Cummins Inc (CMI) — Q3 2015 Earnings Call Transcript

Thank you, Tia. Good morning, everyone, and welcome to Meritor's third quarter 2015 earnings call. On the call today, we have Jay Craig, CEO and President; and Kevin Nowlan, Chief Financial Officer. The slides accompanying today's call are available at meritor.com. We'll refer to the slides in our discussion this morning. The content of this conference call, which we are recording, is the property of Meritor, Inc. It's protected by U.S. and international copyright law and may not be rebroadcast without the expressed written consent of Meritor. We consider your continued participation to be your consent to our recording. Our discussion may contain forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. Let me now refer you to Slide 2, for a more complete disclosure of the risks that could affect our results. To the extent we refer to any non-GAAP measures in our call, you'll find the reconciliation to GAAP in the slides on our website. Now I'll turn the call over to Jay.

Thanks Carl, and good morning everyone. I told you in April that I was confident in our ability to beat our commitments and drive enhanced value for our shareholders. Our results this quarter demonstrate the progress we are making toward our M2016 objective and provide us with increased confidence for the future. Our financial performance also demonstrates the efforts we have put in to managing labor, burden, and material performance to drive expanded margins. At the same time we are growing through new contracts with important customers like PACCAR that we will talk about today. Looking at Slide 3, you will see that the quarter reflects continued strong execution, while revenues were down $70 million year-over-year primarily due to unfavorable currency headwinds. Adjusted EBITDA margins were up 120 basis points year-over-year at 9.6% for the quarter, which puts our year-to-date margin at 9.5%. Adjusted EPS for the quarter also improved $0.12 from fiscal 2014, which demonstrates that our improved margins are translating to bottom line earnings for our shareholders. In July of last year, we announced a $210 million share repurchase program, which was the first time we returned value directly to the shareholders since 2000 to date. In the second quarter of the fiscal year, we repurchased $31 million of securities, and this quarter we repurchased another $18 million. We remained on track to complete the entire repurchase program by the end of fiscal 2016. We also refinanced and repurchased a portion of convertible notes which will help reduce the dilution impact to the number of shares outstanding going forward. Although volume headwinds outside of North America have continued to present challenges, our performance throughout the year has exceeded our expectations and we intend to raise our outlook for earnings and cash flow. Let's turn to Slide 4. In January of this year, we announced a long-term agreement with PACCAR for rear axles in North America and in Australia. At full run rate, we expected revenues to be approximately $150 million as we ramp up to more than 50% penetration for rear drive axles on PACCAR brands. Today, we're pleased to tell you that we've added standard positioning for front steer axles to that agreement reflecting execution on another opportunity for growth in our core business. This change formally took place in data books on July 1st for Kenworth and Peterbilt trucks, although we started to see the penetration ramp up earlier in the year. We expect revenue from this piece of the business to be approximately $40 million at full run rate. Wins like this are an important part of our M2016 plan to organically grow the business by expanding product plans with our global customers. Now let's turn to Slide 5. In terms of volumes in North America, we're slightly increasing our outlook for Class 8 volumes to approximately 325,000 units. Class 8 net orders have resulted in a strong backlog-to-build ratio of just over five months which we believe will carry current production levels into fiscal 2016. Related to the trailer business, our forecast remains unchanged for the year. This month we purchased the majority of the assets of the Cyprus facility in North Carolina that produces trailer axle beams and machine carriers and differentials for us. The work done at this facility is important to our trailer operation. This transaction allows us to further stabilize our supply chain and become more vertically integrated as we explore our opportunities to grow this business. Europe remains flat from our previous forecast at a midpoint of 390,000 units but is continuing to show signs of a potential economic recovery, as reflected in slightly higher order intake at our major customers. In China, we're reducing our volume outlook to reflect a 35% volume decrease year-over-year. This market continues to be volatile as the mining and construction markets remain extremely weak. South America continues to face a number of challenges as well; we produce our production outlook in this region to a range of 85,000 to 90,000 units for the fiscal year. India, on the other hand, is showing signs of recovery. Growth prospects in the region are improving as the government drives structural, fiscal, and bureaucratic reforms. While the Light Commercial segment remains weak, there is an increased demand for higher tonnage vehicles. We've therefore raised our forecast for this region by 10,000 units. And finally, in our defense business, we are partnered with Lockheed Martin on the JLTV program. We expect to file an award announcement later this quarter. At this point, I'll turn the call over to Kevin.

Thank you and good morning. Let's turn to Slide 6. On today's call, I'll review our third quarter financial results and then I'll take you through our revised 2015 guidance. Overall, the key takeaway you'll see from our results is that we continued to drive financial performance. Our M2016 strategies are generating improved margins and bottom-line EPS. As a result, in the third quarter we generated an adjusted EBITDA margin of 9.6% and $41 million of adjusted income from continuing operations. So, let's walk through the details on slide 7, where you'll see our third quarter income statement compared to the prior year. Sales were $909 million in the quarter, down $70 million or 7% year-over-year. The lower revenue was driven entirely by currency headwinds in Europe and Brazil. Without the stronger U.S. dollar, revenue would have been higher this year compared to last year. As robust production in North America and other revenue increases more than offset lower production in South America and China. Gross margin as a percent of sales was 13.6%, reflecting a 90 basis point improvement over the prior year. This improvement was driven by continued material, labor, and burden performance and pricing actions consistent with our M2016 strategy. SG&A was $12 million higher in the third quarter compared to the prior year. The increase was due to a $20 million recovery of legal fees associated with the Eaton antitrust settlement in the prior year, which did not repeat this year. Excluding this SG&A cost, it was actually lower by $8 million, mostly due to lower spending and variable compensation accruals. Restructuring costs were $9 million this quarter and were related to severance costs associated with previously announced restructuring actions taken in our South America truck business, as well as costs associated with the closure of our Newark, Ohio facility. Interest expense was $38 million in the third quarter compared to $22 million a year ago. The increase is due to a $19 million loss on debt extinguishment that was recognized this quarter as a result of the repurchase of $85 million of our 7-7/8% convertible notes. I’ll provide more detail on the balance sheet actions we executed this quarter later in the presentation. Excluding this loss, interest expense decreased by $3 million year-over-year due to the benefits we're now experiencing from the capital markets transactions we executed last year. Income tax expense was $6 million in the third quarter representing an effective tax rate of 27%. The rate was higher than what we had experienced in the last couple quarters, primarily due to the impact of the $19 million loss on debt extinguishment for which no tax benefit was recognized. Excluding this loss, our effective tax rate would be approximately 15%, reflecting the fact that we are generating positive operating earnings in jurisdictions like the U.S. and parts of Western Europe where we have valuation allowances against our deferred tax assets. All of that totals to adjusted income from continuing operations of $41 million or $0.41 per diluted share. Slide 7 shows third quarter sales and segment EBITDA for commercial truck industrial. Sales were $705 million, down $56 million or 7% from the same period last year. FX headwinds were more than $70 million year-over-year, which means that stronger sales primarily in our North America truck business more than offset the lower production we experienced in South America and China. Segment EBITDA was $58 million, an increase of $3 million compared to the prior year. Segment EBITDA margin was 8.2% in the quarter representing a 100 basis point improvement. The combination of continued cost performance and pricing actions more than offset the unfavorable impact of lower revenue. Next on Slide 8, we summarize the aftermarket and trailer segment financial results. Sales were $233 million, down $20 million from last year, mostly due to currency headwinds in our European aftermarket business. Segment EBITDA was $31 million, up $3 million over last year. Similar to our commercial truck and industrial segment, the increase was driven by continued cost performance and pricing actions. The segment EBITDA margin of 13.3% is in line with what we told you to expect from this business at these levels of revenue. Now let's move to Slide 9, which shows the sequential adjusted EBITDA walk from Q2 to Q3. Walking from the $87 million of adjusted EBITDA generated in our second quarter, the net impact of volume mix and pricing was $10 million for the quarter. Higher sales in North America and European truck more than offset the impact of lower sales in South America. We continue to execute on our M2016 objective of achieving material labor and burdens savings. The incremental $7 million benefit sequentially from the second quarter includes both $3 million for performance and $4 million benefit associated with lower cost due to steel index movements. The benefit from the index movements is partially offset in the pricing line as we passed through the impact of prior period changes to our customers this quarter. Next, foreign exchange movements negatively affected EBITDA by $3 million in the third quarter. Moving down the schedule, you recall that we generated a one-time $6 million benefit last quarter related to mark-to-market gains associated with several foreign exchange hedges. This benefit was discreet to the second quarter and is a margin headwind to us on a sequential basis. We also experienced an incremental $6 million headwind associated with variable incentive compensation accruals. The sequential change includes the impact of some favorable accrual adjustments last quarter combined with an increase in accrual this quarter. The portion booked in the current quarter reflects the increased accrual related to our updated earnings and cash flow outlook for 2015, which I’ll discuss in a few slides. Overall, this was a strong margin quarter for us. We generated $87 million of adjusted EBITDA, which resulted in an adjusted EBITDA margin of 9.6%. We continue to execute on our M2016 cost reduction initiatives to drive margin performance while at the same time managing through the dynamics of our global end markets. Now let's turn to Slide 10. For the third quarter, total free cash flow was $71 million, which was flat compared to the prior year. Our year-to-date free cash flow is $77 million, slightly better than where we were this time last year. This performance puts us on track to achieve our updated free cash flow guidance which I’ll discuss in a few slides. Let's turn to Slide 11. As I mentioned earlier, we executed several capital markets transactions this quarter and among other things reduced the dilution impact associated with our 7-7/8% convertible notes. First, we issued $225 million of 6.25% notes that mature in 2024. A portion of the net proceeds were used to repurchase $85 million aggregate principle amounts of our 7-7/8% convertible notes. Since the end of the quarter, we repurchased an additional $25 million of the notes pursuant to a rule 10B51 plan. To date, we repurchased $110 million of the notes at an average price of 162% of par. The premium paid over par reflects the market price of these notes which include the embedded auction values of security. Since the convertible has the strike price of $12 per share, it's in the money which drives the significant premium. By issuing new debt to execute these repurchases, we lowered the interest rates while simultaneously reducing the ongoing dilution impact of these notes by 44%. We plan to use the remaining net proceeds in the fourth quarter to purchase an annuity to settle our German pension plan obligations. The recent foreign currency and discount rate decreases make annuity purchase in Germany more attractive from a U.S. dollar perspective that would allow us to permanently de-risk this portion of our pension liability. We do expect to recognize a non-cash loss of approximately $40 million to $50 million in the fourth quarter associated with the settlement of these pension obligations. Now let's move to Slide 12 which provides an update on our equity and equity-linked repurchase program. As of the end of the quarter, we had repurchased $49 million of equity and equity-linked securities reflecting 2.3 million common shares and $19 million of 4% convertible notes. Although not shown on the slide since the end of the quarter, we repurchased 1.5 million additional common shares under a 10b5-1 plan. To date, we've actually now purchased 3.8 million common shares under the program. In total including all activity to date in July, we've now repurchased nearly $70 million of equity and equity-linked securities under the program of which almost three-quarters is in the form of common equity, and we remain on track to complete the program by September 2016. Next, I'll review our updated fiscal year 2015 outlook. Based on the demand assumptions Jay highlighted on Slide 5, our fiscal year 2015 sales guidance remained unchanged at a range of $3.5 billion to $3.55 billion. We now expect to achieve an adjusted EBITDA margin of approximately 9.3% for 2015 compared to our previous range of 9.0% to 9.2%. We expect to drive this margin result largely through continued strong execution of M2016 initiatives. Implicit in this full year margin guidance is that we expect lower margins in Q4 than in the first nine months of the year. There are two drivers of this. First, we expect overall revenue to decline sequentially from Q3 due to the normal European summer holiday which always drives a revenue headwind in the fourth quarter. In addition, we received updated year-end liability valuations in September; any adjustment required as a result of these valuations would be recorded in the fourth quarter and could impact margin performance. Nonetheless, we still believe the results point to an improved outlook for the year with our margin guidance now at approximately 9.3%. Driven by the improvement in our adjusted EBITDA margin guidance as well as from the impact of our equity and equity-linked repurchase activity, we are raising our adjusted earnings per share guidance to a range of $1.40 to $1.50 for fiscal year 2015, which is an increase of $0.10 compared to our prior guidance. Our effective income tax guidance remains unchanged at approximately 15% for fiscal year 2015. As I have mentioned in prior quarters, we are generating positive earnings in the U.S. and certain European jurisdictions where we previously established valuation allowances against our deferred tax assets. We will continue to evaluate the positive and negative factors to determine whether there is sufficient evidence to reverse these valuation allowances in future quarters. Finally, as Jay mentioned earlier, we are raising our free cash flow guidance to approximately $110 million for 2015 compared to our previous guidance of approximately $100 million, which means we're expecting back-to-back years of cash flow above the $100 million level. This guidance excludes the expected cash payment of approximately $90 million related to the German pension plan settlement. In the end, we're pleased that our continued strong performance is allowing us to again raise earnings and cash flow guidance. Now, I'll turn the call back over to Jay to provide some closing remarks.

Thanks Kevin. Let's turn to Slide 14. In developing M2016, we identified key issues, established and communicated measurable objectives aligned with the organization and are successfully executing against our plan. As you know, our performance metrics include margin improvement, net debt reduction, and revenue growth. We are on track to achieve all three and are committed to bringing the plan home next year but also hard at work on our strategy for beyond 2016. Our next three-year plan will put more emphasis on executing opportunities for growth in our core and adjacent markets while remaining focused on expanding our margins and driving a balanced approach to capital allocation. We look forward to providing you with a detailed review of that plan in our December Analyst Day Meeting. And now, we'll open it up to your questions.

Can you just give us a broad sense of your China exposure? I think it's mostly off-highway, but just want to understand and also what you're seeing in that market vis-à-vis order rates, backlog, etc.

Brian, this is Jay. That's a good question. Our business today is primarily off-highway, comprising construction and mining with some premium bus and coach axles. I think what we're seeing is stability in the bus and coach axle business with extreme weakness in the other segments of the market. As implied in our Q4 guidance, we expect a further step down in Q4 compared to Q3 in off-highway and construction business, something we typically see this time of the year seasonally, but we don’t expect to see any recoveries soon in those end markets.

So that's not -- but would you say it's bouncing along the bottom or further downside?

I would say it continues to step down bit-by-bit but quite frankly, it's getting to be at such low volume levels, the impact on our guidance and the overall financial impact to Meritor is becoming relatively insignificant.

Second question, on the military side. While we wait for hopefully new awards, can you give us an update on FMTV and your expectations in fiscal 2016?

Right now we are working with the prime contractor Oshkosh on this program trying to determine what production levels to expect in 2016. I think at this point we would say we don’t see values changing too much in that period compared to 2015.

And final question, how do you think about consolidation in the driveline industry? I guess a couple questions. One, do you see opportunities within the commercial and off-highway world? Do you see any potential tuck-ins? And three, what about the idea of combining light vehicle axles and commercial vehicle axles in the same entity?

I can address the second question first. Obviously, we've worked hard for a long time to become a commercial vehicle focused business and I would tell you a big part of the PACCAR wins we've had is that PACCAR has complemented us. In fact, I think you saw the comment about Christianson made in our Analyst Day, regarding being focused on commercial vehicles. So we're very pleased with that focus, and more importantly, our customers are pleased that all of our capital and research and development goes to that area. We don’t see a lot of synergies and overlap between the two as we've evaluated that over time. But as far as expansion within the commercial vehicle business, as we review our next three-year planning cycle, that is something we're considering, looking at growth opportunities. So I mentioned in my comments regarding the core, which would be new geographies or new customers along with newer adjacencies where we think we can provide additional value to our customers. As we look at that growth, we will consider certain what I would call bolt-on acquisitions that may help us expedite that growth.

And just final question, quickly, I know I ask it every time. Any update on Meritor WABCO's participation in truck active safety, and ADAS, and can we look forward to any given that's increasing, given their braking requirements coming in, whether through the resale of active safety equipment or just higher spec brakes, is there any contribution we can expect over the next three years from that, and, if so, how to dimension it?

We've seen very solid performance in Meritor WABCO participating obviously in the increasing value of North America along with some increasing penetration, particularly of collision avoidance systems, and we're very pleased with the performance of that entity. I think it's a fair expectation of ours and should be of our investors as we could see further penetration of those safety systems in the vehicles.

But any way to dimension the impact on your equity income or your financials?

And Brian, it's Kevin. If you look, we have filed Meritor WABCO's financial statements for last year because they were a material subsidiary over the last couple of years, so you can actually see what our earnings are coming from that entity.

Wanted to ask a little more on the front axle business win at PACCAR. Our channel actually picked up that your front axles were already installed on a meaningful percentage of PACCAR's production in the second quarter. So would you expect the ramp-up to greater than 50% share to be even faster than the rear axles, now that you have a standard positioning? Just really trying to get at when you would expect to hit the $40 million revenue run rate?

Neil, this is Kevin. Yes, you are exactly right. We did start to see the ramp-up of this happen early on in the year as PACCAR started to ramp up in advance of the LTA being executed. So as we look ahead to the $40 million of revenue that we’re expecting at run rate, I would tell you that we're expecting that already two-thirds of that is hitting in fiscal year 2015 and it really started in our second fiscal quarter.

And then, Kevin, revenue from the front axle business win generate incremental EBITDA margins within your stated 15% to 20% conversion rate range you had previously provided?

We don’t give specific margin guidance on any particular program, but I think it's a fair assumption on any of our new business wins to think about it being in that general range. I think that's the fair way to think about it.

And then just one final one. Aftermarket and trailer segment EBITDA margins, very impressive in the quarter and up year-over-year again. That sounds like it was primarily driven due to continued execution of the M2016 initiatives. But you do have a tough comp in the fourth quarter versus last year. Do you guys think you can exceed last year's margin, given the momentum you built for the segment?

I don't think we're prepared to give specific margin guidance on each segment in the quarter, but I think if you look at the last four quarters in a row now, we've generated 12% to 14% EBITDA margins in that segment, and that's not an accident. I think the 14% numbers that you saw in a couple of quarters had some one-timers in there and as you think about the 13% or 13.3% we generated in the quarter which really didn't have any real type of one-timers, that's probably more of what you should expect as the run rate of this business at the current revenue level.

Just following up on that last question firstly, what was -- sorry, you said there were some one-off items that impacted the fourth quarter last year in trailer. Can you just remind us of what those were?

Well, I guess I was speaking to the 14% we generated a quarter ago where we had some FX tailwinds, the one-time foreign exchange hedges that generated some gains. So I think we've had a couple of guidances that drove us with 14% numbers, but I think you should expect something in that 13% range is about the right margin for the business right now.

And the liability true-up, I guess in September, can you tell us a little bit more about that? Is that something that you've kind of factored in a base amount, and you're being a little cautious because you don't know what the variance is, or how specifically are you -- because I'm not familiar with that particular issue?

I mean if you look at the last couple of quarters, we have seen some liability true-ups happen to us at year-end particularly around some of our legacy liabilities. Unfortunately, last year we saw a pretty meaningful step up in our legacy liability, although we saw some big upsets to that as well. So as we think about our forecast for Q4, we are assuming a few million dollars of potential liability adjustments as part of our planning process, but it remains to be seen what the actual valuations are going to come in at.

And what are -- is that like interest rate or discount rate-driven, or what kind of factors affect that?

For example, last year when we had some of our asbestos exposure, it really related to the forecast of our tenured liability based on actual experience that we were incurring in the current year. So as we just look ahead, we're being cautious and assuming that there is some risk that we could have a few million dollars of true-up, probably nothing material like we saw last year, given where we sit today. But the potential exists that there could be a few million dollars and that's what we planned for thus far in our guidance.

And lastly, any update on your M2016, $500 million sales target? Where do you stand now with the recent win?

We will update that in November, but this win, the $40 million PACCAR business win, is incremental to what you’ve seen before.

Can you just remind us the percent of sales that you have today in China and how they're structured? I believe they're through joint ventures, just so I understand the earnings?

Yes, in China, if you look a year ago, our China revenue was about $150 million. It's down 35% this year, so we're going to be in the $100 million range. That’s predominantly conducted through a 60-40 joint venture where we own 60% and our JV partner owns 40%. There are two JVs there, but the bigger of the two is with XCMG.

And then regarding the PACCAR win, can you give a sense of how your capacity is today to handle that, because the market's pretty strong in North America? What kind of capacity are you running at and are there going to be any challenges with all the new wins coming online?

I think we feel confident meeting what we estimate as the demand currently in North America with current penetration we see including the incremental business with PACCAR. I would say we wouldn't commit to that type of business without having some assurance that we could deliver on that without incurring additional expediting costs or other costs and just as importantly that we should expect PACCAR wanted to do some due diligence on that before committing to us. So I think all of us feel very comfortable where we are at and I think it's displayed in the actual quarter performance. You are not seeing premium costs impacting our ability to match the ramp up in volumes in North America.

Can you remind us on the pensions, the impact, the mortality when we measure at year-end?

Yes, this is Kevin. When we first started looking at this a year ago and looked at the Society of Actuaries tables as they were published in the exposure draft, we modeled that through our liabilities and thought the impact would be about $124 million on our liability. However, as we as the final rules about how to apply the tables were published, we realized we are able to apply some of our actual experience to modify the baseline tables. So in the end, our experience defers from that, that was published by the Society of Actuaries. The end result for the U.S., we think is going to be less than a $25 million impact on our liability at the end of the year versus the 124 we thought about a year ago at this time. So less than $25 million, we think at this point.

And lastly, any update on your M2016, $500 million sales target? Where do you stand now with the recent win?

We will update that in November, but this win, the $40 million PACCAR business win is incremental to what you've seen before.

I know you guys look at fiscal year a little bit differently, but I want to talk a little about the North American market. Obviously we're at very high levels. Where do you see that going, in terms of are we at peak? There's a lot of debate in the market. And would it be a bad thing to kind of come down from these really, really high levels? It sounds like you're not incurring any premium cost, kudos to you, but would it be a little bit more comfortable for you if the market cooled off just a little bit in North America next year?

Well, as I mentioned in my comments, I typically foresee this high volume level continuing through the calendar year, as we have discussed previously through this calendar year. Certainly we would like to see orders pick up a bit to continue these very strong levels through next fiscal year, but will be providing our detailed outlook next quarter in conjunction with our guidance for fiscal '16. As far as whether it's a good thing if it cools off, I think it's important to note that we are able to perform very well at these volumes. I think we are in a broad range where this market can be very profitable for us. So if it comes down a bit certainly we will miss those volumes. I wouldn't mislead you but I think we'd still have a very profitable business in North America.

And then kind of the same question in Europe, but kind of the reverse. It seems like it's a little bit more slower ramping there, but are there any things that we should watch out for in that market as things seem to get better? Are you anywhere near how you think about operationally ramping up there? Are there any challenges as that market continues to accelerate?

I think we feel good about Europe. We did have a pre-buy a little over a year ago now that we actually hit very well on. We lost it about one quarter, but again, we expect very few if any premium costs can be incurred to deal with that spike in volumes. Right now I think what you're seeing in that market is just slow building confidence and increased orders. It looks like it could be a slow ramp up which we could respond to very effectively. We are very pleased with the profitability of our European business overall.

This is Jay Craig. I just want to thank everyone for joining the call and for your continued interest in Meritor. More importantly, I want to thank the Meritor employees for their efforts this quarter and for delivering outstanding results for our investors. Our results in the third quarter are really a testimony that our focus on execution and revenue growth is working. We're committed to delivering increased shareholder value by driving margin improvement, reducing debt, and positioning our core businesses for profitable growth. I look forward to either seeing you before the next quarter or speaking to you next quarter. Thank you.