Brad Pogalz - Director-Investor Relations Tod E. Carpenter - President, Chief Executive Officer & Director James F. Shaw - CFO, Vice President & Head-Investor Relations.

Eli S. Lustgarten - Longbow Research LLC Brian P. Drab - William Blair & Co. LLC Rick C. Eastman - Robert W. Baird & Co., Inc. (Broker) Laurence Alexander - Jefferies LLC Brian C. Sponheimer - Gabelli & Company, Inc. Larry Robert Pfeffer - Avondale Partners LLC.

Good day and welcome to the Donaldson Company Incorporated Donaldson's Third Quarter Fiscal Year 2015 Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Brad Pogalz, IR Director. Please go ahead..

Tod Carpenter, Donaldson's CEO; Jim Shaw, our CFO; and Bill Cook, our Chairman. Following this brief introduction, Tod and Jim will cover our third quarter performance, review our outlook for fiscal 2015, and provide an update on some of our strategic initiatives. But first, let me review our Safe Harbor statement.

Any statements in this call regarding our business that are not historical facts are forward-looking statements. 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'll turn the call over to Tod Carpenter.

Tod?.

Thanks, Brad, and good morning, everyone. Our third quarter results were in line with our revised guidance, reflecting a constant currency sales decline of 2% and adjusted earnings per share of $0.36. Additionally, our expectations for full-year sales and adjusted earnings per share are in line with our prior guidance.

In fact, results across our businesses were in line with what we discussed a few weeks ago, and Jim and I will today supply the details now that the quarter has closed.

Beyond those details, I plan to spend time this morning talking to our response to projected market conditions, along with providing some perspective on how we're executing against our growth strategy. With that, I'll do a quick review of our third quarter segment results.

Our third quarter Engine Products sales declined 1% from last year, led by a 17% decline in our off-road business. Pressure from agriculture and mining end markets continued in our third quarter with mining taking another step down.

Most notably, off-road sales in China declined more than 20% from last year, a sharp drop-off from the roughly 10% decline we saw through the first six months of fiscal 2015. Within our engine replacement parts business, our business posted year-over-year sales growth of 2% in our third quarter.

However, the pace of growth in this business moderated during the quarter, driven both by our OEM and independent channels. Our largest OEM customer's accelerated destocking in the quarter, driven by lower end market demand for their products.

As I mentioned three weeks ago, our independent channel shifted behavior from cautiously optimistic to cautious. Switching to Industrial Products, total sales declined by 3% from 2014, reflecting an 11% decline in our gas turbine business and a 2% decline in industrial filtration solutions.

Our gas turbine business is a lumpy, project-based business with large shipments subject to the readiness of our customers' build site to take delivery. We did experience roughly $10 million in project shipment delays in the quarter.

Importantly, we still expect the delayed projects will be completed, albeit on a different timeline than originally expected. This is in line with our pre-released guidance.

Our industrial filtration solution sales declined 2% from last year as strong growth in our replacement part sales were not able to offset our soft first-fit capital goods portion of this business. With our business performance as context, I want to provide a quick update on how we're responding to market conditions.

As I said a few weeks ago, while I remain very confident in our long-term strategy and our proven business model, what is different today is the increased urgency across our company to deal with the current state of our complex and changing interconnected global economy.

We will take the necessary actions that conditions require, however, with the proper balance so that we continue to execute our strategic growth plan. Our completed restructuring actions are expected to generate roughly $20 million of savings with the majority of the benefit being realized next fiscal year.

Additionally, over the past several weeks, following a thorough review of our business, we have identified an additional $15 million to $20 million of savings that we will action. These actions will largely impact Asia-Pacific with particular focus on our operations in China.

Our third quarter sales in China were roughly 15% below last year, which was a more significant decline than our year-to-date trend. Although China represents only 6% to 7% of our total company sales, we have been aggressively investing in the China market.

We have now tempered our time lines for growth in our China business, and will adjust our organic investments accordingly. To be clear, our long-term expectation for China has not changed.

We will see – we see China as a strong opportunity for growth and we have won share in China, but we also recognized that achieving our planned growth will now take longer than anticipated. Now, I'll turn the call over to Jim for a review of our financials.

Jim?.

Thanks, Tod. Good morning, everyone. While sales trend during the quarter were not what we expected, the strength of the U.S. dollar against other currencies also added additional volatility to our results. In February, we forecast the euro at €1.13 to the dollar and we currently forecast the euro to be about €1.12.

The seemingly small change includes increased year-over-year pressure during the quarter, resulting from several weeks of setting records for multi-year lows; and then in the final days of April, a rebound versus the dollar, but still much weaker than this time last year.

With that in mind, our third quarter sales decreased 9%to $568 million from $624 million last year. Roughly, $44 million of the $56 million decrease was attributable to foreign currency translation, reducing total sales by about 7% from last year. Excluding the translation impact, sales increased 2% from last year.

We also experienced about $2 million of net income pressure from exchange rates during the quarter. Producing as much of our product as possible locally and hedging helped us manage most of the transactional impact during the quarter.

We also had incremental impact from restructuring actions we took during our third quarter, which resulted in pre-tax charges of about $3.9 million. In addition, we incurred charges of $1.3 million related to the previously announced closure of our exhaust facility in Grinnell, Iowa.

The combined charge of $5.2 million was split fairly evenly between cost of goods sold and operating expenses, and reduced operating margin by about 90 basis points. Adjusted operating margin, which excludes the impact of restructuring charges, was 12.3% or about 260 basis points below last year's operating margin of 14.9%.

Excluding the 40-basis-point impact from restructuring, gross margin was 34.2% in the quarter compared with 35.8% last year. This decrease was driven almost entirely by lower fixed cost absorption, which resulted from the sudden deceleration of third quarter sales.

Importantly, our continuous improvement efforts continue to help offset margin pressures, including the impact from a slightly unfavorable mix of sales we experienced in the third quarter. These efforts benefited gross margin by approximately 50 basis points.

Operating expense as a percentage of sales drove the remaining 100 basis points of the year-over-year decline in adjusted operating margin. Excluding the 50-basis-point impact from restructuring charges, operating expenses increased to 21.9% of sales from 20.9% in 2014, primarily driven by the lack of leverage on softer-than-expected sales.

Let me stop here and provide a bit more context on how the change in sales created pressure across our margin metrics. As I mentioned previously, our expense structure typically absorbs the first 10% to 15% of change in sales. While this structure creates margin expansion and sales growth, it also creates pressure when sales unexpectedly decline.

As Tod said in our last call, we're currently aligning production with current and projected demand to bring our cost structure in line with that current demand. Our free cash flow rebounded to $54 million in the third quarter from $12 million in the second quarter.

For fiscal 2015, we expect full-year cash flow from operating activities to be $250 million to $275 million and that with our forecasted CapEx, we expect to generate $155 million to $180 million of free cash flow this year. In terms of capital deployment, we continue to invest in our business and return cash to our shareholders.

Third quarter capital expenditures were roughly $22 million, bringing the year-to-date CapEx to $72 million and putting us on track to invest between $90 million and $100 million back into our business this fiscal year.

Included in those capital investments is the implementation of our global ERP, which went live in parts of Europe during the third quarter.

I want to thank all the employees across the globe who are working hard to ensure our continued success with the implementation as we complete our rollout in Europe and begin going live in Asia later this calendar year.

Finally, investments in plants and capacity, including our facility in Poland, make up approximately 35% of total capital expenditures. Our longstanding approach to investing in our business for the long term is unchanged.

Beyond investing in our business, we returned nearly $50 million of cash to our shareholders during the third quarter through dividends and share repurchase. So far this year, we've returned about $270 million to shareholders or more than 170% of net income. During the quarter, we repurchased 717,000 shares for $27 million.

We also paid dividends of $22.5 million, an increase of 11.3% from last year. Year-to-date, we spent over $200 million to repurchase about 3.6% of our outstanding shares, and remain committed to repurchasing at least 4% by the end of this year. We're committed to maintain our strong balance sheet.

At the end of the quarter, our leverage ratio was 1.4%, slightly below our long-term target of 1.5%. Additionally, we closed third quarter with cash and short-term investments of about $250 million. Turning to our guidance. We made some minor refinements, but the midpoint of our top and bottom line expectations is intact.

We expect full-year sales to be approximately $2.35 billion, or about 5% below 2014. I'll remind you that pressure from currency translation will be greatest in our fourth quarter compared with the other three quarters of this year.

We expect sales in fourth quarter to decline between 10% and 12%, which reflects over $50 million of exchange rate pressure, or a decline of roughly 8% compared with 2014. Excluding the pressure from currency translation, we expect full-year sales will increase about 1%.

Also, in local currency, sales of Engine Products are expected to decline 1% to 2%, while sales of Industrial Products are expected to increase between 4% and 5%. Our forecast reflects a stable sales trend in our Industrial business and continued softness in our aftermarket and off-road businesses.

Touching quickly on segment guidance, the Engine performance is reflective of continued substantial year-over-year declines in OEM mining and agriculture markets. We expect sales in our OEM and independent aftermarket channels to continue to be pressured with the aftermarket sales finishing the year with a low single digit increase in local currency.

Although we've seen slight moderation in on-road aftermarket performance, our OEM business continues to perform well. External data including truck build rates and customer feedback continues to provide support for continued strength of this business. In local currency, all businesses within the Industrial segment are expected to increase over 2014.

The largest increase is expected in our gas turbine business with about 15% to 20% growth from last year. Our industrial filtration and special applications businesses are expected to experience low single digit increases.

Our full-year adjusted operating margin is expected to be between 12.7% and 12.9%, and fourth quarter adjusted operating margin is expected to be between 13.5% and 14.1%. This guidance reflects continuing pressure from the lower level of sales on both gross margin and expense leverage.

Altogether, fourth quarter adjusted earnings per share is expected to be $0.38 to $0.44. We expect full-year adjusted earnings per share to be $1.53 to $1.59 per share. Also note that the midpoints of our fourth quarter and full-year EPS guidance ranges are consistent with the guidance provided in our recent pre-release.

GAAP earnings per share are expected to be about $0.06 lower than adjusted earnings per share, reflecting $0.04 from restructuring charges and $0.02 related to the U.S. pension settlement we executed in our second quarter.

The restructuring charges from actions implemented in the third quarter are somewhat lower than the original estimates, and this forecast does not yet include the impact of any restructuring actions that Tod outlined this morning.

Before turning the call back over to Tod, I want to provide a little perspective on the impact of the restructuring actions on our future results. As Tod described, we're in the process of executing additional restructuring actions, which should generate annual savings on par with those we announced just a few weeks ago.

Given the timeframe in which we're taking these actions, we expect that the vast majority of these benefits will be realized in fiscal 2016, but they'll be on a similar order of magnitude as the actions we took in April.

I'm planning to provide more details about these impacts and our overall fiscal 2016 outlook when we release our fourth quarter earnings in a few months. Now, I'll turn the call back to Tod for his closing remarks.

Tod?.

defend our current base and win new programs in our long cycle or first-fit businesses, investing and accelerating growth in our short-cycle businesses, and executing acquisitions. To provide a little more context, let me first explain how defending our current base and winning new programs is critical to our long-term success.

While winning a new program or platform today may not appear as revenue for several years, winning new platforms serves as foundation for our future growth. We use our proprietary technology to offer customer solutions, which help drive aftermarket retention.

For example, we do this by offering leading-technology products marketed under our PowerCore and PowerPleat brands. During this fiscal year, on average, we've won a new engine first-fit program every day. To be fair, many of these programs are small, but we have had large successes as well.

For example, within our Engine business, we have a must-win list for first-fit air programs, both on- and off-road. We define a must-win program as one that will generate at least $5 million in sales over a 10-year horizon. So far this fiscal year, we have won roughly 75% of the programs in which we've competed.

Importantly, all the two of these larger programs are incremental to Donaldson and all but one of them offer our customer industry-leading Donaldson proprietary technology. In our industrial filtration solutions business, our new Downflo Evolution, or DFE, reduces the customer's first-fit solution by as much as 40% from previous technology.

We have now booked over $6 million and 250 systems of this new technology since its introduction last September.

The result of these examples and more, which I did not cite today, our daily work, if you will, is that we will be gaining first-fit installed base and therefore strengthening our aftermarket business as these program launch or systems are delivered.

Just to reiterate, many of these fiscal year's wins will translate into future revenue, however, these wins give me confidence that our long cycle business is poised for future growth. We're also investing in our short cycle or replacement parts business. Our proprietary first-fit strategy leads to higher aftermarket sales.

For example, within Engine aftermarket, our PowerCore-branded replacement parts increased more than 24% in the quarter in spite of multiple end-market headwinds. In our Industrial business, PowerCore replacement sales increased 18% in the quarter.

We are also very encouraged by aftermarket trends in Latin America, where we are now up 17% year-to-date, reflecting the benefit of our investments in distribution in Chile, Peru, and soon, Colombia. Adding distribution capabilities in Latin America is one example of investing in our replacement parts business.

We have also expanded our global product offering by adding over 2,000 new parts for sale during this fiscal year. Finally, I'll touch on our approach to acquisitions. Our strategic plan calls for, on average, 2% to 3% of revenue to be added to our company annually through acquisition.

We have not executed well on this portion of our strategy in the past five years. While we continue to research filtration opportunities in the new platform for our company, the more likely near-term opportunities will be what we call bolt-on acquisitions.

Bolt-on acquisitions can be characterized as accelerating the build-out of our organic plans within a business that is already part of our company. Our acquisition process is more robust than it was a year ago and we do have more people playing a role than previously, however, it's important to note that our approach to investing has not changed.

We will continue to be thoughtful, ensuring that we strike a balance between growth and returns. We have a solid growth plan and I'm very confident in our future. Now, I'll turn the call back to Don to open the lines for questions.

Don?.

Thank you. And we'll take our first question from Eli Lustgarten with Longbow Securities..

Good morning, everyone..

Good morning, Eli..

Eli..

It's nice to not be surprised for a change, right? Can we get a little bit of a rundown of what you're actually seeing in the business conditions? I know you talked about a step-down in mining, ag is still weak growth. But I mean, the expectations for the weakness was there all year just maybe exacerbated a little bit more.

But there's an expectation that we're seeing almost the worst of it or something the worst of it in mining and ag, which I personally don't believe.

So, what are your customers telling you with the step-down, does it stay at this level for awhile, does it change, can we get some feel as we go through the fourth quarter, so we can get some insight into what kind of conditions, I guess, as we go into fiscal 2016 for you?.

Eli, this is Tod. When we – I'll start first with mining. When we take a look at mining and we take the inputs from our customer, it's clear across our customer base that mining is taking another step down after multiple years of decline. We had – previously had and guided our first-fit portion of that business to be down 10%.

We've now taken that down to 15% to 20% within our model. So mining, globally, is really creating more headwind than we had originally predicted. That's a big one on us. The other one that really is the change on the first-fit portion is ag.

Ag remains weak, as we all know, in North America and Europe; but Latin America due to Brazil, weakened in this quarter. We had, as you know, we've talked before, Eli, between – agriculture down 35% to 40%, we've now taken ag down between 40% and 50% on the first-fit piece. Those are the two changes that we've seen.

As we look to the replacement parts portion of our company, there has been change as well and specifically, that is within mining. So, we've seen aggressive destocking through our OE channel – through the OE channel of replacement parts, but we've also – that's particularly in mining. That's also in agriculture.

And then, the additional surprise for us this time was that on the replacement parts revenue in on-road, which we had expected to be flat, North America really became cautious as their demand had kind of – had weakened. So, the independent channel for on-road softened for us in this last quarter.

Those are the changes we're seeing and that's what we put within our guidance..

Yeah.

Well, I guess, what I'm trying to drive at is the step-down that we're going through now into the fourth quarter, are your customers saying this is the level we're going to stay at for a while? Is there any indication of, well, this is just immaterial condition and we get a little bounce? Or how do we – as we exit 2015, is the momentum staying the same at these lower levels? I mean, that's what I was sort of driving at more than anything..

You know, Eli, I would just point to, for example, CAT's guidance where they're suggesting that the full year, they'll be down 10%. When we look to that external information and when we talk directly to the customers, I think there's a really cohesiveness to what you're hearing and what we're hearing.

However, the visibility, the long-term visibility is not great out there. We'll bake into what we see when we give fiscal 2016 outlook here in about three months..

Okay. And if we go over to Industrial's outlook, the $10 million postponements, I guess, we talked about it was $7 million during your guidance change postponements. And I guess at that time you indicated in gas turbine that it was – the postponement from the third to fourth has an equal amount from the fourth and to next year.

Can you give us some profile of what we're seeing in gas turbines? I think you indicated you expected $10 million to be shipped but not necessarily when.

And so, are we seeing just a stretch out of business going into – well, into next year leaving conditions, say, uncertain and slowing in that market?.

Eli, this is Jim. The changes that Tod referred to are consistent with what we talked about a couple weeks ago on our pre-release that the delays are not indicative of the projects not being completed or us not getting the revenue. It's simply timing.

And because we're on the back half, very near the commissioning of these projects, any delays upstream affects our delivery date. So, you summarized it well. We had roughly $10 million go from our third quarter to fourth quarter. And then in our guidance, we did take out a similar number going from fourth quarter to early next year.

So it's simply timing. I would say these shifts are not reflective of any changes in the end markets. This is typical for this business that we would see some of these delays. I would say we're probably just seeing a few more than what I would call normal..

And frankly, (27:04) are we seeing any pricing changes or so, any pricing pressures you go through all these because of the weakened condition?.

Eli, this is Tod. No, there's no change in behavior across our markets; not at this time. It's not – we are not seeing any of that..

Great. Thank you very much..

We'll go next to Brian Drab with William Blair..

Good morning. Thanks for taking my questions..

Good morning..

Good morning. The first, and I guess, set of questions, quickly just on the restructuring and make sure that I have this correct.

You said an additional $15 million to $20 million in savings expected for 2016; so the total of savings is $35 million to $40 million expected for 2016?.

That's correct. The second one....

Okay..

...as Tod mentioned, we're still refining, but that's right..

Okay. And then, we've completed the actions in the first round of restructuring and that's a $20 million annual run rate; so for the fourth quarter of 2015, we should expect about $5 million in restructuring savings.

Is that correct?.

This is Jim, Brian. Not entirely because some of those, depending on the timing of the action being implemented. We're substantially complete, but there's still some open items.

So, in terms of the savings that we've already reflected here in the guidance, it's a little less than $5 million, I would say about half to little over half of that will be realized. But that's in our guidance..

Got it. Okay. Thanks. And then next set of questions focusing on the aftermarket.

So, you talked about softening and caution in the independent on-road segment of the market, but can you tell us whether volume or maybe in terms of organic revenue, was that up or down year-over-year in the quarter and focusing again specifically on the independent on-road?.

Yeah. While Jim looks that up, Brian, do you have another question you want to....

Yeah. Yeah. Independent off-road was my next one and then – and I guess – also, I'm wondering to the OE aftermarket, I assume that that was down. Did you tell us how much of that OE aftermarket was down just in general, including off-road and on-road independent....

Yeah..

...or sorry, excluding independent but including off-road and on-road for the OE?.

Yeah. Jim is going to....

Yeah..

He's going to break down the three segments for you..

Okay. Okay..

So, with regards to the aftermarket, if we just look in local currency, the aftermarket in total was up about 2%. And as we look at the independent versus OE, it's fairly similar; our independent was up about 1% and the OE was up just slightly more than that to make up that difference.

So, they were fairly similar, both the OE and the independent, with the independent showing a little bit softer year-over-year. But at the same time, the independent had a very difficult comp. We were very strong third quarter last year..

Okay.

But both grew year-over-year organically?.

Yes..

Okay.

And can you tell us anything about the trends that you're seeing in the independent channel and the OE channel for aftermarket from March to April?.

I don't think there's been a change from March to April. I think the characterization that I gave and Jim summarized within aftermarket holds through between the two months..

Okay. Okay. And I guess one last question.

Can you talk a little bit – I know you don't want to talk specifically about 2016 guidance obviously, but can you talk a little bit about the puts and takes that we'll have to take into account as we're modeling 2016 in terms of ERP spending that will be incremental in 2016 versus 2015? You've done a good job laying out the restructuring savings, but any other big moving parts that you can help us on directionally for 2016? Thanks..

Sure. Brian, it's Jim. The ERP year-over-year is going to be fairly similar to this year. I would estimate right now, it's about $2 million more next year because we're going to be implementing essentially in two regions. I'd say the other thing, if FX stays similar to where it's at today, that's about a 2%, or $50 million, headwind for next year.

Obviously, that's – who knows where that will be in a month, but that would be one to call out. Other unusuals, we have some investments that we've made this year in terms of distribution centers, our new plant in Poland, and the like; but those, especially the plant in Poland, we'll begin to recognize those revenues.

So, those pressures should subside. So, those would be the couple I'd call out..

Okay. Thanks very much..

We'll go next to Rick Eastman with Robert Baird..

Yes. Good morning..

Good morning..

Jim, could you just kind of – I just want to follow up on aftermarket.

If you just take the overall Engine aftermarket business, can you just give an approximate split on off-road versus on-road, just in total, irrespective of channel?.

One second. I've got – it's hard to track those just given the fact that some of the parts....

Sure. The part number. Yeah. The part numbers. I'm sure..

Yeah. But....

Yeah.

I mean, it would almost appear by the growth rates that you're talking about – I mean, are you talking about 50%-50% or – I presume the off-road must be larger than 50%, though?.

Yes, it is. Give me one second. I'm looking for the number, but it is..

While he digs, Rick, do you have another?.

Yeah, no, that's fine. I just had a similar question. On the IFS business, maybe a thought or two as to – I think, Tod, you defined the aftermarket piece of IFS as strong versus capital equipment soft..

Right..

I'm a little bit curious if there's any difference between the dust collection piece and the compressed air piece.

And then, also, are we anywhere near a 50%-50% split of capital equipment in aftermarket in IFS?.

So, Rick, the....

It's another Jim question, perhaps..

No, it's okay. So, let me help you through that. So, if you compare our dust collection aftermarket with our first-fit business, our first-fit business still is heavier than our aftermarket within dust collection. We are not near to 50%-50%.

We're probably closer to 60%-40%, but it does reflect really our opportunities within our aftermarket globally for dust collection for growth.

We have been growing our aftermarket business within dust collection double digits worldwide and we can – we really look at that as an opportunity going forward in order to push that to that 50%-50% number that you quote. I do not see a lot of similarity within our dust collection aftermarket versus our compressed air aftermarket.

We have different models the way we run those businesses. One in our compressed air aftermarket, it's a more service-based model where we actually have people visiting the customers to provide the service versus our dust collection business is more touching direct to end users and shipping parts to help their maintenance personnel install.

So, very different in the way that we approach those and so, therefore, I'm not sure you can really draw a strong correlation..

Okay.

So, again, when you're talking about the IFS aftermarket and you're kind of quoting those comments, you're really thinking specifically to dust collection?.

Correct. Dust collection is double-digit growth....

Yes..

...globally. That is correct..

Okay. Okay..

Hey, Rick, it's Jim. The aftermarket split – and these are approximations, like I mentioned, but it runs – about 25% of that business is on-road, and the rest being construction, ag, mining, et cetera..

Yeah. Okay. I understand. And, Jim, when you – we talked a little bit about the incremental – or, Tod, we talked a little bit about the incremental cost takeout and expected savings from that. And again, summed up, it's – it pushes $40 million.

How would you approach the net savings number when you get into next year?.

In terms of how much goes to the bottom line and then how much is invested back or....

I mean, because obviously, we have growth investments here. And when you look at the cost of sales but more importantly, the operating expense number, we're going to net out at a number. I'm sure you don't want us to take $40 million out of the expense number; hold it flat and take $40 million out because we have growth investments.

But again, how would you approach, trying to forecast maybe a net savings number for the full fiscal 2016?.

Sure. Yes. So, like you mentioned, we have investment opportunities. We're looking at areas for growth because we do see good opportunities moving forward. So, the way we're looking at the cost savings is really to get our operating metrics back in line with where they've been the last couple of years.

So really, as we look at it, we're going to keep making investments, but the net of these savings, really the target is to get our operating metrics back essentially over the next year or two to where they were heading into this year, if that helps..

Okay.

And just to simplify operating metrics, can we just speak to the EBIT line?.

Yeah. Yeah. EBIT, I look at it as an operating margin but it's essentially the same..

Yeah. No. I understand. Okay. And then just one last question for Tod. As you tightened up maybe the M&A pipeline, the process, is there a focus – I mean, I understand the bolt-on versus maybe more of a – entering a new vertical and that'll take a little bit of time.

But is there a focus on Engine or Industrial; and if it's Industrial, is there any focus on liquid process versus air?.

Rick, what we do is we have taken both portions of our company, Engine and Industrial. We've started with those growth strategies across the business segments for each portion of our company; so it could be first-fit, it could be replacement parts, it could be liquid, it could be air.

Where we see an opportunity to accelerate that organic model that we already have in place and laid out, we'll take it. It's not one particular side over the other. We see many opportunities and we're pressing that broadly across our company..

I see. Okay. Great. Well, thank you very much..

We'll take our next question from Laurence Alexander with Jefferies..

Good morning. Two quick ones – or actually, three.

What's your – is there a net FX headwind still flowing through in 2016 given the timing of the move this year?.

Laurence, it's Jim. Yeah, there is. If we hold rates similar to where they are today, it's about a 2% impact on our revenue next year, just given a lot of this headwind didn't start until December..

And then how are you thinking – given the restructuring you're doing, how is that going to affect your incremental margins going forward? If we did get an upside surprise in demand trends next year or the year after, how do you see your incremental margins and how much room would you have to grow before you'd have to start reinvesting again?.

The way we look at that, Laurence, is generally the first 10% to 15% of a fluctuation in our sales gives us higher than company average margin impact.

So, from a gross margin standpoint, we've said historically that that could be 40% to 50% gross margin incremental on that first portion, but then we'd have to get back to adding shifts, people, et cetera.

It also depends how quickly it comes back because to the extent it comes back more suddenly, it does result in overtime and some of those types of cost. So, it does depend on the slope of the increase but generally, we would see some incremental margin just like we've seen some degradation here this quarter on that first 10% or so..

And then, lastly, do you have any perspective on the impacts on your business over the next couple of years or opportunities created by the Poland and Polypore (42:00) situations?.

I think it's hard to tell any direct impact to us. I think one thing it does do is reemphasize that the filtration business is a very attractive business and we're very happy to be part of it..

Thank you..

We'll take our next question from Brian Sponheimer with Gabelli & Company..

Hi. Good morning, guys..

Good morning..

Just to go – kind of go back to that – the idea of acquisitions. I think in your comments you had mentioned some degree of – I wouldn't say frustration, but a lack of activity over the course of the past several years.

Talk about just from a strategic standpoint, the ways in which you're potentially changing how you're looking at companies or potential targets internally now versus, say, the past five years..

Brian, there's two pieces to it. So, the first piece is really the identification of the opportunity.

And that really- what we've done is we've circled back and we'd made sure that we are identifying through the strategic opportunities across all of our businesses a lift essentially and really kind of opened our minds to accelerating our growth through acquisitions.

However, I want to reemphasize that our financial metrics of what a good acquisition versus a bad acquisition is has not changed. We'll still be thoughtful when we apply an opportunity. We still have to have a solid value-creation model to be able to acquire.

So, all of the metrics that we've talked about, 15% ROI in year five, accretive in year two; these are still baseline metrics that we apply to any opportunity as we see forward..

And, I guess, just to follow that up, you mentioned that there's – it's a – I suppose, a target-rich environment at this point.

Has anything changed about potential sellers multiples, particularly, if you see areas to grow in, say, in Engine or for off-highway where markets are depressed?.

Brian, I don't think that we look at the multiple as much as we stress do we have a clear path to value creation right now. And if we see that opportunity to create the proper shareholder value and deliver those returns, then clearly, we'll act. We really focus on shareholder value and a way forward. That's our focus..

Right.

And would you able to say if you have any NDA signed right now?.

No, we would not..

All right. I had to ask. Thank you very much, guys..

We'll go next to Larry Pfeffer with Avondale Partners..

Good morning, gentlemen..

Good morning..

So, just sticking in the same vein, obviously, with the share repurchase activity, you're around 4% of the float and looking at more acquisition candidates.

Does it say hypothetically you found one or multiple candidates you liked; are you comfortable taking the leverage ratio to 2 to 2.5 times and continuing the share repo at the same time?.

Larry, it's Jim. I think we have to evaluate it. We would definitely look at all potential acquisitions that can add the value and the fit with the company that we're looking for. The share repurchase is the variable piece of our cash deployment.

So, depending on the facts and circumstances, yeah, we'd tank it up (46:24) temporarily, but then I think we have to look how aggressive would we continue with the share repurchase part of that. And like I said, that would be the variable lever that we would fluctuate..

Okay. Got you. And then just kind of a quick macro question.

How are you guys seeing things progress in Europe right now?.

This is Tod, Larry. So, Europe for us is going fairly well, to be honest. We're still up roughly 4% to 5% year-over-year year-to-date. It has been a little bit more cautious in the last quarter. So we're being careful. But it's still implementing our strategies going forward that we have, just being a bit more cautious..

Okay. Thanks, guys. Best of luck..

Thank you..

This concludes today's question-and-answer session. At this time, I would like to turn the conference back to Mr. Tod Carpenter for any additional remarks..

Thank you, Don. That concludes today's call. I want to thank everyone for their time and continued support of Donaldson. I also want to thank the employees for what they do every day to make our company a filtration leader. Thank you and goodbye..

This concludes today's conference. Thank you for your participation..