Donaldson Company Inc (DCI) 2014 Q1 法說會逐字稿

Good day, ladies and gentlemen.

Thank you for standing by.

Welcome to the Donaldson first-quarter 2014 earnings call and webcast conference call.

(Operator Instructions)

This conference is being recorded today, November 21, 2013.

I would now like to hand the presentation over to Rich Sheffer, please go ahead, sir.

Thank you, Danielle.

Welcome, everyone, to Donaldson's fiscal 2014 first quarter earnings 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 first-quarter earnings and our updated outlook for fiscal 2014.

Next, I need to review our Safe Harbor statement with you.

Any statements on 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.

We are very pleased to report that our new fiscal year is off to a good start.

We delivered record operating results on a 2% sales increase in the quarter.

Our 15.3% operating margin was our third consecutive quarterly record and I believe is a great indicator of how well our Company is running.

In this global environment that is still challenged by many economic and political uncertainties, we are fortunate to have seen real progress from our growth strategies.

Our core growth model across all of our businesses is based on ongoing filtration and emission innovations, which provide our customers with breakthrough, first-fit systems for their equipment.

The proprietary nature of our first-fit products allows our customers, and us, to retain more of the aftermarket for replacement parts.

In addition, we have supplemented this strategy with an expansion of our overall aftermarket presence by adding new parts and distributors to grow our Aftermarket sales much faster in both developed and developing economies.

Let me next review some of the key details of our first-quarter sales.

Measured in local currency, our total sales increased 3% over last year.

Within our Engine Products' segments, our OEM businesses in the Americas decreased 9%.

However, our other major regions delivered OEM sales increases.

Our European OEM businesses were up 13% in local currency, as we benefited from the continued growth in agricultural equipment market and a pickup in heavy truck sales in advance of the upcoming Euro VI Emissions Standard implementations.

Our Asia-Pacific OEM sales increased 2% in the quarter, our On-Road sales improved in Japan and in China we have our first On-Road programs beginning to ramp up.

We continued to see improving conditions in our Engine Aftermarket where we supply replacement filters and exhaust products through both our or OEM and independent distribution channels.

Our Engine Aftermarket sales increased 9% in the quarter with strong sales in all of our major regions.

We attribute this growth to the combination of improving equipment utilization in the field, the actions of any more significant customer channel inventory reductions, and our own market growth initiatives.

Aftermarket is our earliest cycle end market, and the improvements we've seen provide some confidence that condition in our end markets have improved since the sudden contraction we experienced almost exactly a year ago.

Finishing my review of our Engine Products businesses, our Aerospace and Defense sales posted a 20% local currency sales increase, with strong program shipments for the Black Hawk helicopters during the quarter.

Now, switching to Industrial Products segment, sales decreased 4% in local currency.

This decline was attributable to a 27% decrease in our Gas Turbine shipments.

As we highlighted in our outlook in August, we expected a pause in our Gas Turbine business during the first half of fiscal 2014, as the marketplace digested the surge of large turbine projects from last year.

We are continuing to call this a pause, and I will discuss it more when we get to the discussion of our outlook.

Local currency sales increased in our other two Industrial Product business units, helping to soften the impact of the Gas Turbine shipments decreased.

In our Industrial Filtration Solutions business, our sales increased 2% in local currency, as solid levels of manufacturing activity drove record demand for replacement filters for our Torit dust collectors and compressed air systems.

This aftermarket growth was enough to offset the continuing weak manufacturing capital spending levels, which has reduced the demand for our new dust collectors.

Finally, and our Special Applications business, our sales increased 5% on continued growth of our integrated venting products, an increase in disk drive filters sales and an upturn in our semicon and imaging business.

In summary, we believe this quarter demonstrated the value of our time-tested business model of having a diversified portfolio of global filtration businesses.

Our diversified portfolio provides exposure to many different end markets and regions that are typically cycling up and down at different times.

As you may recall during lat year's sudden OEM and industrial contractions, the downturn was softened for us by our late-cycle gas turbine business in some of our emerging regions.

Now, we are seeing incremental improvement in our replacement filter sales across our engine and industrial markets.

At the same time, we are seeing stabilization in a number of our first-fit end markets.

In addition, we are again seeing solid growth in some of our key emerging regions.

For example, in the quarter, Latin America and India were up 10% and 8% respectively.

All of these combined to offset this quarter's decline in our Gas Turbine shipments.

This is how we expect the model to work - enough of our businesses and regions are either stable or growing to offset other businesses or regions that are in different parts of their cycles.

I will now turn the call over to Jim for his comments on our operational metrics before I discuss our updated outlook.

Jim?

Thanks, Bill.

Good morning, everyone.

Our gross margin for the quarter was 35.8%, an increase of 210 basis points from the 33.7% we reported in last year's first quarter.

As we noted in our press release, one of the drivers of this gross margin increase was favorable product mix, due to an uptick in the percentage of our sales coming from replacement filters.

Replacement filter sales were 54% in the current quarter, compared to 51% last year.

In many of our end markets, the utilization of the existing equipment in the field is good, which helps our replacement filter sales.

Our product mix was also favorably impacted by the decrease in large Gas Turbine shipments in the quarter, which were a margin headwind in fiscal 2013.

Overall, mix had a positive 60 basis point impact on gross margin.

In addition, our ongoing Continuous Improvement initiatives also benefited our gross margin by approximately 90 basis points compared to last year.

Last year we took many cost containment actions to aggressively control our manufacturing costs.

This work we did to align our cost structure with our current level of sales is continuing to payoff.

As a result, we saw fixed cost absorption deliver approximately 7 basis points of benefit compared to the first quarter of last year.

We are continuing to make incremental adjustments to our cost structure in certain regions and incurred $600,000 of restructuring costs in gross margin in support of these efforts.

Our operating expenses declined by $2 million compared to last year's first quarter.

As a percentage of sales, operating expenses decreased 70 basis points.

The impact from our ongoing expense control initiatives, slightly lower pension expense, and leveraging our fixed cost base reduced our operating expenses as a percentage of sales by 130 basis points.

These items more than offset the increases resulting from higher incentive compensation expense, the incremental expenses related to our Strategic Business Systems project, higher US medical insurance expenses, and $200,000 of restructuring expenses in operating expense.

As result of our strong gross margin and expense controls, our operating margin was a first quarter record, 15.3%.

This is up 280 basis points from last year's first quarter.

Looking forward, we expect our full-year fiscal 2014 operating margin to be between 14.2% and 15%.

We began accruing incentive compensation at normal levels again at the beginning of fiscal-year 2014, and our investment spending on our Strategic Business Systems project will start increasing in the second quarter, as we start bringing our first three facilities live on the new system.

As a reminder, as you update your models, our second-quarter operating margin is normally our lowest of the year due to seasonal holidays causing the fewest shipping days of any quarter for us.

In addition, we have almost half of our annual stock option expense occur in our second quarter, so about $4 million.

We are also planning to increase our operating expense investments in the second quarter to pursue organic growth opportunities.

Finally, the first [go-lives] on our Strategic Business Systems project will increase our operating expense in our second quarter compared to the first quarter by approximately $2 million.

In total, we are anticipating our second-quarter operating margin to be between 12% and 12.5%.

We do expect our operating margin to be more in line with our first quarter run rate beginning again in our third quarter.

Again, we expect our full-year operating margin to be between 14.2% and 15%.

We did have one other restructuring item on the P&L in the quarter, and that's for the sale of our Ultratroc dryer business in Flensburg, Germany.

We recorded a $900,000 loss, which is recorded in other income this quarter.

Our effective tax rate was 32.2% in the quarter versus 29.4% last year.

The increase was mainly attributable to $2.1 million of tax expense related to an inter-company dividend.

Based on our projected mix of earnings in fiscal-year 2014, we forecast our full-year tax rate to be between 29% and 31%.

We are no longer anticipating the renewal of the US research and experimentation credit prior to the end of our fiscal year, which is the reason we increased the bottom our of our full-year range from 28%.

Our first-quarter capital expenditure was $21 million.

Looking at our fiscal year 2014 forecast, we continue to expect to spend approximately $90 million on CapEx for the full year.

The breakdown of the $90 million spend is projected to be approximately -- 20% related to capacity expansion; 30% for our technology initiatives, which includes our Strategic Business Systems project and our R&D lab expansion project; another 30% is 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 $65 million and $70 million in fiscal 2014.

Free cash flow was a record $78 million this quarter.

For fiscal 2014, we expect full-year cash flow from operating activities to be $320 million to $350 million.

With our forecast $90 million of CapEx, we expect to generate $230 million to $260 million of free cash flow this year.

Regarding capital deployment, we repurchased 339,000 shares in the first quarter for $12 million.

As previously announced in May, we increased our dividend payout policy from paying 25% to 30% of the prior 3 years average EPS to paying 30% to 40% of the prior 3 years average EPS, which resulted in a 30% increase in our dividend declaration in May.

Looking to capital deployment for fiscal 2014, we plan to maintain our new dividend payout policy and repurchase between 2% and 4% of our outstanding shares.

We expect interest expense in fiscal 2014 to be between $8 million and $10 million and our balance sheet remains very strong with $383 million of cash in short-term investments.

We did use some of that cash last week to retire an $80 million senior secured note that matured.

With that, I will pass it back to Bill who will provide additional details on our updated outlook for fiscal 2014.

Bill?

Thanks, Jim.

Looking forward, as we mentioned earlier, we believe that many of our end markets have either stabilized, or in the case of our Aftermarket sales, have begun to grow again.

We are forecasting that growth will continue to pick up during the second half of our fiscal year.

In aggregate, and while we've made some minor tweaks, our current full-year sales outlook is very similar to what we provided in August.

Our outlook for fiscal 2014 is for a sales increase of 1% to 5%, which would result in sales of between $2.45 billion and $2.55 billion.

As Jim discussed, based on a first-quarter operating performance and forecast for the balance of the year, we have adjusted our operating margin range so that the midpoint of our new range is 10 basis points higher than our original outlook.

On the other hand, we now believe our full-year effective tax rate will be slightly higher than in our original outlook, as we do not now anticipate a renewal of the US R&D tax credit before the end of our fiscal year.

The net of all of these factors is that our EPS range remains the same, at between $1.65 to $1.85, the midpoint of which would represent a new record and a 6% increase over last year.

Now, I'd like to briefly discuss some of our growth initiatives.

As we've discussed in previous calls, we continue to have significant growth opportunities in emerging economies where our current product presence is generally lower.

We are continuing to add sales resources, parts to our product lines, distribution capabilities and new distributors and OEM customers in these regions.

For example, in our Engine Aftermarket, we added 89 new distributors and over 800 new part numbers in our first quarter.

Another of our key growth initiatives is the utilization of our innovative technologies to help better solve our customers' filtration issues, while protecting the aftermarket or replacement filter business over time.

One of our most successful proprietary technologies is PowerCore.

It is a great example of how we invest centrally into R&D and then leverage our technologies into as many applications and businesses as possible.

We are now very successfully using the newest generations of PowerCore in both our Engine and Industrial segments.

Our Engine PowerCore sales in the first quarter were $34 million, up 14% over last year.

Within that, sales of PowerCore replacement filters are up 21%.

We have a number of new PowerCore programs going to production over the next 12 to 24 months.

These are the result of the new diesel emission regulations in North America and Europe that are going into effect and causing our engine OEM customers to launch new product platforms to meet these stricter requirements.

As these programs launch, we expect the demand for our replacement filters for these new programs to begin ramping up.

We are currently working with the same OEM customers on their next generation of new equipment platforms that they plan to launch later this decade.

On the Industrial side of our business, we sold over 400 Torit PowerCore dust collection systems in the quarter, which represented a 16% increase over last year.

In addition, or sales of Torit PowerCore replacement filters increased 73%.

If you put all that together, in total, our Company PowerCore sales totaled $40 million in the quarter, up 16% over last year.

We believe we are still in the early innings of rolling out our proprietary filtration technologies, such as PowerCore or our liquid media Synteq, and we remain very excited about the future of these products.

To quickly summarize, despite the continuing mixed global economic conditions, we posted a very good start to our new fiscal year, both from a sales and especially from an operating-metric perspective.

In our first quarter, we fortunately saw the combination of stabilization in some markets and growth in others that we had projected in August.

This continues to further support our outlook for the full year.

For the balance of our fiscal year, and especially the second half, we forecast a further strengthening of conditions in our Business.

Bottom line, we are forecasting a sales increase with record operating margins in fiscal 2014, which will continue our advance in pursuit of our strategic goals of growing our Company to $3 billion in sales by fiscal 2016 and $5 billion by fiscal [2021].

This concludes our prepared remarks, Danielle.

We'd now like to open the call up to questions.

(Operator Instructions)

Eli Lustgarten, Longbow Securities.

Very nice quarter.

Thanks, Eli.

One clarification.

I know Jim gave us the operating expense increases in the second quarter from stock options to $4 million and the strategic investments.

Where is all that going to be reported?

Is that going to be in the corporate expense, or -- just wondering where we should put those numbers?

Eli, this is Jim.

Basically, all of that will be in operating expense, in terms of -- maybe I'm not understanding.

Are you asking me from gross margin -- ?

Is that going to be flowing through the segments, so the segment margins will be affected --?

I'm sorry, thank you.

Yes, that will be reflected in the segments, basically in proportion to their sales.

Okay.

So, it will affect equally across the board?

Yes.

By sales difference?

As far as operations, you start talking about emerging markets.

You mentioned the China initiative are starting to ramp up some OEM stuff.

Can you give us color as to what the emerging market, size of opportunity?

What kind of magnitude can we expect out of China and some of these -- the new products that you had in India that you talked about?

Can we get some magnitude of what we can expect for 2014 and maybe 2015, as these initiatives ramp up?

Eli, this is Bill.

I think the bricks in total are about 13% of our sales today roughly.

As part of our strategic plan I'm going to go out even further than the years you mentioned, so fiscal 2021.

We are looking at Asia-Pacific in total being almost one-third of our company -- almost one-third of the $5 billion.

We're looking at similar healthy growth percentages from some of the other emerging markets like Latin America.

The emerging markets in Asia-Pacific, Latin America, are going to have disproportionately higher growth and that's part of our plan.

We've invested over the last couple of years in order to achieve that.

We haven't given specific guidance for them for fiscal 2014.

But, how big did you say they were?

The phone cut out and stuff, I didn't hear exactly.

You made a first comment about how big those businesses were at this point?

I think if you take a look at the bricks, as we define them, it's about 13% of our sales today.

Okay.

One final question.

The operating profitability in Engine was spectacular and I know they're going to be down in the second quarter.

Can you give us an idea of what's going on in the operating profitability of the Engine business across major markets?

The same thing, I guess a drop-off in Gas Turbine was probably a little bit bigger than we expected.

Is the forecast, still the same for the year, so we'll have some little better results?

Or is it just going to be weaker for the year, at the bottom end of what your original guidance was?

Eli, this is Jim.

In terms of the Engine margins, it was really the same.

We experienced the same benefit, really, across the globe.

Really, just a function of this time last year, if you remember, our volumes really dropped off pretty significantly.

We did have some unabsorption in the comparable quarter.

As we've adjusted our cost structure, really worldwide, and that affected the Engine plants maybe a little more so than the Industrial plants, we've been able to benefit both from volume and our cost reduction.

I think the other thing on the Engine side was a little bit of favorable mix towards replacement parts versus OEs.

It's not any one region of the world.

It's really all of our plants worldwide where we saw that.

In terms of Gas Turbine, maybe Bill will comment on that.

Eli, it's Bill.

Gas Turbine, our guidance for Gas Turbine is the same as what we provided at the end of August.

I think it came in about where we were expecting it for this quarter.

We continue to see that backend or second half loaded, about 60% of the sales in the second half are for Gas Turbine in the second half of our year.

As you well know, the Gas Turbine business for us, quarter to quarter, is pretty lumpy.

I would say the first quarter came in where we expected for Gas Turbine.

As I mentioned, was offset by strength that we saw in the aftermarket, some of the regions and stabilization of some of the other markets.

Thank you very much.

Charley Brady, BMO Capital Markets.

Talking about destocking and one of your major customers that paints their stuff yellow had orders out.

They were a bit soft.

They're still talking about dome destocking in some of their areas, which steps off Latin America.

Sounds like that's not really having much of an impact on Donaldson.

I'm just trying, can you try and square that up for us as why you are not seeing that impact?

This is Bill.

I will start with that.

A lot of our business is replacement parts and we think that's behind us.

I think what we read about with the destocking with that yellow customer you mentioned is related to some pockets of finished equipment that they have and that they've been working off.

So, there's still a little bit of an impact for us, in terms of ramping back up, say, in China where there's excess finished good inventory.

We think the destocking is done in terms of replacement filters.

Okay.

That's helpful.

Thanks.

Just one more.

Can you talk about in terms of restructuring activity?

You have outlaid some stuff for the rest of this year.

Outside of just normalized ongoing stuff, do you see any other larger projects moving beyond fiscal 2014?

Or does it pretty much tie everything up, what you need to get done?

Bill, again.

We did a lot in the recession in terms of restructuring the Business, and I think what we're doing, these are minor projects and we do not see anything significant going forward.

Maybe some more of these smaller activities, but not anything major.

Great.

Thanks a lot, guys.

Kevin Maczka, BB&T Capital Markets.

I think your Q2 EBIT margin guidance is pretty clear.

I think we understand some of the headwinds that you've laid out there in terms of the business systems and stock options.

I'm wondering if you could say a little bit more about the second half?

I think, usually, those margins are a bit higher than you experienced in Q1 and you've got the favorable mix, which seems like it would continue, as far as Gas Turbine and aftermarket.

Can you just comment on the back-half expectation a little bit more?

This is Jim, Kevin.

I think, we definitely do see that uptick from second quarter to third and fourth quarter.

It obviously depends on the volumes we'll see.

We are anticipating ramp up in the volume third into our fourth quarter.

The other thing is some of that sales volume is coming from GTS.

Those generally, as they're primarily first-fit projects, carry a lower margin.

The other thing is some of these investments that we've talked about, the Strategic Business System.

Our incentive compensation being restored will have an impact, maybe a little bit more than other years, just given the year-over-year impact of that.

So, we see the third and fourth quarter really being comparable to the first quarter, maybe the third quarter being a little bit more challenged than the fourth.

Okay.

Got it.

How does that business systems spending flow through the year?

I think you said $2 million in Q2 and it was a smaller number in Q1?

Yes.

The Q2 number is going to be about $2 million higher than Q1, in the $3 million range.

That will be a similar number into the remaining quarters.

Okay.

Finally, in terms of the P&L, the top- and bottom-line guidance isn't much changed, but the cash flow guidance is.

Can you just comment on what is driving that improvement?

Yes.

We've had -- some of it is mix as we are seeing better aftermarket.

That generally helps our receivable balance a little bit.

Then, a lot of it has just been -- we've had a lot of success, in terms of inventory management.

Our inventories have remained relatively stable, in spite of sales coming up.

As we've worked through the first quarter and updated our models based on what we've seen, we've just been able to have better outcomes in terms of working capital management.

Okay.

Thank you.

I will get back in line.

Laurence Alexander, Jefferies.

This is George D'Angelo on for Lauren.

As you look at your share gains in the Engine applications, is there any geographic skew?

That is would the growth rate in the next few years be sensitive to a particular geography because the launches are maybe tilted there?

Thanks.

George, it's Bill.

I think that over our strategic planning period and tying it back to the question that Eli answered.

We see significantly higher growth percentage wise in the emerging markets, so and say in most of Asia, outside of Japan and Latin America.

The higher growth percentages from these new launches will be, from a percentage basis and dollars, will be in the emerging markets.

Okay.

Thanks, guys.

Brian Drab, William Blair.

These guys are taking most of my questions.

(laughter) Congratulations.

Sorry, Brian.

I'm sure you've got a good one left for us.

I'm going to make up a couple.

Congratulations on a record first quarter.

Thank you.

Could you give us a little more granularity on China in terms of, specifically in China, the OEM sales and what you're seeing in the aftermarket?

You mentioned that you feel like you've worked past the inventory issue.

Maybe start with what percent of your sales were in China in the quarter?

The percentage of our sales in China in the quarter, we're just looking it up.

We were roughly in the neighborhood of about $50 million of sales in the quarter in China.

Okay.

A little bit less than 10%.

Brian, we had some of the impact of Gas Turbine was in China.

They had a strong shipments last year and not this year, looking at the quarter year over year.

If you take a look at our Engine business was solidly up in the double digits in local currency, over 20%.

I think maybe tying that back to the question that we answered earlier about in terms of the impacts of inventory may be still stuck.

Maybe last year was really bad, we had an easy comp.

But, we're certainly seeing the percentages of our Business recover, our growth percentages, well in China.

Okay.

How did the sales roughly break down now by end market in China?

Gas turbine versus Engine versus other?

I think in the quarter, I'm just looking, Brian.

It's probably about two-thirds Industrial and one-third Engine right now.

Okay.

That's great.

On Aerospace and Defense, with such a strong result here in the first quarter, and I'm not sure if you commented this specifically in your prepared remarks.

The balance of the year, is this going to be the strongest growth that we see for the Aerospace and Defense segment for the year?

Brian, Bill, again.

I think from -- some of the Aerospace, especially the Defense business, is sort of lumpy with these government programs.

As I mentioned in our prepared remarks we had a lot of Black Hawk shipments in the first quarter and that is essentially done for the rest of the year.

It will be not as strong for the balance of the year and that's why our guidance for the full year sounds a little bit different than what we did in the first quarter.

That one program really helped us in the first quarter.

Okay.

Thanks a lot.

Brian Sponheimer, Gabelli & Company.

I'm sorry, just a kind of a historical question.

Last year you had a big quarter from an other income perspective.

What was the number there that drove that $5.8 million?

Brian, Rich and Jim are looking up something.

One second.

Do you have another question for me while they're looking it up?

Balance sheet is in great shape.

You have $180 million in net cash.

You spoken about opportunities from an acquisition standpoint, and clearly are looking to deploy that cash over the next few years.

Take a couple of minutes to talk about the acquisition pipeline that you are seeing.

What's preventing you from maybe pulling the trigger on something sizable at this point?

Brian, Bill.

Most of our growth objectives are based around organic growth, and a lot of the things that Jim and I talked about in terms of investment, in terms of CapEx and operating expense investments are really to support that organic growth.

We are and will remain mostly an organic growth story, because we see the opportunities to do that.

We still believe or target about 2% of our annual revenue growth should be from acquisition.

At our current size that would be about a $50 million in sales a year, if we hit that average each year.

Not huge, although as you pointed out, we certainly have the capacity to do larger ones.

We are not restricted to doing only $50 million, but that's sort of our sweet spot.

We have a team that is focused on looking for acquisitions, trying to cultivate the relationships.

We haven't been successful, primarily because of the pricing in the market.

With our return expectations, we get priced out.

We are patient.

We are fortunate that most of our growth is based on organic, but we are continuing to work it very hard.

Over time, I'm hoping that we can do more, but we are going to continue to focus mostly on organic at the same time.

In the absence of that, your free cash flow is outstanding.

You are doing a tremendous job from an operating perspective.

While you've called out that you are increasing how you look at share repurchase, we've been seeing a lot of companies that -- Johnson Controls just entered into an ASR this morning.

Would you ever consider something that's a little bit out of, I guess, the character of the Company, to return cash to shareholders?

Well, I would say we'd always be open to other ideas.

I think at some point -- I guess we are blessed to be able to build up the strength in our balance sheet and if at some point we can't figure out ways to deploy as much of it as we think we should, than we are open to other ideas.

Jim has something he wants to add, as well.

Brian, this is Jim.

I think one of the other things with our balance sheet, is the majority -- actually, now after this quarter, all of that cash is overseas.

As we execute on the dividend we talked about and the share repurchase, just by doing the share repurchase at the 4% or so this year, that will add about $125 million to $150 million of new debt to the balance sheet this year.

So, we will start to leverage up fairly quickly, just executing the strategies we talked about.

We're also open to looking at other things.

Thanks, Jim.

I can touch base with Rich off-line about that $5.8 million number.

Actually I have the other one here.

As we look at other income, it's actually more driven by this year being a little bit lower than last year.

So, in that number this year is about $1 million on the loss of the operations in Germany that I mentioned.

We also have a little bit of variance in terms of interest income year over year.

Then, we did make a small donation to our foundation this year.

That lowered this year's number.

The one thing in last year, that raised that little bit is we did have a small insurance recovery in there last year.

Those couple things combined to reconcile the year over year.

All right.

That's helpful.

I was going to give you credit for having an even higher-quality quarter than it looks.

(laughter) Thanks, guys.

Richard Eastman, Robert W. Baird.

Bill, could you just in the Industrial business, the IFS business had the 2% consolidated growth.

Again, I think the guides still were stuck at 5% to 11% for the year.

Is there any order growth or backlog at this point in the fiscal year to support that acceleration?

Rick, Bill.

The backlog in that business doesn't go out that far.

We are looking at the next quarter, the second quarter.

As you point out, we are forecasting a recovery, and this is mostly on the new equipment side in the second half of the year.

At this point, it's based on the forecasts and the quoting activity for our salespeople.

I would say most of that is not yet in the backlog, but it will hopefully be in their over the next 3 months.

Okay.

At least you could point to an uptick in the quote activity?

That, and I'd go back to what we said about the aftermarket.

In that business, that's usually the leading indicator.

We are knocking it out of the park, in terms of aftermarket or replacement filter sales, which is indicative of not only our own growth initiatives but it's also a function of how the equipment is being used in the field.

Typically, customers, a plant manager will use the equipment he has as fully as possible before he invests.

The fact that equipment is running a lot means that the investment should follow.

Was the Equipment sales, was that a negative number year over year?

It was, yes.

Can you just give us a sense of mix replacement filters in IFS, maybe 30%?

I think it's about 40%, roughly, Rick.

40%?

Okay.

Then, just a quick question.

Again, just fantastic number on the aftermarket business in Engine, especially in the Americas on the 12%.

It just strikes me that the 12% growth in the Americas Engine aftermarket, it was against a decent comparison.

I think was up 3% or 4% last year.

Is there any color -- is there any price in that?

Can you give us any additional color?

Was the independent channel up bigger than the captive channel?

In terms of price, Rick, really nothing there.

So, it's real business.

Okay.

Yes.

The one thing, Rick, that we've talked about for a long time is PowerCore and other breakthrough technologies.

We are seeing the replacement parts grow in the 20% range year over year.

That's an element, as well.

That retention, increasing our ability to retain that through our OEMs and in the independent channel, over time, that's where we are getting traction.

There's no price -- I don't want to cut this too thin, but is there any price on a PowerCore replacement versus, obviously, you would have had a previous element?

Is PowerCore aftermarket price point higher than the product that it would have replaced?

Rick, it's Bill again.

It might be a little bit.

A lot of that pricing is done by our OEM customers, as to terms of how they price it in the channel.

What we're trying to do, generally, with both the first-fit and aftermarket, is it's about increasing penetration, not by trying to increase the margin.

We've talked about that before.

It's about trying to get as many of those systems out in the field, so then we can harvest the aftermarket annuity.

Okay.

At least, would you guys take some credit for taking some market share, not just in the 12% in the Americas, but also in Asia on the 11% aftermarket?

Would you be willing to say, hey, we are taking share there?

I would.

(laughter)

Okay.

Just one last thing, aftermarket --

Jim's nodding his head, too, so we're good.

You are in agreement.

Just in the Americas on the aftermarket side, can you just give any color around the captive versus independent channel?

Yes, we had stronger growth in the OED channel, Rick, this quarter.

That's really a derivative of our proprietary first-fit strategy.

Okay.

That makes sense.

That's where you would see the PowerCore replacement sales accelerate the fastest, right?

Exactly.

Right.

Great.

That's all I had.

Thank you and thanks for the commentary.

Bill, one more question, sorry.

Sure.

With the commentary you gave around Engine, there is still the assumption that the ag market is stable.

Yesterday, Deere through some commentary out just around first part of -- well, really, calendar 2014 for them.

They pretty much had all their categories with a negative number in front of them, somewhere between 5% and 10%.

Is that outlook pretty dynamic?

Are you watching that relative to your own guidance in ag?

Yes, we are, Rick.

We followed the Deere announcement very closely.

We still felt comfortable with the outlook based on the mix of how much it's first-fit versus replacement parts.

I think, as you might recall, a couple quarters ago or last year, we were talking about some new emission platforms that we launched that were in the ag segment.

We've got some other things that are in there that help us feel good about our outlook.

Okay.

Great.

Thanks again.

Really, nice quarter.

Thank you.

Thank you.

Anna Kaminskaya, Bank of Merrill Lynch.

It's actually Andrew Obin.

I don't want to beat this thing to death, but just on the inventory level.

Do you guys have a sense of days inventory in your distributor channel?

How do those compare to where they were maybe a year ago?

I guess what I'm trying to figure out, you guys highlighted that the destocking in the channel was coming to an end.

It just seems, looking at your numbers, looking at Parker's, Eaton's, ABB's numbers, that this might actually have happened?

Can you give us a comment on that?

How long do think the tailwind from the end of destocking will last, in terms of how much of a benefit we're going to see and for how long?

Andrew, Bill.

I will start.

We are talking about replacement filter inventory.

Yes.

That's right.

Okay.

There might be some equipment inventory, and you know this better than me.

Yes, that's separate.

That's right.

I would say, our feeling is that the independent channel, the independent distributors, work through their inventory issues faster and more aggressively than the OEDs.

It's more of a cash flow business and they want to manage that -- or a working capital business and they want manage that very closely.

They tend to react the fastest and work through it the soonest.

I think the OEM parts and service, I think the tail on that working through it was longer.

I think if we go back to a year ago, we probably, at that point, thought it was going to be over sooner than it actually was.

That was also a function of how far things went down.

Our feeling is that that's behind us now from the OED.

It took longer, maybe lasted longer, but it's behind us now on the OE as well.

Now, all that is really a function of what people think are current business levels.

If things get better faster or go down again, there will be an adjustment, the better, faster, than we typically see.

Almost like a bull whip effect as people, not only as the end-market demand almost starts to go up, but then there's a restocking on top of that.

We are already starting to plan for that.

At some point, that's going to happen.

That when activity levels in the field goes up, that will also be a surge of restocking in the channel.

I know, Bill, that there's only so much you can tell us.

What are the big off-highway OEMs telling you about next year, specifically on construction?

Because, you know, Deere has come out pretty positive, but then they were positive a year ago and then it turned out they shouldn't have been that positive.

Then, you look at Cat retail sales and they're not particularly good.

Without naming any customers, what is the broad sense as to where North American production is going into next year?

Andrew, Bill again.

I would probably -- I'm going to say sort of a global statement.

I think what we see, if we start globally at the 40,000-foot level and I'll point to some of the customer pronouncements is that a lot of them are talking about a pretty flat calendar year 2014 versus 2013.

The mix of that, in terms of regions, could be different.

As we've seen this year.

We are not looking at a tremendous surge in their sales, but we also think that we will have less of that headwind from the finished goods equipment that clogged up the channel over the last year.

We touched on China before.

There was a significant overhang of new equipment in China, and maybe in some other parts of the world.

A lot of that has already been worked off.

Even if their production levels get back to the end-user, the actual end-user demand, that's going to be better for us, because they're not trying to work off inventory at the same time.

Right.

Thank you very much.

Always good to know that you guys execute.

There's one certain thing.

Thanks a lot.

Thanks, Andrew.

(Operator Instructions)

Gary Farber, CL King.

Just curious, we've had some good PMI data come out.

You guys had a very solid quarter and good, positive commentary.

Just to get your perspective, and have, obviously, good margin leverage, your perspective on, are we at the beginning of a cycle do you think?

If so, how do you see it?

If not, what things you'll be looking for to have more conviction about a cycle coming, just a general macroeconomic cycle?

Gary, Bill here.

Maybe tying in a couple of comments that Jim and Rich and I made before.

We are forecasting a stronger second half of our year than the first half.

Our first half, we think, is going to be okay or good, but stronger second half.

A lot of that is based on our feeling that there is going to be a general recovery.

As I mentioned to Rick's question, part of that we feel that with our aftermarket businesses, both in the Engine side and the Industrial side, strengthening.

That's a good leading indicator for us, historically, that the equipment side will follow.

How soon it follows and the angle of that slope, we don't know.

We think that's going to happen, and that's based into our guidance.

I think the PMI and other data suggests that is happening in the industrial sector, both in this country and in other major economies.

We factored all of that in.

Right.

Then, just on market share gains, are you doing anything different this year that you didn't to last year?

Changing any of your programs or anything like that?

I think it's more of the same, Gary.

We've been talking about this focus on innovative proprietary technologies on the first-fit that provide our customers with a better solution and then help them and us retain the aftermarket.

That's a journey we've been on for a number of years.

Every opportunity that we have to do that on a new platform, we are doing that.

Probably, it's been a great opportunity the last couple of years and will be for the next handful of years, given all the new platforms that are being developed, both on the on- and off-road around the different waves of emission regulation.

We see that install base with these proprietary technologies really growing very significantly over the next half a dozen years.

Right.

Okay.

Thank you.

Eli Lustgarten, Longbow Securities.

Just one question.

You referenced during the comments the emission changes.

Can you talk a little bit about, as we roll out final tier 4 beginning in 2014 here and Euro 6 or so, is there any change in content or any change in programs that you have coming over the next year or two that you can quantify for us or give us some indication of?

Eli, Bill.

On average, you would say the content per vehicle for us would probably remain the same.

We are not looking at a step function in terms of content.

We do have some emissions business on different platforms, but I wouldn't want to average that in.

A lot of what we're, on the air side, I would say the content would remain very similar.

The liquid side is probably where we get the opportunity, as they start to adopt our Synteq media technology to add more liquid filtration to those, both on- and off-road vehicles.

All right.

Thank you very much.

I am seeing no more questions in the queue.

Bill, please continue with any closing remarks.

Thanks, Danielle.

To concludes our call, first, I'd like to recognize and thank all of my fellow employees for their contributions to our wonderful first-quarter performance.

I'd like to thank everyone on the call today for your time and continued interest in our Company.

Thank you and have a great day.

Goodbye.

Ladies and gentlemen, this concludes the Donaldson first-quarter 2014 earnings conference call.

This conference will be available after 12 noon today through November 28, 2013 at midnight.

You may access the replay system at any time by dialing 1-800-406-7325 and entering the access code of 4648250.

Thank you again for your participation.

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