Donaldson Company, Inc. (DCI) Q2 2017 Earnings Report, Transcript and Summary

Good morning. My name is Denise and I will be your conference operator today. At this time, I would like to welcome everyone to the Donaldson’s Q2 Fiscal Year 2017 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 Instructions] Thank you. Brad Pogalz, you may begin your conference.

Thank you. Good morning, everyone. Thank you for joining Donaldson’s fiscal 2017 second quarter earnings conference call. With me today are Tod Carpenter, President and Chief Executive Officer and Scott Robinson, Chief Financial Officer. This morning, Tod and Scott will walk through the details of our second quarter performance, the drivers of our increased guidance for fiscal 2017 and provide an update on some of our strategic initiatives. During today’s call, we may reference non-GAAP metrics such as adjusted earnings per share. You can find a reconciliation of GAAP to non-GAAP metrics within the schedules attached to this morning’s press release. Also, for reference, we posted a schedule on our Investor Relations website showing the year-over-year sales change with and without the impact from currency translation. I want to remind everyone that any forward-looking statements made during this call are subject to risks and uncertainties, the most important of which are described in our press release and SEC filings. Now I will turn the call over to Tod Carpenter. Tod?

Thanks Brad. Good morning, everyone. We are pleased with the results we delivered during the first half of the fiscal year. We now expect to generate full year sales and profit above our original forecast. Scott will cover the guidance in more detail but the midpoints of our new ranges implies sales will be up 3% from last year and adjusted EPS will be up about 8%. I want to thank our Donaldson employees for their contributions so far this year. They’ve done an excellent job executing our strategic priorities and meeting the needs of our customers. Everyday our employees around the world demonstrate the innovation, value and stability that Donaldson provides. I sincerely appreciate the commitment they have shown and their efforts are reflected in our strong performance. In second quarter total revenue was $551 million, up 6.4% from last year in dollars and 7% in local currency. The strength in the quarter was entirely driven by the Engine segment which was up 13% as we compared against a very soft quarter last year. Within Engine there was clear evidence that our strategy to win innovative first fit programs and grow our replacement parts business is working. In the quarter, we also saw some positive macro trends with restocking being the most notable. As an aside, I feel compelled to add a bit of restraint to the recent enthusiasm regarding market conditions. Beyond restocking the signs of stabilization are becoming more apparent; key measures like commodity prices, rig counts and industrial production all appear to be moving in the right direction. While these trends are encouraging there is still uncertainty relating to the timing of sustainable demand driven growth. The mixed outlooks provided by our large customers reinforce the point that it is unlikely that we will see a meaningful turn prior to the end of our fiscal year in July. There is also lingering uncertainty related to policy changes and global economic conditions, which is underscored by the dramatic exchange rate fluctuations in recent months. While our assessment may seem conservative, we believe a cautious stance is appropriate because it gives us flexibility to react to market changes. Turning back to the recap of engine sales strengthened aftermarket off-road and aerospace and defense, offset continued weakness in on-road. Sales in on-road were down 28% from last year with the U.S. accounting for more than half of the decline as the production of Class 8 trucks remains depressed. Part of the decline is also attributable to the strong comp we had one year ago, which highlights the dramatic cyclicality inherent in U.S. truck production. The off-road business reversed a multi-year decline during second quarter when it generated 10% sales increase. Additionally ordering patterns from our large customers continue to be stable. We did not see the typical calendar year-end demand fluctuations and sales were actually up from first quarter. These trends reinforce our perspective that off-road is stabilizing, but it is still unclear as to whether we will see end market expansion in the near term. We were pleased with the aftermarket performance in the quarter, which jumped 20% from a historically low second quarter in fiscal 2016. For the fourth quarter in a row both the OE and independent channels contributed to the year-over-year increase. There were several areas of strength in aftermarket last quarter. The OE channel benefited from restocking, while the growing rig count helped the independent channel. Beyond these market driven tailwinds, we are seeing benefits from executing our strategy. First, we continued to gain traction from winning new programs to provide OE service parts, for example liquid sales were up more than 20% last quarter as a result of this new service part program. Additionally PowerCore remains a strong contributor to overall success as aftermarket sales of this product were up more than 30% last quarter. Finally, Partmo generated sales of $4 million in the quarter, which contributed about 1.5% to total aftermarket growth. As we said at the beginning of the year, our focus is on growing replacement part sales and our first half performance is evidence of the success we have had. Rounding of the engine discussion, sales of aerospace and defense grew 10% last quarter as we saw strength in the commercial and defense businesses. Within commercial, the strength has been coming from fixed wing aircraft, as we are gaining traction with our cabin air system. The Industrial segment was under pressure last quarter with total sales down 4% as currency translation and year-over-year declines in both gas turbine systems and special applications were only partially offset by growth in industrial filtration solutions. Total IFS sales grew 6% last quarter or 7.5% in local currency. We were pleased with the strong replacement part sales, while first fit remains under pressure. On the positive side, quoting activity is increasing in most geographies as current and potential customers respond to our offering, including our LifeTec filters and Downflo Evolution. Within the quarter sales of Downflo Evolution or DFE more than doubled as we continue to expand outside the U.S. The gas turbine business continues to face pressure from an increasingly competitive market. The 36% sales decline was led by a sharp drop in large turbine projects, reflecting a combination of our strategic shift to bid these projects more selectively and customer delays. We expected a sales decline from executing our strategy, but project delays in the Middle East and other regions speak to the volatility in this business. Finally, special application sales declined about 8% last quarter, primarily driven by membrane and disk drives. I will now turn the call over to Scott, for a recap of our second quarter performance and full year outlook. Scott?

Thanks, Tod. Good morning everyone. We are pleased with the quarter, as we converted a 6.4% sales increase in second quarter to a sharp increase in net earnings, as we saw better absorption and expense leverage. Our Q2 EPS of $0.35 was up 25% from last year on a GAAP basis and 20.7% when compared with last years adjusted EPS. As a reminder, the prior GAAP metrics included about $1 million of one-time charges. These items reduced second quarter 2016 GAAP EPS by $0.01 and operating margin by about 30 basis points. Our second quarter 2017 operating margin grew to 12.6% from last year's GAAP and adjusted rates of 10.4% and 10.7% respectively. The improvement from last year split fairly evenly between gross margin and operating expense. Higher fixed cost absorption drove the gross margin up to 34.1% while the expense ratio of 21.5% reflects leverage on the sales volume that was partially offset by a headwind from incentive compensation. Our effective tax rate in the quarter increased to 29.8% from 23.0% in 2016. The prior rate was artificially low due to retroactive benefits from the FAST [ph] tax act and other discrete items. Additionally the mix of earnings lowered the rate last year and pushed this year's rate up. We continue to manage our balance sheet with discipline. We ended the quarter with a gross debt-to-EBITDA leverage ratio of about 1.5 times, right in line with our long-term targets. Compared with last year, receivables are up slightly and inventory is down more than 5%. We are pleased with how we have kept working capital in check, while managing the sales increase. During the second quarter, we returned $23 million to our shareholders through dividends and invested another $10.5 million to repurchase 0.2% of our outstanding shares. So far this year, we have repurchased about 1% of our outstanding shares. Including CapEx of $13 million and reflective of our efforts to optimize working capital cash conversion in the quarter was a robust 112%. Of course the location of cash continues to be a hard topic. So I'll remind you that nearly all of our cash is outside the U.S. Another hard topic is overall tax reform. So I wanted to quickly address a question that many of you have asked. At Donaldson, the U.S. is a net exporter. In fiscal 2016, Donaldson U.S. exports totaled roughly $200 million, while imports into the U.S. were less than half that amount. So we’re talking about small dollars here relative to cost of goods sold, driven in large part by our decade old strategy to build our region to support region production model. We always continue [ph] the full economic impact of production decisions, so our approach will continue to be guided by the interest of our customers and shareholders. Turning to our fiscal 2017 outlook, we now plan to exceed our original forecast for full year sales, operating profit and EPS. I want to underscore a point Tod made though. There are still of lot of unanswered questions, related to the timing and magnitude of a market recovery. While recent trends are undeniably positive, we feel strongly that maintaining the cautious stance is the most prudent approach for keeping our expenses, inventory and other investments in line. We have reflected this balance in our guidance, which includes some puts and takes within the business that yield and adjusted EPS forecast between a $1.60 and a $1.68. The midpoint of this range is 8% above last year and $0.06 above the midpoint of our prior guidance. We continue to expect GAAP EPS will be $0.05 above adjusted EPS, as a result of the Northern Technical escrow settlement from earlier this year. On the top line, total sales are forecasted to increase between 2% and 4% from last year, compared with prior guidance of plus or minus 2%. Included within this forecast is a headwind for currency translation of about 1%. The Engine segment is driving all of the upside in our sales forecast with notable strength in off-road and aftermarket. Our third-party estimates for heavy-duty equipment production are still depressed with ag and mining declines in the mid-to-high single digit range and construction flat to down slightly. We've seen our off-load business pick up. We now expect full year sales will increase in the mid-single digit range reflecting the first full year sales increase in this business since mining's peak in 2012. Aftermarket sales accelerated in the second quarter and we're forecasting the trend to continue through the balance of this fiscal year. The factors Todd mentioned like restocking and the pickup from oil and gas are compounded by benefits from our innovative product and the short cycle wins we've had in the liquid business. Including the benefit of $12 million to $13 million from the Partmo acquisition we now forecast aftermarket sales will increase in the high-single to low-double digit range which is well above our forecast for flat overall market utilization. We also fine-tuned the forecast for on-road and aerospace and defense. Sales of AMD [ph] are now forecast to be up in the low single digit range while on-road sales will be down from last year in the high-teens. Specific to on-road the downward revision reflects slightly more pressure in the US and a modest softening elsewhere in the world. Altogether engine sales are now forecast to increase between 5% and 7% from last year compared with the prior guidance for sales to be roughly flat. On the other side we expect industrial segments sales will be below our initial guidance. Total industrial sales are forecast to decline between 1% and 3% from last year which includes an impact from currency translation of about 1.5% and lower projections for both GTS and special applications. There are no notable market changes contributing to this update in special applications. We sharpened our pencils [ph] for the back half of the year and now see sales being down in the mid-single digit range. The GTS business however is facing increased pressure from the inherent lumpiness of large turbine projects. We now expect sales will decline in the mid-teens with the guidance revision driven primarily by project delays. The decline in GTS and special applications are being partially offset by a lower single-digit increase in industrial filtration solutions which is consistent with our prior forecast. Our fiscal '17 operating margin is now expected to between 13.7% and 14.3%. The midpoint of this range is up 40 basis points from our prior guidance and 80 basis points from last year's adjusted rate. Included within the full year forecast are benefits from restructuring that we did in 2016 which totaled about $12 million and the headwind from compensation expense. In light of the updated sales and profit forecast we now expect another $8 million to $10 million of incentive comp this year bringing the total year-over-year headwind to somewhere between $28 million and $30 million. Another less precise headwind is coming in gross margin as we invest in staffing and premium freight to meet our high service level commitments in the face of increased demand. It's a welcome problem but these charges do affect the amount of incremental profit we deliver. As a reminder, our rate of incremental profit can fluctuate given a variety of factors including the pace of change and the mix of business. Additionally, with fixed expenses accounting for 15% to 20% of cost of goods sold and more than two thirds of operating expense the incremental rate can vary widely. We wrap our perspective on all these things in our full year guidance which does demonstrate our ability to generate incremental profit on a stable sales base. Further down the income statement we still expect other income between $15 million and $17 million and our full year tax rate is now expected to be 27.1% to 29.1%. In terms of capital deployment, we lowered our full year CapEx forecast to between $60 million and $70 million and we still expect to repurchase between 2% and 3% of outstanding shares. We plan to generate free cash flow of $240 million to $260 million and expect cash conversion between 105% and 115%. Now I want to offer some color on the back half of fiscal '17. Compared to the first half our guidance implies strong sequential improvements in sales and operating profit. We also expect to see a bigger step up from the second to the third quarter than we do from Q3 to Q4. Please keep in mind that the comps in the second half are much tougher than the first, so the year-over-year improvement will also be more modest. We have plans in place to leverage and momentum we have seen in the business but we are also focused on the long-term. A notable example, and one that I am particularly passionate about is our global ERP. We closed the quarterly books in the system for the second time now, and I can confidently say that we are gaining a deeper understanding of our business and processes every day. I’m also confident that in that our efforts surrounding the global ERP are part of a journey that will take years. I see a large pipeline of projects to help us increase efficiency, get smarter about ourselves and our customers and take costs out of the business in a thoughtful matter. I am very pleased by the progress to date and look forward to continuing this journey. With that, I’ll turn the call back to Tod.

Thanks Scott. To summarize our sentiment we are encouraged by overall end market conditions but not yet confident that sustainable market growth is right on the horizon. We are however confident in our strategic priorities and our ability to maintain our focus on those things that are within our control. More specifically we continue to act with the future in mind. Our sales teams are in this field building and deepening our customer relationships while our engineers are developing new and innovated filtration techniques and products. The combination of their efforts is perfectly aligned with our strategy, win new innovative first-fit business to drive sales of replacement parts. Over the past few year our customers have become increasingly interested in signing longer-term supply agreements with us because they see how our strategy creates value for them. We used to discuss two or three year contracts but now we are talking about arrangements that can last up to 10 years resulting in strong customer relationships. The strategy begins with the innovative first-fit wins and we continue to be pleased with the in-roads we are making. Our win rates for new programs are at or above historical levels. Importantly a large portion of those wins are incremental business for Donaldson and we have a big pipeline of new opportunities. In liquid for example, first-fit wins with our innovative Synteq XP media are starting to show up in revenue. This product effectively addresses challenges created by high fuel injector pressure and increasing use of low sulfur and bio-diesel. Although the dollars are still small our Select Fuel business which leverages Synteq XP media has increased by nearly 50% so far this year. We are also excited about the progress with down flow evolution in the industrial segment. As I mentioned early in the call, sales of these dust collectors more than doubled in the quarter. Customers continue to respond to DFE's value proposition and the innovative technology will drive our replacement part sales. We also see geographic growth opportunities with this product. We launched in the U.S. in 2015 and began selling worldwide in fiscal 2016. One year ago international DFE sales where only about 10% of the total. So far this year they have grown to nearly 25% of the total while sales in the U.S. are also growing. Another area of strength is the progress we have made to grow our replacement part sales across the company. Year-to-date replacement parts account for more than 60% of total revenue and sales of these products is up in the low double-digit range. We’re seeing growth in both segments and in geographies around the world, which reflects our robust selling and distribution model. We are also investing in our future by developing an ecommerce capability. A comparative advantage of Donaldson has been making it easy for customers to do business with us and ecommerce is another way we are going to reinforce that advantage. We expect to launch the site for selected businesses during fiscal 2018. So there is still some work to be done, but we are making good progress. These are just a few examples of how we are delivering against our strategic priorities. We are confident that our continued strong execution will position us to deliver on our strategic and financial commitments for the balance of this year and in to the future. Now, I’ll turn the call back to Denise to open the line for questions. Denise.

[Operator Instructions] Your first question comes from Nathan Jones with Stifel. Your line is open.

Good morning, Tod, Scott, Brad.

Good Morning.

I wonder if we could just start a little bit in the Engine business there, clearly strong sales, clearly a big increase in your forecast for the year. Could you give us a little bit more color on what you think is fundamental market improvement there versus customer restocking and maybe how long you think that restock could last?

Sure, this is Tod. Relative to restocking and where we are in the cycle of restocking it’s really tough to say. What we have seen clearly is good execution and share gain. We’ve seen restocking. As far as the third component end market increase, really unclear at this time. On the restocking I want to remind you that our sales on the independent channel are roughly 60% of our aftermarket and our OES channel is 40% and you’ll see less of a restocking phenomenon in the independent channel than you will on the OES and we are seeing it on the OES. So where we are within that particular cycle of restocking, it’s not sure, we’re not sure.

Historically could you give us some color on maybe an average length of the restocking cycle, just give us some kind of idea of maybe how long to expect on that?

Again it’s just unclear, we’re looking at what happened in this quarter as an acute event. And really we kind of shrug that off, we take care of our customers. We’re really focused on them make sure that our delivery rates are where they need us to be in order to strengthen our long term relationships, but as far as the longevity of the restocking it’s really tough to say.

Okay, fair enough.

Nathan, this is Brad. One point I’d add on the historic side, just to give you a context when things were going the other way a couple of years ago we were talking about the old rules of thumb on destocking where typically one to two quarters, and then it ended up being 4, 5, 5.5, 6 quarters where we saw more aggressive destocking. So I think part of what’s happened in the market in the last couple of years is some of those old paradigms have changed as well which clearly adds to the uncertainty.

Okay, understood and then just a follow up question on the mining market. I think you said you’re still expecting that to be down mid-single digits this year. I know that does drive some outsize off the market in that. I think people are starting to get more positive on the mining market. Can you talk about what you’re seeing there and what the expectations are going forward, maybe added to 2018 if you have any ideas there?

Sure, I think what you see are articles about the actual mining operators and producers like the Rio Tintos of the world coming out a little more positive on their balance sheet recovery et cetera, and so that’s getting people more positive about the mining sector. But for us it’s really about vehicle utilization and overall quantities of that product, that’s been shipped. And so we continue to look for vehicle utilization. You are looking at highly dependent, look forward in highly dependent mining based economies like Australia, South Africa et cetera. And then it’s still a little modest out there and mixed. So we did not change our projections on mining as a direct result of lack of clarity.

Have you seen any directional change there at all?

No.

Okay, thanks very much for the help.

Your next question comes from Brian Drab with William Blair. Your line is open.

Hey, good morning, thanks for taking my questions.

Good morning.

Good morning. First, just on I guess a little bit more on the restocking, I'm looking at the aftermarket forecast and just looking at first half of fiscal ’17 versus second half of fiscal ’17 and the guidance that you just gave us, where I think you said up high single-digits to low double-digits for the year. And that would put aftermarket up about 8% in the second half of ’17 versus the first half and that seems sort of like just typical seasonality and I'm just wondering if you can comment, does that increase second half over first half in your mind and your model contemplate just typical seasonality or is there continued restocking and is there I guess potentially upside to that number if we see continued restocking?

Brian, I think you’ve analyzed that correct. We would look for the normal seasonality. We built that within our guidance here and that's the way we really look at the aftermarket activity. We see -- we really don't know where we are in this restocking channel if you will, in cycle and so consequently we're really a bit more business as usual on the predictability of things and that's what you're interpreting in the guidance. So I think that's fine.

Okay. Thanks and then I guess, related to predictability and visibility, I'm not sure if this is a great question, because I know you many, many data points that you look at to solve the market and competitive landscape. But does that acquisition of CLARCOR in anyway takeaway meaningful important indicator data points that you had -- I mean that you previously tracked to keep an eye on the market in the competitive landscape?

As far as the way we view the market and the way that we overall forecast the market, it does not, right. Obviously, it takes away just a data point of competitive analysis of how we're doing as compared to a competitive, but as far as the macro trends and how we operate Donaldson company and what we look for within our forecasting, it doesn't change anything.

All right, great and then last one from me, you mentioned the SynTech Product again and that the dollars are still small, but I wonder if you can tell us a little bit more about which products and markets are driving the great growth in liquid filtration and are you taking share there and if you could tell us what percent of total sales, liquid sales account for today given, it sounds like you're seeing great growth in that -- with that product line?

Sure, Brian. The overall share gain that we're experiencing is in fuel. We've been talking to you about fuel and our competitive advantage with some of our innovative technologies that we created over the last three, four, five years and you're starting to see that come forward. We've highlighted that story for quite some time and you're really now seeing that come into production. So we would look to build on that, based upon the share, the clear share gains that we have had in that segment and so it's really fuel driven.

Brian, this is Brad. I'll give you the stats on it. liquid is about a third of total engine and the fuel lube business Tod is talking about is a little more than half of that.

Okay. And liquid as a percent of total sales today, and maybe compared to what it was a year or two ago?

I have to do the math, it's again about a third of total engine, but where it was…

Okay, and that's all -- that's the only place that we have liquid and so you are saying it's all in engine, right, right. So okay.

So liquid in total this year is up in the low teens, so versus a year ago we're – we continue to do quite well in this business.

Great. Okay.

Yes, yeah in the industrial segment, Brian, you see us going after liquid with things like our LifeTec products and other. So you will see our liquid based strategy really starting to go over to the industrial side as well in quarters to come.

Okay. All right, great, thank you.

Thanks Brian.

Your next question comes from Charlie Brady with SunTrust Robinson Humphrey. Your line is open.

Hey thanks, good morning guys.

Good morning, Charlie.

I wanted to dig into a little bit more on the off-road piece of engine. I mean clearly was -- you've touched on a little bit, but I guess I'd just like to a get a little more deeper in granularity into kind of where you're seeing on that, and you talked about some of the restocking but that sounds more like an aftermarket phenomenon then on OE side. I'm just trying to understand the strength on the off-road business from an OE perspective, it just seems a little stronger than we would have thought it would have been to coming into this quarter?

Charlie this is Tod. It's actually stronger than we have predicted in our models as well. And I think the primary comp when you go year-to-year is last year we had year-end shutdowns and extended year-end shutdowns as it was a pretty difficult moment, and you saw across all sectors of the off-road really managing finished goods inventories, and therefore producing less. We did not see those extended shutdowns this year. So in a way it's kind of early easy comps year-over-year but really what carries that strength is less shutdowns across all sectors ag, construction and mining.

Okay. That's helpful understanding that, so I guess I would take from that then, I you alluded to it going into the second half, you don’t really have that same phenomenon. So the rate of increase may be stronger than it was otherwise going to be we thought. But you’re not going to get the similar types of surprising pop to the upside in the second half just because you don’t have the similar phenomenon on shutdown comp, is that correct?

That’s correct. That’s the way we view it and that analysis is what we built in guidance.

Okay. And just on the gas turbine business, on the order delays, it sounds that that's pushed into 2018, is it in fact order delays or you are seeing things may be being pushed out, when you are saying delayed, delayed to date unknown type of delay as opposed to six, eight month type of timeframe.

Two types of delays. So we’ve seen projects that are in hand move out of this fiscal into next fiscal year. But we’ve also seen quotes that were expected to be awarded move out much further as well.

Okay, thank you. That’s helpful, thanks.

Your next question comes from Matthew Paige with Gabelli and company. Your line is open.

Good morning everybody. Just wanted to touch on some points, kind of what you brought up earlier. Have you evaluated, what kind of impact you would see from the administration's tax proposals?

Yeah, I mean we’ve been following that closely. I mean, I provided a little bit of additional information this quarter to discuss, the fact that Donaldson is a net exporter, out of the U.S. So we feel like we’re well positioned there. I am also indicated that our of our cash sits outside of the U.S. so any sort of repatriation changes, we would love to take advantage of. And you know obviously a lower corporate tax rate would help our company. So we feel like we sit in a strong position, in relation to the various tax changes that have been considered and we continue to monitor that every day.

Great. And then how do you view a potential boost in infrastructure spending effecting Donaldson's products in your end market

We are really pleased that the administration is taking look at boosting infrastructure spending. However that would not affect our fiscal ’17 typically, as I want to remind you that we’d end in -- our fiscal year ends July 31st. So any infrastructure spending boost by the time it would roll through the overall end market, would likely be in future fiscal years.

Got it. And then the last question from me is obviously on road class 8 has been under pressure, but seeing some signs of life in envisioned orders. Could you may be provide some color on how your conversations with customers there have gone?

I think it’s really just more bouncing along at the current levels and everybody trying to understand when the U.S. base market which has really driven so much of the headwinds here, when that U.S. market will start to see a turn. We are really with all of our on-road OE's more fixated on winning future business and winning new platforms than any kind of euphoria about end market turn around.

Matthew this is Brad, one thing I would add is just looking at ACT data I guess from our point of view the other positive that’s varied in some of this declines is that, the forecast as they’ve been moving through the year are coming down at a less dramatic pace. I think a year ago the quarterly forecast from -- were moving down by 10% or 15% or 20% each quarter from what they thought, just 90 days ago. And now that seems to a stabilized. Still declining production but at least the forecast seemed to have a better handle on it.

Great. Thanks for the time.

Thank you.

Your next question comes from Richard Eastman with Robert W. Baird. Your line is open.

Yes. Good morning and congrats on the nice surprise, nice quarter. I am sure you’ve breathed a little bit sign of relief here. I have just a quick question, when I look at the geographic growth rates, kind of by segment engine and industrial what maybe strikes me a little bit here is EMEA and the strength in EMEA across the board. Is did -- from a geographic stand point was EMEA the biggest may be surprised to you and is there a macro perspective that you could overlay on to what amounted to 10% growth rate, local currency

No, I don’t think EMEA really surprised. If you take a look at our previous calls I have been talking about the gains we have been making in our after-market strategy and pressing forward with our replacement parts businesses across EMEA and they have been executing very well on those strategies for some time and to a larger extent that really just a microcosm of our comprehensive plan for the year, which is grow replacement parts to offset the headwinds we should experience in the first fit, and really all segments all regions in the company are performing quite well there. So the things that I would suggest about EMEA is that throughout all of this it's held up in the core base businesses a bit stronger than for example the U.S. region cycled down much heavier and there was a less of a drop in Europe. So I think overall we’re pretty proud of the execution across our European organization.

I understand. And then just a quick question as well. Do you have any visibility, when you look at the aftermarket business and the nice kind of bounce there, do you have any visibility into the sell-through in that channel versus your sell-in this quarter?

We don’t Rick, and that’s what really creates the difficultly for us to predict where we are in any kind of an acute event like a restocking.

Okay, and then just maybe last question. Really good incremental EBIT leverage in the quarter and obviously we’re surprised here with the restock and just the acceleration here and the upside in the revenue. As we go -- as we push forward over the next, call it 12 months so we capture the first half of next year, should we expect that incremental to settle down more in the 25 to 30 range or, how do you think about that, because you obviously do reinvest if you feel there is some sustainability in the revenue top line. So should that be the way we’re thinking about the incremental here moving forward?

Hi, Rick, this is Scott. So I mean we were pleased with the incremental improvement we delivered in the first half. We did have a pretty good lift in sales. We have taken our guidance up a little bit on increased sales for the last half of the year. So we are comfortable with the current guidance and as we have always said, we believe that we can slowly improve our profit on increasing sales and that something we’re going to work on everyday. We do have some headwinds coming this quarter, as I mentioned, we have some variable comp that we’re going to have to absorb. We do have some additional margin costs associated with suddenly increase in demand that being freight you know and maybe some additional cost in the plant that we have to manage. But at the end of the day we believe we can slowly increase incremental margins on improving sales.

And is there any issue, Scott, or any concern around any materials inflation, materials cost inflation at the cost to goods sold end?

Yeah, there is certainly some inflation coming. We monitor our commodity prices every day and they are providing a little bit of a headwind going forward. We work to mitigate that, but that’s something that we are aware of.

Okay, okay, very good and thank you and congrats again, nice quarter.

Thank you.

Your next question comes from Laurence Alexander with Jefferies. Your line is open.

Hi, good morning this is Dennis on for Lauren. You mentioned that Ag was going to be down mid-single digits, could you provide some color what you are seeing there, I mean are trough conditions forming or is it just not showing any signs of firming up, just any insight?

Sorry, what was the last part Den. Not sure we got your whole question. Could you please repeat that?

Sure, I think you indicated that Ag was down mid-single digits. I was wondering if any if trough conditions are starting to form, if there is any signs of strength at all?

Within Ag, I think you see Deer for example they took up their latest forecast and so they gave, they signaled some positivity out there. So we do hear those kind of data points and we -- but we did take that into account, because it's as you look outside the U.S. it’s a little bit more of a troubled story with other large based customers. So overall there is clearly mixed signals across the Ag market, and there is just not clarity. And so we just did not feel comfortable altering where we currently stand on ag as we don't see it in our backlogs and we don't really translate that obviously therefore into revenue.

Okay. And then the cost you removed through last year's restructuring or 2016 restructuring, is there any chance both cost could seep back in as some of -- as things kind of accelerate or some of your end markets accelerate?

Sure. We said there was $12 million of benefit coming into this year. Those are structural cost. I would say that we worked to take out. Sales continue to accelerate. We are certainly going to have to address our expense levels. And some of our expenses are fixed, others are variable. But in general I think if revenues are way up then our expenses are going to have to address that. We're cautious in adding infrastructure. So we're very careful about adding in. but we will continue to invest in the future of the company on sales increases.

Okay. and then finally, with your e-commerce efforts, that's coming online in the next year or I think you said 2016. Is using e-commerce unusual for the industry? Is that something Donaldson (phon) would have ever looked to before? I was just wondering what the dynamics look like.

It's not unusual but for Donaldson it represents a new channel just simply because we're very inconsistent in its usage. Today you could order an e-commerce part in some of our businesses in some of the regions. But you can't order a part over the internet from Donaldson everywhere in the world. And that's the thing we're out to change. There will be multiple models of e-commerce, the engine model for aftermarket because we are distribution based partnership model. We'll keep that intact but there are other businesses also that will have an direct end-market model because that's the way we run that business. And so we are building in the flexibility necessary to arm all of our businesses to really use this e-commerce channel as a positive for growth.

Great, thank you very much.

There are no further questions at this time I turn the call back over to Brad Pogalz.

That concludes today's call. I want to thank everyone for listening for their time and interest in Donaldson. I also want thank our employees again. I'm very appreciative with their efforts and because of them I am confident that we can deliver our strategic and financial commitments. Have a good day. Good bye.

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