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Edited Transcript of PCAR earnings conference call or presentation 29-Jan-19 5:00pm GMT

Q4 2018 Paccar Inc Earnings Call

BELLEVUE Jan 31, 2019 (Thomson StreetEvents) -- Edited Transcript of PACCAR Inc earnings conference call or presentation Tuesday, January 29, 2019 at 5:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Harrie C. A. M. Schippers

PACCAR Inc - President & CFO

* Ken Hastings

PACCAR Inc - Senior Director of IR

* Michael T. Barkley

PACCAR Inc - Senior VP & Controller

* R. Preston Feight

PACCAR Inc - VP & President of DAF Trucks N.V.

* Ronald E. Armstrong

PACCAR Inc - CEO & Director

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Conference Call Participants

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* Adam William Uhlman

Cleveland Research Company - Partner & Senior Research Analyst

* Andrew Millard Casey

Wells Fargo Securities, LLC, Research Division - Senior Machinery Analyst

* Ann P. Duignan

JP Morgan Chase & Co, Research Division - MD

* 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

* Joel Gifford Tiss

BMO Capital Markets Equity Research - MD & Senior Research Analyst

* Joseph O'Dea

Vertical Research Partners, LLC - Principal

* Neil Andrew Frohnapple

The Buckingham Research Group Incorporated - Analyst

* Robert Hudson Salmon

Wolfe Research, LLC - Research Analyst

* Ross Paul Gilardi

BofA Merrill Lynch, Research Division - Director

* Seth Robert Weber

RBC Capital Markets, LLC, Research Division - Analyst

* Stephen Edward Volkmann

Jefferies LLC, Research Division - Equity Analyst

* 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 morning, and welcome to PACCAR's Fourth Quarter 2018 Earnings Conference Call. (Operator Instructions) Today's call is being recorded and if anyone has an objection, they should disconnect at this time. I would now like to introduce Mr. Ken Hastings, PACCAR's Director of Investor Relations. Mr. Hastings, please go ahead.

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Ken Hastings, PACCAR Inc - Senior Director of IR [2]

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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; Preston Feight, Executive Vice President; 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. A summary of risks and uncertainties is described in more detail in our periodic reports filed with the SEC. For additional information, please see our SEC filings and the Investor Relations page of paccar.com. I would now like to introduce Ron Armstrong.

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Ronald E. Armstrong, PACCAR Inc - CEO & Director [3]

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Good morning. Harrie Schippers, Preston Feight and I will update you on our excellent fourth quarter and full year results for 2018, important business highlights and PACCAR's focus on innovation. Thanks to PACCAR's 28,000 outstanding employees around the world, 2018 was a record-setting year for the company.

PACCAR achieved record revenues of $23.5 billion and record net income of $2.2 billion, a 9.3% after-tax return on revenues. PACCAR Parts set annual revenue and profit records, and PACCAR Financial achieved record new business volume and a 17% improvement in pretax income. PACCAR's celebrating 80 consecutive years of net income. We celebrated many other 2018 accomplishments. PACCAR delivered a record 189,000 trucks worldwide. DAF earned the prestigious International Truck of the Year 2018 award. Kenworth, Peterbilt and DAF introduced a broad range of battery-electric, hybrid and hydrogen fuel cell truck models, which are currently in field testing with customers. DAF Brasil earned the Truck Brand of the Year honor for the third consecutive year, and increased its market share in just 5 years of operation to 6.7%. PACCAR's focus on sustainable business practices were recognized by the environmental reporting firm, CDP.

PACCAR achieved an A rating, which puts us in the top 2% of the over 6,000 companies, which report to CDP. And we're especially proud that Peterbilt and Kenworth were recognized as top workplaces for women by the organization Women In Trucking. PACCAR has a strong record of shareholder returns. PACCAR's paid a dividend every year since 1941, and has delivered annual dividends of approximately 50% of net income for many years. In 2018, PACCAR declared dividends of $3.09 per share, which was a 41% increase over 2017. Total dividends declared exceeded $1 billion for the first time. PACCAR's increased its regular quarterly dividend an average of 11% per year during the last 20 years and raised the quarterly dividend another 14%, beginning in 2019.

PACCAR's total dividends declared for 2018 result in a robust yield of 5.4% at year-end. PACCAR repurchased 5.8 million shares for $354 million in 2018, which was the most since 2007. The Board of Directors authorized additional share repurchases last year with $540 million remaining at year-end.

PACCAR's fourth quarter revenues were a record $6.3 billion, and fourth quarter net income was $578 million. Revenues were 15% higher than the fourth quarter last year, and net income was 39% greater compared to the adjusted net income of $416 million earned in the fourth quarter last year.

PACCAR delivered a record 50,400 trucks during the fourth quarter, 6% more than the third quarter. The increase in production resulted from more build days in Europe compared to the third quarter and better supplier performance.

Truck and parts gross margins were 14.2% in the fourth quarter. Truck pricing was good with price realization comparable to the second and third quarter at about 2%.

During the quarter, we incurred some additional material labor cost due to supplier constraints, but conditions improved compared to the third quarter. By the end of the fourth quarter, supplier deliveries to the factories were in good shape. Our Peterbilt, Kenworth and DAF factories and purchasing and supplier management teams, again, did a fantastic job of managing production, delivering a record number of trucks and achieving the highest operating margins in the industry.

In the first quarter, we're expecting slightly higher deliveries compared to the fourth quarter. Deliveries are projected to be up over 15% when compared to last year's first quarter. Truck and parts gross margins are estimated to increase in the first quarter to around 14.5%. Now Preston Feight will provide an update on DAF, PACCAR Parts and PACCAR Financial Services.

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R. Preston Feight, PACCAR Inc - VP & President of DAF Trucks N.V. [4]

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Thanks, Ron. DAF had an outstanding 2018. DAF achieved record European above 16-tonne market share of 16.6% compared to 15.3% in 2017. DAF was the market leader in European tractor registrations, and is making great progress towards its goal of 20% market share. Europe's greater than 16-tonne truck market was a robust 319,000 registrations, reflecting continued strong demand and growing European economies. European economies and freight transport activity are projected to grow again in 2019.

We expect 2019 to be another excellent year with the market in the range of 290,000 to 320,000 trucks. In 2018, PACCAR's Parts business generated record annual revenues of $3.8 billion, and record annual pretax profit of $769 million.

Annual revenue grew 15% and annual profit grew 26% compared to 2017. Parts fourth quarter revenue were a record $971 million, and quarterly pretax profit was a strong $194 million. PACCAR has steadily increased its truck and engine market share over the years, resulting in greater number of PACCAR trucks and engines in operation. This, combined with consistent investments in parts distribution capacity and customer-focused technologies, has created a very strong growth environment for PACCAR Parts. We expect parts sales to grow by 5% to 8% this year. PACCAR Financial Services annual pretax income increased 17% in 2018 to $306 million. 2018 revenues were $1.36 billion.

Fourth quarter pretax income increased 21% to $87 million. The portfolio increased to record size and continues to perform well. Kenworth and Peterbilt Class 8 used truck values increased over 10% in the fourth quarter compared to the same period last year. Kenworth and Peterbilt truck resale values commanded 10% to 20% premium over competitor's vehicles. We expect 2019 to be another good year for used trucks volumes and prices.

PACCAR Parts and PACCAR Financial Services profit contributions are much larger than they were 20 years ago. These businesses are inherently less cyclical than the sale of new trucks, and their consistent profitability enhances PACCAR's financial results throughout all phases of the business cycle.

Harrie Schippers will now provide an update on Kenworth and Peterbilt and PACCAR innovation.

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Harrie C. A. M. Schippers, PACCAR Inc - President & CFO [5]

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Thanks, Preston. In 2018, U.S. and Canadian Class 8 truck retail sales were 285,000 units. Kenworth and Peterbilt had record production and achieved a strong 29.4% market share. In 2019, we expect the U.S. and Canada Class 8 truck market to expand further to a range of 285,000 to 315,000 vehicles. Kenworth and Peterbilt have a records backlog with production visibility into late 2019.

U.S. economic and freight indicators were strong in 2018, with nearly 3% GDP growth, 3.8% industrial production growth and 6.6% freight tonnage growth. Fleet utilization levels are very high at 97% in the fourth quarter of 2018.

In 2019, U.S. GDP and industrial production are expected to grow another 2% to 3%, which bodes well for freight volumes and demand for trucks. In the past, a surge in orders was often driven by a prebuy related to an emissions change. That is not the case in this cycle, which has been driven by economic and freight growth. Kenworth and Peterbilt customers are benefiting from the industry-leading operating efficiency provided by our trucks as well as superior aftermarket support from PACCAR Parts and PACCAR Financial Services.

PACCAR showcased many innovative products and technologies last year. DAF introduced the CF electric, LF electric, XF hybrid and CF hybrid trucks. Peterbilt introduced Model 579, Model 520 and Model 220 electric trucks. Kenworth introduced a T680 hybrid truck and 2 T680 hydrogen fuel cell models. Earlier this month, several of these trucks were on display at the CES technology show in Las Vegas. We had a terrific turnout of people interested in PACCAR technology and the opportunity to see the trucks and technology firsthand. We were the only OEM displaying trucks at the show.

Kenworth, Peterbilt and DAF's alternative powertrain products are in field trials with customers, focusing on regional distribution, refuse, urban delivery and port applications. These applications will be the most economically feasible for customers in the medium term. Longer term, alternative powertrain vehicles will likely be competitive in more applications. While we are preparing for the long-term by making investments in alternative powertrain technologies, we do expect diesel to remain the most efficient and cost-effective powertrain technology in heavy-truck applications for the foreseeable future.

The PACCAR Innovation Center in Silicon Valley completed its first full year of operations in 2018. The Innovation Center team complements PACCAR's extensive R&D efforts and is focused on developing a production-ready level 4 autonomous PACCAR truck. The team has developed an excellent reputation with the entrepreneurial community of start-up companies, venture capital firms and academia. PACCAR was recognized in 2018 for its innovations in software and manufacturing. DAF has won it with a computable award 2018 in the Netherlands for its 3D truck configurator web application. Peterbilt in Denton, Texas, the PACCAR engines factory in Columbus, Mississippi and a PACCAR truck factory in Sainte-Thérèse, Canada, each earned a prestigious manufacturing leadership award from Frost & Sullivan. These manufacturing innovations and arms factory capacity, efficiency and safety exemplify PACCAR's operational excellence.

We invested $437 million in capital and $306 million in R&D expenses in 2018. In 2019, we're planning to increase capital investments to $525 million to $575 million, and increase R&D expenses to $320 million to $350 million. These investments will develop the next generation of Kenworth, Peterbilt and DAF trucks, enhance PACCAR's diesel and alternative powertrain technologies and add additional capacity and efficiency to the company's manufacturing and parts distribution facilities. Thank you. We'd be pleased to answer your questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from the line of Ross Gilardi with Bank of America Merrill Lynch.

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Ross Paul Gilardi, BofA Merrill Lynch, Research Division - Director [2]

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Just got a couple of questions. First of all, maybe you could talk a little bit more about the parts business. Where do you think we are in the cycle? You'll be factoring in some deceleration this year. But I remember an interesting chart you had at your Investor Day showing that we're in somewhat of a sweet spot for parts, given the age class of the active fleet. So why would that actually even slow down this year?

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Ronald E. Armstrong, PACCAR Inc - CEO & Director [3]

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Well, I'd just say last year was an extraordinary year for PACCAR Parts, they put a lot of things in place, which -- we reaped the benefits of those last year, we continue to invest in additional capacity this year, so we've got 2 pretty major projects: 1 in Las Vegas and 1 in Brazil for next year. So the programs that have been put in place will continue to generate positive returns, and so we think -- or at this point, somewhere in the 5% to 8% range. But we'll see how the year progresses and we'll have better insight in that as we have this discussion 3 months from now.

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Ross Paul Gilardi, BofA Merrill Lynch, Research Division - Director [4]

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Yes, got it. Ron, and then maybe you could just talk about Class 8 order trends a bit, I mean, obviously, they were at supernormal levels throughout the year, and they've started to slow, just back towards more normal levels. What have you seen there? Is it the big fleets, the smaller fleets? Is it really just everybody there? I mean, you sound like you're still quite positive this year. But any color on order trends would be great.

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Ronald E. Armstrong, PACCAR Inc - CEO & Director [5]

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Yes. Over 450,000 orders last year was -- I would sort of call it supernormal, I would call it abnormal, which was, yes, great for the backlog. I was just at the ATD meeting last week, meeting with several of our dealers, the dealers are very confident about the ability to deliver the trucks that are in the backlog and very confident about orders that will continue to fill in the openings that are there. And we've already taken some orders for 2020. I'd say industry conditions are very positive from our perspective.

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Operator [6]

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Our next question comes from Joel Tiss with BMO.

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Joel Gifford Tiss, BMO Capital Markets Equity Research - MD & Senior Research Analyst [7]

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Two things. Can you give us a sense, maybe, this is more of a Harrie question? Why the inventories are running up kind of 27.5% at the end of the year? Usually you normalize them toward the end of the year and I just wondered if there's something unusual in there or you just gearing up for a strong 2019?

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Ronald E. Armstrong, PACCAR Inc - CEO & Director [8]

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Are you talking about by looking at the balance sheet, the carrying value from year to year?

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Joel Gifford Tiss, BMO Capital Markets Equity Research - MD & Senior Research Analyst [9]

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Yes.

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Ronald E. Armstrong, PACCAR Inc - CEO & Director [10]

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I'd say, it's -- I mean, Harrie can have this one. But I think it's mostly just reflecting higher production levels.

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Harrie C. A. M. Schippers, PACCAR Inc - President & CFO [11]

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Exactly right, Ron. It's reflecting the higher build rate.

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Ronald E. Armstrong, PACCAR Inc - CEO & Director [12]

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Yes.

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Joel Gifford Tiss, BMO Capital Markets Equity Research - MD & Senior Research Analyst [13]

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And then can you give us a little background on -- can you tell us what your penetration rate is on your parts? Out of your total installed base, what do you guess your market share is on the parts penetration? Is it 15% or 40%, or just an idea so we can also gauge how much growth potential there is longer term?

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Ronald E. Armstrong, PACCAR Inc - CEO & Director [14]

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Yes, that's a very -- unfortunately, there's not a real strong gauge of the parts market like there is on trucks. But I would say, based on seeing our parts revenue growth relative to the competition, what we can glean from that is that our share position improved really in all of our markets last year. And again, kudos to the parts team for the great things and investments they've made in warehousing, in programs. And I think we'll continue to grow our share without -- again, without knowing precise numbers.

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Operator [15]

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Our next question comes from Steve Volkmann with Jefferies.

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Stephen Edward Volkmann, Jefferies LLC, Research Division - Equity Analyst [16]

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Ron, I was going to see if I could push you a little bit for a little bit more color on your pricing commentary. I think you said the prices were up about 2% in the second, third and it sounds like also the fourth quarter. And I'm curious about 2 things. One, is how does that sort of compare with the increases that you saw in things like parts' costs and labor inflation and so forth? In other words, price cost, neutral, negative or positive, I'd just be curious on how that trended? And then, as we look into 2019, are there some opportunities to maybe get a little bit more price with the backlog being as long as it is? And how does the price cost kind of balance look to you guys going forward?

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Ronald E. Armstrong, PACCAR Inc - CEO & Director [17]

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We'll let Michael talk a little bit about the details of the cost side, and then I'll talk about 2019. Michael?

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Michael T. Barkley, PACCAR Inc - Senior VP & Controller [18]

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The cost side for the fourth quarter, they were up about 1.6% or -- which was less than our revenue side, which is up by over 2%. So we had some positive price realization during the quarter.

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Ronald E. Armstrong, PACCAR Inc - CEO & Director [19]

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So as you look next year, Stephen, I think, the orders are pretty well in the house for North America, and so we know what that pricing is. And we commented on what we think the first quarter margins, a little bit enhancement up to around 14.5% in the first quarter. And we'd say, if you look at the full year, probably in the 14% to 15% range for the year.

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Operator [20]

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Our next question comes from Jerry Revich with Goldman Sachs.

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

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I wonder if you can talk about the new products that you were stepping through at the beginning of the call, the battery-power products are in various stages of customer testing. Can you talk about what are the most successful variants so far? And when do you think we'll see them in commercial production and in your facilities? I appreciate that it's early, but maybe you could share with us the early results?

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Ronald E. Armstrong, PACCAR Inc - CEO & Director [22]

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Yes. I think we sort of think about it in 3 different layers. I think where we're at today in sort of the demonstration phase where we're learning about new technologies and how they work, next step, would probably be some level of low-volume production, which would probably be starting next year. And then at some point, once the commercial viability of these technologies are good and the customers -- the customer demand is there, I mean, ultimately for us, it's all about the customer demand. And I think the economic feasibility will dictate a lot of that as time goes on. And so we're doing everything we can to be prepared and be ready and be as smart as we can be about those technologies. And we'll be ready to start production when the customer's demand is there for those products.

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Jerry David Revich, Goldman Sachs Group Inc., Research Division - VP [23]

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Okay. And then the low-volume production that's expected next year, can you talk about what the powertrain looks like in terms of is it a PACCAR-supplied powertrain? Is it third party? I guess, what we've seen from you folks in the past from that diesel side is lower volume products you've tended to use third-party powertrains and where you have more scale you've done in-house, and I'm wondering is that the framework we should be thinking about at least in the early stages of EV?

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Ronald E. Armstrong, PACCAR Inc - CEO & Director [24]

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Yes, I think in the early stages we're working with a variety of partners to identify what technologies work best. But also getting smarter about what role we want to play and what position we want to have in these alternative powertrain components. So that's still being studied and evaluated for the long term.

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Jerry David Revich, Goldman Sachs Group Inc., Research Division - VP [25]

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And in PACCAR Financial, you folks had really strong margins this quarter, sounds like used truck values were a contributor to that? Can you just flesh that out, was that a mark-to-market or is that sustained benefit now that values have moved higher? Can you just give us a bit more context behind the strong parts or -- excuse me, FinCo margin improvement?

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Ronald E. Armstrong, PACCAR Inc - CEO & Director [26]

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Yes, there is no mark-to-market. We adjust, we look at valuations of our used truck inventories every quarter and once we adjust, typically, if there is a write-down needed, we take the write-down and then that becomes the basis going forward. So no mark-to-market enhancements. It's all about just the market pricing is better, and we're getting a better result from our used truck activities, particularly in North America.

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Operator [27]

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Our next question comes from the line of David Raso with Evercore ISI.

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David Michael Raso, Evercore ISI Institutional Equities, Research Division - Senior MD & Head of Industrial Research Team [28]

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Regarding the first quarter delivery comment, if I heard correctly, up 15% year-over-year. Can you help us geographically, how we're thinking about deliveries sequentially?

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Ronald E. Armstrong, PACCAR Inc - CEO & Director [29]

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I think the lion's share of that will probably be in North America with some improvement in Europe as well compared to last year's first quarter. And we'll see -- yes, we're seeing -- we'll see some improvement in South America as well. So I think most of the regions will be up and Mexico, I think, will be up as well.

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David Michael Raso, Evercore ISI Institutional Equities, Research Division - Senior MD & Head of Industrial Research Team [30]

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Yes, I'm just trying to look at normal sequentials, usually Europe and the rest of world are down 4Q to 1Q. So most of the sequential growth is North America. And I guess what was driving it, you haven't found this constructive on the supply chain for a little while, sounds like that's improving?

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Ronald E. Armstrong, PACCAR Inc - CEO & Director [31]

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It is...

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David Michael Raso, Evercore ISI Institutional Equities, Research Division - Senior MD & Head of Industrial Research Team [32]

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So I appreciate the price cost, I have to believe the inefficiencies in the supply chain have been rather notable the last couple of quarters. So with that starting to pass, I guess, maybe I'm just pushing a little bit on the gross margin, to have the gross margin in the first quarter still down year-over-year? I'm just trying to get a sense of do we see, at some point, that gross margins can grow on that strong a delivery growth, especially if North America's sort of driving the growth? I would have thought the supply chain improvements might be able to bump up the gross margin pots?

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Ronald E. Armstrong, PACCAR Inc - CEO & Director [33]

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Yes, I -- so if you look at truck margins, truck margins in the fourth quarter, I think, were about 11.9% -- 11.8%, 11.9%. And so because the revenue growth in the first quarter will be more related to trucks than parts, you get a bit of a mix effect that has a margin impact. So that's sort of what we're seeing. And if -- we're seeing good, really good performance by our suppliers in the month of January and should that continue, that -- there could be some upside. But right now, we're making our best call based on how we see it currently.

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David Michael Raso, Evercore ISI Institutional Equities, Research Division - Senior MD & Head of Industrial Research Team [34]

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No, I appreciate that. Yes, we have -- on a pretax level, margin truck was still down year-over-year in the fourth quarter. But are you saying that at least there's a chance, say, the pretax truck margins should have a chance to start growing year-over-year with the deliveries? That answer or we're looking for that extra little pop to earnings power can we start to assume some improving year-over-year margin?

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Ronald E. Armstrong, PACCAR Inc - CEO & Director [35]

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It could. And so we'll -- again, I think we'll see how things progress here as we work through the first quarter.

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David Michael Raso, Evercore ISI Institutional Equities, Research Division - Senior MD & Head of Industrial Research Team [36]

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Okay. And quick follow-up on Europe. I appreciate the -- derisking the guide down a little bit, but can you help us with how the orders were in the fourth quarter year-over-year?

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Ronald E. Armstrong, PACCAR Inc - CEO & Director [37]

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Let me just see if we can -- well, the orders were strong while we look for the numbers. We had a really strong December in Europe. And...

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Harrie C. A. M. Schippers, PACCAR Inc - President & CFO [38]

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Yes, fourth quarter orders were up 8%, and for the full year, orders were up 17% in Europe.

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David Michael Raso, Evercore ISI Institutional Equities, Research Division - Senior MD & Head of Industrial Research Team [39]

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Okay. Well, so it's up 8% going into the year. And lastly, the repo. The repo was a nice step-up in the fourth quarter. Maybe if you can just help us how you think about the cycle and how it maybe influences at your thoughts on the share repo.

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Ronald E. Armstrong, PACCAR Inc - CEO & Director [40]

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Yes, I mean, we -- when the evaluation is attractive as it is currently, we step up our efforts on the repurchase activity. And so that's been the approach we've taken for years, and we'll continue to apply that. We still have $540 million of authorization that we'll continue to manage through 2019.

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Operator [41]

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Our next question comes from the line of Seth Weber with RBC.

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Seth Robert Weber, RBC Capital Markets, LLC, Research Division - Analyst [42]

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Just kind of going back to David's question on the gross margin, is there any way to quantify how much the supply chain disruption or some hiccups cost you in margin in the fourth quarter? I think you said it was maybe 50 basis points in the third quarter. Did it get less onerous in the fourth quarter?

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Ronald E. Armstrong, PACCAR Inc - CEO & Director [43]

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Yes, that's a tough one. There's just -- there's so many inputs that go with that. So I don't recall that being that specific. So it is an impact in -- it's tens of millions, but it's hard to quantify.

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Seth Robert Weber, RBC Capital Markets, LLC, Research Division - Analyst [44]

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Okay, fair enough. And then I wanted to ask about the higher CapEx that you're looking for in 2019. You did mention some incremental spend on manufacturing facilities. I'm wondering, is that -- are you adding brick-and-mortar or is it just sort of adding incremental machine tools, or what? Can you just give us any color on that specific part of the higher CapEx on the manufacturing side? And also, are you ramping up spending on any suppliers?

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Ronald E. Armstrong, PACCAR Inc - CEO & Director [45]

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So I'd say it's a combination of all those things. There will be some additional bricks and mortar added to some of our facilities to really increase the efficiency. One of the things that we're going to be doing, we're going to be investing in a new paint shop in Chillicothe, Ohio. So that'll be a pretty sizable addition, and we'll redirect the current paint shop to be more involved with assembly capacity. We're also looking at machining investments to support the success of the PACCAR MX engine and just to continue to increase the efficiency of all of our factories around the world. And we'll be preparing for new product launches and the facility requirements to go with that.

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Seth Robert Weber, RBC Capital Markets, LLC, Research Division - Analyst [46]

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Okay. And are you investing in suppliers to help -- kind of help them along a little bit these days? Or the...

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Ronald E. Armstrong, PACCAR Inc - CEO & Director [47]

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We definitely are. Where there's -- supplier is -- you can't get it done fast enough to support what we want to do, then yes, definitely, we're providing suppliers with a capital investment and it's going to benefit PACCAR.

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Operator [48]

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Our next question comes from the line of Andy Casey with Wells Fargo.

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Andrew Millard Casey, Wells Fargo Securities, LLC, Research Division - Senior Machinery Analyst [49]

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In your European outlook, I mean, some of the questions have already been asked, but you're expecting the industry sales down around 4% at the midpoint. You had 8% organic growth -- or sorry, order growth in the fourth quarter. Should we read that to mean that you expect industry trends, not necessarily PACCAR but industry trends, to kind of deteriorate for the year?

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Ronald E. Armstrong, PACCAR Inc - CEO & Director [50]

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Yes, the European market has been above 300,000 for 3 straight years. We -- based on how we see things, we think 2019 could be the fourth. And so we're starting the year in a real positive vein with where we're at. But it's 4 years, and it's -- we'll see how long it runs, but we do have some conservatism baked into our thinking as we progress through the year. But hopefully, that doesn't turn out to be the case.

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Andrew Millard Casey, Wells Fargo Securities, LLC, Research Division - Senior Machinery Analyst [51]

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Yes, okay. And then just a little bit further on that topic, have you started to see any weakness in any of those select countries that create the Europe region?

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R. Preston Feight, PACCAR Inc - VP & President of DAF Trucks N.V. [52]

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You could say that Germany is the place where, if there's anything, there's a little bit of noise and, obviously, the U.K. But in general, as Ron just said, we see strong performance in order intake and how the trucks are certainly being received with the customers. So with order intake up and market share growth that we've achieved, it feels pretty good for 2019.

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Ronald E. Armstrong, PACCAR Inc - CEO & Director [53]

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Yes, we're pretty fortunate in the U.K. We have -- we're the only OEM in Europe that has a plant manufacturing products in the U.K., and that provides us a bit of a competitive advantage, depending on how things play out with Brexit. And I think everybody believes that there won't be a hard Brexit. But in the event there is, it actually -- from a competitive situation, it actually plays into our favor. So we'll see how it all develops, but we're hopeful that's there's a nice, smooth approach to the transition there.

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Andrew Millard Casey, Wells Fargo Securities, LLC, Research Division - Senior Machinery Analyst [54]

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Okay. And then if we can flip over to parts, if I look at it on an annual basis, you had around 150 basis points of operating margin improvement year-over-year. Clearly, a very strong performance. When you look back on the entire year, could you kind of review of what the main factors driving that improvement were? And then kind of reflect on whether you expect further upside to the margin during 2019?

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Ronald E. Armstrong, PACCAR Inc - CEO & Director [55]

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So the big thing is just the operating leverage on the warehouse and sales and marketing spend, and so you get the benefit of that. You get to -- we continue to see growth in our engine park and engine parts sales, which typically have a little bit higher-than-average margin, and I don't think that's going to change. I think we'll continue to see engines -- engine parts growth probably still be a leading product line that will help us develop the parts business into 2019. So offsetting that, we -- last year, we constructed the Toronto PDC, which is now up and running and doing great. And so you have some project costs that we continue to incur just to support the growth of the business going forward. So that tends to offset a little bit, but that'll be pretty -- all pretty normal. And so we'd see some -- probably some leverage from that 5% to 8% revenue growth.

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Operator [56]

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Our next question comes from Ann Duignan with JPMorgan.

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Ann P. Duignan, JP Morgan Chase & Co, Research Division - MD [57]

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Sorry, I had you on mute. I guess, a lot of my questions have been answered, but if we could take a step back and look at your backlog again, strictly in North America, can you talk a little bit about the mix in there of sleeper versus Class 8? And also maybe large fleet versus smaller owner-operator? Or any other color you can give us on the mix of that backlog, it would be great.

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Harrie C. A. M. Schippers, PACCAR Inc - President & CFO [58]

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Ann, if I look at the backlog for 2019, it's pretty normal. We got a very normal mix of fleet business, bigger fleets and smaller fleets retail business by our dealers. And we try to manage that backlog also that in a year where our lead times extend, that we're able to supply all our loyal customers with the trucks that they need.

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Ann P. Duignan, JP Morgan Chase & Co, Research Division - MD [59]

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So nothing unusual sleeper versus Class 8 straight? I'm thinking more oil and gas kind of related infrastructure?

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Harrie C. A. M. Schippers, PACCAR Inc - President & CFO [60]

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No, very normal.

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Ann P. Duignan, JP Morgan Chase & Co, Research Division - MD [61]

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Okay, that's good to hear. And then in that context also, perhaps we could talk about used values and also the cancellations that escalated for the industry over the last couple of months? Can you talk about what you've seen in cancellation rates? Or were your dealers not ordering for stock to begin with, so there have not been the same level of cancellations? If you could talk a little bit about that, that'll be good.

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Harrie C. A. M. Schippers, PACCAR Inc - President & CFO [62]

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Used truck prices have improved nicely as we mentioned. And if we look at cancellations, we don't see a lot of real cancellations. If we see cancellations, it's cancellations for reorders. So a dealer changes the type or a customer for a truck, but not any significant cancellations so far.

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Ann P. Duignan, JP Morgan Chase & Co, Research Division - MD [63]

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And is that your assessment of the industry cancellation rates? That it is more canceling and resetting of delivery train trucks that...

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Ronald E. Armstrong, PACCAR Inc - CEO & Director [64]

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We don't know what the other -- we know what our situation is, but we don't really have any read into what the competitor numbers look like.

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Ann P. Duignan, JP Morgan Chase & Co, Research Division - MD [65]

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Okay. And one quick follow-up on your European outlook. What exactly do you have baked in the outlook for Brexit? You're assuming it's a normal or that it doesn't happen? Or what's the downside risk if we do not get order past the expiration date?

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Ronald E. Armstrong, PACCAR Inc - CEO & Director [66]

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I think there's -- there are bound to be some -- if there is a hard Brexit, it's -- there's bound to be some temporary disruption. But that's, again, that's temporary. And again, because we are the sole producer in the U.K., from a competitive standpoint, it's actually a bit of an advantage for us.

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Ann P. Duignan, JP Morgan Chase & Co, Research Division - MD [67]

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No, but in the long-term, pulls to any disruption, obviously?

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Ronald E. Armstrong, PACCAR Inc - CEO & Director [68]

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Yes, I think in the long term, it's all sorts itself out, yes. But short-term, there could be challenges.

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Operator [69]

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Our next question comes from the line of Jamie Cook with 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 [70]

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I guess, first question, I was sort of surprised when you talked about customers already starting to talk about 2020. And obviously, when we look at your stock price and the multiple the world assumes in 2020, the truck market, obviously, rolls over. So can you just talk, understanding it's far out, but sort of what your customers are talking about in terms of how they're thinking about 2020 and sort of how far out you are?

And then my second question, I'm sorry, I just wanted to push again on the margins for 2019. I know you said -- I think you said 14% to 15%. But like, how is not the midpoint to the high end 14.5% to [5] more realistic, just given price? I mean, material costs are going down. The supplier constraints and inefficiencies should be going away. I just -- I don't understand how we'd get to the low end?

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Ronald E. Armstrong, PACCAR Inc - CEO & Director [71]

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So the backlog -- the customers are engaging in discussions about 2020. They've got their build slots outlined for 2019, and so some of those discussions are occurring and...

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Harrie C. A. M. Schippers, PACCAR Inc - President & CFO [72]

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But it's still very limited for 2020. The big fleets plan their requirements into 2020. In general, we haven't issued our pricing for 2020 yet, so that's still to come. So once we launch or issue our pricing for 2020, we'll see more orders for 2020.

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Ronald E. Armstrong, PACCAR Inc - CEO & Director [73]

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Yes, and as far as margins...

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Jamie Lyn Cook, Crédit Suisse AG, Research Division - MD, Sector Head of United States Capital Goods Research, and Analyst [74]

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I'm just wondering if you have a strong view on whatever the industry forecasts are out there for 2020 down 25% based on what you're hearing. If you think the market is too pessimistic or you don't forecast you'll run the business no matter what's…

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Ronald E. Armstrong, PACCAR Inc - CEO & Director [75]

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Yes, I mean, what will actually be 2020, that's to be determined. But as we see it right now, there's -- people still need and want trucks, and we're trying to figure out how to build more trucks. Not -- that's -- and that's what you see a little bit in our first quarter delivery plan.

As far as margins, we're just starting the year, given a pretty broad range. And we'll have better feel for how suppliers are going to perform over the year and how cost movements will be, what's the impact of commodities and tariffs, et cetera. So that's still -- we think we have all that pretty well dialed in, but we'll see how it progresses as we go through the first quarter.

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Operator [76]

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Our next question comes from Steven Fisher with UBS.

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Steven Fisher, UBS Investment Bank, Research Division - Executive Director and Senior Analyst [77]

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I wanted to follow up on the supply chain topic. And I think, Ron, you said that the suppliers reached a good shape by the end of the fourth quarter. But I guess I'm curious, you're confident that they'll be able to seamlessly ramp up further to meet a still higher rate of production in 2019.

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Ronald E. Armstrong, PACCAR Inc - CEO & Director [78]

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Yes, our teams are -- our materials teams, our purchasing teams, our quality teams, they're working closely with our suppliers. And they had some -- our suppliers had some difficult hands they got dealt with a few hurricanes and a few things like that in the second half of last year, which -- that's sort of behind us. And so they've gotten their legs under them, and so we're working closely with them to be able to support the progression of build that we want to achieve during the 2019.

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Steven Fisher, UBS Investment Bank, Research Division - Executive Director and Senior Analyst [79]

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So is it smooth so far in, say, the month of January?

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Ronald E. Armstrong, PACCAR Inc - CEO & Director [80]

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Yes, January has been the best we've seen in -- through a couple of quarters.

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Steven Fisher, UBS Investment Bank, Research Division - Executive Director and Senior Analyst [81]

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Okay, terrific. And then just on Financial Services, just curious how much visibility you have at this point for 2019. I mean, the current quarter of profit was a nice run rate at $87-or-so million. Is that something you expect to build on in 2019? Or might it kind of sustain here and then moderate after a couple of quarters?

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Ronald E. Armstrong, PACCAR Inc - CEO & Director [82]

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Well, we've grown the portfolio with the additional truck deliveries, record truck deliveries and the ability that we've -- we financed about 24% of those globally last year, and we expect that will continue next year. So I think we'll continue to see some modest portfolio growth, and right now, the portfolio is performing excellently. Our past dues are really at historically low levels. And so we enter 2019 in good shape, and so we feel good about where we're at for 2019 with our Financial Services business, for sure.

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Operator [83]

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Our next question comes from the line of Joe O'Dea with Vertical Research.

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Joseph O'Dea, Vertical Research Partners, LLC - Principal [84]

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First, just wanted to understand gross margin potential. And when you talk about another strong year in 2019 and a 14% to 15% range. And you go back to the middle part of last decade in a strong market conditions when you're doing a 15% to 16% range, a host of things on the emissions front, obviously, price cost considerations, but just wanted to understand the major kind of structural swings that appear to mark a step down in the structural sort of gross margin potential.

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Ronald E. Armstrong, PACCAR Inc - CEO & Director [85]

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14% to 15% margins are excellent. There could have been some unusual circumstances 10 years ago, 15 years ago, but I think we're in great shape. The cost and the revenue side of trucks these days are much higher, given all the emissions add-ons that have occurred over time, so that probably could have some impact on the percentage realization over time. But whether it's 14% or 15%, 15% to 16%, it's pretty strong.

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Joseph O'Dea, Vertical Research Partners, LLC - Principal [86]

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Okay. And then on the share repo front, stepping it up in 2018, but vis-à-vis, the cash that's on the balance sheet, the potential to do something much larger than, and I guess, maybe just why not step it up and be a little bit more active on the share repo front?

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Ronald E. Armstrong, PACCAR Inc - CEO & Director [87]

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Yes. We just -- we feel really good. If you look at our cash over time, it's plus or minus 15% of our balance sheet, and we're basically sitting about that point. And so we're quite comfortable with where we're at and continuing to opportunistically buy shares has worked for us, and we will continue to apply that approach in 2019.

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Joseph O'Dea, Vertical Research Partners, LLC - Principal [88]

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And then just one on DAF and the share gains in 2018. I think some nice progress toward the 20% target. When you think about the momentum you have there, the good orders that you have in 4Q, I mean, do you have any kind of sense on sort of hitting that 20% target? Does that time line look more in view today than it has over the past couple of years, I imagine? And just trying to think about the -- what you see out there as a reasonable time line to get there?

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Ronald E. Armstrong, PACCAR Inc - CEO & Director [89]

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Yes, so if you look at 20 years' history, we were at 10% 20 years ago, and now we've progressed to 16.6%. So is 20 in our sights? Absolutely. And a key reason for the success this year was the -- that model year '17 truck that was an excellent investment, both from a performance standpoint, a apparent standpoint, a fit-and-finish standpoint. So it's -- the truck has just gotten better and better, and we're continuing to make investments for the future. And I think as -- just as we've seen in North America, we've grown -- in that 20-year period, we've grown basically 9 share points in North America from 21 to 30. And so yes, 20% is definitely in our sights.

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Operator [90]

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Our next question comes from the line of Neil Frohnapple with The Buckingham Research.

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Neil Andrew Frohnapple, The Buckingham Research Group Incorporated - Analyst [91]

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At the Investor Day, Ron, you guys talked about the potential down the road of expanding further into China. Can you provide any commentary here? Has the vision changed at all with all the cross-currents?

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Ronald E. Armstrong, PACCAR Inc - CEO & Director [92]

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It hasn't changed. We continue to look for a window of opportunity that can provide a return, and that's the challenge in China is finding the right combination where you can get a reasonable return. Harrie, Preston and I, we've all traveled there in the last several months. And so we continue to be there, evaluate it. And the window will open, but it's just -- it's an area of future opportunity, and we'll continue to evaluate just there as we do other parts of Asia.

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Neil Andrew Frohnapple, The Buckingham Research Group Incorporated - Analyst [93]

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All right. And then can you provide an outlook for the North American medium-duty market. It seemed to show more signs of life and exhibit faster growth in 2018. So yes, just curious on what your thoughts are for that market in 2019.

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Ronald E. Armstrong, PACCAR Inc - CEO & Director [94]

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Yes, the Class 6 and 7 market, which is where we play, is roughly up 100,000 trucks in 2018, and Peterbilt and Kenworth achieved record deliveries, record market share, 17.5%. So the products that we have are doing great. And just like everything else, we'll continue to make investments into product enhancements as we go forward. And as time goes on, more and more and more of our dealers get more engaged in that business. And so as we look at 2019, we think 100,000 trucks is probably a pretty reasonable approximation of that market for this year.

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Operator [95]

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Our next question comes from the line of Adam Uhlman with Cleveland Research.

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Adam William Uhlman, Cleveland Research Company - Partner & Senior Research Analyst [96]

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I was wondering if you could chat about the MX engine. I think I heard earlier, Ron, you mentioned adding some more machining capacity. I assume you're kind of maxed out on production today, but correct me if I'm wrong. And what type of growth should we expect in that business, either in terms of penetration or production rates in 2019 as that investment comes online?

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Ronald E. Armstrong, PACCAR Inc - CEO & Director [97]

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Yes, so the -- we'll start making those investments in 2019. The coming online is probably 2020 and will -- that'll be able to support the increased penetration. As we said before, the MX engine, basically, will support 80% of customer applications, and it just takes time to increase that penetration. We could put more in today if we had the capacity. And so that's why we're making the additional investments, and we'll continue to see that penetration grow to 50%, 60% over the coming near-term period, I think.

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Adam William Uhlman, Cleveland Research Company - Partner & Senior Research Analyst [98]

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And where did we end in 2018?

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Ronald E. Armstrong, PACCAR Inc - CEO & Director [99]

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Yes, just over 40% in North America. And of course, it's 100% for all the DAF products that get sold in Brazil and Europe. And so I think, overall for PACCAR, it's about 60% penetration for all of PACCAR.

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Adam William Uhlman, Cleveland Research Company - Partner & Senior Research Analyst [100]

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Got you. And then can we switch back to Europe? And could you talk about what you're seeing in the used truck pricing there? And then is there any difference between Western Europe or Eastern Europe? Any kind of changes will be helpful.

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Ronald E. Armstrong, PACCAR Inc - CEO & Director [101]

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Yes, it's -- pricing is pretty steady. Not seeing any appreciation, but just pretty steady. And demand, more of the used trucks tend to go towards Central and Eastern Europe. There's -- that's also a big growth area for DAF for new trucks. DAF is the leader in the Central European markets. And so that's steady as she goes is how I would think about it. That's what we saw in 2018 is how we're thinking about 2019 at this point.

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Operator [102]

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Our next question comes from the line of Scott Group with Wolfe Research.

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Robert Hudson Salmon, Wolfe Research, LLC - Research Analyst [103]

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It's Rob Salmon on for Scott. In the guidance that you provided, at the midpoint, it's implying roughly a little under 10% growth in the R&D budget. Could you talk about how we should be thinking about the R&D as we look out a few years in light of some of the emission standards changes as well as the investments that you guys are making into some kind of new trucking products? And what the flexibility you guys have on that line item if we do kind of encounter an industry downturn in 2020?

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Ronald E. Armstrong, PACCAR Inc - CEO & Director [104]

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Well, the flexibility of managing cost structure is a real strength of PACCAR, and we can manage that quite well. But also, we're making some great investments, as we always do, in the products for the future. I would say, incrementally, we're going to -- we're seeing more investments in R&D on the alternative powertrain and software development side. That's where the intellectual property is being created, and we're making those investments there. And we continue to make good, strong investments in diesel powertrains. We've got emissions requirements being enhanced in really all of our markets. And so we continue to invest in those arenas and in the new products of the features that are going to get us to those market share goals that we talked about earlier.

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Robert Hudson Salmon, Wolfe Research, LLC - Research Analyst [105]

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Okay, that makes sense. With the record backlog, has that given you any ability to kind of make the pricing as well as the orders be much more firm throughout kind of 2019, just given that we're looking at roughly a 12-month delay in terms of when a truck is ordered to when it gets produced today?

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Ronald E. Armstrong, PACCAR Inc - CEO & Director [106]

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The pricing has been negotiated, agreed, and it's representative of our market price and the great value that our products bring to our customers. So it's pretty well set.

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Operator [107]

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Our next question comes from the line of Joel Tiss with BMO.

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Joel Gifford Tiss, BMO Capital Markets Equity Research - MD & Senior Research Analyst [108]

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I just wondered if you could talk a little bit about your approach on autonomous. Are you guys going to outsource that whole process? Or are you thinking that there's parts of that, that you'd like to take control of? Or just give me a little sense in that regard of how you guys are thinking about that?

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Ronald E. Armstrong, PACCAR Inc - CEO & Director [109]

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Yes, we're still working through that, Joel. We've worked with quite a few companies who are developing autonomous technology, so partnering with them. But we're also developing our own capabilities. We have our Silicon Valley Innovation Center, and we've hired software engineers specifically focusing on developing our own Level 4 capability. And so we're very focused on, again, sort of like alternative powertrains, trying to figure out where we want to have the intellectual property and where we want to partner with others on developing that capability.

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Operator [110]

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There are no other questions in queue at this time. Are there any additional remarks from the company?

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Ronald E. Armstrong, PACCAR Inc - CEO & Director [111]

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We'd like to thank everyone for joining the call, and thank you, operator.

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Operator [112]

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Ladies and gentlemen, this concludes PACCAR's earnings call. Thank you for participating. You may now disconnect.