Donaldson Company Inc (DCI) 2012 Q4 法說會逐字稿

Good morning, Ladies and Gentlemen, and thank you for standing by.

Welcome to the Donaldson's Fourth Quarter Fiscal Year 2012 Conference Call.

At this time all participants are in listen-only mode.

Following the presentation there will be a question and answer session and instructions will be given at that time.

(Operator Instructions)

As a reminder this call is being recorded today, August 27, 2012.

I would now like to turn the call over to Rick Sheffer, please go ahead, sir.

Thank you, Craig.

Welcome, everyone, to Donaldson's fiscal 2012 fourth quarter conference call and webcast.

Following this brief introduction, Bill Cook, our Chairman, President, and CEO, and Jim Shaw, our Vice President and CFO, will review our record fourth quarter and full year earnings and our initial outlook for fiscal '13.

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 set fourth quarter records for sales, operating margin, net earnings and earnings per share.

This very successful conclusion to our fiscal '12 also resulted in record sales and profits for the full year.

Our fiscal '12 performance means that we have now delivered earnings records in 21 of the last 23 years.

Now I'd like to take a few minutes to summarize our results for the fourth quarter.

Our fourth quarter sales were $657 million, up 5% over last year.

Excluding the negative impact of foreign currency translation due to the stronger US dollar, we had organic sales growth of 11%, which we are very, very pleased with.

This combination of our 11% organic sales growth and a 15.1% operating margin helped to deliver an increase in pretax income of 13% and an EPS increase of 12% resulting in a record $0.43 per share.

As you know, we have two reporting segments and I will now cover highlights for each.

First, in our Engine Product segment, excluding the impact of foreign exchange, our local currency sales in the quarter increased 6% over last year.

The primary drivers of this increase were our OEM businesses, off-road and on-road, which were up 11% and 6% respectively.

Our off-road product sales were up 16% in the Americas and 11% in Europe, as the agricultural equipment markets we serve remain strong globally.

This offset slower growth in Asia where excess inventory of mining and construction equipment in China has impacted the overall Asian off-road equipment market.

The 6% increase in our on-road product sales was primarily due to higher North American new heavy truck build rates at our customers.

Class 8 heavy truck builds in North America were 76,000 in our last fiscal quarter, a 24% increase over last year.

Partially offsetting this was a 5% decrease in new truck sales in Japan.

Now we also had help from our engine aftermarket business, as our replacement filter sales were up 6% globally.

Replacement filter sales in the Americas were up 10%, with solid growth in sales to our independent dealers and distributors.

The strong growth in the Americas offset 1% growth in Europe and a 5% decrease in Asia, mainly due to the continuing slow recovery in China.

As we have discussed in previous calls, one key area of focus in our aftermarket business is continuing to expand our distribution networks and product line.

We added another 126 distributors since our last call.

The majority of these latest additions in Asia, Latin America and the US.

Also we've added nearly 500 part numbers to our product offering since our last call with a majority of these adds in our emerging market businesses.

Now switching to our Industrial Product segment, our local currency sales increased 20%.

Our largest Industrial Product group, industrial filtration solutions, grew local currency sales by 17%.

Their sales growth was good in both the US and Europe for both new Torit dust collection equipment and the replacement filters for those systems already installed in the field.

We also had a very large project ship in South Africa this quarter.

Sales in gas turbine were up 51% in the quarter, driven mainly by strong shipments for new power generation systems.

And finally, sales of our special application products increased 3%, with sales growth in our venting, disk drive filters and membrane product lines.

Now I'll quickly summarize our sales by region.

We again had very good growth in the Americas, with local currency sales increasing 9% in the quarter.

In Europe, our local currency sales increased 11%, with our gas turbine, off-road and industrial filtration businesses all posting double digit percent year over year sales increases.

And in Asia, strong gas turbine sales drove an overall local currency sales increase of 7% for the region in the quarter.

I'm now going to turn the call over to Jim for his comments on our operations before I discuss our initial outlook for fiscal '13.

Jim?

Thank, Bill, and good morning, everyone.

Our gross margin was 35% in the quarter compared to 36.3% in last years fourth quarter.

In the quarter, the biggest drivers of the decrease were slightly lower fixed cost absorption from softer customer demand in Asia, as well as the planned ramp up of our new plant in Aguascalientes, Mexico, including the related product transfer costs.

This combined to lower our gross margin by 100 basis points.

Also contributing were higher commodity costs outside the United States due to the strengthening US dollar.

And finally, we saw a shift in our total sales from first fit towards aftermarket.

Last year, aftermarket sales were 52% of our total sales, but this quarter they were 48%, as engine aftermarket sales were weak in Europe and China, while a ramp up in project sales of gas turbines and industrial filtration solutions moved more of our overall mix towards first fit.

Partially offsetting this was the impact of our continuous improvement initiatives, which increased gross margin by 110 basis points.

Our operating expenses remain well under control and have provided much of our operating leverage this year.

In the fourth quarter, operating expenses were 19.8% of sales, which was down 210 basis points from last year.

Reduced distribution and warranty costs contributed 100 basis points to the improvement.

In addition, while we continue to assess the direction of the overall global economy, we've been cautious in managing our discretionary operating expenses, such as adding headcount additions that had been previously planned.

This operating leverage resulted in a 60 basis point improvement in the quarter.

There's still a lot of uncertainty regarding the European economy, the pace of general industrial recovery in China, as well as the potential for a fiscal cliff in the United States, so we'll continue to manage our operating expense levels cautiously in the near term.

Our operating margin came in at 15.1% this quarter, which is a fourth quarter record.

Looking at our operating margin forecast, we believe fixed cost absorption will be positive in fiscal year '13.

Material costs will be stable in the United States and slightly higher overseas and we'll continue to generate benefits from our continuous improvement initiatives.

We plan to continue making long-term, key long-term strategic operating investments, the most significant of which is the kickoff of a global ERP project, which we estimate will have a $6 million impact on operating expenses in fiscal year '13 beginning in the first quarter.

We're also expecting pension expense to increase by approximately $6 million in fiscal year '13.

The sharp drop in US interest rates and lower rates of return on our plan assets are the primary drivers of the increase in pension expense this coming year.

However, despite all of these headwinds, in total, we expect our operating margin for fiscal '13 to be another full year record between 14.6% and 15.4%.

Our effective tax rate was 30.7% in the fourth quarter versus 27.3% last year.

Last year's fourth quarter had $2.6 million of tax benefits from the expiration of some statute of limitations and the favorable impact in dividends from some foreign subsidiaries.

For the full year our effective tax rate was 28.7%.

Based on our projected global mix of earnings in fiscal '13, we forecast our fiscal '13 tax rate to be between 28% and 31%, the mid point of the range being about 1% higher than fiscal '12 rate.

As I mentioned in last quarter's call, we've seen the profitability of our US operations improve considerably.

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

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

Of particular note is the settlement in last year's first quarter that reduced our effective tax rate to 25.5% in last year's first quarter.

This will not repeat in the first quarter of fiscal '13, as we expect our tax rate in the first quarter to be approximately 30%.

As you undoubtedly noticed in our press release, our outlook is based on a $1.24 exchange rate between the US dollar and the Euro.

In fiscal '12 the dollar to Euro averaged $1.39 in our first quarter, $1.32 in both our second and third quarters, and $1.25 in our fourth quarter.

With this in mind, we're forecasting foreign currency headwinds of approximately 5% in the first quarter and 3% in the next two quarters of fiscal year '13.

Our fourth quarter CapEx came in at $19 million, bringing our total spend for the year to $77 million.

This ended up being less than our original guidance of $100 million for the year, mainly due to the timing of execution of these projects and the cash spend.

We expect to spend about $125 million on CapEx in fiscal year '13.

About a third of this is carryover from fiscal '12 projects that were authorized but not spent prior to year-end and the balance will be from fiscal year '13 Board approved capital budget of $100 million.

The breakdown of this year's CapEx is projected to be -- approximately 30% related to capacity expansion; another 30% for our technology initiatives, which includes our global ERP implementation; another 20% is for tooling for new products; and 20% will be related to cost reduction activities through our continuous improvement initiatives.

We expect depreciation and amortization will be between $62 million and $66 million in fiscal year '13.

Free cash flow was $58 million this quarter.

As mentioned, CapEx was $19 million compared to $17 million in last year's fourth quarter.

Working capital was a source of cash this quarter, as DSOs and inventory turns improved sequentially from our third quarter.

For fiscal '13 we expect full year cash flow from operating activities to be $280 million to $310 million.

As part of our longstanding share repurchase policy, we repurchased 1.5 million shares or 1% of our diluted outstanding shares in the fourth quarter for $48 million.

For the year, we repurchased approximately 4.5 million shares or 2.9% of our diluted outstanding for $130 million.

Our debt-to-cap and debt to EBITDA ratios are now at 24.5% and 0.7% respectively, well within the financial covenants of our various credit and note agreements.

We expect interest expense in fiscal '13 will be between $11 million and $13 million and our balance sheet remains strong with $318 million of cash and short-term investments.

So with that, I'll pass it back to Bill, who will provide additional details on our initial outlook for fiscal year '13.

Bill?

Thanks, Jim.

So, now looking forward into our new year, fiscal '13.

We expect that the overall European economy will remain in a shallow recession for the first half of our fiscal year before beginning to slowly recover in our second half and as we enter the new calendar year.

We also expect the Chinese economy to continue improving, but slowly, for the next two quarters.

We expect North and Latin America to remain the strongest regions globally, although their growth is expected to be moderated by the situations in Europe and China.

As Jim mentioned, our outlook includes a strong US dollar at $1.24 versus the Euro.

We expect our full year fiscal '13 sales to be between $2.62 billion and $2.72 billion for an increase of between 5% to 9% over last year's record of $2.5 billion.

Now as you update your models for fiscal '13, as Jim mentioned, please note that we're expecting our most difficult year over year comparisons in our first quarter.

When factoring in the significant year over year impact of currency translation, we are anticipating sales growth in the low single digits in the first quarter with the continued mix towards first fit keeping our operating margin roughly equal to last year's first quarter.

As Jim discussed, we also expect a year over year increase in our effective tax rate in the first quarter.

So in total, when combining the impact of the foreign currency translation and a higher tax rate we're expecting little, if any, of our full year fiscal '13 EPS growth to be generated in our first quarter.

Now switching gears, I want to review our outlook by segment.

Our full year engine sales are forecast to increase between 3% and 10% over fiscal '12.

This includes the impact of the foreign currency translation we both mentioned earlier.

Within our off-road product sales we expect agricultural equipment demand to remain strong globally.

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

We do foresee the current softer demand for mining related equipment continuing and the excess inventory of some categories of mining equipment keeping production of new equipment below last years levels.

Recent market forecasts for on-road truck builds have been reduced.

ACT Research forecast for heavy truck builds at our North American customers is for an 8% decrease during our fiscal '13 and their forecast for medium duty truck builds is flat year over year.

While the average age of the current truck fleets is also historically very old, which indicates a continuing need for replacement cycle, we don't expect a pick up in build rates during our fiscal '13.

Finally, we expect our aftermarket or replacement filter sales to increase moderately based on the current utilization rates of both off-road and on-road heavy trucks.

Off-road equipment and on-road heavy trucks, excuse me.

We expect aftermarket dealers in Europe and in parts of Asia to remain cautious with their inventory levels, while our dealers in the Americas could grow more cautious if economic conditions in the US deteriorate this fall for whatever reason.

However, the better news is that there are a number of factors still working in our favor.

First are our efforts to continue increasing our presence in emerging economies where we remain underrepresented.

This is a very significant opportunity for us to expand the distribution of our current products.

Second factor is the opportunity for us to expand our liquid product, liquid filtration product offerings through all aftermarket channels.

Also helping us is the ever increasing numbers of systems in the field with our proprietary filters, which will help us retain an increasing percentage of the replacement filter sales.

Now switching to our industrial segment.

Our sales forecast is to be up between 5% and 12% in fiscal '13 and this also includes the impact from the foreign currency translation we discussed earlier.

We expect industrial filtration solution sales to be up between 1% and 7%, as customer demand for new industrial filtration equipment remains good in the Americas, as new plant and manufacturing equipment capital spending remains healthy.

In Asia we see conditions continuing so slowly improve, but in Europe we see conditions moderating somewhat from fiscal '12.

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

We are anticipating a significant increase in our gas turbine business, as we see two very positive trends continuing.

First, there are many large gas turbine system projects under way at our customers.

These large projects are typically 200 megawatts each, which could provide equivalent power for 200,000 homes.

So, very large projects and many of these projects will be installed in Middle East, China and the US.

The second positive trend relates to the high oil prices and the resulting demand for smaller turbines.

This creates as more are needed in the energy exploration and for oil and gas transportation.

Overall, we expect our gas turbine product sales to be up between 17% and 23% in fiscal '13.

Finally, we're forecasting special application sales to be up between 8% and 14%, with solid growth in all three product groups, disk drive filters, membranes and venting products.

Incorporating all of this into the sales guidance, into the operating guidance Jim covered earlier, our full year EPS forecast for fiscal '13 is between $1.82 and $1.96.

The mid-point of this range is up 9% from the EPS record we just achieved in fiscal '12 and will, obviously, be another EPS record and our 22 record in the last 24 years.

Finally, I'd like to give you a quick update on some of our new technologies before we wrap up our prepared comments.

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

Our PowerCore sales totaled $33 million in our fourth quarter, up approximately 39% over last year.

Our Engine PowerCore sales in the quarter totaled $28 million and were up 31% over last year.

On the industrial side of our business we sold another 300 Torit PowerCore systems, which accounted for over $5 million in sales.

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

We also continue to make progress in the liquid filtration markets.

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

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

So, now to summarize.

We delivered record results in our fiscal '12, our 21 record in the last 23 years.

And despite the current high levels of economic uncertainty in many regions of the world, we do have good momentum in many of our regions and businesses, as we set a number of new sales records during the past year.

A partial list off some of our new regional sales records includes the US, Mexico, Brazil, South Africa, China, India, Australia and the Czech Republic.

We also have very good operational momentum within our Company, as evidenced by the record 15.1% operating margin we achieved in the fourth quarter.

So, putting all this together, looking forward, we're projecting a record fiscal '13.

And finally, during fiscal '13 we will continue to make the key long-term technology and capital investments to both fulfill our customers ever increasing filtration needs and to support the $3 billion and $5 billion sales targets we established in our strategic growth plan.

Now, that concludes our prepared remarks.

Craig, now we would like to open up to questions.

(Operator Instructions)

Kevin Maczka with BB&T Capital Markets.

Bill, first question on the Engine guidance.

Strong year this year up 9%, but we exited the year flat in the fourth quarter.

So, my question is given what you said about the truck environment and the declining OEM build rates, I know we have more emerging market expansion, we have new products, but what gives you the comfort that we can accelerate to as much as 10% for the year when things seem to be moderating and we exited the year flat?

Kevin, part of it is taking a look at China, we are forecasting for China to begin recovering.

In the fourth quarter, might have been sort of the bottom for us.

So, part of it is our business in Asia and it's not just our business in China, but how it impacts the rest of Asia in terms of South Korea and Japan.

And then I think a lot of it you touched on in terms of our emerging market growth objectives in terms of more distribution, more product line expansion will help us in the aftermarket.

So, those are a couple of the factors.

We're also seeing the ag equipment market remaining good and construction, absent mining, also remaining good.

So, the heavy truck numbers are the ones that we've all been looking at the last couple of weeks and, as I noted, they're projecting builds to be down in our fiscal year by about 8%, but that's still from pretty good levels from where we were in fiscal '12.

So, we put all that together, Kevin, in our guidance and so it's a couple of minuses and some pluses as well.

So, do you have a minus assumed in your guidance for the OEM truck build portion of the business?

We do, yes.

On the ERP, if I can shift gears and just ask a question there.

That sometimes makes investors nervous for good reason when they hear about ERP rollout globally.

We did recently see another big filtration company have some issues with that.

Can you just talk about the scope of this project and kind of what you're doing to prepare for it to hopefully avoid some issues that other companies have had?

Yes, it's a good question, Kevin, and I know there's some sensitive about when the ERP is mentioned.

We are taking a very cautious and planful approach.

This is a four year project, so it's not a revolutionary change.

It's an evolutionary change.

We feel this is critical to supporting our strategic growth goals.

At a $5 billion company, our goal to be that by fiscal '21, that we need to be acting as a global Company with really on one system.

So, it's in support of that but it's a four year project so it's very planful in terms of how we'll execute it.

We're going to not jeopardize the business as we do this, but we are going to do it in conjunction with running the business on a day-to-day basis.

Okay, thanks for that.

I'll get back in queue.

Okay.

Charley Brady with BMO Capital Markets.

On the Engine Products growth question and the OEM truck build rate, I know you said you're factoring or forecasting that to be down, but I'm trying to gauge you expecting that to be down to the same degree as kind of industry build rates or are you picking up -- is there some share build in there?

And also, how much of that fiscal '13 Engine Product growth is coming from having those liquid programs starting to hit the revenue line?

So, Charley, the first question, we factored in, as I mentioned to Kevin, the recent forecast in terms of the build rate production.

We feel that we're probably getting a little bit of share during fiscal '13, additional share to offset that, but mostly it's some downward pressure due to the build rates.

And on the liquid filtration, we haven't quantified publicly how much of that's going to be in fiscal '13.

It's a little bit, but it is additive.

So, that also helps offset the build rate reductions.

And then just on your Engine growth forecast.

Again, first half versus second half, given your commentary on what you said about Q1 and the comparison there, it sounds like you'd expect a second half -- more growth in second half versus first half; is that correct?

Yes, we do.

We talked, Jim and I both talked about the first quarter and we have the currency headwinds is the strongest there, if you're looking at this in dollars.

And then the second quarter is traditionally one of our weaker ones just with the holidays.

So, certainly this year for the Engine side we're looking for a stronger second half versus first half.

And then just can you give us what the share count is, the total shares outstanding at the end of the quarter rather than just the average for the quarter?

Charley, Rich is looking it up as I speak.

Okay, I'll get back in the queue, thanks.

Okay.

Hamzah Mazari with Credit Suisse.

The first question is just on market share gains.

You guys have highlighted that you expect 2% to 4% on a normalized basis in any given year, just wondering what you're seeing on the market share gain side in either both Industrial and Engine, particularly with some of your competitors having a tougher time than you are.

Hamzah, Bill here.

I think that you're right, the 2% to 4% is what we target and that's actually when we look backwards over the last two decades, the last 20 years, that's what we've averaged.

It's hard to measure that on a day-to-day or week-to-week basis, but over longer periods of time we can subtract out from our growth both the overall market growth, really pricing isn't much of a factor and then we're left with what we believe is our share gains and we feel like we're on track with that.

A lot of this is being driven by the PowerCore products that we mentioned and also the liquid filtration, but it's hard to measure that on a quarter to quarter or month to month basis, but we feel like we're on track for that in fiscal '13.

That's driving a lot of the technology investments that we're making in fiscal '13 is to maintain that going forward.

And then just on your investment spend, could you maybe talk about how much visibility you have in your business right now?

You talked about Asia improving, Europe being worse, just curious to see how that impacts your investment decision-making right now.

Do you pull back that spend if share doesn't recover or gets worse relative to your expectation and has visibility improved in your business, say, now relative to six, eight months ago?

Hamzah, this is Bill.

I'll start and maybe Jim will add a few comments.

The visibility, I would say, is probably less than we've had six or eight months ago.

And just in terms of our overall visibility, you have to remember that a little bit over 50%, about 50% of our business is first fit or filters for production at our customers and 50% is replacement parts.

And replacement parts there is very little visibility because the orders tend to come in and go out in very short periods of time.

But, on the 50% where we have visibility, longer term visibility, and this would include new filtration systems for our Engine OEMs or gas turbines, et cetera, what we've seen is that customers might not be changing the amount that they're ordering per month, but they are not ordering out as many months as they were six or eight months ago.

So, they're not placing forward orders like they were even though they might be ordering the same amount per month.

So, visibility is a little bit less.

And so we respond to that situation by making sure that we're trying to stay in contact with our customers and getting also the qualitative assessment of what they think they see in terms of their business.

From our investment perspective, since we're mostly an organic growth Company, we spend a lot on capital investments in terms of supporting our organic growth opportunities.

We tend to look at those in terms of multi-year plans and a lot of them are projects that take maybe 1.5 years to complete.

So, you can't wait until you need the capacity to start it.

You have to have the capacity coming online when the need is growing.

So, we take a look at it that way, but we do have the ability and have done in the past, as you know, to slowdown capital projects if business conditions slowdown, like we did in 2009.

So, we can adjust that dial, but we also want to make sure that we've got the capacity in place, especially in emerging economies when we need it, because if we don't have it then we are going to miss the opportunity.

Fair enough.

Thank you very much.

Jim, do you want to add anything?

No, I think you hit it.

I think the only other thing I would add is on some of our larger capital projects, we do have monthly or more frequent meetings where we review the status of those and we do have the ability to put the brakes on depending on what we're seeing.

So, we do have flexibility, but as Bill said, these are investments we need to make for the long-term, but we can manage the timing a little bit.

I think Rich has got the number on the share count.

Yes, referring back to Charley's question, we ended the year with fully diluted share count at 151.4 million.

So a little bit less than average quarter.

Eli Lustgarten with Longbow Capital.

I hate to pursue, but maybe give us some more color on the first half/second half split in both segments.

We talked about Engine and most of us have a lot of fear because of the 15%, 20% production cut in truck taking place now.

It's a lot more -- ACT seems to be lagging in they're bringing the numbers down.

Ag because of the drought we're hearing some deferrals.

Are you seeing any some deferrals or stretch out of production.

Deere just did it arbitrarily by missing by $700 million.

And in construction they seem to have been stuffing the channels a bit in the rental channels where over half the sales.

There's a lot of fear of some real change in the OEM side of it.

And alternatively, with such a big gain in gas turbines, can you give us some idea of what (inaudible) would have that business would look like as we look out?

Eli, this is Jim.

I think Bill sort of hit on the Engine side of it and even though we do see some organic growth opportunities, that plan is modeled more back end heavy.

However, on the Industrial side, with some of the gas turbine and other projects, we have fairly good visibility to those.

It's always a matter of because they are larger projects they could slip from one quarter to the next, sometimes outside of our control.

But the Industrial business is a little more even to maybe weighted slightly higher to the first three quarters versus the fourth quarter.

So, Industrial is a more ratable plan, even taking into account the headwinds in the first quarter with FX.

And you expect that to be enough to give you positive comparisons in the first half of the year?

Yes.

At this point.

And when you look at the income statements, the corporate unallocated sort of disappeared again, $700,000, as opposed to a more normal run rate.

Can you give us some idea of what's going on there and what should we model for 2013 in corporate unallocated, particularly with the pension and SAP system going in?

Yes, as we talked about before, that one is a little difficult for us to predict going forward, but it -- to put a little color around it.

The ERP and the pension really shouldn't affect that number, because those do get built into our business plans, both for Engine and Industrial.

But a couple things that impact that as you look at the year over year comparison.

One is for the year we did have a little bit of favorable FX and also some of our interest expense comparisons were favorable.

The other thing which makes that number, what I said, a little harder to predict, is some of our inner Company eliminations when we're selling amongst ourselves.

Typically when we're in higher growth modes like we were last year where we were high growth building a little bit of inventory, you'll see that number grow or you'll see a bigger number there than this year where we have been a little more stable.

So, I think if I were modeling it, again it's hard to predict, but I would say something around like we see this quarter is probably a little more normal than what you saw last year.

So, between $0.5 million and $1 million a quarter is what we're talking about?

Yes, but again it can fluctuate with things outside our control.

I understand.

And you just touched on another point.

Your inventory seems to have come down, corporate wise of course, have you been -- with kind of growth have you been sort of balancing, bringing inventory down across the system in anticipation of a slower period in the next six months?

I wouldn't say it's that.

I think we have a lot of initiatives to improve.

We've talked before about a project we kicked off a couple years ago to really improve our distribution and having the right inventory in the right places.

So, a lot of its been just focused on our distribution.

Also in fairness, part of that is FX.

So, about $20 million impact is FX.

So, it would be up on a dollar to dollar comparison.

So, that is playing into it a little bit as well.

You had not seen any change in ag production schedules to you guys at this point or construction at all in the second half of the year?

Eli, this is Bill.

No, we have not seen any meaningful changes.

Thank you very much.

Brian Drab with William Blair.

Good morning, congratulations on a great fiscal year.

Solid end of the year.

Thanks, Brian.

First question, just on PowerCore.

Can you give us an idea of how PowerCore breaks down between first fit and aftermarket in the Engine business?

Yes, Brian.

Rich is looking it up right now.

So, Brian, in our latest quarter, it's still working out to be about one-third first fit, two-thirds replacement.

In the quarter, the majority of the growth was in the aftermarket, as our aftermarket sales were up 35% in the quarter in PowerCore.

So, at this point would you say that it's safe to say that you're starting and you are clearly, I think, starting to see the benefits of PowerCore driving share gains in the aftermarket and that's become a factor that's adding at least a few points to your growth in the aftermarket.

Is that your perception?

Brian, that's a fair assessment.

That really supports what we were talking about earlier in the call about the question around the 2% to 4% market share growth.

This is -- PowerCore does that for us in the aftermarket.

Sorry, Bill, did I cut you off?

I was just saying -- and it is doing it based on the percentages that Rich mentioned in terms of the growth.

What would you say is the more significant factor in driving growth in the aftermarket.

Is it adding the 126 distributors or is it PowerCore and other proprietary technology?

Brian, Bill again.

We haven't quantified the individual pieces for the quarter.

I would say over the long-term it's going to be the PowerCore.

In the short-term I think we pick up a lot from adding distribution as you start to switch distributors over to Donaldson or by adding part numbers, because you'll probably get -- that ramps up quicker than the PowerCore in the short-term, but longer term PowerCore will be -- is transformational for us.

And then at the September 2010 Analyst day and since then you've talked about a modest change in your capital allocation plan in terms of share repurchases going to 2% repurchase as opposed to the historical 3%, but in this fiscal year it was 3%.

Can you talk a little bit about why that was in this last fiscal year and what we should expect there in the next fiscal year?

Sure, Brian, it's Bill again.

I think when we talked about it two years ago and as we modeled it out as part of our updated strategic plan, part of our assumption would be we would be getting slightly more of our growth through selected sort of bolt-on acquisitions.

And we're always looking.

We have an active process and team doing that, but we haven't made any acquisitions in the last couple years.

We haven't found either targets that fit and/or at prices that we were willing to pay.

And so, then it was well what do we do with the cash that we're generating and how do we return value to shareholders?

So, we stepped up the share repurchase this year based on that.

I think the model that we talked about two years ago, about targeting 2% is probably going to be more like our long-term average, but it is dependent on whether we're doing acquisitions or not.

Brian, it's Jim, too.

I think the other thing I would add is that number is more of a longer term view and we were a little bit opportunistic here this quarter.

Got it.

Okay, thank you.

Thanks, Brian.

Laurence Alexander with Jefferies & Company.

Two quick questions.

One, can you give a little bit more color on how you're thinking about cost pressures, raw material inflation in 2013, but also your commentary about special application products.

Can you tease out a little bit where you're seeing the growth in particular in disk drive filtration and what is driving your optimism there?

Sure.

This is Jim.

I'll start with the commodity piece of your question.

What we're seeing for the most part on our significant commodities, which would be steel and media, which is a paper-based product, is generally in the United States we're seeing it be relatively flat with not a lot of pressure one way or another.

Some of the petroleum based products we're seeing a little more pressure on those.

But where we are seeing some pressures is overseas, especially in Europe, where most of those commodities trade based on dollar.

So, they're seeing pressures in their local currency, which does give us some margin pressures, as well as any products they would source from the US, including some of our product that is sourced inner Company to Europe.

So, while we're not seeing a lot of commodity pressures in the United States, we are seeing some based on the dollar fluctuation overseas.

Laurence, Bill here on the special applications.

I'll talk specifically about disk drive, because I think that's probably an easy story to tell.

Part of it is really if you think back to last fall with the floods in Thailand and how that disrupted the entire disk drive chain for our customers and for other suppliers.

What we've seen in the last, since really the first quarter of this calendar year, is a continued recovery back to more normal levels in that market.

So, in the second calendar quarter there were 157 million drives that were shipped.

That was up 30% over the fourth quarter of last calendar year.

And we see that 156 million, 157 million drive rate continuing through the current quarter.

So, part of the rebound that we're seeing or our sales forecast is predicated on the recovery from the Thai floods last year.

Thank you.

Brian Sponheimer with Gabelli & Company.

Great job in the quarter, particularly on the Industrial side from an operating profit standpoint.

We just wanted to dig a little bit deeper into the Engine side.

There was about a $5 million decline in EBIT versus or on flat sales.

If you just dig into the puts and takes of what you saw there, just a little bit more than what we heard before, please?

Sure.

This is Jim.

I think a couple of the drivers there were some of the margin items I mentioned in my prepared comments.

So, within the Engine group, we did see more of a mix shift in terms of the sales mix was higher towards first fit versus aftermarket.

We also did over the last couple of quarters see more softness in some of our business in Asia Pacific and that really affected -- it was driven by China, but it was really impacting Korea, as well as Japan and we did have a little less absorption of some of our fixed costs in the engine plants as a result of that.

So, those are probably the two main drivers in terms of the profitability shift a little bit on the Engine side.

It would also be -- Brian this is Rich -- it would also be the start up of our plant in Aguascalientes, Mexico which is primarily supporting our engine business in Mexico and central and South America.

And that was planned, but it doesn't --.

Could you guys quantify that start up cost?

It was -- in terms of transfers of product, that was about $1 million and then just the plants not being at full capacity yet is probably another $2 million.

So, probably 50 basis points year over year.

I guess just staying with this, if we're thinking about the first half of the year and the mix shift, you did a good job breaking this down.

We're likely to see some fairly similar environment for you to be selling into for the next three to six months as it relates to the mix shift; correct?

Yes, I think that's fair.

As Bill mentioned, it's probably one of our more difficult times right now in terms of visibility looking forward, but to the extent it's status quo in Europe and Asia, specifically China, I think that's a fair assessment.

Okay, great.

Thank you very much.

Good quarter.

Thanks, Brian.

Richard Eastman with Robert W. Baird.

Nice quarter, nice finish to the year.

Thank you.

Bill, could you just talk a minute about the puts and takes on gross margin going forward into '13.

Obviously, there will be more -- first fit truck business will fade, so that would be a positive, but gas turbine picks up, that's a negative, FX is a negative.

Would you expect maybe fiscal '13's gross margin to come in about flat with '12 or will there be a little bit of pressure there?

This is Jim.

I can start on that one.

I think we probably will see a little more pressure on the gross margin line year over year, similar to what we saw here in this fourth quarter.

And it will be the things you talked about.

As we have a higher project base, some of the absorption, some of the headwinds with regards to currency and what that does to our margins on the foreign source goods or the goods sourced outside the Euro zone.

So, I think it's fair to say that we will see a little bit of pressure year over year on margins, but our guidance anticipates working the operating expenses and holding those and managing those carefully, so that we can produce the operating margin guidance that we've laid out.

So clearly the volume line here and the absorption at the operating expense line pretty key to the quarter in terms of where you come out in the range here, very volume driven year.

Yes.

Volume holds the key.

And then, Bill, in IFS you'd mentioned some, a comment around the replacement business being kind of accelerating beyond the new equipment business maybe slowing a bit.

Can you just remind us in IFS maybe what percentage of sales is replacement?

Sure, Rick.

And Rich is looking that up.

The one thing I wanted just to add to Jim's comments on the margin is that we have our continuous improvement initiatives, which are ongoing, and we have ramped those up or have continued to maintain a strong focus on those to offset any possible cost increases and also the mix and currency impacts that Jim mentioned.

I just wanted to highlight that.

Sometimes we don't talk about that because it's part of the normal course of business, but it's a really big deal for us in terms of protecting the gross margin.

Hi, Rick, this is Rich.

Within IFS about 60% of our sales would be first fit or new systems, 40% would be replacement filters.

We have seen that trend up over time.

We go back a couple of years ago, we were maybe at about 35% replacement.

So, we picked up about 5 points.

And then just one last question and just kind of big picture.

If I look at the local currency kind of core growth rate assumption, so adding currency back in, we're looking at maybe an 8% to 12% growth rate the next 12 months.

And if I just think about that geographically, it's a little tougher than by product line.

So, are we kind of thinking that between the Americas, Europe and Asia is the growth leader here -- is it the Americas or is it kind of gas turbine business in Asia.

So, is Asia or how do we just portion that growth rate by the three geographies?

Rick, it's Bill here.

So, in terms of what we see as the strongest region probably would be the Americas, so, North America and Latin America.

So, that's been sort of the Engine, so far we see that continuing.

So, that would be a positive tailwind for really all of our businesses that are selling there.

And then gas turbine is really a global market.

So, the turbines are going -- the order might be placed in Europe, it might be built in China and it might be shipped to the Middle East.

But, that one gas turbine is in a strong cycle up into fiscal '13, as it was in fiscal '12.

So, the sales there it could show up in Europe, gas turbine sale, but it could be going somewhere else, but the sales will be recorded where the customer places the order.

So, between Europe and Asia though, we obviously are showing at least mid single digit growth in each of those regions?

Yes.

I am trying to figure it out with the gas turbine, but --.

I understand.

I think the way we're looking at it sort of by region, Rick, I mentioned our view on the Americas, we do see Asia recovering.

China, that the conditions will continue to recover, maybe slowly, I think I said in my comments, first ever fiscal year.

That's going to help our business in China and in Japan and in South Korea, because a lot of our equipment customers are there.

So, through fiscal '13 we see conditions continuing to get better in Asia generally.

In Europe we see some moderation, so not quite as strong as we saw in fiscal '12.

But, not a train wreck either.

And then just lastly, real simple question.

In terms of your EPS guidance for fiscal '13, is the share base assumption around like 148 million?

Is it basically assuming 2% of the shares outstanding brought back?

Yes, the guidance assumes the more long-term view of the 2%.

Okay, great.

Thank you so much.

Thanks, Rick.

(Operator Instructions)

Gary Farber with C.L. King & Associates.

Just a couple questions.

I think you gave out a number 120 some odd distributors that you picked up?

Yes, 126.

That was in the quarter?

Yes.

How would that compare to other quarters, that consistent or different?

Was a pretty good quarter.

It was maybe just a tic higher than what we had the last quarter, but within the range of the full year.

And then just on the aftermarket.

In the press release, I don't know if you talked about this before, the 6% globally was stronger in North America.

Did you talk at all about the growth rates in the other areas, like Europe and Asia for aftermarket in the quarter?

Gary, this is Rich again.

In local currency terms, I think Bill mentioned that Europe aftermarket was up just a little over 1% and in Asia Pacific it was down almost 5%.

Right, okay.

Thanks.

At this time there are no further questions.

I would like to turn the call back over to Bill Cook for any closing comments.

Thanks, Craig.

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

I would like to especially thank my 13,600 fellow employees for their efforts and contributions in creating the record results we just delivered in fiscal '12.

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

Thank you all and have a great day.

Thank you.

Ladies and Gentlemen, that will conclude the conference for today.

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