Cummins Inc

NYSE:CMI

Earnings Call Transcript 2018-Q2

[Operator]

Good day, ladies and gentlemen, and welcome to Cummins Incorporated's Second Quarter 2018 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be provided at that time. And, as a reminder, this conference call is being recorded.

I'd now like to turn the conference over to Mark Smith Vice President of Financial Operations. Please go ahead.

[Mark Andrew Smith, Cummins, Inc.]

Thank you, good morning everyone and welcome to our teleconference today to discuss Cummins' results for the second quarter of 2018. And 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'll all be available for your questions after 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 and Exchange Act of 1934. Such statements express our forecasts, expectations, hopes, beliefs and intentions on strategies regarding the future. 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 our forward looking disclosure statement and in our filings with the Securities and Exchange Commission particularly the Risk Factors section of our most recently filed annual report and any subsequently filed quarterly reports.

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

Now I'll turn it over to Tom.

[Norman Thomas Linebarger, Cummins, Inc.]

Thank you Mark. Good morning. I'll start with a summary of our second quarter results and finish with a discussion of our outlook for 2018. Pat will then take you through more details of both our second quarter financial performance and our forecast for this year.

We delivered record quarterly sales and profits in the second quarter. Revenues were $6.1 billion, an increase of 21% compared to the second quarter of 2017, with growth in all of our operating segments and most of our major geographic markets. EBITDA was $897 million or 14.6% of sales compared to $764 million or 15% a year ago.

During the second quarter we finalized our plans and our full cost estimate for our previously disclosed product campaign to address the performance of an after treatment component in certain on-highway engines produced between 2010 and 2015. In determining the best course of action to support our customers we have elected to increase the number of after treatment systems to be addressed through hardware replacement compared to our estimate last quarter.

As a result we recorded a charge of $181 million or 3% of sales in the second quarter and we believe that we have now fully you provided for the expected costs of this campaign. The charge was shared between the Engine and Components segments. We've reached agreements with the appropriate regulatory agencies regarding our proposed actions and we will launch that campaign in phases starting in the third quarter this year and expect to substantially complete the campaign by the end of 2020. This issue does not affect any of our current products which are performing very well and our market share remains strong.

And to that point Engine business revenues increased 17% compared to a year ago due to strong demand in on-highway markets in North America and growth in construction markets in both China and North America. EBITDA for the quarter was 13.4% of sales compared to 14% a year ago. EBITDA percent declined as the benefits of higher volumes, improved pricing and increased joint venture earnings in China were more than offset by a $91 million charge related to the product campaign.

Sales for our Distribution segment grew by 16% year over year driven by higher demand for new engines, parts and service in off-highway markets as well as some targeted price increases. Second quarter EBITDA was 7.3% compared to 7.4% in the second quarter of 2017. EBITDA increased 14% in dollar terms but declined slightly as a percent of sales due to a lower mix of parts sales. Second quarter revenues for the Components segment rose by 30%. Sales in North America increased 36% and revenues in international markets grew 22% as a result of rising market demand, strong market share and the success of new products aimed at lowering emissions.

Sales of the Eaton Cummins Automated Transmission business contributed 10% to Components' segment growth. EBITDA for the second quarter was 12.6% compared to 15.7% in the same quarter a year ago. EBITDA declined as the benefits of stronger sales and material cost reduction programs were more than offset by the charge of $90 million related to the product campaign.

Power Systems sales in the second quarter grew 23% year over year driven primarily by higher demand for power generation equipment and an increase in sales to oil and gas and mining customers. EBITDA in the second quarter was 14.9% compared to 8.8% a year ago. The benefits of stronger volumes, improvements in quality, cost reduction programs and stronger joint venture earnings in China all contributed to EBITDA margin expansion.

In our Electrified Power Train business, second quarter EBITDA was a loss of $21 million in line with our projections. Given the potential for this technology, especially in urban and short range applications, we will continue to invest in development and new product programs ahead of broad market adoption.

Now I will comment on the performance of some of our key markets for the second quarter of 2018 starting with North America and then I'll cover some of our largest international markets. Our revenues in North America grew 22% in the second quarter due to growth in demand in most of our end markets and the ramp up of the Eaton Cummins Automated Transmission joint venture.

Industry production of North American heavy duty trucks grew 20% in the second quarter of 2018 while sales of our heavy duty engines increased by 38%. Our year to date market share through May was 33% in line with last year.

Industry production of medium duty trucks improved 16% in the second quarter while our engine shipments grew 15%. Year to date our market share in the medium duty truck market was 81% through May up from 79% a year ago.

Total shipments to our North America pickup truck customers were decreased by 20% compared to a year ago due to a short-term adjustment to production by one of our OEM customers.

Engine sales for construction equipment in North America increased 18% in the second quarter reflecting general strength in the economy. Engine shipments to high horsepower markets in North America rose 42% compared to a year ago driven by higher demand in both oil and gas and mining customers. And revenues for power generation grew by 9% due to higher demand in the data center and recreational vehicle markets.

Our international revenues increased by 18% in the second quarter of 2018. Second quarter revenues in China including joint ventures were $1.4 billion an increase of 9% due to higher sales and off-highway markets. Industry demand for medium and heavy duty trucks in China increased by 13% compared to a year ago.

Year-to-date our market share was 11% through June compared to 14% last year. We are confident that we'll regain this market share as we increase penetration of our engine at Foton, ramp up our new market, our new partnership with JAC and launch new products for NS VI with all of our partners in China.

Industry sales of light duty trucks grew by 25% in the second quarter and our engine market share was 7%. Demand for excavators in the third quarter increased 74% from a year ago in China. Our market share through June increased to 14%, up fully 2% year-over-year, driven by strong performance by our OEM partners.

Revenues for our Power Systems business in China increased 53%, due to growth in engine shipments to mining customers and higher demand for power generation equipment for data centers.

Second quarter revenues in India, including joint ventures, were $575 million, an increase of 33% from second quarter a year-ago. Industry truck production more than doubled year-over-year following the introduction of broad Stage IV regulations in April last year. Year-to-date market share was 42% through June, up 2% from 2017, with Tata trucks powered by our new BSIV compliant engine systems. In Brazil, our revenues increased by 29%, primarily due to a moderately recovering economy resulting in improved demand for trucks compared to a weak 2017.

Now, let me provide our overall outlook for 2018 and then comment on individual regions and end markets. We are now forecasting total company revenues for 2018 to be up 15% to 17%, higher than our previous guidance of up 10% to 14%, reflecting a stronger outlook for industrial, power generation and construction markets as well as stronger market share in North America on-highway markets.

We are maintaining our forecast for industry production of heavy duty trucks in North America at 286,000 units, up 29% compared to 2017. We expect our market share to be between 31% and 34%, which is unchanged from our last quarter. However, we now expect to be at the higher end of this range.

In the medium duty truck market, we've increased our forecast for industry production to reach 133,000 units, up 13% year-over-year and above our prior forecast of 124,000 units. We expect our market share to be in the range of 75% to 78%, an increase from our prior guidance of 72% to 75%.

We expect our engine shipments for pickup trucks in North America to be flat for the full year of 2018 compared to a very strong 2017. In China, we expect domestic revenues, including joint ventures, to be up 1% compared to our previous guidance of being lower by 2% in 2018. We have raised our outlook for medium and heavy duty truck market demand slightly to 1.3 million units from our prior forecast of 1.2 million units, representing a flat market compared to last year.

In the light duty market, we now expect growth of 5% in 2018, up from our previous guidance of no growth. We expect our market share in the medium and heavy duty market to be 12%, up from the first half of this year but down from our prior forecast at 14%.

In light duty, we expect our full year share to be 7% compared to our previous guidance of 8%. In India, we expect total revenues, including joint ventures, to be up 18% year-over-year, lower than our previous forecast of growth of at least 20% due to a lower outlook for truck demand.

Earlier this month, the Indian government surprised the industry by introducing regulations that allow higher loads per vehicle. The new regulations have caused a sharp decline in truck sales, as customers await upgraded models from OEMs in response to the regulations. Underlying demand for trucks remains strong and we expect growth in truck sales to resume once OEMs and customers adjust to the new regulations.

In Brazil, we now forecast truck production to increase 20% in 2018, up from our previous guidance. We expect our global high horsepower engines to increase 35%, up from our previous forecast of 30%, reflecting strong demand from mining customers and an improved outlook for sales of power generation equipment.

In summary, we have raised our full year outlook and expect to deliver record sales, EBITDA, operating cash flow and earnings per share in 2018. We revised our forecast for EBITDA to be in the range of 14.8% to 15.2%, down from our previous guidance of 15.4% to 15.8% with the benefit of stronger sales offset by the charge for the product campaign in the second quarter and the addition of approximately $100 million of trade tariffs and tariff-related cost inflation in the second half of the year.

Full year incremental EBITDA margins are projected to be 20%, excluding the impact of the Eaton, Cummins joint venture and our electrified power train business, but including both the product campaign and the tariff-related costs.

During the quarter, we returned $393 million in cash to shareholders in the form of dividends and share repurchases and recently announced a 5.6% increase in our quarterly cash dividend. We now plan to return 75% of our operating cash flow to shareholders in 2018, up from our previous plan to return 50%.

At our Analyst Day last November, we discussed several growth platforms that we're working on to drive future profitable growth. For each platform, we said that we would evaluate the best options for growth between organic investment, partnerships and acquisitions and we continue to make progress in executing this strategy.

Consistent with our goal to be a leader in electrified power trains for commercial vehicles, we recently announced that we will acquire Efficient Drivetrains, Inc. or EDI. Based in Milpitas, California, EDI develops and produces hybrid and fully electric power solutions for commercial vehicle applications.

The acquisition of EDI will complement our existing capabilities in electrified power trains and we expect to complete the acquisition in the third quarter of this year. For those of you planning to attend the IAA truck show in Hannover in September, you'll have the opportunity to view a range of Cummins products, including our electrified power trains and commercial vehicles.

In discussing our plans to grow in attractive markets last November, we covered an approach to growth in the light commercial vehicle market which we said would be likely through consolidation or a partnership. And we said that we would pursue with discipline acquisitions that could increase our participation in larger horsepower, power generation, oil and gas, rail and marine markets.

In May, we announced plans to form a joint venture with JAC Motors in China, building on our 20 year relationship between the two companies. This joint venture will be focused on the light commercial vehicle in China the largest market in the world and global export markets.

In forming this new alliance, Cummins will acquire Navistar's interest in the joint venture with JAC. The change in ownership will go into effect upon completion of regulatory reviews and we are continuing to actively pursue acquisitions and partnerships in the larger horsepower industrial markets.

Thank you for your interest today. We had a strong quarter and are on track for record full year results, extending our track record of proving performance over prior cycles and continuing to return cash to shareholders. We are also making significant strides in executing our strategy to drive more profitable growth in the future.

Now let me turn it over to Pat.

[Patrick Joseph Ward, Cummins, Inc.]

Thank you, Tom. Good morning, everyone. I will start with a review of the company's second quarter financial results before discussing the performance of the operating segments in some more detail. I will then provide an update on our outlook for the remainder of the year.

Second quarter revenues were $6.1 billion, an increase of 21% from a year ago and a quarterly record for the company. Sales improved in each of our operating segments driven by stronger demand in global on-highway, industrial and power generation markets. Sales in North America which represented 59% of our second quarter revenues grew 22% from a year ago, due to increased sales of engines and components to entire levels of heavy and medium duty truck production and stronger demand for industrial engines.

Our international sales increased by 18% from a year ago, due to higher demand in China, India, Europe and Latin America for on-highway construction and industrial markets as well as benefiting from a weaker U.S. dollar.

Gross margins were 23.5% of sales down from 24.6% a year ago, primarily due to the product campaign charge that Tom just discussed. The campaign charge negatively impacted our gross margin by 300 basis points offsetting the positive effects of the stronger volumes, favorable pricing and material cost reductions.

Selling, admin and research and development cost of $832 million were $51 million higher than last year with most of the increase occurring in research and development. As a percent of sales, selling, admin and research and development spending was 13.6%, a decrease as a percent of sales by 180 basis points from a year ago.

Joint venture income of $110 million increased by $12 million compared to last year. Earnings before interest and tax, depreciation and amortization were $897 million, or 14.6% of sales for the quarter compared to $764 million, or 15% a year ago. EBITDA as a percent of sales declined due to the campaign charge which more than offset the benefits realized from the stronger operating performance in the quarter. Excluding the campaign charge EBITDA was $1.1 billion or 17.6% of sales.

Net earnings for the quarter were a record $545 million or $3.32 per diluted share compared to $424 million or $2.53 from a year ago. Effective tax rate for the second quarter was 22.5% in line with our full year guidance of 23% and down from 26.4% last year.

Moving on to the operating segments. Let me summarize their performance in the quarter and the outlook for the full year and then I will review the company's revenue and profitability expectations for the full year and conclude with some comments on cash flow.

In the Engine segment, revenues were $2.7 billion in the second quarter, an increase of 17% from last year, due to a 16% growth from on-highway sales and a 20% increase in off-highway revenues primarily due to growth in construction markets.

Segment EBITDA in the second quarter was $362 million or 13.4% of sales. This compares to $323 million, or 14% from a year ago. The benefits from the stronger volumes, higher contribution from joint ventures and very good operating leverage were partially offset by the campaign charge and investment in new products. Including the campaign charge, EBITDA margins for the segment were 16.8% in the quarter.

We now expect full year Engine segment revenues to be up 17% to 19% compared to our previous guidance of up 10% to 14% due to continued strength in North American truck and international construction markets. We are forecasting EBITDA margins to be in the range of 13.25% to 13.75% of sales which includes the campaign charges booked in the first half of the year and compares to 13.5% to 14% in our previous guidance.

For the Distribution segment, second quarter revenues were $2 billion, an increase of 16% compared to last year. The growth in sales was primarily driven by higher demand for both new engines and parts and service in North America, favorable pricing and the impact of a weaker U.S. dollar.

EBITDA margins for the quarter increased by 14% to $145 million or 7.3% of sales which compares to $127 million or 7.4% a year ago. The EBITDA percent declined due to a lower mix of parts sales. For 2018, distribution revenue is now projected to increase 9% to 11% compared to our previous guidance of up 6% to 10% due to strong off-highway demand for engines and parts. We are now forecasting EBITDA margins to be in the range of 7% to 7.5% of sales versus our previous guidance of 7.75% to 8.25%.

For the Components segment, revenues were $1.9 billion in the second quarter, a 30% increase from a year ago and a quarterly record. The Eaton, Cummins joint venture contributed 10% to growth. Sales in North America increased 36% due to higher medium -- higher heavy and medium duty truck production while international revenues grew 22% as a result of strong growth in Europe and India and the depreciation of the U.S. dollar.

Segment EBITDA was $237 million or 12.6% of sales compared to $228 million or 15.7% of sales a year ago. The positive impact of the higher sales and favorable material costs were offset by the product campaign charge. Excluding that campaign charge, EBITDA margins were 17.3% of sales in the quarter.

For 2018, we now expect revenue to increase 23% to 25% compared to our prior guidance of up 18% to 22%. Stronger than expected demand in both the North America truck market and in Europe are the main contributors to the improved outlook. EBITDA is projected to be in the range of 14% to 14.5% of sales which includes the campaign charges booked in the first and second quarter compared to 15.25% to 15.75% in our previous forecast.

In the Power Systems segment, second quarter revenues were $1.2 billion, an increase of 23% from a year ago. Industrial sales rose 37% as a result of stronger oil and gas and mining demand. Power Generation sales grew by 17% as a result of higher demand for Power Gen Equipment in North America and in China.

EBITDA more than doubled in dollar terms to $186 million or 14.9% of sales in the quarter, up from $90 million or 8.8% last year, driven by the positive impact of the higher sales, favorable material costs and higher joint venture earnings. For 2018, we now expect Power Systems segment revenues to increase 15% to 17% versus our prior guidance of up 7% to 11% as a result of stronger demand in industrial and power generation markets.

EBITDA margins are forecasted to be between 13.5% and 14% of sales compared to our previous guidance of 13% to 13.5%. And in the Electrified Power segment, EBITDA losses were $21 million due to our investment in new products. For the full year, we expect a net expense of between $60 million and $80 million in line with our previous guidance, as we continue to invest in new products.

And as you heard from Tom, for the company we're raising our outlook for revenues to be up 15% to 17% this year versus a previously guidance of up 10% to 14%. The increase is driven by continued strength in North American on-highway markets and an improved outlook in power generation, construction and mining markets.

For foreign currency, primarily driven by a weaker U.S. dollar is expected to increase revenues by approximately $100 million this year. Income from our joint ventures is now expected to be flat in 2018 compared to our previous guidance of down 10%. We're forecasting EBITDA margins to be in the range of 14.8% to 15.2% for 2018, down from our previous forecast of 15.4% to 15.8%. Full year incremental EBITDA margins are forecast to be 20%, which excludes the impact of the Eaton, Cummins joint venture and the electrified powertrain business, but does include all the campaign and tariff related costs.

Turning to cash flow. Cash generated from operating activities for the second quarter was $590 million, $143 million higher than last year. Capital expenditures during the quarter were $114 million bringing the year-to-date total to $186 million. And we still expect the full year capital expenditure will be in the range of $730 million to $760 million.

In the second quarter we returned $393 million to shareholders through dividend payments and share repurchases. For the first six months of this year we have returned $734 million, which includes the repurchase of approximately 2.5 million shares.

As Tom mentioned, our Board of Directors recently authorized an increase in our quarterly dividend of 5.6% to $1.14 per share and we now plan to return 75% of operating cash flow to our shareholders this year in the form of dividend and share repurchases.

In summary, we had a very strong operating performance in the second quarter. And we are on track to deliver record sales, EBITDA, operating cash flow and earnings per share in 2018.

And before I turn back over to Mark, I would just like to take a minute to recognize and thank Adam Schumm for all his contributions in investor relations over the last 2.5 years as he prepares to move on to his new role in our Emission Solutions business. And at the same we'd like to welcome James Hopkins who is taking over from Adam into Investor Relations.

Now let me turn it back over to Mark.

[Mark Andrew Smith, Cummins, Inc.]

Great. Thanks Pat. Now we're the ready for questions. We do have plenty of time available. So please, if you can limit your first question to one question and one related follow-up and then get back in queue. Thank you very much. We're ready to start.

[Operator]

Thank you. Our first question comes from Adam Uhlman with Cleveland Research. Your line is now open.

[Adam Uhlman, Cleveland Research Co. LLC]

Hi. Good morning, everyone.

[Norman Thomas Linebarger, Cummins, Inc.]

Good morning, Adam.

[Adam Uhlman, Cleveland Research Co. LLC]

Yeah, I was wondering if we could start with the discussion around material costs. It sounds like that was favorable across several segments, Components and Power Systems and others. Could you expand your expectations for the second half of the year? And then related to that how you're thinking about price realization for the second half of the year?

[Richard Joseph Freeland, Cummins, Inc.]

Okay. Hey, Adam, this is Rich. Let me start with that. I'll just talk a little bit since we referenced it, the whole pyramid of metal markets, material costs and tariffs, and then we can come back to impact kind of for the second half. So, roughly, the way I think you should think about it is, it's about $200 million of impact to the company annually. So roughly half of that in the second half of this year. And it's split between material costs, so metal market increases and tariffs about 50%-50%. And the way that we'll manage the kind of the metal market material cost piece of that is through contracts we have, both with suppliers and with customers.

And so there can be a lag effect on those, but we'll manage those through the channel kind of over two to four quarters; a little faster in components, a little slower in engines. From a tariff standpoint, so again half of that $200 million, there's a couple actions we'll take which relates a little bit to your question. So we can make some short term supply chain changes, where we already have supply bases set up around the globe. And maybe a third of those we can mitigate in the shorter term. The balance of that, of the tariff-related, will either be done through pricing, much of that you'll see a little bit yet in the second half, but most of that will begin in 2019, and also we'll look at kind of longer term supply chain changes to address that.

[Norman Thomas Linebarger, Cummins, Inc.]

Adam, it's Tom. The only thing I'd add is we've been pretty successful in finding cost reductions in our material cost area. That's, you mentioned the first half being favorable. We are still seeing, we have been in an inflationary environment but we've been working hard to find reductions.

Our view, in our industry, is we have the most efficient supply chain from a cost point of view. We've got a very effective global supply chain. We have a bunch of folks on the engineering and purchasing side that work to find reductions all the time. And so we're getting that net $50 million benefit from cost reduction every quarter in the last couple quarters. And that was hard work and we feel great about that. We're going to continue that work. That doesn't change.

The frustrating thing about the tariffs and steel and aluminum tariffs as well is they just drive inflation. So what's happening is we're just adding taxes and inflation to our cost structure, which was already inflating given how strong the economy was. So that's just going to drive more cost into the business. We'll do our best to pass that on to other people. And, of course, readjusting our supply chain to deal with tariffs is frustrating because it's a really cost effective and efficient supply chain. It is what it is. We'll have to do it, but it's a frustrating situation to be in considering how well we're positioned today as a manufacturer with our global supply chain.

[Adam Uhlman, Cleveland Research Co. LLC]

Okay. Got it, thank you. And then, secondly, on the lowered truck market forecast for India, I'm wondering if the weight regulation change means that there could be a change in the size of engines that your OEM customers are looking to buy going forward.

[Richard Joseph Freeland, Cummins, Inc.]

Yes. It's a good question. I think what we're sorting through, kind of the timing of the new introduction. It's a positive to us. So it's going to move to bigger engines. We're positioned really well, especially in the six cylinder side, where Tata uses their own engine at the four cylinder. So we're going to learn how you move up into a higher horsepower, which will be a positive for us.

[Adam Uhlman, Cleveland Research Co. LLC]

Great, thank you.

[Mark Andrew Smith, Cummins, Inc.]

Thanks, Adam.

[Operator]

Thank you. Our next question comes from Jerry Revich with Goldman Sachs. Your line is now open.

[Jerry Revich, Goldman Sachs & Co. LLC]

Yes, hi. Good morning, everyone.

[Mark Andrew Smith, Cummins, Inc.]

Hi, Jerry.

[Norman Thomas Linebarger, Cummins, Inc.]

Hi, Jerry.

[Jerry Revich, Goldman Sachs & Co. LLC]

Tom, wondering if you could talk about how the JAC acquisition fits in within the broader China partnership structure for you folks? What's the ultimate market share opportunity that you folks are targeting now? Does that add to the 20% target you had before? And then, from a near term standpoint, you mentioned the lower market share in the quarter. I'm wondering if you folks can just flesh that out a bit in terms of the path to get back towards prior year market share levels too?

[Norman Thomas Linebarger, Cummins, Inc.]

Yeah. Thanks for that, Jerry. Yeah, you highlighted, the China situation, we've gone backwards a little bit in market share. I mean, our business has been great, the market's been incredible. So our business has been doing well, but our market share has dropped a little bit, and we could have been doing even better. And part of that was related to the quality issues we had with the ISG some time ago. We have now resolved those, but we're still regaining penetration at Foton, as a result of that. We feel confident we will do that. I was just in China. I met with Foton and we've been meeting with them extensively. We're very confident that we will restore penetration into the heavy-duty market and that will drive up some.

Second thing is, this JAC partnership fits in and since that there is a very large light-duty market, it's the largest one in the world in China. Plus, JAC also has a relatively significant export market. Again, they're mostly targeting markets that are similar emissions levels to China. So, and of course that would, as China moves to China 6, that expands their potential export markets. They make an inexpensive, but quite capable small truck. So we're happy to add them into the partnerships.

We see that as being able to drive our light-duty market share from something like 7% or 8% today to 15% over some number of years. Our plan says five. We'd like to move faster, but our plan says five years, we get back up to 15% plus.

So with that, and the heavy-duty penetration and then at NS VI, that's, again we'll have another shake out where some of the smaller players will be unable to get to China 6. That's a very, very tough standard. And we think our partners, using Cummins engines, will again gain share, which we think will bring us back to our old numbers and passed again.

We need to get a little further on the NS VI. We'll work to kind of figure out exactly where we'll get by when. But, that's what I said in my remarks, I'm highly confident that we will get back to our old market share numbers and passed again based on these three things.

The JAC numbers, again they'll take a little bit to ramp up, because we're just getting started with them. It's not even approved yet. But I think the Foton work will start. We're probably at our low point today. So in the next few quarters, we'll start to see that ramp back up again, and then China 6 and JAC follow on.

[Jerry Revich, Goldman Sachs & Co. LLC]

Okay, great. Thank you. And then, it was nice to see the better operating leverage in Power Systems. Can you just talk about whether you folks are completely done with the manufacturing transition that you're working through and consolidating some of the facilities and just give us an update if you think we're on a path to meaningfully improved incremental margins starting with this quarter?

[Richard Joseph Freeland, Cummins, Inc.]

Okay, Jerry. Thanks. Yeah. I'm really pleased with the progress that's been made there. It's kind of been a three-year journey both in taking cost out, restructuring that business, and gaining share and introducing new products. And so you saw that kind of for the first time coming through. We've introduced a lot of the cost saving pieces, but there's still another -- there's still a piece left which was our plant closure that in Stanford that we're just now finishing. So, we've had, it's actually been a negative synergy this year. So we've had the restructuring costs. We'll have an additional $20 million savings with that one beginning in 2019. So lots of good work there kind of from cost, product introduction, market share gain; I feel really good about it.

[Norman Thomas Linebarger, Cummins, Inc.]

And then, Jerry, we're really at mid-cycle there too. So our view is that not only are we're seeing the benefits of the costs, but we're also really midway through the ramp. So we expect to continue to see benefits from increased revenues as plants get fully utilized and we feel good with our supply chain, we're having to work hard to make sure our supply chain stays on good lead times. But that's the work we're good at, so we feel confident about that.

[Jerry Revich, Goldman Sachs & Co. LLC]

Okay, thank you.

[Operator]

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

[Jamie L. Cook, Credit Suisse Securities (NYSE:USA) LLC]

Hi, good morning. I guess two questions. One, Tom, just a little more color on the decision to return 75% of operating cash flow to shareholders. I mean is that to signal larger M&A is over? Or is that just signaling you think your stock is really cheap right now and we're all missing something? So I'm just trying to understand what you're trying to tell the market with that statement.

And then my second question, can you comment on any markets where you have visibility into 2019 because lead times are extended, and that is I think about sort of normalized incremental margins. I'm just thinking about 2019 versus 2018. I'm assuming the product campaign costs, obviously, they go away. Is the JV and EV investment, does that change, I mean at all in (37:26) sort of risks that tariffs or price increases are an incremental negative to 2019 because some companies are already talking about that. So I'm just trying to think about, how I think about one-time items in 2019. I can make my own forecast on the end markets? Thanks.

[Norman Thomas Linebarger, Cummins, Inc.]

Thanks Jamie. Thanks for those questions. So on the 75%, as I mentioned in my remarks -- in my opening, we are continuing with our strategy. So we are still seeking to drive partnerships or acquisitions in the large power area. We're still driving, trying to drive growth in our distribution and telematics area. So the strategy hasn't changed, but what we are trying to signal with the 75% is three things really. Number one, our performance this year is really good. Our cash flow is really good. And our needs for investing in the business are less than the cash flow we're generating. And so we want to make sure that we don't need to inventory cash. We have very strong balance sheets. We can return cash flow to shareholders and still meet all our needs and that's a good thing.

Second thing is that there are no imminent needs for the cash. Obviously if we were months away from a large acquisition we would not do that. But, so what we are seeing is that we are not imminently doing things. We are still actively working on that. And again there's been a lot of rumors and things about what we've been involved with. I think what I guess I wanted to remind everyone is that our intent in all of our growth partnerships, acquisitions, et cetera, is to remain disciplined and to make sure that the result of the acquisition is a positive impact for shareholders not just more revenue.

And so we're continuing to do that and as we look at the field today we are active. There are a number of things which would be attractive to put into Cummins, but right, we just don't see it eminently happening. But we are active on a number of partnerships and acquisitions as we, we announced two more this quarter and we will continue that. So the signal is still moving but nothing imminent. I think that'd be the safest way to say.

And the third thing we wanted to signal is that we think the stock is significantly undervalued. I mean, it's obvious that in the last quarter with the emissions issue and maybe people getting worried about cyclical peaks that our stock got, had a pretty heavy wet blanket on it and we think it's overshot.

Our view is the earnings of the company are incredibly strong. Our incremental margins are good. And we don't think we're at the peak. We think we've got quite a bit more room to run. And, by the way, in each cycle, down cycle, we do better and strengthen again each up cycle. So we do believe, in fact, that our stock is a good investment now. So, it's all three of those things and thanks for giving me a chance to talk about that.

With regard to the – 2019, obviously we don't want to forecast 2019, but a couple things you mention I think do deserve some highlights. We are expecting to finish our warranty numbers around 2.4% this year, as Pat said. So we are coming down into that same low 2% range that we said we would get to. And we have done a lot of work to improve the quality of launches and the quality of the product. So we believe that that's going to be a good tailwind going into 2019.

In addition, from the point of view of all the tariffs and material costs, there's no question that right now we're fighting an uphill battle, but it's not clear how long all these last. It's not clear what administration plans are there.

So what we're trying to remain, is resilient as we can. We have a very cost effective supply chain. We're going to try to keep that in place. We're going to make the moves that we need to make short-term to try to minimize the impacts, we're going to pass on prices where we can, as Rich said.

But, we have a very good supply chain organization that's working to continue to drive costs down. So again we, we're planning to mitigate, I guess, is the main point. So while it's a short term a pretty nasty hit we will work hard to mitigate those plans.

And I think we will have some positive impact on those. So while it will be a headwind, we'll make this headwind smaller by the time we get to next year. So those are both worthy of commenting on.

[Jamie L. Cook, Credit Suisse Securities (NYSE:USA) LLC]

Okay. Thank you. I'll get back in queue.

[Norman Thomas Linebarger, Cummins, Inc.]

Thanks, Jamie.

[Operator]

Our next question comes from Alex Potter with Piper Jaffray. Your line is now open.

[Alexander Eugene Potter, Piper Jaffray & Co.]

Hi guys.

[Norman Thomas Linebarger, Cummins, Inc.]

Hi how are you?

[Alexander Eugene Potter, Piper Jaffray & Co.]

I'm doing okay. A couple questions both related to China. So first on the JAC joint venture was just wondering if you could comment on the risk of any overlap or perceived overlap with the Foton 2.8 and 3.8 liter engines to the extent that that creates any I guess friction between your two OEM partners?

[Norman Thomas Linebarger, Cummins, Inc.]

Yeah. I mean both Rich and I have spent time with Foton recently about that and there's no question there was some friction about it. They do compete in the market.

And by the way we're -- this is a thing we deal with everywhere. We're an independent engine maker, so everyone loves the fact that we're independent. So, we have lots of volume and we'll work with them but then they're annoyed that we work with their competitors.

It's both, right? It's always both. And so I think those are things that we work through pretty regularly. We, they were frustrated, we did have a lot of discussions. I think we're through that now.

I think that Foton has now said that we understand where our opportunity to work with you is and they're excited about that. Again Rich had good discussions. Anything you would add Rich?

[Richard Joseph Freeland, Cummins, Inc.]

No, I mean like we always do, in building scale try to find win-wins in this. So we will be able to utilize existing capacity and share that across the different ventures to help mitigate that so everyone will see a lower cost out of it too. It's a piece we always try to implement.

[Alexander Eugene Potter, Piper Jaffray & Co.]

Okay. Very good. And the second one I know this is maybe a bit of unfair given the amount of uncertainty here with tariffs and everything. But was wondering whether you've had the opportunity to reevaluate or look more closely at the plan to import the 12 liter blocks from China into the U.S. Class 8 market, the extent to which the landscape has changed at all? Clearly, trading things between China and the U.S. looks as though it's going to become incrementally more difficult. So I guess any comments on that as well as maybe an update on that program in general would be helpful? Thank you.

[Richard Joseph Freeland, Cummins, Inc.]

No it's a very fair question and we've been looking at it. So we do pick-up some headwinds on some tariffs that hit some of the products that we're introducing. At this point, the high dollar ones, the block and head are not included on the tariff list. And so I think we feel pretty good we can mitigate those costs that are coming in. It's a nice low cost engine that we've got. We're able to use the scale we've got in India, the whole strategy of -

[Norman Thomas Linebarger, Cummins, Inc.]

In China.

[Richard Joseph Freeland, Cummins, Inc.]

I'm sorry. Thank you. In China, introducing the product in China, building scale, building a low cost supply base and then moving it across. So, we give back a little bit of that with this plan, but we're going to move – we're moving ahead with the program.

[Norman Thomas Linebarger, Cummins, Inc.]

And by the way, sorry for this paid political announcement, Alex. But this is a little bit of my frustration is, that product was developed with engineers, purchasing people, et cetera, a whole bunch of people in the U.S. And so the fact that we might use some of the volume or some of the components from China to help build up and then of course assemble in the U.S. and have assembly jobs here that we might lose those because of this tariff. It just seems exactly backwards of what we're trying to achieve. So it does seem, I get, to say that I'm frustrated with this would be a understatement. And again, I'm hopeful that what we're in for here is a lot of tariffs to get everybody to the table and then we get to the table and then we take this away, because this doesn't seem to be helping very many people.

So I'm, that's what I'm hopeful for. But in the meantime as Rich said we are actively looking for ways to mitigate and to figure out which of these things we keep in place, the supply chain to keep in place and which ones, if they have longer term impacts, we switch around.

[Alexander Eugene Potter, Piper Jaffray & Co.]

Okay. Understood. Thanks guys.

[Operator]

Thank you. Our next question comes from Noah Kaye with Oppenheimer. Your line is now open.

[Noah Kaye, Oppenheimer & Co., Inc.]

Good morning. Thanks for taking the questions. So you kept your NAFTA Class 8 outlook intact. At this point, is that mainly a function of production capacity? How backed up do you see orders? And what does that tell us as an early indicator for 2019?

[Richard Joseph Freeland, Cummins, Inc.]

Yeah, Noah, exactly right. So, when we looked at the backlog, right now the backlog at 235,000 units, is the highest it's been since July of 1999, okay? So it's a very robust backlog. I think you're going to see that backlog continue through the end of the year just for the reason you gave. So the OEMs, the truck production is being constrained by a variety of supplier constraints. I think you might see some relief here and there. But, I think that limits how quickly the backlog can be addressed and how much production will go up the second half of the year. So it gives me a little more bullish that we're going to end the year, this year, with a really strong backlog. And again, the fundamentals look pretty good also. I mean, the retail sales, the stuff we all look at, the freight, the rates. And so the underlying fundamentals are pretty good. The, and like you said, the production is being constrained right now. So I think that bodes well for us going into 2019.

[Noah Kaye, Oppenheimer & Co., Inc.]

Great. And then, if we can get an update on your electrification program, seeing that spending ramp up and you did agree to acquire EDI this quarter, as you mentioned. So, now you'll have a short haul Class 8 offering with actually a track record in trains and bus (47:50). And we are seeing that short haul market appear to be developing. Some of the industry data we've seen, as playing to several tens of thousands of confirmed orders for electric trucks and buses to be delivered over the next six year. Wondering if you could provide us with some color on any pre-orders you're seeing for your electric power train offering? And just generally how we should think about the state of the program?

[Norman Thomas Linebarger, Cummins, Inc.]

Yes, I think from a segment point of view, you've got it right, that essentially transit bus is the number one, where I think if we have a good offering, we'll have customers that want it. It's, in transit buses the big cities especially have committed to moving towards electric or hybrid or some combination of these things. And they're wanting to step by step it, because the charging infrastructure and all the challenges related to running electric powertrains are still in front of most of them. They don't have that all figured out. But they all want them. And so our first launch at the end of next year is there. And we have a number of pre-orders for those. In fact, we are in our first months of production, we'll only be supplying orders that we already have.

And then with regard to the light duty vehicles, especially again urban short range vehicles, there is a lot of interest in that area. And again, when you do the math on it, you can make it work, as long, again as you have a way to manage the charging and charging infrastructure. So those that go away and come back to the same place are going to have a lot easier time of it than those that have to go and stop and then go somewhere else and go somewhere else. This kind of challenge, same as we saw with natural gas, will be an issue for electric vehicles. But again lots of interest.

And as you said, one of the reasons we are interested in EDI is, not only do they have, have they already fulfilled orders, but they have a really good ability to put together prototypes, demonstrators, pretty quickly so people can actually get out and try it. Because, I think, today, there's a lot of interest. But again, most of the interest is, we'd like to try some. We'd like to try it on this leg, see how it goes, see what the charging's like. And it's really difficult to know if you want to move your whole fleet there or your business model can work on this unless you can actually start dealing with some of the practical issues.

And now, with where lithium ion batteries are, and the system in total is, as compared to several years ago, you are at a place where you actually have some practical jobs you can do. So I think that's why people are interested in trying it. So we do feel like there's plenty of interest relative to our capacity. What we're trying to do is make sure that we have a commercially viable powertrain so that we're not just doing demonstrators and prototypes forever; that this is actually a thing that can work in larger scale.

And so we have both efforts going on, making sure people can try things and see that and that will really start at the end of next year, we'll start putting production units in. But right now, we're doing mostly trials and prototypes. We want to be able to do that so people can try, but then also move to this commercially viable long run, segment replacing, kind of powertrain. And that's still in the development and launch phase next year.

[Noah Kaye, Oppenheimer & Co., Inc.]

Really appreciate the color. Thank you.

[Operator]

Thank you. Our next question comes from Andrew Casey with Wells Fargo. Your line is now open.

[Chris Laserinko, Wells Fargo Securities LLC]

Hi, guys. This is Chris Laserinko on for Andy.

[Norman Thomas Linebarger, Cummins, Inc.]

Hi, Chris.

[Chris Laserinko, Wells Fargo Securities LLC]

Hi. Just have a quick housekeeping item. The press release this morning didn't have the unit shipments for Power Systems. Can you provide that or will you be providing that going into the future?

[Richard Joseph Freeland, Cummins, Inc.]

Yes. We can provide it. Yes. As you know, unit shipment for those is, because of the revenue varies, a whole lot by unit that if, it's not as meaningful, as the heavy duty ones where there's unit prices are really similar. But we can definitely provide it to you and I think, Mark, actually...

[Mark Andrew Smith, Cummins, Inc.]

Well, I see it in the copy of the 8-K, but I'll follow-up with you to make sure.

[Chris Laserinko, Wells Fargo Securities LLC]

Okay.

[Richard Joseph Freeland, Cummins, Inc.]

Okay, great.

[Chris Laserinko, Wells Fargo Securities LLC]

Thanks. So the next question I have is the engine segment updated guidance supply is about 15% to 18% incremental EBITDA margins. Kind of relative to the 20%. I just wanted to know the difference between. But also that 15% to 18% suggests a little bit better operating leverage from the first half of 2018 and the second half of last year. Just wondering if you can provide some color around the cadence of the incrementals in the back half of the year between Q3, Q4 and what's giving you guys the confidence that you can generate that additional leverage?

[Patrick Joseph Ward, Cummins, Inc.]

I think there's two factors going on. One, we're going to have lower earnings in China in our joint ventures. So that's typical seasonality. We forecast for the market to decline in the second half, so that's going to be a drag. On the other hand, obviously, we don't have the charges and the warranty in the first half of the year. Generally, volumes are remaining strong, with higher North American heavy duty truck production. So those are the puts and takes really and a little bit of the tariff costs.

[Chris Laserinko, Wells Fargo Securities LLC]

Okay.

[Patrick Joseph Ward, Cummins, Inc.]

And the underlying operating performance is very strong.

[Norman Thomas Linebarger, Cummins, Inc.]

Yes, underlying operating, I guess that's maybe, Chris, just backing up a step. Underlying operating performance throughout the year is quite good. And I know it's frustrating to get these incremental margins, because it depends on what you include and what you exclude from last quarter and this quarter. But simply put, underlying operating margins are good. We had the campaign in the first half of this year and a little bit of the last half of last year. That kind of distorted the numbers some. I mean, those are real issues. So they belong there, but they're distorting the numbers.

Then, we've got, as Mark mentioned, in the second half, you've got these incremental costs related to tariff and material cost inflation and then a little bit of dip in China sales. But other than that, if you kind of move those around in your model, the basic operating performance goes, you're seeing sales grow and you're seeing 20% plus incremental margins on an operating basis across the whole way.

[Chris Laserinko, Wells Fargo Securities LLC]

And then in the Power Systems segment guidance, you increased the revenue outlook pretty handily. And there's just kind of, I hate to call a 50 basis point move slight, but there's 50 basis point move in the EBITDA margin guidance. Just wondering if there's something embedded in this. Is it conservatism? Or is it kind of a real time look at what's going on with production costs, freight or other supply chain issues?

[Patrick Joseph Ward, Cummins, Inc.]

It's the same two issues really, the Engine business with the buying patterns in most of our end markets in China are typically weaker in the second half than the first half. So that's true for Power Systems, which has a large joint venture in China, off-highway markets. And then, they'll also suffer a little bit on some of the tariffs and related inflation. But overall, we're expecting a very strong year, as Tom said earlier and Rich said.

[Chris Laserinko, Wells Fargo Securities LLC]

Okay. Thanks, guys. I appreciate it.

[Operator]

Thank you. Our next question comes from Steven Fisher with UBS. Your line is now open.

[Steven Michael Fisher, UBS Securities LLC]

Hi. Thanks. Good morning. I'm wondering if you could give us just a little more color on your domestic oil and gas exposure, how fast that piece is growing? Where is it relative to peak and trough levels? And where you see it going from here?

[Richard Joseph Freeland, Cummins, Inc.]

Let me go ahead and start here and then, so it's doubled this year off of very low numbers. So it's been a really solid just as we started the year. I think it's going to be, it's going to continue to go up, it's going to be bumpy kind of quarter-to-quarter, how we're going to see new orders going in and so we've actually projected a little bit of a decline in the second half of the year of new orders.

Having said that, we're putting a lot of population out there, we're gaining share and so I think the trend remains really good. We're, it's hard to say what normal cycle is on this quite frankly. But I think, at least my view is, there's more, lots more upside than down if you look over an annual basis; quarter-to-quarter there's just going to be some big orders and then some periods of shorter or small orders kind of quarter-to-quarter.

[Patrick Joseph Ward, Cummins, Inc.]

Yeah. I think it's hard to measure against peak just on revenue because we're selling more advanced products now with the introduction of Tier 4 emissions regulations. And then with all this extra new equipment going into the field over the last 12 months we expect that rebuilding, parts and service activity to continue to build. But yes, through the first half of this year we've already delivered more than all of last year, but probably a little bit of a pause while this equipment's put to work, but the underlying demand seems pretty stable right here.

[Steven Michael Fisher, UBS Securities LLC]

Okay. That's very helpful. And then just on the Eaton joint venture. When do you think you'll hit a breakeven level on EBITDA in that business? I think you're targeting profitability next year, but what about a breakeven level?

[Richard Joseph Freeland, Cummins, Inc.]

I think what you're going to see is, again, it's a loss this year. We're looking really at 2020 till we get to that, to a profitability standpoint. So the rate of losses kind of think of it half next year and then moving towards profitability in 2020.

And I think the good thing is the products, part of the strategic investment in the product was that we develop the best powertrain in the market. And that piece I, we feel, so both the financials are on plan, but what I feel even better about is when you see it in our market share numbers is that the combined powertrain product is doing terrific. As we've introduced the new product, and more importantly, is we've done the integration work between the engine and the transmission.

[Patrick Joseph Ward, Cummins, Inc.]

So the key to the profitability is expanding those gross margins and we have seen steady progress so far. We just need to continue that going forward.

[Steven Michael Fisher, UBS Securities LLC]

Thanks very much.

[Norman Thomas Linebarger, Cummins, Inc.]

Thank you.

[Operator]

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

[Joseph John O'Dea, Vertical Research Partners LLC]

Hi. Good morning.

[Norman Thomas Linebarger, Cummins, Inc.]

Hey, Joe.

[Joseph John O'Dea, Vertical Research Partners LLC]

Tom, you guys have provided some helpful details on costs related to tariffs and trade. Could you talk a little bit about demand? Is there any demand impact factored into back half of the year guide? Certainly, backward looking it doesn't look like we've see any impact. But, based on customer interactions and what you're hearing out there and in particular North America and China, is there any direct demand impact that you're seeing at this point?

[Norman Thomas Linebarger, Cummins, Inc.]

Not really. I mean, I'm grateful that were not, it's a good question. Both in terms of just, when I was just in China, I was looking for signs that people are beginning to change preferences and saying, well we don't want to buy American products. And, I didn't see any of that on the consumer level, no less in the industrial level which would be kind of secondary, which is good. I mean I think that's always a possibility in China and the problem is once you lose the share it's pretty hard, I mean if you lose the customer it's pretty hard to get it back.

And so far I haven't seen any of it. I mean, I didn't hear a whiff of it. I asked around a lot. I asked customers, I asked our employees, just what are they seeing and nobody seeing any of that. There's definitely some negative feeling about the negotiations or about the administration but not, nothing against American or American companies today, so far, and vice versa in the U.S.

And I think in the U.S, I do, I'm very worried about the inflationary effects, but the economic numbers now are good enough that people seem to be driving right through it. So I guess mostly what I'm worried about now is when and if things turn down, how bad is that and are we going to have inflation and economic downturn at the same time because of, because the inflationary effect. So, again I'm worried about that. But right now it is just not visible anywhere. People are busy. They're buying stuff there. Fleets are, as Rich said, fleets are so busy and making so much money, they're just busy buying trucks and trying to put more trucks to work and find drivers. So far so good is what I'm seeing.

[Joseph John O'Dea, Vertical Research Partners LLC]

I appreciate those details. Last one is on the $200 million cost impact that you've sized, it sounds like pricing will be able to address the raw material side of that and then some supply chain switching can address a portion of the tariff side of that, basically sounding like it's $100 million back half of the year headwind, but rolling into 2019, we shouldn't be thinking about a $200 million headwind. In fact, it sounds like that headwind might be down year-over-year overall.

[Norman Thomas Linebarger, Cummins, Inc.]

It's hard to know about the net. The way you're thinking about it is right. The net, we just don't know yet because again there's some decisions as Rich was highlighting about, do you move the supply chain or do you feel like the tariffs are temporary? So you just suck it up. Do the price things you're trying to do stick or not? As you said on the whole material cost side that mechanism is pretty much in place, that's likely to go. There's always delays on either side. We try to delay them from putting it in our cost side and our customers try to delay it from putting it in the price side but broadly speaking the agreements are in place.

It's the other ones where there's just more left to play for. So, our supply chain group as you guess, is super busy trying to figure out how to mitigate that. So we'll have a much better view of what we think the net effect is when we do our 2019 plan and of course the environment is changing pretty quickly too. I mean my guess is between this call and next call there'll be another announcement either to add tariffs or take them away. And so we're not sure which it is but I wouldn't know which one I hope it is, but we'll see which one it is. So, I think we need to be pretty nimble in terms of thinking about how we mitigate the costs.

[Joseph John O'Dea, Vertical Research Partners LLC]

Hoping for the latter. Thanks very much.

[Norman Thomas Linebarger, Cummins, Inc.]

Yeah, thank you.

[Mark Andrew Smith, Cummins, Inc.]

Thank you very much. And James and Adam will be available to take your calls later. Thank you.

[Patrick Joseph Ward, Cummins, Inc.]

Thanks so much you guys.

[Operator]

Thank you ladies and gentlemen that does conclude today's conference. Thank you very much for your participation. You may all disconnect. Have a wonderful day.