Ladies and gentlemen, thank you for standing by and welcome to the Donaldson’s Fiscal 2020 Second Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. [Operator Instructions] I would now like to hand the conference over to your speaker today Mr. Brad Pogalz, Director of Investor Relations. Please go ahead, sir.

Thanks, Megan. Good morning. Thank you for joining Donaldson’s second quarter 2020 earnings conference call. With me today are Tod Carpenter, Chairman, CEO and President of Donaldson; and Scott Robinson, our Chief Financial Officer. This morning, Tod and Scott will provide a summary of our second quarter performance and an overview of what we are planning for the balance of the year. During today’s call, we may reference non-GAAP metrics. Please note that there is 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, which are described in our press release and SEC filings. With that, I'll now turn the call over to Todd carpenter. Todd?

Thanks Brad. Good morning everyone. We delivered strong profit performance in second quarter. Our initiatives to increase gross margin are building momentum and we are controlling expenses in a softer-than-expected demand environment. We are managing those things under our control and I want to thank our employees for their discipline and focus. Strengthening our portfolio filtration businesses is under our control. To that end, I want to comment on last week's announcement. As we discussed on February 24, Nelson Global Products made a binding offer to purchase our Exhaust and Emissions business. We got into Exhaust and Emissions in the 1920s when we began selling mufflers for tractors. Exhaust and Emissions is our second oldest business and it is our only business that could be characterized as non-filtration. We have great employees and customers, but Exhaust and Emissions does not leverage our core technologies or material science expertise, nor is there a replacement parts model that aligns with our razor to sell razor blades strategy. Through that lens, Donaldson is not the best owner of Exhaust and Emissions, so working with Nelson makes sense. Pending consultation with our employee works councils in Europe along with other customary and regulatory approvals, we would expect to close the transaction in the coming months. Turning to second quarter results, total sales were down 6% with benefits from pricing, offsetting a headwind from currency translation. At a high level, expected declines in our first-fit and new equipment businesses were compounded by a broad-based down. Customers were cautious during our second quarter and then conditions worsened in February with the coronavirus outbreak. I'll touch more on that in a few minutes. Turning back to second quarter, Engine segment sales were down 7%, about two thirds of the decline came from our on-road and off-road first-fit…

Good morning everyone. I want to echo Tod sentiment. Our teams are doing an excellent job navigating the challenges granted by the coronavirus. As the outbreak in China was becoming more serious, we were beginning the second quarter financial close. That's a stressful time in any quarter and our teams rally together to support the process. I am really impressed by what they accomplished. The coronavirus outbreak is one more item on a long list of things that are making our customers cautious. Based on the general slowdown across markets, we revised our full year forecast. I'll talk more about that later. But first, let me provide a quick overview of our second quarter key financial metrics. We converted a 6% sales decline into EPS growth of 9%. We feel good about our profit leverage and non-operating items push EPS for a second quarter record of $0.50. Operating margins grew 70 basis points to 12.8% including a 50 basis points headwind from incremental depreciation and the capacity expansion, that's our strongest second quarter operating margin since 2012. Profit margins were also strong in both segments with Engine and Industrial up 90 and 160 basis points respectively. Consolidated gross margin grew substantially to 33.7% from 32% last year. Off the 170 basis point improvement, we estimate about a point came from our optimization initiatives. New capacity is coming online. We are steadily adjusted supply chain. Our procurement teams are driving cost reductions and our commercial teams continue to manage pricing. Solid progress on these initiatives was complemented by our favorable mix of sales and lower raw material costs. As we said coming into the year, increasing gross margin is our top operational priority and we're pleased with the progress. Operating expenses as a rate of sales increased to 21% from 19.9%…

Thanks, Scott. While markets are uncertain, we remain focused on supporting our customers and driving our strategic priorities through innovation. While we feel confident in our efforts, external acknowledgement is also positive. Our Filter Minder team recently enjoyed some recognition from a well regarded industry publication, which included our wireless monitoring system on their list of top 20 products for 2020. Products were judged on innovation, the ability to address important industry issues and the potential to improve a fleet bottom-line. We are pleased to be on this year's list, and we're excited about the commercial launch of our monitoring solution. Customers can easily retrofit our device onto existing systems, giving them better visibility into their filtration performance and the ability to optimize service intervals. We are also expanding the launch of our industrial segments connected solutions IQ. We began selling IQ in the U.S. late last year, and we plan to expand to other parts of the world in the coming months. Like our Filter Minder offerings, IQ can be set up easily and provides real time information to users about the performance of their dust collection equipment. We also continue to innovate with our existing portfolio of products. A long running example is PowerCore. We launched the product 20 years ago and made our 40 million filters last year. We have continued to resolve PowerCore, making it better for our customers and more efficient for us to produce. Based on a study we conducted last year, which compared PowerCore against a small number of competitive offerings, our performance advantage continues to hold up. With consistent use of PowerCore, we estimate that fleets with 500 trucks can save as much as $100,000 per year in fuel costs. By helping you engine work more efficiently, PowerCore can reduce fuel consumption,…

[Operator Instructions] Our first question is from Brian Drab with William Blair. Your line is open.

Just first on the Exhausted Emissions business, can you make any comment on what's operating profit is within that business or even where it is relative to the corporate average?

Yes. This is Tod, Brian. Overall, what we've said in the release that 2019, the revenue was roughly $120 million. We would also tell you that the profitability is below the Company average.

And then sounds like GTS business obviously is doing really well in terms of profitability. Was there anything in particular that happened in the quarter that drove that? Is that level of possibility is sustainable and was that the main factor that drove the outperformance and profitability for the Industrial segment?

Nothing unusual that we didn't expect to be truthful, it's really just excellent execution. That put together a strategic plan three years ago. Frankly, they just plan their work and work their plan and they're just doing a great job.

So, sustainable level there and was that possibility in that business the main reason that it would be my expectations, I think you, I think your expectations for the quarter and profitability and industrial? Is there anything going on in industrial? Or is that the main driver?

No. I think the main driver overall of the Company is really that we've been working on our gross margins all year and we have had really strong execution to the gross margin improvement plans on broad-based level all across the Company, all in all regions. And so, we're very proud of that and you can see that reflective and leveraged all the way to the bottom line.

And then on pricing, you guys mentioned that price is going to allow you to offset some of these headwinds. Commodity prices have generally been coming down in steel and filtration media. I would imagine, there’s polymer and oil derivatives, what are you expecting for price as contribution to revenue growth for the full year? And maybe you can see what you're expecting the second half of the year? And how are you getting that price?

Brian, this is Brad. The realized savings on a like-for-like was down in the low single digits in the second quarter. So, certainly creates some favorability. It's interesting though because it really is still a mix of price, buy raw material. So, filtration media for us actually ticked up slightly as a cost in the quarter, whereas steel, as you point out is down, more aligned with what you're seeing in the indices. In terms of the back half, we think the favorability will start to narrow because we had some favorability towards the back end of last year, as we made progress on some of these initiatives. But I'd echo Todd's comment on execution and on our procurement side, they're doing a lot of work to be smart about how we're buying as well and that's helping us also.

So in terms of price increases as a contribution to revenue growth, are you talking about -- like, if you're getting 50 basis points of price or 100 basis points or is there any comments there that could be a little more specific?

In terms of pricing or pricing of raw materials?

Maybe I misheard. So, let's just be clear. I thought that in Scott's comments that he said that pricing would offset some of the headwinds that you're seeing there and I'm assuming we're talking some about selling price?

You're correct, Brian. This is Scott. You’re correct. I did mention pricing which meant prices to our customers. So, we expect to have a continued small pricing benefit, which will help to offset some of the negative currency impacts that we're expecting. So you had that correct.

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

Hi, this is Dan Rizzo for Laurence. When you talk about the gross margin improvements and the increased probability, is that more from mixed improvement of new products? Or is that productivity gains?

Our gross margin improvement is driven by several factors. Number one, and most important is the initiatives that we are specifically undertaking to really try and drive it gross margins up, which was always our plan for this year. So, the improvement this quarter of 170 basis points, we estimated that 100 basis points were driven solely by our improvement initiatives. We do get a benefit of mix and we also had a benefit of raw material pricings offset slightly by a deleveraging due to reduce volumes. So, there's several factors driving that the biggest of which is the initiatives we're undertaking.

And then a couple of questions. First, you have exposure to some 737 MAX within aerospace the defense?

No.

And finally, just given the changed dynamics and the kind of violate landscape, how is that affecting, I guess, M&A or the pipeline of potential do you have positions?

Yes, there's no real change in the M&A activity. The way that we view the M&A activities, we would suggest you that we still have a full pipeline, strategic. And I remind you that we remain a selective buyer, a disciplined buyer, if you will relative to the metrics that that we view from evaluation principles, so no real behavioral changes at this point quarter-over-quarter.

Your next question is from Nathan Johnson with Stifel. Your line is open.

This is Adam Farley on for Nathan. Going back to the gross margin line and the capacity you guys added, so where's the business in terms of capacity constraints today? Are there still any pockets in the business experiencing capacity issues? Or is declining the demand kind of easy not across the business?

Yes, this is Tod, Adam. And so capacity, we're comfortable with where we are relative capacity. The expansions that we have done in the past year really are paying off. We talked about our supply chain normalization, internal corporation that helping lifts our gross margins and as part of that, that strong execution that you saw within the quarter. We still have some of that normalization ahead of us in the balance of the fiscal year, but we're very comfortable where we are on the capacity side of things and utilizations across the Company.

Turning over to engine aftermarket down in the quarter, can you provide more color on what end markets were weakest how aftermarket progressive the quarter? And then OE channel versus aftermarket, are you seen destock and I know last quarter, you said, it was real demand, any color that would be great?

So, the decline if you take a look at statistically is led by the U.S., it's our biggest piece of the aftermarket business. If it does have a nuance and it when you compare it to Latin America, we have had some strategic shift of that supply chain normalization. If you just look and normalize that, then Latin America will be roughly about flat and U.S. would be down about 5% rather than the reported 6.8. So that's a small nuance. But at a macro level, overall aftermarket, it's really a story of utilization, now down across led by guess as I said, by the U.S. but across all regions. And so, it starts with transportation, a lot of less good to be in the moved and then it moves into oil and gas. The oil and gas piece being more with us a story therefore helping U.S. to lead this downward cycle. And so, OE versus independent channel is off both about equal is how to really look at that. So when you factor in everything that we're seeing, we would suggest you that we are not seeing some kind of a step down and acute destocking across the industry. We would tell you that it's more of just a normalized slowdown and you can see that and reduce pull through to the overall aftermarket business.

And now turn the call back to Tod Carpenter for closing remarks.

That concludes today's call. I want to thank everyone listening for your time and interest in Donaldson Company. And to our 14,000 employees, I want to thank you for all you do. Your safety is our priority. So please continue to do an excellent job navigating in this dynamic situation. Thank you and goodbye.

Ladies and gentlemen, this concludes today's conference call. You may now disconnect.