Rich Sheffer - Director of Investor Relations and Assistant Treasurer Bill Cook - Chairman of the Board, President, Chief Executive Officer Jim Shaw - Chief Financial Officer, Vice President Tod Carpenter - Chief Operating Officer, Director

Laurence Alexander - Jefferies Hamzah Mazari - Credit Suisse Eli Lustgarten - Longbow Research Charlie Brady - BMO Capital Markets Kevin Maczka - BB&T Capital Markets Andrew Obin - Bank of America Merrill Lynch Jim Giannakouros - Oppenheimer & Company Richard Eastman - Robert W Baird Brian Drab - William Blair Brian Sponheimer - Gabelli & Company Stanley Elliott - Stifel, Nicolaus

Thank you, Craig, and welcome, everyone to Donaldson's fiscal 2014 second quarter earnings conference call and webcast. Following this brief introduction, Bill Cook, our Chief Executive Officer, Tod Carpenter, our Chief Operating Officer and Jim Shaw, Chief Financial Officer will review our second quarter earnings and our updated outlook for the balance of fiscal '14.

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 would like to turn the call over to Bill Cook.

Bill?

Thanks, Rich, and good morning, everyone. Before we talk through the details of our second quarter results and our outlook, I would like to offer some summary comments.

First, despite the ongoing uncertainty in some of our end-markets and regions, we are very pleased with delivered record earnings this quarter, and we did this despite slightly lower sales versus last year by focusing on our Continuous Improvement initiatives, which delivered an operating margin 50 basis points better. This, I believe, speaks to how well our company is operating and especially how well it's positioned for the future.

Our sales decline year-over-year is a function of two factors, some foreign currency headwinds, the Japanese Yen, the Aussie dollar and the Brazilian Real but mostly due to the year-over-year decline in our gas turbine sales which we had foreseen after last year's record second quarter. My second point is that many of our other businesses have local currency sales increases year-over-year, as well as we did in many of our regions.

This speaks to the benefits of the diversification model we built into our company over the past 20 years and which has allowed us to deliver these results. I would now like to turn the call over to Tod for a review of our second quarter sales.

Tod?

Thanks, Bill and good morning, everyone. Our reported sales decreased 2.4% from last year's second quarter.

1.5% of this decrease came from foreign currency translation, particularly from the weakening of the emerging market currencies against the U.S. dollar.

Measured in local currency, our total sales decreased a little less than 1% from last year. As a reminder, you can find a detailed analysis of currency translation by business unit and region on the Investor Relations homepage of our website.

The rest of this review will discuss local currency results. Within our Engine Products segment, our OEM businesses in the Americas decreased 7%, however our other major regions delivered OEM sales increases.

Our European OEM businesses were up 7%, as we benefited from the continued growth in agricultural equipment market and a pickup in truck sales in advance of the upcoming Euro VI emission standards implementations. Our Asia-Pacific OEM sales increased 10% in the quarter.

Our off-road sales improved in Japan and in China as OEM customers have now mostly completed their inventory level adjustments. We continue to see improving conditions in our Engine Aftermarket where we supply replacement filters and exhaust products through both our OEM and independent distribution channels.

Our Engine Aftermarket sales increased 11% in the quarter with strong sales in all of our major regions. We attribute this growth to the combination of improving equipment utilization in the field, the absence of any more significant customer channel inventory reduction and our market growth initiatives.

Aftermarket is our earliest cycle end-market and improvements we have seen over the last couple of quarters provide some confidence that conditions in our end-markets have sustainably improved. Finishing my review of our Engine Products business, our aerospace and defense sales increased 5% as the slowdown in defense spending for ground-based military equipment continued in the quarter.

Sales in our Industrial Products segment decreased 12%. In our Industrial Filtration Solutions business, our sales increased 1% as solid levels of manufacturing activity drove record demand for replacement filters in our Torit dust collectors and our compressed air systems.

This Aftermarket growth was enough to offset the continuing weak manufacturing capital spending levels, which has reduced demand for new industrial dust collectors. In our Special Applications business, our sales increased 7% on continued growth of our integrated venting products, an increase in disk drive filter sales and an upturn in our Semicon imaging product sales.

Offsetting these increases was the anticipated decline in our gas turbine business, which decreased 50% from last year's record quarter. As we highlighted in our outlook in August, we expect a short slowdown in our gas turbine business during the first half of fiscal '14, as the market commissions the surge of large turbine projects from last year.

We are continuing to view this is a short slowdown. Jim will discuss this more as he talks through our outlook.

So excluding the big decline in gas turbine sales, our other Engine and Industrial businesses combined for a 5% sales increase in the quarter. This result exemplifies how our business model is designed to work.

Our diversified portfolio provides exposure to many different end-markets and regions that typically are cycling up or down at different times. During last year's sudden OEM and industrial contractions, the downturn was softened by our late cycle gas turbine business in some of our emerging regions.

Now we are seeing incremental improvement in the replacement filter sales across our engine and industrial end-markets. At the same time, we are seeing stabilization in a number of our first-fit end-markets.

In addition, we are again seeing solid growth in some of our key emerging regions. For example, Southeast Asia, India and Latin America were up 21%, 18% and 13% respectively in the quarter.

All of these combined to mostly offset this quarter's decline in the gas turbine system shipments. I will now turn the call over to Jim Shaw for his comments on our operational metrics.

Jim?

Thanks, Tod, and good morning, everyone. Our gross margin was 34.7%, an increase of 130 basis points from the 33.4% we reported in last year's second quarter.

As we noted in our press release, one of the drivers of this gross margin improvement was the lower number of large gas turbine shipments in the quarter, which were a headwind to our gross margin in fiscal '13. We also benefited from a higher percentage of replacement filter sales which were 55% in the current quarter compared to 50% last year.

In many of our end-markets the utilization of equipment existing in the field is good, which helps our replacement filter sales. Overall, product mix had a positive 80 basis point impact on gross margin.

In addition, our ongoing Continuous Improvement initiatives benefited our gross margin by approximately 60 basis points compared to last year. Last year we took many cost containment actions to aggressively control our manufacturing costs.

This work we did to align our cost structure with our current level of sales is continuing to payoff and as a result, we saw fixed cost absorption deliver approximately 40 basis points of benefit compared to the second quarter of last year. Offsetting this benefit was the impact on margin of the stronger dollar in some of our entities as well as higher incentive compensation costs.

Our operating expenses increased by $2 million compared to last year's second quarter. As a percentage of sales, operating expenses increased 90 basis points.

Higher incentive compensation expense, incremental expenses related to our Global ERP project and some reduced fixed cost leverage due to lower sales impacted operating expenses by 140 basis points. These increases were partially offset by lower pension, insurance and warranty expenses which reduced our operating expenses as a percent of sales by 50 basis points.

The combination of our improved gross margin and slightly higher operating expenses resulted in a 50 basis point improvement to our operating margin which was 12.4%. Looking forward, we expect our full year fiscal '14 operating margin to be between 14.2% and 14.8%.

We began accruing incentive compensation at normal levels again at the beginning of fiscal '1'4 and our investment spending on our Global ERP project begin increasing in the second quarter with four locations going live on the new system during the quarter. We expect that both of these expenditures will continue at these higher levels for the balance of the year.

Our effective tax rate was 22.1% in the quarter versus 28.3% last year. The current quarter included $6.2 million in tax benefits related to the favorable settlement of a tax audit.

In our prior outlook, we had estimated to $2 million benefit. So this ended up being a $4.2 million of $0.03 per share higher than we had forecast.

Based on our projected global mix of earnings in fiscal '14 and the additional benefit we receive in the second quarter, we now forecast our full year tax rate to be between 28% and 30%. This is 1% lower than our previous outlook.

Our second quarter CapEx was $22 million. Looking at our fiscal '14 forecast, we continue to expect approximately $90 million on CapEx for the full year.

The breakdown of the $90 million spend is projected to be approximately 20% related to capacity expansion, 30% for our technology initiatives which includes our Global ERP project and our R&D lab expansion project, another 30% is for tooling for new products and 20% will be related to cost reduction activities through our Continuous Improvement initiatives. We continue to expect depreciation and amortization will be between $65 million and $70 million in fiscal '14.

Free cash flow was a record $30 million this quarter. For fiscal '14, we expect full-year cash flow from operating activities to be $282 million to $320 million and with our forecast of $90 million of CapEx, we expect to generate $192 million to $230 million of free cash flow this year.

We repurchased 1.3 million shares in the second quarter for $54 million. Year-to-date, we have repurchased 1.6 million shares or 1.1% of our outstanding shares for $66 million.

We plan to repurchase between 2% and 4% of our outstanding shares in fiscal '14. We expect interest expense in fiscal '14 to be between $8 million and $10 million and our balance sheet remains very strong with $360 million of cash and short-term investments.

I would now like to add a little more detail on our Global ERP project before I move on to the outlook. As I mentioned earlier, we went live at four locations in the second quarter and we also converted another six locations in early February.

These go lives have gone very well. Our ability to receive, process and ship orders at these locations have gone seamlessly as we transition to the new system.

We will continue to rollout the new system to our Americas locations through the fall of 2014 and then we will be shifting the implementation efforts to our Europe locations. Now I would like to provide some comments on our outlook for the rest of the fiscal year.

Our first half results have increase our confidence that many of our OEM first-fit equipment end-markets have stabilized and in the case of our Aftermarket sales, are seeing increasing demand. We are forecasting that growth will continue to pickup during the second half of our fiscal year.

We did make two adjustments to our outlook for Industrial Product sales. First, we reduced our outlook for gas turbine system sales as several of projects that were originally scheduled to ship before the end of fiscal '14 have been rescheduled for shipment in early fiscal '15.

We expect gas turbine sales to be sequentially higher in our third quarter and again in our fourth quarter. In fact, we are currently expecting our fourth quarter gas turbine sales to be higher than fiscal '13.

More positively, we saw a ramp up in gas turbine orders in our second quarter that are forecast for fiscal '15 delivery. This gives us increased confidence that the sales growth trend will continue into fiscal '15.

In our Industrial Filtration Solutions business, we are now expecting more modest growth this year as business investment for new dust collection systems has been slower to develop than we previously forecasted. Despite these adjustments to our Industrial Products forecast, our full year sales outlook for the company as a whole is unchanged from what we have provided in August.

Our full year sales outlook for fiscal '14 is for sales to increase 1% to 5% which would result in sales of between $2.45 billion and $2.55 billion. Based on our first half performance and forecast for the balance of the year, we adjusted our operating margin range slightly.

So the midpoint of our new range is 14.5%. We also adjusted our full year tax rate guidance lower by 1% after larger than anticipated second quarter benefit.

The net of all these factors is that our EPS range remains at $1.65 to $1.85 per share, the midpoint of which would represent a new record and a 6% increase over last year. So with that I will pass it over to Bill who will discuss some of our growth initiatives.

Bill?

Thanks, Jim. So while some of our end-markets remained challenged by the ongoing economic uncertainty, we are continuing to make the key investments in our business and our people to growing them.

We have a number of very focused initiatives that will help us to grow over time, regardless of the economic environment. I would like to highlight a few of these initiatives.

The first is with the emerging economies such as Latin America, Southeast Asia, India, China and Russia, where our current presence in these markets is generally lower than in North America or Europe. In these emerging markets, we are continuing to add sales resources, parts to our product line, distribution capabilities, additional distributors and OEM customers.

For example, in our Engine Aftermarket we added 83 new distributors and over 700 new part numbers in the quarter. Another of our key growth initiatives is the utilization of our innovative technologies to help better solve our customer filtration issues on their new equipment while retaining the Aftermarket or replacement filter business over time.

One of our most successful innovative technologies for air filtration is PowerCore. It is a great example of how we invest centrally into R&D and then leverage our technologies into as many different applications and as many of our businesses as possible.

And we are now very successfully using the newest generations of PowerCore in both our Engine and Industrial segments. Our Engine PowerCore sales in our second quarter were $34 million, up 19% over last year.

We had good growth to both first-fit PowerCore systems and the replacement filter sales which increased 18% and 19%, respectively. And we have a number of new PowerCore programs going into production with our OEM customers now and over the next 12 to 24 months.

As you know, successive waves of new diesel emission regulations in North America and Europe have already and are continuing to go into effect. Our heavy-duty equipment OEM customers are launching their new equipment platforms with latest engine technology in order to meet these stricter requirements.

As our customers' new platforms launch, our sales of new PowerCore systems will increase and as their new equipment gets out in to the field, then the demand for replacement filters will ramp up and continue to grow year after year. And we are currently working with these same OEM customers on their next generation of new equipment platforms that will launch later this decade.

Switching to the industrial side of our company, we sold another 350 new Torit PowerCore dust collection systems in the quarter. In addition, the sales of our Torit PowerCore replacement filters for those systems already in the field increased 28%.

So in total, our company's PowerCore sales totaled $39 million in the quarter, up 14% over last year. Another of our strategic growth projects is expanding our liquid filtration business.

Currently about 20% of our sales or about $500 million on an annual basis is in liquid filtration but we have many, many opportunities to grow. In the quarter, our liquid filtration sales increased 11% with very strong growth in hydraulic filtration filters, which use our Synteq family of filtration medias.

Our new SELECT diesel fuel filters, which also use our Synteq media are starting to go into production as our OEM customers begin launching their new engines and equipment platforms. So while we have made very good progress already with the introduction of our new technologies, we still believe we are in the early innings of rolling out our innovative proprietary filtration strategy and we are very excited about the future of these products.

Now to quickly summarize, we delivered a very good first half in fiscal '14 from an operating metric perspective with a 13% increase in operating income and a 14% increase in net earnings and EPS both of which are records. In our second quarter, we saw the combination of stabilization within many of our OEM first-fit equipment end-markets and increasing demand for our replacement filters across both our engine and industrial end-markets.

For the second half of the year, we continue to forecast further gradual improvement of end-market conditions, including a gradual recovery in the global CapEx cycle and this supports our outlook for the year. Bottom line, as Jim mentioned, we are maintaining our forecast for sales increase, with strong operating margins in fiscal '14 which will continue our progress towards our strategic goals of $3 billion in sales by fiscal '16 and $5 billion by fiscal '21.

This concludes our prepared comments. Craig, we would now like to open the call up to questions.

Good morning.

Good morning.

I guess two questions. First, given the volatility that's in the emerging markets, are there either opportunities to do bolt-ons that are more attractive?

Are you seeing more assets become available from a bolt-on perspective? Or there are opportunities to take share is because of competitor financing cost?

Laurence, this is Bill. Our focus is to execute our organic growth plans while at the same time looking for acquisitions.

We have been doing acquisitions in the emerging markets that obviously would get us to our goals faster. So were doing both.

We continue to look at acquisitions in both the emerging markets and the developed markets. We have a team that is focused on doing that.

We obviously can't comment prospectively on what we are going to do but we are looking for opportunities.

And secondly, can you give an update or an elaboration on your thinking around whether the ERP system will play out over the next, call it two to three years? And is it going to be another cycle of investments on productivity measures leveraging that in the 2015 to 2020 period.

Yes. Laurence, this is Jim.

In terms of the investment we are going to continue at a similar level to what were investing this year over the next really two more years because we are going to be rolling this out next fiscal year in Europe and in the following year in Asia. But as we begin to bring entire regions online, we will start to see some of the benefits we anticipated.

We won't start getting those benefits in full until we get a whole region online, because as we are transitioning we have the difficulty of being on two systems until we are fully converted. But once we to get a region on, we will start to see those benefits.

We will start to see some incremental benefits in fiscal '15 but that will be offset by the similar level of investment that we are making today.

Okay, and I guess, are you seeing any opportunities to do a more extensive productivity cycle enabled by the information you get from the ERP system? Or after this, it should tail off?

Laurence, Bill here. I commented on that.

As Jim mentioned, we are a year out. Once we get completely through this project, and we are making great progress so far, we are very pleased, we will see a significant benefit from being on one system both in terms of the cost but also in terms of the facilitating our growth to get to the $5 billion mark.

So a lot of this is around supporting the growth in addition to making our operations more efficient. The other thing I would mention is that we have our ongoing Continuous Improvement initiatives that we talked about every quarter and that's a continual focus across the company in terms of working on that and we see the benefits of that every month and every quarter.

A lot of the big the heavy lifting in terms of restructuring, we get a couple years ago, but we still see a smaller but still significant opportunities going forward. We are not forecasting any big restructuring dollars as a result of the Global ERP.

Thank you.

Good morning. Thank you.

Good morning, Hamzah.

The first question is just on your truck exposure. Could you maybe breakdown where you are exposed within truck, both Europe and North America?

And maybe your perspective of where we are within the truck cycle regionally?

Sure. Hamzah, this is Tod.

So as we look at our on-road market across engine, as you probably know, we are mostly a Europe and an America story. If we look at Europe and we break that down and we look at Euro VI, we did see a bit of a pre-buy but it was as forecasted in the model.

And so we have built that in to our forecast previously and feel very comfortable about what we have within our forecasted model across Europe. In the Americas, as you know, there is a lot more positive news surrounding the on-road markets lately and some people have expected and forecasted as much as a 15% increase.

Now going forward in calendar year '14, with first-fit build, we have not seeing that come through our backlogs as of yet, but we have built-in roughly about half of that forecast in our model. So that's the way that we are looking in shaping up the total on-road market for Engine.

Tod, if I can add something. The first-fit heavy truck is about 5% of sales today.

Got it, and any updated view on how we should think about incremental margins going forward? I realize you have some growth investments rolling through the P&L as well, but utilization rates seems like they are still below normal for you guys.

Any color?

Yes. Hamzah, this is Jim.

We are a little bit below ideal utilization and that varies by type of products because some products are very higher on the utilization standpoint than others. But as we look at margins, it's really no different than how we look at that longer term, it's 20 to 30 basis point improvement annually, which is driven by greater Aftermarket penetration but then offset a little bit by some of these investments we are making in growing our topline, as well as things like the ERP.

So I think we anticipate better margins in the second half than the first half just due to the pickup in those volumes, but for the year, we are continuing to look at that 20 to 30 basis point improvement every year.

Hamzah, we are trying to optimize our operating margin expansion with growth. That's why we are trying to maximize margin.

We are trying to get the growth at the same time. So as Jim noted, a lot of this is in terms of releasing a lot of the margin expansion opportunity to reinvest back into the business for growth.

Understood. Last question, I will turn it over.

Maybe for Bill. Congratulations, actually, on the COO role for dog maybe if you could you speak to the establishment of the COO role for Tod, but maybe if you could just speak to the establishment of the COO role.

I don't think you had a COO role before. I assume it's part of succession planning but any color with regard to that particular role.

Thank you.

Sure, Hamzah. So we had a CAO, Chief Administrative Officer, Charles McMurray who is going to be retiring in about a month and as part of that, looking at the organization and also to your point about organizational succession planning, we reorganized the company a little bit and promoted Tod to the COO role.

So I was doing a lot of that before. So this represents a significant upgrade bringing Tod in the role.

So does that help?

Yes. It helped.

That's perfect. Thank you.

Good morning, everyone.

Good morning, Eli.

Can we talk, I guess, about a technical thing. This is the first quarter where you took the corporate unallocated and put it back into the segments.

So can we get some color on how that was set up because you didn't do it in the first quarter and the ERP expenses, what were they and how they were allocated, so we can get some idea how to remodel going on, on the segments? The operating margin doesn't change but it does affect how the models work, I believe.

Yes, Eli. This is Jim.

We didn't change anything in terms of our methodology on the corporate unallocated. I think we have talked about before, that does fluctuate sometimes based on certain other things we don't allocate to the markets, which would be interest expense and interest income as well as some foreign exchange.

So that varies from time to time. The other bigger fluctuation is how the elimination of some of our intercompany sales are handled.

Generally what we find is, when inventories are going down, there is a little bit of a benefit in the corporate unallocated and our inventories have come down $20 million since last year. So that's part of that, but nothing has been changed in terms of our process and if you look second quarter last year to second quarter this year, it's a pretty similar amount in the corporate unallocated.

So I think it's just mostly a lack of any unusuals that we sometimes have.

So that will go back to the $2 million a quarter or so for the rest of the year? Is it expected to do that?

Yes. I mean we can't really forecast what's going to happen with FX and some of those other things but I think that's a good proxy.

In terms of compass, those costs are in the business unit. So they don't affect the corporate unallocated.

Maybe the follow-on to that for the year, we are anticipating about $7 million more. I am sorry.

I said compass, but our ERP project, $7 million year-over-year impact with more of that being in the second half. So we have incurred year-to-date a little over $4 million.

I am sorry, year-to-date, it's been a little under $1 million of incremental. So a lot of that $7 million is going to hit us in skin the second half of the fiscal year.

And then you said, the numbers would be relatively flat for the next two years in that.

Yes. That's our best estimate as of now.

Okay and can we now talk a little bit about what we are seeing in the demand. You basically held your industrial products, for example, relatively flat, you said down slightly.

You maybe taking about $12 million, $13 million off your gas turbine. That said, even though you lowered filtration a bit or so, you are more in the upper end of it than the lower end.

Can you give us some color on what's going on in the various pieces of that to offset it there? And is Ag holding up enough because there is a lot of fear now that Ag production looks like it could get softer as you go through the rest of the year?

Eli, Bill. I will start and then I will pitch it to Tod.

So on gas turbines, Jim mentioned, one of the reasons why we took that down as had some projects that were going to be shipped but just based on the customers' schedules they are going to move out into fiscal '15. So we can already see that, the lead time that we have on these projects.

So that was the reason on the gas turbine. On the Industrial Filtration Solutions, as Jim mentioned, we adjusted that in the Aftermarket business.

The Aftermarket part of that business is going like a train. It's the first-fit, the new equipment which is sort of related to the delay in the global CapEx recovery.

But we still see that, as I mentioned in my comments, gradually improving. So those are the major reasons for the adjustments on industrial side.

Tod, Ag?

Yes. So, Eli, just talking a little about Ag.

So, our major customers, of course, Deere, AGCO are all saying flat to a little bit down, maybe as much as 5% or so. And we have baked that into the model.

So we also expect it to be stable to down and that's really what we are seeing throughout our business currently within that market.

And just a final question. Construction equipment, you are saying a modest increase in the mid-single-digit or that's going to approach double-digit for the year from the OEM side.

Yes. So, within the construction business, it's actually kind of mixed.

So Europe would be more favorable. Asia would be more modest, particularly across China.

There is a little bit of an uptick. And the U.S.

is a little bit stable at this point in time, but we do expect to see a little potential uptick as we have a listen to some of our customers' guidance.

Thank you very much.

Thanks.

Thanks. Good morning, guys.

Good morning.

Just on part of that on the industrial filtration business, just parsing it out a little bit, it looks as though in Europe that was probably one your strongest regions with that business up, I guess, 3% or so. Just speaking directly to what you are seeing in Europe for industrial filtration, is the first-fit stronger in Europe than you are seeing in other areas or is it the same situation where it is all driven by the aftermarket?

In Europe, Charlie, this is Bill, it's a little bit better than in the U.S. It all depends on the comps, but I would say that where the U.S.

had held up stronger or longer, but we haven't, in the last probably year, we just haven't seen the strength on the equipment side. And Europe has picked up or recovered a little bit sooner.

So in Europe, we are seeing both. In the U.S., we are fortunate to have a very strong aftermarket business, which is helping to offset the current weakness in the new equipment.

All right. Then just on the on-road side.

I know heavy truck is only trucks 5% or so of total business, but the European heavy truck business is up 45% local currency. You alluded to the fact that you are seeing some pre-buy on that.

I guess what I am trying to is, how much of that plus 45% was driven by pre-buy and how much is just the underlying market itself is getting better.

Yes. So we actually have taken a lot of care to try to pair that part of our sales and talking to the customer base, we would say that a greater portion of that is really market driven rather than pre-buy driven across Europe.

So the pre-buy portion that we have modeled has really met our models and it's been modest low double digits is what we have seen as far as pre-buy. That's direct input across our customer base from Europe.

All right. That's helpful.

One more and I will get back in the queue. On the special apps, can you just break out how much the hard disk drive business was up or down or how much the membranes was up or down?

Charlie, this is Rich. If you look at the disk drive portion, that was up maybe around 15% while membranes was down about the same as a percentage.

Fortunately disk drives was a little bigger percentage of overall special applications. So that helped to drive the upside.

Great. Thanks.

Thanks. Good morning.

Good morning, Kevin.

Bill, we talk every quarter about Continuous Improvement and distributor adds, and on the distributors, I am just wondering if you can give some sense of where we are in that process? Is that something that will be ongoing all the time like Continuous Improvement and there is a many year runway still ahead of us?

Is it entirely focused on emerging markets and we are more mature in the developed markets? If you can just give a little color on the distributor add trajectory from here?

Kevin, Bill here. Yes, it is a race without an end, to be honest with you.

If you think we had a company started and up until maybe 25 years ago, we were mostly in North America and some with a pretty good presence in Europe and the rest of the world, we had certainly nice beachheads, but our positions were not as strong. That's a function when we started here in the U.S.

almost 100 years ago, and so we see tremendous opportunities to add products to our product line and distribution to get the proper coverage. We talk about it every month in terms of where we see the opportunities and we continue to see as far as we can look really opportunities to do both.

And it's just not about the numbers of distributors. It's really about the quality of distributors.

So it's not just the sheer numbers but finding the right distributors and not every distributor can cover every end-market. So some are focused on on-road and some are focused on mining or construction or Ag.

So we are trying to make sure that we have got the most effective coverage in each of the emerging markets, and we continue to see tremendous opportunities for that. It's sort of like the Continuous Improvement.

You have to keep looking and you keep finding and you keep finding, kicking over rocks and finding more opportunities to do more and growing. Since we are mostly an organic growth story, that's really what we have been focused on, is looking for those type of things.

Yes, that is understandable. I guess my main question is, when we hear you say added 70 or however many distributors any given quarter to try to take that, the next step and think about how does that move the needle or how might it move the needle going forward because again we have been adding distributors all along and cycle still matter and we can still have down revenues even though we are adding lots of distributors?

Yes. This is Tod.

Maybe I will add a little bit more to that. If you really take a look at our distributor math worldwide, obviously we have a lot of runway across Asia where we have a very, very small presence and maybe we are maturing, we would probably say in Europe, while we are mature in the U.S.

and then maybe maturing across Latin America. So if you just use that as the barometer, we have a lot of opportunity to add strength across our distribution and we really believe that that will be one of the contributing factors to driving growth across our engine business worldwide.

Okay. Just shifting gears, you did trend the cash flow guidance for the year even though we maintain sales and earnings and I think Jim said you pointed out, you took inventories down $20 million.

I am just wondering, if you can say more about what drove that cut? What's going on the working capital alignments contributing to that?

Kevin, this is Rich. One of the bigger drivers of that is the push out of some of the gas turbine systems in our fourth quarter.

That will, towards the end of the year, lead us to have a little bit more inventory than we had originally anticipated. So that's the primary driver right there.

This is Jim. Nothing else in terms of how we have always looked at free cash flow other than the net change.

Okay. Great, that's all I had.

Thank you.

Thanks.

Good morning, guys.

Good morning, Andrew.

I just wanted to make sure that on gas turbine, so all it is, is just timing of the shipments, right, because the GE PowerCore transaction, that's not sort of upsetting the market dynamic, right? There is nothing going on that right now?

Andrew, Bill. No, nothing like that.

It's simply the shifting the timing of some of these projects, when they are going to be shipped.

So the second thing, I know it's sort of a broader philosophical question for you. As we look at your results and compare it to other multi-industrial names, nobody posted good industrial CapEx commentary.

I am just surprised that we all got excited about improving ISM, global IT improving, going in to the end of last year. Then it sort of all fizzled this quarter.

You have been saying for a long time. What are you guys seeing?

What do you think is different? Why do you think everybody has gotten it so wrong?

You know, the place I look, Andrew, for my best guidance is obviously your reports, okay. So but I think that a lot of us industrial companies who, our products or parts of the customers' CapEx have been waiting for that and I think I have seen some other industrial report results come out in the last month and I think to your point, there is a delay in this recovery cycle for global CapEx.

I think the good news, from our perspective, as Jim mentioned, is that with the recovery in the aftermarket, that's usually as people start using equipment more, they start replacing filters more. We are seeing that in the industrial space.

Historically, that's a good precursor to an investment in new equipment. So we think it's out there and we are forecasting some gradual improvement during second half, but it hasn't come, to your point, as quickly as people were forecasting late in '13.

And then just a final wrap up question. If I missed you answering it, I apologize.

On mining, talk about mining, stabilizing, is it because the volumes are so low that they just can go lower? Are you seeing any chance of actually your shipments going up in the second half of the year?

Because apart from some of the OEM suppliers that production is just basically actually collapsing in Q1 and it may actually get better in the second half, not because things aren't necessarily getting better but just because the volumes are getting to a point where they are unsustainably low in terms of shipments?

Andrew, this is Tod. I will take that.

So within the mining sector, basically as we look out in and we talk to our customer base, I think you described it pretty well, we say that obviously, it has softened dramatically for us, but it is at such a low level, it came off the floor perhaps just a little bit, but we see it stabilizing at its current low levels and that's what we have built within our forecast, is really just stabilize at the current low level, looking forward.

Thank you very much.

Thanks.

Good morning, guys.

Good morning, Jim.

I am sorry if I missed it, but can you get a bit more granular as far as the strength in aftermarket sales, particularly in engine? How much you would attribute to higher retention rates of your proprietary product and how much is due to the higher utilization you are seeing out there both in off-road and on-road?

Jim, this is Rich. So I would use, as a proxy for that, the difference between the growth rates that we have seen from our OED channel versus the independent channel.

So in this last quarter, we saw the independent channel grow in the neighborhood of about 8% in local currency, while the OED channel was up about 15%. There is a little bit of evidence of some minor restocking in the OEDs.

We wouldn't say that that entire difference is due to the benefit from our PowerCore and other proprietary first-fit systems, but it's a good portion of it.

Okay. Thanks.

That's helpful. A jump into SAP.

I don't know if I was supposed to catch this, but what kind of improvement in hard disk drives does your model factor in for the rest of '14?

Jim, you want to take that?

Yes. In terms of disk drive, I think we saw more benefit here in the second quarter than we had originally forecasted and that we built into the forecast.

We see it remaining relatively flat in terms of where it is for the rest of the year.

Okay. Thank you.

Just to add to that, the forecast for hard drive shipments by our customers is essentially flat year-over-year, plus or minus 1%. So it seems like it stabilized at that level.

Good morning. Can I just double-back for one second on the aftermarket business.

When I look at the comp from last year and I look at the results from this year, if you stack the comps, you get maybe 5% to 6% growth rate over that two years, so maybe adjusting for some of this distributor restocking, destocking. Is that maybe a better feel for what the market actually looks like out there, mid-single-digit growth rate?

Or do you believe that, again your reference on the distribution side and some of those things, you have pushed that growth rate up in to the high single-digits?

Rick, Bill here. I will start.

You are right. There is a bunch of different components of this.

One is the underlying market growth. We take a look at ton miles there as sort of maybe a proxy for, at least, the on-road segment of the market in terms of utilization of equipment, and that would be in the low single-digits increase.

Then above that what we see, the way we do the math and we haven't quantified all of this publicly, would be is that the things that we talked about in terms of adding, especially in emerging markets, part numbers to our product lines, we have broader coverage and adding more distribution capabilities internally or distributors adds to that. Then we take a look at the growth of the PowerCore and we talked about in terms of the year-over-year, we are talking about 18% increase year-over-year.

That's factored in there as well. That's one example.

So the proprietary technology is an icing on the cake, so to speak, to get us up to the numbers you mentioned. So underlying market growth, emerging market and then proprietary technology.

That, in your mind, sums to what, high single-digit or mid-single? I am not trying to --

You are trying to pin us down. Over time, it should be high single digits.

Yes. Okay.

Then the comments that Rich made on the OED channel versus independent channel, was that a global?

Yes, that was.

Okay. Thank you.

And then just lastly on the industrial side of the business. I would like to, the split, if you pulled dust collection out, we had your IFS and special apps was plus 5% and you had mentioned the replacement side.

Can you give us a sense of what percentage of that industrial non gas turbine is aftermarket versus OE sales? Just roughly?

Is it 30%? Or?

Rick, you mean our industrial filtration solutions business, because that's the piece we were talking about.

Yes. I am just trying to, you gave us that, the IFS business and special apps combined, were up 5% in the quarter and you said replacement element sales were up, but it sounds like the OE first-fit equipment side of IFS was a negative number and I was just curious as to how that split looks approximately?

This is Jim. Within the IFS side of the business, replacement parts were about 43% of the total sales there this year.

Okay.

And gas turbine, that's running more along the lines of 40%.

Okay, maybe I can clean that one up offline.

Okay, well, thanks so much.

Thanks, Rick.

Good morning. I don't want to jinx it but leave it to Donaldson to get off to a flawless start in the rollout of an ERP system.

So congratulations on that.

Brian, as Yogi Berra said, it ain't over 'til it's over.

Yes. You don't hear that that often.

I don't know if you commented yet, but looking at the aftermarket performance in the quarter, it doesn't look like you saw really any impacts in North America from the severe weather and can you comment on that? Or do you think we might see some of that show up next quarter and could you maybe give a breakdown of the aftermarket segment by geography?

Brian, we had a number of our plants in the Midwest and our main distribution center were impacted by the weather in January, and there intersates were being shutdown in Indiana and things like that. We recovered very, very quickly to the point that we were getting compliments from customers.

So it's in the quarter and it's not material. Our people got through it exceptionally well.

Okay, great. Then could you just clarify, you have talked quite a bit about the Synteq opportunity and this is a new diesel fuel filtration opportunity that could be, I think you said, $30 million to $40 million in revenue, and that's on the first-fit side, I believe, right.

I am just trying to clarify that what has your presence been in diesel fuel filtration to-date? And it's been more on the aftermarket side, is that the right?

Hi, this is Tod. So as we look at the diesel fuel where we really played and where we entered the market years ago is within the aftermarket.

So our presence has really been through the aftermarket channel and what we have done now with Synteq is we have successfully turn the model to a proprietary first-fit solution using Synteq and winning new programs to our OE customers. We have won a number of programs on the Synteq and when those programs that Bill referred to earlier today come to full maturity here in a couple years, actually that select product line of fuel filtration will be more along the lines of about $50 million annually, is the way that we look it.

Okay. Great and then how big has that business been historically, the aftermarket diesel fuel filtration, roughly?

Brian, we don't the break out fuel portion separately in the aftermarket for liquid. Historically, it's been about half, hydraulic about half, while lube and fuel but the split between lube and fuel we have never retracted that closely.

Okay. All right.

Thanks very much.

Thank you.

Hi, guys.

Good morning, Brian.

Good morning. How are you?

Just a question for you on the M&A front. Lydall made a small acquisition last night of an air filtration business and didn't pay very much.

Should we not think about air filtration as an area where you would even bother to look at this point, given your product portfolio?

Brian, Bill here. I think we are open to anything that fits into our strategy.

So that's the qualifier and we use our strategy as the filter, excuse the pun, for looking at acquisitions. We have a team that's focused on it.

It is a very tough market right now in terms of planning acquisitions and doing it at prices that make sense for us. So we continue to look.

We look at acquisitions as that the adder to our organic growth and we want to be still mostly an organic growth story but we are continuing to very aggressively to look at acquisitions. Really across almost all of our business, we look for them.

And just maybe update us on how you see that pipe developing, whether you would expect without guiding obviously anything I guess in this, the third or fourth quarter of discussion?

Brian, you didn't want me to give a date. Did you?

You are very good at this, Bill.

I can't talk prospectively, but we have the capital capacity and we are very focused on trying to find the opportunities. And I think as I have mentioned in our last call, we know we have to get better at it because the market is very, very hot.

So we want to find the candidates sooner and cultivate a relationship faster and hopefully be able to reach a deal that fits our financial metrics. So we are working on it very hard.

All right. Thank you.

Thanks, Brian.

Great, guys. Thanks for fitting me in.

Two quick questions. One on the OED comment.

Was that for the quarter or was that for six months? Then also, I thought I heard you say some commentary in and around some restocking at the aftermarket level.

I just wanted to make sure I heard that correctly.

Stanley, this is rich. The comment was about the quarter.

The difference between the independent and the OED channels, that same relationship has been consistent year-to-date. As far as the minor restocking, that was really related to the OED channel.

And I imagine, we are still fairly down from where we had been in the past. Conversations with those customers, are they getting more optimistic about this year?

Any thoughts around that front? Please.

Yes. So this is Tod.

So as we talk across our OEDs, it is obviously very mixed across the aftermarket, when you talk to construction, Ag and mining and on-road. I would say, there hasn't really been a change over the last quarter in the way that each characterized their individual markets.

So I would say that there hasn't been a shift to optimism by any of them and that's what we have in our forecast as well.

Perfect. Thanks very much.

I thought this was a great quarter. That's good work.

Thank you.

Thanks for taking my follow-up. I think I understand in terms of your second half margin outlook what most of the moving parts are but I just want to make sure we are all clear here.

Why can't second half margins at least match what we did in the second half last year? Because we even have higher volumes.

We always have continuous improvement. We accrued in the second quarter the higher comp in ERP and we still yet saw our margins come up.

So can you just kind of square that for the second half?

Yes. This is Jim, and I appreciate the question, because I think this gives me the opportunity maybe answer the question Eli asked earlier a little bit better.

In terms of probably the two investment items that we have talked ,about at the start of the year we said we had about $30 million of incremental expenses this year related to our ERP project which is about $7 million of that and then the remainder is the restoration of our incentive compensation. So I think I mixed apples margins when I talked about the ERP earlier.

So year-to-date, we have incurred about $2 million to $3 million of that incremental expense for our ERP. We are going to have about $4 million to $5 million of that in the second half.

So that is a little more backend loaded of that about $7 million incremental. Then of our incentive comp, which is going to be in the neighborhood of $20 million, that's also going to be back half loaded into our third quarter because last year's third quarter is where it became apparent that we weren't going to hit our financial metrics that that we were goaled on and we reversed some of our incentive comp.

So those factors are going to hit us harder in the second half than the first half.

Okay. Very helpful.

Thanks, Jim..

Thanks, Craig. Now to conclude our call, first, I would like to again recognize and thank my fellow employees for their contributions to our second quarter performance.

And finally I would like to thank everyone on the call today for your time and continued interest in our company. Thank you and have a great weekend, all.