Cummins Inc

NYSE:CMI

Earnings Call Transcript 2018-Q3

[Unknown Speaker]

MANAGEMENT DISCU9SSION SECTION

[Operator]

Good day ladies and gentlemen, and welcome to the Q3 2018 Cummins Incorporated 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 follow at that time. As a reminder, today's conference is being recorded.

I would like to introduce your host for today's conference, Mr. Mark Smith, Vice President of Finance. Sir, 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 third quarter of 2018.

Joining me today are our Chairman and Chief Executive Officer, Tom Linebarger, our Chief Financial Officer, Pat Ward, and our President and Chief Operating Officer, Rich Freeland, will all be available for your questions after our prepared remarks.

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 in our filings with the Securities and Exchange Commission, particularly the Risk Factors section of our most recently filed Annual Report on Form 10-K.

During the course of this call, we will be discussing certain non-GAAP financial measures and will 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 are available on our website, at cummins.com, under the heading of Investors and Media (1:50).

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 third quarter results and finish with a discussion of our outlook for 2018. Pat will then take you through more details of both our third quarter financial performance and our forecast for this year.

We delivered strong quarterly sales and record profits in the third quarter. Revenues were $5.9 billion, an increase of 12% compared to the third quarter of 2017, with growth in all of our operating segments and most major geographic markets. EBITDA was a record $983 million, or 16.5% of sales compared to $788 million or 14.9% of sales a year ago.

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 both in China and North America. EBITDA for the quarter was 14.9% of sales compared to 11.8% a year ago. EBITDA percent increased with the impact of higher material costs more than offset by the benefit of higher volumes, improved pricing and lower warranties.

Sales for our Distribution segment grew by 10% year-over-year, driven by higher demand for new engines and for parts and service in off-highway markets. Third quarter EBITDA was 8% of sales compared to 6.8% in the third quarter of 2017. EBITDA percent and dollars have improved throughout 2018 because of targeted price increases and cost control measures.

Third quarter revenues for the Components segment rose by 14%. Sales in North America increased 25% and revenues in international markets grew 2%. Increased truck build rates in North America along with sales from the automated transmission business drove domestic growth. International sales increased through strengthened European truck markets offset lower demand in China. The automated transmission business contributed 5% to segment growth.

EBITDA for the third quarter in the Components segment was a record $288 million or 16.4% of sales compared to 16.9% in the same quarter a year ago. EBITDA margin declined due to the dilutive effect of the automated transition business, which reached its one-year anniversary in the third quarter.

The share of heavy-duty trucks in North America with an automated transmission has risen steadily over the last year, with adoption rates now at 73% in new trucks. Fuel economy benefits and improvement in drivability have lead to the strong adoption of the technology and even Cummins is a market share leader in North America.

Power Systems sales in the third quarter grew 5% year-over-year, with higher demand for power generation equipment and an increase in sales to oil and gas customers, partially offset by a reduction in marine revenues. EBITDA in the third quarter was 14.7% of sales compared to 10.5% a year ago, driven by the positive impact of higher sales and the benefits of previous restructuring actions.

In our electrified powertrain business, third quarter EBITDA was a loss of $30 million. There's a strong customer interest in our technology and we are actively developing products for urban and shorter-range applications where we expect the quickest adoption of this technology.

Now I will comment on the performance in some of our key markets for the third quarter of 2018, starting with North America, and then I will cover some of our largest international markets. Our revenues in North America grew 17% in the third quarter due to growth in demand in most end markets and ramp-up of the automated transmission business.

Industry production of North American heavy-duty trucks grew 23% in the third quarter of 2018 while sales of our heavy-duty engines increased by 30%. Our year-to-date market share through August was 34%, up 1.5% from last year. Demand in the medium-duty truck market remains near record levels, with industry production of medium-duty trucks improving 24% in the third quarter and up 17% year-to-date.

Our market share in the medium-duty truck market is 81% year-to-date through August, up from 79% a year ago. Total shipments to our North American pickup truck customers increased 17% compared to a year ago and are on track to be flat for the full year.

Engine sales for construction equipment in North America increased 36% in the third quarter, reflecting general strength in the economy and a 6% increase in U.S. construction spend. Engine sales to high-horsepower markets in North America were flat compared to a year ago.

Higher demand from oil and gas customers was offset by lower marine sales while mining revenues were flat. Current oil prices will support continued investment in fracking, an important market for us in North America. While fundamentals for this market remain strong, we have seen OEMs reduce their orders in the second half 2018 due to pipeline constraints in the Permian Basin impacting the ability to increase production.

Revenues for power generation grew by 10%, due to higher demand in the global data center and North American recreational vehicle markets. Orders were above shipments for the third consecutive quarter, with industry supply chain challenges constraining production.

Our international revenues increased by 6% in the third quarter of 2018 compared to a year ago. Third quarter revenues in China including joint ventures were $1.1 billion, a decrease of 7%, due to lower sales in on-highway markets.

Industry demand for medium and heavy-duty trucks in China decreased by 24% compared to a year ago, in line with our expectations. Year-to-date, our market share was 12% through September compared to 14% last year.

Third quarter market share improved to 16% from 11% in the first half of the year, as we increased power penetration of our engines at our OEM partners. We continue to work diligently with our partners in preparation of new product launches for NS VI emission standards in 2019. For example, we recently received certification on our 12-liter heavy-duty engine, fitted with a Cummins fuel system, turbocharger and aftertreatment system, making the ISX12 the first heavy-duty engine certified to the NS VI standards in China.

Industry sales of light-duty trucks grew by 8% in the third quarter and our engine market share was 7%, in line with our full-year guidance. Demand for excavators in China in the third quarter increased 34% from a year ago. Our market share through September increased to 15%, up 1% year-over-year.

Revenues for our Power Systems business in China increased 8%, due to growth in engine shipments to mining customers, higher demand for power generation equipment for data centers and increased sales into the domestic oil and gas market. Third quarter revenues in India, including joint ventures, were $543 million, an increase of 20% from the third quarter a year ago. Industry truck production increased 39% compared to a year ago, driven by strong economic growth and domestic infrastructure investment.

Year-to-date, our market share is 40%, unchanged from 2017. In Brazil, our revenues increased by 16%, primarily due to a recovering economy resulting in improved demand for trucks compared to a weak 2017. Third quarter revenues were the strongest in four years.

Now, let me provide our overall outlook for 2018 and then comment on individual regions and end markets. We continue to forecast total company revenues for 2018 to be up 15% to 17%. 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 continue to expect our market share to be at the high-end of the market share range we gave of 31% to 34%. In the medium-duty truck market, we are maintaining our forecast for industry production to reach 133,000 units, up 13% year-over-year.

We are increasing our market share expectations in this market to the top end of our prior guidance range of 75% to 78%. We continue to expect our engine shipments for pickup trucks in North America to be flat for the full year, compared to a very strong 2017 and at the highest level in 10 years.

In China, we expect domestic revenues, including joint ventures, to be up 1%, unchanged from our prior guidance. We are maintaining our outlook for medium and heavy-duty truck sales of 1.3 million units, 1% lower than 2017. Having said that, there is uncertainty about the demand for medium and heavy-duty trucks in China over the next 9 months to 12 months, given the impact of China's blue sky initiative, which includes certain incentives to replace older NS III trucks and the potential for a pre-buy of NS V vehicles before the implementation of the more stringent NS VI regulation in the middle of 2019.

Our year-to-date market share in the medium and heavy-duty truck segment in China is 12% and we expect full year market share to be 12% consistent with our prior forecast. In the light-duty truck market, we now expect growth of 10% in 2018, up from our previous guidance of 5%, primarily due to government policy changes designed to increase demand. In our light-duty truck market, we expect our full-year share to be 7%, consistent with our prior projection.

In India, we expect total revenues including joint ventures to be up 20% year-over-year, higher than our previous forecast of 18%, due to higher outlook for truck demand. In July, the Indian government surprised the industry by introducing regulations that allow higher loads per vehicle. The new regulations caused a sharp decline in truck sales in July followed by a recovery in August and September. Underlying demand for trucks remains strong, and we expect the industry to produce a record number of trucks in 2018.

In Brazil, we continue to forecast truck production to increase 20% in 2018 compared to a weak 2017. Improved domestic demand for trucks in Brazil offset lower demand for exported Brazilian trucks in Argentina.

We expect our global high horsepower engine shipments to increase 20%, down from our previous forecast of 35% growth, with oil and gas shipments up 66% and mining shipments up 30%. These compare to our prior guidance of oil and gas up 100% and mining up 40%, respectively.

While engine shipment growth is moderated from level seen in the first half of the year, we continue to benefit from higher rebuild and part sales due to size and utilization of the engine population in the field.

In summary, we have maintained our full-year outlook and expect to deliver record sales, EBITDA, operating cash flow and earnings per share in 2018. Our full-year EBITDA range of 14.8% to 15.2% represents incremental EBITDA margins of 20% at the midpoint, excluding impact of our two startup businesses, automated transmissions and electrified power trains, but including the campaign in tariff-related costs.

We expect tariff-related costs of $80 million in 2018, down from our previous estimate of $100 million, and our plans and estimated cost for the aftertreatment campaign in North America remain unchanged. Tariff-related costs in 2019 are expected to be $50 million more than our prior projections, due to the finalization of Section 301 List 3, and we expect to offset the majority of the tariff costs through a combination of pricing and supply chain adjustments.

During the quarter, we delivered just under $1 billion of operating cash flow, allowing us to invest in our business and return cash to shareholders. In Q3, we returned $682 million in cash to shareholders in the form of dividends and share repurchases, consistent with our plans to return 75% of operating cash flow this year.

Our Board of Directors recently approved a new $2 billion share repurchase authorization, underscoring our plans to continue returning cash to shareholders in the future. We also continue to actively pursue opportunities for acquisitions and partnerships that will add to our profitable growth while maintaining strong returns.

Last week, we received regulatory approval for the previously announced purchase of Navistar's 50% equity of the JAC Navistar Diesel engine company. The new joint venture will continue its operations at its manufacturing facility at Hefei.

Cummins already supplies some light-duty midrange and heavy-duty engines to JAC Motors for its domestic markets in China as well as its global operations. This joint venture will continue offering leading NS V diesel engines, and focus on developing new products to meet NS VI standards.

In October, we also announced that we have signed a Letter of Intent with Isuzu Motors to explore partnership opportunity in the powertrain area. We're optimistic that this partnership will result to increased growth and profitability for both companies.

With that, I would like to thank you for your interest today. We had a strong quarter. We're on track for record full-year results, extending our track record of improving 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 third 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 2018.

Third quarter revenues were $5.9 billion, an increase of 12% from a year ago. Sales improved in each of the operating segments driven by stronger demand in global on-highway, industrial and power generation markets.

Sales in North America, which represented 61% of our third quarter revenues, grew 17% from a year ago due to increased demand for our Engines and our Components to meet higher levels of truck production and for construction equipment.

International sales increased by 6% from last year due to higher demand in India, Latin America, and in China from on-highway and construction markets. A stronger U.S. dollar negatively impacted international sales by 3%.

Gross margins were 26.1% of sales, up from 25.4% a year ago as a result of stronger volumes, more (16:56) warranty expense and favorable pricing, which more than offset the headwind from currency and from tariffs.

Selling, admin and research and development costs of $833 million were $13 million lower than last year and 200 basis points lower as a percent of sales. Increased research and development spend related to investment in new technologies was more than offset by lower variable compensation expense.

Joint venture income of $90 million decreased by $5 million compared to last year due mainly to weaker truck demand in China. Other income decreased by $23 million due to the absence of a gain recognized in the third quarter of last year from the sale of power generation rental assets to acquire our (17:43) Distribution business.

Earnings before interest, tax, depreciation and amortization were a record $983 million or 16.5% of sales for the quarter, compared to $788 million or 14.9% a year ago. EBITDA as a percent of sales improved primarily due to the positive impact of the higher sales warranty and variable compensation expense, partially offset by a stronger U.S. dollar.

Net earnings for the quarter were a record $692 million or $4.28 per diluted share compared to $453 million or $2.71 from a year ago. Our tax rate in the quarter was 13.3%, which included $37 million or $0.23 per share of favorable discrete items, most of which related to the 2017 tax reform bill.

In addition to this we have now lowered our projected full-year effective tax rate to 21% excluding discrete items compared to our prior guidance of 23%. Excluding the discrete tax items, the net income attributable to Cummins in the third quarter was $655 million or $4.05 per diluted share.

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

In the Engine segment, revenues were $2.7 billion in the quarter, an increase of 17% from last year. On-highway revenues grew by 17%, driven primarily by increased truck production in North America. Off-highway revenues increased by 14% as a result of stronger demand for construction equipment in both China and in North America.

Segment EBITDA in the quarter was $405 million or 14.9% of sales. This compares to $276 million or 11.8% a year ago. Benefits from stronger volumes, warranty expense and favorable pricing actions more than offset increased material costs.

We expect full-year Engine segment revenues to be up 17.5% to 18.5% compared to a prior guidance of 17% to 19%. Our forecast for EBITDA margins remains in the range of 13.25% to 13.75% of sales.

For our Distribution segment, third quarter revenues were $1.9 billion, an increase of 10% compared to last year. The growth in sales was primarily driven by higher demand across all product lines in North America and favorable pricing partially offset by the impact of a stronger U.S. dollar.

EBIT for the quarter increased by 29% to $155 million or 8% of sales compared to $120 million or 6.8% a year ago. Benefits from the higher sales, favorable pricing and low variable compensation expense more than offset unfavorable currency movements and the absence of the gain of a divestiture of assets related to the power generation rental equipment last year.

For 2018, Distribution revenue and EBITDA guidance is unchanged with revenues projected to increase 9% to 11% and EBITDA margins to be in the range of 7% to 7.5% of sales.

For the Components segment, Revenues were $1.8 billion in the quartera, 14% increase from a year ago. The Eaton Cummins joint venture contributed 5% to growth. Sales in North America increased 25% due to higher heavy-and medium-duty truck production, while international revenues grew 2%, with lower demand in China offset by stronger sales in Europe.

Segment EBITDA for the quarter increased by 11% to $288 million or 16.4% of sales compared to $259 million or 16.9% of sales last year. The decline in the EBITDA percentage is due to the impact of the Eaton Cummins joint venture.

For 2018, we expect revenue to increase 22% to 24% compared to our prior guidance of up 23% to 25% due to the negative impact of the stronger U.S. dollar. And we continue to expect EBITDA to be in the range of 14% to 14.5% of sales, in line with our prior guidance.

In the Power Systems segment, third quarter revenues were $1.1 billion, an increase of 5% from a year ago. Power generation sales grew by 10% as a result of higher demand for power generation equipment in North America, the Middle East and in India.

Industrial sales declined by 1%, as increased sales to oil and gas customers were offset by a reduced demand for Marine equipment. EBITDA increased by 47% to $163 million or 14.7% of sales in the quarter up from $111 million or 10.5% last year, driven by the positive impact of the higher sales and benefits of the previous restructuring actions.

For 2018, we now expect Power Systems segment revenues to increase 12% to 14% versus our prior guidance of up 15% to 17%. Although demand in mining and oil and gas markets remains strong, we have seen a modest decline in near-term orders as customers focus on redeploying recently purchased equipment.

EBITDA margins are forecasted to be between 13.75% to 14.25% of sales compared to a previous guidance of 13.5% to 14%, as a result of continued improvements in our operational performance.

In the Electrified Power segment, EBITDA losses were $30 million as we continue to invest in new products and get closer to the launch of the 2019 products. For the full year, we now expect a net expense of $85 million to $95 million. And for the company we continue to project revenue growth of 15% to 17% this year. Foreign currency headwinds in the second half of the year are now expected to fully offset the benefit to revenue that we experienced in the first half of the year compared to a prior estimate of an increase of $100 million for the full year.

Our third quarter revenues were negatively impacted by $70 million compared to a year ago and we expect the headwind in the fourth quarter of $150 million at current rates. Income from our joint ventures is expected to be flat in 2018 in line with our previous guidance. We are forecasting EBITDA margins to be in the range of 14.8% to 15.2% for 2018, unchanged from our previous guidance.

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

Turning to cash flow. Cash generated from operating activities for the third quarter was $915 million, $270 million higher than last year. And we anticipate operating cash flow performance for the year will remain within our long-term guidance of 10% to 15% of sales. Capital expenditure during the quarter was $175 million, bringing the year-to-date total to $361 million. And we start to expect the full year capital expenditure will be in the range of $730 million to $760 million.

As we indicated during our previous earnings teleconference, we plan to return approximately 75% of the cash generated from operations to our shareholders in the forms of dividend and share buybacks this year. In the third quarter we repurchased 2.8 million shares with the previously announced $500 million accelerated share repurchase program and made dividend payments totaling $183 million. For the first nine months of the year, we have returned $1.4 billion which includes the repurchase of approximately 5.3 million shares.

In summary, we delivered very strong operating performance in the third quarter with 12% growth in sales, EBITDA up 25% from last year and operating cash flow of over $900 million. And we remain on track to deliver record sales, EBITDA, operating cash flow and earnings per share in 2018.

Now let me turn it back over to Mark.

[Mark Andrew Smith, Cummins, Inc.]

Okay. Thanks, Pat. Now we're ready to move to the Q&A portion of the call. You can please try and limit your questions to initial question and a related follow-up and then get back in queue, please.

[Operator]

Our first question comes from the line of Jerry Revich with Goldman Sachs.

[Jerry Revich, Goldman Sachs & Co. LLC]

Yes, hi. Good morning everyone.

[Norman Thomas Linebarger, Cummins, Inc.]

Hi, Jerry.

[Jerry Revich, Goldman Sachs & Co. LLC]

Tom, I'm wondering if you could expand on the China National VI opportunity set for you folks. What is the incremental components opportunity as you see it? What's the timing of the line reviews, if you will? And then in terms of the enforcement actions next year, how do you expect the enforcement to play out on this emission cycle compared to others?

[Norman Thomas Linebarger, Cummins, Inc.]

Yes. So let me just first talk about how the NS VI thing will play out. I'll ask Mark to comment a little bit on the numbers for each of the component in engines. But how the NS VI is going to go now is originally the plan was for 2020 with some cities going earlier and then the country going across the 2020. The blue sky initiative, which is China's effort to obviously to reduce pollution and clean up the environment, many, many cities have pulled forward now. And the national implementation is now moved up to the middle of 2019.

What will actually happen, how it will be implemented across the country, cities versus the full country, I think there's still some uncertainty about that actually. I mean, even though I would've said that they were locked down on the middle of 2019, I think given economic challenges and other things, I'm not as clear as I was then. So we'll see. We are driving our programs to be ready for the middle of 2019.

In addition to that, they've also launched this program I mentioned in my script about offering incentives to turn in NS III vehicles. So if you have an older truck, you can get compensated for turning it in and purchasing a newer truck, which, of course, is trying to drive older more polluting trucks off the road. And we're not sure what impact that's going to have on demand, but it has already had a positive impact on demand to-date. So we'll see what happens over the next 9 to 12 months.

There's also of course this general decline in the need for trucks given that the economy is not growing as strongly. So, all these factors are coming in together. And that's why I mentioned in my remarks, it's just not clear to me, especially over the next 12 months what demand is likely to do.

Our opportunity though is pretty clear and we see both opportunity for market share gain and components addition into each of our engines that we sell, which represents a big sales growth opportunity for us. And, Mark, you might want to highlight further numbers.

[Mark Andrew Smith, Cummins, Inc.]

Yes, over China and India, because we've got similar regulations coming in, in India as well, we've got about an incremental $700 million of components revenue opportunity there, Jerry, and about 70% of that plus is going to be in China.

[Jerry Revich, Goldman Sachs & Co. LLC]

Okay. Thank you. And then in Power Systems, really strong margin performance this quarter, despite what I would imagine was a negative surprise from demand standpoint in mining in particular. Can you just talk about the year-over-year improvement? How much of that was the restructuring benefits and any other moving pieces that played out in the quarter for Power Systems?

[Mark Andrew Smith, Cummins, Inc.]

I think there's no one factor really, Jerry. It's just a combination of good operating performance and a tight supply chain environment. And most of it is really on the cost reduction side and the volume.

[Norman Thomas Linebarger, Cummins, Inc.]

I guess to add to that, as you know, we've had a pretty strong program now over several years and the restructuring benefits that we mentioned we've been tracking over time and those are now playing through. There's still some yet to get in the alternator business, but broadly speaking, we've worked through most of those restructuring activities and with volumes increasing, even when they're not as much as we were originally expecting in mining and oil and gas, we're still seeing benefits of higher volumes in a lower cost structure. That's fundamentally what's going on and why we're seeing improved margins.

[Jerry Revich, Goldman Sachs & Co. LLC]

Okay. Thank you.

[Norman Thomas Linebarger, Cummins, Inc.]

Yes.

[Operator]

Thank you. And our next question comes from the line of Jamie Cook with Credit Suisse. Your line is open. Please go ahead.

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

Hi. Good morning. I guess two questions. Tom, probably understanding you don't want to talk about 2019, but a lot of your customers are talking about sort of extended visibility into 2019, in particular on the heavy-duty truck side. So can you just talk to which markets you feel most comfortable with that we could see sort of growth next year?

And then the other question I keep getting from investors is as they think about 2019 they're trying to understand the correct earnings base to grow earnings off of. So, when we think about 2019 and the right base, can we add back the product campaign costs? Or do we include that in the base as we think about things?

[Norman Thomas Linebarger, Cummins, Inc.]

Let me let Rich talk a little bit about market since he's been together the plans, he's been paying pretty close attention to where markets are and then I'll come back and talk a little bit about the campaign.

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

Okay. Thank you.

[Richard Joseph Freeland, Cummins, Inc.]

Yes. Let me just circle around two or three of the bigger markets, Jamie, then you can follow up. Let's start with the truck North America. You see the numbers; it still looks really good. I mean we're – retail sales are strong. The freight data continues very strong. I'd say we have seen maybe some leveling of what the spot rates are now that we pay attention to, but we're right now the backlog of 286,000 units, okay? And I don't see that backlog going down significantly between now and end of the year. So I think we're going to enter 2019 in a pretty strong position on North America trucks. I don't think we're done there.

Kind of the same story on medium-duty truck in North America. I think Tom talked about China, so I think there's more downside in China. We've seen kind of potentially offset by this blue sky on NS V. We think that could be as much as 100,000 units incremental to what it would've been next year in China. So I think that'll help shore that up a little bit.

The PowerGen business, the power generation business we think still has more momentum going into 2019. And so we're going to end the year there again with over the last three quarters we've added about $150 million of future orders going into next year, which is the strongest we've been in five or six years.

And then we touched a little bit on mining and oil and gas. We've seen a pause in both of them. And so I think from a – in the second half of the year, we do view that as a pause right now based on what we see capital spending going in those industries, so actual rates going up from where we are in the second half of the year. So that's some of the bigger markets that we've got out there.

[Norman Thomas Linebarger, Cummins, Inc.]

And I'll let Rich comment more on the warranty and emissions campaign, but we do not expect the emissions campaign to repeat as a P&L item. Obviously, we have to still execute the campaign so that's going to take – happen over several years. But we do expect that we will not repeat the expenses there and that was a big hit to us in 2018. So of our total warranty numbers, which were something like 0.1% for the year, 1.6% of that is this emissions campaign.

So as Rich just talked about we're kind of that at 2.5, 2.4 level and we're trying to drive that down. So as we put together the plan, we'll be trying to put a warranty plan together and the actions that we're taking, we hope to drive that number down for 2019. We haven't finished our plan yet, so will see what we come up but we do not expect that significant hit of 1.6% to continue.

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

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

[Operator]

Thank you. And our next question comes from the line of Steven Fisher with UBS. Your line is open. Please go ahead.

[Steven Fisher, UBS Securities LLC]

Hi. Thanks. Good morning.

[Norman Thomas Linebarger, Cummins, Inc.]

How you doing, Steve?

[Steven Fisher, UBS Securities LLC]

Good. Thanks. Just on the JV, I think last quarter you said you were looking at profitability in 2020. It seems like you maybe hit the breakeven a little bit faster than expected. Was that just volume-related? And how does that timing change? Or how does that achieving the breakeven earlier change your view of timing of profitability?

[Richard Joseph Freeland, Cummins, Inc.]

I think we had a really good Q3. I will say there were a couple of one-time positives in Q3, Steven, that helped us out. But we are generally ahead of schedule. We've talked about 2020 as a breakeven, and I'm optimistic that we will certainly achieve that and potentially beat that. But there was a couple of unusuals in Q3. Small, but it helped us get to breakeven a little sooner.

[Steven Fisher, UBS Securities LLC]

Okay. And then you guys have done a handful of deals and partnerships. But it sounds like you had a much longer list of things that you've been reviewing in the hopper. Can you just give us a sense of how that pipeline looks for deals and JVs? And how many of these partnerships as we think about over 2019 would be additive to earnings versus sort of just net cost additors and fill technology are the partnership blossoms and develops?

[Norman Thomas Linebarger, Cummins, Inc.]

Steve, it's a great question. And what I'll do just given time is I'll try to give a reasonably short answer, and then obviously we can talk more about it in Investor Day or through calls. But broadly speaking, we've got several major growth initiatives that which I laid out the last Investor Day where we have a set of candidates that we're looking for. It's not a gigantic universe. We started with a big universe, but we've really narrowed down the places that we like to grow through acquisition or partnership.

And then what we're looking for is the opportunity so that we could make that partnership or acquisition at a cost that we think drives positive return for shareholders and grow profitable growth for our company. And given asset prices and thing that's not that easy to do right? And we're just going to make sure that we get the right spot on that and that's so it's not a gigantic universe.

The second area that we're looking is in these new technology areas we need to build capabilities. That's a very big universe. There's a lot of companies. But then again, we want to make sure that we're getting capabilities that add to the ones we have. And so the example is the battery companies we purchased, and just recently EDI. Very, very good acquisition, not very large in size and, as you mentioned, tend to have more technical capabilities than they have earnings. So those are kind of the ones that produce earnings in the future, and basically produce expenses today.

And then the third category is the partnerships you see with JAC, and now this Letter of Intent we have with Isuzu, which are basically trying to make sure that in our core business there is a lot of companies looking around trying to figure out what they're going to spend their investment on. And we want to make sure that as those companies think about investing less in diesel or natural gas or want some support on their new investments in electrification and other technologies that they see us as a potential partner.

So we are very active in that space. We have a discussion, at least I do at least twice a month, and I think Rich is about the same with different large OEMs around the world thinking about this issue. So those are very active and there is a lot of potential partnerships there. It's the people in our industry, but those are very active discussions.

So that's kind of the field. So in total it's a pretty large set of potential. But each one is pretty focused on either building capabilities, forming partnerships to add to our base or looking for these particular growth opportunities at the right price. Those are kind of the combination of things we're looking for.

[Steven Fisher, UBS Securities LLC]

That's very helpful, Tom. Just any sense of whether it's sort of net additives to earnings or dilutive. Or...

[Norman Thomas Linebarger, Cummins, Inc.]

I would say this, that the partnerships that we form are generally speaking additive to earnings or neutral. The technology investments for the most part are not. And the other – the opportunities for growth I mentioned at the start, those would be additive to earnings significantly, but they're fewer and harder to do.

[Steven Fisher, UBS Securities LLC]

Got it. Thanks, Tom.

[Norman Thomas Linebarger, Cummins, Inc.]

Yeah. You bet.

[Operator]

Thank you. And our next question comes from the line of Joe O'Dea with Vertical Research Partners. And your line is now open. Please go ahead.

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

Hi. Good morning. First just on the incremental margins on the Engines and Components segments, if we back out some of the charges from a year ago and looking at double-digit top line growth, your incremental seem to come in a little bit below kind of target range and from quarter-to-quarter any number of swings. But just wanted to understand supply chain-related pressures, anything that was specific to the quarter? And kind of general outlook for seeing a little bit better flow-through moving forward?

[Mark Andrew Smith, Cummins, Inc.]

Hi, Joe. You're right. There's a lot of moving parts. I would say both took a little bit of a hit on FX and both segments had some challenges from supply chain, probably around $10 million in each business in the quarter from kind of expedited costs and things like that. And then the rest is natural variation.

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

Is there anything in general that you see is preventing you from getting closer to 20% plus kind of incrementals on the EBIT line moving forward in those segments?

[Patrick Joseph Ward, Cummins, Inc.]

Not in the base business. We've got the joint venture which is – we've talked about separately, but no not in the businesses.

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

Okay. And...

[Norman Thomas Linebarger, Cummins, Inc.]

Joe, I'd add one more thing, just, Kevin, for you. This year and then looking forward tariffs is a bit that hits both of those businesses too. And so, we got hit with about $30 million in Q3 and we'll get another $50 million in Q4 in tariffs. Tariffs either direct through the tax, if you will, or through indirect, through metal market increases. And so those are a little bit of a headwind we've got in this year.

We have very active plans to mitigate those going forward. Okay? So just from a modeling standpoint, so we are going to hit those incremental margins, there's no question about that. We've got a little bit of a headwind there. It's probably worth just spending a minute on how it looks going forward.

So Tom mentioned in our earlier statement, the gross tariff impact, either direct or indirect now is at $215 million annually. Okay? Think of that and $150 million of that is direct tariffs and $100 million in metal market increases. We'll manage the metal market like we always do, through suppliers and through contractual ranges. So that $100 million in metal markets will go hopefully through the course of 2019.

The $150 million on direct tariffs, we're actively working on that. We've got pretty aggressive plans short-term to address about a third of that, where we can address it quickly as where we already have capacity set up someplace in the world, so we have got capability and capacity where we can move production. So you know, one example that in our Power Systems business, we do alternators in China. We have capacity in India. We're in the process. Those will be moved yet this year. And so we've got actions like that they're moving forward. So a bit of a hit in the second half of the year. The impact of that will decrease as we go forward in 2019.

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

When you think about some of the actions you can take both on the direct and the metal markets and we're running right now at $250 million just because there is timing sensitivity to some of this and how quickly you can reroute supply chains change suppliers. What do you think about that $250 million being in 2019 just given the timing sensitivity to the actions you can take?

[Richard Joseph Freeland, Cummins, Inc.]

Just repeating, so I said $150 million of that is direct impact with tariffs. We'll get rid of $50 million of that with the actions we've got in place in the short-term. And through the course of the year we'll work on the additional $100 million. The actual metal markets those will go down through the course of the year just on normal contractual agreement that we have. So the majority of it being managed out each quarter getting a little bit better.

[Norman Thomas Linebarger, Cummins, Inc.]

So if you just kind of do the math roughly speaking, Joe, I mean we said we think there is kind of like an $80 million-ish kind of this year number and not that much opportunity to mitigate, right? A little bit through pricing, a little bit through metal markets not much because it's all delayed.

Next year it's $250 million for a full year number. Again, you're comparing a half year number with a full year number but the full year number $250 million, $100 million of it we think will address through metal market not everything happens in the first day of the year. But we think we'll decrease it to zero over the course of the year and so you can kind of average that.

And then of the $150 million you got $50 million mitigated now and then you're going to keep going. So if we think we have $80 million this year, we're something over $100 million right now without our secondary mitigation factor. So we're hoping to get that year-over-year number to be not much of an increase year-over-year. But it won't be zero impact next year.

But again, trying to get it down to a number that's not much of an increase over this year. And that's with piles more new tariffs coming in. So we're being as agile as we can on it and moving fast. But, as you mentioned, things take time, so that's what we're trying to manage through.

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

That's really helpful. One other question on the AMT and the JV and the Endurant out over a year now, I was just trying to think about your kind of primarily area of focus on the net market. I think one is probably just keeping up with demand with higher penetration rates. But when you think about some medium-duty opportunities there, some overseas opportunities there are you pivoting at all and putting a little bit more attention on some other growth areas in the AMT world at this point?

[Norman Thomas Linebarger, Cummins, Inc.]

Definitely. That's a little bit when we were talking about profitability and when it reaches profitability a part of that is the heavy-duty Endurant is doing terrifically well. Sales are going well, but we're also investing in the JV, we're also investing in engineering, we're building up more versions of the transmission to meet more markets. And then also we are looking at other markets around the world at medium-duty markets so that we're very active in that.

As you know, each market has kind of got their own plan for when the price reaches the customer where they want to adopt. But our experience so far is once it does it adopts pretty quickly. So I just got back from India, for example, and right now I don't think a full-blown AMT is really at the price point that the market will accept. But it's a matter of time and I don't think it's a matter of a decade either. I think it's a matter of a couple of years before the fuel economy benefit begins to look like it works for a bunch of professional fleets that are growing there. So can each market will be different, but we are positioning ourselves to be part of those markets as well developing country markets as well.

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

Thanks very much.

[Operator]

Thank you. And our next question comes from the line of Rob Wertheimer with Melius Research. Your line is open. Please go ahead.

[Rob Wertheimer, Melius Research LLC]

Hi. Good morning. There's obviously a lot of moving parts in China and a bunch of different markets you serve. But could you give your general impressions of where you think the trade war has affected demand in a material way in an accelerating way and then whether blue sky or other things are offsetting it or whether there's worse ahead? I'm just curious about how big an impact you are seeing there.

[Norman Thomas Linebarger, Cummins, Inc.]

Yes. I guess, generally speaking, the tariffs have not been good for Cummins. I'll just speak about that and then I'll come to the general economy in the following ways we just discussed, they've just driven up cost or just more taxes to Cummins as we try to – because we are a global company and we serve markets all over the world and we move parts back and forth. Again, we generally build in the regions that we sell. So it's not a – we're not moving most of our products but there is some number that we're better to build it in one place than all places. And of course as we increase tariffs, it just means that we have less markets that we can serve from one place.

For example, our Light-Duty Engine, 28 and 38 Engines that we make in our Foton Cummins joint venture, we make several hundred thousand engines there. We have an opportunity to probably sell some of those in the U.S. a few thousand though, but with a big tariff, we don't. And so that's just an opportunity we probably won't be able to pursue and we're not going to set up a plant for a few thousand. So that's a good example.

I would also say that, in general, it appears to me that the Chinese companies that we compete with are not paying as much in the tax there because of currency weakening. In fact their costs are not increasing at the same rate that ours are. So generally speaking, I think we're becoming less competitive against them not more.

Your specific question might have been more about demand in China, though. And I would say that the economy in China, it is not growing at the same rate. How much that has to do with the trade war versus all the other trends in China is not at all clear to me. What we're are not seeing is that the Chinese government or Chinese customers are yet saying well we're not going to buy from that American company or that American company which, of course, we're very fearful of.

We don't know if and when that's going to happen, but we have not seen that yet so far. So that's a good thing. We are seeing decreased demand, as Rich said, in the truck market. And the blue sky, all that stuff is kind of making things more complicated. It is hard to read the exact signal, but it looks like we're seeing decreased demand.

But, again, we can't tell what that's due to. I know that the Chinese government is worried, though. And I know that some of their activity is to promote in our industry are to kind of offset potential weakness from trade and other kind of economic weakening.

[Rob Wertheimer, Melius Research LLC]

Great. Thank you for the answer. And a clarification, I'm sorry. The $150 million in tariff incremental cost next year, on which bucket and at what rate is that? Is that a 25% on $200 billion? Or are you able to get clarity on what that is?

[Norman Thomas Linebarger, Cummins, Inc.]

I don't think so at this time. We can talk off-line on that.

[Patrick Joseph Ward, Cummins, Inc.]

We're going to have to do some math on that to get it exact.

[Rob Wertheimer, Melius Research LLC]

Okay. Fair enough.

[Norman Thomas Linebarger, Cummins, Inc.]

Yes.

[Rob Wertheimer, Melius Research LLC]

All right. Thank you.

[Operator]

And our next question comes from the line of Ross Gilardi with Bank of America. Your line is open. Please go ahead.

[Ross Gilardi, Bank of America Merrill Lynch]

Good morning, guys.

[Norman Thomas Linebarger, Cummins, Inc.]

Good morning.

[Ross Gilardi, Bank of America Merrill Lynch]

Tom, how should we think about the EBITDA losses in electrification? I mean, you've taken – you've increased them a little bit. I think you've made some acquisitions in that area. I'm not sure where you put some of those acquisitions, but I think maybe it's related to that.

But more importantly, over the next several years what is the general trajectory we should be thinking about? I mean, you've talked about commercialization of electrified powertrains and I think late 2019 early 2020. Correct me on that if I'm wrong.

But what about the losses here? Do they get wider before they narrow? Because I think most people are just kind of sort of linearly taking this up to a flat number in the next several years. And I'm wondering if like you actually have to invest more first before you can actually see that inflection.

[Norman Thomas Linebarger, Cummins, Inc.]

Yeah. It's a great question and here's what – you are right that the reason this year's up a little bit is because we purchased EDI. So the purchase of EDI just added more expenses. And since they weren't in a profit position when we acquired them that just meant that our third and fourth quarters are a little higher in expense levels than we had originally intended.

You remember we laid out kind of our $500 million investment, which included R&D investment and acquisitions over three years. And we still think that's going to be roughly correct. We don't have exact number. But because they're some moving parts, which I'll talk about that but that feels about right to us still. But to your P&L question, I do think the losses widen before they narrow.

And I think that reflects the number of product programs and prototype and other demonstrator projects that we're doing. Because what essentially it's a market that's burgeoning. I mean, it's being created as opposed to existing.

So we're trying to basically ensure that OEM customers and end-user customers that are thinking about using electrification products think that Cummins is a good supplier for them. So if you're just absent all those demonstrators and all those different kind of projects, then they don't think that you're a supplier. So we want to make sure that we're in those.

But frankly, most people are ordering some number and then not ordering again for a while because the economics aren't perfect. The markets that look like they are right for actually trying some at some numbers are urban buses and then short-range vehicles like things that work in warehouses and on ports.

And so we are focusing – overwhelming focusing our attention on those. So, the launch that you mentioned, which you did have the timing right, end of 2019 beginning of 2020 is buses. And we have a launch again a year later another version of the powertrain for buses and then following right after that will be these other short-range vehicles.

So we will be investing and what's widening the expense is really prototype demonstrators were down the road plus the investment in these product programs to make sure we're ready for production launch in those few markets.

And then the revenue side is the side that's very difficult to say. So the hard part about calling the breakeven or cash breakeven in this business is we just don't know what the revenue side is. We know a bunch of bus fleets big ones that want to buy a lot of them.

But we don't know the rate of adoption that goes more broadly across the bus market. It looks like to us like it's going to go pretty fast, but you just don't know and then you don't know how much you're going to win. So the breakeven point is kind of hard to predict. What is easy to predict is the loss is likely to widen a little bit before it goes.

And I do expect to begin to earn revenues though, significant ones in the sense that they'll begin to offset some of these losses beginning in 2020 and probably more so and even in 2021 when we have multiple versions of our powertrain out for buses.

[Ross Gilardi, Bank of America Merrill Lynch]

So the implied loss for the fourth quarter in electrification. I think in electrified power I think is about $30 million. Do you think that is a good run rate to use for next year or does it actually widen even more than that?

[Norman Thomas Linebarger, Cummins, Inc.]

I think that's a good base to work.

[Ross Gilardi, Bank of America Merrill Lynch]

Yeah.

[Norman Thomas Linebarger, Cummins, Inc.]

So maybe a slight widening, but not a big exponential growth like 5% to 10% off of that up off of that maybe precisely.

[Richard Joseph Freeland, Cummins, Inc.]

Yeah. So we'll be adding some engineering, but again, right now we've got our programs in place and they're funds have been going. So not a big change.

[Ross Gilardi, Bank of America Merrill Lynch]

Okay. And then I just want to ask you a little bit more about the slowing that you're talking about in mining. Can you give a little bit more color on that? When did that start for the order slowdown? Or is it any particular geographies anything like that that you could add?

[Richard Joseph Freeland, Cummins, Inc.]

I'll take a shot at that. We're trying to understand a little bit ourselves. So we now saying mining up 30% for the year, we were saying up 40%. And we've seen most of the slowdown is in new production. So, in new equipment going to the field.

Utilization still looks pretty good. The CapEx for next year that we're hearing from the mining sites is growing 7% a year. And so I just think there's a lot of history there with people that carried away the last cycle and bought a lot of equipment, there's a little more consciousness out there right now. I don't think it's necessarily a bad thing. And we're seeing the parts and service strong. And so our estimate is we'll see it bouncing back from where we are in the second half of the year next year.

And we talk regular communications, not a long list of OEMs that we sell to and not a long list of mine sites. So we don't think we're done on the cycle yet I guess is I think where we are right now.

[Ross Gilardi, Bank of America Merrill Lynch]

But, Rich, is it more North America, or is it in China or Australia? Or is it global?

[Richard Joseph Freeland, Cummins, Inc.]

It's pretty broad-based. It's pretty broad-based.

[Ross Gilardi, Bank of America Merrill Lynch]

Got it. Thanks very much.

[Richard Joseph Freeland, Cummins, Inc.]

Yep.

[Operator]

Thank you. And our next question comes from the line of Noah Kaye with Oppenheimer. Your line is open. Please go ahead.

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

Thanks so much. We've had a lot of questions about incremental margins and I just want to see if I can possibly ask you to simplify it for everyone all these puts and takes electrification campaign costs are positive. Maybe headwind of variable comp costs a little bit better-than-expected. Just how should we think about overall incremental margins for 2019 at this point?

[Richard Joseph Freeland, Cummins, Inc.]

Well, I think it's pretty consistent with what we said at Investor Day. The base business we commit to a lot at least 20% incremental EBITDA margins on the base business. And we will continue to invest in the JV. And we will continue to invest in electrification beyond that. So no change really from what we said this time last year. We will give more specific guidance as we always do on our fourth quarter call in January.

[Norman Thomas Linebarger, Cummins, Inc.]

And we've delivered a 20% incrementals on the business while absorbing the after-treatment campaign costs earlier in the year.

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

Right. Much appreciated. And then just to go back to electrification. There does seem to be appetite both internationally and on road do you have the agreement with Hyundai you announced for off-road. You are investing more heavily in this space?

And then, Tom, I think you said that you're having a more frequent number of partnership discussions versus a year ago. So can you just sort of frame for us, basically how you're framing to the customers Cummins value proposition here? Is it really on the integration side? Is it around power conversion? Where do you see Cummins best able to compete versus what you may be out there in the market?

[Norman Thomas Linebarger, Cummins, Inc.]

Yeah. It's a good question. And there's essentially three big areas I think customers see us as in add in their powertrain strategy including electrification by the way is that we have focused on the powertrain. And basically at this point in time most OEMs are looking for partners here. It's just very difficult to figure out how to invest in all the things they had to invest in, be it autonomous, new vehicles, meeting emissions in all these locations, all the investments they need to make in capacity and different kinds of vehicles, and then all the power trains they need. Most of them are going to do some powertrains.

And even when they get to electrification, they're looking at this and saying I need to be in it but I need partners. I just don't think I can do it on my own. And I'm talking about partners from parts of the world that never wanted partners on anything, those people. Even they look at this and say it's just too much.

And so we are playing our role we've always played, which is we will see and we'll do the parts of this that you don't want to do, so we'll sell you components, we'll sell you engines, we'll sell you systems, we'll sell you a parts of our battery system, we'll sell you all of it, et cetera.

With regard to specific technologies within the electrification space we've kind of laid out our focus areas. So we are definitely investing in battery packs and our value proposition there is that we will develop battery packs that work for commercial vehicles. It doesn't mean that we won't use battery cells that cars also use, but we won't just make car battery packs. And the reason is it just doesn't work – different power, different energy, different durability and life.

And so, much like engines, there are diesel engines made for cars and higher volume, but because we are focused on commercial vehicles, we can essentially not only apply the system, but design the system to better work with the applications and duty cycles that apply for commercial vehicles.

Second thing we're going to do is we're going to have a service network and support network that can support your vehicles and your use of electrified powertrains. And that's a pretty big benefit in a market where the new players don't really have anything like that.

And, again, you might think well there is less service and less parts in the car, but there's still stuff to do. They're still in a bunch of service and support work to do even if it's only recharging or replacing batteries but it's a lot.

So our service network is a big added for both OEMs and also and end user partner. So big bus fleets are worried if they use and somebody who doesn't have any support or any presence in the market that they'll buy the things and they'll be stranded and with no support.

So I think that those are kind of the key value propositions. I think it's working well. It's as I mentioned earlier the challenge for us is it looks a lot of investment at the front end for a good opportunity, but where the revenues come and at which pace is still a few years off and I think that's what we're dealing with today.

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

Okay. That color was very helpful. Thank you so much.

[Norman Thomas Linebarger, Cummins, Inc.]

You're welcome.

[Mark Andrew Smith, Cummins, Inc.]

Okay. Thank you very much. I appreciate your time. Thanks.

[Operator]

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