Good morning. My name is Denise, and I'll be your conference operator today. At this time, I'd like to welcome everyone to the Donaldson's Fiscal 2019 Q4 Earnings 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, Director of Investor Relations, you may begin your conference.

Thanks, Denise. Good morning. Thank you for joining Donaldson's fourth quarter and full year 2019 earnings conference call. With me today are Tod Carpenter, Chairman, CEO and President of Donaldson; and Scott Robinson, Chief Financial Officer. This morning, Tod and Scott will provide a summary of our fourth quarter performance and an overview of what we are planning for the new fiscal year. During today's call, we will reference non-GAAP metrics such as adjusted earnings. You can find a reconciliation of GAAP to non-GAAP metrics within the schedules attached to this morning's press release. I want to remind everyone that any forward-looking statements made during this call are subject to risks and uncertainties, which are described in our press release and SEC filings. With that, I'll now turn the call over to Tod Carpenter. Tod?

Thanks, Brad. Good morning, everyone. We set several new records in fiscal 2019. Sales reached an all time high of $2.85 billion, adjusted earnings per share of $2.21 were 10.5% above last year's record and we invested $0.25 billion in our future with $150 million of CapEx expenditures and $100 million for the acquisition of BOFA. On top of investing for the future, we returned nearly $230 million to shareholders through dividends and share repurchase. By these measures, 2019 was a solid year for Donaldson Company. I want to thank our employees for their contribution and continued commitment to our stated purpose of advancing filtration for a cleaner world. We have a strong plan for 2020, which Scott and I will talk about later. But first, I'll share some thoughts on fourth quarter sales. Total sales of $727 million were in line with our forecast and slightly up from last year. Pricing added 1%, while gains from BOFA and revenue recognition accounting offset a currency headwind of 2%. Results in the quarter highlighted the uneven demand environment, Engine sales were down 1% and slightly ahead of projections while the industrial sales were slightly below projections with a 3% increase. In Engine, the forecast favorability came from Aerospace and Defense. Sales were up 4% last quarter with first-fit orders driving the growth. As expected, On-Road growth moderated to 2% last quarter, which follows nearly two years of significant growth in the U.S. and China. While heavy duty truck production in the U.S. is likely at peak, our fourth quarter sales grew at a robust rate of 26%. In China, sales were down as we lapped a 600% increase last year. As we have previously discussed, our new programs in China are with local manufacturers that have more order volatility than their…

Thanks, Tod. Good morning, everyone. In 2019, we focused on supporting our customers, enhancing our global processes and strengthening our foundation for future growth. This year, our focus is navigating an uneven demand environment and driving gross margin improvement. I'll share some thoughts about 2020 after a quick recap of 2019. Overall, we're pleased to have delivered fourth quarter sales and EPS that were both in line with forecast. In constant currency, sales were up 2.3% last quarter and GAAP EPS was $0.45 versus $0.78 last year. The year-over-year change was largely due to tax reform. We had a $0.20 benefit in 2018 compared with a $0.16 charge in 2019. A portion of the charge related to final regulations for the Tax Act, and we also had some strategic restructuring of our legal entities. With the flexibility enabled by tax reform, we simplified our structure to more easily match global cash with operating needs. Please note that the restructuring charge resulted in non-operating expense this year compared with income last year. Excluding non-recurring items, fourth quarter adjusted EPS grew 5% to $0.61 and audit settlement led to a better than expected tax rate, which was offset by a lower than expected margin. Operating margin was down 50 basis points last quarter, or 40 basis points without the revenue recognition change. Lower incentive compensation contributed to a favorable expense rate, which partially offset the gross margin decline. At a high level, we didn't make as much progress on gross margin as we had expected. Pricing offset higher costs in the quarter, which we feel good about, but we still have work to do on key initiatives, including line transfers take ups within our manufacturing process and strengthening our part level profitability. Market level mix pressure was also one thing that held…

Thanks, Scott. I think it's clear, but just to reiterate, our focus this year is navigating uneven demand and improving gross margin. Our global team is aligned around this mission and each area has plans in place to achieve this result. That's our tactical plan. But we will also drive our strategic plans. We are a returns-focused company that is committed to long-term profitable growth. So I'll share a few examples of our progress. As always, Donaldson's story begins with innovation. We plan to spend $65 million on R&D this year. That's up 7% from 2019 and another year of developing breakthrough technology. Material science capabilities are the biggest opportunity for us, and the new research facility is under construction. These technologies can be applied in many areas like Process Filtration. The customers in the food and beverage industry cared deeply about the integrity of their products, which creates an opportunity for us to further leverage our advanced LifeTec filters. Sales of Process Filtration are planned up again this year and we see a long runway ahead. We also leverage new technology in Venting Solutions. These high-tech products protect sensitive devices and parts. And this business is the one place at Donaldson where we are targeting the automotive industry. To that point, we recently launched a vent that protects battery packs, which is critically important in electric vehicles. We see a big opportunity in this new space and we are excited about the role of Venting in our future. Connected Solutions is another unique offering for us. With remote sensing, we can provide end users with real-time actionable information about their dust collector performance. Based on our research, this level of support is highly valuable, further solidifying our brand as an innovative and customer-focused partner. We are also innovating the way we sell and we are doing that through e-commerce, which we launched nearly two years ago. Since launch, we've invoiced more than $480 million in sales through hundreds of thousands of transactions. There have been millions of sessions from customers around the world and those figures should grow again this year. For the Engine business, e-commerce gives us an opportunity to better serve existing Aftermarket customers. They appreciate the efficiency and we appreciate the speed and cost savings from processing the orders. The same is true with our Industrial customers, with one added benefit. We turned on the ability to receive guest orders earlier this year, and that can drive incremental revenue from customers we couldn't efficiently serve in the past. Cultivating innovation is a core principle at Donaldson and we see it everywhere in the company. With our excellent employees, clear strategic focus, and disciplined approach to investing, I am more confident than ever in our ability to create long-term value for all our stakeholders. Now, I'll turn the call back to Denise to open the lines for questions. Denise?

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

I'd like to just start off in IFS, and that part of the guidance. You guys here have got mid-to-high single-digit growth in IFS in 2020, which on the surface looks pretty strong in this kind of macro environment. It looks like 1 point to 2 points from BOFA, probably offset by 1 point to 2 points of currency headwind. So you're still looking at organic growth in that range. I would've thought Industrial CapEx -- new Industrial CapEx is probably down in 2020, Industrial production is probably flattish. So maybe you could just bridge that gap for us, how you get to -- what's pretty strong growth there in an environment that's not that strong?

Sure, this is Tod. So, Nathan I think you have your numbers built in that model accurate. BOFA will add $9 million to $10 million of that growth. And then when we really consider the comprehensive portfolio of what's in IFS, we -- while there is that CapEx portion of our dust collection business or our brand we call Torit, that likely will face some headwinds. Also in that IFS business, in our Advance and Accelerate portion of the portfolio, is our dust collection Aftermarket business, which we've been growing, frankly, at high-single-digits for a number of years. And we have good opportunities in taking share in China based upon the Blue Sky initiatives there. We have good momentum in Europe. We have multiple growth opportunities across the Americas. And then also don't forget that IFS carries our Process Filtration business, which we've been growing at double-digits for multiple years and we look for another year of strong growth. So we roll that all together and IFS has some really strong opportunities for us in fiscal '20.

Second question here maybe just on the cash conversion. You guys are spending pretty heavily last year, this year, or this coming year on the strategic initiatives. Can you maybe give us an update on how long we should expect this kind of level of CapEx? When we should return to a more normalized level, what that is and what the long-term free cash flow conversion targets are?

Yes. So -- hey Nathan, this is Scott. So it's consistent -- it's still consistent with what we said at Investor Day. So this year, we ended right on our target of $150 million of CapEx. And we said at Investor Day and in the past, that we were expecting higher levels of investment last year and this year. So for this year, we have continued elevated levels of $110 million to $130 million. And the purpose for that is to finish the projects that we have in-flight. So we've been adding significant amounts of capacity and we need to finish these projects and grab the returns to help with the margin improvement. So we feel good about where we're at. We're right on line with the projects and we have to complete those. Longer term, this spending will come down. We expect a more average or normal range will be 3% of revenues. We said our cash conversion is 80% to 95% this year, and that's with CapEx of $110 million to $130 million. So we expect over time that will improve as we come back to a more normalized CapEx spending of 3% of sales. So we're still at elevated spending with slightly lower cash conversion and that will improve as we bring down the CapEx spending.

And you would anticipate $100 million plus long-term in terms of conversion?

Yes, I mean, $90 million to $110 million, depending on the revenue growth and what other things we're doing. But that's a reasonable range.

And then just on gross margins. You guys called out gross margins as the big driver of 30 basis points to 90 basis points of margin expansion. And clearly, you'd be growing margins here outside of any kind of volume leverage. Can you maybe talk about the biggest initiatives that you guys have got, that are going on to drive that gross margin improvement? What you're looking at in terms of price cost tailwinds? I assume that will be in fiscal 2020. And just any information you can give us on what's driving that margin improvement?

Yes. So, I mean as I said, we were disappointed in our margin improvement for this year. We did not accomplish everything that we wanted to, and that's why our margins ended up a bit short. But the projects are in-flight and that's what that CapEx relates to. So, number one is, complete the projects we have in-flight and drive the returns that we expected out of those. As we complete those projects, we will begin to normalize our supply chain and improve our inbound freight and focus a lot more on regaining efficiencies with cost takeout and allow our teams to spend more time on raw materials. We have to work on our product level pricing to improve products with low margin parts. And we're going to -- we had a 1% increase for pricing this year that will drive any costs associated with raw material increases to more of a neutral position. In terms of media, we are expecting slight increases in media costs this year, and that's one of the reasons that we have to continue to increase our prices to offset the raw material impacts. That's kind of a overall summary on all the things that are going into margin, and why we believe we have great opportunities to improve our gross margins going forward. And we are going to drive those projects to completion.

And maybe just to add a little bit of color here, Nathan, is that overall the organization is really focused on and every region has specific targets, every business is focused. They understand this is the number one problem in the corporation across the entire leadership. This is really, from an operational standpoint of view, our focal area.

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

At the Analyst Meeting, you talked about the $100 million target for cost cutting and clearly discussion of cost cutting so far today on this call too. I'm just wondering, do you have maybe a little more urgency around that $100 million, maybe pull some of that forward, accelerate that schedule somewhat? And in the -- I guess, it's about five months only since the Analyst Day, but where are we on that $100 million program at this point?

Sure, Brian. This is Tod. So we still feel strongly that $100 million is a proper target. We embrace that challenge. We have specific plans across our operations teams. Now, the lead time of some of those projects, we had urgency even at Investor Day relative to the $100 million. And so, the opportunity to accelerate that from what we had thought is really not there. These projects are multiple quarter projects that we have in-flight that we're really pressing hard on in order to bring forward. But it's still the target that we covered, it's still being executed on, but I do not see opportunity to really accelerate that.

And then given the -- not a huge change, but change in trajectory in the top line versus what we discussed at the Analyst Day over the next few years, is there any change in your plans for capacity expansion or reducing capacity potentially, given that change in trajectory?

Yes. Brian, Tod again. So this is what we talked about in Investor Day as well. We have a multiple year, five-year plan within our operations teams. And what we did in order to expand the capacity is we pulled forward by year, sometimes as much as three years, many of those two years ahead are in within that five year plan when we expanded capacity. So we're really just executing what were our plans to begin with, and so consequently, we really feel good about where we are. And frankly, that allows us to now really work hard at normalizing our internal supply chain for our customer base. And that's what our focus is today. We're comfortable with where we are on capacity and we'll just continue to execute that plan.

And then just one last one, kind of along the same lines. Just wondering, as these end markets are challenged at the moment or at least many of them are, is there any way that you can accelerate getting some of these new end markets up and running, especially chemical, electronics, medical, pharmaceuticals, some of these things that you talked about at the Analyst Day to offset some of the pressure?

So, we're clearly pressing hard in the Process Filtration, but also with the markets that we talked about and we highlighted this at Investor Day as well. The sales cycle on those, in order that we have validation, are often multiple year type of activities. We have Process Filtration well in-flight, people are pressing hard. But we're as much as two years to three years into that cycle already, which is the reason why we're seeing some momentum and doing quite a nice job. The others are still going to take some time. And if you remember, on that whole medical opportunity, we still need to advance our material science opportunities and we'll continue to do so. The other one we didn't talk so detailed about in our Investor Day is our Venting product. And so Venting is a good opportunity and we're pressing hard on that, which is the reason why in my prepared remarks, I really highlighted about our opportunities in automotive, in supporting electric-based vehicles within Venting. So that's a good opportunity that we'll be pressing harder in order to grow as quickly as possible.

And just quickly, Tod, can you make any comment on August versus what you guide in terms of overall demand?

Everything we've experienced in August is baked into the guidance that we gave for the full year.

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

If we could just circle back for a minute on the gross margin, can I just ask from a -- you gave some decent guide on the op margin improvement, 30 basis points to 90 basis points. You did mention OpEx will be up some here, mainly incentive comp. But is the target -- what would be the target for the gross margin improvement? What would be that range? Would it be 100 basis points to -- maybe you could just lay that out? And I'm curious how much mix should be beneficial for you this year.

Yes, I mean we -- this is Scott, Rick. We factored certainly mix into the guide and we are working to grow our Advance and Accelerate and grow higher margin products, right, which you can mix the company up by investing in higher margin products. And that's something we're always going to be working to do with our Advance and Accelerate category. So that helps with mix, and that's one of the ways we're driving our gross margins up. So we've said we're going to be up quite a bit in op margin and that's mainly driven by gross margin for the most part, with just a little bit of a headwind from our operating expenses. So all the improvement is really coming solely from gross margins. And it -- all the things that we've talked about with Nathan's questions and on my script, and we have to finish those projects to improve our margins. But gross margins are the key for this year and the operating margin improvement is going to be driven solely by gross margin improvements. And part of that comes from mix and part of that comes from all the other things I've referred to with regard to improving our margins.

Okay. So might we expect 100 to 125 of gross margin improvement, basis points?

Well, it's -- 60 basis points of operating improvement is the midpoint for margin and that all comes from gross margin. It's a little bit of a headwind from the expenses. So all of that operating margin comes through gross margin improvements.

Yes. Rick, this is Brad. I would pull on that. That's the thing to keep in mind. If you just pick something within the range and for the exercise it's 60 basis point, assume that the incremental incentive compensation, the math on $10 million just gets into the neighborhood of 30 basis points. So we've got to offset that right away. So that's kind of where you get to it. You start talking way into a 100 plus basis points, and that's just above where we'd expect to end the year. But we certainly expect strong improvement.

And then one would expect -- again, given how this year lays out relative to the comps, relative to the deceleration we're seeing in some of the engine markets to be sure, one might think that -- again, that maybe the first half revenue was down. We still may see first half gross margin. The financial metric still across the P&L are probably still down in the first half, and then the improvement for the full year that you're laying out is really going to be second half driven when the sales growth kind of materializes against the easier comps. Is that how the P&L should shake out first half, second half?

Yes, I think that's a fair characterization, Rick, especially when you start to look at our gross margin projects -- improvement projects that are in-flight. They're more back-half related, based upon we have to finish up those projects in order to drive what we would expect to take place. So, yes, clearly it -- that correction, if you will, ramps up as we progress through the year.

And this is Brad. I'll add to that. Scott touched on this. But keep in mind, the incentive comp headwind starts August 1, the first day of the fiscal year.

And then just as a quick follow-up here maybe. On the Industrial side of the business, it's good to see finally, the gas turbine forecast maybe being up low-single-digits. We should probably presume then the equipment side of that business is kind of based out, it's probably a little north of zero. But the big risk there around the equipment side seems to be washed out of the numbers. Now we're kind of talking about replacement parts. Is that accurate there that the risk of gas turbine kind of bottoming here is finally -- maybe finally in the rearview mirror?

Hi Rick, Tod. Yes, that's absolutely right. Your characterization is fair. We look at our large turbine projects as being somewhere between zero and 5%. So it'll be mid-single-digits at best this year. So yes, it's washed out. We've been highlighting that in the last couple of quarters, saying that it's less of an overall risk to the corporation and that really aligns well with our long-term strategy whereby the growth of the business will come from Aftermarket or share gains within Aftermarket. But then also keep in mind that we have a small turbine project base there, things such as oil and gas pipelines, offshore oil rigs, things like that. And that we -- is essentially the bulk of our project base business, and we call it small turbine as opposed to making projects for the power grid.

Because overall, your sales guide for the full -- for fiscal '20 for the full year, it looks like you've kind of stress test this pretty well this early in the fiscal year with the guide. And maybe the risk to the low end, the minus 2% revenue is kind of concentrated down in the Industrial sales and maybe macro risk. Can I summarize it that way?

I'd say, the risk would be, yes, more macro geopolitical of what's going to take place. The risks of uncertainties that we're all experiencing in our daily lives now, and yes, I think that's fair to characterize and wrap up as a risk.

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

I guess two quick ones. Can you give an update on how your thinking has evolved around the M&A opportunities, both valuations that you're seeing and the areas that might be more likely over the next year or so if the current environment continues? And on the Chinese side, could you speak a little bit about what you're seeing in the Aftermarket there, and what you now see as a timeline before the Aftermarket really kicks in as a growth driver for your China business?

Hi, Laurence. This is Tod. Let me take the M&A portion first. So M&A continues to be part of our long-term strategy. Nothing has appreciably changed from a market standpoint view. We still work it as part of our normal base processes. We would suggest that we still have a robust pipeline. It's very strategic. We remain a disciplined buyer. So our behaviors all remain intact and we have seen no appreciable change in the overall M&A markets at this point. Longer term for China, relative to the Aftermarket, we have some momentum, particularly on the Industrial side within China because of the Blue Sky initiative in our IFS-based businesses. And so we are starting to see the Aftermarket portion of that already come through. And that is one of the reasons why we would suggest our IFS has a good growth opportunity and that is baked into our fiscal '20 guide that you have received today. So we think that China has some momentum already that we are seeing in the Aftermarket, and we're really quite happy with that.

And there are no further questions in queue at this time. I'll turn the call back over to Tod Carpenter for closing remarks.

That concludes today's call. I want to thank everyone listening for your time and interest in Donaldson Company. Have a great rest of the week. Good bye.

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