Donaldson Company, Inc.

Ladies and gentlemen, thank you for standing by and welcome to the Donaldson's First Quarter 2021 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 need to press star one on your telephone. If you require any further assistance, please press star zero. I would now like to take the call over to Charlie Brady, Director of Investor Relations. Thank you. Please go ahead.

Good morning. Thanks for joining Donaldson's first quarter 2021 earnings conference call. With me today are Todd Carpenter, Chairman, CEO, and President of Donaldson, Scott Robinson, Chief Financial Officer, and Brad Fogel, who you all know. This morning, Todd and Scott will provide a summary of our first quarter performance, along with an update on key considerations for fiscal 2021. During today's call, we will also 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'll now turn the call over to Todd Carpenter. Todd? Good morning, everyone. I want to start by welcoming Charlie to the team. He joined Donaldson last week after two decades on the sell side. which included 15 years of covering our company. He already knows us well, so our investor relations program is in good hands. Welcome, Charlie. Turning to the quarter, we feel good about our results. First quarter sales were up 3% sequentially, which is not typical seasonality, signaling that the worst of the impact from the pandemic on our business may be behind us. Sales of replacement parts outperformed first fit by a wide margin, providing valuable stability. And we saw continued evidence of share gains in strategically important markets and geographies, helped in part by our robust portfolio of innovative products. First quarter profit performance was another highlight. Gross margin was up 60 basis points from the prior year, resulting in the highest first quarter gross margin in four years and the best sequential improvement in at least a decade. We reduced operating expenses by 5% while maintaining investments in our strategic growth priorities, particularly as they relate to the industrial segment. And altogether, we had a decremental operating margin of only 4% which we view as very positive given the uneven economic environment. Finally, our company remains in a strong financial position. We had excellent cash conversion during the quarter, and our balance sheet is solid. We're on track to deliver our strategic and financial objectives in fiscal 21, and we'll talk about those plans later in the call. But first, let me provide some additional color on recent sales trends. Trouble sales were down 5.4% from prior year or 6.4% in local currency. In the Indian segment, more than a third of the decline came from aerospace and defense due largely to the significant impact from the pandemic on commercial aerospace. We have a great team and strong customer relationships, so we expect our aerospace business will recover. In the meantime, we are pursuing optimization initiatives to put our cost structure on a firmer footing during this rough patch. In our other engine businesses, trends seem to be improving. On-road sales were down 21% in the quarter, which is still a steep decline, but notably better than the past few quarters. Although Class 8 truck production in the U.S. remains depressed, Order rates are increasing, and third-party forecasts for the next calendar year suggest a Class 8 recovery is on the horizon. Should that happen, we believe our strong position with OEM customers would give us nice momentum in the on-road, first-fit market. In off-road, trends were mixed by region. In Europe, sales from new exhaust and emissions programs were not yet enough to offset the lower rate of production for programs already in place. In the U.S., lower production of construction and mining equipment is still a headwind for off-road, but we had a meaningful sequential increase in first quarter, and year-over-year trends are also improving. We had a very strong quarter in China, with off-road sales up more than 50%. Their economic recovery appears to be underway, and we are also benefiting from new relationships with Chinese manufacturers that want our high-tech products, including PowerCore. China produces more heavy-duty equipment than any other country in the world, and our team is doing an excellent job building and strengthening relationships with large local customers. While we expect to have some variability in quarter-to-quarter trends, we are also confident that we have a long runway for growth in China. First quarter sales in aftermarket were down only slightly from the prior year, and they were up 6% from the prior quarter. All of the year-over-year decline in aftermarket came from the U.S. The independent channel is still being impacted by the oil and gas slowdown, which we partially offset with pricing actions implemented earlier this calendar year. And large OE customers are still tweaking inventory to match demand. Outside the U.S., aftermarket performed very well. In Europe, first quarter sales were up 4% in local currency as conditions improved in Western Europe. In China, first quarter sales of Indian aftermarket were up more than 30%, reflecting strong growth in both channels. We are gaining share with the new OEM customers, and end users are paying greater attention to equipment maintenance. Part of our success in China is due to PowerCore, which is growing rapidly from a small base. Importantly, PowerCore continues to do well outside of China. Global sales of PowerCore replacement parts were up in the low single digits last quarter, and we set another record. PowerCore is our most mature example of how our razor-to-cell razor blade strategy works, and the brand is still going strong after 20 years. Turning now to the industrial segment, first quarter sales were down about 6%, including a benefit from currency of about 2%. The decline was driven primarily by industrial filtration solutions, or IFS. The pandemic is creating a headwind in terms of equipment utilization and a lower willingness to invest. Quoting activity for new dust collectors was down in the first quarter, and the quote-to-order cycle remains elongated. Generally, customers are focusing on must-do projects while deferring expansion and productivity investments to a future date. With the market under pressure, we are focused on building our brand and gaining share. We have strengthened our capabilities related to market analysis and virtual selling, and our e-commerce platform gives us incredible reach. We also continue to leverage our technology advantage and we are encouraged by the opportunity that presents in an underserved market like China. First quarter sales of dust collectors were up modestly in China, and the needs in that region are changing in our favor. Some manufacturers are dealing with compliance upgrades related to the Blue Sky Initiative, while others are going beyond the minimum requirements and striving for better air quality. That shift represents an exciting opportunity for us, so we will continue to invest for growth in that region. Process filtration for the food and beverage market is another exciting opportunity. We launched our LifeTech brand filter late in 2016, and we have seen tremendous growth since then. Sales of process filtration parts increased. were up again last quarter with a low single-digit increase, which partially offset the pandemic-related pressure on sales of new equipment. Our strategy for growing process filtration is solid. We are focused on winning new contracts with large global manufacturers, which gives us the opportunity to sell their plants. Some of these customers have hundreds of plants, so we are once again doubling our sales team for process filtration. We also made an organizational change to better align our team with the needs of our food and beverage customers. While these types of optimization initiatives are standard work for us, I'm calling it out because during our fourth quarter call, we said process filtration sales were about 50 million in fiscal 2020. Following our reorganization, that number is more like 68 million. Our IFS numbers are unchanged, but we wanted you all to have the right baseline as we talk about year-over-year trends in this exciting business. Trends across the balance of our industrial segment were mixed. Sales of gas turbine systems were up 11%, driven by strong growth of replacement parts as we continue to gain share. In special applications, we face pressure from the secular decline in the disk drive market combined with lower sales of our membrane products. We partially offset the decline with strength in our venting solutions business, which is also benefiting from share gains as we expand into new markets, including the auto industry. Overall, we see strong evidence of how our diverse business model is providing some insulation from the pandemic. We are gaining share in strategically important markets and geographies. We are investing to keep the momentum and we continue to show progress on our initiatives to increase gross margin. I'll talk more about our longer term plans in a few minutes. So I'll now turn the call over to Scott. Scott.

Good morning, everyone. I also want to welcome Charlie. He's got great perspective, and he's a strong addition to our team. We are excited to have him join us, and I hope you all will have a chance to connect or reconnect with him soon. Now turning to the quarter, like Todd said, we are pleased with our results. Economic conditions were better than what we had in the fourth quarter, and we made progress on our strategic initiatives. First quarter margin was a highlight for us, in terms of year-over-year and quarter-over-quarter performance. Versus the prior year, operating margin was up 50 basis points, driven entirely by gross margin. That translates to a decremental margin of 4%. But that's probably not the level to expect over time. For a better comparison, I'd point you to our sequential trends. First quarter sales were up 3% from the fourth quarter, and our operating profit was up almost 6%. That yields an incremental margin of 24.5%, which is in line with our longer-term targets from investor day and several points ahead of our historic average. As I've said many times, we are committed to increasing levels of profitability on increasing sales, and we have solid plans to keep driving margins higher. We saw evidence of those actions last quarter, so let me share some details. First quarter gross margin increased 60 basis points to 35%, despite the impact from lost leverage and higher depreciation. On the other hand, gross margin benefited from lower raw material costs. Our procurement team has done an excellent job capturing cost improvements by working with existing suppliers and identifying new ones, which added to the benefits from lower market prices. We also had a favorable mix of sales in the first quarter. Specifically, aggregate sales of our advanced and accelerated portfolio, which includes a significant portion of our replacement parts sales along with many of our higher tech businesses, outperform the company. And our advanced and accelerated portfolio also comes with a higher average gross margin. As we continue to drive investments into these businesses, we are shifting more weight towards higher margin categories. Over time, Mix should be a constant factor in driving up our gross margin. Our strong gross margin performance in the first quarter was complemented by disciplined expense management. Operating expenses were down 5% from the prior year, which resulted in a slight increase as a rate of sales. We had significant savings in discretionary categories like travel and entertainment due in large part to pandemic-related restrictions. At the same time, we continue to invest in our strategic priorities. We are building teams and adding resources to areas like R&D, process filtration, connected solutions, and dust collection. These investments are tilted heavily towards the industrial segment, which contains most of the advanced and accelerated businesses. Given that dynamic, we are not surprised that the first quarter industrial profit margin was down slightly. Importantly, First quarter gross margin was up in both segments, so we feel good about where we ended. As our investments translate to growth, we expect our margin and return on invested capital will go up over time. Moving down to P&L, first quarter other expense was $1.5 million, compared with income in the prior year of $2.6 million. The delta was largely due to a pension charge and the impact of certain charitable actions. During the first quarter, we contributed to the Donaldson Foundation, and there was also a charge for securing face masks that will go to frontline workers in our communities. We generally spread these contributions over a fiscal year, so the impact was more timing-related than a change in trajectory for us. I also want to share some highlights of our capital deployment in the first quarter. As expected, capital expenditures dropped meaningfully from the prior year, with our large projects related to capacity expansion mostly complete, We are turning our attention to optimization and productivity initiatives. We returned more than $40 million of cash to shareholders last quarter, including the repurchase of 0.3% of outstanding shares and dividends of $27 million. We have paid a dividend every quarter for 65 years, and we are on track to hit another milestone next month. January marks the five-year anniversary of when we were added to the S&P High Yield Dividend Aristocrat Fund. So this anniversary signals that we have been increasing our dividend annually for the past 25 years. We are proud of this record, and we intend to maintain our standing in this elite group. As we look to the balance of fiscal 21, there are still plenty of reasons to be cautious. The magnitude and ultimate impact from the pandemic are still unknown, and we continue to face uneven economic conditions. Given these dynamics, we feel prudent to hold back on detailed guidance, but we did want to expand our information provided during our last earnings call. In terms of sales, we expect second quarter will end between a 4% decline and a 1% increase in the prior year, and that means sales should be up sequentially from the first quarter. We also expect a year-over-year sales increase in the second half of fiscal 21, and sales are planned to migrate towards a more typical seasonality, meaning the second half will carry slightly more weight than the first. We are modeling a full-year increase in operating margins driven by gross margin. Our productivity initiatives should ramp up over the fiscal year, and we expect benefits from lower raw material costs and mix will still contribute to a higher gross margin but to a lesser extent than what we have been seeing. Of course, a caveat to gross margin impacts on a strong recovery. While we would be happy if our first-fit businesses accelerate beyond their expectations, that could create a scenario where a mix goes from a tailwind to a headwind. That's obviously a high-grade problem, and we would address the situation if that's the case. As a rate of sales, we intend to keep fiscal 21 operating expenses about flat with the prior year. Specific to the second half of the year, we are still expecting headwinds from higher incentive compensation, and pending a return to a more normal operating environment, we would anticipate year-over-year increase in expense categories that have been significantly depressed by the pandemic. But as always, we are exploring optimization initiatives to offset these headwinds. I am confident that we can maintain an appropriate balance, allowing us to invest in our longer-term growth opportunities by driving efficiency elsewhere in the company. For our full-year tax rate, we are now expecting something between 24% and 26%. The forecast range is more narrow than last quarter, simply due to having a clarity with the first quarter complete. There were no changes to our other planning assumptions, but let me share some context. Capital expenditures are planned meaningfully below last year, reflecting the completion of our multi-year investment cycle. Our long-term target is plus or minus 3% of sales, and we would expect our capex to be below that level this year. We plan to repurchase at least 1% of our outstanding shares, which would offset pollution from stock-based compensation. Should we see incremental improvement in the economic environment, it is reasonable to expect that we would repurchase more than 1% this fiscal year. Finally, our cash conversion is still expected to exceed 100%. We had a very strong cash conversion in the first quarter, driven by reduced working capital, lower capital expenditures, and lower bonus sales. As sales trends improved versus the first quarter, we would expect our cash conversion to drift down a bit over the year, which is typical of a more favorable selling environment. Stepping back from the numbers, our objectives for the year are consistent with what I shared last quarter. We will invest for growth and market share gains in our advanced and accelerated portfolio, execute productivity initiatives that will strengthen growth margin, maintain control of operating expenses, including the implementation of select optimization initiatives, and protect our strong financial position through disciplined capital deployment and working capital management. As I close my section, I want to take a moment to thank my colleagues around the world for their continued resilience. We had a solid start to the fiscal year despite the pandemic fatigue that I know everyone is feeling. I am proud of what you all accomplished, and I look forward to continued success. I also want to thank Brad for his great contributions and his friendship. I wish you and your family my best as you move to Europe. The good news is we will still work together. With the mushy stuff out of the way, I'll turn the call now back to Todd.