Earnings Call: Q2 2017

Jul 25, 2017

Summary

Q2 revenue was $4.7B and net income $373M, with record Parts results and 14.6% combined truck and parts gross margin. Higher Q3 deliveries and solid backlogs support the outlook, while currency remains the main margin headwind.

Good morning, and welcome to Paccar's second quarter 2017 earnings conference call. All lines will be in a listen-only mode until the question and answer session. Today's call is being recorded, and if anyone has any objections, they should disconnect at this time. I would now like to introduce Mr. Ken Hastings, Paccar's Director of Investor Relations. Mr. Hastings, please go ahead. Good morning. We would like to welcome those listening by phone and those on the webcast. My name is Ken Hastings, Paccar's Director of Investor Relations, and joining me this morning are Ron Armstrong, Chief Executive Officer, Harrie Schippers, Executive Vice President and Chief Financial Officer, and Michael Barkley, Senior Vice President and Controller. As with prior conference calls, we ask that any members of the media on the line participate in a listen-only mode. Certain information presented today will be forward-looking and involve risks and uncertainties, including general economic and competitive conditions that may affect expected results. I would now like to introduce Ron Armstrong. Good morning. Paccar reported strong revenues and net income for the second quarter of 2017. Paccar's second quarter sales and financial services revenues were $4.7 billion, and second quarter net income was $373 million, a 7.9% after-tax return on revenues. Paccar Parts achieved record quarterly revenues of $823 million and record pre-tax profits of $152 million. Paccar achieved excellent combined truck and parts gross margins of 14.6%, driven by higher North American truck deliveries, the strong European truck market, and the record Paccar Parts results. I'm very proud of our 24,500 employees around the world who have delivered outstanding products and services to our customers. Paccar delivered 39,400 trucks during the second quarter, 13% higher than the first quarter and 6% above last year's second quarter. Peterbilt and Kenworth raised build rates during the quarter in response to robust order intake this year. Looking ahead, Paccar expects 2%-3% higher deliveries in the third quarter compared to the second due to the higher build rates in all markets, partially offset by fewer build days in Europe due to the normal summer shutdown. Third quarter gross margins are projected to be comparable to second quarter margins. We've raised our forecast for Europe's above 16 ton market to a range of 290,000-310,000 units, reflecting strong demand and the steady economic outlook. Europe's GDP growth expectations for this year are 1.8% in the U.K. and on the continent. Freight transport activity on German highways year-to-date was at record levels and up 3.6% compared to the same period last year. During the second quarter, DAF introduced new model year 2017 XF and CF trucks, which deliver up to 7% higher fuel economy compared to the previous models. This contributed to DAF's 10% growth in above 16-ton orders in the first half of this year compared to the same period last year. U.S. and Canadian Class 8 truck industry retail sales are expected to be in a range of 200,000-220,000 units this year. Class 8 truck industry orders were up 44% in the first half of this year compared to the same period in 2016. Peterbilt and Kenworth Class 8 retail sales market share was an excellent 31% in the second quarter and 29.6% year-to-date through June. Customers appreciate the ongoing investments by Kenworth and Peterbilt in enhanced truck models, expanded Paccar powertrain options, and onboard technology. The U.S. economy's steady expansion is projected to be 2.2% GDP growth and 1.8% industrial production growth this year, supporting healthy freight levels. Paccar Parts' quarterly pre-tax income of $152 million was 14% higher than a year ago. Paccar Parts' quarterly revenues of $823 million were 9% higher than in the same quarter last year. These results were driven by the growing number of Paccar trucks and engines in operation, our outstanding logistics capabilities, which provide high parts availability to dealers and customers, and the growing number of TRP all-makes retail stores globally. Paccar Financial Services' second quarter pre-tax income increased 10% to $63 million compared to $57 million last quarter. The portfolio continued to perform well. U.S. Class 8 industry used truck volumes increased during the quarter. Kenworth and Peterbilt truck resale values continue to command a 10%-20% premium over competitors' vehicles. Paccar's strong balance sheet and positive cash flow have enabled the company to invest over $3 billion in new products and facilities in the last five years. This year, capital expenditures of $375 million-$425 million and research and development expenses of $250 million-$270 million are targeted for truck and powertrain product development, enhanced manufacturing and parts distribution facilities, and aftermarket support programs. We're pleased to announce the new Paccar Silicon Valley Innovation Center, which will open this year in Sunnyvale, California. The facility will coordinate next-generation product development and will identify emerging technologies for the benefit of future vehicle performance. The innovation center will develop exciting new technology applications for advanced driver assistance systems, artificial intelligence, vehicle connectivity, and augmented reality, complementing the research and development currently happening in Paccar's truck divisions and technical centers. Paccar looks forward to expanding its partnerships with the many innovative technology companies in Silicon Valley. We're very proud of our team at the Paccar engine factory in Columbus, Mississippi. Since opening in 2010, the plant has demonstrated its world-class diesel engine manufacturing capabilities and was recently named Quality Magazine's Plant of the Year. We are nearing completion of a $35 million investment in additional capacity at Columbus to support growing customer demand for the PACCAR MX-13 and PACCAR MX-11 engines. Paccar continues to enhance its leadership position in the global truck market by delivering the highest quality products and services in the industry. Thank you. I'd be pleased to answer your questions. As a reminder, ladies and gentlemen, if you would like to ask a question or if you have a comment, please press star followed by the number one on your telephone keypad. If you are on speakerphone, please pick up your handset before you register your question. Your first question will come from the line of Ann Duignan of JPMorgan. Hi. Good morning. Good morning, Ann. Can I just clarify the comments you made about higher deliveries quarter-over-quarter in Q3, because that would not typically be the seasonal expectation we'd have. Was that a North America comment, or was that total deliveries? Total deliveries are up 2%-3%, so the higher average build rates in North America, as well as in Australia, Mexico, and Brazil, are then offset by the seasonal summer shutdown in Europe. Okay. Thank you. That's helpful and good to know. There's nothing to suggest, given the level of backlog you have and given the orders that you have, there's nothing to suggest that daily builds would slow in Q4, is there? At this point, assuming the economy continues to tick along, we feel good about our build rates and maintaining those through the rest of this year. Okay. Then just as a follow-up, on the Financial business, can you talk about used values? I know you mentioned that, yes, you command a premium, but the premium could be off zero. So can you talk about used values and what you're seeing out there and whether we've really stabilized, or is there any downside risk still to used values? Yeah, I think in the second quarter, the values in Europe were very stable. In the U.S., down just slightly, but very comparable to first quarter levels. The amount of the used truck results in the second quarter were about $4 million better than the first quarter. Okay. I'll leave it there in the interest of time. I appreciate the color. You betcha. Your next question will come from the line of Jamie Cook of Credit Suisse. Hi. Good morning. Morning, Jamie. I appreciate your color on the gross margins for the third quarter. I think you said comparable to the second quarter. Yeah. Should we assume your margin forecast for the year is now up versus where you guys guided to last quarter just because of the run rate that we're at? I guess that would be my first question. Then I guess my second question, can you just talk about sort of the order board in the U.S. and Europe, how widespread it is in the U.S.? Are the big guys stepping in? Is it the small fleet? Just any color on where strength is coming from. Thanks. I think we talked earlier about a range of 14%-14.5%. I think we'll be closer to the upper end of that range for the full year. Okay. When it comes to demand, I think it's pretty broad-based, whether you look at vocational, you look at on-highway, you look at fleet, both small, mid, and large. I think it's a good cross-section. We've seen all the segments go up as we've progressed through the course of the year. Any color on the order board geographically, whether it's in Europe or the U.S.? Both are very solid. We're in good shape as we sit here today. The backlogs are strong. Okay. Thanks. I'll get back in queue. Sure. Thank you. Your next question will come from the line of Ross Gilardi of Bank of America Merrill Lynch. Good morning. Thank you. Good morning. I was wondering if you guys could talk a little bit more about truck margin. I know clearly that you saw some sequential recovery in truck margin, but you're still down on positive sales growth in truck only. Can you help us a little bit with the year-on-year bridge and specifically what's happened with pricing? It's really the primary thing impacting is currency movements, primarily the impact of the pound versus the euro and the peso versus the dollar. If you adjust for those, then they're very comparable. Got it. Okay. Can you say, did you experience any disruption in the European truck business due to bottlenecks in the supply chain or anything? One of your competitors was pretty vocal about that last week. No, we have not seen any impacts as a result of supplier disruptions at all. Suppliers are doing great. Got it. Thanks, guys. Thank you. Your next question will come from the line of Joel Tiss of BMO Capital Markets. Hey, guys. How's it going? Good. Really terrible quarter. We're getting bored from all these beats. I just wondered, I guess you guys got to stick with your strengths, right? We do what we do, and we try and do it well. I just wondered if you could give us a sense, has Brazil turned the corner? Is it profitable at this point? Any sense, maybe by 2020, to fuzz it up enough to give us some color, where do you think your market share could be? Well, the team has done a great job of building the business, and as we have progressed through the course of this year, we're going to take an additional build rate increase during the third quarter to support the increasing demand. The product is doing just extremely well in the market. Our dealers are continuing to invest and build their businesses in spite of a very difficult economy and difficult truck market. We feel like the investments that we've made will provide an excellent long-term return for our shareholders. We've been able to grow our share from zero up to 5% plus in the above 40-ton segment of that market. I think that pace of growth will continue to be an opportunity for our DAF business there as we progress through the next two, three, four, five years. Hopefully we could double that position in that timeframe. Oh, great. On the engine business, is the North American aftermarket starting to kick in, or is it still a little bit too early for that? No, I think the more engines, I think we're up to about 140,000 PACCAR MX engines in the park as we sit here today. We'll continue to increment that as we progress. It's progressing all the time. It's probably the single biggest growth area for the parts division in terms of the various segments of their parts business. Okay, great. Thank you so much. Thank you. Your next question will come from the line of Jerry Revich of Goldman Sachs. Hi, good morning, everyone. Morning, Jerry. I'm wondering if you could talk about your longer-term R&D outlook. In the press release, you spoke about all of the growth initiatives you folks are pursuing on the technology side. As you think about your R&D budget, should we be thinking about that moving higher as a percentage of sales off of 2017 levels, or is that just a change in prioritization versus other investments? How should we think about that? Yeah, we usually don't think about it as a percent of revenue. We think about it in terms of absolute dollars and how much we're investing to support what we see as our strategic direction for the next four or five years. I think what you'll see is maybe a steady, slight increase year on year as we continue to invest in the many things that we talked about with the advanced driver assistance systems, vehicle connectivity, continuing to build on the efficiency of our powertrain, adding powertrain options for our customers. I think it'll be pretty steady with a slight increase over time. In terms of the front axle production that you folks are highlighting is ramping up in Texas, can you just give us a timeframe of when you expect that facility to be at the full production rate? Based on the specifications that you plan to produce there, what proportion of your models will be covered by your own front axles once production ramps up? This is a 20,000-pound front axle, and it's primarily for heavier vehicle applications. We'll start initial production in the third quarter, and we'll see that ramp up over a 12-month period. At full production, it could be up to 20% of the axles that we put in our Class 8 vehicles. Okay, perfect. Thank you. Thank you. Your next question will come from the line of Seth Weber of RBC Capital Markets. Hi, good morning. Morning, Seth. I just wanted to ask about a couple of questions on the FinCo margin. It improved from the first quarter, 1Q to 2Q, but how long do you think it will take to get back to that mid to high 20% operating margin level? You talked about stabilizing used truck pricing. Do you expect the decks to be cleared here by the end of the year, or do you think that this bleeds out further? First question. Well, I think we are probably selling a few more trucks than we are taking in in the first half of this year. We will probably see that continue a little bit in the second half, and then things, in terms of volumes, will get balanced as we start next year in terms of what we are selling versus what is coming in. Okay. You think it is fair to expect that margins next year could be more, quote-unquote, normal relative to what we have seen over the last half a dozen years or so? Yeah, it really just depends. The key thing is the used truck valuations. Sure in the market, so we'll see how that moves. Part of the positive thing for Paccar Financial, particularly in the U.S., is that beginning next year, pretty much all the returns that will be coming off lease will be the 2.1-meter model truck, compared to the legacy 1.9 meter. So, that gives us some upside on the used truck valuations going forward as well. That's good color. Thank you for that. Then just maybe a follow-up on Europe. Is there any granularity you can help with Eastern Europe versus Western Europe? I think last quarter you talked about some strength in Russia or some of the Eastern European markets. Is there any update there that you could share? I would say the strength in Russia continues. We're seeing good orders, continuing to deliver, and so we'll. The rest of Eastern Europe is developing very similar to Western Europe for the first half of this year. Okay. Thank you very much, guys. Thank you. Your next question will come from the line of Nicole DeBlase of Deutsche Bank. Or good afternoon, I guess. Good morning and good afternoon. Yeah, I do not even know what time it is anymore. I guess, starting with price cost. I suspect that higher material costs were probably a headwind within the truck segment with respect to margins this quarter. Does that continue into the second half, or do material cost headwinds ease from here? Yeah. It was not much of a factor in the results for the quarter. There are some upward pressures, but we have long-term agreements, and those impacts tend to get spread over time and managed through, and that was not a significant impact. The key impact on margins for the quarter primarily was the currency impacts I referenced earlier. Okay, got it. That is helpful, Ron. Secondly, if it is possible to give us a little bit more color on the 3Q delivery guidance. The up to 3% Q1 Q, what is the order of magnitude for the growth in North America versus the decline in Europe that you guys are embedding? Let me see if I can. Europe would be down about 10% because of the summer shutdown period. Conversely, North America is probably up about 10%. Okay, got it. Thanks. I will pass it on. Sure. Your next question will come from the line of Andy Casey of Wells Fargo Securities. Good morning out there. Morning, Andy. Just wanting to go back to an earlier question, I think it was Jamie, about segments within the NAFTA market. Are you seeing any increase in interest from the long-haul truckload customers compared to earlier in the year, that may support an expectation that the normal increase order activity towards the end of the year would take place? Yeah. Our order intake has trended upward during the course of the year compared to, if you look back, the latter parts of last year, and we've continued to see on-highway truck orders build quarter on quarter. Oh, that's good to hear. Has vocational and energy remained strong for you folks? Oh, yeah, for sure. It's been a good order inflow in terms of the mix. Both of them have gone up and probably on-highway a little bit faster from an order standpoint than vocational. Okay. Thank you very much. Thank you. Your next question will come from the line of David Leiker of Robert W. Baird. Good morning. Good morning. A couple of numbers related questions here for you. When you look at the cash flow statement, there's a pretty big negative outflow on working capital, and it looks like receipts, and most of that, any additional color on that? I think the biggest item was floor plan financing. I'll let Michael talk about that. Yeah. Last year as our build rates were coming down, and our dealer inventories were going down, we had an inflow from flooring receivables. And this year as our build rates are coming up and our dealer inventories are going up, we're having an outflow with respect to that. So it's about a $400 million movement that you'll see moving that operating cash flow number. But as those trucks get delivered, it'll become realized cash as the year progresses. Right. The accounting rule make us put that up in operating, and the financing that we do for that is down in the investing section. Yep. Okay. Thanks. I figured there was a good answer for that. Then, just a follow-up question on currency. I want to see if we can dig a little bit deeper into it. With the strength in the euro here, well, we had a couple of years of really weak euro. From a transactional perspective, would guess that that's probably positive for Paccar. With the euro going back up, any way you can characterize how much of an impact a stronger euro might have on your gross profit dollars? We have a bit of a natural hedge with respect to the translation of our euro-based financial statements, and we have euro-sourced components in the U.S. that we get the benefit of. As the currency weakens, as it strengthens, we'll have more revenues and profits from DAF, but that'll be offset by some reduction then in the purchase cost for the components coming out of Europe. It's a nice natural hedge that doesn't fully offset, but it does offset. Yeah. At the line items, there's probably a little bit of a mismatch on gross profit versus SG&A. Yeah, there is. That's correct. Okay. Then just one last item on the vertical integration, producing axles for trucks here in North America. You are doing engines here in North America. The next logical step there would seem to be transmissions. Any thoughts on that? Yeah, we have great partners, both in Europe with ZF and Eaton here in North America. We work very closely with them to have integrated customized solutions for our powertrains, and so, we expect that to continue for the foreseeable future. Okay, great. Thank you. Thank you. Your next question will come from the line of Steven Volkmann of Jefferies. Hi, good morning, guys. Morning. Ron, I think in the past we've talked about once we hopefully get past kind of a mid-cycle replacement kind of level of activity, which seems to be kind of around where we are now in North America, that you have an opportunity, hopefully, for some pricing. Do you still view the market that way? Yeah, I think the market is good. We feel good about where it's at. Obviously, if you look back at 2015, 278,000 truck market compared to 215 or so this year. That supply-demand equation does provide some opportunities for pricing, and so that could be in the future. If next year were to be higher, not asking you to forecast that, but we might have a better pricing environment in that scenario. It could be. Yeah. Can I ask you to maybe put on your long-term prognostication, isn't that right, hat? You've opened your new center down in Silicon Valley and thinking a little bit about the future of truck transportation, et cetera. When you think about that, things like battery-powered trucks, maybe I know you may have a new competitor soon, automated trucking, platooning, et cetera, do you have a view on which of those technologies is likely to be sooner rather than later? Then sort of following on to that, do you feel like you want to do this kind of stuff internally to Paccar, or is this the kind of thing where you look for some partners, as you go forward, I'll let you answer that however you like. That is a multifaceted question, but a good question. As we think forward, we're talking with a lot of suppliers who are very interested in partnering with us for a variety of technology paths that we may take. I'd say we're currently in that assessment phase of evaluating the best path for our company. Part of opening this office is getting greater, more immediate access to the technologies and the technology development, so that we can be better informed and make better decisions. I think we'll start with this office in a relatively small way, but I think it will probably grow as time goes on. All those things will be parts of the areas of study that are done in this office. We'll stay very close to those developments and continue to formulate the specifics of our strategy as we go through the next year or two. Okay. Any of those technologies kind of more attractive to you, or maybe you're more skeptical about one or another of them or? I think the advanced driver assistance systems, those continue to progress. The camera technology, radar, lidar, all those technologies are developing pretty quickly. So I think there'll be the technology to support autonomy, but how quickly will it actually happen in reality? For the next decade, you're going to have a majority of non-autonomous trucks on the street. So it's going to be a transition, and I'd say a relatively gradual transition over time. So I think there will be progress in that area for sure. Batteries is, just the size, there has to be a breakthrough in battery technology for there to be an economically viable solution for heavy-duty trucks. So again, we'll be very close to those developments, and as they occur, we work with a lot of potential partners in that arena now, and we'll continue to stay close to that. Great. Thanks so much. Thank you. Just a reminder, ladies and gentlemen, if you would like to ask a question or if you have a comment, please press star followed by the number one on your telephone keypad. Your next question will come from the line of Steven Fisher of UBS. Thanks. Wonder if you could give us some color on how far out your backlog extends at this point, and how that lead time has developed over the course of the year. Just curious how much of your second half production schedule is booked at this point. We typically don't talk that extensively about backlog. I'll just tell you that they're very solid and in good shape. The backlog position has maintained sort of that strong position throughout the year, and we've been able to increase the build rates in all of our markets as a result of that. We feel good about the current build rate plans for the next quarter and hopefully progressing through the rest of the year. Are you taking a notable amount of orders for 2018, or is it too soon for that? No, I think we're starting to see some. I wouldn't call it a notable amount, but there are some orders in the backlog for 2018 currently. But I think the discussion level about 2018 with obviously many of our larger customers, those discussions are starting to occur. Okay, just a quick one on the MX-11. How has that been performing from a warranty perspective? Do you have enough volumes to note any trends? I know you mentioned that the currency was the big impact on the margins in the quarter. Did warranty have any notable impact on the margins this quarter? No notable impact. The MX-11 is doing very well. The MX-11 was launched in Europe the fourth quarter of 2013, and we launched it here the beginning of 2016, and the engine has performed very well in both markets. We're excited about the prospects for getting a greater penetration of that engine with our customers going forward. Okay. Thank you. Thank you. Your next question comes from the line of Barry Haimes of Sage Asset Management. Thanks very much. I wonder if you could talk a little bit about the medium-duty market and what you're seeing there just in terms of order rates, trends, et cetera. Thank you. This year, based on how we've produced medium-duty trucks for the first half and our planned build rates for the second half, this could be a record medium-duty production year for Paccar. I think part of that is continued relatively strong market conditions, probably 50,000-55,000 trucks in Europe in the 6-16 ton, and in the Class 6, 7 market, probably in the 80,000-90,000 truck range. The Peterbilt, Kenworth, and DAF products are very well received in the markets, and share positions are good. Like I said, this could be a record medium-duty production year for Paccar. Thanks very much. Thank you. Your next question will come from the line of Faheem Fahiba of Longbow Research. Faheem, your line is open. If you're on speakerphone, please pick up your handset. Oh, I'm sorry. Sorry if I missed this, but following the strong performance of your Paccar Parts business in the first half of the year, what is your outlook now for the full year 2017? For the full year, we expect the global parts sales to be up in the range of 5%-7% for the year. Okay. Thank you. Can you comment on used truck inventory levels in the industry? Are they still excessive? If fleets do plan to replace more trucks next year versus this year, can the market absorb these additional trucks entering the market? Our used truck position is, I guess I would characterize very normal. I would say in the industry, there probably still are excessive trucks from some of the competitor makes. We feel good about our ability to manage our inventory in the near and mid-term. Okay. Thank you. Thank you. There are no other questions in the queue at this time. Are there any additional remarks from the company? Yes, I'd like to thank everyone for their participation, and thank you, operator. Thank you. Ladies and gentlemen, this concludes Paccar's earnings call. Thank you for participating. You may now disconnect.