Cummins Inc.
Q2 2017 Earnings Call Transcript

Published: 1 Aug 2017

[Operator:]

Good day, ladies and gentlemen, and thank you for standing by. Welcome to the Second Quarter 2017 Cummins Incorporated Earnings Conference Call. At this time, all participants are in a listen-only mode to prevent background noise. We will have a question-and-answer session later and the instructions will be given at that time. And now, it's my pleasure to turn the call to the VP of Finance Operations, Mr. Mark Smith.

[Mark Andrew Smith:]

Thank you and good morning, everyone, and welcome to our teleconference today to discuss Cummins' results for the second quarter of 2017. Participating with me today are our Chairman and Chief Executive Officer, Tom Linebarger, and our Chief Financial Officer, Pat Ward, who will be available for your questions after our 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 number of risks and uncertainties. More information regarding such risks and uncertainties is available in our forward-looking disclosure statement in our slide deck and our filings with the SEC, particularly in the Risk Factors section of our most recently filed Annual Report on Form 10-K. 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. 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 turn it over to Tom.

[Norman Thomas Linebarger:]

Brilliant. Thank you, Mark. Good morning. I'll start with a summary of our second-quarter results and finish with a discussion of our outlook for 2017. Pat will then take you through more details of both our second-quarter financial performance and our forecast for the year. Revenues for the second quarter of 2017 were $5.1 billion, an increase of 12% compared to the second quarter of 2016, due to stronger demand for trucks and construction equipment in North America and China and improving orders from customers in mining and oil and gas markets. EBIT was $620 million or 12.2% compared to $591 million or 13.1% a year ago. EBIT decreased as a percentage of sales and was below our own expectations primarily due to higher warranty costs. Variable compensation costs also increased both year-over-year and versus the first quarter as a result of our improved outlook for full-year earnings. Warranty costs were 3.7% of sales in the second quarter, up from 2.2% a year ago. Two unrelated issues caused most of the increase. In our Power Systems segment, engine testing at our manufacturing plant identified a component quality issue that may impact engine performance. Although no performance issues have yet occurred in the field, we are taking actions to protect our customers and we record a $31 million charge to reflect the estimated costs of the campaign. Secondly, we experienced higher warranty claims associated with late light components in on-highway applications in North America that caused us to increase our warranty reserve by $36 million for products delivered in 2012 and 2013. This additional charge primarily impacted the Components segment. We've made significant improvements to the quality of our products and especially in our new product launches. Cummins' products are performing at record levels of reliability and our market share reflects that strong performance. On the other hand, the complexity of our products has increased significantly to meet tough emissions regulations. Customer expectations have also increased and the environments where our products are used are more demanding than ever. Thus, we are redoubling our efforts on improving product quality and developing new techniques using telematics and Big Data to complement our existing quality tools. We expect to resolve the specific quality issues we experienced this quarter quickly and we expect warranty costs to decline as a percent of sales by 50 basis points in the second half of the year. Engine business sales increased by 15% in the second quarter compared to a year ago due to higher industry truck production and growth in our market share. We also experienced strong growth in demand from construction OEMs in China and North America. EBIT for the quarter was 12% compared to 10.3% for the same period in 2016. Benefits from higher volumes and stronger joint venture earnings in China and the absence of a loss contingency charge recorded a year ago more than offset higher variable costs and warranty costs. Sales for the Distribution segment increased by 12% year-over-year, resulting from 6% organic growth, net of currency, and an additional 6% increase resulting from the acquisition of a last remaining distributor joint venture in North America in the fourth quarter of last year. Stronger parts and service revenues in oil and gas and mining markets in North America and higher parts sales in China drove the improvement in organic revenues. Second-quarter EBIT was 5.6%, flat compared to the second quarter of 2016, as the benefit of higher sales were offset by higher variable compensation costs. Second-quarter revenues for the Components segment increased by 14%. International revenues increased by 25% due to strong growth in truck demand in China and the sale of new products in India to meet the broad Stage IV emissions regulations introduced in April this year. EBIT for the second quarter was 13.1% compared to 14.9% in the same quarter a year ago. The benefit of the higher volumes and material cost-reduction programs were more than offset by the increase in warranty costs that I discussed earlier. Power Systems sales increased by 10% in the second quarter, primarily driven by an increase in engine and parts sales to mining and oil and gas customers. EBIT in the second quarter was 6% compared to 9.8% a year ago. The primary driver of the lower EBIT margin was the accrual for the estimated cost of the quality campaign. The business also experienced an increase in commodity costs and higher variable compensation costs associated with the company's improved outlook for the full year. Excluding the campaign and some additional one-time costs, the business is operating at approximately 10% EBIT margin. With improving market conditions in some key markets and the benefits of our UK manufacturing restructuring still to come in 2018, we are confident that we will see a significant step-up in profitability in the coming quarters. Now, I will comment on the performance in some of our key markets for the second quarter of 2017, starting with North America and then I will comment on some of our largest international markets. Our revenues in North America improved 13% in the second quarter, primarily due to higher levels of industry production and increased market share in on-highway markets. We also experienced growth in sales of engines and parts to customers in construction, oil and gas and mining markets. Industry production of North American heavy-duty trucks increased 4% in the second quarter of 2017, while sales of our heavy-duty engines increased 16% due to higher market share at 32%, up from 29% a year ago. Production of medium-duty trucks increased 15% in the second quarter, while our engine shipments increased 27% as our market share improved 600 basis points reaching nearly 80% in the quarter. Total shipments to our North American pickup truck customers increased 6% compared to a year ago due to strong demand from FCA. Engine sales for construction equipment in North America increased 31% in the second quarter, compared to a weak quarter a year ago with some OEMs optimistic about the prospects for increased infrastructure investment. Sales of engine shipments to high-horsepower markets in North America increased 147% compared to a very weak quarter a year ago, driven by higher sales to oil and gas customers. Revenues for power generation showed little change from weak levels a year ago with shipments of mobile generators for recreational vehicles helping to offset lower military sales. Our international revenues increased by 11% in the second quarter of 2017 compared to a year ago. Second-quarter revenues in China, including joint ventures, were $1.2 billion, an increase of 28% due to continued strength in truck and construction markets. Industry demand for medium and heavy-duty trucks in China increased by 46% compared to a year ago and our market share for the quarter was 14%, slightly below the level a year ago, reflecting a mix shift in industry sales to dump trucks in which we have a lower share of the market today. Penetration of our products with our key OEM customers remains very strong. Shipments of our light-duty engines in China increased by 35%, above the overall increase in the market of 10%. Our market share rose by 150 basis points from a year ago to more than 8% as we continued to displace local competitors from Foton's vehicle lineup. Chinese industry demand for excavators in the second quarter increased 102% from a year ago, reflecting a rebound in construction activity. Our shipment of engines to construction customers across all equipment categories increased 125%. Revenues for our Power Systems business in China increased 4% due to higher demand from mining and rail customers. Second-quarter revenues in India, including joint ventures, were $431 million, a 5% increase from the second quarter a year ago. Revenues for power generation equipment increased 6% and sales of construction engines increased 25%, reflecting growing investment in infrastructure. Industry production of trucks in India decreased 25% year-over-year, following the introduction of the Bharat Stage IV emissions regs in April. In Brazil, our revenues increased by 16%, primarily due to an increase in truck production in the quarter and the appreciation of the Brazilian real. Now, let me provide our overall outlook for 2017 and then comment on individual regions and end-markets. We are now forecasting total company revenues for 2017 to be up 9% to 11%, higher than our previous projection of up 4% to 7%, due to stronger demand in on-highway and construction markets in both North America and China and improving orders from global mining customers. We've raised our forecast for industry production of heavy-duty trucks in North America to 205,000 units, up 2% compared to 2016 and above our prior forecast of 195,000 units. We expect our market share to be above the midpoint of our prior projection of 29% to 32%. In the medium-duty truck market, we've raised our outlook for the market size to 115,000 units, an increase of 6% compared to 2016 and 2% higher than our previous forecast. We now expect our market share to be at the top-end of our prior forecast of 73% to 75%. Consumer demand for pickup trucks in North America remains strong with our full-year shipments of engines expected to increase 5%, above our previous projection of 1% growth. In China, we expect full-year domestic revenues, including joint ventures, to grow 26% compared to our previous projection of a 3% increase. Revenues for the second half of the year are expected to decline by approximately 20% compared to the first half, reflecting an easing in demand for trucks and typical seasonality in construction markets. Industry sales of medium and heavy-duty trucks are expected to reach 1.25 million units, a 28% increase from last year and higher than our previous forecast of 1 million units, driven in part by demand resulting from the introduction of regulations last year, aiming at curbing overloading. We expect truck market to grow 3% in 2017, unchanged from our previous guidance. Our market share in the medium and heavy-duty truck market in China is expected to be 15%, flat with 2016. And in light-duty, we expect our share to exceed 8%, up from 7% in 2016. We currently project revenue from all off-highway markets in China to grow by 15% to 20%, up from our previous guidance of 10% to 15%. In India, we expect total revenues, including joint ventures, to be flat to up 3% year-over-year with a 5% increase in off-highway demand and growth from new product sales in our Components business, partially offset by a 12% decline in truck production. In Brazil, full-year truck production is projected to increase 10% in 2017 compared to a very weak 2016, when the industry experienced the lowest level of truck production in more than a decade. We expect our global high-horsepower engine shipments to increase more than 30%, up from our prior forecast of 10% to 15% growth, as demand from mining customers continues to strengthen. Engine demand from oil and gas customers in North America has exceeded our previous expectations for this year, although visibility into 2018 remains limited. In summary, we've raised our full-year outlook for sales to increase 9% to 11%. We've maintained our forecast for EBIT to be in the range of 11.75% to 12.5%. Comparing second half to first half performance, we expect lower warranty costs in the second half of the year balanced with weaker demand in China, targeted investments in critical new technologies and some risk from higher commodity costs. With improving demand in a number of important markets, our leading market share and strong operating performance, we remain very confident in the future earnings power of our business. During the quarter, we returned $241 million in cash to shareholders in the form of dividends and share repurchases and also announced a 5.4% increase in our quarterly cash dividend, consistent with our plans to return 50% of operating cash flow to shareholders in 2017. Finally, we announced earlier today that we have formally closed our deal with Eaton to form the Eaton Cummins Automated Transmission's joint venture. We are excited about working with a capable partner to offer customers leading technology in both automated transmissions and now fully-integrated powertrains. Rising demand for automated transmissions around the world should drive growth for the joint venture and opportunities for our customers and partners. Now, let me turn it over to Pat.

[Patrick Joseph Ward:]

Thank you, Tom, and good morning, everyone. I will start with the review of the company's second quarter financial results before discussing the performance of the four operating segments in more detail. I will then provide an update on our outlook for the remainder of the year. Second-quarter revenues were $5.1 billion, an increase of 12% from a year ago, with sales increasing in each of the operating segments, primarily driven by stronger demand in global on-highway, construction, mining and oil and gas markets, partially offset by continued weakness in power generation markets. Sales in North America, which represented 58% of our second-quarter revenues, improved by 13% from a year ago due to increased sales of engines and components to meet higher levels of heavy and medium-duty truck production and increased demand in industrial markets. International sales improved by 11% from a year ago, primarily due to increased sales in China, India and Russia, partially offset by declines in the Middle East and in Africa. Gross margins were 24.6% of sales, which declined from 26.4% a year ago, primarily due to a higher warranty and variable compensation expenses, which more than offset the benefits from stronger volumes and material cost-reduction initiatives. Selling, admin and research and development costs of $770 million or 15.2% of sales increased by $91 million and increased as a percent of sales by 20 basis points from last year, mainly due to higher variable compensation expenses and increased investments for new products. Joint venture income of $98 million increased by $10 million from last year, primarily due to increased demand in China for both on-highway and off-highway segment. Other income and expense improved by $18 million due to a gain on a fixed asset sale and higher royalty income. And in the second quarter of 2016, we had a $39 million charge for the loss contingency that did not repeat this year. Earnings before interest and tax were $620 million or 12.2% of sales for the quarter compared to $591 million or 13.1% a year ago. EBIT as a percent of sales declined primarily due to the increased warranty expenses in addition to the higher variable compensation expense. Net earnings for the quarter were $424 million or $2.53 per diluted share compared to $406 million or $2.40 a share from a year ago. The effective tax rate for the quarter was 26.4%, in line with our previous guidance of 26%. Moving on to the operating segments, let me summarize their performance in the second quarter and then I will review the company's revenue and profitability expectations for the full year and conclude with some comments from cash flow. In the Engine segment, revenues were $2.3 billion in the quarter, an increase of 15% from last year due to a 14% increase in on-highway sales, driven primarily by increased global truck production and from strong demand for engines for construction equipment in both China and North America, which drove a 20% increase in off-highway revenues in the quarter. Segment EBIT in the second quarter was $277 million or 12% of sales and this compares to $206 million or 10.3% a year ago. Earnings increased as the benefits from higher engine and parts sales, material cost-reduction initiatives, stronger joint venture earnings in China and the absence of the loss contingency charge recorded a year ago more than offset higher variable compensation and warranty costs. We now expect full-year revenues to be up 10% to 12% compared to our previous guidance of up 2% to 6% due to improved outlook in most markets. Our forecast for the EBIT margins is to be in the range of 10.5% to 11.5% of sales, an increase compared to 10.35% to 11.25% that we provided before. For the Distribution segment, second-quarter revenues were $1.7 billion, an increase of 12% compared to last year. Organic sales for the quarter increased by 7%. Revenue from the acquisition completed in the fourth quarter of 2016 added 6% and this was partially offset by 1% unfavorable currency impact. The EBIT margin for the quarter was $96 million, an increase of 10% from last year and remained flat at 5.6% of sales due to higher variable compensation cost offsetting the benefits of volume growth. For 2017, Distribution revenue is now projected to increase 9% to 11% compared to our previous guidance of up 4% to 8% due to strengthening off-highway demand for engines, parts and rebuilds. We are forecasting EBIT margins to be in the range of 5.75% to 6.25% of sales, slightly lower than our previous guidance of 6% to 6.75%. For the Components segment, revenues were $1.5 billion in the second quarter, a 14% increase from a year ago and a quarterly record. International revenues increased 25% primarily due to 47% increase in sales in China and the first sales of new aftertreatment systems in India to meet the new emissions standard that was introduced in April. Sales in North America increased 6% due to higher heavy and medium-duty truck production. Segment EBIT was $190 million or 13.1% of sales compared to 14.9% a year ago. An increase in warranty expense recorded for the change in estimate for the prior model year aftertreatment products was the primary driver of the margin decline. In 2017, we now expect revenue to increase 13% to 15% compared to our prior guidance of up 6% to 10%. The change in guidance is the result of stronger truck demand in China and improvements in the North American truck market. EBIT is projected to be in the range of 13% to 13.5% of sales compared to 12.5% to 13.5% in our previous forecast. In the Power Systems segment, second-quarter revenues were $1 billion, an increase of 10% from a year ago. Mining revenues increased 50% and oil and gas revenues more than tripled compared to the same quarter a year ago, while power generation sales declined by 5% due to weak demand in the Middle East and in Africa. EBIT margins were 6% in the quarter, down from 9.8% last year, primarily due to the higher warranty expenses recorded for the quality campaign as well as an increase in commodity costs and higher variable compensation costs associated with the company's improved outlook for the full year. For 2017, we expect Power Systems segment revenues to increase 8% to 10% versus our prior guidance of up 1% to 5%, with stronger demand in industrial markets, particularly in mining and oil and gas markets driving the improvement. EBIT margins are expected to be between 7% and 8% of sales, unchanged from our previous guidance. And for the company, we are raising our outlook for revenues to be up 9% to 11% versus the previous guidance of up 4% to 7%. The increase is primarily due to stronger demand in Chinese construction and truck markets and an increase in our outlook for truck production and higher demand from oil and gas customers in North America. Foreign currency headwinds are expected to reduce revenues by approximately $100 million, which is a smaller impact than previously forecasted, primarily due to the euro and British pound strengthening against the U.S. dollar over the last three months. Income from our joint ventures is now expected to increase by 12% in 2017 compared to our previous guidance of flat. Stronger demand in China is driving the year-over-year growth in earnings and is expected to more than offset the reduction in income from the consolidation of the last remaining distributor in the fourth quarter of 2016. We expect EBIT margins to be between 11.75% and 12.5% of sales for 2017, unchanged from our previous forecast, due to the higher-than-expected warranty costs, offsetting the benefit of higher volumes. And this compares to 11.4% last year. Looking ahead to the second half of the year, warranty costs will come down. However, the benefit from this will be offset, as we do expect to see weaker demand in China, an increase in commodity costs as well as an increase in targeted investments in critical new technologies. The revenue and earnings guidance provided today does not include the impact from the Eaton Cummins joint venture. We are still in the process of completing the purchase accounting associated with our investment in this new venture, but we do not expect the joint venture to have a material impact on the company's financial results in 2017. We will provide an update on our third-quarter earnings call. Turning to cash flow, cash generated from operating activities for the second quarter was $447 million, bringing the year-to-date total to $826 million, a 12% increase from the same period last year. We anticipate the operating cash flow for the full year will be within our long-term guidance of 10% to 15% of sales. Capital expenditure during the quarter was $101 million, bringing the year-to-date total to $182 million. And we still expect that investments will be in the range of $500 million to $530 million for the full year. In the second quarter, we returned $241 million to shareholders through dividend payments and share repurchases. For the first six months of the year, we have returned $463 million. We continue to demonstrate our commitment to shareholder returns with the recent 5.4% increase in our quarterly cash dividend, which is part of the plan to return 50% of operating cash flow to shareholders this year. Although we were clearly disappointed with the increase in product coverage costs in the second quarter, we are encouraged with the progress made so far in our overall performance with sales up 10% compared to the first half of 2016, EBIT up $111 million or 10% higher and earnings per share up 15%. Markets are returning as you can see from the increase in guidance across all four segments and we believe we are well prepared to meet customer demand as market conditions continue to improve. Finally, I would like to announce that we will be holding our Analyst Day on November 16 in Indianapolis, Indiana and invitations to this event will be sent out in the middle of August. Now, let me turn it back over to Mark.

[Mark Andrew Smith:]

Okay. We're now ready to move to the Q&A section of the call.

[Operator:]

Thank you. And our first question is from the line of David Raso from Evercore ISI. Your line is open.

[David Raso:]

Hi. Good morning. My question is I'm trying to think about incremental margins year-over-year on a segment basis. If you pull out the warranty costs for 2Q, it implies the incrementals were about 15% to 16%. Still not fantastic. When you look at the implied second half at first blush, it feels better, it looks like 24%, 25%. But, actually, if you go back to the third quarter of last year and pull out that big loss contingency, it implies the second-half incremental this year still only 14%. So, I know a lot of puts and takes given all the different parts of your company, but I mean big picture, Tom, how should we think about the company's incremental margins as we try to model beyond 2017?

[Patrick Joseph Ward:]

So, David, let me take the first shot at that and then Tom can jump in with the long-term outlook. So, in the second half of the year, the one other factor that is impacting the margin improvement is the increase in variable compensation costs. So, compared to last year, they're performing much better on a full-year basis. And as a result of that, we will be incurring significantly more higher variable comp accruals in the second half of the year than the second half of last year. For the full year, all-in, we're still looking – we've been looking at higher variable comp somewhere around a 20% incremental EBIT margin at the midpoint. So, to your point, we don't have the loss contingency that we recorded last year, but we do have much higher variable compensation costs this year. And I don't think – I'll let Tom speak for himself in a second, but I don't think our thoughts on the long-term incremental margin targets have changed at all. We've said 20% for some time and I think we remain committed to that.

[Norman Thomas Linebarger:]

Yeah, that's right. I mean the variable compensation cost thing does normalize. What we have is when we are performing worse than planned because markets negatively surprise us, we have lower variable compensation costs, which bolster our financials. And when things bounce up faster than we expected, the reverse occurs. But in the end, they work themselves out. So, I just agree with Pat's point of view, we feel like the earnings power of the company remains the same and we still think 20% incremental margins is what we're capable of and what we're demonstrating when we pull out these kind of one-time or unusual period costs. So, we feel just as strong as we ever did about that.

[David Raso:]

All right. Thank you.

[Operator:]

Thank you. And our next question is from the line of Adam Uhlman with Cleveland Research. Your line is open.

[Adam William Uhlman:]

Hi. Good morning, everyone.

[Norman Thomas Linebarger:]

Good morning.

[Patrick Joseph Ward:]

Adam.

[Adam William Uhlman:]

I was wondering if we could start with the quality and the warranty costs. First of all, could you talk through, is there any likelihood of recovery from any suppliers that might have been involved in this or is this all Cummins' components, specifically? And then, secondly, related to that, if you could just spend some time about what process changes are under way to reduce the likelihood of these expenses going forward?

[Norman Thomas Linebarger:]

That's great. I'll take that one, Adam, and let me start with the second question first. As I mentioned in my remarks, we've made a lot of improvement in quality, especially related to new product launches and that has dramatically improved the liability of products over the last several years and our products are performing well in the market as a result of that. But also, as I mentioned, the complexity of the products continues to increase. There are many new markets like China and other markets where the use of the products is really demanding and used in various ways. And so, what we're trying to do is utilize the benefits of data we're getting from our telematics system to begin to use new methods to improve quality of products, both at launch, but also in longer mileage situations. Because, again, expectations of performance of these products over sustained periods of time have gone up by customers. I think that's normal for every industry. So, we've got to have the ability to maintain quality over a long period of time and, again, over multiple owners and multiple applications. So, that's why we're using a lot of this new data with new techniques to mine that data and make – correlate that data with how products perform in the field. So, again, this is not new. We've been working on that for some time, but we now have some pretty useful tools we think we can apply to our quality efforts and we need to do that. That's what I was mentioning in my remarks. With regard to supplier recovery, it is an area of focus for us. And in the specific quality issues we have in the second quarter, we do think there're some potential for supplier recovery, but right now, what we're focused on is improving the situation for customers, making sure there's no negative impact on customers, getting the products right. Again, we just feel like we're in a really strong position with our products in terms of how they're performing. And, of course, that's shown up in market share. So, we want to make sure we get that right, get the issues behind us and move on and then we'll deal with the supplier recovery issues.

[Adam William Uhlman:]

Okay. So, the supplier recovery isn't embedded within your expectation of an improvement in warranty expense in the second half. That's just...

[Patrick Joseph Ward:]

Yeah, we have nothing assumed within that 50 basis point improvement number that you have for any supplier recovery in the second half.

[Adam William Uhlman:]

Okay. Thank you.

[Operator:]

Thank you. And our next question is from the line of Steven Fisher with UBS. Your line is open.

[Cleve Rueckert:]

Hey, good morning, guys. This is Cleve Rueckert on for Steve. Just looking at your markets, how would you compare the potential for continued strength in oil and gas versus mining? Do they both have the same potential or does one market give you more visibility? And which one do you think would have a bigger impact on Cummins?

[Norman Thomas Linebarger:]

Mining seems to be demonstrating a more sustainable improvement path. We have more visibility to it also based on the number of OEMs we serve and our participation in the market, we have more visibility. Again, right now, we don't have long visibility in mining. We don't know where it reaches relative to previous peaks or anything, but it looks like it's on a relatively sustained recovery. And, of course, we're experiencing some of the reasons for that in our commodity costs. We're seeing higher commodity costs coming in as costs which again says that that's more favorable conditions for mining. So, we're seeing some benefit on revenue and some hit on costs. On the oil and gas side, I'd say we don't see that. First of all, we have less visibility, but secondly in fact, we're seeing and hearing more conservatism in that market. We saw a lot of rebuilds, a lot of redeployment of products, but we didn't see so much new equipment being built and going out in the markets. And what we're hearing is that people wanted to get things redeployed, but there's not a lot of growth in equipment yet. It doesn't mean it won't come, but right now, I think the market's kind of leveling off at best is kind of what we're hearing. Again, there's other people that may be closer and be able to give you more data, but that's what we're hearing.

[Cleve Rueckert:]

Okay.

[Norman Thomas Linebarger:]

And then, just (34

[Cleve Rueckert:]

Okay. That's helpful. Thank you. And then, I guess just bigger picture going over to some discussion that's been ongoing recently. Can you give us a sense of the relative content or profitability in an electric bus versus a diesel bus?

[Norman Thomas Linebarger:]

Yeah. I've actually heard that question a fair number of times too. And we will, by the way, be talking at our Analyst Day a lot more about our electrification efforts, including kind of what parts we intend to participate in. But clearly, we don't know yet. I mean there's essentially none sold and those that are sold are ones and twos and they're prototypes. So, we don't really know what the profitability's going to be like. But let me just say two or three words about how we're thinking about it. We believe that the segments in the market that we serve, some will find electrified powertrains to be advantageous in the next 5 or 10 years, some will not. And so, we don't think that all the markets are going to move. We think they're going to move in phases and some will move relatively soon to at least try some. And bus is what you mentioned, it's one of the areas that we'll see some activity in buses relatively soon and that we intend to provide a fully electrified powertrain as well as hybrid or range-extended powertrains, we also intend to electrify some of the auxiliaries on our diesel engines and natural gas engines. So, we will be active in the market and we will approach the problem in the same way that we've approached other power solutions problems. We'll look from the customers' lens, try to figure out what their application is and figure out what the best technology to serve them is. In order to ensure profitability in those efforts, we'll make sure that we have a leading position, which means our technology provides customers with monetary advantage. So, they get fuel economy benefits, they get cost reductions, they get other things of value to them, because that's how we maintain profitability. I don't think one technology is necessarily more or less profitable than the other. What creates profitability is advantage for customers and advantage versus competitors and that's what we're going to see.

[Cleve Rueckert:]

Thank you, guys, very much.

[Norman Thomas Linebarger:]

You bet.

[Operator:]

Thank you. And our next question is from the line of Jerry Revich with Goldman Sachs. Your line is open.

[Jerry Revich:]

Hi. Good morning, everyone.

[Norman Thomas Linebarger:]

Hi, Jerry.

[Jerry Revich:]

I'm wondering if you could talk about the warranty guidance outlook of – it looks like they're about 3% or so of sales in the back half of the year. I think that's well above the low-2s that you folks have targeted historically and I'm wondering if you've identified incremental products that have product coverage costs coming up in the back half of the year or is this you folks getting recalibrated to the complexity issues that you mentioned? In other words, do you have discrete products where – that are driving that higher than historical targeted spend in the back half or is that to provide room to execute?

[Patrick Joseph Ward:]

Yeah. So, let me start on that one, Jerry. First of all, warranty in the second half, we expect to be in the range of 2.7% of sales. We were 3.2% in the first half. So, we're going to be 2.7% for the second half. So, for full year, somewhere at around 2.9% to 3%. As Tom indicated in his remarks earlier, we're dealing with a lot more complexity in the other half in the environment and conditions that these products have to perform in. And while reliability is better and the number of failures is actually lower, the cost of failure is higher. So, we continue to work away at that. We will redouble our efforts to make improvements on it. And I think you will see an improvement as we go through the second half of the year. We're clearly disappointed with what we see in the second quarter and we know that's an area that we're going to have to go after and make significant improvements on.

[Norman Thomas Linebarger:]

It's worth saying that we are not recalibrating our target at all, Jerry. We are adding new tools to get to our target, but we still believe that we can reduce warranty costs significantly from where we are and do it in a way that improves customer performance and customer experience. So, that's what we're targeting. So, we haven't changed and we still see the same kind of targets in reach that we did before, because we made improvement on our prior efforts. So, we kind of took away a lot of challenges and now we're facing new challenges. I think that's just part of being in a competitive industry.

[Jerry Revich:]

Okay. Thank you. And I'm wondering if you could talk about the raw materials in the back half of the year. You folks have been working on reducing your materials spent through reengineering. How much of an offset is that? What magnitude of raw material inflation, pure inflation, are you folks embedding in the numbers and is it fair to assume you're using spot prices when evaluating that dynamic? Thanks.

[Patrick Joseph Ward:]

Yeah, so, for the first half of the year, Jerry, we benefited by about 0.7 point in net material cost reduction. It's higher than the first quarter, a little bit more than second quarter. We expect that trend to continue through the second half of the year. And the second half of the year is currently forecast around 0.3 point. So, full year 50 basis points improvement over last year, but on the declining trend as we see an increase in commodity costs in particular.

[Jerry Revich:]

Thank you.

[Operator:]

Thank you. And our next question is from the line of Jamie Cook with Credit Suisse. Your line is open. Jamie L. Cook - Credit Suisse Securities (USA) LLC Hi. I guess a couple questions on the – back to the implied incrementals in the back half of the year again. You did know we got the warranty. We got China. You noted higher costs associated with investing in technology. Has that changed versus your original assumptions? And can you just tell me what that headwind is as well as quantify the variable comp headwind in the back half of the year? And then, my second question, actually, the implied incrementals in the Power Systems business are pretty healthy in the back half of the year, given that business has disappointed your comfort level there? And then, my third question, Tom, obviously on M&A, there's been a – sorry, on M&A, there's been a lot of noise in the clutter with WABCO, with ZF, I'm just trying to get a sense of where you're headed on potential for larger M&A with some of the other players in this space in play. Does that make you feel like you have to be a little more aggressive on the M&A front, because other things could be happening? Thanks.

[Norman Thomas Linebarger:]

Thanks, Jamie. So, let me start with the last one, because I think that's one we've talked about a couple times. The answer is that there has been some conversation with WABCO. Of course, we've paid close attention to that. We have continued with the same strategy on M&A and – sorry, it may sound a little boring, but same strategy we laid out at the investor conference, which is that we are going to be disciplined about ways to add value through both making sure that it drives profitable growth for the company and does so in a way where we can demonstrate returns over time. And that, of course, means that not only do we have to find – have a strategy that makes one plus one equals three. It means, if we acquire something, it has to add up to something more than just the combination of the two things. And, secondly, we have to be able to do it at a cost to generate returns for our shareholders. And so, that's – as you get, that's a challenge. Having said that, we've been working on it for some time. We have some very good prospects. We are actively working on those. We feel confident that we will be able to make positive moves in the M&A and joint venture front, which will add value to the company. The size of that will depend on which of our projects succeed, so – how big each one is. Frankly, we are not trying to make sure that we have a big one. We're trying to make sure that the combination of our organic growth, our joint ventures and partnerships and our acquisitions add up to profitable growth and returns for our shareholders. And so, whether that's in several acquisitions and joint ventures or in one or two is really not our main focus. So, it is a challenging environment. As it turns out, it's no easier to grow in a profitable high-return way through acquisition than it is organically. They both take a lot of effort and serious-minded work and that's the way we're approaching it, but let me now switch over. Pat, I think you wanted to say a couple words about the incrementals.

[Patrick Joseph Ward:]

Let me just try and answer Jamie's first question. So, if I look at the components that's driving the incrementals in the second half of the year, Jamie, I think the lower joint venture incomes in China, we expect to have about 50 basis point negative impact second half to first half. The higher commodity costs around 15 basis points. On the technical investment question, probably that's around 25 basis points higher second half versus first half. And then, on the variable comp, I don't have those numbers at hand, but it's probably in the range of 1.5% or 150 basis points higher than the second half of last year. I can't give it to you versus the first-half market, (44

[Norman Thomas Linebarger:]

And I think, Jamie, you asked too, have we changed our outlook on investment in critical technologies. There's no question that we are speeding up some of our investments in both electrification and digital accelerators, the sort of telematics effort. We talked about those earlier. We are definitely speeding up efforts. And the reason we're doing that is we're noting that in some of the shorter-distance markets, the urban markets, there is significant interest from our customers in electrified powertrains and, again, not for gigantic volumes this year, obviously, but it's going to take us some time to get a product range out and ready and we've heard from them and people are interested. So, we are trying to make sure that our efforts are aggressive enough to make sure we meet customer demand there. So, that's what's happening. It's not a huge amount as Pat said, but it is an increase from what we were anticipating. With regard to the large – go ahead, you want to talk about large engine markets, just I'll close that and then you can follow up on that. So, on large engines, we are feeling pretty confident about the mining growth, as the earlier question said, oil and gas, we don't see a lot of – we're not expecting a lot of growth in the second half, but we are seeing continued strength in mining, which gives us confidence that we'll continue to see some sales growth in the large engine markets and incremental margins there have been good as we mentioned. I mean we had some issues in the second quarter that we think were one-off related, but with regard to engine growth and incremental margins, we're feeling good about that. Jamie L. Cook - Credit Suisse Securities (USA) LLC Okay. That's helpful. I'll get back in queue. Thank you.

[Norman Thomas Linebarger:]

Thanks, Jamie.

[Operator:]

Thank you. And our next question comes from the line of Joe O'Dea with Vertical Research. Your line is open.

[Joseph John O'Dea:]

Hi. Good morning.

[Norman Thomas Linebarger:]

Hi.

[Joseph John O'Dea:]

First question on the North America heavy-duty market share, if you could just talk about the various drivers of that in terms of seeing share come in, in the first half of the year higher than the range you had given and the degree to which some of that is mix-related as we see some mix shift within the industry, otherwise just in terms of preference for the engines and new engines launched recently there, but just to kind of understand some of the outperformance versus initial expectations.

[Patrick Joseph Ward:]

Yeah. I think a couple of things. We've seen a lot of variation as the industries move down in build rates through the first and second half of last year, Joe, there's still a lot of volatilities. So, I think we've settled in at more of a sustainable rate. I don't think we're seeing a mix shift in terms of engine displacement. We haven't seen significant changes there. For what you have seen, particularly you've seen one of our customers picking up share that uses – basically our largest customers picked up share using combination of Cummins and their own engines and that's really helped. That's really helped our position. So, we've got the domestic players picking up share.

[Joseph John O'Dea:]

Got it. And then on power gen, a competitor talking about some stabilization outside of Middle East. This is another quarter seeing some year-over-year declines, but if you could talk about what you're seeing on the order front, maybe talk about it by region or by major kind of end-market activity, but just whether you've got any signs of some stabilization there, if orders are starting to look encouraging at all.

[Patrick Joseph Ward:]

Yes, it's a little choppy in some parts, but the areas that are most troubling are the Middle East. As you said, we were down over 30% Q2 versus a year ago. It's been very tough. Latin America, there's a lot of demand, but we still continued to face question marks about customer liquidity. And so, the net sales are down there. We are seeing good growth in India. So, it's been a while coming, but within structured investment we're seeing not just in power gen, but in pretty much all of our Power Systems and construction markets. So, India will be up 5% to 10% in power gen this year. U.S. is bumping along kind of low-single digits. In the second quarter, we're seeing strong demand from small RV customers, less demand from the military, pockets of datacenter spends still positive. So overall in the U.S., I'd say low-single digit positive. And then in Europe, it's kind of flattish in total with one or two larger big projects.

[Norman Thomas Linebarger:]

But I think it's fair to say that from a power gen point of view, we would not yet say we're at the bottom and stabilizing. It could be, but we're really looking for some quarter-to-quarter stabilization infrastructure building rates and things like that around the world before we would say okay, now I think we expect things to consistently get better. A couple of times we thought we were at the bottom and stabilizing and then things got a little bit worse. So, I guess, we'd like to see a few more quarters in the power gen space to say that.

[Joseph John O'Dea:]

Got it. Appreciate the details.

[Norman Thomas Linebarger:]

Yeah.

[Operator:]

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

[Ann P. Duignan:]

Hi. Good morning, guys.

[Norman Thomas Linebarger:]

Good morning, Ann.

[Patrick Joseph Ward:]

Good morning, Ann.

[Ann P. Duignan:]

Good morning. A lot of my questions have been answered, the detailed questions. Maybe could get some thoughts from you more strategically on electric vehicles, where you think they will succeed and then versus we get a lot of questions electric vehicles, autonomous, which – where do you see the opportunities, where do you see the threats for both and do you think autonomous is a reality in trucking at all?

[Norman Thomas Linebarger:]

Well, again, we'll spend a fair bit of our time on this in the Analyst Day in Indianapolis. I hope you can join us for that. So, given the time, I'll make my remarks brief. Let me just say that I think both autonomous vehicles if we mean not fully autonomous, but using autonomous technologies are certainly going to be a reality in the trucking market. So, just as we've seen in car markets, we'll see safety systems come in very quickly and already we're starting to see those and those will increase and offer more, more opportunities for customers in places like yards and ports and places where they want to control how vehicles move around. Those could provide significant value to customers. Over what period of time those will become economically viable and how many customers will buy them, that's sort of the charge ahead. But you know just by the investments that people are making in the truck market that, that technology is moving and people are definitely going to find ways to implement that technology and to try to figure out how to add value for customers. I think the same is true on electrified powertrains. What an electrified power train looks like in different applications, as I mentioned earlier, remains to be seen, but it'll be driven by how the customer can best operate their applications. So, in places where things go out and back in relatively limited miles, carry loads that are not so heavy, then things like fully electrified or range-extended electrified make sense and especially in urban environments where they're trying to reduce noise, pollution and fueling. So, those are all things that they care about. Electrified powertrains can provide a solution that meets multiple objectives. And I believe that cities will be pushing for solutions like that, which will mean they'll show up in those areas. And I think it'll happen. In five years or so, we'll start to see some of those buses and pickup and delivery vehicles with electrified powertrains. The question is how many and how many cities really can afford to replace that many of the fleet, that will depend a lot – on a lot of different factors. But – so, I think it's coming, both of these technologies are coming and it will be while we're still sitting here working on it. The question is, in what volume and how many applications and a lot of that is playing out right now. As you heard from me, Cummins intends to be in the middle of those technologies, especially electrified powertrains, because we think we understand customer applications.

[Ann P. Duignan:]

Okay. Thank you. And any lessons learned from natural gas? And we've seen new technologies come and go previously, but anything you've learned from prior...

[Norman Thomas Linebarger:]

It's a great question, Ann. Anyhow, there's many, but let me just put the one out there, which is that infrastructure takes a long time to build. So, the more that your technology depends on common infrastructure or things like it, the less likely it is to occur quickly. The more that local infrastructure or a customer base, customer purchases can allow you to use the technology, the more likely it is to succeed at least in the shorter timeframe.

[Ann P. Duignan:]

Good. Thank you. I'll get back in queue and see you in November.

[Operator:]

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

[Andrew M. Casey:]

Thanks a lot. Good morning, everybody.

[Norman Thomas Linebarger:]

Good morning, Andy.

[Patrick Joseph Ward:]

Andy.

[Andrew M. Casey:]

Just a quick question on what you're seeing in North American truck Class 8. Are you seeing any mix shift to the heavier engines than you realized in the first half?

[Patrick Joseph Ward:]

Not significantly, Andy. The shares are pretty simple. A little bit stronger in the second quarter. We've seen pockets of vocational customers renewing and they have a strong preference for that 15 liters and I think that's certainly helped in the first half of the year, but on the line haul, no big shift.

[Andrew M. Casey:]

Okay. Thank you. Lot of the questions have been answered.

[Norman Thomas Linebarger:]

Thanks, Andy.

[Operator:]

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

[Stephen Edward Volkmann:]

Hi.

[Norman Thomas Linebarger:]

Hi, Steve.

[Patrick Joseph Ward:]

Steve.

[Stephen Edward Volkmann:]

Quick question, couple quick follow-ups. I'm just trying to think about sort of the cadence of a couple of these issues. Do you think the warranty expense will be lower in 2018 than it was sort of in the second half run rate of 2017?

[Patrick Joseph Ward:]

Yeah, I think it should be. We've got a lot do to kind of plan out 2018, but if we're going to finish the second half of 2017 at 2.7% and then back to comments that Thomas made earlier on that is near and (55

[Stephen Edward Volkmann:]

Okay. Great. And then, I would assume the incentive compensation expense would kind of go away assuming you kind of hit whatever target you set for yourselves in 2018, so that would not be a headwind either?

[Norman Thomas Linebarger:]

Right. I mean, that's the idea. We set a plan out, which is based on what we think we can achieve and guidance we give, we set a plan out and if we end up with that plan and that that pays out at a 1.0 (55

[Stephen Edward Volkmann:]

Got it. So, you're basically telling me you always want to be paying out more?

[Norman Thomas Linebarger:]

No, I always want to be paying out what we planned.

[Stephen Edward Volkmann:]

All right. Fair enough. (56

[Stephen Edward Volkmann:]

On the flip side, I would assume that some of these investment costs, especially for technology-related things, will probably ramp up in 2018 versus 2017?

[Norman Thomas Linebarger:]

Yeah, I mean, we don't know that yet, but that's the way it's leaning. I mean, again what we're trying to do is make sure that we can deliver to customers on two broad new technology areas. One is to deliver much more value in telematics and other services that go along with engines and the vehicles that they operate and secondly, to be able to make sure that we can be in the market in 2019 and across at least several applications in 2020 with electrified powertrains and range-extended powertrains. So, we will need to increase investments, especially in the electrified powertrains space over the course of the year. How much that is year-over-year, we'll see, but that is a reasonable expectation those costs will ramp up. And, again, we're looking at how we structure that business to make sure that it looks like a long-term growth opportunity for Cummins' shareholders.

[Stephen Edward Volkmann:]

Okay. And then, just one quick sort of philosophical follow-up, Tom. I guess I'm trying to get a sense of how big a deal you think the sort of alternative drivetrain market could be, because, clearly, there's going to be some competitors that are going to have fairly deep pockets, perhaps lower cost of capital than you and certainly don't seem in early days always to be motivated by rate of return. Some of them even seem to be willing to set up infrastructure. Thank you for not doing that on natural gas by the way, but anyway I'm just curious if this is one, where you kind of feel like you have to go all in or do you take a more measured approach kind of going forward?

[Norman Thomas Linebarger:]

Yeah. Here is my view, it's not clear how big a deal it would be and I think we've talked a little bit about some of the reasons and again we'll talk more in November about that, but it clearly depends on how many of the customers these technologies actually give them a better deal. And, right now, it's pretty clear that in some buses, it could. There's a whole bunch of other markets where it's not clear yet, especially because diesel continues to improve, electrified trucks with diesel engines continue to improve, light hybrids continue to improve. So, there's a lot of technologies competing for the same space. And then – and I think you can expect from us that we will be all-in in the sense that we will lead in technology. We will not be all-in in the sense that we will not be building infrastructure. We will not be betting on one technology. We'll be betting to serve customers better than others with the range of technologies where the best one is what they need.

[Stephen Edward Volkmann:]

Great. Thank you, guys.

[Norman Thomas Linebarger:]

Same return guidelines we use for everything, though. You can count on that.

[Stephen Edward Volkmann:]

Got it. Thank you.

[Norman Thomas Linebarger:]

Thank you.

[Patrick Joseph Ward:]

Thanks, everybody. Adam and I will be available for calls later.

[Operator:]

And, ladies and gentlemen, this concludes our Q&A and program for today. We hope you have a wonderful day. You may all disconnect.