Cummins Inc.
Q3 2017 Earnings Call Transcript

Published: 31 Oct 2017

[Operator:]

Good day, ladies and gentlemen, and welcome to the Third Quarter 2017 Cummins Inc 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. [Operator Instructions] As a reminder, today’s program is being recorded. And now I’d like to introduce your host for today’s program Mark Smith, VP of Finance Operations. Please go ahead, sir.

[Mark Smith:]

Thank you, Jonathan. Good morning everyone and welcome to our teleconference today to discuss Cummins' results for the third quarter of 2017. Participating with me today are our Chairman and Chief Executive Officer, Tom Linebarger, our Chief Financial Officer, Pat Ward, our President and Chief Operating Officer, Rich Freeland, we will all be available for your questions at the end of 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 Securities and Exchange Commission, particularly the Risk Factors section of our most recently filed Annual Report on Form 10-K and any subsequently filed quarterly reports on Form 10-Q. During the course of this call, we will be discussing certain non-GAAP financial measures and we’ll refer you to our website for the reconciliation of those measures to GAAP financials. Our press release with a copy of the financial statements and a copy of today's webcast are available on our website at cummins.com under the heading Investors and Media. Now, I'll turn it over to Tom.

[Tom Linebarger:]

Thank you, Mark, riveting as always. Good morning everybody. I'll start with a summary of our third quarter results and finish with a discussion of our outlook for 2017. Pat will then take you through more details about our third quarter financial performance and our forecast for the year. Revenues for the third quarter of 2017 were $5.3 billion, an increase of 26% compared to the third quarter of 2016. EBIT $640 million or 12.1% compared to $398 million or 9.5% a year ago. EBIT increased primarily due to stronger volumes and the benefit of cost reduction initiatives, but fell below our expectations as a result of an increase in quality cost. Engine business sales in the third quarter increased by 26% compared to a year ago due to higher demand from truck customers in North America and stronger sales to global construction. EBIT for the quarter was 9.8%, up from 4.8% in the same-period last year. EBIT percent increased due to strong operating leverage and higher sales and the benefit of material cost initiatives. Engine business incurred elevated costs for the product campaigns in the third quarter as it did in the third quarter last year. Sales for the distribution segment increased 17% year-over-year including 6% growth resulting from an acquisition completed last year. Organic sales increased as a result of higher demand for new engine, parts and engine rebuild from off-highway customers. Third quarter EBITDA was 5.2% compared to 6.4% in the third quarter of 2016. EBIT percent declined as the benefit of higher sales was more than offset by an increase in variable compensation costs, resulting from stronger overall company performance. Third quarter revenues for the component segment increased by 34% to $1.5 billion. International sales increased 45% due to strong truck demand in China and the growth of new products developed to meet the recently implemented Bharat Stage IV Emission Regulations in India. In North America, revenues increased 26% as a result of stronger truck demand and increase market share. Our new Eaton Cummins Automated Transmission Technology joint venture became fully operational on August 1 and contribute 6% to segment revenue in the third quarter - segment revenue growth. We are already experiencing strong customer pull for next generation products being designed and manufactured by the joint venture, which is encouraging. Segment EBIT for the third quarter increased to 14.2% from 12.9% in the same quarter a year ago as a result of stronger volumes and material cost reduction programs. Power system sales increased by 23% in the third quarter primarily driven by an increase in engine parts - engine and parts sales to mining and oil and gas customers. EBIT in the third quarter was 7.7% compared to 6.9% a year ago. EBIT percent improved as the positive impact of stronger volumes and joint venture earnings more than offset the negative impact of rising commodity costs and higher variable compensation costs. We continue to drive further improvements in operating performance in the power systems business. In the fourth quarter, we will complete our previously announced plans to consolidate generator set assembly from our Kent, UK facility into our Daventry engine plant and other generator set plants. Recently, we announced additional actions to rationalize the manufacturing footprint in our alternator business, which will result in a reduction in manufacturing capacity at our Stamford UK site. When complete the combination of these two initiatives will yield more than 100 basis points of margin improvement for the power systems segment even at current revenue levels. Now, I will comment on the performance in some of our key markets for the third quarter of 2017 starting with North America and then I will discuss some of our largest international markets. Our revenues in North America improved 25% in third quarter with the addition of Eaton Cummins Transmission Technologies joint venture and a distributor acquisition contributing 5% growth. Organic sales increase primarily due to higher truck demand, increased sales of construction equipment and an improvement in orders from oil and gas and mining customers. Our shipments of engines to North American heavy-duty truck customers increased 39% in the third quarter and our year-to-date market share stands at 32.5%, up 2% over last year. In the medium-duty truck market, our unit sales increased 41%. Our market share in the medium-duty truck market is 78% year-to-date, a 4% improvement from last year. Engine shipments to our North American pickup truck customers increased 19% reflecting strong consumer demand and a weaker quarter last year when our largest OEM customer took an extended shutdown. Sales of engines for construction equipment in North America grew 39% in the third quarter compared to a weak market last year. Sales to high horsepower markets in North America increased almost 200% from extremely low levels a year ago driven by higher sales to oil and gas, and mining customers. Revenue for power generation increased 6% due to higher demand in the recreational vehicle market and stronger sales to prime power customers. Our international revenues for the third quarter increased by 28% compared to a year ago driven by strong market growth in China and new products in India. Third quarter revenues in China including joking ventures were $1.2 billion, an increase of 46% due to stronger on-highway and construction markets. Industry demand for medium and heavy duty trucks in China increased by 69% compared to a year ago, while our engine shipments increased 39%. Increased enforcement of overloading regulations and improved growth in the economy contributed due to the strong truck demand. Our volumes grew at a lower rate than the overall market as Dongfeng one of our partner OEM experienced a decline in its truck market share. Year-to-date our engine market share is 14%, down from 15% in 2016. Shipments of our light-duty engines in China increased by 23% above the overall market growth rate of 13% as Foton continues to displace local competitor engines from its vehicle lineup with engines produced by our joint venture. Our share of the light-duty market is now 8% year-to-date, up from 7% a year ago. Chinese industry demand for excavators in the third quarter increased 99% from a year ago due to an improvement in property construction and infrastructure investment. Our shipments of construction engines more than doubled as we picked up share in excavators and wheel loaders in the expanding market. Revenues for our power systems business in China increased 38% due to increased demand for power generation equipment from data center and telecom customers, and growth in industrial engine shipments to mining and rail markets. Third quarter revenues in India including joint ventures were $374 million, a 28% increase from the third quarter a year ago, driven by growth in sales of new products developed by our components business to meet the recently introduced Bharat Stage IV Emission Regulations for trucks. Industry truck production increased 17% year-over-year reflecting a growing economy and the implementation of overloading regulations. Year-to-date, our engine market share is 38%, down from 40% a year ago. We did see an acceleration in our market share in September though, reflecting a very positive customer feedback we've received on the performance of our BS4-compliant engine compared to local competitors. Revenues for our power systems business decreased 8% driven by a temporary slowdown in orders due to the implementation of the new Goods and Service Tax System called GST. In Brazil, our revenues increased by 32% compared to very weak levels in 2016 primarily due to an increase in truck production to meet export demand. Now let me provide our overall outlook for 2017 and then comment on individual regions and end markets. We are forecasting total company revenues for 2017 to be up 14% to 15% higher than our prior guidance of up 9% to 11% due to stronger demand in number of regions and markets. We've raised our forecast for industry production of heavy-duty trucks in North America to 218,000 units, up 8% from 2016 and above our prior forecast of 205,000 units. We have updated our market share projection to be in the range of 30% to 33%. In the medium-duty truck market, we have raised our outlook for the market size to 118,000 units, an increase of 9% to 2016 and above our previous forecast of 115,000 units. We now expect our full-year market share to be in the range of 74% to 76%, up one market share point from our previous guidance range. Engine shipments for pickup trucks in North America are expected to be flat for the full year, down from our prior forecast of 5% growth as our largest OEM customer plans to take an extended shutdown in December to prepare for a new model change. In China, we expect domestic revenues including joint ventures to be up between 35% and 40% compared to our previous projection of 26% growth in 2017, with demand running ahead of our previous forecast in most end markets. We've raised our outlook for medium and heavy truck demand to 1.37 million units, a 42% increase from 2016 and higher than our previous guidance of 1.23 million units. In the light-duty truck market, we now expect growth of 8% in 2017, up from our previous guidance of a 3% increase. We currently project our market share in the medium and heavy duty truck market to be 14%, down from 15% in 2016. In the light-duty market we expect our share to exceed 8%, up from 7% in 2016. Our construction revenues in China are now expected to more than double for 2017. In India, we expect total revenues including joint ventures to be up 14% year-over-year. Truck demand has rebounded much faster than expected barring the implementation of Bharat Stage IV Emission Regulations and as a result we are raising our guidance for full-year productions to 346,000 units, an improvement of 12% from our prior forecast and flat to last year. We currently project our full-year market share to be 40% compared to 41% a year ago. As the government continues to advance improvements in infrastructure, we also expect growth in rail, construction and power generation next year. In Brazil, we expect truck production to increase 26% in 2017 from extremely low levels - in 2017 from extremely low levels last year representing the first annual increase in production since 2013. We currently project global high horsepower engine shipments to increase more than 30%, unchanged from our previous forecast. Improving demand from global mining customers and higher sales of engines for oil and gas applications in North America are driving the growth. In summary, we've raised our full-year outlook for sales to increase 14% to 15%, above the prior forecast of sales growth between 9% and 11%. We raised our forecast for EBIT to be in the range of 11 - we've devised our forecast for EBIT to be in the range of 11.8% to 12.2%, which is actually unchanged from the prior projection except for the inclusion of the Eaton Cummins Automated Transmission Technologies joint venture. We are experiencing strong momentum in a number of important markets and we are executing well with the successful launch of new products delivering growth and higher market share. We’ve also continued to advance our strategy to be the leading provider of electrified powertrains. Recently we reached an agreement to purchase the assets of Brammo Inc, a company that has expertise in design and development of battery packs, a critical capability in the development of electrified powertrains. Cummins will gain access to new markets and generate revenues from Brammo's existing industrial customer base, while continuing to advance the optimization of battery packs, learning from the real world operation of a technology and demand in custom applications. During the third quarter, we recorded a charge of $29 million for the expected cost of field actions to address the emissions performance of certain pre-2013 model year engine systems in North America. These field actions are necessary to address the unexpected degradation in performance of a component of the aftertreatment system in certain circumstances and applications. Furthermore, we are evaluating other engine systems in model years 2010 through 2015 in North America that could potentially be subject to similar degradation issues. As this evaluation is still ongoing, we are currently unable to estimate the outcome of these matters. It's important to note that our engines have passed multiple emissions tests over a number of years and that the issue of degradation aftertreatment performance does not apply to our current products which are performing well and gaining market share. Completing this evaluation and addressing any issues that may arise is our highest priority. We will provide updates as quickly as possible, but given the variety of applications and operating conditions under which the engine systems are operating, it may take until the middle of 2018 to finalize the analysis and any associate actions that may arise. We are collaborating closely with both the EPA and CARB and do not expect any fines or penalties related to this matter. Although there's a lot to be positive about in our business today, we're disappointed with the unexpected quality issues and associated cost that we've experienced in recent quarters. After Pat has provided a more detailed update on our financial performance, which is going to outline for you a number of steps that the company is taking to drive sustainable improvement in costs associated with product quality going forward. Now let me turn it over the Pat.

[Pat Ward:]

Thank you Tom, and good morning everyone. I will start with a review of the company's third quarter financial results before discussing the performance of the operative segments in more detail. I will then provide an update on our outlook for the full year. Third quarter revenues were $5.3 billion, an increase of 26% from a year ago and a record for the company. Sales increased in each of our four operating segments primarily driven by stronger demand in global on-highway, construction, mining, and oil and gas markets. Sales in North America which represented 59% of our third quarter revenues, improved by 25% from a year ago due to increased sales of engines and components in the higher levels of heavy and medium-duty truck production and an increase in demand for industrial engines. International sales improved by 28% from a year ago due to increased demand in China, India, Europe and South America which offset weaker demand in the Middle East. Gross margins were 25.3% of sales, which declined from 25.8% a year ago, primarily due to higher warranty and variable compensation expense, which offset the benefits from the stronger volumes and material cost reduction initiatives. Warranty cost increased from 2% of sales up to 3.9% in the third quarter. Selling, admin, and research and development cost of $837 million or 15.8% [ph] of sales decreased as a percent of sales by 20 basis points. The increase of $167 million year-over-year was mainly due to higher variable compensation expense and investments for new products. Joint venture income of $95 million increased by $21 million compared to last year primarily due to increased demand in China for both on and off highway equipment. Other income and expense improved by $29 million mainly due to a gain recognized in the third quarter of this year for the sale of power generation rental assets. And as mentioned earlier, results in the third quarter of 2016 were negatively impacted by a loss contingency. Earnings before interest and tax were $640 million or 12.1% of sales for the quarter compared to $398 million or 9.5% of sales last year. EBITDA as a percent of sales improved primarily due to the absence of the previously discussed loss contingency while the positive impact of higher sales, lower material cost and stronger joint venture income was partially offset by the increase in warranty and variable compensation expense. Net earnings for the quarter were $453 million of $2.71 per diluted share compared to $289 million or $1.73 last year. The effective tax rate for the quarter was 26.5%. Moving onto 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 cash flow highlights. In the engine segment, revenues were $2.3 billion in the quarter, an increase of 26% from last year. On-highway sales grew by 25% as a result of increased truck production in North America, while strong demand for engines - for construction equipment in China and North America led to 30% increase in off-highway revenues. Segment EBIT in the third quarter was $229 million or 9.8% of sales. This compares to $89 million or 4.8% a year ago which included $99 million charge for the loss contingency. Benefits from the higher volumes, stronger joint venture earnings in China and the absence of the loss contingency more than offset higher warranty costs on variable compensation expense. We now expect full-year revenues to be up 12% to 14% compared to previous guidance of up 10% to 12% due to sustained demand in North America truck and international construction markets and we're now forecasting full-year EBIT margins to be in range of 10.5% to 11% of sales. For the distribution segment, third quarter revenues were a record $1.8 billion, which increased 17% compared to last year. Organic sales for the quarter increased 11% while revenue from the acquisition completed in the fourth quarter of 2016 added a further 6%. The EBIT margin for the quarter was $91 million or 5.2% of sales compared to $96 million or 6.4% a year ago. Increased variable compensation cost resulting from the stronger overall company performance offset the benefits of higher sales and gains from a divestiture of assets related to power generation rental equipment. For 2017, distribution revenue is now projected to increase 11% to 13% compared to our previous guidance of up 9% to 11% due to strong off-highway demand for engines, parts and rebuilds. We are now forecasting EBIT margins to be between 5.25% and 5.75% of sales for the full year. For the components segment, revenues were $1.5 billion in the third quarter, a 34% increase from the year ago and a quarterly record. Excluding the revenues in the Eaton Cummins joint venture, the components segment still delivered record revenues for the quarter, which were 28% higher than last year. International revenues increased by 45% primarily due to 52% increase in sales in China and from continued growth in sales of aftertreatment systems in India to meet the new on-highway emissions standard that was introduced in April. Sales in North America increased 26% as a result of the higher heavy-duty and medium-duty truck production. Segment EBITDA was $217 million or 14.2% of sales compared to $148 million or 12.9% of sales a year ago driven primarily by the increased volumes and the benefits from material cost reductions, which more than offset higher variable compensation and warranty expense. For 2017, we now expect revenue to increase 20% to 22% compared to prior guidance of up 13% to 15%. Stronger than expected truck demand in China and in North America along with the inclusion of the estimated sales of $150 million for the Eaton Cummins joint venture are the main contributors to the increase in our sales forecast. EBIT is projected to be in a range of 13% to 13.5% of sales for the full-year. In the power systems segment, third quarter revenues were $1.1 billion, an increase of 23% from a year ago. Mining revenues increased 56% and oil and gas revenues by almost 500% from extremely low levels a year ago, while power generation sales increased by 7%. Segment EBIT was $81 million or 7.7% of sales in the quarter, up from $59 million or 6.9% last year. Benefits from the growth and industrial engine shipments and part sales were partially offset by higher variable compensation costs resulting from the overall company's performance and an increase in commodity costs. For 2017, we now expect power system segment revenues to increase 11% to 13% versus prior guidance of up 8% to 10%. The stronger demand in industrial markets, particularly in mining, and oil and gas markets driving the improvement. EBIT margins are now expected to be between 6.5% and 7% of sales for the full year. And for the company, we are raising our outlook for revenues to be up 14% to 15% from the previous guidance of up 9% to 11%. This increase is driven by higher levels of truck production in North America, increased demand for rebuild and new engine sales for the oil and gas, and mining customers in North America and strong demand in construction and truck market in China. We do not anticipate foreign currency to have a significant effect on the revenue for the full year due to the recent appreciation of foreign currencies against the US dollar. And this guidance also includes sales of approximately $150 million from the new Eaton Cummins Automated Transmission Technologies joint venture. Income from unconsolidated joint ventures is now expected to increase by 25% in 2017 as a result of the higher than expected levels of demand in China for both on and off highway equipment which is continued into the second half of the year and this compares to previous guidance of 12% increase. We expect company EBIT margins to be between 11.8% and 12.2% of sales which includes the impact of Eaton Cummins joint venture and compares to 11.4% reported last year. And the tax rate for the full year is expected to be 26%. Turning to cash flow, cash generated from operating activities for the third quarter was $645 million, bringing the year-to-date total to $1.5 billion, a 12% increased from the same nine month period last year. We anticipate operating cash flow in 2017 to be within our long-term guidance range of 10% to 15% of sales. Capital expenditures during the quarter were $100 million bringing the year-to-date total to $282 million and we still expect that investments will be in range of $500 million to $530 million for the full year. And consistent with our plans to return 50% of operating cash flow to shareholders this year, we have returned $913 million to shareholders through share repurchases and dividend payments in the first nine months of the year. And in the third quarter, we increased the dividend by over 5% and repurchased 1.7 million shares. As Tom said, although we are disappointed with the increase in warranty costs we are encouraged with the progress made so far this year in our overall performance with sales up 15% on a year-to-date basis, EBIT up $350 million or 24% higher and earnings per share up 27%. Market is sort of turning as you can see from the results so far and from the increase in guidance across all four segments and we are well prepared to meet customer demand as market conditions continue to improve. Finally, I would like to remind everyone that we will be holding an Analyst Day on November 16 in Indianapolis, Indiana, a webcast of our presentation will be available in the Investor Section of our website. Now let me turn over to Rich.

[Rich Freeland:]

Thank you, Pat and good morning everyone. As mentioned, we have had quality charges in recent quarters that have been unacceptable. And while our overall quality as seen by our customer remains excellent and we're gaining share in many markets, we have had specific issues that have impacted financial results and our customers and we are committed to eliminating these issues. To this end, we're reviewing all aspects of product quality to identify where improvements can be made. This work is underway including and listing outside specialists where appropriate to review specific aspects of our operating systems. Areas of this work include an overall assessment of our product development process focused on preventing problems, a focus on supplier quality and supplier accountability as most of our recent issues have been in this area and the increased use of telematics and analytics to find and fix issues quicker. We are implementing real changes in moving quickly with these corrective actions. These initiatives have the highest attention of our leadership team and improvements will be monitored by our board. It is important to note that we've made clear and significant improvement in our warranty cost over time. For example, warranty costs on our 2017 heavy-duty engines are down more than 40% from four years ago. Our products are performing well, gaining share, but we can and will do better in this area. In summary, we know the issues, we know how to fix them and we have strong corrective actions underway to drive sustainable improvement. Now I'll turn it back to Mark.

[Mark Smith:]

Thanks Rich and now we're ready to turn it over to the Q&A section of the call. Please limit your call to one question and a related follow-up and then get back in queue. And then I'll be available after the call for any follow-up questions. Thank you very much please proceed.

[Operator:]

[Operator Instructions] Our first question comes from the line of Jerry Revich from Goldman Sachs, your question please.

[Jerry Revich:]

I’m wondering if you could talk about the adjustment to power systems EBIT and distribution EBIT, so reduction to absolute level of EBIT even as sales are up. How much should we think about those costs as being transitory versus sustained price cost as we all try to get calibrated on what operating leverage looks like in ‘18?

[Mark Smith:]

Hey Jerry, this is Mark, so I think we've got a clear line of sight in margin improvement in power systems and distribution. I think in power systems we’ve had basically two significant operating challenges this year. One has been as described as disappointing performance on one large power project, which is going to run out through the end of this year. That's impacted profitability. And then we've had some pressure on commodity costs, particularly copper costs within our alternative business and we are taking pricing actions to recover, but those -- we’ve been kind of chasing those costs. In addition, we've got the execution of our previously announced restructuring actions to move our Kent genset assembly operations into our Daventry engine plant. That's almost complete and so we're on track to get savings next year. And then just this quarter, we've announced further actions to rationalize the footprint within our alternator business to downsize our Stamford, UK facility. Just those two restructuring actions alone are going to add over 100 basis points of margin, Jerry at the current level and then probably we’ll get another 75 basis points from the other -- from the other project performance year over year. Again, volumes can move around, but we've got clear plans for improvement plus the copper pricing. So I think we’re confident we're going to get margin improvement.

[Tom Linebarger:]

I think on the distribution, if I could just add on that, distribution, as we mentioned in the remarks that it’s, as a divisional matter, still smaller than the other divisions and takes a little harder hit when we have variable compensation costs going up, which is just a matter again of timing, where we are now starting the upcycle, and so our variable compensation costs went up. Next year over this year, that won't be such a factor and again also as we've acquired the distributors, we've done a lot of consolidation and we've 8 32

[Jerry Revich:]

And then separately on the joint venture, can you talk about your expectations of the cadence of new product rollouts, nice to see the product rolled out at PACCAR, can you talk about if you expect that number of additional roll outs over the next 12 months and as you see the rollouts in your models, what timeframe does this business become a positive earnings contributor?

[Rich Freeland:]

This is Rich. Yeah. So the customer poll on the next gen heavy duty transmissions is strong. So we're rolling out with PACCAR right now this month and we’ll add additional OEMs early in 2018 and so -- and we're counting on getting really good fuel economy improvement from that. So the results look really encouraging. We're talking up to 7% additional. And then we'll also -- longer term, we're looking to more of the international market. So that's not in the short-term projections, but there's interest in particular in China, lots of interest in this, there is discussions about [indiscernible] probably slower in India, but like we said, it will be a couple of years of rollout, kind of moving expenses as we absorb amortization and pretty heavy development costs in the early -- in the first couple of years.

[Operator:]

Our next question comes from the line of Jamie Cook from Credit Suisse.

[Jamie Cook:]

Two questions. Both probably to you Tom. I guess my first question, what I'm hearing from investors is, as we look to 2018, US truck production should be up double digit, but moderates after that, so that cycles over and then China is probably like the headwind. And given some of the issues that you're having, the concern is sort of you missed the cycle much potential incremental headwinds to margins again this year, given the concerns on the quality and the warranty issues. So can you sort of help me out there where there is potential positive opportunities in 2018 to make up for what we're seeing? And then my second question is, the other question I get from investors is just given, I mean I know you've been spending a lot of your time looking externally on acquisitions or developing the strategy for EV or more broadly, but the concern is that some of -- because we're so focused externally that perhaps this is part of the reason why we're seeing some of these issues consistently across the business.

[Tom Linebarger:]

So first, let me just start with the point about where we are in the cycle. As I mentioned, we are clearly not at the top of the cycle, so we are mid cycle at best and again, it's a range depending on which market you're looking at, but we see 2018 as a significant opportunity for the company to expand and our markets further, power systems markets, we see a lot more upside, including in truck markets, some markets like China feel pretty, like, they might be getting near the top, but other markets, North America, India, et cetera, we still think there's much more room to grow and of course Brazil, which is a big market for us has barely come off the bottom. So we do see upside across our markets and as I mentioned in my remarks, as we've added these new components to meet some of these emissions cycles, we're seeing now -- we're starting to get the benefit, both in terms of market share, because the products are performing better, but also then in terms of content. So all of those look like upsides to us. Mark went through some of the benefits we've seen on the cost side, which we think are going to add margin, even at current revenues, so then as the revenues go further, we see a lot of opportunity again to expand margins. So from our point of view, we think we're nowhere near past the cycle and I think the evidence would suggest that's true based on kind of where we are in our market recoveries. And again, we are working hard to make sure that the cost reductions we started in the downturn, we continue now as markets improve in that way, we continue to expand margins. Also as Rich said, on the quality side, our products are performing well in the field, so our market share remains strong, which means that we continue to see volume growth, both from market and from market share. And as we improve our -- the financial cost of our quality, we think that represents further upside for the company’s performance. And I want to be really clear about this. I'm incredibly confident in the team's ability to lead improvement and quality. We have incredible experience and knowledge in our business leadership. We have done this before. We know what to do when it's time to focus on quality. And as Rich said, we have a very focused program to do so. I am completely confident in that. There is no lack of focus in this business on how to improve quality. So I am very confident that we will get those improvements and that we’ll see the results from it and again Rich and the team, I have my complete confidence and I am -- I support them on that work. I guess the only other thing to say is, there are some headwinds this year that we don't expect to repeat next year, for example, the variable comp numbers I mentioned to Jerry's question. So again, we are very optimistic about performance next year. We're excited about the position we have in our markets as a result of a lot of investment we've made in new products and in building customer loyalty over the last several years.

[Jamie Cook:]

And I guess, just let me be unfair Tom, but just my second question was just because we're focusing a lot externally on potential M&A strategies, is that impacting results.

[Tom Linebarger:]

And again I -- maybe just two more words on that. We have separated our work, so there is a group that I lead, strategy and business development that looks externally for acquisitions. It's a big group for us in that it's a relatively small group compared to the 55,000 people, it's a couple handfuls of people that are focused outside. All the rest of people are focused inside. So, there's no distraction from our business -- running our business successfully. There's no way to do that. Our business is incredibly competitive, our customers are very demanding, we have to keep complete focus on winning every day in our business and that's what we're doing. So yes, we have -- for Cummins, we have a significantly enhanced effort to look externally and we think we have some really significant opportunities to expand and grow the company based on the capabilities we've built over the years. We are very focused on that, but it is a handful of people -- a couple of handfuls of people not distracting the rest of the business at all.

[Operator:]

Our next question comes from the line of Steven Fisher from UBS.

[Steven Fisher:]

Wondering if you could just talk about what the net impact of the commodity input costs was in the quarter on a year-over-year basis and if steel prices and I guess Mark you mentioned copper, if they stay where they are today, how long it's going to take to sort of flat line the impact there on a year-over-year basis?

[Mark Smith:]

Yes. So just to be clear, Steven, I was talking specifically about the power systems business. For the company overall, we've been -- largely been able to offset commodity pricing, because no doubt there has been a good pressure, so we’ll get about 60 basis points of net improvement in material costs this year, even though there's been overall inflation, but on the copper side and commodities within the power systems business, we’re talking about a net $20 million exposure this year. Whereas coppers continue to accelerate in the second half of the year, even though we've seen underlying improvement in that business.

[Tom Linebarger:]

And Mark, I think it's probably obvious, but just in case people aren’t clear, the way that we offset those commodity costs, when it inflates, is that our purchasing and engineering group worked to find ways to reduce costs of other commodities or other products that we purchase through cost reduction work, engineering work, et cetera to find ways to lower costs. So we've been able to drive cost down that more than offset that inflation and then of course on the engine side, we benefit from inflation in commodities because mining of course has picked up as a result of inflation and commodity costs. So as a net matter, Cummins does better when commodities are stronger, we just have to work really hard on our supply side to offset the increase in commodity costs, in our purchased material.

[Mark Smith:]

And Steven just to give you the fourth quarter numbers, so metal markets were up 50 basis points year over year, but to Tom's point, we offset that total material costs, excluding metal, came down by 100 basis points, a net 50 basis points positive in the fourth quarter.

[Steven Fisher:]

And can you just give us a little more detail on the carbon, the EPA testing program in terms of the size of the population of engines that still need to be tested and what are these unresolved variables that you still have out there?

[Rich Freeland:]

This is Rich. Just so you know where we are right now, so in Q3, some pre-2013 engines failed in used tests, those are the ones we're taking action on. Okay. And so because there are some similarities in that system and some of our other 2010 to 2015 systems, we're going to do a look with the EPA at that population. And so while there are similar characteristics, there are certainly not identical characteristics and there's lots of variation in the engines, in the vehicles, in operating conditions and so we're working with the EPA right now and it's just -- it's very early. So we're just starting that work. So we're not at a point where we -- we will over the coming months understand what that population and if there's additional actions to be taken, but we're just not at that point to say what it is yet.

[Tom Linebarger:]

And all the actions that we know we need to take are in our costs already for Q3. So everything we know, we've already accrued for, the rest of this stuff, we're only in investigation phase and it’s early.

[Steven Fisher:]

And is this beyond Class 8 on highway?

[Tom Linebarger:]

We really don't know all the populations that are affected, but it's on highway is the focus.

[Operator:]

Thank you. Our next question comes from the line of Andrew Casey from Wells Fargo Securities.

[Chris Lazarenko:]

This is Chris Lazarenko on for Andy Casey. Just a quick clarification on the warranty expense. Within the quarter, is that total 63 inclusive of the 29 million related to EPA CARB or is that incremental? So a total of 92 million.

[Mark Smith:]

Total of 92, when the 29 was distributed between components and engines.

[Chris Lazarenko:]

And if I take the onetime charges year-to-date, the 15 million from Q1, 57 million from Q2 and the 92 million, do you expect to see some tailwinds in 2018 or is there increased new product costs to partially offset?

[Mark Smith:]

No increased new product costs going forward, Chris. And just to give an example, the way we're thinking about this, the gross margin from a year ago was down two points because of the warranty issues. Okay. And that's been total that we have. So we're going after this really hard to get back to that level, which is where we've been for the last five years, five, six years, back down in the 2% range.

[Operator:]

Our next question comes from the line of Rob Wertheimer from Melius Research.

[Rob Wertheimer:]

So I guess understanding all you've said about the focus on quality and getting it fixed and you've already recorded all that you obviously have identified, are you able to give any kind of a sense as to whether the 29 million is 10% of the -- obviously maybe it's certain applications, so that it's not fair to extrapolate like I'm about to do, but I mean is it 10% of the engines you sold, it is it more or less and then could this potentially affect component systems that you sold to other manufacturers and is the 29 million right now just your own engines?

[Tom Linebarger:]

Okay. So the 29 million is just our own engines. Okay. And Rob, I think it will be very dangerous to extrapolate. It's just too early. We don't know. And so again all we've done is where we’ve actually identified the issue, we’ve taken that charge and we're just starting the investigation.

[Rob Wertheimer:]

And then could you just kind of delineate the 29 million charge you’ve mentioned, what was the cause of the $63 million charge that was separate in engines in the quarter and then are either directly related to the 2Q issues or are they all just sort of separate issues that have popped up?

[Rich Freeland:]

Good to clarify that. So the 29 is the emission issue we're talking about. We had another charge around a proactive safety campaign that we're going after in another population. So that's the 63 million. So much like we had in Q2 in power systems where we identified some issues internally, where there actually hadn't been issues yet with customers, we've gone proactively out to campaign and get those -- to get those engines. So that was the 63 million.

[Mark Smith:]

And those are unrelated issues.

[Rob Wertheimer:]

Perfect. Unrelated. And then that 63 obviously, you did the whole population, so we assume that issue is closed and that’s the 29 that may or may not develop into the more?

[Mark Smith:]

Exactly. Right. Correct.

[Operator:]

Our next question comes from the line of Steve Volkmann from Jefferies.

[Steve Volkmann:]

Just another quick follow-up. Rich, I think you just said that you're sort of targeting over the long term to kind of get warranty back to about 2% of sales and I think somebody said, correct me if I'm wrong, but it was like 3.9 or something this quarter and I'm just curious, let's put all this CARB stuff sort of separate and aside since we don't really know what that looks like, but how do we think about the trajectory of the warranty to sales ratio kind of over the next year or two.

[Rich Freeland:]

Yes. So I think the trajectory looks pretty good on that. I mean I intend to get back in that level over the next several quarters with the actions we've taken, what we've seen. So again we've got the emission thing separate that we're going to deal with, but I'm actually very confident on that. And just, we've been there for -- we've been there for five years and so we've had two or three issues pop up, we know what they are, we put very robust, corrective actions in place and so I have confidence we'll get back to where we are. And in fact, what we're trying to do is use this as kind of a call, and say how do we take this to a new level going forward, down below the 2% where we've been.

[Tom Linebarger:]

And Steve, we do expect improvement in this warranty in Q4.

[Steve Volkmann:]

And then maybe kind of a philosophical question, maybe this is for Tom, but historically for many decades, I think the idea was that Cummins should probably not be involved in making end products because you don't want to compete with certain of your customers, but the world seems to be changing and I'm wondering if you have a view on whether it might make sense to actually vertically integrate into end products and kind of any of the end markets that you touch, if that's philosophically something you'd be willing to do or is that still seems like a bad idea.

[Tom Linebarger:]

Steve is the philosopher in chief. I want to be clear about this. As we think through our strategy, all things are on the table. We never really block ourselves off from anything in particular and we regularly revisit questions like this, like are we -- should we expand our definition of what the power system is to include the piece of equipment, not just things around and we frequently reach this point where I think we do well, because we support equipment makers in their work to serve their customers. And as soon as we step over the line into the other side, our relationship with them changes once and forever. So a decision like that is a one-time decision, a good perfect example that we went from making engines for generator sets to making generator sets and then every single large generator set manufacturer decided we would not be a good strategic supplier anymore. It took them all some time to change us out, but they eventually did. And then we competed with them on a generator set basis, which turned out to be successful in time. But it's a one-time decision. So we are very clear that that is a thing that when you make it, you make it once. And right now, we don't see any reason to change it in trucks or construction equipment or any of our major markets. We think we're best served by partnering with OEM partners to help them be successful again. So philosophically, it's not off limits, it just turns out to be not a good decision.

[Operator:]

Our next question comes from the line of David Raso from Evercore ISI.

[David Raso:]

First question is on cost. I'm just trying to think through some moving parts here. The R&D costs went up 22% sequentially. Can you help us understand are any of these unique costs that you've mentioned in that line item on the P&L or is that truly a increase in R&D that’s significantly, how should we think about then R&D going forward?

[Mark Smith:]

Good question. During the course of any given year, we receive significant funding, whether that's from government agencies, customers for specific programs and it just so happens that the timing of those recoveries is lumpy. You should expect to see the engineering costs moderate from that Q. That's not a permanent elevated level. I mean, there are clearly some areas of the business where we're investing more in engineering, but that's not a run rate.

[David Raso:]

So the 4% of revenues and I assume we’ll dive into this a little bit in Columbus at the meeting, but structurally the R&D moving forward, obviously, it spooked me a little bit to see that bigger revenue growth, but R&D that high and you're saying again, it was more on the engineering side and that will moderate?

[Mark Smith:]

Yeah. I think again, within the engine business, particularly there was a spike related to that and then of course over the course of this full year, variable compensation higher. And last year this time, we were actually reducing our variable compensation as markets comp turned down. So you're seeing kind of a delta there as well, which will play into the overall numbers. But we’ve said over the long run, 4% has been a reasonable target for engineering. We just don't expect to see significant jumps like that in any given quarter.

[Pat Ward:]

And David, we will talk more about that at the Investor Conference, especially about how it relates to the continued investment in our current business and what our expectation should be for the investment required for that and then what about some of these new areas like electrified power trains, what should investors reasonably expect Cummins to invest in that, how will the return go on that, we are going to talk about that in some detail. We've heard a lot of investors ask about that and I think they're good questions. It's a new area, so we actually had to do quite a bit of work to get a sensible answer to it, but we will talk about that in a fair bit of detail in the Investor Day.

[David Raso:]

And not to put words in your mouth for Columbus, obviously I’ll be there. It’s -- again your commentary doesn't sound like there's a notable step function coming in R&D.

[Pat Ward:]

Exactly. There's a notable increase in investment which we've already started making which you’ve seen in electrification, but as Mark said, we think we are in a good trajectory with our current business to keep R&D as a percent of sales in the same sort of area and we're not changing it for our base business and the question is what do we need to add for these new areas and how do we expect to earn a return on that, that's what we're going to address and by the way, I'm glad you're coming, I look forward to seeing you.

[David Raso:]

On the warranty expense, you mentioned fourth quarter lower than the third quarter. So we had 3.7 last quarter, we’re hoping that would come down to 3.2, we came in at 3.9, so that clipped about 17 cents on the quarter right there. The fourth quarter, can you give us some handicap on that? I'm just trying to think of the year-over-year ’18 versus ’17, but what's the base for ’17, like what is the fourth quarter?

[Pat Ward:]

David, that is in our guidance, fourth quarter will be around 2.5% of sales.

[David Raso:]

If it's already down at 2.5, but you did mention this analysis with the EPA doesn't really get resolved there, at least last two -- mid of 2018, how should we extrapolate that fourth quarter warranty expense going down that much to think about ’18?

[Pat Ward:]

The thing that we're really doing here again is, and as mentioned in my remarks, Dave, we’re just disappointed with these one-off issues that are showing up and the thing that we feel good about is that Rich and the team have been proactive on all these quality issues to make sure that customers do not experience problems. That's I think why our products are doing well in the field, why we're gaining market share. So our proactive approach I think and the fact that we're finding the issues and resolving them quickly is helping and that's a good thing. The bad thing is, financially, they’ve offered us surprises in each year scores. You mentioned the numbers, you were expecting quite a bit lower warranty and instead we ended up with higher warranty. That was a surprise based on primarily this safety campaign that Rich talked about. So, that's the disappointing part and if it was just one quarter, you would say, well, it’s just one quarter, but it's been several. So that's what we're trying to deal with. What we're trying to deal with quality system review is why do we keep getting these one-off issues and yes, we're doing the right thing by taking care of customers, but what we really need to do is eliminate them as an issue. And so that's what we're trying to address the really complicated system we sell. We need some more proactive and new tools to figure out how to avoid those issues. So that's what we're trying to do. The base level of warranty has already been operating in that low area. So really just by avoiding these one-off issues, we get right back down to those numbers in that 2% range that Rich was talking about. So it's not hard for us to imagine as being there the issue to address these one-offs.

[David Raso:]

I mean the wild cards are what they are, but if you're at 2.5 for the fourth quarter and we agree there are some wildcards to whatever the EPA conversation goes to, the work you're doing with them and that's a pretty big population, I mean 2010 through 2015. But every 150s of warranty expense at current sales is almost $1 of earnings. So I'm just trying to understand if there's no more wildcards, we’re ready at 2.5 in the fourth quarter, you're saying we're running at 2.5, running out and hopefully as Rich said, hopefully we're toward 2 at some point in ’18, just no wildcards, that's the run rate base case.

[Mark Smith:]

Yeah. Well 2s, so I'll give you 2018 guidance at the end of the year.

[David Raso:]

Yeah. It’s just the 2.5 pretty low and you’re not assuming any more wild cards, but we're engaged conversation with the EPA and I just want to understand, is the three months from now and the 2.5 turns and the 3.5 in the fourth quarter, these wild cards aren't really that wild. I'm just trying to understand.

[Mark Smith:]

I think that’s really the point is that, so far, we've been able to forecast what our base warranty is pretty well and then we got off these one-off issues. The emissions work that Rich was talking about, we just don't know where that's going to go. So what we're talking about, we're talking about the fact that our base level warranty, we are confident of where it is and what we're trying to do is reduce the impact of these one-off issues, this emission study, we do not know whether that will result in these -- more of these one-off costs or not. It is just too early to tell, but we know we're taking a look and we’ll let you know as soon as we know.

[Operator:]

Our final question then for the day comes from the line of Joe O'Dea from Vertical Research Partners.

[Joe O'Dea:]

Can you give us any sense of just how to think about variable comp and the headwinds you're facing this year as you've had guide revised higher and sort of the flow through of that higher variable comp and just how to think about the impact of when that level sets to a baseline.

[Mark Smith:]

So variable comp in the third quarter, Joe, just to give you a baseline, was $145 million higher than the third quarter of last year and for the full year, we expect it to be around $300 million higher than what it was for 2016. I think Tom mentioned earlier on, last year, we underperformed, so variable comp was more. So what we've expected to be, we’re over performing relative to plan. So I think there’s clearly at least 100 basis points of opportunity as we move into 2018 and we normalize variable comp back to planned levels.

[Joe O'Dea:]

And then the other question is just on the engine segment, when you think about a lot of these would appear to be kind of one-off or timing cost burdens you got, it sounds like higher R&D in the quarter, warranty obviously, the emissions system, higher incentive comp. I mean if you start to back some of that stuff out, it looks like you might have been at an all-time record engine segment margin. And so maybe just to kind of validate that kind of observation and then talk a little bit about what you're seeing underneath the surface a little bit, how much the price might be in there, the mix advantages or some of the high horsepower comes back, but just to understand some of that underlying margin strength?

[Mark Smith:]

You're absolutely right, not to diminish some of those one-offs, Joe, but clearly the underlying manufacturing operating performance is strong. Very little of it's got to do with price. It's operating improvement, net material cost servings, productivity gains and then of course joint venture earnings in China where we're doing pretty well also contributed a strong performance in that segment. So definitely, the business is operating well. The bit that we need to correct there is that the high horsepower engines are no longer in the end user segment. They’re in the power systems segment and of course we’re seeing a nice demand growth there and we’d expect that certainly in earnings to continue. Nothing to do with high horsepower in the engine business.

[Mark Smith:]

Okay. Thank you very much.

[Operator:]

Thank you, ladies and gentlemen for your participation in today’s conference. This does conclude the program. You may now disconnect. Good day.