Ladies and gentlemen, thank you for standing by, and welcome to the Donaldson Q2 FY 2021 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 will now hand the conference over to your speaker today, Mr. Charlie Brady, Director of Investor Relations. Thank you. Please go ahead sir.

Thanks. Good morning and thank you for joining Donaldson's Second Quarter 2021 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 second quarter performance, along with an update on key considerations for fiscal 2021. During today's call, we will reference non-GAAP metrics. A reconciliation of GAAP to non-GAAP metrics is provided 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 now turn the call over to Tod Carpenter. Tod?

Thanks, Charlie. Good morning everyone. Looking at second quarter results, we are pleased with our performance. Second quarter sales were up 3% versus a year ago and up 7% sequentially from the first quarter. Our second quarter results demonstrate the strength of our business model, with replacement part sales, providing valuable stability as we grew market share in key markets and geographies. During this quarter, we also built momentum in first-fit sales in our Engine segment and we're seeing increases of incoming orders across our Industrial segment. We are pleased to see the uptick in second quarter sales and incoming orders within our first-fit equipment businesses. While this creates mix pressures in the short term, it also sets the stage for replacement parts in our razor to sell razor blade strategy and provides continued confidence that the worst of the pandemic-related economic impacts are behind us. We played the long game during the pandemic, maintaining our disciplined focus on the future and avoiding the temptation to make potentially shortsighted decisions on our cost structure. During the second quarter, we took planned full actions with a longer view towards optimizing our organization and our cost structure, primarily in Europe. We incurred $14.8 million in restructuring expense and expect annualized savings of approximately $8 million once the restructuring activities are completed over the next 12 months. Excluding the impact from our restructuring actions, gross margin was up 30 basis points from the prior year, as lower raw material costs including benefits from our procurement initiatives more than offset the increasing pressure from an unavoidable mix of sales. With continuing momentum, we expect full year sales to be up 5% to 8% over 2020, including favorability from FX of about 3%. We're also projecting adjusted operating margin to increase 60 to 100 basis…

Good morning, everyone. As Tod said, we are pleased with our second quarter performance. Sales were up 2.6% from the prior year and adjusted operating income grew 7.6%. Given the uneven macroeconomic environment, it was a strong quarter in terms of both absolute growth and leverage. Looking ahead, we plan to build on that momentum. As I said many times, we are committed to increasing levels of profitability and increasing sales. I know I'm repeating myself, but I also want all of you to know that that statement is a guiding principle for us. One way we deliver on that commitment is through select optimization initiatives, which is how I would characterize the restructured actions we took in the second quarter. Most of these activities are happening in Europe and all of them support our long-term objectives. For example, we are centralizing key aspects of our aerospace business, giving us a strong platform for when the market returns to growth. We are moving the production of certain compressed air products to Eastern Europe, where we have an excellent team and a competitive cost structure. And we are centralizing our European accounts payable and customer service functions to improve standardization and optimization, giving us the ability to leverage common tools as we grow. The projects we initiated in the second quarter should generate annual savings of about $8 million once fully implemented, with about $1 million realized in this fiscal year. These actions drove a second quarter charge of $14.8 million and resulted in an operating margin headwind of about 220 basis points and an EPS impact of $0.08. We have excluded these charges from the calculation of our adjusted operating metrics and the with and without details can be found in this morning's press release. We are confident in the…

Thanks, Scott. As we saw during the first year of our fiscal year, improving economic conditions are complementing the benefits from consistently strong execution of our strategic priorities. Of course, achieving the significant sales and profit growth projected in the second half is not without risks. Costs are going up. Demand for raw material is quickly increasing. The global supply chain is getting stretched and above everything else, the pandemic is still hanging over all of us. While the pandemic is certainly a new occurrence, the other pressures are not. We have successfully navigated them time and again due in large part to our talented employees and strong customer relationships. As always, we will manage our costs, execute strategic price increases and pursue profitable sales. It's a straightforward plan and it has served us well for 106 years, giving me confidence we are in an excellent position to deliver a strong finish to fiscal 2021. I will also say that I'm more excited than ever about our long-term prospects. As a reminder, our strategic priorities include expanding our technologies and solutions, extending our market access and executing thoughtful acquisitions. The recent announcement of our newly formed life sciences business development team represents a significant move that supports all those priorities. As previously announced, we hired a new Vice President to build and lead the life sciences team and drive our growth strategy. This team comes to Donaldson with tremendous industry experience including strong M&A backgrounds. With the leadership in place, we are now poised to drive our expansion plans into the fast-growing, highly technical and highly profitable life sciences markets. While there are no specific details to share today, we are highly confident that technology-led filtration has a critical role in these spaces. With our strong balance sheet and disciplined…

[Operator Instructions] Your first question is from the line of Bryan Blair with Oppenheimer.

Thanks. Good morning, guys.

Good morning, Bryan.

I just wanted to level-set if we can on a couple of the guidance points. With IFS flattish for the year that implies approaching high single-digit rate down in the back half, so decent momentum there. How does that break down between first-fit and replacement sales?

Bryan what's happening is right now I would tell you in the IFS markets, as we went into the pandemic, essentially people started to – on the CapEx side pull back and go to if it breaks, fix it type of mentality. We've now seen our CapEx-based orders change from just a fix-it mode to hey, let's replace it. And you see that in our incoming order cycle. What we have ahead of us is that mental shift from a replacement type of a cycle to an invest-and-expand cycle. So we see orders now picking up on the first-fit cycle of IFS and picking up on the equipment side and that's being led by the US and China. We haven't given specific breakouts of overall of the two pieces but we do see an increasing momentum on the equipment side today.

Okay. Very helpful color. And it looks like the midpoint of guidance ranges implies a little over 20% incremental margin in the back half. How should we think about that by segments? And in that context any additional color on volume mix price cost impacts would be appreciated.

Yes. So I mean there's a lot of factors in there. Maybe starting with Engine. First of all we're going to have in terms of gross margin, in general, we're going to have raw material increases and freight increases across both businesses. And so those will be a constant. In terms of volume, our volumes will be relatively flat in Industrial with a plus two to minus two guide and up pretty significantly in Engine with the guide. So Engine will have a stronger ability to leverage the volume and that'll help them. And then our cost-reduction projects that we have going in operations will help reduce or offset the headwinds we're facing. So we expect positivity in both. Engine has a much larger growth foreseen and so they'll have a little bit of an edge up because of their ability to leverage that Industrial won't have.

That makes sense. And Scott you mentioned the Investor Day targets from 2019. And obviously the world has changed since then. If we think of what was put out there by segment, it looks like Engine maybe made it comfortably in the revenue range that you had targeted initially for fiscal 2021. Is the 14.8%-plus operating margin in play assuming momentum continues into next year? And then on the Industrial side I know that's a bit more of a stretch from run rate revenue but as they scale to $1 billion plus is the 17% margin or higher still achievable, or have there been some structural changes or increased investment rate that may lower that target?

Yes. So I mean I have the book right here in my hand. I carry it with me everywhere I go, because we still keep these targets in mind, and we're still driving towards those numbers that we laid out. Certainly, Engine is further along than Industrial because their growth has picked up. So I think you've captured it appropriately in that we're closer to the Engine targets than we are in the Industrial targets, because of their current growth trajectories. And so therefore they're a little bit ahead in the race, but we expect and are still driving both sides of the equation to get to the finish line. And as we've said before the targets are still in play, but we've just pushed them out because of the pandemic-related stalls in revenue growth.

Okay. Fair enough. Thanks again guys.

And the next question is from the line of Brian Drab with William Blair.

Hi, good morning. Thanks for taking my questions. And I may have missed the answer to this one, but just quickly the restructuring in EMEA is focused on which segments? Is it more Industrial, or can you just talk about where that focus is or is aerospace?

Yes. I can take that Brian. This is Scott. Good morning.

Thanks. Good morning.

So the restructuring the total charge was $14.8 million. If you break that down between gross margin and OpEx, it was about $5.8 million in gross margin and $8.9 million in OpEx. And that's split across the company both in Engine and in Industrial. And Engine it's a little more focused on aerospace as we mentioned. And the Industrial example I gave was the move of some of the production to Eastern Europe. And then some corporate functions, which included for example centralization of accounts payable and also the centralization of the customer service functions. So it's relatively spread out and broad across various functions with the targeted initiatives that I talked to. So hopefully that provides you with a little more color. It's approximately $0.08 of EPS.

Got it. And is that something that's been contemplated, or is this more a response to situations that we're seeing now related to the pandemic?

Yes, Brian. This is Tod. So I would tell you on the Aerospace and Defense move we had contemplated them. I think the pandemic exacerbated the need to do them much quicker than we had expected. So clearly that's more of a pandemic response. All the rest of the other moves were in our longer-term plans. They were in our sights and it was time to move forward.

Got it. And there's -- Tod, there's quite a bit of discussion around China. It sounds like things are going really well there now. Can you update us on whatever you're willing to disclose in terms of a percent of total sales that China accounted for in the quarter and percent of On-Road sales that China accounted for in the quarter?

Yes. Let me have Charlie look that up within the model and get back to you here Brian, so…

Maybe while he's looking that up, can I just ask just generally Tod you also talked about PowerCore quite a bit in China. And how are your margins on PowerCore in China relative to the rest of the world? And just in general, Power margins in the, I guess, particularly in the Engine business in China versus outside China lately?

Overall, PowerCore right now in China is a little bit tougher, but it's because it's an import product for us today. We don't have our PowerCore line up and running in China. It is now in China. It's being installed in China. So, when we get that pivot to in-country for country revenue, then it will be on par with the balance of the world in PowerCore. Right now it's a little bit of trouble because of importations and such a long way of shipping. Overall, the Engine-based margins in China are on par with the balance of the world, I would say. Off-Road is on par with Off-Road. On-Road is on par with On-Road with the rest of the world.

Great. Okay.

Brian just to answer your question on China growth for the entire company in the quarter, China was up 31% or in local currency up 23%. And then we'll follow up with you on the balance of the splits relative to the segments Brian. Okay, next operator.

Your next question is from the line of Richard Eastman with Baird.

Yes. Thank you. Thanks for the questions. Nice work on the quarter. Tod, just curious we're all kind of watching the commodity prices and you've referenced it a number of times here, for the second half being a little bit more of a headwind. But I'm curious if you kind of back up a little bit, I'm listening to a lot of the OEMs that you supply and in particular one of them on the ag side is really suggesting some pretty significant price increases for their products into the marketplace. But is there an acknowledgment on the OE side that customer base that maybe there's more of an acceptance if you were to raise prices as a vendor to them in the current market with the current commodities pressures emerging post-pandemic? Is the pricing environment to you feel a little bit more flexible than maybe it has in other past rebounds?

Short answer, no.

Okay.

I think it's -- really -- I think, Rick, it's going to behave as it has every other time. It's standard work for us. We know when overall inflationary pressure's up down. We -- it's the same type of a cycle all the time. It's constant support of the OEs with what's happening. I would acknowledge the inflationary pressures that we're seeing particularly on steel. Steel is a pretty rough commodity out there right now. The increases are frankly seeming excessive. And so that's forcing us because of availability to buy on the spot, so spot markets. And so consequently we are seeing some inflationary pressures across steel. And as you know that's our largest commodity across our products. We do have protections that would push some of that off into the fourth quarter. Those inflationary pressures though likely come harder next year, because we have the full year of those than it would for the balance of this fiscal.

Okay, okay. Fair enough. So we'll have that headwind. And then just as a kind of dovetail into -- we see the pressures here on the commodity side. Obviously, the incentive recovery here -- wages incentives back into the model. But as you think about out to fiscal 2022 and we're looking for maybe a normalized conversion margin -- incremental margin at the OP line, are we -- how do we feel about that? Because it looks like in the second half here with the pressures we've spoken to will be around 20% conversion. But how do you start to think about this model producing a conversion margin of -- give me a range where that should start to normalize here.

Yes, this is Scott. Good morning Rick. So we're definitely committed to higher levels of profitability and increasing sales. So we need to continue to drive the incremental earnings and we're committed to that. And we had 37% this quarter which is much higher than our historical average say in the 20% to 25% range. So we're going to continue to drive to those numbers. We wanted to invest in the company in our Advance and Accelerate portfolio which we will continue to do but with an eye towards we need to be able to deliver those incremental margins. I would say consistent with our overall history it can jump around in any one quarter. But longer term I think you see we're in the 20% 25% range. And we want to continue to drive to that because we're committed to increasing levels of profitability on increasing sales and you got to have margins in that range to feel comfortable about delivering that at least that's how we look at it.

Okay. All right. Fair enough. And then just my last question really quickly. Tod as we add resources into the Advance and Accelerate portfolio and in particular on the life sciences and adding to those capabilities and maybe using M&A to boost the technology portfolio for life sciences is there -- what's the willingness -- or what's the thought process around looking at more of an adjusted EPS type of metric? And I'm thinking as much about comp plans for senior management as I am just from a reported standpoint. And again the assumption being that it'd be somewhat costly. There could be some more -- could be increased purchase accounting amortization. And just curious how you think about that metric given the longstanding objective at Donaldson for EPS growth?

Yes that's an excellent question and something we've thought about. And it's a little bit hard to know until you have a deal in hand how you're going to address that. But I think those are all excellent points to consider as we move forward with this life sciences strategy and I think we will consider those points.

Yes. And just maybe a little bit more color here for you Rick. We certainly discussed that. We haven't landed on a hardcore spot as to whether an adjusted type of metric is the appropriate way to go. Certainly it makes it all more comfortable if there are no adjustments. But we do have those conversations. We just haven't landed in a hard spot on that yet.

Yes, yes. I just I think of it more as from my vantage point or our maybe our vantage point an adjusted EPS number is almost accepted these days. But I think my point being that, it's always felt like a bit of a restraint at Donaldson to pay up for some of these -- for developing a presence in some of these other markets.

I can tell you Rick that we have a strategic plan where we recognize particularly in the life sciences sector what the multiples are to enter that point and to do deals. We're very realistic about that multiple and that type of behavior will not hold us back.

Yes, fair enough. Okay, great. Thank you.

And our next question is from the line of Laurence Alexander with Jefferies.

Hi, just following up on that. As you extend your footprint in the life sciences should your R&D to sales or your capital intensity change? So if we think about just the total investments you'll be making in that area would there be a shift in the intensity of the business?

Yes. It's a great question Laurence. It's Tod. So if you remember we have long been a 2% to 3% R&D as a percent of sales type of a company. And at Investors Day I had referenced that we would be moving to 3% to 4% of sales. And it was all with this change in mind in order to support that. So we've already put that target out there letting you know that hey we're going to go to 3 to 4. That feels very comfortable to us in order to be able to do everything that we would need to do to go organically into the life sciences sector and then support it as well. Given the overall size of our corporation it would support it on the R&D for supporting acquisitions as well.

Right. Thanks.

And your next question is from the line of Nathan Jones with Stifel.

This is Adam Farley on for Nathan.

Good morning, Adam.

So turning to Engine Aftermarket the business returned to growth after five quarters of year-over-year decline even growth sequentially for the second straight quarter. So are you guys seeing any restocking yet in the different channels the independent channel or the OE channel?

Yes great question. So what we have seen is pull-through levels at the independent channel and the OE channel. And so we would tell you that the majority of our growth clearly is being pulled through. We would however caveat and say maybe 1% of that particular growth that we see would be increased as a result of some of the supply chain issues that is being felt across the industries and that we have some of the OEs, as well as the independent channel worried about stock-outs. And so they probably ordered ahead just a little bit, but it's not like it's been a big inventory step-up or anything like that. It's really pull-through levels with this slight protection if you will for their markets.

Okay. And then on the pricing side, I know it's harder for the first-fit business but are you guys going out with any price increases on the Aftermarket side?

We returned to our typical pricing behavior which would suggest to you that we took pricing actions effective January 1st, across multiple businesses in the corporation. We did that as normal. And so, we are in the normal type of pricing activities in our businesses. Should we see that inflationary pressure increase as in other inflationary cycles, we would not hesitate to take a secondary -- a second pricing action where needed anywhere in the world. But right now, we returned to our normal pricing behavior.

Okay. Thanks for taking the questions.

And the next question is from the line of Dillon Cumming with Morgan Stanley.

Great. Good morning guys. Thanks for the question. Sorry to ask a question on your On-Road business. I think it's pretty clear that everyone is kind of expecting an inflection here over the next couple quarters. And I just wanted to ask you've talked a little bit about in the past some of your exposure on the hydrogen side. So, as you look across your order book are you seeing customers within your On-Road business that are starting to look at more Industrial Air Filtration offerings for hydrogen trucks or SUEV. That's the only detail. I guess it's mostly still kind of legacy SUV business?

We would tell you that across the hydrogen sectors, we see more customers talking about it, curious about it, working with our engineers to try to understand what would be necessary from an absorption and a filtration stand point of view. They've not announced formal programs to actually build powertrains and that in that sense but it's certainly an increased level of conversation across the overall market yes.

Got it, that's helpful. Thanks. And then maybe if I can spin the conversation back to margins. I'm asking this question in a little bit different way. But Scott you were very clear. You outlined the number of timelines that you see kind of in the back half and into next year talking about the price cost instead of comp some mix headwind here. But you're obviously still giving a pretty strong margin guide. I think that's already been alluded to. Do you see the restructuring actions that you've taken that $8 million is fully offsetting those headwinds that you've outlined, or do you still feel like there's some kind of cost creep in the back half that's kind of offsetting some of those restructuring tailwinds there?

Well, I mean we're really complete with the restructuring actions, so we don't foresee any more restructuring coming currently. So, we wanted to show it with and without numbers so we took the $14.8 million and we pulled it out. And so all the guidance provided is on an adjusted metric basis. There'll be $1 million estimated of savings from the restructuring this year and then an $8 million estimated savings once the actions are completed within the next 12 months. So, we feel good about that. So, we project margins to improve so we're trying to offset that by improving nicely in the back half but those costs are behind us now. And we expect margin and op margin improvements into the third and fourth quarters of this year.

Yes. And Dillon this is Tod. It's important for everybody to understand that the restructuring actions that we took are complete and that we do not have any additional plans pending out there and that they have all been rolled out in the organization.

Got it, that's helpful. Thanks Tod. And then maybe just to wrap it up. It's clear and you guys outlined at the Investor Day in 2019 obviously, Donaldson is definitely a different company now than it was over the last industrial cycle. You guys have taken a lot of cost out. You kind of realigned your capacity footprint and you come out of some of these more attractive end markets. I guess Scott you alluded to kind of committing to profitable growth as revenues increase. But I guess looking back versus the last cycle are you kind of confident that you're not going to see the same level of margin choppiness as these inflationary prices impact that business, or do you feel like it's still a bit too early to tell there?

I think it's a little bit too early to tell. When we talked about the inflationary pressures clearly the commodities that we have are steel. That's number one. Media is number two call it. Oil-based products or urethanes number three. You know what the long-term outlook for oil -- a barrel of oil is which would give us pressures. Media has its own pressures. And steel, frankly, right now is frankly, a bit unfair to the world I would expect if you look at the indexes that are going out there. So, there are clearly some headwinds that could crop up that would provide choppiness to us. But in the company the more choppiness, I think that could happen immediate is the mix situation that we typically get off of the OE-based balance that we're seeing on the Engine. And so the greater the OE mix up that we get that would likely provide some choppiness in the more near-term quarters with the inflationary headwinds being in the out quarters. That's standard work for us. We get it. But as you build your model that would be the type of thing to consider.

Okay, great. Appreciate the time guys.

Thanks.

And there are no further questions.

Thanks Tabitha. That concludes today's call. I want to thank everyone listening for your time and interest in Donaldson Company and I hope that you, your families, and friends are safe and healthy. Good bye.

Ladies and gentlemen, this concludes today's conference call. You may now disconnect.