Donaldson Company Inc (DCI) 2005 Q1 法說會逐字稿

Ladies and gentlemen, welcome to the Donaldson Company first quarter earnings call.

There will be a question-and-answer session at the end of the presentation, and instructions to queue up will be given at that time.

I'd like to now turn the time over to Tom VerHage, Chief Financial Officer of the Donaldson Company.

Please go ahead.

Good morning and thank you, Ben.

As Ben said, I am Tom VerHage, Donaldson's Chief Financial Officer.

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

Those present include Bill Van Dyke, our Chairman;

Bill Cook, President and Chief Executive Officer; our two business unit Senior Vice Presidents, Lowell Schwab, for Engine Products; and Jim Giertz, Industrial and Commercial;

Nick Priadka, Senior Vice President of International;

Bill Vann, Vice President of Operations.

And also with us are Norm Linnell, our general counsel; and Rich Sheffer who handles 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'd like to briefly review the financial highlights from our first quarter.

As you read in our press release, first quarter sales were a record $373 million, up 14 percent, with all of our product lines reporting double-digit increases with the exception of gas turbine, which had a 15 percent revenue decrease for the quarter.

Customer delays on two orders, scheduled and ready for shipment in October, resulted in $4 million of sales slipping from our first quarter to our second quarter.

As noted in our press release, our first quarter gross margin was 31.2 percent.

We dealt with multiple commodity price increases, with steel being by far the most significant.

Year-over-year steel prices were up 8 to $9 million in the quarter.

And we estimate that we recovered roughly half of that increase from our customers.

Unrecovered steel price increases cost us in excess of a full point at gross margin buying.

As Bill Cook will discuss in his comments, there are plans for new prices to fully reflect current commodity costs by the end of our second quarter, and for our second-half gross margin to approximate our gross margin of the last two years.

While the steel price increase was the major driver of our margin for the quarter, I need to emphasize that we have a complex business model and we produce and sell many different products in multiple currencies.

In addition, there can be product mix changes that are significant on a quarterly basis.

Some of our products have a significant steel component and some have none.

So while steel prices were the major event impacting our margins in the first quarter, they are not and will not be the sole driver of fluctuations in our gross margin.

Operating expenses were in line with our expectations, coming in at 21.5 percent of sales.

So absent the steel costs, the business is running very well when considering the strong revenue and expenses that are in line with expectations.

We saw a year-over-year increase in interest expense, as debt levels are higher following our repurchase of 3 million shares of our stock.

Other income was also higher compared to last year.

We had a foreign exchange gain this quarter versus a loss last year.

We had higher joint venture income, and we had some other miscellaneous items that accounted for the increase.

As I mentioned, we repurchased 3 million shares in the quarter through the overnight share repurchase that we announced in early September.

This transaction was accretive in the quarter by a penny per share.

And just one other item of note is the improvement in free cash flow this quarter.

Free cash flow totaled $34 million, or 125 percent of net income, which is a dramatic improvement from $9 million last year.

This year working capital generated $5 million of cash in the quarter, whereas last year working capital used $17 million of cash.

And now I would like to introduce Bill Cook, who will discuss our outlook and the business conditions shaping that view.

Bill?

Thanks, Tom.

And again, good morning to all of you.

So what is our first quarter story?

In so many ways our first quarter was the quarter we've been waiting for, for at least a couple of years, as it captured so many of the good things that come with a strong industrial recovery.

We saw broad-based strength across almost all of our businesses, which resulted in strong sales, up 45 million, or 14 percent, and a new first quarter record.

We had good operating leverage in our plants from the higher volumes, and as Tom mentioned, we had our operating expenses well under control.

So overall this was set up to be the quarter where we should have enjoyed some of the fruits of our hard work of the last couple of years.

So what happened?

In one word, steel.

While we set records for both revenues and profits, we didn't get the level of profitability that we expected because of the explosion in steel prices.

I'd like to take a few minutes to outline why the steel had the impact that it did.

First, it's important to explain that what has happened in the steel market over the past year has driven a major paradigm shift in our customer relationships and how we jointly view the world.

For many years Donaldson operated in an environment where our major OEM customers expected and received annual price decreases, and we have been successful at delivering on these decreases while growing our business and protecting our margins.

This very recent and dramatic rise in steel prices changed all that.

We had to wrestle with first shifting within our own company, then with our customers, from this price decrease mentality to an expectation and acceptance of price increases.

The next issue we wrestled with was whether the steel price increases were temporary, as first thought, or really permanent.

And there was a sense of denial that this was really happening or that it would last.

However, both our customers and we now realize that the new steel prices will be here for awhile.

And finally, we struggled with implementation, with implementing the very complex administrative processing required to recover these steel price increases from our customers.

And these processing requirements varied from customer to customer.

Working through both these attitudinal and process changes translated into a lot of time lost before our recovery efforts began to pay off.

And this time lag issue hit us hard in the first quarter.

At the start of this fiscal year our steel prices on a global basis had increased about 25 percent over the previous year, with the majority of that increase occurring last spring.

Prices did seem to stabilize during our fourth quarter while we made progress in recovering the increases via mostly temporary surcharges.

So, again, we started this fiscal year and we felt that we were in pretty good shape.

However, in August and September we saw another very significant spike in steel prices, doubling the year-over-year impact to nearly $3 million per month.

So that's what happened.

We worked this issue hard over the past three months and have now turned the situation around.

For example, new engine aftermarket prices went into effect on November 1st.

And we're on a time line with our major OEM engine customers to have updated prices or surcharges in place before the end of January.

Our second quarter shipments of industrial filtration products will have the steel increases fully covered, and in our gas turbine business, the 2004 contracts which were based on old steel pricing, will be expiring within the month and we'll bill future sales at the updated steel costs.

So by the end of our second quarter, we will have implemented all of our price recovery initiatives.

What does this mean from a gross margin perspective?

Well, first we expect that we will regain in our second quarter about half of our first quarter gross margin slippage, and that then gross margins for the rest of the year will be on target, approximately 32 percent or in line with our performance over the last two years.

So we believe that we now have the steel cost issue firmly in hand and while price recovery activity remains intense, our focus is now shifting to the strong pace of our markets and the opportunity that they bring.

We had record in coming orders in October, and our 90-day backlog is up 38 million, or 20 percent over last year with almost all of our businesses reporting year-over-year increases.

We are very confident of our revenue forecast for the year, with at least a low teen percent increase on both sides of our business.

This means that our full-year revenues should be around 1.6 billion, which would be up about 200 million over this year, and another revenue record.

As we discussed in our press release, business conditions remain strong.

The build rates at our NAFTA truck customers are forecasted to continue to increase and we continue to gain share in the truck market in both Europe and Asia.

Our off-road business is strong globally and conditions remained favorable as the agriculture, construction, and mining end markets remain robust around the world.

Momentum is also strong in our engine aftermarket parts business.

We continue to add new distribution around the world and our new North American emissions business is continuing to grow.

We also have more good news on our new PowerCore technology.

We added another PowerCore win during the quarter, which brings our total to 31 different customer programs won with PowerCore filters.

Further evidence of the power of PowerCore is that we saw a 45 percent increase in PowerCore replacement filter sales during the quarter.

Switching to our industrial businesses, order backlogs for industrial filtration solutions are up 27 percent as the industrial economy in Asia continues to boom and the North American rebound continues.

And finally disk drive filter sales reflect a continued strong market and more share gains.

In summary, we are enjoying great economic conditions in almost all of our businesses.

And as I look inside our company, I'm very excited by many things I see: record incoming orders, very strong backlogs, our continued PowerCore filter successes, our emerging emissions business, and at how well our plants are running.

The one cloud in the picture has been steel prices.

Things are running very well except for the steel issue, and we will have this issue fixed in our second quarter.

And then a clearer picture of how well this company is operating will emerge.

The bottom line, I am confident that we are on track to achieve our goal to deliver our 16th consecutive earnings record.

Ben, that concludes my remarks, and now we'll open the call up to your questions.

[Operator Instructions].

Lorraine Maikis, Merrill Lynch.

Just wanted to talk a little bit about the 32 percent margin assumption for the second half.

What does that include in terms of steel pricing and how could increases or decreases in prices affect your results going forward?

Lorraine, this is Tom.

The 32 percent assumption for the second half of the year assumes that we will pretty much have fully recovered the steel cost increases that we've received to date.

I do need to point out, as I mentioned in my opening remarks, though, that there's a lot of other items that could impact gross margin for the second half of the year.

We're starting to experience some commodity price increases in plastics, freight, packaging, and there's just a whole lot of other moving parts.

Furthermore, we are receiving some very favorable fixed cost absorption in our plants.

So the 32 percent is comparable to what we experienced in the last couple of years, and that's our projection at this point for the second half of the year.

Lorraine, one part of your question is around future increases.

This is Bill Cook.

And I think I just want to comment that the process that we worked through this last quarter we have compressed the recovery time for any future increases.

So the time lag that we talked about, while there will always be a little bit of lag, it won't be like the first quarter, if there are any further increases.

We've got the processes in place to get the recovery a lot quicker.

Great.

And the strength in industrial filtration, was there a specific industry that you're selling to that's really recovered, or was it more broad-based?

Jim Giertz will take that question.

I guess my answer would be it's very broad-based.

I think we're seeing strength really across industries and across all of our regions, so I would say it's very broad-based.

Okay.

Finally, could you give us the local currency gains for each of your segments?

Sure.

Lorraine this is Rich Sheffer.

Starting in the engine business, the translation effect on the transportation business was 600,000.

In the off-road market, it was 1.7 million.

In aftermarket it was 3.1 million, for a total of 5.4 million for the engine business.

The industrial side, 3.9 million for industrial filtration solutions, 800,000 for gas turbine, 400,000 for special applications, so 5.1 million for industrial.

And the total of 10.6 million for the corporation.

Thanks.

And then one final question.

Could you just give us a little bit more detail on the gas turbine outlook?

Are you certain that some of those sales will come in in the second quarter, and then what should we expect for the second half?

Sure, this is Jim Giertz responding.

Our outlook for gas turbine is really quite similar to what it was in the fourth quarter, or three months ago when we talked.

For the full year we're expecting our gas turbine revenue to be about 120 million, which is just slightly up from prior year.

And over the last three months our outlook has pretty much been unchanged.

I think that in general, the gas turbine market is a little bit stronger, particularly the oil and gas related applications for gas turbines is showing some strength, and also geographically the Middle East in general is a strong market, and the Asian market is also strong.

So we're seeing some -- we're seeing some pickup or some pockets of strength in the market.

The reason our outlook is flat is because last year we had a significant piece of revenue that came in from Iraq projects that won't be replaced -- well, we need to replace with other business this year.

So we think that without the Iraq business this year, staying flat really indicates that there's some kind of underlying better tone in the gas turbine industry overall.

Thank you very much.

Bill Benton.

Good morning, guys.

Quick question I guess on the aftermarket side of the business.

It looked like the Asian piece of that business slowed pretty significantly sequentially, and Europe also slowed a little bit.

Is there anything to that, or are there tougher comparisons or other items going on there?

This is Lowell Schwab .

We looked into the Asia increase of 3 percent, and actually the bulk of the issue is in our southeast Asia area.

We have a very high seasonality in the fourth quarter of the year, and the business tends to be a little volatile in the first quarter of our fiscal year.

So if you take that out of there, actually all the other regions are up, you know, decently, so the volatility and seasonality of the southeast Asian area is all of that reason.

In Europe, I believe the aftermarket business is actually doing well, and they expect to have a good year.

Okay.

So it sounds like maybe something -- then a good quarter in southeast Asia last year, that may be a slip between quarters?

Right.

Okay.

And then could you just maybe, in terms of you talked about recapturing a significant portion of the commodity cost faster, what percentage of your pricing right now is indexed, or your purchasing from customers right now is indexed to steel or some other commodity cost?

Lowell Schwab will address that question for engine, and Jim will for industrial.

I would say about 40 to 50 percent of our pricing is directly indexed.

We have situations with several major customers where we have a variable surcharge that's calculated based on the actual steel cost in the month.

The rest of the customers either get price increases or go off a general price list increase, and for those the lag is somewhere between one and three months, depending on how long it takes to implement it.

But as far as the customers where we do have indexed, it's not indexed prices, it's indexed surcharges.

We've consciously -- Bill Cook here -- we've consciously moved more of it to the indexing over the last quarter because of the volatility of the steel, just in case there's further movement, that will help us.

Okay.

From the industrial side of the business -- this is Jim Giertz, it was quite a different situation.

We used very little indexing.

In our gas turbine business where we're working in stainless steel we'll use indexing, but that's a relatively small portion of our business.

But we rely on being able to change list prices.

Most of our Torit DCE and Ultrafilter business is sold off of a list price, so we're relying on our ability to adjust our list prices in a timely manner to recover steel prices.

Okay.

And then a quick question, I guess on your outlook, low teens.

Are you able to comment, I guess, what percentage of that may be related to currency, volume, and price increases as it stands now, and maybe tied in with that -- I mean does your backlog figure right now, as you look at it, I presume that includes pricing adjustments as you kind of walk through earlier.

Is that a fair statement?

Bill, this is Tom.

I can tell you that approximately 3 percentage points of that backlog increase relates to foreign currency translation.

Okay.

And the outlook on the low teens kind of -- is there a -- any color you can offer in terms of the components there?

In terms of volume and price increase?

Most of it's real volume because we're not -- we don't forecast what's going to happen with the dollar -- or any changes to the dollar from where it is now.

So most of it is real volume, Bill, and then there's a little bit of the pricing, as we discussed, but we haven't broken it out into the pieces.

We'll be updating our revenue forecast as we get through the second quarter, and we'll have a better view of how the second half of the year is going to look.

Okay.

Final question is I guess one of your competitors announced a deal I guess with Caterpillar dealers in the quarter on an aftermarket program.

Have you seen any impact from that, or kind of what are your general thoughts on that?

Actually, our understanding is that's not a new program, and the official announcement may have some significance, but we have not seen any loss of business because of that.

Okay.

So that program has been in the market for how long do you think you've been competing against that program?

As far as we know, 18 months or so.

Okay.

Great, guys.

Thanks a lot.

Thanks, Bill.

Kevin Monroe.

Good morning.

Good morning, Kevin.

You talked about raising prices to recoup the steel and the change in the mentality of your customers from previously getting price declines no now accepting these increases.

What's been the reaction of your customers?

I'll start generally, Kevin, Bill Cook here, and then I'll let Lowell and Jim comment as well.

I think -- as I mentioned in my remarks, that there was really that mentality changes both inside our company and with our customers.

I think last spring there was sort of a hope or a sense of denial that the steel prices would go back down and that we wouldn't have to do anything, and we had lot of customers pushing back based on their premise that it was also a temporary thing.

I think since probably August everybody realizes that the steel pricing is going to be here for awhile, so I think there's -- while they're not welcoming us with open arms, okay, for price increases, there's a general level of understanding and acceptance that they're going to have to pony up in order to -- in order to continue to get supplied.

Secondly, the business is very strong, so in general there -- they're mostly pretty interested in making sure they ensure their source of supply.

So even though we still have very difficult negotiations with them, and there's a lot of push-back, in general we've been able to do what we have to do, and our plants have done such a good job of supplying the customers that they do know that we are reliable supplier and they do value our support.

Okay.

And another question you mentioned some plastic and freight is also appearing, I guess, as cost head winds.

Do you see these -- what are the trends there?

Are things getting worse?

Are things stabilizing?

What's going on with those two issues?

Kevin, we've noticed those costs increase in the first quarter, primarily in the second half of first quarter, and clearly not as significant as steel price increases.

So where they go from here, we don't know.

Anything that's petroleum based will likely increase for awhile, but we just don't know what the real impact on our margins might be as a result of those commodity price increases.

Okay.

And maybe kind of a nit-picking question, in terms of the other income line, what can we expect from that going forward?

You had a decent amount of benefit this quarter.

Is that something we can expect going forward, or is that going to fluctuate?

Kevin, this is Rich.

It's a difficult one to forecast, because you do have generally kind of unusual items that flow through there.

This time we had a larger foreign currency gain versus a loss last year.

Trying to predict that, you know, is like trying to predict where the currency markets are going to go, and we'd be doing different things if we could do that.

Right.

So it's probably going forward, our best estimate it's going to mimic historical levels for the most part.

Okay.

Thank you.

[Operator Instructions].

Richard Eastman.

Hi.

Just a couple of things.

One, was there any reclassifying of sales from the specialty applications to the industrial filtration piece?

Did you move anything?

Rick, this is Tom.

No, we didn't.

I'm going to correct that.

Rich is going to correct that statement.

Rick, there was a couple of things that moved out of the special applications.

Okay.

Our -- last year, industrial hydraulic was reported through special applications.

That's now been combined with our industrial filtration solutions business.

So we had some movement there.

We also, through another reorganization, combined our aircraft filtration business with our defense unit, which rolls up through the off-road in the engine business.

My intent is to put an attachment on our website, in the Investor Relations portion of our website, restating last year's revenues based on this year's reporting relationships.

Okay.

And just -- can you repeat, where did the aircraft filtration sales fall?

They went from aftermarket up to off road?

No, they went from special applications to off road.

Okay.

And then I just have a -- we'll look for that.

Do you think you'll get to that today or this week?

My intention is that before the end of the day we should have this things posted, it's a matter of what's your definition of the end the day.

That's close enough.

That's good.

And then secondly, I also had a question.

I just want to circle back for a minute to the incremental gross margin, and the leverage that you're getting.

I think the comment was made earlier that you're getting good fixed cost absorption in the plants.

If I go and add, you know, 50 basis points or -- put it this way.

If I add 100 basis points to your gross margin and I look at the incremental gross margin year-over-year, we still see a number that looks like 30 percent, you know, relative to your reported gross margin of 31 and change.

Right.

And I guess I don't see the fixed cost absorption, and I'm wondering where, you know, is there -- if it's a mix issue, what is that, and if it's -- you know, is it the other raw material costs absorbing some of that, or why is that number not 400 basis points better.

Rick, this is Tom.

Our margin for the quarter was 31.2 percent, and we estimated that the impact of the steel pricing that we did not recover is about -- that we did not recover is about 1.1 percent.

So that gets us over 32 percent, about 32.3 percent, which actually does compare relatively favorably with last year's 31.8 percent.

So there's no question that the spending in the plants is under control, and we are getting good fixed cost absorption leverage there, but there's a lot of other things, Rick.

There's mix changes.

We had at least on the engine side, a much higher proportion of our sales had steel related components in them in the first quarter.

That had an impact, and then there's -- I mentioned the other commodity price increases earlier.

Okay.

Because what should we -- the way I would do the math, and I understand what you're doing, but if I say 1 percent was steel in the quarter, that adds maybe 3.7 million to your gross margin, and I look at the incremental margin year-over-year, again, I'm coming up with like 30 percent -- a little over 30 percent.

So, you know, I'm sitting back saying, look, the incremental 44 million of sales is coming in at, you know, a 30 percent gross margin, even adjusted for steel, that's -- you know, that's the part that's confusing to me.

I'm not seeing the overhead absorption, so you're suggesting maybe that's mix?

There's mix, Rick, there's the other commodity price increases that I mentioned before, there's currency fluctuations, as I mentioned, we make products in one currency and sell them in another currency.

So there's really -- there's really a lot going on, and finally, as you know, in the U.S., we're on the LIFO method of accounting, and all of that inflation drops through our income statement before we get the sales.

And that gives us a bit more of a conservative number as well.

And let me just -- I guess you're probably accounting for this, but just to talk for a second about the LIFO accounting, our backlog, then, as we roll through our 90-day backlog, you've accounted for in that your gross margin guidance, and presumably as we roll through our total backlog you've accounted for the margin on that in your second-half guidance, I presume.

Is that --?

Yeah, yeah, we have considered the backlog and steel price recoveries, and these other matters that I mentioned in our projection for the second-half gross margin rate.

Okay.

Very good.

Thank you.

Brandon Marona [ph].

Couple of quick questions.

In the earnings release you talked about freight cost.

Is that -- and how they're higher and hurting margins.

Are the price increases going to capture some of that increased freight cost also?

This is Tom.

Yeah, we're rolling up all of the commodity and other related cost increases and the intent is to capture them over time in our price increases.

Okay.

And then just one quick cleanup item on the other income that you spoke about before.

Can you break out where that 3.4 million comes from between FX income, JV, and miscellaneous?

Yeah, this is Rich Sheffer.

About half of it is coming from the pickup in the currency gain.

Okay.

We had another few hundred thousand coming through the increase in JV income versus last year, then the balance would have been the miscellaneous items.

Okay.

Thank you.

Thanks, Brandon.

[Operator Instructions].

Dana Walker.

Good morning.

Could you talk about your operating expense experience and in a strong environment like this, why you wouldn't be seeking to strike some leverage?

This is Tom, Dana.

Our operating expenses in the quarter were about 21.5 percent of sales, which is down slightly from 21.6 last year.

Foreign currency was a component of that, and, of course, there's certainly an element to the operating expenses that are variable to sales growth.

And then we had some other items running through the quarter.

We're starting to incur some Sarbanes-Oxley related costs and the like, so the 21.5 percent is in line with our guidance that we've provided for the year.

Would it be a normal expectation, though, in an improved revenue environment to see leverage on operating expenses, and as we enter the second half of the year, should that be an expectation, or should that not?

Well, we generally don't project improvement -- year-over-year improvements in ratios like that.

If they happen, great.

It's something that we strive for.

But at this point our guidance on operating expenses is something in the range of 21 to 21.5 percent for the year.

Okay.

Your membrane business was very strong in the quarter, small business, but what's it worth there?

Jim Giertz will take that question.

The membrane business was strong really in all three of the regions that we operate in.

The bulk of the revenue in that business comes from industrial filtration applications and that particular market was very strong.

In all three regions, Asia, Europe, and the Americas.

The comment that you gentlemen made earlier about PowerCore and a new OE, can you talk more expansively about PowerCore and what's happening on the first fit side of that, as well as perhaps some amplified comments on the replacement market that were mentioned in the press release?

This is Lowell Schwab.

PowerCore continues to do very well.

We have it proposed on 45 more platforms.

We think those will close over the next one to two years.

We have, I believe 18 platforms in production of the 31 that we have been awarded, so the other 13 will we implemented over the course of the next 12 to 18 months.

Actually, 6 to 18 months.

So there's a lot of growth potential there.

We expect more light vehicle platform wins there.

It provides a superior product for small diesel engines that have a high air intake capacity and in the space that it requires there is -- there is no competitive product, so it is a terrific product for us, we're starting to see the growth in the aftermarket.

If you were to go back to how radial seal grew back in the 90s I think would you say that the real explosions in the element growth really happened about the fifth or sixth year of the program.

So we're still two years away from the real explosion, based on the number of holds we've put out there, but PowerCore is doing at least as well as we could have hoped, and we're getting better at the technology all the time.

The gross margin guidance of 32 in the back half of the year and the comments about Q2, are you suggesting that you would hope to navigate half the difference of the 31.2 to 32 in the second quarter?

That's right.

If you look -- this is Tom.

If you look at the steel recovery issue alone, we would expect to recover roughly half of the 1.1 percent dilution that we experienced in the first quarter, roughly half of that would be recovered in the second quarter, and hopefully all of it in the last half of the year.

Final question.

You provide segment data concurrent with the press release for the first time.

It appears that you leveraged in industrial, you didn't leverage in engine, and the corporate and unallocated number is quite a bit higher than prior year.

Any thoughts there would be helpful.

Yeah, this is Tom, and Rich will comment on the unallocated costs.

Dana, on the unallocated costs, a piece of that is the higher interest expense and the year-over-year gain, so that accounted for about a million of the pickup.

Most of the balance of that has to do with higher inter-company activity that under segment reporting rules doesn't get eliminated from a segment standpoint, but does on a consolidated basis.

So that accounted for about another 1.7 of the increase.

So that pretty much are the two big items that make up that increase in the corporate and unallocated.

Very well.

Thank you.

[Operator Instructions].

Dick Henderson.

Yes, I had a quick question on the recapturing of the raw material increases.

Besides increasing prices and renegotiating contracts, what are you doing internally to offset these increases?

Dick, Bill Cook.

I'll start.

I think as we talked in the past, we have very aggressive internal cost reduction programs underway which we're getting traction on which are helping to offset -- and helping to offset that time lag, but we didn't see much of that in the first quarter.

I'll turn it over to Bill Vann to talk from our manufacturing plants some of the things that are going on there.

Dick, we have annual cost reduction plans at all of our manufacturing plants in the area of about a million dollars a piece or more and we're recovering these at a pretty solid pace.

I think to date we're at a 43 percent pace overall.

One other quick question.

Is that the growth expectations of Europe continue to come down, and given the decline of the dollar, it suggests that they'll continue to come down, the growth expectations for western Europe, and you guys are talking about the broad-based recovery.

Do you see any of that, or is that -- could you just comment?

Nick Priadka will take that question.

Yes, I can comment a bit on what's happening in Europe.

Our business level in Europe continues to be strong.

Our year to year backlog change is in the level of about 15 percent versus last year, so we're up.

At the same time we're seeing some softening in the German economy which is evident, but the overall growth rate in Europe continues to be positive, and as we've gained share there we offset some of that economic softening that we've seen.

So outlook looks good in Europe.

Okay.

Thank you.

[Operator Instructions].

Dana Walker.

One final question.

As I recall in your industrial business you rearchitected how you go to market over the last year with more products being covered by a similar number of sales people.

I may have garbled that, but can you talk about what you've done and with the strengthening in that business whether you attribute the strengthening to those steps taken or whether it's outside of that?

Jim Giertz responding.

What you're referring to is we reorganized, we grouped our Ultrafilter product line and Torit product lines together under the industrial filtration solutions umbrella organization at the beginning of fiscal year 2004, so we're about 15 months into that.

The reorganization has gone very well.

The organization is stable, and everybody's in place and operating well, so that part of it is behind us, and that adds -- that improves our situation because we're spending obviously a lot more time selling products now and a lot less time organizing ourselves, and that's where we were a year ago.

So we're happy about that.

The business overall is very strong for IFS in all three regions of the world: Asia, Europe, the Americas.

I really attribute that mostly just to the strength of our market position and our ability to capture market share.

It has very little to do with the reorganization, I would say.

The independent pieces were strong before the reorganization.

They're showing their strength in their markets today.

Benefits that we'll get from the joining of the groups is long term prospect, and we'll see that come through as the years and -- the quarters and the years go by.

To the degree that you're willing, how would you describe the momentum in your Ultrafilter business?

Generally good.

The revenue side of the Ultrafilter business has been a little soft in Europe as we start the year.

Partly because they are very German-oriented, but, on the other hand, the profitability of the business is vastly improved, and it's just performing better.

So even on weaker or softer revenue than we had hoped for, we're actually putting to the bottom line profits above our expectations.

One final thought.

On free cash flow, a better quarter here but you finished somewhat weaker in the latter part of last year, so perhaps some of this is recapture of where you might have been.

What is your free cash flow outlook for the remainder of the year?

Dana, this is Rich Sheffer.

Last year, we saw an increase in the usage of cash as working capital started to build, as the business started to ramp up.

We saw inventory levels ramping up pretty fast, we saw receivables ramping up pretty fast.

We've got a number of initiatives underway right now to make sure those things stay in control.

The outlook for the year is probably somewhere between capturing 100 percent to the current level today.

So somewhere between 100, 125 percent of net income should be converted to free cash flow this year.

That would be welcome.

Thank you, gentlemen.

[Operator Instructions].

At this time there do not appear to be any questions.

Thanks, Ben.

I guess before I conclude our presentation I'd like to reiterate what I said a little while ago is that I am confident that we are on track to achieve our goal to deliver our 16th consecutive earnings record.

And with that, I'd like to thank all of you for your time and attention this morning, and I'd also like to recognize all 10,000 Donaldson employees for their continued effort and support.

So thank you, and happy holidays.

This now concludes the presentation for today.

Thank you for attending.

You may now disconnect.