretty close.

Pretty close.

Okay.

Let me just ask you a question, Bill.

As we push into, you know, late fiscal '02, again playing around with the top line, we obviously have a decline on the horizon in gas turbine.

We potentially, you know, have an air pocket in the transportation business in Q3 or so.

Looking at the sales growth that you are anticipating for next year in the low single digits, at what point do we, you know, take, again, another hard look at our cost structure and try to build in some additional earnings there?

We aren't anywhere close to done working on our cost structure.

We are partway through a multi-year set of tasks we expect to continue to deliver for us out into next year.

Okay.

So you would anticipate, if we show a double digit, you know the goal is double digit earnings per share growth that half or two-thirds of that will, again, probably have to come out of the cost structure?

That's the way it looks at this point.

Yeah.

Okay.

Thank you.

Thank you.

The next question comes from Alan Metrany.

Please state your company name followed by your question.

Hi, Copper Beach Capital.

You talk about a double digit year-over-year growth.

Now that you are the fourth quarter it sounds like you have about six months of visibility right here.

Can you talk about whether you are more comfortable with the low end of the range or the high end of the range given that cost controls seem to be the necessity gating factor.

On the EPS growth?

Yes.

We shoot for a minimum of a double digit.

That's all we really talk about.

And we are -- as Bill mentioned earlier, we are off to a very good start with the first 9 months of the year.

And we are continuing to work the plans we have in place to deliver it for the fourth quarter.

Okay.

Can you also talk about what, from here on in uses of cash.

I know you have been decent buyers of your stock and dividends are there, you have been consistent payers and debt pay down has been a priority.

Can you talk about acquisitions to be able to bolster the top line from here on in, or acquisitions in your plans?

We are always looking at acquisition opportunities.

We never comment on them perspectively in terms of what we are doing.

We look.

We are looking for things that would fit into the portfolio of businesses we have and add to them.

Okay.

That would be a possible use of cash if we found the right one.

Okay.

Lastly, in terms of it, which are your end markets outside of the truck markets -- outside of the truck market for obvious reasons is really strong or can you foresee being very strong going out 12, 24 months?

Where do you think the driver will come from over the next couple years for Donaldson's growth?

The presumption is that a recovery in the North American industrial economy is going to give us a very strong boost in the dust collection business.

We have just seen that as virtually everybody who is selling capital equipment into that section the mid sector of industry has seen very severe contraction in volume.

We expect that to come back.

So we'll get a boost out of that.

The truck business has got, we think, a pretty substantial upside from where it is going forward without having to flirt with the kind of levels it was at a couple years ago.

Just a couple of things that are out there.

Some of the other segments like our engine aftermarket which has been flat with general increase in the health of the economy will also improve.

A lot of this is tied to the general recovery in North America.

I think your question gets to the heart of what the Donaldson story is, and that is, it's not about home runs.

It's not that there's going to be some silver bullet that gets us the revenue increase.

I think it will be $10 million here and $10 million there.

Okay.

Thank you very much.

Thank you.

The next question comes from Eli Lustgarden.

Good morning.

Good morning.

Can you give me an idea what percentage of your gas turbine business goes to GE directly?

Probably about 60 percent.

Okay so -- secondly, can we talk or go back to the truck marked a little bit.

You talked about some of your customers trying to stretch out passed October 1.

Virtually all the truck manufacturers have told us the bulk of the backlog ends October 1.

I was under the impression EPA rules forbid shipments of noncompliant trucks after October 1.

The pre-buy must be a pre-buy and there can't be -- is there any bending of the rule or are they hoping to ship some new engine trucks afterwards?

Our understanding has been what you have just said.

Recently we have been told that the regulation really applies to the building of engines.

And any engine that is completed before October 1 can be inserted in a truck.

That will give them the opportunity to push some production out into the latter part of the fall.

Okay.

Can you talk a little bit about -- one of the things in the truck market is the used truck market.

But that would be a good aftermarket for Donaldson if you began some ship, refurbish some of the trucks.

Have you seen any change in the aftermarket business whatsoever as far as, particularly for the truck sector.

There's been a big movement in used trucks at this point, and whether that's benefitting the company at all?

We can't distinguish anything there.

The aftermarket generally has been kind of soft for all of this fiscal year.

I'm seeing that.

Finally can you talk a little bit, are you seeing any changes in demand for either construction or farm equipment?

I think the nonresidential construction is continuing to be pretty flat.

The residence piece of construction is still strong.

On the agriculture side with the commodity prices as low as they are, that's been flat as well.

So on the agriculture side that will be lifted whenever there's a rebound in commodity prices.

Thank you.

Thanks.

Thank you.

The next question comes from Greg McCosco.

Please state your company name followed by your question.

Good morning.

Lord abbott.

Could you talk a little bit about the demand from sort of OE versus aftermarket.

I realize you, perhaps, don't have a sense of where those filters are going in the heavy-duty market.

Heavy-duty truck I'm talking about now.

Just to get a sense of what the potential fall-off could be after the shipments of the trucks in October or in the fall.

On the -- I guess to your question, Greg, about the fall-off.

We are anticipating that, like near the end of this calendar year, once the manufacturers get passed regulations, there will be a decrease in their build schedules.

We are sort of anticipating that.

Beyond that, we see that a -- we see a gradual recovery in the truck build rates sort of on an ongoing or sustaining basis.

So we are, you know, we are planning for or anticipating some drop-off.

Actually, as we mentioned earlier, the fact that the truck manufacturers are trying to sort of spread out the demand actually works to our purposes as well.

This pre-buy demand.

They don't want to hire a lot of people, or pay a lot of overtime and then have to lay everybody off anymore than the rest of us do.

But, I mean, given Eli's question about the aftermarket and sort of stretching out of older trucks, et cetera, my sense is, perhaps, that the -- are the installations on new trucks, you know, the filters that you are selling for new trucks, perhaps it's not that much of a demand and there may be some positive upside from the standpoint of the demand on the aftermarket?

I think on the aftermarket what that's mostly related to is ton miles and truck utilization.

As the economy in North America, we are talking about North America starts to come back, the aftermarket -- the onroad part of the aftermarket will pick up.

Our feeling is it's less related -- there will be less of an impact on the pre-buy than trucks start moving generally more and utilization improves.

Then with regard to dust collection, you mentioned that it's improving.

Is there anything particular behind that that is driving that?

I guess the sequential improvements you are seeing?

What we are seeing, we talked about this in the last call, we are starting to see where a lot of the equipment that was installed in factories, dust collection equipment on production lines where the lines have been running maybe, not full-time or actually moth balled are starting to come back into use.

Our aftermarket business has picked up over the last quarter.

So those are customers that are know bringing equipment back on line and doing the maintenance and replacing parts.

That's one part of the change we have seen.

Then over the last quarter we have seen the backlog.

Our order backlog in dust correction and in North America improved both on a monthly and a quarterly basis.

Those are the signs we can point to to say that maybe now the recovery is actually happening.

That would be driven by basic industrial demand?

Yes.

Right.

Thank you.

Thank you.

Ladies and gentlemen, if there are any additional questions, please press the star followed by the one at this time.

As a remainder, if you are on speaker equipment lift the hand set before pressing the numbers.

One moment please for the next question.

Gentlemen, I show no further questions.

Please continue.

All right.

We want to thank all of you for tuning in and your participation in the call.

Especially, I would like to thank all of the people here at Donaldson for their continued efforts and support.

This is -- there are a lot of players behind the numbers.

And we are really proud of what they have delivered.

Thank you.

Thank you, sir.

Ladies and gentlemen, this concludes the Donaldson third quarter earnings release conference call.

If you would like to listen to a replay of the conference dial 1-800-405-2236 or 303-590-3000.

The access code is 473064.