Ladies and gentlemen, thank you for standing by and welcome to the Donaldson's fourth quarter and full year 2020 earnings conference call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. [Operator Instructions].

I would now like to hand the conference over to your speaker today Brad Pogalz, Director of Investor Relations. Thank you. Please go ahead..

Thank you. Good morning everyone. Thank you for joining Donaldson's fourth quarter and full year 2020 earnings conference call. With me today are Tod Carpenter, Chairman, CEO and President of Donaldson; and Scott Robinson, Chief Financial Officer.

This morning, Tod and Scott will provide a summary of our 2020 performance, along with an update on key considerations for 2021. I want to remind everyone that we issued a business update press release on August 6, which included some details that we will reference on this morning's call. During today's call, we will also reference non-GAAP metrics.

We included a reconciliation of GAAP to non-GAAP metrics within the schedules attached to this morning's press release. Finally, please keep in mind that any forward-looking statements made during this call are subject to risks and uncertainties, which are described in our press release and SEC filings.

With that, I will now turn the call over to Tod Carpenter.

Tod?.

Thanks Brad, and good morning everyone. I want to start today by thanking our employees for their resilience, flexibility, and commitment in fiscal 2020. I greatly appreciate the work they do every day to keep us moving forward. As always, we remain focused on those things under our control.

Despite a significant shift in the economic environment during fiscal 2020, there were several things that went as planned, including sales of replacement parts performed better than new equipment and first-fit products, gross margin increased from the prior year, we reduced our discretionary expenses while investing in growth businesses, and we maintained a strong financial position while returning cash to shareholders through dividends and share repurchase.

We are entering fiscal 2021 with clear priorities and engaged employees. We do not anticipate strong market conditions overall this year, but our diverse business model and robust operational capabilities give me confidence that we can make progress on our strategic initiatives in any economic environment.

We will talk more about our longer-term opportunities later in the call. So, I will now turn to a brief overview of fourth quarter sales. Total sales were $617 million in the quarter with sequential increases in June and July. Compared with the prior year, sales were down 15%, which is consistent with the forecast we provided in early August.

Both segments experienced a similar decline, however, there was quite a bit of variability within the results. In the engine segment, our first-fit businesses remain under the most pressure. Fourth quarter on-road sales were down 44% from the prior year. The U.S.

is the largest portion of on-road, and it accounted for much of the decline as the cyclical slowdown in Class 8 truck production was magnified by the pandemic. As a reminder, on-road first-fit in the U.S. is only about 3% of total Donaldson sales, so our aggregate exposure to that market is limited. Sales in off-road were down 24% in the quarter.

More than half the decline was due to exhaust and emissions. There were pre-buys in Europe last year related to an oncoming regulatory change and new programs for our exhaust and emissions products are not yet at meaningful volumes.

In the U.S., production of heavy-duty off-road equipment remains depressed, particularly for the construction and mining industries. On the other hand, off-road sales in China were up nearly 50% in the fourth quarter. The Chinese government is investing to stimulate activity which is benefiting our off-road business.

Additionally, we continue to win new programs with local manufacturers and some of those programs were won with PowerCore. These are new customer relationships in the country that produces more heavy-duty equipment than anywhere in the world.

We are learning how to best support these local manufacturers, and we know that will come with order volatility, but our team in China is motivated as we see the opportunity for significant long-term growth. Sales trends for engine aftermarket were predictably better than our first-fit businesses.

Fourth quarter aftermarket sales were down 11%, reflecting a decline in the mid-teens for sales through our independent channel. The headlines in our independent channel are fairly consistent with third quarter. Sales in the U.S. fell with the collapse of the oil and gas market, combined with slowing transportation activity.

In Latin America, utilization is slowing across the region as the spread of the virus is compounding the impact from geopolitical uncertainty. And fourth quarter sales in Eastern Europe remained strong as we continued gaining share. Sales through the OEM channel of aftermarket experienced a more modest, low-single-digit decline.

In the U.S., large customers pulled down inventory to match demand, which was partially offset by strong growth in China as we continue gaining share with local customers. In fact, aftermarket sales in China were at a record level last quarter, and we see a long runway as we expect to continue winning new programs with innovative technology.

Our portfolio of innovative products performed well in the fourth quarter. This portfolio makes up nearly a quarter of the total aftermarket revenue, and fourth quarter sales were up in the low-single digits. For nearly two decades, we have been improving, expanding, and reinventing our offering related to these razor-to-sell razor blade products.

After all that time, we still have very strong retention rates. These products create a significant opportunity for growth and relative stability in our engine business, so we will continue to invest in new technologies for a long time to come.

Sales of aerospace and defense were down 3% in the fourth quarter driven by soft sales of products for commercial helicopters. The decline was partially offset by a strong increase in sales for ground defense vehicles, but some of the growth is timing related as key distributors build inventory in the quarter.

I also want to update you on a change to our strategic portfolio classification. Beginning in fiscal 2021, we are re-categorizing the defense business to critical core from mature.

Our mature businesses are committed to generating cash that allows for investment elsewhere, while critical core businesses are geared towards driving share gains in existing markets with new technology, services, and relationships.

The defense business has won new programs with our robust engineering capabilities, and we expect these wins will deliver solid returns over a long-time horizon. Turning to our industrial segment, fourth quarter sales were down 15%, driven in large part by the dust collection business within industrial filtration solutions or IFS.

Sales of new dust collectors and replacement parts were down as customers continued to defer investment and reduce output. The quote to order cycle remains elongated with large projects being put on hold while smaller must-do projects tend to move forward. At the same time, our value proposition still resonates.

Fourth quarter sales of our Downflo Evolution dust collection systems were up in the low teens, and the sales of those replacement parts grew more than 30%.

The Downflo family of products is only about 15% of total dust collection sales today, but it has grown rapidly as customers appreciate the space and energy savings it offers and we value the ability to retain the aftermarket We are also building the dust collection business through our e-commerce platform shop.donaldson.com.

We turned on the ability to take guest orders earlier this year and we are encouraged by the results. While incremental dollars are still small, we have seen a significant number of new dust collection customers.

With our robust sales and delivery model, we believe the simplicity of our e-commerce platform gives customers another reason to choose Donaldson. Fourth quarter sales of process filtration were down in the low single digits after an increase of more than 10% last year.

The decline was driven by new equipment while replacement parts were about flat with the prior year. We continue to make progress penetrating the highly valuable food and beverage industry.

We have positioned ourselves as an engaged partner and we market our ability to quickly fulfill orders with a product that can help improve efficiency in our customers' processes. The pandemic gave us the opportunity to prove this value proposition to our customers in the food and beverage industry and our process filtration teams delivered.

We remain very excited about this market. So we will continue to invest in growing the sales force and adding new tools to drive this profitable business. Sales of special applications were down 10% in fourth quarter.

Disk drive was down from the prior year after having a significant increase in third quarter while the slowdown in the automotive market resulted in lower sales of venting solutions. Fourth quarter sales in gas turbine systems or GTS were up 6%, due primarily to strength in small turbines.

Once again, the GTS team delivered another profit increase in terms of both dollars and rate. As you know, we shifted the GTS go-to-market strategy four years ago. We determined that the best path forward was to focus on replacement parts and small turbines while being highly selective in deciding which large turbine projects we pursue.

The GTS team has done an incredible job executing that strategy and we see it in the results. In the past quarter, we also chose to consolidate our joint venture in Saudi Arabia into our company. Once again, we are focused on rightsizing and streamlining GTS to enhance our profitability.

Based on what the GTS team has delivered and the opportunities in front of us, we are reclassifying GTS as a mature business in our portfolio. The GTS team has transitioned from fixing the business to driving profitability and we are on solid footing today.

I want to thank them for the incredible job they did executing their strategy and delivering on their commitment. The success in GTS is not an isolated incident. Our company is filled with great people working together to deliver results and create value for all our stakeholders. That's why I am comfortable and confident in our future.

Before turning the call to Scott, I want to briefly touch on fiscal 2021. We are not sure how long the pandemic will last nor are we sure about its ultimate impact on our business. Given those uncertainties, we will remain focused on what we control.

Prioritizing the health and safety of our employees, filling our customer commitments, pursuing market share and growth opportunities around the world, executing margin enhancement initiatives and maintaining a balanced approach to expense management which includes making targeted investments to advance our strategic priorities.

Scott will share some more fiscal 2021 details. So I will now turn the call over to him.

Scott?.

Thanks Tod. Good morning everyone. Like most companies, we had to quickly adjust to a new way of working over the past six months and our employees did an excellent job of that pivot.

We increased our level of collaboration, we deepened our relationship with customers and suppliers and we supported critical businesses around the world with minimal disruption. Overall, I am very impressed by what our team accomplished. To my colleagues around the world, thanks for all you do. As we turn to fiscal 2021, we have a solid foundation.

But the markets are not yet on firm footing. Given the wide range of possible outcomes, including the timing and shape of the inevitable recovery, we are no issuing detailed guidance at this time. We do however want to provide some of our 2021 planning assumptions.

I will cover those later in the call but first I will share some thoughts on fiscal 2020 results. Decremental margin was a notable highlight for us. We delivered 20% in the fourth quarter and 18% for the full year. Those results are stronger than our historic averages. So let me walk through some of the details.

I will start with operating expenses, which declined 10% to $125 million in the fourth quarter. That's flat sequentially and it's our lowest fourth quarter level in four years.

Discretionary expenses were down significantly, due in part to pandemic-related travel restrictions and we maintained our investments in strategic growth businesses like process filtration, dust collection and connected solutions.

We will continue to focus on balancing expense savings with investment and we are pleased with the performance in the fourth quarter. We are also pleased with our gross margin performance.

Fourth quarter gross margin was up 20 basis points than the prior year and our full year rate was up 50 basis point, despite headwinds from lower sales and higher depreciation related to our capacity expansion projects.

As a side note, many of these projects are now completed and so our capital expenditures in fiscal 2021 are planned well below the $122 million we invested last year. Our focus has now shifted to the optimization opportunities enabled by these investments. We plan to lower our cost structure while maintaining or improving service levels.

While benefits from these initiatives will ramp up over time, out list of optimization project gives me confidence that we can deliver strong returns with these new assets. Lower raw material costs are helping to offset the loss of leverage impact on the gross margin.

We have seen favorability in market prices for steel, media and petroleum-based products and our procurement team is driving incremental savings as they strengthen our supplier network while improving terms. I also want to touch on pricing. While it hasn't been a major contributor to the year-over-year gross margin increase, it hasn't been a headwind.

We have more latitude to drive pricing in many of our replacement parts businesses and it seems like those in the independent channel of engine aftermarket have done an excellent job consistently executing our pricing strategies. I know that takes a lot of work.

So I want to thank the commercial teams around the world for meeting their customers' needs while promoting the value we bring in terms of technology and service. It makes a big difference, especially in this economic environment. A favorable mix of sales is also making a difference to gross margin.

In the fourth quarter and for most of the year, we have realized mixed benefits as replacement parts make up a greater share of total sales. To a certain extent, these mix benefits are by design. We invest in technology to win first-fit programs that drive aftermarket retention.

As we move through an economic cycle, our strong base of recurring revenue creates some relative stability and provides some gross margin insulation. Replacement parts now account for 64% of total sales, giving us confidence in the durability of our business model.

Before moving further down the P&L, I want to quickly talk about segment profit margins. The story of engine is consistent with the consolidated results. Mix benefits and lower raw material cost after the loss of leverage resulting a year-over-year margin increase of 20 basis points in the fourth quarter.

Within the industrial segment, the loss of leverage was magnified by continued investments in our strategic growth businesses. We expect industrial margins will bounce back helping us deliver our goal of mixing the company's margin up over time. Moving back to the P&L.

Other income was $2.7 million in the fourth quarter compared with an expense of $0.5 million in the prior year. Improved performance in our joint ventures was a benefit in fiscal 2020 and the fourth quarter expense in the prior year reflects a charge related to our global cash optimization initiatives.

These initiatives, which allowed us to streamline our legal entity structure, were enabled by tax reform. We excluded the charge from last year's calculation of adjusted earnings per share and we also excluded a nonrecurring charge related to tax reform legislation.

With that in mind, it's best to compare the reported fourth quarter tax rate of 21.1% with the prior year's adjusted tax rate of 21.4%. While the delta between rates is not significant, I will point out that current and prior rates were well below what we would typically expect.

The fourth quarter 2020 rate benefits from a favorable mix of earnings across jurisdictions while the 2019 adjusted rate included a nonrecurring benefit related to the favorable settlement of an audit. As we think about fiscal 2021, we see our full year tax rate going up in 2020 to be more in line with our long-term estimate of 24% to 27%.

In terms of our financial position, we feel good about where we ended the year. Our leverage ratio was 0.9 times net debt to EBITDA and in the fourth quarter we paid off a term loan for $50 million and we reduced borrowings on our revolvers by $110 million.

We proactively drew from our revolvers in the early days of the pandemic as a way to bolster our liquidity out of an abundance of caution. While markets still are uncertain, we are confident in our current position and no longer feel the need for that extra layer of security.

Receivables were down meaningfully from the prior year, which is what we expect in this environment. Inventory was also down but we plan further improvements this year as we focus on leveling with demand.

Our fourth quarter and full year 2020 cash conversion rate increased meaningfully to 165% and 103%, respectively and we plan to exceed 100% again this year. Our fiscal 2021 assumptions for sales are directionally consistent with recent trends.

Sales are expected to vary widely by geography and market and sales of our replacement parts and products for new markets should continue to outperform the company average. Additionally, we expect sales during the first half of 2021 will be down versus the prior year due to the timing of when the pandemic began.

We are seeing these sales trends play out in August which we expect will be down about 10% from the prior year. Total sales for the month will also be down from July but that's past typical seasonality. Regional trend in August match what we saw in the fourth quarter.

Sales in the APAC region are performing the best versus the prior year led by growth in China. Europe is faring better, due in part to currency. While the U.S. and Latin America remain under the most pressure.

And as expected, we have pockets of relative strength from some of our more stable businesses, including engine aftermarket and process filtration which are most up in Europe, while new equipment remains under more pressure.

In terms of fiscal 2021 gross margin, benefits from product mix and lower raw material costs should lesson as we compare against strong tailwinds in the prior year. At the same time, we will execute our optimization projects to position ourselves for long term increases in gross margin.

Our fiscal 2021 operating expenses will also have some puts and takes. Resetting our annual incentive compensation plan generates a headwind of about $13 million and we are planning to make further investments in our strategic growth businesses and technology development.

We plan to substantially offset these increases by controlling expenses, which will likely see some from benefits from pandemic-related restrictions and comparing against the higher level of spend from the first half of the prior year. Should we see an opportunity that makes sense, we will also explore additional optimization initiatives.

Finally, we plan to repurchase at least 1% of outstanding shares in fiscal 2021 which should offset any dilution from stock-based compensation. Any repurchases beyond that level will be governed by macroeconomic conditions, our investment opportunities and our balance sheet metrics.

Should conditions improve, it is not unreasonable to assume we will go above the 1% in fiscal 2021. At a high level, our objective for the new year are consistent with our long term strategic agenda.

We will pursue growth and market share opportunities in our advance and accelerate portfolio of businesses, drive optimization initiatives that will strengthen gross margins, control discretionary expenses while making targeted investments and protect our strong financial position through disciplined capital deployment and working capital management.

These are the actions we can control and I am confident in our ability to deliver in 2021. Before turning the call back to Tod, I want to share some news. After five years as our Investor Relations Director, Brad is going to be moving to Belgium to take over as Finance Director of our Europe Middle East region.

COVID makes the timing a little uncertain, but I know he is committed to facilitating a smooth transition when we find his replacement. Thanks, Brad, for all your work in IR. You have done an excellent job and congratulations on the exciting new adventure with Donaldson. I will now turn the call back to Tod.

Tod?.

Thanks Scott. And I offer my congratulations to Brad as well. You will clearly be missed in this role, but we all know it's a great opportunity. So we are very excited for you.

I am confident in our ability to navigate the complexities of the current environment and I am equally confident in our ability to create long term value by meeting the evolving needs of our customers. We have strong relationships with our customers and they range from some of the world's biggest brands to small business owners.

We are grateful for the partnership we have and I want to thank our customers around the world for their continued support of our company. Our goal is to solve our customers' complicated filtration challenges in a way that allows them to deliver great products efficiently and I think we are doing well against that objective.

Let me share some examples of what I mean. In the engine segment, our filter minder team released a wireless monitoring system that helps fleet managers optimize their maintenance schedules for on-road and off-road equipment.

Our system integrates into their existing telematics and fleet management infrastructure, making it easy for our customers to adopt this valuable technology. We are also expanding connected solutions into the dust collection market with our IQ offering.

This service provides customers with real-time monitoring of their equipment performance, helping them save energy costs and reduce unplanned downtime. Once again, we made it easy to adopt. Our IQ setup can be used on any brand of dust collector and the retrofit process is very simple.

Our e-commerce platform is another tool for helping customers operate more efficiently. Shop.donaldson.com has a global reach and offers features like real-time availability and personalization functionality, making it easy for customers to find what they need and place new or repeat orders.

As always, new technology is a critical part of our success formula and we continue to expand our technologies and solutions to drive growth. Many of our engine customers are looking to improve fuel economy and reduce emissions and our products can help them achieve their goals.

We have shown that consistent use of our PowerCore products can help end-users improve fuel economy and it provides value to our OEM customers as they can retain more of their parts business.

We still see many opportunities with diesel engines and we also see a growing opportunity with alternative powertrains like hybrid solutions and hydrogen fuel cells. Hybrid platforms leverages the portfolio of air and liquid solutions we have today so we have good opportunity with that equipment.

The needs are different for fuel cells and we have a specialized air filtration system that is specifically designed to meet those needs. In addition to our air systems, we also have venting products and specialized membranes for fuel cells. With our technical capabilities, we are well-positioned to participate in this growing market.

We are also pursuing non-engine markets like food and beverage. Sales of process filtration were about $50 million in fiscal 2020. That's an increase of more than 60% over the past three years. We have continued investing in new technologies and we are building capabilities that will facilitate our future expansion into life sciences.

Our long term success is dependent on our team. So we are committed to making our company a great place to work. We have a strong culture and we place a high value on integrity, commitment, respect and innovation. We also have a continuous improvement mindset.

So we recently created a diversity, equity and inclusion council that will help identify and implement practices to make us a stronger company. The council is being led by a passionate group of employees and I want to thank them for stepping up to move us along in this important journey. We are also on a journey with our sustainability practices.

We began developing our global sustainability strategy last year. We had engaged our stakeholders and we have identified a long list of projects for reducing greenhouse gas emissions, energy consumption and wastewater.

Implementing and maintaining sustainable practices is one more way we drive towards our purpose of advancing filtration for a cleaner world. As I close today's call, I want to thank again our employees for their contributions during fiscal 2020. I am proud of what we accomplished as One Donaldson and I look forward to another successful new year.

Now I will turn the call back to Lisa to open the line for questions.

Lisa?.

[Operator Instructions]. And our first question comes from the line of Nathan Jones from Stifel. Your line is open..

Good morning everyone..

Good morning..

Hi Nathan..

Maybe we can start on the topline. Fourth quarter sales in aggregate down about 15%. And you said, August was down about 10%.

Can you talk a little bit about how the comparisons in the fourth quarter progressed? And is that August down 10% a better comparison than the kind of the exit rate out of the fourth quarter or have things started to settle down here and it's kind of hovering in that minus 10% range? Just any color you can give us on how that's progressed over the last few months?.

Nathan. This is Brad. I will start. And as a reminder for you and the group, a few months ago, we announced that May sales will be down 24%, and of course that came out the way we expected. So, when you put June and July together, they were down in the low-double digits, which is pretty consistent with the trend we saw year-over-year in August.

The decline in August from July is also not a typical seasonality. We would typically see that falling off as we get more towards the fall and winter months..

Maybe then, as I said, June, July, and August have been fairly consistent on the comparison levels there.

Can you talk about which parts of the business there are seeing a recovery? Which parts are slower to recover, and would you anticipate some of those lagging parts of the business to gradually begin to improve as we go through the back half of the calendar year here?.

Sure, Nathan. This is Tod. So, the businesses are very mixed, as you might imagine. So, any first-fit type business, so on-road vehicles or off-road vehicles with first-fit production have the most significant headwinds and the most significant headwinds in the company is on-road United States first-fit business.

The rest of the businesses such as aftermarket, both in the independent channel and the OE channel, are more modest headwinds and we do see that with the destocking that has occurred in the previous two quarters really at a pull-through like level.

As we turn to the industrial side, the most significant headwinds are going to be first-fit equipment in our industrial air filtration business. We also see slight headwinds in the replacement parts because industrial production has not come back particularly in the United States, to the levels that we would expect. That's where we are at the moment.

We would expect the first half, especially because COVID hit in the second half of last year, we would expect the headwind to be more predominant in the first half and then of course, with the easier comps and such, growth overall for the company to be in the second half of our fiscal year..

So I guess with where you are at now, kind of low-double-digit declines in July and June, 10% in August, you should probably see some of those lagging businesses get a little bit better as we go through the back half.

So, is it at least fair to say that that first half revenue comparison should be down in the single digits somewhere rather than the potential for it to be down in the double digits?.

Tough to say specifically where, clearly, a high-single to low-doubles in the first half is not out of any of the models that we have built here..

Okay. Thanks very much. I will pass it on..

Thanks Nathan..

Thanks Nathan..

Our next question comes from the line of Bryan Blair from Oppenheimer. Your line is open..

Thanks. Good morning guys..

Hi Bryan..

Hi Bryan..

I was hoping if we could dig in a little more on your gross margin performance, up 50 bps for the year despite the topline headwind, but it obviously stands out. I was hoping you could parse out the operational lifts from your initiatives.

I think you were targeting 50 basis points to 75 basis points there, and then the benefits of favorable mix and lower material costs relative to the clear hit from utilization..

Yes. So, I mean we are pleased with the overall gross margin performance. It's obviously been something we have focused on for quite a while. And I think you’ve covered the main points there. If you look at mix in raw materials, we would probably put that in the 100 basis points range.

If you look at the loss of leverage offset somewhat by all the imperatives that we have had, that probably took us down 80 basis points. And then you have a lot of little puts and takes in that, the depreciation and some other things to sum to that overall improvement.

So, it's been mix in raw materials on one hand and then loss of leverage, but we saved or spared quite a bit of that by all the great projects that have been completed. And we look forward to those projects moving to more of an optimization phase this year, which will help our margins next year and into the future..

Got it. I appreciate the detail. And on that front, it sounds like gross margin dynamics will be somewhat similar in fiscal 2021? Just a lessening impact from the favorable mix and then lower raws that you have had.

Given your current outlook, is the expectation for further gross margin improvement this year or is it too early to call?.

No. We are committed to improving those gross margins, and I think you hit it right on the head, and we are going to continue to push to drive margin improvement, pending reasonable levels of sales..

Okay. And kind of a housekeeping question. And I understand you are not providing a hard number on your CapEx guide.

Is there a range as a percentage of revenue we should think about for 2021? And then looking forward, any shift to normalized CapEx in that 3% of sales range?.

Yes. So that's what I was going to say, a kind of a normalized range where we have always said 3% of the sales. I think we can be under that for next year quite a bit. We said we were now at a net number of $122 million for this year, which is completion of our investment period that we are quite happy to be kind of done with.

So we would expect to be under our normal run rate and then obviously significantly under FY2020. So we are going to get into a point. I noted that we expect our cash conversion for next year to be greater than 100% and that's driven partly by improvements in working capital and then on a lower level of CapEx..

Got it. One last one, if I can.

Any quick update you can offer on your M&A pipeline? It seems like there has been a little bit of an uptick in activity, at least for companies that have more proprietary funnels and you certainly have capacity if the right deals are there?.

Yes. Bryan, this is Tod. We continue to work the M&A pipeline that we have. We would suggest you that it still remains robust and no change in our stance, our philosophy, our ability to do a deal. We just continue to work it and we will continue to do so because we believe that's an important part of our long term strategy..

Okay. Thanks again guys..

Thank you..

Our next question comes from the line of Joe Aiken from William Blair. Your line is open..

Hi. This is Joe, on for Brian today. Thanks for taking my questions..

Hi Joe..

Hi Joe..

So first of all, just on the model. Looking at operating expense, you mentioned the $13 million incremental incentive comp expected for fiscal 2021.

Is that expected to hit in any quarters in particular, can you remind me?.

Yes. That will be, most of it, year-over-year in the second half of 2021..

Okay. And I am looking at the run rates OpEx dollars of $125 million in the fourth quarter.

How much of that primarily temporary costs that have been taken out? Or are there some permanent costs that been taken out there as well?.

I mean we haven't had any like big restructurings or permanent cost structure changes. We have been obviously working hard to control our expenses. We do get some benefit from travel restrictions that are in existence in the world today.

And we been working hard to control our discretionary expenses that we could still spend because we are really trying to protect those investments that we are making to help drive the longer term success of the company..

So Joe, I will give just a little bit of color. So if you just look at the macro level from the way we are approaching this, we are playing the long term game here.

And our people around the world are doing a fantastic job at controlling what they can control, the discretionary expenses, while the company continues to invest in the long term strategy and the controlling of the expenses right now is allowing us to play offense where we can play offense.

And so that's how we are looking at it and we would congratulate and thank all the employees around the world for doing just an excellent job..

Got it. I appreciate color there. And then just switching gears, looking at some of the momentum you are seeing in China right now.

How long can some of these tailwinds last? Have you seen some projects pulled forward as a result of the Blue Sky Initiative and some of the investments China is making in stimulating the economy? Have you seen projects pulled forward? And how long can some of those tailwinds last?.

So it's important to understand that our representation in China is still low single digit across almost every one of our markets there. And so consequently, it can last a very, very, very long time.

And we are just now getting some momentum with technology-based wins that are actually shipping to China national based customers, which is expansion for us from the multinational based customers that we had there. So our expansion in China can last a very long time as we continue to gain momentum and it's broad.

It's in our engine-based business on the first-fit with the first-fit technology of PowerCore. It's on the aftermarket side that we are gaining momentum. And it's also Blue Sky Initiative on the industrial side, particularly in the IAF business..

Okay. Thanks a lot. I will pass it on..

Thanks Joe..

Our next question comes from the line of Dillon Cumming from Morgan Stanley. Your line is open..

Great. Thanks. Good morning guys..

Good morning..

Good morning..

I was just wanted to jump back to industrial margins for a second. I think you guys have been extending margins kind of year-to-date but then obviously the decrementals stepped up a bit this quarter.

I guess, Scott, you mentioned in your remarks, but how much of that decrementals, would you say, was driven by some of the more internal investments you mentioned versus sales and favorable mix and just general loss of operating leverage?.

Yes. I mean I think you hit it exactly on the head. I would say, it's spread across those three factors. Hit to leverage on loss of volume. We keep talking about even on the questions here about how we want to continue to make investments and we are continuing those and those are targeted higher percent to industrial.

And then finally, we had a little weaker mix in the quarter compared to the year-over-year comps, which drove down a little bit. So we expect the mix to improve and so that headwind will ultimately probably abate. And we have got to get those sales starting to increase over time. So we can get rid of the deleveraging issue..

Got it. That's helpful. Thanks Scott. And then maybe on the aftermarket side, I think that was kind of one of the few revenue verticals within engine where the knife is still falling a bit.

I guess, if you kind of had to rank the headwinds on aftermarket sales there, how much would you say is related to just general weakness in utilization versus more kind of acute end-market pressure in areas like oil and gas or something else?.

Yes. We would tell you that the oil and gas as well as the fraking pullback, specifically, were significant headwinds, even more so than we had originally modeled, to be fully transparent there. So that's the most significant headwind that we have.

And then of course just a general more broad-based utilization slowdown would likely be the second largest hit..

Okay. Got it. Thanks Tod. And then if I can sneak one more in here. I mean it kind of seems like the aftermarket inventory levels have been pretty volatile over the past two quarters and particularly on the OEM side. It seems like that declined a bit in the quarter.

I guess, do you have a view on kind of whether inventory levels are rightsized at this point? Or are you kind of still anticipating some level of destock in the first half?.

Yes. We would say, the independent channel actually destocked first. The OE channel just tweaked a little bit, not a dramatic destocking. And so we would suggest to you that based upon the behaviors and the forward-looking orders that we have today that both channels are at pull-through levels..

Got it. That's helpful. Thanks for the time guys..

Thank you..

Thank you..

Our next question comes from the line of Laurence Alexander from Jefferies. Your line is open..

Hi guys. It's Daniel Rizzo, on for Laurence.

How are you?.

Hi Dan..

Hi Dan..

Can we just circle back on the pricing you mentioned before? How does it work? Could you give some color there? I mean is it negotiated every time? Do you have any rebates or you have to justify your price increase? Just any color would be great..

On the first-fit side of pricing, particularly within the engine side of our business, we have price downs on annual long term contracts. So each year, we start in a negative position relative to that revenue. And that would also be in the OE aftermarket piece of that business.

On the independent channels of aftermarket, clearly we have more leeway there and we do it on a region-by-region basis based upon local conditions. On the industrial side of the company, it more resets quickly with more of that revenue being project-based business.

So as you wash out project-based lead times, typically three, four, five months, you will to wash out the old pricing and come back with the new quoted project base. And then aftermarket, of course, is more like an independent channel where we have better control..

That's actually very, very helpful. Thank you. And then just one other question on CapEx. You mentioned it's going down.

I am sorry if I missed this, but is there a percentage of that that's just temporary response to the pandemic? Because I know you had some big projects end, but I was just wondering what the mix was there and how should think about it over the long term?.

Yes. I think you have it right. So we have been and said that we were in a period of high investments as we have many projects that were in-flight. And we are happy to report that we have completed the majority those projects. And so our investment will come way down.

And next year, we are going to be really focused on driving the optimization of those projects instead of bringing in new equipment.

So it's a great time for the company in that we get to fine tune the things we already have and drive improvements from that versus having to invest additional dollars which is why we expect a strong cash conversion in FY2021..

And just maybe a little bit of color. So people often will try to connect a dot of the pandemic, equating to our CapEx based reductions here this fiscal year. And that's not really what you are seeing in our behavior. Remember, the past three years, we have had a significant run-up based upon our strategic plan to optimize our supply chain internally.

And so we are now coming to the end of that pretty significant investment. And now we will be essentially shuffling the back internally to continue to expand our gross margins and optimize our supply chain.

So the fact that we have less CapEx this fiscal year is less connected to the pandemic and more to our strategic priorities and what we are executing longer term..

Thank you very much, guys..

Our next question comes from the line of Richard Eastman from Baird. Your line is open. Richard Eastman, your line is open..

Yes. Thank you. Sorry, I was on mute. And thanks for the questions. And best of luck to Brad. Congrats Brad. This can be exciting, congrats. Just a quick question around gross margins. I just wanted to go back to this for one second. In total, the gross margins for the full year were, what, plus 50 bips.

And I am curious the progress that was made in the engine versus industrial segments. And also just, Tod, you spoke to price there a little bit.

But net net, was price kind of a neutral on gross margin for the year? Again, it's going to move with, presumably will move with the mix, but I presume it's more the volume than it is a price impact on gross margin for the year?.

Yes. Net net, Rick, pricing was flat across the company. Obviously, the very mixed result in different businesses but the total company, it comes out flat..

Okay.

And then the progress on the engine versus industrial side? Relative to that 50 basis points overall consolidated?.

Yes. I noted in my script that overall the engine story is consistent with the consolidated results which is mix benefit, lower raw material costs, offsetting by the loss of leverage. For industrial, they had similar factors but they also have the added comfort of a little more investment and probably a little bit weaker mix.

So those two additional factors come into play when you think about industrial..

Okay.

So was there any progress made in gross margin on the industrial side year-over-year? Or was that a bit of a drag and the 50 basis points consolidated was driven by the engine side?.

Rick, this is Brad. I would say that there's progress made. It's just unfortunately masked a bit by [indiscernible].

So the things that we have been talking about with procurement savings, for example, the team there is doing a lot of work to try and find ways to either negotiate differently locally, find new qualified vendors, things like that that help us and that benefits both segments. I would say, the same is true on pricing discipline.

That's happening across the company. As Tod mentioned, it is quite varied by business. And then this year, as we grow into some of the new capacity, industrial will certainly benefit from that. And then one more thing, the long game of industrial is also favorability with mix.

These high-tech markets are where we are putting a lot of technology dollars are going to benefit the industrial segment, probably disproportionately over time..

Okay. And then just maybe, as it just kind of leads me into my next question. But lots of commentary around the puts and takes on the gross margin side, as you just addressed and then also the OpEx. Obviously, we have the incentive coming back in and then some other cost actions there.

I think the reference was also made to some additional cost optimization, if necessary. But I am curious, when you look at where you exited or finished fiscal 2020, I think your operating margins were 13.2%.

With the puts and takes in the commentary here around gross margins and OpEx, under the assumption that maybe sales are flat this year, that would be my assumption, but under that assumption, would the target be here to have flat operating margins here as well? I mean I am trying to figure out how you are may be looking at the incrementals, decrementals..

But if the assumption is flat revenue for the year, is the goal and the target here to hold margins flat as well, as a percentage of sales?.

Rick is Tod. So with all of the moving pieces, we would still expect, even on flat sales, to expand our operating margin, though very slightly obviously..

Okay..

And that would likely be driven by the gross margin work that we continue to do across the company because we are very focused on gross margin..

Okay. All right. Very good. And just maybe one last thought around some of the first-fit businesses and maybe IFS in particular. Anything that you are seeing, you talked about elongated quote to order trend.

But is there any sense there that your backlog around some of these first-fit businesses has hit bottom here and we are waiting for maybe calendar 2021 capital budgets to start kicking in? Or how do you look at where your backlog is in some of these in your first-fit business, in particular IFS?.

So within IFS, on the first-fit business, we have seen roughly, on the conversion rate, from quote to order, it's kind double than its behavior, right. So it's out over 100 days before people are making decisions. They are deciding on the must-do projects.

The things that they have to do in order to protect, say, a particular environmental issue or whatever the case may be. They are doing the must-do. But the rest, they are really pushing out. And it's been slow and that's pretty broad-based around the world with the notable exception of China.

China is a little slower, but not as slow as the rest of the world. They continue to more forward. So what do we look on the backlog? When will that change? I think people are waiting for industrial production to gain a little bit more confidence so that they can take really gear up their factories again.

And that level of competence is just not out there yet across our customer base..

Okay. Yes. Makes total sense. Okay. Thank you again. And again, thanks to Brad for all his help. And I am sure he will be fully engaged and a contributor from Europe..

Thanks Rick..

But congrats, yes. Thanks guys..

Our next question comes from the line of Nathan Jones from Stifel. Your line is open..

Hi guys. I just wanted to put a finer point on the operating expense expectations here. And I think maybe you have narrowed in on this. First half of the year is running at about that $140 million level. Second half of the year is running at about $125 million per quarter. You have got obviously the stock comp coming back in.

And you are probably going to have some of these temporary cost reductions, things like travel, that are going to increase here as we go forward.

I think you said, on flat sales, you would look at operating margins expanding a little bit, a bit mostly on gross margins, which would imply that the annual operating expense in 2021 is probably targeted to be roughly flat.

So is it a reasonable expectation for us to think that kind of this low $130 million is where we are going to go to and see that through 2021? And as these temporary costs start to naturally roll off as the economies reopen, are there any plans to take some more structural cost actions in order to offset those expenses coming back?.

Nathan, below $130 million would to be aggressive. We would not expect on a quarterly basis to hit that level of rate, just simply because we do have the investments coming online. So for example, we have our new material research center that will be stepping up and putting online here in Q2 and other strategic investments that we have.

So below $130 million what would be aggressive, we would suggest.

And then longer term, with al this expansion that we have done to normalize our internal supply chain to really get after our gross margin initiatives, all we have done is we have advanced our strategic plan, our three to five year plan within operations and we have built out our internal footprint, if you will.

And so we continue to look at what are our next steps within that plan? And looking forward, should there be any kind of, say, tweaks or move the restructuring actions relative to that operations plan that are necessary? Clearly, we would take those actions.

And that would be the first place that we would look relative to where we are at in the company's actions. But what we are doing is, we are just playing in our operations playbook in order continue to expand our gross margins and that's how we are looking at it..

Okay. So just to clarify that, Tod. I said low $130 million, not below $130 million..

I am sorry. Okay. Thank you. I heard below $130 million and that would be aggressive. So low $130 million makes more sense..

Okay. Thanks very much for the clarification..

Yes..

Thanks Nathan..

Thanks to you as well..

I will now turn the call back over to Tod Carpenter for closing remarks..

That concludes today's call. And I want to thank everyone listening for your time and interest in Donaldson Company. And I hope that you and your families and friends are all safe. Goodbye..

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect..