Donaldson Company Inc (DCI) 2014 Q2 法說會逐字稿

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

Welcome to the Donaldson second-quarter earnings conference call.

(Operator Instructions)

Following the presentation there will be a question-and-answer session.

(Operator Instructions)

As a reminder, this call is being recorded today, February 21, 2014.

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

Please go ahead, sir.

Thank you, Craig.

Welcome, everyone, to Donaldson's FY14 second-quarter earnings conference call and webcast.

Following this brief introduction, Bill Cook, our Chief Executive Officer; Tod Carpenter, our Chief Operating Officer; and Jim Shaw, our Chief Financial Officer; will review our second-quarter earnings and our updated outlook for the balance of FY14.

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.

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.

Good morning, everyone.

Before we talk through the details of our second-quarter results and our outlook, I'd like to offer some summary comments.

First, despite the ongoing uncertainty in some of our end markets and regions, we are very pleased to have delivered record earnings this quarter.

We did this, despite slightly lower sales versus last year, by focusing on our Continuous Improvement initiatives, which delivered an operating margin of 50 basis points better.

This, I believe, speaks to how well our Company is operating and especially how well it's positioned for the future.

Our sales decline year over year is a function of two factors: some foreign currency headwinds; the Japanese yen; the Aussie dollar; and the Brazilian real; but mostly due to the year-over-year decline in our gas turbine sales, which we had foreseen after last year's record second quarter.

The second point is that many of our other businesses have local currency sales increases year over year, as well as we did in many of our regions.

This speaks to the benefits of the diversification model we built into our Company over the past 20 years, which has allowed us to deliver these results.

I'd now like to turn the call over to Tod for a review of our second-quarter sales.

Thanks, Bill.

Good morning, everyone.

Our reported sales decreased 2.4% from last year's second quarter.

1.5% of this decrease came from foreign currency translation, particularly from the weakening of emerging market currencies against the US dollar.

Measured in local currency, our total sales decreased a little less than 1% from last year.

As a reminder, you can find a detailed analysis of currency translation by business unit and region on the Investor Relations home page of our website.

The rest of this review will discuss local currency results.

Within our Engine Products segment, our OEM businesses in the Americas decreased 7%, however our other major regions delivered OEM sales increases.

Our European OEM businesses were up 7% as we benefited from the continued growth in agricultural equipment market and the pickup in truck sales in advance of the upcoming Euro VI emissions standards implementations.

Our Asia-Pacific OEM sales increased 10% in the quarter.

Our off-road sales improved in Japan and in China as OEM customers have now mostly completed their inventory level adjustments.

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

Our Engine Aftermarket sales increased 11% 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 absence of any more significant customer channel inventory reductions, and our market growth initiatives.

Aftermarket is our earliest cycle end market and improvements we have seen over the last couple of quarters provide some confidence that conditions in our end markets have sustainably improved.

Finishing my review of our Engine Products business, our aerospace defense and defense sales decreased 5%, as the slowdown in defense spending for ground-based military equipment continued in the quarter.

Sales in our Industrial Products segment decreased 12%.

In our Industrial Filtration Solution business our sales increased 1%, as solid levels of manufacturing activity drove record demand for replacement filters in our Torit dust collectors and are compressed air systems.

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

In our Special Applications business, our sales increased 7% on continued growth of our integrated venting products, an increase in disk drive filters sales, and an upturn in our semicon imaging product sales.

Offsetting these increases was the anticipated decline in our Gas Turbine business, which decreased 50% from last year's record quarter.

As we highlighted in our outlook in August, we expect a short slowdown in our Gas Turbine business during the first half of FY14, as the market commissions the surge of large turbine projects from last year.

We are continuing to view this as a short slowdown.

Jim will discuss this more as he talks through our outlook.

Excluding the big decline in Gas Turbine sales, our other Engine and Industrial businesses combined for a 5% sales increase in the quarter.

This results exemplifies how our business model is designed to work.

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

During last year's sudden OEM and Industrial contractions, the downturn was softened by our late cycle Gas Turbine business in some of our emerging regions.

Now, we are seeing incremental improvement in the replacement filter sales across our Engine and Industrial end 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, Southeast Asia, India, and Latin America were up 21%, 18% and 13%, respectively, in the quarter.

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

I will now turn the call over to Jim Shaw for his comments on our operational metrics.

Jim?

Thanks, Tod.

Good morning, everyone.

Our gross margin was 34.7%, an increase of 130 basis points from the 33.4% we reported in last year's second quarter.

As we noted in our press release, one of the drivers of this gross margin improvement was a lower number of large gas turbine shipments in the quarter, which were a headwind to our gross margin in FY13.

We also benefited from a higher percentage of replacement filter sales, which were 55% in the current quarter, compared to 50% last year.

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

Overall, product mix had a positive 80 basis points impact on gross margin.

In addition, our ongoing continuous improvement initiatives benefited our gross margin by approximately 60 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 40 basis points of benefit compared to the second quarter of last year.

Offsetting this benefit was the impact on margin of the stronger dollar in some of our entities, as well as higher incentive compensation costs.

Our operating expenses increased by $2 million compared to last year's second quarter.

As a percentage of sales, operating expenses increased 90 basis points.

Higher incentive compensation expense, incremental expenses related to our Global ERP project and some reduced fixed cost leverage due to lower sales impacted operating expenses by 140 basis points.

These increases were partially offset by lower pension, insurance, and warranty expenses, which reduced our operating expenses as a percent of sales by 50 basis points.

The combination of our improved gross margin and slightly higher operating expenses resulted in a 50 basis point improvement to our operating margin, which was 12.4%.

Looking forward, we expect our full year FY14 operating margin to be between 14.2% and 14.8%.

We began accruing incentive compensation at normal levels again at the beginning of FY14.

Our investment spending on our Global ERP project began increasing in the second quarter, with four locations going live on the new system during the quarter.

We expect that both of these expenditures will continue at these higher levels for the balance of the year.

Our effective tax rate was 22.1% in the quarter, versus 28.3% last year.

The current quarter included $6.2 million in tax benefits related to the favorable settlement of a tax audit.

In our prior outlook, we had estimated a $2 million benefit, so this ended up being a $4.2 million, or $0.03 per share, higher than we had forecast.

Based on our projected global mix of earnings that FY14, and the additional benefit we received in the second quarter, we now forecast our full-year tax rate to be between 28% and 30%.

This is 1% lower than our previous outlook.

Our second quarter CapEx was $22 million.

Looking at our FY14 forecast, we continue to expect 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 Global ERP project and our R&D lab expansion project, another 30% is for tooling for new products, and 20% will be related to cost reduction activities through our Continuous Improvement initiatives.

We continue to expect depreciation and amortization will be between $65 million and $70 million in FY14.

Free cash flow was a record $30 million this quarter.

For FY14 we expect full-year cash flow from operating activities to be $280 million to $320 million.

With our forecasted $90 million of CapEx, we expect to generate $190 million to $230 million of free cash flow this year.

We repurchased 1.3 million shares in the second quarter for $54 million.

Year to date, we've repurchased 1.6 million shares, or 1.1% of our outstanding shares, for $66 million.

We plan to repurchase between 2% and 4% of our outstanding shares in FY14.

We expect interest expense in FY14 to be between $8 million and $10 million.

Our balance sheet remains very strong with $360 million of cash in short-term investments.

I'd now like to add a little more detail on our Global ERP project before I move on to the outlook.

As I mentioned earlier, we went live at four locations in the second quarter, and we also converted another six locations in early February.

These go-lives have gone very well.

Our ability to receive, process and ship orders at these locations has gone seamlessly as they transition to the new system.

We will continue to roll out the new system to our Americas locations through the fall of 2014, and then we will be shifting the implementation efforts to our Europe locations.

Now, I'd like to provide some comments on our outlook for the rest of the fiscal year.

Our first-half results have increased our confidence that many of our OEM first-fit equipment end markets have stabilized.

In the case of our Aftermarket sales, are seeing increasing demand.

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

We did make two adjustments to our outlook for Industrial product sales.

First, we reduced our outlook for Gas Turbine systems sales as several of the projects that were originally scheduled to ship before the end of FY14 have been rescheduled for shipment in early FY15.

We expect Gas Turbine sales to be sequentially higher in our third quarter and again in our fourth quarter.

In fact, we are currently expecting our fourth-quarter Gas Turbine sales to be higher than FY13.

More positively, we saw a ramp-up in Gas Turbine orders in our second quarter that are forecast for FY15 delivery.

This gives us increased confidence that the sales-growth trend will continue into FY15.

In our Industrial Frustration Solution's business, we are now expecting more modest growth this year as business investment for new dust collection systems has been slower to develop then we previously forecasted.

Despite these adjustments to our Industrial Products forecast, our full-year sales outlook for the Company as a whole is unchanged from what we provided in August.

Our full-year sales outlook for FY14 is for sales to increase 1% to 5%, which would result in sales of between $2.45 billion and $2.55 billion.

Based on our first-half performance and forecast for the balance of the year, we adjusted our operating margin range slightly, so the midpoint of our new range is 14.5%.

We also adjusted our full-year tax rate guidance lower by 1%, after a larger than anticipated second-quarter benefit.

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

So, with that, I will pass it over to Bill, who will discuss some of our growth initiatives.

Bill?

Thanks, Jim.

While some of our end markets remain challenged by the ongoing economic uncertainty, we are continuing to make the key investments in our Business and our people to grow and win.

We have a number of very focused initiatives that will help us to grow over time, regardless of the economic environment.

I'd like to highlight a few of these initiatives.

The first is with the emerging economies such as Latin America, Southeast Asia, India, China and Russia, where our current presence in these markets is generally lower than in North America or Europe.

In these emerging markets, we are continuing to add sales resources, parts to our product line, distribution capabilities, additional distributors and OEM customers.

For example, in our Engine Aftermarket, we added 83 new distributors and over 700 new part numbers in the quarter.

Another of our key growth initiatives is the utilization of our innovative technologies to help better solve our customer filtrations issues on their new equipment, while retaining the aftermarket or replacement filter business over time.

One of our most successful innovative technologies for air filtration is PowerCore.

It is a great example of how we invest centrally into R&D and then leverage our technologies into as many different applications and as many of our 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 our second quarter were $34 million, up 19% over last year.

We had good growth of both first-fit PowerCore systems and the replacement filter sales, which increased 18% and 19% respectively.

We have a number of new PowerCore programs going into production with our OEM customers, now and over the next 12 to 24 months.

As you know, successive waves of new diesel emission regulations in North America and Europe have already, and are continuing to go into effect.

Our heavy-duty equipment OEM customers are launching their new equipment platforms with the latest engine technology in order to meet these stricter requirements.

As our customers' new platforms launch, our sales of new PowerCore systems will increase.

As their new equipment gets out into the field, then the demand for replacement filters will ramp up and continue to grow year after year.

We are currently working with these same OEM customers on their next generation of new equipment platforms that will launch later this decade.

Switching to the Industrial side of our Company, we sold another 350 new Torit PowerCore dust collection systems in the quarter.

In addition, the sales of our Torit PowerCore replacement filters, for those systems already in the field, increased 28%.

In total, our Company's PowerCore sales totaled $39 million in the quarter, up 14% over last year.

Another of our strategic growth projects is expanding our liquid filtration business.

Currently, about 20% of our sales, or about $500 million on an annual basis, is in liquid filtration, but we have many opportunities to grow.

In the quarter, our liquid filtration sales increased 11%, with very strong growth in hydraulic filtration, filters which use our Synteq family of filtration medias.

Our new SELECT Fuel diesel fuel filters, which also use our Synteq media, are starting to go into production as our OEM customers begin launching their new engine and equipment platforms.

While we have made very good progress already with the introduction of our new technologies, we still believe we are in the early innings of rolling out our innovative proprietary filtration strategy.

We are very excited about the future of these products.

Now to quickly summarize, we delivered a very good first half in FY14 from an operating metric perspective, with a 13% increase in operating income and a 14% increase in net earnings and EPS, both of which are records.

In our second quarter, we saw the combination of stabilization within many of our OEM first-fit equipment end markets and increasing demand for our replacement filters across both our Engine and Industrial end markets.

For the second half of the year, we continue to forecast further gradual improvement of end-market conditions, including a gradual recovery on the global CapEx cycle.

This supports our outlook for the year.

Bottom line, as Jim mentioned, we are maintaining our forecast for a sales increase with strong operating margins in FY14, which will continue our progress towards our strategic goals of $3 billion in sales by FY16 and $5 billion by FY21.

This concludes our prepared comments, Craig.

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

Thank you very much.

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

(Operator Instructions)

Laurence Alexander, Jefferies.

I guess two questions.

First, given the volatility that's in the emerging markets, are there either opportunities to do bolt-ons -- are you seeing more assets come available from a bolt-on perspective?

Or, are there opportunities to take share because of competitor financing costs?

Laurence, this is Bill.

Our focus is to execute our organic growth plans, while at the same time looking for acquisitions.

If we can do acquisitions in the emerging markets, that obviously will get us to our goals faster.

So, we're doing both.

We continue to look at acquisitions in both the emerging markets and the developed markets.

We have a team that's focused on doing that.

We obviously can't comment prospectively on what we are going to do, but we are looking for opportunities.

Secondly, can you give an update or an elaboration on your thinking around the way the ERP system will play out over the next, call it, 2 to 3 years?

Is there going to be another cycle of investment on productivity measures leveraging that in the 2015 to 2020 period?

Laurence, this is Jim.

In terms of the investment, we are going to continue at a similar level to what we are investing this year over the next, really, two more years, because we are going to be rolling this out next fiscal year in Europe and then the following year in Asia.

As we begin to bring entire regions online, we will start to see some of the benefits we anticipated.

We won't start getting those benefits in full until we get a whole region online, because as we are transitioning, we have the difficulty of being on two systems until we are fully converted.

Once we get a region on, we will start to see those benefits.

We'll start to see some incremental benefits in FY15, but that will be offset by the similar level of investment that we're making today.

Okay.

Are you seeing any opportunity to do a more extensive cycle, product series cycle enabled by the information you get from the ERP system?

Or, is after this it should tail off?

Lawrence, Bill here.

I'd comment on that, as Jim mentioned.

Once we get completely through this project, and we are making great progress so far.

We are really pleased.

We will see a significant benefit for being on one system, both in terms of the cost but also in terms of facilitating our growth to get to the $5 billion mark.

A lot of this is around supporting the growth in addition to making our operations more efficient.

The other thing I would mention, is that we have our ongoing Continuous Improvement initiatives that we talk about every quarter.

That's a continual focus across the Company in terms of working on that.

We see the benefits of that every month and every quarter.

A lot of the heavy lifting, in terms of restructuring, we did a couple of years ago.

We still see smaller, but still significant, opportunities going forward.

We are not forecasting any big restructuring, though, as a result of the Global ERP.

Thank you.

Hamzah Mazari, Credit Suisse.

The first question is just on your truck exposure.

Could you maybe break down where you are exposed within truck, both Europe and North America?

Maybe your perspective of where we are within the truck cycle regionally?

Sure.

Hamzah, this is Tod.

As we look at our on-road markets across Engine, as you probably know, we are mostly a Europe and an Americas story.

If we look at Europe and we break that down, and we look at Euro VI, we did see a bit of a pre buy, but it was as forecasted in the model.

We have built that in to our forecast previously and feel very comfortable about what we have within our forecasted model across Europe.

In the Americas, as you know, there's a lot more positive news surrounding the on-road markets lately.

Some people have expected and forecasted as much as a 15% increase now going forward in calendar year 2014 with first-fit builds.

We have not seen that come through our backlogs, as of yet, but we have built in roughly about half of that forecast in our model.

That's the way that we're looking and shaping up the total on-road markets for Engine.

If I could add something?

First-fit heavy truck is about 5% of our sales drag.

Got it.

Any updated view on how we should think about incremental margins going forward?

I realize you have some growth investments rolling through the P&L, as well, but utilization rates seem like they are still below normal for you guys.

Any color?

Hamzah, this is Jim.

We are a little bit below ideal utilization and that varies by type of products because some products are higher on the utilization standpoint than others.

I think as we look at margins, it's really no different than how we look at that longer term.

It's 20 to 30 basis point improvement annually, which is driven by greater Aftermarket penetration.

Then, offset a little bit by some of these investments we are making in growing our top line, as well as things like the ERP.

We anticipate better margins the second half than the first half, just due to the pickup in those volumes.

For the year, we are continuing to look at that 20 to 30 basis point improvement every year.

Hamzah, we are trying to optimize our operating margin expansion with growth.

It's not trying to maximize the margin, we're trying to get the growth at the same time.

As Jim noted, a lot of this is in terms of we're using a lot of the margin expansion opportunity to reinvest back into the business for growth.

Understood.

Last question and I will turn it over, maybe for Bill.

Congratulations, actually, on the COO role for Tod.

Maybe if you could just speak to the establishment of the COO overall?

I don't think you had a COO role before?

I assume it's part of succession planning.

Any sort of color with regard to that particular role?

Thank you.

Sure, Hamzah.

We had a CAO, Chief Administrative Officer, Charlie McMurray, who is going to be retiring in about a month.

As part of that, looking at the organization, and also to your point about organizational succession planning, I reorganized, we reorganized the Company a little bit and promoted Tod to the COO role.

I was doing a lot of that before, so this represents significant upgrade, putting Tod in the role.

Does that help?

Yes, that's perfect.

Thank you.

Eli Lustgarten, Longbow Research.

Can we talk -- just a technical thing?

This is the first quarter where you took the corporate and unallocated and put it back in to the segments.

Could we get some color on how that was set up?

Because you didn't do it in the first quarter.

The ERP expenses, what were they and how they allocate?

Can we get some idea of how to re-model going on, on the segments?

The operating margin doesn't change, but it does affect how the models work, I believe.

Eli, this is Jim.

We didn't change anything in terms of our methodology on the corporate unallocated.

As I think we've talked about before, that does fluctuate sometimes based on certain of the things we don't allocate to the markets, which would be interest expense and interest income as well as some foreign exchange.

So, that varies from time to time.

The other bigger fluctuation is how the elimination of some of our inter-company sales are handled.

Generally what we find is, when inventories are going down, there's a little bit of a benefit in the corporate and unallocated.

Our inventories have come down $20 million since last year, so that's part of that.

Nothings been changed in terms of our process.

If you look second quarter last or to second quarter this year, it's a pretty similar amount in the corporate unallocated.

It's just mostly a lack of any unusuals that we sometimes have.

That would go back to the $2 million a quarter or so for the rest of the year?

Is it expected to do that?

Yes.

We can't really forecast what's going to happen with FX and some of those other things, but I think that's a good proxy.

In terms of a compass, those costs are in the business unit, so they don't affect the corporate and unallocated.

Maybe to follow onto that, for the year, we are anticipating about $7 million more -- I'm sorry, I said compass but our ERP project, $7 million year-over-year impact with more of that being in the second half.

We've incurred, year to date, it's been a little under $1 million of incremental.

A lot of that $7 million is going to hit us in the second half of the fiscal year.

Then you said the numbers would be relatively flat for next two years in that?

Yes.

That's our best estimate as of now.

Can we now talk a little bit, what we are seeing in the demand?

You basically held your Industrial Products, for example, relatively flat, you said down slightly, even though you are taking about $12 million, $13 million off your Gas Turbine.

That said, you maybe, even though you lowered filtration a bit or so, you saw it more in the upper and than the lower end.

Can you give us color what's going on in the various pieces of that to offset it there?

Is ag holding up enough?

There's a lot of fear know that ag production looks like it could get softer as you go through the rest of the year.

Eli, Bill.

I will start and then I'll pitch it to Tod.

On Gas Turbine, as Jim mentioned, one of the reasons why we took that down is we had some projects that were are going to ship, but they are going to -- just based on the customer's schedules, they're going to move out into FY15.

We can already see that, the lead time that we have on these projects.

That was the reason on the Gas Turbine.

On the Industrial Filtration Solutions, as Jim mentioned, we adjusted that.

The Aftermarket part of that business is going like a train.

It's the first-fit, the new equipment which is related to the delay in the global CapEx recovery.

We still see that, as I mentioned in my comments, gradually improving.

Those are the major reasons for adjustments on the Industrial side.

Tod, ag?

Eli, just talking a little bit about ag.

Our major customers, of course, Deere, AGCO, are all saying flat to a little bit down, maybe as much as 5% or so.

We have baked that into the model.

We also expect it to be stable to down, and that's really what we are seeing throughout our business currently within that market.

Just a final question.

Construction equipment, are you seeing a modest increase in middle-single digits?

Or can that approach double digits for the year from the OEM side?

Yes.

Within the construction business, it's actually mixed.

Europe would be a more favorable.

Asia would be more a modest, particularly across China, there's a little bit of an uptick.

The US is a little bit stable at this point in time, but we do expect to see a little potential uptick as we listen to some of our customers' guidance.

Thank you very much.

Charley Brady, BMO Capital Markets.

Just back on part of that on the Industrial Filtration business.

Just parsing that out a little bit, it looks as though in Europe, that was probably one of your strongest regions with that business up 3% or so.

Just speaking directly to what you are seeing in Europe, in Industrial Filtration, is the first fit stronger in Europe than you are seeing in other areas, or is it kind of the same situation where it's driven all by the aftermarket?

In Europe, Charley, -- this is Bill, it's a little bit better than in the US.

It all depends on the comps.

I would say that the US had held up stronger or longer, but the last probably year we just haven't seen the strength on the equipment side.

Europe has picked up or recovered a little bit sooner.

Europe we are seeing both.

The US, we are fortunate to have a very strong aftermarket business, which is helping to offset the current weakness in the new equipment.

All right.

On the on-road side, I know heavy truck's only 5% or so of total business, but the European heavy truck business, was up 45% local currency.

You alluded to the fact that you are seeing some pre buy on that.

What I'm trying to get to is, how much of that plus 45% was driven by pre buy and how much is just the underlying market, itself, is getting better?

We actually have taken a lot of care to try to pare that apart ourselves.

In talking to the customer base, we would say that the greater portion of that is really market driven rather than pre-buy driven across Europe.

The pre-buy portion that we have modeled, has really met our models.

It's been modest, low-double digit, is what we've seen as far as pre buy.

That's direct input across our customer base from Europe.

All right, that's helpful.

One more and I will get back in the queue.

On the special apps, can you just break out how much the hard disk drive business was up or down, and how much the membranes was up or down?

Charlie, this is Rich.

We look at the disk drive portion, that was up maybe around 15%, while membranes was down about the same as a percentage.

Fortunately, disk drive is a little bigger percentage of overall special applications, so that helped to drive the upside.

Thanks.

Kevin Maczka, BB&T Capital Markets.

Bill, we talk every quarter about Continuous Improvement and distributor add.

On the distributors, I'm just wondering if you can give some sense of where we are in that process?

Is that something that will be ongoing all the time, like Continuous Improvement, and there is a many year runway still ahead of us?

Is it entirely focused on emerging markets and where more mature in the developed markets?

If you can just give a little color on the distributor add trajectory from here?

Kevin, Bill here.

I think it's a race without an end, to be honest with you.

If you think of how the Company started, and up until maybe 25 years ago, we were mostly a North American and some -- with pretty good presence in Europe.

The rest of the world we had certainly nice beachheads, but our positions were not as strong.

That's a function of we started here in the US almost 100 years ago.

We see tremendous opportunities to add products to our product line and this distribution to get the proper coverage.

We talk about it every month, in terms of where we see the opportunities.

We continue to see, as far out as we can look, really, opportunities to do both.

It's just not about the numbers of the distributors, is really about the quality of the distributors.

It's not just a sheer numbers, but finding the right distributors.

Not every distributor can cover every end market.

Some are focused on on-road and some are focused on mining or construction or ag.

So, trying to make sure that we have got the most effective coverage in each of the emerging markets.

We continue to see tremendous opportunities for that.

It's sort of like the Continuous Improvement.

You have to keep looking and you keep finding, kicking over rocks and finding more opportunities to do more and to grow.

Since we are mostly organic growth story, that's really what we focus on is looking for those type of things.

That's understandable.

My meaning question is, when we hear you say you added 70 or however many distributors any given quarter, to try to take that the next step and think about how does that move the needle?

Or, how it might move the needle going forward?

We've been adding distributors all along and cycle still matter, and we can still have down revenues even though we are adding lots of distributors.

This is Tod.

Maybe I will add a little bit more to that.

If you really take a look at our distributor map worldwide, obviously, we have a lot of runway across Asia, where we have a very small presence.

Maybe we are maturing, we would probably say, in Europe, while we're mature in the US.

Then, maybe maturing across Latin America.

If you just use that as the barometer, we have a lot of opportunity to add strength across our distribution.

We really believe that that will be one of the contributing factors to driving growth across our Engine business worldwide.

Okay.

Shifting gears, you did trim the cash flow guidance for the year, even though we maintained sales and earnings.

I think Jim said, you pointed out you took inventories down $20 million.

I'm just wondering if you can say more about what drove that cut?

What's going on the working capital line that's contributing to that?

Kevin, this is Rich.

One of the bigger drivers of that is the push out of some of the Gas Turbine systems in our fourth quarter.

That will, towards the end of the year, lead us to have a little bit more inventory than we had originally anticipated.

That's the primary driver right there.

This is Jim.

Nothing else, in terms of how we've looked at free cash flow, other than that change.

Okay.

Great.

That's all I had.

Thank you.

Andrew Obin, Bank of America Merrill Lynch.

I just want to make sure that on power, on Gas Turbines, all it is just timing of shipments, right?

Because, the GE PowerCore transaction, that's not upsetting the market dynamic, right?

There is nothing going on there right now?

Andrew, Bill.

No, nothing like that.

It's simply the shifting of the timing of some of these projects, when they're going to ship.

Sure.

The second thing, and it's a broader philosophical question for you.

As we look at your results and compare it to other multi-industrial names, nobody posted good industrial CapEx commentary.

I'm just surprised that we all got excited about improving ISM, global IT improving, going into the end of last year and then it sort of fizzled this quarter.

You've been turning it for a long time.

What are you guys seeing?

What do think is different?

Why do you think everybody has gotten it so wrong?

The place I look, Andrew, for my best guidance is, obviously, your reports.

Okay?

(laughter)

I think that a lot of us industrial companies, where our products are part of a customer's CapEx and have been waiting for that.

I think I've seen some other industrial report results come out in the last month.

I think, to your point, there's a delay in this recovery cycle for our global CapEx.

The good news, from our perspective, as Jim mentioned, is that with the recovery in the Aftermarket, as people start using equipment more, they start replacing filters more and we are seeing that in the Industrial space.

Historically, that's a good precursor to an investment in new equipment.

We think it's out there.

We are forecasting some gradual improvement during second half, but it hasn't come, to your point, as quickly as people were forecasting late in 2013.

Just a final wrap up question.

If I missed you answering, I apologize.

On mining, talk about mining stabilizing.

Is it because the volumes are so low that they just can't go lower?

Are you seeing any chance of actually your shipments going up in the second half of the year?

Because we've heard from some of the OEM suppliers that production is just basically, effectively collapsing in Q1.

It may actually get better in the second half, not because things are necessarily getting better, but just because the volumes are getting to a point where they are unsustainably low in terms of shipments.

Andrew, this is Tod.

I will take that.

Within the mining sector, basically, as we look out and we talk to our customer base, I think you described it pretty well.

We say that obviously it softened dramatically for us, but it is at such a low level it came off the floor, perhaps, just a little bit.

We see it stabilizing at its current low levels.

That's what we've built within our forecast, is really just stabilized at the current low levels looking forward.

Thank you very much.

Jim Giannakouros, Oppenheimer & Company.

I'm sorry if I missed it.

Can you get a bit more granular as far as the strength in Aftermarket sales, particularly in Engine?

How much you would attribute to higher retention rates of our proprietary product?

How much is due to the higher utilization you are seeing out there, both and off road and on road?

Jim, this is Rich.

I would use as a proxy for that, the difference between the growth rates that we've seen from our OED channel versus the independent channel.

In this last quarter we saw the independent channel grow in the neighborhood of about 8% in local currency, while the OED channel was up about 15%.

There's a little bit of evidence of some minor restocking in the OEDs.

We wouldn't say that entire differences do to the benefit from our PowerCore and other proprietary first-fit systems, but it's a good portion of it.

Okay, thanks.

That's helpful.

Jump in to SAP.

I don't know if I was supposed to catch this, but what kind of improvement in hard disk drives does your model factor in for the rest of 2014?

Jim, do you want to take that?

Yes.

In terms of disk drive, I think we saw more benefit here in the second quarter than we had originally forecast.

That we built into the forecast.

We see it remaining relatively flat, in terms of where it is the rest of the year.

Great.

Thank you.

Just add to that, the forecast for hard drive shipments by our customers is essentially flat year over year, plus or minus 1%.

Seems like it's stabilized at that level right now.

Richard Eastman, Robert W Baird.

Can I just double back for one second?

On the Aftermarket business, when I look at the comp from last year and I look at the results from this year, if you stack the comps, you get maybe a 5% to 6% growth rate in over that two years, maybe adjusting for some of this distributor restocking, destocking.

Is that a better feel for what the market actually looks like out there, a mid single-digit growth rate?

Or do you believe that, again, your reference on the distribution side and some of those things have pushed that growth rate up into the high-single digits?

Rick, Bill here.

I will start.

You are right.

There's a bunch of different components of this.

One is certainly the underlying market growth.

We take a look at ton miles there as maybe a proxy for, at least for the on-road segment of the market in terms of utilization of equipment.

That would be in the low single-digits increase.

Above that, what we see, the way we do the math, and we haven't quantified all this publicly, would be is that the things we talked about in terms of adding, especially in emerging markets, part numbers to our product lines.

We have broader coverage.

And adding more distribution capabilities internally, where distributors adds to that.

Then, we take a look at the growth of the PowerCore that we talked about in terms of the year over year.

We talk about say an 18% increase year over year.

That's factored in there as well.

That's one example.

The proprietary technology is then the icing on the cake, so to speak, to get us up to the numbers you mentioned.

Underlying market growth, emerging market and then proprietary technology.

That, in your mind, sums to what high-single digit or mid-single?

I'm not trying to --

You are trying to pin us down.

(laughter) Over time, it should be high-single digits.

Okay.

Yes.

The comment that Rich made on the OED channel verse the independent channel, was that a global comment?

Yes, that was.

Okay.

Thank you.

Just last, on the Industrial side of the business, I liked the split.

If you pulled dust collection out, we had IFS and Special Apps was plus 5%.

You had mentioned the replacement side.

Can you give us a sense of what percentage of that Industrial non Gas Turbine is Aftermarket verse OE sales?

Just roughly?

Is it 30%?

Rick, you mean our Industrial Filtration Solutions business?

That's the piece you are talking about?

Yes.

I'm trying to -- you'd give us that.

That the IFS business and Special Apps combined were up 5% in the quarter.

You said replacement elements sales were up.

It sounds like the OE, first-fit equipment side of IFS was a negative number.

Just curious as to how that split looks approximately?

This is Jim.

Within the IFS side of the business, replacement parts were about 43% of the total sales there this year.

Okay.

Gas Turbine, that's running more along the lines of 40%.

Okay.

I can maybe clean that one up offline.

Thank you much.

Brian Drab, William Blair.

I don't want to jinx it.

I guess leave it to Donaldson to get off to a flawless start in the rollout of an ERP system.

So, congratulations on that.

(laughter) Brian, you know as Yogi Berra said, it ain't over till it's over.

You don't hear that that often.

I don't know if you commented yet, but looking at the Aftermarket performance in the quarter, it doesn't look like you saw really any impact in North America from the severe weather.

Can you comment?

Do think we might see some of that show up next quarter?

Could you maybe give a breakdown of the Aftermarket segment by geography?

Brian, we had a number of our plants in the Midwest and our main distribution center were impacted by the weather in January where interstates were being shut down in Indiana and things like that.

We recovered very quickly to the point that we were getting complements from customers.

It's in the quarter and it's not material.

We got through it.

Our people got through it exceptionally well.

Okay.

Great.

Could you just clarify?

You talked quite a bit about the Synteq opportunity and this is a s a new diesel fuel filtration opportunity that could be, I think you said, $30 million to $40 million in revenue.

That's on the first-fit side, I believe.

Right?

I'm just trying to clarify.

First of all, what has your presence been in diesel fuel filtration to date?

It's been more on the Aftermarket side, is that right?

This is Tod.

As we look at diesel fuel, where we've really played and where entered the market years ago was within the aftermarket.

Our presence has really been through the aftermarket channel.

What we've done now with Synteq is we've successfully turned the model to are proprietary first-fit solution using Synteq and winning new programs to our OE customers.

We have won a number of programs on Synteq.

When those programs that Bill referred to earlier today, come to full maturity here in a couple of years, actually, that select product line of fuel filtration will be more along the lines of about $50 million annually, is the way that we look at it.

Okay.

Great.

How big has that business been historically, the Aftermarket diesel fuel filtration?

Brian, we don't break out the fuel portion separately in the Aftermarket.

For liquid, historically, it's been about half hydraulic about half lube and fuel.

Okay.

The split between lube and fuel, we've never really tracked it that closely.

Okay.

All right.

Thanks very much.

Brian Sponheimer, Gabelli & Company.

Just a question for you on the M&A front.

Lydall made a smaller acquisition last night of an air filtration business and didn't pay very much.

Should we not think about air filtration as an area where you'd even bother to look at this point given your product portfolio?

Brian, Bill here.

We are open to anything that fits into our strategy.

That's the qualifier.

We still use -- our strategy is to filter, excuse the pun, for looking at acquisitions.

We have team that's focused on it.

It is in a very tough market right now in terms of finding acquisitions and doing them at prices that make sense for us.

We continue to look.

We look at acquisitions as the adder to our organic growth.

We want to be still mostly an organic growth story, but we are continuing a very aggressive look at acquisitions.

Really, across almost all of our businesses, we look for them.

Just any update on how you see that pipe developing, whether you'd expect, without guiding, obviously, anything in this the third or fourth quarter of discussions?

(laughter)

Brian, you don't want me to give a day, did you?

(laughter)

You are very good at this, Bill.

I can't talk prospectively.

We have the capital capacity.

We are very focused on trying to find the opportunities.

I think as I mentioned in our last call, we know we have to get better at it because the market is very hot.

We want to find the candidates sooner and cultivate the relationship faster.

Then, hopefully be able to reach a deal that fits our financial metrics.

We are working on it very hard.

All right.

Thank you.

(Operator Instructions)

Stanley Elliott, Stifel Nicolaus.

Two quick questions.

One on the OED comment.

Was that for the quarter, or was that for six months?

Also, I thought it heard you say some commentary in and around some restocking at the aftermarket level?

I just wanted to make sure I heard that correctly?

Stanley, this is Rich.

The comment was about the quarter, the difference between the independent and the OED channels.

That same relationship has been consistent year to date.

As far as the minor restocking, that was really related to the OED channel.

I imagine we are still fairly down from where we had been in the past.

The conversations with those customers, are they getting more optimistic about this year?

Any thoughts around that front, please?

Yes.

This is Tod.

As we talk across our OE base, it's obviously very mixed across the markets when you talk to construction, ag, mining and on road.

I'd say there hasn't really been a change over the last quarter in the way that they each characterize their individual markets.

I would say that there hasn't been a shift to optimism by any of them.

That's what we have in our forecast, as well.

Perfect.

Thank you very much.

I thought this was a great quarter.

Keep up the good work.

Thank you.

Kevin Maczka, BB&T Capital Markets.

I think I understand in terms of your second-half margin outlook, what most of the moving parts are.

I just want to make sure we are all clear here.

Why can't second-half margins at least match what we did in the second half last year?

We're going to have higher volumes, we always have continuous improvement.

We accrued in the second quarter, the higher comp in ERP, and we still saw margins come up.

Can you just square that for the second half?

Yes.

This is Jim.

I appreciate the question, because this gives me an opportunity to maybe answer the question Eli asked earlier a little bit better.

In terms of the probably the two investment items that we've talked about, at the start of the year we said we had about $30 million of incremental expenses this year related to our ERP project, which is about $7 million of that.

The remainder is the restoration of our incentive compensation.

I think I mixed apples and oranges when I talked about the ERP earlier.

So, year to date, we've incurred about $2 million to $3 million of that incremental expense for our ERP.

We're going to have about $4 million to $5 million of that in the second half, so that's a little more back-end loaded, of that $7 million incremental.

Of our incentive comp, which is going to be in the neighborhood of $20 million, that's also going to be back-half loaded into our third quarter, because last year third quarter is where it became apparent that we weren't going to hit our financial metrics that we were gold on and we reversed some of our incentive comps.

Those factors are going to hit us harder in the second half than the first half.

Okay.

Very helpful.

Thanks, Jim.

At this time, I would now like to turn the conference back over to Bill Cook for any closing comments.

Thanks, Craig.

Now, to conclude our call.

First, I'd like to, again, recognize and thank my fellow employees for their contributions to our second-quarter performance.

Finally, 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 weekend, all.

Thank you.

Ladies and gentlemen, that will conclude the conference call for today.

If you would like to listen to a replay of this conference you may do so by dialing either 303-590-3030 or 1-800-406-7325.

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(Operator Instructions)

Again, we do thank you for your participation on today's call.

You may disconnect your lines at this time.