Good morning. My name is Jody, and I will be your conference operator today. At this time, I would like to welcome everyone to the Donaldson's Q4 Fiscal Year 2017 Conference Call. [Operator Instructions] Thank you. Brad Pogalz, you may begin your conference.

Good morning. Thank you for joining Donaldson's Fourth Quarter and Full Year 2017 Earnings Conference Call. With me today are Tod Carpenter, President and Chief Executive Officer; and Scott Robinson, Chief Financial Officer. This morning, Tod and Scott will provide a recap of our fiscal 2017 performance and discuss our fiscal 2018 strategic priorities and financial targets. During today's call, we may reference non-GAAP metrics, such as adjusted earnings per share. You can find a reconciliation of GAAP to non-GAAP metrics within the schedules attached to this morning's press release. Also for reference, this morning, we posted a schedule on our Investor Relations website showing the year-over-year sales change with and without the impact from currency translation. I want to remind everyone that any forward-looking statements made during this call are subject to risks and uncertainties, the most important of which are described in our press release and SEC filings. Now I'll turn the call over to Tod Carpenter. Tod?

Thanks, Brad. Good morning, everyone. We are proud of our fiscal 2017 performance, which reflects benefits from our strategic priorities combined with improving conditions and engine-related markets. Total sales increased 7% to $2.37 billion, which brings us back to where we were two years ago. We grew operating margins at 13.9%, which is 70 basis points up from last year's adjusted rate and a full percentage point above adjusted rate in 2015. I want to thank our employees for their contributions last year. They did an excellent job executing our strategy while meeting our customers' needs, and they showed characteristic resilience as we dealt with the mixed environments between Engine and Industrial. As we look forward, we expect Engine markets to stay in recovery mode, while key Industrial markets will likely remain uncertain. Our fiscal '18 plan is comprised of a robust strategic agenda, which includes a continued focus on driving growth and enhancing operational efficiency. We also plan to make investments in capacity expansion, customer engagement and technology development. The midpoints of our fiscal '18 sales and EPS guidance both reflect record performance for our company, as we plan to deliver 10% EPS growth on a 6% sales increase. Before Scott and I cover our plans for fiscal '18, I want to share some of our sales highlights from 2017. Our full year sales were nearly 1% above our previous guidance as we saw fourth quarter favorability in both segments. In total, Q4 sales grew 11% to $660 million, with the Engine segment driving the increase. Engine sales were up 18% in the quarter, as both first-fit and Aftermarket showed strength. Aftermarket sales were up 19% from last year, which included a combined benefit of about 5% from the Partmo and Hy-Pro acquisitions. Strategically important product categories also contributed…

Thanks, Tod. Good morning, everyone. We are pleased to have delivered fourth quarter sales above forecast and earnings per share in line with our guidance. Sales jumped 11% to $660 million, and GAAP EPS was $0.51 in the quarter. Our Q4 operating margin of 14.3% was down from last year's GAAP and adjusted rates of 15.2% and 15.8%, respectively. For reference, the prior year adjusted rate excludes $3.5 million of restructuring charges. Fourth quarter gross margin declined to 34.8% from last year's adjusted rate of 35.4%. We saw headwinds from inflation, mix and incremental freight charges. Better fixed cost absorption offset some of those pressures. Our fourth quarter expense rate increased to 20.5% from last year's adjusted rate of 19.6%, driven primarily by higher incentive compensation. Once again, leverage on the sales increase provided some relief. The tax rate was 25.6% in the fourth quarter, down from 28% last year as we had a favorable mix of earnings between tax jurisdictions. I also want to share some perspective on our full year results. We delivered sales of $2.37 billion, which is $150 million above the prior year and the midpoint of our initial FY17 guidance. Despite pressure from incentive compensation and incremental costs from higher-than-expected demand, we delivered an adjusted operating margin growth of 70 basis points. As Tod mentioned, the 13.9% margin in 2017 is a full percentage point above the adjusted rate in 2015 on comparable sales. Our two-year operating margin improvement reflects our ability to capture margin as sales stabilized in a more predictable range, which is what began in the back half of 2016. Over the past six quarters, several key markets moved through stabilization and into recovery. As we added costs over the course of 2017 to meet demand, our incremental profit settled into a…

Thanks, Scott. Our fiscal '18 agenda includes plans for driving growth and enhancing operational efficiency. We are also planning to make several strategic investments this year, including projects focused on capacity expansion, customer engagement and further diversification through technology development. Let me share some color on these investments. We will increase our manufacturing capacity for our innovative air and liquid technologies. Customer demand remains strong, and we expect these businesses have a long runway for growth. The plan includes a mix of adding new lines and new square footage based on current and projected demand. We are also expanding our distribution capacity. Work is under way in some locations, such as our European distribution center, and we will continue those efforts into fiscal '18. We see a cost benefit to having this capacity, and we also see an opportunity to further deepen our customer engagement. Additional distribution capacity allows us to maintain our high service levels while accommodating the customers' desire to receive products from fewer locations and/or consolidate their orders. Another investment related to customer engagement is e-commerce. We began building the site last year and will launch globally later this fiscal year. By making it easier for our current and potential customers to engage with Donaldson, we expect that this channel will be an efficient way for us to meet demand. Finally, we'll be making technology investments to further diversify our product offering. Over the next several years, we will plan to increase our R&D spend to somewhere between 3% and 4% of sales, which is up from our prior target of 2% to 3%. We spent about 2.3% last year, and we plan to increase that by 20 to 30 basis points this year. Developing connectivity solutions is one of our initiatives. Our customers in both segments are becoming increasingly interested in this technology, which could help them better manage things like service intervals or product integrity. We're in the early stages of development, but we are preparing to meet the customer demand as it emerges. We are also investing in new filtration technologies to expand further into adjacent markets. All of the strategic investments I discussed are critical to our long-term success, as they support our technology leadership and global presence. We also believe that our fiscal '18 plan strikes the right balance between making these investments and delivering incremental profit for -- on our sales increase. Again, I want to thank our employees. They've done an excellent job executing our strategy throughout this recent downturn, and I am confident that we will continue to build momentum and deliver on our financial and strategic commitments in 2018. Now I'll turn the call back to Jody to open the line for questions. Jody?

[Operator Instructions] Your first question comes from the line of Charley Brady of SunTrust Robinson. Your line is open.

Hi guys, this is actually Patrick Wu standing in for Charlie. Thanks for taking my questions. Good morning. It looked like the APAC Aftermarket business did fairly well in the quarter, I think up over 30%, even though it's off of slightly negative comps. Can you talk a little bit about what you're doing there and how should we sort of look at fiscal '18 sort of to be? And can you also remind us how big a size the APAC Aftermarket business is?

Sure, this is Tod. Within APAC, it's really driven by the success we're having in China. We entered China and started having success with the multinational companies, the John Deere, Caterpillar, et cetera. And now we're having success with the Chinese nationals such as the LiuGong, Lonking and the Sanys, etcetera, of the world. As we look to expand and grow in China, we have a lot of opportunity there, because our share is in the very low single digits. So some of the percentage gain is just simply because it's a low base. That said, our strategy and our execution is really working well in China. Coupled with a bit of end-market improvement in China has really driven our success in APAC for the quarter.

Patrick, this is Brad. I'll just give you that stat that you're interested. Total APAC Aftermarket is in the mid-teens as a percent of total. But to Tod's point, China is a few percentage points of total Aftermarket revenue. So there is a lot of runway there.

And when you say mid-teens as a percent of total, that's percent of total Aftermarket, right?

Correct.

Got it. And then you've mentioned that you -- that the team is sort of rethinking and exploring ways in terms of how to bid for certain projects and gas turbines. It's down 15% this quarter, off of close to down 20% comps. And obviously, you're expecting another down year in '18. I guess, can you provide a little bit more color on -- it sounds like it's mostly on the large turbine side. You guys added some color on percentages from Aftermarket and large and small turbines. Can you guys talk a little bit -- can you give a little more color on that market and if you guys can see it pass toward an inflection point sometime in maybe the latter half of the fiscal year?

Sure. We projected gas turbine to be down this year, but we believe also that fiscal '18 is likely going to be the bottom point for that particular market. We do have quite long visibility, more visibility in the gas turbine market than any other business that we have. We see the long-term larger turbine projects, if you will. And therefore, we can say pretty confidently that the overall long turbine project is going to continue to remain depressed throughout the balance of this fiscal year. As we turn into fiscal '09 though, we do expect an uptick to that. It really reflects the proper alignment with our strategy -- our strategic choice over the last year, where we became far more selective in our gas turbine -- large turbine project and that we're really pretty happy with where we sit. But again, we expect it to take the upturn more in later fiscal years, but not fiscal '18.

Just as a very quick follow-up to that. And when you say you're more selective on the large projects, are you speaking more along the lines of looking at just going after higher-margin business? If a project isn't fitting into the profile, it's -- that sort of dynamic has changed, where you are okay with walking away from projects?

Absolutely, that's exactly what we're doing. We're walking away from those that we feel are low margin and not paying for our technology.

Okay, great. Thanks for the color.

Your next question comes from the line of Jim Giannakouros of Oppenheimer. Your line is open.

Good morning. Just taking a step back and looking at your revenue margin profile. When I look four, five, six years ago when you had higher revenue level, certainly in engine, a little bit of a choppier comparison, just given the volatility in gas turbines over the last five years. But just overall, back in like FY12, FY13, FY14, 15% was in the -- margins -- overall margins was part of the conversation or was potentially contemplated. But we enter 2000 -- your fiscal '18. You've done a number of -- you had your restructuring efforts several years ago. You're entering an up-cycle in Off-Road and On-Road at a higher Engine Products segment to overall revenue level. I'm just trying to figure out what the major puts and takes are as to why that margin of 15%-plus is not even contemplated currently? What's structurally different now versus then?

Yes, this is Scott, I'll start. I have here in front of me FY13 to the current. And FY13 and FY14 were in the low 14% range. Our high revenues peaked out at $2.493 million; next year it will be right at about $2.5 billion. So we've gotten the sales forecasted to a level approximately equal to our prior record. And in our -- as our revenue started to turn down, we hit the twelve's of operating margin. So we've harvested 100 basis points of improvement in the last two years. And we plan, at the midpoint of our guidance, another 30 basis points next year as we grow revenues and invest in the business. So we are committed to increasing our levels of profitability on increasing sales, but we also want to invest back in the business. So we're into the low 14s. And as sales grow, that will grow, but we also want to invest back in the company.

Got it. I guess, where I'm struggling is just maybe on a per segment basis. When you look at Engine Products back in FY13, you were knocking up against 15%. And that was at a lower revenue level versus what, I think, you're guiding to for next year, right? You're going to be 1 point -- over 1.6 easily if you hit your mid- to high single-digit kind of growth rate next year versus the 1.5 that you did years ago. If you can, I guess, isolate the puts and takes on the differences between now and then on a per segment basis, that might be helpful, understanding that Engine Products might be a little simpler story. A lot of noise obviously in GTS, in industrial.

This is Tod, I'll start. If you take a macro step back, look at our overall Engine business, we have added a number of different capacity expansions between 2013 and now. Additionally, we have some capacity expansion in flight. For example, the [indiscernible] project that we've talked about a number of times, we have additional capacity expansion to support our liquid initiatives going on this year, which will add additional footprint in multiple locations in order to meet the customer needs. And then as you just step back at the performance from last year, we enjoyed really quite a nice bump in our Engine business. We're still catching up with some of that and making sure that our priority is always to take care of our customers. So there is a bit of a higher spend in support of some of that business at this point, simply because we're having to really air ship some shipments, for example, to meet our customers' demand. So there's a little bit of operational efficiency that we'll be focused on this year to gather it. Long-term is as we look across our company, that 10 to 20 basis point improvement of operating margin is -- on an annual basis, is still within conversation here. We're just in a little bit of a point where we got -- we have the need for capacity expansion investment in our company and we had a nice pickup of business.

Got it. Thank you.

Your next question comes from the line of Nathan Jones from Stifel. Your line is open.

Good morning, everyone. I wonder if we could just start on the uncertainty you're talking about in Industrial markets. And I think particularly, you're talking about IFS and first-fit there. Some of the macro indicators globally look pretty good. Some of the leading indicators look pretty good. Do you feel like we're on the cusp of a recovery in that market? What do you think needs to happen to drive that? Just where you think we are in that cycle.

This is Tod. We're seeing utilization numbers nicely. And so you see that in our Aftermarket segment, for example, that we talked about in our prepared remarks. But we're still very guarded on the first-fit CapEx project space. Our quote-to-order cycle is still elongated, and we do not see a more regular cadence of projects coming through really in any region at this point in time. So we're -- if you just step back and look at it, what we're experiencing growth across our industrial segment is really on the replacement parts. So that's the first step to CapEx expansion. But it's -- we have not seen that yet. So we remain pretty guarded on that outlook, and that's what we put within the guidance.

If that changed and things improved there, how long would you see that in advance of that starting to come? I mean, how -- you said your quote-to-order is still elongated. What's kind of the time frame that you're looking at there in terms of what that quote-to-order length is? What is it normally when you start seeing a first-fit recovery cycle?

Sure. The CapEx projects typically, we're given about a 90-day period on average to deliver, say, an average-sized project within the Industrial segment. So we'll get about a quarter's look at that before -- when it does start to pick up. And we've not seen evidence of that type of a cadence at this point.

Okay, that's helpful. And then on the investments, it sounds like some of these are going to run through CapEx, some of these are going to run through the P&L. Can you give us just some order of magnitude on what the impact is to margins or EPS from the increased investments that are running through the P&L in '18?

Yes, the total investments that would impact the P&L is about $10 million to $15 million, and that's 40 to 60 basis points of operating margin if you just isolate those exact numbers. There is some CapEx associated with some of the projects as you recommended, but the $10 million to $15 million is the P&L impact.

And that's incremental over '17, yes?

Yes.

All right. Thanks very much for the help.

Your next question comes from the line of Laurence Alexander from Jefferies. Your line is open.

Good morning, this is Dan Rizzo on for Laurence. If we think about the Chinese environmental regulatory crackdown, is that providing increased demand for filtration systems? And could that provide a tailwind for you guys over the next couple of years, or is it already?

It's not. It's really -- what's happening in China is their desire to export. And so therefore, the need to meet Western-based standards, since they have a lot of capacity in country. So what's giving us opportunity is they have to meet U.S. or European standards. And therefore, they know we already meet that and given us opening not specific to the Chinese government slate, if you will.

Okay. And then just a little more color on, sorry if I missed this, but on order trends for mining vehicles, what do you expect going forward?

So -- sure. For mining vehicles, we see mid-single-digit increase on the production to high single digit is what we have baked in within the guidance.

Okay. Thank you very much guys.

Your next question comes from the line of Richard Eastman of Robert Baird. Your line is open.

Good morning. Could I just ask -- again, in the fourth quarter here with the revenue number that we were able to generate, which is quite impressive, I'm just curious where was the -- where did the margin kind of slip out to give us the midpoint EPS number? Because the operating expense looked high to me. Was that somewhat discretionary on the comp side? Or did something surprise you within the midsection of the P&L to deliver the kind of the midpoint of profit guide?

Hi, Rick, this is Scott. There was several impact -- factors impacting the Q4 operating margin, as I tried to kind of lay out in my script. We had increased demand, which we were happy to see. And we had some cost incurred associated with fulfilling that in terms of freight and overtime. We had a slight uptick in commodity prices, a slight uptick in freight, also an uptick in incentive compensation based on the higher sales. So you put those main factors together, and that's what drove what you're seeing in the fourth quarter.

Yes, okay. And then as we roll into '18 with your guide, do you expect to see -- does your gross margin improve with leverage, your gross margin and mix? Should that be up 20 or 30 basis points or something like that, similar to what we're seeing at the guided up profit line?

Right. So we have a 30 basis point improvement in operating margin, and that comes from both. Gross margin and OpEx are contributing to that. So you get a little bit of an uptick in both sides of that equation.

Yes, okay. And then just a question maybe -- and I think you might have touched on this a minute ago. But when you looked at your high single-digit growth rate expectation for -- you kind of combined On-Road, Off-Road kind of first-fit. Could you just kind of segment those two? Is the -- is your expectation around the On-Road business to be up kind of mid-single digits, with Off-Road up maybe closer to double digits build rate?

Globally, when you step back and look at Off-Road and On-Road, they're about the same, both mid-single digits to high single digits. But they're very different stories geographically. So the On-Road sector will be really driven by the U.S., which is going to be up in the double digits, really pulled down by the other geographies, therefore in aggregate, being mid- to high single digits. And the Off-Road is very broad-based, it's mid-single digits to high single digits in all geographies. So they're very different stories, they just happen to end up at the same point of mid- to high single-digit growth.

Yes, I understand, okay. But pretty healthy environment, just generally speaking, in the Off-Road market globally?

Correct.

Okay, very good. Thank you.

Your next question comes from the line of Kyle Dicke of William Blair. Your line is open.

Hi, good morning guys, thanks for taking the questions. Just a couple of quick ones from me. But first, I know you've commented a few times on the commodity inflation as a headwind to gross margin in the quarter. But were you able to offset any of that with pricing?

Yes. So we -- as we said, we have some commodity inflation. We work to offset that by two ways. One is, we have continuous cost improvements, and our plants do a very good job at this of continuing to identify cost-saving initiatives and bring our costs down to provide margin. And also, we work -- on the pricing side, certain of our contracts will have a basket concept in them that allows us to adjust pricing should certain commodity costs move outside a certain range. And so we work via that approach as well as just general pricing mechanisms that we might in place -- put in place such as an improve -- or an increase in Aftermarket parts or whatever it may be.

Okay. But -- so that kind of that spread between the price and the cost was negative in the quarter?

That is correct.

Okay. And then I'm not sure if -- I apologize if you've provided this previously. But how do the margin profiles of the Partmo and Hy-Pro businesses compare to kind of the company overall average?

We haven't provided that specific detail in terms of a forecast going forward. But they're consistent, I would say, with the general line of the business that they participate in within our company. And we have improvement initiatives identified for both those businesses. And I would say at this point, the acquisitions are performing quite well.

I do want to add, though, we're in the early innings of integration there. So in time, we have plans. Because we remain a disciplined buyer through acquisitions, we can see the opportunity to get to company averages. But we are -- we've owned both of them less than a year. So we're in the early innings of integration.

Right, okay. And then lastly, could you just provide an update on the acquisition pipeline and what you're seeing there?

Sure. The acquisition pipeline still remains robust, but we remain a selective buyer. We're very strategically focused on what we have within the pipeline. We're pleased with the process as evidence of the fact that over the last couple of years, we had five acquisitions, really aligning with our long-term strategy. So nothing really gets changed from prior quarter.

Okay, great. That's it for me, thanks.

Your next question comes from the line of Brian Sponheimer of Gabelli. Your line is open.

Hi, everyone. Most of my questions have been answered but just to stay on the acquisition front; have you seen any change in business multiples that have come largely as a result of the Hy-Pro acquisition?

No, we've not seen that, Brian. It's really business as usual. Filtration multiples are higher than typical other industrial averages, and we have not seen any difference within the marketplace.

Okay, thank you very much. Best wishes for 2018.

Thank you, Brian.

Your next question comes from the line of George Godfrey of CL King. Your line is open.

Thank you, and good morning. Thank you for taking my question. I just wanted to ask about the increase in investments, specifically the R&D and the CapEx. You talked about developing new products here. Based on your assumptions today, as you roll out and bring these new products to market, do you think the -- our margin uplifting, that there'd be more profitable higher returns on invested capital? Or do you think they're neutral with where you are now? And I guess, to follow on, is it getting harder and harder to raise the margin on return profile as you roll out new products? Understanding that you don't go where commodities are, you want to have a specialized products. But I'm just trying to get a sense of looking out 1 or two or three years what your expectations are on returns on capital and profitability on new products incrementally.

Sure. We're a technology-led filtration company. It's an important part of our strategy. As we look to invest in additional R&D, we look for them to be margin-enhancing overall for the company, so definitely above company averages.

Understood. Thank you for taking my questions.

I'd like to turn the call back over to Tod Carpenter.

That concludes today's call. I want to thank everyone for their time and interest in our company. Goodbye.