Ladies and gentlemen, thank you for standing by and welcome to the Donaldson’s Q1 FY 2020 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. [Operator Instructions]. I would now like to hand the conference over to your speaker today Mr. Brad Pogalz, Director of Investor Relations. Please go ahead, sir.

Thanks, Julian. Good morning, everyone. Thank you for joining Donaldson’s first quarter 2020 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 first quarter performance and an overview of what we are planning for the balance of the year. During today’s call, we may reference non-GAAP metrics. Please note that there is 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. I want to highlight two important points in our quarter. First quarter market conditions were consistent with what we expected and we are pleased with our improvement in gross margin. As we look ahead, our perspective on fiscal 2020, sales, operating margin and the EPS is aligned with our prior guidance. We are planning for an uneven demand environment this year and we saw that in first quarter. During 2020, we expect softer sales of new equipment, a stable base of recurring revenue, and strong increases in our strategic growth areas. We also expect operating margin will be up from last year, driven by gross margin. Scott will provide more details later, so I’ll now turn to an overview of first quarter sales. Total sales of $673 million were down 4% from last year. Currency was a headwind of 140 basis points, which we offset with the benefits from both BOFA and price realization. Sales in the Engine segment declined 4.5%, driven primarily by our first fit businesses. On-road sales were down 11% in the quarter, with China accounting for nearly half the decline. We’re now lapping some of our earliest fuel wins in the region and demand has yet to stabilize. As we expand our business with Chinese manufacturers, we expect on-road sales will grow over time. Until then, we are focused on building and deepening these new relationships, winning programs and launching PowerCore in China. In the U.S., we are seeing early signs of the peaking truck market. After growing more than 30% in each of the last two years, on-road sales in the U.S. were about flat with last year. Blowing production of Class A truck is widely expected and that’s reflected in our full-year forecast as well. First quarter sales in…

Thanks, Tod. Good morning, everyone. We generated first quarter sales of $673 million and EPS was $0.51 per share. First quarter operating margin declined 90 basis points to 13.2% and our EBITDA margin of 16.7% was down 40 basis points. The delta between the two rates reflects incremental depreciation related to our significant capacity investments. While operating margin is still our primary metric, EBITDA offers a helpful reference point, as we progress through two years of elevated capital expenditures. As the rate of sales, operating expenses were up 130 basis points from last year. The increase was driven by loss leverage on lower sales and investments in our strategic growth opportunities. For example R&D was up 5% in the quarter, and we are adding more headcount and tools to the Industrial segment to build our connected solutions and thus, collection businesses. We offset a portion of these investments with gross margin, which grew 40 basis points in the first quarter. Importantly, gross margin was up in both segments. The increase was driven by benefits from pricing, along with lower raw material supply chain cost, which was partially offset by lack of volume leverage on lower sales. While we are pleased with the gross margin increase, we also recognize there is more work to do to create a sustainable level of improvement. Our top initiatives include leveraging new capacity; lower the cost of manufacturing and optimize the supply chain; cost takeouts within our mature manufacturing plants and strengthening our part level profitability, including continued refinement of pricing strategies. We expect to complete many of these projects over the coming quarters and we will continue to pursue new opportunities that will further enhance our gross margin. Turning to our other financial metrics. Our leverage ratio at the end of the quarter was…

Thanks, Scott. I’m proud of the work our team is doing to navigate the environment and deliver on our commitments. I’m also proud of the spirit of innovation I see everywhere at Donaldson, so let me take a moment to share a few examples. We’ve announced some new developments with Connected Solutions in the past couple of months, so I’ll start there. Within the Engine segment, we continue to leverage the Filter Minder brand. We bought this Iowa-based company a few years ago because of their capabilities related to sensors and indicators. Today, it’s our center of excellence for our Engine segment’s Connected Solutions business. Our newest product is a wireless monitoring system for truck air filters, which we believe has great potential for fleets. It can be easily retrofitted onto existing systems, giving our customers better visibility into filtration performance and allowing them to optimize service intervals. This technology has clear value to fleets and we also see great opportunities with the OE customers. One of our R&D priorities relates to the move from what we call best effort filtration to intelligent filtration. Ensure we believe we can create more value by designing filters that are right-sized to the customer’s application. Given our deep expertise with filter media development and design, we believe we are uniquely positioned to meet that need. With our breadth of offering and depth of knowledge, we also feel uniquely positioned to meet the needs of our industrial customers. One year ago, we announced an early adopter program for dust collection monitoring and we followed that with a commercial launch this past September. Our new offering, which we call IQ, is a subscription-based service that allows customers to receive real-time information about the performance of their dust collectors. Once again, we made it easy to…

Thank you. [Operator Instructions] Your first question comes from Brian Drab from William Blair. Your line is open.

Good morning. Thanks for taking my questions.

Good morning, Brian.

Good morning, Brian.

Hey. So, Scott, kind of proactively was addressing this. But I was wondering if you could just have a little more detail around the Industrial segment. I’m just looking at the numbers and seeing the guidance for the Industrial segment overall to grow 5% for the year after being down what looks like 6% organically in the first quarter. And then you have the benefit of the both acquisition, that contribution of acquisition revenue won’t be there for the balance of the year. So can you just talk a little bit more about how it looks like you need to grow 6%-plus high-single-digits sort of for the rest of the year in Industrial and how do you do that?

Yes. So I will start, maybe Tod can jump in. So, yes, the guidance is 2% to 8%, as you noted, with the current for IFS being mid-single to high-single, GTS is low-single and then Special Apps is down low singles. And if you look at the implied, as you noted, that comes up a little. The comps get a little bit easier in the second-half. In GTS, it was down a little bit in the first quarter and we expect that to be the weakest quarter of the year. So, when you roll those out, we still see that 2% to 8% guidance range.

Yes, Brian, it’s Tod, maybe a little bit more color as well. It’s clear that what’s happening also, we entered the year talking about the risk relative to industrial base equipment sales were in our industrial air filtration business. I commented that in the script. And consequently, we do recognize that as a risk looking forward. However, we want to emphasize that, we do not see a taper off of quoting activity at this point. We do see a cautiousness in an elongation of quote to order cycles within this first quarter, but we don’t expect it to step down at this point. And that’s important to note as we look to the balance of the guide.

Okay, thanks. So you don’t view this guidance as particularly aggressive, right? And you wouldn’t – would you say, which way you’d lean towards low-end or high-end of that guidance, or just kind of here’s the range and it’s wide given the uncertainty?

Right. We went into the year and we talked about leaving the ranges wide due to the uncertainties that we see. They still remain wide. We also went into the year talking about, if we went to the low-end, the risk would be equipment base revenue. Those all still hold true for what we’ve said 90 days ago.

Okay, thanks. And then you gave some numbers around China. But can you just give us what the percentage of total revenue was in China in the first quarter? And then, I think, you may have given some of the split the decline or growth in both Industrial and the Engine segments in China in the quarter?

Hi, Brian, this is Brad. I’ll take that. China in total is right about 6% of total Donaldson revenue. Engine in the quarter was down in the high singles. Industrial was down in the 20% range. There are a couple of caveats with Industrial that I want to call out the first is GTS is, that’s a pretty small business and that had a pretty notable decline due to turbines in – large turbines in the first quarter. And then on top of it, remember, half of our Disk Drive business comes out of China. So Disk Drive in total is something like mid-teens as a percent of China and that business is just under the secular pressure. So the decline for Industrial is a little bit misleading down 20% range. But while we’re on the topic, I guess, I also want to point out that the couple of things that were encouraging to us are that our engine aftermarket business and our industrial air filtration businesses both had pretty strong growth in the quarter in China. So we are gaining share on the replacement parts side. It’s just that that market and, as Tom and Scott alluded to, that’s more of a volatile market than the rest of the world.

Okay. Thanks, Brad. How does that break down in China between Engine and Industrial?

Engine is a little more than half and again, keep that Disk Drive in mind.

Okay. Thanks very much. I’ll pass it along.

Thanks, Brian.

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

Yes. Good morning. Just a quick…

Good morning, Rick.

Just a quick question around – in the IFS business when we talk about the strength on the process side there, do our wins in process give you visibility at this kind of growth rate through the balance of the year as they kind of phase-in and ship? And then also within process and particularly food and beverage, is that business – are those wins skewed towards Europe?

Rick, this is Todd. So if you take a look at the way our backlog flows through the food and beverage, our process-based filtration businesses, it’s really very similar to all the other more repeatable or replacement parts businesses in Donaldson, a bit of a shorter type of the timeframe, so, say, 90 days or so, if not like some of our equipment-based businesses that give you six and seven months visibility. So that would be the answer to relative to our time sense. We do see good order momentum within that particular business. We’re really right where we thought we would be in our growth rates within the plan. And yes, it is slanted more toward Europe, with roughly about 60% of it being in Europe.

I see. Okay. And then just, maybe just one last question around the Engine aftermarket. Given how that business performed here in this quarter, I guess, you referenced the fact that, the marketplace now, from your perspective, is really being driven by demand and utilization rates. Are you pretty comfortable here that the big step-downs – destocking step-downs are pretty much washed out of the numbers. And as we move forward here, we’re really looking at demand proxy here?

Yes. Rick, if you take a look at the first quarter performance range in aftermarket and we look all across the world, all areas of the world are continuing to move in a positive direction. We’re up year-over-year. Our aftermarket headwinds are a U.S.-based story. And when we further break that down, it really goes of the U.S. at points directly more toward an oil and gas type of the story. And so, therefore, we’re pretty comfortable that it’s more utilization within that particular segment and – so it’s a U.S.-based headwind story.

Okay. And similarly, in aftermarket, again, being U.S.-based, but is Latin America – is that growth rate – is that share gain like in a channel or I wouldn’t think the markets are quite that strong, the business probably isn’t that big. But are there some channel gains in Latin American aftermarket?

There are some channel gains. There’s clear market gains within that particular segment. If you talk to Brazil, for example, and other other countries, we do have a slight phenomenon there, however, to where we’re shifting some of the manufacturing from the United States to our Latin America-based facilities and then shipping directly to customers. So there’s a slight transfer tailwind, if you will. But yes, we also have clear share gains.

Gotcha. Okay, great. Thank you.

Thanks, Rick.

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

Good morning. This is Dan Rizzo on for Laurence. How are you?

Hi, Dan.

The A&D seems to be – and it continues to do very well. I was just wondering what the visibility on that? And when you might think that could be reaching peak as well? I mean, is it just tells you how far out can you see?

So on the defense side of things, where it’s largely a ground-based vehicle, we have a good longtime sense. It’s one of the longest in the companies. I would, however, caution that it gets lumpy within the ground-based vehicles when we get drop in retrofit orders from allies, if you will, that also use our ground-based vehicles are being in United States government’s ground-based vehicle. So we have a long visibility there. We are picking up share within the Aerospace segment, primarily the replacement parts for our helicopter-based business. That’s a little bit shorter visibility more like the typical replacement parts business, but just generally the larger share of our aerospace and defense business. When you put all that OE and ground-based vehicle business together, we do have quite a significant timeframe – time visibility on.

All right. Thank you. Thanks for the clarification there. And then you said R&D is up 5% in the quarter. I mean, given what the different dynamics of everything you guys are doing, is there a point where you think R&D is going to peak anytime soon, or is it going to continue to be elevated, I guess, for the foreseeable future?

It’s – we’re continuing to invest in our opportunities, where we see really opportunities to support our strategy of further diversification in the company and strengthening our technical sciences for filtration. This is the third year in a row, whereby we have increased our R&D by roughly 10%. And so, we’ll continue to do so in support of our strategy. We are on a longer-term pass to increase our R&D spend from 2% to 3% to 3% to 4%. However, I do not feel encumbered to raise it to 3%. I do feel that it’s important to make sure that it’s funded properly to support our strategic chosen initiatives and I think we’ve done a very good job there.

All right. Thank you very much.

Your last question comes from Nathan Jones from Stifel. Your line is open.

Hi, good morning. This is Adam Farley on for Nathan.

Hi, Adam.

Hey. So turning to gross margins and capacity additions, maybe just a little more color on what has been brought online so far and maybe how should we expect those additions and gross margin expansion to sequence going forward?

So this is Tod. I’ll start and then maybe Scott can give a little bit more color. What has been brought online so far is some of the expansions within Europe, some of the expansions also down in Latin America, and in U.S. the major expansion that we have still lies ahead of us. And so, as we talked about our year and as it unfolds when we refer to our gross margin expansion, while we have some good work that’s already hitting the gross margin opportunity, we’ve always talked about the project-based work being more of a second-half story versus a first-half story. And so much of that capacity expansion, where we’ll be really realizing that internal supply chain balancing really lies ahead of us. So we’ll look for that gross margin expansion as it goes through the year to really ramp-up.

Okay. And then with demand looking potentially weaker than expected, are there any additional cost levers that you could pull in the event that demand takes another step-down?

Sure. So this is Tod, again. So when we look at our overall corporation, I think, and you look at our history and how we react to the overall cycles that we experienced within our company, we have a strong history of performing overall adjustments for the transactional base across the corporation and we’ll continue to do that. We have been doing that even in last year in the second quarter in – from the second quarter, third quarter, fourth quarter. And we have done a bit of that also in the first quarter of this fiscal year and we’ll just continue to do that. For us, that’s a standard work in normalizing the overall internal supply-based in support of our customers. And so we’ll continue to look to do that.

Okay, great. Thank you.

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

Yes, thanks for the follow-up. Could I just ask – could we just tease through maybe for a second the gross margin impact, the 40 bps, and Scott, maybe this is for you, I guess. But if we could tease through that for a second, because I think the commentary kind of blew by me a little quickly. But I think you said the raws were down year-over-year, so you’ll get to maybe 20 basis points of the 40 out of price and then raws were down, maybe you could just tease through that a little bit, if you don’t mind?

Yes. There’s a lot obviously in the soup when it comes to the margin improvement. And our whole operating improvement for the year is based on our planned gross margin improvements. As you mentioned, we had benefits from pricing and lower supply chain costs. Those were offset, because our volume was a bit down. And we continue to work the projects, as Tod mentioned, all the capacity expansion. And we’re, I would say, we are bringing on new projects pretty evenly throughout the remainder of the year and we kind of expect a slow and steady improvement throughout the year. So I think you had it right when he talked about benefits from pricing, lower supply chain costs offset partially in the first quarter by lower volumes. And then from there for the rest of the year, we’re expecting 30 to 90 basis points of operating margin improvement and that’s all driven by gross margin. And so we feel comfortable that we’re going to kind of have a slow and steady march up for the next three quarters.

Yes. And that – so that if we did 40 bps here in the first quarter with down sales, if we hold that maybe based on price and lower raws, then the 40 basis points grows in the back-half with these project contributions…

Yes, they gets there.

…and better volume for that matter. Okay.

Yes, [indiscernible] planning.

Okay. Excellent. Thank you, again. Oh, sorry?

This is Brad. I’ll just add one point on that. The raws are going to be more of a favorability in the first-half of the year than the last-half. If you’ll recall one-year ago, prices were higher with some of the key inputs like steel in EMEA than they were towards the back-half.

Okay.

So just keep in mind that, that’s not a bank and steady amount of favorability.

Yes, yes. Okay. Excellent. Thank you.

Thanks.

Thanks, Rick.

We have no further questions. I would like to hand the call back over to Mr. 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 day. Goodbye.

Ladies and gentlemen, this concludes today’s conference call. Thank you for your participation. You may now disconnect.