Donaldson Company Inc (DCI) 2010 Q3 法說會逐字稿

Good morning, ladies and gentlemen, thank you for standing by.

Welcome to the Donaldson third quarter fiscal year 2010 conference call.

During today's presentation, all parties will be in a listen-only mode.

Following the presentation, the conference will be open for questions.

(Operator Instructions) This conference is being recorded today, Tuesday, May 25th, 2010.

I would now like to turn the conference over to Rich Sheffer.

Please go ahead, sir.

Thank you, Brandy and welcome everyone to Donaldson's fiscal 2010 third 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 third quarter.

Tom will then turn the call over to Bill Cook, our Chairman, President and CEO, who will discuss our updated outlook for the balance of 2010, the business conditions shaping that view.

Following Bill's remarks, we'll open up the call for 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.

I would like to turn the call over to Tom VerHage.

Tom.

Well thanks, Rich and good morning, everyone.

Yesterday we released our third quarter earnings after the market closed and updated our guidance for the balance of the year.

Sales increased 20% from last year's third quarter, which was the trough quarter for us during the global recession.

Our sales have increased each quarter sequentially since then, and were up 14% over the second quarter as our early cycle businesses continued growing, hence some of our mid-cycle businesses have now started to rebound.

Bill will discuss this further in a few minutes.

We have completed our previously announced restructuring plans and incurred a $3.7 million pretax cost in gross margin in the quarter compared to $1.9 million in last year's third quarter.

There were no charges in operating expenses this quarter versus $4.9 million last year.

This quarter's charges related to a downsizing at one of our plants in Europe and included severance, a charge for an inventory write-down and an asset impairment charge to write down the book value of the building.

Since we began these restructuring efforts in January 2009, we have incurred costs totaling $27.9 million or $0.24 per share.

The difficult but necessary actions we undertook allowed us to appropriately match our cost structure to our reduced sales levels during the downturn helping us to remain solidly profitable through the recession and benefit as we now emerge from the downturn.

Our gross margin was a record 35.6% in the quarter, a year-over-year increase of 400 basis points from 31.6% last year.

Better absorption of fixed costs due to improved volumes in our plant increased gross margin by 210 basis points, while savings from our restructuring actions combined with our ongoing cost reduction activities increased gross margin by 250 basis points.

For the third consecutive quarter, replacement filter sales were over 50% of our total sales.

This quarter replacement sales were 52% of total sales, a little less than the last two quarters as our first-fit businesses are beginning to rebound.

Our strong replacement filter sales are the leading cause of the 40 basis point margin improvement due to product mix.

Finally, the previously mentioned restructuring and asset impairment charges of $3.7 million compared to $1.9 million in gross margin last year.

We are beginning to experience purchased material commodity cost increases.

To date, we are containing the impact of these increases through our continuous improvement programs.

We do expect raw material costs and especially steel, which is our largest purchase material, to increase moderately early in our fiscal 2011 as we begin to negotiate new contracts.

Operating expenses as a percent of sales fell to 21.2% compared to 22.5% last year, which included $4.9 million in restructuring charges.

The combination of our record gross margin and operating expense control delivered a record operating margin of 14.5% in the quarter.

Including the restructuring charges we have taken, we're now expecting our full year operating margin to be between 12.3% and 12.9%.

Our effective tax rate was 29.4% in the quarter versus 24.8% last year.

Last year's third quarter included tax benefits of $2.6 million primarily from the favorable conclusion of an international audit.

Based on our projected global mix of earnings, we expect our tax rate to be between 26% and 28% this year as our geographic mix of profits appears to be more favorable than we originally forecasted.

Our third quarter CapEx came in at $9.1 million.

We are moving forward with strategic projects, such as tooling for new product platforms, capital investments that allow us to achieve cost reductions and our new European technical center in Belgium.

Our full year CapEx guidance for fiscal 2010 is between $35 million and $45 million.

We expect depreciation and amortization to be in the range of $58 million to $62 million.

Free cash flow was $54 million this quarter versus $100 million last year.

Working capital was flat in the quarter despite the 14% sequential sales growth as both DSOs and inventory turns improved over last quarter.

We expect free cash flow to be $145 million to $165 million for the year.

At the end of the quarter, our debt to cap ratio was 26.4% and debt to EBITDA was 1.0%.

Both of these improved from the previous quarter and are well within the financial covenants in our various debt agreements.

We're now expecting interest expense in fiscal 2010 to be between $11 million and $13 million.

Our balance sheet remains strong with over $208 million in cash.

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

Bill.

Thanks, Tom and good morning, everyone.

I am also very pleased to be discussing the results of our very good quarter.

Just to summarize, we had solid growth in our top line with sales up 20% year-over-year and up sequentially 14% from our second quarter.

Our operating income was up the 91% year-over-year with an operating margin record of 14.5%.

Bottom line, the combination of our solid revenue growth, record operating margin performance delivered a net income increase of 86% and an all time EPS record of $0.62 per share.

Probably needless to say, but I will anyway, I am very proud of the performance of our Company and very thankful for the outstanding efforts of my fellow employees who delivered these wonderful results.

Now I'd like to talk about some of the details in the quarter.

As Tom discussed, our business operations executed very well as we quickly ramped up to meet the strong order increases we saw with many of our customers.

New order strength we saw was relatively broad based as most of our business units reported higher local currency sales compared to last year.

So starting first with our Engine Product segment, local currency sales increased 26% over the same quarter last year.

Within this segment, our aftermarket, or replacement filter business, was up 37% in local currency as the utilization rates of existing trucks and Off-Road equipment fleets continued to improve.

We also believe that the improved utilization rates have caused some of our customers, dealers and our distributors to adjust their inventory levels upwards.

We have continued to aggressively add dealers and distributors globally through the recession and believe that we have increased our market share.

Our two Engine OEM businesses were both up strongly in local currencies as well.

Our Off-Road product sales were up 18% as both construction and mining markets have rebounded for our customers.

And the ag equipment market had been better than we expected last fall.

Our On-Road sales were up 50% in local currency as the North American heavy truck builds have finally began to rebound.

And finally local currency sales in our Aerospace and Defense business declined 9% this quarter as our military shifts its emphasis from Iraq to Afghanistan.

This change has impacted our business as the type of filtration equipment used tends to be different and with less content.

Now switching to our Industrial Product segment, local currency sales increased 3%, sales in our Special Application products increased 37% as both our disk drive filter and membrane product lines had strong quarters.

However sales in our Industrial Filtration Solutions declined 2% local currency.

While sales of replacement filters continued to increase, our sales of large industrial equipment, especially dust collectors which we believe is a later cycle business, has been slower to recover.

And finally, in our latest cycle business, Gas Turbine systems, our sales decreased 8% year-over-year.

We do, however, believe that the power generation industry we serve is nearing the bottom of its current cycle.

Now, looking at our sales by region, we also see evidence of how broad based our sales increase was, as in local currencies our sales in Asia were up 25%, up 17% in Europe and 10% in the Americas.

Now I'd like to switch and summarize our outlook for the balance of the fiscal year.

And as noted in our press release, we have increased our full year sales guidance to be between $1.83 billion and $1.86 billion, which means sales in our fourth quarter are roughly $470 million to $500 million which will be an increase of between 11% and 18% over the same quarter last year.

We expect slightly higher local currency sales, an increase of local currency sales but also expect foreign currency translation to be a headwind in our fourth quarter due to the recent strengthening of the US dollar versus the Euro.

Looking at our outlook by segment, our Engine segment sales are forecast to be up between 6% and 8% for the full year.

We expect sales to our Engine OEM customers to continue improving as their production rates increase to match growing end user demand.

As noted a few minutes ago, we are forecasting slightly lower Aerospace and Defense sales due to the changes in US military activity.

And we expect our aftermarket sales to remain strong as utilization rates for heavy trucks and Off-Road equipment continue to improve.

The outlook for our Industrial segment is a full year forecast down 8% to 12% as we are expecting demand -- we are, however, expecting demand for Industrial Filtration equipment to begin improving in the fourth quarter and replacement filter sales to continue to grow.

However, as we noted a minute ago, we're not expecting an imminent rebound in demand for large power generation filter systems in our Gas Turbine business.

And finally, we are expecting our Special Application sales to remain strong.

But coupled with our overall higher sales, we are expecting our operating margin, as Tom noted, to be between 12.3% and 12.9% for the full year, which includes all restructuring charges.

Year-to-date we're at 12.0%, so we are expecting another strong quarter operationally.

Now I'd like to give you a few highlights on some of the other things going on in our Company and really to support our growth objectives going forward.

First thing I'd like to talk about is new technology platforms and we have continued our release of PowerCore Generation 2 or G2.

G2 allows us to further reduce the system size and enhance the performance for our customers really versus anything else on the market.

So we've won 23 platforms, 10 On-Road and 13 Off-Road with G2, and we have another 14 programs currently in the proposal stage.

On the Industrial side of our business, we've introduced the PowerCore technology into our Torit Dust Collectors, these new dust collectors are 50% smaller than the bag house collectors they compete with.

And despite the recession, these new collectors have been very well received by the market as we've already received orders for almost 800 Torit PowerCore systems.

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

Also despite the recession, we continue to make progress with our key international expansion plans to support our customers as they expand around the world as well as new customers in emerging economies.

Last year we broke ground on our new technical center in Belgium to better support our European based customers.

This new technical center is now complete.

December we had the grand opening of our new Indian facility, and I'm very happy to report that this new facility has allowed us to set new production records each of the past five months.

Our emerging market growth has been outstanding, just a few statistics, these are year-over-year growth during the third quarter.

So Southeast Asia was up 42%, India 27%, Brazil 180%, Russia 133%, China 36% and Australia over 50%.

So very, very solid recoveries and growth in these emerging economies.

So to summarize our comments, we had a record EPS quarter marked by strong top line growth and great operational execution.

And clearly there still is a lot of uncertainty and many problems weighing down on the global economy.

And in addition, we see headwinds from both exchange rates and some commodity cost increases.

However, we are in a very different and much better position than we were this time last year.

Despite the fact that our sales are still a bit behind our pre recession pace, our strong execution focus should bring us very close in fiscal 2010 for the full year EPS record we set in fiscal 2008 before the onset of the recession.

Brandy, that concludes our prepared remarks.

Now we'd like to open it up to questions.

Thank you, sir.

(Operator Instructions) And our first question comes from the line of Kevin Maczka with BB&T Capital Markets.

Please go ahead.

Good morning.

Good morning, Kevin.

Bill, I guess my first question on the revenue guidance for the year and for Q4, it seems like the top end is -- implies flat sequentially and you commented about the FX headwind.

But is that really all FX related or are you seeing any slowdown at all in the pace of recovery in some of your early cycle markets?

Kevin, Bill here.

So I think as we look at the fourth quarter, our forecast for the fourth quarter over the third quarter and we've dug a lot into this, we're seeing sort of a stabilization of the business at -- in local currency at the current rates.

There's pluses and minuses by end markets, but if you put it all together, it would be stable, roughly stable in local currency and then the slight decrease is due to the change in the, essentially the Euro and the dollar, with stable in local currency fourth over third.

Got it.

And how should we think about seasonality going forward?

Because Q4 I think is typically better seasonally than Q1 but yet you've got this backdrop of this sequential global recovery happening.

Would you expect that normal seasonality to continue to be the case?

Kevin, Bill again.

I think the normal seasonality, those -- that probably ended with the onset of the recession.

I think there's lots of variables now at play.

I'm holding -- so holding aside the exchange rates in local currency, we're looking at sort of flat over -- fourth over third.

But then again, the third was up 20% over the same quarter last year and we're looking at a fourth quarter that is going to be up in double-digits over the fourth quarter last -- same quarter last year.

So I don't know when we'll get back to a normal seasonal pattern where our fourth quarter is usually the strongest, but that's just what we're seeing given how this recovery we think is playing out.

Okay.

And then in terms of new products and then I'll get back in line, but new products you mentioned that in the release.

Can you quantify at all how much new products introductions helped the top line this quarter or what your expectations are for future quarters?

Kevin, Bill again.

It's sort of an all-in number with our guidance, we sort of break it apart by piece.

And I use the Torit PowerCore as an example of those systems that we -- those orders that we've received.

We've estimated that about 80% of those are for systems we would not have gotten because they were going into end markets that we don't traditionally play in, so it's allowing us to get into new dust collections segments, but we haven't quantified that.

But we think between the new products and then the new distribution that we're adding, and a lot of that's in the emerging economies, that we're picking up share and that's contributed to the 20% year-over-year increase in the quarter.

And your aftermarket win rate, your batting average, if you will, on some of those new products, are you able to quantify that at all that that's better or worse than sort of normal levels?

Yes, generally, Kevin, Bill again, what we see is with PowerCore and other proprietary technologies but -- is that if you go back ten years ago when we introduced a new product and if it didn't have proprietary technology, maybe we had about a 30% aftermarket share retention sort of right out of the gates.

Now with technologies like PowerCore, and we have other ones on both the Engine and the Industrial side, out of the gates when we put a new installation whether it's an air cleaner on a truck or a dust collector in the field, our market share on the aftermarket is 100%.

So that's from 30% to 100% for a period of time.

That's really how we're changing our market share in the aftermarket and how it's contributing to the aftermarket growth that we're getting on both sides of the business.

Got it.

Okay.

Thank you.

Thanks.

Thank you.

And our next question comes from the line of Hamzah Mazari with Credit Suisse.

Please go ahead.

Good morning.

Thank you.

Good morning.

If you could just comment on the impact of the Euro and the fiscal issues in Europe and how you see that affecting you both from not just a top line perspective but from your cost base standpoint and any kind of longer term demand implications?

It's probably too early for most corporations to tell right now, but how should investors be thinking about this and the impact to you going forward both just short term and long term?

Hamzah, Bill here.

Good question, lots of different components to it.

I think the way we're looking at the Euro is that it changed very dramatically over the past month or so with the crisis in Greece and maybe looking at some other economies.

And so that's a -- we're forecasting a headwind in the fourth quarter due to the foreign currency translation, so the stronger dollar versus the Euro, so we'll get less dollars generated from our financial results in Europe during the fourth quarter, that's our forecast and our guidance.

I think that there's probably a couple of other things that we're trying to -- we baked into our guidance.

One is is that actually a weaker Euro over time would actually be good for our business in Europe because it would make many of our customers more competitive and especially in Germany where so much of their economy is export-based.

So a weaker Europe could be good for our local currency sales over time if it stays that way.

The other variable is just whether just this whole crisis in Europe around the Greece or Spain or whichever one you want to pick, whether that has a dampening impact on their recovery.

And we can't really see that -- how that's going to play out.

But we -- as far out as we've given guidance, which is our fourth quarter, we've included both of those impacts in our guidance, both the weak Euro and our anticipation of what's going to happen to business levels in our fourth quarter.

Okay.

How much of your cost base is in Europe, your production costs?

We're sort of naturally hedged as most of what we sell in Europe is in Euros and most of what we -- our cost of goods sold is in Euros as well.

Okay.

Great.

And then you talked about completing most of your restructuring and sort of becoming leaner.

How should we think about your current cost structure going forward relative to demand?

When do we expect sort of some of the costs to start rolling back?

Is that second half fiscal year 2011 or what's your best guess there?

I'll start and then I think Tom has a few things he wants to add.

I think we're looking at our margins and we've really done a lot of things during the recession to restructure our business and we use our lean or continuous improvement principles to do that.

A lot of it is really -- I think that the changes that we made we believe are permanent.

But as our volumes continue to improve, we are adding back costs, but we did that during the third quarter and you can see what our margin performance was.

So we're not -- we don't anticipate going back to what our margins were pre recession but maintaining many of the gains that we've achieved over the past 18 months.

Tom?

Bill did such a great job there's not a whole lot more to add.

But Hamzah, you might recall that in the past we talked about incremental margins of 30% for up to the first 10% sales increase.

And actually we believe we've exceeded that a bit.

Bill mentioned that some of these cost takeouts that we mentioned out of the $100 million that we have discussed in the past certainly have been permanent with actions like downsizing our distribution centers and the like.

But we have started to add back people.

We took out 2700 during the recession and so far this fiscal year we've added just a little over 800 back.

So as volumes continue to increase, we will continue to do that especially in the plants.

Got you, that's very helpful.

I appreciate it.

Thank you.

Thank you.

And our next question comes from the line of Laurence Alexander with Jefferies & Co.

Please go ahead.

Hi.

This is Lucy Watson on for Laurence today.

Just two quick questions.

I think you mentioned in your scripted comments that there's -- you're seeing a bit of restocking with your aftermarket customers, and I'm just wondering if you're expecting this to continue in your outlook for Q4?

Lucy, Bill here.

I think what we've seen talking to customers is that as those -- they have been, well let me back up.

They have been very cautious with building inventory as we all have been, just given maybe how uncertain the recovery has been, we've seen it over the past six months.

But as over the past few months and during our third quarter, we have heard anecdotally from large dealers and large distributors in some cases they've increased their stock levels, which has given us a little bit of a boost.

But generally everyone is being very cautious in terms of adding back the same level of inventory that they had pre recession.

So in our fourth quarter guidance, we're not -- we did not forecast a big replenishment because we're really not sure that that's going to happen that way.

We think it's going to be very gradual over time as customers get more comfortable with the strength of the recovery.

Okay.

Great.

And with debt to EBITDA down to I guess one time, have you, guys -- what is your -- or would you mind visiting your balance sheet targets longer term?

Lucy, this is Tom.

Good question.

At this point, we're -- we know we have a conservative balance sheet.

But we're pretty comfortable with the capitalization structure right now just given all of the global uncertainties.

So we certainly have a balance sheet that's strong enough for acquisitions and organic growth and we're going to continue to look at those opportunities.

Thank you very much.

I just want to add, I mean having $200 million in cash this point in the recovery is a great thing.

And as Tom mentioned, it gives us lots of maneuvering room for doing lots of different things, investing back in our business in terms of capital projects or making acquisitions if we see the right candidates.

Thank you.

Thank you.

And our next question comes from the line of Eli Lustgarten with Longbow Securities.

Please go ahead.

Good morning.

Too bad you picked such a day for nice numbers.

Good morning, Eli.

We can't control the market, we just focus on what we can control.

I know.

Couple quick questions.

One, you had $0.03 of profits from foreign currencies in your press release this quarter.

The third are similar to your -- the impact of the currency change will probably cost you $0.02 in the fourth quarter as opposed to giving you gain in the third.

Is that sort of the magnitude that we're looking at?

Yes, Eli this is Tom, if you look at the spot rates that we've put in our press release, you'll see that foreign currencies might actually shave about 2% to 3% off of our top line in the fourth quarter and that's about the percent that would drop to our bottom line too.

Guys, [not sure] I mean the Euro is not helping you today I think you had $1.26 in there and they're at $1.22 at the moment.

And can you talk a little bit about you touched on just now the restocking, were most of these sales particularly in the aftermarket really a flow-through to increased usage of product as opposed to do you have any sense of how much would have gone through as inventory and how much would have gone through as end market demand?

Because it looks like most of it would have been end market demand at this point, just revamping up when you need the products.

Eli, Bill here.

Yes, I think almost all of it went -- flowed right through to market demand with the increased utilization and maintenance of existing fleets and with a little bit of maybe stock levels were increased, but most of it was around -- flowed right through.

And is that happening with builds going up now in particularly in the construction of mining sector the rest of the year, are we expecting the first-fit to become the dominant portion of sales as we go maybe in the fourth quarter particularly in fiscal 2011 I would assume at this point as that ramps up in the current boom in the replacement market begins to level off?

I think the -- Eli, Bill again, I think the balance will shift a little bit as the first-fit business comes back.

I mean we talked about larger construction equipment obviously is really very, very strong and sort of the heavy truck business in North America bottoming out and now starting to come back.

So I think the balance will shift a little bit.

But a lot of what we've done in the aftermarket, back to my earlier answer, was around adding distribution, increasing our share in the aftermarket through like PowerCore and other technologies.

But it's not going to flip back, we don't think, to where it was a couple years ago.

Okay.

Now one final question, I know you don't like to talk about 2011, but you indicated Gas Turbine probably at bottom, is it fair to say that probably as we look out that we're probably seeing the worst right now, the levels of Gas Turbine demand and that should begin to improve somewhat as we go out over the next 12 months?

Eli, Bill again and you're right, we're not going to give guidance on 2011 yet.

But I think we -- we think we're getting close to the bottom of that cycle and it'll start to come back.

All right.

Thank you.

Thank you.

And our next question comes from the line of Brian Drab with William Blair & Company.

Please go ahead.

Good morning.

Good morning, Brian.

First question is on the restructuring expenses, maybe a question for Tom, I think that you were originally expecting roughly another $6 million in restructuring beyond, maybe $5 million to $7 million, beyond what you're going to end up doing for the year; is that right?

And if so, why did you decide not to go through with some of those projects?

Yes Brian, this is Tom.

We did give you a range.

So the $6 million that you mentioned would have taken us to the top end of the range.

Our restructuring costs that we ended up with are just below the bottom end of the range.

So we came pretty close.

The short answer is we simply did not downsize in Europe a specific plant as much as we intended to.

So there was less severance, less asset impairment and that is the reason.

Okay.

Great.

Thanks.

And just one more question.

You mentioned expectations for rising in raw material costs going into early fiscal 2011.

How do you expect that to impact your gross margin?

Do you feel like the pricing environment is pretty good for you guys or do you expect that we're going to see some pressure on gross margin during that period?

Brian, Bill here.

I think well we already can see what's happening in the market and we have the benefit of having many of our commodity contracts are concurrent with our fiscal year, so they go through July.

So we -- but we can see what's happening outside of our contracts.

We've been trying to get ahead with that with our continuous improvement and lean initiatives to offset as much of that as we can through cost reduction.

We do have some commodities indexed and pricing agreement with our customers, and then we also will look for where we can increase prices.

So it's going to be a combination of cost reduction and price increases to try and offset that.

But bottom line, we do anticipate -- but we foresee the pressure and we're trying to get ahead of it.

Okay.

Thank you.

Thank you.

And our next question comes from the line of Adam Brooks with Sidoti & Company.

Please go ahead.

Yes.

Just one or two quick questions.

As far as speak about gaining market share, I mean can you maybe provide some color on the regions where more market share has been gained, setting aside emerging, maybe specifically Europe, Japan and domestically as far as, I guess, where you've gained the most share over the past year?

Adam, Bill here.

We don't break it out or report it that way, so I can't help you with that question.

But a lot of the products that we're talking about, like PowerCore, we're selling those globally so it's helping, these proprietary technologies are helping us everywhere.

In some cases where we're adding distribution, that is, I would say mostly, but not exclusively, an emerging market focus, so setting up more distribution, more coverage in say Brazil or Russia or Southeast Asia.

So it's sort of -- the product technology, those share gains are global, because we release the products globally, and then the distribution share gains are probably more in the emerging markets but some in the developing markets as well.

Okay.

And real quick on the emerging markets, has the growth come by way of international OEMs or domestic or just kind of both?

The emerging markets a lot of it's aftermarket in terms of replacement parts and the distribution -- back to the distribution comment that I just made, but we are also supporting both our current global OEMs and making significant progress with local equipment OEMs say in China and India and Brazil.

Thank you.

Thank you.

And our next question comes from the line of Charles Brady with BMO Capital Markets.

Please go ahead.

Good morning, this is actually Tom Brinkmann standing in for Charlie Brady.

Just a couple of quick questions, a lot of my items have been answered here.

But which end markets are served by the European facility that's being restructured less than expected and was that decision made due to a sooner than expected improvement in those markets?

Yes, the end market that's served is our Industrial Filtration Solutions business, part of the Industrial group.

And part of it was a change in terms of our focus within that product line in terms of which products we can source versus which products we make.

Okay.

And then given the restructuring cost savings initiatives, where do you see operating margins getting to at the next peak in terms of like cyclical peak and operating margins, where do you think it can go?

Yes, Tom this is Tom VerHage again.

Bill said it well earlier, we aren't providing guidance post fiscal 2010.

And we gave this guidance for the rest of this year, which gets you pretty close to the fourth quarter, but we just -- we're in the midst of planning for next year and we're just going to be putting a lot of work into that.

Okay.

And just to do a backward looking question then, can you quantify how much of the third quarter 2010 sales uptick might have been from customers just restocking inventory after having to run it down so low?

Can you sort of just break out how much of the sales were actually exceeding real demand?

Tom, it's Bill.

I think Eli had asked a similar question.

So I think what we believe is that most of the sales increase was -- flowed right through to the end users.

And we mentioned that we have seen a little bit of restocking, but I would say the majority, the overwhelming majority of the sales increase we've seen has been pulled through to the end user due to increasing utilization existing equipment.

And I think generally all companies are trying to be very, very cautious with rebuilding inventory just because there is so much uncertainty in the economy.

And so where they're doing it's just maybe to support a service level increase that they can really see, but they're doing it really after they are very confident that it's going to -- but most of it's flowed through.

I see.

Okay.

That's all I had, thank you.

Thank you.

And our next question comes from the line of Richard Eastman with Robert W.

Baird.

Please go ahead.

Hi, good morning.

Tom, could you go back over your gross margin commentary?

If I pull out the restructuring charges in both the third quarters 2009 and 2010, I mean I come up with about a 430-basis point increase in gross margin.

And I caught some of what you said earlier, but you basically -- what I caught you outlined a greater increase than 430 basis points, and what was the offset?

Like for instance, you said absorbed fixed cost that was 210, savings and restructuring was 250, you mentioned product mix was 40, can you walk me to that 430 number?

Yes, I'd be happy to, Rick and once again your math is really good.

Okay.

All right.

So we've got to have some offsets here.

So there's about four points of difference.

The offsets that you did not mention is that we had higher restructuring charges last year.

I'm sorry, this year we have higher restructuring charges of $1.8 million.

And then also, with the improving operations, we have higher incentive compensation this year.

Okay.

That was about $3 million.

So with the higher restructuring charges this year of about four-tenths of a point, the higher incentive comp and a couple of inventory adjustments.

Okay.

That was about seven-tenths of a point.

That's going to get you about 1.1 percentage points.

Okay, okay.

I think that gets you pretty close.

And is it -- when you guys -- do you guys tend to lump some of these costs into like absorption of fixed costs due to volumes, but I may be a little bit surprised that maybe you haven't gotten more gross margin improvement year-over-year out of the mix, namely the aftermarket growth and also the Special Apps business.

Is some of that mix benefit calculated in your absorbed overhead kind of number?

No, Rick.

And actually I think our mix was fairly positive last year too to the aftermarket side, especially in Industrial.

So that 400 basis points of mix is really our best guess of the true year-over-year mix impact.

Okay.

Forty or 400?

Forty.

Forty.

Forty.

Yes, okay, okay.

And then, Bill as some of these areas, your later cycle businesses start to recover, namely Gas Turbine, but dust collection, in the past you have outsourced some of that production, incremental production, the hardware side, would that be the same strategy this go-around as those businesses come back or do you plan to keep more of that production in-house?

Rick, Bill.

First I want to just pick on you a little bit that a 400% -- or 400 basis point improvement in the gross margin isn't very good.

Not very good?

You give us a hard time on it, so --

Oh, no, no I just want to understand it because I -- as we go forward and these later cycle businesses come back, I mean you tell me but can I continue to model that same gross margin going forward?

Because a lot of these issues don't seem to be structurally sustainable.

Well I think back to two things.

One is we're -- we'll update our guidance for fiscal 2011 at the end of the fourth quarter, but I mean generally we're trying to maintain as much -- many of the gains that we've gotten in both operating and gross margin that we've achieved over the past 18 months.

So the objective is not to go back to where we were before, neither one of the margins, but we're not going to give specific guidance.

And a lot of the things that we've done even to the restructuring that Tom talked about earlier in Europe was something that we had been thinking about doing and sort of making decisions to do pre the recession, but we got it done.

So it's not -- it wasn't just about taking capacity down, it was a strategic decision in terms of which products we make versus which ones we buy for that business.

So, again, those gains, a lot of those gains will be -- are permanent.

But back to your question about dust collection and Gas Turbine, most of our Gas Turbine production is now outsourced, the large sheet metal housings.

We make the proprietary filter elements inside.

We do the design and drafting work of the large systems inside, but we subcontract the majority of the sheet metal fabrication to subcontractors around the world.

A lot of that, Rick, is essentially to get as close to we can as to where the customers or the end users are rather than shipping the facilities around the world.

It's actually really helped in terms of our facility management and our return -- our ROI in that business.

Okay.

In the dust collection business we actually make more of those units, they're more standard.

We actually make the overwhelming majority of those inside.

Okay.

And that is still part of our strategic plan going forward.

But we do occasionally, we'll supplement that with subcontractors especially in emerging markets where we don't have that capability or we don't have enough of it if there's a spike in business.

Okay.

And in terms of the Aero Defense business, is there a PowerCore initiative in that business?

I mean can we see that business start to grow next year despite the military's decision as to where they're going to fight wars?

I think whether it's PowerCore or another technology, a lot of the -- what we're doing there is proprietary technology and we've -- the best example of that is the Pulse Cleaning air cleaner system we put on the Abrams Tank which has been a home run for the past 15 years.

I think the majority of that business is first-fit and I think it'll take some time.

And that's where probably, Rick, where we're seeing, we're actually seeing a decrease on both sides with first-fit and aftermarket now just in terms of the change and where the conflict is being waged and the type of utilization of equipment where we have filters.

So we're not really making a forecast for next year, but I think what we said this quarter and in our script is sort of consistent with what we said at the end of the second quarter that we see that business coming down a little bit.

But, again, that was one of our heroes last year, that was strong right through the fourth quarter of last fiscal year.

And so that's cycling down for the reasons that I mentioned.

Understood.

Okay, very good.

Thank you.

Thanks, Rick.

Thank you.

(Operator Instructions) And our next question comes from the line of Josh Pokrzywinski with KeyBanc.

Please go ahead.

Hi, good morning, guys.

Good morning, Josh.

Just to maybe go after this margin question a little differently.

Understanding that there was quite a bit of structural cost taken out.

How do you guys think about the balance of operating leverage versus reinvesting in the business?

It seemed like much over the last cycle there was an internal comfort with 10% to 11% operating margins and reinvesting for growth with the rest of it.

Are we seeing a shift to where there's more of a balance of letting the leverage come through and a lot of the growth initiatives have been tapped and from here we get to farm them or how should we think about the internal reinvestment?

Josh, it's Bill.

If you take a look at our operating margin over time, let's say the last 15 years, it's been a steady improvement over time.

So it was at one point between 8% and 9% and then it was 9% and then it was 10% and then the last couple years we've been talking about before the recession 11% and now we're past that.

So we have a history of trying to improve or increase our operating margin over time, which is still our goal, while also reinvesting back in the business.

There are some things that we're doing as we grow our replacement parts business as we've talked about in the past that will naturally help that because the operating margin on replacement parts is generally better than first-fit.

But I -- so as we look forward without giving any specific guidance, what we're hoping to do is further improve our operating margin from the 11% historical target we've had for the last couple of years while investing back in the business to grow.

So it's a combination of growth and improving the operating margin.

But I put them in that order, we want to grow and minimum maintain our operating margin but opportunistically also improve it.

Okay.

But the fact that this quarter was kind of a quantum leap beyond just the steady improvement that you guys have done over time, should we view that as a resetting of the bar or maybe the growth is still -- the growth reinvestment is still dialed back because we're early in the cycle and want to make sure we're feeling our way out of this thing first?

I would say it's the latter.

Okay.

We're being still cautious.

Okay.

We are starting to gear up more investments in our business.

But we're -- think of where we were just say maybe eight or nine months ago, we're in a lot better place, but there's still a lot of uncertainty and a lot of challenges, especially when you look at the situation in Europe and now people talking about what that could possibly mean.

So we're being cautious but starting to opportunistically reinvest back in the business.

So I would not take the 14.5% and say that's a resetting of the bar.

Okay.

And then just one follow on, the -- with some of the emerging economies I'm thinking specifically China, India, I guess Brazil has also had some help, there seemed to have been some stimulus programs for -- to help out with commercial vehicle demand.

Are you seeing any change of pace there that would suggest that as those roll off, the underlying demand is coming down?

Or should we continue to view some healthy growth out of those regions?

I think we're going to continue to see some very healthy growth out of all of the emerging economies.

Great.

Thanks a lot, guys.

Thanks.

Thank you.

And our follow-up question is from the line of Eli Lustgarten with Longbow Securities.

Please go ahead.

Just one quick follow up since we like to spend time on operating margins.

But can we do it -- instead of doing it as corporate wise, can we talk about these two different segments?

Is it fair to say -- I mean, Industrial products has had a nice step-up in reported operating margins, pre-tax margins 13.5% in the quarter, and you're doing it with Gas Turbine flat on its back that there's still probably some reasonable leverage in that sector that there's no reason why that market's margins couldn't get sort of in the mid-teens over time, I'm not talking in any one quarter or even next year.

And alternatively in the Engine which had such a big step up, could such a favorable mix -- is that sort of a -- the goal was to try to maintain that level of business because it first had come back and it's lower margin business, is that a fair way to look at the businesses?

Eli, this is Tom.

Yes, you're right as you look at 2009 to 2010, there was significant increase in margins.

One point on the Industrial side, and be sure to factor in the restructuring costs in both years, but setting those aside, first on Gas Turbine, Bill mentioned before that we outsource the metal fabrication.

So as Gas Turbine comes back, that really doesn't give us improved absorption opportunities because of the outsourcing.

And then on Engine, phenomenal performance this past quarter, a lot of that or a good portion of that was due to the aftermarket mix, and we're hoping that that continues.

I mean the implication is that the kind of profitability you wouldn't set new targets for the very -- the two major segments, [unless you're at a] materially higher than where we are today?

No, Eli, this is Tom.

No, we wouldn't.

But as Bill appropriately mentioned, we're going to continue to consider investment opportunities, whether it's product development, organic growth, and we're just going to weigh that in with maintaining these very strong margins.

Okay.

Thank you very much.

Thanks, Eli.

Thank you.

And at this time, there are no further questions.

I'd like to turn the conference back over to Bill Cook for any closing remarks.

Thanks, Brandy.

To everyone on the Donaldson team, while we still have some challenges in the global economy, by focusing on what we can control, we are performing very well.

We are continuing to execute very well on all fronts by developing leading products, by delivering the best customer service, by continuing our focus on continuous improvement and lean to drive costs and inefficiencies out of all of our operations.

These efforts have delivered our first record quarter since the recession began.

A sincere thanks to all of you.

And then finally to all participating and listening, this is Bill Cook and I want to thank you for your interest and time -- your time and interest in our Company.

Thank you.

Goodbye.

Ladies and gentlemen, this concludes the Donaldson third quarter fiscal year 2010 conference call.

If you'd like to listen to a replay of today's conference for the US phone numbers please dial 303-590-3030 or 1-800-406-7325.

Or the UK numbers plus 44-207-1542833 or 0-800-358-3474 followed by pass code of 4295923.

ACT would like to thank you for your participation and you may now disconnect.