Cummins' CEO Discusses Q4 2012 Results - Earnings Call Transcript

| About: Cummins Inc. (CMI)

Cummins Inc. (NYSE:CMI)

Q42012 Earnings Call

February 06, 2013 10:00 am ET


Mark Smith - Executive Director of Investor Relations

Tom Linebarger - Chairman of the Board, Chief Executive Officer

Patrick Ward - Chief Financial Officer, Vice President

Richard Harris - Vice President, Chief Investment Officer

Richard Freeland - Vice President, President of Engine Business


Stephen Volkmann - Jeffries

Tim Denoyer - Wolfe Research

Jamie Cook - Credit Suisse Securities

Robert Wertheimer - Vertical Research Partners

David Raso - ISI Group

Jerry Revich - Goldman Sachs

Mike Shlisky - JPMorgan

Andrew Kaplowitz - Barclays Capital


Good day, ladies and gentlemen, and welcome to the fourth quarter 2012 Cummins earnings conference call. My name is Darcella and I will be your coordinator for today. At this time, all participants are in listen-only mode. Later, we will conduct a question-and-answer session. (Operator Instructions)

I would now like to turn the conference over to your host for today, Mr. Mark Smith, Executive Director of Investor Relations. Please proceed.

Mark Smith

Thank you, and good morning, everyone. Welcome to our teleconference today to discuss Cummins' results for the fourth quarter of 2012. Participating with me today are our Chairman and Chief Executive Officer, Tom Linebarger, our Chief Financial Officer, Pat Ward, and the President of our Engine Business, Rich Freeland. We will all be available for your questions at the end of the conference.

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 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 any subsequently filed quarterly reports on Form 10-Q.

During the course of this call, we will be discussing certain non-GAAP financial measures and we 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 under the heading of Investors and Media.

Now, I would like to turn it over to our Chairman and CEO, Tom Linebarger.

Tom Linebarger

Thank you, Mark. Good morning, everyone. I will start with a summary of our fourth quarter and full year results, and then I will also talk about our outlook for 2013. Pat will then take you through more details of our fourth quarter financial performance and our forecast for this year. In the fourth quarter we made good progress in reducing inventory throughout the supply chain and largely completed our restructuring actions.

During our second quarter earnings call we targeted $200 million in inventory reductions in the second half of the year. As demand continues to weaken, we made more of the cuts to production in the fourth quarter. Excluding the impact of acquisitions and currency movements, we reduced inventory by $355 million in the fourth quarter for a total reduction of $428 million in the second half of the year. We expect to make further improvements in working capital efficiency this year.

Revenues for the fourth quarter were $4.3 billion, a decrease of 13% compared to the fourth quarter of 2011. Fourth quarter EBIT, excluding one-time items, was $552 million compared to $677 million in the same quarter last year, resulting in a decremental EBIT margin of just under 20%. Revenues in the engine business, components and power generation all declined year-over-year, as we experienced weak demand in most major markets. Revenues in the distribution business were essentially flat year-over-year excluding acquisitions.

Reviewing 2012 overall, demand in the U.S. Start out strong but weakened as the year progressed. In Brazil and China, we expected a difficult start to the year but the anticipated and improvement in the second half did not materialize with the economies of both countries continuing to slow. After a solid first quarter of 2012, the Indian economy also faltered with the third quarter GDP the lowest in a decade. Europe remained weak all year as expected and markets in the Middle East and North Africa were negatively impacted by events surrounding the Europe's spring.

For the full year Cummins sales were $17.3 billion, a decrease of 4% year-over-year. Despite lower revenues, we were able to deliver record gross margins in 2012 due to lower product coverage costs, lower material cost and supply chain improvement. Full year EBIT margin, excluding special items, reached 13.7% in 2012, a decrease from 14.2% in 2011. EBIT decreased as a percent of sales due to lower joint venture earnings and continued investments in selling, admin and research activity to support the future growth of the company, which offset improvement in gross margins.

Before I turn to our outlook, I would like to make a few comments about some of our key markets in 2012. Our revenues in North America grew 9%, but this simple statistic does reflect the changes we experienced as the year progressed. After seeing year-over-year growth of 40% in the first quarter, growth slowed to 12% in the second quarter, 2% in the third and fourth quarter revenues actually dropped by 8% as the slowing U.S. economy and decline in business confidence impacted demand across multiple end markets.

The North American heavy duty truck market reached approximately 250 units in 2012, the increase of 9% over 2011 levels. Our full year market share was 39%, up from 38% the year before and we delivered a record number of ISX 15-liter engines in 2012. The U.S. medium-duty truck market reached approximately 107,000 units in 2012, an increase of 9%. We continue to be the market leader in medium-duty truck engines with a market share of 52%.

We enjoyed very strong demand from Chrysler for the Dodge Ram with engine shipments increasing by 37% year-over-year. In December, we delivered our 2 millionth engine to Chrysler, reflecting the successful partnership between our two companies and a strong customer demand for the Ram truck combined with the Cummins' engine.

In our power generation business, demand in our traditional market segments, including non-residential construction, soften in the second half of the year. Fourth quarter sales were actually down 19% year-over-year as the U.S. economy slowed. The weakness in our traditional markets was offset by growth in sales of generator sets to the U.S. military.

Our international revenues decreased by 15% in 2012, with the most significant declines in Brazil, China and Europe. In Brazil, our revenues declined 38% driven by the weaker truck market. Industry truck production declined by 37% as a result of the weakening economy and the impact of the transition to Euro IV emission standards.

Full year revenues in China, including joint ventures were $2.6 billion in 2012, a decrease of 20% year-over-year. The China construction industry continued to experience weak demand for new excavators through the end of 2012 with fourth quarter excavator sales of excavators down 25% year-over-year. Full year industry sales declined 35%, in line with our previous guidance. There is still significant overhang of inventory both, in distribution channels and in OEMs that will dampen new equipment production in 2013, even after the end market begin to recover.

The truck market in China for medium and heavy-duty trucks combined, declined by 21% for the full year as the slowing economy impacted the utilization of existing truck fleet and depressed demand for new trucks. Demand for trucks stabilized in the fourth quarter. Demand for power generation equipment declined sharply in the second half of 2012 as the Chinese economy slowed. Full year revenues declined 15% year-over-year.

As a reminder, revenues in 2011 were boosted by wide spread power shortages in the country. Full year revenues in China, Full-year revenues in India, including joint ventures were $1.[505] billion, down 10% due to weaker truck market and the impact of the depreciation the rupee [the] U.S. dollar. The truck market in India weakened significantly during the second half of the year with full year industry production declining by 14% to 318,000 units. A slowing economy coupled with the government's decision to eliminate fuel subsidy negatively impacted truck demand [the] economic trends power generation sales remained strong all year due to widespread power shortages with full year unit growth of 18%.

In Africa, our revenues for the full year excluding currency impacts were flat year-over-year, which was disappointing. We made good progress in Ghana, almost doubling sales year-over-year. In, Angola, we also generated growth, however it took longer than anticipated to get our new Angolan distribution business operational, so we fell short of our targets for the year. We also fell short of plants in Nigeria. It is early days for us in our strategic efforts to build capability in Africa, but I am confident that with the additional investments we have made in people and training that we will deliver better performance in 2013. We also experienced we demand both, in Europe with total revenues down 13% and in the Middle East, where revenues declined 11%. In both regions, our power generation business was the most negatively impacted.

Now, I would like to provide our overall outlook for 2013, and then comment on individual regions and end markets. Due to continued weakness in developing economies and continued uncertainty in the U.S., we are currently forecasting total company revenues to be flat to down 5% in 2013. We expect EBIT to be in the range of 13% to 14% of sales. In North America, we expect our on-highway business in the aggregate to be relatively flat to 2012. Shipments to Chrysler are projected to decline 10% following a very strong year in 2012, as Chrysler manages a new model change beginning in the first quarter.

We forecast that 2013 market size for heavy-duty trucks to be 240,000 units, a decrease of 4% year-over-year with our market share projected to be approximately 40%. In the medium-duty truck market, we expect the market size to increase slightly to 109,000 units and we expect to maintain our market share of 52%.

In China we expect domestic revenues including joint ventures to increase 5% in 2013. We do not expect growth in sales of our engines to excavator OEMs as the industry needs to work through high levels of equipment inventory. If there is a strong spring selling season in construction equipment, industry equipment inventory levels will fall but demand for new production will still lag until inventory levels throughout the supply chain are reduce and market confidence increases.

We expect the market size for heavy and medium duty trucks in China in 2013 to be similar to 2012 levels. As you are aware, there is an emissions change scheduled for July 1, 2013 with the planned introduction of National Standard 4 or NS4, which is roughly equivalent of Euro IV standards. Based on our discussions with Chinese regulatory bodies and industry participants, we remain confident that NS4 will be introduced on July 1. Encouragingly the only engines to receive certification of the NS4 standard so far are electronic engines, which contrasts with the Euro3 when both mechanical and electronic engines were approved, which contributed to a difficult and lengthy transition to Euro3.

In major cities in China, you can now find urea tanks and pumps at some viewing stations but these are not yet widespread. Despite these encouraging signs, it is not clear how broadly and how quickly the new regulations will be adopted. The current order board for the first quarter and OEM forecast for the first half of 2013 do not suggest a pre-buy prior to the introduction of NS4 providing strong indication that the market anticipates inconsistent enforcement, at least initially.

In India we expect total revenues including joint ventures to be flat year-over-year. Demand for power generation equipment remains strong, due to ongoing power shortages and we currently project unit growth of 12% and revenue growth of 9% in 2013. In the commercial vehicle market though, we are now anticipating industry sales of 303,000 units. In 2012 the Indian government increased excise taxes on commercial vehicles and last September announced the removal fuel subsidies that effectively increase the price of diesel by 14%. Only this month the government announced further declines in fuel subsidies that will increase consumer fuel prices by a further 15% over time.

We expect these further actions were negatively impact truck sales, especially given the sluggishness of the overall economy [AUDIO GAP] and a very challenging 2012. Although truck production has been slow to recover in 2012 we did see industry retail sales exceed industry production in the fourth quarter for the first time in more than a year. The industry ended 2012 with a truck inventory of 66,000 trucks, down significantly from 114,000 at the end of 2011 and consistent with levels experienced in 2008 through 2010.

The Brazilian economy appears to be improving slowly and we expect demand for engines and aftertreatment systems to improve steadily through the year. In power generation, we expect demand to increase by 9%, driven by infrastructure spending and ongoing good reliability issues.

In Europe, it is hard to see a catalyst for growth in the near term given the weak (inaudible) economy and austerity measures planned in multiple countries. Our business with the largest exposure to Europe is power generation, and our largest individual customer in Europe has already announced significant cuts in capital expenditures.

I think it is also important to comment on our global mining business. Typically, during a downcycle in mining activity, we observe three successive phases of adjustments to mining operations by industry participants. First the mining companies announce cuts to future capital expenditure plans, which has little or no effect on current orders. This happened of course during the first half of 2012. Second, we experience cancellations of existing orders from mining equipment OEMs. Third, depending on the depth of the downcycle, we see a declined aftermarket revenues as equipment in used less and service work is deferred.

During the second half 2012, we observed all three phases of adjustment to mining activity. In the fourth quarter of 2012, our shipments of engines for mining equipment declined by 30% driven primarily by weaker demand from international markets. Our aftermarket revenues decreased by more than 10% in the fourth quarter with lower demand for parts and engine rebuilds, we currently have a very weak order board heading in the first quarter of 2013, and we anticipate that our total mining revenues including aftermarket could decline by as much as 25% for the full year. We do know that when confidence improves, the business can come back very rapidly and we will be ready to meet increased demand when it returns, but at this time the outlook for our mining business is the weakest of any major end market that we serve.

2012 proved to be a challenging year with mark change in business conditions in the second half of the year, but we have a very experienced leadership team at Cummins that is well versed in managing through periods of volatility. We start 2013, with a high degree of uncertainty about business conditions in several markets, but the work we have undertaken to reduce costs and lower inventory should benefit the company when the global economy improves.

I would like to acknowledge the contribution of all of our employees around the world for their hard work in 2012, for their support and agility reaction to changing marketing conditions and for their efforts to reduce cost and still meet our commitments to customers and shareholders. Finally, I would like to thank our customers for the continued confidence in Cummins.

Thanks for your interest today, and now I'll turn it over to Pat, who will cover our 2012 performance and 2013 guidance in more detail.

Patrick Ward

Thank you, Tom, and good morning everyone. As Tom described, we faced challenging conditions in many of our markets in 2012, with demand weakening across a number of geographies and end markets in the second half of the year. We responded to the changing market conditions with a number of actions that were intended to reduce costs and position the company to deliver stronger financial performance when market conditions improve.

Specifically, we reduced discretionary expenses as evidenced by the reduction in operating cost in the fourth quarter. We largely completed our restructuring actions by the end of 2012. We aggressively lowered build rates at the manufacturing plants which allowed us to reduced inventory by more than $400 million in the second half of the year, excluding the impact of acquisitions and we maintained our investments in product development and critical growth initiatives.

Full year revenues for the company were $17.3 billion, a decrease of 4% over the prior year. Despite the low revenues, we were able to deliver record full-year gross margins of 26.2%, an increase of 80 basis points over 2011, as a result of lower material and supply chain costs, improved pricing and ongoing cost reduction initiatives in our manufacturing plants.

Selling, administration and research and development costs increased by $139 million in the year with over two-thirds of the increased relating to research and development's investments and joint venture income was $32 million compared to last year reflecting the weaker markets in China. In total, earnings before interest and tax or EBIT, excluding the restructuring charge in the fourth quarter was 13.7% of sales in 2012, down from 14.2% of sales, excluding the gains from the divestiture of two businesses and from the flood insurance settlement in the previous year.

Net income was $1.66 billion or $8.74 per share. Excluding restructuring charges and gains from divestitures, net earnings were $1.7 billion or $8.90 a share. This compares to $1.75 billion or $9.07 a share in the previous year, excluding the gains from the divestiture of two businesses and from the flood insurance settlement. The operating tax rate for the full year was 26% with one-time items [reducing] in all-in of the rate of 23.6%.

Now let me comment specifically on the fourth quarter and provide some more details on our performance. All the numbers in comparisons exclude the $52 million pre-tax benefit or $35 million after-tax restructuring charge that we took in the fourth quarter of 2012 and the gains from the divestiture of two businesses and from the flood insurance settlement in 2011.

Revenue of $4.3 billion was 15% lower than the previous year, but increased 4% from third quarter levels. Compared to the prior year, North American revenues were down 8%, as a result of a decline in the heavy-duty truck market and oil and gas market, partially offset by increased shipments to Chrysler and in the North American bus markets. International revenues were down 18% due to weaker demand in the Brazilian truck market and lower demand for power generation, construction and mining equipment. Quarter-over-quarter growth was driven by increased revenues in the distribution business, primarily from the impact of acquisitions and from some improvement in North America, Europe and in Africa.

Despite a drop in volumes, gross margins for the quarter were slightly higher than a year ago at 25.3% of sales with improved pricing and lower material costs offsetting the impact of lower volumes and higher product coverage cost. Sequentially, gross margins were unchanged from the prior quarter with cost reductions, both material and operating cost, offsetting increased product coverage cost and an unfavorable product mix.

Selling, admin and research and development costs decreased compared to both the prior year and the prior quarter, as we saw the benefit of reduced discretionary expenses and other cost reduction actions. Cost decreased by $42 million or 6% compared to the fourth quarter of last year and declined $9 million or 1% sequentially.

Joint venture income was $82 million, 19% lower than the prior year and 13% lower than the prior quarter. The year-over-year decline was driven primarily by lower volumes of our engine joint ventures in both China and in India. The sequential decline was driven by lower revenues in North American distributors.

Earnings before interest and taxes were $552 million or 12.9% of sales, down from 7.8% a year ago but up from the 12% we reported in the third quarter. The significant drop in volume along with weaker joint venture earnings and higher warranty costs as a percent of sales were the most significant drivers of the lower EBIT margin. Sequentially. EBIT margins improved due to both lower material and operating costs. Net earnings for the quarter excluding restructuring, were $416 million or $2.21 per diluted share, which includes a one-time tax benefit of $0.21 per share.

Moving onto the operating segments, let me highlight their performance in the fourth quarter and conclude with the revenue and profitability expectations for 2013. In the engine segment fourth quarter revenues were $2.5 billion, down 18% compared to last year and a decline of 1% compared to the third quarter. Compared to the prior year, stronger demand for bus and light duty engines in North America was more than offset by reduced demand in the Brazilian truck market, heavy-duty truck and bus markets in North America, global construction and in international mining markets.

Segment EBIT margins were 10.9% in the quarter compared to 12% last year and 9.5% in the prior quarter. Compared to the prior year, lower volumes and weaker joint venture earnings negatively impacted EBIT margins, partially offset by improved pricing and lower material costs. Compared to the third quarter improvements in material and manufacturing costs and lower spending contributed to the improvement in EBIT margins.

In 2013, we expect revenues to be down 5% and EBIT margins are forecasted to be in the range of 10% to 11% down from 11.8% for the full year of 2012 but an improvement over second half 2012 results. Fore volumes with a less favorable product mix, along with higher warranty rates and lower joint venture income are the key contributors to the year-over-year margin drop. This will be partially offset by material cost, pricing and supply chain benefits.

In the components segment, fourth quarter sales were $939 million, down 14% over the prior year, primarily driven by reduced demand in the North American heavy-duty truck market and lower demand in Europe partially offset by increased demand for aftertreatment systems in Brazil following implementation of Euro V emission standard.

Sales were flat compared to the fourth quarter with the significant changes in an individual markets. EBIT margins for the quarter were 8.9% of sales compared to 12.1% in the prior year and 9.5% in the third quarter. The decrease in margins over the prior year was driven by lower volumes and increased investment and technical spending to support future growth. Compared to last quarter, increased spending on research and development on flat sales negatively impacted margins. We expect revenues to be up 2% in 2013, with increased penetration of aftertreatment systems in the North American heavy-duty truck markets and growth in the Brazilian medium-duty truck market being offset by weaker demand in the truck markets in both, India and in Europe.

EBIT margins are expected to be in the range of 10.5 to 11.5 [of sales] with lower material cost and supply chain savings been partially offset by increased technical spending and product coverage costs. This compares to 10.8 for full-year 2012, and just over 9% in the second half of the year.

In the Power Generation segment, fourth quarter sales were $765 million, down 17% from last year due to lower demand in Europe, the Middle East, Latin America and China, partially offset by better demand in North America. Sequentially, revenues declined by 6% due to weaker demand in China, Europe, the Middle East and in Africa.

EBIT margins were 7.1% of sales in the quarter compared to 9.5% in the prior year and 9% last quarter. Compared to last year, margins declined due to lower volumes and increased technical spending focused on new products. Sequentially, margins declined due to lower volume and lower joint venture income.


For 2013, we expect power generation sales to be down 3%, primarily due to continued weakness in Europe and in the Middle East, with EBIT margins in the range of 9% to 10% of sales. This compares to 9.1% for full-year of 2012, and just over 8% in the second half of last year. Positive pricing impacts as well as productivity improvements and targeted actions to reduce overcapacity in some parts of the business will drive the majority of the margin improvement.

For Distribution segment, fourth quarter revenues were $907 million, an increase of 9% over the fourth quarter of 2011, which is mainly driven by acquisitions. Revenues increased 13% over the prior quarter due to acquisitions and some growth in whole good sales in North America, Europe and in Africa.

EBIT margins for the quarter were 10.8% of sales, compared to 10.4% a year ago and 12.4% in the third quarter. Compared to the prior year, margins improved due to lower spending, partially offset by weaker joint venture income. And compared to the third, quarter margins were impacted by lower joint venture income and a mix shift away from aftermarket towards whole goods.

2013, we are forecasting 10% growth in revenue over the prior year, including the impact of acquisitions and expect EBIT margins in the range of 11.5% to 12.5% of sales. As Tom mentioned, we are now projecting total company revenues to be in the range of flat to down 5% in 2013. We expect a challenging first quarter, however based on improving economic data points in some regions, we do expect demand to start to improve in the second quarter and be up year-over-year in the second half of 2013.

Tom has already covered the assumptions for a number of key markets in 2012, and you can also refer to our earnings presentation for additional information.

We expect EBIT margins of between 13% and 14% for 2013, and this compares to 13.7% for full-year 2012 and 12.5% for the last six months of the year. We remain focused on driving improvements in the gross margin in 2013, despite relatively weak revenue outlook.

Gross margins are expected to benefit from price realization of between 0.5% to 1% from lower material costs of approximately 0.5% based on current assessment and 0.2% from our supply chain initiatives. Offsetting these items will be higher warranty costs and an arduous product mix within the engine business. We are currently projecting the tax rate to be approximately 26% in 2013, excluding any discrete items.

Finally, let me turn to the balance sheet and cash flow. We generated $1.5 billion in cash from operating activities in 2012, and continued to use our cash to reinvest back into the company and return value to our shareholders. We've raised our dividend by 25% in 2012, and the board recently authorized an additional $1 billion share repurchase plan.

Our pension plans remain very well funded and our debt-to-capital position at the end of year was 10%. Our strong balance sheet allows us to continue to invest in the business and return value to shareholders. We invested $690 million in capital expenditure projects in 2012 and expect investments of approximately $850 million in 2013. Key projects include continuing development of new high horsepower engines, on-highway natural gas engines and investing in our global technical centers, which will allow us to maintain our position as a leader in emissions compliance and fuel efficiency.

Finally I wanted to share with you that we will hold our analyst day on September 17 at the New York Stock Exchange. Now let me turn it back over to Mark.

Mark Smith

Thanks, Pat, and operator, we are now ready for questions. If you can please ask one question and keep it to one related follow-up, we are fine with one related follow-up. Thank you very much.

Question-and-Answer Session


(Operator Instructions) Your first question comes from the line of Stephen Volkmann. Please proceed.

Stephen Volkmann - Jeffries

I am wondering, Tom, if we could ask you to go a little deeper on some of your end-market outlook. Here you talked about mining, very helpful. What about things like oil and gas and construction? Just maybe go around it more a little bit and tell us what you are seeing and thinking here?

Tom Linebarger

Yes. So, oil and gas, we continue to see weakness in the U.S. That has not changed really. We still at gas prices which have slowed down the fracing business significantly. It has improved a little recently but not enough to move the numbers. So we are still seeing weakness and in fact we will it weaker year-over-year. I think it is about 10% down year-over-year.

In China we are seeing a little bit better. That’s a small number for us in relative terms. U.S. is still our largest market though it doesn’t, in no way, goes to offset it, but we are seeing outside the U.S. some increased activity. But overall it's down year-over-year for us, in oil and gas.

Construction is basically flat. We did see some improvements in construction markets in the second half of the year. Not in the U.S. anyway. China, you have got to hear all my China remarks and it was a pretty rough year in China. There is a lot of talk now about a strong spring selling season in China and that would be awesome. It's not going to do enough. We do not think it changed engine demand because you have to get rid of inventory. In the field, you have equipment inventory and engine inventory and by the time you get rid of all of that, it is going to be a real monstrous selling season to really get demand for engines moving in the near term. So our view is it's going to be pretty weak.

You asked about AG which is a pretty small market for us, but Mark, do you have any comments on AG?

Mark Smith

It is improving a little bit in Latin America. It is relatively modest piece of the business.

Tom Linebarger

Anything else? Any other markets, Steve?

Stephen Volkmann - Jeffries

It is probably good. Thanks. Maybe I will just ask my related for all the others. Just, Pat mentioned 1Q would be the weakest. I think we all expect that but is there any more color you would like to give us? Or are we on our own there?

Patrick Ward

Yes, I will give you a little bit more color. Essentially, as you look at the year, clearly it is going to be the opposite of what we have experienced in 2012 where the first half of the year was very strong and as you enter second half was relatively weak. As I look into 2013 and if you go through the midpoint of our guidance, it would not be unreasonable to think first half sales to be down in the range of 10% year-over-year. Obviously, first quarter will be more challenging than that but then we would expect some recovery in the second half. So second half would be up somewhat, maybe 5% compared to the second half of last year.

Stephen Volkmann - Jeffries

Thank you very much.


Your next question comes from the line of Tim Denoyer with Wolfe Research. Please proceed.

Tim Denoyer - Wolfe Research

Good morning. I guess a couple of questions around the North America Class A, if I could. Are you expecting market share for 2013 to be roughly flat? Did you see in the fourth quarter any customer inventory build ahead of the new ISX that launched in 2013?

Richard Harris

Yes, this is Rich. Didn’t see much of pre-buy at all from much customer builds. So don’t see any overhead in there. As Tom said before, we are projecting 40% and you ought to think of that as relatively flat, but probably a little better second half of the year than first half of the year. We get to the year at about 37% this year, so we were 38 a year ago or two years ago, we were 39% last year and we projected 40% this year.

Tim Denoyer - Wolfe Research

Okay. That 40% includes, can you give a sense of what it includes for Navistar?

Patrick Ward

No. We won't comment on the specifics there,

Tom Linebarger

But Tim, you know one way to think about all this, we talked about this before, but what we've got of course is different shares at different OEMs, and so part of our goal is to be available in more OEMs, and of course the our business with Navistar helps with that and the other thing we are trying to do is help those truck suppliers who are selling more of our stuff win one market, so a lot of it has to do with how they do in the marketplace. And so, you know, we are of course trying to drive more PACCAR trucks with Cummins' engines in it and more Freightliner trucks with midrange engine, so we are trying to drive those sales and help those customers using our engines sell more trucks and those that makes also affects how you see our market share. So that's why even though we gave you the number for the full year in fact as Rich said, our fourth quarter market share was 36 to 37 and the full year was 39. That just gives the mix of what gets sold it just changes quarter-to-quarter.

Tim Denoyer - Wolfe Research

Thanks very much. I'll get back in line.


Your next question comes from the line of Jamie Cook. Please proceed.

Jamie Cook - Credit Suisse Securities

Two questions, and I appreciate the top line guide, because who knows what's going to happen in macro, but I guess (Inaudible) which markets do you feel like have the potential for more upside relative to sort of what you are guiding today. Just based on anecdotally what you are you hearing from customers and just share sort of own view of the market, and then I guess my second question relates to the margin guidance and just margins longer time. I was impressed with the margins you put up in the quarter given the environment that you are in and as I think about the inventory issue going away and I think about some of the restructuring that you did and potentially volumes getting better. I don't know the low end of the margin guide doesn't seem realistic to me, so can you sort of help me through that and just sort of help think thorough how I should think about incremental assuming markets to improve. Thanks.

Tom Linebarger

So, Jamie, I can make a few comments and Mark may have a few to add. Obviously from our point of view, we tried to call the market in the middle not to be overly negative or overly positive, so I guess my broad view not to be glib is that you all of them have a chance to overachieve and many have a chance to underachieve. The reason we do not have very good visibility is the truth. I mean, if we look out today, we expected second half of last year to see improvements in most developing economies and we did not see them.

As you know, in our previous calls we were consistently disappointed especially by China. We thought with the new government got ceded in, we'd see some improvement and we did not see that. We saw stabilization in the truck market by the end of the year, but it was a pretty rough year for every one of our major markets in China.

Brazil, we already talked about things seem to be going the right way and they could go the right way little faster. That would be awesome. We would benefit from that. And of course, the big economies that can really make a difference in our business on U.S. and China. If the U.S., if we get our act together on budget issues and confidence build, I mean, it's not just about the budget, but it's about general confidence in the U.S. and if China kind of gets its economy back going again I think that not only helps us in those markets, but I think it drags the whole bunch of these other markets with them, including Brazil.

So, there is some really good upside if we get the two biggest economies going. I think, the reverse is also true. If we stay stagnant and figure out ways to decrease confidence in the U.S., which we have been very good at over the last 12 or 18 months, we could see worst results, and so we are just trying to say, A, we think it's going be about like it was, because we don't really have a better picture. I realize it's not a terrific.

Jamie Cook - Credit Suisse Securities

That was still helpful. That was helpful. And then Pat, just on the margins?

Patrick Ward

I will only spend a couple more seconds on the margin and then maybe Rich can talk a little about the EBU or engine business. So if you look at the total margin outlook for the company in 2013 versus the second half of 2012, we improved from 12.5% to between 13% and 14%. Given the midpoint of our sales guidance, basically what we are seeing is that second half is going to continue all the way through 2013. Now it will be different in first half and second half but for the full year that is running out.

So, on flat sales, we are seeing improved margins, not just for the company then each of the four operating segments too. The one segment that is probably under more margin pressure in 2013 is the engine segment. I talked to some of the reasons in my structured comments but we are seeing more volumes, we are seeing an unfavorable mix as we see a drop in high horsepower engines, in mining, oil and gas and power GEN markets. We are expecting warranty rates to higher in 2013 and that’s due to the launch of 2013 engines.

We always tend to take a more conservative view when we launch new engines and the warranty rates will definitely be higher and we are expecting more joint venture income with the startup of some new joint ventures in China and in South Korea. So all those factors put into the engine segment being a little bit lower than what you would maybe thinking? Rich, there is anything you want to add to that?

Richard Harris

I think you covered it all.

Tom Linebarger

But again, Jamie, we are not really taking a conservative view there either. We have done the math and said, as you know, we think driving margins on flat sales and certainly on up sales is our job, as a management. So we have pushed very hard on that in our guidance to say we expect to drive better margins on flat sales or even slightly down sales.

But there are a couple of trends there that Pat highlighted to you. They are real that we are going to have to manage. You know the formula we drive on warranty. When we launch a new product we just push up the rates. We don’t have any experience. We just push them up. That is just what we do and then as we deliver the product and we get better results than our projected rates, we bring them back down. That’s, again, we do that every time and our last set of launches in heavy-duty, we had great results there and because we had good launches and we expect the same in 2013 but we have to let the numbers play out and we have to let the process play out. That is just the thing we do.

Patrick Ward

The other part of the question, Jamie, when you were asking for some comments on long term incremental margins. I don’t think we have changed our position on that at all. They are, over the long term, 20% incremental EBIT margins is still the target for the company.

Jamie Cook - Credit Suisse Securities

Okay, thanks.

Tom Linebarger

Jamie, just one last thing. Pat alluded to it, but we are continuing our investment, and in fact, it ramps up on flat to lower sales on some of the big growth initiatives. So like the high horsepower engine for fuel economy improvements for additional tier 4 set for market. So we are continuing the investment on our side, in fact, increasing it in 2013.

Richard Harris

That’s not just unique to engine. It is also true for components as well.


Your next question comes from the line of Robert Wertheimer with Vertical Research Partners. Please proceed.

Robert Wertheimer - Vertical Research Partners

One structural question on how you approach the restructuring that you did? Did you worry that you might just be adding back people in six or 12 months and there is a frictional cost above the actual termination expense and the training and retraining? Were you thinking about a two-year issue when you did this? How do you put it?

Tom Linebarger

Rob, I always worry about that. I think it is always a risk any cyclical business that you take cost bringing people on and then when you reduce some of your pay again and have to have to bring it back on. We experienced some of that in the '08, '09 downturn. The issue is, and each time these things come, you don’t really know how long they are going to last. So there is a little part of our business where we have quite flexible arrangements in our plants that allow us to bring people on relatively quickly and with very low frictional cost and those we manage well and we have no issues.

With professional, especially engineering people and things, that sort of issue is much more complicated. The way that we try think of it is we always make sure that we deal with the part of our workforce where we think there has performance issues or they are not doing as well as we hope they do or they not a good fit we do those first. In that way, while there may be frictional cost we feel like we are always trading up. The second thing we do is look and say how long do we expect the downturn to last and based on that, how much action should we take. It is always a judgment call. We have made as best a judgment as we could in this last set of reductions and I think that was related to my comment that many of us have been through this four or five times over our career. It's not that it's fun any time, but you just get a little better at making the judgments to the more times you have to do it.

Robert Wertheimer - Vertical Research Partners

Okay. That was helpful. This is my second question. To the extent you can are you able to comment on Dongfeng and the developments there with the JV partnered. Do you see any medium-term risk of engines getting pushed out?

Tom Linebarger

Yes. So that announcement, Dongfeng announced a partnership they are doing with Volvo and I think you probably know this, but have been partners with Dongfeng from more than five years now. A year before last, I went out to their 25th anniversary and whole bunch of our leaders met with some of their, there's was a bunch of theirs, and we realized that over the course of that time, they have had multiple partners, they have continued to buy engines, make engines themselves during that entire 25 years and bought engines from others over that 25 years.

Unfortunately despite my best intentions, I most of my customers decided they are going to buy from some other people or make their own as well. That's not different for them, so really there's not a big strategic shift here. I mean it is (Inaudible) strategy in any of those 25 years and what's more they have global intentions for their truck business and they need partners to help them with that, so they were thinking about their truck business and how they want to grow that and so they think Volvo was a good partner for them.

In medium-term, here's a couple of things to think about. We now have roughly little under 60% share at Dongfeng, so we are very successful in getting our engines into their vehicles. We sell to nine different divisions of Dongfeng, so we sell all over and in fact we launched into four new vehicles last year, so we added more vehicles last year and every year we add more vehicles among those multiple divisions and we are continue engineer in new trucks now, so not only is it going to take a while for that joint venture to even have products that may be competitive, in the meantime we will not sit still, because we think the way we win with all of our partners. No matter whether they make their own or partner with other people is that we have a better product. They win more by working with us than by other means.

We never get the all exclusive. We're the only one choice, so we are always looking to we are going to beat them on results. So, yes, so I guess always those partnerships have a potential for threat, but our view this is not a significant change and we are continuing on with our strategy and see pretty good results in the future with Dongfeng.

Robert Wertheimer - Vertical Research Partners

That's great. Thank you very much.


Your next question comes from the line of David Raso with ISI Group. Please proceed.

David Raso - ISI Group

Hi. Good morning. It's regarding the use of the balance sheet. The last couple quarters combined, the share repo was only a total of $70 million. I know the authorization was getting a bit low, but it was still I would have thought that able to do more than and now you have a $1 billion new authorization, so I am just trying to think the use of the balance sheet, because you are roughly looking at company free cash flow of $1 billion. You can pay your increased dividend and the JV investments and still have $500 million here to invest or payback to shareholders.

On top of the starting point here is your internet cash already $900 million, and we can't describe it as while you are leaving money on the table maybe for big CapEx expenditures in the future because you've already been spending a lot on CapEx. The last couple of years' CapEx has been almost 200% of the D&A, the guidance for '13 and looks like CapEx again 200% D&A, so you're definitely putting money to work there.

The use of the balance sheet, can you explain now that we are starting in New Year, how are you thinking about that Pat? It just seems like the authorization of even $1 billion should be something should be able to utilize this year and raise the dividend and still be under leverage.

Patrick Ward

Yes. Thanks, David. I don't think there was any change in outlooks how we think about using the balance sheet, using the cash we generate from what we talked about over the last years now. So, you will recall that we've talked about reinvesting between 60% and 70% of the cash we generate back into the business where we see good profitable growth opportunities and were clearly doing that. Our pension plans are very well funded. And as we look forward, we'll only have to put 5% to 10% of the cash we generate into those plans to keep them well funded and that allows us to then to return around 30% of the cash we generate back to shareholders and we do that through increasing dividend and over the few years, in fact we have tripled the dividend. So we are pleased with the progress, and we have not yet done, but we are pleased with progress. On stock buybacks, we go in to each year with our nominal target to reduce our understanding shares by 1%. If you look at just the average number of shares we had in 2011 compared to the average numbers you have in 2012, we actually came down by 2% over the full year.

So I think we would do exactly what we said we would do with regard to using our cash and using our balance sheet. I know the balance sheet is strong. We are determined to keep it strong. We have to be able to move fast when opportunities arise. We see promising growth opportunities but at the same time when market conditions turn and economies turn as they have, we have got to be able to continue to fund those most important investments the company is making.

David Raso - ISI Group

I guess at the end of the day, everything you describe just kind of ask the question, why? Why is the balance sheet that strong? What opportunities are you thinking about? Just it because you don’t somebody else thinking should we be leveraging this balance sheet for you? I am trying to understand why the balance sheet is at this level.

Tom Linebarger

It's a super question, Dave. What we are trying to do is develop a use of cash that we think serves shareholders over time the best, and again, Pat laid out the formula. I won't lay it for you again, but that formula, we think adds up to the best answer. We decreased cash, year-over-year. So it is not like we are trying to build up. We don’t have a targeted amount we want on the balance sheet.

We just want to have enough to operate and then if we exceed our expectations then we, as Pat said, we have more then to put in that formula and return to shareholders. So whenever we have more cash we will look at exactly that formula to say how do we return to shareholders and our view, we are not waiting enough for anything. We are not storing up for anything. We are not planning any big acquisitions. Nothing has changed there. All we are trying to do is make sure that we have a good conservative structure of our balance sheet so we can go up and down.

By the way, with regard to even the leverage point, if we had a good use of proceeds to borrow and lever more, we would be happy to do so. We do not feel like our leverage position is stuck where it is. It doesn’t have to be debt-to-capital of 10%. It could be higher and we have a view on that of what it could go up to. It's just that we don’t have a good use of proceeds to borrow today. So we think where we need to be on the balance sheet.

It is a good set of questions, by the way and one we ask ourselves all the time. Should we be doing something different and right now we think we are in a good spot.


Your next question comes from the line of Jerry Revich with Goldman Sachs. Please proceed.

Jerry Revich - Goldman Sachs

Good morning, Tom or Mark, on national four standards in China, I guess in the past you have spoken about providing engine customers several aftertreatment product options for those standards and I am wondering if you could give us an update on how that’s going and how optimistic are you on your ability to get your aftertreatment products on non-Cummins engines in China?

Mark Smith

Those developments are going well. We feel very optimistic that we will have our aftertreatment and other engines. I think you know we have started doing work with Dongfeng. That is one of the new platforms we have got going with them where we will provide their engines with some aftertreatment. As I had mentioned in my remarks, our big concern in the short run is, what's the implementation rate of NS 4.

We feel very good about the engineering and where our products are and our customers' interest in the product. The question is to what degree will adoption occur, especially, in the early quarters. In Q3 and Q4, how much is there going to be?

I mentioned that the approval of electronic engines is really good. That means that at least the products are ready to take on aftertreatment. That was a real mixed bag back in NS 3 period. But how fast they will put them on? What will enforcement look like? That's still a lot in the year. Again, I don’t mean to say, I know the answer but the early signs of pre-buy other things aren’t particularly good that adoption rate will be higher in the early period.

Jerry Revich - Goldman Sachs

Sure, thank you. And in a similar vein, can someone you talk about your capacity utilization in your U.S. aftertreatment facilities? You continually picked up shares since 2010 and I am wondering do you enough of roofline capacity in place if you were to pick up meaningful additional share on medium duty engine platforms?

Mark Smith

Yes, we will be fine. We feel good about capacity. As you know, we have a very strong partnership with Foresia on, what we do as stamp parts. We have good assembly capacity with them. We also have been building up our capacity to engineer and develop more products and that's really been the bottleneck as opposed to production capacity is making sure we can get enough folks on the development side with knowledge and capability to run the different programs we have and so far we are managing that, but that's our tightest spot.


Your next question comes from the line of Ann Duignan with JPMorgan. Please proceed.

Mike Shlisky - JPMorgan

Hi, there. It's Mike Shlisky filling in for Ann today. I just want to touch quickly on you natural gas engines, your CNG and LNG engines. Can you walk us perhaps on the development of your 15-liter spark-ignited engine that you guys have been talking about as well as how it's going with the 12-liter that was going to be launching with Cummins Westport at some point in 2013? As well as maybe your overall view of how the natural gas truck market is shaping up in like the U.S. and Canada?

Rich Freeland

Mike, this is Rich Freeland. To start with the 12-G, so we will go into production as planned in April and through the year we'll add more ratings and so we will start with the 350 horsepower. By August, we'll have the full line of ISX12-G through the Cummins Westport joint venture in place.

For the 15-liter's issue, as we've announced we started work on that, so that's one of the places where we are increasing investment and so what we are really sorting out is when that comes to market and so as you know there needs to be an infrastructure put in place. That's not there yet to support the long-haul. So, customers, we're talking to them. We are doing work on it. The infrastructure does need to be there. We think the 12-G introduction, which again rolls out this year and then expands in 2014 will be a piece of creating demand for that infrastructure which will help build it out.

So, we don't have an exact date on the 15. I would say when you use ISX15, I would say that we'll not be in at this point we wouldn't see there being a market for that through 2014, so we will be looking out into 2015 for the introduction of that. Again, lots of moving pieces as you know, and so what we are doing is doing investment in getting ourselves in a position that we can introduce.

Tom Linebarger

The only thing I would add to Rich's comment is we feel very good about customers' response, which again start off pretty slow, but now it's unusual to meet a fleet that either doesn't want to buy one or two and try them or wants to buy a bunch. People are very interested in trying it and I think as the infrastructure develops I think it could be a significant part of the market. And when I say significant, I don't know mean that will be the whole market. I just mean it could be a real part of the market and that's been a very marginal part of the market for all of its history now. So, there is growing interest and as Rich said, the infrastructure I think gets built when people want to fuel up trucks, so the 12 G working on the regional markets I think has the potential to help build that infrastructure more than just the people writing essays about how great the market is going to be one day in the future. Actual demand for fuel will be a much better hybrid infrastructure.

Mike Shlisky - JPMorgan

Okay. Thanks so much, everyone.


And your next question comes from the line of Andrew Kaplowitz. Please proceed.

Andrew Kaplowitz - Barclays Capital

Good morning, guys. Maybe for Tom or Rich, if we could back to U.S. heavy-duty truck. I mean, it looks like now orders have been pretty good four months in a row. I am just wondering if this is an area where you are actually getting some better visibility. Some of your freight customers out there, most of them are making good money now and we (Inaudible) so there's lots of others out there. So have things improved over the last few months in the business that you are seeing?

Tom Linebarger

Marginally, yes. We are seeing right now that well-capitalized we are saying they are replacing their fleets. We don’t have a lot of evidence of people expanding, still at this point. So we have had three or four months in row of over 20,000 on the net order board which is good. The production rates are currently lower than that 240 we are projecting for the year.

So it requires an improvement in the second half of the year. So I would say our confidence in that happening, that improvement in the second half year has grown with the order board having three or four strong months. But there is not strong evidence of people or fleets wanting to expand their fleets at this time.

Andrew Kaplowitz - Barclays Capital

Okay, that’s helpful. Tom, frankly I am bit confused about the power gen business globally. Maybe I could even just take the view as in, you have got cost cutting like everybody at non-residential and then of course, to the extent that there weren’t any. How do you really think about power gen business and these flips and takes as we enter 2013?

Tom Linebarger

Guy, you are right though that there are some sort of countervailing things going on. The basic trend though I would say is that the general economy is weak. Non-res construction spending is not great around the world. Again there is exceptions to that. As you noted there is a few segments which are doing okay. But broadly speaking that’s a problem.

Then some of these infrastructure projects in Africa and other places have also been slowed down. Graco is a big customer of ours. That’s the one I mentioned in Europe and there, they have cut their capital purchases for rental equipment quite a bit. They do a lot of that infrastructure kind of work. Those were also down I think in part because of general economic weakness and some of that sort of political and other things going on in North Africa and the Middle East. So all that together says, we are thinking power gen is down in that flat to down 5%range again with, as you said, a lot of puts and takes, up and down and it is a little complicated but all in it doesn’t look great.

Thank you very much for your interest today.

Mark Smith

Thanks, everybody.


Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect. Have a great day.

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