Cummins Inc (CMI) — Q3 2017 Earnings Call Transcript

Thank you. Good morning, everyone, and welcome to Meritor’s Third Quarter 2017 Earnings Call. On the call today, we have Jay Craig, CEO and President; and Kevin Nowlan, Senior Vice President and Chief Financial Officer. The slides accompanying today’s call are available at meritor.com. We’ll refer to the slides in our discussion this morning. The content of this conference call, which we’re recording, is a property of Meritor, Inc. It’s protected by U.S. and international copyright law and may not be rebroadcast without the expressed written consent of Meritor. We consider your continued participation to be your consent to our recording. Our discussion may contain forward-looking statements as defined in the Private Security Litigation Reform Act of 1995. Let me now refer you to Slide 2 for a more complete disclosure of the risks that could affect our results. To the extent we refer to any non-GAAP measures in our call, you’ll find the reconciliation to GAAP in the slides on our website. Over the next few months, we plan to participate in the following investor conferences: the Jefferies industrial conference on August 9, the Longbow investor conference on August 29, and the RBC global industrial conference on September 13. In addition, we are always happy to host investors at any of our facilities. Please contact me directly to schedule a visit. Now, I’ll turn the call over to Jay.

Thanks, Carl. Good morning, everyone. On Slide 3, you’ll see this was another excellent quarter for Meritor. Sales were $920 million, up 9% from the same quarter last year. This increase is due primarily to the stronger Class 8 market in North America as well as higher production in Europe and China and the continued positive benefit of new business wins. Adjusted EBITDA was $103 million this quarter, the highest the company has reported in over the past seven years, resulting in an adjusted EBITDA margin of 11.2%. Adjusted diluted EPS from continuing operations was $0.64, and free cash flow increased to $94 million. Higher-than-anticipated volumes in most of our end markets and continued operational performance across the company are improving our outlook for the full fiscal year. In past quarters, our margin performance was strong despite the revenue challenges associated with weaker end markets. Now that we’re seeing higher volumes come through in North America, Europe, China, and even South America, our results are reflecting that benefit as we successfully convert on the incremental revenue. So as a consequence, we are raising our outlook again for the full year; and are particularly pleased to announce that we are taking our revenue guidance up by $150 million, with about a quarter of that being driven by market outperformance. We’re driving increases in share beyond our prior expectations with key customers around the globe, particularly in North America, Europe, and India. We’re delivering new business wins as part of our M2019 program that are starting to come into the P&L this year. Take a look at Slide 4. We remain confident in our ability to meet the financial objectives we set for M2019. We are increasing our market share with key customers, renewing long-term contracts, and winning new business in all regions around the globe across both of our operating segments. In addition to the wins we outlined for you on our last call, we continue to execute on new revenue opportunities that should contribute another $45 million of revenue outperformance in 2019. As we said in the past, these wins vary in size but are all important and are beginning to flow through our financials this year. With regard to contract renewals, we’ve recently finalized agreements with IVECO to continue supplying axles for its trucks in Europe. We also announced a new three-year agreement with the REV Group. Under this agreement, REV will continue to equip its bus, fire, and specialty vehicles with Meritor’s fully dressed axle assemblies. In addition to our current product offering, we’re looking forward to working with these customers on new products and the development of future designs. This is consistent with the strategy we’ve talked about now for a few years, which is to ensure we stay closely aligned with our customers in the development of new technology and forward product programs. We also continue to look at opportunities to invest in future products and technologies like the electric drive train solutions we told you about a couple of quarters ago and which we will profile at the upcoming NACV Show in September. On Slide 5, you can see four important recognitions we received this quarter from Daimler, Ashok Leyland, PACCAR, and Hino. You’ll also remember that, last quarter, we received the Diamond Supplier Award from Navistar and the excellent supplier award from XCMG. Our global team is working hard to provide all of our customers with excellent quality and on-time delivery. This has been and will remain our top priority for us. We know that being a reliable partner in an industry with such rapid demand changes is absolutely critical. If you turn to Slide 6, I will give you some color on the changes we see in our end markets. We meaningfully increased our production outlook since the last quarter for Class 8 trucks in North America from a midpoint of 210,000 units to approximately 230,000. While longer-term indicators remain mixed, we are seeing strong production right now in our facilities. As a result, we do expect the second half of fiscal 2017 to be stronger than the first. In terms of Class 8 builds, we were encouraged to see the largest quarter-over-quarter increase in recent history occur from the second fiscal quarter to the third, a 29% increase or close to 15,000 units. Meritor delivered exceptionally well during this demand cycle in which we experienced not only higher market volumes but also increased share in certain product lines. Excellent execution in all cycles is now a distinguishing characteristic of this company and one that our customers consider when selecting strategic partners. We tightened our range for medium duty this quarter, with the midpoint remaining the same from last quarter at 240,000 units, essentially flat to last fiscal year. In Western Europe, we slightly increased our midpoint for medium- and heavy-duty production. The economic outlook in the region remains as strong as it has been in six years, with growth expected at 3% this year. Heavy truck registrations were up more than 13% in May year-over-year, contributing to a stable upward trend. We increased our revenue forecast in China approximately $25 million for the year. This is primarily driven by increased activity in the construction segment and new products that we’ve launched in the region. China continues to be important for us, as we believe our opportunities for growth in this market as we look ahead to 2019 and beyond. We are now offering a broad range of axle and brake solutions for truck, bus, and coach applications that are specifically designed for the Asia Pacific market with localized manufacturing that provides optimized cost savings for our customers. In India, we lowered our production range for the year as third quarter production dipped below previous expectations. This was due to a decrease in heavy truck registrations related to the introduction of emission regulations that took effect on April 1. We still see strong demand, however, with GDP expected in the low 7% range this year and next. And with the growth we’re seeing with our largest customer in the region, our revenue is actually expected to be up year-over-year. Finally, we are maintaining our forecasts for South America, 60,000 to 70,000 units. No real change from last quarter, but as we’ve said, this remains an important market for us. We’re encouraged with some signs of recovery, albeit at a very slow rate. Before I turn the call over to Kevin, I wanted to give you an update on the OPEB litigation, as there were a few developments this quarter, which are shown on Slide 7. In April, the Sixth Circuit court of appeals ruled in our favor and subsequently issued a mandate returning the case to the district court for any further proceedings necessary to carry out the Sixth Circuit’s judgment. At this point, we are waiting for the injunction to be lifted but cannot make any changes to retiree health care benefits until that time. So as I said last quarter, it’s premature to speculate on the outcome, but we’ll keep you posted. Overall, this was a great quarter for us. And as I said earlier, we remain on track, with the entire Meritor team aligned around achieving our M2019 objectives. We are particularly pleased to be in a position to significantly raise our full-year guidance for the second quarter in a row. And we remain committed to sustaining the strong performance we’ve delivered throughout the year. With that, I’ll let Kevin give you more detail on the financials, and then we’ll take your questions.

Good morning. As you just heard from Jay, we had an excellent quarter across the board. We expanded bottom line earnings by 17%, generated significant free cash flow, and continue to make good progress toward our M2019 targets. Let’s walk through the details by first turning to Slide 8, where you’ll see our third quarter financial results compared to the prior year. Sales were $920 million in the quarter, an increase of 9%. Roughly half of the higher revenue was within North America, as we experienced higher Class 8 truck production. Our new business wins continued to come into the P&L, and our market share increased in certain product categories. We also had higher revenue in Europe and China as both of those markets continued to trend positively. As you can see in the line item volume, mix, performance, and other, we had $22 million of higher adjusted EBITDA related to $81 million of revenue increase. We continue to see the benefits of our M2016 operational improvements, which are driving strong earnings conversion on incremental revenue. Also included in this line item are $6 million of higher net steel costs on a year-over-year basis, partially offset by $5 million of higher joint venture earnings resulting from the improvement in the North American market. Next you’ll see that we had a $6 million favorable supplier litigation settlement in the third quarter of 2016 that did not repeat this year. You’ll recall that this was an important contributor to last year’s margin exceeding 11%. Moving down the causal, you can see that SG&A was an $8 million increase this quarter, excluding the impact of the supplier settlement in the previous year. This can be explained entirely by an increase in variable compensation expense to catch up our accruals through nine months given that this year’s financial performance is now outpacing our annual plan. These items provide the walk from an adjusted EBITDA of $96 million a year ago to $103 million this year and to our reported 11.2% adjusted EBITDA margin. This resulted in adjusted income from continuing operations of $60 million or $0.64 per share, which is an increase of $0.07 per share from last year. Slide 9 details third quarter sales and adjusted EBITDA for both of our reporting segments. In our Commercial Truck & Industrial segment, sales were $728 million, up 14% from last year. In our two largest markets, North America and Europe, truck production was up 5% and 3%, respectively, but as you’ll see, we’re outperforming this end market growth because we’re realizing the benefit from our new business wins and we’re seeing higher market share in certain of our product categories. Segment adjusted EBITDA was $75 million, up $14 million from last year. Segment adjusted EBITDA margin for Commercial Truck & Industrial came in at 10.3%, an increase of 80 basis points from a year ago. This margin improvement was driven by conversion on the higher revenue and continued material performance. In our Aftermarket & Trailer segment, sales were $228 million, up just $1 million from last year. Segment adjusted EBITDA was $26 million, down $12 million compared to last year. As a result, segment adjusted EBITDA margin decreased to 11.4% compared to 16.7% in the same period last year. The decrease in margin performance was primarily driven by the supplier litigation settlement we had a year ago. In addition, we had $4 million of higher allocated variable compensation accruals as well as higher steel costs that impacted the current quarter. Adjusting for the higher-than-normal incentive compensation accruals, our margin performance came in at just over 13% this quarter. Our margin expectations for this operating segment continue to be in the 14% to 15% range as we go forward. Turning to Slide 10. Free cash flow was $94 million, an $8 million improvement over last year. The increase is being driven by our stronger year-over-year earnings. That speaks to the quality of the earnings we’re generating. Earnings are translating to cash flow. Overall, for the first nine months of the year, we have generated $84 million of free cash flow, a $6 million increase over the same period last year. Next I’ll review our fiscal year 2017 outlook on Slide 11. As Jay told you, we are raising our fiscal year 2017 revenue, earnings, and free cash flow guidance. Building on our performance in the third quarter, combined with stronger market expectations and continued success in driving our business wins into the P&L, we now expect revenue to be approximately $3.25 billion for fiscal year 2017. This is an increase of $150 million from our previous guidance. From an earnings perspective, we are increasing our adjusted EBITDA margin expectation to approximately 10.2%, up 20 basis points from our previous outlook. We are also increasing adjusted diluted earnings per share from continuing operations by $0.30 to approximately $1.70. The combination of higher revenue and increased margin is driving this increase in adjusted EPS. And finally, based on these higher earnings expectations, we are also raising our free cash flow guidance to a range of $80 million to $90 million, up from our previous range of $50 million to $70 million. Overall, we are very pleased with our results this quarter and over the first nine months of our fiscal year. Our continued strong performance, coupled with improving revenue expectations, has provided us the ability to significantly take up our guidance expectations for 2017. Now we’ll take your questions.

This is Samik representing Ryan Brinkman from JP Morgan. My first question concerns the commercial truck segment. Your revenues in that area increased by 14% year-over-year this quarter. Could you provide a breakdown of how much of that growth was due to overall industry performance versus your market share gains?

I think, overall, you can see that when you look at the two major markets we have in commercial trucks, North America and Europe, they increased by approximately 3% and 5%. The majority of the remaining growth came from our strong business performance, which includes new business wins, increased product penetration, and expanded share with customers.

Got it. No, that’s helpful. And then in terms of probably strength here in terms of also the raising the revenue guide. You’re raising the revenue guide on the end market strength. How should we think about the sustainability of the end market strength going into 2018? Like, what’s your outlook in terms of how sustainable these end market strengths are going into the next year?

Ryan, this is Jay. I think the way we’re thinking about it is, right now even with that increase in market expectations, for the full year, we’re starting to push towards replacement demand. I think, as we look longer term at the U.S. economy and its health, we see no reason that the Class 8 market shouldn’t be able to sustain that replacement demand level going forward. Obviously, we’re not giving our guidance yet for 2018, but I think, as we look at the market fundamentally, we just think with a healthy economy that replacement demand expectation should be reasonable.

Got it, got it. And then just a last question. How should we think about sort of a typical incremental margin for the last quarter of the year? Because if I sort of look at what your guidance is implying in terms of revenue growth, which is sort of a $100 million increase; and put a 15% incremental margin on it, which you seem to have done this quarter as well, excluding the sort of backout of the benefit you had last quarter from the supplier payment, the math then sort of indicates that you could sort of outperform the 10.2% margin guidance you’re sort of issuing today for the year. So can you just help me in terms of is there anything that could depress incrementals in the last quarter?

As we look at the transition from Q3 to Q4, it's important to note that the supplier litigation settlement is not relevant for this year; that was positive news from last year. Therefore, it is not included in our Q3 2017 guidance or results. Regarding our Q4 expectations, we anticipate a revenue decline of approximately $95 million from Q3 to Q4, primarily due to the European shutdown, which typically results in lower revenue sequentially. We will also experience a decline in revenue as we exit our seasonal peaks in both our aftermarket and China businesses. Overall, the expected revenue decrease is around $95 million. From our guidance, we are projecting about a 20% conversion on the approximately $20 million reduction in EBITDA, which is reflected in our Q4 guidance.

Yes. You seem to have stronger end markets and new business wins, but you lowered your CapEx guidance. Is that timing of investments? Is that going to be added to next year’s CapEx? Or just how, given the growth, should we be thinking about that?

Yes, yes, Brian, this is Jay. I think that’s right. It’s really a timing issue. A lot of our projects are quite large. And although we’re encouraging the team to continue to invest to achieve as much labor and burden and material cost savings as they can, it’s just a question of timing. And I think the run rate that you’ve seen us at the last couple years is what we think a go-forward picture looks like.

Okay. Can you help us refine in terms of bucketing or breaking down, obviously in the Commercial Truck & Industrial sector, just the growth between what was end market growth, what was market share wins, what was new business? And then were there some things either in industrial or military that kind of came through that we haven’t seen in prior quarters?

I think we’ll be bucketing that at the end of the year and then at our Investor Day as we scorecard ourselves against our M2019 targets. So we’ll give you more detail at that time. As I spoke to in our initial comments, of the revenue guidance increase, roughly 25% of that was due to new business wins. And another data point that we called out was, even though the India market is down, we expect to be up because of the market share gains with primarily our largest customer but across the market.

I wanted to ask about the REV Group deal. They have a wide range of product types. Are you doing business with them across their entire product portfolio, or is it focused on specific types of products they manufacture?

No. Great question, Mike. In fact, that’s what makes us most excited about that announcement is, prior to this, we really didn’t have a single overarching agreement with the REV Group, so the opportunities were with each of the individual brands. This is the first consolidated agreement we’ve had with that group. So I think on both sides of the table we have expectations of increasing penetration with them as we become much more closely aligned with the engineering teams in the entire group.

Great. Can you give us a sense of how much revenue that they represents initially? I realize it’s going to ramp up over time.

Again, we’ll be scorecarding all the M2019 wins at the end of the year. And as we start to look at the opportunities individually, we’ll certainly highlight the larger ones individually when we come through at the end of the year. But again, we’re very pleased with just being right on track with where we expected to be and wanted to be on that revenue growth program overall.

Great. And I also wanted to ask you IVECO. You said that it was a continuation of an existing relationship with them. I mean, was it any larger than the prior relationship in terms of what you’re supplying to them?

No, it was a predual long-term agreement. We provide IVECO in Europe all their single-reduction drive axle needs that they require in Europe. But again, every major customer agreement that are long term is very critical to us and took an enormous effort by our team to make sure we execute it successfully.

Okay, great. Can you remind us if there have been any changes in market share among the OEMs in Europe? Are there certain ones that we are more exposed to and others that we are less exposed to?

Well, the big customers we’re exposed to are Volvo, Werner, and IVECO. And then we’ve recently won the Scania disc brake business, a large share of that, so you can look at Scania. And we have another win that we alluded to last quarter of another European OE that we’ll talk about in more detail in the future.

It sounds good. And also just wanted to ask you quickly: I mean you hired a Chief Strategy Officer in the quarter. I mean, should we think of that person as primarily being someone that prospects for acquisitions, or just looks at corporate strategy overall? Or just any detail there would be great.

Sure. The reason for that hire. We’re thrilled to have Cheri in our team. Cheri is someone we’ve worked with quite extensively before from the Boston Consulting Group, so we are excited to have her join us. It was primarily to support us in all our growth initiatives, both organic and through bolt-on acquisitions that we’re looking at. Obviously, a large part of our M2019, in fact, has come from revenue growth, and we want to make sure we go about that in the most thoughtful and organized way. And we have a lot of good opportunities that we needed to make sure we were sorting through properly.

It doesn’t sound like you’re prepared to talk about your revenue target specifically or where you’re at. And I’m wondering what is your confidence level at achieving that 2019 revenue target?

It’s stated, Brett. So far, what we disclosed last quarter and this quarter, we’re at $115 million towards that target of $450 million. I think we are very confident in our ability to achieve that target. I think we’re right on the flight path we expected to be. As you would expect, we have detailed meetings with all the operating teams, going through their risk-adjusted pipelines. What I’m most pleased about is the overarching strategy of becoming closer to the marketplace and our major customers. And then having significant additional new product launches is really getting a lot of traction, and you can see that in this quarter’s results. We’re also looking at some interesting bolt-on acquisition opportunities, and we’re hopeful that we’ll have some of those consummated in the not-too-distant future.

And switching gears, can you talk a little bit about what you’re seeing? You talked about near term the European market, commercial vehicle market; and the South American market. Can you kind of speak to those markets in terms of your outlook into 2018? Do you see strengths continuing in Europe? And where do you see South America?

I believe it is too early for us to provide guidance for 2018. However, looking at each market separately, Europe seems to be keeping pace with replacement demand. We are finally seeing progress in a replacement demand market, which is great for us, especially with our market share gains. What is encouraging about that market for the future is that there is no immediate need for changes in emissions or safety regulations. Additionally, GDP in Europe is strong and on the rise. As for South America, it remains stable, as we've mentioned. Political stability is crucial there. Whenever the political environment stabilizes, we typically see a surge in business activity, but there are often setbacks due to emerging issues. Therefore, in that market, we are particularly watching for political stability, and we believe that the underlying demand for business will be quite strong.

And then finally, from a commodity standpoint, have you seen any particular headwinds, particularly from a steel standpoint?

Steel has posed challenges this year, but we are beginning to observe some stability in that area. The company has effectively managed these issues so far. It’s important to note that most of our contracts include pass-through clauses that typically have a six-month delay, meaning we will gradually recover most of those increased costs over time. Despite the challenges we've faced this fiscal year, I am very pleased with how the team has worked to reduce additional material costs over a significant period.

And to dimension that numerically, Brett, it’s the quarter year-over-year, it’s about a $6 million headwind. And year-to-date, we’re about a $21 million headwind, but as we sit here today and look at the full year, we’ll be in about a $25 million to $30 million full year headwind, which is really unchanged from what we were thinking a quarter ago. We’ve seen a little bit more stability in the steel indices in the last few months than what we saw in the early part of the year.

Just to follow up on that last point about steel. If steel prices moderate here, it seems that for the fourth quarter, there will be a slightly reduced net headwind. Looking into 2018, if steel prices stabilize, we could see some potential benefits from a recovery. Is that the correct way to understand it?

That’s right, because the steel recovery mechanisms will start to kick in at the tail end of this year and really into the beginning of next year for the steel price increases we’ve really seen in the last quarter or two.

Okay. I may be reading too much into this, but I noticed that you've mentioned steel more in the aftermarket segment compared to the commercial vehicle segment. Is that because there are more contractual recoveries in that area within the commercial truck segment?

It’s a really good point. As you think about the $6 million headwind we had in the quarter year-over-year, about $3 million of it was in Aftermarket & Trailer. $3 million of it was in commercial truck. The reason we saw a little bit of a disproportionate hit to the Aftermarket & Trailer business relative to its revenue is because of pass-through mechanisms. Commercial Truck & Industrial, with the OE customers, has the traditional pass-through mechanisms with a lag on about a six-month basis. When you think of aftermarket, the aftermarket business in and of itself doesn’t operate with the same types of pass-through mechanisms. We tend to go out with pricing periodically maybe once a year; it could be more often than that, on a general basis, but the pricing is established, whether it’s up or down, based on a whole set of market dynamics, not just steel. So when we look at a particular quarter, year-over-year we saw a steel headwind in the segment but we didn’t have a specific recovery mechanism to offset that in the segment.

That's insightful. Looking at the bigger picture regarding Haldex and their recent announcement about disruptions in their business and order book, are you observing any advantages in the air disc brakes sector? Additionally, I'm curious if the potential deal will proceed, and whether or not aspects of that business would be of interest to Meritor.

Haldex competes in the foundation brake business, and their share, especially on the truck side, is quite small. Therefore, we haven't experienced significant impacts. Their focus is more on the trailer foundation brake side, where we have a notable presence in North America but less so in Europe. I haven't perceived any immediate effects. Regarding potential mergers and acquisitions, we do not discuss specific opportunities, so we will refrain from further comments on that.

It seems the appeal could extend through September. In terms of an updated communication to the market around that time, is that a reasonable expectation?

Well, I obviously, our next quarterly call will be in early November. And so we’ll, at the latest, have an update at that point. We did file a motion with the district court on the 19th of July and have had a hearing scheduled for late August. If there is a ruling from the bench at that hearing, we’ll update the market at that point in time, but we remain optimistic that this will get resolved over the coming months. When it does and once we’ve communicated to the company and any impacted retirees, we’ll then update the market.

Thank you. This does conclude our Third Quarter Earnings Call. If you have any further questions, please feel free to reach out to me directly. Thank you for your participation.