Good morning. My name is Virgil and I will be your conference operator today. At this time I would like to welcome everyone to the Donaldson Second Quarter Fiscal Year 2018 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. Thank you. Brad Pogalz, you may begin your conference.

Thanks Virgil. Good morning. Thank you for joining Donaldson's second quarter 2018 earnings conference call. With me today is Tod Carpenter, Chairman, President, and CEO of Donaldson; and Scott Robinson, Chief Financial Officer. This morning Tod and Scott will provide an overview of our recent performance and fiscal 2018 outlook along with an update on some of our strategic priorities. During today's call, we may reference non-GAAP metrics such as adjusted tax rates and 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. 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. At the halfway point in our fiscal year, we have excellent sales traction and support of market conditions around the world. Second quarter sales increased in every business unit and the sales for both segments were up in every major region. These results highlight the broad nature of the recovery. We expect momentum to continue, so we increased the midpoint of our full year sales guidance by 2%. The new midpoint for fiscal 2018 is 14% above last year and $200 million above our previous sales record of $2.5 billion. As market conditions support our drive towards a new revenue record, they are also giving way to increased pressure on gross margin. We are seeing inflation across the business from raw materials like steel and media to wages as we compete for talent. Mix of sales is also a headwind. Products for OE customers generally have lower margins and they are currently the fastest growing part of our portfolio. High demand, combined with capacity constraints, is also affecting gross margins. Meeting our customers' needs is our top priority, so we are choosing to invest a portion of our gross margin to maintain service levels as demand spikes. At the same time, we know we need leverage, so we are pursuing additional cost reduction and pricing initiatives to address these pressures. Scott will discuss this topic later in the call, so let me now turn to a recap of our second quarter sales performance. Total sales of $665 million were 21% above last year and ahead of our forecast. Currency translation added nearly 5% to the year-over-year increase. Growth in the Engine segment continues to lead the company and the segment is being led by our OE businesses. Total Engine sales increased 22%, while On-Road and…

Thanks Tod. Good morning everyone. I want to start with a quick overview of the impact from the Tax Cuts and Jobs Act, which resulted in a charge of $109.7 million in the second quarter. The majority of this charge reflects our provisional estimate of total tax on repatriation of foreign earnings and the results of a small write-down of our deferred tax assets. These charges reduced second quarter GAAP EPS by $0.83, resulting in a net loss in the quarter of $0.40 per share. Longer term, we estimate our effective tax rate will be 24% to 28%, which is below our historic range of 27% to 29%. Roughly 35% of our profit today comes from the U.S, so the 14-point reduction in the corporate tax rate is muted by our global operations. Overall, we believe tax reform is positive for Donaldson. In addition to the benefits from a lower tax rate, we are particularly encouraged by the increased flexibility in how we deploy our cash. We are still in the process of analyzing legislation and exploring our options, but nothing about our strategy or capital deployment priorities will change. We remain a returns-focused company and we invest first on growth driving initiatives, then dividends, and finally, share repurchase. I'll now turn to a brief recap of our second quarter key metrics. As Tod outlined, sales were strong across the company. Total sales were up 21%, which we converted to a 23% increase in adjusted EPS. Our second quarter operating margin was 12.3% compared with 12.6% in the prior year. Strong expense leverage only partially offset pressure on gross margin. Higher raw material costs reduced gross margin by more than half a point. As expected, costs for our largest inputs, steel and media, were both up versus last year. Another…

Thanks Scott. We are encouraged by the market condition and we remain on track to deliver record sales and adjusted EPS this year. While we understand that the level of incremental margin is perhaps a disappointment, we are not willing to significantly lower our customer service levels or defer investments in long-term growth as a means of offsetting short-term gross margin pressure. However, we will implement off-cycle price increases, further manage discretionary expenses and explore other cost saving measures to mitigate this pressure without compromising our customer service or strategic agenda. Our agenda this year includes $10 million to $15 million of incremental investment in R&D, e-commerce, and the expense portion of capacity expansion. We're making excellent progress on our e-commerce site, which has been in pilot phase for the past four months. We've now processed more than $10 million in orders from hundreds of customers in 45 countries, and we're very excited about the official launch later this fiscal year. We have also made progress on capacity expansion, but these investments have a longer timeline. We doubled the size of our European distribution center and we are adding new lines and new square footage around the world. The production investments are centered on PowerCore, engine liquid, process filtration, and dust collection, all the businesses that are contributing to our strong growth right now. As new capacity comes online over the course of this calendar year, we expect some of the demand-related margin pressure will moderate. Another critical portion of our investment plan is new technology development. We are on a multiyear journey to increase R&D spend by about 1% of sales. We are investing to strengthen our materials science capabilities and advance our offering of connected solutions. These new technologies are largely geared towards penetrating further into new and…

[Operator Instructions] Your first question comes from Brian Drab from William Blair. Please go ahead.

Good morning guys. This is Kyle Dicke on for Brian Drab. Thanks for taking the questions.

Good morning.

Good morning.

Just looking at that -- at the gross margin and we appreciate all that color on the puts and takes, it looks like some of these pressures are going to continue in the second half. But I guess are you able to provide any more color on how much you expect to alleviate in the back half of the year? I know you said some on the supply chain comps look like they might come down a little bit, but can you provide any more color there?

Yes, sure I'll start. So, first-off, we're working on pricing, right? We have increasing costs and we have to work to pass that on to our customers and we've been doing that. In many cases, it takes time for the price to actually layer in because notification periods or existing orders in the system we have to work through. So, we're working on increasing our pricing to offset the cost. And as that comes in, we'll see an improvement in margin. We expect margins to improve in the back half. So, it will get better as we go forward. But we do expect there's going to be costs that are continuing to pressure us both raw material, freight, and excess demand. So, you really have many factors that are driving the equation, both from the pricing and the cost side and working to normalize our operations and get the true cost of our product being reflected in the price.

Okay. And then just to clarify on that, when you say margin improvement in back half that would be kind of from a sequential level, from the Q2 level, not on a year-over-year basis?

Sequential. This is Brad. Sequential, yes, and if you take the midpoint of our operating margin guidance range, we're up pretty meaningfully about half a point from the prior year. So, we certainly expect to get some traction with expense leverage in the back half as well. And gross margin, as Scott pointed, will be a little bit more tame, but in the neighborhood of the prior year.

Okay. Thank you. And then looking at the Off-Road business, looks like you're seeing broad-based growth there. But could you -- are there any specific end markets that you would call out that improved more than you would have expected over the last three months?

Sure, this is Tod. Two; mining, but mining is coming from a very, very low bottom. But mining is clearly outpacing the average as well as energy-related type of activities is also outpacing the average.

Okay. Thanks. And then just looking at -- given the top line growth, when you think about capacity, do you think you're in a good place right now for the next 12 -- to meet demand over the next 12 months? Or you having to expand investment even more than you had planned maybe a few months ago?

Our capacity is kind of a mixed story. On the Industrial side of our company, our capacity is fine. We have a number of opportunities for growth where we can just continue to execute quite well. On the Engine side, we're a bit more pressured and so therefore, we're adding capacity throughout the company. Specifically, on the liquid initiative, we're doing quite well. We'll add new liquid capacity that will come online later this calendar year as well as PowerCore. PowerCore capacity is being added in multiple regions in the world and that will come online also later this year. Additionally, we did accelerate an investment whereby we will be doubling the size of our Poland plant. And that was an investment we thought we would need in about two years and we are launching that this quarter.

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

Your next question comes from Jim Giannakouros from Oppenheimer. Please go ahead.

Hey good morning everyone.

Good morning Jim.

Good morning.

So, just tacking on to that last point. Is that -- the accelerated investment, the plant in Poland, is that basically the incremental investments that you have hitting FY 2018 plan relative to your original? And if there's other ones, can you please outline those, and how we should be thinking about level of investment overall, I guess, for FY 2019 and 2020, if you have the line of sight? Thanks.

Well, for FY 2018, we increased the midpoint of the guidance slightly in CapEx. So, -- we completed the Poland plant a while back. We are planning to add capacity there. And we are adding capacity around the world, not just specifically related to Poland, to meet kind of the current sales situation that we have. So, there's several different initiatives underway, which was one -- if you remember at the beginning of the year was one of our original investments was to plan to add capacity as we could see demand coming. And so that's kind of spread around the world, our goal is to meet local demand with local production as much as possible. And so we're spreading the capacity investments to meet the expected demand.

Okay. And somewhat in related, just in meeting local demand, just trying to understand the working capital needs. Can you talk about specifically what's going on there? Is it from your larger customers? Or is it that smaller OEs that are playing catch-up that hadn't matched build rates to demand effectively or is it in Aftermarket? How should we be thinking about the working capital hit that you're taking?

So, working capital, we -- our growth has been broad based. So, it's coming pretty well spread across the whole company. When I look at our AR, our days are up two since the end of the year. And if I look at our turns since the end of last year on a three-month trailing, we were 6.1, and now we're 5.4. So, there's been a spike in demand and we have to work to improve our metrics as things normalize. And we are making investments in the supply chain and in inventory builds to account for future expected demand. But it's kind of everyday work for us and we have to continue to manage that the best we can.

Maybe I'll just add a little bit in the fact that, Jim, this is all part of what we consider to be very important, that investment portion to keep that customer relationship long-term. We have a number of customers out there. They've talked within their quarters things such as saying sales were moderated by their supply chain issues. That's not Donaldson causing those items, just simply because the strategic actions that we're taking. And we're using the power of our balance sheet to make sure that we keep those long-term relationships solid and so you'll see that from a working capital standpoint of view.

That's helpful. Thank you. And one more if I may. You guys continue to outpace relative. I think you said you're gaining share and I missed it if it was an OE comment or an OE and Aftermarket comment. What do you attribute your share gains on the Engine side? Is it more in liquid? Is it new product intros that are more broad based? How should we be thinking about your share gains? Thanks.

Sure. So, number one, it is liquid. Liquid is doing really quite well across the liquid portfolio. We're now over $600 million within our liquid initiative. And really, our growth rates there have been quite strong this year. PowerCore also has grown very nicely within the quarter and so you start to see the whole proprietary first-fit to help drive the Aftermarket is really helping the share gain. And so it's really just good execution of our strategy overlaid by the fact that we do have an end market lift coming onboard.

That's all I had. Thank you.

Thank you.

Your next question comes from Charley Brady from SunTrust Robinson Humphrey. Please go ahead.

Hey thanks. Good morning.

Good morning Charley.

Good morning.

Just want to go back and clarify the commentary on the gross margin in the second half. Just trying to make sure I'm very clear on that. You're expecting improvement sequentially, but not year-over-year or both?

Gross -- this is Brad. Gross margin improves sequentially. Year-over-year, it will be in the neighborhood of last year's. Operating margin is up year-over-year, pretty meaningfully in the back half, and again, sequentially.

So, we're going to get better expense leverage to drive the majority of that improvement on increasing revenues.

Okay, that's helpful. And just switching gears here, so on Aftermarket, two questions related to that. On the GTS business, can you tell us how much of that business today is in the Aftermarket versus the OE mix? And what's the growth rate on the Aftermarket piece of that?

Charley, this is Brad again. The split is a little more than 60% of the total GTS revenue that's going towards replacement parts and that was up in the 50%-ish range in the quarter.

Okay. And then Aftermarket Engine, can you give us a little more granularity about the separate parts of Engine where you're seeing the Aftermarket growth? Is it just strong right across the Board or is it one area that you're seeing a lot more growth than the others? I assume Off-Road and On-Road, like the OE businesses, are probably the strongest pieces of Aftermarket as well.

Charley, it's very broad based geographically. However, within the U.S., I would suggest that the oil and gas portion is really coming through. And then worldwide, mining is also showing strength. So, it's very broad based.

Thank you.

Thanks Charley.

Your next question comes from the line of Alexander from Jefferies. Please go ahead.

Hi. This is Nick Cecero on for Laurence. You called out large turbine market is still under pressure. I am just wondering are there any adjacent markets where you could leverage that technology to relieve some of the pressure.

Nick, this is Tod. No, not really. That is a very specialized project-based business that really can be filtering ambient air of up to 1.2 million cubic feet a minute. And so it's very unique and it's project-based sale, particularly for peak and base loads. That is the portion of the business where we strategically changed our focus about two years ago in taking a look forward just to see this downturn. And our strategic change has surely been right in step with what the business has done and what the end market has done. So, we're very happy with that change that we made, but we do not see adjacencies that's very -- from that project-based business.

Nick, this is Brad. I might turn the question around too. And one thing to point out and a benefit from our technology portfolio is there are aspects of the technology that we can use in the gas turbine business to expand the offering. So, there are filters that maybe go into Pacific Northwest where there is more moisture in the air, where we use Synteq XP media to wrap the filter. So, this notion of diversification through technology that we've done across the business can help enhance our offerings in some of these businesses.

Okay, it's very helpful. And just one more. I was wondering if you could provide some color on demand trends by region. Are you seeing any areas where demand is accelerating or decelerating?

It's very broad based, Nick. There's not one particular geography that's standing out from the other. We are gaining traction in China, but -- and we're doing very, very well as we highlighted that very large growth rate that we had within the quarter. But regionally, it's pretty straightforward. That's just share gain on our part and excellent execution, just a very broad-based geographic recovery.

Got it. Thank you very much.

Thanks.

There are no further questions at this time. I will turn the call back over to Tod Carpenter for closing remarks.

That concludes today's call. I want to thank everyone for listening and for their time and interest in Donaldson Company. Have a great day. Good bye.