Good morning. My name is Kim, and I will be your conference operator today. At this time, I would like to welcome everyone to the Donaldson’s Q4 Fiscal 2018 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 [Operator Instructions]. Thank you. Brad Pogalz, Director of Investor Relations, you may begin your conference.

Thanks Kim. Good morning, everyone. Thank you for joining Donaldson's fourth quarter and full year 2018 earnings conference call. With me today are Tod Carpenter, Chairman, CEO and President of Donaldson and Scott Robinson, Chief Financial Officer. Tod and Scott will provide a summary of our fiscal 2018 performance and an overview of our plan for 2019. During today’s call, we will 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. 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 have a strong finish to a strong year and we are pleased with our performance. Fourth quarter sales were up 10% and adjusted EPS was up almost 14%. We grew fourth quarter operating margin 40 basis points from last year, reflecting our actions to improve gross margin and drive expense leverage. For the year, our Company achieved record sales of more than $2.7 billion and record adjusted earnings of $2 per share. We also held our operating margin flat with the prior year despite significant demand related pressures and incremental investments related to our strategic priorities. I want to thank our employees for their commitment to executing these priorities while supporting our customers. I'm confident their efforts further strengthened our reputation as a top tier supplier while positioning us for future success. We have excellent momentum of across our Company as we head into 2019, which we expect will be another year of record sales and profit. Scott and I will provide more details later in the call, so I will now turn to a recap of our sales performance. Fourth quarter sales grew 10% to $725 million, reflecting growth in both segments. Engine continues to lead the Company with sales increasing 14% to $492 million. The performance drivers are unchanged supportive market conditions are compounding the benefits from a significant amount of past program wins. Within On-Road, continued strength in the U.S. and China drove sales up 36% to a new quarterly record. The U.S. market continues to benefit from higher production of Class A trucks and China is all about share gains. Sales in China were up six-fold last quarter and this region grew to 10% of total On-Road sales in fiscal 2018, up from 3% in 2017. As local manufacturers shift…

Thanks Tod. Good morning everyone. As Tod said, we had a strong finish to the year; fourth quarter sales were up 10%; operating margin increased to 40 basis points; and adjusted EPS grew 14%, which excluded $0.20 benefit related to tax reform; fourth quarter operating margin was 14.7%, reflecting expense leverage and modest gross margin improvement; price increases initiated earlier this calendar year began to take hold, which fully offset pressure from raw materials inflation and other demand related costs. On the operating expense line, sales leverage easily offset higher freight costs. Operating profit in the quarter was also up for both segments with Engine growing 80 basis points to 15.3% and industrial growing 200 basis points to 17.2%. Rate improvement, including price realization benefits combined with leverage of higher sales, were strong contributors. Segment favorability was partially offset by higher corporate and unallocated expenses with the pension settlement cost being the largest single driver. Our fourth quarter tax expense included $26 million benefit related to tax reform. Excluding the benefit, our tax rate was 26.2% compared with 25.6% last year. Pressure from foreign withholding tax and other reform related matters combined with an unfavorable mix of earnings, more than offset tailwinds from a lower U.S. corporate tax rate, stock option activity and audit settlements. We invested $23 million of CapEx last quarter and $96 million for the year to support initiatives like new capacity and ecommerce. We also returned $270 million of cash to shareholders last year through share repurchase and dividends. Our balance sheet is in good shape as we head into 2019. We ended the year with a net leverage ratio of 0.7 times, which includes last year's $35 million discretionary contribution to our U.S. pension plans. As working capital needs have gone up with sales, the…

Thanks Scott. We had strong performance last year, and those areas are tied to our strategic growth priorities like Engine, air, fuel and hydraulic, along with industrial dust collections, process filtration and venting solutions. Supportive market conditions amplified benefits from our investments, allowing us to deliver record sales and adjusted earnings per share. Although, there is global uncertainty related to trade and we still expect inflationary pressure on raw materials and freights, our plan reflects new sales and profit records in 2019. Additionally, we are planning to grow our incremental margin while maintaining investments in strategic opportunities. We will continue to pursue near and long-term growth opportunities in certain businesses. Liquid filtration in Engine and dust collection and process filtration in industrial are prime examples, and we will also continue to develop connected solutions for both segments. Large OEM customers in the Engine segment are valuing connected filters as a tool to improve their product offering, while the IoT space in industrial is more about how we support the end user. We have many dust collectors already giving us data from the field, and our deep knowledge of filtration performance will help us to build a strong offering that creates additional value for our customers. Growing our R&D spend is another top priority for us. We increased spend by roughly 10% in 2018 and we expect a similar increase this year. We are pursuing several initiatives to expand further into market where customers place a high value on technology. Products that meet these needs typically command gross margins above our Company average, which supports our business case for these incremental R&D investments. We're also enhancing the way customers engage with us by leveraging our e-commerce site shop.donaldson.com. Over the past nine months, we moved through pilot phase and have made…

[Operator Instructions] Your first question comes from George Godfrey from CL King. Your line is open.

Just two, the first one is, it was nice to see the price increase push through. And I'm just curious if you can segment how much of the price increase is strictly input higher costs related versus pricing that's being raised for value related on Donaldson products? And then secondly, the CapEx pretty significant increase this year versus last. Can you just give some more detail on where the incremental spending is going? Thanks.

The price increase, we've been focused on addressing our increasing raw material costs and that's what our price increases has been primarily focused on. So in the fourth quarter, you saw an improvement in our gross margin of 10 basis points so we were happy with that. But it’s really been focused on addressing the increased commodity cost.

And relative to CapEx, George, this is Tod. Our capacity expansion across both our air and liquid based products, including PowerCore and our proprietary liquid filtration solutions, are really driving much of that CapEx increase year-over-year in order to meet our customer demands. And we talked a little bit about how we will have up attracted time frame in order to normalize our supply chain and make it efficient for our customer base and that's really what's happening here.

Your next question comes from Charlie Brady from SunTrust. Your line is open.

This is actually Patrick Wu standing in for Charlie, thanks for taking my questions. Just wanted to -- you speak a little bit about the, obviously, capacity expansion. Just wanted to get a sense of where you guys are at now versus where would you like to be, I guess by fiscal '19? And how utilization rates are looking for you in the facilities that you guys are running?

On our air capacity, we’re at a utilization rate of about 80% to 90% companywide and on liquid, we're above 90%. We have a new manufacturing footprint coming online for liquid this month. So that will be ramping up over the current fiscal year, and we will be bringing on additional capacity on air throughout this current fiscal year and actually into 2020. We have a five year CapEx plan across our operations and what we are doing is accelerating some of that into 2019 and 2020, and that's across all regions in the world.

And I just want to have a question on your other income expectations for fiscal '19. It seems like it's stepped up from fiscal '18, although, I guess when you look back historically it's not very different from your other years. But just wanted to get a sense of where the increase -- I guess, what is going to drive that increase at least versus fiscal '18?

Yes, you're right in that. The guidance this year of $12 million to $16 million is certainly above last year. The biggest driver of that has to do with the new literature on pension accounting. The literature requires us to shift the income we generate on our pension investments out of operating income and into other income and expense. So that’s going to be a drag on operating income and an increase in other income for next year. So that’s the biggest piece.

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

Just a follow up on that other income question, since you have 5 million bucks in 2018 and press release does talk about $3 million that would have been in there in 2018 out of the pension change, which would still lay $5 million to $9 million of additional other income. Is there anything else in there of note? Or is the '19 estimate on the pension stuff higher than what it would have been for '18?

No, the biggest piece is clearly the income generated from our pension investments and then we do have a slightly lower FX losses planned for next year. So those two pieces make up the difference.

And then I want to talk about something more interesting, the incremental growth investments. You stepped up growth investments in 2018. It sounds like you're going to step up R&D spending and maybe some other growth investments in 2019. Can you give us an idea of how much that’s dragging on income on a year-over-year basis? And then maybe if you could just talk a little bit about some of the benefits you're seeing from the investments that you've made previously and what things we're investing in 2019 and beyond to drive growth?

I'll start maybe and talk about the things that we're investing in and then Brad can get a little bit more into the model based numbers. So the things that we're investing in within the R&D segment are what we highlighted in our comments things like, in venting solutions, our food and beverage initiative is going quite well and then core based products, such as liquid. We have wonderful wins in our Synteq XP based products in liquid and so we'll continue to invest in that, as well as PowerCore and additional air based investments. And then lastly, I do want to highlight connectivity. So connectivity in both segments of our Company, are getting a nice investments and connectivity is important, particularly as we go direct to that end user in the industrial base space where we have tens of dust collectors across this country right now, feeding millions of pieces of data to us. And with our filtration expertise, we believe that we can turn that into a revenue generating opportunity going forward. And so we have a good investment in that as well. And so maybe I'll let Brad then talk a little bit more specifics about the numbers.

All else equal, R&D you can think about that as going up another $5 million to $6 million, but part of our expense planning for this year was to make sure we create capacity to absorb that. So last year as we took a step up with a significant number of new projects hitting in '18 essentially at the same time, we don’t expect that this year. R&D will go up, we're funding that with other initiatives. And all the things Tod mentioned are also choices that we're making to invest in. And we're not viewing that as incremental to our overall expense.

And then if we think a little bit longer time, I guess both on the R&D or growth investment side and also on the CapEx side, because you're seeing that step up again. Should we begin to say that plat toe -- where should CapEx be longer term just how you're thinking about. Do we continue to ramp up these growth investments, should we continue to see R&D increase or should it flatten out from here and where CapEx goes longer time?

Yes, I'll start with CapEx. So we had $130 million to $150 million. As Tod mentioned, we have a planned increase capacity. We would expect to be at that level for the next couple of years and then it would come down. And as Tod said, we've accelerated some of our capacity expansion into the near future and that's driving up our CapEx in the shorter term and then we expect it to come down. In terms of R&D, we have a longer term goal of increasing our R&D spend to be a higher percent of revenues. So we're going to continue to focus on running the Company as efficiently as possible, and making targeted investments in R&D. We're committed to generating increasing levels of profitability and increasing sales, and we want to increase our R&D spend to generate new technologies and continue to find products with higher than average gross margin. So we'll continue to invest in R&D as well as we go forward.

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

This is Daniel Rizzo on for Laurence. As we think about the R&D spend as you increase that, I mean, when do you start to see like new products get commercialized? What's that I guess the time frame in terms of from when you come up with something to versus when it's flows through to meaningful sales and earnings?

So it's elongated answer. What you have is on food and beverage activities, we highlighted that in the call today that we are seeing revenue generation on that investment immediately. And we are also seeing a revenue generation on some of the liquid base initiatives that we have with Synteq XP, et cetera and we talk about the wins there. But beyond that, we also have some that will be potentially years down the road before we see some revenue line to that. So it's really a balance based portfolio spend in order to drive additional revenues over time. I would remind you that we are a technology led filtration company, and so technology investments are going to continue to be our focal point and thus the R&D focus for us.

And then you mentioned taking share in China, I think particularly in On-Road. I was just wondering if you -- are you taking share in a cooling environment, I mean or obviously, you're outperforming. But I was just wondering if the environment overall is flattish to just coming down a bit?

In China, specifically to our share, we are a low single-digit. So we have a lot of runway in China and we're able to take share now, because we went into China initially on the backs of the multi-national based companies and now we're winning with Chinese national based companies, both in on and off road and that's what's really driving our share gain currently. So we have a nice runway ahead of us, but we are starting to experience some notable success in that region.

And then finally, I mean it doesn’t appear so. But has anybody has there been any direct impact from tariffs or are there any signs of customers reducing inventory to see how things play out? Has there been any changing customer behavior at all?

No, there has not been any direct effects that we can attribute to tariffs about sorts of things from customer-to-customer based behavior. Obviously, everyone in the world is wondering about the geopolitical uncertainties. Steel is currently more of a commodity base or a raw materials headwind for us as a result of tariffs, but customers are not changing a behavior as a result.

Your next question comes from Brian Drab from William Blair. Your line is open.

On the industrial guidance for 2019, it's really solid. I'd like to just focus on the industrial filtration sub-segment for second. And if I look at your guidance for total industrial up 3% to 7% with 2 point FX headwind, the organic is 5% to 9%, and you've got this gas turbine and special apps those sub-segments weighing somewhat on that growth rate. Am I correct in interpreting your organic growth expectation for industrial filtration for that sub-segment, is somewhere in, I don’t know, the 6% to 10% range for next year?

So if you just breakdown the major segments, so our IFS segment, we would put up in the high single digits and gas turbine would be down in the high single digits and special applications would be roughly flat. Whereby have things like venting offsetting the secular decline so that we expect to continue to trend in disk drive.

So I guess the question is that that high single digit for industrial filtration that's really great growth. What gives you the visibility there through fiscal '19 that you achieve that?

It’s a project based business and CapEx spending has increased throughout the balance of the previous fiscal year, we expect that to continue. And additionally, we have some very nice growth across -- broad based growth across our dust collection aftermarket organization we expect that to continue. And then that is also the segment where our process filtration investments are really starting to pay dividend, and we experienced over 20% growth in process filtration last fiscal year. We expect good growth to continue throughout 2019.

This is Brad, Brian. One quick thing on your question about FX, you can certainly consider that IFS is under pressure in that neighborhood as a function of FX as well. So if that was part of your first question, I want to make sure we touch on that.

Yes, I was just saying you gave the guidance of 3% to 7% for the total segment and 5% to 9% would be the organic, that’s -- I was pointing on and clarifying.

Yes.

And then you put out the press release yesterday on the e-commerce site. Do you think that that is -- I mean, I guess obviously some of those sales cannibalize sales that would have happened otherwise. Do you think that that is incremental to your growth rate in fiscal '19, just rolling out that site?

No, it's not. So remember there is two types of usage across e-commerce. And the primary numbers that you're seeing today is Engine base related and so we go through distribution. And we're having our customers come through the e-commerce site, and so it's more of an efficiency play on that side of the Company. And we're very pleased with the fact that so many of our distribution partners across the world have adopted that site and come online in order to be able to have a successful implementation. Later as we look forward and continue to expand it, particularly over on the industrial side of our Company, that is where we will see more of an end user based experience and that's when it will start to be incremental. We've taken into account how we believe that will play out and we've baked that into our guidance currently.

And then two more quick ones, so the revenue guidance for the total company for fiscal '19, what have you incorporated into that in terms of price? How many points of growth do you think you're getting just from price alone?

We have prices in there of 1% to 2%.

And then zooming out in the larger question, if I'm doing the math correctly, for fiscal '19, the incremental operating margin at the midpoints would be around 19%. It's been in that high teens range. I think going back, if I would have asked Bill Cook this question 10 years ago or eight years ago, the incremental margin always seem to be little bit higher than that, like something in the 20s or even above that in some periods. But if this high teens incremental margin, something that is what we'll see through the growth investment phase that you're in right now? Or is this -- I'm getting the sense like we're probably and should be always in the growth investment phase. And does that result in this being the norm for incremental margin something in the high teens?

Brian, if you go back and rebuild our model over the last decades, you'll see that in growth periods versus trough periods that we do fluctuate, it's never been a constant low 20% range within our incremental margin. We just experienced the same thing over the last six years. And currently 2019 guidance actually comes up into the low 20s, which puts us back to the average overtime that we have experienced. And so we're very proud of the fact that we've been able to get our incremental margins back from low double-digits back into the low 20s, and really take advantage of leveraging the growth that we have.

Brian, this is Brad, let me add one thing and we can talk more offline if it would be helpful. But I want to make sure we're starting from the same spot. We have incremental margins planned for this year in the low 20% range and that's factoring in the pension adjustments on the fiscal '18 operating profit. So keep in mind that that reduces the '18 operating profit by about 10 basis points. So there is the change there. And what that low 20% range isn’t factoring in is the drag that comes from revenue recognition. So from our point of view, we think this is a pretty strong operating margin and incremental margin for the year.

[Operator Instructions] Your next question comes from Richard Eastman from Baird. Your line is open.

If we could, could we just spend a minute or two on the gross margin here on a forward-looking basis. So for '19, I think you've referenced it being flat. And could you just maybe walk through and maybe the puts and takes there a little bit. I think there is a reference to price adding 1 to 2 percentage points to revenue. I wasn't sure, is the net price capture this year or meaning from fiscal '19 expected to be about zero. Is that what the reference was there, some of them which were always up high 1% to 2% on a blended basis? So maybe can you just walk through the puts and takes down the gross margin line?

Yes, I think you got it right but let me just confirm. We just talked about pricing adding 1% to 2% to revenues next year. We estimate $30 million of expense headwinds from increasing commodity costs. And our guidance implies that gross margins will essentially be flat. So the pricing actions that we contemplate for next year will offset our contemplated increases in costs and gross margins will result in flat. We generate a good improvement in operating income, because we're really leveraging our operating expenses.

And then the mix here with OE strength would offset some of the volume benefits at the gross margin line. Is that the other conservative way to look at this?

Rick, this is Brad. So mix is a little bit more benign for the year, because we certainly have the strength in aftermarket. But then on top of that some of the industrial businesses, there is very nice growth there. So at a company level, it mixes out and do more of a plus or minus. One thing I want to add on gross margin and again with the accounting changes, what we're calling an optical drag on gross margin is about 30 basis points from revenue recognition. And that’s a year-over-year, so don’t think about it as a headwind per se as much as just when you compare against the prior year. If we were under the old standard gross margin all else equal would be 30 basis points higher, at flat.

And then if I might -- can I just return back on the Engine side of the business. Again, I mean another just significant quarter here of share gains in China on the On-Road side, but also the Off-Road strength was there as well. Just curious, how far do we have to run on that? I mean, you had mentioned that perhaps China was -- is it 10% of Engine sales, was that the reference there?

It's 10% of Off-Road sales. So China On-Road represents 10% of total On-Road.

And Rick, I would share there is still very low in China and as you know, it's a very massive market. And so we have tremendous opportunity in China still that lies ahead of us. And we're really pleased with the fact that we're winning not only as multinational companies but also now in national companies. And we're winning in the Off-Road segment but also in the On-Road segment as they continue to value technology.

And then just a last question on the industrial side of the business, with IFS is the mix there now running about half aftermarket and half capital equipment? And then could I just ask what that mix is but then also what did the book-to-bill look, like on the capital equipment side. Were you pleased with that in the quarter, does that give you good visibility on your full year outlook there of high single digits for all of IFS?

So book-to-bill and order intake do give us confidence within our forecast within 2019. And we saw our -- when we talk CapEx spending our project based spending across the manufacturing sectors picked up as we progress through last fiscal year. We expect that to continue through this fiscal year. And so we're therefore baking that within the guide. And I think Brad has that split for you.

Rick, to answer the question about the split, it typically -- or it's about 50-50. It's tilted towards the new equipment this year. And I would say that that's just testimonial to the market improvement there and seeing some traction where folks are investing more in their facilities now, so that part of the business was -- had a really strong year.

The method I find interesting is when I look at the op profit on the industrial side of the business. Obviously, you've done a great job protecting profitability in gas turbine without -- with the big decline we've seen in large turbine stuff. But I'm curious, the 200 basis points in op margin within industrial year-over-year. Would you attribute that to volume, to aftermarket sales? Or is there anything in the mix here that's significantly more profitable, for instance the special apps? How should we think about that op margin improvement there given the mix?

Sure. It's favorable mix for sure. In that, special applications held being very nicely throughout the year. But it's also a tip of the cap to the excellent execution work across our GTS business in executing that strategy. That's a very tough business model for our GTS team worldwide to execute. And they had an excellent year executing a strategy that really helped us to drive profitability across our industrial based businesses.

And with the large turbine stuff being less than 10% forecast from '19. Presumably, that business when you look out to '20, should start to see some modest growth off of '19 base?

It's tough to say when large turbine projects are going to come back. I mean if you look to for example GEs release recently, I mean they sold single digit gas turbines in a quarter here. So when will that pick-up, well, it's pretty low bottom, its down considerably. Just not sure when we could expect that to tick-up, we thought it would have moderated as we looked in the 2019, clearly, it has not. So we'll wait to get a little bit more data before calling bottom on that.

There are no further questions at this time. I now turn the call back over to Tod Carpenter.

That concludes today’s call. I want to thank everyone listening for their time and interest in Donaldson Company. Have a good rest of the week. Good bye.