Donaldson Company Inc (DCI) 2011 Q1 法說會逐字稿

Good day ladies and gentlemen.

Thank you for standing by.

Welcome to Donaldson's first quarter FY 2011 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, November 18, 2010.

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

Please, go ahead, sir.

Thank you, Christina.

Welcome to Donaldson's fiscal 2011 first quarter conference call and qebcast.

Following this brief introduction, Bill Cook, our Chairman, President and CEO, and Thomas VerHage, our Vice President and CFO, will review our record first quarter earnings and our updated outlook for the balance of fiscal '11.

Next, 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.

Our future results could different 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 would like to turn the call over to Bill Cook.

Bill?

Thanks, Rich.

Good morning, everyone.

We just announced our first quarter results early this morning and we are very happy to report that we are in a much better and different position than we were this time a year ago, and even three months ago when we last had a webcast.

Bottom line, we had a very strong start to our fiscal year with a record first quarter.

Now, I would like to recap some of our highlights.

We had solid top line growth with sales up 25% over last year and maybe even more significant was that we saw another sequential improvement in sales as they were up 4% from our fourth quarter.

This was the sixth consecutive quarter of sequential sales growth.

As we will discuss, we believe our early and mid-cycle businesses have now either recovered or are solidly in recovery.

Our first quarter operating margin was 13.9% and a first quarter record.

This strong performance resulted in an operating income increase of 42% from last year.

The combination of our solid revenue growth and a relentless focus on service to our customers and our continuous improvement initiatives delivered a net income increase of 54% and an all time EPS record of $0.68 per share.

Now, I would like to spend a few minutes to review the sales by segment.

Within our our Engine Products segment, local currency sales increased 34% over last year.

Within engine, our aftermarket sales were up 30% as utilization rates of existing trucks and off-road equipment fleets continue to improve.

We've also continued to aggressively add distribution, products and customers through the recession, and we believe as a result that we have increased our market share.

Our two engine OEM, or First Fit businesses, were also up strongly in local currency terms.

Our off-road product sales are up 65% as the mining, ag, and most of the construction new equipment markets have continued to strengthen.

Our on-road product sales are up 60% as North American and European heavy truck build rates continued rebounding.

We also saw Japanese sales rise on strong export demand and a pre-buy ahead of the new diesel emission regulations in Japan.

We just read yesterday in the build-rate data released by ACT Research that North American class 8 builds increased 29% in our first fiscal quarter and medium duty builds increased by 28%.

Now, switching to our Industrial Products segment, local currency sales increased 16% from the prior year.

Sales of our industrial filtration solutions products increased 21% as sales of new dust collection equipment continued to grow and our sales of replacement filters for dust collectors already installed in the field remain strong.

Sales in our special applications products group grew 13%.

Sales in some of our newer product lines, serving the semiconductor, imaging, and venting end markets more than doubled in the quarter.

In addition, sales of our membrane products remained strong and our disk drive filter sales were up 5%.

Finally, our gas turbine system sales increased 5% over last year as we are now seeing better demand for the smaller systems used in the oil and gas industry and we are also beginning to benefit from the new products we introduced last fiscal year.

As we noted in our release, we also see good evidence of how broad-based our sales increase was across the globe.

As in local currencies, our sales in the quarter versus last year were up 32% in the Americas, 29% in Europe, 16% in Asia Pacific, and 7% in South Africa.

Our sales growth in just the brick countries were up about 30% -- actually over 30%, and now account for over 8% of our total sales.

If we drill down into some of our other operations by country outside of the US, we also see strong sales growth in Japan, South Korea, Singapore, Australia, and Mexico as each of these were also up over 30% over last year.

Now, I am going to turn the call over to Tom to discuss more comments on our operations before I discuss our updated sales outlook.

Tom?

Thanks, Bill.

Good morning, everyone.

Our gross margin was 35% in the quarter, a year-over-year increase of 30 basis points from 34.7% last year.

Better absorption of fixed costs due to improved volumes in our plants, increased gross margin by approximately 130 basis points.

The benefit from improved volumes is starting to revert to normal historical levels as many of our engine filter plants in North America and in Europe are either nearing or have reached prerecession capacity levels, as we were at about 80% at the end of the quarter.

Our ongoing continuous improvement initiatives also increased gross margin by approximately 150 basis points.

Mix was less favorable compared to last year's first quarter and decreased gross margin by 120 points.

For the sixth consecutive quarter, replacement filter sales were over 50% of our total sales, but decreased to 52% of total sales compared to 55% last year as our First Fit sales are now grower faster than aftermarket sales.

We have begun to experience purchased material cost increases, which decreased gross margin by 130 basis points.

We experienced increases in steel prices beginning in August when our contracts renewed.

Our current contracts are shorter in duration compared to last year, as we believe that prices will decrease somewhat in the near future and we want to avoid being locked into higher than market pricing.

We also experienced increases in petrochemical-based raw materials such as plastics, urethanes, and adhesives.

So far, we have offset some of the impact of these increases through our continuous improvement initiatives and some selective price increases.

We do expect petrochemical-based raw materials to continue increasing in the near term due to the weak US dollar and associated increase in oil prices.

Operating expenses remained well under control, coming in at 21.2% of sales compared to 22.4% last year.

Restructuring expenses were essentially flat, year-over-year as we had $700,000 in the current quarter and $500,000 in the prior year quarter.

The combination of our record gross margin and continued operating expense controls delivered a first quarter record operating margin of 13.9% in the quarter.

Looking at our operating margin forecast for fiscal 2011, we expect the increase in our purchased raw material costs and a less favorable sales mix to reduce our gross margin compared to last year.

We expect the planned strategic operating investments, which will support our strategic growth plans to begin ramping up in our second quarter and through the second half of fiscal '11.

We spent $2 million on these initiatives in the first quarter and believe we will spend an approximately $12 million in the remainder of the year.

These strategic investments include adding resources for our growth initiatives in Asia, Europe, and Latin America; a specific growth initiative in China; along with increased investment in technology and product development for liquid filtration; and finally our global supply chain project.

Offsetting the incremental costs of these investments will be the absence of $10 million of restructuring costs we took in fiscal 2010 and the benefit of our ongoing continuous improvement initiatives.

In total, we expect our operating margin for the year to be between 12.8% and 13.8%.

Then as a reminder, our second quarter is our seasonally weakest sales and margin quarter due to holidays and annual year-end shut downs at many of our customers.

Also, we will incur approximately 70% of our expected $8 million of annual stock option spend in our second quarter due to the timing of our annual grants.

Our effective tax rate was 26.2% in the quarter versus 30.9% last year.

The year-over-year decrease was primarily due to the favorable settlements of foreign tax audits during the quarter.

Based on our projected global mix of earnings, we continue to expect our tax rate to be between 27% and 30% in fiscal '11.

Our first quarter CapEx came in at $10 million.

We approved increased spending for strategic projects during the quarter, such as tooling for new product platforms and capital investments that allow us to achieve cost reductions.

Our fiscal '11 CapEx guidance is unchanged at $70 million to $80 million, and we expect appreciation and amortization to be approximately $60 million.

Precash flow was $53 million this quarter.

Working capital was basically flat in the quarter despite the strong sales growth.

We expect precash flow to be $175 million to $200 million this year.

At the end of the quarter, our debt to cap ratio was 25.9%, and debt to EBITDA was 0.9%.

Both remain well within the financial covenants in our various debt agreements.

We are expecting interest expense in fiscal '11 to be between $12 million and $14 million.

Our balance sheet remains strong with $268 million in cash.

So with that, I will now pass it back to Bill, who will provide additional details on our outlook for fiscal '11.

Bill?

Thanks, Tom.

Now, looking forward into our updated fiscal '11 outlook, for those of you that have followed the Company since our last quarter, you will see that we have increased our full-year guidance from approximately $2 billion we had forecasted at the end of August and discussed in our last webcast.

We now expect our full-year sales to be approximately $2.2 billion, or an increase of between 15% and 20% over last year and up approximately 10% from our previous guidance.

This increase in guidance is due to two factors.

The first is the continued strengthening in conditions of -- in many of our end markets and the second is the favorable impact of the weaker US dollar and its positive translation impact on our overseas results.

Now, I'll take a look at each of the segments starting first with Engine.

In Engine our full-year sales are forecasted to be up between 19% and 24% for the year as we expect sales to our construction and mining OEM customers to remain strong as their production rates continue to increase to match their growing end market demand.

The ag or farm equipment market is one of the biggest changes over our original plan as we have seen in the forecast for farm cash receipts that have significantly increased, now estimated to be up 24% for the 2010, 2011 season.

Based on the latest harvest estimates and due to the drought conditions in Russia combined with the rapidly increasing demand from China.

We anticipate that all of this is positive for new ag equipment demand at our OEM customers.

The forecast for North American class 8 new truck builds is expected to increase from the approximately 150,000 estimated in calendar 2010 to between 200,000 and 240,000 for calendar 2011.

This forecast is supported by the ACT research numbers I mentioned earlier.

In Europe and Japan, new heavy truck build rates are also expected to continue growing, although probably at a slower pace than that in North America.

And we expect our aftermarket replacement filter sales to remain strong as the utilization rates for those heavy trucks and off-road equipment fleets already in the field continue to improve.

We also expect the continued benefit from the continued expansion of our distribution networks in emerging markets.

Now switching to our Industrial segment, sales here for the year are forecast to be up between 10% and 15%, and within the segment, in our industrial filtration solutions business, which includes dust collection and compressed air filtration systems, we expect our sales to be up between 13% and 18%.

We are expecting demand for new filtration systems to continue improving as general manufacturing capital spending increases.

We also anticipate our replacement filter sales to continue to grow as general industrial plant utilization continues to recover, which means that our equipment already in the field would be used and maintained more frequently.

We expect our gas turbine sales to be up approximately 5%, due primarily to continued strength in the oil and gas markets and the continued market penetration for our new products.

Then, finally, we are forecasting our special application sales to increase between 9% and 14% as the numerous end markets we serve are expected to continue growing.

Incorporating this sales guidance into the operating guidance that Tom laid out earlier, we expect our full-year EPS to be between $2.54 and $2.74, which would be a new full-year record.

Now, finally, a quick new product update before we wrap up our comments.

Over the past few years, we've highlighted one clear example, our PowerCore technology, of our goal to continually reinvest back in our business and introduce new breakthrough filtration technologies.

Our first generation PowerCore was a great success for our customers.

The second generation of PowerCore or G2, as we call it, looks like it will be every bit as successful as the first as it delivers world class technology in a 30% smaller footprint.

We've already won 26 platforms, ten on-road and 16 off-road with G2.

We have another 14 programs currently in the proposal stages with our OEM customers.

Our engine PowerCore sales in the quarter totaled $20 million with First Fit sales growing 104% as the new OEM programs we've talked about in previous calls are now beginning to ramp up.

Our replacement PowerCore filter sales for those systems already in the field grew by 35% over last year.

On the Industrial side of our business, we introduced PowerCore technology in our Torit Dust Collectors.

You may have seen the press release we announced earlier this quarter that we had passed the 1,000 systems sold milestone since introduction.

Since that announcement, we sold another 200 Torit PowerCore systems, accounting for another $3 million in system sales.

Our PowerCore technology and its generations of new technology is just one example of how we are using technology to execute our updated strategic plan.

Another example is how we are increasing our liquid filtration sales by introducing new proprietary technology to that market.

One great example is our Synteq XP Media which we've been using to win new mobile hydraulic system programs.

To date, we've won 19 hydraulic programs with our next generation of Duramax filters utilizing Synteq XP Media.

And we plan to release our next generation of fuel filters with Synteq XP later this fiscal year.

Diesel fuel and hydraulic fluids are two of our key target areas for liquid filtration growth and Synteq XP is an example of how we will use our breakthrough technologies to solve our customer's filtration needs and capture those opportunities.

Now, to summarize, we had a record EPS quarter, marked by solid topline growth and great operational execution.

Looking forward, we've increased our sales, operating margin, and EPS guidance for the full-year.

As I look back over the past few years, I would like to offer a few summary thoughts.

Almost exactly two years ago, we had just posted our 19th consecutive EPS record and added to a long track record of delivering consistent growth and performance which had resulted in above average increases in shareholder value.

When I talked during our webcast two years ago in November of 2008, we already knew we were entering an economic downturn, the depths or duration of which we couldn't imagine at that time, but the entire Donaldson team rallied to this challenge.

We focused on managing and improving those things we could control, including and especially protecting our Company, our shareholders, and our customers for the long term.

The recession clearly impacted us more than I had hoped, but we did take the opportunity over the past two years to reposition, invest in, and improve our Company for the long term.

We also updated our strategic plans during the recession; maybe for us this is the best possible time to do it.

We looked at our long term goals, what we were doing, how we were doing it, and asked and answered a lot of hard questions.

Results of this exercise include a renewed optimism regarding our long-term prospects to grow our Company into first a $3 billion, and then a $5 billion filter Company.

The opportunities are clearly there for us.

We now have the detailed plans that provide the road map to guide us there and we embark on this journey with the strength of a very solid balance sheet and record operating performance.

While there are always challenges in every journey, we see our prospects as very bright, and we look forward with incredible excitement to rebuilding the wonderful track record we had prior to the recession.

We thank our customers for the opportunities they provide for us to grow with them, and we thank our shareholders for their ongoing support.

That concludes our prepared remarks, Christina.

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

Ladies and gentlemen, at this time we will begin the question and answer session.

(Operator Instructions)

Our first question from the line of Laurence Alexander with Jefferies.

Please, go ahead.

Good morning.

This is Lucy Watson on for Laurence today.

Just a clarification question on raw materials.

What was the gap between pricing in raws in the quarter?

As a follow-up to that, do you expect to be playing catch up with raws for the rest of this year or should you recover those costs and then some to get to your operating margin targets?

Good morning.

This is Tom.

If I understood the question correctly, gross margin was impacted in the quarter about 1.3 percentage points from the standpoint of material costs increasing more than our selling prices were adjusting.

Then, going forward on a year-over-year basis, there will continue to be, I think, a relatively comparable impact, perhaps a little bit less, if there is some softening, but it should not be any greater than it was in the first quarter.

Okay.

Looking at your full-year sales target, $2.2 billion in sales would imply approximately a 6% CAGR to get to your fiscal 2016 target of $3 billion, which, I think if I'm doing the math correctly, would be followed by an 8% CAGR to get to your fiscal 2021 target of $5 billion.

I'm wondering is this the right way to think about the 10-year plan or is there something else to it?

Hi, this is Bill.

I'll take that one.

I think maybe the first point is we are still coming out of this recession, but as we looked forward and updated our strategic plan -- and we've talked about this in some of our investor presentations since August -- that our sales growth target annually, once we get back to normal economic conditions is 9% to 10% per year.

We anticipate doing most of that organically.

Once we get past this year, we would be looking at more of a normalized 9% to 10% per year.

Okay.

Thank you.

Thank you.

Our next question from the line of Kevin Maczka with BB&T Capital Markets.

Please, go ahead.

Good morning.

Good morning, Kevin.

Tom, I guess first, I want to go back to your comments on the gross margin.

Of the four items that you mentioned that were puts and takes this quarter, if raw materials made the -- a similar headwind, but perhaps less of a headwind going forward, I would expect you'll still have the same mix headwind and maybe you'll still benefit from better absorption and continuous improvement.

When you roll all that up, should we be thinking about higher gross margins going forward and not lower?

Kevin, the events that you just mentioned are going to be somewhat offsetting.

In our first quarter, as you saw our gross margin was 35%, and for the entire year, if you extrapolate the mid-point of our range, there are somewhere between 34.5% and 35%.

We are talking just a couple of basis points there, with the puts pretty much offsetting the takes.

So, I don't think you are going to see a whole lot of change from Q1 and then, certainly, keep in mind my comments on Q2, which is our seasonally weakest quarter from a margin perspective.

Tom, you also mentioned the stock comp item.

Can you talk about or remind us, how big was that expense last year in the Q2 of last year?

Was that about $5 million?

It was.

You have a good memory, Kevin.

It was $5 million in Q2 of last year.

I mentioned in total it's going to be approximately $8 million this year with we think about 70% of that following in Q2 of this year.

That's how get from about $5 million to approximately $5.6 million.

Finally, can I ask a couple of questions on some of your industrial end markets, the gas turbine and the special applications?

You have a comment in the release about the strength in the oil and gas space affecting the gas turbine market.

Can you just comment on that first, because I don't think investors often associate that business with an oil and gas play; and also on the special applications can you comment specifically on the disk drive outlook?

Okay, Kevin.

Bill here.

The gas turbine market is really made up of maybe two First Fit equipment segments, one is smaller turbines used in the oil and gas, so this would be either on shore or offshore platforms; and these would be typically 20 megawatts or less.

And then the other equipment segment is very large gas turbines which are hundreds of megawatts that are used in power stations for municipal electricity power generation.

The third segment is the aftermarket for both of those.

I think what we had seen going into the end of the last quarter is that we saw the large turbine market, very, very quiet and the soft turbine market stable, But what we have seen recently, is with the increase in oil prices and investments in oil and gas that the smaller turbine market, which is about 30% of our equipment market, is now recovering.

So, that is good news.

That's why we increased our guidance on gas turbine; it's related specifically to that.

On the special applications, there is two larger businesses within that, our membranes business and disk drive business, and then as I noted in my comments, there is a number of smaller newer businesses that we are trying to develop.

You asked about the disk drive business.

That was one of our earliest cycle recoveries, started actually maybe 15 months ago with the recovery, so that was good news for us last fiscal year.

We see that business now sort of stabilizing, but it was up 5% in the quarter over the same quarter last year, and we do see that the hard disk drive market that we serve, the estimates are that in calendar 2011, it will be up about 10% over calendar 2010.

That's the shipments by our customers of hard drives.

The numbers there are continuing to go up, but they are not going up at the same rate that they did the first quarter of last year.

Okay.

Thank you.

Thanks.

Thank you.

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

Please, go ahead.

Thanks.

Just a follow up on the hard disk drive market, you are not seeing then in the inventory in the channel stacking up on customers given that it was up, I'm guessing not?

Charlie, Bill here.

There's always -- that market moves very quickly and there is always inventory adjustments up and down.

That happens almost on a monthly basis.

So, we put our guidance in over the longer term.

We are very positive about that market, but we are not going to see the same type of increase over comps that we did in the first quarter last year, because it came back very strongly a year ago.

Right.

And then just looking at the Industrial filtrations, is there a meaningful difference geographically around the world?

Is Europe materially slower than North America?

Charlie, Bill again.

I think in terms of the -- we have seen the same phenomena and really in our Industrial filtration around the world is that what comes back first is replacement parts business as the equipment already in the field is used more and more; and then, at some point the customers that are running plants invest in new production equipment which requires more dust collectors.

We see that.

That is the later cycle part of that business is the new equipment, but we are seeing that come back both in Europe and the US.

All right.

One follow-up, and I'll get back in the queue.

The aerospace/defense, your commentary in your release sounds like you are a little bit more negative than you had been previously on aerospace/defense.

Can you give us some granularity on how much of that really is commercial aerospace that's being offset by weakness in the defense?

Charlie, Bill again.

If we sounded more negative, we didn't mean to be.

The guidance is very similar to -- essentially the same as what we had in the last quarter.

That is what we were trying to do.

It's mostly related to the defense side of that business and the wind down of some of the major programs and a general pressure on reducing military spending as part of the federal budget.

Longer term, we see very good opportunities in the defense side of the business, but many of the new programs that we are launching both for the US military as well as some of our allies and, so, we are very optimistic longer term.

This, again, was one of our, probably, later cycle businesses.

It held up longer than really almost any other business in gas turbine.

So it's a different spot in our cycle.

Guidance was meant to be neutral with what we had last time.

Charlie, this is Rich.

Just as an FYI, the mix within aerospace and defense is about 0.75 defense and about 0.25 aerospace, if that helps you out.

That is helpful.

I'm going to sneak one more in here.

On agriculture -- how much is ag of that segment?

Within the OEM space, ag accounts for about 30%, 25% to 30% of our off-road OEM sales.

Thanks, that's helpful.

Appreciate it.

Thank you.

Our next question comes from the line of Brian Drab with William Blair.

Please, go ahead.

Good morning.

Congratulations on a great quarter.

Thanks, Brian.

First question, I guess this is probably for Tom.

You talked about the plan to invest $18 million in growth opportunities, I believe, on the last call.

If I'm hearing you correctly today, you have invested $2 million in the first quarter with expectations for nearly $12 million for balance of the year to get to $14 million.

Does that $14 million compare to the original $18 million, or am I off?

Brian, you are not off.

We have the same initiatives in place, so we haven't changed anything strategically.

What we have found is, because of the tight employment markets, especially for engineers in certain areas around the world, we have to push some of the hiring back a little bit more than we would have liked.

So the initiatives haven't changed, but the estimate for this year has, indeed reduced from $18 million to $14 million.

Some of that $18 million -- it's a matter of timing?

It will fall under maybe fiscal 2012, then?

That's correct, Brian.

Okay.

Then one other question on the tax rate then, it came in a little bit below expectations in the quarter, but you maintained the guidance for the year, so, are you expecting now a higher average tax rate for the last three quarters in the year than you were previously?

Yes.

Yes, Brian, it will be higher than the first quarter, but our guidance for 27% to 30% is what it is.

What happens is, as our mix of earnings changes around the world, that will change our base rate a bit.

And that happened in the first quarter where we had a little higher taxable income in certain of our higher tax rate countries.

Okay.

And then, maybe I just can't remember, but can you tell us what the specific growth initiative is in China that you referred to?

Brian, Bill here.

It's really focused around continuing the investment in our disk drive business where we do a large part of that, so maintaining the very strong position that we have there; and then the second part of that is around expanding our position in the diesel engine filtration markets within China.

Okay.

Thanks very much.

Thank you.

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

Please, go ahead.

Good afternoon.

This is Chris Parkinson on behalf of Hamzah.

Just a real quick maintenance question.

What percent is the PowerCore technology of your current installed base?

And then how long do you think that will take to materially increase after market penetration rates?

Also, very quickly, if you could add a little more color on the opportunities of the First Fit side?

Chris, Bill here.

I'll start with just talking about PowerCore.

We talk about the number of programs that we've won.

A significant portion of those are won, but not yet launched.

I think I made it in my comments I talked about that we are starting to see a lot of those programs now launched with the new platforms by our customers.

So in terms of the timing that it takes, it's over a number of years, because if we win a program, it might be two or three years before it's actually launched.

We see that dramatically changing the -- on our Engine side of the business, the filtration technology over the next five years.

By the end of the five years, essentially all these platforms, both on- and off-road that our customers are designing and launching will have been launched.

It's probably another five year cycle that we are going to see, and it's all related to these diesel emission regulations where they have to change the engines and vehicles or pieces of equipment.

It's evolutionary from that perspective.

Once we get to that point, we see that as PowerCore technology, regardless of what generation, Generation 2, or -- we're working on 3 or 4.

That will be the standard for air filtration in that market.

We are doing the same type of thing on the industrial space that I mentioned with our dust collectors, and we launched our second product line for specific applications, working on our third for different end market applications.

We see that probably over the next five or six years, that becoming the predominant style of technology in those end markets as well, so evolutionary over like a five or six-year period.

Perfect, thank you.

Then, just a very quick question in addition to what you were mentioning on your analyst day.

In terms of acquisitions on the liquid filtration side, can you currently update us on what you are seeing there and whether valuations have came down?

Have they come down to more comfortable levels, and if so, which geographies are you seeing potential targets?

Chris, we don't really comment specifically prospectively on acquisitions, but I will go back to a little bit of what we covered in our analyst day.

We are mostly an organic growth story, but the 9% to 10% revenue growth that we target annually over the long term, we do look to supplement our organic with maybe 1% to 3% from acquisitions.

We went through a pretty quiet period in terms of candidates and maybe interest in doing acquisitions generally in the recession.

We have seen, at least as reported by investment bankers that there is more activity or interest now in the market.

We are always looking.

We have a small focused team looking at acquisitions and cultivating relationships.

But again, we're -- we don't comment prospectively on what we are going to do and when we're going to do it, but we are working on it.

I think conditions are better to find something.

Perfect.

Thank you very much.

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

Baird.

Please, go ahead.

Good morning.

Hi, Rick.

Bill, could you just maybe talk to the off-road piece of the business, the strength you are seeing there.

You did comment about ag being quite strong, but I'm curious how that business looks today from a geographic mix standpoint versus when you look back to '07, '08?

Is that an area of the business that you gained meaningful share in Europe and, importantly, in China and some of the Asian markets?

Good question, Rick.

The way I look at it is, it's really a global market.

Many of our OEM customers, regardless of where they are building equipment, they are exporting it around the world.

You think of where mining trucks are being made and where they are going; they are made in one geography, but they are going everywhere.

So I'd say that what we are seeing is a pretty broad based strength in every geography especially around large equipment.

I think that -- I think that's good.

Around our specific China growth initiative that we were asked about earlier, a lot of that is -- we are having great success.

It's really focused at addressing the needs of the Chinese equipment manufacturers as they are beginning to look for say Western or more advanced type of technology that we have.

So probably over time, our biggest share gain is around the emergence of these local OEMs that maybe five years ago weren't interested in the type of technology that we have to offer and now are; and we are working aggressively in China and India and other parts of the world in cultivating those relationships and winning programs.

If we look at that business -- again, I'm thinking quarterly and where the strength we saw in the first quarter.

You go back to '07, '08, this was kind of an $80 million, maybe $90 million quarterly run rate business, meaning the off-road piece.

I guess, what I'm curious, is have we expanded the addressable market, namely in those overseas regions so that once we return to those '07, '08 levels, in terms of quarterly run rate in volume, do we -- is our penetration better and should that volume be higher?

Rick, Bill again.

I'll take this again.

Sure.

The -- I would say if you take a look at say, some of our largest customers that have come out with their own releases and where they are relative to where they were, say in 2008, they are not back there yet.

I would say for the established OEM's and our established customers, conditions are a heck of a lot better than they were a year ago, or two years ago, but they are not back to where they were three years ago.

I think over time though, to your point that -- I think that this transition for the local OEM, equipment manufacturers in places like China and India that say three years ago weren't interested in our technology but now are, I think that does over time increase the addressable market for us.

That's not just on off-road equipment, we also see that on heavy trucks, as well.

It's not a, this year, it's probably a two or three or four year deal.

When you look at that -- and maybe Rich has these right at the top of his head here -- but if you look at the off-road business, can you just give relative by region?

Is it 50% US, 30% Europe or just roughly, in off-road?

Okay.

I'm flipping pages.

Sorry.

Let's see.

Well, if I look, excluding impact to currency, we are about -- we are probably about a third in Europe, maybe about 20% in Asia Pacific, and then the balance would be the Americas.

Okay.

All right.

Again, Rick, that is where we are selling the equipment.

That's not where the equipment may be -- ultimately ends up.

So your customer is in Europe, but they could be exporting to China or something?

Or our customers in the US we know are exporting everywhere else in the world.

Yes.

Okay.

I understand.

Then just one question, Tom, when you were talking to the gross profit margin and you were talking about mix and mix being somewhat less favorable for the balance of the year, are you talking about end markets, namely the industrial now starting to rebound faster, or are you basically just looking at replacement versus equipment?

Rick, it is primarily replacement versus equipment.

Okay.

There will always be some minor movements outside of that, but I think you want to be thinking about replacement versus First Fit.

Okay.

Then just -- sorry, lastly, as we've had this string of consecutive sales increases, five or six quarters now, I would presume that we are back in more of a seasonal quarterly sales pattern.

Is that fair to assume that the second quarter here maybe doesn't match from a sales perspective the first quarter.

Rick, I think your first comment is a good one.

I think we are back in our traditional seasonal pattern.

So I think if you would extrapolate our quarters out this year, like we were before the recession, that would be a pretty good way to look at it.

Sure, great, thank you.

Really nice quarter guys.

Thanks.

(Operator Instructions)

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

Yes, good morning.

You talked about ag and that seemed to be the biggest change with (inaudible).

Can you maybe rank after that, maybe on the First Fit and on the aftermarket as far as what was the biggest change from end of fiscal 2010 to now as far as the guidance, whether it be construction, mining, or trucking?

Adam, Bill here.

I would say -- you probably just -- other than the ag maybe being the biggest pleasant surprise, what we saw is a general strengthening in really those segments of both the Engine and the industrial, the construction, heavy truck and then the industrial.

Mining, I think, continues to strengthen and then as I noted, to answer -- to a question earlier, is that we have seen a little bit of a pick up in terms of our guidance and forecast for our gas turbine business.

Maybe the ag was the largest single one, and then the rest, sort of a general improvement from what we saw three months ago.

Are you going to seek any impact from the pending Caterpillar acquisition, maybe more mining business, Caterpillar your largest customer, or are you not expecting really much change?

They are both -- both companies are customers today.

We have a very strong, very long relationship with Caterpillar, it goes back now almost 80 years.

I think maybe -- I think we are hopeful that over time -- I will emphasize the over time, that it will provide some additional opportunities for us, this acquisition, but it will be -- it's not expected to close until mid-next year and I think, then, beyond that there will be some integration.

But I do think that over time it's positive for us.

Right.

Lastly, just quickly on the contribution margin, year-over-year has slowed down as you guys have mentioned.

Is 15% the best way to look at on a normalized rate going forward?

Adam, this is Tom.

You are talking 15%.

Our operating income percent for Q1 was 13.9% and if you look at our guidance for this year, I think you'll see that the midpoint was 13.3%.

Sorry.

I mean on a contribution margin, not on the pure margin as far as incremental operating income for every dollar of revenue added.

Thanks for that clarification, Adam.

As you know when we came out of the recession, our -- we had very high incremental margins, we think in the 40% to 50% range, but I believe I mentioned in my prepared comments that we are hitting those capacity levels again in many of our plants.

So we are reverting back to a pretty normal incremental margin, which just generally is going to be a couple points higher than our overall margin, because we are going to be adding back costs, and I guess I can only call those fixed, discretionary costs.

We are at that level of adding back costs, so I would not expect significant incremental margins from here on out.

Thank you.

Adam, this is Bill.

Just to follow on to Tom's comments, we are very consciously investing in growth.

We're back in that mode, now.

We have got our strategic plan, 9% to 10% growth targets that we have -- we talked about our incremental operating expense investments that we are making this year, incremental CapEx.

So that's -- we are trying to optimize our growth with operating margin, not maximize operating margin.

It's a combination there, a balance.

Thank you.

Thank you.

I'm showing no further audio questions at this time.

I will now turn the call back over to Mr.

Cook for any closing remarks you may have.

Now, to conclude our call, I would like to thank all of you for your interest in our Company.

And to everyone on the Donaldson team, your tireless efforts and relentless focus have positioned us very well for both fiscal '11 and for the achievement of our strategic goals.

Sincere thanks to all of you.

Good-bye.

Ladies and gentlemen, this concludes the Donaldson first quarter FY 2011 conference call.

If would you like to listen to a replay of today's conference, please dial 1-800-406-7325 and enter in the access code 4381130.

ACT would like to thank you for your participation.

You may now disconnect.