Donaldson Company Inc (DCI) 2005 Q2 法說會逐字稿

Good morning.

My name is Deborah and I will be your conference facilitator today.

At this time, I would like to welcome everyone to the Donaldson Company second-quarter earnings conference call.

All lines have been placed on mute to prevent any backroom noise.

After the speakers' remarks, there will be a question-and-answer period. (Operator Instructions).

Thank you.

Mr. Sheffer, you may begin your conference.

Good morning, and thank you, Deborah.

I'm Rich Sheffer, Donaldson's Assistant Treasurer and Director of Investor Relations.

And I'd like to welcome you today to Donaldson's Donaldson second-quarter conference call and webcast.

Following my brief introduction, Tom VerHage, our Vice President and Chief Financial Officer, will give us a brief review of our second-quarter results.

Tom will then turn the call over to Bill Cook, our President and Chief Executive Officer, who will discuss our outlook and the business condition shaping that view.

Following Bill's remarks, we will open the call up to questions.

Several members of our management team are available to field your questions today, including Bill Van Dyke, our Chairman, our two business unit Senior Vice Presidents, Lowell Schwab from our Engine Products business and Jim Giertz from our Industrial and Commercial business.

Also with us today is Amy Becker, our Assistant General Counsel.

Before I turn the call over to Tom VerHage, 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 turn the call over to Tom VerHage.

Tom?

Thank you, Rich, and good morning, everyone.

I would like to briefly review with you the financial highlights for our second quarter.

As you read in our press release, second-quarter sales were a record $388 million, up 17 percent with all of our product lines in all of our geographic regions reporting year-over-year sales growth.

Six-month sales were a record $761 million, which is up 15 percent.

As we noted in our press release, our second-quarter gross margin was 31.2 percent.

We spent much of the quarter working to recover steel price increases.

Those efforts were successful as we implemented increases with our original equipment customers and raised list prices in the aftermarket by the end of the quarter.

However, early in the quarter, we were not fully recovering the increased steel prices while we continue to work with our customers on this matter.

Unrecovered steel price increases diluted margins approximately $3 million in the quarter.

A large portion of this dilution is due to the shipment of some cash turbine orders in the quarter that were received and priced prior to the steel price increases last year.

The gas turbine pricing issue is now substantially behind us.

And there are only a couple of orders that will ship in the third quarter that will have steel pricing which reflects pre-steel price run-up costs.

The majority of our third-quarter gas turbine shipments should approximate our normal margins.

We are still targeting an overall corporate gross margin of approximately 32 percent in the second half of fiscal 2005.

And that is very close to our actual margin for the last two years.

Operating expenses were near our expectations, coming in at 21.7 percent of sales, which is down from 22.4 percent last year.

Typically, our operating expense ratio runs a little higher in our second quarter compared to the rest of the year as we have fewer shipping days due to the holidays while our fixed costs remain unchanged.

We continue to see operating expenses running between 21 and 21.5 percent for the rest of the year.

We also saw an increased interest expense as debt levels are higher following the repurchase of 3 million shares of our stock earlier this year.

In addition, short-term interest rates have risen over 1 percentage point since last year, also contributing to the increased interest expense.

Other income was also higher compared to last year and just as rising debt levels and interest rates had impacted interest expense, similarly, higher cash levels and rising interest rates have led to higher interest income.

In addition, we also had more foreign exchange gains compared to last year.

We repurchased 3 million shares last quarter through the overnight share repurchase we announced in early September.

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

So just to summarize, we substantially completed our work in steel price recovery by the end of the second quarter and are in good shape on price recovery going forward.

Some low-margin gas turbine orders masked the improvement that would have otherwise been evident from the recovery efforts.

But going forward, such low-margin orders should have a very minimal impact.

As I mentioned previously, we expect our second-half gross margin to be approximately 32 percent.

And we are expecting our operating expenses to run between 21 and 21.5 percent of sales.

Now with that, I'd like to introduce Bill Cook, who will discuss our outlook and the business conditions shaping that view.

Thanks, Tom.

And good morning to all of you that have joined us this morning.

Before I talk about our outlook and business conditions, I'd like to make a few comments on our second-quarter performance.

First, we had a great revenue quarter.

Record revenue of 17 percent with strong performances on both sides of the Company, engine sales up 19 percent and industrial up 14 percent.

And as Tom mentioned, the strength in our sales performance was broad-based.

All of our product lines in all of our regions, the sales were up year-over-year.

The second point I'd like to make is on our gross margin.

As Tom mentioned, by the end of the quarter, we substantially had all of our price recovery actions in place.

The steel issue that we spent a lot of time working on -- we talked a lot about it in our first-quarter webcast -- it cost us a lot in the first quarter.

We had some hangover impact in the second quarter.

But we feel that it is behind us.

And going forward, we will not need to talk about the steel issue as we have.

The third point is on operating expenses.

We feel they're under control.

And as Tom pointed out, we posted a 70 point basis improvement in operating expenses year-over-year.

Now, you get down to the bottom line and take a look at either net earnings or earnings per share and it's hard to see all the improvements that we talked about for one reason, which is the unusual land sale gain that we had in Japan last year.

As you may recall, last year, we sold a facility and land in Japan.

We recorded a $3.2 million gain, net of all the costs related to that.

So a $3.2 million gain, 3 cents a share.

So you take a look at comparing net earnings or earnings per share, we have a little bit of an apple and an orange.

If we take that unusual gang out of last year, we posted a 24 percent increase in earnings per share in the second quarter year-over-year.

So in the 17 percent revenue increase, 24 percent increase in earnings per share, we think that's pretty good.

The bottom line in the second quarter, record sales, record earnings, and record earnings per share.

Now I'd like to switch gears and talk about what we see coming at us.

Our business remains very good.

Our total order backlog is $417 million which is a new record.

Taking a look at the pace of our incoming orders, in December and January, incoming orders were up 12 percent over the same time last year.

So with the combination of that backlog number and the pace of incoming orders, we feel that revenue growth during the second half of the year will average between 10 and 11 percent.

With that, we expect for the full year to have our year-over-year increase in revenues in the low teens and to set a new revenue record of about $1.6 billion.

Our focus in the second half will be, as Tom mentioned, on getting our gross margin back to 32 percent and keeping our operating expenses in control and between 21 and 21.5 percent.

We expect that with the combination of the strong revenue that we see, the improving gross margin and operating expense control, that we will show an improvement in our gross margin in the second half of the year -- or excuse me, improvement in our operating margin in the second half of the year.

Now I'd like to talk about the business conditions that we see across the Company.

And I'll start with the engine businesses.

First, on-road heavy truck -- our North American customers built at an annual rate of about 330,000 trucks last quarter.

This industry is red hot and near manufacturing capacity.

The current industry estimates are that in calendar '05, new Class 8 production will be between 300 and 315,000 trucks, up 15 to 20 percent over calendar '04.

So we see continued strong growth in this segment.

In our off-road businesses, we see continued strength in the construction and agricultural equipment end markets.

For example, Caterpillar announced recently that their retail machine sales were up 31 percent in the last three months and that they expect their '05 revenues to be up between 12 and 15 percent over '04.

Similarly, in the agricultural end markets, we see strong conditions. 2005 foreign cash receipts are forecasted to be the second highest ever, which we think will support continued new demand for new equipment.

So overall, we expect off-road equipment production rates to remain strong through the rest of this calendar year.

In our engine aftermarket, where we supply replacement filters and parts for trucks and off-road equipment, and which by the way posted an 18 percent revenue increase in the first half over the same period the year before, we see continued strong utilization rates for existing equipment -- remaining strong for the balance of this calendar year.

In 2004, Class 8 ton miles were up 3.6 percent and we see a continued increase in 2005 of 2.9 percent.

So again, increased utilization rates should continue to drive our aftermarket business.

In addition, we have two new programs which are kicking in, one being our PowerCore and the second being our North American retrofit emissions business.

In PowerCore, as we mentioned in the press release, with the installation of new systems that we put out in the field over the last couple of years, our replacement parts sales doubled in the second quarter and we see that trend continuing.

In our retrofit emissions business, we're forecasting a doubling of that business as well year-over-year.

Switching to our industrial businesses, conditions there remain very strong.

Industrial capacity utilization reached 78 percent in the U.S. in November and is projected to rise above 80 percent in 2005.

Machine-tool consumption was up 44 percent in 2004.

So with strong recovery in 2004 in economic conditions and we see that continuing into 2005, all of that should generate a continuing growing need for our equipment.

Our IFS product lines had a strong first half and we expect them to have a good second half as well.

In our gas turbine business, conditions are good internationally.

We had strong incoming order flow in the second quarter.

Our backlog is up 14 percent.

And we have good visibility in this business as the leadtimes are long.

As a result, we expect our second half sales to be stronger and end up at about $120 million, which is where we were in fiscal '04 as well.

In special applications, one of the major segments there is the disk drive business.

Industry estimates are that hard disk drives are forecasted to increase 24 percent from '04 to '05, which will mean more filters.

At the same time, we're bringing online our new tide (ph) plant.

It's complete and we'll start production in March.

So we'll have additional capacity in a low-cost setting to support this increasing demand.

So to summarize, overall, our business conditions are very good in almost all of our businesses.

Our business will continue to grow over last year's strong second half.

We expect our gross margin will improve in the second half with our steel price recovery efforts completed, with most of the gas turbine low-margin jobs behind us, and our continued focus on internal cost reduction.

We continue to watch our operating expense closely.

And our goal remains in sight of delivering our 16th consecutive year of record earnings.

That concludes our prepared remarks.

Deborah, now I'd like to open it up to Q&A.

Certainly, sir. (Operator Instructions).

Bill Benton, William Blair.

Good morning, guys.

Just a few questions.

The first one is back on the steel price side.

I know you don't want to talk about this anymore probably.

It would be nice if no one had to talk about it.

But I guess some of the negotiations that we've read about with regard to iron ore price increases up 70 percent, it seems to portend another raising of steel costs to some degree.

And I guess I'm trying to get a sense at how quickly can you -- if there are further steel price increases from here, move (ph) those up?

I don't know what percentage of it is index versus fixed at this point in your -- among your relationships.

Bill, this is Bill Cook.

I'll start with that.

We're watching it very closely.

We have not seen any indication that, directly, that there's another rise in the types of steel that we buy.

But having said that, and as we talked about in the last webcast, we think we have the mechanisms in place to compress the time delay that we experience in the first half.

So that if something does happen with steel pricing, if it continues to go up, that we'll be able to quickly go back to our customers and get the pricing relief.

Do you have a timeframe on when you think the turnaround now would be for pricing?

And renegotiations on any sort of increase that are substantial?

I think if something happened, it might take us a couple of months versus in some cases it took us five or six months in the past.

Okay, okay.

And then on the operating expense, I know you said 21 to 21.5 percent.

Is it fair to assume if I just look back a couple of years and look at kind of where the top line is trending that you might be at the lower end of that range toward the back half of the year/

Bill, this is Tom.

Our guidance, as I said, 21 to 21.5 percent.

And we're working the issue.

We would like for it to be on the low end of the range.

But really at this point to be any more precise, I think would be difficult to do.

Okay.

Are there any expenses that I guess you see to the back half of the year that are unusual -- I don't know if there's Sarbanes-Oxley or some of the -- kind of may be lumpy toward the back half of the year?

Maybe you could -- that's noticeable that's something we could know about?

Yes, Bill, this is Tom again.

We really don't see anything significant in the second half that we haven't experienced in the first half.

Sarbanes-Oxley clearly will be weighted to the second half.

We estimate that that expense in total is about $3 million for the year.

And year-to-date, those costs have been about $900,000.

So yes, there's going to be more Sarbanes-Oxley expenses in the second half.

Okay.

And then just a final question, the off-road segment, obviously very strong in Europe in particular.

Is there anything about something happening in the European market in the off-road segment that's notable?

Well they have gained share with PowerCore and some other new products over there as well as the market being up in general.

You said they've gained share over there?

We've gained.

We have gained, yes.

Our subsidiary in Europe has gained share with PowerCore and other products in Europe.

Okay.

Okay.

Great guys.

Thanks a lot.

Richard Eastman, Robert W. Baird.

Good morning.

A couple of things.

One is I appreciate and like the segment detail that you provided on the op profit.

And I just had a question -- when I look at the industrial growth rate in sales, the op profit was pretty flat.

And I'm curious, is that where the bulk of the steel costs hit you?

Is that the reason for that?

Rick, this is Rich.

That's where the lower-margin gas turbine jobs would have flowed through.

So that would have kept it more depressed than normal in this quarter.

Okay,.

So we can see that gradually improve here as you work your way through the residual backlog in that business and then get past that in the second half?

Yes.

Does that go up?

And then also, just I'm curious -- you talked a little bit about the gas turbine backlog and order flow.

Is some of that business the new PowerCore technology?

Are we yet getting that in the marketplace on the gas turbine side?

Hi, Rick.

This is Jim.

Most of the order backlog increase of the orders that were referenced came out of our European operations.

And most of that is for the oil and gas industry.

Okay.

The other part of your question is about PowerCore.

I think we have six jobs now that we've -- for PowerCore into the gas turbine market.

We actually shipped two systems in the second quarter.

So we're making progress on PowerCore, but it's not a meaningful part of the backlog or the order pattern that you're seeing right now.

And do you have the help of the OE's in terms of pushing that technology?

Or are you still in the process of convincing them that that's the direction to go?

It depends on the OE.

Some are convinced already.

Others we're working on.

Okay.

It's generally a slow process and obviously it takes longer than we wish it would.

And Jim, where -- you know, again, just looking at the pretax displeasure on the industrial side, just what would be a realistic target for your segment, I guess of your business, if you look out 12 months?

I mean can that be a 10 percent op margin, tax, I should say?

I'm just curious -- when you look out in a perfect world --

I'm hesitating a little bit because I don't look at the margin numbers on the same basis as we report them.

So I have to recalibrate myself for a second.

But I think the basic part of the answer I'd give you is we think there's significant opportunity to raise our operating margins in the industrial group.

And we're busy at it, okay?

And there's various reasons for that.

But we've made pretty decent improvement this year so far.

We've got good trends going.

We've got a lot of programs in place to get the most of our revenue.

And that's going to be a -- that's a continuing effort in the second half of the year -- tremendous amount of focus (multiple speakers) the next year or the next year after that.

Okay.

And could I -- the steel cost variance year-over-year was -- in the quarter was I think you said 3 million.

Could I assume maybe 2 million falls in the industrial business?

You're close there.

Okay, okay.

Close.

And again, that's primarily because of the GTF lower-margin orders.

Okay.

And then I'm sorry, just one last question -- maybe Bill, you could address this.

But I'm curious if you could just give us maybe a technology update on the transportation side regarding the admission regs that go in in '07; we've been road testing technology.

And I'm curious if we're further along that path.

And maybe if you have -- can give us any added clarity on DCI's content gain when in fact those regs become effective.

Rick, I'll ask Lowell.

He's closer to it for us.

Well as you know, the particulate (ph) amount (ph) of rigs going into place for the over-the-highway market in 2007.

And going of course the next twelve months, there will be a lot of decisions made as to who will get that market.

And we have a lot of competition.

But we like our product.

We actually have an active system working in the field in a couple of locations now.

So -- and we think we're running a few companies that can say that.

But it is, it's a hard struggle and we haven't -- we don't know what the end result will be for another 12 months.

But we like our technology and we're making progress.

Okay.

Rick, just to add to that, we're shipping catalytic converter mufflers today for first fit.

So we're already in that business.

And in addition, we're -- the retrofit, where we're doing retrofit emission installations state-by-state with those regulations -- that's one of our -- should be a good growth opportunity this year as well.

We mentioned that before.

Isn't the biggest variable though in your content is going to be kind of the decision as to what piece -- what subassembly people are going to expect you to ship and -- because we've talked about your content going anywhere from $80 to 200 to 400.

Is there any better clarity on that potential content pickup?

It will depend on whether we're selling them a whole emission system or we're selling them or we're doing the production of the unit for -- of the muffler CCM unit for them.

If we're doing the production of it, our content will be somewhere between 100 and several hundred dollars.

In the case where we might sell a whole system, the content could be several thousand dollars.

So there's a wide gap in the potential there and we're not going to know what it is for another six to 12 months.

And that will be almost order by order then after that?

No, it will be customer by customer depending on which route the customers choose to go.

Okay.

Very good.

Thanks again.

Lorraine Mikis, Merrill Lynch.

Hi, this is Gina Gordon (ph) calling in for Lorraine.

Two quick questions.

First, your industrial filtration segment remains pretty strong and solid.

Has that been driven by one specific industry or is it more broad-based overall?

Hi, this is Jim.

I think your question was, is there a sales growth in IFS broad-based, or is it due to a particular sector?

It's very broad-based.

By region, by product family, by industry segment that we serve.

Okay.

And my second question would be could you possibly provide local currency gains by segment?

I'll take care of that, Gina.

This is Rich.

In the quarter, starting on the engine side of the business, transportation was up 0.5 from translation; off-road, 2.0 million; aftermarket, 3.2 million, for a total of 5.7 million.

The Industrial side, IFS was up 4.1 million; gas turbine, 1 million even; special applications, 0.5 million for 5.6 million for Industrial.

Total in the quarter, 11.3.

Great.

Thank you much.

(Operator Instructions).

Mr. Sheffer, at this time, there are no further questions.

Thanks, Deborah.

My closing remarks, I'd just like to say I hope that we've been able to communicate to all of you how well our Company is running.

The steel issue that we talked about in our remarks and in the Q&A has really been a big deal for us in almost all of our businesses.

And we spent a lot of time on it in the last 12 months fixing it.

It hurt us a lot in the first half.

But as we've talked about, essentially it's behind us now.

Despite the impact and distraction of the steel issue, we posted record first-half profits, and we're on track for another record year.

I'm very proud of this performance.

And I'd like to thank all of my fellow employees for their part in making this happen.

In closing, I'd like to thank all of you for participating in this call today and for your interest in Donaldson.

Thank you and good bye.

This concludes today's Donaldson Company second-quarter earnings conference call.

You may now disconnect.