PACCAR (PCAR) Ronald E. Armstrong on Q2 2016 Results - Earnings Call Transcript

| About: PACCAR Inc. (PCAR)

PACCAR, Inc. (NASDAQ:PCAR)

Q2 2016 Earnings Call

July 26, 2016 12:00 pm ET

Executives

Ken Hastings - Director of Investor Relations

Ronald E. Armstrong - Chief Executive Officer & Director

Analysts

Stephen Edward Volkmann - Jefferies LLC

Timothy W. Thein - Citigroup Global Markets, Inc. (Broker)

Jamie L. Cook - Credit Suisse Securities (NYSE:USA) LLC (Broker)

Joe D. Vruwink - Robert W. Baird & Co., Inc. (Broker)

Andrew M. Casey - Wells Fargo Securities LLC

Ann P. Duignan - JPMorgan Securities LLC

Steven Michael Fisher - UBS Securities LLC

Jerry Revich - Goldman Sachs & Co.

Joel Gifford Tiss - BMO Capital Markets (United States)

David Raso - Evercore ISI

Michael David Shlisky - Seaport Global Securities LLC

Mike J. Baudendistel - Stifel, Nicolaus & Co., Inc.

Neil A. Frohnapple - Longbow Research LLC

Joe J. O'Dea - Vertical Research Partners LLC

Robert Wertheimer - Barclays Capital, Inc.

Scott H. Group - Wolfe Research LLC

Jeffrey A. Kauffman - The Buckingham Research Group, Inc.

Kwame Webb - Morningstar, Inc. (Research)

Alexander Eugene Potter - Piper Jaffray & Co. (Broker)

Operator

Good morning, and welcome to PACCAR's Second Quarter 2016 Earnings Conference Call. All lines will be in a listen-only mode, until the question-and-answer session. Today's call is being recorded, and if anyone has any objections, they should disconnect at this time.

I would now like to introduce Mr. Ken Hastings, PACCAR's Director of Investor Relations. Mr. Hastings, please go ahead.

Ken Hastings - Director of Investor Relations

Good morning. We would like to welcome those listening by phone and those on the webcast. My name is Ken Hastings, PACCAR's Director of Investor Relations. And joining me this morning are Ron Armstrong, Chief Executive Officer; Bob Christensen, President and Chief Financial Officer; and Michael Barkley, Senior Vice President and Controller.

As with prior conference calls, if there are members of the media on the line, we ask 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 Ron Armstrong.

Ronald E. Armstrong - Chief Executive Officer & Director

Good morning. PACCAR reported good revenues and excellent operating income for the second quarter of 2016. PACCAR's second quarter sales and financial services revenues were $4.4 billion, and second quarter adjusted net income, a non-GAAP measure, was $372 million, an 8.4% after-tax return on revenues.

Adjusted net income excludes a favorable $109 million adjustment to the reserve, established in the first quarter this year, reflecting the settlement of the European Commission investigation. Including the reserve adjustment, PACCAR reported net income of $481 million in the second quarter. PACCAR achieved excellent truck, parts and other gross margins of 15.2%, driven by Kenworth, Peterbilt, and DAF's premium products, DAF strong 16% market share, a robust European truck market and rigorous costs control. I'm very proud of our 23,000 employees who have delivered industry-leading products and services to our customers worldwide.

PACCAR delivered 36,700 trucks during the second quarter, in line with our expectations, deliveries in Europe were 17% higher than last year second quarter. In the third quarter, PACCAR deliveries will be slightly lower than the second quarter, due to the normal summer shutdown at DAF. Third quarter gross margins are projected to remain strong, but down slightly from the second quarter margins due to the lower production in Europe. PACCAR's industry-leading operating margins reflect the benefits of DAF, Peterbilt and Kenworth's new truck models, record plant operating efficiency, good truck markets and continued material cost savings.

We've raised our forecast for Europe's greater than 16-tonne market to a range of 280,000 units to 300,000 units, reflecting strong demand and the steady economic outlook. The Eurozone's GDP growth expectations for this year are 1.5%. Freight transport activity on German highways in the first half of this year was up 3.4% over the same period last year. Since the vote in the UK to exit the European Union, DAF's truck orders, parts and service sales and finance business continue at strong levels comparable to the period prior to the vote.

The economic picture in the U.S. is positive, with GDP forecast to grow 1.9% this year. The housing and automotive industries create a large amount of freight. Housing starts are projected to grow 11% this year to 1.2 million and the automotive industry is expected to deliver 17.2 million vehicles similar to last year's record sales.

The ISM Manufacturing Index has been over 50 indicating expansion for the last four months. Consumer spending and disposable income are outgrowing the overall economy, which is supportive of freight in the truck industry. We estimate U.S. and Canadian Class 8 truck industry retail sales will be in a range of 220,000 units to 240,000 units this year, which is the third best in the last decade.

Peterbilt and Kenworth's combined retail sales market share of the U.S. and Canadian market was 28% in the second quarter. Our share of net orders so far this year is strong at 34%, as customers benefit from Kenworth and Peterbilt's reliable, fuel-efficient trucks, and industry-leading resale values.

PACCAR Parts business generated quarterly revenues of $756 million, a 5% increase compared to the first quarter. PACCAR Parts quarterly pre-tax income was $133 million, with a return on revenues of 17.6%. These results were driven by good fleet utilization, the growing number of PACCAR trucks and engines in operation, and the many innovative products and services offered by PACCAR Parts and our dealers. Second half Part sales are expected to improve from first half levels.

PACCAR Financial Services second quarter pre-tax income was $77 million, excellent portfolio performance contributed to the good results. During the quarter, PACCAR Financial began providing retail financing in Romania, its 23rd country of operation. PACCAR Financial also acquired land in the Chicago area to construct a new Used Truck Center and expand its sales of Kenworth and Peterbilt premium used trucks.

PACCAR strong balance sheet and cash flows have enabled the company to invest $6 billion in new products and facilities in the last 10 years. PACCAR achieved record net operating cash flow of $1.6 billion in the first half of 2016. PACCARs' capital spending of $325 million to $375 million this year is targeted at enhanced aftermarket support, manufacturing facilities and new product development.

Research and development expenses are estimated to be in the range of $240 million to $260 million. PACCAR continues to enhance its leadership position in the global truck market by developing the highest quality products and services in the industry.

Thank you, and I look forward to your questions.

Question-and-Answer Session

Operator

Your first question comes from the line of Ross Gilardi with Bank of America Merrill Lynch.

Ronald E. Armstrong - Chief Executive Officer & Director

Good morning, Ross.

Operator

It looks like Ross withdrew his question, I apologize. So, your next question comes from the line of Steve Volkmann with Jefferies.

Ronald E. Armstrong - Chief Executive Officer & Director

Good morning, Steve.

Stephen Edward Volkmann - Jefferies LLC

Good morning. I'm here. Maybe just if I could ask you to give us an update on how you see your and industry inventory levels in North America and in Europe? And I guess specifically, I'm trying to think about the potential that you will need to adjust production levels at all in the second half? Or do we think of them as being fairly stable going forward?

Ronald E. Armstrong - Chief Executive Officer & Director

The dealer inventories are in excellent shape, in both of our key markets North America and Europe, and they have been. We adjusted build rates in the second half of last year to balance with demand and we've had steady inventories and steady build during the first half of this year, and projected to see that continue for the second half of this year.

Stephen Edward Volkmann - Jefferies LLC

Okay. Great. Then maybe just a quick follow-up. Retail sales have been running obviously ahead of orders for a while.

Ronald E. Armstrong - Chief Executive Officer & Director

Yes.

Stephen Edward Volkmann - Jefferies LLC

And I guess the market maybe is having a little bit of trouble figuring out whether we should be paying more attention to one versus the other. Is it your view that orders will sort of recover to retail levels once inventories get in shape? Or do you think that once people take deliveries of these trucks, the order rates will continue to be lower and things will sort of take another step down?

Ronald E. Armstrong - Chief Executive Officer & Director

No, I think there's a lot of trucks still being produced on some of the backlog. And so, I think orders will come back to better reflect what the retail sales activity is. The great news is that Peterbilt and Kenworth, because of their approach to building trucks to customer orders, they've gotten a higher share of the orders during the first half of the year, just under 35%. So they've done a great job of supporting their customers.

Stephen Edward Volkmann - Jefferies LLC

And then just finally, you guys have traditionally a pretty high share in the oil and gas markets, which have obviously been very weak. Any signs of any kind of life there yet?

Ronald E. Armstrong - Chief Executive Officer & Director

Oh, I think it's – I think I'd say, it's bottomed out and so the opportunity is up from here, I think.

Stephen Edward Volkmann - Jefferies LLC

Thank you.

Ronald E. Armstrong - Chief Executive Officer & Director

Yeah.

Operator

Your next question comes from the line of Timothy Thein with Citi Research.

Timothy W. Thein - Citigroup Global Markets, Inc. (Broker)

Thank you. Good morning.

Ronald E. Armstrong - Chief Executive Officer & Director

Yeah.

Timothy W. Thein - Citigroup Global Markets, Inc. (Broker)

The first question is just – good morning. Just to come back to the outlook that you provided from a margin standpoint, of 14.5% to 15%, there's been some shifting in terms of your regional expectations. But can you come back and revisit us in terms of how you're thinking on that from a full year standpoint?

Ronald E. Armstrong - Chief Executive Officer & Director

I think we think that's still a good range for the full-year Tim, that's where we expect to land.

Timothy W. Thein - Citigroup Global Markets, Inc. (Broker)

Okay. Got it. And then just on Parts specifically, I think the expectation had been North America up – call it I think 3%, and Europe around that range as well. We're starting from a little bit of a hole here in the first half. So any update to that guidance from a revenue standpoint?

Ronald E. Armstrong - Chief Executive Officer & Director

I think as we look at the second half – I think we see second half Parts sales, probably be up 2% to 4% compared to the first half levels. Traditionally, the second half Parts activity has been a little higher than the first half.

Timothy W. Thein - Citigroup Global Markets, Inc. (Broker)

Okay. Understood. Thanks a lot.

Ronald E. Armstrong - Chief Executive Officer & Director

You bet.

Operator

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

Jamie L. Cook - Credit Suisse Securities (USA) LLC (Broker)

Hi. Good morning.

Ronald E. Armstrong - Chief Executive Officer & Director

Good morning, Jamie.

Jamie L. Cook - Credit Suisse Securities (USA) LLC (Broker)

Just a couple questions. One, well I know you won't give the official retail sales forecast outlook until next quarter. You've seen some industry experts in the U.S. like ACT, I mean they've taken down their forecast for 2017. They're now assuming a down year. You guys have, within – and then I guess with Europe there's some greater concerns on the longer-term implications of Brexit and how that impacts things. So I guess my question is, I know you're not going to give a specific number, but do you think the market is too bearish on 2017? Or given what you see today, is it fair to assume that 2017 would be down in the U.S.? And then given that you've raised your forecast in Europe, it appears you're not that worried about Brexit, but just sort of your thoughts there?

And then my second question is you said PACCAR dealer inventories were good. I don't think you answered or talked about what you're seeing from the competitors – if you could provide any color there? Thanks.

Ronald E. Armstrong - Chief Executive Officer & Director

Well, based on the information we have about dealer inventories, I think we're probably below where some of the competition are with respect to their inventory positions, but we're very comfortable with where we're at, both Europe and North America. With respect to 2017, I guess based on as we sit here today, it feels like some of the negative forecasts feel a bit bearish at this point. That's about all I can say at this point.

Jamie L. Cook - Credit Suisse Securities (USA) LLC (Broker)

Okay. Thanks. I'll get back in queue.

Operator

Your next question comes from the line of David Leiker with Robert W. Baird.

Joe D. Vruwink - Robert W. Baird & Co., Inc. (Broker)

Hi, this is Joe Vruwink for David.

Ronald E. Armstrong - Chief Executive Officer & Director

Good morning, Joe.

Joe D. Vruwink - Robert W. Baird & Co., Inc. (Broker)

When you look at commodity price movements through the first six months of the year, particularly steel, do you have any sense if prices stay at current levels and you get your resets on your pass-throughs into next year, maybe $1 margin headwind you would expect to encounter?

Ronald E. Armstrong - Chief Executive Officer & Director

I think at this point, we've seen reductions over the last several quarters. I'd say their prices are – or costs are firming, but we don't anticipate any significant impact of material costs movements in the near-term.

Joe D. Vruwink - Robert W. Baird & Co., Inc. (Broker)

Okay. That's helpful. And then just on the extent of market share gains, both in the U.S. and in Europe, share is typically hard to come by in this industry and it's tougher to hold onto, so you're six months into a pretty big share spike or share improvement. Do you think that can hold? Obviously your residual values, particularly at Peterbilt are well above what the industry is doing, so I'd imagine that's a big positive. But are there things with the new product lineup or other intangibles with PACCAR where you think 34%, 35%, that doesn't just need to be the first six months, it could be a 2016 outcome ultimately?

Ronald E. Armstrong - Chief Executive Officer & Director

Well, again, that's orders in terms of retail sales of second quarter.

Joe D. Vruwink - Robert W. Baird & Co., Inc. (Broker)

Right.

Ronald E. Armstrong - Chief Executive Officer & Director

Peterbilt and Kenworth were 28% and reflecting the great products and services with parts and finance that we provide through our dealer network. We have the strongest dealer network. So, when I started with the company, Peterbilt and Kenworth were 21% and they've grown to 28% over a period of time. And over the 20-year period, we've owned off, we've gone from 10% – less than 10% to 16%, so we have a long-term track record of incrementing that share and I think that's our focus with the product lineup and the support activities that we have in place today that will continue to be our focus to achieve those increments.

Joe D. Vruwink - Robert W. Baird & Co., Inc. (Broker)

Maybe let me ask it this way. You're at 28%, you're booking at 34%, so in 2017 are you maybe in the low 30s% for retail share?

Ronald E. Armstrong - Chief Executive Officer & Director

I think that's – I'd love to be, but that might be optimistic.

Joe D. Vruwink - Robert W. Baird & Co., Inc. (Broker)

Okay. Thanks very much.

Ronald E. Armstrong - Chief Executive Officer & Director

Thank you.

Operator

Your next question comes from the line of Andy Casey with Wells Fargo.

Andrew M. Casey - Wells Fargo Securities LLC

Good morning, everybody.

Ronald E. Armstrong - Chief Executive Officer & Director

Good morning, Andy.

Andrew M. Casey - Wells Fargo Securities LLC

A question on the European orders? A few of your European competitors have kind of talked about modest declines in their EU region truck orders compared to last year. Can you comment on what you saw in terms of order intake during the quarter compared to Q2 2015?

Ronald E. Armstrong - Chief Executive Officer & Director

I'd say it was very comparable, nice consistent order board throughout the quarter. So, I'd say it's very consistent with what we saw in 2015 levels. And if you recall 2015, we were increasing build rates throughout the year, this year we started at a stronger pace and we've maintained that and anticipate further build rate enhancements in the second half.

Andrew M. Casey - Wells Fargo Securities LLC

Okay. Thanks, Ron. And then the finance companies saw little uptick in provisions for losses on receivables, compared to both last year and Q1. Was that driven by a specific region or can you help us understand? It was small, but what was going on there?

Ronald E. Armstrong - Chief Executive Officer & Director

Yeah. It's small and it's very discrete in terms of particular customers and activity. So, it really is – the portfolio is performing great, the past dues have been less than 1% now for many years and it continues to perform at that level.

Andrew M. Casey - Wells Fargo Securities LLC

Okay. Thanks. And then the last question is kind of how to look at the short term? You talked about the production pattern already slightly lower Q3 versus Q2. Should the margin be somewhat similar in Q3 versus Q2 because you had kind of an earlier than industry production decrease last year in North America that seemed to impact the margin?

Ronald E. Armstrong - Chief Executive Officer & Director

Yeah. I think as I mentioned, we'll see both production and margins down slightly in the third quarter as a result of the European summer shutdown period.

Andrew M. Casey - Wells Fargo Securities LLC

Okay. Thank you very much.

Ronald E. Armstrong - Chief Executive Officer & Director

You bet.

Operator

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

Ann P. Duignan - JPMorgan Securities LLC

Hi. Good afternoon.

Ronald E. Armstrong - Chief Executive Officer & Director

Good afternoon, Ann.

Ann P. Duignan - JPMorgan Securities LLC

At least in our time zone it's afternoon. Can you talk a little about what you're hearing from your customers in terms of – we're getting into that seasonal timeframe where large fleets start to contemplate placing orders for 2017 delivery. What are you hearing from the customer base out there?

Ronald E. Armstrong - Chief Executive Officer & Director

I think it's – looking at the results some of our customers, those that have reported, you see the results are still good. They are not maybe as buoyant as they were a year ago, but still good solid results. And I think a lot of their decisions about truck orders will be driven by the economic conditions. We're seeing lower orders in the first half, and as we talked about I think we'll see orders pickup and customers start to place orders to get in their positioning for 2017 build slots.

Ann P. Duignan - JPMorgan Securities LLC

And those comments were for North America?

Ronald E. Armstrong - Chief Executive Officer & Director

I think both, both markets.

Ann P. Duignan - JPMorgan Securities LLC

Okay. And then on used prices, we've seen softness in used equipment prices. Could you talk about your brand's used pricing? And also does that have any impact on PACCAR leasing? And is there any downside risk on residual values for PAC leasing?

Ronald E. Armstrong - Chief Executive Officer & Director

So, used truck prices in Europe are pretty steady. They have been and we're starting to see a few Euro 6 trucks enter into the market and the Euro 6, DAF Euro 6 trucks are really earning a nice premium in the used market.

In North America, we have seen a reduction, several of our competitors have sizable quantities of used truck inventories, that sort of dampen the entire market. The good news is that Peterbilt and Kenworth continue to enjoy 10% to 15% premium, relative to the competition. And that's part of the impact on PACCAR Financial Services. Last year, we were earning nice gains with a buoyant used truck market. This year those gains have gone down as a result of just lower average sales prices.

Ann P. Duignan - JPMorgan Securities LLC

And any residual value risks?

Ronald E. Armstrong - Chief Executive Officer & Director

No. No, I think, we'd look at that every quarter and adjust our residual values based on the current market at that time. And so that's been reflected in our quarterly results.

Ann P. Duignan - JPMorgan Securities LLC

Okay. I'll leave it there. Thank you.

Operator

Your next question comes from the line of Steven Fisher with UBS.

Steven Michael Fisher - UBS Securities LLC

Thanks. Good morning.

Ronald E. Armstrong - Chief Executive Officer & Director

Good morning.

Steven Michael Fisher - UBS Securities LLC

Wondering if you could just talk about the duration of your backlog today, how it's changed over the last few months and the visibility you have for the rest of the year?

Ronald E. Armstrong - Chief Executive Officer & Director

Well, orders have been, just talk about Europe first, orders have been, as I mentioned, very good, and we have a solid backlog and we're anticipating that we'll probably increase our daily build rates during the course of the second half. And North America orders have been below production and retail sales. So, we continue to produce trucks that were ordered in 2015. So, but that – we got some good solid orders in the backlog and we'll continue to build those trucks as well as the orders that are coming in on an ongoing basis.

Steven Michael Fisher - UBS Securities LLC

Okay. And then shifting over to the Parts side of the business, how do you see the margin opportunity for parts going forward? One of your competitors reported a pretty notable – notably high number. Can you just refresh us on the rebranding strategies you have here to augment parts margins and where you see these margins going from here?

Ronald E. Armstrong - Chief Executive Officer & Director

Well, as we develop new products and have developed new products over the years, we always take a look at enhancing our proprietary content of our vehicles and obviously, with the increasing mix of MX engines in the truck park in North America, that's going to enhance our margin opportunity over time with respect to engine parts. But we also trying to focus a lot on selling parts – our TRP lineup of all makes and those have a little bit narrow margin on those.

So it's a balance. And so, I'd say, margins will be fairly consistent with what we've seen in the recent quarterly performance.

Steven Michael Fisher - UBS Securities LLC

Okay. Helpful. Thank you.

Ronald E. Armstrong - Chief Executive Officer & Director

Thank you

Operator

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

Jerry Revich - Goldman Sachs & Co.

Hi, good morning, and good afternoon, everyone.

Ronald E. Armstrong - Chief Executive Officer & Director

Good morning, Jerry.

Jerry Revich - Goldman Sachs & Co.

I'm wondering if you could talk about your key partners as you develop the autonomous vehicle platform? Whether it's DAF or Peterbilt or Kenworth, whoever's taking the lead on that? If you could just, to the extent you're willing to comment, talk about the timeframe of when you expect to have a commercial product? Nice to see the progress in platooning. I'm wondering if you're willing to flesh that out a bit more for us?

Ronald E. Armstrong - Chief Executive Officer & Director

Well obviously, it's very early days with, you know, advanced driver assistance systems, and all of the divisions are actively engaged in discussions with suppliers across divisional lines, technology companies, really there's a lot of participants that we think can help support our entrance into those technologies. So, we're very active and it's going to be probably more than five years before you see something on the road that is fully autonomous and operating day-to-day. Don't know how long that will be, but it's something that everybody is focused on, and we're making some sizable investments in the technologies and capabilities in that area.

Jerry Revich - Goldman Sachs & Co.

Okay. And then from a shorter term standpoint, can you talk about what was pricing in the quarter for you in U.S. and Europe in the first quarter 10-Q, looks like there was a modest headwind in Europe? I'm wondering was that just a timing phenomenon? Can you talk about if pricing turned positive in Europe in the second quarter?

Ronald E. Armstrong - Chief Executive Officer & Director

I think pricing in Europe is pretty – is relatively steady and has been for some time, and U.S. pricing is also steady, obviously the lower used truck prices can impact large transactions you do with fleets. But that's – I'd say the pricing in both markets is pretty consistent.

Jerry Revich - Goldman Sachs & Co.

Okay. And lastly, I'm wondering if you're willing to talk about what order inquiry levels have been like in Europe in July, just to calibrate us, what you're hearing from your customers post Brexit, if you're willing to comment directionally?

Ronald E. Armstrong - Chief Executive Officer & Director

Yeah. So, post Brexit, as I said in my comments, the order activity and inquiries continue at good solid rates. We upped our range estimate for the European market. And as I mentioned, we're going to be enhancing our build rate in the second half in Europe to reflect that demand.

Jerry Revich - Goldman Sachs & Co.

Okay. Thank you.

Ronald E. Armstrong - Chief Executive Officer & Director

Thank you.

Operator

Your next question comes from the line of Joel Tiss with BMO.

Joel Gifford Tiss - BMO Capital Markets (United States)

Hey guys. How is it going?

Ronald E. Armstrong - Chief Executive Officer & Director

Good. How about you, Joel?

Joel Gifford Tiss - BMO Capital Markets (United States)

I'm hanging in there.

Ronald E. Armstrong - Chief Executive Officer & Director

Good.

Joel Gifford Tiss - BMO Capital Markets (United States)

On medium-duty, can you talk about where your share is trending? I'm trying to gauge the success of the new products that you guys rolled out. Maybe like a three-year view of what's happened to your share there?

Ronald E. Armstrong - Chief Executive Officer & Director

So, the medium-duty product is the same excellent product that we've had in the market for the last several years. And last year, we achieved a record share of 17.2% and we're in that same range, slightly lower than that year-to-date this year. The medium-duty market is – last year was in Class 6 and Class 7, where we participate, was about 80,000 trucks and we think that market is going to be comparable to that level this year. And the durability and again the residual value of those trucks is great in the market, well received by our customers.

Joel Gifford Tiss - BMO Capital Markets (United States)

Can you just help us to understand the incentive for you guys to sell used trucks outside of the dealer network? You know, building a new facility in Chicago?

Ronald E. Armstrong - Chief Executive Officer & Director

Yeah. So, we have two facilities, one in Salt Lake City, one in Spartanburg, and as there are more larger – the average order size of transactions increases over time, more of those involve trade activity, and we participate with our dealers in consummating those transactions. And so, we want to have a very efficient way and effective way of selling those used trucks into the marketplace. And so this just enhances our capability, and I think we'll see some additional investments over the coming years in used truck distribution capability.

Joel Gifford Tiss - BMO Capital Markets (United States)

All right. Thank you.

Ronald E. Armstrong - Chief Executive Officer & Director

Thank you.

Operator

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

David Raso - Evercore ISI

Hi, thank you. Maybe I missed this. I apologize. The second quarter to third quarter progression, you highlighted the DAF shutdown. But did you express North America, or I should say U.S., Canada and Other, how do you view them sequentially, 2Q, 3Q?

Ronald E. Armstrong - Chief Executive Officer & Director

The change from second quarter to third quarter, I think we'll be down 500 trucks to 1,000 trucks, and substantially all that's Europe.

David Raso - Evercore ISI

Okay. So, U.S., Canada, you expect to be similar to the 19,800 you just posted in 2Q.

Ronald E. Armstrong - Chief Executive Officer & Director

Yeah. North America numbers will be comparable.

David Raso - Evercore ISI

Okay. That's impressive. And the Other number was a little higher than I would have thought, 1Q to 2Q. Again, I apologize, I might have missed it. What was the strength in the Other geography, to go from 3,300 units up to 3,900? Talking deliveries, units?

Ronald E. Armstrong - Chief Executive Officer & Director

Yeah. I think that was primarily some additional units delivered in Mexico.

David Raso - Evercore ISI

Okay. That's helpful. And just big picture question – just trying to think about units versus gross margins. Your units this past quarter, if you look back over the last couple years, maybe you look at third quarter of 2014 and say – okay, similar units, in fact, a little bit lower, but the gross margins are nearly 200 basis points higher. Can you just characterize for us just so we have a better understanding – because the parts revenues from them, they're not really much higher as a percent of total revenues so you can't say it's just parts mix. That 200 BPS, how much would you characterize, a) lower input costs, b) I know you're going to say the great work of your people, lowering the costs, I understand that, but maybe that bucket as well?

And another key difference is the European shipments are a higher percent of the total now than a couple years ago. So maybe we're not appreciating the profitability of Europe as the mix is going that direction? Just trying to help understand the framework of similar units but 200 basis points higher gross margin – how would you bucket that improvement?

Ronald E. Armstrong - Chief Executive Officer & Director

I think your first two comments were pertinent. The input costs we've benefited from lower input costs. In 2014, we were still transitioning to the Euro 6 product into the factories, we were ramping up the 2.1 meter product and we were gaining a lot of ground with the MX engine production over that period. And so, the efficiencies that have come with being two years after some of those transitions getting the full benefit of the 2.1 meter products, and our North American factories, all those factors have added and incremented that operating margins. So those are sort of the key elements of it.

David Raso - Evercore ISI

Okay. So I mean the capturing of the Euro 5 pricing, that was harder to get initially, just when you look at – again, it's not perfect math. You try to figure out the average price per truck in Europe by the units and the revenue. It doesn't appear that we don't have the mix exactly within it. The price of the average truck has gone up that much. So I was thinking initially, if you recapture the Euro 5 pricing more now than a couple years ago maybe that's part of the reason.

Ronald E. Armstrong - Chief Executive Officer & Director

It's not so much the pricing as it is the operating efficiency. The Euro 5 to Euro 6 transition was occurred in a short period of time and as you get past the launch period, you start achieving the operating efficiencies and performance in the field that goes with the enhanced products. And so I think that's just what we've seen over that couple of year period.

David Raso - Evercore ISI

So that's fair. Do you have a warranty number that maybe you can help us with? The warranty provisions, particularly in Europe, from this discussion, how much they've come down in the last couple years?

Ronald E. Armstrong - Chief Executive Officer & Director

I don't have that, but that certainly is something that's been an enhancement in our results, is the (32:52).

David Raso - Evercore ISI

I appreciate the conversation.

Ronald E. Armstrong - Chief Executive Officer & Director

Sure. Absolutely.

David Raso - Evercore ISI

Thank you. I appreciate it. Bye.

Operator

Your next question comes from the line of Mike Shlisky with Seaport Global.

Michael David Shlisky - Seaport Global Securities LLC

Good morning, guys.

Ronald E. Armstrong - Chief Executive Officer & Director

Good morning.

Michael David Shlisky - Seaport Global Securities LLC

Quick question on Financial Services. I saw that margins are down a few points in the first half from the prior year. Is what we saw in the first half similar to what we should expect in the back half of the year? Or if we look at prior years, the margins are actually a little bit higher in the second half versus the first half in other years. Could that happen again this year? Just your kind of outlook on financial margins for the back half would be helpful.

Ronald E. Armstrong - Chief Executive Officer & Director

Yeah. I think, the second half would be comparable to the first half. As I mentioned earlier, the first half of this year compared to last year was primarily the effect of lower used truck prices and the resell of used trucks that come off lease in our Financial Services operations.

Michael David Shlisky - Seaport Global Securities LLC

Okay. Great. I also wanted to turn secondly to Brazil. Obviously it's still small for you guys. You haven't really mentioned much. Is there any kind of outlook you could say since last quarter? Have things gotten worse in Brazil in your opinion or better? Do you feel like maybe 2017 could be a better year if it's past bottoming out here?

Ronald E. Armstrong - Chief Executive Officer & Director

I'd say, based on some recent visits to Brazil that, there is, I guess positive momentum in the country with the transition of leadership and the feedback that we get from our customers and our dealers, the product is being very well received. Dealers are enthusiastic about the long-term future as are we. And what we need is just a market. The market is going to be 35,000 trucks or so this year, that's down from a peak of 100,000 trucks.

We're continuing to increase our deliveries and our share, albeit at low levels, but the opportunity is definitely there. Our team has done a great job of positioning the brand, establishing the parts and service capabilities. So, I think there's going to be a nice upside, as we progress and I'm hopeful that 2017 is going to be a stronger year than 2016.

Michael David Shlisky - Seaport Global Securities LLC

Can I just ask that question also on the margin in Brazil? Could Brazil eventually be your best margin business or up there with the other businesses once it's kind of at a bit higher volume rates going forward?

Ronald E. Armstrong - Chief Executive Officer & Director

If you look at the history of Brazil in those peak markets, there were very strong margins in that market. And so, there is no reason that can't happen again, but that's ways away.

Michael David Shlisky - Seaport Global Securities LLC

Got it. Thanks so much, guys.

Ronald E. Armstrong - Chief Executive Officer & Director

Thank you.

Operator

Your next question comes from the line of Mike Baudendistel with Stifel.

Mike J. Baudendistel - Stifel, Nicolaus & Co., Inc.

Thank you. Just wanted to ask you what your long-term growth outlook is for the parts business? Historically, you've done a great job of growing that well ahead of the other markets, 5%, 6%, 7%, 8% a year. Just wondering what your expectation is in light of the investments you've made there? And in light of the fact that we could be in it for a period of lower Class 8 production than we've had the past few years?

Ronald E. Armstrong - Chief Executive Officer & Director

I think if you look at the history of our Parts business. In the last 10 years, it's grown in an average annual rate 6%, 7% per year and I don't see any reason that can't be comparable pace as we go forward. We continue to invest. We just, in June, had the grand opening of our new distribution center in Renton here in the State of Washington. We're looking at additional distribution center, expansions or new locations both in North America and Europe, and looking at some of the other countries supporting that distribution capability as well. The team continues to invest in their e-commerce capabilities, their support of dealer programs, making it as easy to do business with PACCAR Parts as possible, expansion of their TRP brands and PACCAR branding. So, there's no reason that the team can't continue to grow that business sort of beyond and get a bigger share of that aftermarket Parts market.

Mike J. Baudendistel - Stifel, Nicolaus & Co., Inc.

Great. Thank you.

Ronald E. Armstrong - Chief Executive Officer & Director

Thank you.

Operator

Your next question comes from the line of Neil Frohnapple with Longbow Research.

Neil A. Frohnapple - Longbow Research LLC

Hi. Good morning.

Ronald E. Armstrong - Chief Executive Officer & Director

Good morning.

Neil A. Frohnapple - Longbow Research LLC

I know you guys provided a view on Parts segment sales for the second half, sorry if I missed it. Did you provide a view on profitability for the second half as well? And would you expect pre-tax margins to be comparable to second quarter levels? Any thoughts there?

Ronald E. Armstrong - Chief Executive Officer & Director

Yeah. I think the pre-tax relationship to revenues would be consistent with what we've seen historically.

Neil A. Frohnapple - Longbow Research LLC

Okay. And then with regard to – can you comment on the MX engine penetration rate in the second quarter in North America? Just any thoughts on the mix of the MX on your current order board?

Ronald E. Armstrong - Chief Executive Officer & Director

Yeah. I think both the penetration and the order board mix are right at nearing 50%.

Neil A. Frohnapple - Longbow Research LLC

Great. Thanks very much.

Ronald E. Armstrong - Chief Executive Officer & Director

You bet.

Operator

Your next question comes from the line of Joe O'Dea with Vertical Research.

Joe J. O'Dea - Vertical Research Partners LLC

Hi.

Ronald E. Armstrong - Chief Executive Officer & Director

Good morning.

Joe J. O'Dea - Vertical Research Partners LLC

On Europe delivery trends, just seeing sequentially the delivery volumes step down a little bit, and then just with seasonality and some plant shutdowns expected to step down a little bit more in 3Q. And comparing that versus seeing the guidance step up, I guess it was in the fourth quarter of last year deliveries were very strong, and should we be anticipating a similar type of volume in the fourth quarter of this year? Just given the strength of Europe and no apparent impact of Brexit?

Ronald E. Armstrong - Chief Executive Officer & Director

So, a lot of that delivery volume is driven by the number of workdays. And fourth quarter for DAF typically has the highest number of workdays in their year. So, all of the things being equal, the fourth quarter is typically one of their stronger quarters.

Joe J. O'Dea - Vertical Research Partners LLC

Okay. And then just in terms of when you think you'll have greater confidence in terms of- we transition out of the summer lull in order activity in North America, will it take – when does inquiry activity really start to pick up for you? We won't see it in actual orders I guess until you get into October and seasonality picks up. But when do you start to feel more confident around the visibility you have into 2017? Just knowing that it was the third quarter of last year when you started to take build rates down toward the end of that. We didn't hear anything about that in the second quarter of last year. Just trying to think about when you'll have a firmer feel for exactly how demand is shaping up into 2017?

Ronald E. Armstrong - Chief Executive Officer & Director

Well, I mean, we obviously monitor orders daily. And so, we're very vigilant and we based our production on the level of order activity. And so, as we progress through the summer, get to the September-October timeframe is typically when sort of gauge the level of order activity for the rest of the year and how things might shape up for the beginning of 2017. So three months from now, we'll talk about what our initial expectations are for 2017, a little early at this point.

Joe J. O'Dea - Vertical Research Partners LLC

Okay. Thanks a lot.

Ronald E. Armstrong - Chief Executive Officer & Director

Thank you.

Operator

Your next question comes from the line of Robert Wertheimer with Barclays.

Robert Wertheimer - Barclays Capital, Inc.

Hi, good morning.

Ronald E. Armstrong - Chief Executive Officer & Director

Good morning.

Robert Wertheimer - Barclays Capital, Inc.

Two small ones from me. Just a clarification on the steel comment, which I think you said was firming up but not going to be really material near term. Does that reflect the full increase that you've seen in the markets? Or is that more like you don't expect it to affect 2016, and not going to comment on 2017?

Ronald E. Armstrong - Chief Executive Officer & Director

Yeah, I think, again we have long-term arrangements with our suppliers that sort of feed the cost movements into the product over time. And so, at this point, it's not a significant item and we continue, obviously, to work with our suppliers on other elements of cost reductions and incorporating new technologies and new materials into our products. And so, there is always some ongoing cost reduction efforts that we have that tend to offset some of the commodity cost movements.

Robert Wertheimer - Barclays Capital, Inc.

Perfect. Thank you. And then the second one, maybe I'm reading your press release too closely, but when you mentioned investing for future growth in PACCAR Integrated Powertrain components, is that a reference to the 11-liter and the (42:15) and the things that you talked about in the release or is that future, as yet unreleased powertrain changes?

Ronald E. Armstrong - Chief Executive Officer & Director

Well we continue to work very closely with our suppliers of transmissions, axles, after-treatment and get – be able to achieve the integration of their products and our products, to provide our customers with the most efficient powertrains in the industry. And so that's our focus, is to continue to have calibrations and capabilities that are customized and suited to our powertrain technologies.

Robert Wertheimer - Barclays Capital, Inc.

Perfect. Thank you.

Ronald E. Armstrong - Chief Executive Officer & Director

Thank you.

Operator

Your next question comes from the line of Scott Group with Wolfe Research.

Scott H. Group - Wolfe Research LLC

Hey, thanks. Good morning, guys.

Ronald E. Armstrong - Chief Executive Officer & Director

Good morning, Scott.

Scott H. Group - Wolfe Research LLC

So a couple of just quick ones. Just following up on the gross margin question, can you just comment directionally how gross margins are right now in Europe versus US – Canada?

Ronald E. Armstrong - Chief Executive Officer & Director

Directionally – I mean, I'd say...

Scott H. Group - Wolfe Research LLC

Meaning higher – where are we higher right now?

Ronald E. Armstrong - Chief Executive Officer & Director

Boy, I'd say it's fairly comparable if you look at the all-in external margin, it's pretty comparable.

Scott H. Group - Wolfe Research LLC

Okay. And then as we contemplate potential impacts at some point from Brexit, can you just share, within Europe, how much of the revenue is in the UK? And then if there's any difference of how much of the cost structure is UK and pound-denominated versus Euro-denominated.

Ronald E. Armstrong - Chief Executive Officer & Director

So, we have the benefit of having manufacturing operations in the UK, the only OEM to have that. So, we have a partial offset to our revenues that we earn out of the UK. So, the impact as we see it for 2016 is relatively insignificant. And assuming the currency stays at its current level, then the OEMs will make pricing adjustments to achieve a reasonable margin on their businesses in the UK over time. So, we don't see it as being a major factor in our margins over time.

Scott H. Group - Wolfe Research LLC

Okay. That's helpful. And just can you put some numbers just around the size of UK for you in broader Europe?

Ronald E. Armstrong - Chief Executive Officer & Director

So, it's about 25% of our revenues for DAF.

Scott H. Group - Wolfe Research LLC

Okay. Perfect. Thank you, guys.

Ronald E. Armstrong - Chief Executive Officer & Director

Sure.

Operator

Your next question comes from the line of Jeff Kauffman with Buckingham Research.

Jeffrey A. Kauffman - The Buckingham Research Group, Inc.

Thank you very much. Congratulations.

Ronald E. Armstrong - Chief Executive Officer & Director

Thank you.

Jeffrey A. Kauffman - The Buckingham Research Group, Inc.

I just want to – a lot of my questions have been asked but I just want to dig in a little bit deeper on the question David Raso was asking on costs versus maybe benefits from sourcing parts in different locations? So two questions. Number one, if I look at your revenue per unit, it was down about 5%. I want to disaggregate what's a mix issue versus a currency issue versus what actual pricing's doing. And then the same thing with costs. If I take a look at maybe how currency is affecting cost per unit, raw materials affecting cost per unit, versus what's volume related? How do I think about those buckets?

Ronald E. Armstrong - Chief Executive Officer & Director

So, again, I don't know what you're comparing. If you're comparing back to 2014 to now, clearly currency has had a sizable impact on the revenue side, but also on the cost side. And the cost side has gone down over that period of time because of the excellent factory efficiencies that we've gained with our new products, the performance of those products in the field, the material cost savings, the benefits of commodities, and just ongoing, working with our suppliers to incorporate new materials, new technology into the products to achieve better operating efficiency and cost levels. So the MX engine penetration is beneficial to that as well. So all those things are the elements that are driving that enhancement over that period of time.

Jeffrey A. Kauffman - The Buckingham Research Group, Inc.

All right. Maybe I'll ask it differently. If I look at just the change versus a year ago, in the cost of goods sold, how much of that should I attribute to lower raw material costs? How much of that should I attribute to currency?

Ronald E. Armstrong - Chief Executive Officer & Director

To a year ago...

Jeffrey A. Kauffman - The Buckingham Research Group, Inc.

Yeah.

Ronald E. Armstrong - Chief Executive Officer & Director

I'd say, very little on currency.

Jeffrey A. Kauffman - The Buckingham Research Group, Inc.

And raw material costs?

Ronald E. Armstrong - Chief Executive Officer & Director

Yeah. I think that would be most of the other difference.

Jeffrey A. Kauffman - The Buckingham Research Group, Inc.

Okay. And just the last follow-up on the revenue side. If I look at the difference in the revenue per unit, how much of the decline is a mix issue versus a currency issue? And I think you mentioned that your units were retaining their used values well for Peterbilt and Kenworth? But what's happening with retail pricing?

Ronald E. Armstrong - Chief Executive Officer & Director

I think, that's a lot of that is mix, because the European units have a slightly lower average sales price in the North American units.

Jeffrey A. Kauffman - The Buckingham Research Group, Inc.

Okay, beautiful. Thank you very much.

Ronald E. Armstrong - Chief Executive Officer & Director

Thank you.

Operator

Your next question comes from the line of Kwame Webb with Morningstar.

Kwame Webb - Morningstar, Inc. (Research)

Good morning, everyone.

Ronald E. Armstrong - Chief Executive Officer & Director

Good morning.

Kwame Webb - Morningstar, Inc. (Research)

I just had one question and it was following up on the investments that you guys were making. I think there was a comment about connectivity? I understand, I can't remember if it was this year or last year but PeopleNet was going to be the standard telematics solutions provider? Just sort of curious to know why you chose to go with them exclusively on the MX engine? Also, should I read that commentary about investments to mean something more substantial beyond that partnership?

Ronald E. Armstrong - Chief Executive Officer & Director

I mean yeah. Truck connectivity is just something that everybody has to have in today's market. And we're into Phase 1 of a probably 20 phase era of enhancing that on an ongoing basis. And we evaluate our suppliers and capabilities of who can provide that. And so, we'll continue to work with our partners and provide the best solution that we think is available in the marketplace for them to get the best result operating the truck.

Kwame Webb - Morningstar, Inc. (Research)

And so I guess, the point is for right now it's going to be largely through partnerships to pursue that versus home-growing anything?

Ronald E. Armstrong - Chief Executive Officer & Director

Yeah. I think that's – we have suppliers that – I guess I would add the connectivity pieces, call it common technology. What's most important is, what we do with the data and how we interpret that data in a way that makes our trucks perform better in the marketplace, helps our dealer, support customers and that's all home-grown, so the connectivity piece is pretty common technology.

Kwame Webb - Morningstar, Inc. (Research)

Great. All right. Thanks so much.

Ronald E. Armstrong - Chief Executive Officer & Director

Thank you.

Operator

Your next question comes from the line of Alex Potter with Piper Jaffray.

Alexander Eugene Potter - Piper Jaffray & Co. (Broker)

Hi, guys. Thank you. Most of the questions have been answered for me. I just had one on Parts guidance. I think last quarter – somebody touched on this partially in an earlier question – but last quarter you had said you expected Parts to be up 3% for the full year, first couple quarters of the year we've been tracking behind that. I was wondering what it was that has changed in that segment versus last quarter to account for the implicit guide-down in revenue for that particular segment? Thank you.

Ronald E. Armstrong - Chief Executive Officer & Director

Yes. This is reflective of what the retail activity is at our dealer locations and our team continues to have great products and services for our dealers to help them to gain share, but I think the overall market is little softer than what we had anticipated previously.

Alexander Eugene Potter - Piper Jaffray & Co. (Broker)

Okay. So that's just mileage, tonnage, actual freight hauling activity or parts consumption by the truck park out there is just lower than what you thought?

Ronald E. Armstrong - Chief Executive Officer & Director

Absolutely.

Alexander Eugene Potter - Piper Jaffray & Co. (Broker)

Okay. Very good. Thank you.

Ronald E. Armstrong - Chief Executive Officer & Director

Thank you.

Operator

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

Ken Hastings - Director of Investor Relations

We'd 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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