Earnings Call Transcript - DCI Q2 2026

Operator, Operator

Thank you for being here. My name is Krista, and I will be your conference operator today. Welcome to Donaldson Company's Second Quarter Fiscal Year 2026 Earnings Webcast and Conference Call. I would now like to turn the conference over to Sarika Dhadwal, Head of Investor Relations. Please proceed.

Sarika Dhadwal, Head of Investor Relations

Good morning. Thank you for joining Donaldson's Second Quarter Fiscal 2026 Earnings Conference Call. With me today are Tod Carpenter, Chairman, President and CEO; Rich Lewis, Incoming President and CEO; and Brad Pogalz, Chief Financial Officer. This morning, we will provide a summary of our second quarter performance and our outlook for fiscal 2026. During today's call, we will discuss non-GAAP or adjusted results. For second quarter 2026, non-GAAP results exclude pretax charges of $6.7 million, including $2.9 million of restructuring and other, and $3.8 million of business development charges. This compares to prior year pretax charges of $6.6 million, including $2.2 million of restructuring and other, and $4.4 million of business development charges. A reconciliation of GAAP to non-GAAP metrics is provided within the schedules attached to this morning's press release. Additionally, please keep in mind that any forward-looking statements made during this call are subject to risks and uncertainties, which are described in our press release and SEC filings. With that, I will now turn the call over to Tod.

Tod Carpenter, Chairman, President and CEO

Thanks, Sarika. Good morning, everyone. Donaldson Company achieved record sales in the second quarter as we worked hard to meet strong customer demand across all three of our segments. Our underlying business is robust as evidenced by our high backlogs and continued strong order intake. While we faced short-term execution challenges in our Industrial segment, we saw strength in areas such as independent aftermarket within Mobile Solutions and Food and Beverage and Disk Drive within Life Sciences. We also announced the acquisition of Facet, the largest acquisition in company history, which I will discuss in a few minutes. Entering the second half of the year, I have confidence in the strength of our organization and our commitment to deliver on our updated fiscal 2026 outlook, which represents record sales of approximately $3.8 billion with operating margin and adjusted earnings per share at all-time highs. Throughout our history, our talented global teams have demonstrated a commitment to deliver for all of our stakeholders, including our customers, shareholders, and employees. We continually do this through our leadership position in filtration, which was built on decades of solving our customers' most difficult filtration problems; our best-in-class technology, uniquely powerful because we focus on filtration capabilities and then leverage these technologies across markets; our ability to help customers meet evolving environmental and operational goals by helping to protect equipment, processes, and people; and our clear strategic and balanced growth strategy. This is how we have and will continue to win. In late January, we announced our next President and CEO, Rich Lewis, effective next week on March 2. This transition reflects a long-term succession planning process that comes at a time when we are well positioned for the future, thanks to the talent, dedication, and discipline of our global team. Rich has been with Donaldson since 2002 and has been our Chief Operating Officer since August. On behalf of the entire organization, I want to congratulate him, and I look forward to his future success. Before I turn it over to Rich to discuss our second quarter results in more detail, I want to touch on our recent acquisition of Facet, which we are very excited about. This acquisition complements and expands Donaldson's product portfolio, bringing high-performance fuel and fluid filtration capabilities for mission-critical applications and broadening our exposure to durable end markets such as Aerospace and Defense and Power Generation. Importantly, approximately 70% of Facet's revenue is driven by recurring regulated replacement part sales, a nice fit with our already large composition of replacement parts. Facet makes us stronger, adding nearly $110 million in sales with gross margins and EBITDA margins significantly above our current company average. The company has low capital intensity and strong cash flows. We look forward to welcoming the Facet team to Donaldson and reporting on our combined performance. Now I will turn it over to Rich, who will talk more about the second quarter highlights, and then Brad will take us through the financials in more detail.

Rich Lewis, Incoming President and CEO

Thanks, Tod. Good morning, everyone. First, I'd like to thank Tod for his leadership and congratulate him on his successful Donaldson career, including his impact as CEO over the past 11 years. I am honored to step into the CEO role and look forward to working alongside our broader leadership team to build on our momentum and deliver for our stakeholders. I also look forward to my continued partnership with Tod as he transitions to the Executive Chairman position. Now I'll cover our second quarter results. At a high level, sales were a record $896 million, 3% above prior year with growth across all three segments. Currency translation and pricing benefits were partially offset by volume declines in both Mobile and Industrial Solutions. Operating margin was 14%, down from 15.2% a year ago as a result of gross margin pressure. Volume deleveraging, concentrated operational inefficiencies related to our production shifts to support higher demand in Power Generation and footprint optimization costs negatively impacted gross margin in the quarter. Adjusted earnings per share were $0.83, flat versus the record achieved in 2025. Now looking at our segments. Mobile Solutions sales were $557 million, up 2% driven by currency benefits. Aftermarket sales were $447 million, up 1% with high single-digit growth in our independent channel, offset by OE channel declines. Overall, we are benefiting from share gains and increases in global vehicle utilization. On the first-fit side, off-road sales of $86 million increased 8% as we cycle against weak market conditions from the prior year, particularly in agriculture. On-Road sales of $23 million decreased 9% as a result of continued declines in global truck production. Touching on our Mobile business in China. Sales were up 18% due to strength in off-road and aftermarket. This marks our sixth consecutive quarter of growth in China, and we are optimistic about the future opportunities in this important market. In Industrial Solutions, sales were $260 million, a 2% increase compared with 2025, driven by currency benefits. IFS sales of $223 million grew 7% from continued strength in Power Generation, particularly in North America and Europe, and demand for new equipment remains significant. Rounding out our Industrial Solutions performance, Aerospace and Defense sales were $37 million, down 19% versus prior year due to project timing, primarily in defense. In Life Sciences, sales of $80 million increased 16% year-over-year, largely as a result of robust growth in Food and Beverage and Disk Drive. In Food and Beverage, our largest business within Life Sciences, new equipment sales grew substantially in all regions, laying the foundation for future replacement parts sales growth. We continue to win, including in areas such as liquid cooling for data centers, and we are winning with key OEMs and channel partners through our strong sales processes and technology-led products. Given our second quarter results and our expectations for the second half of the year, we are updating our margin and earnings outlook for fiscal 2026. At the midpoint of our revised guidance ranges, we continue to expect a record year for Donaldson, now inclusive of record sales of $3.8 billion and sales growth in each of our segments, consistent with our previous expectations. Operating margin expansion of 50 basis points to an all-time high of 16.2%, including second half operating margin consistent with our prior guidance. Earnings per share of $3.97, roughly 8% above prior year, and free cash flow conversion of approximately 90%, which provides us capital allocation optionality to return value to our shareholders. In summary, I am proud of the agility and resilience displayed by the Donaldson team as we navigate some short-term operational headwinds to set ourselves up for stronger performance over the long term. With that, I will now turn it over to Brad, who will provide more details on the financials and our outlook for fiscal 2026.

Brad Pogalz, Chief Financial Officer

Thanks, Rich. Good morning, everyone. I want to start by thanking the Donaldson team. They demonstrated tremendous agility as we work to deliver for our customers while making progress on several big projects, including the work done on the Facet acquisition. Facet will be an important addition to our company. We expect to close in the next couple of quarters. And as Tod mentioned, Facet will make us stronger, strategically and financially. Beyond Facet, we're focused on delivering the strong second half performance reflected in our guidance. But first, a summary of our results. Note that my profit comments exclude the impact from the nonrecurring charges Sarika referenced earlier. Total sales increased 3% and adjusted EPS of $0.83 was flat year-over-year. Operating margin declined 120 basis points to 14% due primarily to the impact from discrete operational issues on gross margin. Second quarter gross margin was 33.7%, down 150 basis points from the prior year and below our expectations. About 60 basis points of the total gross margin decline was due to deleveraging from lower volume in the Mobile and Industrial segments. We anticipated some year-over-year gross margin pressure in the quarter as there were certain businesses, particularly OE aftermarket and defense with difficult comparisons from last year. But the timing of orders and delivery had a greater impact than planned. For the second half of fiscal '26, we expect the volume pressures abate based on our strong backlogs and the leverage that comes with our typical second half sales step-up. Second quarter gross margin was also impacted by inefficiencies driven by changes we are making to our manufacturing footprint. One item that spiked this quarter relates to Power Generation and specifically, the production of our large turbine systems. To meet the super cycle demand and deliver on customer-specific requirements of producing in North America, last year, we began producing these large systems for the first time at one of our facilities in Mexico. The combination of a protracted startup process in Mexico and surging demand resulted in a gross margin headwind of about 40 basis points in the quarter. We have plans in place to accelerate our improvement and expect to make progress in the second half of this fiscal year. Another area where we expect improvement in the second half relates to our ongoing footprint optimization initiatives. This fiscal year is an important milestone for this work with the most significant projects expected to be completed by fiscal year-end. In the quarter, we had about 30 basis points of gross margin pressure as we go through the final stages of a plant closure in the U.S. and associated transfer of production. Once through this heavy lift period, we will begin to realize cost benefits later in this fiscal year and into the future. While gross margin in the second quarter was not to our expectation, the drivers of the performance reflects short-term headwinds from the work we are doing to establish long-term efficiencies in several of our most important businesses. Our forecast contemplates sequential improvement in gross margin and full-year expansion. I'm confident we will deliver on that target. At the same time, our team continues to do an excellent job managing our operating expenses. As a rate of sales, operating expenses improved to 19.7% from 20% a year ago, reflecting benefits from the structural cost optimization initiatives launched during the prior fiscal year as well as continued expense discipline. We are prioritizing opportunities while conserving where we can, providing necessary offsets to the footprint work we are doing. In terms of segment profitability, Mobile Solutions pretax profit margin was 16.8%, down 60 basis points from prior year, primarily due to volume deleveraging in the aftermarket OE channel and footprint optimization efforts. Industrial Solutions pretax margin was 11.9%, down from 16.1% in 2025, stemming from the previously mentioned operational inefficiencies and footprint optimization costs. With improving plant efficiency and benefits from leverage on higher sales, we expect Industrial pretax operating margin to step up notably in the second half. Life Sciences pretax margin improved to 9.3% from a loss of about 1% a year ago. Strong sales in our higher-margin Food and Beverage and Disk Drive businesses and benefits from a more focused expense structure following optimization programs a year ago drove the improvement. Turning to our fiscal '26 outlook. First on sales, we are reaffirming our consolidated sales guidance of 1% to 5% growth, with stronger-than-expected sales in Mobile Solutions and Life Sciences being offset by lower Industrial Solutions sales. Our forecast assumes pricing and currency translation will each contribute about 1% to growth. Within Mobile Solutions, we're increasing our growth forecast to a range between 2% and 6% compared with flat to up 4% previously, primarily due to favorable currency. We are raising our guidance for aftermarket and now expect sales up mid-single digits versus our previous low single-digit forecast, primarily due to strength in our independent channel from currency, pricing, and volume. Consistent with our prior guidance, off-road sales remain on track to grow mid-single digits, mainly due to a modest rebound following significant declines in agriculture a year ago. On-road sales are expected to be flat for the year, also in line with our prior guidance due to muted global truck production. In Industrial Solutions, sales are forecast to decline by 1% to an increase of 3% versus the previous expectation for growth between 2% and 6%. Sales of IFS are now expected to grow in the low single digits, down from mid-single digits previously due largely to declines in sales of dust collection and industrial hydraulics systems. Aerospace and Defense sales are projected to decline mid-single digits versus flat previously due to the timing of certain programs. In Life Sciences, we are increasing our sales forecast as benefits from favorable currency translation are expected to complement already strong Food and Beverage and Disk Drive momentum. To that end, we project sales to increase between 5% and 9% versus a 1% to 5% increase previously. We expect benefits from sales leverage and continued cost discipline to generate full-year pretax margin in the mid- to high single digits, up from mid-single digits previously. Given our second quarter performance and our outlook for the balance of the year, we revised our operating margin guidance to a range between 16% and 16.4%, a decline of 30 basis points at the midpoint from our prior forecast. Despite the temporary gross margin headwinds in the second quarter, the full-year operating margin forecast still reflects a record level, and at the midpoint, an incremental margin approaching 35%. With that change, we now expect fiscal 2026 EPS between $3.93 and $4.01 per share. At the midpoint of $3.97, we are projecting EPS growth of 8% on 3% sales growth. Our earnings guidance contemplates a second half step-up in sales, supported by our strong backlogs as well as gross margin expansion resulting from the operating improvements I discussed earlier. Now on to our balance sheet and cash flow outlook. Our capital expenditures are expected to be between $60 million and $75 million with focused investments, including new products and technologies across all verticals. We continue to project cash conversion in the range of 85% to 95%, an improvement versus 2025 and consistent with historical averages. The balance sheet remains a strength of Donaldson's with our net leverage ratio currently at 0.7x. Adjusting for the Facet acquisition, Donaldson would have a net leverage ratio of approximately 1.7x, still leaving us ample financial flexibility to thoughtfully invest for our future growth. As we think about shareholder value creation for the long term, our capital allocation priorities are unchanged. First, reinvest back into the company. We are the leader in technology-led filtration and intend to maintain our position. R&D investments in strategically important high-growth, high-margin areas where we have a clear path to win will drive our success. Our longer-term efforts are also supported by ongoing working capital investments and capital expenditures. Our second capital deployment priority is disciplined M&A. We actively work through a pipeline of opportunities. Discipline is key to our approach. We are excited about our Facet acquisition and look forward to pursuing additional opportunities that meet our strategic and financial criteria. We are creating long-term value through our growth investments, but also through the return of cash to our shareholders. Our third capital allocation priority is dividends. Calendar year 2025 was our 70th year in a row of paying dividends and the 30th in a row of increasing our dividend. We have every intention of maintaining our status as a proud member of the S&P High-Yield Dividend Aristocrat Index. Share repurchase is our fourth capital deployment priority and it has always been the variable component. Given the pending close on our acquisition of Facet, we do not expect to repurchase additional shares in the balance of this fiscal year. Year-to-date, we have repurchased 1.2%, which offsets dilution. And our focus now is using the strength of our business to rapidly pay down debt. Looking beyond the quarter, the underlying fundamentals of our business are strong, and we have the right priorities to deliver another year of profitable growth and value creation. Now I'll turn the call back to Tod.

Tod Carpenter, Chairman, President and CEO

Thanks, Brad. As I sit and reflect today, I am particularly pleased with Donaldson Company's continued evolution as a premier global provider of technology-led filtration solutions, and I'm excited for the opportunities that lie ahead. It has been a privilege to be part of this organization for the last 30 years and an honor to have led the company for the last 11. I won't be far away as I take on the role of Executive Chairman. I am highly confident in our teams around the globe who make Donaldson what it is and who I know will reach new heights under Rich's leadership. With that, I'll now turn the call back to the operator to open the line for questions.

Operator, Operator

Your first question comes from Angel Castillo with Morgan Stanley.

Oliver Z Jiang, Analyst

This is Oliver on for Angel today. Can I just double click on A&D? I know you guys guided down here for '26. Is that because of projects shifting into 2027 or something to do with underlying demand? And then how should we think about your guide versus what you're seeing for Facet? Is that just a product of different portfolios and aftermarket?

Rich Lewis, Incoming President and CEO

Yes, I'll take your first question. When considering A&D, we are coming off record sales levels from the past couple of years, but we have experienced lower revenue in the first half of the year. This is mainly due to timing issues with some of our military projects, which can be inconsistent, along with ongoing supply chain challenges. Overall, however, we are very comfortable with the order intake. The backlog for this business post-October has increased by over 20%, indicating that orders are coming in well. We are optimistic that the run rate for the second half will significantly improve. The key is to work closely with our suppliers to ensure we can fulfill all the orders, especially since some suppliers are sole-source directed buys. We are also in the process of qualifying new suppliers, which can take time. Ultimately, it’s about managing this order book effectively, and we expect to see a notable increase in the second half. Regarding Facet, we operate in different segments of the market, focusing more on ground vehicles, while they are more involved in military fixed-wing and marine sectors. We anticipate an improvement in revenue performance in the second half.

Oliver Z Jiang, Analyst

Great. That's really helpful. And then just maybe one follow-up on Industrial. I know some footprint changes this quarter. Do you expect that to continue or abate somewhat into fiscal 3Q and 4Q? And then can you talk just a little bit about what that buys you in terms of Power Gen? Does that potentially expand throughput or potentially even a bigger portfolio there? So any color there would be helpful.

Rich Lewis, Incoming President and CEO

Sure. Yes, let's take the footprint optimization work. I know we've been talking about this for a while. These projects are pretty complex. They typically last 12 to 24 months. We have had an accelerated amount of activity in this space over the last couple of years. Just to put it into perspective, we have four plant closures that we've been working on, none of which touch Power Gen. It's other parts of the industrial business. Two of these are in their final phase, which basically means the plants are closed. The assets have been transferred to the new location, and they're working through the learning curve and the productivity increase. We would expect that work to come to a conclusion through the balance of the fiscal year. We also have two other plants. We will close those in quarter 3. And they'll be working through the learning curve and the productivity increase in Q4. Maybe a way to think about it is you'll start to see the benefit, the margin improvement benefit in our guide in fiscal '27. We also do these projects for a couple of reasons. We're trying to reduce our asset base, and we're also trying to reduce or improve our risk profile. So we believe these projects ultimately will be very successful, but we do have a few more months here of work ahead of us.

Operator, Operator

Your next question comes from the line of Bryan Blair with Oppenheimer.

Bryan Blair, Analyst

Tod, congratulations on a very successful career, including over a decade as CEO. And Rich, congrats on the transition.

Tod Carpenter, Chairman, President and CEO

Thanks, Bryan.

Rich Lewis, Incoming President and CEO

Thanks, Bryan.

Bryan Blair, Analyst

Of course. I was hoping that you guys could offer a little more color on how IFS orders trended through fiscal Q2 and what your team is seeing thus far in Q3. Year-on-year growth was stronger sequentially, aligning with the prior guidance framework of mid-single-digit growth. Power Gen, some inefficiencies in the second quarter, but certainly a good guy in terms of growth path. Brad, I know you called out dust collection and hydraulic systems as the areas of relative weakness. I guess, if you can offer some finer points on whether there is accelerated weakness through fiscal Q2 into Q3 in those areas or you're simply taking a more cautious or conservative stance on continued macro uncertainty.

Rich Lewis, Incoming President and CEO

Yes. I'll discuss the business side and the macro situation, and if Brad has anything to add about the numbers, he can chime in. When we look at the IFS segment, Power Generation is currently very strong. From a broader perspective, we have solid bookings through the end of the fiscal year and have already secured good bookings for the next two fiscal years. We feel very optimistic about the demand in Power Generation, which is widespread, encompassing both the compressed gas sector in oil and gas and peak and base load energy generation. Much of this demand is linked to the growing focus on data centers. On the IFS side, the situation is somewhat mixed. Globally, we see relatively stable ordering patterns outside of the Americas, which have been quite soft. However, there's still a significant amount of quoting activity in the Americas. The economic uncertainty is making companies hesitant to finalize purchase orders. Overall, replacement parts are performing well, with good utilization rates and order intake in that area.

Brad Pogalz, Chief Financial Officer

Bryan, this is Brad then. I'll just add. I think as you look at the first couple of quarters, dust collection is about where it was in the second quarter in terms of the overall year-over-year conditions. So not much to comment there, but I do want to underscore a point Rich made. This is really about our new systems and the first-fit side of the business. The machines are still running. Aftermarket is still doing well in IFS, and we've got good opportunities there with our placement. It's just about getting these capital expenditure decisions of our customers to break free a little bit.

Bryan Blair, Analyst

Understood. That's helpful color. Facet is an intriguing deal for your team, certainly mix enhancing. Can you speak to the historical growth rates of the asset, whether we should expect accelerated growth under Donaldson ownership? If so, what the drivers are there? And how we should think about P&L impact looking to fiscal '27? I know you had said close within the next couple of quarters, so sometime in the fiscal back half. But if we look to next year, how should we think about impact?

Rich Lewis, Incoming President and CEO

Yes. I'll take a moment to discuss Facet from a broader perspective. We are really excited about the possibility of Facet joining the Donaldson family. We will continue to work through the regulatory process to finalize this deal in the next few quarters. This is a business we have admired for a long time, and it aligns perfectly with our M&A strategy. It generates stable recurring filtration revenue and has a strong competitive advantage due to the regulatory nature of its market. Additionally, it operates in a high-margin, high-growth sector. The growth rates are high single digits, influenced by a mix of volume and pricing, and we expect this trend to continue. Facet also has many potential growth opportunities outside its core military and commercial markets in the aerospace sector, where we have a strong presence in our industrial business. We anticipate significant growth synergies over time, although we have not included those in our projections, so that remains potential upside. Overall, we believe Facet will be a great fit for us, and we are very enthusiastic about the opportunity.

Brad Pogalz, Chief Financial Officer

Bryan, on the P&L side then, obviously, we expect to close in a couple of quarters. So nothing factored into the fiscal '26 guidance, but you mentioned fiscal '27. As we think ahead, I think the important point that we said in the prepared remarks is that it's mix positive on our most important operating metrics, gross margin and EBITDA. Obviously, this is a business that we will work to integrate properly. We don't expect much in the way of cost synergies, a few million dollars, but more from procurement because it sits in a unique spot relative to where we sit in these markets. So I think, overall, we'll give more detail with fiscal '27 guidance, but we're excited about this from the strategic side that Rich mentioned and the financial implications to Donaldson.

Operator, Operator

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

Timothy Thein, Analyst

Congrats again to both Rich and Tod. And Tod, I'm hopeful that you're able to observe its turnaround and go for basketball and retirement.

Tod Carpenter, Chairman, President and CEO

Thanks, Tim.

Timothy Thein, Analyst

Yes, there is only one direction to move. The question pertains to the mobile business. Based on the full year guidance, it suggests that growth in that sector will accelerate somewhat in the latter half of the year. Can you discuss the continued strength in the independent channel and share what you are hearing from the OEM dealers? Additionally, as the first-fit business is anticipated to improve, how do you foresee the relationship between the two? What have you noted historically when the first-fit side starts to gain momentum? That’s my first question.

Rich Lewis, Incoming President and CEO

Thanks, Tim. Maybe let me break this down. Let's talk about the replacement parts side for a second. So as you pointed out, the replacement part orders through our independent channel have been very strong. We still continue to see that performance continuing. No slowdown there at all. When we think about the OE side, this year, we returned to what I would call a sort of typical normal year-end, their fiscal year-end inventory management practices. So we did see a pretty good pullback relative to the prior year where we actually saw people stocking up, which was pretty atypical. So year-over-year, it was a pretty drastic change. What we always look for is when you come out of those holidays, what happens with your backlogs? And we saw a sharp increase. Unlike our independent aftermarket, which is really you get orders, you ship them within 24 hours, our OE partners do give us really good visibility on lead times. And we've seen a sharp increase in our hard backlogs on the OE. So we're really confident the second half will be a significant improvement there. Maybe touching on the first-fit markets. If you think about ag and truck, they still continue to be performing near, what we would call, bottom of the cycle. We're monitoring this closely because when these markets come back, and hopefully, this answer your question, they come back aggressively. I think 20% to 30%. And we want to be really ready to make sure we address our customers' needs. So we're staying very tight with our customers on that. I will say we're seeing signs of pockets of optimism and ag with some increased order intake on the first-fit side with select OEs, but it's not broad-based at this point. Also, in the truck market, we're having signals from some of our truck manufacturers that in the second half of calendar year '26, so which will be our fiscal year '27, they're planning for increased truck builds. I would say we remain cautious on this and being ready for the upturn because when it does happen, it happens aggressively. But that's how we characterize the markets as we sit here today.

Brad Pogalz, Chief Financial Officer

Certainly. You've identified the key point. It's multifaceted, but there's a mixed effect as we increase sales to the original equipment manufacturers, particularly with the return of new equipment. We're preparing for this, and while we might experience a slight rate mix impact in upcoming quarters, the earnings will ultimately benefit from it. I believe we'll see substantial leverage as it progresses through the profit and loss statement. Additionally, regarding the markets, as Rich mentioned, I anticipate a rebound in the Mobile Solutions segment this quarter. In my earlier remarks, I noted the volume adjustments, which I expect to recover. Specifically for the latter half of the year, we foresee an acceleration in Mobile Solutions profits as volume starts to increase.

Operator, Operator

Your next question comes from the line of Adam Farley with Stifel.

Adam Farley, Analyst

Can we go back to the operating efficiencies and power generation? I just wanted to put a finer point on what exactly happened there? What was the underlying cause? And then just expectations on how that kind of ramps going forward?

Brad Pogalz, Chief Financial Officer

Yes. So I gave you the macro perspective on Power Gen. So clearly, the demand is very strong. We're in the middle of sort of rebalancing our product portfolio across both sites so we can maximize output. So we've moved production into our facility in Monterrey, Mexico. We've ramped that facility's capacity up significantly through a combination of process improvements to increase flow and a dramatic increase in staffing. And so we're working through the learning curve and onboarding these employees. A lot of the hiring is behind us, and now it's really about training and onboarding these employees in the third quarter here. We do expect output from this site to continue to improve with this increased capacity and their productivity will continue to get better throughout the fiscal year.

Adam Farley, Analyst

Okay. And then maybe one more on the pending acquisition of Facet. Could you maybe talk about the total addressable market for Facet, Facet's market position and maybe primary competitors in the space?

Rich Lewis, Incoming President and CEO

Yes. So from a competitor standpoint, they're one of the leaders. There's a couple of historic players that lead in this space, and then it fragments from there. They play in a lot of different markets. And so they're in the commercial, the marine, and military space. We believe there's a lot of headroom for continued growth. And some of the interesting opportunities are actually in what I would consider maybe our core industrial markets, which would be relatively new to them. And so yes, there's a lot of space for us to grow this business over the coming years.

Operator, Operator

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

Brian Drab, Analyst

Congratulations, Tod and Rich. I will follow up with both of you later and save the sentimental comments for the private call. Recently, the Life Sciences segment has shown some of the strongest growth. Could you explain a bit about the Disk Drive business? I know you've previously discussed the HAMR technology that is increasing demand for your products. Given the strong growth, do you think it could accelerate? Could that business grow significantly larger? How connected are you to the data center build-out? Also, could you provide some insights into that business, including your customers and the total addressable market in that area?

Rich Lewis, Incoming President and CEO

Yes. Brian, as you point out, the Life Science business has been doing very well. We restructured that business last year to bring more focus. And the two largest businesses, Food and Bev and Disk Drive have been really excelling. On the Disk Drive side, if you think about what's driving a lot of that demand, it is AI and cloud storage. There's a strong demand for drives and more and more dense storage. HAMR clearly addresses that. I would say our growth is a combination of market comeback and share gains. And we do believe that the market has runway to grow. A lot of our customers are building at very high utilization rates right now. And so as they bring on more capacity, the demand feels like it's there for the foreseeable future. So HAMR has been a big success so far. We've ramped that business up with one of our OE customers this year, and we look forward to that continuing to gain market penetration.

Brian Drab, Analyst

What exactly is your technology or the products used in that application? Can you remind me?

Rich Lewis, Incoming President and CEO

Yes. So it's a filter. In the early days, it was a filter to remove particles, much like some of the air filters. But as these drives have become way more sophisticated, now we're doing absorption technologies that really take out harmful gases and fumes. These drives are very, very, very sensitive. And that's part of our share gain in this space. As the technology continues to increase, we were able to continue to differentiate our capabilities and take additional market share there.

Brian Drab, Analyst

And then is there any detail that you can give on your liquid cooling exposure? I know you mentioned it today on the call again, but what products, technologies are you supplying there? And what's the potential addressable market for Donaldson there?

Rich Lewis, Incoming President and CEO

Yes. So on the liquid cooling, it's really an extension of the products that we sell in the Food and Bev. Their products have applicability in several other process filtration applications. And this is one. We've seen a sharp uptick in interest. A lot of these data centers are converting from air cooling to liquid cooling and our products fit very nicely with that. It's a pretty fragmented market right now because there's really no clear standards on the systems. And so I'd say it's a bit early to judge how big it's going to be. But certainly, we're seeing a lot of activity and a lot of interest in that space.

Operator, Operator

Your next question comes from the line of Laurence Alexander with Jefferies.

Laurence Alexander, Analyst

I have two quick questions. First, regarding the Power Generation side, could you provide some insight on how the competitive landscape has evolved since the last cycle? Additionally, how much more capacity expansion do you anticipate needing to keep pace with the order books announced by the equipment manufacturers? Secondly, concerning the acquisition, what is your timeline for achieving an acceptable return on capital?

Rich Lewis, Incoming President and CEO

So I'll take the Power Gen, and then I'll let Brad address the second question. So from a Power Gen perspective, yes, I mean, the demand is very, very high. I would say the dynamic that's different now is because, as you're aware, we sort of narrowed our focus after the last cycle. We're seeing, I would say, more interest in being fair and balanced with the commercial deals. And so we'll continue to take orders that make sense for us commercially. We're increasing our capacity in our Mexico facility fairly significantly. And so we believe we're in a good position from addressing our customers' needs. They have many other constraints besides our product. And so it feels like we're well aligned with what their build capability is right now.

Brad Pogalz, Chief Financial Officer

Laurence, this is Brad. In terms of the returns, this is much more of a strategic acquisition than a synergy play. And with that, thinking about it on a cash basis, probably more at our cost of capital in the 5-year time horizon. But I think the really positive side of this business is it's throwing off cash immediately. We get to earnings accretion pretty rapidly. We said year 2. And of course, our goal is to make that even faster.

Operator, Operator

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

Robert Mason, Analyst

And Tod, Rich, I want to congratulate you on the transition. Rich, in your earlier comments, you mentioned that the margin outlook for the second half hasn't changed in the updated guidance. However, it seems like there is still work to be done on the footprint optimization. Can you provide some insight into your confidence level regarding the ability to improve margins, whether that improvement will occur more significantly in the third quarter or if it will be more apparent in the fourth quarter? Additionally, can you share your level of confidence in maintaining the second half margin outlook in light of the challenges faced in the second quarter?

Rich Lewis, Incoming President and CEO

Yes, I think you made a good point, Rob. Clearly, we need to see the volume increase in our OE and Aerospace and Defense businesses. We have those backlogs, so we feel really confident about that part. We will have to keep addressing the supply chain issues in A&D, but the team is focused on that and is collaborating closely with our suppliers. We believe we are in a strong position. Regarding the restructuring work, a couple of initiatives are complete, and we should begin to see costs decrease and benefits start to materialize. The other two initiatives are still in progress in Q3, and the risk there would be any delays or unexpected issues. However, we are currently on track and expect to finish those by the end of the fiscal year for sure. In Power Gen, as we mentioned, we've doubled the workforce just in our first quarter, and we feel optimistic. Turnover is low, and staffing is becoming productive. We need to see continued progress in the second half, but based on all the insights from the team, we're on track for them to keep improving through the second half of the year.

Brad Pogalz, Chief Financial Officer

Rob, I'm going to add one point, too. And I think an important note here is as we look at the second half step up, some of that comes with expense leverage as well. We've got really good controls over what's going on with expenses in the company. When you think about the improvement in the second half, a big portion of that also comes from the natural leverage. So as Rich said, we've got the backlogs to deliver the sales. We'll keep expenses at a rate that's, give or take, are at a dollar level. That's give or take where we were in the first half. So there's the leverage that comes with that too.

Robert Mason, Analyst

Okay. That was actually my next question. Since the operating expenses in the second quarter decreased sequentially, I was wondering about the thought process regarding this smaller business. We're aware of the on-road truck challenges, but reaching flat for the year suggests that you expect some recovery in that business. Should we anticipate that recovery to be mainly in the fourth quarter, sequentially?

Brad Pogalz, Chief Financial Officer

Yes, I believe the shift towards the latter part of the second half is significant. As Rich mentioned earlier regarding the trough, we are noticing some positive indicators. The public data sources many of us monitor indicate a potential rise in Class 8 heavy-duty truck production in North America this year. These insights provide us with optimism. Additionally, we discussed last quarter the progress we’ve made with certain programs in our business that we’ve secured. This aspect of our first-fit business continues to gain traction with original equipment manufacturers. Therefore, if production resumes, it will be additional growth for us.

Operator, Operator

And that concludes our question-and-answer session. And I will now turn the conference back over to Rich Lewis for closing comments.

Rich Lewis, Incoming President and CEO

That concludes our call today. Thanks to everyone who participated. We look forward to reporting our third quarter fiscal 2026 results in June. Goodbye.

Operator, Operator

Ladies and gentlemen, this does conclude today's conference call. Thank you for your participation, and you may now disconnect.