Donaldson Company, Inc. (DCI) Q4 2007 Earnings Report, Transcript and Summary

Good morning. My name is Amanda, and I will be your conference operator today. At this time I would like to welcome everyone for the Donaldson Company Fourth Quarter and Fiscal Year End Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks there will be a question-and-answer session. [Operator’s instructions. ] Thank you, Mr. Sheffer you may begin your conference.

Thank you, Amanda. And welcome everyone to Donaldson’s 2007 fourth quarter conference call and webcast. Following my brief introduction Tom VerHage, our Vice President and CFO will give us a brief review of our record fourth quarter operating results. Tom will then turn the call over to Bill Cook, our Chairman, President and CEO who will discuss our positive outlook for fiscal 2008 and the business conditions shaping that view. Following Bill's remarks we’ll open up the call to questions. Before I turn the call over to Tom, I need to review our Safe Harbor Statement with you. Any statements in this call regarding our business that are not historical facts are forward-looking statements. And our future results could differ materially from the forward-looking statements made today. Our actual results may be affected by many important factors including risks and uncertainties identified in our press release and in our SEC filings. Now I’d like to introduce Tom VerHage, Tom.

Thanks, Rich. And good morning, everyone. Now as you saw in our press release late yesterday, we closed out the year with a fine quarter, thanks to our continued strong sales growth, and an improved operating margin in comparison with the third quarter. Since I'm sure you’ve all had a chance to read our press release, I don’t want to take your time this morning, summarizing items that are disclosed there. But I do want to emphasize a few points that you may want to consider in your analysis for fiscal '08. Sales in both our engine and industrial segments came in at the high end of the range that we provided at the end of our third quarter. As we previously mentioned, our fourth quarter this year included an extra week of sales for our US operations, which had the impact of increasing sales by $16 million. Gross margin for the quarter improved to 32.4% from a disappointing 31% in the third quarter. We discussed three reasons for the lower gross margin last quarter, and I’ll give you a brief update on the comparative impact of these items between the two quarters. First, startup and restructuring costs dropped by nearly $2 million. One driver of this reduction is that our new Dust Collector Plant in the Czech Republic is off to a great start, reducing our need to subcontract the assembly of these units at a higher cost. Secondly, we had unusually low margins in some gas turbine and industrial filtration projects in the third quarter. We did not have a repeat of this situation in the fourth quarter. And we did experience some progress in the fourth quarter in optimizing our distribution processes, particularly with our new distribution center in Belgium. This area continues to be a global improvement opportunity for us, and we will continue our investments in new systems and process enhancement. Our improved gross margin combined with a continuing decrease in operating expenses as a percent of sales, allowed us to as achieve a 12.3% operating margin in the quarter and hit our 11% target for the year. Our tax rate for the year was 30.9%, which is down from the 35.2% in last year’s fourth quarter. Last year, we recorded a $3.6 million charge related to our dividend reinvestment plan, pursuant to the American Jobs Creation Act. Our CapEx for the year of $76.5 million exceeded the top end of the range of $70 million that we provided to you last quarter. This was primarily due to planned, or a few planned projects, for which payments were made sooner than we previously anticipated. Now, I’d like to provide you with a few further details on some matters that you may want to consider for your analysis for 2008. Our sales growth guidance of 5% to 7% for engine and 8% to 10% for industrial is noted in our press release. Engine sales in 2008 will again be impacted by lower NAFTA heavy truck build rates that we started to see in our third quarter. We expect a year-over-year sales decline of $30 million to $40 million in the first three quarters of our fiscal year, due to the lower build rates. The sales to this portion of the market beginning to level out in the third quarter. We expect grass margin to once again exceed 32% and operating expenses to be in the range of 21%. If we achieve these targets, our operating margin should be a minimum of 11%. Interest expense should increase by $2 million to $3 million with the primary driver being the full year of debt, related to our acquisition of AFS in March. We’ve explained on previous calls that our tax rates will fluctuate more than it did a few years ago, as discrete screening events occur and our global earnings mix fluctuates. Our guidance is for a tax rate in the range of 29% to 32%. As we cannot anticipate at this point, a repeat of the magnitude of the favorable discrete items reduced that rate to 26.4% in 2007. However, one example of a favorable discrete item that will impact the tax rate in the first quarter, is a lower corporate tax rate that was signed into law in Germany which will allow us to reduce our German deferred tax liabilities. This, and the settlement of one other item related to a prior year will have a favorable impact of approximately $3 million on a first quarter tax provision. Our CapEx guidance for 2008 is a range of $60 million to $70 million which is down from 2007’s actual CapEx of $76.5 million. We expect depreciation and amortization to be in a range of $51 million to $55 million, which includes $2 million of amortization related to the intangible assets acquired in the AFS acquisition. Our current view is that free cash flow should improve in 2008 from $40 million to a range of $100 million to $140 million. So just to sum up, we were very pleased with our fourth quarter results from a standpoint of continued solid sales growth, and the improvement in operating margins from the third quarter. And our press release provides our EPS guidance for 2008, of a range of a $1.92 to $2.01, with an operating profit increase of approximately 10%. So now with that, I’ll pass it over to Bill, who will provide some more background on our outlook. Bill?

Thanks, Tom. Good morning, everyone. Before I talk about our outlook, I want to add a few more comments to our fourth quarter highlights. Maybe to start, it was a great quarter but not a surprise as it really fit right in with our long-term strategy and operating philosophies. But there were a couple of notable milestones that we look at. One is that it was the first time that our quarterly sales exceeded $500 million. And the first time that our quarterly EPS exceeded $0.50 per share. And obviously, the combination of both of those helped us to deliver our 18th consecutive year of record earnings. Now, I'll talk a little bit about our two businesses, our engine and industrial. And I’ll start with engine and talk about Europe first, where business conditions were very good, a combination of the overall strength of the European economy as well as growth through new business at both, some of our existing and new customers. In local currency our European engine business was up 13% in the quarter and up 17% for the year. And again that isn’t local currency without the positive impact of translation. So 13% in the quarter, 17% for the year. Very good numbers. We also saw very good growth in our engine aftermarket across Europe. We have one… for example we have one initiative in emerging markets where we are adding distributors in Eastern Europe, Russia and the Middle East. And in total, this initiative… our emerging markets initiative grew over 30% during fiscal '07. This is just one great example of how we’re growing by adding new and more distribution by making additional market share gains and also continuing to diversify our business geographically. In Asia, our off-road equipment and aftermarket segments also had strong quarters with local currency sales up 25% and 12%, respectively. This strength was broad-based with healthy increases in Japan, China, Australia, Korea, Thailand and India. Switching to NAFTA. In our NAFTA engine business, the heavy construction and mining equipment sectors remained strong, and the Ag equipment sector continues to improve. So in total, our NAFTA off-road equipment sales were up 17% in the quarter. In addition, as the industry truck ton miles picked up and general equipment utilization rates remained high, we saw increased demand for replacement filters and our NAFTA aftermarket business was up 12% in the quarter. We’ve been asked about, and talk a lot about the new Class A production downturn following last year’s truck pre-buy. However, what we experienced was somewhat better than we had expected. Our NAFTA new truck filter sales were down 14% in the quarter, but this was better than our prior guidance of 15% to 20% decrease. So the bottom line for our engine business worldwide was that total sales in the quarter were up 8%, or 6% excluding the currency impact. Switching now to our industrial business. Within that, our industrial filtration solutions business had a great quarter globally with sales up 15% excluding any currency impact. Local currency sales were up 28% in the Asia, 12% in Europe and 12% in NAFTA, as demand remained strong for our industrial dust collectors, compressed air and industrial hydraulic filter products. Our gas turbine filter business finished the year strong with sales of $47 million. This is our best quarter for gas turbines since the power bubble in 2002. This also marks our second consecutive year of growth in gas turbine as the global power generation market continues to rebound. And finally, in our special applications business we also had a good quarter with local currency sales up 11% due to growth in both our membrane products and disk drive filter sales. In total, the sales in our industrial business were up 17% in the quarter, 13% excluding the impact of currency. Just to reinforce what Tom had mentioned about our margins, we saw a dramatic improvement in our gross margin in the fourth quarter. That coupled with our continued focus on operating expenses helped us to deliver the 12.3% operating margin in the quarter and helped us to achieve our 11% target for the full year. That’s a brief recap for fiscal ’07. Now I am going to switch to some thoughts about our outlook for fiscal ’08. To start with, our sales outlook is good. As noted in our press release, we expect our engine business to be up 5% to 7% and our industrial business to be up 8% to 10%. The total company revenue should be up between 6% and 8% excluding any possible acquisitions. Looking first at the engine side of our business, the end-markets for our off-road equipment customers remained strong as both construction and mining equipment sales continue to grow globally. And in addition, agriculture equipment sales have improved. The latest reports on forecast crop prices and farmer incomes are up, which is positive for the Ag equipment market. Whilst overall construction equipment sales were down in NAFTA due to the US housing market problems, heavy construction equipment demand remains healthy. Our replacement parts businesses for existing fleets of construction, truck and Ag equipment should remain strong as utilization rates for these equipment are… these types of equipment are good. And as we said before, solid equipment utilization continues to drive the need for regular maintenance in our replacement filters. As mentioned earlier, the drop-off in new Class A truck builds in North America has been slower than anticipated. As Tom mentioned, we expect our NAFTA truck sales be down $30 million to $40 million in our first three quarters of fiscal ’08 before returning to year-over-year growth in our fourth quarter. In our industrial businesses, we see all of our major groups up in fiscal ’08, although at more moderate growth rates than what we experienced in fiscal ’07. In our IFS business which includes our dust collectors and compressed air filters, incoming new orders remained good for both new equipment and replacement filters and we currently expect sales to grow approximately 10% in fiscal ’08. In our gas turbine business, we see considerable market strength based on orders in our hands already for fiscal ’08 and beyond. However, our gas turbine customers are extremely busy and significant further volume increases are dependent on them being able to add production capacity. So at this time we are expecting a 7% to 8% revenue growth in our gas turbine business in fiscal ’08. And finally, in our special applications group, we see sales growth of 5% in our disk drive filter and membrane sales. And as Tom mentioned, for the company, we expect our fiscal ’08 operating profits to be up 10% year-over-year and to deliver an operating margin of a minimum of 11%, as we continue to work on improving and optimizing our various operating initiatives to achieve our long-term improvement targets. I would like to give you a little bit of an update on our PowerCore technology. We are now on 93 equipment platforms with our various OEM customers. 73 of these are already in production and another dozen are expected to go into production sometime during the next year. PowerCore sales were up 38% in our fourth quarter and 28% in the year, as sales of replacement filters continue to ramp up growing 56% in the quarter. So we have 93 platforms won and we still have another 75 in the proposal stage with our OEM customers. And with our current win rate of over 90%, we remain very confident of the continued growth of our PowerCore technology. Another big growth opportunity we see over the next few years is our emissions. We are optimistic regarding our participation in the diesel emissions marketplace. We expect our emissions business for on-road equipment or trucks will grow from what was a $50 million exhaust business into a $150 million exhaust and emissions business by the end of 2012. So in conclusion, we are very pleased to have finished fiscal ’07 on a very positive note with our fourth quarter performance. We are also very proud to have achieved our 18th consecutive year of record earnings. Now, looking in, from the outside of our company, it may not be obvious how we did this. So here is the essence of how it works. First, over the past 20 years, we had developed a well-diversified portfolio of different filtration businesses around the world. None of you probably don’t fully understand how this has transformed our company. This diversification has minimized the impact on us of any one business cycle. So while Class A trucks are still a very important business for us, they don’t define our total company and we have been able to offset the current NAFTA Class A truck cycle that we often are asked about. So what we offset with other businesses are growing or extending a different cycle. Another example for those of you who have followed us for a while, you may recall that we delivered record sales four years ago when the gas turbine markets cycled down, again, because of our portfolio of other businesses. That’s the first factor, is this portfolio of diversified businesses. But the second reason is we were fortunate to have generally good economic conditions in most parts of the world this past year. But good conditions alone don’t generate business for us. We had to and did make the right strategic investments and then executed very well. Over the past two years, we have invested over $200 million back into our business in both capital expenditures and technology for our growth in future. The third factor is our continuous improvement focus. This is relentless, and it has to be, as generally the prices for our products are going down, not up, over time. We can afford to do this, protect our margins and deliver improved value to our customers, through our fanatical approach to product cost reductions. We use many continuous improvement tools within our business to accomplish this, including new technologies and designs and manufacturing process investments. But the bottom line is that these efforts generated approximately $25 million in cost reductions just last year. Our people do this year-in and year-out. It’s pretty amazing, but it's part of our culture and we have a similar target for fiscal ’08. And the final factor is, we need great people to execute, and we have them. We have 12,000 great people around the world, executing our model and business plans, and we have a great company because of them. This is a simple description of how we accomplished what we did in fiscal ’07 and what we plan to do in fiscal ’08. The bottom line is that we expect the strength of our diversified portfolio of filtration businesses combined with our relentless operational focus and technology leadership to allow us to deliver another record year of sales and earnings in fiscal ’08, which would make that our 19th consecutive earnings record. That concludes our prepared remarks, Amanda. Now we'd like to open it up for questions. Question and Answer

[Operator Instructions]. Your first question comes from Linc Gordon with HB Wellington [ph].

Okay. Good morning. I’d like as many of the international numbers, as I could. International sales, as a percent of the total and of the different product lines, if possible?

Sure. One second. Rich.

Yes, the international sales were 53% of our total this year.

Okay.

And what was the second part of your question, Linc?

By product line. How much was Asia? How much was Europe?

Okay. If you give me two seconds, I will have that for you.

Do you have any other questions while Rich works on that?

No. That was basically it. I’ve gotten… been looking at the details of these markers.

Well, we'll let Rich work on that. We’ll come back during the call. And we’ll go to the next question, and keep things moving, if that’s okay?

Okay. Sure. Thanks.

Your next question comes from Bill Harrison with Robert Baird.

Hi, good morning.

Good morning, Bill.

In your industrial segment, you mentioned the gas turbine business is expected to be up 7% to 8%. Is any lumpiness expected, any lower margin business in the backlog?

I think the first part of your question was lumpiness? Is that right?

Yes.

It doesn’t come in equally by quarters. So there is, during the year, there is a variation by quarter in terms of how the sales come in. So that’s the first part of your question. Second one, in terms of low margins, we don’t see any unusual margin business in the backlog, no.

Okay. And then I guess in terms of pricing, do you have any strategies implemented for ’08, and is this embedded in your guidance?

Whatever pricing we get is embedded in our guidance. Generally, our prices are going down over time, not up. So, we don’t count on pricing to grow our top line.

Okay. All right. Great. Thanks.

[Operator Instructions] Your next question comes from Scott Graham with Bear Stearns.

Hey, good morning.

Good morning, Scott.

Well, I’m trying to do the math here of the operating income growth of up about 10% versus the range of EPS that you’ve given for 2008. I guess I’m maybe in need of your connecting the dots a little bit for me, because it would suggest that at about 10% operating income growth, you’d be at the low-end of the range that you've given, given further that you've talked about the interest expense increase and the taxes, the tax rate for the year. Could you … is about 10% supposed to be more than 10%... I mean, maybe you can just give us a little bit more clarity on that, because my math isn’t working on that?

Yes, Scott, this is Tom. We broadened out various numbers with various operating margin percents, tax rates and the like and came up with that 10% guidance. So it does assume the minimum operating income percent of 11%. And as we work through the various gross margin percentages and operating expenses, we really did come out sort of in the middle of that range, as we ran through a number of different scenarios.

Okay. Could you talk about the potential for increasing your operating margin target, once we get through these the rougher waters of this high margin business in obviously OEM transport, once we get through that the first couple of quarters of the year, and things may be stabilized in the third quarter? Is it possible that you guys would retarget to another level of operating margin given some of the cost reductions that you guys constantly talk about, that you strive for? Is that a possibility as we go through 2008?

Scott, this is Tom once again. Certainly that is a possibility, and we’re always striving for that. Our guidance is annual guidance. If you look at … actually if you go back to F’06 when our operating income was 11.4%, that was I think our best year in history. We would like to achieve that again, and that’s one of the reasons that we have provided the minimum of 11% guidance. So I’d say Scott, stay tuned, and we'll update the guidance throughout the year, if it’s appropriate.

Sounds good. Last question. As far as your US businesses are concerned, given the tumultuous nature of the credit markets which began I guess, I guess you could say earlier this summer but probably hit more forcefully in July, would you say that, have you seen a change in the pattern of your order rates really among any of your businesses since that time?

This is Bill. I think that the one segment that we talked about, or the one sector is really around the residential construction and where that affects us is in the small construction equipment market. But again, the heavy equipment that’s related to non-residential construction and mining is very, very strong. So our guidance includes the impact of what happened in the residential market.

Very good. Thank you.

Sure.

[Operator Instructions].

While we are waiting to see if there’s any more questions, just follow up with Linc Gordon's question regarding the geographic split of our sales. In Q4, Europe was 33%, Asia was 21%, South Africa was 2% and NAFTA was 44%. And those numbers are fairly consistent for the full year results as well.

Okay. Amanda, there’s another question.

Your next question comes from Jeff Hammond with Key Banc Capital Markets.

Hi, good morning gentlemen.

'Morning Jeff.

What I wanted to try to get to is, if you try to add up the inefficiencies, the added investments, that kind of hit your P&L in ’07, how should we think about that for all of fiscal ’07? And then given that you're going to have some added investments, maybe some additional inefficiencies. How should we think about that number for fiscal ’08?

Yes, Jeff, this is Tom. I think what you are referring to are the three items that diluted our results in the third quarter, and I touched on those briefly in my prepared remarks. I think the key issue sequentially, Q3 to Q4 is, if you go back to the webcast notes for Q3, we mentioned that there were about $6 million of mix and low margin orders. And those items for the most part did not repeat in the fourth quarter. So that gave us some sequential improvement. In addition, we had approximately $2 million less plant startup and restructuring costs. So that total of $8 million pretty much constituted our quarter-over-quarter gross margin improvement. As we go into F'08, as Bill I think touched on too, we are not anticipating at this point low margin orders in GTS, in IFS. Plant startup and restructuring costs for the year should be down a bit from the $5.3 million that we experienced in F’07. But we are going to continue invest in the distribution systems that I mentioned, process improvements and those investments are going to be going on for another couple of quarters.

Would you say that those process improvements and distribution costs or inefficiencies are comparable in fiscal ’08 versus fiscal ’07? Or is there a downtick there as well?

There is going to be… in the first half of fiscal ’08 we are going to be making investments that we did not make in fiscal ’07. So that should impact first half results. And then we will look for improvements hopefully in the second half of fiscal ’08.

Okay. And then as you look at the engine after market business, very good growth in fiscal ’07 versus maybe just a historical run rate of 8% to 10% growth, I think you are at low teens in fiscal ’07. I mean, do you attribute that to just strong global economic conditions. Or how much is driven by kind of the capture of PowerCore starting to take hold?

Jeff, this is Bill. It's a combination of factors. Certainly there's some help from the global… improvement in the economic conditions. But a lot of it is around some of the initiatives that we have, and I used an example in my remarks about new and more distribution around the world, more salespeople, and a lot of it's around product. And PowerCore is part of that, where we can install a proprietary product on the first fit, and then protect the aftermarket. And PowerCore continues to grow, as I mentioned. I think right now it represents about 5% of our aftermarket sales. But it's growing, you heard the percentages earlier. So, over time… and that’s not the only one like that. But that’s one example of how we're going to grow independent of any economic cycle in the replacements parts by hopefully locking up the replacement part business to balance it [ph].

Okay, and then final question. On the tax rate, 29% to 32%, is that inclusive of the 1Q tax items?

That is, Jeff, this is Tom. Our range, 29% to 32% does contemplate those two items that I've mentioned that we already know about for the first quarter.

Okay, perfect, thanks, guys.

Thanks.

Your next question comes from Mario Gabelli of Gabelli and Company.

Hey, Bill, hi.

Hi, Mario. Good morning.

Yes. Just going to 30,000 feet for a second, have you allocated any R&D money towards wet filtration? Like, have you started looking at that? I know you've always been in the dry world.

Mario, Bill here. It is one of our initiatives. We have a pretty significant position already in hydraulic fluid filtration. So what we want to do is expand out into, on both the engine side, into other engine liquids, like fuel and lube, and also on the industrial side, into process liquids. So we are making investments to accomplish that, yes.

And how much has it stepped up?

I don't think we've given that number publicly, Mario. But our R&D is growing at a lot higher… expenditures are growing at a lot higher rate than our revenue growth, and have, for the last couple of years.

And the percentage increasing for liquids?

They are higher than air, yes. We're trying to catch up.

Okay, thanks.

Sure, thanks.

[Operator Instructions]. At this time there are no further questions, and I would like to turn the floor back over to Mr. Bill Cook for closing remarks.

Thanks, Amanda. For all of you participating and listening, I'd like to thank you for your time and interest. To my fellow employees, every one of you played a critical role in our success. I want to thank you for delivering another record quarter and year. I'm very proud of what we’ve accomplished together, and I hope you are, too. You should be. So thank you all, and goodbye.

This concludes today's conference. You may now disconnect.