Donaldson Company Annual Report 2002

Plain-text annual report

WE’RE HERE BECAUSE... WE’RE HERE BECAUSE... THIRTEEN CONSECUTIVE RECORD YEARS 2002 Annual Report WE’RE HERE BECAUSE…diversiﬁcation means much more than diversity of products – a keystone of our strategy. It also means global diversiﬁcation – by end market, supply sources, labor expertise and logistical advantage. It is this global focus that drives decisions to locate our high-volume disk drive ﬁlter business (cover) in Wuxi, China. > WUXI, CHINA. Donaldson Company operations in China represent a major – and growing – component of our global strategy. Our two state-of-the-art cleanrooms in Wuxi produced more than 175 million disk drive ﬁlters during ﬁscal 2002. We also have facilities producing industrial air ﬁltration equipment and ﬁltration membranes. About the Company Donaldson Company, Inc., is a leading worldwide manufacturer of ﬁltration systems and replacement parts. The company’s product mix includes air and liquid ﬁlters and exhaust and emission control products for mobile equipment; in-plant air cleaning systems; compressed air puriﬁcation systems; air intake systems for industrial gas turbines; and specialized ﬁlters for such diverse applications as computer disk drives, aircraft passenger cabins and semiconductor processing. Products are manufactured at more than three dozen Donaldson plants around the world and through four joint ventures. Our ﬁnancial objective is to build shareholder value through superior share price appreciation and con- sistent dividend payouts. We believe value is created by delivering consistent, double-digit growth in earn- ings per share. Growth will be achieved by aggressively pursuing new opportunities in our existing and related markets. Consistency will be reinforced by maintaining a diversiﬁed portfolio of related ﬁltration businesses around the world. Mission Statement To provide superior return for our shareholders, through consistent, long-term earnings growth built on global leadership in ﬁltration solutions, thereby creating security, opportunity and challenge for our employees. Contents 1 2 3 4 5 6 7 10 12 14 Perfecting Production in Mexico Optimized to Compete in Europe Aggressive in Asia-Paciﬁc Capitalizing on the Aftermarket Growth Through Business Balance Letter to Shareholders Financial Highlights Operating Segments Eleven-Year Comparison of Results Management’s Discussion and Analysis 23 24 25 26 Consolidated Statements of Earnings Consolidated Balance Sheets Consolidated Statements of Cash Flows Consolidated Statements of Changes in Shareholders’ Equity Notes to Consolidated Financial Statements Report of Independent Accountants Corporate and Shareholder Information Board of Directors Corporate Ofﬁcers 27 39 40 40 41 Back Worldwide Operations PERFECTING PRODUCTION IN MEXICO PERFECTING PRODUCTION IN MEXICO > MONTERREY, MEXICO. Today, one year after opening the Monterrey plant, about two-thirds of our North American gas turbine output is manufactured here. The plant is continuing to develop its highly motivated workforce and grow its capabilities. ONE OF OUR MOST NOTABLE SUCCESSES is our year-over-year gross margin improvement – even as we’ve responded to price reduction pressure in our markets. One factor: aggressive cost management from the design phase through delivery to our customer. This includes relocation of our manufacturing capabilities when it makes good sense. The evolution in bringing gas turbine solutions to the market is a good example. First, we shifted to a modular design strategy for these large systems, increasing both production capacity and product margins. We then moved a portion of our production to lower-cost suppliers in Mexico, and ﬁnally, last year opened our own dedicated plant in Monterrey. Our Mexican presence now consists of three manufacturing plants and a sales ofﬁce in Mexico City. 1 OPTIMIZED TO COMPETE IN EUROPE OPTIMIZED TO COMPETE IN EUROPE > HULL, ENGLAND. This geographically critical manufacturing and distribution operation supports our industrial air, gas turbine and engine businesses throughout the European markets. Dramatic increases in production volume over the past 10 years parallel our progress growing our air ﬁlter business through the combination of new products, new customers and geographic expansion. DONALDSON COMPANY’S PAN-EUROPEAN STRUCTURE is complex and compelling. Complex because we conduct business daily in 10 different currencies and at least 10 distinct languages. Compelling because we sustain both a targeted, local-market approach and the big-picture perspective required to win global opportunities. Our customers’ business models drive us to structure, produce, sell and service markets that expand daily. In addition to balanced growth in existing Western European markets, our strategy emphasizes diversiﬁed expansion into Eastern Europe and the Middle East. Our European presence now consists of 11 manufacturing plants and more than 20 ofﬁces in 20 countries. 2 AGGRESSIVE IN ASIA-PACIFIC AGGRESSIVE IN ASIA-PACIFIC > GUNMA, JAPAN. During the past two years, a comprehensive program to improve return-on- investment at Nippon Donaldson has tripled the ROI from single-digit levels to above 20 percent, despite the on-going Japanese recession. FISCAL 2002 MADE THE THIRD YEAR of a region-wide diversiﬁcation focus, which includes signiﬁcant progress expanding our product offerings and leveraging our low-cost production capabilities. China, the base for our disk drive business, also is now home to our Asian industrial air ﬁltration production. Additional gas turbine capabilities have come on line in India. Engine aftermarket distribution increased in Southeast Asia, mainland China and New Zealand. Our Asian presence now consists of eight manufacturing plants and more than 20 ofﬁces in 11 countries. 3 CAPITALIZING ON THE AFTERMARKET CAPITALIZING ON THE AFTERMARKET > AGUASCALIENTES, MEXICO. Aguascalientes is strategically important for supplying customers in the United States, Mexico and South America with replacement ﬁlters and parts. Aguascalientes’ low cost structure, skilled workforce and central location allow us to deliver high-quality ﬁlters and parts where and when the customer needs them. SIGNIFICANT SALES AND EARNINGS GROWTH opportunities exist where Donaldson’s unique ﬁltration technologies intersect with ever-growing aftermarket demand. Expertise in the science of ﬁltration leads to development of value-added solutions that provide us with the competitive edge supplying end-users with replacement parts. The higher- margin aftermarket business will also grow along with our expanding international presence. North America also remains a growth territory as we continue to introduce new products and expand distribution outlets and channels to win more share of the replacement parts business. 4 GROWTH THROUGH BUSINESS BALANCE GROWTH THROUGH BUSINESS BALANCE > DÜLMEN, GERMANY. Opened in 1970, the Dülmen plant and sales ofﬁce is one of our longest estab- lished international operations. It’s also at the leading edge of capitalizing on steadily growing European opportunities in applications ranging from engine air intake systems to industrial air ﬁltration systems. OUR INDUSTRIAL/COMMERCIAL BUSINESS represented only one-third of Donaldson’s revenue a decade ago. In ﬁscal 2002, our Industrial/Commercial segment comprised almost one-half of sales. We achieved this strategic balance by leveraging our existing customer relationships, extending our technologies into new markets and products, and using our applications expertise to increase customer value. Examples include: miniature disk drives migrating into consumer devices such as digital cameras; leveraging our PowerCore™ technology into our gas turbine business, reducing both the footprint and cost to our customers; and Donaldson Torit Downﬂo® Oval 1™ providing more effective and efﬁcient ﬁltration while requiring signiﬁcantly less ﬂoor space. 5 > WILLIAM G. VAN DYKE Chairman, President and Chief Executive Ofﬁcer DEAR SHAREHOLDERS > After 30 years here, I’m still sometimes surprised, impressed – and delighted – with what a good company this is. I am pleased to be writing to you about our 13th consecutive year of double-digit earnings growth – our best ever. The Donaldson people rose to the challenge of a second this business cycle was going to have on their lives. consecutive difﬁcult revenue year. Despite those conditions, They refocused on making the business run better. In resulting in a year of no revenue growth, we improved dozens of locations around the world, we saw truly all other lines of our income statement, improved inven- stunning operating improvements. Processes changed. tory and overall working capital levels and used record Product lines pared. Facilities closed; more cost-efﬁcient cash ﬂow to reduce debt costs, buy back stock and fund ones were opened and brought on line ahead of schedule. our acquisition activity. The list goes on, but it has a simple manifestation: six The past ﬁscal year was the most difﬁcult revenue consecutive quarters of climbing gross margin, yielding environment in 20 years, and yet we not only extended a record 31 percent for the year. Most exciting of all: our string of double-digit earnings growth, but clearly the work that delivered these results is a work in process strengthened our business in the process. There is no and promises additional lift going forward. magic to this. What it took was a commitment from people all over our company to control the impact that 6 FINANCIAL HIGHLIGHTS Donaldson Company, Inc. and Subsidiaries Year ended July 31 Net sales (000s) Net earnings (000s) Return on sales Return on average shareholders’ equity Long-term capitalization ratio Diluted earnings per share Dividends paid per share Shareholders’ equity per share Diluted shares outstanding (000s) Employees at year-end Sales per employee (000s) 2002 $1,126,005 86,883 7.7% 24.8% 21.5% $ 1.90 $ .310 $ 8.72 45,714 8,166 $ 137.9 2001 $1,137,015 75,548 6.6% 25.2% 23.7% $ 1.66 $ .295 $ 7.19 45,612 8,230 $ 138.2 % change (1.0)% 15.0% 1.1 pts. (.4) pts. (2.2) pts. 14.5% 5.1% 21.3% .2% (.8)% (.2)% Our fundamental business model is that effective end markets for our other businesses, and expect organic diversiﬁcation of our end markets will support consistent, growth from our existing businesses to roughly offset superior results. That model was once again tested the slowdown in gas turbine. and reinforced in ﬁscal 2002, as continued strength in Having said that, none of us takes this North American gas turbine and an upturn in truck offset weakness in gas turbine contraction lightly. Manufacturers’ forecasts industrial capital spending, which impacted most of our are strikingly severe. Still, our North American downturn industrial product offering. will be softened by increased market share in Europe, Geographic diversiﬁcation again played an important where demand remains strong. Replacement ﬁlters role. Overseas revenues grew faster than U.S. revenues should see solid growth, as plants we equipped during in all six of our major product groups. With 39 percent the early part of the boom are starting to come due for of sales coming from outside the United States, we moved their ﬁrst ﬁlter replacements. closer to our goal of a 50:50 split between domestic and To ﬁll the gas turbine hole, the Engine business overseas. The results reinforced our belief in the great appears to be turning up. Incoming orders have trended growth opportunities outside the United States. up strongly since the second quarter – especially A recurring question from investors concerns how overseas. New equipment orders in the fourth quarter Donaldson will cope with the now certain contraction in were up 5 percent domestically and 24 percent overseas gas turbine. It is a fact that we expect the North American from last year. Coupling higher volume with ongoing gas turbine contraction to be severe, dropping perhaps improvements in Engine proﬁtability gives us important $50 million from next year’s gas turbine sales. However, leverage for the coming year. the larger fact is that we are seeing improvements in the 7 LONG-TERM PERFORMANCE (Cumulative total return) Year ended July 31 = DCI = S&P 400 1,115 1,015 796 687 729 623 580 630 642 590 373 412 384 492 461 294 317 236 280 228 225 203 148 142 173 172 90 91 92 93 94 95 96 97 98 99 00 01 02 S 100 100 88 133 82 89 We think that too much has been made of the North projected gas turbine drop. Revenue from the recently American “pre-buy” in heavy trucks – at least as it per- completed ultraﬁlter acquisition will likely add another tains to Donaldson. Yes, it will buoy our ﬁrst quarter $100 million. numbers and deﬂate at least the second quarter. But, in So with our operations in solid shape and continuing the end, we expect to equip more trucks this year than to improve, and a cautious, modest, careful optimism last – truck sales will be a helpful, though not a critical, about the revenue outlook, the other piece of the story piece of ﬁscal 2003. More important will be the impact for next year is the marrying of our latest acquisition, of increased volume in emissions products and of several ultraﬁlter, into the company. As a European manufacturer new light truck intake programs coming on line this year. of replacement parts for compressed air puriﬁcation, In industrial air ﬁltration – dust collection – the good ultraﬁlter satisﬁes all three dimensions of our diversiﬁ- news is that the business contraction appears ﬁnally to cation strategy. In one transaction we achieved better be at an end. Fourth quarter delivered the ﬁrst positive balance between the U.S. and overseas economies, sequential quarter in two years. While this doesn’t yet between capital equipment and replacement parts and translate into an upturn, we’ve pared our product line between the mobile-diesel and industrial markets. This and our cost structure so that incremental revenue, when better-balanced portfolio should enhance the stability it comes, will have an immediate bottom line impact. of our performance over time. In sum, fourth quarter order volume for Engine was up This acquisition builds on the AirMaze acquisition of 10 percent and, exclusive of North American gas turbine, two years ago. Where AirMaze brought us to the ﬁltra- Industrial was up 6 percent. If we do no better than hold tion needs of the compressor itself, ultraﬁlter moves out gains like that for ‘03, we’ll comfortably backﬁll the of the compressor room to all points of use in the factory. 8 CONSISTENT DOUBLE-DIGIT EPS GROWTH (Annual EPS % change) 35 10% Goal 0 15 10 10 24 16 19 15 15 15 15 14 10 90 91 92 93 94 95 96 97 98 99 00 01 02 Ultraﬁlter’s products remove particulate, mist and mois- The headwind is abating. This year, while coping with ture from the compressed air stream that ultimately ﬁnds the gas turbine change, we expect some modest sales lift its way to conveying systems, pneumatic tools, controls, from our other businesses, and we’re a long way from spraying operations and many other applications. done with tuning our operations. We remain committed Ultraﬁlter is about a $100 million business and has to sustaining our earnings growth record. grown at a rate of 14 percent over the past ﬁve years, but operating margins have been slim as the business Sincerely, was run as a privately held German company. Combining ultraﬁlter’s growth track with Donaldson’s operating controls, systems and infrastructure yields a business opportunity that will play a meaningful role in our future financial performance. Cyclical markets inevitably deliver periods of low sales growth – 2003 will be the third consecutive year where a down cycle has subtracted $50 million from one of our prime markets. Yet, through the strength of our solid operations and the dedication of our employees, we have reafﬁrmed our commitment to earnings growth. WILLIAM G. VAN DYKE Chairman, President and Chief Executive Ofﬁcer 9 INDUSTRIAL PRODUCTS OPERATING SEGMENT 2002 REVENUE $514 MILLION INDUSTRIAL DUST COLLECTION AIR FILTRATION GAS TURBINE SYSTEMS SPECIAL APPLICATIONS Under the trade names Donaldson Torit®and Donaldson Torit DCE®, Donaldson provides equipment to control and cap- ture process dust, fumes and mist in manufacturing and industrial processing plants. In addition, a full line of replace- ment ﬁlter cartridges, bags and spare parts are offered. Donaldson provides complete systems to deliver clean air to combustion turbines. Products include self-cleaning ﬁlter units, static air ﬁlter units, inlet duct- ing and silencing, evaporative coolers, chiller coils, inlet heating and anti-icing systems. Also, a full line of replacement ﬁlters and parts is offered. Donaldson provides a wide range of high efﬁciency media, ﬁlters and ﬁltration systems for various commercial, industrial and product applications. Product is applied in a wide variety of industrial settings including metal working plants, paint operations, welding stations, woodworking shops and food processing plants. Essentially all combustion tur- bines require inlet air ﬁltration and noise attenuation systems. These turbines provide base electricity, peaking capacity and remote power generation for special applications such as pipelines and off-shore oil drilling platforms. Products for the computer disk drive market include particulate filters, desiccant pouches and chemical adsorbing ﬁlter pouches. Customers include major disk drive manufacturers such as IBM, Seagate and Western Digital. Products for special market applications include aircraft cabin air ﬁlters, chemical ﬁlter systems for semi-conductor processing facilities, as well as other ﬁlters for process-critical applications. Donaldson sells expanded PTFE membrane through its Tetratec unit. Primary appli- cations for this membrane are industrial dust collection, product recovery applications and specialty fabrics. $175 MILLION $231 MILLION $108 MILLION Dedicated ﬁeld sales force uses multiple selling channels to end-users including: direct sell- ing, distribution, installers, OEM accounts and telemarketing. Products are primarily sold to gas turbine OEMs (e.g., General Electric, Solar, Siemens Westinghouse). Replacement parts are sold direct to end-users. Products are sold to disk drive manufacturers by a direct sales force supported by product development and application engineers. Products are primarily sold direct to end-users. Membrane and laminates are sold to various ﬁlter and garment manufacturers. S T C U D O R P S N O I T A C I L P P A E U N E V E R 2 0 0 2 T E K R A M O T S E T U O R 10 ENGINE PRODUCTS OPERATING SEGMENT 2002 REVENUE $612 MILLION Donaldson sells a broad line of ﬁlters and housings for industrial hydraulic and lubricating ﬂuids. Products are sold through an extensive network of industrial distributors. OFF-ROAD EQUIPMENT TRUCKS AFTERMARKET Products sold to industrial equipment and defense con- tractor OEMs for agriculture, construction, mining, military and other industrial applica- tions. Products sold to manufactur- ers of medium- and heavy-duty trucks. Broad line of replacement ﬁlters and hard parts for all of the equipment applications noted at left. Caterpillar, John Deere, Komatsu, CNH, Volvo Construction Equipment, General Dynamics and Stewart & Stevenson Freightliner, PACCAR, Volvo, Scania, International and Mitsubishi Original equipment dealers (such as Freightliner dealers or Caterpillar dealers), independent distributors and private label accounts $186 MILLION $91 MILLION $335 MILLION Engine Intake Air Filtration Systems Exhaust Systems Hydraulic Filtration Systems Lube, Fuel and Coolant Filtration Systems Cabin Air Filters 11 S T E K R A M - D N E S R E M O T S U C E V I T A T N E S E R P E R E U N E V E R 2 0 0 2 S E I L I M A F T C U D O R P ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ELEVEN-YEAR COMPARISON OF RESULTS Donaldson Company, Inc. and Subsidiaries (Thousands of dollars, except per share amounts) 2002 2001 2000 1999 OPERATING RESULTS Net sales Gross margin Gross margin percentage Operating income Operating income percentage Interest expense Earnings before income taxes Income taxes Effective income tax rate Net earnings Return on sales Return on average shareholders’ equity Return on investment FINANCIAL POSITION Total assets Current assets Current liabilities Working capital Current ratio Current debt Long-term debt Total debt Shareholders’ equity Long-term capitalization ratio Property, plant and equipment, net Net expenditures on property, plant and equipment Depreciation and amortization SHAREHOLDER INFORMATION Net earnings per share – assuming dilution Dividends paid per share Shareholders’ equity per share Shares outstanding (000s) Common stock price range, per share High Low $1,126,005 $ 349,492 $1,137,015 $1,092,294 341,734 327,521 $944,139 275,681 31.0% 30.1% 30.0% $ 123,850 112,108 105,594 11.0% 9.9% 9.7% $ 6,531 $ 119,018 $ 32,135 27.0% $ 86,833 7.7% 24.8% 19.2% $ 850,131 $ 456,484 $ 272,790 $ 183,694 1.7 $ 60,394 $ 105,019 $ 165,413 $ 382,621 11,608 104,928 29,380 28.0% 75,548 6.6% 25.2% 19.1% 706,830 407,227 217,279 189,948 1.9 59,416 99,259 158,675 319,093 9,880 100,333 30,100 30.0% 70,233 6.4% 25.9% 19.4% 677,525 383,347 243,590 139,757 1.6 85,313 92,645 177,958 280,165 29.2% 88,390 9.4% 6,993 89,210 26,763 30.0% 62,447 6.6% 24.1% 19.0% 542,246 326,388 142,055 184,333 2.3 20,696 86,691 107,387 262,763 21.5% 23.7% 24.9% 24.8% $ 240,913 $ 40,529 $ 31,751 $ 1.90 $ .31 $ 8.72 43,885 $ 44.99 $ 26.93 207,658 38,924 38,577 1.66 .295 7.19 204,545 36,417 34,326 1.51 .27 6.27 182,180 29,539 27,686 1.31 .23 5.69 44,383 44,658 46,197 33.05 19.13 24 .81 19.13 25.88 14.44 Amounts are adjusted for all stock splits and reﬂect adoption of SFAS 128. Return on investment is net earnings divided by average long-term debt plus average shareholders’ equity. Long-term capitalization ratio is long-term debt divided by long-term debt plus shareholders’ equity. (1)Excludes the cumulative effect of an accounting change of $2,206, or $.08 per share, in 1994. 12 1998 1997 1996 1995 1994 1993 1992 $940,351 263,262 $833,348 250,273 $758,646 222,874 $703,959 197,979 $593,503 166,599 $533,327 152,236 $482,104 133,574 28.0% 86,799 9.2% 4,671 86,441 29,390 34.0% 57,051 6.1% 22.8% 20.5% 512,987 300,817 165,068 135,749 1.8 45,896 51,553 97,449 30.0% 82,715 9.9% 2,358 79,094 28,474 36.0% 50,620 6.1% 21.4% 20.8% 467,501 283,367 177,346 106,021 1.6 42,674 4,201 46,875 29.4% 75,642 10.0% 2,905 71,120 27,684 38.9% 43,436 5.7% 19.3% 18.5% 402,850 250,751 138,578 112,173 1.8 13,145 10,041 23,186 28.1% 65,531 9.3% 3,089 63,172 24,636 39.0% 38,536 5.5% 18.8% 17.6% 381,042 247,904 123,747 124,157 2.0 20,800 10,167 30,967 28.1% 52,079 8.8% 3,362 50,193 18,244 36.3% 31,949 (1) 5.4% 17.6% 16.0% 337,360 220,308 115,757 104,551 1.9 16,956 16,028 32,984 28.5% 45,246 8.5% 2,723 44,682 16,468 36.9% 28,214 5.3% 16.9% 15.0% 300,217 196,014 93,666 102,348 2.1 7,595 18,920 26,515 255,671 243,865 228,880 221,173 189,697 174,008 16.8% 1.7% 4.2% 4.4% 7.8% 9.8% 178,867 54,705 25,272 1.14 .19 5.28 154,595 47,327 21,494 .99 .17 4.93 124,913 39,297 21,674 .84 .15 4.52 110,640 25,334 20,529 .73 .14 4.23 99,559 24,642 16,365 .59 (1) .12 3.58 90,515 15,005 14,752 .51 .10 3.19 27.7% 41,249 8.6% 2,681 41,721 15,952 38.2% 25,769 5.3% 17.2% 14.8% 286,348 187,360 89,956 97,404 2.1 11,425 23,482 34,907 160,303 12.8% 84,899 15,538 14,047 .46 .09 2.91 48,382 49,452 50,650 52,370 53,020 54,564 55,138 27.19 18.56 20.38 12.69 14.00 11.94 14.00 10.94 13.06 9.13 10.06 7.00 7.94 5.19 13 MANAGEMENT’S DISCUSSION AND ANALYSIS Results of Operations The following discussion of the company’s ﬁnancial condition and results of operations should be read in conjunction with the Consolidated Financial Statements and Notes thereto and other ﬁnancial information included elsewhere in this Report. Fiscal 2002 Compared to Fiscal 2001 The company reported sales in 2002 of $1.126 billion, down 1.0 percent from $1.137 billion last year. Despite a decrease in sales, the company achieved its 13th consecutive year of double- digit earnings growth. The company’s diversiﬁcation of filtration products was important to its success in ﬁscal 2002 in a difﬁcult economic environment. Decreased sales in the Industrial Products segment were partially offset by increased sales in the Engine Products segment. Sales for the Industrial Products segment were $514.4 million, down 3.0 percent from a record $530.2 million in the prior year. Sales totals do not include results from ultraﬁlter international AG (“ultraﬁlter”), which was acquired immediately prior to the end of the ﬁscal year. Within the Industrial Products segment, sales of gas turbine products were a record $230.9 million, up 18.4 percent from a record $195.0 million in the prior year. Sales of gas turbine products were strong domestically as well as internationally as market conditions remained steady outside of North America. Based on public comments from gas turbine manufacturers, the company expects the North American gas turbine contraction to be severe, possibly reducing gas turbine sales in the next ﬁscal year by $50 million. Sales in industrial air ﬁltration prod- ucts (formerly referred to as dust collection) of $175.7 mil- lion decreased 19.2 percent from $217.3 million in the prior year, impacted by weakness in industrial capital spending. Although these sales decreased from the prior year, sales of industrial air ﬁltration products improved 21.8 percent in the fourth quarter of ﬁscal 2002 over the third quarter, showing the ﬁrst meaningful improvement on a sequential quarter basis in two years. Sales of special application products were $107.8 million, an 8.5 percent decrease from a record $117.8 million in the prior year, reﬂecting weakness in the markets served by these products such as the computer, electronics, semiconductor and air- craft markets. Sales for the Engine Products segment were $611.6 mil- lion, up 0.8 percent from $606.8 million in the prior year. This increase from the prior year reﬂects improved business conditions in some of the markets served by products in this segment. Within the Engine Products segment, sales of truck products were $91.2 million, up 14.5 percent from $79.7 million in the prior year, reﬂecting increased demand for new truck orders in the North American truck market prior to the new October 2002 diesel emissions regulations. Sales of off-road products were $185.6 million, an increase of 2.1 percent from $181.8 million in the prior year. After- market product sales of $334.8 million decreased 3.1 per- cent from $345.3 million in the prior year. NET SALES Revenue has grown more than 8 percent per year, on average, over the last 13 years. EARNINGS PER SHARE Earnings per share were up 14.5 percent in 2002, the 13th consecutive year of double-digit increases in EPS. (Millions of dollars) (Dollars) 1,137 1,126 1,092 940 944 833 759 704 594 533 482 .84 .73 .59 .51 .46 1.90 1.66 1.51 1.31 1.14 .99 92 93 94 95 96 97 98 99 00 01 02 92 93 94 95 96 97 98 99 00 01 02 14 Domestic sales in the Industrial Products segment decreased 5.8 percent from the prior year. Within this segment, domestic gas turbine product sales posted an increase of 16.0 percent from the prior year. Offsetting this increase was a decrease in sales of industrial air ﬁltration products of 25.7 percent from the prior year, as the pace of recovery in the U.S. manufacturing economy remained slow with historically high levels of excess capacity. Additionally, domestic sales of special application products decreased 23.0 percent from the prior year reﬂecting a gen- eral weakness in the served markets. Domestic sales in the Engine Products segment were down 1.3 percent from the prior year. Within this segment, higher demand in the North American truck market drove an increase of domestic truck product sales of 12.6 percent from the prior year. Offsetting this increase was a decrease in domestic aftermarket product sales of 4.8 percent result- ing from weakness in U.S. truck and construction equip- ment utilization. Domestic sales of off-road products also declined from the prior year posting a decrease of 1.9 percent. In U.S. dollars, total international sales increased 2.9 percent from the prior year. Excluding the negative impact of foreign currency translation of $5.2 million, sales increased 4.1 percent over the prior year. Total inter- national sales in the Industrial Products segment were up 1.1 percent from the prior year. International sales of products within this segment were mixed. International sales of gas turbine products increased 25.7 percent, reﬂect- ing positive market conditions outside of North America with Europe showing the most improvement in these sales. International sales of industrial air ﬁltration products and special applications products decreased 9.4 percent and 2.0 percent, respectively. Total international sales in the Engine Products segment were up 4.8 percent from the prior year. International sales of aftermarket products were ﬂat while international sales of off-road and truck products increased from the prior year by 9.5 percent and 20.3 percent, respectively. The company reported record net earnings for 2002 of $86.9 million compared to $75.5 million in 2001, an increase of 15.0 percent. Net earnings per share – diluted were $1.90, up 14.5 percent from $1.66 in the prior year. Despite a decrease in sales for the year, the company achieved its 13th consecutive year of double-digit earnings growth. This was a result of the company’s efforts in improving operating performance as well as improvements made to the company’s manufacturing infrastructure, prod- uct costs and expenses. These efforts have resulted in more efﬁcient operations across the company. The company’s operating income increased from the prior year by 10.5 percent. Operating income in the Engine Products segment showed signiﬁcant growth from the prior year as it grew to over 50 percent of total operating income in the year from about 40 percent in the prior year. This growth reﬂects the efforts in improving operating efﬁciencies in the North RETURN ON EQUITY Donaldson Company is delivering shareholder value through consistently high returns on shareholders’ equity. DIVIDENDS PER SHARE Dividends paid per share increased 5 percent in 2002. The company distributes about 20 percent of net income to shareholders through regular quarterly dividends. (% Per annum) (Dollars) 25.9 25.2 24.8 24.1 22.8 21.4 19.3 18.8 17.2 16.9 17.6 .19 .17 .15 .14 .12 .10 .09 .31 .295 .27 .23 92 93 94 95 96 97 98 99 00 01 02 92 93 94 95 96 97 98 99 00 01 02 15 American Engine business. Operating income in the Industrial Products segment grew slightly during the year. International operating income totaled 68.9 percent of consolidated operating income in 2002 as compared to 64.6 percent in 2001. Of the 2002 international operating income, Europe contributed 41.0 percent while Asia-Paciﬁc contributed 55.1 percent. Total international operating income increased 3.5 percent from the prior year. In U.S. dollars, Europe’s operating income increased 14.6 percent and on a local currency basis increased 10.9 percent from strong results throughout the Engine Products segment and gas turbine products within the Industrial Products segment. On a local currency basis, Asia-Paciﬁc’s operating income increased 0.9 percent with mixed results across the entities within Asia-Paciﬁc. In U.S. dollars, Asia-Paciﬁc’s operating income decreased by 3.2 percent due to contin- ued weakness in the Japanese yen. Gross margin for 2002 increased to 31.0 percent com- pared to 30.1 percent in the prior year. Ongoing efforts to reduce product costs and improve the company’s manu- facturing infrastructure through plant rationalization drove margin improvements, more than offsetting contin- ued strong pricing pressures from major customers. Operating expenses as a percentage of sales for 2002 and 2001 were 20.0 percent and 20.2 percent, respectively. Operating expenses in 2002 totaled $225.6 million com- pared to $229.6 million in 2001, a decrease of $4.0 mil- lion, or 1.7 percent. The decrease in operating expenses relative to the prior year reﬂects the company’s expense reduction initiatives, implemented late in ﬁscal 2001, which reduced the number of contractors and temporary employees and managed discretionary spending levels. Interest expense decreased $5.1 million, or 43.7 percent, partially due to lower interest rates and lower short-term debt levels throughout most of the year. This decrease is also due to a decrease in interest expense ($1.2 million) on a portion of the company’s long-term debt as a result of an interest rate swap agreement entered into in ﬁscal 2001. Other income, net totaled $1.7 million in 2002 compared to $4.4 million in the prior year. Components of other income for 2002 were as follows: interest income of $0.9 million, earnings from non-consolidated joint ventures of $4.2 million, $2.5 million of funding to the Donaldson Foundation, foreign exchange losses of $1.3 million resulting from the movement of cash into Europe to complete the ultraﬁlter acquisition and other miscella- neous income and expense items netting to $0.4 million of miscellaneous income. 16 The effective income tax rate of 27.0 percent in 2002 decreased from the 28.0 percent tax rate in 2001. The tax rate was adjusted in the second quarter of ﬁscal 2002 to reﬂect state tax savings from infrastructure improvements. The company anticipates maintaining the 27.0 effective income tax rate for the foreseeable future. Total backlog was $307.6 million, down 13.4 percent from the same period in the prior year. In the Industrial Products segment, total backlog decreased 29.4 percent from the same period in the prior year reﬂecting the projected downturn in the North American gas turbine market. In the Engine Products segment, total backlog increased 3.4 percent compared to the same period in the prior year, reﬂecting improvement in business conditions in the markets served. Hard order backlog, goods scheduled for delivery within 90 days, was $178.3 million, down 0.9 percent from $179.9 million in the prior year. In the Industrial Products segment, overall hard order backlog decreased 10.9 percent from the prior year. Within this segment, hard order backlog for gas turbine products and industrial air ﬁltration products decreased 21.1 percent and 7.4 percent from the prior year, respectively. These decreases were somewhat offset by a strong increase in special application products of 34.3 percent. In the Engine Products segment, overall hard order backlog increased 8.7 percent from the prior year. Within this segment, truck products showed a solid increase of 22.9 percent from the prior year. Hard order backlog for aftermarket products decreased slightly at 0.3 percent, while off-road products posted an increase of 7.6 percent. The company completed the acquisition of ultraﬁlter for $68.3 million in cash on July 12, 2002. The acquisition is reﬂected in the consolidated balance sheet as of July 31, 2002. Ultraﬁlter’s results of operations will be included in the consolidated ﬁnancial statements beginning with ﬁscal 2003 as the results in ﬁscal 2002 were not material to the company as a whole. Ultraﬁlter is a global leader in the design and manufacture of components, replacement parts and complete systems for the compressed air puriﬁcation industry. Ultraﬁlter’s operations will be included in the Industrial Products segment. Fiscal 2001 Compared to Fiscal 2000 The company reported record sales in 2001 of $1.137 billion. This was an increase of 4.1 percent over prior year sales of $1.092 billion. Excluding the impact of businesses acquired in 2000, sales for the year ended July 31, 2001 were up 0.5 percent over the prior year. This modest growth in sales for the year reﬂected the diversiﬁcation of our Industrial Products and Engine Products segments as shown by the strength in the gas turbine market offsetting the slump in the North American truck market. Sales for the Industrial Products segment were a record $530.2 million, up 26.7 percent over the prior year. Excluding the acquisition of DCE dust con- trol business of Invensys, plc (“DCE”), sales for the year were up 18.9 percent from the prior year. Leading this increase were sales in gas turbine products with an increase over the prior year of 66.6 percent to record sales of $195.0 million, reﬂecting the continued high demand in this market. Sales in industrial air ﬁltration and special application products also increased from the prior year by 12.5 percent and 8.9 percent, respectively. Excluding the acquisition of DCE, sales of industrial air ﬁltration products decreased 4.4 percent from the prior year. Sales for the Engine Products segment of $606.8 million were down 10.0 percent over the prior year reﬂecting the U.S. economic weakness and the strong U.S. dollar overseas. Worldwide markets for medium and heavy-duty trucks were severely depressed, reﬂected in a decrease in truck product sales of 47.6 percent from the prior year. Excluding the company’s second quarter exit from a block of truck related business due to unfavorable commercial terms, sales were down 37.1 percent from the prior year. Sales in off-road products decreased 5.9 percent from the prior year while aftermarket product sales increased 5.0 percent. Domestic Industrial Products sales increased 28.1 percent from the prior year. This increase was led by strong sales of gas turbine systems products domestically, reﬂecting continued demand for large turbines in North America, with domestic sales almost doubling from the prior year. Domestic sales of industrial air ﬁltration products grew slightly with an increase of 1.7 percent, while sales of special application products domestically decreased 8.2 percent. Domestic Engine Products sales were down 10.5 percent from the prior year. The medium and heavy-duty truck market continued to show its effects on the company’s truck product sales domestically with a decrease of 51.8 percent from the prior year. This was somewhat offset by increases in domestic aftermarket and off-road product sales of 1.7 percent and 13.1 percent, respectively. In U.S. dollars, total international sales increased 5.6 per- cent from the prior year. Excluding the negative impact of foreign currency translation of $35.6 million, sales increased 14.4 percent over the prior year. Total international Industrial Products sales were up 24.9 percent from the prior year. Sales of all products within this segment were strong internationally, with increases across the board. Leading this growth were sales of industrial air ﬁltration products with an increase of 34.1 percent from the prior year. Sales of gas turbine products and special application products increased 20.2 percent and 18.9 percent from the prior year, respectively. Total international Engine Products sales were down 8.9 percent compared to the prior year despite an increase in aftermarket product sales of 11.3 percent. International sales of off-road and truck products decreased from the prior year by 28.3 percent and 29.0 percent, respectively. The company reported record net earnings for 2001 of $75.5 million compared to $70.2 million in 2000, an increase of 7.6 percent. Net earnings per share – diluted were $1.66, up 10.0 percent from $1.51 in the prior year. With only a modest increase in sales, the increase in net earnings is also a result of cost management, particularly in plant rationalization efforts throughout the year and other cost reduction initiatives in the second half of the year. This along with the decrease in the company’s effec- tive tax rate due to increased proﬁtability from foreign operations helped to offset the effect of negative foreign currency exchange rates. The Industrial Products segment continued to grow, contributing 46.6 percent of consoli- dated sales, approximately 70.0 percent of the operating income and all of the growth in operating income for the year. International operating income totaled approximately 68.9 percent and 62.1 percent of consolidated operating income in 2001 and 2000, respectively. International operations also contributed all of the growth in operating income. Europe’s operating income increased 7.1 percent (16.2 percent in local currency) as a result of strong gas turbine results, the completion of the DCE integration and improved results in most markets. Asia-Paciﬁc’s operating income increased by 38.0 percent (44.4 percent in local currency), led by increases from Japan’s ROI improvement project and strong disk drive results in the Hong Kong and Wuxi, China, operations. Gross margin for 2001 remained virtually ﬂat with only a slight increase to 30.1 percent compared to 30.0 percent in the prior year. This reﬂects an improved product mix and beneﬁts of plant rationalization efforts, offsetting strong pricing pressure from major customers. Operating expenses as a percentage of sales for 2001 and 2000 were 20.2 percent and 20.3 percent, respectively. Operating expenses in 2001 totaled $229.6 million com- pared to $221.9 million in 2000, an increase of $7.7 mil- lion, or 3.5 percent. The increase in operating expenses relative to the prior year reﬂects higher sales levels and the continued impact of the businesses acquired in 2000. Interest expense increased $1.7 million, or 17.5 percent, primarily due to higher short-term debt levels throughout the year related to last year’s acquisitions. Other income totaled $4.4 million in 2001 compared to other income of $4.6 million in the prior year. The major components 17 of other income in 2001 were: interest income of $1.2 million, earnings from non-consolidated joint ventures of $3.0 million, and other miscellaneous income and expense items netting to $0.2 million of miscellaneous income. The effective income tax rate of 28.0 percent in 2001 decreased from the 30.0 percent tax rate in 2000. The tax rate was adjusted in the third quarter to provide for the increased contributions from the company’s international operations in lower tax rate countries and reﬂects the foreign tax credit generated by the receipt of a dividend from the company’s operations in Japan. The company anticipates that it will have a comparable proportion of income coming from its international operations located in lower tax rate countries in 2002. The company anticipates that its effective income tax rate will be approximately 28.0 percent in 2002. Total backlog was $355.3 million, up 7.2 percent from the same period last year. In the Industrial Products segment, total backlog increased 16.8 percent from the same period last year. In the Engine Products segment, total backlog was down 1.3 percent compared to the same period last year. Hard order backlog, goods scheduled for delivery in 90 days, was $179.9 million, down 2.1 percent from $183.7 million in the prior year. Within the Industrial Products segment, hard order backlog for gas turbine products increased 28.7 percent from the prior year. This increase was offset by decreases in industrial air ﬁltration and special application products of 26.2 percent and 24.1 percent, respectively, resulting in a slight overall increase in the Industrial Products segment from the prior year. In the Engine Products segment, overall hard order backlog decreased 4.5 percent from the prior year. Within this segment, off-road and truck products posted decreases of 6.4 percent and 16.3 percent, respectively, while after- market hard order backlog increased 4.5 percent from the prior year. Liquidity and Capital Resources Financial Condition At July 31, 2002, the company’s capital structure was comprised of $60.4 million of current debt, $105.0 million of long-term debt and $382.6 million of shareholders’ equity. The ratio of long-term debt to total capital was 21.5 percent and 23.7 percent at July 31, 2002 and 2001, respectively. Total debt outstanding increased $6.7 million for the year to $165.4 million outstanding at July 31, 2002. The increase is a result of an increase in long-term debt of $5.8 million from the prior year. The increase in long-term debt is primarily due to an increase in an unsecured senior 18 note of $1.5 million as a result of an interest rate swap agreement entered into in ﬁscal 2001 and the addition of capitalized lease obligations of $3.5 million resulting from the acquisition of ultraﬁlter. Long-term debt also increased by $0.7 million due to foreign exchange translation for two guaranteed notes in our Japan operations due to continued weakness in the Japanese yen. Short-term borrowings out- standing at the end of the year increased $0.9 million as compared to the prior year. The company has a multi-currency revolving credit facility totaling $100.0 million with a group of banks and an additional $45.0 million available for use under uncommitted facilities which provide unsecured borrow- ings for general corporate purposes. There was $35.5 mil- lion outstanding under these facilities at July 31, 2002. The following table summarizes the company’s ﬁxed cash obligations as of July 31, 2002 over various future years (in thousands): Contractual Cash Obligations Less than 1 Year Total 1 – 3 Years 4 – 5 Years After 5 Years Payments Due by Period Long-term debt $105,076 $ 57 $39,660 $38,640 $26,719 Short-term debt 60,337 60,337 – – – Total $165,413 $60,394 $39,660 $38,640 $26,719 At July 31, 2002, the company had a contingent liability for standby letters of credit totaling $14.8 million that have been issued and are outstanding. Currently, there are no amounts drawn on these letters of credit. The company believes that the combination of present capital resources, internally generated funds, and unused ﬁnancing sources are adequate to meet cash requirements for ﬁscal 2003. Shareholders’ equity increased $63.5 million in 2002 to $382.6 million. The increase was due to current year earnings of $86.9 million offset by $21.3 million of trea- sury stock repurchases, $13.7 million of dividend payments and a net increase in other comprehensive income of $9.9 million and $1.7 million of other miscellaneous stock activity. The increase in other comprehensive income con- sisted primarily of a foreign currency translation adjus- tment of $13.5 million offset by an additional minimum pension liability of $3.3 million. Cash Flows During ﬁscal 2002, $154.3 million of cash was generated from operating activities, compared with $82.8 million in 2001 and $88.5 million in 2000. The increase in 2002 was primarily due to a decrease in accounts receivable of $8.1 million, a decrease in inventory of $13.6 million and an increase in accounts payable and other accrued expenses of $25.2 million during the year. In addition to cash generated from operating activities, the company increased its outstanding short-term debt by $3.0 million while net long-term debt increased by $1.6 million. Cash ﬂow generated by operations was used primarily to support $40.5 million for capital expenditures, $21.3 million for stock repurchases and $13.7 million for dividend payments. Cash and cash equivalents increased $9.5 million during 2002. Capital expenditures for property, plant and equipment totaled $40.5 million in 2002, compared to $38.9 million in 2001 and $36.4 million in 2000. Capital expenditures primarily related to productivity enhancing investments at various plants worldwide and continuing upgrades to the U.S. information systems. Capital spending in 2003 is planned at $45.0 million. Signiﬁcant planned expenditures include the further upgrade of U.S. information systems and investment in manufacturing equipment and tooling. It is anticipated that 2003 capital expenditures will be ﬁnanced primarily by cash generated from operations and existing lines of credit. Dividends The company’s dividend policy is to maintain a payout ratio which allows dividends to increase with the long-term growth of earnings per share, while sustaining dividends in down years. The company’s dividend payout ratio target is 20.0 percent to 25.0 percent of the average earnings per share of the last three years. The current quarterly dividend of 8.5 cents per share equates to 20.1 percent of the average net earnings per share for 2000 through 2002. Share Repurchase Plan In ﬁscal 2002, the company repur- chased 0.7 million shares of common stock on the open market for $21.3 million under the share repurchase plan authorized in January 2001, at an average price of $32.37 per share. The company repurchased 0.5 million shares for $10.3 million in 2001 and 1.7 million shares for $35.9 million in 2000. Environmental Matters The company has established reserves for potential environmental liabilities and plans to continue to accrue reserves in appropriate amounts. While uncertain- ties exist with respect to the amounts and timing of the company’s ultimate environmental liabilities, management believes that such liabilities, individually and in the aggre- gate, will not have a material adverse effect on the company’s ﬁnancial condition or results of operations. New Accounting Standards In June 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 141, “Business Combinations,” and SFAS No. 142, “Goodwill and Other Intangible Assets.” Major provisions of these statements are as follows: all business combinations must now use the purchase method of accounting; intangible assets acquired in a business combination must be recorded separately from goodwill if they arise from contractual or other legal rights or are separable from the acquired entity and can be sold, transferred, licensed, rented or exchanged, either individually or as a part of a related contract, asset or lia- bility; goodwill and intangible assets with indeﬁnite lives are not amortized but tested for impairment annually and whenever there is an impairment indicator; all acquired goodwill must be assigned to reporting units for purposes of impairment testing and segment reporting. The company adopted the provisions of these statements as of August 1, 2001. As required by SFAS No. 142, the company has per- formed step one of the impairment testing of goodwill for the balances as of August 1, 2001. The results of this test show that the fair market value of the reporting units that the goodwill is assigned to is higher than the book values of those reporting units resulting in no goodwill impair- ment. The company will perform impairment tests annu- ally and whenever events or circumstances occur indicating that goodwill or other intangible assets might be impaired. As of August 1, 2001, the company is no longer amortizing goodwill. Goodwill amortization expense was $2.7 million and $1.9 million, net of income taxes, for the year ended July 31, 2001 and 2000, respectively. The company esti- mates that goodwill amortization expense would have been approximately $2.6 million, net of income taxes, for the year ended July 31, 2002. The following table presents a reconciliation of net income and earnings per share adjusted for the exclusion of goodwill, net of income taxes: (In thousands, except per share amounts) 2002 2001 2000 Reported net income $86,883 $75,548 $70,233 Add goodwill amortization, net of tax – 2,722 1,895 Adjusted net income $86,883 $78,270 $72,128 Basic earnings per share: Reported basic earnings per share $ 1.97 $ 1.70 $ 1.54 Add goodwill amortization, net of tax – .06 .04 Adjusted basic earnings per share $ 1.97 $ 1.76 $ 1.58 Diluted earnings per share: Reported diluted earnings per share $ 1.90 $ 1.66 $ 1.51 Add goodwill amortization, net of tax – .06 .04 Adjusted diluted earnings per share $ 1.90 $ 1.72 $ 1.55 19 As of July 31, 2002 and 2001, goodwill was $86.4 mil- lion and $57.5 million, respectively. In ﬁscal 2002, goodwill increased $28.1 million for the acquisition of ultraﬁlter and decreased $0.5 million for the reversal of restructuring reserves that were unused from previous acquisitions. The remaining increase of $1.3 million was due to foreign exchange translation. For the Industrial Products and Engine Products segments, goodwill as of July 31, 2002 totaled $62.6 million and $23.8 million, respectively, and as of July 31, 2001 totaled $33.4 million and $24.1 mil- lion, respectively. In June 2001, the FASB issued SFAS No. 143, “Accounting for Asset Retirement Obligations.” This statement addresses ﬁnancial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. SFAS No. 143 is effective for the company in ﬁscal 2003. Management does not expect this statement to have a material impact on the company’s consolidated ﬁnancial statements. In August 2001, the FASB issued SFAS No. 144, “Accounting for the Impairment or Disposal of Long- Lived Assets.” SFAS No. 144 establishes a single model for the impairment of long-lived assets and broadens the presentation of discontinued operations to include more disposal transactions. SFAS No. 144 is effective for the company in ﬁscal 2003. Management does not expect this statement to have a material impact on the company’s consolidated ﬁnancial statements. In June 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” SFAS No. 146 addresses signiﬁcant issues relating to the recognition, measurement and reporting of costs associated with exit and disposal activities including restructuring. SFAS No. 146 is effective for the company in ﬁscal 2003. Market Risk The company’s market risk includes the potential loss arising from adverse changes in foreign currency exchange rates and interest rates. The company manages foreign cur- rency market risk, from time to time, through the use of a variety of ﬁnancial and derivative instruments. The com- pany does not enter into any of these instruments for trad- ing purposes to generate revenue. Rather, the company’s objective in managing these risks is to reduce ﬂuctuations in earnings and cash ﬂows associated with changes in for- eign currency exchange rates. The company uses forward exchange contracts and other hedging activities to hedge the U.S. dollar value resulting from anticipated foreign currency transactions. The company’s market risk on inter- est rates is the potential increase in fair value of long-term debt resulting from a potential decrease in interest rates. See further discussion of these market risks below. Foreign Currency During 2002, overall the U.S. dollar strengthened throughout the year relative to the currencies of the foreign countries in which the company operates. The stronger dollar had a negative impact on the com- pany’s international net sales results because the foreign denominated revenues translated into fewer U.S. dollars. The overall impact to net earnings, though, was nominal. It is not possible to determine the true impact of foreign currency translation changes; however, the direct effect on net sales and net earnings can be estimated. For the year ended July 31, 2002, the impact of foreign currency trans- lation resulted in an overall decrease in net sales of $5.2 million but had a nominal impact on net earnings. Foreign currency translation had a negative impact in Japan, where the stronger U.S. dollar relative to the Japanese yen resulted in a decrease in net sales of $6.4 million and a decrease in net earnings of $0.3 million. The stronger U.S. dollar rela- tive to the South African rand also had a negative impact on foreign currency translation with a decrease in net sales of $4.7 million and a decrease in net earnings of $0.2 mil- lion. In Europe, the euro strengthened, and almost reached parity with the U.S. dollar by the end of the ﬁscal year. This resulted in an increase in net sales of $5.7 million and an increase in net earnings of $0.4 million. Going forward, the company expects local currency results to remain strong; excluding the effect of translation, revenues outside the United States increased 4.1 percent for the year ended July 31, 2002. The company maintains signiﬁcant assets and operations in Europe, countries of the Asia-Paciﬁc Rim, South Africa and Mexico. As a result, exposure to foreign currency gains and losses exists. A portion of the company’s foreign currency exposure is naturally hedged by incurring liabili- ties, including bank debt, denominated in the local currency in which the company’s foreign subsidiaries are located. The foreign subsidiaries of the company purchase prod- ucts and parts in various currencies. As a result, the com- pany may be exposed to cost increases relative to local 20 currencies in the markets to which it sells. To mitigate such adverse trends, the company, from time to time, enters into forward exchange contracts and other hedging activities. Additionally, foreign currency positions are partially offset- ting and are netted against one another to reduce exposure. Some products made in the United States are sold abroad, primarily in Canada. As a result, sales of such products are affected by the value of the U.S. dollar relative to other currencies. Any long-term strengthening of the U.S. dollar could depress these sales. Also, competitive conditions in the company’s markets may limit its ability to increase product pricing in the face of adverse currency movements. Interest The company’s exposure to market risks for changes in interest rates relates primarily to our short-term investments, short-term borrowings and interest rate swap agreement. We have no earnings or cash ﬂow exposure due to market risks on our long-term debt obligations as a result of the ﬁxed-rate nature of the debt. However, interest rate changes would affect the fair market value of the debt. At July 31, 2002, the fair value of the company’s long-term debt approximates market. Market risk is estimated as the potential decrease in fair value resulting from a hypotheti- cal one-half percent increase in interest rates and amounts to approximately $3.3 million. During ﬁscal 2001, the company entered into an inter- est rate swap agreement effectively converting a portion of the company’s interest rate exposure from a ﬁxed-rate to a variable rate basis to hedge against the risk of higher borrowing costs in a declining interest rate environment. The company does not enter into interest rate swap con- tracts for speculative or trading purposes, as the differential to be paid or received on the interest rate swap agreement is accrued and recognized as an adjustment to interest expense as interest rates change. The interest rate swap agreement has an aggregate notional amount of $27.0 million maturing on July 15, 2008. The variable rate is based on the current six-month London Interbank Offered Rates (“LIBOR”). This transaction resulted in a decrease to interest expense of $1.2 million for the year ended July 31, 2002. Critical Accounting Policies The company’s consolidated ﬁnancial statements are pre- pared in conformity with accounting principles generally accepted in the United States of America. The preparation of these ﬁnancial statements requires the use of estimates, judgments and assumptions that affect the reported amounts of assets and liabilities at the date of the ﬁnancial statements and the reported amounts of revenue and expenses during the periods presented. Management bases these 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 mak- ing judgments about the recorded values of certain assets and liabilities. The company believes its use of estimates and underlying accounting assumptions adhere to generally accepted accounting principles and are consistently applied. Valuations based on estimates and underlying accounting assumptions are reviewed for reasonableness on a consis- tent basis throughout the company. Management believes the company’s critical accounting policies that require more signiﬁcant judgments and estimates used in the preparation of its consolidated ﬁnancial statements and are the most important to aid in fully understanding its ﬁnancial results are the following: Allowance for doubtful accounts – Allowances for doubtful accounts are estimated by management based on evaluation of potential losses related to customer receivable balances. Estimates are developed by using standard quan- titative measures based on historical losses, adjusting for current economic conditions and, in some cases, evaluating speciﬁc customer accounts for risk of loss. The establish- ment of this reserve requires the use of judgment and assumptions regarding the potential for losses on receivable balances. Though management considers these balances adequate and proper, changes in economic conditions in speciﬁc markets in which the company operates could have an effect on reserve balances required. Inventory – The company’s inventories are valued at the lower of cost or market. Reserves for shrink and obsoles- cence are estimated using standard quantitative measures based on historical losses, including issues related to speciﬁc inventory items. Though management considers these balances adequate and proper, changes in economic condi- tions in speciﬁc markets in which the company operates could have an effect on reserve balances required. Product warranty – The company estimates warranty costs using standard quantitative measures based on historical warranty claim experience and, in some cases, evaluating speciﬁc customer warranty issues. The establish- ment of reserves requires the use of judgment and assump- tions regarding the potential for losses relating to warranty issues. Though management considers these balances adequate and proper, changes in the future could impact these determinations. 21 The company wishes to caution investors that any forward-looking statements made by or on behalf of the company are subject to uncertainties and other factors that could cause actual results to differ materially from such statements. These uncertainties and other risk factors include, but are not limited to: risks associated with currency ﬂuctuations, commodity prices, world economic factors, political factors, the company’s substantial interna- tional operations including key disk drive ﬁlter production facilities in China, highly competitive markets, changes in product demand and changes in the geographic and prod- uct mix of sales, acquisition opportunities and integration of recent acquisitions, including the acquisition of ultra- ﬁlter, facility and product line rationalization, research and development expenditures, including ongoing information technology improvements, and governmental laws and regulations, including diesel emissions controls. For a more detailed explanation of the foregoing and other risks, see exhibit 99, which is part of the company’s Form 10-K ﬁled with the Securities and Exchange Commission. The com- pany wishes to caution investors that other factors may in the future prove to be important in affecting the company’s results of operations. New factors emerge from time to time and it is not possible for management to predict all such factors, nor can it assess the impact of each such factor on the business or the extent to which any factor, or a combina- tion of factors, may cause actual results to differ materially from those contained in any forward-looking statements. Investors are further cautioned not to place undue reliance on such forward-looking statements as they speak only to the company’s views as of the date the statement is made. 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. Income taxes – As part of the process of preparing the company’s consolidated ﬁnancial statements, management is required to estimate income taxes in each of the jurisdic- tions in which the company operates. This process involves estimating actual current tax exposure together with assess- ing temporary differences resulting from differing treatment of items for tax and book accounting purposes. These dif- ferences result in deferred tax assets and liabilities, which are included within the company’s consolidated balance sheet. These assets and liabilities are evaluated by using estimates of future taxable income streams and the impact of tax planning strategies. Management assesses the likeli- hood that deferred tax assets will be recovered from future taxable income and to the extent management believes that recovery is not likely, a valuation allowance is established. To the extent that a valuation allowance is established or increased, an expense within the tax provision is included in the statement of operations. Reserves are also estimated for ongoing audits regarding federal, state and international issues that are currently unresolved. The company routinely monitors the potential impact of such situations and believes that it is properly reserved. Valuations related to tax accruals and assets can be impacted by changes to tax codes, changes in statutory tax rates and the company’s future taxable income levels. Forward-Looking Statements The company desires to take advantage of the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995 and is making this cautionary statement in connection with such safe harbor legislation. This Annual Report to Shareholders, any Form 10-K, Form 10-Q, Form 8-K, earnings releases or other press releases of the company or any other written or oral state- ments made by or on behalf of the company may include forward-looking statements which reﬂect the company’s current views with respect to future events and ﬁnancial performance. The words “believe,” “expect,” “anticipate,” “intends,” “estimate,” “forecast,” “plan,” “project,” “should” and similar expressions are intended to identify “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. All fore- casts and projections in this Annual Report are “forward- looking statements,” and are based on management’s current expectations of the company’s near-term results, based on current information available to the company. 22 CONSOLIDATED STATEMENTS OF EARNINGS Donaldson Company, Inc. and Subsidiaries (Thousands of dollars, except share and per share amounts) Year ended July 31, Net sales Cost of sales Gross Margin Selling, general and administrative Research and development Operating Income Interest expense Other (income) expense, net Earnings Before Income Taxes Income taxes Net Earnings Weighted Average Shares – Basic Weighted Average Shares – Diluted Net Earnings Per Share – Basic Net Earnings Per Share – Diluted The accompanying notes are an integral part of these consolidated ﬁnancial statements. 2002 $1,126,005 776,513 349,492 197,492 28,150 123,850 6,531 (1,699) 119,018 32,135 $ 86,883 2001 $1,137,015 795,281 341,734 201,201 28,425 112,108 11,608 (4,428) 104,928 29,380 $ 75,548 2000 $1,092,294 764,773 327,521 194,623 27,304 105,594 9,880 (4,619) 100,333 30,100 $ 70,233 44,158,074 44,381,082 45,716,482 45,714,409 45,612,165 46,664,196 $ 1.97 $ 1.70 $ 1.54 $ 1.90 $ 1.66 $ 1.51 23 CONSOLIDATED BALANCE SHEETS Donaldson Company, Inc. and Subsidiaries (Thousands of dollars, except share amounts) At July 31, 2002 2001 ASSETS Current Assets Cash and cash equivalents Accounts receivable, less allowance of $6,620 and $6,309 Inventories Raw materials Work in process Finished products Total Inventories Deferred income taxes Prepaids and other current assets Total Current Assets Property, Plant and Equipment, at cost Land Buildings Machinery and equipment Construction in progress Less accumulated depreciation Intangible Assets Other Assets Total Assets LIABILITIES & SHAREHOLDERS’ EQUITY Current Liabilities Short-term borrowings Current maturities of long-term debt Trade accounts payable Accrued employee compensation and related taxes Accrued liabilities Other current liabilities Total Current Liabilities Long-term Debt Deferred Income Taxes Other Long-term Liabilities Commitments and Contingencies (Note J) Shareholders’ Equity Preferred stock, $1.00 par value, 1,000,000 shares authorized, none issued Common stock, $5.00 par value, 80,000,000 shares authorized, 49,655,954 shares issued in 2002 and 2001 Retained earnings Accumulated other comprehensive loss Treasury stock – 5,741,417 and 5,273,121 shares in 2002 and 2001, at cost Total Shareholders’ Equity Total Liabilities & Shareholders’ Equity The accompanying notes are an integral part of these consolidated ﬁnancial statements. 24 $ 45,586 251,417 $ 36,136 230,046 49,162 16,796 51,733 117,691 18,417 23,373 456,484 13,549 134,660 375,275 29,240 552,724 (311,811) 240,913 103,681 49,053 $ 850,131 $ 60,337 57 115,299 31,171 31,542 34,384 272,790 105,019 13,376 76,325 50,426 21,209 40,999 112,634 12,746 15,665 407,227 6,890 117,029 345,073 22,603 491,595 (283,937) 207,658 58,205 33,740 $ 706,830 $ 59,393 23 100,287 29,945 17,597 10,034 217,279 99,259 9,189 62,010 – – 248,280 274,395 (14,296) (125,758) 382,621 $ 850,131 248,280 203,499 (24,235) (108,451) 319,093 $ 706,830 CONSOLIDATED STATEMENTS OF CASH FLOWS Donaldson Company, Inc. and Subsidiaries (Thousands of dollars) Year ended July 31, 2002 2001 2000 OPERATING ACTIVITIES Net earnings Adjustments to reconcile net earnings to net cash provided by operating activities $ 86,883 $ 75,548 $ 70,233 Depreciation and amortization Equity in (earnings) loss of afﬁliates Deferred income taxes Other Changes in operating assets and liabilities, net of acquired businesses Accounts receivable Inventories Prepaids and other current assets Trade accounts payable and other accrued expenses Net Cash Provided by Operating Activities INVESTING ACTIVITIES Purchases of property, plant and equipment Acquisitions and investments in afﬁliates Net Cash Used in Investing Activities FINANCING ACTIVITIES Proceeds from long-term debt Repayments of long-term debt Change in short-term borrowings Purchase of treasury stock Dividends paid Exercise of stock options Net Cash (Used in) Provided by Financing Activities Effect of exchange rate changes on cash Increase (Decrease) in Cash and Cash Equivalents Cash and Cash Equivalents, Beginning of Year Cash and Cash Equivalents, End of Year The accompanying notes are an integral part of these consolidated ﬁnancial statements. 31,751 82 (5,266) (2,973) 8,053 13,608 (2,979) 25,153 154,312 (40,529) (68,349) (108,878) 1,590 (23) 2,961 (21,271) (13,713) (1,334) (31,790) (4,194) 9,450 36,136 $ 45,586 38,577 (635) 7,093 (12,949) (35,220) 2,816 2,838 4,731 82,799 (38,924) – (38,924) 9,462 (1,136) (24,417) (10,297) (13,092) 525 (38,955) (801) 4,119 32,017 $ 36,136 34,326 74 (449) 3,121 (5,704) (26,227) (3,316) 16,437 88,495 (36,417) (88,220) (124,637) 5,752 (4,522) 66,328 (35,923) (12,384) 326 19,577 (1,053) (17,618) 49,635 $ 32,017 25 CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY Donaldson Company, Inc. and Subsidiaries (Thousands of dollars, except per share amounts) BALANCE JULY 31, 1999 Comprehensive income Net earnings Foreign currency translation Comprehensive income Treasury stock acquired Stock options exercised Tax reduction – employee plans Cash dividends ($.27 per share) BALANCE JULY 31, 2000 Comprehensive income Net earnings Foreign currency translation Additional minimum pension liability Net gain on cash ﬂow hedging derivatives Comprehensive income Treasury stock acquired Stock options exercised Performance awards Tax reduction – employee plans Cash dividends ($.295 per share) BALANCE JULY 31, 2001 Comprehensive income Net earnings Foreign currency translation Additional minimum pension liability Net loss on cash ﬂow hedging derivatives Comprehensive income Treasury stock acquired Stock options exercised Performance awards Tax reduction – employee plans Cash dividends ($.31per share) BALANCE JULY 31, 2002 Common Stock $248,280 Additional Paid-in Capital $ 1,833 1,134 2,967 248,280 248,280 (6,196) 3,229 – (3,023) 3,023 $248,280 $ – Accumulated Other Comprehensive Income (Loss) Treasury Stock Total $ (5,670) $ (69,367) $262,763 (4,853) (35,923) 2,555 (10,523) (102,735) (13,717) (341) 346 (10,297) 4,262 319 (24,235) (108,451) 13,515 (3,256) (320) (21,271) 3,749 215 $(14,296) $(125,758) 70,233 (4,853) 65,380 (35,923) (805) 1,134 (12,384) 280,165 75,548 (13,717) (341) 346 61,836 (10,297) (3,058) 310 3,229 (13,092) 319,093 86,883 13,515 (3,256) (320) 96,822 (21,271) (1,603) 270 3,023 (13,713) $382,621 Retained Earnings $ 87,687 70,233 (3,360) (12,384) 142,176 75,548 (1,124) (9) (13,092) 203,499 86,883 (2,329) 55 (13,713) $274,395 The accompanying notes are an integral part of these consolidated ﬁnancial statements. 26 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Donaldson Company, Inc. and Subsidiaries > NOTE A Summary of Signiﬁcant Accounting Policies Description of Business Donaldson Company, Inc., is a leading worldwide manufacturer of ﬁltration systems and replacement parts. The company’s product mix includes air and liquid ﬁlters and exhaust and emission control prod- ucts for mobile equipment; in-plant air cleaning systems; compressed air puriﬁcation systems; air intake systems for industrial gas turbines; and specialized ﬁlters for such diverse applications as computer disk drives, aircraft passenger cabins and semi-conductor processing. Products are manufactured at more than three dozen Donaldson plants around the world and through four joint ventures. Principles of Consolidation The consolidated ﬁnancial state- ments include the accounts of Donaldson Company, Inc. and all majority-owned subsidiaries (the company). All signiﬁcant inter-company accounts and transactions have been eliminated. The company also has four joint ventures that are not majority-owned, all accounted for on the equity method. Certain amounts in prior periods have been reclassiﬁed to conform to the current presentation. The reclassiﬁcations had no impact on the company’s net earnings or shareholders’ equity as previously reported. Use of Estimates The preparation of ﬁnancial statements in conformity with generally accepted accounting principles in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. Foreign Currency Translation For most foreign operations, local currencies are considered the functional currency. Assets and liabilities are translated using the exchange rates in effect at the balance sheet date. Results of operations are translated using the average exchange rates prevailing throughout the period. Translation gains or losses, net of applicable deferred taxes, are accumulated in the foreign currency adjustment in accumulated other comprehensive income (loss) in shareholders’ equity. Foreign currency transaction losses of $1.3 million in 2002 are included in earnings before income taxes. There were no signiﬁcant foreign currency transaction gains or losses in 2001. Foreign currency transaction losses of $0.2 million in 2000 are included in earnings before income taxes. Cash Equivalents The company considers all highly liquid temporary investments with a maturity of three months or less when purchased to be cash equivalents. Cash equiva- lents are carried at cost which approximates market value. Inventories Inventories are stated at the lower of cost or market. Domestic inventories are valued using the last-in, first-out (LIFO) method, while the international subsidiaries use the ﬁrst-in, ﬁrst-out (FIFO) method. Inventories valued at LIFO were approximately 41 percent and 53 percent of total inventories at July 31, 2002 and 2001, respectively. For inventories valued under the LIFO method, the FIFO cost exceeded the LIFO carrying values by $20.8 million and $22.5 million at July 31, 2002 and 2001, respectively. Property, Plant and Equipment Property, plant and equipment are stated at cost. Additions, improvements or major renewals are capitalized, while expenditures that do not enhance or extend the asset’s useful life are charged to operating expense as incurred. Depreciation is computed principally by use of declining balance methods on facili- ties and equipment acquired on or prior to July 31, 1992. The company adopted the straight-line depreciation method for all property acquired after July 31, 1992. Depreciation expense was $31.7 million in 2002 and 2001 and $32.1 million in 2000. The cost and related accumu- lated depreciation of assets sold or disposed of are removed from the accounts and the resulting gain or loss, if any, is recognized. The estimated useful lives of property, plant and equip- ment are as follows: Buildings Machinery and equipment 10 to 40 years 3 to 10 years Intangible Assets Goodwill represents the excess of the pur- chase price of acquired companies over the fair value of net assets acquired. As a result of adopting Statement of Financial Accounting Standards (SFAS) No. 142, “Goodwill and Other Intangible Assets,” in the ﬁrst quar- ter of ﬁscal 2002 the company no longer amortizes good- will. See pro forma effects of adopting this standard under “New Accounting Standards” later in Note A. Other intangible assets are recorded at cost and are amortized on a straight-line basis over their estimated useful lives. There was no signiﬁcant amortization expense in 2002. Amortization expense was $3.8 million and $2.7 million in 2001 and 2000, respectively. Accumulated amortization was $9.6 million as of July 31, 2002 and 2001. 27 Impairment of Long-Lived Assets The company reviews the long-lived assets, including identiﬁable intangibles and associated goodwill, for impairment when events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. If impairment indicators are present and the estimated future undiscounted cash ﬂows are less than the carrying value of the assets and any related goodwill, the carrying value is reduced to the estimated fair value as measured by the undiscounted cash ﬂows. Income Taxes Deferred tax assets and liabilities are recog- nized for the expected future tax consequences attributed to differences between the ﬁnancial statement carrying amounts of existing assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are measured using the enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to reverse. Valuation allowances are recorded to reduce deferred tax assets when it is more likely than not that a tax beneﬁt will not be realized. Comprehensive Income Comprehensive income consists of net income, foreign currency translation adjustments, additional minimum pension liability and net gain or loss on cash ﬂow hedging derivatives, and is presented in the Consolidated Statements of Changes in Shareholders’ Equity. Earnings Per Share The company’s basic net earnings per share is computed by dividing net earnings by the weighted aver- age number of outstanding common shares. The company’s diluted net earnings per share is computed by dividing net earnings by the weighted average number of outstanding common shares and dilutive shares relating to stock options. The following table presents information necessary to calculate basic and diluted earnings per share: (In thousands, except per share amounts) Weighted average shares – basic Dilutive shares Weighted average shares – diluted Net earnings for basic and diluted earnings per share computation Net earnings per share – basic Net earnings per share – diluted 2002 44,158 1,556 45,714 $86,883 $ 1.97 $ 1.90 2001 2000 44,381 1,231 45,612 45,716 948 46,664 $75,548 $70,233 $ 1.70 $ 1.54 $ 1.66 $ 1.51 Treasury Stock Repurchased common stock is stated at cost and is presented as a separate reduction of shareholders’ equity. The company believes the share repurchase program is an excellent means of returning value to the shareholders. Research and Development All expenditures for research and development are charged against earnings in the year incurred. 28 Stock-Based Compensation SFAS No. 123, “Accounting for Stock-Based Compensation,” encourages, but does not require, companies to record compensation cost for stock- based employee compensation plans at fair value. The com- pany has chosen to continue to account for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related Interpretations. Accordingly, compensation cost for stock options is measured as the excess, if any, of the quoted market price of the company’s stock at the date of the grant over the amount an employee must pay to acquire the stock. Compensation cost for performance equity units is recorded based on the quoted market price of the company’s stock at the end of the period. Revenue Recognition Revenue is recognized when product is shipped and invoiced and title to the goods transfers to customers. The company records estimated discounts and rebates as a reduction of sales in the same period revenue is recognized. Shipping and handling costs are classiﬁed as a component of cost of sales. Product Warranties The company provides for estimated warranty costs and accrues for speciﬁc items at the time their existence is known and the amounts are determinable. Derivative Instruments and Hedging Activities In ﬁscal 2001, the company adopted SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended by SFAS No. 138, “Accounting for Certain Derivative Instruments and Certain Hedging Activities – an amendment of FASB Statement No. 133.” With the adoption of SFAS 133, the company recognizes all derivatives on the balance sheet at fair value. Derivatives that are not hedges are adjusted to fair value through income. If the derivative is a hedge, depending on the nature of the hedge, changes in the fair value of derivatives are either offset against the change in fair value of the hedged assets, liabilities or ﬁrm commitments through earnings or recognized in sharehold- ers’ equity through other comprehensive income until the hedged item is recognized. Gains or losses related to the ineffective portion of any hedge are recognized through earnings in the current period. The impact of the adoption of SFAS 133 was not considered material to the company. The company uses derivative instruments, primarily for- ward exchange contracts and interest rate swaps, to man- age its exposure to ﬂuctuations in foreign exchange rates and interest rates. It is the company’s policy to enter into derivative transactions only to the extent true exposures exist; the company does not enter into derivative transac- tions for speculative purposes. The company enters into derivative transactions only with highly rated counterpar- ties. These transactions may expose the company to credit risk to the extent that the instruments have a positive fair value, but the company has not experienced any material losses, nor does the company anticipate any losses. Each derivative transaction the company enters into is designated at inception as a hedge and is expected to be highly effective as the critical terms of these instruments are the same as those of the underlying risks being hedged. The company evaluates hedge effectiveness at inception and on an ongoing basis. When a derivative is no longer expected to be highly effective, hedge accounting is discon- tinued. Hedge ineffectiveness, if any, is recorded in earnings on the same line as the underlying transaction risk. The company is exposed to changes in the fair value of its ﬁxed-rate debt resulting from interest rate ﬂuctuations. To hedge this exposure, the company entered into a ﬁxed to variable interest rate swap. This interest rate swap is accounted for as a fair value hedge. The fair value of the swap is recorded net of the underlying outstanding debt. Changes in the payment of interest resulting from the interest rate swap are recorded as an offset to interest expense. Effectiveness is assessed based on changes in the fair value of the underlying debt, using incremental borrowing rates currently available on loans with similar terms and maturities. See Note D for further discussion of the interest rate swap. The company enters into forward exchange contracts to hedge forecasted transactions with its foreign subsidiaries, to reduce potential exposure related to ﬂuctuations in foreign exchange rates for anticipated intercompany trans- actions such as purchases, sales and royalty payments denominated in local currencies. Forward exchange contracts designated as cash ﬂow hedges are designed to hedge the variability of cash ﬂows associated with the underlying anticipated transactions. Changes in the value of derivatives designated as cash ﬂow hedges are recorded in other comprehensive income in shareholders’ equity until earnings are affected by the variability of the under- lying cash ﬂows. At that time, the applicable amount of gain or loss from the derivative instrument that is deferred in shareholders’ equity is reclassiﬁed to earnings and is included in other income or expense. Effectiveness is assessed based on changes in forward rates. Ineffective portions of the hedges are recorded in earnings through the same line as the underlying transaction. Unrealized gains from cash ﬂow hedges recorded in Accumulated Other Comprehensive Income as of July 31, 2002 were not material. These unrealized gains will be reclassiﬁed, as appropriate, into earnings during the next 12 months. New Accounting Standards In June 2001, the Financial Accounting Standards Board (FASB) issued SFAS No. 141, “Business Combinations,” and SFAS No. 142, “Goodwill and Other Intangible Assets.” Major provisions of these statements are as follows: all business combinations must now use the purchase method of accounting; intangible assets acquired in a business combination must be recorded separately from goodwill if they arise from contractual or other legal rights or are separable from the acquired entity and can be sold, transferred, licensed, rented or exchanged, either individually or as a part of a related contract, asset or liability; goodwill and intangible assets with indeﬁnite lives are not amortized but tested for impairment annually and whenever there is an impairment indicator; all acquired goodwill must be assigned to reporting units for purposes of impairment testing and segment reporting. The company adopted the provisions of these statements as of August 1, 2001. As required by SFAS No. 142, the company has per- formed step one of the impairment testing of goodwill for the balances as of August 1, 2001. The results of this test show that the fair market value of the reporting units that the goodwill is assigned to is higher than the book values of those reporting units resulting in no goodwill impair- ment. The company will perform impairment tests annu- ally and whenever events or circumstances occur indicating that goodwill or other intangible assets might be impaired. As of August 1, 2001, the company is no longer amortiz- ing goodwill. Goodwill amortization expense was $2.7 million and $1.9 million, net of income taxes, for the year ended July 31, 2001 and 2000, respectively. The company estimates that goodwill amortization expense would have been approximately $2.6 million, net of income taxes, for the year ended July 31, 2002. The following table presents a reconciliation of net income and earnings per share adjusted for the exclusion of goodwill, net of income taxes: (In thousands, except per share amounts) 2002 2001 2000 Reported net income $86,883 $75,548 $70,233 Add goodwill amortization, net of tax – 2,722 1,895 Adjusted net income $86,883 $78,270 $72,128 Basic earnings per share: Reported basic earnings per share $ 1.97 $ 1.70 $ 1.54 Add goodwill amortization, net of tax – .06 .04 Adjusted basic earnings per share $ 1.97 $ 1.76 $ 1.58 Diluted earnings per share: Reported diluted earnings per share $ 1.90 $ 1.66 $ 1.51 Add goodwill amortization, net of tax – .06 .04 Adjusted diluted earnings per share $ 1.90 $ 1.72 $ 1.55 29 As of July 31, 2002 and 2001, goodwill was $86.4 million and $57.5 million, respectively. In ﬁscal 2002, goodwill increased $28.1 million for the acquisition of ultraﬁlter and decreased $0.5 million for the reversal of restructuring reserves that were unused from previous acquisitions. The remaining increase of $1.3 million was due to foreign exchange translation. For the Industrial Products and Engine Products segments, goodwill as of July 31, 2002 totaled $62.6 million and $23.8 million, respectively, and as of July 31, 2001 totaled $33.4 million and $24.1 million, respectively. In June 2001, the FASB issued SFAS No. 143, “Accounting for Asset Retirement Obligations.” This statement addresses ﬁnancial accounting and reporting for obligations associated with the retirement of tangible long- lived assets and the associated asset retirement costs. SFAS No. 143 is effective for the company in ﬁscal 2003. Manage- ment does not expect this statement to have a material impact on the company’s consolidated ﬁnancial statements. In August 2001, the FASB issued SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” SFAS No. 144 establishes a single model for the impairment of long-lived assets and broadens the presentation of discontinued operations to include more disposal transactions. SFAS No. 144 is effective for the company in ﬁscal 2003. Management does not expect this statement to have a material impact on the company’s consolidated ﬁnancial statements. In June 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” SFAS No. 146 addresses signiﬁcant issues relating to the recognition, measurement and reporting of costs associated with exit and disposal activities including restructuring. SFAS No. 146 is effective for the company in ﬁscal 2003. > NOTE B Acquisitions, Plant Closures and Plant Openings Acquisitions All acquisitions were accounted for as pur- chases. The purchase price assigned to the net assets acquired was based on the fair value of such assets and lia- bilities at the respective acquisition dates. The operating results of these acquired companies have been included in the consolidated statement of earnings from the dates of acquisition with the exception of the acquisition of ultraﬁl- ter international AG, which took place immediately prior 30 to the end of ﬁscal 2002. Consolidated pro forma earnings and earnings per share would not be materially different from the reported amounts for all years presented. The company completed the purchase of all of the out- standing shares of ultraﬁlter international AG (“ultraﬁlter”) for $68.3 million in cash on July 12, 2002. Ultraﬁlter is headquartered in Haan, Germany with operations in 30 countries. Ultraﬁlter is a global leader in the design and manufacture of components, replacement parts and com- plete systems for the compressed air puriﬁcation industry. Its products include compressed air ﬁlters and a wide assortment of replacement ﬁlters, a complete offering of refrigeration and desiccant dryers and condensate manage- ment devices. The acquisition of ultraﬁlter satisﬁes the company’s diversiﬁcation strategy by expanding the com- pany’s presence in industrial markets, focuses on replace- ment parts and expands revenues outside of the United States. This acquisition in compressed air puriﬁcation builds on the acquisition of AirMaze Corporation in ﬁscal 2000 which brought the company access to the ﬁltration needs of the compressor itself and ultraﬁlter moves out of the compressor room to all of the points of use in the fac- tory. The company has completed a preliminary purchase price allocation resulting in an excess of purchase price over the fair values of the net assets acquired of $28.1 mil- lion. The company has not yet ﬁnalized the allocation of the purchase price to the assets acquired and liabilities assumed and thus it is subject to change. Ultraﬁlter’s oper- ations are a part of the company’s Industrial Products segment. Restructuring liabilities recorded in conjunction with the acquisition were approximately $1.2 million as of July 31, 2002 for costs associated with the termination and relocation of employees. The company acquired the DCE dust control business of Invensys, plc (“DCE”) for $56.4 million effective February 1, 2000. DCE, which was headquartered in Leicester, England (UK), with smaller facilities in Germany and the United States and assembly operations in South Africa, Australia and Japan, is a major participant in the global dust collection industry. The excess of purchase price over the fair values of the net assets acquired was $31.5 million and was recorded as goodwill. DCE operations are part of the company’s Industrial Products segment. The inte- gration of DCE resulted in a reduction in the work force of approximately 140 employees during ﬁscal 2001. During ﬁscal 2002, the unused balance of restructuring liabilities recorded in conjunction with the acquisition of $0.5 million of costs associated with the closure and sale of acquired facilities as well as termination and relocation of employ- ees was reversed against goodwill. Costs incurred and charged to these reserves associated with the closure and sale of acquired facilities amounted to $0.9 million for the ﬁscal year ended July 31, 2002. Costs incurred and charged to these reserves associated with the termination and relo- cation of employees amounted to $0.7 million for the ﬁscal year ended July 31, 2002. During the ﬁscal year ended July 31, 2001, costs incurred and charged to these reserves amounted to $0.8 million associated with the closure and sale of acquired facilities and $0.8 million associated with the termination and relocation of employees. Adjustments to these reserves for the ﬁscal year ended July 31, 2001 amounted to an increase of $0.9 million. The company completed the purchase of all of the outstanding shares of AirMaze Corporation (“AirMaze”) for $31.9 million in cash effective November 1, 1999. AirMaze was merged into Donaldson Company, Inc. effec- tive April 1, 2000. AirMaze products include heavy-duty air and liquid ﬁlters, air/oil separators and high purity air ﬁlter products. AirMaze manufacturing facilities are located in Stow, Ohio, and Greeneville, Tennessee. The excess of purchase price over the fair values of the net assets acquired was $27.2 million and was recorded as goodwill. AirMaze operations are a part of the company’s Engine Products segment. The integration of AirMaze resulted in a reduction in the work force of approximately 15 employees during ﬁscal 2001. During ﬁscal 2002, the unused balance of restructuring liabilities recorded in conjunction with the acquisition of $0.2 million for costs associated with the termination and relocation of employees was reversed against goodwill. There were no costs incurred and charged to this reserve for the ﬁscal year ended July 31, 2002. Costs incurred and charged to this reserve amounted to $0.3 million and adjustments to this reserve amounted to a decrease of $0.7 million for the ﬁscal year ended July 31, 2001. The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at the date of acquisition. (Thousands of dollars ) ultraﬁlter DCE AirMaze Current assets $ 42,153 $28,742 $ 9,389 Property, plant and equipment Goodwill Other non-current assets Total assets acquired Current liabilities Long-term debt Other long-term liabilities Total liabilities assumed 21,189 28,082 20,189 111,613 27,941 3,546 11,777 43,264 14,346 31,458 874 75,420 16,758 – 2,301 19,059 5,975 27,193 – 42,557 4,640 3,991 2,067 10,698 Net assets acquired $ 68,349 $56,361 $31,859 Other non-current assets include other intangible assets such as patents and trademarks and deferred tax assets. Other long-term liabilities include deferred tax liabilities and other miscellaneous long-term liabilities. Plant Closures During ﬁscal 2002, the company closed its manufacturing facility located in Old Saybrook, Connecticut. The closure of this facility was completed by the end of the ﬁscal year. A pretax charge of $0.3 million was recorded in ﬁscal 2002 in the company’s consolidated statement of earnings. This charge was primarily related to severance and other employee-related costs associated with the elimination of approximately 30 positions. Additionally, the company closed its manufacturing facility located in Guilin, China. The closure of this facility was completed by the end of the ﬁscal year. A pretax charge of $0.2 mil- lion was recorded in ﬁscal 2002 in the company’s consoli- dated statement of earnings. The charge was primarily related to severance and other employee-related costs asso- ciated with the elimination of approximately 44 positions. During ﬁscal 2001, the company closed its manufactur- ing facilities located in Mooresville, North Carolina, and Louisville, Kentucky. The closures of these facilities were completed by the end of the ﬁscal year. For the closure of the Mooresville manufacturing facility, a pretax charge of $0.7 million was recorded in ﬁscal 2001 in the company’s consolidated statements of earnings. For the closure of the Louisville manufacturing facility, costs were charged against the purchase liabilities recorded in conjunction with the acquisition of DCE. These charges were primarily related to severance and other employee-related costs asso- ciated with the elimination of approximately 130 positions in Mooresville and 80 positions in Louisville. During ﬁscal 2000, the company completed the closure of its manufacturing facility located in Oelwein, Iowa. A pretax charge of $2.8 million was recorded in ﬁscal 1999 in the company’s consolidated statements of earnings. The charge was primarily related to severance and other employee-related costs associated with the elimination of approximately 125 positions. Plant Openings During ﬁscal 2002, the company opened new manufacturing facilities both domestically and inter- nationally. Domestically, the company opened new head- quarters and a new manufacturing facility for production of its Tetratec™ PTFE technologies in Ginko Industrial Park in Northampton Township, Pennsylvania. The new facility combined and consolidated the operations from three existing facilities while doubling manufacturing capacity. 31 Internationally, the company opened a new manufacturing facility in Monterrey, Mexico. The facility was constructed to produce gas turbine products and employs approximately 130 employees. Additionally, during the year the company expanded its manufacturing facilities in Wuxi, China. The expansion included a new clean room used in the production of disk drive products and a new manufacturing facility for the production of industrial air ﬁltration products. The expan- sion of these facilities added approximately 430 employees. During ﬁscal 2000, the company opened a new manu- facturing facility in Auburn, Alabama. The facility was constructed to produce mufﬂers for the truck manufactur- ers located in the southwestern U.S. region and employs approximately 100 employees. > NOTE C Credit Facilities In December 1997, the company amended and renewed a ﬁve-year multi-currency revolving facility with a group of participating banks under which it may borrow up to $100.0 million. The agreement provides that loans may be made under a selection of currencies and rate formulas including Base Rate Advance or Eurocurrency Rate Advance. The interest rate on each advance is based on certain adjusted leverage and debt-to-capitalization ratios. Facility fees and other fees on the entire loan commitment are payable for the duration of this facility. There was $20.0 million and $50.0 million outstanding at July 31, 2002 and July 31, 2001, respectively, leaving $80.0 million and $50.0 million available for further borrowing under such facility at July 31, 2002 and July 31, 2001, respectively. The weighted average interest rate on these short-term borrowings outstanding at July 31, 2002 and 2001 was 2.00 percent and 3.99 percent, respectively. The company also has three agreements under uncom- mitted credit facilities, which provide unsecured borrowings for general corporate purposes. At July 31, 2002 and 2001, there was $45.0 million and $35.0 million available for use under these facilities, respectively. There was $15.5 million and $7.7 million outstanding under these facilities at July 31, 2002 and 2001, respectively. The weighted aver- age interest rate on these short-term borrowings outstand- ing at July 31, 2002 and 2001 was 2.05 percent and 3.98 percent, respectively. International subsidiaries may borrow under various credit facilities. As of July 31, 2002 and 2001, borrowings under these facilities were $24.8 million and $1.7 million, 32 respectively. This increase in short-term debt reﬂects bor- rowings for the acquisition of ultraﬁlter at the end of ﬁscal 2002. The weighted average interest rate on these interna- tional borrowings outstanding at July 31, 2002 and 2001 was 3.17 percent and 10.73 percent, respectively. Also, at July 31, 2002, the company had outstanding standby letters of credit totaling $14.8 million. Currently, there are no amounts drawn upon these letters of credit. > NOTE D Long-Term Debt Long-term debt consists of the following: (Thousands of dollars) 2002 2001 6.20% Unsecured senior notes due July 15, 2005, interest payable semi-annually, principal payment of $23.0 million is due July 15, 2005 6.31% Unsecured senior notes due July 15, 2008, interest payable semi-annually, principal payment of $28.6 million is due July 15, 2008 6.39% Unsecured senior notes due August 15, 2010, interest payable semi-annually, principal payments of $5.0 million, to be paid annually commencing August 16, 2006 1.9475% Guaranteed senior note due January 29, 2005, interest payable semi-annually, principal amount of 1.2 billion yen is due January 29, 2005 1.51% Guaranteed note due March 28, 2006, interest payable quarterly, principal amount of .8 billion yen is due March 28, 2006 Variable Rate Industrial Development Revenue Bonds (“Lower Floaters”) due September 1, 2024, principal amount of $8.0 million, interest payable monthly, and an interest rate of 1.6% as of July 31, 2002 Capitalized lease obligations, with maturity dates of March 31, 2009 and February 2, 2012 resulting from the ultraﬁlter acquisition. Capital lease obligations have principal amounts of $2.9 million and $0.6 million with interest rates of 6.02% and 6.51%, respectively Other Total Less current maturities $ 23,000 $23,000 28,640 27,157 25,000 25,000 9,996 9,592 6,664 6,395 8,000 8,000 3,546 230 105,076 57 – 138 99,282 23 Total long-term debt $105,019 $99,259 Annual maturities of long-term debt for 2003 and 2004 are not signiﬁcant and are $33.0 million in 2005, $6.7 million in 2006 and $5.0 million in 2007. The company estimates that the carrying value of long-term debt approximates its fair market value. On June 6, 2001, the company entered into an interest rate swap agreement effectively converting a portion of the company’s interest rate exposure from a ﬁxed rate to a vari- able rate basis. The interest rate swap agreement has an The funded status of the company’s pension plans as of April 30, 2002 and April 30, 2001, is as follows: (Thousands of dollars) Change in beneﬁt obligation: 2002 2001 Beneﬁt obligation, beginning of year $150,101 $137,056 Addition of non-U.S. plans Service cost Interest cost Participant contributions Plan amendments Actuarial (gain)/loss Currency exchange rates Beneﬁts paid 16,786 10,351 11,850 580 1,433 2,553 (203) (10,673) 16,589 6,936 11,626 125 174 (10,012) (2,022) (10,371) Beneﬁt obligation, end of year $182,778 $150,101 Change in plan assets: Fair value of plan assets, beginning of year $143,201 $146,210 Addition of non-U.S. plans Actual return on plan assets Company contributions Participant contributions Currency exchange rates Beneﬁts paid 15,613 10,300 14,791 580 41 7,857 (10,978) 11,250 125 (892) (10,673) (10,371) Fair value of plan assets, end of year $173,853 $143,201 Reconciliation of funded status: Funded (unfunded) status $ (8,925) $ (6,900) Unrecognized actuarial (gain) loss Unrecognized prior service cost Unrecognized net transition obligation Fourth quarter contributions Net amount recognized in consolidated balance sheet Amounts recognized in consolidated balance sheet consist of: Prepaid beneﬁt cost Accrued beneﬁt liability Additional minimum liability Intangible asset Accumulated other comprehensive income Net amount recognized in consolidated 10,342 3,802 3,527 416 2,322 2,527 3,792 1,891 $ 9,162 $ 3,632 $ 17,586 $ 9,853 (8,423) (11,399) 7,801 3,597 (6,220) (5,126) 4,784 341 balance sheet $ 9,162 $ 3,632 aggregate notional amount of $27.0 million maturing on July 15, 2008. The variable rate is based on the current six-month London Interbank Offered Rates (“LIBOR”). This transaction resulted in a decrease to interest expense of $1.2 million for the year ended July 31, 2002. As of July 31, 2002, the fair market value of the interest rate swap was $1.6 million. Total interest paid relating to all debt was $6.1 million, $11.1 million and $9.1 million in 2002, 2001 and 2000, respectively. In addition, total interest expense recorded in 2002, 2001 and 2000 was $6.5 million, $11.6 million and $9.9 million, respectively. Certain note agreements contain debt covenants related to working capital levels and limita- tions on indebtedness. Further, the company is restricted from paying dividends or repurchasing common stock if its tangible net worth (as deﬁned) does not exceed certain minimum levels. As of July 31, 2002, the company was in compliance with all such covenants. > NOTE E Employee Beneﬁt Plans Pension Plans Donaldson Company, Inc. and certain of its subsidiaries have deﬁned beneﬁt pension plans for substan- tially all hourly and salaried employees. The domestic plan provides deﬁned beneﬁts pursuant to a cash balance feature whereby a participant accumulates a beneﬁt comprised of a percentage of current salary which varies with years of service, interest credits and transition credits. The interna- tional plans generally provide pension beneﬁts based on years of service and compensation level. The company’s general funding policy is to make contributions as required by applicable regulations. The assets are primarily invested in diversiﬁed equity and debt portfolios. In 2000, the actu- arial valuation date was changed from July 31 to April 30. This change did not have a material impact on the actuar- ial valuation. Costs for the company’s pension plans include the following components: (Thousands of dollars) Net periodic cost: Service cost Interest cost Expected return on assets Transition amount amortization Prior service cost amortization Actuarial (gain) loss amortization 2002 2001 2000 $ 10,351 $ 6,935 $ 6,084 11,850 (14,415) 11,626 9,852 (12,862) (11,475) 75 158 (77) 173 119 (829) (1,097) 64 71 Net periodic beneﬁt cost $ 7,942 $ 5,162 $ 3,499 33 The projected beneﬁt obligation, accumulated beneﬁt obligation and fair value of plan assets for pension plans with accumulated beneﬁt obligations in excess of plan assets were $47.3 million, $45.3 million and $31.7 million, respectively, as of April 30, 2002 and $20.9 million, $17.1 million and $5.8 million, respectively, as of April 30, 2001. Weighted average actuarial assumptions April 30, 2002 April 30, 2001 July 31, 2000 All U.S. plans: Discount rate Expected return on plan assets Rate of compensation increase Non-U.S. plans: Discount rate Expected return on plan assets Rate of compensation increase 7.25% 8.50% 5.00% 4.59% 6.63% 3.39% 7.50% 9.00% 5.50% 2.50% 4.00% 2.00% 8.00% 9.00% 6.00% N/A N/A N/A The expected return on plan assets is used in the devel- opment of the net periodic beneﬁt cost for the ﬁscal year ending in the year shown. Pension expense related to international plans was $4.1 million, $4.3 million and $2.5 million for 2002, 2001 and 2000, respectively. 401(k) Savings Plan The company provides a contributory employee savings plan to domestic employees which permits participants to make contributions by salary reduction pursuant to section 401(k) of the Internal Revenue Code. The company’s contributions under this plan are based on the level of employee contributions including a discretionary contribution based on performance of the company. Total contribution expense was $6.8 million, $4.1 million and $4.2 million for the years ended July 31, 2002, 2001 and 2000, respectively. > NOTE F Shareholders’ Equity Stock Rights On January 12, 1996, the Board of Directors of the company approved the extension of the beneﬁts afforded by the company’s existing rights plan by adopting a new shareholder rights plan. Pursuant to the new Rights Agreement, dated as of January 12, 1996, by and between the company and Wells Fargo Bank Minnesota, N.A., as Rights Agent, one right was issued on March 4, 1996 for each outstanding share of common stock of the company upon the expiration of the company’s existing rights. Each of the new rights entitles the registered holder to purchase 34 from the company one one-thousandth of a share of Series A Junior Participating Preferred Stock, without par value, at a price of $130.00 per one one-thousandth of a share. The rights, however, will not become exercisable unless and until, among other things, any person acquires 15 per- cent or more of the outstanding common stock of the company. If a person acquires 15 percent or more of the outstanding common stock of the company (subject to cer- tain conditions and exceptions more fully described in the Rights Agreement), each right will entitle the holder (other than the person who acquired 15 percent or more of the outstanding common stock) to purchase common stock of the company having a market value equal to twice the exercise price of a right. The rights are redeemable under certain circumstances at $.01 per right and will expire, unless earlier redeemed, on March 3, 2006. Employee Incentive Plans In November 2001, shareholders approved the 2001 Master Stock Incentive Plan (the “Plan”) which replaced the 1991 Plan that expired on December 31, 2001 and provided for similar awards. The Plan extends through December 2011 and allows for the granting of nonqualiﬁed stock options, incentive stock options, restricted stock, stock appreciation rights (SARs), dividend equivalents, dollar-denominated awards and other stock-based awards. The Plan allows for the granting of performance awards to a limited number of key execu- tives. The awards are payable in common stock and are based on a formula which measures performance of the company over a three-year period. Performance award expense under the 1991 Plan totaled $2.6 million, $2.4 million and $1.7 million in 2002, 2001 and 2000, respec- tively. Options under the Plan are granted to key employ- ees at or above market price at the date of grant. Options are exercisable for up to 10 years from the date of grant. Stock Options Stock options issued after ﬁscal 1998 become exercisable for non-executives in each of the following three years, in an equal number of shares each year and become exercisable for executives immediately upon the date of grant. Stock options issued during ﬁscal 1997 and 1998 become exercisable in each of the following three years, in an equal number of shares each year, for both executives and non-executives. Stock options issued prior to ﬁscal l997 for non-executives and during ﬁscal 1996 for executives become exercisable in a four-year period in an equal number of shares each year. Prior to ﬁscal 1996, stock options vested immediately for executives. In ﬁscal 1997, the company adopted the disclosure-only provisions of SFAS No. 123, “Accounting for Stock-Based Compensation.” SFAS No. 123 encourages entities to adopt a fair value-based method of accounting for employee stock compensation plans, but allows companies to continue to account for those plans using the account- ing prescribed by APB Opinion 25, “Accounting for Stock Issued to Employees.” The company has elected to continue to account for stock-based compensation using APB 25, making pro forma disclosures of net earnings and earnings per share as if the fair value-based method had been applied. Accordingly, no compensation expense has been recorded for the stock option plan. Had compensation expense for the stock option plan been determined under SFAS No. 123 in ﬁscal 2002, 2001 and 2000, the company’s net income and diluted earnings per share would have been approximately $83.0 million and $1.82, $71.0 million and $1.56, and $67.7 million and $1.45, respectively. For purposes of computing compensation cost of stock options granted, the fair value of each stock option grant was estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions: risk free interest rate of 2.85 percent, 4.72 percent and 6.5 percent in 2002, 2001 and 2000, respec- tively; two, three, six, or seven year lives in 2002, and two or seven year lives in 2001 and 2000; expected volatility of 30.9 percent, 30.5 percent and 29.7 percent in 2002, 2001 and 2000, respectively; and 1.0 percent expected dividend yield in 2002, 2001 and 2000. Black-Scholes is a widely accepted stock option pricing model; however, the ultimate value of stock options granted will be determined by the actual lives of options granted and the actual future price levels of the company’s common stock. The weighted average fair value for options granted during ﬁscal 2002, 2001 and 2000 is $9.56, $8.01 and $7.49 per share, respectively. The number and option price of options granted were as follows: Outstanding at July 31, 1999 Granted Exercised Canceled Outstanding at July 31, 2000 Granted Exercised Canceled Outstanding at July 31, 2001 Granted Exercised Canceled Options Weighted Average Outstanding Exercise Price 3,382,322 $14.50 489,086 (204,004) (14,468) 3,652,936 862,515 (1,025,995) (25,297) 3,464,159 633,968 (603,551) (23,661) 23.01 10.09 20.41 15.86 26.04 12.88 21.19 19.24 36.12 15.11 26.60 Outstanding at July 31, 2002 3,470,915 $22.99 At July 31, 2002, 2001 and 2000, there were 2,955,018, 2,954,542 and 3,109,926 options exercisable, respectively. Shares reserved at July 31, 2002 for outstand- ing options and future grants were 4,235,652. Shares reserved consist of shares available for grant plus all out- standing options. An amount is added to shares reserved each year based on criteria set in the plan. The following table summarizes information concerning currently outstanding and exercisable options: Weighted Average Remaining Number Contractual Weighted Average Exercise Number Outstanding Life (Years) Price Exercisable Weighted Average Exercise Price Range of Exercise Prices $5 to $15 713,622 $15 to $25 1,471,224 $25 to $35 695,169 $35 and above 590,900 3,470,915 1.82 5.87 7.34 8.99 5.86 $11.98 713,622 $11.98 21.05 26.81 36.60 1,392,809 516,887 331,700 20.94 27.11 36.77 $22.99 2,955,018 $21.63 > NOTE G Income Taxes The components of earnings before income taxes are as follows: (Thousands of dollars) 2002 2001 2000 Earnings before income taxes: United States Foreign Total $ 62,294 $ 48,705 $ 54,913 56,724 56,223 45,420 $119,018 $104,928 $100,333 The components of the provision for income taxes are as follows: (Thousands of dollars) 2002 2001 2000 Income taxes: Current: Federal State Foreign Deferred: Federal State Foreign $21,146 $ 8,502 $18,192 1,900 14,355 37,401 (5,033) (287) 54 (5,266) 622 13,163 22,287 7,304 417 (628) 7,093 2,361 9,996 30,549 52 3 (504) (449) Total $32,135 $29,380 $30,100 35 The tax effects of temporary differences that give rise to deferred tax assets and liabilities are as follows: > NOTE H Segment Reporting (Thousands of dollars) Deferred tax assets: Compensation and retirement plans Accrued expenses NOL carryforwards Inventories Investment in joint venture Cumulative translation adjustment Other Gross deferred tax assets Valuation allowance Net deferred tax assets Deferred tax liabilities: Depreciation and amortization Other Gross deferred tax liabilities 2002 2001 2000 $ 9,226 $ 3,619 $ 12,839 7,658 6,346 1,967 777 – 6,094 32,068 (2,158) 29,910 (15,698) (9,171) (24,869) 6,938 6,092 1,938 636 – 3,215 22,438 (2,054) 20,384 7,818 8,174 1,526 754 4,574 3,162 38,847 (4,499) 34,348 (16,209) (14,626) (618) (903) (16,827) (15,529) Net deferred tax assets $ 5,041 $ 3,557 $ 18,819 The following table reconciles the U.S. statutory income tax rate with the effective income tax rate: Statutory U.S. federal rate State income taxes Foreign taxes at lower rates Other 2002 35.0% 1.0 (4.6) (4.4) 2001 35.0% 0.4 (8.2) 0.8 2000 35.0% 1.5 (6.1) (0.4) 27.0% 28.0% 30.0% U.S. income taxes have not been provided on approx- imately $187.0 million of undistributed earnings of non-U.S. subsidiaries. The company plans to reinvest these undis- tributed earnings. If any portion were to be distributed, the related U.S. tax liability may be reduced by foreign income taxes paid on those earnings plus any available foreign tax credit carryovers. Determination of the unrecognized deferred tax liability related to these undistributed earnings is not practicable. While non-U.S. operations have been proﬁtable overall, cumulative tax losses of $20.0 million are carried as net oper- ating losses in certain international subsidiaries. These losses can be carried forward to offset future taxable income. The majority of such carryforwards expire after 2003. Due to the uncertainty of being able to realize certain of these losses, a valuation allowance of $2.1 million has been recorded at July 31, 2002. The company made cash payments for income taxes of $23.7 million, $16.2 million and $24.6 million in 2002, 2001 and 2000, respectively. 36 Consistent with SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” the company has identiﬁed two reportable segments: Engine Products and Industrial Products. Segment selection was based on the internal organizational structure, management of operations and performance evaluation by management and the company’s Board of Directors. The Engine Products segment sells to original equip- ment manufacturers (OEMs) in the construction, industrial, mining, agriculture and transportation markets and to independent distributors, OEM dealer networks, private label accounts and large private ﬂeets. Products include air intake systems, exhaust systems, liquid ﬁltration systems and replacement ﬁlters. The Industrial Products segment sells to various indus- trial end-users, OEMs of gas-ﬁred turbines, OEMs and end-users requiring highly puriﬁed air. Products include dust, fume and mist collectors, compressed air puriﬁcation systems, static and pulse-clean air ﬁlter systems and specialized air ﬁltration systems for diverse applications including computer disk drives. Corporate and Unallocated include corporate expenses determined to be non-allocable to the segments, interest income and expense, non-operating income and expense, and expenses not allocated to the business segments in the same period. Assets included in Corporate and Unallocated principally are cash and cash equivalents, inventory reserves, certain prepaids, certain investments, other assets and assets allocated to intercompany transactions. The company has developed an internal measurement system to evaluate performance and allocate resources based on proﬁt or loss from operations before income taxes. The company’s manufacturing facilities serve both reporting segments. Therefore, the company uses a complex allocation methodology to assign costs and assets to the segments. A certain amount of costs and assets is assigned to intercompany activity and is not assigned to either seg- ment. Certain accounting policies applied to the reportable segments differ from those described in the summary of signiﬁcant accounting policies. The reportable segments account for receivables on a gross basis and account for inventory on a standard cost basis. Segment allocated assets are primarily accounts receiv- able, inventories, property, plant and equipment and goodwill. Reconciling items included in Corporate and Unallocated are created based on accounting differences between segment reporting and the consolidated, external reporting as well as internal allocation methodologies. Segment detail is summarized as follows (in thousands): Following are net sales by product within the Engine 2002 Net sales Depreciation and amortization Equity earnings in unconsolidated afﬁliates Earnings before income taxes Assets Equity investments in unconsolidated afﬁliates Capital expenditures, net of acquired businesses 2001 Net sales Depreciation and amortization Equity earnings in unconsolidated afﬁliates Earnings before income taxes Assets Equity investments in unconsolidated afﬁliates Capital expenditures, net of acquired businesses 2000 Net sales Depreciation and amortization Equity earnings in unconsolidated afﬁliates Earnings before income taxes Assets Equity investments in unconsolidated afﬁliates Capital expenditures, net of acquired businesses Engine Products Industrial Corporate & Total Products Unallocated Company Products segment and Industrial Products segment: (In thousands) 2002 2001 2000 $611,647 $514,358 $ – $1,126,005 Off-road products $ 185,607 $ 181,795 $ 193,229 Engine Products segment: 16,095 9,427 6,229 31,751 4,160 – – 4,160 69,894 324,952 73,047 381,467 (23,923) 143,712 119,018 850,131 14,033 – – 14,033 20,544 12,033 7,952 40,529 $606,810 $530,205 $ – $1,137,015 23,100 11,268 4,209 38,577 3,017 – – 3,017 49,539 315,706 72,891 228,505 (17,502) 162,619 104,928 706,830 14,115 – – 14,115 23,308 11,370 4,246 38,924 $673,982 $418,312 $ – $1,092,294 20,959 8,509 4,858 34,326 4,392 – – 4,392 57,453 320,805 53,862 172,837 (10,982) 183,883 100,333 677,525 13,600 – – 13,600 22,236 9,028 5,153 36,417 Transportation products Aftermarket products Total Engine Products segment Industrial Products segment: 91,244 334,796 79,670 345,345 151,950 328,803 611,647 606,810 673,982 Industrial air ﬁltration products Gas turbine products Special application products Total Industrial Products segment 175,663 230,897 107,798 217,343 195,042 117,820 193,119 117,038 108,155 514,358 530,205 418,312 Total company $1,126,005 $1,137,015 $1,092,294 Geographic sales by origination and property, plant and equipment (in thousands): 2002 United States Europe Asia-Paciﬁc Other Total 2001 United States Europe Asia-Paciﬁc Other Total 2000 United States Europe Asia-Paciﬁc Other Total Property, Plant & Net Sales Equipment – Net $ 687,889 $139,975 225,669 184,269 28,178 40,013 21,652 39,273 $1,126,005 $240,913 $ 711,268 $138,631 211,397 185,395 28,955 36,801 19,609 12,617 $1,137,015 $207,658 $ 688,899 $135,480 206,429 166,221 30,745 37,698 22,304 9,063 $1,092,294 $204,545 Sales to one customer accounted for 13 percent and 12 percent of net sales in 2002 and 2001, respectively. There were no sales over 10 percent of net sales to any customer in 2000. One customer accounted for 18 percent and 21 percent of gross accounts receivable in 2002 and 2001, respectively. 37 > NOTE I > NOTE J Quarterly Financial Information (Unaudited) Commitments and Contingencies The company is involved in litigation arising in the ordi- nary course of business. In the opinion of management, the outcome of litigation currently pending will not materially affect the company’s results of operations, ﬁnancial condition or liquidity. (Thousands of dollars, except per share amounts) First Quarter Second Quarter Third Quarter Fourth Quarter 2002 Net sales Gross margin Net earnings Diluted earnings per share Dividends declared per share 2001 Net sales Gross margin Net earnings Diluted earnings per share Dividends declared per share $288,429 $264,281 $269,423 $303,872 88,318 19,724 .43 .075 81,274 20,760 .45 .080 84,976 21,474 .47 .080 94,924 24,925 .55 .085 $289,869 $279,631 $269,721 $297,794 85,956 16,804 .37 .075 86,316 18,105 .40 .075 79,180 17,826 .39 .075 90,282 22,813 .50 .075 SIX-YEAR QUARTERLY HIGH-LOW STOCK PRICES (Unaudited) High Low 14.63 17.00 18.31 20.38 12.69 14.31 15.38 17.75 27.19 25.69 26.19 25.13 20.31 22.25 22.63 18.56 21.94 21.00 23.50 25.88 14.44 17.69 17.25 21.94 23.50 19.50 24.81 24.06 24.25 20.63 20.25 19.13 23.86 29.48 28.92 33.05 19.13 21.62 24.39 27.30 32.80 40.35 44.99 43.12 26.93 32.35 34.10 30.03 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1997 1998 1999 2000 2001 2002 38 REPORT OF INDEPENDENT ACCOUNTANTS To the Shareholders and Board of Directors of Donaldson Company, Inc. In our opinion, the accompanying consolidated balance sheet and the related consolidated statements of earnings, changes in shareholders’ equity and cash ﬂows present fairly, in all material respects, the consolidated ﬁnancial position of Donaldson Company Inc. as of July 31, 2002, and the consolidated results of its operations and its cash ﬂow for the period ended July 31, 2002, in conformity with accounting principles generally accepted in the United States of America. These ﬁnancial statements are the responsibility of Donaldson Company Inc.’s manage- ment; our responsibility is to express an opinion on these ﬁnancial statements based on our audit. We conducted our audit of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the ﬁnancial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the ﬁnancial statements, assessing the accounting principles used and signiﬁcant estimates made by management, and evaluating the overall ﬁnancial statement presentation. We believe that our audit provides a reasonable basis for our opinion. The ﬁnancial statements of Donaldson Company Inc. as of July 31, 2001, and for the two years in the period then ended, were audited by other independent accountants who have ceased operations. Those independent accountants expressed an unqualiﬁed opinion on those ﬁnancial state- ments in their report dated August 27, 2001. PricewaterhouseCoopers LLP August 21, 2002 The following report is a copy of a report previously issued by Arthur Andersen LLP. This report relates to prior years’ ﬁnancial statements. This report has not been reissued by Arthur Andersen LLP. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Shareholders and Board of Directors of Donaldson Company, Inc. We have audited the accompanying consolidated balance sheets of Donaldson Company, Inc. (a Delaware corpora- tion) and subsidiaries as of July 31, 2001 and 2000, and the related consolidated statements of earnings, changes in shareholders’ equity and cash ﬂows for the years then ended. These ﬁnancial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these ﬁnancial statements based on our audits. The consolidated ﬁnancial statements of Donaldson Company, Inc. and subsidiaries as of July 31, 1999, were audited by other auditors whose report dated September 8, 1999, expressed an unqualiﬁed opinion on those statements. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the ﬁnancial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the ﬁnancial statements. An audit also includes assessing the accounting principles used and signiﬁcant estimates made by management, as well as evaluating the overall ﬁnancial statement presenta- tion. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the ﬁnancial statements referred to above present fairly, in all material respects, the ﬁnancial position of Donaldson Company, Inc. and subsidiaries as of July 31, 2001 and 2000, and the results of their oper- ations and their cash ﬂows for the years then ended, in conformity with accounting principles generally accepted in the United States. Minneapolis, Minnesota, August 27, 2001 39 CORPORATE AND SHAREHOLDER INFORMATION NYSE Listing 10-K Reports Dividend Reinvestment Plan The common shares of Donaldson Company, Inc. are traded on the New York Stock Exchange, under the symbol DCI. Shareholder Information For any concerns relating to your current or prospective shareholdings, please contact Shareowner Services at (800)468-9716 or (651)450-4064. Annual Meeting The annual meeting of shareholders will be held at 10 a.m. on Friday, November 15, 2002, at Donaldson Company, Inc., 1400 West 94th Street, Bloomington, Minnesota. You are welcome to attend. Copies of the Report 10-K, ﬁled with the Securities and Exchange Commission, are available on request from Shareholder Services, Donaldson Company, Inc., M.S. 101, P.O. Box 1299, Minneapolis, MN 55440. Auditors PricewaterhouseCoopers LLP Minneapolis, Minnesota Public Relations Counsel Padilla Speer Beardsley Inc. Minneapolis, Minnesota Transfer Agent and Registrar Wells Fargo Bank Minnesota, N.A. South St. Paul, Minnesota As of September 20, 2002, 1,130 of Donaldson Company’s approximately 1,871 shareholders of record were par- ticipating in the Dividend Reinvestment Plan. Under the plan, shareholders can invest Donaldson Company dividends in additional shares of company stock. They may also make periodic voluntary cash investments for the purchase of company stock. Both alternatives are provided with- out service charges or brokerage com- missions. Shareholders may obtain a brochure giving further details by writ- ing Wells Fargo Bank Minnesota, N.A., Shareowner Services, P.O. Box 64854, St. Paul, MN 55164-0854. BOARD OF DIRECTORS F. Guillaume Bastiaens, 59, Vice Chairman, Cargill, Inc., Minneapolis (Agribusiness). Director since 1995. (2) (3) John F. Grundhofer, 63, Chairman, U.S. Bancorp, Minneapolis (Financial Services). Director since 1997. (1) (3) Paul B. Burke, 46, Retired Chairman, President and Chief Executive Ofﬁcer, BMC Industries, Inc., Minneapolis (Manufacturing). Director since 1996. (1) (3) Janet M. Dolan, 53, President and Chief Executive Ofﬁcer, Tennant Company, Minneapolis (Manufacturing). Director since 1996. (2) (3) Jack W. Eugster, 57, Non-Executive Chairman, ShopKo Stores, Inc., Green Bay, WI (Specialty Discount Retailer). Director since 1993. (1) (3) Kendrick B. Melrose, 62, Chairman and Chief Executive Ofﬁcer, The Toro Company, Minneapolis (Manufacturing). Director since 1991. (1) (2) Paul David Miller, 60, Chairman and Chief Executive Ofﬁcer, Alliant Techsystems Inc., Minneapolis (Defense). Director since 2001. (3) Jeffrey Noddle, 56, Chairman, President and Chief Executive Ofﬁcer, SUPERVALU INC., Minneapolis (Food Retailer and Distributor). Director since 2000. (1) (2) 40 S. Walter Richey, 66, Retired Chairman, President and Chief Executive Ofﬁcer, Meritex, Inc., Minneapolis (Distribution Services). Director since 1991. (2) (3) Stephen W. Sanger, 56, Chairman and Chief Executive Ofﬁcer, General Mills, Inc., Minneapolis (Consumer Products). Director since 1992. (1) (2) William G. Van Dyke, 57, Chairman, President and Chief Executive Ofﬁcer, Donaldson Company, Inc. Director since 1994. (1) Human Resources Committee (2) Audit Committee (3) Corporate Governance Committee CORPORATE OFFICERS William G. Van Dyke, 57, Chairman, President and Chief Executive Ofﬁcer. 30 years service. William M. Cook, 49, Senior Vice President, International and Chief Financial Ofﬁcer. 22 years service. James R. Giertz, 45, Senior Vice President, Commercial and Industrial. 9 years service. Nickolas Priadka, 56, Senior Vice President, Engine Systems and Parts. 33 years service. Lowell F. Schwab, 54, Senior Vice President, Operations. 23 years service. Dale M. Couch, 59, Vice President and General Manager, Asia Paciﬁc. 5 years service. Norman C. Linnell, 43, Vice President, General Counsel and Secretary. 7 years service. John E. Thames, 52, Vice President, Human Resources. 14 years service. Geert Henk Touw, 57, Vice President and General Manager, Europe/Africa/Middle East. 17 years service. Thomas A. Windfeldt, 53, Vice President, Controller. 22 years service. W. Cook J. Giertz L. Schwab W. Van Dyke N. Priadka T. Windfeldt G. Touw D. Couch J. Thames N. Linnell WORLDWIDE OPERATIONS World Headquarters Donaldson Company, Inc. 1400 West 94th Street Minneapolis, Minnesota U.S.A. U.S. Plants Auburn, Alabama Norcross, Georgia Dixon, Illinois Frankfort, Indiana Cresco, Iowa Grinnell, Iowa Nicholasville, Kentucky Port Huron, Michigan Chillicothe, Missouri Stow, Ohio Philadelphia, Pennsylvania Greeneville, Tennessee Baldwin, Wisconsin Stevens Point, Wisconsin Distribution Centers Ontario, California Rensselaer, Indiana Antwerp, Belgium Singapore Joint Ventures Advanced Filtration Systems Inc. Champaign, Illinois MSCA, LLC Monticello, Indiana PT Panata Jaya Mandiri Jakarta, Indonesia Rashed Al-Rashed & Sons – Donaldson Company Limited Dammam, Saudi Arabia TM(cid:31) Mailing Address: P.O. Box 1299 Minneapolis, Minnesota 55440 U.S.A (952) 887-3131 www.donaldson.com Subsidiaries Donaldson Australasia Pty. Limited Wyong, Australia Donaldson Filtration Industrial S. de R.L. de C.V. Monterrey, Mexico Donaldson Sales, Inc. Barbados Donaldson Coordination Center, B.V.B.A. Leuven, Belgium Donaldson Europe, B.V.B.A. Leuven, Belgium Brugge, Belgium (plant) Donaldson Czech Republic s.r.o. Prague, Czech Republic Donaldson Scandinavia APS Horsholm, Denmark Donaldson France, S.A.S. Bron, France Tecnov Donaldson, S.A.S. Domjean, France Donaldson Gesellschaft m.b.H. Torit DCE G.m.b.H Dülmen, Germany ultraﬁlter international, AG and subsidiaries Haan, Germany Donaldson India Filter Systems Pvt. Ltd. New Delhi, India PT Donaldson Systems Indonesia Jakarta, Indonesia Donaldson Italia s.r.l. Ostiglia, Italy Nippon Donaldson Limited Tokyo, Japan Donaldson Luxembourg S.a.r.l. Luxembourg Donaldson, S.A. de C.V. Aguascalientes, Mexico Diemo S.A. de C.V. Guadalajara, Mexico Donaldson Torit, B.V. Donaldson Nederland B.V. Krommenie, Netherlands Donaldson Far East Limited Hong Kong, S.A.R., People’s Republic of China Donaldson (Wuxi) Filters Co., Ltd. Wuxi, People’s Republic of China Donaldson Polska Sp. z.o.o. Warsaw, Poland Donaldson Filtration (Asia Paciﬁc) Pte. Ltd. Singapore Donaldson Filtration Systems (Proprietary) Ltd. Cape Town, South Africa Donaldson Korea Co., Ltd. Seoul, South Korea Donaldson Ibérica, Soluciones en Filtracion, S.L. Barcelona, Spain Donaldson Filtros Iberica S.L. Madrid, Spain Donaldson Schweiz G.m.b.H. Aarau, Switzerland Donaldson Filter Components Limited Hull, United Kingdom DCE Donaldson Ltd. Leicester, United Kingdom Tetratec Europe Limited Wigan, United Kingdom Donaldson Capital, Inc. Minneapolis, Minnesota

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