00:02 Good morning. My name is Chris, and I'll be your conference operator today. At this time, I'd like to welcome everyone to the Donaldson First Quarter twenty twenty two 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] 00:31 Now I'll turn the call over to Sarika Dhadwal, Donaldson's Director of Investor Relations.

00:38 Good morning. Thank you for joining Donaldson's first quarter of fiscal twenty twenty two earnings conference call. With me today are Tod Carpenter, Chairman, CEO and President; and Scott Robinson, Chief Financial Officer. This morning, Tod and Scott will provide a summary of our first quarter performance and details on our outlook for the balance of fiscal twenty twenty two. 01:01 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. Additionally, 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. 01:22 With that, I'll turn the call over to Tod Carpenter.

01:25 Good morning, everyone. I’m pleased to report record first quarter results. We grew our sales to seven hundred and sixty one million dollars, sales were up twenty percent and EPS was up twenty six percent versus last year. It was an encouraging quarter for Donaldson, particularly given the backdrop of well documented supply chain disruptions, labor shortages, and significant cost inflation. 01:54 In the face of these challenges, our team rose to the occasion and delivered, and I’m proud of what we accomplished. As we look to the remainder of the year, we expect the macro headwinds to persist. While we are well-positioned to deal with these challenges, there is no doubt that we will feel near-term impacts. 02:18 To address these macro challenges, we are pulling many levers, including raising prices to mitigate the impact of cost increases, utilizing our geographically-diverse manufacturing and distribution footprint to meet the needs of our global customers and to mitigate labor-constraint issues, particularly in the U.S. and aggressively recruiting and competing for talent to expand our strong team of dedicated employees. 02:46 As we navigate the year, we are also investing for future organic and inorganic growth. We continue to spend on our R&D to ensure we remain the leader in what we do best, technology-led filtration. I'm also pleased to have two new acquisitions under our belt. First, we recently announced the acquisition of Solaris Biotech. Solaris is a designer and manufacturer of bioprocessing and filtration equipment used in food and beverage, biotechnology and other life sciences markets. 03:22 We've been working hard to expand our reach in the life sciences, and this acquisition is the first step in our string of pearls strategy to get there. We can now leverage Solaris' technology and customer relationships to advance our capabilities in…

11:00 Thanks, Tod. Good morning, everyone. To sum up the first quarter, our employees did an excellent job delivering solid results in a tough environment. First quarter sales grew twenty percent, operating income was up twenty three percent and EPS of zero point sixty one dollars was twenty six percent above the prior year. 11:21 First quarter operating margin increased forty basis points to fourteen point one percent. The increase was from leverage on higher sales, which was partially offset by gross margin pressure. Driving into gross margin a bit further, the impact of raw material cost inflation built through the quarter. This impact was compounded by the fact that we were experiencing a deflationary environment one year ago. 11:45 As we look at the remainder of the year, we will be impacted by ongoing inflationary headwinds. We will continue to build on the success we have had implementing price increases in several of our businesses to offset the cost pressure. That said, the full impact of the pricing benefits may take longer to materialize due to certain large OEM customers. We are in ongoing discussions with these customers, and we'll continue to drive towards offsetting the incremental costs we are currently absorbing. 12:14 On the operating expense front, we are pleased with our discipline and success in optimizing our levels of spend. We continue to invest in our Advance and Accelerate portfolio. This spend was offset by controlled expense management elsewhere in the organization. First quarter operating expense as a percent of sales was favorable by approximately one hundred sixty basis points, driven primarily by volume leverage. Other expense was favorable this quarter by one point five million dollars, mostly due to a pension curtailment charge we took in the first quarter of last year. 12:51 Turning to the…

21:00 Thanks, Scott. As we look to the rest of the fiscal year and beyond, I would like to touch on a few key paths we are pursuing to build on our success and push the company forward to the next stage of its evolution through profitable growth. 21:17 First, we are continuing to invest in our existing Advance and Accelerate solutions, including Process Filtration, dust collection and replacement parts and Engine Aftermarket. Second, we are diversifying the company's offerings, both organically and inorganically to ensure we meet the needs of our existing and future customers globally. 21:39 On the organic side, we are committed to our R&D. We previously invested fifteen million dollars for our materials research center, which will enable further development of our polymer-based chemistry solutions. It is also important to note, we increased our R&D budget this fiscal year by ten percent over last year. 22:01 On inorganic diversification, the recent acquisitions of Solaris and P-A Industrial Services are just the beginning. Solaris is the first inorganic step on our journey to create a life sciences business. We are excited about the value we can add through our global market reach, science and technology, filtration capabilities and our ability to invest for future growth. This, combined with Solaris' market reputation and product portfolio are a winning combination. 22:35 Third, we are investing in our people and recruiting the right talent to drive the company forward. We have made people investments in areas such as life sciences, food and beverage, and ESG. Donaldson employees with their dedication and hard work are the core of our business. 22:53 Before we close, I also want to touch on our ESG efforts as this is an important part of our culture. We began global implementation of our environmental health and safety policies in twenty eighteen. Safety and greenhouse gas emission reductions are near-term priorities and we're making progress. 23:16 We are well on our way of reducing CO2 emissions by six thousand metric tons by the end of fiscal twenty twenty two. Our company is geographically and culturally diverse. We have strong governance, including a seasoned board with balanced tenure. Also critically important is the alignment of the compensation of our board and management with shareholder interest. So, as I look out over the long-term, I strongly believe we have the right strategy in place to continue delivering value to our stakeholders for years to come. 23:54 Now I'll turn the call back to the operator to open the line for questions.

23:59 Thank you. [Operator Instructions] Our first question is from Brian Drab with William Blair. Your line is open.

24:12 Hi. Good morning. Thanks for taking my questions.

24:14 Good morning, Brian.

24:15 Good morning. First, can you -- and I may have missed this. But can you talk about the big step up in the operating margin in Industrial versus what you saw in Engine and just the difference in the end markets and raw material situation that you're seeing in those two segments?

24:40 Yeah. Hi. This is Scott. Hi, Brian. Nice to talk to you. So, our Industrial products operating margin last year was thirteen point seven percent and this year it was sixteen point four percent. So first of all, keep in mind, we're coming off of COVID comps with tough volumes and then weaker leverage. So, we're pleased with the performance of our Industrial business. 25:06 We're investing in higher margin opportunities that are driving the mix up and they're doing an excellent job of leveraging the new volumes that they're experiencing, especially as compared to last year when we were kind of under the COVID bug a bit. Engine margins were down twenty basis points from thirteen point nine to thirteen point seven. And that's a result of the inflationary pressures we're seeing and the pricing actions we're executing and our pricing actions are behind our cost increases. 25:44 And that's one of the reasons we brought our margin guidance down for the year because we're assessing our inflation and our pricing and trying to determine the ultimate impact of both of those two. So, we're pleased with our margin performance this year. Overall, we're committed to higher levels of profitability on higher sales. We did fourteen point zero total last year. This year we have a guide of fourteen point one to fourteen point seven. So, at the midpoint, that's fourteen point four or forty basis points of improvement this year, which I think would be a good accomplishment for the company and something I think we can deliver.

26:22 Yeah, Brian. This is Tod. Maybe just one point to add. So as Scott referred to and as we have referred to in prior calls, our ability to mix up on the Industrial side with our strategic execution is really what you're seeing sum up, but also, as we've talked about multiple times about our pricing model in Industrial and the fact that we can take quicker action in Industrial rather than against some of the other backdrops and headwinds that we feel on the Engine-based OE side. So, Industrial, it does reflect some positive pricing actions as well.

27:00 Got it. And in IFS, you have this momentum in food and beverage, is that higher margin business…

27:10 Yes, entire company average.

27:13 Okay. And can you say maybe give us a rough idea of what percentage now does process filtration account for within IFS?

27:22 Yeah. I believe we said in the past, it’s roughly between eighty million dollars and ninety million dollars So we've grown it rather nicely and we continue to have good momentum.

27:36 Okay. And then last one just on this topic, are there specific applications I guess particularly in Europe and that you're winning and are there some big share gain opportunities potentially in those applications as you look globally or even with other customers in Europe?

27:57 Yeah. So, we're pretty broad-based with the wins that we have. It's heavily replacement parts related at the moment with the acquisition of Soliris though it brings us the opportunity to do more food and beverage type project-based work as well, because they have the applications expertise and we have the sales teams to be able to combine those strengths. And so, we would look to grow our food and beverage business based upon a combination of those two into a broadening product portfolio, if you will.

28:36 Got it. Okay. Thank you very much.

28:39 Thanks, Brian.

28:41 Our next question is from Dillon Cumming with Morgan Stanley. Your line is open.

28:47 Great. Good morning, guys. Thanks for the question.

28:51 Good morning, Dillon.

28:51 Good morning. Wondering [indiscernible] I think it was Soliris for a second, I mean, obviously, I know a huge transaction from a revenue perspective, but it does seem like the technology and kind of market advantages were a big focus of the deal. So, I guess just to what extent do you feel like some of the value proposition there was just being able to leverage any kind of technology advantages that they had within kind of the larger Donaldson platforms as you kind of go after these new customers and new end markets.

29:14 Sure. A couple of things that they bring to Donaldson Company from a product standpoint of view. So, they manufactured bioreactors. So, if you don't know a bioreactor essentially is a piece of equipment that allows you to grow sales or tissues in R&D or manufacturing a buyer -- biopharmaceutical type applications, but also food and food additives. And so, when you get into that overlap with our sales force, where we're have growing momentum within the food and beverage activity, it allows us now to really take our sales team combined with their applications and equipment experience and look to drive into that type of the food and beverage type business as well. 29:55 But it also brings a foundational filtration capability called tangential flow filtration within biopharmaceutical and within that whole business process. It's a filtration capability that Donaldson currently does not have. We have overall polymer chemistry-based membranes that we could use, but this is a specific type of application in biopharmaceutical that allows us now to really step a little deeper into that medical space with the application of that technology and we'll look to do that.

30:36 Okay. Yeah. That's very interesting. Maybe switching over to the guidance for a second. I mean, given the level of top line out performance this quarter, it just seems like that might have supported a bit of a higher increase I guess, in terms of the revenue outlook versus where you revised guidance too. I mean, are you able to say are you kind of baking in any kind of cautions regardless the supply chain backdrop still. I guess, do you feel like you might have visibility into kind of a sharper growth acceleration in the back half of the year. I'm just kind of underwriting that view.

31:01 Yeah. I mean, we talked about this last quarter and we're trying to take a prudent view towards the overall supply chain difficulties that we face and trying to balance that with our revenue forecast. So, we were able to do a bit better in the first quarter, but our costs are also up. So, we have to factor in that we have to raise prices a bit more than we originally planned and that also drives revenues up. So, it could always be higher. We try to take a reasonable approach. We were at a midpoint of seven point five and now we're at a midpoint of ten. We think that's a reasonable place for the company based on where we sit right now.

31:50 Okay. That’s helpful color, Scott. Thanks. And then maybe just one last one for me. Todd, I think you mentioned the kind of figure out the venting business for batteries and power trends in the auto industry. I'm not sure those meant to be a comment around battery electric powertrains or kind of legacy IC out of those, I was curious if -- just kind of provide some more color there? If it was the comment around battery electric, I guess I'd also be curious you kind of apply similar technology and batteries from the of highway space as well?

32:16 Sure. It's really meant to be a statement about our technology and our opportunity for growth that where we feel like we have a very strong technological leadership position within that space that we have brought over from frankly our disk drive-based technologies as well as other foundational technologies invented in our corporate technology group. And we often look to spread those across the technology that we invent spread those across multiple business units and in this case, integrated venting solutions is clearly the winner there. And so, we're looking to press harder to the automotive opportunity because we frankly can and we see a lot of the battery based automotive space, really given us double-digit and about company average growth and you'll see that we'll expand that business and we'll continue to invest strongly in that business to be able to get that to at least between three percent and four percent of our overall company revenue.

33:17 Okay. Great. Thanks for the time, guys.

33:21 Our next question is from Robert Mason with Baird. Your line is open.

33:26 Yes. Good morning and thanks for the question as well. I wanted to go just a little bit deeper on, I guess the first quarter, you did outperform your typical seasonality in the quarter and deliver more revenue. Todd, I just want to see if you could comment just on how the incoming order rate look where your backlog ended up at the end of the quarter versus year end? And just your thoughts on where maybe channel inventories are at this stage as well?

33:56 Sure. Incoming order activity remains very strong across the corporation. It's obviously led by the United States across all Industrial and Engine-based businesses all in markets, so very strong in the U.S. I would say it's strong in Latin America, same across both segments. I would say it's strong in Europe across both segments all end markets. Asia-Pacific, I would say it's good across Asia Pacific, but a little bit more trouble than China. So, China is the only weak spot in both Engine and Industrial, we have seen a bit of a bit of a pullback there. We baked all of that within the guide. 34:37 Our backlog remains very high. Our delinquency rate to our customers remained at an uncomfortable position and non-Donaldson like position that we continue to work very hard to improve and even as we see this higher order level come in our backlogs are at -- our higher ship levels, our backlogs have not gone down. We do see the typical seasonality that you see in the December timeframe. So, nothing out of the ordinary, nothing suggesting that it's falling down out there.

35:21 And so it's fair to infer that your customers really are not restocking. This is almost hand to mouth type deliveries.

35:30 Yeah. On the inventory restocking question, the supply chains are really causing a more troubled ability for our customers to be able to accomplish restocking. And so consequently, at these high levels, it's still all pull through and so we've not seen on the independent or the OE channels, the ability of our customers to be able to build that inventory up.

35:59 Yes. Just as a follow-up, I wanted to see if you could provide any color on how the gross margin curve may look as we go through the balance of the year. So, the extent you expected to be down fifty basis points to one hundred basis points. For the full year, are you comfortable saying that the second quarter could be a trough in the gross margin? Do we – we go lower and then come back up with some better pricing, better volume leverage in the second half of the year?

36:32 Yeah. So, we maybe – just at a high level, right, if you think about our prior guidance to our current guidance, so we essentially said at the end of the last quarter, we thought we had three hundred basis points of headwind. And if you go through my comments on the script, we now forecast that to be five hundred basis points of headwind. And that's one of the reasons that -- that's the main reason we took the overall margin guidance from flat to slightly down to down fifty to one hundred. So, you can see, we have additional two hundred basis points of headwind and we won't be able to offset that one hundred percent this fiscal year. We do think over the longer term, we will balance out the price versus cost. And we have to work through that with our customers. But the hardest quarter with the new headwind that we're seeing is the first quarter -- is the next quarter, right, so obviously, as the raising prices we're chasing the cost going up. 37:36 So our next quarter will be the heaviest headwind quarter. So, I think your thinking is correct. The biggest challenge will be the next quarter, and then as pricing layers in from what we've done last year and through this quarter and into next quarter, that will help offset the price increases that we're facing.

37:56 How much within the fifty basis points to one hundred basis points down for the year? How much -- we've seen inflation continue up since you’ve guided in September. How much additional inflation is built into that from where we stand today?

38:14 Yeah. So well, I mean, we originally projected the cost we were paying for materials, for example to be up eight to ten and we now project that to be up twelve percent to fourteen. And so that's the additional headwind that we're facing. In addition, we've added one hundred basis points of headwind forfeit rate and labor costs. So that's the kind of the cost increases that we're experiencing and why we have to continue to raise prices to offset those headwinds.

38:46 And that -- but that is, Scott that assumes some the curve continues upward from current spot rates at the high level of those increases?

38:57 Yeah. There is some additional increases expected. I mean, our procurement job does an excellent job of assessing all the indexes where we're purchasing and trying to forecast that forward and manage the price increases the best we can. So, it's a combination of current prices and expected future prices.

39:18 Very good. Thanks for the questions.

39:22 Thank you, Rob.

39:24 Our next question is from Laurence Alexander with Jefferies. Your line is open.

39:29 Hey, guys. It's Dan Rizzo on for Laurence. Thank you for taking my question. If we look past to twenty twenty two, you mentioned a holy hiring inventory to kind of meet customer needs. And I don't know, if this has been asked before but I was just wondering if this is kind of changing the way you think longer term with the amount of inventory that needs to be held. given the logistical smallest [indiscernible] we're seeing around the world.

39:51 Yes. It's a great question. As we spoke about during the last couple of quarters, we're going to use the strength of our balance sheet and really take our inventory up so that we can look to take care of our customers in the best possible fashion during all of these uncertain times. You see that clearly within our inventory actions but we do think that this is more of a finding a new normal and after we get to the new normal, we'll get back to more properly managed inventory levels that we would expect the company to need in order to be able to meet our customer delivery expectation percentages. 40:33 So we think this is likely not the new model going forward. In other words, we're not going to drive our overall inventory turns down to very low-single digits just to hold on. That doesn't make sense. But in this moment of uncertainty, we're just using every strength that the company has make too sure our customers are taken care of.

40:59 That's very helpful. Then, with the price increases again, this is just more -- little more philosophical. Are we at the point where customers are kind of trying [indiscernible] so to speak where I mean you have to raise prices because cost is so high, but our customers starting to push back or is it their demand trends so much that it's just kind of accepted at this point we will be for the foreseeable future?

41:21 I think we've got the best type of an environment working cooperative environment relative to pricing that I've seen in my entire Donaldson career. I think people get it. They understand this is very unusual, everybody is trying to work hard leading each other in order to be able to get through it. Obviously, there is some back and forth with regards to it. But what's really important is you have to move quickly in order to wash out the old prices from your backlogs and get to the new situation if you will. I think the receptivity is really good. We've had a lot of success. We do have some severance out there, but we're working through that and we'll drive that to ground here in short order.

42:15 And then finally in your history or have you in the past given price concessions, some instant times, I guess, would it be a give back if things normalize?

42:24 Sure. On some of our longer-term contracts, particularly with the OEs, we have annual based price downs and so we'll start on that part of the model in the negative position on an annual basis. Right now, it's a bit different, obviously. But then also if inflation does abate and let's say they give all of this back down in the indexes for raw materials, truly do go down and stay down than, sure It's a matter of competitiveness. And so yes, we have done that in the past and we would look to do that. The stable type of environment that you referenced there though it's something we look forward to, let's say.

43:14 Okay. Thank you very much.

43:18 We have no further questions at this time. I'll turn the call back over to Mr. Carpenter for any closing remarks.

43:25 I want to wish everyone a happy and safe holiday season and I look forward to reporting our second quarter results in the new year. That concludes today's call. Goodbye.

43:37 Ladies and gentlemen, this concludes today's conference call. You may now disconnect. Thank you.