Donaldson Company Inc (DCI) 2007 Q1 法說會逐字稿

Good morning.

My name is Cynthia and I will be your conference operator today.

At this time, I would like to welcome everyone to the Donaldson Company First Quarter Earnings Conference Call. [OPERATOR INSTRUCTIONS] All lines have been placed on mute to prevent any background noise.

After the speaker's remarks, there will be a question-and-answer session.

If you would like to ask a question during this time, simply press star and then the number one on your telephone keypad.

If you would like to withdraw your question, press star and then the if you remember two on your telephone keypad.

I will now turn today's call over to Rick Sheffer, Assistant Treasurer and Director of Investor Relations for Donaldson.

Please go ahead, sir.

Thank you, Cynthia.

And welcome, everyone, to Donaldson's 2007 First Quarter Conference Call and Webcast.

Following my brief introduction, Tom VerHage our Vice President and CFO will give us a brief review of our record first quarter operating results.

Tom will then turn the call over to Bill Cook our Chairman, President and CEO, who will discuss our positive outlook for fiscal 2007 and the business conditions shaping that view.

Following Bill's remarks, we'll 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 in our SEC filings.

Now I'd like to introduce Tom VerHage.

Tom?

Thanks, Rick, good morning, everyone.

As you saw in our press release late yesterday, we had a strong start to our fiscal year.

With sales up 11% and a 120 basis point improvement in our operating margin, which in spite of an increase in our tax rate helped deliver a 16% EPS increase.

Since I'm sure you've all had a chance to read our press release, I don't want to take your time this morning summarizing items that are disclosed there, but I do want to emphasize a few points that you may want to consider as you adjust your models for fiscal '07.

I'll start with our tax rate, which was 31.2% in the quarter.

At this point, we are forecasting a tax rate of 29 to 31% for 2007.

We are now providing a range while our previous guidance was a rate of approximately 29% for the year.

The current accounting rules preclude us from anticipating discreet events that could reduce our tax rate in the second half of the fiscal year.

So while there may be events that could occur in the second half of our fiscal year that could bring our annual effective rate closer to 29%, we need to wait until those events occur before we can factor them into our tax rate analysis.

Examples of such events are the possible reinstatement of the U.S.

R&D tax credit and favorable resolution of tax contingencies in various countries.

Our operating margin of 12% was 120 basis points better than last year's 10.8% operating margin and in-line with the last several quarters' strong margin.

We continue to project our fiscal 2007 operating margin to be comparable with our fiscal 2006 full-year margin of 11.4%.

Our second quarter operating margin will include about 75% of our full-year stock option expense.

This is due to the timing of our annual grants and this charge in the second quarter is expected to be $0.02 to $0.03 per share.

Our second quarter operating margin will also be impacted by the significant number of holidays in the quarter.

The higher number of holidays means more days that both our customers and our plants are closed.

Which makes the second quarter our weakest sales quarter of the year.

However, our fixed cost base remains unchanged, so we will have our normal level of fixed costs to spread over a smaller sales base, which also reduces our operating margin in the quarter.

Now just a couple of items of note on our balance sheet.

First, inventory was up 16.5 million in the quarter and there were a couple of explanations for this increase.

First, we have seen inventory related to upcoming gas turbine shipments increase since year end.

And second, we are increasing inventory in the new capacity at our distribution centers to facilitate continued high levels of customer surface.

We've also seen current liabilities decrease, most notably, employee compensation liabilities.

This decrease is mainly due to the payout of incentive compensation that was accrued at year end.

We are projecting CapEx to be in the range of 60 to $70 million this year, and that includes a $12 million carryover from projects that began in 2006.

Most of the carryover was incurred in Q1, accounting for the year-over-year increase in capital spending in the first quarter.

We expect depreciation and amortization to be 45 to $50 million in '07.

The combination of high use of cash for working capital in $18 million of CapEx in the first quarter resulted in slightly negative free cash flow.

We continue to expect that free cash flow will be between 100 and $120 million for the year.

So just to sum up, we are very pleased with our first quarter results from the standpoint of both sales and operating margins.

And our press release provides our EPS guidance for 2007 of $1.72 to $1.82 per share, which would provide yet another year of record earnings.

So with that, I'll pass it over to Bill who will provide more background on our outlook.

Bill?

Thanks, Tom.

As Tom just mentioned, our new year is off to a good start.

Sales grew by 11% and our operating margins remained strong and above our target level.

These performances combined to help deliver 16% increase in earnings per share and provide a good momentum as we enter our second quarter.

I just want to briefly cover a few highlights from our first quarter.

First, our NAFTA sales were up 7.4% due primarily to strong performances in our engine OEM truck and off-road segments.

Our engine aftermarket business, and on the industrial side in our special applications business.

Our nonNAFTA or international sales were very strong in the quarter, growing 14%.

Our international sales represented 51% of our total consolidated sales in the quarter, and this reflects both our continued focus on the further diversification of our business as well as the further growing of our international presences.

In Europe, our business is strong across the board with 20% sales growth in both engine and industrial products.

What we see in Europe is good local market conditions as well as continued opportunities to grow our market shares.

In Asia Pacific, our revenues are up 7.3% driven primarily by strong performances in our truck and off-road sales and engine, as well as our IFS and gas turbine businesses.

Now I'd like to switch to our outlook for the year.

Starting first with our sales forecast, it remains good for fiscal 2007 and is noted both in our last conference call and yesterday's press release.

We continue to expect our engine product sales to be up in the mid-single digits for the year and our industrial businesses to be up in the low teens.

Diving down into a few more details in our outlook and starting first with the engine side, the end markets for our off-road business remain good.

Both construction and mining equipment sales continue to grow globally, despite the recently announced softness in the residential construction market in the U.S.

Nonresidential and highway construction remains strong in North America and overall conditions also remain good internationally.

We see our replacement parts businesses for existing fleets of trucks, construction, and farm equipment remaining strong as utilization rates for these types of equipment are good.

As we've discussed in the past, high equipment utilization will continue to drive the need for regular maintenance and our replacement filters.

Also, our retrofitted emissions business, which is also reflected in our aftermarket sales is expected to be up 30% this year.

One area that we've been forecasting and discussing a lot for the past several quarters that's expected to have a tougher year is our NAFTA heavy truck business.

We continue to expect our North American truck sales to be up during the first half of our fiscal year and then to be down 30 to $35 million during the second half.

This is the period that corresponds to next February through July.

The good news for Donaldson is that despite the second half drop from the NAFTA heavy truck business, we expect our overall global engine sales to grow in the mid-single digits this year.

I would just like to reiterate that comment.

So the revenue guidance I just gave you that our global engine sales are expected to grow in the mid-single digits this year includes the impact of the upcoming downturn in the NAFTA heavy truck cycle.

Now, switching to our industrial business, we see overall revenue growth up in the low teens as the global industrial economy is healthy across most sectors.

Within industrial, our IFS businesses, which include our industrial dust collector and compressed air filters, so our broad-based volume increases, again and incoming orders remain good for both new equipment and replacement filters.

In our gas turbine business, we see considerable strength in orders in-hand already for 2007, so we have confidence in our outlook that our gas turbine sales should be up approximately 20% over last year.

We continue to see gas turbine business conditions strong in the Middle East, Asia, and parts of Africa.

And finally, we expect high single digit growth in our special applications business this year, with our disk drive sales continuing to lead this group.

Now I would like to switch gears and give you an update on our PowerCore Technology.

In the quarter, we won another six equipment platforms with our OEM customers bringing our total wins to date with PowerCore to 66.

Twenty-nine of these 66 wins are already in production with the majority of the remaining expected to go into production sometime during 2007.

Our PowerCore sales are up 30% in the first quarter due to a combination of new first fit and replacement parts.

Replacement part sales with PowerCore now represent about 45% of the total PowerCore business.

The good news is we still have another 60 plus platforms in the proposal stage with our OEM customers and with our historical win rate of over 90%, we are confident of the continued growth of our innovative PowerCore Technology.

Another thing I would like to give you an update on is our expansion projects.

We've talked a lot in the last year about the up tick in our CapEx, and we started many facility projects during the past year with two primary objectives.

The first was to support our OEM customers with cost effective local manufacturing in developing parts of the world, and the second was to enhance our distribution capabilities for replacement parts service.

I'm happy to report as mentioned in our press release that our two newest plants in China as well as our new plant in the Czech Republic have all began production.

These three new plants represent approximately $350 square foot of new manufacturing capability.

We've also been making major investments in distribution centers to better serve our customers.

New distribution centers in South America and New Mexico were completed and opened during the first quarter.

The 50% increase to our main U.S. distribution center in Rensleer, Indiana will be completed in the next couple of months, and this will expand that facility to over 600,000 square feet.

And finally the expansion and conversion of our Bruit, Belgium facility into a distribution center is expected to be completed in February.

In total, these new distribution projects will add about 450,000 square feet in new capabilities, paying dividends in terms of both future growth and operating efficiencies.

So in conclusion, we had a good first quarter and our outlook for the balance of the year remains solid.

The strengths of our basic business model, that is a portfolio of diversified filtration businesses around the world should be evident again this year as the revenue drop I mentioned created by the North American heavy truck cycle will be offset by strength in our other engine businesses and by solid sales growth across our industrial businesses.

In addition, as we've discussed in the last couple of conference calls, we have been and remain focused on improving the profitability of our businesses.

We made good progress again this quarter and will be looking to continue the work.

The bottom line is that we expect the underlying strength of our markets combined with our diversified portfolio of filtration businesses should deliver another year of record sales and earnings, making this our 18th consecutive EPS record.

Cynthia, that concludes our prepared remarks.

Now we would like to open it up to questions.

Thank you. [OPERATOR INSTRUCTIONS] Your first question comes from Charles Brady with BMO Capital Markets.

Hi, thanks.

Good morning, guys.

On the turbine business, that's going to play out over the next three quarters in this fiscal year and given what would happen in the first quarter and what your outlook is for the full year, obviously it's going to be a pretty good ramp-up.

If you look at the second quarter versus second half, is there a waiting to how these projects are going to fall in on a quarterly basis?

Charles, Bill Cook here.

We don't comment specifically by quarter and I think as you know, our gas turbine sales are pretty lumpy coming in in varying amounts by quarter, so we don't give the guidance by quarter, but just the full year that we expect it to be up 20%.

It should be obviously stronger throughout the year to hit that number.

In the quarter, in the first quarter you just reported, were there any shipments that were, you expected to go out in this quarter that maybe got pushed out farther?

Charles, Bill again.

We don't comment specifically on the timing of the shipments.

I'll just refer back to our full-year guidance.

Okay, thanks.

Your next question comes from Scott Graham with Bear Stearns.

Yes, good morning.

I've got questions about each of the segments' margins and if it's at all possible to the extent you can, at least, perhaps you can sort of give us buckets on volume leverage, productivity, raw materials, pressures, that kind of thing.

The dynamics behind what was a really good engine products operating margin, but was also a year-over-year decline in the industrial products operating margin.

Could you maybe put some type of parameters, even if it's just suggestive on what were the puts and takes in each business?

Scott, this is Tom.

You're probably referring to the segment detail in our press release and that's about as much as we break out margins.

But you're right.

Engine had a very strong first quarter from a margin standpoint and there's a couple of items in there last year, the restructuring charges that we took in the first quarter were primarily engine related.

And then, of course, this year, volumes were very, very strong in the engine segment.

So those are the primary drivers of the improvements in the margin in the engine segment.

On the industrial segment, you're right, that margin did drop a couple a tenths of a point.

And really, there's no single item in there that caused that.

That's a fairly small drop.

I would say that the restructuring charges that we did have in this quarter approximately $800,000 primarily fell in the industrial segment.

So that would be the primary driver for the couple basis point drop in the industrial segment.

That's helpful.

Thank you.

Your next question comes from Jeff Hammond with KeyBanc Capital Markets.

Hi, good morning.

Hi, Jeff.

Can you hear me?

Yes.

Great.

I just want to -- with cat being your largest customer and making some more cautious comments in terms of domestic slowing in the U.S. and some production -- or inventory adjustments, can you just maybe speak to that, with them being your largest customer and what maybe has changed within your forecast relative to those updates.

Jeff, I think the one thing that's probably changed is what they've talked about with the residential construction slowdown in the U.S.

But other than that, most of the other business conditions, especially around the larger equipment have been used for road construction or nonresidential construction and for mining remains very good.

And so we see those prospects as remaining good.

The other part of it is is they have a strong push to grow their replacement parts business, and obviously that plays the parts that we supply them, filters.

Okay.

You left your topline guidance for that segment unchanged, but did revise the commentary around the residential construction piece.

Are there some offset there is, or is that just an immaterial component or maybe just give a little granularity there?

I think the offsets, Jeff, would probably be more around -- more strength than we expected internationally.

That's probably -- if you wanted to balance out the residential -- the U.S. residential, it would be stronger than expected growth internationally in that segment.

Okay.

As you talk about your manufacturing footprint expansions, your distribution footprint expansions.

Is there any way to quantify maybe year one, year two, what incremental impact that provides or too early to tell there?

Probably too early to tell, Jeff.

We consciously decided last year to ramp up those investments just in view of the opportunities that we saw, and so we focused on it last year.

A lot of projects, as Tom mentioned, our CapEx guidance for this year is down, so we're going to take a little bit of a breather.

We have a lot of additional capacity and we can live off of that for a couple of years.

I jumped on a little bit late and you were talking about free cash flow, which sounds like is unchanged for the year, but you had a pretty big use on the working capital.

Can you speak to the increase in inventories, what's going on there?

Jeff, again, this is Tom.

I mentioned it in the prepared comments, but two comments on inventory.

One, we've had a bit of a buildup in our gas turbine inventory, because we expect an increase in shipments in the upcoming quarters and then secondly, a bit of a temporary buildup as we migrate to our new distribution centers, put inventory in those distribution centers, and want to ensure that we maintain our high levels of customer service during that transition period.

Okay, perfect.

Thanks, guys.

[OPERATOR INSTRUCTIONS] Your next question comes from Richard Eastman with Robert W. Baird.

Hi, Bill.

Good morning.

Hi, Rick.

Could you just provide a little bit of added color, just on the off-road segment of the business.

How did that look -- looking at the local currency growth, which was close enough to 17%, how did that look internationally versus U.S. or NAFTA?

Rick, Bill here.

Just back to that comment I made a minute ago.

We saw probably higher than expected growth internationally in that segment, the off-road.

And that's to some extent, if you wanted to put that together with the questions around the residential construction in the U.S., it's offsetting that.

In particular -- on the off-road side.

Okay.

In particular, is that more driven on a secular basis in Asia, or is the spike in Europe also been noticeable in.

Both.

Yes, okay.

In terms of business realignment, expenses, we took $800 in the quarter.

Do you have a general feel of what you'll need to do for the year?

Rick, this is Tom.

Roughly we think -- and this is both start-up costs and restructuring costs.

We think the range for the year is about 3 to $5 million, so a pretty normal level.

Okay.

Weighted towards the second half, then, or just as we go here?

Yes.

It's going to vary quarter to quarter, as I said, we were at about 800 to $1 million in the first quarter, so it could be fairly evenly spread throughout the rest of the year, but we'll just half to see.

Okay.

And anything, Tom, in terms of pricing, can you give us a sense of, are you ahead of the curve there, are we getting 50 to maybe 100 basis points of growth off consolidated price, or -- any sense of that?

With all of the products and geographies around the world, with some products having cost downs and some pricing opportunities in others, that would be a really, really tough one to answer on an overall basis.

Okay.

But is there -- when one looks at the EBIT or the pretax margin in the industrial sector, is there a sense that we are ahead of the price cost variance curve there, or steel still an issue or anything like that?

I think we're holding our own, Rick.

Okay.

The couple of tenth of a point drop there is really the mix of where the restructuring costs fell out on a year-over-year basis.

Okay.

All right.

Very good.

Thank you.

Thanks, Rick.

[OPERATOR INSTRUCTIONS] Your next question comes from Bill Benton with William Blair.

Hi, guys.

It's actually Steve Livingston in for Bill.

Hi, Steve.

On gross margins, looked like it ticked down a little bit year-over-year in sequentially.

Is that mainly due to a sales mix work is there something else there going forward?

This is Tom.

There's really no one significant event.

There's going to be some puts and takes every quarter.

We did experience an uptick in steel prices during the quarter and that might have been impacted the margins by a tenth or two.

And then we'll always have minor mix variations on a quarter to quarter basis and there were a myriad of little mix issues that went on between last year's first quarter and this year's first quarter.

But there was no one event that stood out that's impacting that change.

Okay.

And just lastly, kind of a clean up, just the $1.5 million in other income, just wondered what that was made up of?

Steve, Rich Sheffer.

A couple of items, we had some joint venture income, about $1.5 million in the quarter, interest income was down a bit from last year after we repatriated a lot of cash, about $300,000.

Other income and then offset with foreign currency loss, released foreign currency loss of about $900,000 in the quarter.

That was kind of the mix there.

Okay.

Great.

Thanks very much.

At this time, there are no further questions.

Mr. Cook, are there any closing remarks?

Yes.

Thank you.

To all of you participating and listening, I would like to thank you for your time and interest.

To my fellow employees, I would like to thank you for delivering yet another record quarter of both sales and earnings.

Thank you all and good-bye.

Ladies and gentlemen, this concludes today's Donaldson Company first quarter earnings conference call.

You may now disconnect.