Good day and thank you for standing by. Welcome to the Donaldson Fourth Quarter 2021 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, Charlie Brady, Director of Investor Relations. Please go ahead.

Good morning. Thank you for joining Donaldson's fourth quarter and full-year 2021 earnings conference call. With me today are Tod Carpenter, Chairman, CEO and President, and Scott Robinson, Chief Financial Officer. This morning, Tom and Scott will provide a summary of our fourth quarter performance and the key considerations for our fiscal 2022 outlook. During today's call, we'll reference non-GAAP metrics. A reconciliation of GAAP to non-GAAP metrics is provided within the schedules attached to this morning's press release. Additionally, please keep in mind 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 Tod Carpenter. Tod?

Good morning, everyone. We had an excellent finish to a strong year. We achieved another quarterly sales record and EPS was up 32% in fourth quarter, resulting in full-year sales and EPS that were both near the high end of our guidance ranges. Our team did an incredible job over the past 12 months, and I want to thank them for their contributions. As we look ahead, conditions will likely become more challenging, particularly in the first half of fiscal 2022. We are already facing supply chain disruptions primarily due to labor shortages in the Americas and raw materials inflation put significant pressure on gross margin. While the magnitude of these issues are greater than what we have experienced in recent years, our playbook for addressing them is time tested. We are pursuing growth opportunities in our advanced and accelerate businesses. We are raising prices to mitigate the impact of cost increases and we are leveraging our strong relationships to remediate and overcome the current supply chain challenges. When we roll these things together, we feel good about where we land. Our plan reflects continued progress on our strategic initiatives and we expect to deliver record levels of sales and record profit in fiscal 2022. We will share more details about that later in the call. So, I will now provide some context on fourth quarter sales. Total sales were $773 million, which is up 25% from last year as we compare it against the toughest patch from the pandemic. If you normalize the trend with a two year stack comparison, fourth quarter is right in line with what we had in the third quarter, suggesting we are maintaining sales momentum. In Engine, total sales were up 28%, and the increase was again led by our first-fit businesses. Fourth quarter…

Thanks, Tod. Good morning, everyone. Every way we look at it, fiscal 2021 was a solid year. We generated strong sales despite the pandemic hanging over us and margin growth contributed to record full-year EPS. What was more impressive was how our people operated. The level of teamwork was unbelievable. And I'm inspired by the commitment they showed. I want to thank my colleagues around the world for all they did in fiscal 2021 and for putting us in an excellent position to deliver record sales and profit in fiscal 2022. Before getting to the details of the new year, let me share some 2021 highlights. Fourth quarter sales grew 25%. Operating income was up 36%. And EPS of $0.66 was 32% above the prior year. As I know you've heard me say, we are committed to increasing levels of profitability on increasing sales. And we did that in 2021. I want to add a short disclaimer. That commitment is over time, and it won't be easy to achieve in the first half of fiscal 2022. I'll touch on that in a few minutes. So, back to the fourth quarter recap. Fourth quarter operating margin was 14.5%, an increase of 110 basis points from the prior year. Most of the increase was from gross margin, which grew 70 basis points to 34.4%. Strong volume leverage and initial pricing benefits more than offset the impact from higher raw material costs and mix headwinds. The impact on raw materials increased throughout the quarter as inflation has begun coming through in full force. We were in front of this impact with price increases in certain businesses, while increases in areas with supply agreements that had index clauses tend to lag the market. That's true when prices go up or down, so it works…

Thanks, Scott. While there's a lot to consider in our fiscal 2022 plan, our priorities are straightforward. Gain share and outperform our markets, protect gross margin, deliver best-in-class levels of service, and continue to invest in our team and company culture. Let me share a few of the ways we are attacking these priorities. The best tactic for growing our share is continued investment in our advance and accelerate portfolio. We are adding staff and developing tools to help these teams deliver strong growth again in fiscal 2022. Areas like process filtration, dust collection replacement parts and engine aftermarket are all positioned to have another very successful year. We will also drive above-market growth by capitalizing on the market recovery related to new equipment. We seek opportunities to plant first fit seeds in both segments from engine products to new industrial equipment, and we must take advantage of this moment to capture future aftermarket growth. We have a strong value proposition for every customer. And this year, we have aggressive plans to get back into the field and drive selling. Additionally, we remain committed to growth through acquisitions. We continue to work a robust pipeline of potential targets, with the primary focus on expanding into life sciences and supporting our Industrial segment growth. While there is no update to share today, I'm confident that our strong balance sheet, laser focus and disciplined adherence to our long-term strategy gives us an excellent opportunity for success. Another priority in fiscal 2022 is protecting our gross margin. At our Investor Day two years ago, we talked about our plans to improve gross margin. Since then, we have executed. Compared with fiscal 2019, fiscal 2021 sales are about flat and gross margin is up 90 basis points. We acted with speed and fiscal 2022…

[Operator Instructions]. Your first question comes from the line of Bryan Blair with Oppenheimer.

I was hoping you could frame run rate demands versus pre-pandemic levels a bit more. Total 4Q sales were up a little over 6% versus fiscal 2019, although I suspect supply chain constraints may be masking some underlying strength beyond that level. Can you offer a little more color on backlog, order rates or any other metrics you should keep in mind versus pre-pandemic rate?

This is Tod. If you take a look at our backlog, our backlog is obviously very high. Higher than, frankly, we would like to see it. And it really reflects the difficulties across the supply chain, primarily a US-based story. It's very difficult right now to get steel and urethane-based products. And so, given the guide that we have, we have baked that consideration in. Additionally, we are really under pressure now to get employees hired in the United States in order to be able to build up the backlog. That said, other parts of the world are really uneven as a result of COVID. And so, what we have tried to do is recognize and embrace those difficulties. And we have put that into our guide.

In terms of your guide, top line dynamics certainly makes sense, particularly first versus second half in Engines. And we'll see how the next couple of quarters shakeout overall. Is there any more detail you can offer on segment margin outlook and how understood price cost headwinds and some potentially unique mix impacts are likely to flow through during the year?

It's Scott here. We were obviously pleased with the margin performance of both segments this year. We had good volume growth and good pricing and good leverage. And next year, we see headwinds for both segments. As Tod mentioned, supply chain is pretty stressed. And obviously, raw material pricing is way up. And so, we said, in my script, that we have an 8% to 10% increase in typical commodity cost, representing in 300 basis points of operating margin headwind that we need to offset. And so, we're focused on driving pricing in both segments to counter that, and we've done some already and we have some to go. We said, our gross margins would be flat to just slightly down. So, we're expecting to pull that 300 basis points back through our own actions that we're focused on, which, again, is really price driven, and then volume leverage. So, I think both segments are equally challenged in terms of commodities and raw material pricing. And the guide overall is expecting another year of operating margin growth, and that comes from relatively flat gross margin and then leverage on the operating expenses to allow us to drive an operating margin improvement, some 10 basis points to 70 basis points, 80 basis points.

I think you mentioned process filtration sales up around 20% in 4Q. Sorry, if I missed the detail, what was the full-year sales level? And what's contemplated for process growth in your 2022 guide?

We'd be mid-teens for the full year on a growth level for process filtration. And we also expect to have double-digit growth looking forward in 2022.

One more, if I can. Portfolio question. What was advance and accelerate revenue as a percentage of fiscal 2021 total? And on the other side of things, is it only exhaust and emissions at this point in the fix and reposition bucket?

While Charlie looks at the portion of the first portion of question, exhaust and emissions remains in the fix and reposition, but we also have our aerospace business in there, as you might imagine. We do expect aerospace to come out of it at the end of this year, but we actually bring portion of the company out of fix and reposition after they've delivered. We're very confident and comfortable with the plan that aerospace has this year. However, now we have to deliver it and then we would expect them to probably come out of it next year. So, before the next question, Charlie, you have the number?

The advance and accelerate portfolio, fourth quarter sales were up in the mid 20% range. They were about 950 basis points better on a margin than the overall company excluding the A&A business.

And as a percentage of company's – 60 to 65.

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

I wanted to start off digging a bit further into gross margin. Overall, roughly flat. But there's a lot of moving pieces in there. You guys have added some capacity to remove some bottlenecks couple of years ago. Leveraging the ERP system was supposed to be lifting up gross margins. And you're offset here, obviously, by significant cost inflation, whether the pricing is making up for that or not. So, I was hoping you could maybe give us a little bit more color on the puts and takes there. What is the headwind from price cost to gross margins? Just any more color you can give us around the puts and takes in the gross margin line.

Certainly, there's a fair amount going on in there, Nathan, as you noted. Again, the biggest impact is, obviously, the commodity cost increases of, say, 8% to 10%, which gives us a 300 basis point headwind that we have to offset. And we're offsetting that with pricing and higher volume, which allows us to leverage our facilities. And so, the way we see the year rolling out is what we have termed a bit of a bathtub curve. And so, your first quarter will be down the most significant, and that will be offset by improvements in the fourth quarter. Your second quarter will be down a bit, and that will be offset by improvements in the third quarter. So, as we layer in pricing, and hopefully, commodities begin to stabilize a bit, we're going to work our way out of this cycle. And hopefully, gross margins for the year will be flat to just slightly down. And so, you can imagine the first quarter being the toughest quarter, and then things slowly start to improve, whereby when you land in the fourth quarter, you're essentially offsetting your gross profit negativity from the first quarter to allow flat to slightly down margins for the whole year. So, it's, number one, commodity pricing that drives our raw material input costs up. There's also certainly some interest that we have, an increase in our salaries because demand is higher for people, and that's a headwind. We have our cost reduction improvements that our operations team is consistently operating on. We've had the capacity expansion that we've talked about previously, which allows us to operate more efficiently. We have increased volume, which gives us better leverage and ability to leverage the overall fixed costs in the plants. So, that's kind of all in the soup. We expect this year to be flat to just slightly down in terms of gross margin, with improving operating margin based on general expense leverage.

Maybe just a strategic comment on that too, Nathan, is capacity expansions that we did across the company here the last three years, we stand in in really good shape to take advantage of the leverage with the higher book of business. Clearly, if we can work through the supply chain problems that we're experiencing, the raw materials activities right now, I like our competitive position, given our ability to produce and where we stand right now.

Do you expect for the full year of fiscal 2022 to offset the cost headwinds with price on a dollar basis that it's still dilutive to margins?

We think our gross margin will be flat to just slightly down. So, from a percentage perspective, we should be flat to just slightly down. But our dollars, because our sales are up significantly, our gross profit dollars will be higher, obviously. And we're going to leverage our OpEx. So, we're going to grow OpEx, but not nearly as fast as revenues. And so, that gives us a bigger driver in operating margin as well as operating profit.

Just a question on the labor shortages. You're talking about labor shortages for your own facilities in order to produce products. What kind of steps are you taking to try and get more skilled labor in, retaining the labor that you've got currently, and how you see that playing out going forward?

It is not just Donaldson Company with labor shortages. It is our supply base that has labor shortages, to the point of where we have actually called retirees in to help Donaldson Company to sit at our supply base to try to help with overall scheduling, to get our demands. We have done, overall, typical type of salary-based adjustments across the manufacturing plants and recruiting base adjustments with signup bonuses, et cetera. It's primarily US-based story relative to that. And we're pulling all the levers that you typically would read anyone else doing right now across the United States. But I would suggest to you that in other parts of the world, it's not a labor story. It is really more of a raw material story.

Do you have an expectation for labor inflation this year?

We've baked it into the guidance that we've given you at this point.

Your next question comes from the line of Brian Drab with William Blair.

Congratulations on a great year in such a tough environment. I just want to make sure, first of all, that I understand what we're saying about the 300 basis points. What's the time period that we're talking about there because we just finished the year at 34% gross margin? Is that to say that first quarter 2022 is going to be around 31% and then we build from there?

I think we already have some things that are building. So, clearly, our first quarter would be less than 300 basis points. That's the total dollar impact of the raw materials cost. But we've been layering in price increases. And we'll have good volume growth in the first half because of the softer comps. So, it'll be less than 300 basis points and it'll be the highest in the first quarter and then a little bit less in the second quarter. But less than 300 basis points because we have some things that are already in place. And we'll also be working on that in the first quarter.

The 300 basis points is just the impact related to raw materials and you're already dealing with some significant – what's the magnitude of – how would you quantify what the headwind from raw materials was in the second half of fiscal 2021?

Actually, that's an interesting dynamic of last fiscal year, is that we actually have raw materials favorability in the first half because things were – really hadn't started to take off yet. And so, the impacts that we've seen from a negative perspective are primarily related to the second half of the fiscal year, and now those are layering into next year. So, I think you have it kind of analyzed properly.

You talked about the segments and the margin, but just to kind of help us model there, the segments ended the year with Industrial operating margin as about Engine. For the year, they're pretty even. I know you said you expect to see kind of similar pressure from raw materials across both segments, but should we – and I don't know if you said this in the guidance already, but are the segments going to probably have similar operating margins in the next year or one have more pressure than the other?

From a cost perspective, they're going to both have similar raw material issues. Obviously, mix is a big driver and we generally don't provide specific guidance in terms of each segment and their profitability. But we look for continued growth and profitability from both sides.

Brian, maybe a little bit more color for the model is that, if you just remember how we drive our industrial based business, it's a project-based business. And so, as we wash those projects out, we're able to adjust to the pricing across that business, as well as the independent channels on our aftermarket, which we control more on the industrial side than we do on the engine side. We do quite well on the independent aftermarket channels. But it's the OE portion of that business, which is roughly 35% of that business, that always lags within the pricing. And so, you'll see likely more headwinds on the Engine side in the first portion of the year as we work through it

Just the last question, high level kind of strategic question. Over the last 18 months, I imagine, just given how fragmented the filtration industry is that you have seen some competitors either really struggling or disappearing. And obviously, that's not the case with Donaldson, a very strong, established company. So, I was just wondering, are you seeing opportunities to take share, win customers, are there new opportunities that you're hoping to capitalize on over the next year?

We have seen some small kind of, call them, mom and pop shops go away. Obviously, they've been pressured across the world, but that really hasn't changed the overall long-term environment for us. And we look to win every single day and we look to plant seeds for future growth with our leading technology-based products. Those that are falling off by the wayside are typically chasing the commodity-based activities. And so, while that may change the filtration landscape, it doesn't change Donaldson's ability to capture share or to go off and really invent new cool things, which we continue to do every day. So, not really a lot of competitive changes, if you will, [indiscernible].

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

This is Dan Rizzo on for Laurence. You mentioned urethane, I think, as one of the raw material costs that are kind of on the rise, supply being a little constrained. I was wondering if the storm in the Gulf earlier this week, if your suppliers have signaled to you that that might make things even worse?

Actually, we've been dealing with that here, obviously, throughout the last short period of time. And, yes, we do have some urethane-based concerns taking place across the supply chain right now. We are working with that group of suppliers. We do have that concern. It's an immediate concern. And damage is being really inventoried at this point to see how quickly they can come back online. So, yes, we have that concern. But we did bake as what we think we understand about all that into the guidance that we give you as well. That's probably the risk that we have talked about on the overall top line and our ability to deliver it. It's more than the typical things. Now, we have the storm. The last weather event in Texas, the bad one really hurt the supply chain significantly. And this hurricane season has us all very concerned as well.

Just with the labor issues, I guess it's not happening, but I was wondering if the enhanced benefits might make things ease starting like now basically? I don't know, but I guess you've not seen that.

We've done some of that already across the corporation. It's not really driving people to come back into the offices or into the – look for jobs and come to our manufacturing plants. So, we clearly have done those things. I'm not sure what's going to change the overall psyche of the labor force here in the United States. But we'll look to see where we are as schools open up and kids go back in September and hope for the labor force to pick up back then. And until then, right now, it's very good to be a global company.

[Operator Instructions]. Your next question comes from the line of Dillon Cumming with Morgan Stanley.

Tod, I was wondering if I can just ask you, and you made some comments on your prepared remarks saying, you didn't kind of have an immediate update here. I'm still curious kind of around the outlook for the life sciences M&A over the next year. So, I think we're kind of coming up on a couple of quarters now where we made some hires in that area. So, just curious if you'd kind of update us around the pipeline and what your kind of expectations are around M&A for this year.

I'll tell you that our pipeline is more robust than it's ever been. It's really healthy within the life science sector. We like the game that we're playing here. Continue to knock on doors, have very talented people helping us to really execute that. Obviously, can't predict when deals will happen. Wouldn't comment on any specific deal. But strategically, what we're trying to accomplish, I'm very pleased with our progress and the execution to date.

Maybe to ask a kind of competitive question and will ask it a very different way. I think one of your larger peers, they've made public their intentions to kind of spin or sell their own filtration business. I was just curious your kind of view there as to whether the business operating as a standalone entity might actually contribute to more discipline in the market or kind of any other competitive implications you might call out as a result of that dynamic?

We're very aware of what they have been talking about and the potential options that they face. And so, we'll follow that very closely. Obviously, we wouldn't specifically comment about a competitor like that. It's inappropriate. And so, consequently, we'll just continue to keep a keen eye on that, watch the proceedings and move forward.

Last question for me. I think you were kind of clear calling out the disconnect between your kind of onroad build guidance versus where, call it, ACT might have their Class A forecast of the year. You kind of attributed that as some product line exits you were discussing. So, I was curious if you could quantify that headwind for the year and whether or not we should expect that over the next few quarters or so?

Could you maybe say that again?

Sorry, that was just for the onroad business that you were discussing. In the prepared remarks, you were saying that you were exiting some product lines there.

What we did is there's a particular directed by, it's non-filter business that we've been doing because we have strong customer relationship. We've been doing it in the onroad business. It's emissions related. It's not even our typical emissions business. And we were subcontracting a portion of that and we just helped with the sourcing transfer, to make it go to a subcontractor directly and Donaldson got out of the business. That's a positive mix to us. And frankly, it's also good for our customer in the onroad segments. So, that's part of the positive mix. Overall, mix headwinds that we have, the emissions businesses is certainly – overall a tough headwind for us. It typically operates on a profitability level of roughly half of Donaldson average. And so, we're going to have significant growth in that business, as well as some other mix challenges that we have in our OE business, for example.

[Operator Instructions]. Your next question comes from the line of Robert Mason with Baird.

Just quickly, a lot of discussions around price, but I'm just curious, within the 5% to 10% revenue guidance for the year, what are you assuming for price? Or what range is built into that?

We talked about the 300 basis points of commodity cost headwind that we face. And we think our gross margins can be flat, just slightly down. So, our plan is to offset a significant portion of that commodity cost increase with pricing.

And volume as well?

And volume leverage.

You also had just discussed the backlog. Backlog may be above where you would normally expect it. Just how are you thinking about your ability to work down that backlog, either in the first half or the second half? And really, maybe where I'm going with this is just trying to get at how you think about your second half of the year visibility versus how you may typically start out a fiscal year, whether on the first fit side or the aftermarket side?

We typically are in a much more comfortable position with our backlog execution as we start a fiscal year than we are at this point. We'll grind through the supply shortages. Inventory levels across the independent channels and the OE channels are low, lower than they want them low and we want them. So, we look to execute and get back on our feet. But it's going to take into the next calendar year, as we see it. So, we're going to be working through this first half of this fiscal year for us. And then, we should be able to see some improvement on the back half. And that also goes into the guide. We're typically a 48%, 52% type of a company on the swings. And of course, last year, we were more like 46%, 54%. And so, we looked to return a bit more normal. We're actually thinking we'll do about a 49%, 51% on the split this year. So, you can see how much of a jump in the first half as we walked through that backlog and get our customers really serviced. And that's how we're kind of breaking it out, working through it.

Tod, how much of your backlog is a function of your first fit customers planning further ahead, given the supply chain challenges? Are you seeing that? Are you seeing longer ranging forecast? Or is their situation so dynamic, it may be the inverse?

Tough to quantify. We talk about that all the time. It's absolutely clear we are seeing some order-aheads in order to try to – the theory being, if you have more on the order, you'll get more. Not really working that way. But people do think that way. And we do see that behavior in our backlog. No question about it. But we can't really quantify it, Rob. The computers are linked to each other on the OE side. And we look at it all the time. I would suggest to you that what will happen over time is – right now, we would tell you our backlogs are probably extended to maybe as much as four and five months as being solid, is the way we look at it. And in a normal behavioral period, we would tell you it's 90 days. So, it's probably like three months. And then, in really tough cycles, it cuts down to 30 days. But we would tell you that our backlogs for as much as five months are solid and they're high. And that's an indication that people are trying to restock to us. And now we just have to work through and get it done.

Just the last question is, again, framing the outlook for the year. How do you think about that geographically. In particular, China obviously had the tough comp this past quarter, but how are you thinking about China, in particular in the context of the 5 to 10?

China, it's interesting, right? Because if we just look at Q4 2020, China as a country had record excavator production, record equipment utilization as they were coming out of the pandemic, right? And we're big in excavators, heavy duty trucks and offroad equipment utilization in China. However, in 2021 Q4, excavator production was down double digits, low-double digits. Heavy duty truck production was down in the high teens and equipment utilization was down in the mid-teens. And yet, our business was actually in local currency down single digits. So, we know we're winning share there. We've baked that into our overall China-based model, if you will, into the guidance. And one other thing that's really important to know to suggest how we're doing in China is, we have quoted, in the last year, high teens worth of first fit production products – with proprietary products first fit programs in China. And of those high teens, we won them all. So, that's planting seeds for future growth. And that's the momentum that we see ahead of us in China. And so, we're still very bullish on the excellent work that our teams are doing over there.

There are no further questions. I will now turn the call over to Tod Carpenter for any closing remarks.

Thank you. Before signing off, I just want to acknowledge that we have talked to a number of our customers that have been affected by the hurricanes of the past week and just want to acknowledge that you're important to us and that our company stands by to help you get through the difficult times. So, please raise your hand. We'll help where we can. And we wish you and your families nothing but the very best. That concludes today's call. I want to thank everyone listening for your time and your interest in Donaldson Company. Goodbye.

This concludes today's conference call. Thank you for participating You may now disconnect.