PACCAR's (PCAR) CEO Ron Armstrong on Q1 2016 Results - Earnings Call Transcript

| About: PACCAR Inc. (PCAR)

PACCAR Inc. (NASDAQ:PCAR)

Q1 2016 Earnings Conference Call

April 26, 2016 11:00 ET

Executives

Ken Hastings - Director, Investor Relations

Ron Armstrong - Chief Executive Officer

Bob Christensen - President and Chief Financial Officer

Michael Barkley - Senior Vice President and Controller

Analysts

Jamie Cook - Credit Suisse

Alex Potter - Piper Jaffray

Mike Conlon - JPMorgan

Joe Vruwink - Robert W. Baird

Steven Fisher - UBS

Jerry Revich - Goldman Sachs

Ross Gilardi - Bank of America

Seth Weber - RBC Capital Markets

Joe O’Dea - Vertical Research

Adam Uhlman - Cleveland Research

Mike Shlisky - Seaport Global

Robert Wertheimer - Barclays

Operator

Good morning and welcome to PACCAR’s First Quarter 2016 Earnings Conference Call. [Operator Instructions] Today’s call is being recorded, and if anyone has any objections, they should disconnect at this time. I would now like to introduce Mr. Ken Hastings, PACCAR’s Director of Investor Relations. Mr. Hastings, please go ahead.

Ken Hastings

Good morning. We would like to welcome those listening by phone and those on the webcast. My name is Ken Hastings, PACCAR’s Director of Investor Relations. And joining me this morning are Ron Armstrong, Chief Executive Officer; Bob Christensen, President and Chief Financial Officer; and Michael Barkley, Senior Vice President and Controller. As with prior conference calls, if there are members of the media on the line, we ask that they participate in a listen-only mode. Certain information presented today will be forward-looking and involve risks and uncertainties, including general economic and competitive conditions that may affect the expected results.

I would now like to introduce Ron Armstrong.

Ron Armstrong

Good morning. PACCAR reported good revenues and excellent operating income for the first quarter of 2016. PACCAR’s first quarter sales and financial services revenues were $4.3 billion and first quarter adjusted net income, a non-GAAP measure, was $348 million, an 8.1% after-tax return on revenues. Adjusted net income excludes a $943 million non-recurring charge for the European Commission investigation of all European truck manufacturers. Including the non-recurring charge, PACCAR reported a net loss of $595 million in the first quarter.

PACCAR achieved excellent truck, parts and other gross margins of 14.9%, helped by the strong European truck market. I am very proud of our 23,000 employees who have delivered industry leading products and services to our customers worldwide. PACCAR delivered 35,300 trucks during the first quarter in line with our expectations. Deliveries in Europe were over 30% higher than last year’s first quarter. Looking ahead, we expect a slight increase in deliveries in the second quarter compared to the first quarter. Second quarter gross margins are projected to be comparable to the strong first quarter margins, reflecting the benefits of DAF, Peterbilt and Kenworth’s new truck models, the benefits of steady build rates, good truck markets and continued material cost savings.

PACCAR’s forecast for Europe’s greater than 16-tonne market is a range of 260,000 to 290,000 units, reflecting strong demand and a steady economic outlook. Europe’s GDP growth expectations for this year are 2% in the UK, which is DAF’s largest market and 1.5% on the continent. Freight transport activity on German highways in the first quarter was up 4% over the same period last year. Year-to-date, DAF has achieved a record 16.6% share of the heavy-duty market.

The economic picture in the U.S. remains positive, with GDP forecast to grow 2.1% this year. The housing and automotive industries create a large amount of freight. Housing starts are projected to grow 11% this year to over $1.2 million and the automotive industry is expected to deliver 17.5 million vehicles, which would be a record. Other positive signals are that the ISM Manufacturing Index has returned to expansion and manufacturing inventories in the economy appear to be stabilizing.

We estimate U.S. and Canadian Class 8 truck industry retail sales will be in the range of 220,000 to 250,000 units this year, the third best in the last decade. The economy’s steady growth is supportive of healthy freight levels. The ATA tonnage index continues at record levels. Peterbilt and Kenworth’s combined retail sales market share of the U.S. and Canadian market is 26% year-to-date. Our share of net orders so far this year is strong at 37% as customers appreciate the benefits of Kenworth and Peterbilt’s reliable and fuel-efficient trucks and industry leading resale values.

PACCAR’s parts business generated quarterly revenues of $720 million compared to $753 million in the same quarter of last year. PACCAR Parts quarterly pre-tax income was $135 million, an excellent return on revenue of 18.7%. These results were driven by good fleet utilization, the growing number of PACCAR trucks and the engines in operation and the many innovative products and services offered by PACCAR parts and our dealers. PACCAR Financial Services first quarter pre-tax income was $80 million compared to $89 million a year ago. Excellent portfolio performance contributed to the good results.

PACCAR’s strong balance sheet and positive cash flow have enabled the company to invest $3.3 billion in new products and facilities in the last 5 years. PACCAR’s capital spending of $325 million to $375 million this year is targeted at enhanced aftermarket support, manufacturing facilities and new product development. Research and development expenses are estimated to be in the range of $240 million to $260 million. PACCAR continues to enhance its leadership position in the global truck market by developing the highest quality products and services in the industry. Thank you. And I would be pleased to answer your questions. Operator?

Question-and-Answer Session

Operator

Your first question comes from the line of Jamie Cook.

Jamie Cook

Hi, good morning and nice quarter.

Ron Armstrong

Good morning. Thank you very much.

Jamie Cook

I guess a couple of questions. The gross margins in the first quarter were higher I think than you expected and that relative to what The Street expected. So, can you just talk through, because the Q isn’t out yet, how much of that was material cost, how much of that was benefits from increasing production? And then I also think last quarter, you alluded to being able to achieve flat gross margins year-on-year. Can you talk about your comfort level with that today versus where we sat last quarter with material costs potentially being a headwind in the back half of the year and with the pricing environment?

Ron Armstrong

Sure. So first quarter, we had excellent quarter from an execution standpoint. Our plants had steady build rates, as I mentioned and so able to operate the plants very efficiently during the quarter, continue to see favorable benefits from some of the material cost movement that are purchasing and materials teams are providing with our suppliers working closely with them to provide good value for our customers. The products are performing great in the field, so we have seen a good performance in our warranty cost during the quarter. So, all the elements are just a good quarter of execution provided the results that we have seen. As we look forward for the full year, margins I think will still be in that 14.5% to 15% range for the full year at these build rates. So, we will continue to operate at the kind of levels that we saw in the first quarter, I believe.

Jamie Cook

And I am sorry, can you just also, I will get back in queue, comment I mean last quarter, you talked about your inventory levels being at a much healthier rate relative to your peers. Can you just provide an update on that?

Ron Armstrong

I think the same situation exists. Our inventories are below 60 days in the field and so in great, great position. So, what we produce will find its way to the customers’ hands.

Jamie Cook

Okay, great. I will get back in queue. Thank you.

Ron Armstrong

Thank you.

Operator

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

Alex Potter

Hi, guys. Maybe just to follow-up on that question, the initial question there on gross margin. Can you comment on pricing, if you have been seeing any sort of funny business with pricing given the inventory build up that other OEMs in the channel?

Ron Armstrong

I would say, pricing is pretty steady in the marketplace and that’s what we experienced in the first quarter.

Alex Potter

Okay, very good. Then I was wondering also if you could comment a little bit on your outlook for areas other than North America and Europe, so Brazil obviously, but also the rest of South America, Mexico, Australia and maybe the other regions that you sell material amount of trucks into?

Ron Armstrong

Yes. First talk about Australia and Mexico, I would say the markets there are good, steady and our plants out there also operated very efficiently during the quarter and markets are pretty reasonable. Brazil, the country is challenging, but we continue to move forward with our business. Build rates are steady and the team is doing an excellent job of continuing to establish and deepen the footprint of DAF in the marketplace. And we continue to see pretty good activity with respect to the Andean countries in South America with both the Kenworth and DAF brands.

Alex Potter

Okay, thank you.

Ron Armstrong

Thank you.

Operator

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

Mike Conlon

Hi, good morning. This is Mike Conlon for Ann.

Ron Armstrong

Good morning.

Mike Conlon

I just wanted to get a little bit of color on the Financial Services margins, a little bit weaker than expected and if there was any particular reason why that may happen or may continue?

Ron Armstrong

Well, one of the things that we saw late last year, first quarter this year, there is several of our competitors have a pretty sizable oversupply of used truck inventories and then it dampened the overall market prices. And so whereas last year in our Financial Services business, we had nice used truck gains, this first quarter this year, those used truck gains didn’t repeat. So it’s primarily used trucks, a little bit impact of currency movement, but they are primarily the effects of used truck pricing.

Mike Conlon

Okay, thank you.

Ron Armstrong

Sure.

Operator

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

Joe Vruwink

This is Joe Vruwink for David.

Ron Armstrong

Good morning.

Joe Vruwink

I was wondering if you could give your European order growth in the quarter and when I just look at what individual countries are doing, it would seem like DAF in the quarter was over 30% growth is doing quite a bit better than just what the UK and Netherlands markets might be doing, so are you gaining market share of countries that might not have been typically DAF countries in the past?

Ron Armstrong

Yes, I think in most countries, DAF gained share year-over-year on the quarter perspective. The Euro 6 product that DAF has had in the market now for a couple of years is now performing excellently. And the fuel efficiency, the reliability of the product is the best it’s ever been and so as time goes on, more and more customers are recognizing that. And when you look at some of the Southern markets that had been pretty depressed for quite a few years, those are recovering and DAF has a strong presence in Central Europe in countries like Poland, Czech Republic, Hungary and many of those is number one or two in those markets. So I think just the combination of all those elements coming together and DAF achieved 16.6% share for the first quarter which is a record level for them. And so it’s really across the continent.

Joe Vruwink

Okay. And similar conversation, but here in the U.S. to get 37% share of incoming orders, I think your Class 8 retail is closer to 25% right now, so is that particular vocations maybe or regions of the country where you are just more positioned relative to the other OEMs or is it similar and that new product is driving the gains?

Ron Armstrong

I think new product is a big thing. The Peterbilt 579, 567 models and the Kenworth T680 and T880 models are very well received by the customers. The engine, PACCAR engine penetration increased to 46% in the quarter. So there is more and more acceptance of the PACCAR engine in the product and so just the continued appreciation of the product, the fuel efficiency, the reliability of the current products is excellent.

Joe Vruwink

Great, I will hop back in queue. Thank you.

Ron Armstrong

Thank you.

Operator

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

Steven Fisher

Thanks. Good morning.

Ron Armstrong

Good morning.

Steven Fisher

Just want to follow-up on the cost savings, I mean I know you mentioned continuing material cost savings expected in Q2, I guess given the rise we have seen in commodity prices, how is that baked into your expectations of the 14.5% to 15% margins for the full year and I guess particularly in the second half?

Ron Armstrong

We have long-term agreements with most of our suppliers, which tend to smooth out both the up-ticks and downticks and material cost movements from a commodity standpoint. So it will be pretty muted in terms of any up-tick that we might see and how that might play into our costs and pricing.

Steven Fisher

Well, do you think you can get pricing benefits on top of the higher costs as the smoothing sort of works itself through over the course of the year?

Ron Armstrong

You typically do. I mean it may not be exactly at the same time, but typically those things find their way to the marketplace.

Steven Fisher

Okay. And then just on the Finco earnings, I wanted to clarify what it was within the interest and other that drove the higher cost, I am not sure if that was the used pricing that you were talking about earlier and do you think the 10% year-over-year decline in profit is going to be better or worse or the same as what the full year could be?

Ron Armstrong

A lot of it will depend on how the used truck market develops in the coming quarters. And so we will see how that develops. In terms of the interest in other, just part of that is just the larger portfolio, the asset, the average earning assets in the first quarter this year are higher and so that just reflects. We have higher assets and higher debt levels that go with that and that just reflects the higher costs to go with it.

Steven Fisher

Okay, thank you.

Ron Armstrong

Thank you.

Operator

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

Jerry Revich

Hi, good morning everyone.

Ron Armstrong

Good morning Jerry.

Jerry Revich

Ron, I wonder if you could talk about the pricing environment in Europe, specifically you folks have spoken about once the market gets good enough, you might be at a point where you get to make a margin on the new emissions components, are we at that point yet, can you just give us an update within the context of the steady pricing environment that you outlined across the business?

Ron Armstrong

Yes. I wish that were the case Jerry, but pricing is pretty steady in terms of this year versus what we saw last year during the course of the year. Market is good, so pricing environment has been, as I said pretty steady without much up or down movement.

Jerry Revich

Okay. And then can you talk about what you are seeing out of your customers in terms of parts consumption in North America, it looks like your North America Parts business may have been down more than the overall parts business, is that an issue of timing or what drove that, I think we are hearing from construction industries that it was a pretty seasonally positive quarter for business, so I am wondering if you can just fill in the gaps on what you are seeing out of your customers there?

Ron Armstrong

Yes. So from a customer standpoint, the actual retail sales at the dealer level were up a bit during the quarter. What we saw was the dealers rebalancing their inventories to sort of adjust to individual local market conditions. So we expect that we will see in the second quarter beyond an improvement in part sales for the rest of the year.

Jerry Revich

Okay. And lastly, you have done a nice job bringing down warranty costs on your Euro 6 engines, I am wondering if you can just update us on how that’s tracking, the warranty accruals continued to decline sequentially based on the experience level or are we at the run rate based on actual warranty instances that you are seeing?

Ron Armstrong

Yes. The DAF trucks, the PACCAR engines, the Kenworth, Peterbilt trucks around the world are performing very well, best reliability I think in the industry. And we have seen that reflected in our warranty provisions quarter-over-quarter. So the first quarter was at a good run rate that we think is appropriate for our product.

Jerry Revich

Okay, thank you.

Ron Armstrong

Thank you.

Operator

[Operator Instructions] Your next question comes from the line of Ross Gilardi with Bank of America.

Ross Gilardi

Good morning. Thank you.

Ron Armstrong

Good morning.

Ross Gilardi

I was wondering if you can just talk a little bit about your internal engine effort. Obviously, PACCAR has been targeting sort of a 50% make versus buy in North America for a long time and you have been inching closer to that target. I am just wondering any reason why you would stop at 50% and if you were to go beyond 50%, would you need to go all the way to 100% to justify the capital investment or can we see that target to slowly be dragged higher?

Ron Armstrong

The wonderful thing about our facility in Columbus, Mississippi, we built it at 400,000 square feet. We are continuing to add additional equipment into the facility to achieve what’s possible within that footprint, but we have a lot of – we have 400 acres of land and it’s expandable just as what we had planned it to be. So, we are earning a strong return off of the investment that we have made and will continue to make additional investments as the engine penetration grows in North America. The 50% is sort of a short midterm target. The longer term target, as we look at our customers and the applications they have, we feel the engine can meet up to 80%, 85% of customer needs. So, that’s sort of the target at this point, longer term. And so we will continue to invest in increment capacity as we needed and we will be making some of those investments in the next couple of years to support the growing acceptance of the engines doing great.

Ross Gilardi

Okay, thanks. And then what about your vertical integration effort and other product categories and I think in your – one of your more recent Investor Days, you had talked about things like axles also you can make internally. And are you doing more of that? And is that a driver of success in the gross margin?

Ron Armstrong

Well, DAF has been making axles for the 20 years that PACCAR has owned them and that’s what you get when you order a DAF truck, our PACCAR axles. We are working – in North America we are looking at opportunities to take advantage of DAF’s axle technology and capabilities. We have great working relationships with Dana and Meritor who are providing really customized applications that integrate well with the rest of the PACCAR powertrain to be able to offer our customers the unique capability of the fully integrated powertrain to operate their vehicles.

Ross Gilardi

Thank you very much.

Ron Armstrong

Thank you.

Operator

Your next question comes from the line of Seth Weber with RBC Capital Markets.

Seth Weber

Hey, good morning everybody.

Ron Armstrong

Good morning, Seth.

Seth Weber

I appreciate the color on the Europe market. We have been hearing some discussion about some rising dealer inventories in Europe. I am wondering if you have seen anything there with just across the industry or with DAF specifically?

Ron Armstrong

We don’t have any visibility to the industry as a whole, but I will say DAF inventory is in great shape, very similar to what we see with Peterbilt and Kenworth in North America in the 45 to 60 day range, which is really optimal to meet customer demand and not have excess inventories on the ground.

Seth Weber

Okay, thank you. And then if I could just go back to the parts business for a minute, I know in prior quarters, FX has been a headwind there. I mean, are you still expecting – I mean, was it a headwind here in the quarter and are you still expecting kind of the low to mid single-digit growth for the parts business this year? And then I guess, just separately, could you give us what FX impact was for the company for revenue and operating income altogether?

Ron Armstrong

So for the parts business, we are getting pretty close now where foreign exchange rates have been pretty comparable. A little bit of effect on revenue, I think, it was $10 million in the parts business in the first quarter. And I will let Michael sort of comment on the overall effects for the company.

Michael Barkley

For the truck parts and other, net sales and revenue impact was $68 million and the impact on financial services revenues was $9 million and the impact on profitability was negligible.

Seth Weber

Okay. And then just – sorry on the parts outlook for the year, is sort of low to mid single-digits is still the right way to think about it or how you are thinking about it?

Ron Armstrong

Yes, I think we will see a return to growth as we progressed through the year. I think parts sales globally could be up towards the 3% range for the year.

Seth Weber

Terrific. Thank you very much.

Ron Armstrong

Thank you.

Operator

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

Joe O’Dea

Hi, good morning.

Ron Armstrong

Good morning, Joe.

Joe O’Dea

Just a question relative to the order share and we don’t typically see those kinds of swings then translate into retail sales, but given that kind of order of magnitude, do you think that, that creates any more volatility over the course of the year or based on the timing of when those orders are scheduled to ship, would you not see any kind of disruption?

Ron Armstrong

No, I don’t think the orders create any additional volatility. They just bolster the backlog. And I think because of our – we build the truck when we have an order. We don’t build for inventory. We prudently manage our build schedule and so the fact to that we had 37% of the orders just reflects that we have got customers really appreciating the vehicle and ordering for what they need for the coming couple of months.

Joe O’Dea

Okay. And do you have kind of a targeted share, where you think your share will be in the U.S. and Canada for 2016 on retail?

Ron Armstrong

Yes. So last year, we were 27.5%. So I think we will be slightly above that for the full year in terms of retail sales.

Joe O’Dea

Great. Thanks very much.

Ron Armstrong

Sure.

Operator

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

Adam Uhlman

Hi, good morning guys.

Ron Armstrong

Good morning Adam.

Adam Uhlman

I guess first a clarification, I might have missed it, but did you mention the magnitude of the used truck pricing that you are seeing right now and if not could you tell us kind of want that trend has been looking like recently and when you would expect to see a stabilization in used truck prices?

Ron Armstrong

I think we are starting to see a stabilization during the quarter from the, say fourth quarter into the first quarter. It was probably a 5% to 10% impact for the market as a whole. The good news is that the Peterbilt, Kenworth and DAF products continue to maintain their premium relative to the competition in 10% to 20% range.

Adam Uhlman

Okay, got it. And then back to the share of orders that you got in North America, congrats on pointing those. Could you tell us what the first quarter of last year’s share was or what the year-over-year order growth was for you?

Ron Armstrong

I don’t think we have that number readily at hand. So we will have to come back to you on that.

Adam Uhlman

Okay. And then the record share at DAF, you had mentioned that there was a good breadth of strength in share across the continent, I am wondering if you believe that this, directionally, that this level of retail share can persist for the rest of the year?

Ron Armstrong

DAF in 2012, ‘13, was in the 15%, 15.5%, 16% range. So yes, I believe this is probably more consistent. We had some interruptions if you will with the Euro 5, Euro 6 transition. And I think this is more indicative of where DAF’s position in the market.

Adam Uhlman

Got it. Thank you very much.

Ron Armstrong

Thank you.

Operator

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

Mike Shlisky

Good morning guys.

Ron Armstrong

Good morning.

Mike Shlisky

So in your release you actually mentioned you are going to be expanding your Denton facility in the near future to expand the capacity there, I guess I was kind of wondering this past year was a very, very strong year for Class 8 in 2015, I don’t think you had too many problems delivering to your customer, so I guess what’s being expanded attention that’s so important and when can we start seeing some of the margin benefits from that expansion?

Ron Armstrong

Well, you see the margin benefits, whenever we get it finished and we are utilizing the facility. But as you go through the cycles, you identify opportunities to continue to make your facilities and your processes more capable. And this is just sort of the continuing effort that we go through and have gone through for 110 years of the company of continuing the best during all phases of the business cycle to be able to be prepared, one, to get the efficiencies, but also to get that incremental capacity. The penetration of the 2.1-meter products both at Peterbilt and Kenworth has been outstanding and we continue to invest in the robotic capacity in those facilities. And this is just part of that overall process that we go through throughout our history of making good prudent investments that prepare us, not only for today, but also for tomorrow.

Mike Shlisky

So it’s more efficiency gains and it’s not intended to substantially increase the number of parts you can make in a year, just you just make them faster or better?

Ron Armstrong

It’s a combination of both, yes.

Mike Shlisky

Okay. And then just one quick model question for you as well, could you give us the diluted share count adjusted if you had not posted a loss for the last year – for the quarter?

Bob Christensen

It would have been 351.9.

Mike Shlisky

Okay, perfect. Thanks guys. I appreciate it.

Ron Armstrong

You bet.

Operator

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

Robert Wertheimer

Hi. Thanks for the commentary, great results.

Ron Armstrong

Thank you.

Robert Wertheimer

Are you able to talk just a little bit about how you are approaching the 11-liter launch and any numbers you are willing to update on the penetration in Europe and the U.S.?

Ron Armstrong

Yes. So the MX-11, as you know we have launched that in Europe in the fourth quarter of 2013. It’s been very well received in Europe by both our truck customers, as well as we sell several thousand engines each year to bus and coach customers and that has become the engine of choice of those bus and coach customers for their applications. So 2 years of experience in Europe and launched it in January this year in North America and the launch has gone very well. I was recently on a trip visiting with some of our customers and there is a lot of interest by a lot of different types of customers particularly those that are sensitive to weight, because its 400 pounds lighter than our other offering. And so it’s a very attractive option. And so the launch has gone good. The customers who have put that into their product early days is performing as expected. And we will continue to ramp that up as we progress through the course of this year.

Robert Wertheimer

That’s perfect and do you launch it in many models at once or is it just sort of a stage thing where we can expect to take a couple of years to be fully out there in the fleet?

Ron Armstrong

It will be a stage. I mean we are purposely ramping up both the plant so that they get more comfortable with the assembly process. But early days is very promising.

Robert Wertheimer

Okay, thank you.

Ron Armstrong

Thank you.

Operator

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

Ron Armstrong

We would like to thank everyone for their excellent questions. And thank you, operator.

Operator

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

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