Donaldson Q4 2024 Earnings Call Transcript

Quartr
Provided by Quartr
August 28, 2024

There are 9 speakers on the call.

Operator

Thank you for standing by, and welcome to The Donaldson Company 4th Quarter and Full Year 2024 Earnings 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. Thank you. I'd now like to turn the call over to Sarika Donwal, Senior Director of Investor Relations and ESG.

Operator

You may begin.

Speaker 1

Good morning. Thank you for joining Donaldson's Q4 and full year fiscal 2024 earnings conference call. With me today are Todd Carpenter, Chairman, CEO and President and Scott Robinson, Chief Financial Officer. This morning, Todd and Scott will provide a summary of our Q4 and full year performance and details on our outlook for fiscal 2025. We will also provide an update on our fiscal 2026 financial targets.

Speaker 1

During today's call, we will discuss non GAAP or adjusted results. For Q4 and full year fiscal 2024, non GAAP results exclude pre tax restructuring and other charges of $6,400,000 related to footprint optimization and cost reduction initiatives. This compares to $4,900,000 $21,800,000 of charges in Q4 and full year fiscal 2023, respectively, related to the organizational redesign as well as costs associated with exiting a lower margin customer program. A reconciliation of GAAP to non GAAP metrics is provided within the schedules attached to this morning's press release. Additionally, 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.

Speaker 1

With that, I'll now turn the call over to Todd Carpenter. Please go ahead.

Speaker 2

Thanks, Erica. Good morning. Fiscal 2024 was another record year for Donaldson Company, record sales, record margins and record EPS. We surpassed $3,500,000,000 in sales, achieved operating margin of 15.4 percent and delivered adjusted EPS of $3.42 a 13% increase above prior year. Our cash conversion was over 97% well above our historical average and we returned $286,000,000 to our shareholders through dividends and share buybacks.

Speaker 2

Through mixed end market conditions, the Donaldson team furthered our mission of advancing filtration for a cleaner world through our investments and progress on our strategic initiatives, including our 2,030 ESG ambitions. I'll now discuss our Q4 results, which capped off a tremendous year for our company. Sales increased 6% over prior year driven by higher volumes across all three operating segments. Operating margin improved 200 basis points over 2023 and EPS increased 21%. Each of our segments demonstrated sales growth and improved profitability.

Speaker 2

Here are some highlights. In Mobile Solutions, volume was the primary driver of sales growth as a result of strength in our aftermarket business. Segment profitability continued to be robust as a result of mix, higher volumes and pricing. In Industrial Solutions, Aerospace and Defense sales rose approximately 40% to a record level and drove Industrial profit margin to an all time high. In Life Sciences, sales grew above 20% and profitability improved year over year.

Speaker 2

Shortly after the end of the quarter, we completed the acquisition of a 49% stake in Medica SPA, a leader in hollow fiber membrane technology and retain a call option to purchase the remaining 51% stake in the years to come. We are pleased with this investment and our joint development agreement as we work towards developing and commercializing hollow fiber modules for applications including bioprocessing and food and beverage. Throughout the quarter, we maintained our focus on strong and consistent execution for our customers through our best in class operations teams and global footprint. With relatively stable supply chain conditions, we significantly improved on time delivery rates and our backlogs remain in great shape as we begin fiscal 2025. We executed and also laid the groundwork for the future through R and D and capital expenditures.

Speaker 2

R and D investment increased approximately 16% over 2023 and included product development initiatives in our legacy and newly acquired businesses. Capital expenditures were primarily focused on increasing capacity and expanding new products and technology, including in our Life Sciences segment. Now some detail on 4th quarter sales. Total company sales were $935,000,000 up 6% year over year driven primarily by volume. Price contributed approximately 1%.

Speaker 2

In Mobile Solutions, total sales were $575,000,000 a 6% increase versus 2023. Aftermarket sales grew 13% to $453,000,000 driven by solid growth in both the OE and independent channels. OE channel sales were up high teens versus prior year benefiting from a return to more normalized levels of demand following destocking in the prior year. In the independent channel, sales increased high single digits as a result of improved product availability and market share gains. The strength in aftermarket was partially offset by continued declines in our first fit businesses.

Speaker 2

Off road sales of $90,000,000 decreased 13% as weak agriculture markets persisted in most regions. On road sales declined 12% to $33,000,000 due to lower equipment production in China and the United States. I'll provide some additional color on our mobile business in China where the macro environment remains difficult. Sales decreased 19% year over year driven by declines in our first fit businesses. While China now represents a low single digit portion of total segment sales, it remains a strategically important area for us over the long term.

Speaker 2

We are optimistic about our ability to gain share over time through programs already won and through our technology led products as regulations become tighter and as Chinese manufacturers compete in Western markets. Now on the Industrial Solutions segment. Industrial sales increased 4% to $288,000,000 Aerospace and Defense sales rose 40% to $50,000,000 driven by robust commercial aerospace and rotorcraft markets as well as ongoing demand in defense due to the modernization of equipment and the impact of global conflicts. Industrial Filtration Solutions or IFS sales declined 1.5% from weaker dust collection demand in Europe and power generation project timing. In the Life Sciences segment, sales were $72,000,000 up 21% year over year, largely as a result of disk drive sales, which continued to rebound from trough levels a year ago.

Speaker 2

Food and beverage sales also increased in the quarter. Looking to fiscal 2025, Donaldson is poised for another record year delivering value to our shareholders through record sales and record earnings. We are forecasting a sales increase between 2% and 6% driven by solid growth in all three segments, adjusted operating margin between 15.3% 15.9% and adjusted earnings per share between $3.56 $3.72 Given fiscal 2024 results and our projections for fiscal 20252026, we are also taking the opportunity to update our fiscal 2026 financial targets previously laid out at our last Investor Day. 1st, on sales. We now expect consolidated sales to increase at a 3 year CAGR between 3% and 7%, slightly below our previous 4% to 8% projection.

Speaker 2

Our updated view is driven by slower than expected sales ramp up in life sciences where biopharmaceutical markets have slowed. Our outlook for mobile and industrial solutions is unchanged. With respect to consolidated operating margin, our fiscal 2026 target range is now 15.8% to 16.6%, slightly above our previous range of 15.6% to 16.4% with mobile and industrial operating margins far exceeding our previous expectations and with the path to life sciences operating margin strength elongating. Our mobile and industrial businesses have benefited from sales mix, volume growth, pricing and deflation of select input costs and we expect current profitability levels to continue. With respect to Life Sciences, we now believe the ramp up in profitability will take longer than initially expected given macro pressures and constrained customer capital spending, particularly for early stage assets.

Speaker 2

Our view of sales and profitability mix in the 3 year projection period since Investor Day has somewhat changed. However, our ability to return value to our shareholders through higher levels of profitability on higher sales has not. We remain committed to and confident in our long term strategy of utilizing our diversified technology led portfolio of businesses to further penetrate existing markets and enter into new markets. Now, I'll turn it over to Scott, who will provide more details on the financials and our outlook. Scott?

Speaker 3

Thanks, Todd. Good morning, everyone. I would like to start by thanking our teams around the globe for their hard work. We had a terrific quarter, which concluded a terrific year. Our employees delivered for our customers and our shareholders, and I am proud of what we accomplished.

Speaker 3

Before I cover our outlook, I will provide details on 4th quarter results. EPS grew 21% year over year to $0.94 on 6% sales growth. Operating profit increased 21% and operating margin was 16.3 percent, 200 basis points above 2023, driven by gross margin expansion and operating expense leverage. Gross margin of 36.2 percent increased 190 basis points above prior year from select input cost deflation and leverage on higher sales. Operating expenses as a percent of sales were 19.9% versus 20.0% a year ago from leverage on higher sales, partially offset by higher people related costs and acquisition related expenses.

Speaker 3

Now, I will discuss segment profitability. Mobile Solutions pre tax profit margin was 18.3%, 2 10 basis points above prior year due to favorable mix from strong aftermarket performance, volume growth and pricing benefits. Improved manufacturing efficiency in our plants also contributed to strong performance. Industrial Solutions pre tax profit margin was a record 20.1%, 90 basis points above a tough comparison 19.2% in the prior year period. The year over year improvement was driven by volume and pricing.

Speaker 3

Our margin performance in both mobile and industrial has been outstanding all year, pushing Donaldson's blended margins to record levels. We look forward to continuing this robust performance in the years to come. Our Life Science business generated a pre tax loss of approximately 1%, including a headwind from acquisitions of 15 percentage points. This compares to a pre tax loss of 12% in the prior year period. Leverage on higher sales from our legacy businesses drove the improvement, while profitability in the segment has been negatively impacted by a slower acquisition related sales ramp combined with investments for growth, we are committed to and confident in the scaling of our acquisitions and to long term profitable growth in this segment.

Speaker 3

Turning to a few balance sheet and cash flow statement highlights. 4th quarter capital expenditures were approximately 19,000,000 dollars Cash conversion in the quarter was 93% above historical averages and on par with prior year as our focus on working capital efficiency continued. In terms of other capital deployment, we returned approximately $82,000,000 to shareholders, inclusive of $32,000,000 in the form of dividends and $49,000,000 in share repurchases. Before turning to our fiscal 2025 outlook, I will touch on the footprint and cost optimization program we put in place this quarter, which resulted in pre tax charges of $6,400,000 or approximately $0.04 of EPS. One of Donaldson's core strengths and competitive advantages is our global footprint.

Speaker 3

With investments in every major region, we are able to support the production and distribution of our innovative and high growth products in region for region. As our business evolves, we continually strive to optimize our footprint and have identified certain projects resulting in improved efficiency. Now our fiscal 2025 outlook. 1st on sales. We forecast full year total sales to increase between 2% and 6%.

Speaker 3

This includes a pricing benefit of approximately 1% and an immaterial impact from currency translation. For Mobile Solutions, we are expecting an increase of between 0% and 4% with growth in aftermarket and off road more than offsetting on road declines. Aftermarket sales are projected to increase low single digits after lapping solid results in the prior year as vehicle utilization rates remain high and as we continue to gain market share. Off road sales are forecast to increase low single digits from market share gains, partially offset by weaker demand from softer end market conditions, including in agriculture and construction. On road sales are expected to decrease low double digits as we exit certain non strategic products and as global heavy duty truck production remains muted.

Speaker 3

Industrial Solutions sales are projected to grow between 4% 8%. IFS sales are expected to increase high single digits with strains across most businesses including dust selection, industrial hydraulics and industrial gases. Aerospace and Defense sales are forecast to be flat year over year at high levels due to lapping of an outstanding 2024 with the backdrop of supportive end market conditions. For Life Sciences, we expect an increase of low double digits driven by sales growth across all businesses. Our legacy businesses including disk drive, food and beverage and vehicle electrification are all poised for strong performance and we are pleased with the progress we have made on integrating our bioprocessing acquisitions.

Speaker 3

As Todd mentioned, challenging market conditions and tightened customer capital spending have dampened our expectation for the segment in the near term. We expect profitability to be approximately breakeven for the full year. On a consolidated basis, we are forecasting adjusted operating margin between 15.3% and 15.9%, driven by sustained gross margin performance. At the midpoint, this represents an all time record for the company and compares to an adjusted operating margin of 15.4% in 2024. Our all of our interest expense is approximately 21,000,000 dollars on par with the prior year.

Speaker 3

Other income net is forecasted to be between $16,000,000 $20,000,000 up from $13,000,000 a year ago. Our tax rate is forecast between 23% 25%, an increase from 22.7% in fiscal 2024 due to a reduction in discrete tax benefits. For adjusted EPS, we expect between $3.56 and $3.72 a $0.22 or 7% increase at the midpoint from adjusted EPS of $3.42 in the prior year. In total, in fiscal 2025, we are well poised to once again deliver higher levels of profitability on higher sales. Now on to our balance sheet and cash flow outlook.

Speaker 3

Cash conversion is anticipated to be in line with historical averages at 85% to 95%. Capital expenditures are projected between $85,000,000 $105,000,000 and will continue to include growth investments, including capacity and new products and technologies. Our capital deployment strategy has not changed. Reinvestment back into Donaldson organically or inorganically is our top priority. To that end, our R and D investments are forecast to continue to increase and our M and A focus areas remain life sciences and industrial services.

Speaker 3

We also intend to continue our long history of paying and increasing our dividend. Lastly, we plan to repurchase approximately 2% to 3% of shares outstanding. Before turning the call back to Todd, I will provide some additional details on our updated fiscal 2026 financial targets. For mobile solutions, our sales outlook is unchanged. From a profitability standpoint, given our recent outperformance and expectations for continued strength,

Speaker 4

we

Speaker 3

are increasing our fiscal 2026 targeted operating margin range to between 18.1% and 18.9%, which at the midpoint is up 250 basis points from the initial range of 15.6% to 16.4%. In Industrial Solutions, our sales outlook is also unchanged. However, given recent higher than expected profitability trends and our forecast for continued leverage from higher sales, we have increased the operating margin range to between 17.8% 18.6%, which at the midpoint is over 100 basis points of improvement from 16.6% to 17.4% previously. For Life Sciences, we are reducing our sales and margin expectations given the aforementioned market dynamics. We now look for sales to increase at a 12% to 16% CAGR over the 3 year period versus 18% to 22% previously and forecast profitability between 5% 11% below our previous range of 22.1% to 22.9%.

Speaker 3

Importantly, for the consolidated company, while we have lowered our total sales growth expectation to between 3% 7% from 4% to 8% previously, we have improved our profitability outlook to between 15.8% 16.6%, which at the midpoint is 20 basis points above our previous target. I'll now turn the call back to Todd for some closing remarks.

Speaker 2

Thanks, Scott. I'm excited by what lies ahead for Donaldson Company. Through our mission of advancing filtration for a cleaner world, the company has evolved driven by the strength of our team and our dedication to executing on our long term strategic initiatives. I am confident in our ability to deliver value to all of our stakeholders in the years to come. We are optimistic about the future in each of our segments.

Speaker 2

In Mobile Solutions, we remain the market leader with our technology led product portfolio. Our proprietary razor to sell razor blade model has been paying dividends and we expect to continue to gain share. In Industrial Solutions, we are excited about our connectivity strategy and the ongoing build out of our services capabilities. Our one stop shop approach is working. In life sciences, we are making progress in commercializing our bioprocessing business.

Speaker 2

We recently announced the expansion of our relationship through our Universe Cells Technologies business with the gene therapy program at the University of Pennsylvania. The gene therapy program or GTP is renowned for its pioneering work seeking to make gene therapies for rare diseases accessible worldwide. This expanded relationship is aimed at determining the scalability of product manufacturing using our bioreactors. Overall, the interest in our technologies is robust and our therapy pipeline is growing. While market conditions across our segments have and will continue to fluctuate, we are committed to investing for the future, executing and remaining agile, again with the overarching mission of the company as our guiding principle.

Speaker 2

In fiscal 2024, we made considerable progress on our 2,030 SG ambitions as well, and we look forward to providing an update in the quarters to come and with our upcoming fiscal 2024 sustainability report. With that, I will now turn the call back to the operator to open the line for questions.

Operator

Thank you. We will now begin the question and answer session. Your first question comes from the line of Brian Blair from Oppenheimer. Your line is open.

Speaker 5

Thank you. Good morning, everyone. Good morning, Bryan. I was hoping to level set a bit more on life sciences trends and outlook, at least with our growth trends and outlook. I know that bioprocessing, trailing revenue base is quite limited.

Speaker 5

So the numbers are impacted by that. But you want to speak to fiscal 2024 growth rates across prudent bev, disk drives, vehicle electrification and bioprocessing and then what's contemplated in your fiscal 2025 outlook for each?

Speaker 2

Brian, we haven't broke the model out externally to that level. We can tell you that we do expect low double digit growth though in food and beverage. Bioprocessing will certainly be a bit more muted and that's what we put within the model. That's really the longer term change, if you will. And then disk drive will continue to crawl forward from the bottoms we experienced here over the past year.

Speaker 2

That's just generally kind of how you would put the model together.

Speaker 5

Okay, understood. And the step up in fiscal 26 mobile and industrial profit expectations is encouraging, certainly supported by the trends of your operations. Maybe speak to what the key drivers have been for much stronger than expected margin expansion in the legacy segments, particularly in mobile. And then on the life sciences side, we know that the demand backdrop for biopharma is still muted. Is that the exclusive driver of the lowered growth and profit outlook or are there also differences in the forward model in terms of investments required cost structure etcetera?

Speaker 2

So let's take mobile first. Within mobile, what you have is really the power of the mix overall, expanding the operating margin. Specifically, we have clear share gain within our aftermarket organizations. We also have the benefit of a little bit of tailwind due to the OE destocking in the past. So given a sense of where we are, for example, on that mix, you will have seen on our OE channel within aftermarket, which is about 40% of that business is up, say, high teens within the quarter.

Speaker 2

And then when you look at the independent channel, which is 60%, you'll have seen clear share gains and up high single digits. That really shows the power of the mix. You also have obvious headwinds within the OE sector of the first fit production within Mobile Solutions. And specifically, what really showed up in this quarter, the new piece of data would be a little bit more headwind in mining, which we had not been experiencing in the past. So net net, we've got a good strong mix opportunity.

Speaker 2

We're very optimistic about the future and been able to hold that operating margin specifically because of the share gains we have in aftermarket. And we've been working really hard to get a fair relationship with our OEs and get the pricing opportunities appropriate there. Within the life sciences sector, yes, the bioprocessing upstream and downstream is really where we look to grow. That is clearly a more careful market at this point in time. We also would point out that new cell and gene therapy development is also a place where we look to grow.

Speaker 2

What's interesting about when you combine those, we see less expansion by the biopharma within the bioprocessing equipment sector. And so that has become more muted as well as in the cell and gene therapy activities. We told you we had about 140 or so development programs within therapeutics. We're up in the quarter double digits. You can see the slowness happening for example with less programs going into Phase 1, Phase 2 clinical trials.

Speaker 2

And so things are just evolving more slowly than we would have expected and it's just really the backdrop of the comprehensive sector if you will.

Speaker 5

Understood. Appreciate the color. And I have one more quick one, if I may. Perhaps offer a little more color around Medica SPA and then fit in the portfolio and your continued build out of the bioprocessing puzzle that you've laid out?

Speaker 2

Yes. We're really optimistic about what we have within the bioprocessing activities. We look at the sum of the parts and we're very positive. Clearly, the market is telling us it's going to take longer than we had originally hoped. In our typical Donaldson other models, when programs slip, they'll slip a quarter or 2 quarters, but within bioprocessing, they seem to slip a year or 2 years.

Speaker 2

And so that's really we just thought it was prudent within the longer term outlook to take that into account, and therefore the model change. But overall, when you sum it up, we're excited about what we have. The customers are telling us they're excited about the overall products that we're bringing to them. They are disrupted. They like the efficiency output that it brings to them.

Speaker 2

We just need to continue as a company to work our process to commercialize them and push them out. It's just going to take a little bit more time than we had originally thought, but on a good track.

Speaker 5

Okay, understood. Thanks again.

Operator

Your next question comes from the line of Tim Thein from Raymond James. Your line is

Speaker 6

open. Good. Thank you. Good morning. The first question was on good morning.

Speaker 6

Yes, just on the Industrial segment, I was hoping you could maybe give a little bit more color specifically on IFS and you mentioned in the release some of the timing issues that may have impacted sales in the quarter, but that's kind of a step up in growth projected here in 'twenty five. And I guess it's a little hard to generalize for that segment just given the number of end markets. But one of the themes has kind of been around larger scale CapEx just a little slower to move forward and just maybe just some malaise around larger capital projects. And I know that's not a great generalization for what drives that segment, but maybe just give some color around the pieces within the portfolio that are giving you confidence in that high single digit growth projected in 2025?

Speaker 2

Yes, Tim, just generally as you describe the macro of what we're experiencing, I think you're very spot on to the overall condition that we're experiencing. For example, IAF, so dust collection equipment in Europe certainly is muted. It's the biggest headwind that we have. And it's specific to Europe. It's not other region based.

Speaker 2

And so that is the biggest headwind that we have. And then the other one is timing relative to power generation projects. We still feel very good. It's a multi year positive trend within power generation certainly going up. Our backlogs are healthy.

Speaker 2

It's a very lumpy business as we talked about many times before. It's just in a lumpy moment again. Therefore, it was down in the quarter. But as we look forward, we do not expect it to be down next year. We do expect it to be up year over year and we see that within our backlogs.

Speaker 2

So we feel like that gives us confidence on the movement up and then in dust collection, I. E. Up in Europe, it's pretty tough there. We do expect conditions to repair slightly going forward. So the comp becomes a little bit easier to give us some tailwinds there.

Speaker 2

And then the third thing, very importantly, is our connected base products really are gaining momentum. We put up and set up about another 1,000 in the last fiscal year. We do see they help us drive aftermarket and we are gaining share really across the world largely though in the United States within our aftermarket execution. And so net net when you roll out together that gives us the positive outlook for IFS within fiscal 2025.

Speaker 6

Very good. Thank you. And then just I guess turning to capital deployment with I guess half a turn of net leverage, obviously, in a really good position to be on the offensive. Maybe just with respect to the growth aspirations in Life Sciences in light of the tougher cyclical backdrop. Does that does it change your motivation or just change your plan in terms of how much you want to invest in that area in light of a market that's shaping up to be tougher than you thought.

Speaker 6

And I guess maybe the corollary to that would be, is there potentially less maybe you're competing for less investment just broadly speaking? Or is that just not the case? And so I don't know, open ended question, but however you want to touch on that. Thank you.

Speaker 2

Yes. Let me try to unpack that. There's a lot there. So just generally at the company level relative to capital deployment, our priorities have not changed. I mean, Scott points it out within the script.

Speaker 2

We specifically will invest back into the company organically and inorganically. We are targeted specifically at life sciences as well as service aspects in some pieces of the industrial, primarily life sciences. We like the play that we have within life sciences. Sure, it's a little bit elongated, but the longer term returns within that space still look very positive for us as we continue to enter it. As far as opportunities for M and A within the space at this point in time, It has gone, let's say, that's also perhaps a little bit more elongated than it has been in the past.

Speaker 2

But we saw a very full pipeline. We're still developing good relationships. It's very strategic, very pleased. Nothing changes at all relative to our strategy and we sit in good shape.

Speaker 3

Maybe I can just add on a bit to that. I mean, if you back to your comment about our half a turn debt level, I mean, we generated cash conversion of 113% last year, 97% this year. We're forecasting in our guide 85% to 95%. So very strong cash flows over the last few years and another strong year projected. I mean we've stumped the acquisitions that we've completed, bought 2% of our shares, increased the dividend and our debt slowly trickles down.

Speaker 3

So in the guide, we also noted this year, we are forecasting a share repurchase of 2% to 3% of our shares outstanding. If you look back the last several years, it's been spot on 2%. And so we've increased that a little bit in light of the very strong cash flows that the company has generated the last 2 years and again expected for next year. So we feel like we're in a really good shape from a strategic capital deployment perspective and that we're really being smart with how we're allocating capital into this business, which is evidenced by the debt slowly coming down. So we feel like we're in a pretty strong position.

Speaker 3

We do look to execute acquisitions and those timing of which is always something that's impossible to estimate. But we feel like we're in a very strong position and we did slightly tick up the share buyback guide for this year because of those strong cash flows.

Speaker 6

Okay. I'll squeeze one last one in and this the risk of cutting this or slicing this too finely, but I'll just ask on with respect to the growth in aftermarket within the mobile business, does the fact that you had the contract win in that share gain that you experienced in the independent channel, is that normalizes? Is there a much of a mix impact in 2025 if you have maybe the independent channel doesn't see the level of growth visavisvov channel in 2025? I know there's some can be some different margin dynamics there, but just curious if that's a meaningful factor in any way?

Speaker 2

I think the more meaningful factor to really take into account here is the OE destocking portion of the mix that you referred to, because we do end up lapping when that was when that began last fiscal year and we start to lap that within fiscal within this fiscal year into 2. And so maybe that's something more important than what you're calling out rather to a particular large win on the independent channel. That's something to think about. And you kind of when you roll that within our overall growth rate, then expect it from that maybe massage it from that perspective.

Speaker 6

Excellent. Thanks for all the time.

Operator

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

Speaker 7

Good morning. This is Adam Farley on for Nathan.

Speaker 4

Hi, Adam.

Speaker 7

So gross margin improvement has been very impressive. Besides price cost, what are the main buckets leading to better than expected gross margins in the businesses? And any thoughts on expectations for gross margin going forward as the environment normalizes?

Speaker 3

Yes. I mean, the company has obviously worked very hard on its gross margins over the last several years, dating back to the spikes of inflation that we saw. And we just want to have reasonable commercial relationships with our customers. And so if costs are going up, we got to pass price increases on and they do the same to their customers. And certainly, we think things are stabilizing now.

Speaker 3

We have some costs still going up, but some going down. So that's a good place to be. I think the world is hopefully normalizing. And we've worked hard on all aspects of gross margin to get to a 36.2% gross margin for the Q4 and 35.6% for the year is where down should be right now. We're expecting to maintain that level of gross margin going forward.

Speaker 3

So we're not projecting any massive increases price for next year is forecasted to only be 1% of revenues. So we're pretty pleased with our gross margin performance. The plants have performed very well. And so hats off to their work to maintain costs and ensure we're executing as efficiently as possible. And then we always have to be able to continue to leverage what we're doing with higher levels of sales to generate higher levels of profitability.

Speaker 3

We are generating higher levels of sales. And as things have calmed down now, we've really moved back to our traditional roots of improving our cost structure. And we did announce a 4th quarter program whereby we're looking at footprint and cost optimization program. And while that won't necessarily provide benefits immediately, longer term there'll be benefits from that. So we're going to keep working on our gross margin.

Speaker 3

We feel like we're definitely headed in the right direction with how things are performing. And that's why we think we can maintain these current levels.

Speaker 7

That's really helpful. And then just a quick follow-up. What is the on road product line exit related to? And do you expect to do any more product line rationalization?

Speaker 3

Yes. If you remember a while back, we talked about the exit of some product lines across the company. And we have one particular product, it's a DEF tank product. That's really not at our core and we've been producing those for years years years. And because it's really not a technology led filtration solution, we're going to move out of that business and work with our customer to transition elsewhere.

Speaker 3

And there's a revenue haircut from that, but thinking about the capital we employ, the investments for future, we decided that wasn't strategic to the company. So that's a headwind that we've accounted for in our guidance this year in terms of first fit sales, but I think it's the right decision for the company.

Speaker 7

Okay. Thank you for taking my questions.

Operator

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

Speaker 4

Hi, good morning. Thanks for taking my questions. I just have a couple at the moment now. I was wondering if you could talk more specifically about the Napa partnership and what went into that wind. Specifically, I'm curious if you could talk about the Napa Gold product line.

Speaker 4

What end markets are you getting increased access to? And anything else that you can do just to flush out that win and add some detail to that?

Speaker 2

Yes, sure. So, just basically it really hits the strengths of the companies as to why we won, right? So one where we have the technologies necessary that they cover across a full portfolio of product that covers all the medium heavy duty diesel engine opportunities across multiple end market segments, like construction, ag, mining, etcetera. And that really targeted because of our catalog. 2nd is because of we really take great pride in customer service and customer relationships.

Speaker 2

And we have taken time to really get a strong relationship and good information share between the two companies such that our service levels to them are really quite good. And so you roll those things together and it allows us to win this thing over time. And we believe it allow us to have a strong relationship with them as well. So really place

Speaker 7

in the strength.

Speaker 4

Yes, great. Thank you. And then just to be clear, I see a press release from August, but this is a partnership or you stepped up your business with them prior to August, right? And this has been contributing to the growth in the independent channel?

Speaker 2

It has been we felt as though we should put that press release out because it is material and we wanted to signal to everybody that, hey, we do have this program win and now it is clearly continuing to add to the growth on the independent channel, yes.

Speaker 4

Yes. Okay, got it. Thank you. And then we talked a lot about margins, but I just want to ask one more there. I'm not sure that this was discussed in great detail, but I'm just thinking that one of the things that I believe has been helping margins lately has been the mix, right, between aftermarket and 1st fit.

Speaker 4

1st fit has been a little bit soft. And can you just comment specifically on whether there could be a headwind from the 1st fit business eventually recovering and the proportion of sales from 1st fit increasing? Thanks.

Speaker 3

Yes, Brian. I think you have it right. Certainly, our aftermarket sales, which is one of the critical strengths of the company to have 2 thirds of your business being replacement parts is really what drives the company. And we want to continue to sell proprietary first fit solutions because every time we do that, we secure aftermarket business for many, many years to come. So as things cycle up and down in off road and on road and first fit sales, obviously tend to cycle, there is a mix impact to that.

Speaker 3

And if your aftermarket business is growing at a rate much faster than your first fit businesses, you're going to have margin accretion. And if it switches the other way around, you're going to have some dilution. We think we could continue to weather those storms. And we've really factored that in to our guidance going forward. So, we do expect longer term that certainly the 1st fit businesses are not going to be in decline.

Speaker 3

And certainly, there's some well publicized short term issues in the 1st fit business where you see some of our big customers retrenching just a bit. And we expect that to happen for a while and then ultimately return to growth. And so I think you have it right. We factored those concepts into our guide for next year as well as our revised investor targets where we're taking mobile solutions and industrial solutions up quite a bit. So we feel pretty good about the operating margin even in light of the fact that at some point, Persit will come back.

Speaker 4

Right. Okay. Thank you very much.

Operator

Your next question comes from the line of Rob Mason from Baird. Your line is open.

Speaker 8

Hi, good morning. Just real quickly, I had a question on the fiscal 2025 outlook. How are you thinking about the sales cadence if you just want to break it down between first half, second half? Yes, if you could just comment on that.

Speaker 2

Sure. We're closer to a 49, 51 than we are a 48 our traditional 48.52.

Speaker 8

I see. Well, that kind of bleeds into my second question just around the Mobile Solutions outlook. The share gains have been notable here. I think you outlined or detailed some what seemed like maybe incremental share gains in the off road business that support the outlook there. Just that my read is those are somewhat meaningful.

Speaker 8

Just your customer base is talking about more pressure there certainly through the back half of the calendar year. Just if you could comment on your thoughts around how you may be performing there versus market volumes within your outlook?

Speaker 2

Yes, we definitely have some share gain there. No question about it. And we did make that within the guide.

Speaker 8

Any particular region that this bias to?

Speaker 2

Well, they're global based customers. So when we win, we really win by platform. And so it's tough to specifically on this particular win say, hey, this is the region because it'll be more broad based.

Speaker 4

Sure, sure.

Speaker 8

Okay. And then just last question, stepping back to the 2026 target revisions, Scott, I think in your commentary you talked about R and D would continue to increase, which is something we would expect. But could you put a little more context around how you think R and D trends over the next couple of years relative to your upwardly revised op margin guidance? And really more specifically, how should we think about that as a percent of sales? Does it go up as a percent of sales?

Speaker 8

Does it stay where it is?

Speaker 3

No. Tom and I have been pretty consistent over the years. R and D is of critical importance to Donaldson. We are a technology led filtration company. When we start thinking about our budget for the next year, we really think hard about what monies we want to allocate to R and D and we expect to continue to increase our R and D spend both in terms of dollars and in terms of rate of sales.

Speaker 3

If you look at the it does go up and down, but the longer trend is pretty significant increase over the last few years and we want to continue that. We want to continue to invest in new technologies. We have some great opportunities in life sciences to invest. And we're nearing 3% of sales and we've been under that and we're going to continue to allocate both capital and expense dollars into R and D because that's really our best opportunity for returns on invested capital is to do it in house with our spectacular R and D team that we have.

Speaker 2

Yes. And the way we talk throughout the company is we're a technology led company. We want to continue to

Speaker 8

invent cool things, pretty straightforward. No, understood. And just like one last quick one, just related to the restructuring that you outlined. Scott, you'd mentioned that would those benefits would play out over time. Is there something included in the 2025 outlook related to the benefits from those or they extend beyond 2025?

Speaker 3

No, there would be much impact in 2025. We're going to continue to focus on our footprint and cost optimization and there will be some more actions that I'm sure we can identify this year. But they take a while to run through and start to show up. But we're just trying to make the company consistent with our historical approach of things, more efficient every year and that takes some investment, but the returns on those investments, while not a 1 year payback, usually shows up in year 2 or year 3 for sure.

Speaker 8

Very good. Appreciate the update. Thank you.

Operator

That concludes our question and answer session. I will now turn the call back over to Todd Carpenter for some final closing remarks.

Speaker 2

That concludes the call today. Thanks to everyone who participated and we look forward to reporting our Q1 fiscal 2025 results in November. Goodbye.

Operator

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

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Earnings Conference Call
Donaldson Q4 2024
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