Donaldson Company Inc (DCI) 2012 Q3 法說會逐字稿

Good day, ladies and gentlemen.

Thank you for standing by.

Welcome to the Donaldson's third-quarter fiscal year 2012 conference call.

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

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

(Operator Instructions)

This conference is being recorded today, Friday, May 18, 2012.

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

Please go ahead, sir.

Thank you, Alicia, and welcome, everyone, to Donaldson's fiscal 2012 third-quarter conference call and webcast.

Following my brief introduction, Bill Cook, our Chairman, President, and CEO, and Jim Shaw, our Vice President and CFO, will review our record third-quarter earnings and updated outlook for fiscal '12.

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 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 turn the call over to Bill Cook.

Bill?

Thanks, Rich, and good morning, everyone.

As you've seen in the press release we issued earlier this morning, we had a very good third quarter, as we set records for our sales, our operating margin, and our earnings per share.

I'd like to take a few minutes to review our results.

Our third-quarter sales were $647 million, up 9% over last year.

Excluding a negative impact of foreign currency translation, due to the strengthening of the US dollar, we actually achieved organic sales growth of 11%.

The combination of our 11% organic sales growth and a 15.2% operating margin helped to deliver a net income increase of 15% and earnings per share increase of 18% to an EPS record of $0.46 per share.

As you know, within our Company we have two reporting segments.

I'd like to cover a few highlights for each.

I'll start first with our Engine Products segment.

Excluding the impact of foreign exchange, our local currency sales increased 10%.

The primary drivers of this 10% year-over-year increase were our first-fit OEM businesses, On-Road and Off-Road, which were up 37% and 13%, respectively.

The 37% increase in our On-Road product sales was primarily due to a significant rebound in North American new heavy truck build rates at our customers.

For example, Class-8 heavy truck builds in North America were 77,000 in our third quarter, a 44% increase over last year.

We also saw strong year-over-year growth in Japan, as a result of that country's recovery from last year's earthquake and tsunami.

Our Off-Road product sales were up 13%, as the agricultural and mining end markets our customers serve remained strong globally and the US construction equipment market continued to enjoy a strong replacement cycle.

The ongoing strength in these end markets has increased the demand for our customers' new equipment, upon which our air and liquid filtration systems are installed.

We also had health during the quarter from our engine aftermarket business, as replacement filter sales were up 6% as utilization rates of existing truck and off-road equipment fleets were good in the Americas.

We also are continuing to expand our distribution networks and product line.

Since our last call, we've added another 94 distributors, with the majority of these latest distribution additions in Asia, Latin America, and the US.

Also during the past three months we've added over 300 part numbers to our product offering, with the majority of these adds in our emerging markets business.

Now, switching to our Industrial Products segment, our local currency sales increased 13% as we delivered very good results across all three product groups.

Our largest Industrial Product group, Industrial Filtration Solutions, grew local currency sales by 11%.

Sales growth was good in both the US and Europe during the quarter, for both new Torit dust collection equipment and replacement filters for those systems already installed in the field.

In our second Industrial Product group, Gas Turbine Systems, our sales were up 17% in the quarter, driven mainly by strong demand for new power generation systems, as this late cycle business is now just beginning to ramp up.

And, finally, our sales of special applications products increased 14%, with solid sales growth from product lines serving the disk drive membrane and venting markets.

As we mentioned on our last call, our disk drive filter sales have continued to recover from the impact of last fall's flooding in Thailand and are now back to pre-flood or normal levels.

Now I'll summarize our sales by region.

We had very good growth in the Americas, with local currency sales increasing 15% in the quarter, and this remains the strongest economic region for us in the world.

In Europe, our local currency sales increased 6%, despite a number of European economies having slipped back into recession during the last few months.

And in Asia our local currency sales increased 9%, as conditions continued to improve in China.

I'm now going to turn the call over to Jim for his comments on our operations before I discuss our outlook for the balance of fiscal '12.

Jim?

Thanks, Bill.

And good morning, everyone.

Our gross margin was 35.3% in the quarter, which is up 10 basis points from last year.

Even though the percentage is fairly consistent with last year, there were some pluses and minuses in our gross margin number, which I'll walk you through.

In the quarter, we benefited from improved absorption of fixed costs, which increased gross margin by 40 basis points compared to last year.

This increase was mainly driven by higher volumes in our plants and from fewer holidays, and therefore more shipping days, in this year's third quarter.

You may recall that the Chinese New Year holiday fell on our third quarter last year, while it was in our second quarter this year.

The other positive factor to mention was the impact of our continuous improvement initiatives, which increased our gross margin by 60 basis points.

Slightly higher commodity prices compared to this time last year and the mix of our product sales were the primary unfavorable factors impacting our gross margin.

We are expecting commodity prices to be stable at current levels for the balance of our fiscal year.

Our operating expenses remain well under control, coming in at 20.1% of sales, which was down 110 basis points from last year.

This improvement over last year comes from increased leverage of our fixed costs due to higher sales levels, partially offset by selective operating expense investments we have made over the past year to support our strategic growth initiatives.

In addition, while we continue to assess the direction of the global economy, we have been selective in adding our planned head count additions.

There is still a lot of uncertainty regarding the European economy and the pace of recovery in China.

So we'll continue to be measured in the pace with which we add to our fixed-expense level.

Our operating margin came in at 15.2% this quarter, which is a record.

Looking at our operating margin forecast for the balance of fiscal '12, we believe fixed-cost absorption will remain positive in the fourth quarter, as we continue to benefit from higher volumes and from our continuous improvement initiatives.

We are expecting a strong fourth quarter for large product shipments in the Gas Turbine and Industrial Filtration Solutions, which will likely have a slightly negative impact on mix.

In total, we now expect our operating margin for fiscal '12 to be between 14.2% and 14.8%, which represents another full year operating margin record.

Our effective tax rate was 29% in the third quarter, versus 24.5% last year.

We had $1.8 million of tax benefits this quarter, primarily from a statute of limitation expiration.

Last year's third quarter had $3.5 million of tax benefits from the expiration of some statutes of limitations and the favorable conclusion of two international tax audits.

Based on our projected global mix of earnings in fiscal '12, we now forecast our tax rate to be between 28% and 29% for the full year.

Looking beyond the current period, we have seen the profitability of our US operations improve significantly.

While this is obviously very good news, it unfortunately has a negative impact on our overall tax rate.

In addition, we've been fortunate to have realized the benefit from favorable tax settlements the last couple of years, which has benefited our rate.

These were discrete events and consequently, we do not see those benefits repeating in the next one to two years.

So, in total, it's likely that our effective tax rate next year will be a little higher than this year.

We're in the midst of working on our operating plan for next year, so we'll quantify this for you with our fourth-quarter release.

Our third quarter CapEx came in at $22 million.

In total, we now expect CapEx spending of between $75 million and $80 million this year.

This estimate is down from our earlier estimate of $85 million for the year, but we still plan to authorize and begin work on over $100 million of capital projects.

This change from our early estimate -- earlier estimate is simply related to the timing of when we estimate the cash payments will be made.

An example of this is our new manufacturing campus in Xuzhou, China, that we announced earlier this week.

Very little of the overall cost of that project will be incurred in fiscal '12; the majority of the costs will occur in '13 and '14 with the expected opening of the two new plants in 2014.

These global investments are a very important part of our strategic growth plan.

We have many projects included within our CapEx plan for this year, and we expect all of these will positively impact our corporate ROI when completed.

As we've mentioned before, approximately 25% of this year's CapEx is for capacity expansion, another 25% is for tooling for new products, 25% will be related to cost reduction activities through our continuous improvement initiatives, and the final 25% will be for our technology initiatives.

We continue to expect depreciation and amortization to be between $60 million and $64 million this year.

Free cash flow was $59 million this quarter.

As mentioned, CapEx was $22 million, compared to $18 million in last year's third quarter.

Working capital was a use of cash this quarter as sales increased $66 million sequentially from our seasonally weak second quarter.

We expect full-year cash flow from operating activities to be $260 million to $280 million in fiscal '12.

We repurchased 261,000 shares in the third quarter for $9 million.

Over the past three quarters, we have repurchased approximately 3 million shares, or 2% of our diluted outstanding, for $83 million.

Our debt-to-cap and debt-to-EBITDA ratios are now at 22.5% and 0.7 respectively, well within the financial covenants of our various credit and note agreements.

We continue to expect interest expense in fiscal '12 will be between $11 million and $13 million, and our balance sheet remains strong with $308 million of cash and short-term investments.

So with that, I'll pass it back to Bill, who will provide additional details on our updated outlook for fiscal '12.

Bill?

Thanks, Jim.

As many of you know, and as Jim just mentioned, we're in the midst of our normal planning process for next fiscal year, fiscal '13, which starts in August.

Consequently, our standard practice during our third quarter calls such as this is to provide guidance for what we can currently see, which is through the end of our fiscal '12.

Per our normal practice, and once our Board approves our new plan, we'll provide our outlook for our fiscal '13 when we release our year-end results on August 27.

So, for the balance of this fiscal year, we expect that the overall European economy will remain at current business levels, with southern Europe back in a recession and northern Europe growing slightly.

We also expect the Chinese economy to continue to improve, which should also benefit the rest of Asia as well as our businesses in China.

We expect North and Latin America to remain the strongest regions globally.

Our outlook includes a stronger US dollar than what we had assumed in our previous guidance that we issued in February.

At the time we updated our forecast earlier this week, the US dollar was at $1.28 versus the euro.

This translates into about a 5% foreign currency headwind in our fourth quarter, as the US dollar was much weaker last year -- it was approximately $1.43 to $1.44 then against the euro.

So we expect our full-year sales to be approximately $2.5 billion, or an increase of about 9% over last year's record of $2.3 billion.

This means that our fourth quarter is expected to be up organically about 11% in local currency terms, and then, after adjusting for the projected 5% foreign currency headwind, about 6% as we hope to report.

Bottom line, we continue to see many growth opportunities and expect that we will continue to grow faster than the end markets we serve through the introduction of new filtration technologies and products, and also by increasing our sales coverage, especially in emerging geographies.

Now I'll review our outlook by segment.

Our full-year Engine sales are forecast to be up between 8% and 10% over last year.

Based on where our nine-month or year-to-date Engine sales are at, this means that we'll see approximately 5% growth in local currency in our Engine segment in the fourth quarter.

Within our Off-Road products, we expect to see continued strong demand for our OEM customers' equipment; agricultural equipment demand remains strong, while mining equipment demand is seen as plateauing at the current high levels, as commodity costs have leveled out.

Demand for construction equipment remains good as the average age of equipment in the field remains historically old.

This should support an ongoing stronger equipment replacement cycle.

We're also forecasting continued strength in our On-Road product sales, as outside research firms, such as HCT, are forecasting that heavy truck builds at our North American customers are expected to increase from 256,000 in calendar '11 to 298,000 in calendar '12, a 16% increase.

The average age of current truck fleets also remains historically very old indicating continuation of the need for a replacement cycle.

Finally, we expect our aftermarket or replacement filter sales to remain good, especially in the Americas.

Now, switching to our Industrial Products segment, our sales are also forecast to be up between 8% and 10% for the year.

Based on where our year-to-date sales are, this means that we should see local currency sales growth of about 20% in our fourth quarter.

Including the foreign currency headwind we mentioned, this should result in a mid-teen percentage growth for the fourth quarter.

For the full year, we expect Industrial Filtration Solution sales to be up between 7% and 10% as customer demand for new industrial filtration equipment continues to improve with new plant and manufacturing equipment capital investments.

We also expect our replacement filter sales to continue to grow, again with the increased utilization by our customers of those filtration systems and dust collectors already installed in the field.

As I mentioned earlier, we anticipate a significant increase in our Gas Turbine business as we see two very positive trends.

First, there are many large gas turbine systems now underway at our customers, and these are typically 200-megawatt projects, each of which could provide the equivalent power for about 200,000 homes.

Many of these large projects are underway in the Middle East, China, and the US.

Second positive trend relates to higher oil prices and the resulting demand for smaller turbines this creates as more investments are made in energy exploration and transportation.

Overall, we expect for the year to finish up between 17% and 20% in our gas turbine products.

And, finally, we're forecasting our special applications sales for the full year to be level with last year, as the growth in our membrane and venting product sales should offset the reduction we experienced in our second quarter and disk drive related to the Thai floods.

Incorporating all of this sales guidance into the operating guidance Jim covered earlier, we've adjusted up our full year EPS forecast for fiscal '12 to be between $1.66 and $1.76.

The midpoint of this range is up 20% from the EPS record we achieved last year.

This will be another EPS record and our 21st record in the last 23 years.

Finally I'd like to make a few comments on some of our new technology and major investments before we wrap up our prepared comments.

Over the past few years we've highlighted our PowerCore air filtration technology as a great example of how we continually introduce new filtration technologies to our customers in order to help both them and us grow our businesses.

PowerCore sales totaled $32 million in our third quarter, up approximately 30% over last year.

Our engine PowerCore sales in the third quarter totaled $27 million and were up 27% over last year.

On the Industrial side of our business, our Torit PowerCore products, which offer many of the similar advantages to our customers that we do in Engine, including much smaller systems -- in the third quarter we sold another 300 Torit PowerCore systems, which accounted for over $5 million in sales.

So, in total, our PowerCore sales are now approaching $130 million on an annual basis.

We also continue to make significant advances in our liquid filtration markets.

Since we unveiled our new select fuel filters with our proprietary Synteq XP media at CONEXPO last year, we've won seven OEM platforms and interest in this new generation of diesel fuel filters remains very high.

We should begin to see some revenue from these wins beginning in fiscal '13, with additional programs starting up in fiscal '14.

Finally, I'd like to highlight our recent announcement of another major strategic investment.

Earlier this week we announced plans to build two filter plants at a new campus in Xuzhou, China.

We currently have four plants at our campus in Wuxi.

Our Wuxi campus has been and we will continue to be a wonderful operation for us, but we are essentially out of room on that campus so we needed to expand.

These two new plants that we are building in Xuzhou represent key elements of our strategic growth plan as we build additional capacity to serve our customers in the growing Chinese market.

One plant will be dedicated to air filters for the diesel equipment and industrial end markets; the other plant will build liquid filters for the diesel equipment markets.

This is our first liquid filter plant in China, which is a critical step in our corporate growth strategy, helping to grow both our liquid filter and Chinese businesses.

Our total investment in this project is expected to be between $35 million and $40 million, between now and calendar '14 when these plants are expected to open.

And these openings are timed with our forecast for needing the additional filter production capacity in China.

So, to summarize, we've delivered record results in each of the first three quarters of fiscal '12.

We see a significant upswing in our industrial businesses in our fourth quarter.

As a result, we're projecting another record for both full-year sales and earnings, as we continue to focus on investing and developing new technologies and products to help meet our customers' increasing filter needs.

We will continue to make additional key long-term investments, such as the one I highlighted in China, to support our $3 billion and $5 billion sales growth targets that we established in our strategic growth plan.

Now, that concludes our prepared remarks.

Alicia, now we'd like to open it up to questions.

Thank you.

(Operator Instructions)

Hamzah Mazari, Credit Suisse.

The first question, Bill, I was wondering if you could maybe walk us through how we should think about operating leverage in your business model going forward.

You have some negative mix coming from slower aftermarket, but you're getting a low volume.

And then you've got some growth initiatives, as well.

How should we think about that operating leverage going forward in your Business?

Hamzah, this is Bill.

I will start, and then maybe Jim has some things he wants to add.

As we look forward in our strategic plans, our goal is to grow our sales, as we've talked about, between 8% and 10% per year and to continue to expand our operating margin as we have been.

As we've mentioned, we're forecasting our operating margin to be a record this year.

And it's been up significantly over the past four years since we entered the recession.

But going forward, we're looking at probably about, maybe a 20 basis point improvement year-over-year, not as significant as we saw in the last four years.

Because part of our goal is not to maximize operating margins but to optimize that with the revenue growth, so we want to reinvest back in the Business.

And we are going to continue to expand it but not at the same rate.

So we want to make sure that we protect the growth investments that we are going to make.

Hamzah, this is Jim.

The only thing I'd add to that is this quarter, as I mentioned in my comments, we've been very cautious in terms of headcount adds.

If the growth continues as we expect it, we will be adding headcount for some of the strategic investments.

So, our operating margin in terms of our operating expenses was very good this quarter.

But I don't think you can model in a lot of improvement from that number here at least in the short term.

Okay.

That's very helpful.

And then maybe if you could comment on your liquid filtration exposure, what you're seeing in terms of acquisitions there?

Do you intend on building that organically or look for further acquisitions?

It seems like multiples have probably come off with the market.

Or how do you feel about multiples in this Business, particularly given you've seen some deals in this space from some of the larger guys?

Okay, Hamzah, Bill, I will start.

Our 8% to 10% that we talk about in terms of our annual growth target is mostly organic, and that's consistent with the way we've grown over the past two decades.

That is our business model.

Unfortunately, we see the organic growth opportunities in order to achieve most of that organically.

So in that 8% to 10%, we assume about maybe 2% of that will be through acquisitions, and the balance will be organic.

So, while we are mostly an organic growth story, we do look for acquisitions.

We have a team that's always looking.

We have the last one we did, though, is a couple years ago, three years ago with Western Filter, which was a liquid filtration business, which we acquired in California that serves the aerospace and defense market.

That would be the types of things that we would look for is liquid filtration businesses in markets we already know that bring us more product coverage or our new customer contacts.

We are always looking -- in terms of the multiples, we have financial disciplines for our acquisition process and we look for an acquisition to be earnings accretive by the end of the second year.

Because we want to do the heavy lifting quickly and then move past that and then get to our corporate ROI targets by the end of the year five to the 15% corporate target.

So we're always looking.

We don't comment prospectively.

And while we are looking we focus on our organic growth plan.

And then we'll try and do acquisitions if we can find them that fit our business model and our financial targets.

Great.

And just last question, maybe if you could touch on your European exposure, it sounds like Southern Europe declined sequentially for you, but Northern Europe held in.

Is that fair?

This is Bill again, Hamzah.

I think what we see -- my comments were really around those economies.

First, our exposure in Greece is immaterial.

But we have businesses in other parts -- more major economies in Southern Europe, in Spain and Italy.

We do see those economies in a recession now, back in a recession, while we see the Northern European economies growing slightly.

All of that is baked into our guidance.

So, I think we've got the exposure as we can see it now already incorporated.

Great.

Thank you.

Sure.

Thank you.

Charley Brady, BMO Capital Markets.

First off, on the off-road business can you remind us what the mix is between the ag, mining, and construction markets?

Charley, this is Rich.

Construction and mining combined are over half, probably, 55%, 60%.

Some of those customers play on both sides, so it's a little hard to split them out.

I would say construction is more than the mining of that 55% to 60%.

Ag would be next at, call it 25% to 30%.

And the balance would be light industrial.

So think things like forklifts and dock equipment, things like that.

And on the mining side, in your prepared comments you talked about see a plateauing out kind of at current level.

And obviously there's a lot of discussion on longer-term mining CapEx.

I just wonder, can you get some more granularity on what you're hearing from your mining customers as to their visibility on what they are doing with their plans?

And how far visibility do you get into, what they are thinking of?

Charlie, Bill here.

I think with our major customers, we try to be as close to them as possible so that we can coordinate with their plans so that we are where they need us to be.

And to some extent, I will cite the example of the investment we're making in Xuzhou, as one example to not only to serve the Chinese OEMs but also our global OEMs that are making investments there.

So longer-term, we see construction and mining as being very strong opportunities for us with a growing need for both infrastructure in both the emerging economies, as well as the developed ones, where a lot of that needs to be upgraded or replaced.

And then mining because of the continuing expanding need as economies like China and India and Brazil develop, they need more of the raw materials.

So longer-term we're very, very bullish, as are our customers on those.

Thanks.

Switching gears, on the Gas Turbine business -- I know you don't want to give a forecast for next year yet, but it sounds as though that business is looking pretty strong for you just on the end market backdrop.

I'm trying to get a sense of, do you see a pretty meaningful pick up next year on the Gas Turbine business, kind of what you are seeing currently and going into Q4?

Charlie, Bill.

Again, so Jim and Rich won't let me comment specifically on next year, because we haven't finished the plan yet, but just to comment on that market, that is for us our latest cycle business.

So it was the last one into the recession, maybe the last one out, just given the long lead times for those projects, both to finish some once they are started and to restart them.

But now that has happened, so we do see this market on a pretty nice uptick on both parts that we talked about.

So, smaller turbines, which are around energy exploration and transmission.

So, smaller turbines used on platforms, offshore, or in pipelines, and then on the larger ones, which would probably have been the latest part of this business in terms of coming back, around, say, municipal power generation.

These large plants, as we talked about that would be, that would be used for electricity generation for industry or communities, and we see that happening in many parts of the world/.

And we do see that and our customers -- I think GE is projecting their turbine shipments being up about 20% in calendar '12 over calendar '11.

So, we're not going to comment exactly on what we see for next fiscal year but we do see the market on an uptick.

Great.

Thanks.

That's probably going to be for the next two or three years, we think.

Kevin Maczka, BB&T Capital Markets.

Bill, on continuous improvement, you are still making nice progress there.

I know that's kind of an ongoing thing and will always be, but 60 basis points, that added to the gross margin.

Is this the kind of run rate, if you will, that we can continue to expect going forward?

And can you say anything about any particular initiatives you're doing there that are really moving the needle and driving that 60 basis points?

So, Kevin, a couple questions there.

One is in terms of can you expect that exactly going forward?

Well, no, not 60 basis points quarter-over-quarter, but I think that is part of our model going forward, in terms of supporting that increase in the expansion on our operating margin.

And that is part of the DNA at Donaldson, continuous improvement, and it has been for many years.

It's what we need to do to make sure that we can maintain and improve our margins while basically at the same time delivering cost decreases for many of our customers and offsetting purchase material cost increases.

So, as we've talked about in the past, our pricing over long periods of time is essentially zero.

The way we expand margins is through growing our business and getting leverage and expanding our gross margin through continuous improvement.

Jim talked about in his comments that about a quarter of our capital is in support of our continuous improvement efforts.

And that's probably been a pretty good trend the last few years, and that would be new equipment, upgrading equipment and processes in our existing plants.

So, it starts with the product and it goes into the processes.

So, it's both an engineering and a manufacturing and a purchasing initiative, so it really encompasses all of the Company.

Every plant has a goal.

And many of our plants, the gain sharing arrangements are based on their success with that.

So, I think it is part of the DNA here, and I see that continuing to deliver dividends for us and help with the margin expansion we talked about earlier.

Okay.

And a similar question as it relates to operating expense, nice progress there again this quarter.

Growing that much slower than revenues grew.

I think last quarter, there was a comment about slowing some headcount adds based on some uncertainties.

And maybe can you just comment again on what you said earlier about headcount coming back in perhaps as we go forward and how that might impact the OpEx line.

Yes.

This is Jim.

I mentioned that also in my comments today that we have been selective, given the uncertainty in Europe.

A quarter or so ago, the slowdown in China did give us reason to be a little bit careful in how we added the headcount that were in our plan for this year.

So, we did get really good leverage this quarter.

But at the same time, I think as we get more comfortable, that for sure the rest of this year looks solid, and as we develop our plan into next year, we are going to have to make some incremental adds in terms of supporting some of these strategic investments.

So, I think we achieved really good leverage from an operating expense standpoint this quarter.

But I don't think you can -- I think that's going to be under a little bit of pressure.

Longer-term, we've been shooting for the 21%, and we are a little bit ahead of that here this year.

Just as a reference point on headcount, we're at about 13,300 now, which is just about back to where we were at the peak of the recession so we're well upon sales, but essentially where we were back in '08 on headcount.

I will add to that, Kevin, our model is to grow our expense base over time at a slower rate than our sales.

There's nothing new about that.

That's been Donaldson's model for the past 20 years and we'll continue to do that.

Okay.

Got it.

Thank you.

Eli Lustgarten, Longbow Securities.

One clarification question.

In your segment data, the corporate and unallocated was less than $1 million, I guess it was $987,000, whatever it was.

I think that's an arbitrarily lower number than most of us expect.

Can you give us an idea what happened there and what's going on?

Eli, this is Jim.

There's a couple things that impact that corporate number.

Some of it is corporate-related and some of it is timing-related, in terms of when certain costs hit our business units.

So, on the corporate-related items that aren't allocated out to our business units, would include things like interest income and expense, FX.

We had some fees last year for registration fees for a tax project we did.

All of those went a favorable this year over last, so that's about $2 million of the difference.

The other piece of the corporate and unallocated relates to how some of our intercompany eliminations in sales work.

And some of those costs, when we are building inventory or in a very high growth mode like we were last year to meet the 20% growth in demand, we ended up having more costs unallocated initially as we are growing that inventory last year.

So, if you look historically last year' s unallocated was quite high compared to our normal run rate, and now as our growth rates have come back to what we consider our more normal growth rates, you will see a normalization of that number.

So those are the two factors at play.

Would you assume it's about a $3 million run rate?

You just indicated, is that the fair number?

It does fluctuate, so it's hard to predict because of things like FX and other things we just can't have a lot of visibility to.

But historically, it's been in that range.

Another clarification, your guidance implies about a 50% increase in gas turbine sales in the first fourth quarter.

Third quarter seemed a little light to me versus the guidance we expected so was some of the shipments postponed into the fourth quarter, or transitted out arbitrarily, or is it just the way the shipping schedules were?

Eli, this is Rich.

Our Gas Turbine business, those are really large projects, so it can really be affected by the timing of when some of these systems are supposed to ship.

I think the scientific name for that is, lumpy.

So, there were a couple projects that slipped a couple of weeks that are now going to be in our fourth quarter.

We tend not to give specific quarterly guidance because of just factors like that.

But we feel pretty comfortable in our full-year guidance at this point.

So we will have a very good fourth quarter.

And can you give us -- when you talk about end market particularly how strong the on-road and off-road markets have been, the problem in the on-road market is it was 77,000 production the first quarter and whether it goes up or not in the second quarter, they're overproducing yearly forecast.

And orders have been slower.

Are you seeing any indications from anyone yet of paring back production schedules, or how they are going to adjust?

If 298,000 is right, and that's almost considered high, 77,000 times 4 is 308,000 so we are producing over the annual rate at this point.

So, are we hearing about anything about the intent to cut back?

Or they are going to build some inventory or what's going on in the on-road business?

Eli, this is Bill.

I think where we see the cutbacks is in Europe, where customers announced that related to the conditions there.

And you are right, if you annualize this 77,000 it's a little bit more than what they are forecasting for the year.

But we take a look and take some comfort in the fact that the 298,000 that's up 16% over last year.

So might not be growing at the same rate but it was a year ago, year-over-year, but it's still going to be a nice, healthy increase during the balance of the year.

One final question, are we hearing anything going on in pricing for products going on both here or outside United States?

Any change in pricing?

Any improvement in cost-price relationships, what have you?

Eli, Bill.

I will turn it over to Jim, and he can talk a little bit about what we are seeing from a purchasing perspective.

But I would say maybe the good news is we haven't seen a replay of some of the significant commodity increases that we saw a couple years ago, or two years ago.

And that's good for us and for our customers.

Jim?

Yes.

This is Jim.

In terms of commodity costs, as I mentioned we are up year-over-year.

But what we've seen is the last three, four months, and actually anticipating here, at least for the rest of the year, that commodity costs have really calmed down.

I think one of the services we subscribed to call it a pause.

So, there haven't been any real significant -- really pricing action has been almost none, here, over the last quarter or so.

And we don't really see any for the next couple months.

Thank you.

Thanks.

Brian Drab, William Blair.

Congratulations on another great quarter.

Thanks, Brian.

Good morning to you.

Most of my questions have been asked at this point, but I wanted to follow up on the question that was just asked about the North American truck market.

And I know the first-fit North American market is not a very significant portion of your sales at this point, but you mentioned the ACT data.

The retail sales and order rates really have slowed down, and it doesn't seem to connect with the forecast for continued strength in engine builds.

So, I'm wondering if you can talk a little bit more about them.

Surprised that you didn't today talk about potential for that to slow down, but instead, cited that bullish forecast from ACT, which a lot of people are now expecting would be revised downward a little bit.

I'm wondering if you could add any more color there.

It sounds like you are not seeing any slowdown in that market at this point.

Brian, Bill here.

I might not have said this clearly.

I think we've seen the rate of increase is certainly different now than they were this time a year ago in North America.

And so slowing down isn't the same as going down to us, okay?

So we -- right now, we take a look at putting it all together and getting away from what some of the gyrations month-to-month.

If we look at what our customers and outside experts like ACT say, in terms of the year-over-year, the calendar year-over-year increase.

So, that gives us some visibility through the balance of this calendar year and the first half of our next fiscal year.

The North American Heavy Truck business is an important part of our Business, first fit, but it's a small part of our overall sales.

(technical difficulty) 10%.

So, we'll continue to watch it, but we don't see the market going down; it's the rate of increase slowing down.

Okay.

And then just one more question.

On the China market can you -- a few questions on that market.

Can you remind us what percentage of your sales in China are in the on-road truck market, and then what was the growth rate that you saw in that market in the quarter?

And what do you expect in the next quarter?

It's Bill again.

The percentage, Brian, of on-road truck market, first the heavy truck market in China is very small percentage of our Chinese business.

We just won a couple of major platforms and those are just launching, so the opportunity is out in front of us.

We have seen industry statistics that say the build rates for heavy trucks in China is going to be down year-over-year from '11 to '12, so '12 is going to be down.

I think it's going to be down about 12% or 13% in the low double digits.

But that's about -- we're talking about numbers of around 900,000 trucks.

So, it's a huge market still, of which we have very small share but growing share.

So, it's a small part of our Business but we hope to make it a lot larger part of our Business going forward.

Okay.

Thanks very much.

Thank you.

Gary Farber, CL King.

Can you comment on just as you move through each month in the quarter, how you saw things in North America and China?

Did North America strengthen during the quarter?

Were the growth rates relatively stable?

And then if possible, just comment on your customer base, just the order patterns.

Do you see some degree of caution in different geographies, or do you see full-out conviction, really?

I will start.

This is Bill.

Maybe Jim will add something.

I think in terms of -- we don't comment specifically month-to-month by quarter.

Just to give you a flavor, in North America I don't think we saw any change in the trends from month-to-month during our third quarter.

We talked earlier about the gas turbine which is lumpy.

But I'm talking about the rest of our markets.

I would say the ones where we can connect the dots for trend, we didn't see any change during the quarter in North America.

I think in China, what we've seen over the past two quarters is sort of a steady improvement coming out of -- into this new calendar year and coming out of Chinese New Year.

So I think maybe China generally the economy there is recovering slower than most people expected, but it is recovering.

And we've seen that continue and we expect it to further continue.

Right.

And that's sort of you would say -- short period of time but you had a bunch of data points come out yesterday.

That's sort of continued into May as well, you would say?

No real change in what you've just said?

We watch it closely.

And they lot of it -- industry reports have been -- especially feedback from customers, and I think we haven't seen any changes.

The only area that's maybe changed over the last two quarters is Europe.

We talked about that, with Southern Europe going back into recession and Northern Europe slowing down, but I think we covered that on our comments.

Right.

This is Jim.

I think with Europe, we haven't seen any changes since the quarter going forward, but I think just like everybody we're watching what impact the turmoil there will have, but we haven't seen anything to this point.

Right.

Okay.

Thank you.

I think all of our customers are very cautious, and so are we.

There isn't a tremendous amount of visibility in terms of forward-looking.

We've worked with our or order backlog, but that really only covers about half of our business, because a lot of our orders come in and they are shipped out the same day.

But a lot of the OEM production platforms we do have some more visibility and we track that.

But we know our customers are being very careful about how far they place orders.

And that's been pretty much the story or the trend for much of the recovery, you would say?

From the middle of the recession, or the start of the recession through the recovery, right?

Maybe this time last year people were a little bit more optimistic, a little bit longer term.

But now with so many elections this year and so many different countries, and so many economic questions swirling around, I think people are generally more cautious, as are we.

And I think we should be.

Right.

Okay.

Thanks for all your help.

Sure.

(Operator Instructions)

Richard Eastman, Robert W. Baird.

Bill, just to carry that theme, one more question here on Europe.

In particular on the IFS business, do you have any sense that the back half of this calendar year might reflect the declining PMI in Europe?

Generally, your IFS business has a bit of a backlog, a quarter or two.

Have you seen any slowdown in the backlog or order flow in the last quarter?

Right, Bill.

We have.

Our IFS business, the first bit, the new system part of that is sort of in midcycle.

The replacement parts are maybe earlier.

But, on the equipment side of that, we have seen some slowdown over the past few months in Europe.

Yes.

And that's related to the general -- what we talked about with the slower growth in Northern Europe and much of the Southern Europe economy entering a recession.

We have seen that and we have factored that into our guidance in terms of the back half of the year --

For the fourth quarter?

For the fourth quarter.

We're putting our plans together for next year, now.

And so it wouldn't be appropriate for me to try and guess yet, until we get the numbers together in terms of what we see in the back half of this calendar year, which will be the first half of our new fiscal year.

Yes.

Okay.

And then as one question, can you give us what China sales were in the quarter?

I know you addressed a little bit of the truck exposure, but just curious what the China sales number was,

Rick, they were $43 million.

Okay.

So, that's a nice sequential improvement from the second then?

Without question.

Yes.

It is.

Yes.

And then, Bill, I just wanted to get a couple comments.

The Engine Liquid business, and now you've introduced the diesel fuel filters, is there a segment of your engine products business that maybe are the early adopters of the early platforms?

Is it off-road or on-road, or does that product appeal to any class of vehicle first?

Rick, this is Bill.

I would say our primary target is off-road.

Okay?

Ag and construction equipment for that technology.

But we are looking at other end markets as well, but primarily off-road.

Okay.

All right.

And then just one last question, the other income number, I'm curious, continues to work higher.

Is that being influenced by any PowerCore royalty or -- what's influencing that number?

Rick, this is Rich.

Two biggest driving factors that we've got going right now, one is we've got some higher interest income.

Okay.

In the mix.

And also we've seen foreign exchange gains on the income line where last year against the dollar weakened, we have losses there.

That's really the offset on our hedging of our (technical difficulty).

Okay.

Great.

Thank you.

Thanks, Rick.

Very nice quarter.

Laurence Alexander, Jefferies & Company.

This is Rob Walker on for Laurence.

On the next generation of PowerCore, can you give us some sense of scale for how much share you've gained on the OEM platforms?

Obviously, they will roll out over time but if you had to benchmark it, for example, if they were all commercial today, do you think your OEM product sales would be up 1% 5% or 30%?

That's a good question, Rob.

I'm going to comment sequalitatively, and stay away from quantitatively.

I think on the OEM side, on PowerCore, we were in a leadership position on first fit air filtration before.

In many cases on OEM first fit we are replacing ourselves.

But we are also picking up market share on some platforms that we didn't have before.

But I would say the bigger upside for us is in the aftermarket.

So by putting PowerCore or other proprietary technologies that we have -- because we have others in addition to PowerCore, but we used PowerCore as one of our -- we talked about that as one of our key performance indicators with folks like you.

The big upside is in the aftermarket.

So we can take where we and our customers might be getting 30% share of the aftermarket replacement filters to 100% for a period of time.

So it's a -- bigger upside is on the aftermarket for us, but we are winning some new first fit platforms as well on the engine side.

And the same comments go for, in dust collection on our industrial side, although on dust collection we're actually able to participate in some new end markets that we weren't very strong.

So the industrial side is both first fit, share gains, and aftermarket.

Okay.

Thanks.

And then I guess can you sketch out your contingency plans around European exposure in case that economy were to slow down more sharply?

And likewise in China, would the strategy be to cut regional exposure or invest through a potential downturn?

You mentioned your liquids facility in China.

Thank you.

Yes, Rob, this is Bill again.

I think we had a pretty good live exercise on having to go through a downturn a couple years ago.

And I think we did okay or maybe even better than okay.

And I think we learned a lot from it, which we've been incorporating into our contingency plans going forward.

One of the things that I think we did pretty good the last time and that we will continue to do is that we really focused on prioritizing to make sure that we didn't shut everything off for the long-term.

So, we continued to make key strategic investments through the recession, not as many as we had planned before we went into the recession, but we continued with a number of them including capital projects, because we knew we would need them when we came out of the recession.

And we were right; we did.

We would prioritize the projects by region and manage our short-term exposure while investing for the long-term on key projects.

All right.

Thank you very much.

Thank you.

Thank you.

There are no further questions at this time.

I will turn the conference back over to Bill Cook for any closing remarks.

Thanks, Alicia.

Just to conclude our call, first I'd like to thank everyone for your time and continued interest in our Company.

I'd like to especially thank my 13,300 colleagues for their efforts and contributions in creating these wonderful results and what we delivered in the third quarter.

This quarter clearly demonstrates further significant progress in our execution of our strategic growth plan and reinforces our objectives of building our Company into first a $3 billion and then a $5 billion filter company.

Thank you all, and have a great weekend.

Goodbye.

Ladies and gentlemen, this does conclude the conference call.

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