Donaldson Company, Inc.

Ladies and gentlemen, thank you for standing by, and welcome to the Donaldson Fiscal 2020 Second Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker's presentation, there will be a question-and-answer session. To ask a question during the session, you will need to press star 1 on your telephone. If you require any further assistance, please press star 0. I would now like to hand the conference over to your speaker today, Brad Portas, Director of Investor Relations. Thank you. Please go ahead.

Thanks, Megan. Good morning. Thank you for joining Donaldson's second quarter 2020 earnings conference call. With me today are Todd Carpenter, Chairman, CEO, and President of Donaldson, and Scott Robinson, our Chief Financial Officer. This morning, Todd and Scott will provide a summary of our second quarter performance and an overview of what we're planning for the balance of the year. During today's call, we may reference non-GAAP metrics. Please note that there is a reconciliation of GAAP to non-GAAP metrics within the schedules attached to this morning's press release. I want to remind everyone 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 Todd Carpenter. Todd?

Thanks, Brad. Good morning, everyone. We delivered strong profit performance in second quarter. Our initiatives to increase gross margin are building momentum, and we are controlling expenses in a softer-than-expected demand environment. We are managing those things under our control, and I want to thank our employees for their discipline and focus. Strengthening our portfolio of filtration businesses is under our control. To that end, I want to comment on last week's announcement. As we discussed on February 24th, Nelson Global Products made a binding offer to purchase our exhaust and emissions business. We got into exhaust and emissions in the 1920s when we began selling mufflers for tractors. Exhaust and emissions is our second oldest business, and it is our only business that could be characterized as non-filtration. We have great employees and customers, but exhaust and emissions does not leverage our core technologies or material science expertise, nor is there a replacement parts model that aligns with our razor to sell razor blade strategy. Through that lens, Donaldson is not the best owner of exhaust and emissions. So working with Nelson makes sense. Pending consultation with our employee works councils in Europe, along with other customary and regulatory approvals, we would expect to close the transaction in the coming months. Turning to second quarter results, total sales were down 6%, with benefits from pricing offsetting a headwind from currency translation. At a high level, expected declines in our first fit and new equipment businesses were compounded by a broad-based slowdown. Customers were cautious during our second quarter, and then conditions worsened in February with the coronavirus outbreak. I'll touch more on that in a few minutes. Turning back to second quarter, engine segment sales were down 7%. About two-thirds of the decline came from our on-road and off-road first-fit businesses. Second quarter on-road sales were down 21%. Half the decline came from the U.S. as Class 8 truck production predictably slowed. However, third-party data indicates that we continue to outperform the overall market. On-road sales in China were also down last quarter. We had difficult comparisons from the prior year, and the revenue remains choppy as we ramp up programs with local manufacturers, many of whom are new customers to Donaldson. In off-road, second quarter sales were down nearly 15%. Consistent with our expectations, about a quarter of the decline was from exhausted emissions as we compare against last year's pre-buys. Soft market conditions also pressured off-road. Second quarter sales to many of our largest customers in construction, mining, and agriculture were down from last year. Based on persistent uncertainty, we expect these trends will continue. Similarly, lower equipment utilization contributed to the 4% decline in aftermarket sales. Both the independent and OEM channels were down in the mid-single digits with variability by region and market. For example, oil and gas is still a headwind in the U.S., while Eastern Europe is recovering after soft business in the prior year. Importantly, our innovative products with strong aftermarket retention continue to outperform their legacy counterparts. These products are about a quarter of total aftermarket and second quarter sales were up in the mid single digits, including PowerCore. The continued success with PowerCore validates our strategy. Develop innovative products that solve complex problems and drive aftermarket retention. Second quarter sales in aerospace and defense were up almost 1%. Sales to helicopters were up from the prior year, and our replacement parts business continues to perform well. Second quarter sales in the industrial segment were down 3.5%, driven by industrial filtration solutions and gas turbine systems. The 5.9% decline for industrial filtration solutions, or IFS, has several moving pieces. Sales related to dust collection, which make up about 60% of IFS, were down in the high single digits. About a quarter of the decline is attributable to a tough comp from last year, and the rest appears to be market driven. Customers are focused on their immediate needs versus investments for future growth, resulting in lower sales of new equipment. Sales of dust collector replacement parts were also down in the quarter. Lower utilization is extending the replacement cycle, and customers are holding off on purchases. These near-term trends do not change our long-term view, so we will continue to invest for share gains with specific go-to-market strategies in all our major regions. We see evidence of share gains with innovative products happening already. Second quarter sales of new downflow equipment for dust collectors were up in the mid-teens and the razor blade replacement part sales were up more than 30%. We believe the strong value proposition and high aftermarket retention of downflow products will continue to drive profitable share gains in dust collection. Process filtration is another example of gaining share and growing margin. Sales were up in the low double digits last quarter. We are winning new accounts with large strategic customers, extending our relationship with existing accounts, and expanding globally. We continue to believe process filtration will be a powerful sales and margin driver well into the future. Sales in gas turbine systems, or GTS, were down about 12% in second quarter. Demand for new turbine projects remains low and delays in planned maintenance contributed to a decline in sales of replacement parts. We do, however, expect demand for replacement parts will recover as the maintenance happens. I know I've done it before on these calls, but I feel compelled to once again recognize our GTS team. Year-to-date sales are down about $8 million, while profit dollars are up meaningfully from last year. The GTS team is doing an incredible job growing profit in a difficult business cycle and they are making great progress on repositioning this business for long-term success. Wrapping up industrial, sales of special applications grew 11% last quarter. Our disk drive business was unexpectedly strong due to demand for near-line storage. We're not anticipating growth and our overall disk drive business will continue, but we will continue to pursue share gains in this highly technical market. We are also getting share with Venting Solutions, where sales were up in the low double digits last quarter. We continue to expand our offering for the automotive market, including powertrain and battery vents. These technical products align well with the growing demand for electric passenger cars, creating an exciting growth opportunity for us. Overall, our model is working as we would expect. New equipment appears to be gaining share in a down market replacement parts are outperforming first fit by a wide margin, and sales of innovative and proprietary products are growing. Overall cautiousness was the prevailing theme during our second quarter, and that has been amplified by the coronavirus. Before turning the call to Scott, I want to share some thoughts on the outbreak. Our top priority is the health and safety of our employees. We have implemented several countermeasures to mitigate risks to them, including travel restrictions, work from home flexibility, extended facility closures in China, incremental cleaning schedules, and the availability of specific items like hand sanitizer and face masks where appropriate. I'm very happy that as of today, none of our employees have reported being infected with coronavirus. We will continue to promote health and safety in all Donaldson facilities around the world. Specific to China, our operations in Wuxi are stabilizing after an extended closing period following the Chinese New Year. Since reopening on February 10th, we have been ramping up production as our staff returned to work and nearly all our suppliers are back online. Orders are down from our forecast, which is to be expected, but they have started to ramp back up as customers resume operations. As a reminder, China is 6% to 7% of total revenue, including about a quarter of our global disk drive production. Outside of China, we have not yet experienced significant disruption, but the cautious stance is clearly visible. We are executing on contingency plans while closely monitoring the situation in places like Italy, South Korea, and Japan. Overall, I'm very proud of the level of global collaboration our teams have demonstrated in response to the outbreak. It is truly impressive. The hard part for us, and all companies, is assessing the near and medium-term impact from coronavirus. We have factored some incremental uncertainty into our fiscal 20 forecast, which I'll let Scott cover more in his remarks.