Tod Carpenter - President and CEO Scott Robinson - CFO Brad Pogalz - Director, IR

Ben Hearnsberger - Stephens Eli Lustgarten - Longbow Securities Brian Drab - William Blair Charlie Brady - SunTrust Robinson Humphrey Nathan Jones - Stifel Richard Eastman - Robert W. Baird Laurence Alexander - Jefferies Dan Rizzo - Jefferies Larry Pfeffer - Avondale Partners Jim Giannakouros - Oppenheimer

Good morning. My name is Sharon, and I will be your conference operator today. At this time, I’d like to welcome everyone to the Donaldson’s Fourth Quarter Fiscal 2016 Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. [Operator Instructions]. Thank you. Mr. Brad Pogalz, Director of Investor Relations, you may begin your conference.

Thanks, Sharon. Good morning, everyone. Thank you for joining Donaldson’s fourth quarter earnings conference call. With me today is Tod Carpenter, President and Chief Executive Officer; and Scott Robinson, Chief Financial Officer. This morning, Tod and Scott will discuss our recent performance, review our outlook for fiscal 2017 and provide an update on some of our strategic initiatives. Before we begin, I want to cover a few housekeeping items. During the call, we may reference non-GAAP metrics such as adjusted earnings per share. You can find a reconciliation of GAAP to non-GAAP metrics within the schedules attached to this morning’s press release or within a supplemental schedule posted on the Events & Presentations page of our Investor Relations Web site. Also on the Web site is a schedule showing the year-over-year sales change with and without the impact from currency translation. I want to remind everyone that any forward-looking statements made during this call are subject to risks and uncertainties, the most important of which are described in our press release and SEC filings. Now, I’ll turn the call over to Tod Carpenter. Tod?

Thanks, Brad. Good morning, everyone. I want to start by thanking our employees around the world for their contributions over the past year. It has been a challenging year that was filled with difficult decisions, but our employees have remained resilient and focused. Our company has been successful for more than 100 years because of dedication to our customers, and I sincerely appreciate the work our employees do every day to maintain that culture. Throughout the year, we further strengthened our company’s foundation. We’ve prioritized operational efficiency and proactively removed cost from the organization. Additionally, we continue to push forward with our strategic growth initiative. I’ll talk about a few notable successes later in the call, but first I’ll provide a brief update on our sales performance and overall market conditions. We are pleased with our fourth quarter sales performance. In total, sales declined 3% to $594 million which includes a negative impact from currency translation of 1%. Excluding that impact, total sales declined 2% from last year reflecting a decline of 5% in Industrial and flat sales in Engine. The equilibrium we’re finding between our forecast and demand is a sharp contrast from what we experienced during the past year and a half. We continue to be encouraged by some of the trends in the business such as the return to a more normal seasonality which we saw in the back half of 2016. In terms of market conditions, the macro trends affecting our Engine business are fairly consistent with what we discussed last quarter. On-road was down 12% in the quarter driven by a 24% decline in North America as build rates of heavy duty trucks continued to deteriorate. On the other hand, the off-road business has remained relatively predictable. Once again we saw a sequential increase from third quarter to fourth quarter and the pace of decline versus the prior year continues to moderate. Although none of our customers are officially calling bottom, we continue to be encouraged by signs of aggregate stability in this market. We are also encouraged by Engine aftermarket results in the quarter with another quarter of sequential improvement and year-over-year increases in both channels. The OE channel was up in the mid-single-digit range but results were a bit mixed by end market. Off-road was left volatile while in on-road customers appeared to be destocking a bit. Overall, we still believe the impact from destocking is becoming less significant; however, there is still enough variability in week-to-week ordering to suggest that both off- and on-road customers have yet to find a stable bottom. In the independent channels, sales increased in the low-single-digit range. Compared with the prior quarter, we saw another sequential improvement indicating a return to the typical seasonality we would expect in a more stable environment. Turning to the Industrial segment, sales in local currency declined 5% from last year led by a 19% decline in gas turbine systems. Our Industrial segment businesses were on forecast last quarter but given the magnitude of the sale decline in GTS, I want to give a little more color on those results. The 19% sales decline in fourth quarter compares with a 22% increase last year, as we saw the characteristic lumpiness of revenue from large turbine projects. Our project-related sales still includes those projects won before we made a strategic shift to be more selective in our bidding. We will begin seeing the impact of that shift in fiscal 2017 but we also expect to benefit from efforts to grow our GTS replacement part business. Stepping back, I want to share a few highlights of our full year results. Total sales were down more than 6% for the year or $150 million. Currency translation accounted for half of the decline and the first-fit portions of our Engine and Industrial businesses made up the majority of the balance. When we look a little deeper into the business, there are some positive indications that our strategy is working. In local currency, our replacement part sales were essentially flat with last year despite headwinds from things like OE destocking, the oil and gas slowdown, and geopolitical uncertainty around the world. Replacement part sales represent more than 55% of our business, so we are very pleased that we held our revenue in such a volatile environment. We also saw further evidence that our focus on innovative product is working. For example, PowerCore sales in Engine increased almost 4% last year reflecting an aftermarket increase of almost 8%. Also in Engine, moving fuel products which are a critical component to our long-term growth formula saw a several percentage point increase from last year. Within Industrial, sales of Downflo Evolution equipment more than doubled versus the prior year as we began selling around the world. Additionally, sales of our Integrated Venting Solutions delivered an increase in the high teens last year, as we use this innovative product to expand our addressable market to automotive, consumer electronics, and medical electronics. Including replacement part sales, the businesses I referenced represent nearly three-quarters of our total revenue signaling to us that we have a very strong foundation to build upon this year. As we transition to fiscal 2017, our performance on the overall market conditions is still somewhat guarded. We expect that global production of heavy-duty equipment will decline across all of our end markets. Within off-road, we estimate that production of agriculture and mining equipment will continue their multitier slowdowns with declines of another 5% to 10% each. We also expect the year-over-year decline in production of construction equipment, albeit in a bit more modest, flat to down 5% range. There are a wide range of factors pressuring these off-road markets but they’re not new. For example, depressed commodity prices, the impact from the oil and gas slowdown, and a decline in overall infrastructure spending has been affecting production for some time now. We have definitely seen a moderating pace of decline but it is clear to us that there is still some uncertainty. The transportation market is also expected to be down in our fiscal year, leading industry forecasters are calling for continued declines of Class A truck production in North America while the heavy-duty on-road markets in Europe and Asia Pacific appear to be more stable. Turning to equipment utilization, which is a key driver of our aftermarket business, we are estimating the market will be somewhat flat this fiscal year. More specifically, we expect modest increases in utilization of transportation and construction equipment that will likely be offset by continued declines in both ag and mining. With that context, I'll turn the call over to Scott for an update on recent performance and our fiscal '17 guidance. Scott?

Thanks, Tod. Good morning, everyone. I also want to start by thanking our employees. We finished our global ERP implementation in August and our team did an incredible job. The decision to embark on this four-year project was a courageous one. Throughout the implementation, we upheld our customer-first approach and we delivered on our commitments. As we transition to the optimization phase, we still have hard work in front of us. We expect to realize pockets of benefits across the organization from things like better inventory management, pricing sophistication, and enhanced global processes, but that will take time. Of course, these are just a few examples of the power created by a global system, so we are excited to begin the next phase. Many thanks to everyone involved. I am very proud of our global team. I am also proud of our efforts to manage the business responsibly during a very challenging environment. Our top priority for the company has been and will be enhancing operational efficiency. Throughout the year, we maintained a very tight control on expenses due in part to proactive restructuring across the company. During the fourth quarter, we implemented additional restructuring actions including a change to our footprint in China. Given current market headwinds in that region, we consolidated our headquarter locations and closed our office in Hong Kong. We are still optimistic about the long-term growth prospects in China but the uncertainty today prompted us to take action. Turning to our financial metrics, we delivered fourth quarter EPS of $0.44 or $0.46 when you take out restructuring charges. Compared with last year, we saw an increase on both a GAAP and a non-GAAP basis but we fell short of our forecast due primarily to higher-than-expected loss on foreign exchange. For context, certain gains or losses on foreign exchange are included within the other income and expense line of our P&L. This line includes a variety of other items such as income from joint ventures, royalties and interest income. The impact from foreign exchange swung from a net gain in 2015 to a loss in 2016. The swing from a gain to a loss had been happening throughout the year, but the impact in the fourth quarter was greater than expected given some variability within our basket of currencies. On a full year basis, loss in other income and expense was compounded by lower income from joint ventures reflective of the same end market pressure facing other parts of our business. Our operating margin results in the fourth quarter partially offset the impact I just discussed. On a non-GAAP basis, which excludes restructuring and other one-time charges, we delivered a 15.8% adjusted operating margin. That compares with 14% last year reflecting year-over-year improvement in both gross margin and expense rate. Gross margin benefited from several things, including lower raw material costs, improved fixed cost absorption and the overall mix of sales. On the expense side, savings from restructuring combined with overall expense discipline drove our results. As most of you know, we've been talking about expense discipline and our focus on operational efficiency all year, so I want to pause briefly on my discussion of the quarter to talk about the full year impact of those efforts. As Tod referenced, total sales declined by 150 million from last year placing significant pressure on the bottom line. In response to this pressure, we reduced expenses by about 40 million or 8.5% when you adjust for one-time charges. Our discipline led to full-year operating margin growth on both a GAAP and non-GAAP basis in the year where sales declined 6%. Turning back to the quarter, we continue to make progress on strengthening our balance sheet. Our primary focus has been working capital with our sights set on reducing inventory and receivables. Both metrics are down when compared with the beginning of the year but the most substantial improvement occurred after we set region-level targets following the first quarter. Compared with that point, inventory is down more than 18% and we reduced our days sales outstanding by one a half days. As we saw our gross debt to EBITDA ratio fall more in line with our long-term target of about 1.5 times, we resumed our share repurchase activity. In the quarter, we invested 16 million to repurchase 470,000 shares. For the year, we returned $84 million to our shareholders by repurchasing 1.9% of outstanding shares. We also paid dividend of $91 million to our shareholders last year and we are very proud to have recently been added to the S&P Dividend Aristocrats Index. After paying a dividend every quarter for more than 60 years, the recent inclusion in the index marked our 20th year of consecutive annual dividend increases. Our focus on operational efficiency, maintaining a strong balance sheet and returning excess cash to shareholders are a foundational to our near and long-term success. I'll talk about how we build on this foundation as I now turn to our fiscal '17 guidance. As we said last quarter, we took a cautious stance when developing our plans for this year. Given the market conditions Tod referenced, we believe this approach is the most responsible. Our plans reflect continued expense and the balance sheet discipline while also giving us the flexibility to pursue sales should an opportunity emerge. In total, full year sales are expected to be within a plus or minus 2% from fiscal '16. At the midpoint, sales are roughly flat with last year despite a continued headwind from end markets. Both segments are also in the plus 2% to minus 2% range with modest growth in certain businesses being offset by declines in others. In the Engine segment, we expect aftermarket sales growth in the low-single-digit percentage range as we leverage past investments and our innovative technology. Continued production declines of heavy-duty equipment will drive our other Engine businesses. We expect the most pressure in on-road resulting in high-single-digit percent decline from last year. In both off-road and aerospace and defense, we are forecasting a decline in the mid-single-digit range. Within the Industrial segment, we expect industrial filtration solutions sales will increase from last year in the low-single-digit range, reflecting a tepid first-fit environment that is more than offset by strong growth of replacement parts. In gas turbines, we also see strong growth of replacement parts; however, our decision to be more selective on large turbine project mixes out to a full year sales decline for GTS in the high-single or low-double-digit range. Finally, sales of special applications are expected to decline from 2016 in the low-single-digit range as pressure from disk drives is only partially offset by growth in areas like Venting Solutions. Within our total sales guidance, we have included the incremental benefit from the Partmo acquisition, which is roughly 12 million to 13 million in fiscal '17. Additionally, based on current exchange rates in a basket of currencies, our full year guidance does not contemplate an impact from currency translation on total sales. Of course, we would revise our perspective if we see any material shift in currency during the year. We are forecasting full year operating margin between 13.3% and 13.9%. At the midpoint of the range, operating margin is expected to improve 40 basis points from 2016’s adjusted operating margin of 13.2% reflecting some stability in gross margin and expense leverage. Included within our forecast is a year-over-year headwind related to compensation expense of 20 million, which is in line with the estimate we provided last quarter. One offset to this headwind in a benefit from previously taken restructuring actions. In fiscal '17, we expect to realize 12 million of savings with the incremental benefits skewed heavily towards the first half of the year. Additionally, we expect to leverage against flat sales as we benefit from our recent and ongoing efforts to enhance operational efficiency. Moving down the P&L, we expect income in our OI&E line between 8 million and 10 million compared with 4 million in 2016. We typically don't guide to this metric and we don't intend to give line item specifics, but we wanted to provide some perspective given the foreign exchange variability I discussed earlier. We are forecasting a slight year-over-year increase in our interest expense and our tax rate is expected between 26.7 and 28.7, as we return to a more normal historic average. In terms of capital deployment, we remain focused on our core priorities; invest in the business, pay dividends, and to the extent our balance sheet allows repurchase shares. We are forecasting capital expenditures between 70 million and 80 million and we expect to repurchase between 2% and 3% of our outstanding shares. Our forecast resulted in another strong year of cash conversion. After achieving 113% last year, we expect this year's cash conversion in a 90% to 100% range. Altogether, we expect fiscal 2017 earnings per share between $1.50 and a $1.66. As of today, we are not forecasting any impact from adjusting items, so GAAP and adjusted EPS are expected to be one and the same. Before turning the call to Tod, I want to provide a little color on the forecasted cadence of sales and operating profit in 2017. Our sales forecast reflects a similar seasonality as what we saw in 2016, meaning that sales will be weighted towards the back half of the year. Compared with last year, operating margin is expected to show more improvement in the first half of FY '17 than the back half, driven by a couple of factors. As I said earlier, the incremental benefits from last year’s restructuring are weighted towards the first half. Additionally, the first half of 2017 has an easier comparison given the gross margin pressure from sales volatility that we experienced earlier in the year. Now, I’ll turn the call over to Tod for an update on some of our strategic efforts. Tod?

Thanks, Scott. I’m very proud of the operational discipline our employees have shown over the past year. In 2017, we will retain this discipline while making progress on the critical components of our strategic plan, which include grow the core business and technologies, expand geographically and expand through acquisitions. Over the past 12 months, we have made progress in all of these areas. Earlier in the call, I highlighted the 2016 results for a few of the growing businesses within our portfolio; PowerCore, engine liquid, DFE and Integrated Venting Solutions. During fiscal '16, this innovative lineup of products was also helping us plant seeds for future growth. In both Engine air and liquid, we saw very solid program win rates with air in the 75% range and liquid higher than that. In both businesses, a significant portion of the wins were incremental business to Donaldson and one with innovative technology. As we weather the near-term pressure from end markets, our program wins position us well for future growth. In terms of geographic expansion, we have begun production of both air and liquid products at our new facility in Poland. This plant is particularly beneficial to our liquid business as we pursue additional growth across the world. Beyond capacity, increasing our local production in Europe further insulates us against future exchange rate volatility. In addition to Poland, we now have liquid manufacturing in South America through the Partmo acquisition. This acquisition will help bolster our aftermarket business in this critical market with a brand that is very well known in that region. We are excited to begin the integration. Earlier in fiscal '16, we acquired Engineering Products Company or EPC. This technology-related company broadens our offering of sensors and indicators that measure filter life, which is becoming increasingly important to our customers. Finally, I also want to thank the employees around the world for the time and energy they put into our global ERP implementation. This system creates a greater level of transparency into our business than ever before, and I look forward to our company benefiting from that transparency in the future. In the coming year, we are focused on a core set of actions. Specifically, we will continue developing our technology to drive new first-fit program wins. We will invest in pockets of our business that have near-term growth opportunities, including replacement parts. We will focus on enhancing operational efficiency to protect our bottom line without sacrificing the future. And we will be disciplined in our investments, maintaining a strong balance sheet and redeploy cash to our shareholders. Our fiscal 2017 plans have tactics in place for every one of these items, which gives me confidence that we can deliver our financial and strategic objectives in the new year. With that, I'll turn the call back to Sharon to open the line for questions. Sharon?

[Operator Instructions]. Your first question comes from Ben Hearnsberger from Stephens. Your line is open.

Thanks for taking my question. Tod, I’m wondering, clearly China has been difficult. Can you just update us on your strategy there going forward?

Sure. China’s been difficult due to their end markets and their clear GDP pressures. We have restructured China to align our company with the realities of that market. However, we still believe in China and it’s a very important market for our long-term strategy. We continue to invest in China to make sure that we press forward with our innovated products both on the Industrial and the Engine side, and we continue to have wins in China. So long term, we still stay the course with China because we believe in it and it’s important for us.

Okay. And on the ERP implementation, it is a cost headwind in '16. What is the tailwind now that it’s rolled off?

Yes, we addressed that last quarter but as the project rolls off, it will be about flat with regard to next year as baked into the plan.

And that’s on an operating basis. How much from a capital expense standpoint was in '16 I guess that we’re not going to see again in '17?

Well, the total project was about 90 million that we spent and that was over a period of four years, and that ended at the end of this fiscal year. We have about 60 million to 70 million of total CapEx planned for next year.

Okay. And then a question on GTS, it sounds like the expectation is that replacement grows in '17. I guess can you parse out the guide a little bit further between replacement and then project declines year-over-year in '17?

Hi, Ben. This is Brad. We expect replacement parts will probably be up in the high-singles area and then it will mix out with projects being down there. That’s the balance.

Okay.

So replacement parts for context are in the plus or minus 40% of total GTS sales.

Got it. Okay. Thank you, gentlemen.

Thank you.

I think Scott said CapEx of 60 to 70, next year’s CapEx guidance in total is 70 to 80. I just want to correct that before we move on.

Your next question comes from Eli Lustgarten from Longbow Securities. Your line is open.

Can I – just one clarification. Can you give us what the adjusted operating margins for Engine and Industrial were for the quarter if we adjust the charges? And can you give us a little feel of – I realize that first half was much weaker last year, so there’s much easy comparison. But can you give us some feel for what we should expect year-over-year in the operating margin segment adjusted for both sectors?

We’re going to look that up, Eli. Could we move to the next question? Brad will get the tables specifically for you and break down Engine and Industrial. Can we come back to that?

Sure, not a problem. And in discussing relatively flat sales as you went through the various segments, can you give us some feel – maybe a little more color on what’s going on with the declines that you’re expecting particularly in mining and ag? Is that all a first-half phenomenon or is that down for the entire year because it looks like, this ag market looks like it’s been shambled for a while and the 5%, 10% [indiscernible]. But can you give us an idea, is it more heavily weighted to the first half than the second half and the same thing too when you get to the construction on-road? We’re talking a 30% decline in production that you’re going to feel the brunt of, because of the fiscal year than anything else?

Yes, that’s exactly right, Eli. So on the on-road, it would likely be more first half weighted than second half just simply because we’re in the midst of a large decline already. And if you take a look at calendar '17 from ACT and our customers, it’s a more modest decline which hits our second half. So that’s the 5 to 10 range within the transportation side. But in the first half of the year, we’re still going through that as much as 30% decline that everyone is talking about in the Engine. So on-road is pretty straightforward. Within the ag and mining it’s a little bit more spread equally through the year, if you will. It’s more of a drip down should there be that continued pullback as we see no real impetus for those markets to pick up steam.

And can you give us a little bit insight about what’s going on in pricing across the board? This is a tough market and with raw materials starting to be a benefit for most companies, are you seeing that and if you have enough offsets internally for the price increases that are coming in raw material or do you have to raise prices, just give us some feel for what’s going on there?

So, Eli, pricing really has always mattered, as you know, within our model. We have pressure from the OEs with long-term contacts that pull pressure down. We take opportunities regionally within the aftermarkets that present themselves. Pricing has always mattered but no one is acting irrationally out there. And so it’s a bit more business-as-usual and we’ll continue to take those regional opportunities that present themselves as possible. Relative to materials, we have longer-term contracts on our largest percentage of the materials, which happens to be steel and urethanes. And with those longer-term contracts we have actually experienced a more positive material tailwind, if you will, because of those longer-term contracts. It’s the reason why looking forward it’s a more modest tailwind to us just simply because we’ve been experiencing that and we’ve been ahead of that overall market tailwind, if you will.

So you still have contracts going through most of '17 to give you good favorable things, how long do the contracts go out before we have --?

No, to this calendar year and then we look forward after that.

Okay, all right. Thank you very much.

Eli, I want to address – this is Brad, I want to address the question you asked about segment EBITs. The Engine segment had about 40 bps of impact from restructuring charges and Industrial was about 70 bps. So removing those, Engine would be 14.4% and 17.1% for industrial. That’s for the reference of others. That’s on the segment detail tab within our release schedules. There’s segment level.

Great. Thank you very much.

Thanks, Eli.

Your next question comes from Brian Drab from William Blair. Your line is open.

Good morning. Thanks for taking my questions.

Good morning, Brian.

First question is on acquisitions. Can you talk about the pipeline? As we sit here today, you’ve got over 200 million in cash generating over 200 million in free cash. The end markets that you’re playing in are pretty beat up and I’m wondering within this fragmented filtration market, are you seeing a lot of opportunities? Because by my count I guess we’ve only spent 20 million to 30 million in acquisitions over the last 12 to 18 months.

Brian, we continue to work our new and improved process for acquisitions. Our robust process has yielded four acquisitions over the last two years. We have a robust pipeline as a result of that process. We continue to work that diligently. I would describe our pipeline as robust, strategic but also selective. And we will remain a disciplined buyer. I would also characterize and say that even though it’s a bit of a tough environment out there, we do not see any kind of irrational behavior within the acquisition markets at this time.

Okay. Thanks. And then on restructuring, I just want to make sure that I understood it; 12 million in incremental savings for fiscal '17, is that what I heard? And then you said it’s weighted more towards the first half of the year. Does that mean that – is it a 12 million run rate by the end of the year or is it actually 12 million that we would load into the model for '17?

It’s 12 million for fiscal '17 and the benefits when you compare to last year will impact first and second quarters more than third and fourth quarters.

Are there restructuring activities that are taking place throughout '17 or is this 12 million related to activities that were completed in '16?

It’s related to activities that were completed this fiscal year, so fiscal '16.

Okay. Thanks. And then maybe just comment on the liquid side of the business and I’d be interested if you could tell us what percent of sales were liquid in the quarter, maybe an update on some of the wins there in that segment?

So I’ll have Brad get the percent for you. This is Tod. The wins that we’ve had as we look across the overall year, we have had a very successful year on winning liquid and air. Our liquid win rate is about 70% to 75%, air is about 60% to 65%. In fuel specifically, it’s 90%. So when you then translate that longer term, those are clear wins that are going to plant proprietary future growth, help our OE businesses but then also circle back and help bolster on our aftermarket strategies as well. So we’re very proud of the success worldwide because we’ve been winning in emerging markets, we’ve been winning in developed economies. It’s been very broad.

Brian, liquid – the lube fuel business in total for Donaldson last year was just about quarter of a billion.

Okay. Thanks very much.

Thanks, Brian.

Your next question comes from Charlie Brady from SunTrust Robinson Humphrey. Your line is open.

Thanks. Good morning, guys.

Good morning, Charlie.

Just on industrial filtrations and your outlook for '17, can you just parse out what your expectation is on the parts aftermarket growth versus the OE, presumably declining OE in '17 for that business?

Hi, Charlie. This is Tod. We’ve not parceled that out specifically before and we don’t give that level of guidance. We do say that our IFS business total will be low-single-digits. I would suggest to you that the headwind on the OE side will be offset by our expected replacement parts growth.

Okay, fair enough. And I wonder if you can just, on the other expense in the fourth quarter when you called out it’s comprised primarily of the JV income being lower in the FX switch from a tailwind, could you parse out of that 2.7 million kind of how much of that came out the FX, how much was from the JV piece of it?

Yes, so I think just to – I think you had it right. The Q4 expense was 2.7 million versus income of 3.8 million last year. That contains several items; income from the joint venture, royalties, interest income as well as FX. For the year, the largest piece of that change was driven by the FX. The second largest piece of that was driven by reduced joint venture income driven by the market pressures that the company has faced in the rest of its business.

I guess what I’m trying to get to you is was it majority driven by one versus the other as far as FX or the JV income, was it mostly the FX swing?

Yes. The biggest piece was the FX.

And then in your commentary, your press release, you talked about aerospace and defense declining in the commercial helicopters but I wonder if you can just look at the other piece of that business outside of that, are you expecting any particular piece of that to be up? So I think you called out for that – that business segment would be down in '17. So I’m just trying to understand are there other pluses in that piece of the business in '17?

Right. So there are not pluses. When you take a look and parcel that back, defense which is a much lower portion after a multiple year step down, defense is again expected to decline slightly but the story in why we have aerospace and defense down mid-single-digits is really coming from the aerospace sector and particularly the rotocraft. And that links back to the oil and gas markets where there are less rotocraft being purchased which used to ferry people out to offshore oil platforms, et cetera, and that’s the headwind within that particular market.

Okay. Thank you.

It’s definitely a more challenged market across the board.

Got it. Thanks.

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

Good morning, Tod, Scott, Brad.

Good morning.

Good morning.

Good morning.

I wonder if I can take a follow up to Eli’s question but from a little different angle talking about increased steel cost and other increased raw material costs. Do you expect or have you seen any kind of improvement in utilization from mining equipment as those prices increase? And how would you expect that to progress if we see higher raw material costs or set more stable raw material costs as a demand driver rather than a cost driver?

So right now it’s definitely commodity-based. Of course, the mining companies can get more for the raw materials they’ll continue to improve vehicle utilization. But the consumption does have a role in the long run. They’re not just going to continue to stock all of that as we saw with an abundant coal supply, for example, in China that really put pressure all the way down through Australia and Indonesia in this downward cycle. So it needs a little bit more of a pickup of a global GDP, if you will, to get the comprehensive mining sector really moving forward. So it’s a bit more structural than just simply if commodity prices rise, things will all of a sudden turn for us. We see it more incremental going forward as that whole market recovers. I think you see that in Caterpillar’s guidance, for example, as well where they’re calling for a more modest calendar year '17, for example.

Okay. And then one on the GTS. You’ve made this strategic decision to steer away from low price OE projects and it sounds like your forecasting the impact of that on the original equipment project side to get you in 2017. How does that play out over the coming few years on the aftermarket side of that business as – whether it’s your decision or somebody else’s decision? This equates to a loss of share on the project side. What I’m wondering is how that impacts the aftermarket as we go forward over the next several years?

We don’t believe it does because we have a strong brand in the number one market, which is the Middle East. We also now with our Northern Technical acquisition have a strong presence in the Middle East. And therefore we’re much closer to our end user customers than we have been before. So this gives us a stronger position to really continue to capture, have a higher capture rate in the aftermarket. We also expanded our product family within the aftermarket with that Northern Technical acquisition. And so we actually have a much broader market opportunity within GTS to address within aftermarket. So we’re very comfortable in this typical, a little bit more pressured cycle with projects from – clearly GTS is pressured from pricing on the project side but also the quantity of projects out there is less. And so we need to be very selective. This market goes through these types of cycles. You have to prudent and responsible while in that and that’s what we’re doing with this particular strategy.

Okay. That’s helpful. And then I guess just one on the guidance. Can you talk about what the major sources of variability are in the guidance, kind of what would you get you to the bottom end and what would get you to the top end?

Sure. The answer for the low and the high is really the same. It’s a GDP story. So to the extent that a geography has GDP headwinds, such as Western Europe or the U.S. and not significantly changes the overall behavior of industrial-based production or vehicle utilizations we would feel in our aftermarket first, which would then step down again into the OE. So that’s the headwind side. The tailwind side would be if we do start to see a little bit more positive across the GDPs worldwide, clearly we would leverage that quite nicely to be able to hit the high end of the guidance.

Okay. That’s helpful. Thanks for taking my questions.

Sure.

Your next question comes from Richard Eastman from Robert W. Baird. Your line is open.

Yes. Good morning.

Good morning, Richard.

Tod, a couple of quick questions but let me just focus on the Engine aftermarket business. In the quarter we saw less than typical seasonal improvement from Q3 to Q4 considerably less. And I just had a question kind of surrounding that. Why would that be the case here if we return to typical seasonality? Then also was the weakness – why was the weakness in Asia – pronounced in Asia on the aftermarket engine side?

Rick, so what we had last year of course is a lot of headwind at fourth quarter. We had a bit more of a pickup in this year’s fourth quarter. If you look at – I mentioned in my prepared comments that we have a bit more erratic ordering pattern, our aftermarket sales time fence, if you will, is much more compressed than it ever has been. We’re talking maybe just a couple of weeks of visibility in some of these areas, in some of the geographies. And so I believe we did see the seasonality but we did not see people take back all of the stock that they’re used to normally carrying. And so there was a little bit of a balance and notice that I said that there’s some of the geographies that have been destocking just a little bit. And so they’ve compressed on a destock but also compressed their ordering patterns. And they kind of offset each other to really mute a little bit of what we would have hoped would be mid-single-digit growth to become low-single-digit growth.

I see. And was that more pronounced in Asia just given the status of the end market there or that you saw more destocking there in the Asia market?

More destocking for sure across Asia, across our distribution channels, yes.

I got you. And then just a question real quickly on the gas turbine side of the business. Does Donaldson – you guys suspect or have any content on GE’s new H-class turbine where the backlogs have been getting – have grown considerably? Do you have any OE content there?

So when a gas turbine is sold, no matter what the technology in F and H or whatever technology from GE, Siemens or Mitsubishi, they’re all projects. And so what you have to have is the technology that really reaches across, if you will, that product family of gas turbines for that particular customer and be qualified. So are we qualified for the H engine? Absolutely. With Donaldson technology, we are. But you still win those on a project. You don’t win, for example, like you do in engines where you can win all of the 10-liter engines. In this, you still go one particular project where that H engine is going to be implemented worldwide. But we are qualified. We do sell to the H engine and we’ll continue to do so, however, in that selective fashion as we mentioned our strategy.

I see, okay. And then just one last question on the adjusted op margin guidance for '17, I think the 13.3 to 13.9, the low end and the upper end, you're talking about maybe 10 to 70 basis point improvement over fiscal '16 and again, at the midpoint we have zero growth. The commentary earlier suggested that the increase at the midpoint here, call it, 40 basis points on zero growth is a function of the operational efficiencies that you targeted and mix here with your aftermarket business growing. Is that how we --?

Yes, I would say a more stable volume situation.

And does that guidance include the 20 million comp step up?

Yes, it does.

Okay. So we'll offset that with the restructure savings plus some additional operating efficiencies plus we should have a more favorable mix with aftermarket growth and OE declining.

All those things are considered. That is correct.

Okay, I got you. All right, thank you.

Thanks, Rick.

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

Dan Rizzo on for Laurence. How are you guys doing? You mentioned and we talked about improved fixed cost absorption on the gross margin. Could you just kind of elaborate on what’s driving that and is there any particular product lines or anything?

Yes, I think it’s general cost containment, cost improvement across the board. So I don’t think there’s any one particular specific area. We’ve had some restructuring to improve our cost structure, continued cost discipline and that spreads across pretty much all the pipelines.

And then you mentioned briefly about the specialty product business, what’s going on there. Can you just give a little more granularity? I think you said disk drive pressure – or disk drive growth is offsetting weakness in Venting Solutions. Did I hear that right or can you just give us some elaboration on just that segment?

You actually have that reversed. So disk drive headwind which will likely be high-single-digits is being offset by the other pieces of special applications which we expect to grow, things like Integrated Venting Solutions.

Okay, all right. Thanks. And then finally, you mentioned the M&A pipeline, how you have the new and improved product process and you’re not seeing any rationality. But are you looking more towards like technology improvements or improving product offerings or footprint? Is there a specific way you’re going about it in terms of M&A?

There’s not a specific piece of that strategy that you mentioned that we would target. The way that we do this is each business unit has a particular organic growth strategy and within that strategy, if we see a way to accelerate that organic growth plan through an acquisition as you saw us do with our recent Partmo acquisition, we knew we eventually we had to manufacture product in Latin America, down in South America because we had already expanded our distribution, expanded our product line and now we had to get closer to the customer to give them a quicker response. So that’s just a normal strategic step for us and so we acquired. So it could be a channel, could be a product expansion, it could be all of those, but it starts with that organic strategy that we have within a business segment.

All right. Thanks guys for the clarification.

Thanks, Dan.

Your next question comes from Larry Pfeffer from Avondale Partners. Your line is open.

Good morning, guys.

Good morning, Larry.

Good morning.

So, Tod, just trying to get a little more color on this. You used the word encouraged quite a few times in your script. Is that more just on stability in end markets and then the projects you guys are winning, or are you actually seeing improving end-market fundamentals out there?

I use the word encouraged because it’s been a tough slog for the last 18 months and it’s been a walk down that has been tough to get through. And I think as I look forward, the range of possible outcomes has certainly narrowed significantly for our company. And so the encouragement is that while I’m not ready to call bottom, I am encouraged by the fact that we’re a little bit more predictable than we have been at any time in the last 18 months.

Okay, that’s helpful. And then looking – you touched on the special apps segment in the last question. Obviously, IVS looks like it’s doing well and you have the secular pressure on the disk drive side. Is there a timeframe you’re looking at for when that business can get you back to posting overall growth?

The disk drive business specifically?

The special apps segment, I guess.

We’re not calling out a timeframe as to when we would see special apps be able to offset the headwinds we expect looking forward in the disk drive. It’s just that as you called out, it’s a natural secular decline that we’ll see. So we’ve not laid that line in the sand, if you will.

Okay, understood. Thanks, guys.

Thanks.

Your next question comes from Jim Giannakouros from Oppenheimer. Your line is open.

Hi, Jim. Good morning, Jim.

Your line is open. [Operator Instructions]. Your next question comes from Eli Lustgarten from Longbow Securities. Your line is open.

Hi. Thank you for giving me a quick follow up. Two specific ones. One, in the segment details, you have your corporate and allocated and I noticed everything that goes in there, but do you have any feel for what corporate and allocated would do in '17 versus '16? So should that be relatively stable, similar numbers, up, down a little bit?

We haven’t specifically guided to that, but the FX loss that we’ve talked about and some of the variability from the OI&E line does flow through corporate and allocated. So that gives you a sense that that’s where some of the improvement will come from or show up.

Okay.

What Scott talked about is OI&E guide.

The second piece is, you’ve basically forecasted plus or minus 2% across the company. When you looked at the quarterly detail, you tried to give us some of that. Your second half is strong as first half. Is this plus or minus 2% sort of the guidance for every quarter or is there bigger swings in one part of the year that would be offset in the second half of the year?

Eli, this is Brad again. When we look at the plus or minus, it’s flat on the year and I think as we said in the remarks, the seasonality is about the same as well. So it was a little bit back half weighted this year and I think using that triangulation, that will get you in the ballpark. But there isn’t a notable story in quarter A versus quarter B.

Got it. So basically they’re similar. You get similar plus or minuses throughout this whole year is what you’re still betting on at this point?

Yes.

All right. Okay. Thank you.

[Operator Instructions]. Your next question comes from Jim Giannakouros from Oppenheimer. Your line is open.

Hi, guys. Sorry about that.

Good morning, Jim.

Actually wanted to tack on to Rick’s couple of questions. First, on GTS, just curious as to how competition for GE’s new class of turbines is looking? Appreciating that a major competitor of yours has an increased focus there, so curious if you can speak to what your competitive advantages are and/or trends from a share perspective. Just in general, how things are progressing and I guess the differences in the landscape that affords you an advantage in winning those projects that you alluded to? Thanks.

So the overall atmosphere of winning any kind of project in H and F or whatever the turbine may be is GE is always a disciplined buyer and the value proposition that Donaldson Company brings forward is we essentially 20 years ago started this particular market. We are number one in the gas turbine market and it’s because of the technology that we have which in this particular market we call Spider-Web. And if you think about it, we have now fibers which are roughly about one-tenth the diameter of a human hair that we put within on our medias, which then protect or filter out the particulate ambient air better than anyone else in the marketplace, which then allows you to have a cleaner turbine and produce more energy out the backside. That’s our value proposition as well as our strong customer project execution, which we have a long strong track record and that’s how we win. We’ll build a gas turbine project anywhere in the world. It’s not uncommon for these complicated projects to have one line item purchase order to be worth millions of dollars, have 50 to 60 semi-trucks that are manufactured in four different countries and they all come together on a site. And it takes special coordination and a special team to be able to do that and Donaldson has that.

That’s helpful. Thank you. And going back to the margin guide, I suspect that organic growth is the biggest swing factor and if – curious if you’re trending towards the lower end, how much you could actually flex expenses down to offset and if you could cite specifics as to where exactly? And then as a follow on, is further restructuring actions, are they being considered in 2017 or are you pretty confident that it’s substantially behind you and now you’re just in a block and tackle mode from an expense side? Thanks.

This is Tod, I’ll start with the restructuring answer and then toss it over to Scott to finish off. Within restructuring, we currently do not have any additional restructuring plans in the company. However, we continue to look at aligning our company overall with the end market demand. Should there be a demand shift, surely we would look deeply among ourselves and adjust accordingly. To be honest with you, at Donaldson that’s standard work. That’s what we do every day and we’ll continue to act in that fashion.

[Operator Instructions]. We do not have any questions at this time. I will turn the call over to the presenters.

Thanks, everyone. That concludes today’s call and I want to thank all of you there for your time and your interest in Donaldson Company. Good-bye.

This concludes today’s conference call. You may now disconnect.