Cummins Inc.
Q1 2017 Earnings Call Transcript

Published: 2 May 2017

[Operator:]

Good day, ladies and gentlemen, and welcome to the Cummins Inc. First Quarter 2017 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will be given at that time. As a reminder, this conference is being recorded. I would now like to turn the call over to Vice President of Financial Operations, Mr. Mark Smith. Please go ahead, sir.

[Mark Andrew Smith:]

Thank you, Andrew. Good morning, everyone, and welcome to our teleconference today to discuss Cummins results for the first quarter of 2017. Joining me today are our Chairman and Chief Executive Officer, Tom Linebarger; our Chief Financial Officer, Pat Ward; and our President and Chief Operating Officer, Rich Freeland. We'll all be available for your questions at the end of the prepared remarks. Before we start, please note that some of the information you will hear or be given today will consist of forward-looking statements within the meaning of the Securities and Exchange Act of 1934. Such statements express our forecasts, expectations, hopes, beliefs and intentions on strategies regarding the future. Our actual future results could differ materially from those projected in such forward-looking statements because of a number of risks and uncertainties. More information regarding such risks and uncertainties is available in the forward-looking disclosure statement in the slide deck and our filings with the SEC, particularly in the Risk Factors section of our most recently filed Annual and Quarterly Reports. During the course of this call, we will be discussing certain non-GAAP financial measures, and we refer you to our website for the reconciliation of those measures to GAAP measures. Our press release with a copy of the financial statements and a copy of today's webcast presentation are available on our website at cummins.com under the heading Investors and Media. Now, I'll hand it over to Tom. Thank you.

[Norman Thomas Linebarger:]

Thank you, Vice President Smith. Good morning, everyone. Today, I'll provide you with summary of our first quarter results as well as some comments on our outlook for 2017. Pat will then take you through more details of both our first quarter financial performance and our forecast for the year. But before I provide my comments on the quarter, I'd like to talk about our recently announced agreement with Eaton, to form a joint venture to design, develop, and manufacture automated transmissions. We are really excited about this joint venture with Eaton, and we have provided some additional slides on our website, which lay out why this joint venture presents a significant opportunity for Cummins. The strategic rationale for the joint venture is simple. Since fuel is one of the largest cost drivers for our customers, fuel efficiency will be a primary differentiator of commercial powertrains across our global markets. Cummins and Eaton had been partners for decades and today offer the leading combination of engine and transmission performance in the North American heavy-duty truck market. We believe that the next-generation of transmissions designed, developed and manufactured by the joint venture combined with Cummins' capability and system integration can yield significant improvements in fuel efficiency for Cummins and our OEM customers and partners. Cummins will invest $600 million for a 50% share of this joint venture. And in return, we'll be able to develop integrated powertrains that offer a significant performance advantage, add to our portfolio of technology offerings to our customers and benefit from the value created by the joint venture as it leads the secular shift to more automated transmissions. Eaton will contribute the current design for the next-generation heavy-duty automated to manual transmission, its current automated manual transmission for medium-duty markets called the precision, direct (03

[Patrick Joseph Ward:]

Thank you, Tom, and good morning, everyone. I will start with a review of the company's first quarter financial results before discussing the performance of each of the four operating segments in more detail. I will then provide an update on our outlook for the rest of the year. First quarter revenues were $4.6 billion, an increase of 7% from a year ago after six consecutive quarters of year-over-year sales declines, the longest period of year-over-year revenue declines since 2002. Sales in North America, which represented 57% of our first quarter revenues, increased 1% from a year ago, primarily due to increased revenue in the Distribution segment, which more than offset lower Engine and Component revenues due to a decline in heavy- and medium-duty truck production compared to the previous year. International sales improved by 17% from a year ago, primarily due to increased sales in China and in Europe, which offset weakness in the Middle East. Gross margins were 24.6% of sales, unchanged from last year. The benefits from increased volumes were offset by warranty expense, which was a 50-basis-point headwind, as we increased accrual rates with new engine introductions and recorded an unfavorable change in estimates on older engines. Selling, admin and research and development costs of $695 million or 15.1% of sales decreased as a percent of sales by 20 basis points but increased by $39 million from a year ago mainly due to higher compensation expense. Joint venture income of $108 million increased by $36 million compared to a year ago as a result of strong market demand in China for both on- and off-highway equipment. Earnings before interest and tax improved to $566 million or 12.3% of sales in the quarter compared to 11.3% a year ago, and this reflects a 28% incremental EBIT margin. Net earnings for the quarter were $396 million or $2.36 per diluted share compared to $1.87 from a year ago. The effective tax rate for the quarter was 26.1%, in line with the full year guidance of 26%. Moving on to the operating segments, let me summarize their performance in the quarter, and then I will review the company's revenue and profitability expectations for the full year and conclude with some comments on cash flow for the quarter. In the Engine segment, revenues were $2 billion in the first quarter, an increase of 2% from last year. International revenues were up 11%, primarily due to growth in off-highway markets in China. Revenues in North America declined by 1% due to lower on-highway revenues as a result of the lower production of heavy-duty trucks. Segment EBIT in the first quarter was $229 million or 11.3% of sales. This compares to 10% of sales from a year ago. The margin improvement was driven by higher joint venture income, favorable pricing and material cost savings, which were partially offset by higher warranty costs and an increase in current product support expense to support recently launched products. For the Engine segment in 2017, we now expect revenues to be up 2% to 6% compared to our previous guidance of down 3% to 6% due to an improved outlook in most of our markets. Our forecast for EBIT margins is to be in the range of 10.25% to 11.25% of sales compared to 9.5% to 10.5% previously. For the Distribution segment, first quarter revenues were $1.6 billion, which increased 12% compared to last year. Organic sales for the quarter increased by 6%, and revenue from the acquisition completed in the fourth quarter of 2016 added an additional 6%. The EBIT margin for the quarter was $100 million or 6.1% of sales compared to 5.9% a year ago. An improvement to margins from an increase in sales during the quarter was partially offset by higher compensation and benefit costs from integration of previous acquisitions. For 2017, Distribution revenue is now projected to increase 4% to 8% compared to our previous guidance of flat to up 4% with the increase driven by improvements in off-highway markets and higher parts sales. We still expect EBIT margins to be in the range of 6% to 6.75% of sales as higher variable compensation and benefits offset improvements to operating margins. For the Components segment, revenues were $1.3 billion in the first quarter, a 9% increase from a year ago. International revenues grew 25% primarily due to a 60% increase in sales in China, which more than offset a 2% decrease in North American revenues due to the lower heavy- and medium-duty international truck production. Segment EBIT was $179 million, or 13.3% of sales compared to 13.2% of sales a year ago. As mentioned in our previous call, we did incur additional expenses to support the launch of our Single Module aftertreatment system, but we were able to mitigate part of the cost we previously forecast, while still meeting our delivery commitments in the quarter. For 2017, we now expect revenues to be up 6% to 10% compared to our prior guidance of a 2% to 6% decline. The change in guidance reflects stronger-than-anticipated demand in the China truck market and improved outlook for the North American heavy- and medium-duty truck market. EBIT is projected to be in the range of 12.5% to 13.5% of sales compared to 11% to 12% in our previous forecast. In the Power Systems segment, first quarter revenues were $882 million, an increase of 9% from a year ago. The increase in revenues for the segment was driven primarily by a 28% increase in industrial markets, led by mining and oil and gas with growth in new engine and rebuild revenues. Global power generation markets remained weak despite a small revenue gain in the quarter. EBIT margins were 6.5% of sales in the quarter, up from 5.7% last year due to the increase in industrial engine shipments. For 2017, we expect Power Systems segment revenues to be up 1% to 5% versus a previous guidance of flat to down 4% due to increased customer demand from mining and oil and gas engines in addition to higher parts sales. EBIT margins are still expected to be between 7% and 8% of sales with this segment experiencing a more significant increase in commodity costs than we anticipated at the start of the year. For the company, we are raising our outlook for revenues to be up 4% to 7% versus our previous guidance of flat to down 5%. The increase is primarily due to improving off-highway market demand, stronger-than-anticipated growth in China and a more resilient North American truck market. Foreign currency headwinds are expected to reduce revenues by approximately $180 million, slightly lower than the $200 million impact in our previous forecast. The guidance provided today does not include the impacts from the announcement of the Eaton-Cummins joint venture. We will provide the forecast upon regulatory approval of the deal. Income from our joint ventures is now expected to be relatively flat to last year. Our strong results in China will offset the impact of the acquisition of the last remaining North American distributor in the fourth quarter of 2016. We now expect EBIT margins to be between 11.75% and 12.5% for 2017, up from our previous forecast of between 11% and 11.5%. The increase in profitability reflects increased outlook for both the global off-highway markets and the North American truck market. Finally, turning to cash flow, cash generated from operating activities for the first quarter was $379 million, which was a 42% increase from a year ago. We anticipate operating cash flow in 2017 will be within our long-term guidance range of 10% to 15% of sales. Capital expenditure during the quarter was $81 million, and we still expect our investments to be in the range of $500 million to $530 million this year. And as Tom said, in the first quarter, we returned $322 million to our shareholders through dividend payments and share repurchases. And for 2017, we plan to return at least 50% of operating cash flow to our shareholders, in line with our long-term commitment. Now, let me turn it back over to Mark.

[Mark Andrew Smith:]

Okay. Thank you, Pat. And we're now ready to move to the Q&A section of the call. Please try and limit your call to one question and a related follow-up and then get back in the queue if there's time. Thank you.

[Operator:]

And our first question comes from the line of Steven Fisher with UBS. Your line is now open.

[Steven Michael Fisher:]

Great. Thanks. Good morning.

[Norman Thomas Linebarger:]

Morning, Steve.

[Steven Michael Fisher:]

I'm wondering if you can give us a sense of the visibility you have on oil and gas and mining rebuilds for the rest of the year. Clearly, (25

[Rich Freeland:]

Okay. Hey, Steven, this is Rich. Yeah, we're off to a good start on the oil and gas rebuilds. In fact, there are some relatively low numbers that it's up 300% right now, and it's pretty broad based. So we're seeing that kind of across geographies – although primarily North America, but across geographies in North America. What we also saw in Q1 is some new orders for new frac rigs, and so that is a little less broad based. We've seen that with one or two customers. And that's the one kind of yet to be determined is kind of the rate of new versus putting idled equipment back to work. But I think the rebuild piece will continue through the year.

[Steven Michael Fisher:]

And that's what you have baked in your 10% to 15% for high horsepower for the rest of the year?

[Patrick Joseph Ward:]

Well, that's for engine shipment, Steve, not rebuilds. But the overall – it's embedded in the Power Systems guidance here.

[Rich Freeland:]

(26

[Steven Michael Fisher:]

Okay. And just, Tom, last quarter, you stated a lot of dealer inventory in construction in China. So, I guess, how surprised are you that the China construction was so strong? Was this further building of inventories or is it all getting deployed on projects? And then what does that imply for your second half expectations?

[Rich Freeland:]

It looks to be not an inventory build. It appears to be the – while the inventory is a little higher than what we thought, this seems to be, again, a little more broad based on the construction side. We were surprised by it, okay? It was not in our forecast. But there seems to be a little more sentiment, maybe not data, that says that this could continue on the construction side, in the excavator side, in particular.

[Norman Thomas Linebarger:]

Steve, utilization rates are definitely up, and so that's a good sign. That means people are using the equipment there in addition to buying some new. So that's a good sign. I think it's worth us being cautious just to see where dealer inventory levels are and to understand all that. But we definitely saw sales grew higher and we saw utilization rates higher, both of which are a good sign. The question is how lasting is it and how healthy are the dealers and how is the inventory looking? We've still got some more work to do to understand that, because, frankly, we were surprised by the uptick.

[Steven Michael Fisher:]

Okay. Thanks very much.

[Operator:]

And our next question comes from the line of Jamie Cook with Credit Suisse. Your line is now open. Jamie L. Cook - Credit Suisse Securities (USA) LLC Hi. Good morning. Nice quarter. I guess a couple questions. One relates to your full year guidance. When you guys guided last quarter, you said the first quarter should be the lightest for a number of different reasons. Yet if we look at your margins for the quarter, they came in at like 12.3%, which is the midpoint of your full year guide. So something doesn't seem right. Maybe we're conservative, maybe the cost on ISG and the single modular treatment system was lower in the first quarter than we thought. So, if you could just sort of walk me through the guidance and whether there's potential for upside. And then, I guess, my second question, Tom, specifically on the Eaton-Cummins joint venture, just a little more color, I guess, I'm looking at it. You're paying $600 million for potentially $900 million or more revenues five years out, which just seems, I don't know, light or expensive to me. So are there incremental positives that perhaps the market is under appreciating? And I don't know what's your...

[Patrick Joseph Ward:]

Hi, Jamie, this is Pat. Let me – Sorry, let me... Jamie L. Cook - Credit Suisse Securities (USA) LLC Sorry, I don't know what your assumptions are behind that. So sorry, go ahead.

[Patrick Joseph Ward:]

Sorry, I interrupted you there. Let me take the first question, and then Tom can take that second question. I didn't mean to interrupt it. So on full year guidance, the first quarter included very strong earnings from China and our China JVs in particular. Traditionally, we tend to see a mix of 60% of China earnings in the first half of the year, 40% in back half of the year. We are a little bit hesitant to assume that the strong demand that we're seeing through the first quarter and we probably expect to see in the second quarter will continue into the second half of the year. It's close to a year now since overloading regulations come into play. That's clearly been a factor in driving that. So we are assuming second half earnings will drop in China from first half and that's probably the number one reason why we are – maybe our guidance shows a little bit weaker in the second half of the year. But the other fact that is material cost, which drove 80 basis points of margin improvement in the first half of the year as we see rising commodity prices through the year. For the full year, we expect that to be nearly in line with the 30 basis point improvement. So other than that, everything else should continue much the same as what we've seen so far. Jamie L. Cook - Credit Suisse Securities (USA) LLC Okay. Thanks.

[Norman Thomas Linebarger:]

Jamie, thanks for your question on the Eaton JV. So here's the – and again in simple terms, we're convinced that leading powertrains will be integrated. That will be industry-wide, that will be whether you have a diesel engine driving at a fuel cell or a battery. We think integrated powertrains will win and that's basically performance, quality, all the elements that we think make a difference. And as you know, as a company, we are continuing to invest in the components that we think are essential to driving performance in fuel efficiency and emissions for powertrains because we think that's what made us successful in differentiating in the market of integrateds with powertrain focus. So we think we have to have an integrated powertrain. So, as we discussed in New York a couple of years ago, that we've been focused on figuring out ways to do that, and we look at every single option available to us and explore every option in detail. And we felt like, given the consolidation of the industry, it's already highly consolidated and it's going to consolidate further. Both strategically and technically, we needed to figure out a move into powertrains and our view is that this by far the most attractive entry point that we could find. And we look at everything. And so we feel very good about this. Good because we think we're getting leading technology that's implementable right now, that we are partnering with a customer – I mean a partner that we feel we have a strong – we share cultural values; we operated successfully in the past; we know each other well so we can ramp up very quickly. And lastly, we see opportunities for growth outside of the base plan internationally as those markets begin to ramp up into automated transmission. And then we think by providing a better powertrain, our view is we can grow engine share. And, of course, that's the big variable in the mix. There is a variable that's hard to calculate in here is what happens to our engine share with and without this joint venture, and we are 100% convinced that when you start looking at that, this deal looks not only attractive to Cummins but essential to our strategy. Jamie L. Cook - Credit Suisse Securities (USA) LLC Is there any way you could provide a range of how – the range of where market share should go? Like just variability around that so that joint venture could make more sense. Can 30% go to 40% in heavy-duty? Or is it China? I am just trying to think about how to justify the investment?

[Norman Thomas Linebarger:]

I think we will as the joint venture begin to talk about what our growth plans are, et cetera. We need to complete the transaction. As you know, there's a series of regulatory approvals in front of us. And before those are completed, we just need to say the main things and then do our legal work. When that's done, I believe, we'll be able to say a lot more about what we plan to do together. And, again, I'm a 100% convinced that the shareholders of Cummins will believe that this was a essential move and a good move for the company. And I believe the shareholders of Eaton will agree with that. So I feel, again, very excited about this joint venture. And again, just from a financial point of view, it doesn't take a lot of math to figure out how this could be attractive for Cummins. Again, you basically have to understand that or agree with the basic premise that this is essential to being successful in powertrain. But once you do that, I think it works – it's pretty straightforward. Jamie L. Cook - Credit Suisse Securities (USA) LLC Okay. That's fair. Thank you. I will get back in queue.

[Norman Thomas Linebarger:]

Yeah.

[Operator:]

And our next question comes from the line of Ann Duignan with JPMorgan. Your line is now open.

[Ann P. Duignan:]

Hi, guys. It's still me.

[Norman Thomas Linebarger:]

Hello, Ann.

[Patrick Joseph Ward:]

Hi, Ann. We just (34

[Ann P. Duignan:]

Could you do us a favor and just comment a little bit more on pricing versus input costs? Could you quantify the impact of higher input costs and when you would expect to be able to offset the higher input costs? And then as a follow-up, I get a lot of questions recently on penetration of electric vehicles and autonomous driving et cetera, et cetera. Could you just maybe comment on Cummins' perception of the penetration of electric vehicles particularly in long hauls? Thank you.

[Mark Andrew Smith:]

Hi, good morning, Ann. This is Mark. So on pricing we've probably been closer to net neutral for the year on pricing across our various segments. Where we're having the biggest challenge is, as Pat mentioned, the costs are rising particularly in the Power Systems business, and as you know, we're experiencing still weak global demand in power generation. So, when you've got persistent weak demand, you've got that balancing act to choose how much you want to press the price lever. So we'll continue to evaluate what options we've got there. And as we said, hopefully that's going to be supportive of growing capital goods demand going forward. But definitely, less of a net favorable in the second half than the first half.

[Norman Thomas Linebarger:]

And, Ann, this is Tom. Thanks for your question on the technology area. So not surprising, I guess, in our strategy work, we've done several years of work now developing both projections and analyses of substitute technologies that might play a role in our end markets. And we are convinced that electrification, specifically, will substitute in some of our applications over a period of time. And again, our projections for that depend in large degree, as you guess, on how battery and power electronics cost come down and performance goes up, especially the energy side, how much I can store? And then also, the cost of fuel and other kinds of environmental-related costs, but assuming most of our scenarios come up with electrification playing a significant role in cities, especially stop-and-go applications, bus, maybe refuse, pickup and delivery trucks, we think it'll play a significant role, and especially after it makes a major substitution in cars since that will drop cost and increase volume. And we intend, by the way, to compete in that business and win. So we've already launched an electrification business development area in our company. It's people dedicated to not only launching fully electrified powertrains, but are currently selling those powertrains to some customers. So we intend to compete with and these are our markets; buses, refuse vehicles, we are the leader in those markets and we intend to be the leader in those markets when they're electrified. And we already have pilot products running with fully electrified powertrains designed and built by Cummins. So we will compete in those markets, and we believe we'll win. And so the fully integrated powertrains, as I was mentioning to Jamie, we think are Cummins future, be they diesel driven, battery driven or other. We also think, by the way, fuel cells could potentially play a role in longer haul. One of the challenges for battery driven longer-haul trucks, which is I think might be obvious in your question, is that you use most of the weight that you would otherwise carry goods for batteries. And so right now, it doesn't look like that's a winner based on the technologies that are available now or in the foreseeable future. Whereas fuel cells, I think, do a better job of – they are still heavier than diesel because the fuel is necessary but closer, and some of the same advantages as other electrified powertrains. But there's a long way of development to go on fuel cells. They're not nearly as close from a cost, performance and quality point of view as batteries are. So both of those technologies, by the way, I mentioned electrified powertrains and fuel cells, are feasible and could play a role. But both are relatively modest sellers today even in the car side. So it'll be a number of years. We know from the natural gas front that even when things are very attractive, it takes a long time to substitute in mature markets. And right now, neither of those technologies is attractive. So there's work to do to make them more attractive, and then there's work to make them work in commercial operations in a sensible way that will work for commercial operators who, as you know, are very sensitive to capital returns. So I think they'll definitely play a role. It's going to be sometime before the markets are large enough to make a big dent, but we intend to lead in both. And we are putting together the technologies and the customers to be able to do that.

[Ann P. Duignan:]

Okay. Thank you. I appreciate the color. I'll get back in line in the interest of time. Appreciate it.

[Operator:]

Your next question comes from the line of Jerry Revich with Goldman Sachs. Your line is now open.

[Jerry Revich:]

Hi, good morning, everyone.

[Norman Thomas Linebarger:]

Hi, Jerry.

[Patrick Joseph Ward:]

Hi, Jerry.

[Jerry Revich:]

Tom, for your significant joint ventures in the past, you folks have been able to deliver mid-teen margins by leveraging SG&A. And I'm wondering in the Eaton-Cummins joint venture, do you folks expect a similar profile once that business ramps, or is there anything structurally different on the joint venture either in pass-through cost or R&D intensity that we should keep in mind as we move towards hopefully the five-year revenue targets that you laid out?

[Norman Thomas Linebarger:]

Absolutely the same approach, Jerry. As you said, this one because we have a lot of upfront development to get the products to market. It will be heavier on R&D expense in the early years, but as the revenues ramp up, we expect to be at very similar margins. And again that's a little bit why we feel confident with this. It looks like a lot of things we've done before with a partner that we really like working with and know very well. So we have every expectation we'll be able to operate at similar margins or JVs we've operated before.

[Jerry Revich:]

And Tom, how back-end loaded is the ramp? Do we have to look for a significant new product introduction cycle, so we see a bigger contribution in terms of the growth rate 2020, 2021, or can we see it kick-in potentially sooner?

[Norman Thomas Linebarger:]

There's at least 18 to 24 months of developments dominating the expense ratios in the joint ventures. So that is a while. I mean, from that point of view, we have a lot of work in front of us to do. Again, a lot of the work has been done on the base transmission, but there's a lot of work to do for integrating with customers. And I think that's again likely to take us 18 to 24 months, and then we'll start to see the ramp up more significantly. So, again, we'll be able to say more about that as the joint venture closes and then we can talk a little bit more about who our customers are and all those sorts of things. But I think just generally speaking, it's a first couple years look more like development, and there will be sales, of course, but there's going to be pretty heavy development costs.

[Jerry Revich:]

Okay. And then, Rich, China Foton comments that you folks had warranty issues that you're working through last quarter. Can you give us an update on how the business performed this quarter? Were there any warranty or product introduction-related costs and the outlook for those costs over the next couple of quarters?

[Rich Freeland:]

Yeah, thanks, Jerry. Just to remind you, we talked about we had some specific issues in some different regions or different markets or duty cycles we're working through and incurred some costs. And the good news is we've worked through those faster and actually been able to reduce the cost of doing that. Because as I talked last quarter, I said we've been living with this through the first half of the year. And so we're really pleased that we got through it well, took care of customers and generally, by the end of Q1, have any unusual costs behind us.

[Jerry Revich:]

Okay. Thank you.

[Operator:]

And our next question comes from the line of Ross Gilardi with Bank of America. Your line is now open.

[Ross P. Gilardi:]

Hey, good morning. Thanks guys.

[Norman Thomas Linebarger:]

Morning, Ross.

[Patrick Joseph Ward:]

Morning.

[Ross P. Gilardi:]

I was just wondering if you could talk about capital allocation from here. I mean, you made an investment that you think is very attractive, but you haven't added the leverage that you initially identified you'd be willing to consider. So should we be anticipating other acquisitions from here? Are those leverage targets that you talked about a year, year-and-a-half ago still kind of in the game plan, or is it just that valuations across a lot of the areas of interest have become too expensive, and we should sort of expect Cummins to go back to returning more cash?

[Norman Thomas Linebarger:]

Thanks for the question, Ross. So the answer is, we are still pursuing our strategic areas that we talked about a year-and-a-half ago. I think maybe as you saw in the Eaton joint venture and our powertrain expansion, we think to do a good deal takes more time than to do a lousy deal, or at least that's what we're seeing in the market. To your point, valuations are pretty high in some places. So, in typical fashion, to do the things that we think add strategic growth and profitable growth to Cummins and good capital returns just turns out are taking us some effort to work through. And, I guess, that's probably to be expected. But we intend to continue to pursue those areas. And, yes, the leverage targets we laid out to you are still what we think make sense for the company. We haven't changed that at all. And we have a number of things that we're pursuing right now that we hope to be able to turn into attractive projects for the company. But as you suggested by your question, we looked through a lot of things that turned out to be less attractive, frankly, from a return point of view and, therefore, passed them by. So I think we are active still. I'm confident that we're going to find other good things that will add to the growth and profitability and return profile of the company. But it's taken some effort and some work to grind through those, and we're still active in them though.

[Ross P. Gilardi:]

And then just as a follow-up to that, I mean, there were some news reports a couple of months ago about the potential sale of, I believe, your filtration business. And I don't know if you can comment on that. But if you can't, just wondering, is there any reason to anticipate that Cummins would ever consider a sizable divestiture, if you don't actually have a larger target on the horizon given the strength of your balance sheet today?

[Norman Thomas Linebarger:]

Yeah. Thanks. That's a great question, Ross. And the filtration business is not for sale as we said then. So I'll just repeat that. The second thing is that we would not link our sale of a division with the need to acquire another division – another business. And the reason is, as you remember from the strategy discussion a year-and-a-half ago, we have enough debt capacity and capital raising ability to acquire a company that we would be interested in, at least the ones that we're considering, we have enough with our existing balance sheet and cash. So we don't see that as necessary. We would consider selling parts of Cummins in the same way as we always have, which is, if we believe that a division is no longer strategically essential to the company in a sense that it's not making the whole greater than the sum, which has been kind of the way we've thought about our business for a long time. If it's not doing that, then if we think the shareholders would benefit from the price that we can get versus what we can generate internally, we'd sell it. And we do a review of our big divisions across the company every single year with that exactly in mind. So we believe that we owe the shareholders that work to say, is the current portfolio of Cummins best owned by Cummins and by the shareholders or should we sell something to realize value and then put it to work in a new and better way? So, we go through our divisions and look at those. And so we always do that, and if one of them ended up in that box that said it's as not as strategic and we think we can get a better valuation, at the very least we would go test to see if we can get that valuation. And if we could, we would sell it. And if we couldn't, we would not. So that's something we do as a matter of strategic practice.

[Ross P. Gilardi:]

Thanks very much.

[Norman Thomas Linebarger:]

Yeah.

[Operator:]

And our next question comes from the line of Nicole Deblase with Deutsche Bank. Your line is now open.

[Nicole Deblase:]

Yeah. Thanks. Good morning, guys.

[Norman Thomas Linebarger:]

Morning, Nicole.

[Nicole Deblase:]

So my first question is around mining. So I thought it was good that you guys went through what's going on within oil and gas for rebuild versus OE. But we've heard from some of the mining OEMs that OE activity is actually picking up a bit. So I'm just curious if you're seeing something similar.

[Norman Thomas Linebarger:]

Okay. Yeah, Nicole, we are. So, again, like in oil and gas, we're seeing it first on parts, which we started to see, in fact, last year and that's continued. So our parts sales are up double-digits in the high horsepower space, mostly driven by mining and oil and gas. And so from the Engine side or the OEM side, we're now projecting up 10% to 20%. So we are seeing some of that kind of come through and a little less of the idled equipment to deal with that we have in the oil and gas business. So early days, commodity prices are up, and so there's certainly more activity and more discussion, and we're starting to see it in some orders.

[Nicole Deblase:]

Okay. Got it. Thanks. That's really helpful. And I guess my second question is just around China. So last quarter you guys talked about a competitive pricing environment within China truck. I'm just curious if that's continued into the first quarter or if you've seen that ease?

[Patrick Joseph Ward:]

I don't think it's impacting our results right now. So probably there hasn't been significant change at this point in time.

[Norman Thomas Linebarger:]

Yeah, most of that was related to market share acquisition by one OEM or the other (49

[Nicole Deblase:]

Okay. Thanks. I'm going to pass it on.

[Operator:]

And our next question comes from the line of Stephen Volkmann with Jefferies. Your line is now open.

[Stephen E. Volkmann:]

Great. Thank you. Just a couple of quick follow-ups. And Tom, I apologize, I'm a little bit slow this morning. But I want to make sure I understand, with this Cummins-Eaton joint venture, what does this allow you to do that you weren't doing before? Because I think you already had a pretty close relationship with them previously, and I'm curious why you felt the need to sort of allocate all this capital to this?

[Norman Thomas Linebarger:]

Yeah. It's a great question, Steve. From our point of view, like with most of our Components businesses, we always have the choice of purchasing outside or bringing something inside. And we typically bring it inside if two conditions are right. One is that we believe that because of our knowledge of engines and systems, we think we can make a better product for ourselves and for others. And we believe that's true now. We believe that in integrated powertrains that we can impact the design of the transmission in a positive way by what we bring to the table in terms of engines. Now, we can, of course, do that through partnerships. It's just not as efficient and not as effective to do. So when we think we can make a big positive impact technically, then we want to bring them in. Second thing is that we believe in this case that together we can offer an integrated powertrain with features that are harder to negotiate on when it's commercial negotiation. We're adding software features, control features, which frankly are difficult to price across markets. And we want to make sure that we can do that and win market share in the market and come up with an effective package that includes those features. And it was just hard to do so with a commercial arrangement only. I think, on the same front, we want to invest in those technologies and features. But we want to make sure that our partners felt that investing was going to earn a return for them, and it wasn't as clear over the long run that they felt that way. So to make sure we could add the technology we want, develop the features, price for the features, et cetera, and to make sure that we can offer a better powertrain, we felt the need to bring them in. And, again, as I mentioned to Jamie, we spent a long time understanding this, looking at different ways to do it, everything from developing our own solutions to acquisitions and joint ventures in different parts of the world with different partners. And we decided in the end that this was by far the best choice. And I think, from Eaton's point of view, they see it in much the same way.

[Stephen E. Volkmann:]

Okay. Good. Yeah, that definitely helps. And then secondarily, I'm just curious, you talked a little bit about electric drivetrains and fuel cells and so forth and interesting to hear that you're already sort of testing this stuff. But I'm wondering if you feel like you have internally that kind of core competency that you need there or is this a situation where, ultimately, you're going to have to either acquire or joint venture or something in order to be able to do what you need to do with those alternative type drivetrains?

[Norman Thomas Linebarger:]

Yeah. I think it's much like the situation we just spoke about. Our view is that that we have the capability to integrate today just as we had the capability to integrate a powertrain before. But we will likely want to acquire some subsystems of electrified powertrain to make sure that we not only can do it, but we can do it better than everybody else. So I think it's right what you said that the capabilities that we need to outperform everybody else, we will have to acquire or develop those capabilities in-house for some of the subsystems, things like battery control, packaging, power electronics, especially for the size of the commercial vehicles, these are things where there are suppliers today in the market, but those technologies will develop the fastest. And our ability to have the best ones of those subsystem technologies and integrating the best will certainly require us to invest more in those areas. Whether that means acquiring a company or joint venturing again or otherwise hiring and developing our own will remain to be seen. But we are active in all those spaces to figure out exactly that. I mean, again, there's time in front of us, so we can produce one now and a good one, but we want be the winner, as I mentioned, which means we're going to have to be expert in some of those subsystem technologies just as we are with diesel, just as we are with natural gas.

[Stephen E. Volkmann:]

Great. Thanks for taking the questions.

[Norman Thomas Linebarger:]

Yeah.

[Operator:]

And our next question comes from the line of Robert Wertheimer with Barclays. Your line is now open.

[Robert Wertheimer:]

Good morning and thanks for the discussion on the sort of forward thinking strategy. It's very interesting. Tom, if you were rumored to be spending two-thirds of your time on acquisitions over the past year or two, do you anticipate that to be just as intense now or does the Eaton JV fill a big enough hole that there's just a little bit less? And, secondarily, and you've touched on this, but I mean, do you see more opportunity or more need in acquiring things related to hydrogen or related to electric or related to whatever versus maybe the upside of acquiring pools of revenue where you can operate the businesses differently or better? Thanks.

[Norman Thomas Linebarger:]

Thanks, Rob. I thought where you were going with that is, since you spent two-thirds of your time and all you've got is one joint venture to show for it, that you weren't sure the time was well spent. But I'll just assume you didn't mean that. So, yeah, there is no change in my focus in terms of time. So this joint venture with Eaton is a really important strategic move, as I mentioned. We feel very good about it. It only addresses a portion of the strategy areas that we discussed, and so we have a lot more work to go. So I have not slowed down at all. And the answer to your question about which of those is more interesting to us is both. So the way that I guess I think about it is that we have things that we need to do to acquire capabilities in order to stay the course. In order to be the leading company in what we do now, we have to continue to develop technologies and, in some cases, joint venture and acquire technologies in some of these new technology areas and things like that, as we were just talking to Steve and earlier with Jamie. But we also need to look at opportunities to leverage our capabilities that we have now and potentially expand into new revenue pools. Both of those things are essential for our growth and development as a company. So we're thinking of growth and capability building both as part of our strategic effort, and I think the Eaton joint venture demonstrates some of both. And you'll see us continue to look at both as essential to the company's future.

[Robert Wertheimer:]

Thank you.

[Norman Thomas Linebarger:]

Yeah.

[Operator:]

And our next question comes from the line of Andy Casey with Wells Fargo Securities. Your line is now open.

[Andrew M. Casey:]

Thank you. Good morning.

[Norman Thomas Linebarger:]

Good morning, Andy. I wondered if you were going to make it in.

[Andrew M. Casey:]

Thanks for squeezing me in there. Just a couple of follow-ups. The JV stuff has been asked and answered several different ways. But in the near term, it looks like your Power Systems outlook is not anticipating much over the next three quarters, and part of that might be this uncertainty that you described with respect to China. But I'm wondering why not more of a follow through given your comments on oil and gas and mining?

[Rich Freeland:]

Okay. Yeah, Andy, it's Rich. Well, again, I think what we have seen is, in that Power System area, our parts sales are going to be up 16% this year. So we're seeing this kind of broad-based activity, which activity is a precursor hopefully to new equipment going in. And so, until we see it, I guess, we're not putting that in the forecast. And like I talked on oil and gas, we've even had some indications that this was kind of a onetime blip until some equipment gets rebuilt and refurbished. So we're just paying attention. I think there needs to be some prolonged commodity prices staying higher for a bit longer so that people are going to make the capital investment. And so when we see that, we'll put it in the forecast. And, lastly, you know we're prepared for it. So we've got capacity in place. And one of the things we always try to do is being the best at responding when it comes back. And even if we get surprised and it comes back quickly, which it does sometimes, we'll be ready for that.

[Norman Thomas Linebarger:]

The other challenge is, Andy, at these lower levels, even though mining and oil and gas are improving, still two-thirds of the revenue are tied to power gen, which at least for now will remain fairly (59

[Andrew M. Casey:]

Okay. Thank you. And then another detailed question on warranty, the 50-basis-point headwind that you called out in the quarter and maybe you've discussed this, but I missed it. How much of that was the adjustment, meaning the one-time, and how much is kind of go forward for the rest of the year?

[Patrick Joseph Ward:]

Well, the one-time adjustment, Andy, was probably close to two-thirds of that, maybe a little bit more. So that's one time, not going to repeat through the rest of the year. We did anticipate higher expense in the first quarter as we launched the new engines, and we do increase our rates when we launch our engines. I think you'll see warranty come down in the second quarter to more normalized levels, so to speak.

[Andrew M. Casey:]

Okay. Thank you very much.

[Patrick Joseph Ward:]

Thank you.

[Norman Thomas Linebarger:]

Okay. Thank you very much, everyone. Adam and I will be available for your calls later. Thank you.

[Operator:]

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program, and you may all disconnect. Everyone, have a wonderful day.