UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

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Form 10-K

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DONALDSON COMPANY, INC.

ANNUAL REPORT ON FORM 10-K

TABLE OF CONTENTS

Table of Contents

PART I

Item 1.  BUSINESS

GENERAL

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;turbines and specialized filters for such diverse applications as computer disk drives aircraft passenger cabins and semiconductorsemi-conductor processing. Products are manufactured at more than thirty30 plants around the world and through three of our 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 and emissions systems, liquid filtration systems and replacement parts. The Engine Products segment sells to original equipment manufacturers (OEMs)(“OEM”) in the construction, industrial, mining, agriculture and transportation markets and to independent distributors, OEM dealer networks, private label accounts and large privateequipment fleets. Products in the Industrial Products segment consist of dust, fume and mist collectors;collectors, compressed air purification systems;systems, liquid filters and parts;parts, static and pulse-clean air filter systems for industrial gas turbines; computer disk drive filter products; otherturbines, and specialized air filtration systems and PTFE membrane and laminates.for diverse applications including computer disk drives. 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 KJ in the Notes to Consolidated Financial Statements on page 48.44.

        The Company makes its annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, and amendments to those reports, 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.

COMPETITION

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Seasonality

        The Company’s business in aggregate is not considered to be seasonal. A number of our end markets are dependent on the construction and agricultural industries, which are generally stronger in the second half of our fiscal year.

Competition

        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 highly competitive filtration markets in both the Engine Products and Industrial segments and both segments operate in a highly competitive environment.Products segments. The Company believes it is a market leader in many of its primary product lines within the Industrial Products segment.lines. 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 for OEMs and is a significant participant in the aftermarket for replacement filters and hard parts in its engine-related businesses.parts. The Engine Products segmentsegment’s 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

Raw Materials

        Although the Company experienced an increase in steelcommodity prices, during the year, the Company responded through a combination of cost reductions and by recovering a portion of these price increases from customers and will continue these recovery efforts in the next fiscal year.customers. 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

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.Major Customers

        Sales to Caterpillar Inc. and its subsidiaries (“Caterpillar”) accounted for 12 percent of net sales in 2006 and 2005, respectively, and 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 severalmany 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. There were no customers over 10 percent of gross accounts receivable in 2006 or 2005.

BACKLOG

Backlog

        At August 31, 2004,2006, the backlog of orders expected to be delivered within 90 days was $216,428,000.$291,011,000. The 90 day90-day backlog at August 31, 20032005 was $188,507,000.$227,243,000. Backlog is one of many indicators of business conditions in our market. However, it is not always indicative of future results for a number of reasons, including short lead times in our aftermarket and the timing of receipt of orders in many of our original equipment and industrial markets.

RESEARCH AND DEVELOPMENT

Research and Development

        During 2004,2006, the Company spent $35,374,000$33,887,000 on research and development activities relating to the development of new products or improvements of existing products or manufacturing processes. The

Company spent $30,456,000$32,234,000 in 20032005 and $28,150,000$30,487,000 in 20022004 on research and development activities. Essentially all commercial research and development is Company-sponsored.

ENVIRONMENTAL MATTERS

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Environmental Matters

        The Company does not anticipate any material effect on its capital expenditures, earnings or competitive position during fiscal 2007 due to compliance with government regulations involving environmental matters.

EMPLOYEES

Employees

        The Company employed approximately 10,40011,500 persons in worldwide operations as of August 31, 2004.2006.

GEOGRAPHIC AREAS

Geographic Areas

        Financial information about geographic areas appears in Note KJ of the Notes to Consolidated Financial Statements on page 49.44.

Item 1A.  RISK FACTORS

        There are inherent risks and uncertainties associated with our global operations that involve manufacturing and sale of products for highly demanding customer applications throughout the world. The risks and uncertainties associated with our business could adversely affect our operating performance or financial condition. The following discussion along with discussions elsewhere in this report outlines the risks and uncertainties that we believe are the most material to our business. However, these are not the only risks or uncertainties that could affect our business. Therefore, the following is not intended to be a complete discussion of all potential risks or uncertainties.

Unfavorable fluctuations in foreign currency exchange rates could negatively impact our results of operations and financial position.

        We have operations in many countries. Each of our subsidiaries reports its results of operations and financial position in its relevant foreign currency, which is then translated into United States dollars. The translated financial information is included in our consolidated financial statements. The strengthening of the United States dollar in comparison to the foreign currencies of our subsidiaries could have a negative impact on our results of operations or financial position.

Operating internationally carries risks which could negatively effect our financial performance.

        We have sales and manufacturing operations throughout the world, with the heaviest concentrations in North America, Europe and Asia. Our stability, growth and profitability are subject to a number of risks of doing business internationally that could harm our business, including:

Maintaining a competitive advantage requires continuing investment, with uncertain returns.

        We operate in highly competitive markets and have numerous competitors who may already be well established in those markets. We experience price pressures from these competitors in certain product lines and geographic markets. We expect our competitors to continue improving the design and performance of their products and to introduce new products that are competitive in both price and performance. We believe that we have certain technological advantages over our competitors but maintaining

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these advantages requires us to continually invest in research and development, sales and marketing and customer service and support. There is no guarantee that we will be successful in maintaining these advantages. We are currently making investments in emissions technology development to meet the changing regulatory requirements worldwide. Our financial performance may be negatively impacted if a competitor’s successful product innovation reaches the market before ours or gains broader market acceptance before our product offerings.

        A number of our major OEM customers manufacture component products for their own use. Although these OEM customers rely on us and other suppliers for other of their component products, they could choose to manufacture additional component products for their own use. There is also a risk that one of our customers would acquire one of our competitors.

        We may be adversely impacted by changes in technology that could reduce or eliminate the demand for our products. We are at risk with respect to:

Acquisitions may not necessarily have a positive impact on our results.

        We have and continue to pursue acquisitions of complementary product lines, technologies and businesses. We cannot guarantee that these acquisitions will have a positive impact on our results. These acquisitions could negatively impact our profitability due to dilutive issuances of equity securities, the incurrence of debt and contingent liabilities and amortization expenses related to intangible assets. There are also a number of risks involved in acquisitions. For example, we could have difficulties in assimilating the acquired operations, assume unanticipated legal liabilities or lose key employees of the acquired company.

Compliance with environmental laws and regulations can be costly.

        We are subject to many environmental laws and regulations in the jurisdictions in which we operate. We incur product development capital and operating costs in order to comply with these laws and regulations. We may be adversely impacted by new or changing environmental laws and regulations that affect both our operations and our ability to develop and sell products that meet our customers’ product and performance requirements.

Demand for our products relies on economic and industrial conditions worldwide.

        Demand for certain of our products tends to be cyclical and responds to varying levels of construction, agricultural, mining and industrial activity in the United States and in other industrialized nations.

        Sales to Caterpillar, Inc. and its subsidiaries have accounted for greater than 10 percent of our net sales in the past three fiscal years. An adverse change in Caterpillar’s financial performance or a material reduction in our sales to it could negatively impact our operating results.

Unavailable or higher cost materials could result in our customers being dissatisfied.

        We obtain raw material and certain manufactured components from third-party suppliers and tend to carry limited raw material inventories. Even a brief unanticipated delay in delivery or increases in prices by our suppliers could result in the inability to satisfy our customers on delivery and pricing. This could negatively affect our financial performance.

Changes in our product mix impacts our financial performance.

        We sell products in various product lines that have varying profit margins. Our financial performance can be impacted positively or negatively depending on the mix of products we sell during a given period as compared to a previous period.

Item 1B.  UNRESOLVED STAFF COMMENTS

        None.

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Item 2.  PROPERTIES

        The Company’s principal office and research facilities are located in Bloomington, Minnesota, a suburb of Minneapolis, Minnesota. The principal European administrative and engineering offices are located in Leuven, Belgium. The principal Asia-Pacific regional administrative offices are locatedCompany also has extensive operations in Singapore.Asia-Pacific.

        The Company’s principal plant activities are carried onout 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 lesseealso leases certain of its facilities, primarily under several long-term leases.leases, some of which provide for options to purchase the facilities at the end of the lease term. The denoted facilities (*) are leased facilities.

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

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 otherwisecurrently subject to any pending litigation other than routine litigation arisingwhich arises out of and is incidental to the conduct of the Company’s business. All such matters are subject to many uncertainties and outcomes that are not predictable with assurance. The Company does not consider any of such proceedings that are currently pending to be likely to result in the ordinary course of business, none of which is expected to have a material adverse effect on the business,Company’s consolidated financial position or results of operations, financial condition or liquidity of the Company.operation.

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, 2004.2006.

EXECUTIVE OFFICERS OF THE REGISTRANT

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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 executive officer.

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

Touche, LLP, an international accounting firm, from 2002 to 2004 and prior to this a partner for Arthur Andersen, LLP.LLP, an international accounting firm, from 1987 to 2002. Mr. McMurray was appointed Vice President, Human Resources in September 2003.2003 and was promoted to Vice President, Human Resources, Information Technology, Europe, South Africa and Mexico in August 2005. In September 2006, Mr. McMurray most recentlywas promoted to Senior Vice President, Industrial Products, Technology, and South Africa. Mr. McMurray served as Director of Information Technology from 2001 to 2003 and prior to that position as Director of Manufacturing for Donaldson Europe.2003. 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. Mr. Touw was appointed Senior Vice President, Asia-Pacific in November 2004 and prior to that served as Vice President and General Manager of Donaldson Europe, Middle East and South Africa from 2000 to 2004. Ms. Joppa was appointed Vice President, Human Resources and Communications in November 2005. Prior to that time Ms. Joppa was a Director of Manufacturing.Human Resources at General Mills, a consumer food products company, from 1999 to 2005. In September 2006, James R. Giertz resigned his position as an executive officer of the Company to accept a position with Residential Capital Corporation.

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 Stockcommon stock for 20042006 and 20032005 appear in Note ML of the Notes to Consolidated Financial Statements on page 50.48. Also see Note ED on page 3633 for restrictions on payment of dividends. As of September 28, 2004,30, 2006, there were 1,9021,905 shareholders of record of Common Stock.common stock.

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        The highlow and lowhigh sales prices for the Company’s Common Stockcommon stock for each full quarterly period during 20042006 and 2003,2005 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 Stockcommon stock during the quarterly period ended July 31, 2004.2006.

(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 20002002 through 20042006 on page 48 of the 20042006 Annual Report to Shareholders is incorporated herein by reference.

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

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.

Overviewreport.

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 strengthcontinued strong demand in most of itsthe Company’s 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 2004.2006.

        The Company reported record sales in 20042006 of $1.415$1.694 billion, up 16.16.2 percent from $1.218$1.596 billion in the prior year. The Company’s results were positivelynegatively impacted by foreign exchangecurrency translation for the year. The impact of foreign currency translation during the year increaseddecreased sales by $70.0$25.3 million. Excluding the current year impact of foreign currency translation, worldwide sales increased 10.47.8 percent during the year.

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        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 comparable 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)millions):

Steel price increases also impacted results        Commodity prices continued to impact the Company during the year, particularlyyear. These cost pressures were effectively offset by cost reduction programs, improved production efficiencies and selective price adjustments. Gross margin of 32.9 percent was up from the gross margin of 31.7 percent 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 fiscalprior 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 0.92006 were 21.5 percent, down 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 11.521.9 percent from $95.3 million in the prior year. Operating expenses in fiscal 2006 included $2.8 million of stock option expense that was not included in fiscal 2005. However, operating expenses in fiscal 2005 included $6.4 million, or $.05 per share, related to the ruling of the Federal Circuit on the patent litigation between the Company and Engineered Products Company, Inc. (“EPC”).

        Although not as significant as the impact on net sales, the Company’s net earnings were also positivelynegatively impacted by foreign currency translation for the year. The impact of foreign currency translation during the year increaseddecreased net earnings by $4.7$0.8 million. Excluding the current year impact of foreign currency translation, net earnings increased 6.620.4 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 comparable 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)millions):

The Company reported record diluted earnings per share of $1.18,$1.55, a 12.422.1 percent increase from $1.05$1.27 in the prior year.

During fiscal 2004,2006, the Company continued to see growth in itsCompany’s Engine Products segment increased slightly from the prior year as sales in that segment grew to 58.8a percent of total net sales up from 56.1at 58.5 percent compared to 57.9 percent in the prior year. This reflectsFor the Company’s Industrial Products segment, percent of total net sales decreased slightly to 41.5 percent from 42.1 percent in the prior year. The comparable sales percentages reflect the strength in the conditions in the markets that the Engine Products segment servesboth segments serve and the Company’s efforts to capitalize on this strength. Incontinued strong demand in most of the Company’s Industrial Products segment, conditionsend markets in the markets it serves showed improvement during the year.each segment.

        Following is financial information for the Company’s Engine Products and Industrial Products segments. Corporate and Unallocated includeincludes corporate expenses determined to be non-allocable to the segments, interest income and expense, non-operating income and expense and expenses not allocated to the business segments in the same period. During the first quarter of 2006, the Company adjusted its basis of measurement for earnings before income taxes such that certain expenses, such as amortization of intangibles, which were previously considered to be Corporate and Unallocated, are now included in the Engine and Industrial Products segment results. The impact of the change in the basis of measurement resulted in approximately $16.0 million of Corporate and Unallocated expenses being charged to

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the Engine and Industrial Products segments’ aggregate earnings before income taxes in fiscal 2006 as compared to fiscal 2005. This change resulted in approximately $8.0 million of additional expense to each of the Engine and Industrial Products segments during fiscal 2006. This adjustment to the basis of measurement of segment earnings did not change the business components included in each of the Company’s reportable segments. See further discussion of segment information in Note J of the Company’s Notes to Consolidated Financial Statements.

Factors within the Company’s reporting segments that contributed to the Company’s results for fiscal 20042006 included strong resultsbusiness conditions across all of the products within the Engine Products segment worldwide. North American heavy truck build rates increased significantly for the yearremained at record levels. Strength in new construction and mining equipment spurred off-road equipment markets strengthened, thus resulting in increased sales.sales worldwide. Additionally, equipment utilization improved in bothrates remained strong and sales of diesel emission retrofit equipment continued to ramp up throughout the truck and off-road markets, spurringyear, driving 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, improvement initiatives, higher volumes and a focus on selling more replacement parts drove sales growth 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 worldwidesolutions products. Worldwide sales in gas turbine products were down forhigher than the prior year as business conditions in that market began to strengthen, specifically in the gas turbine business showed improvement duringMiddle East, Asia and parts of Africa. Sales of special application products were strong with continued strong demand for computer hard drives and other consumer electronics impacting the year.Company’s special application products sales.

        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

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.Outlook    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 conditionsmid single-digit sales growth in the markets it serves will continue to impact the Company’s growth. The Company anticipates low-teens percentage growthfiscal 2007 for sales in its Engine Products segment in fiscal 2005 as it expects continued growth insegment. North American heavy-duty truck build rates are expected to remain at their current high levels through calendar 2006 as truck manufacturers are near capacity. Build rates are then

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expected to decrease resulting in a decrease in sales of approximately $30 million to $35 million in the second half of fiscal 2007 as compared to the second half of 2006 as a result of the implementation of the new diesel emissions standards. Strong worldwide conditions are expected to continue in the production of new construction and mining equipment. Aftermarket sales are expected to grow with continued strong equipment utilization, ongoing growth by our OEM customers of their replacement parts business and the increasing amount of equipment in the field with the Company’s PowerCore™ filtration systems. The Company expects sales growth in fiscal 2005 and continued strong business2007 for its Industrial Products segment to be in the low double-digits. Industrial filtration solutions sales growth is expected to continue with healthy global industrial conditions. Globally, the Company expects full-year gas turbine sales to continue rebounding with sales increasing approximately 20 percent. Market conditions in Europe and Asia. Sales of off-roadfor special applications 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 20042006 Compared to Fiscal 2003

        Engine Products Segment    The Engine Products segment sells to original equipment manufacturers (OEMs)OEMs in the construction, industrial, mining, agriculture and transportation markets and to independent distributors, OEM dealer networks, private label accounts and large privateequipment 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$991.6 million, an increase of 21.87.3 percent from $683.3$923.8 million in the prior year, reflecting increased sales across all products within this segment both in North Americathe United States and internationally.

        Within the Engine Products segment, worldwide sales of truckoff-road products were $156.4$308.2 million, an increase of 34.47.7 percent from $116.3$286.2 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 growthSales 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

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 salesUnited States showed an increase of 15.15.8 percent ondue to continued improvements in new construction and agriculturemining equipment demand. Internationally, sales of off-road products were up 31.79.9 percent from the prior year with sales increasing in both Asia and Europe by 38.314.0 percent and 28.78.4 percent, respectively, reflecting the strength in the off-road equipment market internationally.

        Worldwide aftermarket product sales of $439.0truck products were $184.3 million, increased 18.0an increase of 5.3 percent from $372.1$175.0 million in the prior year. SalesTruck products sales in North Americathe United States increased 11.96.9 percent overfrom the prior year due to record heavy truck build rates and strong diesel emission sales. International truck products sales increased 0.9 percent from the prior year. Strong sales in Europe resulted in an increase of 10.4 percent from stronger build rates and increased market share. Offsetting Europe’s increase was a decrease in sales in Asia of 5.9 percent primarily as a result of the weaker Japanese Yen.

        Worldwide aftermarket product sales of $499.1 million increased 7.9 percent from $462.6 million in the prior year as equipment utilization rates continued to improve resulting in increasingremained high spurring demand for replacement parts. Additionally,filters. Sales in the Company’s investment into additional staff, training tools and additional product coverage continued to drive sales results. International sales were strong with an increaseUnited States increased 9.1 percent over the prior year of 26.7while international sales increased 6.5 percent with sales increasing in both Europe, Asia and AsiaMexico by 31.86.1 percent, 5.4 percent and 20.125.7 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$702.8 million, an increase of 8.94.6 percent from $535.0$671.9 million in the prior year resulting from stronger sales of industrial filtration solutions, gas turbine products and special application products.

        Within the Industrial Products segment, worldwide sales of industrial filtration solutions products of $440.2 million increased 3.6 percent from $424.7 million in the prior year. Sales in the United States, Asia, South Africa and Mexico increased 5.8 percent, 2.7 percent, 33.6 percent and 45.1 percent, respectively. Sales in Europe decreased 0.9 percent from the prior year reflecting stability in the market despite the negative impact of foreign currency translation.

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        Worldwide sales of gas turbine products were $121.2 million, an increase of 7.4 percent from $112.9 million in the prior year as business conditions strengthened primarily toward the end of fiscal 2006.

        Worldwide sales of special application products were $141.3 million, a 5.3 percent increase from $134.3 million in the prior year. Sales in the United States decreased 16.9 percent from the prior year due primarily to softness in the end markets served by our membrane product line while sales in Europe and Asia increased 13.4 percent and 8.5 percent from the prior year, respectively, due to strong demand for computer hard drives and other consumer electronics.

Consolidated Results    The Company reported record net earnings for 2006 of $132.3 million compared to $110.6 million in 2005, an increase of 19.7 percent. Diluted net earnings per share was a record $1.55, up 22.1 percent from $1.27 in the prior year. The Company’s operating income of $192.8 million increased from prior year operating income of $156.5 million by 23.2 percent. Operating income in the Engine Products segment as a percent of total operating income decreased to 67.7 percent from 77.4 percent in the prior year. Operating income in the Industrial Products segment as a percent of total operating income of 33.6 percent decreased from the prior year of 34.2 percent. This growth resultschange is primarily attributable to the Company’s decision to adjust its basis of measurement for earnings before income taxes such that certain expenses, such as amortization of intangibles, which were previously considered to be Corporate and Unallocated, are now included in the Engine and Industrial Products segment results. This adjustment is discussed further in Note J. International operating income, prior to corporate expense allocations, totaled 77.2 percent of consolidated operating income in 2006 as compared to 82.7 percent in 2005. Of the 2006 international operating income, prior to corporate expense allocations, Europe contributed 42.4 percent while Asia contributed 48.5 percent. Total international operating income increased 15.0 percent from the prior year. This increase is attributable to strong sales of special application products and gas turbine systems.

        Gross margin for 2006 was 32.9 percent, an improvementincrease from 31.7 percent in industrial air filtration productsthe prior year. The margin benefited from the Company’s focus on cost reduction efforts, production efficiencies and some selective price increases. The Company continued its efforts to improve manufacturing infrastructure and reduce product costs through plant rationalization. Plant rationalization and start-up costs for new facilities were $5.4 million in 2006, up from the $4.0 million in the prior year.

        Operating expenses for 2006 were $363.8 million or 21.5 percent of sales, up from $349.1 million or 21.9 percent in the prior year. Operating expenses in fiscal 2006 included $2.8 million of stock option expense that was not included in fiscal 2005. Operating expenses in fiscal 2005 included a $6.4 million increase to the Company’s legal reserve for the EPC patent infringement judgment. The Company continued to focus on operating expense controls in 2006.

        Interest expense of $9.9 million increased $0.5 million from $9.4 million in the prior year. These increasesNet other income totaled $6.3 million in 2006 compared to $7.7 million in the prior year. Components of other income for 2006 were as follows: interest income of $1.7 million, earnings from non-consolidated joint ventures of $5.0 million, charitable donations of $2.1 million, foreign exchange gains of $0.3 million and other miscellaneous income and expense items resulting in income of $1.4 million.

        The effective income tax rate for fiscal 2006 was 30.1 percent. In the fourth quarter of fiscal 2006, the Company recognized a $3.6 million tax charge for the $80.0 million foreign earnings repatriation plan pursuant to the American Jobs Creation Act of 2004. The effective income tax rate for fiscal 2005 was 28.6 percent and also included a $4.0 million tax charge for a previous $80.0 million foreign earnings repatriation plan pursuant to the American Jobs Creation Act of 2004. Although the tax rate going forward is dependent upon the applicable tax rates and the geographic mix of profits, the Company expects that it will be approximately 29 percent in fiscal 2007. The higher fiscal 2006 effective tax rate as compared to the prior year is primarily a result of the mix of earnings in our various jurisdictions. Higher tax jurisdictions such as Japan, Germany and the United States contributed a higher proportion of our taxable earnings as compared to the prior year. The unfavorable timing of the phase-out/phase-in provisions of the United States export credit versus the manufacturing credit and the expiration of the research and development credit also adversely affected the rate for fiscal 2006. The Company undergoes examination by various taxing authorities in the multiple jurisdictions in which it operates. Such

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taxing authorities may require changes in the amount of tax expense to be recognized when their interpretations differ from those of management. The Company maintains reserves against such differences and the effect of such adjustments are recorded at the time of resolution of the applicable examination.

        Total backlog at July 31, 2006 was $516.7 million, up 25.4 percent from the same period in the prior year. Backlog is one of many indicators of business conditions in our market. However, it is not always indicative of future results for a number of reasons, including short lead times in our aftermarket and the timing of receipt of orders in many of our original equipment and industrial markets. In the Engine Products segment, total open order backlog increased 20.3 percent from the prior year. In the Industrial Products segment, total open order backlog increased 36.4 percent from the prior year. Because some of the change in backlog can be attributed to a change in the ordering patterns of our customers, it may not necessarily correspond to higher future sales.

Fiscal 2005 Compared to Fiscal 2004

        (Certain fiscal 2004 amounts have been reclassified between the segments to conform to the current structure for comparison between years.)

Engine Products Segment    Sales for the Engine Products segment were $923.8 million, an increase of 13.8 percent from $811.5 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 off-road products were $286.2 million, an increase of 16.9 percent from $244.7 million in the prior year. North American sales showed an increase of 12.4 percent due to continued improvements in new construction, agriculture and mining equipment demand. Internationally, sales of off-road products were up 23.6 percent from the prior year with sales increasing in both Asia and Europe by 22.8 percent and 23.4 percent, respectively, reflecting the strength in the off-road equipment market internationally.

        Worldwide sales of truck products were $175.0 million, an increase of 11.9 percent from $156.4 million in the prior year. North American truck sales increased 23.3 percent from the prior year due to growing truck build rates and strong diesel emission sales. International truck sales decreased 10.7 percent from the prior year. Strong sales in Europe resulted in an increase of 24.7 percent from stronger build rates and increased market share. Offsetting Europe’s increase was a decrease in sales in Asia of 23.2 percent as emission sales spiked in Japan in the prior year ahead of new emissions regulations.

        Worldwide aftermarket product sales of $462.6 million increased 12.7 percent from $410.4 million in the prior year as equipment utilization rates remained strong and sales of diesel emission retrofit equipment continued to ramp up throughout the year, driving aftermarket parts sales growth. Sales in North America increased 13.1 percent over the prior year while international sales increased 13.0 percent with sales increasing in both Europe and Asia by 13.7 percent and 6.5 percent, respectively.

Industrial Products Segment    Sales for the Industrial Products segment were $671.9 million, an increase of 11.3 percent from $603.4 million in the prior year resulting from strong sales of industrial filtration solutions and special application products, partially offset by a slight decrease in sales of gas turbine products.

        Within the Industrial Products segment, worldwide sales of gas turbineindustrial filtration solutions products were $117.7of $424.7 million a decrease of 9.2increased 14.8 percent from $129.6$370.1 million in the prior year. A declineSales in North American sales of 41.4America and Asia increased 20.2 percent was partially offset by increased international sales of 27.6and 17.3 percent, which softenedrespectively, from the consolidated impact in this market. The increase internationally reflectsprior year reflecting strength in the gas turbinemanufacturing economy. Sales in Europe increased 10.0 percent from the prior year, reflecting stability in the market overseas with increased sales in both Europe and Asiathe benefits of 35.5 percent and 10.1 percent, respectively, and includes units shipped to Iraq.foreign currency translation.

        Worldwide sales of industrial air filtrationgas turbine products were $112.9 million, a decrease of $202.2 million increased 16.04.1 percent from $174.3$117.7 million in the prior year as business conditions in that market remained stable. North American sales decreased 6.5 percent from the prior year while sales in Asia increased 5.5 percent and sales in Europe decreased 5.9 percent.

        Worldwide sales of special application products were $134.3 million, a 16.1 percent increase from $115.6 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 46.6decreased 2.2 percent from the prior year while international

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sales increased 21.7 percent. Sales of disk drive products in Europe and Asia increased 29.328.1 percent due toand 18.8 percent from the prior year, respectively. Continued strong demand for computer hard drives.drives in Asia impacted the Company’s special application product sales. Worldwide sales of membrane products increased 25.413.6 percent from the prior year due to improvementstrong sales in the Company’s core industrialthat market in both Europe and fabric marketsAsia with the majorityincreases of the gain in North America. Worldwide sales of hydraulic products increased 58.732.0 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 2004.29.4 percent, respectively.

        Consolidated Results    The Company reported record net earnings for 20042005 of $106.3$110.6 million compared to $95.3$106.3 million in 2003,2004, an increase of 11.54.0 percent. Net earnings per share — diluted were a record $1.18,$1.27, up 12.47.6 percent from $1.05$1.18 in the prior year. The Company’s operating income of $141.6$156.5 million increased from prior year operating income of $131.8$141.6 million by 7.510.5 percent. Operating income in the Engine Products segment again showed strong growth from the prior year as it increased to 79.1a percent of total operating income from 69.2was consistent with the prior year at 77.4 percent of total operating income compared to 77.5 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 28.534.2 percent was slightly lower thanincreased from the prior year’s 29.3year percent of 29.8 percent of total operating income. International operating income, prior to corporate expense allocations, totaled 83.782.7 percent of consolidated operating income in 20042005 as compared to 72.983.7 percent in 2003.2004. Of the 20042005 international operating income, prior to corporate expense allocations, Europe contributed 41.149.2 percent while Asia-PacificAsia contributed 54.142.3 percent. Total international operating income increased 23.59.2 percent from the prior year.

        Gross margin for 20042005 was 31.831.7 percent, compared to 32.1flat with 31.6 percent in the prior year. DespiteCommodity price increases related to steel and, to a lesser extent, petrochemicals later in the year, impacted gross margin even though the Company worked to recover these increases through cost reduction programs and price adjustments. Somewhat offsetting the unrecovered portion of commodity price increases was operating leverage gained from higher production volumes gross margin was down fromthroughout the prior year due primarily to the unrecovered portion of the steel price increases. Also, theyear. 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 and start-up costs were $6.2$4.0 million in 2004, slightly2005, lower than $6.5the $6.2 million in the prior year. The effect on diluted earnings per share was $.05 in both years.

        Operating expenses for 20042005 were $314.5$349.1 million or 22.221.9 percent of sales, up from $259.4$311.8 million or 21.322.0 percent in the prior year. Operating expenses in fiscal 2005 included a $6.4 million increase to the Company’s legal reserve for the yearEPC patent infringement judgment recorded in the fourth quarter. Also included in 2005 operating costs were impacted by higherincremental costs in Japan while managing throughassociated with compliance with 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 includedSarbanes-Oxley Act of 2002 totaling approximately $3.0 million. 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 thea $3.0 million increase to the Company’s warranty reserve regarding ongoing discussions on a specific warranty-related matter. Also,matter and $1.3 million for the fiscal 2003 adjustment that was identified in the fiscal 2004 closing process negatively impacted operating expenses in 2004 by $1.3 million.process. The Company continued to focus on operating expense controls in 2004.2005.

        Interest expense of $9.4 million increased $4.4 million from $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$7.7 million in 20042005 compared to $4.7$5.2 million in the prior year. Components of other income for 20042005 were as follows: interest income of $1.9$2.7 million, earnings from non-consolidated joint ventures of $4.4$3.5 million, foreign exchange lossesgains of $0.5$1.0 million and other miscellaneous income and expense items netting to $0.6 million of miscellaneous expense.totaling $0.5 million.

        The effective income tax rate for fiscal 2005 was 28.6 percent. During fiscal 2005, the Company filed an amended tax return related to a prior year, which resulted in additional research and development tax credits. This resulted in a $1.0 million reduction in the income tax provision during fiscal 2005. Additionally, at the end of fiscal 2005, the Company recognized a $4.0 million tax charge for the $80.0 million foreign earnings repatriation plan pursuant to the American Jobs Creation Act of 2004. The effective income tax rate for fiscal 2004 was 25.0 percent in 2004 was lower than the prior year tax rate of 27.0 percent. The decrease in the tax rate reflectsand included a $1.8 million reduction in the income tax expense during the year relating to the recognitionprovision as a result 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.study.

        Total backlog at July 31, 20042005 was $375.5$412.0 million, up 19.911.0 percent from the same period in the prior year. In the Engine Products segment, total open order backlog increased 28.115.1 percent compared to the same period in the prior year, reflecting the strength in business conditions in the markets served.year. In the Industrial Products segment, total open order backlog increased 7.11.9 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

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Table 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,

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.Contents

        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.)

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

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, 2004,2006, the Company’s capital structure was comprised of $54.1$79.9 million of current debt, $70.9$100.5 million of long-term debt and $549.3$546.8 million of shareholders’ equity. The Company had cash and cash equivalents of $99.5$45.5 million at July 31, 2004.2006. The ratio of long-term debt to total

capital was 11.415.5 percent and 19.016.5 percent at July 31, 20042006 and 2003,2005, 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 $5.0decreased $32.7 million for the year to $124.9$180.4 million outstanding at July 31, 2004.2006. The increasedecrease is a result of an increasea decrease in short-term borrowings outstanding at the end of the year by $5.6of $28.6 million fromas compared to the prior year. Offsetting the increase in short-term borrowings wasyear and a decrease in long-term debt of $0.6 million.$4.0 million (including current maturities) from the prior year. The decrease in long-term debt was comprised of an addition of a decrease of $1.9$4.1 million as a result ofcommercial property loan offset by payments made during the year andof $7.6 million, which includes a decrease in unsecured senior notespayment of $0.3a $7.1 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.guaranteed note.

        The following table summarizes the Company’s fixed cash obligations as of July 31, 20042006 for the years indicated (in thousands)(thousands of dollars):

        For its U.S. pension plans, the Company does not have a minimum required contribution for fiscal 2005.2007. However, the Company may elect to contribute up to its maximum deductible contribution of $36.5$28.6 million in fiscal 2005.2007. For its non-U.S. pension plans, the Company estimates that it will contribute approximately $2.4$8.1 million in fiscal 2005.2007. 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 has a three-year multi-currency revolving facility with a group of banks under which the Company may borrow up to $150.0 million. The facility, as amended in September 2004, expires in September 2009. 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 were no amounts outstanding at July 31, 2006 and $65.0 million outstanding at July 31, 2005, leaving $150.0 million and $85.0 million available for further borrowing under such facilities at July 31, 2006 and July 31, 2005, respectively. The weighted average interest rate on these short-term borrowings outstanding at July 31, 2005 was 3.77 percent.

        The Company also has twothree agreements under uncommitted credit facilities, which provide unsecured borrowings for general corporate purposes. At July 31, 20042006 and 2003,2005, there was $40.0$70.0 million and $35.0$60.0 million available for use under these facilities, respectively. There was $12.4 millionwere no amounts outstanding under these facilities at July 31, 2006 and $2.4$36.7 million outstanding under these facilities at July 31, 2004 and 2003, respectively.2005. The weighted average interest rate on these short-term borrowings outstanding at July 31, 2004 and 20032005 was 1.75 percent and 1.36 percent, respectively.3.67 percent.

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        The Company also has a 100 million euro program for issuing treasury notes for raising short, mediumshort-, medium- and long-term financing for its European operations. AtThere was 35.3 million euro outstanding at July 31, 20042006 and July 31, 2003 there were no amounts outstanding at July 31, 2005 under the program. The weighted average interest rate on these short-term issuances at July 31, 2006 was 3.13 percent. Additionally, the Company’s European Operationsoperations have lines of credit in the amount of 25.250.2 million euro. As of July 31, 2004 and2006 there was 20.1 million euro outstanding. As of July 31, 20032005 there were no amounts outstanding. The weighted average interest rate on these short-term borrowings outstanding at July 31, 2006 was 3.38 percent.

        Other international subsidiaries may borrow under various credit facilities. As of July 31, 2006 and 2005, borrowings under these facilities were $2.6 million and $0.3 million, respectively. The weighted average interest rate on these international borrowings outstanding at July 31, 2006 and 2005 was 7.92 percent and 8.50 percent, respectively.

        Also, at July 31, 20042006 and 2003,2005, the Company had outstanding standby letters of credit totaling $18.4 million and $16.1 million, respectively.$18.7 million. 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, 20042006 and 20032005, there were no amounts drawn upon these letters of credit.

        The Company repatriated $160.0 million of its accumulated foreign earnings in fiscal 2006 under the favorable provisions of the American Jobs Creation Act of 2004. Total U.S. income taxes of $3.6 million and $4.0 million have been provided on these repatriations in 2006 and 2005, respectively.

Shareholders’ equity increased $101.9$22.2 million in 20042006 to $549.3$546.8 million. The increase was due to current year earnings of $106.3$132.3 million, an increase in accumulated other comprehensive income of $38.4$23.6 million $4.8and $18.9 million of stock option and other stock activity offset by $29.8$118.9 million of treasury stock repurchases and $17.8$33.7 million of dividend payments.declarations. The increase in accumulated other comprehensive income consisted primarily of a foreign currency translation adjustment of $23.7$15.3 million and a decrease in the Company’s additional minimum pension liability of $14.4$8.4 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, $118.12006, $156.7 million of cash was generated from operating activities, compared with $146.7$142.6 million in 20032005 and $153.0$118.1 million in 2002. The decrease2004. Operating cash flows in cash generated2006, which increased by $14.1 million from operating activities in 2004 resulted primarily from an increasethe prior year, included payment of the previously accrued EPC judgment of $14.2 million, the payment of $41.3 million to the Company’s defined benefit plans, smaller increases in accounts receivable of $37.3$12.1 million and in inventorythe presentation of $20.7the tax benefit of equity plans of $10.9 million partially offset by an increaselarger increases in trade accounts payable and other accrued expenses of $26.4 million during$26.6 million. The tax benefit is required to be presented as a financing activity pursuant to new accounting standards. The tax benefit from equity plans was presented as an operating cash flow in the year.

prior years and not shown separately as a financing activity. In addition to cash generated from operating activities, the Company increaseddecreased its outstanding short-term debt by $5.2$31.7 million whileand net long-term debt decreased by $1.9$3.2 million. Cash flow generated by operations was used primarily to support $47.7$81.3 million for capital expenditures, $29.8$118.9 million for stock repurchases and $17.8$26.4 million for dividend payments. Cash and cash equivalents increased $32.4$88.6 million during 2004.2006.

        Capital expenditures for property, plant and equipment totaled $81.3 million in 2006, $55.0 million in 2005 and $47.7 million in 2004 and 2003 and $46.2 million in 2002.2004. Capital expenditures primarily related to new overseas facilities and productivity enhancing investments at various plants worldwide and continuing upgrades to the U.S. information systems.worldwide.

        Capital spending in 20052007 is planned between $45.0at $60.0 million and $50.0to $70.0 million. Significant planned expenditures include the further upgrade of U.S. information systems and investment in manufacturing plants, equipment and tooling. It is anticipated that 20052007 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 2005.2007. At July 31, 2004,2006, the Company had $99.5$45.5 million cash, $177.6$220.0 million available under existing credit facilities in the United States and 125.294.8 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 20052007, including debt repayment, issuance of anticipated dividends, and share repurchase activity.activity,

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capital expenditures, and execution of the Company’s domestic reinvestment plan pursuant to the American Jobs Creation Act of 2004.

        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 25.030.0 percent of the average earnings per share of the last three years. The current quarterly dividend of 0.0550.09 cents per share equates to 20.827.0 percent of the average net earnings per share for 20022004 through 2004.2006.

        Share Repurchase Plan    In fiscal 2004,2006, the Company repurchased 1.13.8 million shares of common stock on the open market for $29.8$118.9 million under the share repurchase plan authorized in January 2003,

March 2006 at an average price of $27.79$31.43 per share. The Company repurchased 1.43.8 million shares for $24.9$116.3 million in 2003 and 1.42005. The Company repurchased 1.1 million shares for $21.3$29.8 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.2004.

        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 LK of the Company’s Notes to Consolidated Financial Statements. The Company does not believe that this guarantee will have a current or future effect on its financial condition, results of operation, liquidity or capital resources.

        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,In September 2006, the Company adoptedFASB issued SFAS No. 149, “Amendment158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of Statement 133FASB Statements No. 87, 88, 106, and 132(R) (“SFAS 158”). This statement requires recognition of the overfunded or underfunded status of defined benefit postretirement plans as an asset or liability in the statement of financial position and to recognize changes in that funded status in comprehensive income in the year in which the changes occur. SFAS 158 also requires measurement of the funded status of a plan as of the date of the statement of financial position. SFAS 158 is effective for recognition of the funded status of the benefit plans for fiscal years ending after December 15, 2006 and is effective for the measurement date provisions for fiscal years ending after December 15, 2008. The Company is currently evaluating the effect of SFAS 158 on Derivative Instruments and Hedging Activities.”its consolidated financial statements.

        In March 2005, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 47,Accounting for Conditional Asset Retirement Obligations, (“FIN 47”) which clarifies that the term “conditional asset retirement obligation” as used in SFAS No. 149 amends and143,Accounting for Asset Retirement Obligations, refers to a legal obligation to perform an asset retirement activity in which the timing and/or method of settlement are conditional on a future event that may or may not be within the control of the entity. However, the obligation to perform the asset retirement activity is unconditional even though uncertainty exists about the timing and/or method of settlement. FIN 47 requires that the uncertainty about the timing and/or method of settlement of a conditional asset retirement obligation be factored into the measurement of the liability when sufficient information exists. FIN 47 also 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 Statementwhen an entity would have sufficient information to reasonably estimate the fair value of an asset retirement obligation. FIN 47 was effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 20, 2003.the Company’s fiscal period ended July 31, 2006. The adoption of SFAS No. 149FIN 47 in the fourth quarter of fiscal 2006 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 freestandingconsolidated 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.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 Related109-1,Application of FASB Statement No. 109, Accounting for Income Taxes, to the Medicare Prescription Drug, Improvement and ModernizationTax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of

2003” (FSP 106-2) 2004 (“FSP 109-1”). FSP 106-2 requires an employer to initially account109-1 concludes that the deduction should be accounted for any subsidy received under the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the “Act”) as an actuarial experience gaina special deduction in accordance with SFAS No. 109. This deduction, which was available 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 doCompany during fiscal 2006, did not reflect the effects of the Act, if any,have a material impact on the APBOCompany’s consolidated financial statements.

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        In June 2006, the FASB issued FASB Interpretation No. 48,Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109 (“FIN 48”). This pronouncement prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of tax positions taken or net periodic postretirement benefit cost. The Company has not yet determined whether its postretirement benefit plans are “actuarially equivalent”expected to Medicare Part D under the Act. FSP 106-2be taken in a tax return. FIN 48 is effective for thefiscal years beginning after December 15, 2006. The Company beginning in the first quarter of its fiscal 2005 andis currently evaluating the effect of the Act is not expected to have a material effectFIN 48 on the Company’s Consolidated Financial Statements.its 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 existing recognized foreign currency denominated asset and liability balances and also for 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 2004,2006, the U.S. dollar was weakergenerally stronger throughout the year relative to the currencies of the foreign countries in which the Company operates, with the notable exception of the Mexican peso.operates. The overall weaknessstrength of the dollar had a significant positivenegative impact on the Company’s international net sales results because the foreign denominated revenues translated into moreless 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, 2004,2006, the impact of foreign currency translation resulted in an overall increasedecrease in net sales of $70.0$25.3 million and an increasea decrease in net earnings of $4.7$0.8 million. Foreign currency translation had a positivenegative impact in several regions around the world. In Europe, the weakerstronger U.S. dollar relative to the euro and British pound sterling resulted in an increasea decrease of $47.8$17.9 million onin net sales and an increasea decrease of $2.5$0.9 million onin net earnings. In the Asia-Pacific region, the weakerstronger U.S. dollar relative to the Japanese yen had a positivenegative impact on foreign currency translation with an increasea decrease in net sales of $10.7$9.9 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 increasedecrease 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 United States are sold abroad, primarily in Europe and Canada. As a result, sales of such products are affected by the value of the U.S. dollar relative to other currencies. Any

long-term strengthening of the U.S. dollar could depress these sales. Also, competitive conditions in the Company’s markets may limit its ability to increase product pricing in the face of adverse currency movements.

        Interest    The Company’s exposure to market risks for changes in interest rates relates primarily to its short-term investments, short-term borrowings and interest rate swap agreement.agreements as well as the potential increase in fair value of long-term debt resulting from a potential decrease in interest rates. The Company has no earnings or cash flow exposure due to market risks on its long-term debt obligations

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as a result of the fixed-rate nature of the debt. However, interest rate changes would affect the fair market value of the debt. AtAs of July 31, 2004,2006, the estimated fair value of the Company’s long-term debt approximates market. Market riskwith fixed interest rates was $91.3 million compared to its carrying value of $92.5 million. The fair value is estimated asby discounting the potential decrease in fair value resulting from a hypothetical one-half percent increase in interest rates andprojected cash flows using the rate that similar amounts to approximately $2.5 million.

        The Company entered into two interest rate swap agreements to hedge itsof debt could currently be borrowed. As of July 31, 2006, our financial liabilities with exposure to changes in the fair valueinterest rates consisted mainly of its fixed-rate debt. The$73.4 million of short-term debt outstanding. Assuming a hypothetical increase of one-half percent in short-term interest rate swap agreement entered into on June 6, 2001 has an aggregate notional amount of $27.0rates, with all other variables remaining constant, interest expense would have increased $0.4 million maturing on July 15, 2008. The interest rate swap agreement entered into on March 18, 2003 has an aggregate notional amount of $25.0 million maturing on August 15, 2010. The variable rate on both of the swaps is based on the six-month London Interbank Offered Rates (“LIBOR”). As of July 31, 2004, the interest rate swaps had a fair value of $1.0 million, which is recorded net of the underlying debt in the liabilities section of the balance sheet.fiscal 2006.

Subsequent Events On August 2, 2004, the Company terminated its two interest rate swaps that were in place as of July 31, 2004. The aggregate value of the two interest rate swaps at the termination date of $1.0 million will be amortized over the remaining life of the underlying debt.

        On August 2, 2004, the Company entered into an interest rate swap agreement to hedge its exposure to changes in the fair value of the $30.0 million senior notes that it had engaged a placement agent to issue. The interest rate on the $30.0 million senior notes offering was locked at 4.35 percent on August 2, 2004. The interest rate swap agreement has an aggregate notional amount of $30.0 million maturing on December 17, 2011. The variable rate on the swap is based on the six-month London Interbank Offered Rates (“LIBOR”).

        On September 30, 2004, the agreement to issue the $30.0 million, 4.85 percent senior notes due December 17, 2011 was executed. The Company will receive the proceeds from the debt issuance on December 17, 2004.

Critical Accounting Policies

        The Company’s Consolidated Financial Statementsconsolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States of America. The preparation of these Financial Statementsfinancial

statements requires the use of estimates, judgments and assumptions that affect the reported amounts of assets and liabilities at the date of the Financial Statementsfinancial statements and the reported amounts of revenue and expenses during the periods presented. Management bases these estimates on historical experience and various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the recorded values of certain assets and liabilities. The Company believes its use of estimates and underlying accounting assumptions adhereadheres to generally accepted accounting principles and areis consistently applied. Valuations based on estimates and underlying accounting assumptions are reviewed for reasonableness on a consistent basis throughout the Company. Management believes the Company’s critical accounting policies that require more significant judgments and estimates used in the preparation of its Consolidated Financial Statementsconsolidated financial statements and that are the most important to aid in fully understanding its financial results are the following:

        AllowanceRevenue recognition and allowance for doubtful accounts —    Revenue is recognized when product ownership and the risk of loss has transferred to the customer and the Company has no remaining obligations. The Company records estimated discounts and rebates as a reduction of sales in the same period revenue is recognized. Allowances for doubtful accounts are estimated by management based on evaluation of potential losses related to customer receivable balances. The allowance for doubtful accounts is the Company’s best estimate of the amount of probable credit losses in its existing accounts receivable. The Company determines the allowance based on historical write-off experience in the industry, regional economic data and evaluatingevaluation of specific customer accounts for risk of loss. The Company reviews its allowance for doubtful accounts monthly. Past due balances over 90 days and over a specified amount are reviewed individually for collectibility. All other balances are reviewed on a pooled basis by type of receivable. Account balances are charged off against the allowance when the

Company feels it is probable the receivable will not be recovered. The Company does not have any off-balance-sheet credit exposure related to its customers. The establishment of this reserve requires the use of judgment and assumptions regarding the potential for losses on receivable balances. Though management considers these balances adequate and proper, changes in economic conditions in specific markets in which the Company operates could have an effect on reserve balances required.

        Goodwill and other intangible assets    Goodwill is tested for impairment annually, or more frequently if events or changes in circumstances indicate that the asset might be impaired. The Company performs impairment reviews for its reporting units and uses a discounted cash flow model based on management’s judgments and assumptions to determine the estimated fair value. An impairment loss generally would be recognized when the carrying amount of the reporting unit’s net assets exceeds the estimated fair value of the reporting unit. The Company performed an impairment test during the third quarter of fiscal 2006 to satisfy its annual impairment requirement. Impairment testing in the third quarter indicated that the estimated fair value of each reporting unit exceeded its corresponding carrying amount, including recorded goodwill and, as such, no impairment existed at that time. Other intangible assets with definite lives continue to be amortized over their estimated useful lives. Definite lived intangible assets are also subject to impairment testing. A considerable amount of management judgment and assumptions are required in performing the impairment tests, principally in determining the fair value of each reporting unit. While the Company believes its judgments and assumptions are reasonable, different assumptions could change the estimated fair values and, therefore, impairment charges could be required.

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Inventory —The Company’s inventories are valued at the lower of cost or market. Domestic inventories are valued using the last-in first-out (“LIFO”) method, while the international subsidiaries use the first-in, first-out (“FIFO”) method. Reserves for shrink and obsolescence are estimated using standard quantitative measures based on historical losses, including issues related to specific inventory items. Though management considers these balances adequate and proper, changes in economic conditions in specific markets in which the Company operates could have an effect on reserve balances required.

        Product warranty —The Company estimates warranty costs using standard quantitative measures based on historical warranty claim experience and, in some cases, evaluating specific customer warranty issues. The establishment of reserves requires the use of judgment and assumptions regarding the

potential for losses relating to warranty issues. Though management considers these balances adequate and proper, changes in the future could impact these determinations.

        Income taxes —As part of the process of preparing the Company’s Consolidated Financial Statements, management is required to estimate income taxes in each of the jurisdictions in which the Company operates. This process involves estimating actual current tax exposure together with assessing temporary differences resulting from differing treatment of items for tax and book accounting purposes. These differences result in deferred tax assets and liabilities, which are included within the Company’s Consolidated Balance Sheet. These assets and liabilities are evaluated by using estimates of future taxable income streams and the impact of tax planning strategies. Management assesses the likelihood that deferred tax assets will be recovered from future taxable income and to the extent management believes that recovery is not likely, a valuation allowance is established. To the extent that a valuation allowance is established or increased, an expense within the tax provision is included in the statement of operations. Reserves are also estimated for ongoing audits regarding federal, state and international issuesuncertain tax positions that are currently unresolved. The Company routinely monitors the potential impact of such situations and believes that it is properly reserved. Valuations related to tax accruals and assets can be impacted by changes to tax codes, changes in statutory tax rates and the Company’s future taxable income levels.

        Employee Benefit Plans —The Company incurs expenses relating to employee benefits such as noncontributorynon-contributory defined benefit pension plans and postretirement health care benefits. In accounting for these employment costs, management must make a variety of assumptions and estimates including mortality rates, discount rates, overall Company compensation increases, expected return on plan assets and health care cost trend rates. The Company considers historical data as well as current facts and circumstances when determining these estimates. The Companyand uses a third-party specialistsspecialist to assist management in the determination ofdetermining these estimates and the calculation of certain employee benefit expenses.estimates.

        To develop the expected long termlong-term rate of return on assets assumption for its pension plans, the Company considered the historical returns and the future expectations for returns for each asset class, as well as the target asset allocation of the pension portfolio. Reflecting the relatively long-term nature of the plans’ obligations, approximately 70 percent of the plans’ assets were invested in equities and 30 percent of plans’ assets in alternative investments with the balance primarily invested in fixed income instruments. A one percent change in the expected long-term rate of return on plan assets would change the 2006 annual pension expense by approximately $2.3 million. The expected long termlong-term rate of return on assets assumption for the plans outside the U.S. reflectfollows the same methodology as described above but reflects the investment allocation and expected total portfolio returns specific to each plan and country.

        The Company’s objective in selecting a discount rate for its pension plans is to select the best estimate of the rate at which the benefit obligations could be effectively settled on the measurement date taking into account the nature and duration of the benefit obligations of the plan. In making this best estimate, the Company looks at rates of return on high-quality fixed-income investments currently available and expected to be available during the period to maturity of the benefits. This process includes looking at the universe of bonds available on the measurement date with a quality rating of Aa or better. Similar appropriate benchmarks are used to determine the discount rate for the non-U.S. plans. As of our measurement date of April 30, 2006, the Company increased its discount rate on U.S. plans to 6.25 percent from 5.5 percent as of April 30, 2005. The increase of 75 basis points was consistent with the changes in published bond indices. The change decreased the Company’s U.S. projected benefit obligation as of April 30, 2006 by approximately $14.5 million and is expected to decrease pension expense in fiscal year 2007 by approximately $0.9 million.

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        At April 30, 2006, the Company’s annual measurement date for its pension plans, the plans were over-funded by $18.8 million since the fair value of plan assets exceeded the projected benefit obligation. As of April 30, 2006, the Company has an unrecognized actuarial loss of $18.7 million which will be recognized as pension expense into the future over the average remaining service period of the employees in the plans in accordance with SFAS 87.

Forward-Looking Statements

        From time to time, theThe Company, through its management, may make forward-looking statements reflecting the Company’s current views with respect to future events and financial performance. These forward-looking statements, which may be included in reports filed under the Securities Exchange Act of 1934, as amended (The(the “Exchange Act”), in press releases and in other documents and materials as well as in written or oral statements made by or on behalf of the company,Company, are subject to certain risks and uncertainties, including those discussed belowin Item 1A of this Form 10-K, which could cause actual results to differ materially from historical results or those anticipated. The words or phrases “will likely result,” “are expected to,” “will continue,” “estimate,” “project,” “believe,” “expect,” “anticipate,” “forecast” and similar expressions are intended to identify forward-looking statements within the meaning of Section 21e of the Exchange Act and Section 27A of the Securities Act of 1933, as amended, as enacted by the Private Securities Litigation Reform Act of 1995 (“PSLRA”). In particular the Company desires to take advantage of the protections of the PSLRA in connection with the forward-looking statements made in this Annual Report to Shareholders.

        Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date such statements are made. In addition, the companyCompany wishes to advise readers that the factors listed below,in Item 1A of this Form 10-K, as well as other factors, could affect the company’s financial or otherCompany’s performance and could cause the Company’s actual results for future periods to differ materially from any opinions or statements expressed with respect to future periods or events in any current statement. Thisexpressed. The discussion of factors in Item 1A is not intended to be exhaustive, but rather to highlight important risk factors that impact results. General economic and political conditions and many other contingencies that may cause the Company’s actual results to differ from those currently anticipated are not separately discussed. The Company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

Risks Associated with Currency Fluctuations The Company maintains international subsidiaries and operations in many countries, and the results of operations and the financial position of each of the company’s subsidiaries is reported in the relevant foreign currency and then translated into United States (“U.S.”) dollars at the applicable foreign currency exchange rate for inclusion in the Company’s consolidated financial statements. As exchange rates between these foreign currencies and the U.S. dollar fluctuate, the translation effect of such fluctuations may have an adverse effect on the Company’s results of operations or financial position as reported in U.S. dollars.

Risks Associated with International Operations The Company does business and has manufacturing operations in numerous countries and regions, including China, Hong Kong, India, Indonesia, Japan, Korea, Malaysia, Philippines, Singapore and other Asia-Pacific countries, Western and Eastern Europe, the Middle East, Africa, Canada, Mexico, Central America and South America. The stability, growth and profitability of this portion of the company’s business may be affected by changes in political and military events, trade, monetary and fiscal policies and the laws and regulations of the United States and other trading nations. In addition, the Company’s international operations are subject to the risk of new and different political and military events, legal and regulatory requirements in local jurisdictions, tariffs and trade barriers, potential difficulties in staffing and managing local operations, credit risk of local customers and distributors, potential difficulties in protecting intellectual property, risk of nationalization of private enterprises, potential imposition of restrictions on investments, potentially adverse tax consequences, including imposition or increase of withholding and other taxes on remittances and other payments by subsidiaries, and local economic, political and social conditions, including the possibility of hyper-inflationary conditions, in certain countries. If for whatever reason, the U.S. were to enter a recession, then demand for Company products would be negatively impacted in North America and throughout the rest of the world.

Competition and Technology Issues The markets in which the Company operates are highly competitive and fragmented both geographically and by application. As a result, the Company competes with numerous regional or specialized competitors, many of which are well established in their respective markets. The Company has, from time to time, experienced price pressures from competitors in certain product lines and geographic markets. The Company’s competitors and new entrants into the

Company’s lines of business can be expected to continue to improve the design and performance of their products and to introduce new products with competitive price and performance characteristics. Competition in the Company’s lines of business may limit its ability to recover future increases in labor and raw material expenses. Although the Company believes that it has certain technological and other advantages over its competitors, realizing and maintaining these advantages will require continued productive investment by the Company in research and development, sales and marketing and customer service and support. There can be no assurance that the Company will be successful in maintaining such advantages. Successful product innovation by competitors that reach the market prior to comparable innovation by the Company or that are amenable to patent protection may adversely affect the Company’s financial performance.

        A number of the Company’s major OEM customers manufacture products for their own use that compete with the Company’s products. Although these OEM customers have indicated that they will continue to rely on outside suppliers, the OEMs could elect to manufacture products for their own use and in place of the products now supplied by the Company. In addition, customers of the Company’s engine filtration and exhaust products business line could decide to meet their filtration requirements through alternative methods, such as engine design modifications, rather than rely on the Company’s products.

Risks Relating to Acquisitions The Company has in the past and may in the future pursue acquisitions of complementary product lines, technologies or businesses. It also completed the acquisition of Ultrafilter at the end of fiscal 2002. Acquisitions by the Company may result in potentially dilutive issuance’s of equity securities, the incurrence of debt and contingent liabilities and amortization expenses related to goodwill and other intangible assets, which could adversely affect the Company’s profitability. In addition, acquisitions involve numerous risks, including difficulties in the assimilation of the operations, technologies and products of the acquired companies, corporate culture conflicts, the diversion of management’s attention from other business concerns, assumption of unanticipated legal liabilities and the potential loss of key employees of the acquired company. There can be no assurance that the Company will be able to identify and successfully complete and integrate acquisitions. There can be no assurance as to the effect of acquisitions on the Company’s business or operating results.

Environmental Matters The Company is subject to various environmental laws and regulations in the jurisdictions in which it operates, including those relating to air emissions, wastewater discharges, the handling and disposal of solid and hazardous wastes and the remediation of contamination associated with the use and disposal of hazardous substances. The Company, like many of its competitors, has incurred and will continue to incur, capital and operating expenditures and other costs in complying with such laws and regulations in both the United States and abroad.

Product Demand Considerations Demand for certain of the Company’s products tends to be cyclical, responding historically to varying levels of construction, agricultural, heavy equipment manufacturing, mining and industrial activity in the United States and in other industrialized nations. Other factors affecting demand include the availability and cost of financing for equipment purchases and the market availability of used equipment.

        Sales to each of Caterpillar, Inc. and its subsidiaries and General Electric and its subsidiaries have accounted for greater than 10 percent of the Company’s net sales in one or more of the last five fiscal years. An adverse change in Caterpillar’s or General Electric’s financial performance, condition or results of operations or a material reduction in sales to this customer for any other reason could negatively impact the Company’s operating results.

Availability and Cost of Product Components The Company obtains raw material and certain manufactured components from third-party suppliers, including significant purchases of steel. The Company maintains limited raw material inventories, and as a result, even brief unanticipated delays in delivery or increases in prices by suppliers, including those due to capacity constraints, labor disputes, tariffs, impaired financial condition of suppliers, weather emergencies or other natural disasters, may adversely affect the Company’s ability to satisfy its customers on delivery and pricing and thereby affect the Company’s financial performance.

Changes in the Mix of Products Comprising Revenue The Company’s products constitute various product lines, which have varying profit margins. A change in the mix of products sold by the Company from that currently experienced could adversely affect the Company’s financial performance.

Research and Development The Company makes significant annual investment in research and development activities to develop new and improved products and manufacturing processes. There can be no assurance that research and development activities will yield new or improved products or products which will be purchased by the Company’s customers, or new and improved manufacturing processes.

Other Factors The Company wishes to caution investors that other factors may in the future prove to be important in affecting the Company’s results of operations. New factors emerge from time to time and it is not possible for management to predict all such factors, nor can it assess the impact of each such factor on the business or the extent to which any factor, or a combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements.

        Investors are further cautioned not to place undue reliance on such forward-looking statements as they speak only to the Company’s views as of the date the statement is made. The Company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

Item 7.A.7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

        Market Riskrisk disclosure as discussed under “Market Risk” appears in Management’s Discussion and Analysis on page 17.17 under “Market Risk.”

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Item 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Management’s Report on Internal Control over Financial Reporting

        Management is responsible for establishing and maintaining adequate internal control over financial reporting for the Company. Management conducted an evaluation of the effectiveness of internal control over financial reporting based on the framework inInternal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Based on this evaluation, management concluded that the Company’s internal control over financial reporting was effective as of July 31, 2006.

        Management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of July 31, 2006 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in its report which is included herein.

William M. Cook Chief Executive Officer September 30, 2006	Thomas R. VerHage Chief Financial Officer September 30, 2006

Report of Independent Registered Public Accounting Firm

To the Shareholders and Board of Directors
of Donaldson Company, Inc.

        We have completed integrated audits of Donaldson Company, Inc.’s July 31, 2006 and 2005 consolidated financial statements and of its internal control over financial reporting as of July 31, 2006, and an audit of its 2004 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.

Consolidated financial statements and financial statement schedule

        In our opinion, the consolidated balance sheets and the related consolidated statements of earnings, of cash flows and of changes in shareholders’ equity present fairly, in all material respects, the financial position of Donaldson Company, Inc. and its subsidiaries (the “Company”) at July 31, 2006 and 2005, and the results of their operations and their cash flows for each of the three years in the period ended July 31, 2006, in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the index appearing under Item 15(2) presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

        As discussed in Note A to the consolidated financial statements, the Company changed its method of accounting for share-based payments as of August 1, 2005.

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Internal control over financial reporting

        Also, in our opinion, management’s assessment, included in Management’s Report on Internal Control over Financial Reporting appearing under Item 8, that the Company maintained effective internal control over financial reporting as of July 31, 2006, based on criteria established inInternal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of July 31, 2006, based on criteria established inInternal Control – Integrated Framework issued by COSO. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.

        A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for

external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

        Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

PricewaterhouseCoopers LLP

Minneapolis, Minnesota
September 30, 2006

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Consolidated Statements of Earnings
Donaldson Company, Inc. and Subsidiaries

The accompanying notes are an integral part of these Consolidated Financial Statements.

Consolidated Balance Sheets
Donaldson Company, Inc. and Subsidiaries

			At July 31,
			2004			2003
			(Thousands of dollars, except share amounts)
Assets
Current assets
Cash and cash equivalents			$	99,504		$	67,070
Accounts receivable, less allowance of $8,741 and $5,836				274,120			226,815
Inventories
Raw materials				52,979			45,088
Work in process				21,109			12,374
Finished products				69,330			57,428
Total inventories				143,418			114,890
Deferred income taxes				16,129			16,917
Prepaids and other current assets				24,209			29,013
Total current assets				557,380			454,705
Property, plant and equipment, at cost
Land				14,979			13,195
Buildings				147,339			127,532
Machinery and equipment				441,893			405,895
Construction in progress				19,277			26,400
Property, plant and equipment held for sale				—			7,349
				623,488			580,371
Less accumulated depreciation				(361,959	)		(324,935	)
Net property, plant and equipment				261,529			255,436
Goodwill				96,574			92,143
Intangible assets				19,127			17,188
Other assets				66,999			62,525
Total assets			$	1,001,609		$	881,997
Liabilities and shareholders’ equity
Current liabilities
Short-term borrowings			$	19,736		$	14,152
Current maturities of long-term debt				34,346			646
Trade accounts payable				124,401			122,759
Accrued employee compensation and related taxes				45,701			33,013
Accrued liabilities				23,789			23,597
Other current liabilities				27,551			19,909
Total current liabilities				275,524			214,076
Long-term debt				70,856			105,156
Deferred income taxes				25,981			21,316
Other long-term liabilities				79,955			94,056
Total liabilities				452,316			434,604
Commitments and contingencies (Note L)
Shareholders’ equity
Preferred stock, $1.00 par value, 1,000,000 shares authorized, none issued				—			—
Common stock, $5.00 par value, 120,000,000 shares authorized, 88,643,194
and 99,311,908 shares issued in 2004 and 2003, respectively				443,216			248,280
Retained earnings				111,768			337,245
Deferred stock compensation				22,092			14,524
Accumulated other comprehensive income (loss)				31,558			(6,888	)
Treasury stock — 2,361,899 and 6,237,469 shares in 2004 and 2003, at cost				(59,341	)		(145,768	)
Total shareholders’ equity				549,293			447,393
Total liabilities and shareholders’ equity			$	1,001,609		$	881,997

The accompanying notes are an integral part of these Consolidated Financial Statements.

Consolidated Statements of Cash Flows
Donaldson Company, Inc. and Subsidiaries

The accompanying notes are an integral part of these Consolidated Financial Statements.

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Consolidated Statements of Changes in Shareholders’ EquityCash Flows
Donaldson Company, Inc. and Subsidiaries