Cummins' CFO Presents at Barclays Industrial Select Conference (Transcript)

Feb.19.14 | About: Cummins Inc. (CMI)

Cummins, Inc. (NYSE:CMI)

Barclays Industrial Select Conference

February 19, 2014 08:55 am ET

Executives

Pat Ward – Vice President & Chief Financial Officer

Mark Smith – Executive Director, Investor Relations

Analysts

Andy Kaplowitz – Barclays Capital

Andy Kaplowitz – Barclays Capital

So we’re going to get started here actually. I know most of you guys but some of you don’t know me. My name is Andy Kaplowitz; I cover machinery and engineering construction for Barclays. We’re very happy to have you guys down here, I know you’re very happy to be here given where we were yesterday most of us.

But we are extremely excited to have Cummins lead off for us in machinery. Cummins has been one of our top picks over the last couple years. I think they have a great story focused around their missions in energy efficiency. These are I think pertinent secular trends.

You know, we’ve had some cyclical issues with Cummins over the last couple years. Last year at this time Pat was morose. He looks a lot happier now so I think that’s good.

The first thing I want to do is, we do have an automated response system as we’ve had in the last couple years. I want to just take the pulse of the room. So what we’re going to do is we’re going to do just the first two questions in the automated response system if we could and then we’re going to open up to Pat for introductory remarks.

So do you currently own this stock? Again, this is very easy. You just put in 1, yes overweight; 2, yes equal weight; 3 yes underweight; or 4 no. And we give you ten seconds to put in your response.

Alright, there’s a lot of people to convince here today, Pat. So 64% say no but there are 29% who are overweight. So let’s ask question #2: what is your general bias towards the stock right now? 1, positive; 2, negative; or 3, neutral.

Okay, so there’s a lot of neutral people. I mean I remember last year actually probably being a little bit more positive even though you were not, which is of course interesting. But we’re going to turn it over to Pat now. Pat, maybe if you can give us just a couple minutes – I know you just reported earnings so if you could just talk about sort of the puts and takes of what you reported, what the outlook looks like for this year, and then we’ll launch right into questions.

Pat Ward

Yeah, thanks and good morning, everyone. I’m Pat Ward. I’ll apologize up front – I’ve had a bad cold for the last week so if I start coughing and sputtering it’s because of that. Secondly, if there are any Canadians in here this morning congratulations on winning the Curling. You’re in the favor now at my expense, so well done.

Let me make a few comments first of all for 2013. 2013 was a mixed year for the company. There was good stuff in there but there were some disappointing elements, too. We clearly were pleased with the market share gains that we’ve picked off in some elements of the engine segment, some elements of the component segment. We were delighted with the performance of the components segment – record sales, record profits in dollar terms, record profits as a percent of sales. And that started playing out exactly as we had hoped it’d play over the last few years.

Record operating cash flow in what was a fairly difficult environment, so we’re pleased with that. And we managed and we started the North American distribution acquisitions, so we’re pleased that that’s underway. And at the same time we increased the dividend as we said we’d like to continue to do. We bought back almost 3.5 million shares and the amount of cash we returned to shareholders was up by 34% compared to what it was back in 2012.

So on one side of the ledger there was a whole bunch of stuff that we’re fairly happy about, but being quite honest, speaking for myself, speaking for Tom and the Management Team there was a sense of disappointment about the year. Sales were flat year-over-year but profits were down, and I think everyone who’s followed the stock over the past year or two, you’re familiar with the slowdown in some very important markets to us.

So where we sell high horsepower engines and gen sets into oil & gas, into power generation, into mining we make very good margins. So if there’s a really bad mix to get we got it last year, and that’s really hurt the performance from a profitability standpoint. Secondly, the performance of the power gen business wasn’t very good. I think we talked about that on the call last week, the earnings call last week. It was disappointing. Demand kept falling and we never got ahead of it, so that’s one area. The restructuring that’s going on right now, that will continue through the summer but that was another area we were disappointed in.

So I was a little bit flat at the end of the year I think, but then yesterday we filed our 10(k). And one thing I do when I file a 10(k) every year, I go back and look at trends. And it’s interesting – if you look at the net income that we have reported over the last three years it’s equivalent to the net income over the previous 16 years. So I think it just illustrates how far the company’s come over the past few years, even in difficult environments.

Looking forward to 2014 I think the region we’re most excited about is North America. Again, those of you who have talked with us over the past few months will not be surprised by that. We’re seeing better economic conditions I think. Some of the issues that were holding up positive confidence and sentiment with end users and consumers are starting to move in a better way now.

The North America truck market we believe is going to be up what, 8% next year? We think that our market share is still going to remain very strong around 38%. The medium duty, the class 5 to 7 market we’re calling for a 7% increase; and our market share, which went up last year from 50% to 63%, we’re now talking about going from 63% to 70%. So very pleased with the market share gains there, and also the North American distribution acquisitions will have a significant influence this year. We think that by itself will add around $400 million of revenue to the top line and be immediately accretive to the bottom line.

So North America is definitely feeling more positive than I think any other region of the world just now. China is turning the corner. China I think over the last year and a half we were maybe a little bit flat on it. We had a good year last year – some of that was artificial with the pre-buy ahead of NS4. This year we’re projecting record revenues in China including our joint ventures; I think we’re talking about revenues being up close to 11% year-over-year. That’s despite the China truck market, the medium-duty and heavy-duty truck market being down year-over-year, and that’s just a reflection of the pre-buy. So with a strong second half of the year in 2013 we expected a softer first half in 2014.

We are introducing two new engines this year – a 10 liter and a 12 liter engine with our partner Foton. That’ll come out sometime in Q2, probably towards the end of Q2 so we’re really excited about that. And we’re starting now to see a lot of our progress on the construction side. So it’s minimal – we’re talking about 3% improvement in revenues in the excavator market which is where we tend to play more in China than anywhere else.

India is not so good. India, I think we’re looking at flat revenues year-over-year. The economy as you’ve been following has been going through some difficult times. They’ve got elections coming up. I think nothing’s really going to happen before the elections and if I’m pessimistic more about India just now because I don’t see that coming out immediately. I’m very confident about the long-term outlook for India but I think the truck market will stay flat year-over-year.

I think power gen volumes will be down maybe in the range of 5% to 10% but revenues will be flat. So India is implementing some new emissions standards regarding the power gen market this year that will allow us to add more content and more price to the gen set, so revenues are projected to be flat year-over-year. So that’s the story of India.

Brazil – Brazil was good last year but it came off a very weak 2012. And more recently I think we’re getting a little bit more concerned about Brazil. The government, I’m sure you’ve read this but the government, their subsidized financing program which is called FINAMI, they raised interest rates by 150 basis points over the last few months; and somewhere around 7 out of 10 trucks that are sold in Brazil actually use or are dependent on that program. So I’m not expecting any great movement in the demand for trucks in Brazil, it’ll probably be flat year-over-year.

And then Europe, I think Europe’s going to be good components with the emissions standards being put in place on Euro-6. I think we’re going to benefit from more content. On the other hand we did see a pre-buy last year on the truck side so that’s going to have an effect on the first half of this year. And I think power gen’s going to remain fairly muted for our European customers who tend to sell outside Europe of course, at least the first half of the year but may (inaudible) the rest of the year.

And then finally on the markets, the one global market we always spend some time talking about is mining. Mining was a difficult market for us last year as it was with many other people. Engine revenues were down by 44%. This year I think we’re talking about engine revenues being down between 5% and 10% and the aftermarket being flat. So mining continues to be a headwind although not as much of a headwind as it was in 2013.

So to wrap up with the guidance we gave, we’re talking about growth of 4% to 8% this year, probably closer to the lower end of that range for the first six months of the year, improving conditions in the second half of the year.

We are expecting to develop incremental EBIT margins in the range of 20% and we’ve been consistent on that target for a number of years now. When we had our Analysts Day last September in New York that was a target we gave over the next five years. So if you’re looking to see if we’re on track with what we’re saying profitability-wise look at those incremental EBIT margins and test us on that.

I am expecting a record year for the components segment and for distribution, both in revenues and in dollars. I think engines will improve but as long as we have that soft high-horsepower market they will not reach the levels they have been in the past. But they will be better in 2014 than in 2013 as will power gen. The power gen improvements are going to be more visible I think in the second half of the year as we continue to work through some of the restructuring in the first half of the year. So all four businesses will improve, two of which will have record years in terms of record sales and record profits.

As we said at the Analysts Day and as we said on the call over the last week or so, we expect to return 50% of the cash that we generate from operations to shareholders. So that’s through a combination of dividends and stock buybacks, and that would represent a 25% increase over what we did in 2013.

So let me wrap up there. I think the company’s in a really good position to continue to grow when markets come back. And I think we’re going to see some of that happen in North America in 2014, we started to see it in North America last year – that’s why components did so well in particular. I think we’re going to see more of that in the next 12, 18, 24 months in North America. International markets I think will remain mixed and start to recover probably late into 2014, 2015.

So Mark, is there anything you want to add before we go into questions? No?

Question-and-Answer Session

Andy Kaplowitz – Barclays Capital

So Pat, there’s a lot there that you talked about. When I talk to investors about Cummins I think that most investors believe that Cummins is a relatively high-quality company, one of the highest-quality companies in machinery. But you know, over the last two years it’s been tough for you to forecast. And you just gave us this whole forecast when it comes down to it. What lessons have you learned over the last couple years that you would factor in or that you have factored into your forecast as you look at 2014, because you know, I’ll delve into some of the parts of your forecast. But just stepping back how do you become more dependable as a company that we can count on what you’ve given us just now?

Pat Ward

Yeah, I think that our forecast has been disappointing. There’s no two ways to talk about that. We were disappointed over a number of quarters that the revenue growth that we were thinking was going to come never actually materialized. And I think if there’s one lesson I would take away from that, Andy, and I think is very pertinent to what’s gone on just now, is don’t get carried away on a couple of data points. So the fact that… I know I’ve already gotten some pushback today from investors that we’re being conservative on our outlook for the North America Class-A truck market.

So the last two months have been really good and we’re delighted about that. We’d seen that in 2012 as well and to some extent we’ve seen it in the start of 2013. So once I see a few more data points now I’ll become more confident, but I think part of our problem is that we were looking for areas to offset weakness. We knew mining was going to be a tough area and high horsepower in general was going to be a tough area, so I think we grasped looking at early data points to think “Okay, things are going to turn out okay in these markets.” And it didn’t turn out as well so I’m going to be a little bit more patient and wait to see the chips fall.

Andy Kaplowitz – Barclays Capital

Okay, that’s good. Let me ask you about North America. I know obviously you’re going to get pushback on it, but backlog for Class-A is up 30% year-over-year and you’ve been saying that it feels the same as it has over the last couple years – maybe you start out early strong and then it falters. But is it different because backlog is significantly higher? We also know that again, you had more Navistar business coming in last year but you still have some incremental coming in this year. The only thing I see that’s really more negative is Paccar is slowly upping its MX engine content.

Pat Ward

Yeah, I think conditions are a little bit different than where they were before. We have not seen any real uptick in build rates. So until I start seeing more demand come in and that means build rates have picked up, again, I’ll remain a little more subdued. Certainly if you step back and just look at general economic confidence in the US, and I’ve been saying this for months now it’s feeling better.

I think the fact that we’re making progress on the budget and the debt ceiling, which was holding back customers from making decisions – like now they want it, they put in the order, now they want it. I think we’re looking at moving past that now. I think people are feeling a little bit more confident and conditions are better. I just want to see orders come in for another couple of months and build rates pick up, then I’ll maybe (inaudible).

Andy Kaplowitz – Barclays Capital

So I remember Rich who is the head of your engine business talked about if the budget stuff really started to go away as a big overhang that customers would really open their wallets. Is that really what we sort of see is happening here?

Pat Ward

Yeah, essentially and that’s what I was trying to talk about a few minutes ago. As people get more confidence that there’s not going to be a stalemate in Washington that’s going to slow down the economy then I think they’ll start to feel better about making investments, that they’re going to feel they can get utilization on these investments.

Mark Smith

Maybe just a couple of smaller points on these. So we do see that the vehicles that are in use today are incurring increasing maintenance and repair costs consistent with an aging fleet. So our parts business for Class-A engines is growing at double digits in North America right now, so that’s indicative of higher use. So we think the fuel economy benefits from the new engines, the negative from rising repair costs and at least some independent data – not our data – is that the trucks that are in service have quite decent utilization rates. So I do think it’s not just the orders in the backlog; I think there’s some underlying indicators that the cost of running those existing vehicles is rising so that’s beneath the surface as another factor that gives us some confidence.

Andy Kaplowitz – Barclays Capital

Okay. So alternatively, why is flat right for Brazil and India? See, this is what I worry about for you guys, is that if you look at India why is anybody going to order anything before elections when it comes down to it? Why can’t it get still a little bit worse before it gets better? And then in Brazil again, what we’ve seen is a pretty big interruption as you ended the last FINAMI program and you start the new one – interest rates are a lot higher. So what gives you conviction to say flat especially because you’ve been wrong before when it comes down to it?

Pat Ward

Yeah, we could be wrong. I could be wrong in India. We were wrong in Q3 and it’s possible we’ll be wrong again. But if you look at that drop we’ve seen in the truck market in India over the past six months it’s been fairly steep and it’s difficult to see…It could go down more; it’s difficult to see it going down much more. I think clearly there’s still a demand for infrastructure investment in India, maybe not to the extent we were seeing before.

The power generation demand has been impacted by the slowdown in the economy but it’s not going away. There are still blackouts and brownouts in India so there’s always going to be an underlying need for power generation and for engines that we can supply into those applications – all those things we think are going to be flat compared to 2013. Could it be down 5% or 10%, or up 5% or 10%? Yeah, absolutely. You’re talking $100 million either way when you look at the size of the Indian market for us.

Mark Smith

I was just going to say on these costs unfortunately with the level that India and Brazil are at right now you’re talking about maybe 10% of consolidated revenues, whereas North America is more than 50% at this point in time. But there are some balances I think (inaudible).

Andy Kaplowitz – Barclays Capital

Another thing I wanted to ask you about just sort of your overall guidance, as you talked about sort of the breakdown of the 6%, the midpoint of the 4% to 8% - and let’s say that 2.5% to 3.0% is what you’d call market share, emissions, new products. And so when you’re looking at… I think maybe some of the investors I’ve talked to were modestly disappointed about that, thought you could do more here in 2014.

But I guess the way I think about it is maybe this is just the start for you guys and as you go over the next couple of years that growth number can get higher as all these sort of new product launches happen, because they’re really just happening now most of them. Is that the right way to think about it, that that number actually can get better in terms of incremental growth as we go into ’15 and beyond? Because I think a lot of investors, they want to buy stories where there’s so called “self-help,” you know? I think this is your self-help.

Pat Ward

I think it is. We’ve given guidance of 4% to 8% this year for 2014. If you go back to what we said back in September, over the next five years we said 8% to 12%. So I think this is just the start and that you should expect to see further improvement given the economic conditions as we get into 2015 and 2016.

Andy Kaplowitz – Barclays Capital

And what would be the thing that would accelerate most as you look to go from 4% to 8% to 12%? What can we count on most to drive that growth besides market?

Pat Ward

The thing you can turn to most is acquisitions. The acquisitions are within our control, sorry, the North American distribution acquisitions are within our control. We executed I think two or three last year; we’ve got another five or six lined up this year. So they’re right on pace and we’re feeling very good about the timing and the execution, and that we will get at least what we said we would get from these acquisitions.

Andy Kaplowitz – Barclays Capital

Gotcha. Okay, so I want to do a couple more audience participation questions and then I do want to open up to the audience in case you guys have questions or else I’ll continue. So if we can do questions #3 and #4: in your opinion, through cycle EPS growth for Cummins will be 1, above peers; 2, in line with peers; or 3, below peers.

So 59% say above peers which I think is great. Let me ask you a question on this though, because one of the reasons I think most investors believe you’ll be above peers is because you’ll continue to take market share over time or at least hold your market share. When I look at sort of what you’ve said for this year, you’re talking about 38% for Class-A heavy duty in North America, you’re talking about 70% in medium-duty.

Pat Ward

Mm-hmm.

Andy Kaplowitz – Barclays Capital

I mean 70% seems like a very high number and 38% is acutally down from 39%. So are we peak-ish with market share or can you still do more here over the next couple of years? And then what’s really the opportunity in the emerging markets, because I guess the fear that I sometimes have is Europe has gone the way of vertical integration – why are the emerging markets not going to do that too to a certain extent?

Pat Ward

I’ll take you back to what we said in September at the Analysts Day, and we said of that 8% to 12% growth, I think we said 1% was going to come from market share. So 38% is a high number for us in Class-A. We’ve given a range of between 35% to 40%; we’ve been consistent on that now for a number of years. Clearly we’re really happy with the 70% number. We haven’t got there yet, but it’s 63% going up to 70%. Could it even go above that? Quite possibly.

But if you look in the international markets the one I think I’m probably most excited about is China, and as we bring the 10 liter and 12 liter to market I think we have the opportunity to grow our share in the truck market from around 10% today to somewhere north of 20% over the next two or three years. So that’s the one emerging market I’d be most excited about.

I think if you look at Brazil we have market share in the mid-30%s in a tough market. In India, even though the market is muted our market share is back up close to 40% with the alliance with Tata. So I wouldn’t get too excited that market share’s going to continue to jump in increments of 5% every year. I think that would be wrong and that will be misleading. But we’ll clearly look to improve market share providing I can do it in a profitable way. I’m not really interested in market share only if it doesn’t hit the bottom line.

Andy Kaplowitz – Barclays Capital

I understand. I get a lot of questions on China in terms of concerns about the visibility there, but the way I think about it is you probably have better than average visibility given the new product launches and given your positioning in China. I understand the market is very uncertain. To me, Brazil and India are a bigger risk for you guys than China is. Do you agree with that statement, that over the next couple years… Again, China can always fall off a cliff but it’s already pretty muted. So maybe in the next two years people don’t really understand that China could actually be a source of upside for you guys still.

Pat Ward

Oh, I think it will be. I don’t think there’s any doubt over the next two or three years once we get past the pre-buy hangover there’s potential upside in China. And probably at this point in time it looks better than what it does in India or Brazil. Over the long term, over the next five, ten years I think there’s as much upside if not more than India.

In terms of visibility, yeah, we’ve got great partners, we’ve got great presence in the market, but we don’t have the same visibility as we do in North America. I think everyone gets that. So some things we get wrong but in general we’re in everyone’s engine with some component so we’ve got some visibility of what’s happening throughout the industry, and we’ve got pretty strong growth on both the heavy-, medium- and now on the smaller engines that are coming into play as well.

Andy Kaplowitz – Barclays Capital

And the Chinese government is starting to institute NS4 more, you know – it’s not official and standard but…

Pat Ward

Well, it’s officially effective the 1st of July last year. Unfortunately the regulations and oversight have not been clear yet, it’s not exact yet how they’re going to adopt those and put those in place. Until we can get to a (inaudible) on that I think things will go slower than what we wanted. Mark?

Mark Smith

And I think you bring up an important point, Andy, about the emissions regulations. So our market shares do look high and they are high in engines and components in a number of markets, and there are some pretty good reasons for that. I think investors need to remember these are not static markets.

We’re on a journey to improve emissions regulations so these are not static markets. So there’s an increasing complexity, cost of compliance, and again, you know, what we’ve seen in developed markets where emissions standards are the most stringent in the world we’re doing better than the average competitor in the market. We’ve gained share in engines and components, we’ve helped others be successful. So you know, there’s no guarantees but that’s what we’re looking for.

Again to your point is there risk that more OEMs in China make their own engines? I guess it’s possible. The other attractive advantage they get with Cummins is we can help them access international markets because we’ve got a variety of products with different emissions regulations, a distribution service that can help them. So I think that’s another strength of [the bull].

Pat Ward

The one other comment I’d like to make about EPS and profitability, there’s a tremendous amount of focus within the company on gross margin – on expanding our gross margin even on flat sales. That’s been difficult given the high horsepower mix issue but even with that we’ve improved pricing last year, its contribution to the margin; we’ve just [decreased] our costs by 1.2%.

I think as we look into 2014 and beyond we’ll continue to focus on material costs, continue to focus on supply chain. Our [warranty’s] come down from what it used to be, it’s still too high. Maybe it was 4% three or four years ago and now it’s 2% but that’s still too high. So there’s a lot of improvements still in the gross margin that can drop all the way to the bottom line even in the absence of strong growth at the top.

Andy Kaplowitz – Barclays Capital

You brought up gross margin so I have to ask this question before we move on around power generation. So it’s been a pretty big drag on results. When do you just say “Hey, there’s something wrong with this business so we’ve got to make more remedial changes to it?” It seems like it’s gotten ultra-competitive in a sense in some places, and again, it’s still you guys and Caterpillar for a lot of the big stuff.

But it seems like it’s just a harder market than it ever was before, and it also seems like whereas Cummins has an excellent position in its truck businesses, Cummins doesn’t have as good a position in power generation. I don’t want to put words in your mouth but what can you do better, make us feel better that margins aren’t still going to be a drag on results going forward?

Pat Ward

Yeah, before I talk about the margins let me come back on the position. I do think we have a very good position in the power gen market. So Cat and us probably have about what, two –thirds of the global market; and Cat’s probably closer to 40% and we’re closer to 25%. But there certainly [are areas where we’re dominant]. You look at India and the demand for power in India, albeit given what’s happening today with the economy, and you look at 160 kVA and above we have over 50% market share in that market. So I think we’ve got regions of the world where we’re very strong and other regions of the world where we’re number two, in some cases maybe a number three player.

We have been disappointed with the profitability. I think we tried to be very open in the call a week or so ago about that, that we didn’t get ahead of demand. When we start to see the slowdowns coming we like to jump ahead of where we think demand’s going to go and cut costs to get ahead of it. We didn’t do that this time. And I traveled a lot last year, and in the first half of the year our folks in power gen who were close to the market were talking about second half improvement, second half recovery, and it never happened. So it’s a tough one for us.

I mean Tony and his team are taking actions to restructure the business. It’s been encouraging that the gross margin over the last three quarters has improved quarter after quarter after quarter. But when volume is as light as it is today it’s tough for us to hit the double-digit targets we want to get to. But that’s the goal, that’s the goal still.

Andy Kaplowitz – Barclays Capital

Okay, so let’s do question number four if we could. In your opinion what should Cummins do with excess cash? Number 1, bolt-on M&A; 2, larger M&A; 3, share repurchases; 4, dividends; 5, debt pay down; and 6, internal investment.

Okay, so relatively predictably share repurchases are winning for you guys. It’s interesting – you’ve been big I think at internal investment in the past, both in buying distribution and sort of bolt-on M&A. So your priorities are a little different it seems than the audience here. So I asked Mark this question yesterday but I’ll ask you, Pat, because you’re here today: how do you respond to… So you see some of the big machinery peers, like a Caterpillar and a Deere announcing big repurchase for big percentages of the market cap. Yes, they give a long dated timeframe on it but at the same time I think that Deere could buy back 5% to 10% of its stock this year.

So like I know you’re an innovative company, I know you want to spend a lot on new products but when do you sort of give into this and say “Maybe we do need to do a little bit more?”

Pat Ward

Yeah, I think we have a very deliberate strategy around how we use cash, and first and foremost we want to reinvest it back into the company where we see profitable growth opportunities. So this is going to sound like an old record, Andy, you’ve heard this before but that still remains the case. And when we look at the strongest correlation to total shareholder return is improving the returns of the business. And I don’t think I can improve the returns of the business as well by deploying cash in other ways.

I think our record over the last five or six years justifies that, supports that. If you look at what’s happened with returns on invested capital in the business, as we call it the return on [average days assets] we supplemented that with increasing the dividend and doing stock buybacks. But the predominant use of cash has been reinvesting where we’ve got good opportunities. And I think the stock was up awfully high at the end of last year; it was up again yesterday. I think the market sees that and shareholders want long-term value. They’re not looking for a quick payback today or tomorrow; the majority of them are not looking for a quick payback today or tomorrow. They want consistent, long-term value and I think our strategy supports that.

Now, if the whole gross scenario picture changed and we didn’t think we could grow at 8% to 12%, which is not the case but you’re asking me under what circumstances, I think we would then look at what we do with cash differently. But that’s not on the agenda today. We think we’ve got terrific growth opportunities. We want to continue to invest in new markets, new technology, new products. We want to return cash to shareholders – that’s why we said 50% of cash from operations this year and over the next five years will be returned through dividends and stock buybacks.

If you look at what we’ve done in the dividend over the past three or four years it’s up 250%, and if you look at stock buybacks over the last three years it’s close to 5%, close to 6%. So I think we’re doing exactly what we said we would do and I don’t see any reason to change that just yet.

Andy Kaplowitz – Barclays Capital

Okay. Let’s open it up to the audience if the audience has any questions. We’re going to come around with a microphone otherwise I will continue… A question over there.

Analyst

So just following up on your comments on China, how do you see the market there evolving? Because if we look at sales today especially on the engine side it’s still dominated by very low priced and albeit lower quality engines. And these guys are already becoming compliant with the new pollution controls and everything else. So how much of a shift do you see in demand coming from lower-priced, lower quality trucks moving up the scale? Or is it simply going to be that your market share gains are going to be at the expense of Daimler and the other higher-end players?

Pat Ward

Yeah, as we think about China, the way we look at it, think about our pyramid. And we’ve tended to play at the top end of that pyramid, the high-quality, premium end of the market. And what we’re looking to do is move into the midsection. So midsection does not mean low quality, so we will not produce an engine or a gen set that is not as high quality as anyone else in the world.

The expectations of the customer in China might be a little bit different than what it is in North America. So for example, in North America one of our top customers might not want their engine to run a million miles in a truck. In China the expectation is not for a million miles – it’s somewhere around 250,000 km, 300,000 km. So the expectation of the market is a little bit different. But I am starting to see a move towards higher quality, more reliable, better fuel economy engines than what they’ve had to date.

There’s always going to be a market at the lower end of the pyramid that will focus primarily on cost. That’s not the market we’re in. That’ll be a market other people will play in, that’s fine for them – that’s not where we’re going to go.

Analyst

(inaudible audience question)

Mark Smith

I think it’s been slower than we wanted, I think that’s the first observation. But another part is because we’re actually displacing locally made engines. It’s not the global OEMs who have large market shares in China – they’re all investing and wanting more access to that market. But with our partner, with Foton for example in the light-duty we’ve displaced locally-made engines with the new 10 liter and 12 liter engine; we’re displacing local medium engines.

So to some extent you’re right – the emissions NS4 or Euro-4 standard are widely available. You’ve still got to apply those, right, you’ve still got to have good performance of the vehicle. But I think we’re on a longer-term view and we need to push on the emissions regulations to help us outcompete over time. But just as a reminder, you know, we’re a large engine manufacturer in China. [Anhow] engines are all made in China, they’re all sourced in China or provided global sourcing. We’ve put more engineering power into the hands of our engineers in China to get the designs lower cost.

So a vehicle in China, and this is not a negative comment but might last 300,000 km or 400,000 km. In the US our customers want engine warranty or expect the engine to run up to 500,000 miles under extended warranty – they actually expect the vehicle to last over 1 million miles. So one of the challenges we’ve got is to design things that have everyday reliability that don’t last 2x the life of the vehicle, so that’s some of the challenges in getting our cost structure right and what we’re focused on. But we are about as local as you can get in China, but bringing that knowhow from other markets.

Andy Kaplowitz – Barclays Capital

Any other questions from the audience? Okay, let’s do ARS questions #5 and #6 and then I’ve got a couple more for you if we could. In your opinion, what multiple of 2014 earnings should come in trade? 1, less than 10x; 2, 10x to 12x; 3, 13x to 16x; 4, 16x to 18x; 5, 19x to 21x; 6, higher than 21x. You can both do this, too.

Pat Ward

Okay.

Andy Kaplowitz – Barclays Capital

Okay, relatively predictable – there’s usually a machinery multiple of around 13x to 15x. If you do grow like you say you’ll grow maybe you could trade toward the higher end of that range.

Let’s do question #6. What do you see as the most significant investment issues for Cummins? 1, core growth; 2, margin performance; 3, capital deployment; or 4, execution strategy.

So core growth is, it’s always been like that for you – core growth wins with 39%. It’s always been like that for you. You’ve got to come up with the core growth and the last couple years that has been more difficult. For me, I think margin performance is also equally important because you know, you did have a good revenue quarter for instance but the margins left something to be desired in Q4.

But I wanted to ask you about some of the sort of, I’ll call them “frontier” opportunities for you like natural gas. Tom was pretty excited about Africa a few years ago and now you never talk about that anymore. Oil & gas has become a very small part of your business at this point but high natural gas prices maybe you can worry about a little bit for the truck companies – you actually can get excited given oil & gas collapsed for you guys a couple of years ago.

So maybe you can talk about sort of these frontier opportunities, of course the highlight is probably the overall nat gas engine opportunity, and what they can mean over the next two to three years for the company.

Pat Ward

Yeah, there has been and continues to be fairly significant investment in developing natural gas engines and gen sets through the company. I don’t think we’ve deviated at all from that. I think we’ve got a 12 liter that’s gone out through the joint venture with Westport over the past twelve months, it’s doing very well. We have gone a little bit slower on the deployment of a [13 liter] and that was a conscious decision. The market wasn’t feeling it, and I think it’s going to come eventually but I don’t think it’s going to be this kind of light switch event that some people are going to want to promote.

But we continue to make investments both on-highway and off-highway for natural gas products and we’ll continue to do so. We think it’s a good market over time. I would just caution that it’s going to explode and be a terrific market tomorrow or early next year, 2016.

Mark Smith

I think power gen’s an area particularly in natural gas that’s exciting. The new high horsepower engine is going to have natural gas there. And I think part of the thing that I run into with investors, Andy, is a little bit of confusion. We’re always trying to be realistic, so two years ago we were saying 5% to 10% of the Class-A market over five to ten years will move to nat gas. Here we are this year, maybe it’ll move to 3% two years on. So certainly we’re not wrong by a multiple.

Andy Kaplowitz – Barclays Capital

Up from pretty much zero.

Mark Smith

I mean you can talk about what that percentage growth is but our basic predictions have been about right. And again, we’re not trying to downplay it. We’re really excited about natural gas but we’re just trying to caution investors about massive adoption rates, there’s lots of factors. And we’re just as excited off-highway. As you say, there’s no guarantee where natural gas prices will settle over the long run or what tax regimes will be but we think extraction’s going to be important.

Our nat gas business got smaller primarily because we’ve been tied principally to the fracking engines or applications because we don’t have as big a reach of engines as some of our well-established competitors. So again, we’re investing a lot. I think at Analysts Day we tried to let people know we actually have a lot of natural gas engines we sell into construction, power generation, on-highway, extraction industries – we just maybe don’t talk about it as much as some of the people who like to get excited. But we are very excited and committed to more nat gas.

I think in power gen it’s probably the better potential for a high proportion of our revenues to go in nat gas, only because we’re sitting at 40% in India for truck – that’s not going to natural gas anytime soon. Brazil’s not moving large proportions anytime soon. China, the margin’s increasing but distributions are challenged. So we’ve still higher aspirations in diesel and in natural gas.

Pat Ward

I think on the Africa thing, Africa’s been a bit of a disappointment. I think we had ambitious goals two or three years ago. We continue to make progress but it’s been a lot slower. It’s been a much tougher challenge to become established throughout the continent than maybe what we had anticipated. But it still remains a very important area for the company. I was down there last year; I’ll be going back down there again this year. We just haven’t moved the ball as much in that one as what we had hoped we would.

Andy Kaplowitz – Barclays Capital

I wanted to ask you one more thing that’s topical. So Obama continues to talk about lots of different things, and his latest again is more fuel efficiency rules in the later years. How do you look at… So you’ve always said that you get much more content when emissions change, but as fuel efficiency standards continue to increase Cummins should do well also? So how do you look at sort of what Obama said recently and how do you look at the next sort of five to ten years in North America in terms of how we should think about what better or higher fuel efficiency standards mean for Cummins?

Pat Ward

I think we’re going to continue to see a move towards more regulated, higher fuel efficiency, fuel economy standards. I think that’s inevitable. For us I think that’s good. I think it’s the same type of opportunity as what we had back at the end of the ‘90s when the emissions standards started to become visible. Exactly what it’s going to mean (inaudible)-wise and how we’re going to get there remains to be seen, but we’ve always said that we think we’re the technology leader.

We believe we have the best products, the best technology out there. So if the emissions standards get tougher in other parts of the world as they will, or fuel economy standards get tougher in North America which for us is an integral part of the world – we think that represents another long-term opportunity for the company to continue to grow.

Andy Kaplowitz – Barclays Capital

So we have one more minute for you guys, a quick question on your distribution strategy. It seems like, I don’t want to say a slam dunk but it seems like a great opportunity for you guys to get some growth, and you get some growth at pretty stable business – it’ s 55% aftermarket. What can go wrong if anything in buying out your distributors? Why should I be worried about it if I’m going to be worried? It just seems like really upside – what’s the downside?

Pat Ward

I think the biggest risk is the execution. So we have I think it’s around 7000 or 8000 employees in North America in those distributors who do a fantastic job today at serving the customer. We have to continue to maintain that service to the customer if we’re going to make this a good investment, and so far the ones we’ve done have gone very well. But it’s not an easy challenge.

We need to integrate systems, different policies and practices into what we do in the company and we have to do that in a thoughtful way so we keep all the key employees that do such a great job and we maintain the relationships that we have with customers and don’t let them down. So that’s the biggest risk – execution, if we screw something up.

You’ve seen the numbers – financially it’s a very attractive investment. I think it gives us a stronger footprint across the continent. So we want to continue. Everything so far is right on track. Our job is to keep it going.

Andy Kaplowitz – Barclays Capital

Thank you very much for coming. Thank you.

Pat Ward

Thank you, everyone.

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