Cummins (CMI) N. Thomas Linebarger on Q2 2016 Results - Earnings Call Transcript

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Cummins, Inc. (NYSE:CMI)

Q2 2016 Earnings Call

August 02, 2016 10:00 am ET

Executives

Mark Andrew Smith - Vice President, Operations Finance

N. Thomas Linebarger - Chairman & Chief Executive Officer

Patrick Joseph Ward - Chief Financial Officer

Rich Freeland - President & Chief Operating Officer

Analysts

Jerry Revich - Goldman Sachs & Co.

Robert Wertheimer - Barclays Capital, Inc.

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

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

Joe J. O'Dea - Vertical Research Partners LLC

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

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

David Raso - Evercore ISI

Operator

Good day, ladies and gentlemen, and welcome to the Second Quarter 2016 Cummins Incorporated Earnings Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will follow at that time. As a reminder, this conference call is being recorded.

I would now like to introduce your host for today's conference, Mr. Mark Smith, Vice President of Financial Operations. Sir, you may begin.

Mark Andrew Smith - Vice President, Operations Finance

Thank you. Good morning, everyone, and welcome to our teleconference today to discuss Cummins's results for the second quarter of 2016. Participating with me today are our Chairman and Chief Executive Officer, Tom Linebarger; our Chief Financial Officer, Pat Ward; and President and Chief Operating Officer, Rich Freeland. We will all be available for your questions at the end of our prepared remarks.

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

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

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

Now, I'll turn it over to Tom.

N. Thomas Linebarger - Chairman & Chief Executive Officer

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

Revenues for the second quarter were $4.5 billion, a decrease of 10% compared to the second quarter of 2015. Second quarter EBIT was $591 million, or 13.1% of sales compared to $721 million or 14.4% in the same quarter last year.

We made strong progress in our cost reduction initiatives in the second quarter as benefits from restructuring actions, material cost reduction initiatives and improvements in product quality helped to mitigate the impact of weak demand in a number of important markets.

Our decremental EBIT margin was 27% for the second quarter and 23% for the first half of 2016 compared to our full year guidance of 25%.

Engine business revenues decreased by 14% year over year, primarily due to lower demand in heavy and medium duty truck markets in North America. EBIT of 10.3% of sales declined from 12% a year ago, as strong operational performance and benefits from restructuring, material cost reduction initiatives and a 90 basis point improvement in warranty costs were offset by the impact of lower volume.

Second quarter results include a $39 million increase in our provision for a product campaign that we initially recorded in the fourth quarter of 2015. As we previously discussed, this provision is for a quality issue related to a third party after-treatment system that's impacting the performance of some of our engines in vehicles produced by one of our OEM customers.

The increase in our provision reflects a more conservative approach to protecting vehicle owners with a higher proportion of vehicles now planned to have full replacement of after-treatment system hardware than we had originally anticipated, resulting in a higher estimated cost for the campaign. Discussions over how the cost of this campaign should be shared with our OEM customer are ongoing.

Revenues in our Components segment decreased 8% from a year ago with lower demand in North America more than offsetting growth in China. Sales in China increased by 17% due to a stronger demand in the truck market. EBIT of $190 million or 14.9% of sales declined from $223 million or 16% as the impact of lower volumes offset the benefit of material and other cost reductions. Earlier today we announced the closure a filtration manufacturing facility in Turkey as we continue to implement plans to improve our cost structure.

Distribution revenues increased 3% compared to the second quarter of 2015. The positive impact of acquisitions made in the second half of 2015 more than offset the negative impact of currency and weaker sales to off-highway markets. EBIT for the quarter of 5.6% declined from 7.6% a year ago, due mainly to the negative impact of currency and weaker organic sales. Last quarter we announced our plans acquire the last remaining distributor joint venture in North America and we currently expect to complete the acquisition in the fourth quarter of this year.

Revenues for the Power Systems business declined by 16% year over year, with lower sales in most regions due to weaker demand in power generation, commercial marine and oil and gas markets. EBIT declined from 11.6% to 9.8% a year ago as the impact of lower sales more than offset an 18% reduction in operating expenses. EBIT did improve from 5.7% in the first quarter, due to good operating leverage on incremental sales and strong cost control. We continue to make progress with our plans to close three Power Systems manufacturing operations in India, Mexico and the UK. Our actions in India and Mexico will be completed in the second half of 2016.

In the UK we are on track to commence assembly of high horsepower generator sets at our Daventry Engine Plant in the fourth quarter of this year, a key milestone in the first phase of our closure plan for our assembly operations in Kent. There will be both expenses and savings in the second half of 2016 associated with these actions that will improve our cost structure when complete.

Now, I will comment on some of our key markets starting with North America. Our revenues in North America declined by 13% in the second quarter, due to weaker demand in on-highway markets especially heavy duty truck. We shipped 16,000 engines to the North American heavy duty truck market in the second quarter, a decrease of 43% from a year ago.

We have lowered our projection for full year industry production to 200,000 units at the midpoint of our guidance, down from our prior forecast of 210,000 units, as weak industry orders and high dealer inventories are likely to cause OEMs to lower their build rates in the second half of the year. Our market share through the end of June was 28.9%, and we expect our full year market share to be in the range of 27% to 30% for the year, unchanged from our projection three months ago.

In the medium duty truck market we delivered almost 21,000 engines in the second quarter, down 20% from last year as our customers produced at a lower rate compared to the overall industry. Our market share through the end of May was almost 75%, slightly ahead of our full year forecast of 74%, which is unchanged from last quarter. We have lowered our forecast for full year industry production to 117,000 units, down 6% compared to both 2015 and our prior guidance for 2016, as the growth in new orders has leveled off in recent months and OEMs are trimming build rates.

Our engine shipments to North American pickup truck customers increased by 18% in the second quarter. Shipments to Chrysler increased 4% to more than 33,000 units. Sales also increased to Nissan, following the launch of our five liter V8 engine in the fourth quarter last year. We currently expect our revenues in the pickup segment to increase by 12% in 2016, again unchanged from our prior forecast.

Our Engine revenues from the North American construction market decreased by 30%, compared to the second quarter last year. While housing and commercial construction activity remains positive, demand from rental companies for new equipment has declined due to weakness in the oil and gas market. Power Systems revenues declined 9% in North America in the second quarter due primarily to lower engine orders from oil and gas customers, which more than offset 4% growth in Power Generation.

Our international revenues declined by 4% year-over-year, with weaker sales in Latin America and the Middle East. Second quarter revenues in China, including joint ventures, were $940 million, an increase of 3%, with growth in on-highway revenues partially offset by the depreciation of the renminbi against the U.S. dollar and weaker demand for power generation equipment and industrial engines.

Industry demand for heavy and medium duty trucks in China increased by 21% in the second quarter. Our market share in the second quarter was just under 15%, level with last year. Although demand from Foton for our heavy duty ISG engine increased year-over-year, growth in shipments to our other primary partner, Dongfeng did not keep pace with the market.

One truck OEM in particular is being very aggressive on pricing this year and has increased its share at the expense of several OEMs including Dongfeng. We now forecast full year industry sales to grow by 9% for the year, up from our prior forecast of a decline of 4%, as industry sales were well ahead of our expectations in the first half of the year. Visibility to demand in the second half is limited and we remain cautious until we see broader improvement in macroeconomic indicators.

Shipments of our light duty engines in China grew 14% in the second quarter, compared to a 6% decline for the overall market as we increased penetration at Photon, displacing local competitor engines. Our share of the overall market was almost 7%, up more than 100 basis points year-over-year. We currently project industry sales to decline by 4% for the year, unchanged from three months ago.

Industry sales of excavators in China decreased by 11% in the second quarter, as sales moderated from inflated first quarter levels following the transition to Tier 3 emission standards that came into force in April. The overall numbers of excavators sold remains very low with no obvious catalyst for significant growth in this near term.

Revenues for our Power Systems business in China declined by 25% in the second quarter reflecting weak demand in mining, marine and power generation markets. Full year revenues in China across all segments, including joint ventures, are expected to grow 3% for the year, up from our prior forecast of flat, due to stronger demand in the heavy and medium duty truck market.

Second quarter revenues in India, including joint ventures, were $423 million, up 9% year-over-year, primarily due to strong demand in the truck market, which more than offset the impact of a weaker rupee. Industry demand in the truck market increased 22% as the economy continued to improve. Our market share in the second quarter was 44%, up from 42% a year ago, and our penetration with Tata increased to 78% from 73% a year ago. We now expect industry truck production to increase 15% for the full year, up from our prior forecast of 10% growth.

Power Systems revenues in India declined by 6% in the second quarter with a weak rupee offsetting volume growth. We currently project full year revenues across all segments and including joint ventures to increase 5% in India, up from our prior forecast of up 1%, due to a stronger truck demand.

Second quarter revenues in Brazil were $80 million, down 27% from the second quarter last year, as the economy remains in recession and the real depreciated 14% against the U.S. dollar. Industry truck production fell 12% year-over-year, while our engine shipments declined 30%. Industry production for heavy commercial vehicles greater than 15 tons increased in the quarter while medium and light vehicles, in which we have a higher market share, declined significantly. We project full year industry truck production to decline by 20%, unchanged from three months ago. Revenues for our Power Systems business in Brazil declined by 45%, due to the continuing economic challenges in the region.

Our sales in the Middle East also declined by more than 30% in the second quarter, primarily impacting our Power Systems business and reflecting a slowdown in infrastructure investments in the region.

Clearly, we are facing challenging market conditions; however, in the face of a 43% decline in shipments to North American heavy duty truck market and very weak conditions in most of our end markets, strong operational performance and execution of our cost reduction initiatives enable us to deliver EBIT above 13% of sales in the second quarter.

Looking forward, we now expect company revenues to decrease between 8% and 10% for the year, lower than our prior guidance of 5% to 9% due to a lower outlook for truck production in North America and weaker demand in power generation and off-highway markets. Revenues in the third and the fourth quarters of this year are projected to be lower than second quarter levels and we continue to identify opportunities to further improve our productivity and lower our cost structure. We expect EBIT to be in the range of 11.6% to 12.2% for the year, unchanged from our prior forecast, reflecting full year decremental EBIT margin of 25%.

In the first half of this year, we returned more than $1 billion to shareholders in the form of dividends and share repurchases, and our Board of Directors recently increased quarterly dividend by more than 5%, all consistent with our plans to return 75% of operating cash to shareholders.

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

Patrick Joseph Ward - Chief Financial Officer

Thank you, Tom and good morning, everyone. I would like to make clear to everyone that the results I'm about to share reflect the recently reorganized business segments. A copy of the restated segment financial results for prior periods referred to in my comments can be found in our 8-K filed with the SEC and on our website.

For the second quarter, revenues were $4.5 billion, a decrease of 10% from a year ago. Sales in North America, which represented 58% of our second quarter revenues declined 13% from last year, due primarily to lower demand in North American on-highway truck markets and continued weakness in industrial markets.

International sales declined by 4% from a year ago due to weak demand for industrial engines and power generation equipment. While revenues grew in India and in China, this was more than offset by weaker demand in Latin America and in the Middle East.

Gross margins were 26.4% of sales, a decline of 20 basis points from last year. The negative impact of lower volumes and unfavorable product mix were offset by material cost savings, benefits from restructuring actions and lower warranty expense.

Selling, admin and research and development expenses of $679 million or 15% of sales, decreased by $24 million from a year ago but increased as a percent of sales by 100 basis points as sales declined. Joint venture income of $88 million decreased by $6 million compared to last year, primarily due to the acquisition of North American distributors, previously held as unconsolidated joint ventures.

Other income and expenses, including interest income, netted to an expense of $50 million in the quarter, including the increase in the provision for a quality issue relating to a third party after-treatment system that Tom referred to early.

Earnings before interest and tax were $591 million or 13.1% of sales for the quarter, which equates to a 27% decremental margin when compared to our record $721 million or 14.4% of sales that we reported last year.

For the first six months of the year, decremental EBIT margins are 23%, slightly better than our target of 25%. Net earnings for the quarter were $406 million or $2.40 per diluted share, compared with $2.62 from a year ago. The effective tax rate for the quarter was 25.7%, lower than a year ago, due to the change in the geographic mix of earnings.

I will now highlight the performance of the individual operating segments during the second quarter. In the Engine segment, revenues were $3 billion, a decrease of 14% from last year. On-highway revenues declined by 15%, due to a reduction in heavy and medium duty truck industry production in North America, partially offset by stronger sales to bus and pickup truck customers. Off-highway revenues declined by 9%, primarily due to a decline in the construction and the marine markets.

Segment EBIT was $206 million or 10.3% of sales compared to 12% last year. Material cost savings, lower warranty expense and the benefits from previous restructuring actions offset the negative impact of lower volumes and an unfavorable product mix. Included in the results for the second quarter in the Engine segment was a $39 million charge to increase our estimate for the loss contingency recorded in the fourth quarter of 2015. Excluding this additional provision, segment EBIT would have improved over last year despite the 14% drop in sales.

For the full year 2016, we expect Engine segment revenues to decline by 9% to 12%, primarily due to weaker truck demand in the truck markets in North America. 2016 EBIT margins are expected to be in the range of 10% to 11%, compared to 9.9% for the full year 2015, excluding restructuring and impairment charges. The expected year-over-year improvement in EBIT percent is primarily due to lower warranty cost, benefits from the restructuring actions and material cost reduction initiatives.

For the Distribution segment, second quarter revenues were $1.5 billion, which increased 3% compared to last year. Prior year acquisitions contributed 8% to the sales growth, partially offset by a 3% decline in organic sales, and a 2% negative impact from currency. Engine and service revenues declined in the quarter as demand for new engines and rebuilds remains weak in off-highway markets, especially in oil and gas and marine markets.

EBIT margins for the quarter decreased from 7.6% to 5.6%, due primarily to the unfavorable impact of currency and lower organic sales.

On our prior earnings call we shared our plans to acquire the last remaining unconsolidated North American distributor. We currently expect to complete the acquisition in the fourth quarter of 2016.

We are updating our full year revenue guidance now to be between down 1% and up 1%, incorporating the new acquisitions and reflecting continued weakness in off-highway markets, especially in North America and weaker power generation sales in the Middle East. We expect full year EBIT margins to be in the range of 5.5% to 6.5% of sales.

The Components segment recorded revenues of $1.3 billion, which declined 8% from a year ago. A 17% increase in revenue from China along with increased revenue from Europe, helped to partially offset a 17% sales decline in North America.

Segment EBIT was $190 million or 14.9% of sales, compared to 16% of sales a year ago. Strong operating performance, material cost reductions and the benefits from restructuring actions helped to partially offset the impact from weaker sales in North America, lower pricing and the negative impact of currency. We currently expect full year revenue in 2016 to decline by 6% to 9%. EBIT guidance for the full year is unchanged from before, and is expected to be in the range of 12.75% to 13.75% of sales.

In the Power Systems segment, second quarter revenues were $921 million, down 16% from last year. Sales declined 20% in international markets, primarily due to lower demand for power generation equipment in Asia, in the Middle East and in Latin America. Sales in North America declined 9% compared to the same quarter last year, primarily due to lower oil and gas demand. EBIT margins were 9.8% of sales in the quarter, down from 11.6% last year, primarily due to the much lower demand across most of our markets.

We currently expect full year revenues for the Power Systems segment to decline between 12% and 14%, with EBIT in the range of 7% to 8% of sales. Forecasted year-over-year volume declines, the negative impacts from a competitive pricing environment in international markets and additional expenses related to new cost reduction actions in 2016 will more than offset the benefits of restructuring and material cost reductions.

We're now projecting total company revenues to be down between 8% and 10% in 2016, which is lower than our prior guidance of down 5% to 9%, due to a weaker outlook in North America and a softer demand in Power Generation markets. Declining production in the North American truck markets and weak demand globally for off-highway and power generation equipment will drive the majority of the reduction in revenue for the full year.

We expect EBIT margins of between 11.6% to 12.2% of sales, unchanged from our prior guidance. Cost reduction initiatives across the company will mitigate the impact of weaker revenues. Joint venture income is still expected to be flat compared to 2015, and we now expect our effective tax rate to be 27% for the year.

Turning to cash flow, cash generated from operating activities was $471 million in the second quarter, better than the same quarter last year by $75 million, primarily due to lower working capital. For the first six months of the year, cash from operations is $734 million, compared to $569 million at the same point last year. We anticipate operating cash flow performance in 2016 will be within our long-term guidance range of 10% to 15% of sales.

Capital expenditures were $189 million for first six months of the year, and they are expected to be in the range of $600 million to $650 million for the full year. And year-to-date, we've returned more than $1 billion to shareholders which includes the repurchase 6.7 million shares, and as Tom said recently, our Board of Directors authorized an increase in our quarterly dividend of 5% to $1.025 share, consistent with our plans to return 75% of full year operating cash flow to shareholders in this year.

Now let me turn it back over to Mark.

Mark Andrew Smith - Vice President, Operations Finance

Okay, thank you, Pat, and now we are ready to move to the Q&A part of the call. If you could limit your questions to an initial question, one follow-up, and then get back in queue, please. Thank you.

Question-and-Answer Session

Operator

Our first question comes from the line of Jerry Revich with Goldman Sachs. Your line is now open.

Jerry Revich - Goldman Sachs & Co.

Hi. Good morning, everyone.

N. Thomas Linebarger - Chairman & Chief Executive Officer

Good morning, Jerry.

Patrick Joseph Ward - Chief Financial Officer

Good morning, Jerry.

Jerry Revich - Goldman Sachs & Co.

Can you talk about India, your IV regulations. You stand to have a pretty good market share just based on your own engines, for the SCR systems, do you have other opportunities to sell the SCRs systems to other market participants? Do you have any contracts locked in, can you just flesh out the opportunity for us?

Rich Freeland - President & Chief Operating Officer

Hey, Jerry, this is Rich. The first most visible opportunity as the emissions come in will be in the components area on fuel systems. So we will introduce our own fuel system as we move to the BS IV standard in April next year. That's a new opportunity for us. So most of the growth we'll see will be on the component side with our own engines to start with. Again, our goal is – we feel pretty confident as we have seen in other markets that one, we'll add more content with components but also grow share as the standards get tougher as we start with a good platform there.

N. Thomas Linebarger - Chairman & Chief Executive Officer

And we do, Jerry, have opportunities to sell our emissions control systems to other participants. As you know, the market – Tata has a very strong market share. So compared to other markets we participate in that incremental opportunity is less because it's just fewer participants with significant share.

Jerry Revich - Goldman Sachs & Co.

Okay. And then secondly, in Power Systems, so big changes to the manufacturing footprint this year, cycle time reductions and out of the UK consolidation. What sort of cost reduction run rate should we be thinking about exiting 2016 compared to where we are at this quarter once all the costs that you alluded to, Tom, with the transition are done with?

N. Thomas Linebarger - Chairman & Chief Executive Officer

Yeah, we're still figuring that out ourselves, Jerry, from a fourth quarter point of view. As I mentioned, as we've worked through the plans, we are now confident that we're going to have the high horsepower assembly for gensets out which was the biggest portion of the work. But we still have some other smaller lines in there to move, plus we've got to figure out all the actions we need to take with regard to supply chain logistics. So we just haven't zeroed in on the number about where we are going to be at the end of the year. Maybe as we get closer, we do the third quarter earnings we'll be able to give you a better view of that.

Jerry Revich - Goldman Sachs & Co.

Okay. Thank you.

Rich Freeland - President & Chief Operating Officer

I think in general, Jerry, through the end of the year, the benefits and the costs will be pretty close through this year and most of the benefits will then begin to go net positive in next year.

Jerry Revich - Goldman Sachs & Co.

Thank you.

Operator

Thank you. Our next question comes from the line of Robert Wertheimer with Barclays. Your line is now open.

Robert Wertheimer - Barclays Capital, Inc.

Thank you and good morning. Two questions, I will just ask them both at once. Does the shift in capacity at Power Systems say anything about your long-term view on those markets? We had thought some of them would be stronger years ago. Just curious if you've moderated the long-term outlook or structurally reduced capacity? And second, can you talk a little bit about what drove the resegmenting? Thank you.

N. Thomas Linebarger - Chairman & Chief Executive Officer

Yes, maybe I will start with the long-term view, Rob. As we discussed, before, our view of power generation business continues to be bullish long term, but what we've noticed is three things. First, that we have reset our overall view about growth in emerging markets to – moderated those over prior views. I think that's not a surprise. Everyone has probably done that. And then secondly, the time it's going to take to recover, looks like it's going to be longer and that's, year-by-year, we've been pushing that out, unfortunately which is one of the reasons we are in a bit of a catch-up mode in power generation but we basically said we need to act now, because the recovery of the markets doesn't seem imminent.

And I think the third thing that we talked about before is that one of the things that our company feels strongly about is when we have downturns, we want to use those as opportunities to improve the efficiency and productivity of our operations. So we think by combining our generator set assembly, for example, with our high horsepower engines, that we will be able to restore the same capacity, if not more, but reduce costs and reduce inefficiencies related to the supply chain. So we're going to put the entire capacity of that assembly line in the Daventry plant. We're going to save shipping. We're going to save test time. We're going to save logistics coming into the plant. So there's a whole bunch of opportunities and we just couldn't make those changes when the market was strong. You can't reduce capacity for long enough to actually consolidate plants. So, again, this is not the only one like that, but many of the operations changes that we're taking now are opportunities that we can take advantage of because markets are slower, so we can manage the inventory and things and the demand much better. And then our hope is as markets improve, we're then able to supply even greater capacity but at much lower cost and at better efficiency. That's what we are aiming for through this effort.

Patrick Joseph Ward - Chief Financial Officer

And I would just add that demand for the new 95-liter engine is actually ahead of plan this year. It's a bright spot in very tough markets.

Robert Wertheimer - Barclays Capital, Inc.

That's perfect. Could you remind me, Mark, what is that – is that on sale in – how many end markets is that on sale in?

Mark Andrew Smith - Vice President, Operations Finance

Three right now. So power generation is the largest, rail and marine.

N. Thomas Linebarger - Chairman & Chief Executive Officer

Yeah, I think the segmenting – you asked about the combining of segments, that really reflects the fact that as I was talking there about the opportunities for efficiency between the high horsepower engine division, and the generator set division, where 50% or more of the engines are consumed. So the same kind of idea I talked with the Daventry plant, we are trying to get that same opportunity, engineering processes and new product processes as well as manufacturing and supply chain. So our idea was now that business is lower, we have the opportunity to make some of those changes and combinations that maybe would have been harder to make and we also, in the meantime, can reduce overhead between those two divisions at a time when that's sorely needed given where the markets are today.

Robert Wertheimer - Barclays Capital, Inc.

Makes sense. Thank you.

N. Thomas Linebarger - Chairman & Chief Executive Officer

Thank you.

Operator

Thank you. Our next question comes from the line of David Raso with Evercore ISI. Your line is now open.

Mark Andrew Smith - Vice President, Operations Finance

Hello, David?

Operator

Pardon me. Our next question comes from the line of Alex Potter with Piper Jaffray. Your line is open.

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

Hi, guys.

N. Thomas Linebarger - Chairman & Chief Executive Officer

Hi, Alex.

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

I was wondering, you bumped up that loss contingency again this quarter. The supplier issue that you have alluded to again here over the last couple of quarters. Just wondering how, if it's possible to sort of frame up how big the problem potentially could be or if this is sort of the last time that you see this resurfacing and impacting quarterly results?

Rich Freeland - President & Chief Operating Officer

Okay. Hey, Alex, this is Rich. Let me try to do that. So it's a unique situation that we have here, where we have our engine with a different after-treatment system. In fact, we don't do that anywhere else except for in this one market. So that's the uniqueness of it. We took the charge in Q4 as you recall, and estimated at that time, and we kind of voluntarily went to the market, both for the customers to get ahead of this, and we thought we could fix it with more of a software fix. Now we've concluded that a hardware fix will be more effective and the right way to go, and so that's what we've protected for. So this is kind of the high end of what we would expect to see here. You also note that Tom commented we have not concluded our discussions with the partner, given this is a complicated system, we're selling of which we're one piece of it. So there will be some cost sharing done in this. Those discussions are still ongoing.

N. Thomas Linebarger - Chairman & Chief Executive Officer

To your point, we always try to give you an estimate that represents what we think the exposure is in in full. So we definitely do not want to have situations where we have to come back and increase or change the exposure. So we're trying to be accurate and conservative. And as Rich said in this case, the technical fix needed to change. And by the way, we have complete agreement with our customer about what the right activities are to protect the end customer. So that's good, we are working on that. We've agreed that we know the hardware replacement is the right thing to do, that's – we're on with that. And so we feel comfortable that the actions we're taking are the right ones and that we've provided for them correctly. There's no way I can say there's no chance we'll ever increase, but we are trying to give you an estimate that says this is the full exposure, and as Rich said, our hope is, based on negotiations with the customer, we'll be able to reduce it

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

Sure. Okay, fair enough. The second one is on the profitability of the Engine joint venture. So if I'm looking at things correctly here, I know there's been some resegmenting and I don't know how that maybe impact how the segment disclosure comes out. But the number that we're looking at, it looks like the margins of those joint ventures have been doing pretty well recently and I'm wondering if that's just a function of increased volume or any other factors that you would call out and then whether these relatively high margins can be sustained? Is there any reason that they would move up or down or sideways from here? Thanks.

Patrick Joseph Ward - Chief Financial Officer

I think the joint venture earnings didn't grow, Alex. I think you look in the Engine business, they just represented a higher proportion of sales because the sales have dropped. So, in fact, earnings are pretty level in most parts of the world. There's currencies impacting the underlying improvement of earnings in China, for example. So there isn't a significant change in the underlying profitability of the businesses going forward

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

Okay. Understood. Thanks, guys.

N. Thomas Linebarger - Chairman & Chief Executive Officer

Thanks, Alex.

Operator

Thank you. Our next question comes from the line of Jamie Cook with Credit Suisse. Your line is now open.

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

Hi, good morning.

N. Thomas Linebarger - Chairman & Chief Executive Officer

Hi, Jamie. Good morning.

Patrick Joseph Ward - Chief Financial Officer

Good morning.

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

I guess my question, Tom or Pat, you guys can handle this. As I look at Cummins earnings in 2017 given the severity of the downturn in most all markets you participate in, your earnings power has been much higher than previous cycles. At the same time, I look to 2017 and I look at where our decrementals are holding, and I guess what I'm concerned about is as we look to 2017 and assuming we don't get a market recovery, is that you've pulled all the levers that you could to hold profitability and 2017 is going to be much tougher. So while I know you don't want to talk about guidance or end market, can you talk about the things in 2017 that you can control to hold the profitability, whether it's incremental restructuring benefits we'll get in 2017, whether it's the North American distributor acquisition, or just your view share on repurchase? Thank you.

Patrick Joseph Ward - Chief Financial Officer

Yeah, hi, Jamie. Thanks for that. So I'll start off and then Tom or Rich can jump in behind me. I think you know us well enough that we're always looking out for ways to improve our cost structure, and we've made some good progress this year, I think, being able to offset a significant volume decline by driving material cost savings of around, I think we're looking at 1.4%, 1.5% for the full year, and we're taking warranty down. And warranty I believe for the first half of this year as a percent of sales might be the lowest in the last decade. So we are making some good progress there.

So, that's going to continue, I think, regardless of what's happening with the markets next year. Clearly we would like to see some recovery, and those markets have been weaker for a while now. But if they don't recover, we'll continue to pursue cost improvement in those areas in particular, material cost and warranty, even though it's still just over 2% of sales, you can do the math and figure out that's $350 million to us. So there's still a lot of money for us to go after there.

N. Thomas Linebarger - Chairman & Chief Executive Officer

Yeah, I would also say, Jamie, that we've got some, there's headwinds of sales, as you mentioned, but there's also some tailwinds. As we've talked about, we've got synergies that we're driving into our Distribution business that have mostly been negative to date as we've absorbed these and now we're heading in with opportunities for positive synergies. We've got some of our restructuring activities that we talked about with the large engines where we've moved from where mostly we're taking the cost actions now and the benefits will come later. Thirdly, we've got the opportunity for the 95, where when we launch engines are more expensive and as we build volume, they'll get better. So there's tailwinds as well as headwinds. And I would just reemphasize what Pat said, is that every single quarter, every single year, we are looking for new opportunities to drive cost reduction and improvement. And again, we haven't run out of ideas yet, and hopefully as long as this management team is here, we will not run out of ideas or probably it's time for a new management team. Because that's what we think our job is.

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

The one thing you didn't address was, because obviously this is the other topical thing, is you bought a lot of stock back this year, more so in the first quarter versus the second quarter, but the other side of it was your appetite to do M&A. So are we closer on the M&A front? Or if we're in this type of environment, and the M&A doesn't present itself, should we assume that you'll be as aggressive on share repurchase as we look at 2017 versus 2016 to offset potentially some top line dilution?

N. Thomas Linebarger - Chairman & Chief Executive Officer

Yeah, as we talked about in the investor meeting and I'll just repeat here, a couple harder things is it's hard to talk about anything until there's something, and it's hard to say if you are closer until you have a thing to talk about. That said, the work continues and I feel very positive about the work we are doing and feel like there's opportunities for us. And also, we said we are going to be very tight on our view about capital returns, and so if the things don't present themselves in the way that we think we can earn superior returns to shareholders, we will not pursue unattractive acquisitions and we'll just continue to increase returns to shareholders through dividends and share repurchases.

So, how those work quarter to quarter and year to year depend on what we see in front of us, but right now our view is if we cannot find attractive acquisitions, yes, we'd continue to have high levels of share repurchases, but we feel optimistic that there's opportunities out there for us.

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

Okay. Thanks. I'll get back.

N. Thomas Linebarger - Chairman & Chief Executive Officer

And we'll just continue to update you guys on where we sit on them.

Mark Andrew Smith - Vice President, Operations Finance

Yeah.

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

Okay, thank you. I'll get back in queue.

N. Thomas Linebarger - Chairman & Chief Executive Officer

Okay.

Operator

Thank you. Our next question comes from the line of Joe O'Dea with Vertical Research Partners. Your line is now open.

Joe J. O'Dea - Vertical Research Partners LLC

Hi, good morning.

N. Thomas Linebarger - Chairman & Chief Executive Officer

Hi, Joe.

Patrick Joseph Ward - Chief Financial Officer

Hi, Joe.

Joe J. O'Dea - Vertical Research Partners LLC

You talked about the first half of the year decremental. I think if you exclude the contingency charge that was about 19% and looking at what's implied for the back half of the year, it looks like that steps up to more like your long-term target around 25%, 26%. Could you just talk about some of the drivers of that shift from first half to second half, the volume impact, any mix considerations or other items you're looking at for the steeper decremental in the back half?

Patrick Joseph Ward - Chief Financial Officer

I'll start this one again, Joe. I think as we're looking into the second half of the year, we obviously see continued pressure on the top line. If you look at the implied sales for the second half of the year, they are going to be lower than the first half of the year. And they are going to be lower than some of those areas where we do have pretty good margins today.

In addition to that, we are going to see, continue to see material cost savings, but not at the rate that we have been booking through the first half of year. They will come down in the second half of the year. And the third element I would throw in there, too, we increase people's salaries in the middle of the year. So there's another cost increase component of this that's also going to play to some extent, not a huge extent, on the decremental margins in the second half compared to the first half.

I'm very pleased with what we've done in the first half of the year at 23%, even with the one-offs that we've talked about, and I'm feeling pretty confident we can at least deliver the 25% that we committed to at the start of the year.

Joe J. O'Dea - Vertical Research Partners LLC

Okay. Thank you. And then you kept the guidance for the market share on North America Class A at the range of 27% to 30%. The year-over-year decline that we've seen is primarily driven by lower volumes with Daimler, which you talked about a little bit last quarter. But just as we think about navigating through some of the under production right now in North America Class A, you move into next year and maybe things get aligned with end market demand. Do you think that the most likely scenario is that 2016 is a low point, and do you anticipate that your share moves up after we move beyond some of the under production considerations this year?

Rich Freeland - President & Chief Operating Officer

Yeah, this is Rich. I think what you've seen over this year is a lot of movement in our share with OEs as the volumes change and that drove some different activities. As you'll notice in recent months, that's pretty much settled out now. Where our share is with each customer, and so our approach now is how do we help the customers that are using our engines gain share? And so we're actually quite excited about the changes we've got in 2017 with the improved fuel economy, again, that you're going to see. We're going to have the best service intervals in the industry and the best connectivity. And so we're going to help those customers grow. So I think we do view this as kind of the settling point.

And then also just remind you, the end of next year, in small numbers we'll begin introducing our X12 product. Okay? So our 12-liter product aimed at the low end to the medium bore market, where we haven't really had an offering there. So, again, I think we've settled out for where we are now and kind of start the slow slog of improving share from this point.

Joe J. O'Dea - Vertical Research Partners LLC

Okay. Thanks very much.

Operator

Thank you. Our next question comes from the line of Mike Baudendistel with Stifel. Your line is now open.

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

Thank you. I just wanted to ask you about your outlook for your medium duty market share. I know you said 74% this year, but just wanted to see if you had any thoughts longer term considering Daimler introducing the DD5 and the DD8 and considering what Ford is doing?

Rich Freeland - President & Chief Operating Officer

So, again, we won't give our guidance for 2017 on that. But for this year we'll stay in the same range and we'll see potentially some small reductions in 2017 as Daimler will introduce the MDEG engine late this year and will be seating that into 2017. So there's a little negative pressure there. There also is – we intend to grow our share at Navistar and so those two will be competing with each other. And then at some point we'll give guidance what the net of all of that is. But don't look for big changes in share through the next – through 2017.

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

Great. Thank you.

Operator

Thank you. Our next question comes from the line of Tim Thein with Citi. Your line is now open.

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

Great. Thank you. The first question just on high horsepower in light of Mark's comments earlier in terms of the progress at the facility in Seymour. Are you still expecting – I know you've tweaked the overall guidance number down here today, but are we still assuming a full year decline of – I think you were at 5% or 6% for the full year. Are we still sticking with that?

Patrick Joseph Ward - Chief Financial Officer

It's more like 7% to 8%, Tim, in overall high-power engines.

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

7%, 8%. Okay, got it. And then just second on the JV income forecast's maintained, you did you take up your overall forecast for both China and India and I know there is a lot of moving pieces in there, but just curious, what's kind of the limiting the flow through there in terms of the little better end markets and it doesn't seem to be changing the full-year outlook for earnings, is that a function of customer mix or maybe just a comment on that.

Patrick Joseph Ward - Chief Financial Officer

I think we are just running a little behind flat for the first half of the year. So I think the guidance has come up and so we'll stay close to flat. There are some moving pieces in some of the smaller JVs that don't get the headlines. It's just really noise around the numbers.

N. Thomas Linebarger - Chairman & Chief Executive Officer

Tim, in India, we are seeing good progress in the truck market and that's benefiting our joint venture straight through. The challenge we've had is the Indian rupee just keeps falling against the dollar. So every incremental dollar we make we give X percent back in currency losses but still, I mean, the joint venture is benefiting from a stronger market. That's straightforward. In China, because we have this situation where we are keeping good share. We are doing well with our customers, but our customer Dongfeng is not holding share in the market relative to another competitor, that's kind of offsetting some of our – the benefit of the market and that's what we are highlighting there.

So, as Mark said, that's just some of the dynamics in the market. We'd of course love our customer Dongfeng to win and our intent is to help them find ways to help them win. But right now, that's what happened in the first half. It just offset part of what we saw as a strong market in China. We don't think that's a long-term trend. We think that will come back over time, but it's just in the first half, and we just don't know what's going to happen in the second half.

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

Okay thank you.

Patrick Joseph Ward - Chief Financial Officer

Having the additional distributor acquisition in the fourth quarter which will tweak down the joint venture line only.

N. Thomas Linebarger - Chairman & Chief Executive Officer

Well a little bit.

Patrick Joseph Ward - Chief Financial Officer

These are small movements.

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

Yeah, okay. Thank you.

Operator

Thank you. Our next question comes from the line of David Raso with Evercore ISI. Your line is open.

David Raso - Evercore ISI

Hi, good morning. A clarification.

N. Thomas Linebarger - Chairman & Chief Executive Officer

Hi, David. You made it on.

David Raso - Evercore ISI

Yeah, thank you. The second half of the year, the incremental margin, and I'm thinking of it year-over-year incremental, did I hear correctly, that you're saying the second half decremental is larger than the first half. The math I'm running is different than that, I just want to clarify that. I have second half incremental more like 14% after the first half of the year was 23% or if you want to adjust for the loss, it's like 19%.

Patrick Joseph Ward - Chief Financial Officer

I think if you take to the midpoint of the guidance and assume everything falls that way, you are probably closer to your number than anything else, David. Yes.

David Raso - Evercore ISI

Okay, so the decremental is lower in the second half of the year, year-over-year, than the first half? Just to...

Patrick Joseph Ward - Chief Financial Officer

If you go to the midpoint of the guidance, yeah.

Mark Andrew Smith - Vice President, Operations Finance

It's exactly there.

David Raso - Evercore ISI

Okay, and specific to that, I guess, within the Engine business, and using the restates, of course, it seems like you have sales declining $400 million or so year-over-year in Engines. But the profits actually go up $20 million, $30 million. And I maybe want to get back to your comment about the warranty or what would be driving that kind of performance, sales down $320 million to be exact but your EBIT actually goes up, it's actually $34 million to be exact. What is such a big swing year-over-year on the Engine profitability?

Rich Freeland - President & Chief Operating Officer

Hey, Dave. I'll take the first shot at this, so you hit it, the three things. The one is the material cost, we've continued to drive down on that, and that was a little bit heavy weighted to the front end of the year. The other big success is in warranty and Pat said it, the rate of the first half of the year is the lowest we have been in 10 years. We talked the second quarter last year where we took a bump up and said we're going to put plans together and we'd invest a little bit more second half of the year, but those actions would drive warranty down. That's what you are seeing right now.

The third piece is around just our restructuring actions that we took across the company, where we took across the company and tried to get ahead of this back late last year saying we're nervous about the truck market going into 2016. And our whole approach is to react fast when we see that. And so that was the $160 million cost reduction of which given this is our biggest business, much of this hit the Engine business. So those are the three biggest drivers. In addition -

Patrick Joseph Ward - Chief Financial Officer

The one I'd add to that, it's more significant is the ones that Rich just talked about, if you go back and look at the 8-K that we filed last week, we did explain that in 2016, we'd take another look at how we're allocating some of the corporate costs across the four business segments we've lowered some of the costs that were being allocated to the Engine segment and recognized the Distribution and Components, and they've incurred more corporate support and as result more corporate overhead too. That, by far, is not anywhere near as significant as a material cost of warranty that Rich was talking to, but that would be the fourth leg of the...

David Raso - Evercore ISI

True, true. But year-over-year if it's already restated to last week, that is an apples-to-apples comp now, though, right? You're handling the second half of this year the same as the restated second last year, though, correct?

Patrick Joseph Ward - Chief Financial Officer

No, that's not correct, David. We did not restate 2015 numbers because we believed the way we were allocating corporate overhead in 2015 was appropriate. We did restate the first quarter of 2016.

David Raso - Evercore ISI

Okay. So obviously, you officially restated the numbers, but you didn't restate that methodology change?

Patrick Joseph Ward - Chief Financial Officer

Correct. Just on that part. And I would just remind you, David, and everyone else that in fact even in the second quarter when heavy duty truck volumes were down 43%, the engine business did, in fact, improve its gross margin in the second quarter. So the improvement underlying is real and pretty positive in tough markets.

David Raso - Evercore ISI

So, I guess last question then. If just hypothetically if engine sales were flat next year, let's say some off highway up, heavy down, however you want to say it, the run rate that you are exiting 2016, would that be, in your mind, a recipe for margins up on flat sales? I'm just making sure how confident you are. Because obviously the material cost, there's some, obviously, debate on how far that carries.

Patrick Joseph Ward - Chief Financial Officer

Yes, that's a nice try but you're not going to tempt me into giving 2017 guidance.

David Raso - Evercore ISI

All right.

Patrick Joseph Ward - Chief Financial Officer

As Tom indicated, we'll talk more about this when we get to the end of Q3 and into Q4.

David Raso - Evercore ISI

I appreciate it. Thank you.

Patrick Joseph Ward - Chief Financial Officer

Thank you.

N. Thomas Linebarger - Chairman & Chief Executive Officer

Thanks, David.

Operator

Thank you. And this does conclude our Q&A session for today. I would like to turn the call back over to Mark Smith for any closing remarks.

Mark Andrew Smith - Vice President, Operations Finance

Thank you very much, everybody. I will be available later for any follow-ups if you have any. Thank you.

Operator

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program and you may all disconnect. Everyone have a great day.

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