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Donaldson Company Inc. (NYSE:DCI)

Q3 2014 Earnings Conference Call

May 20, 2014 10:00 AM ET

Executives

Bill Cook - Chairman of the Board, President, Chief Executive Officer

Jim Shaw - Chief Financial Officer, Vice President

Tod Carpenter - Chief Operating Officer, Director

Rich Sheffer - Director of Investor Relations and Assistant Treasurer

Analysts

Charley Brady – BMO Capital Markets

Eli Lustgarten – Longbow Research

George D'Angelo – Jefferies & Co.

Kevin Maczka – BB&T Capital Markets

Richard Eastman – Robert W. Baird

Josh Berman – William Blair & Company

Operator

Good day, ladies and gentlemen. Thank you for standing by. Welcome to the Donaldson Company third quarter conference call. During today's presentation, all parties will be in a listen-only mode. Following the presentation, the conference will be opened for questions. (Operator Instructions). This conference is being recorded today, May 20, 2014.

I would now like to turn the call over to your host, Mr. Rich Sheffer, Assistant Treasurer and Investor Relations. Please go ahead

Rich Sheffer

Thank you, Elizabeth, and welcome, everyone to Donaldson's fiscal 2014 third quarter earnings conference call and webcast. Following this brief introduction, Bill Cook, our Chief Executive Officer, Tod Carpenter, our Chief Operating Officer and Jim Shaw, our Chief Financial Officer will review our third quarter earnings and our updated outlook for the balance of fiscal '14.

Next 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’d like to turn the call over to Bill Cook. Bill?

Bill Cook

Thanks, Rich, and good morning, everyone. In a few minutes, Tod and Jim will cover both the details of our third quarter results and our outlook for the balance of fiscal '14. But first I’d like offer some summary comments.

As most of you may recall, during last year’s third quarter we enjoyed a record surge in gas turbine shipments which wasn’t repeated this year. This large change in gas turbine year-over-year masks what happened in the rest of our businesses this quarter. Our other businesses were up 6% in aggregate year-over-year despite the fact that the economic conditions in many of their end markets remained flat. For example, we had double digit percentage revenue increases in our on-road and engine after-market businesses. We also had an 8% increase in our industrial filtration business, which much of that driven by growth in replacement filters.

While the pace of this industrial recovery remains weak and uneven across many of our end markets and can be very frustrating, we are focused on those things that we can control to grow our business, expand our margins, and deploy our capital in order to return superior value to our shareholders. We are very proud of how our company is operating. We delivered a 14.9% operating margin in the quarter, and during the quarter returned $120 million in value to our shareholders between our quarterly dividend and share buybacks. And our sights remained fixed on our long-term objectives of building our company to first $3 billion in sales and then $5 billion.

Despite the temptation to cut expenses in the short term, we continued to make the strategic investments that will make this into a larger and even stronger company in the long run. During the quarter, we had discretionary spending of about $6 million to support our global ERP system implementation and our special growth initiatives. Even with these higher spending levels, our third quarter EPS of $0.46 per share matched our prior third quarter record.

Now, I’d like to turn the call over to Tod for a review of our third quarter sales. Tod?

Tod Carpenter

Thanks, Bill and good morning, everyone. Our reported sales increased 1% from last year’s third quarter. Foreign currency translation had a minimal impact at the consolidated level. However, that is the summary result of larger offsetting swings across the region. For example our European business had a 5% benefit from translation while our Asian businesses had a 5% headwind from translation. As a reminder, you can find a detailed analysis of currency translation by business unit and region on the investor relations homepage of our website. The rest of this review will discuss local currency results.

Within our Engine product segment, our OEM sales decreased 1%. Our on-road OEM sales increased 13% with strong local currency growth in both Europe and Asia Pacific. Our off-road OEM sales decreased 5% as the slowdown in new agricultural equipment began impacting sales in both Europe and the Americas, while continued softer mining and construction equipment demand in our OEM drove a sales decrease in Asia Pacific. Based on our customers’ commentary, we believe the mining equipment market will remain soft until sometime next calendar year and that the agricultural equipment is in the beginning stages of a gradual weakening.

We continued to see improving conditions in our Engine aftermarket where we supply replacement filters through both our OEM and independent distribution channels. Our Engine aftermarket sales increased 11% in the quarter, with strong sales in all of our major regions. We attribute this growth to the combination of improving equipment utilization in the field and our market growth initiative. We are continuing to see strong replacement filter sales growth in developed markets from our OE customers’ dealer organizations and are benefiting from our increased aftermarket penetration with independent dealers and distributors in emerging economies.

Aftermarket is our earliest cycle end market, and the improvements we have seen over the last few quarters provides evidence that diesel equipment in the field is being used at an increasing rate and that is generally what drives after-market demand. This higher utilization will result in improving demand for new equipment. This is beginning to show up in the on-road truck market and in the construction equipment market, although at different rates regionally.

Finishing my review of our Engine products business, our aerospace and defense sales decreased 12% as the slowdown in defense spending for ground based military equipment continued in this quarter.

Sales in our Industrial products segment decreased 6%. In our industrial filtration solutions business, our sales increased 8% as solid levels of manufacturing activity drove record demand for replacement filters for our Torit dust collectors and our compressed air systems. This aftermarket growth was enough to offset continued weak manufacturing capital spending levels in North America, which has reduced demand for our new industrial dust collectors.

In our Special Applications business, our sales increased 4% on continued growth of our integrated venting products and increase in disk drive filter sales and an upturn in our Semicon imaging product sales. Offsetting these increases was the anticipated decline in our gas turbine sales, which decreased 40% from last year’s record third quarter. As we’ve highlighted in the last few quarters, we expect a short slowdown in our gas turbine business during the first half of fiscal 2014 as the market place digests the surge of large turbine projects from last year.

Third quarter sales improved by $9 million sequentially from our second quarter, and we believe sales will continue to gradually improve over the next few quarters. Jim will discuss this more when he discusses our outlook.

So excluding the big decline in Gas turbine sales this quarter, our other Engine and Industrial businesses combined for a 6% sales increase. Generally this is how our business model is designed to work. Our diversified portfolio provides exposure to many different end markets and regions that typically are cycling up or down at different times. During last year’s sudden OEM and Industrial contractions, the downturn was softened by our late cycle gas turbine business, and by some of our emerging regions. Now, we are seeing incremental improvements in our early cycle replacement filter businesses across both our Engine and Industrial end markets. At the same time, we are seeing a variety of improving, stable, and weakening conditions in our first-fit end markets. All of these combined to offset this quarter’s decline in gas turbine system shipments and deliver a 1% sales increase.

I’ll now turn the call over to Jim Shaw for his comments on our operational metrics. Jim?

Jim Shaw

Thanks, Tod, and good morning, everyone. Our gross margin was 35.8% which was the same as the gross margin that we reported in last year’s third quarter. As we noted in our press release, there were pluses and minuses in the gross margin this quarter which offset each other. One of the drivers was a lower number of large gas turbine shipments in the quarter, which were a headwind to our gross margin in fiscal 2013.

We also benefited from a higher percentage of replacement filter sales. which were 56% in the current quarter compared to 51% last year. In many of our end markets, the utilization of the existing equipment in the field is good and that helps our replacement filter sales, which carry a higher margin.

Overall, product mix had a positive 40 basis point impact on gross margin. In addition, our ongoing continuous improvement initiatives benefited our gross margin by approximately 60 basis points compared to last year. Offsetting these benefits was the 70 basis point impact on margin from higher compensation and indirect costs as we’ve made investments in engineering and management in our operations. We’ve also had higher incentive compensation costs compared to last year.

Our operating expenses increased by $8 million compared to last year’s third quarter. As a percentage of sales, operating expenses increased 110 basis points. Higher incentive compensation expense, incremental expenses related to our global ERP project, and increased travel and entertainment expenses impacted operating expenses by 150 basis points. These increases were primarily offset by lower pension, insurance, and warranty expenses, which reduced our operating expenses as a percentage of sales by 40 basis points. As gross margins were consistent with last year, the higher operating expenses resulted in a 100 basis point decrease to our operating margin in the quarter, which was 14.9%. However, our year-to-date operating margin remains 70 basis points higher than last year through our third quarter. Looking forward, we expect our full year fiscal 2014 operating margin to be between 14.1% and 14.5%.

We began accruing incentive compensation at normal levels again at the beginning of fiscal 2014 and our investment spending on our global ERP project begin increasing in the second quarter, with our first facilities going live on the new system during the second quarter and additional facilities going live during our third quarter. We expect that we will spend an incremental $22 million in fiscal 2014 on these items, with $5 million of the $22 million expected in our fourth quarter.

Our effective tax rate was 28.5% in the quarter versus 29.8% last year. The decrease compared to the prior year was primarily due to changes in the mix of earnings between tax jurisdictions. Based on our projected global mix of earnings in fiscal 2014, we now forecast our full year tax rate to be between 28% and 29%.

A third quarter CapEx was $23 million. Looking at our forecast for the balance of fiscal 2014, we continue to expect to spend approximately $90 million on CapEx over the full year. The breakdown of the $90 million spend is projected to be approximately 20% related to capacity expansion, 30% for our technology initiatives, which includes our global ERP project and our R&D lab expansion project. Another 30% is for tooling for new products and 20% will be related to cost reduction activities through our continuous improvement initiatives.

We continue to expect depreciation and amortization will be between $65 million and $70 million in fiscal 2014.

Free cash flow was $55 million this quarter. For fiscal 2014 we expect full year cash flow from operating activities to be $310 million to $330 million. With our forecast at $90 million of CapEx, we expect to generate $220 million to $240 million of free cash flow this year.

We repurchased 2.4 million shares in the third quarter for $100 million. Year to date we’ve purchased 4 million shares or 2.7% of our diluted outstanding shares for $166 million. Our share repurchase target remains at 4% of our diluted outstanding shares in fiscal 2014.

We expect interest expense in fiscal 2014 to be between $9 million and $10 million and our balance sheet remains very strong, $391 million of cash and short term investments, which is almost entirely held outside the United States.

During the quarter we issued $125 million of 3.72% senior notes in the US that will be due on March 27, 2024. The proceeds were used to refinance existing indebtedness and for general corporate purposes.

I’d like to give you an update on our ERP project before I move on to the outlook. We went live at four locations in the second quarter, another 10 locations in our third quarter and two more locations earlier this month. These go-lives have gone well. Our ability to receive, process and ship orders at these locations has not been impacted as we transition to the new system. We are now more than 50% complete and converting our Americas locations to the new system, and we will continue to roll out to the remainder of Americas location through the fall of 2014. Then we will be shifting the implementation efforts to our Europe locations.

Now I’d like to provide some comments on our outlook for the rest of the fiscal year. Our nine months results have shown that conditions in our OEM first-fit equipment end markets remains mixed, with some improving, some stable and some weakening. Conditions are better for aftermarket sales as we are seeing increasing demand for replacement filters in both our Engine and industrial end markets.

Based on the updated outlook in our press release, we are continuing to forecast the growth will improve on our fourth quarter. I’ll now highlight some of the adjustments we made to our forecasts. In our Engine product segment, we forecast a full year sales growth of 3% to 7%. In our OEM markets, we’ve began to see improvement in truck builds and construction equipment builds where we are seeing demand for new agriculture equipment begin to decline. In total, the pluses and minuses within our OEM end markets are offsetting and do not impact our forecast.

Demand for aftermarket products is forecast to remain strong through our fourth quarter as utilization rates of equipment that is in service remains good. This is consistent with our prior forecast. The one area within Engine products forecast that we have modified is our aerospace and defense group. The defense portion has continued to weaken so we lowered our forecast from flat to now being down slightly. This resulted in the midpoint of our guidance range for Engine products being reduced from 6% growth to 5% growth.

We also made adjustments to our outlook for industrial products sales. We now expect lower growth from our industrial filtration solutions and special application groups and a bigger decline in gas turbine project sales, resulting in our industrial product segment sales decreasing 4% to 7% for the year. We reduced our outlook for gas turbine sales again as the few of the projects that we originally scheduled to ship in our fourth quarter have now been rescheduled for early fiscal 2015. We still expect gas turbine sales to sequentially be higher in our fourth quarter. More positively gas turbine orders that are for fiscal 2015 delivery were strong again in our third quarter. This gives us increased confidence that the gradual sales improvement we saw in the third quarter and are expecting in the fourth quarter will continue into fiscal year 2015.

In our Industrial filtration solutions business we are now expecting more modest growth this year as business investment for new dust collection systems continues to be slower to develop than we previously forecasted. Sales of replacement filters for in-service equipment, remains very strong.

Finally we adjusted our forecast for special applications as we anticipate sales of distract filters, Membrane products and semiconductor filters to be slightly lower than we previously forecast. For our total company, we are now expecting a slight increase in sales for the full year, with sales of between $2.44 billion and $2.48 billion. Based on our nine month performance and forecast for the fourth quarter, the midpoint of our guidance range is a 20 basis point improvement in our operating margin over fiscal year 2013. We also adjusted our full year tax rate guidance slightly lower due to a larger than anticipated second quarter benefit and a more favorable mix of earnings in our third quarter. The net of all these factors is that our updated EPS range is now a $1.69 to $1.77, the midpoint of which would represent a 5% increase over last year.

So with that, I’ll pass it over to Bill, who will discuss some of our growth initiatives. Bill?

Bill Cook

Thanks, Jim. As Tod and Jim have already noted, we have continued to make key expense and capital investments to support the long term objectives outlined in our strategic plan. This plan is a compilation of the very detailed plans by business unit and region that when aggregated add up to our sales target of $3 billion and $5 billion. We have a number of very focused initiatives underway that will help us grow over time regardless of the economic environment.

I’d like to take a minute to highlight a few of these initiatives. The first is with emerging economies such as Latin America, Southeast Asia, India, China and Eastern Europe. We have entered these regions more recently and as a result our presence in these markets is generally lower than it is in North America, Western Europe or Japan, each of which we’ve been in for decades. The other way of saying this is that we have pretty significant growth opportunities in these emerging economies.

So in our targeted emerging markets, we are continuing to add sales resources, parts to our product lines, distribution capabilities, distributors and OEM customers. For example in our Engine aftermarket business we added 94 new distributors and over 600 new part numbers in the quarter. By having more of our product offering available locally supported by local distributors, inventory and sales people, we have shown time and time again we can grow our business. As we noted earlier our global Engine aftermarket business is up globally 11% in the quarter and these emerging economies it was up 19%.

Another of our key growth initiatives is the utilization of our technologies to help better solve our customer’s filtration issues on their new equipment while protecting their replacement filter business over time. One of our most successful technology introductions for air filtrations is PowerCore. It is a great example of how we invest centrally in R&D and then leverage a technology into as many different customer applications and as many as our businesses as possible. We are now very successfully using the newest generations of PowerCore in both our Engine and Industrial segments.

Our Engine PowerCore sales in our third quarter were $35 million, up 14% over last year. We had great growth in both first-fit PowerCore systems and replacement filter sales which increased 16% and 13% respectively. We have a number of new PowerCore programs going into production with our OEM customers now and over the next 12 to 18 months. As you know, successive waves of new diesel emission regulations in North America and Europe have already and are continuing to go into effect. Our heavy duty equipment OEM customers are launching their new equipment platforms with the latest Engine technology in order to meet these stricter requirements.

As our customers new platforms launch, our sales of new PowerCore systems will increase as their equipment gets out into the field and then demand for replacement filters will ramp up and continue to grow each year. This was evident in this quarter’s strong first-fit PowerCore sales and we are currently working with the same OEM customers on our next generation of new equipment platforms that they will launch later this decade. We’ve talked a lot about PowerCore over the past few years and I should note that during this period we have also been launching successive ways of new PowerCore technologies, with each new generation offering a step function improvement and performance to our customers. We are currently in the midst of launching generation three

On the Industrial side of our business, we sold another 440 new PowerCore dust collection systems in the quarter. In addition, the sales of our Torit PowerCore replacement filters for those systems already in the field increased to 41%. So in total, our companies PowerCore sales total $42 million in the quarter, up 16% over last year. In addition, in conjunction with our PowerCore efforts, we are now launching another brand new Air filtration technology called PowerPleat. PowerPleat will complement our PowerCore technology by providing an innovative radio seal alternative with improved system performance and a 20% space savings while protecting our customers’ replacement filter business. We’ve already won three programs with PowerPleat and we’ll start reporting our quarterly sales in fiscal 2015.

And last but certainly not least, I’d like to give you a brief update on our liquid filtration growth initiatives. Our liquid filtration sales increased 11% in the quarter, with very strong growth in all categories. We highlighted many of our new liquid filtration products at the recent CONEXPO show in Las Vegas. Our new select diesel fuel filters which use our Syntech XP media have gone into production as our OEM customers began launching their new Engine and equipment platforms. Our other recently launched product lines that use this Syntech filter media include our select and Bulk fuel product lines. While sales of both of these are still relatively small, both showed very promising growth in the quarter of over 100% and 20% respectively. So we are off to a very good start.

We’ve also combined our premium liquid Aftermarkets products under our new Donaldson Blue product line which we launched at CONEXPO. Market reception to all these new product lines has been great. New technology has been the lifeblood of our company now for almost 100 years and we will remain focused on the introduction, new technologies to achieve our future growth goals.

Now let’s quickly summarize our year to date results. Through the first nine months of fiscal 2014, we have seen a variety of end-market conditions across our businesses that have impacted our topline growth. Much of the industrial recovery that was hoped for in the press last fall has still not materialized. This has dampened and delayed capital investments and capacity expansions by our customers. However, as Jim noted, our operating metrics are improved over the prior year. We have delivered a 5% increase in operating income, a 7% increase in net earnings and a 9% increase in EPS year-to-date. We’ve also returned over $225 million to our shareholders through dividends and share repurchases. For the balance of the fiscal year, we are forecasting a good finish with the strongest quarter of our fiscal year in terms of sales, operating income and EPS.

Now that concludes our prepared remarks Elizabeth, now we’d like to open the call up for questions.

Question-and-Answer Session

Operator

Thank you, sir. (Operator Instructions) And our first question is from the line of Charley Brady with BMO Capital Markets. Please go ahead.

Charley Brady – BMO Capital Markets

On the agriculture side, can you just quantify what your expectation is for the decline in growth there currently? I guess a similar question on the commercial aerospace, it sounds like some of that's come down as well in addition to kind of maybe weaker defense.

Tod Carpenter

Yeah. Charley, this is Tod. So, I’ll talk about Ag first. So within Ag, we take a look and obviously you’ve seen the reports of Deere and others, and we see between 5% and 10% decline, but we see it gradually declining all the way into our calendar year 2015, so we have that baked into our new model, so it will continue to slowly decline. When you look at the aerospace and defense, commercial aerospace is not actually the issue for us. It’s really just defense. It’s ground vehicles, and it’s the continuing defense slowdown that really is driving what we call A&D on the decline. We will kind of -- it’s not going to be -- its low-single digits as an overall company as far as percentage of revenue, and we’ll continue to see a little bit of a decline there, but it should be stabling at the current levels, and our ability to really offset the defense decline has been in the aerospace. This time, defense has declined faster than we’ve been able to pick up on aerospace, and so that’s why we had to take that guidance down.

Rich Sheffer

So Charley, this is Rich. One follow-up to Tod’s comments on the Ag market. The gradual decrease we see is really specific to OEM. At least in the near term, we are not anticipating and have not seen any kind of a decrease in demand for replacement filters in the Ag market.

Operator

And our next question is from the line of Eli Lustgarten with Longbow Securities. Please go ahead.

Eli Lustgarten – Longbow Research

Can we follow up here the same trend? Can you talk about one, gas turbine we had postponed, but things are getting better. The implication is that we can get a mid upper single to double digit gain in 2015. Is that sort of the path we are on that we are stabilizing enough that we should be able to be up a bit next year? And then can you take us through construction inside North America versus the rest of the world and stuff? What’s going on in that market?

Tod Carpenter

Sure, Eli, this is Tod. So first on gas turbine, as we have talked about in last quarter as well, the way we view gas turbine is a bit of a downturn at this point. But we do see healthy quotes out there and we have confidence that our forecast in fiscal 2015 which does suggest that that business will pick up will ring through. We have that good visibility and we are comfortable with that forecast. As far as the construction markets, it’s really led by the positive outlook in the United States. Europe is a little mixed but it is slightly positive. And then when we turn our attention over to Asia Pacific, we would say that Asia Pacific for us is more positive and it’s really driven because we have a lot of opportunity there since we have a lower share within the construction markets.

Eli Lustgarten – Longbow Research

Is the implication of your visibility in gas turbines, I guess is that you should have positive comparisons for most of next year, and I don’t know if you can quantify it for us. And then the other part that you sort of touched on is mining, can you give us some feel for what's going on there?

Jim Shaw

Eli, this is Jim, I’ll touch on the gas turbine. I think what we are seeing right now does suggest that we’ll see some incremental improvement, at least as we move into the early part of fiscal 2015, but we are in the process of pulling our guidance together right now for next year, and we’ll be able to give you definitive comments on that at our next quarter.

Tod Carpenter

Eli, this is Tod, I’ll take the mining portion. So, within mining, we see mining continuing at the current low levels. We have had some issues from time to time, for example South Africa within this labor issues that they’ve had that slowed us for a month or two, but really we just have mining continuing at the current low levels to perhaps if we would look forward maybe an additional slight deterioration of very low single digits. So longer term as we look out, that will continue on into our calendar year 2015 is really what our customers are suggesting to us.

Operator

Thank you. And our next question is from the line of George D'Angelo with Jefferies. Please go ahead.

George D'Angelo – Jefferies & Co.

Hello, good morning. As you look at the bridge to 2015, should ERP costs be flat year over year?

Jim Shaw

Yeah. This is Jim. I think as we look to 2015, they will be around the same level but we are probably anticipating a little bit more and that’s just a function of how the costs that we incur get treated between expense and capitalization and as we bring on more sites will have a little bit more on the expense side. So, I don’t have that quantified yet as we are pulling together our budgets, but I would say slightly higher, not dramatically higher, but slightly higher than what we’ve been running this year.

George D'Angelo – Jefferies & Co.

Thanks. For the OEM on-road business, given what you guys said in your press release, do you see that accelerating over the next few quarters?

Tod Carpenter

Yeah. This is Tod again. So what we’ve done is we’ve baked that increase that everyone is talking about in the US into our forecast. We still have it in low double digits and we look at it at that level to continue. So I wouldn’t say it’s an acceleration in future quarters, it’s really going to be at the same level of increase for a while.

Operator

Thank you. And our next question is from the line of Kevin Maczka with BB&T Capital Markets. Please go ahead.

Kevin Maczka – BB&T Capital Markets

The $30 million cost item that you trimmed to $22 million, that's ERP and incentive comp. Two questions there. Does that include some additional strategic investments that you're making, and can you just talk about what drove the $8 million reduction?

Jim Shaw

Yeah. This is Jim, Kevin. The $22 million is just incentive related and our ERP project. So the other clocks we refer to would be outside of that. As we started the year we had anticipated about $8 million related to our ERP and about in the range on $22 million from just the increase and incentive camp over last year where we didn’t have the kind of year we would have liked. As we move through the year now and looked at the breakdown of those two categories. It looks now like our ERP cost is going to be about $5 million compared to the $8 million and that’s just as I mentioned before our function between how much gives capitalize and how much gives expense then. As we’ve got smarter about that, we’ve refined that number and then the remainder is our incentive compensation previously that $22 million number. We are now anticipating that to be around $17 million and that’s the function of some of the sales not coming in as good as we would have liked and that’s the way this is supposed to work. So that is the reason for the $22 million.

Kevin Maczka – BB&T Capital Markets

Okay, got it. And can we switch over to the segment margins, and maybe starting with Engine. I'd like to touch on both, but starting with Engine. We had revenue up 19%. We had profits down 4%. Aftermarket grew 10%. So that would seem to be at least slightly more favorable mix, and you had your continuous improvement. I'm just wondering, that lower profitability, is that -- how much of that is driven by the higher strategic investments that you called out beyond the ERP and incentive comp issue?

Jim Shaw

Yeah. I think there’s two issues there. One, Engine as a percentage wise gets more of these investment type costs like our ERP. But on the incentive comp side, given that generally our engine business has performed better this year, they have a very higher proportionate of those incentive comps. So, essentially all of them are on the Engine side in terms of the year-over-year. So that’s a big part of it. the other part is these investments that we discussed earlier in terms of there’s a number of engineering efforts going on for new product launches and those are primarily focused on the engine side. So those are the main drivers. The margins and so forth as we talked about are being helped by the aftermarket, but as a percentage being offset by some of these investments.

Kevin Maczka – BB&T Capital Markets

Got it. And same type of question, Jim, on Industrial. The margin was down over 100 basis points there. I assume with gas turbine down so dramatically, that's a favorable mix item, and again, there's continuous improvement. If we don't have the same incentive comp type issue there or engineering effort there, what drove that reduction?

Jim Shaw

That one is exclusively leveraged. as we said, we don’t have the headwinds on compensation to the extent we do on Engine, but with the sales down, the percentage they are, it’s just a function of some of those fixed costs we can’t and frankly don’t want to adjust because we see opportunities going forward.

Kevin Maczka – BB&T Capital Markets

Okay, great. Just finally from me, can you just touch on the corporate expense line? I know currency can be volatile, but maybe not as much this quarter. I think usually we get a benefit as inventories come down, which didn't happen this time. Can you just talk about why that corporate line was so favorable?

Jim Shaw

Yeah. And that one is hard for us to predict, but we had a little bit higher interest expense. So that’s maybe about $0.5 million of it. The rest really relates to some timing items in terms of our inner company profits and even though inventory was fairly stable, it’s a function of which inventory is being sold and growing where. So a little bit of that. I’d say about $1 million of that is just timing in terms of some corporate expenses that don’t get to the markets right away just based on the way we account for them. Those are probably the two main drivers.

Kevin Maczka – BB&T Capital Markets

Any color at all you can give in terms of crystal ball on that line item?

Jim Shaw

I wish. That one is a hard one. I think in a normal state where we probably end up is in that $2 million to $4 million range like last year is probably a little bit more normal. But again normal has a pretty wide standard deviation just given the nature of some of those items.

Operator

Our next question is from the line of Richard Eastman with Robert W. Baird. Please go ahead.

Richard Eastman – Robert W. Baird

Yes. Jim, could you just -- can I just double back for one second on the comp and the ERP expenses that sum for the third quarter towards the $22 million. What did you absorb here? Was it $6 million total?

Jim Shaw

For the third quarter, yeah it was roughly 5 to -- round it to $6 million between the two.

Richard Eastman – Robert W. Baird

Okay. And ERP was maybe $1 million?

Jim Shaw

Yeah. ERP was a little -- right around $1 million, yeah.

Richard Eastman – Robert W. Baird

Okay, all right. And then so just wanted to ask, on the on-road side of the business, the Engine business, Bill or maybe Tod, Europe continues to show some big gains. And I'm curious if there's -- was there a new win there on the on-road OEM side? It's fairly substantial. I know the comp was easy, but it's still fairly substantial gains year over year.

Tod Carpenter

This is Tod, Rich. So you’re right. The comp was pretty easy, but we don’t have a new win over in Europe and I think everyone points to what’s taking place. So we really have dissected that pretty hard and see that really as market conditions and it’s been depressed for quite some time. So that’s one. Also the other is it does point to some of the success that we’re having in our aftermarket and we’re getting our main spread further across our European base. So that’s really what’s driving our growth there.

Richard Eastman – Robert W. Baird

Okay. And the aftermarket in general being low double digits, again if you look at maybe an average two year growth rate, it’s maybe 5% or 6% which feels a little bit more sustainable, but I’m just curious again, is the aftermarket growth in the low double digits? Is that new part numbers, some share gains? How do you attribute that growth? Because again no tonnage numbers you look at would suggest that we should be able to sustain that.

Tod Carpenter

Rich, this is Tod again. So it really starts with our strategy. Our strategy within our global aftermarket group was to really strengthen our distribution across all regions of the world and pay specific attention to emerging markets. So we have done that. And Bill talked about adding 94 new distributors this year. Our distributing base now worldwide is over 3,000 and we still have a runway there. The second thing is making parts available. So availability is obviously a very important metric in this particular model and we’ve done a real nice job again this quarter by adding over 600 more parts to the model. So those two strategic thrusts that we had, those strategic imperatives are really driving us quite nicely. Last is, it starts with the overall company strategy which is the proprietary first fit that drives our aftermarket retention share and we are benefiting from that and it’s the reason that in these calls that we highlight PowerCore, and now we’ll talk about PowerPleat and we’ll be reporting that in our gains in fiscal 2015 we’ll talk about that. Those are the air new products, but we also have select and bulk fuel on our liquid products. So that’s really what’s driving our aftermarket growth and we would suggest we are taking market share and our strategy is working nicely.

Richard Eastman – Robert W. Baird

And is the PowerPleat product the same -- is that a liquid based product? Or is that, again, some of the same applications that PowerCore would address?

Tod Carpenter

Yeah. So this is Tod again. It is not a liquid product. It’s an air product and it’s not the same applications that PowerCore would address. So what happens is it really would go to different end users ones that for example do not have a space limitation at this time and we would be able to actually sell that into that type of requirement. But it’s really kind of a drop in replacement for what they used to have. So we’re replacing our self with proprietary technology in many of those opportunities and that will longer term, help us drive that aftermarket.

Richard Eastman – Robert W. Baird

I see. Okay, very good. And just if you don't mind, one last question for Jim. On the cash flow from ops, you bumped that up somewhere between $10 million and $30 million for the year. Is that a mix issue, more replacement? So again, cash flows quicker, or?

Jim Shaw

Yeah. It’s a little bit of that, but related to that it’s really based on the fact that we’ve taken the sales forecast down a little bit. There’s less investment in that receivables growth or the fourth quarter built in.

Richard Eastman – Robert W. Baird

Okay. Great. Thank you very much.

Operator

(Operator Instructions). Our next question is from the line of Josh Berman with William Blair. Please go ahead.

Josh Berman – William Blair & Company

So just curious what growth was specifically in China in the quarter, and how much of sales comes from China in the quarter.

Rich Sheffer

Josh, this is Rich. In local currency terms, China in total was down around 15%, but if we -- the biggest driver there was a big decrease in our gas turbine business. So if we exclude gas turbine, the other businesses combined to be up 13%.

Josh Berman – William Blair & Company

Got it. Thank you. And then just back to gas turbine overall, I guess. So that was all just push out, there are no project cancellations that you're expecting?

Tod Carpenter

Yeah. This is Tod again. No project cancellations or push outs.

Josh Berman – William Blair & Company

Okay, great. Thank you.

Operator

I’m showing no further questions. I would now like to turn the call back over to Mr. Bill Cook for closing remarks.

Bill Cook

Thanks, Elizabeth. Now to conclude our call, we’d like to thank our fellow employees for their contributions to our third quarter performance. And I’d like to thank everyone on the call today for your time and continued interest in our company. Thank you and have a great day. Goodbye.

Operator

Thank you. Ladies and gentlemen, that will conclude the conference call for today. If you would like to listen to a replay of today’s conference call, please dial 303-590-3030 or 1800-406-7325 and enter access code of 4681999. We’d like to thank you for your participation and you may now disconnect.

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