And now it's my pleasure to turn the call to the VP of Financial Operations, Mr. Mark Smith. Please go ahead.
Thank you. Good morning, everyone, and welcome to our teleconference today to discuss Cummins results for the second quarter of 2017. Participating with me today are our Chairman and Chief Executive Officer, Tom Linebarger, and our Chief Financial Officer, Pat Ward. We'll be available for your questions after our 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 Exchange Act of 1934. Such statements express our forecasts, expectations, thoughts, beliefs, and intentions on strategies regarding the future. Our actual future results could differ materially from those projected in such forward-looking statements because of a number of risks and uncertainties.
More information regarding such risks and uncertainties is available in our forward-looking disclosure statement in our slide deck and our filings with the SEC, particularly the risk factors 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 webcast presentation are available on our website at cummins.com under the heading of Investors Media. Now I'll turn it over to Tom.
Brilliant. Thank you, Mark. Good morning. I'll start with a summary of our second quarter results and finish with a discussion of our outlook for 2017. Pat will then take you through more details of both our second quarter financial performance and our forecast for the year. Revenues for the second quarter of 2017 were $5.1 billion, an increase of 12% compared to the second quarter of 2016, due to stronger demand for trucks and construction equipment in North America and China and improving orders from customers in mining and oil and gas markets. EBIT was $620 million, or 12.2%, compared to $591 million, or 13.1%, a year ago. EBIT decreased as a percentage of sales and was below our own expectations, primarily due to higher warranty costs.
Variable compensation costs also increased both year-over-year and versus the first quarter as a result of our improved outlook for full-year earnings. Warranty costs were 3.7% of sales in the second quarter, up from 2.2% a year ago. Two unrelated issues caused most of the increase. In our Power Systems segment, engine testing at our manufacturing plant identified a component quality issue that may impact engine performance. Although no performance issues have yet occurred in the field, we are taking actions to protect our customers, and we recorded a $31 million charge to reflect the estimated costs of the campaign. Secondly, we experienced higher warranty claims associated with late-life components in on-highway applications in North America that caused us to increase our warranty reserve by $36 million for products delivered in 2012 and 2013. This additional charge primarily impacted the Components segment.
We've made significant improvements to the quality of our products, and especially in our new product launches. Cummins products are performing at record levels of reliability, and our market share reflects that strong performance. On the other hand, the complexity of our products have increased significantly to meet tough emissions regulations. Customer expectations have also increased, and the environments where our products are used are more demanding than ever. Thus, we are redoubling our efforts on improving product quality and developing new techniques using telematics and big data to complement our existing quality tools. We expect to resolve the specific quality issues we experienced this quarter quickly, and we expect warranty costs to decline as a percent of sales by 50 basis points in the second half of the year.
Engine business sales increased by 15% in the second quarter compared to a year ago due to higher industry truck production and growth in our market share. We also experienced strong growth in demand from construction OEMs in China and North America. EBIT for the quarter was 12% compared to 10.3% for the same period in 2016. Benefits from higher volumes and stronger joint venture earnings in China and the absence of a loss contingency charge recorded a year ago more than offset higher variable costs and warranty costs. Sales for the Distribution segment increased by 12% year-over-year, resulting from 6% organic growth net of currency and an additional 6% increase resulting from the acquisition of the last remaining distributor joint venture in North America in the fourth quarter of last year.
Stronger parts and service revenues in oil and gas and mining markets in North America and higher parts sales in China showed the improvement in organic revenues. Second quarter EBIT was 5.6%, flat compared to the second quarter of 2016, as the benefit of higher sales were offset by higher variable compensation costs. Second quarter revenues for the Components segment increased by 14%. International revenues increased by 25% due to strong growth in truck demand in China and the sale of new products in India to meet the Bharat Stage IV emissions regulations introduced in April this year. EBIT for the second quarter was 13.1% compared to 14.9% in the same quarter a year ago. The benefit of the higher volumes and material cost reduction programs were more than offset by the increase in warranty costs that I discussed earlier.
Power Systems sales increased by 10% in the second quarter, primarily driven by an increase in engine and parts sales to mining and oil and gas customers. EBIT in the second quarter was 6% compared to 9.8% a year ago. The primary driver of the lower EBIT margin was the accrual for the estimated cost of the quality campaign. The business also experienced an increase in commodity costs and higher variable comp costs associated with the company's improved outlook for the full year. Excluding the campaign and some additional one-time costs, the business is operating at approximately 10% EBIT margin. With improving market conditions in some key markets and the benefits of our U.K. manufacturing restructuring still to come in 2018, we are confident that we will see a significant step up in profitability in the coming quarters.
Now I will comment on the performance in some of our key markets for the second quarter of 2017, starting with North America, then I will comment on some of our largest international markets. Our revenues in North America improved 13% in the second quarter, primarily due to higher levels of industry production and increased market share in our highway markets. We also experienced growth in sales of engines and parts to customers in construction, oil and gas, and mining markets. Industry production of North American heavy-duty trucks increased 4% in the second quarter of 2017, while sales of our heavy-duty engines increased 16% due to higher market share at 32%, up from 29% a year ago. Production of medium-duty trucks increased 15% in the second quarter, while our engine shipments increased 27% as our market share improved 600 basis points, reaching nearly 80% in the quarter.
Total shipments to our North American pickup truck customers increased 6% compared to a year ago due to strong demand from FCA. Engine sales for construction equipment in North America increased 31% in the second quarter compared to a weak quarter a year ago, with some OEMs optimistic about the prospects for increased infrastructure investment. Sales of engine shipments to high-horsepower markets in North America increased 147% compared to a very weak quarter a year ago, driven by higher sales to oil and gas customers. Revenues for Power Generation showed little change from weak levels a year ago, with shipments of mobile generators for recreational vehicles helping to offset lower military sales. Our international revenues increased by 11% in the second quarter of 2017 compared to a year ago.
Second quarter revenues in China, including joint ventures, were $1.2 billion, an increase of 28% due to continued strength in truck and construction markets. Industry demand for medium and heavy-duty trucks in China increased by 46% compared to a year ago, and our market share for the quarter was 14%, slightly below the level a year ago, reflecting a mix shift in industry sales to dump trucks in which we have a lower share of the market today. Penetration of our products with our key OEM customers remains very strong. Shipments of our light-duty engines in China increased by 35% above the overall increase in the market of 10%. Our market share rose by 150 basis points from a year ago to more than 8% as we continue to displace local competitors from Foton's vehicle lineup.
Chinese industry demand for excavators in the second quarter increased 102% from a year ago, reflecting a rebound in construction activity. Our shipment of engines to construction customers across all equipment categories increased 125%. Revenues for our Power Systems business in China increased 4% due to higher demand from mining and rail customers. Second quarter revenues in India, including joint ventures, were $431 million, a 5% increase from the second quarter a year ago. Revenues for Power Generation equipment increased 6% and sales of construction engines increased 25%, reflecting growing investment in infrastructure. Industry production of trucks in India decreased 25% year-over-year following the introduction of the Bharat Stage IV emissions regs in April. In Brazil, our revenues increased by 16%, primarily due to an increase in truck production in the quarter and the appreciation of the Brazilian real.
Now let me provide our overall outlook for 2017 and then comment on individual regions and end markets. We are now forecasting total company revenues for 2017 to be up 9%-11%, higher than our previous projection of up 4%-7% due to stronger demand in on-highway and construction markets in both North America and China and improving orders from global mining customers. We have raised our forecast for industry production of heavy-duty trucks in North America to 205,000 units, up 2% compared to 2016 and above our prior forecast of 195,000 units. We expect our market share to be above the midpoint of our prior projection of 29%-32%. In the medium-duty truck market, we have raised our outlook for the market size to 115,000 units, an increase of 6% compared to 2016 and 2% higher than our previous forecast.
We now expect our market share to be at the top end of our prior forecast of 73%-75%. Consumer demand for pickup trucks in North America remains strong, with our full-year shipments of engines expected to increase 5% above our previous projection of 1% growth. In China, we expect full-year domestic revenues, including joint ventures, to grow 26% compared to our previous projection of a 3% increase. Revenues for the second half of the year are expected to decline by approximately 20% compared to the first half, reflecting an easing in demand for trucks and typical seasonality in construction markets.
Industry sales of medium and heavy-duty trucks are expected to reach 1.25 million units, a 28% increase from last year and higher than our previous forecast of 1 million units, driven in part by demand resulting from the introduction of regulations last year aiming at curbing overloading. We expect truck market to grow 3% in 2017, unchanged from our previous guidance. Our market share in the medium and heavy-duty truck market in China is expected to be 15%, flat with 2016. In light duty, we expect our share to exceed 8%, up from 7% in 2016. We currently project revenue from all off-highway markets in China to grow by 15%-20%, up from our previous guidance of 10%-15%.
In India, we expect total revenues, including joint ventures, to be flat to up 3% year-over-year, with a 5% increase in off-highway demand and growth from new product sales in our Components business, partially offset by a 12% decline in truck production. In Brazil, full-year truck production is projected to increase 10% in 2017 compared to a very weak 2016, when the industry experienced the lowest level of truck production in more than a decade. We expect our global high-horsepower engine shipments to increase more than 30%, up from our prior forecast of 10%-15% growth as demand from mining customers continues to strengthen. Engine demand from oil and gas customers in North America has exceeded our previous expectations for this year. Although visibility into 2018 remains limited. In summary, we have raised our full-year outlook for sales to increase 9%-11%.
We have maintained our forecast for EBIT to be in the range of 11.75%-12.5%. Comparing second half to first half performance, we expect lower warranty costs in the second half of the year, balanced with weaker demand in China, targeted investments in critical new technologies, and some risk from higher commodity costs. With improving demand in a number of important markets, our leading market share and strong operating performance, we remain very confident in the future earning power of our business. During the quarter, we returned $241 million in cash to shareholders in the form of dividends and share repurchases and also announced a 5.4% increase in our quarterly cash dividend, consistent with our plans to return 50% of operating cash flow to shareholders in 2017. Finally, we announced earlier today that we have formally closed our deal with Eaton to form the Eaton Cummins Automated Transmission Technologies joint venture.
We are excited about working with a capable partner to offer customers leading technology in both automated transmissions and now fully integrated powertrains. Rising demand for automated transmissions around the world should drive growth for the joint venture and opportunities for our customers and partners. Now let me turn it over to Pat.
Thank you, Tom, and good morning, everyone. I will start with a review of the company's second quarter financial results before discussing the performance of the four operating segments in more detail. I will then provide an update on our outlook for the remainder of the year. Second quarter revenues were $5.1 billion, an increase of 12% from a year ago, with sales increasing in each of our operating segments, primarily driven by stronger demand in global on-highway, construction, mining, and oil and gas markets, partially offset by continued weakness in Power Generation markets. Sales in North America, which represented 58% of our second quarter revenues, improved by 13% from a year ago due to increased sales of engines and Components to meet higher levels of heavy and medium-duty truck production and increased demand in industrial markets.
International sales improved by 11% from a year ago, primarily due to increased sales in China, India, and Russia, partially offset by declines in the Middle East and in Africa. Gross margins were 24.6% of sales, which declined from 26.4% a year ago, primarily due to the higher warranty and variable compensation expenses, which more than offset the benefits from stronger volumes and material cost reduction initiatives. Selling, admin, and research and development costs of $770 million or 15.2% of sales increased by $91 million, an increase as a percent of sales by 20 basis points from last year, mainly due to higher variable compensation expenses and increased investments from new products. Joint venture income of $98 million increased by $10 million from last year, primarily due to increased demand in China for both on and off-highway equipment.
Other income and expense improved by $18 million due to a gain on a fixed asset sale and higher royalty income. In the second quarter of 2016, we had a $39 million charge for the lost contingency that did not repeat this year. Earnings before interest and tax was $620 million or 12.2% of sales for the quarter, compared to $591 million or 13.1% a year ago. EBIT as a percent of sales declined primarily due to the increased warranty expenses in addition to the higher variable compensation expense. Net earnings for the quarter were $424 million or $2.53 per diluted share, compared to $406 million or $2.40 a share from a year ago. The effective tax rate for the quarter was 26.4%, in line with the full-year guidance of 26%.
Moving on to the operating segments, let me summarize their performance in the second quarter, then I will review the company's revenue and profitability expectations for the full year and conclude with some comments on cash flow. In the Engine segment, revenues were $2.3 billion in the quarter, an increase of 15% from last year due to a 14% increase in on-highway sales, driven primarily by increased global truck production and from strong demand for engines for construction equipment in both China and North America, which drove a 20% increase in off-highway revenues in the quarter. Segment EBIT in the second quarter was $277 million or 12% of sales, and this compares to $206 million or 10.3% a year ago.
Earnings increased as the benefits from higher engine and parts sales, material cost reduction initiatives, stronger joint venture earnings in China, and the absence of the loss contingency charged recorded a year ago, more than offset higher variable compensation and warranty costs. We now expect full-year revenues to be up 10%-12% compared to our previous guidance of up 2%-6% due to improved outlook in most markets. Our forecast for EBIT margins is to be in the range of 10.5%-11.5% of sales, an increase compared to the 10.25%-11.25% that we provided before. For the Distribution segment, second quarter revenues were $1.7 billion, an increase of 12% compared to last year. Organic sales for the quarter increased by 7%. Revenue from the acquisition completed in the fourth quarter of 2016 added 6%, and this was partially offset by 1% unfavorable currency impact.
The EBIT margin for the quarter was $96 million, an increase of 10% from last year, and remained flat at 5.6% of sales due to higher variable compensation costs offsetting the benefits of volume growth. For 2017, Distribution revenue is now projected to increase 9%-11% compared to our previous guidance of up 4%-8% due to strengthening off-highway demand for engines, parts, and rebuilds. We are forecasting EBIT margins to be in the range of 5.75%-6.25% of sales, slightly lower than our previous guidance of 6%-6.75%. For the Components segment, revenues were $1.5 billion in the second quarter, a 14% increase from a year ago, and a quarterly record.
International revenues increased 25%, primarily due to a 47% increase in sales in China and the first sales of new after-treatment systems in India to meet the new emission standard that was introduced in April. Sales in North America increased 6% due to higher heavy and medium-duty truck production. Segment EBIT was $190 million or 13.1% of sales, compared to 14.9% a year ago. An increase in warranty expense recorded for the change in estimate for the prior model year after-treatment products was the primary driver of the margin decline. In 2017, we now expect revenue to increase 13%-15% compared to our prior guidance of up 6%-10%. The change in guidance is the result of stronger truck demand in China and improvements in the North American truck market.
EBIT is projected to be in the range of 13%-13.5% of sales, compared to 12.5%-13.5% in our previous forecast. In the Power Systems segment, second-quarter revenues were $1 billion, an increase of 10% from a year ago. Mining revenues increased 50%, and oil and gas revenues more than tripled compared to the same quarter a year ago. While Power Generation sales declined by 5% due to weak demand in the Middle East and in Africa. EBIT margins were 6% in the quarter, down from 9.8% last year, primarily due to the higher warranty expenses recorded for the quality campaign, as well as an increase in commodity costs and higher variable compensation costs associated with the company's improved outlook for the full year.
For 2017, we expect Power Systems segment revenues to increase 8%-10% versus our prior guidance of up 1%-5%, with stronger demand in industrial markets, particularly in mining and oil and gas markets, driving the improvement. EBIT margins are expected to be between 7% and 8% of sales, unchanged from our previous guidance. For the company, we are raising our outlook for revenues to be up 9%-11% versus the previous guidance of up 4%-7%. The increase is primarily due to stronger demand in Chinese construction and truck markets and an increase in our outlook for truck production and higher demand from oil and gas customers in North America.
Foreign currency headwinds are expected to reduce revenues by approximately $100 million, which is a smaller impact than previously forecasted, primarily due to the euro and British pound strengthening against the U.S. dollar over the last three months. Income from our joint ventures is now expected to increase by 12% in 2017 compared to our previous guidance of flat. Stronger demand in China is driving the year-over-year growth and earnings and is expected to more than offset the reduction in income from the consolidation of the last remaining distributor in the fourth quarter of 2016. We expect EBIT margins to be between 11.75% and 12.5% of sales for 2017, unchanged from our previous forecast due to the higher-than-expected warranty costs offsetting the benefit of higher volumes. This compares to 11.4% last year. Looking ahead to the second half of the year, warranty costs will come down.
However, the benefit from this will be offset as we do expect to see weaker demand in China, an increase in commodity costs, as well as an increase in targeted investments in critical new technologies. The revenue and earnings guidance provided today does not include the impact from the Eaton Cummins joint venture. We are still in the process of completing the purchase accounting associated with our investment in this new venture, but we do not expect the joint venture to have a material impact on the company's financial results in 2017. We will provide an update on our third quarter earnings call. Turning to cash flow. Cash generated from operating activities for the second quarter was $447 million, bringing the year-to-date total to $826 million, a 12% increase from the same period last year.
We anticipate that operating cash flow for the full year will be within our long-term guidance of 10%-15% of sales. Capital expenditure during the quarter was $101 million, bringing the year-to-date total to $182 million. We still expect that investments will be in the range of $500 million-$530 million for the full year. In the second quarter, we returned $241 million to shareholders through dividend payments and share repurchases. For the first six months of the year, we have returned $463 million. We continue to demonstrate our commitment to shareholder returns with the recent 5.4% increase in our quarterly cash dividend, which is part of our plan to return 50% of operating cash flow to shareholders this year.
Although we were clearly disappointed with the increase in product coverage costs in the second quarter, we are encouraged with the progress made so far in our overall performance. With sales up 10% compared to the first half of 2016, EBIT up $111 million or 10% higher, and earnings per share up 15%. Markets are returning, as you can see from the increase in guidance across all four segments, and we believe we are well prepared to meet customer demand as market conditions continue to improve. Finally, I would like to announce that we will be holding our Analyst Day on November the 16th in Indianapolis, Indiana. Invitations to this event will be sent out in the middle of August. Now let me turn it back over to Mark.
Okay, we're now ready to move to the Q&A section of the call.
Thank you. Ladies and gentlemen, to get into the queue, just press star and the number one key of your touchtone telephone. If your question has been answered or you wish to remove yourself from the queue, press the pound key or hash key. Again, to ask a question, just press star and the number one. To prevent any background noise, place your line on mute once your question has been stated. Our first question is from the line of David Raso from Evercore ISI. Your line is open.
Hi, good morning. My question's on trying to think about incremental margins year-over-year on a segment basis. If you pull out the warranty cost for 2Q, it implies the incrementals were about 15%-16%. Still not fantastic. When you look at the implied second half at first blush, it feels better. It looks like 24%-25%. But actually, if you go back to the third quarter of last year and pull out that big loss contingency, it implies the second-half incrementals this year are still only 14%. I know a lot of puts and takes, given all the different parts of your company. Big picture, Tom, how should we think about the company's incremental margins as we try to model beyond 2017?
David, let me take the first shot at that, and then Tom can jump in with the long-term outlook. In the second half of the year, the one other factor that is impacting the margin improvement is the increase in variable compensation costs. Compared to last year, we're performing much better on a full year basis. As a result of that, we will be incurring significantly more higher variable comp accruals in the second half of the year than the second half of last year. For the full year, all in, we're still looking, even with that higher variable comp, at somewhere around a 20% incremental EBIT margin at the midpoint. To your point, we don't have the loss contingency that we recorded last year. We do have much higher variable compensation costs this year.
I will let Tom speak for himself in a second, but I do not think our thoughts on our long-term incremental margin targets have changed at all. We have said 20% for some time, and I think we remain committed to that.
Yeah, that is right. The variable compensation cost thing does normalize. What we have is when we are performing worse than planned because markets negatively surprise us, we have lower variable compensation costs, which bolster our financials. When things bounce up faster than we expected, the reverse occurs. But in the end, they work themselves out. I just agree with Pat's point of view. We feel like the earnings power of the company remains the same, and we still think 20% incremental margins is what we are capable of and what we are demonstrating when we pull out these kind of one-time or unusual period costs. We feel just as strong as we ever did about that.
All right. Thank you.
Thank you. Our next question is from the line of Adam Uhlman with Cleveland Research. Your line is open.
Hi, good morning, everyone.
Morning.
I was wondering if we could start with the quality and the warranty costs. First of all, could you talk through, is there any likelihood of recovery from any suppliers that might have been involved in this, or is this all Cummins Components specifically? Secondly, related to that, if you could just spend some time about what process changes are underway to reduce the likelihood of these expenses going forward.
That's great. I'll take that one, Adam, and let me start with the second question first. As I mentioned in my remarks, we've made a lot of improvement in quality, especially related to new product launches, and that has dramatically improved reliability of products over the last several years, and our products are performing well in the market as a result of that. Also, as I mentioned, the complexity of products continues to increase. They're in many new markets like China and other markets where the use of the product is really demanding and used in various ways. What we're trying to do is utilize the benefits of data we're getting from our telematics system to begin to use new methods to improve quality of products, both at launch, but also in longer mileage situations.
Because again, expectations of performance of these products over sustained periods of time has gone up by customers. I think that's normal for every industry. So we've got to have the ability to maintain quality over a long period of time, and again, over multiple owners and multiple applications. So that's where we're using a lot of this new data with new techniques to mine that data and correlate that data with how products perform in the field. Again, this is not new. We've been working on that for some time, but we now have some pretty useful tools we think we can apply to our quality efforts, and we need to do that. That's what I was mentioning in my remarks. With regard to supplier recovery, it is an area of focus for us.
In the specific quality issues we had the second quarter, we do think there's some potential for supplier recovery. But right now what we're focused on is improving the situation for customers, making sure there's no negative impact on customers, getting the products right. Again, we just feel like we're in a really strong position with our products in terms of how they're performing, and of course, that's showing up in market share. So we want to make sure we get that right, get the issues behind us and move on, and then we'll deal with the supplier recovery issues.
Okay, so the supplier recovery isn't embedded within your expectation of improvement in warranty expense in the second half. That's just—
Yeah, we have nothing assumed within that 50 basis point improvement number that you have for any supplier recovery in the second half.
Okay, thank you.
Thank you. Our next question is from the line of Steven Fisher with UBS. Your line is open.
Hey, good morning, guys. This is Cleve Rueckert on for Steve. Just looking at your markets, how would you compare the potential for continued strength in oil and gas versus mining? Do they both have the same potential, or does one market give you more visibility? Which one do you think would have a bigger impact on Cummins?
Mining seems to be demonstrating a more sustainable improvement path. We have more visibility to it also based on the number of OEMs we serve and our participation in the market, we have more visibility. Again, right now we don't have long visibility in mining. We don't know where it reaches relative to previous peaks or anything, but it looks like it's on a relatively sustained recovery. Of course, we're experiencing some of the reasons for that in our commodity costs. We're seeing higher commodity costs coming in as costs, which again says that that's more favorable conditions for mining. So we're seeing some benefit on revenue and some hit on costs. On the oil and gas side, I'd say we don't see that. First of all, we have less visibility, but secondly, in fact, we're seeing and hearing more conservatism in that market.
We saw a lot of rebuilds, a lot of redeployment of products, but we didn't see so much new equipment being built and going out in the markets. What we're hearing is that people wanted to get things redeployed, but there's not a lot of growth in equipment yet. That doesn't mean it won't come, but right now I think the market's kind of leveling off at best is kind of what we're hearing. Again, there's other people that may be closer and be able to give you more data, but that's what we're hearing.
And then just—
Okay.
Mining's about 5x to 6x the size of our oil and gas business, even on current depressed levels.
Okay, that's helpful. Thank you. Then I guess, just bigger picture going over to some discussion that's been ongoing recently. Can you give us a sense of the relative content or profitability in an electric bus versus a diesel bus?
Yeah. I've actually heard that question a fair number of times too, and we will, by the way, be talking in our Analyst Day a lot more about our electrification efforts, including kind of what parts we intend to participate in. But clearly, we don't know yet. There's essentially none sold, and those that are sold are ones and twos in their prototypes, so we don't really know what the profitability is going to be like. But let me just say two or three words about how we're thinking about it. We believe that the segments in the market that we serve, some will find electrified powertrains to be advantageous in the next five or 10 years. Some will not. So we don't think that all the markets are going to move.
We think they're going to move in phases, and some will move relatively soon to at least try some. Bus is what you mentioned is one of the areas that we'll see some activity in buses relatively soon, and that we intend to provide a fully electrified powertrain as well as hybrid or range-extended powertrains. We also intend to electrify some of the auxiliaries on our diesel engines and natural gas engines. We will be active in the market, and we will approach the problem in the same way that we've approached other power solutions problems. We'll look from the customer's lens, try to figure out what their application is and figure out what the best technology to serve them is. In order to ensure profitability in those efforts, we'll make sure that we have a leading position, which means our technology provides customers with monetary advantage.
They get fuel economy benefits, they get cost reductions, they get other things of value to them, because that's how we maintain profitability. I don't think one technology is necessarily more or less profitable than the other. What creates profitability is advantage for customers and advantage versus competitors, and that's what we're going to seek.
Thank you guys very much.
Yep.
Thank you. Our next question is from the line of Jerry Revich with Goldman Sachs. Your line is open.
Hi, good morning, everyone.
Hi, Jerry.
I'm wondering if you could talk about the warranty guidance outlook. It looks like about 3% or so of sales in the back half of the year. I think that's well above the low 2% that you folks have targeted historically. I'm wondering if you've identified incremental products that have product coverage costs coming up in the back half of the year, or is this you folks getting recalibrated to the complexity issues that you mentioned? In other words, do you have discrete products that are driving that higher than historical targeted spend in the back half, or is that to provide room to execute?
Yeah. Let me start on that one, Jerry. First of all, warranty in the second half, we expect to be in the range of 2.7% of sales. We were 3.2% in the first half. So we're going to be 2.7% for the second half. So full year, somewhere around 2.9%-3%. As Tom indicated in his remarks earlier on, we're dealing with a lot more complexity than we ever have in the environments and conditions that these products have to perform in. While reliability is better and the number of failures is actually lower, the cost of failure is higher. So we continue to work away at that. We will redouble our efforts to make improvements in it. I think you will see an improvement as we go through the second half of the year.
We're clearly disappointed with what we've seen in the second quarter, and we know that's an area that we're going to have to go after and make significant improvements on.
It's worth saying that we are not recalibrating our target at all, Jerry. We are adding new tools to get to our target, but we still believe that we can reduce warranty costs significantly from where we are and do it in a way that improves customer performance and customer experience. So that's where we're targeted, so we haven't changed, and we still see the same kind of targets in reach that we did before, because we made improvements on our prior efforts. So we kind of took away a lot of challenges, and now we're facing new challenges. I think that's just part of being in a competitive industry.
Okay. Thank you. I'm wondering if you could talk about raw materials in the back half of the year. You folks have been working on reducing your materials spent through re-engineering. How much of an offset is that? What magnitude of raw material inflation, pure inflation, are you folks embedding in the numbers? Is it fair to assume you're using spot prices when evaluating that dynamic? Thanks.
Yeah. So for the first half of the year, Jerry, we benefited by about 0.7 percentage of a point in net material cost reduction. It was higher in the first quarter, a little bit lower in the second quarter. We expect that trend to continue through the second half of the year, and the second half of the year is currently forecast around 0.3 percentage of a point. So full- year, 50 basis points improvement over last year, but on a declining trend as we see an increase in commodity costs, in particular.
Thank you.
Thank you. Our next question is from the line of Jamie Cook with Credit Suisse. Your line is open.
Hi. I guess a couple questions on the back to the implied incrementals in the back half of the year again. You did note we got the warranty, we got China. You noted higher costs associated with investing in technology. Has that changed versus your original assumptions? Can you just tell me what that headwind is, as well as quantify the variable comp headwind in the back half of the year? My second question, actually, the implied incrementals in the Power Systems business are pretty healthy in the back half of the year, given that business has disappointed your comfort level there. My third question, Tom, obviously on M&A, there has been a lot of noise in the quarter with WABCO, with ZF.
I am just trying to get a sense of where your head is on potential for larger M&A with some of the other players in the space in play. Does that make you feel like you have to be a little more aggressive on the M&A front because other things could be happening? Thanks.
Thanks, Jamie. Let me start with the last one, because I think that is one we have talked about a couple times. The answer is there has been some conversation with WABCO. Of course, we paid close attention to that. We have continued with the same strategy on M&A. Sorry, it may sound a little boring, but same strategy we laid out at the investor conference, which is that we are going to be disciplined about ways to add value through both making sure that it drives profitable growth for the company and does so in a way where we can demonstrate returns over time. That, of course, means that not only do we have to find a strategy that makes one plus one equals three, meaning if we acquire something, it has to add up to something more than just the combination of the two things.
Secondly, we have to be able to do it at a cost to generate returns for our shareholders. As you get, that is a challenge. Having said that, we have been working on it for some time. We have some very good prospects. We are actively working on those. We feel confident that we will be able to make positive moves in the M&A and joint venture front, which will add value to the company. The size of that will depend on which of our projects succeeds. How big each one is. Frankly, we are not trying to make sure that we have a big one. We are trying to make sure that the combination of our organic growth, our joint ventures and partnerships, and our acquisitions add up to profitable growth and returns for our shareholders.
Whether that is in several acquisitions and joint ventures or in one or two is really not our main focus. It is a challenging environment. It turns out it is no easier to grow in a profitable, high-return way through acquisition than it is organically. They both take a lot of effort and serious-minded work, and that is the way we are approaching it. Let me now switch over. Pat, I think you wanted to say a couple of words about the increment.
Yeah, let me just try and answer Jamie's first question there. If I look at the Components that is driving the incrementals in the second half of the year, Jamie, I think the lower joint venture incomes in China, we expect to have about 50 basis point negative impact second half to first half.
Okay.
The higher commodity costs, around 15 basis points. On the technical investment question, that is around 25 basis points higher second half versus first half. On the variable comp, I do not have those numbers at hand, but it is probably in the range of 1.5% or 150 basis points higher than the second half of last year. I cannot give it to you versus the first half. Mark or Adam can follow up with you after that. In the second half of last year, our variable compensation factor was declining. The delta first half to first half versus second half to second half will look worse in the second half of this year. We can follow up afterwards and get you some more precision on that.
I think, Jamie, you asked too, have we changed our outlook on investment in critical technologies? There is no question that we are speeding up some of our investments in both electrification and Digital Accelerator, the sort of telematics effort. We talked about those earlier. We are definitely speeding up efforts. The reason we are doing that is we are noting that in some of the shorter distance markets, the urban markets, there is significant interest from our customers in electrified powertrains. Again, not for gigantic volumes this year, obviously. It is going to take us some time to get a product range out and ready, and we have heard from them, and people are interested. We are trying to make sure that our efforts are aggressive enough to make sure we meet customer demand there. That is what is happening.
It is not a huge amount, as Pat said, but it is an increase from what we were anticipating. With regard to the large. Go ahead. Do you want to talk about large engine market? I will close that, and then you can follow up on that. On large engines, we are feeling pretty confident about the mining growth. As the earlier question said, oil and gas, we are not expecting a lot of growth in the second half, but we are seeing continued strength in mining, which gives us confidence that we will continue to see some sales growth in the large engine markets and incremental margins there have been good, as we mentioned. I mean, we had some issues in the second quarter that we think were one-off related, but with regard to engine growth and incremental margins, we are feeling good about that.
Okay, that is helpful. I will get back in queue. Thank you.
Thanks, Jamie.
Thank you. Our next question comes from the line of Joe O'Dea with Vertical Research. Your line is open.
Hi, good morning.
Good morning.
First question on the North America heavy-duty market share. If you could just talk about the various drivers of that in terms of seeing the share come in in the first half of the year higher than the range you had given. The degree to which some of that is mix-related, as we see some mix shift within the industry. Otherwise, just in terms of preference for the engines, some new engines launched recently there. Just to kind of understand some of the outperformance versus initial expectations.
Yeah, I think a couple of things. We have seen a lot of variation as the industry has moved down in build rates through the first and second half of last year. You have seen a lot of volatility. I think we have settled in at more of a sustainable rate. I do not think we are seeing a mix shift in terms of engine displacement. We have not seen significant changes there. What you have seen, particularly, you have seen one of our customers picking up share that uses basically our largest customers picked up share using a combination of Cummins and their own engines, and that has really helped our position. You have got the domestic players picking up share.
Got it. On PowerGen, a competitor talking about some stabilization outside of Middle East. This is another quarter seeing some year-over-year declines. If you could talk about what you are seeing on the order front, maybe talk about it by region or by major kind of end market activity, just whether you have got any signs of some stabilization there, if orders are starting to look encouraging at all.
Yeah, it is a little choppy in some parts, but the areas that are most troubling are that Middle East. As you said, we were down over 30% Q2 versus a year ago. It has been very tough. Latin America, there is a lot of demand, but we still continue the first question marks about customer liquidity. The net sales are down there. We are seeing good growth in India, so it has been a while coming, but with infrastructure investment, we are seeing it not just in PowerGen, but in pretty much all of our Power Systems and construction markets. India will be up 5%-10% in PowerGen this year. U.S. is bumping along kind of low single digits. In the second quarter, we are seeing strong demand from smaller RV customers, less demand from the military. Pockets of data center spend still positive.
Overall in the U.S., I'd say low single digit positive. In Europe, it's kind of flattish in total with one or two large, big projects.
But I think it's fair to say that from a Power Systems point of view, we would not yet say we're at the bottom and stabilizing. It could be. But we're really looking for some quarter-to-quarter stabilization, infrastructure building rates, and things like that around the world before we would say, "Okay, now we expect things to consistently get better." A couple of times we thought we were at the bottom and stabilizing, and then things got a little bit worse. So I guess we'd like to see a few more quarters in the Power Systems space to say that.
Got it. Appreciate the details.
Yep.
Thank you. Our next question comes from the line of Ann Duignan with JP Morgan. Your line is open.
Hi. Good morning, guys.
Morning, Ann.
Morning. A lot of my questions have been answered on the detailed questions. Maybe could get some thoughts from you, more strategically on electric vehicles, where you think they will succeed, and then versus, we get a lot of questions, electric vehicles, autonomous. Where do you see the opportunities, where do you see the threats for both, and do you think autonomous is a reality in trucking at all?
Well, again, we'll spend a fair bit of time on this in the Analyst Day in Indianapolis. I hope you can join us for that. Given the time, I'll make my remarks brief. Let me just say that I think both autonomous vehicles, if we mean not fully autonomous, but using autonomous technologies are certainly going to be a reality in the trucking market. Just as we've seen in car markets, we'll see safety systems come in very quickly and already we're starting to see those, and those will increase and offer more opportunities for customers in places like yards and ports and places where they want to control how vehicles move around, those could provide significant value to customers. Over what period of time those will become economically viable and how many customers will buy them, that's sort of the charge ahead.
But you know, just by the investments that people are making in the truck market, that technology is moving and people are definitely going to find ways to implement that technology and to try to figure out how to add value for customers. I think the same is true on electrified powertrains. What electrified powertrain looks like in different applications, as I mentioned earlier, remains to be seen, but it will be driven by how the customer can best operate their application. So in places where things go out and back and relatively been at miles, carry loads that are not so heavy, then things like fully electrified or range extended electrified can make sense, and especially in urban environments where they are trying to reduce noise pollution and fueling. So those are all things that they care about. Electrified powertrains can provide a solution that meets multiple objectives.
I believe that cities will be pushing for solutions like that, which will mean they will show up in those areas, and I think it will happen in five years or so. We will start to see some of those buses and pickup and delivery vehicles with electrified powertrains. The question is how many and how many cities really can afford to replace that many of the fleets. That will depend on a lot of different factors. So I think it is coming. Both of these technologies are coming, and it will be while we are still sitting here working on it. The question is in what volume and how many applications, and a lot of that is playing out right now. As you heard from me, Cummins intends to be in the middle of those technologies, especially electrified powertrains, because we think we understand customer applications.
Okay. Thank you. Any lessons learned from natural gas and, we have seen new technologies come and go previously, but anything you have learned from prior tech—
It is a great question, Ann, and there is many, but let me just put the one out there, which is that infrastructure takes a long time to build. The more that your technology depends on common infrastructure or things like it, the less likely it is to occur quickly. The more that local infrastructure or customer purchases can allow you to use the technology, the more likely it is to succeed, at least in a shorter timeframe.
Cool. Good. Thank you. I will get back in queue and—
Yeah.
—see you in November.
Thank you. Our next question is from the line of Andy Casey with Wells Fargo Securities. Your line is open.
Thanks a lot. Good morning, everybody.
Morning, Andy.
Just a quick question on what you're seeing in North American truck Class 8. Are you seeing any mix shift to the heavier engines than you realized in the first half?
Not significantly, Andy. Shares are a little bit stronger in the second quarter. We've seen pockets of vocational customers renewing, and they have a strong preference for that 15 L, that I think that's certainly helped in the first half of the year. On the line haul, no big shifts.
Okay. Thank you. A lot of the questions have been answered.
Thanks, Andy.
Thank you. Our next question comes from the line of Stephen Volkmann with Jefferies. Your line is open.
Hi.
Thank you, Steve.
Quick question, a couple quick follow-ups. I am just trying to think about the cadence of a couple of these issues. Do you think the warranty expense will be lower in 2018 than it was in the second half run rate of 2017?
Yeah, I think it should be. Now we've got work to do to plan out 2018, but if we're going to finish the second half of 2017 at 2.7%, then back the comments that Tom was making earlier on, that is lower than where we've been for the last three or four years. I would expect it to be lower than that for 2018.
Okay, great. I would assume the incentive compensation expense would kind of go away, assuming you kind of hit whatever target you set for yourselves in 2018, so that would not be a headwind either.
Right. That's the idea. We set a plan out, which is based on what we think we can achieve and guidance we give, we set a plan out, and if we end up with that plan, then it pays out at a one, and that's what we put in the plan, so everything's as expected. If it's stronger, then we pay out more, and if it's weaker, we pay out less. To your point, we reset each year, and assuming we hit to the plan in 2018, then it would be one. Again, the surprise here is that sales growth happened faster than we thought, just as the surprise last year was things were lower than we thought.
Got it. You're basically telling me you always want to be paying out more.
No, I always want to be paying out what we planned.
All right, fair enough. On the flip side, I would assume that some of these investment costs, especially for technology-related things, will probably ramp up in 2018 versus 2017?
Yeah, we don't know that yet, but that's the way it's leaning. Again, what we're trying to do is make sure that we can deliver to customers on two broad new technology areas. One is to deliver much more value in telematics and other services that go along with engines and the vehicles that they operate. Secondly, to be able to make sure that we can be in the market in 2019 and across at least several applications in 2020 with electrified powertrains and range extender powertrains. So we will need to increase investments, especially in the electrified powertrain space over the course of the year. How much that is year-over-year, we'll see. But that is a reasonable expectation that those costs will ramp up.
Again, we're looking at how we structure that business to make sure that it looks like a long-term growth opportunity for Cummins shareholders.
Okay, and then just one quick sort of philosophical follow-up, Tom. I guess I'm trying to get a sense of how big a deal you think the alternative drivetrain market could be, because clearly there's going to be some competitors that are going to have fairly deep pockets, perhaps lower cost of capital than you, and certainly don't seem, in early days, always to be motivated by rate of return. Some of them even seem to be willing to set up infrastructure. Thank you for not doing that on natural gas, by the way. I'm just curious if this is one where you kind of feel like you have to go all in, or do you take a more measured approach going forward?
Yeah. Here's my view. It's not clear how big a deal it would be, and I think we talked a little bit about some of the reasons, and again, we'll talk more in November about that, but it clearly depends on how many of the customers these technologies actually give them a better deal. Right now it's pretty clear that in some buses it could. There's a whole bunch of other markets where it's not clear yet, especially because diesel continues to improve. Electrified trucks with diesel engines continue to improve. Light hybrids continue to improve. So there's a lot of technologies competing for the same space. I think you can expect from us that we will be all in the sense that we will lead in technology. We will not be all in the sense that we will not be building infrastructure.
We will not be betting on one technology. We'll be betting to serve customers better than others with a range of technologies where the best one is what they need.
Great. Thank you, guys.
Same return guidelines we use for everything, though. You can count on that.
Got it. Thank you.
Thanks, everybody. Adam and I will be available for calls later.
Ladies and gentlemen, this concludes our Q&A and program for today. We hope you have a wonderful day. You may all disconnect.