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Text: During today's call, we Will also reference non-GAAP metrics.
I want to start by welcoming Charley to the team.
He joined Donaldson last week after two decades on the sell side, which included 15 years of covering our company.
He already knows us well, so our Investor Relations program is in good hands.
Turning to the quarter, we feel good about our results.
First quarter sales were up 3% sequentially, which is not typical seasonality, signaling that the worst of the impact from the pandemic on our business may be behind us.
Sales of replacement parts outperformed first-fit by a wide margin providing valuable stability, and we saw continued evidence of share gains in strategically important markets and geographies helped in part by our robust portfolio of innovative products.
First quarter profit performance was another highlight.
Gross margin was up 60 basis points from the prior year resulting in the highest first quarter gross margin in four years, and the best sequential improvement in at least a decade.
We reduced operating expenses by 5% while maintaining investments in our strategic growth priorities, particularly as they relate to the Industrial segment.
And altogether, we had a decremental operating margin of only 4% which we view as very positive given the uneven economic environment.
Finally, our company remains in a strong financial position.
We had excellent cash conversion during the quarter and our balance sheet is solid.
We're on track to deliver our strategic and financial objectives in fiscal '21 and we'll talk about those plans later in the call.
But first, let me provide some additional color on recent sales trends.
Total sales were down 5.4% from prior year or 6.4% in local currency.
In the Engine segment more than a third of the decline came from Aerospace and Defense, due largely to the significant impact from the pandemic on commercial aerospace.
We have a great team and strong customer relationships, so we expect our Aerospace business Will recover.
In the meantime, we are pursuing optimization initiatives to put our cost structure on a firmer footing during this rough patch.
In our other Engine businesses trends seem to be improving.
On-Road sales were down 21% in the quarter, which is still a steep decline, but notably better than the past few quarters.
Although Class 8 truck production in the US remains depressed, order rates are increasing and third party forecast for the next calendar year suggest the Class 8 recovery is on the horizon.
Should that happen, we believe our strong position with OEM customers would give us nice momentum in the On-Road first-fit market.
In Off-Road, trends were mixed by region.
In Europe, sales from new Exhaust and Emissions programs were not yet enough to offset the lower rate of production for programs already in place.
In the US, lower production of construction and mining equipment is still a headwind for Off-Road but we had a meaningful sequential increase in first quarter and year-over-year trends are also improving.
We had a very strong quarter in China with Off-Road sales up more than 50%.
Their economic recovery appears to be under way and we are also benefiting from new relationships with Chinese manufacturers that want our high-tech products, including PowerCore.
China [Indecipherable] is more heavy duty equipment than any other country in the world and our team is doing an excellent job building and strengthening relationships with large local customers.
While we expect to have some variability in quarter-to-quarter trends, we are also confident that we have a long runway for growth in China.
First quarter sales and aftermarket were down only slightly from the prior year and they were up 6% from the prior quarter.
All of the year-over-year decline in aftermarket came from the US.
The independent channel is still being impacted by the oil and gas slowdown, which we partially offset with pricing actions implemented earlier this calendar year.
And large OE customers are still tweaking inventory to match demand.
Outside the US, aftermarket performed very well.
In Europe, first quarter sales were up 4% in local currency as conditions improved in Western Europe.
In China, first quarter sales of Engine aftermarket were up more than 30% reflecting strong growth in both channels.
We are gaining share with the new OEM customers and end users are paying greater attention to equipment maintenance.
Part of our success in China is due to PowerCore which is growing rapidly from a small base.
Importantly, PowerCore continues to do well outside of China.
Global sales of PowerCore replacement parts were up in the low single-digits last quarter and we set another record.
PowerCore is our most mature example of how our razor to sell razor blade strategy works and the brand is still going strong after 20 years.
Turning now to the Industrial segment.
First quarter sales were down about 6% including a benefit from currency of about 2%.
The decline was driven primarily by Industrial Filtration Solutions or IFS.
The pandemic is creating a headwind in terms of equipment utilization and a lower willingness to invest.
Quoting activity for new dust collectors was down in the first quarter and the quote-to-order cycle remains elongated.
Generally, customers are focusing on must do projects, while deferring expansion in productivity investments to a future date.
With the market under pressure, we are focused on building our brand and gaining share.
We have strengthened our capabilities related to market analysis and virtual selling and our e-commerce platform gives us incredible reach.
We also continue to leverage our technology advantage and we are encouraged by the opportunity that presents in an underserved market like China.
For quarter -- first quarter sales of dust collectors were up modestly in China and the needs in that region are changing in our favor.
Some manufacturers are dealing with compliance upgrades related to the Blue Sky initiative, while others are going beyond the minimum requirements and striving for better air quality.
That shift represents an exciting opportunity for us, so we Will continue to invest for growth in that region.
Process Filtration for the food and beverage market is another exciting opportunity.
We launched our LifeTec brand filter late in 2016, and we have seen tremendous growth since then.
Sales of Process Filtration parts were up again last quarter with a low single-digit increase which partially offset the pandemic related pressure on sales of new equipment.
Our strategy for growing Process Filtration is solid.
We are focused on winning new contracts with large global manufacturers which gives us the opportunity to sell their plants.
Some of these customers have hundreds of plants, so we are once again doubling our sales team for Process Filtration.
We also made an organizational change to better align our team with the needs of our food and beverage customers.
While these type of optimization initiatives are standard work for us, I'm calling it out because during our fourth quarter call, we said Process Filtration sales were about $50 million of fiscal 2020.
Following our reorganization that number is more like $68 million.
Our IFS numbers are unchanged, but we wanted you all to have the right baseline as we talk about year-over-year trends in this exciting business.
Trends across the balance of our Industrial segment were mixed.
Sales of Gas Turbine Systems were up 11%, driven by strong growth of replacement parts and we continue to gain share.
In Special Applications, we faced pressure from the secular decline in the disk drive market, combined with lower sales of our membrane products.
We partially offset the decline with strength in our Venting Solutions business, which is also benefiting from share gains as we expand into new markets including the auto industry.
Overall, we see strong evidence of how our diverse business model is providing some insulation from the pandemic.
We are gaining share in strategically important markets and geographies.
We are investing to keep the momentum and we continue to show progress on our initiatives to increase gross margin.
I'll talk more about our longer term plans in a few minutes.
He's got great perspective and he is a strong addition to our team.
We are excited to have him join us and I hope you all Will have a chance to connect or reconnect with him soon.
Now turning to the quarter, like Tod said, we are pleased with our results.
Economic conditions were better than what we had in the fourth quarter and we made progress on our strategic initiatives.
First quarter margin was a highlight for us in terms of year-over-year and quarter-over-quarter performance.
Versus the prior year operating margin was up 50 basis points, driven entirely by gross margin.
That translates to a decremental margin of 4%, but that's probably not the level to expect over time.
For a better comparison, I'd point you to our sequential trends.
First quarter sales were up 3% from the fourth quarter and our operating profit was up almost 6%.
That yields in incremental margin of 24.5%, which is in line with our longer term targets from Investor Day and several points ahead of our historic average.
As I've said many times, we are committed to increasing levels of profitability and increasing sales, and we have solid plans to keep driving margins higher.
We saw evidence of those actions last quarter.
So let me share some details.
First quarter gross margin increased 60 basis points to 35% despite the impact from the loss of leverage and higher depreciation.
On the other hand, gross margin benefited from lower raw material costs.
Our procurement team has done an excellent job capturing cost improvements by working with existing suppliers and identifying new ones, which added to the benefits from lower market prices.
We also had a favorable mix of sales in the first quarter, specifically aggregate sales of our Advance and Accelerate portfolio which includes a significant portion of our replacement part sales along with many of our higher tech businesses outperformed the company and our Advance and Accelerate portfolio also comes with a higher average gross margin.
As we continue to drive investments into these businesses, we are shifting more weight toward higher margin categories.
Over time, mix should be a constant factor in driving up our gross margin.
Our strong gross margin performance in the first quarter was complemented by disciplined expense management.
Operating expenses were down 5% from the prior year, which resulted in a slight increase as a rate of sales.
We had significant savings in discretionary categories like travel and entertainment, due in large part to pandemic related restrictions.
At the same time, we continue to invest in our strategic priorities.
We are building teams and adding resources to areas like R&D, Process Filtration, Connected Solutions and dust collection.
These investments are tilted heavily toward the Industrial segment, which contains most of the Advance and Accelerate businesses.
Given that dynamic, we are not surprised that the first quarter Industrial profit margin was down slightly.
Importantly first quarter gross margin was up in both segments, so we feel good about where we ended.
As our investments translate to grow, we expect our margin and return on invested capital Will go up over time.
Moving down the P&L, first quarter other expense of $1.5 million compared with income in the prior year of $2.6 million.
The delta was largely due to a pension charge and the impact of certain charitable options.
During the first quarter we contributed to Donaldson Foundation and there was also a charge for securing face masks that were billed to frontline workers in our communities.
We generally spread these contributions over our fiscal year, so the impact is more timing related than a change in trajectory for us.
I also want to share some highlights of our capital deployed in the first quarter.
As expected capital expenditures dropped meaningfully from the prior year, with our large projects related to capacity expansion mostly complete, we are turning our attention to optimization and productivity initiatives.
We returned more than $40 million of cash to shareholders last quarter, including a repurchase of 0.3% of outstanding shares and dividends of $27 million.
We have paid a dividend every quarter for 65 years and we are on track to hit another milestone next month.
January marks the five-year anniversary of when we were added to the S&P High Yield Dividend Aristocrats Fund.
So this anniversary signals that we have been increased our dividend annually for the past 25 years.
We are proud of this record and we intend to maintain our standing in this elite group.
As we look to the balance of fiscal '21, there are still plenty of reasons to be cautious.
The magnitude and ultimate impact from the pandemic are still unknown and we continue to face uneven economic conditions.
Given these dynamics, we feel prudent to hold back on detailed guidance, but we did want to expand our information provided during our last earnings call.
In terms of sales, we expect second quarter Will end between a 4% decline and a 1% increase from the prior year and that means sales should be up sequentially from the first quarter.
We also expect a year-over-year sales increase in the second half of fiscal '21, and sales are planned to migrate toward a more typical seasonality meaning that second half Will carry slightly more weight than the first.
We are modeling a full year increase in operating margin driven by gross margin.
Our productivity initiatives should ramp up over the fiscal year and we expect benefits from lower raw material costs and mix Will still contribute to a higher gross margin, but to a lesser extent than what we have been seeing.
Of course the caveat to the gross margin impact from a strong recovery, while we Will be happy of our first-fit businesses accelerate beyond our expectations, that could create a scenario or mix close from a tailwind to a headwind.
That's obviously a high-grade problem and we would address situation if that's the case.
As the rate of sales, we intend to keep fiscal '21 operating expenses about flat with the prior year.
Specifically, the second half of the year, we are still expecting headwinds from higher incentive compensation and planning a return to a more normal operating environment, we would anticipate year-over-year increase in expense categories that have been significantly depressed by the pandemic.
But as always, we are exploring optimization initiatives to offset these headwinds.
I am confident that we can maintain an appropriate balancing -- balance, allowing us to invest in our longer term growth opportunities by driving efficiency elsewhere in the company.
For our full year tax rate, we are now expecting something between 24% and 26%.
The forecast oriented is more now than last quarter, simply due to having a clarity with the first quarter complete.
There were no changes to our other planning assumptions.
So let me share some context.
Capital expenditures are planned meaningfully below last year, reflecting the completion of our multi-year investment cycle.
Our long-term target is plus or minus 3% of sales and we would expect our capex to be below that level this year.
We plan to repurchase at least 1% of our outstanding shares which Will opt dilutions [Phonetic] with stock based compensation.
Should we see incremental improvement in the economic environment, it is reasonable to expect that we Will repurchase more than 1% this fiscal year.
Finally, our cash conversion is still expected to exceed 100%.
We had a very strong cash conversion in the first quarter driven by reduced working capital, lower capital expenditures and lower bonus payouts.
As sales trends improve versus the first quarter, we would expect our cash conversion to drift down a bit over the year, which is typical of a more favorable selling environment.
Stepping back to the numbers, our objectives for the year are consistent with what I shared last quarter, we Will invest for growth and market share gains in our Advance and Accelerate portfolio, execute productivity initiatives that Will strengthen gross margin, maintain control of operating expenses including the implementation of select optimization initiatives and protect our strong financial position through disciplined capital deployment and working capital management.
We had a solid start to the fiscal year, despite the pandemic fatigue [Phonetic] that I know everyone is feeling.
I am proud of what you all accomplished and I look forward to continued success.
I wish you and your family my best as you move to Europe.
The good news is we Will still work together.
This year we have a straightforward plan.
We play offense where we can and defense where we must.
Our defensive efforts are all about managing costs and one way we are doing that is through optimization.
The most significant example relates to productivity improvements in our plants, which are being enabled by the capital investments we made over the last two years.
But it's not just about large projects for us, our employees have a continuous improvement mindset and our culture has a shared commitment to operating efficiently.
Our teams are consistently finding ways to leverage tools and technology and their work allows us to deploy more resources to support our strategic growth priorities.
As we look forward, we are excited about those opportunities.
For example, food and beverage is the first step on our journey into life sciences.
We expanded production capabilities of our LifeTec filters and our new R&D facility in Minnesota, we believe we are in an excellent position to press forward.
At the same time we're pressing forward in our more mature markets, driven by our spirit of innovation, we continue to bring new technology to applications that have been using old technology for a long time.
A great example is a recently announced product for Baghouse dust collection.
Baghouses have used the same low-tech solution for decades, and they represent about half of the $3 billion to $4 billion industrial air filtration market.
Our game-changing product the Rugged Pleat Collector delivers improved performance and lower cost of operation for customers, heavy-duty applications like mining, wood working and grain processing.
So we Will deploy new technology to gain share in this significant market.
In the Engine segment, we continue to lead with technology which is critical given the size of the opportunity.
We are currently competing for projects with an aggregate 10 year value of more than $3.5 billion, telling us the market for innovation is healthy and we have a significant opportunity to win new business.
Our OE customers are working to improve fuel economy and reduce emissions from the diesel engine and they are also increasingly interested in growing their parts business.
Our products meet both of those needs.
We have a multi-decade track record of providing industry-leading performance and we can also show that our technical and design characteristics help our customers retain their parts business.
Based on the opportunities in front of us, we believe the diesel engine Will remain a valuable part of our growth story for a long time, but we also know the market is changing.
So our focus on growing the Industrial segment, while expanding our global share of the Engine market, including new technologies related to air filtration for hydrogen fuel cells puts us in a strong position for long-term growth.
I also want to touch on the role of acquisitions in our growth formula.
With capital markets recovering from the pandemic, we've been getting more questions lately about our philosophy.
So I thought I'd take a minute to realign everyone.
Our focus is very consistent with what we laid out 18 months ago at our Investor Day.
At a high level, we remain a disciplined buyer.
We're most interested in new capabilities and technologies, especially those that accelerate our entrance into strategically important markets.
And we are targeting companies that Will be accretive to our EBITDA margin.
As always, we Will pursue companies that align with our long-term plans versus simply buying share.
The filtration market is split between a small number of large companies, us included and a significant number of smaller companies.
The timing for executing an acquisition is always uncertain, so we Will continue to work our process.
Additionally, we recognize and appreciate that filtration is a high value market.
So our goal is finding the best opportunity at a reasonable price.
With a robust acquisition strategy and significant organic growth options we feel confident that we can continue to drive strong returns on invested capital for a long time to come.
The level of global coordination and collaboration continues to impress me and I believe we have done very well during the pandemic as a business and as a culture.

user
fiscal 2021 operating margin expected to be up from prior year, due to higher gross margin.
sales trends improving, with year-over-year growth anticipated in second half of fiscal 2021.
donaldson company - q2 sales expected to be up sequentially from q1, with a year-over-year change between a 4 percent decline and a 1 percent increase.
donaldson company - sales in h2 of fiscal 2021 expected to increase.

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