Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message| ()  

Executives

Mark Smith

N. Thomas Linebarger - Chairman, Chief Executive Officer and Chairman of Executive Committee

Patrick J. Ward - Chief Financial Officer and Vice President

Richard J. Freeland - Vice President and President of Engine Business

Analysts

David Leiker - Robert W. Baird & Co. Incorporated, Research Division

Jerry Revich - Goldman Sachs Group Inc., Research Division

Linda Yuan

Andy Kaplowitz - Barclays Capital, Research Division

David Raso - ISI Group Inc., Research Division

Ann P. Duignan - JP Morgan Chase & Co, Research Division

Timothy J. Denoyer - Wolfe Trahan & Co.

Robert Wertheimer - Vertical Research Partners, LLC

Cummins (CMI) Q1 2013 Earnings Call April 30, 2013 10:00 AM ET

Operator

Good day, ladies and gentlemen, and welcome to the Q1 2013 Cummins Inc. Earnings Conference Call. My name is Ian. I'll be your operator for today. [Operator Instructions] As a reminder, this call is being recorded for replay purposes. I'd like to turn the call over to Mr. Mark Smith, Executive Director of Investor Relations. Please proceed, sir.

Mark Smith

Thank you, Ian. Good morning, everyone, and welcome to our teleconference today to discuss Cummins' results for the first quarter of 2013. Participating with me today are our Chairman and Chief Executive Officer, Tom Linebarger; our Chief Financial Officer, Pat Ward; President of our Engine business, Rich Freeland. We'll all be available for your questions at the end of our prepared remarks.

Before we start, please note that some of the information that you will hear or be given today will consist of forward-looking statements within the meaning of the Securities Exchange Act of 1934. Such statements express our forecasts, expectations, hopes, beliefs and intentions on strategies regarding the future. Our actual future results could differ materially from those projected in such forward-looking statements because of a number of risks and uncertainties. More information regarding such risks and uncertainties is available in the forward-looking disclosure statement in the slide deck and our filings with the Securities and Exchange Commission, particularly the Risk Factors section of our most recently filed annual report on Form 10-K and 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 the website at www.cummins.com under the heading of Investors And Media.

With that out of the way, we'll begin with our Chairman and CEO, Tom Linebarger.

N. Thomas Linebarger

Thank you, Mark. Good morning. I will start with a summary of our first quarter, including comments on the performance of our businesses, then I will talk about our outlook for the full year. Pat will then take you through more details of our first quarter financial performance and our full year forecast. As anticipated, we experienced weak demand in a number of our end markets and geographies in the first quarter.

Revenues were $3.9 billion, a decline of 12% year-over-year. EBIT for the quarter was 11.1% of sales compared to 14.7% a year ago. Excluding the impact of acquisitions, all 4 businesses delivered reductions in SG&A costs for both year-over-year and sequentially, due in part to the restructuring actions we implemented last quarter. The Component segment delivered very strong results this quarter, delivering record gross margins despite revenues being down 7% year-over-year. EBIT was 11.7%, down from 13% a year ago due to lower volumes and higher research and development spending to support future growth. However, EBIT percent improved 280 basis points from the fourth quarter due to higher volumes and overall cost improvement. We expect that the component segment will continue its strong performance this year, as demand in on-highway markets in North America improved from first quarter levels. We have raised our full year EBIT guidance for the component segment, as Pat will cover in more detail.

First quarter revenues for the Distribution business were flat year-over-year. EBIT margins at 12.2% increased 10 basis points compared to a year ago and improved 140 basis points sequentially, due to a strong mix of aftermarket revenues. Our full year EBIT guidance for Distribution is unchanged.

The Engine business experienced the most significant decline in demand with unit volumes down 18% year-over-year and revenues lower by 19%. Unit shipments of High Horsepower engines declined by 24%, due to weakness in mining, oil and gas and power generation markets. EBIT margin for the quarter was 8.5% compared to 13.3% a year ago. Engine business margins were negatively impacted by the lower volumes, especially the sharp decline in shipments of High Horsepower units, as well as higher warranty costs. Performance in our Power Generation business fell short of our expectations in the first quarter. EBIT margin was 6.8%, down from 9.7% year ago and the lowest level since the first quarter of 2010. As a result of the weak performance in the first quarter, we have lowered our guidance for Power Generation for the full year. However, we have not changed our expectations for the business for the rest of the year, as we believe Q1 was a low point.

In total, while we have adjusted our guidance up for Components and down for Power Generation, we are not changing our overall guidance for the company. We still expect revenues to be flat to down 5% for the year, and we still expect to deliver EBIT in the range of 13% to 14% of sales.

Now I want to talk in more detail about our sales and our key markets. As I said, overall company revenues declined by 12% in the first quarter, with revenues in North America declining 15%, international revenues declining 10%. In North America, our revenues were most heavily influenced by a decline in on-highway markets. Our shipment of engines for North American heavy-duty trucks were 19,000 units in the quarter, a decrease of 37%. Demand declined as our industry continued to run at lower production levels following a period of overproduction in the first half of 2012. Retail sales for the industry have exceeded industry production for the last 6 months and OEM backlogs are increasing. We do expect to see sequential improvement through the year, driven largely by replacement demand. For the full year, we are adjusting our forecast for the market size to 233,000 units, down from our previous forecast of 240,000. Our market share for the quarter was 41.6% through February, and we are maintaining our full year market share forecast of 40%. We shipped 11,000 units to the U.S. medium-duty truck market this quarter, a decrease of 23% year-over-year. Demand is expected to increase in Q2 and beyond, as OEMs continue to ramp up their production of 2013 models. We continue to expect a full year market size of approximately 109,000 units in 2013, an increase of 2%, and our market share to be approximately 52%.

Demand from Chrysler decreased in the first quarter by 17%, due to the planned model year changeover that started in January. For the full year, we expect shipments to decline by 10%, in line with our previous forecast. Our international revenues decreased by 10% in the first quarter of 2013, with the most significant declines in Europe and China, and relatively flat markets in Brazil and India. In the Brazilian truck market, our unit shipments increased by 20% compared to very weak levels last year. We are raising our estimate of 2013 industry sales to increase 19%, compared to our previous forecast of an increase of 15%. We continue to be cautiously optimistic about improvement in the Brazilian economy, although truck industry sales declined 8% in quarter 1, and industry inventory increased by approximately 12% from fourth quarter levels. Continued growth in the economy and the availability of credit will be important factors determining full year truck demand in Brazil. In total, our revenues in Brazil declined 8%, with the improvement in the truck demand more than offset by the impact of depreciation of the real against the U.S. dollar.

Moving to China, our first quarter revenues in China included joint venture -- including joint ventures, decreased 11% year-over-year, with the decrease due to lower demand in most end markets. Demand for excavators remained weak in the first quarter, with industry sales down 26%. We did observe a modest reduction in inventory levels at OEMs in the first quarter, but we continue to believe that it will take most of the year to normalize industry inventory levels. Our forecast for our own revenues in the construction market has not changed significantly in the last 3 months, with no growth expected in Engine shipments this year. The truck market in China for medium- and heavy-duty trucks combined declined by 12% in the first quarter, as uncertainty over the strength of the economy continued to impact the industry. The revenues of our Dongfeng-Cummins joint venture were down 11%, in line with the market. We expect a modest increase in orders for the second quarter. At this time, we are maintaining our full year forecast for industry sales to be flat year-over-year. Having said that, actual industry behavior is going to be heavily influenced by the final implementation rules for the new NS4 emission standard scheduled for July of this year.

Just last week, there was a meeting of the largest 8 domestic truck manufacturers, the so-called C8, and out of that meeting came a set of recommendations to the government on how to proceed with the implementation of NS4 regulations. We are still evaluating these recommendations. However, on first review, it appears that the truck manufacturers are seeking a phased approach to NS4 implementation which would likely defer widespread adoption of fully compliant solutions, including aftertreatment, to 2014. It is not clear at this stage what impact, if any, these recommendations will have on the government's approach to implementation of NS4, or even when the government will respond to these recommendations. As a reminder, our current forecast assumes slow adoption of aftertreatment in 2013.

Volume and revenues at our Light-Duty joint venture with Foton continued to grow in the first quarter, with revenues for the domestic market up 90%, off a low starting point. We continue to have high expectations for the growth of our Light-Duty engines, both in China and in other markets. The joint venture is now consistently operating above breakeven. Power Generation revenues, including joint ventures, declined 13% year-over-year, with the pace of industrial activity in China still relatively weak. Orders for the second quarter currently indicate a modest improvement with the first quarter -- from the first quarter, and we expect the full year to be at least flat with 2012 levels. For the full year, we still expect total revenues in China to be up 5%, with growth in Light-Duty engines driving the increase. First quarter revenues were in line with expectations, and our current full year forecast is unchanged. In addition to the market-specific factors I have discussed, uncertainty remains about the rate of improvement of the Chinese economy as a whole, and we continue to monitor conditions in China very closely.

Business conditions in India have weakened further and we are lowering our outlook for the truck market. In prior calls, I have discussed measures taken by the government to address the fiscal deficit that have not been helpful to truck demand. Road-building has also slowed in India, and overall confidence for capital purchases has weakened. Industry sales for the medium and heavy commercial vehicle market declined 33% in the first quarter. We are lowering our full year view of the market and now expect a full year decline of 14%, compared to our previous expectation of a decline of 5%.

In the Power Generation business, we experienced an 11% growth in revenues in the first quarter, driven by continued power shortages in the country. As a result, our full year forecast is that revenues will grow by 10%, despite weaker economic conditions, though clearly, the outlook is more uncertain. In Europe, we experienced a 12% decline in revenues year-over-year, with the Power Generation business most negatively affected. Power Generation revenues in Europe were down 45%, with demand in Russia notably weaker in the first quarter. We do not expect revenue growth for our Components -- sorry, we do expect revenue growth for our Components Business next year, with the introduction of Euro 6 emissions regulations, but for this year, Europe will remain challenging across all of our businesses.

I will conclude my market comments with an update on our mining business. 3 months ago, we predicted that our full year revenues, including aftermarket, will decline by 25% for the full year. Actual first quarter revenues declined by 28%. Overall customer sentiment has been a little more negative over the last 3 months, and our revised mining revenue guidance is for a decline of 27%. Not a significant change, but certainly, we do not see any signs of improvement in the near term. Aftermarket revenues were down year-over-year, but in line with the fourth quarter levels.

Although uncertainty exists in a number of markets, we do expect that the first quarter marks a low point for revenues this year, and we expect to see sequential improvement in revenues, driven most significantly by on-highway markets in North America, in which we have strong market share for Engines and Components, and by the construction market in North America. Power Generation demand should also improve from first quarter levels, driven mostly by seasonality and increasing demand in North America.

I've covered a lot of ground on markets, but before I turn it over to Pat, I would like to share some of the recent company news that highlights the strength of our partnerships and our ongoing focus on bringing new products to market. At the Mid-America Truck Show in March, we revealed the new integrated engine and transmission combination of a Cummins ISX15 engine and Eaton transmission, that will deliver both improved performance and 3% to 6% better fuel economy for truck customers. Also at MATS, we highlighted the new Cummins Westport ISX12 G natural gas engine that is now in limited production and is generating a lot of interest among end-users. At the recent BAUMA show in Munich, we displayed 3 all new off-highway engines. The new QSM 12-liter engine, the QSF3.8-liter engine and the L9.3 made at our Guangxi Cummins Engine joint venture. These engines are designed to offer leading performance and emissions at world-class cost levels for off-highway equipment. They are also the most recent examples of a strong pipeline of new products that will help drive strong profitable growth as our global markets improve.

Thank you for your interest today. And now, I'll turn it over to Pat.

Patrick J. Ward

Thank you, Tom. And good morning, everyone. Fourth quarter revenues were $3.9 billion, a decrease of 12% from a year ago, reflecting expected weakness across many markets and regions. As I said during the fourth quarter earnings call, we expected a tough first quarter, and it came in pretty close to what we were thinking back then. North America sales, which represented 50% of our first quarter revenues, were down 13% from a year ago, primarily as a result of lower demand from on-highway markets and also continuing weakness in the oil and gas market. International sales decreased by 10%, driven by weak demand in both power generation and in mining markets.

Compared to the fourth quarter of 2012, sales were down 9%. The decrease was driven by weakness in the North American bus market, following the emissions change, and in the Chrysler business, due to the planned model year changeover which occurred in January of this year. Mining revenues also declined sequentially as we had projected, and we experienced normal seasonality in the Distribution and Power Generation businesses.

Gross margins were 24.4% of sales, down from 26.8% last year. The decrease was driven by the impact of the reduced volumes, unfavorable mix and higher warranty costs, partially offset by the benefit of improved pricing and lower material costs. Margins also decreased compared to the fourth quarter of 2012, due to reduced volumes and an expected increase in our warranty costs.

Selling, admin and research and development spending was down $30 million from last year and down $7 million from the previous quarter. Both the sequential and year-over-year reduction in spending was concentrated in administration expenses. Joint venture income of $82 million was down 21% compared to a year ago and was flat compared to the prior quarter. The year-over-year decline was driven by a lower contribution from our joint ventures in China and in India, where truck demand was lower compared to the first quarter of 2012. Earnings before interest and tax were $437 million or 11.1% of sales. This compares to 14.7% of sales last year and 12.4% in the previous quarter, excluding special items. And as Tom said, we expect this to be the low point of our performance this year. Earnings per share in the first quarter were $1.49 compared to $2.38 a year ago, with a tax rate of 27.6% in the quarter.

Now let's move on to the operating segments and further discuss first quarter performance and the outlook for the full year. All the numbers and comparisons exclude the $52 million pretax or $35 million after-tax restructuring charge that we took in the fourth quarter of 2012. In the Engine segment, revenues were $2.3 billion, a decrease of 19% over last year. The decrease was driven by weak demand in oil -- on-highway and oil and gas markets in North America, and by a 28% decrease in global mining revenues. This weakness was partially offset by improving demand in the Brazilian truck market, where revenues were up 26% and across global agricultural markets.

Compared to the prior quarter, sales were down 8%. Sequentially, we experienced weaker demand for Chrysler and North America bus engines, along with weakness in mining and in oil and gas markets. Segment EBIT of $195 million, or 8.5% of sales, was down from 13.3% last year, as a result of weaker volumes, unfavorable product mix, higher product coverage costs and a lower joint venture contribution. This was partially offset by improved pricing and lower material costs. Sequentially, the decline in volume, a more unfavorable product mix, the higher product coverage costs and increases in research spending resulted in lower margins. For the full year, we continue to forecast the revenue for the Engine segment will be down 5%, driven by weakness in industrial markets, particularly in mining, partially offset by improved demand in the Brazilian truck market. EBIT projections for the full year remain unchanged at 10% to 11% of sales.

In the Component segment, first quarter revenue was $1 billion, down 7% from last year and up 8% from the prior quarter. Compared to the prior year, the lower revenues were primarily driven by a reduced demand in the North American heavy-duty truck market and lower demand in Europe, partially offset by increased demand in Brazil. Sequentially, sales increases were driven by strength in North American and Brazilian truck markets. Segment EBIT was $119 million or 11.7% of sales, down from 13% last year. Continued technical investment on lower sales and higher coverage costs resulted in lower margins compared to a year ago. Compared to last quarter, EBIT margins increased almost 300 basis points, or an 8% increase on sales. The sequential increase in margins was driven by higher volumes, improved pricing and lower material costs. We continue to expect revenue growth of around 2% this year, primarily as a result of increased penetration of aftertreatment systems in the North American heavy-duty truck market, and growth in the Brazil truck market being offset by weaker demand in both Indian and European truck markets.

We are raising EBIT projections for the full year from 10.5% to 11.5% of sales, to 11% to 12%, due to strong gross margin performance. This compares to a full year 2012 margin of 10.8% of sales. In the Power Generation segment, first quarter sales of $746 million, down 4% from last year and down 2% from last quarter. Year-over-year, we saw weakness in Europe and Russia, partially offset by increases in India and in our North American military business. Sequentially, we saw a deterioration in Europe and Russia, partially offset by continued strength in India. EBIT margins were 6.8% of sales in the quarter, down from 9.7% last year. While lower volumes and unfavorable mix contributed to this lower profitability, we also had some unplanned costs that negatively impacted margins, including warranty costs in our alternator business and some gas project costs that were higher than expected. We expect to see improvement in the second quarter, as these costs don't repeat, and volumes improve sequentially.

EBIT margins were slightly lower than those reported in the fourth quarter, as a result of higher product coverage costs, partially offset by reduced administration expenses and increased pricing. For 2013, we continue to expect sales to be down 3% compared to last year, primarily due to weakness in Europe and in Russia. We are lowering our EBIT projections for the full year from a range of 9% to 10%, to a range now of 8.5% to 9.5% of sales.

For our Distribution segment, first quarter revenues were $778 million, an increase of less than 1% compared to the prior year and a 14% reduction compared to the prior quarter. During the quarter, the Distribution segment acquired a North American distributor, which added revenue of $21 million. Excluding acquisitions, first quarter revenue decreased 11% compared to the prior year and 17% sequentially. In both comparisons, organic growth is lower due to weaker demand in power generation markets in Europe and in Russia, North American oil and gas markets and global mining markets. EBIT margins for the quarter were 12.2%, flat with margins a year ago, with positive mix being offset by reduced joint venture contribution and higher selling and administration expense, which were both impacted by acquisitions.

Compared to last quarter, EBIT margins improved by 140 basis points, driven by positive mix and higher joint venture contribution. For 2013, we continue to forecast 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. And as Tom mentioned, we continue to project total Cummins revenues to be flat to down 5% in 2013, with sequential improvement throughout the year, driven mostly by recovery in the North America on-highway markets, with modest improvements in a number of international engine and power generation markets also contributing to higher revenues starting in the second quarter. We continue to project EBIT margins for the company will be in the range of 13% to 14% of sales, compared to 13.6% last year, and as we discussed on the prior quarter's call, for the full year, we expect pricing to add 50 to 100 basis points of margin, and lower material cost to also benefit margin by 50 to 100 basis points. These will help offset the headwinds from lower volumes and unfavorable mix, as well as from higher product coverage costs. We are now projecting the tax rate for the year to be around 29.5%, excluding any discrete items. The increase in the rate over last year and over previous guidance is due to changes in the geographic mix of forecasted earnings.

Finally, with regards to cash flow, we produced $428 million in cash flow from operations in the first quarter. We did increase inventory levels in the quarter. In the fourth quarter of last year, we knew that some parts of the business would have very low volumes at the start of the year. For example, in our manufacturing plant that supplies Chrysler, we knew that with the model year changeover volumes, we'd be very light at the start of the year, so inventory levels were cut back at the end of the fourth quarter. Also in some parts of our business, we expect the second quarter demand will be higher than first quarter; for example, parts of the Engine and Components businesses that supply on-highway markets in North America. So inventory has increased in those locations. In the parts of the business with the weakest outlook for the year, for example, in our High Horsepower engine business, we have made good progress in reducing inventory and continue to reduce inventory levels throughout the first quarter.

There are always opportunities to improve our inventory management. And we're not suggesting it was perfect globally, and we do expect inventory and working capital metrics to improve as the year progresses. Overall, we did reasonably well in managing cash flow in the first quarter. The company's financial strength is reflected by a single A credit rating from both Fitch and from Standard & Poor's. In addition, Moody's recently upgraded our unsecured debt rating to single A3 status. The strength of our balance sheet allows us the flexibility to continue to invest back into the company and also return value to our shareholders, even during periods of volatility. As we discussed on our last call, we expect to invest $850 million in capital expenditure projects this year. We announced a new $1 billion share repurchase program last year, and have started to repurchase stock in April and will continue to do more in the second quarter. Over the last 3 years, we've almost tripled our dividend and remain committed to further increases in a stable and sustainable manner. We are well-positioned to continue to return cash to our shareholders, in addition to funding our organic growth plans.

The first quarter results represent an expected trough in both sales and profitability for the company in 2013, based on our current view of global markets. Although revenues were down across most major markets, there are signs of improving demand from these low levels, particularly in on-highway markets in North America where we continue to have a very strong market share.

Now let me turn it back over to Mark.

Mark Smith

Thank you, Pat. We're now ready for questions. [Operator Instructions] Operator, we're now ready for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Please standby for your first question, which is from the line of David Leiker of Baird.

David Leiker - Robert W. Baird & Co. Incorporated, Research Division

Just want to make sure -- one item first, and then the follow-up on that. It sounds like you -- these first quarter results were as you expected to fall in the quarter. Is that accurate?

N. Thomas Linebarger

Yes.

David Leiker - Robert W. Baird & Co. Incorporated, Research Division

Okay, and then if we look through the balance of year, it looks like most of your end-market assumptions really don't assume any sequential improvement in demand. Year-over-year, you have comps. But sequentially, that seems like you're expecting something pretty similar to what we saw here in the first quarter? Maybe North America truck will look, you know, better just given where the build rates ended up there?

Patrick J. Ward

I think if you look at the guidance we've given for the full year, David, that we do expect sequential improvement in revenues beginning in the second quarter. And we think that will help provide a platform for improved margin performance, too, for the company throughout the remaining 3 quarters of the year. The first quarter, as you mentioned, was expected to be low. And as we went through the quarter, it was encouraging to see that the performance both at gross margin level and in EBIT margin level improved month after month. So we started off the quarter close to 10%. We finished off the quarter close to 13%. So that made me feel good that we've got momentum going into the second quarter that can carry us forward towards this guidance.

David Leiker - Robert W. Baird & Co. Incorporated, Research Division

Yes, maybe it's more accurate to say, given the current level of demand that you're seeing here in April, that you're -- things generally are sequentially at the current pace, is that fair?

N. Thomas Linebarger

Yes. That's generally fair. I mean, the only thing, I guess, I would add, is that, as I mentioned in my remarks, Power Gen was lower in margin than we expected. That was the one that -- it did a disappointing run [ph]. There were a number of items that occurred in the first quarter we did not expect. But overall, revenue levels for them, even for them, we thought were right. The second thing that happened, as Pat was mentioning, is the -- our January was weaker than we expected. We had a lot of bus orders and other prebuy orders at this end of last year. I'll let Rich give you more details on that. But it just slowed down our first quarter, and as I talked about in my remarks, mining weakened even a little bit further. So things were weaker in January. But again, as Pat said, we really started to strengthen through the quarter and began to look more like we expected in total for the quarter, with the right trajectory. Now we are expecting sales to improve Q2 to Q4 as we had planned, and again, it's not major market recoveries.

David Leiker - Robert W. Baird & Co. Incorporated, Research Division

Now I guess, what I was trying to get at is...

N. Thomas Linebarger

Yes. No, North America, as we said, people were basically producing below demand. And now, they're going to step-up and produce a little above demand. We have seasonality in Power Gen. So there's nothing dramatic. But the results across all those markets is a reasonably decent step-up in sales as expected, and without this kind of major adjustment in January that we had to fight through. So those things combined lead to better results. We also, of course, finished all of our restructuring actions, those are all through. We're seeing benefits of those in our expense line. So we feel pretty good about the margin step-up we've laid out through the quarter.

David Leiker - Robert W. Baird & Co. Incorporated, Research Division

Now, great. And what I'm trying to get at, I guess, is that when you look at some of these end markets for other industrial companies, there's expectations that the second half is significantly better than the first half. When you look at Eaton's estimate for Q4, North America truck production at 78,000. Now you're not baking those types of assumptions into your numbers, it sounds like?

N. Thomas Linebarger

I'll let Rich get -- that's a good question, so let me let Rich comment on North America truck.

Richard J. Freeland

Yes, let me do that. Let me just add one more bit of technicolor around the midrange side. Where we got a little surprised, quite frankly, was in the midrange side around bus, RV, firetruck. We saw OEs increase their orders in Q4, and basically, bought most of their Q1 demand in Q4. And so we got a little positive surprise in Q4 and a bit of a negative surprise on Q1, on that. And that was part of the -- we've seen that come through and we've seen orders get back to kind of a normal rate, kind of the end of March, early April. On the heavy-duty side, we've taken our overall forecast down from 240,000 to 233,000. So that does imply an increase sequentially through the year; you can do the math on that. I won't give quarterly guidance. We are seeing that increase in production rates has started here in Q2, where we forecasted to be to get to that 233,000 or [indiscernible].

N. Thomas Linebarger

Right. There's no magic surprise in Q4. We're already seeing build rates come up now, I guess, is the main point there.

Operator

We another have question for you. This one is from the line of Jerry Revich at Goldman Sachs.

Jerry Revich - Goldman Sachs Group Inc., Research Division

I'm wondering if you gentlemen can flush out a couple of assumptions behind your guidance on the Navistar aftertreatment business, specifically, what kind of sales contribution are you assuming, and what's your heavy-duty truck market share assumption? And Tom, did I hear you right? You're assuming 52% market share in medium-duty, where I think you're running a couple of points ahead of that in the first quarter. So would you mind just flushing those points out a little bit?

N. Thomas Linebarger

Yes, I think -- I'll let Rich add if he wants to. I think, heavy-duty, medium-duty; we're thinking 40%, heavy duty, 52% in medium-duty. And both of those were a little ahead in the first quarter. And just basically, our general view is those things fluctuate based on the market shares of our -- of the end-use truck manufacturers and other variations. So that's why we do it, we look across the year and take an estimate based on those fluctuations. So we don't see major changes happening. It's the same progressions we've seen across all the markets. But so far, we've seen good strengths, for people using our products, good feedback on our products, so that all remains good. With regard to aftertreatment systems, as you know, we did get our system and -- on the 13-liter engine Navistar, approved by the EPA. That was good news. We don't give any specific forecast by customer on sales because, obviously, that's confidential to them and those things vary quarter-to-quarter. But I would just say that we are pleased to see that, it was a lot of hard work by both companies to get them approved. And those will start -- sales will start -- I mean, they're starting now. They are Q2, we're going. So we're off and running on those things which is a good sign.

Jerry Revich - Goldman Sachs Group Inc., Research Division

And Mark, you laid out pretty significant Components content increase coming up on Tier 4 Final in one of the appendix slides here, and I don't know that you've used it in the past here. Can you just frame for us the Cummins opportunity on non-Cummins engines, and just help us understand the pace of the transition that you expect in 2014 versus 2015?

Mark Smith

I think -- so the comment on the pace, Jerry -- I don't think I want to talk about so much on the new wins at this point in time. But on the pace, you've got the between 175-horsepower and 750-horsepower engine sizes going to Tier 4 Final next year. And then, quite frankly, the bigger dollar content per engine opportunity for Components, both are important, but also comes 2015, 2016 on the high horsepower engines above the 750-horsepower. So those are going to come in 2 waves, if you like.

N. Thomas Linebarger

Yes, and then we've also got -- Jerry, remember, as I mentioned in my remarks, Euro 6 starting in 2014. So while we can't comment on individual wins until the customer does, because they still reserve the right to talk about their products, what I'd say is that we feel very good about our position with regard to Euro 6 and Tier 4 Final, both for our own products but also for winning business with our Components company on other people's engines. At BAUMA, for example, in Munich, Rich and I were both there, and if you looked around the construction business there, there were Cummins engines in just about every booth, except 1 or 2 obvious ones, that we were all over the show. And the reason is because we have a very good Tier 4 Final solution and people see us as an opportunity to grow business, both in their home market, but also internationally -- as they spread their business internationally. So I think our off-highway engine business -- everything we said about people wanting to partner with us to be able to get the technology and to grow globally, was showing up there at that -- in that show.

Operator

We have another question for you. This one's from the line of Jamie Cook at Crédit Suisse.

Linda Yuan

This is actually Linda Yuan, in for Jamie Cook. Could you go into a little more detail on your end-market outlooks? I know you guys already went into mining, but sort of those other segments like oil and gas, ag, construction?

Mark Smith

Yes, sure. Okay. So construction for the full year, I think, we were fairly flat across all our markets we do expect -- we had a fairly low Q1 in North America following on from our weakish second half, but we do see improvement going forward. But in aggregate, for construction, across the globe, flat full year. Oil and gas is very weak, so we're going to be down, heavy double-digits, still year-over-year. Natural gas prices have improved, but we still need to work through the excess equipment in the market in North America. We are seeing increased orders in China for oil and gas, frac-ing engines, but the volumes there are still relatively low. Which -- and in the mining, ag...

N. Thomas Linebarger

Ag.

Mark Smith

Ag is a relatively small part of our business, very low single-digits, but up -- was up quite, is one of the few segments that was actually up significantly in the first quarter and will be probably up double-digits for the full year, driven by North America and Latin America.

N. Thomas Linebarger

That is one of the questions we get, is, why are we still seeing oil and gas business down with natural gas prices adjusting upwards? And I think, our view is that natural gas prices being up will certainly positively impact the industry; it just hasn't really that much yet. There is still a relatively high number of unused frac rigs out in the market. And crude oil production has gone up; it has not gone up very much. And so those -- we still need gas companies to feel like the price is right, that they want to produce -- put it more out of the ground, and then they need to use up the frac rigs they have. So that's why we still have a relatively conservative view. We do think the higher prices will help; it just isn't going to do it yet and it's going to still take a few more quarters, we think, before there's a move in our demand.

Linda Yuan

Okay, great. And then moving over to Engines. You guys saw a little bit of unfavorable mix this quarter. I mean, going through the rest of the year, how should we kind of expect that mix to trend -- yes, kind of through the rest of the year?

Patrick J. Ward

I don't think the mix is going to change very much, as we go through the rest of the year. I mean, you heard Tom's comments in the mining business. But then I think it's a little bit more pessimistic than what we said 3 months ago. So I wouldn't anticipate much change. The one business that might be a little bit better, but only marginally, is Power Generation. That may pick up a little bit from a mix perspective, more in the second half of the year, I would guess, than the first half of the year. But overall, I don't think we're going to see much change in the mix profile.

Operator

We have another question for you. This one's from Andrew Kaplowitz of Barclays.

Andy Kaplowitz - Barclays Capital, Research Division

Tom, so I like the color you guys gave on sequential margins in the quarter, but if you just take the quarter overall, I mean, if I'm doing the math right, it looks like almost 40% decrementals. It's not like you guys, to some extent. And I guess, maybe Pat, was there extra warranty cost that really threw the quarter off? I know R&D was up; what do you expect for that going forward? But is it just -- I can't believe that you kind of expected that result on the margins side. I know you talked about Power Gen being a little weaker than expected, but on the Engine business; that's what I'm focused on.

Patrick J. Ward

I think, Andy, it's exactly what we expected for the company overall. If I go back to -- you obviously don't see the plan we share with the Board, but if I look at our first quarter plan, where we came in both on revenue and profits, it was within a very small range of number, of a difference. So Engine business came in exactly when we thought; we knew the margin was going to be happy, [ph] as well as the [ph] unfavorable mix with mining. They were taking a much higher warranty cost, with the higher accrual rates in the 2013 engines. And for the Engines segment, well, the warranty cost probably was a headwind of 1% relative to what we'd seen in the fourth quarter. So it was not a small number. Distribution came in exactly where we thought it would be. Components, as Tom said, a little bit better, and then the ones -- the one negative, relative to what we were anticipating, is Power Gen. But overall, when you look at it for the company, it was pretty much in line with what we'd expected.

N. Thomas Linebarger

That said, Andy, there's no question that your point about decrementals is right, that it's not what we're aiming for. I think that Pat's talked a lot about what our goals with regard to decremental and incremental margins are, and this is definitely higher. So this is not the kind of quarter we're aiming for and we -- while we knew it going in, it was a difficult quarter. And then some of the things that we saw that we didn't expect until the very end were as much activity on prebuy in the midrange segment. And then the mining segment, while we knew it by the fourth quarter, as Pat said, it dropped really quick, it dropped really significantly in our High Horsepower Business. So we had to adjust very quickly. So I think that once you take the trend over a couple of quarters, I think you'll see the decrementals in line with the way that we think about it. So just in terms of averaging the numbers, Q1 was not great on decrementals, not where we want to be. But if you take it over a couple of quarters, our view is that you'll look back at us and say, "Yes, that's the decrementals that they're looking for" and then you'll see the same thing on the incrementals. But just in terms of timing, seasonality, prebuys, a whole bunch of stuff hit this quarter that made it sting more than we would expect normally.

Andy Kaplowitz - Barclays Capital, Research Division

And Tom, is it fair to say that by March, a lot these things that were stinging stopped stinging whereas that they were really bad in January? Is that what you're trying to say?

N. Thomas Linebarger

Yes, not to carry the insect analogy too far, yes. I would say that they were stinging less. But no, you're definitely right. So we -- the reason we have confidence in our forward estimates is that we saw improvement month over month, whereas we began to pick up orders some. Again, they weren't gigantic increases, but they were enough. We were starting the -- the negative adjustments got through the system. We started to see improvements as we went January, February, March, and by time we left March, and now as we look into April, we're already seeing improvements that make us confident that we'll get the kind of incrementals that we're looking for, as volumes increase. There are uncertainties out there. I don’t mean to overstate the position; I talked about some of my markets [ph]. There are uncertainties in markets. But assuming we get the sales that we got in here, our view is that we can make the margins based on what we've already seen this year.

Andy Kaplowitz - Barclays Capital, Research Division

And Tom, a related question comes up then. How is this really different from last year? I mean, last year, we had a strong North America that sort of dissolved as the year went on, and we were expecting an improvement in emerging markets that didn't happen. This year, we're starting out weak again. And you're kind of expecting the whole business to rebound over time. I mean, I appreciate your comments very much on January through April. Is that what gives you more confidence in the rest of the year, or something else?

N. Thomas Linebarger

Yes, there's some pretty different -- big differences. For one thing, the first half of last year, remember, North America was good, and what we saw with the fall; this first quarter, North America was not good. And what we're seeing that's different is that after several quarters of producing at less than demand, we are now seeing them begin to increase order rates. Right? So we've already -- as Rich mentioned, we've already seen increases in order rates. It's a little bit different. We're not -- and the second thing, I guess, I'd highlight as a major difference, is, we were expecting improvements in the emerging markets and we didn't see them. This year, we are not improving -- expecting improvements in the emerging markets. So there's really none of that built into the forecast. What we've got built in the forecast from a sales point of view is seasonal improvements, this thing I talked about with North America, the basic kind of things that just because Q1, they did a prebuy and now they're just going to go back to regular order rates. So no heroic improvements in demand. And then just getting back to our normal orders and shipment rates that fit that demand, that's all we're really expecting to do here. So there's really nothing, no heroic assumptions anywhere. And I would say that, again, if something drops off dramatically like it happened in the second half of the year last year, then that would make things worse. And we just don't expect that. We just don't see, given our conservative forecast in markets, that there's something that's going to drop off a bunch more. As -- you heard Rich's forecast for North America; it's not aggressive.

Operator

We have another question for you. This one's from David Raso at ISI Group.

David Raso - ISI Group Inc., Research Division

Not to belabor the margin issue, but I think, by far, it's the major issue here with the release. So we're just trying to better understand it. The rest of the year guidance implies basically 100% incremental margin. $117 million of sales gain year-over-year; you need $128 million of EBIT gain year-over-year. Right? So we have to see a big reversal on how the margins just played out. So this first quarter, the revenue decline year-over-year, isn't much different than what we saw in the fourth quarter and third quarter. And since then, we have laid off 2% to 3% of the headcount, I assume some other cost actions, and maybe, the warranty maybe was bigger, but -- and I appreciate the mix comment, but I'm still trying to appreciate, why are the decrementals this much worse after some cost actions, and then the next 3 quarters, I have to look at an incremental margin -- which, I know it's a low number, 1% revenue growth. So it's possible when the revenue growth is that low. But obviously, 100% incremental is not a walk in the park. So can you help us better understand what happened and why the incrementals would be so positive the rest of the year?

Patrick J. Ward

Yes, so David, let me take a shot at that. When we look at the incremental margins going forward, and if you look at it from a first quarter baseline, the numbers that take us to the midpoint of our guidance are closer to 35% to 40%. So you can talk to Mark afterwards about the calculation. But we've allotted that type of incremental margin improvement before. And as I see the Engine business picking up as we go through the first quarter, I'm pretty confident that, that trajectory is going to continue to play out. The fact that the decrementals in Q1 were as steep as what they were -- I apologize because we're repeating ourselves here, but really, the negative mix impact, the Engine business, in particular, suffered from the lower High Horsepower volumes; it was a very significant headwind. In addition, we had the higher warranty costs that we tried to talk about in our last call and explained that the impact of those. So there wasn't anything else in there. There was a couple of oneoffs in the Power Generation business that helped them in the first quarter. But the key drivers for that decremental was the lower volumes, the unfavorable mix and the higher warranty costs, all of which we expected as we came into the quarter.

N. Thomas Linebarger

I would just add, David, we did see the improvements in SG&A from the reductions we made in Q4. And on the other hand, we did stay the course on our R&D spending. That was something we decided strategically to do, was to continue to invest in our new products and make sure that we were ready -- while other people may be hesitating, we're going to continue to release new products so that as markets improve, we position ourselves for growth. That was obviously a decision we made that we could have made differently, but we decided that was the thing to do. And as a result, we have a lot of new products coming out and we will have again next year, and that, I think, positions as well for growth. So those were decisions we made that, of course, impacted quarter results. But I think they were the right ones for the company, long run.

David Raso - ISI Group Inc., Research Division

Okay. And I mean, is there a price cost change? Because Pat, I mean, you can talk sequentially, but I'm looking at it properly, year-over-year, first quarter down 40. The mix in the fourth quarter, we already had mining down, oil and gas down, and then since then, we've taken some costs out. At least, that was the way it was presented in October; about 1,000 and 1,500 heads coming out. So again, I'm just trying to gain comfort. Is there something about heavy -- High Horsepower that you already have in order book, that's notably improving on the High Horsepower to make it clear the mix snaps back?

Mark Smith

No.

David Raso - ISI Group Inc., Research Division

It is 100% incremental year-over-year in the math for the rest of the year. I'm just trying to understand, I mean, obviously, the revenues were generally in line with what people thought. It was similar to declines in the last 2 quarters. It's all about the margin.

Mark Smith

Right. So we are not expecting a snap back in mix. The mining drop was much more significant in the fourth quarter -- first quarter year-over-year that it was in the first quarter, significantly.

N. Thomas Linebarger

More in the first than the fourth.

Mark Smith

More in the first than the fourth. Sorry. So that was that. We're not really, other than we expect seasonal improvement in High Horsepower demand from the Power Gen business to the Engine business going forward, that's really the only improvement in High Horsepower going forward. And again, as Pat said, if you start from the Q1 base and look at what we need to deliver from that base, which we accept has got some costs in there that we wouldn't expect to see on a run-rate basis, we're talking in the 30% to 40% of incrementals going forward from where we are, and we feel comfortable with that.

David Raso - ISI Group Inc., Research Division

And just one clarification, the tax rate, before it was 26%. Do you remember correctly that, that did not include the tax benefit in the first quarter?

Patrick J. Ward

That is correct. The 26% did not include the discrete item, the R&D tax credit that related to 2012, that we did book in the first quarter.

David Raso - ISI Group Inc., Research Division

And the 29.5% also doesn't include the tax help?

Patrick J. Ward

29.5% is the operational rate for the full year, excluding discrete tax items.

Operator

We have another question for you. This one's from Ann Duignan at JPMorgan.

Ann P. Duignan - JP Morgan Chase & Co, Research Division

Can we take a step back and talk a little bit about your outlook for market share for the heavy-duty business? It was very obvious at the Mid-America Truck Show that you and Eaton joining forces to deliver new products is more of a defensive move to react to the Price, Lenner and Volvo [ph] offerings of their own drivetrain. Should we think about the 40% market share as being the ultimate potential for this business? Should we expect market share to decline somewhat as we move forward?

N. Thomas Linebarger

Obviously, it's going to be our goal for it not to decline. And so we -- the dynamics of the heavy-duty truck business and Engine sourcing really haven't changed in quite a while. We are now kind of the only independent engine company in -- at least in these developed country markets, and what we're trying to do is make sure that we offer technologies and systems that make customers think that partnering with us, in addition to making their own, makes more sense for them and gives them more technology they can use to sell value to customers. So that remains our strategy. And they -- our customers remain focused on ensuring that they have technology that they need and that they don’t depend just on one supplier. That hasn't changed either. And all of our customers are thinking about what technologies they want to own and what technologies they want to buy. So we have very open and frank discussions with them about that. So what that means, as far as final market share, I think depends on which players make which decisions in there. But we've talked about this before. Our market share is not our #1 measure of success. We want to make sure we have profitable and profitable growth in the heavy-duty business, and that's what we're aiming for. We think our market share reflects the fact that today, we can still offer technologies that even though our customers make their own engines, they think that our technologies help them sell more trucks to customers. And again, I don't mean to get overly philosophical on you, I just mean, it's really hard to say that there's a peak or a valley or whatever, in market share. It just depends on how well we continue to do that.

Ann P. Duignan - JP Morgan Chase & Co, Research Division

Yes, that's a fair point, and it's good to hear that market share is not the ultimate goal. Switching gears a little bit onto natural gas. Could you give us an update on the 12-liter engine and where we are with that? Are you taking orders for that already, or is that for later in the year?

Patrick J. Ward

Let me let Rich update you because, obviously, there's been quite a bit going on in that this year.

Richard J. Freeland

Okay, so no, we are taking orders. Okay? Beginning in April. So we've offered [ph] some ratings. And then we'll continue, we'll offer some higher horsepower ratings later in the year, kind of in the August, September, October range. So we're right on track with what we said, with the April introduction.

Patrick J. Ward

That-- and that's a big deal because, of course, as more customers want to explore options of using natural gas and we really were limited to a 9-liter and that engine just isn't big enough for some of the applications people want to try it on. So the 12-liter really gives customers a chance to try it in a broader range of applications. And since there's so much interest in natural gas, it's just the right product at the right time, in our opinion.

Ann P. Duignan - JP Morgan Chase & Co, Research Division

Yes, and the final question, just a quick follow-up on that. If the 12-liter and the 15-liter are highly successful, then what's the impact on the aftertreatment business, since for spark ignition you don't need aftertreatment?

N. Thomas Linebarger

Yes, it would obviously be -- push aftertreatment demand down. So from our point of view, this is, of course always -- when we -- we have a range of technologies in the power technologies we're looking at, so -- and using all over the world, and the impact of using one over another definitely -- there is cross impact on the companies. There's no question that if we -- if natural gas grows, then the need for FCR on those engines isn't there. So that demand would go down for those products. Now again, the good news for us is we sell a lot of -- we're pretty high market share in natural gas engines. So the trade-off looks okay to us, so far. But we're always looking at technologies that are going to add value to engines systems and component systems. So we do a bunch of work on the component systems and natural gas, too, not just FCR.

Operator

And we have another question from -- sorry, this one's from Tim Denoyer at Wolfe Trahan.

Timothy J. Denoyer - Wolfe Trahan & Co.

Not to beat the Engine segment margin too much, but a couple of other components if you could just give us a little bit more color on sort of how that goes through the year. I mean, did you see the full impact of the price increases in the first quarter? And you've talked about warranty costs coming down through the quarter; I think you said there was 1 percentage point increase in warranty costs from 1Q -- in 1Q from 4Q. Can you give us a sense of how that might ramp down through the year? And I guess, the same kind of question on raw materials. Are you expecting a bigger benefit through the year?

Richard J. Freeland

Okay. Yes, I'll take a shot at that. So a few things going on. So we do see the volumes going up. To hit our midpoint, we need to be in that 35% to 40% incremental margins, which is a place we've been before and feel very confident we can get there. There's a few pieces of it. One is, as the volumes come up, we -- January was a pretty bad month for us. So we saw some really low demand in many of our plants. So we will get the incremental there. We are going to see warranty going down in the range of 0.5 point. As you know, we set warranty on our new products at a higher rate, and then as we demonstrate that the products are doing well, we take our rates down. So we will see warranty coming down through the years, sequentially. We are seeing and driving increased supply chain improvements, which is a key piece of our action, which is logistics cost, but also on material costs. So we're having success on driving material cost down. So it's kind of the combination of normal incremental margins, warranty down, some material cost down, and then not continuation of some the, really, the January issues that we had, gets us in that -- which is a place we've been before, in that 30.5% to 40%.

Timothy J. Denoyer - Wolfe Trahan & Co.

Yes, sure. And then, just as a follow-up. On Brazil, you've got a few -- there are a few truck OEMs building plants down there, at the moment, you have good relationships with. Can you give any sense of R&D activity, and is there any market share pickup in Brazil baked into your guidance for this year? I think they are [ph] potentially opening these plants, the 3 of them later this year?

N. Thomas Linebarger

Yes, we don't expect a big impact this year, Tim. I think -- but we have a lot of activity going on in this. I think this is just an extension of our strategy that said, "Hey, we can use our global position and partnerships around the world to help our customers grow in the markets they want to grow into." I think Brazil is a perfect example of that. So there's a number of OEMs going into Brazil who -- who are trying to be part of the growth of that market, and who can use Cummins engines, both because we have leadership position at market, we have a strong brand name, and we have service operations there to help support them. So we are very active doing application work and other kinds of work with customers and potential customers in Brazil. But I think although some will open, there aren't going to be significant volumes this year. And some of them, I think, it will take them -- even after they theoretically open, production won't begin for some time. So I think there may be some impact next year, but it's probably a year or 2 before we see significant volumes for most of those new players coming in.

Operator

The question is from Rob Wertheimer of Vertical Research.

Robert Wertheimer - Vertical Research Partners, LLC

Just one quick question on R&D. Was it any heavier than expected in the quarter or different seasonality this year? And this, just generally, Power Gen's been on a multi-decade uptrend. I'm just curious if you can explain any more needed [ph] on geography, whether it's credit-related, the general weakness, prime power versus back up. Just any more color on that market?

N. Thomas Linebarger

Yes. Nothing really unusual in R&D. The only thing that kind of influences quarter-to-quarter swings are if we are buying significant prototypes in major programs, and there is a little movement each quarter and we had less of it in Q4 and more of it in Q1, and that's just -- but that's normal and what we expected. With regard to Power Gen, the geography I'd give you is that, generally speaking, our developing country markets which have been growing infrastructure at a pretty high rate have clearly slowed down in the last couple of years. So places like China and India, infrastructure development have slowed down. India, we still see power shortages, which have held up the market, but the rate of growth has definitely slowed as the infrastructure slowed. And I think as those markets begin to pick up again, we'll see demand increase. And those are -- think of those -- that product primarily as prime power or at least part-time usage; it's not standby. And then generally weak economies across the world have driven down non-res capital spending now in most markets. Of course, that's significantly true in Europe, but it's also been true in the U.S. now for several years, and low non-res capital means low standby markets. So really the only places where we've seen improvements in power generation have been data centers, where we continue to see activity there, and then kind of spot issues. Power shortages and other kinds of things, where there's just these chronic shortfalls in power, we have seen -- continued to see strong markets. But the basic trends on both the developing country infrastructure, which require more grid support or companies needing generators to run their factories when the grid ground's [ph] out, or just basic standby markets, have been down now in a slump for a couple of years, and that's what you've seen, which -- in revenues and Power Gen.

Mark Smith

Thank you very much, everyone. I'll be available for calls shortly.

Operator

Thank you, ladies and gentlemen. That concludes your conference and presentation. You may now disconnect. Have a very good day.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Cummins Management Discusses Q1 2013 Results - Earnings Call Transcript
This Transcript
All Transcripts