© 2024 Alpha Spread Limited. All Rights Reserved.
www.alphaspread.com is not operated by a broker, a dealer, or a registered investment adviser. Under no circumstances does any information posted on www.alphaspread.com represent a recommendation to buy or sell a security. The information on this site, and in its related newsletters, is not intended to be, nor does it constitute, investment advice or recommendations. The information on this site is in no way guaranteed for completeness, accuracy or in any other way. In no event shall Alpha Spread Limited be liable to any member, guest or third party for any damages of any kind arising out of the use of any content or other material published or available on www.alphaspread.com, or relating to the use of, or inability to use, www.alphaspread.com or any content, including, without limitation, any investment losses, lost profits, lost opportunity, special, incidental, indirect, consequential or punitive damages. Past performance is a poor indicator of future performance.
You don't have any saved screeners yet
Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Good day, ladies and gentlemen, and welcome to the Q4 2017 Cummins, Inc. Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will follow at that time. And as a reminder, this conference call is being recorded.
I would now like to introduce your host for today's conference, Mr. Mark Smith, the Vice President of Finance Operations. Sir, you may begin
Thank you, and good morning, everyone, and welcome to our teleconference today to discuss Cummins' results for the fourth quarter of 2017. Participating with me today are our Chairman and Chief Executive Officer, Tom Linebarger; our Chief Financial Officer, Pat Ward; and President and Chief Operating Officer, Rich Freeland. We'll all be available for your questions at the end of the prepared remarks.
Before we start, please note that some of the information you will hear or be given today will consist of forward-looking statements within the meaning of the Securities and 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 the 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 Factor section of our most recently filed annual report on Form 10-K.
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. Our press release with a copy of the financial statements and a copy of today's presentation material are available on our website at cummins.com under the heading of Investors and Media.
Now, I'll turn it over to our Chairman and CEO, Tom Linebarger.
Thank you, Mr. Smith. Good morning, everyone. I'll start with a summary of our fourth quarter and full-year results and finish with the discussion of our outlook for 2018. Pat will then take you through more details of both our fourth quarter financial performance and our forecast for this year.
Included in our fourth quarter results were charges related to the U.S. Tax Cuts and Jobs Act, which Pat will cover in full in his remarks. My comments today will exclude the $39 million of tax-related charges, which impacted the fourth quarter earnings of our unconsolidated joint ventures.
Revenues for the fourth quarter of 2017 were $5.5 billion, an increase of 22% compared to the fourth quarter of 2016. EBIT was $659 million or 12.0%, compared to 526 million or 11.7% a year ago. For the full-year, Cummins' sales were $20.4 billion, up 17% year-over-year. Our EBIT margin was 12.2%, up from 11.4% in 2016.
Engine business sales increased by 15% in 2017, due to stronger truck production in North America and global growth in demand for construction equipment. Engine business EBIT was 11% compared to 8.8% in 2016 due to the impact of stronger revenues and the realized benefits of cost reduction initiatives, partially offset by higher quality costs and variable compensation.
Sales for our Distribution segment increased by 14% due to higher demand in off-highway markets in North America and Asia. Full-year EBIT was 5.5% compared to 6.3% in 2016 as higher variable compensation costs resulting from stronger overall company performance more than offset the benefit of higher sales.
Full-year revenues for the Components segment increased by 22% due to stronger truck demand in North America and China as well as the sale of new products to meet the Bharat Stage IV emissions regulation in India that were introduced in April.
Our new Eaton Cummins Automated Transmission joint venture, which went into operation August 1 contributed 3% to full-year growth. EBIT was 13% compared to 13.3% in 2016.
Excluding the results of the Eaton Cummins joint venture, EBIT was 13.8%, up 50 basis points year-over-year as the benefits of higher volumes and cost reduction initiatives more than offset higher variable compensation costs.
Power Systems sales increased by 15% in 2017 with stronger demand for engines, for mining, in oil and gas customers and increased power generation sales in Europe.
EBIT was 7.2% compared to 7.5% in 2016 as the benefit of higher volumes and cost reduction programs were more than offset by higher warranty costs and losses associated with a large power project in the U.K.
Fourth quarter EBIT was 8.6% representing clear improvement from a year ago and we expect margins to improve further in 2018 as you will see from our guidance.
Now, I will comment on some of our key markets in 2017 starting with North America, and then I will comment on some of our largest international markets.
Our revenues in North America increased 15% in 2017, primarily due to stronger production and market share gains in truck markets and higher sales to oil and gas, construction, and mining customers.
Industry production of North American heavy-duty trucks increased to 221,000 units, up 10% from 2016 levels. Our market share was 33%, also up from 2016. The market size for medium-duty trucks was 118,000 units in 2017, an increase of 9% from 2016.
The market size for medium-duty trucks was 118,000 units in 2017, an increase of 9% from 2016. Our full-year market share of 78% increased from 75% a year ago. 2017 marked another strong year for pickup truck sales in North America with our engine shipments reaching 153,000 units, up 2%.
Engine sales to construction customers in North America increased 27% in 2017 due to improving customer confidence compared to a weak 2016. Engine shipments to high-horsepower markets in North America increased by 138% year-over-year, reflecting a rebound in oil and gas and mining markets.
Revenue for power generation increased by 3% due to stronger sales to consumer markets. Our international revenues increased by 19% in 2017. Our full-year revenues in China, including joint ventures were a record $4.9 billion, an increase of 40% reflecting stronger demand in truck and construction markets.
Industry demand for medium- and heavy-duty trucks in China increased 40% for the full-year, partially driven by the enforcement of regulations in the combating vehicle overloading which accelerated truck replacement.
Our market share in 2017 was 14%, down from 15% in 2016 as one of our OEM partners, Dongfeng Motors, experienced a decline in its truck market share.
Shipments of our light-duty engines in China increased by 24%, twice the rate of the market growth as Foton continued to increase the proportion of its trucks powered by our joint venture engines, displacing local competitor engines.
Our full-year share in the light-duty truck market was 8% in 2017, up 80 basis points over the prior year. Demand for construction equipment improved in 2017 due to increased infrastructure investment and property construction. Industry sales of excavators rose 100% year-over-year.
Cummins construction engine volumes increased by 175% as we gain share with key customers. Revenues for our Power Systems business in China increased by 13% due to growth in power generation and mining markets. Full-year revenues in India, including joint ventures were $1.8 billion, a 12% increase over 2016.
Industry truck production decreased 5% to 327,000 units, driven by implementation of the Bharat Stage IV emissions regulations in India. Our market share increased by 100 basis points to 42%, with more than 90% of Tata Motors trucks, powered by our joint venture engines, reflecting strong market acceptance of our new products.
Sales for our Components business more than tripled due to the introduction of new products to help our customers meet the emissions regulations. Revenues for power generation increased by 5% and construction sales grew by 17% due to ongoing infrastructure development in the country.
In Brazil, our revenue increased by 26% compared to a very weak 2016. The growth was due, in large part, to a 37% increase in truck production to meet export demand.
Now, let me provide our overall outlook for 2018 and then comment on the individual regions and end-markets. We are forecasting total company revenues for 2018 to be up 4% to 8%. Industry production for heavy-duty trucks in North America is projected to be 266,000 units in 2018, a 20% increase year-over-year. We expect our market share to be between 31% and 34%.
In the medium-duty truck market, we expect the market size to be 124,000 units, up 5% compared to 2017. We project our market share to be in the range of 72% to 75%.
Our Engine shipments for pickup trucks in North America are expected to be flat compared to a very strong 2017. And in China, we expect domestic revenues, including joint ventures, to decrease by 5% in 2018.
We currently project a 15% decline in heavy and medium-duty truck production and a flat light-duty truck market. We expect our market share in the medium, heavy-duty market to be 14%, level with 2017. And in light-duty, we expect our share to grow to 9%.
We currently project 8% growth in off-highway markets in China. In India, we expect total revenues, excluding joint ventures, to increase by 15% to 20%, mainly due to stronger truck demand, a full-year of new component product sales to meet Bharat Stage IV emissions standards and continued strength in off-highway markets.
In Brazil, we expect truck production to be flat in 2018, with some uncertainty about the pace of economic recovery and election scheduled for October. We expect our global high-horsepower engine shipments to be up 5% to 10% in 2018 due to further improvement in orders from mining customers.
In summary, we expect full-year sales to be between 4% and 8% up over 2017. We expect EBITDA to be in the range of 15.8% to 16.2% of sales, up from 15% in 2017. The improvement in EBITDA margins reflects approximately 45% incremental margins at the midpoint of our guidance, and we exclude the impact of our investment in our Electrification business and our start-up losses in our Eaton Cummins joint venture.
Improving market demand, continued execution of cost reduction initiatives and lower variable compensation costs will drive the improvement in margins. We plan to again return at least 50% of operating cash flow to shareholders in 2018 through both dividends and share repurchases.
We continue to make progress in the execution of our strategy and we recently announced the acquisition of Johnson Matthey's automotive battery systems business based in the UK, a subsidiary of Johnson Matthey that specializes in high-voltage automotive grade battery systems for electric and hybrid electric vehicles.
The addition of Johnson Matthey Battery Systems technical expertise and customer base in markets that are more rapidly adopting electrification further strengthens our position, both as an electrified powertrain provider and as an energy storage supplier.
As we discussed in our Analyst Day last November, we plan to invest approximately $500 million over the next three years as part of our strategy to develop an electrified powertrain product line, along with key component technologies and service and support offerings.
Starting in the first quarter, we will report the results of our Electrification business separately, so that investors can see the level of investment and understand the pace of development in different commercial vehicle markets over time
Now, let me turn it over to Pat.
Thank you, Tom. Good morning, everyone. I will start with a review of our fourth quarter results, before I move on to our full-year 2017 performance. Fourth quarter revenues were $5.5 billion, an increase of 22% from a year ago and a quarterly record for the company.
Sales in North America increased by 22% from last year, as a result of higher commercial truck production and improved demand for industrial engines and power generation equipment. International sales also improved by 22% from a year ago due to stronger demand in China, India and in Europe.
Gross margins were 25.1% of sales, an increase of 20 basis points from last year. The positive impact from higher volumes and material cost savings more than offset higher variable compensation expense and the dilutive impact on the gross margin percent from the Eaton Cummins joint venture.
Selling, admin and research and development costs of $840 million or 15.3% of sales, increased as a percent of sales by 30 basis points due to an increase in investments for developing new products, higher variable compensation expense and the inclusion of the Eaton Cummins joint venture in 2017.
Joint venture income of $56 million includes a $39 million tax charge related to the tax reform bill passed in December. Excluding that tax adjustment, joint venture income was $95 million, a $28 million or 42% increase from last year.
Earnings before interest and tax were $620 million or 11.3% of sales for the quarter, and again if you adjust for the $39 million tax adjustment to joint venture income, earnings before interest and tax were $659 million or 12% of sales compared to $526 million or 11.7% last year.
Our fourth quarter earnings were negatively impacted by one-time charges related to the tax reform bill passed in December. These include the $39 million reduction in joint venture income I already mentioned; a $43 million credit to non-controlling interests; and a $781 million in additional tax expense.
All in, the total impact of this tax legislation was a charge of $777 million, which is a combination of the write-down of our net deferred tax assets, reflecting the reduction in the U.S. tax rate from 35% to 21% and the cost associated with a mandatory deal repatriation of overseas earnings, including the associated withholding tax that will be paid as we move cash out of certain jurisdictions and countries. These charges represents our best estimates at this point in time that could change as additional guidance is issued with assumptions supporting our estimates are defined.
Page 11 of the Form 8-K illustrates the impact of the tax legislation on our fourth quarter results. As a result of the $777 million impact to net income from the impact of the tax reform, we reported a net loss for the quarter of $274 million or $1.65 per diluted share. Excluding the tax adjustment, net earnings for the quarter were $503 million or $3.03 per diluted share compared to $378 million or $2.25 from a year ago. The effective tax rate for the quarter, excluding the tax reform charges was 19.5%, down from 22% last year.
Now, let me comment on our full-year results and provide some more details on our performance. Revenues for the company were a record $20.4 billion, an increase of 17% compared to the prior year. As Tom just described, the growth in international truck production in North America and China, strong demand in our global construction markets and improved demand in mining and oil and gas markets led to the overall revenue increase.
North American revenues increased by 15% in 2017 and represented 58% of our total revenues. International revenues increased by 19% compared to 2016. Gross margins of 24.9% were 50 basis points lower than last year. Higher warranty and variable compensation expense, along with dilutive impact on the gross margin percent from the Eaton Cummins joint venture offset the benefits from the stronger volumes and material cost reduction initiatives.
Selling, admin and research and development costs increased by $460 million or 10 basis points due to higher compensation costs, increased investment in new products and technologies and the inclusion of Eaton Cummins joint venture in our results. Joint venture income increased by $56 million compared to last year, net of the $39 million tax charge related to the tax reform bill passed in December. If we exclude that tax charge, our joint venture income increased by $95 million compared to 2016 primarily due to higher contributions from our China joint ventures amidst strong demand in on-highway markets.
Other income and expense improved by $213 million compared to a year ago, primarily due to the loss contingency charge that we reported back in 2016 and gain on asset sales and fair value gains on company-owned life insurance plans in 2017.
In total, earnings before interest and tax was $2.45 billion or 12% of sales, and adjusting for the $39 million tax adjustment to joint venture income, EBIT was $2.5 billion or 12.2% of sales compared to $2 billion or 11.4% a year ago.
Our reported net earnings were $999 million or $5.97 per share. Excluding the full impact of the tax charge, 2017 net earnings were just under $1.8 billion compared to $1.4 billion last year, and diluted earnings per share was a record $10.62, up from $8.23 a share last year.
The operating tax rate for the full-year was 58% or 24.5% if we exclude the tax charge, compared to 24.6% a year ago. Page 12 of the form 8-K illustrates the impact of the tax legislation on our full-year results.
Moving on to the operating segments, let me summarize their performance in the fourth quarter and the full-year and then provide some more details in our forecast for 2018. I will then review the company's revenue and profitability expectations for the upcoming year and conclude with some details on cash flow. My comments in the segments will exclude the $39 million of tax charges that did impact the joint venture earnings and details by segment can be found in the notes on pages 7 and 8 of our Form 8-K.
In the Engine segment, revenues were $2.3 billion in the fourth quarter, an increase of 16% from last year. On-highway revenues grew by 14%, driven by higher heavy- and medium-duty truck engines sales. Off-highway revenues increased by 27%, primarily due to higher construction sales in North America and in China. Segment EBIT in the fourth quarter was $247 million or 10.8% of sales compared to $194 million or 9.9% of sales a year ago. Stronger volumes and increased joint venture income more than offset cost increases from variable compensation and research and development spending.
For the full-year, revenues increased by 15% from a year ago, and earnings before interest and taxes were $982 million or 11% of sales, up from $686 million or 8.8% last year. For 2018, we expect revenues to be up by 4% to 8% due to stronger demand in the North American heavy-duty truck market and continuing strength in global construction markets.
EBITDA margins are projected to be in the range of 14% to 14.5% compared to 13% in 2017. For the Distribution segment, fourth quarter revenues were $1.9 billion, increasing 16% compared to last year. The increase in sales was primarily driven by improved demand for both new engines and parts and service in North America. EBIT for the fourth quarter was $101 million or 5.2% of sales; compared to last year, fourth quarter EBIT margins decreased by 2.1%. The decrease in EBIT margin was primarily driven by higher variable compensation expense incurred as a result of the company's overall performance and the one-time gain of $15 million last year for the acquisition of the last remaining unconsolidated North American distributor.
For 2017, sales for the segment grew by 14%. Organic sales for the year increased by 11% for a revenue from acquisitions increased sales by 3%. EBIT as a percent of sales declined from 6.3% down to 5.5%, driven by higher variable compensation cost, again resulting from the stronger overall company performance.
For 2018, Distribution revenue is projected to increase 2% to 6%, driven by improving demand in many of our key markets. We expect EBITDA margins to be in the range of 7.75% to 8.25% of sales compared to 7.1% in 2017.
For the Components segment, revenues were $1.6 billion in the fourth quarter, an increase of 32% from a year ago and a quarterly record. Sales in North America increased 35% due to higher commercial truck production and the inclusion of revenues from Eaton Cummins joint venture.
International sales increased by 30%, primarily due to the higher content in India, with the introduction of the Bharat Stage IV emissions standard in 2017 and from increased commercial truck production in China.
Segment EBIT was $180 million or 11.6% of sales compared to $140 million or 11.9% of sales last year. Higher variable compensation costs and costs related to the Eaton Cummins joint venture offset the benefits from increased volumes and material cost reductions. Excluding the impact of the Eaton Cummins joint venture, segment EBIT percent improved by 120 basis points.
For 2017, our Components segment delivered record revenue, up 22% compared to the previous year, driven by higher demand in North America, China and India in addition to the inclusion of revenues received from the Eaton Cummins joint venture. EBIT as a percent of sales decreased from 13.3% down to 13%. Excluding the Eaton Cummins joint venture, Components revenue grew by 18%, and EBIT as a percent of sales was 13.8%, an increase of 50 basis points from last year.
For 2018, we expect revenue to increase by 8% to 12%, driven by the continued strength in truck production in North America and the full-year of operations for the Eaton Cummins joint venture, partially offset by U.S. sales and China. EBITDA is projected to be in the range of 15% to 15.5% of sales compared to 15.8% in 2017.
And on the Power Systems segment, fourth quarter revenues were $1.1 billion, up 18% from a year ago. Industrial sales grew by 51%, primarily due to stronger mining and oil and gas demand while power generation sales increased by 6% compared to last year.
EBIT margins were 8.6% of sales in the quarter, up from 7.3% last year. Higher volumes and material cost reductions more than offset higher variable compensation and restructuring costs related to the closure of our STAMFORD manufacturing plant in the UK.
For the full-year, Power Systems revenues increased by 15% from 2016, primarily driven by growth in the mining and oil and gas markets. EBIT increased to $294 million or 7.2% of sales compared to $263 million or 7.5% last year. Higher volumes and material cost reductions were offset by higher variable compensation expense and the absence of a $17 million gain last year relating to the divestiture of a Power Systems joint venture.
For 2018, we expect Power Systems revenues to increase 4% to 8%, driven by the continuing strength of the mining market and improved demand for power generation equipment at data centers. EBITDA margins are expected to be between 12.25% and 12.75%, up from 10.1% last year.
For 2018, we're forecasting total company revenues to be up 4% to 8%, primarily driven by the increased demand in the North American heavy-duty truck market, a full-year of operations for the Eaton Cummins joint venture and increased demand in mining and power generation markets. We expect EBITDA margins to be between 15.8% and 16.2%, up from 15% last year. Higher volumes will positively impact margins in addition to lower warranty and lower variable compensation costs.
We remain focused on cost reduction with improvements in material cost, plant productivity and the quality of products helping to offset investments in new products, merit increases and restructuring costs relating to the downsizing of our STAMFORD automated manufacturing operation in the UK.
Income from our joint ventures is expected to decline by approximately 15%, driven by weaker market demand in China. And we expect our effective tax rate to be approximately 23% this year, excluding any discrete items or adjustments to provisional estimates.
Finally, turning to cash flow, cash generated from operations for the full-year was a record $2.3 billion. We anticipate operating cash flow in 2018 will be within our long-term guidance range of 10% to 15% of sales.
Capital expenditures for the full-year of $506 million and we're forecasting our 2018 investments will be in the range of $730 million to $760 million as we continue to invest in new product lines.
In 2017, we returned $1.2 billion to our shareholders or 51% of operating cash flow. We repurchased 2.9 million shares and increased our dividend by 5%. Our capital allocation plans are consistent with what we told you at our Analyst Day back in November. We will maintain a strong financial position to sustain us across cycles and variation in our business levels.
We will focus on growth, targeting high-return investments, both organic and inorganic. And we continue to plan to return at least 50% of operating cash flow to shareholders. Our strategy to create shareholder value remains centered on improving our return on capital. That starts with performance improvement. We will expand our EBITDA margins on our base business and increase the amount of cash that we generate from our operations.
Secondly, will continue to be disciplined in our investments, so we're focused on the opportunities that offer high returns, both organic and through acquisitions and partnerships, and we will continue to invest in new technologies to make sure that we are well-positioned for the opportunities ahead.
And finally, we will deliver strong returns to our shareholders with top quartile performance and returns on capital that we invest in the business as well as through dividends and stock buybacks.
We are pleased with the record sales, record earnings per share and record operating cash flow in 2017. Our returns on capital were also top quartile. (29:51) That being said, there were clearly areas where we could have done better, and you can see from our guidance that we expect clear improvement in operating margins in 2018.
Now, let me turn it back over to Mark.
Thanks, Pat. We're now ready to move to the Q&A session of the call. Could you please restrict your question to one question and one related follow-up and then get back in queue. Thank you very much. Now, we're ready for questions.
And our first question comes from the line of Tim Thein with Citigroup. Your line is now open. Tim Thein, if your line is on mute, please unmute it.
Yeah, I'm sorry about that. Sorry, folks. I just wanted to dig in a little bit on the Power Systems sales guidance for 2018. Maybe you could just expand a little bit, obviously, power gen returned to growth first time, I think, in a number of years. So maybe just segmenting power gen as well as some of the key drivers for the industrial market here in 2018, just coming at that 4% to 8% expected sales growth.
Okay. Yeah, Tim, this is Rich. So it's coming in a few areas. Mining, we anticipate to continue being strong, up 10%, again here in 2018. Overall, power gen – so it's been depressed for some time, up 5% to 10% and part of that is in data centers. In fact, we will double the number of Hedgehog engines we sell this year in 2018 compared to 2017, but just a bit of improvement in several markets. North America is up a bit for the first time; China is up; India is up. This forecast assumes oil and gas is flat from a pretty big increase in 2017 and marine remains flat in this forecast.
The only thing I'd add, Tim, is we had one large power contract in the UK in 2017 that's complete, and that's kind of a 3% headwind to revenues as we start the year.
Okay, but presumably, tailwind to the EBIT line, Mark?
Absolutely.
Okay. And then maybe for Rich, while you're on, just on the North American Class 8 market share forecast. There's in 2018, a view that some of the large fleets come back to the market in a bigger way and I guess that's consistent with what we've heard from some of the larger carriers here in recent days, talking about bringing their fleet ages down. And obviously that's, historically, been a segment of the market that you've done better with, so maybe just a quick sentence or two in terms of I don't know if I heard what you're assuming in terms of market share in Class 8 for North America?
Sure. So let me just touch briefly on the market, and then I'll get to market share. So, as Tom said, we're projecting up 20% in the North American truck market. And orders are off to a really good start if you saw the January orders. And so the backlog, end of the year, the 134,000, it'll grow through the first quarter. So I think we're going to see production rates building through the first quarter, maybe starting out a little lower, but we should see some good momentum through the year is what we're seeing.
And on the market share, we're forecasting relatively flat. And we're building the plan around a flat share. We made good progress in 2017. We gained share. The product's doing really well as we've talked to all the major fleets that we have business with; we're either remaining flat or growing with them. So I feel pretty good about the share piece again from a projection standpoint, this plan assumes flat.
Okay. Thank you. I'll pass it on.
Thanks, Tim.
Thank you. And our next question comes from the line of Jamie Cook with Credit Suisse. Your line is now open.
Hi. Good morning. I guess, two questions. One, Rich, back on the North American heavy-duty truck markets as 2018 continues to surprise on the upside, can you talk about your view on 2019, whether that takes away from 2019 or should we get start to get concerned that 2018 is the peak?
And then my second question relates to the Power Systems margin guidance that you gave. I guess, can you talk about how much benefit we're getting from restructuring, what you assume sort of price cost, just the drivers to get your margin guidance? Thank you.
Okay, I'll start first on North America truck. Well, the crystal ball is not that quite clear out to 2019. But if you just step back at 2017, we're really at kind of a replacement level. And so with this increase in 2019 that we're projecting, we're going to be building at a rate greater than replacement. Historically, these upturns have run kind of in the 2-year range.
So it's a little too early to call it yet. It probably depends on how quickly 2018 comes up, but all the indicators, underlying principles, as you know, are pretty good. I've spent the last few weeks talking to many of the fleets, and I do think the January orders were a little bit front-loaded. So I wouldn't anticipate that continuing at the rate we saw in January as many of the big fleets got their orders in. But it feels pretty strong right now, kind of – and I think, potentially, building momentum through 2018.
I think on the Power Systems margin side, Jamie, a couple of factors. One, we're still going to have net costs in 2018 as we complete the rightsizing of our alternate and manufacturing facility in the UK, so that margin improvement is still with $29 million and our incremental $25 million of costs in the performance there included in the segment margins.
The big piece is really going to be with half of the improvement in margins is going to be volume and cost reduction – material cost reduction. The quarter is going to be the absence of the UK power project, and end of the half is really going to be leveraged on the operating costs.
Okay. I'm sorry, just one other follow-up then I'll get back in queue. Just on – you're evaluating the engines from 2010 to 2015, potential degradation issues can you just talk about it? Are we still expecting any update there? Are we still expecting some sort of update by mid-2018? Thanks and I'll get back.
Thanks. Jamie, this is Rich again. Yeah, so no new update there. We're continuing like we talked last quarter to do the analysis with the agencies. That work is collaborative and so our mix kind of round of discussions with them is later this quarter.
So my anticipation goal is that we'll share data and we're really targeting to get this behind us by mid-year, but no new update, kind of off-schedule of what we told you last quarter on the analysis.
Thank you. And our next question comes from the line of Rob Wertheimer with Melius Research. Your line is now open.
Hi. Good morning, everybody.
Good morning, Rob.
Good morning, Rob.
My question is really just on the Eaton JV, can you give us any kind of an update on profitability, on spending level, on how the product launches are going? How is it going versus your expectation once you're investing in and how you expect to get a return on it – when you guys expect to get a return on it rather?
Rob, I can just give you the view of where it is versus expected. I'll have Mark fill in to some of the numbers. But from an expectation level, we expect it to be investing at the end of last year and this year in new products, heavier than we were seeing growth in volume and revenue. So we were expecting to have a loss for the second half of last year and for this year, and we expect to be in profitability next year.
In terms of volume and take-up of the product, it's right on plan, doing terrifically well and we're getting good acceptance from the market. Our development plans are right on plan.
So while not every investment we make goes exactly like expected, this one is going like we expected which is terrific and I think it speaks well to the fact that both Eaton and ourselves have very complementary cultures and very complementary approaches to products and so we feel like we're right on plan. Mark, I don't know if you want to highlight any of the numbers?
Yeah. So the full-year sales for the joint venture, which of course, was only 5 months but $163 million in 2017 and EBITDA loss of $7 million, and then in 2018 at the midpoint of our guidance, we've got about $430 million of sales and an EBITDA loss of $32 million, again with the engineering ramp-up and the launch of the new products, and as Tom said, then we start to have the positive incrementals going into 2019.
That's perfect. Thank you. And Tom, if I may, is that investment that's ongoing for engineering the products so that their kind of out there in the market that we know about and be designed in or is there a substantial investment for a whole next-generation that we haven't seen yet?
It's basically both. I mean, the issue is we have indeed engineered the basic platform. But now we have to engineer all the releases that are needed to get them into all the customers that we want to get them into, so that turns out that's not a small effort, right? So you get the basic design of what you're trying to put together and then you have to do all of the application engineering and product releases that get you all across the product lines. And that's really what drives the volume, not just the one main product that goes in the one Class 8 truck. So that's really what's going on. We're building out the product line. We are also investing in some new products, the next-generation products that have not been released yet. So both are going on, but I'd say the big work this year is to get the new, enduring product line and get it out to all the various customers that will benefit from using it.
Thank you so much.
Thank you.
Thank you. And our next question comes from the line of Ross Gilardi with Bank of America. Your line is now open.
Hey, good morning.
Good morning, Ross.
Hey, Tom, I was just looking to get your kind of your latest view on the balance sheet and M&A. Obviously it's kind of a dynamic as we go forward. But just your general view on buying conventional assets that are tied to the internal combustion engine and are accretive today versus buying intellectual property. And you bought Brammo, you bought the Johnson Matthey asset. Obviously, you're investing in the Eaton joint venture and are very optimistic there. We've also seen a big spike in goodwill and intangibles on your balance sheet, so how are you thinking about that now? And I've got a follow-up as well.
Great. Ross, it's a terrific question. Thanks for that. Obviously, that is – that exact question of where do we see the technology is evolving, where are we building up capabilities that we need in the future and where we're adding growth and earnings, that's kind of – those are at the heart of how we're figuring out how to invest with discipline and to drive value for shareholders. So there is not one simple answer to your question. But suffice it to say, that we've identified the four areas that we think we can leverage our capabilities to make one plus one equals three, because making acquisitions, to buy earnings, to just add to the total does not create value for shareholders. It has to be that by us coming together with that company, we're able to find synergies, more growth, more something that would justify any kind of premium we would pay.
So what you've seen us do so far is we've identified in the automotive space, significant changes in technology and we've made it clear that we want to be the provider of a range of technologies that meets the needs of our customers. So we've made the acquisitions we need to make there. And since we're pretty strong in internal combustion engines in that area, what we've needed to add is capabilities and electrified powertrains and other things. So we're not really looking at expanding our internal combustion engine in that space.
If you look in some of the other spaces where we're talking about going up into larger engines than we have today, then we might invest in assets that include internal combustion engines because there we think the internal combustion engine has a much longer life, has fewer substitutes over time, so it will depend on which area we're in. I think – I hope what you also see is that we're not in a hurry to spend money. We're basically seeing this as an opportunity to build value and growth for shareholders. And when we find something that we think we can add value and growth, we're going to do it; and if we don't, we're going to return money to shareholders. We're going to continue to use that discipline so that acquisitions we have been making or joint ventures have been relatively small, and they've been a perfect fit strategy-wise, so we're continuing in that vein. If we were able to get a larger acquisition that met the same criteria, we do it; if we don't, we'll be happy with that and we'll continue to look at relatively incremental additions to capabilities and growth.
So just to expand what you just said there, Tom, I think your comment on if you're to sustain – focus more on the internal combustion engine and you focus more on larger engines, fair to assume that you'd probably be more off-highway focused if you were to acquire kind of in the conventional technology? And then can you guys just elaborate on what exactly is in this Electrification segment that you've broken out? Is that just Brammo, these Johnson Matthey assets?
Yes. So I'll give you a couple of comments on both. The answer to your first question is yes, most engines larger than 16 liters are off-highway. That's true. And again, in terms of where substitution rates are happening more quickly in Electrification, as you know, most are on-highway, not only though. There are some very interesting markets from an Electrification point of view off-highway Q, but most of the action is happening now in urban transportation on-highway.
So – and then with regard to Electrification, we have basically three things going in there. One is the battery acquisitions that you mentioned, the Brammo work, the new Johnson Matthey Battery Systems division that we just acquired. In addition to that, we have internal programs where we are developing electrified powertrains. Cummins developed and designed and manufactured electronic powertrains for application first in buses – in urban buses, which you heard we announced that we would be in production in urban buses, first offerings at the end of 2019 and in full production in 2020. So we are full on in development phase for those products.
And then we have groups that are looking at longer-term, where the rest of the application is going to, doing R&D and also market development work for the applications beyond buses. So internal people plus the two divisions we acquired, but the threads inside the group are what do we need to be in production right away, that's a very focused group of people and then what are we looking at longer run.
Thank you.
Okay.
Thank you. And our next question comes from the line of David Raso with Evercore ISI. Your line is now open.
Hi, good morning. One data point, if you can just provide us quickly, the D&A by segment for 2018, you're at $670 million total for the company, but you're only at $580 million last year.
Yeah.
I just want to make sure we have the moving parts here, would you mind for the segments?
The two biggest moving parts are the full-year impact of the Eaton Cummins joint venture, David, which will be in the Components segment and then the other big piece will be accelerated depreciation on the assets as part of the restructuring of the Power Systems business in the UK. And those two will account for at least two-thirds of the increase in the D&A and the balance will be more routine, capitalized software amortization and depreciation of regular fixed assets across the segments.
Yes. I'm just trying to back into, obviously, still thinking out of the EBIT if you don't mind, the incremental EBIT margins are about 25% in the guidance. Within that, component (sic) [Components] is one, but then if I pull out the Eaton JV from 2017 and 2018, it still feels like the incremental is very low in that segment. And, obviously, Electrification is now separate. So I'm just trying to understand that that business, am I reading it properly the incrementals are very low on Component (sic) [Components] in the guide?
They certainly improved, as Tom mentioned and Pat in his comments, year-over-year, excluding the joint venture, and we still expect to have underlying EBIT margin improved. I don't have the exact math in front of me ex that item. (48:02)
David, from memory, we can check these numbers and come back to you afterwards, but I think if you exclude the Eaton Cummins joint venture, the Components EBITDA last year was just around 16.3% or 16.4% and our guidance for the base business of Components is 16.5% to 17% this year. So we'll come back and confirm those numbers.
Yeah, if we could. The numbers aren't quite adding up. And back to the balance sheet, in Indianapolis, you sounded a little more willing to use your balance sheet than I've heard this decade. And you talked about 2 times net debt-to-EBITDA and you're guiding EBITDA this year $3.5 billion, right? So obviously, that would be a $7 billion net debt target. Net debt right now is only $400 million to $500 million, so can you help us understand, say, a larger deal does not come along? Tom, you had mentioned return some to shareholders.
Can we imagine a year from now, no deals come up that large size, and we're talking $6.5 billion-plus, over 20% of your market cap, how should we think about your willingness to wait for a deal to come to fruition or then decide, hey, at some point this year, we'll return a significant amount to shareholders? And I'm not talking about the 50% of operating cash flow. This is solely a balance sheet story.
David, it's a super question. I mean, it's really important to shareholders, this question. And of course, it's a judgment call, right? There is not a straightforward way to answer that. Here is the way that I've been thinking about it, though, and I framed it up in the investor meeting, is that my goal, as the leader of this company, is to make sure that we continue to create the most value for shareholders. And I'm trying to figure out which one adds more value.
And as long as I believe that we can use cash generated by our business to either invest in organically, invest in partnerships or in acquisitions, and that can create value for shareholders, not just make us bigger but actually create value, then I want to pursue those efforts.
But not indefinitely and not just on some chasing windmills adventure. So the idea is that when I begin to see the opportunity for us to make major investments, either, by the way, with one larger acquisition or with a series of smaller and medium acquisitions, which, frankly, is slightly more attractive to me in terms of risk mitigation and that kind of thing, when I see those opportunities, I'm going to continue to pursue them.
And when I don't see many opportunities in front of us, I'm going to increase the amount of money we return to shareholders. So I don't think there's a magic date this year. I don't think there's a magic date ever, but I do think that it's incumbent upon me to not just continue to go on forever, but to have a view about when these opportunities look less attractive or that I view that there's fewer and to increase the return to shareholders at that point.
So we are watching that really closely and thinking about that a lot. Right now, I believe there are still a number of opportunities that we are looking at both small, medium and larger acquisitions, partnerships, et cetera. But, again, we are evaluating that each quarter, not a year, but each quarter to see if that remains true.
No, I appreciate that. I'm not trying to hold you to a strict deadline, but it would just seem like a year from now, we're sitting here by then with net cash, the tax policy change has made M&A, in a way, even easier. I'm just making sure though if something doesn't happen in 12 months, are we looking at off-highway markets that might have a couple of year run in them, but on-highway, maybe domestic getting a little harder to see growth and we're still just sitting there with a great balance sheet, but we're not using it, what's really the value creation, right? So...
Okay. I definitely appreciate the thought.
I'll follow-up with the incrementals. David, I think there's something wrong with the numbers maybe.
All right.
(51:58) but I think we're above 30% incrementals on the base here.
Ex the JV, right?
Yeah.
Thanks, David.
Great. Thank you.
Thank you. And our next question comes from the line of Jerry Revich with Goldman Sachs. Your line is now open.
Hi. Good morning, everyone.
Hi, Jerry.
Tom, can you talk about where we are in the Electrification investment cycle? So, really appreciate the disclosures on $60 million to $80 million in investment in 2018. How should we think about the investment curve into 2019? Does that need to head higher? Can you just calibrate us the same way you did on the Eaton joint venture, on when does an investment peak, effectively?
Yeah. So right now, as we talked about, Jerry, we're thinking about – again, we are estimating. There's a lot of work to figure out here, but we're estimating about $500 million over three years. So, obviously, $60 million to $80 million, we'll have to ramp a little further to make $500 million over three years. But, again, we've got them split into those buckets where we're going to have to make investments to launch our current products. So we understand that investment schedule really, really well. And yet that will continue to ramp until the launch. And then we also understand the investment we're making in terms of new market development and some of the ranges beyond the bus market and other urban transportation markets.
The part that's a little less certain is where do we want to invest organically, where do we want to acquire or partner to add capabilities? Because you may remember from the investor conference, the capability we're trying to build up is to make sure that we have electrified powertrains as well as diesel and natural gas powertrains for the range of potential users plus we have component technologies that allow us to differentiate our overall system and to help our customers develop their systems plus service and support capabilities in our Distribution network so that we can build a profitable return model in each of those technologies as well as create advantage for our customers. That's the investments we're trying to make.
So there is going to be some combination of organic partnerships and joint ventures. And as you guess, some of those will be lumpier and a little bit harder to predict. But, nonetheless, $500 million is our estimate. We feel like it's pretty well grounded but there'll be some variation around it and the ramp-up is less clear in some of those lumpier investments.
And just to add one point there, Jerry, the $500 million is the cash number over the three years as we said at Analyst Day, so you're not going to see a tripling of the annual expense. There may be some increase next year, but the cash outlay could include some inorganic is still the same, $500 million over three years, about 40% operating expenses over the three years.
Okay. Thank you. And Rich, on the North America truck market, can you just provide us on the platform release schedule? How is the 12-liter looking? And Volvo, you folks have won increased specification last year, what's the timing of that ramp? Can you just flush that out for us?
Okay, yes. So the X12, which again is pretty geared to the vocational market and regional whole market, we're going to be late 2018 before we come to market and working our schedules with OEs. That's about a year behind what we said before. We're still excited about it. With the 15 liters, it was really only have completed half of that market. And so this will give us a shot, kind of at the low end of the 13-liter side and it's a big weight advantage. And so we got a lot of customers calling for it. We've got to work out the schedules and deals with OEs but it's got an 800-pound advantage, and so – where that's important and we remain optimistic and excited about that, but about a year behind what we've told you before. So not being really material until 2019, just beginning to ramp up. And did you have a second question?
Yeah, Rich, the 15-liter on Volvo be given the platform release?
Yes. So, no – so we're engineered in. I'd say the take has been slow to-date and so I'm excited we got another offering – it will be exclusive in there, but the uptake is going to take a little bit of time, I think.
Jerry from that point, on the Volvo side, this is an opportunity for both Volvo and Cummins I think to grow share. But, just honestly, the fact is that Volvo worked for many years to make sure they were a sole powertrain provider, and so they're not only as the offering side, but there's the whole adjustment of our two organizations to get in the business of selling their trucks with our powertrain, and that's been pushing and pulling new operation.
Sometimes, we're going good, and other times, we're not going good, but our two organizations really are relearning how to do that well, and I think that's creating some of the weakness, moving slower than both of us would like. But there is commitment and I think both of us feel like this is an opportunity for both the companies to increase their market participation.
Okay. And just a clarification if I may on the X12, Rich, what's driving the year later schedule? Is that a function of how good the market is so it's tougher to get engineering resources or product performance? Can you just comment on that?
I think it's – quite all of those things factored in. There's not a single piece that I think, if doing the engineering work and building it into schedule is still there, plus we did a little extra work on the engines. So it was a bit of our delay and a bit of working out the schedules with DOE. (57:52)
Thank you.
Thank you very much
Thank you. And our next question comes from the line of Andy Casey with Wells Fargo. Your line is now open.
Thanks a lot. Good morning, everybody. Can you – I don't think you covered this, but can you provide a little bit more detail on product coverage costs as a percent of sales in Q4? And then, separately, what level of coverage costs is embedded in the 2018 guide?
Yes. So Q4 came back down into a more normalized level, and the 2.3% is where we finished up in the quarter. So full-year 2017, it was 3.1%. Within the guidance for 2018, we are assuming 2.4%.
Okay, thanks Pat. And for this yet to be determined whether you're going to take incremental warranty mid-year or what that obviously has yet to be determined, but where is that work being done? Is that being done on the Engine side or is it in the Components side?
It is being done jointly as you can imagine. So it's really looking at the whole system, so both teams are jointly working on that.
Okay. Thank you very much.
Okay. Thank you very much everybody. We'll be available for your questions later. Thank you very much.
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.