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Text: During today's call, we will reference non-GAAP metrics.
Looking at second quarter results, we are pleased with our performance.
Second quarter were up 3% versus a year ago and up 7% sequentially from the first quarter.
Our second quarter results demonstrate the strength of our business model with replacement part sales providing valuable stability as we grew market share in key markets and geographies.
During this quarter, we also built momentum in first-fit sales in our Engine segment, and we're seeing increases of incoming orders across our Industrial segment.
We are pleased to see the uptick in second quarter sales and incoming orders within our first-fit equipment businesses.
While this creates mix pressures in the short term, it also sets the stage for replacement parts in our razor to sell razor blade strategy and provides continued confidence that the worst of the pandemic-related economic impacts are behind us.
We played the long game during the pandemic, maintaining our disciplined focus on the future and avoiding the temptation to make potentially shortsighted decisions on our cost structure.
During the second quarter, we took planned full actions with a longer view toward optimizing our organization and our cost structure, primarily in Europe.
We incurred $14.8 million in restructuring expense and expect annualized savings of approximately $8 million once the restructuring activities are completed over the next 12 months.
Excluding the impact from our restructuring actions, gross margin was up 30 basis points from the prior year as lower raw material costs, including benefits from our procurement initiatives more than offset the increasing pressure from an unavoidable mix of sales.
With continuing momentum, we expect full year sales to be up 5% to 8% over 2020, including favorability from FX of about 3%.
We're also projecting adjusted operating margin to increase 60 to 100 basis points, driven largely by gross margin strength.
Finally, our company remains in a strong financial position.
We had solid cash conversion during second quarter, and our balance sheet is in good shape with our net debt to EBITDA ratio sitting at 0.7 times.
Our balance sheet gives us ample capacity to pursue our strategic initiative to move into the life sciences market via acquisitions and continue to invest in organic growth opportunities.
We're delivering on our strategic and financial objectives so far in fiscal 2021, and we are planning for a strong finish to the year.
Scott will talk more about our forecast later in the call.
But first, let me provide some additional color on recent sales trends.
Total second quarter sales were up 2.6% from the prior year or 0.2% in local currency.
Total Engine segment sales rose over 6%, and Industrial was down 4%.
Geographically, the Asia-Pacific region led our positive performance as we continued to see very good growth in China.
In the Engine segment, the sales increase was driven by meaningful growth in both Off-Road and Aftermarket.
The growth was partially offset by a slight decline in On-Road and a drop in Aerospace and Defense.
Off-Road growth was widespread with sales in all major geographic regions up from the prior year.
Importantly, our incoming order rates and backlog point to building momentum through the second half of fiscal 2021.
Within Off-Road, our second quarter sales in China were up about 70%.
We are seeing momentum in the market with construction equipment build rates remaining at high levels.
We are also seeing strong growth of PowerCore in China, and several new PowerCore programs for Tier three upgrades have gone into production.
On-Road sales were down about 1% in the quarter, which is our best year-over-year result since fiscal 2019, signaling to us that the second quarter was the cyclical trough in this business.
Our view is supported by external data with order rates for Class eight trucks launching higher in the past several months and higher build rates projected in the coming quarters.
With increasingly favorable market conditions, combined with our strong share in North America heavy-duty trucks, we are optimistic about our opportunities to drive growth in our On-Road business.
Second quarter sales of Aftermarket were up over 7% year-over-year, and they were also up 4% sequentially from the first quarter, which is atypical and serves as another indicator that market conditions are improving.
In China, second quarter sales of Engine Aftermarket were up over 30%.
We are beginning to see service parts benefit from new equipment under warranty, which includes an increasing percentage that have proprietary PowerCore and PowerPleat air cleaners installed.
Overall, PowerCore sales increased about 9% in second quarter with strong growth in both first-fit and replacement parts.
As I mentioned earlier, in China, we are seeing significant growth, which we expect to continue as PowerCore becomes more mainstream.
Aerospace and Defense, which represents about 3% of our business, faced another tough quarter due primarily to the ongoing pandemic-related weakness in commercial aerospace while sales for helicopters continue to perform well.
As we expect, the time line for recovery in commercial aerospace to be protracted, we took restructuring actions within the quarter to improve our cost structure and better position the organization for the current business environment.
Turning now to the Industrial segment.
Second quarter sales were down about 4%, including a 3% benefit from currency.
We continue to face pressure on sales of dust collection sale products within Industrial Filtration Solutions, or IFS, as utilization rates were lower and customers remain cautious in making capital investments.
Once again, a bright spot in the quarter was Process Filtration.
Our Process Filtration for the food and beverage market with our LifeTec brand continues to grow, particularly on the replacement side.
Overall Process Filtration sales increased in the high teens with contributions from both first-fit and replacement.
And we see a long runway for further expansion of this business.
We are making new inroads with some of the world's biggest food and beverage companies, and we are also gaining share with existing customers.
The sales process for these massive brands involves winning at the parent and then selling one plant at a time, which is why we continue to grow our sales force and invest in new tools and resources.
We launched LifeTec five years ago with fewer than 10 salespeople, and we're on track to be over 100 by the end of this fiscal year.
Sales of Gas Turbine Systems, or GTS, were down 3.5% in second quarter as large project deliveries, though a smaller part of our business, were less than the prior year.
Our replacement parts business, on the other hand, delivered another quarter of double-digit growth.
We continue to win share of aftermarket while being selective in which large turbine projects we pursue.
The team has done a tremendous job of improving the profitability of GTS, and our more focused approach is clearly paying off.
In Special Applications, we again saw very good growth in integrated venting solutions as we continue to drive adoption in the automotive market with our high-tech products.
However, overshadowing these wins were continuing softness in disk drive filters and lower sales of membrane products.
Second quarter results highlight the strength of our diversified portfolio of businesses and disciplined focus on the long game.
We are well positioned to benefit from the recovery in cyclical end markets, and we continue to press forward on our strategic initiatives, including the recently announced investments to grow our life science business.
I'll talk more about that later.
As Tod said, we are pleased with our second quarter performance.
Sales were up 2.6% from the prior year, and adjusted operating income grew 7.6%.
Given the uneven macroeconomic environment, it was a strong quarter in terms of both absolute growth and leverage.
Looking ahead, we plan to build on that momentum.
As I said many times, we are committed to increasing levels of profitability and increasing sales.
I know I'm repeating myself, but I also want all of you to know that, that statement is a guiding principle for us.
One way we deliver on that commitment is through select optimization initiatives, which is how I would characterize the restructured actions we took in the second quarter.
Most of these activities are happening in Europe, and all of them support our long-term objectives.
For example, we are centralizing key aspects of our aerospace business, giving us a strong platform for when the market returns to growth.
We are moving the production of certain compressed air products to Eastern Europe, where we have an excellent team and a competitive cost structure.
And we are centralizing our European accounts payable and customer service functions to improve standardization and optimization, giving us the ability to leverage common tools as we grow.
The projects we initiated in the second quarter should generate annual savings of about $8 million once fully implemented with about $1 million realized in this fiscal year.
These actions drove a second quarter charge of $14.8 million and resulted in an operating margin headwind of about 220 basis points and an earnings per share impact of $0.08.
With that, I'll dig into our second quarter results a bit more.
As I said earlier, adjusted operating profit, which excludes restructuring charges, was up 7.6% from the prior year.
That translates to an adjusted operating margin of 13.4%, which is 60 basis points up from the prior year.
Second quarter adjusted gross margin grew 30 basis points to 34%, accounting for half the operating margin increase.
The price we paid for raw materials in second quarter was lower than last year due in part to our strategic procurement initiatives, and the gains were partially offset by an unfavorable mix of sales.
While we expect gross margin will be up in the back half of fiscal '21, the drivers are predictably changing.
As expected, raw materials will move from a tailwind to a headwind, and the pressure from mix is going to increase with the anticipated sharp growth in our first-fit businesses over the next two quarters.
As always, we remain focused on managing the price cost relationship.
Net pricing for the company was a push last quarter, and we will take a proactive stance as raw material costs trend higher.
We also remain focused on being deliberate with our operating expenses.
As a rate of sales, second quarter adjusted operating expense was 30 basis points favorable versus the prior year, continued benefits from lower discretionary expenses due in part to the pandemic-related restrictions were partially offset by higher incentive compensation.
Importantly, we continue to invest in our strategic priorities.
Compared with last year, we invested more on research and development, and we increased our headcount-related expense to drive growth in our Advance and Accelerate portfolio of businesses.
You can see the impact of these choices more prominent in our Industrial segment, where many of our high-growth businesses are reported.
If you exclude restructuring charges, the second quarter Industrial profit rate was down about 50 basis points from the prior year, reflecting incremental investments in businesses like Process Filtration and Venting Solutions.
On the other hand, solid growth in our Engine segment is creating leverage across the P&L.
The team is doing an excellent job of focusing on share gains and market expansion, especially in China, and they are also thinking long term.
We are aggressively pursuing share gains in new markets and driving higher aftermarket retention with innovative products.
We have great partnerships with many of the world's largest equipment manufacturers.
We will be leveraging those relationships as we all navigate inflationary pressures related to raw materials and fulfilling rapidly elevating demand.
Across our company, we believe the balanced approach we have taken throughout the pandemic puts us in a strong position to capitalize on the economic rebound.
Instead of making deep cuts to manage a short-term demand pressure, we focused on supporting our investors and making targeted investments into our strategic growth priorities.
While we anticipate uneven market trends will continue, we are confident in our long-term positioning.
Capital deployment is another area we have a disciplined and balanced approach.
We invested about $12 million in the second quarter, which is down more than 70% from the prior year.
With the economic environment improving and many of our new apps online, our focus is shifting toward driving productivity gains and working toward the operating margin targets we shared at our Investor Day in 2019.
We returned more than $57 million to shareholders through dividends and share repurchase, bringing our year-to-date total to almost $100 million.
Maintaining our dividend is a priority for us, and we have demonstrated our willingness and ability to grow it over a long period of time.
We have increased our dividend each calendar year for the past 25 years, making us part of the elite group included in the S&P High Yield Dividend Aristocrat index.
Our position on the dividend is the same as it was 65 years ago when we began paying it every quarter.
And I am proud of this trend.
Share repurchase is also an important part of our capital deployment priorities, but it's a bit more variable.
At a minimum, we plan to offset dilution from stock-based compensation in any given year, and we are on track to meet or exceed that objective this year.
Beyond that, our share repurchase is guided by our balance sheet metrics, strategic opportunities and overall market conditions.
Overall, our narrative is consistent over time.
Our year-to-date results demonstrate both the strength of our business model and the value we create by taking a long-term focused view.
We plan to build on this momentum in the back half of 2021.
So let me share some details on our expectations.
As Tod mentioned, we see building momentum in our first-fit business throughout the past quarter.
With this in mind, we expect sales this year to return to a pattern that is generally in line with our typical seasonality, where about 52% of our full year revenue occurs in the back half.
Therefore, we expect full year sales will increase between 5% to 8%, which includes the benefit from currency translation of about 3%.
In the Engine segment, full year sales are projected to increase between 8% and 12% with our first-fit business comprising a bigger piece of the recovery story in the back half.
We expect full year Off-Road sales to increase in the low 20% range with building strength in commodity prices driving an acceleration in equipment production in agriculture and other select markets.
In On-Road, we expect a full year increase in the low teens, driven by the strong rebound in global truck production rates.
We expect the momentum to continue in our Aftermarket business with a full year sales increase in the high single digits.
We expect to continue to benefit from improving equipment utilization trends globally and market share gains in the Asia-Pacific region, particularly in China, where PowerCore is experiencing significant growth.
Our Aerospace and Defense business is anticipated to decline in the high-teens digits overall as demand in the commercial aerospace is expected to remain depressed.
We do expect to see sequential improvements as we lap the pandemic-related impacts, and helicopter and ground defense programs continue to grow over time.
In the Industrial segment, full year sales are projected to be between a 2% decline and a 2% increase as recovery in the capital investment environment is still emerging.
We continue to press forward with market share gains during this period, and our investments in building the Advance and Accelerate portfolio are expected to continue to result in sales growth above the company average.
We expect IFS sales to be roughly flat for the full year, reflecting a return to growth in the back half of the year.
While uncertainty remains, we are seeing signs of increased quoting activity and expect we are well positioned to capitalize on any recovery in addition to our gains in share and continued progress with our innovative products in important markets like food and beverage.
Our GTS revenue is expected to increase by the mid-single digits, driven by continued growth in replacement parts.
In special applications, we are anticipating a decline in low single digits based on our year-to-date results and expected softness in the market for disk drive products.
At a company level, we are expecting an adjusted operating margin to increase to within a range of 13.8% and 14.2% compared to 13.2% in 2020.
This implies a sequential step up in our operating margin to 14.4% for the back half of the year and aligns with our commitment to increasing profitability on increasing sales.
Gross margin expansion continues to be an important lever for us.
We expect to benefit from our ongoing initiatives to drive cost efficiency in our operations and are positioned to gain leverage on a higher sales volume.
Over time, mix should also be a consistent factor in driving our gross margin up.
As we think about the near term, however, mix is likely to be a headwind as improving market conditions and our strong position with our large OEM customers will likely result in stronger first-fit sales growth in replacement parts.
We are also beginning to see increases in our input costs, including steel and freight rates, so we are expecting a cost headwind for the remainder of fiscal 2021.
We continue to invest in our customer relationships and in maintaining our position as a top-tier supplier.
We will continue to work to align our pricing with the increases in our input and supply chain costs.
Additionally, we expect to maintain a disciplined approach to our operating expenses and deliver further leverage in the back half of the year despite an expected full year headwind of approximately $20 million from increased incentive compensation, about 2/3 of which is in the back half of the fiscal year.
For our other operating metrics, we expect interest expense of about $13 million, other income of $2 million to $4 million, and a tax rate between 24% and 25%.
Capital expenditures are planned meaningfully below last year, reflecting the completion of our multiyear investment cycle.
Taking the midpoint of our sales and capex guidance for 2021 would put it at just over 2% of sales.
We expect to repurchase 1% to 2% of our outstanding shares.
Finally, our cash conversion was very good in the first half, and we continue to expect to exceed 100%, reflecting strong first half conversion and anticipated increases in working capital later in the fiscal year.
We have had a solid first half of our fiscal year and are expecting even better results in the second half.
I am very proud of what our employees have been able to achieve in this unprecedented time, and I'm optimistic about Donaldson's future.
As we saw during the first year of our fiscal year, improving economic conditions are complementing the benefits from consistently strong execution of our strategic priorities.
Of course, achieving the significant sales and profit growth projected in the second half is not without risks.
Costs are going up.
Demand for raw material is quickly increasing.
The global supply chain is getting stretched, and above everything else, the pandemic is still hanging over all of us.
While the pandemic is certainly a new occurrence, the other pressures are not.
We have successfully navigated them time and again due in large part to our talented employees and strong customer relationships.
As always, we will manage our costs, execute strategic price increases and pursue profitable sales.
It's a straightforward plan, and it has served us well for 106 years, giving me confidence we are in an excellent position to deliver a strong finish to fiscal 2021.
I will also say that I'm more excited than ever about our long-term prospects.
As a reminder, our strategic priorities include expanding our technologies and solutions, extending our market access and executing thoughtful acquisitions.
The recent announcement of our newly formed life sciences business development team represents a significant move that supports all those priorities.
As previously announced, we hired a new Vice President to build and lead the life sciences team and drive our growth strategy.
This team comes to Donaldson with tremendous industry experience, including strong M&A backgrounds.
With the leadership in place, we are now poised to drive our expansion plans into the fast-growing, highly technical and highly profitable life sciences markets.
While there are no specific details to share today, we are highly confident that technology-led filtration has a critical role in these spaces.
With our strong balance sheet and disciplined approach to capital deployment, we are well positioned to pursue acquisition opportunities that make strategic and financial sense.
And we are also enhancing our internal capabilities to drive organic growth.
Our new materials research center, which was completed last year, will further strengthen our material science capabilities.
The technical skills we gain can be used right away by fueling growth in our current markets, like food and beverage, and they can be used to support longer-term growth in broader life sciences markets.
We are committed to these new markets, and establishing the life sciences business development team is one step on a long journey, but it was an important step.
I'm excited about our opportunities and look forward to sharing our success with all of you over time.
One year ago, we were all wondering about how COVID-19 was going to ripple through the economy, and there were more questions than answers.
We all still have questions, but one thing that I am more certain about is the quality of our employees.
They are truly remarkable.
I've seen that personally, and we can all see it in our company's results.

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expects fiscal 2021 sales to increase between 5% and 8%.
q2 gaap earnings per share of $0.44 includes $0.08 of restructuring expense.

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