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Donaldson Company Inc. (NYSE:DCI)

F1Q10 Earnings Call

November 19, 2009; 11:00 am ET

Executives

Tom VerHage - Vice President & Chief Financial Officer

Bill Cook - Chairman, President & Chief Executive Officer

Rich Sheffer - Director of Investor Relations

Analysts

Hamzah Mazari - Credit Suisse

Amanda Sigouin - Jefferies & Co.

Kevin Maczka - BB&T Capital Markets

[Derrick Jose] - Longbow Research

Jeff Hammond - KeyBanc Capital Markets

Adam Brooks - Sidoti & Co.

Charley Brady - BMO Capital Markets

Brian Drab - William Blair

Richard Eastman - Robert W. Baird

Operator

Welcome to the Donaldson Q1 fiscal year 2010 webcast. During today’s presentation all parties will be in a listen-only mode. (Operator Instructions) This conference is being recorded today Thursday, November 19, 2009.

I’d now like to turn the conference over to Rich Sheffer; please go ahead.

Rich Sheffer

Thank you, Brandey. Welcome to Donaldson’s fiscal 2010 first quarter conference call and webcast. Following my brief introduction, Tom VerHage, our Vice President and CFO will give us a brief review of our first quarter operating results.

Tom will then turn the call over to Bill Cook our Chairman, President and CEO who will discuss our updated outlook for fiscal 2010 and the business conditions shaping that view. Following Bill’s remarks, we’ll open up the call to questions.

Before I turn the call over to Tom, I need to review Safe Harbor statement with you. Any statements in this call regarding our business that are not historical facts are forward looking statements. Our future results could differ materially from the statements made today.

Our actual results maybe affected by many important factors including risks and uncertainties identified in our press release in our SEC filings. One more note before I turn it over to Tom. In yesterday’s release, you will notice that we have added two new product groups.

Our aerospace and defense products, which was previously products, which was previously included in Off-Road products, and our Retrofit Emissions products, which was previously included in our aftermarket products, all of those within our Engine segment.

We have added a schedule to our website that shows our fiscal 2008 and 2009 historical net sales in this new reporting format. You can go to the Investor Relations section of our website, www.donaldson.com to see this schedule and our normally posted foreign exchange translation schedule.

Now, I’d like to introduce Tom VerHage. Tom.

Tom VerHage

Thanks Rich and good morning everyone. Yesterday we released our fiscal 2010 first quarter earnings. After the market closed and updated our guidance for the balance of the year. For the second consecutive quarter, our sales were up 2% on a sequential quarter basis after bottoming in the third quarter of fiscal 2009. Conditions in many of our end markets have either stabilized or are slowly beginning to recover.

So, we have increased our earnings guidance and Bill will discuss this further in a few minutes. We are continuing to execute our previously announced restructuring plans and incurred an additional $1.3 million pre-tax cost or $0.01 per share in the quarter, with approximately $800,000 charge to cost of sales and $500,000 charge to operating expenses.

By segment, $900,000 was incurred in our Engine product segment and $400,000 was incurred in our Industrial segment. Since we began these restructuring efforts last January, we have incurred restructuring costs totaling $19.1 million pre-tax, or $0.16 per share.

We are continuing to work our plans and anticipate incurring an additional $11 million to 16 million of restructuring this fiscal year, assuming we can get the necessary government and labor related approvals. While we hope to incur the majority of these costs over the next two quarters, the regulatory approval process creates some uncertainty.

The realized savings of $27 million in the quarter from restructuring actions we have completed since January of this $27 million savings, $12 million was in cost of sales, and $15 million was in operating expenses. By segment, $13 million of savings was in the Engine segment and $14 million was in the Industrial segment.

Including the pre-tax restructuring charges we expect to incur in fiscal 2010 we are now expecting our full year operating margin to be between 11% and 12%. Our operating margin will continue to be impacted by lower than normal absorption of fixed costs and the $11 million to $16 million of additional restructuring costs.

Our gross margin was 34.7% in the quarter, a year-over-year increase of 210 basis points, and a sequential quarter increase of 190 basis points. We had year-over-year benefit of 180 basis points from a greater mix of higher margin aftermarket sales versus the lower margin first-fit product sales in the first quarter and we achieved our first quarter where aftermarket sales were over 50% of our sales mix.

Lower absorption of fixed manufacturing costs in the quarter reduced gross margin by 130 basis points, net of savings from completed restructuring activities, all other factors, including production cost reduction activities, the $800,000 of additional restructuring costs and improved distribution efficiencies combined to increase gross margin by 160 basis points.

Operating expenses decreased by $21 million year-over-year. We have continue the operating expense reduction programs that we have discussed the last few quarters, including targeted restructurings and various other expense reduction actions. Our effective tax rate was 30.9% in the first quarter versus 30% last year.

Last year’s first quarter included a benefit of $1.8 million from the reinstatement of the R&D tax credit and a positive development regarding a foreign tax contingency. Based on our projected global mix of earnings, we expect our normal tax rate to approximate 31% going forward, but our geographic earnings mix and any unplanned discrete items will continue to cause the rate to vary from quarter-to-quarter.

Our first quarter CapEx came in at $7.7 million, we’re moving forward with strategic projects such as tooling for new product platforms, the completion of our plant expansion in India, and our new European Technical Center in Belgium. Our full year CapEx guidance for fiscal 2010 is between $30 million and $40 million. We expect depreciation and amortization to be in the range of $58 million to $62 million.

Free cash flow was $62 million in the first quarter, an increase of $22 million from last year’s first quarter. Our cash conversion ratio was 180% in the quarter and we expect free cash flow to be $145 million to $165 million. At the end of the quarter, our debt-to-cap ratio was 28% and debt-to-EBITDA was 1.3%. Both of these are well within the financial covenants in our various debt agreements.

We’re now expecting interest expense in fiscal 2010 to be between $14 million and $15 million. So, our balance sheet remains 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 over three years until it matures.

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

Bill Cook

Thanks, Tom and good morning everyone. Although it seems like a long time ago, just this time one year ago we were completing a record first quarter. While the recession hadn’t yet hit us, we already see the gathering clouds unfortunately started taking many difficult, but appropriate actions early.

So obviously our current quarter comparisons to last year’s record first quarter are difficult ones. On a year-over-year basis, our sales are down 25% from last year, pretty dramatic and so while this is obviously a very negative year-over-year comparison it does accurately reflect the severe impact of the recession on our customers, our end markets, and our company.

Now I would like to point out a few other year-over-year comparisons, a much better picture and suggest how well we have responded and how well our company is running today. So, despite the loss of 5% of our sales volume year-over-year or about $150 million, our gross margin percent actually is better by 210 basis points than it was in last year’s record first quarter.

Our operating expenses are down 18%, and our current operating margin at 12.3% is up from last year’s record first quarter. We also made significant improvements in our balance sheet generating over $60 million in free cash flow just in the last quarter. To be clear, we’ve still had a dramatic sales volume decrease and consequently have we generated fewer dollars on the bottom line than last year’s record first quarter.

However, I’m very proud at how efficiently our company is running today and how well positioned we are for the future. It almost goes without saying, but I will say it anyway, getting our operating metrics to this point wasn’t easy and required a lot of very difficult decisions, sacrifices and hard work, but it was necessary for us both to effectively lead our company through this crisis and protect our future.

Now I’m going to switch gears and talk about current trends. When we compare our first quarter on a sequential basis to our last two quarters, we believe that we can now say that the worst of this current cycle is behind us. As general conditions have stabilized and maybe even are starting to ends up.

Our sales as Tom mentioned were up 2% in the current quarter, from our fourth quarter, which was that May through July period. This represents our second consecutive quarter or sequentially sales growth. Sales in our Engine segment were up 7% sequentially, just a few highlights, first our On-Road products were up 24%. They have rebounded from multiyear lows and this also included the small pre-buy ahead of the January emission regulations in North America.

Our Off-Road products sales were up 6% on higher sales in the Americas and Europe, and our Engine Aftermarket sales are up 9% with growth in all three major geographic regions. The sequential sales results in our Industrial segment are a little more mixed with one early cycle business now recovering and two later cycle businesses still declining. Early cycle business is our Special Applications Group, where the sales are up 3% with the early recovery in the hard disk drive market.

On the other hand our Industrial Filtration sales were down 1% sequentially slightly weaker sales in Europe and the Americas were only partially offset by stronger sales in Asia Pacific. Our latest cycle business which is our Gas Turbine Products, sales decreased 24% sequentially as demand for new systems, new power systems continues to decline due to the general decrease in electricity demand.

Now switching to our outlook for fiscal 2010, as Tom mentioned we have updated this, and while we have a mix of early and later cycle businesses and end markets, we believe that the overall end market conditions appear to have at least stabilized. We see utilization rates of existing equipment in the field, whether it’s trucks, construction, or Ag equipment, stabilizing at current rates.

We see capital spending in most industrial end markets continue to be constrained and especially for large equipment whether plan investments or power generation projects. The better news that positive inventory adjustments or restocking, happening following last year’s dramatic inventory destocking and this activity is providing some near term benefit in all of our replacement filter businesses.

Based on recent customer feedback and the current macroeconomic forecast, we are forecasting our second quarter sales, so this would be the period November through January, to be slightly lower sequentially than our first quarter sales. This is mainly due to our second quarter being historically our seasonally lowest quarter due to the holidays and calendar year end customer shutdowns.

Based on our forecast of a gradual economic recovery in calendar 2010, we are now forecasting both year-over-year and sequential sales growth during the second half of our fiscal 2010. This would be the period February through July. As noted in our press release with our improved outlook, we have now increased our full year sales guidance and expect our fiscal 2000 sales to be approximately $1.8 billion.

However, given that we’re expecting a gradual economic recovery rather than a strong V-Shaped one, we will continue to focus on our cost control initiatives to ensure that we balance our expenses with our current and projected business levels. Under our corporate philosophy of Kaizen or continuous improvement, we have dozens of project teams working across our organization to further reduce costs and improve our operating efficiencies, in our product designs, in our purchase materials, manufacturing processes, and our operating departments.

Our objectives include not only managing today’s costs, but also optimizing our business for the future. We also have on going return on investment initiatives focused on implementing long term improvements in our working capital utilization specifically inventory, accounts payable and accounts receivable. All this work has paid big dividends so far and will continue to do so.

Now switching to our new technology platforms, despite the recession, we have continued our new product introductions. We continue to raise the bar in air filtration with our PowerCore technology, building on our incredible success of our first generation PowerCore. We have released PowerCore generation 2, or G2.

G2 allows us to further reduce the system size and enhance the performance for our customers versus anything else on the market. We’ve already won 22 platforms, 10 On-Road, 12 Off-Road with G2. We have another 16 programs in the proposal stage. G2 will be going into production over the next several months and years to coincide with our customers’ new product or new platform launches.

On the industrial side of our business, we’ve introduced PowerCore technology in our Torit dust collectors. These new dust collectors are 50% smaller than the baghouse collectors they compete with. Despite the recession, demand for these new collectors really took off and we’ve already received orders almost 500 Torit PowerCore Systems. We believe 80% represent of these orders represent incremental business for incremental business for us.

In this past week, we launched our next line of Torit PowerCore systems at the FABTECH show in Chicago. These new collectors are targeted at the cartridge collector markets and are up to 65% smaller than the systems they compete with. We’ve also continued to make progress on our long term international expansion plans. To support our customers as they expand around the world as well as new customers in developing economies.

As we mentioned last quarter, we’ve won four new Engine platforms in China and India with major local customers, the first production starting in calendar 2010. To support both our customers and our regional growth plans, we are now completing a major plant expansion in India and also, as Tom mentioned, during the past year we’ve broken ground on a new technical center in Belgium also to better support our European based customers. Both of these expansion projects should be completed this spring.

Both the PowerCore and recent OEM wins in China and India represent real market share gains which overtime we believe will help to us recover from the recession sooner and grow our business long term. So as we progress through fiscal 2010, our overwriting goals remain. We first improve our service levels and value propositions for our customers. Second, to maintain our strong financial position, and third, to continue to pursue our highest priority strategic initiatives; these are the keys to our long term success.

I just briefly summarize, we are currently expecting a slow or more gradual economic recovery, starting in the in the second half of our fiscal 2010. We’ve seen many of our early and mid cycle businesses stabilize and now see some of them beginning to show signs of early recovery. However, we do see several of our later cycle businesses continuing to decline in fiscal 2010.

We expect this to be the major theme of our fiscal 2010 as our end markets transition from a severe recession to some stage of recovery, but whatever shape this eventual recovery takes, gradual or rapid, I believe that we are very well positioned for both long term growth and financial performance.

Brandey, that concludes our prepared remarks. Now, we’d like to open it up to the questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Hamzah Mazari - Credit Suisse.

Hamzah Mazari - Credit Suisse

Just a question on your margins, how should we be thinking about your margins going forward over the next couple of years as a cyclical recovery takes hold, at some point you have some costs coming back into your system, but at the same time, you have a better absorption of fixed costs, which are hurting you right now, but at the same time, you have a longer term aftermarket opportunity with PowerCore that begins to take shape as well.

Could you help us put that into perspective, and I’m not asking you to throw out a long term margin target out there unless you really love to do that, but just if you want to add some more color there or help us think about that?

Bill Cook

Hamzah, this is Bill. We’re not prepared to throw out a long term margin target, but I’ll turn it over to Tom to talk about some of the details.

Tom VerHage

I want to thank Bill for taking care of the obvious question there. Hamzah, we can maybe talk about this year. As you saw, our gross margin was up very nice sequentially from the fourth quarter. I think it was 32.8% in the fourth quarter and 34.7% in the first quarter. I talked about some reasons for that being product mix.

Certainly in the fourth quarter, I want to remind you we had restructuring costs as well, but our long term gross margin target as you recall has been 32%. Just given the favorability that we’ve seen so far this year of cost reduction efforts, product mix, we think now for fiscal ‘10 that gross margin target to be between 33% and maybe even pushing 34%, depending on a lot of things that can happen yet in fiscal 2010.

So that besides mix, besides cost reduction efforts, some of which we certainly hope will be permanent. We are going to have some of the variable costs creep back in and for example, we think our incremental margin for the first couple of percentage points of sales of increase could be in the 30% range.

Then when we bring back more sales, we’re of course, going to have to bring back some more fixed and discretionary fixed costs. So that 30% incremental margin after we get past the first 8% or 10% sales increase will certainly comedown back into the range of the mid teens. Hopefully that helps you out.

Hamzah Mazari - Credit Suisse

Then just a follow-up, on your replacement parts business, which is now bigger than the first side, some of that is your aftermarket business growing, but it’s also weaker. Is the mix going to be 50/50 on a normalized basis going forward? How should we be thinking about that part?

Bill Cook

Hamzah it’s Bill here. You are right, to some extent the change in the relationship is because first-fit is down, and that will hopefully recover. I think as we’ve talked in other presentations, on an ongoing basis, sort of last fiscal year, our aftermarket parts business was under 50%, but our goal is to get it up over 50% in the near term and then over the longer period of time to move that closer to 60%. So those are the longer term target is to grow the parts business and all of our businesses be a bigger proportion of sales for the Company.

Operator

Your next question comes from Amanda Sigouin - Jefferies & Co.

Amanda Sigouin - Jefferies & Co.

This is actually Amanda Sigouin on for Laurence. I wanted to ask if you guys have an impression of the year end customer shutdowns, if they’re going to be kind of a typical couple of weeks or if they’re going to be longer this year?

Bill Cook

I think probably not as severe as last year, but longer than maybe a couple of years ago the average earlier this decade. There’s still balancing with some customers with orders and production using the holiday period to make those adjustments.

Amanda Sigouin - Jefferies & Co.

Just one other, if I may, how do you see order trends in the turbine business by the geographic regions?

Bill Cook

We don’t break it out geographically because it’s really a global market and I think probably one of the statistics that we follow is what GE, who is one of the leaders in the gas turbine market and one of our major customers talks about, and in their third quarter, which is the third calendar quarter, they talked about receiving orders for 23 gas turbines versus 33 same quarter the prior year.

So in the short term or maybe over the next year, because of the contraction in electricity requirements, there’s been a slowdown in a number of turbines being ordered or built and that’s going to affect our business and why it’s a later cycle decline for us. The longer term, we’re very, very positive on the gas turbine market. It’s the cleanest fossil fuel in terms of power generation and the recent discoveries of natural gas supply has improved, so we think over the longer term it’s going to be a very good market.

Operator

Your next question comes from Kevin Maczka - BB&T Capital Markets.

Kevin Maczka - BB&T Capital Markets

Bill, I guess it’s good to hear the word restocking and pre-buyback on the call again. I guess, my first question on restocking, the destocking was a multi-quarter event. Do you see a tailwind for a couple more quarters here at least on the restocking side?

Bill Cook

I think we see it’s happening, and I think it’s going to continue to happen through our second and third quarter. It’s harder to see what’s going to happen beyond. That part of that destocking and we heard this from one of our customers in one of their investor presentations a week or so ago is just how severe and deep that was.

Now going forward that their actual production is going to be more closely aligned with what the end user demand is and that’s not what happened over the past year, because part of that end user demand was satisfied with stuff coming off the shelf or out of the showroom. So I think it’s going to be through the second and third quarter, we would expect to see some of the year-over-year benefits of the absence of that destocking.

Kevin Maczka - BB&T Capital Markets

On your gas turbine business and any of your other major later cycle businesses. I guess you’ve got some visibility now clearly into the early cycle rebound as it relates to gas turbine. What kind of visibility do you have there into when that may bottom out? Is that a second half 2010 type of event or should that have a multiyear tail to it until you get to this more attractive longer term story?

Bill Cook

Kevin, Bill here. I think we have better visibility through the balance of our fiscal year. So that would be through July. We just given size of these projects and the lead time it takes to order and build them. So I can speak to that, and we feel pretty comfortable with the guidance that we provided given the lead time or the long visibility that we have in that market.

I think beyond that, it becomes a little bit of a guessing game and dependent really on how strong the general economic recovery is. If the recovery is stronger, then the electricity requirements are going to grow or recover and there will be a demand for more power and gas turbines are going to be one of the solutions to that. They actually are sort of the shortest cycle way of satisfying increasing power. So I’m sort of dodging the question beyond this fiscal year because it really just depends on the strength of the global recovery.

Kevin Maczka - BB&T Capital Markets

Just one more, if I could, Bill. On PowerCore, you always do a nice job of breaking out the number of platforms you’ve won, the number of proposals you’re working on. Can you just kind of frame the size of PowerCore today and maybe anything you can say about the opportunity over the next year or so?

Bill Cook

Kevin, Rich is pulling out the details, but just to say to get the frame this up initially, a lot of the platforms that we won are related to product launches that our customers will launch either in 2010 or 2011 as they launch their new vehicles, whether it’s a piece of construction equipment or a truck or whatever.

So the wins are in advance of when the production actually begins, but it will begin depending on when the customer is going to launch it. A lot of that’s being driven by the changes in the emission regulations, because they’ve got to redesign the engines and the pieces of equipment to satisfy that. A lot of this is still out in front of us.

Over the longer period of time, we do see PowerCore being the dominant technology in the air filtration market in the segments that we serve. So it will be evolutionary in terms of how it happens, due to the customer platform launches, but over the next couple of years, we believe it will be the dominant technology, and replace the current technology, which was introduced about 20 years ago. Rich has got some specifics around numbers.

Rich Sheffer

If we look at PowerCore as a percentage of our engine OEM and aftermarket, so I’m excluding the aerospace and defense and retrofit stuff, it’s about 6% of our sales now, and growing as a percentage last year PowerCore sales on both the first-fit and aftermarket basis were about $55 million of sales. We expect that percentage to be growing soon.

Bill Cook

On the Torit side, same numbers, Rich?

Rich Sheffer

Torit side, just because it was introduced a little bit later, the percentages aren’t quite there, so it’s somewhere around 3% to 5% of our Torit sales, but again as that’s growing on the baghouse side, and we just recently launched, I mean, that was like last weekend, launched the new cartridge collectors for Torit PowerCore, that’s going to start growing pretty fast also as a percentage of the overall base of revenue there.

Operator

Your next question comes from [Derrick Jose] - Longbow Research.

Derrick Jose - Longbow Research

I just had a question in terms of volumes. I was wondering if you saw in your first half of the year you guys were seeing higher volumes, because of the pre-builds, because of the 2009 pre-builds, and that if in the second half of the year, because you said you were going to see sales growth, if you were seeing that mostly because of pricing.

Bill Cook

So on the pre-buy, the truck business is an important part of our company, but it’s a pretty small part of our company today. So we did see a little bit of the pre-buy, but it’s not really material in the aggregate for our business. Their comments on the pre-buy, but I think that probably sort of summarizes it. On your second question was around pricing, and that’s not our second half recovery. We talk about our sales going up, that’s not assuming any significant pricing that would be more around the volume recovery.

Derrick Jose - Longbow Research

I was also wondering, you guys continue to see weakness in the construction and farm equipment segments. I was wondering if you could provide any color there about what continue to see.

Bill Cook

I think on the construction, starting with that one, on the parts side, we’re actually seeing that being better, because of the absence of the destocking that we talked about a little earlier. Generally, if we take a look at indicators for construction, spending was up in the U.S. eight-tenths of a percent in September, so we do see that gradually recovering. On the farm equipment side, we see probably the biggest news there is, that we do see that market declining outside of North America during the balance of our fiscal year.

Derrick Jose - Longbow Research

Last, real quick one, in terms of the aftermarket, I know it was asked previously if it was going to be about 50/50. Do you see the volumes primarily growing in that area in terms of, not the retrofit products, but the aftermarket products, and as such, would the margins, I guess, longer term, would you expect to see them increase?

Bill Cook

Holding aside the retrofit, we’re reporting that separately, so I’m just talking the about filters. We do see that the volume is growing there both with the recovery and utilization, but more specifically, around the introduction of more and more proprietary systems, whether it’s PowerCore or other proprietary technologies, into the first-fit, which then allows us to retain more of the aftermarket.

So it’s around using proprietary technologies to maintain our aftermarket or replacement filter market share. So we see that growing over time as I mentioned earlier, our target has been to get that over 50%, and longer term to get that approaching 60% of our total sales. Really this speaks to the second part of your question, is why. The way to grow our business, obviously, if you’re designing the first-fit, you want to maintain as much of the aftermarket as you can.

It’s also a more stable the parts business, than first-fit, so it helps us from a diversification. Then finally, it is more profitable by between 100 and 200 basis points on an operating margin, because we’ve already made that the investments in the technology on the first-fit, but we don’t have to he repeat that on the aftermarket, so it’s a way to grow, it’s a way to diversify, and it’s a way to improve our margins overtime.

Operator

Your next question comes from Jeff Hammond - KeyBanc Capital Markets.

Jeff Hammond - KeyBanc Capital Markets

Just a question on the restructuring, can you just give me a better sense of what you were originally expecting for the first quarter, and then just, as you frame the year, is this simply a timing issue, or as things start to get better you’re kind of pushing off some restructuring?

Tom VerHage

Our, first quarter restructuring costs of, as I mentioned, a little over a million, were pretty much in line with what we thought we would be incurring in the first quarter. It’s for the reasons I indicated in my prepared remarks, it’s a little hard to determine specifically what quarters it’s going to fall, just given government dole and labor issues, but just something for you to think about.

We think that the second quarter might be in the range of about $6 million, and then in the second half of the year, I would expect to see more in Q3 than in Q4, but we really can’t be more specific at this point for some reasons that are outside of our control.

Jeff Hammond - KeyBanc Capital Markets

Just on the aftermarket, I think you mentioned in all geographies the aftermarket was up sequentially. Can you just give us a better sense, and maybe just overall, what you’re seeing between different regions in terms of kind of pace of recovery, kind of this restocking phenomenon?

Bill Cook

I think in terms of pace of recovery, we see most of Asia, maybe aside from Japan, as sort of leading in terms of the strength and the pace of the recovery, from the recession. So I don’t think that’s probably consistent with what everybody else is seeing. So Asia came out of it faster and stronger than Europe, or the U.S., or Japan. I think that from a pace, that’s what we’re seeing. Second part of your question was?

Jeff Hammond - KeyBanc Capital Markets

I guess any differentiation in your mind between how you’re feeling about Europe recovery versus North America? Whether it be specific to aftermarket or just overall?

Bill Cook

I think we see probably the U.S. possibly coming out of it ahead of Europe. Both of those geographies have some very specific unusual circumstances that could change that, but that would be my guess is that the U.S. might come out of it a little bit sooner than Europe. It seems like the U.S. went in sooner, so we’re hoping it comes out sooner, from our perspective. On the other thing you asked about was the destocking, I think the destocking, that’s a global phenomenon and I think I can try to tell whether there’s any difference by region on that.

Jeff Hammond - KeyBanc Capital Markets

Then just finally, it seemed like we had a pocket earlier in the year where raw material costs maybe that. I’m just wondering if over the near term you’re getting any benefit from cause raw materials running through.

Tom VerHage

We track that pretty closely. Some commodities and some purchase parts have gone up a little bit. There have been a couple that has gone down, and there really hasn’t been a real significant trend or impact on our margins. Looking forward for the next quarter, again, we see some ups and downs, but in large part, there’s going to be any real inflation, it’s going to depend on the robustness of the economic recovery. So not a big deal in Q1, and based on what we know at this point, we don’t expect a significant impact inQ2.

Operator

Your next question comes from Adam Brooks - Sidoti & Co.

Adam Brooks - Sidoti & Co.

Yes, a few quick questions. You guys bought back stock in this quarter. Maybe could you talk a little bit going forward kind of what your philosophy is I guess, and can we continue to see at the pace we’ve seen? I guess, historically where that’s kind of been some driver of the EPS a little bit?

Bill Cook

I’d probably refer back to our long term strategy, which, as we say, we target to repurchase 3% of our outstanding each year, which after new option grants, should result in a net 2% reduction. I want to emphasize, we say target, not promise, because it’s obviously subject to other uses of the cash and the stock price. So overtime, that is what we’ve done, but we haven’t done it exactly in those numbers every year.

So we don’t comment prospectively in any year what we’re going to do, but I just sort of go back to what we say over long periods of time what we’re trying to do.

Adam Brooks - Sidoti & Co.

On the gross margin, I guess Tom said around 33% or 34%, does that exclude any restructuring charges this year, or is that inclusive of the restructuring charges?

Tom VerHage

Adam, that actually includes the restructuring charges.

Operator

Your next question comes from Charley Brady - BMO Capital Markets.

Charley Brady - BMO Capital Markets

With respect to the aftermarket, I’m just wondering, normally you get a sequential decline Q2 from Q1, and I’m just wondering what your thoughts are on maybe that not happening or certainly being much more muted given that business seems to be picking up and the year ago comp was such a sharp drop-off, and maybe you don’t get a normal sequential decline into Q2?

Bill Cook

Not breaking out all the different pieces by quarter, I think that, as I mentioned earlier, we do think that we’re going to get some positive benefit from the absence of the destocking that we had last year that you mentioned, and also in some cases the inverse of that, restocking.

We said, generally that this quarter is going to be in total down a little bit sequentially, just because of the holiday period and the customer shutdowns. We would expect our aftermarket business continue to be stronger than our first-fit businesses because it’s one of our earliest cycle businesses.

Charley Brady - BMO Capital Markets

Just one housekeeping question, can you give me the number of shares outstanding as of the end of the quarter, as of October 31?

Tom VerHage

On a diluted basis, give me two seconds here, Charley, was 79.3 million actual shares out at the end of the quarter excluding any dilution was just a little over 77 million.

Operator

Your next question comes from Brian Drab - William Blair.

Brian Drab - William Blair

So just a couple more questions on margin and you talked a lot about the difference between the two ideas of that the absence of destocking and the beginning of restocking; I don’t think I really have a clear sense of what you think you saw in this particular quarter. Was it more just the absence of destocking, which I would think it would be, or are you really starting to see given stability, rather than growth in utilization and truck builds, are you really seeing restocking?

Bill Cook

I think it’s more probably the absence of the destocking, but that’s still a big deal, because that was reducing of the demand from our perspective, they worked that immature off the shell for out of the field last spring or last winter. So if we’re more closely aligned with actually how equipment is being used in the field, that’s going to help us and I think that’s. Now, we’re selling parts I think more directly with how the equipments being used in the field.

Brian Drab - William Blair

Yes, I certainly agree it’s a big deal. Just trying to get gauge what’s happening in the end markets a little bit clearer. Then could you talk a little bit about, are you seeing more of the growth in the aftermarket in the On-Road business, or is it the Off-Road business or about the same?

Bill Cook

It’s hard for us to separate that I think we’re seeing growth in both segments.

Brian Drab - William Blair

I just wanted to ask if you could give I think I see what did you with the new segment categorization, but maybe Rich other someone could make sure that everyone is on the same page in terms of what you did to change the structure there and maybe whether or not you are going to restate some historical data for us?

Rich Sheffer

We actually have a schedule posted on the IR page of our website that breaks down fiscal ‘08 and fiscal ‘09 into the new reporting structure. What we did as aerospace and defense used to be rolled into Off-Road. We have separated that out of Off-Road now, and Retrofit Emissions used to be rolled into aftermarket that’s been separated out now. Both of those or all of that is in the Engine segment of our business. So there’s no change to the Industrial segment.

Operator

Your final question comes from Richard Eastman - Robert W. Baird.

Richard Eastman - Robert W. Baird

Bill, could you just comment, when you look at the business quarter-to-quarter, from fourth to first quarter. In local currency, again the sales were maybe down about 5% in local currency total and when you look at first-fit versus the aftermarket piece, how did those businesses do was the aftermarket business in total, was it up sequentially?

Tom VerHage

This is Tom. Let me comment first. I think the FX impact quarter-to-quarter for us was more like 3%. So, that 2% sequential growth might be more like pretty flat or down 1% on a local currency basis. Aftermarket was up sequentially about 9%. So, when I talked about margins and the mix impact sequentially, that was a pretty significant driver.

Richard Eastman - Robert W. Baird

Tom, I’ll just direct this to you as well, given your commentary on the incremental margins and I think you commented that, until sales growth maybe surpasses 8% to 10%, that we can deliver 30% incremental EBIT. Again depending on how everybody wants to model this out, in local currency, we maybe don’t quite get to those kinds of growth rates by the end of your fiscal year. So, it would seem as though, I mean, 30% incremental to the EBIT probably a pretty good place to stay for the fiscal year?

Tom VerHage

If the overall growth in local currency does remain under 10%, we think that is achievable. That’s what we accomplished in the first quarter, but it is really hard to tell. It’s going to be determined a little bit by the mix of businesses that grow and those that don’t grow, but that’s our hope.

Richard Eastman - Robert W. Baird

Then, Bill, again maybe just to not simplify this too much, but your sales guidance is up about $100 million literally for the balance of the fiscal year here, from where we were. Again, if I look at your segment commentary, it all appears, really coming from the Engine side of the business, Engine product side and where we more optimistic here since early September to the current time on the Engine side of the business to get that kind of incremental sales growth?

Bill Cook

Rick, Bill here. There’s also some foreign exchange that helped us as well, the weaker dollar, so I just want to get that out on the table. Beyond that we have increased our constant currency volumes and I think it’s a combination of things, is that maybe from when we gave our guidance that we developed back in August, that things stopped going down.

Okay, which we weren’t sure we saw the end of it summer and have stabilized from what we had been projecting in the late summer and we’ve seen some recovery in terms of utilization in the aftermarket. So the aftermarket business has been stronger over the last three months, came back sooner than we had anticipated that’s generally in all parts of the aftermarket for us.

Richard Eastman - Robert W. Baird

Then in terms of either construction or mining, are you any more optimistic there on the first-fit side?

Bill Cook

I think I look to our major customer forecast, like Caterpillar, for example it was our largest single customer, they had said Mr. Owens said that the third calendar quarter would be their worst. He said that as they went into that quarter, and he said it coming out when they announced a couple weeks ago, and that sequentially their business would be going up.

They’ve given guidance for next year for 2010, pretty wide range, but the range is positive between 10% and 25%. So, I think we look at using them as one indicator they’ve said would suggest that the worst is behind them from both new equipment and parts perspective.

Richard Eastman - Robert W. Baird

Just the cycle back, on the aftermarket being stronger and the tone better, is that globally?

Bill Cook

Yes.

Operator

(Operator Instructions) At this time there are no further questions in the queue. I’d like to turn the call back over to management for any closing remarks.

Bill Cook

To everyone on the Donaldson Team, just want to point out that we had a very good quarter and one that all of us and you especially, should be very proud of and while we haven’t seen a dramatic economic recovery, by focusing on what we could control, including providing the best possible service to our customers.

We are leading our company very successfully through this crisis and positioning ourselves to achieve our long term growth plans. Sincere thanks for your efforts and support and finally, to all of you participating and listening, this is Bill Cook, and I’d like to thank all of you for your time and interest in our company.

Operator

Ladies and gentlemen, this concludes the Donaldson Q1 fiscal year 2010 webcast. If you would like to listen to a replay of today’s conference please dial, 303-590-3030 or 1-800-406-7325, followed by pass code of 4178320. ACT would like to thank you for your participation. You may now disconnect.

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