Donaldson Company Inc (DCI) 2005 Q3 法說會逐字稿

Good morning.

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

At this time, I would like to welcome everyone to the Donaldson Company third quarter earnings conference call. [OPERATOR INSTRUCTIONS].

I would now like to turn the call over to Rich Sheffer, the Assistant Treasurer and Investor Relations Officer.

Please go ahead, sir.

Good morning.

Thanks, Anissa.

As Anissa said, I'm Rick Sheffer, Donaldson's Assistant Treasurer and Director of Investor Relations.

I'd really like to welcome you to Donaldson's third quarter conference call and webcast.

A special welcome to those on the East Coast suffering from some pretty lousy weather right now.

It is sunny here, but we feel your pain.

It's supposed to rain again this weekend.

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

Tom will then turn the call over to Bill Cook, our President and CEO, who will discuss our outlook and the business conditions shaping that view.

Following Bill's remarks, several members of our management team are available to field your questions.

Next on the agenda is the reading of our Safe Harbor statement.

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 ladies and gentlemen, here's Thomas VerHage.

Well, thanks, Rich.

And good morning, everyone.

Well, we had a very good third quarter.

We posted all-time sales, earnings, and earnings per share records.

And importantly, operating profits grew a couple of percentage points faster than sales this quarter.

This performance follows several quarters in which our operating leverage was masked by the impact of unrecovered steel price increases on our business.

As we discussed during last quarter's call, we had the actions substantially completed with our customers to recover steel price increases by the end of January.

But on the other hand, in the third quarter, we did experience rising costs for freight and petroleum-related raw materials; and we also saw some impact from fabricated metal parts, which have lagged the overall steel price increases.

Of course, these cost pressures are receiving attention from our business unit managers.

Plant rationalization and new plant start-up costs impacted operating profits by approximately 1.1 million in the third quarter, compared to approximately $200,000 last year.

The majority of these costs were related to the start-up of our new disk drive filter plant in Thailand, and we will begin shipping product to customers from that plant in the fourth quarter.

Sales in our gas turbine business were down 9% from last year's third quarter; however, we are expecting a turnaround in the fourth quarter and that should lead to sales on an annual basis being fairly close to last year's level.

As we mentioned during the second quarter call, we knew there would be a few low-margin jobs that would ship in the third quarter.

These jobs were priced before the dramatic steel price run-up.

So the combination of lower sales for gas turbine and low margins on a few jobs had an adverse impact on profits for the quarter.

Our operating expenses as a percent of sales were just slightly less this year than last year.

We did not see more improvement in this percent because of expenses associated with Sarbanes-Oxley compliance, we continued to invest quite heavily in the intellectual property area, and operating expenses in gas turbine are relatively constant, even in a quarter like this when sales are down.

We do look for some improvement in our operating expense ratio in the fourth quarter.

Another item of note in the quarter is that our effective tax rate was 24.6%, which is down from 27% in the first six months of this year.

Similar to last year's third quarter, we filed an amended tax return related to a prior year to claim additional research and development tax credits; and the benefit from this amended return is reflected in the tax rate for the quarter.

During last year's third quarter, we also filed amended returns for additional R&D tax credits, which dropped last year's third quarter tax rate to 22.3% versus 24.6% in this year's third quarter.

So just for -- just for perspective, last year's drop in tax rate benefited EPS by approximately $0.02 per share versus $0.01 this year.

So let me just summarize, unrecovered steel price increases had minimal impact in the third quarter.

But we did have some impact from rising petroleum-related commodities and freight costs.

We experienced the tail end of the low-margin gas turbine projects and more start-up expenses in Thailand.

Sarbanes-Oxley-related costs will continue to increase in the fourth quarter; we do, however, expect our gas turbine business to have a stronger fourth quarter in terms of both sales and a positive impact on the bottom line.

And now I would like to introduce Bill Cook, who will discuss our outlook.

Bill?

Thanks, Tom.

And thanks to all of you for joining us this morning.

Before I talk about the business conditions, I just wanted to reiterate.

I think there are three key messages in our release.

First is that we had solid sales growth, up 11% in the quarter over last year.

The other part of that is that we saw good sales growth on both sides of the business, both engine and industrial were up 11%, so the strength in our business is broad-based.

The second point is that we saw operating leverage, as Tom mentioned.

On 11% revenue increase, operating income was up 13%; and this is despite a number of unusuals that Tom mentioned, such as the Sarbanes-Oxley work that we're working on to complete by the end of the fiscal year.

And the third point is related to our outlook.

Our backlogs at the end of the quarter were up 8%, so we have a good outlook and all three of these factors re-enforce our guidance for the year, which is that we see the full year sales being up in the low teens over last year; and second, that we'll deliver our 16th consecutive earnings record.

Now, I'd like to switch gear and talk about our business conditions.

And before I start, we should say overall the conditions are strong and that our outlook has not appreciatively since last quarter's call.

I'll start first with our engine business.

In our North American truck business, while we've seen that the published incoming order rates that are customers have slowed slightly during the last couple of months, our customers are building Class A trucks at a near-capacity level, and we believe that their order books are basically filled through the end of the calendar year.

The current industry estimates on Class A new production are that it should be between 300 and 315,000 for calendar '05, up 15 to 20% over last year.

In the off-road segment, we also see strong underlying economic indicators.

For example, March construction spending was up 8%, and we saw strength in both the residential and non-residential segments.

We also see continued strong indicators in the farm and mining segments.

All three of these, the construction, farm, and mining, are driving continued strength in the production of new agricultural construction and mining equipment.

We also talk to our customers, and they expect their equipment production rates to remain strong through the balance of this calendar year.

In our engine after-market business, where we supply replacement filters for the equipment I just mentioned, the trucks, construction and farm equipment, that business, the replacement business is up 10% year-to-date.

We see continued strength there with the -- with increasing utilization rates of the existing fleets of heavy truck and off-road equipment out there in the field, and this utilization rate increase is driving the need for our filters.

We are also continuing to add part numbers and distribution in both North America and Europe.

And then also, with our PowerCore -- our new PowerCore technology, as more and more of the new vehicles get out in the field with the PowerCore air cleaners, we're seeing our replacement filter business for PowerCore grow.

From quarter 2 to quarter 3, our PowerCore replacement sales were up 67%.

And finally, as noted in our press release, our new emissions retrofit solution in North America continues to take off.

So overall, lots of good things going on in our after-market, and we expect that to continue.

Before I switch to the industrial side, I just want to make one other note on our engine business.

We did complete one acquisition during the quarter, Le Bozec, a French aviation filter company, which will significantly add to our product range for the commercial aircraft segment.

Now, talking a little bit about our industrial businesses, I'll start with industrial filtration solutions.

We see good underlying indicators there with U.S. machine tool consumption up 19%.

We also see manufacturing capacity utilization continuing to improve.

Both of these indicators suggest a continuing improvement in the environment for the investment in new factories and equipment driving the need for our dust collectors and compressed air filtration equipment.

In our industrial filtration solutions group, all of the product lines had a good first nine months and we expect sales to remain strong in quarter 4.

Switching to our gas turbine segment, there are really two stories here, as we've talked about in the past.

First, in North America, we believe that this market is now at the bottom of the cycle.

As you may remember, that went through a boom and a bust, the overall gas turbine market in the U.S.

We think it's bottomed out.

Internationally, the conditions are much better, fortunately.

There was no boom and there was no bust, and we have good visibility in this segment as the lead times are long.

As noted in our press release, our 90-day backlog in gas turbines is up 10%.

We have the orders in hand to expect a strong finish to 2005.

And finally, in special applications, we had a very good third quarter with revenues up 19%.

A major component of that segment is our disk drive filter business.

We see continued strength in the market for hard disk drives for PCs and laptops, driving the need for our filters.

In addition, we see a growing segment in the application of hard disk drives for consumer electronics, so this would be for video cameras or portable music devices like the Apple iPod.

That segment is growing at about 40% per year.

So you put the PC and the consumer electronic segments together and we see the hard disk drive market that we supply into growing at between 13 and 15% over the next couple of years.

So, good strength foreseen in that segment as well.

Maybe one fun fact related to this business is that we are now building and shipping over 1 million filters a day in our Asian plants for the disk drive market.

We opened up a -- another factory in Thailand -- our first factory in Thailand last month.

So we will have plenty of additional capacity to support the future growth of this segment.

So just to summarize, our business conditions remain good.

We are expecting about 10% revenue growth in the fourth quarter over last year's strong Q4.

We are also expecting, as Tom suggested, that our operating profits in the fourth quarter will again grow faster than sales, and our goal remains to deliver our 16th consecutive year of record earnings in 2005.

That concludes my prepared remarks, Anissa.

Could -- now we'd like to open it up to some Q&A.

Thank you. [OPERATOR INSTRUCTIONS].

James Gentile, Sidoti & Company.

Good afternoon.

Good morning.

I was wondering if you can comment just kind of on the outlook for the engine cycle?

We've gone through a pretty interesting period of growth where a lot of the manufacturers are at capacity, as you've mentioned.

Looking out, perhaps, I guess the tail-end of 2006 and through 2007, what you're expecting, the kind of trends that will dictate your OEM business to indicate, and it could potentially be negative.

So I was wondering how you'd be able to manage through that given the already seemingly effective utilization of your assets.

Good morning.

This is Lowell Schwab from the engine business.

We expect business really in all segments to be up again in 2006, calendar year 2006, which is -- covers 2 years for us, 2000 -- F '06 and F '07.

We do expect there'll be a decrease in the Class A truck build rate in -- in calendar -- in 2007, excuse me.

And that will affect the back half of 2007 for us and 2008, related to emission.

So we do expect there'll be a downturn in our -- in our fiscal '07, but we should be able to manage through it.

Secondly, our expectation is that we will gain market share and improve margins with new air products and other products, and that will help offset that.

So, one of the good things about the business is the after-market is less cyclical -- much less cyclical than the first fit business, and that's why we've been trying to grow that.

In addition, James, as we've discussed in the past, as a new -- as a forecasted decrease in new truck production happens in 2007, as Lowell suggested, we anticipate that our content per vehicle will go up as they start to install the new emission control devices.

So that'll -- production rates will go down, but our content will go up.

Thanks.

Bill Benton, William Blair.

Good morning, guys.

Good morning.

Just a couple of questions.

How much was S-Ox this quarter, and I think you suggested that it would increase next quarter.

I didn't know if you could provide some -- some granularity on that.

Bill, this is Tom.

Good morning.

Sarbanes-Oxley expenses in the quarter were about $800,000 over last year.

Okay.

And we expect the -- the total increase on a year-over-year basis to be about $3 million, so the fourth quarter could be a million or just slightly north of that.

Okay, so it'll be a million increase year-over-year, but 200,000 sequentially?

Right.

Okay.

200 or just a little bit more, Bill.

Okay.

And then with regard to the gas turbine area, I know you mentioned the visibility.

You have orders in hand.

It does seem to suggest a very large fourth quarter in that segment in the neighborhood, I think, of 35, 36 million or so, to be flat, I think you said in your press release.

So I guess I'm trying to -- one of the things I'm trying to figure out is I know you guys expected the strong growth in the second half from the last quarter.

Was there something that maybe slipped this quarter into the fourth quarter, given that you do have pretty good visibility in that segment?

This is Jim Giertz.

I'll answer that question.

You're right.

The fourth quarter should -- the fourth quarter revenue for gas turbines should be 35 million or so.

That's accurate.

That's not an unprecedented level for us.

That's obviously higher than what we did in the third quarter, but it's easily manageable.

We've done that in quarters in the past quite easily.

Okay.

We've had some -- some projects have shifted.

There has been a little bit of that going on this year, certainly not as much as we've seen in the past years, but we had -- we have had some projects that have slipped from one quarter to the next.

Okay.

And -- .

But that's all being considered when I tell you that we should do 35 million or so in the fourth quarter.

Okay.

And then just a couple of questions on your guidance.

As an analyst, I get to compare your last quarter to this quarter, that's the extent of my job right now.

But you mentioned last quarter, you said the after-market on retrofit opportunity is increasing, and this quarter you took that out.

Should I read into that at all?

No, we still think that's going to grow, and --

And it is growing.

It is growing.

Okay, and then my second comparison point is that you mentioned a strong Asia in IFS last quarter and didn't mention it this time.

Has that changed at all?

This is Jim again.

Our third quarter, IFS in Asia for the third quarter that we just completed, I think was flat over the prior year.

But the long-term -- the long-term outlook there is still very positive.

We're showing significant growth for the full-year.

I think the flatness -- flatness year-over-year was related to just timing of certain projects that went through last year versus this year, but the overall outlook is very positive, and the year-to-date numbers are very strong.

Okay.

And then one another -- I'm sorry.

One final question.

You backlog growth by segment.

You guys didn't provide this time.

Do you have that level of granularity you're willing to offer?

Just bear with me two seconds.

This is Rich.

By segment in the business, total backlog in the engine business was up 12% year-over-year, and in the industrial side it was up 2% year-over-year for a total of 8% up.

Okay, and the 90 day, do you have?

90 day, let's see here, on the engine side was down 1%, up 3%, on the industrial side flat year-over-year.

Okay.

Great, guys.

Thanks.

Lorraine Maikis, Merrill Lynch.

Thank you, good morning.

Just a follow-up on James Gentile's question.

Can you just give us a little bit more detail about your expected content per vehicle change once the emission regulations become effective in 2007?

Well, we have a large share of the Class A muffler market, and if you're taking exhaust market, if you're looking at that business right now, our content in those vehicles is in the neighborhood of $30 to the --

For the muffler.

For the muffler.

On the programs that we win in emissions, the content will be from several hundred -- from several hundred dollars to, in a few cases, thousands of dollars, so -- but it will be a lower share because there'll be a lot more participants in that market segment going forward.

And are you currently working through that bidding process, or are we not there -- are we not in the timeframe yet that you need to do that?

Yes, we are working through the -- through the vendor selection process with several customers.

There's about 13 platforms in North America if you look at it that way, and four of them we never had a chance for because of long-standing legal relationships between supplier and the engine manufacturer.

So, if you look at those nine -- nine programs, three of those have concluded and six of them have yet to be resolved.

Can you comment on if you won any of the three?

We won -- we won -- actually, yes.

We won one of the three.

Thank you very much.

Kevin Monroe, Thomas Weisel Partners.

Good morning.

Morning, Kevin.

Could you give us some more detail on this announcement you guys put out today with this partnership with SurModics?

I mean, this sounds like a completely new area for Donaldson.

Just give us a little more color on what you guys are doing here.

Sure.

This is Jim Giertz.

Well, it goes back a couple of years ago.

About three years ago, we put in an initiative together to try to find other commercial applications for a very unique technology that we have at Donaldson Company, nanofibers, what we call Ultraweb, in most of our applications that we serve in our industry.

So for the last three years, we've had a dedicated team working on trying to find non-traditional commercial applications for this very unique technology, and we've come up with various -- various potential ideas.

This one, that we announced this morning, to use Ultraweb as a synthetic ECM for cell culturing, is one of the most exciting ones that we have out there, and, of course, the combination of our technology, Ultraweb, with the technology that SurModics brings, makes the -- makes the product even more attractive and commercially viable.

So this has been a long time in development.

To say a little bit more specifically about what this -- what this is, we're focusing right now in the laboratory market.

Universities, other places where basic research is being done on human -- human cells.

And our Ultraweb technology - our fibers, coincidentally, look -- look very much the same as -- very similar to the extracellular matrix that is actually inside of a human body, that human cells grow on naturally.

So it's just serendipity that these -- that these fibers mimic the -- the conditions inside the human body, and our research has shown and the research of our partners has shown that human cells like to grow on our fibers and that's the big idea.

We're pursuing that together with SurModics.

And how are you bringing it -- bringing this product to market in terms of distribution?

Are you creating a sales force for this?

What's -- ?

The distribution right now is direct from us.

We sell it over the internet, basically.

But the distribution is yet to be determined.

We're in the stage right now of just getting it in the hands of researchers so that they can demonstrate for themselves that the product actually works in their environment, and once we have that established, then we can be more aggressive about setting up distribution to get the products to the customers on a regular basis.

We have about 800 trial users out there right now; 200 I would describe as very active trial users, and so we're still in the phase of them convincing themselves that the product is effective in their applications.

And who are you -- what are your competitors?

Is there a competing product to this out there that people are using, or is this something completely new?

Ours is unique.

There are competing products, but ours is unique because it's synthetic.

The competing products are based on animal -- derived from animal tissue, and they're very difficult to work with, and they introduce extraneous biology into the -- into the experiments and so the truly unique part of our product is the synthetic nature of it.

It doesn't -- it doesn't add anything into the experiment, basically.

It's benign.

Okay.

And back to the -- kind of a quarter, what in terms of the acquisition you guys did, how much revenue did that contribute in the quarter?

We did it in --- we completed it in April.

Oh.

April.

Okay.

It was small.

How about in terms of like annual --?

Its annual sales are about 9 or $10 million.

Okay.

Thank you.

Charlie Brady, Hibernia Southcoast Capital.

Hi.

Thanks, guys.

In the -- on the off-road segment, some pretty good growth there.

And there's been a lot of talk about shipments of large tires for off-road trucks.

Are you seeing impact on your business there from that going forward?

Well, there -- it's a limit to growth.

At several customers that, that is the hardest component for them to get.

So, yes.

There's a -- there's a limit to how much our -- we can grow in the off-road segment next year, but there's -- there's good backlogs and good activity at virtually every off-road segment.

So we think there'll still be growth next year.

Okay, and then back on the -- on the emissions for the Class A trucks.

With your content, obviously, ramping up fairly significantly, can you talk about the profitability of the higher content product versus where your profitability are today?

Well, the profit -- that is, one of our least profitable products today, I would say, in terms of the exhaust systems for off-road trucks and going forward, it will be considerably more profitable than that.

Thank you.

Richard Eastman, Robert W. Baird.

Just a couple of things.

I wanted to circle back for a minute to the gas turbine business.

Can you just give us a sense of what the international North American mix is right now in that business?

Yes, this is Jim.

I think this year that what we call U.S.-based business is going to be about 40% of our total revenue.

Okay.

And international will be 60, and then how -- when you talk about the backlogs, this is kind of longer lead-term shipping stuff, what's -- where's the strength coming from?

International still as you look out into early FY '06, or are we starting to see the North American business hit the backlog?

Well, the strength -- the market conditions are really similar now that they have been for the last couple of quarters, really.

The strength of the market at the end-user level is in the Middle East, north Africa and Asia.

There is very, very little going on in the North American market.

The end-user market in North American is very, very quiet.

Okay.

And then in the third quarter with the level of business, I think there was some reference to the expenses being up level of business down, and some business being pushed; but gas turbine business was profitable, correct?

At this level of sales?

We don't talk about profitability by segment.

Okay.

And then overall for the quarter, what was the net price realization year-over-year?

For the Company overall, Rick?

Yes.

Tom, do you -- ?

Rick, I -- just with all of our products around the world and the different product lines for the different geographies, that's just a question that would be impossible for us to give you one answer to.

There's probably a hundred answers to that question.

So, we don't have it all rolled up into -- into one answer.

Okay.

But given -- given your pricing strategy during the quarter, is the -- is the dynamic in place to improve your incremental margin year-over-year in the fourth quarter, all things equal even on the volume side?

In other words, did the price increases roll through in -- throughout the quarter, or were they pretty much in place at the beginning of the quarter?

Rick, a lot of the price increases were in place early in the quarter.

Okay.

So we would expect the fourth quarter -- as you noticed, the gross margin showed a healthy improvement in the third quarter versus the first two quarters of the year; and we would hope to maintain that level for the fourth quarter.

Okay.

Okay.

And then Jim, could you just talk a little bit about the IFS business, North America up 25%, big strong number, even with an easy comparison.

What exactly -- where exactly did you see that growth?

Well, in IFS North America, the business is really strong across the board.

You may recall that, I guess it's about a year or so ago, we got this very large order with Siemens for the U.S.

Post Office, and that business has been ramping up all the way through the year.

We had a very active third quarter building product for our customer, Siemens, and the post office.

We'll have an even more active fourth quarter.

So that's giving some underlying positive tone to the revenue numbers.

But even setting that aside, our bookings are very strong in Torit in our dust collection business.

But across the board, hydraulics, compressed air and gas, we're very strong across the board in IFS North America.

Okay.

Okay.

Our after market is good.

I mean, it's really across the board.

Very solid results.

Okay, and then just the last question.

I just -- I wanted to circle back to the comment that was made when we were talking about the exhaust platforms and the fact that three -- three of these were concluded.

Prior to that, you said that you expect a lower market share?

Why do you expect that at this point?

Were one of these -- one or two of these three that were, that have been concluded, was that business that you previously had?

Well, Rick, part of the answer is that we have today, say 70 or 80% of the heavy truck mufflers, okay?

So we're comparing that 70 to 80 that we have today in mufflers to what we think we're going to get with these new emission platforms a couple of years out, and we don't think we're going to be able to maintain a 70, 80% of this much bigger market because so many people are chasing it.

Okay.

Because of that significant ramp-up, as we mentioned earlier, in the content per vehicle.

Okay.

And is there any -- are there any plans right now for Donaldson to more aggressively pursue the European emission business?

No, not at the moment.

Okay.

Thank you.

[OPERATOR INSTRUCTIONS].

Bill Benton, William Blair.

Hey, guys.

All that talk about nano, you guys will be in a nano index soon.

Let's see.

I just had a few little quick follow-ups.

In terms of the impact from the start-up costs, was that about 20 basis points in the gross margin?

Approximately.

Okay.

So it could've even been stronger.

Okay.

What is your expectation -- I know you did the R&D credits this quarter.

Are you still expecting kind of 27% for the fourth quarter?

This is Tom.

The tax rate from our normal ongoing operations is approximately 27%; and at this point, that's our projection for the fourth quarter as well.

Okay.

And final question is could you just talk about maybe the pattern of sales through the quarter?

Were there any particular signs of weakness and strength as the quarter progressed?

Bill, Bill here.

Just back to my comments about the outlook.

I mean we're -- we're seeing pretty broad-based solid business conditions across almost essentially all of our businesses with the exception of gas turbine North America.

Okay.

Great, guys.

Thanks a lot.

Sure.

Dick Henderson, Pershing.

Yes.

Good morning.

I just had a -- two questions.

One, in your release, you had indicated that your business in Europe was strong, and that kind of flies in the face of the growth expectations in the EU, which have been -- continually being scaled back.

Could you -- could you explain why you're doing as well as you are and does -- as European growth continues to slow, does that catch up with you next year?

Thanks.

Dick, Bill Cook here.

Well, we read the same statistics.

And yyou're right.

Our performance continues to, as you said, fly in the face of it.

But we're continuing to see great strength in our businesses -- our business overall in Europe, and we think it's related to the new products and new technologies that we're introducing that we're taking -- we're taking share.

We have -- we have a lower share in Europe than we do here.

So there's a lot more upside opportunity.

We have more opportunity here.

All right.

Second question on pricing.

You had been behind the curve on increases such as commodities, such as steel.

Within your price adjustments are they straight price increases, or are there surcharges, et cetera, which if steel prices, as an example, continue to decline, there would be a give-back.

We have -- in many cases with our largest customers -- I'll give you two answers.

In our after-market area, it's straight price increases, and generally off externally published lists, so -- so unless there were major changes in materials cost, we would not adjust them.

With our large customers, many of them we have indexed to steel cost so -- and they would be adjusted quarterly.

So if they go up, we'll adjust them quarterly, or down.

Okay.

Thank you.

At this time, there are no further questions.

Mr. Cook, do you have any closing remarks, sir?

Sure.

Thanks, Anissa.

In closing, I would like to summarize a couple of points.

We had record third quarter sales, net income, and EPS.

Our business conditions remain good.

As a result, we see a strong finish to the year and another revenue and earnings record.

And with the good business conditions that we've talked about, we think we'll -- we should be also very well-positioned for fiscal '06.

All of this that we've talked about this morning is a result of the hard work and extraordinary efforts of our 10,000 employees around the world.

Finally, I'd like to, again, thank all of you for participating in our conference call.

We really appreciate your time and interest in our Company, and we hope that we've been able to provide with you an updated picture of how we're doing.

Thanks, Anissa.

Thank you.

This does conclude today's Donaldson Company third quarter earnings conference call.

You may now disconnect.