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Cummins (NYSE:CMI)

Q2 2010 Earnings Call

July 27, 2010 10:00 am ET

Executives

T. Solso - Chairman of the Board, Chief Executive Officer and Chairman of Executive Committee

N. Linebarger - President, Chief Operating Officer and Director

Dean Cantrell - Director of Investor Relations

Patrick Ward - Chief Financial Officer and Vice President

Analysts

Ann Duignan - JP Morgan Chase & Co

Jerry Revich - Goldman Sachs Group Inc.

Henry Kirn - UBS Investment Bank

Eli Lustgarten - Longbow Research LLC

Chase Becker - Credit Suisse

Timothy Denoyer

David Raso - Citigroup

Operator

Good day, ladies and gentlemen, and welcome to the Second Quarter 2010 Cummins Inc. Earnings Conference Call. My name is Yvette, and I will be your operator for today. [Operator Instructions] I would now like to turn the call over to Mr. Dean Cantrell, Director, Investor Relations. Please proceed, sir.

Dean Cantrell

Thank you, Yvette. Welcome, everyone, to our teleconference today to discuss Cummins' results for the second quarter of 2010. Participating with me today are Chairman and Chief Executive Officer, Tim Solso; our President and Chief Operating Officer, Tom Linebarger; and our Chief Financial Officer, Pat Ward. We will all be available for your questions at the end of the teleconference.

This teleconference will include certain forward-looking information. Any forward-looking statement involves risk and uncertainty. The company's future results may be affected by changes in general economic conditions and by the actions of customers and competitors. Actual outcomes may differ materially from what is expressed in any forward-looking statement. A more complete disclosure about forward-looking statements begins on Page 3 of our 2009 Form 10-K, and it applies to this teleconference.

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 statement and a copy of today's webcast presentation, are available on our website at www.cummins.com under the heading of Investors and Media.

With those formalities out of the way, we will begin our remarks with our President and Chief Operating Officer, Tom Linebarger.

N. Linebarger

Good morning. I will start today by sharing some thoughts on our performance in the second quarter. Pat will then provide greater detail on the quarter and our updated 2010 outlook, and Tim will talk about our longer-term priorities.

The second quarter was very strong in terms of our sales and even more importantly, our ability to convert those sales into profits. Sales of $3.2 billion were 32% higher than the same period in 2009. All four business segments reported significantly higher sales led by our Engine and Components segments, which increased by 45% each.

Earnings before interest and taxes increased significantly from second quarter of 2009 to $401 million or 12.5% of sales. That compares to 4.5% of sales during the same period in 2009 and 10.7% of sales during our strong first quarter this year. For the first time, all four business segments reported quarterly EBIT above 10% of sales.

Strong markets in China, India and Brazil continue to drive large sales increases as those economies have now fully recovered from the global recession and are growing robustly. Our sales growth in those countries was even better than we had anticipated for the second quarter, and we expect continued strong results from those markets in the second half of the year.

As you know, our leadership in markets outside the U.S. has played a large role in our success in recent years. Our geographic diversification has reduced the impact of economic cycles on our business as evidenced by our performance in the current economic downturn. In addition, our growth rates have increased as a result of our strong position in the fastest-growing markets in the world.

In the first half of this year, 64% of our consolidated sales have come from outside the U.S., the highest percentage ever. During that period, sales in China have increased 99% from the same period last year, while sales in India are up 45% and sales in Brazil have risen 94%. And as you know, our consolidated sales picture understates the true impact of our International business because of our joint ventures in countries such as China and India. JV sales in China were up 105% compared to the same period last year and 64% in India.

Our Dongfeng Cummins joint venture produced a record 63,000 engines in the second quarter. It's expected to be a $1.3 billion business this year. The second major driver of our strong financial performance in the second quarter and really throughout the downturn has been improved productivity across our manufacturing operations worldwide.

As we have highlighted in previous earnings calls, we worked very hard in the early days of the recession to quickly align capacity with real demand for our products. At the same time, we took advantage of the slowdown in volumes in the first half of last year to implement significant improvements in many of our manufacturing plants and our supply chain. That work has resulted in improving efficiency and allowed us to leverage higher engineering components demand to increase gross margins in both business units. We have also benefited from increased efficiencies in our Power Generation and Distribution businesses.

Here are just a few examples of improved productivity in our manufacturing plants. Productivity, as measured in turbochargers produced per engine per day at our Huddersfield, England plant, in the second quarter was nearly double the rate from the same period last year. Using the same productivity measure, our turbocharger plants in Charleston, South Carolina, China and India all increased productivity between 20% and 25% compared to the second quarter of 2009.

Our MidRange Engine business produced approximately the same number of engines in the second quarter as during the third quarter of 2008 with 900 fewer people. Our high-horsepower engine plant in Daventry, England has nearly tripled its daily output over the last five quarters, while we have doubled our output at our high-horsepower plant in Pune, India. Critical to those gains has been our work to coordinate the shared-supply base between these two plants.

Also, despite the increased production, managing expenses at Daventry have been reduced by 20% since the peak of the last cycle in 2008. At our heavy-duty engine plant in Jamestown, New York, our direct labor cost per unit produced was flat compared to the fourth quarter of 2009 despite a 58% drop in volumes. Across our Power Generation business, generator set revenue per factory employee per day is up 28% from the same period in 2009.

Now I will speak in detail about how each of these business segments performed during the quarter. But before I turn it over to him, I wanted to offer a few high-level of thoughts on our performance in each of the businesses.

The Components segment has turned the corner, is now placed to consistently deliver the kind of results that we have been telling you to expect from this business. Growth prospects are also very robust for this business unit. EBIT margin for this segment was at an all-time high during the second quarter. Our productivity improvement has taken hold more quickly than we had expected especially in the Turbocharger and Filtration businesses. We also are seeing volumes outside the U.S. return faster than we had anticipated and are beginning to see the impact of increased component content on our engines.

Our Power Generation segment, which is a later-cycle business for us, seems to have bottomed out late in 2009 and has started to rebound. Compared to the same period last year, we experienced gains across all lines of business within the segment. In particular, demand for Commercial Products was much stronger in all four BRIC countries as well as generator set assemblers in the U.K. who export to emerging markets.

Our Engine business had an outstanding quarter, reporting its best quarterly EBIT percentage ever. What makes the results even more impressive is the fact that the North American heavy-duty truck engine market remained soft in the second quarter as we projected. That weakness has been more than offset, however, by strong gains in many of our industrial markets as well as in medium-duty truck markets outside the U.S. and for engine parts and kits.

Sales to the construction and mining industries outside the U.S. to medium-duty truck markets in Brazil and our DCEC joint venture in China was significantly better than the same period last year. We also saw a rebound in sales to Chrysler compared to last year when Chrysler stopped truck production for several weeks during its reorganization.

Our 2010 engine launch in North America has been very successful. We now have 14,000 new medium- and heavy-duty engines in the field, and they are performing extremely well and delivering the type of fuel economy improvements that we expected.

Based on 60,000 hours of testing at our technical center and more than 5 million miles of customer fuel test, we're confident that our 2010 15-liter ISX engine operating with an SCR system is providing 5% to 6% better fuel economy over our EPA '07 engine. Also, we estimate that our new engine is 5% to 8% better than the 2010 EGR-only engine, even including the use of diesel emissions fluid in the SCR system.

As I said, the new engines are performing well, and we are seeing orders start to pick up. For example, we already have more than 30 fleets who will each take delivery of at least 20 ISX15 engines in the third quarter. We've also heard from customers that are pleased with their new Cummins engine. One such customer is Frost Trucking located near Chattanooga. Frost regularly runs Cummins-powered Peterbilt trucks to and from the West Coast averaging 5,000 miles a week. The owner told us recently he already has two Cummins ISX engines with more than 65,000 miles on them. It makes me extremely happy with the overall performance and fuel economy of the new engine. In particular, Frost drivers have been very pleased with the improved acceleration and quieter ride as a result of using the new ISX15.

The Distribution business continues to perform extremely well as it has throughout the downturn. Sales rose significantly from the same period last year, and the business produced EBIT margins in line with our expectations.

We are pleased with how our performance has continued to improve despite the fact that some of our key product and geographic markets have yet to fully recover from the recession. As a result, we are increasing our guidance for 2010 to reflect that performance and our expectations for the rest of the year. We now expect to earn 12% EBIT on sales of $13 billion for 2010.

I will now turn it over to Pat who will give you some additional details about the second quarter.

Patrick Ward

Thank you, Tom, and good morning, everyone. Second quarter revenues of $3.2 billion were up 32% in the same quarter last year, with revenues in our international markets increasing by 51% led by stronger demand in China, India and Brazil, while sales in the United States were up by 8%.

Compared to the prior quarter, revenues were up 29% with similar growth across all major regions. The emerging markets continue to trend a sequential growth, while European and North American markets started to recover. Earnings before interest and taxes were 12.5% of sales in the quarter, significantly better than a year ago as well as last quarter's performance. In fact, this is the best EBIT percentage we have recorded over the last 25 years.

The main reasons for the strong EBIT margin performance were the productivity improvements in our manufacturing plants just mentioned by Tom, increased demand for products across all four segments, lower material cost compared to last year and placing increases in certain markets, the record joint venture income particularly from engine joint ventures in China and India and lower warranty costs, earnings per share of $1.25 in the quarter. Now let me turn to each business and give you some details of their performance in the second quarter, as well as an update for 2010 revenue and profitability outlook for each of them.

Starting with the Engine segment. Revenues of $1.9 billion were up 45% from last year. Revenues to the on-highway markets grew 35% due to stronger demand in the RAM Pickup and Medium-Duty Truck segments, while shipments from North American heavy-duty truck engines were 38% below previous year levels.

Revenues to off-highway industrial markets grew 49% year-over-year led by stronger demand in construction and in mining. Compared to the prior quarter, revenues increased 33%. Sales to on-highway markets were up 43%, with medium-duty truck and bus revenues up 63%, light-duty automotive and recreational vehicle revenues up 43% and heavy-duty truck sales up 35%. Industrial revenues were up 14% mainly due to strength in the construction, mining and oil and gas markets.

Segment EBIT margin of 10.4% of sales this quarter improved significantly from the near breakeven level of a year ago. The improvement in EBIT margins was driven by the productivity improvements in our manufacturing plants and the benefit from increased volumes, stronger joint venture income, lower material costs, benefits from pricing actions and lower warranty costs.

EBIT margins also increased from the relatively strong prior quarter mainly by leveraging on operating cost and higher sales. For the full year, we now expect Engine segment revenues to grow 25%.

For heavy-duty trucks, we continue to forecast NAFTA truck production to grow 30% in 2010. However, Cummins revenues are expected to decline 11%, as the recovery in aftermarket and international markets will only partially offset the decline in engine shipments due to the EPA '10 transition.

Revenues from the medium-duty truck and bus markets will be 12% higher this year. Strong demand in Brazil, the recovery of OEM truck production in Europe and market share increases in North America will more than offset the drop in engine demand in North America due to the EPA '10 transition.

Light-duty automotive and recreational vehicle revenues are projected to grow 42% due to the RAM pickup truck recovery in North America and strong demand for Ford pickup trucks in Brazil. We are now forecasting industrial revenues to increase 55% this year with stronger demand from the mining, construction and oil and gas markets.

As I mentioned in our previous call, our engine joint ventures are expected to perform at record levels of production this year. Our Dongfeng Cummins joint venture in China and our Tata Cummins joint venture in India were both earning at record levels in the second quarter. We now project full year Engine segment EBIT margins of 10% of sales, which imply profitability in the second half of the year will remain strong.

The leverage from higher sales volumes in the second half will offset some of the challenges that we cited last quarter such as the production ramp up of new EPA '10 engines which initially will carry high warranty rates from higher research and development investment and the reinstatement of merit increases from rising commodity costs early in the quarter are now beginning to flow through our spending with suppliers and from the slowing of demand in China as a result of government efforts to control economic growth, although the amount of the slowdown was less severe than what we thought three months ago.

In the Components segment, revenues increased 45% from the prior year and 16% from the prior quarter. Both year-over-year and quarter-over-quarter improvement in revenues were driven by strong orders from truck OEMs in China and India, global aftermarket demand improvements, production recovery from European truck OEMs and higher technology content on our EPA 2010 engines.

EBIT margins of 10.3% of sales this quarter was a record for the segment and a significant improvement from the prior year as a result of operational improvements and volume leverage from higher sales. Profitability also improved from the strong first quarter performance due to the higher sales volume.

For the full year, we are now forecasting revenues for the Components segment to increase 30% over 2009 levels. EBIT margins in the second half of the year will continue to improve, and full year EBIT margins are now expected to be 10% of sales.

Revenues from the Power Generation segment were up 16% from last year as a result of stronger demand in Latin America, China and India. Compared to the fourth quarter, revenues were up 37% with recovery in most regions. Although we are beginning to see increase in orders in North America, second quarter sales from North America were down from the prior year and up almost slightly from the prior quarter.

EBIT margins of 10.7% of sales improved both from the prior year and from the prior quarter. Year-over-year profitability was positively impacted by higher sales and productivity improvements, while improvement compared to last quarter was driven by sales growth and strong operating leverage.

The outlook for the full year has also improved. We are seeing better order activity in all regions driven by data centers in North America and Western Europe and strong economic activity in Latin America and Asia, as well as some recovery in the Middle East and Russia. We now expect Power Generation revenues to grow 20% in 2010 and deliver full year EBIT margins of 10% of sales.

And finally, the Distribution segment delivered another excellent quarter. Sales were up 24% from the prior year with a consolidation of the Western Canada distributor accounting for 13% of that growth. Compared to the prior quarter, revenues were up 21%. Most regions were up sequentially due to seasonality and recovery in demand for industrial engines in Europe and Power Generation in both Europe and the Middle East.

EBIT margins were 12% of sales and were in line with prior year results. Profitability was also in line with the previous quarter if the onetime gain from the consolidation of the Western Canada distributor is excluded from the first quarter results.

For the full year, we continue to forecast revenues to be up 25% with about half of that growth coming from the recent distributor consolidation. EBIT margins are now projected at 12.5% of sales.

As a result of the improved outlook for all four operating segments, we now expect the company to deliver $13 billion in revenue, up 20% from last year and EBIT margins of 12% of sales in 2010 compared to our previous guidance of $12 billion in revenue and 10% EBIT margins.

While first half profitability levels have been very good, we expect profitability to improve further in the second half of the year. The leverage from higher sales volumes in the second half will offset some of the headwinds we expect to face over the next six months including the higher warranty rates as we ramp up production of new EPA '10 engines from higher research and development investment and the reinstatement of merit increases, some slowing of demand in China and from rising commodity cost in the quarter that are now coming through from our suppliers.

Now before I turn it over to Tim, let me say a few words about our balance sheet and cash flow and also reinforce what we said last quarter. Our cash position remains strong. In the first half of the year, we have reinvested $130 million back into the business in the form of working capital, particularly inventory as we respond to increasing demand for our products. We invested over $100 million in capital expenditure projects and software investments. We contributed over $150 million into our pension funds, and we have repurchased $162 million of common shares.

For the remainder of the year, we expect further investment in working capital to support growth. Our capital investment plan remains at $400 million for the year, which means that spending will accelerate in the second half to support capacity expansion and new product introductions, and we will continue to return value to our shareholders through our stock repurchase program and sustainable growth in our dividend, as evidenced by the recent announcement to increase the dividend by 50%.

Finally, we just completed the renegotiation of our revolving credit facility, which was due to expire next year. The new $1.2 billion facility extends through July 2014, and along with internal cash from the operations gives us adequate liquidity to meet the future growth needs of the company.

Now before we address your questions, let me turn it over to Tim.

T. Solso

Good morning. I want to start by adding just a few thoughts on our outstanding second quarter results. Our performance is the latest indication that our work to manage the business conservatively during the recession while continuing to invest in critical technologies has paid off. Our EBIT margin has improved from 2.8% in the fourth quarter of 2008 to 12.5% in the most recent quarter on similar level of sales.

Our second quarter EBIT percentage was the best in more than 25 years. As you heard Tom discuss, our manufacturing plants around the world are working more efficiently than ever. I would add that Tom, Pat and I have visited manufacturing operations around the world over the past several months, and we can say they are all performing better now from a productivity standpoint than they did at the peak of the last economic cycle. As a result, we are earning very strong margins as our volumes start to return. We expect even better results as our U.S. and European markets continue to recover.

In March, we shared our long-term growth projections, which calls for Cummins to be a $20 billion company that will earn 12% EBIT in 2014. Based on our current performance and our plans for the future, I have every reason to believe we will deliver on that commitment, perhaps even earlier than expected.

As we look beyond 2010, we see significant growth opportunities across our businesses, and we are already started to plan to take advantage of those opportunities. For example, we are investing heavily in our High-Horsepower Engine business. We announced this month that we are investing $100 million in capital and another $200 million in R&D in our high-horsepower plant in Seymour, Indiana over the next five years. This will allow us to expand into even larger displacement engines that take advantage of long-term opportunities in markets such as oil and gas, mining and commercial marine, while helping customers in these markets meet future emission standards.

We have started production for our second light-duty diesel engine in China at our Foton joint venture. Our forecast call for our Foton joint venture to generate more than $1 billion in revenue in 2014, making it the same size as our Dongfeng Cummins JV today.

As emission standards tighten around the world, the demand for Cummins engine components will increase, both on our engines and on those engines produced by our customers and competitors. That type of growth can already be seen in our 2010 guidance for the Components segment, which is expected to grow faster than any other part of the company. We expect that to continue into the future as well.

We also are increasing capacity for current products to meet growing demand in key international markets. For example, by the end of this year, we will have expanded capacity at our Tata Cummins Engine JV in India by 50% and have plans to expand future in 2011.

We are strengthening our presence in newly emerging global markets such as Africa, the Middle East and Southeast Asia, much as we did in the 1960s and 70s in China, India and Brazil. Africa, in particular, holds significant potential as the next large emerging market for Cummins. We already have manufacturing presence in South Africa, and we are strengthening our distribution network across the continent. Our leadership team has spent considerable time in Africa over the past year learning about the different markets for our products.

These opportunities and others are consistent with the four key long-term trends that we expect to drive much of the growth over the next several years. I won't go into detail on each one again, but as a reminder, they are: One, the price and availability of energy, especially as it pertains to the power needs of newly emerging markets such as the Middle East and Africa; the second is more stringent emission standards around the world, which Cummins is uniquely positioned to meet and which provides us with competitive advantage; the third trend is increasing infrastructure spending around the world; and the fourth trend is the globalization of our business and continued growth in large international markets such as China, India and Brazil, where we already hold leadership positions. I also want to say just a few words to reinforce Tom's comments on our 2010 engine launch.

Just as we did in 2002 and 2007, we have met the new EPA emission requirements with products that have met our customer expectations. Our 2010 SCR engines are meeting fuel economy requirements and are performing to high standards on our customers' demand. We are already working toward the next big challenge in emissions, which is the regulation of carbon emissions expected midway through this decade. This translates into the need for fuel efficiency improvements of between 15% and 30% from today's standards. We expect SCR to be a part of the recipe that helps us achieve this type of improvement, but we're also exploring new technologies such as waste heat recovery systems that have considerable potential. In fact, Cummins and PACCAR are teaming up on a SuperTruck project to explore ways to improve fuel economy in heavy-duty trucks, which we see the large Department of Energy grant this year. This is just one way we are committed to working with our customers who will always have the final say over which products best meet their needs.

We work with some of the best companies in the world, and we recognize that to be successful, we need to care about our customers' success more than anyone else in the industry. Increasingly, we are using tools such as Six Sigma to help us better understand our customers' business, so we can fully leverage our skills to their benefit.

Finally, I want to recognize the work of our people throughout the recession. Our employees around the world have done a terrific job staying focused on the job at hand, often succeeding under very challenging circumstances. Keeping the company strong over the past two years has required a lot of hard work and discipline from employees around the world. As our business continues to improve, we now are facing the challenge of taking that work ethic and discipline and applying it to the significant growth opportunities ahead of us. I am confident that we have the right people and leadership in place to take maximum advantage of these growth opportunities that will lead to a period of continued and sustained long-term growth.

Thank you, and we'll now take your questions.

Dean Cantrell

Thank you, Tim. [Operator Instructions] With that, we are now ready for our first question.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Jerry Revich with Goldman Sachs.

Jerry Revich - Goldman Sachs Group Inc.

Excellent performance out of the component supply chain. How comfortable are you with your suppliers' ability to continue to meaningfully ramp up production further as interim Tier 4, China Europe 4 and U.S. truck production ramp up in 2011? Perhaps you can discuss any of their capacity expansion plans as you did yours?

N. Linebarger

Yes, as you'd guess, the supply chain ramp up, Jerry, is a big focus for the company. We switched from trying to reduce the size of our plants and supply chains to really happen to ramp it up. So certainly, really since the last quarter of '09, we've been in the process, and we got -- I think we were more ahead of it that we've been in previous recessions preparing our supply base. So for the large number of suppliers, we're feeling pretty good about where they are in terms of their ramp up. And certainly, in the Components segment, that's true. We are facing some constraints that have driven some temporary lengthening lead times, but we expect those to be resolved relatively shortly. And really, they are mostly around foundries and forges. Some of the foundries and forges are a little bit slower to ramp up. We've worked extensively with them to help them, make sure they can get capacity in place and most are doing a really good job on that and some are a little behind. But as a general matter, I'd say we feel pretty good about where we are in terms of ramping up the supply chain and see our way clear to working that through 2011. I think it won't be too long from now before the worst part of the ramp up is behind us. The first part of turning the gas on is harder than making the next incremental steps.

T. Solso

This is Tim. I would just add to Tom's comments, is that we've identified the most typical critical suppliers in this area and have early on assigned teams to help them, whether it be improve bottlenecks, help with financing, help with guaranteeing certain support levels and volumes and guaranteeing an effort to really help them improve. So as one gets off the list and another one gets on the list, and I think we're much more organized and much more disciplined in this ramp up than I've seen in prior times.

Jerry Revich - Goldman Sachs Group Inc.

And can you please provide an update on Foton Cummins and Xi'an Cummins engine production rates and contribution in the quarter and what your guidance assumes for the back half of the year?

Patrick Ward

This is Pat. Let me take that one. I think in the first half of the year, I think we produced about 5,000 engines from the Foton joint venture. We're now in production with both the 3.8-liter and 2.8-liter. The second half of the year calls for a fairly significant ramp up from that level, and I think we'll probably end up the year somewhere around 20,000 engines coming out of Foton.

Jerry Revich - Goldman Sachs Group Inc.

And Xi'an Cummins, can you comment there?

Patrick Ward

Yes, it's picking up and I think we've seen more volumes come through that joint venture this year than we ever had before. I don't have exact numbers in front of me. But it's likely this will be their best year in terms of volume shipments.

Operator

Your next question comes from the line of Henry Kirn with UBS.

Henry Kirn - UBS Investment Bank

What do you expect for the cadence for North American truck engine shipments in the second half of the year? When do things get revved up and start to hum along at a better pace?

Dean Cantrell

Jerry (sic) [Henry], this is Dean. We still feel that our production of EPA '10 is probably balanced much more heavily towards the second half of the year. I think the split, first half to second half, is looking like a 25% in the first half and 75% of what we do in the second half of the year. We are starting to hear some signs from some of the OEMs that they might be taking their build rates up of towards the end of the third quarter. And so, it is feeling much more heavily towards the back end of the year.

Henry Kirn - UBS Investment Bank

So more fourth quarter weighted there?

Dean Cantrell

Yes.

Henry Kirn - UBS Investment Bank

And could you talk about, I guess, the fuel economy delta between your engine and the 13-liter SCR competition?

N. Linebarger

So which competition specifically are you talking about?

Henry Kirn - UBS Investment Bank

Any of them you're willing to address. Any of the 13-liter SCR competition as opposed to the EGR guys.

N. Linebarger

Again, it's early on in terms of the launch. I mentioned in my remarks that our engine have had a very successful launch. We've met our expectations, with regard to fuel economy improvement, which is no small feat. We worked on those engines for four, five years. We worked on the SCR technology for a decade. We were able to get them launched at the fuel economy deltas we're hoping for, so we feel really, really good about that. This is always the period during a launch where the fuel economy stuff is kind of in up in the air because essentially, people that don't have roots that they are able to run and compare on, they have new tires, they have all these other confounding factors. We're, of course, all over it trying to figure out where we stand, trying to get as much data as we can. Our own view is that our 15-liter is going to compare on fuel economy very well to 13 liters. Some cases we expect to be better than a 13-liter, in other cases, maybe we'll be even, but we expect to compare quite favorably to 13. And I think the other point to make there is that you know a 15-liter offers other advantages besides just fuel, it also offers power and torque, which people will like for specific applications. And over the last decade, the number of customers that buy 15 versus 13 or smaller has grown, and a part of that is because the other performance factors, durability, reliability, resale, torque and power that the 15 offers. So our view is we'll be competitive with 13 and sometimes better, but we'll offer all those other advantages as well. But I guess the answer to your question will be sometime before we'll know exactly how we're doing against each engine, but we'll be checking. And we're making sure that customers are able to compare fairly because we think we'll do pretty well in those comparisons.

Operator

Your next question comes from the line of Jamie Cook with Crédit Suisse.

Chase Becker - Credit Suisse

It's Chase Becker in for Jamie. Just had a question with respect to your implied incrementals for the second half of the year. I believe this quarter you're kind of in the high-30% range, in the back half, it's more mid-20s is what you're implying. And I know you mentioned some headwinds on the Engine side, but I wonder if you can kind of flush that out a little bit more please?

Patrick Ward

Sure. I think our incrementals are actually quite good in the second half of the year, whether you compare them to the first half of this year or compare them to the second half of last year. Clearly, the comparables are easier when you go back to the first half of 2009 and compare that to the first half of 2010. But if you look at the second half of 2010 to the first half, just based on the guidance we gave you, our incremental gross margin is going to be very close to that 25% number I've talked about in a number of these calls before, which is our target going forward. And when you compare it to the second half of 2009, Chase, I think our incremental gross margin is higher than that, it's actually closer to 30%. So I'm not seeing much slippage at all when you compare really good quarters against good quarters. And keep in mind, in the fourth quarter of 2009, we delivered over 11% EBIT. It was a really strong quarter for us. So no slippage there at all.

Chase Becker - Credit Suisse

And then on the material cost side, how much benefit did you get in the quarter? And then I think you mentioned you expect some rising material costs in the back half of the year, I was wondering what you're kind of embedding in your assumption there?

Patrick Ward

Yes, in the quarter, on material cost, when you compare it to a year ago, it is probably a 1% improvement on the bottom line. For the full year, we're looking at material cost being 0.6% better than what we were in 2009, which is consistent with the previous guidance we've given on that topic in the last couple of calls. We do expect increases coming through from metal markets. We started to see some of that as the second quarter progressed, that is why I made those remarks, giving the outlook for next six months. That year-over-year, we expect to offset that by improvements in low-cost country sourcing, value engineering, et cetera. So year-over-year, we do expect it to be favorable by 0.6%.

Operator

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

Ann Duignan - JP Morgan Chase & Co

Could you walk us through, maybe by segment, the net impact of FX on revenues and EBIT?

Patrick Ward

Yes, let me take that one, Ann, because everyone else have been quiet here. It really wasn't that significant overall for the company or for any one segment, when you look at quarter-over-quarter or year-over-year. I mean, one segment that tends to be most impacted by this is Distribution, just because they're far more exposed to some of the provinces. But year-over-year, Q2 to Q3, at a higher-level, had about a $68 million, $65 million favorable impact on sales, just under 3% of a tailwind I guess on sales. And the bottom line, it was about a $25 million benefit, that would include some remeasurement improvement from last year when we took a hit in the second quarter of last year. Then the currencies that we paid most attention to are the pound, the euro, the Australian dollar, the Brazilian real and the Indian rupee. And when you compare the second quarter of this year to the second quarter of last year, the Aussie dollar's up 20%, real in Brazil's up 23%, the rupee's up 8%. And really, although there's been a lot of focus recently on the euro and on the pound, year-over-year, when you look at the average for the second quarter of last year to the second quarter of this year, they haven't moved an awful lot. When you compare second quarter to the first quarter, our sales were negatively impacted by about $20 million in future currency movements, and that's all really the pound and the euro. The pound was down about 6% from what the average rate was in the first quarter, and the euro's down about 7%. The impact on the bottom line was negligible just given the mix of business that we do around the world.

Ann Duignan - JP Morgan Chase & Co

Then I guess that's what I wanted to get some clarification on. You're so durable that you really have to do basket of currency, not just euro. I was just going to -- for my follow-up question, I want to take a step back and talk about the fuel efficiency. Again, if the 15-liter engine, I mean, I'd like to you to at least talk us through your reaction to Navistar's recent press release, where they're assuming that their engine is 1% to 2.5%, or their engine with their ProStar is 1% to 2.5% more fuel efficient than a 15-liter at Cummins in a Kenworth truck. Can you talk about where are they coming from if you're saying, no, our 15-liter's going to be as full fuel efficient as anybody else's? And also, the comments you made about your 15-liter versus a 15-liter 2010 EGR. Can you just help us clarify where you think the apples and oranges are in Navistar's press release versus what you're saying?

N. Linebarger

Yes, I don't have a good answer about all the differences and facts between theirs and ours. Here's what, I guess, I'd like to say about that, because there's a lot of stuff out now, of course, about their press release and some of the other comments they're making about FCR technology. And if you wouldn't mind, I just want to say a few things about that. Well, none of them will surprise you, we've been talking about this for a while. But we've been working on FCR technology for about a decade and EGR technology for another five years before that. We used both technologies extensively, we have been for some time. We produced a lot of FCR engines and components in Europe, even prior to the 2010 launch. And now of course, we have quite a few in the field now operating, and they're working really well. The FCR technology is not only good but getting better as the improvements in technology we've seen for the zeolites, the catalysts themselves and then of course, the robustness of the system. So my own view is FCR technology is here to stay and will be in place for sometime, because it's going to help on the carbon requirements because of its improvements in fuel efficiency. So our view is that FCR is kind of doing everything we expected, and that's terrific and that doesn't surprise us. We spent thousands of hours of development and tens of millions of dollars making sure we had it right, and we feel good about that. I guess the second point I'd say is our products are doing really well. They met the standards that we expected with regard to fuel economy. And what's more is, in our typical launch, we'll continue to make improvements on the engine that we've launched from here. So we're already looking at ways to improve calibrations and other things to drive better than the 5% to 6% we've already seen. We'll continue to work on that. I'm confident we'll even improve that further. So all that stuff came out the way we expected. We will definitely be encouraging our customers and helping our customers run head-to-head in tests. We're doing our own tests to make sure that we're, relative to others, we're as good as we think we are, and we think we're going to be in a good position on those. And our customers, of course, will be the end judge of that, not press releases we put out or anybody else puts out. And so far, again, our feedback has been really good on that. We haven't had the opportunity to run head-to-head tests with Navistar engines. We just haven't been able to get one and put them together and do one. But over time, we'll compare with all competitors and we'll be able to talk to you about that, David (sic)[Ann]. Just now, we don't have those comparisons. And I feel very good about the position we're in. And I guess that's the way we're talking to our customers about it. I think a lot of those comments and press releases, frankly, are just kind of a distraction from what really matters, which is making sure we're meeting the emissions requirements, which we definitely are, and that we're meeting customer requirements on improving fuel economy, which we are. So I guess my general answer is, tech for tat [ph](48:02) with their press release is not our action. Our action is trying to help our customers succeed by selling better products.

T. Solso

This is Tim and I'd like to add just a couple of things. There's some experience associated with this, is that when there's a diversion in technology and two companies or two groups of companies go certain ways and you're at the introduction phase, there can be aggressive claims. And the marketplace, including the analyst community, loves to see these kinds of disputes and fights. I can go back to the last one was the Caterpillar ACERT engine versus the EGR, and there was at least two or three years of debate and claims and studies and so for forth. And I think where Cummins' position is that we want to stay away from some of the behavior in the marketplace that isn't necessarily constructive. And I think what Tom's talking about and what I agree with is that you'll see over a period of time which technology prevails. And the fact that we've had as much experience as we've had, both in Europe and here, we're very, very confident, we're on the right path. And I think over six months, over a year, over a year and a half, the marketplace will determine which technology will prevail. And I agree with Tom, as I think, I like where we are and I like where the position is that we have with certain customers, and we're getting a lot of confirmation from the marketplace that we're on the right track. But we're going to try and keep this at a civilized level.

Operator

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

David Raso - Citigroup

My question relates essentially to Engine margin, trying to peak into '11 a little bit by some of the implications on the second half of '10 in the guidance. The Engine business, as you know, grew about 19% in the first half of the year. You have it accelerating to 30% growth in the second half, but the margins you essentially have flat sequentially. And of course even incrementally, year-over-year, you go from a 67% incremental first half down to only 18% and for a lot of reasons, obviously, you cited. Trying to think through those moving pieces, if you add back a certain level of warranty incentive comp, commodity cost, R&D, you can kind of get back toward maybe you're implying something like 32% core incrementals on Engines. I guess first, before the question on '11, the incremental warranty costs for the heavy and medium duty engines in the back half, is the 3% incremental warranty expense too severe? Is that how you're thinking of it roughly? It's kind of the math I'm...

Patrick Ward

I think, David, the way you should think of warranty in the second half of the year is going to be just under 4% of sales. So we were 2.4% across the company in the first half of the year. We were 1.7%, 1.5% in the first quarter, that increased to 3% in the second quarter. And I'm thinking the second half of the year is going to be just under 4%. So it's going to increase as more of our EPA '10 engines come in. Again, keep in mind the comments I made initially in the first number of quarters, in particular, after we launched the engine, we will occur higher rates. We started the year off indicating there's going to be close to 4% this year. And now I think we're going to be much closer to 3% given the performance of our engines and products are out there in the field already. But the floor question, rates are going to increase in the second of the year and probably stay high through most of 2011.

David Raso - Citigroup

But for the Engine division itself, sequentially, it sounds like maybe 150, 200 bps sequentially, because already you were raising it a bit in the second quarter. Is that a fair assessment roughly?

Patrick Ward

Yes, well, I don't have those numbers and I don't think I'd get in these by segment, [indiscernible](52:23).

David Raso - Citigroup

And the incentive comp's about a 100 bps hit would be fair sequentially and commodity cost's about 50 bps? I'm just trying to get this base down so I can think about '11.

Patrick Ward

Was the first part available...

David Raso - Citigroup

The incentive comp, the merit pay, is that 100 bps?

Patrick Ward

Yes, the merit pay is going to be about 0.3% increase as we go into the second half of the year. The commodity cost is going to be about 0.6% increase as we go into the second half of the year.

David Raso - Citigroup

That means the incrementals in the back half of the year for the Engine, even out on those back, is still relatively not low but, say, 25-ish to 30? The question on '11 is just I'm trying to think through Heavy-Duty is going to be a bigger piece of the pie you would think in '11 that it was in '10? I mean, North America Heavy and just trying to think the implications on mix. If we're looking at 10% guidance for Engine margin this year, trying to think through that mix and trying to think through all that you've done, obviously, since the days having two Heavy-Duty engine plants and now up to one in Upstate New York, how should we think about your thoughts about the Engine margins for '11 that said?

N. Linebarger

David, I think one way to, I think, address is this is you might want to, for some of the more detailed questions, want to help talk to Dean after. But here's what I'd say is, that for 2011, we are going to do our normal thing, which is we're going to finish the year and we're going to come out with guidance. But we've given our long-term view, I think, about each of the segments including the Engine. You can see where we are today. You can expect us to try to make steady headway towards what our long-term objectives are for 2014 and 2015 from here, and we're ahead of the game in nearly every segment towards where we're headed. So I think as you get to talk about 2011 now, there's more variables than we could we can really address. So what I'd say is, we're going to continue to make steady progress. We'll have mix issues, we'll have growth in different regions, all those will affect the mix. So my suggestion is, in terms of modeling purposes, I'd talk to Dean and see if you can get some of the incrementals. And then, unfortunately, you'll have to kind of wait for us to get through 2010 before we can give you 2011 views.

David Raso - Citigroup

Quickly on the back half guidance, you raised the sales guidance a lot on Power Gen and the industrial engine revenue growth accelerate from 36% in the first half to 74% in the second half. I was just trying to think through those division sales in the U.S. and Europe, how much is the interim Tier 4 potential pre-buy? I'm not sure what your reaction is to customers view of it. But how are you thinking about the implications on interim Tier 4 in those divisions and how that dovetailed into your back-half guidance?

N. Linebarger

Yes, Tier 4 interim is not having a big effect in 2010 numbers. It's not that there is nobody, but it's negligible. It's not a significant issue. What's going on in Power Gen is that sales in the Brit countries, as I mentioned, are ramping up more quickly than we expected in-line with general economic recovery in those areas, especially in large units. We've seen a lot of large unit demand in those regions. In addition, there's a bunch of other -- we're selling components in the Gen side business to other assemblers who are shipped, we think, mostly into those regions, both those are happening. The second factor that's affecting the second half is that we're seeing order rates pickup for the U.S. So they're not -- shipment rates haven't picked up so much, but order rates have, mostly for shipment in the second half, which is a good sign. I mean, that's kind of the first we're seeing, really. The U.S. may be starting to come back to some reasonable level, not to its speak, but back to some level that's a good deal. On the industrial side, really, throughout this year, we've been pleasantly surprised by the strength of the industrial markets. We talked about mining already, construction and again, in mostly, in the construction markets and those markets that we've been talking about, Brazil, India, China just really taking off for construction equipment. So all that is really what's driving that. Tier 4 interim, which will be a driver for our technology for increased content for our components, the pre-buy concept there is it's not really a big driver for volumes this year. And we don't think pre-buy is going to be a big factor in that market, the markets that have Tier 4 interim.

David Raso - Citigroup

So you're looking at a very core pick up, nothing related to the interim Tier 4.

Operator

Your next question comes from the line of Tim Denoyer with Wolfe Trahan.

Timothy Denoyer

Can you talk about the Components' strength in terms of the margins? How much of that is coming from aftermarket relative to OEMs? Do you have a great sense of that in the second quarter and then your expectations in the second half?

Patrick Ward

I think the improvement in Component margins in the second quarter are really driven by the volumes both in aftermarket and with prospect [ph](57:47) OEMs in China, India and Europe, as we talked about in our earlier remarks, and I would expect that to continue in the second half. And along with that, the productivity improvements that Tom is mentioning have driven considerable better results in that segment, so I would expect that to continue. I don't think there's been any significant difference between the margins or the improvement in margins we're seeing through aftermarket versus OEM.

Timothy Denoyer

And then just one follow-up on the earlier discussion of FCR versus EGR. The workshop that the CARB and EPA recently held, if they did revise the interest to require FCR systems to warn drivers when DEF is low, do you raise the engine when it was almost out and prevent using other liquid like they were talking about, water instead of DEF? Are your FCR systems already set up to prevent that kind of thing or would there be any material changes?

N. Linebarger

No, our engines are indeed set up to do that. There are requirements for that called inducements, now where you are engine already, first, has a reduction in power, significant reduction in power, 25%. And then has a 5-mile an hour limit limp home after a period, after the derate. So there's already significant inducements to: a, use DEF and secondly, to have it at the right concentrations. So those limits exist, our engines are ready for it. And so we don't see any significant negative impact of the workshop or any of the outcomes of the workshop.

T. Solso

One of the issues though that we have with the tone of the question is that it assumes that the marketplace is looking for ways to avoid regulations and so forth. And our experience has been is, the vast majority of the trucking industry, when they understand what the regulations are and what's required, they do everything they can to follow what's the right way. So I think there's some flaws and even having that kind of discussion. That's kind of the distraction that Tom's referred to.

N. Linebarger

There's no question though that the rules to govern technologies and emissions requirements by the EPA and CARB are developed over the many years. Our company and others in our industry contributed to developing those rules for some time. First, they have to stand for at least three years and there's a comment period before that, and even before that, all the measurement technologies out there. So again, really interesting point is that 2010 emission standards are a huge win for the environment. And these are -- is a massive reduction in air pollutants that's achieved in this 2010. And it turns out now with darn good products, products that work, that have good fuel economy, and it's a great win for the industry and the environment and took a lot of work. And what I'd say is, that these are kind of tweaks that people are talking about, but in fact, the rules were set for many years. And so they're kind of after-the-fact debates about the rules. And anybody -- is we're fine if there are some adjustment to them. I think our engines are ready to do it. But it is kind of looking backwards at a process that took, remember, five plus years to develop and is a huge achievement by the industry. So again, we're just feeling really good about where we are. We think the rules are sound and measurable on a good place. And so, we'll react and obviously participate in any process that's there, but we're already feeling pretty good about where the engines are.

Operator

Your next question comes from the line of Eli Lustgarten with Longbow Securities.

Eli Lustgarten - Longbow Research LLC

Could we talk a little bit about what's going on outside the United States, since by [ph](1:01:57) in the quarter? And then you've already told us that China's going to be a little bit slower, but not as slow as you thought, and we knew that. But you're getting phenomenal results in Europe and terrific results in Brazil. Can you tell a bit of what you're seeing second half here? We all know everybody's paranoid that Europe is going to suffer, maybe not this year but early next year. Brazil does have elections coming later this year that kind of impact next year. Give us some idea of sustainability of this phenomenal demand that we're looking at, because those are just big market share gains in Europe?

Patrick Ward

Let me start, and I'll try and talk a bit through three of those regions, and then Tom can jump in. Let me start with China, since there is some concern, now that I think is they just -- how severe the slowdown is going to be. It's certainly not shaping up and if, and like what we thought three months ago. Three months ago, you'll recall, I gave guidance that total revenues in China were going to be in the range of $2.6 billion or $2.7 billion for the company, and now we're revising up to north of $3 billion. So not only are the markets improving in China but we're getting market share pretty much in every segment that we participate in there. And although the growth rate is going to come down from 10% to 11%, it's going to bottom out 8% to 9% which is still pretty attractive to us. And I don't see any slowdown on our performance and our growth in China as we look forward over the next two or three years. Same story in India, business is growing very nicely. I think we're going to be close to $1.9 billion total revenue this year when you include the joint ventures, which is up about 45%, 48% from a year ago. And all the macroeconomic factors, the government actions that are in infrastructure investment continue to make India a very attractive growth market for us. And I think our market results were in very good condition there. I was in Europe with Dean six weeks ago, five or six weeks ago, at a time where there was probably most concern about the euro. Back then, the euro was down at $1.20, $1.22, and everyone was getting a little bit nervous about. The euro was back to close to $1.30 now, which is actually better than what the 10-year average, and we've done pretty well over the last 10 years. My sense of the European markets, we're definitely starting to see them come back. We expressed some of that in our remarks with the truck market, in particular. And supporting the Engine segment, our Component segment coming back strongly. We'll see an increased demand in Power Gen. And our Distribution business has seen an uptick in demand industrial engines too. I don't have a skeptical outlook for Europe as some of the experts do. So obviously, they're far more expert in this than I am. But when I talk to people over there, I think Europe's going to be okay. It's not going to be as much difficult as a think, some people are speculating a number of months ago. You're not going to see significant growth rates in Europe, but I do expect to see somewhere between 1% to 2% over the next couple of years as we go forward.

N. Linebarger

And then, with regards to Brazil, you did mention the elections that are in the latter part of the year. We've seen some of the incentives extended through the end of the year, through the elections. That's helped to really propel the Brazilian market forward. As we look into next year, I think we still see the potential of a pre-buy taking place in the truck markets in Brazil as they move Euro V emission standard at the begin of 2012, so we still see that on the horizon. Obviously, just the growth with the economy, there's been a lot of infrastructure development that's helping to fuel some of the construction. The commodity markets in Brazil and obviously, other countries in South America is helping propel, engines for the mining markets as well. So we see a lot of potential, still, for continued growth in South America more broadly, even in 2011.

Eli Lustgarten - Longbow Research LLC

I wanted to follow up with the great quick margins that you've got now, and you're almost approaching your 2014. Is the goal over the next couple of years is just basically sustained profitability or is there -- you saw even a point that maybe your target for 2014 maybe a little bit conservative at this point?

N. Linebarger

Eli, I knew the question is coming. So the answer is, we're definitely -- there's just no question that we're ahead of where we thought we'd be now. So what we need to do is we need to finish this year out, see where it comes. And then we need to come back and talk about investment community, about what are we seeing about our longer-term targets. Right now, we're going to leave them the same. There's significant improvement over our past. They represent terrific value growth to the shareholders in terms of profitable growth. But we need to look at it and say, once we finish this year, are they right? Do we need to adjust them? It's a good question. I just think we want to make sure we get through the year, have a chance to sit and reflect, and we will definitely do so. Because as you know, we're not a group that just wants to sit and maintain, we definitely want to figure out how to drive more for profitable growth. So we'll be thinking about that and we'll come back to you. It's a good question, I don't mean to deflect you. It's just, I think now is not the time to answer it though. We are definitely ahead of where we thought we'd be now.

Dean Cantrell

Thank you, everyone. That concludes today's earnings call, and we will be available for your questions off-line at our offices for the rest of the day. So thank you, everyone, for joining us.

Operator

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Have a great day.

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Source: Cummins Q2 2010 Earnings Call Transcript
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