Paccar Inc (PCAR) — Q2 2017 Earnings Call Transcript

Good morning. We would like to welcome those listening by phone and those on the webcast. My name is Ken Hastings, PACCAR's Director of Investor Relations. And joining me this morning are Ron Armstrong, Chief Executive Officer; Harrie Schippers, Executive Vice President and Chief Financial Officer; and Michael Barkley, Senior Vice President and Controller. As with prior conference calls, we ask that any members of the media on the line participate in a listen-only mode. Certain information presented today will be forward-looking and involve risks and uncertainties, including general economic and competitive conditions that may affect expected results. I would now like to introduce Ron Armstrong.

Good morning. PACCAR reported strong revenues and net income for the second quarter of 2017. PACCAR's second quarter sales and Financial Services revenues were $4.7 billion and second quarter net income was $373 million, a 7.9% after-tax return on revenues. PACCAR Parts achieved record quarterly revenues of $823 million and record pretax profits of $152 million. PACCAR achieved excellent combined truck and parts gross margins of 14.6%, driven by higher North American truck deliveries, the strong European truck market and the record PACCAR Parts results. I'm very proud of our 24,500 employees around the world who have delivered outstanding products and services to our customers. PACCAR delivered 39,400 trucks during the second quarter, 13% higher than the first quarter and 6% above last year's second quarter. Peterbilt and Kenworth raised build rates during the quarter in response to robust order intake this year. Looking ahead, PACCAR expects 2% to 3% higher deliveries in the third quarter compared to the second due to the higher build rates in all markets, partially offset by fewer build days in Europe due to the normal summer shutdown. Third quarter gross margins are projected to be comparable to second quarter margins. We've raised our forecast for Europe's above 16-tonne market to a range of 290,000 to 310,000 units, reflecting strong demand and the steady economic outlook. Europe's GDP growth expectations for this year are 1.8% in the U.K. and on the continent. Freight transport activity on German highways year-to-date was at record levels and up 3.6% compared to the same period last year. During the second quarter, DAF introduced new model year 2017 XF and CF trucks which deliver up to 7% higher fuel economy compared to the previous models. This contributed to DAF's 10% growth in above 16-tonne orders in the first half this year compared to the same period last year. U.S. and Canadian Class 8 truck industry retail sales are expected to be in the range of 200,000 to 220,000 units this year. Class 8 truck industry orders were up 44% in the first half this year compared to the same period in 2016. Peterbilt and Kenworth's Class 8 retail sales market share was an excellent 31% in the second quarter and 29.6% year-to-date through June. Customers appreciate the ongoing investments by Kenworth and Peterbilt in enhanced truck models, expanded PACCAR powertrain options and onboard technology. The U.S. economy's steady expansion is projected to be 2.2% GDP growth and 1.8% industrial production growth this year, supporting healthy freight levels. PACCAR Parts' quarterly pretax income of $152 million was 14% higher than a year ago. PACCAR Parts' quarterly revenues of $823 million were 9% higher than in the same quarter of last year. These results were driven by the growing number of PACCAR trucks and engines in operation, our outstanding logistics capabilities which provide high parts availability to dealers and customers, and the growing number of TRP All Makes retail stores globally. PACCAR Financial Services' second quarter pretax income increased 10% to $63 million compared to $57 million last quarter. The portfolio continued to perform well. U.S. Class 8 industry truck - used trucks volumes increased during the quarter. Kenworth and Peterbilt truck resale values continue to command a 10% to 20% premium over competitors' vehicles. PACCAR's strong balance sheet and positive cash flow have enabled the company to invest over $3 billion in new products and facilities in the last 5 years. This year, capital expenditures of $375 million to $425 million and research and development expenses of $250 million to $270 million are targeted for truck and powertrain product development, enhanced manufacturing and parts distribution facilities, and aftermarket support programs. We're pleased to announce the new PACCAR Silicon Valley Innovation Center which will open this year in Sunnyvale, California. The facility will coordinate next-generation product development and will identify emerging technologies for the benefit of future vehicle performance. The Innovation Center will develop exciting new technology applications for advanced driver assistance systems, artificial intelligence, vehicle connectivity, and augmented reality, complementing the research and development currently happening in PACCAR's truck divisions and technical centers. PACCAR looks forward to expanding its partnerships with many innovative technology companies in Silicon Valley. We're very proud of our team at the PACCAR engine factory in Columbus, Mississippi. Since opening in 2010, the plant has demonstrated its world-class diesel engine manufacturing capabilities and was recently named Quality Magazine's plant of the year. We're nearing completion of a $35 million investment in additional capacity at Columbus to support growing customer demand for the PACCAR MX-13 and PACCAR MX-11 engines. PACCAR continues to enhance its leadership position in the global truck market by delivering the highest quality products and services in the industry. Thank you. I'd be pleased to answer your questions.

Can I just clarify the comments you made about higher deliveries quarter-over-quarter in Q3 because that would not typically be the seasonal expectation we'd have. Was that a North America comment? Or was that total deliveries?

Total deliveries are up 2% to 3%, so the higher average build rates in North America as well as in Australia, Mexico, and Brazil are then offset by the seasonal summer shutdown in Europe.

Okay. That's helpful to know. Would you expect that there is no indication that daily builds would slow in Q4 based on your current backlog and orders?

At this point, assuming the economy continues to tick along and we feel good about our build rates and maintaining those through the rest of this year.

Okay. And then just as a follow-up. On the Finco business, can you talk about used values? I know you mentioned that yes, you command a premium but the premium could be up 0. So can you talk about used values? And what you're seeing out there? And whether we've really stabilized? Or is there any downside risk still to used values?

Yes, I think in the second quarter, the values in Europe were very stable and in the U.S., down just slightly but very comparable to first quarter levels. And the amount of the used truck results in the second quarter were about $4 million better than the first quarter.

I appreciate your insights on the gross margins for the third quarter, which you mentioned are comparable to the second quarter. Should we assume that your margin forecast for the year has improved compared to your guidance from last quarter, due to the current run rate? That would be my first question. My second question is about the order board in the U.S. and Europe. How widespread is the activity? In the U.S., are the larger companies getting involved, or is it mainly the smaller fleets? Any information on where the strength is originating would be helpful.

So I think we talked earlier about a range of 14% to 14.5%. I think we'll be closer to the upper end of that range for the full year. And when it comes to demand, I think it's pretty broad-based whether you look at vocational, you look at on-highway, you look at fleet, both small, mid and large. I think it's a good cross-section. We've seen all the segments go up as we progress through the course of the year.

And any color on the order board geographically? Whether it's in Europe or the U.S.?

Both are very solid, so we're in good shape as we look, sit here today. The backlogs are strong.

I was wondering if you guys could talk a little bit more about truck margin. I mean I know clearly that you saw some sequential recovery in truck margin but you're still down on positive sales growth in truck only. Can you help us a little bit with the year-on-year bridge? And specifically what's happened with pricing?

The primary thing impacting is currency movements, primarily the impact of the pound versus the euro and the peso versus the dollar. If you adjust for those, then they're very comparable.

Got it. Okay. And then can you say did you experience any disruption in the European truck business due to bottlenecks in the supply chain or anything? One of your competitors was pretty vocal about that last week.

No. We have not seen any impacts as a result of supplier disruptions at all. Suppliers are doing great.

Really terrible quarter. We're getting bored from all these beats. I just wondered, I guess you guys got to stick with your strengths, right?

We do what we do and we try to do it well.

I was curious if you could provide some insight on Brazil. Has it become profitable at this point? Additionally, by 2020, what are your expectations for market share?

Well, the team has done a great job of building the business. And as we have progressed through the course of this year, we're going to take an additional build rate increase during the third quarter to support the increasing demand. The product is doing just extremely well in the market. Our dealers are continuing to invest and build their businesses in spite of a very difficult economy and difficult truck market. We feel like the investments that we made will provide an excellent long-term return for shareholders. So we've been able to grow our share from 0% up to 5-plus percent in the above 40 tonne segment of that market. So I think that pace of growth will continue to be an opportunity for our DAF business there as we progress through the next 2, 3, 4, 5 years. So hopefully we could double that position in that timeframe.

Great. And then on the engine business, is the North American aftermarket started to kick in? Or is it still a little bit too early for that?

No, I believe we're currently at about 140,000 PACCAR MX engines in operation. We will continue to increase that number as we move forward, and it is consistently growing. This area represents the largest growth opportunity for the Parts division in the various segments of their Parts business.

I'm wondering if you could talk about your longer term R&D outlook. So in the press release, you spoke about all of the growth initiatives you folks are pursuing on the technology side. And as you think about your R&D budget, should we be thinking about that moving higher as a percentage of sales off of 2017 levels? Or is that just a change in prioritization versus other investments? How should we think about that?

We typically don’t consider it as a percentage of revenue; we focus on the actual dollar amount and how much we are investing to align with our strategic direction for the next four to five years. You can expect a steady, slight increase year over year as we continue to invest in various initiatives we discussed, including advanced driver assistance systems, vehicle connectivity, enhancements to our powertrain efficiency, and expanding powertrain options for our customers. Therefore, I anticipate it will remain fairly stable, with a gradual increase over time.

Can you provide a timeframe for when the front axle production facility in Texas will reach full production capacity? Additionally, what percentage of your fleet and models will be equipped with your front axles once production increases?

So this is a 20,000-pound front axle and it's primarily for heavier vehicle applications. And so we'll start production, initial production in the third quarter and we'll see that ramp up over a 12-month period. And at full production, it could be up to 20% of the axles that we put in our Class 8 vehicles.

I wanted to ask a couple of questions. The Finco margin improved from the first quarter to the second quarter, but how long do you think it will take to return to that mid- to high 20% operating margin level? You mentioned stabilizing used truck pricing. Do you expect things to be cleared up by the end of the year, or do you think this will extend further?

I believe we are selling more trucks than we are receiving in the first half of this year. I expect this trend to continue slightly into the second half. By the beginning of next year, the volumes should balance out regarding what we are selling versus what we are bringing in.

Okay. So you think it's fair to expect that margins next year could be more kind of normal relative to what we've seen over the last half a dozen years or so?

Yes, it really just depends. The key thing is the used truck valuations in the market and so we'll see how that moves. But part of the positive thing for PACCAR Financial, particularly in the U.S., is that beginning next year, pretty much all the returns that will be coming off lease will be the 2.1-meter model truck compared to the legacy 1.9 meter. So that gives us some upside on the used truck valuations going forward as well.

That's good insight. Could you provide more detail about Eastern Europe compared to Western Europe? Last quarter, you mentioned some strength in Russia and other Eastern European markets. Do you have any updates to share on that?

I'd say the strength in Russia continues. We're seeing good orders continuing to deliver.

And the rest of Eastern Europe is developing very similar to Western Europe for the first half of this year.

I guess starting with price cost. So I suspect that higher material costs were probably a headwind within the truck segment with respect to margins this quarter. Does that continue into the second half? Or do material cost headwinds ease from here?

Yes. It wasn't much of a factor in the results for the quarter. There are some upward pressures but we have long-term agreements and those impacts tend to get spread over time and managed through. And so that wasn't a significant impact. The key impact of margins for the quarter primarily was the currency impacts I referenced earlier.

Okay, got it. That's helpful, Ron. And then secondly, if it's possible to give us a little bit more color on the 3Q delivery guidance. So the up 2% to 3% Q-on-Q, what's the order of magnitude for the growth in North America versus the decline in Europe that you guys are embedding?

Let me see if I can. So Europe would be down about 10% because of the summer shutdown period. And conversely, North America is probably up about 10%.

Just wanted to go back to an earlier question, I think it was Jamie, about segments within the NAFTA market. Are you seeing any increase in interest from the long haul truckload customers compared to earlier in the year that may support an expectation that the normal increase order activity towards the end of the year would take place?

Yes. Our order intake has trended upward during the course of the year compared to if you look back to the latter parts of last year and we continue to see on-highway truck orders build quarter-on-quarter.

Well, that's good to hear. Has vocational and energy remained strong for you folks?

Yes, for sure. It's been a good order inflow in terms of the mix. Both of them have gone up and probably on-highway a little bit faster from an order standpoint than vocation.

A couple of numbers-related questions here for you. When you look at the cash flow statement, there's a pretty big negative outflow on working capital. It looks like receipt in most of that. Any additional color on that?

I think the biggest item was floor plan financing. I'll let Michael talk about that.

Yes. Last year, as our production rates were decreasing and dealer inventories were declining, we experienced an inflow from foreign receivables. This year, as our production rates are increasing and dealer inventories are rising, we are seeing an outflow related to that. There is about a $400 million change that you will notice affecting the operating cash flow number. However, as those trucks are delivered, it will convert into realized cash as the year progresses.

So the accounting rule, Mike has put that up in operating and the financing that we do for that is down in the investing section.

That's a good response. I have a follow-up question regarding currency. I want to explore it in more detail. Considering the recent strength of the euro, after experiencing several years of a weak euro, it seems that this could be beneficial for PACCAR from a transactional standpoint. Could you provide some insight on how much impact a stronger euro might have on your growth profit dollars?

So we have a bit of a natural hedge with respect to the translation of our euro-based financial statements and we have euro-sourced components in the U.S. that we get the benefit of. So as the currency weakens and as it strengthens, we'll have more revenues and profits from DAF but that will be offset by some reduction then in the purchase cost for the components coming out of Europe. But it's a nice natural hedge that doesn't fully offset but it does offset what we're seeing.

At the line items, there's probably a little bit of a mismatch on gross profit versus SG&A.

Yes, there is. There is. That's correct.

Okay. And then just one last item on the vertical integration, producing axles for trucks here in North America, you're doing engines here in North America. I mean the next logical step there would seem to be transmissions. Any thoughts on that?

We have great partners both in Europe with ZF and Eaton here in North America. We work very closely with them to have integrated customized solutions for our powertrains. And so we expect that to continue for the foreseeable future.

Ron, I think, in the past we've talked about once we get past, hopefully get past, kind of a mid-cycle replacement kind of level of activity which seems to be kind of around where we're now in North America, that you have an opportunity hopefully for some pricing. Do you still view the market that way?

Yes, I think the market is good. We feel positive about its current state. If we compare it to 2015, when the truck market was at 278,000, this year's figure of around 215,000 shows a notable difference. The supply and demand situation offers some potential for pricing opportunities in the future.

So if next year were to be higher, I'm not asking you to forecast that, but we might have a better pricing environment in that scenario?

It could be. Could be.

Yes. And then can I ask you to maybe put on your long-term prognostication, is that right, hat? And you've opened your new center down in Silicon Valley and thinking a little bit about the future of truck transportation, et cetera. When you think about that, things like battery-powered trucks maybe, I know you may have a new competitor soon, automated trucking, platooning, et cetera, do you have a view on which of those technologies is likely to be sort of sooner rather than later? And then sort of following onto that, do you feel like you want to do this kind of stuff internally to PACCAR? Or is this the kind of thing where you look for some partners as you go forward? I'll let you answer that however you like.

That is a multifaceted question but a good question. So as we think forward, we're talking with a lot of suppliers who are very interested in partnering with us for a variety of technology paths that we may take. And so I'd say we're currently in that assessment phase of evaluating the best path for our company. And so part of opening this office is getting greater, more immediate access to the technologies and the technology development so that we can be better informed and make better decisions. And I think we'll start with this office in a relatively small way but I think it will probably grow as time goes on. And all those things will be parts of the areas of study that are done in this office. And we'll stay very close to those developments and continue to formulate the specifics of our strategy as we go through the next year or two.

Okay. Any of those technologies kind of more attractive to you? Or maybe you're more skeptical about one or another?

No, I think the advanced driver assistance systems, those continue to progress. The camera technology, radar, lidar, all those technologies are developing pretty quickly. So I think they'll be the technology to support autonomy but how quickly will it actually happen in reality and for the next decades, you're going to have a majority of nonautonomous trucks on the streets. So it's going to be a transition and I'd say, a relatively gradual transition over time. So I think there will be progress in that area for sure. Batteries is just the size. There has to be a breakthrough in battery technology for there to be an economically viable solution for heavy-duty trucks. So again, we'll be very close to those developments. And as they occur, we work with a lot of potential partners in that arena now and we'll continue to stay close to that.

I wonder if you could give us some color on how far out your backlog extends at this point and how that lead time has developed over the course of the year. Kind of curious how much of your second half production schedule is booked at this point.

We usually don't discuss backlog in detail, but I can say that it is solid and in good condition. The backlog has remained strong throughout the year, and we have been able to increase build rates across all our markets as a result. We feel optimistic about our build rate plans for the upcoming quarter and as we move through the rest of the year.

And are you taking a notable amount of orders for 2018 or is it too soon for that?

I think we're starting to see some. I wouldn't call it a notable amount, but there are some orders in the backlog for 2018 currently. But I think the discussion level about 2018 with, obviously, many of our larger customers, those discussions are starting to occur.

Okay. And then just a quick one on the MX-11. How has that been performing from a warranty perspective? Do you have enough volumes to note any trends? And I know you mentioned that the currency was the big impact on the margins in the quarter. Did warranty have any notable impact on the margin this quarter?

No, no notable impact. The MX-11 is doing very well. The MX-11 was launched in Europe the fourth quarter of 2013 and we launched it here the beginning of 2016. And the engine has performed very well in both markets. And we're excited about the prospects for getting a greater penetration of that engine with our customers going forward.

I wonder if you could talk a little bit about the medium duty market and kind of what you're seeing there just in terms of order rates, trends, et cetera.

This year, based on our medium-duty truck production in the first half and our planned production rates for the second half, we could set a record for medium-duty production at PACCAR. This is partly due to ongoing strong market conditions, with estimates of approximately 50,000 to 55,000 trucks in Europe within the 6- to 16-tonne range and around 80,000 to 90,000 trucks in the class 6 and 7 market. The Peterbilt, Kenworth, and DAF products have been well received and our market share remains solid. Therefore, we could see a record year for medium-duty production at PACCAR.

I'm sorry if I missed this, but following the strong performance of your Parts business in the first half of the year, what is your outlook now for the full year 2017?

So for the full year, we expect the global parts sales to be up in the range of 5% to 7% for the year.

Okay. And can you comment on used truck inventory levels in the industry? I mean are they still excessive? And if fleets do plan to replace more trucks next year versus this year, I mean, can the market absorb these additional trucks entering the market?

Our used truck position is quite normal. I would say there are still some excessive trucks in the industry from certain competitors. However, we feel confident in our ability to manage our inventory in the near and midterm.

Yes. I'd like to thank everyone for their participation. And thank you, operator.