Q2 2020 Earnings Call

And welcome to the Donaldson, that's supposed to 2022nd quarter earnings Conference call. At this time, all participants to listen only mode. After the speakers presentation. There will be a question answer session asked a question during the session you'll need to press star one on your telephone fewer fire or any further assistance. Please press star zero I would now like to hand the call.

But your speaker today fresh fruit director of Investor Relations. Thank you. Please go ahead.

Thanks, Meghan good morning, Thank you for joining Donaldson second quarter 2020 earnings conference call.

They said they are Tod Carpenter, chairman, CEO, and President Donaldson and Scott Robinson, our Chief Financial Officer. This morning, Cotton, 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 was a reconciliation of GAAP to non-GAAP metrics within the schedule attached to this mornings press release.

I want to remind everyone that any forward looking statements made during this call are subject to risks and uncertainties.

Described in our press release, and SEC filings with that I'll now turn the call over to Tod 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're 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 filtration businesses is under our control to that in I want to comment on last weeks announcement.

As we discussed on February 24, Nelson Global products made a binding offer to purchase are exhausted emissions business.

We got into exhaust emissions in the 19 twenties, when we began selling mufflers for tractors.

Exhaust emissions as our second oldest business and it is our only business that could be characterized as non filtration we.

We have great employees and customers, but exhaust 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 emissions. So we're working with Nelson makes sense.

Pending consultation with our employee works councils in Europe, along with other customary and regulatory approval we would.

We expect to close the transaction in the coming month.

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 Corona virus 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 offer a person businesses.

Second quarter on old sales were down 21%.

Half the decline came from the U.S. as class eight truck production predictably slowed however, third party data indicates that we continue to outperform the overall market.

I'm old 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 our 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 exhaust 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 and 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 child channels were down in the mid single digits with variability by region and market.

For example, oil and gas, it's still a headwind in the U.S. well Eastern Europe is recovering after soft business in the prior year.

Importantly, our innovative products with strong aftermarket retention continued 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 power core.

The continued success with Powercore validates our strategy.

Hello, 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 are I Fs has several moving pieces.

Sales related to dust collection, which make up about 60% of ISS 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 their 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 downfall equipment for dust collectors were up in the mid teens and the razorblade 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 in 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 counts 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 are GTS were down about 12% in second quarter demand for new turban 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 happened.

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 described business was unexpectedly strong demand for near line storage, we're not anticipating growth in our overall described business will continue but we will continue to pursue share gains in this highly technical market.

We're 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 bats. 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 Corona virus.

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 schedule and the availability of specific items like hand, sanitizer and face masks where appropriate.

Oh.

I'm very happy that as of today, none of our employees have reported being infected with Corona virus.

We will continue to promote health and safety in all Donaldson facilities around the world.

Specific to China, our operations in Mucci are stabilizing after an extended closing period following the Chinese new year.

Since reopening on February 10, we had 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 resumed 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 Corona virus.

We have factored some incremental uncertainty into our fiscal 2000 forecast, which I'll, let Scott cover more in his remarks Scott.

Good morning, everyone.

I want to Echo Todd sentiment.

Our teams are doing an excellent job navigating a challenge is granted by the quanta virus.

As the outbreak in China was becoming more serious we were beginning to second quarter financial close that's a stressful time in any quarter.

And our teams rallied together to support the process.

Really impressed by what they accomplished.

Krona virus outbreak is one more item on a long list of things that are making our customers cautious.

Based on the general slowdown across markets, we revised our full year forecast.

I'll talk more about that later.

But first let me provide a quick overview of our second quarter key financial metrics.

We converted a 6% sales decline into escrow of 9%.

We feel good about our profit leverage and not bride non operating items push estimates second quarter record up 50 cents.

Operating margin grew 70 basis points to 12.8%, including a 50 basis point headwind from incremental depreciation related to capacity expansion, that's our strongest second quarter operating margin since 2012.

Profit margins were also strong in both segments with engine and industrial up 90, and 160 basis points respectively.

Consolidated gross margin grew substantially to 33.7% from 32% last year.

Of the 170 basis point improvement, we estimate about a point came from our optimization initiatives.

New capacity is coming online.

We are steadily adjustment supply chain.

Procurement teams are driving cost reductions and our commercial teams continue to manage pricing.

Solid progress on these initiatives was complemented by a favorable mix of sales and lower raw material costs.

As we said coming into the year, increasing gross margin is our top operational priority and we are pleased with the progress.

Operating expenses as a rate of sales increased to 21% from 19.9% last year, driven primarily by loss of leverage on lower sales in the quarter.

We continue to spend wisely by managing discretionary expenses, while funneling dollars towards our Andy and our advance and accelerate portfolio.

Second quarter non operating income was about 2 million better than last year and our forecast.

Driven by lower loss on foreign exchange.

Our consolidated tax rate of 22.2 was also better than expected, reflecting benefits from stock option activity and the favorable mix of earnings.

We made dividend payments of 27 million in the second quarter I did not repurchase any shares we take a long view of share repurchase consider many things, including our leverage ratio business outlook, and our liquidity needs, which means that the amount of repurchase in any quarter can vary.

We are still committed to 2% this year and I purchased half of that amount in the first quarter.

Our balance sheet remains in good shape at the ended the quarter, we had a one times net debt to EBITDA.

And our working capital was down from the prior year, which is what we would expect send a slower sales environment as we make progress converting receivables and optimizing our payables.

Our balance sheet is a competitive advantage, especially as markets turn down.

Based on where we are today, we feel confident that we can continue pursuing our long term strategic priorities.

As we think about the second half of fiscal 20, we have one goal. Thank enac long term by controlling what we can.

With that I'll walk through our guidance, starting with the economic environment.

Regarding thrown a virus situation is changing to rapidly to give a precise estimation of the near or long term impact.

February sales in China were soft, but the rest of world is more consistent with trends in the second quarter.

Given the overhang of uncertainty from a variety of factors, including growing of Iris, we made a downward revision to our forecast and kept our guidance ranges wide.

We now expect full year sales to decline between three and 7%, including the headwind of 1% to 2% from currency.

That should be partially offset by pricing.

About 80% of a change in our sales forecast relates to lower projections in the second half of fiscal plenty.

We now expect the back half to be down in the mid single digits from last year within the back half we anticipate the sequential increase from second to third quarter will be much smaller than a historic average over a long period.

And the engine segment.

Full year sales are expected decline between five and 9%.

We did not change aerospace and defense for class, which is up in the mid single digits.

For on road, an App off road, we now expect full year declines in the high teens as equipment production slowest further.

They also estimate a lower level of equipment utilization so sales of aftermarket our north now forecast down in the low to mid single digits.

Importantly, we continue to expect share gains as our innovative products outperform legacy technology.

Our industrial segment sales are now projected between a 3% decline and a 1% increase we continue to expect special applications will be down in the low single digits as increasing mark level uncertainty unwinds. The strength, we had in second quarter.

TTS is now projected to be about flat with last year, driven by a lower rate of growth in sales of replacement parts.

Sales and I have asked are now projected down in the low single digits, reflecting continued strength in process filtration.

Offset by a softer market conditions for dust collection.

We still expect the performed better than the market, but it's likely that new equipment and replacement parts will remain under pressure from a cautious customer stance.

Based on lower sales in both segments, our full year operating margin is now forecast between 13.5 and 13.9%.

We continue to expect a notable year over year increase in gross margin, reflecting benefits from the initiatives we outlined earlier.

Additionally, we plan to keep tight control of operating expenses.

And we expect our incentive compensation headwind will be less than 5 million down from 10 million in our prior forecast.

The implied detrimental margin and our current versus prior guidance is in the low 20% range, which we view as strong given the unexpected sales decline.

We also made a handful of other adjustments to our forecast for your interest expense is now projected to be about 18 million. Other income is projected between seven and 11 million with the change driven primarily by the second quarter favorability.

And our effective tax rate is forecast between 24.3 and 25.3%.

We still expect capital expenditures of 110 to 130 million.

Share repurchase of 2% and cash conversion of 80% to 95%.

Altogether, we now expect full year GAAP EPS between two all five and $2 a 19 cents.

Please keep in mind that our forecast is not adjusted for the potential any transaction.

Pending completion of the necessary steps and closing that transaction, we will provide a more comprehensive view of how the divesture impacts your financial metrics on outlook.

Until we called you're unable to provide detailed the on what's been Chad.

As we look to next year.

Current market conditions, and the impact from the krona virus make our fiscal 21 projections more uncertain.

Based on where we are today, we expect our sales and operating margin in fiscal 21 will be below the ranges provided that are investor day last April.

Well the forecast is under review the themes from Investor day remain intact.

We plan to direct investments to our advanced and accelerate portfolio, which will drive share gains and increase our margin profile.

We will extend its a new markets by developing new technologies and leveraging our existing portfolio and we have a disciplined approach the capital deployment, we focus on generating strong returns and returning cash to shareholders.

With a stable based recurring revenue, which makes up more than 60% of total sales.

We believe we are well positioned to execute on initiatives, while effectively managing through a more uncertain economic cycle.

Now I'll turn the call back to Todd Todd.

Thanks, Scott while markets are uncertain, we remain focused on supporting our customers and driving our strategic priorities through innovation.

While we feel confident in our efforts external acknowledgement is also positive.

Our filter reminder, team recently enjoyed some recognition from a well regarded industry publication, which included our wireless monitoring system on their list of top 20 products for 2020.

Products were judged on innovation the ability to address important industry issues and the potential to improve a fleets bottom line.

We're pleased to be on this year's list and we're excited about the commercial launch of our monitoring solution.

Customers can easily retrofit our device onto existing system systems, giving them better visibility into their filtration performance and the ability to optimize service intervals.

We're also expanding the launch of our industrial segments connected solution.

You.

We began selling I Q in the U.S. late last year, and we plan to expand to other parts of the world in the coming month.

Like our filter reminder, offering I could you can be set up easily and provides real time information to users about the performance of their dust collection equipment.

We also continue to innovate with our existing portfolio of products.

A long running example is power core.

We launched the product 20 years ago, and made our 40 million filter last year.

We have continued to evolve powercore, making it better for our customers and more efficient for us to produce.

Based on study, we conducted last year, which compared powercore against a small number of competitive offerings. Our performance advantage continues to hold up.

With consistent use of power core we estimate that fleets with 500 trucks can save as much as $100000 per year in fuel costs.

By helping engine work more efficiently power Cork and reduced fuel consumption, creating a strong economic and environmental value proposition.

Our eye at best products also provide benefits beyond just the economics.

Manufacturing customers have historically focused on total cost of ownership and our products perform well against that measure.

Recently, we are seeing increased engagement as our technology helps customers address higher levels of safety and environmental regulations places like China, where they're launching the blue Sky initiative, and Mexico, where new pollution controls are being implemented in certain cities allow us to expand our business in.

Underpenetrated markets.

Our company's purpose statement is advancing filtration for cleaner world and these opportunities are exactly how we do that.

I'm excited about the world Donaldson will play in driving towards solutions that have strong economic social and environmental value propositions with our deep understanding of filtration and media design and development I believe we are uniquely positioned to meet that growing need.

As I close our prepared remarks, I want to once again recognize our team's efforts related to the Corona virus outbreak.

The situation is changing rapidly and they're working to stay on top of it.

I am truly impressed by the level of global coordination and I'm inspired by the amount of support and teamwork.

We often talk inside the company about acting as one Donaldson and I am witnessing the power of that mindset first hand further adding to my conviction that Donaldson company will continue to be a global leader in the filtration industry.

Now I'll turn the call back to Meghan to open the line for questions Megan.

At this time I'd like to pick any questions. You may have for US today ask your question. Please press star one on your telephone keypad.

First question is from Brian drab.

Blair Your line is open.

Hi, good morning, Thanks for taking my questions.

And Brian.

Hey.

Just first on the exhaust emissions business can you make any comment on what the operating profit is within that business or even where it is relative to the corporate average.

Yeah. This is this is Todd Brian.

Overall, what we've said in the release that 2019, the revenue was 100 and roughly 120 million.

We would also tell you that the profitability is below company average.

Okay. Thanks.

And then sounds like a the GTS business, obviously is doing really well in terms of profitability.

Was there anything in particular that happened in the quarter that that drove that.

Does that level of profitability sustainable and was that the main factor that.

Drove the outperformance and profitability for the industrial segment.

Nothing unusual in that we didn't expect to be truthful.

It's really just excellent execution that team put together a strategic plan three years ago frankly, they just plan. They are working work their plan and they're just doing a great job.

Okay, so sustainable level, there and what was that the was that profitability in that business. The.

Main reason that.

You beat my expectations I think you think you beat your expectations for the quarter in profitability in industrial.

Is there anything I think going on in industrial or is that the main driver.

No I think the main driver overall at the company is really that we've been working on a gross margins all year and we have had really strong execution to the gross margin improvement plans on a broad based level all across the company all in all regions and so we're very proud of that and you can see that reflective and leverage all the way to the bottom line.

Okay, and then on pricing you guys mentioned that.

Price is.

Going to allow you to offset some of these headwinds commodity prices I think generally been coming down your steel and.

And filtration media I would imagine.

As polymer oil derivatives.

What are you expecting for price those contribution to revenue growth for the full year.

Maybe you can see what you're expecting the second half of the year in and.

How are you getting that price. Thanks.

Brian This is Brad the realized savings on on a like for like was down in a low single digits in the second quarter. So certainly creates some favorability it's interesting, though because it really is still a mix of price by raw material. So.

Filtration media for us actually ticked up slightly as a cost in the quarter, whereas steel as you point out is down more more aligned with what you're seeing in the indices in terms of the back half. We think the favorability will start to narrow because we had some favorability towards the backend of last years, we made progress on some of these initiatives, but I'd Echo Todd's comment on.

Execution on our procurement side, they're doing a lot of work to be smart about how we're buying as well and that's that's helping us also.

So in terms of price increases as a contribution to revenue growth are we talking about like if you're getting 50 basis points of price or.

100 basis points or.

Is there any.

You know comments, there that could be a little more specific.

In terms of pricing or pricing of raw materials.

I.

Maybe I misheard, but just so let's just be clear I thought that in Scott's comments that he said.

That pricing would offset some of the headwinds that you're seeing there and I'm, assuming we're talking about.

About selling price.

If you're talking about price.

I guess.

You're correct, Brian as this has got your you're correct that I did mentioned pricing, which meant prices to our customers. So we expect to have a continued small pricing benefit which will help to offset some of the negative currency impacts that we're expecting so you had that correct.

Okay, alright, thanks, I'll get back in line pellet more later thank you.

Okay. Thanks.

Your next question is from Laurence Alexander with Jefferies. Your line is open.

Hi, This is Dan was wonderful Lawrence how would you.

Hey, thanks.

What are you talking with the gross margin improvements and the increased profitability is that more from mix improvements with new products or is that productivity.

Our gross margin improvement you know is driven by several factors.

Number one and most importantly, the initiatives.

We are specifically undertaking.

Really try and drive the gross margins up which was always our plan for this year. So may improvement. This this quarter of a 170 basis points. We estimated that 100 basis points were driven solely by our improvement initiatives, we do get a benefit of net.

And we also had a benefit of raw material pricing.

Offset slightly by a de leveraging due to reduced volumes. So there are several factors in our driving that the biggest the which is the initial because we're undertaking.

Okay. Thank you for the clarification and then a couple of questions and first do you have any exposure to some pretty seven banks within the aerospace and defense and the second.

No.

Okay.

And finally, just given the change dynamics and the kind of volatile landscape how is it.

Acting I guess, M&A, where the pipeline of potential do new acquisitions.

Yes, there's there's no real change in the M&A.

Activities the way that we view the M&A activities. We would suggest you that we still have.

A full pipeline strategic.

And remind you that we remain.

A selective buyer a disciplined buyer if you will relative to the metrics that that we view from a valuation principle.

So so no real behavioral changes at this point quarter over quarter.

Thank you very much.

Exactly.

Your next question is from Nathan Jones.

Your line is open.

Hi, Good morning, this is Adam Farley on for Nathan.

Good morning, Adam.

Hi, going back to the gross margin line and capacity you guys added.

So where's the business in terms of capacity constraints today.

Other show any pockets in the business experiencing capacity issues.

It is declining to demand.

Using that across the business.

Yes. This is kind Adam so capacity, we're comfortable with where we are relative capacity expansions that we have done in the past year really are paying off we talked about our supply chain normalization internal incorporation.

That helping lift our gross margins and that's part of that strong execution that you saw within the quarter.

We still have some of that normalization ahead of us in the balance of the fiscal year, but we're very comfortable where we are on the capacity.

Side of things and Utilizations across company.

Okay, and then turn it over to engine aftermarket.

Down in the quarter.

Okay, probably more color on what end markets from where you just how aftermarket progressed through the quarter and Oh.

Well, we don't we channel versus aftermarket or.

Are you seeing.

Stock and I know last quarter, you said it was real demand any color there would be great.

Sure. So the decline if you take a look at statistically is led by the US it's our biggest piece of the aftermarket business.

It it does have a nuance and it when you compared to Latin America, we have had some strategic shift of.

Thats supply chain normalization. If you just look and normalize that then Latin America would be roughly about flat in U.S. would be down about 5% rather than the reported 6.8, so thats, a small nuance, but but at a macro level overall aftermarket, it's really a story of utilization.

Now down across.

Again, as I said by the U.S., but across all regions and so it starts with transportation.

A lot of a lot less goods being being moved and then it moves into oil and gas the oil and gas piece being more of a USA story.

Therefore, helping us to lead the downward cycle.

And so OE versus independent channel is off goal.

About equal.

Is how to really look at that so so when you when you factor in everything that we're seeing we would suggest to you that we are not seeing some kind of step down an acute destocking across the industry. We would tell you that it's more of just a normalized slowdown.

And you can see that in reduced pull through to the overall aftermarket business.

Thank you for taking my questions.

Thanks.

Now turn the call back to Todd for closing remarks.

That concludes today's call I want to thank everyone listening for your time and interest in Donaldson company.

And to our 14000 employees I want to thank you for all you do.

Your safety is our priority. So please continue to do an excellent job navigating in this dynamic situation.

Thank you and goodbye.

Ladies and gentlemen. This concludes today's conference you may now disconnect.

[music].