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 Third Quarter 2022 Earnings Conference Call. [Operator Instructions] Thank you. Sarika Dhadwal, Director Investor Relations, you may begin.

Good morning. Thank you for joining Donaldson's third quarter fiscal 2022 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 third quarter performance and details on our outlook for the balance of fiscal 2022. 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. With that, I'll now turn the call over to Tod Carpenter.

Thanks, Sarika. Good morning, everyone. Before getting into our performance this quarter, I want to make a few comments about the impact of the ongoing conflict in Eastern Europe. From a business perspective, we complied with all sanctions and have taken a further step to stop direct product shipments into Russia and Belarus. As a reminder, our sales to this region represent less than 2% of total company sales and we are not forecasting any revenue for the foreseeable future. On the personal side, on behalf of the Donaldson team, I would like to extend our support and sympathy to all of those impacted. We recently donated €150,000 to the Polish Red Cross which is facilitating relief efforts with the Ukrainian Red Cross. Several of our local teams in Europe have also contributed by creating various donation drive to help the communities where they operate. These actions exemplify our commitment to corporate responsibility which has always been an important part of Donaldson. To that end, this quarter, we also published our fiscal 2021 sustainability report in which we outlined our commitment and efforts in reducing our environmental impact, engaging and empowering our people and maintaining our strong corporate governance. I look forward to reporting our progress and future initiatives over time. Now I'll turn to our third quarter results. Donaldson had another quarter of record sales at $853 million, up 12% year-over-year. As expected, pricing was the largest sales driver and I'm pleased with the agility of the organization to increase these efforts as cost inflation has continued to outpace our projections. Raw material, freight, energy and labor costs were up significantly year-over-year, negatively impacting our profitability. Consequently, third quarter EPS increased to $0.67 versus $0.66 a year ago. This quarter, we made progress in meeting demand and saw some…

Thanks, Tod. Good morning, everyone. This quarter, we were pleased with the top line results. However, inflation and supply chain challenges were greater than our expectations, negatively impacting our profitability. In summary, third quarter sales grew 12%, operating income was up 2% and EPS of $0.67 was $0.01 above last year. Operating margin this quarter is up 13%, it was down 130 basis points year-over-year on continued gross margin pressure. Gross margin, while up sequentially was below our expectations mainly due to the continued step-up in raw materials, freight, energy and labor costs. Other more temporary headwinds, such as manufacturing inefficiencies and driven by an acute supply issue of one of our key raw materials was also a factor in the quarter. Operating expense as a percentage of sales was 18.5% favorable by 90 basis points over prior year, driven primarily by sales leverage. We continue to actively manage our expenses by strategically investing in growth areas such as our Advance and Accelerate portfolio. Now, I'll touch on segment profitability before turning to the balance sheet and cash flow statement. Third quarter Engine pretax profit margin was 14.8%, down 110 basis points year-over-year. The decline was driven by the timing lag of pricing realization as we catch up to costs. Unfavorable sales mix also negatively impacted margins. Industrial margin was 15.4%, down 70 basis points year-over-year. There are two things I would highlight on the industrial margin. First, the recent integration of the Solaris and Pace acquisitions into the Industrial segment has resulted in additional expenses this quarter. Overall, we are pleased with the progress we have made in integrating these businesses and expect them to be margin accretive over time as they scale. Excluding the acquisitions, industrial margin was flat to prior year. Secondly, unfavorable sales mix also negatively…

Thanks, Scott. We've talked a lot over the past few quarters about the difficulties we have faced operating within this extremely volatile and inflationary environment. I want to extend my sincerest gratitude to the hardworking Donaldson employees who have showed up every day with a commitment to the organization, our customers and our shareholders. I would also like to thank our customers and suppliers as we jointly work through these challenging times. At Donaldson, we have a clear vision and a path to achieving our long-term goals and I know we are taking the right steps in achieving our purpose of advancing filtration for a cleaner world. We will reap the benefits of the investments we are making now for years to come. Within our existing businesses, we are committed to providing our Advance and Accelerate businesses with the capital required to increase sales and market share and optimize margins. We are also expanding our new product portfolio through our R&D and inorganic investments. On the acquisition front, we completed our first Life Sciences acquisition with Solaris in the second quarter and continue to look for ways to expand our reach in this sector. Looking beyond the fourth quarter and into fiscal 2023, we are encouraged by the resiliency of the team and know that we have the right people, the right investments and the right strategy in place to profitably grow the company. Now, I'll turn the call back to the operator to open the line for questions.

[Operator Instructions] Our first question is from Brian Drab with William Blair.

So I just want to make sure that I have this right and this is probably a risk to ask this question since we're kind of updating the model as we speak here. But did you make a comment specifically about fourth quarter operating margin because to get to the midpoint of the guide, I think I'm getting something in the 15.5% type of range for operating margin in the fourth quarter. I just want to make sure that's what you're implying.

Well, we gave the updating guidance for operating margin for the full year of 13.5% to 13.9%. And that's 10 basis points [ph] down on the high point compared to last year. But to back into that math, I think you'd have to get over 15% for the fourth quarter as you calculate.

Yes. Okay. So yes, I'm getting over 15%. And I just wanted to confirm that we're doing the math right. So -- and then here's a question that I guess you won't answer it. I'm just curious what you would say about this. As you look as you look forward from there, is this -- is that kind of a one pop because pricing is now caught up and just the dynamics of volatility with input costs and pricing? Or is that a level that we can extrapolate in any way?

Well, I mean, first of all, I would say our fourth quarter is always our -- generally our seasonally strongest quarter. And I think if you look back historically, has pretty good margins but we do expect year-over-year margins will continue to improve. As we said, we had a bit of a tougher quarter on gross margin this quarter and that was driven by factors whereby our pricing increases are lagging our material cost increases. We had a big supplier issue this quarter that's now behind us. So we would expect our margins to continue to improve. We're always committed to higher levels of profitability on higher sales and we're investing for that. And so we feel not the greatest about the margin performance this quarter but we do expect continued improvement on a year-over-year basis as we move forward.

Okay, great. And then, I was wondering if you could just -- you touched on a couple of areas but if you could just update on what kind of growth you're seeing in the Advance and Accelerate as you segmented the business how you think about it a couple of years ago. What are you seeing in some of the higher growth Advance and Accelerate markets? And specifically, I'm wondering also about some of the -- even the newer markets like getting into the water filtration, et cetera.

Right. Sure. So when you take a look at our Advance and Accelerate portion of the portfolio, what we experienced in the third quarter is mid-teens growth across that portion of our portfolio. In the core, we would suggest it was mid-single digits. So you can see how Advance and Accelerate really is significantly more than other portions of our company. So we feel good about that.

The next question is from Laurence Alexander with Jefferies.

This is actually Kevin [ph], I'm on for Laurence Alexander. I just had one about I guess, the mix between price and volume contributions for the increase in the midpoint of your top line outlook. And I guess I was just wondering if it's largely price or which it likely maybe is -- I guess I'm just wondering if you guys thought about, I guess, demand destruction from those pricing actions? I guess I just want to get your thoughts behind that.

Yes. So in the third quarter, pricing impacted revenues by 9% and volume was 6%, offset by currency headwinds of 3%. In the fourth quarter, pricing will be even a larger impact. And so we're layering these price increases and we don't feel like it's impacting demand. I mean we're trying to have reasonable commercial relationships with our customers. They're raising their prices. They certainly understand that costs are up and we have to pass those cost increases. One, we see them from our suppliers and then two, pass them on to our customers. And we're going to continue to do that to maintain reasonable margins as our part of the profit pool as long as costs continue to grow up. So, we do hope and expect that the cost increases we're seeing will start to level off and hopefully neutralize here at some point relatively soon. But right now, I don't think it's affecting demand. I mean, demand is very strong. I think we continue to slowly gain market share through our program wins with proprietary technology and we continue to invest in the company and work hard on our strategy even in light of kind of some challenging conditions that are out there.

[Operator Instructions] The next question is from Rob Mason with Baird.

I wanted to go back around the commentary on your gross margin outlook for gross margins to be up sequentially as you said, I'm teasing out a fairly healthy sequential increase. I'm just curious to provide a little visibility on that. How did gross margins exit the quarter? Or how have they played out thus far in the month of May relative to the 31.5% in the third quarter.

Yes. Rob, this is Tod. So maybe I'll start and then I'll let Scott get a little bit more detail. One thing that really happened to us in the third quarter was we had an acute supply issue Scott referenced that in his prepared remarks, that was pretty significant for us. We did not see that coming into the quarter but it presented significant headwinds relative to the gross margin on our execution across multiple manufacturing plants. It was a petroleum-based chemical that suddenly became unobtainable. And it goes in about 90% of all the air-based products that we manufacture as a company. As a result of that, we lost a significant amount of plant shifts between 25 and 30 shifts of work were lost. And as a direct result of that, that did affect our margins in the third quarter. We have solved that issue now. We have enough clearly to get through the third quarter, et cetera. But that was a significant action to us in Q3 that should not repeat. So, I'll let Scott pick margin building...

In terms of pricing, Rob, I said we had a 9% price impact on revenues in the third quarter. We expect we'll have a larger impact in the fourth quarter as we layer in additional pricing mechanisms. The plants are cranked back up. We have additional pricing that we're going to catch here as we move forward each month. And so we feel pretty good back to Brian's original question about the sequential operating margin improvement pick up in the fourth quarter as well as a reasonable gross margin pickup in the fourth quarter. Certainly, third quarter margins were behind our expectations based in part on what Tod just mentioned and we expect to recover that and improve from there. So we're committed to increasing that margin in the fourth quarter and into next year on higher levels of sales.

And Scott, in your earlier commentary, you referenced margins higher, I thought, year-over-year, that, that would apply to the fourth quarter operating margin. Does that apply to the fourth quarter gross margin?

Yes.

Okay. Just a follow-up question. Last year, on the third quarter call, you did make some preliminary commentary around your, I'll just call it, calendar second half view a peak into that. I'm just curious if you have any thoughts for this calendar second half as you look in particular around maybe seasonality given your backlog it sounds like they're still elevated, whether that causes any change in your seasonality?

Yes. I mean we still expect fourth quarter to be you know our best quarter and you can kind of back into that based on the guidance provided. I mean last year, we had just COVID kind of madness. So we felt obligated to try to give a little bit more guidance into, like you said, the early part of next year. I mean we feel good about our growth prospects our demand continues to be strong. As we said, the backlogs are high. Channel inventories are still at low levels. And so we feel like there's plenty of demand there, at least for what we can see reasonably well in the future. And we're, as I said, committed to higher levels of profitability on higher sales. If you think about next year, with all this pricing that we've had to layer in, that comes in month by month, quarter by quarter, there'll be a tailwind next year -- in next year's revenues based solely on the price increases that we're layering this year. And so we would kind of put that in the mid-single-digit range. One offsetting factor is currencies to that. Currencies were a headwind this quarter, certainly. And if they stay at this level, they would be a headwind into next year. So I think, overall, we feel pretty good. We're working through our planning process. The finance teams are cranking away along with their business partners as we speak to come up with a good solid plan. for next year and we look forward to coming back to you with that in about 90 days.

The next question is from Nathan Jones with Stifel.

This is Adam Farley on for Nathan. I wanted to first talk about the Engine Aftermarket channel continues to show very robust growth. Are you seeing any channel inventory builds?

Yes. So this is Tod. So when you really look at the overall aftermarket, there have not been inventory builds. We within the quarter, took the opportunity to visit a number of different distributors. And so we know firsthand that the levels that we're at, at this point in time, our pull-through we have not seen the channel build. It's what also gives us confidence that the current levels would continue, as Scott mentioned, when he talked about in the fourth quarter.

Okay. And then on the free cash flow guidance, I understand the higher inventory and accounts receivable impacting working capital. Maybe looking ahead into 2023, would you expect the return of cash from working capital? Or would you run higher inventory levels in the medium-term?

Well, as I said, our trustee finance team is still cranking away on the plan. But we would certainly expect cash conversion to improve next year. We'll have to make a call on what we want to do with inventories based on the supply chain situation. But we would expect cash conversion will improve. I would say, while we're not really to commit to this, I would expect our raw material balances to start to trend down as we hopefully catch up. Things seem to be improving slightly right now and we're hoping that those things will continue. But certainly, we would expect to see cash conversion improve next year.

Yes. Just maybe a little bit of color. Going into the fourth quarter, I would say that our supply chain issues that we've been experiencing as compared to going into third quarter, we've seen some slight improvements on that, clearly we had that acute issue in the -- unforeseen in the third quarter that hurt us. But again, that has been solved. We do see that we have been gaining on supply chain-based issues. And so we'll be making a call as to when to put pressure to bring the inventories down.

We have no further questions at this time. I'll turn it back to the presenters for any closing remarks.

Thanks, Chris. That concludes the call today. Thanks to everyone who participated and I look forward to reporting our fourth quarter and full year fiscal 2022 results in late August. Goodbye.

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