Donaldson Company, Inc. — Fiscal 2016 Second-Quarter Form 10-Q
Reporting period: Three and six months ended January 31, 2016. Donaldson manufactures filtration systems and replacement parts, reported through Engine Products and Industrial Products segments. Unless stated otherwise, amounts are in millions of dollars. Prior-year interim results shown below were revised for improperly accelerated revenue recognition in the European Gas Turbine Systems business.
Financial performance
| Metric | Q2 FY2016 | Q2 FY2015 | Six months FY2016 | Six months FY2015 |
|---|---|---|---|---|
| Net sales | $517.2 | $588.5 | $1,055.2 | $1,185.0 |
| Gross profit / margin | $170.8 / 33.0% | $203.1 / 34.5% | $348.9 / 33.1% | $412.2 / 34.8% |
| Operating income / margin | $53.7 / 10.4% | $65.8 / 11.2% | $109.2 / 10.3% | $142.8 / 12.1% |
| Net earnings | $38.0 | $48.0 | $76.5 | $103.9 |
| Diluted EPS | $0.28 | $0.34 | $0.57 | $0.74 |
| Operating cash flow | Not separately reported for quarter | $109.3 | $85.4 |
- Q2 sales fell 12.1%; excluding currency translation, sales declined 7.6%. Six-month sales fell 11.0%, or 5.6% on a constant-currency basis. Currency translation reduced Q2 sales by $26.3 and net earnings by $4.9.
- Lower volumes and foreign exchange contributed to weaker gross and operating margins, including under-absorption of fixed manufacturing costs. Lower raw-material costs, continuous-improvement initiatives, restructuring benefits, and expense controls partially offset pressure.
- Q2 effective tax rate was 23.0% versus 26.7%; the six-month rate was 25.6% versus 27.2%. The lower rate reflected earnings mix and discrete benefits, including a nonrecurring foreign-dividend tax benefit in Q2.
Segments and operating developments
- Engine Products: Q2 sales were $320.9, down 10.1%; six-month sales were $667.5, down 10.7%. Segment pretax earnings were $27.4 in Q2 and $63.4 for six months, versus $41.5 and $94.6. Weakness in off-road markets and aftermarket demand weighed on results; on-road sales increased in Q2.
- Industrial Products: Q2 sales were $196.3, down 15.1%; six-month sales were $387.7, down 11.3%. Segment pretax earnings were $27.7 in Q2 and $51.7 for six months, versus $35.1 and $62.7. Gas Turbine Systems sales fell 40.8% in Q2 and 34.1% year to date amid project deferrals and softening demand.
- Fiscal 2016 restructuring actions were completed at a pretax cost of $6.2; total restructuring charges in the six-month period, including prior actions, were $8.5. Management estimates the 2016 actions will produce $25 of annual pretax savings.
- The August 2015 acquisition of Engineered Products Company added about $9 of annual sales; acquisition spending net of cash acquired was $12.9 in the six-month cash-flow statement.
Liquidity, debt, and capital allocation
- At January 31, cash and cash equivalents were $222.1, short-term investments $9.8, current assets $1,006.7, and current liabilities $587.5. Short-term borrowings were $261.4; current maturities of long-term debt were $1.2 and long-term debt was $389.0.
- Operating cash flow was $109.3; investing activities used $37.7 and financing activities used $34.0. Capital expenditures were $42.8, dividends paid $45.2, and treasury-stock purchases $68.0. Cash increased $32.2 to $222.1.
- Unused credit lines were approximately $403.1. The company reported covenant compliance and said financial resources and operating cash flow should fund operations for the next 12 months, while noting future borrowing cost and availability could be affected by capital-market disruptions.
- Days sales outstanding increased to 69 from 64 at July 31, 2015, partly reflecting delayed payments and longer terms on some large gas-turbine projects. Inventory was $274.8, up $9.8 from fiscal year-end, with higher Gas Turbine Systems inventory for upcoming projects; inventory turns declined to 3.9 from 4.3.
- The company repurchased 2.07 million shares for $68.0 during the six months; no public-plan repurchases occurred in the quarter. The board authorization had 10.9 million shares remaining at January 31. Quarterly dividends were $0.17 per share.
Outlook, risks, and unusual matters
- FY2016 adjusted EPS guidance was narrowed to $1.51–$1.61 from $1.49–$1.69. GAAP EPS was expected to be about $0.06 lower due to restructuring and investigation-related costs.
- Management forecast sales of $2.20–$2.25 billion, down 5%–7% year over year, including $90–$100 of adverse currency impact; local-currency sales were expected to decline 1%–3%. Adjusted operating margin guidance was 13.0%–13.6%; the expected tax rate was 25.5%–27.5%. The company expected to repurchase up to 2% of outstanding shares.
- Revenue-control weakness: The company disclosed that individuals had altered documents to accelerate revenue recognition in European Gas Turbine Systems in FY2015, requiring revisions to previously reported second- and third-quarter statements. The material weakness in controls remained as of January 31, 2016; disclosure controls were deemed ineffective. Management described remediation steps, but said controls must operate and be tested for a sufficient period before the weakness can be considered remediated.
- Goodwill risk: A revised Gas Turbine Systems forecast and strategic shift toward aftermarket growth and greater selectivity on large projects triggered an interim impairment test. No impairment was recorded; estimated fair value exceeded carrying value by 13.6%. Management said sufficiently adverse changes in forecast cash flows or valuation assumptions could indicate impairment in the future.
- Other items include $3.1 of investigation-related costs in six-month operating expenses; higher warranty costs (warranty reserve of $12.2 versus $8.4 a year earlier); a $1.2 six-month loss from the AFSI joint venture; and the prior-year $3.9 pension settlement charge. The company guarantees half of AFSI’s $20.3 outstanding debt. It also reported $7.8 of undrawn standby letters of credit and possible tax obligations of $21.6, including interest and penalties; timing and amount of tax payments were uncertain. Management did not expect identified litigation or warranty matters to materially affect financial position, results, or liquidity.
- Management cited economic and market uncertainty, currency fluctuations, commodity prices, global operations, competitive markets, and political and other global events as risks to forward-looking results.
Important facts for investors to verify
- Whether revenue-recognition remediation is independently tested and the disclosed material weakness is formally resolved.
- Gas Turbine Systems order timing, customer payment performance, revised outlook, and the assumptions and headroom in its goodwill valuation.
- Whether sales, adjusted EPS, margin, and tax-rate guidance are achieved, particularly under the stated currency and end-market conditions.
- Whether restructuring savings materialize and whether margins recover as volumes, costs, and warranty claims evolve.
- Debt, borrowing availability, covenant compliance, cash accessibility across foreign subsidiaries, and the eventual outcome of tax examinations.