Cummins Inc.
Q1 2016 Earnings Call Transcript

Published: 3 May 2016

[Operator:]

Good day, ladies and gentlemen, and welcome to the Cummins Incorporated First Quarter 2016 Earnings Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will be given at that time. As a reminder, this conference call is being recorded. I would now like to introduce your host for today's conference, Mr. Mark Smith, Vice President of Investor Relations. Sir, you may begin.

[Mark Smith:]

Thank you, Kelly. Good morning, everyone, and welcome to our teleconference today to discuss Cummins's results for the first quarter of 2016. Participating with me today are our Chairman and Chief Executive Officer, Tom Linebarger; our Chief Financial Officer, Pat Ward, and our President and Chief Operating Officer, Rich Freeland. We will all be available for your questions at the end of the teleconference. Before we start, please note that some of the information that you will hear or be given today will consist of forward-looking statements within the meaning of the Securities Exchange Act of 1934. Such statements express our forecasts, expectations, hopes, beliefs and intentions on strategies regarding the future. Our actual future results could differ materially from those projected in such forward-looking statements because of a number of risks and uncertainties. More information regarding such risks and uncertainties is available in the forward-looking disclosure statement in the slide deck and our filings with the Securities and Exchange Commission, particularly the Risk Factors section of our most recently filed Annual Report on Form 10-K, and subsequently filed quarterly reports. 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 financial measures. Our press release with a copy of the financial statements and a copy of today's webcast presentation are available on our website at cummins.com under the heading of Investors and Media. Now, I'll turn it over to our Chairman and CEO, Tom Linebarger.

[N. Thomas Linebarger:]

Thank you for that warm introduction, Mark. Good morning, everybody. I'll start with a summary of our first quarter results and provide an update on our outlook for the full year. Pat will then take you through more details of both our first quarter financial performance and our forecast for the full year. Revenues for the first quarter were $4.3 billion, a decrease of 9% compared to the first quarter of 2015. First quarter EBIT was $484 million or 11.3% of sales compared to $562 million or 11.9% in the same quarter last year. Our decremental EBIT margin was 19% as the benefits of restructuring actions, improved quality, lower material costs, all helped mitigate the impact of lower sales. Engine business revenues decreased by 10% year-over-year due to lower demand in North American heavy-duty truck market and weaker sales to global off-highway and Power Generation markets. Shipments of high horsepower engines declined by 20% and reached the second lowest quarterly total in the past 12 years. EBIT of 8.6% of sales declined from 9.7% a year ago as strong operational performance from our manufacturing plants and benefits from restructuring material cost reduction initiatives and improved quality were offset by the impact of lower volumes. Revenues in our Components segment decreased 5% from a year ago with lower demand in North America more than offsetting growth in China. Sales in China increased by 27%, outpacing our end markets as we continue to capitalize on tighter emissions regulations and capture increased content and market share. EBIT of $173 million or 14% of sales declined from $195 million or 15%, due to the impact of lower volumes and currency. Distribution revenues decreased by 1% compared to the first quarter of 2015. The negative impact of currency and weaker sales to off-highway markets more than offset the positive impact of acquisitions made in the second half of 2015. EBIT for the quarter of 6.5% improved from 6% a year ago, with operational improvements more than offsetting the negative impact of currency. In the Power Generation business, revenues declined by 19% year-over-year, with weaker sales in most markets, especially Asia and Latin America. EBIT declined from 7.2% to 5.6% as the impact of lower sales more than offset a 17% reduction in operating expenses. The first quarter is typically the weakest quarter for revenues in the Power Generation business and we do expect sales and margins to improve in subsequent quarters due to improving order intake in Europe and North America. Over the past three months, we've announced plans to further rationalize our manufacturing footprint including the closure of an alternator facility in Mexico, a generator assembly plant in India, and the exit of generator assembly operations in Kent, England. These actions will start to generate savings in the second half of 2016 with additional savings in 2017 and 2018 and should help us stay ahead of any further risk of declining volumes. Now, I will comment on some of our key markets, starting with North America. Our revenues in North America declined by 10% in the first quarter, due to weaker demand in on-highway markets especially heavy-duty trucks. Shipments to the North American heavy-duty truck market exceeded 16,000 units in the first quarter, a decrease of 33% from 2015 levels. First quarter market share was 29%. We have lowered our projection for full-year industry production to 210,000 units, at the midpoint of our guidance, down from our prior forecast of 22,000 units as slower freight activity has contributed to weak industry orders and higher dealer inventories. We currently expect our market share to be in the range of 27% to 30% for the year, down from our prior forecast of 30% to 33%, as Daimler has reduced the number of engines that it plans to order from Cummins and Navistar's market share has declined. In the medium-duty truck market, we delivered almost 22,000 engines in the first quarter, down 13% from last year. Our market share in the first quarter was 78%, down from 80% a year ago when we completed our final shipments to Ford. We expect full-year industry production to be 123,000 units, down 1% compared to 2015, and our market share to be 75%, unchanged from our prior forecast. Our engine shipments to North American pickup truck OEMs increased by 29% in the first quarter. Shipments to Chrysler increased 9% to more than 34,000 units, the highest first quarter volume in 10 years. Sales also increased to Nissan following the launch of our 5-liter V8 engine in the fourth quarter last year. We currently expect our revenues in the pickup segment to increase by 12% in 2015, unchanged from our prior forecast. Our Engine revenues from the North American construction market decreased by 9% compared to the first quarter last year. While housing and commercial construction activity remains positive, demand for new equipment from rental companies has declined due to a slowdown in business in the oil and gas market. Power Generation revenues declined 4% in North America in the first quarter due to lower orders from data center customers. We expect full-year revenues in North America to be flat to up 2% as order rates have improved this year following the weak close to 2015. Our international revenues declined by 8% year-over-year, with weaker sales in Latin America and Asia, driving the decline. First quarter revenues in China, including joint ventures, were $767 million, a decrease of 5% due to the negative impact of the depreciation of the RMB against the U.S. dollar and weaker demand for Power Generation equipment. Industry demand for heavy and medium-duty trucks in China increased by 9% in the first quarter. We continue to increase our penetration at Foton, which is now at 74%, up from 55% a year ago, and at Dongfeng, which is up more than 5% to 50%. Our overall market share was over 15% in the first quarter, down slightly from a year ago, as both Dongfeng and Foton adopted a more cautious start to the year than some of their competitors and under produced relative to the overall industry. We still expect that our share will reach 18% for the year as our partners increased production and sales more in line with the industry and our penetration continues to grow. We currently forecast full-year industry sales to decline by 4%, unchanged from our previous forecast. Industry demand for the first quarter was stronger than expected, but visibility to demand in the second half is limited. We believe it is prudent to be cautious about market improvement. Shipments of our light-duty engines in China grew 9% in the first quarter, compared to 3% decline for the overall market as the increased penetration at Foton is displacing local competitor engines. Our share of the overall market reached 7% in the first quarter, up from 6% a year ago. We currently project industry sales to decline by 4% for the year, again unchanged from three months ago. Our Power Generation revenues decreased by 27% year-over-year compared to a strong quarter a year ago. Sales weakened in the second half of 2015 as the industrial economy slowed and we haven't seen any signs of improvement yet. Industry sales of excavators in China increased by 15% in the first quarter as OE dealers pushed sales of Tier II inventory ahead of the transition to Tier III emission standards that came into force in April. Overall numbers of excavators sold, though, remains low, and while there is little downside risk left, there is no obvious catalyst for significant growth in the near term. Full-year revenues in China across all segments, including joint ventures, are expected to be flat for the year, consistent with our view three months ago with no major changes to any of our market assumptions. First quarter revenues in India including joint ventures were $390 million, up 7% year-over-year primarily due to recovery in the Indian truck market. Industry demand in the truck market increased 25% compared to the first quarter a year ago as the economy continues to improve. Our market share in the first quarter was 38%, down from 39% due to stronger growth in sales of vehicles below 10 tons in weight where our penetration in the market is lower. We now expect industry truck production to increase 10% for the year, up from our prior forecast of 8% growth. Power Generation revenues in India declined 1% in the first quarter, with a weaker rupee offsetting 3% growth in volumes. We currently project full-year revenues, including joint ventures, to be flat to up 2%, with higher domestic volumes largely offset by the depreciation of the rupee against the U.S. dollar. First quarter revenues in Brazil were $72 million, down 42% from the first quarter last year with the economy in recession and the real having to depreciate a further 16% against the U.S. dollar. Industry truck production fell 36% year-over-year while our engine shipments declined 35%. Revenues in all of our businesses were lower than a year ago due to the economic challenges in the region. We currently expect a full-year decline of 20% industry truck production with slightly easier comparisons to come in the second half of the year. Let me now make a few comments on high horsepower markets. As I said in my opening remarks, volumes are extremely weak with the first quarter's volumes down 20% due to lower demand in commercial marine, mining and power generation markets. New orders in the U.S. oil and gas markets are very scarce. We expect full-year shipments of high horsepower engines to decline by 6% helped by growth in sales of our new QSK95 liter engine and easier comparisons in the second half of the year. We were very pleased to receive EPA Tier IV final certification for our QSK95 engine for rail applications recently, allowing us to win some important business in the high-speed passenger rail market. In summary, we currently expect company revenues to decrease between 5% and 9% for the year, unchanged from three months ago. We did lower our outlook for heavy-duty truck production in North America, offset by an additional North American distributor acquisition and a less negative impact from currency in our forecast from three months ago. We expect EBIT to be in the range of 11.6% to 12.2% for the year, consistent with our prior forecast. We made solid progress in executing our cost reduction plans in the first quarter and every organization throughout Cummins remains focused on driving further productivity and cost improvements. As one example, starting in April, we combined our Power Generation segment and higher horsepower Engine business into a newly formed segment called Power Systems. This reorganization will consolidate two businesses that are already strongly interdependent, and will allow us to streamline business and technical processes to accelerate innovation in those markets to grow market share and more efficiently manage our supply chain and manufacturing operations. Dave Crompton, previously leader of the Engine business, is now leading the new Power Systems segment; and Srikanth Padmanabhan heads the remaining engine business. Tracy Embree and Tony Satterthwaite will continue to lead Components and Distribution segments respectively. Finally, we returned $745 million to shareholders in the first quarter through dividends and the execution of our accelerated share repurchase program, consistent with our plan to return approximately 75% of our operating cash flow to shareholders in 2016. Thank you for your interest today. Now, I'll turn over to Pat who will cover our first quarter results and full-year guidance in more detail.

[Patrick Joseph Ward:]

Thank you, Tom, and good morning, everyone. First quarter revenues were $4.3 billion, a decrease of 9% from the year ago with currency movements reducing our sales by 3%. Sales in North America, which represented 61% of our first quarter revenues, declined 10% from a year ago due primarily to lower demand in North American truck markets and continued weakness in industrial markets. International sales declined by 8% as a result of more demand in power generation and industrial markets and the impact of the stronger U.S. dollar. Gross margins were 24.6% of sales, a decline of 80 basis points from a year ago. More volumes and an unfavorable product mix were partially offset by improvements in the field costs and warranty expenses and the benefits from the restructuring actions. Selling, admin and research and development expense of $656 million, or 15.3% of sales, decreased $56 million from a year ago after taking restructuring actions in the fourth quarter of last year. This is 20 basis points higher as a percentage of sales due to lower revenues. Joint venture income of $72 million increased by $4 million compared to a year ago. Results in the first quarter a year ago included an impairment of our investment in an off-highway joint venture which did not repeat. Earnings before interest and tax were $484 million, or 11.3% of sales for the quarter compared to 11.9% of sales last year, and this equates to a decremental EBIT margin of 19%. Net earnings for the quarter were $321 million, or $1.87 per diluted share, compared to $387 million or $2.14 per share from a year ago. And the effective tax rate for the quarter was 28.4%. I will now highlight the performance of the individual operating segments during the first quarter. In the Engine segment, revenues were $2.3 billion, a decrease of 10% from last year. Industrial revenues declined by 13% from weak global demand for engines in marine, mining and oil and gas markets. On-highway revenues decreased 8% as production in the North American heavy-duty truck market declined compared to a year ago. Segment EBIT was $200 million, or 8.6% of sales compared to 9.7% last year. The benefits of the restructuring actions, material cost savings and more warranty expense were more than offset by lower volumes and an unfavorable product mix, primarily from a reduction in North American heavy truck and medium-duty truck volumes and the 20% reduction in high horsepower engine shipments. For the Distribution segment, first quarter revenues were $1.5 billion, a decrease of 1% compared to the prior year. Foreign currency movements negatively impacted sales by 4%, where organic sales declined by 5% with lower sales in North American off-highway markets more than offset in growth in China and in Europe. Acquisitions added 8% to revenues. EBIT margins for the quarter increased from 6% to 6.5% despite the 70 basis point unfavorable impact from foreign currency. Excluding the currency impact, margins improved by 120 basis points due to the benefits of restructuring, a stronger mix of aftermarket revenues and positive pricing. The Components segment recorded sales of $1.2 billion, a decrease of 5% from a year ago. Sales in China increased in the first quarter by 27%, which helped partially offset the decline for more heavy-duty truck production in North America and the negative impact of foreign currency. Segment EBIT was $173 million, or 14% of sales compared to 15% of sales a year ago as lower volumes, unfavorable pricing, and currency more than offset the benefits of material cost reductions and restructuring actions. In the Power Generation segment, first quarter sales were $550 million, down 19% from last year. International sales declined 27%, with Asia and South America experiencing the largest declines year-over-year due to the slow pace of investment and infrastructure projects. EBIT margins were 5.6% in the quarter, down from 7.2% last year. The benefits from the restructuring actions and more material costs partially offset the impact of the volume decline and helped keep decremental margins to 14%. For the company, cash flow from operations was $263 million, better than the same quarter last year by $90 million due to lower working capital requirements as sales decline. As we indicated at the beginning of the year, we planned to return approximately 75% of cash generated from operations to our shareholders in the form of dividends and share repurchases this year. During the first quarter, we repurchased 4.9 million shares, primarily resulting from the previously announced $500 million accelerated share repurchase program. And we made dividend payments totaling $170 million, up from $140 million a year ago. Our cash and marketable securities balance declined in the quarter by $537 million primarily due to the share repurchases, the increased dividend payments of $170 million, and capital expenditure of $71 million. As Tom mentioned, our guidance for our full-year performance is unchanged from three months ago. We are projecting total company revenues to be down 5% to 9% in 2016, lower levels of production in the North American on-highway markets, reduced demand globally for off-highway and power generation equipment and the negative impact of currency movements will drive the majority of the reduction in revenue. We expect some offset from the introduction of new products and increased revenue from distributor acquisitions. We expect EBIT margins of between 11.6% to 12.2% for 2016 and this compares to 12.5% for the year 2015, excluding the restructuring and impairment charges and represents a decremental EBIT margin of 25%. Benefits from material cost savings, restructuring and other actions will help mitigate the impact of lower volumes. Joint venture income is still expected to be flat compared to 2015. We anticipate operating cash flow performance in 2016 will be within our long-term guidance range of 10% to 15% of sales, and capital expenditures are expected to be in the range of $600 million to $650 million in 2016. As Tom just discussed, effective April, we reorganized the company into new operating segments. We will issue restated results for the first quarter of 2016 and results for 2015 and 2014 to reflect the new operating segments before we report second quarter results. We will also issue full-year guidance for each of the new operating segments when we report second quarter results. And just to confirm, our current full-year guidance for the company is unchanged from three months ago. Now, let me turn it back over to Mark.

[Mark Smith:]

Thank you, Pat. And now we'll move to the Q&A section of the call. In respect of the feedback that many of you give me, I would like to ask that you limit your questions to one question and one related follow-up to give everybody the chance to ask a question. Thank you very much. And now we are ready for the questions.

[Operator:]

Our first question comes from the line of Joel Tiss with BMO. Your line is open.

[Joel Gifford Tiss:]

How is it going, guys?

[Patrick Joseph Ward:]

Great, Joel.

[N. Thomas Linebarger:]

Hi, Joel.

[Joel Gifford Tiss:]

I wonder if you could break out the impact of the warranty change in the quarter and are we getting toward more normalized levels, or is that going to be a number that continues to come down?

[Patrick Joseph Ward:]

Yes, so let me start on that one. So, warranty in the quarter was 2.2% of sales for the company. That was down from 2.6% last year. We are very comfortable with our full-year guidance of 2%. We're right on track with that. So no real difference from what we talked about three months ago, Joel, with regards to our outlook for warranty and improvements that we're seeing in the quality of the products throughout the company.

[Joel Gifford Tiss:]

Okay. And just sort of a bigger picture question, it seems like Power Gen in general has been declining for kind of five years or so. Are we getting toward the end of that process or do you think there is still pockets of weakness out there that are going to last for the next two years or so?

[N. Thomas Linebarger:]

Yeah, it's a good question, Joel. I don't really know the answer for sure but we've certainly been declining for much longer than we expected. I think that's why you've seen us take a succession of actions as opposed to just one bigger one which, in retrospect, would have been better. But we are, of course, preparing, as you can tell from these actions, for continued weakness for some time. I think that's why we decided to take further actions in the business. When we did our restructuring in the fourth quarter we did much more out of the Power Generation segment. We've now taken some plant – significant plant capacity out now with these three closures. So we are anticipating that we may be weak for some period. Hopefully, it improves faster than that, but we are prepared for it now after watching it decline for quite some time.

[Joel Gifford Tiss:]

That's great. Thank you very much. Okay, sorry.

[N. Thomas Linebarger:]

Hey, Joel, if I could just add that the combination of our segments also, I think, gives us the opportunity now to begin to share overhead, drive improvement and efficiency in our processes between a large engine and the Power Gen business, which we think not only will help us in this tough time, but as the market springs back, we will be able to capture more share and respond more quickly. So, we think it's good for the short run to reduce costs but it also, I think, drives productivity and launch and ramp-up processes – are much better in the future.

[Rich Freeland:]

Joel, this is Rich. Just one more comment is, I agree with Tom that the overall markets we are not too optimistic on, but we are restructuring like we talked about, but also creating some of our own growth opportunities. So most of the QSK95 sales that we have are into the Power Generation markets and they're into places we weren't there before. So trying to grow share at a time when the markets are low, we're having some good success.

[Joel Gifford Tiss:]

That's great. Thanks. And I'm not getting back in queue. Thank you very much.

[Rich Freeland:]

Thanks, Joel.

[Operator:]

Our next question comes from the line of Stephen Volkmann with Jefferies. Your line is open.

[Stephen Edward Volkmann:]

Hi, good morning. Maybe let's just go one step further with that line of questioning, and you've talked about, Tom, the margins in Power Gen getting better sequentially, I guess as – on the back of the restructuring that you've done already. If the markets don't recover and sort of stay in this depressed period – situation, where do we think these margins can kind of normalize just based on what you've done so far?

[N. Thomas Linebarger:]

Yeah, we have some work to figure that out, Steve. Of course, we're – as you know, we've talked before about trying to get back to double-digit margins even in weaker markets. The markets have clearly fallen far more than any of us anticipated, and we've now taken a set of actions that we think normalizes us to these volumes. But we have some work to do to figure out where we think we can get margins at these levels. Clearly, it would help a bunch if revenues stabilized and stopped dropping. But it won't take us long to figure that out. The reason we still have work to do, as you know – we've just combined the segments. We just figured out – we're just now eliminating some of the capacity and the comparison like-for-like will be a little complicated given the combination of segments. But expect us to be figuring that out pretty quickly and being able to set guidance for what the combined segment is and where we can take that in the future. But we're targeting all our segments at double-digit margins even in tough times. So we're trying to figure out how to get there again. There's no question that right now we're not there and we've got work to do to get there.

[Stephen Edward Volkmann:]

Okay, fair enough. And my follow-up is just more on the heavy-duty truck side. Can you just tell us what you're seeing relative to cadence as we go through the quarters? I assume we'll sort of march down again here in the second quarter, but then what happens in the second half if you have any visibility there? Do things stabilize? Does it turn up a little towards the end of the year, or do we just kind of continue the glide slope?

[Rich Freeland:]

Yeah. So, the way we're looking at what's implied in our guidance is – actually it's a more downward pressure in the second half of the year. So if you just look at where we were in Q1, that would be a 224 market if you just multiply that by four. And so, I think actually Q2 holds in okay. And I just – past history says that with backlog down as low as it is, that we start to see some reductions in production in the second half of the year. There's just – we need order boards more full. That's a normal reaction that we see. So that's what we're putting into where we've taken the guidance down to 200 to 220 from the 220 range before. It's potentially some backend, but most of the reductions happened. We're down 33% already Q1 to Q1. And so most of the reduction is in place for what we saw in Q1.

[Stephen Edward Volkmann:]

Great. That's helpful. I appreciate it.

[Operator:]

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

[Jerry Revich:]

Hi, good morning, everyone.

[Rich Freeland:]

Hey, Jerry.

[N. Thomas Linebarger:]

Good morning.

[Jerry Revich:]

Tom, wondering if you could update us on your plans for the distribution back office integration now that you're on the tail end of wrapping up the acquisitions. Over what timeframe are you looking for to complete the back office integration at this point? And can you just calibrate us on the magnitude of cost savings opportunities we should look for when that plays out?

[Rich Freeland:]

I'll go ahead and take that, Jerry. And Tom can pitch in here. So, the piece that's behind us or a lot of it is most the back office work has been done. And so, we got a little more integration work to do there, but some of the bigger ones are still in front of us. So like the distribution, we talked about we had 15 distribution centers. We want to go to much smaller. We put two in place and we'll put three more in place this year. And so by over the next couple of years, we'll get that savings. The purchasing savings, which is to build and we've got a really good purchasing process. You've seen the results we've had in the business of driving costs down. We're just now beginning that one. So, we talked about getting $100 million in synergies, kind of maybe $40 million to $50 million of it in cost and the rest in sales. We're just really getting started. We're probably a quarter away through that on the cost side and more to come over the next couple of years.

[N. Thomas Linebarger:]

And, Jerry, I would just add that the processes that do the back office work, we have now set all those in place. There's still some follow-through work to do on those, but as Rich said, it's really now just a little bit of – it's just follow through on making sure that all that HR processes work and we're still acquiring a distributor, so each time we acquire, we got to do them again. The opportunities are still in front of us. So we've actually had to go negative before we've gone positive. We've added cost in various processes to make sure that everybody's on the same pay systems and pension systems. So we're going to see the benefits really starting to flow now. So we're pretty excited about those and both from a sales and support and service point of view for customers, but also on the cost and return side which Rich talked to you about.

[Jerry Revich:]

Okay. Thank you. And, Pat, can you talk about where Engine margins should count on the quarter relative to your internal expectations? Looks like decrementals were 25%. I think the full-year guide at the midpoint would imply 17% decremental, so an improvement. Is that in line with your plan? Then, I guess, what's the offset to the weaker volumes through heavy-duty truck based on your market and market share forecast?

[Patrick Joseph Ward:]

Yeah, I was really pleased with how the Engine segment came out in the quarter. I think decrementals – my numbers, Jerry, show the 20% decremental EBIT margin for the quarter, which in the face of a 33% reduction in North America heavy-duty truck volumes and a 20% reduction in high horsepower, I think, is a very, very good performance. Clearly, we're seeing benefits come through from material costs, we're seeing the benefits from the lower warranty expense I was talking to Joel about a few moments ago. And the restructuring actions that the Engine business took in the fourth quarter and the results are in more SAR spend, I think is all helping to keep those decrementals below what would normally be an acceptable level for them. So I think we are off to a pretty good start this year.

[Jerry Revich:]

And the comps are easier is your point, Pat, in coming quarters? Because I think the guide at the midpoint would imply better decrementals than the first quarter.

[Patrick Joseph Ward:]

Yeah, I think if you look at the Engine segment last year, certainly by the time we got to the fourth quarter, it was a very difficult fourth quarter for them. So the second half, I would expect to see a little bit better performance year-over-year.

[Jerry Revich:]

Okay. Thank you very much.

[Patrick Joseph Ward:]

Thank you.

[Operator:]

Our next question comes from the line of Jamie Cook with Credit Suisse. Your line is open. Jamie L. Cook - Credit Suisse Securities (USA) LLC (Broker) Hi, good morning. Sorry, just a couple more questions on Power Gen and high horsepower. Can you talk about how comfortable you feel with your inventory levels and what's in the channel in both of those segments? And as I think about the restructuring you've announced and combining those segments, does that imply you think things could be take another leg down? Could 2017 potentially be up? I'm just trying to think if there's any read through with regards to what you're doing and what that means for how you're thinking about demand, if you're more negative or positive. And then, I guess, my second question relates to market share on the heavy-duty truck side. You brought that down. Again, you talked about Navistar, you talked about freightliner. Tom, confidence level in your longer-term market share goals in North America heavy-duty truck with, I think, Packard saying on their call a couple of weeks ago their addressable market is now 80% to 85% versus before they were targeting a 50% market share. Thanks.

[N. Thomas Linebarger:]

Thanks, Jamie. So I'm going to let Rich talk a little bit about inventory and maybe heavy-duty truck, but again just getting back to the high-level question about when we get – and we think there's more downside to come in the Power Gen side and then the large engine side generally. What we decided to do was prepare ourselves for that potential outcome. We just don't know. The truth is we don't know if there's more downside to come. We do not see obvious signs of turnaround today. And so what we decided to do with this last set of actions both in terms of the restructurings we did in Q4, the manufacturing footprint reductions, and the combination of this. And reorganization of these businesses is to prepare ourselves for whatever is in front of us. That's what we committed to do and that's what we're doing. And we've said that all along if we need to take more actions, we'll take them. So these are an example of that. So we just don't know what's going to happen in the future, but we feel more prepared to deal with it, whatever it is. And we feel like we've got our cost structure in place for what the business is now and if, again, it gets a lot worse we'll figure that out and take actions when we need to. But we really like the actions we've taken here as better positioning us for a really, really challenging market that exists today. And, Rich, you can talk a little about the inventory question.

[Rich Freeland:]

Okay. Let me take your last question first, Jamie, and then I'll get to the high horsepower inventory. So, the long-term view on share, let me just repeat what I think is going on in the market today. What we see is that we took it down as we saw our share go down at Daimler but – and we've forecasted it to go down, but I think in an environment of excess capacity, we're clearly seeing more pressure to utilize internal resources and more incentives and discountings to do that. We've also seen some modest increase in Navistar this year. Again, nothing major, but we've actually seen that go down. So those two things are what are behind the immediate change we put in place. Our approach, we're going to stay disciplined. We're not going to chase share with discounting. The product's performing well. And so, we're going to continue to just sell that value to the customer to get that back and at the same time, align our cost to deliver really good financials in this environment. I think longer-term, as we think about the share, our view is it's still a 50% big bore, 50% medium bore market. Okay? And today, we compete really with the 15-liter product. And that was part of our announcement that we made in New York that we'll be bringing a medium bore product to the market in 2017 to compete on the other end where we used to have kind of ISM product. We're going to have a terrific product down there at that end. So we see our share with Packard kind of in that 50% or 57% range now. Their market tends to be a little more big bore than medium bore. And so we see from a horsepower range, 13-liter products can cover a larger part of the horsepower range. So just the wrong – they're the wrong product in certain duty cycles and the customer kind of draws that to more of a 50/50. So that's what's behind our guidance kind of looking forward.

[N. Thomas Linebarger:]

I think on the inventory side, I'll let Rich comment more, but we don't feel any concern about our inventory of high horsepower engines. We produce to demand. It's a really easy thing to look at that we do not have any issues with that. And Jen (37

[Operator:]

Our next question comes from the line of Ann Duignan with JPMorgan. Your line is open.

[Ann P. Duignan:]

Hi, good morning.

[N. Thomas Linebarger:]

Good morning.

[Ann P. Duignan:]

Just a couple of follow-up questions. I know you won't guide for 2017, and that's not the purpose of this question, but can you talk a little bit about on the heavy-duty North America on-highway side? Do you see 2016 as kind of a mid-cycle slowdown that we just have too much inventory and we need to clean that up and next year will be a more normal year? Or are you seeing cracks in the fundamentals out there? I mean, I think you addressed it somewhat with the unused idled trucks that are out there? But, just your kind of philosophical thinking on 2017 for on-highway.

[Rich Freeland:]

Ann, the way I would answer that, the actual amount of freight moving is pretty reasonable, especially if you're in the consumer side, the housing side, the pass-car side – some of the industrial folks are down. But the freight, actually – most of those indicators look pretty good. What we had last year, we shipped – the backlog came down 60,000 units. So we shipped 60,000 units of backlog last year and that's just not needed this year. And I just think we're in more of a normal replacement cycle right now, which is in kind of the 220 to 240 range is where we are. I think this year could be potentially lower because the backlogs are pretty low and it's hard to run plants. There's just no future visibility. So I think what you'll see, and what we're projecting anyway, and again, not that we have any great insight, it just happened in past cycles, is production rates come down a bit in the second half of the year to build up a little bit of backlog. And then I would look – then you're back to kind of macroeconomic for 2017, and which your guess is as good as mine. But right now, the general freight looks pretty good.

[N. Thomas Linebarger:]

And, Ann, my comment about unused equipment was really in the high horsepower market, but not about trucks. And really, just to add to Rich's comments, the only real negative on the freight side have been there's – the oil and gas business is down and they do buy a lot of trucks. And in and around that market there is a lot of trucks. You know the currency is a little strong so some of the exporters have been down, but that's been true for a while. That's not really changing very much. So the freight activity that we have seen has been pretty steady, as Rich said. So I think it is normal. I think we'll see obviously the macro economy in the U.S., I think, will be the primary driver of whether we see further reductions from here or whether we kind of stabilize and hang out at the levels of – at the second half on into 2017.

[Ann P. Duignan:]

Yeah. I guess I would share your view on that, so I appreciate that. And just to follow up on, I think, when you were at our conference in March, there was some discussion that if there were any upside risk that it would be to JV income. Can you just talk about the pluses and minuses? What you're seeing in the joint ventures?

[N. Thomas Linebarger:]

Yeah, I think the – I'll highlight a couple and then I'll let Pat or Rich add. But you heard us comment on China. We had a strong quarter in China in the first quarter and there are some signs that things may be – could be improving and we are just remaining a little cautious. So we left our forecast where it was. And it's partially because we have just seen China promise better and beat the market, not be that strong the rest of the year, a couple of years in a row, so we want to be prudent and watch and see a couple of quarters before we really call an upside and also just fundamentals don't look that much different. So, I think that's the place where maybe if things are improving, as some people suggest, we could have some upside in JV income there. But right now our view is we are just – we think we're pretty – we're going to stay where we are from the point of view of forecasting. And on the off-highway side, maybe it's the opposite. It's not that things are great now, but I just feel like it's weak markets all over the place and so maybe there is a little bit of downside still on off-highway. But again, there is not much to go. The good news is that we're so low that there's not much to go. But there is just a lot of parked equipment and a lot of challenge in those markets. So again, I think we are pretty balanced on our forecast. I think our JV income lines are pretty well balanced and I'd leave it where it is. But I – Rich, do you have anything to add?

[Rich Freeland:]

I think from a market standpoint, 100% agree, and I think just our position in that market – a couple positive things that we feel good about. One is the enforcement for the regs are pretty good and probably maybe better than we would have guessed even a year ago as we introduce them, which is good for us. And second, we saw the growth in market share as we've displaced competitive engines, especially with Foton, with the ISF and the ISG engine. And these engines are doing a terrific job. You heard Steve (43

[Operator:]

Thank you. Our next question comes from the line of Ross Gilardi with Bank of America Merrill Lynch. Your line is open.

[Ross P. Gilardi:]

Yeah, good morning, thank you.

[N. Thomas Linebarger:]

Hi, Ross.

[Ross P. Gilardi:]

I just wanted to stay on that China discussion. So you mentioned that your market share took a little step backward, and obviously you guys had been growing share pretty rapidly over there. You characterize it as more of a – it sounded like a customer downtime issue. But I'm just wondering, has there been a stronger competitive response from Weichai or any of your local competitors there, given how quickly you have taken share in that market? And is that part of the reason why the share stepped back a little bit?

[N. Thomas Linebarger:]

Thanks for the question, Ross. No, it's – in fact, that's what I highlighted – what I wanted to highlight in my comments that our penetration at our customers, which also by other engines has grown. So, to the contrary, we continue to make inroads for exactly the reasons Rich mentioned. The engines are doing really well; they're advantaging our customers. What happened with our truck customers, basically didn't discount as much and didn't participate in the market as much in the first quarter. There was quite a bit of activity in the market and quite a bit of discounting by a couple of folks, but just more activity. They didn't participate in that same sort of thing and so they stepped back in their truck share. We are not the least bit worried about that. We think that that all works itself out over the course of the year. So we feel very good about our market share projections. In fact, our penetration is ahead of where we hoped it would be, so we're feeling really good about that. So, very good position, very strong. The real question really is going to be how well did the market do. If the market does well, we'll see good pickup where there's better position than we've ever been and so that – we are just waiting for the market to pick back up.

[Ross P. Gilardi:]

Got it. Thank you. And I think you mentioned 25% to 30% growth in China components, if I got that correct? And is that showing up in your Components segment or your JV income? And assuming it's in the segment, is that a major reason why you were able to hold a 14% margin in Components? And if that tailed off, would you have to give some of that back, do you think, over the course of the year? And I'm talking on the way you're currently reporting it, obviously, as opposed to the restatement that you're going to make.

[N. Thomas Linebarger:]

Yeah, so Components will not be affected by the restatement just – or the restructuring, just to be clear. But the point about Components, the China business that you talked about, 27% increase and that was a result of – again, as Rich was saying, they are enforcing their standards. And so we are having much more equipment go on Chinese engines, both after treatment – that's the main one, but also fuel systems going into these equipment, because electronic fuel systems are now pretty much required in order to meet the standard. So what we are seeing is more content on our customer's engines and our own engines in order to meet these new standards. That's really what's driving that. They do – it's good business. It does contribute to our business. But it's not a higher mix in terms of margin or anything else. So I would say our 14% margin is good all the way around.

[Patrick Joseph Ward:]

Yeah. The reason why the margin stayed up as strong as what it did in Components even though North American markets were down quite significantly is, again, back to that material cost focus. We've seen terrific improvement in material costs in the Components segment, which enabled them to offset the volume and offset a fairly significant foreign currency impact and still stay at 14%.

[Ross P. Gilardi:]

Thanks very much.

[N. Thomas Linebarger:]

You're welcome.

[Operator:]

Our next question comes from the line of David Raso with Evercore. Your line is open.

[David Raso:]

Hi, good morning. I was curious, six months now since the analyst meeting, and obviously the tone there was very positive about looking for deals. And I was just curious if you can give us some updates six months later? Are we closer, further away? And what are some of the impediments to getting the deals done?

[N. Thomas Linebarger:]

Great. Thanks, David. Thanks for the question. Yeah, so we remain actively engaged in that process, as I mentioned at the investor conference. I have got a group of people that I'm working with directly on that, so I'm very engaged in it personally. And we are dutifully looking along the tracks that we talked about there where we think we can leverage our capabilities to grow. We are also, of course, remaining disciplined in terms of what we think is value added to the shareholders in terms of how we do it. The unfortunate thing about things like this is there is nothing to report until there is something to report. And anything in the interim would be – would buy us our own process. So, unfortunately, I can only say that we are remaining active. I'm very optimistic that we're looking in the right places and thinking about the right things and that whatever we do when we do something, it will be beneficial to our shareholders and beneficial to the company long run. That part I'm sure. I'm sorry that I can't provide you more details and it's just because anything I'd say would just not help us in any way and help our shareholders. But I'd just tell you that nothing has changed about our process. We are still very active and I still feel good about what we are looking at.

[David Raso:]

I guess maybe a way to answer a little bit, are you, six months later, a lot further down the road on narrowing and focusing on what you logically can target, and think a deal could occur? Or is it still as wide as it was six months ago?

[N. Thomas Linebarger:]

No, we have done a lot of work to focus and think about what's most important to us, a lot of work on that.

[David Raso:]

Okay. Thank you very much. Appreciate it.

[N. Thomas Linebarger:]

Yep.

[Operator:]

Our next question comes from the line of Steven Fisher with UBS. Your line is open.

[Steven Michael Fisher:]

Thanks. Good morning.

[N. Thomas Linebarger:]

Good morning.

[Steven Michael Fisher:]

Could you just talk about how you expect to manage higher input costs in the second half of the year, given the higher commodity prices? And what's your latest thinking on pricing impact overall for the year?

[Patrick Joseph Ward:]

Yeah. So pricing impact overall for the year is pretty much in line with what we said again three months ago, that it's somewhere around 0.4%, 0.5% negative impact on margins. So no, we've seen that in Q1. We clearly overcame that through material cost improvement and no change or update in that as we look forward now through the rest of the year. And the first part of the question was?

[Rich Freeland:]

Commodity prices.

[N. Thomas Linebarger:]

Commodity prices are increasing.

[Steven Michael Fisher:]

Yeah. So how do you expect to manage that in the second half?

[Rich Freeland:]

I think that what we've looked at it, it will be minimal impact on us. So we do see some of that and we also have agreements with both customers and suppliers, we do some hedging in that area. So at least at the level that we are projecting commodity price increase the second half of the year that it would be minimal impact on our EBIT.

[N. Thomas Linebarger:]

The good thing for us is we're kind of operationally hedged in the sense that as commodity prices increase, of course, so does demand for mining products. So there are short-term differences where things move a little bit and mining doesn't pick up and costs do, but generally speaking, when commodity prices rise in a significant amount, that's hard for us to offset in our cost structure. We also see mining business improve, which more than offsets it. So, in a way, commodity prices improving is a good thing rather than a bad thing for us.

[Steven Michael Fisher:]

Okay. And then outside of M&A that David was asking about, to what extent has the weakness in the heavy-duty truck market caused you to accelerate any of your other strategic plans, maybe product oriented that you talked about at your Investor Day? I thought you had said at the Investor Day the 10-liter and 12-liter was a 2018, and I think on this call you said 2017. So are you accelerating some of those maybe more product strategies?

[Rich Freeland:]

No, on – let me clear that up. So, we will actually bring product here in 2017 late in the year, which is the same as what we intended to say at the investor conference and then really go into production in 2018.

[N. Thomas Linebarger:]

Yeah. And in terms of the strategy work that David asked about, we are accelerating now, we were accelerating then. There's really – we are fully focused on the efforts that are important to us strategically. So there's not a change. But we are working pretty quickly to figure out what's the most important for us to do and figure out how to do it.

[Steven Michael Fisher:]

Okay. Thank you.

[Rich Freeland:]

Yep.

[Operator:]

Our next question comes from the line of Tim Thein with Citigroup. Your line is open.

[Tim W. Thein:]

Good morning. Thank you. Question on distribution. First off, just in light of the updated currency assumptions, which obviously hits that segment especially hard in both ways, what – how should we think about the update there and as well as the distributor acquisition? I know at this point that there's probably only small ones left. But maybe any color on those two items, in terms of how it potentially impacts the balance of the year?

[Patrick Joseph Ward:]

I think on foreign currency, I'll answer really for the company and then we can dive into distribution deeper if you want. In the first quarter, we had a 3% negative impact on sales, and then had a $19 million impact on profitability negative for the company. Given where currency rates currently are today, we expect the foreign currency headwind on the company for the rest of the year to be much less than what we've seen for the past year and a half. We're now guiding for the full-year on currency to be down around $200 million in sales, so one percentage point. And fairly mutual actually on profitability for the full-year. So if you just back into the rest of the year, that would imply that the sales impact is going to be less than 1% negative as opposed to 3% in the first quarter. And profitability should get a little bit better across all the segments than what we've seen in Q1 and for most of last year. And obviously distribution, given its footprint, it's been the segment that's been most exposed to currency movements, so that should help it as it moves forward too.

[N. Thomas Linebarger:]

It doesn't always balance out. I think you probably know that, Tim, that sometimes because distribution operates in every currency. Still we can have currencies which are strengthening or weakening relative to the U.S. dollar, but on balance they can work their way out, because some might be going the other way. But – so I think distribution still has currency exposure, but hopefully as Pat said, on balance, we'll see a little bit less of a negative impact. The one thing I would just highlight to you is that we did see improvement in margin this quarter and that's despite currency and other challenges there. So that's a pretty good evidence that some of the synergies and other work we've been doing is starting to pay off to the question earlier. I think with the distributor acquisition, you're right. There's just the one left in North America left to do. That's the one we'll finish this year. That's in California. So it's not that small a distributor, actually. It's not the biggest, but it's decent size. And we'll be acquiring that in the second half of the year and when that's complete, we'll now then own all the North American distributors and the process will be complete for North America. And as Rich highlighted earlier, will we then kind of fall in to figuring out how we capture the synergies that we know are available to us.

[Patrick Joseph Ward:]

So I think just to summarize, Tim, a little bit more negative on the Engine business revenue outlook given the heavy-duty truck market, a little bit better on distribution from currency, and from the acquisitions leads us basically in the same place overall for the company. And then we'll refresh every segment's guidance with a new reporting structure next quarter.

[Tim W. Thein:]

Okay. Understood. And just maybe one quick cleanup on Components. And again, surprised at how few questions relative to the contribution of profits there. But I know that that segment, you can have some lumpiness just in terms of how some of the engineering costs flow through the quarters. Was it unseasonably low in the first quarter and it will pick up? Or was that not much of a factor either way in the first quarter?

[Patrick Joseph Ward:]

That was not much of a factor in the first quarter.

[Rich Freeland:]

Yeah.

[Tim W. Thein:]

All right. Very good. Thank you.

[Patrick Joseph Ward:]

Thank you, Tim.

[Operator:]

Our next question comes from the line of Joe O'Dea with Vertical Research Partners. Your line is open.

[Rich Freeland:]

Hello.

[Joe J. O'Dea:]

Hi. Good morning. Could you talk a little bit about the heavy-duty truck revenue? You talked about some of the challenges in the OE volumes into North America, but the overall revenue there better than what we're seeing in North America new equipment trends. So what you're seeing on the parts side, whether owning distribution is improving some of the demand there as you manage that process? But some of the offsets to North America heavy-duty truck volumes within the reported heavy-duty truck segment volumes?

[Rich Freeland:]

Yeah, so the parts revenues have remained pretty steady and actually continue to grow slightly through this in the heavy-duty side. The distribution piece is more indirect on the parts sales. So we think by our regional distribution strategy increasing availability, et cetera, we'll get some upside there. But it's more around the synergies of getting product out there on parts. So I wouldn't attribute the acquisition to increasing part sales, although now we participate in those where we didn't used to within the joint venture at the same level. The other thing that I was just going to mention indirectly to your question and it relates a little bit to components in the heavy-duty space. Our strategy is to – we sell engines to people who are vertically integrated, and we sell engines, but where we don't sell engines, we sell components. So some of the movement between engines and components, the components business continues to benefit from that. And our share in things like turbos are over 60%, and that's remained solid, our share in after treatment over 50%. And so we've continued to maintain that in a time regardless of what's happening on market share on the engine side.

[Patrick Joseph Ward:]

And then just to address your specific question, I think, asking about the overall heavy-duty revenue segment, Joe, really the North American on-highway, there's no other changes since we planned around flattish parts revenue for the year. That's still the assumption. We're not seeing any significant change in trajectory. We're not seeing any significant change in some of the international markets like Australia or South Africa that make up the rest of that segment. So a modest lower outlook for the overall heavy-duty as you're asking that question, I think.

[Joe J. O'Dea:]

Yep. That's perfect. Thanks very much.

[Rich Freeland:]

Thank you, Joe.

[Patrick Joseph Ward:]

Okay, thank you very much, everybody, and I'll be available for your calls later on. Appreciate your time. Thank you.

[Operator:]

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