Donaldson Co Inc DCI
Q2 2013 Earnings Call Transcript
Transcript Call Date 02/25/2013

Operator: Good morning ladies and gentlemen, thank you for standing by. Welcome to the Donaldson Q2 Earnings Conference Call Webcast. At this time all participants are in a listen-only mode. Following the presentation we will conduct a question-and-answer session and instructions will be provided at that time.

I would like to remind everyone that this conference call is being recorded today, Monday February 25, 2013 at 9.00 am Central Time.

I will now turn the conference over to Mr. Rich Sheffer, Assistant Treasurer and Director of IR. Please go ahead sir.

Richard Sheffer - IR: Thank you, Ron and welcome to Donaldson's fiscal 2013 second quarter earnings conference call and webcast. Following this brief introduction, Bill Cook, our Chairman, President and CEO and Jim Shaw, our Vice President and CFO will review our second quarter earnings and our updated outlook for fiscal '13.

Next, I need to review our Safe Harbor statement with you. Any statements in this call regarding our business that are not historical facts are forward-looking statements, and our future results could differ materially from the forward-looking statements made today. Our actual results may be affected by many important factors, including risks and uncertainties identified in our press release and in our SEC filings.

Now, I'd like to turn the call over to Bill Cook. Bill?

William M. Cook - Chairman, President and CEO: Thanks, Rich, and good morning, everyone. Those of you who have followed our company know that we've been focused on building a diversified portfolio of global filtration businesses over the past 25 years. During our second quarter, this diversified portfolio worked again to our advantage as our Gas Turbine product sales increased 79%, offsetting decreases in our Engine Product businesses and helping to deliver an overall 3% increase in company sales during the quarter.

And I'd like to take a few minutes to review the sales trends within each of our reporting segments starting first with Engine Products. Except for agricultural equipment markets, where conditions for large farm equipment remained strong, our other engine OEM end markets had a slower quarter. Many of our OEM customers cut back their production levels to reflect the drop-off in end-user demand for equipment and also to reduce their own finished equipment inventory levels. Among those end markets that had notable decreases were North American and Asian heavy truck and the global construction and mining equipment markets.

While recent economic report suggests that conditions are starting to improve in some of these end markets, many of our customers have recently reported that they're still working to reduce their finished equipment inventories. Therefore, we now believe it will take several months for our customer's production rates to improve enough for our businesses serving these end markets to post year-over-year growth. We did however see better conditions in our Engine Aftermarket where we supply replacement filters and mufflers through both our OEM and independent channels. Our Engine Aftermarket businesses in North America, Latin America and Asia all grew at least 4% in the quarter. Only our European aftermarket business was down year-over-year.

Now, I'll switch to our Engine Products segment. As I have already noted, the outstanding quarter of Gas Turbine, which had sales of $66 million, up 79% from the same quarter last year and up 40% sequentially from our first quarter. I'm also pleased to note that during the quarter we shipped our largest gas turbine order ever worth about $22 million consisting of 11 systems to be installed to support power generation in Karaia, Saudi Arabia.

In our Industrial Filtration Solutions business sales were flat as sales increases in North America were offset by decreases in Europe and Asia, and in our special application products sales of our disk drive filers increased 8% in the quarter. However to be fair, I should note that our second quarter last year was impacted by the floods in Thailand, in addition our integrated (welding) filter business increased sales 45% in the quarter.

We also had a number of countries with very solid year-over-year local currency sales performances including China, South Africa, Mexico, Brazil, Chile and Australia. So there were some pluses and minuses during the quarter, but fortunately enough went right to generate positive overall sales growth. Again, I attribute this to our relentless focus on growth through diversification.

I'll now turn the call over to Jim for his comments on our operations before I discuss our updated outlook for fiscal '13. Jim?

James F. Shaw - VP and CFO: Thanks, Bill and good morning everyone. Our gross margin was 33.4% in the quarter to 34.6% in last year's second quarter. As we noted in our press release the biggest drivers of the decrease in the gross margin were lower fixed cost absorption due to the decrease in production volumes in our plants and the mixed impact of the large gas turbine project shipments.

The lower fixed cost absorption was primarily in our plants which support our engine OEM businesses. As Bill noted earlier conditions were worse than we had initially forecast for the end of the calendar year as our OEM customer plant holiday shutdowns were longer than we expected as customers continue to adjust their production and inventory levels.

This lower fixed cost absorption along with the mix impact generated by the larger number of gas turbine shipments during the quarter combined to lower our gross margin by 280 basis points. We also incurred $500,000 of restructuring costs in gross margin which reduced the gross margin by another 10 basis points in the quarter.

Partially offsetting this was the impact of our continuous improvement initiatives which increased gross margins by 110 basis points. Operating expenses were up slightly in dollars year-over-year, but decreased as a percentage of sales to 21.4% versus 21.7% in last year second quarter. The impact from our ongoing discretionary cost containment initiatives along with the increase in overall sales which helped leverage our fixed operating expenses improved our operating expense as a percentage of sales by 170 basis points.

Our discretionary cost containment actions helped to offset the 120 basis points of increase resulting from higher pension expense, the incremental expenses related to our strategic business systems projects, higher U.S. medical expenses and the $900,000 of restructuring expenses incurred in operating expense.

There is still a lot of uncertainty regarding how long the European economy will remain in recession, the pace and timing of a general industrial recovery in China and the unknown impact from the upcoming potential sequestration in the United States. So we'll continue to aggressively manage our discretionary expense levels in the near-term. We are now planning to take additional targeted restructuring actions in our third quarter to further align our cost structure with our current sales volumes.

We anticipate that these planned actions will be similar in magnitude to those actions taken in our second quarter. We do however plan to continue making strategic operating investments which are critical to helping us achieve our strategic $3 billion and $5 billion sales goals.

As we highlighted in our press release, we are also continuing engineering work and many new programs that we have won with our engine OEM customers that will be going into production in the next 24 months. This work has to be performed now in order to successfully meet our customer launch dates for these programs. We are also continuing to work on our strategic business systems projects. We view these as critically important long-term investments, but they do somewhat limit our ability to cut costs as steeply as we otherwise might to offset the margin pressure from the lower fixed cost absorption in the short-term.

Our operating margin came in at 11.9% this quarter. We expect our operating margin to increase in the second half of our fiscal year due to the combination of less customer holiday shutdowns compared to the first half, a better sales outlook in our second half and the benefits from the cost containment and restructuring actions we have completed. For the full year, we expect our operating margin to be between 13.9% and 14.7%.

Our effective tax rate was 28.3% in the quarter versus 29.6% last year. We had an $800,000 discrete tax benefit during the quarter from the retroactive reinstatement of the research and experimentation credit in the U.S. Based on our projected global mix of earnings in fiscal '13, we forecast a full year tax rate to be between 28% and 30%, the midpoint of the range being in line with fiscal '12s rate.

Our second quarter CapEx came in at $30 million, bringing us to $52 million year-to-date. With the slowdown in many end markets that we've experienced, we have delayed a number of projects that we originally expected to complete during fiscal '13. We now expect to spend between $90 million and $100 million on CapEx this year. About $40 million of this is carryover for fiscal '12 projects that were authorized but not spent prior to last year end and the balance will be selectively spent from fiscal '13's reduced capital budget of $70 million.

The breakdown of this year's CapEx is projected to be approximately 20% related to capacity expansion; 30% for our technology initiatives, which includes our strategic business systems projects; another 25% is for tooling for new products and 25% will be related to cost reduction activities for our continuous improvement initiatives. We expect depreciation and amortization will be between $64 million and $68 million in fiscal '13.

Free cash flow was $15 million this quarter. As mentioned, CapEx was $30 million compared to $18 million in last year second quarter. Working capital was a source of cash this quarter has decreases in accounts receivable and inventory from last quarter generated $19 million of cash, but was partially offset by a decrease in accounts payable. For fiscal '13 we expect full-year cash flow from operating activities to be between $240 million and $270 million. As part of our long-standing share repurchases policy, we repurchased 320,000 shares or 0.2% of our diluted outstanding shares for $10 million. Our debt-to-cap and debt-to-EBITDA ratios are now at 21% and 0.6 respectively, well within the financial covenants of our various credit and note agreements. During the quarter we also completed the renewal of our $250 million revolving credit facility. We expect the interest expense in fiscal '13 to be between $11 million and $13 million and our balance sheet remained strong with $284 million of cash and short term investments.

So with that I'll pass it back to Bill, who will provide additional details on our updated outlook for fiscal '13. Bill?

William M. Cook - Chairman, President and CEO: Thanks Jim. We completed our most recent sales forecast last week incorporated in the latest market data and input from key customers. Unfortunately high levels of uncertainty remain in many of our markets. In addition we're getting significantly less order visibility from our customers than we did a year ago.

The result of all of this is that we've adjusted our total full year sales to be slightly lower than our previous outlook.

This update includes our just completed second quarter which was weaker than we had originally anticipated. In addition we have tampered our growth outlook for the balance of this fiscal year. So in total we now expect our fiscal '13 sales to be approximately equal to the $2.5 billion sales record we achieved last year. Within our engine products segment recent forecast and announcement from our key global equipment OEM customers suggests that their production rates in both the U.S. and Brazil should increase even further over last year strong levels.

However in other equipment categories we have not yet seen signs that our OEM customers production rates for construction and mining equipment or heavy trucks will improve materially before the end of our fiscal year in July.

In our engine aftermarket business, we are expecting a gradual improvement as the utilization rates of existing offroad equipment and on-road heavy truck fleets continues to improve.

In summary we now expect full year sales in our engine product segment to be slightly lower year-over-year.

Now switching to Industrial Products, our Gas Turbine sales for the full year are now expected to be up 27% to 32% over the last year. We have much longer lead times in this business than we have in any of our others businesses, so most of what we're forecasting is already in our open order backlog. Within Gas Turbine we're expecting very strong third quarter shipments and forecasting that our fourth quarter sales should be similar to what we reported in our first quarter.

Our global Industrial Filtration Solution sales are now expected to be slightly lower year-over-year. While we are continuing to see positive manufacturing indicators in the U.S., we have yet to see signs of a pickup in Europe. But based on what we are now seeing in the market we do expect some further improvement in China. Finally, in our special application products we are forecasting sales to decrease 1% to 6% as the now weaker end market for disk drive filters is expected to only partially be offset by the growth in venting filters and membrane products. So in total, based on the strength of Gas Turbines our full year Industrial Product sales are forecast to increase 2% to 7% for the full year.

As we look around the world to the regions we expect most of Europe to remain in the recession for the balance of our fiscal year. As I just noted recent economic reports from China have been encouraging with reports of solely improving end market conditions. An improvement in China will also help our businesses in Japan and South Korea, which support many equipment OEMs who export to China.

In the U.S., the continuing uncertainty post the fiscal cliff issue now with the looming sequestration issue on Friday has dampened the investment in many end markets. We hope for a speedy resolution of this issue along with the debt ceiling issue behind it. If these levels of uncertainty are reduced, businesses will be better able to make investment decisions which will drive the demand for our customers equipment and obviously then for our filtration systems.

Bottom line given the high levels of uncertainty in all three major regions of the world we will continue to closely monitor conditions. So that we can quickly respond if conditions begin to recover faster than we are currently forecasting or conversely if conditions remain week, we will expand our cost saving actions to further adjust our structure to our actual business levels.

Now I'd like to switch gears. As Jim mentioned fortunately we have many new programs that we've won with our OEM customers that will be going into production over the next two years.

In order to support their platform launches. We have to do the design and engineering work now to meet our commitments. We are also continuing to work on our strategic business systems project. We received approval from our Board last July for this four year project and work is well underway. This investment will enable us to utilize standard systems and processes globally to provide an effective foundation for the achievement of both our short and long-term strategic plan objectives.

Since both of these investments around the engineering work for our customers platforms and our strategic business systems are directly related to supporting our long-term growth objectives. We are continuing work on both despite the current economic conditions.

Now as I've discussed in previous calls we still have significant market share opportunities in the faster growing emerging economies.

So we're continuing to add sales resources, distribution capabilities and distributors and OEM customers in these regions. For example in our engineering aftermarket we added 130 now distributors and nearly 650 new part numbers to our product offering in the last quarter.

We also continue to add to our own distribution capabilities. In December we completed the expansion of our existing distribution center in Aguascalientes, Mexico. This most recent expansion doubles the distribution capacity for our Latin American customers.

Another key item benefiting us is the ever increasing number of systems in the field installed with our innovative filter systems. Those of you who have followed Donaldson know that we have a very unique position in most of the markets we serve since we are the leader in providing the first-fit air filtration systems to our OEM customers. So we have a great opportunity to use our new technologies for these first-fit applications which will help our OEM customers and us retain a much higher percentage of the replacement filter sales in the future.

Within our company, we focus on continually developing breakthrough filtration technologies for our customers. We then use the combination of these innovative filtration technologies and our internal engineering capabilities to design first-fit systems that provide both better value and performance as well as help retain our customer's replacement filters business.

We have a number of different unique designs and breakthrough technologies that we are now using to accomplish these objectives. We estimate that about 30% of the first-fit air filtration systems we are currently manufacturing for our customers are already in this category, and most of the new programs we are currently working on will be with new technology.

One of these technologies that we specifically highlighted is PowerCore. It is a great example of how we invest centrally into our R&D and then leverage our new technology into as many applications and businesses as possible. We are now very successfully using PowerCore in both our Engine and Industrial segments. Our Engine PowerCore sales in our second quarter were $29 million, up 13% over last year, and within that, sales of PowerCore replacement filters were up 28%. On the Industrial side of our business, we sold another 400 Torit PowerCore dust collection systems and doubled our Torit PowerCore replacement filter sales. In total, Torit PowerCore sales increased 22% from last year's second quarter. So in total, our company's PowerCore sales totaled $34 million in the quarter, up approximately 14% over last year.

Now to quickly summarize before we turn it over to Q&A, we do continue to face a more challenging global environment than we had anticipated last summer. We do have a detailed game plan which will allow us to successfully lead our Company through these challenges. We're also taking advantage of the growth opportunities we still see. We will continue to invest in our Company for the future, both to support our growth opportunities as well as add the necessary infrastructure for the long-term. We will continue to utilize, grow and expand our global diversified portfolio of our filtration businesses and system proven over time to be the right business model for our Company and our shareholders. We are expecting this diversified portfolio to deliver full year sales consistent with last year's record of $2.5 billion, and EPS of between $1.61 and $1.81.

Ron, this concludes our prepared comments. Now we'd like to open it up to Q&A.

Transcript Call Date 02/25/2013

Operator: Hamzah Mazari, Credit Suisse

Hamzah Mazari - Credit Suisse: The first question is just on – if you could just remind us what the priority is on other strategic investment spend other than the engineering and design work and business system work that you are doing and how you are thinking about capacity expansion in light of current demand and maybe give us a sense of how dilutive the investment spend is as well?

James F. Shaw - VP and CFO: In terms of the other strategic priorities we're focused on, it's really been similar to the focus we've had over the last couple of years in a couple of key areas. One would be continued development of liquid product, so we're very focused on expanding our breadth of both replacement parts and new first-fit solutions on the liquid side. So we're continuing full speed ahead in terms of that investment. I think the other key one is on our Asia Pacific development. We see a lot of opportunities longer term in China, India all of the emerging markets in Asia Pacific and we're continuing to develop our infrastructure to make sure that we can support that growth and when that comes back be ready to take advantage of that. So I think those would be the two probably big strategic investments. We're continuing to also invest on our industrial businesses in terms of growing some of the ancillary type businesses like the expansion of our Special Applications to other areas. So, we are continuing to make those investments. I think where we've scaled back a little more is on the capacity type investment. So we have previously announced a second campus in China. We are continuing to move forward with that, but at a much slower pace, so we've delayed the timing because we are not going to need that capacity quite as quickly as we had anticipated and we're also making similar decisions on other capacity related investments where at the start of the year we had intended to make some – we're still continuing to make certain of those in terms of key investments like our PowerCore production and the like, but some of the other strictly capacity expansions we've dialed back.

William M. Cook - Chairman, President and CEO: Hamzah, this is Bill. I'll add on to what Jim mentioned. So the example of where we'd continue would be the distribution center expansion that I mentioned in Mexico that we completed in December. We know we need that and we were at a capacity and so we went ahead with that as we looked at things over the last six months. And as Jim mentioned, in other investments, say the second campus in China, we know that for the long term, we are going to need it, but we just don't need as quickly as we thought a year ago, so we are slowing some of them down to sort of match the current business conditions.

Hamzah Mazari - Credit Suisse: Any sense of how dilutive the investment spend is to your margin profile right now?

James F. Shaw - VP and CFO: There's a lot of different categories there that are sort of hard to quantify each of them, but I would say heading into the year, we were probably looking at $5 million a quarter type expansion, growth just in terms of infrastructure, we've dialed that back now, so it's somewhat less than that, but I don't have a great answer for you on each particular one of those.

Hamzah Mazari - Credit Suisse: Then, just last question on – what are you seeing in the M&A landscape? You haven't done a deal in a while. Have multiples come down given the current demand environment or are you just more focused organically to grow currently?

William M. Cook - Chairman, President and CEO: Hamzah, Bill here. Good question. As we've talked about in the past, we're mostly in organic growth story. We want to get like 75% of our revenue growth organically and that's lot of the things that Jim and I talked about new products, new technologies, new distribution, new distributors et cetera. But we do look at acquisitions is adding maybe about, on average about 2% of revenue growth per year. We have a dedicated team that's looking at acquisitions and they continue to work very, very aggressively. We have been (standard) over the last couple of years in terms of the multiples because of the financial targets that we have – that we haven't been able to go or some of the deals were went, but we are patient and we continue to primarily work on smaller deals that are bolt-on to things that we already do. So, we're working on it on an ongoing basis, but we are patient.

Operator: Eli Lustgarten, Longbow Securities

Eli Lustgarten - Longbow Securities: Ken, can you give us a little bit more color on recurring conditions that you are saying? I mean, you mentioned big ag was doing fine, but how weak is mining at this point? We are getting a lot of concern not only a mining weakness in 2013 but it will effect it's spilling into '14 and also in construction in truck, I mean, are they looking – truck is probably going to be down for the year but construction was like relatively flat. Can you give us some color how to look at it as we go forward particularly in the second half of the year into next year?

William M. Cook - Chairman, President and CEO: Eli, Bill here. I think one thing – going back over our last quarter call and looking at the question you asked, I think you were probably more right with your question that the inventory reduction was going to be more severe than we heard from our customers. I think as Jim mentioned we saw – we did see a lot of inventory drawdown in the fourth calendar quarter, but then we've seen that continuing and not just in China where we probably have been expecting but I think more in general it sort of carried over more than we thought. We do – as we said in our prepared comments we see our OEM customers, and again this is construction and mining. I mean, ag market is strong. The construction and mining and heavy truck that there's a continued focus by our customers to try and balance their production with their needs to continue to drawdown in some cases inventory and then with the weaker end market demand and we see that probably continuing or not materially improving I should say before the end of our fiscal year. So it's more of a second half of calendar year '13 that we see though it's starting to come back and that’s based on what we are hearing from our customers now.

Eli Lustgarten - Longbow Securities: That includes mining, looks like a little bit better in in the second half. I mean, that’s what I am most concerned about?

William M. Cook - Chairman, President and CEO: I had given you sort of a generic statement. I think if you talk about may be large mining trucks and we probably read some of the same things that maybe that one takes a little bit longer, but as a general statement we're seeing that most of those end markets should start recovering. The inventory reduction should be behind them and then the market demand should start picking up in the second half of calendar '13 that’s our assumption.

Eli Lustgarten - Longbow Securities: Can you give us some idea with the new platforms and technologies you won for the next couple of years, what the magnitude of revenue we might see as we go into '14 and '15 from these I mean what kind of incremental top line can we get from these projects?

William M. Cook - Chairman, President and CEO: It's really part of our targets getting to 8% to 10% revenue growth and it really supports the 75% that I was mentioning a minute ago that we look to get organically. So those are – that’s all part of the share gains that we've historically talked about these new platforms and a bigger percentage of retention in the aftermarket. So it's included in our overall growth objectives, which I'll note are 2x what we expect GDP to do at share.

Eli Lustgarten - Longbow Securities: So we're really talking about 4%, 5%, coming from these new projects?

William M. Cook - Chairman, President and CEO: 4% or 5% is what we typically estimate that we get from share between 2% and 4% per year.

Eli Lustgarten - Longbow Securities: Another question, Gas Turbine is extremely strong and you've had – you finally getting out the shipment and you talked about a strong third quarter back off a bit in the fourth quarter. How's the order fill in the Gas Turbine business, are we able to sustain the current production levels to go into '14 or is it some uncertainty as to which way that business goes?

William M. Cook - Chairman, President and CEO: Eli, Bill again. I'd say right now that there's a question over sort of the – as we get into '14 about how strong it's going to be, and I think that's going to be firmed up here in the next month. Some of the OEMs are sort of talking about maybe a pause in the market, not a retrenchment but sort of a pause. But we're not going to get fiscal '14 guidance yet, but we're looking out there now and trying to figure out where the order backlog and how it's going to fill in. But we can see through the end of our fiscal year and we feel confident in our guidance for that.

Eli Lustgarten - Longbow Securities: One final question on profitability. I mean, you sort of indicated better profitability in the second half. I mean, material costs should be helping you to some degree, I mean, what's going in pricing and just better internal improvement should be what's driving the better bottom line next few quarters?

James F. Shaw - VP and CFO: Yeah. Eli, its Jim. It's primarily – the second half being a little bit stronger in terms of just historically without the holidays, better absorption and we are forecasting bit of a pick-up compared to the first half in terms of our sales. So, commodities aren't necessarily a headwind, but we do have indexing arrangements that we share. So with our OEs, that's neutral, but the biggest impact in terms of the improvement is just better leveraging the fixed cost.

Operator: Laurence Alexander, Jeffries.

Laurence Alexander - Jeffries: Two questions. First, on the comment about the Chinese pickup in the back half, are you seeing that in your order trends or is that more of the top-down assessment? Secondly, as you think about the new product wins, are they going to have any impacts on your incremental margins in a recovery or how should we think about sort of the dynamics this time around compared with the last downturn?

William M. Cook - Chairman, President and CEO: I'll start with the second question first. This is Bill. I think in terms of over time, as we continue to increase the proportion of our business that's replacement filters, that's going to help our margin, because as we've talked about in the past our operating margin on replacement filters is better than it is on the first-fit systems primarily because we've already made the investments in the technology which the first-fit systems carries. So, as the mix shifts more towards replacement filters, our profitability will gradually improve. I think these new systems that Jim talked about are going to help us because using the proprietary technology that I mentioned we're going to retain more of the aftermarket. So that's going to help us grow the first-fit, but also increase the percentage of our total business that's replacement filter. Back on your China question, we had a good quarter in China. I mean, if you takeout the Gas Turbine business our China sales were up 19%. So, it wasn't – it's not bad, it just wasn't what we were planning that as we started the year and it's not for a long-term growth strategy or objectives, but it was a good quarter. We have seen in most of the end markets a pickup or some signs of a pickup above that level is going to continue, I think the one that is probably the exception would be probably construction equipment and we've seen from major customers, use carriers as an example, that they are still trying to take down inventories – finished equipment in China, and they're not alone. So, we think the construction part of that market is going to take longer to recover, but eventually it will.

Operator: Kevin Maczka, BB&T Capital Markets.

Kevin Maczka - BB&T Capital Markets: Bill or Jim I guess a question on margins I just wanted to get a little more color in terms of your confidence level in your margin outlook. I understand why the second half margins ought to be better than the first with better volumes and absorption and less holidays. But it looks like you are implying they are considerably year-over-year as well. So with flat revenues and this additional growth spending can you just give a little more comment there around that issue.

James F. Shaw - VP and CFO: The struggle we've had the first and second quarter is that we went into the quarter assuming one level of demand and saw something different. So we've been adjusting both our production headcount levels as well as some of our other discretionary type manufacturing expenses and we've been very aggressive with that throughout the quarter, second quarter. But we don't see the full impact of that in the quarter. So I think that's one thing that we'll see now going forward from a second quarter and third quarter standpoint as we've been in the process of making sure the organization is aligned with this level of sales and if we get pleasantly surprised with better demand we'll adjust to that, but we're planning for a similar type demand to slightly up than what we've been seeing. So I think that's the biggest factor in terms of just the discretionary spending the control as well as assessing our headcount in the regions around the world to make sure that we can deliver a little better performance here than we did in the first two quarters.

Kevin Maczka - BB&T Capital Markets: Okay, 110 basis points on continuous improvement in the second quarter seem like a pretty impressive result is that something that actually accelerates going forward based again on some of these discretionary spending cuts that you have done, haven’t been fully realized yet.

James F. Shaw - VP and CFO: I would say that one is a pretty consistent measure that we are focused on in both good times and bad, if you look back we probably averaged somewhere between 80 basis points to 120 basis points a quarter. So that’s more long term projects where it's really institutionalized in the company both in terms of process improvement. Some of the capital we spend is designed to reduce the labor and places where it makes sense. So I wouldn’t say we anticipate that one accelerating, that’s more of a constant.

Kevin Maczka - BB&T Capital Markets: Then finally for me just to piggyback on the gas turbine comment. I think at one point based on your shipment timing you are planning for a very big Q2 and Q3 but possibly as much as a 30% decline in Q4 just based on timing. Now the cycle rolling over, is that still generally the expectation?

William M. Cook - Chairman, President and CEO: The gas turbine business is lumpy and these are big projects I mentioned the big project we shipped out this quarter. So we are looking at the fourth quarter being similar to the first quarter and that’s all about timing.

Operator: Charles Brady, BMO Capital Markets.

Charles Brady - BMO Capital Markets: You've talked about it little bit, but I just want to make sure I understand can you give us what kind of plant utilization you guys are running kind of currently in the quarter and where you see that picking up into the back half. Then just on the capacity expansions you talked about part of your CapEx I am just trying to understand where are you putting out more capacity kind of given your outlook in lot of your end markets?

James F. Shaw - VP and CFO: This is Jim. I'll start with kind of our current capacity. Where we've been running really through first and second quarter is probably in the mid-60s in terms of our capacity. So, looking back few years ago at the prerecession levels, we were probably in the 80 plus kind of capacity levels. So, we're clearly lower than we'd like to be in terms of capacity, and one of the things to keep in mind is, the one product we generally use third-party subcontractors for is our Gas Turbine business. So, well that business has been real busy, it hasn't necessarily driven a lot of volume through our plants.

William M. Cook - Chairman, President and CEO: Then, Charlie, this is Bill. Just sort of expanding looking forward in terms of where we're – how we're thinking about capacity for the future. We – if I back up and say maybe for a minute, we take a look at our manufacturing capacity by major regions, so the Americas, Asia-Pacific and Europe and what we try and do in each one of those is to have the capacity there to serve the customers in that region. So it's a regional manufacturing strategy driven really around providing excellent customer service and managing our logistics cost. So, within each of those regions we are trying to get a balance of a low-cost manufacturing, and in addition to that, distribution capacity for the aftermarket. So, as I mentioned in prepared remarks, we added a distribution capacity in Mexico for Latin America, we were at a capacity, so that was an easy one to do. Some of the other projects, as Jim mentioned earlier that we had planned around manufacturing capacity, say for example our second campus in China, we are delaying that or slowing that one down, because while we know we need it long-term, we don't need it as quickly as we planned a year ago, so we're managing those by slowing things down and then not adding new projects to the list yet until we use – get back to the capacity utilization levels that we target that Jim mentioned.

Charles Brady - BMO Capital Markets: Then just on the Special Applications business, the guidance for this year now a minus 1 to a minus 6, that's a pretty sharp turnabout from prior guidance of plus 1 to plus 7. I'm assuming it's all in the disk drive side of the space, but can you just maybe give us a little more color on what's really – where you are seeing a sharp turnaround on disk drive business and how much has that really turned around given that the membranes business is probably not doing as badly?

William M. Cook - Chairman, President and CEO: Charlie, Bill again. I think as we talked in the past that the disk drive market is still a very good market for us and we have a very strong leading position in it. But what we're seeing is that the double-digit growth rates that we enjoy for – the market enjoyed for many years are now in the single mid or even lower single-digits. So this what we're seeing now is adjustments in that market related to a couple of things, one is the emergence of the tablet devices, which use Flash and not hard drives where our filters are used and that's being partially offset by the growth in terms of the amount of storage that needs to be stored somewhere whether it's in the cloud or wherever and that uses hard drives, but it's not – it's probably not a 1 for 1 tradeoff and so that tablets are eating into that and slowing down the rate in the overall hard drive market growth. I think we're also seeing at least in the short-term and this is probably the bigger reason for the change in our guidance is just in terms of capital spending and concerns about people buying computers that's down. So that would be, I would say the biggest change quarter-to-quarter is that reduced capital spending, affecting computer purchases using hard drives.

Richard Sheffer - IR: Just couple of other comments for color. We had expected a very strong second quarter in the disk drive market coming off last year's downturn from the Thailand floods and while we were up a little bit disappointing just based on what was going on in the market with still holding inventory levels down and the investment spend that Bill mentioned. Looking forward we have a very tough comp in the third quarter ahead of us here, when we really saw the rebound from the Thailand floods positively impact this last year was in our third quarter. So that that's looming out in our third quarter that we're facing now.

Operator: Brian Drab, William Blair.

Brian Drab - William Blair: First just maybe a little more detail on China, can you go through at least roughly what your breakdown is between first fit aftermarket on-road, off-road industrial in China in the latest quarter.

William M. Cook - Chairman, President and CEO: So if we look at, if we look at our sales in China in the last quarter. in total our engine business in local currency terms was up about 4% with positive sales in aftermarket, up around 21% while the first fit business was down over 30%, so that’s consistent with Bill's earlier comments. On the industrial side, we had strong results in all three of the industrial businesses there with a rebound in our IFS businesses up about 25%, Special Applications up around 30% and our Gas Turbine business was up between five and six times of the size it was last year, and that's just really due to the lumpiness of the Gas Turbine business.

Brian Drab - William Blair: Could you just roughly give me an idea what the relative proportion – how those businesses – what they accounted for in terms for sales proportionally in the quarter? Just maybe for – just between industrial and engine would be helpful.

James F. Shaw - VP and CFO: Sure. Yeah, engine was around $12 million this last quarter and the industrial business with the big quarter from Gas Turbine was $54 million.

Brian Drab - William Blair: Then, overall, can – I don't know if you commented on this, but can you make any comment on how your gas turbine orders were in the quarter or in recent last six months, just what that trend is?

William M. Cook - Chairman, President and CEO: Brian, Bill here. So, I think Eli had a related question. So, the orders have been good in terms of filling out the second half of our fiscal year. So as I mentioned we have a lot of visibility on that. So we feel very comfortable with the guidance that we have there. It's about now as when we'd start to see what's going to happen in fiscal '14, so we haven't given guidance on that yet, and we're going to be monitoring what the incoming orders are for fiscal '14, so too soon to tell really.

Operator: Brian Sponheimer, Gabelli & Company.

Brian Sponheimer - Gabelli & Company, Inc.: Just wanted to dig a little bit deeper into the aftermarket business, it came off slightly during the quarter but you are still calling that good volumes. Maybe some of the puts and takes in there. Your Off-Road business, what's working, what's taken a bit of a breather and then the On-Road business whether tonnage is sufficient to continue to help you there?

William M. Cook - Chairman, President and CEO: Brian, Bill, I'll start. I think the good news is that a lot of the inventory, maybe not all of it, but a lot it was taken out by our customers in terms of the distribution and our OEDs or OEMs who distribute in the second quarter. So we see less of a headwind from that as we're looking to the third and fourth quarters on both the On-Road and the Off-Road side. Then I think what the other thing that were – the ton miles were up about 1.9% in the fourth calendar quarter, so the quarter ending in December, and the forecast is that that's going to improve from that 1.9 to about 2.7 in 2013 calendar year. So we're looking at – it was pretty good utilization in the quarter. The inventory drawdown was probably mostly behind us on replacement parts in the quarter and then looking forward we're looking at increased utilization as measured by ton miles for On-Road in the third and fourth quarter. So that's why we're – that's all the components of our guidance for the aftermarket.

Brian Sponheimer - Gabelli & Company, Inc.: How far we are away from getting a PowerCore aftermarket developing?

William M. Cook - Chairman, President and CEO: Well, it is Brian. I mean, in my comments I mentioned that how much –that's up. So that's growing faster than really the aftermarket generally by leaps and bounds and I think – but the bigger opportunity, maybe this is your point is around as we're getting more and more of these systems into the field, that 30% that I mentioned of our current first-fit sales that are proprietary on the data, that's going to grow. We are going to continue to put more new technologies in there that will help protect that aftermarket. So as that 30% continues to grow, it's going to be – it's going to help further fuel that aftermarket growth with products like PowerCore.

Richard Sheffer - IR: So Brian, this is Rich. Just for a little additional color there. In the quarter, of the $29 million of PowerCore sales we had in the Engine business, 75% of that was aftermarket.

Operator: Richard Eastman, Robert W. Baird.

Richard Eastman - Robert W. Baird: Bill, just a couple of quick things. On the IFS business, in the quarter, the Americas were up kind of mid-single-digits, Europe down mid-single-digits. Is the difference there – again, its end markets, but is it also a sales mix is more the compressed air business in Europe than the Torit business?

William M. Cook - Chairman, President and CEO: Yes Rick, it is.

Richard Eastman - Robert W. Baird: So from your perspective, is Europe bottoming or is there anything in the order flow there that suggest that Europe is bottoming in IFS?

William M. Cook - Chairman, President and CEO: Well, it's a great question, Rick. I hope you'd give me the answer to that one. We don't yet to be honest. I think the one change from what we talked about last quarter is that we've moderated our outlook for the U.S. IFS business just given the uncertainty that we mentioned. So it's still good, but it's not as good as we saw at the end of our first quarter, and I would say Europe is about the same.

Richard Eastman - Robert W. Baird: In the Torit business within IFS, the PowerCore piece of that -- I know when you've spoken in the past, there was a lot of opportunity in displacing baghouses with the PowerCore filter units, and one of their restraining – maybe restraining elements to the growth there was that there was a fair amount of engineering content that had to go into each one of these opportunities. Has there been progress in standardizing PowerCore for more of those baghouse opportunities?

William M. Cook - Chairman, President and CEO: Good question, Rick. So, what we've done with Torit PowerCore, it is a standard product that's designed for specific end market, so whether it's grain handling, that would be different than say laser cutting, but the product we develop for each of those is a standard product using PowerCore, but it has to be designed – each product family has to be designed specifically for – excuse me, the application. So, what we've been doing is sort of picking them off one by one, targeting an end market, designing the product for it, releasing it, sort of getting it out of the field if we had to do any tweaks to it, then we'll do that, and then we go on to the next one. So we are going down the list of those now, and we've had very good success with it. In some cases, it's replaced existing products that we had, but to your point, in many cases, that's replacing baghouse products that we never had, so in those cases, it's a win both on the first-fit as well as our aftermarket, because it has the same advantage as in the aftermarket that we talk about with engine, with the unique design of the Torit PowerCore, we captured the replacement parts business.

Richard Eastman - Robert W. Baird: So we should be able to see that product line to those applications start to accelerate sales there I guess in a healthier environment, but should perhaps have a bigger impact going forward?

William M. Cook - Chairman, President and CEO: Rich, that is exactly the plan. I think getting them out there and then demonstrating the people what our customers feel what they can do and there's always a little bit of maybe reticence initially that nobody – everybody likes the new technology, but nobody wants to be first. But as we get them out there and people start to see them I think it will start to really accelerate.

Richard Eastman - Robert W. Baird: Then just an FX question for – maybe Rich could jump on this one, but it looks like from our math now FX for the full year will be about neutral, and that's what's now embedded in the sales outlooks?

James F. Shaw - VP and CFO: This is Jim. The FX is pretty much neutral to last year. So, at the rates that we have in the release, it's roughly in the neighborhood of about $10 million headwind is what we have included. So that's favorable in the second half. We're already unfavorable – almost $19 million through the second quarter. So, there's a little bit of a pickup mostly in the fourth quarter this year compared to last.

Richard Eastman - Robert W. Baird: Then just the last question, on the op expense line, Jim what was – is there a number that you can just give us – if we look at fiscal '13 year-over-year for the pension step up and also the ERP spend, just approximate kind of expense headwind for those?

James F. Shaw - VP and CFO: Yes. They're both about the same number of about $6 million each. So the pension just slightly less than $6 million and the ERP depending on how much is in this year versus next is about $5.5 million to $6 million.

Operator: There are no further questions at this time. I will now turn it over to Mr. Cook for closing remarks.

William M. Cook - Chairman, President and CEO: Thanks Ron. Now to conclude our call, I'd like to thank everyone for your time and your continued interest in our company. Thank you and have a great day. Good bye.

Operator: Ladies and gentlemen, this concludes our conference call for today. Thank you for participating. You may now disconnect your lines.