Hello, and thank you for standing by. My name is Regina, and I will be your conference operator today. At this time, I would like to welcome everyone to the Donaldson Company, Inc. First Quarter 2023 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] I would now like to turn the conference over to Sarika Dhadwal. Please go ahead.

Good morning. Thank you for joining Donaldson's first quarter fiscal 2023 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 an update on our outlook for fiscal 2023. As a reminder, we have posted a supplemental quarterly earnings presentation summarizing our results and our outlook on our Investor Relations website at ir.donaldson.com. During today's call, we will discuss non-GAAP or adjusted results. For fiscal 2023, non-GAAP results exclude $7.6 million in pretax restructuring and related charges stemming from our previously announced organizational redesign. It is important to note that the redesign is ongoing, and there will be additional charges forthcoming. For fiscal 2022, non-GAAP results exclude $3.4 million in pretax charges related to the termination of our operations in Russia. 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 the 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. Please go ahead.

Thanks, Sarika. Good morning, everyone. I am pleased to report a strong start to fiscal 2023 as we build upon momentum we had in the fourth quarter. Once again, we delivered double-digit top and bottom line growth. Our margins improved, gross margin increased both sequentially and year-over-year and operating margin of 15% reached a six year quarterly high. This improvement resulted in solid incremental margins and contributed to strong free cash flow conversion. Before diving deeper into sales, I will address the organizational redesign we announced in October. This company wide redesign is aimed at better positioning us to serve our end market customers. One of the key value propositions of Donaldson is our deep, long-standing customer relationships. Once completed, this redesign will allow us to more efficiently direct resources to strengthen commercial execution across our entire customer base. We have moved away from our previous matrix organization structure, which included a regional focus towards a more comprehensive end-market customer focused model. That said, due to our global presence, all of our employees play an important role in our growth. With the new model, our three focus areas now include: one, end market customers, we're aligning resources and cost structures to meet the specific needs of each end market in which we operate. This will enable expedited decision making and allow us to serve customers in a more efficient and effective manner. Two, employee development. This simplified structure reduces our organizational complexity and enables clear advancement paths for our employees. Three, profitable growth. Our business units will now have full P&L responsibility as opposed to that previously shared with the regions. This creates greater internal ownership and accountability for short and long-term performance. It also provides strong alignment with respect to strategic capital allocations. With these changes and as of…

Thanks, Tod. Good morning, everyone. I would like to start by saying how pleased I am for the employees around the globe who are able to see the results from their hard work and dedication over the last several quarters. It was undoubtedly an unprecedented and challenging operating environment. I will provide some additional color on our outlook for the balance of the year. But first, we'll give more details on first quarter results. To summarize, sales grew 11%. Operating income was up approximately 18%, and EPS of $0.75 increased 23% year-over-year. Gross margin of 33.9% improved 10 basis points versus 2022 and 100 basis points sequentially. As our pricing actions from last year continue to work through our financials and given the expectation for ongoing input cost stabilization, we anticipate continued year-over-year gross margin improvement through the balance of the year. Operating expenses as a percentage of sales were 18.9%, favorable by 80 basis points over prior year driven primarily by leverage on higher sales. Operating margin of 15.0% was up 90 basis points versus prior year largely due to operating expense leverage. I'll now touch on segment profitability. On the Engine side, pretax profit margin of 15.0% was up 130 basis points year-over-year as our pricing efforts more than offset inflationary pressures. On the Industrial side, pretax profit margin was 15.6%, down 80 basis points versus prior year. As a reminder, our three fiscal 2022 acquisitions, Solaris, PAIS and Purilogics fall into the segment. Excluding these acquisitions, pretax profit margin would have been up 50 basis points versus prior year. As Tod discussed earlier, we remain focused on growing these businesses. We are pleased with the integration progress and look forward to seeing them scale. Now turning to a few balance sheet and cash flow statement highlights. First…

Thanks, Scott. I would like to thank the Donaldson team for the tremendous work they continue to do every day. I view our results this quarter as a testament to their strength, agility and talent. We are well positioned for a successful fiscal 2023. Our job now is to not only deliver for our customers and shareholders this year, but to lay the groundwork for the future. A major component of this groundwork is the organizational redesign we have embarked upon, and I look forward to reporting on our progress in this regard as we move throughout the year. While the potential for a recessionary environment looms, we can and will build upon our position as the leader in technology led filtration. Our free cash flow generation and balance sheet strength put us in a position to continue our company's evolution irrespective of macroeconomic fluctuations through the following. One, our Advance and Accelerate solutions, our more resilient existing businesses such as replacement parts, process filtration and Venting Solutions remain priority areas of investment as we build out our capabilities and work to drive increased market share gains. Two, R&D investments. At the core, we are technology led, and our commitment to R&D is steadfast. We are very excited about the work that is taking place in areas such as our Materials Research Center, which was built to further the development of our polymer based chemistry solutions. Three, M&A. Last year, we acquired three companies, two in the life sciences space and one in services, all in sectors with structurally higher margin profiles than our company average. While we are thoughtful about our acquisition strategy, we are committed to deploying capital in this regard. Finally, our outlook for the remainder of the year reflects some caution. However, I am excited about our future growth prospects. Aided by the new organizational structure and our strong leadership team, Donaldson is poised to execute and invest faster, delivering for our customers and shareholders, and continuing on our mission of advancing filtration for a cleaner world. Now I'll turn the call back to the operator to open the line for questions.

[Operator Instructions] Our first question will come from the line of Brian Drab with William Blair. Please go ahead.

Hi. Good morning. Thanks for taking my questions.

Good morning.

Tod, good morning. Tod, you just mentioned that the prospects of a recession loom. But like many other industrial companies, you're not seeing it right now, at least not outside of special apps. Your large customers like CAT and Deere reported strong results recently and don't appear to be seeing a recession. I'm just wondering, if you could talk a little bit more about what you're seeing, what you're hearing from your customers about what they're expecting for the operating environment in calendar '23?

That's correct, Brian. We're really not seeing the oncoming recession at this point in time. Order intake is kind of about what we would have expected. We do have slight destocking on some of the OES channels. And so therefore, a little bit of a softness just as we would have expected to have happened that we've talked about in the past. But right now, across all end markets, all geographies, our backlog remains strong and the end market remains strong across the full portfolio with the noted exception of our disk drive business.

So I guess is it fair to say -- when you say a recession might be looming, it's more the headlines what the autonomous are saying. But if you were operating Donaldson without seeing all these headlines, you would be expecting a recession at this point. Is that correct?

We're just trying to be balanced, Brian. As we take a look at our company, as we consider all the potential factors going forward in the next fiscal year, we are looking to give a balanced outlook based upon all the economical factors as well as all the facts and data that we have when we do a hard internal look into our corporation, and we believe that we've achieved that with this guide and so that's where we're coming from.

Yeah. Got it. Okay. And then the $7.6 million associated with the redesign, what was that spent on? Is that -- was there severance involved there? I'm just curious how that breaks down.

Hey, Brian. This is Scott. So yeah, it's both severance and then some costs associated with execution of the redesign. We're working through the redesign. And we still have a bit of a ways to go. So we'll have more to say about that at the end of next quarter, but those were the costs that were incurred in the first quarter.

Are there ongoing cost savings associated with the redesign?

Yeah. Well, like I said, we're partway through that. So when we get -- we'll be done by the end of next quarter, and we'll have an update on total expenses and any associated savings at the end of the next quarter.

Okay. And then just what was organic volume growth in Engine and organic volume growth -- revenue growth in Industrial in the first quarter?

We had total -- in terms of total impact for the quarter, we had 11% price, 8% volume and then a minus 8% in terms of FX. So our FX impact will be greatest. Presuming rates stay where they are, the FX impact will be the greatest this quarter. We bumped up the FX impact by 1% for the year, up to 5% now. So we kept the overall revenue guidance the same at 3% and even with an increase in the FX headwind from 4% to 5%.

Okay. Those numbers you gave are for consolidated, right?

Correct.

Okay. All right. I’ll follow up more later. Thank you.

Thank you.

Thanks.

Your next question will come from the line of Laurence Alexander with Jefferies. Please go ahead.

Hi. This is actually Dan Rizzo on for Laurence. You mentioned the pricing flowing through as costs decreased, I was wondering if historically speaking price concessions or is it something you guys do or something that your clients look for -- customers look for?

Yeah. So I mean it's different across the various components of the business. The largest piece would always be the OE piece, right? And we've been working with those customers for a couple of years now as costs started increasing to make sure the relationship was reasonable. And I think we've made good progress there. There's still a few actions left to complete to catch all the lay (ph) up on costs, you can see that in our gross margin improvement over the last several quarters sequentially. It's slowly layering in. We were happy with the gross margin performance this quarter. And so we're expecting cost to be hopefully flat when we're all said and done with this year. And if costs suddenly went down, I'm sure our OE friends would be knocking on our door, and we would have those conversations with them just as they were willing to have a conversation with us as costs are going up. And the other businesses, if it's a business where we're providing a bid, we adjust based on current costs to stay competitive in the market. And then the independent aftermarket, we certainly have more latitude for pricing there. And we just want to make sure we stay competitive in the markets that we operate in.

Thanks. And then I don't know if I missed this or not, but the COVID lockdowns in China or just everything that's going on there, is that having an effect on your -- I guess, your growth or your just demand within the region?

So clearly, it's having an effect on the demand within the region. Also the uncertainty looking forward within the region However, it's not having an effect on our ability to win new projects with Chinese based national companies. and we continue to do so. So we look forward to when China opens up, their economy gets back to normal, and we would expect that to be a tailwind. We're just not sure when that is going to take place given the fits and starts relative to COVID within the country.

All right. And then finally, is there a target that I may have forgotten about for operating margin? I mean, is it like 15% or is it higher? I don't know if you've said this before.

Well, we -- we gave -- I mean, a target for the guidance for this year or for the future?

No. Just long term outlook. In terms of this is what we think we can achieve, given what's going on, and this is what we hope to achieve. That type of thing. Not for this year.

Yeah. So I mean, we gave a prior target at our last Investor Day, April 9, 2019. We have another Investor Day April 2023, where we'll be glad to host you in Bloomington here, and we'll be providing longer-term targets at that point in time.

Okay. Thank you very much.

Thank you.

Your next question will come from the line of Dillon Cumming with Morgan Stanley. Please go ahead.

Great. Good morning. Thanks for the question. I just wanted to ask kind of on the flurry (ph) sales outlook again, maybe framing this up a bit differently, but you mentioned you were starting to work down some of the late backlog in the quarter. When you look at your level of backlog coverage for the full year, kind of current levels of backlog versus implied, full year sales, would you say that coverage is maybe higher than normal or kind of in line with normal seasonality. It's kind of like a flavor of how you're framing the full year sales guide relative to that backlog level?

Yeah. Thanks, Dillon. So we'd say it's in line with the guide. We baked that in. We haven't seen an appreciable change since we gave full year guidance. Surely, we're really very, very proud of the quarter that we just turned in. But we also believe that we have really given a balanced approach to how we expect the year to play out.

Okay. Got it. Thanks. And then maybe just one last one on Life Sciences. I know you mentioned you're going to release some intra-quarter data maybe to help frame up the modeling side of it, but just wanted to see if you can give us a flavor ahead of time around what the kind of revenue margin profile that Life Sciences business might look like when those numbers do come out.

Yeah. So like we said, we're going to -- our new organizational structure was effective the 1st of November. So we're completing our updated segment analysis as we speak, but we expect to have three segments going forward and moving into more of a focus on the Life Sciences business. We would expect that business to have higher margins in our traditional businesses, which is where we've been investing in good solid growth rates. But before we issue the second quarter's results, we'll give you an 8-K with updated historicals for the new segments going forward. So people can see how those businesses performed and that will help our great analyst group with their modeling.

[indiscernible] it's very much appreciated. Thanks for the time guys.

Thanks, Dillon.

[Operator Instructions] Your next question will come from the line of Rob Mason with Baird. Please go ahead.

Yes. Good morning. I had a question just around your margin guidance. It did not change for the full year, and you certainly can appreciate we're only one quarter into the year, but you did get off to a very good start, particularly on the gross margin line. And Scott, I thought you mentioned operating margin this year would benefit from both gross margin expansion as well, operating expense leverage. So I guess, thinking literally, it kind of suggests that -- yes, I'm not sure how much gross margin opportunity we still have for the balance of the year versus, again, the first quarter start. And again, understand the seasonality potentially in the second quarter is typically a seasonally lower quarter. But I'm just curious, was there anything unusual in the first quarter gross margin that benefited there or how we should think about gross margin for the year relative to the first quarter?

Yeah. So I mean we expect the majority of the operating income improvement to come from gross margin improvement. You had it right. Our second quarter is always our seasonally weakest gross margin quarter mainly due to all the holidays that fall in that hurts production, and that brings our margin down. So we're expecting, I would say, relatively traditional seasonality for the company this year. And you can see we layered in this quarter, pretty significant pricing. So that will benefit the second quarter and the quarters going in. We are lapping pricing from last quarter. But we do expect year-over-year margin improvement for the rest of the year, which is what really drives that operating margin improvement, with the second quarter being the weakest.

Okay. Maybe just a follow-up. Tod, you kind of touched on a balanced outlook for the year within your guidance. When we established the guidance, it portended a fairly strong confidence level around the first half and wider range of outcomes, potentially around the second half. Has your second half visibility improved any at all since September or degraded? I'm just curious, based on your order rates, fill rates, how you're maybe thinking about the second half now?

Overall, our visibility in the second half really hasn't changed from the beginning of the fiscal year. We would say that the visibility that we do have supports the guidance that we have. We would tell you that we see typical structure first half, second half. Within this guidance, more like our typical behavior is 48% or 49% in the first half, 51% or 52% in the second half. We would expect that to really lay in that way for our company. We do believe the first half is a bit stronger on the comps in our balance guide than the second half. So for example, we just did $847 million and grew 11% in Q1, but keep in mind, in Q4 of last year, our number was $890 million. And so when you really take a look at all of that and really kind of layer that in, we really believe that we have a properly balanced approach to first half, second half, and we're returning back to a more normal type of a cadence that we've seen in previous years.

Very good. Appreciate it. Thank you.

We have no further questions at this time. With that, I'll turn the conference back over to management for any closing remarks.

That concludes the call today. Thanks to everyone who participated. I look forward to reporting our second quarter results in early March. Have a great holiday season, everyone. Bye.

Ladies and gentlemen, that concludes today's call. Thank you all for joining. You may now disconnect.