Donaldson Company Inc (DCI) 2003 Q2 法說會逐字稿

Good morning, ladies and gentlemen.

And welcome to the Donaldson second quarter 2003 earnings conference call.

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

Following today's presentation, instructions will be given for the question and answer session.

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

As a reminder, this conference is being recorded Thursday February 20th, 2003.

I would now like to turn the conference over to Mr. Bill Cook, vice president and chief financial officer of Donaldson Company.

Please go ahead.

I'm Bill Cook the chief financial officer for Donaldson.

Joining me today are Bill Van Dyke, chairman, CEO and president.

Nick Priadka, SVP engine systems and parts.

Jim Giertz, senior vice president commercial and industrial.

Rich Sheffer assistant treasurer and director of investor relations, Thomas Windfeldt, vice president and controller.

And Norm Linnell, VP, general counsel and corporate secretary.

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

Our actual results may be affected by many important factors, including the risks and uncertainties identified in yesterday's press release and in our SEC filings.

We appreciate the opportunity to discuss with you the business and financial matters important to all of us at Donaldson Company.

Yesterday afternoon we announced second quarter numbers and are very pleased with our results, especially in light of the continuing weak economic conditions.

As our press release has quite detailed, I'll start out by summarizing our financial highlights.

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

At yesterday's market close, we reported revenue in our second quarter of $284 million, a second quarter record and up 8% from last year.

Revenues for the first half of our fiscal year now total $586 million, also a record, and up 6% from last year.

Our gross margin improved to 31.9% in the quarter, up from 30.8% in last year's second quarter.

Included in the 31.9% was the equivalent of two cents per share of plant rationalization costs, versus one cent in last year's second quarter.

These costs relate to our closing of two North American plants, one for manufacturing exhaust parts in Port Huron, Michigan and the second one for the production of gas turbine systems in Baldwin, Wisconsin.

As is our customary practice we ran these costs through our income statement in the quarter without any special charges.

Operating expenses in the quarter were 22% of sales, versus 20% last year.

This increase as a percent of sales is attributable to the addition of Ultra Filter, which, as a result of their end user sales model, has higher selling expenses than our traditional businesses.

Throughout the company, we have continued to maintain our discipline on managing our operating expenses.

Without Ultra Filter, our first half operating expenses as a percentage of sales remain flat year-over-year.

Moving to the bottom line, we reported second quarter diluted net earnings per share of 45 cents, unchanged from last year.

This is in line with the street consensus estimate for the quarter.

For our first six months, our net earnings now total a record $42.8 million, up 5.8% from $40.5 million last year.

First half EPS is also a record at 95 cents per share, up 8% from the first half last year.

In summary, we are very pleased with our second quarter and first half results.

We have continued to focus on those things within our control while waiting for general business conditions to improve.

Despite the uncertainty surrounding the global, economic and political climate, we maintain our resolve to deliver another record year.

That is, our 14th consecutive year of double digit growth in earnings per share.

Now I'd like to introduce Bill Van Dyke, our chairman, president and chief executive officer.

Bill.

Thank you and good morning.

Those of you who follow us know that we've structured this company on the belief that effective diversification in our end markets is the key to consistent superior results.

That model was once again tested and reinforced as the continuing upturn in our engine businesses and solid performance in most of our international operations offset ongoing weakness in our North American industrial businesses.

Second quarter worldwide revenues rose in all three of our engine businesses, trucks, after market, and off road.

Incoming orders were strong across all three markets in both 90-day and total back logs were up at the end of the quarter.

The trend is strong enough that we are now expecting engine revenues to be up as much as $80 million this fiscal year.

That's a significant up tick from our last outlook.

Last summer we foresaw a dip in our North American truck business following a surge in first quarter shipments driven by the October '02 emissions regulations.

As we discussed last quarter, our outlook changed as it emerged that truck manufacturers would continue to build with so-called pre-emission engines that they had acquired in warehouse.

That outlook was supported as the market firmed and our truck sales rose from prior year.

The current outlook has truck builds bottoming during our third quarter, but at much higher levels than anyone would have thought six months ago, then increasing gradually over the next several quarters.

Market data show that incoming orders for the truck manufacturers have been gradually increasing for six consecutive months.

More encouraging is that these new orders are for emission compliant engines.

Market acceptance of these engines is important to sustaining a healthy truck industry.

In sum, we expect trucks to be a significant plus for us this year.

Our international engine sales continue strong with 19% increases in both Europe and Asia.

Both the 90-day and the total backlogs for international engine are up over 25%.

And incoming order trends are strong so we expect continued solid performance going forward.

We began shipments of the new light diesel Power Core programs shortly after the first of the year.

Donaldson has traditionally been the leader in air intake systems for medium and heavy trucks, but hasn't played in the diesel pickup truck market.

Because of space constraints, those trucks have traditionally used automotive style filters which have evolved to be inadequate for the higher air flow needs and harsh operating environments that most of these vehicles see.

Our innovation of the proprietary Power Core system delivers diesel class filtration in an automotive size package, translating into more efficient and lower cost solutions for our customers.

We're on track to see second half sales more than double from the first half in year ago levels.

Geographic diversification again played an important role in the second quarter's results.

International sales growth outpaced domestic in all of our product groups.

And we move closer to one of our key diversification goals as international sales through six months grew to 48% of our total, from just 38% last year.

Balancing this encouraging news, industrial capital investment continued to languish throughout the quarter.

Our industrial air filtration business is pairing existing product lines while adding new performance optimized products to open new niches.

These initiatives, supported by the trend of incoming orders have us projecting the first quarterly sales increase in over two years in this coming quarter.

Our North American gas turbine business continues to track down as we have long predicted.

Partially offsetting the trend in the U.S. were stable conditions internationally and solid growth in the gas turbine after market.

We continue to project that our full year global gas turbine revenues will be down approximately 35%.

This is roughly in line with the decrease that we saw in each of the first two quarters of this year.

Note that our current scenario has these revenue losses in gas turbine virtually negated by the upturn now foreseen in our engine business, as I discussed earlier.

Our recently acquired Ultra Filter business continued performing well in its second quarter, as part of Donaldson.

Sales grew about 17% in both the first and second quarters from comparable periods before the acquisition.

Overheads have been trend and over $2 million of identified product cost reduction opportunities are the top priorities before year end.

Combination of sales growth and rapid progress in cost and expenses makes us optimistic that Ultra Filter will play a role in this year's earnings growth.

Having said that, we're only six months into this marriage; too early to declare victory or to speculate about the size of Ultra Filter's earnings contribution.

We expect we will be able to be more explicit on this at the end of the third quarter.

The persistence of investor doubts about Donaldson's ability to absorb the sharp contraction in North American gas turbines underlines one truth, that we see the strength of Donaldson's portfolio diversification much more clearly than do many of our investors and analysts.

Projecting from order trends, backlogs and new opportunities in our other businesses, we still expect organic growth to roughly offset the gas turbine drop.

With the addition of Ultra Filter, revenues in fiscal '03 should increase mid to high single digits.

Granted, this isn't a particularly bullish outlook, but we see it as sufficient to keep us in the hunt in pursuit of our 14th year.

This isn't the game we'd prefer to play, but our track record says we can play it successfully.

Early in my comments I said that the Donaldson model was once again tested and reinforced as the continuing upturn in our engine business and solid performance in most of our international operations offset ongoing weakness in our North American industrial business.

That statement has a lot more drama in it than is first apparent.

Let me try to explain it this way: If we isolate the pre-Ultra Filter Donaldson, that is the Donaldson Company that you saw last year, and look at that entity, excluding gas turbine, operating profit in the first half was up more than 20%.

Operating profit in the first half was up more than 20%.

In this economic climate, that's performance that I think any industrial company would be proud of.

But of course we can't exclude gas turbine, we have to absorb the sharp contraction in turbine demand, and that contraction is consuming a large share of the operating profit increase from the rest of the business.

Though gas turbine gross margin has held steady and expenses have contracted with sales, the marginal arithmetic is obvious, dropping 35% of some very profitable sales creates a big hole.

Our people have done a marvelous job so far with a very difficult situation driving the rest of the business to fill in that hole.

We're only halfway.

We all recognize that we have to finish the game and finish strongly.

The underlying trends in our business, new, light vehicle sales, rising second half disk drive sales, strong performances overseas and the blossoming profitability of Ultra Filter encourage our commitment to continuing our string of double digit growth years to make this number 14.

And that's the end of my prepared comments.

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

Thank you sir.

Ladies and gentlemen at this time we will begin the question and answer session.

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One moment please for our first question.

Our first question comes from Kevin Monroe with Thomas Weisel Partners; please go ahead with your question.

I was wondering if you guys could give us more detail on Ultra Filter and basically what have you done or accomplished this quarter that could be accretive as opposed to your previous expectations that it would be neutral.

I think Jim Giertz would be the best spokesperson for that.

He's been shepherding that through the life of it.

The activity in the second quarter was the same as the activity in the first quarter.

We've been focusing on trying to maintain sales momentum which we've been doing a good job of and also cutting costs, the cost reduction stream lining effort we've undertaken is really comprehensive.

It's across the board.

It's really every line item on the income statements taking focus.

It's a continuation of that process.

Your operating margins were down on a year over year basis.

Now was some of that from doing more Ultra Filter integration this quarter than you maybe had expected or is there some other reason operating margins being down?

Part of it relates to what Bill was mentioning about the loss of that higher margin GTS business and replacing it with the Ultra Filter right now.

We expect the operating margins in the Ultra Filter to get up to Donaldson-like margins in the next year or so.

As we said in the last couple of conferences we came into the year not looking for help from Ultra Filter on the profit line.

So but we're getting sales growth there.

But we're seeing the margins ramping up from a pretty low level, it’s a mix problem.

On the engine business, seems like things are improving pretty significantly there.

What's kind of the macro drivers behind that improvement in the business there?

I think we'll hand this one to Nick Priadka.

Good morning.

The engine business, and particularly the truck business, has performed exceptionally well for a couple of reasons for Donaldson.

Mainly a market share gain has been the name of the story for us overseas.

That's starting to show some real dividends as we begin to deliver additional product to a higher share.

We have seen a significant change in the overall market composition for trucks or commercial vehicles for us here, which has both the heavy duty component as well as the light vehicle component.

In other words, we're seeing major growth in the light component portion of this.

We also gained, despite the fact that the market declined in terms of build rates for heavy duty trucks, we actually increased our vehicle content.

And that vehicle content increase was significant enough that we actually increased our overall revenue year to year despite the decline in build rates.

So as those build rates start to come back and we're beginning to see the bottom there as they move up, we anticipate a continuing growth in this segment of the business.

What do you mean by increased billable content.

You're selling more products into --

We're selling more products into each vehicle.

Some of which is related to emissions products, some to our new Power Core technology.

And the combination of those two have put significantly more dollars per vehicle Donaldson content on the vehicle.

Okay, and if you could just clarify something for me.

It seems like you're saying the industrial air filtration business kind of remains under pressure but you're also saying that incoming orders are picking up and it's being led by this business.

Can you clarify what you're seeing on the industrial air filtration business?

This is Jim again.

I would say that the tone is slightly better.

You have to -- the different pieces of the business.

There are various pieces of the business doing a little bit better.

We're tending to do better in after market.

Some of our private label or key account customers are better.

Some of the tone of our business in Europe and also in Asia is a little bit better.

So it's certain smaller things or pockets of our business are showing a little bit of a more sign of life, particularly relative to last year, relative to the same time last year.

You're not seeing kind of an overall broad pickup in industrial production or anything like that?

No.

Particularly here in North America, which is kind of the core of our hardware selling, equipment selling in North America, there's maybe some glimmer of improvement, but nothing very remarkable.

One more question.

DSOs were up in the quarter.

Why was that?

This is Rich Sheffer (ph).

It's a two part answer to this one.

The first part is a mix issue.

Internationally, receivables are up as a percent of the total composition is the word I'm looking for of the receivables balance.

Typically international collections lag what we do in North America.

The second part of that answer is that we saw deterioration in collections in North America, November/December; the customers were starting to pay slower.

We started to see a return on that in January, started to improve.

We're going to continue to work that over the next quarter to get it back into previous levels.

Okay.

Thank you.

Our next question comes from Richard Eastman.

Please state your company name followed by your question.

Robert W. Baird.

Three things; first of all, could you possibly give the sales growth and the adjusted sales growth and sales decline in the engine and industrial segments in local currency?

In engine it was 9.6% as reported.

Is there a local currency number that you'd have your hands on?

Why don't you go ahead with your other two while we're looking that one up.

Maybe you could address this one.

On the gas turbine side of the business, we've really stuck with a sales decline number I think of 35%.

You've been pretty consistent there.

And we're running I think a little bit ahead of that.

Meaning a little bit worse than that.

As we roll into the second half of the year, do the declines become smaller or does the replacement business start to offset or where do we, how do we reconcile where we are versus where we think we'll end the year?

We see the data differently, Rick.

I think our figures show that the first quarter was down just under 34%on the second quarter was down just over 34%.

So I think we're marginally under our 35% reduction for the year.

So we're really forecasting not much a change.

Don't the comparisons become pretty difficult here as well in the second half or?

I think we were pretty steady all last year, weren't we?

Typically our fourth quarter is a normal time when there are more shipments and we are not seeing any drop off from the pace that we have seen so far this year.

Let me ask it a different way, is the replacement business, currently we saw 20% increase, can you give a general sense is replacement sales are they running at $25 million?

Are they running at $40 million?

I'm just curious how big an impact that 20% growth on that base can have in gas turbine.

After market is a little bit over 15% of our total revenue in the gas turbine business this year.

20% growth rate, just kind of in the second half is realistic?

Yes.

Then just the third question here, before we circle back to the first one, you had mentioned, Bill, that the engine business, the orders were coming in; emission compliant engines her for the second half.

Can you give us a flavor for the increased content that we may see that would mute some of the decline we may see up against the top comparers?

That's a good question.

The content is really coming in the emissions product.

We're replacing ourselves a product typically muffler exhaust system with an emission control system.

And the actual ratio of that, the value there, is a factor of four or greater.

So we're replacing a product with a value four times greater than was on the vehicle prior.

Okay, very good.

That was it other than the local currency.

Rick, this is Rich Sheffer.

What I'll give you is the effective translation on each of those pieces, starting with engine.

Engine off road translation increased sales by $3 million.

In transportation, $1.1 million.

After market, $1.7 million.

Industrial side, industrial air filtration, $2.1 million.

Gas turbine, $1.5 million.

Special applications, $800,000.

And Ultra Filter, $2.5 million.

Very good.

Thanks so much.

Our next question comes from Barry Haynes (ph).

State your company name followed by your question.

[inaudible] management.

I had a question on the incoming order growth that you said in the press release in engines.

It was up 14%.

And you mentioned that foreign exchange contributed to that.

I wonder if you could break out of that 14% how much, what that number would be [inaudible].

This is getting pretty deep.

I don't know that anybody can.

We don't have that right now.

I'll call you back.

Next question comes from Ken Herbert (ph).

Please state your company name and question.

Salomon Smith Barney.

Could you tell us what you're seeing with the Power Core program within light duty diesel sales?

Is that growth more driven by your taking market share and increased penetration in that or is that obviously dieselization is a big driver here are you seeing fundamentally just strong continued growth in this sector?

We'll give it to Nick again.

It clearly is market share gain and our ability to displace typical automotive filtration products with a heavy duty product more geared towards what's going into those vehicles.

And you mentioned dieselization, that's a big factor as more and more of the light vehicles, light trucks, in particular, are becoming diesel powered.

And those engines are very similar in their performance characteristics to the same engines that go into class seven trucks.

And as a result they require a lot more air demand and a lot more performance.

And yet there's very little room in those vehicles to put the air filtration system.

And thus the Power Core system fits very nicely into that application.

So we're moving more of that product into that segment of the market and growing share pretty significantly.

We'll see a pretty good impact in the second half of the year of that product offering.

It's safe to say that throughout the remainder of your fiscal year and perhaps for calendar '03, double digit growth rates continue to be realistic?

In that segment it is safe to say that.

Okay.

And just finally, one other question, on the heavy duty truck side, do you have any sense of the, for your after market how you see the sales and service rolling over or are you impacted at all by the fact that as fleets roll over and incorporate a greater percentage of the engine in their fleets to the post October engines, is that having any impact on the service side?

As that penetration within the fleets really starts to increase?

Well, it's fairly early in the game.

The new engines are only out there for just several months.

But in fact the emission controlled engines, depending on the strategy used to control those emissions, might in fact, we believe will require increased servicing of lube filtration, for example, we haven't seen the impact of that yet but we anticipate that that would potentially drive additional service part sales.

So the EGR engines could in fact have a greater need or from a service standpoint require a little more than sort of the pre engines?

Than the standard engines, that's correct.

Do you have any sense on the C9, the first one the [inaudible] rolled out, any sense on that as to what the sort of parts and service implications might be?

No, we don't.

That obviously uses a different strategy.

And we haven't seen any difference at this point.

Okay.

Thank you very much.

Thank you.

Our next question comes from David Kurzman.

Please state your company name followed by your question.

HC Wainwright and company.

Let me start out with the easy one.

In terms of insurance costs and materials and pension costs, have we seen those top out yet or do you expect to see further increases in that going forward.

This is the controller.

Our costs spiked quite dramatically after September 11th.

They've been coming down starting about last summer.

Insurance costs.

What about materials and pension?

Pension costs have been incrementing up on a rate of about 10% the last couple of years, and we project that into the future.

Okay.

The other thing I wanted to ask about was your assumptions in the outlook for currency FX.

What have you built in for currency FX?

This is Rich Sheffer again.

We look at the revenues, the plan rates that we're using are still on the conservative side.

We're not projecting huge further devaluation of the dollar at this point.

So you are, though, looking for a further devaluation, although it's a small number?

Pretty consistent with where rates are right now.

Right.

Okay.

So further devaluation would actually benefit the U.S. dollar P&L.

Okay.

And let me just sure I've got your truck build numbers for the heavy duty right.

You were saying that you're actually expecting them to pick up?

This is Nick Priadka.

During calendar year '03, towards the end of '03 we would see a pick up, but not to the level of '01.

But certainly much higher than `02.

Okay.

All right.

Thank you.

Thank you.

Ladies and gentlemen, if there are any additional questions, please press the star followed by the 1 at this time.

If you are using speaker phone you will need to lift the hand set before pressing the numbers.

One moment please for our next question.

Our next question comes from Eli Lefgarden (ph).

Please state your company and question.

HC Wainwright.

Your truck outlook bothers me a bit.

If you look at what happened in '02, you have a production ramp in the second quarter, peaking in the third quarter calendar year, dramatically.

And falling off a bit the fourth quarter calendar year, the third quarter, the first quarter of '03 production is below the second quarter.

And is virtually no forecast in the industry that had production higher quarter over quarter for the rest of the year.

Most forecasts are flat for the year and most of the gain is the first quarter because there’s a real problem in comparison with the third quarter.

So I guess I'm having trouble reconciling with what the industry is saying versus your forecast.

I just gave you an indication of what I believe the class eight build rate would be.

And we look at this build rate within our fiscal year and that's slightly different than the calendar year.

I know you have a July Fiscal year.

But production ramped in March, April, May, June, through July, particularly July over September.

You're going to catch part of it in July.

They say reduction we know in January, February, March, is below January, October, November, December in the industry.

And virtually every industry forecast is below that.

Yeah, and --

Are you seeing something that indicates or is it truly market share gains that are driving your numbers different from the industry.

There are two questions I think you're asking, what's actually happening to the build rates and then what's happening to our participation within those.

We see the build rates within the way we measure within our fiscal year going up slightly.

As I said, we're not going to reach fiscal '01 rates.

We'll be above the '02 rates for us.

But what's really going to drive our business is our participation and market share gains literally in that market.

We have added a significant amount of dollar content per vehicle on average.

And there has been, as you probably understand, a mix change within the customer base that's out there.

And we have been benefiting by that as well.

Can you talk about the profitability of the added products you put on the trucks versus the standard products that you original products added on the truck compared to that.

Gas turbine has been a very profitable business.

What kind of trade off are we making?

I can give you just a comparison.

The profitability on the emissions products, replacing the exhaust products, is substantially better than the exhaust products historically.

And that's typical.

And it's typical of any value-added.

Versus the gas turbine drop that you're taking, are we paying a big penalty or modest penalty now.

I'm not sure there's a penalty there at all.

I would have to take a look at that product specifically.

We don't discuss specific product line profitability.

Most of our business groups profit abilities are clustered around the corporate average.

The quarter you just report gave you about two cents from currency, is that what we should expect for the rest of the year, per quarter?

Could you repeat that Eli?

The quarter reported I guess we broke out the currency benefit to income, which is very close to two cents.

I think its 1.7 cents something like that, close to two cents.

Is that something we should expect for the next couple of quarters?

I think as long as the exchange rates remain where they are, that's probably a pretty good estimate.

Thank you.

Gentlemen, at this time we have no further questions.

Please continue.

Just following up on a question that Barry answered earlier about the engine orders in the quarter being up 19% year-over-year.

Of that increase, Barry, about 8% is due to exchange rates and 11% is operations.

Christine, I'll turn it back over to Bill Van Dyke now.

Okay.

I want to thank all of you, all of our listeners for the participation in the call.

And I especially want to thank all of my fellow employees here at Donaldson for their continued efforts and support.

They are the people who are proving that our strategy works.

Thank you and good day.

Thank you, gentlemen.

Ladies and gentlemen, this concludes the Donaldson second quarter 2003 earnings conference call.

If you would like to listen to a replay of today's conference, please dial 1-800-405-2236 with access number 525661.

If you would like to a replay of today's conference, dial in 1-800-405-2236 with the access number 525661.

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