Cummins' (CMI) CEO Tom Linebarger On Q2 2014 Results - Earnings Call Transcript

Jul.28.14 | About: Cummins Inc. (CMI)

Cummins Inc. (NYSE:CMI)

Q2 2014 Earnings Conference Call

July 28, 2014, 10:00 AM ET


Mark Smith - VP, IR

Tom Linebarger - Chairman & CEO

Pat Ward - CFO

Rich Freeland - President & COO


Andrew Casey - Wells Fargo

Alex Potter - Piper Jaffray

Scott Group - Wolfe Research

Nicole Deblase - Morgan Stanley

Jerry Revich - Goldman Sachs

Jamie Cook - Credit Suisse

Ted Grace - Susquehanna

Ann Duignan - JPMorgan

Tim Thein - Citigroup


Good day, ladies and gentlemen, and welcome to the Q2 2014 Cummins Incorporated Earnings Conference Call. My name is Stephanie, and I’ll be your operator for today. At this time, all participants are in a listen-only mode. And we will conduct a question-and-answer session towards the end of this conference. (Operator Instructions) As a reminder, this conference is being recorded for replay purposes.

And now, I would like to turn the call over to Mr. Mark Smith, Vice President of Investor Relations. Please proceed, sir.

Mark Smith

Thank you, Stephanie, and good morning, everyone, and welcome to our teleconference today to discuss Cummins results for the second quarter of 2014. Participating with me today are our Chairman and Chief Executive Officer, Tom Linebarger; our Chief Financial Officer, Pat Ward; and our President and Chief Operating Officer, Rich Freeland. We’ll all be available for your questions at the end of the teleconference.

Before we start, please note that some of the information that you will hear or be given today will consist of forward-looking statements within the meaning of the Securities Exchange Act of 1934. Such statements express our forecasts, expectations, hopes, beliefs and intentions on strategies regarding the future. Our actual future results could differ materially from those projected in such forward-looking statements because of a number of risks and uncertainties.

More information regarding such risks and uncertainties is available in the forward-looking disclosure statement in the slide deck and our filings with the Securities and Exchange Commission, particularly the Risk Factors section of our most recently filed Annual Report on Form 10-K and subsequently filed quarterly reports on Forms 10-Q.

During the course of this call we will be discussing certain non-GAAP financial measures and we refer you to our website for the reconciliation of those measures. Our press release with a copy of the financial statements and a copy of today’s webcast presentation are available on our website at under the heading of Investors and Media.

Now, I will turn it over to our Chairman and Chief Executive Officer, Tom Linebarger.

Tom Linebarger

Thank you, Mark. Good morning. I will start with a summary of our second quarter results and provide an update on our outlook for the full year. Pat will then take you through more details of both our second quarter financial performance and our forecast for the year.

Revenues for the second quarter were $4.8 billion, an increase of 7% compared to the second quarter of 2013. Second quarter EBIT was $657 million or 13.6% of sales, compared to $621 million or 13.7% in the same quarter last year.

The highlight of the quarter was the performance of the Components business, which delivered record revenues and EBIT percent. Revenues increased 15% year-over-year and EBIT percent improved by 230 basis points to 14.5%. Higher volumes, lower warranty costs, and stronger cost control contributed to the improved EBIT margins.

We have raised our full-year outlook for the Components business and now expect revenue up 12% to 17%, up 2% at the midpoint from our previous forecast, and EBIT to be in the range of 13% to 14%, up 25 basis points.

Engine business revenues increased by 3% year-over-year, but EBIT margins were down to 11.3% of sales from 12.8% a year ago. Warranty expense was the main driver of the lower EBIT percent year-over-year.

While our new products are performing well and product failure rates continue to be at very low levels, warranty costs on EPA 2013 engines are higher than we expected, due to higher average cost per repair. The higher average cost is driven by the increased complexity in our new engine systems, especially with the addition of OnBoard Diagnostics.

We expect that it will take several quarters for our warranty rates to reflect the improvements we are making to our engines. So our full-year guidance assumes that warranty costs in the second half of 2014 will continue at second quarter levels.

It’s important to note that our warranty costs per engine on EPA 2013 engines are still well below the cost of EPA 2010 engines at the same stage of launch. And we are highly confident that we will be able to reduce these costs even further in 2015.

The Engine business delivered very strong operational performance in the second quarter, especially in our manufacturing operations. Despite weakness in a number of our end markets, the Engine business delivered strong gross margins before product coverage costs.

As a result, our full-year guidance for the Engine business is unchanged with revenues expected to grow between 6% and 8% and EBIT to be in the range of 10.5% to 11.5% of sales.

Revenues in the Power Generation business declined by 9% compared to a year ago, due to continuing weakness in international markets and lower sales to the U.S. Military. EBIT of 8.2% declined from 9.3% a year ago due primarily to lower volumes, but did improve from first quarter levels.

Gross margins improved both year-over-year and sequentially due to cost reduction actions taken in the business. Despite the difficult marketing conditions, our full-year guidance for the Power Generation business is unchanged with revenues expected to be in the range of down 3% to up 3% and EBIT margins expected to be between 7% and 8%.

Revenues in the Distribution segment increased 30% in the second quarter due primarily to acquisitions in North America. EBIT for the quarter was 10.2% and EBIT dollars were a record of $126 million, up 26% year-over-year.

Earnings increased due to stronger performance from existing operations and the positive impact of North American acquisitions. We are progressing well with our North American acquisition strategy. We’ve completed three acquisitions so far this year and expect to complete four more by the end of the year.

The integration of the newly acquired distributors has gone smoothly and we are very pleased with the support and commitment of Cummins distribution managers and employees across the country.

We expect to deliver incremental revenues of $500 million from acquisitions this year for the company, up $100 million from our last forecast and we expect the acquisitions to increase the company’s earnings per share by approximately $0.30, higher than our previous forecast of between $0.20 and $0.25.

We have also raised our guidance for the segment revenue growth to between 30% and 35% and EBIT is still expected to be in the range of 9% to 10% of sales.

Now, I’ll comment on some of our key markets, starting with North America. Our revenues in North America grew 14% in the second quarter due to strong demand in on-highway markets. Shipments to the North American heavy-duty truck market exceeded 23,000 units in the second quarter, an increase of 11% from 2013 levels.

Our market share is 38% year-to-date, consistent with our full-year forecast. We now expect the full-year market size to increase by 15%, up from our previous forecast of a 12% increase.

In the medium-duty truck market, we delivered almost 20,000 engines in the second quarter, up 28% compared to a year ago. We expect the market to grow by 9% for the year, unchanged from our previous guidance. Our market share has improved to 73% for the first half of 2014 and we now expect to maintain this market share for the full year, which would be 3% higher than our prior forecast and fully 10% higher than 2013.

Shipments to Chrysler decreased by 4% in the second quarter compared to last year. For the first half of 2014, our shipments are up 11% and we expect that for the full year shipments will increase 5% compared to 2013, consistent with our prior forecast.

Power Generation revenues declined in North America by 18% year-over-year, due primarily to the ramp down of our Military contract. Excluding the Military business, Power Generation revenues were down 2%.

Our International revenues declined 1% year-over-year with growth in China offset by declines in India, Mexico, and Brazil. As I will discuss, end markets in China and Brazil weakened compared to three months ago while our outlook for India remains unchanged.

Second quarter revenues in China, including joint ventures, were $865 million, an increase of 10% year-over-year. The growth was driven primarily by stronger demand for engines and components in on-highway markets.

The industry demand for heavy and medium-duty trucks in China declined 10% for the second quarter. Industry demand for trucks grew year-over-year for 13 straight months through April, but demand has weakened significantly over last two months with sales in May and June down 11% and 20% year-over-year, respectively.

Cummins revenues in the second quarter increased despite the weak market due to higher revenues associated with National Standard 4 Products. Demand has been strong for the year -- for the past year due in part to end users buying ahead of the new NS4 emission regulations.

Communication last quarter from the Ministry of Industry and Information Technology, MIIT, instructed OEMs to cease sales of NS3 products by the end of 2014. And we had anticipated in our guidance a decline in OEM production in the second half of the year as the deadline for compliance with the new regulations approached.

However, with industry levels increasing and a slow rate of growth in the industrial economy, we are further lowering our forecast for industry sales in the second half. As a result, we now expect industry sales to decline by 5% for the full year, lower than our previous forecast of a flat market.

We are encouraged by recent evidence of actions taken by the government to enforce compliance with the new regulations. And based on discussions with OEMs, we are optimistic that the progress we have seen this year and transition to NS4 products will continue in 2015. We estimate that between 50% and 60% of industry production of heavy and medium-duty trucks in the fourth quarter of this year will be NS4 compliant, higher than our earlier estimates.

Shipments of light-duty engines in China increased 69% year-over-year as our partner, Foton, increased the proportion of its trucks powered by the 2.8 and 3.8 liters engines manufactured in our joint venture. Our engines have been very well received by end users and we remain excited about the prospects for further growth in the light-duty market as emissions regulations advance in China. We continue to grow our partnership with Foton and in the second quarter we launched our new ISG heavy-duty engine.

Demand in construction markets has softened already from already weak levels as the pace of investment in infrastructure has not rebounded in China. Industry demand for excavators is expected to decline by 14% for the year, down from our previous forecast for the market to be flat. Power Generation revenues are also expected to be close to flat for the full year.

Full-year revenues in China, including joint ventures, are now expected to increase 10% for the year, down from our previous guidance of growth of 15%. As you have heard, industry demand is flat or down in all of our major end markets in 2014. So, all of our growth is coming from new products and increased content in this weak environment.

Fortunately, we see opportunities for further growth in our Engine and Component businesses as the adoption of new NS4 emission standards advance.

Second quarter revenues in India, including joint ventures, were $293 million, down 14% year-over-year as conditions remained weak in most end markets. Enthusiasm over the election results in May and the prospect of pro-business reforms by the new government have not yet translated into significant change in orders in our key markets.

Industry demand in the truck market declined 10% in the second quarter compared to the second last year and is 16% lower for the first six months of the year. We expect the truck market to be flat for the full year, unchanged from our view three months ago with much easier comparisons to come in the second half of the year.

Power Generation revenues in India declined 16% in the second quarter. The weak economy has resulted in lower electricity consumption and fewer orders for new power generation equipment. The implementation of new CPCB-II emissions regulations in the power generation market went into effect on July 1 with prices for the new lower emissions products to be 15% to 20% higher than the products they replace.

For the full year, we expect Power Generation revenues to decline by 15%, unchanged from our previous forecast. In total, we expect revenues in India to decline by 8% for the year.

Second quarter revenues in Brazil were $194 million, down 16% from the second quarter last year. Industry production of trucks declined 36% in the second quarter as the weak economy continued to impact demand for capital goods and OEMs responded to slowing sales.

We now expect that the full-year truck market could decline by 25% or more compared to our previous forecast that industry production would decline 20%. We now expect our full-year revenues in Brazil to decline by 15% to 20%, down from our previous forecast of a decline of 15%. Power Generation and Distribution revenues have held up relatively well in the weak environment in Brazil.

In summary, we currently expect global company revenues to increase between 8% and 11% for the full year, up from our previous forecast of growth between 6% and 10%. The biggest driver of the increase in our revenue outlook is higher revenues from the acquisition of our North American distributors, reflecting both better-than-expected execution of our plan and improving business conditions in North America. We expect EBIT to be in the range of 12.75% to 13.25%, consistent with our prior forecast.

Finally, I would like to comment on our recent announcement of changes to our leadership team. To ensure that we continue to dedicate the appropriate time and attention to both day-to-day operational execution and long-term strategy, we recently expanded the leadership team.

Rich Freeland, who is here with us today, has assumed the role of President and Chief Operating Officer. Rich joined Cummins in 1979 and has developed a deep understanding of our business, our customers and markets and our people, and brings a very strong track record of performance improvement as a previous leader of three of our four operating segments. Rich will focus on the company’s operations to ensure that we meet our financial commitments and exceed customer expectations every day.

Dave Crompton succeeds Rich in leading the Engine business. Dave brings 25 years of experience of driving improvement in the Engine business and has led teams that have dramatically improved our products, expanded our global partnerships, and navigated through challenging economic conditions to produce outstanding financial results.

We’ve also added several key people to our top level leadership team, including Sherry Aaholm, our Head of IT; Sharon Barner, our General Counsel; Thad Ewald, our Head of Strategy and Business Development; and Mark Osowick, our Head of Human Resources Operations. I’m excited about these changes and the opportunities for Cummins to help our customers succeed.

Thank you for your interest today. And now, I’ll turn it over to Pat who will cover our second quarter results and full-year guidance in more detail.

Pat Ward

Thank you, Tom, and good morning, everyone. Second quarter revenues were $4.8 billion, an increase of 7% from a year ago and included record revenues for both the Components and Distribution segments.

Sales in North America, which represented 56% of our second quarter revenues, were up 14% from a year ago, due to stronger demand in on-highway markets and from the acquisitions in the Distribution business completed in the last 12 months.

International sales decreased by 1% with weaker demand in international construction and power generation markets and the sharp decline in demand in the Brazilian truck market offsetting growth in China. Increased sales in Western Europe were offset by lower demand in Eastern Europe and in Russia.

Compared to the first quarter of 2014, sales were up by 10%. The increase was driven primarily by higher demand in North American on-highway markets, the impact of acquisitions in the Distribution business, and seasonal improvement in power generation markets.

Gross margins were 25.4% of sales, flat with the prior year and the prior quarter. Compared to the prior year, stronger volumes, lower material costs and a positive mix were offset by higher warranty costs and unfavorable foreign currency movements primarily related to the British pound and to the Australian dollar. Compared to the previous quarter, stronger volumes and a positive mix were offset by higher warranty costs.

Selling, admin and research and development costs were up $53 million from the prior year. The acquisitions in our Distribution segment accounted for $23 million of this increase. Compared to the prior quarter, selling, admin and research and development costs increased by $22 million, of which the acquisitions added $13 million.

Joint venture income of $105 million was relatively flat compared to a year ago. Sequentially, joint venture income increased by $15 million primarily due to increased earnings in China.

Earnings before interest and tax were $657 million or 13.6% of sales for the quarter while earnings per share were $3.43. This compares to $621 million or 13.7% of sales last year and earnings per share of $3.20.

The tax rate was 26.5% for the second quarter.

Let’s move on now to the operating segments and further discuss second quarter performance and the outlook for the year. In the Engine segment, revenues were $2.7 billion, an increase of 3% from last year.

Global on-highway revenues were up 7%, driven by strong demand in North America and a record quarter for our parts business. Industrial revenues were down 1% compared to the prior year with weakness in global mining markets, offset by improving demand in North American oil and gas market and record revenues in our global commercial marine business.

Compared to the prior quarter, sales were up 7%. Sequentially, we experienced stronger demand in North America with growth in all end-markets except mining and agriculture.

Segment EBIT was $311 million or 11.3% of sales, down from 12.8% we reported last year. The increased warranty expense and lower joint venture income was partially offset by higher volumes, lower material costs, and a positive mix. Sequentially, volume, positive mix, higher joint venture income and lower selling, admin and research and development costs, as a percent of sales, resulted in EBIT margins increasing by 80 basis points.

For the full year, we continue to forecast that revenue for the Engine segment will be up 6% to 8%, primarily driven by North American on-highway demand. Compared to the guidance from three months ago, we expect stronger growth in North America on-highway markets offset by a weaker outlook in Brazil and lower demand in several industrial markets.

We now project that Brazil truck market to be down 25% compared to our prior guidance of 20%, and are projecting lower revenues in mining, trainer/construction and global agriculture markets. We continue to expect the high horsepower volumes will be flat to down 10% for the full year. And we are maintaining our EBIT projections for the full year at 10.5% to 11.5% of sales, which compares to the 10.4% we reported in 2013.

The Components segment delivered record sales of $1.3 billion and a record EBIT margin of 14.5% of sales in the quarter. Revenues were up 15% from last year and up 4% from last quarter. Compared to the prior year, the higher revenues were primarily driven by increased truck demand in North America and China, along with increased revenues for our after-treatment systems in Europe which transitioned to Euro 6 standards on the 4th of January this year. Sequentially, higher revenues were primarily driven by increased demand in North American on-highway markets.

Segment EBIT was $185 million or 14.5% of sales, up 230 basis points from last year, as a result of the stronger volumes, lower material costs and lower warranty expense. Compared to last quarter, EBIT margins increased 90 basis points primarily due to stronger volumes.

We now expect revenue growth of between 12% and 17% this year, higher than our previous guidance of 10% to 15%. The increase is a result of the stronger demand for all four businesses in North American truck markets, partially offset by lower demand in Brazilian and Chinese truck markets. We are raising our EBIT projections for the full year to 13% to 14% of sales, which compares to a full-year 2013 margin of 12.1%.

In the Power Generation segment, second quarter sales were $743 million, down 9% from the prior year, but up 16% sequentially. Year-over-year, revenues declined in international markets and in North America. An 18% reduction in North American sales was primarily related to lower military revenues.

In international markets, weaker demand in India, Eastern Europe and the Middle East offset stronger demand in both Africa and China resulting in a net 2% decline. Sequentially, we saw improving demand in all markets except in Eastern Europe and in Latin America.

EBIT margins were 8.2% of sales in the quarter, down from 9.3% last year. The impact of lower volumes and foreign currency movements primarily from a stronger British pound negatively impacted margins. The foreign currency movement adversely impacted margins by 70 basis points.

EBIT margins improved compared to a very weak first quarter. Increased volumes, lower manufacturing costs and lower selling, admin and research, as a percent of sales, all contributed to the margin improvement.

For 2014, our guidance for revenue and EBIT remains unchanged from three months ago. We expect revenue to range from down 3% to up 3% and we expect EBIT margins of between 7% and 8% of sales compared to 7.2% last year.

For the Distribution segment, second quarter revenues were a record $1.2 billion, an increase of 30% compared to the prior year. Acquisitions accounted for 28% of the growth year-over-year. Organic growth of 5% was partially offset by foreign currency movements that negatively impacted sales by 3%. The organic growth was driven by strong parts and service demand, especially in North America.

EBIT margins for the quarter declined from 10.5% last year to 10.2%, primarily due to the dilutive impact of joint venture acquisitions on the EBIT percent. More importantly, EBIT dollars increased by 26% to a record $126 million, due to stronger business performance and from the acquisitions in North America.

For 2014, we have increased our expectations for revenue growth due to the acquisitions. Distribution revenue is now forecasted to grow by 30% to 35% compared to our previous range of 22% to 30%. We continue to expect 3% organic growth with the balance coming from acquisitions.

We are maintaining our EBIT margin percent guidance in the range of 9% to 10% of sales. Acquisitions are now on track to add $500 million of revenue to the company in 2014 and earnings of approximately $0.30 per share, an increase from our previous expectation of $0.20 to $0.25.

As Tom mentioned, we now project total company revenues to be up 8% to 11% in 2014, driven primarily by improving North American on-highway demand, and from the impact of the distributor acquisitions. We continue to expect high horsepower markets to be flat to down 10% this year and now expect total industrial markets to be down 2%, which is consistent with the market conditions in the first half of the year.

While we are increasing our expectations for revenue growth in North American on-highway markets, we continue to see weakness in a number of international markets. We have lowered our expectations for truck production in Brazil and China for 2014. And although demand in India has stabilized, there are no obvious signs of significant improvement at this time.

We continue to project EBIT margins for the company will be in the range of 12.75% to 13.25% of sales. Most of the increase in revenue growth compared to our prior guidance is coming from distributor acquisitions, which add to EBIT dollars and add to earnings per share but not EBIT percent.

As Tom mentioned, warranty costs were higher than we anticipated in the second quarter and are included in our EBIT percent guidance for the full year of warranty costs of approximately 3.6% of sales, up 30 basis points from last year. We are now projecting a tax rate to be 28% in 2014, excluding any discrete items, slightly lower than our previous projection of 28.5%.

And finally, with regard to cash flow, we generated $438 million in cash flow from operations in the second quarter. And through the first half of the year, cash flow from operations has totaled $701 million.

Working capital increased by $386 million during the quarter to support higher sales and as a result of the distributor acquisitions. We continue to expect that operating cash flow to be in the range of 10% to 15% of sales for the full year with stronger cash flow generation in the second half of the year than the first as is typical for our business.

Capital expenditures will be between $700 million and $800 million for the full year.

Earlier this month, we increased our dividend by approximately 25%. With this announcement, we have increased the dividend by almost 350% over the last five years. We also announced a new $1 billion share repurchase authorization to commence after the completion of the existing $1 billion share repurchase program. The company has returned $659 million of cash to shareholders in the first half of the year and we are on track to return 50% of operating cash flow to shareholders as we have previously discussed.

And finally, year-to-date, the cash balance has declined by approximately $500 million as a result of the distributor acquisitions and the dividend and share repurchase activity.

Now, let me turn it back over to Mark.

Mark Smith

Okay. Thanks, Pat. Okay, operator, we are ready now to move to the Q&A section of the call. And participants please do limit your questions to one question, one related follow-up and then get back in the queue. Thank you very much. Now, we’re ready.

Question-and-Answer Session


(Operator Instructions) First question comes from the line of Andrew Casey from Wells Fargo. Please go ahead.

Andrew Casey - Wells Fargo

Can we look at the Engine segment margin a little bit more? You had a 150 basis point decline from last year, how much of that was driven by the higher warranty costs that you talked about in the prepared remarks and a couple of others, was that exaggerated by steeper international shipments? And then, if there were any other large headwinds that you encountered in Q2 versus prior year? Thanks.

Pat Ward

Hi, Andy, this is Pat. Let me start with that one and then I’ll turn it over to Rich, and he can jump in. So the product coverage impact year-over-year in the Engine segment by itself was 1.2% of sales. We did see benefits from volume, we did see benefits from material costs, but the warranty headwind really took all that back out, so we were down 1.5% year over year and the warranty is 1.2% of them.

Rich Freeland

Hey, Andy, this is Rich. Just a couple of things on this. First, just reminding folks, our guidance remained unchanged. Our incrementals, Q1 to Q2 were at 23%, about right where they thought they would be. But the warranty was higher than what we had anticipated, so we offset that with the improvements we made in supply chain, material costs, but those were offset from the warranty standpoint.

We also have a little bit of headwinds just from our mix so the parts of our business that are growing, which is more the North America which are products where we cover the -- carry the higher warranty compared to standby genset volumes, which you heard are down.

So, again we feel pretty good, the change in total, we don’t like that the warranty rate is up, and it is up as Tom mentioned based on the cost per claim. So our actual warranty failure at number claims is right where we thought it would be and in fact down significantly better than our 2010 product, but we did get a bit of surprise in the cost of those claims.


Thank you. Our next question comes from Alex Potter from Piper Jaffray. Please proceed.

Alex Potter - Piper Jaffray

Was wondering if you could comment a bit on top line initiatives in Power Gen, obviously you guys have been focused a lot on the cost side there and from what I understand a lot of the restructuring initiatives and things of that nature ought to be wrapping up here pretty quickly, so I was just wondering what sort of cards the company can play now to get volume and revenue moving in the right direction? Obviously, there is only a certain number of things that the company control if the markets aren’t doing well, but there are some things presumably that you can’t control, so I was wondering if you could comment on those.

Tom Linebarger

There is a couple of things. I’ll let Rich talk a little bit about maybe on the restructuring side, what’s going on the cost actions, you mentioned those are -- we have made some progress on those. But on the revenue side, Tony Satterthwaite, our leader there has been really working since mid-last year, generating plans to take revenue up in places that we do have an opportunity to do so.

A good example is we launched our new lower cost product in the U.S., it’s called the Connect series where we’re trying to establish larger market share in small commercial, even down to residential size generators, it's early days. We’ve got one product out there, we’ve got a series of products coming out, but we made good progress on that.

Secondly, you know that we’ve been expanding our distribution footprint around the world and one of the reasons we’ve been doing that is because we have a very cost-effective and high-quality low kVA or low-power node product coming out of India now. We think it’s the best product in the world at its output level and in terms of both cost and performance.

And we’ve been winning share in telecom markets, that’s in Africa, in the Middle East, in Southeast Asia, places that the really weren’t a big player in the past because our products were on the larger power range and again expanding distribution footprint so you can service those has been a big part of being successful there.

And I guess the last thing I would say is we’re continuing to expand our footprint and ability to sell generator sets, not just G-Drives in some markets like China and India and although the markets aren’t strong, we are still expanding our product range and making sure that we are offering more newer technology. While those markets have been lagging U.S. and Europe, in fact product technology is advancing now in those markets.

I talked about CPCB-II which is the new emissions regulations in India, there will be a significant bump up in prices as there would be in any emissions launch in India because those products have much more technology in them. And I think again by being first there, by getting our products certified first there, we will gain more market share than competitors who will be behind. So in those markets we’re just trying to make sure our technology just like in the automotive markets is cost effective, but still leading so customers get the advantage of that technology in those markets.

That’s just an example of a couple of things. You know about Tier 4 already because we talked about that in the previous calls, but we were first to certify in Tier 4 and so we’re also trying to lead there. Rich, maybe you can just say a few words about the cost side.

Rich Freeland

Yes, Alex, I think given the market conditions not so good as we know, there’s kind of three things we’re trying to do. One is that Tom talked about is gaining share, so where we can gain share, the distribution footprint is there. Second, we continue to bring out new products even though the market is not so good.

So the Connect series, the Tier 4, the Hedgehog, the 95-liter, we now have field engines out running with the Hedgehog. And then the third piece is to drive costs down. So, all getting ready, when volumes come back, we’re prepared for with more shares, with more products and a lower cost base.

And I think you saw some pretty good progress even Q1 to Q2. So with sales down 9%, we actually took gross margin down by 80 basis points -- gross margins up, sorry, took gross margins up by 80 basis points. So the restructuring we talked about is in place. We’ve got about half of the benefits from that now as volumes had deteriorated a little further than we thought, but the cost structure -- the work on the cost structure is really good.

And so we’re doing things we -- we’ve moved the work that we talked about from Germany to Romania, we’ve consolidated warehouses, we’re driving down material costs. So we like the position we’re getting at in material costs and getting ourselves kind of prepared for when the market does recover.

Alex Potter - Piper Jaffray

And then, I was wondering if you could comment very quickly on the Components business, obviously huge margins in the quarter, guidance seems to imply, even though the guidance did come up for EBIT margins, it seems to imply that you might have a downtick in the back of the year? I was wondering why that might be. Thanks.

Pat Ward

Yes, this is Pat again. We do. So the third quarter tends to be a little softer quarter, not just for the company, but for the Components business and a couple of their businesses as OEMS take shutdowns and also in the second half of the year, we are expecting a little bit weaker demand in both Brazil and in China. So that’s why we’ve taken the guidance up maybe as high as what some people may be expecting for those two reasons.


Thank you. Our next question comes from the line of Scott Group from Wolfe Research. Please proceed.

Scott Group - Wolfe Research

So I had a similar kind of question, but on the Power Gen margin targets that you talked about, so you got about 8% in the second quarter. I understand first quarter was really weak, but do you think that you can stay above this 8% and maybe get better as some of the restructuring gets behind you in the back half of the year? And the 7% to 8% is really just reflective of the weak first quarter or do margins maybe take a step back in the back half of the year again?

Pat Ward

Well, Scott, this is Pat. If you look at margins for the first half of the year for Power Gen, we’re just over 6% and to get to the midpoint of the guidance for the full year, it means second half has to be somewhat just over 8%. So by looking for the second quarter performance to continue clearly as Rich said, we are seeing some benefit in the gross margin from the actions we’re taking on the cost structure activities, our cost structure initiatives. So, we are expecting margins to remain at around second quarter levels given the outlook for sales that we see just now.

Rich Freeland

And really from a Power Gen point of view, the future is kind of Alex into that is really about trying to get more volume. The company has -- we’ve got our cost structure into a good position at this very low volume level. So if volumes improve, we think we’ll benefit significantly and we’re trying to drive more volume into the business, that’s really and the markets are still quite volatile.

We’ll get a couple of weeks of good orders and then couple of weeks of weak orders and we’re having a hard time seeing forward very far. That said, we are out seeking more volume and more share and we will see how the second half goes with regard to the markets.

Scott Group - Wolfe Research

That’s good color. And just as you have gotten through the restructuring, do you still feel good about kind of getting to a 9% to 10% margin there next year?

Rich Freeland

Yes. I mean again just back to my main comment; I think our costs have never been positioned better. We’ve got new products out and more coming. It really is just going to be about markets and about getting some more volume. And our view is that we are positioned very well for volumes at this level and above. And as margins -- as volumes rise, we will see significant incremental margins from that.


Thank you. Your next question comes from the line of Nicole Deblase from Morgan Stanley. Please go proceed.

Nicole Deblase - Morgan Stanley

I hate to kind of harp on Power Gen because it seems like you’re getting a lot of questions on that, but I just -- you guys commented a little bit on the order activity you had during the first quarter and I was curious how order activity has progressed during Q3.

Rich Freeland

Through Q2 I assume.

Nicole Deblase - Morgan Stanley

During Q2, I’m sorry.

Rich Freeland

As Tom said, as you go look at it, there is lots of quotations, there is lots of activity and turning those into orders is lumpy and fragile. And so we just don’t have a lot of visibility into that. So, when we put our forecast going into Q2, we knew what the order board looked like and again they are not full through a full quarter ever in this environment. We have real low lead times we accept orders and I think kind of as we go into Q3, the order board again, which is just one predictor, looks a lot like it did in Q2.

But again there is not a lot of visibility on that, other than I think activity on quoting seems to be trending positive would be probably the only positive, the only positive indicator that I can give right now.

Nicole Deblase - Morgan Stanley

Okay, got it. That’s helpful. And then, secondly I mean it’s probably a little bit early to talk about this, but I thought I’d take a stab at it anyway. In China, so we’ve met with a few OEMs in the region and they expect kind of a 10% volume decline in 2015 after the pre-buy in 2014, so I’m just curious how you parse out what you think 2015 will look like in that region given the mix shift towards and NS4, what does that mean for Cummins?

Tom Linebarger

I gave a few comments on China. I think, as you suggested, it’s really early to tell and I think most of the OEMs forecast that -- at least we’ve been using throughout the last couple of years have not been so good in a sense not that they are necessarily any worse than anybody else, it’s just been a really hard market to predict in part because the regulation has been kind of stuntingly implemented and people have been -- had a hard time predicting which thing gets to which, but also the underlying economic conditions in China have not been that robust.

And so that has meant that although truck markets have improved, generally speaking, the demand is not as robust as it was before -- when they were doing a lot of infrastructure building. And so those combination of factors is why we lowered the second half. I think it’s really hard to say what’s going to happen next year, because I don’t know how much pre-buy there really is going to result in this year.

We really don’t have good numbers about what sell-through has been, I talked about that in the last call, we don’t have a good feel for where inventory levels are at dealers. We obviously know that the dealers that we check with, but it’s a big market. There is a lot of folks out there. We just don’t know how good that is yet. And I think at the end of the -- in the fourth quarter we’ll be able to check all those things and have a much better idea about what 2015 looks like.

And I think the one economic comment I would make is that even without all the infrastructure building that China was doing back in the 2010 period that was driving construction demand, trucking demand can still continue to grow even in this more consumer-driven economy. So there is a little brighter outlook I think for trucking over the next several years than there might be for some infrastructure kind of construction projects.


Thank you. Your next question comes from the line of Jerry Revich from Goldman Sachs. Please go ahead.

Jerry Revich - Goldman Sachs

I’m wondering if you gentlemen could just flush out the warranty cost of repair item that you’re dealing with, is it labor learning curve issue, just some more color would be great. And based on the actions that you’ve taken as of today, have you already seen the cost per repair come down or do you expect that to happen later this year?

Rich Freeland

Okay. Yeah, Jerry, this is Rich. I’d say most of the increases, as you know the systems are pretty complex, the whole after-treatment engine, so I think a lot of the costs that’s been somewhat new is just the diagnostics cost to figure out exactly what it is. And then, if there is things aren’t caught soon enough, is there any progressive damage. So we’ve seen some of that, even though the rates are low, we’ve seen some of that.

I feel real good about where the product is and the status of the fixes. As you know, the way we roll this out, we won’t take the accrual rates down until it’s been demonstrated for several -- at least a couple of quarters in the field. And so that’s why we’ve said for the balance this year we’ve left them kind of at the Q2 rates. Our intentions are those are definitely coming down. Our intent is those are going to come down and it will come down in the ways we told you in the past.

Tom Linebarger

Jerry, the only thing I would add about Rich’s comment about progressive damage, it’s an expression we use a lot, I don’t know if everyone is familiar with it. It’s where -- there might be a failure in one part of the engine and then it might hit other subsystems in the engine because everything is so interconnected, you might have damage of more than one component and that’s kind of what drives up average cost per repair.

It’s either you have to spend a long time diagnosing what’s wrong and therefore you replace different things or secondly, you have -- something damages more than one component and you have to replace more at once. And the more integrated these things are, engine, after-treatment, turbo air handling system, the more integrated they are, the more of that kind of stuff we’ve seen.

And again we had a lot of that in 2010. We’ve resolved a lot of issues, had a lot of learning in 2010 and put that into our -- both service process as well as design process in 2013, which is why we’re better than we were then at this stage of a launch. We’re just not as much better as we expected and we’re disappointed with that. I mean there is no other way to say it. We expected to be better than we are here and we intend to get back to those expectations quickly.

Jerry Revich - Goldman Sachs

And then on the new products side, can you please give us an update on the U.S. light-duty diesel program, when do you expect to announce additional platforms, If you’re willing to share that. And on Foton light-duty, what’s your penetration rate today and where do you expect that to shake out post full National 4 implementation?

Rich Freeland

Okay, thanks. This is Rich again. So on the -- our light-duty diesel, the 5-liter V8 North America, we will go into production before year-end with some commercial customers. They have not announced at this time. So who and the -- but there will not be big quantities this year. And then our Nissan production goes in kind of the middle of next year, we go into production with Nissan the sun on that product. So really no change from what we’ve been saying.

On the Foton side, it’s actually kind of a good story. You heard us say that while the truck demand is down 10%, market now down, then our sales will be up 10% in China. And so the BFCC product, the 2.8, 3.8-liter product is a big piece of that.

We will go from producing 90,000, less than 100,000 last year to closer to 125,000, 130,000 this year. And that’s in a worst market. And that’s just NS4 coming on board being engineered into more and more of the Foton products, we’re going to continue to see that grow as we go forward.

So NS4, the products, if you call, is really designed around NS4 introduction and so our volumes have been a bit lower to this point. As NS4 comes on, we’ll see that continue to grow going forward. Then I’d just touch quickly on the ISG, someone will ask, but we have gone into production on our 10 and 12 liter product, again the same strategy, introduced in China, low cost with a product that we can take globally.

So, we’ve demonstrated on the 2.8, 3.8 that we’re selling at every emissions level even Euro 6 levels now. We’ll be doing the same thing with the 10, 12. So we’ve gone into production. We’re really pretty limited numbers at this date. We really begin ramping up here next month. I think the last I saw we will be building 80 a day in August on the 10 and 12 liter.


Thank you. Your next question comes from the line of Jamie Cook from Credit Suisse. Please proceed.

Jamie Cook - Credit Suisse

Two questions, one, I know your forecast for high horsepower isn’t changed, I think you’re saying flat to down 10%, but it sounds like sort of marine and oil and gas were a little better, mining weak. So if you could just quantify or give a little more color there and specifically, how you are thinking about what you’re seeing in mining on the OE in the aftermarket side? And then, I guess my second question, Tom, is sort of also to you in terms of given we’re in the second half of the year, you’ve been able to raise your guidance upwards two quarters in a row or so with the mixed macro front. In that context, how are you feeling about your implied 2015 EPS targets that you’ve laid out at the Analyst Day about last year? Thanks.

Tom Linebarger

Okay. I’ll go and take the first part of that Jamie and not a lot of new information to give you. So we said mining down 10 to 20 and kind of we are now saying that it appears to be the low-end of that is the more accurate one, so we’re saying now down 20. The Parts side has held in there okay. So our parts sales remained flat to date.

Jamie Cook - Credit Suisse

Is that year-over-year -- can you just - year-over-year or sequential?

Tom Linebarger

Yes, that’s year-over-year. Yes.

Jamie Cook - Credit Suisse

And are you seeing a sequential improvement yet?

Tom Linebarger

No, improvement, no. So it’s actually the number hasn’t moved a lot. We saw kind of a weird thing went on in Q4 of last year and then that bounced back up in Q1 which appeared to just be inventories setting and other than that, it’s been pretty steady and pretty flat.

Again, we’ve seen some small increases from very low bases on the oil and gas. We’re excited about the Tier 4 product, we’ve got it out, we’re accepting orders now and have orders for 2015 for Tier 4 in the oil and gas area. Marine up a bit, but again not -- I think the numbers we laid out, not much new there on the high horsepower side.

Rich Freeland

And Jamie, just speaking to the 2015 target, we still feel good about being in the range of sales growth and EBIT margins that we described at the last investor conference. Clearly, we have some of our businesses like Power Gen that are behind given that the lasting recession, you talked about the high horsepower markets which are behind.

We got some things that are going a little bit better like the Components business. So our view is, all in all, we think we’ll be in the range, and which is expected given the economic conditions are not at the high end of what we hoped and nor they are at the worse end of what we hoped. We expect to be in the range on both sales and margins even if by BU we’re not exactly where we expected to be.


Thank you. Your next question comes from the line of Ted Grace from Susquehanna. Please go ahead.

Ted Grace - Susquehanna

I was hoping to tag on to Nicole’s question on China and now that you’ve got your crystal ball out, as you look out to just the heavy-duty truck market in China, maybe looking out three to five years, can you just kind of share what your thoughts are kind of looking at more broadly and what kind of growth we may be looking at as the economy kind of transitions away from infrastructure and more towards consumer?

Tom Linebarger

Yes. That’s a hard one. Here is the thing. We talked a little bit about this in the last investor conference. We definitely have lowered our long-term growth rates for China. A couple of investor conferences ago, we were saying, hey, we thought we might be growing 9% to 10% for several years. We have of course lowered that down and now what we hear from even from China was a pretty optimistic view is sort of 7% to 8% and increasingly our number is more like 7%.

And again, it’s hard for me to say though exactly what that translates into our markets because the difficulty has been just, as you described it, a shift in emphasis on consumer driven versus infrastructure driven. On the one hand, you can make some predictions about what that would mean for our different sectors. On the other hand, their execution of that transition has been mixed and it’s a hard thing to do.

But as I mentioned earlier, I do believe that trucking still has a big role in the economy in either case, and we see significant investment in trucking throughout the country, but that’s not only -- all the stuff we’ve been talking about National Standard 4, but just in terms of development of highways and other things, there is still an emphasis on making sure they have good logistics roots.

And frankly, the logistics costs in China are quite high compared to other countries. So investments there will lower cost and improve on a consumer-based economy or an infrastructure based. What’s going to happen in the infrastructure side really, I just don’t know. I know they are struggling a bunch with figuring out how to get provinces and things, keep them flourishing in this new model and there is a lot of debate inside China among different agencies, among different provinces about how to do that.

So it’s just too early for me to say, but you can bet in our next investor conference we’ll be back with some views about what we think it means for our long-term growth for the economy and also what it means for our different sectors.

Ted Grace - Susquehanna

Okay. And then, shifting just a little bit towards India, I know you made the comment that there is growing optimism after the elections. You haven’t seen it yet translate into orders, but as you talk to customers and dealers in India, can you just talk about kind of what may be the timetable is to see the rubber hit the road? And hopefully the positives of the outcome of the elections start to manifest itself in business opportunities?

Rich Freeland

That again depends on who you talk to, of course. The Head of our India Operations, Anant, believes that it will be still through the end of the year before -- we won’t see much improvement maybe until beginning of next year. I think he’s basing that on a bunch of consensus. He think sentiment will continue to improve, it’s pretty good right now and he thinks it’s going to continue to improve. But before you can see significant improvement in the markets, it may be that long before you see it.

Again people have different points of view, but that’s his is the most balanced I’ve heard on the optimistic and pessimistic side. And the only thing I want to add to both my India and China comments is that Cummins will grow faster than the markets that we’re in. You can expect us because of expansion of products, both up and down, expansion of relationships with partners, expansion of our distribution capabilities that we will, in all those cases, grow faster than the markets to make sure whatever economy we’re in that we’re doing better than everybody else in the same environment, that’s kind of our commitment as a leadership team in those markets.

Tom Linebarger

I guess just maybe to quantify that question, what we’ve said at the Analyst Day, we’re around 10%, for example, in the truck market. With the introduction of NS4 and more volume on the 2.8, 3.8 and with the introduction of the 10 and 12 liter, we’re committed to 17% market share.

So even in a market that’s not growing, we’re going to see some pretty rapid growth. Just to remind, the heavy-duty market that we really don’t play in today is a 250,000 size market. So it’s as big as the U.S. and we have a 1% share now, something like that. So, again we’re going to see some growth there with the engine and then all the components that come with that.


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

Ann Duignan - JPMorgan

North America market share has been trending down, and I don't think you gave us a guidance for the full year today. I mean you reiterated medium-duty. But can you talk a little bit about where would you expect your North America heavy-duty market share to be at year end? And there's a lot of noise out there about freightliner trying to push through and drive train et cetera, et cetera, if you could just comment on that?

Mark Smith

Firstly and, this is Mark. I will confirm we did give our market share guidance for the year of 38%, which is unchanged and consistent with where we are year to date. So we haven’t changed the full year outlook on share. I’ll let Rich add some comments.

Rich Freeland

I think what you’ll see kind of month-to-month, it’s hard to pick up trends because just based on build rates and production schedules at different OEMs. You remember back in December, we’re at 35% and so we’ve said in any given month, we’re going to be in that 35% to 40%. I think in January, we were 41% or something. So we’re going to see some bouncing around, so I wouldn’t view the variation you see as a trend at this point, we still think a 38% is the best number to use going forward.

Ann Duignan - JPMorgan

Okay, that's helpful color. And then just one comment, if you don't mind, expand a little bit on your comments on global agriculture weakening? Can you just talk about A, what you're seeing in the different regions? And B, how material is that business to Cummins?

Tom Linebarger

It’s not so material to us. The biggest markets for our products and our North American and Latin America and we saw, for small businesses, quite strong unit growth last year in North America and that’s clearly a reverse trend, but we’re relatively small player in a pretty big market. So I think just generally those markets have come off. Brazil ag cycle has been very strong, that’s come off a little bit as well, but not overall material, just a change in trend that we mentioned.

Ann Duignan - JPMorgan

Okay, that's great. I didn't think it was that material, so just wanted to double check. Okay. I'll leave it there, thanks.


Thank you. The next question comes from the line of Tim Thein, company name has not been provided.

Tim Thein - Citigroup

Great, that’s Citigroup. Thanks. Rich, just quickly on your Class 8 heavy-duty build forecast, that 250,000 number. I know it's -- we're getting to the point of the year, it looks like the current six-month build plans for the OEMs would point to a number 4% or 5% higher than that. I'm just curious, is there some kind of a -- something you're seeing or hearing out there that makes you go towards a more conservative number? Or is that -- it gets -- those numbers -- those build plans, obviously, can move around. But maybe just a bit more color, in terms of what you're expecting for the back half of the year?

Rich Freeland

No, we’re not seeing anything that you don’t see. So, we’re looking at the same data and maybe taking a bit more conservative approach. We’re a little behind ACT. I think the only kind of headwind that I just - I talked to someone this morning even this -- the area of driver shortage, so I’ve talked to several fleets that say I have as much as 5% of my fleet down at any given time with the driver shortage problem and therefore it might slow down my acquisition rate. So I don’t think that’s a long-term issue. We’ve been here before in this industry and it gets addressed, but I’d say that’s the only kind of headwind I see right now. And other than that, we’re looking at the same data as you are.

Tim Thein - Citigroup

Okay. Fair enough. Real quick on distribution, Tom. Are you able, at this point, enough time has lapsed post some of the acquisitions in the U.S. and Canada of the distributors. Are you able to tease out kind of a pre and post acquisition or ownership change? Just -- I'm curious how the performance has been, as you go from a -- as it goes from a distribution -- partly owned to one in which Cummins is now taking a majority stake? Can you tease out any kind of trend there?

Mark Smith

That’s a great question, Tim. I would -- just to be fair, not really so much yet, here is a couple of things I would say. One is, these have been Cummins employees in spirit for a long time. So one of the things that we’ve noticed is how smoothly the integration has gone. There is all kinds of system issues and everything to be sorted.

But if you just think about the people, the managers, the employees, all that kind of thing, things we are worried about where here comes the big corporate entity and comes and acquires a small distributor, that stuff has gone surprisingly smoothly. We’ve put in some new leaders where people have retired as a result of the acquisition, that’s gone incredibly smoothly.

Some really capable people now out in the distribution organization, adding some new thinking which I am personally very excited about. And then, also some distributors who are staying on. So, we’ve had a mix which I think is a good sign. So all that kind of integration and the cultural adaptation has gone incredibly smoothly.

Again, there is cost associated with it, all the IT stuff, as I mentioned, there is stuff we have to do, but there is no question that that’s gone smoothly. What I can’t say yet is I haven’t seen, because we really haven’t focused very much on, is to what degree are we going to evolve the system over time to take advantage of the fact that it’s collectively in one organization yet. We’ve got a lot of ideas on that and a lot of plans, but right now we’re not doing that much of that because we’re still in the process of kind of acquiring and so I don’t want to get ahead of myself on that.

Rich Freeland

The only thing I would add, Tim, is the results are stronger this year regardless of ownership in the channel because the end markets are improving. So that’s clearly a positive as we’re acquiring that.

Tom Linebarger

And Tim, I did see a couple of things, write-ups early this morning from some of the analysts about where are the costs of the acquisitions and things like that and I think we talked about this last time, but there is a little noise as we go through the acquisitions. There are some write-ups that end up and then there is some amortization expenses and those slowed somewhat in the other income line.

So there is one-time gains and then there is some one-time costs in the gross margin and the SAR line. So unfortunately there is just a lot of noise in the system, so what I saw in some of the rough analysis is people took the other income and said well, that’s not - that’s one-time, it doesn’t matter. But that wouldn’t be exactly right because of course there is one-time expenses in the other lines too.

So we just have a little noise, it’s not big, it’s not material, but it would definitely be a mistake to take the other income line say well, that’s one-off and it’s not part of Cummins earnings, because you got a fair bit of that stuff in the other lines too of relatively similar amounts.

So broadly speaking though, all those amounts are washing through pretty quickly and what we are getting to is just what Mark said, good performance on the North American distributors because those end markets are doing well, the integrations are going quickly, the leadership stuff is going well. So, all in all, quite good results in distribution. I give the distribution leadership team and the employees throughout the system a lot of compliments for really working through a complicated set of acquisitions over a really fast time.

Mark Smith

Thanks a lot everybody. We are at the end of the hour plus at this time. I will be available for questions later. Thank you very much.


Thank you. Ladies and gentlemen, that concludes your conference call for today. You may now disconnect. Thank you for joining and enjoy the rest of your day.

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