Cummins Inc (CMI) — Q1 2017 Earnings Call Transcript

Thank you, Andrew. Good morning, everyone, and welcome to our teleconference today to discuss Cummins results for the first quarter of 2017. 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. We'll all be available for your questions at the end of the prepared remarks. Before we start, please note that some of the information you will hear or be given today will consist of forward-looking statements within the meaning of the meaning of 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 on the forward-looking disclosure statement in the slide deck and our filings with the SEC, particularly the Risk Factor section of our most recently filed annual and quarterly reports. During the course of this call, we will be discussing certain non-GAAP financial measures, and we refer you to our website for the reconciliation of those measures to GAAP measures. Our press release, with a copy of the financial statements, and a copy of today's webcast presentation are available on our website at cummins.com under the heading Investors and Media. Now I'll hand it over to Tom. Thank you.

Thank you, Vice President Smith. Good morning, everyone. Today, I'll provide you a summary of our first quarter results as well as some comments on our outlook for 2017. Pat will then take you through more details of both our first quarter financial performance and our forecast for the year. But before I provide my comments on the quarter, I'd like to talk about a recently announced agreement with Eaton, to form a joint venture to design, develop and manufacture automated transmissions. We are very excited about this joint venture with Eaton, and we have provided some additional slides on our website, which lay out why this joint venture presents a significant opportunity for Cummins. The strategic rationale for the joint venture is simple. Since fuel is one of the largest cost drivers for our customers, fuel efficiency will be a primary differentiator of commercial powertrains across our global markets. Cummins and Eaton have been partners for decades and today, offer the leading combination of engine and transmission performance in the North American heavy-duty truck market. We believe that the next generation of transmissions designed, developed and manufactured by the joint venture, combined with Cummins capability and system integration, can yield significant improvements in fuel efficiency for Cummins and our OEM customers and partners. Cummins will invest $600 million for a 50% share of this joint venture. In return, we'll be able to develop integrated powertrains that offer a significant performance advantage, add to our portfolio of technology offerings to our customers and benefit from the value created by the joint venture as it leads the secular shift to more automated transmissions. Eaton will contribute the current design for the next-generation heavy-duty automated manual transmission if current automated manual transmission meet for medium-duty markets call to precision-specific manufacturing assets as well as intellectual property and people associated with the development, testing and assembly of automated transmissions. The joint venture has a clear path to profitable growth, and we'll benefit from accelerating transition from a fully manual transmission to automated transmissions in global markets. We expect that the next generation of products with advanced performance will gain market share, and the joint venture will leverage Cummins' strong position to grow in international markets where the penetration of automated transmissions is currently very low. The joint venture will also capture aftermarket revenues. We project that the joint venture can more than triple its current sales of approximately $300 million over the next 5 years. Cummins will consolidate the results of the joint venture within the Components segment, and we expect that the joint venture will be operational in the third quarter of this year, subject to regulatory approvals. Now let me turn to our first quarter financial results. Revenues for the first quarter of 2017 were $4.6 billion, an increase of 7% compared to the first quarter of 2016 and stronger than we anticipated 3 months ago. EBIT was $566 million or 12.3% compared to $484 million or 11.3% a year ago. All 4 operating segments increased sales, EBIT dollars and EBIT percent. Our incremental EBIT margin was 28%. Engine business revenues increased by 2% in the first quarter due to strong sales to construction customers, especially in China. EBIT for the quarter was 11.3% compared to 10% for the same period in 2016, with the increase due to profitable growth in our off-highway business and strong performance in our on-highway joint ventures in China. Sales for the Distribution segment increased by 12% with organic sales growth of 6%, driven by stronger demand for engine rebuilds, parts and new engines in on-highway markets. We acquired the last remaining joint venture distributor in North America in the fourth quarter last year, and this acquisition contributed 6% to growth. First quarter EBIT was 6.1% compared to 5.9% in the first quarter of 2016 and improved as a result of higher organic sales. First quarter revenues for the Component segment increased by 9%, primarily driven by strong growth in sales to Chinese truck OEMs. EBIT for the first quarter was 13.3% compared to 13.2% in the same quarter a year ago and much improved from the fourth quarter last year when we incurred additional launch costs associated with our new single module aftertreatment system in North America. We made clear progress in reducing the cost of the single module and improving supply chain performance in the first quarter. We expect to see further improvement in the second quarter. Our system sales increased by 9% in the first quarter, primarily driven by an increase in new engine and aftermarket sales to mining and oil and gas customers. EBIT in the first quarter was 6.5% compared to 5.7% a year ago due to the benefit of higher sales and lower operating costs. During the quarter, we had disappointing performance on a large power project in the U.K., and excluding the impact of this single project, first quarter incremental EBIT margin was 40%. We expect profitability to improve for the rest of the year and again in 2018, as we get the full benefits from the restructuring of our U.K. generator set assembly operation, which continues to progress on schedule. Now I will comment on our performance in some of our key markets for the first quarter of 2017, starting with North America, and then also discuss some of our largest international markets. Our revenues in North America increased 1% in the first quarter with higher sales from the distributor acquisition more than offsetting lower engine and component sales to the North American heavy- and medium-duty truck markets. Industry production of North American heavy-duty trucks declined by 20% in the first quarter of 2017 while our sales of heavy-duty engines declined only 12%, as our market share for the quarter improved to 32.7% from 29% a year ago. Production of medium-duty trucks declined 6% in the first quarter while our engine shipments declined 9% with our market share of 72%, down from 76% a year ago. Our shipments of engines to pickup truck customers in North America declined by 1%, but we remain on course for a strong year in this segment. Engine sales for the construction market in North America increased 10% in the first quarter, reflecting increased customer confidence after a challenging couple of years in which the market had to absorb an excess supply of used equipment resulting from the slowdown in oil and gas markets. Shipments to high horsepower markets in North America increased by 42% compared to very weak levels last year due to the higher sales to oil and gas and rail customers. Revenues for Power Generation declined by 1% with growth in consumer markets, offset by lower sales to data center customers. Our international revenues increased by 17% in the first quarter of 2017 compared to a year ago. First quarter revenues in China, including joint ventures, were $1.1 billion, an increase of 49% due to growth in our on-highway and construction businesses. Industry demand for medium- and heavy-duty trucks in China increased by 73% for the first quarter, driven by a higher pace of infrastructure investment and truck replacement in response to overloading regulations introduced last year. Our market share for the first quarter was 14%, down from 15% last year. Sales of our ISG heavy-duty engine to Foton grew in line with the market, but growth in Dongfeng's truck sales were not as strong as the industry as a whole. Last quarter, we discussed actions that we were taking to improve performance of the ISG engine in some applications, and we have made good progress in executing on our plans to support customers who have been able to reduce the cost of these actions below our initial expectations. Shipments of our light-duty engines in China increased by 22%, well ahead of the overall market growth of 12% as Foton continued to increase the proportion of its trucks powered by our joint venture engines, displacing local competitor engines. Our market share during the quarter was 7.6%, up a further 60 basis points from a year ago. Demand for construction equipment doubled from a year ago in China in response to stronger infrastructure investment. Our construction engine volumes increased by over 300% as OEMs ramped up their production of excavators. Revenues for our Power Systems business in China declined by 3% due to continued weakness in Power Generation, marine and mining markets. First quarter revenues in India, including joint ventures, were $408 million, a 5% increase from the first quarter a year ago. Industry truck production declined 3% compared to a strong quarter a year ago while our market share increased 1% to 39%. Revenues for Power Generation equipment increased by 9%. We also grew sales in marine and rail markets as a result of growing infrastructure investment. In Brazil, our revenues increased by 13%, all driven by appreciation of the real as end markets remained very weak. Now let me provide an overall outlook for 2017 and then comment on individual regions and end markets. We are now forecasting total company revenues for 2017 to increase 4% to 7%, higher than our prior guidance of flat to down 5% with a modest increase in our projections for a number of regions and end markets. Industry production for heavy-duty trucks in North America is projected to be 195,000 units, up from our prior forecast of 178,000 units in 2017 but still down 3% from last year and below replacement demand. We expect our full year market share to be between 29% and 32%, unchanged from our previous projection. In the medium-duty truck market, we have raised our outlook for the market size to be 112,000 units, up 4% from 2016 and up from our prior guidance. We project our market share to be in the range of 73% to 75%, consistent with our view 3 months ago. Our engine shipments for pickup trucks in North America are expected to increase 1% for the full year. In China, we expect full year domestic revenues, including joint ventures, to grow 11% compared to our previous guidance of up 3%. We have raised our outlook for demand for medium- and heavy-duty truck markets to exceed 1 million units, a 7% increase from our previous guidance. Our forecast anticipates the demand for trucks will slow from first quarter levels due to normal seasonality and a slowing of truck replacement. We expect the light-duty truck market to grow 3% in 2017 compared to our previous guidance of flat. Our market share in the medium- and heavy-duty truck market is expected to be 15%, flat with 2016. In light duty, we expect our share to exceed 8%, up from 7% last year. We currently project 10% to 15% growth in off-highway markets in China compared to our previous guidance of up just 5%, primarily due to higher demand for construction equipment. In India, we expect total revenues, including joint ventures, to be flat compared to our previous projection of a 5% decline, due mainly to a stronger rupee. We currently project 5% growth in off-highway markets, offset by an expected 10% to 15% decline in truck demand. In Brazil, we expect truck production to be flat in 2017, unchanged from our previous projection with no clear signs of improvement in the near term. We expect our global high horsepower engine shipments to grow 10% to 15% compared to our previous guidance of no growth in 2017. Demand has picked up in mining and oil and gas markets compared to extremely weak levels last year. In summary, we expect full year sales to increase 4% to 7% compared to our prior forecast of flat to down 5%. We are experiencing an increase in some commodity costs, which we are working hard to mitigate. Rising commodity costs should be supportive of growing demand for capital goods but in the near term, will likely reduce our net material cost savings in the second half of the year compared to our original expectations. Our forecast for EBIT is now in the range of 11.75% to 12.5%, above our previous guidance of 11% to 11.5% of sales. During the quarter, we returned $222 million in cash to shareholders in the form of dividends and share repurchases, consistent with our plans to return at least 50% of our operating cash flow this year. We're off to a solid start, and I look forward to updating you again next quarter. Now let me turn it over to Pat.

Thank you, Tom, and good morning, everyone. I will start with a review of the company's first quarter financial results before discussing the performance of each of the 4 operating segments in more detail. I will then provide an update on our outlook for the rest of the year. First quarter revenues were $4.6 billion, an increase of 7% from a year ago after 6 consecutive quarters of year-over-year sales declines, the longest period of year-over-year revenue decline since 2002. The sales in North America, which represented 57% of the first quarter revenues, increased 1% from a year ago primarily due to increased revenue in the Distribution segment, which more than offset lower Engine and Component revenues due to a decline in heavy- and medium-duty truck production compared to the previous year. International sales improved by 17% from a year ago primarily due to increased sales in China and in Europe, which offset weakness in the Middle East. Gross margins were 24.6% of sales, unchanged from last year. The benefits from increased volumes were offset by warranty expense, which was a 50 basis point headwind, as we increased accrual rates with new engine introductions and recorded non-favorable changes in estimates on older engines. Selling, admin and research and development costs of $695 million or 15.1% of sales decreased as a percent of sales by 20 basis points but increased by $39 million from a year ago mainly due to higher compensation expenses. Joint venture income of $108 million increased by $36 million compared to a year ago as a result of strong market demand in China for both on- and off-highway equipment. Earnings before interest and tax improved to $566 million or 12.3% of sales in the quarter compared to 11.3% a year ago, and this reflects a 28% incremental EBIT margin. Net earnings for the quarter were $396 million or $2.36 per diluted share compared to $1.87 from a year ago. The effective tax rate for the quarter was 26.1%, in line with our full year guidance of 26%. Moving on to operating segments. Let me summarize their performance in the quarter, and then I will review the company's revenue and profitability expectations for the full year and conclude with some comments on cash flow for the quarter. In the Engine segment, revenues were $2 billion in the first quarter, an increase of 2% from last year. International revenues were up 11% primarily due to growth in off-highway markets in China. Revenues in North America declined by 1% due to lower on-highway revenues as a result of the lower production of heavy-duty trucks. Segment EBIT in the first quarter was $229 million or 11.3% of sales. This compares to 10% of sales from a year ago. The margin improvement was driven by higher joint venture income, favorable pricing and material cost savings, which were partially offset by a higher warranty cost and an increase in current product support expense to support recently launched products. For the Engine segment in 2017, we now expect revenues to be up 2% to 6% compared to our previous guidance of down 3% to 6% due to an improved outlook in most of our markets. Our forecast for EBIT margins is to be in the range of 10.25% to 11.25% of sales compared to 9.5% to 10.5% previously. For the Distribution segment, first quarter revenues were $1.6 billion, which increased 12% compared to last year. Organic sales for the quarter increased by 6%, and revenue from the acquisition completed in the fourth quarter of 2016 added an additional 6%. The EBIT margin for the quarter was $100 million or 6.1% of sales compared to 5.9% a year ago. The improvement to margins from an increase in sales during the quarter was partially offset by higher compensation and benefit costs from the integration of previous acquisitions. For 2017, Distribution revenue is now projected to increase 4% to 8% compared to our previous guidance of flat to up 4% with the increase driven by improvements in off-highway markets and higher parts sales. We still expect EBIT margins to be in the range of 6% to 6.75% of sales as higher variable compensation and benefits offset improvements to operating margins. For the Components segment, revenues were $1.3 billion in the first quarter, a 9% increase from a year ago. International revenues grew 25% primarily due to a 60% increase in sales in China, which more than offset a 2% decrease in North American revenues due to lower heavy- and medium-duty commercial truck production. Segment EBIT was $179 million or 13.3% of sales compared to 13.2% of sales a year ago. As mentioned in our previous call, we did incur additional expenses to support the launch of our Single Module aftertreatment system, but we were able to mitigate part of the cost we previously forecast while still meeting the delivery commitments in the quarter. For 2017, we now expect revenue to be up 6% to 10% compared to our prior guidance of a 2% to 6% decline. The change in guidance reflects stronger-than-anticipated demand in the China truck market and improved outlook for the North American heavy- and medium-duty truck market. EBIT is projected to be in the range of 12.5% to 13.5% of sales compared to 11% to 12% in the previous forecast. In the Power System segment, first quarter revenues were $882 million, an increase of 9% from a year ago. The increase in revenues for the segment was driven primarily by a 28% increase in industrial markets led by mining and oil and gas with growth in new engine and rebuild revenues. Global Power Generation markets remain weak despite a slow revenue gain in the quarter. EBIT margins were 6.5% of sales in the quarter, up from 5.7% last year due to the increase in industrial engine shipments. For 2017, we expect Power Systems segment revenues to be up 1% to 5% versus the previous guidance of flat to down 4% due to increased customer demand from mining and oil and gas engines in addition to higher part sales. EBIT margins are still expected to be between 7% and 8% of sales with this segment experiencing a more significant increase in commodity costs than we anticipated at the start of the year. For the company, we are raising our outlook for revenues to be up 4% to 7% versus our previous guidance of flat to down 5%. The increase is primarily due to improving off-highway market demand, stronger-than-anticipated growth in China and a more resilient North American truck market. Foreign currency headwinds are expected to reduce revenues by approximately $180 million, slightly lower than the $200 million impact in our previous forecast. The guidance provided today does not include the impacts from the announcement of the Eaton-Cummins joint venture. We will provide a forecast upon regulatory approval of the deal. Income from the joint ventures is now expected to be relatively flat from last year. Our strong results in China will offset the impact of the acquisition of the last remaining North American distributor in the fourth quarter of 2016. We now expect EBIT margins to be between 11.75% and 12.5% for 2017, up from our previous forecast of between 11% and 11.5%. The increase in profitability reflects increased outlook for both the global off-highway markets and the North American truck market. Finally, turning to cash flow. Cash generated from operating activities for the first quarter was $379 million, which was a 42% increase from a year ago. We anticipate operating cash flow in 2017 will be within our long-term guidance range of 10% to 15% of sales. Capital expenditure during the quarter was $81 million, and we still expect investments to be in the range of $500 million to $530 million this year. And as Tom said, in the first quarter, we returned $222 million to our shareholders through dividend payments and share repurchases. For 2017, we plan to return at least 50% of operating cash flow to our shareholders, in line with our long-term commitment. Now let me turn it back over to Mark.

Thank you, Pat. We are now ready to begin the Q&A section of the call. Thank you.

Okay. Steven, it's Rich. Yes, we're off to a good start on the oil and gas rebuilds. In fact, they're off some relatively low numbers that are up 300% right now. It's pretty broad-based. We're seeing that kind of across geographies, although primarily North America, but across geographies in North America. What we also saw in Q1 is some new orders for new frac rigs. That is a little less broad-based. We've seen that with 1 or 2 customers, and that's the one kind of yet to be determined is kind of the rate of new versus putting idled equipment back to work. But I think the rebuild piece will continue through the year.

And that's what you have baked into your 10% to 15% for high-horsepower for the rest of the year?

The engine shipment, Steve, includes the overall figures embedded in the Power Systems guidance, not just the rebuilds.

Okay, and just, Tom, last quarter, you stated a lot of dealer inventory in construction in China. So, I guess, how surprised are you that the China construction was so strong? Was this further building of inventories? Or is it all getting deployed on projects? And then what does that imply for your second half expectations?

It seems that we are not experiencing an inventory build. The current inventory levels are slightly higher than we anticipated. There appears to be a broader trend in the construction sector that was unexpected. This was not included in our forecast. However, there seems to be some positive sentiment, if not concrete data, suggesting that this trend, particularly in excavators, could continue in the construction sector.

Steve, utilization rates are definitely up, and so that's a good sign. That means people are using the equipment there in addition to buying some new. So that's a good sign. I think it's worth us being cautious just to see where dealer inventory levels are and to understand all that, but we definitely saw sell-through higher and we saw utilization rates higher, both of which are a good sign. The question is how lasting is it, and how healthy are the dealers and how's the inventory looking? We've still got some more work to do to understand that because frankly, we were surprised by the uptick.

I guess a couple of questions. One relates to your full year guidance. When you guys guided last quarter, you said the first quarter should be the lightest for a number of different reasons. Yet, if we look at your margins for the quarter, they came in at like 12.3%, which is the midpoint of your full year guide. So something doesn't seem right. Maybe we're conservative, maybe the cost on ISG and the single modular treatment system was lower in the first quarter than we thought. So if you could just sort of walk me through the guidance and whether there's potential for upside. And then, I guess, my second question, Tom, specifically on the Eaton-Cummins joint venture, just a little more color, I guess, I'm looking at it, you're paying $600 million for potentially $900 million or more of revenues 5 years out which just seems, I don't know, light or expensive to me. So are there incremental positives that perhaps the market is underappreciating?

Jamie, this is Patrick. Let me start with... Sorry, I interrupted you there. Let me take the first question, and then Tom can take your second question that I rudely interrupted. So on the full year guidance, the first quarter includes very strong earnings from China and our China JVs in particular. Traditionally, we tend to see a mix of 60% of China revenues in the first half of the year and 40% in the back half of the year. We are a little bit hesitant to assume that the strong demand that we're seeing through the first quarter, which we'll probably expect to see in the second quarter and will continue into the second half of the year. It's close to the announcements overloading regulations come into play that have clearly been a factor that'll be driving that. So we are saying second half earnings will drop in China from first half. And that's probably the #1 reason why our guidance feels a little bit weaker in the second half of the year. The other fact that is material cost, which drove 80 basis points of margin improvement in the first half of the year as we see rising commodity prices through the year. For the full year, we expect that to be nearly in line with a 50 basis point improvement. So other than that, everything else should continue much as we've seen so far.

Jamie, thank you for your question regarding the Eaton joint venture. In straightforward terms, we are convinced that integrated powertrains will dominate the industry, whether powered by a diesel engine, fuel cell, or battery. We believe that integrated powertrains will be the key to superior performance, quality, and other crucial factors. As a company, we have consistently invested in components that are vital for enhancing performance, fuel efficiency, and emissions in powertrains, which is what differentiates us in a market focused on integration. We have been exploring various ways to achieve this, analyzing every available option in detail. Given the industry’s current high level of consolidation and the likelihood of further consolidation both strategically and technically, we recognized the necessity of advancing into powertrains. Our belief is that this presents the most appealing entry point possible. We are optimistic about this partnership, as we are collaborating with a company whose cultural values align with ours, and we have a successful track record together, allowing for a quick ramp-up. Furthermore, we see potential for growth outside our core plan internationally as those markets begin to adopt automated transmission. By offering an improved powertrain, we believe we can increase our engine market share. The challenging variable to assess is the impact on our engine share with and without this joint venture. We are fully confident that when evaluating this, the deal not only appears attractive to Cummins but is essential to our strategic direction.

Is there any way you could provide a range of how the range of where market share should go? Like just the variability around that? So the joint venture could make more sense. Can 30% go to 40% in heavy-duty? Or is it in China? I'm just trying to think about how to justify the investment.

I believe that as the joint venture starts discussing our growth plans, we will have more clarity. However, before we can proceed, we need to finalize the transaction, which requires several regulatory approvals. Once those are in place, we will be able to share more detailed information about our plans. I am fully confident that Cummins shareholders will see this as a crucial and beneficial move for the company, and I believe Eaton shareholders will agree as well. I am truly excited about this joint venture. From a financial perspective, it’s clear how this could be beneficial for Cummins, especially when you consider that it is vital for success in powertrains. Once you understand that, the rationale becomes quite simple.

Could you do us a favor and just comment a little bit more on pricing versus input costs? Could you quantify the impact of higher input costs and when you would expect to be able to offset the higher input costs? And then as a follow-up, I get a lot of questions recently on penetration of electric vehicles and autonomous driving, etc. Could you just maybe comment on Cummins perception of the penetration of electric vehicles in particular, particularly in long hauls?

Pricing is expected to be roughly net neutral for the year across our various segments. Our main challenge lies in the Power Systems business, where costs are increasing, and we are still facing weak global demand in Power Generation. With this ongoing weak demand, we are at a crossroads regarding whether to adjust prices. We will continue to assess our options in that regard. We hope this will support growth in capital goods demand moving forward, but the outlook for the second half of the year is definitely less favorable compared to the first half.

And Ann, this is Tom. Thanks for your question on the technology area. Not surprisingly, we have done several years of work now developing projections and analysis of substitute technologies that might play a role in our end markets. We are convinced that electrification will substitute in some of our applications over a period of time. Our projections for that depend on large degree, as you guess, on how battery and power electronics costs come down and performance goes up, especially the energy side, how much I can store and then also the cost of fuel and other kinds of environmental-related costs. But assuming most of our scenarios come up with electrification playing a significant role in cities, especially stop-and-go applications, bus, maybe refuse, pickup and delivery trucks, we think it will play a significant role, especially after it makes major substitution in cars since that will drop cost and increase volume. By the way, we intend to compete in that business and win. We have already launched an electrification business development area in our company, with people dedicated to not only launching the fully electrified powertrains but are currently selling those powertrains to some customers. We intend to compete and win. These are our markets, buses, refuse vehicles; we are the leader in those markets. So we intend to be the leader in those markets when they're electrified. We already have pilot products running with fully electrified powertrains designed and built by Cummins. We will compete in those markets, and we believe we'll win. The fully integrated powertrains are, as I mentioned to Jamie, the future for Cummins, whether they are diesel-driven, battery-driven, or otherwise. Additionally, fuel cells could potentially play a role in longer hauls. One of the challenges for battery-driven longer-haul trucks, which may be obvious in your question, is that most of the weight that would otherwise be used for carrying goods is taken up by batteries. Currently, it doesn't appear that this is a viable option based on the technologies available now or in the foreseeable future. In contrast, fuel cells do a better job, being heavier than diesel due to the fuel required but closer in weight, and they share some advantages with other electrified powertrains. There is still significant development needed for fuel cells; they are not nearly as advanced in terms of cost, performance, and quality as batteries are. Both electrified powertrains and fuel cells are feasible and could have a role, but they are relatively modest sellers today, even in the car segment. It will take several years, as we've seen in the natural gas sector where even appealing options take time to gain traction in mature markets. Presently, neither technology is particularly attractive without further development to improve their viability and operational effectiveness for commercial users, who are very focused on capital returns. I believe they will eventually play a role, but it will take time before these markets are large enough to make a substantial impact, and we plan to lead in both areas. We are bringing together the technologies and the customers to achieve that.

Tom, for your significant joint ventures in the past, you folks have been able to deliver mid-teen margins by leveraging SG&A. And I'm wondering in the Eaton-Cummins joint venture, would you folks expect a similar profile once that business ramps? Or is there anything structurally different on the joint venture either in pass-through calls or R&D intensity that we should keep in mind as we move towards hopefully the 5-year revenue targets that you laid out?

Absolutely the same approach, Jerry. As you said, this one, because we have a lot of upfront development to get the products to markets, it'll be heavier on R&D expense in the early years, but as the revenues ramp up, we expect to be at very similar margins. Again, that's a little bit why we feel confident with this. It looks like a lot of things we have done before with a partner that we really like working with and know very well. So we have every expectation we'll be able to operate at similar margins as JVs we've operated before.

And Tom, how back-end loaded is the ramp? Do we have to look for a significant new product introduction cycle so we see a bigger contribution in terms of the growth rate 2020, 2021? Or can we see it kick in potentially sooner?

There's at least 18 to 24 months of developments dominating the expense ratios in the joint ventures, so that is a while. From that point of view, we have a lot of work in front of us to do. Again, a lot of the work has been done on the base transmission, but there's a lot of work to do for integrating with customers. I think that's, again, likely to take us 18 to 24 months, and then we'll start to see the ramp up more significantly. We'll be able to say more about that as the joint venture closes and then we can talk a little bit more about who our customers are and all those sorts of things. Generally speaking, it's first couple of years with more light development, and there'll be sales, of course, but there's going to be pretty heavy development costs.

Yes, thanks, Jerry. Just to remind you, we talked about we had some specific issues in some different regions and different markets, duty cycles we were working through and incurred some cost. The good news is we've worked through those faster and actually been able to reduce the cost of doing that. As I talked last quarter, I said we'd be living with those through the first half of the year. We're really pleased that we got through it well, took care of customers and generally, by the end of Q1, have any unusual cost behind us.

I'm just wondering if you could talk about capital allocation from here. I mean, you made an investment that you think is very attractive, but you haven't added the leverage that you initially identified that you'll be willing to consider. Should we be anticipating other acquisitions from here? Are those leveraged targets you talked about a year, 1.5 years ago still kind of in the game plan? Or is it just that the valuations across a lot of the areas of interest have become too expensive, and we should sort of expect Cummins to go back to returning more cash?

Thanks for the question, Ross. The answer is we are still pursuing our strategic areas that we talked about 1.5 years ago. I think maybe as you saw in the Eaton joint venture and our powertrain expansion, we think to do a good deal takes more time than to do a lousy deal, or at least that's what we're seeing in the market. To your point, valuations are pretty high in some places. So in typical fashion, to do the things that we think add strategic growth and profitable growth to Cummins and good capital returns just turns out are taking us some effort to work through. I guess that's probably to be expected. But we intend to continue to pursue those areas. Yes, the leverage targets we laid out to you are still what we think makes sense for the company. We haven't changed that at all. We have a number of things that we're pursuing right now that we hope to be able to turn into attractive projects for the company. As you suggested by your question, we look through a lot of things that turn out to be less attractive from a return perspective and therefore pass them by. We are active still, and I'm confident that we're going to find other good things that will add to the growth and profitability and return profile of the company. But it's taken some effort and some work to grind through those, and we're still active in them though.

And then just as a follow-up on that. There were some news reports a couple of months ago about the potential sale of, I believe your filtration business. And I don't know if you can comment on that, and if you can't, just wondering if there is any reason to anticipate that Cummins would ever consider a sizable divestiture if you don't actually have a larger target on the horizon, given the strength of your balance sheet today?

Yes, thanks for the question, Ross. The filtration business is not for sale, and I want to reiterate that. Additionally, we would not tie the sale of a division to the need to acquire another one. As we discussed in our strategy meeting 1.5 years ago, we have sufficient debt capacity and the ability to raise capital to acquire a company we are interested in, at least the ones we are currently considering. Our existing balance sheet and cash are adequate for this, so we do not view it as necessary. We would consider selling parts of Cummins as we have in the past, which is when we believe a division is no longer strategically important to the company and does not contribute to the overall strength of the business. If it is not doing that, and we believe that shareholders would benefit more from the sale price than from what we can generate internally, then we would proceed with the sale. We conduct an annual review of our major divisions with a focus on maximizing shareholder value. We assess whether the current portfolio of Cummins is best managed by us or if there are assets we should sell to create value and invest in more promising opportunities. Our analysis is thorough; if any division appears non-strategic and we believe it could achieve a better market valuation, we would explore that option. If we found a suitable valuation, we would proceed with the sale, otherwise, we would retain it. This process is a standard part of our strategic approach.

So my first question is around mining. So I thought it was good that you guys went through with Reynolds in oil and gas for rebuilds versus OE, but we've heard from some mining OEMs that OE activity is actually picking up a bit, so I'm just curious if you're seeing something similar?

Yes, Nicole, we are. Again, like in oil and gas, we're seeing it first on parts, which we started to see, in fact, last year. That's continued. So our part sales are up double digits in the high-horsepower space, mostly driven by mining and oil and gas. From the engine side or the OEM side, we're now projecting up 10% to 20%. We are seeing some of that kind of come through and a little less of the idled equipment to deal with that we have in the oil and gas business. So early days, commodity prices are up. There is certainly more activity, more discussion, and we're starting to see it in some orders.

Okay, got it. That's really helpful. And, I guess, my second question is just around China. Last quarter, you guys talked about a competitive pricing environment within China truck. I'm just curious if that's continued into the first quarter? Or if you've seen that eased?

I don't think it's impacting our results right now. So there's probably there hasn't been significant change at this point in time.

Yes, most of that was related to market share acquisition by one OEM of the other that launched some new models. With the new regulations on overloading requiring some fleets to purchase new trucks, our expectation is that pricing competition will ease. Frankly, we were even surprised by the size of the growth in the truck market in the first quarter as we were with the excavators. We have some work to do to understand how well that's going to hold up and how pricing markets are just reflecting back on the first quarter. Right now, we expect the pricing to ease under the circumstances.

Just a couple of quick follow-ups, and Tom, I apologize, I'm a little bit slow this morning, but I want to make sure I understand with this Cummins-Eaton joint venture, what does this allow you to do that you weren't doing before because I think you already had a pretty close relationship with them previously, and I'm curious why you felt the need to sort of allocate all this capital to this?

Yes, that's a great question, Steve. From our perspective, like with most of our Component businesses, we have the option to either purchase from external sources or bring the solution in-house. We usually choose to bring it in-house when two conditions are met. First, we believe our expertise in engines and systems enables us to create a better product for ourselves and for others. We think that with integrated powertrains, we can positively influence the design of the transmission with our engine knowledge. This isn’t something we can achieve through partnerships, as it's generally less efficient and effective. So when we see the potential for significant technical improvements, we prefer to handle it internally. The second factor is our belief that together, we can provide an integrated powertrain with features that are challenging to negotiate in commercial agreements. We're adding software and control features that are hard to price across different markets, and we aim to ensure we can deliver these capabilities while gaining market share, which is difficult to accomplish through a standard commercial arrangement. Furthermore, we want to invest in these technologies and features, but we need our partners to feel confident that their investments will yield a return. Long-term confidence on that front wasn't clear. To incorporate the technology we desire, develop the features, and ensure appropriate pricing, we felt it necessary to bring this in-house. We took considerable time to evaluate various approaches, from developing our own solutions to acquisitions and joint ventures in different regions with various partners. Ultimately, we concluded that this route was the best option. I believe Eaton shares a similar perspective.

Okay, good. That definitely helps. And secondarily, I'm just curious, you talked a little bit about electric drivetrains and fuel cells and so forth. It's interesting to hear that you're already sort of testing this stuff. But I'm wondering if you feel like you have internally that kind of core competency that you need there? Or is this a situation where ultimately, you're going to have to either acquire or a joint venture or something in order to be able to do what you need to do with those alternative type drivetrains?

Yes, I think it's much like the situation we just spoke about. Our view is that we have the capability to integrate today just as we have the capability to integrate a powertrain before. We will likely want to acquire some subsystems of electrified powertrain to make sure that we not only can do it, but we can do it better than everybody else. I think it's right what you said that the capabilities we need to outperform everybody else, we will have to acquire or develop those capabilities in-house for some of the subsystems. Things like battery control, packaging, power electronics, especially for the size of the commercial vehicle. These are things where there are suppliers today in the market, but those technologies will develop the fastest, our ability to have the best ones of those subsystem technologies and integrate them the best will certainly require us to invest more in those areas. Whether that means acquiring a company or joint venturing again or otherwise hiring and developing our own will remain to be seen. But we are active in all those spaces to figure that out. There's time in front of us, but we can produce one now and a good one. We want to be the winner, as I mentioned, which means we're going to have to be expert in some of those subsystem technologies just as we are with diesel, just as we are with natural gas.

Thanks for the discussion on the sort of forward-thinking strategy. It's very interesting. Tom, if you were rumored to be spending 2/3 of your time on acquisitions over the past year or two, do you anticipate that to be just as intense now? Or does the Eaton JV fill a big enough hole that there's a total little bit less? And secondarily, and you've touched on this, but I mean, do you see more opportunity or more need in acquiring things related to hydrogen or related to electric or related to whatever versus maybe the upside of acquiring pools of revenue where you can operate the business a different way about?

Thanks, Rob. I thought you might be implying that after dedicating two-thirds of your time and only achieving one joint venture, you were questioning whether that time was well spent, but I'll assume that wasn't your intention. My focus hasn’t changed regarding time. The joint venture with Eaton is a significant strategic move, and we feel very positive about it. It addresses just part of our strategic goals, and there’s still much work ahead. I have not decreased my efforts at all. To answer your question about which aspect interests us more, it's both. I believe we need to acquire capabilities to stay on track. To maintain our position as a leading company in our field, we must continue developing technologies. In some areas, this may involve joint ventures or acquisitions in new technology sectors. We need to seek opportunities to utilize our current capabilities and potentially explore new revenue streams. Both aspects are crucial for our growth and development as a company. We view growth and capability building as integral to our strategic initiatives. The Eaton joint venture illustrates both of these elements, and you can expect us to continue to pursue both as vital to the company’s future.

Just a couple of follow-ups. The JV stuff has been asked and answered several different ways. But in the near term, it looks like your Power Systems outlook is not anticipating much over the next 3 quarters, and part of that might be this uncertainty that you described with respect to China. But I'm wondering why not more a follow-through given your comments on oil and gas and mining.

Okay. Yes, Andy, it's Rich. Well, again, I think what we have seen is in the Power System area, our part sales are going to be up 16% this year. So we're seeing this kind of broad-based activity, which is a precursor, hopefully, to new equipment going in. Until we see it, I guess we're not putting that in the forecast. Like I talked in oil and gas, we've even had some indications that this was kind of a one-time bit until some equipment gets rebuilt and refurbished. We're just paying attention. I think there needs to be some prolonged commodity prices staying higher for a bit longer for the people who are going to make the capital investment. Until we see that, we'll put it in the forecast. We're prepared for it. We have capacity in place, and one of the things we always try to do is be the best at responding when it comes back. Even if we get surprises, if it comes back quickly, which it does sometimes, we'll be ready for that.

The other challenges, Andy, at these low levels, even though mining and oil and gas are improving, still two-thirds of the revenue are tied to Power Generation, which for now remains fairly muted. So that's what we are trying to weigh in the outlook for this year, along with the commodity cost.

Okay. And then another detailed question on warranty, the 50 basis point headwind that you called out in the quarter, and maybe you discussed this, but I missed it. How much of that was the adjustment, meaning the one-time? And how much is kind of go forward for the rest of the year?

The one-time adjustment, Andy, was probably close to 2/3 of it, maybe a little bit more. That's onetime that will not repeat, has been through for the rest of the year. We did anticipate higher rates, higher expense in the first quarter. As we launch some new engines and we do increase our rates when we launch engines, I think you'll see warranty come down in the second quarter to more normalized levels, so to speak.

Okay. Thank you very much, everyone. Adam and I will be available for your call later. Thank you.