Donaldson Company, Inc. F4Q09 (Qtr End 07/31/09) Earnings Call Transcript

Sep. 2.09 | About: Donaldson Co (DCI)

Donaldson Company, Inc. (NYSE:DCI)

F4Q09 Earnings Call

September 2, 2009 11:00 am ET

Executives

Richard Sheffer - Director of Investor Relations

Thomas R. VerHage - Vice President and Chief Financial Officer

William M. Cook - Chairman, President and Chief Executive Officer

Analysts

Kevin Maczka - BB&T Capital Markets

Hamzah Mazari – Credit Suisse

Analyst for Charles Brady – BMO Capital Markets

Eli Lustgarten – Longbow Research

Jeffrey Hammond - Keybanc Capital Markets

Brian Drab - William Blair & Company

Richard Eastman - Robert W. Baird

Adam Brooks - Sidoti & Company

Operator

Welcome to the Donaldson fourth quarter conference call on the 2nd of September, 2009. (Operator Instructions) I will now turn the conference over to Rich Sheffer. Please go ahead sir.

Richard Sheffer

Thank you and welcome to Donaldson's 2009 fourth quarter conference call and webcast. Following my brief introduction Tom VerHage, our Vice President and CFO, will give us a brief review of our fourth quarter operating results. Tom will then turn the call over to Bill Cook, our Chairman, President, and CEO, who will discuss our initial outlook for fiscal 2010 and the business conditions shaping that view. Following Bill's remarks, we will open up the call to questions.

Before I turn the call over to Tom, I need to review our Safe Harbor statement with you. Any statements in this call regarding our business that are not historical facts are forward-looking statements and our future results could differ materially from the forward-looking statements made today. Our actual results may be affected by many important factors, including risks and uncertainties identified in our press release and in our SEC filings.

Now I would like to introduce Tom VerHage. Tom?

Thomas VerHage

Thanks Rich and good morning everyone. Yesterday we released our fourth quarter earnings after the market closed and provided our initial guidance for fiscal 2010. Conditions in nearly all of our end markets either remained weak or deteriorated in the quarter. However, we have begun to see signs of stabilization in some of our businesses and while our future visibility remains limited beyond the first quarter and it is too early to call a turnaround we feel that the worst of the economic downturn is behind us in many of our early and mid-cycle end markets. This view is factored into our FY10 outlook in our press release.

As the recessionary conditions continue to unfold in our fourth quarter we saw our sales return to our fiscal 2005 and 2006 levels. We have aggressively reduced our cost structure to match these lower sales levels. We continued our previously announced restructuring plans and incurred an additional $6.7 million tax cost or $0.05 per share in the quarter. That brings our total restructuring costs for the year to $17.8 million pre-tax or $0.15 per share. We planned to complete more actions before the end of the quarter but encountered delays in implementing our plans.

For the actions we completed, approximately $3.2 million was charged to cost of sales. $3.5 million was in operating expenses. As a result of our outlook for near-term business conditions we are planning additional restructuring actions in fiscal 2010 that will likely result in a pre-tax charge between $12-17 million or between $0.10 and $0.15 per share for the full year. These include those items we planned to complete but were unable to in the fourth quarter. The majority of these additional restructuring charges will occur in the first half of fiscal 2010.

In addition to the workforce restructuring actions discussed in our press release, we completed the consolidation of two leased distribution centers in the U.S. into our main U.S. distribution center in Indiana and the consolidation of another leased distribution center in the U.K. into our central European distribution center in Belgium. We expect the cumulative impact of the restructuring actions taken during fiscal 2009 will generate over $100 million of annualized pre-tax cost savings in fiscal 2010 at our current volume levels.

Including the pre-tax restructuring charges we expect to incur in fiscal 2010 we are expecting our full year operating margin to be between 9.5-10.5%. Our operating margin will continue to be impacted by lower than normal absorption of fixed costs and the $12-17 million of additional restructuring costs.

Our gross margin was 32.8% in the quarter which improved from our Q3 and Q2 gross margins of 31.6% and 29.1% respectively. It was below the 33.2% we had achieved in last year’s fourth quarter. The lower absorption of fixed manufacturing costs in the quarter reduced gross margin by just over three percentage points net of savings from completed restructuring activities and the $3.2 million of restructuring costs lowered gross margin by a little less than a percentage point. A positive year-over-year LIFO accounting impact, slightly lower purchased material costs compared to last year, better execution on large project shipments and improved distribution efficiencies combined for approximately a three point improvement in gross margin. As you may recall, last year’s fourth quarter contained a $5 million LIFO accounting charge and that did not recur this year.

In operating expenses we continued the expense reduction programs we discussed last quarter including a hiring freeze, salary freeze, targeted restructurings and various other expense reduction actions. The restructuring charges increased operating expenses by $3.5 million in the quarter while we realized $9 million of cost savings that are reflected in operating expense.

Our effective tax rate was favorably impacted in the quarter by a favorable earnings mix as our Asia Pacific entities which generally have lower tax rates performed relatively better than other regions. This helped us achieve a lower than forecasted effective rate of 26% in the quarter. Based on our projected global mix of earnings we expect our normal tax rate after additional discrete items to approximate 31% going forward but our geographic earnings mix will continue to cause the rate to vary from quarter-to-quarter.

Our fourth quarter CapEx came in as expected at $11.4 million as we continue to scrutinize our capital spending plans. We are moving forward with strategic projects but as we mentioned over the last couple of quarters we are delaying beginning any new expansion until the recessionary conditions ease. Our full year CapEx guidance for fiscal 2010 is between $30-40 million and we expect depreciation and amortization to be in a range of $58-62 million which includes the amortization of intangibles from the Western Filter acquisition that we made in October 2008.

Free cash flow was $61 million in the fourth quarter which was $10 million higher than last year’s fourth quarter. For the year free cash flow was a record $231 million, an increase of $128 million over last year. Our cash conversion ratios were 258% in the quarter and 175% year-to-date. We expect free cash flow to be between $120-140 million for fiscal 2010 as the benefit from reduced working capital levels diminishes while the business stabilizes.

At the end of the quarter our debt to cap ratio was 29.5%. Debt to EBITDA was 1.2. Both of these are well within the financial covenants in our various debt agreements. We are now expecting interest expense in fiscal 2010 to be approximately $15 million. Our balance sheet remained strong. We continue to have no issues accessing our credit lines. We do not have any material long-term debt maturities in the next two years and our revolving credit line has almost four years until it matures.

With that I will pass it over to Bill who will provide more background on our business conditions and our outlook for fiscal 2010. Bill?

William Cook

Thanks Tom. Good morning everyone. While we continue to be impacted by the global recession we are now seeing signs that some of our end markets are stabilizing. At Tom noted, our sales increased 2% sequentially from our third quarter. What I would like to do first is review the past year and our fourth quarter. In doing that it may seem like a long time ago but you may recall that a year ago we were just announcing our first $2 billion plus revenue year and our 19th consecutive earnings record. Then nine months ago we announced a record first quarter. So we got off to the beginning of fiscal 2009 in a very strong position but then the global recession hit our customers and consequently us.

At the end of November the order backlogs in many of our markets started to dramatically and suddenly decline. Fortunately we had started early with our planning for this contingency and had already begun to prepare for a recession. While we couldn’t control how fast our end markets decelerated we did focus on managing those things we could control. We proactively cut our operating expenses, reduced our working capital and CapEx, reduced both our variable and fixed manufacturing costs and capacity and generally balanced our resources with the reduced business levels.

Through the winter as global conditions continued to collapse we continued to adjust to the continuing drop in the incoming customer orders. It was unfortunate but necessary that many difficult decisions were made this year to protect the long-term health of our company. As we noted in our press release we had to significantly reduce resources across our global organization. While we cut many things we did continue with a number of key projects we deemed were essential for our long-term strategy and that would help position us to capitalize on growth opportunities as they emerge.

The results of all this hard work were demonstrated by the financial results delivered during the second half of our year. During our last two quarters, the third and fourth, in the face of a year-over-year sales decline of 30% we achieved a gross margin of 32.2% and an operating margin of 8.7%. Both of these included about $13.5 million of restructuring charges.

Looking specifically at our sales results in the fourth quarter our sales were down 31%, about 4% due to currency and the balance of 27% due to a drop in business volume. The recession hit us almost equally hard in both our reporting segments during the quarter as our engine business was down 30% and industrial was down 31%. All of our major regions were down. We will look at these in local currency. Asia was down 19% primarily due to Japan. NAFTA was down 25% and Europe was down 35%. However, we are as I mentioned earlier now seeing signs of stabilization in many of our end markets as we did see a sequential increase from the third to the fourth quarter.

Some of the highlights from our product groups include our special applications where sales were up 24% from the third to the fourth quarter due to growth in sales for both disk drive filters and membrane products and our engine aftermarket business was up 10% sequentially due to an improvement in our replacement filter sales.

Now I am going to switch gears and talk about our outlook for fiscal 2010. First a qualifier; in my business career our current lack of visibility into the future is unprecedented at least since the early 1980’s. Consequently we do remain very cautious to forecasting a return to growth in the near-term. We know that capital spending in most industrial end markets continues to be constrained, especially for large equipment whether mobile or plant investments or power generation projects.

We also know that financing remains difficult for many of our smaller customers. So based on recent input from our customers and the current macroeconomic forecasts that we read we are forecasting our sales for the next two quarters or the first half of fiscal 2010 will be approximately at the pace of our previous two quarters, the third and fourth. We are then forecasting a modest sequential improvement during the second half of fiscal 2010. Our year-over-year comparisons will be difficult especially for our first quarter since as I mentioned a minute ago we posted record sales of $573 million last year just prior to the recession hitting us.

We expect our full year sales to be between $1.65 billion and $1.75 billion or down 6-12% from fiscal 2009. Given we are not forecasting anything like an immediate, strong v-shaped recovery, we are continuing to focus on our cost control initiatives to ensure that we continue to balance our expenses with our current and projected business levels. Under our corporate philosophy of Kaizen, or continuous improvement, we have dozens of specific projects working across our organization to further reduce costs and improve our operating efficiencies in our product designs, purchased materials, our manufacturing processes and our operating departments.

Our objective includes not only managing today’s cost but also optimizing our business for the future. We also have ongoing return on investment initiatives focused on implementing long-term improvement in our working capital utilization. Specifically in inventory, accounts payable and accounts receivable. You can already see solid evidence during our recent quarter of the success of these initiatives with the sequential improvement of our gross margin percent and our record free cash flow of $61 million during the fourth quarter.

While we have had to prioritize our strategic projects during this recession, we continue to invest in both select new filtration technologies and geographic expansion projects which will help to position us to realize our long-term growth plans. For example, we have continued to raise the bar in the air filtration market with our PowerCore technology. Building on the incredible success of our first generation PowerCore, we have released PowerCore Generation 2 or G2. G2 allows us to further reduce the systems size and enhance the performance of our customers versus both our original PowerCore technology or anything else on the market. We have already won 18 platforms, 7 on-road and 11 off-road with G2 and we have another 20 programs in the proposal stage.

On the industrial side of our business we introduced PowerCore technology in our Turit Dust Collectors. These new dust collectors are 50% smaller than the outback house collectors they compete with and in spite of the recession demand for these new collectors really took off as we have already received orders for over 300 systems and quoting activity remains high. We believe about 80% of these orders represent incremental business for us.

In addition to continuing to bring our customers better and better filtration technology, remaining focused on the value we bring in order to support our global customers as they expand around the world as well as new customers in developing economies we did continue to make progress in our long-term international expansion plans. Recently in India and China we won four new engine OE programs at major local customers with the first production starting late in calendar 2010. To support both our customers and our regional growth plans, we completed a major project expansion in India. We also broke ground on a new technical center in Belgium to better serve our European based customers. We started up a new manufacturing plant in Brazil and we completed an expansion to our disk drive filter production in Thailand.

Both PowerCore and our recent OEM wins in China and India represent real market share gains which will help us to recover from this recession sooner and grow our business long-term. As we begin fiscal 2010 our overriding goals remain; first, to improve our service levels and value proposition for our customers. Second, to protect the financial health of our company while continuing to pursue our highest priority strategic initiatives. All of these are key to our long-term future.

It is a difficult balancing act but it is one that the Donaldson team has done very successfully in the past. We do believe the worst of this recession is behind us. We are currently expecting a slower, gradual recovery. However, we do firmly believe in the long-term growth opportunities in the filtration markets we serve. When growth conditions do return we will have our company positioned with the right global organization, the right investments already made and with a balance sheet and cost structure that will allow us to fully capitalize on the global recovery. I am very proud of how well we have responded to this economic crisis and I remain very excited about our long-term future.

Operator that concludes our prepared remarks. Now we would like to open it up for questions.

Question-and-Answer Session

Operator

(Operator Instructions) The first question comes from the line of Kevin Maczka - BB&T Capital Markets.

Kevin Maczka - BB&T Capital Markets

First, on the restructuring, you talked about consolidating a couple of distribution centers in the U.S., one in the U.K. and of course the headcount reduction. I am just wondering with your guidance for another down year in fiscal 2010 if there is other maybe even larger restructurings or other cost initiatives of any type you are contemplating or if there some trigger point where you are ready to move forward in 2010 with more than just what you didn’t finish in 2009?

Thomas VerHage

You are right. We did announce another $12-17 million of restructuring costs in F10. We think that should take us through where we are today on the global economy. We don’t have any other plans at this point but I think very importantly if you think back to Bill’s comments he mentioned many efforts we have going on in the company from cost productivity efforts, cost controls, return on investment efforts that should continue to pay dividends. We are going to continue to work those plans but there are not any additional restructuring actions other than the ones I referred to.

Kevin Maczka - BB&T Capital Markets

In terms of some of the end markets it is good to hear the talk about stabilization. I think a couple sound like they are not stabilizing; gas turbine, the guidance suggests that 2010 will be another leg down even from the Q4 run rate. Aerospace and defense I think with the Blackhawk and other programs it seemed like you were doing better in Q3 than your outlook for 2010. Can you talk a little bit more about those two end markets?

William Cook

I just wanted to add something to Tom’s comment on the restructuring. As we noted, some of the things we planned to do in the fourth quarter we didn’t for a variety of reasons complete. So some of this is stuff that we have contemplated in the fourth quarter that is carrying over into the new fiscal year.

On the end markets, it is a mixture. One of the strengths of the Donaldson Company is our diversification we have with our end markets. We do have some end markets that are sort of later cycle decline. I think we alluded to that. Gas turbine is one of those. We sort of look at as an indicator what GE talks about and they are talking about their orders through their second quarter being about half what they were in the previous year and their shipments being down. We see the gas turbine market as being one of those later cycles.

You mentioned aerospace and defense. Defense specifically that business was one of our heroes in fiscal 2009. It had a great year. What we are seeing is that is not going to continue at that pace. Part of that is a reflection of some of the changes in government spending but more specifically to the changes in where our troops are going to be from Iraq to Afghanistan and Afghanistan there is less need for a lot of the equipment that uses our filters and so that is going to moderate the growth in that business.

Kevin Maczka - BB&T Capital Markets

So in gas turbine specifically there is no share loss going on here? Your customers’ trends are actually worse than what you are suggesting in your guidance?

William Cook

Exactly. I think in GE’s conference call they said their orders through the first half of their year were 26 versus 58 a year before. Less than 50% of the order intake. They are probably the barometer for the large gas turbine market. That market is a later cycle decline.

Operator

The next question comes from the line of Hamzah Mazari – Credit Suisse.

Hamzah Mazari – Credit Suisse

I was wondering if you could touch on the aftermarket opportunity you have. Whether you can quantify that or put a timeframe on it for the opportunity as it relates to increasing the amount of equipment in the field with PowerCore as well as what the current run rate of aftermarket is on the engine side as well as what that should be on a normalized basis as a percent of the overall mix in your view.

William Cook

The aftermarket business is doing better on the engine side than the first fit business is in all regions. That is generally because while new equipment isn’t being produced or hasn’t been produced at the rate it has been before people are using existing equipment in the field so we are getting less of a decline I should say in the aftermarket than we are in first fit. We are seeing that generally in every region. I think what we are seeing with PowerCore and other technologies like PowerCore is over time we are increasing our share as we use proprietary technology where it is very difficult for our competitors to replace us.

PowerCore today in terms of our percentage of our after market is still a small percentage but it is growing as we get more and more of these vehicles out into the field with first the Gen 1 and now the Gen 2 system. We are doing the same thing on the industrial side as I mentioned with the Turit PowerCore. We are going to see the same advantages that will make it very difficult for anyone else to replace our filters and dust collectors as we start to get more of those into the field.

Hamzah Mazari – Credit Suisse

My other question has to do with trying to understand your guidance a little better. You commented that the worst was over in some of the early and mid cycle businesses. Could you elaborate on your definition of those businesses? Which businesses are you referring to there? How much of a pickup you are baking in the second half of 2010 in those specific businesses?

William Cook

I will start on this and then ask Tom to add as well. The end markets we see are stabilizing are market such as the construction market with both small and heavier construction. We see that stabilizing now say in this third calendar quarter we are in. We look to guidance there from major customers like Caterpillar. They talk about their calendar quarter being their worst quarter and then starting to recover. We think we are in that construction. We think heavy truck is there and that over time I think most people are estimating a very gradual recovery through calendar 2010 so we think that is stabilized.

On the industrial side we see our disk drive market has stabilized and the membrane market probably has stabilized. Those are a couple of examples. We have some regional examples as well like in China they stabilized maybe a couple of months ago and now are coming back generally. Those would be the earlier cycle end markets that are now stabilized or starting to recover.

Was there another part to that question?

Hamzah Mazari – Credit Suisse

You talked about mid-cycle as well.

William Cook

We are separating those into the categories I mentioned and the other ones are either going down or we are not sure if they have stabilized. We talked about earlier about gas turbine and defense and aerospace. Gas turbine going down and defense and aerospace moderating. I think the other industrial markets that we have would be dust collection, compressed air filtration. Those are a later cycle and those we are not sure if they have bottomed out yet or not. I think today talking about the manufacturing recovery maybe that is the precursor for those to stabilize and eventually starting to recover. The one other one we talked about is the aftermarket and that is related to equipment utilization both on and off-road and I think we would say we have seen that one stabilize.

Operator

The next question comes from the line of Analyst for Charles Brady – BMO Capital Markets.

Analyst for Charles Brady – BMO Capital Markets

First of all can you give us what the first quarter fiscal 2010 would be for the restructuring charge? Any estimate on that?

Thomas VerHage

I said in my comments that our restructuring charge estimate for fiscal 2010 would likely result in the vast majority of those charges being in the first half. The split between Q1 and Q2 we really aren’t prepared to talk about to the extent that is going to be a little bit outside our control at this point. Look for the majority of those charges in the first half.

Analyst for Charles Brady – BMO Capital Markets

What do inventory levels look like in the channel at this point?

William Cook

I think most of the work down of inventories is now behind us. We talked about this in the last call and at that point we thought it had already happened with our smaller distributors and now we think that most of that is also behind us in terms of our larger OE’s as well. We think most of that is behind us.

Analyst for Charles Brady – BMO Capital Markets

Of the costs you have taken out of your business, how much is variable cost that will come back when volume comes back? I think in the past it had been sort of a 60/40 split between cost of sales and operating expenses. Can you talk about how you expect that to breakdown going forward?

Thomas VerHage

I will take a stab at that. I think we got that question last quarter too. I think I will start out by saying at these volume levels the cost take outs that we mentioned would be permanent. As volumes come back it is just really, really hard to put any dollars associated with that come back. I would say that what is going to come back first from a cost standpoint would be variable costs in the plants; bringing back direct labor people. We don’t have any precise formula as to what percent of the costs come back if volumes pick up 10-15%. It is just too hard to do.

Analyst for Charles Brady – BMO Capital Markets

Can you give us any color on the on-road business as it relates to the stabilizing of the build rates? Do you see that both in North America and Europe? For the latter half of fiscal 2010 do you expect any pick up there?

Richard Sheffer

What we have seen is the build rates kind of stabilize at levels last seen in the early 1990’s. Most of the forecasts for the calendar year suggest somewhere around 110,000 to 115,000 builds in the U.S. We are kind of at that run rate now. Europe is running down around 50% on a year-over-year basis. That appears to have stabilized at those levels.

Analyst for Charles Brady – BMO Capital Markets

In terms of the defense sales you touched on this a little bit. I am wondering if Donaldson filters are on any of the large contracts that have just been won for the military vehicles including the MRAP all terrain vehicle or the next generation family of medium tactical vehicles. Do you have any magnitude of how much you think aerospace defense sales might be off in fiscal year 2010?

William Cook

We are on most of those platforms with our filtration equipment so that is great news and it is going to help us longer-term. All of that is baked into the guidance in terms of the numbers that we provided for fiscal 2010. If I can just back to your question on the on-road. We are looking for an improvement in calendar 2010 so this would be starting in January, about mid-year, in these on-road markets. I am talking specifically North America probably maybe about 25-30% in terms of build rates year-over-year calendar 2010 over calendar 2009. This year was a pretty bad year but the good news is it looks like it is going to be heading up. That is in our second half of our fiscal year.

Operator

The next question comes from the line of Eli Lustgarten – Longbow Research.

Eli Lustgarten – Longbow Research

You mentioned last year you had a LIFO charge of $5 million. Do you know what the LIFO incremental benefit was in the fourth quarter? Was is similar to $5 million?

William Cook

That $5 million charge did not repeat this year and we did not have a real significant adjustment either way in the fourth quarter of this year.

Eli Lustgarten – Longbow Research

So it was just the [explain] that you are referring to? There was no real benefit to earnings from LIFO?

William Cook

Yes. Think about the $5 million as the year-over-year change.

Eli Lustgarten – Longbow Research

There was no absolute benefit by itself in the quarter?

William Cook

No.

Eli Lustgarten – Longbow Research

Secondly, you gave a forecast for gas turbines down 21-26%. That includes the aftermarket. I assume that includes the aftermarket and therefore the OEM business is probably down 40-50% and the aftermarket is down a lot less. Is that how to look at it?

William Cook

Yes it does include the aftermarket. The aftermarket in gas turbines is only about 30% of the total revenues. Just given the size of these first fitting projects. So the projects are down more than the aftermarkets. You are right.

Eli Lustgarten – Longbow Research

You talked about the truck market stabilizing. We are seeing a lot of evidence of the truck industry over-building in the next six months between now and December 31st. Particularly in engines we are building the current engine…I think they want to do what they did in 2006 and 2007 and sell 10 trucks with 9 engines. Are you seeing any pick up in incremental volume from that over-build that is taking place or is that mostly going to come into air filtration?

William Cook

Our filtration equipment is generally sold to the truck manufacturers, not to the engine builders. So it is installed with the truck so even if the engines are being built that is not going to materially pull ahead our sales. It would only be if the completely built the trucks ahead.

Eli Lustgarten – Longbow Research

So you will ride with the market. You mentioned construction was stabilizing and Cat did tell you that the third quarter was by far the worst of everything. Have you gotten any sense for what kind of incremental improvement after the third quarter you can expect in construction equipment or do we stay at these levels for the next couple of quarters? I am trying to get a sense as we progress through your fiscal year we go through the bad quarter but does it get better or does it stay at that level in construction as we look ahead?

William Cook

I think they were pretty modest in what they said in their call at the end of July and what they have told us. I think it is back to that visibility. They have been pretty consistent in saying they believe this third calendar quarter which we are half way through will be their worst. Then it will start to pick up in the fourth and then going into calendar 2010 continue to improve sequentially. I think they used words like moderately or modestly or things like that. They are not talking about a strong recovery.

Eli Lustgarten – Longbow Research

You mentioned you have a new plant that just started up in Brazil during your comments. In your forecast you talk about equipment particularly outside the U.S. going down which is true. It is the Brazilian market that has been focused on by many of us who are seeing the same signs of potential improvement next year because of increased funding from the government and a lot of suppliers. Can you talk about your new Brazilian plant and are you expecting to benefit from any of that improvement on the horizon at this point?

William Cook

We are. We had been importing into Brazil before we opened the plant up so now we are making locally and it is tremendous upside for us there whether the economy goes up or down just because our market share is so low. We have a lot of global customers relocating to Brazil. Brazil was one of the bright spots year-over-year in fiscal 2009 versus fiscal 2008. The numbers are small but we look for them growing significantly over the next couple of years.

Operator

The next question comes from the line of Jeffrey Hammond - Keybanc Capital Markets.

Jeffrey Hammond - Keybanc Capital Markets

You mentioned the sequential improvement in the aftermarket business and special applications. Is that just simply the end of de-stocking? Maybe just speak to the sequential improvement; where you saw it, is there real demand improvement? Just a little more color there.

William Cook

I will start with the aftermarket. I think we are sort of guessing but we think on the aftermarket it is the end of the de-stocking and then improved utilization of equipment that is out there. On the disk drive that is a first fit business we are selling to the hard disk drive manufacturers. They also had inventory they had to work through, the hard drives at the computer makers, and I think they worked through that and maybe there is some pick up in terms of consumer and business demand for PCs.

Jeffrey Hammond - Keybanc Capital Markets

Where are you seeing better utilization of equipment for the aftermarket?

William Cook

I think we are seeing it both in on-road and off-road.

Jeffrey Hammond - Keybanc Capital Markets

You have talked a lot about Defense, which I think falls into the off-road business, but that went from $82 million to $72 million sequentially. What was the big driver of that drop off sequentially?

Richard Sheffer

The real sequential difference was just the shift in theaters of operation. There is less maintenance going on in the equipment in Iraq now. Most of it is not being used to the extent that it was. As Bill mentioned in Afghanistan the equipment they are using is smaller, has less content and obviously fewer pieces of equipment there as well.

Jeffrey Hammond - Keybanc Capital Markets

My question though is more broadly on off-road which I think captures AG and construction, down $10 million sequentially. My understand was the defense business was pretty small within that.

Richard Crystal

Defense is about 20% of that.

Jeffrey Hammond - Keybanc Capital Markets

That was where you saw the biggest variation?

Richard Sheffer

There we were still okay in the quarter. We did have some benefit from the Western Filter acquisition. After that it was construction starting to stabilizing, e.g. starting to go down a bit. That was probably the biggest shift there so not really a benefit from construction going up but lack of a downdraft really.

Jeffrey Hammond - Keybanc Capital Markets

Would you put AG in the category of still deteriorating?

Richard Sheffer

Yes, on a global basis, yes.

Jeffrey Hammond - Keybanc Capital Markets

Good improvement on the gross margin line. A lot of moving pieces there. How should we think about that gross margin line and sustainability going forward? Obviously adjusting for any restructuring noise.

Thomas VerHage

With the guidance that we gave for F10 we are looking at gross margin in the 32-33% range and that would include some of that restructuring charge. The programs again that Bill mentioned from a cost reduction and productivity improvement standpoint have had a big impact. For that reason, even at these volume levels with some restructuring charges and with excess capacity in the plants we are hopeful we can hold gross margins north of 32% in F10.

Operator

The next question comes from the line of Brian Drab - William Blair & Company.

Brian Drab - William Blair & Company

I first wanted to ask about SG&A and sequential change. If I am looking at the numbers correctly and remove any charges from restructuring it looks to me like operating expenses in SG&A specifically increased about $10 million from the fiscal third quarter to fiscal fourth quarter. That is surprising to me given all the focus on cost cutting and I was wondering if you could explain that?

Thomas VerHage

Once you backed off restructuring there is a bit of an increase quarter-over-quarter. If you think back to our third quarter call we talked about a reduction in incentive compensation for the third quarter and because of the downturn we needed to adjust our accruals, both accruals that we recorded earlier in the year and for our long-term incentive accruals that may be paid in the previous two years. So in the third quarter there was about a $10 million quarter-over-quarter benefit and that in itself is by far the largest reason for the sequential year-over-year increase.

Brian Drab - William Blair & Company

I wanted to ask for a point of clarification. I think you mentioned that first half 2010 sales are expected to come at the same pace as second half 2009. Does that mean overall to expect volumes to be about flat sequentially over those periods?

William Cook

Right. The mix of the all the markets we would expect our corporate sales to be about what they were the last two quarters.

Brian Drab - William Blair & Company

A follow-up on a question asked earlier in the call regarding off-road. I have the same question about the decline of about $10 million in that business sequentially. Were you seeing some of the end of inventory reduction at Caterpillar there or was that really not as big a factor in the quarter?

William Cook

I think some of the decline in off-road, and we might have touched on this earlier, is related to there are a number of plant shut downs in the fourth quarter at major customers. On the first fit side that dropped quite a bit. We are trying to balance their inventory of equipment and they took advantage of much longer shut downs during the summer period.

Brian Drab - William Blair & Company

On the restructuring you mentioned there were some delays in the restructuring. Are those issues completely behind you at this point? I don’t know if you would be willing to offer any detail on what were the causes of some of those delays?

Thomas VerHage

We aren’t saying a whole lot about that. We haven’t announced it internally so we are just going to be pretty quiet on that. We have plans to get there and we are quite confident we can execute those plans in fiscal 2010. As you probably know sometimes these just take a little bit longer than we initially anticipated.

Operator

The next question comes from the line of Richard Eastman - Robert W. Baird.

Richard Eastman - Robert W. Baird

When you give your sales guidance for fiscal 2010 and we have this minus 6-12% guidance my assumption is the residual cost savings which is a number like $57 million gross savings that should be all realized and in your guidance given that sales assumption?

Thomas VerHage

Yes it is in our guidance. I think your math is pretty good.

Richard Eastman - Robert W. Baird

So the cost of $12-17 we should net about $40-45 million of savings pro rata throughout the year?

Thomas VerHage

That is roughly the number.

Richard Eastman - Robert W. Baird

Just to clarify, the engine segment guidance you presented that rolls up to this minus 3% to minus 8% that includes a bit of positive currency. Transportation has gotten pretty tiny if you start to weight this and if we are saying aftermarket should be slightly improved? It would suggest the off-road piece may decline something like 15%? Is that right?

William Cook

Richard is checking his numbers. The currency part is 1%. I just want to go back to the comments about the guidance and put this in perspective for a second. Coincidentally, our guidance for fiscal 2010 approximates what we did in fiscal 2006. If you go back to fiscal 2006 we did about $1.7 billion and so that is how much of a reset this whole thing has been for us and many other companies. If you take a look at our EPS guidance and exclude the restructuring charges and just take a look at it excluding those, on that same sales level of approximately $1.7 billion we are talking about doing roughly the $1.50 which is what we did in fiscal 2006 which was our 17th consecutive record. So we are trying to do our best in a pretty sluggish, maybe slowly recovering environment. I just wanted to relate it just coincidentally because sales are back to about that level and the EPS is what we are planning and guiding to X restructuring is what we did. That was a record when we did it.

Richard Eastman - Robert W. Baird

A good point. And resizing to that $1.7 billion revenue.

William Cook

Exactly.

Richard Sheffer

If we look at the engine segment on a year-over-year basis the biggest negative comparison we are going to have is the off-road business. You are right there.

Richard Eastman - Robert W. Baird

We have AG headed south, we have construction at best flat, we have defense headed south. So we are likely to get kind of a double digit decline.

Richard Sheffer

Also our off-road business had a really good start to the year last year. On-road kind of flattish. Quite frankly the aftermarket when we say slightly we are not looking for historic record breaking growth this year. It is off the bottom but not 50% or anything crazy like that.

Richard Eastman - Robert W. Baird

In terms of the engine side of the business, is there any reason to fear that pricing might start to get aggressive or are you pretty comfortable pricing in both the aftermarket and the first fit side are reasonably stable here?

William Cook

Pricing is always aggressive so I think it is more of the same. It reflects the world that we life in. We don’t see it changing from where it has historically been.

Richard Eastman - Robert W. Baird

The industrial piece of the business historically has been kind of the lagging piece. Comparisons aside, if you are just thinking about revenue and volumes in the industrial piece as a whole it would seem that timing maybe places the bottom in industrial maybe in the April quarter. Is that cutting it too close for guidance?

William Cook

Next April?

Richard Eastman - Robert W. Baird

Your April quarter. Your third quarter. If you are just thinking about it in terms of volume and backlog, shipping schedules…

William Cook

I hope that it would come back sooner than that. Every day brings more news; some of it positive and some of it negative. Today was a little bit more positive. We do know that industrial dust collection and compressed air is a later cycle business. That held up very strong, right up to the first part of this calendar year back in January when a lot of the engine markets had already sort of collapsed. Then it started in that first calendar quarter. We are not really guessing exactly when it is going to bottom or turn. We are just saying it is later cycle and we are not sure when that is going to happen.

Richard Eastman - Robert W. Baird

On the raw materials side is there a positive there at all? Are your raw materials year-over-year less cost wise?

Thomas VerHage

There is a small benefit year-over-year.

Operator

The next question comes from the line of Adam Brooks - Sidoti & Company.

Adam Brooks - Sidoti & Company

On the aftermarket side could you maybe break down what the performance was within engines and maybe within industrial air filtration within the different regions? Asia, Europe and North America?

William Cook

Rich is getting the data on that. Do you have another question while he is doing that?

Adam Brooks - Sidoti & Company

Talking about PowerCore obviously and more first fits in the field, can you talk about maybe any market share gains where you are seeing greatest or maybe it has been a little less than expected?

William Cook

I think it has been maybe almost everything we hoped so as expected or slightly better. On the Turit side, the dust collection side, I might have mentioned in my remarks we think about 80% of those 300 systems we have sold as incremental business where we would not have won the business if we didn’t have a product that was competitive. So all incremental. On the engine side we are already the first fit on many of those platforms so we are picking up business there as well that we think is incremental. So both sides of the business there is an incremental benefit to market share that is going to benefit us going forward.

Adam Brooks - Sidoti & Company

I know you won’t necessarily speak about this, as far as acquisitions clearly valuations are around more reasonable levels than they have been in the last two years. Are you still on the acquisition front with an improving balance sheet?

William Cook

We are always looking. We don’t comment prospectively. We did one earlier this year Western Filter. We had been working on that a couple of years and even as we saw the recession starting to come over us we knew it was the right, long-term thing to do so we did it. We have been looking. I would say generally though we haven’t seen a lot of activity in the marketplace. My guess is a lot of potential acquisitions have been dealing with the recession and they are working on that rather than trying to put themselves on the market. Maybe as things start to improve there will be more activity and we are always looking. We are mostly an organic growth story as I said before but we do strategic acquisitions to help supplement that. Rich has got the questions on the aftermarket.

Richard Sheffer

If we look at engine aftermarket if you look at it on a regional basis in local currency terms in Europe it was down 19% year-over-year, down 5% in Asia. In the Americas it was down 17%.

Adam Brooks - Sidoti & Company

That is fourth over fourth?

Richard Sheffer

Yes that was fourth quarter over fourth quarter.

Adam Brooks - Sidoti & Company

Was there any big disparity within industrial for Europe versus North America specifically?

Richard Sheffer

I think it was a little bit weaker in North America than it was in Europe. Europe was down about 28%. North America was down a little bit more than that.

Operator

The next question comes from the line of Kevin Maczka - BB&T Capital Markets.

Kevin Maczka - BB&T Capital Markets

I am wondering if you can say a little bit more about this CapEx outlook. It looks like that is taking another leg down to $30-40 million and it wasn’t exactly a high growth year or a year for high investment in expansion projects. Can you just say some more about that?

Thomas VerHage

You are right; the guidance for F10 is $30-40 million. We did come in at $46 million in fiscal 2009 so it is not a significant reduction from fiscal 2009. The real key is we really don’t have any significant expansion efforts in process. What drove us to the peak in say fiscal 2008 of $71 million was a number of the expansions we had mentioned over the last couple of years. So if you strip out the expansion what we have left in there is CapEx for tooling, cost reduction projects and process improvement projects. We feel pretty comfortable we can stay within that $30-40 million in F10 again assuming we don’t initiate any expansion projects which we do not have on our planning horizon at this point.

Kevin Maczka - BB&T Capital Markets

The low end, that $30 million is kind of a bare bones, maintenance level CapEx?

William Cook

It is that and then supporting our cost reduction and new tooling investments for some of the future programs but it is a lower level. As Tom mentioned and I just want to reiterate, for three years from 2006 to 2008 we spent on an average about $75 million consciously. We focused a lot on CapEx expansion efforts around the world. Part of that was we didn’t see a lot of acquisition opportunities so we focused internally. We have the benefit now of those investments we can enjoy. As I mentioned as a response to Rick Eastman’s question earlier, we are looking at a year that is more like our 2006 in terms of revenue. So we have the investments in place that we shouldn’t have to, as Tom mentioned, make any big additions until the economy has really started to take off again. We see that out probably a couple of years at least.

Kevin Maczka - BB&T Capital Markets

How much corporate expense is baked into your margin outlook?

Richard Sheffer

A very comparable, I don’t have a specific number for you but a very comparable level to what we experienced this year. We certainly have taken out some corporate expenses in the second half of the year and that we would expect to be pretty much our run rate for fiscal 2010.

Kevin Maczka - BB&T Capital Markets

Did you give the restructuring costs for Q4 by segment?

Thomas VerHage

For Q4, by engine and industrial?

Kevin Maczka - BB&T Capital Markets

Yes.

Thomas VerHage

Roughly 55% industrial and 45% engine.

Operator

That concludes the question and answer session. I would now like to hand the call back to William Cook for any closing remarks.

William Cook

Thanks operator. To all of you participating and listening I would like to thank you for your time and interest. To the Donaldson team, we obviously didn’t plan for what happened in fiscal 2009. It was a very challenging and unusual year as a result. We were tested and I am very proud and grateful at how wonderfully we responded to this crisis. While we will face some continuation of these challenges in fiscal 2010 we are ready for them and as a result I truly believe that the best days for Donaldson remain ahead of us. Thanks for your efforts and your support. Good bye.

Operator

This concludes the Donaldson fourth quarter conference call. Thank you for participating. You may now disconnect.

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