Donaldson Company Inc (DCI) 2006 Q1 法說會逐字稿

Good morning.

My name is Sabrina, and I will be your conference facilitator.

At this time, I would like to welcome every to the Donaldson first quarter earnings conference call.

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

After the speakers remarks, there will be a question-and-answer session. [OPERATOR INSTRUCTIONS] Thank you.

Mr. Sheffer, you may begin your conference.

Good morning and thank you Sabrina.

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

I would like to welcome to you Donaldson's 2006 first quarter conference call and webcast.

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

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

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

Before I turn the call over to Tom, I need to review our Safe Harbor statement with you.

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 our SEC filings.

Now, ladies and gentlemen, here is Tom VerHage.

Thanks, Rich.

And good morning, everyone.

As you saw in our press release, late yesterday, we had a good sales quarter and an even better quarter from an operational perspective.

The 10.8% operating margin for the quarter was the highest that we have delivered since the first quarter of fiscal 2004.

And is close to our long-term target of 11%.

We continue to experience cost pressure from petro chemical prices in the quarter.

However, we more than offset those cost pressures by continuing to work hard on cost reduction efforts throughout our operations, that help deliver this operating margin in the quarter.

We do however expect the petrochemical cost pressures to accelerate as the year proceeds.

During the first quarter, we had $1.2 million of plant rationalization, and startup expenses which compares to $700,000 in last year's first quarter.

As I mentioned at the year-end webcast, we expect to spend between approximately 5 and $6 million on plant rationalization and startup expenses this year, versus $3.6 million last year.

We expect our heaviest spending will occur in the second quarter, with approximately 35% of full-year costs hitting in the second quarter.

We had a small impact of stock option expensing in our first quarter, and expect the majority of the annual impact to occur during our second quarter.

As you perhaps noted from our press release, we have refined our estimate of the total impact of expensing stock options, and now expect the full year expense being between $0.02 and $0.03 per share, down from our previous estimate of $0.03 to $0.06 per share.

A couple of comments regarding our tax rate.

The first quarter effective rate was lower than our expected annual rate, due to an amended return we filed for additional R&D tax credits related to a prior year.

For the balance of the year, we expect our tax rate to be approximately 28%.

This is an increase of about 1 percentage point over our normal tax rate from the last couple of years, and this increase is due to the mix of where we earn our profits around the globe.

In last year's fourth quarter, we took a $4 million tax charge related to our $80 million foreign cash repatriation plan, under the American Jobs Creation Act of 2004.

In the first quarter, we repatriated 57 million of the 80 million, but we are well on our way to completing that plan.

A comment on the drop in our corporate and unallocated expense this quarter.

During the first quarter, we adjusted our allocation methodology for costs assigned to the two business segments.

The impact of this change is about $4 million of additional costs assigned to the segment, which is split about equally between Engine and Industrial.

We will be using this revised methodology going forward.

We had a good free cash flow quarter.

Excluding the one-time payment of $14 million for the EPC litigation judgment, free cash flow was slightly higher than net income for the quarter.

We still expect capital expenditures to be in the range of 85 to $95 million in fiscal 2006.

But as we mentioned last quarter, we have several major projects under way this year, including two new plants in China, a new plant in the Czech Republic, a new distribution center and warehouse in South Africa, and a significant expansion of our U.S.

Distribution Center in Indiana.

We continue to expect depreciation and amortization expense to be between 45 and $50 million this year.

We are projecting fiscal 2006 EPS to be between $1.47 and $1.57 per share.

We expect sales growth in the high single digits, and an operating margin in the range of 10.5 to 11%.

This of course, assumes no significant spikes in commodity costs.

Our operating margin range includes our previously mentioned forecasted plant rationalization and startup expenses and the impact of expensing stock options.

We still plan for interest expense to be approximately 3 to $4 million higher than last year.

And we expect our tax rate to be approximately 28% for the balance of the year.

An important factor to consider when reviewing your projections is that the second quarter is usually our seasonally weakest sales quarter for us because, due to holidays in each month of the quarter, we do have fewer shipping days in the quarter compared to the other three quarters.

Also, as we noted, we expect this year's plant rationalization startup expenses, and the impact of stock option expensing to be higher in the second quarter, than any other quarter this year.

But just to sum up, our outlook for 2006 is mostly unchanged from our previous guidance.

That is, we expect fiscal 2006 to be our 17th consecutive record year of earnings.

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

Bill?

Thanks, Tom.

I would like to start with a brief recap of our first quarter.

The sales were 403 million, up 8%, or 30 million from last year.

We had a very solid gross margin at 32.6%, up 1.4 points.

We had a great or very strong operating margin at 10.8%, up from 9.7% last year.

And the combination of the strong sales and strong operating margin performance, resulted in net earnings of 32 million, up 18%, and earnings per share of $0.37, up $0.06, or 19% from last year.

Boiling all those numbers I just mentioned down, all-in-all it was a very good first quarter, and we are very pleased with our start to our new fiscal year.

Now, I would like to start looking forward, in terms of what we see happening in our markets.

First, as Tom mentioned, our overall sales outlook is essentially unchanged from a quarter ago in our last webcast.

As generally conditions within our markets are consistent with our earlier assessments.

But as Tom noted, one change in our earnings release, is that we've added an EPS forecast for the year.

We felt that this would provide more clarity, in terms of what we expect down the road.

Now, I will talk about each of our business segments starting with Engine.

Our Engine business has delivered 10% growth in the first quarter, led by offroad and after-market sales, both of which continue to be strong.

In addition, our North American heavy truck business had a very good first quarter.

A lot has been written about this heavy truck industry.

As you may recall, North American Class A truck builds last year in 2004 were 260,000 units, and are expected this year to be about 340,000.

That's for calendar year 2005.

In addition, it is expected it will be another 340,000-unit year in 2006.

So we see continued strength in this heavy struck segment through the end of calendar year 2006.

One editorial comment I would like to add, is that the North American truck business is a very important segment for Donaldson, but it is also sometimes misunderstood how it fits into the Company.

It is important to remember that our North American first fit truck business is now only 7% of our consolidated sales.

So it is very important to us, but as a result of our extensive diversification efforts over the past 20 years, it does not define the entire Company.

Now, I will switch to some of our other Engine markets.

In our Construction and Mining-related business, these end markets continue to be strong globally.

Our major customers continue to forecast approximate 10% revenue increases, for their products in 2006, which should also drive the demand for our filters.

We also see continued strength in our after-market or replacement parts business.

As the existing fleets of trucks and construction equipment around the world are being used, the filters need to be replaced.

Again, driving the demand for our replacement filters.

So overall, we expect engine segment sales to be up approximately 10% in fiscal 2006.

A couple of other highlights related to our engine business, first PowerCore, our PowerCore sales were up 46% in the first quarter.

In addition, we won another 11 OEM platforms with PowerCore in the quarter bringing our total wins to date to 47.

Most of these new wins will go into production late in our fiscal 2006.

In addition, we have another 60 PowerCore platforms in the proposal stage with our OEM customers, and with our current win rate of over 90%, we are confident of the continued growth of PowerCore.

We're also optimistic about the long-term opportunity related to the on-road emission opportunity we've talked about in the past.

We expect our onroad emission business to be $150 million by the end of 2010.

A $100 million increase from today's level.

To recap, there are three components of this onroad emission opportunity for Donaldson.

First is the North American EPA regulations for 2007 and 2010.

The second is this expanding retrofit opportunity in North America, centered primarily around school buses.

And the third opportunity we see is around the European Regulations in 2009.

We're making great progress in all three fronts.

We've won two in the North American 2007 platforms.

We have over 11,000 retrofit systems already in the field.

And we're making good inroads in Europe.

Now, I'm going to switch gears and talk about our industrial businesses.

Overall business conditions in our Industrial filtration solutions group are good, and we continue to execute our growth plan around the combination of our Ultra filter and Dust collection product lines.

Our special applications business should have another very good year, led by our Disk drive filter business.

Special apps is off to a great start in '06.

Revenues are up 9% in the first quarter and it is expected to maintain that type of momentum.

And then finally our gas turbine business is improving modestly.

As we discussed over the past year, we do not see much near term growth opportunity in North America, but we continue to see good growth opportunities internationally, and putting those two pieces together, would we see modest growth overall.

But putting all of our Industrial businesses together, we're expecting sales growth in the high single digits.

So to summarize, we're off to a good start in our first quarter.

We expect fiscal '06 to be another year of record sales and earnings.

And our goal is to deliver our 17th consecutive EPS record.

In addition, as we've discussed previously, we see lots of great opportunities for Donaldson over the next couple of years.

We're very excited about the continued market adoption of our PowerCore technology.

This emerging diesel emission opportunity is another great application of Donaldson technology.

Our industrial filtrations business, which includes our Dust collection and Ultra Filter businesses, has come to gether and will provide a solid platform for continued market penetration.

And finally, we see a host of international growth opportunities, and as Tom mentioned, we're putting the infrastructure in place to capitalize on these.

The bottom line is that we have good momentum today, and we see many opportunities to continue our performance into the future.

That concludes our prepared remarks, Sabrina, now we'd like to open it up to questions.

[OPERATOR INSTRUCTIONS] We will pause for just a moment to compile the Q&A roster.

The first question comes from Charlie Brady with Harris Nesbitt.

Hi, thanks.

Good morning, guys.

Good morning.

Talk a little bit about the gas turbine business, I know back in the fourth quarter, you said you had a couple of orders slip from Q4 to Q1, did those orders actually go out in Q1?

I guess I would have thought that that business might have been up a little bit more, just from the slippage instead of down sequentially.

Good morning.

This is Jim.

The answer to your question is yes, the projects that were delayed in the fourth quarter did ship in the first quarter.

I guess to put that in perspective, what I would really like to do is point you back to our full year forecast.

To me, the best way to look at the trends that the condition of this business, is to forecast over a longer period of time, so that single projects, when they move from month to month, or quarter to quarter, don't impact the consideration.

But let me reiterate, we're going to stick with our forecast.

We're going to do about $120 million of revenue in this business in this fiscal year.

And that's up 6% from prior.

Which I think was 113.

We forecast project by project, customer by customer, line by line, all over the world.

We do it every month.

So what I'm telling you our best information that we've got.

So that's what I can tell you.

The other thing I would mention is most likely, or almost certainly, according to our forecasts, our revenue is going to be stronger in the second half of the year than the first half of the year.

Okay.

Thanks.

And then on the PowerCore, I don't know if you mentioned, how many platforms are in production currently?

Right now, out of the ones that we've won, 28 are in production, Charlie.

This is Bill Cook.

Great.

Thanks very much.

Your next question comes from Kevin Monroe with Thomas Weisel Partners.

Good morning.

Good morning, Kevin.

The after-market business on the Engine side, you had a nice acceleration of growth there.

Could you give us some color in terms of what the driver of that acceleration was?

Was it PowerCore?

Was it increased utilization?

What is driving that growth?

It is probably -- you have part of the answer already, Kevin, already there.

And the PowerCore because the replacement parts aspect of that is really starting to ramp up.

It is the increased utilization of existing fleets of trucks and construction equipment.

And it is the retrofit emission opportunity that we're, that is ramping up, and we're looking at, and that was $12 million last year, as we mentioned in our last call, and we're looking at that retrofit piece growing at about 50% again this year.

Okay.

The other question I guess on the reclassification of the corporate expense, you mentioned that you reclassified about 4 million, but also if you look at the year-over-year change, there was, you went from 6 million change to 2 million change, and is that 4 million reduction due to the reclassification, or did you reduce this corporate cost by 4 million?

Trying to get some clarity there.

Kevin, this is Tom.

That approximate $4 million reduction, that column is directly attributable to moving those expenses into the individual business segments.

So approximately half of that 4 million went into Engine.

And the other half went into Industrial.

Okay.

So the historical numbers you provide for fiscal '05 are not adjusted then?

They are not adjusted.

Okay.

Thank you.

[OPERATOR INSTRUCTIONS] Your next question comes from Jeff Hammond with Key Banc Capital Markets

Hi, good morning.

Good morning.

I guess wanted to understand the nature of the reclassification.

What was kind of in there that prompted the change?

Jeff, this is Tom again.

Really, what was in there are expenses that we can directly assign to the business segments.

You know, one example would be amortization of the intangible assets that related to prior acquisitions.

And then there is just a host of different items.

But they are items that do directly relate to the business segments, and we thought more appropriately belonged in the segment.

So if we looked at, I mean is this kind of a good run rate on a quarterly basis to look at?

We will continue to follow this allocation methodology going forward.

And the answer is yes.

Okay.

And then if I kind of do an apples-to-apples comparison, and pull out the 2 million out of each, you had tremendous incrementals in the Industrial business, and I just wanted to understand better is that just good flow-through profitability, or you know, are you getting some, you know, costs, you know, more notable cost reduction or restructuring benefits in that business?

Again, Jeff, this is Tom.

I think it is really a number of factors.

The Industrial group has focused on profitability, and streamlining.

There is profit improvement plans in place.

And they're gaining some traction.

On any given quarter, you're also going to have some mix issues, and that had a bit of an impact in the quarter as well.

So really, it is a lot of factors that came together in the first quarter.

Okay.

And then finally, on the diesel emission change in opportunity, you mentioned, you know, two wins in North America, I guess there are a number of engine OEMs that were still undecided.

I mean we're getting closer.

When do you expect some resolution.

Well, this is taking longer than we had expected.

We had thought that these decisions would be made, and as Lowell Schwab who runs the Engine business mentioned in our last webcast in September, we are now guessing, or at that point we were get guessing it would probably be out 9 or 12 months before all these decisions are made.

And my guess now that it is almost December, is that within the next 5 or 6 months.

Okay.

And then just finally, if you look at that opportunity of 50 million to 150 million, you've talked I think to some extent at, you know, what the increased content is, and you know, I think what your historical market share is.

What does that imply in terms of increased content per vehicle, and where your market shares might go relative to where they are today?

It is going to be, as we've discussed, it is going to be a lot more content per vehicle, because say, keep it simple, we're essentially swapping out a $50 truck muffler with at least a couple hundred dollars, and maybe in some cases a couple thousand dollars emissions opportunity, so it is a lot more content per vehicle.

But today, we have the majority of the onroad North American truck muffler market, and we never expected to keep that same market share, because there are a lot of people chasing this emerging emissions opportunity.

So you know, we're going to lose, our share percent will go down, but our content per vehicle will go way up, and our sales will go up by the incremental annual number of $100 million that we mentioned, from 50 to 150.

Okay.

Great.

Thanks, guys.

Sure.

Have you a follow-up question from Charlie Brady with Harris Nesbitt.

Charlie?

I just want to go back to your comments in your prepared remarks about about some of the margin improvement coming from not only cost reductions but some price increases.

Are you realizing the full impact of price increases you've already put in place?

And are there more to come down the road?

And are you recapturing, or what percentage are you recapturing on your higher material costs currently?

Well, Charlie, Bill Cook here.

As I think we mentioned in the press release, we dealt with the steel issue last year through a combination of selective price increases and cost reductions, and cost reductions with our customers, that we worked on in partnership with them.

And we haven't really accounted for how much is in each bucket but in the end, as you saw at the end of last fiscal year, we actually got our gross margin back up to where it was the prior year, and we were covered on the steel increase from last year, through the combination of that work.

And that's sort of our plan going forward, is to where we can, where we can get selective price increase, we are going to do that, but I would say probably our primary drivers is through cost reduction efforts.

Did I get your question, Charlie?

It does.

Thank you.

[OPERATOR INSTRUCTIONS] Your next question comes from Ed [Litman] with William Blair.

I apologize if you answered these questions.

We hopped on the call late.

But can you talk a little bit about what gives you the confidence in keeping the upper single digit estimate for Industrial out there, and if that upper single digit is coming from the backlog growth that you saw this quarter?

Yes, hi, this is Jim answering your question.

I think it is a couple of different things.

We just talked about the gas turbine business.

Obviously, we're up a couple percent in the first quarter.

We're going to be up 6% for the year.

So you can see, and we can forecast that pretty closely.

So that piece, we feel pretty confident in.

If you look at IFF, which is the other big piece of the Industrial group, it got off to a little bit of a slow start outside of North America, but we can see from the backlog, and just the trends, the daily sales trends that we see in most of our businesses that we are seeing a pickup right now, and we feel pretty confident we can stick with the original forecast that we gave you originally.

Okay.

And then last quarter, in the gross margins, you said plant integration costs and the delay in the Thailand facility, and obviously gross margins have improved nicely this quarter.

Is the Thailand facility fully ramped now?

Hi, Ed.

This is Tom.

Yes, it is.

Is it was in production in the fourth quarter of last year.

And it is off to a very good start in this fiscal year.

So that plant is operating very nicely.

And there are no additional startup costs relating to the Thailand plant in the first quarter numbers.

Okay.

Great.

Thanks, guys.

At this time, there are no further questions.

Mr. Cook, are there any closing remarks?

Yes, thanks, Sabrina.

To all of you in the audience today, I want to thank you all for your time and interest in our Company.

To my fellow employees, I want to say I'm very proud of the record we built, and I want to thank you again for delivering another record quarter.

Thank you all, and Happy Holidays!

Goodbye.

This concludes today's conference.

You may now disconnect.