Good morning. My name is Emma, and I will be your conference operator today. At this time, I would like to welcome everyone to the Donaldson Company, Inc. Third Quarter 2023 Earnings Conference Call. . Sarika Dhadwal, Senior Director of Investor Relations, you may begin your conference.

Good morning. Thank you for joining Donaldson's Third Quarter Fiscal 2023 Earnings Conference Call. With me today are Tod Carpenter, Chairman, CEO and President; and Scott Robinson, Chief Financial Officer. This morning, Tod and Scott will provide a summary of our third quarter performance and an update on our outlook for fiscal 2023. During today's call, we will discuss non-GAAP or adjusted results. 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. Please go ahead.

Thanks, Sarika. Good morning. Third quarter was another record quarter for Donaldson Company. We continued the trends seen in the first half of this fiscal year. Compared with prior year, we grew our top line to a quarterly record, expanded both gross and operating margins over 100 basis points, delivered double-digit earnings growth and produce cash conversion of approximately 105%. Before diving deeper into the quarterly results, I would like to express how pleased we were to have so many of you participate either in person or virtually at our Investors Day in April. It was a big day for our company, and I will recap some key takeaways. We demonstrated our leadership position and strategy across all 3 segments that together drives our expectation to achieve sales of approximately $4 billion and operating margins in the 16% range by fiscal 2026. More specifically, I would like to highlight our new Life Sciences segment where there are significant compelling opportunities driven by organic and inorganic investments, including the recent acquisitions of Solaris, Purilogics and Isolere Bio. These businesses combined with Donaldson's technologies and expertise provide a portfolio of opportunities across several end markets such as food and beverage, alternative proteins, bioprocessing and medical devices. Focusing in on bioprocessing, for example, we see game-changing opportunities to support the development of vaccine and advanced cell and gene therapies with our newly acquired technologies. Traditional chromatography systems are slow and not optimized for larger molecules such as mRNA and plasmid DNA. Purilogics' innovative technology provides faster flow rates and what's less stress on cells and Isolere Bio allows us to introduce breakthrough technology that provides purification and solutions with no size limitations. Together, and combined with Donaldson's capabilities, we are at the cusp of driving scale across vaccine and cell and gene therapies…

Thanks, Tod. Good morning, everyone. Third quarter results reflect another solid quarter for Donaldson in which our employees delivered for our customers and planted seeds for future profitable growth, laying the groundwork for achieving our longer-term financial and strategic objectives. I thank our employees around the globe for their daily contributions. I will provide color on our outlook for the balance of the year in a few minutes, but first, we'll give more details on the results this quarter. To summarize, sales grew 3% versus 2022. Operating income was up 12% and EPS of $0.76 increased 14% year-over-year. Gross margin was 33.0%, a 150 basis point improvement versus prior year. Similar to the first half of the year, this quarter, we saw benefits from our pricing and the stabilization of input cost inflation. Gross margin was down sequentially as expected due to an unseasonably strong second quarter, driven in part by inventory valuation and the timing of deflation. Overall, third quarter gross margin results were consistent with our internal expectations. Operating expenses as a percentage of sales were 18.8%, slightly above 18.5% a year ago. The deleveraging of operating expenses in the quarter was due to an increase in Life Sciences, investments and post Covid hiring. Operating margin was 14.2%, up 120 basis points versus prior year, driven by gross margin improvement. In line with my comments on gross margin, operating margin was down sequentially due to an unseasonably high second quarter. Now I'll discuss segment profitability. Mobile Solutions pretax profit margin was 15%, up 70 basis points year-over-year and Industrial Solutions pretax profit margin was 18.8%, up 390 basis points from the prior year. Gross margin expansion was a key driver in both of these segments. On the Life Sciences side, pretax profit margin was 0.3% versus 20.6% a…

Thanks, Scott. As we close out another record quarter, I want to thank my Donaldson colleagues around the globe for their dedication and hard work. With this outstanding team in place, the future is bright, and I'm excited about what lies ahead for our company. I spoke earlier about some of the game-changing opportunities we are pursuing in our Life Sciences segment. We are also investing in pursuing growth in our Mobile Solutions and Industrial Solutions segments. For example, in Mobile, we are making progress on building our portfolio of alternative power solutions. And in Industrial, we are pushing ahead with our goal of increasing our Industrial Services business by leveraging our connected solutions offerings. Underpinning all of our future growth initiatives is Donaldson's commitment to our people, customers and communities through our purpose of advancing filtration for a cleaner world. To that end, coinciding with our Investors Day in April, we published our 2022 Sustainability Report in which we outlined 2030 ESG ambitions. In summary, by fiscal 2030, we are targeting an absolute reduction of Scope 1 and 2 greenhouse gas emissions by 42% from fiscal 2021 baseline. We expect to reach 35% in terms of women and global leadership positions, starting from a January 2023 baseline. And we plan to increase charitable giving through the Donaldson Foundation by 25% every 4 years, giving cumulatively at least $13.5 million starting from fiscal year 2022. In closing, we look forward to reporting on the progress we are making towards all of our key strategic initiatives and longer-term financial goals in the future. Now I'll turn the call back to the operator to open the line for questions.

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

Good morning, everyone. Maybe we could just start with a bit more color on gross margins. Obviously, you guys talked about 2Q being unseasonably high, but gross margin is a bit lower than maybe I would have expected here with price catching up to cost. So maybe you could talk about the inputs there? I mean I assume this drives higher gross margin, so it's probably a headwind there. Just where we could -- where you think once we see all the normalization of price cost and the headwinds out of Disk Drives maybe, what you're thinking about for gross margins at a normalized level?

Nathan, this is Scott. So yes, we've had kind of an interesting run of gross margins. The first quarter was 33.9%, second quarter 34.5% and then the third quarter came in at 33%. As you remember, we said at the end of the second quarter, we expected third quarter to be down and it was. And there continues to be a lot of things going on in our income statement with inflation and inventory costing and the pretty significant reduction in inventories that we took this quarter along with a decline in Disk Drive sales. So there's really a lot in the soup there, but we landed at 33%. We expect fourth quarter to certainly be up from third quarter as things normalize and hopefully in our price cost situation for the whole world starts to kind of slow down and balance out a bit. So it was a little bit tougher quarter on gross margin. We expected it to come down and it did. We expect fourth quarter to be up, so that's kind of a high-level summary for you.

So we're going to get maybe between 33.5% and 34% for the full year. If I go back a few years, I know you had some capacity issues back in like '19 and '20 and obviously, COVID created a lot of noise. We're kind of in the 34% to 35% range before that. Is that a reasonable expectation for what the business should be running at for gross margins?

Yes, Nathan, this is Tod. Yes, it is. And the 1 new variable that we have coming in there is obviously all of the investments that we're putting into the Life Sciences activities, which will give us a little bit of a mix pressures, but we would believe still 34% to 35% is reasonable and where we expect to land.

And maybe just 1 more on those investments in Life Sciences. Can you talk about the magnitude of those, the duration of those? I mean I would assume that those are likely to continue to step up year-on-year as we go forward as you continue to invest in those businesses. I mean, like you said, we're not even at -- them generating any revenue yet, so is there an expectation that this is an investment cycle that lasts a few years here?

Yes, Nathan, so the way we look at this thing so far, it's actually evolving as we would have expected. We believe that we're going to give you a bit more information here when we guide full year in about 90 days. But we would expect, clearly, as we see through the balance of this fiscal year for it to be all in the investment column for the balance -- fiscal -- for the balance of this calendar year, it will be all in the investment column, but we'll come out with more detail here when we full year guide.

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

I was wondering if you could just start by elaborating a little bit on the timing. This issue, the timing of the bioprocessing equipment and when does it ship? When was it expected to ship, et cetera?

Yes. Brian, this is Tod. So 3 components, right? Solaris is already revenue generating, it's project-based. That is the project type of activities that could go from quarter-to-quarter based upon when customers are ready to take shipments, and so we're actually on plan to meet what was in the full year guide for Solaris' activities and shipments this year, will again guide next year here in about 90 days. But then when you look at the other 2, Isolere Bio and Purilogics, that's revenue generating ahead of us that their revenue today is 0. And so that -- we're planting solid seeds for future growth with both of those activities in both of those businesses, so that's future revenue. We'll give you a little bit more color here next year or when we report next fiscal, but certainly, we would expect that to be more headwinds for the balance of this calendar year.

Okay. All right. And then in the Disk Drive business, if the analyst meeting that you had recently, I was -- I guess, under the impression that headwind in this fiscal year, but normalizing and maybe, I don't know, I guess I got the impression, at least be stable in the next fiscal year, is that a growth business do you think going forward? Or is it stable? And then the whole segment starts to grow when we get the Life Sciences, the newer Life Sciences pieces growing?

We believe that we're stabilizing now flattening, if you will. It's been a very difficult run for that business, almost cut in half within this fiscal year. For example, we have taken the necessary cost actions to support the current levels of that business. We're flattening at this point in time. We think we'll start to crawl forward or get slight lift for the balance of this calendar year, so it will turn into a slight growth business looking forward.

And then just lastly, I missed it. What did you say about food and beverage in the most recent period? How did that business do specifically?

Yes. Food and beverage did really strong again, continues to do quite well in the portfolio. And at this point in time, we're up in local currency, low double digits in the quarter and continuing to expand and really are very happy with our performance.

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

This is Dan Rizzo on for Laurence. Just with in regards to China, just given everything that's kind of occurred and is occurring, have your expectations for the region been kind of, I don't know, have they diminished at all as we look in the next 2 to 3 quarters, just given the, I guess, the lack of a strong rebound as of yet?

Not at all. Actually, when you look at China and the opportunity for the company long term, it remains very strong. We continue to win national based programs, which will continue to gain share within region. I just want to remind everyone that we are in China to support China. We are not a China-based exporter, for example, it's China to support China-based customers, largely nationally now with technologies such as PowerCore. And the thing that's a bit muted is with China is just simply the economic recovery, obviously, and so we're experiencing that. But even given the careful outlook on China's based economy, we continue to win programs, which gives us confidence in the long-term direction of China.

Okay. And then 1 of the things you mentioned, I think, was labor cost being up. Well, that's except understandable, but you also mentioned more hiring. I was wondering if it's hard to find people now still given what we're reading with labor tightness and if you are going to be doing some significantly more hiring over the next couple of quarters or years or whatever?

So within our manufacturing base, if you will, it's a little bit different by region. I would say that within the U.S., it's certainly improved, but not great, not pre-COVID based levels, but certainly improved. Within Europe, it's fine. Asia, it's fine. Latin America, it's strong. So really, the headwinds really and the concerns, if anything, are U.S.-based. Within salary-based positions, little bit more careful everywhere actually. People are just being careful to come on board. We do expect to be able to support the expansions that we have of the strategic plans that we have. So we have to work a little bit harder in order to get there, but we're pretty pleased with our progress.

Okay. And then final question. On the free cash flow conversion, can you just remind us what the long-term target is? I know it was elevated because of all the fluctuations, but what should we think about as we model out over the next couple of years?

Yes. So we've had kind of unusual cash conversion as I'm sure you've seen, right? So we took inventories up by $100 million during COVID to help fight the supply chain and make sure we were living up to our commitments to our customers, and then we got into this year we said we were going to take that $100 million out. As of the third quarter, our inventory has gone from $502 million down to $449 million, so we've made good progress there, and you're starting to see that flow through our cash conversion this year. And if you go to Page, I guess, 99 or the -- my slides in the investor deck, we said that our longer-term average was about 85% on cash flow conversion.

Your next question comes from the line of Rob Mason with Baird.

Tod, when you were commenting on the Mobile Solutions business, Aftermarket, you talked about the OE dealer channel bringing inventory down to normal levels. Is that action -- is that activity destocking activity complete here in the third quarter? And then I'm also just curious what kind of impact that had on the third quarter Aftermarket business as well.

So what you see across the OE channel in Mobile Solutions aftermarket, specifically to OE is a step down in the third quarter. So think in terms of certainly teens level being pulled out in the quarter, whereas on an independent channel, you would see that we have growth at the revenue level, so call it low to mid-single digits growth on the independent. Now that means of volume on the independent is slightly down based upon pricing, so you'll see a little bit of a pullback there. That would be the behavior that we would have expected because they were never able to actually get their stock levels up to where we would have expected them to and the OEs kind of won out, so the OEs are pulling it back down. We would expect that to kind of normalize here as we get through the summer, but the independent channel, we feel is that pull-through level is pretty comfortable at this point.

That's helpful. And just -- I'm doing some quick back of the math -- back of the envelope math here, but it looks like for the First-fit Mobile business in the fourth quarter, the revenue would decelerate sequentially, and I just wanted to check that. And if that's the case, is that a function of just normal seasonality? Or were there some catch-up shipments in the third quarter?

Yes. So actually, we would see it just kind of be a normal seasonality type of activity for us. Very comfortable with the First-fit side of production at this point based upon what we're seeing in backlogs, et cetera. The first it continues to do quite well. We're happy with it. And that's across all end markets, construction, ag, mining, first-fit on the over-the-road trucks. It was the aftermarket that kind of came in a little bit more on the pull back to the OE side this quarter than we would have expected.

Sure. And then just finally, a larger question around price. You did take up your price expectations for the full year. I'm just curious what were the main drivers behind that increase? And then how do you think about pricing going forward from here to the extent that you noted raw material prices have kind of normalized, but to the extent labor is still a pressure, your ability to offset the labor impact if needed?

Maybe I'll let Scott start here with the first part of the question, then I'll jump in for additional color on the second half.

Yes, Rob, this is Scott. So we did take our guide for price up 2%. I mean part of that is just a refinement of our calculation and our estimate for the year. Part of that is related to the labor comments Tod previously made. And we got to continue to make sure we manage our price and cost, and we're going to continue to adjust prices for the next 10 years. If our costs are going up, we have to be compensated for that in the market, and we're going to pass those prices on. So a 2% increase is within a normal range for us, I would say. But we continue to push price where appropriate and we're going to continue to drive those increases into the market to just make sure we have a reasonable commercial relationship with our customers and that we treat our suppliers properly.

Yes. So I would say that we've returned to a more normal behaving price activity across the company in all regions of the world. However, I also want to say that we remain very committed to price cost recovery, and so we keep an eye on it, which means we would take an out-of-cycle action should that be necessary.

This concludes our Q&A session for today. I now turn the call back to Tod Carpenter for closing remarks.

That concludes the call today. Thanks to everyone who participated, and I look forward to reporting our fourth quarter results in late August. Have a great rest of the week. Goodbye.

This concludes today's call. You may now disconnect.