Cummins Inc (CMI) — Q4 2016 Earnings Call Transcript

Thank you, and good morning, everyone, and welcome to our teleconference today to discuss Cummins results for the fourth quarter of 2016. Joining me today are our Chairman and Chief Executive Officer, Tom Linebarger; our Chief Financial Officer, Pat Ward; and our President and Chief Operating Officer, Rich Freeland. Before we start, please note that some of the information you will hear or be given today will consist of forward-looking statements within the meaning of the Securities and Exchange Act of 1934. Such statements express our forecasts, expectations, hopes, beliefs and intentions on strategies regarding the future. Our actual future results could differ materially from those projected in such forward-looking statements because of a number of risks and uncertainties. More information regarding such risks and uncertainties is available in the forward-looking disclosure statement in the slide deck and our filings with the SEC, 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'll 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 today's presentation, are available on our website at cummins.com under the heading Investors and Media. Now I'll turn it over to Tom.

Thank you, Mark, for that inspiring introduction. Good morning, everybody. I'll start with a summary of our fourth quarter and full year results and finish with a discussion of our outlook for 2017. Pat will then take you through more details of both our fourth quarter financial performance and our forecast for this year. Our references to EBIT and EBIT percent exclude restructuring and impairment charges taken in the fourth quarter of 2015. Revenues for the fourth quarter of 2016 were $4.5 billion, a decrease of 6% compared to the fourth quarter of 2015. EBIT was $526 million or 11.7% compared to $531 million or 11.1% a year ago. EBIT increased as a percentage of sales as the benefits of our cost-reduction actions and the absence of a loss contingency charge recorded in the fourth quarter of 2015 more than offset the impact of weaker volume. For the full year, Cummins sales were $17.5 billion, down 8% year-over-year. Our EBIT margin was 11.4%, down from 12.5% in 2015. Our decremental EBIT margin for the year was 24%, consistent with our plan even after absorbing $138 million additional accrual for the loss contingency. This solid performance reflects strong execution of our restructuring plan, material cost-reduction programs and quality improvements that helped mitigate the impact of lower volumes in very weak markets. Engine business sales declined by 10% in 2016 due to weaker production of medium- and heavy-duty trucks and softer demand for construction equipment in North America. EBIT was 8.8% compared to 9.9% in 2015 due to the impact of weaker revenues and the increased accrual for the loss contingency in 2016. Sales for our Distribution segment declined by 1% as weaker sales to off-highway markets and the negative impact of a stronger U.S. dollar offset growth from acquisitions. In the fourth quarter of 2016, we completed the acquisition of our last remaining distributor joint venture in North America, bringing the total number of acquisitions to 13 since we announced our plan in September 2013. Full year EBIT was 6.3% compared to 7% in 2015 due to weaker organic sales and the negative impact of currency. Full year revenues for the Components segment decreased by 6% as weaker truck demand in North America more than offset strong growth in China. EBIT was 13.3% compared to 14.5% in 2015, mainly due to the impact of lower sales. EBIT in the fourth quarter was 11.9% as we incurred additional costs associated with the launch of our new Single Module aftertreatment system in North America. We do expect to continue to incur additional costs through the first half of 2017 as we resolve startup issues in our production supply chain for this important new product. Power Systems sales declined by 14% in 2016, with weak demand in most major geographies and end markets. EBIT was 7.5% compared to 8.9% in 2015 as the impact of lower sales more than offset a 17% reduction in operating expenses achieved through restructuring and other cost-reduction activities. We continue to make good progress with our plans to exit our U.K. generator set manufacturing plant in Kent, with high-horsepower generator set assembly now transferred to our Daventry engine plant. By the end of 2017, we will complete the transfer of the remaining wide variety of small generators currently produced in Kent to existing locations in China and India. These actions will position the business for further cost reduction in 2018. Now I will comment on some of our key markets in 2016 starting with North America, and then I will comment on some of our largest international markets. Our revenues in North America declined 12% in 2016, primarily due to lower engine and components sales to North American heavy- and medium-duty truck market. Industry production of North American heavy-duty trucks declined to 201,000 units, a decrease of 31% from 2015 levels. Our market share clearly improved in the second half of 2016 and exceeded 31% for the full year but was down from 33% in 2015. 2016 marked the 10th straight year that customers have selected Cummins as the leading engine supplier to the heavy-duty truck market. The market size for medium-duty trucks was 108,000 units in 2016, a decline of 13% from 2015. We remain the clear leading engine manufacturer in the medium-duty truck market with full-year market share of 75%, down slightly from 78% a year ago. 2016 marked another strong year for pickup truck sales in North America, and we shipped 131,000 engines to Chrysler, slightly ahead of 2015 volumes and sold 19,000 units to Nissan in our first full year of production. Engine sales to construction customers in North America declined 15% in 2016 as the market faced an overhang of equipment inventory, driving OEMs to cut production. Engine shipments to high-horsepower markets in North America declined by 14% year-over-year, reflecting weaker demand in all end markets. Revenues for Power Generation decreased by 4%, driven by lower sales to rental companies as they cut back their capital expenditures. Our international revenues declined 2% in 2016. Our full year revenues in China, including joint ventures, were $3.5 billion, an increase of 6%, as some end markets rebounded from weak levels in 2015. Industry demand for medium- and heavy-duty trucks in China increased by 28% for the full year as the OEMs increased production, partially driven by new regulations aimed at combating vehicle overloading. Our market share in 2016 was 15%, down from 16% in 2015 as our partner, Dongfeng, lost share in the face of very competitive pricing in the industry. Sales of our ISG heavy-duty engine grew in line with the market. Shipments of our light-duty engines in China increased by 14% while the overall market declined 1% as Foton continued to increase the proportion of its trucks powered by our joint venture engine, displacing local competitor engines. Our full year share in the light-duty truck market exceeded 7% in 2016, up 90 basis points. Earnings at our Foton-Cummins joint ventures declined in 2016 while volumes increased. During the fourth quarter, we initiated actions to improve the performance and reliability of our ISG engine in some duty cycles. We incurred costs in the joint venture to make product changes and support customers. We expect the product improvements to be complete by the third quarter of this year and expect to incur additional costs associated with these actions until the actions are complete, albeit at a lower level than experienced in the fourth quarter of last year. Despite these issues, we remain very confident that the ISG is a game-changing engine for the Chinese truck market, and customer demand for this engine remains strong. Demand for construction equipment in China improved, with sales of excavators rising 19% in 2016. This marks the first annual increase in demand for excavators since 2011, but demand remains well below historical levels. Our construction engine volumes increased by 40% as excavator demand increased and we picked up share in wheel loaders. Revenues for our Power Systems business in China declined by 17% due to continued weakness in power generation, marine, and mining markets. Full year revenues in India, including joint ventures, were $1.6 billion, a 7% increase over 2015. Industry truck production increased 8% to 346,000 units, and our market share remained at 41% for 2016, with nearly 80% of Tata Motors trucks powered by our joint venture engines. Revenues for Power Generation increased by 2%. In Brazil, our revenues decreased 19%, driven mainly by an 18% reduction in truck production in a very challenging economy. Now let me provide our overall outlook for 2017 and then comment on individual regions and end markets. We are forecasting total company revenues for 2017 to be flat to down 5% from 2016. We expect market conditions to continue to be challenging in 2017, especially in the first quarter. Industry production for heavy-duty trucks in North America is projected to be 178,000 units in 2017, an 11% decrease year-over-year. We expect our market share to be between 29% and 32%. In the medium-duty truck market, we expect the market size to be 108,000 units, flat compared to 2016. We project our market share to be in the range of 73% to 75%. Our engine shipments for pickup trucks in North America are expected to be flat compared to a strong 2016. In China, we expect domestic revenues, including joint ventures, to be up 3% in 2017. We currently project flat demand in light-, medium- and heavy-duty truck markets. We expect our market share in the medium- and heavy-duty truck market to be at least 15%, flat with 2016. In light duty, we expect our share to grow to 8%, up from 7%. We currently project 5% growth in off-highway markets in China. In India, we expect total revenues, including joint ventures, to decline 5%, mainly due to weaker truck demand driven by the transition to Bharat Stage IV emission standards starting in April. Bharat Stage IV is the first major countrywide emissions change in the Indian truck market involving the introduction of aftertreatment systems. As a result, it's hard to predict the impact on truck demand post-implementation. Truck dealers do appear to be well-stocked with new trucks, and we anticipate that any end user pre-buy activity will likely be met with current truck inventories and without a significant increase in production in the first quarter. We do expect demand to drop off after the implementation of the new regulations, and we have factored in a decline in industry production of between 10% and 20% for the full year into our forecast. We currently expect growth of 5% in off-highway markets in India. Demand in off-highway markets was growing at a faster rate in the first half of 2016, but the pace of economic growth has slowed following the introduction of the government's demonetization policy. We're optimistic that the government's focus on improving infrastructure will support growth in both our on- and off-highway businesses in the coming years. In Brazil, we expect truck production to be flat in 2017. Demand is at very low levels. And while we are optimistic that the next move in production will be up, there's no clear catalyst for sustained improvement in the near term. We expect our global high-horsepower engine shipments to be flat in 2017. We expect a modest improvement in new engine orders from mining consumers while demand in marine markets remains very weak. Orders for new engines for oil and gas applications in North America also remain very low, although demand for rebuilds of existing engines has increased. In summary, we expect full year sales to be flat to down 5% due mainly to weaker truck production in North America. We expect EBIT to be in a range of 11% to 11.5% of sales, with performance expected to be weakest in the first quarter. Through our cost-reduction initiatives and focus on operational improvements, we have effectively managed through a multiyear decline in some of our largest markets and delivered EBIT margins well above prior troughs. We have continued to invest in new products in our Distribution network that position us to drive profitable growth when end markets do improve. Demand in most of our key markets remains below replacement levels. Having said that, for the first time in a number of years, there are some early signs that point towards improvement in 2018. In addition to our strong focus on operational improvements, we have also continued to return cash to shareholders. We returned 75% of operational cash flow to shareholders in 2016, and we'll return at least 50% in 2017 through dividends and share repurchases. Finally, we continue to make progress in advancing our strategy as we outlined in the last Analyst Day. And although I have nothing to announce today, we are optimistic that we will continue to make progress in executing our plans. Now let me turn it over to Pat.

Thank you, Tom, and good morning, everyone. I will start with a review of the full year 2016 financial results before moving on to our fourth quarter performance. All comparisons in the full year and the fourth quarter of 2015 for the company and for each of the operating segments will exclude the charges for impairment and restructuring actions that we took in the fourth quarter of 2015. Full year revenues for the company were $17.5 billion, a decrease of 8% compared to the prior year. And as Tom just described, declines in commercial truck production in North America and the lowest level of demand for high-horsepower industrial engines and power generation equipment in more than a decade led to the overall revenue decrease. Negative currency movements against the U.S. dollar reduced our sales by approximately 2%. North American revenues declined 12% in 2016 and represented 58% of our total revenues, down from 61% in 2015. International revenues declined by 2% compared to the previous year, mainly due to foreign currency movements. Excluding the impact of the currency movements, international revenues grew almost 3%, with growth in China and in India being offset by weaker demand in Latin America, the Middle East, and Africa. Gross margins were 25.4% of sales and are 50 basis points lower than last year. Material cost reductions and the benefits from restructuring actions taken in the fourth quarter of 2015 offset most of the negative impact from lower volumes and an unfavorable product mix. Selling, administrative and research and development costs were up 50 basis points as a percent of sales. They decreased by $145 million in the year due to savings from previous restructuring actions, which were partially offset by added expense through distributor acquisitions. Joint venture income decreased by $14 million compared to last year due to the acquisition of the North American distributors and lower earnings from the joint ventures in China. Other income expenses improved by $50 million, primarily due to the change in the cash surrender value on corporate-owned life insurance plans, gains recorded on the divestiture of a power system joint venture, and an increase in royalty income. In total, earnings before interest and tax, or EBIT, was 11.4% of sales in 2016, down from 12.5% of sales that we reported in the previous year. The decremental EBIT margin was 24% for the full year. EBIT for 2016 and 2015 included charges for a loss contingency of $138 million and $60 million, respectively, as we previously reported. Net income was $1.4 billion or $8.23 per share. This compares to $1.6 billion or $8.93 per share in the previous year. The operating tax rate for the full year was 24.6% compared to 27.4% in 2015 due to changes in the geographic mix of earnings. Now let me comment specifically on the fourth quarter and provide some more details on our performance. Fourth quarter revenues were $4.5 billion, a decrease of 6% from a year ago. Sales in North America, which represented 56% of our fourth quarter revenues, declined 13% from a year ago as a result of lower commercial truck production in North America and weaker demand from industrial engines and power generation equipment. International sales improved by 6% compared to 2015 due to stronger demand in China and in Mexico, which more than offset the weaker conditions in the Middle East and in Africa. Gross margins were 24.9% of sales, a decline of 30 basis points from a year ago. Warranty was an 80 basis point headwind due to the variable expense recorded in the fourth quarter of '15. The negative impact from the lower volumes and an unfavorable product mix were partially offset by material cost savings and the benefits from previous restructuring actions. Selling, administrative and research and development costs of $677 million or 15% of sales increased as a percent of sales by 60 basis points but decreased $8 million from a year ago. The benefits of previous restructuring actions offset the added expenses from the distributor acquisition. Joint venture income of $67 million was $8 million lower compared to a year ago. Earnings declined due to costs incurred associated with quality improvements in our Foton-Cummins joint venture in China, largely offset by earnings growth in a number of our other international joint ventures. Earnings before interest and tax was $526 million or 11.7% of sales for the quarter compared to $531 million or 11.1% a year ago. Our EBIT in the fourth quarter of 2015 included a $60 million charge for the loss contingency. Net earnings for the quarter were $378 million or $2.25 per diluted share compared to $2.02 from a year ago, and the effective tax rate for the quarter was 22%. Moving on to the operating segments, let me summarize their performance in the quarter and for the full year 2016 and then provide a forecast for 2017. I will then review the full year cash flow and conclude with the company's revenue and profitability expectations for the upcoming year. In the Engine segment, revenues were $2 billion in the fourth quarter, a decrease of 6% from last year. On-highway revenues declined by 9% overall, with lower heavy and medium-duty truck engine sales in North America being partially offset by increased sales in bus and pickup markets. Off-highway revenues increased 8%, primarily due to higher construction sales in all regions except in Latin America. Segment EBIT in the quarter was $194 million or 9.9% of sales, an increase compared to the 7.6% that we reported a year ago. EBIT in the fourth quarter of 2015 did include the $60 million charge for the loss contingency. In addition, benefits from restructuring and material cost reduction helped mitigate the impact of lower volumes in the quarter. For the full year, revenues decreased by 10% from a year ago, and earnings before interest and taxes declined from 9.9% to 8.8% of sales. For the Engine segment in 2017, we expect the revenues to be down by 3% to 6% due to weaker demand in North America, and EBIT margins to be in a range of 9.5% to 10.5% of sales. For the Distribution segment, fourth quarter revenues were $1.7 billion, which decreased 2% compared to last year. The decrease was the result of a 6% decline in organic sales and a 1% unfavorable impact from the stronger U.S. dollar, which were partially offset by a 5% increase in revenue from the acquisition completed in the fourth quarter. The EBIT margin for the fourth quarter was $122 million or 7.3% of sales, an increase from 6.5% a year ago. The increase was primarily driven by a one-time gain of $15 million for the acquisition of the last remaining unconsolidated North American distributor. For 2016, full year sales for the segment declined by 1%, with a 5% organic sales decline and a 2% unfavorable impact from currency being offset by 6% growth from the acquisitions. EBIT as a percent of sales declined from 7% to 6.3%. For 2017, revenue is projected to be flat to up 4%, with increased revenue from the acquisition completed in the fourth quarter of 2016 expected to add approximately $200 million or approximately 3% to the top line, which will be partially offset by the negative impact of foreign currency. And we expect EBIT margins to be in the range of 6% to 6.75% of sales. For the Components segment, revenues were $1.2 billion in the quarter, a decline of 5% from a year ago. Sales in North America declined 16% due to lower industry truck production, while international sales increased by 13%, primarily due to a 66% increase in our sales in China. Segment EBIT was $140 million or 11.9% of sales compared to $175 million or 14.2% of sales a year ago. In addition to the impact of the lower volumes, warranty costs were higher against a very tough comparison a year ago, and we also experienced higher-than-expected startup costs associated with the transition to our new Single Module aftertreatment system, which are likely to persist through the first half of 2017. For the full year, revenues were 6% lower than in 2015. Sales in North America were down 14%, partially offset by very strong growth in China. EBIT as a percent of sales decreased from 14.5% in 2015 to 13.3% of sales in 2016. For 2017, we expect revenue to decline by 2% to 6% as a result of weaker demand in North America, and EBIT is projected to be in the range of 11% to 12% of sales. In the Power Systems segment, fourth quarter revenues were $932 million, down 5% from a year ago. Sales of Power Generation equipment declined 7% compared to a year ago while industrial engines revenues were down 4%, primarily due to weaker marine and mining engine sales compared to last year. EBIT margins were 7.3% in the quarter, up from the 6% we reported last year. Lower volumes and an unfavorable product mix and the project cost overrun in the U.K. were more than offset by the benefits from cost reductions, favorable currency impacts and the gains recorded on the sale of some assets. For the full year, Power Systems revenue declined 14% from 2015, and EBIT margins declined from 8.9% to 7.5% of sales. The focus on cost reduction is key to holding decremental margins in the segment to 18% despite a significant drop in revenue. For 2017, we expect Power Systems segment revenues to be flat to down 4%. EBIT margins are expected to be between 7% and 8% of sales, which is relatively similar to 2016, given no significant improvement in our end markets. And as Tom discussed, we are on track to complete the exit of manufacturing from our site in Kent in the United Kingdom, which will yield net savings in 2018. Turning to cash flow. Cash generated from operations for the full year was just over $1.9 billion. We anticipate operating cash flow for 2017 will be within our long-term guidance range of 10% to 15% of sales. We lowered our capital expenditures by more than $200 million to $531 million in 2016, and we expect that our 2017 investments will be in the range of $500 million to $530 million. Last year, we returned $1.5 billion to shareholders or 75% of operating cash flow. We repurchased 7.3 million shares, and we increased our dividend by 5%. For 2017, we plan to return at least 50% of operating cash flow to shareholders, in line with our long-term commitment. As Tom described, the majority of our businesses have experienced multiyear declines in demand. We are forecasting company revenues to be flat to down 5% this year, primarily driven by the lower demand in the North American heavy-duty truck market and modest declines in power generation and off-highway markets. Foreign currency headwinds are expected to reduce our revenues by approximately $200 million. We expect EBIT margins to be between 11% and 11.5% of sales this year. We do face lower volumes again in 2017, which will negatively impact our margins, especially in the first half of the year. We remain focused on cost reduction, with improvements in material costs, plant productivity and the quality of our current products helping to offset the impact of lower volumes, cost inflation of some commodities and increased variable compensation, merit and pension expense. We do expect EBIT margins in the first quarter will be at the low point for the year and below fourth quarter 2016 levels on lower sales. Income from our joint ventures is expected to decline by approximately 8% in 2017, primarily due to the acquisition of the last remaining North American joint venture distributor. We expect our effective tax rate to be 26% this year. As we outlined in our Analyst Day back in November of 2015, we expected a period of weaker demand ahead of us. We have managed effectively through this decline in sales so far and have taken actions necessary to improve our cost structure while continuing to invest in new products and services that will help drive profitable growth when the markets improve and continuing to return value to our shareholders. Now let me turn it back over to Mark.

Thank you, Pat, and we're now ready to move to the Q&A section.

First, Tom, I'm curious about the tone of your conversations with North American customers and distributors considering the events of the past 90 days. I'm interested in their overall perspective on underlying investments and whether there has been any significant shift in their attitude.

Thanks, Tim. Let me just say at a high level, as I mentioned in my remarks, our markets are at historically low levels. We're way below replacement in nearly all of our major markets, and you heard our forecast for the numbers for North American truck. It's really weak, and that's clearly a big headwind going into 2017. And we've been sprinting for quite a few years now to keep costs under control. In fact, improve productivity and cost in all of our facilities and still be able to invest to make sure that we can grow faster than the market when things improve. So we feel like 2017 is one of those years. On the other hand, it appears that the next move in many of those markets is likely to be upward, which we haven't been able to confidently state until now. We are planning conservatively and assuming that this year we will gain very little benefit from any of that. We are adjusting our costs accordingly, but there are some positive signs. I think Rich has a better insight into what the OEMs are saying in North America, so I will ask Rich to discuss the truck market specifically and share any additional signs he is observing.

Thank you, Tom. As I speak with fleets, there is a noticeable trend of increasing discussions about returning to replacement levels after a few years of reduced mileage. This is not universal among all fleets but is quite common. The preliminary data appears to be improving, and dealer inventory is at a healthy level. There is also potential for dealer inventory growth, which is something we haven't been able to report before. However, used truck values remain a concern, yet overall sentiment about upcoming improvements is positive. For three consecutive months, production has fallen short of orders, leading to a growing backlog. We are also witnessing an expansion in future orders for OEMs, with many customers increasing their orders as their order books fill up. Concerning the off-highway segment, particularly in oil and gas, we are not yet seeing engine orders, but there is significant activity in parts, indicating a return to rebuilds. Additionally, we previously mentioned that the mining sector is showing signs of progress, starting with parts, which is typical for us. On a generally positive note, there are a couple of areas that may experience a downturn, such as the truck market in India and the marine business, where we do not anticipate recovery in the near term.

So hopefully that helps, Tim. Sentiment, good; orders, low.

Yes, understood. Regarding Rich's comments on off-highway parts, could you provide more details about Distribution? It appears that the contribution is flat to up by 4% and up by 3% from the last acquisition. I would have anticipated a more positive outlook there. Could you elaborate on the specific drivers within Distribution?

Tim, it's Mark. We are expecting some growth in parts. The one market where we're seeing continued weakness globally is really Power Generation. So that's what's kind of tempering the outlook in the near term.

Well, target range in sales is generally through the Distribution business, and I think we're looking at that being down again this year, I think 3% to 4%, something like that.

I have two questions. First, regarding the guidance, and the second is more strategic. When looking at your engine sales, the margins, and the implied decrementals, the decremental appears normal. However, when you exclude the charges from 2016, the implied decrementals seem to be in the mid to high 30s, which appears it should be better. I’m curious if I’m overlooking something and if you could clarify that. My second question is directed at you, Tom. Observing the past three quarters, the repos have significantly declined and we’re not making much progress. Could you provide an update on our status? Are we closer to finalizing a deal? Additionally, as I reflect on the company's future direction, I initially thought you might consider acquiring a business, but I haven't considered which parts of the business might no longer align with Cummins. If that’s the case, could you explain why? Is it to pursue a larger cash deal because certain areas are not yielding adequate returns? Those are my two questions, and I would appreciate your insights.

Jamie, I'll address the first question, and then Tom will respond to the second one. Regarding decrementals, I want to provide a broad overview for the company, which is relevant to the Engine segment as well. Starting with the 11.4% of EBIT that we reported in 2016, we are facing challenges due to lower volume, an unfavorable mix, and certain launch costs associated with our new products. These factors together contribute about 70 basis points of headwind. Additionally, we are experiencing increased inflation costs related to staffing in 2017, manifested as higher pension expenses because of lower discount rates, increased variable compensation from 2016, and merit increases, along with general inflation in personnel costs. That's about 120 basis points year-over-year. And then we had some onetime gains in 2016 over about 30 basis points, and they came through in the form of some of that fair market value gains in Distribution and the gain on sale of the Power Generation asset in the fourth quarter. Offsetting most of that are cost reductions really coming through material costs. We're looking at 80 basis points this year. That's down from 150 basis points last year really given the swing in metal markets. We had 50 basis points of improvement last year in metal markets, 20 basis points negative this year. So net, 80 basis points on cost reduction. The loss contingency that we pointed out is worth 80 basis points. And then pricing, we're thinking some modest pricing improvements that would add around 30 basis points. So when you net all that together, that leaves us somewhere in the midpoint between 11% and 11.5% of sales.

Okay. That's helpful. On the M&A front, any potential for divestitures?

Yes. So let me first just talk about the repurchase of shares. We have continued with our plans on repurchased shares. As you know, we set a goal at the beginning of the year. We drive that program to achieve that goal. We have guidelines that we run with the board about price ranges that we're acquiring in, and we try to make sure that we stay within that, and we run programs through the year. So when you see differences in repurchased shares by quarter, that's more to do with just when we're taking the actions and more the mechanics of it than it is to do with where we've lost interest. We're still hitting our targets for the year of how much we want to repurchase, and so that wouldn't change our strategy at all on that. That's continuing. And then secondly, with regard to the acquisition front, as I mentioned, we are actively working on those strategy areas that we talked about in the Investor Conference, and I'm feeling like we're making good progress. I understand that discussing our progress publicly can be challenging, especially since I can only share concrete updates when they are ready to be announced. I know this can be frustrating for you and other investors, as well as for me. However, I can express my optimism about our current progress. I believe we are on track to enhance our growth platforms while ensuring that our strategies are sound and beneficial for investors over the medium and long term, if not in the short term. And then last thing, you asked about divestitures. And as we described in the Investor Conference, we review our portfolio of businesses every year. Often times, that review doesn't yield very much. And sometimes, it makes us think more. But always, what we're looking at is what are the businesses that we have, and we have a 3-part criteria. One is, are they a strategic fit? Meaning, are we able to create more value with that business because we're the owner, because of the things that it links with and the competencies that we share across the business? Two, is it meeting our return guidelines? Or do we know, through management action, how to get it to that place? And three, is there some way that we can potentially add to our growth platforms or otherwise by reconstituting that business in some way? So we're pretty active at reviewing that portfolio, and we do it every single year. So we did it again this year, and we're always active on that and very much like the acquisition front, of course, until we are actually doing anything, there's actually nothing I can say publicly. It's bad for our employees. It's bad for everything else. So we aren't going to say anything until we do something. But again, I just want you to know, as someone who writes about us, and I want our investors to know that we always think we should evaluate our portfolio to make sure, as a management team, that we are actively managing the businesses that we're in as well as managing each one we have for success.

I'm just going to respond to your first question, Jamie. My calculation shows in the low 20s decrementals on the engine business. We can maybe follow up on that later, but those are pretty normal levels, I think.

A couple of kind of cleanup questions, I guess. The contingency charges, you had some in a few historical quarters, are we clear of those? Or is there some risk those could come back in 2017?

Okay, yes, Andy. Yes, we believe we're clear of those. So the process is we booked what we think was the estimated charge, and there's been no change in that.

Okay, Rich. Regarding the Beijing Foton joint venture, you mentioned the costs related to improving productivity and other areas. Can you quantify those for the fourth quarter, as there was a significant drop? I want to ensure that there aren’t any other factors at play. Additionally, how should we anticipate the JV's contribution will progress throughout 2017? Will it start off weak and then return to expected levels over the year?

Okay, let me take that, and Mark, if you need to correct any of my numbers, jump in. But yes, so on the ISG, we did take a charge in Q4. And to quantify it, it's roughly $25 million. And so just reminding folks where we are on this product, we remain very excited about it. In fact, our share of Foton now is over 75%. But frankly, we've run into issues in certain duty cycles as we've added more applications in certain regions where either fuel quality or service practices or things we've learned. And so we wish that wouldn't have happened. That hasn't changed our fundamental view. I believe there will be a charge in Q1, but it will be to a lesser extent, approximately half of what we experienced before, and that will be eliminated as we move into Q2 and Q3 regarding the ISG. Our strategy remains the same. Just as we did with the 2A and 3A, we introduced a new product in China for the market, competing there before taking the product globally. So we've done that on the 2A and 3A. We're producing 150,000. Quite frankly, we went through a little bit of an issue on introduction as we entered new markets on the 2A and 3A inside China, but we're now selling 50,000 of those outside of China even at Euro 5 and Euro 6 levels part of our strategies. We'll do the same thing on ISG. It hasn't changed our approach.

And I would just add, we've assumed flat markets in heavy, medium and light duty in our guidance. Even in that environment, we'd expect earnings growth in light duty with projected share gains. But as Rich said, improving earnings as the year unfolds.

Okay, great. And then lastly, a similar question that I think Tim asked with respect to North America. Could you kind of discuss what you're seeing in China at this point? You clearly indicated construction equipment's coming back. Truck had a fairly good second half to the year last year for market basis, yet you're talking about, as you just said, Mark, kind of flat markets for truck in China. What's kind of going on over there?

Yes, we're expecting flat performance; however, our sentiment is gradually becoming more positive. The new weight restrictions that have been implemented are beneficial and are being enforced. There are signs of improvement, but we remain cautious in our forecast due to uncertainties about its sustainability. There are varying opinions, with some being more optimistic about the truck market than we are. We will plan for flat conditions. From a capacity standpoint, of course, we can flex up, and we'll beat it if it's better than.

In the construction market, Andy, it is improving. But just remember, where we're starting from is a far, far cry from where we've seen good markets there before. So yes, we're pleased to see them move up, but it's got a long way to go. And I think it's going to be pretty gradual in its improvement, too. It's just that in the overall market, there's a lot of overhang of equipment still. There's still a lot of dealer inventory. There's a ways for the industry to go. But again, we're happy to see the improvement up.

Yes, there's not a lot of momentum in the high-horsepower side, I would say.

I'm wondering if you could talk about your updated timing of the 12-liter engine production ramp in U.S. truck. It sounds like the quality issues in China are unrelated based on the description that you laid out, Rich, but maybe you can update us on the time frame. And also, do you have new platform opportunities with Volvo now that they're exiting their 16-liter engine in the U.S.?

Sure, Jerry. First, I want to clarify that the quality issues are unrelated. We are actively addressing customer concerns, which are specific to certain regions or duty cycles in China. Our schedule remains unchanged. You can expect to see some trucks arriving late in the year. While the impact won't be significant in 2017, we do have agreements with several OEMs to start offering it, and we remain very enthusiastic about this development. From the question on heavy-duty on Volvo, we're exclusive on 15-liter with 2 customers with Navistar and PACCAR. And so I am pleased to say we'll now be exclusive on a third, with Volvo, with their announcement of discontinuing the 16-liter.

And Rich, sorry, just the number of platforms that you'll be available on, can you give us just a rough flavor?

I'll say at least two.

Okay, okay. And then coming back on the M&A discussion, you folks have been really focused on driving structurally-higher returns on capital over the course of your time leading the company. And I'm just wondering, are you signaling a longer-term focus on returns on capital, with potential to absorb lower returns near term as you build a sort of meaningful growth platform via acquisitions? Or maybe you could just talk about if you folks are changing the framework in terms of the time frame of which you're targeting the types of return on capital that you folks have generated internally.

I'm definitely not trying to signal or change anything. We've always had a medium to long-term view on return of capital. That's never changed. As you know, we operate a cyclical company and things do go up and do go down even in our own returns on capital. We have long return cycles in our business, as a matter of course, which, of course, is frustrating and difficult to manage, frankly, but it is just the case that we have that. So I'm definitely not trying to signal anything. As we talked about when we talk about potential acquisitions, joint ventures, and other partnerships is that we have high return guidelines. We believe that we serve investors well when we retain that attitude that we need to earn good returns on capital with new things we do, just like we do with existing things we do and that taking long ventures into things that don't generate a return would not be good for shareholders, and we're not going to do it. We know that if we plan to make inorganic investments, we need to create a strategy that benefits shareholders. The specifics regarding short, medium, and long-term implications will become clear as we progress. I want to assure you and everyone else that we remain committed to generating strong returns for shareholders, and that commitment will not change as long as I am here.

Specifically on Power Gen, we are anticipating another down year in 2017. Can you discuss how significantly that business has been impacted? It seems we are now entering over five years of declines—what do those declines look like from the peak? Additionally, beyond the general macroeconomic factors, what indicators are you monitoring for signs of improvement, whether by end markets or geographies? Where can we start to find some optimism in Power Gen given the extended decline we've experienced?

I can start by saying that we have been experiencing a long-term situation. For five consecutive years, we have faced very weak markets due to low capital investment, particularly in developing markets where we hold strong positions, as well as decreased non-residential capital spending. These two trends have negatively impacted our business for a while. Regarding how low the market is, we share your concerns. I'll let Mark provide the specific percentage decrease, but we certainly have considerable capacity, which is why we took the actions we did last year to restructure and reduce costs, allowing us to ramp back up when conditions improve.

We're seeing more than 30% decline compared to five years ago. This situation isn't solely reliant on one aspect of the economy or a specific cycle. As Tom mentioned, it's not always about a lack of demand; for instance, in Latin America, there's considerable demand. However, liquidity issues among customers are slowing down project progress this year. Additionally, early last year, the Middle East was performing well, but that situation has since changed. It's been a mix of various factors. I would say Europe's stable. North America's stable but down a little bit. So it's really the emerging markets, as Tom said, over the last 3 years to 4 years.

And then on the tax rate and looking for, I think, 26% in 2017, should we think about that as being more representative of the tax rate on a go-forward basis? Is there anything unique in 2017? But just you go back a year ago, I think you were looking for something more in kind of high 20s range. Just want to think about this on kind of a longer-term outlook and what the right tax rate is.

The main differences from what we discussed a year ago are twofold. First, we're seeing a lower share of profits from the U.S., which is now facing a higher tax rate. Second, there have been some recent changes in legislation in the U.K. that affect our investments. These factors contribute to the difference between the 24.6% we reported for 2016 and the 26% projected for 2017. The geographic mix of earnings will be the most significant factor in the long term.

My question's about the component guidance. It appears to be implying a decremental margin of 55% on a 4% revenue decline. I just want to get more color on why do you think the decrementals would be that poor?

David, this is Rich. I'll take that. Really, fundamentally, 2 things. One is, volumes down again in North America is what we're projecting. And then two is, as was mentioned, some startup costs associated with our new Single Module aftertreatment in our aftertreatment business. And so just to remind you, we're making a really big change there, and it's not a small change in our aftertreatment. One is that it's half the size and weight, which increases the maintenance intervals by two times. It's a completely new product, and we've incurred some expedited startup costs in the fourth quarter that will extend into the first quarter. These two factors are significantly affecting our performance for 2017.

How much are those investments? Because even if I hit you with a 30% decremental, it adds almost $0.20 to your guidance for the year. So I'm just trying to think about how big those costs are just so I can get a better feel for how reasonable the guidance is.

Well, the aftertreatment piece of the startup, we're talking in the $20 million to $30 million range for the year, and then you know what our incremental margins are, and you've seen before as volumes come back. So if volumes come back to more normal levels, when and if that happens, then you'll see that turnaround.

Yes. The other thing I would throw in there, David, too, if you go back to my answer to Jamie Cook earlier on, we are seeing some inflationary metal markets, which is impacting the segment, and we are seeing some impact on compensation inflation, too. So there's 2 or 3 headwinds that's impacting us in 2017.

But you should see improvement in the second half versus the first half.

Yes, and without getting too technical, even with the startup costs, you are still suggesting decrementals over 40? I'm just trying to clarify if the inflation issues related to components are more significant than in other areas.

No, it's not. So again, just thinking through your view of our guidance. Again, as I've said kind of as an overview, we're taking a pretty conservative view of bad markets. And so I think the biggest opportunity we have in the Components business is that North American markets strengthen more and faster than what we have in our guidance, and you probably have a reasonable view about your opinion on that. So that would be one thing that you could take a look at if you wanted to. But again, our view is that we're going to continue to manage conservatively. We're going to continue to find ways to take costs out. So again, as you know, we are not satisfied with decremental margins of that level. We're not pleased with that. We are working hard to figure out how to make that less of an impact, but we're giving you the forecast based on what we think we understand how to do right now. We will keep focusing on improving decremental margins in that business. It is a highly profitable and valuable area for Cummins, and we will continue our efforts to enhance it.

And last quick question on the M&A conversation. How do you think about strategically off-highway versus on-highway, just all the secular issues that we're all aware of on-highway as well as some of the benefits you've built up with your Distribution acquisitions? Just how should we think about those 2 markets and how they impact your strategy?

Yes. On-highway represents a larger volume and drives much of the technology development. We maintain a strong position in this area, particularly in emissions and other technologies. Conversely, off-highway has less vertical integration, but our global Distribution network is well positioned to serve various markets that others cannot reach. Both segments play crucial roles in our strategy. And frankly, we think one of the advantages of Cummins is we're able to put the 2 together in a way that drives synergies that most others can't. So as I think about it strategically and I think about things we might do more of, I'm thinking about both those areas and how we can continue to use the synergy between the 2 to drive more returns to shareholders than others can.

I think we're at the top of the hour. Thanks, everyone, for your questions, and Adam and I will be available for follow-up later.