Donaldson Company, Inc.

Thank you for standing by. Welcome to the Donaldson Third Quarter 2021 Earnings Conference Call. At this time, all participants are in listen-only mode. After the speaker's presentation, there will be a question and answer session. To ask a question during this session, you will need to press star 1 on your telephone. Please be advised that today's conference is being recorded. If you require any further assistance, please press star 0.

would now like to hand the conference over to your speaker today charlie brady director investor relations you may begin good morning thank you for joining donaldson's third quarter 2021 earnings conference call with me today are todd carpenter chairman ceo and president and scott robinson chief financial officer this morning todd and scott will provide a summary of our third quarter performance along with an update on key considerations for fiscal 2021 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. 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'm very pleased with our third quarter results, which exceeded our expectations and was the highest sales quarter in our company's history. Third quarter highlights include sales increased 22% year over year and 13% sequentially from second quarter, the largest second to third quarter increase in over 10 years. Gross margin improved 50 basis points year over year, and earnings per share grew 32%. This could not have been accomplished without our dedicated Donaldson employees who come to work every day, whether at home or in the office, to ensure we are meeting our goals and serving our customers. Thank you to all of my fellow teammates for the work you do. Now let me provide some insights on our third quarter sales. Total company sales increased 22% in third quarter from prior year. In local currency, sales rose 17%. While we acknowledge this is a soft comparison to last year when the pandemic slowed things, we also note this result is 7% above the strong pre-pandemic third quarter of fiscal 2019. We are pleased with this level of growth and believe our momentum will continue. Engine sales recorded strong year-over-year growth of 26%, 22% in local currency. Our 51% off-road business growth was widespread with all regions experiencing an increase in sales. In particular, local currency sales in Europe and Asia Pacific were up 78% and 42%, respectively. China's sales increased almost 50%. Several factors give us confidence in the outlook for off-road. Global demand for construction and agriculture equipment remains high, and mining is also seeing increased demand. PowerCore continues to gain traction in China, and we are on track to deliver two times as many PowerCore air cleaners in 2021 compared to 2020, and our backlogs continue to build as we exited third quarter. On-road sales experienced a sharp rebound from the 1% year-over-year decline in second quarter, increasing 58% from 2020. Order and bill rates for Class A trucks in the U.S. have risen significantly over the past few months and are projected by external data sources to remain at a high level over the next several quarters. In China, our on-road sales more than doubled, driven by increased heavy-duty truck production and market share gains. With a favorable economic backdrop, our strong market position in North America, and the significant opportunity to grow in China, we are optimistic on the outlook for our on-road business. Aftermarket sales increased 23% in third quarter, including a 4% currency benefit. Utilization rates for construction and agriculture equipment and heavy-duty trucks remain at a high level, which is driving increased demand for replacement products. In local currency sales, Latin America increased by over 40%, and Europe and Asia Pacific were up 17% and 18% respectively. Aerospace and defense continues to be pressured. primarily due to a weak commercial aerospace market as a result of the COVID-19 pandemic. A bright spot in aerospace and defense is rotary aircraft, where sales increased due to previous program wins now coming online. Looking at the industrial segment, sales in third quarter increased 12% or 7%, excluding the favorable impact of currency translation, and growth was widespread across geographies. Industrial Filtration Solutions, or IFS, saw a significant sequential uptick in quoting activity for dust collection systems in third quarter. IFS benefited from increased sales of dust collection products on both a first-fit and replacement parts basis. This is a nice turnaround from the declines experienced in second quarter, which we believe was the trough. We have seen this business move from the if it breaks, you fix it cycle to the if it breaks, you replace it cycle, and now move to the investment and expansion cycle where we see increased purchases for new projects. We also saw increased sales in first-fit and replacement products across the rest of the IFS businesses, including greater than 50% growth at BOFA and mid-20s percentage growth in process filtration sales. These growth rates indicate to us that not only are we winning share in targeted growth areas, we are also retaining the replacement business, which should only increase as our installed base becomes larger sales of gas turbine systems or gts declined about 13 percent year-over-year due to a decline in demand for gas turbines used in the oil and gas market a slowing of retrofit activity and the timing of projects sales and special applications saw double-digit growth in integrated venting solutions and membranes which was partially offset by a high single-digit decline in our disk drive business. These broad-based positive company results give us increased confidence in our ability to have a strong finish to our fiscal 2021. Finally, we believe supporting the communities in which our people live and work and where we do business is the right thing to do. Therefore, in third quarter, Donaldson contributed $1 million to support our local community and help rebuild areas in Minneapolis and St. Paul that were damaged from the unrest over the last year. With that, I'll now turn the call over to Scott. Scott?

Good morning, everyone. Like Todd, I'm also very pleased with our results in the third quarter, which were stronger than our expectations and As previously mentioned, the highest quarterly sales in the company's history. I want to thank our employees for this remarkable accomplishment in light of the challenges faced. Total sales increased 22% year over year, and operating margin increased 90 basis points to 14.3%. As you have heard me say many times, we are committed to generating higher levels of profitability and higher sales, and our third quarter results demonstrate our commitment to this, even in the face of pressures from higher raw material costs and supply chain disruptions. As we entered the third quarter, we were building momentum, and that continued through the end of the quarter. Given our incoming order rates and backlog levels, we expect this momentum should maintain through the end of fiscal 21. Now, let me get into our third quarter results in a bit more detail. Our engine segment profitability increased 250 basis points year over year as we leveraged a significant uptick in sales. The industrial segment, in contrast, recorded a 50 basis decline in profitability. This decline is a result of a business unit mix with an industrial and weaker gross margins in GTS and disk drive products. Third quarter, company gross margin improved by 50 basis points to 33.7%. which accounted for a bit over half of the 90 basis point increase in operating margin. Raw material and freight cost inflation were headwinds, and the reversal from the tailwind we experienced in the first half of the fiscal year. Sales mix was also in favor both of gross margin, primarily as a result of strong engine sales. However, we were able to offset the margin pressures with sales leverage and pricing. We continue to expect second half gross margin will be up year over year. However, the headwinds from higher raw material and freight costs are increasing from what we experienced in the third quarter. Given the sharp increases in our raw material and freight costs, we are focused on pricing actions to mitigate the impact on our margins. We remain committed to managing our price-cost relationship, particularly in an environment of strong demand for our products. We are also committed to controlling operating expenses. In the third quarter, operating expenses as a percentage of sales declined 40 basis points year over year. This was driven by leverage on increased sales, partially offset by increased incentive compensation expense. Investing in our strategic priorities remains a focus for us, Our advanced and accelerated portfolio receives the largest amount of our investment and, over time, is expected to generate sales growth and higher margins than company average. We are also excited about the growth opportunities with our first-fit engine businesses. These businesses tend to be more cyclical and command leadership positions in their markets. In the case of on-road, off-road, and the fence, There are multi-year programs that provide a solid base of business to help grow our aftermarket sales. We see opportunities for additional program wins and further penetrations in markets where we have a smaller share. One example is China, where the market is large. There is an increasing willingness of OEMs to adopt the filtration technology we provide, and we are winning new programs. We have taken a disciplined approach to managing our business and opportunities by focusing on selective cost optimization projects and leveraging our global presence while continuing to invest in growth areas. As the world recovers from the pandemic, we are in a great position to participate in the post-pandemic upswing, some of which is represented in our third quarter results. We made capital investments of approximately $10 million in the third quarter, a decline of over 60% from the third quarter of last year, as we bring to completion many of our significant capital projects from the prior two years. We paid over $26 million in dividends and repurchased over $32 million of our stock in the third quarter. Year-to-date, we have returned almost $160 million to shareholders. We have paid a dividend every quarter for the past 65 years and increased our dividend every calendar year for the past 25 years, making Donaldson among a small group of companies that are included in the S&P High Yield Dividend Aristocrat Index. Maintaining this track record is important to us. Our results through the third quarter of fiscal 21 demonstrate that our focus on higher margins and higher sales is working. The results also underscore the diversification of our business model and that our long-term view adds value to the company and our shareholders. We have good sales momentum as we head toward the end of the fiscal year, which should carry through into fiscal 22. As such, we are raising our fiscal 21 sales and EPS guidance. With that, let me share our updated expectations for fiscal 21. In the third quarter, we saw continued sales momentum in our off-road, on-road, and aftermarket engine businesses and an uptick in our industrial filtration solutions business. Given the strong results we experienced and our visibility into the remainder of our fiscal year, we expect full-year sales will be up 9% to 11% year-over-year versus our prior guidance of 5% to 8% increase. Our annual guidance assumes a full-year 3% benefit from currency translation. In our engine segment, we project a sales increase of 12% to 14%, which is up from our prior guidance of an 8% to 11% increase. We project full-year off-road sales will now increase in the mid to high 20% range, driven by continued strong demand for construction and agriculture equipment and increased order activity in mining. Our prior guidance was for low 20% range growth. In on-road, we expect full-year sales will increase in the mid-teens compared to our prior guidance of low teens. This increase is due to a stronger improvement in global heavy-duty truck production rates. Our engine aftermarket business has continued to see stronger than expected sales momentum as global equipment utilization continues to improve. We now believe sales will increase in the mid-teens compared to our prior guidance of high single-digit increase. We believe utilization rates for construction and agriculture equipment, as well as on-road trucks, will remain at a high level through our fiscal year end. We continue to expect our full-year sales of aerospace and defense to decline in the mid-to-high 20% range, given the pandemic-related stock conditions and commercial aerospace resulting in weak demand. In the industrial segment, we expect a full-year sales increase of 3% to 5% versus our previous guidance of down 2% to up 2%. As Todd mentioned earlier, we are experiencing increased demand for industrial dust collection products, particularly replacement parts. We have increased our outlook for IFS sales and now project sales growth in the mid-single digits compared to our previous expectation of flat sales. Quote and sales activity have increased more quickly than we previously forecasted. GTS sales are expected to decline in the lowest single digits versus our prior expectation of a mid-single digit increase. In special applications, we continue to anticipate a decline in the lowest single digits based on our year-to-date results and expected softness in the market for disk drive products. Expanding our gross margin remains a key focus for us. We continue to work to reduce costs and drive operational efficiency to leverage higher sales. In the near term, however, increases in raw material prices and higher freight costs will pressure margins through fiscal 21 and into at least the early part of fiscal 22. To offset some of the sharp increases in our input costs, we have selectively raised prices and may do so again. We know the value we bring to our customers, and we will continue to demonstrate this value with technology-led products and best-in-class service. We are expecting a gesturing operating margin in a range of 13.8% to 14.2% compared to 13.2% in 2020. The midpoint of this range implies a sequential step-up in operating margin to about 14.5% for the back half of the year, compared to 13.5% in the first half. Additionally, we expect to maintain a disciplined approach to our operating expenses and deliver further leverage in the remainder of the year, despite an expected full year headwind of approximately $25 million from increased incentive compensation. about half of which was incurred in the third quarter. Other fiscal 21 operating metrics expectations are interest expense of about 13 million, other income of five to seven million, and a tax rate between 24 and 25%. Capital expenditures are planned to be in the range of 55 to 60 million. Taking the midpoint of our sales and capital expenditure guidance for 2021, would put us at just over 2% of sales, which, as we previously noted, is lower than the last few years due to completion of major projects. We also plan to repurchase 1.5% to 2% of our shares outstanding. Our cash conversion has been very good in the first nine months of fiscal 21, and we expect to exceed 100% cash conversion for the full year. We'll provide detailed guidance for fiscal 22 with our fourth quarter earnings release. However, I did want to provide a framework to help with modeling. The sales momentum we're currently experiencing is likely to carry through to the first half of fiscal 2022. We expect first half fiscal 2022 sales to account for a greater percentage of our full year sales as compared to the first half of fiscal 2021. Looking at our fiscal 22 gross margin, we expect the headwinds from higher raw material and freight costs to increase from what we've experienced in FY 2021, particularly in the first half of FY 2022. Our operating expenses in fiscal 22 will have some pluses and minuses relative to fiscal 21. As we begin to operate on our more normal post-pandemic environment, We expect to see an increase in expenses related to in-person customer engagement costs, including marketing and travel costs, as our sales and engineering employees return to on-site visits and attend trade shows. Investment in our knowledge and employees, including training and development, and increased headcount to meet demand. However, we should see an offset in reduced incentive compensation expense on a year-over-year basis as we reset our annual compensation plans. Our objectives for the remainder of this fiscal year and 2022 are unchanged. We will continue to invest for growth and market share gains in our advanced and accelerated portfolio, including inorganic growth and life sciences. execute productivity initiatives and pricing actions that will strengthen gross margins, maintain control of operating expenses, and protect our strong financial positions through disciplined capital deployment and working capital management. As I finish my commentary, I want to acknowledge all the Donaldson employees globally for the outstanding work they have done and continue to do every day. Our second half started off strong, and we have solid momentum to carry us to the end of fiscal 21 and into fiscal 22. I'll now turn the call back to Todd. Todd?

Thanks, Scott. Our third quarter results demonstrate the momentum we have in our business and the benefits of having a diversified portfolio. We continue to maintain a disciplined, long-term focus on our strategy. To remind you, our strategic priorities remain unchanged, and we are focused on expanding our technologies and solutions, extending our market access, and executing thoughtful acquisitions, particularly in life sciences. Some recent examples of new products include our new UltraPak smart dryer for compressed air process filtration, an upgrade to our iq connected filtration service which now comes standard on many of our industrial dust collectors and over time will provide recurring revenue the expansion of our filter minder real-time monitoring service to engine liquid filtration in addition to air filtration and our rugged pleat baghouse industrial dust collector that we introduced in first quarter, which is already on pace to generate two times our initial first year forecasted sales. Our strategy also involves seeking out inorganic growth opportunities, and we are well positioned to expand our addressable market in life sciences. We have a solid roadmap and a pipeline of potential opportunities in life sciences. While I can't comment on when or if a deal might happen, I can say I'm very encouraged by what the life sciences business development team is doing. They have increased our understanding of the life sciences market and improved our strategic focus in that area. We have the right people in place to execute our strategy. We continue to maintain a strong balance sheet and discipline on our capital deployment, which positions us well to make acquisitions that will expand our markets, increase our margins over time, and allow us to further leverage our filtration technology expertise. We have the ability to continue to invest in organic growth, to extend our market reach, increase market share, and maintain our market leadership positions. This is a very exciting time for Donaldson, and I look forward to sharing our successes with you. Before I close, I want to again thank our employees around the world for their continued dedication to Donaldson, each other, and our customers to meet our goal of advancing filtration for a cleaner world. Now I'll turn the call back to the operator to open the line for questions.

Thank you. As a reminder, to ask a question, you will need to press a star 1 on your telephone. To withdraw a question, press the found key. Please stand by while we compile the Q&A roster. First question comes from the line of Brian Blair with Oppenheimer. Your line is open.

Thanks. Good morning, guys. Good morning, Brian. Really strong momentum, you know, overall for the most part in the quarter. Definitely encouraging to see growth accelerate in IFS. And, Todd, you mentioned kind of the mentality shifts in the markets from break and fix to replace to now more of an investment cycle, at least the early stages of one. I was wondering if you could parse out replacement first growth rates in the quarter or order rates going into your fourth quarter. Any color there would be very helpful.

Sure. So typically that business runs at about 40% replacement parts and 60% on the first fifth cycle. And so we're starting, that had shifted during the pandemic, almost reversed itself. And so now we start to see that first fifth bounce starting to happen with momentum carrying forward First, with replacement parts bouncing, so we see strong replacement parts orders led by U.S. as well as Western Europe. And now, especially with our new products that we have brought online within Q1 this year, we really start to see the momentum on a first fit picking up quite nicely. We also see a reduction in, quote, the order cycle.

Understood. When you look across your businesses, you noted increasing backlog entering the fourth quarter, expecting momentum into the first half of your fiscal 22. But as you think about the related moving parts, how does your team look at underlying demand inflection? versus the pull forward of shipments based on your own pricing actions, general supply chain uncertainties, et cetera. Just trying to get a sense of, I guess, that mosaic as we look at the next couple of quarters.

Yeah, it's good. If we step back and look at the macro, we've seen overall our backlogs increasing through the quarter, and that also continued as we turned the page into the fourth quarter. We see, if you just take an important data point, which is our Indian aftermarket business, and you look at the aftermarket OE versus the aftermarket independent channel, the growth within those two pieces of our company was roughly equal. And so, therefore, we see everything as a pull-through-based demand taking place within the corporation. We have not really begun to see the stocking event happen. That still lies ahead of us as evidenced by the growing backlog that we have.

That's very helpful. And a last one for me, if I can, any additional detail you can offer on any major supply chain challenges that you faced in the quarter or what's anticipated in your fiscal Q4? And on that front, if you could describe how your capacity investments and the scale that you now have and the efficiencies that you now have. have allowed your team to manage the unique environment we're in and meet surging demand relative to what you faced in the run-up to fiscal 18.

Sure. As you remember, we were talking three years ago or so that we were going to accelerate investments back in capacity expansion as a corporation, and we made that strategic thrust to do so, much as our competitors more stood pat, so to speak, within that last ramp-up. That is paying quite wonderful dividends to us right now. Clearly, we got that strategic decision correct. It is the reason why we have good sales momentum. We were telling you about our capacity utilization rates right now, and the engine business are roughly in the mid-'80s, and the industrial business are in the 70s, so we have room to run. However, we would also say the supply chain challenges within the quarter and that we see progressing or really continuing into the fourth quarter have been significant. Now, that said, I would tell you that our operations teams worldwide are doing absolutely a stellar job. We feel comfortable that we are out-executing our competition, and we hear that through our customer feedback on a pretty consistent basis. We do have supply chain challenges still remaining, with the most notable being the Texas storm, the four-day event that happened earlier in this calendar year, still presenting force majeures on us for some of the raw material-based supplies. We look for those force majeures to start to abate within the fourth quarter. Some may go into the first quarter of next fiscal year, but we are continuing to work through those. We do see those challenges. kind of holding us back a bit in the fourth quarter. Should they abate a little bit better? And, again, our supply chain teams are really doing absolutely woman's work. It's just really exemplary what's taking place. Should they start to abate a little quicker, we do see that we can have a better outcome than is currently envisioned.

Again, helpful detail. Thanks again, guys.

Okay, next question comes from the line of Nathan Jones with Space4. Your line is open.

Good morning, everyone.

Hi, Nathan. Good morning.

I'm going to say what I can do on a 2022 question here. If I go back to your 2018 analyst day, the target revenue for 2021, which will give you a pass on not hitting with COVID, was $3 billion to $3.3 billion. Current revenue trends looks like you'll be kind of around the middle of that range somewhere next year. And you had a 15 to 15.8 operating margin target on that revenue. Is there any reason why, if that's the kind of revenue range that you're in, that you can't get to that 15, 15.8 operating margin? Or are the price-cost dynamics and things going on around that at the moment maybe negate you being able to get to quite that level next year?

Hi, Nathan. This is Scott. So if you take the midpoint of our guidance sales finish for this year, it would take about a 6% growth to hit the low end of the range of the target. And so we could likely get to the low end of that range at a 6% revenue growth in FY22. So that's clearly in sight for FY22. In terms of operating margin, you know, you saw that we had maintained the guidance of 13.8 to 14.2 because of, you know, some of the supply chain and the input cost challenges that we've noted. The guidance in the investor day targets was 15 to 15.8. So that would be, you know, 100 basis point improvement over a two-year period. That would be a pretty significant growth. I think we could get in that vicinity, but probably still a little bit below that range. Probably reasonable to get into the revenue range and probably around the operating margin range.

Fair enough. That's helpful. maybe a question on price cost here um you know you guys have some fixed price contracts particularly the oem engine side um and have to balance obtaining pricing with driving customers towards more of your proprietary products that generate you know better revenue and better retention over time i i got a hint on on today's comments that you're maybe being a little more aggressive with pricing this time around than you were in 2018, which is reasonable. We've got significantly more inflation. Can you talk about how you're balancing those two things and if you are being a little more aggressive on pricing this go-round?

Chair Nathan, this is Todd. So if you just split our company into that OE first fit side, which is 35% of revenue, 65% on that replacement parts or project-based activities, you're right. On the 65% of the corporation, we are being aggressive. There are pricing activities in flight everywhere in the world as we speak. We will start to see those coming early next fiscal year. They will be in effect. I do want to caution, though, that we do have to work through some backlogs to see the new pricing actually take effect and then start to leverage, right? But we are being more aggressive with the pricing to say mid-single-digit to low double-digit-based increases dependent upon the business. With regards to the OE side of things, The OE-based conversations with the bumps of as much as 50% of business expansion on the OE side has really taken all the energy of both our customers as well as us to coordinate more of the demand satisfaction, if you will, rather than the pricing conversation. Some pricing conversations are happening, and you're right, they are absolutely more aggressive than they have been in the past. And it is a better environment than perhaps we've ever felt on the OE side relative to being able to enact pricing actions. But as you know and as we've talked about many times, they'll likely stretch out longer than the actions that we have in flight with regards to that 65% of our corporation.

Great. Thanks for the call, Todd. I'll pass it along.

Okay, we have our next question from Richard Eastman with Baird. Your line is open.

Yes, thank you, and thanks for the question. Just to pick up on that, Scott, just to pick up on the last question there, was the price cost positive or negative in the quarter?

Well, we were able to increase our margin, so all things being considered, it was positive. There's a lot of pluses and minuses going on in there, right? We have... You know, price is obviously a benefit. Mix is a headwind. Commodities are obviously a headwind. Freight is obviously a headwind. We talked about the bonus increase being a headwind. And then you get a big benefit from leverage. So there's a lot of pieces in there, you know, that make the margin, you know, probably a bit more complicated than typical. But we were pleased that we were, you know, able to continue to drive up the margins for the company on increasing sales. But there's a lot in the soup there, you know, as you can see.

Yeah, yeah. And just to clarify your comments. Scott, I think you made him first, Todd. But as we roll into the first half of 22, your comment was the first half of 22 would be a greater percentage of the full year revenue than was the first half of 21. Is that what you're suggesting?

That is correct. So if you take the midpoint of our guidance, This year we're 46% in the first half and 54% in the second half. So that's a pretty big difference for us. Generally we're a bit closer to even. And so we expect the momentum that we're seeing, you know, towards the end of the year to continue into next year. And we don't think that kind of, you know, 50% growth rates and off-road kind of momentum can continue for an extended period of time. So we've seen it reversing next year. So we wanted you to help with your models in that, you know, those percentages will probably flip next year because the momentum, you know, will be strong and it will be harder to keep growing sequentially to keep those kind of percentages continuing.

Yeah, understood. And Todd, just maybe to build off of that point, you know, when you look at, you know, build slots as, you know, for the OEs, both on the off-road and on the on-road side, you know, we're hearing a lot about the build slots, you know, for the next 12 to 18 months being pretty full. Maybe just your thoughts around how that may or may not impact that number that Scott just referenced. But your sales outlook on the OE side, is it being constrained by your customer supply chain issues as well as the forecast looking like maybe build slots are getting pretty tight?

Yeah, thanks, Rick. So, you know, as you really look back at our business and where we are in the backlog, clearly the on-road sector is really seeing quite a nice bump. The off-road sector on the first bit is also seeing a bump, but the level of jump on the on-road sector is really – quite impressive year-over-year as they are just looking to build more trucks as we turn into F22. But really all they're doing is getting back to 2019 base levels, maybe a little bit above that. So we've been able to satisfy that base requirement during that timeframe, and we have since that time additional capacity expansion online. So what we really need to do to be able to get the necessary bump and take care of our customers is get past the mostly raw material-based shortages that we have been seeing and really continue working hard on the supply chain activities because our capacity is there. And so once we get past the raw material portions, then it becomes a people-based conversation in the United States and can we get more additional personnel into our manufacturing plants and Other parts of the world, Latin America, Western Europe, we're absolutely fine. And even in China, we're doing really quite well there. So that will likely become a little bit of a U.S.-based story, as you have been hearing in the news. We are not immune to some of those conversations.

Okay. Okay. And just one last thing. Just from your comments around the analyst state plan, some of your comments here around raw materials pricing, when you put this all in the bucket and shake it up, it does sound like the expectations going into you know, fiscal 22 are still, you know, somewhere around this 100 beeps of op margin leverage with all the levers, you know, being pulled and pushed. Is that still, you know, just a realistic starting spot assumption for op profit in 22? Yeah.

So, you know, we're working hard through our plan right now. Our FP&A team is is faced with a very dynamic environment and doing an excellent job keeping track of things. And so back to the FY, you know, the targets that were in the investor day. So we had a 15% was the low end of the range. And as you point out, you know, our current range is 14% at the midpoint. And so I would view that more as a two-year target. versus a one-year journey. I mean, we're committed to increasing levels of profitability and increasing sales, and we think we can do that while continuing to invest in our growth initiative. So we want to continue to push money into the places that have good growth opportunities. And so I would look at that journey more of a two-year step, and I think you might have been looking at it more as a one-year step.

Okay, with incentive, you know, one more lever, with investment, you're suggesting, you know, 50 beeps would be the better 22 target, but that's what you're implying there.

Yeah, I mean, we have to finish our plan, and we'll give you a detailed guidance at the end of Q4 here, but, you know, I look at it more as a two-year journey.

Yeah, I understand. Okay, excellent, and thank you, and it's great to see the volumes return.

Okay, next question. We have the line of Brian Grav with William Blair. Your line is open. Hey, good morning. Thank you for taking my questions.

First one, just, hi. So on a specific question just on the cost that you're seeing this year for the full year, fiscal 21, as a result of supply chain issues, input costs and freight, just with the thought that these are temporary. I know you said clearly some of this will trail into fiscal 22, but I'm just trying to gauge the magnitude of a potential gross margin tailwind in fiscal 22 relative to 21 with all of these unusual items that are happening this year.

Yeah, so, I mean, like I said, it's kind of a dynamic environment to predict where some of these input costs will go and will they come back down and when will they come back down. So we're expecting, you know, obviously pressure in the fourth quarter and into next year. And so our raw materials and our freight are going to be pressured. And so we'll have to see where that goes and where we want to kind of cast our final plan assumptions. And so right now, I don't know if I can predict whether there's a headwind or a tailwind. I would predict for sure there's a headwind in the first part of next year. And then the big question is, right, when will the cost start to abate or will they abate and when will that happen and how will that flow through our results? So we want to get a bit smarter with another 90 days. So, again, the big pieces will be raw materials and freight. You know, we'll certainly start out as a headwind. We have a $25 million incentive comp tailwind that we'll get because we can reset bonuses. So that will obviously bring us some relief against those first two items I mentioned. And then we'll expect to get continued leverage on increasing sales. So, you know, those are the big pieces that will go into our calculus on the plan. And, you know, I promise to come back to you at the end of the fourth quarter with some more specifics in that regard.

Yeah, Miranda, Scott, I'd just add a little bit of color and tell you that we are laser-focused on the issue, laser-focused on the map, and also the commodity-based spreadsheets that we have in order to be able to put pricing actions in flight, and that is consuming our energy these days across the organization in order to make sure we can press forward. But as Scott says, The more difficult piece to predict is the back half of next fiscal year.

One more question.

I just want to understand what you're thinking for the fourth quarter here because the industrial sales were up 8% sequentially and engine sales were up 15% sequentially in the third quarter, but the the full year guide implies a sequential downtick slightly in engine and about flat and industrial. I'm just wondering why that's not conservative in this environment. And also the fourth quarter historically is up seasonally, isn't it?

Yeah, historically our fourth quarter would be up just slightly. And so, as you know, we're kind of more in the flat, but just barely down in the fourth quarter with the current guidance. You know, so we're really focused on the supply chain issues that are there that governing how fast we can run the plants and our operations team is doing an excellent job of procuring all the materials they can get their hands on to build as many filters as we can get and get them out the door. We have May in hand for the most part. May was a little bit softer than the current run rate and we expect June and July will pick up. And so, therefore, we wanted to take what we thought was a reasonable posture with regard to a Q4, you know, with even being generally – You know, and that flash area will still be up 25% over the last year and pretty consistent with this third quarter, which was a really big quarter for the company. In fact, our biggest quarter in our company's history. So, you know, we wanted to keep that in mind as we look at the fourth quarter.

yeah brian this is todd maybe a little bit more color i i would tell you this is not an incoming order question this is not our ability to execute inside a manufacturing plant space question um this is a raw materials input question and and um uh also um you know really the supply chain issues and challenges that that we continue to work through we we're really proud of the way that we are executing uh in the moment um but that is that is the question that still remains uh couldn't get even more than our current record that we just set in third quarter.

Got it. Thanks for that, Tyler, and congrats on the record quarter.

Thanks, man. Thank you. Next question comes from the line of Florence Alexander with Jefferies. Your line is open.

Good morning. Thank you for taking my questions. You mentioned that the capital projects were coming to an end, and CapEx is a bit lower. I was just wondering, as we look out over the next two or three years, what your thought process is for additional capital projects. Are you comfortable with where you are, or are you looking at more expansions, or what?

Yes, that's a good question. So, you know, we've said, you know, for the last several quarters that our CapEx is going to come down this year. as we really focus on completion of many of the large-scale projects that we have undertaken. And so we're very pleased to be bringing these projects to completion and beginning to get the return out of those projects that we always expected. And so this year we spent more time kind of fine-tuning and completing projects than really buying new equipment. And we said that that would happen and that next year we would expect a return to a more normal level. So our capex is clearly going to go up from this year, probably back to more along the lines of our historical average. If you look in the Investor Day, it seems like people have the Investor Day book out, you'll see there's a slide in there that shows our long-term history and then projected an increase for a short period of time. We would expect to be down from the big years that we've had and more in line with with what we've done in the past. So you can take a 2.5% to 3% of sales as kind of a reasonable range for us. If we can find projects that are bigger, that have a good return, we'll always be willing to execute on those projects. We want to be good stewards of capital, but we want to deploy capital to help increase the capital invested and help increase the return on capital investment. So we look at that as part of our planning process, but maybe in short, it will go up from this year.

That's very helpful. And then just one other question. You mentioned, obviously, improving profitability is a focus. I was wondering if there's still areas where you could do some bottom slicing or discontinuing certain sales products or just areas where you would be removing things just to improve overall profitability that would maybe be a sales headwind now.

Yeah, so I mean, I think our, you know, we've talked for years about our Oracle implementation that we completed about four years ago, and our finance team and our IT team have done excellent work to improve the visibility and information we get out of the system, such that we have much more granular information at a product level. And so I think our business units have been doing an excellent job, you know, looking at their product level performance profitability by part by region and so we can give them reports that show the their weakest prod products or projects and then they can begin to focus on those by either de-emphasizing the product and or increasing the prices on those products so I would say that that's something we work on on our daily daily basis and our finance people I think are doing a good job helping identify those opportunities instead of growing revenue, improving the profitability on your existing revenue. So I would say we're doing that, and we still have room to improve, but that's something we will definitely continue to focus on.

Thank you very much. Thank you. Our next question, we have Dylan Cumming with Morgan Stanley.

Good morning, guys. Thanks for the question. I want to go back to the – good morning, Todd. I just wanted to go back to the kind of commentary around the restocking. I guess you kind of alluded to this in one of your earlier comments, but it's your sense just kind of that the supply chain is not in a position to kind of meet the demands of a restock. And when I say that, I guess I'm looking at the production rate that you're really partners in that. in your commentary about utilization in the aftermarket channel i mean that to me is it kind of should be suggesting a more meaningful recycling cycle so is it this question of you can't produce to that um and do you kind of expect to do that more meaningfully as you look into next year i i think you handy handicapped that very well okay got it um Maybe this is kind of along the same lines, so I'll kind of piggyback on this question, but you kind of laid out some of the commentary around the capacity investments, and you really feel like you're kind of well aligned for the next, I should say, cycle here. But I guess, you know, taking a step back, When you look at where inventories are relative to historical averages, your kind of customers and within the independent distribution channel, and you kind of see the utilization and the production trends that are materializing more recently, what is your view of this kind of current industrial upcycle, maybe versus the one you saw in 17 and 18? I mean, are you expecting this to be a three to four-year cycle versus the kind of two, two and a half one that we saw over the 17, 18 period?

Yeah, it's a great question. So we take a look at that and debate it internally as well. Clearly, we think it's a month-a-year cycle for sure because of the fact that if you just look at ag, we're probably early cycle on ag. If you look at mining, mining is frankly, just waking up compared to a payday. Construction might be early-late cycle. However, if we do get an infrastructure bill, then overall utilization goes up across the country. And so, consequently, that probably then goes mid-cycle because we should see a bump and a pickup from that. Overall truck rate production, they are not building yet at the level that they were at, say, 350,000 trucks. Sure, they have the orders, but they're not being kicked out at this point in time. So we see a lift there that is going to be a multi-year lift. And then on the industrial side, what we just talked about as a result of all the OE-based demands that we have, that's when CAPEX starts to flow real well and bodes well for our project-based industrial businesses. So we overall, when we step back and we look at our corporation, we do see this as a multi-year uptick. And we look to be in a position based upon the capacity investments that we've made across our corporation and the strategic choices to invest in our people and really protect the foundation of our corporation long-term throughout the pandemic as really excellent strategic choices that will be paying dividends for our company for this multi-year cycle for sure.

Got it. And that's a really helpful call there. And maybe just one last one to wrap it up. I wanted to go back to your commentary on kind of on-road in particular. I think you were calling out higher build rates in China and kind of an increase in revenues there just for the on-road business. I guess it was kind of a bit surprising to me because I think some of the more recent market data we've seen coming out of there suggested that market seems to be rolling over a bit. I mean, obviously you've had a lot of share gain there over the past few years, so I guess do you feel like that level of performance is just more reflective of some of those share gain efforts or what's kind of going on in the market for you guys?

Yeah, we do believe that we can outperform the market within China. But please remember, we're coming from a low share. And so, you know, we were low single digits. And so the number and percentages look pretty wonderful. But that also gets us, say, to a mid-single digit share. And so we have some wonderful runway ahead of us. And the share gains that we're winning on the first-fifth production does see us have capacity expansion in China to be able to meet our region-for-region-based manufacturing strategy going forward. But we do expect to outperform the growth rates within the China-based markets just simply because of the share gains that we have, but also because, frankly, the comps are a little easier.

Sure. Okay, got it. Thanks for the time, guys.

There are no further questions.

Thanks, Brian. So that concludes today's call. I want to thank everyone listening for your time and interest in Bouncing Company. Goodbye.

Ladies and gentlemen, this concludes today's conference call. Give me now a disconnect.