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

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

Henry Kirn - UBS Investment Bank

Andrew Casey - Wells Fargo Securities, LLC

Eli Lustgarten - Longbow Research LLC

Robert Wertheimer - Morgan Stanley

Meredith Taylor - Barclays Capital

Adam Uhlman - Cleveland Research

Jamie Cook - Crédit Suisse AG

Cummins (CMI) Q3 2010 Earnings Call October 26, 2010 10:00 AM ET

Operator

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

Dean Cantrell

Thank you, Anne. Welcome, everyone, to our teleconference today to discuss Cummins' results for the third quarter of 2010. Participating with me today, our 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 condition and by the action 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 statements 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'll 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 third 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 third quarter was a continuation of our strong performance throughout 2010. Sales and profits rose sharply from the same period last year, led by strength in our international markets and the significant improvements we have made in manufacturing productivity during the downturn. Sales of $3.4 billion were 34% higher than the same period in 2009. All four business segments reported significantly higher sales, led by our Engine and Power Generation segment, which increased by 44% each. Earnings before interest and taxes also increased from the third quarter of 2009 to $449 million or 13.2% of sales. That compares to 7% of sales, excluding restructuring charges, during the same period in 2009.

To further illustrate our improved profitability, consider that in the second and third quarters of this year, we produced the same EBIT as we did during the second and third quarters of 2008 at the height of our business before the recession on $1 billion lower in sales.

Our Engine business reported record quarterly EBIT of 10.8% of sales despite continued weakness in the North American truck market. The Power Generation business has rebounded strongly from its low point of the downturn during the third quarter last year and matched its best-ever quarterly EBIT percentage at 12.3%. Our Distribution businesses set a quarterly record by earning EBIT of $74 million. And our Components group continued to perform well during the quarter as EBIT doubled from the same period in 2009.

As has been the case all year, strong markets in China, India and Brazil continues to drive large sales increases in the third quarter. Consolidated sales in China rose 72% from the third quarter of last year, while sales in Brazil increased 90%, and sales in India were up 49%. Overall, sales outside the U.S. increased 56% from the same period last year, accounting for 63% of our total consolidated revenues in the quarter.

For example, international sales of engines to the industrial markets increased 96% compared to the same quarter last year, led by sharply higher demand for construction engines in emerging markets. Sales to the mining market doubled in the third quarter, due to stronger demand for coal and other commodities. And Power Generation sales to international markets increased 65% compared to last year. Many of our U.S. markets remain weak as a result of the slow recovery in the U.S. economy. We are well positioned for the recovery in these markets but don't expect to see any meaningful improvement until 2011.

While we're on the topic of our U.S. business, I want to provide an update on our 2010 engine launch, which continues to go extremely well. To the end of September, we have shipped nearly 37,000 medium- and heavy-duty engines to North American truck and bus customers equipped with Selective Catalytic Reduction aftertreatment devices. The feedback we have received from our customers has been very positive and confirms that the new engines are performing as expected in terms of both reliability and fuel economy. Many of our heavy-duty customers say they are experiencing a 5% to 6% improvement in fuel economy compared to our EPA 2007 engines, with some reporting even greater improvement.

More than ever, we are confident that SCR is the right choice to meet current and future emission standards in this market while helping us to achieve the fuel economy our customers demand. In addition to our leadership positions in several growing international markets, we continue to benefit from our efforts to become low-cost producer around the world. We have talked in recent quarters about productivity improvements in our manufacturing operations, which have allowed us to respond quickly to demand fluctuations, to gain market share and to improve our profitability. Today, I want to share a few thoughts about a broad effort we have launched to strengthen our global supply chain.

The growth we have seen in recent years has made us a stronger company but has also significantly increased the complexity of our global supply chain. Our ability to become the low-cost producer in our industry will depend to a great degree on the competitiveness of our supply chain. We have been studying ways to manage our global supply chains to that it better meets our customers' needs for responsiveness at a lower cost.

As an important next step in that process, we have created a new senior leadership role to direct our global supply chain work, reporting directly to me. Lisa Yoder, a long-time operations and supply chain leader at Cummins, will lead a multi-year initiative that will focus on improving the performance of all elements of our supply chain, including cost, lead time, reliability, responsiveness and optimizing flows from different supply points. Part of the answer to achieving these improvements is integration and alignment between our businesses, increasing our investment in supply chain capability and tailoring our supply chains to meet customer needs.

As one small example of the type of change we're talking about, we have recently started work to reduce the number of our parts distribution centers around the world from 61 to 35 over the next five years while improving the availability of parts for our customers. Before I turn it over to Pat to discuss details of the third quarter, I want to say a few words about our long-term financial targets and our planning for 2011, both of which I know are of interest to all of you.

Our performance this year has clearly been better than we had anticipated. Our business, especially in the emerging markets, has come back much faster than we had forecasted. And we are also seeing stronger margins on the increased sales as a result of improved productivity in our manufacturing operations. As a result, we are ahead of where we expected to be at this point relative to the targets we communicated in March. We will be revisiting those targets in the near future, but first, we are focused on finishing 2010 as strongly as possible and preparing our 2011 plan. We will provide our 2011 outlook, including details by business segment and end markets, when we report fourth quarter earnings next February. But I can offer you a few thoughts on some market trends that will be influencing our planning.

In North America, we expect significant growth in engine shipments and components to the truck market for two reasons. First, we expect the NAFTA Class 8 truck markets to grow nearly 60% next year to near-replacement levels. And second, our shipments will grow faster than the overall market. As you know, we underproduce relative to the truck OEMs during the first half of 2010 as they consume transition engines. And this phenomenon will not repeat, of course, in 2011.

We expect continued growth in our markets in China, India and Brazil in 2011. But we will not see nearly the same year-over-year growth rates we have been this year, though we expect our sales growth to exceed the GDP growth rate in all three countries.

Once we have completed our 2011 plan, we will then revisit our long-term targets, this time looking out to 2016. When that work is complete, we will share our new long-term targets with the investment community. Let me close by saying that we are very optimistic about our future prospects in both the short term and the long term. As I have said, the first three quarters of this year have exceeded our initial expectations. And the longer-term growth trends, that we have discussed on several occasions, continue to look extremely promising.

I'll now turn it over to Pat, who will give you additional details about the third quarter as well as our updated guidance for 2010.

Patrick Ward

Thank you, Tom, and good morning, everyone. As Tom said, demand for our products continued to improve in the third quarter with revenues reaching $3.4 billion. Compared to the same quarter of last year, revenues were up $871 million or 34% with significant growth from all regions outside of the U.S. Revenue in both China and Latin America grew in excess of 70%, while sales in India and Europe were up 49% and 45%, respectively. Compared to the second quarter, revenues were up $193 million or 6%, led by stronger demand in India, in Latin America and some recovery in North America.

Earnings before interest and taxes were $449 million, 13.2% of sales, significantly better than the 7% reported a year ago, excluding restructuring charges.

The third quarter results included a $32 million pretax benefit in the gross margin from a favorable legal ruling in Brazil on the tax treatment of imports during the period 2004 through to 2008. Excluding this one-time benefit, EBIT was 12.3% of sales, but it was in line with the guidance we gave for the second half of the year on our previous call in July.

Joint venture income of $88 million was up significantly from last year, mainly driven by the strength of the Chinese and Indian truck markets but down 9% from the prior quarter as a result of slightly lower volumes in China and India following a record second quarter. Our profitability improvements from the third quarter of last year are driven from our ability to leverage higher sales volumes, the productivity improvements in our manufacturing plants, strong joint venture income, more warranty cost and favorable pricing.

Net income almost tripled, from $95 million a year ago to $283 million in the third quarter of 2010. So earnings per share improved to $1.44 in the quarter compared to $0.48 per share a year ago. Now let me give you some details for each operating segment.

The Engine segment delivered $2.1 billion in revenue. It was up 44% from last year despite the 54% drop in shipments to the North American heavy-duty truck market. Shipments to the construction, mining and power generation markets, as well to truck markets outside of North America, drove significant revenue growth year-over-year. Compared to the second quarter, Engine segment revenues were up 9% as we began to see higher shipments to the North American on-highway markets as well as continued growth in mining, oil and gas and construction markets.

EBIT of $223 million or 10.8% of sales was a record for the Engine segment and significantly better than the $61 million or 4.2% of sales reported last year. Compared to last year, this improved performance came from increased volumes and productivity improvements in our manufacturing plants, stronger joint venture income, benefits from pricing in certain markets and more warranty costs.

Compared to the performance in the second quarter, EBIT margins improved as a result of higher sales volume and strong operating leverage. This sequential revenue improvement will continue for the Engine business next quarter, led by strength in global industrial markets, particularly construction, mining and oil and gas and also recovery in engine demand for heavy-duty trucks in North America. We now expect full year revenues to be close to $7.8 billion, up 21% in 2010, which is slightly below our previous guidance due to the slow recovery of the U.S. heavy-duty truck market than we had previously anticipated.

Engine joint ventures will continue to deliver strong results on a record year for shipments in China and in India. We continue to forecast the Engine segment EBIT margins at 10% of sales for the full year, which is significantly better than the 3.9% we reported last year.

The Power Generation segment also delivered a very strong quarter. Revenues were up 44% compared to the prior year, with strong recovery in all markets outside of North America. Compared to the second quarter, revenues were up 12%, led by Commercial product sales in India, Latin America, the U.K. and in the Middle East. Power Generation profits of $97 million sharply increased from the $23 million we reported in the third quarter of 2009. EBIT margins were 12.3% of sales in the quarter compared to 4.2% last year, a performance that is comparable to the record level achieved at the peak of the last cycle in the second quarter of 2008. Most of the improvement came from strong operating leverage off the higher sales volume.

We expect demand to remain strong in emerging markets and slower recovery in North America and Europe. For the full year, we are now forecasting 18% revenue growth to over $2.8 billion and segment EBIT margins of 10.5% of sales compared to 6.9% last year. In our Components segment, revenues were up 30% from the same period last year, driven by a higher technology content on EPA '10 engines, production recovery from European truck OEMs, improved global aftermarket demand and strength in emerging markets. Revenues were up 5% when compared to the second quarter, with almost all of the growth coming in, first, from OEM sales as a result of the increased shipments of EPA '10 products in North America.

Components segment profitability of $63 million was more than double the profit from a year ago. EBIT came in at 8.2% of sales compared to 5.2% of sales in the third quarter of 2009 as a result of volume leverage from higher sales and operational improvements. Compared to the second quarter, EBIT margins were down two percentage points due to some warranty adjustments on legacy products, higher investment spending in research and development and some increased expense related to manufacturing operations in our Filtration and Turbocharger businesses.

For 2010, we now expect full year revenues of just below $3 billion, an increase of 26% over 2009, which is slightly lower than our previous guidance, due to the slower recovery of the U.S. truck market. We are forecasting the Components segment EBIT margin to finish the year at 9% of sales compared to 4% last year and remain very confident that we will continue to see further margin improvement in our Components segment as we move into 2011.

In the Distribution segment, revenues were up 36% from a year ago. The Western Canada consolidation accounted for 16% of the growth, while the remaining 20% organic growth came from higher engine shipments in Europe, power generation recovery in the Middle East and improved service revenues in the South Pacific region. Revenues were essentially flat with the second quarter.

Segment EBIT of $74 million was a record for this division. The EBIT margin of 12.9% of sales was essentially flat from last year as a result of the dilutive impact of the consolidation of the Western Canada distributor in the early 2010. Compared to the second quarter, favorable product mix and currency movements as well as higher joint venture income helped to improve the segment EBIT margin by almost one percentage point. We are now forecasting Distribution revenues to be up 28% in 2010 to almost $2.3 billion and deliver segment EBIT margins of 13%, which is essentially at the same level as 2009 despite the dilutive impact of the Western Canada consolidation.

As a result of the stronger performance in the Power Generation and Distribution segments, we are now raising the full year financial guidance for the company to an EBIT of 12.5% on revenues of $13 billion. This represents a 20% growth in revenues and over 100% growth in profits compared to 2009. Finally, we now project the effective tax rate for the year to be 30%, slightly lower than our previous guidance.

Looking at the balance sheet and cash flow statement, we continue to perform well. Our balance sheet has probably never been stronger. And in the third quarter, our credit rating was upgraded by both Moody’s and Standard & Poor's. In the first nine months of the year, we have invested $385 million in working capital to support the increasing demand for our products. While working capital dollars have increased compared to the third quarter of last year, our inventory turns are higher, our receivable days sales outstanding and past dues are lower, and in total, working capital is lower as a percent of sales. We have invested $170 million in capital expenditure so far this year and expect an outflow of between $375 million and $400 million for the full year. We have several capacity expansion and new product introduction projects to be completed in the fourth quarter.

In addition to increasing the dividend in the third quarter by 50%, we have repurchased over 1 million shares this quarter bringing our total this year to 3.5 million shares at the cost of $241 million. We will continue to return value to our shareholders in the form of sustainable dividend growth and share repurchases.

Let me turn over now to Tim for his remarks before we take your questions.

T. Solso

I want to start by repeating just a few thoughts on our outstanding third quarter results. Our performance in the quarter is further confirmation that we are on a path towards sustained long-term profitable growth. As Tom said, we are ahead of the growth pace we shared with you during our Analyst Day in March. Our EBIT margin has improved steadily over the past seven quarters, and all of our businesses are operating at or near all-time highs in terms of EBIT margins. We continue to see strong margins as our volumes grow as a result of the improvements we made across our manufacturing operations over the past two years.

As you heard Tom discuss, our 2010 product launch is going extremely well. And we are more convinced than ever that our choice of FCRs, the technology to meet new emission standards, was the correct one for now and in the future. As we look ahead to 2011 and beyond, the picture is probably even brighter than what we thought at the beginning of the year. In addition to a number of favorable long-term trends that we have discussed over the past year, we are preparing for growth in many of our markets outside the United States next year, both in our consolidated businesses and at our joint ventures. We plan to invest significantly across all business segments in 2011. Much of that investment will go to increase capacity or to launch new products in international markets, where we already hold leadership positions. For example, in India, we are opening a second facility for our mid-range engines and our Tata Cummins joint venture to expand capacity by 50% by the end of this year and are investing more to further increase capacity in 2012.

Work also continues on our mega site location in Phaltan, India, which will house a number of operations across all our business segments in a single location when it's complete. A remanufacturing operation is scheduled to be completed there by end of this year, and a parts distribution center will open in the first quarter of 2011. The mega site investment will strengthen our ability to serve the Indian market and also provide a base for exporting even more products, such as generators, out of India.

In China, we plan to expand MidRange Engine capacity by 25% at Dongfeng Cummins joint venture and investing capacity expansion and new products at our High-Horsepower engine joint venture in Chongqing. We also have capacity expansion projects planned across all of our Component businesses in China. In Brazil, we will significantly increase our capital spending in order to prepare for the Euro 5 product launch in 2012. We will also make investments to improve processes and facilities across all our operations in the country.

And here in the U.S., we are investing heavily in our High-Horsepower Engine business to meet expected demand both in this country and in international markets. Work has begun on the $100 million expansion in our High-Horsepower plant in Seymour, Indiana that will allow us to produce larger displacement engines to take advantage of long-term opportunities in markets such as power generation, oil and gas, mining and commercial marine.

In addition to the capital investment in the plant, we expect to spend $200 million to develop the new engine platform over the next few years. These new larger displacement engines will use both diesel and natural gas fuels. I want to remind you that our success this year has come despite continued economic weakness in the U.S. and Western Europe. And while much of our future growth will continue to come from emerging markets, we do expect to see a return to meaningful growth in our developed markets starting next year. Our market share in North America in medium-duty truck engine markets is over 50%, and we currently have more than 40% of the heavy-duty truck engine market. Because of that, we are well positioned to take advantage of the industry growth expected in 2011 and beyond.

This benefits our Engine businesses as well as our Components businesses, which are producing significantly greater content for the EPA 2010 engines than for previous engine models. We expect additional growth for our Components segment in Europe as Europe and other parts of the world adopt tougher emission standards for both on-highway and off-highway markets, both over the next several years. While I'm speaking of growth opportunities, I wanted to talk a little bit about Mexico. I, along with the rest of Cummins' Board of Directors and several senior Cummins leaders, visited our operations in Mexico last week and returned excited about our operations and leadership position in Mexico. We have been in San Luis Potosi and Juarez, Mexico for than 25 years and have developed a strong manufacturing base for Engines and Components products.

We are the leading producer of heavy-duty truck engines in the country, with an 85% market share. Cummins total sales in Mexico through the first three quarters of this year are up 60% compared to the same period last year. We currently employ about 3,600 people in Mexico, and our presence will continue to grow. For example, our low-cost filtration plant in San Luis Potosi is in the final stages of an expansion that will allow us to serve the majority of our North American market from a single location, allowing us to remain competitive in an extremely price-sensitive market.

Let me close by saying that our people have done an outstanding job over the past two years, first, by taking quick and decisive action in the early days of the recession to keep the company strong and then in managing the business very conservatively through the downturn. The results have been a quick return to growth and a very bright future for Cummins. We are well positioned to capture growth opportunities for next year and beyond and continue to make investments in people, facilities and technologies around the world in order to capture those opportunities. In fact, I've never been more optimistic about our future than I am right now. Thank you, and we'll take your questions.

Dean Cantrell

Thank you, Tim. Out of consideration to others on the call, I would ask that you limit yourself to one question and a related follow up. If you have additional questions, you are free to rejoin the queue. Anne, we are now ready for our first question.

Question-and-Answer Session

Operator

[Operator Instructions] And our first question comes from the line of Adam Uhlman with Cleveland Research.

Adam Uhlman - Cleveland Research

Just a clarification on the earnings guidance for the year. First of all, the $0.11 gain is included in the numbers, correct?

Patrick Ward

Yes, that's correct.

Adam Uhlman - Cleveland Research

And then within the margin forecast, it would appear that the corporate expense line is going to be turning into a gain in the fourth quarter, about a $100 million swing or so relative to the last quarter. Is that correct? And could you -- Pat, could you talk through what's happening there?

Patrick Ward

Yes. I think what you're looking at is the elimination [ph] (0:50:28). And we did have a sizable profit inventory increase in the third quarter. Inter-company inventory increased over the second quarter levels. We do not expect inventory levels to increase in the third quarter. In fact, our current thinking is certainly fourth quarter. Our current thinking is it could come down. So I would not expect to see any sizable increase in that column, in that charge in Q4. And my guess is that this is going to play close to zero.

Operator

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

Henry Kirn - UBS Investment Bank

Could you talk a little bit about what your order book is telling you about the kings of the North American Class 8 rebound? And not maybe this magnitude for guidance, but the timing for...

N. Linebarger

Yes. Henry, we are starting to see the order board pick up. It definitely started later than we originally planned. And so the third quarter was not as good as we originally planned. It's not a huge difference, but it didn't come up quite as quickly. And we were getting a little worried about that for next year even, but it is starting to pick up now in the fourth quarter. So we are seeing forward orders, not as far out that would tell you it's going to get to replacement demand yet so that the order board isn't that full up. But we are definitely seeing increases in the fourth quarter. So what we're sort of projecting is step-by-step increase. It's not going from flat to way up again. It's sort of step-by-step Q4 will be better than Q3 and then Q1 again, more improvement.

Henry Kirn - UBS Investment Bank

And what are you seeing in terms of price discipline in the market?

N. Linebarger

On the truck side, I can't comment so well. But on the engine side, we're in long-term agreements there. So there's very high display. We don't change them, because we have a long-term agreements with our OEM customers on how we're going to deal with engines. But for the truck side, you'd be better off to talk to our customers about that. And they could give I think quite detailed comments about that point.

Operator

And our next question comes from the line of Jerry Revich with Goldman Sachs.

Jerry Revich - Goldman Sachs

Tim, can you give us an update on Foton Cummins production rates and profitability in their quarter? And rough order of magnitude, what kind of contribution do you think we could expect from that business in 2011?

Patrick Ward

In terms of the production rates by quarter, you would recall that we started off very slowly this year. We did about 1,000 engines in the first quarter. We did 4,000 in the third quarter, and I expect we'll be closer to 8,000 in the fourth quarter. So for the full year, we're going to be somewhere around 17,000, 18,000 compared to what just 1,000 last year.

Jerry Revich - Goldman Sachs

And Pat, is the P&L position of that business in the fourth quarter, is that enough of a production run rate to get it into the black?

Patrick Ward

No, it's not. As we expected, we're still in the ramp-up phase of the Foton joint venture. And we're still losing money on that joint venture, which we expected from the venture.

N. Linebarger

We're also stepping up development of more -- of different variants of the engine. So the engineering spend over that period has also continued to increase. So we are spending more money as we go. And then also to the point that Pat made, the ramp up is not enough yet to cross the break-even line of the joint venture. So both are happening at the same time. So prospects for the joint venture look even brighter, because we've added more products to the list, and we're doing more work together. But it's obviously behind where we'd hoped in terms of ramp up. And that's primarily as a result of the implementation of the Euro 3 standard in China being delayed by some degree and also having different kinds of enforcement by region, which has slowed down Foton's implementation of the engine into their vehicles. So as that implementation continues to happen, then volumes will increase.

T. Solso

We will also plan for a loss for next year.

Jerry Revich - Goldman Sachs

And Pat, can you say more about the sequential margin performance in Components? What proportion of the margin decline was due to out-of-period warranty accruals? And what specifically were the drivers of the higher manufacturing expenses you cited?

Patrick Ward

Sure. So off that 2% drop from the second quarter, 1% related to warranty and then the other 1% split fairly evenly between the increased investment in research and development and in some of the operation issues we've been having in a couple of our plants. They are mainly in our Filtration business and in our Turbocharger business. The Filtration issue, we've moved some lines to a plant in Mexico. It's a little bit behind where it should be in the ramp up, so that's going to cost us a little bit more expense than what we had anticipated and what we've seen in the second quarter. In our Turbocharger business, we had some system issues. So we upgraded some systems at the start of the year and for the first quarter, and we're recovering from that. We are behind in some shipments for customer. So that means we now have to incur more premium on faith and make sure we deliver product on time to customers.

T. Solso

I just wanted to add that in both those cases, we have a lot -- I mentioned a lot of productivity improvements in our previous calls that we've seen in the plant. And both those changes that Pat talked about, the Filtration consolidation in the San Luis Potosi plant and the consolidation of the turbocharger plants in Charleston plus the IT upgrade, both those will lead to the same kind of productivity increases in those two businesses. In the short run though, we're behind where we should be. So our implementation of those two things weren't nearly as good as the other productivity improvements we made, and that's why we're finding ourselves losing some ground in third quarter. But we will get those resolved, and we do expect both those to lead to better productivity and better profitability in those two businesses.

Jerry Revich - Goldman Sachs

With the timing, when are you expecting those issues to be resolved roughly?

T. Solso

We'll definitely be through them by the end of the year. It doesn't mean there won't be any things we're still resolving. But from a financial impact, we'll definitely be through them by the end of the year. And I think the biggest impact has already occurred in the third quarter.

Operator

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

Eli Lustgarten - Longbow Research LLC

Just a clarification, you talked about lower warranty expenses throughout. What were the warranties -- could you give me just the warranty expenses for year-over-year and quarter-to-quarter?

Patrick Ward

Warranty expenses for the quarter was 2.9%. I think this time last year, we were at 3.9%. We do expect warranty to increase in the fourth quarter as we ramp up our EPA '10 product launches. So fourth quarter warranty expense, expected up to 3.4% of sales. Full year will be at the 2.9%, and that's going to be about one percentage point better than the 2009 level.

Eli Lustgarten - Longbow Research LLC

During some of the commentary, you talked about moderate, I guess is the word, gains in China, India, Brazil next year, more in line of a better-than-GDP year. So with all the expansion going on, do you expect to be able to hold profitability in that part of the world with your more moderate gains? Or are we looking -- or can you give us some idea what you'll be able to do given that the growth rate is now roughly low-double digits with the preliminary talk about it and you have the huge expansions going on?

N. Linebarger

We do expect to be able to maintain profitability there, Eli. As you noted, in each different joint venture or different operation, as we add capacity or we ramp up engineering spending for investments, there are definitely impacts, at least on the short run, on profitability. But if you kind of look across all of them, while one's a little bit down -- we talked about the Foton joint venture already, then the other's doing well. So DCEC this year, for example, had a tremendous year. So Foton was a little bit lower. DCEC was a little bit higher. So if you kind of looked across all of them, even with growth rates coming off there in sort of a torrential pace this year, they'll still be good growth rates. So we're not going to have any absorption issues or anything. We're out of capacity and adding, as you know. In Tata Cummins, for example, we'll be adding more capacity in Dongfeng. So we're still operating at very efficient kind of levels in both China and India. So we still expect to be able to maintain profitability. And our final planning really isn't done for those regions. I tried to get some indication that growth rates will still be decent. Because I mean there's a little bit of concern that after these kind of growth rates, are you expecting it to be down or something, and we don't expect that at all. How good they'll be, we still have to figure out. But we've said -- as I've said to you in my remarks, they'll be better than GDP, and we think they could be significantly better. We just have to go through all the planning and seeing country by country and see where we're going to come out.

Eli Lustgarten - Longbow Research LLC

The Distribution step up in profitability, can you talk a little more -- is this a new permanent level that we should be thinking about? I mean, 12.9%, hanging around at 13% and over in the fourth quarter also is what you're guiding. So can we we're talking -- can you talk about the profitability step up and how sustainable this is as we look in next year?

Patrick Ward

I'm trying to recall the long-term targets for Distribution comes to 12%. So I think what you're seeing just now, Eli, is that aftermarket demand is seldom much better than whole goods demand over the last couple of years. And aftermarket has better margins than whole goods. So that's kind of inflated the market to some extent. I do expect long-term margins to remain pretty much what we've said at around the 12% level, just that we're performing slightly better than that.

Operator

And our next question comes from the line of Meredith Taylor with Barclays Capital.

Meredith Taylor - Barclays Capital

I'm hoping that we can just dig a little -- I wanted to revisit the Components margins. Maybe if you can, it would very helpful to hear you parse out some of the couple of points of headwind that you saw on a sequential basis. I'm hoping that you can talk a little bit about the swing that you mentioned in R&D expenses. I mean, was this a full forward from 4Q, from 2011? Or is this kind of a net increase in how you view R&D over heading into 2011 in that business? And then can you talk a little bit about -- I know you talked about some of the operational challenges that you saw in the Filtration and Turbo side of the business. But could you talk about some of the mix impacts that you're seeing and then some of the operational improvements that you're seeing in other pieces of the business and how much more runway you have with those?

Patrick Ward

I think in the first part of the question, the R&D, we are going to continue to see further investment in research and development as we go forward. In order to stay ahead of the pack, that's clearly one area that we've got to continue to make good investment sense. So it's not a significant surprise that R&D investment was up. I think it somewhat was highlighted as a more significant factor than what it could've been, because warranty was also up and has some of the production issues in a couple of those plants. On the operational issues in Turbos and Filtration -- the other issue in Filtration, it was much less of a dollar impact. But you asked if there was any mix issues going on. All the growth in the third quarter was really through across the OEMs. So the aftermarket business did not really increase much at all in Q3 over Q2. In Turbo, there wasn't much of a mix issue at all sequentially. Outside those two businesses, I think CES are performing very well, CES being our Emission Solutions business, and that we are seeing very strong margins as we expected in that business as it continues to ramp up. And I would think this is the opportunity for them to grow further as we go into next year.

N. Linebarger

And Meredith, if I could just comment. I appreciate your question about so what's kind of going right there or examples of that. The Filtration business is operating now at margins that are up near its historical highs again. So it's operating incredibly well. Do I wish we kind of got our consolidation there in Mexico? Sure, I do, but their plants across the world are doing very well. Our business is improving. We're adding new technology to our fuel filtration, other Filtration businesses, which is driving up premiums on our products. On CES, Emissions Solutions, we've had this delay in the 2010 truck market. But despite that, we've ramped up both volumes and margins very, very well in that business, and it's now meeting target margins. And as the 2010 ramp up continues, we'll see further improvement in that business. The Turbocharger business is now doing very well globally. We just launched a new light-duty turbocharger that'll be manufactured first in China and that will go on these Foton Cummins engines as well as a number of other people's engines. So all those businesses are performing incredibly well. What you've seen, of course, because we've come off two years where we had the two of them not going so well, is I think there's questions about what the potential is of those companies. But we, inside the company, see the Components business as both our fastest-growing segment and one which will -- we're highly confident will meet target margins and will be a significant engine for growth in the company. So we're very optimistic about it. And I recognize that when we have these blips, it's hard for people to be sure. But we feel very confident about in each of those businesses have seen improvement in productivity and quality and in margin over the period. So I think you can look forward to continued improvement there.

Meredith Taylor - Barclays Capital

I noted that your heavy-duty build outlook, the 130k, actually hasn't changed from 2Q. I mean, can you bridge the fact that this build outlook for the industry hasn't changed with the change to your heavy-duty outlook?

Dean Cantrell

Meredith, this is Dean. That outlook of 130,000 Class 8 NAFTA Group II or those engines that are bigger than 10 liters has not changed. I think what we have seen is the number of transition engine in the marketplace that are still being consumed by the truck OEMs is the difference between what you've seen in our revenue forecast versus the market outlook of the 130.

Operator

And our next question comes from the line of Andrew Casey with Wells Fargo.

Andrew Casey - Wells Fargo Securities, LLC

If I could, a question on the engine JVs. Could you clarify if you continue to expect the second half to be approximately what you benefited from in the first half? Or is it a little down given the increased R&D going into some of them?

Patrick Ward

I think, on the engine joint ventures, we do anticipate second half to be a little bit softer than the first half. So, for example, in the largest joint venture we have with Dongfeng Cummins in China, we built 120,000 engines in the first half of the year, and we're going to be somewhere around 110,000 in the second half of the year. So second half engine joint venture earnings will be a little bit softer than the first half. They're still significantly better than the second half of last year.

N. Linebarger

Remember, Andy, we had thought in China early on that we were going to see was a much stronger first half than second half, because the government was planning to try to put a handle on growth rate to control the money supply and do other things to rein in growth a little bit, which they did do. The stimulus package ended to a large degree, and the government did try to produce money to supply. And we have seen some impact on the economy. But really, the joint ventures that we're involved, with Dongfeng, Foton and Chongqing, all have seen their demand tail off much less than we originally planned, which just, I think, in part demonstrate the fact that there was more demand than there was capacity. So while the economy may have come off its torrential growth rate to just growing really fast, in fact, there were some pent-up demand. And so the second half is not much weaker. It is weaker, as Pat said, but not much. In India, on the other hand, we are kind of capacity paced in TCL. So we don't expect the second half to be weaker than the first half from a production or a revenue point of view. And in fact, we're really anxious to get our second TCL joint venture on stream at the end of the first quarter so that we can begin to ramp up production and revenue.

Patrick Ward

And Andy, just to be clear, I was talking about Engine joint ventures. When you look at the total business of the rest of the business, in the second of the year, Power Generation joint ventures gestures will be better than what they did in the first half of the year. And our Distribution joint ventures will do better than what they did in the first half of the year.

Andrew Casey - Wells Fargo Securities, LLC

And then lastly, on the Tier 4 implementation, how are you looking at that as -- I know it's next year and you don't want to give guidance. But qualitatively, is that progressive through the year, is getting better? Or is that more lumped into the second half and really see benefit in the following year?

N. Linebarger

Well, I think as we talked about Tier 4, because in both the European implementation and the U.S. implementation, they have phase-in kind of processes. There are different processes, and the phase-in process is a little bit more -- has more flexibility in the U.S. then it does in Europe. But in both cases, the phase-in process is likely to make demand for Tier 4, I think, stretch out and be less of a cliff event than we might see in an automotive market. So that affects timing to a large degree. But having said that, we will be implementing on time. And we do expect, just like with automotive, it will drive up the content of our components and our engines. It positions us well competitively compared to other folks as we have good solutions for those Tier 4 products. And we've seen some wins with OEMs as a result of the fact that we're ready and have the right technologies ready to go. So I guess, overall, we're seeing it as continued positive messages, because, again, we're prepared for those and the OEMs like that. But I think it will be more of a phase-in, and we won't see sort of a dramatic impact in one single quarter. Dean, is there anything you'll add to that?

Dean Cantrell

Just as we talked about before with the fourth quarter of this year in Europe, we are still seeing pre-buy orders for engines in the European market but not so in the U.S. market. So there will be a little bit of a change, much like we've seen in the U.S. truck markets following an implementation. We will see that in Europe, or the volume that was pulled forward into the fourth quarter of 2010 will be weaker in the first quarter of 2011. But other than that, to Tom's point, in the U.S. market, it's just going to be a gradual phase in. We'll get another size band of engines moving at the beginning of 2012 but below 174 horsepower. So a little bit 6B, 4B, 3B or be a 3.3-liter engine that will move to the next emission change in 2012. So it's going to be an ongoing phase in for the industrial market.

Operator

And our next question comes from the line of Robert Wertheimer with Morgan Stanley.

Robert Wertheimer - Morgan Stanley

Just a quick one on -- because you've been pretty clear on the JVs, but there was another manufacturer out there that saw some weak orders in Brazil and China. Have you seen any market change in the order outlook, whether in response to China tightening or otherwise?

N. Linebarger

Not that I'm familiar with, Robert. I mean, we're still seeing Brazil as being very strong. So it doesn't mean that it won't turn down at some point. But as we said in my remarks, we're still looking at Brazil in 2011 as being further growth over 2010.

Robert Wertheimer - Morgan Stanley

The kind of wins you're seeing, I just wanted to ask about the timing of it, whether you're getting more and more activity as people have had a chance to try out the trial engines of other manufacturers that are not working out as the thought. There's also other waves in implementations. So would you say that you've gotten most of the wins you expect to get on platforms out of Tier 4 Interim? Or is that just starting?

N. Linebarger

Yeah, I will. First of all, remember with Tier 4 Interim, there's been a ghost of Tier 4 finals. So as Dean was saying, there's kind of going to be a steady stream of activity between now and 2014 of implementations of Tier 4. So we do not think we've won all the wins that we're going to win. We hope to see many, many more wins. So we're still fighting a bunch of battles, trying to make sure that people see what we can bring to their equipment. And again, we expect to continue to do well in that competitive arena. So we don't think we've won them all. And as you maybe were hinting out there, in the off-highway markets, definitely, the cost of transitions relative to the volume of sales is more difficult for them. They're talking about lots of variety of equipment, lots of changes to make and maybe not nearly as much volume as a highway manufacturer might have. So for them, these transitions are complicated and difficult, and they take them time to figure out how to manage it most effectively. So again, there's still a lot of decisions being made, I guess, is what I'm getting on with that.

Robert Wertheimer - Morgan Stanley

Are you still in competition for anything that's Jan 1, 2011, do you think or not?

N. Linebarger

No. Jan 1, 2011, we'd already be way, way too late to change there.

Operator

And our next question comes from the line of Jamie Cook with Credit Suisse.

Jamie Cook - Crédit Suisse AG

You talked about growing of the heavy-duty truck market in North America being up 60% next year. You'll be able to outgrow the market. Could you just give us your updated thoughts on sort of a market share shift from 15 to 13 or what your assumptions are so we can -- what your assumptions are for 2011? And then my second question is I'm just looking at your implied earnings for the fourth quarter, which is about a $1.70. That gets you through a run rate of earnings next year of at least $6.80 in EPS, which is pretty impressive. I know you don't want to give guidance, but are there any big sort of headwinds we should be aware of, whether it's R&D, warranty cost, whatever it may be, as we're just thinking about the year ahead?

N. Linebarger

Jamie, just on the truck side first. We have not seen a big shift from 15 to 13 by the way. It's early days, and there's a lot of transition in this year. So I think there's a lot of stuff left to happen. But we haven't seen it, and we're not really seeing it in a significant way. So we're...

Jamie Cook - Crédit Suisse AG

And it doesn't sound like you're expecting it?

N. Linebarger

No, not per se. Now again, there are more 13-liter engines out there, as you know, with PACCAR and. So they'll definitely be promoting their engine, and they expect us to see a certain amount of share with that. We've talked before about what we think's going to happen. We're expecting to end this year around 40% market share. And we think, over time, as international stops using our engines and PACCAR introduces their engines, that we'll sort of settle in in this 35% to high-30s kind of market share. That's kind of what we're targeting to do, and we think that'll be a good and profitable place for us to operate. So that's where we're headed. And what that -- you can do your own kind of calculations on what you think that means on mix versus 15, versus 13 on that, just see how that works out. But that's kind of where we're headed for 2011 and beyond. With regard to the guidance, the only thing I'm allowed to respond to in your question -- it looks like I'm getting shoved into guidance one way or the other. But let me see if I can avoid that dance by saying that we don't see a whole bunch of big headwinds. There are obviously -- there's obviously a bunch of uncertainty about U.S. markets and European markets, and you read about as much about that as I do. But the developing economies looks strong, as I mentioned in the my comments. There are some sectors that look like they're poised to recover. We talked about the heavy-duty truck. We do think commodity costs are likely to continue to increase. That's the one front. On the other hand, we saw a lot of equipment into commodity-generating markets. So on balance, I think that's a good thing, not a bad thing, but it will be a headwind to some degree in cost. But there's really nothing big that I would highlight to you as saying this really has a big offsetting push to what we're trying to do. But we're still rolling together all the growth rates and making sure we've got a good balance between investing for long-term and generating returns in the short run. That's a big part of our we're going to generate the new long-term growth targets that you're waiting for us to produce for you.

T. Solso

This is Tim. Let me add a couple more comments on the 15- versus the 13-litered engine. First of all, the large-bore engines have represented about 60% of the market for some period of time. These debates periodically appear, but there really hasn't been any change. And if you consider over the road, a 15-liter is better than a 13-liter in fuel economy. The resale value is better. It's more durable and reliable. So I know there's lot of discussion out there, but we really don't see a mix change here.

Operator

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

Ann Duignan - JP Morgan Chase & Co

I want to take a step back and wonder if you could comment a little bit on yesterday's joint announcement from the DOT and the EPA in terms of fuel efficiency and greenhouse gas emissions for the truck industry for 2014. I spoke to some industry folks yesterday at the Defense convention in DC, and the impression I got was that the industry was very much involved with these such decision and therefore, not a huge negative reaction to the press release yesterday. However, there were some people at the show who thought that it might lead to a significant pre-buy in 2012 and 2013. Could you just comment on each of those perspectives that we got in both, not a big surprise? And then might we see a pre-buy on the back of this announcement?

N. Linebarger

Yes. And with regard to the industry involvement, I think that's accurate. I think that's our experience that we were involved for a significant period of time. The EPA made a really big effort to try to get input from a wide range of people in the industry repeated times. So there were several different forms by which they did that. And that includes all of our industry trucks, engines, et cetera, as well as truckers, American truck associations, et cetera, we we're all asked for input over the writing of that rule, not just now that that's in the comment period. So I think there was a lot of the industry involvement and to-ing and fro-ing before they got to the rule. Another positive about the rule is that what we've got is several agencies, who each could have taken a separate path, actually working together on one rule. And that's the principle for -- if you're going to have regulation, having one enforced one way is a huge benefit. Second thing they did well is they have lead time between the time they're introducing the rule and the time it actually hits. And third is that they're trying to get technology introduced that can both meet the standard and perform well for customers at reasonable cost. And so they're growing in technology, and they've got a couple of funding mechanisms through the DOE, like the SuperTruck program we talked about, to kind of push technology forward. So those three elements, I think, make it, on balance, a relatively good regulation in terms of as regulations go. Now we still have to read the details of the rule. They're just out for public comment. Reviewing those is a really important thing to do, so we're going to do that in some detail and give comments as we see necessary. But in general, I would say that the process was relatively robust.

T. Solso

I would just add a couple of comments that this is one time where the end user will benefit, because they'll get better fuel economy as opposed to earlier regulations. And Cummins has been really in the lead with the EPA and working this. And we've supported this for the reasons that Tom talked about. We were at the White House when the memo of understanding was signed between CARB, the DOT and EPA as were Navistar, Freightliner and Volvo. So the industry is supportive of it, but Tom's correct when he says that we need to see the details. And we'll be working, again, closely with both the EPA and CARB on it.

T. Solso

And with regarding pre-buy, for the first level, anyway, I don't expect a significant pre-buy. I don't see significant technology changes involved. Again, we need to read the rule on some detail. But based on the initial look, I don't think the first, the 2014 targets are likely to have a significant technology effect. So I don't see those necessarily driving a big pre-buy. And I think for future levels, pre-buys are driven by either increases in cost or people being concerned about technology. So again, the better the industry is at introducing proven technologies that are well field tested at reasonable cost, the better we'll do on reducing pre-buy.

Ann Duignan - JP Morgan Chase & Co

And would this ruling benefit any of your businesses more than the other? I mean, is there any competitive advantage, whether it's SCR, EGR, maybe even natural gas, as we look past 2014?

N. Linebarger

What I'd say is that it's our view that Cummins is well positioned in the fuel efficiency technology market, just as we were in the emissions technology. The kind of technologies that are relevant for our customers have huge overlap, because you're really trading fuel efficiency against emissions. And so we do believe that our Components business, our Engine business are very well positioned to benefit when customers are looking for fuel economy leadership. So we do think that's a plus for Cummins.

Dean Cantrell

I think that's all the time we have for questions today. I appreciate everyone dialing in and engaging us in our Q3 earnings call. And we look forward to talking to you out in the market during the fourth quarter. Thank you, everyone.

Operator

Ladies and gentlemen, we thank you for your participation in today's conference. This concludes the presentation, and you may now disconnect. Have a great day.

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

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

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

Source: Cummins CEO Discusses Q3 2010 Results - Earnings Call Transcript
This Transcript
All Transcripts