康明斯 (CMI) 2016 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the second-quarter 2016 Cummins Incorporated conference call. At this time, all listeners are in a listen-only mode.

(Operator Instructions)

As a reminder, this conference call is being recorded. I would now like to introduce your host for today's conference, Mr. Mark Smith, Vice President of Finance Operations. Mr. Smith, you may begin.

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

Before we start, please note that some of the information that you'll 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 forecast expectations, hopes, beliefs and intentions on strategies regarding the future. Our actual future results could differ materially from those projected in such forward-looking statements because of a number of risks and uncertainties.

More information regarding such risks and uncertainties is available in the forward-looking disclosure statement in our slide deck and our filings with the Securities and Exchange Commission, particularly the risk factors section of our most recently filed annual report on Form 10-K and any subsequently filed quarterly reports on Form 10-Q. During the course of this call, we will be discussing certain non-GAAP financial measures, and we 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 presentation are available on our website at cummins.com, under the heading of Investors and Media. Now, I'll turn it Over to Tom.

Thank you, Mark. Good morning.

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

Revenues for the second quarter were $4.5 billion, a decrease of 10% compared to the second quarter of 2015. Second-quarter EBIT was $591 million or 13.1% of sales, compared to $721 million or 14.4% in the same quarter last year. We made strong progress in our cost-reduction initiatives in the second quarter as benefits from restructuring actions, material cost reduction initiatives, and improvements in product quality helped to mitigate the impact of weak demand in a number of important markets.

Our decremental EBIT margin was 27% for the second quarter, and 23% for the first half of 2016, compared to our full-year guidance of 25%. Engine business revenues decreased by 14% year over year, primarily due to lower demand in heavy and medium-duty truck markets in North America. EBIT of 10.3% of sales declined from 12% a year ago, as strong operational performance and benefits from restructuring material cost-reduction initiatives and a 90 basis-point improvement in warranty costs were offset by the impact of lower volumes.

Second-quarter results include a $39 million increase in our provision for a product campaign that we initially [recorded] in the fourth quarter of 2015. As we previously discussed, this provision is for a quality issue related to a third-party aftertreatment system that is impacting the performance of some of our engines in vehicles produced by one of our OEM customers. The increase in our provision reflects a more conservative approach to protecting vehicle owners with a higher proportion of vehicles now plan to have full replacement of aftertreatment system hardware than we had originally anticipated, resulting in a higher estimated cost for the campaign.

Discussions over how the cost of this campaign should be shared with our OEM customers are ongoing. Revenues in our components segment decreased 8% from a year ago, with lower demand in North America more than offsetting growth in China. Sales in China increased by 17% due to a stronger demand in the truck market.

EBIT of $190 million or 14.9% of sales declined from $223 million or 16% as the impact of lower volumes offset the benefit of material and other cost reductions. Earlier today, we announced the closure of a filtration manufacturing facility in Turkey, as we continue to implement plans to improve our cost structure.

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

Revenues for the power systems business declined by 16% year over year, with lower sales in most regions due to weaker demand in power generation, commercial marine, and oil and gas markets. EBIT decline from 11.6% to 9.8% a year ago, as the impact of lower sales more than offset an 18% reduction in operating expenses. EBIT did improve from 5.7% in the first quarter due to good operating leverage on incremental sales and strong cost control.

We continue to make progress with our plans to close three power systems manufacturing operations in India, Mexico, and the UK. Our actions in India and Mexico will be completed in the second half of 2016. In the UK, we are on track to commence assembly of high-horsepower generator sets at our Daventry engine plant in the fourth quarter of this year, a key milestone in the first days of our closure plan for our assembly operations in Kent.

There will be both expenses and savings in the second half of 2016 associated with these actions that will improve our cost structure when complete. Now, I will comment on some of our key markets, starting with North America.

Our revenues in North America declined by 13% in the second order due to weaker demand in on-highway markets, especially heavy duty truck. We shipped 16,000 engines to the North American heavy-duty truck market in the second quarter, a decrease of 43% from a year ago. We have lowered our projections for full-year industry production to 200,000 units at the mid-point of our guidance, down from our prior forecast of 210,000 units.

As weak industry orders and high dealer inventories are likely to cause OEMs to lower their build rates in the second half of year, our market share to the end of June was 28.9%, and we expect our full-year market share to be in the range of 27% to 30% for the year, unchanged from our projections three months ago. In the medium-duty truck market, we delivered almost 21,000 engines in the second quarter, down 20% from last year, as our customers produced at a lower rate compared to the overall industry. Our market share through the end of May was almost 75%, slightly ahead of our full-year forecast of 74%, which is unchanged from last quarter.

We have lowered our forecast for full-year industry production to 117,000 units, down 6% compared to both 2015 and our prior guidance for 2016, as the growth in new orders have leveled off in recent months and OEMs are trimming build rates. Our engine shipments to North American pickup truck customers increased by 18% in the second quarter. Shipments to Chrysler increased 4% to more than 33,000 units, sales also increased to Nissan following the launch of our 5-liter V8 engine in the fourth quarter last year.

We currently expect our revenues in the pickup segment to increase by 12% in 2016, again unchanged from our prior forecast. Our engine revenues from the North American construction market decreased by 30%, compared to the second quarter last year. While housing and commercial construction activity remains positive, demand from rental companies for new equipment has declined due to weakness in the oil and gas market.

Power systems revenues declined 9% in North America in the second quarter due primarily to lower engine orders from oil and gas customers, which more than offset 4% growth in power generation. Our international revenues declined by 4% year over year, with weaker sales in Latin America and the Middle East. Second-quarter revenues in China, including joint ventures were $940 million, an increase of 3%, with growth in on-highway revenues partially offset by the depreciation of the renminbi against the US dollar, and weaker demand for power generation equipment and industrial engines.

Industry demand for heavy and medium duty trucks in China increased by 21% in the second quarter. Our market share in the second quarter was just under 15%, level with last year.

Although demand from Foton for our heavy-duty ISG engine increased year over year, growth in shipments to our other primary partner Dongfeng did not keep pace with the market. One truck OEM in particular is being very aggressive on pricing this year, and has increased its share at the expense of several OEMs, including Dongfeng.

We now forecast full-year industry sales to grow by 9% for the year, up from our prior forecast of a decline of 4%, as industry sales were well ahead of our expectations in the first half of the year. Visibility to demand in the second half is limited and we remain cautious until we see broader improvement in macroeconomic indicators.

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

Industry sales of excavators in China decreased by 11% in the second quarter as sales moderated from inflated first-quarter levels following the transition to Tier 3 emission standards that came into force in April. The overall numbers of excavators sold remains very low with no obvious catalyst for significant growth in this near-term. Revenues for our power systems business in China declined by 25% in the second quarter, reflecting weak demand in mining, marine, and power generation markets.

Full-year revenues in China across all segments, including joint ventures, are expected to grow 3% for the year, up from our prior forecast of flat, due to stronger demand in the heavy and medium-duty truck markets. Second-quarter revenues in India, including joint ventures, were $423 million, up 9% year over year, primarily due to strong demand in the truck market, which more than offset the impact of a weaker rupee. Industry demand in truck market increased 22% as the economy continues to improve.

Our market share in the second quarter was 44%, up from 42% a year ago, and our penetration with Tata increased to 78% from 73% a year ago. We now expect industry truck production to increase 15% for the full year, up from our prior forecast of 10% growth.

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

Second-quarter revenues in Brazil were $80 million, down 27% from the second quarter last year, as the economy remains in recession and the real depreciated 14% against the US dollar. Industry truck production fell 12% year over year, while all our engine shipments declined 30%. Industry production for heavy commercial vehicles greater than 15 tons increased in the quarter, while medium and light vehicles, from which we have a higher market share, declined significantly.

We project full-year industry truck production to decline by 20%, unchanged from three months ago. Revenues for our power systems business in Brazil declined by 45% due to continuing economic challenges in the region. Our sales in the Middle East also declined by more than 30% in the second quarter, primarily impacting our power systems business and reflecting a slowdown in infrastructure investments in the region.

Clearly, we are facing challenging market conditions. However, in the face of a 43% decline in shipments to North American heavy-duty truck market and very weak conditions in most of our end markets, strong operational performance and execution of our cost-reduction initiatives enabled us to deliver EBIT above 13% of sales in the second quarter. Looking forward, we now expect Company revenues to decrease between 8% and 10% for the year, lower than our prior guidance of 5% to 9%, due to a lower outlook for truck production in North America and weaker demand in power generation in off-highway markets.

Revenues in the third and fourth quarters of this year are projected to be lower than second-quarter levels, and we continue to identify opportunities to further improve our productivity and lower our cost structure. We expect EBIT to be in the range of 11.6 % to 12.2% for the year, unchanged from our prior forecast, reflecting full-year decremental EBIT margin of 25%.

In the first half of this year, we returned more than $1 billion to shareholders in the form of dividends and share repurchases, and our Board of Directors recently increased quarterly dividend by more than 5%, all consistent with our plans to return 75% of operating cash to shareholders. Thank you for your interest today, and now I will turn it over to Pat, who will cover our second-quarter results and full-year guidance in more detail.

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

For the second quarter, revenues were $4.5 billion a decrease of 10% from a year ago. Sales in North America, which represented 58% of our second-quarter revenues declined 13% from last year, due primarily to lower demand in North American on-highway truck markets and continued weakness in industrial markets. International sales declined by 4% from a year ago due to weak demand for industrial engines and power generation equipment.

While revenues grew in India and in China, this was more than offset by weaker demand in Latin America and in the Middle East. Gross margins were 26.4% of sales, a decline of 20 basis points from last year. The negative impact of lower volumes and unfavorable profit mix were offset by material cost savings, benefits from restructuring actions, and more warranty expense.

Selling, admin, and restructuring development expenses are $679 million, or 15% of sales, decreased by $24 million from a year ago, the increase as a percent of sales by 100 basis points as sales declined. Joint venture income of $88 million decreased by $6 million compared to last year, primarily due to the acquisition of North American distributors previously held as unconsolidated joint ventures. Other income and expenses, including interest income, netted us an expense of [$15] million in the quarter, including the increase in the provision for a quality issue related to a third-party aftertreatment system that [caused the engines to fail].

Earnings before interest and tax were $591 million, or 13.1% of sales for the quarter, which had placed a 27% decremental margin when compared to a record $721 million or 14.4% of sales that we reported last year. For the first six months of the year, decremental EBIT margins of [23%], slightly back from the target of 25%.

Net earning for the quarter was $406 million or $2.40 per diluted share, compared with $2.62 from a year ago. The effective tax rate for the quarter was 25.7%, lower than a year ago, due to the change in the geographic mix of elements.

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

Off-highway revenues declined by 9% primarily due to a decline in the construction and marine markets. Segment EBIT was $261 or 10.3% of sales, compared to 12% last year. Material cost savings, lower warranty expense and the benefits from previous restructuring actions offset the negative impact of lower volumes and an unfavorable product mix.

Included in the results from the second quarter in the engine segment was a $39 million charge for increase of estimate for the loss contingency recorded from the fourth quarter of 2015. Excluding this additional provision segment EBIT, [these have] improved over last year despite the 14% drop in sales. For the full-year 2016, we expect engine segment revenues to decline by 9% to 12% primarily due to weaker truck demand in the truck markets in North America.

2016 EBIT margins are expected to be in the range of 10% to 11%, compared to 9.9% for the full-year 2015, excluding restructuring and impairment charges. Expected year-over-year improvement on [8%] is primarily due to lower warranty cost, benefits from the restructuring actions and material cost-reduction initiatives. For the distribution segment, second-quarter revenues were $1.5 billion, which increased 3% compared to last year.

Prior-year acquisitions contributed 8% to the sales growth, partially offset by a 3% decline in organic sales and a 2% negative impact in currency. Engine and segment from service revenues declined in the quarter as demand for new engines and rebuilds remains weak in off-highway markets, especially in oil and gas, and marine markets. EBIT margins for the quarter decreased from 7.6% to 5.6%, due primarily to the unfavorable impact of currency and lower organic sales.

On our prior earnings call, we shared our plans to acquire the last remaining unconsolidated North American distributor. We currently expect to complete the acquisition in the fourth quarter of 2016. We are updating a full-year revenue guidance now to be between down 1% and up 1%, incorporating the new acquisitions and the slightly continued weakness in off-highway markets, especially in North America and weaker power generation sales in the Middle East.

We expect full-year EBIT margins to be in the range of 5.5% to 6.5% of sales. The components segment recovered revenues of $1.3 billion, which declined 8% from a year ago. A 17% increase in revenue from China, along with increased revenue from Europe, helped to partially offset a 17% sales decline in North America.

Segment EBIT was $190 million or 14.9% of sales, compared to 16% of sales a year ago. Strong operating performance, material cost reductions, and the benefits from restructuring actions helped to partially offset the impact from weaker sales in North America lower pricing on the negative impact of currency.

We currently expect full-year revenue in 2016 to decline by 6% to 9%. EBIT guidance for the full year is unchanged from before, and is expected to be in the range of 12.75% to 13.75% of sales. In the power systems segment, second-quarter revenues were $821 million, down 16% from last year.

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

We currently expect full-year revenues for the power systems segment to decline between 12% and 14%, with EBIT in the range of 7% to 8% of sales. Forecast as year-over-year volume declines the negative impacts from a competitive pricing environment in international markets, and additional expenses related to new cost reduction actions in 2016, will more than offset the benefits of restructuring and material cost reductions. We are now projecting total company revenues to be down between 8% and 10% in 2016, which is lower than our prior guidance of down 5% to 9%, due to a weaker outlook in North America and a softer demand in power generation markets.

Declining production in the North American truck markets and weak demand globally for off-highway power generation equipment will drive the majority of the reduction of revenue for the full year. We expect EBIT margins of between 11.6 % to 12.2% of sales, unchanged from our prior guidance. Cost-reduction initiatives across the Company will mitigate the impact of weaker revenues.

Joint venture income is still expected to be flat compared to 2015, and we now expect our effective tax rate to be 27% for the year. Turning to cash flow, cash generated from operating activities was $471 million in the second quarter, [better than] the same quarter last year by $75 million, primarily due to lower working capital. For the first six months of the year, cash from operations is $734 million, compared to $569 million at the same point last year.

We anticipate operating cash flow performance in 2016 will be within our long-term guidance range of 10% to 15% of sales. Capital expenditures were $189 million for the first six months of the year, and they are expected between the range of $600 million to $650 million for the full year.

In year to date we returned more than $1 billion to shareholders, which includes the repurchase of 6.7 million shares, and as Tom said, recently, our Board of Directors authorized an increase in our quarterly dividend of 5% to $1.025 per share, consistent with our plans to return 75% of full-year operating cash flow to shareholders in this year. Now, let me turn it back over to Mark.

Okay. Thank you, Pat, and now we are ready to move to the Q&A part of the call.

If you could limit your questions to an initial question and one follow-up, and then get back in the queue, please. Thank you.

(Operator Instructions)

Jerry Revich, Goldman Sachs

Good morning, everyone.

Good morning, Jerry.

Can you talk about India? Your four regulations [your stamps] have a pretty good market share just based on your own engines for the SER systems. Do you have other opportunities to sell the SER system for other market participants? Do you have any contracts locked in? Can you just flesh out that opportunity for us?

Hey, Jerry. This is Rich. The first most visible opportunity if the emissions come in, will be in the components area on fuel systems. So, we will introduce our own fuel system as we move to VF4 standard in April next year. That is a new opportunity for us.

So, most of the growth we will see will be on the component side with our own engines to start with. Again, our goal -- we feel pretty confident as we have seen in other markets that one we will have more content with components, we will also grow shares as the standards get tougher as we start with a good platform.

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

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

Yes. We are still figuring that out ourselves, Jerry, from a fourth quarter point of view.

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

Okay. Thank you.

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

Thank you.

Thank you. Robert Wertheimer, Barclays

Two questions, I'll just ask them both at once. Does the shift in capacity of power systems say anything about your long-term view on those markets? We had thought some of them would be stronger years ago, just curious if you have moderated a long-term outlook or restructured its capacity.

And second, can you talk a little bit about little bit about what drove the resegmenting? Thank you.

Yes, maybe I will start with the long-term view, Rob. As we discussed before, our view up our power generation business continues to be bullish long-term. But what we have noticed is three things.

First, we have said our overall view about growth in emerging markets to moderated those over prior views, I think that's not a surprise, everyone has probably done that. And then secondly, the time it is going to take to recover looks like it is going to be longer, and that is year by year we have been pushing that out, unfortunately, which is one of the reasons we are in a bit of a catch-up mode in prior generation.

But we've basically said we need to act now because the recovery of the market doesn't seem eminent. And I think the third thing that we talked about before is that one of the things that our company feels strongly about is when we have downturns, we want to use those as opportunities to improve the efficiency and productivity of our operations.

So we think by combining our generator set assembly, for example, with our high-horsepower engines, so we will be able to restore the same capacity if not more, but reduce costs and reduce inefficiencies related to the supply chain. So, we're going to put the entire capacity of that assembly line in the Daventry plant. We are going to save shipping, we are going to save test time, we are going to save logistics coming into the plant.

So, there is a whole bunch of opportunities, and we just couldn't make those changes when the market was strong. We can't reduce capacity for long enough to actually consolidate plants. So, again, this is not the only one like that.

But many of the operations changes that we are taking now are opportunities that we can take advantage of because markets are slower, so we can manage the inventory and sanction the demands much better, and then our hope is as markets improve, we are than able to supply even greater capacity, but at much lower costs and at better efficiency. That is what we are aiming for through this effort.

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

That is perfect. Can you remind me, Mark, what is that -- is that on sale -- how many end markets is that on sale in?

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

You asked about the combining of segments. That really reflects the fact that, as I was talking there about the opportunities for efficiency between the high-horsepower engine division and the generator set division, where 50% or more of the engines are consumed.

So, the same kind of idea I talked about with the Daventry plant, we are trying to get that same opportunity engineering processes and new product processes, as well as manufacturing and supply chains. So our idea was now that business is lower, we have the opportunity to make some of those changes in combinations that maybe would have been harder to make. And we also in the meantime can reduce overhead between those two divisions at a time when that is sorely needed, given where the markets are today.

Makes sense. Thank you.

Thank you. David Russell, Evercore ISI -- Alex Potter, Piper Jaffray

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

Okay. Hey, Alex, this is Rich. Let me try to do that.

It's a unique situation that we have here, where we have our engine with a different after treatment system. In fact, we don't do that anywhere else, except for in this one market, so that is the uniqueness of it.

We took the charge in Q4, as you recall, and estimated that time, and we kind of voluntarily went to the market, both for the customers to get ahead of this, and we thought we could fix it with more of a software fix. Now we have concluded that a hardware fix would be more effective and the right way to go, and so that is what we have protected for. So, this is kind of the high end of what we would expect to see here.

We also note that Tom commented that we have not concluded our discussions with the partner, given this is a complicated system we are selling [of which we're] one piece of it, and so there will be some cost-sharing done in this. Those discussions are still ongoing.

To your point, we always try to give you an estimate that represents what we think the exposure is in full. So, we definitely do not want to have situations where we have to come back and increase or change to exposure. So, we are trying to be accurate and conservative. And as Rich said, in this case, the technical fix needed to change, and by the way, we have complete agreement with our customer about what the right activities are to protect the end customers, so that is good, we are working on that.

We've agreed that we know the hardware replacement is the right thing to do. That's [spot] what we're on with that, until we feel comfortable that the actions we're taking are the right ones, and that we have provided for them correctly.

So, there is no way I can say there is no chance it'll ever increase, but we are trying to give you an estimate that says this is the full exposure. And as Rich said, our hope is, based on negotiations with the customer, we will be able to reduce it.

Sure. Fair enough.

The second one is on the profitability of the engine joint ventures. If I'm looking at things correctly here, I know there has been some resegmenting, and I don't know how that may be -- how the segment disclosure comes out, but the numbers that we're looking at, it looks like the margins of those joint ventures have been doing pretty well recently, and I am wondering if that should increase volume or any other factors that you would call out, and then whether these relatively high margins can be sustained. Is there any reason that they would move up or down or sideways from here?

I think the joint venture earnings didn't grow, Alex. I think if you look in the engine business, they just represented the higher proportion of sales because the sales have dropped.

So, the earnings are pretty level in most parts of the world. It's currencies impacting the underlying improvement of earnings in China, for example. So, there isn't a significant change in the underlying profitability of the businesses going forward.

Okay. Understood. Thanks, guys.

Thanks, Alex.

Thank you. Jamie Cook, Credit Suisse

Good morning. I guess my question, Tom or Pat, you guys can handle this. As I look at Cummins's earnings in 2017, given the severity of the downturn in most all markets you participate in, your earnings power has been much higher than previous cycles.

At the same time, I look to 2017 and I look at where our decrementals are holding, and I guess what I'm concerned about is, as we look to 2017 and assuming we don't get a market recovery, is that you've pulled all of the levers, sort of, that you could to hold profitability in 2017 is going to be much tougher.

So, while I know you don't want to talk about guidance or end market, can you talk about the things in 2017 that you can control to hold the profitability, whether it is incremental restructuring benefits we will get in 2017, whether it is the North American distributor acquisition or just your view on share repurchase. Thank you.

Yes, hello, Jamie. Thanks for that. I will start off and Tom can jump in behind me.

I think you know us well enough that we are always looking out for ways to improve our cost structure. And we have made some good progress this year, I think, in EBIT offset the significant volume decline by driving material cost savings, of what I would -- we're looking at 1.4% or 1.5% for the full year, and we are taking warranty debt, and warranty, I believe, for the first half of this year, is a percent of sales maybe the lowest in the last decade, so we are making some good progress there.

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

I would also say, Jamie, that we have got some -- there's headwinds of sales, as you mentioned, but there's also some tailwinds. As we've talked about, we have got synergies that we are driving into our distribution business that have mostly been negative to date, as we've absorbed these and now we're heading in with opportunities for positive synergies. We've got some of our restructuring activities that we talked about with our large engines, where we have moved from mostly taking the cost actions now and the benefits will come later.

Thirdly, we've got the opportunity for the 95, where when we launched engines are more expensive, and as we build volumes they will get better. So, there is tailwinds as well as headwinds.

And I would just reemphasize what Pat said. Every single quarter every single year, we are looking for new opportunities to drive cost reduction improvement, and we haven't run out of ideas yet, and hopefully as long as this management team is here, we will not run out of ideas, or probably it is time for a new management team, because that is what our job is.

The one thing you didn't address was -- because obviously this is the other topical thing, is you have bought a lot of stock back this year, more so in the first quarter versus the second quarter, but the other side of it was your appetite to do M&A.

So, are we closer on the M&A front, or if we're in this type of environment should we -- and the M&A doesn't present itself, should we assume that you will be as aggressive on share repurchase as we look at 2017 versus 2016 to offset, potentially, some top-line dilution.

Yes. As we talked about in the investor meeting, and I will just repeat here, a couple harder things is that it is harder to talk about anything until there is something, and it is hard to say if you are closer until you have a thing to talk about.

That said, the work continues and I feel very positive about the work we are doing. I feel like there's opportunities for us. And also we said we are going to be very tight on our view about capital returns, and so if the things don't present themselves in a way that we think we can earn superior returns to shareholders, we will not pursue unattractive acquisitions, and we will just continue to increase returns to shareholders through dividends and share repurchases.

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

Okay. Thanks, I will get back in the queue.

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

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

Okay.

Thank you. Joe O'Dea, Vertical Research Partners.

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

Yes. I will start this one, Joe. And I think as we look into the second half of the year, we are going to see (inaudible) in the top-line, if you look at the implied sales for the second half of the year, they are going to be lower than the first half of the year, they are going to be a little lower than some of those others were we do have pretty good margins to date.

In addition to that, we are going to see -- continue to see material cost savings, but not at the rate that we have been [doing] the first half of the year. It will come down in the second half of the year. (Inaudible)

We increased people's salaries in the middle of the year. So, there is a numeric cost increase component of this that is also going to play, to some extent, not a huge extent, on the decremental margins in the second half compared to the first half. I'm very pleased with what we've done in the first half of the year, at 23%, (inaudible) that we've talked about, and I'm feeling very confident we can at least deliver the 25% that we committed to at the start of the year.

Okay. Thank you. And then you kept the guidance for the market share on North America Class 8 through a range of 27% to 30%.

The year-over-year decline that we've seen is primarily driven by lower volumes with [dimer], which you talked about a little bit last quarter. But just as we think about you navigating through some of the underproduction right now in North America Class 8, you move into next year and maybe things get aligned with end-market demand. Do you think that the most likely scenario is that 2016 is a low point, and do you anticipate that your share moves up after we move beyond some of the underproduction considerations this year?

Yes, Rich. I think what you have seen over this year is a lot of movement in our share with the leads as the volumes changed and that drove some different activities. As you'll notice through recent months, that is pretty much settled out now, where our share is with each customer, and so our approach now is how do we help the customers that are using our engines gain share.

So, we are actually quite excited about the changes we've got in 2017 with improved fuel economy, again, that you're going to see. We're going to have the best service intervals in the industry and the best connectivity. And so, we're going to help those customers grow. So, I think we do view this as kind of the settling point.

Then also just remind you, the end of next year, in small numbers, we'll begin introducing our X12 product. So, our 12-liter product kind of aims at the lower-end of the medium-bore, where we haven't really had an offering there. So, again, I think we're pretty settled out for where we are now, and kind of start the slow slog of improving share from this point.

Okay. Thanks very much.

Thank you. Mike Baudendistel, Stifel.

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

So, we won't give our guidance for 2017 on that, but for this year, we will stay in the same range, and we will see, potentially, some small reductions in the 2017 as Daimler will introduce the MDEG engines late this year, and will be seeding that into 2017. So, there's a little negative pressure there.

There also is, we intend to grow our share at Navistar. So, those two will be competing with each other, and at some point we will give guidance what the net of all that is, but don't look for big changes in the share through the next -- through 2017.

Great. Thank you.

Thank you. Tim Thein, Citi.

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

Is more like 7% to 8%, Tim, in overall high-horsepower engines.

7% or 8%. Got it.

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

I think we are just running a little behind flat for the first half of the year, so I think we'll -- the guidance has come up, and so we will stay close to flat. Some moving pieces in some of the smaller [JV's] that don't get the headlines, just really noise around those.

But I think, Tim, in India we are seeing good progress in the truck market, and that is benefiting our joint venture straight through the challenge we have had as the Indian rupee just keeps falling at the dollar. So, every incremental dollar we make, we give X percent back to currency losses, but still, the joint venture is benefiting from a stronger market, that's pretty forward.

In China, because we have the situation where we are keeping good share, we are doing well with our customers, but our customers Dongfeng is not holding share in the market relative to another competitor. That is kind of offsetting some of the benefit of the market. And that is what we highlighted there.

As Mark said, that is just some of the dynamics in the market. We'd of course love our customer Dongfeng to win, and our intent is to find ways to help them win. But right now that's what happened in the first half.

It just kind of offset part of what we saw as a strong market in China. We don't think that is a long-term trend. We think that will come back over time, but it just was in the first half, and we just don't know what is going to happen in the second half.

Okay. Thank you.

Having the additional distributor acquisition in the fourth quarter, which will tweak down the joint venture line only, as well. These are small movements.

Yes. Okay. Thank you.

Thank you. David Raso, Evercore ISI.

Good morning.

Hello, David, you made it on.

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

I think if you take to the [mid-point of the guidance] (inaudible) you are probably closer to the number than half [and offset it]. Yes.

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

Yes. (Inaudible) It is exactly there.

Okay. And, specific to that I guess, within the engine business, and using the restates of course, it seems like you have sales declining $400 million or so year-over-year in engines.

But the profits actually go up $20 million to $30 million, and maybe I want to get back to your comment about the warranty.

What would be driving that kind of performance, sales down $320 million to be exact, but your EBIT actually goes up, it's actually $34 million, to be exact. What is such a big swing year-over-year on the engine probability?

I will take the first shot at this. So, you hit at the three things. One is the material costs we've continued to drive down on that, and that was a little bit heavy-weighted to the front end of the year.

The other big success is in warranty, and Pat said it, the rate at the first half of the year is the lowest we have been in 10 years. So, we talked in the second quarter last year, where we took a bump up and said we were going to put plans together and we'd invest a little more in the second half of the year, and that these actions would drive warranty down. That is what you are seeing now.

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

The one I'd add to that, it's not as significant as the ones that Rich just talked about, but if you go back and look at the 8K that we filed last week, we did explain that in 2016 we have taken another look at how we are allocating some of the corporate costs across the four business segments.

And we cannot ignore some of the costs that have been allocated to the engine segment and recognize that distribution of components have not incurred more [profit] support, and as a result, more profit overhead, too. That by far is not anywhere near as significant as we feel the cost of a warranty that Rich was talking to, but that would be the fourth --

True, but year-over-year restate last week, that is an apples-to-apples comp now, though, right? You're handling the second half of this year the same as the restate at second half last year, correct?

No, that's not correct there. We did not restate 2015 numbers because we believe that we would allocate in corporate overhead in 2015 is appropriate. (Inaudible) 2016.

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

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

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

Yes. It's a nice try, but you are not going to [trick me into giving you] (inaudible) 2016 guidance. (laughter) we will talk more about this when we get to the end of Q3 into Q4.

I appreciate it. Thank you.

Thank you.

Thanks, David.

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

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

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.