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Annual Report on Form 10-K
 
Donaldson Company, Inc.
 
JULY 31, 2004

DONALDSON COMPANY, INC.
 
ANNUAL REPORT ON FORM 10-K
 
TABLE OF CONTENTS

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

Form 10-K

Commission File Number: 1-7891

DONALDSON COMPANY, INC.
(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code (952) 887-3131

Securities Registered Pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act:  NONE

        Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes    X    No       

        Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  [  ]

        Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).
Yes    X    No       

        As of January 30, 2004, the last business day of the registrant’s most recently completed second fiscal quarter, the aggregate market value of voting and non-voting stock held by non-affiliates of the registrant was $2,296,371,347 (based on the closing price of $27.01 (adjusted for the two-for-one stock split effected in the form of a 100 percent dividend distributed on March 19, 2004) as reported on the New York Stock Exchange as of that date).

        As of September 28, 2004, there were approximately 83,323,984 shares of the registrants common stock outstanding.

Documents Incorporated by Reference

        Portions of (1) the Company’s Annual Report to Shareholders for the fiscal year ended July 31, 2004 are incorporated in Item 6 of Part II, and (2) the Proxy Statement for the 2004 annual shareholders meeting are incorporated by reference in Part III, as specifically set forth in Part III.

PART I

Item 1.  BUSINESS

GENERAL

        Donaldson Company, Inc. (“Donaldson” or the “Company”) was founded in 1915 and organized in its present corporate form under the laws of the State of Delaware in 1936.

        The Company is a 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 thirty plants around the world and through three joint ventures. The Company has two reporting segments engaged in the design, manufacture and sale of systems to filter air and liquid and other complementary products. The two segments are Engine Products and Industrial Products. Products in the Engine Products segment consist of air intake systems, exhaust systems, liquid filtration systems and replacement parts. The Engine Products segment sells to original equipment 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 in the Industrial Products segment consist of dust, fume and mist collectors; compressed air purification systems; liquid filters and parts; static and pulse-clean air filter systems for industrial gas turbines; computer disk drive filter products; other specialized air filtration systems and PTFE membrane and laminates. The Industrial Products segment sells to various industrial end-users, OEMs of gas-fired turbines and OEMs and end-users requiring highly purified air.

        The table below shows the percentage of total net sales contributed by the principal classes of similar products for each of the last three fiscal years:

        Financial information about segment operations appears in Note K in the Notes to Consolidated Financial Statements on page 48.

        The Company makes its annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K available free of charge through its website, at www.donaldson.com, as soon as reasonably practicable after it electronically files such material with (or furnishes such material to) the Securities and Exchange Commission. Also available on the Company’s website are various corporate governance documents, including the Company’s code of business conduct and ethics, corporate governance guidelines, Audit Committee charter, Human Resources Committee charter, and Corporate Governance Committee charter. These documents are available in print free of charge to any shareholder who requests them. The information contained on the Company’s website is not incorporated by reference into this Annual Report on Form 10-K and should not be considered to be part of this Form 10-K.

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COMPETITION

        The Company’s business is not considered to be seasonal. Principal methods of competition in both the Engine Products and Industrial Products segments are price, geographic coverage, service and product performance. The Company competes in a number of filtration markets in both the Engine Products and Industrial segments and both segments operate in a highly competitive environment. The Company believes it is a market leader in its primary product lines within the Industrial Products segment. The Industrial Products segment’s principal competitors vary from country to country and include several large regional or global competitors and a significant number of small competitors who compete in a limited geographical region or in a limited number of product applications. The Company believes within the Engine Products segment it is a market leader in its off-road equipment and truck product lines and is a significant participant in the aftermarket for replacement filters and hard parts in its engine-related businesses. The Engine Products segment principal competitors vary from country to country and include several large regional or global competitors, and small local and regional competitors, especially in the engine aftermarket businesses.

RAW MATERIALS

        Although the Company experienced an increase in steel prices during the year, the Company responded by recovering a portion of these price increases from customers and will continue these recovery efforts in the next fiscal year. The Company experienced no other significant or unusual problems in the purchase of raw materials or commodities. The Company has more than one source of raw materials essential to its business. The Company is not required to carry significant amounts of inventory to meet rapid delivery demands or secure supplier allotments. However, the Company does stock limited amounts of inventory in order to meet anticipated customer demand.

PATENTS AND TRADEMARKS

        The Company owns various patents and trademarks, which it considers in the aggregate to constitute a valuable asset. However, it does not regard the validity of any one patent or trademark as being of material importance.

MAJOR CUSTOMERS

        Concentrations Sales to one customer accounted for 10 percent and 13 percent of net sales in 2004 and 2002, respectively. There were no sales over 10 percent of net sales to any customer in 2003. There were no customers over 10 percent of gross accounts receivable in 2004 and 2003.

        Sales to Caterpillar Inc. and subsidiaries (“Caterpillar”) accounted for 10 percent of net sales in 2004. There were no sales over 10 percent of net sales to any customer in 2003. Sales to General Electric Company and subsidiaries (“GE”) accounted for 13 percent of net sales in 2002. Caterpillar has been a customer of the Company for many years and it purchases several models and types of products from the Engine Products segment for a variety of applications. GE has been a customer of the Company for many years and it purchases several models and types of products from the Industrial Products segment for a variety of applications, the majority of which are for use on their gas turbine systems. Sales to the U.S. Government do not constitute a material portion of the Company’s business.

BACKLOG

        At August 31, 2004, the backlog of orders expected to be delivered within 90 days was $216,428,000. The 90 day backlog at August 31, 2003 was $188,507,000.

RESEARCH AND DEVELOPMENT

        During 2004, the Company spent $35,374,000 on research and development activities relating to the development of new products or improvements of existing products or manufacturing processes. The

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Company spent $30,456,000 in 2003 and $28,150,000 in 2002 on research and development activities. Essentially all commercial research and development is Company-sponsored.

ENVIRONMENTAL MATTERS

        The Company does not anticipate any material effect on its capital expenditures, earnings or competitive position due to compliance with government regulations involving environmental matters.

EMPLOYEES

        The Company employed approximately 10,400 persons in worldwide operations as of August 31, 2004.

GEOGRAPHIC AREAS

        Financial information about geographic areas appears in Note K of the Notes to Consolidated Financial Statements on page 49.

 
Item 2.  PROPERTIES

        The Company’s principal office and research facilities are located in Bloomington, Minnesota. The principal European administrative and engineering offices are located in Leuven, Belgium. The principal Asia-Pacific regional administrative offices are located in Singapore.

        The Company’s principal plant activities are carried on in the United States and internationally. Following is a summary of the principal plants and other materially important physical properties owned or leased by the Company. The Company’s properties are utilized for both the Engine and Industrial Product segments except as indicated with an (E) for Engine or (I) for Industrial.

        The Company is a lessee under several long-term leases. The denoted facilities (*) are leased facilities.

        The Company’s properties are considered to be suitable for their present purposes, well maintained and in good operating condition.

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Item 3.  LEGAL PROCEEDINGS

        Legal Proceedings The Company is a defendant in a lawsuit filed in November 1998 in the United States District Court for the Northern District of Iowa (Eastern Division) by Engineered Products Co. (“EPC”). EPC claims patent infringement by the Company arising out of its sales of graduated air restriction indicators in the period from 1996 through the expiration of the EPC patent in May 2001 and seeks monetary damages. EPC is also seeking damages for some period of time beyond the expiration of the patent. On May 11, 2004, the jury found in favor of EPC on its willful infringement claims against the Company and awarded damages in the amount of approximately $5.3 million. On August 12, 2004, the Court ruled that EPC was entitled to enhanced damages based on the Company’s willful infringement of the EPC patent and increased damages to a total of approximately $16.0 million, plus an award of prejudgment interest in the amount of $1.1 million, together with post-judgment interest. On September 20, the Court granted EPC’s motion for attorneys’ fees and awarded attorneys’ fees and expenses in the amount of approximately $1.9 million. The Company intends to vigorously challenge the judgment and filed its notice of appeal on September 13, 2004. EPC’s patent expired on May 1, 2001 and will not impact the Company’s ongoing business operations. The Company increased its reserve by $5.0 million for this matter in fiscal 2004 recording an expense in selling, general and administrative expenses.

        The Company is currently not otherwise subject to any pending litigation other than routine litigation arising in the ordinary course of business, none of which is expected to have a material adverse effect on the business, results of operations, financial condition or liquidity of the Company.

 
Item 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

        No matters were submitted to a vote of security holders of the Company during the quarter ended July 31, 2004.

EXECUTIVE OFFICERS OF THE REGISTRANT

        Current information regarding executive officers is presented below. All terms of office are for one year. There are no arrangements or understandings between individual officers and any other person pursuant to which the officer was selected as an officer.

All of the above-named executive officers have served as officers of the Company during the past five years, except for Mr. VerHage, Mr. McMurray and Mr. Vann. Mr. VerHage was appointed Vice President and Chief Financial Officer in March 2004. Prior to this Mr. VerHage was a partner for Deloitte &

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Touche, LLP from 2002 to 2004 and prior to this a partner for Arthur Andersen, LLP. Mr. McMurray was appointed Vice President, Human Resources in September 2003. Mr. McMurray most recently served as Director of Information Technology from 2001 to 2003 and prior to that position as Director of Manufacturing for Donaldson Europe. Mr. Vann was appointed Vice President, Operations in May 2004 and prior to that served as General Manager of Industrial Air Filtration from 2000 to 2004 and prior to that as Director of Manufacturing.

PART II

 
Item 5.  MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

        The common shares of the Company are traded on the New York Stock Exchange under the symbol DCI. The amount and frequency of all cash dividends declared on the Company’s Common Stock for 2004 and 2003 appear in Note M of the Notes to Consolidated Financial Statements on page 50. Also see Note E on page 36 for restrictions on payment of dividends. As of September 28, 2004, there were 1,902 shareholders of record of Common Stock.

        The high and low sales prices for the Company’s Common Stock for each full quarterly period during 2004 and 2003, were as follows:

         The following table sets forth information in connection with purchases made by, or on behalf of, the Company or any affiliated purchaser of the Company, of shares of the Company’s Common Stock during the quarterly period ended July 31, 2004.

(1)  On January 17, 2003, the Company’s Board of Directors authorized the repurchase of up to 8.0 million common shares. This repurchase authorization, which is effective until terminated by the Board of Directors, replaces the existing authority that expired at the end of March 2003. There were no repurchases of Common Stock made outside of the Company’s current repurchase authorization during the fourth quarter ended July 31, 2004.

Item 6.  SELECTED FINANCIAL DATA

        The information for the years 2000 through 2004 on page 4 of the 2004 Annual Report to Shareholders is incorporated herein by reference.

Item 7.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION

Results of Operation

        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.

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Overview

        The Company manufactures filtration systems and replacement parts. The Company’s core strengths are leading filtration technology, strong customer relationships and global presence. The Company operates through two reporting segments, Engine Products and Industrial Products and has a product mix including air and liquid filters and exhaust and emission control products. As a worldwide business, the Company’s results of operations are affected by global industrial and economic factors. The Company’s diversity between its original equipment and replacement parts customers, its diesel engine and industrial end markets, and its North American and international end markets has helped to limit the impact of these factors on the consolidated results of the Company. The Company’s broad strength in most of its end markets drove record earnings in fiscal 2004 as the Company transitioned from weak conditions in many of its end markets to rapid demand acceleration in fiscal 2004.

        The Company reported record sales in 2004 of $1.415 billion, up 16.1 percent from $1.218 billion in the prior year. The Company’s results were positively impacted by foreign exchange for the year. The impact of foreign currency translation during the year increased sales by $70.0 million. Excluding the current year impact of foreign currency translation, worldwide sales increased 10.4 percent during the year.

        Although net sales excluding foreign currency translation is not a measure of financial performance under GAAP, the Company believes it is useful in understanding its financial results and provides a measure for understanding the operating results of the Company’s foreign entities between different fiscal periods excluding the impact of foreign currency translation. Following is a reconciliation to the most comparable GAAP financial measure of this non-GAAP financial measure (in Millions):

Steel price increases also impacted results during the year, particularly in the second half of fiscal 2004. The Company responded by recovering a portion of these price increases from customers and will continue these recovery efforts in the next fiscal year. The negative impact from the unrecovered portion of the steel price increases was partially offset by the operating leverage gained from higher production volumes. Operating expenses as a percent of net sales in fiscal 2004 increased 0.9 percent from the prior year as the Company invested in additional sales and engineering resources to capture the sales growth opportunity from the improved economic conditions. The Company believes that it has added sufficient resources and any incremental additions in the next year will not be significant. Net income in fiscal 2004 totaled $106.3 million, up 11.5 percent from $95.3 million in the prior year. Although not as significant as the impact on net sales, the Company’s net earnings were also positively impacted by foreign currency translation for the year. The impact of foreign currency translation during the year increased net earnings by $4.7 million. Excluding the current year impact of foreign currency translation, net earnings increased 6.6 percent during the year.

Although net earnings excluding foreign currency translation is not a measure of financial performance under GAAP, the Company believes it is useful in understanding its financial results and provides a measure for understanding the operating results of the Company’s foreign entities between different fiscal periods excluding the impact of foreign currency translation. Following is a reconciliation to the most comparable GAAP financial measure of this non-GAAP financial measure (in Millions):

The Company reported record diluted earnings per share of $1.18, a 12.4 percent increase from $1.05 in the prior year.

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During fiscal 2004, the Company continued to see growth in its Engine Products segment, as sales in that segment grew to 58.8 percent of total sales, up from 56.1 percent in the prior year. This reflects the strength in the conditions in the markets that the Engine Products segment serves and the Company’s efforts to capitalize on this strength. In the Company’s Industrial Products segment, conditions in the markets it serves showed improvement during the year.

        Following is financial information for the Company’s Engine Products and Industrial Products segments. Corporate and Unallocated include corporate expenses determined to be non-allocable to the segments, interest income and expense, non-operating income and expenses not allocated to the business segments in the same period.

Factors within the Company’s reporting segments that contributed to the Company’s results for fiscal 2004 included strong results across all of the products within the Engine Products segment worldwide. North American truck build rates increased significantly for the year and off-road equipment markets strengthened, thus resulting in increased sales. Additionally, equipment utilization improved in both the truck and off-road markets, spurring aftermarket parts sales growth. In North America, regulations at both the federal and local levels created strong demand for diesel emission control products for trucks. In the Industrial Products segment, sales in the Company’s disk drive filters showed strong results as demand for computer hard drives remained high. Also, conditions in industrial air filtration improved, resulting in increased sales for the year worldwide, and although total worldwide sales in gas turbine products were down for the year, conditions in the gas turbine business showed improvement during the year.

        Following are net sales by product within the Engine Products segment and Industrial Products segment:

There were several items that impacted the Company’s fiscal 2004 results. The Company recorded a pre-tax gain of $5.6 million for the sale of its Ome City, Japan facility which was partially offset by higher

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one-time costs related to the sale and the associated consolidation of production in Japan. Although this type of gain is not expected to recur, the Company anticipates that it will continue to have plant rationalization and expansion charges that will occur in future years and expects that they will continue to be consistent with prior year levels. Also, the Company recorded a reduction in income tax expense of $1.8 million from increasing research and development tax credits from prior years. In the last quarter of the fiscal year, the Company recorded three expense items totaling $11.6 million. The Company increased its litigation reserve by $5.0 million after the U.S. District Court for the Northern District of Iowa entered judgment against the Company on August 12, 2004 on patent infringement claims brought against the Company by EPC. The Court ruled that EPC was entitled to enhanced damages based on the Company’s willful infringement of the EPC patent and increased damages to a total of approximately $16 million, plus an award of pre-judgment interest in the amount of $1.1 million, together with post-judgment interest. On September 20, 2004, the Court granted EPC’s motion for attorneys’ fees and awarded attorneys’ fees and expenses in the amount of approximately $1.9 million. The Company intends to vigorously challenge the judgment and filed its notice of appeal on September 13, 2004. Additionally, as a result of ongoing discussions on a specific warranty-related matter, the Company increased its warranty reserve by $3.0 million. The Company believes that it is adequately reserved for these expenses based upon the facts that are known at this time. And finally, during the year-end close process, the Company identified and recorded an adjustment of $3.6 million relating to certain fiscal 2003 transactions between several of its Ultrafilter entities.

Overall, the Company anticipates sales growth percentages in the low-teens in the next fiscal year. The Company expects that increasing commodity prices, especially steel, will be partially offset by price increases to its customers and improving manufacturing efficiencies from continued strong volume. Economic conditions in the markets it serves will continue to impact the Company’s growth. The Company anticipates low-teens percentage growth for sales in its Engine Products segment in fiscal 2005 as it expects continued growth in North American heavy-duty truck build rates in fiscal 2005 and continued strong business conditions in Europe and Asia. Sales of off-road products are expected to remain strong in Asia and North America as conditions in construction and agriculture equipment markets have improved. Both North American and international sales of aftermarket products are expected to continue growing as increasing equipment utilization spurs replacement filter sales. Diesel emission retrofit sales in North America are anticipated to continue increasing as the Company’s technology solution gains acceptance. The Company also anticipates low-teens percentage growth for sales in its Industrial Products segment in fiscal 2005 as general conditions in the industrial market continue to improve. Global business conditions for gas turbine are expected to be stable and the Company expects that fiscal 2005 sales will be unchanged. Sales in industrial filtration solution products are expected to be strong in fiscal 2005 as North American and European industrial air and compressed air filtration markets are expected to continue improving in the near-term. Also, the Company anticipates that business conditions in this market in Asia will remain strong. The growth rate of disk drive product sales is expected to be lower following fiscal 2004’s strong recovery.

Fiscal 2004 Compared to Fiscal 2003

        Engine Products Segment The Engine Products segment sells to original equipment 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 and emissions systems, liquid filtration systems and replacement filters.

        Sales for the Engine Products segment were $832.3 million, an increase of 21.8 percent from $683.3 million in the prior year, reflecting increased sales across all products within this segment both in North America and internationally.

        Within the Engine Products segment, worldwide sales of truck products were $156.4 million, an increase of 34.4 percent from $116.3 million in the prior year. North American truck sales increased 29.5 percent from the prior year due to growing truck build rates and strong diesel emission sales as well as continued growth in the Company’s PowerCore™ products. International truck sales increased 45.2 percent with strong sales in both Asia and Europe showing increases of 49.1 percent and

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36.2 percent, respectively. Sales in Asia reflect high demand for diesel truck emission control products in Japan resulting from new regulations.

        Worldwide sales of off-road products were $236.9 million, an increase of 21.6 percent from $194.8 million in the prior year. North American sales showed an increase of 15.1 percent on continued improvements in new construction and agriculture equipment demand. Internationally, sales of off-road products were up 31.7 percent from the prior year with sales increasing in both Asia and Europe by 38.3 percent and 28.7 percent, respectively, reflecting the strength in the off-road equipment market internationally.

        Worldwide aftermarket product sales of $439.0 million increased 18.0 percent from $372.1 million in the prior year. Sales in North America increased 11.9 percent over the prior year as equipment utilization rates continued to improve resulting in increasing demand for replacement parts. Additionally, the Company’s investment into additional staff, training tools and additional product coverage continued to drive sales results. International sales were strong with an increase over the prior year of 26.7 percent with sales increasing in both Europe and Asia by 31.8 percent and 20.1 percent, respectively. Both of these regions experienced strong demand for both truck and off-road equipment filters throughout the year.

        Industrial Products Segment The Industrial Products segment sells to various industrial end-users, OEMs of gas-fired turbines, and OEMs and end-users requiring highly purified air. Products include dust, fume and mist collectors, compressed air purification systems, liquid filters and parts, static and pulse-clean air filter systems, specialized air filtration systems for diverse applications including computer disk drives and PTFE membrane and laminates.

        Sales for the Industrial Products segment were $582.7 million, an increase of 8.9 percent from $535.0 million in the prior year. This growth results from strong sales of special application products and an improvement in industrial air filtration products for the year. These increases were partially offset by a decrease in sales of gas turbine products.

        Within the Industrial Products segment, worldwide sales of gas turbine products were $117.7 million, a decrease of 9.2 percent from $129.6 million in the prior year. A decline in North American sales of 41.4 percent was partially offset by increased international sales of 27.6 percent, which softened the consolidated impact in this market. The increase internationally reflects strength in the gas turbine market overseas with increased sales in both Europe and Asia of 35.5 percent and 10.1 percent, respectively, and includes units shipped to Iraq.

        Worldwide sales of industrial air filtration products of $202.2 million increased 16.0 percent from $174.3 million in the prior year. North American sales increased 12.7 percent, reflecting an improvement in the manufacturing economy. International sales were up 20.4 percent with increases in Asia and Europe of 29.9 percent and 15.0 percent, respectively. The increase in Asia reflects strong business conditions throughout the year, especially in China and Japan, while the smaller increase in Europe is from the improvement in Europe’s industrial economy during the second half of fiscal 2004 and favorable currency translation.

        Worldwide sales of Ultrafilter products of $122.2 million increased 1.1 percent from $120.9 million in the prior year. In the fourth quarter of fiscal 2003, additional sales of $11.5 million were recorded as a result of conforming Ultrafilter to the Company’s year end. The increased sales of Ultrafilter products were driven by additional market penetration as well as recovering industrial markets in Europe during the second half of fiscal 2004 and favorable currency translation.

        Worldwide sales of special application products were $140.6 million, a 27.6 percent increase from $110.2 million in the prior year. North American sales increased 46.6 percent from the prior year while international sales increased 21.7 percent. Sales of disk drive products in Asia increased 29.3 percent due to strong demand for computer hard drives. Worldwide sales of membrane products increased 25.4 percent from the prior year due to improvement in the Company’s core industrial and fabric markets with the majority of the gain in North America. Worldwide sales of hydraulic products increased 58.7 percent due to strong market conditions and the acquisition of the LHA industrial hydraulic business of Berendsen Fluid Power, Inc. in the first quarter of fiscal 2004.

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        Consolidated Results The Company reported record net earnings for 2004 of $106.3 million compared to $95.3 million in 2003, an increase of 11.5 percent. Net earnings per share — diluted were a record $1.18, up 12.4 percent from $1.05 in the prior year. The Company’s operating income of $141.6 million increased from prior year operating income of $131.8 million by 7.5 percent. Operating income in the Engine Products segment again showed strong growth from the prior year as it increased to 79.1 percent of total operating income from 69.2 percent in the prior year. This growth reflects the strength in the markets that the Engine Products segment serves as well as the Company’s continuing efforts in improving operating efficiencies. Operating income in the Industrial Products segment as a percent of total operating income of 28.5 percent was slightly lower than the prior year’s 29.3 percent of total operating income. International operating income totaled 83.7 percent of consolidated operating income in 2004 as compared to 72.9 percent in 2003. Of the 2004 international operating income, Europe contributed 41.1 percent while Asia-Pacific contributed 54.1 percent. Total international operating income increased 23.5 percent from the prior year.

        Gross margin for 2004 was 31.8 percent compared to 32.1 percent in the prior year. Despite operating leverage gained from higher production volumes, gross margin was down from the prior year due primarily to the unrecovered portion of the steel price increases. Also, the fiscal 2003 adjustment that was identified in the fiscal 2004 closing process negatively impacted gross margin in 2004 by $2.3 million. The Company continued its efforts to improve manufacturing infrastructure and reduce product costs through plant rationalization. Plant rationalization costs were $6.2 million in 2004, slightly lower than $6.5 million in the prior year. The effect on diluted earnings per share was $.05 in both years.

        Operating expenses for 2004 were $314.5 million or 22.2 percent of sales, up from $259.4 million or 21.3 percent in the prior year. Operating expenses for the year were impacted by higher costs in Japan while managing through the plant rationalization and expenses relating to the strong revenue growth as well as necessary adjustments in incentive pay resulting from strong fiscal year results. Also included in operating expenses for 2004 was the adjustment of $5.0 million to increase the Company’s reserve for the patent infringement judgment and the $3.0 million increase to the Company’s warranty reserve regarding ongoing discussions on a specific warranty-related matter. Also, the fiscal 2003 adjustment that was identified in the fiscal 2004 closing process negatively impacted operating expenses in 2004 by $1.3 million. The Company continued to focus on operating expense controls in 2004.

        Interest expense of $5.0 million decreased $0.9 million from $5.9 million in the prior year, reflecting lower interest rates and debt levels from the prior year. Net other income totaled $5.2 million in 2004 compared to $4.7 million in the prior year. Components of other income for 2004 were as follows: interest income of $1.9 million, earnings from non-consolidated joint ventures of $4.4 million, foreign exchange losses of $0.5 million and other miscellaneous income and expense items netting to $0.6 million of miscellaneous expense.

        The effective income tax rate of 25.0 percent in 2004 was lower than the prior year tax rate of 27.0 percent. The decrease in the tax rate reflects a $1.8 million reduction in income tax expense during the year relating to the recognition of additional credits resulting from the completion of a research and development tax credit study and also reflects the increased contribution from the Company’s international operations. Although the tax rate going forward is dependent upon the applicable tax rates and the geographic mix of product sales and Company locations, the Company expects that it will return to approximately 27 percent in fiscal 2005.

        Total backlog at July 31, 2004 was $375.5 million, up 19.9 percent from the same period in the prior year. In the Engine Products segment, total backlog increased 28.1 percent compared to the same period in the prior year, reflecting the strength in business conditions in the markets served. In the Industrial Products segment, total backlog increased 7.1 percent from the same period in the prior year reflecting improving conditions in the industrial markets. Ninety-day backlog at July 31, 2004, goods scheduled for delivery within 90 days, was $208.9 million, up 14.0 percent from $183.2 million in he prior year. In the Engine Products segment, overall 90-day backlog was $124.4 million, an increase of 13.4 percent from the prior year. Within this segment, off-road products showed a solid increase of 29.4 percent from the prior year. Ninety-day backlog for aftermarket products increased 3.7 percent while truck products decreased by 1.7 percent. In the Industrial Products segment, overall 90-day backlog was $84.6 million,

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an increase of 15.0 percent from the prior year. Within this segment, 90-day backlog for gas turbine products decreased 9.2 percent. This decrease was offset by increases in industrial filtration solutions (industrial air filtration and Ultrafilter products) of 40.4 percent and special application products of 11.3 percent.

        In July 2003, the Company closed on the sale of the land and building in Ome City, Japan. The Company received full payment of the purchase price of $10.8 million in fiscal 2003. The Company recorded a gain on the sale of $5.6 million in the second quarter of fiscal 2004, after completion of approvals for the environmental remediation of the site, which was a condition of the sale. The environmental remediation was completed by the Company in the first quarter of fiscal 2004 and approvals were received in the second quarter of fiscal 2004. During the first quarter of fiscal 2004, the Company vacated and disposed of the property, plant and equipment.

Fiscal 2003 Compared to Fiscal 2002

(Earnings per share amounts have been restated to reflect the Company’s two-for-one stock split effected in the form of a 100 percent stock dividend distributed on March 19, 2004.)

        The Company reported sales in 2003 of $1.218 billion, up 8.2 percent from $1.126 billion last year, and recorded its 14th consecutive year of record earnings per share. The Company’s Engine Products segment showed strong sales and earnings growth worldwide. Within the Industrial Products segment, despite the significant contraction in the gas turbine business and the resulting drop in sales, the Company reported profitable operating income in gas turbine products. Additionally, sales and earnings were favorably impacted by the July 2002 acquisition of Ultrafilter and its integration into the Industrial Products segment.

        Engine Products Segment The Engine Products segment sells to original equipment 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 and emissions systems, liquid filtration systems and replacement filters.

        Sales for the Engine Products segment were $683.3 million, an increase of 11.7 percent from $611.6 million in the prior year, reflecting increased sales across all products within this segment both in North America and internationally.

        Within the Engine Products segment, worldwide sales of truck products were $116.3 million, an increase of 29.9 percent from $89.5 million in the prior year. North American truck sales increased 20.0 percent from the prior year as light-duty diesel sales more than doubled over last year, reflecting additional sales from the new small diesel filtration offering featuring the Company’s PowerCore™ technology. International truck sales increased 59.4 percent from the prior year, reflecting continued high demand for emission control products in Japan.

        Worldwide sales of off-road products were $194.8 million, an increase of 10.1 percent from $177.0 million in the prior year. North American sales showed a slight increase of 1.1 percent and were impacted by continued weak equipment demand but were somewhat offset by increased defense sales over the prior year. Internationally, sales of off-road products were up 33.7 percent from the prior year with sales increasing in both Europe and Asia by 27.1 percent and 28.7 percent, respectively. The increase in Asia reflects strong sales in Japan, including the continued export demand for off-road equipment into China.

        Worldwide aftermarket product sales of $372.1 million increased 7.8 percent from $345.1 million in the prior year. Sales in North America increased 2.8 percent over the prior year as equipment utilization rates improved, thereby increasing demand for replacement parts. International sales were strong with an increase over the prior year of 15.5 percent with sales increasing in both Europe and Asia by 16.3 percent and 12.5 percent, respectively.

        (Certain fiscal 2002 product sales amounts were reclassified within the Engine Products segment in 2003 to conform to the 2003 presentation. There was no impact to the total Engine Products segment for fiscal 2002.)

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        Industrial Products Segment The Industrial Products segment sells to various industrial 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.

        Sales for the Industrial Products segment were $535.0 million, an increase of 4.0 percent from $514.4 million in the prior year. Excluding Ultrafilter, sales decreased 19.5 percent to $414.1 million, reflecting the contraction in North American gas turbine product sales.

        Although sales exclusive of Ultrafilter is not a measure of financial performance under GAAP, the Company believes that providing a year-over-year sales comparison of the Industrial Products segment without Ultrafilter sales for both full fiscal year periods is a useful measure, both of the change in operating performance of the Industrial Products segment and of the effect of the Ultrafilter acquisition on the 2003 operating results of the Industrial Products segment. A shortcoming of this non-GAAP measure is that it does not reflect the actual results of the Company because Ultrafilter was part of the actual results of the Company in 2003.

        Following is a reconciliation to the most comparable GAAP financial measure of this non-GAAP financial measure:

        Within the Industrial Products segment, worldwide sales of gas turbine products were $129.6 million, a decrease of 43.9 percent from a record $230.9 million in the prior year. Despite the decrease, the gas turbine business maintained its gross margin percentage and remained profitable on the operating income line for the year by effectively managing its capacity utilization. Sales in North America declined 59.8 percent from the prior year while sales internationally increased 2.3 percent as market conditions were steady outside of North America.

        Worldwide sales of industrial air filtration products of $174.3 million decreased 0.8 percent from $175.7 million in the prior year, reflecting the continued impact of weakness in industrial capital spending. In North America, sales decreased 9.9 percent from the prior year, though orders in the fourth quarter showed the first year-over-year increase in almost three years. International sales were up 10.5 percent primarily due to foreign currency translation.

        Worldwide sales of special application products were $110.2 million, a 2.2 percent increase from $107.8 million in the prior year. Sales of membrane products increased 20.4 percent from the prior year on an improvement in its core filtration markets, growing acceptance of its performance fabrics and success in technical product markets. Sales in hydraulic filter products increased from the prior year by 23.4 percent. Disk drive sales decreased from the prior year by 7.2 percent, although the computer industry is beginning to pick up following several difficult quarters. In North America, sales of special application products decreased 6.1 percent from the prior year while sales increased 5.1 percent internationally.

        Worldwide sales of Ultrafilter products totaled $120.9 million. In fiscal 2003, the Company had a favorable impact from conforming the year end of Ultrafilter to the Company’s year end, resulting in $11.5 million of additional sales.

        Consolidated Results The Company reported record net earnings for 2003 of $95.3 million compared to $86.9 million in 2002, an increase of 9.7 percent. Net earnings per share — diluted were a record $1.05, up 10.5 percent from $.95 in the prior year. An increase in net sales as well as continued manufacturing infrastructure improvements, product cost reductions and operating expense controls all contributed to the Company achieving its 14th consecutive year of record earnings per share. The Company’s operating income increased from the prior year by 6.4 percent. Operating income in the Engine Products segment again showed significant growth from the prior year as it grew to almost

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70 percent of total operating income in the year from about 50 percent in the prior year. This growth reflects the continuing efforts in improving operating efficiencies in the Engine business and the increased demand for Engine products discussed above. Operating income in the Industrial Products segment decreased to about 30 percent of total operating income in the year from almost 60 percent in the prior year. International operating income totaled 72.9 percent of consolidated operating income in 2003 as compared to 64.6 percent in 2002. Of the 2003 international operating income, Europe contributed 39.1 percent while Asia-Pacific contributed 51.2 percent. Total international operating income increased 20.0 percent from the prior year. In U.S. dollars, Europe’s operating income increased 14.5 percent, resulting from the effects of foreign currency translation due to the continued strengthening of the euro against the U.S. dollar. In U.S. dollars, Asia-Pacific’s operating income increased 11.6 percent, resulting from the effects of foreign currency translation.

        Gross margin for 2003 increased to 32.1 percent compared to 31.0 percent in the prior year. The addition of Ultrafilter was the main driver for the increase. Also contributing were the Company’s continued efforts to improve manufacturing infrastructure and reduce product costs through plant rationalization. Plant rationalization costs, including plant closure costs, came to $.05 per share versus $.03 per share in the prior year.

        Operating expenses as a percent of sales for 2003 and 2002 were 21.3 percent and 20.0 percent, respectively. Operating expenses in 2003 totaled $259.4 million compared to $225.6 million in 2002, an increase of $33.7 million, or 15.0 percent. The increase over the prior year was attributable to the addition of Ultrafilter, where operating expenses, as a percent of sales, were higher than the Company’s existing businesses. Operating expense control remained one of the Company’s key initiatives across the Company in 2003.

        Interest expense decreased $0.6 million, reflecting lower interest rates and debt levels from the prior year. Other income, net totaled $4.7 million in 2003 compared to $1.7 million in the prior year. Components of other income for 2003 were as follows: interest income of $1.2 million, earnings from non-consolidated joint ventures of $3.2 million, foreign exchange losses of $0.1 million and other miscellaneous income and expense items netting to $0.4 million of miscellaneous income. Miscellaneous income included a gain in the amount of $1.9 million resulting from the demutualization of a life insurance company in which the Company held shares, offset by $1.5 million of various miscellaneous expense items. Prior year net other income included an expense for a discretionary $2.5 million contribution for funding the Donaldson Foundation.

        The effective income tax rate of 27.0 percent in 2003 remained unchanged from the prior year. The Company’s tax rate going forward is dependent upon the applicable tax rates and the geographic mix of product sales and Company locations, and is subject to change.

        Total backlog at July 31, 2003 was $313.1 million, down 1.8 percent from the prior year. In the Engine Products segment, total backlog increased 6.8 percent compared to the prior year, reflecting improvement in business conditions in the markets served. In the Industrial Products segment, total backlog decreased 5.3 percent from the prior year reflecting the continued downturn in the North American gas turbine market. Ninety-day backlog, goods scheduled for delivery within 90 days, was $183.2 million, up 2.8 percent from $178.3 million in the prior year. In the Engine Products segment, overall 90-day backlog increased 9.8 percent from the prior year. Within this segment, truck products showed a solid increase of 25.8 percent from the prior year. Ninety-day backlog for off-road products increased by 10.9 percent, while aftermarket products decreased 6.6 percent. In the Industrial Products segment, overall 90-day backlog decreased 6.1 percent from the prior year. Within this segment, 90-day backlog for gas turbine products decreased 34.5 percent. This decrease was somewhat offset by increases in industrial air filtration products and special application products by 11.8 percent and 17.2 percent, respectively.

Liquidity and Capital Resources

        Financial Condition At July 31, 2004, the Company’s capital structure was comprised of $54.1 million of current debt, $70.9 million of long-term debt and $549.3 million of shareholders’ equity. The Company had cash and cash equivalents of $99.5 million at July 31, 2004. The ratio of long-term debt to total

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capital was 11.4 percent and 19.0 percent at July 31, 2004 and 2003, respectively. The decrease in the ratio of long-term debt to total capital is due to the reclassification of $33.7 million of long-term debt to current maturities as of July 31, 2004.

        Total debt outstanding increased $5.0 million for the year to $124.9 million outstanding at July 31, 2004. The increase is a result of an increase in short-term borrowings outstanding at the end of the year by $5.6 million from the prior year. Offsetting the increase in short-term borrowings was a decrease in long-term debt of $0.6 million. The decrease in long-term debt was comprised of a decrease of $1.9 million as a result of payments made during the year and a decrease in unsecured senior notes of $0.3 million as a result of the market value adjustment for the interest rate swap agreements. Long-term debt also increased from the prior year by $1.6 million due to foreign exchange translation.

        In September 2002, the Company entered into a new three-year multi-currency revolving facility with a group of banks under which the Company may borrow up to $150.0 million. The agreement provides that loans may be made under a selection of currencies and rate formulas including Base Rate Advances or Off Shore Rate Advances. The interest rate on each advance is based on certain market interest rates and leverage ratios. Facility fees and other fees on the entire loan commitment are payable over the duration of this facility. There was no balance outstanding at July 31, 2004 and $5.0 million outstanding at July 31, 2003, leaving $150.0 million and $145.0 million available for further borrowing under such facilities at July 31, 2004 and July 31, 2003, respectively. On September 2, 2004, the Company amended and restated its existing $150 million, three-year credit agreement that was to mature on September 27, 2005. The amendment extended the maturity date of the facility to September 2, 2009. There were no material changes to other terms and conditions.

        The following table summarizes the Company’s fixed cash obligations as of July 31, 2004 for the years indicated (in thousands):

        For its U.S. pension plans, the Company does not have a minimum required contribution for fiscal 2005. However, the Company may contribute up to its maximum deductible contribution of $36.5 million in fiscal 2005. For its non-U.S. pension plans, the Company estimates that it will contribute approximately $2.4 million in fiscal 2005. Future estimates of the Company’s pension plan contributions may change significantly depending on the actual rate of return on plan assets, discount rates, discretionary pension contributions and regulatory rules.

        The Company also has two agreements under uncommitted credit facilities, which provide unsecured borrowings for general corporate purposes. At July 31, 2004 and 2003, there was $40.0 million and $35.0 million available for use under these facilities, respectively. There was $12.4 million and $2.4 million outstanding under these facilities at July 31, 2004 and 2003, respectively. The weighted average interest rate on these short-term borrowings outstanding at July 31, 2004 and 2003 was 1.75 percent and 1.36 percent, respectively.

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        The Company also has a 100 million euro program for issuing treasury notes for raising short, medium and long-term financing for its European operations. At July 31, 2004 and July 31, 2003 there were no amounts outstanding under the program. Additionally, the Company’s European Operations have lines of credit in the amount of 25.2 million euro. As of July 31, 2004 and July 31, 2003 there were no amounts outstanding.

        Also, at July 31, 2004 and 2003, the Company had outstanding standby letters of credit totaling $18.4 million and $16.1 million, respectively. The letters of credit guarantee payment to beneficial third parties in the event the Company is in breach of specified contract terms as detailed in each letter of credit. At July 31, 2004 and 2003 there were no amounts drawn upon these letters of credit.

        Shareholders’ equity increased $101.9 million in 2004 to $549.3 million. The increase was due to current year earnings of $106.3 million, an increase in accumulated other comprehensive income of $38.4 million, $4.8 million of stock option and other stock activity offset by $29.8 million of treasury stock repurchases and $17.8 million of dividend payments. The increase in accumulated other comprehensive income consisted primarily of a foreign currency translation adjustment of $23.7 million and a decrease in the Company’s additional minimum pension liability of $14.4 million.

        Stock Split On January 16, 2004, the Company’s Board of Directors declared a two-for-one stock split effected in the form of a 100 percent dividend. The Company distributed 43.4 million shares of common stock on March 19, 2004, to shareholders of record as of March 5, 2004. All share and per share amounts have been retroactively adjusted to reflect the stock split.

        Cash Flows During fiscal 2004, $118.1 million of cash was generated from operating activities, compared with $146.7 million in 2003 and $153.0 million in 2002. The decrease in cash generated from operating activities in 2004 resulted primarily from an increase in accounts receivable of $37.3 million and in inventory of $20.7 million, partially offset by an increase in accounts payable and other accrued expenses of $26.4 million during the year.

        In addition to cash generated from operating activities, the Company increased its outstanding short-term debt by $5.2 million while net long-term debt decreased by $1.9 million. Cash flow generated by operations was used primarily to support $47.7 million for capital expenditures, $29.8 million for stock repurchases and $17.8 million for dividend payments. Cash and cash equivalents increased $32.4 million during 2004.

        Capital expenditures for property, plant and equipment totaled $47.7 million in 2004 and 2003 and $46.2 million in 2002. Capital expenditures primarily related to productivity enhancing investments at various plants worldwide and continuing upgrades to the U.S. information systems.

        Capital spending in 2005 is planned between $45.0 million and $50.0 million. Significant planned expenditures include the further upgrade of U.S. information systems and investment in manufacturing equipment and tooling. It is anticipated that 2005 capital expenditures will be financed primarily by cash generated from operations and existing lines of credit.

        The Company expects that cash generated by operating activities will exceed $100 million again in 2005. At July 31, 2004, the Company had $99.5 million cash, $177.6 million available under existing credit facilities in the United States and 125.2 million euro available under existing credit facilities in Europe. The Company believes that the combination of existing cash, available credit under existing credit facilities and the expected cash generated by operating activities is adequate to meet cash requirements for fiscal 2005 including debt repayment, issuance of anticipated dividends and share repurchase activity.

        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. 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 0.055 cents per share equates to 20.8 percent of the average net earnings per share for 2002 through 2004.

        Share Repurchase Plan In fiscal 2004, the Company repurchased 1.1 million shares of common stock on the open market for $29.8 million under the share repurchase plan authorized in January 2003,

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at an average price of $27.79 per share. The Company repurchased 1.4 million shares for $24.9 million in 2003 and 1.4 million shares for $21.3 million in 2002.

        Subsequent to July 31, 2004, the Company repurchased 3.0 million shares from Banc of America Securities LLC under an overnight share repurchase program at a total cost of approximately $86.5 million. The overnight share repurchase program permitted the Company to purchase the shares immediately, while Banc of America Securities will purchase the shares in the market over the next six to nine months. At the end of the program, the Company may receive or be required to pay a price adjustment based on the actual cost of Banc of America Securities share purchases. After the repurchase, the Company had 83.1 million common shares outstanding.

        Off-Balance Sheet Arrangements The Company does not have any off-balance sheet arrangements, with the exception of the guarantee of 50 percent of certain debt of its joint venture, Advanced Filtration Systems, Inc. as further discussed in Note L of the Company’s Notes to Consolidated Financial Statements.

        Environmental Matters The Company establishes reserves as appropriate for potential environmental liabilities and will continue to accrue reserves in appropriate amounts. While uncertainties exist with respect to the amounts and timing of the Company’s ultimate environmental liabilities, management believes that such liabilities, individually and in the aggregate, will not have a material adverse effect on the Company’s financial condition or results of operations.

        New Accounting Standards Effective August 1, 2003, the Company adopted SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” SFAS No. 149 amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” This Statement was effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 20, 2003. The adoption of SFAS No. 149 did not have a material impact on the Company’s Consolidated Financial Statements.

        Effective August 1, 2003, the Company adopted SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” This statement requires that three types of freestanding financial instruments be classified as liabilities: mandatorily redeemable shares; instruments that do or may require the issuer to buy back some of its shares in exchange for cash or assets; and obligations that can be settled with shares, the value of which is fixed, tied to a variable or varies inversely with the share price. The Statement is effective for all financial instruments modified or entered into after May 31, 2003 and was otherwise effective for interim periods beginning after June 15, 2003. The adoption of SFAS No. 150 had no impact on the Company’s Consolidated Financial Statements.

        In December 2003, the FASB issued SFAS No. 132 (Revised 2003), “Employers’ Disclosures about Pensions and Other Postretirement Benefits,” relating to financial statement disclosures for defined benefit plans. The new Statement does not change the measurement or recognition of those plans that is required by SFAS No. 87, “Employers’ Accounting for Pensions,” SFAS No. 88, “Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits” and SFAS No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions.” The Statement retains the disclosure requirements contained in SFAS No. 132, “Employers’ Disclosures about Pensions and Other Postretirement Benefits,” which it replaces and also requires additional disclosures about the assets, obligations, cash flows and net periodic benefit cost of defined benefit pension plans and other defined benefit postretirement plans. SFAS No. 132(R) was effective for the Company’s fiscal 2004. See Note G in the Notes to Consolidated Financial Statements for the new disclosures related to the Company’s pension and other postretirement benefit plans as required by SFAS No. 132(R). As SFAS No. 132(R) only provides for additional disclosures and does not impact the accounting for the Company’s pension plans, the adoption of this Statement did not have any impact on the Company’s Consolidated Financial Statements.

        In May 2004, the FASB issued FASB Staff Position No. FAS 106-2, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of

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2003” (FSP 106-2). FSP 106-2 requires an employer to initially account for any subsidy received under the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the “Act”) as an actuarial experience gain to the accumulated postretirement benefit obligation (APBO), which would be amortized over future service periods. Future subsidies would reduce service cost each year. The Company’s financial statements as of July 31, 2004 do not reflect the effects of the Act, if any, on the APBO or net periodic postretirement benefit cost. The Company has not yet determined whether its postretirement benefit plans are “actuarially equivalent” to Medicare Part D under the Act. FSP 106-2 is effective for the Company beginning in the first quarter of its fiscal 2005 and the effect of the Act is not expected to have a material effect on the Company’s Consolidated Financial Statements.

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 currency market risk, from time to time, through the use of a variety of financial and derivative instruments. The Company does not enter into any of these instruments for trading 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 foreign 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 also naturally hedges foreign currency through its production in the countries in which it sells its products. The Company’s market risk on interest rates is the potential decrease in fair value of long-term debt resulting from a potential increase in interest rates. See further discussion of these market risks below.

        Foreign Currency During 2004, the U.S. dollar was weaker throughout the year relative to the currencies of the foreign countries in which the Company operates, with the notable exception of the Mexican peso. The overall weakness of the dollar had a significant positive impact on the Company’s international net sales results because the foreign denominated revenues translated into more U.S. dollars.

        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, 2004, the impact of foreign currency translation resulted in an overall increase in net sales of $70.0 million and an increase in net earnings of $4.7 million. Foreign currency translation had a positive impact in several regions around the world. In Europe, the weaker U.S. dollar relative to the euro and British pound sterling resulted in an increase of $47.8 million on net sales and an increase of $2.5 million on net earnings. In the Asia-Pacific region, the weaker U.S. dollar relative to the Japanese yen had a positive impact on foreign currency translation with an increase in net sales of $10.7 million and an increase on net earnings of $0.7 million. The weaker U.S. dollar relative to the Australian dollar also resulted in an increase of $5.5 million in net sales and an increase of $0.7 million on net earnings. In addition, the weaker U.S. dollar relative to the South African rand also had a positive impact on foreign currency translation with an increase in net sales of $6.1 million and an increase in net earnings of $0.6 million. As stated earlier, the U.S. dollar did strengthen compared to the Mexican peso with a corresponding decrease of $1.2 million on net sales and no impact on net earnings.

        The Company maintains significant assets and operations in Europe, countries of the Asia-Pacific Rim, South Africa and Mexico, resulting in exposure to foreign currency gains and losses. A portion of the Company’s foreign currency exposure is naturally hedged by incurring liabilities, including bank debt, denominated in the local currency in which the Company’s foreign subsidiaries are located.

        The foreign subsidiaries of the Company purchase products and parts in various currencies. As a result, the Company may be exposed to cost increases relative to local 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 offsetting and are netted against one another to reduce exposure.

        Some products made in the Unit