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Edited Transcript of CMI earnings conference call or presentation 30-Jul-19 2:00pm GMT

Q2 2019 Cummins Inc Earnings Call

COLUMBUS Aug 2, 2019 (Thomson StreetEvents) -- Edited Transcript of Cummins Inc earnings conference call or presentation Tuesday, July 30, 2019 at 2:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* James Hopkins

Cummins Inc. - Executive Director of IR

* Mark A. Smith

Cummins Inc. - CFO & VP

* N. Thomas Linebarger

Cummins Inc. - Chairman & CEO

* Richard J. Freeland

Cummins Inc. - President, COO & Director

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Conference Call Participants

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* Adam William Uhlman

Cleveland Research Company - Partner & Senior Research Analyst

* Alexander Eugene Potter

Piper Jaffray Companies, Research Division - Principal & Senior Research Analyst

* Ann P. Duignan

JP Morgan Chase & Co, Research Division - MD

* David Jon Leiker

Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst

* David Michael Raso

Evercore ISI Institutional Equities, Research Division - Senior MD & Head of Industrial Research Team

* Jamie Lyn Cook

Crédit Suisse AG, Research Division - MD, Sector Head of United States Capital Goods Research, and Analyst

* Jerry David Revich

Goldman Sachs Group Inc., Research Division - VP

* Noah Duke Kaye

Oppenheimer & Co. Inc., Research Division - Executive Director and Senior Analyst

* Robert Cameron Wertheimer

Melius Research LLC - Founding Partner, Director of Research & Research Analyst of Global Machinery

* Steven Fisher

UBS Investment Bank, Research Division - Executive Director and Senior Analyst

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Presentation

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Operator [1]

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Good day, ladies and gentlemen, and welcome to the Q2 2019 Cummins Inc. Earnings Conference Call. (Operator Instructions) As a reminder, this call is being recorded.

I would now like to turn the call over to James Hopkins, Executive Director of Investor Relations. You may begin.

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James Hopkins, Cummins Inc. - Executive Director of IR [2]

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Thank you, Michelle. Good morning, everyone, and welcome to our teleconference today to discuss Cummins' results for the second quarter of 2019. Participating with me today are our Chairman and Chief Executive Officer, Tom Linebarger; our Chief Financial Officer, Mark Smith; and our President and Chief Operating Officer, Rich Freeland. We will all be available for your questions at the end of the teleconference.

Before we start, please note that some of the information that you will hear or be given today will consist of forward-looking statements within the meaning of the Securities Exchange Act of 1934. Such statements express our forecasts, expectations, hopes, beliefs and intentions on strategies regarding the future. Our actual future results could differ materially from those projected in such forward-looking statements because of a number of risks and uncertainties. More information regarding such risks and uncertainties is available in the forward-looking disclosure statement in the slide deck and our filings with the Securities and Exchange Commission, particularly the Risk Factors section in our most recently filed annual report on Form 10-K and any subsequently filed quarterly reports on Form 10-Q.

During the course of this call, we will be discussing certain non-GAAP financial measures, and we refer you to our website for the reconciliation of those measures to GAAP financial measures.

Our press release, with a copy of the financial statements and a copy of today's webcast presentation, are available on our website at www.cummins.com under the heading of Investors and Media.

With that out of the way, we'll begin with our Chairman and CEO, Tom Linebarger.

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N. Thomas Linebarger, Cummins Inc. - Chairman & CEO [3]

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Thank you, James. Good morning. I'll start with a summary of our second quarter results and finish with a discussion of our outlook for 2019. Mark will then take you through more details of our second quarter financial performance and our forecast for the full year.

Revenues for the second quarter of 2019 were a record $6.2 billion, an increase of 1% compared to the second quarter of 2018. EBITDA was a record $1.1 billion or 17% compared to $897 million or 14.6% a year ago. Lower campaign costs, positive pricing and lower material costs more than offset our increased investments in research and engineering, the impact of tariffs and lower joint venture income in China.

Engine business revenues were flat in the second quarter compared to a year ago. Revenues in North America increased by 7%, driven by higher industry production of heavy- and medium-duty trucks as well as continued strong demand in construction markets. International revenues declined by 15%, primarily as a result of lower demand in Chinese light-duty truck and construction markets. EBITDA margin for the quarter was 15.4% compared to 13.4% for the same period in 2018. Lower campaign costs, improved pricing and lower material costs more than offset lower joint venture income, increased investment in research and engineering and the negative impact of tariffs.

Sales for our Distribution segment grew by 2% year-over-year, driven by higher demand for power generation equipment in North America. Second quarter EBITDA was a record $172 million or 8.5% of sales compared to 7.3% in the second quarter of 2018. EBITDA margins benefited from higher volumes and positive pricing.

Second quarter revenues for the Components segment declined by 2%. Sales in North America increased 5%, driven by higher truck build rates, while revenues in international markets declined by 12% as a result of lower truck demand in Europe, China and India. EBITDA for the second quarter was $297 million or 16.1% compared to 12.6% in the same quarter a year ago. The increase in EBITDA margins was primarily due to lower campaign costs and the benefit of material cost reduction programs, which more than offset increased development -- increased investment in the development of new products aimed at emission standards in China and India.

We are currently selling a limited number of National Standard VI products for specific urban applications in China such as sanitation vehicles, and we'll ramp up production in 2020 and again in 2021 when all medium- and heavy-duty commercial vehicles are scheduled to comply with NS VI standards. In India, we'll begin producing new products later this year as we prepare for a transition to the Bharat Stage VI standard in April 2020.

Power Systems sales in the second quarter declined by 3%. Demand in industrial markets declined 11% due to lower sales of oil and gas and mining engines, while sales of power generation products were flat. Power generation sales increased 12% in North America, driven by continued strength in the data center markets, offset by 11% decline in international markets, mainly in Europe and the Middle East. Foreign currency movements negatively impacted sales by 2%. EBITDA in the second quarter was 14.4% compared to 14.9% a year ago. The decrease in EBITDA was due largely to lower joint venture income in China, where we experienced a decline in demand for standby generator sets.

In the Electrified Power business, EBITDA was a loss of $33 million in the second quarter, in line with our expectations as we invest in the development of new products for commercial launch beginning in the fourth quarter of this year.

Now I will comment on the performance in some of our key markets for the second quarter of 2019, starting with North America, and then I'll cover some of our largest international markets.

Our second quarter revenues in North America grew 7% to a record $3.9 billion, driven by higher industry build rates of medium- and heavy-duty trucks, continued growth in the sales of construction equipment and increased sales of power generation equipment to data center customers. Industry production of heavy-duty trucks grew 19% in the second quarter of 2019 compared to a year ago, and 4% compared to the first quarter of this year, supported by a strong but declining industry backlog. Our market share through June was 35% compared to 33% a year ago, representing our highest market share in 5 years and reflecting the strong performance of our products in the eyes of our customers.

Production of medium-duty trucks increased 14% in the second quarter. A growing U.S. economy, coupled with high levels of consumer spending, low unemployment and low interest rates, continues to drive demand for medium-duty trucks. Our market share in the medium-duty truck market was 78% through June compared to 80% a year ago.

Total shipments to our North American pickup truck customers increased 20% compared to a year ago as we increased production of a new engine for Ram 2500 and 3500 pickup trucks. Year-to-date shipments for pickup truck customers have increased 6%.

Engine demand for construction equipment in North America increased 10% in the second quarter and remains at historically high levels, supported by nonresidential construction and infrastructure spending.

Revenues for power generation grew by 12% due to higher demand in data center markets, partially offset by lower sales to recreational vehicle OEMs. Demand for engines in oil and gas markets declined by 91% due to a sharp reduction in purchases of new fracking equipment.

Our international revenues grew -- decreased by 6% in the second quarter of 2019 compared to a year ago. Second quarter revenues in China, including joint ventures, were $1.5 billion, an increase of 3% over the prior year. Higher power generation equipment sales to data center customers and engine sales to oil and gas markets were partially offset by lower demand in on-highway and construction markets.

Industry demand for medium- and heavy-duty trucks in China decreased by 9% compared to a year ago even though the market was positively impacted by a prebuy of natural gas engines, ahead of the move to NS VI standards in July. We estimate that the impact of this prebuy was approximately 20,000 units, increasing market size by 5% in the quarter. Our market share improved to 12.8% this quarter from 10.9% a year ago as we increased our share at Foton. We expect further improvement in our market share in subsequent quarters due to further share expansion at our OEMs and a shift in the market towards over-the-road trucks versus construction-related dump trucks.

Industry sales of light-duty trucks declined by 9% in the second quarter and our engine market share was 8%, which is 1% higher than a year ago. This increase was driven by our new joint venture with JAC, which launched in late 2018. In the second quarter, the light-duty market was impacted by increased enforcement of loading regulations, significantly reducing both second quarter industry demand and our projections for the remainder of the year. Some truck models that have historically been registered as light-duty trucks are now to be classified as medium-duty trucks, which limits access to urban areas and requires additional licensing for drivers.

Second quarter demand for excavators in China increased 4% from a year ago. Our market share increased from 15.3% to 15.6%, driven by the strong performance of our local partners. Demand for power generation equipment was down 3% in the second quarter, with lower demand for standby power partially offset by growth in data center markets.

Second quarter revenues in India, including joint ventures, were $516 million, a reduction of 1% from the second quarter a year ago, with lower industry truck production and the impact of a weaker rupee, partially offset by increased demand for power generation equipment. Industry truck sales decreased 21% year-over-year, in line with our expectations, with lower demand driven by the timing of elections as well as challenges in the truck financing industry.

Within the truck market, we saw a more severe decline in heavy-duty applications, where we have the highest share.

Now let me provide our overall outlook for 2019 and then comment on individual regions and end markets. We now expect company revenues to be flat for the year, which is at the low end of our prior guidance range. We are maintaining our forecast for industry production of heavy-duty trucks in North America at 300,000 units, up 5% compared to 2018. The industry backlog declined this quarter to below 200,000 units from its peak of over 300,000 units 8 months ago while inventory is elevated at 80,000 units. Our guidance assumes lower industry production of trucks in the fourth quarter, driven both by fewer workdays as well as reduced build rates. We expect our [market share] to be at the high end of our prior forecast of 32% to 34%.

The combination of the increased capacity of fleets and lower freight demand has resulted in lower utilization of available equipment in the industry. Because of this reduced utilization, we've seen lower demand in our parts and remanufacturing business. We expect parts demand to continue to be relatively weak through the end of the year as dealers begin to reduce parts inventory in anticipation of lower market activity.

In the medium-duty truck market, we are maintaining our forecast for industry production of 140,000 units, up 6% year-over-year, and we expect our market share to be in the range of 74% to 76%, unchanged from prior guidance. We expect our engine shipments for pickup trucks in North America to be flat for 2019 compared to a very strong 2018 and unchanged from our expectations 3 months ago.

In China, we now expect domestic revenues, including joint ventures, to be down 2% in 2019. We are maintaining our outlook for medium- and heavy-duty truck demand at 1.2 million units, representing a 10% decline from last year.

In the light-duty truck market, we now expect a 12% reduction in demand compared to our prior guidance of 7% down. This decline is driven by the more stringent enforcement of overloading regulations I discussed earlier. We expect our market share in the medium- and heavy-duty market to be in the range of 13% to 14%, and in light-duty, we expect our share to be 8% to 9%, both in line with our prior guidance.

We now expect industry sales of excavators to be flat with the record levels achieved in 2018. This compares to our prior guidance of down 10% and is driven by increased exports of excavators to developing countries, primarily in Southeast Asia.

In India, we now project revenue, including joint ventures, to be down 5% compared to our prior guidance of flat. We anticipate industry demand for trucks to be 17% lower than the record levels experienced in 2018 and compared to our prior guidance of down 5%. Truck demand is being negatively impacted by the continuing high cost and low availability of credit in India's shadow banking system, which has been under pressure due to defaults by nonbank lenders. We continue to expect power generation and construction to grow 5% to 10% due to continued infrastructure investment.

In Brazil, we are now projecting truck production to increase 2% in 2019, down from 13% 3 months ago. Economic growth has not accelerated in Brazil as much as we had anticipated this year, with GDP growth now projected at 1%. Lower economic growth has resulted in lower demand growth in truck, construction and power generation markets compared to 3 months ago. We now project our revenues in Brazil to be down 10% compared to our prior projection of flat.

We continue to expect our global high-horsepower engine shipments to be down 5% this year. We project demand for oil and gas engines will decline 40%, which is unchanged from our prior guidance. However, we now anticipate sales in North America will decline by 75% compared to our 60% down expectation 3 months ago, with lower demand for new equipment in the Permian Basin as well as reduced demand for engine rebuilds. This deterioration in our outlook for North America is offset by increased sales to China.

The demand for mining engines has moderated over the last 3 months as commodity prices have fallen and capital budgets have been cut. We now expect mining engine sales to be down 5%, lower than our prior guidance of up 5%.

Demand for power generation equipment was flat in the second quarter, and we expect demand to remain at second quarter levels through the remainder of the year. We expect revenue to be flat for the full year, with growth in data center markets and increased military revenue offset by lower sales of generator sets to the RV market, lower demand in backup power applications in China and a drop in large prime power applications in Europe.

In summary, we are now expecting revenues to be flat for the year, at the low end of our previous guidance, driven by lower demand in international truck markets, moderating aftermarket demand in North America and the negative impact of a stronger U.S. dollar.

We are maintaining our EBITDA guidance of 16.25% to 16.75% of sales as lower joint venture income and the impact of lower volumes will be offset by lower material and other costs.

During the quarter, we increased our quarterly dividend by 15%, the 10th consecutive year of annual dividend increases. We continue to project returning 75% of operating cash flow to shareholders for the year.

In June, we entered into a definitive agreement to acquire the majority of shares of fuel cell systems provider Hydrogenics Corporation, for $290 million. This agreement is still subject to Hydrogenics shareholder approval as well as other customary closing conditions.

Strong execution across all of our businesses resulted in record revenues being translated into record EBITDA and operating cash flow in the first half of the year. As we move into the second half of 2019, our guidance projects that revenues will decline from second quarter levels as several of our end markets experience lower levels of industry production. The company is well positioned as we move through this period to repeat our track record of increasing cycle over cycle earnings and returning significant cash to shareholders. We will continue to invest in technology to ensure the future success of our stakeholders, while reviewing areas for additional cost reduction and efficiency gains, as we have in prior cycles.

Now let me turn it over to Mark.

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Mark A. Smith, Cummins Inc. - CFO & VP [4]

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Thank you, Tom, and good morning, everyone. I'll start with a quick summary of the drivers of our strong financial performance in the second quarter and then comment on our revised outlook for the full year.

Second quarter revenues were a record $6.2 billion, up 1% from a year ago. Sales in North America grew 7%, and international revenues declined by 6%. Currency movements negatively impacted overall company revenues by 2%.

Earnings before interest, tax, depreciation and amortization or EBITDA were a record $1.1 billion or 17% of sales for the quarter. EBITDA increased by $161 million over the second quarter of last year as a result of stronger gross margins and higher other income, which more than offset increased research and development expenses and lower joint venture income.

Gross margin of $1.6 billion or 26.4% improved by $201 million. Results for the second quarter of 2018 included a $181 million charge for an engine system campaign.

In addition to lower product campaign costs, improved pricing benefits from material cost reduction programs more than offset the impact of higher tariffs year-over-year.

Our selling, administrative and research costs of $880 million increased by $48 million year-over-year, driven primarily by new product development in the Engine, Components and Electrified Power segments.

Joint venture income declined by $14 million, driven by a weaker demand in light-duty truck and power generation markets in China in addition to some increased expenses in China associated with the launch of new on-highway products to meet the new National VI emissions regulations.

Other income of $43 million increased by $18 million, primarily driven by $18 million of mark-to-market gains on the investments that underpin our nonqualified benefit plans. The mark-to-market gains were recorded in other income in the income statement and with eliminations in our segment reporting.

The effective tax rate in the quarter was 21.4%, down from 22.5% in the second quarter last year and in line with our full year forecast of 21.5%.

Diluted earnings per share were $4.27 in the second quarter, up from $3.32 last year, resulting from stronger earnings, a lower effective tax rate and the positive impact of share repurchase activity completed over the prior 12 months.

Operating cash flow in the quarter was an inflow of $808 million, bringing the year-to-date total to a record $1.2 billion, up $747 million from the same period last year, driven by stronger earnings and a much slower pace of working capital expansion.

I will now comment on our revised guidance for 2019.

For the Engine segment, we expect full year revenues to be down 2% to up 2% compared to our previous guidance of growth of 1% to 5%. This lower revenue outlook is the result of a weaker projection for part sales in North America, weaker demand in the Chinese light-duty truck market and a slower pace of economic growth in Brazil.

We have revised our forecast for EBIT -- EBITDA margins in the Engine business to be in the range of 15 to 15.5%, down from our prior guidance of 15.5% to 16%, driven primarily by the impact of the lower sales outlook and weaker joint venture income in China.

For the Distribution segment, we now expect revenues to be up 1% to 5% compared to our prior guidance of up 2% -- 2% to 6%, with the slight adjustment driven by a stronger dollar and therefore a higher currency headwind. We are raising our outlook for EBIT margins -- EBITDA margins to be in the range of 8% to 8.5% compared to our prior guidance of 7.5% to 8.5%, driven by stronger operational performance which more than offsets the negative impact of a depreciating dollar.

In 2019, we now expect Components revenue to be between down 2% to up 2% compared to our prior projections of growth of 1% to 5%, reduced -- driven by a lower truck demand in China and India. We have raised our forecast for EBITDA margins to be in the range of 15.75% to 16.25%, up from our prior guidance of 15.5% to 16.25%, driven by stronger operational performance year-to-date.

In Power Systems, revenues are forecast to be down 2% to up 2%, unchanged from our prior guidance. We are also maintaining our forecast for EBIT -- EBITDA margins to be in the range of 13.25% to 14%.

In the Electrified Power segment, we continue to expect a net expense of $120 million to $150 million as we continue to make targeted investments and advance new product development towards commercial launch.

The net impact of the changes to individual segment projections is that we now forecast total company revenues to be flat in 2019, at the lower end of our previous range of flat to up 4%.

[So I've said] we're maintaining our forecast for company EBITDA margins to be in the range of 16.25% to 16.75%.

Full year operating cash flow is projected to exceed 10% of sales.

Capital expenditures for the second quarter were $133 million, bringing our year-to-date total investment to $242 million, and we still expect our full year investments to be in the range of $650 million to $700 million.

In the second quarter, we returned $179 million to shareholders. For the first 6 months, we returned $458 million through dividends and share repurchase activity.

As Tom mentioned, our Board recently approved a 15% increase in our quarterly cash dividend, which reflects our confidence in the long-term performance and commitment to strong shareholder returns. We expect to return 75% of operating cash flow to shareholders this year through share repurchase and dividend.

To summarize, we delivered a strong second quarter and record first half of the year in terms of sales, EBITDA and operating cash flow. These results extend our track record of improving earnings cycle over cycle, delivering first quartile return on invested capital and enabling us to invest in future growth while maintaining strong cash returns to shareholders.

Now I'll turn it back over to Tom.

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N. Thomas Linebarger, Cummins Inc. - Chairman & CEO [5]

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Thank you, Mark. As you'll remember, we announced on April 29 and then discussed in our first quarter earnings call that we'd initiated an internal review of our emissions certification and compliance processes for our pickup truck applications as a result of conversations with the EPA and the California Air Resources Board. Our review continues, and we are proactively working closely with the EPA and CARB and other agencies to address their questions.

During conversations with the EPA and CARB about the effectiveness of our 2019 pickup truck applications, the agencies raised concerns that certain aspects of our emission systems may reduce the effectiveness of our emissions control systems and did not fully comply with the requirements for certification. As a result, our internal review has been largely focused on the agencies' concerns. We are working closely with the agencies to enhance our emission systems, to improve the effectiveness of our pickup truck applications and to fully address the agencies' requirements and meet the expectations of our customers. Consistent with the values and the history of the company, which include a strong commitment to compliance, we will work with regulators and other agencies to address the issues identified in our internal review and develop future technologies that will advance our industry.

It's too early to conclude on any changes that we will make to our processes and organization as a result of our internal review. It's also too soon to know what the response of the regulators will be to our review or to determine any potential financial consequences.

Now let me give it back to James to open for Q&A.

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James Hopkins, Cummins Inc. - Executive Director of IR [6]

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Thanks, Tom. (Operator Instructions) Michelle, we are now ready for our first question.

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Questions and Answers

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Operator [1]

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Our first question comes from Jamie Cook of Crédit Suisse.

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Jamie Lyn Cook, Crédit Suisse AG, Research Division - MD, Sector Head of United States Capital Goods Research, and Analyst [2]

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I guess, two questions. One for Mark, one for Tom. Mark, just on the change in engine guidance, understanding you took your sales down a little. The margins, I guess, were down a little lower than what I would have thought. So if you could just help me understand the puts and takes there.

And then Tom, a question for you on 2020, understanding you probably want to frame that more when we get to your Analyst Day or the fourth quarter. But can you just -- given you touch so many markets, can you give us some view on how you're thinking about 2020 given the macro concerns out there? And then any positives and negatives investors should think about outside of the markets that could help or be a drag on Cummins' earnings that are within your control?

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Mark A. Smith, Cummins Inc. - CFO & VP [3]

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Okay. Jamie, so quickly the 2 main drivers of the lower margins for the Engine business are lower top line outlook which, in part, is due to a kind of leveling off of parts demand in North America and then, of course, the lower outlook for joint venture earnings is principally driven by China, and especially driven by kind of the lower outlook for the light-duty market, which has really all negatively impacted the JV earnings, which come straight off the EBITDA percent. So those are the 2 primary reasons. Otherwise, everything else is pretty much in line.

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N. Thomas Linebarger, Cummins Inc. - Chairman & CEO [4]

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And with regard to next year, I will just make a few general comments, Jamie, and of course, we'll be very detailed when we get to the Analyst Day about what we're seeing. But broadly speaking, as you know, many of our markets are either at or near cyclical peaks in our view, which means that inevitably we will start to see some of these markets decline. We don't know the exact quarter. We've done a fairly detailed projection for the U.S. truck market because there's a lot of data, and it's easier to do. But even that has some variance depending on who in the industry you ask. Most of the other markets have more variance as to when people think they fall, but many of them will inevitably fall, at least to some degree. So we are prepared for 2020, and even into 2021, for markets to be relatively lower cyclically, at least many of our major ones. And we are prepared in the following sense: we are already managing our cost to make sure that our capacity levels and cost levels will be at the right place when it's time and making sure that we're the first to be ready and the first to react. And so a lot of our focus is on ensuring that we are prepared from a cost structure point of view for that cyclical downtrend. That's how we ensure that in the next downturn we have better margins than the prior downturn.

The second thing is that our products are performing incredibly well. That's why you see many of our market share projections sort of tipping towards the higher end of our estimations for the year, it's because we think our products are performing very well. We think that serves us well in downturns because a few points of market share can make up for some cyclical downturn. So we will continue to emphasize the quality and performance of our products, and we will continue to launch new products. So that when we're in a downturn, our competitors will see us continue to go from strength to strength because in downturns is where we also think we can gain market share and commitment from customers.

Also, we will be seeing some gain, hopefully, from the BS VI and NS VI. We have been investing significantly in engines and components for those launches, and we think we will be ready. We feel ready now, and we think our products will outperform competitors'. And we think that will give us a chance to step up our market positions in both India and China which, we think, will be lasting positions. So those are just some of the puts and takes. Again, not all markets will fall at the same time. We have a very global market, and as you know, not all of the cycles are the same. But we are just prepared for cyclical downturns and are turning into this mode that says, while it's lower we're going to make sure our cost structure is right and we're going to gain share from competitors and continue to launch new products in a way that positions us better for the fall -- the next upturn.

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Operator [5]

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Our next question comes from Steven Fisher of UBS.

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Steven Fisher, UBS Investment Bank, Research Division - Executive Director and Senior Analyst [6]

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On your down 10% earnings from JVs in your guidance, I think that implies around flat for the second half versus down 15% to 20% in the first half. How much of that is easier comps, or is it an expected pickup in sales, in meeting the emissions guidance, or something else?

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Mark A. Smith, Cummins Inc. - CFO & VP [7]

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I think we're starting to see a tail off, certainly on the Power Systems side of our joint venture earnings towards the back half of the last year, so your math is exactly right, Steve. There's no heroic assumptions. It's just kind of leveling out in aggregate and flat in the second half of the year.

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Steven Fisher, UBS Investment Bank, Research Division - Executive Director and Senior Analyst [8]

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Okay. And then could you just clarify the parts outlook? To what extent are you already seeing lower demand exiting the quarter? I think you had 2% growth disclosed in the Distribution segment. So has that already started to turn negative? Or are you just adjusting production in anticipation of lower demand later this year and into next year?

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Richard J. Freeland, Cummins Inc. - President, COO & Director [9]

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Steven, this is Rich. Let me give just a little background on parts, some perspective. We -- our parts and service business over the last 3 years has grown about 10% a year. So as we put more and more product out there, more complex power trains, we have seen some pretty rapid growth in that. What we forecast, about a 4% to 5% growth again this year, including pricing, and what we've seen is a bit of a fallback on that, and mostly in North America. As we've looked at truck utilization, the data is not as strong here but hypothesis is the older trucks are not being run as heavily and so therefore our parts and service is down a bit. And when that happens, we've seen there'll be some adjustment, kind of in dealer inventories and adjustment there. We don't think inventories are bloated at this time or excessive. I think just some prudent trimming of inventories is what I would expect to see. Again, this reduction that we put in our forecast basically says we will still be flat to last year, so at a record level, so -- and remain bullish going forward. We are putting out about 1.5 million engines a year. And so over the last 3 years, so those engines move into the parts consuming business. So we think a little bit of an adjustment in second half of the year, bullish long term.

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Operator [10]

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Our next question comes from Rob Wertheimer of Melius.

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Robert Cameron Wertheimer, Melius Research LLC - Founding Partner, Director of Research & Research Analyst of Global Machinery [11]

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Actually, my question was on parts. And that was fantastic color, Rich, on the past growth rate, et cetera. Just out of curiosity, I mean, you mentioned you don't think it's bloated. How much of your parts sales goes to non-Cummins, I guess, distribution? If you're willing to give that number. And then do you think there's a 6-month adjustment, and then we're kind of all clear? Part of the reason I'm asking is just, we didn't see this sort of slowdown as yet impact our -- obviously selling to similar markets.

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Mark A. Smith, Cummins Inc. - CFO & VP [12]

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Yes. So I'd say -- I don't have the exact numbers in, but more than half the channel is pretty split. More than half going through non-OEM channels. So there's a wide range of customers buying the inventory.

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N. Thomas Linebarger, Cummins Inc. - Chairman & CEO [13]

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Yes. What Mark is saying is more than half will go through OEM dealer channels versus our own channel. And that's on the truck side. As you said, the adjustments in parts, they're kind of hard to predict this time because they're relatively small adjustments in the grand scheme of parts inventories, but they can have an effect on a quarter. And we see this every downturn. There's some adjustment. And frankly, we're not that good at predicting which quarter it is. So we are now kind of -- we were surprised that it was now, but it was. And I think what Rich is saying is that every time we see this, we see it every downturn, it tends not to be lasting very long. Parts is a very stable business, our services business is -- so we don't expect it to keep going down. We expect it to level off and then we expect to see it continue to increase in future quarters. So we're just trying to be prudent that it seems inevitable in a downturn that dealers will adjust some inventories. And we saw a little bit of that in this second quarter, and we expect to see a little bit more of it as we go in second half of the year. But we'll see what happens. Like you said, everybody is going to have different circumstances depending on where they're holding inventories, how much they're holding and all that kind of thing. I think we should just expect variability. But it's inevitable if you just look over the cycle, that parts inventories drop some in the downturn and then they rise up again as things start to rise.

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Operator [14]

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Our next question comes from Ann Duignan of JPMorgan.

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Ann P. Duignan, JP Morgan Chase & Co, Research Division - MD [15]

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Maybe you could walk us through the different regions of your business and comment a little bit further on which markets you see as being at peak. I mean everybody understands North America heavy-duty and maybe the impact that has on Components also, but what other end-markets do you feel are at or close to peak?

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N. Thomas Linebarger, Cummins Inc. - Chairman & CEO [16]

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Well, most of the truck markets are at or near peak. Brazil is a notable exception because it's kind of running along the bottom. But most of the others. So India is already on the way down. China look like it's on the way down. Heavy duty, you talked about. Medium duty is holding strong, but it's been up for a while. So it just -- and Europe is the one we, we're not sure about, but even that showed a little weakness in this last quarter. It's hard to say exactly how much -- what that means. But we've heard some rumblings out of Europe, that some of the truck makers are getting concerned. So it's sort of hard to find a truck market that doesn't feel peak-ish, if not already headed down the other side.

It looks to us like mining is a little bit of a different story. It doesn't look like it's at peak, but it's definitely leveled off. I mean, there's just nothing else to say about that. Now whether it's going to turn back up again or just sort of steadily grow, we're not sure. Kind of our view is that it's going to have a slow growth from here for a little bit longer, but there's no question that compared to a year ago, it's leveled off. And so that doesn't look like it's got a whole bunch more left in it.

And then I'd say construction markets, U.S. construction market is still strong, but at some point, after the truck market, it feels like the construction market has to also tail down. And we already think China has got to start tailing done because China has been up for a while, and unless they continue to stimulate the market, it's likely to head down.

India has got some -- the government has continued to invest and stimulate there, and we think they probably still will. So India might hold up a little longer on the construction side. But again, that's some of them. But you remember that cartoon, Ann, we show where we kind of put all the markets up there, we'll bring that to the Analyst Day, and we'll kind of put all the markets on there. But suffice it to say that, as we look at that, there is more kind of up and around the top of that little hill than there are at the bottom on their way up. So we're just being realistic about what that means for revenues in 2020.

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Ann P. Duignan, JP Morgan Chase & Co, Research Division - MD [17]

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Okay. I appreciate it. I'll leave it there.

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Operator [18]

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Our next question comes from Jerry Revich of Goldman Sachs.

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Jerry David Revich, Goldman Sachs Group Inc., Research Division - VP [19]

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Tom, I'm wondering now that you folks have an Isuzu joint venture set up, can you just update us on the market share opportunity for you folks on light-duty diesel globally. I'm wondering if you flesh out what the opportunity set is and what the strategy is now with the joint venture and how it fits into the company's overall opportunity set.

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N. Thomas Linebarger, Cummins Inc. - Chairman & CEO [20]

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Sure. It's early days in that joint venture, but we're really pleased with our conversations. It's a terrific company. And it's not a company that we had done a lot of business with until we started having conversations with them. Although we've always been impressed with them from afar, we kind of feel like at least in the off-highway market where we see each other, they are the one -- the engine that we think is actually competitive to ours, and we think highly of them. So anyway, we've had terrific conversations, but we are early days as to kind of what the market share opportunity. But here's how we're thinking about it together, is that the 2 companies are both spending a lot of investment -- putting a lot of investment into the various technologies that will occupy the commercial industrial equipment space. So think about not only diesel but natural gas and hybrid and electrification and fuel cells and start to think about what that means. Then they also have a truck business, which also has to do autonomous, safety, other integration of their vehicle. So they are thinking about all the investments they need to make in that, all the investments they need to make in power train, and coming up and thinking that tips us over, a company our size. But they need to be leading. There's no room for laggards. There's not going to be any second place there. I mean they're the strongest truck company in Japan. They have a terrific market share in Southeast Asia. And they're the second largest diesel engine maker with us. So what we're going to try to do is figure out how we can make sense and rationalize these investments in these various technologies. And it's my sense that they would like to figure out a way to do that so that Cummins can do a lot of the investments in the power train, and they can focus more investment on the truck. And if they can do that in a way that allows them to ensure supply, make sure they're leading, utilize the technology and assets they have, I think that's going to be a solution that they like. But there's a lot of conversations got to have about how you do that. And the reason we think this is really a great opportunity for both companies is, if we can figure this out, I think a lot of other OEMs around the world would like to figure out something similar. All of us are stuck with the same problem of a lot of investment in new technology for essentially the same markets at essentially the same size, which looks like an equation that again tips most of us over unless we can figure out some solutions to either add content and/or find new ways to rationalize investment. So I think it's a really important set of work that we're doing that could be indicative of how some of the other industry discussions go.

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Jerry David Revich, Goldman Sachs Group Inc., Research Division - VP [21]

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That's really interesting. And on the shorter-term side, you folks are preemptively looking at markets where demand could be weaker. Can you just update us on your framework for decremental margins? So the decremental margins were really in the teens on this revision, which was nice to see. Are you optimistic that you can achieve better decrementals than the mid-20s that, I believe, you've targeted in the past?

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Mark A. Smith, Cummins Inc. - CFO & VP [22]

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We'll give you a more precise update in the Analyst Day, Jerry, as we get a closer view on those markets. But as you know, the clear goal of improving cycle over cycle earnings, and you're right, yes, in the second half of this year, we'll be in the kind of mid-teens. I think we've got to balance that against just some of the investment needs in the near term on some of the new technologies. So we'll come out and give you a clear answer, but you should be clear that we're committed to improving those earnings on the down cycle as well as the up.

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Operator [23]

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Our next question comes from David Leiker of Baird.

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David Jon Leiker, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [24]

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I wanted to talk a little bit -- you gave a great amount of detail in terms of your end-markets and what you're looking for. I was wondering if you could dig into it a little bit further in terms of, does that pace of production going into the third quarter and fourth quarter. We're hearing different things from different folks, build rates may hold up through the end of the year. But you're seeing lower -- you're thinking that daily build rates actually fall as we go through Q4. Is that something you're thinking that might happen? Or are you seeing that in some of the schedules as you look further out towards the end of the year?

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Richard J. Freeland, Cummins Inc. - President, COO & Director [25]

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David, this is Rich. So a few things. One, we're not seeing it in the short-term schedules. They remain strong when we see out our visibility through Q3. And what we're doing is just planning for a scenario where production begins to fall off as the backlog goes down, okay? So we have no visibility to that. We've just seen it in past cycles, that some OEMs don't run at this elevated rate because people are working pretty close to capacity right now. As the backlog comes down, what we've seen in past cycles is that people begin -- don't run full steam all the way until the backlog is gone. They begin to moderate their production schedules. So we haven't seen a lot of that. We've built that into our guidance, that, that will happen in Q4. And of course, there's a scenario where that doesn't happen, and we are prepared for that also. But that's the vision we have, is more on what we've seen in past cycles, David.

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David Jon Leiker, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [26]

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Okay, great. And then just one additional item on the balance sheet. The working capital number is pretty high. It looks like receivables and inventory mostly. Just any thoughts on that and where you think that trends over the second half of the year.

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Mark A. Smith, Cummins Inc. - CFO & VP [27]

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I think when we look at our metrics, they're pretty, been pretty similar to where we were last year. Our inventory hasn't certainly kind of leveled off in the second quarter, so I would expect to be in that kind of 20% of sales range for working capital overall. Past dues are in pretty good shape. Collections are in good shape. So yes, but as we -- to the extent we're facing some weaker outlook, then we'd expect to bring it down and there would be some positive cash flow impact from that earlier in the downturn.

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David Jon Leiker, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [28]

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I was looking on the cash flow statement and you have pretty significant use of working capital in this quarter versus the same quarter last year.

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Mark A. Smith, Cummins Inc. - CFO & VP [29]

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Yes, that's just -- typically Q2 is just one of the strongest quarters ramping up from Q1, David. So I don't see another one.

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Operator [30]

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Our next question comes from Adam Uhlman of Cleveland Research.

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Adam William Uhlman, Cleveland Research Company - Partner & Senior Research Analyst [31]

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A follow-up on David's question on the cash flow. The share repurchase has been kind of low so far this year, and you reiterated the plan of returning 75% of the operating cash to shareholders this year. I'm just wondering if any -- the pending deal activity or potential deal activity could lead to a pause in that share repurchase plan for the second half of the year.

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Mark A. Smith, Cummins Inc. - CFO & VP [32]

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I guess there are a number of factors that go into share repurchase in any given quarter, but we just restated -- our current expectation is we'll get to around 75% of operating cash flow item. I guess, there are some scenarios in which that could be a little bit different, but those are not the ones that we see right now for this year.

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Adam William Uhlman, Cleveland Research Company - Partner & Senior Research Analyst [33]

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Okay. Got you. And then on the PowerGen market, it sounds like the data center demand has been holding up relatively strong. Wondering if you can talk through what you're seeing with your order rates. Have you seen any kind of, any softness within the data center market? And just how much visibility do you really have on the global genset market at this time?

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Richard J. Freeland, Cummins Inc. - President, COO & Director [34]

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That remains -- that looks strong as far out as we can see. And the quarter activity is good, our hit rate on getting market share on that, so -- the general consensus is we're not giving 2020 guidance, but that looks strong through the end of the year into next year, at least.

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N. Thomas Linebarger, Cummins Inc. - Chairman & CEO [35]

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And the bright spot, Adam, has been this China side. One of the things we've always been worried about is how big is the data center market relative to the total because we've kind of been looking at it as a U.S. and maybe European phenomenon. But now we're starting to see developing countries, especially China, build out data centers. And because of our position in that market, at kind of the premium end of the market, we've been actually been able to develop quite good share. And our team in China has done a terrific job ensuring that as these data center markets start to build out, that Cummins is the player that they look to. So I think again that's a big reason why you are seeing continued strength in data centers is that although it's just one segment of the market, we're seeing it build globally. So I think that's steadied out the growth and kept it robust for longer.

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Mark A. Smith, Cummins Inc. - CFO & VP [36]

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We've seen a little bit of increase in our military business and then a little bit of weakness in the RV segment in North America, which has been on a multiyear strong run, so that feels like it's cycling down a little bit.

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Operator [37]

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Our next question comes from David Raso of Evercore ISI.

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David Michael Raso, Evercore ISI Institutional Equities, Research Division - Senior MD & Head of Industrial Research Team [38]

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I'm just trying to gain comfort with the margins. Obviously, the downside operating leverage is really critical to the story, looking into 2020. So I'm just trying to understand, like say the Engine division, if a year ago, we adjust for that campaign charge, we just saw the Engine business year-over-year have up sales a little bit, but profits down over $40 million, while the second half of the year, Engine business is supposed to have revenues down over $200 million, but profit is only down about $40 million to $50 million. So just coming off that second quarter performance it obviously is implying the second half is a lot better despite somewhat notable sales decline. Can you help build some confidence on what is changing in the second half? I assume materials. I'm just trying to understand after that second quarter -- our comfort with the second half margin for Engines.

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Mark A. Smith, Cummins Inc. - CFO & VP [39]

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Yes, David. It's Mark. So I think you've just got some moving parts in some of those different comparisons. So number one, we finished a tougher comp on China JV earnings partly due to the adjustment in light-duty. I think that comp gets a little bit easier in the second half of the year. And then we are lapping with a higher tariff run rate. Remember, the actual tariff expenses in the first half of the year were close to 0, and so we're just kind of lapping on those higher numbers. And then of course, we're doing relatively well on, certainly on the heavy-duty market share. So I think, by and large, there's nothing heroic in the second half of the year. We've taken down our outlook for parts. As Tom said, some of the actually weaker outlook are leveling off, there may be a better way to describe it, already occurred in the second quarter, so we're not expecting a significant downshift. Those, I think, are the major moving parts. Not a significant amount of change in price or material cost, first half to second half.

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David Michael Raso, Evercore ISI Institutional Equities, Research Division - Senior MD & Head of Industrial Research Team [40]

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I guess I'd push back a little bit on the JV income. JV income was down about 10% in Engines year-over-year. It seems like the second half is not terribly different in the context of your overall company JV income for the second half. So is there some number around the materials or something about mix that we can, again, gain comfort that we can handle that big a sales decline in the second half with more or less the same EBIT as this one?

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Mark A. Smith, Cummins Inc. - CFO & VP [41]

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If I could just raise it back up to the overall company guidance we've delivered, something like 17.1% for the full -- for the first half of the year we are at 16.25% to 16.75%. We've kind of maintained the margin guidance on a slightly weaker revenue outlook, so generally things are going pretty according to plan on the cost side. So I got to think we -- with what we know today, that's our best guidance. So I don't think there's anything heroic in the numbers.

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Operator [42]

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Our next question comes from Alex Potter of Piper Jaffray.

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Alexander Eugene Potter, Piper Jaffray Companies, Research Division - Principal & Senior Research Analyst [43]

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I was wondering if you could comment a bit on the light-duty policy changes that you're seeing impact demand in China in the truck markets and the reclassification from light-duty to medium duty. Is there -- well, first of all, any qualitative commentary you can offer on that policy would be helpful. But then secondly, is there a reason to think that you could have demand shifting to the medium-duty side of the market as a result of this? And if so, presumably the Dongfeng joint venture should be able to capitalize on that?

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N. Thomas Linebarger, Cummins Inc. - Chairman & CEO [44]

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Thanks, Alex. Just a couple of qualitative points, and I'll let Rich add if he has more. If you're in China, they call this the blue plate issue because you get a blue plate if you're a light-duty. And what this means is you have easier driver licensing requirements. It's closer to a car license. And you can access the very inner parts of the city. You can imagine why that would be: smaller vehicles, lighter vehicles, less congestion, et cetera. And the rules were already in place. It's just that they didn't enforce them quite as tightly in every city. And so now what they've done is they just picked a day, and all of a sudden enforcement started. To say that it had a disruption in the market would be an understatement. When I was in China recently, there wasn't a single OEM that didn't complain about this because it just all of a sudden happened, and it created absolute havoc in the market.

I'm wondering, in part, if there'll be some sort of compromise proposal to kind of rationalize this a little bit because it really takes a lot of vehicles that were previously being sold and used in cities and bring them outside the city. And again, it's not just the fact that you have to spend more money to get more licenses; it's that you can't actually get into all the spots. So that is a significant change. And the ones that can get in have to be very lightly loaded. And so now your freight moving capacity has just reduced significantly. So anyway, there's a bunch of that going on. To say there's only so much you can figure out about that in China and how fast that's going to move as you know from your experience, but my sense is there's quite a bit of consternation and there are some potential outcome where things get compromised or rationalized.

Whether or not this demand moves to medium-duty is another question. My feeling is that there's not a lot of movement there because really this is the part that takes the final -- this is the final mile delivery stuff. And most of the larger cities anyway have restrictions on vehicle size doing that final mile delivery. So a medium -- a bigger medium-duty truck is not really going to solve your problem, and they maybe don't need so many more of those. But could be, there could be some substitution. I think the biggest impact for us was we got this new JAC JV. We've got Foton going. And they're both going gangbusters with great products and great trucks. And so it just kind of came to a screeching halt for a second while this thing is getting rationalized. We think we still have a great lineup in either case. It's just that it had a pretty abrupt hit in the second quarter.

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Alexander Eugene Potter, Piper Jaffray Companies, Research Division - Principal & Senior Research Analyst [45]

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That's super helpful. And then I guess, one, you mentioned the relationship with Foton there. I noticed that Yuchai has just announced a joint venture or partnership of some kind with Foton. Is there a potential for overlap there with what Cummins does? I guess, any commentary there would be helpful as well.

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N. Thomas Linebarger, Cummins Inc. - Chairman & CEO [46]

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Here's the situation. As you know, each of the OEMs has a number of businesses in another number of segments that they're trying to make sure that they're competitive in. They use domestic engines in some of those segments, and they use joint venture engines with us in other segments. And then a fair bit of those for export. They always have to have multiple partnerships to cover themselves, not to mention there are a number of government programs where they need to have domestic engine supply to comply with it. We're now -- after many, many years there, we're now getting more used to this kind of thing, where we think we've got the engine thing good to go and then all of a sudden there's another partner in. But again, all in all, we still feel very good about our partnership with Foton. And Rich, I know, has spent some recent time with them, so I want to let Rich comment, too, on the Foton partnership.

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Richard J. Freeland, Cummins Inc. - President, COO & Director [47]

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I would say our relationship with Foton is as good as it's been in recent years. In fact, both the relationship there and then the customers' view of the Foton-Cummins product. So, in fact, our share of Foton is up from 46% a year ago to in the mid-60s now. And so again, I think it's just -- as Tom said, it's the nature of the business, there's going to be multiple options always. And so our strategy remains the same: to work with the partners, develop the best powertrain product and let customers choose, and so we've kind of gotten used to it. There'll be -- customers will have multiple options. But right now, I feel really good where we're positioned with Foton.

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Operator [48]

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Our next question comes from Noah Kaye of Oppenheimer.

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Noah Duke Kaye, Oppenheimer & Co. Inc., Research Division - Executive Director and Senior Analyst [49]

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First, a shorter-term question on 2019 pricing. I believe you'd been expecting about an 80 bps growth from pricing, and I think a lot of that had to do with the parts business. What are the current expectations? And can you still get that sort of price growth in parts if we're seeing lower activity levels?

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Mark A. Smith, Cummins Inc. - CFO & VP [50]

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There's puts and takes around the business, but that's roundabout where we said at the start of the year. So yes, a little bit lower on parts. But overall, we're in that 80 basis points range for the year. Again, the pricing hasn't gone down. Just a little bit of the volume here.

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Noah Duke Kaye, Oppenheimer & Co. Inc., Research Division - Executive Director and Senior Analyst [51]

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Okay. That's helpful. And then longer term, the EU just formally adopted the CO2 regs for the first time for heavy-duty trucks. You already talked about the potential Euro 7. Can you talk a little bit about the potential tailwind there for your Components business over the coming years and how you think you're positioned and maybe even kind of contextualize some of your recent investments, electrification and fuel cells, in light of those regs?

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N. Thomas Linebarger, Cummins Inc. - Chairman & CEO [52]

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I think -- thanks for that, Noah. I do think those are just -- those regs -- by the way, those are tough and draconian. There isn't a single OEM that is feeling nonplussed about those. But here's what I'd say is that they are just -- they are emblematic of what we're going to see across the world. And especially now that regulators have in their sight some of these new technologies, which look like they have lower -- at least local emissions and the potential to potentially be economically viable, things like of course electrified powertrains or hybrids or fuel cells, et cetera. Once they have those in their sights and they think they can be economically viable, they are going to shove regulations harder for obvious reasons. And Europe is, of course, one of them. But we'll see them inevitably in the U.S. and elsewhere.

So we think that the -- and that's kind of linked back to my conversation when Jerry asked me about Isuzu. I think all of our customers and Cummins are all seeing significant investments required in powertrains, powertrain components and systems and as well as in vehicles in order to be competitive and at the front end of their markets. Everybody has a good view of what kind those might be, but the amount of investment, the number of models that have to be covered, the different regulations that they're going to have to meet in cities, countries, regions, it looks daunting. So what we think is that, that's the space where Cummins has historically been most successful. When that's the, kind of the technology challenge in front of us, we've made a bunch of investments, as you know, in EV, in hybrid, in diesel, in natural gas, and if we can complete this transaction with Hydrogenics, we'll also have the beginnings of fuel cell offerings. So our intent is to have the powertrain of choice for each of these providers and including providing components in those technologies for them to integrate their own systems. So we think -- again, we will be at the forefront of technology. So we are talking to every European manufacturer about the role they'd like us to play in their system, and everyone has a different view about that. We're clear that they are the system provider, and we are there to support them technically. And we think, as you said, whenever there is technology change, whenever regulations are challenging, that's a tailwind to Cummins because that's essentially where we make -- that's what we differentiate on, that's where our meals are made. So we will invest. We will lead there. We will ensure that we are ready when they are ready to use us. And again, a lot of people are wringing their hands, figuring out how they're going to meet all these requirements, and we are just -- we show up every day and say we're ready to help, let us know where you want us to help.

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Noah Duke Kaye, Oppenheimer & Co. Inc., Research Division - Executive Director and Senior Analyst [53]

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Right. And it would seem to me just that in a market where you're providing a lot of subcomponents currently and you're going into alternative powertrains where not every OEM is going to do a vertically integrated powertrain, I mean they may spec their motors outside or something like that, I mean there's more of a gain opportunity, it would seem to me at least.

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N. Thomas Linebarger, Cummins Inc. - Chairman & CEO [54]

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It seems to me, too, although I'm sure there'll be plenty of others that also see that. So we will show up with others there, too, but I agree with you that it looks like an opportunity to us. We just don't want to get our cart in front of the horse. It's up to our OEMs to announce what they think. But we will be pushing hard to help those OEMs meet that standard with technology and components that we have.

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James Hopkins, Cummins Inc. - Executive Director of IR [55]

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Great. So with that, it looks like we are at the end of our hour. So I'd like to thank everybody for your interest in Cummins today. And as always, I'll be available for any follow-up questions this afternoon. Thank you very much.

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Operator [56]

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Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program, and you may all disconnect. Everyone, have a great day.