Paccar Inc (PCAR) — Q4 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, 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. Thanks to the accomplishment of PACCAR's 25,000 outstanding employees around the world. 2017 was an excellent year for the company. PACCAR achieved record revenues of $19.5 billion and net income for $1.68 billion. Net income includes a $173 million one-time benefit from the new U.S. tax law. Excluding the one-time tax benefit, PACCAR reported annual adjusted net income of $1.5 billion, the second highest in the company's history. 2017 was PACCAR's 79th consecutive year of generating positive earnings. Last year's results reflect record heavy-duty truck market share in the U.S. and Canada, record worldwide after-market parts results, and a strong European truck market. PACCAR celebrated many important achievements in 2017. DAF XF and CF trucks earned a prestigious international truck of the year award. Kenworth and Peterbilt achieved record U.S. and Canada Class 8 retail market share of 30.7%. Kenworth and Peterbilt also launched the new PACCAR front and rear axles and the PACCAR automated transmission in North America. The PACCAR engine factory in Mississippi earned the 2017 plant of the year honor from Quality magazine. The PACCAR Innovation Center opened in Silicon Valley. PACCAR parts opened new distribution centers in Brisbane, Australia and Panama City, Panama; and is constructing a new PDC in Toronto. DAF was honored as truck brand of the year in Brazil for the second year in a row. PACCAR's fourth quarter sales and financial services revenues were a quarterly record, $5.45 billion and quarterly net income was $589 million including the $173 million one-time tax benefit. Quarterly adjusted net income excluding the one-time tax benefit was $416 million. PACCAR delivered a record 44,300 trucks during the fourth quarter, 10% higher than third quarter deliveries. PACCAR increased its regular quarterly dividend in April last year and declared total annual cash dividends of $2.19 per share including $1.20 per share special dividend declared in December. PACCAR has paid a dividend every year since 1941 and its total dividend yield was an excellent 3.1% at year-end. We estimate that PACCAR's 2018 effective tax rate will be 23% to 25% compared to an effective tax rate of approximately 31% prior to the new law. The new U.S. corporate tax rate and accelerated depreciation of machinery and equipment will generate positive cash flow for PACCAR and its customers. We expect first quarter margins to be about 50 basis points higher on similar truck and parts volumes when compared to the fourth quarter last year. And based on our current market assumptions, we expect 2018 full-year margins to be comparable to first quarter levels. U.S. and Canada Class 8 truck industry retail sales totaled 218,000 units last year. In 2018, we estimate that the market will be in a range of 235,000 to 265,000 units. The 2018 U.S. and Canada truck market will benefit from U.S. GDP and industrial production growth, as well as greater capital investment resulting from the new U.S. tax law. The European heavy truck market was a robust 306,000 units in 2017 and looking at this year we anticipate that the above 16 ton truck market will be another strong year and be in a range of 290,000 to 320,000 vehicles. PACCAR parts generated record pretax profit of $614 million and revenues of $3.3 billion in 2017. These outstanding results were driven by a growing population of PACCAR trucks and engines and investments in technology and distribution centers. For the fourth quarter, PACCAR parts achieved record quarterly revenues of $877 million and record pretax income of $157 million. We expect parts revenues to grow 5% to 8% this year. PACCAR financial services revenues were $332 million in the fourth quarter and pretax income was $73 million. The good results benefited from continuing strong portfolio performance. U.S. Class 8 industry used truck sales volume increased during the quarter. And Kenworth and Peterbilt truck resale values continue to command a 10% to 20% premium over competitors' vehicles. For the full year, PACCAR financial services earned pretax income of $264 million. For 2018, PACCAR plans to increase research and development spending to a range of $280 million to $310 million and capital expenditures to a range of $425 million to $475 million. PACCAR is investing in new aerodynamic truck models, integrated powertrains including zero-emission electric and hydrogen fuel cell technologies, advanced driver assistance and truck connectivity technologies, and expanded manufacturing and parts distribution facilities. As the company begins its 113th year, we are in an excellent position to lead the industry with the highest quality products and services. Thank you. I'd be pleased to answer your questions.

Can you give us maybe what the year-over-year contribution was for volume and currency and the quarter on revenue and gross margin? And maybe how you're thinking about the components of what gets you that 50 basis point margin improvement over the course of 2018?

Let's discuss the revenues and currency effects, and I'll provide some insights into the margins. Looking at the fourth quarter, the holiday period in North America resulted in fewer production days for Peterbilt and Kenworth. This led to higher margins in North America compared to Europe, creating an unfavorable effect in the fourth quarter. However, this will turn favorable in the first quarter. Additionally, other expenses and the customer and product mix in the first quarter are more favorable than what we experienced in the fourth quarter.

The overall currency effects for the fourth quarter were $142 million, additive to revenue and about $8 million to pretax income.

That was foreign currency you said?

Yes.

And then, I wondered if you could talk about the supply chain here; how is it managing the increased demand for trucks and where are the tightest points that you're seeing at this point? Is it able to meet the wrap up here?

As we do in our wrap ups, we always work very closely with our suppliers, giving a lot of forewarning about our plans and so at this point we don't see any particular challenges in working with suppliers to achieve the market demands that we currently see.

I just wanted to make sure I understand Ron when you're talking about the margins in the first quarter and for the full year; are you talking EBITDA or gross margin?

I'm talking about gross margin.

Regarding SG&A, should we expect it to remain flat in dollar terms, or do you anticipate spending a bit more in that area?

So if you look at the fourth quarter, that's probably fairly indicative of what our run rate will be for 2018, probably with a little bit of upward pressure because of exchange rates. Year-to-date, exchange rates will be higher in 2018 as they were in 2017.

And then you talked about sort of spending a little bit more on some drivetrain integration, electric and all that; how should we think about this kind of longer term over the next kind of three to five years? Are you going to have to sort of spend increasingly larger amounts of R&D and CapEx to kind of get ready for whatever the future looks like in heavy truck or is this sort of a sustainable kind of rate?

I believe it's more sustainable. With the 2021 greenhouse gas submissions approaching, we are investing now, so I think we have a clear understanding that this level is likely to be sustainable for the next several years.

Do you have a targeted year for when you think you will have an electric vehicle of any sort ready for the market?

We'll have it ready when the customer demand is there to support that. We're obviously investing like a lot of companies are in zero-emission technologies and as the world evolves and as those vehicles become economical to the customers, that's the point at which we will definitely have a product in the market.

I'm wondering if you can update us on factory overhead performance in the quarter over the year. You folks have had cost rising to support the production ramp and I'm just wondering how did that evolve for the fourth quarter?

Yes, it was very normal, reflected our billed rates. We got good operating leverage on our factory operations, so I would say it's very normal.

And in terms of the drag from that factory overhead ramp, how does that evolve as we think about '18? Is it any easier to ramp from here or are we thinking about similar drag in terms of factory overhead cost growth in '18 as we saw in '17?

I think we'll see again, very normal progression, factory overhead will go up as we increment build rates or come down as we decrement build rates and so all very normal, so I don't have anything else to add there.

Can you discuss the parts business? The price-cost dynamic has been a challenge year-over-year for the past few quarters. Are you able to improve this in the fourth quarter? Please elaborate on your strategy, particularly why the pricing for parts has not kept pace with inflation.

I don't believe pricing is the issue. We have incentives in place, and due to the strong volume and the excellent programs offered by our PACCAR parts teams, dealers have achieved higher incentive levels than before. This is evident in our record sales and profits.

And lastly, in terms of the new tax structure; does that impact your thinking in terms of how much excess cash you need on the balance sheets and now you don't have unremitted foreign earnings the way you did under the prior tax jurisdiction; any change to how you're thinking about target levels of cash?

Yes, we'll progress as we progress through this year, we'll become much smarter each quarter about how this progresses but we do see definitely a favorable benefit. So we'll be thinking about our capital allocation strategy as we go forward.

I'm curious if you can share some of the reasons behind the incremental margins in 2017; have you fully optimized your production or are there additional factors at play?

No, the single biggest item Joel was just material cost movement. In 2016 we had very nice favorable material cost movements, 2017 was just the opposite. So they went in different directions year-over-year and so that was probably the single biggest item. And then we launched some new products that had a lot of renewable elements to it so as we launched those products we put our initial accrual rates for warranty and some of the other costs that have slightly higher rates, just to be conservative. Products are performing excellently in the market, so we'll see some benefit from that as we go forward.

And I didn't see in the press release here, your market share when you're up; can you give us a sense of what it was?

Yes, 15.3% for the full year and 15.7% in the fourth quarter.

And then just last, on the AMT product; is that a PACCAR product or do you buy it from someone else and rebrand it?

It's rebranded but I would say Joel, it is customized to mesh with our actuals and our MX engines. So it's a unique configuration for our vehicles.

Ron, I was just curious what you're seeing in and with huge stock pricing are you seeing any recovery there, and if so was it translating at all into better new truck pricing?

I would say it's stable; used truck prices have remained fairly stable during the second half of the year, and as we enter 2018, I would say the same for new truck pricing, which is also relatively stable.

Do you have any thoughts on how FIMCO will perform? In 2018, the start was weaker, similar to early 2017, which was influenced by low new truck pricing. Do you anticipate a slight increase there as we evaluate the Q4 earnings run rate for 2018?

Yes, I think if you take an average of the full year, divide that by last year's full year and then divide by four, that's likely a fairly indicative run rate, with some variation for developments throughout the year.

Starting with the state of the UK market, the UK registrations have been weak, making it difficult to determine if that reflects your experiences. Did you notice a slowdown in momentum or actual declines in your UK business as the year concluded and what are your expectations for the UK in 2018?

Our team did a great job, finishing above 16 ton and the 6 to 16 ton market, achieving over 30% market share for the second consecutive year. We are working closely with our customers to negotiate orders for 2018, and we expect that by the end of the year, the UK market will be similar to the levels seen in 2017.

I have two questions. First, regarding the margin commentary for 2018, you mentioned adjustments to your margins, which seem to be flat compared to what you indicated last quarter. However, your industry retail sales forecasts have increased, so I'm curious about what has changed. Is it related to material costs or market share? Could you explain why operating leverage might not improve with higher sales? If you manage to reach the high end of your forecast, how should we consider margins? Second, there is growing concern that with the U.S. truck market remaining strong, and the 2018 industry forecast continuously being raised, this could impact 2019. Are you becoming more apprehensive that 2018 might be the peak of the cycle given the current strength? Thank you.

No, we were not concerned about the peak, we're obviously working closely with our customers to meet their needs today, tomorrow, and whatever those needs are we will be working closely with them to make sure that we meet those and we'll flex to adjust whatever the market demands are and it's a real strength of our company. As we think about margins, there are a lot of factors that can impact 2018 margins, material costs, other factors as we progress through the year; so it's early days, we feel pretty good about the first quarter and we'll see how things develop for the full year.

Can you discuss the expected impact of changes in the U.S. on your capital allocation strategy? Additionally, do you anticipate any adjustments to your dividend payout, which is currently set at 50% of net income?

No, I don't foresee any particular change, obviously that will be a matter for discussion with the board as we discuss things during 2018 but I don't see us making radical changes in our capital allocation approach in our dividend practices.

I just wanted to circle back with your comments earlier on pricing; maybe you can just talk a little bit more about the outlook in terms of what you're assuming here in '18 and both in the U.S. and Europe? And I guess somewhat related to that, I'm just thinking from an industry standpoint, here we're approaching 2.5 kind of 3 plus year highs in terms of quarterly projected build rates. I'm just curious, what do you think another some changes in terms of potential ownership dissimilar to what we saw in Europe I guess a couple of years back but maybe just what do you think the dynamic is holding back or dynamics that are holding back the pricing opportunity in North America and I guess lesser in Europe? So maybe just some comments there.

Maybe Tim, can you clarify for me what you talked about changes in potential ownership. What…

Yes, there may be some potential consolidation. A couple of years ago in Europe, there was an ownership change by another entity. I'm wondering if a similar situation could occur here, particularly in North America, without naming specific companies.

Certainly. The transportation industry is continuously experiencing consolidation, and we collaborate closely with both predecessor and successor companies to maintain strong relationships. This industry relies heavily on personal connections, which is crucial for us and our teams. When it comes to pricing, we see it as a competitive market. We focus on meeting our customers' needs with our high-quality trucks that command a premium. Our goal is to capture profitable market share, and we are committed to that effort. The competitive landscape will determine the pricing options available to us.

I wanted to ask about the strength in parts sales; is there anything specific you can mention regarding whether the MX engine is beginning to contribute? Is it correct to think of this business as having a mid to high single-digit growth rate going forward?

I believe the growth in our parts business is driven by a combination of a larger truck population and the increasing number of MX engines in North America. The initiatives our teams have developed with fleet services, billing, and our e-commerce capabilities have led us to exceed 130 TRP stores worldwide under the TRP brand. All these factors contribute to growth rates in the parts sector that are above industry averages, and we aim to continue expanding this business throughout the year.

I think I heard that delivery is flat from the fourth quarter to the first quarter. Can you provide any regional insight on that?

Yes, I think just because of the workday adjustments there will be slightly higher North America deliveries in the first quarter and slightly lower European deliveries in the first quarter.

I enjoyed your booth, so it was good to see a truck company at a talk show.

Harrie was there. Harrie, what's your comments about that.

We showcased an impressive hydrogen truck and our autonomous trucks, which received a lot of attention and positive feedback from everyone who attended the show.

So I actually wanted to ask about the zero-emission truck because it's obviously not new for PACCAR, you've had vehicles imports I think for several years now. What are some of the challenges in getting the existing electric platforms into higher volume applications at existing fleets?

I think the major thing we need is a breakthrough in battery technology for electric trucks to really scale, really be significant for heavy commercial trucks.

When considering fuel cell trucks, significant infrastructure is needed to support hydrogen fuel cell technology. We are collaborating with our truck divisions and some suppliers to develop the necessary capabilities to be prepared when demand increases.

And when we think about breakthroughs in battery technology, is that energy density, is it packaging, is it thermal on a heavy-duty application? There is obviously very aggressive forecasts for automotive lithium-ion battery technology, what are some of the limitations in taking that into a heavy-duty application?

For the heavy-duty applications it's way more important because a truck carries a lot more than a person, like a passenger car does. And the cost and the range that the truck can operate, those are three things that are much more important for heavy trucks than they are for a car.

And the packaging on the chassis and on the truck. So I think there is a lot of things that will matter as that technology gets closer to the market.

It will see applications in the smaller trucks for us and it will make its way in the coming years.

And if you have your crystal ball in the room, five years from now, what sort of value might this be commanding of PACCAR overall?

That crystal ball is a little bit dim right now.

I guess on the truck segment, last quarter you guys did 1% positive pricing; did that continue onto 4Q?

I assume you're getting that from the 10-K or 10-Q.

That was from the queue, yes.

There are many factors within those individual line items that influence the overall mix, whether it involves heavy-duty, medium-duty, or customer segments. Therefore, it's essential to view the total picture as a whole, making it challenging to break down into any specific line item.

So we should just want for that I guess. And then, I guess on what you guys have seen internally with respect to order activity in the fourth quarter, so it's been really strong for the whole industry. Just curious about the mix, so anything interesting that you're seeing with respect to like daycabs versus sleepers versus vocational vehicles, etcetera?

No, I think the demand is up in really all segments. I would say that they are probably in terms of percentage growth, maybe a little bit higher demand on the day cab side and we're seeing some of that in the used truck market where the used day cabs have a bit of a benefit compared to what they had been say six months, nine months ago.

Ron, could you discuss how Q4 gross margin performed compared to the expectations set in the Q3 call? Given that volume growth ended up being a bit higher, was the margin lower, and if so, can you elaborate on that?

I cannot recall the exact details of our previous statement, but when comparing the third quarter to the fourth quarter, one factor we noted was that the fourth quarter saw higher deliveries in Europe than in North America, which somewhat affected the overall margins. Additionally, there were influences from customer and model mix regarding the products sold and the customers we served. We mentioned that the fourth quarter was a record sales period for our parts business, and although we had to offer slightly higher incentives, these incentives effectively contributed to increased volume and profitability.

I want to take a broader view and ask if the company has adjusted its approach to balancing short-term truck margins with the potential for long-term total margin growth or profit growth. This could be influenced by an increasing engine population in the field, which may lead to higher aftermarket sales in the future.

I don't believe there has been any fundamental change in our views on operating leverage and margin enhancement. In some years or quarters, circumstances like material costs may work in our favor, while in others they may not. However, I think our long-term perspective on margins and operating leverage remains consistent.

And then, I know you suggested no new pricing right now is pretty stable at North America; I'm just wondering if you're seeing any of the typical forward signals that could suggest pricing could start to improve during 2018?

As we sit here today, pricing is fairly stable.

I'm trying to understand the fourth quarter margins, specifically the price-cost incurred and your price-cost expectations for 2018. If we look at the gross margin, it was 14% when excluding currency impacts, compared to 14.7% a year ago. Despite North America accounting for 51% of deliveries this quarter, up from 42% in the fourth quarter last year, I'm curious about how significant the price-cost impact was in the fourth quarter and what your expectations are for next year to recover from this level and maintain growth.

So as I mentioned before, the key differences are the mix between Europe and North America in terms of volume.

And I apologize, I'm talking year-over-year; year-over-year North America deliveries were 51% of the total, they were only 42% a year ago. So the mix is positive year-over-year but the margins ex-currency were down, that's all, it's a plain cost issue, I'm just trying to reconcile.

I don't know what currency numbers you're using and how you're getting those. All I can just tell us is that when you look at fourth quarter '17 versus fourth quarter '16, you have the effects of material cost movements with the single biggest factor beneficial in '16, challenging in '17, the parts incentives had a bit of an impact and those are sort of the two biggest factors and as you look forward into next year, those sort of tend to reverse and you've got the European and North American mix favorable as we get into the first quarter.

And just to be clear, maybe I misheard you. I thought early you did give us the currency impact for the quarter, it was $142 million for revs and $8 million for profit. So…

And that's for the total company, total revenues, total profitability, truck parts, finance, etcetera.

But again, just on clear price-cost next year, what's the basis, is it neutral after this year, negative or '17 a negative; just to make sure we understand the puts and takes.

Yes, at this point we're probably thinking about it neutrally.

I wanted to discuss the used truck market again. It's certainly good that your brands have solid value retention and achieve strong pricing. However, with respect to new truck sales in 2018, there is a possibility that the supply of used trucks could increase, which might lead to a decrease in pricing. Can you provide more details on what PACCAR has been doing to collaborate with their dealers since the last time we experienced high inventories in the used market to minimize the impact moving forward?

As we think about used trucks I mean we're seeing good demand from used trucks as we sit here today. And no reason to indicate that that's not going to continue for the near-term. We've done a lot of things to support our ability to handle greater volumes of used trucks, we built a new used truck center in the Chicago area that's been open now just about a year, we're just opening another used truck facility in the Los Angeles area, in Montana. So we continue to enhance our internal abilities and obviously, we've always worked very closely with our dealers on the distribution of used trucks through the market; so we've done a lot of things to enhance our capabilities over the last several years.

And then secondly, just on parts; can you tell us how many TRP part stores are open during the quarter and how far along are you to fill buildout to what you're hoping to do globally?

I don't know how many during the quarter, I know we finished over 120 at year end and we're over 130 as we sit here today. I don't think we have a view of what full population is and just as we continue to add dealer locations for Peterbilt, Kenworth, DAF; we'll add locations for TRP to meet market demands as they develop. So there is no end number or end game in sight, it's just continue to take advantage of distributing parts to all the areas that we can support our customers.

Can I understand if that contributes significantly to the planned 5% to 8% growth for parts in 2018? Are there more locations planned with initial stock arrivals, or is the primary source of your growth for 2018 the organic growth of parts?

I'd say it's a combination of both. I think it's the programs, it's the population of vehicles and it's TRP expansion.

I just wanted to ask you if you have any preliminary expectations for Class 8 market share in 2018; I mean does the decline from where it was in 2017, if there is a big shift from vocational trucks to sales to large fleet?

Our teams have worked very hard over the years to develop market share. When I started with the company 24 years ago, Peterbilt and Kenworth had a combined share of 21%, and over the 24 years they've been able to increase that to 25%, 28%, and now they have 30%. Our goal is to continue developing the best trucks in the market, provide the best value for our customers, and profitably grow our share in our primary markets. That will be our focus for 2018 as well.

And I also wanted to ask you is there anything we should be thinking about in terms of the mix impact of TRP, I mean if TRP consists of a larger portion of your total parts business that's adding a drag on margins and parts at all?

No, in terms of the percentage, it's in the 10% to 15% range of total sales, so I don't see it being a major factor in parts margins.

First question is just on build rates, and are you currently building to the kind of volumes that you expect in 2018 or do you think that there is still some upward move in where you build this to, kind of a midpoint of your expectations?

As we have progressed into 2018, we have taken some additional build rate increases, both in North America and Europe to support demand and so we'll maintain that as long as the demand is there.

And then a quarter ago you talked about this sort of 14% to 15% gross margin range, it looks like initial expectations for '18 are that kind of be in the middle of that range. There are industry forecasts out there with volumes, particularly North America well above where it were you or currently. If we think about the market maybe turning closer to those expectations versus yours, how do you think about the operating leverage on that? Would that mean gross margin closer to the higher end of the range or there are reasons why we shouldn't anticipate some leverage on that?

As I mentioned earlier, many factors influence the overall margin outcome, and we are optimistic about what we are seeing and anticipating for the first quarter and the remainder of the year. There could be opportunities; we will need to see how the year unfolds.

Ron, can you give us more granularity on the outlook for the European above 16 ton market for this year? What are the drivers that get you kind of the higher end of the range and then conversely the lower end? And as a follow-up, can you share anything regarding the trends in your order for DAF, like you've done in prior quarters?

Yes, orders for DAF have been very strong. We look at fourth quarter compared to the second or fourth quarter, I think they are up about 27%. So as I mentioned, we've taken some additional plans to increase our build rate this quarter and so it's going to be dependent on the market, you look at the freight activity in Germany; in the month of December I think the activity was up 6%, and for the full year up about 4%, so we enter the beginning of this year with strong freight activity. DAF obviously has a great product, just won truck of the year in the fourth quarter and those products provide up to 7% improved fuel efficiency, so it's a great value proposition for the customers if the customers haven't bought trucks for four or five years, today's trucks is double-digit improvement in terms of operating efficiency. So there is a lot of reason for customers to purchase new vehicles, take advantage of the lower operating cost.

And then Ron, given the outlook for North America heavy-duty industry production that continue to increase this year and it sounds like you guys have already increased your daily build rate; as we begin to close in on the recent peak 2015 levels does PACCAR have enough capacity in its factories to support this level of demand or if the market continues to in fact higher considering where your market share is today versus just a few years ago?

Yes, we definitely do and we continue to monitor that and make the investments. As you know, we completed the west paint facility in Europe last year which basically increased the capacity of our paint operations in Europe by about 50% and we continue to monitor those capacity factors and make the investments. So in our capital plans this year or next year, we'll continue to look at that not just for our factories but obviously we're looking at that for our parts distribution activities as well, we're building the new PDC in Toronto and we're looking at some additional investments on the parts side to continue to support our customers with their truck uptime.

Yes, we'd like to thank everyone for their participation, and thank you, operator.