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PACCAR (NASDAQ:PCAR)

Q4 2010 Earnings Call

February 01, 2011 12:00 pm ET

Executives

Robin Easton - CFO

Mark Pigott - Chairman, Chief Executive Officer and Chairman of Executive Committee

Thomas Plimpton - Vice Chairman and Principal Financial Officer

Analysts

Tim Denoyer - Wolf Trahan

Jerry Revich - Goldman Sachs Group Inc.

Ann Duignan - JP Morgan Chase & Co

Kristine Kubacki - Avondale Partners, LLC

Stephen Volkmann - Jefferies & Company, Inc.

Seth Weber - RBC Capital Markets, LLC

Basili Alukos - Morningstar

J. B. Groh - D.A. Davidson & Co.

Henry Kirn - UBS Investment Bank

Andrew Casey - Wells Fargo Securities, LLC

Robert Wertheimer - Morgan Stanley

Ben Elias - Sterne Agee & Leach Inc.

Patrick Nolan - Deutsche Bank AG

Adam Uhlman - Cleveland Research

Andrew Obin - BofA Merrill Lynch

Jamie Cook - Crédit Suisse AG

Operator

Good morning, and welcome to PACCAR's Fourth Quarter 2010 Earnings Conference Call. [Operator Instructions] I would now like to introduce Mr. Robin Easton, PACCAR's Treasurer. Mr. Easton, please go ahead.

Robin Easton

Good morning. We would like to welcome those listening by phone and those on the webcast. My name is Robin Easton, Treasurer of PACCAR. And joining me this morning are Mark Pigott, Chairman and Chief Executive Officer; Tom Plimpton, Vice Chairman; and Michael Barkley, Vice President, Controller.

As with prior conference calls, if there are members of the media participating, we request that they participate in a listen-only mode. Certain information presented today will be forward-looking and involve risks and uncertainties, including general economic and competitive conditions that may affect expected results.

I would now like to introduce Mark Pigott.

Mark Pigott

Good morning. PACCAR reported improved revenues in net income for the fourth quarter of 2010. PACCAR's fourth quarter sales and financial services revenue were $3 billion compared to $2.2 billion in the fourth quarter of 2009. Quarterly net income increased to $170 million compared to $46 million a year ago, a 370% improvement. PACCAR's 2010 yearly net income of $458 million is the company's 72nd consecutive year of net profit, quite an achievement.

I'm very proud of our 17,700 employees who have delivered outstanding performance to our shareholders and customers in a global economy which is beginning to emerge from recession.

PACCAR's results reflect the benefits of higher truck deliveries, particularly in Europe and Mexico, and a continued improvement in aftermarket part sales and financial services worldwide.

In the U.S. and Canada, industry orders in the fourth quarter of 2010 increased by 100% compared to the third quarter. U.S. and Canadian retail truck sales are estimated to improve in 2011 to a range of 180,000 to 200,000 units, an increase from the 126,000 units last year. This is still below replacement demand of 225,000 vehicles.

European truck registrations for the fourth quarter improved by 19% compared to the third quarter. As a result, we expect the greater than 15-ton truck market to be between 220,000 to 240,000 units this year, up from 183,000 units last year.

The improving global economy is benefiting the truck market, no doubt about it. PACCAR delivered 20% more trucks in the fourth quarter than the third quarter of 2010, and truck production is expected to increase this year.

However, recent commodity price increases, particularly steel, aluminum and copper, and the added cost of installing engine emission equipment over the last three years, particularly the 2007 to 2010 EPA cycles, added costs of about $15,000, which will likely impact PACCAR's operating margins as compared to prior cycles.

On recent calls, I've talked about the three-step process that the truck industry progresses through as it recovers from a recession. First is an improvement in parts and service, second is an increase in used truck prices, and third is new truck orders improving.

Well, the good news is that PACCAR parts delivered record quarterly revenues due to the highest average age in recent history in the U.S. truck fleet. Used truck prices in North America are up 10% to 15% from their lows and used truck prices in Europe are up 20% from their lows. And finally, year-on-year, quarterly industry truck orders in the U.S. and Canada increased by 63% and in Europe by 86%.

Our customers are benefiting from improved freight volumes which were up 4% from a year ago, and higher freight rates which were up approximately 5%. They continue to increase the utilization of their fleets which is, in turn, driving increased aftermarket parts and service business for our dealers.

PACCAR's strong balance sheet and positive operating cash flow of $1.5 billion last year that allowed the company to accelerate its investment in the business, enhance operating efficiency and develop innovative new products, such as the PACCAR MX diesel engine. We have now received over 10,000 orders for the MX engine. The engine is being installed in 25% of Kenworth and Peterbilt trucks, and the feedback from our customers has been excellent.

PACCAR Financial Services revenue were $244 million in the fourth quarter compared to $255 million a year ago. PACCAR Financial's fourth quarter pretax income improved to $50 million compared to $36 million earned in Q4 2009. This was due to better finance margins and reduction in the provision for credit losses. The credit loss provision for the fourth quarter 2010 were $12.6 million compared to $23.7 million a year ago.

2010, in many ways, was an excellent year for new PACCAR product introductions. The success of the Kenworth T700 and the Peterbilt Model 587 and the complete line of DAF vocational vehicles enhances our quality leadership, as well as delivering low cost of ownership for our customers.

In 2011, PACCAR will more than double capital expenditures. The company will focus on new vehicle development, customer service initiatives, meeting the Euro 6 and EPA 2013 emission requirements and global business opportunities. One of the primary areas we will focus this year is initiating construction of our DAF factory in Brazil. Our long-term goal is DAF achieving a 20% share of the Brazilian medium and heavy-duty truck market.

A lot of exciting opportunities. PACCAR will incur some increased expenses due to these business initiatives. But as we all know, that's normal, considering the benefits of growing in the global markets.

Looks like a good year. I look forward to your questions. Thank you.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question is from the line of Robert Wertheimer of Morgan Stanley.

Robert Wertheimer - Morgan Stanley

A couple of questions on the awards data that just came out, and then I know the monthly stuff is highly variable, but your vertical integration it slipped just a bit. I wanted to see what the 15-liter, 13-liter was trending like? And whether you feel like that's going to continue to move your way?

Mark Pigott

Well, it's hard to talk about the whole industry, but I can tell you the customers and the dealers certainly love the MX engine. And we're getting anywhere from 25% to 30% order intake on that. And right now, we have about 25% production. So it looks very good. 13 liters, the most popular configuration in the rest of the world, 15-liter, with our great partner, Cummins Engine, continues to be a strong player. But I think over time, you'll see a little bit more 13-liter activity.

Robert Wertheimer - Morgan Stanley

And then the second question is this, on the margin front, with the '10 trucks, I understand the increased cost commissions but there's also pricing that went up. Has pricing become more of an issue? Can you quantify how much of a margin headwind is, splitting up commodities for a second, just the emission side of this?

Mark Pigott

Well, the commodities and obviously in the paper and many industries are running in and out. And obviously, PACCAR prides itself from being the most efficient and low-cost manufacturer in every market in which we participate. And so you work with your suppliers and try to minimize the impact of commodities. And over time, hopefully, you're able to do that. But in recent three to six months, has had an impact to some amount. I think more important is the impact on the emission requirements. And once again, that's a regulatory requirement, which we all need in the industry. In '07 and '10 added about $15,000 of cost, and I think you'll find any OEM saying about that same figure. The market happened to be in a recession in the last few years, so it's very difficult to pass that through. I think on the supplier side, they've had a little more success passing through to the OEM, but when we deal with the end customer, who has some difficult times whether because their business is down or freight rates are down, it's just much more difficult to pass that $15,000 through.

Robert Wertheimer - Morgan Stanley

Do you think that the pass-through could get easier throughout the year if the economy continue to recover and you see an upswing, continued upswing, let's say in orders? Or you think you're kind of waiting, you're done in pricing for the year?

Mark Pigott

Well, never say never. And we obviously look forward to improved economy in many markets. But that's quite a bit to try to pass through. I think it's going to take time, and that could be several years.

Operator

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

Ann Duignan - JP Morgan Chase & Co

I just wanted to touch on the emissions cost up also, but more thinking about the upcoming cost for Euro 6. Could you comment a little bit, you mentioned the cost will be going up to contend with that? Can you talk about kind of the expense cost, the R&D cost, the CapEx cost, just the different kind of costs, the elements that we're going to see to meet Euro 6?

Mark Pigott

Well, Euro 6, we've been working on that, obviously, for a couple of years, and that's coming in, in a few years. We are increasing our R&D and the CapEx to meet some of the requirements to meet Euro 6, as well as EPA 2013. A little tough to quantify. I think in Europe, we have a little more flexibility in terms of some price movement, which tends to cover a little bit more of those cost increases. But in the U.S., with a little bit more rapid introduction cycles, it's been just a little harder to pass through those costs.

Ann Duignan - JP Morgan Chase & Co

And then on the Brazil strategy, can you talk a little bit about what your strategy is for distribution? We think about building manufacturing plants, great, but it's all about distribution. What's your plan for distribution in Brazil?

Mark Pigott

Right. Well, we've gotten public with the announcement that we're going to be putting in a factory . And I tend to agree with you that people can build factories pretty straightforward. We pride ourselves at building great factories. The distribution is a several-pronged approach. First of all, we've had quite a few independent inquiries from different groups, whether they're currently representing a competitor of ours in the marketplace or they're in a related field, say agricultural; or maybe new entrants from other parts of South America, Mexico, and even Europe, who said we recognize the advantages of having a DAF franchise. It's a very profitable franchise. We make a lot of investments for our dealers, which benefit our dealers. So we're finding a much more broad-based support from different constituents in helping us put distribution into place in Brazil. It's very encouraging.

Ann Duignan - JP Morgan Chase & Co

And so the key takeaway, I think, what you're saying is that your long-term market your target of 20% is long term?

Mark Pigott

Yes, long term. Like we've talked about in Europe, and now we're up to 15.2%, so that's the goal.

Ann Duignan - JP Morgan Chase & Co

Yes, but did acquire some of that share in Europe as opposed to...

Mark Pigott

Probably about 6% of it.

Ann Duignan - JP Morgan Chase & Co

You mentioned how customers and dealers love the new MX engines. Can you talk about any feedback you're getting on fuel efficiency versus the '07?

Mark Pigott

I think the fuel efficiency in anywhere from 3% to 5% on the '07. So it's positive. And of course, we also have the benefit of great reliability. Very quiet, as I think you've found when you drove it a few months ago at our tech center.

Ann Duignan - JP Morgan Chase & Co

Indeed.

Mark Pigott

Easy to operate. So it's really going well.

Ann Duignan - JP Morgan Chase & Co

Easy to operate will be the...

Mark Pigott

That's your main takeaway.

Operator

Your next question is from the line of Jerry Revich of Goldman Sachs.

Jerry Revich - Goldman Sachs Group Inc.

Mark, you highlighted rising material costs in your prepared remarks, but can you touch on the pricing landscape. I guess, considering how much used equipment values have recovered in both North America and Europe, I would think the pricing discussion should be relatively easy for you relative to your customers. Can you give us an update on what kind of pricing actions you're seeing in the marketplace out of your competitors? And are you optimistic that you can push the recent raw material inflation through on the pricing side?

Mark Pigott

Good question. I think you summed it up, actually, pretty well. That we're seeing some price improvement, I say generally, although on any particular deal there's always a lot of to-ing and fro-ing. Over the course of the year, we hope to be able to recover material price increases, whether it's through efficiency in our factory, we've got a lot of Six Sigma projects going on; or through general improvement in pricing, which I think every competitor would like to see some improvement.

Jerry Revich - Goldman Sachs Group Inc.

And as you ramp up production in the Mississippi plant, as we think about the cost savings on the content, should we just think of the, call it, 5% to 8% logistics cost savings as the biggest opportunity there? Or are there any absorption benefits that we'd be losing in Europe that we should be thinking about as we try to quantify the margin rate for that business going forward?

Mark Pigott

Yes, I think, of course, Europe continues to be a supplier to Mississippi, although that is, over time, will diminish. So I don't think there's no negative impact in terms of the absorption in Europe. Yes, it's getting more efficient in Mississippi. We'd love to show you around, if you get a chance to get down there. And of course the real benefit is reduced cost of installing the engine. You've got more of an integrated powertrain, that helps our manufacturing efficiency. You also have the back end, with the parts and service, so that helps our dealers and our Parts business. And also, maybe even gets a little bit of a finer point when we're out unleashing deals, in terms of residual values and the value of operating the vehicles. I think that's the real benefit. There's some logistics benefit, but I think that's just one of many.

Jerry Revich - Goldman Sachs Group Inc.

And lastly, can you give us an update on your backlog in Europe at the end of the quarter? And also, you picked up some share over the course of 2010, so should we look for Europe build rates for DAF to be higher than your guidance for the industry in 2011?

Mark Pigott

Well, of course, the build rate at DAF over the last year is up, gosh, almost 100%. So that's a pretty significant increase. Obviously, the market is stronger. The share has increased, and we're looking to have some steady share increase during this year. In a rising market, everybody is out grabbing share as fast as they can. But we continue to have strong dealers, appoint a few more dealers. And I think DAF will, obviously, grow a lot more trucks this year than it did last year. But maybe some moderate share increase at DAF is the plan.

Operator

Your next question is from the line of J.B. Groh of D.A. Davidson.

J. B. Groh - D.A. Davidson & Co.

You talked about commodity prices and touched on that a little bit. Is there any way to kind of defend yourself? Or what sort of hedging mechanisms do you have in place to kind of stem the rise in some of these oil-based products?

Mark Pigott

Yes, that's a great question. I mean, I think like most companies, you take a look at what you can hedge. We tend to focus more on having over 70% of our suppliers on long-term agreements, so that there's some hedging built into those agreements in terms of cost sharing and efficiency. And I think as I've mentioned over the last number of years, we actually go out and work with our suppliers on trying to help make them more efficient, whether it's installing capital equipment, which we retain ownership of in their factories; doing Six Sigma programs with them. And they're trying to offset some of the costs that even our suppliers are unable to control. So it's a teamwork approach. And I think, over time, it's worked very, very well.

J. B. Groh - D.A. Davidson & Co.

So there's nothing explicit in place. It's more of a PSA, "pain-sharing agreement?"

Mark Pigott

I've not heard that particular term. We look at it as a "productivity-sharing agreement."

J. B. Groh - D.A. Davidson & Co.

And then on a lot of talk on the CSA 2010 and hours-of-service agreements and those sort of things. What are your customers saying about that? And sort of thoughts on how that impacts their buying patterns and, eventually, your business?

Mark Pigott

Yes, I mean it's a good long-term question. I'm not sure it's having any impact right now in terms of more regulations impacting drivers, type of drivers, the background of the drivers. I think, overall, it's going to be positive for the industry. There's, once again, some fleets or some areas may have a little bit more up and down than others, but it's a great industry. Sometimes it's difficult to be on the road a long time, that's why we want to make a great product. I think we're working with ATA and other groups in making sure that they're fair, thoughtful industry changes to the regulations. And I think it'll all turn out okay.

J. B. Groh - D.A. Davidson & Co.

In the past, you kind of mentioned your premium brand is a driver-retention tool, and I'm just thinking of driver shortages and that sort of impact...

Mark Pigott

I think that's a good point. And of course, with all the new products that we introduced in the last year, including our own engine, we are seeing, I guess, a renewed driver-retention tool. And people love our products and are very supportive with the products. But I think for the whole industry, in general, we'll get to an equilibrium because you've got to move the freight. Either we'll have to pay the drivers more, or maybe people have to buy more PACCAR product to entice the drivers to come back into the industry. But either way, we'll work through it.

Operator

Your next question is from the line of Henry Kirn of UBS.

Henry Kirn - UBS Investment Bank

Since you called out some headwinds from emission costs over the next cycle compared with last cycle, how should we be thinking about achievable margins this time around?

Mark Pigott

Excellent question, Henry. Well, I think just looking at this year 2011 in terms of margins, I think there'll be probably comparable to fourth quarter of 2010, give or take. Obviously, we work hard to keep trying to improve the margins, over time we do. But as we've talked to some of the earlier questions, these are real cost impacts. We're still not just a booming economy, particularly in North America. And customers are thinking about how can we get even better value and how can we keep the pricing down when we purchase new equipment. I mean they love our equipment, but they can't pass that through to their end customers. So it's just a little bit slower process. We're probably not in a recession, but you've got 9.4%, 9.6% unemployment and housing at a 50-year low, and cars improving but still at a 20-year low. There's some challenges out there for many industries.

Henry Kirn - UBS Investment Bank

And as far as parts, what do you expect in your Parts business for 2011?

Mark Pigott

We are looking to grow our Parts business around the world. I think there was a nice picture in the press release of our new facility we have in Santiago, Chile. And so that's providing our customers and dealers even better service. I think our Parts business should have some improvement. We've got the highest field population of PACCAR trucks in our history. We've got great dealers who are profitable and investing in new stores, in new technologies. So I don't have a specific number, but I think that's some improvement.

Henry Kirn - UBS Investment Bank

And one final housekeeping one, if I may. How should we think about the tax rate as we go into 2011?

Thomas Plimpton

You should anticipate the tax rate to be in the 31%, 32% range for the year.

Operator

Your next question is from the line of Andy Casey of Wells Fargo Securities.

Andrew Casey - Wells Fargo Securities, LLC

I guess it kind of dovetails with Henry's question on the margins. You gave granularity on R&D. Can you talk about any incremental administrative expense related to the global growth initiatives vis-a-vis the past cycles? And is that material at all during 2011?

Mark Pigott

I'd say not so much in terms of -- I mean, we'll add some expenses. we're going to be hiring people because we have these different globally initiatives, SG&A. And we're also ramping up. We have a lot of exciting new projects we're working on so that takes some more people, whether they're new people or hiring people back that we had to let go in the last few years. It has some impact, but I won't read too much into that.

Andrew Casey - Wells Fargo Securities, LLC

And then on the incremental cost related to installing the internally produced engines, is that primarily warranty accrual expense? And if so, does that go down as a percent total revenue during the year, not volume-adjusted, but kind of flattish?

Mark Pigott

I'm not sure I understood that. But if I didn't understand it, the cost to install our engine is -- it's less expensive to install our engine than a third-party engine.

Andrew Casey - Wells Fargo Securities, LLC

I understood, in the release, you called out some incremental costs associated with that related to moderate -- moderation on the overall margins. I'm just wondering where that is coming from.

Mark Pigott

Yes, that was related to, primarily, the cost to purchase the componentry to meet the emission regulations. So the DAFs and the bracketry and just the myriad of equipment that needs to go on to the engine to meet the EPA regulations. Yes, there's a little bit of additional cost to install it, but the vast majority is the equipment, itself, the after-treatment, things like that.

Operator

Your next question is from the line of Adam Uhlman of Cleveland Research.

Adam Uhlman - Cleveland Research

Mark, just a clarification on Henry's question earlier about margins in 2011. Were you speaking to gross margins or operating margin or incremental margin being similar to the fourth quarter? Which one?

Mark Pigott

Yes, I think we're talking about the gross margin line to be comparable to the fourth quarter.

Adam Uhlman - Cleveland Research

And then could you also talk about -- with builds expected to ramp up pretty materially here in North America in 2011, are you seeing any indications from your suppliers that we might have problems meeting that increased demand?

Mark Pigott

We're looking at 2011 production. It's 5%, 10% improvement in the first quarter versus the fourth quarter. And we stay very close to our suppliers. We have about 800 total global suppliers. I'd say, generally, they're reading the tea leaves as well as we are. And they're hiring people and increasing their capacity, or maybe getting their capacity back onstream, which they might have reduced during the recession. Every day there's something that keeps our production people busy in terms of suppliers. But generally, great suppliers, and everybody recognizes an opportunity to improve business, so they're making the investment to do that. Right now, I think it's steady as she goes.

Operator

Your next question is from the line of Steve Volkmann of Jefferies & Company.

Stephen Volkmann - Jefferies & Company, Inc.

Wondering if we can talk just for a minute about the Finance business, which was better than what I was expecting on the quarter. You mentioned margins were a little better. Is there a change happening there that we should think about that as a better business going forward, or is there something temporary there?

Mark Pigott

I think the Finance business has always been a very steady business for PACCAR. Obviously, as our customers see improved business conditions, they're getting a little bit more margin. A number of our customers are obviously publicly traded transport companies, and you can see that their margins are improving, their profits are improving. Perhaps not to the record levels that any of us saw three, four years ago, but steady business. The general economy, GDP growth, 2%, 3%. That's good for them. So I think in terms of any of the downside of the Finance business, obviously, there will always be some customers that might get into difficulty. But our reserves are good, and I think we're just seeing some improvements overall. More business. In fact, the assets are growing in the Finance business.

Stephen Volkmann - Jefferies & Company, Inc.

Would you expect margins in that business to be better in 2011 than they were in 2010?

Mark Pigott

Let's say they're going to be comparable, maybe slightly better. But yes. I think the big improvement is, obviously, less losses, credit issues and growing business. As the economy is improving during the recession, we saw a number of competitors in the finance world exit. Some of them are now dipping their toe back in, and you've got more competitors. Some of them come in at some lower rates, so that's always a challenge. But of course, another benefit is we've seen good improvement in used trucks. In fact, speaking of that, it wasn't in our press release, but we are building our third used truck center in Salt Lake, working through the snow. But that's gong to be very good. And I think PACCAR has been a real technology innovator in terms of the used truck programs online, and that's really added to the breadth of what our dealers can offer to our end customers. And that's very exciting. So Finance business, very good business. Lease business, very good. We're even seeing good improvement in Europe for our Lease and Finance business.

Stephen Volkmann - Jefferies & Company, Inc.

And it seems like you still probably have more cash on your balance sheet than you need to run the business. Any evolution in your thinking about what you'll ultimately do with that?

Mark Pigott

Well, that question didn't come up the last two years and people didn't have any cash. We've got just the right amount. Obviously, we have a program of steadily increasing our dividends, which you've seen. And we've got a lot of new product-development programs. We're doubling the CapEx. We're going into Brazil. And if there's an opportunity on the M&A side, we'll always take a look at it. So I think we're well positioned.

Operator

Your next question is from the line of Jamie Cook of Credit Suisse.

Jamie Cook - Crédit Suisse AG

Believe it or not, another question on margins, but it's longer term. I appreciate the margin headwinds in the short term. But as you historically, PACCAR's been a company that's always improved their margins peak-to-peak. As you look at the headwinds, the cycle, when we think about the material costs, when we think about emissions, and then the costs that you're going to have to grow globally and you offset that with efficiencies in the engine and higher service aftermarket. I mean, do you think that -- I mean, you'll still be able to surpass prior peak margins like we've done every other cycle? Or is there something different this cycle that would suggest that, that's not achievable anymore?

Mark Pigott

Our goal is obviously to set records. And certainly, our goal is to achieve higher margins. And we are putting many elements of business in place to do that. I think you accurately summarized that there will be some additional costs, but there'll also be some additional business profit and margin opportunities. So certainly, our goal is to continue to improve, and we have achieved that for 105 years, and we're going to keep doing that going forward. Just on a simple note, and I think we talked about this a few months ago, Brazil, which is a good market, and obviously we know South America, although we don't have a presence as such in Brazil is typically regarded as the highest margins in the world for the truck business. And as you follow a number of our competitors, you'll see that called out, or you can deduce that very clearly that, that's where they get the majority of the profit. In some cases, the only place they get their profit, so I think that will have some benefit.

Jamie Cook - Crédit Suisse AG

Next question, what do you assume your adoption rate for the MX engine is next year? How should we think about that relative to this year?

Mark Pigott

Well, we've got, as I indicated earlier, we're getting 25% to 35% share. It varies by month depending on fleets we get. But we're looking over time to get that up towards 50%. It's going to take a year or two or three, but that's certainly the goal. And we're way ahead of our schedule. As I said, the customers and the dealers love it.

Jamie Cook - Crédit Suisse AG

So the high end of the 25% to 35% probably is an unreasonable in 2011?

Mark Pigott

Well, I mean, we've only been in the business out of Mississippi since last summer.

Jamie Cook - Crédit Suisse AG

But you guys are PACCAR, you can do anything.

Mark Pigott

But it's going to take us six months of history and try to overlay it. But certainly, 25% to 30% is a reasonable expectation.

Operator

Your next question is from the line of Patrick Nolan of Deutsche Bank.

Patrick Nolan - Deutsche Bank AG

Just a couple of quick ones. I apologize if I missed this first one, but can you give us the regional change in production in the fourth quarter?

Mark Pigott

The regional, okay. Well let's see.North America, you're talking about fourth quarter to third quarter?

Andrew Casey - Wells Fargo Securities, LLC

Whatever you guys have. I can figure it out.

Mark Pigott

Well, I'd say fourth quarter to third quarter for North America was flattish. And in Europe, it was up by about 30%, 40%. That's fourth to third.

Patrick Nolan - Deutsche Bank AG

And also, I mean, it's been really helpful that you guys have been giving detail how the Parts business have been tracking when you break down the margins. What was the Parts business margin in the quarter? And what was the year-over-year change in revenue?

Mark Pigott

Let's get back to you off-line on that. We'll give you the numbers on that, okay?

Patrick Nolan - Deutsche Bank AG

My last question is more of the longer-term question. When you think about -- I mean, you guys have historically been able to price your products arguably better than your competitors. And you've had a price agreement because of that.

Mark Pigott

Because we've delivered better products.

Patrick Nolan - Deutsche Bank AG

Yes, absolutely. But I mean, when you think about your comment that margins may not exceed the previous peak, or may not even reach that level...

Mark Pigott

I didn't say that. I said that we're hoping they will.

Patrick Nolan - Deutsche Bank AG

So you mean, is your assumption that your pricing premium will hold?

Mark Pigott

I think our pricing premium will improve. Because we now have our own engine, which is a big contributor. Also we have a broader range of products. We're coming out with new products, faster than our competitors.

Patrick Nolan - Deutsche Bank AG

And when you think about the incremental margin in the fourth quarter, it came off -- it's a little bit lower than it was in the third. Is that mainly because the raw material hit -- started hitting you and there's more of the EPO '10 costs coming through in the fourth quarter, as you're completely '10 engines by that point?

Mark Pigott

Yes, there might be an element of that.

Operator

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

Tim Denoyer - Wolf Trahan

Question on the Parts. I'm kind of following up, I was wondering, do you want to give the revenue offline? Or is that -- can you give us the fourth quarter revenue?

Mark Pigott

Fourth quarter revenue, $597 million, fourth quarter 2010.

Tim Denoyer - Wolf Trahan

And in terms of the gross margin?

Mark Pigott

A little over 34%.

Tim Denoyer - Wolf Trahan

And within Parts, how does it break down geographically? Is it similar to the Truck business mix, or is there more in one region of the world? I'm wondering what's growing faster and if there's any impact, potentially, from CSA 2010, which seems to be driving some maintenance?

Mark Pigott

Well, it's reflective of the amount of product we have out there. It's a complicated question. We have the benefit in Europe of having perhaps higher margins because they've had more of a vertically integrated approach. We have the PACCAR engine and the PACCAR axle, so there's a benefit there. On the other side, you got probably more Kenworth and Peterbilt trucks around, it's an older fleet in North America, so there's a benefit there. I'd say -- so both are strong markets for us.

Tim Denoyer - Wolf Trahan

In proportion to the truck revenue, would you say that there's more parts revenue in U.S. and Canada just because that's a more established market?

Mark Pigott

Yes, definitely. There's more trucks running around, too.

Tim Denoyer - Wolf Trahan

One more question just in terms of the sequential production, it seems like Europe ramped up in the quarter a lot more than North America. Do you expect that to kind of reverse going into the first quarter and North America to pick up, I think, maybe you said 5% pick up?

Mark Pigott

Yes, about 5% to 10%. I think North America on a percentage term, probably may pick up a little bit more than Europe, but we see Europe improving also. There'll be some interesting stories written about the recovery comparing Europe to North America in many industries, because they obviously both got hit by a pretty difficult recession. But we've just seen a lot faster ramp-up in the truck industry in Europe than in North America. Part of it didn't have the housing bubble. Part of it was different governments had incentive programs to sort of keep their economies going. So Europe's had a little faster recovery than North America.

Operator

Your next question is from Andrew Obin of Bank of America Merrill Lynch.

Andrew Obin - BofA Merrill Lynch

Just a question on your comment regarding gross margin throughout 2011 being similar to Q4. Assuming that we are going to start raising North American production sometime in the spring, why would gross margin not benefit from improved absorption? And to that also, you guys cut a ton of cost during the downturn, you shut down a big facility. You're vertically integrated in North America, so you're definitely getting benefit from capacity absorption in Europe. How does it work that margins will be flat throughout the year? I'm just not exactly sure how the math works?

Thomas Plimpton

Well, one thing to keep in mind is that the incremental margin on truck sales is lower than that of part sales, and the growth is going to be on the truck sales side. And so you're going to have a waiting effect because of the relative margins between truck and parts, so that comes into play. So while truck margins are going to be going go up, as a percentage of the total, the overall margin is going to be on the flat side as a percentage. Margin dollars will grow, of course, as sales go up.

Mark Pigott

And I think also, all the other point you indicated, obviously, we are the low cost. We are getting the benefits of integrated. There are more, maybe we'll get some pricing improvement as the economy improves across a wide range of industries. So I mean, hey, our goal is to keep improving margins. But we're just trying to share with you what's going on.

Andrew Obin - BofA Merrill Lynch

And would you quantify just for Q4? I know you didn't, but revenue went up by $500 million and profitability only went up by $50 million. Can we assume that between $50 million to $100 million of raw materials drag in the quarter?

Mark Pigott

No, no. It didn't have that much of an impact. I mean, it had a slight impact but...

Andrew Obin - BofA Merrill Lynch

So why was there no operating leverage in the quarter, then, if it wasn't raw material prices?

Mark Pigott

Well, we had an excellent quarter. I'm not quite sure of the question, because we had a great quarter-on-quarter, year-on-year improvement in income.

Andrew Obin - BofA Merrill Lynch

No, I understand. But if go and I look at the second quarter and if I look at third quarter, now there's a metric we use and I understand that's not how you run the company, but we had incremental margins of 22% and 27%, showing very strong operating leverage as volumes kept improving. And I'm not saying that there's anything wrong with this quarter, but it's also where our expectations are. I'm just trying to understand, given that your penetration of your truck engine has improved, why -- and you're now saying that there wasn't that much of raw material drag, why wasn't there sort of more bang for the buck, speaking, about it, on the volume increases in Europe in particular. That was the question.

Thomas Plimpton

I think what you're seeing is the impact of pricing in the market. I mean, it's taking a while for pricing to roll through the market and as orders get placed and delivered, it takes a while for them, the improved pricing, to run through the bottom line.

Mark Pigott

Yes, we had great improvement and excellent leverage. So just because the market goes up doesn't mean you're going to get more money for your vehicles either. It takes some time. We're still in a very tough marketplace, but we thought we did very well. Good leverage.

Operator

Your next question is from the line of Basili Alukos of MorningStar.

Basili Alukos - Morningstar

Just two. The first one, anecdotally I'm hearing that the current freight rates aren't high enough to support the increase in truck purchases for the smaller owner-operators and, historically, you guys have had a big percentage, or maybe not big, but a percentage of exposure to them. And I'm wondering if you can kind of talk about the conversation that are happening, and if you're seeing owner operators decide more to kind of refab old trucks and buy used. And I know this has been, obviously, happening for a while, but now kind of how that's change versus actually being able to afford the new trucks with the higher ticket price.

Mark Pigott

It's a good question. I think you have to be a little bit careful on the anecdotal, I think some of the smaller operators that have very good customers that allow them to purchase new trucks are able to do that. Some are perhaps extending the life of their trucks another year or two in hopes that the economy will improve. And some are aligning themselves, as they have for the last 10-plus years, with larger companies to take advantage of some economies of scale in purchasing. So there has been, certainly, a trend towards more medium and large-sized fleets in North America and in Europe. I think we'll see that trend continue. But the good news is that more and more large fleets love our product. And they can do the math and understand that the low operating cost of running a PACCAR product is a real financial benefit. We're still seeing a number of our smaller customers buy product. But it's still -- it's early days.

Basili Alukos - Morningstar

So it's not a material change, I guess, this time around versus previous price increases on trucks? I guess, given how many bankruptcies there have been, it seems like there's a lot of talk that the owner-operator is dead, and it's kind of what you said, it's not good to go based on anecdotes, but you got to start somewhere.

Mark Pigott

Right. Certainly, there was about 12,000, 14,000 bankruptcies. Eight years ago, the previous recession, there was probably 3,000, 4,000, 5,000. So the people who are still operating are actually very efficient. They've been through two tough, tough recessions. And if you're a small operator and you're still operating, you've got some great customers. You know how to control your costs. You understand the cost of product and when you need to trade it in. So this is a pretty seasoned, experienced group. So I think they'll be purchasing when it makes sense for them.

Basili Alukos - Morningstar

And then one more question dealing with the market share on your 13-liter engines, it's impressive, it's running so high. From what I understand, historically, the 15-liter engine has been substantially heavier than the 13-liter engine. And obviously, that's a drag on fuel efficiency. But now as the 15-liter engine have become lighter, the fuel efficiency difference has shrunken and, obviously, the larger the engine the more powerful and I'm just wondering -- and there's been a lot of talk that the industry is going to shift to 13. And I'm just wondering how that has actually played out versus the fuel efficiency of the two engines. The differential is shrinking as well as the weight of the 15-liter engine, and how that's kind of played out with your customers now that, obviously, you have your own 13-liter engine...

Mark Pigott

Right, that's a good question. Well, there's still about a 400-pound differential between a 13- and a 15-liter. I don't think that's shrinking. I mean, everybody is trying to become more weight sensitive, if you will, on their powertrain. So if there's weight reduction on a 15-liters, there's weight reduction on a 13, 10, eight, six, whatever. Everybody's trying to reduce the weight. But it's still 400 pounds. A little bit more fuel efficient on the 13-liter. So there's some real benefits to the 13-liter, and it's less expensive to purchase.

Basili Alukos - Morningstar

I guess, what I was referring to was maybe 15 years ago, the differential was 1,000 pounds.

Mark Pigott

I'm not sure that's correct.

Basili Alukos - Morningstar

But as far as your customers coming -- I mean, the big question is, and I think you mentioned this last call, in Europe, diesel prices are equivalent of $8 and that's for a 13-liter engine review or a 13-liter equivalent is predominantly used, but in the U.S. there still isn't -- while dealer prices are higher, it's not that great. And I'm just wondering if the improvements in the fuel economy and, also, the power on the 13-liter engine, specifically yours, if that's offsetting the need for having a larger engine to a substantial degree that you might see the 13-liter engine take over in the next few years?

Mark Pigott

Well, there's a lot of advantages to the 13-liter in terms of the fuel efficiency and also the power, horsepower ratings, the ability to have an excellent life cycle. I mean, it's comparable to a 15-liter. As you've indicated, the 13-liters are used all around the world, hauling through deserts and over mountains, and for million-mile engines, that's certainly what we're selling. So North America is a little bit of a unique market. There's still a lot of people who enjoy the 15-liter. And we're proud to partner with Cummins, making an excellent 15-liter. And the good thing is we offer both of them, so our customers are happy either way.

Operator

Your next question is from the line of Seth Weber of RBC.

Seth Weber - RBC Capital Markets, LLC

Mark, just going back to your comments on the strength in Europe, have you noticed any improvement in the vocational market share? I know that's been an area that you've been relatively weaker.

Mark Pigott

That is a great question, Seth, thank you very much for asking that. Our entire focus at the Hanover show last September was on vocational. We're battling for the number one position in the tractor on-highway segment. But we're only about fifth place in the vocational. We are going to increase that. We've established partnerships with the major bodybuilders, vocational segment leaders throughout Europe. And that's starting to percolate out to the industry through many different countries. And our dealers are excited about it. We're establishing good customer contacts with people in vocation. So we're seeing some improvement. It will take time, just really put this as a major agenda item for our product development last September. So we're, five, six months into it. But certainly, people are aware of us offering -- or DAF offering the full line. And it's a very exciting future.

Seth Weber - RBC Capital Markets, LLC

And do you think that, that would be -- I mean, would we notice any change there in 2011 in that business, or is it just too small to matter at this point?

Mark Pigott

I think it's too small. It's a much stronger market overall, but it's something that we're focused on. And we keep working it.

Seth Weber - RBC Capital Markets, LLC

Just a separate question, given the strength of the balance sheet, I mean would you undertake concurrent initiatives, like while you're doing South America to also go expand your presence in Russia or Turkey, or things that you've talked about as far as a return, would you accelerate any of that?

Mark Pigott

We've been in Russia. We put it out in the press release. We've been in Russia for decades. We're expanding our sales office. It's a good market. We know the market well. We're adding dealers in Russia. So yes, we're looking all around the world. But I want to make sure everything we do, we want it to be, obviously, high quality, and as Andrew said, strive for perfection if we can. And so I want to make sure we really focus on a few items and do them very, very well.

Operator

Your next question is from the line of Ben Elias of Sterne Agee.

Ben Elias - Sterne Agee & Leach Inc.

I just want to pick up on an earlier theme that you have, the CSA and driver's retention. And just wondering what else you're offering in terms of product? I know SCR is the industry's standard and a requirement, but are you offering things like disk brakes and things like that? Are they not optional, are you just sort of trying to push that through to attract drivers, maybe get better safety scores?

Mark Pigott

Well, our Peterbilt group was really the first in the industry to make disk brakes standard on a number of their models. I applaud them for that. Obviously, disk brakes in many parts of the world are standard. In fact, they're pretty much all you can get, unless you're into a off-road or vocational application. Our cabs, the chassis, exceed all of the global safety standards. And but I think the real benefit for our customers are the low cost of operations, the quality, the pride of all of our product. That's what draws people to a Kenworth of Peterbilt or a DAF. And they'd get all of that and great service, incredible residual value. We love seeing these used-truck prices going up, and many, many auctions we're finding our products are worth 25% more than the competitors on a like-for-like basis. That's a real contributor to the economic decision when you purchase a PACCAR product.

Ben Elias - Sterne Agee & Leach Inc.

From what I understand, in the U.S., there's great emphasis or greater use of drum brakes. So all you're saying is people are moving to disk brakes, I mean, certainly you're offering it as standard equipment, but are you -- now that freight rates are up and the economy's improving, and I think truck purchases are improving and your core segment's coming back, are you seeing more discretionary spending on some of these add-ons, I mean, if we sort of continued the theme, maybe just safety products, are you seeing more of these components being installed? Or how do we understand higher margin...

Mark Pigott

That's a good question. Obviously, we're seeing our Parts business improve, and a lot of that has been driven by an older population of vehicles out there. But there is some improvement in discretionary. Some of it is safety-related. Some of it is feature and benefit. Some of it just luxury led. Some people just say, I want it a little more comfortable, maybe I'll add a few more gauges or have some more pieces of chrome to highlight my vehicle, make it distinctive. So we're seeing some of that, but I think people are still recognizing that we're still in some challenging times, so they're -- people are thinking about it before they are purchasing.

Ben Elias - Sterne Agee & Leach Inc.

And does safety come back before luxury? Or how does it is generally work?

Mark Pigott

I think there have probably libraries written on that.The good news is that we like to be a leader on both.

Operator

The next question is from the line of Kristine Kubacki of Avondale Partners.

Kristine Kubacki - Avondale Partners, LLC

Just a quick question. North American production, I guess, isn't as up as much as what I would've thought in the first quarter. Can I infer, then, that the order strength that we've seen in the last few months, are they being spotted for later the year? And I guess, is this normal behavior for fleet at this point, to spread the orders over 2011?

Mark Pigott

I'd say yes to all your questions. We are going to be increasing production. And we're saying 5% to 10%. It might be a little bit more than that. Certainly, could be 15%-plus in North America for the first quarter. But a lot of the fleets are spreading it out over 2011. They can only absorb so much new product, and they may have a used truck trade-in package that may be financing related. But whatever their business model is. It's very, very normal. It's been going on for 70, 80 years, I bet.

Kristine Kubacki - Avondale Partners, LLC

On the pricing side, is the pricing a little bit weaker now or it's still coming off the bottom? Is it just the general lag in the market with capacity and demand? Or are there specific actions by any of your competitors to drive maybe market share, that we're seeing pricing being a little bit weaker than we would expected at this point in the cycle given the order rates?

Mark Pigott

The pricing, I think, is actually probably pretty much in line with coming out of a recession. And everybody is trying to grab what they think is their fair share, whatever that might be. Certainly, a number of our competitors are always very excited about saying what their market share goal is, and then you all hold their feet to the fires and now they got to go get that and profit isn't so important to them. But we're coming out of a recession. I think we're out of the recession, but we're not in a boom economy, by any means. So customers are cautious, they're evaluating how they can get the best price. And there are always people, in any industry who will drop the price, for whatever reason, so you need to work through that, too.

Operator

Our final question is from the line of Andrew Obin of Bank of America Merrill Lynch.

Andrew Obin - BofA Merrill Lynch

Just two follow-up questions. On your order rates, did you say a number in terms of your order book, did you quote a specific number on that in terms of your backlog or you didn't?

Mark Pigott

No, we did not.

Andrew Obin - BofA Merrill Lynch

And the second question, if let's say demand for your engine was running ahead of 25% to 30%, if you're experiencing now, would you be able to satisfy if it was more like 40% to 50%? Do you have the capacity to do it in 2011?

Mark Pigott

Yes, yes, we do. And if you place a lot of large orders, we'll try to accommodate you, Andrew.

Operator

We did have a final question come into queue, a follow-up from the line of Ann Duignan. [JPMorgan]

Ann Duignan - JP Morgan Chase & Co

Can you just give us a little bit of a color on, SG&A was significantly higher than we had forecast, it was higher than last year, as well, and higher than last quarter. Was there anything in there, like variable comp? What kind of a run rate should we assume going into 2011?

Mark Pigott

We were hoping you'd ask that, Ann. I think the run rate will be comparable to fourth quarter of 2010. Yes, be comparable.

Ann Duignan - JP Morgan Chase & Co

So there was no one-off...

Mark Pigott

No, we're just ramping up business. People, expenses, growing the business.

Operator

There are no other questions in the queue at this time. Are there any additional remarks from the company?

Robin Easton

Yes, I'd just like to thank everyone for their excellent questions. And thank you, operator.

Operator

Ladies and gentlemen, this concludes PACCAR's earnings call. Thank you for participating. You may now disconnect.

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