PACCAR Inc
Q4 2018 Earnings Call Transcript

Published: 29 Jan 2019

[Operator:]

Good morning, and welcome to PACCAR’s Fourth Quarter 2018 Earnings Conference Call. All lines will be in a listen-only mode until the question-and-answer session. Today’s call is being recorded. And if anyone has an objection, they should disconnect at this time. I would now like to introduce Mr. Ken Hastings, PACCAR’s Director of Investor Relations. Mr. Hastings, please go ahead.

[Ken Hastings:]

Good morning. We would like to welcome those listening by phone and those on the webcast. My name is Ken Hastings, PACCAR’s Director of Investor Relations. And joining me this morning are Ron Armstrong, Chief Executive Officer; Harrie Schippers, President and Chief Financial Officer; Preston Feight, Executive Vice President; and Michael Barkley, Senior Vice President and Controller. As with prior conference calls, we ask that any members of the media on the line participate in a listen-only mode. Certain information presented today will be forward-looking and involve risks and uncertainties, including general, economic, and competitive conditions that may affect expected results. A summary of risks and uncertainties is described in more detail in our periodic reports filed with the SEC. For additional information, please see our SEC filings in the Investor Relations page of paccar.com. I would now like to introduce Ron Armstrong.

[Ronald Armstrong:]

Good morning. Harrie Schippers, Preston Feight, and I will update you on our excellent fourth quarter and full-year results for 2018, important business highlights and PACCAR’s focus on innovation. Thanks to PACCAR’s 28,000 outstanding employees around the world. 2018 was a record-setting year for the company. PACCAR achieved record revenues of $23.5 billion and record net income of $2.2 billion, a 9.3% after-tax return on revenues. PACCAR Parts set annual revenue and profit records and PACCAR Financial achieved record new business volume and a 17% improvement in pre-tax income. PACCAR is celebrating 80 consecutive years of net income. We celebrated many other 2018 accomplishments. PACCAR delivered a record 189,000 trucks worldwide. DAF earned the prestigious International Truck of the Year 2018 Award. Kenworth, Peterbilt and DAF introduced a broad range of battery-electric, hybrid and hydrogen fuel cell truck models, which are currently in field testing with customers. DAF Brazil earned the Truck Brand of the Year honor for the third consecutive year and increased its market share in just five years of operation to 6.7%. PACCAR’s focus on sustainable business practices were recognized by the environmental reporting firm, CDP. PACCAR achieved an A rating, which puts us in the top 2% of the over 6,000 companies, which report to CDP. And we’re especially proud that Peterbilt and Kenworth were recognized as Top Workplaces for Women by the organization Women In Trucking. PACCAR has a strong record of shareholder returns. PACCAR has paid a dividend every year since 1941, and has delivered annual dividends of approximately 50% of net income for many years. In 2018, PACCAR declared dividends of $3.09 per share, which was a 41% increase over 2017. Total dividends declared exceeded $1 billion for the first time. PACCAR has increased its regular quarterly dividend at an average of 11% per year during the last 20 years and raised the quarterly dividend another 14% beginning in 2019. PACCAR’s total dividends declared for 2018 result in a robust yield of 5.4% at year-end. PACCAR repurchased 5.8 million shares for $354 million in 2018, which was the most since 2007. The Board of Directors authorized additional share repurchases last year with $540 million remaining at year-end. PACCAR’s fourth quarter revenues were a record $6.3 billion and fourth quarter net income was $578 million. Revenues were 15% higher than the fourth quarter last year and net income was 39% greater, compared to the adjusted net income of $416 million earned in the fourth quarter last year. PACCAR delivered a record 50,400 trucks during the fourth quarter, 6% more than the third quarter. The increase in production resulted for more build days in Europe compared to the third quarter and better supplier performance. Truck and parts gross margins were 14.2% in the fourth quarter. Truck pricing was good with price realization comparable to the second and third quarter at about 2%. During the quarter, we incurred some additional material and labor costs due to supplier constraints, but conditions improved compared to the third quarter. By the end of the fourth quarter, supplier deliveries to the factories were in good shape. Our Peterbilt, Kenworth and DAF factories and purchasing and supplier management teams again did a fantastic job of managing production, delivering a record number of trucks and achieving the highest operating margins in the industry. In the first quarter, we’re expecting slightly higher deliveries compared to the fourth quarter. Deliveries are projected to be up over 15% when compared to last year’s first quarter. Truck and parts gross margins are estimated to increase in the first round to – first quarter to around 14.5%. Now Preston Feight will provide an update on DAF PACCAR Parts and PACCAR Financial Services.

[Preston Feight:]

Thanks, Ron. DAF had an outstanding 2018. DAF achieved record European above 16-tonne market share of 16.6%, compared to 15.3% in 2017. DAF was the market leader in European tractor registrations and is making great progress towards its goal of 20% market share. Europe’s greater than 16-tonne truck market was a robust 319,000 registrations, reflecting continued strong demand and growing European economies. European economies and freight transport activity are projected to grow again in 2019. We expect 2019 to be another excellent year, with a market in the range of 290,000 to 320,000 trucks. In 2018, PACCAR’s Parts business generated record annual revenues of $3.8 billion and record annual pre-tax profit of $769 million. Annual revenue grew 15% and annual profit grew 26% compared to 2017. Parts fourth quarter revenues were record $971 million and quarterly pre-tax profit was a strong $194 million. PACCAR has steadily increased its truck and engine market share over the years, resulting in greater number of PACCAR trucks and engines in operation. This combined with consistent investments in parts distribution capacity and customer-focused technologies has created a very strong growth environment for PACCAR Parts. We expect parts sales to grow by 5% to 8% this year. PACCAR Financial Services annual pre-tax income increased 17% in 2018 to $306 million. 2018 revenues were $1.36 billion. Fourth quarter pre-tax income increased 21% to $87 million. The portfolio increased to record size and continues to perform well. Kenworth and Peterbilt Class 8 used truck values increased over 10% in the fourth quarter compared to the same period last year. Kenworth and Peterbilt truck resale values command a 10% to 20% premium over competitors’ vehicles. We expect 2019 to be another good year for used truck volumes and prices. PACCAR Parts and PACCAR Financial Services profit contributions are much larger than they were 20 years ago. These businesses are inherently less cyclical than the sale of new trucks and their consistent profitability enhances PACCAR’s financial results throughout all phases of the the business cycle. Harrie Schippers will now provide an update on Kenworth and Peterbilt and PACCAR innovation.

[Harrie Schippers:]

Thanks, Preston. In 2018, U.S. and Canadian Class 8 truck retail sales were 285,000 units. Kenworth and Peterbilt had a record production and achieved a strong 29.4% market share. In 2019, we expect the U.S. and Canada Class 8 truck market to expand further to a range of 285,000 to 315,000 vehicles. Kenworth and Peterbilt have a record backlog with production visibility into late 2019. U.S. economic and freight indicators were strong in 2018, with nearly 3% GDP growth, 3.8% industrial production growth and 6.6% freight tonnage growth. Fleet utilization levels are very high at 97% in the fourth quarter of 2018. In 2019, U.S. GDP and industrial production are expected to grow another 2% to 3%, which bodes well for freight volumes and demand for trucks. In the past, the surge in orders was often driven by a pre-buy related to an emissions change, that is not the case in this cycle, which has been driven by economic and freight growth. Kenworth and Peterbilt customers are benefiting from the industry-leading operating efficiency provided by our trucks, as well as superior after-market support from PACCAR Parts and PACCAR Financial Services. PACCAR showcased many innovative products and technologies last year. DAF introduced the CF Electric, LF Electric, XF Hybrid and CF Hybrid trucks. Peterbilt introduced Model 579, Model 520 and Model 220 electric trucks. Kenworth introduced a T680 hybrid truck and two T680 hydrogen fuel cell models. Earlier this month, several of these trucks were on display at the CES Technology Show in Las Vegas. We had a terrific turnout of people interested in PACCAR technology and the opportunity to see the trucks and technology firsthand. We were the only OEM displaying trucks at the show. Kenworth, Peterbilt and DAF alternative powertrain products are in field trials with customers, focusing on regional distribution, refuse, urban delivery and port applications. These applications will be the most economically feasible for customers in the medium-term. Longer-term, alternative powertrain vehicles will likely be competitive in more applications. While we are preparing for the long-term by making investments in alternative powertrain technologies, we do expect diesel to remain the most efficient and cost-effective powertrain technology in heavy truck applications for the foreseeable future. The PACCAR Innovation Center in Silicon Valley completed its first full-year of operations in 2018. The Innovation Center team complements PACCAR’s extensive R&D efforts and is focused on developing a production-ready level for autonomous PACCAR truck. The team has developed an excellent reputation with the entrepreneurial community with start-up companies, venture capital firms and academia. PACCAR was recognized in 2018 for its innovations in software and manufacturing. DAF was honored with the Computable Award 2018 in The Netherlands for its 3D Truck Configurator web application. Peterbilt in Denton, Texas, the PACCAR engine factory in Columbus, Mississippi and the PACCAR truck factory in Ste-Thérèse, Canada each earned a prestigious Manufacturing Leadership Award from Frost & Sullivan. These manufacturing innovations and arms factory capacity, efficiency and safety exemplify PACCAR’s operational excellence. We invested $437 million in capital and $306 million in R&D expenses in 2018. In 2019, we’re planning to increase capital investments to $525 million to $575 million and increased R&D expenses to $320 million to $350 million. These investments will develop the next generation of Kenworth, Peterbilt and DAF trucks, enhance PACCAR’s diesel and alternative powertrain technologies and add additional capacity and efficiency to the company’s manufacturing and parts distribution facilities. Thank you. We’d be pleased to answer your questions.

[Operator:]

[Operator Instructions] Our first question comes from the line of Ross Gilardi with Bank of America Merrill Lynch. Your line is now open.

[Ross Gilardi:]

Hey, good morning, good afternoon, everybody. I just got a couple of questions. First of all, maybe you could talk a little bit more about the Parts business, where do you think we are in the cycle? You’ll be factoring in some deceleration this year. But I remember an interesting chart you had at your Investor Day showing that we’re in somewhat of a sweet spot for parts, given the age Class of the active fleet. So why would that actually even slowdown this year?

[Ronald Armstrong:]

Well, I’d just say, last year was an extraordinary year for PACCAR Parts. They put a lot of things in place, which we reap the benefits of those last year. We continue to invest in additional capacity this year. So we’ve got two pretty major projects

[Ross Gilardi:]

Yes, got it. Thanks, Ron. And then, maybe you could just talk about Class 8 order trends a bit. I mean, obviously, they were at super normal levels throughout the year and they’ve started to slow just back towards more normal levels. What do you see in there? Is it the big fleets, the smaller fleets? Is it really just everybody there? I mean, you sound like, you’re still quite positive this year, but any color on order trends would be great?

[Ronald Armstrong:]

Yes, over 450,000 orders last year was – I would still call it super normal, I would call it abnormal, which was, yes, great for the backlog. I was just at the ATD meeting last week, meeting with several of our dealers. The dealers are very confident about the ability to deliver the trucks that are in the backlog and very confident about orders that will continue to fill in the openings that are there and we’re already taking some orders for 2020. So industry conditions are very positive from our perspective.

[Ross Gilardi:]

Thank you.

[Ronald Armstrong:]

Thank you.

[Operator:]

Our next question comes from Joel Tiss with BMO. Your line is now open.

[Joel Tiss:]

[I’m not used to make it on so early.] [ph]

[Ronald Armstrong:]

We always love, yes.

[Joel Tiss:]

Two things. Can you give us a sense, maybe this is more of a Harrie question. Why the inventories are running up kind of 27.5% at the end of the year? Usually, you normalize them towards the end of the year. And I just wondered if there’s something unusual in there, or you just gearing up for a strong 2019?

[Harrie Schippers:]

Are you talking about by – looking at the balance sheet, the…

[Joel Tiss:]

Yes.

[Harrie Schippers:]

…the carrying value from year-to-year?

[Ronald Armstrong:]

Yes. I’d say, I mean, Harrie can have this one. But I think it’s mostly just reflecting the higher production levels.

[Harrie Schippers:]

Exactly you’re right, Ron, reflecting the higher build rate.

[Ronald Armstrong:]

Yes.

[Joel Tiss:]

And then can you give us a little background – can you tell us what your penetration rate is on your parts out of your total installed base? What do you guess your market share is on the parts penetration? Is it 15% or 40%, or just an idea, so we can also gauge how much growth potential there is longer-term? Thank you.

[Ronald Armstrong:]

Yes. I’d say – that’s a very – unfortunately, there’s not a really strong gauge of the parts market like there is on trucks. But I would say, based on seeing our parts revenue growth relative to the competition, what we can glean from that is that, our share position improved in – really in all of our markets last year and again, kudos to the parts team for the great things and investments they’ve made in warehousing, in programs. And I think we’ll continue to grow our share without – again, without knowing precise numbers.

[Joel Tiss:]

All right. Thank you.

[Ronald Armstrong:]

Thank you.

[Operator:]

Our next question comes from Steve Volkmann with Jefferies. Your line is now open.

[Steve Volkmann:]

Hi. Good morning, guys.

[Ronald Armstrong:]

Good morning, Steve.

[Steve Volkmann:]

Ron, I was going to see if I could push you a little bit for a little bit more color on your pricing commentary. I think, you said prices were up about 2% in the second, third and sounds like also the fourth quarter, and I’m curious about two things. One is, how does that sort of compare with the increases that you saw in things like parts’ costs and labor inflation and so forth? In other words, price cost neutral, negative or positive, I’d just be curious on how that trended? And then as we look into 2019, are there some chance – opportunities to maybe get a little bit more price with the backlog being as long as it is? And how does the price cost kind of balance look to you guys going forward? Thank you.

[Ronald Armstrong:]

I’ll let Michael talk a little bit about the details of the cost side and then I’ll talk about 2019. Michael?

[Michael Barkley:]

On the cost side for the fourth quarter, they were up about 1.6% or – which was less than our revenue side, which is up over 2%. So we had some positive price realization during the quarter.

[Ronald Armstrong:]

So – but as you look next year, Steven, I think, the orders are pretty well in the house for North America. And so we know what that pricing is and we commented on what we think the first quarter margin is a little bit enhancement up to around 14.5% in the first quarter. And we’d say, if you look at the full-year, probably in the 14% to 15% range for the year.

[Steve Volkmann:]

Okay, thanks. That’s helpful.

[Ronald Armstrong:]

Thank you, sir.

[Operator:]

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

[Jerry Revich:]

Hi, good morning and good afternoon, everyone.

[Ronald Armstrong:]

Good morning, Jerry.

[Jerry Revich:]

I’m wondering if you could talk about the new products that you were stepping through at the beginning of the call, the battery power products are in various stages of customer testing. Can you talk about what are the most successful variants so far? And when do you think we’ll see them in commercial production in your facilities? I appreciate that it’s early, but maybe you could share with us about the early results?

[Ronald Armstrong:]

Yes. I think, we sort of think about it in three different layers. I think where we’re at today in the – sort of the demonstration phase where we’re learning about new technologies and how they work, next step would probably be some level of low volume production, which would probably be starting next year. And then at some point, once the commercial viability of these technologies are good and the customers – the customer demand is there, I mean, ultimately, for us, it’s all about the customer demand. And I think, the economic feasibility will dictate a lot of that as time goes on. And so, we’re doing everything we can to be prepared and be ready and be as smart as we can be about those technologies. And we’ll be ready to start production when the customers’ demand is there for those products.

[Jerry Revich:]

Okay. And then the low volume production that’s expected next year, can you talk about what the powertrain looks like in terms of – is it a PACCAR supplied powertrain? Is it third-party? I guess, what we’ve seen from you folks in the past on the diesel side is lower-volume products you’ve tend to use third-party powertrains and where you have more scale you’ve done in-house. And I’m wondering is that the framework we should be thinking about at least in the early stages of EV?

[Ronald Armstrong:]

Yes. I think in the early stages, we’re working with a variety of partners to identify what technologies work best, but also getting smarter about what role we want to play and what position we want to have in these alternative powertrain components. So that’s still being studied and evaluated for the long-term.

[Jerry Revich:]

And in PACCAR Financial, you folks had really strong margins this quarter. It sounds like used truck values were a contributor to that. Can you just flesh that out? Was that a mark-to-market, or is that sustained benefit now that values have moved higher? Can you just give us a bit more context behind the strong parts – or excuse me, FinCo margin improvement?

[Ronald Armstrong:]

Yes, there’s no mark-to-market. We just look at valuations of our used truck inventories every quarter. And once we adjust typically, if there’s a write-down needed, we take the write-down and then that becomes the basis going forward. So no mark-to-market enhancements, it’s all about just – the market pricing is better and we’re getting a better result from our used truck activities, particularly in North America.

[Jerry Revich:]

Okay. Thank you.

[Ronald Armstrong:]

Thank you.

[Operator:]

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

[David Raso:]

Hi, thank you very much.

[Ronald Armstrong:]

Good morning, David.

[David Raso:]

Regarding the first quarter delivery comment, if I heard correctly, up 15% year-over-year. Can you help us geographically how we’re thinking about delivery sequentially?

[Harrie Schippers:]

I think the lion’s share of that will probably be in North America with some improvement in Europe as well compared to last year’s first quarter. And we’ll see – yes, we’re seeing – we’ll see some improvement in South America as well. So I think, most of the regions will be up in Mexico, I think, will be up as well.

[David Raso:]

Yes. I’m just kind of looking at normal sequentials, usually Europe and the rest of world are down 4Q to 1Q, so most of the sequential growth is North America. And I guess, what was driving it, you haven’t found this constructive on the supply chain for a little while, it sounds like that’s improving?

[Ronald Armstrong:]

It is.

[David Raso:]

So I appreciate the price cost. I have to believe the inefficiencies in the supply chain have been rather notable the last couple of quarters. So with that starting in the past, I guess, maybe I’m just pushing a little bit on the gross margin to have the gross margin in the first quarter still down year-over-year. I’m just trying to get a sense of, do we see at some point, the gross margins can grow on that stronger delivery growth, especially if North America is sort of driving the growth? I would have thought the supply chain improvements maybe able to bump up the gross margin thoughts?

[Ronald Armstrong:]

Yes. So if you look at truck margins, truck margins in the fourth quarter, I think, we’re about 11.9% – 11.8%, 11.9%. And so, because the revenue growth in the first quarter will be more related to trucks than parts, you get a bit of a mix effect that has a margin impact. So that’s sort of what we’re seeing. And if – and we’re seeing good – really good performance by our suppliers in the month of January and that ensured that continue that there could be some upside. But right now, we’re making our best call based on how we see it currently.

[David Raso:]

No. I appreciate that, yes. We have on a pre-tax level margin, truck was still down year-over-year in the fourth quarter. But are you saying that at least, there’s a chance, say, the pre-tax truck margins should have a chance to start growing year-over-year with the deliveries? That’s what we’re looking for the extra little pop to earnings power. Can we start to assume some improving year-over-year margin?

[Ronald Armstrong:]

It could. And so, we’ll – again, I think we’ll see how things progress here as we work through the first quarter.

[David Raso:]

Okay. And a quick follow-up on Europe. I appreciate the derisking the guide down a little bit. But can you help us with how the orders were in the fourth quarter year-over-year?

[Ronald Armstrong:]

Let me just – if we can – the orders were strong while we look for the numbers. We had a really strong December in Europe, and…

[Harrie Schippers:]

Yes, fourth quarter orders were up 8%, and for the full-year, orders were up 17% in Europe.

[David Raso:]

Okay, all right. So it’s up 8% going into the year.

[Harrie Schippers:]

Yes.

[David Raso:]

And lastly, the repo. The repo was a nice step up in the fourth quarter. Maybe if you can just help us how you think about the cycle and how it maybe influences your thoughts on the share repo?

[Ronald Armstrong:]

Yes. I mean, we – when the valuation is attractive as it is currently, we step up our efforts on the repurchase activity. And so that’s been the approach we’ve taken for years and we’ll continue to apply that. We still have $540 million of authorization that will continue to manage through 2019.

[David Raso:]

Okay, I appreciate it. Thank you so much.

[Ronald Armstrong:]

Thank you, David.

[Operator:]

Our next question comes from the line of Seth Weber with RBC. Your line is now open.

[Seth Weber:]

Hey, good morning, good afternoon, everybody. Just kind of going back to David’s question on the gross margin. Is there anyway to quantify how much the supply chain disruption or some hiccups cost you and margin in the fourth quarter? I think, you said it was maybe 50 basis points in the third quarter. Did it get less onerous in the fourth quarter?

[Harrie Schippers:]

Yes, that’s a tough one. There’s just so many inputs that go with that. So, I don’t recall that being that specific. So it’s – it is an impact and it’s tens of millions, but it’s hard to quantify.

[Seth Weber:]

Okay, fair enough. And then I wanted to ask about the higher CapEx that you’re looking for in 2019. You did mention some incremental spend on manufacturing facilities. I’m wondering, is that – are you adding brick-and-mortar, or is it just sort of adding incremental machine tools or what? Can you just give us any color on that specific part of the higher CapEx on the manufacturing side? And also, are you ramping up spending on any suppliers? Thanks.

[Ronald Armstrong:]

So I’d say, it’s a combination of all those things. There will be some additional bricks-and-mortar added to some of our facilities to really increase the efficiency. One of the things that we’re going to be doing, we’re going to be investing in a new paint shop in Chillicothe, Ohio. So that’ll be pretty sizable addition and we’ll redirect the current paint shop to be more involved with assembly capacity. We’re also looking at machining investments to support the success of PACCAR MX engine and just to continue to increase the efficiency of all of our factories around the world and we’ll be preparing for new product launches and the facility requirements to go with that.

[Seth Weber:]

Okay. And are you investing in suppliers to help – kind of help them along a little bit these days?

[Ronald Armstrong:]

We definitely are, where there’s supplier is, you can’t get it done fast enough to support what we want to do, then yes, definitely, we’re providing investment – suppliers with capital investment and it’s going to benefit PACCAR.

[Seth Weber:]

Great. Okay, thank you very much, guys.

[Ronald Armstrong:]

Thank you.

[Operator:]

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

[Andrew Casey:]

Good morning out there. How’s everybody doing?

[Ronald Armstrong:]

Good morning, Andy, and you?

[Andrew Casey:]

Doing fine. Thanks.

[Ronald Armstrong:]

[Staying arm?] [ph]

[Andrew Casey:]

Trying, the worst is common. You’re welcome to come out and join us.

[Ronald Armstrong:]

Sunny here in Seattle today.

[Andrew Casey:]

That’s great. Hey, in your European outlook, I mean, some of the questions have already been asked, but you’re expecting the industry sales down around 4% at the midpoint. You had 8% organic growth – sorry, order growth in the fourth quarter. Should we read that to mean that you expect industry trends not necessarily PACCAR, but industry trends to kind of deteriorate through the year?

[Ronald Armstrong:]

Yes. The European market has been above 300,000 for three straight years. We based on how we see things, we think 2019 could be the fourth. And so we’re starting the year in a real positive vein with where we’re at. But it’s four years and it’s – we’ll see how long it runs. But we do have some conservatism baked into our thinking as we progress through the year. But hopefully, that doesn’t turn out to be the case.

[Andrew Casey:]

Okay. Thanks for that, Ron. And then just a little bit further on that topic. Have you started to see any weakness in any of those select countries that create the Europe region?

[Michael Barkley:]

You could say that Germany is the place where if there’s anything, there’s a little bit of noise and obviously, the UK. But in general, as Ron just said, we see strong performance in order intake and how the trucks are certainly being received with the customers. So order intake up and market share growth that we’ve achieved feels pretty good for 2019.

[Ronald Armstrong:]

We’re pretty fortunate in the UK. We have – we’re the only OEM in Europe that has a plant manufacturing product in the UK, and that provides us a bit of a competitive advantage depending on how things play out with Brexit. And I think everybody believes that there won’t be a hard Brexit, but in the event there is, it actually, from a competitive situation, it actually plays into our favor. So we’ll see how it all develops, but we’re hopeful that there’s a nice smooth approach to the transition there.

[Andrew Casey:]

Okay, thank you. And then if we can flip over to parts, if I look at it on an annual basis, you had around 150 basis points of operating margin improvement year-over-year, clearly, a very strong performance. When you look back on the entire year, could you kind of review what the main factors driving that improvement were? And then kind of reflect them whether you expect further upside to the margin during 2019?

[Ronald Armstrong:]

So, the big thing is just the operating leverage on the warehouse and sales and marketing spend. And so you get the benefit of that. You get this – we continue to see growth in our engine part and engine part sales, which typically have a little bit higher than average margin, and I don’t think that’s going to change. I think, we’ll continue to see engines – engine parts growth probably still be a leading product line that will help us develop the parts business in 2019. So, offsetting that, we – last year, we constructed the Toronto PDC, which is now up and running and doing great. And so, you’ve got some project costs that we continue to incur just to support the growth of the business going forward. So that tends to offset a little bit, but that’ll be pretty – all pretty normal. And so we’d see some – probably some leverage from that 5% to 8% revenue growth.

[Andrew Casey:]

Okay. Thank you very much.

[Ronald Armstrong:]

Thank you.

[Operator:]

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

[Ronald Armstrong:]

Good morning, Ann.

[Ann Duignan:]

Oh, sorry, I had you on mute. Sorry. Good morning. I guess, a lot of my questions have been answered. But if we could take a step back and look at your backlog again, particularly in North America, can you talk a little bit about the mix in there of sleeper versus Class 8? And also maybe the large fleet versus smaller owner operator, or any other color you can give us on the mix of that backlog, would be great? Thank you.

[Harrie Schippers:]

And if I look at the backlog for 2019, that’s pretty normal We’ve got a very normal mix of fleet business, bigger fleets and smaller fleets, a retail business by our dealers. And we try to manage that backlog also that in a year where the lead times extend that we’re able to supply all our loyal customers with the trucks that they need.

[Ann Duignan:]

And nothing unusual sleeper versus Class 8 straight, I’m thinking more oil and gas kind of related infrastructure…

[Ronald Armstrong:]

That’s very normal.

[Ann Duignan:]

Okay, that’s good to hear. Thank you.

[Ronald Armstrong:]

Yes.

[Ann Duignan:]

And then in that context also, perhaps you could talk about used values and also the cancellations that escalated for the industry over the last couple of months. Can you talk about what you’ve seen in cancellation, cancellation rates, or what you’re dealers not ordering for stock to begin with, so there have not been the same level of cancellations? If you could talk a little bit about that, that would be good.

[Harrie Schippers:]

Yes, used truck prices have improved nicely as we mentioned. And if we look at cancellations, we don’t see a lot of real consolations. If we see cancellations, it’s cancellations for reorders. So a dealer changes the type or the customer for a truck, but not any significant cancellations so far.

[Ann Duignan:]

And is that your assessment of the industry cancellation rates, that it is more canceling and resetting of delivery train trucks that.

[Harrie Schippers:]

We just – we don’t know what the other – we know what our situation is. But we don’t really have any read into what the competitor numbers look like.

[Ann Duignan:]

Okay. And one quick follow-up on your European outlook. What exactly do you have baked in the outlook for Brexit? You’re assuming it’s a normal or that it doesn’t happen, or what’s the downside risk if we do not get order past the expiration date?

[Ronald Armstrong:]

Yes, I think, there’s – there bound to be some, if there’s a hard Brexit, it’s – there’s bound to be some temporary disruption. But that’s – again, that’s temporary and again, because we are the sole producer in the UK. From a competitive standpoint, it’s actually a bit of an advantage for us.

[Ann Duignan:]

No. But in the long-term, pulls to any disruption, obviously?

[Ronald Armstrong:]

Yes. I think in long-term, it all sorts itself out, yes, but short-term, there could be challenges.

[Ann Duignan:]

Yes. Okay. I’ll leave it there and get back in line. Thank you. I appreciate it.

[Ronald Armstrong:]

Okay. Thanks, Ann.

[Operator:]

Our next question comes from the line of Jamie Cook with Credit Suisse. Your line is now open.

[Jamie Cook:]

Hi, good morning.

[Ronald Armstrong:]

Good morning, Jamie.

[Jamie Cook:]

I guess, first question, I was sort of surprised when you talked about customers already starting to talk about 2020. And obviously, when we look at your stock price in the multiple, the world assumes in 2020, the truck market obviously rolls over. So can you just talk understanding far out? But sort of what your customers are talking about in terms of how they’re thinking about 2020 and sort of how far out you are? And then my second question, I’m sorry, I just wanted to push again on the margins for 2019. I know you said, I think, you said 14% to 15%. But like how is not the midpoint to the high-end 14.5% to 5% more realistic just given price, I mean, material costs are going down, the supplier constraints and inefficiencies should be going away? I just – I don’t understand how we get to the low-end?

[Ronald Armstrong:]

So the backlog, the customers are engaging in discussions about 2020. They’ve got their build slots outlined for 2019. And so some of those discussions are occurring and…

[Harrie Schippers:]

But it’s still very – it’s still very limited for 2020. The big fleets plan requirements in 2020. In general, we haven’t issued our pricing for 2020 yet, so that’s still to come. So once we launch or issue our pricing for 2020, we’ll see more orders for 2020.

[Ronald Armstrong:]

Yes. And look, for margins…

[Jamie Cook:]

I’m just wondering if you have a strong view on whatever the industry forecasts are out there for 2020, down 25% based on what you’re hearing, if you think the market is too pessimistic or you don’t forecast you’ll run the business, no matter what…?

[Ronald Armstrong:]

Yes. I mean, what will actually be 2020, that’s to be determined. But as we see it right now, there’s people still need and want trucks. And we’re – are we trying to figure out how to build more trucks, not – that’s – and that’s what you see a little bit in our first quarter delivery plan. As far as margins, we’re just starting the year, given a pretty broad range and we’ll have better feel for how suppliers are going to perform over the year and cost movements will be. What’s the impact of commodities and tariffs, et cetera. So, that’s still – we think we have all that pretty well dialed in, but we’ll see how it progresses as we go through the first quarter.

[Jamie Cook:]

Okay, thanks. I’ll get back in queue.

[Ronald Armstrong:]

Thank you.

[Operator:]

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

[Steven Fisher:]

Hi, guys.

[Ronald Armstrong:]

Hey, Steven.

[Steven Fisher:]

Hi. I wonder – I wanted to follow-up on the supply chain topic. And I think, Ron, you said that the suppliers reached a good shape by the end of the fourth quarter. But I guess, I’m curious you’re confident that they’ll be able to seamlessly ramp up further to to meet a still higher rate of production in 2019?

[Ronald Armstrong:]

Yes. Our teams are – our materials teams, our purchasing teams, our quality teams, I mean, they’re working closely with our suppliers. And they had some – our suppliers had some difficult hands and they got to dealt with a few hurricanes and a few things like that in the second-half of last year, which – that’s sort of behind us. And so they’ve gotten their legs under him and so, we’re working closely with them to be able to support the progression of build that we want to achieve during the 2019.

[Steven Fisher:]

So is it smooth so far in, say, the month of January?

[Ronald Armstrong:]

Yes. January has been the best we’ve seen it in – to a couple of quarters.

[Steven Fisher:]

Okay, terrific. And then just on financial services, just curious how much visibility you have at this point for 2019? The current quarter of profit was a nice run rate at $87 million or so. Is that something you expect to build on in 2019, or might it kind of sustain here and then moderate after a couple of quarters?

[Ronald Armstrong:]

Well, we’ve grown the portfolio with the additional truck deliveries, record truck deliveries and the ability that we’ve financed about 24% of those globally last year and we expect that will continue next year. So I think, we’ll continue to see some modest portfolio growth. And right now, the portfolio is performing excellently. Our past dues are really at historically low levels. And so we entered 2019 in good shape, and so we feel good about where we’re at for 2019 with our Financial Services business for sure.

[Steven Fisher:]

Very good. Thanks a lot.

[Ronald Armstrong:]

Thank you.

[Operator:]

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

[Joseph O’Dea:]

Hi. Thanks for taking my questions.

[Ronald Armstrong:]

Hi, Joe.

[Joseph O’Dea:]

First, just wanted to understand gross margin potential. And when you talk about another strong year in 2019 in a 14% to 15% range and you go back to the middle part of last decade in strong market conditions when you’re doing a 15% to 16% range, host of things on the emissions front, obviously, price cost considerations. But just wanted to understand the major kind of structural swings that appear to market a step down in the structural sort of gross margin potential?

[Ronald Armstrong:]

Yes, 14% to 15% margins are excellent. There could have been some unusual circumstances 10 years ago, 15 years ago, but I think, we’re in great shape. The cost and the revenue side of trucks these days are much higher given all the emissions add-ons that have occurred over time. So that probably could have some impact on the percentage realization over time, but whether it’s 14% or 15% or 15% to 16%, it’s pretty strong.

[Joseph O’Dea:]

Okay. And then on the share repo front, stepping it up in 2018, but vis-à-vis the cash that’s on the balance sheet, the potential to do something much larger. And I guess, maybe just why not step it up and be a little bit more active on the share repo front?

[Harrie Schippers:]

We just – we feel really good. If you look at our cash over time, it’s plus or minus 15% of our balance sheet and we’re basically setting about that point. And so we’re quite comfortable with where we’re at and continuing to opportunistically buy shares is work for us and we will continue to apply that approach in 2019.

[Joseph O’Dea:]

And then just one on DAF and the share gains in 2018, I think, some nice progress towards the 20% target. When you think about the momentum you have there – the good orders that you have in 4Q, I mean, do you have any kind of sense on sort of hitting that 20% target to the timeline look more in view today than it has over the past couple of years I imagine and just trying to think about that – what you see out there is a reasonable timeline to get there?

[Ronald Armstrong:]

Yes. So if you look at 20 years history, we were at 10% 20 years ago and now we’ve progressed to 16.6%. So is 20 in our sights? Absolutely. And a key reason for the success this year was that model year 17 truck that was an excellent investment both from a performance standpoint, a parent standpoint, fit and finish standpoint. So it’s – the truck has just gotten better and better and we’re continuing to make investments for the future. And I think it’s just as we’ve seen in North America, we’ve grown – in that 20-year period, we’ve grown basically 9 share points in North America from 21 to 30. And so, yes, 20 is definitely in our sights.

[Joseph O’Dea:]

Great. Thanks very much.

[Ronald Armstrong:]

Thank you.

[Operator:]

Our next question comes from the line of Neil Frohnapple with Buckingham Research. Your line is now open.

[Neil Frohnapple:]

Hi, guys.

[Ronald Armstrong:]

Good morning, Neil.

[Neil Frohnapple:]

Hi, guys, good morning. At the Investor Day, Ron, you guys talked about the potential down the road of expanding further into China. Can you provide any commentary here as the vision changed at all with all the crosscurrents?

[Ronald Armstrong:]

Yes. It hasn’t changed. We continue to look for window of opportunity that can provide a return. And that’s the challenge in China is finding the right combination where you can get a reasonable return. Harrie, Preston and I was well travelled there in the last several months. And so we continue to be there, evaluate it and the window will open, but it’s just – it’s an area of future opportunity and we’ll continue to evaluate just there as we do other parts of Asia.

[Neil Frohnapple:]

All right. And then can you provide an outlook for the North American medium duty market. It seems to show more signs of life and exhibit faster growth in 2018. So, yes, just curious on what your thoughts are for that market in 2019?

[Ronald Armstrong:]

Yes. The Class 6 and 7 market, which is where we play is roughly 100,000 trucks in 2018. And Peterbilt and Kenworth achieved record deliveries, record market share of 17.5%. So the products that we have are doing great. And just like everything else, we’ll continue to make investments into product enhancements as we go forward. And as time goes on, more and more and more of our dealers get more engaged in that business. And so as we look at 2019, we think 100,000 trucks is probably a pretty reasonable approximation of that market for this year.

[Neil Frohnapple:]

Okay. Thanks, Ron. I’ll pass it on.

[Ronald Armstrong:]

Sure.

[Operator:]

Our next question comes from the line of Adam Uhlman with Cleveland Research. Your line is now open.

[Adam Uhlman:]

Hi. Good morning, everybody.

[Ronald Armstrong:]

Good morning.

[Adam Uhlman:]

Yes, I was wondering if you could talk about the MX engine. I think, I heard earlier, Ron you mentioned, adding some more machining capacity. I assume you’re kind of maxed out on production today, but maybe correct me if I’m wrong? And what what type of growth should we expect in that business either in terms of penetration or production rates in 2019? Is that investment comes online?

[Ronald Armstrong:]

Yes. So the – we’ll start making those investments in 2019. The – coming online is probably 2020 and we’ll – that’ll be able to support the increased penetration. As we said before, the MX engine basically will support 80% of customer applications and it just takes time to increase that penetration. We could put more in today if we had the capacity. And so that’s why we’re making the additional investments and we’ll continue to see that penetration grow to 50%, 60% over the coming near-term period, I think.

[Adam Uhlman:]

And where did we end in 2018?

[Ronald Armstrong:]

Just over 40 in North America. And, of course, it’s 100% for all the DAF products that get sold in Brazil and Europe. And so, I think overall for PACCAR, it’s about 60% penetration for all of PACCAR.

[Adam Uhlman:]

Gotcha. And then can we switch back to Europe and could you talk about what you’re seeing in used truck pricing there? And then is there any difference between Western Europe or Eastern Europe? Any kind of changes would be helpful? Thank you.

[Ronald Armstrong:]

Yes, pricing is pretty steady. Not seeing any appreciation, but just pretty steady. And demand – more of the used trucks tend to go towards Central and Eastern Europe. That’s also a big growth area for DAF for new trucks. DAF is the leader in the Central European markets. And so that’s steady as she goes is how I would think about it, that’s what we saw in 2018, that’s how we’re thinking about 2019 at this point.

[Adam Uhlman:]

Great. Thanks.

[Operator:]

Our next question comes from the line of Scott Group with Wolfe Research. Your line is now open.

[Robert Salmon:]

Hey, good morning, good afternoon. It’s Rob Salmon on for Scott.

[Ronald Armstrong:]

Good morning, Rob.

[Robert Salmon:]

Good morning, guys. In the guidance that you provided at the midpoint, it’s implying roughly a little under 10% growth in the R&D budget. Could you talk about how we should be thinking about the R&D as we look out a few years in light of some of the emission standards changes, as well as the investments that you guys are making into some kind of new trucking products? And what’s the flexibility you guys have on that line item, if we do kind of encounter an industry downturn in 2020?

[Ronald Armstrong:]

Well, the flexibility of managing cost structure is a real strength of PACCAR, and we can manage that quite well. But also, we’re making some great investments as we always do in the products for the future. I would say incrementally, we’re going to see – we’re seeing more investments in R&D on the alternative powertrain and software development side. That’s where the intellectual property is being created and we’re making those investments there and we continue to make good strong investments in diesel poweredtrains. We’ve got emissions requirements being enhanced in really all of our markets. And so we continue to invest in those arenas and in the new products of the future that are going to get us to those market share goals that we talked about earlier.

[Robert Salmon:]

Okay. That makes sense. With the record backlog, has that given you any ability to kind of make the pricing, as well as the orders be much more firm throughout kind of 2019, just given that we’re looking at roughly a 12-month delay in terms of when a truck is ordered to when it gets produced today?

[Ronald Armstrong:]

The pricing has been negotiated, agreed, and that’s representative of our market price and the great value that our products bring to our customers. So it’s pretty well set.

[Robert Salmon:]

That makes sense. That’s what we’re hearing from your end customer as well here. So I appreciate the time, guys.

[Ronald Armstrong:]

Sure.

[Operator:]

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

[Joel Tiss:]

Lovely, guys, too much I can’t stay away.

[Ronald Armstrong:]

I appreciate it, Joel.

[Joel Tiss:]

I just wondered if you could talk a little bit about your approach on autonomous. Are you guys going to outsource that whole process, or are you thinking that there – that there’s parts of that, that you’d like to take control of, or just give me a little sense in that regard of how you guys are thinking about that?

[Ronald Armstrong:]

Yes. We’re still working through that, Joel. We’ve worked with quite a few companies who are developing autonomous technology. So partnering with them, but we’re also developing our own capabilities. We have our Silicon Valley Innovation Center and we’ve hired a software engineer specifically focusing on develop – developing our own level for capability. And so, we’re very focused on, again, sort of like alternative powertrains, trying to figure out where we want to have the intellectual property and where we want to partner with others on developing that capability.

[Joel Tiss:]

Okay. Thank you. Everything else has been asked already. Thank you.

[Ronald Armstrong:]

Okay. Thanks, Joel.

[Operator:]

There are no other questions in queue at this time. Are there any additional remarks from the company?

[Ronald Armstrong:]

We’d like to thank everyone for joining the call and thank you, operator.

[Operator:]

Ladies and gentlemen, this concludes PACCAR’s earnings call. Thank you for participating. You may now disconnect.