DONALDSON: Management report and analysis of the financial situation and operating results (form 10-K)

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The following Management's Discussion and Analysis of Financial Condition and
Results of Operations (MD&A) provides a comparison of the Company's results of
operations, as well as liquidity and capital resources for the years ended
July 31, 2021 and 2020. A discussion of changes in the Company's results of
operations and liquidity and capital resources for the year ended July 31, 2020
from July 31, 2019 can be found in Part II, "Item 7. Management's Discussion and
Analysis of Financial Condition and Results of Operations" of the Company's
Annual Report on Form 10-K for the year ended July 31, 2020 (the "2020 Annual
Report"), which was filed with the SEC on September 25, 2020.
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The MD&A should be read in conjunction with the Company's Consolidated Financial
Statements and Notes included in Item 8 of this Annual Report. This discussion
contains forward-looking statements that involve risks and uncertainties. The
Company's actual results could differ materially from those anticipated in these
forward-looking statements as a result of various factors, including those
discussed elsewhere in this Annual Report, particularly Item 1A, "Risk Factors"
and in the Safe Harbor Statement under the Private Securities Litigation Reform
Act of 1995, below.
Throughout this MD&A, the Company refers to measures used by management to
evaluate performance, including a number of financial measures that are not
defined under generally accepted accounting principles (GAAP) in the U.S.
Excluding foreign currency translation from net sales and net earnings (i.e.
constant currency) are not measures of financial performance under GAAP;
however, the Company believes they are useful in understanding its financial
results and provide comparable measures for understanding the operating results
of the Company between different fiscal periods. Reconciliations within this
MD&A provide more details on the use and derivation of these measures.
Overview
The Company is a global manufacturer of filtration systems and replacement
parts. The Company's core strengths include leading filtration technology,
strong customer relationships and its global presence. Products are manufactured
and sold around the world. Products are sold to OEMs, distributors, dealers and
directly to end users.
The Company's operating segments are Engine Products and Industrial Products.
The Engine Products segment consists of replacement filters for both air and
liquid filtration applications, air filtration systems, liquid filtration
systems for fuel, lube and hydraulic applications, exhaust and emissions systems
and sensors, indicators and monitoring systems. The Engine Products segment
sells to OEMs in the construction, mining, agriculture, aerospace, defense and
transportation end markets and to independent distributors, OEM dealer networks,
private label accounts and large fleets. The Industrial Products segment
consists of dust, fume and mist collectors, compressed air purification systems,
gas and liquid filtration for food, beverage and industrial processes, air
filtration systems for gas turbines, PTFE membrane-based products and
specialized air and gas filtration systems for applications including hard disk
drives and semi-conductor manufacturing and sensors, indicators and monitoring
systems. The Industrial Products segment sells to various dealers, distributors,
OEMs and end users.
Coronavirus (COVID-19) Pandemic
The effects of the ongoing COVID-19 pandemic continue to impact global economic
conditions. Management cannot predict with specificity the extent and duration
of any future impact on the Company's business and financial results from the
COVID-19 pandemic.
Supply Chain Disruptions
The Company's supply chain and manufacturing operations have experienced
logistical and production constraints, and may continue to experience such
constraints in the future. The supply chain disruptions the Company experienced
due to a labor shortage, reduced freight transportation capacity and timing in
receiving certain raw materials slowed the Company's production speed and
increased lead times. The Company has undertaken steps to mitigate the supply
chain disruptions, such as qualifying additional suppliers. These disruptions
impeded the Company's ability to meet strengthening demand. This dynamic is
expected to remain into fiscal 2022.
Inflation
In connection with the supply chain disruptions described above, the Company has
experienced the effects of inflation related to raw materials and operating
expenses. These inflationary pressures typically have an adverse impact on
profit margins, particularly in the near term, because the Company is limited in
its ability to pass cost increases onto certain of its customers due to fixed
pricing under contracts that are not subject to adjustment until certain
conditions are met or sometimes until the next renewal of the contract. In
addition, there may be competitive pricing pressures in the markets in which the
Company operates. These inflationary pressures impacted results in the second
half of fiscal 2021 and are expected to continue in fiscal 2022.
Consolidated Results of Operations
Net sales for the year ended July 31, 2021 were $2,853.9 million, compared with
$2,581.8 million for the year ended July 31, 2020, an increase of $272.1
million, or 10.5%, including a positive impact from foreign currency translation
of $78.0 million. On a constant currency basis, net sales for the year ended
July 31, 2021 increased 7.5% from the prior year.
Net earnings for the year ended July 31, 2021 were $286.9 million, compared with
$257.0 million for the year ended July 31, 2020, an increase of $29.9 million,
or 11.6%. Diluted earnings per share were $2.24 for the year ended July 31,
2021, compared with $2.00 for the year ended July 31, 2020, an increase of
12.0%.
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Operating Results
Operating results were as follows (in millions, except per share amounts):
                                                                                   Year Ended July 31,
                                                              2021         % of net sales               2020         % of net sales
Net sales                                             $ 2,853.9                                 $ 2,581.8
Cost of sales                                           1,882.2                   66.0  %         1,710.2                   66.2  %
Gross profit                                              971.7                   34.0              871.6                   33.8
Selling, general and administrative                       519.2                   18.2              470.3                   18.2
Research and development                                   67.8                    2.4               61.2                    2.4
Operating expenses                                        587.0                   20.6              531.5                   20.6
Operating income                                          384.7                   13.5              340.1                   13.2
Interest expense                                           13.0                    0.5               17.4                    0.7
Other income, net                                          (9.3)                  (0.3)             (12.5)                  (0.5)
Earnings before income taxes                              381.0                   13.3              335.2                   13.0
Income taxes                                               94.1                    3.3               78.2                    3.0
Net earnings                                          $   286.9                   10.1  %       $   257.0                   10.0  %

Net earnings per share - diluted                      $    2.24                                 $    2.00


Net Sales
Net sales by operating segment were as follows (in millions):
                                                           Year Ended July 31,
                                           2021      % of net sales           2020      % of net sales
   Engine Products segment          $ 1,957.7               68.6  %    $ 1,727.5               66.9  %
   Industrial Products segment          896.2               31.4           854.3               33.1
   Total Company                    $ 2,853.9              100.0  %    $ 2,581.8              100.0  %


Net Sales by Origination
Net sales, generally disaggregated by location where the customer's order was
received, were as follows (in millions):
                                                                           Year Ended July 31,
                                                     2021          % of net sales               2020          % of net sales
U.S. and Canada                              $ 1,084.2                    38.0  %       $ 1,059.9                    41.1  %
Europe, Middle East and Africa (EMEA)            865.7                    30.3              760.2                    29.4
Asia Pacific (APAC)                              649.2                    22.8              553.2                    21.4
Latin America (LATAM)                            254.8                     8.9              208.5                     8.1
Total Company                                $ 2,853.9                   100.0  %       $ 2,581.8                   100.0  %

Impact of currency conversion on Net net sales sales were affected by exchange rate fluctuations. The impact was as follows (in millions):

                                                             Year Ended July 31,
                                                                 2021           2020
         Prior year net sales                            $  2,581.8      $ 2,844.9
         Change in net sales excluding translation            194.1         

(225.0)

         Impact of foreign currency translation (1)            78.0         

(38.1)

         Current year net sales                          $  2,853.9      $ 

2,581.8

(1) The impact of currency conversion was calculated by converting net sales in currencies for the current year into we dollars using average exchange rates from the previous year.

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Net Sales
Net sales for the year ended July 31, 2021, increased $272.1 million, or 10.5%
from fiscal 2020, reflecting higher sales in the Engine Products segment of
$230.2 million, or 13.3%, and the Industrial Products segment of $41.9 million,
or 4.9%. Foreign currency translation increased total net sales by $78.0 million
compared to the prior fiscal year, reflecting increases in the Engine and
Industrial Products segments of $48.0 million and $30.0 million, respectively.
In fiscal 2021, the Company's net sales increased as a result of the improved
economic conditions, which increased demand most notably for the Engine Products
segment, particularly in the second half of the fiscal year.
Gross Margin
Cost of sales for the year ended July 31, 2021 was $1,882.2 million, compared
with $1,710.2 million for the year ended July 31, 2020, an increase of $172.0
million, or 10.1%. Gross margin for the year ended July 31, 2021 was 34.0%
compared with 33.8% for the year ended July 31, 2020, an increase of 0.2%. Gross
margin benefited from an increased leverage from higher sales and increased
pricing, partially offset by increased raw material and freight costs, an
unfavorable sales mix and restructuring charges of $5.8 million.
Operating Expenses
Operating expenses for the year ended July 31, 2021 were $587.0 million, or
20.6% of net sales, compared with $531.5 million, or 20.6% of net sales, for the
year ended July 31, 2020, an increase of $55.5 million, or 10.4%. Operating
expenses as a percentage of net sales were flat, resulting from increased
incentive compensation and restructuring charges of $9.0 million, offset by
increased leverage from higher sales.
Non-Operating Items
Interest expense for the year ended July 31, 2021 was $13.0 million, compared
with $17.4 million, for the year ended July 31, 2020, a decrease of $4.4
million, or 25.0%. The decrease was primarily due to lower debt levels.
Other income, net for the year ended July 31, 2021 was $9.3 million, compared
with $12.5 million, for the year ended July 31, 2020, a decrease of $3.2
million, or 25.7%. The decrease was related to costs associated with the
Company's support of its communities.
Income Taxes
The effective tax rates were 24.7% and 23.3% for the years ended July 31, 2021
and 2020, respectively. The higher effective tax rate was primarily due to an
overall decrease in discrete tax benefits.
Net Earnings
Net earnings for the year ended July 31, 2021 were $286.9 million, compared with
$257.0 million for the year ended July 31, 2020, an increase of $29.9 million,
or 11.6%. Diluted earnings per share were $2.24 for the year ended July 31,
2021, compared with $2.00 for the year ended July 31, 2020.
Net earnings were impacted by fluctuations in foreign currency exchange rates.
The impact of these fluctuations on net earnings was as follows (in millions):
                                                         Year Ended July 31,
                                                                 2021         2020
Prior year net earnings                            $     257.0           $ 267.2
Change in net earnings excluding translation              19.1              

(7.2)

Impact of foreign currency translation (1)                10.8              (3.0)
Current year net earnings                          $     286.9           $ 257.0

(1) The impact of currency conversion was calculated by converting the net income in currencies for the current year into we dollars using average exchange rates from the previous year.

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Restructuring

In the second quarter of fiscal 2021, the Company initiated activities to
further improve its operating and manufacturing cost structure, primarily in its
EMEA region. These activities resulted in restructuring charges, primarily
related to severance, of $14.8 million in the second quarter of fiscal 2021.
Charges of $5.8 million were included in cost of sales and $9.0 million were
included in operating expenses in the Consolidated Statement of Earnings for
year ended July 31, 2021. Charges of $2.5 million relate to the Engine Products
segment, $6.5 million relate to the Industrial Products segment and $5.8 million
were included in Corporate and unallocated. For the year ended July 31, 2021,
$4.5 million of the restructuring charges were paid and $10.3 million were
accrued as of July 31, 2021. The Company expects approximately $8 million in
annualized savings from these restructuring activities once completed by the
beginning of the third quarter of fiscal 2022.
Segment Results of Operations
Net sales and earnings before income taxes were as follows (in millions):
                                            Year Ended July 31,
                                                2021           2020     $ Change      % Change
Net sales
Engine Products segment                 $  1,957.7      $ 1,727.5      $  230.2         13.3  %
Industrial Products segment                  896.2          854.3          41.9          4.9
Total Company                           $  2,853.9      $ 2,581.8      $  

272.1 10.5%

Earnings before income taxes
Engine Products segment                 $    289.0      $   229.3      $   59.7         26.0  %
Industrial Products segment                  133.3          124.9           8.4          6.7
Corporate and unallocated (1) (2)            (41.3)         (19.0)        (22.3)       117.4
Total Company                           $    381.0      $   335.2      $   45.8         13.7  %


(1)Corporate and unallocated includes corporate expenses determined to be
non-allocable to the segments, such as interest expense, certain incentive
compensation and restructuring charges.
(2)The increase from fiscal 2020 to 2021 was driven by higher variable incentive
compensation.
Engine Products Segment
Net sales were as follows (in millions):
                                                     Year Ended July 31,
                                                        2021               2020         $ Change               % Change
Off-Road                                       $    328.1          $   256.5          $     71.6                     27.9  %
On-Road                                             138.8              124.4                14.4                     11.5
Aftermarket                                       1,394.6            1,228.9               165.7                     13.5
Aerospace and Defense                                96.2              117.7               (21.5)                   (18.3)
Total Engine Products segment                  $  1,957.7          $ 1,727.5          $    230.2                     13.3  %

Engine Products segment earnings before
income taxes                                   $    289.0          $   229.3          $     59.7                     26.0  %


Net sales for the Engine Products segment for the year ended July 31, 2021 were
$1,957.7 million, compared with $1,727.5 million for the year ended July 31,
2020, an increase of $230.2 million, or 13.3%. Excluding a $48.0 million
increase from foreign currency translation, net sales increased 10.5%.
Net sales of Off-Road were $328.1 million, an increase of 27.9% compared with
the year ended July 31, 2020. In constant currency, net sales increased $59.8
million, or 23.3%. Off-Road net sales increased in every major region, with
strong growth in EMEA and APAC, due to increased levels of equipment production
as economic conditions improved compared to the prior year, which had
experienced a greater impact from the COVID-19 pandemic.
Net sales of On-Road were $138.8 million, an increase of 11.5% compared with the
year ended July 31, 2020. In constant currency, net sales increased $11.9
million, or 9.5%. On-Road sales reflected strong growth particularly in EMEA and
APAC, with overall net sales higher in every major region due to increased
levels of equipment production driven by greater new truck demand due to
improved economic conditions.
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Net sales of Aftermarket were $1,394.6 million, an increase of 13.5% compared
with the year ended July 31, 2020. In constant currency, net sales increased
$133.8 million, or 10.9%. Aftermarket net sales experienced broad growth across
all regions as economic conditions improved.
Net sales of Aerospace and Defense were $96.2 million, a decrease of 18.3%
compared with the year ended July 31, 2020. In constant currency, net sales
decreased $23.2 million, or 19.7%. Aerospace and Defense net sales decreased
primarily due to commercial aerospace experiencing significantly lower
replacement part sales as a result of lower demand caused by the COVID-19
pandemic.
Earnings before income taxes for the Engine Products segment for the year ended
July 31, 2021 were $289.0 million, or 14.8% of Engine Products' net sales, an
increase from 13.3% of net sales for the year ended July 31, 2020. The increase
was driven by greater leverage from higher sales and increased pricing,
partially offset by higher incentive compensation, unfavorable sales mix and
restructuring charges of $2.5 million incurred in the second quarter of fiscal
2021.
Industrial Products Segment
Net sales were as follows (in millions):
                                                         Year Ended July 

31,

                                                              2021               2020         $ Change               % Change
Industrial Filtration Solutions                 $     621.9              $   581.2          $     40.7                      7.0  %
Gas Turbine Systems                                    96.2                  101.6                (5.4)                    (5.3)
Special Applications                                  178.1                  171.5                 6.6                      3.8
Total Industrial Products                       $     896.2              $   854.3          $     41.9                      4.9  %

Industrial Products segment earnings
before income taxes                             $     133.3              $   124.9          $      8.4                      6.7  %


Net sales for the Industrial Products segment for the year ended July 31, 2021
were $896.2 million, compared with $854.3 million for the year ended July 31,
2020, an increase of $41.9 million, or 4.9%. Excluding a $30.0 million increase
from foreign currency translation, fiscal 2021 net sales increased 1.4%.
Net sales of Industrial Filtration Solutions (IFS) were $621.9 million, an
increase of 7.0% compared with the year ended July 31, 2020. In constant
currency, net sales increased $17.5 million, or 3.0%. IFS sales increased across
all business units and regions.
Net sales of Gas Turbine Systems (GTS) were $96.2 million, a decrease of 5.3%
compared with the year ended July 31, 2020. In constant currency, net sales
decreased $6.5 million, or 6.4%. The decrease in GTS net sales was driven by
lower sales of small turbines in the U.S., partially offset by growing
replacement parts sales in the U.S. and LATAM.
Net sales of Special Applications were $178.1 million, an increase of 3.8%
compared with the year ended July 31, 2020. In constant currency, net sales
increased $0.9 million, or 0.5%. The increase in Special Applications net sales
reflected higher sales of Integrated Venting Solutions filters and
Semicon/Imaging products, partially offset by lower sales of Membrane products.
Earnings before income taxes for the Industrial Products segment for the year
ended July 31, 2021 were $133.3 million, or 14.9% of Industrial Products' net
sales, an increase from 14.6% of net sales for the year ended July 31, 2020. The
increase was driven by greater leverage from higher sales, partially offset by
restructuring charges of $6.5 million incurred in the second quarter of fiscal
2021 and higher incentive compensation.
Liquidity and Capital Resources
Liquidity Analysis
Liquidity is assessed in terms of the Company's ability to generate cash to fund
its operating, investing and financing activities. Significant factors affecting
liquidity are cash flows generated from operating activities, capital
expenditures, acquisitions, dividends, repurchases of outstanding shares,
adequacy of available credit facilities and the ability to attract long-term
capital with satisfactory terms. The Company generates substantial cash from the
operation of its businesses as its primary source of liquidity, with sufficient
liquidity available to fund growth through reinvestment in existing businesses
and strategic acquisitions.
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Capital Resources
Secondary sources of liquidity are existing cash and available credit
facilities. As of July 31, 2021, cash and cash equivalents were $222.8 million.
A significant portion of the Company's cash and cash equivalents are held by
subsidiaries throughout the world as over half of the Company's earnings occur
outside the U.S. Additionally, the Company has short-term and long-term
borrowing capacity of $655.2 million available for further borrowing under
existing credit facilities as of July 31, 2021.
Short-term borrowing capacity as of July 31, 2021 was as follows (in millions):
                                                                                        European
                                                             European                  Operations
                                        U.S. Credit         Commercial                   Credit           Rest of the World
                                         Facilities       Paper Program                Facilities         Credit Facilities      Total
Available short-term credit
facilities                            $     100.0                        $  118.2                         $          54.3                $   64.1          $  336.6

Reductions to borrowing
capacity:
Outstanding borrowings                       48.5                               -                                       -                       -              48.5
Other non-borrowing reductions                  -                               -                                    30.6                    19.6              50.2
Total reductions                             48.5                               -                                    30.6                    19.6              98.7

Remaining borrowing capacity          $      51.5                        $  118.2                         $          23.7                $   44.5          $  237.9

Weighted average interest rate
as of July 31, 2021                          0.96    %                           N/A                                     N/A                     N/A               N/A


Other non-borrowing reductions include financial instruments such as bank
guarantees and foreign exchange instruments.
Long-term borrowing capacity is maintained through a $500.0 million revolving
credit facility that is reported on the Consolidated Balance Sheets. Borrowing
capacity as of July 31, 2021 was as follows (in millions):
                                                           July 31, 2021
Revolving credit facility                                $      500.0

Reductions to borrowing capacity:
Outstanding borrowings                                           75.0
Contingent liability for standby letters of credit                7.7
Total reductions                                                 82.7
Remaining borrowing capacity                             $      417.3

Weighted average interest rate as of July 31, 2021               1.10  %


In the fourth quarter of fiscal 2021, the Company entered into a new credit
agreement that maintained the borrowing availability of $500.0 million, which
replaced the previous agreement. The revolving credit facility is with a group
of lenders and allows for borrowings in multiple currencies. The facility
matures on May 21, 2026, and bears interest payable monthly at a variable
interest rate. The interest rate is calculated using the appropriate benchmark
rate plus the applicable rate. The borrowing availability can be reduced or the
agreement terminated early at the option of the Company. The Company can request
to increase the revolving credit facility by up to $250.0 million, subject to
terms of the credit facility agreement, including written notification and
lender acceptance, through an accordion feature. Borrowings are automatically
rolled over until the credit facility maturity date, unless the agreement is
terminated early or the Company is found to be in default. The total facility
includes a commitment fee of 0.08% to 0.25%, depending on the Company's leverage
ratio. The remaining borrowing capacity reflects the issued standby letters of
credit, as discussed in Note 16 to the Consolidated Financial Statements
included in Item 8 of this Annual Report, as issued standby letters of credit
reduce the amounts available for borrowing.
Certain debt agreements contain financial covenants related to interest coverage
and leverage ratios, as well as other non-financial covenants. As of July 31,
2021, the Company was in compliance with all such covenants.
In the fourth quarter of fiscal 2021, the Company entered into an agreement, in
which the Company would issue and sell two tranches of unsecured senior notes.
The first tranche is a $100.0 million ten year note due 2031 at a fixed interest
rate of 2.50%, with proceeds received in August 2021. The second tranche is a
$50.0 million seven year note due 2028 at a fixed interest rate of 2.12%, with
proceeds to be received in November 2021.
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The Company believes that the liquidity available from the combination of the
expected cash generated by operating activities, existing cash and available
credit under existing credit facilities will be sufficient to meet its cash
requirements for the next 12 months, including working capital needs, debt
service obligations, capital expenditures, payment of anticipated dividends,
share repurchase activity and potential acquisitions. For further discussion on
short-term borrowings and long-term debt, refer to Note 7 in the Notes to the
Consolidated Financial Statements included in Item 8 of this Annual Report.
Capital Expenditures
In fiscal 2022, the Company expects its cash paid for capital expenditures to be
within a range of $100.0 to $120.0 million, primarily associated with projects
to enhance production capabilities.
Cash Flow Summary
Cash flows were as follows (in millions):
                                                                        

July 31,

                                                                2021        

2020 2019

Net cash provided by (used in)

     Operating activities                                  $ 401.9      $ 387.0      $ 345.8
     Investing activities                                    (58.3)      (128.9)      (246.4)
     Financing activities                                   (363.3)      (199.5)      (123.3)
     Effect of exchange rate changes on cash                   5.9         

0.2 (3.0)

(Decrease) increase in cash and cash equivalents $ (13.8) $ 58.8 $ (26.9)


Operating Activities
Cash provided by operating activities for the year ended July 31, 2021 was
$401.9 million, compared with $387.0 million for the year ended July 31, 2020,
an increase of $14.9 million. The increase in cash provided by operating
activities was primarily driven by improved earnings for the Company compared to
prior year, which was negatively impacted by the COVID-19 pandemic.
Investing Activities
Cash used in investing activities for the year ended July 31, 2021 was $58.3
million, compared with $128.9 million for the year ended July 31, 2020, a
decrease of $70.6 million. In fiscal 2021, the Company continued investing in
its strategic priorities, though capital expenditures decreased in fiscal 2021
as the Company brought to completion many of its significant capital projects
from the prior two fiscal years.
Financing Activities
Cash used in financing activities generally relates to the use of cash for
payment of dividends and repurchases of the Company's common stock, net
borrowing activity and proceeds from the exercise of stock options. To determine
the level of dividend and share repurchases, the Company considers recent and
projected performance across key financial metrics, including earnings, cash
flow from operations and total debt. Dividends paid for the years ended July 31,
2021 and 2020 were $107.2 million and $106.4 million, respectively. Share
repurchases for the years ended July 31, 2021 and 2020 were $142.2 million and
$94.3 million, respectively.
Cash used in financing activities for the year ended July 31, 2021 was
$363.3 million, compared with $199.5 million for the year ended July 31, 2020,
an increase of $163.8 million. In fiscal 2021, cash was used to repay borrowings
and to fund the Company's needs, driven by expenditures on property, plant and
equipment, dividends, share repurchases and purchases of non-controlling
interests. In fiscal 2020, proceeds from long-term debt were used to fund the
Company's needs, driven by expenditures on property, plant and equipment,
dividends and share repurchases.
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Financial Condition
The Company's total capitalization components and debt-to-capitalization ratio
were as follows (in millions):
                                                                      July 31,
                                                       2021            %           2020            %
      Short-term borrowings                     $    48.5         2.9  %    $     3.8         0.2  %
      Current maturities of long-term debt              -           -      
      5.7         0.4
      Long-term debt                                461.0        28.0           617.4        38.1
      Total debt                                    509.5        30.9           626.9        38.7
      Total stockholders' equity                  1,137.1        69.1      
    992.9        61.3
      Total capitalization                      $ 1,646.6       100.0  %    $ 1,619.8       100.0  %


As of July 31, 2021, total debt, including short-term borrowings and long-term
debt, represented 30.9% of total capitalization, defined as total debt plus
total stockholders' equity, compared with 38.7% as of July 31, 2020.
Long-term debt outstanding as of July 31, 2021 was $461.0 million compared with
$617.4 million as of July 31, 2020, a decrease of $156.4 million. The Company
used cash flows to pay down balances on its revolving credit facilities.
Accounts receivable, net as of July 31, 2021 was $552.7 million, compared with
$455.3 million as of July 31, 2020, an increase of $97.4 million, primarily due
to higher levels of sales. Days sales outstanding were 62 days as of July 31,
2021, down from 63 days as of July 31, 2020. Days sales outstanding is
calculated using the count back method, which calculates the number of days of
most recent revenue that is reflected in the net accounts receivable balance.
Inventories, net as of July 31, 2021 was $384.5 million, compared with
$322.7 million as of July 31, 2020, an increase of $61.8 million. Inventory
turns were 5.5 times and 4.9 times per year as of July 31, 2021 and 2020,
respectively. Inventory turns are calculated by taking the annualized cost of
sales based on the trailing three month period divided by the average of the
beginning and ending net inventory values of the three month period.
Accounts payable as of July 31, 2021 was $293.9 million, compared with
$187.7 million as of July 31, 2020, an increase of $106.2 million, primarily due
to greater levels of purchasing associated with higher levels of sales.
Off-Balance Sheet Arrangements
Joint Venture Guarantee
The Company and Caterpillar Inc. equally own the shares of Advanced Filtration
Systems Inc. (AFSI), an unconsolidated joint venture, and guarantee certain debt
and banking services, including credit and debit cards, merchant processing and
treasury management services, of the joint venture. The Company accounts for
AFSI as an equity method investment.
As of July 31, 2021, the joint venture had $37.8 million of outstanding debt, of
which the Company guarantees half. The Company does not believe this guarantee
will have a current or future effect on its financial condition, results of
operations, liquidity or capital resources.
Critical Accounting Policies
The Company's Consolidated Financial Statements are prepared in conformity with
GAAP. The preparation of these Consolidated Financial Statements requires the
use of estimates and judgments that affect the reported amounts of assets and
liabilities at the date of the Consolidated Financial Statements and the
reported amounts of revenue and expenses during the periods presented.
Management bases estimates on historical experience and various other
assumptions that are believed to be reasonable under the circumstances, the
results of which form the basis for making judgments about recorded amounts. The
Company believes its use of estimates and underlying accounting assumptions
adheres to GAAP and are reasonable and consistently applied. The Company's
Critical Accounting Policies are those which require more significant estimates
and judgments used in the preparation of its Consolidated Financial Statements
and are the most important to aid in fully understanding its financial results.
The Company's Critical Accounting Policies are as follows:
Revenue Recognition - Variable Consideration
The transaction price of a contract could be reduced by variable consideration
including volume, purchase rebates and discounts, product refunds and returns.
At the time of sale to a customer, the Company records an estimate of variable
consideration as a reduction from gross sales. The Company primarily relies on
historical experience and anticipated future performance to estimate the
variable consideration. Revenue is recognized to the extent that it is probable
that a significant reversal of revenue will not occur when the contingency is
resolved.
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For volume, purchase rebates and discounts, management estimates are based on
the terms of the arrangements with customers, historical payment experience,
field inventory levels, volume in quantity or mix of purchases of product during
a specified time period and expectations for changes in relevant trends in the
future. Actual results may differ from estimates if competitive factors create
the need to enhance or reduce sales promotion and incentive accruals or if
customer usage and field inventory levels vary from historical trends.
Adjustments to sales promotions and incentive accruals are made as actual usage
becomes known in order to properly estimate the amounts necessary to generate
consumer demand based on market conditions as of the balance sheet date.
For product refunds and returns, estimates are based primarily on the expected
number of products sold, the trend in the historical ratio of returns to sales
and the historical length of time between the sale and resulting return. Actual
refunds and returns could be higher or lower than amounts estimated due to such
factors as performance of new products or significant manufacturing or design
defects not discovered until after the product is delivered to customers.
Goodwill
Goodwill represents the excess of the purchase price over the fair value of net
assets acquired in business combinations under the purchase method of
accounting. The Company performed its annual impairment assessment during the
third quarter of fiscal 2021 and determined that there were no indicators of
impairment for any of the reporting units evaluated. The goodwill impairment
assessment is conducted at a reporting unit level, which is one level below the
operating segment level, and utilizes either a qualitative or quantitative
assessment.
The optional qualitative assessment evaluates general economic, industry and
entity-specific factors that could impact the reporting units' fair values. For
reporting units evaluated using a qualitative assessment, if it is determined
that the fair value more likely than not exceeds the carrying value, no further
assessment is necessary. The Company has elected this option for certain
reporting units. For reporting units evaluated using a quantitative assessment,
the fair values are determined using an income approach, a market approach or a
weighting of the two. The income approach determines fair value based on
discounted cash flow models derived from the reporting units' long-term
forecasts. The market approach determines fair value based on earnings multiples
derived from prices investors paid for the stocks of comparable, publicly traded
companies. An impairment loss would be recognized when the carrying amount of a
reporting unit's net assets exceeds the estimated fair value of the reporting
unit. Estimates and assumptions are utilized in the valuations, including
discounted projected cash flows, earnings before interest, taxes, depreciation
and amortization (EBITDA) margins, terminal value growth rates, revenue growth
rates, discount rates and the determination of comparable, publicly traded
companies. Changes in these estimates and assumptions could materially affect
the determination of fair value and goodwill impairment.
Income Taxes
Management is required to estimate income taxes in each of the jurisdictions in
which the Company operates. This process involves estimating current tax
exposure and assessing future tax consequences attributable to temporary
differences between the financial statement carrying amount of existing assets
and liabilities and their respective tax basis. These deferred tax assets and
liabilities are measured using the enacted tax rates expected to apply to
taxable income in the fiscal years in which those temporary differences are
anticipated to reverse based on future taxable income projections and the impact
of tax planning strategies. The Company intends to indefinitely reinvest
undistributed earnings for certain of its non-U.S. subsidiaries and thus has not
provided for income taxes on these earnings.
Additionally, benefits of tax return positions are recognized in the
Consolidated Financial Statements when the position is more likely than not to
be sustained by the taxing authorities based solely on the technical merits of
the position. If the recognition threshold is met, the tax benefit is measured
and recognized as the largest amount of tax benefit that in the Company's
judgment is greater than 50% likely to be realized. The Company maintains a
reserve for uncertain tax benefits that are currently unresolved and routinely
monitors the potential impact of such situations. The liability for unrecognized
tax benefits, accrued interest and penalties was $20.3 million and $19.2 million
as of July 31, 2021 and 2020, respectively.
The Company believes it is remote that any adjustment necessary to the reserve
for income taxes for the next 12 months will be material. However, it is
possible the ultimate resolution of audits or disputes may result in a material
change to the Company's reserve for income taxes, although the quantification of
such potential adjustments cannot be made at this time.
Defined Benefit Pension Plans
The Company incurs expenses for employee benefits provided through defined
benefit pension plans. In accounting for these defined benefit pension plans,
management must make a variety of estimates and assumptions including discount
rates, expected return on plan assets, mortality rates and overall employee
compensation increases. The Company considers current and historical data and
uses a third-party specialist to assist management in determining these
estimates.
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Discount Rates
The Company's objective in selecting a discount rate is to select the best
estimate of the rate at which the benefit obligations could be effectively
settled on the measurement date, taking into account the nature and duration of
the benefit obligations of the plan. In making this best estimate, the Company
looks at the rates of return on high-quality, fixed-income investments currently
available and expected to be available, during the period to maturity of the
benefits. This process includes assessing the universe of bonds available on the
measurement date with a quality rating of Aa or better. Similar appropriate
benchmarks are used to determine the discount rate for the non-U.S. plans. The
Company utilized a 2.55% and 2.37% weighted average discount rate for its U.S.
plans for the years ended July 31, 2021 and 2020, respectively. The Company used
a 1.55% and 1.48% weighted average discount rate for its non-U.S. plans for the
years ended July 31, 2021 and 2020, respectively.
Expected Long-Term Rate of Return on Assets
The Company considers historical returns and future expected returns for each
asset class, as well as the target asset allocation to develop the assumption
for each of its U.S. pension plans. The assumption for the non-U.S. pension
plans reflects the investment allocation and expected total portfolio returns
specific to each plan and country. The Company utilized a 5.33% and 6.08%
asset-based weighted average expected return on plan assets for its U.S. plans
as of the measurement dates of July 31, 2021 and 2020, respectively. The Company
utilized a 3.13% and 3.78% asset-based weighted average expected return on plan
assets for its non-U.S. plans for the years ended July 31, 2021 and 2020,
respectively. The expected returns on plan assets are used to develop the
following fiscal years' expense for the plans.
Mortality Rates
The Company's actuary uses the Pri-2012 mortality table issued by the Society of
Actuaries in 2019, and the Scale MMP-2019 mortality improvement projection scale
for its U.S. pension plans. These assumptions were used for determining the
benefit obligations as of July 31, 2021 and for developing the annual expense
for the fiscal year ending July 31, 2022. For non-U.S. pension plans, the
Company follows the local actuary's recommendation.
Service and Interest Costs
The Company uses a full yield curve approach to estimate service and interest
costs for pension benefits by applying specific spot rates along the yield curve
used to determine the benefit obligation of relevant projected cash outflows.
This method provides a precise measurement of service and interest costs by
aligning the timing of the plans' liability cash flows to the corresponding spot
rate on the yield curve.
Alternative Assumptions
If the Company were to use alternative assumptions for its pension plans as of
July 31, 2021, a 1 percentage point change in the assumptions would impact
fiscal 2021 net periodic benefit cost as follows (in millions):
                                                             +1%         (1)%
                          Rate of return                   $  5.5      $ (5.5)
                          Discount rate                    $ (0.8)     $  2.0


The Company's net periodic benefit cost recognized in the Consolidated
Statements of Earnings was $5.3 million, $7.2 million and $3.8 million for the
years ended July 31, 2021, 2020 and 2019, respectively. While changes to the
Company's pension plan assumptions would not be expected to impact its net
periodic benefit cost by a material amount, such changes could significantly
impact the Company's projected benefit obligation.
Business Combinations
The Company allocates the purchase price of acquired businesses to the estimated
fair values of the assets acquired and liabilities assumed as of the date of
acquisition. The fair values of the long-lived assets acquired, primarily
intangible assets, are determined using calculations which can be complex and
require significant judgment. Estimates include many factors such as the nature
of the acquired company's business, its historical financial position and
results, customer retention rates, discount rates and expected future
performance. Independent valuation specialists are used to assist in determining
certain fair value calculations.
The Company estimates the fair value of acquired customer relationships using
the multi-period excess earnings method. This approach is typically applied when
cash flows are not directly generated by the asset, but rather, by an operating
group which includes the particular asset. Fair value is estimated as the
present value of the benefits anticipated from ownership of the asset, in excess
of the economic returns required on the investment in contributory assets which
are necessary to realize those benefits. The intangible asset's estimated
earnings are determined as the residual earnings after quantifying estimated
economic returns from contributory assets. Assumptions used in these
calculations include same-customer revenue growth rates, estimated earnings and
customer attrition rates.
                                       21
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The Company estimates the fair value of trade names and/or trademarks using the
relief from royalty method, which calculates the cost savings associated with
owning rather than licensing the assets. Assumed royalty rates are applied to
projected revenue for the remaining useful lives of the assets to estimate the
royalty savings. Royalty rates are selected based on the attributes of the
asset, including reputation and recognition within the industry.
While the Company uses its best estimates and assumptions, fair value estimates
are inherently uncertain and subject to refinement. As a result, during the
measurement period, which may be up to one year from the acquisition date, the
Company may record adjustments to the assets acquired and liabilities assumed,
with the corresponding offset to goodwill. Any adjustments required after the
measurement period are recorded in the Consolidated Statement of Earnings. The
judgments required in determining the estimated fair values and expected useful
lives assigned to each class of assets and liabilities acquired can
significantly affect net income.
New Accounting Standards Not Yet Adopted
For new accounting standards not yet adopted, refer to Note 1 in the Notes to
Consolidated Financial Statements included in Item 8 of this Annual Report.
Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995
The Company, through its management, may make forward-looking statements
reflecting the Company's current views with respect to future events and
expectations, such as forecasts, plans, trends and projections relating to the
Company's business and financial performance. These forward-looking statements,
which may be included in reports filed under the Securities Exchange Act of
1934, as amended (the Exchange Act), in press releases and in other documents
and materials as well as in written or oral statements made by or on behalf of
the Company, are subject to certain risks and uncertainties, including those
discussed in Part I, Item 1A, "Risk Factors" of this Annual Report, which could
cause actual results to differ materially from historical results or those
anticipated. The words or phrases "will likely result," "are expected to," "will
continue," "will allow," "estimate," "project," "believe," "expect,"
"anticipate," "forecast," "plan" and similar expressions are intended to
identify forward-looking statements within the meaning of Section 21E of the
Exchange Act and Section 27A of the Securities Act of 1933, as amended, as
enacted by the Private Securities Litigation Reform Act of 1995 (PSLRA). In
particular, the Company desires to take advantage of the protections of the
PSLRA in connection with the forward-looking statements made in this Annual
Report. All statements other than statements of historical fact are
forward-looking statements. These statements do not guarantee future
performance.
These forward-looking statements, speak only as of the date such statements are
made and are subject to risks and uncertainties. In addition, the factors listed
in Part I, Item 1A, "Risk Factors" of this Annual Report, as well as other
factors, could affect the Company's performance and could cause the Company's
actual results for future periods to differ materially from any opinions or
statements expressed. These factors include, but are not limited to, challenges
in global operations; impacts of global economic, industrial and political
conditions on product demand; impacts from unexpected events, including the
COVID-19 pandemic; effects of unavailable raw materials or material cost
inflation; inability to attract and retain qualified personnel; inability to
meet customer demand; inability to maintain competitive advantages; threats from
disruptive technologies; effects of highly competitive markets with pricing
pressure; exposure to customer concentration in certain cyclical industries;
impairment of intangible assets; inability to manage productivity improvements;
inability to maintain an effective system of internal control over financial
reporting; vulnerabilities associated with information technology systems and
security; inability to protect and enforce intellectual property rights; costs
associated with governmental laws and regulations; impacts of foreign currency
fluctuations; effects of changes in capital and credit markets; changes in tax
laws and tax rates, regulations and results of examinations; results of
execution of any acquisition, divestiture and other strategic transactions
strategy; and other factors included in Part I, Item 1A, "Risk Factors" of this
Annual Report. The Company undertakes no obligation to publicly update or revise
any forward-looking statements, whether as a result of new information, future
events or otherwise, unless required by law.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
The Company's market risk includes the potential loss arising from adverse
changes in foreign currency exchange rates, interest rates and commodity prices.
In an attempt to manage these risks, the Company employs certain strategies to
mitigate the effect of these fluctuations. The Company does not enter into any
of these instruments for speculative trading purposes.
The Company maintains significant assets and operations outside the U.S.,
resulting in exposure to foreign currency gains and losses. A portion of the
Company's foreign currency exposure is naturally hedged by incurring
liabilities, including bank debt, denominated in the local currency in which the
Company's foreign subsidiaries are located.
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During fiscal 2021, the U.S. dollar was generally weaker than in fiscal 2020
compared with many of the currencies of the foreign countries in which the
Company operates. The overall weaker dollar had a positive impact on the
Company's international net sales results because the foreign denominated
revenues translated into more U.S. dollars. Foreign currency translation had a
positive impact to net sales and net earnings in many regions around the world.
The estimated impact of foreign currency translation for the year ended July 31,
2021, resulted in an overall increase in reported net sales of $78.0 million and
an increase in reported net earnings of approximately $10.8 million.
Derivative Fair Value Measurements
The Company enters into derivative instrument agreements, including forward
foreign currency exchange contracts, net investment hedges and interest rate
swaps, to manage risk in connection with changes in foreign currency and
interest rates. The Company only enters into derivative instrument agreements
with counterparties who have highly rated credit. The Company does not enter
into derivative instrument agreements for trading or speculative purposes (see
Note 15 to the Notes to the Consolidated Financial Statements in Item 8. of this
Annual Report).
Forward Foreign Currency Exchange Contracts
The Company buys materials from foreign suppliers. Those transactions can be
denominated in those suppliers' local currency. The Company also sells to
customers in foreign countries. Those transactions can be denominated in those
customers' local currency. Both of these transaction types can create volatility
in the Company's financial statements. The Company uses forward currency
exchange contracts to manage those exposures and fluctuations. These contracts
generally mature in 12 months or less, which is consistent with the forecasts of
the related purchases and sales. Certain contracts are designated as cash flow
hedges, whereas the remaining contracts, most of which are related to certain
intercompany transactions, are not designated.
Net Investment Hedges
The Company uses fixed-to-fixed cross currency swap agreements to hedge its
exposure to adverse foreign currency exchange rate movements for its operations
in Europe. This contract terminates in July 2029. The Company has elected the
spot method for designating these contracts as net investment hedges.
Based on the net investment hedge outstanding as of July 31, 2021, a 10%
appreciation of the U.S. dollar compared to the Euro, would result in a net gain
of $6.1 million in the fair value of these contracts.
Interest Rates
The Company's exposure to market risk for changes in interest rates primarily
relates to debt obligations that are at variable rates, as well as the potential
increase in the fair value of long-term debt resulting from a potential decrease
in interest rates. As of July 31, 2021, the Company's financial liabilities with
exposure to changes in interest rates consisted mainly of $75.0 million
outstanding on the Company's revolving credit facility, €80.0 million, or
$95.1 million of a variable rate term loan, and ¥2.0 billion, or $18.2 million,
of variable rate senior notes. As of July 31, 2021, additional short-term
borrowings outstanding consisted of $48.5 million. Assuming a hypothetical 0.5
percentage point increase in short-term interest rates, with all other variables
remaining constant, interest expense would have increased approximately
$0.8 million and interest income would have increased approximately $0.3 million
in fiscal 2021. Interest rate changes would also affect the fair market value of
fixed-rate debt. As of July 31, 2021, the estimated fair value of long-term debt
with fixed interest rates was $297.4 million compared to its carrying value of
$275.0 million. The fair value is estimated by discounting the projected cash
flows using the rate at which similar amounts of debt could currently be
borrowed.
In addition, the Company is exposed to market risk for changes in interest rates
for the impact to its qualified defined benefit pension plans. The plans'
projected benefit obligation is inversely related to changes in interest rates.
Consistent with published bond indices, in fiscal 2021 the Company increased its
weighted average discount rate from 2.37% to 2.55% on its U.S. plans and
increased its weighted average discount rate from 1.48% to 1.55% for its
non-U.S. plans. To protect against declines in interest rates, the pension plans
hold high-quality, long-duration bonds. The rates impact both the projected
benefit obligation and the fair value of the plan assets and hence, the funded
status of the plans. The plans were overfunded by $11.4 million as of July 31,
2021, since the fair value of the plan assets exceeded the projected benefit
obligation.
Commodity Prices
The Company is exposed to market risk from fluctuating prices of purchased
commodity raw materials, including steel, filter media and petrochemical-based
products including plastics, rubber and adhesives. On an ongoing basis, the
Company enters into selective supply arrangements that allow the Company to
reduce volatility in its costs. The Company strives to recover or offset all
material cost increases through selective price increases to its customers and
the Company's cost reduction initiatives, which include material substitution,
process improvement and product redesigns. However, an increase in commodity
prices could result in lower gross profit.
                                       23
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Chinese Notes
Consistent with common business practice in China, the Company's Chinese
subsidiaries accept bankers' acceptance notes from Chinese customers in
settlement of certain customer billed accounts receivable. Bankers' acceptance
notes represent a commitment by the issuing financial institution to pay a
certain amount of money at a specified future maturity date to the legal owner
of the bankers' acceptance note as of the maturity date. The maturity date of
bankers' acceptance notes varies, but it is the Company's policy to only accept
bankers' acceptance notes with maturity dates no more than 180 days from the
date of the Company's receipt of such draft. As of July 31, 2021 and 2020, the
Company owned $14.1 million and $12.1 million, respectively, of these bankers'
acceptance notes, and includes them in Accounts Receivable on the Consolidated
Balance Sheets.
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