Donaldson Company Inc (DCI) 2004 Q2 法說會逐字稿

Good morning, ladies and gentlemen and welcome to the Donaldson second quarter 2004 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 today, Friday, February 27 of 2004.

I would now like to turn the conference over to Mr. Bill Cook, CFO of Donaldson Companies.

Please go ahead, sir.

Good morning.

Thank you.

As Erika said, I am Bill Cook, Donaldson's CFO.

And with me today are many members of our management team, all ready to help answer your questions at the end of our prepared remarks.

Those present include Bill Van Dyke, our Chairman, CEO, and President;

Lowell Schwab, in charge of our manufacturing operations; our two business unit leaders, Nick Priadka and Jim Giertz.

Also with me are Tom Windfeldt, our Corporate Controller, Norman Linnell, General Counsel and Rich Sheffer who handles our treasury and Investor Relations.

Before we start, I need to remind you that any comments in this call regarding our business that aren't historical facts are forward-looking statements.

Our future results could differ materially from any statements made today.

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

Now, I'd like to briefly review our financial highlights.

As you read in our press release, our second quarter was very strong as we again turned in record sales and earnings.

Furthermore, we began the second half of our fiscal year with record order backlogs, up 21%.

This gives us the confidence that we will deliver another full year of double digit earnings growth, which will be our 15th consecutive record.

At yesterday's market close we reported record second quarter revenue totaling 332 million, up 17% of last year.

Year to date, we reported first half revenue of 660 million, also another record and up 19% from last year.

Moving to our bottom line, we had a very good quarter, reporting record second quarter net earnings per share of 56 cents, up 24%.

Year to date, our EPS is now $1.12, which is also a first half record, as it is up 18% over the prior year.

After completing a strong first half, we see even better business levels ahead of us.

This is based on the business we already have in hand in our order backlogs.

On this strength, we reaffirm our expectation of delivering another full year earnings record with a double digit percent increase over last year's record EPS.

Now, I would like to introduce Bill Van Dyke.

Bill?

Thanks, Bill.

There are three things, just three things that I want to talk about this morning before we open up for questions.

Number one, is the prerelease of two weeks ago and why did we handle it as we did?

This isn't the first prerelease we've done.

We did one five quarters ago, first quarter of last year, for the same reason, that we had knowledge that our earnings were not going to match the consensus of analysts' expectations.

If you will remember, that Donaldson has a pretty complex structure with dozen was overseas entities, then you will appreciate that gathering the numbers is one thing, and gathering an understanding of all of the pieces is a different sort of task that takes some time.

So we're in a position where we had preliminary numbers with no explanations or analysis.

And we have no appetite for offering an explanation that we might have to retract or that compromises the facts.

So we had a simple choice.

Release the numbers without explanation.

Or say nothing.

And we concluded that we were better off to let you know what we knew.

The other part of the question of why earnings weren't even stronger than the 25% increase that we reported really turns on two things.

A relatively small piece of the answer was that global spending is running well ahead of prior year, as we've been building resources across the company to handle the growth that's upon us.

We expect that that spending will come into balance with revenue in the third quarter.

Our release of yesterday really points to the primary explanation, and that is what happened as we consolidated our Japanese manufacturing.

We had previously told you that we would see 8-10 cents per share gain from the land sale there.

And that was accurate.

That is what we got.

We also had told that you the bulk of the costs associated with consolidation were behind us.

And that was not correct.

Why not?

The consolidation involved putting essentially all of the machinery and inventory from our major manufacturing site on trucks and moving it to the new plant.

This move was meticulously prepared for, as you can imagine, and carefully planned over months prior to the kickoff date.

And part of that plan was for the business outlook, which was to slow, that we would see a softening of demand in the late fall and early winter.

We were surprised instead by a 20% spike in demand literally as our manufacturing capability was being loaded on to trucks and driven across country.

And that, not surprisingly, blew the plan out of the water.

We had no choice at that point but to do whatever was required to take care of our customers.

We subcontracted lots of work.

And you can imagine the subcontractors had a lot of leverage over the pricing for their services.

And we saw our warehousing and logistics costs rise to impressive levels.

The end result was that, though, we got through the crisis, we took care of our customer, our people who were running the project did a truly marvelous job in a very difficult situation.

I was over there a couple of weeks ago and it is obvious that we've got production back on a stable footing but we spent a lot of money in the process, enough to eat up over half of that land sale gain.

In my view, the take-away value for our investors is not much.

There was unforeseen event that consumed a big chunk of the expected gain.

It is behind us.

The new facility is everything we hoped it would be.

Our expectations around increased efficiency and profitability from our new Japanese platform are unaffected.

So topic number two, PowerCore.

We've talked a lot about PowerCore over the last year or so.

And we continue to believe that this new proprietary innovative product will be the biggest product innovation that we've ever had and we thought it was appropriate to provide some summary data that would give you some substance behind our enthusiasm.

This is a whole new technology, and it's going to grow through introduction on new platforms.

There will be rare instances of manufacturers redesigning a platform to utilize the PowerCore.

But what this means is an ex tended tended gradual ramp-up of the business.

To date, we've offered the PowerCore on 51 new platforms.

Donaldson's win rate exceeds 90%.

Having been awarded 27 and lost 2 to the other guys.

That's 27 for Donaldson and 2 for the other guy, with 22 still to be awarded.

I think our won-loss record suggests that our enthusiasm for this product is pretty well-founded.

The new news is that PowerCore has broken out of the diesel engine market with our first orders for PowerCore into Power Generation, our gas turbine business.

Starting in May, we will ship five small system, one a month, into the Middle East.

Now, this isn't huge sales volume, but it is a critical first step in establishing credibility for this market.

We expect PowerCore to secure our 60% market share position in Power Generation for the foreseeable future.

PowerCore's attraction is powerful, given the huge reductions in system size, complexity and freight and installation costs for our customers.

Still, we're almost sure that it won't have a rapid impact as we need to prove this new technology to a very conservative customer base.

And turning back to the diesel applications, PowerCore is currently 16% of our North American truck revenues.

We had said earlier that we expected a doubling of last year's $13 million PowerCore sales this year.

Since then, one large Retrofit program has failed to develop the expected volume.

So our full year sales in '04 are likely to be a little bit under that earlier expectation.

Now, my final point.

I want to draw your attention to some of the numbers embedded in that press release, the numbers that tell us pretty clearly that the industrial recession is losing its grip.

You will recall that the first quarter sales were up 9% year over year.

Second quarter sales were up 17% year over year.

And going forward, our backlog for the third quarter is up 39% over last year.

So we've gone pretty quickly from wondering when the turn would come to an all hands on deck drill, and profitably embracing this new growth.

Even more important, I think is that this strength is broad-based.

The second quarter sales are up double digits in every one of our major market area, except gas turbine.

With numbers like 35% in offroad and 60% in transportation, and 35% in our special applications area.

And even, very significantly, 10% in our industrial filtration separations group, the in-plant capital equipment piece of our business that has been so like virtually all other in-plant investment across North America, has been so severely contracted over the last couple of years.

Now, to balancing those sunny statistics, are relentless price pressure from our big OE customers.

The new assault on costs from the steel surcharges that you've all read about.

The investments required to, internally here, to secure and service this long-awaited growth.

And of course, the distortions that are caused by the year over year changes in foreign exchange.

Nevertheless, I think the conclusion is clear.

We're no longer wondering when the turn is going to come.

Primary effort, now, is focused on profitable execution of the business now in hand.

It's much more engaging work than struggling with recession but it's no less challenging.

The bottom line is our expectations are high for this being our 15th consecutive year of double-digit earnings growth.

That's the end of my comments.

Erika, we are ready for questions.

Thank you, sir.

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

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

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One moment, please, for our first question.

Our first question is from William Benton.

Please state your company name followed by your question.

Hi, William Blair.

Good morning, guys.

Just a couple of questions.

On the gross margin front, I know you experienced some possibly more one-time expenses related to the Japanese situation.

And I know you're still spending on plant rationalization.

You had, maybe, mentioned I think at the last analyst meeting that a lot of the plant rationalization had been behind you.

But given the strength in the sales right now, are you thinking more about, maybe, just continuing to invest in some additional plant rationalization programs just to prepare yourself for additional future issues that you might face there?

This is Lowell Schwab.

We really do believe most of our rationalization in Europe and Asia is behind us.

Okay.

And, excuse me, in the U.S. and Asia, is behind us.

There might be some in Europe in the future but there is no short-term plans for that.

As far as capacity going forward, we think we have adequate capacity, physical capacity in place to handle the demand increases that we can see going forward.

So our capacity issues are more related to having enough trained people that it is physical assets and we're working on to train people, job at the moment.

Okay.

I guess you had talked before, I guess, about flat gross margin expectations year over year.

Obviously, the first quarter was much stronger, and this quarter it looks like maybe 60 basis points was due to maybe some mix changes in terms of, maybe, a sequential decline.

How do you guys think about your gross margin for the full year now.

If you wouldn't mind updating us on that?

Bill, Bill Cook here.

Just on the plant rationalization, the first half we spent about 9 cents per share and we're looking about spending about half of that in the second half.

About half of that.

So not at the same rate.

So that head wind on the gross margin would be a lot less.

Okay.

And then, you talk in your thing that, obviously, the current order patterns are obviously huge, indicated by the backlogs here.

You talked about continuous strength in most of our businesses.

Is there any business that is not, and besides gas turbines which is obviously recovering actually quite nicely, that isn't, maybe, as strong as, maybe, it was last quarter or as it was in the early part of the quarter?

I think the only exception, Bill, is gas turbine.

Okay.

And we're seeing, as Bill Van Dyke mentioned a few minutes ago, just increasing life in all the other segments.

To varying degrees, but increasing in all of them.

Okay.

Well the numbers look fantastic, guys.

Thanks.

Thanks, Bill.

Thank you.

Our next question is from Lorraine Maikis.

Please state your company name followed by your question.

Thank you.

Merrill Lynch.

First of all, just back to plant rationalization.

You said most of it was done but you still think you will spend 4 1/2 cents.

Is that just finishing work that you've started at this point?

Yes.

We don't intend to start any new rationalizations in the second half of the year and with any luck, we won't spend the 4 1/2 cents, either.

But they are all going well, and they're mostly done with that work.

Lorraine, just maybe a little bit more elaboration on that, as we've talked about in the past, we're always going to have some level of plant rationalization as we continue to invest.

But again, as Lowell just mentioned, the focus in the second half is going to be in that, say, four to five cent range, it is going to be a lot less effort and expense than what we had in the first half.

The Japanese project is behind us.

Okay.

And then just touching on the Japanese issues, would you categorize the spike in demand as a pre-buy similar to what we saw here in the U.S.?

And I guess, why wasn't that spike expected when you're making your plan to switch the factory machinery?

Lorraine, Bill Cook again.

Part of it was a prebuy with these admission regulations in Japan.

But really the magnitude or scale of that wasn't foreseen by our customer, and as a result not by us.

Both the amount and the extent of it.

And we thought, as Bill mentioned earlier, that we planned very carefully to move the production in August and we got caught with this unexpected wave at the same time.

This is Bill Van Dyke.

One other angle on that is that there was a, kind of, threshold date in late fall where supposedly the increase in demand for these mission control devices was going to abate.

And we had really planed the move for after that.

And we were surprised by even though that milestone passed, the demand continued to increase.

It really wasn't foreseeable.

Our customers didn't see it.

And there with we are.

And then finally, on the costs that you're adding to get ready for this uptick in the industrial businesses, what types of people are you hiring, and what types of infrastructure are you adding at this point?

This is Jim Giertz.

Most of what we're referring to there is we have sales people that we've put in place.

We've hired additional sales people in our industrial filtration solutions group in Europe, additional sales people in our membrane business in Europe, for example and similar pattern in the U.S. business as well, though not to that same extent, but generally putting sales and service people on the ground to take orders.

So we should expect the current levels of overhead or operating expenses to continue through the rest of the year?

Yeah, Lorraine, Bill Cook.

At the sort of level we are today, not increasing any further.

Okay.

Thank you.

We have made the investments.

All right.

Nick, do you want to comment?

This is Nick Priadka.

We have made very similar investments, mostly in our engineering side of our business, we've added resources there, as well, in preparation, as you might imagine, for the demand.

We're looking at a lot of new platforms, and that requires a lot of technical activity at the time that our proposals are being pushed forward.

So, we've made a fair amount of investment in that type of resource during the quarter in particular.

Thank you.

Thank you.

Our next question is from Richard Eastman.

Please state your company name followed by your question.

Robert W. Baird.

The question has to do with the gross margin.

Could you just identify, I want to make sure we're not double counting these Japanese expenses, I think you mentioned they were about 2.4 million.

How much of that falls into the cost of sales?

Is it the 2.4, less the 660 or so that is transportation?

Rick, Bill Cook here.

About 1-9 of that falls into the gross margin and the balance is in operating expenses.

Okay.

And then within this plant rationalization cost, six cents, it amounts to about 3.7 million million pretax, does that include some of the Japanese costs as well?

Yes.

We consolidated the plant rationalizations worldwide into that number.

Okay.

All right.

And was the plant rationalization number in this quarter, did it surprise you a little bit?

Because I wasn't under the impression it would be that large in this quarter or was your guidance more aggressive than you thought?

It surprised us, Rick, for the reasons that Bill Van Dyke mentioned earlier for doing the plant move at the same time we got hit with this volume wave, that we had a lot of expenses that had been unforeseen, and they are higher than what we had talked about at the last conference call.

That is all consolidated in there.

Right.

The other question I had, on the sales side, the transportation segment of the business, all the pieces were very good.

That one actually did not look quite as good as I might have thought.

Did you have any issues in terms of getting product out the door.

That 38 million, I would have thought that piece of the business of all pieces might have been higher .

No, we didn't have any - - Bill Cook again.

We didn't have any problems getting product out the door.

This is Nick Priadka.

No, there were no supply issues there.

I thought that the performance there was just about what we expected.

That's fine.

And then could you just throw a little bit of color on the mix issue that you stated in the press release.

I mean given what's going on in the business, the exhaust and emission product sales, as a percentage of total, again, maybe I'm surprised that that surprised a us a little bit.

What is going out the door that is of that much lower margin?

Rick, Bill Cook here.

The exhaust products have a slightly lower margin than our air filters and the percentage increases in those products, the exhaust products in North America is higher than the air.

Is that basically the same as the backlog mix, as well?

Should we expect that to continue to press margins a little bit?

There is some mix impact there, Rick.

But it is not, you know, we're not talking about double digit differences in margin.

So you know, we put it out there because it is something that we're looking at.

But - -

Okay.

It's not that big a deal.

And then lastly, on the gas turbine side of the business, could you just add a little bit of color to the characterization on the outlook?

I know sales are going to be down, not as much as we expected.

Is some of this temporary shipments into the Middle East, or is the slight improvement that we're starting to see, is that maybe sustainable?

Rick, this is Jim responding.

Well, the reason our outlook is up is it is just a variety of small wins that we've had.

Iraq has been one of those, probably the most significant surprise or addition to our forecast.

We have, for the full year now, we're expecting to ship just less than $5 million of product into Iraq.

Okay.

We're actually still looking at some additional orders.

There's still some additional orders out there ticking around.

We might get some additional business but we're not clear about that right now.

Some of the uptick has been translation of the European business because, now, the European part of our business is a bigger percentage of the total.

Yes.

Okay.

Some of it is just doing better with some of the customers that we've not traditionally been strong with all around the world, particularly in Europe, also in Japan.

We expect those increases to perpetuate themselves.

Okay.

Very good.

Thank you.

Thanks, Rick.

Thank you.

Our next question is from Charley Brady, please state your company name followed by your.

Hibernia Southcoast Capital.

Thanks.

Can you elaborate on the PowerCore that you're shipping to the Middle East, the five year and 20 month, and is that going to one customer or is it going to several customers.

This is Jim Giertz responding.

That is the one customer, General Electric, into one site.

In Abu Dhabi, I believe.

Okay.

And on the 22 platform rollouts that have yet to be awarded, can you give us a sense of timing on the rollout of when those awards are expected to come out?

This is Nick Priadka responding.

Yes.

Maybe the best characterization of that is how we're performing today.

We rolled this product out into the light duty market, in particular, but across all of our markets, generally, about three years ago.

We're operating on a platform, on a fairly level, at this point, platform level at the light duty side.

That is expected to ramp up again in 2005, as these platforms are released to production and again in 2006, and again in 2007.

So what we see, generally, is the work being done now, the platform going into production a year or two later.

And of course, the replacement parts business follows that by several years.

Of interest, though, I think is the platforms that we have today are beginning to show after the three-year period, the very first signs of replacement element growth.

Up to now, most of our revenue has been generated by first fit.

And now, we're seeing the beginning of that replacement element growth, which is encouraging, because as you know, down the line, we expect that to be the greater part of our revenue, going forward.

Okay.

Of the 27 platforms that you've won, well, you're on 51 total platforms, how many of those are generating replacement revenues?

Well, all of them are generating replacement revenues as we speak.

It has to do with that initial price line fill on some of the newer platforms, and now as those platforms are out there for several year, you begin to see the replacement parts business.

Just for clarification, I think Nick, correct me if I'm wrong, I think 16 of the 20, whatever it is, are in production, with - -

16 of 20 are in production.

The rest will follow in '05 and '07 and we're working on 22 additional.

Okay.

Yeah, that clarification helps, thank you.

The next question, on the Ultrafilter, you commented that you saw a lift because of entry into new markets in Asia.

Can you expand on that, exactly, clarify what you mean by new market, where are you seeing that growth?

Right, this is Jim Giertz responding.

What what has changed in Asia is that we have consolidated Ultrafilter together with our industrial air filtration business under the IFSG, or industrial filtration solutions group umbrella.

And basically what has happened is that in the past, all Utrafilter had a fairly modest sales organization in place in some of the key market areas.

Now with the addition of the industrial air filtration or [torret] and DC sales people also prospects for Ultrafilter business, we're turning up new opportunities.

The other issue is that some of the business that Ultrafilter does in the Asian region is large projects, and so I think part of what you're see in the second quarter is just some shipments of some big orders that went through.

But generally the tone of the business is pretty good.

We're starting to get some benefit from sharing leads between sales organizations.

In total we have more feet on the street selling product.

And then one last question.

I will get back in the queue.

When you're looking out your projections and you're forecasting currency fluctuations, can you give me a sense of what your dollar-Euro forecast rate is or sort of what - - and the backlog number, what the exchange rate embedded in that backlog number is currently?

Charlie, this is Rich Sheffer.

As far as factor forecasting currency, I don't think anybody here is smart enough to know exactly which way it is going to go so we use it on a constant basis where it is at right now.

So you use current spot rate today?

Yes.

Okay.

And sot backlog numbers that you're quoting in the release are calculated at current spot rate.

Correct.

Okay.

Thanks very much.

I appreciate the answers.

Thanks, Charlie.

Thank you.

Our next question is from Kevin Monroe.

Please state your company name followed by your question.

Good morning.

I'm with Thomas Weisel Partners.

The question I have is on the leverage in the model.

I mean with this pickup in demand, I know there is some one-time costs here but why aren't we seeing the leverage on the manufacturing model as demand picks back up?

Did you guys just go too lean or something or are there other issues I'm not seeing?

Kevin, Bill Cook here.

We do have some nonrecurring expenses and the largest single one of those is related to the plant rationalization in Japan.

Right.

In terms of the plant rationalization.

We have some similar things in operating expenses.

And as Bill VanDyke mentioned, we sort of invested ahead of our backlog on the operating expense side.

But from a, say, manufacturing perspective, a lot of what we talk about the backlog, that is still in front of us and we think we are well positioned to capitalize on that in our plants.

Okay.

So you're making an investment from what you see coming, so we should see it show up in the margins in future quarters?

Right.

Okay.

Second question I had was are there any, you know, you had huge growth in the backlog this quarter.

Are there any kind of weird things in there, like maybe a not sustainable project or something?

Is there anything there that we should be normalizing for or this all kind of good clean growth?

Kevin, Bill Cook again.

It looks like all good clean growth, as you put it, sort of across the company, with the exception of gas turbine, and even in gas turbine, we're seeing good signs of life outside of north America.

Maybe as a further to that, the backlog going into the third quarter is up in gas turbine.

So the pervasiveness of the strength across the business is small.

It is a single digit kind of increase.

But as opposed to a sequential drops that we've seen for the last year and a half, it is a big change.

Okay.

And last question, you talked about PowerCore and the gas turbine market.

Now, you can quantify kind kind of the incremental opportunity there?

This is Jim Giertz replying.

Ruling out PowerCore, I guess, turbine business is going to take a long time.

We are basically replacing our flag ship product, which is what we call GDX.

It is going to roll out over a long period of time.

It is basically replacing a product platform that we have today, with a more cost-effective better value proposition for our customers.

Okay.

So I think we view it more as a way to just retain our leadership position in the marketplace as opposed to really an incremental opportunity, although at some point, way down the road, I think it should certainly help us perform better in our after market.

Okay.

Great.

Thank you.

Thank you.

Our next question is from Fritz VanCarp.

Please state your company name followed by your question.

Hi, Sage Asset Management.

Good morning, gentlemen.

Back to the PowerCore and the new truck platforms, I apologize if this is clear to everybody else, but could you - - I assume there is some sort of embedded growth, organic growth in the next three years, based on the new platforms that you're on.

I mean, there is an industry convention of saying that given holding production constant, assuming that these new platforms do some sort of regular assumption about what they do in production, that there's some growth, organic growth, in having the new platforms.

Could you quantify that in line with the industry convention?

This is Nick Priadka responding.

I'm not sure I understand your question exactly, but let me see if this helps.

We're seeing the delivery of PowerCore units on platforms, new platforms, driven in all markets, but particularly in the transportation market because of many of the emission engine changes that are coming in 2007.

As you know, the engines are going to be flowing more air, there's a higher temperature and the PowerCore adapts very well to those applications.

So the new platforms that we're working on are related to that, and those platforms will come on stream, as those vehicles go into production.

And that's part of those 22 that we're working on today, and a number of others that are just starting.

Now, the organic growth, I think you mean with respect to those platforms that are in position today, occurs primarily through the growth of the replacement element business, to the extent that we can get those units out in the field, with the generation of more and more replacement opportunity.

We expect that number to grow.

And as I said earlier, we're seeing the first indications of that type of growth.

And as we project out, we see the replacement element revenue actually exceeding in the future the revenue of the first step.

Let me follow-up, if you don't mind, just on that.

What is the increase, given that you started to see this phenomena in the after market now, what is the increase in your market share so far or the indication of the old after market situation?

Well, since it is a brand new product, and we are currently the only suppliers of it, it is a pretty dramatic increase.

The increase in the light vehicle market has started from literally zero, three years ago, to a significant number of dollars as we go forward.

So, we're at 100% market share with respect to our replacement rate, if that's what your what you're asking.

Okay.

And how often are these things replaced?

What would be, if given an installed base of some certain size, what would be the annual revenue of replacement?

The replacement rate varies with the application, but generally, our assessment is between, somewhere between one- half to one time per year, at a minimum, and an offroad application, it would be several per year.

Thank you very much.

Thank you.

Our next question is from Dana Walker.

Please state your company name followed by your question.

Hi.

I'm with Cal Mar.

Good morning.

The capital gain tax rates on the Japanese transaction would have been what?

The actual tax rates?

Yeah.

I think the tax rates - - This is Tom Windfeldt.

The tax rate was a little over 40%.

Which is well different from your effective tax rate for the company.

Yes, it put a little pressure on our rate.

Item number two, on cost of goods, you described how there is an upward bias in raw material, steel is certainly no surprise, based on what we are all seeing.

Can you talk about the effect that you expect to see going forward, strictly on cost of goods over the next several quarters?

Well, we're going to try to - - this is Lowell Schwab, by the way.

We are going to try to offset those costs increases, both with other cost decreases, we have ongoing margin improvement projects all the time.

And we with will try to offset more than that amount, but additionally, in cases where we can't, we will be trying to recover some of those cost increases with customers.

So you would hope that that's not discernible in your reported gross margin?

Right.

And even if it is, you would expect it to be minor compared to the general scale of other activities?

Right.

If you look at our general cost reduction goals, we would have goals in excess of $10 million every year and globally half again that amount.

Okay.

On the gas turbine engine front, given the steps you've taken on capacity reduction, when you get a positive surprise on volume, what influence does that have on the flow-through on that volume?

Dana, Bill Cook here.

With gas turbines we use subcontracting as sort of the rubber band in that capacity, because the business cycles so much, and has over time, so we have a ready list of subcontractors that we can pull in for anything that is unexpected like that.

In addition to our own plants.

This is Lowell Schwab.

We subcontract in all regions of the world, so we have large subcontract are in North America, Europe, and Asia, and going forward, the gas turbine business seems to be so mobile, that trying to put brick and mortar in place to serve it is not a good plan.

So if we were to think that your internal ability to serve the customer is, roughly, at the floor of what you consider to be demand levels, which go back to let's say 98 or 99, that around 90 million, that anything above that on a wiggle room basis is served by subcontracting?

That's fair.

In fact even in the 90 million, a part of that is served by subcontractors.

A lot of the capacity we had allocated to gas turbines in the past has been redirected towards the IFSG business.

So if your present outlook, which appears to be 15-20 million dollars more, some of which is currency translation, comes to pass, then that will come at a subcontracted type margin rather than a true manufacturing flow-through margin for you.

Margins are very similar, Dan.

Item number three, on the engine front, can you talk about the difference between units shipped and mix, that is average selling price in the year to date and in your backlog?

Nick Priadka here.

I don't see any substantial difference or any dramatic mix change that would change anything going forward.

We have had about the same in the last quarter as what we expect going forward in the next quarter.

The growth that we expect will be significant in the truck market, as the figures point out.

But the products going into that market are not substantially different in margin than any other.

So, I suppose you're suggesting that the year over year comparisons at this point have normalized for the CAT initiatives and we're unlikely to see further mix benefit change here for a while until we get closer to the '07 pressures?

Yes, generally, that's true.

There will be an effect coming on stream with Retrofit business going forward.

Retrofit is a factor as we see that business picking up, the rest of this year, and into next year, we have seen some changes in that opportunity just recently, that will give us an uptick.

For example, in California, just implemented their solid waste tool, just this past week.

We expect that to open up another large segment of Retrofit opportunity and to the extent that those products start flowing in the next several years, in fact, we're going to see, perhaps, a slight impact there.

But otherwise, we expect things to be relatively the same.

Nick, since have you the floor, you commented earlier about a PowerCore order opportunity that did not transpire.

It sounded like it was a Retrofit.

That has to do with the Retrofit program by one of our automotive OEs.

That was planned to be a one-time volume, primarily in this year, this year's numbers.

The forecast we obtained from the OE, in this case, was not achieved, but a large percentage of it was, but we don't see at this point that number increasing.

This is strictly an after-market program and not a platform or first fed and it would not be reoccuring in any event.

Lowell, a question on manufacturing capacity for PowerCore.

Where are you versus where you want to be and where you would hope to go?

We have all the capacity we think we are going to need for the next year and a half in place.

The recent increase in it is going to be debugged starting next month so we will have plenty of capacity to handle PowerCore for the next two years.

Final question is on Ultrafilter.

Can you comment on where your profitability presently stands and what you would consider to be your 12 to 18 month outlook on the same scale?

This is Jim Giertz responding.

As you know, we don't really make a lot of specific comments about the margins of our business units.

But, I can tell you that we're still confident that we're making progress and the profitability of Ultrafilter.

Volume is going to help, our volumes are not as high as we want them to be right now and Ultrafilter, we had a slow start to the year, particularly in Europe.

But beyond that, I think we're in pretty good shape to produce the kind of profitability in that business that we expect when we acquired the business.

I think you have said in the past, as you went through last year, when you had to respond to some of the offsets to the loss in profitability from gas turbine that were you getting close to a double digit margin as you exited last fiscal year.

So perhaps with that context, could you shed any light?

Right, I think we're still operating within that framework, more or less.

Again, volume would really help.

It is not quite as good as the picture we had in the second half of last year, maybe, but our volumes are not as good, and we expect them to pick up.

So I think we're basically tracking on the guidance that we gave you at the end of last year.

So any further help that you're likely to see on the margin front is not going to come from either the way you purchase and/or the way you organize their activities, but it is going to be volume-driven.

I think in the short term, that's true.

And over the longer term, I mean there is many, many margin improvement opportunities for the Ultrafilter product line, and we will pursue those over time.

I mean that's a long-term gain, though.

Thank you very much.

Thanks.

Thank you.

Our next question is a follow-up from Charley Brady.

Please go ahead.

Thanks.

Just to get back, quickly, to the gross margin, as you see it going throughout the rest of '04, and comparing it to the first quarter, I guess, would you expect any improvement from what you had in the first quarter for the rest of the year or going into next year?

Or do you see it sticking flat to to where it was in the first quarter?

Charlie, Bill Cook here.

If you wanted to take a look at our gross margin performance from last year and use that for this year, for the full year, that would probably be pretty close.

Okay.

So for the full year of fiscal '03.

Right.

You would expect that to be equal for the full year '04?

'04 should be pretty close to that, right.

On a full year basis.

Right.

Okay.

Would that be for the operating line as well, on an operating profit?

No, the operating profit we would expect to improve.

Okay.

Thanks very much. 27% tax rate, any expected change there going forward?

This is Tom Windfeldt.

No we are expecting, right now, to finish the year with that, and we will have to wait and see for next year.

Okay.

You talked about hiring new people and you mentioned it was mostly sales people.

And I assume the comp structure for a sales person is more variable.

Correct me if I'm wrong on that.

So there is not the impact on the operating line by bringing on more personnel but is there on an engineering staff, clearly those people are probably salaried individual.

Are you bringing on more engineering staff, or are you just reallocated existing engineering resources to these new platforms?

This is Nick Priadka.

Actually, both.

We move people from certain areas of our business, including the other group, the industrial group as well as within engine, and we've added people on top of that.

As you know, that is where the activity is, when you're dealing with first fit customers.

You need to put that resource in.

We've got a lot of demand.

We've got a lot of new platform opportunities.

So we've put in a fair amount of engineering resource to deal with that.

Is it fair to say that probably mutes, to somewhat, some of the internal operational improvements, because you're having to bring on the staff to ramp up for the higher demand, and so that's why the - - excluding that, you could see better operating performance and that's maybe why it is not improving significantly year over year?

Or it is it just not material in tough make a difference.

Somebody said earlier, "did we cut back too far and is that why expenses are popping?".

And I think too far is the wrong characterization.

But we've been running lean for a couple of years, and as we came into this year, we could see many signs across the business of a change in the weather.

We were going to get some wind to our backs, and across the business, the different manager in the different business units, moved to get ready for that coming demand.

And so we've seen the expense level move, as I said, pretty much across the business.

It is not very mysterious.

We're going from a pretty defensive posture to a very conservatively offensive posture and there is a change in the expense structure as a result of it.

As I said earlier, we expect the revenue and the expenses to come into balance in the next quarter.

There's not a big story there.

Okay.

And then my final question, on the offroad performance, particularly Asia, European sales being up over 70% in the quarter, what's really driving that and what's sort of the sustainability of that type of robust growth going forward?

This is Nick Priadka.

I think , as he we all look to the Far East, and China in particular, there is an awful lot of industrial activity infrastructure development going on there.

And a lot of our offroad customer, particularly in Japan, are essentially taking advantage of that growth.

And so we see at least over the coming years, a fair amount of sustainability, if you will, in that offroad segment.

Very good.

Thanks very much.

Thank you.

Ladies and gentlemen, if there are any additional questions at this time, please press the star followed by the one and as a reminder, if you are using speaker phone equipment you will need to lift the hand set before pressing the numbers.

Our next question is from Richard Eastman.

Please state your company name followed by your question.

Hi.

Rich, could you just supply us with the FX impact by business segment, engine and industrial in the quarter?

Sure, Rick.

I was hoping somebody was going to ask that before we were done.

I'm preparing.

Okay.

For the quarter, starting with the engine segment, transportation, 2 million.

Offroad, 3.3 million.

After-market, 6.3 million.

Photo for engine segment, 11.6 million.

Industrial, gas turbine, 2.3 million.

Industrial,l air filtration, 3.4 million.

Special applications, 1 million.

Ultrafilter, 4.2 million.

Total, for industrial, is 10.9 million, which should total up to 22.5 million for the company in the second quarter.

Okay.

Thanks.

Thanks again.

Thank you.

Gentlemen, we have no additional questions at this time.

Please continue with any closing comments.

All right.

Let me close by underlining what I guess should be obvious, and that is that the continued progress that Donaldson is making, the strong result, more than anything reflect the capability and commitment of 9,000 people who signed up to play with us around the world.

So for all the shareholders I would like to take this opportunity to say thanks to all of them for a great performance.

We are going to close with that and thanks to all of you for your attention.

Ladies and gentlemen, this concludes the Donaldson second quarter 2004 earnings conference call.

If you would like to listen to a replay of today's conference, you may dial 1-800-405-2236.

Followed by access number 570571.

Once again, if you would like to listen to a replay of today's conference, you may dial 1-800-405-2236, followed by access number 570571.

Once again, we thank you for your participation.

And at this time, you may disconnect.