Cummins Inc (CMI) — Q3 2016 Earnings Call Transcript

Thank you, Sabrina. Good morning, everyone, and welcome to Meritor's third quarter 2016 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're recording, is the property of Meritor, Inc. It's protected by U.S. and international copyright law and may not be rebroadcast without expressed written consent of Meritor. We consider your continued participation to be your consent to our recording. Our discussions 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 our slides on our website. Now, I'll turn the call over to Jay.

Good morning, everyone, and thanks for being with us today. As you probably saw in our press release this morning, we had a great third quarter of financial performance. On slide 3, you can see the highlights. We reported an adjusted EBITDA margin of 11.4%, adjusted diluted earnings per share of $0.57, and free cash flow of $86 million. The excellent operational performance that we've maintained for many quarters continues to drive real earnings growth and cash flow. We continue to win in the marketplace and are very close to achieving our three-year goal of securing $500 million of new business wins. I'll highlight a few of our latest awards in just a moment. We also completed our $210 million equity and equity-linked repurchase program in July, building on the many achievements associated with our M2016 strategy. We are now beginning to shift our focus to initiatives that will ensure the success under our M2019 plan. As part of this plan, we expect to have continued strong cash flow performance. With that in mind, we're pleased to announce today new debt and equity repurchase authorizations. Let's move to slide 4. In the third quarter, we repurchased approximately $39 million or 4.7 million common shares. Based on the trading levels of our stock price, we opportunistically finished the program a quarter early. Overall, we repurchased 12.8 million common shares under this program, which equated to approximately 13% of our total shares outstanding. In addition, we bought back a total of $74 million in convertible debt, which lowered interest expense, improved our debt maturity profile, and mitigated long-term equity dilution risk. We continue to believe that our stock has been an excellent investment, given our consistent earnings and cash flow performance demonstrated during the M2016 program. At the same time, we are committed to reducing our debt levels as part of our M2019 strategy. With that in mind, our board of directors has delegated authority for us to execute up to $150 million of debt and $150 million in equity repurchases over the next three years. These authorizations provide us the flexibility to begin taking capital structure actions aligned with our M2019 goals. You should expect to see us start to execute such repurchases over the coming quarters. As you know, securing new business continues to be a primary focus as we finish out M2016 and turn our attention to M2019. On slide 5, we highlight some of our recent wins. In the third quarter, we earned $25 million of additional new business wins. Part of this incremental business is based on an award we received to supply axles and brakes for a specialized vehicle that the Volvo Group will supply to the Canadian military. We expect that production to begin in fiscal year 2017. The remainder consists of incremental sales in various Aftermarket & Trailer product lines, including an award for remanufactured trailer axles and expanding our air systems business in the aftermarket. In our specialty business, we will be supplying our tandem heavy haul axle to an OE customer for an oil and gas vehicle. With our cumulative M2016 new business awards of $475 million, we are very close and motivated to deliver on our M2016 goal of $500 million. Slide 5 provides our view of the end markets for the remainder of fiscal 2016 with some additional insight as we approach 2017. Overall, our global forecast is relatively unchanged. As we said last quarter, in North America, excess Class 8 inventory and declining used truck prices due to softer freight demand are causing fleets to adjust their orders for new trucks. This has led to reduced build rates and OE production levels. At this time, we are guiding to 245,000 to 250,000 units, basically unchanged from our previous forecast. Last night's release of July orders is in line with this estimate. We continue to believe we're in the midst of an inventory correction in the Class 8 market. Once excess inventory is depleted, we expect to see the markets stabilize to relatively normal production levels to sustain replacement demand. While we are not providing guidance for fiscal year 2017 today, we do want to give you some insights into what we are anticipating in the next fiscal year for two of our major markets. For North America, we're expecting the current headwinds to continue to create some level of downward pressure on orders and subsequent builds, particularly in the first half of the fiscal year until excess inventory clears. And in Europe, while Brexit is certainly an unknown, we are not currently seeing any production impact as we approach 2017. We will provide more detail on 2017 later this year following our fourth quarter earnings announcement. On slide 7, we have provided an update on our M2016 scorecard. And once again, the main takeaway from this chart is that we are on track to achieve all three financial objectives this year. We have continued to improve our margin throughout the M2016 timeframe and we ended last year with a 9.5% margin. Year-to-date for fiscal 2016, we are at 10.2%, and we remain confident in our ability to achieve the 10% EBITDA margin for the full fiscal year that we committed to three years ago. The second financial target was to reduce net debt by more than $400 million to less than $1.5 billion. We achieved that target at the end of fiscal 2015, and we're confident we'll stay at or below that level till the end of our fiscal year. Keep in mind, our net debt definition includes our pension and OPAT. Our unfunded pension position has remained very stable throughout the year even as interest rates have declined significantly. In fact, if we were to mark-to-market our pension liability as of the end of this quarter, we estimate that this would increase our net debt by only $30 million. We have benefited from derisking strategies and strong asset performance even through the most recent quarter just ended. Our third target was to achieve $500 million of incremental booked revenue. As I mentioned earlier, the incremental $25 million of new business means we are now at $475 million: 10% of EBITDA margin, $400 million in debt reduction, and $0.5 billion in new business wins. Those were our M2016 objectives, and we are positioned to deliver on all three. Our ability to achieve these challenging objectives is driven by the expertise, passion, and commitment of the entire Meritor team. As a company, we are completely aligned around our priorities. With that, I'll turn the call over to Kevin for more detail on the quarter and our outlook for the 2016 fiscal year.

Good morning. As you heard from Jay, we had a very strong financial performance in our third quarter. Let's walk through the details of our results by turning to slide 8. Sales are $841 million, down 7% compared to last year. The revenue decline was primarily driven by lower Class 8 truck production in North America, which was down nearly 30% year-over-year. But our new business wins have significantly mitigated the impact of this sizeable market decline in North America. Gross margin was 15.1% this quarter, which is an increase of 150 basis points over last year. Lower material, labor, and burden costs continue to drive gross margin performance. SG&A was $6 million lower compared to the third quarter of last year. The decrease was driven by a $6 million cost recovery from a supplier associated with the product liability damages matter. This settlement partially offset related costs we've incurred over the last few years. We also recognized $3 million related to an asbestos insurance recovery from an insolvent insurer, which partially mitigated our asbestos-related cost in the quarter. While both of these cash recoveries are discrete to this quarter, they are part of our continuing focus on mitigating all costs impact in the business. Income tax expense was $8 million in the third quarter of 2016, which translates to an effective tax rate of approximately 16%, in line with our expectations. For the full year, we're expecting an effective tax rate of between 15% and 20%. The bottom line is that we generated $42 million of income from continuing operations attributable to Meritor. And after adjustments for non-cash tax expense and restructuring cost, which we've detailed in the appendix, we generated adjusted income from continuing operations of $52 million and $0.57 per diluted share, an increase of $0.15 or 36% over last year. Let's move to slide 9, which compares our sales and EBITDA for the third quarter of fiscal year 2016 to 2015. As you can see on the right side of the slide, the year-over-year impact of foreign exchange has finally moderated, with only a slight headwind on both revenue and EBITDA this quarter. As we look forward to our fourth quarter, we don't expect FX to have a material impact on our results. Next, as I mentioned previously, we had two discrete recoveries in the quarter. These yielded $9 million of good news earnings. Further down the income statement, you can see the volume and mix drove revenue lower by $61 million compared to last year. Despite this, we were able to increase EBITDA by $3 million related to volume, mix, performance, and other. This was driven by a combination of lower steel indices and strong material, labor, and burden performance, which more than offset the impact of lower revenue. As a result, our adjusted EBITDA margin was 11.4%, up 180 basis points from last year. Even if you were to exclude the impact of the supplier and insurance recoveries, we still would have generated an adjusted EBITDA margin of 10.3%. Either way, a strong quarter performance. Slide 10 details third quarter sales and EBITDA for each of our two reporting segments. In our Commercial Truck & Industrial segment, sales were $640 million, down $65 million or 9% from the same period last year. Our new business wins significantly mitigated the 30% decline in North America Class 8 truck production. We also benefited from slightly higher revenue in India, as that market continues to increase on a year-over-year basis. Segment EBITDA was $61 million, up $3 million from last year, which drove an increase in EBITDA margin to 9.5%, 130 basis points higher than last year. This increased margin was primarily driven by strong cost management and lower steel indices, both of which continue to favorably impact our earnings. However, we have seen certain steel indices increase in the last couple of quarters, so as we look to Q4, this will be a modest headwind to earnings. In the Aftermarket & Trailer segment, our North America Aftermarket business continues to be a little softer than we were originally anticipating. However, with the new business wins that Jay mentioned earlier, overall revenue in the segment was down only 2% from last year. Segment EBITDA was $38 million, up $7 million compared to last year. This increase was driven primarily by the $6 million supplier recovery we mentioned earlier, as well as favorable material costs. Overall, EBITDA margin was 16.7% in the quarter, up 340 basis points over last year. If you were to exclude the supplier recovery, our margins would have been just over 14%, consistent with what we previously said you should expect for this business. Now, let's turn to slide 11. We generated $86 million of free cash flow this quarter, which was up $15 million from last year. We are converting our strong earnings and solid working capital performance into meaningful cash flow generation and are well on track to achieve our full-year free cash flow guidance of $90 million. Importantly, we're producing this level of cash flow even as we're increasing our year-over-year capital spending to support our growth initiatives and operational performance objectives. Next, I'll review our updated fiscal year 2016 outlook on slide 12. With a couple of months left to go in our fiscal year, we now expect our full year revenue to come in at approximately $3.225 billion, down slightly from our previous guidance. Aside from the modest step down in our Brazil production outlook, our market expectations are relatively unchanged. However, as we look at the last couple of quarters in the fiscal year, we are seeing some modest mix shift in customer production that is causing a slight decline in our revenue outlook. From a margin perspective, we continue to remain on track to achieve our adjusted EBITDA margin target of 10%. Implicit in the full-year margin guidance is that we expect lower margins in Q4 than we've seen year-to-date. This is almost entirely due to the anticipated step down of revenue from Q3 to Q4, which is caused by two things. First, our European revenue will decline due to the normal impact of European summer holidays. Second, we expect that North America Class 8 truck production will step down sequentially as we see the continuing effect of the inventory correction that is underway. As a result of these two factors, we're expecting fourth quarter revenue of around $750 million. We're also maintaining our adjusted diluted earnings per share from continuing operations guidance of approximately $1.60 for fiscal year 2016, the midpoint of our prior guidance. Even though lower revenue will drive slightly lower bottom-line earnings, we expect the EPS impact of that to be completely offset by the impact of lower outstanding shares resulting from the completion of our repurchase program. Finally, we're maintaining our free cash flow guidance of $90 million. We generated $78 million through nine months and have a clear line of sight of finishing the year strong.

Thanks, Kevin. Let's turn to slide 13. As we wrap up fiscal year 2016 in less than two months, we are proud of what we've accomplished during the last three years. Most importantly, we have shown that when we make a commitment, we deliver. And as we go forward, we will maintain that focus. Looking ahead to 2017, we're not expecting to see a rebound in end markets. In fact, we anticipate that the global markets will likely remain under pressure, particularly as inventories continue to correct in the North American Class 8 truck market. In spite of this, we will continue to drive performance in 2017. We will maintain our focus on margin, EPS, and cash flow, and we will begin executing on our capital allocation priorities. 2017 will also be an important year as we remain committed to an aggressive product life cycle that is part of our M2019 program. These important new products represent a critical element of the revenue objective we established to grow sales more than 20% above market. Also, as part of M2019, we plan to increase EPS, achieve our leverage target for net debt, and return 25% of free cash flow to shareholders. We're confident in a strong finish this year and look forward to beginning our new three-year plan that will shift the pendulum towards growth. We demonstrated with M2016 that we know how to develop and deliver on our strategy to drive shareholder value. We plan to do it again with M2019. We'll provide more details as we begin next year. Before we take your questions, I'm pleased to share with you that our board of directors recently elected Jan Bertsch as a new Director. Jan has been Senior Vice President, Chief Financial Officer, and Chief Information Officer of Owens-Illinois since November of 2015. Prior to that, she held executive financial positions with Sigma-Aldrich Corporation, BorgWarner, and the Chrysler Group. We are pleased to add Jan's experience and expertise to our board as we enter the next chapter of our success through the execution of our M2019 strategy. Now, let's take your questions.

Yeah. I have a couple of questions. First, vis-à-vis Europe, your major customer has been doing well in terms of share and it's beginning to call out some capacity constraints. Are you seeing that at all, and where are you capacitized versus where you think those markets and your customer share could go?

Thanks, Brian. This is Jay. Thanks for the question. You're right. We're happy to be part of our customer's success in Europe. We have not experienced any capacity constraints on our end. I think as you know, we've made some significant investments in all our manufacturing facilities around the world, and, in particular, in our Lindesberg, Sweden plant that is the primary supporting facility for our customers in Europe. I should also mention that IVECO is doing quite well, which is also a significant customer of ours in Europe. So, we're benefiting from both of those customers having very strong performance right now.

And the second question also EU, the EU is tightening up CO2 standards supplying them to trucks. What are you working on to help your customers meet those challenges, particularly around disconnecting axles? And also, again, back to the key customer because overall they're trying to drive fuel efficiency technology. How will that partnership evolve as they have to meet tighter fuel economy goals?

That's a great question, Brian. I think overall, as I look at it from 30,000 feet, what it's done is driven our relationship closer on the technical side as we have needs to meet those requirements on both sides of the Atlantic. We've made investments in new lab equipment to help our customers measure the benefits of fuel economy increases. In addition to all the new product development we are pushing forward, you mentioned that Detachable Tandem certainly has those types of products in our future product program plans. We talk about here on this side of the Atlantic to 14X EVO, which will increase fuel economy. We also have a similar product on the European side called 17X EVO, which is expected to have market improvement in fuel economy. But it all fits into what I spoke about at the Analyst Day of us doubling the pace of our product introduction over the next few years. We think we are not only meeting but exceeding our customers' expectations in that regard.

Hi. Good morning, and thanks for taking my question.

Good morning.

On slide 9, you mentioned that volume, mix performance, and other was a positive year-over-year contributor to EBITDA. Now this is despite revenue declining $61 million year-over-year ex FX, indicating volume was a big headwind. If you assume like a 20% detrimental, maybe $12 million. So, what are the other elements of this combined category that are still positive, and what additional color can you provide on what is possibly benefiting mix performance or other?

Okay. Hey, Ryan. It's Kevin Nowlan. There are really two things. First is material, labor, and burden performance. And second is really the benefit of steel indices. And so, if you look at the $61 million, I think you've done the math right. You would expect ordinarily upwards of a $12 million headwind. We've seen three positives. So, we're up $15 million of performance items. It's really those two things more than anything else that are more than offsetting the lower volume.

Okay. That's great. Would you expect more tailwind from steel indices going forward given - or less, given some of the uptick? How do you think about that? I'm sure there's some sort of lag between spot and P&L.

There is. And so as we look ahead to the fourth quarter, I think we're going to see a little bit of a sequential headwind coming from steel indices. Over the last couple of quarters, we've seen some of the indices, particularly in the North American market, creeping up. And so we would expect a few million dollars of headwind, and that's reflected in our guidance for Q4.

Okay. Thanks. That's helpful. And then just a last question on the regional outlook. It looks like on page 6, you're maintaining volume across most regions, except the U.S. - but in South America, right, where you're looking for a steeper decline. Can you remind us - I know there's been some dispositions and re-organization over the years. Can you remind us of the - and then of course, it's sort of organically declined. Can you remind us of your current revenue exposure to South America and then just the principal countries and types of vehicles that we should be mindful of that you're levered to?

As far as our revenue exposure...

Last year, we were at revenue of about $200 million in Brazil.

And you can see what's happened in the market there. So, our revenue this year will be down about 30% in Brazil, probably in the 130s. Our exposure is primarily on the heavy side and less on the medium-duty side in Brazil as you look at those markets. We particularly have exposure on the extra heavy side, which is doing slightly better in a very weak market right now with the wins with DAF most recently. Their product is focused on that extra heavy side, and we have a little more exposure on that side.

Hi. Good morning. Congrats on a great quarter, guys.

Thanks, Neil.

Are you able to provide an update on the amount of incremental revenue expected to be realized in FY 2017 from the new business wins already achieved? I know you won't provide initial FY 2017 revenue guidance until November. What I'm just trying to get at is whether you think you have enough revenue in the pipeline from new business wins to offset the further costs you alluded to in your global line market?

Neil, this is Jay. Just let me give you a couple of data points. Approximately $300 million of that new revenue win we expect to be in fiscal year 2016. Then we expect the remainder to flow through over the next couple of years. So, we expect relatively near-term improvement. Obviously, we're repositioning, focusing on M2019 objectives, and starting to refocus to develop a similar pipeline as well for that period.

Okay. That's helpful. And then can you just talk about the increase in your North American medium-duty forecast? I mean, is that just fine-tuning the outlook based on year-to-date performance, or is the outlook for underlying demand getting better? And then just is your comment about continued pressure on FY 2017 also applicable to this market? And then, I guess, can you just talk about how the launch of the 13X Axle for the medium-duty market is tracking versus your expectations? Thank you.

Sure. Thanks. Yeah. The medium-duty market, you even saw on some of the information coming out last night, has been more stable than the Class 8 market. Right now, down a bit but still even on last night's information, it has been more stable. Our exposure to that market is relatively small compared to our Class 8 exposure. We have a couple of large customers associated with Navistar and Hino. We are in the process of launching the 13X Axle with Navistar, and it's going very well. We would expect to plan that launch with Hino in the future as we go forward. We continue discussions with other OEs about that product because we believe that it's a superior product in terms of performance, fuel economy, and durability.

Thanks for taking my question. Any color - can you just remind us how you're hedged for commodities? I mean, is it something impacting margins on a rolling basis, or do you have actual direct exposure to commodities?

With the bulk of our OE customers, we have a pass-through mechanism that allows us to pass through increases or decreases as steel indices move. These are intended to match up with our purchasing activity from our suppliers. Now, there is a lag between the cost coming through favorably or unfavorably from our supplier and the pass-through mechanism to our customer, and that lag tends to be in the range of about six months. So, as we've gotten some benefit from steel over the course of the early part of this year with indices coming down, we are now giving that back to our customers through the pass-through mechanisms. And as we look to the fourth quarter and we start to see the index tick up, we'll start to see some headwind from that, but then we would get the benefit of that from our customers back sometime during 2017, effectively on a six-month lag.

And when you say bulk, you mean - I mean, any estimate around that in terms of the percent you're directly exposed to versus the percent on pass-through?

With our OE customers in the North America, European, and Brazilian markets, really all of our OE business has done some sort of pass-through arrangement. The only businesses that aren't formally really on a pass-through mechanism would be our African market business, which is really just more subject to the pricing pressures in that market.

Got it. Any color - so you completed the - correct me if I'm wrong, you completed the $210 million repurchase. You now have $100 million repurchase authorized per stock. I mean, how should we be thinking about that going forward as you try to balance repurchases versus improving the balance sheet of the business?

I think you characterized it the right way. If you think about the $150 million debt authorization and the $100 million of common equity authorization, they are authorizations. They're not specific programs; they're authorizations that allow us to execute on our M2019 capital allocation priorities. You remember what those are from Analyst Day: maintaining strong liquidity, achieving BB credit metrics, returning 25% of cash flow to shareholders, and supporting our strategic growth initiatives. What these authorizations do is they give us the flexibility to be opportunistic in executing against those capital allocation priorities, which includes a mix of both taking out some additional debts to reduce our leverage because that's important to achieve BB credit metrics, as well as meeting our commitment to returning value to shareholders. You should expect us to start commencing on execution under those programs within the next few quarters.

Good morning, gentlemen.

Good morning.

Good morning, Brett.

I was hoping you can delve into a little bit more the state of your end markets, in particular, North America and Brazil. I guess what I'm really looking for is a from a 30,000-foot perspective, as you look at them and the puts and takes in the industry and drivers and so forth, where do you think we're at in terms of the cycle? And again, in particular, I'm interested in your thoughts on North America and Brazil.

Sure. I'll start first with Brazil, Brett. I was down there just a few weeks back, and I think what we're seeing appears to market has stabilized at this very low level. Inventory levels seem correct from what the demand is right now. So, if we see an uptick in demand, it should move relatively quickly into production. We're not seeing that at this point, but at least, the inventory levels seem to be balanced in the right direction. If we move to North America, I think it's really an opposite issue. We still have excess inventory in the system. Depending on which figure you look at, it could be upwards of a month's worth of production. It's still inventory that needs to clear the system. Fleets are being very cautious; freight rates have become a bit unstable if you look at the recent public earnings releases from Swift or Knight. They're still seeing pressure on freight rates. I think this is really going to take two things for us to see that market to begin to pick up back to a replacement demand level. And that is that the fleets see stronger freight rates and we start to see that inventory get to a more normalized level. I'm looking towards the ATA meeting in the first week of October that tends to be a good bellwether, with a lot of the larger fleets placing their orders around that time period. We should get a pretty clear view of where inventory stands at that point.

So, in Brazil, it sounds like it's stabilized. Do you have any stance as to a possibility of an inflection point at any point in time? Is there any signs that you see in Brazil that cause you to think, I think that after the Olympics are over, for example, things are going to start to improve or something along those lines?

I'm not confident enough to stick my neck out on predicting the Brazilian economy yet. But as I said, I think the good news is it appears the inventory levels have gotten to the right level. Any upticks should very quickly move into production demand. So, that's the first step they needed to get to, and they've gotten there.

And it sounds like we're still working to do the inventory here in North America, and it's probably out into your 2017 timeframe before there's even a possibility that we could see maybe your production inflection. Is that...

I think as I've mentioned in my comments, we think the first two quarters remain some inventory to be cleared out of the system.

Thank you, everybody. And this will conclude our call today.