Cummins Management Discusses Q3 2012 Results - Earnings Call Transcript

 |  About: Cummins Inc. (CMI)
by: SA Transcripts


Good day, ladies and gentlemen, and welcome to the Third Quarter 2012 Cummins Inc. Earnings Conference Call. My name is Tony, and I'll be your coordinator for today. [Operator Instructions] We will be facilitating a question-and-answer session towards the end of this conference. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the presentation over to your host for today's call, Mr. Mark Smith, Executive Director of Investor Relations. Please proceed, sir.

Mark Smith

Thank you, Tony, and good morning, everyone, and welcome to our teleconference today to discuss Cummins' results for the third quarter of 2012.

Participating with me today are our Chairman and Chief Executive Officer, Tom Linebarger; our Chief Financial Officer, Pat Ward; and the President of our Engine business, Rich Freeland. We will all be available for your questions at the end of the teleconference.

Before we start, please note that some of the information you will hear or be given today will consist of forward-looking statements within the meaning of the Securities Exchange Act of 1934. Such statements express our forecasts, expectations, hopes, beliefs and intentions on strategies regarding the future.

Our actual future results could differ materially from those projected in such forward-looking statements because of a number of risks and uncertainties. More information regarding such risks and uncertainties is available in the forward-looking disclosure statement in the slide deck and our filings with the Securities and Exchange Commission, particularly the Risk Factors section of our most recently filed annual report on Form 10-K and any subsequently filed quarterly reports on Form 10-Q.

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

With that out of the way, we'll begin with our Chairman and Chief Executive Officer, Tom Linebarger.

N. Thomas Linebarger

Thank you, Mark. Good morning, everyone. Before I begin my remarks, on behalf of Cummins, I would just like to express our condolences to the families and communities who have been impacted by the devastation of Hurricane Sandy. I'm guessing that some of you on the phone have been personally affected, and I hope for a quick recovery for each of you.

Now I'll summarize our third quarter results and talk about our key markets. Pat will then take you through more details of our third quarter performance and provide an update on our full year guidance.

Revenues for the third quarter were $4.1 billion, a decrease of 11% from the third quarter of 2011. Third quarter EBIT was $496 million, a decrease of $144 million or 23% compared to the third quarter of 2011. EBIT percent for the quarter was 12%, down from 13.8% a year ago with the negative impact of lower volumes and lower joint venture income, partially offset by lower product coverage cost and material costs.

As previously announced, we now expect full year revenues to be $17 billion, down from $18 billion last year. Demand has clearly weakened in a number of our markets over the last several months. I will talk about our outlook for many of these markets, and we have included for reference a supplementary slide in today's earnings release presentation that further quantifies the change in revenue guidance by both business segment and by market.

We expect to deliver full year EBIT margins of 13.5%, down from our previous guidance of between 14.25% and 14.75%. Pat will cover the changes by business in his remarks. But overall, the reduction in demand across multiple markets and geographies is the main driver of our lower EBIT margin forecast. I will discuss the actions we are taking to reduce costs following my comments on our major markets.

In the third quarter, our revenues in North America increased 2% year-over-year. The rate of growth of our revenues in North America slowed significantly during the third quarter, with the most significant change in the North American heavy-duty truck market. As a reminder, total company revenues in North America grew 43% in the first quarter and 12% in the second quarter compared to the previous year.

In the North American heavy-duty truck market, our Engine shipments decreased by 26% compared to the third quarter last year. Although an industry-wide cut in production rates was anticipated in the third quarter, the reduction was larger than expected, and the industry is experiencing slower-than-expected new order rates. End-users are reluctant to proceed with new purchases apparently due to uncertainty about the U.S. economy and concerns about possible impacts from the fiscal cliff.

Given the lower-than-expected industry order rates, we are now lowering our full year market size expectations to 245,000 units, down from our previous forecast of 260,000. We expect to achieve full year market share of 40%, unchanged from our previous guidance.

Our forecast for the North American medium-duty truck market is for a market size of 104,000 units, an increase of 11% over 2011 and unchanged from our previous guidance. We continue to expect our market share to exceed 50% for the full year. Our shipments declined by 9% in the third quarter, but are up 20% year-to-date.

Our North American on-highway products continue to perform well in the field. We have now shipped more than 335,000 engines equipped with our SCR technology, and the market feedback continues to be extremely positive. Our products continue to demonstrate very good reliability as evidenced by another quarter of low product coverage costs.

Consistent with our track record of being a leader in meeting increasingly stringent global emission standards, Cummins recently became the first engine manufacturer to achieve certification for the EPA 2013 regulations and the new 2014 greenhouse gas rules with our ISX 15-liter engine.

Also in North America, demand from Chrysler for the Dodge Ram truck remains strong. Our engine shipments increased 81% in the third quarter compared to the third quarter last year as Chrysler prepares for a model year change-over. Year-to-date, engine shipments to Chrysler are up 42% year-over-year, and we expect full year shipments to increase by 30%, consistent with our prior guidance.

In the North American construction market, we continue to experience positive growth in the third quarter with engine shipments increasing 12% year-over-year, although the rate of growth has decreased from prior quarters. Demand in the oil and gas market in North America has continued to decline as customers have further reduced capital expenditures in natural gas frac-ing operations, reducing orders for our engines.

Unit shipments in North America declined by 65% in the quarter, and we now expect full year global demand to decline by 50% compared to 2011, a change from our previous expectation of a decline of 41%.

In mining, our engine shipments declined by 32% year-over-year in North America. It is important to note that a significant proportion of the mining engines we delivered to OEM customers in North America are put into service in international markets. And therefore, the decline in shipments should not be interpreted as a 32% decline in North American mining activity.

Global unit shipments declined 14% due primarily to reduced orders in coal mining in the U.S., China, India, Australia and Russia. Mining activity for copper and precious metals remains strong. We have lowered our full year forecast for mining engine revenues as a result of capital expenditure cuts announced by a number of global mining companies. We now expect engine revenues to decline 1% year-over-year compared to our forecast of an increase of 7%.

In our Power Generation business, we recorded a growth of 14% year-over-year in North America. We are maintaining our full year forecast for revenue growth of 15%, driven mainly by new products as we have previously discussed.

In international markets, our consolidated revenues declined by 21% year-over-year. Consistent with prior quarters, revenues were down most significantly in Brazil and China. Demand in Europe, the Middle East and Africa also weakened during the third quarter.

In China, our domestic revenue across all markets, including the revenues of our joint ventures, declined by 26% year-over-year in the third quarter. Demand weakened for trucks, excavators and power generation equipment consistent with the overall slowing of the economy. We continue to experience declining revenues in the construction market with our revenues down 50% in the third quarter. Industry sales for excavators are down 35% year-to-date through September, in line with our full year expectations of a decline of 35%.

Our production of engines will continue to run below industry sales as OEMs lower their existing inventory levels. The outlook for the truck market in China has weakened, as overall growth in the economy has slowed. Our joint venture revenues in the heavy and medium-duty truck market were down 31% in the third quarter. Year-to-date industry sales were down 26% through August. And we now expect full year industry sales to be down 26%, lower than our previous guidance of a decline of 17%.

In the power generation market, we are also lowering expectations for 2012 revenues in China. Our third quarter revenues, including joint ventures, declined by 29% year-over-year against a strong third quarter last year that was driven by summer power shortages. We now expect full year revenues to decline 14% compared to our previous expectations that revenues would be down 5%.

We now expect our full year domestic revenues in China across all end markets, including joint ventures, to decline by 21% compared to our previous expectation of a decline of 13%. We are yet to see any signs of improving demand in the markets we serve despite actions announced by the Chinese government to accelerate infrastructure project approvals.

In India, the economy has remained weak, and recent actions by the government to reduce the fiscal deficit have not helped to stimulate growth in the markets that we serve. On top of an increase in excise duties on commercial vehicles earlier in the year, the government also reduced fuel subsidies, effectively raising fuel prices by 12%.

In India, our total revenues, including joint ventures, declined by 19% in the third quarter compared to the same quarter last year. As we had expected, production at our Tata Cummins joint venture declined by 33%, as Tata lowered third quarter production rates to reduce inventories.

Our full year forecast for the truck market in India is for a decline of 8%, consistent with our previous forecast. Volumes at our Tata Cummins joint venture are down 15% year-to-date and are expected to be down 13% for the full year, also unchanged from our previous forecast.

In the Indian power generation market, we continue to see strong demand for low-horsepower products due to ongoing power shortages in the country. We estimate that demand for Power Gen -- power in India exceeds good capacity by more than 10%. We expect Power Generation volumes in India to increase 15% this year, unchanged from our previous guidance. As we discussed last quarter though, the devaluation of the rupee against the U.S. dollar means our full year expected revenues in dollar terms is a decline of 1%.

Also for the full year, our revenues in India, including joint ventures, are expected to be $1.5 billion, a decrease of 11% year-over-year and unchanged from our previous guidance.

In Latin America, we expect our revenues, including joint ventures, to be $1.4 billion, a decline of 22% year-over-year compared to our previous expectation of a decline of 17%. We are experiencing lower demand for power generation equipment, and the outlook for the truck market in Brazil has also weakened. Industry sales in the truck market in Brazil are down 36% year-to-date through August due to a combination of the impact of the transition to Euro 5 emission standards and a weaker economy. We now forecast a full year decline of 37% compared to our previous guidance of a decline of 33%. Industry sales of Euro 5 products increased in the third quarter, reaching approximately 12,000 units per month compared to an average of 2,000 units per month in the second quarter.

Industry inventory levels have dropped approximately 10% in the last 3 months as a result of improving retail sales. The inventory trend is, however -- sorry, the inventory trend is encouraging. However, a further improvement in new order levels is required before the industry build rates increase.

We experienced our weakest quarter of the year in Europe. Total company revenues were 19% with lower demand in most end markets, particularly power generation, construction and on-highway markets. As a reminder, a significant proportion of the Power Generation products we deliver in Europe are subsequently put into service in other markets outside of Europe.

In the Middle East and Africa, Power Generation represents our largest business. Demand dropped by 17% in the Middle East year-over-year due to lower orders from rental fleets. And in Africa, revenues dropped 10% year-over-year. Third quarter revenues in Africa were similar to the second quarter of this year and well above the weak levels we saw in the first quarter, but still lower than a year ago. Clearly, we are experiencing significantly weaker demand in many of our largest markets. Unfortunately, there is also a high degree of uncertainty about the direction of the global economy. At this point in time, it is not clear when demand will improve.

In this uncertain environment, the leadership team at Cummins is focused on ensuring that we manage our costs appropriately. We have announced a number of actions over the last 3 months to adjust to lower demand environment. We have frozen professional hiring, cut discretionary expenses, re-prioritized and, in some cases, canceled projects. We have reduced production levels at our manufacturing facilities. And in doing so, we have operated some plants with reduced workweeks, and we have taken plant shutdowns.

Given the decline in revenues over the last 3 months, actions are underway to further reduce our cost structure in several of our manufacturing plants and reduce global headcount by between 1,000 and 1,500 people by the end of this year. This management team has demonstrated the ability to effectively manage through periods of uncertainty, and we will continue to make the right decisions to maintain strong financial performance, while ensuring that we deliver the new projects and programs necessary to meet customer commitments and to drive strong profitable growth in the future.

Thank you for your interest today. And now I'll turn it over to Pat.

Patrick J. Ward

Thank you, Tom, and good morning, everyone. Third quarter revenues were $4.1 billion, a decrease of 11% from a year ago. Revenues increased by 2% in North America, but were down 21% internationally compared to the prior year, and currency movement reduced revenues by approximately 4%.

Compared to the second quarter, revenues were down 7% with lower demand in both North America and in international markets. Gross margins were 25.3% of sales, down from 25.7% last year. This decrease was driven by the impact of the reduction in volumes, partially offset by lower material cost and improved price realization.

Sequentially, gross margins decreased from 27.2% in the prior quarter as a result of the lower volume and the more unfavorable mix, partially offset by the benefit from lower material costs. Selling, admin and research and development costs are down by $11 million from last year and down $32 million from last quarter. Both a sequential and year-over-year reduction in spending has occurred in selling and administration expenses.

Joint venture income of $94 million was 8% lower than a year ago and 10% lower than the previous quarter. The year-over-year and sequential declines were driven by lower contribution from joint ventures in both China and in India.

In both comparisons, Dongfeng Cummins in China accounted for the largest variance due to the weaker demand in the China truck market. Earnings before interest and tax were $496 million or 12% of sales. This compares to 13.8% of sales last year.

Earnings per share in the third quarter were $1.86 compared to $2.35 in the third quarter of 2011. The tax rate for the quarter was 24.1%, which included a $16 million benefit for discrete tax items. $6 million of the discrete items were included within our original guidance for the effective tax rate.

Let's now move on to the operating segments and discuss third quarter performance and the outlook for the remainder of the year. In the Engine segment, revenues were $2.5 billion, a decrease of 14% over last year. Sales were down in nearly every international region, particularly on-highway markets in Brazil and industrial markets in China and Europe.

Revenue in North America declined modestly, where strong demand from Chrysler on -- from construction markets was offset by weaker heavy and medium-duty truck, oil and gas and mining markets. Sequentially, segment revenues were down 11% as a result of the decline in the North American heavy and medium-duty truck markets, oil and gas markets and industrial demand in Europe and global mining markets.

Segment EBIT was $239 million or 9.5% of sales compared to 11.8% in the prior year and 13.2% in the second quarter. Compared to the prior year, the benefits from better price realization and lower material costs were more than offset by the drop in volume, lower joint venture contribution and continued technical investments in growth programs.

Sequentially, the decline in volume, a more unfavorable product mix and weaker joint venture income resulted in lower margins. For the full year, we now anticipate revenue for the Engine segment to be down 6% compared to 2011. This is down from our previous guidance of revenue being on par with 2011 levels. The decrease is driven primarily by the reduction in the North American heavy-duty truck market, reduction in sales to our Power Generation business as we focused on reducing inventory levels and lower demand in global mining markets.

As a result of lower volume and weaker contribution from joint ventures in China, we are also lowering our full year expectations for EBIT as a percent of sales. And we now forecast that EBIT will be in the range of 11% to 11.5% of sales.

In the Components segment, third quarter revenue was $938 million, down 8% compared to the prior year and 9% sequentially. Both comparisons were impacted by lower after-treatment and fuel system demand in North America along with weaker turbocharger demand in Europe. In addition, aftermarket demand decreased in several regions.

Revenue in Brazil increased year-over-year due to additional content being sold following the implementation of Euro 5 emission standards. Currency movements negatively impacted revenues by almost 4% compared to the third quarter of 2011. Segment EBIT was $89 million or 9.5% of sales, down from 11.1% last year and down from 11.2% in the prior quarter.

Lower volume, unfavorable currency movements and increased technical investments resulted in lower margins compared to a year ago. Sequentially, the impact of the lower volume was partially offset by reductions in selling and administration expenses. We are now forecasting the Components segment revenue to be flat with 2011. This is down from our previous guidance of 5% growth, resulting from lower on-highway demand in North America and in Europe. Full year segment EBIT margins have also weakened and are now expected to be in the range of 10.5% to 11% of sales. The reduction is due primarily to lower volumes.

In the Power Generation segment, third quarter sales of $814 million were down 7% from the prior year and down 11% sequentially. In both comparisons, international revenue decreased sharply in several regions. The year-over-year revenue decline was primarily driven by lower demand in China and in Europe. And while we experienced volume growth in India, this was more than offset by the devaluation of the rupee against the U.S. dollar. The sequential decline was driven by lower demand in India, Europe and in the Middle East.

Revenue in North America grew 14% over the prior year, driven by new products as we have discussed previously. And sequentially, revenue in North America was down 5%. Segment EBIT was $73 million or 9% of sales in the quarter, down from 10.5% last year and down from 10.3% in the prior quarter. Compared to last year, benefits from improved pricing were offset by lower volume, increased technical spending focused on new products and lower joint venture income.

Sequentially, the impact of reduced volume was partially offset by lower material costs. For 2012, we now expect segment revenue to be down 5% compared with 2011. This is a decrease from our previous guidance of being flat with the prior year. While guidance in North America remains unchanged at 15% growth, international revenue is lower than previously expected.

Power Generation demand in Europe, China, India, Brazil and in the Middle East has weakened over the last 3 months. The reduction in volumes has also caused us to lower our outlook for segment profitability. And now, full year segment EBIT margins are expected to be in the range of 9% to 9.5% of sales.

For the Distribution segment, third quarter revenues were $801 million, an increase of 2% compared to the prior year and 1% compared to the prior quarter. During the quarter, the Distribution segment acquired a North American distributor, which added revenue of $57 million. Excluding all acquisitions, third quarter revenue decreased 7% compared to the prior year and 8% sequentially. Currency movements negatively impacted revenues by almost 5% compared to the third quarter of 2011. In both comparisons, organic growth was lower due to weaker Power Generation demand in Europe and in Africa and in mining markets in the United States and in Australia. Sequentially, we experienced lower demand in Australia, Europe and in Africa. Segment EBIT was $99 million or 12.4% of sales, which includes a $7 million gain from the consolidation of a North American distributor. Excluding this gain, margins were 11.5% of sales, down from 13.3% a year ago. This decrease is the result of currency movements, ongoing investment in our distribution capabilities and the expansion of a distribution footprint and some variation in geographic mix.

Sequentially, EBIT margins were relatively flat with the negative volume impact being offset by lower selling and administration expenses. For 2012, we are now guiding to 5% growth over the prior year. Growth from acquisitions will be offset by a 3% decline in the base business. This reduction from our previous guidance of growth of 10% is the result of weaker international demand, particularly for Power Generation and in some mining markets. And we now expect segment EBIT margins to be in the range of 11.5% to 12% of sales for the full year.

As previously announced, we now project total company revenues to be $17 billion, a reduction of 6% from last year. Growth in North America on-highway, construction and power generation markets will be offset by lower demand internationally. And we anticipate a negative currency impact of approximately $450 million in the year compared to 2011. EBIT margins for the company will be approximately 13.5% of sales compared to the 14.2% margin, excluding gains and divestitures, that we reported last year. Despite the lower sales, we expect gross margins to improve by 100 basis points, but this is offset by higher expenses in selling, admin and in research and development, with research and development cost, for example, up 15% this year as we continue to develop technologies and products focused on future growth.

Other guidance changes include a lower joint venture contribution, where we now expect joint venture income to decline 8% from last year. Growth in contribution from North American distributors will be more than offset by weaker joint venture income in both China and in India, and we now expect our tax rate to be 26.5% for the full year, excluding discrete tax items. The revision is driven by lower projected earnings in markets where the tax rate is less than in the United States.

I continue to be pleased with our gross margin performance. Despite year-to-date revenue being relatively flat with the prior year, gross margins have improved by 100 basis points. And if you just focus on the second half of the year, revenues will be $1.5 billion or 15% lower than the second half of 2011. However, gross margins, as a percent of sales, will be on par with the second half of last year.

As we continue to manage through this period of elevated uncertainty, we are committed to rightsizing our cost structure as Tom just discussed. We also remain committed to investments in new products and in expanding our distribution footprint that are important for our future growth. The strength of our balance sheet provides us with the flexibility to make these investments for growth and provide additional return to our shareholders even during periods of uncertainty.

For example, in July, we increased the dividend by 25%. Also year-to-date, we have repurchased approximately 2.3 million shares, and our outstanding share count is 2% lower than this time last year. In recognition of the performance of the company and our strong balance sheet, Fitch Rating Services recently upgraded our credit rating to single-A status. We remain committed to maintaining our strong balance sheet. And specifically, we are taking steps to improve working capital efficiency in this lower revenue environment.

During our second quarter earnings call, we committed to reduce inventory by $200 million by the end of the year. We made a start on this in the third quarter where, excluding acquisitions, inventory decreased by $72 million from the previous quarter, but we still -- but we know we still have much more work to do on this. We have taken actions to reduce inventory levels further in the fourth quarter, and I expect us to deliver the $200 million of inventory reduction we targeted back in July.

In addition, we have adjusted our capital expenditures and now expect to invest between $650 million and $700 million, down from our previous guidance of between $750 million and $800 million. Cummins is well positioned to manage through this period of uncertainty and emerge stronger when growth returns as we have done before. We have taken actions to address spending and are prepared to do more if required.

Now let me turn it back over to Mark.

Mark Smith

Thanks, Pat. And it's now time for our question-and-answer section. [Operator Instructions] Tony, we're now ready for our first question.

Question-and-Answer Session


[Operator Instructions] Your first question comes from the line of Andy Kaplowitz of Barclays.

Andy Kaplowitz - Barclays Capital, Research Division

Tom, could you talk about the visibility that we have in the U.S. truck market? The OEMs -- still some of them have some decent inventory here. Some of them are talking about increases in production. Some of them are talking about decreases in production. How do you get a handle on that? Do you think, now, we are conservative enough in looking ahead in the next quarter or 2 around U.S. truck production?

N. Thomas Linebarger

Well, I'll give a couple of high-level comments, and I'll have Rich talk a little bit about how we get -- we have pretty decent visibility. I'll let him talk about that. But broadly speaking, I'd say we're pretty well -- we have pretty good handle on how conservative we should be. I feel like we're in the right spot. I think the truck market has latent demand. I think there are people out there who, if they had more confidence in the future of the U.S. economy, would buy more trucks and buy a significant number. So there's no question in my mind that when it turns up, it will turn up significantly, and we'll be able to -- and the whole industry will benefit from that. But as you said, right now, there's a -- each of the truck makers is trying to figure out how to find a profitable level of production that works for their plants and also feeds the market at the right level. And given the uncertainty and the, frankly, weakening retail sale, they've all kind of moved around trying to do that. Rich, why don't you comment about how we understand those movements and plan accordingly?

Richard J. Freeland

Okay, just maybe one additional comment on the longer term. So I think Tom said the demand is there and the pent-up -- it's pent-up, and it's going to release. So part of what we view is when it comes back, we're going to be really well positioned for it. We've put in capacity to meet it. The products are doing well. The fuel economy is good. So I think longer term, when it turns -- it's a bit of your question, when do you see it -- that flip. And so while we don't know exactly when that is, we like where we're positioned when it happens. In the real short term, Q3 was a bigger decline frankly than we anticipated, and so there was some correction. While the industry had been building more than we were selling and, obviously, we're building more engines, that correction happened in Q3. We have pretty good confident -- pretty good view in the short term what things look like, and we're confident through the end of the year, at least, that Q4 is going to look a lot like Q3, and there's not a further deterioration that we're looking at. And then, we're not giving guidance today on the 2013. But kind of looking at those macros and say there will be a turn at some point, and we're just not right now predicting when that will be.


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

Andrew Buscaglia

Actually, this is Andrew Buscaglia for Jamie Cook. So my question is actually on China...

[Technical Difficulty]

Andrew Buscaglia

Sure. Two questions just on China. Can you just give me a little more commentary there? It sounds like things [indiscernible] and things aren't improving despite [indiscernible] potential for government stimulus. Can you just talk about your thoughts on that region?

N. Thomas Linebarger

Sure. There's no question that China has -- this year has not met our expectations, the ones we put in place at the beginning of the year. The market was not strong when we started the year, and we knew it wouldn't be a fantastic market, but we anticipated some improvement specifically in the second half, and we have not seen that. In fact, we've seen, as we mentioned in our remarks, further deterioration. And part of that is a result of the fact that the capital spending sectors of the economy really have not recovered. And part of it is because of the inventory levels that got built up in the construction market. So not only are the -- is capital spending lower, but there is inventory in the field and in the plants of the equipment makers and the excavator market, particularly, that they have to get rid of at much lower retail sales rate. So both of those things have caused our production levels to be lower than we anticipated. Right now, we don't have a good feel for when it's going to turn back the other way, and we know that the government is -- has planned and has, in fact, announced stimulus measures to try to get some of the capital projects going in the provinces. But we have just not seen a significant impact on our markets from those efforts to date. And when the last time we were involved in the stimulus, which was not that many years ago, we saw those impacts, they were significant, and they happened pretty quickly. So right now, we're not seeing those, and we're not sure when and if we will see them. And so, we're -- we are definitely -- it's uncertain to us, and we are planning accordingly. So we're planning for markets to remain down for some time. We don't see it worsening further, but we're not clear when it's going to turn back. We're obviously watching very closely to look for signs for that. But right now, we're just not sure. As you may know, in the truck market, there is a emissions hurdle coming next -- in the middle of next year. So as we enter next year, we'll have to deal a little bit with the uncertainty around that as well. What that means with regard to whether they'll buy more trucks in the first half because of that or less or what will happen I don't -- we just don't know today. But what we do know is the recovery has not started in China, at least not in our markets.


Your next question comes from the line of Andrew Casey.

Andrew M. Casey - Wells Fargo Securities, LLC, Research Division

Back on China, I guess, quickly, can you help us understand the cadence in Q3 versus Q2? It looks like the contribution decline kind of accelerated to 40% from 35% in Dongfeng. What's driving that? Was that higher expenses, or is that all volume deterioration?

N. Thomas Linebarger

It's both. I mean, volume is probably the most significant factor. Of course, there's a normal seasonal decline from Q2 to Q3 as you're well aware, Andy, but of course things have weakened. But then, we have got some expenses within the JV as we prepare for NS4, the new emissions change, so some increase in expense as well, but volume's the biggest challenge.

Andrew M. Casey - Wells Fargo Securities, LLC, Research Division

Okay. So the expense for NS4 pretty much it continued through year -- mid-year next year?

N. Thomas Linebarger

Yes, yes.

Andrew M. Casey - Wells Fargo Securities, LLC, Research Division

Okay. And then a technical question, then a longer-term question. But first, the technical. On the tax rate, does the annual 26.5% x the discrete items -- and I think you had $29 million year-to-date, does that imply something like a 33% rate for the fourth quarter? And then subsequently, are there any remaining discrete items that could affect the rate in Q4?

Patrick J. Ward

Yes. The rate for the fourth quarter, Andy, won't be as high as 33%. So [indiscernible] market, I can take you through the math if you're looking at some numbers there, but it will be lower -- much lower than that. We continue to work on our tax planning strategies. There could be some more discrete items in the fourth quarter. But as of now, I wouldn't bank on it.

Andrew M. Casey - Wells Fargo Securities, LLC, Research Division

Okay. And then, I guess strategically, we're in the midst of these mining company CapEx cutbacks. How are you viewing those? Is that kind of a short-term thing and we get on with life 1 or 2 years from now? Or is that something more prolonged?

N. Thomas Linebarger

Yes. Our view is that the long-term outlook for commodities remains really strong, and I think that's what's going to drive mining. We still believe that to be the case. If you just step back and look at the requirements for commodities and the big economies that have been growing over the last 5 or 10 years, commodities still look like they're going to be in demand and in fact, in a significant way, there is not enough source. So I think we -- our view on mining remains strong, long run. However, in the short run, what we've got is commodity price drops, especially in coal. And so needless to say, it's -- the first thing that happens is the ones who are looking at big capacity additions say, "Well, not now. Don't do it now because we're -- it's a lot of money to put in, and we're -- we have more uncertainty about when the demand picks up." And then the second thing that happens is those that are operating marginal mines start to say, "Well, I'm at the high end of this cost structure. So as prices for my commodity drops, this doesn't look so good to keep going." So some of those in the coal side, some of those mines have either reduced production or stopped production. And then the ones that are effective on cost and have good quality keep on going through this time unless things get really low. And as I mentioned in my remarks, coal is clearly down enough that we've seen both first rung and second rung effects, whereas copper and some of the precious metals have not seen that. So we're kind of in the middle there. We're not as big as the drop we saw last time, but we're definitely -- we've definitely reduced our demand forecast as a result of what's already happening. So we're kind of in between those 2. So it's possible that there's further reductions if things continue to weaken. But I think, again, long run, we see the same strength in these mining markets over the extended period.


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

Jerry Revich - Goldman Sachs Group Inc., Research Division

Tom, can you talk about which businesses are seeing the most significant staffing reductions? And are there any permanent changes for the manufacturing footprint as a result? I think you've been looking to ship your genset assembly to India to a greater extent. Is that part of what's happening here?

N. Thomas Linebarger

So, Jerry, without commenting on specifics too much yet because, of course, as you guess, we need to talk. We need to go through all the efforts, and we need to talk to our employees first and all that kind of thing, but let me just give you a broad view of it. All parts of our company are participating in this cost reduction because we are, as you -- as I mentioned in my remarks, we're seeing weakness in a lot of markets around the world. So if we see reductions in one area, we just deal with that area right away. But in this case, we've got pretty broad reductions in demand. So all businesses and all parts of the company are participating and figuring out how to reduce cost structure. In the plants, most of what we're going to do is reduce within the plants we have and keep largely the same plant footprint. There's not that there will be no changes, there will be because we constantly are looking to say how can we use the efforts in downturns to position ourselves strategically more where we want to be for the long run. So as you mentioned, if we're trying to move more capacity to one area of the world, the other will -- when we reduce headcount, we'll use that as an opportunity to move more towards the production areas that we want to. But far and wide, we've done a lot of that. And so those effects will be relatively small as compared to, say, just reducing capacity in plants that we don't need as much today and then, of course, taking cuts across the company in overhead areas. And I guess the last thing I would say is that we are ensuring that we fund the key product program and other projects that are going to be critical for the future while reducing some of those that we can afford to delay for some period or that we think were the least attractive ones, we'll cut those. So we are doing -- we are being pretty specific about those areas we reduce and those areas we continue to fund and that, of course, ensures that when we come out of this downturn, we'll be -- emerge stronger than we went in.


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

Adam William Uhlman - Cleveland Research Company

Tom, just to continue on that discussion, I was wondering if you could -- and I know it's still early and you're not providing guidance yet, but I was wondering if we could build out a framework of how you're thinking about 2013 in terms of CapEx and hiring plans and even just on the domestic truck market, whether or not you think the market might be up or down next year might be helpful.

N. Thomas Linebarger

Well, as you said, we're not going to do too much in guidance today because, as you know, some of those, once we start down that trend, we're kind of all the way in. But let me just give you a broad feel about how we're planning for it, which fits with my remarks, which is that our view is there's a significant amount of uncertainty in these major markets. And so we're planning accordingly. We're thinking about the market -- we're not counting on the markets to improve, and we're just making sure that we're ready for it to get -- go this flat, go the same, go up, go down. All those outcomes are possible from what we see. As Rich commented in the North American heavy-duty truck markets, specifically, we are thinking that if things do turn back, they could turn back quite dramatically given the latent demand that's there and if we see improvement in confidence in the U.S. economy, so fiscal cliff goes away and some sort of budget deal struck and people start to think the U.S. is going the right direction, that could be an instigation for improvement in the truck market, and it could come back pretty quickly in which case, again, the work that Rich and the Engine business have done to prepare for it, I think, will serve us well. But we'll be ready if it doesn't come back that fast too. That's kind of how we're trying to think about it. And as Pat said, we'll take whatever actions we need to in whatever area of the company. If things worsen further, we'll take the actions we need to, to be in the right cost position for those activities too. So I'm sorry, I'm not giving you more detail, but we are just planning for -- we're going to set a plan that does not assume a great outcome next year, but we'll be ready if things are stronger than that and we'll be ready if things are weaker than that, and we're doing that, kind of, place by place strategically, what's the most important place to have a quick response capability, where could we have a little bit more delayed response capability and then adjust our cost structure and supply chain accordingly.


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

Ann P. Duignan - JP Morgan Chase & Co, Research Division

Tom, could you talk a little bit about -- you talked about relooking at CapEx spend and reevaluating projects. Could you give us some examples of projects that you are moving ahead with regardless that you have total confidence in, regardless of what you're seeing out there right now versus maybe a project or 2 that you've decided to postpone or push back or reevaluate?

N. Thomas Linebarger

Just -- in the interest of not revealing too much about our competitive plans, let me just -- I think I can give you a flavor for the kind of thing. So we had a number of projects that were going to drive capacity increases in preparation for next year or the year after, for example, in China, and we've delayed some of those. We've delayed some of those capital projects which increase capacity further. On the other hand, some of the product programs that are addressing NS4, which is -- it's imminent, as well as some of the product programs that we think have major impacts on our long-term profitable growth, for example, our new high-horsepower program that we announced, we are continuing to fund those. So that at least gives you a flavor. So things that have short-term impact, Tier 4, fuel economy stuff, the ones that have major growth like high-horsepower, those we'll continue to fund. Those that have short-term capacity additions, things that we can postpone, projects that might improve our productivity down the road but cost a lot in the short run, we might delay some of those. IT programs, things like that, we might delay. Those are the kind of the ways we're thinking about it. And as you'd guess, in a company of our size, there are a lot of those to think about. And so we're, of course, reviewing the major ones with my leadership team but then, each of the leadership teams around the world are taking a look at their projects and seeing where they sit on all of them. And all of those do, by looking at these programs, not -- it doesn't just impact capital expenditure, it impacts the demand we have for resources, which means when we have lower demand for resources, we can then reduce the number of resources because we've already frozen hiring. So you can't bring in new people and then, we've -- we're reducing headcount so there'll be fewer resources to do the work.


Your next question comes from the line of Vance Edelson of Morgan Stanley.

Vance H. Edelson - Morgan Stanley, Research Division

So given that you believe there's pent-up demand and you expect a pretty healthy snapback when it does occur. When you do see that turnaround, you've suggested you'll be ready. But just how quickly can you bring back the capacity, bring back the headcount and so forth? Are we talking a number of weeks or months? Could you just provide some color in that regard?

N. Thomas Linebarger

Yes, I'm going to let Rich talk about that.

Richard J. Freeland

Yes. We're actually able to respond really quickly especially if you think about the heavy-duty truck demand. So we've -- the long lead-time capacity items, plant assembly, test cells, we've got in place and in fact, we've -- we're increasing it a bit to be ready for that. We've also -- we've been through this a few times before, and so we know the key suppliers and where the bottlenecks are and we actually tested the system pretty hard earlier in the year. And so we're doing work with those. So we don't have to go out and buy capital equipment, invest in bricks and mortar. We can bounce back and handle different scenarios of a peak demand pretty well. I mean, our workforce flexes really well, and the whole supply base we work with does that. So I think really well -- think in weeks, months, not longer than that to respond.

N. Thomas Linebarger

And we have one -- as Rich said, we have one of the most flexible plants that, at least, I've ever been in contact with in Jamestown, and we have demonstrated -- just in 2010, you can just go look at the production levels that we talked about in 2010 to see the variation that we can deal with at that plant. And it comes because employees are flexible. We've figured out ways to bring in temporaries and let go of temporaries and other kinds of things where we can get ramp-up and ramp-down quite quickly. It's a remarkable place in that regard. And then some of our other plants like Rocky Mount, North Carolina where we serve mid-range truck have some of the same capability. So again, it's not something that we've come to just now. It's something we've been working at for many, many years to be ready to go up and down. Rich has also got some supply chain work he's done to put in some strategic inventory. So one of the things that we're trying to do is reduce inventory, while still maintain some strategic inventory to allow us to ramp up in those markets that we think might come quickly.


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

Stephen E. Volkmann - Jefferies & Company, Inc., Research Division

Tom, this is a finger in the wind kind of a question. But if your implied revenue guide for the fourth quarter is down about 20%, do you think all your customer production is down that much? Or how much of that might be inventory reduction across the various end markets?

N. Thomas Linebarger

It's both for sure, Steve. It's definitely both going on. I mean, some -- I mentioned in my remarks some places where it's pretty clear that there's some inventory adjustments that went on in Q3, and some of those inventory adjustments are definitely not done. We talked about excavator markets in China, which is the most dramatic case of it, where you've got inventory in the system that is going to extend sometime into next year. We don't know how long. It depends on retail rates, but there's a lot of inventory in the chain there. I talked about Brazil trucks being another place where retail demand has picked up, inventory started to drop, but there's no question that there's more inventory to make up. And then we even talked about North American trucks where -- what Rich said is we saw the industry producing at a higher rate than demand was happening in Q3. And so they have adjusted build rates in Q4 to try to balance the 2 things. So that -- both are going on for sure even in the genset market, where there's some of the big project demand dropped off. There'll be some inventory in some places in the field, where they will have to clear out and that will reduce production. So it's both. No question it's both. But make no mistake, end markets are not in those that I -- in the areas I talked about are not strong. So both are going on.


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

David Raso - ISI Group Inc., Research Division

Questions on the thinking of second half 2012 run rate. And if you can indulge me in taking us through which markets you think sequentially, second half '12 to first half '13 -- so if there's some sense of visibility. It's not a full year-type question. Which markets do you think will be better, which will be worse, second half '12, the first half '13?

N. Thomas Linebarger

I'll give you a high level, and Pat may have other comments. But again, I think that's part of what we're not really clear about. I think we -- in my remarks, what I was talking about is that we don't have particularly good visibility about where the markets go from here. And as I mentioned, we're not assuming that things are going to get a lot better really quickly. So we're building our plan and our actions around the fact that things are not going to improve quickly. Again, some markets will improve, some markets may not. But right now, our view is visibility is not very good. And so we're going to assume not a bunch of improvement, but -- Pat, I don't know if you want to make any other...

Patrick J. Ward

Yes, I'll add a couple of things, Tom. I think much of it is dependent on factors outside of our control. So in the U.S., if we get a decent resolution on this fiscal cliff issue early in the new year, I think that could really help a number of markets in North America. If we punt out a bit longer, clearly, that's a different scenario. If you look at Brazilian markets, for example, given the major events that they've got coming up between the World Cup and the Olympic Games, we know they're behind with significant infrastructure investment, and you would expect, at some point, they have to kind of get a move on with that and pick up the pace. So again, we'll talk more about it on our call at the end of the year and hopefully by then, we'll have much more -- a much better view of some of these external factors that can drive it one way or the other.


Your next question comes from the line of Eli Lustgarten of Longbow Research.

Eli S. Lustgarten - Longbow Research LLC

Can I have just one clarification? Somebody asked about the tax rate in the fourth quarter. Since you true up your tax rate in the third quarter, why would you be 26.5%, unless you come up with a somewhat discrete item?

Patrick J. Ward

So let me take you through that. I may have confused a few people with [indiscernible] tax. The tax rate in the third quarter of 24.1% that I talked to, that was the all-in tax rate, so that includes discrete items. The year-to-date tax rate, including all discrete items, is 25.5%. And so when you look at the full year, I was giving you a full year ETR, without discrete, which is 26.5%. All-in, it's going to be somewhere between 24% and 25%. So Q4 is going to look somewhat similar to Q3 when it comes to tax rate. It might be a little bit lower if we get some of the tax planning work we're working on completed by the year. So hopefully, that's clarified it a little bit for people.

Eli S. Lustgarten - Longbow Research LLC

All right. My main question is, you just signed a -- made a finalized agreement with Navistar or so. Do you have any feeling -- would you give us some guidance of what that will mean for the company with some -- what impact on revenue a quarter [ph], something like that? I assume that you won't get anything until fiscal '13, but can you give us some feeling for what it means?

N. Thomas Linebarger

Yes. It's hard to estimate today, as you guessed, Eli, because what -- we understand what products we're doing from them. What we don't know is how quickly those products are going to ramp up and go into the market, right. Because they'll -- Navistar truck with our engine will have to compete with the other trucks with our engine and other engines. So we just don't have a good way to quantify it. Our view is that we're working really hard to be ready on Navistar schedule to have the 15-liter in the ProStar truck and then in other trucks if they ask us to put it in, and we're working with equal urgency to make sure that we've got components on their 13- and 11-liter engines, so that those are available in the market with SCR Systems in the first -- next year as well, hopefully by the end of the first quarter. So we're working with urgency on both things. It's just kind of hard right -- sitting where we are right now to say so what's the estimate of the -- of sales or profit for next year.


And the next question is a follow-up from Andrew Casey.

Andrew M. Casey - Wells Fargo Securities, LLC, Research Division

A question on the heavy-duty truck capacity, given what Eli just alluded to, the Navistar business win. On the Engine side, if memory serves, you were running up against some constraints in the first half of the year, mainly the first quarter. If the industry goes back up to those rates and you have the incremental market share, does that imply that you're adding capacity at Jamestown or somewhere else to support that? I know we're a ways away from there right now.

Richard J. Freeland

Yes. Andy, this is Rich. I'll -- yes, in fact, we have continued to add capacity through the last 12 months because even then while we met demand at that peak, it was pretty hectic, okay. And so we're operating over our capacity. So we've -- again, on all of the bottleneck operations and in some cases, we've added hard capacity or inventory to be able to do that. So, yes, we have added capacity really through last year and then into this year to meet that increased demand or hit those -- to be able to meet those peak demands.

N. Thomas Linebarger

I guess, in summary, Andy, we feel confident we can meet the peak demand even if it comes next year, and hopefully it comes soon next year, we'll be ready to meet the peak demand with our customers that we've agreed to supply. That's part of our commitment to them.


Ladies and gentlemen, due to time, I'm turning it over back to Mr. Mark Smith for closing remarks. Please proceed.

Mark Smith

Thank you, everyone, for your participation and interest today. Obviously, I'll be available for calls later on. Thank you, and that's the end of the call.


Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect, and have a great week.

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