Ladies and gentlemen, thank you for standing by and welcome to the Donaldson’s Fiscal 2020 Third Quarter Earnings 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 first speaker today Brad Pogalz, Director of Investor Relations. Thank you. Please go ahead, sir.

Thanks, Julian. Good morning, everyone. Thank you all for joining Donaldson’s third 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 third quarter performance, including an overview of how we are navigating the complexities created by the coronavirus pandemic. I want to remind everyone that we issued a business updated press release on April 28, which included some details that we all reference on this morning's call. During today’s call, we will also reference non-GAAP metrics. We included a reconciliation of GAAP to non-GAAP metrics within the schedules attached to this morning’s press release. Finally, please keep in mind 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 hope that all of you and your families are staying safe as we deal with these unprecedented times. One thing the pandemic has brought to light is the hard work of everyday heroes, so I want to express our profound appreciation for the frontline workers that keep the world moving forward, and that includes thousands of Donaldson employees. I'm always impressed by our employees, but I'm particularly proud of their performance during the pandemic. Every day they show up with relentless customer-first attitude, which is more important than ever as we support critical markets like agriculture, transportation, and food and beverage. To my Donaldson colleagues around the world, thank you for everything you do. Since the outbreak began, our decision making has been guided by three priorities: supporting the health and safety of our employees; delivering on our customer commitments and doing our part in reducing the transmission of the virus. Providing a safe work environment is always a top priority, but we intensified our efforts. We have significantly limited business travel, implemented a thorough cleaning regimen in factories and office spaces, instituted remote work policies for all that are able, and introduced COVID related paid leave, while promoting existing employee assistance programs. Our Crisis Response Team reviews these protocols regularly and we adjust when appropriate. Social distancing practices and enhanced cleaning schedules will be in place for the foreseeable future, and we are reopening our offices in various locations around the world. The pace of bringing our employees back to the office will be dictated by guidance from health experts, along with our own assessments of workplace readiness. We are taking a cautious approach and we will remain flexible as we execute these plans. I also want to provide an update on the…

Good morning, everyone. I want to echo Tod's sentiment. Donaldson has great employees. The way we work has changed rapidly during the pandemic, and our teams have stayed connected, remain productive and delivered results. I want to thank our employees around the world for everything you're doing to keep us moving forward. As predicted, third quarter was a volatile period. The demand environment deteriorated from month-to-month and things became more uncertain as COVID-19 spread broadly. Unfortunately, the situation is still unclear. Economic conditions are varied by region and markets, resulting in uneven and unpredictable demand. Given that, we feel it's prudent to continue to withhold fiscal '20 and '21 guidance for our key financial metrics. I will, however, talk about some general expectations during my remarks. So I'll turn now to a recap of third quarter performance. All things considered, we are in good position today. Despite a sales decline of 12%, our third quarter EBITDA margin was flat with the prior year. Additionally, our decremental margin was about 19%, which is significantly better than our historic average in the mid to high 20% range. The favorability was due in part to product mix and lower incentive compensation. So let me take you through some of the puts and takes. Third quarter operating margin was 13.4%, compared with 14% in the prior year. Loss leverage on lower sales was a primary driver of the decline and that impact was compounded by a higher depreciation related to our capacity expansion projects. Based on the nature of these investments, the third quarter depreciation impact was skewed towards gross margin in the Engine segment. Overall, our teams are doing an excellent job mitigating the pressure created by lower sales. In terms of gross margin, plant managers are quickly adjusting labor to account for…

Thanks, Scott. Donaldson company turns 105 this year. We have experience with every type of economic environment, and we have always emerged to become an even stronger company. Our playbook is simple and consistent. We leverage our deep technical expertise to build a portfolio filtration capabilities that we deploy into a diverse set of markets. We are a returns focused company. We think long-term, while maintaining a clear focus on those things we control in the near-term. The pandemic has no impact on this playbook or our strategic priorities, which always starts with technology. Along those lines, I'm very excited to share that our new material research center is nearing completion. This R&D facility is a $15 million investment in building our material science capabilities. We leverage some of this knowhow in our process filtration business today. But the new facility is going to give us significantly stronger platform. We plan to further penetrate the food and beverage market, followed by future expansion in specialty chemicals, electronics and eventually life sciences. These markets are less cyclical. Highly technical and therefore highly profitable, making them an attractive complement to our strong engine business. Technology remains a core part of our engine strategy as well. We want to win new business with products that drive aftermarket retention, while the pandemic has created uncertainty, we are still working with large OE customers on new programs, and their demand for proprietary products is going up as they look to grow their parts business. Through our technology, Donaldson becomes a core part of the customer's growth strategy, giving us a wide competitive moat. The value of these products to our company has been demonstrated year-after-year, so we continue to make investments. We recently introduced a new generation PowerCore filter called PowerCore Edge. It has the…

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

Good morning, everyone.

Good morning, Nathan.

Hi, Nathan.

I guess, I'll start with the short-term questions. Your -- guys, third quarter here stands a pretty wide range of business conditions covering February, March, and April. You said you expect May to be down 24%. Can you compare that to what April was down? I think, out in the market at the moment, we're hearing customers going back to work, but not really doing that much in terms of buying in May, more kind of figuring out what they're going to make, what they need in order to do that, and with some expectation that maybe June gets a little bit better. So, can you comment on whether or not you think April and May are kind of the bottom of this cycle for you?

Sure, Nathan. This is Tod. When we look at April, we had some project-based businesses that had some pull forwards in the very end of the month, and so we had a nice pickup, frankly, better than we had expected, but they were slated to go in our May timeframe. And so, when we look at April and May, actually they were about the same when we combine the two together is the way we would forecast that. So, we did not see a pickup or really further deterioration in May. Now, whether that's bottom, tough to call. We really don't know that. We did see a number of OEs come back to work in the month of May, but we also believe that this will be fits and starts ahead of us just because of the fact that OEs we will be trying to find what their overall first-fit production rates are and their demand pull through will be. So, we're looking -- again, we look at April and May to be roughly about equal, and we're a bit more cautious about June and July based upon the first-fit based businesses that we see.

Okay. Thanks for that. You guys have finished a lot of these capacity additions, those were supposed to be accretive to your gross margin level. So, I'm sure that probably helps with the decrementals as we go through this. Can you comment on what kind of decrementals you're expecting to post here in the fiscal fourth quarter?

Hey Nathan, this is Scott. Good morning. So, yes, we are proud of the accomplishments that we've had with all of our expansion projects and those help us to normalize the supply chain as we’ve talked about to reduce our cost, to improve our freight situation. And so, as you stated, we would agree that that helped our margin in the fourth quarter to be let down. Sorry, in the third quarter. The fourth quarter, we would expect that help to continue. The big question is, what will the volume be that will drive the absorption, and that's kind of a tough call right now. But we expect to continue the tailwind from the initiatives that we've undertaken.

Nathan, this is Tod. Maybe just a little bit more color. So, the discretionary expenses are being fantastically controlled by decision makers all across our company, everywhere in the world. And some of those things such as travel and entertainment, we're down 80% on normal run rates. We're not going to be able to withhold that over the months ahead. Eventually, we have to lighten that back up and let people really press back into the marketplaces. And so, there's some puts and takes there such as the comp activities that Scott talked about also that give us a little bit more favorable wind in the third quarter than we would expect looking forward. A little bit tough to predict the overall decremental margins. Clearly, we're running better than we would have expected on the models as we went into February. And the commitment that we have to all of you is that we will continue to be very diligent and controlling what we can in our operational expenses.

Thanks Tod. Just one quick one on the potential OEM aftermarket channel inventory stocking. It might be a bit of a hard question to answer, but do you have any information on, maybe what that additive revenue or how many points of growth that additive to revenue that we might have to pay back here at some point? And I would think that maybe that inventory destocking doesn't come for a little while if those OEMs are still worried about their own supply chain, they might run that inventory a little higher for a little longer.

Yes, let me -- I think that's a fair comment. The way that we would see it is we're not sure when it will come. Clearly, the OEs are holding on the inventory. We already saw some destocking on the independent channel. Clearly, OEs are holding on, likely a little bit longer until they find what their pull through rates will be, really difficult for us to predict at this point in time.

Nathan, this is Brad. And maybe to put a fine point on some of the details that Tod mentioned in his remarks, the independent channel of our aftermarket business, sales through that channel typically are in the neighborhood of 60% of aftermarket, and in the last quarter, it was about 55%. That channel slowed more substantially than the OE channel. Now, we never know precisely whether or not an order is a restock or a destock, so we can't really talk to that specifically, but we do look at the trend between independent and OE to see if there's any sort of alignment or lack of alignment. And clearly, this last quarter, there was a lot of lack of alignment. About a 10 point spread year-over-year between the two. So that gives you a little bit of a sense of magnitude of what we saw on the OE channel, but to the point Tod made, I mean, it's really tough to see where that would come back to.

That's helpful. Thank you very much. I'll pass it on.

Thank you.

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

Hi, good morning. Thanks for taking my questions.

Good morning, Brian.

Hi, Brian.

So if I -- again, I'm as Nathan did, I'm going to think about some near-term questions into sorting through the impact of the pandemic, but if I use the assumption that April and May were roughly, similarly tough, is it fair to assume that at this point, based on what you saw as you exited May, what you're hearing from the customers that June and July probably are tougher than the environment that you had in February and March, and thus the fourth quarter is down sequentially on the top line for sure?

Yes, really hard to say Brian.

Could you give any …

Yes. Let me just give a little bit of color. Really hard to say on that Brian, just simply because clearly we see order incoming patterns and we try to match that up with all the plant shutdown notices. We do have some customers that came back in May, then shut down, then plant shutdowns in June and so that's the fits and starts that I referred to earlier. And so therefore because of that situation, and then on again, off again, it's really difficult to predict where we are on this first-fit cycle of things. There is no consistent line to be drawn at this point.

So there's no way, Tod, that you can say, well I saw things better at the end of May versus the beginning?

No, I -- …

Okay.

… we actually did that analysis. I was very curious about it, and after partialling through every morsel of it, I gave up on it because -- yes, I couldn't really say that with strong conviction that I can give you a line on that.

Okay. And then just asking that -- I mean, it's a question about decrementals, but just asked in another way. Let's just say, given all the levers that you pulled, if revenue, just as a scenario, if revenue were to be similar in the fourth quarter compared with the third, would gross margin be about the same, or up or down from what you reported in the third?

Yes, I will start. So we had a good mix in this last quarter. So I think if you made some assumptions, it's obviously you’ve to do in this kind of situation. But if our mix held, I think we can maintain those margins. We have a lot of different businesses in there, there's a lot of puts and takes going on, so it's hard to say. But I think if we presumed a relatively consistent mix and reasonable sales, I think our margins could hold.

Yes. And I would agree with Scott. I think obviously our biggest variable, if you will, is how much of the first-fit business will come back within the fourth quarter, which is headwinds overall to margin base mix, and then our Special Applications business, also, if should that experience some headwinds as we would expect, that will also be some headwinds to the overall gross margin performance in the corporation. And so those are two of the significant mix components that we continue to keep a strong eye on in order to best understand where we are.

Okay. And then just the same question on operating margin, given the flat revenue scenario.

Yes, the biggest impact would be we had some incentive comp adjustments this quarter. So that was a $6 million expense reduction and naturally catch-up from the first three quarters. So you have to annualize that, it wouldn't be as large in the fourth quarter. We would continue to manage our expenses aggressively and work to keep our discretionary expenses at low levels in light of the sales situation. So I would expect that to continue. We are at our lowest level in three years in terms of OpEx. So we are pretty proud of that performance. I think that shows that we're managing expenses tightly, especially in light of the fact that we continue to invest in the initiatives that we've talked about in the past. So I think save the incentive comp adjustments, I would expect our operating expenses to continue to be managed tightly in the fourth quarter.

Yes, and I just want to add a little bit of color, Brian. I think it's important to understand that we are controlling what we can control. But throughout all of this, we are taking a long-term view, and we are not going to jeopardize the strategic health of this corporation. And that is the way we are managing.

Got it. Understood, Tod. Thanks. And Scott, just to be clear on the -- you're talking about bonus accrual as -- is that -- was a tailwind in this quarter to margins, that isn't a big a tailwind in the fourth quarter. Did I understand that correctly?

Yes, that is correct, both bonus and long-term incentives.

Okay. And then just lastly, these aerospace and defense orders that are -- this has been a good market for you. Does that continue, or some of these larger projects maybe that you're doing there fall off? Thanks.

So headwinds on -- clearly headwinds on fixed wing based aircraft being it made up on ground-based defense vehicles and helicopters. We would expect that performance to continue about where it is at the moment. Our teams have done an excellent job around the world really filling in that gap and that headwind that fixed-wing aircraft is presenting.

All right. Thanks very much.

Thanks.

Thanks.

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

Good morning. So just a couple of things. First, on the bonus accruals. Can you help us think through what normalization would look like? Is that a headwind in 2021, or 2022?

Yes.

And secondly, can you help us with -- can you peel back a little bit how you are thinking about planning assumptions for 2021, but also the longer-term growth like what's really changed from the playbook that you had after the industrial recession, or after the financial crisis. I mean, is there anything in the playbook that's changing in this environment?

Yes, maybe I will start with question number one and I will let Tod take question number two. In terms of the incentive comp, so we had a $6 million benefit from adjustments to the first three quarters and that results when we expect that performance to be less than planned, we don't plan to pay full incentives and therefore we have a reduction. We haven't had our plan for next year, but I would expect our plan will be established for next year and that plan would include a bonus that would likely be higher than this year's bonus, and so therefore you would get a headwind from those expenses, assuming everything else equal and through the third quarter benefit was $6 million, we will get a fourth quarter benefit as well. So that will be a headwind for next year.

And Laurence, this is Tod. So the long-term playbook, nothing has changed for us. In fact, we would argue the investments we made into our corporation over the past two years with capacity expansion to allow for supply chain normalization -- internal supply chain to feed our customers really now works to our advantage, and we are deep into that re-normalization, if you will, and that realignment of that internal supply chain to help really drive gross margin improvement. And so we are really happy where we stand to the execution. We are very proud of the execution of the projects that we have in flight. So we sit in a good position. Longer term, where we're investing and looking at further diversification of the corporation hasn't changed either, we haven't slowed any of that down, and I want to emphasize that we continue to play a long-term game.

And then could you also give an update on your thinking about the Asian market, specifically I think the Chinese NPC had a lot of themes around sort of tighter environmental controls in the work environment and so forth. How is that tied playing into your thinking about investments in Asia relative to other regions?

Sure. In China, we’ve actually had some good momentum, China with their Blue Sky initiatives relative to our dust collection business over there is really helping draw project-based business forward. And so we’ve growth in China, very nice growth on the industrial base side of things that help support the Blue Sky initiative. We continue to invest and bring technology over into China to answer those needs of the Blue Sky initiative. And then on the Engine side of things, as they continue to increase the technology, we have been winning there with PowerCore, we've been winning so much so that we're putting a PowerCore line in China because that aligns best with our region to support region growth. So we continue to press forward with our strategy. The regulation changes that are happening in China are working to our favor and we are doing a good job at share gain there.

Okay. Thank you.

We have no further questions. I will turn the call over to Tod Carpenter for closing remarks.

Thanks, Julian. As we end today's call, I want to make one more comment. The tragic event that recently took place in our Twin City's community and the violence that followed are greatly disturbing. I offer my deepest condolences to the family and friends of George Floyd and with healing to those affected by the subsequent events that unfolded following the tragedy. I want to stress that Donaldson is committed to sustainable change and we stand united with our communities and nation to stop the senseless cycle of discrimination. That concludes today's call. I want to thank everyone listening for your time and interest in Donaldson Company, and I hope that you and your family and friends are safe. Goodbye.

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