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Donaldson Company, Inc. (NYSE:DCI)

F2Q12 Earnings Call

February 22, 2012 10:00 AM ET

Executives

Rich Sheffer – Director, IR

Bill Cook – Chairman, President and CEO

Jim Shaw – VP and CFO

Analysts

Hamzah Mazari – Credit Suisse

Charles Brady – BMO Capital Markets

Kevin Maczka – BB&T

Laurence Alexander – Jefferies

Rick Eastman – Robert W. Baird

Brian Sponheimer – Gabelli & Company

Eli Lustgarten – Longbow Securities

Operator

Welcome to the (inaudible) FY2012 Q2 Conference Call on February 22, 2012. Throughout today’s reports presentation, all participants will be in a listen-only mode. After the presentation, there will be an opportunity to ask questions.

(Operator Instructions).

I’ll now hand the conference over to Rich Sheffer. Please go ahead, sir.

Rich Sheffer

Good morning, and welcome to Donaldson’s fiscal 2012 second quarter conference call and webcast. Following this brief introduction, Bill Cook, our Chairman, President and CEO, and Jim Shaw, our Vice President and CFO, will review our record second quarter earnings and our updated outlook for fiscal 2012.

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. As you’ve seen in the press release we issued earlier this morning, we had a very good quarter as we set second quarter records for sales, operating margin, earnings per share. In fact, this was our fifth consecutive quarter posting new records for all three of these metrics.

Now I’ll take a few minutes to review our results.

Our second quarter sales were $581 million, up 8% year over year. Excluding the negative impact of foreign currency translation, we were very pleased with our organic sales growth of 9%. The combination of organic sales growth of 9% and a 12.9% operating margin helped to deliver a net income increase of 21%, an EPS increase of 25%, an EPS record of $0.70 per share. As you know, we have two reporting segments and I will cover the highlights for each.

First, in our Engine Product segment, excluding the impact of foreign exchange, our local currency sales increased 13% over last year. The primary drivers of this 13% year-over-year increase were our OEM businesses, On-Road and Off-Road, which were up 36% and 18%, respectively. This 36% increase in our On-Road product sales was primarily due to the significant rebound in North American heavy-truck build rates at our customers.

For example, for the past calendar year, Class 8 heavy-truck builds in North America were 256,000, a 66% increase over 2010. Our Off-Road product sales were up 18% as the agricultural, construction, and mining end markets we serve have continued to strengthen, thereby increasing the demand for our customers’ new equipment, upon which our new (inaudible) filtration systems are installed.

We also had help from our Engine aftermarket business as our replacement filter sales were up 9% as the utilization rates of existing truck and off-road equipment fleets have continued to improve. We also continue to expand our distribution networks and product line. In fact, since our last call, we have added another 75 distributors and nearly 800 part numbers to our product offering with the majority of these adds in our emerging market businesses.

Now switching to our Industrial Product segment, our local currency sales increased 2% as we experienced a wide range of business conditions. Starting first in our Industrial Filtration Solutions business, revenues were up 8% as sales of our new Torit dust collection equipment and our sales of replacement filters for those systems already in the field have remained strong.

Sales in Gas Turbine were up 6% in the quarter, driven mainly by strong replacement filter sales. I should note that we also had a number of major new systems in process during the quarter and are now very confident of a strong second half for Gas Turbine System sales, which I will cover in more detail in a few minutes.

And finally, sales in our Special Applications Products decreased 15% as the solid sales growth from our newer product line serving the membrane, semi-con and venting markets was offset by the flooding in Thailand and its impact on our hard disk drive customers. We talked a little bit about this in our last call, and I wanted to give you an update on this situation. So let me explain a little bit about what happened in the hard disk drive market.

As you know and you may recall, we have two cleanroom production facilities where we manufacture our disk drive filters, one in Thailand and the other in China. Our cleanroom in Thailand is located southeast of Bangkok and is outside of the flood plain. So it remained high and dry during the floods that began ravaging a large portion of Thailand in October.

However, several of our hard disk drive customers’ facilities and many of their other suppliers in Thailand were under water for a portion of the period from October until early December. As a result, there were severe supply shortages of critical components that caused disk drive industry volumes to contract by about 40% during this first part of our second quarter.

During the worst of this disruption, we were forced to reduce the production schedules at both our Thai and Chinese cleanrooms. The better news is that some of our customers and their suppliers which had been directly impacted were successful in shifting production to non-flooded facilities while others were able to clean up and restart some production in December. While this situation is not completely back to normal, industry volumes had improved significantly by the end of our quarter – by the end of January.

Now I’d like to switch gears and review our sales by region. We had very good growth in the Americas with local currency sales increasing 18% in the quarter. This is currently the strongest economic region for us. In Europe, our local currency sales increased 7% despite a number of European economies reporting negative GDP growth in the last calendar quarter.

And in Asia, our local currency sales declined 4% in the quarter, obviously impacted by the flood-related issues in Thailand I just discussed. Excluding our disk drive filter sales, the rest of our Asian businesses grew at 3% year over year. This is a lower growth rate than we’ve enjoyed in the prior quarters and was primarily a result of the recent economic slowdown in China, which also hurt growth in those nearby countries such as Japan and South Korea, which heavily export into China.

I’m now going to turn the call over to Jim Shaw for his comments on our operations before I discuss our fiscal 2012 outlook. Jim?

Jim Shaw

Thanks, Bill, and good morning, everyone.

Our gross margin was 34.6% in the quarter, down 70 basis points from last year. There were some pluses and minuses in our gross margin number, which I’ll walk you through now. The largest impact in the quarter was lower absorption of fixed cost, which reduced gross margin by 90 basis points compared to last year.

This decrease was mainly driven by two separate factors. First, our two disk drive filter plants were operating at lower levels of production during the quarter due to the disruption of the entire disk drive market caused by the Thailand floods.

In fact, our factory in Thailand was closed for a period of time in November, not because we were flooded, but because our customers couldn’t get parts from other suppliers to assemble the hard disk drives. Under Thailand labor laws, we continued to pay our workers there a significant portion of their normal pay during the shutdown.

We also reduced shifts at our disk drive filter plant in China due to the supply chain disruption. Fortunately, the industry production levels have improved substantially by the end of January and should be back to pre-flood levels over the next few months.

The second driver of lower fixed cost absorption was a decrease in shipping days by five days in most of Asia compared to last year’s second quarter. This is due to the timing of Chinese New Year which was in February last year but fell in January this year.

There were also less of the traditional holiday shutdowns at our customer in the United States and Europe last fiscal year as demand came back strong from the recession. This year was a more normal holiday shutdown period. Higher commodity prices compared to this time last year and the mix of our product sales also had an unfavorable impact to our gross margin.

Offsetting these negative impacts were our continuous improvement initiatives which increased gross margin by 100 basis points. So in total, our gross margin was down 70 basis points from last year’s strong second quarter margin of 35.3%.

Our operating expenses remained well under control coming in at 21.7% of sales which was down 100 basis points from last year. This improvement over last year comes from increased leverage of our fixed costs due to higher sales levels partially offset by selective investments we have made over the past year to support our strategic growth initiatives.

In addition, while we continue to assess the direction of the global economy, we did selectively slow our plant head count additions during the quarter. Even though recent economic indicators improved during the latter part of our quarter, there’s still a lot of uncertainty regarding the sustainability of these improvements, especially in Europe and China. So we’ll continue to be measured in the pace with which we add to our fixed expense levels.

Our operating margin came in at 12.9% this quarter, which is a record. Looking at our operating margin forecast for fiscal 2012, we believe the fixed cost absorption issues that impacted Q2 are behind us and that purchased raw material costs will continue to moderate over the next couple of quarters.

We continue to benefit from higher volumes as we leverage our fixed costs and benefit from our continuous improvement initiatives. In total, we continue to expect our operating margin for fiscal 2012 to be between 13.7% and 14.5%, which means that anything above the bottom of this range would represent another full year operating margin record.

Our effective tax rate was 29.6% in the quarter versus 34.4% last year. Last year’s second quarter was impacted by a $4 million charge related to the reorganization of our subsidiary holdings, which improved our global business and legal entity structure, offset by a $900,000 benefit from the retroactive reinstatement of the research and experimentation credit in the U.S. Based on our projected mix of earnings in fiscal 2012, we continue to forecast our tax rate to be between 27% and 30% for the full year.

Our second quarter CapEx came in at $18 million. In total, we expect CapEx spending of approximately $85 million this year. This estimate is down slightly from our earlier estimate of $100 million for the year. We still plan to authorize and begin work on $100 million of capital projects. The reduction is simply related to the timing of when we estimate the cash payments to be made. These global investments are an important part of our strategic growth plan. We have many projects included within the $85 million CapEx plan this year, and we expect these will positively impact our corporate ROI when completed.

Approximately 25% of this year’s CapEx is for capacity expansion, another 25% is tooling for new products, 25% will be related to cost reduction activities through our continuous improvement initiatives and the final 25% will be for our technology initiatives. We expect depreciation and amortization to be between $60 million and $64 million this year.

Free cash flow was $27 million this quarter. As mentioned, CapEx was $18 million this quarter compared to $14 million in last year’s second quarter. Working capital was a source of cash this year as sales decreased sequentially from the first quarter as our second quarter is seasonally the weakest quarter. We expect cash flow from operating activities to be $250 million to $280 million in fiscal 2012.

We didn’t repurchase any shares in Q2 leaving us at about 1.4 million shares or 1.8% of our diluted outstanding for $74 million year to date. The absence of share repurchase activity in the second quarter was the primary driver for the $45 million decrease in debt. With this decrease, our debt to cap and debt to EBITDA ratios are now at 24.7 and 0.7 respectively, well within the financial covenants of our various credit and note agreements.

We continue to expect interest expense in fiscal 2012 will be between $11 million and $13 million. Our balance sheet remained strong with $272 million of cash and short-term investments.

So with that, I’ll pass it back to Bill who will provide additional details on our updated outlook for fiscal 2012. Bill?

Bill Cook

Thanks, Jim. I think we’ve covered the quarter pretty well, and now we’re going to switch gears and look forward.

And our current guidance is based on the expectation that overall European economy will remain at current levels during the second half of our fiscal year and for the Chinese economy to improve, which will obviously benefit China as well as the rest of Asia.

We anticipate that the U.S. dollar will remain stronger than what we had assumed in our previous guidance that we issued in November. This stronger U.S. dollar does create about a nickel EPS headwind for us compared to our earlier outlook.

We expect our full year sales to be between $2.45 billion and $2.55 billion or an increase of between 7% and 12% over last year’s record of $2.3 billion. Bottom line, we continue to see many growth opportunities and expect that we will continue to grow faster than the end-market averages through the introduction of new filtration technologies and products and also by increasing our sales coverage in emerging geographies.

Now I’ll review our outlook by segment.

Our full year Engine sales are forecasted to be an 8% to 12% increase over the prior year. Within Off-Road product sales, we expect continued strong demand for our OEM customers, ag, construction and mining equipment as the average age of equipment in the field still remains historically high. This should support an ongoing stronger equipment replacement cycle.

We’re also forecasting continued strength in our On-Road product sales. For example, ACT research forecasts that heavy truck builds at our North American customers is expected to increase from 256,000 in calendar 2011 to 296,000 in calendar 2012, or a16% increase, and then increase again in calendar 2013 by another 8% to approximately 320,000 trucks. The average age of the current truck fleet is also historically very old indicating a need for the continuation of the current replacement cycle.

Finally, we expect our aftermarket or replacement filter sales to remain good. The demand for replacement filters is a function of the increased utilization rates within the existing fleets of heavy trucks and off-road equipment in the field and our ability to retain the aftermarket opportunity where we’re the first-fit OEM supplier. In addition, we are aggressively working to further expand our distribution networks, especially in our targeted emerging markets.

Now switching to our other reporting segment, Industrial, our sales there are forecast to be up between 7% and 11%. Within Industrial, we expect our Industrial Filtration Solution business sales to be up between 7% and 11% as customer demand for new industrial filtration equipment continues to improve due to new plant and manufacturing capital investment decisions. We also expect our replacement filter sales to continue to grow, again, with the increased utilization by our customers of those filtration systems and dust collectors already in the field.

As I mentioned earlier, we anticipate a significant increase in our Gas Turbine business as we see two very positive trends. First, there are currently many large gas turbine system projects underway at our customers. These are typically 200-megawatt projects, each of which could provide the equivalent power for 200,000 homes.

Many of these projects are underway in the Middle East, China and the U.S. The second positive trend relates to high oil prices and a resulting demand for smaller turbines which are needed as more investments are made in energy exploration and transportation. Though overall, we expect our Gas Turbine product sales to increase 18% to 22% year over year.

Finally, we’re forecasting Special Application sales to be level year over year as growth in our membrane and venting product sales should offset the second quarter reduction in our disk drive filter sales that Jim and I talked about earlier.

Incorporating this sales guidance into the operating guidance that Jim covered earlier and accounting for the estimated nickel negative impact from foreign currency translation, we have adjusted our full year EPS forecast for fiscal 2012 to between $3.25 and $3.45 per share. The midpoint of this range is up 17% from last year. Obviously, this would be another EPS record, and it would be our 21st record in the last 23 years.

Finally, I’d like to give you a quick update on some of the new technologies and major investments we’re making before we wrap up our prepared comments.

Over the past two years, we’ve highlighted our PowerCore technology as an example of how we continually introduce new filtration technologies to help our customers in order to help grow both their and our businesses. Our Engine PowerCore sales in the second quarter totaled $25 million and were up 35% over the prior year.

On the Industrial side of our business, we introduced our third Torit PowerCore product line last May. This new product line is targeted towards the high-abrasive, heavy-loading mining and metal working markets. For our customers, this offers many advantages including that it’s up to 70% smaller than competitive collectors. And in our second quarter, we sold another 310 Torit PowerCore systems, which accounted for over $4 million in sales. So in total, our total PowerCore sales are now approaching $30 million a quarter or $120 million on an annual basis.

We also continue to make progress in the liquid filtration markets. We unveiled our new select fuel filters with our proprietary Synteq XP media at the CONEXPO show in March. We’ve already won six OEM platforms with this technology and interest remains high We’re also continuing development on our next generation of Duramax hydraulic filters. When launched, we expect these filters will offer our customers improved filtration performance and longer filter life.

Finally, I’d like to highlight the recent completion of one of our emerging market investments. Last week, I was honored to attend the grand opening of our new plant in Aguascalientes, Mexico. This is our third plant in Mexico and our second plant in Aguascalientes. This latest investment in Aguascalientes, totaling $20 million, adds significantly more liquid and air filtration production capacity to serve our customers throughout the Americas with a special focus on those in Mexico, Brazil and the balance of Latin America.

So now to summarize, we’ve reached the midpoint of over fiscal 2012 with record results and with significant forward momentum in many of our businesses and regions. We are very well-positioned for a strong second half and, as a result, we’re projecting another record for both full year sales and earnings.

We will continue investing and developing new technologies and products to help meet our customers’ changing filtration needs. We will also continue to make the key long-term investments such as the one I just highlighted in Mexico to support our $3 billion and $5 billion sales targets that we established in our strategic growth plan.

Now that concludes our prepared remarks, and now we’d like to open up to your questions.

Question-and-Answer Session

Operator

Thank you, sir. (Operator Instructions) The first question comes from Hamzah Mazari from Credit Suisse. Please go ahead.

Hamzah Mazari – Credit Suisse

Good morning. Thank you. A question on how to think about incremental margins in your business going forward given most of the fixed cost absorption issues are behind you now. At the same time, you’re sort of slowing down head count but also making some capacity investments. How should we think about those incremental margins long term given where you are in the cycle right now?

Jim Shaw

Hamzah, this is Jim. I think as we talked before in terms of coming back from the recession, we had a little bit of a pick-up in terms of incremental margins on some of those first sales that came back. We’re well past that at this point. So I think as you look at, maybe, first gross margin, I think the challenges we had this quarter that I referred to in my prepared comments are past us.

I think the wildcard is commodity prices and, as of right now, those are fairly stable. So I think from an operating margin, our longer-term goal is to continue to expand that in small increments because we’re not out to maximize operating margin because we do want to continue making some of these investments. But over time, we do see opportunities to slowly expand the operating margin.

Bill Cook

Hamzah, this is Bill. Just to add to what Jim said, longer term, we have a goal of achieving and maintaining a 15%-plus operating margin. That’s not this year; point back to the guidance that Jim gave earlier between 13.7% and 14.5%. But over the next handful of years, our goal is to get to and maintain 15%-plus op margin.

Hamzah Mazari – Credit Suisse

Great. And just a follow-up question. You spoke of PowerCore currently being at a $120 million annual run rate. Could you maybe talk about what your current aftermarket capture rate is and, as PowerCore gradually becomes a larger part of the install base, how we should be thinking about that capture rate moving up? Is it going to be a very gradual process? How should we think about that longer term?

Bill Cook

Hamzah, Bill again. I think as we discussed and I’ll just sort of recap this, PowerCore offers advantages both on the first fit, so in some cases we’re picking up first fit business or share we didn’t have before. But probably the most significant opportunity it creates for both us and our customers is in the aftermarket. So with a non-proprietary technology, maybe a year after our system is in the field, we might only be capturing – we and our customers might be only capturing 30% or 40% of the aftermarket. With technologies like PowerCore or like Synteq XP, we can get that up to 100% for a period of time.

So we can maintain at higher share for a longer period of time with these proprietary technologies, and then our goal going forward is to continue to refresh and introduce new technologies to keep that number up as high as possible.

It’s growing very nicely. As we mentioned our Engine PowerCore sales were up 35% over the same quarter last year. We’re at this $120 million annualized rate at the end of the second quarter. We see that continuing to grow or accelerate. It’s really dependent on the launch by our customers of their new equipment platforms. So a lot of the programs that we won are won, but they’re just in the process of being launched. So we see that happening over the next couple of years that they’ll be out there and then we’ll see that that big pick-up in the aftermarket.

Hamzah Mazari – Credit Suisse

Great. And just a last question from me on the acquisition side. Could you update us on your thinking on acquisitions, particularly on the liquid side and how much is liquid of your business right now?

Bill Cook

So Bill again. About 18% of our sales are liquid today. That business has continued to grow very nicely. So by itself, it’s a $400-plus million business and we have plans, as we’ve discussed in other calls and presentations, to significantly grow our liquid business, essentially get that to $1 billion plus by fiscal 2021.

We’re doing that both organically and through acquisitions, and we look at acquisitions on the air filter side as well. But most of our growth target, the, say, the 9% to 10% that we’re targeting as a CAGR in sales is organic. And we think we can do roughly 8% organically, and we say roughly 2% per year via acquisitions. So we’re still mostly an organic growth story, but we are always looking. We have a focused team looking at acquisitions both on the air and liquid side, but we probably are more focused on trying to find the liquid ones today. In fact, the last acquisition that we did, which is a couple of years ago, was Western Filter, which was liquid.

Hamzah Mazari – Credit Suisse

Right. Great. Thank you.

Bill Cook

Thanks.

Operator

Thank you. The next question comes from Charlie Brady from BMO Capital Markets. Please go ahead.

Charles Brady – BMO Capital Markets

Hey, thanks. Good morning, guys.

Bill Cook

Good morning, Charlie.

Charles Brady – BMO Capital Markets

Hey, could you just remind us in the Special Apps segment, the mix between the membranes and the hard disk drives, is it still around 50%?

Bill Cook

Charlie, Bill. The hard disk drive business is probably about 60% of the total Special Apps.

Charles Brady – BMO Capital Markets

On a normalized basis, correct, though obviously, lower than that recently?

Bill Cook

Right.

Rich Sheffer

Charlie, Rich here. Membranes would be 25% to 30% of the balance of Special Applications, and then some of our more niche businesses in semicon, imaging and then venting solutions make up the balance.

Charles Brady – BMO Capital Markets

Okay. Thanks. That’s helpful. I just want to ask, on your guidance as it relates to your assumptions for currency on the euro and the yen, specifically on the yen, you’re now assuming a 76 rate on the yen which is where it was at the end of your quarter but it’s trading at 80. And I’m just wondering, I mean, the impact that that could have potentially, if we were to stay at the current level, on fiscal 2012 revenues and EPS. I guess basically, how much of your business really gets denominated in yen?

Rich Sheffer

Hey, Charlie. It’s Rich again. Well, our subsidiary in Japan is our largest single subsidiary we have globally today at $100 million, $120 million of annual sales. The impact of that moving a couple of percent might be $1 million or $2 million on the top line, and by the time it gets to the bottom line, it’ll be a pretty small impact.

Jim Shaw

Charlie, this is Jim. The one that impacts us to a much higher degree is the euro.

Charles Brady – BMO Capital Markets

Right, okay. And just one more from me. Can you just maybe give some more granularity on what you’re seeing in the South American markets, particularly like Brazil?

Bill Cook

Charlie, Bill. We see very strong growth in Brazil and throughout the rest of South America. In fact, we just opened up a distribution center this past year in Chile to help serve the market down there. So part of the investment that I was talking about in Aguascalientes is directly focused on, not just serving Mexico, but the growing South American market as well. So we see very good prospects there.

Charles Brady – BMO Capital Markets

Thank you.

Operator

Thank you. The next question comes from (inaudible) from BB&T. Please go ahead.

Kevin Maczka – BB&T

Hi. This is Kevin Maczka from BB&T. Good morning.

Bill Cook

Hi, Kevin.

Kevin Maczka – BB&T

Hey Bill. Can I ask the incremental margin question in a little different way? I think we understand that at this point in the cycle we shouldn’t see the big outsized incrementals for the total company. But in Industrial in the first half and again here in Q2, we did see that very strong incremental margins even with this underabsorption from the disk drive issues. So are you saying for Industrial as well that that’ll settle out to a more normal incremental kind of in line with this 15% margin where we are now?

Bill Cook

Kevin, I’ll start and then I’ll turn it over to Jim. We don’t give operating margin guidance by segment. We only do it for the company and there are pluses and minuses in that. And I’ll sort of point back to our full-year guidance and the comments I made earlier about the longer term.

We do see the opportunity to get to a 15%-plus OP margin, but as Jim mentioned, we made a pretty good step-function jump the last couple of years. We don’t see repeating that because that was the advantage or the benefits of some of the restructuring that we did coming through the recession and we’re not planning to repeat that. And we’re also, as Jim mentioned, we’re balancing operating margin expansion with focusing on investing back in the business, so we can get that 8% organic growth I mentioned a minute ago.

Jim Shaw

This is Jim. I think the other thing, too, is when you step down from the company level to the segment level, the mix of products from one quarter to the next can play into that as well. So we talked first quarter about having a real good start on the margin within Industrial, but that can fluctuate depending on project sales and the like. So I wouldn’t call it a trend yet, but we’re certainly happy with where it’s at.

Kevin Maczka – BB&T

Got it. Okay. And if I can shift gears over to what you’re seeing in engine aftermarket. That step down a little bit here, in terms of revenue sequentially, looks like it grew on a year-over-year basis about 10% in the first half, but you’re now calling for moderate growth for the year as a whole. Can you kind of describe a little more about what you’re seeing in terms of incoming order rates and are you suggesting that that may even turn negative in the back half on a year-over-year basis?

Bill Cook

No, we’re not suggesting it’s going to turn negative. So I think it’s just moderating is really what we’re seeing. We saw, coming out of the recession, there was probably some restocking by parts of our distribution channel that helped with higher numbers and we’re seeing, maybe, a more normalized type of growth rate there with the addition of the fact that we’re adding more products in our product line and more distribution. So we still feel, as I tried to say in my comments, that we’re growing faster than the market but the market rate has moderated.

Kevin Maczka – BB&T

Okay. Got it. Thank you.

Bill Cook

Thank you.

Operator

Thank you. The next question comes from Laurence Alexander from Jefferies. Please go ahead.

Laurence Alexander – Jefferies

Hi. This is Jeff on for Laurence. Can you guys provide any initial color, post the Chinese New Year, of demand trends in Asia in the auto market and, also, if you can update us again on any order trends in the aerospace market?

Bill Cook

Hey, Jeff, Bill here. I think, first off, you mentioned the auto market and we’re really not in the auto market. So we’d be talking about heavy trucks and construction equipment and ag equipment on the Engine side.

I think what we saw before Chinese New Year was some of the moves that the Chinese government was making to sort of loosen things up a little bit to facilitate building more momentum in the economy that we’re very hopeful of that second half of our year is we’ll see a recovery. Our team in China just completed a forecast in the last couple of weeks. So our outlook is based on their forecast and incorporates what they’re seeing in ordering trends and from their conversations with customers. So we do see that picking up.

And then on the aerospace and defense, it’s sort of a mixed bag. The commercial side is it’s stronger and offsetting sort of the weakness that we’re seeing on the defense side. We are working on some more significant defense programs, but those are going to help us in the out years, a couple years out. So right now, it’s a mix, commercial strong being offset by sort of a weakening in the defense market.

Laurence Alexander – Jefferies

Great. Thanks.

Bill Cook

Sure.

Operator

Thank you. The next question comes from Richard Eastman from Robert W. Baird. Please go ahead.

Rick Eastman – Robert W. Baird

Yes, good morning.

Bill Cook

Good morning, Rick.

Rick Eastman – Robert W. Baird

Bill, could you just split out the Asian growth rate by Engine and Industrial and maybe speak to the 3% non-disk drive impact growth number?

Bill Cook

For the 3%, excluding disk drives, split between Engine and the rest of Industrial?

Rick Eastman – Robert W. Baird

Yeah. Is it possible to...?

Bill Cook

Well.

Rick Eastman – Robert W. Baird

On short notice?

Rich Sheffer

So, Rick, this is Rich. In total, in local currency terms, the Engine business in Asia was up a little over 3%.

Rick Eastman – Robert W. Baird

Okay.

Rich Sheffer

And as we mentioned, total Industrial was down about 12%. Excluding Special Applications, the rest of Industrial was up between 4% and 5% local currency terms.

Rick Eastman – Robert W. Baird

Okay. So the softness was pretty broad-based and, again, one can look basically to the China PMI and then, obviously, the Chinese New Year was in there. So basically as you look to the second half and you expect an improvement in Asia/China, is that pretty much both pieces of the business or does Engine maybe lead that or...?

Bill Cook

I think – Rick, it’s Bill here. I think we see it in essentially all pieces of the business.

Rick Eastman – Robert W. Baird

Yeah. Okay. All right. Okay, and then can you just give us what China sales were in the quarter or just an annualized rate or...?

Bill Cook

Sure.

Rich Sheffer

Two seconds, Rick.

Rick Eastman – Robert W. Baird

Maybe, Bill, maybe I’ll just jump to the next question real quickly. The IFG business, that 8% growth rate was I thought a pretty good number. Are you seeing a material kind of measurable impact from the Torit dust collection systems in that IFG number and, also, is there anything – at our conference back in the fall you talked about the baghouse business being a big opportunity for PowerCore cartridges. Is there anything in there that’s starting to be measurable?

Bill Cook

Rick, Bill. Yes.

Rick Eastman – Robert W. Baird

Okay.

Bill Cook

A significant portion of what we’re – on these new Torit PowerCore systems, we’re selling those into applications where we didn’t really have – it was a baghouse product before and we didn’t really have a significant market share. So it’s both a significant first fit opportunity for us as well as what I talked about with the replacement filters. So yes, it’s allowing us to play in some segments where really didn’t have a perfect product before.

Rick Eastman – Robert W. Baird

So pure share gains there. Okay.

Bill Cook

And then on your China question, Rick, our sales in China in the quarter were $31 million and, for the first half, they were $66 million.

Rick Eastman – Robert W. Baird

Okay. And then just one last question, Bill. When you’re talking – I think it was either you or it might have been Jim. But when you were talking about the CapEx and you split out the quarter pieces here, the one piece you mentioned, 25% was for technology initiatives. Is that basically – can you just explain that? Is that tooling or is that just pure research? How does that end up in CapEx or what is that?

Jim Shaw

This is Jim. What that is is a combination of IT-type technology initiatives to improve the business as well as technology initiatives in our labs and our product development.

Rick Eastman – Robert W. Baird

I understand. Okay. So it’s more of systems upgrades or spend?

Jim Shaw

Systems and labs and equipment related to the lab.

Rick Eastman – Robert W. Baird

Oh, I see, I see. Okay. Great. Thank you.

Bill Cook

Thanks, Rick.

Operator

Thank you. The next question him from Brian Sponheimer from Gabelli & Company. Please go ahead.

Brian Sponheimer – Gabelli & Company

Hey. Good morning, Bill.

Bill Cook

Good morning, Brian.

Brian Sponheimer – Gabelli & Company

I just had a question for you on return of capital going forward. Obviously, dividend policy and tax treatment thereof is an issue on the front page today and you didn’t repurchase any shares in the quarter. So just thinking about, let’s say there’s some sort of major policy change regarding dividends, how does that affect the Donaldson strategy going forward?

Bill Cook

Major policy change of the government or at Donaldson?

Brian Sponheimer – Gabelli & Company

Well, yeah, if dividends start being taxed at 39%?

Bill Cook

So, Brian, we’ll wait and see on that. I’ll say, as of today, our policy remains the same and it’s been very consistent for the past 20-something years. Our dividend policy is to pay out between 20% and 30% of the average of the prior three years’ EPS. Over the last probably half a dozen years, we’ve really targeted to stay in the upper half of that range, 25% to 30%, which would give us sort of an approximate 1% yield, okay? So we don’t promise that, but that’s what we decided we would do.

And then on share repurchase, historically we’ve targeted 3% gross, which should result in a net 2% reduction per year. We’ve moderated that a little bit in the last couple of years to say we might want to use more of the cash there for acquisition, so a 2% gross. But we also commit that we’re going to buy enough each year at a minimum that options would never be dilutive. And so, as you know, over the last 20-something years, we’ve averaged a net 2% reduction and share count’s always gone down.

So I would say at this point, Brian, we’re going to maintain the course. If there is a significant change in the tax treatment of dividends, we will take a look at that. What we’re trying to do there is deliver a combination of components of value for our shareholders and that’s the way we have been doing it. But we’ll revisit that if something should significantly change.

Brian Sponheimer – Gabelli & Company

Okay, great. Thank you very much.

Bill Cook

Sure.

Operator

(Operator Instructions) The next question comes from Eli Lustgarten from Longbow Securities. Please go ahead.

Eli Lustgarten – Longbow Securities

Good morning, everyone.

Bill Cook

Good morning, Eli.

Eli Lustgarten – Longbow Securities

Kind of just one clarification on China. If, given the size, which is $130 million annual rate at this point, if the Chinese market didn’t pick up for the rest of your fiscal year – because I guess the consensus now is post-July – that really won’t have any material impact on your guidance, maybe $0.01 or $0.02 or something like that. Is that fair?

Bill Cook

Eli, this is Bill. We haven’t quantified that, and I’ll point back to the guidance that we gave. We think that it will pick up. So if it didn’t, then we’ll revisit our guidance at the end of the next quarter. But the reports from our people and what we saw before Chinese New Year would suggest that the Chinese government is trying to move the growth rate back up and that’s ...

Eli Lustgarten – Longbow Securities

I understand. That’s a macro call. The Chinese PMI for February came out at 49.7 and not much change. And what we’re hearing, all of the economies now have given up the post-Chinese New Year upturn and put it in July. That’s the reason I asked the question. I just want to know if it has any – I don’t know what’s right or wrong, I just think about the magnitude of the impact.

Bill Cook

So I’ll leave you with two thoughts. One is that our share in China is very small in many of our markets. So to some extent, the overall economic indicators – we want to grow faster than the markets anyway and we have the share upside to do that. So that would be one thing I would mention.

The other thing to your point, though, is if the Chinese economy remained in the doldrums, as you’re suggesting as a possibility, it would impact our business in China and some of the other businesses in Asia because, as I mentioned in my comments, our businesses in, like, South Korea and Japan serve customers that are exporting into China. So there is some rollover effect outside of China given how fast or how slow the Chinese economy grows.

Eli Lustgarten – Longbow Securities

But you gave us the Japanese business is about $130-odd million, $120 million to $130 million, the Chinese business running the same annual rate. How much is the rest of the other parts of the Asian business, besides that, what’s total Asia at this point?

Bill Cook

Asian total is about 20% of our sales.

Rich Sheffer

Yeah, about 25% of our sales. So Asia, a little over $0.5 billion at this run rate. So you would say that Japan and China on their own make up about 50% of our Asian sales.

Eli Lustgarten – Longbow Securities

Now you talked about in the new fluid business winning six OEM platforms. Can you give us the type of platforms? Are those mostly construction equipment platforms, or is it multiple customers or one major customer that’s putting on multiple platforms?

Bill Cook

Eli, Bill. It’s multiple customers. It’s around fuel filtration and it’s both the On-Road and Off-Road.

Eli Lustgarten – Longbow Securities

Filtration. Do you have any targets set for the next six to 12 months of how many more platforms you think you can do on that?

Bill Cook

We do internally, but we haven’t made those public.

Eli Lustgarten – Longbow Securities

Okay.

Bill Cook

But we’re trying to obviously to win every one that we can.

Eli Lustgarten – Longbow Securities

Yeah.

Bill Cook

We do have targets which support the growth plans that we laid out in terms of the revenue numbers that I mentioned earlier in the call.

Eli Lustgarten – Longbow Securities

And are we seeing anything in the order patterns from most of your markets that would prevent your sight improvement in operating margins in the second half year over year at this point? I mean, that’s sort of what you’ve indicated, you striving for – I mean, I don’t see anything that would prevent that from happening at this point. Is there anything...?

Bill Cook

Eli, it’s Bill. I think, I mean, anything could happen tomorrow or next month or next quarter. But right now the guidance that we’re providing is very fresh and it’s based on a forecast from all of our leaders in the businesses and around the world.

So I think we’re, as Jim mentioned, that doesn’t mean that we’re not continuing to reassess what’s happening out there. And we are being conservative in terms of which investments are, in terms of head count we’re adding because there is some uncertainty around what’s happening in Europe or, to your question, around China. But the forecast is – the ink on it is just drying, so it’s very fresh and that is our best guidance at this point.

Eli Lustgarten – Longbow Securities

And one final one. Can you talk a little about what you’re seeing acquisition-wise and whether that’s taking a little more important priority around the company over the next six to 18 months I guess is the way I would think about it.

Bill Cook

Eli, Bill again. We’re still mostly an organic growth story. You’ve followed the company for many years. So we want to get about 7% or 8% of our revenue growth per year through organic growth, and that’s what we’ve done over the past two decades. So we think we can continue to do that with investments we’re making in technology and sales and distribution.

That leaves about 2% roughly from acquisitions. So at our current size, that would mean we’d have to acquire a company with sales of about $50 million each year. We’re always looking, but we remain mostly focused on organic.

But we do have a small team focused on acquisition looking. But we’re patient, and we have our financial metrics and an acquisition would have to deliver. So we look at a lot and walk away from a lot, but we are always looking. And the pipeline, I don’t think it’s any better or any worse than it was six or eight months ago. There’s some activity, but not a tremendous amount of activity, but we’re always looking to see what’s out there.

Eli Lustgarten – Longbow Securities

Thank you very much.

Bill Cook

Sure. Thank you.

Operator

Thank you. There appears to be no further questions. Please continue with any other points you wish to make.

Bill Cook

Okay. Thanks Michella.

Now to conclude our call, I’d like to thank everyone for your time and continued interest in Donaldson. I’d like especially thank my almost 13,000 colleagues for their efforts and contributions in creating the wonderful results we delivered in our second quarter. This quarter demonstrates further significant progress in our execution of our strategic growth plan with our objective of building our company into, first, a $3 billion then a $5 billion filter company.

Thank you, all, and have a great day. Good-bye.

Operator

This concludes the Donaldson’s Q2 FY 2012 conference call. Thanks for participating. You may now disconnect.

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