Donaldson Company Inc (DCI) 2004 Q3 法說會逐字稿

Ladies and gentlemen, welcome to the Donaldson third-quarter earnings call.

There'll be a Q&A session at the end of the presentation and instructions to queue up will be given at that time.

I would now like to turn the call over to Mr. Tom VerHage, Chief Financial Officer of the Donaldson Company.

Good morning and thank you, Joe.

As Joe said, I'm Tom VerHage, Donaldson's Chief Financial Officer.

We have a number of members of our management on the call again today ready to help you answer your questions at the end of our prepared remarks.

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

Bill Cook, Senior Vice President;

Nick Priadka, Senior Vice President of International; our two Business Unit Senior Vice Presidents, Lowell Schwab for Engine Products and Jim Giertz, Industrial and Commercial.

Also with us are Bill Vann, Vice President of Operations.

In addition, we have Tom Winfield, our Corporate Controller;

Norman Linnell, our General Counsel; and Rich Sheffer, who handles our Treasury and Investor Relations.

Before I start with our comments, I need to review our Safe Harbor policy.

Any statements in this call regarding our business that are not historical facts are forward-looking statements and our future results could differ materially from the forward-looking statements made today.

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

Now I would like to briefly review the financial highlights for the third quarter.

As you have read in our press release, our third quarter was again very strong as we turned in record sales and earnings and as we enter the final quarter of fiscal 2004 with backlogs up substantially over last year and near record levels, which creates confidence that we will deliver yet another year of double-digit earnings growth, which would be our 15th consecutive year.

At yesterday's market close we reported record third-quarter revenue totaling $371 million, which is up 23 percent from $303 million last year.

Year-to-date we reported record nine-month revenue of just over $1 billion, up 16 percent from $888 billion last year.

Moving to our bottom-line, we reported record third-quarter diluted net earnings per share of 33 cents, which is up 18 percent from 28 cents last year.

Year-to-date, diluted EPS is 89 cents per share, up 17 percent over last year.

Operating expenses were stronger in the third quarter than we had anticipated they would be.

Approximately one-third of the year-over-year increase is attributable to the weaker dollar compared to last year.

The balance of the increase came from expenses related to revenue growth such as higher selling expenses from various reserve and expense adjustments.

Some of these adjustments are not expected to recur in the fourth quarter.

As a result, we expect that operating expenses will decrease as a percentage of sales in comparison to the third quarter.

We also decreased the tax rate in the third quarter to 22.3 percent.

This one-time decrease came from extensive research and development tax credit study which identified $1.8 million of additional credit that we are entitled to take from prior years' research efforts.

We expect the tax rate to return to our typical 27 percent in the fourth quarter.

As we enter the fourth quarter, we see a continuation of the strong business conditions seen during the first nine months of the year.

And based on all of these factors, we expect again to deliver yet another full year record earnings and a double-digit increase in earnings per share over last year.

Now with that, I would like to introduce Bill Van Dyke.

Thanks, Tom.

If you have spent any time with our release from yesterday, you have seen that by far the most striking feature of our business today is the strength of our sales volume.

That strength has been building for several quarters and shows no sign of softening.

This is organic revenue growth and is currently running in excess of 20 percent year-over-year.

By some measure outstripping anything we've seen in the last ten years.

Sales are not only up but they have been increasing at an increasing rate for the last several quarters.

Our release offers some of the numbers and I want to draw your attention to some of those just to make a point.

As with last quarter, our ninety-day backlog, our forewarning of what is coming up next quarter, is very strong, up nearly 30 percent over prior year.

That strength is broadly based.

We are not just getting big sales numbers, but more importantly that growth has infected almost every market and productline across the business.

To illustrate, our third quarter sales show off-road up 24 percent; disk drive up 30 percent; our engine aftermarket the replacement parts business for diesel is up 29 percent; transportation products. 36 percent; membranes, 47 percent; compressors, 22 percent; hydraulics, 61 percent; pretty incredible numbers.

And the industrial filtration solutions effort, the combination of our Torit and DCE and Ultrafilter and industrial brands, up 12 percent after languishing for the last couple of years.

Even our gas turbine business, and for those of you who follow the company, you know it was pretty badly hammered last year with the collapse of the North American power generation market; even gas turbines saw third quarter sales flat, not down, with prior year and a 17 percent increase in the ninety-day backlog.

The point of taking you through all those numbers is not the specific numbers but to try to underline the pervasiveness of the sales increases of 20 percent and 30 percent and even more across the many largely unrelated end markets that we serve.

Our ninety-day backlog numbers across those markets show the same strength.

And that leaves us pretty optimistic about the near-term and really defines where we are focused, that is on capturing all of the opportunity that is available to us.

That's what drove up the revision in our revenue guidance that was included in the press release.

Our numbers also show that rapid growth can be a disorderly process, particularly as we continue our program of moving and consolidating and rationalizing our production capacity in the face of the strong demand increase.

It is hard work.

There are occasional setbacks, but we are really excited about the prospects for the future and have got great confidence that this organization is up to the challenge.

One other separate subject that I probably ought to allude to is a previously announced -- I guess it was close to a couple of months ago, management transition here that I will be retiring in 14 months.

I want to report that the day-to-day management of that transition to Bill Cook, who will be the new CEO, is going well, is on schedule and no upsets.

We don't see any issues coming at us and I want to reaffirm that the Donaldson Board and I have full confidence in Bill Cook's ability and the ability of this veteran management team that is assembled here to continue Donaldson's long record of success.

That's I think all I want to start out with here, Joe.

We will turn it over to questions now.

Thank you. (OPERATOR INSTRUCTIONS) Bill Benton.

Good morning.

Congratulations on a nice, strong sales quarter.

Just if you could talk maybe a little bit of the color on the aftermarket strength in engine in particular, which accelerated obviously nicely.

You cite not only utilization rates but you cite -- it sounds like some traction on some of the internal efforts and I was wondering if you could offer little bit of color on that and I have a couple of other questions.

This is Lowell Schwab.

Nick and the aftermarket group have been investing in growing that market for several years, so there is growth in virtually every channel in the aftermarket, in the engine aftermarket.

And it was also helped a little bit by some inventory corrections at some large customers where they had under ordered in prior quarters but the ongoing rate of order is at record levels in virtually every channel in the aftermarket right now.

Okay, is that a -- of the growth, how much it was related to maybe some of the internal efforts -- maybe gaining unusual traction, or have they been getting consistent traction there?

They've been getting consistent traction over time and quite a bit of the growth is actually due to internal efforts in the pure aftermarket channel.

Okay and then you cited non-recurring items.

I didn't know if you could help quantify what maybe some of the non-recurring items were in OPEX and with regard to the reduction in the percentage of sales expected in the next quarter, I presume that is relative to this recently reported quarter, not necessarily last year, if you could offer that?

This is Tom.

Let me take that on.

As we said, about one-third of the year-over-year operating expense increase is foreign currency related and it turns out as we analyze our mix of sales and operating expenses around the world that foreign currency actually had a bit of a more significant impact on operating expenses than it did on sales, which of course results in a bit of a dilutive effect on operating margin.

Of the other two-thirds of the increase, Bill, some of it of course is strictly volume related, with increased sales from increased selling expenses, some engineering expenses and some variable administrative expense increases.

But then also in that other two-thirds are some more one-time type adjustments that we do not expect to recur in the fourth quarter.

We're projecting a good year.

We have more visibility on the year than we did three months ago.

So we did adjust our incentive compensation accruals and then there were just a number of other adjustments that again we considered to be somewhat non-recurring that we took in the third quarter.

So as a result of that, when we look forward into the fourth quarter, I think that the guidance that we would provide is that the operating expenses as a percent of sales would drop back down to the level that they were at for the nine months ended April 30.

Okay and the biggest one-time adjustment might be catch-up on comp plans that are tied to the success?

Right.

Again as I mentioned we have better visibility for our earnings targets at the end of the year.

We made the appropriate adjustments at the end of the third quarter.

One quick final question.

The impact on margins from the commodity price increases that probably will be offset or maybe partially offset this next quarter, can you quantify any of that?

Yes, Bill.

We have had some offsetting issues wiggling around in the gross margin line.

There certainly are cost pressures.

You mentioned the steel price increases.

There's also some other commodity price increases.

We do intend to capture some of those steel price increases in the fourth quarter.

But also items like overtime, our plants are working very, very hard.

There is a lot of overtime being incurred and also we have some plants that are still ramping up and there's hiring costs, training costs, and the like.

So offsetting that are of course the favorable impact due to the absorption of fixed costs and our ongoing productivity improvement efforts.

So all of that sort of washed out to a very consistent margin for the quarter on a year-over-year basis.

And as we look forward to the fourth quarter, we once again think that if you take our nine-month results and the gross margin for the nine months, which I think is about 32 percent, that would be the guidance that we would provide for the fourth quarter.

So you don't necessarily expect it to go up from 32.4 this quarter, even given the maybe likely higher sales levels and maybe some reduction of the -- you maybe recapture some of the increased expenses there?

We will be recapturing some of the increases related to the steel price increases, but we don't think we are over yet with respect to the steel price increases.

There could be some more in the fourth quarter.

There's some other commodity price pressures, particularly related to anything that has petroleum-based products in it, so there is still a lot of moving parts.

And I think we feel comfortable with that guidance that the fourth quarter should shake out pretty comparable to where we were for the nine months.

Okay, thanks.

Good quarter.

Richard Eastman.

Lorraine Maikis of Merrill Lynch.

Just to follow up on that surcharge question, how much of the steel price increase were you able to pass along to your customers?

I will first toss that over to Lowell who will talk about the engine side of the business and then Jim Giertz who will cover the industrial side.

This is Lowell Schwab.

It depends a little bit by the market you're in but we expect to get a pretty high percentage of the steel price increases recovered.

There is a lag in that.

Generally there will be a two- to three-month lag between when the increases occur and when we recover them, but most of that lag happened in the third quarter.

So we would expect to see the recovery in place by the fourth quarter.

This is Jim Giertz.

I would just add for the Industrial Group pretty much the same answer.

We won't recover it all.

It depends on how we are selling a product.

If we sell to a customer on a quote, we can probably recover all or essentially all of the increase.

For situations where we have contractual relationships with OEMs or other large customers, we will not recover all the steel price increases immediately.

It will be a longer term effort.

Okay and I guess to take that one step further; it looks like your gross margins will be down sequentially to the 32 percent level.

If you are planning to receive back some of those steel surcharges, is it really the overtime tissue in Q4 that is bringing them down or what is the main reason for coming down sequentially?

Lorraine, this is Bill Van Dyke.

Let me just try to wrap up a bunch of the loose ends that we've talked about here.

We're projecting the gross margin flattish just because there are a lot of moving pieces and a lot of things we can't see.

We've got operating leverage helping us.

We expect that to be a positive in the fourth quarter, but we've got a lot of friction costs in ramping up our factories.

A 10 percent sales increase is near perfect but when we are looking at the kind of increases that we are experiencing, we get a lot of friction costs and that continues to be a variable in our future.

We have got uncertainty of supply, as well as the impact of cost on steel, and that is an area where there is a wide variety of opinions about what the impact is going to be.

And then we've got the ongoing rationalization costs; product transfers, new plant startups, consolidation, all of that.

The point of all that is there are a lot of moving pieces, there are a lot of balls in the air, and we think it is prudent to project the gross margin the way Tom called it rather than take a more optimistic view.

Okay, and then the plant rationalization costs, you have said that last quarter you expected about two cents in the second half.

Should we expect that to all come on in the fourth quarter?

I think that everything is behind us now and the fourth quarter should be pretty clean.

Okay and one bigger picture question.

For the '07 emissions regs, could you just update us on the status of your product for some of your customers to comply with those regulations?

This is Lowell Schwab.

We still think that we are on track to have a product that meets the '07 emission regulations and in fact we thin we're doing very well on that and have some real product advantages there.

So that will play out over the next year and a half, but we think we are in good shape and we are investing a lot of time and a lot of effort in growing that business and I might add the emissions business globally is up 100 percent over where it was a year ago.

So far we are on track to do what we said we were going to do.

Are any of your customers testing that product at this point?

The new product?

No, not yet.

Thank you very much.

Richard Eastman.

A couple things.

One is could you just circle back?

In the fourth quarter the guidance is pretty clear on the gross margin line but I presume some that there will be some absorption in leverage at the op expense line.

Do we end up with a better op profit margin in the fourth quarter than we did in the third quarter?

Richard, this is Tom VerHage again.

I think based on what I described before from where we expect our operating expenses to go, we do feel comfortable with looking at our year-to-date operating expenses through the nine months.

And something in that 21 to 21.3 percent range is something that we feel comfortable with.

And also in terms of -- could you give us an update if you would on PowerCore sales?

Can you give us a flavor for where those ran in the third quarter?

Yes, PowerCore sales in the third quarter were about the same as PowerCore sales the second quarter.

But year-over-year the PowerCore sales are up 50 percent and we are applying it on even a more broad basis than we have before.

We found it's a more flexible technology than we knew it was.

So there are 30 more programs where its been proposed and we would expect to do well on those.

Most of those will happen in F06 in our fiscal '06 and '07.

Just to update us there, you had been specing on 27 new ply forms in that '04 to '06 timeframe.

You had 22 bids out.

Have some of those bids been hit?

Is our new program number higher than 27?

The new program number is 28 but in reality most of the ones that were outstanding last quarter are still outstanding and in fact the number has gone from 22 to 30, so there's a lot of programs coming and a lot of the decisions will be made in the next year.

Just lastly, this retrofit market has been a little bit fits and starts.

Has that finally gotten into some consistent gear here?

Actually the demand for that has really picked up in the last quarter and we won't hit our annual sales number on that, but its mostly due to supply of cores for that product.

In reality the demand is there to make the annual -- to make the sales plan for that product and the demand is becoming more consistent every month.

Okay, and lastly the guidance, the fourth quarter guidance that you gave in the press release on the revenue line, I'm assuming that all includes currency?

Yes, that includes a flat currency from here through the fourth quarter.

Okay, great.

Thank you.

Kevin Monroe.

Good morning.

The tax credit, any particular reason why it was this quarter?

Yes.

Kevin, this is Tom VerHage.

Our tax department has really done an outstanding job.

They worked very, very hard on looking back at prior research and development expenses.

And this was a lengthy study and extensive study and that study culminated in the third quarter.

They identified expenses that are eligible for tax credits; calculated the amount that would be available to us; and because that information was available to us in the third quarter, we took the $1.8 million adjustment in the quarter.

That is a one-time adjustment.

As I mentioned before, we would expect just based on where we see the mix of income coming in from around the world, we would expect a return to this 27 percent rate for the fourth quarter.

And on the margins, your operating margins were down 120 basis points year-over-year.

Could you walk through what were the big drivers in terms of basis points that drove those margins down so much?

And what changes going forward?

I think, Kevin, I mentioned the key factors.

There are just simply a lot of offsetting factors, but the steel price increases for the third quarter did have a few tenths of a percentage point impact on the margins for the third quarter.

So that is the one that probably stands out, but the others and I mentioned earlier are pretty much offsetting.

So there is no individually significant items in there.

Okay and the final question is, in terms of your guidance in terms of fourth quarter margins, you are going to be down again year-over-year.

Where is the leverage in the model?

I think Bill Van Dyke covered that and once again there is ongoing rationalization expenses.

We are incurring a lot of overtime at the plants.

We are ramping up hiring.

And all of that adds a fair amount of cost pressure.

In addition, as I have pointed out before, we have not seen the end of the steel price increases and there's probably going to be some more of that coming at us in the fourth quarter.

So adding all of that up, we just feel comfortable with the guidance of something again in the range of what we have incurred on a year-to-date basis.

Okay, thank you.

Mike Jorinski (ph) .

I just wanted to try to run through a little bit of this to make sure I understand it.

On the revenue line and I think you answered this when you mentioned 10 percent greater sales as you historically see it.

You are probably looking at about 410 on the revenue?

For the fourth quarter you mean?

Yes.

That would be a great quarter, wouldn't it?

That's kind of in line there and you did say 10 percent.

I'm having trouble with the 10 percent.

He said something about 10 percent more sales growth in one of the comments earlier and that is your historical seasonal pattern that the fourth quarter is about up 10 percent.

And it also dovetails with looking at backlog, ninety-day backlog translating into next quarter revenue.

Is that an achievable number?

I think 410 would be a very strong quarter.

It could happen.

We are expecting something less than that.

Okay, and just on the operating expense line, in reading through the announcement it sounded like you were implying that on a dollar basis it was going to go down, but now maybe I'm hearing differently, that we might actually see dollar basis dollar spending up from the third quarter?

The point we were trying to get across, Mike, is once again operating expenses as a percent of sales, so again I think the rate that we have been running through the first nine months of the year would be a good target to use for the fourth quarter as a percent of sales.

So it sounds like your variable costs are a much greater percentage than the one-timers that we might see the benefits on.

Is that correct?

Yes, the one-time items that came up in the third quarter pretty much all went against us and we just expect that we won't see that level of one-time type costs in the fourth quarter.

Okay, thank you very much.

Charlie Brady.

Could you just comment on the gas turbine business?

Obviously the growth is better-than-expected or its not down or worse than expected and it is coming up from overseas.

Is it mostly all replacements like market or has there been more of an uptick in new builds in Asia?

Could you comment also on any more color on getting PowerCore into the power generation marketplace?

Okay, sure.

First of all, we said in our press release that gas turbine sales were flat in the third quarter.

I just want to take exception to that.

We were actually up 0.4 percent and that is an important distinction because that's the first time we've actually been up year-over-year in a quarter for a very long time.

So it's something that we are quite happy about.

We are going to be up again in the fourth quarter over the prior fourth quarter by 10 percent or so.

I think the message is we are starting to get -- I think it's the bottom.

We are forecasting the bottom here.

Our gas turbine business is going to go higher from here.

And I think you asked me why.

It's a lot of things, a lot of small things.

Our aftermarket business is up.

We've done some business in Iraq.

The Middle East is in general pretty strong.

We've had some improved customer relationships that we have worked hard on, gotten some new business from some customers that have not been our core customers in the past.

The Asian market is stronger.

So it's many things, but in general the tone of businesses much better.

Now at PowerCore, we continue to launch our new product family called XLR, which is PowerCore for the gas turbine market.

The status is mostly the same from what we talked about last quarter.

We have shipped our first units now in the third quarter into the Middle East and continue to ship in the fourth quarter additional units.

And I think we have about six or seven firm quotations outstanding right now in that productline.

And just shifting gears a little bit.

On the ramp up of getting new people in, is there any issue as far as hiring people, the quality people you want to get into or are you finding enough able bodies out there?

We have ample supply of labor and it's just a matter of training and getting these people on board.

Okay, I will get back in the queue.

Thanks.

James Gentile.

Good morning.

I was actually going to ask you some questions on the gas turbine business, but those have already been answered.

Good quarter.

Bill Benton.

Just maybe a follow up on a couple of items.

Could you talk about your sales through the quarter?

Were they pretty consistent or do they strengthen.

And in conjunction with that, did you end the quarter with higher or lower gross margins than the beginning of the quarter?

Bill, I will first toss it over to Lowell who will talk on the engine side and then Jim Giertz, who will discuss the industrial side of our business.

Sales were in the aftermarket channel were up throughout the quarter.

Actually we were shipping at highest rate in the last month of quarter than we've ever -- in fact the last two months were records in the aftermarket.

So very high levels and the rate is not showing any signs of backing off there.

The original equipment markets are a little flatter.

Fourth quarter looks like it will be compared to third but you have to remember that historically the third quarter is our strongest quarter, so for the backlog to look as good as they do in fourth quarter is pretty terrific for us.

Our business levels look very good.

Okay.

For the industrial group, it is a little harder to answer the question.

If you look at our aftermarket business, our daily sales in our aftermarket-related businesses either in Torit, dust collection or gas turbine is a clear, stable uptrend of our daily sales in aftermarket products.

So we can see.

The equipment business is so lumpy that it's really hard to get a pattern I would say.

Okay and then again, I know everyone has asked and I don't mean to beat a dead horse on the gross margins, but I think you said you expect that operating margins to be up in the quarter and with the higher sales up, you get some leverage on the operating expenses, but on the average basis it's probably a little bit -- for the operating margins to be up it feels like you are being very conservative on the gross margin assumption going down to 32 percent.

And I know that's not out of character but I just want to understand -- you do expect the operating margins to go up sequentially and you obviously would have to anticipate all of that and more to be at the operating margin line?

Bill, I will just loop back.

I hope you're right.

I hope we are conservative on the gross margin line, but just to reemphasize what we said before, there really are a lot of items going around in cost of sales, commodity price increases, overtime.

And we are getting the benefit from the increased volumes from a fixed cost absorption standpoint and our ongoing productivity improvement efforts.

But I think to get any more precise than that for the fourth quarter just given the complexity of our global business would maybe not be the right thing to do at this point.

Right.

The earlier question, did your gross margin actually end higher at the end of the quarter than the beginning?

Actually, Bill, I think they were fairly constant during the quarter and as we look at it from a month-to-month basis.

And then a question just on inventory levels and capacity across the engine group, you feel good about where things are at in terms of availability and being able to meet customer needs right now?

Are you missing anything?

I mean the sales are obviously tremendous, that's why I'm asking.

I think our plants have done a wonderful job of adjusting to the volume.

Bill Vann didn't say this earlier but the metal plants that serve the OEM customers, ramping up is very hard work and they've done a wonderful job.

The thing I would say -- the biggest concern we have is steel.

We're still struggling to get all the steel we need.

So far we've been very fortunate and the purchasing people have done a great job.

But we think we will succeed but steel is still is in very short supply in some grades and we are really having to work hard to support these volumes and just getting material.

Great, thanks.

I am glad Jim Giertz caught the gas turbine being up.

I thought I was the only one.

Quick question on in Europe.

It's the weakest performing of the business in the portfolio.

Can you talk about if any of the increased backlog that you're seeing is in Europe either dust collection or Ultrafilter?

First the gas turbine business in Europe is actually very strong.

It's not just translation the gas turbine business generally in Europe and the Middle East where we cover that region is very strong.

Yes, in the industrial businesses, Torit, DCE and Ultrafilter, it's been a tough year in the industrial markets in Europe, mostly because they've had a very slow start and I can tell you that every month is improving.

Our backlog in Torit and DCE products in Europe is I think 60 to 70 percent higher than it was in August of the prior year.

So every month we are improving.

The last six months in a row our order patterns have been higher than the prior year in our torrid DCE product lines.

So we had a very slow start.

We feel pretty confident that we've got momentum coming back to that market and we will steadily improve through the end of the year and into next year.

And Ultrafilter, where are you in getting that business up to Donaldson type margins?

It's still in process.

We have had a lot of -- we've spent a lot of energy on consolidating and reorganizing our businesses, forming the ISS (ph) with the industrial filtration solutions group, pulling toward DCE and Ultrafilter into a single organization.

That's been particularly challenging in Europe and there has been some cost associated with that.

But in general, we are progressing and on a steady pace to earn the margins in that business that we originally forecast when we made the acquisition.

Okay, thank you very much.

Charlie Brady.

Thanks.

Just to get back on -- you touched a little bit on the steel costs as far as being able to procure it.

Are you seeing any significant push out in lead times in getting that equipment?

I know it is scarce to begin with but the stuff you are getting, is it taking longer to get it?

We're finding because we had such strong relationships with our steel suppliers that we are able to get steel.

We do have a very significant shortage in Europe and the NAFTA countries but we're still able to procure the steel.

Yes, it's difficult to get and we are experiencing higher freight costs but we are procuring.

Thanks and back on the expenses in the third quarter, a third of it is the FX and the rest relates to a bunch of different stuff.

How much of the other two thirds relates to the incentive accruals?

Charlie, this is Tom.

We generally don't give out those specific numbers, but I can just tell you that it is a little bit difficult to separate out what is truly one-time related from other costs.

And I think as you maybe know Donaldson doesn't report income adjusted for special or non-recurring items, so what might be non-recurring or one-time for us might be something else for somebody else.

So it was a pretty significant portion that we do not expect to reoccur in the fourth quarter.

Okay, thanks.

(OPERATOR INSTRUCTIONS) It looks like we have no further questions or comments.

Okay.

Let me close then by once again acknowledging what ought to be obvious, and that is we've got 10,000 people working for this company around the world and these results of which we're pretty proud are the result of all of those people and the commitment and some really, really extraordinary performance over a long period of time.

And I want to again express my gratitude and appreciation for that work.

And with that, we will thank you all for your participation this morning and sign off.

Ladies and gentlemen, that now concludes the presentation for today.

Thank you for attending.

You may now disconnect.