Donaldson Company Inc (DCI) 2009 Q4 法說會逐字稿

Welcome to the Donaldson Fourth Quarter Conference Call on the 2nd of September, 2009.

Throughout today's recorded presentation all participants will be in a listen only mode.

After the presentation there will be an opportunity to ask questions.

(Operator Instructions)

I'll now hand the conference over to Mr.

Rich Sheffer.

Please go ahead, sir.

Thank you, Julie, and welcome everyone to Donaldson's 2009 Fourth Quarter Conference Call and Webcast.

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

Tom will then turn the call over to Bill Cook, our Chairman, President, and CEO, who will discuss our initial outlook for fiscal 2010 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 Rich, and good morning everyone.

Yesterday, we released our fourth quarter earnings after the market closed and provided our initial guidance for fiscal 2010.

Conditions in nearly all of our end markets either remained weak or deteriorated in the quarter.

However, we have begun to see early signs of stabilization in some of our businesses.

But while our future visibility remains limited beyond the first quarter and it's too early to call a turnaround, we feel that the worst of the economic downturn is behind us in many of our early and mid cycle end markets.

This view is factored into our FY10 outlook in our Press Release.

As the recessionary conditions continued to unfold in our fourth quarter and we saw our sales return to our fiscal 2005, 2006 levels, we have aggressively reduced our cost structure to match these lower sales levels.

We continued our previously announced restructuring plans and incurred an additional $6.7 million tax cost or $0.05 per share in the quarter.

That brings our total restructuring cost for the year to $17.8 million pre-tax or $0.15 per share.

We planned to complete more actions before the end of the quarter but encountered delays in implementing our plans.

For the actions we completed, approximately $3.2 million was charged to cost of sales, $3.5 million was in operating expenses.

As a result of our outlook for near term business conditions, we are planning additional restructuring actions in fiscal 2010 that will likely result in a pre-tax charge between $12 million and $17 million or between $0.10 and $0.15 per share for the full year.

These include those items we planned to complete but were unable to in the fourth quarter.

The majority of these additional restructuring charges will be incurred in the first half of fiscal 2010.

In addition to the workforce restructuring actions discussed in our press release, we completed the consolidation of two leased distribution centers in the US into our main US distribution center in Indiana, and the consolidation of another lease distribution center in the UK into our Central European distribution center in Belgium.

We expect the cumulative impact of the restructuring actions taken during fiscal '09 will generate over $100 million of annualized pre-tax cost savings in fiscal '10 at our current volume levels.

Including the pre-tax restructuring charges we expect to incur in fiscal 2010, we are expecting our full year operating margin to be between 9.5% and 10.5%.

Our operating margin will continue to be impacted by lower than normal absorption of fixed costs and the $12 million to $17 million of additional restructuring costs.

Our gross margin was 32.8% in the quarter which improved from our Q3 and Q2 gross margins of 31.6%, 29.1% respectively, but it was below the 33.2% we achieved in last year's fourth quarter.

The lower absorption of fixed manufacturing costs in the quarter reduced gross margin by just over three percentage points net of savings from completed restructuring activities.

And the $3.2 million of restructuring costs lowered gross margin by a little less than a percentage point.

A positive year-over-year LIFO accounting impact, slightly lower purchased material costs compared to last year, better execution on large project shipments, and improved distribution efficiencies combined for approximately a three point improvement in gross margin.

As you may recall last year's fourth quarter contained a $5 million LIFO accounting charge and that did not reoccur this year.

In operating expenses we continued the expense reduction programs that we discussed last quarter including a hiring freeze, a salary freeze, targeted restructurings and various other expense reduction actions.

The restructuring charges increased operating expenses by $3.5 million in the quarter while we realized $9 million of cost savings that are reflected in operating expense.

Our effective tax rate was favorably impacted in the quarter by a favorable earnings mix as our Asia Pacific entities which generally have lower tax rates performed relatively better than other regions.

This helped us achieve a lower than forecasted effective rate of 26% in the quarter.

Based on our projected global mix of earnings, we expect our normal tax rate, absent additional discrete items, to approximate 31% going forward, but our geographic earnings mix will continue to cause the rate to vary from quarter to quarter.

Our fourth quarter CapEx came in as expected at $11.4 million as we continue to scrutinize our capital spending plans.

We are moving forward with strategic projects but as we mentioned over the last couple of quarters, we are delaying beginning any new expansions until the recessionary conditions ease.

Our full year CapEx guidance for fiscal 2010 is between $30 million and $40 million and we expect depreciation and amortization to be in the range of $58 million to $62 million which includes the amortization of intangibles from the Western Filter acquisition that we made in October 2008.

Free cash flow was $61 million in the fourth quarter which was $10 million higher than last year's fourth quarter.

For the year, free cash flow was a record $231 million, an increase of $128 million over last year.

Our cash conversion ratios were 258% in the quarter and 175% year-to-date.

We expect free cash flow to be between $120 million and $140 million for fiscal 2010, as the benefit from reduced working capital levels diminishes while the business stabilizes.

At the end of the quarter our debt-to-cap ratio was 29.5%.

Debt to EBITDA was 1.2%.

Both of these are well within the financial covenants in our various debt agreements.

We are now expecting interest expense in fiscal 2010 to be approximately $15 million.

Our balance sheet remains strong.

We continue to have no issues accessing our credit lines.

We do not have any material long term debt maturities in the next two years, and our revolving credit line has almost four years until it matures.

So with that I'll pass it over to Bill who will provide more background on our business conditions and our outlook for fiscal 2010.

Bill?

Thanks, Tom, and good morning, everyone.

While we continue to be impacted by the global recession, we are now seeing signs that some of our end markets are stabilizing.

As Tom noted, our sales increased 2% sequentially from our third quarter.

But what I'd like to do first is review the past year in our fourth quarter, and so doing that, it may seem like a long time ago but you may recall that a year ago, we were just announcing our first $2 billion plus revenue year and our 19th consecutive earnings record.

And nine months ago we announced a record first quarter.

So we got off to the beginning of fiscal '09 in a very strong position but then the global recession hit our customers and consequently us.

At the end of November, the order backlogs in many of our markets started to dramatically and very suddenly decline.

Fortunately, we had started early with our planning for this contingency and had already begun to prepare for a recession.

And while we couldn't control how fast our end markets decelerated we did focus on managing those things we could control.

We proactively cut our operating expenses, reduced our working capital and CapEx, reduced both our variable and fixed manufacturing costs and capacity, and generally balanced our resources with the reduced business levels.

Through the winter, as global conditions continued to collapse, we continued to adjust to the continuing drop in incoming customer orders.

It was unfortunate but necessary that many difficult decisions were made this year to protect the long term health of our Company.

As we noted in our press release, we had to significantly reduce resources across our global organization.

And while we cut many things, we did continue with a number of key projects that we deemed were essential for long term strategy and that would help position us to capitalize on growth opportunities as they emerge.

The results of all this hard work were demonstrated by the financial results delivered during the second half of our year.

During our last two quarters, the third and fourth, in the face of a year-over-year sales decline of 30%, we achieved a gross margin of 32.2% and an operating margin of 8.7% and both of these included about $13.5 million of restructuring charges.

Now looking specifically at our sales results in the fourth quarter, our sales were down 31%, about 4% due to currency and the balance, 27% due to a drop in business volume.

The recession hit us almost equally hard in both of our reporting segments during the quarter as our engine business was down 30% and industrial was down 31%, and all of our major regions were down.

And we'll look at these in local currencies.

Asia was down 19% primarily due to Japan, NAFTA was down 25% and Europe was down 35%.

However, we are, as I mentioned earlier, now seeing signs of stabilization in many of our end markets as we did see a sequential increase from the third to the fourth quarter.

Some of the highlights from our product groups include our special applications area where sales were up 24% from the third to the fourth quarter due to growth in sales for both disk drive filters and membrane products.

And our engine after market business was up 10% sequentially due to an improvement in our replacement filter sales.

Now I'm going to switch gears and talk about our outlook for fiscal 2010.

First a qualifier.

In my business career our current lack of visibility into the future is unprecedented at least since the early '80s.

Consequently, we do remain very cautious to forecasting a return to growth in the near term.

We know that capital spending in most industrial end markets continues to be constrained, especially for large equipment whether mobile or plant investments or power generation projects.

We also know that financing remains difficult for many of our smaller customers.

So based on recent input from our customers and the current macro-economic forecasts that we read, we are forecasting that our sales for the next two quarters, or the first half of fiscal 2010, will be approximately at the pace of our previous two quarters, the third and fourth.

We are then forecasting a modest sequential improvement during the second half of fiscal 2010.

Now our year-over-year comparisons will be difficult, especially for the first quarter since as I mentioned a minute ago we posted record sales of $573 million last year just prior to the recession hitting us.

We expect our full year sales to be between $1.65 billion and $1.75 billion or down 6% to 12% from fiscal '09.

Given that we are not forecasting anything like an immediate strong V-shaped recovery, we are continuing to focus on our cost control initiatives to insure that we continue to balance our expenses with our current and projected business levels.

Under our corporate philosophy of Kaizen, or continuous improvement, we have dozens of specific project teams working across our organization to further reduce costs and improve our operating efficiencies in our product designs, our purchase materials, our manufacturing processes, and our operating departments.

Our objective includes not only managing today's costs but also optimizing our business for the future.

We also have ongoing return on investment initiatives focused on implementing long term improvements in our working capital utilization, specifically in inventory, accounts payable and accounts receivable.

You can already see solid evidence during our recent quarter of the success of these initiatives with the sequential improvement in our gross margin percent and our record free cash flow of $61 million during the fourth quarter.

While we've had to prioritize our strategic projects during this recession, we continue to invest in both select new filtration technologies and geographic expansion projects which will help to position us to realize our long term growth plans.

For example, we've continued to raise the bar in the air filtration market with our PowerCore technology.

Building on the incredible success of our first generation PowerCore, we have released PowerCore Generation 2 or G2.

G2 allows us to further reduce the system size and enhance the performance for our customers versus both our original PowerCore technology or anything else on the market.

We've already won 18 platforms, seven on road and 11 off road with G2 and we have another 20 programs in the proposal stage.

On the industrial side of our business we introduced PowerCore technology in our Torit dust collectors.

These new dust collectors are 50% smaller than the bag house collectors they compete with.

And despite the recession, demand for these new collectors really took off as we've already received orders for over 300 systems and quoting activity remains high.

We believe that about 80% of these orders represent incremental business for us.

In addition to continuing to bring our customers better and better filtration technology, we remained focused on improving the value we bring.

In order to support our global customers as they expand around the world, as well as new customers in the developing economies, we did continue to make progress on our long term international expansion plans.

Recently in India and China we've won four new engine OE programs with major local customers with the first production starting late in calendar 2010.

To support both our customers and our regional growth plans, we completed a major project expansion in India, we also broke ground on a new technical center in Belgium to better serve our European based customers, we started up a new manufacturing plant in Brazil and we completed an expansion to our disk drive filter production in Thailand.

Both PowerCore and our recent OEM wins in China and India represent real market share gains which will help us to recover from this recession sooner and grow our business long term.

So as we begin fiscal 2010, our overriding goals remain, first to improve our service levels and value propositions for our customers; second to protect the financial health of our Company while continuing to pursue our highest priority strategic initiatives.

All of these are key to our long term future.

It is a difficult balancing act but it is one that the Donaldson team has done very successfully in the past.

So we do believe that the worst of this recession is behind us.

We are currently expecting a slower gradual recovery.

However we do firmly believe in the long term growth opportunities in the filtration markets we serve.

When growth conditions do return, we will have our Company positioned with the right global organization, the right investments already made and with a balance sheet and cost structure that will allow us to fully capitalize on the global recovery.

I am very proud at how well we responded to this economic crisis and I remain very excited about our long term future.

Julie, that concludes our prepared remarks.

Now we would like to open it up to questions.

Thank you, sir.

(Operator Instructions) Thank you.

The first question comes from Kevin Maczka from BB&T Capital Markets.

Good morning, everyone.

Bill, first on the restructuring, you talked about consolidating a couple of distribution centers in the US, one in the UK, and of course the headcount reductions.

I'm just wondering with your guidance for another down year in fiscal '10 if there's other maybe even larger restructurings or other cost initiatives of any type that you're contemplating or if there's some trigger point where you're ready to move forward in 2010 with more than just what you didn't finish in 2009?

Kevin, I'll take that.

This is Tom.

You're right.

We did announce another $12 million to $17 million of restructuring costs in F10 but we think that that should take us through where we are today and the global economy.

We don't have any other plans at this point but I think very importantly if you think back to Bill's comments, he mentioned many efforts we have going on in the Company from cost productivity improvement efforts, cost controls, return on investment efforts, that should continue to pay dividends.

So we're going to continue to work those plans but there aren't any additional restructuring actions other than the ones I referred to.

Okay, and then in terms of some of the end markets it's good to hear the talk about stabilization but I think a couple that sound like they're maybe not stabilizing, gas turbine obviously, I think the guidance suggests that 2010 will be another leg down even from the Q4 run rate.

And aerospace and defense I think with the Blackhawk and other programs seemed like they were doing better in Q3 than your outlook for 2010.

Can you just talk a little bit about those two end markets?

Kevin, it's Bill.

I just want to add something to Tom's comment on the restructuring.

As we noted, some of the things we planned to do in the fourth quarter we didn't for a variety of reasons, didn't complete, so some of this is stuff that we had contemplated in the fourth quarter that's carrying over into the new fiscal year.

On the end markets, it's a mixture.

One of the strengths of Donaldson Company is the diversification we have with our end markets.

We do have some end markets that are in a later cycle decline.

I think we alluded to that.

Gas turbine is one of those and we look at, as an indicator, what GE talks about and they're talking about their orders through their second quarter being about half of what they were in the previous year and their shipments being down.

So we see the gas turbine market as being one of those later cycle.

And you mentioned the aerospace and defense.

And defense specifically, that business for us was one of our heroes in fiscal 09, had a great year.

But what we're seeing is that that's not going to continue at that pace and part of that is a reflection of some of the changes in government spending but more specifically the changes in where our troops are going to be from Iraq to Afghanistan.

In Afghanistan there's less need for a lot of the equipment that uses our filter so that's going to moderate the growth in that business.

So in gas turbines specifically there's no share loss going on here?

Your customers' trends are actually worse than what you're suggesting in your guidance?

Exactly.

I think in GE's conference call, they said their orders through the first half of their year were 26 versus 58 the year before, so less than 50% of the order intake.

And they're probably the barometer for the large gas turbine market, so that market is a later cycle decline.

Okay, thank you.

I'll get back in line.

Thank you.

The next question comes from Harnzah Mazari from Credit Suisse.

Please go ahead.

Thank you.

Just was wondering if you could just touch on the after market opportunity you have, whether you can quantify that or maybe put a time frame to it, a frame for us, the opportunity as it relates to increasing amount of equipment in the field with PowerCore, as well as what the current run rate of after market is on the engine side, as well as what that should be on a normalized basis as a percent of the overall mix in your view.

This is Bill.

I'll start.

The after market business is doing better on the engine side than the first fit businesses in all regions, and that's generally because while new equipment isn't being produced or hasn't been produced at the rate it had been before, people are using the existing equipment in the field.

So we're getting better, less of a decline, I should say, in the after market than we are in the first fit and we're seeing that generally in every region.

I think what we're seeing with PowerCore and other technologies like PowerCore is that over time, we're increasing our share as we use proprietary technology where it's very difficult for our competitors to replace us.

PowerCore today, in terms of our percentage of our after market, is still a small percentage but it's growing as we have more and more of these vehicles out into the field with both the Gen 1 and now the Gen 2 systems.

We're doing the same thing on the industrial side, as I mentioned, with the Torit PowerCore, and we're going to see the same advantages that will make it very difficult for anyone else to place our filters in dust collectors as we start to get more of those in the field.

Okay, thank you.

Did I hit all the points of your question?

Yes, that's fair.

And my other question has to do with trying to understand your guidance a little bit better.

You commented that the worst is over in some of the early and mid cycle businesses.

Could you elaborate on your definition of those businesses, which businesses you're referring to there, and how much of a pick up you're baking in in the second half of 2010 in those specific businesses?

Thanks.

I'll start on this and I'll invite maybe Tom to add as well.

This is Bill.

The businesses, the end markets that we see that are stabilizing would be markets, say, like the construction market, both the small and heavier construction.

And we see that stabilizing now in this third calendar quarter that we're in.

And we look to guidance there from major customers like Caterpillar who talks about their calendar quarter being their worst quarter and then starting to recover so we think we're in that on construction.

We think heavy truck is there and that over time, I think most people are estimating a very gradual recovery from calendar 2010, but we think that that's stabilized.

On the industrial side we see our disk drive market had stabilized and the membrane market probably stabilized.

So those are a couple of examples.

We have some regional examples, as well, where we think that, say, in China, that they stabilized maybe a couple months ago and now are coming back generally.

So those would be the earlier cycle end markets that are now stabilized or starting to recover.

Tom, did you want to?

No, you covered my points, Bill.

Okay.

Was there another part to that question?

And you talked about mid cycle as well?

Well, we are probably separating them into those that are in the category I just mentioned and the ones that are still either going down or we're not sure if they stabilized.

I would say what we talked about earlier about gas turbine and defense and aerospace.

Gas turbine going down, defense and aerospace moderating.

I think the other industrial markets we have would be dust collection, compressed air filtration.

Those are a later cycle and those we're not sure if they have bottomed out yet or not.

I think the recent, even today talking about the manufacturing recovery, maybe that's the precursor for those stabilizing or eventually starting to recover.

The one other one we talked about was the after market, and the after market, it's related to equipment utilization both on and off road and I think we would say that we have seen that one stabilize.

Okay, great.

Thank you.

Thank you.

The next question comes from Charles Brady from BMO Capital Markets.

Please go ahead.

Good morning.

This is actually Tom Brinkman for Charles Brady.

Just a couple questions.

First of all, can you give us what the first quarter of fiscal 2010 would be for the restructuring charge, any estimate on that?

Tom, this is Tom.

I said in my comments that our restructuring charge estimate for fiscal 10 would likely result in the vast majority of those charges being in the first half.

The split between Q1 and Q2 we really aren't prepared to talk about, and to a certain extent that's going to be a little bit outside of our control at this point, but look for the majority of those charges in the first half.

Okay, what do inventory levels look like in the channel at this point?

Bill here.

I think that most of the workdown of inventories is now behind us.

We talked about this in the last call and I think at that point we thought it had already happened with our smaller distributors and now we think that most of that is also behind us in terms of our larger OEs, as well.

So we think that most of that is behind us.

Okay, that's good.

And then of the costs that you guys have taken out of your business, how much is variable cost that will come back when volumes come back?

I think in the past it had been about a 60/40 split between cost of sales and operating expenses.

Can you just talk about how you expect that to break down going forward?

Tom, this is Tom.

I'll take a stab at that.

I think we got that question last quarter too and I think I'll start out by saying at these volume levels, the cost takeouts that we mentioned would be permanent.

As volumes come back, it is just really really hard to put any dollars associated with that comeback.

I would say that what is going to come back first from a cost standpoint will be the variable cost in the plants, bringing back direct labor people.

But we don't have any precise formula as to what percent of the costs come back if volumes tick up 10% or 15%, it's just too hard to do.

Okay, and then can you give us any color on the on road business as it relates to the stabilizing of the build rates?

Do you see that both North America and Europe?

And maybe for the latter half of fiscal year 2010, do you expect any pickup there?

Tom, this is Rich.

What we've seen is the build rates stabilize at levels last seen in the early '90's.

Most of the forecasts for the calendar year suggest somewhere around 110,000 to 115,000 builds in the US.

We're at that run rate now.

Europe is running down around 15% on a year-over-year basis and that appears to have stabilized at those levels.

Okay.

And then finally, in terms of the defense sales, you'd touched on this a little bit.

Wondering if Donaldson filters are on any of the large contracts that have just been won for the military vehicles including the MRAP all-terrain vehicle or the next generation family of medium tactical vehicles?

And do you have any magnitude how much you think aerospace and defense sales might be off in fiscal year 2010?

This is Bill.

We are on most of those platforms with our filtration equipment so that's great news and it's going to help us longer term.

And all of that is baked into the guidance in terms of the numbers that we provided for fiscal 2010.

And just if I can jump back to your question about the on road.

We are looking for an improvement in calendar 2010 so this would be starting in January about mid year in the on road market, I'm talking specifically North America.

Probably maybe about 25% or 30% in terms of build rates year-over-year calendar 2010 over calendar 09.

But this year was a pretty bad year but the good news is that it looks like it's going to be heading up.

Okay, great.

That's all I had, thank you.

And that's in our second half of our fiscal year.

I got you, thank you.

Thank you.

The next question comes from the line of Eli Lustgarten from Longbow Securities.

Please go ahead.

Good morning.

A couple of questions and clarifications.

You mentioned last year you had a LIFO charge of $5 million.

Do you know what the LIFO incremental benefit was in the fourth quarter?

Was it similar to $5 million?

That $5 million charge did not repeat this year and we did not have a real significant adjustment either way, Eli, in the fourth quarter this year.

So really just a swing that you're referring to for the benefit more than anything.

There was no real benefit to earnings from LIFO?

Yes, think about the $5 million as the year-over-year change.

But there was no absolute benefit by itself in the quarter from LIFO?

Not in the fourth quarter, no.

Right.

Secondly, you gave a forecast for gas turbines down 21% to 26%.

Now that includes the after market, or I assume that includes that after market, and therefore the OEM business is probably down 40% to 50% and the after market is down a lot less?

Is that how to look at it?

Eli, Bill here.

Yes, it does include the after market.

The after market in gas turbines is only about 30% of the total revenues, just given the size of these first fit projects.

So the projects are down more than the after market, you're right.

You talk about the truck market stabilizing.

Now we are seeing a lot of evidence of the truck industry over building in the next six months between now and December 31, and particularly in engines, we're building the current engine, I think they want to do what they did in '06, '07, and sell 10 trucks with nine engines or so.

Are you seeing any pick up in any incremental volume from that overbuild that's taking place or is that mostly going to come in the air filtration?

Eli, this is Bill.

Our filtration equipment is generally sold to the truck manufacturers not to the engine builders so it's installed with the trucks.

So even if the engines are built ahead, that's not going to materially pull ahead our sales.

It would only be if they completely built the trucks ahead.

So you'll just ride with the market.

And then you mentioned Caterpillar construction stabilizing and Cat did tell you the third quarter and that's by far the worst of everything.

Have you gotten any sense for what kind of incremental improvement after the third quarter you can expect in construction equipment or do we stay at these weaker levels for the next couple quarters?

I'm just trying to get a sense, as we progress through your fiscal year, we go through the bad quarter but does it get better, or does it stay at that level in construction as we look out?

Eli, Bill again.

I think they were pretty modest in what they both said in their call at the end of July and what they've told us because I think it gets back to that visibility but they've been pretty consistently saying they believe this third calendar quarter, which we're almost half way through, will be their worst, and then it will start to pick up in the fourth.

And then going into calendar 2010, continue to improve sequentially.

But I think they talk about it using words like "moderately" or "modestly" or things like that so they're not talking about a strong recovery.

And you mentioned you have a new plant that you just started up in Brazil, during your comments.

In your forecast you talk about farm equipment particularly outside the US going down, which is true, but it's the Brazilian market that's been focused on by many of us showing the same signs of potential improvement next year because of increased funding from the government and a lot of suppliers.

Can you talk about your Brazilian plant, and are you expecting to benefit from any of that improvement that seems on the horizon at this point?

We are.

We had been importing into Brazil before we opened the plant up so now we're making locally and it's tremendous upside for us there whether the economy goes up or down just because our market shares are low.

And we have a lot of global customers relocating to Brazil.

So Brazil was one of the bright spots year-over-year in fiscal '09 over fiscal '08 but the numbers are small but we look for them growing significantly over the next couple years.

Thank you very much.

Thank you.

The next question comes from the line of Jeff Hammond from KeyBanc Capital Markets.

Please go ahead.

Hi, good morning guys.

Bill, you mentioned the sequential improvement in the after market business and special applications.

Is that just simply the end of destocking?

Or maybe just speak to the sequential improvement, where you saw it, is there real demand improvement, just a little more color there.

Jeff, Bill here.

I think I'll start with the after market.

I think it's probably, we're sort of guessing but we think on the after market that it is the end of the destocking and then improved utilization of the equipment that's out there.

And on the disc drive, that's a first fit business, we're selling to the hard disk drive manufacturers and I think that they also had inventory they had to work through with hard drives, the computer makers, and I think that they've worked through that and maybe there's some pickup in terms of consumer and business demand for PCs.

And where are you seeing better utilization of equipment for the after market?

I think we're seeing it in both on road and off road.

Okay.

And then you talked a lot about defense which I think falls into the off road business but that went from $82 million to $72 million sequentially.

What was the big driver of that drop off sequentially?

I'm looking at Rich, Jeff, hang on a second.

The real sequential difference is just the shift in theatres of operation.

There's less maintenance going on in the equipment in Iraq now.

Most of it is not being used to the extent that it was.

And as Bill mentioned, in Afghanistan, the equipment they are using is smaller, less content and obviously fewer pieces of equipment there, as well.

Right but my question, though, is more broadly on off road which I think captures ag and construction down $10 million sequentially.

My understanding was the defense business is pretty small within that.

Defense is about 20% of that.

Okay.

And that was where you saw the biggest variation?

That one and -- I'm just looking at my numbers real quick here to verify.

There we were still okay in the quarter.

We did have some benefit from the Western Filter acquisition.

After that, then, it was construction starting to stabilize, ag starting to go down a bit.

That was probably the biggest shift there.

So not really a benefit from construction going up but a lack of a downdraft, I guess.

So would you put ag in the category of still deteriorating?

Yes.

On a global basis, yes.

And final question, good improvement on the gross margin line, a lot of moving pieces there.

How should we think about that gross margin line in terms of sustainability going forward, obviously adjusting for any restructuring noise.

Jeff, this is Tom.

With the guidance that we gave for F10, we're looking at gross margin in the 32% to 33% range and that would include some of that restructuring charge.

The programs, again, that Bill mentioned from a cost reduction and productivity improvement standpoint, have had a big impact and for that reason, even at these volume levels with some restructuring charges and with excess capacity in the plants, we're hopeful that we can hold gross margins north of 32% in F10.

Okay, thanks, guys.

The next question comes from Brian Drab from William Blair & Company.

Please go ahead.

Good morning.

I just first wanted to ask about SG&A and sequential change.

If I'm looking at the numbers correctly and I remove any charges from restructuring, it looks to me like operating expenses actually, in SG&A specifically, increased about $10 million from the fiscal third quarter to fiscal fourth quarter.

And that's surprising to me given all the focus on cost cutting and I was wondering if you could explain that?

Brian, this is Tom.

Once you back off restructuring, there is a bit of an increase quarter to quarter.

And if you think back to our third quarter call, we talked about a reduction in incentive compensation in the third quarter, and we, because of the downturn, we needed to adjust our accruals, both accruals that we recorded earlier in the year and for our long term incentives accruals that we made in the previous two years.

So in the third quarter there was about a $10 million quarter-over-quarter benefit and that in itself is by far the largest reason for the sequential year-over-year increase.

Okay, great.

That explains that.

And next I just wanted to ask, just for point of clarification, I think Bill it was you mentioned that first half 2010 sales are expected to come at the same pace as second half 2009.

Does that mean that overall expect the volumes to be about flat sequentially over those periods?

Right.

The mix of all of the markets, Brian, we would expect that all corporate sales would be about what they were the last two quarters.

Okay, great.

And then just one more follow-up on one of the questions that was asked earlier in the call regarding off road.

I have the same question about the decline of about $10 million in that business sequentially.

Were you seeing some of the end of the inventory reductions at Caterpillar there or was that not really as big a factor this quarter?

I think some of the decline in the off road, we might have touched on this earlier, is related to a number of plant shut downs in this fourth quarter at major customers, so on a first fit side, that dropped quite a bit.

And they were trying to balance their inventory of equipment and they took advantage of a lot longer shut downs during the summer period.

Okay, great, and then one last quick one.

On the restructuring, you mentioned that there are some delays in the restructuring.

Are those issues that are completely behind you at this point?

I don't know if you'd be willing to offer any detail on what were the causes of some of those delays?

Brian, this is Tom.

We aren't saying a whole lot about that.

We haven't announced it internally, so we're just going to be pretty quiet on that, but we have plans to get there and we're quite confident we can execute those plans in fiscal '10.

As you probably know, sometimes these just take a little bit longer than you initially anticipate.

Okay, great, thank you.

Thank you.

The next question comes from Richard Eastman from Robert W.

Baird.

Please go ahead.

Good morning.

Tom and Bill, when you give your sales guidance for fiscal 2010 and we have this minus 6% to 12% guidance, my assumption is that the residual cost savings, which is a number like $57 million gross savings, that that should all be realized and in your guidance given that sales assumption?

Yes, Rick, this is Tom.

It is in our guidance and I think your math is pretty good.

And then the cost, the $12 million to $17 million, so we should net about $40 million to $45 million of savings pro rata throughout the year?

That's roughly the number, Rick.

Okay, I understand.

And then just to clarify, Bill, the engine segment guidance that you presented that rolls up to this minus 3% to minus 8%, that includes a bit of positive currency.

Transportation has gotten pretty tiny if you start to weight this, and if we're saying after market should be slightly improved, it would suggest that the off road piece may decline something like 15%.

Is that right?

I'm looking at Rich for a second, Rick.

He's checking his numbers.

The currency part of that is 1%, but I just wanted to maybe go back to the comments with Tom about the guidance and just put this in perspective for a second because coincidentally our guidance for fiscal 2010 approximates what we did in fiscal 2006.

If you go back to fiscal 2006.

So we did about $1.7 billion then so that's how much of a reset this whole thing has been for us and many other companies.

And then if you take a look at our EPS guidance and you exclude the restructuring charges we talked about and just take a look at it excluding those, on that same sales level of approximately $1.7 billion, we're talking about doing roughly $1.50 something which is what we did in fiscal 2006 which was our 17th consecutive record.

So we're trying to do our best in what we see as a pretty sluggish, but maybe slowly recovering environment.

But I just wanted to relate it just coincidentally because the sales are back to about that level but the EPS is what we're planning and guiding to ex-restructuring is what we did, and that was a record when we did it.

That's a good point and resizing to that $1.7 billion revenue number.

Exactly.

Right.

Rich?

Rick, if we look within the engine segment, on a year-over-year basis, the biggest negative comparison we're likely to have is going to be the off road business.

You're right there.

And that's, again, we've got ag headed south, we've got construction at best flat, we've got defense headed south, so we are likely to get a double digit decline.

Yes, and also, our off road business had a really good start to the year last year.

So on road flattish.

And quite frankly, the after market when we say slightly, we're not looking for historic record breaking growth this year.

It's off the bottom but we're not talking 50% or anything crazy like that.

Okay.

And in terms of just on the engine side of the business, is there any reason to fear that pricing might start to get aggressive or are you pretty comfortable that pricing in both the after market and first fit side are reasonably stable here?

Rick, it's Bill.

Pricing is always aggressive so I think it's more of the same.

That's the world that we live in so we don't see it changing from where it has historically been.

Okay.

And then the industrial piece of the business historically has been the lagging piece.

Comparisons aside, if you're just thinking about revenue and volumes in the industrial piece as a whole, it would seem that timing maybe places the bottom in industrial maybe in the April quarter.

Is that cutting it too close for guidance?

You mean next April?

Yes, your April quarter, your third quarter?

If you just think about it in terms of volume and backlogs, shipping schedules?

Rick, Bill here.

I hope that it would come back sooner than that.

Every day brings more news, some of it positive, some of it negative.

Today was a little bit more positive.

We do know though that the industrial, the dust collection and compressed air is a later cycle business.

That held up very strong, like right into the first part of this new calendar year back into like January.

And when a lot of the engine markets had already collapsed, and then it started in that first calendar quarter.

We're not really guessing exactly when it's going to bottom or turn.

We're just saying that it's later cycle and we're not sure when that's going to happen.

And then just the last question.

On the raw materials side is there a positive at all?

Are your raw materials year-over-year less price wise or cost wise?

Rick, this is Tom.

There's a small benefit year-over-year.

Okay, all right thank you.

Thank you.

The next question comes from Adam Brooks from LLC.

Please go ahead.

Yes, good morning guys.

Just a few quick questions.

On the after market side could you break down what the performance was within engine, maybe within industrial air filtration, within the different regions, say Asia, Europe and North America?

Adam, it's Bill.

Rich is getting the data on that.

Do you have another question while he's doing that?

Yes, definitely.

Talking about PowerCore obviously more of those first fits in the field.

Can you talk about maybe any market share gains where you see the greatest or maybe it's been a little less than expected?

I think it's been maybe almost everything we hoped, so better than expected or maybe slightly better.

I think on the Torit side, the dust collection side, I think I might have mentioned this in my remarks that we think about 80% of those 300 systems that we've sold, that's incremental business where we would not have won the business because we didn't have a product that was competitive, so all incremental.

And on the engine side, we are already the first fit on many of those platforms but we're picking up business there as well that we think is incremental.

So both sides of the business there's an incremental benefit to market share that's going to benefit us going forward.

I know you guys won't necessarily specifically speak but maybe touch on it a little bit earlier.

As far as acquisitions, clearly valuations are around more reasonable levels than they have been in the last two years.

Are you still on an acquisition hunt with an improving balance sheet?

Adam, Bill here.

We're always looking.

We don't comment prospectively.

I would say we did one early in this last fiscal year, Western Filter.

We did that, and we'd been working on that for a couple years, and even as we saw the recession starting to come over us, we knew it was the right long term thing to do so we did it.

So we've been looking.

I would say generally, though, we haven't seen a lot of activity in the marketplace.

My guess is that a lot of potential acquisitions have been dealing with the recession and they are working on that rather than trying to put themselves on the market, so maybe as things start to improve there will be more activity but we're always looking and that will help us.

We're mostly an organic growth story, as we've said before, but we do do strategic acquisitions to help supplement that.

Thank you.

Rich has got the questions on the after market.

If we look at engine after market, if we look at it on a regional basis in local currency terms, in Europe it was down 19% year-over-year, down 5% in Asia.

In the Americas it was down 17%.

That's fourth quarter over fourth quarter.

Yes, that was fourth quarter over fourth quarter.

I know you probably don't break it out but was there any big disparity within industrial air for Europe versus North America specifically?

Let's see here.

I think it was a little bit weaker in North America than it was in Europe.

Europe was down about 28%, North America down a little bit more than that.

Thank you.

(Operator Instructions) We have a follow-up question from Kevin Maczka from BB&T Capital Markets.

Please go ahead.

Yes, thanks.

Tom, I'm just wondering if you can say a little bit more about this CapEx outlook.

It looks like that's taken another leg down to $30 million to $40 million and it wasn't exactly a high growth year or a year for high investment in expansion projects.

Can you just say some more about that?

Sure, Kevin, you're right.

The guidance for F10 is $30 million to $40 million.

We did come in at $46 million in fiscal '09 so it's not a significant reduction from fiscal '09.

But the real key is that we really don't have any significant expansion efforts in process so what drove us to the peak in, say, fiscal '08 of $71 million was a number of the expansions that we've mentioned over the last couple of years.

So if you strip out the expansions, what we have left in there is CapEx for tooling, cost reduction projects and process improvement projects.

And we feel pretty comfortable we can stay within that $30 million to $40 million in F10, again assuming we don't initiate any expansion projects which we do not have on our planning horizon at this point.

And the low end, that $30 million, is a bare bones, maintenance level CapEx?

Kevin, this is Bill.

It's that and supporting our cost reduction and new tooling investments for some of the strategic programs, but it's a lower level.

And as Tom mentioned, and I just wanted to reiterate, for three years from 2006 to 2008 we spent on an average of about $75 million consciously, we focused a lot on CapEx expansion efforts around the world.

Part of that was we didn't see a lot of acquisition opportunities so we focused it internally.

And we have the benefit now of those investments we can enjoy.

As I mentioned in response to Rick Eastman's question earlier, we're looking at a year that's more like our 2006 in terms of revenue so we have the investments in place.

We shouldn't have to, as Tom mentioned, make any additions until economies really start to take off again.

We see that out probably a couple years at least.

Great and a couple of housekeeping questions.

How much corporate expense is baked into your margin outlook?

A very comparable.

I don't have a specific number for you, Kevin, but a very comparable level to what we experienced this year.

So we've certainly taken out some corporate expenses in the second half of the year and that we would expect to be pretty much our run rate for fiscal '10.

And Tom, I may have missed it but did you give the restructuring cost for Q4 by segment?

You mean by engine and industrial?

Yes.

It's about roughly 55% industrial, 45% engine.

Okay, thank you.

Thank you.

That concludes the question and answer session.

I would now like to hand the call back to Bill Cook for any closing remarks.

Thanks, Julie.

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

To everyone on the Donaldson team, we obviously didn't plan for what happened in fiscal 2009 and it was a very challenging and unusual year as a result.

We were tested and I'm very proud and grateful at how wonderfully we responded to this crisis.

While we will face some continuation of these challenges in fiscal 2010, we are ready for them, and as a result, I truly believe that the best days for Donaldson remain ahead of us.

Thanks for your efforts and your support.

Goodbye.

Thank you.

This concludes the Donaldson Fourth Quarter Conference Call.

Thank you for participating.

You may now disconnect.