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Text: During today's call, we will also reference non-GAAP metrics.
I hope that all of you and your families are staying safe as we deal with these unprecedented times.
One thing the pandemic has brought to light is the hard work of everyday heroes.
So I want to express our profound appreciation for the frontline workers that keep the world moving forward and that includes thousands of Donaldson employees.
I'm always impressed by our employees.
But I'm particularly proud of their performance during the pandemic.
Every day, they show up with relentless customer-first attitude, which is more important than ever as we support critical markets like agriculture, transportation, and food and beverage.
Since the outbreak began, our decision making has been guided by three priorities, supporting the health and safety of our employees, delivering on our customer commitments and doing our part in reducing the transmission of the virus.
Providing a safe work environment is always a top priority, but we intensified our efforts.
We have significantly limited business travel, implemented a thorough cleaning regimen in factories and office spaces, instituted remote work policies for all that are able and introduced COVID-related paid leave while promoting existing employee assistance programs.
Our crisis response team reviews these protocols regularly and we adjust when appropriate.
Social distancing practices and enhanced cleaning schedules will be in place for the foreseeable future and we are reopening our offices in various locations around the world.
The pace of bringing our employees back to the office will be dictated by guidance from health experts along with our own assessments of workplace readiness.
We are taking a cautious approach and we will remain flexible as we execute these plans.
I also want to provide an update on the status of our operations.
Overall, we're in a good position and have not experienced meaningful disruption.
Our success can be attributed to a handful of factors, starting with our footprint.
We have a region to support region production strategy and that allows us to be nimble and flex appropriately based on local conditions.
That has been incredibly valuable as the pandemic affected different parts of the world in different ways, at different times.
Additionally, our defense -- our diverse portfolio of businesses is heavily biased toward replacement parts and essential or critical markets giving us the opportunity to continue production during government-mandated shutdowns.
These structural benefits have been brought to life by our excellent team.
There has been an unprecedented level of collaboration and coordination among us, our suppliers and our customers, and our teams are acting quickly and decisively to mitigate risks and deliver on our commitments.
Of course, things are still uneven.
So I want to provide a run down of our operational situation today.
The Asia-Pacific region is in recovery mode with China furthest along.
Conditions in India are still tighter than other countries, but that has been loosening, and we are on a good path.
Europe is in various stages of reopening and our supply chain risk has gone down over the past month.
The temporary shutdowns due to government mandates have been lifted and we are stabilizing rapidly.
The Americas are further behind on the recovery curve with varying degrees of lockdowns continuing in South America, while large customers in North America only recently began reopening their factories.
The global situation has been improving in recent weeks.
All our critical suppliers are online and our production employees are at work and engaged.
Based on these factors, I am confident we can continue supporting our customers around the world.
I'm going to turn now to a brief overview of our third quarter sales, which were slightly better than we expected based on a strong finish in April.
Total sales for the quarter were down 11.7% from the prior year, or 9.7% without the currency headwind.
Engine segment sales were down 14%, reflecting a sharp decline in our first-fit businesses.
While it is impossible to precisely estimate the impact of COVID-19 on our results, our first-fit businesses were clearly under pressure as many large customers stopped producing equipment during the quarter.
In our On-Road, sales were down 47% as customer shutdowns were compounded by an already weak truck market in the US and China.
As a reminder, our first-fit On-Road business is only about 5% of total revenue.
So our aggregate exposure to the truck market is limited.
In the US, which is the largest portion of our On-Road business, third-party data indicates that our sales fared better than total Class 8 truck production.
Based on our track record of program wins, we are well positioned to have a strong performance when this market recovers.
Third quarter sales of Off-Road products were down 25%, with more than half the decline coming from Exhaust and Emissions.
We are comparing against a large increase in Europe last year related to pre-buys for an upcoming regulatory change.
So we expected pressure this fiscal year.
As a side note, we continue to work on the transaction related to the sale of our Exhaust and Emissions business to Nelson Global Products.
We will provide more details as we have them, but for now, I want to reiterate our commitment to the strong relationships we have with our employees, customers and suppliers.
Excluding Exhaust and Emissions, third quarter sales of our filtration-related Off-Road products were down in the mid-teens.
On a relative basis, products for the agriculture market performed better than the construction and mining markets, and overall global demand for new equipment remains under pressure.
Engine Aftermarket performed much better than our first-fit businesses in the quarter and results were mixed by channel and region.
The total aftermarket decline of 8% was primarily due to a low double-digit decline in sales through the independent channel.
The pandemic is contributing to lower equipment utilization and that impact was compounded in the US by the collapse of the oil and gas market.
Economic and geopolitical uncertainty in Latin America added to the pressure, but share gains in Eastern Europe and China were notable offsets as we build our presence in these markets.
Sales through the OE channel of Aftermarket were down only slightly in the quarter and up in local currency.
We believe a portion of the demand was from large OE customers buying inventory ahead of need, so we expect additional volatility in future periods.
Rounding out the Engine segment, sales of Aerospace and Defense were about flat with last year.
As expected, the commercial fixed-wing market is under pressure, but we were able to largely offset the impact with growth in filters for ground defense vehicles and helicopters.
Turning to the Industrial segment, sales were down 6% in third quarter, driven by a 12% decline in Industrial Filtration Solutions or IFS.
Our dust collection business, which makes up 60% of IFS, was hit hard by the pandemic.
Our quoting activity and replacement demand were under pressure as economic uncertainty went up and global industrial production dropped.
We remain confident in our value proposition and expect that quoting will go back up as the economy reopens, but it is too soon to say how long that will take.
But, we are not just waiting for the recovery.
Our industrial air filtration team has done an excellent job, engaging our customers with things like virtual trainings, reinforcing our brand as a strategic and supportive partner.
The pandemic has also given us an opportunity to demonstrate our value proposition in Process Filtration.
Sales in Europe and the US, our two largest markets, were both up year-over-year, and in local currency.
Sales for all Process Filtration were up in the low single digits.
We continue to expand our share in the food and beverage market and this business remains a strong contributor to our future growth and profit margin expansion.
Third quarter sales in Gas Turbine Systems or GTS were up 6% driven by strong sales for retrofit projects.
Like the large turbine projects, retrofit sales can be lumpy.
We had a solid performance last quarter and we remain very proud of the improved profitability in GTS.
Special Applications' sales were up 5% in the third quarter, driven by strong growth in Disk Drive and Venting Solutions.
Our Disk Drive business continues to benefit from share gains and increased expansion of nearline storage for the cloud and growth in venting is related to value-added solutions for batteries and powertrains in passenger cars.
Given the state of the auto industry, the venting performance was particularly impressive.
We are leveraging our technology and pressing into a new market to meet an expanding need.
There are powerful examples across the company of how innovation is driving results and the pandemic has not changed our long-term priorities.
I'll talk more about that later.
Before turning the call to Scott, I want to provide a few comments on trends in May.
Total sales for the month are expected to be down about 24% from last year.
Many of our large OE customers reopened facilities in the month, but we did not see much of a rebound, which may relate to the inventory building that occurred during our third quarter.
On a regional basis, sales trends are consistent with what we saw in third quarter.
Asia-Pacific is performing the best, while sales in the Americas are the weakest.
Sales in China were up in the month, which is the best performance we've seen in a while, but there is also quite a bit of uncertainty related to the durability of the increase.
So we are more cautious than optimistic at this point.
The situation in both North and South America remains challenging and it is hard to find bright spots in those geographies today.
In terms of product sales, replacement parts are predictably doing better than new equipment.
Businesses like Engine Aftermarket and Process Filtration offer a bit of relative stability, while new equipment production for engine-related products and capital investment for dust collection systems were still under pressure.
While we would not typically go into detail on the current quarter trends, we felt it was important to give a little more context, given the extraordinary pace of change.
As we contemplate the final two months of this fiscal year and our plans for fiscal '21, we will remain focused on executing those things under our control, including promoting the safety and well-being of our employees, maintaining tight control on discretionary expenses, making targeted investments to support near and long-term growth priorities and protecting the strength of our financial position.
I want to echo Tod's sentiment.
Donaldson has great employees.
The way we work has changed rapidly during the pandemic and our teams have stayed connected, remained productive and delivered results.
As predicted, third quarter was a volatile period, the demand environment deteriorated per month demand and things became more uncertain as COVID-19 spread broadly.
Unfortunately, the situation is still unclear.
Economic conditions are varied by region and market, resulting in an uneven and unpredictable demand.
Given that, we feel it's prudent to continue to withhold fiscal '20 and '21 guidance for our key financial metrics.
I will however talk about some general expectations during my remarks, so I'll turn now to a recap of third quarter performance.
All things considered, we are in a good position today.
Despite a sales decline of 12%, our third quarter EBITDA margin was flat with the prior year.
Additionally, our decremental margin was about 19%, which is significantly better than our historic average in the mid to high 20% range.
The favorability was due in part to the product mix and lower incentive compensation.
So let me take you through some of the puts and takes.
Third quarter operating margin was 13.4% compared with 14% in the prior year.
Loss of leverage on lower sales was a primary driver of the decline and that impact was compounded by higher depreciation related to our capacity expansion projects.
Based on the nature of these investments, the third quarter depreciation impact was skewed toward gross margin in the Engine segment.
Overall, our teams are doing an excellent job mitigating the pressure created by lower sales.
In terms of gross margin, plant managers are quickly adjusting labor to account for changes in demand and our procurement and supply chain teams continue to drive optimization initiatives that will have long-term benefits.
These efforts, combined with favorable mix of sales and lower raw material costs, narrowed the third quarter gross margin decrease to 60 basis points.
Additionally, we had strong operating expense performance in the third quarter.
On a dollar basis, operating expenses were at the lowest level in three years, which comes at the three years of incremental investments related to our Advanced and Accelerate portfolio and R&D capabilities.
I want to add that we are not pausing investments in these initiatives, which are critical to our long-term growth plans.
As a rate of sales, third quarter operating expenses were up only slightly from the prior year.
We had favorability from incentive compensation, which was down nearly $6 million and discretionary expenses were significantly reduced in relation to COVID-19.
Despite the near-term pressures from the pandemic, we are pushing forward on our margin initiatives.
New capacity that brings a lower cost to manufacturers coming online, we are steadily adjusting the supply chain, our procurement teams are driving cost reductions and our commercial teams continue to manage pricing.
The list is the same as what we have been sharing for more than a year.
These are our top priorities, and regardless of the macro backdrop, we feel confident in our ability to continue making progress.
We also feel confident in our financial position.
At the end of the third quarter, our leverage ratio was 1.0 times net debt to EBITDA, which is where we were at the end of the second quarter and right in line with our long-term target.
Working capital was down from the prior year, driven by reductions to receivables and inventories and our cash conversion in the quarter was 98%.
We continue to work with our suppliers and customers to manage credit and supply chain risk and we are also working with our valued banking partners to further bolster our liquidity position.
Out of an abundance of caution, we drew an additional $100 million from our revolving credit facility during third quarter.
Then, later in May, we entered into an additional 364-day credit agreement that gives us access to another $100 million.
At the same time, our pace of capital expenditures has decelerated.
Third quarter capex declined by more than 40% and the spend trajectory is consistent with what we communicated previously.
Importantly, the projects were already in various stages of completion as COVID-19 spread.
So we could finish these projects without putting our financial position at risk.
Although the demand environment today is materially different than it was a year ago, we still feel confident that these projects will improve our cost structure, strengthen our customer service at local level and position us to grow in strategically important markets and geographies.
Let me share a few examples of what we're working on.
We are setting up our first PowerCore line in China to support new program wins with local manufacturers.
We doubled the production cap capacity for Process Filtration, position us for larger presence in the food and beverage industry, and new capacity in the Americas and Europe allows us to optimize the point of manufacturer for Engine-related projects.
We still have a little work to do, but our teams are working hard to get them online soon.
Returning cash to shareholders is another important part of our capital deployment priorities.
We are committed to the quarterly dividend, which has been paid every year for more than 60 years and increased annually for 24 years in a row.
As I said to many of you, that's an awesome track record and I don't want to be the person that messes it up.
Share repurchase has always been the more variable component of our capital deployment.
We have been regularly repurchasing our shares for decades and we know that's a valuable activity to many of our shareholders.
We take a thoughtful and measured approach in the execution of our share repurchase plans.
Our minimum objective in any given year is to offset the dilution related to stock-based compensation, which is about 1% of shares.
The level of repurchase beyond that amount is governed by our balance sheet and other opportunities to deploy capital.
We repurchased 1.6% of outstanding shares so far this year.
Based on the uncertainty created by the pandemic, we do not expect additional share repurchase in fourth quarter.
As the situation of the pandemic evolves, we will continue to prioritize a strong financial position and remain focused on executing our strategic priorities.
That has been our approach for a very long time, and we believe it will serve us well for a long time to come.
Donaldson Company turns 105 this year.
We have experience with every type of economic environment and we have always emerged to become an even stronger company.
Our playbook is simple and consistent.
We leverage our deep technical expertise to build a portfolio of filtration capabilities that we deploy into a diverse set of markets.
We are a returns-focused company.
We think long term, while maintaining a clear focus on those things we control in the near term.
The pandemic has no impact on this playbook or our strategic priorities, which always starts with technology.
Along those lines, I'm very excited to share that our new Material Research Center is nearing completion.
This R&D facility is a $15 million investment in building our material science capabilities.
We leveraged some of this know-how in our Process Filtration business today, but the new facility is going to give us significantly stronger platform.
We plan to further penetrate the food and beverage market followed by future expansion in specialty chemicals, electronics, and eventually life sciences.
These markets are less cyclical, highly technical, and therefore highly profitable, making them an attractive complement to our strong Engine business.
Technology remains a core part of our Engine strategy as well.
We want to win new business with products that drive aftermarket retention.
While the pandemic has created uncertainty, we are still working with large OE customers on new programs and their demand for proprietary products is going up as they look to grow their parts business.
Through our technology, Donaldson becomes a core part of the customers' growth strategy, giving us a wide competitive mode.
The value of these products to our company has been demonstrated year after year, so we continue to make investments.
We recently introduced the new generation PowerCore filter called PowerCore Edge.
It has the smallest footprint of any generation yet and our world-class media makes it an excellent solution for Off-Road applications that face heavy dust environments.
PowerCore Edge will be another powerful tool for driving long-term share gains in our core markets.
Additionally, we are building our first PowerCore line in China.
As large Chinese manufacturers move up the technology curve, a couple of things happened that create opportunity for us.
First, a higher performing piece of equipment requires more advanced filtration.
With our strong global brand, decade-long presence in the country, and significant experience supporting world-class OEMs, we are a natural partner for the Chinese manufacturers.
Second, when end users buy a more expensive piece of equipment, they are more likely to maintain it properly.
That makes PowerCore particularly interesting.
As the replacement cycle is created in China, retaining the parts business is now valuable to those manufacturers.
Advancing our R&D capabilities and growing our portfolio of innovative products are what we would consider standard work at Donaldson.
As I mentioned, we think long term and we are committed to creating value for all our stakeholders.
I am confident we can deliver on that commitment because we have dedicated, talented and incredibly smart teams in every part of our company.
I'm proud to be on the team with them.

user
withdrew financial targets for fy 2020 and 2021.
expects may 2020 sales to be down about 24%.
donaldson company - continues to work through process of the binding offer received from nelson global products.

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